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An Overview of Corporate Finance and the Financial Environment

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In a beauty contest for companies, the winner is . . . General Electric. Or at least General Electric is the most admired company in America, according to Fortune magazine’s annual survey. The other top ten ﬁnalists are Cisco Systems, WalMart Stores, Southwest Airlines, Microsoft, Home Depot, Berkshire Hathaway, Charles Schwab, Intel, and Dell Computer. What do these companies have that separates them from the rest of the pack? According to more than 4,000 executives, directors, and security analysts, these companies have the highest average scores across eight attributes: (1) innovativeness, (2) quality of management, (3) employee talent, (4) quality of products and services, (5) long-term investment value, (6) ﬁnancial soundness, (7) social responsibility, and (8) use of corporate assets. These companies also have an incredible focus on using technology to reduce costs, to reduce inventory, and to speed up product delivery. For example, workers at Dell previously touched a computer 130 times during the assembly process but now touch it only 60 times. Using point-of-sale data, Wal-Mart is able to identify and meet surSee http://www.fortune. com for updates on the U.S. prising customer needs, such as bagels in Mexico, smoke detectors in Brazil, and house ranking. Fortune also ranks paint during the winter in Puerto Rico. Many of these companies are changing the way the Global Most Admired. business works by using the Net, and that change is occurring at a break-neck pace. For example, in 1999 GE’s plastics distribution business did less than $2,000 per day of business online. A year later the division did more than $2,000,000 per day in e-commerce. Many companies have a difﬁcult time attracting employees. Not so for the most admired companies, which average 26 applicants for each job opening. This is because, in addition to their acumen with technology and customers, they are also on the leading edge when it comes to training employees and providing a workplace in which people can thrive. In a nutshell, these companies reduce costs by having innovative production processes, they create value for customers by providing high-quality products and services, and they create value for employees through training and fostering an environment that allows employees to utilize all of their skills and talents. Do investors beneﬁt from this focus on processes, customers, and employees? During the most recent ﬁve-year period, these ten companies posted an average annual stock return of 41.4 percent, more than double the S&P 500’s average annual return of 18.3 percent. These exceptional returns are due to the ability of these companies to generate cash ﬂow. But, as you will see throughout this book, a company can generate cash ﬂow only if it also creates value for its customers, employees, and suppliers.

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An Overview of Corporate Finance and the Financial Environment 4

CHAPTER 1

An Overview of Corporate Finance and the Financial Environment

This chapter should give you an idea of what corporate ﬁnance is all about, including an overview of the ﬁnancial markets in which corporations operate. But before getting into the details of ﬁnance, it’s important to look at the big picture. You’re probably back in school because you want an interesting, challenging, and rewarding career. To see where ﬁnance ﬁts in, let’s start with a ﬁve-minute MBA.

The Five-Minute MBA Okay, we realize you can’t get an MBA in ﬁve minutes. But just as an artist quickly sketches the outline of a picture before ﬁlling in the details, we can sketch the key elements of an MBA education. In a nutshell, the objective of an MBA is to provide managers with the knowledge and skills they need to run successful companies, so we start our sketch with some common characteristics of successful companies. In particular, all successful companies are able to accomplish two goals.

Visit http://ehrhardt. swcollege.com to see the web site accompanying this text. This ever-evolving site, for students and instructors, is a tool for teaching, learning, ﬁnancial research, and job searches.

1. All successful companies identify, create, and deliver products or services that are highly valued by customers, so highly valued that customers choose to purchase them from the company rather than from its competitors. This happens only if the company provides more value than its competitors, either in the form of lower prices or better products. 2. All successful companies sell their products/services at prices that are high enough to cover costs and to compensate owners and creditors for their exposure to risk. In other words, it’s not enough just to win market share and to show a proﬁt. The proﬁt must be high enough to adequately compensate investors. It’s easy to talk about satisfying customers and investors, but it’s not so easy to accomplish these goals. If it were, then all companies would be successful and you wouldn’t need an MBA! Still, companies such as the ones on Fortune’s Most Admired list are able to satisfy customers and investors. These companies all share the following three key attributes.

The Key Attributes Required for Success First, successful companies have skilled people at all levels inside the company, including (1) leaders who develop and articulate sound strategic visions; (2) managers who make value-adding decisions, design efﬁcient business processes, and train and motivate work forces; and (3) a capable work force willing to implement the company’s strategies and tactics. Second, successful companies have strong relationships with groups that are outside the company. For example, successful companies develop win-win relationships with suppliers, who deliver high-quality materials on time and at a reasonable cost. A related trend is the rapid growth in relationships with third-party outsourcers, who provide high-quality services and products at a relatively low cost. This is particularly true in the areas of information technology and logistics. Successful companies also develop strong relationships with their customers, leading to repeat sales, higher proﬁt margins, and lower customer acquisition costs. Third, successful companies have sufﬁcient capital to execute their plans and support their operations. For example, most growing companies must purchase land, buildings, equipment, and materials. To make these purchases, companies can reinvest a portion of their earnings, but most must also raise additional funds externally, by some combination of selling stock or borrowing from banks and other creditors.

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An Overview of Corporate Finance and the Financial Environment How Are Companies Organized?

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Just as a stool needs all three legs to stand, a successful company must have all three attributes: skilled people, strong external relationships, and sufﬁcient capital.

The MBA, Finance, and Your Career Consult http://www. careers-in-ﬁnance.com for an excellent site containing information on a variety of business career areas, listings of current jobs, and other reference materials.

To be successful, a company must meet its ﬁrst goal—the identiﬁcation, creation, and delivery of highly valued products and services. This requires that it possess all three of the key attributes. Therefore, it’s not surprising that most of your MBA courses are directly related to these attributes. For example, courses in economics, communication, strategy, organizational behavior, and human resources should prepare you for a leadership role and enable you to effectively manage your company’s work force. Other courses, such as marketing, operations management, and information technology are designed to develop your knowledge of speciﬁc disciplines, enabling you to develop the efﬁcient business processes and strong external relationships your company needs. Portions of this corporate ﬁnance course will address raising the capital your company needs to implement its plans. In particular, the ﬁnance course will enable you to forecast your company’s funding requirements and then describe strategies for acquiring the necessary capital. In short, your MBA courses will give you the skills to help a company achieve its ﬁrst goal—producing goods and services that customers want. Recall, though, that it’s not enough just to have highly valued products and satisﬁed customers. Successful companies must also meet their second goal, which is to generate enough cash to compensate the investors who provided the necessary capital. To help your company accomplish this second goal, you must be able to evaluate any proposal, whether it relates to marketing, production, strategy, or any other area, and implement only the projects that add value for your investors. For this, you must have expertise in ﬁnance, no matter what your major is. Thus, corporate ﬁnance is a critical part of an MBA education and will help you throughout your career. What are the goals of successful companies? What are the three key attributes common to all successful companies? How does expertise in corporate ﬁnance help a company become successful?

How Are Companies Organized? There are three main forms of business organization: (1) sole proprietorships, (2) partnerships, and (3) corporations. In terms of numbers, about 80 percent of businesses are operated as sole proprietorships, while most of the remainder are divided equally between partnerships and corporations. Based on dollar value of sales, however, about 80 percent of all business is conducted by corporations, about 13 percent by sole proprietorships, and about 7 percent by partnerships and hybrids. Because most business is conducted by corporations, we will concentrate on them in this book. However, it is important to understand the differences among the various forms.

Sole Proprietorship A sole proprietorship is an unincorporated business owned by one individual. Going into business as a sole proprietor is easy—one merely begins business operations. However, even the smallest business normally must be licensed by a governmental unit.

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An Overview of Corporate Finance and the Financial Environment

The proprietorship has three important advantages: (1) It is easily and inexpensively formed, (2) it is subject to few government regulations, and (3) the business avoids corporate income taxes. The proprietorship also has three important limitations: (1) It is difﬁcult for a proprietorship to obtain large sums of capital; (2) the proprietor has unlimited personal liability for the business’s debts, which can result in losses that exceed the money he or she invested in the company; and (3) the life of a business organized as a proprietorship is limited to the life of the individual who created it. For these three reasons, sole proprietorships are used primarily for small-business operations. However, businesses are frequently started as proprietorships and then converted to corporations when their growth causes the disadvantages of being a proprietorship to outweigh the advantages.

Partnership A partnership exists whenever two or more persons associate to conduct a noncorporate business. Partnerships may operate under different degrees of formality, ranging from informal, oral understandings to formal agreements ﬁled with the secretary of the state in which the partnership was formed. The major advantage of a partnership is its low cost and ease of formation. The disadvantages are similar to those associated with proprietorships: (1) unlimited liability, (2) limited life of the organization, (3) difﬁculty transferring ownership, and (4) difﬁculty raising large amounts of capital. The tax treatment of a partnership is similar to that for proprietorships, but this is often an advantage, as we demonstrate in Chapter 9. Regarding liability, the partners can potentially lose all of their personal assets, even assets not invested in the business, because under partnership law, each partner is liable for the business’s debts. Therefore, if any partner is unable to meet his or her pro rata liability in the event the partnership goes bankrupt, the remaining partners must make good on the unsatisﬁed claims, drawing on their personal assets to the extent necessary. Today (2002), the partners of the national accounting ﬁrm Arthur Andersen, a huge partnership facing lawsuits ﬁled by investors who relied on faulty Enron audit statements, are learning all about the perils of doing business as a partnership. Thus, a Texas partner who audits a business that goes under can bring ruin to a millionaire New York partner who never went near the client company. The ﬁrst three disadvantages—unlimited liability, impermanence of the organization, and difﬁculty of transferring ownership—lead to the fourth, the difﬁculty partnerships have in attracting substantial amounts of capital. This is generally not a problem for a slow-growing business, but if a business’s products or services really catch on, and if it needs to raise large sums of money to capitalize on its opportunities, the difﬁculty in attracting capital becomes a real drawback. Thus, growth companies such as HewlettPackard and Microsoft generally begin life as a proprietorship or partnership, but at some point their founders ﬁnd it necessary to convert to a corporation.

Corporation A corporation is a legal entity created by a state, and it is separate and distinct from its owners and managers. This separateness gives the corporation three major advantages: (1) Unlimited life. A corporation can continue after its original owners and managers are deceased. (2) Easy transferability of ownership interest. Ownership interests can be divided into shares of stock, which, in turn, can be transferred far more easily than can proprietorship or partnership interests. (3) Limited liability. Losses are limited to the actual funds invested. To illustrate limited liability, suppose you invested $10,000 in a partnership that then went bankrupt owing $1 million. Because the owners are

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An Overview of Corporate Finance and the Financial Environment How Are Companies Organized?

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liable for the debts of a partnership, you could be assessed for a share of the company’s debt, and you could be held liable for the entire $1 million if your partners could not pay their shares. Thus, an investor in a partnership is exposed to unlimited liability. On the other hand, if you invested $10,000 in the stock of a corporation that then went bankrupt, your potential loss on the investment would be limited to your $10,000 investment.1 These three factors—unlimited life, easy transferability of ownership interest, and limited liability—make it much easier for corporations than for proprietorships or partnerships to raise money in the capital markets. The corporate form offers signiﬁcant advantages over proprietorships and partnerships, but it also has two disadvantages: (1) Corporate earnings may be subject to double taxation—the earnings of the corporation are taxed at the corporate level, and then any earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up a corporation, and ﬁling the many required state and federal reports, is more complex and time-consuming than for a proprietorship or a partnership. A proprietorship or a partnership can commence operations without much paperwork, but setting up a corporation requires that the incorporators prepare a charter and a set of bylaws. Although personal computer software that creates charters and bylaws is now available, a lawyer is required if the ﬂedgling corporation has any nonstandard features. The charter includes the following information: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and (5) names and addresses of directors. The charter is ﬁled with the secretary of the state in which the ﬁrm will be incorporated, and when it is approved, the corporation is ofﬁcially in existence.2 Then, after the corporation is in operation, quarterly and annual employment, ﬁnancial, and tax reports must be ﬁled with state and federal authorities. The bylaws are a set of rules drawn up by the founders of the corporation. Included are such points as (1) how directors are to be elected (all elected each year, or perhaps one-third each year for three-year terms); (2) whether the existing stockholders will have the ﬁrst right to buy any new shares the ﬁrm issues; and (3) procedures for changing the bylaws themselves, should conditions require it. The value of any business other than a very small one will probably be maximized if it is organized as a corporation for these three reasons: 1. Limited liability reduces the risks borne by investors, and, other things held constant, the lower the ﬁrm’s risk, the higher its value. 2. A ﬁrm’s value depends on its growth opportunities, which, in turn, depend on the ﬁrm’s ability to attract capital. Because corporations can attract capital more easily than unincorporated businesses, they are better able to take advantage of growth opportunities. 3. The value of an asset also depends on its liquidity, which means the ease of selling the asset and converting it to cash at a “fair market value.” Because the stock of a corporation is much more liquid than a similar investment in a proprietorship or partnership, this too enhances the value of a corporation. As we will see later in the chapter, most ﬁrms are managed with value maximization in mind, and this, in turn, has caused most large businesses to be organized as corporations. However, a very serious problem faces the corporation’s stockholders, who are its owners. What is to prevent managers from acting in their own best interests, rather

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In the case of small corporations, the limited liability feature is often a ﬁction, because bankers and other lenders frequently require personal guarantees from the stockholders of small, weak businesses. 2 Note that more than 60 percent of major U.S. corporations are chartered in Delaware, which has, over the years, provided a favorable legal environment for corporations. It is not necessary for a ﬁrm to be headquartered, or even to conduct operations, in its state of incorporation.

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An Overview of Corporate Finance and the Financial Environment

than in the best interests of the owners? This is called an agency problem, because managers are hired as agents to act on behalf of the owners. We will have much more to say about agency problems in Chapters 12 and 13.

Hybrid Forms of Organization Although the three basic types of organization—proprietorships, partnerships, and corporations—dominate the business scene, several hybrid forms are gaining popularity. For example, there are some specialized types of partnerships that have somewhat different characteristics than the “plain vanilla” kind. First, it is possible to limit the liabilities of some of the partners by establishing a limited partnership, wherein certain partners are designated general partners and others limited partners. In a limited partnership, the limited partners are liable only for the amount of their investment in the partnership, while the general partners have unlimited liability. However, the limited partners typically have no control, which rests solely with the general partners, and their returns are likewise limited. Limited partnerships are common in real estate, oil, and equipment leasing ventures. However, they are not widely used in general business situations because no one partner is usually willing to be the general partner and thus accept the majority of the business’s risk, while the would-be limited partners are unwilling to give up all control. The limited liability partnership (LLP), sometimes called a limited liability company (LLC), is a relatively new type of partnership that is now permitted in many states. In both regular and limited partnerships, at least one partner is liable for the debts of the partnership. However, in an LLP, all partners enjoy limited liability with regard to the business’s liabilities, so in that regard they are similar to shareholders in a corporation. In effect, the LLP combines the limited liability advantage of a corporation with the tax advantages of a partnership. Of course, those who do business with an LLP as opposed to a regular partnership are aware of the situation, which increases the risk faced by lenders, customers, and others who deal with the LLP. There are also several different types of corporations. One that is common among professionals such as doctors, lawyers, and accountants is the professional corporation (PC), or in some states, the professional association (PA). All 50 states have statutes that prescribe the requirements for such corporations, which provide most of the beneﬁts of incorporation but do not relieve the participants of professional (malpractice) liability. Indeed, the primary motivation behind the professional corporation was to provide a way for groups of professionals to incorporate and thus avoid certain types of unlimited liability, yet still be held responsible for professional liability. Finally, note that if certain requirements are met, particularly with regard to size and number of stockholders, one (or more) individuals can establish a corporation but elect to be taxed as if the business were a proprietorship or partnership. Such ﬁrms, which differ not in organizational form but only in how their owners are taxed, are called S corporations. Although S corporations are similar in many ways to limited liability partnerships, LLPs frequently offer more ﬂexibility and beneﬁts to their owners, and this is causing many S corporation businesses to convert to the LLP organizational form. What are the key differences between sole proprietorships, partnerships, and corporations? Explain why the value of any business other than a very small one will probably be maximized if it is organized as a corporation. Identify the hybrid forms of organization discussed in the text, and explain the differences among them.

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An Overview of Corporate Finance and the Financial Environment The Primary Objective of the Corporation

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The Primary Objective of the Corporation Shareholders are the owners of a corporation, and they purchase stocks because they want to earn a good return on their investment without undue risk exposure. In most cases, shareholders elect directors, who then hire managers to run the corporation on a day-to-day basis. Because managers are supposed to be working on behalf of shareholders, it follows that they should pursue policies that enhance shareholder value. Consequently, throughout this book we operate on the assumption that management’s primary objective is stockholder wealth maximization, which translates into maximizing the price of the ﬁrm’s common stock. Firms do, of course, have other objectives— in particular, the managers who make the actual decisions are interested in their own personal satisfaction, in their employees’ welfare, and in the good of the community and of society at large. Still, for the reasons set forth in the following sections, stock price maximization is the most important objective for most corporations.

Stock Price Maximization and Social Welfare If a ﬁrm attempts to maximize its stock price, is this good or bad for society? In general, it is good. Aside from such illegal actions as attempting to form monopolies, violating safety codes, and failing to meet pollution requirements, the same actions that maximize stock prices also beneﬁt society. Here are some of the reasons: 1. To a large extent, the owners of stock are society. Seventy-ﬁve years ago this was not true, because most stock ownership was concentrated in the hands of a relatively small segment of society, comprised of the wealthiest individuals. Since then, there has been explosive growth in pension funds, life insurance companies, The Security Industry Association’s web site, http:// and mutual funds. These institutions now own more than 57 percent of all stock. In www.sia.com, is a great addition, more than 48 percent of all U.S. households now own stock directly, as source of information. To compared with only 32.5 percent in 1989. Moreover, most people with a retireﬁnd data on stock ownerment plan have an indirect ownership interest in stocks. Thus, most members of ship, go to their web page, society now have an important stake in the stock market, either directly or indiclick on Reference Materials, click on Securities Industry rectly. Therefore, when a manager takes actions to maximize the stock price, this Fact Book, and look at the improves the quality of life for millions of ordinary citizens. section on Investor Partici2. Consumers beneﬁt. Stock price maximization requires efﬁcient, low-cost busipation. nesses that produce high-quality goods and services at the lowest possible cost. This means that companies must develop products and services that consumers want and need, which leads to new technology and new products. Also, companies that maximize their stock price must generate growth in sales by creating value for customers in the form of efﬁcient and courteous service, adequate stocks of merchandise, and well-located business establishments. People sometimes argue that ﬁrms, in their efforts to raise proﬁts and stock prices, increase product prices and gouge the public. In a reasonably competitive economy, which we have, prices are constrained by competition and consumer resistance. If a ﬁrm raises its prices beyond reasonable levels, it will simply lose its market share. Even giant ﬁrms such as General Motors lose business to Japanese and German ﬁrms, as well as to Ford and Chrysler, if they set prices above the level necessary to cover production costs plus a “normal” proﬁt. Of course, ﬁrms want to earn more, and they constantly try to cut costs, develop new products, and so on, and thereby earn above-normal proﬁts. Note, though, that if they are indeed successful and do earn above-normal proﬁts, those very proﬁts will attract competition, which will eventually drive prices down, so again, the main long-term beneﬁciary is the consumer.

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3. Employees beneﬁt. There are cases in which a stock increases when a company announces a plan to lay off employees, but viewed over time this is the exception rather than the rule. In general, companies that successfully increase stock prices also grow and add more employees, thus beneﬁting society. Note too that many governments across the world, including U.S. federal and state governments, are privatizing some of their state-owned activities by selling these operations to investors. Perhaps not surprisingly, the sales and cash ﬂows of recently privatized companies generally improve. Moreover, studies show that these newly privatized companies tend to grow and thus require more employees when they are managed with the goal of stock price maximization. Each year Fortune magazine conducts a survey of managers, analysts, and other knowledgeable people to determine the most admired companies. One of Fortune’s key criteria is a company’s ability to attract, develop, and retain talented people. The results consistently show that there are high correlations among a company’s being admired, its ability to satisfy employees, and its creation of value for shareholders. Employees ﬁnd that it is both fun and ﬁnancially rewarding to work for successful companies. So, successful companies get the cream of the employee crop, and skilled, motivated employees are one of the keys to corporate success.

Managerial Actions to Maximize Shareholder Wealth What types of actions can managers take to maximize a ﬁrm’s stock price? To answer this question, we ﬁrst need to ask, “What determines stock prices?” In a nutshell, it is a company’s ability to generate cash ﬂows now and in the future. While we will address this issue in detail in Chapter 12, we can lay out three basic facts here: (1) Any ﬁnancial asset, including a company’s stock, is valuable only to the extent that it generates cash ﬂows; (2) the timing of cash ﬂows matters—cash received sooner is better, because it can be reinvested in the company to produce additional income or else be returned to investors; and (3) investors generally are averse to risk, so all else equal, they will pay more for a stock whose cash ﬂows are relatively certain than for one whose cash ﬂows are more risky. Because of these three facts, managers can enhance their ﬁrms’ stock prices by increasing the size of the expected cash ﬂows, by speeding up their receipt, and by reducing their risk. The three primary determinants of cash ﬂows are (1) unit sales, (2) after-tax operating margins, and (3) capital requirements. The ﬁrst factor has two parts, the current level of sales and their expected future growth rate. Managers can increase sales, hence cash ﬂows, by truly understanding their customers and then providing the goods and services that customers want. Some companies may luck into a situation that creates rapid sales growth, but the unfortunate reality is that market saturation and competition will, in the long term, cause their sales growth rate to decline to a level that is limited by population growth and inﬂation. Therefore, managers must constantly strive to create new products, services, and brand identities that cannot be easily replicated by competitors, and thus to extend the period of high growth for as long as possible. The second determinant of cash ﬂows is the amount of after-tax proﬁt that the company can keep after it has paid its employees and suppliers. One possible way to increase operating proﬁt is to charge higher prices. However, in a competitive economy such as ours, higher prices can be charged only for products that meet the needs of customers better than competitors’ products. Another way to increase operating proﬁt is to reduce direct expenses such as labor and materials. However, and paradoxically, sometimes companies can create even

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An Overview of Corporate Finance and the Financial Environment The Primary Objective of the Corporation

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higher proﬁt by spending more on labor and materials. For example, choosing the lowest-cost supplier might result in using poor materials that lead to costly production problems. Therefore, managers should understand supply chain management, which often means developing long-term relationships with suppliers. Similarly, increased employee training adds to costs, but it often pays off through increased productivity and lower turnover. Therefore, the human resources staff can have a huge impact on operating proﬁts. The third factor affecting cash ﬂows is the amount of money a company must invest in plant and equipment. In short, it takes cash to create cash. For example, as a part of their normal operations, most companies must invest in inventory, machines, buildings, and so forth. But each dollar tied up in operating assets is a dollar that the company must “rent” from investors and pay for by paying interest or dividends. Therefore, reducing asset requirements tends to increase cash ﬂows, which increases the stock price. For example, companies that successfully implement just-in-time inventory systems generally increase their cash ﬂows, because they have less cash tied up in inventory. As these examples indicate, there are many ways to improve cash ﬂows. All of them require the active participation of many departments, including marketing, engineering, and logistics. One of the ﬁnancial manager’s roles is to show others how their actions will affect the company’s ability to generate cash ﬂow. Financial managers also must decide how to ﬁnance the ﬁrm: What mix of debt and equity should be used, and what speciﬁc types of debt and equity securities should be issued? Also, what percentage of current earnings should be retained and reinvested rather than paid out as dividends? Each of these investment and ﬁnancing decisions is likely to affect the level, timing, and risk of the ﬁrm’s cash ﬂows, and, therefore, the price of its stock. Naturally, managers should make investment and ﬁnancing decisions that are designed to maximize the ﬁrm’s stock price. Although managerial actions affect stock prices, stocks are also inﬂuenced by such external factors as legal constraints, the general level of economic activity, tax laws, interest rates, and conditions in the stock market. See Figure 1-1. Working within the set of external constraints shown in the box at the extreme left, management makes a set of

FIGURE 1-1

External Constraints: 1. Antitrust Laws 2. Environmental Regulations 3. Product and Workplace Safety Regulations 4. Employment Practices Rules 5. Federal Reserve Policy 6. International Rules

Summary of Major Factors Affecting Stock Prices

Strategic Policy Decisions Controlled by Management: 1. Types of Products or Services Produced 2. Production Methods Used 3. Research and Development Efforts 4. Relative Use of Debt Financing 5. Dividend Policy

Level of Economic Activity and Corporate Taxes

Conditions in the Financial Markets

Expected Cash Flows Timing of Cash Flows Perceived Risk of Cash Flows

Stock Price

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long-run strategic policy decisions that chart a future course for the ﬁrm. These policy decisions, along with the general level of economic activity and the level of corporate income taxes, inﬂuence expected cash ﬂows, their timing, and their perceived risk. These factors all affect the price of the stock, but so does the overall condition of the ﬁnancial markets. What is management’s primary objective? How does stock price maximization beneﬁt society? What three basic factors determine the price of a stock? What three factors determine cash ﬂows?

The Financial Markets Businesses, individuals, and governments often need to raise capital. For example, suppose Carolina Power & Light (CP&L) forecasts an increase in the demand for electricity in North Carolina, and the company decides to build a new power plant. Because CP&L almost certainly will not have the $1 billion or so necessary to pay for the plant, the company will have to raise this capital in the ﬁnancial markets. Or suppose Mr. Fong, the proprietor of a San Francisco hardware store, decides to expand into appliances. Where will he get the money to buy the initial inventory of TV sets, washers, and freezers? Similarly, if the Johnson family wants to buy a home that costs $100,000, but they have only $20,000 in savings, how can they raise the additional $80,000? If the city of New York wants to borrow $200 million to ﬁnance a new sewer plant, or the federal government needs money to meet its needs, they too need access to the capital markets. On the other hand, some individuals and ﬁrms have incomes that are greater than their current expenditures, so they have funds available to invest. For example, Carol Hawk has an income of $36,000, but her expenses are only $30,000, leaving $6,000 to invest. Similarly, Ford Motor Company has accumulated roughly $16 billion of cash and marketable securities, which it has available for future investments.

Types of Markets People and organizations who want to borrow money are brought together with those with surplus funds in the ﬁnancial markets. Note that “markets” is plural—there are a great many different ﬁnancial markets in a developed economy such as ours. Each market deals with a somewhat different type of instrument in terms of the instrument’s maturity and the assets backing it. Also, different markets serve different types of customers, or operate in different parts of the country. Here are some of the major types of markets: 1. Physical asset markets (also called “tangible” or “real” asset markets) are those for such products as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, and other ﬁnancial instruments. All of these instruments are simply pieces of paper with contractual provisions that entitle their owners to speciﬁc rights and claims on real assets. For example, a corporate bond issued by IBM entitles its owner to a speciﬁc claim on the cash ﬂows produced by IBM’s physical assets, while a share of IBM stock entitles its owner to a different set of claims on IBM’s cash ﬂows. Unlike these conventional ﬁnancial instruments, the contractual provisions of derivatives

11

An Overview of Corporate Finance and the Financial Environment The Financial Markets

2.

3.

4.

5.

6.

7.

8.

9.

13

are not direct claims on either real assets or their cash ﬂows. Instead, derivatives are claims whose values depend on what happens to the value of some other asset. Futures and options are two important types of derivatives, and their values depend on what happens to the prices of other assets, say, IBM stock, Japanese yen, or pork bellies. Therefore, the value of a derivative is derived from the value of an underlying real or ﬁnancial asset. Spot markets and futures markets are terms that refer to whether the assets are being bought or sold for “on-the-spot” delivery (literally, within a few days) or for delivery at some future date, such as six months or a year into the future. Money markets are the markets for short-term, highly liquid debt securities. The New York and London money markets have long been the world’s largest, but Tokyo is rising rapidly. Capital markets are the markets for intermediate- or longterm debt and corporate stocks. The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a prime example of a capital market. There is no hard and fast rule on this, but when describing debt markets, “short term” generally means less than one year, “intermediate term” means one to ﬁve years, and “long term” means more than ﬁve years. Mortgage markets deal with loans on residential, commercial, and industrial real estate, and on farmland, while consumer credit markets involve loans on autos and appliances, as well as loans for education, vacations, and so on. World, national, regional, and local markets also exist. Thus, depending on an organization’s size and scope of operations, it may be able to borrow all around the world, or it may be conﬁned to a strictly local, even neighborhood, market. Primary markets are the markets in which corporations raise new capital. If Microsoft were to sell a new issue of common stock to raise capital, this would be a primary market transaction. The corporation selling the newly created stock receives the proceeds from the sale in a primary market transaction. The initial public offering (IPO) market is a subset of the primary market. Here ﬁrms “go public” by offering shares to the public for the ﬁrst time. Microsoft had its IPO in 1986. Previously, Bill Gates and other insiders owned all the shares. In many IPOs, the insiders sell some of their shares plus the company sells newly created shares to raise additional capital. Secondary markets are markets in which existing, already outstanding, securities are traded among investors. Thus, if Jane Doe decided to buy 1,000 shares of AT&T stock, the purchase would occur in the secondary market. The New York Stock Exchange is a secondary market, since it deals in outstanding, as opposed to newly issued, stocks. Secondary markets also exist for bonds, mortgages, and other ﬁnancial assets. The corporation whose securities are being traded is not involved in a secondary market transaction and, thus, does not receive any funds from such a sale. Private markets, where transactions are worked out directly between two parties, are differentiated from public markets, where standardized contracts are traded on organized exchanges. Bank loans and private placements of debt with insurance companies are examples of private market transactions. Since these transactions are private, they may be structured in any manner that appeals to the two parties. By contrast, securities that are issued in public markets (for example, common stock and corporate bonds) are ultimately held by a large number of individuals. Public securities must have fairly standardized contractual features, both to appeal to a broad range of investors and also because public investors cannot afford the time to study unique, nonstandardized contracts. Their diverse ownership also ensures that public securities are relatively liquid. Private market securities are, therefore,

12

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more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater standardization.

You can access current and historical interest rates and economic data as well as regional economic data for the states of Arkansas, Illinois, Indiana, Kentucky, Mississippi, Missouri, and Tennessee from the Federal Reserve Economic Data (FRED) site at http:// www.stls.frb.org/fred/.

Other classiﬁcations could be made, but this breakdown is sufﬁcient to show that there are many types of ﬁnancial markets. Also, note that the distinctions among markets are often blurred and unimportant, except as a general point of reference. For example, it makes little difference if a ﬁrm borrows for 11, 12, or 13 months, hence, whether we have a “money” or “capital” market transaction. You should recognize the big differences among types of markets, but don’t get hung up trying to distinguish them at the boundaries. A healthy economy is dependent on efﬁcient transfers of funds from people who are net savers to ﬁrms and individuals who need capital. Without efﬁcient transfers, the economy simply could not function: Carolina Power & Light could not raise capital, so Raleigh’s citizens would have no electricity; the Johnson family would not have adequate housing; Carol Hawk would have no place to invest her savings; and so on. Obviously, the level of employment and productivity, hence our standard of living, would be much lower. Therefore, it is absolutely essential that our ﬁnancial markets function efﬁciently—not only quickly, but also at a low cost. Table 1-1 gives a listing of the most important instruments traded in the various ﬁnancial markets. The instruments are arranged from top to bottom in ascending order of typical length of maturity. As we go through the book, we will look in much more detail at many of the instruments listed in Table 1-1. For example, we will see that there are many varieties of corporate bonds, ranging from “plain vanilla” bonds to bonds that are convertible into common stocks to bonds whose interest payments vary depending on the inﬂation rate. Still, the table gives an idea of the characteristics and costs of the instruments traded in the major ﬁnancial markets.

Recent Trends Financial markets have experienced many changes during the last two decades. Technological advances in computers and telecommunications, along with the globalization of banking and commerce, have led to deregulation, and this has increased competition throughout the world. The result is a much more efﬁcient, internationally linked market, but one that is far more complex than existed a few years ago. While these developments have been largely positive, they have also created problems for policy makers. At a recent conference, Federal Reserve Board Chairman Alan Greenspan stated that modern ﬁnancial markets “expose national economies to shocks from new and unexpected sources, and with little if any lag.” He went on to say that central banks must develop new ways to evaluate and limit risks to the ﬁnancial system. Large amounts of capital move quickly around the world in response to changes in interest and exchange rates, and these movements can disrupt local institutions and economies. With globalization has come the need for greater cooperation among regulators at the international level. Various committees are currently working to improve coordination, but the task is not easy. Factors that complicate coordination include (1) the differing structures among nations’ banking and securities industries, (2) the trend in Europe toward ﬁnancial service conglomerates, and (3) a reluctance on the part of individual countries to give up control over their national monetary policies. Still, regulators are unanimous about the need to close the gaps in the supervision of worldwide markets. Another important trend in recent years has been the increased use of derivatives. The market for derivatives has grown faster than any other market in recent years, providing corporations with new opportunities but also exposing them to new risks.

13

An Overview of Corporate Finance and the Financial Environment The Financial Markets TABLE 1-1

15

Summary of Major Financial Instruments

Instrument

Major Participants

Risk

Original Maturity

U.S. Treasury bills Banker’s acceptances Commercial paper Negotiable certiﬁcates of deposit (CDs) Money market mutual funds

Sold by U.S. Treasury

Default-free

91 days to 1 year

2.3%

A ﬁrm’s promise to pay, guaranteed by a bank Issued by ﬁnancially secure ﬁrms to large investors Issued by major banks to large investors

Low if strong bank guarantees Low default risk

Up to 180 days

2.6

Up to 270 days

2.4

Depends on strength of issuer

Up to 1 year

2.5

Invest in short-term debt; held by individuals and businesses Issued by banks outside U.S.

Low degree of risk

No speciﬁc maturity (instant liquidity) Up to 1 year

3.2

Eurodollar market time deposits Consumer credit loans Commercial loans U.S. Treasury notes and bonds Mortgages Municipal bonds

Corporate bonds

Leases

Preferred stocks Common stocksc

Loans by banks/credit unions/ﬁnance companies Loans by banks to corporations Issued by U.S. government

Loans secured by property Issued by state and local governments to individuals and institutions Issued by corporations to individuals and institutions Similar to debt; ﬁrms lease assets rather than borrow and then buy them Issued by corporations to individuals and institutions Issued by corporations to individuals and institutions

Depends on strength of issuer Risk is variable

Variable

Depends on borrower

Up to 7 years

No default risk, but price falls if interest rates rise Risk is variable Riskier than U.S. government bonds, but exempt from most taxes Riskier than U.S. government debt; depends on strength of issuer Risk similar to corporate bonds

2 to 30 years

Riskier than corporate bonds Riskier than preferred stocks

Interest Rates on 9/27/01a

2.5 Variable Tied to prime rate (6.0%) or LIBOR (2.6%)d 5.5

Up to 30 years Up to 30 years

6.8 5.1

Up to 40 yearsb

7.2

Generally 3 to 20 years

Similar to bond yields

Unlimited

7 to 9%

Unlimited

10 to 15%

a Data are from The Wall Street Journal (http://interactive.wsj.com/documents/rates.htm) or the Federal Reserve Statistical Release, http://www.federal reserve.gov/releases/H15/update. Money market rates assume a 3-month maturity. The corporate bond rate is for AAA-rated bonds. b Just recently, a few corporations have issued 100-year bonds; however, the majority have issued bonds with maturities less than 40 years. c Common stocks are expected to provide a “return” in the form of dividends and capital gains rather than interest. Of course, if you buy a stock, your actual return may be considerably higher or lower than your expected return. For example, Nasdaq stocks on average provided a return of about ⫺39 percent in 2000, but that was well below the return most investors expected. d The prime rate is the rate U.S. banks charge to good customers. LIBOR (London Interbank Offered Rate) is the rate that U.K. banks charge one another.

Derivatives can be used either to reduce risks or to speculate. As an example of a riskreducing usage, suppose an importer’s net income tends to fall whenever the dollar falls relative to the yen. That company could reduce its risk by purchasing derivatives that increase in value whenever the dollar declines. This would be called a hedging operation, and its purpose is to reduce risk exposure. Speculation, on the other hand, is done in the hope of high returns, but it raises risk exposure. For example, Procter &

14

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Gamble lost $150 million on derivative investments, and Orange County (California) went bankrupt as a result of its treasurer’s speculation in derivatives. The size and complexity of derivatives transactions concern regulators, academics, and members of Congress. Fed Chairman Greenspan noted that, in theory, derivatives should allow companies to manage risk better, but that it is not clear whether recent innovations have “increased or decreased the inherent stability of the ﬁnancial system.” Another major trend involves stock ownership patterns. The number of individuals who have a stake in the stock market is increasing, but the percentage of corporate shares owned by individuals is decreasing. How can both of these two statements be true? The answer has to do with institutional versus individual ownership of shares. Although more than 48 percent of all U.S. households now have investments in the stock market, more than 57 percent of all stock is now owned by pension funds, mutual funds, and life insurance companies. Thus, more and more individuals are investing in the market, but they are doing so indirectly, through retirement plans and mutual funds. In any event, the performance of the stock market now has a greater effect on the U.S. population than ever before. Also, the direct ownership of stocks is being concentrated in institutions, with professional portfolio managers making the investment decisions and controlling the votes. Note too that if a fund holds a high percentage of a given corporation’s shares, it would probably depress the stock’s price if it tried to sell out. Thus, to some extent, the larger institutions are “locked into” many of the shares they own. This has led to a phenomenon called relationship investing, where portfolio managers think of themselves as having an active, long-term relationship with their portfolio companies. Rather than being passive investors who “vote with their feet,” they are taking a much more active role in trying to force managers to behave in a manner that is in the best interests of shareholders. Distinguish between: (1) physical asset markets and ﬁnancial asset markets; (2) spot and futures markets; (3) money and capital markets; (4) primary and secondary markets; and (5) private and public markets. What are derivatives, and how is their value related to that of an “underlying asset”? What is relationship investing?

Financial Institutions Transfers of capital between savers and those who need capital take place in the three different ways diagrammed in Figure 1-2: 1. Direct transfers of money and securities, as shown in the top section, occur when a business sells its stocks or bonds directly to savers, without going through any type of ﬁnancial institution. The business delivers its securities to savers, who in turn give the ﬁrm the money it needs. 2. As shown in the middle section, transfers may also go through an investment banking house such as Merrill Lynch, which underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. The businesses’ securities and the savers’ money merely “pass through” the investment banking house. However, the investment bank does buy and hold the

15

An Overview of Corporate Finance and the Financial Environment Financial Institutions

17

securities for a period of time, so it is taking a risk—it may not be able to resell them to savers for as much as it paid. Because new securities are involved and the corporation receives the proceeds of the sale, this is a primary market transaction. 3. Transfers can also be made through a ﬁnancial intermediary such as a bank or mutual fund. Here the intermediary obtains funds from savers in exchange for its own securities. The intermediary then uses this money to purchase and then hold businesses’ securities. For example, a saver might give dollars to a bank, receiving from it a certiﬁcate of deposit, and then the bank might lend the money to a small business in the form of a mortgage loan. Thus, intermediaries literally create new forms of capital—in this case, certiﬁcates of deposit, which are both safer and more liquid than mortgages and thus are better securities for most savers to hold. The existence of intermediaries greatly increases the efﬁciency of money and capital markets. In our example, we assume that the entity needing capital is a business, and speciﬁcally a corporation, but it is easy to visualize the demander of capital as a home purchaser, a government unit, and so on. Direct transfers of funds from savers to businesses are possible and do occur on occasion, but it is generally more efﬁcient for a business to enlist the services of an investment banking house such as Merrill Lynch, Salomon Smith Barney, Morgan Stanley, or Goldman Sachs. Such organizations (1) help corporations design securities with features that are currently attractive to investors, (2) then buy these securities from the corporation, and (3) resell them to savers. Although the securities are sold twice, this process is really one primary market transaction, with the investment banker acting as a facilitator to help transfer capital from savers to businesses. The ﬁnancial intermediaries shown in the third section of Figure 1-2 do more than simply transfer money and securities between ﬁrms and savers—they literally create new ﬁnancial products. Since the intermediaries are generally large, they gain economies of scale in analyzing the creditworthiness of potential borrowers, in

FIGURE 1-2

Diagram of the Capital Formation Process

1. Direct Transfers Securities (Stocks or Bonds) Business

2. Indirect Transfers through Investment Bankers Securities

Securities

Investment Banking Houses

Business Dollars

Dollars

Savers Dollars

3. Indirect Transfers through a Financial Intermediary Business’s Securities Business

Savers

Dollars

Financial Intermediary

Intermediary’s Securities Dollars

Savers

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processing and collecting loans, and in pooling risks and thus helping individual savers diversify, that is, “not putting all their ﬁnancial eggs in one basket.” Further, a system of specialized intermediaries can enable savings to do more than just draw interest. For example, individuals can put money into banks and get both interest income and a convenient way of making payments (checking), or put money into life insurance companies and get both interest income and protection for their beneﬁciaries. In the United States and other developed nations, a set of specialized, highly efﬁcient ﬁnancial intermediaries has evolved. The situation is changing rapidly, however, and different types of institutions are performing services that were formerly reserved for others, causing institutional distinctions to become blurred. Still, there is a degree of institutional identity, and here are the major classes of intermediaries: 1. Commercial banks, the traditional “department stores of ﬁnance,” serve a wide variety of savers and borrowers. Historically, commercial banks were the major institutions that handled checking accounts and through which the Federal Reserve System expanded or contracted the money supply. Today, however, several other institutions also provide checking services and signiﬁcantly inﬂuence the money supply. Conversely, commercial banks are providing an ever-widening range of services, including stock brokerage services and insurance. Note that commercial banks are quite different from investment banks. Commercial banks lend money, whereas investment banks help companies raise capital from other parties. Prior to 1933, commercial banks offered investment banking services, but the Glass-Steagall Act, which was passed in 1933, prohibited commercial banks from engaging in investment banking. Thus, the Morgan Bank was broken up into two separate organizations, one of which became the Morgan Guaranty Trust Company, a commercial bank, while the other became Morgan Stanley, a major investment banking house. Note also that Japanese and European banks can offer both commercial and investment banking services. This hindered U.S. banks in global competition, so in 1999 Congress basically repealed the GlassSteagall Act. Then, U.S. commercial and investment banks began merging with one another, creating such giants as Citigroup and J.P. Morgan Chase. 2. Savings and loan associations (S&Ls), which have traditionally served individual savers and residential and commercial mortgage borrowers, take the funds of many small savers and then lend this money to home buyers and other types of borrowers. Because the savers obtain a degree of liquidity that would be absent if they made the mortgage loans directly, perhaps the most signiﬁcant economic function of the S&Ls is to “create liquidity” which would otherwise be lacking. Also, the S&Ls have more expertise in analyzing credit, setting up loans, and making collections than individual savers, so S&Ls can reduce the costs of processing loans, thereby increasing the availability of real estate loans. Finally, the S&Ls hold large, diversiﬁed portfolios of loans and other assets and thus spread risks in a manner that would be impossible if small savers were making mortgage loans directly. Because of these factors, savers beneﬁt by being able to invest in more liquid, better managed, and less risky assets, whereas borrowers beneﬁt by being able to obtain more capital, and at a lower cost, than would otherwise be possible. In the 1980s, the S&L industry experienced severe problems when (1) shortterm interest rates paid on savings accounts rose well above the returns being earned on the existing mortgages held by S&Ls and (2) commercial real estate suffered a severe slump, resulting in high mortgage default rates. Together, these events forced many S&Ls to either merge with stronger institutions or close their doors.

17

An Overview of Corporate Finance and the Financial Environment Financial Institutions

19

3. Mutual savings banks, which are similar to S&Ls, operate primarily in the northeastern states, accept savings primarily from individuals, and lend mainly on a long-term basis to home buyers and consumers. 4. Credit unions are cooperative associations whose members are supposed to have a common bond, such as being employees of the same ﬁrm. Members’ savings are loaned only to other members, generally for auto purchases, home improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to individual borrowers. 5. Life insurance companies take savings in the form of premiums; invest these funds in stocks, bonds, real estate, and mortgages; and ﬁnally make payments to the beneﬁciaries of the insured parties. In recent years, life insurance companies have also offered a variety of tax-deferred savings plans designed to provide beneﬁts to the participants when they retire. 6. Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units. These organizations pool funds and thus reduce risks by diversiﬁcation. They also achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities. Different funds are designed to meet the objectives of different types of savers. Hence, there are bond funds for those who desire safety, stock funds for savers who are willing to accept signiﬁcant risks in the hope of higher returns, and still other funds that are used as interest-bearing checking accounts (the money market funds). There are literally thousands of different mutual funds with dozens of different goals and purposes. 7. Pension funds are retirement plans funded by corporations or government agencies for their workers and administered generally by the trust departments of commercial banks or by life insurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and real estate. Changes in the structure of pension plans over the last decade have had a profound effect on both individuals and ﬁnancial markets. Historically, most large corporations and governmental units used deﬁned beneﬁt plans to provide for their employees’ retirement. In a deﬁned beneﬁt plan, the employer guarantees the level of beneﬁts the employee will receive when he or she retires, and it is the employer’s responsibility to invest funds to ensure that it can meet its obligations when its employees retire. Under a deﬁned beneﬁt plan, employees have little or no say about how the money in the pension plan is invested—this decision is made by the corporate employer. Note that employers, not employees, bear the risk that investments held by a deﬁned beneﬁt plan will not perform well. In recent years many companies (including virtually all new companies, especially those in the rapidly growing high-tech sector) have begun to use deﬁned contribution plans, under which employers make speciﬁed, or deﬁned, payments into the plan. Then, when the employee retires, his or her pension beneﬁts are determined by the amount of assets in the plan. Therefore, in a deﬁned contribution plan the employee has the responsibility for making investment decisions and bears the risks inherent in investments. The most common type of deﬁned contribution plan is the 401(k) plan, named after the section in the federal act that established the legal basis for the plan. Governmental units, including universities, can use 403(b) plans, which operate essentially like 401(k) plans. In all of these plans, employees must choose from a set of investment alternatives. Typically, the employer agrees to make some “deﬁned contribution” to the plan, and the employee can also make a supplemental payment. Then, the employer contracts with an insurance company plus one or more mutual fund companies, and then employees choose among investments

18

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Mutual Fund Mania

Americans love mutual funds. Just over ten years ago, Americans had invested about $810 billion in mutual funds, which is not exactly chicken feed. Today, however, they have more than $5 trillion in mutual funds! Not only has the amount of money invested in mutual funds skyrocketed, but the variety of funds is astounding. Thirty years ago there were just a few types of mutual funds. You could buy a growth fund (composed of stocks that paid low dividends but that had been growing rapidly), income funds (primarily composed of stocks that paid high dividends), or a bond fund. Now you can buy funds that specialize in virtually any type of asset. There are funds that own stocks only from a particular industry, a particular continent, or a particular country, and money market funds that invest only in Treasury bills and other short-term securities. There are funds that have municipal bonds from only one state. You can buy socially conscious funds that refuse to own stocks of companies that pollute, sell tobacco products, or have work forces that are not culturally diverse. You can buy

“market neutral funds,” which sell some stocks short, invest in other stocks, and promise to do well no matter which way the market goes. There is the Undiscovered Managers Behavioral fund that picks stocks by psychoanalyzing Wall Street analysts. And then there is the Tombstone fund that owns stocks only from the funeral industry. How many funds are there? One urban myth is that there are more funds than stocks. But that includes bond funds, money market funds, and funds that invest in non-U.S. stocks. It also includes “ﬂavors” of the same fund. For example, some funds allow you to buy different “share classes” of a single fund, with each share class having different fee structures. So even though there are at least 10,000 different funds of all types, there are only about 2,000 U.S. equity mutual funds. Still, that’s a lot of funds, since there are only about 8,000 regularly traded U.S. stocks. Sources: “The Many New Faces of Mutual Funds,” Fortune, July 6, 1998, 217–218; “Street Myths,” Fortune, May 24, 1999, 320.

ranging from “guaranteed investment contracts” to government bond funds to domestic corporate bond and stock funds to international stock and bond funds. Under most plans, the employees can, within certain limits, shift their investments from category to category. Thus, if someone thinks the stock market is currently overvalued, he or she can tell the mutual fund to move the money from a stock fund to a money market fund. Similarly, employees may choose to gradually shift from 100 percent stock to a mix of stocks and bonds as they grow older. These changes in the structure of pension plans have had two extremely important effects. First, individuals must now make the primary investment decisions for their pension plans. Because such decisions can mean the difference between a comfortable retirement and living on the street, it is important that people covered by deﬁned contribution plans understand the fundamentals of investing. Second, whereas deﬁned beneﬁt plan managers typically invest in individual stocks and bonds, most individuals invest 401(k) money through mutual funds. Since 401(k) deﬁned contribution plans are growing rapidly, the result is rapid growth in the mutual fund industry. This, in turn, has implications for the security markets, and for businesses that need to attract capital. Financial institutions have historically been heavily regulated, with the primary purpose of this regulation being to ensure the safety of the institutions and thus to protect investors. However, these regulations—which have taken the form of prohibitions on nationwide branch banking, restrictions on the types of assets the institutions can buy, ceilings on the interest rates they can pay, and limitations on the types of services they can provide—tended to impede the free ﬂow of capital and thus hurt the

19

An Overview of Corporate Finance and the Financial Environment Financial Institutions TABLE 1-2

21

Ten Largest U.S. Bank Holding Companies and World Banking Companies, and Top Ten Leading Underwriters

PANEL A

PANEL B

PANEL C

U.S. Bank Holding Companiesa

World Banking Companiesb

Leading Underwritersc

Citigroup Inc. J.P. Morgan Chase Bank of America Wells Fargo & Co. Bank One Metlife Inc First Union FleetBoston Financial U.S. Bancorp SunTrust Banks Inc.

Deutsche Bank, Frankfurt Citigroup, New York BNP Paribas, Paris Bank of Tokyo-Mitsubishi, Tokyo Bank of America, Charlotte, N.C. UBS, Zurich HSBC Holdings, London Fuji Bank, Tokyo Sumitomo Bank, Osaka Bayerische Hypo Vereinsbank, Munich

Merrill Lynch & Co. Salomon Smith Barneyd Morgan Stanley Credit Suisse First Boston J.P. Morgan Goldman Sachs Deutsche Bank Lehman Brothers UBS Wartburg Bank of America Securities

Notes: a Ranked by total assets as of December 31, 2000; see http://www.americanbanker.com. b Ranked by total assets as of December 31, 1999; see http://www.ﬁnancialservicefacts.org/inter__fr.html. c Ranked by dollar amount raised through new issues in 2000; see The Wall Street Journal, January 2, 2001, R19. d Owned by Citigroup.

efﬁciency of our capital markets. Recognizing this fact, Congress has authorized some major changes, and more are on the horizon. The result of the ongoing regulatory changes has been a blurring of the distinctions between the different types of institutions. Indeed, the trend in the United States today is toward huge ﬁnancial service corporations, which own banks, S&Ls, investment banking houses, insurance companies, pension plan operations, and mutual funds, and which have branches across the country and around the world. Examples of ﬁnancial service corporations, most of which started in one area but have now diversiﬁed to cover most of the ﬁnancial spectrum, include Merrill Lynch, American Express, Citigroup, Fidelity, and Prudential. Panel a of Table 1-2 lists the ten largest U.S. bank holding companies, and Panel b shows the leading world banking companies. Among the world’s ten largest, only two (Citigroup and Bank of America) are from the United States. While U.S. banks have grown dramatically as a result of recent mergers, they are still small by global standards. Panel c of the table lists the ten leading underwriters in terms of dollar volume of new issues. Six of the top underwriters are also major commercial banks or are part of bank holding companies, which conﬁrms the continued blurring of distinctions among different types of ﬁnancial institutions. Identify three ways capital is transferred between savers and borrowers. What is the difference between a commercial bank and an investment bank? Distinguish between investment banking houses and ﬁnancial intermediaries. List the major types of intermediaries and brieﬂy describe the primary function of each.

20

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An Overview of Corporate Finance and the Financial Environment

Online Trading Systems

The forces that led to online trading have also promoted online trading systems that bypass the traditional exchanges. These systems, known as electronic communications networks (ECNs), use technology to bring buyers and sellers together electronically. Bob Mazzarella, president of Fidelity Brokerage Services Inc., estimates that ECNs have already captured 20 to 35 percent of Nasdaq’s trading volume. Instinet, the ﬁrst and largest ECN, has a stake with Goldman Sachs, J. P. Morgan, and E*Trade in another network, Archipelago, which recently announced plans to form its own exchange. Likewise, Charles Schwab recently announced plans to join with Fidelity Investments, Donaldson, Lufkin & Jenrette, and Spear, Leeds & Kellogg to develop another ECN. ECNs are accelerating the move toward 24-hour trading. Large clients who want to trade after the other markets have closed may utilize an ECN, bypassing the NYSE and Nasdaq. In fact, Eurex, a Swiss-German ECN for trading futures contracts, has virtually eliminated futures activity on the

trading ﬂoors of Paris, London, and Frankfurt. Moreover, it recently passed the Chicago Board of Trade (CBOT) to become the world’s leader in futures trading volume. The threat of a similar ECN in the United States has undoubtedly contributed to the recent 50 percent decline in the price of a seat on the CBOT. The move toward faster, cheaper, 24-hour trading obviously beneﬁts investors, but it also presents regulators, who try to ensure that all investors have access to a “level playing ﬁeld,” with a number of headaches. Because of the threat from ECNs and the need to raise capital and increase ﬂexibility, both the NYSE and Nasdaq plan to convert from privately held, member-owned businesses to stockholder-owned, for-proﬁt corporations. This suggests that the ﬁnancial landscape will continue to undergo dramatic changes in the upcoming years. Sources: Katrina Brooker, “Online Investing: It’s Not Just for Geeks Anymore,” Fortune, December 21, 1998, 89–98; “Fidelity, Schwab Part of Deal to Create Nasdaq Challenger,” The Milwaukee Journal Sentinel, July 22, 1999, 1.

Secondary Markets Financial institutions play a key role in matching primary market players who need money with those who have extra funds, but the vast majority of trading actually occurs in the secondary markets. Although there are many secondary markets for a wide variety of securities, we can classify their trading procedures along two dimensions. First, the secondary market can be either a physical location exchange or a computer/telephone network. For example, the New York Stock Exchange, the American Stock Exchange (AMEX), the Chicago Board of Trade (the CBOT trades futures and options), and the Tokyo Stock Exchange are all physical location exchanges. In other words, the traders actually meet and trade in a speciﬁc part of a speciﬁc building. In contrast, Nasdaq, which trades U.S. stocks, is a network of linked computers. Other examples are the markets for U.S. Treasury bonds and foreign exchange, which are conducted via telephone and/or computer networks. In these electronic markets, the traders never see one another. The second dimension is the way orders from sellers and buyers are matched. This can occur through an open outcry auction system, through dealers, or by automated order matching. An example of an outcry auction is the CBOT, where traders actually meet in a pit and sellers and buyers communicate with one another through shouts and hand signals. In a dealer market, there are “market makers” who keep an inventory of the stock (or other ﬁnancial instrument) in much the same way that any merchant keeps an inventory. These dealers list bid and ask quotes, which are the prices at which they are

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An Overview of Corporate Finance and the Financial Environment The Stock Market

23

willing to buy or sell. Computerized quotation systems keep track of all bid and ask prices, but they don’t actually match buyers and sellers. Instead, traders must contact a speciﬁc dealer to complete the transaction. Nasdaq (U.S. stocks) is one such market, as are the London SEAQ (U.K. stocks) and the Neuer Market (stocks of small German companies). The third method of matching orders is through an electronic communications network (ECN). Participants in an ECN post their orders to buy and sell, and the ECN automatically matches orders. For example, someone might place an order to buy 1,000 shares of IBM stock (this is called a “market order” since it is to buy the stock at the current market price). Suppose another participant had placed an order to sell 1,000 shares of IBM at a price of $91 per share, and this was the lowest price of any “sell” order. The ECN would automatically match these two orders, execute the trade, and notify both participants that the trade has occurred. Participants can also post “limit orders,” which might state that the participant is willing to buy 1,000 shares of IBM at $90 per share if the price falls that low during the next two hours. In other words, there are limits on the price and/or the duration of the order. The ECN will execute the limit order if the conditions are met, that is, if someone offers to sell IBM at a price of $90 or less during the next two hours. The two largest ECNs for trading U.S. stocks are Instinet (owned by Reuters) and Island. Other large ECNs include Eurex, a Swiss-German ECN that trades futures contracts, and SETS, a U.K. ECN that trades stocks. What are the major differences between physical location exchanges and computer/telephone networks? What are the differences among open outcry auctions, dealer markets, and ECNs?

The Stock Market Because the primary objective of ﬁnancial management is to maximize the ﬁrm’s stock price, a knowledge of the stock market is important to anyone involved in managing a business. The two leading stock markets today are the New York Stock Exchange and the Nasdaq stock market.

The New York Stock Exchange The New York Stock Exchange (NYSE) is a physical location exchange. It occupies its own building, has a limited number of members, and has an elected governing body— its board of governors. Members are said to have “seats” on the exchange, although everybody stands up. These seats, which are bought and sold, give the holder the right to trade on the exchange. There are currently 1,366 seats on the NYSE, and in August 1999, a seat sold for $2.65 million. This is up from a price of $35,000 in 1977. The current (2002) asking price for a seat is about $2 million. Most of the larger investment banking houses operate brokerage departments, and they own seats on the NYSE and designate one or more of their ofﬁcers as members. The NYSE is open on all normal working days, with the members meeting in a large room equipped with electronic equipment that enables each member to communicate with his or her ﬁrm’s ofﬁces throughout the country. For example, Merrill Lynch (the largest brokerage ﬁrm) might receive an order in its Atlanta ofﬁce from

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An Overview of Corporate Finance and the Financial Environment

You can access the home pages of the major U.S. stock markets by typing http://www.nyse.com or http://www.nasdaq.com. These sites provide background information as well as the opportunity to obtain individual stock quotes.

a customer who wants to buy shares of AT&T stock. Simultaneously, Morgan Stanley’s Denver ofﬁce might receive an order from a customer wishing to sell shares of AT&T. Each broker communicates electronically with the ﬁrm’s representative on the NYSE. Other brokers throughout the country are also communicating with their own exchange members. The exchange members with sell orders offer the shares for sale, and they are bid for by the members with buy orders. Thus, the NYSE operates as an auction market.3

The Nasdaq Stock Market The National Association of Securities Dealers (NASD) is a self-regulatory body that licenses brokers and oversees trading practices. The computerized network used by the NASD is known as the NASD Automated Quotation System, or Nasdaq. Nasdaq started as just a quotation system, but it has grown to become an organized securities market with its own listing requirements. Nasdaq lists about 5,000 stocks, although not all trade through the same Nasdaq system. For example, the Nasdaq National Market lists the larger Nasdaq stocks, such as Microsoft and Intel, while the Nasdaq SmallCap Market lists smaller companies with the potential for high growth. Nasdaq also operates the Nasdaq OTC Bulletin Board, which lists quotes for stock that is registered with the Securities Exchange Commission (SEC) but that is not listed on any exchange, usually because the company is too small or too unproﬁtable.4 Finally, Nasdaq operates the Pink Sheets, which provide quotes on companies that are not registered with the SEC. “Liquidity” is the ability to trade quickly at a net price (i.e. after any commissions) that is very close to the security’s recent market value. In a dealer market, such as Nasdaq, a stock’s liquidity depends on the number and quality of the dealers who make a 3

The NYSE is actually a modiﬁed auction market, wherein people (through their brokers) bid for stocks. Originally—about 200 years ago—brokers would literally shout, “I have 100 shares of Erie for sale; how much am I offered?” and then sell to the highest bidder. If a broker had a buy order, he or she would shout, “I want to buy 100 shares of Erie; who’ll sell at the best price?” The same general situation still exists, although the exchanges now have members known as specialists who facilitate the trading process by keeping an inventory of shares of the stocks in which they specialize. If a buy order comes in at a time when no sell order arrives, the specialist will sell off some inventory. Similarly, if a sell order comes in, the specialist will buy and add to inventory. The specialist sets a bid price (the price the specialist will pay for the stock) and an asked price (the price at which shares will be sold out of inventory). The bid and asked prices are set at levels designed to keep the inventory in balance. If many buy orders start coming in because of favorable developments or sell orders come in because of unfavorable events, the specialist will raise or lower prices to keep supply and demand in balance. Bid prices are somewhat lower than asked prices, with the difference, or spread, representing the specialist’s proﬁt margin. Special facilities are available to help institutional investors such as mutual funds or pension funds sell large blocks of stock without depressing their prices. In essence, brokerage houses that cater to institutional clients will purchase blocks (deﬁned as 10,000 or more shares) and then resell the stock to other institutions or individuals. Also, when a ﬁrm has a major announcement that is likely to cause its stock price to change sharply, it will ask the exchanges to halt trading in its stock until the announcement has been made and digested by investors. Thus, when Texaco announced that it planned to acquire Getty Oil, trading was halted for one day in both Texaco and Getty stocks. 4 OTC stands for over-the-counter. Before Nasdaq, the quickest way to trade a stock that was not listed at a physical location exchange was to ﬁnd a brokerage ﬁrm that kept shares of that stock in inventory. The stock certiﬁcates were actually kept in a safe and were literally passed over the counter when bought or sold. Nowadays the certiﬁcates for almost all listed stocks and bonds in the United States are stored in a vault beneath Manhattan, operated by the Depository Trust and Clearing Corporation (DTCC). Most brokerage ﬁrms have an account with the DTCC, and most investors leave their stocks with their brokers. Thus, when stocks are sold, the DTCC simply adjusts the accounts of the brokerage ﬁrms that are involved, and no stock certiﬁcates are actually moved.

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An Overview of Corporate Finance and the Financial Environment The Stock Market

25

Measuring the Market

A stock index is designed to show the performance of the stock market. The problem is that there are many stock indexes, and it is difﬁcult to determine which index best reﬂects market actions. Some are designed to represent the whole equity market, some to track the returns of certain industry sectors, and others to track the returns of small-cap, mid-cap, or large-cap stocks. “Cap” is short for capitalization, which means the total market value of a ﬁrm’s stock. We discuss below four of the leading indexes.

Dow Jones Industrial Average

formance. The stocks in the S&P 500 are selected by the Standard & Poor’s Index Committee for being the leading companies in the leading industries, and for accurately reﬂecting the U.S. stock market. It is value weighted, so the largest companies (in terms of value) have the greatest inﬂuence. The S&P 500 Index is used as a comparison benchmark by 97 percent of all U.S. money managers and pension plan sponsors, and approximately $700 billion is managed so as to obtain the same performance as this index (that is, in indexed funds).

Unveiled in 1896 by Charles H. Dow, the Dow Jones Industrial Average (DJIA) provided a benchmark for comparing individual stocks with the overall market and for comparing the market with other economic indicators. The industrial average began with just 10 stocks, was expanded in 1916 to 20 stocks, and then to 30 in 1928. Also, in 1928 The Wall Street Journal editors began adjusting it for stock splits, and making substitutions. Today, the DJIA still includes 30 companies. They represent almost a ﬁfth of the market value of all U.S. stocks, and all are both leading companies in their industries and widely held by individual and institutional investors.

Nasdaq Composite Index

Wilshire 5000 Total Market Index

Recent Performance

The Wilshire 5000, created in 1974, measures the performance of all U.S. headquartered equity securities with readily available prices. It was originally composed of roughly 5,000 stocks, but as of August 1999, it included more than 7,000 publicly traded securities with a combined market capitalization in excess of $14 trillion. The Wilshire 5000 is unique because it seeks to reﬂect returns on the entire U.S. equity market.

Go to the web site http://ﬁnance.yahoo.com/. Enter the symbol for any of the indices (^DJI for the Dow Jones, ^WIL5 for the Wilshire 5000, ^SPC for the S&P 500, and ^IXIC for the Nasdaq) and click the Get Quotes button. This will bring up the current value of the index, shown in a table. Click Chart (under the table heading “More Info”), and it will bring up a chart showing the historical performance of the index. Immediately below the chart is a series of buttons that allows you to choose the number of years and to plot the relative performance of several indices on the same chart. You can even download the historical data in spreadsheet form.

S&P 500 Index Created in 1926, the S&P 500 Index is widely regarded as the standard for measuring large-cap U.S. stock market per-

The Nasdaq Composite Index measures the performance of all common stocks listed on the Nasdaq stock market. Currently, it includes more than 5,000 companies, and because many of the technology-sector companies are traded on the computer-based Nasdaq exchange, this index is generally regarded as an economic indicator of the high-tech industry. Microsoft, Intel, and Cisco Systems are the three largest Nasdaq companies, and they comprise a high percentage of the index’s value-weighted market capitalization. For this reason, substantial movements in the same direction by these three companies can move the entire index.

market in the stock. Nasdaq has more than 400 dealers, most making markets in a large number of stocks. The typical stock has about 10 market makers, but some stocks have more than 50 market makers. Obviously, there are more market makers, and liquidity, for the Nasdaq National Market than for the SmallCap Market. There is very little liquidity for stocks on the OTC Bulletin Board or the Pink Sheets. Over the past decade the competition between the NYSE and Nasdaq has been ﬁerce. In an effort to become more competitive with the NYSE and with international markets, the NASD and the AMEX merged in 1998 to form what might best be referred to as an organized investment network. This investment network is often referred

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to as Nasdaq, but stocks continue to be traded and reported separately on the two markets. Increased competition among global stock markets assuredly will result in similar alliances among other exchanges and markets in the future. Since most of the largest companies trade on the NYSE, the market capitalization of NYSE-traded stocks is much higher than for stocks traded on Nasdaq (about $11.6 trillion compared with $2.7 trillion in late 2001). However, reported volume (number of shares traded) is often larger on Nasdaq, and more companies are listed on Nasdaq.5 Interestingly, many high-tech companies such as Microsoft and Intel have remained on Nasdaq even though they easily meet the listing requirements of the NYSE. At the same time, however, other high-tech companies such as Gateway 2000, America Online, and Iomega have left Nasdaq for the NYSE. Despite these defections, Nasdaq’s growth over the past decade has been impressive. In the years ahead, the competition will no doubt remain ﬁerce. What are some major differences between the NYSE and the Nasdaq stock market?

The Cost of Money Capital in a free economy is allocated through the price system. The interest rate is the price paid to borrow debt capital. With equity capital, investors expect to receive dividends and capital gains, whose sum is the cost of equity money. The factors that affect supply and demand for investment capital, hence the cost of money, are discussed in this section. The four most fundamental factors affecting the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inﬂation. To see how these factors operate, visualize an isolated island community where the people live on ﬁsh. They have a stock of ﬁshing gear that permits them to survive reasonably well, but they would like to have more ﬁsh. Now suppose Mr. Crusoe has a bright idea for a new type of ﬁshnet that would enable him to double his daily catch. However, it would take him a year to perfect his design, to build his net, and to learn how to use it efﬁciently, and Mr. Crusoe would probably starve before he could put his new net into operation. Therefore, he might suggest to Ms. Robinson, Mr. Friday, and several others that if they would give him one ﬁsh each day for a year, he would return two ﬁsh a day during all of the next year. If someone accepted the offer, then the ﬁsh that Ms. Robinson or one of the others gave to Mr. Crusoe would constitute savings; these savings would be invested in the ﬁshnet; and the extra ﬁsh the net produced would constitute a return on the investment. Obviously, the more productive Mr. Crusoe thought the new ﬁshnet would be, the more he could afford to offer potential investors for their savings. In this example, we assume that Mr. Crusoe thought he would be able to pay, and thus he offered, a 100 percent rate of return—he offered to give back two ﬁsh for every one he received. He might have tried to attract savings for less—for example, he might have decided to offer only 1.5 ﬁsh next year for every one he received this year, which would represent a 50 percent rate of return to potential savers. How attractive Mr. Crusoe’s offer appeared to a potential saver would depend in large part on the saver’s time preference for consumption. For example, Ms. Robinson might be thinking of retirement, and she might be willing to trade ﬁsh today for ﬁsh

5

One transaction on Nasdaq generally shows up as two separate trades (the buy and the sell). This “double counting” makes it difﬁcult to compare the volume between stock markets.

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An Overview of Corporate Finance and the Financial Environment Interest Rate Levels

27

in the future on a one-for-one basis. On the other hand, Mr. Friday might have a wife and several young children and need his current ﬁsh, so he might be unwilling to “lend” a ﬁsh today for anything less than three ﬁsh next year. Mr. Friday would be said to have a high time preference for current consumption and Ms. Robinson a low time preference. Note also that if the entire population were living right at the subsistence level, time preferences for current consumption would necessarily be high, aggregate savings would be low, interest rates would be high, and capital formation would be difﬁcult. The risk inherent in the ﬁshnet project, and thus in Mr. Crusoe’s ability to repay the loan, would also affect the return investors would require: the higher the perceived risk, the higher the required rate of return. Also, in a more complex society there are many businesses like Mr. Crusoe’s, many goods other than ﬁsh, and many savers like Ms. Robinson and Mr. Friday. Therefore, people use money as a medium of exchange rather than barter with ﬁsh. When money is used, its value in the future, which is affected by inﬂation, comes into play: the higher the expected rate of inﬂation, the larger the required return. We discuss this point in detail later in the chapter. Thus, we see that the interest rate paid to savers depends in a basic way (1) on the rate of return producers expect to earn on invested capital, (2) on savers’ time preferences for current versus future consumption, (3) on the riskiness of the loan, and (4) on the expected future rate of inﬂation. Producers’ expected returns on their business investments set an upper limit on how much they can pay for savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer, hence how much they will save at different rates of interest offered by producers.6 Higher risk and higher inﬂation also lead to higher interest rates. What is the price paid to borrow money called? What are the two items whose sum is the “price” of equity capital? What four fundamental factors affect the cost of money?

Interest Rate Levels Capital is allocated among borrowers by interest rates: Firms with the most proﬁtable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from inefﬁcient ﬁrms or from those whose products are not in demand. Of course, our economy is not completely free in the sense of being inﬂuenced only by market forces. Thus, the federal government has agencies that help designated individuals or groups obtain credit on favorable terms. Among those eligible for this kind of assistance are small businesses, certain minorities, and ﬁrms willing to build plants in areas with high unemployment. Still, most capital in the U.S. economy is allocated through the price system. Figure 1-3 shows how supply and demand interact to determine interest rates in two capital markets. Markets A and B represent two of the many capital markets in existence. The going interest rate, which can be designated as either r or i, but for purposes of our discussion is designated as r, is initially 10 percent for the low-risk

6

The term “producers” is really too narrow. A better word might be “borrowers,” which would include corporations, home purchasers, people borrowing to go to college, or even people borrowing to buy autos or to pay for vacations. Also, the wealth of a society and its demographics inﬂuence its people’s ability to save and thus their time preferences for current versus future consumption.

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FIGURE 1-3

Interest Rates as a Function of Supply and Demand for Funds

Market A: Low-Risk Securities

Market B: High-Risk Securities

Interest Rate, r (%)

Interest Rate, r (%)

S1

S1 r B = 12 r A = 10 8 D1 D1

D2

Dollars

0

0

Dollars

securities in Market A.7 Borrowers whose credit is strong enough to borrow in this market can obtain funds at a cost of 10 percent, and investors who want to put their money to work without much risk can obtain a 10 percent return. Riskier borrowers must obtain higher-cost funds in Market B. Investors who are more willing to take risks invest in Market B, expecting to earn a 12 percent return but also realizing that they might actually receive much less. If the demand for funds declines, as it typically does during business recessions, the demand curves will shift to the left, as shown in Curve D2 in Market A. The marketclearing, or equilibrium, interest rate in this example declines to 8 percent. Similarly, you should be able to visualize what would happen if the Federal Reserve tightened credit: The supply curve, S1, would shift to the left, and this would raise interest rates and lower the level of borrowing in the economy. Capital markets are interdependent. For example, if Markets A and B were in equilibrium before the demand shift to D2 in Market A, then investors were willing to accept the higher risk in Market B in exchange for a risk premium of 12% ⫺ 10% ⫽ 2%. After the shift to D2, the risk premium would initially increase to 12% ⫺ 8% ⫽ 4%. Immediately, though, this much larger premium would induce some of the lenders in Market A to shift to Market B, which would, in turn, cause the supply curve in Market A to shift to the left (or up) and that in Market B to shift to the right. The transfer of capital between markets would raise the interest rate in Market A and lower it in Market B, thus bringing the risk premium back closer to the original 2 percent. There are many capital markets in the United States. U.S. ﬁrms also invest and raise capital throughout the world, and foreigners both borrow and lend in the United 7

The letter “r” is the symbol we use for interest rates and the cost of equity, but “i” is used frequently today because this term corresponds to the interest rate key on ﬁnancial calculators, as described in Chapter 2. Note also that “k” was used in the past, but “r” is the preferred term today.

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States. There are markets for home loans; farm loans; business loans; federal, state, and local government loans; and consumer loans. Within each category, there are regional markets as well as different types of submarkets. For example, in real estate there are separate markets for ﬁrst and second mortgages and for loans on singlefamily homes, apartments, ofﬁce buildings, shopping centers, vacant land, and so on. Within the business sector there are dozens of types of debt and also several different markets for common stocks. There is a price for each type of capital, and these prices change over time as shifts occur in supply and demand conditions. Figure 1-4 shows how long- and short-term interest rates to business borrowers have varied since the early 1960s. Notice that short-term interest rates are especially prone to rise during booms and then fall during recessions. (The shaded areas of the chart indicate recessions.) When the economy is expanding, ﬁrms need capital, and this demand for capital pushes rates up. Also, inﬂationary pressures are strongest during business booms, and that also exerts upward pressure on rates. Conditions are reversed during recessions such as the one in 2001. Slack business reduces the demand for credit, the rate of inﬂation falls, and the result is a drop in interest rates. Furthermore, the Federal Reserve deliberately lowers rates during recessions to help stimulate the economy and tightens during booms. These tendencies do not hold exactly—the period after 1984 is a case in point. The price of oil fell dramatically in 1985 and 1986, reducing inﬂationary pressures

FIGURE 1-4

Long- and Short-Term Interest Rates, 1962–2001

Interest Rate (%) 18

18

16

16

14

Long-Term Rates

14

12

12

10

10

8

8

6

6

4

Short-Term Rates

2 0

4 2 0

1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

Notes: a. The shaded areas designate business recessions. b. Short-term rates are measured by three- to six-month loans to very large, strong corporations, and long-term rates are measured by AAA corporate bonds. Sources: Interest rates are from the Federal Reserve Bulletin; see http://www.federalreserve.gov/releases. The recession dates are from the National Bureau of Economic Research; see http://www.nber.org/cycles. As we write this (winter 2002), the economy is in yet another recession.

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An Overview of Corporate Finance and the Financial Environment

on other prices and easing fears of serious long-term inﬂation. Earlier, those fears had pushed interest rates to record levels. The economy from 1984 to 1987 was strong, but the declining fears of inﬂation more than offset the normal tendency of interest rates to rise during good economic times, and the net result was lower interest rates.8 The effect of inﬂation on long-term interest rates is highlighted in Figure 1-5, which plots rates of inﬂation along with long-term interest rates. In the early 1960s, inﬂation averaged 1 percent per year, and interest rates on high-quality, long-term bonds averaged 4 percent. Then the Vietnam War heated up, leading to an increase in inﬂation, and interest rates began an upward climb. When the war ended in the early 1970s, inﬂation dipped a bit, but then the 1973 Arab oil embargo led to rising oil prices, much higher inﬂation, and sharply higher interest rates. Inﬂation peaked at about 13 percent in 1980, but interest rates continued to increase into 1981 and 1982, and they remained quite high until 1985, because people were afraid inﬂation would start to climb again. Thus, the “inﬂationary psychology” created during the 1970s persisted to the mid-1980s. Gradually, though, people began to realize that the Federal Reserve was serious about keeping inﬂation down, that global competition was keeping U.S. auto

8

Short-term rates are responsive to current economic conditions, whereas long-term rates primarily reﬂect long-run expectations for inﬂation. As a result, short-term rates are sometimes above and sometimes below long-term rates. The relationship between long-term and short-term rates is called the term structure of interest rates, and it is discussed later in the chapter.

FIGURE 1-5

Relationship between Annual Inﬂation Rates and Long-Term Interest Rates, 1962–2001

Percent 16

16

14

14

12

12

10

10

8

Long-Term Interest Rates

6

8 6

4

4 Inflation

2

2

0 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

Notes: a. Interest rates are those on AAA long-term corporate bonds. b. Inﬂation is measured as the annual rate of change in the Consumer Price Index (CPI). Sources: Interest rates are from the Federal Reserve Bulletin; see http://www.federalreserve.gov/releases. The CPI data are from http://www. stls.frb.org/fred/data/cpi.htm.

0

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An Overview of Corporate Finance and the Financial Environment The Determinants of Market Interest Rates

31

producers and other corporations from raising prices as they had in the past, and that constraints on corporate price increases were diminishing labor unions’ ability to push through cost-increasing wage hikes. As these realizations set in, interest rates declined. The gap between the current interest rate and the current inﬂation rate is deﬁned as the “current real rate of interest.” It is called the “real rate” because it shows how much investors really earned after taking out the effects of inﬂation. The real rate was extremely high during the mid-1980s, but it averaged about 4 percent during the 1990s. In recent years, inﬂation has been running at about 3 percent a year. However, longterm interest rates have been volatile, because investors are not sure if inﬂation is truly under control or is getting ready to jump back to the higher levels of the 1980s. In the years ahead, we can be sure that the level of interest rates will vary (1) with changes in the current rate of inﬂation and (2) with changes in expectations about future inﬂation. How are interest rates used to allocate capital among ﬁrms? What happens to market-clearing, or equilibrium, interest rates in a capital market when the demand for funds declines? What happens when inﬂation increases or decreases? Why does the price of capital change during booms and recessions? How does risk affect interest rates?

The Determinants of Market Interest Rates

The textbook’s web site contains an Excel ﬁle that will guide you through the chapter’s calculations. The ﬁle for this chapter is Ch 01 Tool Kit.xls, and we encourage you to open the ﬁle and follow along as you read the chapter.

In general, the quoted (or nominal) interest rate on a debt security, r, is composed of a real risk-free rate of interest, r*, plus several premiums that reﬂect inﬂation, the riskiness of the security, and the security’s marketability (or liquidity). This relationship can be expressed as follows: Quoted interest rate ⫽ r ⫽ r* ⫹ IP ⫹ DRP ⫹ LP ⫹ MRP.

(1-1)

Here r ⫽ the quoted, or nominal, rate of interest on a given security.9 There are many different securities, hence many different quoted interest rates. r* ⫽ the real risk-free rate of interest. r* is pronounced “r-star,” and it is the rate that would exist on a riskless security if zero inﬂation were expected. rRF ⫽ r* ⫹ IP, and it is the quoted risk-free rate of interest on a security such as a U.S. Treasury bill, which is very liquid and also free of most risks. Note that rRF includes the premium for expected inﬂation, because rRF ⫽ r* ⫹ IP. IP ⫽ inﬂation premium. IP is equal to the average expected inﬂation rate over the life of the security. The expected future inﬂation rate is not necessarily equal to the current inﬂation rate, so IP is not necessarily equal to current inﬂation as reported in Figure 1-5.

9

The term nominal as it is used here means the stated rate as opposed to the real rate, which is adjusted to remove inﬂation effects. If you bought a 10-year Treasury bond in October 2001, the quoted, or nominal, rate would be about 4.6 percent, but if inﬂation averages 2.5 percent over the next 10 years, the real rate would be about 4.6% ⫺ 2.5% ⫽ 2.1%. To be technically correct, we should ﬁnd the real rate by solving for r* in the following equation: (1 ⫹ r*)(1 ⫹ 0.025) ⫽ (1 ⫹ 0.046). If we solved the equation, we would ﬁnd r* ⫽ 2.05%. Since this is very close to the 2.1 percent calculated above, we will continue to approximate the real rate by subtracting inﬂation from the nominal rate.

30

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DRP ⫽ default risk premium. This premium reﬂects the possibility that the issuer will not pay interest or principal at the stated time and in the stated amount. DRP is zero for U.S. Treasury securities, but it rises as the riskiness of issuers increases. LP ⫽ liquidity, or marketability, premium. This is a premium charged by lenders to reﬂect the fact that some securities cannot be converted to cash on short notice at a “reasonable” price. LP is very low for Treasury securities and for securities issued by large, strong ﬁrms, but it is relatively high on securities issued by very small ﬁrms. MRP ⫽ maturity risk premium. As we will explain later, longer-term bonds, even Treasury bonds, are exposed to a signiﬁcant risk of price declines, and a maturity risk premium is charged by lenders to reﬂect this risk. As noted above, since rRF ⫽ r* ⫹ IP, we can rewrite Equation 1-1 as follows: Nominal, or quoted, rate ⫽ r ⫽ rRF ⫹ DRP ⫹ LP ⫹ MRP. We discuss the components whose sum makes up the quoted, or nominal, rate on a given security in the following sections.

The Real Risk-Free Rate of Interest, r* The real risk-free rate of interest, r*, is deﬁned as the interest rate that would exist on a riskless security if no inﬂation were expected, and it may be thought of as the rate of interest on short-term U.S. Treasury securities in an inﬂation-free world. The real risk-free rate is not static—it changes over time depending on economic conditions, especially (1) on the rate of return corporations and other borrowers expect to earn on productive assets and (2) on people’s time preferences for current versus future consumption. Borrowers’ expected returns on real asset investments set an upper limit on how much they can afford to pay for borrowed funds, while savers’ time preferences for consumption establish how much consumption they are willing to defer, hence the amount of funds they will lend at different interest rates. It is difﬁcult to measure the real risk-free rate precisely, but most experts think that r* has ﬂuctuated in the range of 1 to 5 percent in recent years.10 In addition to its regular bond offerings, in 1997 the U.S. Treasury began issuing indexed bonds, with payments linked to inﬂation. To date, the Treasury has issued ten See http://www. bloomberg.com and select of these indexed bonds, with maturities ranging (at time of issue) from 5 to 31 years. MARKETS and then U.S. Yields on these bonds in November 2001 ranged from 0.94 to 3.13 percent, with the Treasuries for a partial listing higher yields on the longer maturities because they have a maturity risk premium due of indexed Treasury bonds. to the fact that the risk premium itself can change, leading to changes in the bonds’ The reported yield on each prices. The yield on the shortest-term bond provides a good estimate for r*, because it bond is the real risk-free rate expected over its life. has essentially no risk. 10

The real rate of interest as discussed here is different from the current real rate as discussed in connection with Figure 1-5. The current real rate is the current interest rate minus the current (or latest past) inﬂation rate, while the real rate, without the word “current,” is the current interest rate minus the expected future inﬂation rate over the life of the security. For example, suppose the current quoted rate for a one-year Treasury bill is 5 percent, inﬂation during the latest year was 2 percent, and inﬂation expected for the coming year is 4 percent. Then the current real rate would be 5% ⫺ 2% ⫽ 3%, but the expected real rate would be 5% ⫺ 4% ⫽ 1%. The rate on a 10-year bond would be related to the expected inﬂation rate over the next 10 years, and so on. In the press, the term “real rate” generally means the current real rate, but in economics and ﬁnance, hence in this book unless otherwise noted, the real rate means the one based on expected inﬂation rates.

31

An Overview of Corporate Finance and the Financial Environment The Determinants of Market Interest Rates

33

The Nominal, or Quoted, Risk-Free Rate of Interest, rRF The nominal, or quoted, risk-free rate, rRF, is the real risk-free rate plus a premium for expected inﬂation: rRF ⫽ r* ⫹ IP. To be strictly correct, the risk-free rate should mean the interest rate on a totally risk-free security—one that has no risk of default, no maturity risk, no liquidity risk, no risk of loss if inﬂation increases, and no risk of any other type. There is no such security, hence there is no observable truly risk-free rate. However, there is one security that is free of most risks—an indexed U.S. Treasury security. These securities are free of default risk, liquidity risk, and risk due to changes in inﬂation.11 If the term “risk-free rate” is used without either the modiﬁer “real” or the modiﬁer “nominal,” people generally mean the quoted (nominal) rate, and we will follow that convention in this book. Therefore, when we use the term risk-free rate, rRF, we mean the nominal risk-free rate, which includes an inﬂation premium equal to the average expected inﬂation rate over the life of the security. In general, we use the T-bill rate to approximate the short-term risk-free rate, and the T-bond rate to approximate the long-term risk-free rate. So, whenever you see the term “risk-free rate,” assume that we are referring either to the quoted U.S. T-bill rate or to the quoted T-bond rate.

Inﬂation Premium (IP) Inﬂation has a major impact on interest rates because it erodes the purchasing power of the dollar and lowers the real rate of return on investments. To illustrate, suppose you saved $1,000 and invested it in a Treasury bill that matures in one year and pays a 5 percent interest rate. At the end of the year, you will receive $1,050—your original $1,000 plus $50 of interest. Now suppose the inﬂation rate during the year is 10 percent, and it affects all items equally. If gas had cost $1 per gallon at the beginning of the year, it would cost $1.10 at the end of the year. Therefore, your $1,000 would have bought $1,000/$1 ⫽ 1,000 gallons at the beginning of the year, but only $1,050/$1.10 ⫽ 955 gallons at the end. In real terms, you would be worse off—you would receive $50 of interest, but it would not be sufﬁcient to offset inﬂation. You would thus be better off buying 1,000 gallons of gas (or some other storable asset such as land, timber, apartment buildings, wheat, or gold) than buying the Treasury bill. Investors are well aware of all this, so when they lend money, they build in an inﬂation premium (IP) equal to the average expected inﬂation rate over the life of the security. As discussed previously, for a short-term, default-free U.S. Treasury bill, the actual interest rate charged, rT-bill, would be the real risk-free rate, r*, plus the inﬂation premium (IP): rT-bill ⫽ rRF ⫽ r* ⫹ IP. Therefore, if the real short-term risk-free rate of interest were r* ⫽ 1.25%, and if inﬂation were expected to be 1.18 percent (and hence IP ⫽ 1.18%) during the next year, then the quoted rate of interest on one-year T-bills would be 1.25% ⫹ 1.18% ⫽ 2.43%. Indeed, in October 2001, the expected one-year inﬂation rate was about 1.18

11

Indexed Treasury securities are the closest thing we have to a riskless security, but even they are not totally riskless, because r* itself can change and cause a decline in the prices of these securities. For example, between October 1998 and January 2000, the price of one indexed Treasury security declined from 98 to 89, or by almost 10 percent. The cause was an increase in the real rate. By November 2001, however, the real rate had declined, and the bond’s price was back up to 109.

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An Overview of Corporate Finance and the Financial Environment

percent, and the yield on one-year T-bills was about 2.43 percent, so the real risk-free rate on short-term securities at that time was 1.25 percent.12 It is important to note that the inﬂation rate built into interest rates is the inﬂation rate expected in the future, not the rate experienced in the past. Thus, the latest reported ﬁgures might show an annual inﬂation rate of 2 percent, but that is for the past year. If people on average expect a 6 percent inﬂation rate in the future, then 6 percent would be built into the current interest rate. Note also that the inﬂation rate reﬂected in the quoted interest rate on any security is the average rate of inﬂation expected over the security’s life. Thus, the inﬂation rate built into a one-year bond is the expected inﬂation rate for the next year, but the inﬂation rate built into a 30-year bond is the average rate of inﬂation expected over the next 30 years.13 Expectations for future inﬂation are closely, but not perfectly, correlated with rates experienced in the recent past. Therefore, if the inﬂation rate reported for last month increased, people would tend to raise their expectations for future inﬂation, and this change in expectations would cause an increase in interest rates. Note that Germany, Japan, and Switzerland have over the past several years had lower inﬂation rates than the United States, hence their interest rates have generally been lower than ours. South Africa and most South American countries have experienced high inﬂation, and that is reﬂected in their interest rates.

Default Risk Premium (DRP) The risk that a borrower will default on a loan, which means not pay the interest or the principal, also affects the market interest rate on the security: the greater the default risk, the higher the interest rate. Treasury securities have no default risk, hence they carry the lowest interest rates on taxable securities in the United States. For corporate bonds, the higher the bond’s rating, the lower its default risk, and, consequently, the lower its interest rate.14 Here are some representative interest rates on long-term bonds during October 2001: 12

There are several sources for the estimated inﬂation premium. The Congressional Budget Ofﬁce regularly updates the estimates of inﬂation that it uses in its forecasted budgets; see http://www.cbo.gov/ reports.html, select Economic and Budget Projections, and select the most recent Budget and Economic Outlook. An appendix to this document will show the 10-year projection, including the expected CPI inﬂation rate for each year. A second source is the University of Michigan’s Institute for Social Research, which regularly polls consumers regarding their expectations for price increases during the next year; see http://www.isr.umich.edu/src/projects.html, select the Surveys of Consumers, and then select the table for Expected Change in Prices. Third, you can ﬁnd the yield on an indexed Treasury bond, as described in the margin of page 32, and compare it with the yield on a nonindexed Treasury bond of the same maturity. This is the method we prefer, since it provides a direct estimate of the inﬂation risk premium. 13 To be theoretically precise, we should use a geometric average. Also, because millions of investors are active in the market, it is impossible to determine exactly the consensus expected inﬂation rate. Survey data are available, however, that give us a reasonably good idea of what investors expect over the next few years. For example, in 1980 the University of Michigan’s Survey Research Center reported that people expected inﬂation during the next year to be 11.9 percent and that the average rate of inﬂation expected over the next 5 to 10 years was 10.5 percent. Those expectations led to record-high interest rates. However, the economy cooled in 1981 and 1982, and, as Figure 1-5 showed, actual inﬂation dropped sharply after 1980. This led to gradual reductions in the expected future inﬂation rate. In winter 2002, as we write this, the expected inﬂation rate for the next year is about 1.2 percent, and the expected long-term inﬂation rate is about 2.5 percent. As inﬂationary expectations change, so do quoted market interest rates. 14 Bond ratings, and bonds’ riskiness in general, are discussed in detail in Chapter 4. For now, merely note that bonds rated AAA are judged to have less default risk than bonds rated AA, while AA bonds are less risky than A bonds, and so on. Ratings are designated AAA or Aaa, AA or Aa, and so forth, depending on the rating agency. In this book, the designations are used interchangeably.

33

An Overview of Corporate Finance and the Financial Environment The Determinants of Market Interest Rates

U.S. Treasury AAA AA A BBB BB⫹

To see current estimates of DRP, go to http.//www. bondsonline.com; under the section on Corporate Bonds, select Industrial Spreads.

Rate

DRP

5.5% 6.5 6.8 7.3 7.9 10.5

— 1.0% 1.3 1.8 2.4 5.0

35

The difference between the quoted interest rate on a T-bond and that on a corporate bond with similar maturity, liquidity, and other features is the default risk premium (DRP). Therefore, if the bonds listed above were otherwise similar, the default risk premium would be DRP ⫽ 6.5% ⫺ 5.5% ⫽ 1.0 percentage point for AAA corporate bonds, 6.8% ⫺ 5.5% ⫽ 1.3 percentage points for AA, and so forth. Default risk premiums vary somewhat over time, but the October 2001 ﬁgures are representative of levels in recent years.

Liquidity Premium (LP) A “liquid” asset can be converted to cash quickly and at a “fair market value.” Financial assets are generally more liquid than real assets. Because liquidity is important, investors include liquidity premiums (LPs) when market rates of securities are established. Although it is difﬁcult to accurately measure liquidity premiums, a differential of at least two and probably four or ﬁve percentage points exists between the least liquid and the most liquid ﬁnancial assets of similar default risk and maturity.

Maturity Risk Premium (MRP) U.S. Treasury securities are free of default risk in the sense that one can be virtually certain that the federal government will meet the scheduled interest and principal payments on its bonds. Therefore, the default risk premium on Treasury securities is essentially zero. Further, active markets exist for Treasury securities, so their liquidity premiums are also close to zero. Thus, as a ﬁrst approximation, the rate of interest on a Treasury bond should be the risk-free rate, rRF, which is equal to the real risk-free rate, r*, plus an inﬂation premium, IP. However, an adjustment is needed for longterm Treasury bonds. The prices of long-term bonds decline sharply whenever interest rates rise, and since interest rates can and do occasionally rise, all long-term bonds, even Treasury bonds, have an element of risk called interest rate risk. As a general rule, the bonds of any organization, from the U.S. government to Enron Corporation, have more interest rate risk the longer the maturity of the bond.15 Therefore, a maturity risk premium (MRP), which is higher the longer the years to maturity, must be included in the required interest rate. The effect of maturity risk premiums is to raise interest rates on long-term bonds relative to those on short-term bonds. This premium, like the others, is difﬁcult to

15

For example, if someone had bought a 30-year Treasury bond for $1,000 in 1998, when the long-term interest rate was 5.25 percent, and held it until 2000, when long-term T-bond rates were about 6.6 percent, the value of the bond would have declined to about $830. That would represent a loss of 17 percent, and it demonstrates that long-term bonds, even U.S. Treasury bonds, are not riskless. However, had the investor purchased short-term T-bills in 1998 and subsequently reinvested the principal each time the bills matured, he or she would still have had $1,000. This point will be discussed in detail in Chapter 4.

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measure, but (1) it varies somewhat over time, rising when interest rates are more volatile and uncertain, then falling when interest rates are more stable, and (2) in recent years, the maturity risk premium on 30-year T-bonds appears to have generally been in the range of one to three percentage points. We should mention that although long-term bonds are heavily exposed to interest rate risk, short-term bills are heavily exposed to reinvestment rate risk. When shortterm bills mature and the funds are reinvested, or “rolled over,” a decline in interest rates would necessitate reinvestment at a lower rate, and this would result in a decline in interest income. To illustrate, suppose you had $100,000 invested in one-year T-bills, and you lived on the income. In 1981, short-term rates were about 15 percent, so your income would have been about $15,000. However, your income would have declined to about $9,000 by 1983, and to just $5,700 by 2001. Had you invested your money in long-term T-bonds, your income (but not the value of the principal) would have been stable.16 Thus, although “investing short” preserves one’s principal, the interest income provided by short-term T-bills is less stable than the interest income on long-term bonds. Write out an equation for the nominal interest rate on any debt security. Distinguish between the real risk-free rate of interest, r*, and the nominal, or quoted, risk-free rate of interest, rRF. How is inﬂation dealt with when interest rates are determined by investors in the ﬁnancial markets? Does the interest rate on a T-bond include a default risk premium? Explain. Distinguish between liquid and illiquid assets, and identify some assets that are liquid and some that are illiquid. Brieﬂy explain the following statement: “Although long-term bonds are heavily exposed to interest rate risk, short-term bills are heavily exposed to reinvestment rate risk. The maturity risk premium reﬂects the net effects of these two opposing forces.”

The Term Structure of Interest Rates

You can ﬁnd current U.S. Treasury yield curve graphs and other global and domestic interest rate information at Bloomberg markets’ site at http://www. bloomberg.com/markets/ index.html.

The term structure of interest rates describes the relationship between long- and short-term rates. The term structure is important to corporate treasurers who must decide whether to borrow by issuing long- or short-term debt and to investors who must decide whether to buy long- or short-term bonds. Thus, it is important to understand (1) how long- and short-term rates relate to each other and (2) what causes shifts in their relative positions. Interest rates for bonds with different maturities can be found in a variety of publications, including The Wall Street Journal and the Federal Reserve Bulletin, and on a 16

Long-term bonds also have some reinvestment rate risk. If one is saving and investing for some future purpose, say, to buy a house or for retirement, then to actually earn the quoted rate on a long-term bond, the interest payments must be reinvested at the quoted rate. However, if interest rates fall, the interest payments must be reinvested at a lower rate; thus, the realized return would be less than the quoted rate. Note, though, that reinvestment rate risk is lower on a long-term bond than on a short-term bond because only the interest payments (rather than interest plus principal) on the long-term bond are exposed to reinvestment rate risk. Zero coupon bonds, which are discussed in Chapter 4, are completely free of reinvestment rate risk during their life.

35

An Overview of Corporate Finance and the Financial Environment The Term Structure of Interest Rates

37

number of web sites, including Bloomberg, Yahoo, and CNN Financial. From interest rate data obtained from these sources, we can construct the term structure at a given point in time. For example, the tabular section below Figure 1-6 presents interest rates for different maturities on three different dates. The set of data for a given date, when plotted on a graph such as that in Figure 1-6, is called the yield curve for that date. The yield curve changes both in position and in slope over time. In March 1980, all rates were relatively high, and since short-term rates were higher than long-term rates, the yield curve was downward sloping. In October 2001, all rates had fallen, and because short-term rates were lower than long-term rates, the yield curve was upward sloping. In February 2000, the yield curve was humped—medium-term rates were higher than both short- and long-term rates. Figure 1-6 shows yield curves for U.S. Treasury securities, but we could have constructed curves for corporate bonds issued by Exxon Mobil, IBM, Delta Air Lines, or any other company that borrows money over a range of maturities. Had we

FIGURE 1-6

U.S. Treasury Bond Interest Rates on Different Dates

Interest Rate (%) 16 14

Yield Curve for March 1980 (Current Rate of Inflation: 12%)

12 10 Yield Curve for February 2000 (Current Rate of Inflation: 3%)

8 6

Yield Curve for October 2001 (Current Rate of Inflation: 2.7%)

4 2 0

1

Short Term

5

10

Intermediate Term

30 Years to Maturity Long Term

Interest Rate Term to Maturity

March 1980

February 2000

October 2001

6 months 1 year 5 years 10 years 30 years

15.0% 14.0 13.5 12.8 12.3

6.0% 6.2 6.7 6.7 6.3

2.3% 2.4 3.9 4.6 5.5

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constructed corporate curves and plotted them on Figure 1-6, they would have been above those for Treasury securities because corporate yields include default risk premiums. However, the corporate yield curves would have had the same general shape as the Treasury curves. Also, the riskier the corporation, the higher its yield curve, so Delta Airlines, which has a lower bond rating than either Exxon Mobil or IBM, would have a higher yield curve than those of Exxon Mobil and IBM. Historically, in most years long-term rates have been above short-term rates, so the yield curve usually slopes upward. For this reason, people often call an upwardsloping yield curve a “normal” yield curve and a yield curve that slopes downward an inverted, or “abnormal,” curve. Thus, in Figure 1-6 the yield curve for March 1980 was inverted and the one for October 2001 was normal. However, the February 2000 curve is humped, which means that interest rates on medium-term maturities are higher than rates on both short- and long-term maturities. We explain in detail in the next section why an upward slope is the normal situation, but brieﬂy, the reason is that short-term securities have less interest rate risk than longer-term securities, hence smaller MRPs. Therefore, short-term rates are normally lower than long-term rates. What is a yield curve, and what information would you need to draw this curve? Explain the shapes of a “normal” yield curve, an “abnormal” curve, and a “humped” curve.

What Determines the Shape of the Yield Curve? Since maturity risk premiums are positive, then if other things were held constant, long-term bonds would have higher interest rates than short-term bonds. However, market interest rates also depend on expected inﬂation, default risk, and liquidity, and each of these factors can vary with maturity. Expected inﬂation has an especially important effect on the yield curve’s shape. To see why, consider U.S. Treasury securities. Because Treasuries have essentially no default or liquidity risk, the yield on a Treasury bond that matures in t years can be found using the following equation: rt ⫽ r* ⫹ IPt ⫹ MRPt. While the real risk-free rate, r*, may vary somewhat over time because of changes in the economy and demographics, these changes are random rather than predictable, so it is reasonable to assume that r* will remain constant. However, the inﬂation premium, IP, does vary signiﬁcantly over time, and in a somewhat predictable manner. Recall that the inﬂation premium is simply the average level of expected inﬂation over the life of the bond. For example, during a recession inﬂation is usually abnormally low. Investors will expect higher future inﬂation, leading to higher inﬂation premiums for long-term bonds. On the other hand, if the market expects inﬂation to decline in the future, long-term bonds will have a smaller inﬂation premium than short-term bonds. Finally, if investors consider long-term bonds to be riskier than short-term bonds, the maturity risk premium will increase with maturity. Panel a of Figure 1-7 shows the yield curve when inﬂation is expected to increase. Here long-term bonds have higher yields for two reasons: (1) Inﬂation is expected to be higher in the future, and (2) there is a positive maturity risk premium. Panel b of Figure 1-7 shows the yield curve when inﬂation is expected to decline, causing the yield curve to be downward sloping. Downward sloping yield curves often foreshadow

37

An Overview of Corporate Finance and the Financial Environment What Determines the Shape of the Yield Curve? FIGURE 1-7 a.

Illustrative Treasury Yield Curves

When Inflation Is Expected to Increase

b.

Interest Rate (%)

When Inflation Is Expected to Decrease

Interest Rate (%)

8

Maturity Risk Premium

7 6

8 7 Maturity Risk Premium

6 Inflation Premium

5

5

4

4

3

3

2

Inflation Premium

2 Real RiskFree Rate

1 0

39

10

0

20 30 Years to Maturity

Real RiskFree Rate

1

10

With Increasing Expected Inﬂation

20 30 Years to Maturity

With Decreasing Expected Inﬂation

Maturity

r*

IP

MRP

Yield

Maturity

r*

IP

MRP

Yield

1 year 5 years 10 years 20 years 30 years

2.50% 2.50 2.50 2.50 2.50

3.00% 3.40 4.00 4.50 4.67

0.00% 0.18 0.28 0.42 0.53

5.50% 6.08 6.78 7.42 7.70

1 year 5 years 10 years 20 years 30 years

2.50% 2.50 2.50 2.50 2.50

5.00% 4.60 4.00 3.50 3.33

0.00% 0.18 0.28 0.42 0.53

7.50% 7.28 6.78 6.42 6.36

economic downturns, because weaker economic conditions tend to be correlated with declining inﬂation, which in turn leads to lower long-term rates. Now let’s consider the yield curve for corporate bonds. Recall that corporate bonds include a default-risk premium (DRP) and a liquidity premium (LP). Therefore, the yield on a corporate bond that matures in t years can be expressed as follows: rCt ⫽ r* ⫹ IPt ⫹ MRPt ⫹ DRPt ⫹ LPt. A corporate bond’s default and liquidity risks are affected by its maturity. For example, the default risk on Coca-Cola’s short-term debt is very small, since there is almost no chance that Coca-Cola will go bankrupt over the next few years. However, Coke has some 100-year bonds, and while the odds of Coke defaulting on these bonds still might not be high, the default risk on these bonds is considerably higher than that on its short-term debt.

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FIGURE 1-8

Corporate and Treasury Yield Curves

Interest Rate (%)

12 BBB-Rated Bond 10

AA-Rated Bond

8

Treasury Bond

6

4

2

10

0

20

30 Years to Maturity

Interest Rate

Term to Maturity

Treasury Bond

AA-Rated Bond

AA Spread over T-Bond

BBB-Rated Bond

BBB Spread over T-Bond

AA Spread over BBB

1 year 5 years 10 years 20 years 30 years

5.5% 6.1 6.8 7.4 7.7

6.7% 7.4 8.2 9.2 9.8

1.2% 1.3 1.4 1.8 2.1

7.4% 8.1 9.1 10.2 11.1

1.9% 2.0 2.3 2.8 3.4

0.7% 0.7 0.9 1.0 1.3

Longer-term corporate bonds are also less liquid than shorter-term debt, hence the liquidity premium rises as maturity lengthens. The primary reason for this is that, for the reasons discussed earlier, short-term debt has less default and interest rate risk, so a buyer can buy short-term debt without having to do as much credit checking as would be necessary for long-term debt. Thus, people can move into and out of shortterm corporate debt much more rapidly than long-term debt. The end result is that short-term corporate debt is more liquid, hence has a smaller liquidity premium than the same company’s long-term debt. Figure 1-8 shows yield curves for an AA-rated corporate bond with minimal default risk and a BBB-rated bond with more default risk, along with the yield curve for Treasury securities as taken from Panel a of Figure 1-7. Here we assume that inﬂation is expected to increase, so the Treasury yield curve is upward sloping. Because of their additional default and liquidity risk, corporate bonds always trade at a higher yield than Treasury bonds with the same maturity, and BBB-rated bonds trade at higher yields than AA-rated bonds. Finally, note that the yield spread between

39

An Overview of Corporate Finance and the Financial Environment Using the Yield Curve to Estimate Future Interest Rates

41

corporate bonds and Treasury bonds is larger the longer the maturity. This occurs because longer-term corporate bonds have more default and liquidity risk than shorterterm bonds, and both of these premiums are absent in Treasury bonds. How do maturity risk premiums affect the yield curve? If the rate of inﬂation is expected to increase, would this increase or decrease the slope of the yield curve? If the rate of inﬂation is expected to remain constant in the future, would the yield curve slope up, down, or be horizontal? Explain why corporate bonds’ default and liquidity premiums are likely to increase with maturity. Explain why corporate bonds always trade at higher yields than Treasury bonds and why BBB-rated bonds always trade at higher yields than otherwise similar AA-rated bonds.

Using the Yield Curve to Estimate Future Interest Rates17 In the last section we saw that the shape of the yield curve depends primarily on two factors: (1) expectations about future inﬂation and (2) the relative riskiness of securities with different maturities. We also saw how to calculate the yield curve, given inﬂation and maturity-related risks. In practice, this process often works in reverse: Investors and analysts plot the yield curve and then use information embedded in it to estimate the market’s expectations regarding future inﬂation and risk. This process of using the yield curve to estimate future expected interest rates is straightforward, provided (1) we focus on Treasury securities, and (2) we assume that all Treasury securities have the same risk; that is, there is no maturity risk premium. Some academics and practitioners contend that this second assumption is reasonable, at least as an approximation. They argue that the market is dominated by large bond traders who buy and sell securities of different maturities each day, that these traders focus only on short-term returns, and that they are not concerned with risk. According to this view, a bond trader is just as willing to buy a 30-year bond to pick up a short-term proﬁt as he would be to buy a three-month security. Strict proponents of this view argue that the shape of the yield curve is therefore determined only by market expectations about future interest rates, and this position has been called the pure expectations theory of the term structure of interest rates. The pure expectations theory (which is sometimes called the “expectations theory”) assumes that investors establish bond prices and interest rates strictly on the basis of expectations for interest rates. This means that they are indifferent with respect to maturity in the sense that they do not view long-term bonds as being riskier than short-term bonds. If this were true, then the maturity risk premium (MRP) would be zero, and long-term interest rates would simply be a weighted average of current and expected future short-term interest rates. For example, if 1-year Treasury bills currently yield 7 percent, but 1-year bills were expected to yield 7.5 percent a

17

This section is relatively technical, but instructors can omit it without loss of continuity.

40

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year from now, investors would expect to earn an average of 7.25 percent over the next two years:18 7% ⫹ 7.5% ⫽ 7.25%. 2 According to the expectations theory, this implies that a 2-year Treasury note purchased today should yield 7.25 percent. Similarly, if 10-year bonds yield 9 percent today, and if 5-year bonds are expected to yield 7.5 percent 10 years from now, then investors should expect to earn 9 percent for 10 years and 7.5 percent for 5 years, for an average return of 8.5 percent over the next 15 years: 10(9%) ⫹ 5(7.5%) 9% ⫹ 9% ⫹ ⭈ ⭈ ⭈ ⫹ 9% ⫹ 7.5% ⫹ ⭈ ⭈ ⭈ ⫹ 7.5% ⫽ ⫽ 8.5%. 15 15 Consequently, a 15-year bond should yield this same return, 8.5 percent. To understand the logic behind this averaging process, ask yourself what would happen if long-term yields were not an average of expected short-term yields. For example, suppose 2-year bonds yielded only 7 percent, not the 7.25 percent calculated above. Bond traders would be able to earn a proﬁt by adopting the following trading strategy: 1. Borrow money for two years at a cost of 7 percent. 2. Invest the money in a series of 1-year bonds. The expected return over the 2-year period would be (7.0 ⫹ 7.5)/2 ⫽ 7.25%. In this case, bond traders would rush to borrow money (demand funds) in the 2year market and invest (or supply funds) in the 1-year market. Recall from Figure 1-3 that an increase in the demand for funds raises interest rates, whereas an increase in the supply of funds reduces interest rates. Therefore, bond traders’ actions would push up the 2-year yield but reduce the yield on 1-year bonds. The net effect would be to bring about a market equilibrium in which 2-year rates were a weighted average of expected future 1-year rates. Under these assumptions, we can use the yield curve to “back out” the bond market’s best guess about future interest rates. If, for example, you observe that Treasury securities with 1- and 2-year maturities yield 7 percent and 8 percent, respectively, this information can be used to calculate the market’s forecast of what 1-year rates will yield one year from now. If the pure expectations theory is correct, the rate on 2-year bonds is the average of the current 1-year rate and the 1-year rate expected a year from now. Since the current 1-year rate is 7 percent, this implies that the 1-year rate one year from now is expected to be 9 percent: 7% ⫹ X% 2 X ⫽ 16% ⫺ 7% ⫽ 9% ⫽ 1-year yield expected next year. 2-year yield ⫽ 8% ⫽

18

Technically, we should be using geometric averages rather than arithmetic averages, but the differences are not material in this example. In this example, we would set up the following equation: (1 ⫹ 0.07)(1.075) ⫽ (1 ⫹ X)2. The left side is the amount we would have if we invested $1 at 7 percent for one year and then reinvested the original $1 and the $0.07 interest for an additional year at the rate of 7.5 percent. The right side is the total amount we would have if instead we had invested $1 at the rate X percent for two years. Solving for X, we ﬁnd that the true two-year yield is 7.2497 percent. Since this is virtually identical to the arithmetic average of 7.25 percent, we simply use arithmetic averages. For a discussion of this point, see Robert C. Radcliffe, Investment: Concepts, Analysis, and Strategy, 5th ed. (Reading, MA: Addison-Wesley, 1997), Chapter 5.

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An Overview of Corporate Finance and the Financial Environment Investing Overseas

43

The preceding analysis was based on the assumption that the maturity risk premium is zero. However, most evidence suggests that there is a positive maturity risk premium, so the MRP should be taken into account. For example, assume once again that 1- and 2-year maturities yield 7 percent and 8 percent, respectively, but now assume that the maturity risk premium on the 2-year bond is 0.5 percent. This maturity risk premium implies that the expected return on 2-year bonds (8 percent) is 0.5 percent higher than the expected returns from buying a series of 1-year bonds (7.5 percent). With this background, we can use the following two-step procedure to back out X, the expected 1-year rate one year from now: Step 1: Step 2:

2-year yield ⫺ MRP on 2-year bond ⫽ 8.0% ⫺ 0.5% ⫽ 7.5%. 7.5% ⫽ (7.0% ⫹ X%)/2 X ⫽ 15.0% ⫺ 7.0% ⫽ 8.0%.

Therefore, the yield next year on a 1-year T-bond should be 8 percent, up from 7 percent this year. What key assumption underlies the pure expectations theory? Assuming that the pure expectations theory is correct, how are long-term interest rates calculated? According to the pure expectations theory, what would happen if long-term rates were not an average of expected short-term rates?

Investing Overseas

Euromoney magazine publishes ranking, based on country risk. Students can access the home page of Euromoney magazine by typing http://www. euromoney.com. Although the site requires users to register, the site is free to use (although some data sets and articles are available only to subscribers.) Yahoo also provides country risk evaluations at http://biz.yahoo.com/ifc/.

Investors should consider additional risk factors before investing overseas. First there is country risk, which refers to the risk that arises from investing or doing business in a particular country. This risk depends on the country’s economic, political, and social environment. Countries with stable economic, social, political, and regulatory systems provide a safer climate for investment, and therefore have less country risk, than less stable nations. Examples of country risk include the risk associated with changes in tax rates, regulations, currency conversion, and exchange rates. Country risk also includes the risk that property will be expropriated without adequate compensation, as well as new host country stipulations about local production, sourcing or hiring practices, and damage or destruction of facilities due to internal strife. A second thing to keep in mind when investing overseas is that more often than not the security will be denominated in a currency other than the dollar, which means that the value of your investment will depend on what happens to exchange rates. This is known as exchange rate risk. For example, if a U.S. investor purchases a Japanese bond, interest will probably be paid in Japanese yen, which must then be converted into dollars if the investor wants to spend his or her money in the United States. If the yen weakens relative to the dollar, then it will buy fewer dollars, hence the investor will receive fewer dollars when it comes time to convert. Alternatively, if the yen strengthens relative to the dollar, the investor will earn higher dollar returns. It therefore follows that the effective rate of return on a foreign investment will depend on both the performance of the foreign security and on what happens to exchange rates over the life of the investment. What is country risk? What is exchange rate risk?

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Other Factors That Inﬂuence Interest Rate Levels In addition to inﬂationary expectations, other factors also inﬂuence both the general level of interest rates and the shape of the yield curve. The four most important factors are (1) Federal Reserve policy; (2) the federal budget deﬁcit or surplus; (3) international factors, including the foreign trade balance and interest rates in other countries; and (4) the level of business activity.

Federal Reserve Policy The home page for the Board of Governors of the Federal Reserve System can be found at http:// www.federalreserve.gov. You can access general information about the Federal Reserve, including press releases, speeches, and monetary policy.

As you probably learned in your economics courses, (1) the money supply has a major effect on both the level of economic activity and the inﬂation rate, and (2) in the United States, the Federal Reserve Board controls the money supply. If the Fed wants to stimulate the economy, it increases growth in the money supply. The initial effect would be to cause interest rates to decline. However, a larger money supply may also lead to an increase in expected inﬂation, which would push interest rates up. The reverse holds if the Fed tightens the money supply. To illustrate, in 1981 inﬂation was quite high, so the Fed tightened up the money supply. The Fed deals primarily in the short end of the market, so this tightening had the direct effect of pushing short-term rates up sharply. At the same time, the very fact that the Fed was taking strong action to reduce inﬂation led to a decline in expectations for long-run inﬂation, which led to a decline in long-term bond yields. In 2000 and 2001, the situation was reversed. To stimulate the economy, the Fed took steps to reduce interest rates. Short-term rates fell, and long-term rates also dropped, but not as sharply. These lower rates beneﬁtted heavily indebted businesses and individual borrowers, and home mortgage reﬁnancings put additional billions of dollars into consumers’ pockets. Savers, of course, lost out, but lower interest rates encouraged businesses to borrow for investment, stimulated the housing market, and brought down the value of the dollar relative to other currencies, which helped U.S. exporters and thus lowered the trade deﬁcit. During periods when the Fed is actively intervening in the markets, the yield curve may be temporarily distorted. Short-term rates will be temporarily “too low” if the Fed is easing credit, and “too high” if it is tightening credit. Long-term rates are not affected as much by Fed intervention. For example, the fear of a recession led the Federal Reserve to cut short-term interest rates eight times between May 2000 and October 2001. While short-term rates fell by 3.5 percentage point, long-term rates went down only 0.7 percentage points.

Budget Deﬁcits or Surpluses If the federal government spends more than it takes in from tax revenues, it runs a deﬁcit, and that deﬁcit must be covered either by borrowing or by printing money (increasing the money supply). If the government borrows, this added demand for funds pushes up interest rates. If it prints money, this increases expectations for future inﬂation, which also drives up interest rates. Thus, the larger the federal deﬁcit, other things held constant, the higher the level of interest rates. Whether long- or shortterm rates are more affected depends on how the deﬁcit is ﬁnanced, so we cannot state, in general, how deﬁcits will affect the slope of the yield curve. Over the past several decades, the federal government routinely ran large budget deﬁcits. However, in 1999, for the ﬁrst time in recent memory, the government had a

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An Overview of Corporate Finance and the Financial Environment Other Factors That Inﬂuence Interest Rate Levels

45

budget surplus. As a result, the government paid back existing debt faster than it issued new debt. The net result was a decrease in the national debt. If these surpluses had continued, the government would be a net supplier of funds rather than a net borrower. However, the events of 9/11, when combined with the current recession and the Bush administration’s tax cuts, have caused a current budget deﬁcit.

International Factors Businesses and individuals in the United States buy from and sell to people and ﬁrms in other countries. If we buy more than we sell (that is, if we import more than we export), we are said to be running a foreign trade deﬁcit. When trade deﬁcits occur, they must be ﬁnanced, and the main source of ﬁnancing is debt. In other words, if we import $200 billion of goods but export only $100 billion, we run a trade deﬁcit of $100 billion, and we would probably borrow the $100 billion.19 Therefore, the larger our trade deﬁcit, the more we must borrow, and as we increase our borrowing, this drives up interest rates. Also, foreigners are willing to hold U.S. debt if and only if the rate paid on this debt is competitive with interest rates in other countries. Therefore, if the Federal Reserve attempts to lower interest rates in the United States, causing our rates to fall below rates abroad, then foreigners will sell U.S. bonds, those sales will depress bond prices, and that in turn will result in higher U.S. rates. Thus, if the trade deﬁcit is large relative to the size of the overall economy, it will hinder the Fed’s ability to combat a recession by lowering interest rates. The United States has been running annual trade deﬁcits since the mid-1970s, and the cumulative effect of these deﬁcits is that the United States has become the largest debtor nation of all time. As a result, our interest rates are very much inﬂuenced by interest rates in other countries around the world—higher rates abroad lead to higher U.S. rates, and vice versa. Because of all this, U.S. corporate treasurers—and anyone else who is affected by interest rates—must keep up with developments in the world economy.

Business Activity Figure 1-4, presented earlier, can be examined to see how business conditions inﬂuence interest rates. Here are the key points revealed by the graph: 1. Because inﬂation increased from 1961 to 1981, the general tendency during that period was toward higher interest rates. However, since the 1981 peak, the trend has generally been downward. 2. Until 1966, short-term rates were almost always below long-term rates. Thus, in those years the yield curve was almost always “normal” in the sense that it was upward sloping. 3. The shaded areas in the graph represent recessions, during which (a) both the demand for money and the rate of inﬂation tend to fall and (b) the Federal Reserve tends to increase the money supply in an effort to stimulate the economy. As a result, there is a tendency for interest rates to decline during recessions. For example, on three different occasions in 1998 the Fed lowered rates by 25 basis points to

19

The deﬁcit could also be ﬁnanced by selling assets, including gold, corporate stocks, entire companies, and real estate. The United States has ﬁnanced its massive trade deﬁcits by all of these means in recent years, but the primary method has been by borrowing from foreigners.

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combat the deepening global economic and ﬁnancial crisis. When the economy is growing rapidly and inﬂation threatens, the Fed raises interest rates, as it did six times in 1999 and early 2000. The Fed gave four reasons for the rate hikes: healthy ﬁnancial markets, a persistent strength in domestic demand, ﬁrmer foreign economies, and a tight labor market. Currently, in early 2002, we are in a period of recession, and the Fed has cut rates eleven times since mid-2000. 4. During recessions, short-term rates decline more sharply than long-term rates. This occurs because (a) the Fed operates mainly in the short-term sector, so its intervention has the strongest effect there, and (b) long-term rates reﬂect the average expected inﬂation rate over the next 20 to 30 years, and this expectation generally does not change much, even when the current inﬂation rate is low because of a recession or high because of a boom. So, short-term rates are more volatile than long-term rates. Other than inﬂationary expectations, name some additional factors that inﬂuence interest rates, and explain the effects of each. How does the Fed stimulate the economy? How does the Fed affect interest rates? Does the Fed have complete control over U.S. interest rates; that is, can it set rates at any level it chooses?

Organization of the Book The primary goal of a manager should be to maximize the value of his or her ﬁrm. To achieve this goal, managers must have a general understanding of how businesses are organized, how ﬁnancial markets operate, how interest rates are determined, how the tax system operates, and how accounting data are used to evaluate a business’s performance. In addition, managers must have a good understanding of such fundamental concepts as the time value of money, risk measurement, asset valuation, and techniques for evaluating speciﬁc investment opportunities. This background information is essential for anyone involved with the kinds of decisions that affect the value of a ﬁrm’s securities. The book’s organization reﬂects these considerations. Part One contains the basic building blocks of ﬁnance, beginning here in Chapter 1 with an overview of corporate ﬁnance and the ﬁnancial markets. Then, in Chapters 2 and 3, we cover two of the most important concepts in ﬁnance—the time value of money and the relationship between risk and return. Part Two covers the valuation of securities and projects. Chapter 4 focuses on bonds, and Chapter 5 considers stocks. Both chapters describe the relevant institutional details, then explain how risk and time value jointly determine stock and bond prices. Then, in Chapter 6, we explain how to measure the cost of capital, which is the rate of return that investors require on capital used to fund a company’s projects. Chapter 7 goes on to show how we determine whether a potential project will add value to the ﬁrm, while Chapter 8 shows how to estimate the size and risk of the cash ﬂows that a project will produce. Part Three addresses the issue of corporate valuation. Chapter 9 describes the key ﬁnancial statements, discusses what these statements are designed to do, and then explains how our tax system affects earnings, cash ﬂows, stock prices, and managerial decisions. Chapter 10 shows how to use ﬁnancial statements to identify a ﬁrm’s strengths and weaknesses, and Chapter 11 develops techniques for forecasting future ﬁnancial

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An Overview of Corporate Finance and the Financial Environment Summary

47

statements. Finally, Chapter 12 shows how to use its cost of capital and projected ﬁnancial statements to determine a corporation’s value. The corporate valuation model is useful to investors, and it also allows managers to estimate the impact that proposed changes in operating strategies will have on the value of the corporation. Chapter 12 concludes with a discussion of corporate governance, which has a direct impact on how much value companies create for their shareholders. Part Four discusses corporate ﬁnancing decisions, which means how money should be raised. Chapter 13 examines capital structure theory, or the issue of how much debt versus equity the ﬁrm should use. Then, Chapter 14 considers the ﬁrm’s distribution policy; that is, how much of the net income should be retained for reinvestment versus being paid out, either as a dividend or as a share repurchase? Finally, in Part Five, we address several special topics that draw upon the earlier chapters, including multinational ﬁnancial management, working capital management, option pricing, and real options. It is worth noting that instructors may cover the chapters in a different sequence from the order in the book. The chapters are written in a modular, self-contained manner, so such reordering should present no major difﬁculties.

e-Resources Corporate Finance’s web site at http://ehrhardt.swcollege.com contains several types of ﬁles: 1. It contains Excel ﬁles, called Tool Kits, that provide well documented models for almost all of the text’s calculations. Not only will these Tool Kits help you with this ﬁnance course, but they will serve as tool kits for you in other courses and in your career. 2. There are problems at the end of the chapters that require spreadsheets, and the web site contains the models you will need to begin work on these problems. 3. The web site also contains PowerPoint and Excel ﬁles that correspond to the Mini Cases at the end of each chapter. When we think it might be helpful for you to look at one of the web site’s ﬁles, we’ll show an icon in the margin like the one that is shown here. Other resources are also on the web page, including Web Safaris, which are links to useful web data and descriptions for navigating the sites to access the data.

Summary In this chapter, we provided an overview of corporate ﬁnance and of the ﬁnancial environment. We discussed the nature of ﬁnancial markets, the types of institutions that operate in these markets, and how interest rates are determined. In later chapters we will use this information to help value different investments, and to better understand corporate ﬁnancing and investing decisions. The key concepts covered are listed below: 䊉

The three main forms of business organization are the sole proprietorship, the partnership, and the corporation.

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An Overview of Corporate Finance and the Financial Environment 48

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An Overview of Corporate Finance and the Financial Environment 䊉

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Although each form of organization offers advantages and disadvantages, corporations conduct most business in the United States because this organizational form maximizes larger ﬁrms’ values. The primary objective of management should be to maximize stockholders’ wealth, and this means maximizing the stock price. Legal actions that maximize stock prices usually increase social welfare. Firms increase cash ﬂows by creating value for customers, suppliers, and employees. Three factors determine cash ﬂows: (1) sales, (2) after-tax operating proﬁt margins, and (3) capital requirements. The price of a ﬁrm’s stock depends on the size of the ﬁrm’s cash ﬂows, the timing of those ﬂows, and their risk. The size and risk of the cash ﬂows are affected by the ﬁnancial environment as well as the investment, ﬁnancing, and dividend policy decisions made by ﬁnancial managers. There are many different types of ﬁnancial markets. Each market serves a different region or deals with a different type of security. Physical asset markets, also called tangible or real asset markets, are those for such products as wheat, autos, and real estate. Financial asset markets deal with stocks, bonds, notes, mortgages, and other claims on real assets. Spot markets and futures markets are terms that refer to whether the assets are bought or sold for “on-the-spot” delivery or for delivery at some future date. Money markets are the markets for debt securities with maturities of less than one year. Capital markets are the markets for long-term debt and corporate stocks. Primary markets are the markets in which corporations raise new capital. Secondary markets are markets in which existing, already outstanding, securities are traded among investors. A derivative is a security whose value is derived from the price of some other “underlying” asset. Transfers of capital between borrowers and savers take place (1) by direct transfers of money and securities; (2) by transfers through investment banking houses, which act as middlemen; and (3) by transfers through ﬁnancial intermediaries, which create new securities. The major intermediaries include commercial banks, savings and loan associations, mutual savings banks, credit unions, pension funds, life insurance companies, and mutual funds. One result of ongoing regulatory changes has been a blurring of the distinctions between the different ﬁnancial institutions. The trend in the United States has been toward ﬁnancial service corporations that offer a wide range of ﬁnancial services, including investment banking, brokerage operations, insurance, and commercial banking. The stock market is an especially important market because this is where stock prices (which are used to “grade” managers’ performances) are established. There are two basic types of stock markets—the physical location exchanges (such as NYSE) and computer/telephone networks (such as Nasdaq). Orders from buyers and sellers can be matched in one of three ways: (1) in an open outcry auction; (2) through dealers; and (3) automatically through an electronic communications network (ECN). Capital is allocated through the price system—a price must be paid to “rent” money. Lenders charge interest on funds they lend, while equity investors receive dividends and capital gains in return for letting ﬁrms use their money.

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An Overview of Corporate Finance and the Financial Environment Questions 䊉

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Four fundamental factors affect the cost of money: (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inﬂation. The risk-free rate of interest, rRF, is deﬁned as the real risk-free rate, r*, plus an inﬂation premium, IP, hence rRF ⫽ r* ⫹ IP. The nominal (or quoted) interest rate on a debt security, r, is composed of the real risk-free rate, r*, plus premiums that reﬂect inﬂation (IP), default risk (DRP), liquidity (LP), and maturity risk (MRP): r ⫽ r* ⫹ IP ⫹ DRP ⫹ LP ⫹ MRP.

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If the real risk-free rate of interest and the various premiums were constant over time, interest rates would be stable. However, both the real rate and the premiums—especially the premium for expected inﬂation—do change over time, causing market interest rates to change. Also, Federal Reserve intervention to increase or decrease the money supply, as well as international currency ﬂows, lead to ﬂuctuations in interest rates. The relationship between the yields on securities and the securities’ maturities is known as the term structure of interest rates, and the yield curve is a graph of this relationship. The shape of the yield curve depends on two key factors: (1) expectations about future inﬂation and (2) perceptions about the relative riskiness of securities with different maturities. The yield curve is normally upward sloping—this is called a normal yield curve. However, the curve can slope downward (an inverted yield curve) if the inﬂation rate is expected to decline. The yield curve can be humped, which means that interest rates on medium-term maturities are higher than rates on both short- and long-term maturities.

Questions 1–1

Deﬁne each of the following terms: a. Sole proprietorship; partnership; corporation b. Limited partnership; limited liability partnership; professional corporation c. Stockholder wealth maximization d. Money market; capital market; primary market; secondary market e. Private markets; public markets; derivatives f. Investment banker; ﬁnancial service corporation; ﬁnancial intermediary g. Mutual fund; money market fund h. Physical location exchanges; computer/telephone network i. Open outcry auction; dealer market; electronic communications network (ECN) j. Production opportunities; time preferences for consumption k. Real risk-free rate of interest, r*; nominal risk-free rate of interest, rRF l. Inﬂation premium (IP); default risk premium (DRP); liquidity; liquidity premium (LP) m. Interest rate risk; maturity risk premium (MRP); reinvestment rate risk n. Term structure of interest rates; yield curve o. “Normal” yield curve; inverted (“abnormal”) yield curve p. Expectations theory q. Foreign trade deﬁcit

1–2

What are the three principal forms of business organization? What are the advantages and disadvantages of each?

1–3

What are the three primary determinants of a ﬁrm’s cash ﬂow?

1–4

What are ﬁnancial intermediaries, and what economic functions do they perform?

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An Overview of Corporate Finance and the Financial Environment 50

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An Overview of Corporate Finance and the Financial Environment 1–5

Which ﬂuctuate more, long-term or short-term interest rates? Why?

1–6

Suppose the population of Area Y is relatively young while that of Area O is relatively old, but everything else about the two areas is equal. a. Would interest rates likely be the same or different in the two areas? Explain. b. Would a trend toward nationwide branching by banks and savings and loans, and the development of nationwide diversiﬁed ﬁnancial corporations, affect your answer to part a?

1–7

Suppose a new and much more liberal Congress and administration were elected, and their ﬁrst order of business was to take away the independence of the Federal Reserve System, and to force the Fed to greatly expand the money supply. What effect would this have a. On the level and slope of the yield curve immediately after the announcement? b. On the level and slope of the yield curve that would exist two or three years in the future?

1–8

It is a fact that the federal government (1) encouraged the development of the savings and loan industry; (2) virtually forced the industry to make long-term, ﬁxed-interest-rate mortgages; and (3) forced the savings and loans to obtain most of their capital as deposits that were withdrawable on demand. a. Would the savings and loans have higher proﬁts in a world with a “normal” or an inverted yield curve? b. Would the savings and loan industry be better off if the individual institutions sold their mortgages to federal agencies and then collected servicing fees or if the institutions held the mortgages that they originated?

Self-Test Problem ST–1 INFLATION RATES

(Solution Appears in Appendix A)

Assume that it is now January 1. The rate of inﬂation is expected to be 4 percent throughout the year. However, increased government deﬁcits and renewed vigor in the economy are then expected to push inﬂation rates higher. Investors expect the inﬂation rate to be 5 percent in Year 2, 6 percent in Year 3, and 7 percent in Year 4. The real risk-free rate, r*, is expected to remain at 2 percent over the next 5 years. Assume that no maturity risk premiums are required on bonds with 5 years or less to maturity. The current interest rate on 5-year T-bonds is 8 percent. a. What is the average expected inﬂation rate over the next 4 years? b. What should be the prevailing interest rate on 4-year T-bonds? c. What is the implied expected inﬂation rate in Year 5, given that Treasury bonds which mature at the end of that year yield 8 percent?

Problems 1–1 EXPECTED RATE OF INTEREST

1–2 DEFAULT RISK PREMIUM

1–3 EXPECTED RATE OF INTEREST

1–4 MATURITY RISK PREMIUM

1–5 EXPECTED RATE OF INTEREST

The real risk-free rate of interest is 3 percent. Inﬂation is expected to be 2 percent this year and 4 percent during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities? A Treasury bond that matures in 10 years has a yield of 6 percent. A 10-year corporate bond has a yield of 8 percent. Assume that the liquidity premium on the corporate bond is 0.5 percent. What is the default risk premium on the corporate bond? One-year Treasury securities yield 5 percent. The market anticipates that 1 year from now, 1year Treasury securities will yield 6 percent. If the pure expectations hypothesis is correct, what should be the yield today for 2-year Treasury securities? The real risk-free rate is 3 percent, and inﬂation is expected to be 3 percent for the next 2 years. A 2-year Treasury security yields 6.2 percent. What is the maturity risk premium for the 2-year security? Interest rates on 1-year Treasury securities are currently 5.6 percent, while 2-year Treasury securities are yielding 6 percent. If the pure expectations theory is correct, what does the market believe will be the yield on 1-year securities 1 year from now?

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An Overview of Corporate Finance and the Financial Environment Spreadsheet Problem 1–6 EXPECTED RATE OF INTEREST

1–7 EXPECTED RATE OF INTEREST

1–8 EXPECTED RATE OF INTEREST

1–9 EXPECTED RATE OF INTEREST

1–10 MATURITY RISK PREMIUM

1–11 INTEREST RATES

1–12 YIELD CURVES

51

Interest rates on 4-year Treasury securities are currently 7 percent, while interest rates on 6year Treasury securities are currently 7.5 percent. If the pure expectations theory is correct, what does the market believe that 2-year securities will be yielding 4 years from now? The real risk-free rate is 3 percent. Inﬂation is expected to be 3 percent this year, 4 percent next year, and then 3.5 percent thereafter. The maturity risk premium is estimated to be 0.0005 ⫻ (t ⫺ 1), where t ⫽ number of years to maturity. What is the nominal interest rate on a 7-year Treasury security? Suppose the annual yield on a 2-year Treasury security is 4.5 percent, while that on a 1-year security is 3 percent. r* is 1 percent, and the maturity risk premium is zero. a. Using the expectations theory, forecast the interest rate on a 1-year security during the second year. (Hint: Under the expectations theory, the yield on a 2-year security is equal to the average yield on 1-year securities in Years 1 and 2.) b. What is the expected inﬂation rate in Year 1? Year 2? Assume that the real risk-free rate is 2 percent and that the maturity risk premium is zero. If the nominal rate of interest on 1-year bonds is 5 percent and that on comparable-risk 2-year bonds is 7 percent, what is the 1-year interest rate that is expected for Year 2? What inﬂation rate is expected during Year 2? Comment on why the average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2. Assume that the real risk-free rate, r*, is 3 percent and that inﬂation is expected to be 8 percent in Year 1, 5 percent in Year 2, and 4 percent thereafter. Assume also that all Treasury securities are highly liquid and free of default risk. If 2-year and 5-year Treasury notes both yield 10 percent, what is the difference in the maturity risk premiums (MRPs) on the two notes; that is, what is MRP5 minus MRP2? Due to a recession, the inﬂation rate expected for the coming year is only 3 percent. However, the inﬂation rate in Year 2 and thereafter is expected to be constant at some level above 3 percent. Assume that the real risk-free rate is r* ⫽ 2% for all maturities and that the expectations theory fully explains the yield curve, so there are no maturity premiums. If 3-year Treasury notes yield 2 percentage points more than 1-year notes, what inﬂation rate is expected after Year 1? Suppose you and most other investors expect the inﬂation rate to be 7 percent next year, to fall to 5 percent during the following year, and then to remain at a rate of 3 percent thereafter. Assume that the real risk-free rate, r*, will remain at 2 percent and that maturity risk premiums on Treasury securities rise from zero on very short-term securities (those that mature in a few days) to a level of 0.2 percentage point for 1-year securities. Furthermore, maturity risk premiums increase 0.2 percentage point for each year to maturity, up to a limit of 1.0 percentage point on 5-year or longer-term T-notes and T-bonds. a. Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury securities, and plot the yield curve. b. Now suppose Exxon Mobil, an AAA-rated company, had bonds with the same maturities as the Treasury bonds. As an approximation, plot an Exxon Mobil yield curve on the same graph with the Treasury bond yield curve. (Hint: Think about the default risk premium on Exxon Mobil’s long-term versus its short-term bonds.) c. Now plot the approximate yield curve of Long Island Lighting Company, a risky nuclear utility.

Spreadsheet Problem 1–13 BUILD A MODEL: ANALYZING INTEREST RATES

a. Start with the partial model in the ﬁle Ch 01 P13 Build a Model.xls from the textbook’s web site. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4 percent, and inﬂation is expected to be 2 percent for the next two years, 3 percent for the following four years, and 4 percent thereafter. The maturity risk premium is estimated by this formula: MRP ⫽ 0.1%

50

An Overview of Corporate Finance and the Financial Environment 52

CHAPTER 1

An Overview of Corporate Finance and the Financial Environment (t ⫺ 1). The liquidity premium for the corporate bond is estimated to be 0.7 percent. Finally, you may determine the default risk premium, given the company’s bond rating, from the default risk premium table in the text. What yield would you predict for each of these two investments? b. Given the following Treasury bond yield information from the September 28, 2001, Federal Reserve Statistical Release, construct a graph of the yield curve as of that date. Maturity

Yield

3 months 6 months 1 year 2 years 3 years 5 years 10 years 20 years 30 years

2.38% 2.31 2.43 2.78 3.15 3.87 4.58 5.46 5.45

c. Based on the information about the corporate bond that was given in part a, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. d. Using the Treasury yield information above, calculate the following forward rates: (1) The 1-year rate, one year from now. (2) The 5-year rate, ﬁve years from now. (3) The 10-year rate, ten years from now. (4) The 10-year rate, twenty years from now.

See Ch 01 Show.ppt and Ch 01 Mini Case.xls.

Assume that you recently graduated with a degree in ﬁnance and have just reported to work as an investment advisor at the brokerage ﬁrm of Balik and Kiefer Inc. One of the ﬁrm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel that she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and, therefore, she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions which you must ask and answer to explain the U.S. ﬁnancial system to DellaTorre. a. Why is corporate ﬁnance important to all managers? b. (1) What are the alternative forms of business organization? (2) What are their advantages and disadvantages? c. What should be the primary objective of managers? (1) Do ﬁrms have any responsibilities to society at large? (2) Is stock price maximization good or bad for society? (3) Should ﬁrms behave ethically? d. What factors affect stock prices? e. What factors determine cash ﬂows? f. What factors affect the level and risk of cash ﬂows? g. What are ﬁnancial assets? Describe some ﬁnancial instruments. h. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers? i. List some ﬁnancial intermediaries. j. What are some different types of markets? k. How are secondary markets organized? (1) List some physical location markets and some computer/telephone networks. (2) Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs).

51

An Overview of Corporate Finance and the Financial Environment Selected Additional References

53

l. What do we call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? m. What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How are these two rates measured? n. Deﬁne the terms inﬂation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed above. o. What is the term structure of interest rates? What is a yield curve? p. Suppose most investors expect the inﬂation rate to be 5 percent next year, 6 percent the following year, and 8 percent thereafter. The real risk-free rate is 3 percent. The maturity risk premium is zero for securities that mature in 1 year or less, 0.1 percent for 2-year securities, and then the MRP increases by 0.1 percent per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-year, 10-year, and 20-year Treasury securities? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping? q. At any given time, how would the yield curve facing an AAA-rated company compare with the yield curve for U.S. Treasury securities? At any given time, how would the yield curve facing a BB-rated company compare with the yield curve for U.S. Treasury securities? Draw a graph to illustrate your answer. r. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates? s. Suppose that you observe the following term structure for Treasury securities: Maturity

Yield

1 year 2 years 3 years 4 years 5 years

6.0% 6.2 6.4 6.5 6.5

Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve given above to “back out” the market’s expectations about future interest rates.) What does the market expect will be the interest rate on 1-year securities one year from now? What does the market expect will be the interest rate on 3-year securities two years from now? t. Finally, DellaTorre is also interested in investing in countries other than the United States. Describe the various types of risks that arise when investing overseas.

Selected Additional References For alternative views on ﬁrms’ goals and objectives, see the following articles:

For a general review of academic ﬁnance, together with an extensive bibliography of key research articles, see

Cornell, Bradford, and Alan C. Shapiro, “Corporate Stakeholders and Corporate Finance,” Financial Management, Spring 1987, 5–14. Seitz, Neil, “Shareholder Goals, Firm Goals and Firm Financing Decisions,” Financial Management, Autumn 1982, 20–26.

Brennan, Michael J., “Corporate Finance Over the Past 25 Years,” Financial Management, Summer 1995, 9–22. Cooley, Philip L., and J. Louis Heck, “Signiﬁcant Contributions to Finance Literature,” Financial Management, Tenth Anniversary Issue 1981, 23–33.

52

An Overview of Corporate Finance and the Financial Environment 54

CHAPTER 1

An Overview of Corporate Finance and the Financial Environment

Textbooks that focus on interest rates and ﬁnancial markets include Fabozzi, Frank J., Bond Markets: Analysis and Strategies (Englewood Cliffs, NJ: Prentice-Hall, 1992). Johnson, Hazel J., Financial Institutions and Markets: A Global Perspective (New York: McGraw-Hill, 1993). Kidwell, David S., Richard Peterson, and David Blackwell, Financial Institutions, Markets, and Money (Fort Worth, TX: The Dryden Press, 1993). Kohn, Mier, Money, Banking, and Financial Markets (Fort Worth, TX: The Dryden Press, 1993). Livingston, Miles, Money and Capital Markets (Cambridge, MA: Blackwell, 1996).

Smith, Stephen D., and Raymond E. Spudeck, Interest Rates: Theory and Application (Fort Worth, TX: The Dryden Press, 1993). For additional information on ﬁnancial institutions, see Greenbaum, Stuart I., and Anjan V. Thakor, Contemporary Financial Intermediation (Fort Worth, TX: The Dryden Press, 1995). Kaufman, George G., The U.S. Financial System (Englewood Cliffs, NJ: Prentice-Hall, 1995).

Time Value of Money1

22

Will you be able to retire? Your reaction to this question is probably, “First things ﬁrst! I’m worried about getting a job, not retiring!” However, an awareness of the retirement situation could help you land a job because (1) this is an important issue today, (2) employers prefer to hire people who know the issues, and (3) professors often test students on time value of money with problems related to saving for some future purpose, including retirement. So read on. A recent Fortune article began with some interesting facts: (1) The U.S. savings rate is the lowest of any industrial nation. (2) The ratio of U.S. workers to retirees, which was 17 to 1 in 1950, is now down to 3.2 to 1, and it will decline to less than 2 to 1 after 2020. (3) With so few people paying into the Social Security System and so many drawing funds out, Social Security may soon be in serious trouble. The article concluded that even people making $85,000 per year will have trouble maintaining a reasonable standard of living after they retire, and many of today’s college students will have to support their parents. If Ms. Jones, who earns $85,000, retires in 2002, expects to live for another 20 years after retirement, and needs 80 percent of her pre-retirement income, she would require $68,000 during 2002. However, if inﬂation amounts to 5 percent per year, her income requirement would increase to $110,765 in 10 years and to $180,424 in 20 years. If inﬂation were 7 percent, her Year 20 requirement would jump to $263,139! How much wealth would Ms. Jones need at retirement to maintain her standard of living, and how much would she have had to save during each working year to accumulate that wealth? The answer depends on a number of factors, including the rate she could earn on savings, the inﬂation rate, and when her savings program began. Also, the answer would depend on how much she will get from Social Security and from her corporate retirement plan, if she has one. (She might not get much from Social Security unless she is really down and out.) Note, too, that her plans could be upset if the inﬂation rate increased, if the return on her savings changed, or if she lived beyond 20 years. Fortune and other organizations have done studies relating to the retirement issue, using the tools and techniques described in this chapter. The general conclusion is that most Americans have been putting their heads in the sand—many of us have been ignoring what is almost certainly going to be a huge personal and social problem. But if you study this chapter carefully, you can avoid the trap that seems to be catching so many people.

1

This chapter was written on the assumption that most students will have a ﬁnancial calculator or personal computer. Calculators are relatively inexpensive, and students who cannot use them run the risk of being deemed obsolete and uncompetitive before they even graduate. Therefore, the chapter has been written to include a discussion of ﬁnancial calculator solutions along with computer solutions using Excel. Note also that tutorials on how to use both Excel and several Hewlett-Packard, Texas Instruments, and Sharp calculators are provided in the Technology Supplement to this book, which is available to adopting instructors.

55

53

54

Time Value of Money 56

CHAPTER 2

Time Value of Money

In Chapter 1, we saw that the primary objective of ﬁnancial management is to maximize the value of the ﬁrm’s stock. We also saw that stock values depend in part on the timing of the cash ﬂows investors expect to receive from an investment—a dollar exExcellent retirement calcula- pected soon is worth more than a dollar expected in the distant future. Therefore, it is tors are available at http:// essential for ﬁnancial managers to have a clear understanding of the time value of www.ssa.gov and http:// money and its impact on stock prices. These concepts are discussed in this chapter, www.asec.org. These allow where we show how the timing of cash ﬂows affects asset values and rates of return. you to input hypothetical The principles of time value analysis have many applications, ranging from setting retirement savings inforup schedules for paying off loans to decisions about whether to acquire new equipmation, and the program shows graphically if current ment. In fact, of all the concepts used in ﬁnance, none is more important than the time value retirement savings will be of money, which is also called discounted cash ﬂow (DCF) analysis. Since this consufﬁcient to meet retirement cept is used throughout the remainder of the book, it is vital that you understand the needs. material in this chapter before you move on to other topics.

Time Lines One of the most important tools in time value analysis is the time line, which is used by analysts to help visualize what is happening in a particular problem and then to help set up the problem for solution. To illustrate the time line concept, consider the following diagram: The textbook’s web site contains an Excel ﬁle that will guide you through the chapter’s calculations. The ﬁle for this chapter is Ch 02 Tool Kit.xls, and we encourage you to open the ﬁle and follow along as you read the chapter.

Time: 0

1

2

3

4

5

Time 0 is today; Time 1 is one period from today, or the end of Period 1; Time 2 is two periods from today, or the end of Period 2; and so on. Thus, the numbers above the tick marks represent end-of-period values. Often the periods are years, but other time intervals such as semiannual periods, quarters, months, or even days can be used. If each period on the time line represents a year, the interval from the tick mark corresponding to 0 to the tick mark corresponding to 1 would be Year 1, the interval from 1 to 2 would be Year 2, and so on. Note that each tick mark corresponds to the end of one period as well as the beginning of the next period. In other words, the tick mark at Time 1 represents the end of Year 1, and it also represents the beginning of Year 2 because Year 1 has just passed. Cash ﬂows are placed directly below the tick marks, and interest rates are shown directly above the time line. Unknown cash ﬂows, which you are trying to ﬁnd in the analysis, are indicated by question marks. Now consider the following time line: Time: Cash ﬂows:

0 100

5%

1

2

3 ?

Here the interest rate for each of the three periods is 5 percent; a single amount (or lump sum) cash outﬂow is made at Time 0; and the Time 3 value is an unknown inﬂow. Since the initial $100 is an outﬂow (an investment), it has a minus sign. Since the Period 3 amount is an inﬂow, it does not have a minus sign, which implies a plus sign. Note that no cash ﬂows occur at Times 1 and 2. Note also that we generally do not show dollar signs on time lines to reduce clutter. Now consider a different situation, where a $100 cash outﬂow is made today, and we will receive an unknown amount at the end of Time 2:

55

Time Value of Money Future Value

0 100

5%

1

10%

57

2 ?

Here the interest rate is 5 percent during the first period, but it rises to 10 percent during the second period. If the interest rate is constant in all periods, we show it only in the first period, but if it changes, we show all the relevant rates on the time line. Time lines are essential when you are ﬁrst learning time value concepts, but even experts use time lines to analyze complex problems. We will be using time lines throughout the book, and you should get into the habit of using them when you work problems. Draw a three-year time line to illustrate the following situation: (1) An outﬂow of $10,000 occurs at Time 0. (2) Inﬂows of $5,000 then occur at the end of Years 1, 2, and 3. (3) The interest rate during all three years is 10 percent.

Future Value A dollar in hand today is worth more than a dollar to be received in the future because, if you had it now, you could invest it, earn interest, and end up with more than one dollar in the future. The process of going from today’s values, or present values (PVs), to future values (FVs) is called compounding. To illustrate, suppose you deposit $100 in a bank that pays 5 percent interest each year. How much would you have at the end of one year? To begin, we deﬁne the following terms: PV present value, or beginning amount, in your account. Here PV $100. i interest rate the bank pays on the account per year. The interest earned is based on the balance at the beginning of each year, and we assume that it is paid at the end of the year. Here i 5%, or, expressed as a decimal, i 0.05. Throughout this chapter, we designate the interest rate as i (or I) because that symbol is used on most ﬁnancial calculators. Note, though, that in later chapters we use the symbol r to denote interest rates because r is used more often in the ﬁnancial literature. INT dollars of interest you earn during the year Beginning amount i. Here INT $100(0.05) $5. FVn future value, or ending amount, of your account at the end of n years. Whereas PV is the value now, or the present value, FVn is the value n years into the future, after the interest earned has been added to the account. n number of periods involved in the analysis. Here n 1. In our example, n 1, so FVn can be calculated as follows: FVn FV1 PV INT PV PV(i) PV(1 i) $100(1 0.05) $100(1.05) $105. Thus, the future value (FV) at the end of one year, FV1, equals the present value multiplied by 1 plus the interest rate, so you will have $105 after one year.

56

Time Value of Money 58

CHAPTER 2

Time Value of Money

What would you end up with if you left your $100 in the account for ﬁve years? Here is a time line set up to show the amount at the end of each year: 0

2

3

Initial deposit:

100 FV1 ? FV2 ?

FV3 ?

Interest earned:

5.00

5.25

5.51

5.79

6.08

105.00

110.25

115.76

121.55

127.63

Amount at the end of each period FVn:

5%

1

4

5

FV4 ? FV5 ?

Note the following points: (1) You start by depositing $100 in the account—this is shown as an outﬂow at t 0. (2) You earn $100(0.05) $5 of interest during the ﬁrst year, so the amount at the end of Year 1 (or t 1) is $100 $5 $105. (3) You start the second year with $105, earn $5.25 on the now larger amount, and end the second year with $110.25. Your interest during Year 2, $5.25, is higher than the ﬁrst year’s interest, $5, because you earned $5(0.05) $0.25 interest on the ﬁrst year’s interest. (4) This process continues, and because the beginning balance is higher in each succeeding year, the annual interest earned increases. (5) The total interest earned, $27.63, is reﬂected in the ﬁnal balance at t 5, $127.63. Note that the value at the end of Year 2, $110.25, is equal to FV2 FV1(1 i) PV(1 i)(1 i) PV(1 i)2 $100(1.05)2 $110.25. Continuing, the balance at the end of Year 3 is FV3 FV2(1 i) PV(1 i)3 $100(1.05)3 $115.76, and FV5 $100(1.05)5 $127.63. In general, the future value of an initial lump sum at the end of n years can be found by applying Equation 2-1: FVn PV(1 i)n PV(FVIFi,n).

(2-1)

The last term in Equation 2-1 deﬁnes the Future Value Interest Factor for i and n, FVIFi,n, as (1 i)n. This provides a shorthand way to refer to the actual formula in Equation 2-1. Equation 2-1 and most other time value of money equations can be solved in three ways: numerically with a regular calculator, with a ﬁnancial calculator, or with a computer spreadsheet program.2 Most work in ﬁnancial management will be done with a ﬁnancial calculator or on a computer, but when learning basic concepts it is best to also work the problem numerically with a regular calculator. NUMERICAL SOLUTION

One can use a regular calculator and either multiply (1 i) by itself n 1 times or else use the exponential function to raise (1 i) to the nth power. With most calculators, you

2

Prior to the widespread use of ﬁnancial calculators, a fourth method was used. It is called the “tabular approach,” and it is described in the Chapter 2 Web Extension, available on the textbook’s web site.

57

Time Value of Money Future Value

59

would enter 1 i 1.05 and multiply it by itself four times, or else enter 1.05, then press the yx (exponential) function key, and then enter 5. In either case, your answer would be 1.2763 (if you set your calculator to display four decimal places), which you would multiply by $100 to get the ﬁnal answer, $127.6282, which would be rounded to $127.63. In certain problems, it is extremely difﬁcult to arrive at a solution using a regular calculator. We will tell you this when we have such a problem, and in these cases we will not show a numerical solution. Also, at times we show the numerical solution just below the time line, as a part of the diagram, rather than in a separate section. FINANCIAL CALCULATOR SOLUTION

A version of Equation 2-1, along with a number of other equations, has been programmed directly into ﬁnancial calculators, and these calculators can be used to ﬁnd future values. Note that calculators have ﬁve keys that correspond to the ﬁve most commonly used time value of money variables:

Here N the number of periods. Some calculators use n rather than N. I interest rate per period. Some calculators use i or I/YR rather than I. PV present value. PMT payment. This key is used only if the cash ﬂows involve a series of equal, or constant, payments (an annuity). If there are no periodic payments in a particular problem, then PMT 0. FV future value. On some ﬁnancial calculators, these keys are actually buttons on the face of the calculator, while on others they are shown on a screen after going into the time value of money (TVM) menu. In this chapter, we deal with equations involving only four of the variables at any one time—three of the variables are known, and the calculator then solves for the fourth (unknown) variable. In Chapter 4, when we deal with bonds, we will use all ﬁve variables in the bond valuation equation.3 To ﬁnd the future value of $100 after ﬁve years at 5 percent, most ﬁnancial calculations solve Equation 2-2: PV(1 i)n FVn 0.

(2-2)

The equation has four variables, FVn, PV, i, and n. If we know any three, we can solve for the fourth. In our example, we enter N 5, I 5, PV –100, and PMT 0. Then, when we press the FV key, we get the answer, FV 127.63 (rounded to two decimal places).4

3

The equation programmed into the calculators actually has ﬁve variables, one for each key. In this chapter, the value of one of the variables is always zero. It is a good idea to get into the habit of inputting a zero for the unused variable (whose value is automatically set equal to zero when you clear the calculator’s memory); if you forget to clear your calculator, inputting a zero will help you avoid trouble. 4 Here we assume that compounding occurs once each year. Most calculators have a setting that can be used to designate the number of compounding periods per year. For example, the HP-10B comes preset with payments at 12 per year. You would need to change it to 1 per year to get FV 127.63. With the HP-10B, you would do this by typing 1, pressing the gold key, and then pressing the P/YR key.

58

Time Value of Money 60

CHAPTER 2

Time Value of Money

Notice that either PV or FVn in Equation 2-2 must be negative to make the equation true, assuming nonnegative interest rates. Thus, most ﬁnancial calculators require that all cash ﬂows be designated as either inﬂows or outﬂows, with outﬂows being entered as negative numbers. In our illustration, you deposit, or put in, the initial amount (which is an outﬂow to you) and you take out, or receive, the ending amount (which is an inﬂow to you). Therefore, you enter the PV as 100. Enter the 100 by keying in 100 and then pressing the “change sign” or / key. (If you entered 100, then the FV would appear as 127.63.) Also, on some calculators you are required to press a “Compute” key before pressing the FV key. Sometimes the convention of changing signs can be confusing. For example, if you have $100 in the bank now and want to ﬁnd out how much you will have after ﬁve years if your account pays 5 percent interest, the calculator will give you a negative answer, in this case 127.63, because the calculator assumes you are going to withdraw the funds. This sign convention should cause you no problem if you think about what you are doing. We should also note that ﬁnancial calculators permit you to specify the number of decimal places that are displayed. Twelve signiﬁcant digits are actually used in the calculations, but we generally use two places for answers when working with dollars or percentages and four places when working with decimals. The nature of the problem dictates how many decimal places should be displayed. SPREADSHEET SOLUTION

See Ch 02 Tool Kit.xls.

Spreadsheet programs are ideally suited for solving many ﬁnancial problems, including time value of money problems.5 With very little effort, the spreadsheet itself becomes a time line. Here is how the problem would look in a spreadsheet:

A 1

Interest rate

2

Time

3

Cash ﬂow

4

Future value

B

C

D

E

F

G

0.05 0

1

2

3

4

5

105.00

110.25

115.76

121.55

127.63

100

Cell B1 shows the interest rate, entered as a decimal number, 0.05. Row 2 shows the periods for the time line. With Microsoft Excel, you could enter 0 in Cell B2, then the formula B21 in Cell C2, and then copy this formula into Cells D2 through G2 to produce the time periods shown on Row 2. Note that if your time line had many years, say, 50, you would simply copy the formula across more columns. Other procedures could also be used to enter the periods.

5

In this section, and in other sections and chapters, we discuss spreadsheet solutions to various ﬁnancial problems. If a reader is not familiar with spreadsheets and has no interest in them, then these sections can be omitted. For those who are interested, Ch O2 Tool Kit.xls is the ﬁle on the web site for this chapter that does the various calculations using Excel. If you have the time, we highly recommend that you go through the models. This will give you practice with Excel, which will help tremendously in later courses, in the job market, and in the workplace. Also, going through the models will enhance your understanding of ﬁnancial concepts.

59

Time Value of Money Future Value

61

Row 3 shows the cash ﬂows. In this case, there is only one cash ﬂow, shown in Cell B3. Row 4 shows the future value of this cash ﬂow at the end of each year. Cell C4 contains the formula for Equation 2-1. The formula could be written as $B$3* (1.05)^C2, but we wrote it as $B$3*(1 $B$1)ˆC2, which gives us the ﬂexibility to change the interest rate in Cell B1 to see how the future value changes with changes in interest rates. Note that the formula has a minus sign for the PV (which is in Cell B3) to account for the minus sign of the cash ﬂow. This formula was then copied into Cells D4 through G4. As Cell G4 shows, the value of $100 compounded for ﬁve years at 5 percent per year is $127.63. You could also ﬁnd the FV by putting the cursor on Cell G4, then clicking the function wizard, then Financial, then scrolling down to FV, and then clicking OK to bring up the FV dialog box. Then enter B1 or .05 for Rate, G2 or 5 for Nper, 0 or leave blank for Pmt because there are no periodic payments, B3 or 100 for Pv, and 0 or leave blank for Type to indicate that payments occur at the end of the period. Then, when you click OK, you get the future value, $127.63. Note that the dialog box prompts you to fill in the arguments in an equation. The equation itself, in Excel format, is FV(Rate,Nper,Pmt,Pv,Type) FV(.05,5,0,100,0). Rather than insert numbers, you could input cell references for Rate, Nper, Pmt, and Pv. Either way, when Excel sees the equation, it knows to use our Equation 2-2 to fill in the specified arguments, and to deposit the result in the cell where the cursor was located when you began the process. If someone really knows what they are doing and has memorized the formula, they can skip both the time line and the function wizard and just insert data into the formula to get the answer. But until you become an expert, we recommend that you use time lines to visualize the problem and the function wizard to complete the formula.

Comparing the Three Procedures The ﬁrst step in solving any time value problem is to understand the verbal description of the problem well enough to diagram it on a time line. Woody Allen said that 90 percent of success is just showing up. With time value problems, 90 percent of success is correctly setting up the time line. After you diagram the problem on a time line, your next step is to pick an approach to solve the problem. Which of the three approaches should you use—numerical, ﬁnancial calculator, or spreadsheet? In general, you should use the easiest approach. But which is easiest? The answer depends on the particular situation. All business students should know Equation 2-1 by heart and should also know how to use a ﬁnancial calculator. So, for simple problems such as ﬁnding the future value of a single payment, it is probably easiest and quickest to use either the numerical approach or a ﬁnancial calculator. For problems with more than a couple of cash flows, the numerical approach is usually too time consuming, so here either the calculator or spreadsheet approaches would generally be used. Calculators are portable and quick to set up, but if many calculations of the same type must be done, or if you want to see how changes in an input such as the interest rate affect the future value, the spreadsheet approach is generally more efficient. If the problem has many irregular cash flows, or if you want to analyze many scenarios with different cash flows, then the spreadsheet approach is definitely the most efficient. The important thing is that you understand the various approaches well enough to make a rational choice, given the nature of the problem and the equipment you have available. In any event, you must understand the concepts behind the calculations and know how to set up time lines in order to work complex problems. This is true for stock and

60

Time Value of Money 62

CHAPTER 2

Time Value of Money

bond valuation, capital budgeting, lease analysis, and many other important financial problems.

Problem Format To help you understand the various types of time value problems, we generally use a standard format. First, we state the problem in words. Next, we diagram the problem on a time line. Then, beneath the time line, we show the equation that must be solved. Finally, we present the three alternative procedures for solving the equation to obtain the answer: (1) use a regular calculator to obtain a numerical solution, (2) use a ﬁnancial calculator, and (3) use a spreadsheet program. For some very easy problems, we will not show a spreadsheet solution, and for some difﬁcult problems, we will not show numerical solutions because they are too inefﬁcient. To illustrate the format, consider again our ﬁve-year, 5 percent example: Time Line: 0

5%

1

2

3

4

100

5 FV ?

Equation: FVn PV(1 i)n $100(1.05)5. 1. NUMERICAL SOLUTION

0

5%

1

100 1.05 →

2 1.05 →

105.00

3 1.05 →

110.25

4 1.05 →

115.76

5 1.05 →

127.63

121.55

Using a regular calculator, raise 1.05 to the 5th power and multiply by $100 to get FV5 $127.63. 2. FINANCIAL CALCULATOR SOLUTION

Inputs:

Output:

5

5

100

0

127.63

Note that the calculator diagram tells you to input N 5, I 5, PV 100, and PMT 0, and then to press the FV key to get the answer, 127.63. Interest rates are entered as percentages (5), not decimals (0.05). Also, note that in this particular problem, the PMT key does not come into play, as no constant series of payments is involved. Finally, you should recognize that small rounding differences will often occur among the various solution methods because rounding sometimes is done at intermediate steps in long problems.

61

Time Value of Money Future Value

63

3. SPREADSHEET SOLUTION

A 1

Interest rate

2

Time

3

Cash ﬂow

4

Future value

B

C

D

E

F

G

0.05 0

1

2

3

4

5

105.00

110.25

115.76

121.55

127.63

100

Cell G4 contains the formula for Equation 2-1: $B$3*(1$B$1)ˆG2 or $B$3*(1.05)ˆG2. You could also use Excel’s FV function to ﬁnd the $127.63, following the procedures described in the previous section.

Graphic View of the Compounding Process: Growth Figure 2-1 shows how $1 (or any other lump sum) grows over time at various interest rates. We generated the data and then made the graph with a spreadsheet model in the file Ch 02 Tool Kit.xls. The higher the rate of interest, the faster the rate of growth. The interest rate is, in fact, a growth rate: If a sum is deposited and earns 5 percent interest, then the funds on deposit will grow at a rate of 5 percent per period. Note also that time value concepts can be applied to anything that is growing—sales, population, earnings per share, or your future salary.

FIGURE 2-1

Relationships among Future Value, Growth, Interest Rates, and Time Future Value of $1 5.0

4.0 i =15% 3.0 i =10% 2.0 i = 5% 1.0

0

i = 0%

2

4

6

8

10 Periods

62

Time Value of Money 64

CHAPTER 2

Time Value of Money

The Power of Compound Interest

Suppose you are 26 years old and just received your MBA. After reading the introduction to this chapter, you decide to start investing in the stock market for your retirement. Your goal is to have $1 million when you retire at age 65. Assuming you earn a 10 percent annual rate on your stock investments, how much must you invest at the end of each year in order to reach your goal? The answer is $2,490.98, but this amount depends critically on the return earned on your investments. If returns drop to 8 percent, your required annual contributions would rise to $4,185.13, while if returns rise to 12 percent, you would only need to put away $1,461.97 per year. What if you are like most of us and wait until later to worry about retirement? If you wait until age 40, you will

need to save $10,168 per year to reach your $1 million goal, assuming you earn 10 percent, and $13,679 per year if you earn only 8 percent. If you wait until age 50 and then earn 8 percent, the required amount will be $36,830 per year. While $1 million may seem like a lot of money, it won’t be when you get ready to retire. If inﬂation averages 5 percent a year over the next 39 years, your $1 million nest egg will be worth only $116,861 in today’s dollars. At an 8 percent rate of return, and assuming you live for 20 years after retirement, your annual retirement income in today’s dollars would be only $11,903 before taxes. So, after celebrating graduation and your new job, start saving!

Explain what is meant by the following statement: “A dollar in hand today is worth more than a dollar to be received next year.” What is compounding? Explain why earning “interest on interest” is called “compound interest.” Explain the following equation: FV1 PV INT. Set up a time line that shows the following situation: (1) Your initial deposit is $100. (2) The account pays 5 percent interest annually. (3) You want to know how much money you will have at the end of three years. Write out an equation that could be used to solve the preceding problem. What are the ﬁve TVM (time value of money) input keys on a ﬁnancial calculator? List them (horizontally) in the proper order.

Present Value Suppose you have some extra cash, and you have a chance to buy a low-risk security that will pay $127.63 at the end of five years. Your local bank is currently offering 5 percent interest on five-year certificates of deposit (CDs), and you regard the security as being exactly as safe as a CD. The 5 percent rate is defined as your opportunity cost rate, or the rate of return you could earn on an alternative investment of similar risk. How much should you be willing to pay for the security? From the future value example presented in the previous section, we saw that an initial amount of $100 invested at 5 percent per year would be worth $127.63 at the end of five years. As we will see in a moment, you should be indifferent between $100 today and $127.63 at the end of five years. The $100 is defined as the present value, or PV, of $127.63 due in five years when the opportunity cost rate is 5 percent. If the price of the security were less than $100, you should buy it, because its price would then be less than the $100 you would have to spend on a similar-risk

63

Time Value of Money Present Value

65

alternative to end up with $127.63 after five years. Conversely, if the security cost more than $100, you should not buy it, because you would have to invest only $100 in a similar-risk alternative to end up with $127.63 after five years. If the price were exactly $100, then you should be indifferent—you could either buy the security or turn it down. Therefore, $100 is defined as the security’s fair, or equilibrium, value. In general, the present value of a cash ﬂow due n years in the future is the amount which, if it were on hand today, would grow to equal the future amount. Since $100 would grow to $127.63 in ﬁve years at a 5 percent interest rate, $100 is the present value of $127.63 due in ﬁve years when the opportunity cost rate is 5 percent. Finding present values is called discounting, and it is the reverse of compounding—if you know the PV, you can compound to ﬁnd the FV, while if you know the FV, you can discount to ﬁnd the PV. When discounting, you would follow these steps: Time Line: 0

1

5%

2

3

4

PV ?

5 127.63

Equation: To develop the discounting equation, we begin with the future value equation, Equation 2-1: FVn PV(1 i)n PV(FVIFi,n).

(2-1)

Next, we solve it for PV in several equivalent forms: PV

n FVn 1 b FVn(PVIFi,n). n FVn a (1 i) 1i

(2-3)

The last form of Equation 2-3 recognizes that the Present Value Interest Factor for i and n, PVIFi,n, is shorthand for the formula in parentheses in the second version of the equation. 1.

NUMERICAL SOLUTION

0

5%

1

2

3

4

5

100 ←—- 105.00 ←—- 110.25 ←—-115.76 ←—-121.55←—-127.63 1.05 1.05 1.05 1.05 1.05 Divide $127.63 by 1.05 ﬁve times, or by (1.05)5, to ﬁnd PV $100. 2. FINANCIAL CALCULATOR SOLUTION

Inputs:

Output:

5

5

0

127.63

100

Enter N 5, I 5, PMT 0, and FV 127.63, and then press PV to get PV 100.

64

Time Value of Money 66

CHAPTER 2

Time Value of Money 3. SPREADSHEET SOLUTION

A 1

Interest rate

2

Time

3

Cash ﬂow

4

Present value

B

C

D

E

F

G

0.05 0

1

2

3

4

5

0

0

0

0

127.63

100

You could enter the spreadsheet version of Equation 2–3 in Cell B4, 127.63/ (10.05)ˆ5, but you could also use the built-in spreadsheet PV function. In Excel, you would put the cursor on Cell B4, then click the function wizard, indicate that you want a Financial function, scroll down, and double click PV. Then, in the dialog box, enter B1 or 0.05 for Rate, G2 or 5 for Nper, 0 for Pmt (because there are no annual payments), G3 or 127.63 for Fv, and 0 (or leave blank) for Type because the cash ﬂow occurs at the end of the year. Then, press OK to get the answer, PV $100.00. Note that the PV function returns a negative value, the same as the ﬁnancial calculator.

Graphic View of the Discounting Process Figure 2-2 shows how the present value of $1 (or any other sum) to be received in the future diminishes as the years to receipt and the interest rate increase. The graph shows (1) that the present value of a sum to be received at some future date decreases and approaches zero as the payment date is extended further into the future, and (2) that the rate of decrease is greater the higher the interest (discount) rate. At relatively high interest rates, funds due in the future are worth very little today, and even at a FIGURE 2-2

Relationships among Present Value, Interest Rates, and Time

Present Value of $1 1.00 i = 0% 0.75

i = 5% i = 10%

0.50

i = 15%

0.25

0

2

4

6

8

10 Periods

65

Time Value of Money Solving for Interest Rate and Time

67

relatively low discount rate, the present value of a sum due in the very distant future is quite small. For example, at a 20 percent discount rate, $1 million due in 100 years is worth approximately 1 cent today. (However, 1 cent would grow to almost $1 million in 100 years at 20 percent.) What is meant by the term “opportunity cost rate”? What is discounting? How is it related to compounding? How does the present value of an amount to be received in the future change as the time is extended and the interest rate increased?

Solving for Interest Rate and Time At this point, you should realize that compounding and discounting are related, and that we have been dealing with one equation that can be solved for either the FV or the PV. FV Form: FVn PV(1 i)n.

(2-1)

n FVn 1 FV a b . n (1 i)n 1i

(2-3)

PV Form: PV

There are four variables in these equations—PV, FV, i, and n—and if you know the values of any three, you can ﬁnd the value of the fourth. Thus far, we have always given you the interest rate (i) and the number of years (n), plus either the PV or the FV. In many situations, though, you will need to solve for either i or n, as we discuss below.

Solving for i Suppose you can buy a security at a price of $78.35, and it will pay you $100 after ﬁve years. Here you know PV, FV, and n, and you want to ﬁnd i, the interest rate you would earn if you bought the security. Such problems are solved as follows: Time Line: 0

i?

1

2

3

78.35

4

5 100

Equation: FVn PV(1 i)n $100 $78.35(1 i)5. Solve for i.

(2-1)

66

Time Value of Money 68

CHAPTER 2

Time Value of Money 1. NUMERICAL SOLUTION

Use Equation 2-1 to solve for i: $100 $78.35(1 i)5 $100 (1 i)5 $78.35 (1 i)5 1.276 1 i (1.276)(1/5) 1 i 1.050 i 0.05 5%. Therefore, the interest rate is 5 percent.

2. FINANCIAL CALCULATOR SOLUTION

Inputs:

78.35

5

0

100

5.0

Output:

Enter N 5, PV 78.35, PMT 0, and FV 100, and then press I to get I 5%. This procedure is easy, and it can be used for any interest rate or for any value of n, including fractional values.

3. SPREADSHEET SOLUTION

A 1

Time

2

Cash ﬂow

3

Interest rate

B

C

D

E

F

G

0

1

2

3

4

5

78.35

0

0

0

0

100

5%

Most spreadsheets have a built-in function to ﬁnd the interest rate. In Excel, you would put the cursor on Cell B3, then click the function wizard, indicate that you want a Financial function, scroll down to RATE, and click OK. Then, in the dialog box, enter G1 or 5 for Nper, 0 for Pmt because there are no periodic payments, B2 or 78.35 for Pv, G2 or 100 for Fv, 0 for type, and leave “Guess” blank to let Excel decide where to start its iterations. Then, when you click OK, Excel solves for the interest rate, 5.00 percent. Excel also has other procedures that could be used to ﬁnd the 5 percent, but for this problem the RATE function is easiest to apply.

67

Time Value of Money Solving for Interest Rate and Time

69

Solving for n Suppose you invest $78.35 at an interest rate of 5 percent per year. How long will it take your investment to grow to $100? You know PV, FV, and i, but you do not know n, the number of periods. Here is the situation: Time Line: 0

5%

1

2

n1

...

78.35

n? 100

Equation: FVn PV(1 i)n $100 $78.35(1.05)n. Solve for n.

(2-1)

1. NUMERICAL SOLUTION

Use Equation 2-1 to solve for n: $100 $78.35 (1 0.05)n. Transform to: $100/$78.35 1.276 (1 0.05)n. Take the natural log of both sides, and then solve for n: n LN(1.05) LN(1.276) n LN(1.276)/LN(1.05) Find the logs with a calculator, and complete the solution: n 0.2437/0.0488 4.9955 艐 5.0. Therefore, 5 is the number of years it takes for $78.35 to grow to $100 if the interest rate is 5 percent.

2. FINANCIAL CALCULATOR SOLUTION

Inputs:

Output:

5

78.35

0

100

5.0

Enter I 5, PV 78.35, PMT 0, and FV 100, and then press N to get N 5.

68

Time Value of Money 70

CHAPTER 2

Time Value of Money 3. SPEADSHEET SOLUTION

A 1

Time

2

Cash ﬂow

3

Interest rate

4

Payment

5

N

B

C

D

E

F

G

0

1

2

3

...

?

78.35

0

0

0

...

100

5% 0 5.00

Most spreadsheets have a built-in function to ﬁnd the number of periods. In Excel, you would put the cursor on Cell B5, then click the function wizard, indicate that you want a Financial function, scroll down to NPER, and click OK. Then, in the dialog box, enter B3 or 5% for Rate, 0 for Pmt because there are no periodic payments, B2 or 78.35 for Pv, G2 or 100 for Fv, and 0 for Type. When you click OK, Excel solves for the number of periods, 5. Assuming that you are given PV, FV, and the time period, n, write out an equation that can be used to determine the interest rate, i. Assuming that you are given PV, FV, and the interest rate, i, write out an equation that can be used to determine the time period, n.

Future Value of an Annuity An annuity is a series of equal payments made at ﬁxed intervals for a speciﬁed number of periods. For example, $100 at the end of each of the next three years is a three-year annuity. The payments are given the symbol PMT, and they can occur at either the beginning or the end of each period. If the payments occur at the end of each period, as they typically do, the annuity is called an ordinary, or deferred, annuity. Payments on mortgages, car loans, and student loans are typically set up as ordinary annuities. If payments are made at the beginning of each period, the annuity is an annuity due. Rental payments for an apartment, life insurance premiums, and lottery payoffs are typically set up as annuities due. Since ordinary annuities are more common in ﬁnance, when the term “annuity” is used in this book, you should assume that the payments occur at the end of each period unless otherwise noted.

Ordinary Annuities An ordinary, or deferred, annuity consists of a series of equal payments made at the end of each period. If you deposit $100 at the end of each year for three years in a savings account that pays 5 percent interest per year, how much will you have at the end of three years? To answer this question, we must ﬁnd the future value of the annuity, FVAn. Each payment is compounded out to the end of Period n, and the sum of the compounded payments is the future value of the annuity, FVAn.

69

Time Value of Money Future Value of an Annuity

71

Time Line: 0

5%

1

2

100

100

3

↑     

100 105 110.25 FVA3 315.25

↑              

Here we show the regular time line as the top portion of the diagram, but we also show how each cash ﬂow is compounded to produce the value FVAn in the lower portion of the diagram. Equation: FVAn PMT(1 i)n1 PMT(1 i)n2 PMT(1 i)n3 PMT(1 i)0 n

PMT a (1 i)nt t1

(1 i)n 1 PMTa b i PMT(FVIFAi,n).

(2-4)

The ﬁrst line of Equation 2-4 represents the application of Equation 2-1 to each individual payment of the annuity. In other words, each term is the compounded amount of a single payment, with the superscript in each term indicating the number of periods during which the payment earns interest. For example, because the ﬁrst annuity payment was made at the end of Period 1, interest would be earned in Periods 2 through n only, so compounding would be for n 1 periods rather than n periods. Compounding for the second payment would be for Period 3 through Period n, or n 2 periods, and so on. The last payment is made at the end of the annuity’s life, so there is no time for interest to be earned. The second line of Equation 2-4 is just a shorthand version of the ﬁrst form, but the third line is different—it is found by applying the algebra of geometric progressions. This form of Equation 2-4 is especially useful when no ﬁnancial calculator is available. Finally, the fourth line shows the payment multiplied by the Future Value Interest Factor for an Annuity (FVIFAi,n), which is the shorthand version of the formula. 1. NUMERICAL SOLUTION:

The lower section of the time line shows the numerical solution, which involves using the ﬁrst line of Equation 2-4. The future value of each cash ﬂow is found, and those FVs are summed to ﬁnd the FV of the annuity, $315.25. If a long annuity were being evaluated, this process would be quite tedious, and in that case you probably would use the form of Equation 2-4 found on the third line: (1 i)n 1 b i (1 0.05)3 1 $100a b $100(3.1525) $315.25. 0.05

FVAn PMTa

(2-4)

70

Time Value of Money 72

CHAPTER 2

Time Value of Money 2. FINANCIAL CALCULATOR SOLUTION

Inputs:

3

5

100

0

315.25

Output:

Note that in annuity problems, the PMT key is used in conjunction with the N and I keys, plus either the PV or the FV key, depending on whether you are trying to ﬁnd the PV or the FV of the annuity. In our example, you want the FV, so press the FV key to get the answer, $315.25. Since there is no initial payment, we input PV 0. 3. SPREADSHEET SOLUTION

A

B

1

Interest rate

2

Time

3

Cash ﬂow

4

Future value

C

D

E

0.05 0

1

2

3

100

100

100 315.25

Most spreadsheets have a built-in function for ﬁnding the future value of an annuity. In Excel, we could put the cursor on Cell E4, then click the function wizard, Financial, FV, and OK to get the FV dialog box. Then, we would enter .05 or B1 for Rate, 3 or E2 for Nper, and 100 for Pmt. (Like the ﬁnancial calculator approach, the payment is entered as a negative number to show that it is a cash outﬂow.) We would leave Pv blank because there is no initial payment, and we would leave Type blank to signify that payments come at the end of the periods. Then, when we clicked OK, we would get the FV of the annuity, $315.25. Note that it isn’t necessary to show the time line, since the FV function doesn’t require you to input a range of cash ﬂows. Still, the time line is useful to help visualize the problem.

Annuities Due Had the three $100 payments in the previous example been made at the beginning of each year, the annuity would have been an annuity due. On the time line, each payment would be shifted to the left one year, so each payment would be compounded for one extra year. Time Line: 0 100

5%

1

2

100

100

3

↑     

105 110.25 115.76 FVA3 (Annuity due) 331.01

↑               ↑                      

71

Time Value of Money Future Value of an Annuity

73

Again, the time line is shown at the top of the diagram, and the values as calculated with a regular calculator are shown under Year 3. The future value of each cash ﬂow is found, and those FVs are summed to ﬁnd the FV of the annuity due. The payments occur earlier, so more interest is earned. Therefore, the future value of the annuity due is larger—$331.01 versus $315.25 for the ordinary annuity. Equation: FVAn(Due) PMT(1 i)n PMT(1 i)n1 PMT(1 i)n2 PMT(1 i) n

PMT a (1 i)n1t t1

(2-4a)

(1 i)n 1 PMTa b(1 i) i PMT(FVIFAi,n)(1 i) .

The only difference between Equation 2-4a for annuities due and Equation 2-4 for ordinary annuities is that every term in Equation 2-4a is compounded for one extra period, reﬂecting the fact that each payment for an annuity due occurs one period earlier than for a corresponding ordinary annuity. 1. NUMERICAL SOLUTION:

The lower section of the time line shows the numerical solution using the ﬁrst line of Equation 2-4a. The future value of each cash ﬂow is found, and those FVs are summed to ﬁnd the FV of the annuity, $331.01. Because this process is quite tedious for long annuities, you probably would use the third line of Equation 2-4a: (1 i)n 1 (2-4a) b(1 i) i (1 0.05)3 1 $100a b(1 0.05) $100(3.1525)(1.05) $331.01. 0.05

FVAn(Due) PMTa

2. FINANCIAL CALCULATOR SOLUTION

Most ﬁnancial calculators have a switch, or key, marked “DUE” or “BEG” that permits you to switch from end-of-period payments (ordinary annuity) to beginning-ofperiod payments (annuity due). When the beginning mode is activated, the display will normally show the word “BEGIN.” Thus, to deal with annuities due, switch your calculator to “BEGIN” and proceed as before: BEGIN Inputs:

Output:

3

5

0

100

331.01

Enter N 3, I 5, PV 0, PMT 100, and then press FV to get the answer, $331.01. Since most problems specify end-of-period cash ﬂows, you should always switch your calculator back to “END” mode after you work an annuity due problem.

72

Time Value of Money CHAPTER 2

Time Value of Money 3. SPREADSHEET SOLUTION

For the annuity due, use the FV function just as for the ordinary annuity except enter 1 for Type to indicate that we now have an annuity due. Then, when you click OK, the answer $331.01 will appear. What is the difference between an ordinary annuity and an annuity due? How do you modify the equation for determining the value of an ordinary annuity to ﬁnd the value of an annuity due? Other things held constant, which annuity has the greater future value: an ordinary annuity or an annuity due? Why?

Present Value of an Annuity Suppose you were offered the following alternatives: (1) a three-year annuity with payments of $100 or (2) a lump sum payment today. You have no need for the money during the next three years, so if you accept the annuity, you would deposit the payments in a bank account that pays 5 percent interest per year. Similarly, the lump sum payment would be deposited into a bank account. How large must the lump sum payment today be to make it equivalent to the annuity?

Ordinary Annuities If the payments come at the end of each year, then the annuity is an ordinary annuity, and it would be set up as follows: Time Line:

95.24 90.70 86.38 PVA3 272.32

1

2

3

100

100

100

↑    

5%

↑           

0

↑                    

74

The regular time line is shown at the top of the diagram, and the numerical solution values are shown in the left column. The PV of the annuity, PVAn, is $272.32. Equation: The general equation used to ﬁnd the PV of an ordinary annuity is shown below: PVAn PMTa

1 2 n 1 1 1 b PMTa b PMTa b 1i 1i 1i

n t 1 PMT a a b t1 1 i 1 1 (1 i)n ¢ ° PMT i PMT(PVIFAi,n).

(2-5)

73

Time Value of Money Present Value of an Annuity

75

The Present Value Interest Factor of an Annuity for i and n, PVIFAi,n, is a shorthand notation for the formula.

1. NUMERICAL SOLUTION:

The lower section of the time line shows the numerical solution, $272.32, calculated by using the ﬁrst line of Equation 2-5, where the present value of each cash ﬂow is found and then summed to ﬁnd the PV of the annuity. If the annuity has many payments, it is easier to use the third line of Equation 2-5: 1 (1 i)n ¢ ° PVAn PMT i 1 1 (1 0.05)3 ¢ ° $100 $100(2.7232) $272.32. 0.05 1

2. FINANCIAL CALCULATOR SOLUTION

Inputs:

3

100

5

0

272.32

Output:

Enter N 3, I 5, PMT 100, and FV 0, and then press the PV key to ﬁnd the PV, $272.32.

3. SPREADSHEET SOLUTION

A 1

Interest rate

2

Time

3

Cash ﬂow

4

Present value

B

C

D

E

0.05 0

1

2

3

100

100

100

$272.32

In Excel, put the cursor on Cell B4 and then click the function wizard, Financial, PV, and OK. Then enter B1 or 0.05 for Rate, E2 or 3 for Nper, 100 for Pmt, 0 or leave blank for Fv, and 0 or leave blank for Type. Then, when you click OK, you get the answer, $272.32. One especially important application of the annuity concept relates to loans with constant payments, such as mortgages and auto loans. With such loans, called amortized loans, the amount borrowed is the present value of an ordinary annuity, and the payments constitute the annuity stream. We will examine constant payment loans in more depth in a later section of this chapter.

74

Time Value of Money Time Value of Money

Annuities Due Had the three $100 payments in the preceding example been made at the beginning of each year, the annuity would have been an annuity due. Each payment would be shifted to the left one year, so each payment would be discounted for one less year. Here is the time line: Time Line: 0

5%

100 95.24 90.70 PVA3 (Annuity due) 285.94

1

2

100

100

3

↑   

CHAPTER 2

↑           

76

Again, we ﬁnd the PV of each cash ﬂow and then sum these PVs to ﬁnd the PV of the annuity due. This procedure is illustrated in the lower section of the time line diagram. Since the cash ﬂows occur sooner, the PV of the annuity due exceeds that of the ordinary annuity, $285.94 versus $272.32. Equation: 0 1 n1 1 1 1 b PMTa b PMTa b 1i 1i 1i n t1 1 PMT a a b 1i t1 (2-5a) 1 1 (1 i)n ¢ ° PMT (1 i) i PMT(PVIFAi,n)(1 i).

PVAn(Due) PMTa

1. NUMERICAL SOLUTION:

The lower section of the time line shows the numerical solution, $285.94, calculated by using the ﬁrst line of Equation 2-5a, where the present value of each cash ﬂow is found and then summed to ﬁnd the PV of the annuity due. If the annuity has many payments, it is easier to use the third line of Equation 2-5a: 1 (1 i)n ¢ ° PVAn(Due) PMT (1 i) i 1 1 (1 0.05)3 ¢ ° $100 (1 0.05) 0.05 $100(2.7232)(1 0.05) $285.94. 1

(2-5a)

2. FINANCIAL CALCULATOR SOLUTION

BEGIN Inputs:

Output:

3

100

5

285.94

0

75

Time Value of Money Annuities: Solving for Interest Rate, Number of Periods, or Payment

77

Switch to the beginning-of-period mode, and then enter N 3, I 5, PMT 100, and FV 0, and then press PV to get the answer, $285.94. Again, since most problems deal with end-of-period cash ﬂows, don’t forget to switch your calculator back to the “END” mode. 3. SPREADSHEET SOLUTION

For an annuity due, use the PV function just as for a regular annuity except enter 1 rather than 0 for Type to indicate that we now have an annuity due. Which annuity has the greater present value: an ordinary annuity or an annuity due? Why? Explain how ﬁnancial calculators can be used to ﬁnd the present value of annuities.

Annuities: Solving for Interest Rate, Number of Periods, or Payment Sometimes it is useful to calculate the interest rate, payment, or number of periods for a given annuity. For example, suppose you can lease a computer from its manufacturer for $78 per month. The lease runs for 36 months, with payments due at the end of the month. As an alternative, you can buy it for $1,988.13. In either case, at the end of the 36 months the computer will be worth zero. You would like to know the “interest rate” the manufacturer has built into the lease; if that rate is too high, you should buy the computer rather than lease it. Or suppose you are thinking ahead to retirement. If you save $4,000 per year at an interest rate of 8 percent, how long will it take for you to accumulate $1 million? Or, viewing the problem another way, if you earn an interest rate of 8 percent, how much must you save for each of the next 20 years to accumulate the $1 million? To solve problems such as these, we can use an equation that is built into ﬁnancial calculators and spreadsheets: PV(1 i)n PMTa

(1 i)n 1 b FV 0. i

(2-6)

Note that some value must be negative. There are ﬁve variables: n, i, PV, PMT, and FV.6 In each of the three problems above, you know four of the variables. For example, in the computer leasing problem, you know that n 36, PV 1,988.13 (this is positive, since you get to keep this amount if you choose to lease rather than purchase), PMT 78 (this is negative since it is what you must pay each month), and FV 0. Therefore, the equation is: (1,988.13)(1 i)36 (78)a

(1 i)36 1 b 0 0. i

(2-6a)

Unless you use a ﬁnancial calculator or a spreadsheet, the only way to solve for i is by trial-and-error. However, with a ﬁnancial calculator, you simply enter the values for the four known variables (N 36, PV 1988.13, PMT 78, and FV 0), and then hit the key for the unknown ﬁfth variable, in this case, I 2. Since this is an

6

This is the equation for an ordinary annuity. Calculators and spreadsheets have a slightly different equation for an annuity due.

76

Time Value of Money 78

CHAPTER 2

Time Value of Money

interest rate of 2 percent per month or 12(2%) 24% per year, you would probably want to buy the computer rather than lease it. It is worth pointing out that the left side of the equation can not equal zero if you put both the PV and PMT as positive numbers (assuming positive interest rates). If you do this by mistake, most ﬁnancial calculators will make a rude beeping noise, while spreadsheets will display an error message. In an Excel spreadsheet, you would use the same RATE function that we discussed earlier. In this example, enter 36 for Nper, 78 for Pmt, 1988.13 for Pv, 0 for Fv, and 0 for Type: RATE(36,78,1988.13,0,0). The result is again 0.02, or 2 percent. Regarding how long you must save until you accumulate $1 million, you know i 8%, PV 0 (since you don’t have any savings when you start), PMT 4,000 (it is negative since the payment comes out of your pocket), and FV 1,000,000 (it is positive since you will get the $1 million). Substituting into Equation 2-6 gives: (0)(1 0.08)n (4,000)a

(1 0.08)n 1 b 1,000,000 0. 0.08

(2-6a)

Using algebra, you could solve for n, but it is easier to ﬁnd n with a ﬁnancial calculator. Input I 8, PV 0, PMT 4000, FV 1000000, and solve for N, which is equal to 39.56. Thus, it will take almost 40 years to accumulate $1 million if you earn 8 percent interest and only save $4,000 per year. On a spreadsheet, you could use the same NPER function that we discussed earlier. In this case, enter 8% for Rate, 4000 for Pmt, 0 for Pv, 1000000 for Fv, and 0 for Type: NPER(8%,4000,0,1000000,0). The result is again 39.56. If you only plan to save for 20 years, how much must you save each year to accumulate $1 million? In this case, we know that n 20, i 8%, PV 0, and FV 1000000. The equation is: (0)(1 0.08)20 PMT a

(1 0.08)20 1 b 1,000,000 0. 0.08

(2-6a)

You could use algebra to solve for PMT, or you could use a ﬁnancial calculator and input N 20, I 8, PV 0, and FV 1000000. The result is PMT 21,852.21. On a spreadsheet, you would use the PMT function, inputting 8% for Rate, 20 for Nper, 0 for Pv, 1000000 for Fv, and 0 for type: PMT(8%,20,0,1000000,0). The result is again 21,852.21. Write out the equation that is built into a ﬁnancial calculator. Explain why a ﬁnancial calculator cannot ﬁnd a solution if PV, PMT, and FV all are positive.

Perpetuities Most annuities call for payments to be made over some ﬁnite period of time—for example, $100 per year for three years. However, some annuities go on indeﬁnitely, or perpetually, and these are called perpetuities. The present value of a perpetuity is found by applying Equation 2-7. PV(Perpetuity)

Payment Interest rate

PMT . i

(2-7)

Perpetuities can be illustrated by some British securities issued after the Napoleonic Wars. In 1815, the British government sold a huge bond issue and used the proceeds

77

Time Value of Money Uneven Cash Flow Streams

79

to pay off many smaller issues that had been ﬂoated in prior years to pay for the wars. Since the purpose of the bonds was to consolidate past debts, the bonds were called consols. Suppose each consol promised to pay $100 per year in perpetuity. (Actually, interest was stated in pounds.) What would each bond be worth if the opportunity cost rate, or discount rate, was 5 percent? The answer is $2,000: PV(Perpetuity)

$100 $2,000 if i 5%. 0.05

Suppose the interest rate rose to 10 percent; what would happen to the consol’s value? The value would drop to $1,000: PV (Perpetuity)

$100 $1,000 at i 10%. 0.10

Thus, we see that the value of a perpetuity changes dramatically when interest rates change. What happens to the value of a perpetuity when interest rates increase? What happens when interest rates decrease?

Uneven Cash Flow Streams The deﬁnition of an annuity includes the words constant payment—in other words, annuities involve payments that are the same in every period. Although many ﬁnancial decisions do involve constant payments, other important decisions involve uneven, or nonconstant, cash ﬂows. For example, common stocks typically pay an increasing stream of dividends over time, and ﬁxed asset investments such as new equipment normally do not generate constant cash ﬂows. Consequently, it is necessary to extend our time value discussion to include uneven cash ﬂow streams. Throughout the book, we will follow convention and reserve the term payment (PMT) for annuity situations where the cash ﬂows are equal amounts, and we will use the term cash ﬂow (CF) to denote uneven cash ﬂows. Financial calculators are set up to follow this convention, so if you are dealing with uneven cash ﬂows, you will need to use the “cash ﬂow register.”

Present Value of an Uneven Cash Flow Stream The PV of an uneven cash ﬂow stream is found as the sum of the PVs of the individual cash ﬂows of the stream. For example, suppose we must ﬁnd the PV of the following cash ﬂow stream, discounted at 6 percent: 0 PV ?

6% 1 100

2

3

4

5

6

7

200

200

200

200

0

1,000

The PV will be found by applying this general present value equation: 1 2 n 1 1 1 b CF2 a b CFn a b 1i 1i 1i n t n 1 b a CFt(PVIFi,t). a CFt a 1i t1 t1

PV CF1 a

(2-8)

78

Time Value of Money Time Value of Money

We could ﬁnd the PV of each individual cash ﬂow using the numerical, ﬁnancial calculator, or spreadsheet methods, and then sum these values to ﬁnd the present value of the stream. Here is what the process would look like: 2

3

4

5

6

7

100

200

200

200

200

0

1,000

↑               ↑                      ↑                             ↑                                 

94.34 178.00 167.92 158.42 149.45 0.00 665.06 1,413.19

1

↑ ↑          

6%

↑                                        

0

All we did was to apply Equation 2-8, show the individual PVs in the left column of the diagram, and then sum these individual PVs to ﬁnd the PV of the entire stream. The present value of a cash ﬂow stream can always be found by summing the present values of the individual cash ﬂows as shown above. However, cash ﬂow regularities within the stream may allow the use of shortcuts. For example, notice that the cash ﬂows in periods 2 through 5 represent an annuity. We can use that fact to solve the problem in a slightly different manner: 0

6%

94.34

1

2

3

4

5

6

7

100

200

200

200

200

0

1,000

↑ ↑ ↑         ↑                                                         

CHAPTER 2

693.02

653.79 0.00 665.06 1,413.19

↑                                        

80

Cash ﬂows during Years 2 to 5 represent an ordinary annuity, and we ﬁnd its PV at Year 1 (one period before the ﬁrst payment). This PV ($693.02) must then be discounted back one more period to get its Year 0 value, $653.79. Problems involving uneven cash ﬂows can be solved in one step with most ﬁnancial calculators. First, you input the individual cash ﬂows, in chronological order, into the cash ﬂow register. Cash ﬂows are usually designated CF0, CF1, CF2, CF3, and so on. Next, you enter the interest rate, I. At this point, you have substituted in all the known values of Equation 2-8, so you only need to press the NPV key to ﬁnd the present value of the stream. The calculator has been programmed to ﬁnd the PV of each cash ﬂow and then to sum these values to ﬁnd the PV of the entire stream. To input the cash ﬂows for this problem, enter 0 (because CF0 0), 100, 200, 200, 200, 200, 0, 1000 in that order into the cash ﬂow register, enter I 6, and then press NPV to obtain the answer, $1,413.19. Two points should be noted. First, when dealing with the cash ﬂow register, the calculator uses the term “NPV” rather than “PV.” The N stands for “net,” so NPV is

79

Time Value of Money Uneven Cash Flow Streams

81

the abbreviation for “Net Present Value,” which is simply the net present value of a series of positive and negative cash ﬂows, including the cash ﬂow at time zero. The second point to note is that annuities can be entered into the cash ﬂow register more efﬁciently by using the Nj key.7 In this illustration, you would enter CF0 0, CF1 100, CF2 200, Nj 4 (which tells the calculator that the 200 occurs 4 times), CF6 0, and CF7 1000. Then enter I 6 and press the NPV key, and 1,413.19 will appear in the display. Also, note that amounts entered into the cash ﬂow register remain in the register until they are cleared. Thus, if you had previously worked a problem with eight cash ﬂows, and then moved to a problem with only four cash ﬂows, the calculator would simply add the cash ﬂows from the second problem to those of the ﬁrst problem. Therefore, you must be sure to clear the cash ﬂow register before starting a new problem. Spreadsheets are especially useful for solving problems with uneven cash ﬂows. Just as with a ﬁnancial calculator, you must enter the cash ﬂows in the spreadsheet: A 1

Interest rate

2

Time

3

Cash ﬂow

4

Present value

B

C

D

E

F

G

H

I

0.06 0

1

2

3

4

5

6

7

100

200

200

200

200

0

1,000

1,413.19

To ﬁnd the PV of these cash ﬂows with Excel, put the cursor on Cell B4, click the function wizard, click Financial, scroll down to NPV, and click OK to get the dialog box. Then enter B1 or 0.06 for Rate and the range of cells containing the cash ﬂows, C3⬊I3, for Value 1. Be very careful when entering the range of cash ﬂows. With a ﬁnancial calculator, you begin by entering the time zero cash ﬂow. With Excel, you do not include the time zero cash ﬂow; instead, you begin with the Year 1 cash ﬂow. Now, when you click OK, you get the PV of the stream, $1,413.19. Note that you use the PV function if the cash ﬂows (or payments) are constant, but the NPV function if they are not constant. Note too that one of the advantages of spreadsheets over ﬁnancial calculators is that you can see the cash ﬂows, which makes it easy to spot any typing errors.

Future Value of an Uneven Cash Flow Stream The future value of an uneven cash ﬂow stream (sometimes called the terminal value) is found by compounding each payment to the end of the stream and then summing the future values: FVn CF1(1 i)n1 CF2(1 i)n2 CFn1(1 i) CFn n

n

a CFt(1 i)nt a CFt(FVIFi,nt). t1

7

(2-9)

t1

On some calculators, you are prompted to enter the number of times the cash ﬂow occurs, and on still other calculators, the procedures for inputting data, as we discuss next, may be different. You should consult your calculator manual or our Technology Supplement to determine the appropriate steps for your speciﬁc calculator.

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Time Value of Money 82

CHAPTER 2

Time Value of Money

The future value of our illustrative uneven cash ﬂow stream is $2,124.92: 0

6% 1 100

3

4

5

6

7

200

200

200

200

0

1,000 0 224.72 238.20 252.50 267.65 141.85 2,124.92

↑   

2

↑          ↑                ↑                       ↑                              ↑                                  

Some ﬁnancial calculators have a net future value (NFV) key which, after the cash ﬂows and interest rate have been entered, can be used to obtain the future value of an uneven cash ﬂow stream. Even if your calculator doesn’t have the NFV feature, you can use the cash ﬂow stream’s net present value to ﬁnd its net future value: NFV NPV (1 i)n. Thus, in our example, you could ﬁnd the PV of the stream, then ﬁnd the FV of that PV, compounded for n periods at i percent. In the illustrative problem, ﬁnd PV 1,413.19 using the cash ﬂow register and I 6. Then enter N 7, I 6, PV 1413.19, and PMT 0, and then press FV to ﬁnd FV 2,124.92, which equals the NFV shown on the time line above.

Solving for i with Uneven Cash Flow Streams It is relatively easy to solve for i numerically when the cash ﬂows are lump sums or annuities. However, it is extremely difﬁcult to solve for i if the cash ﬂows are uneven, because then you would have to go through many tedious trial-and-error calculations. With a spreadsheet program or a ﬁnancial calculator, though, it is easy to ﬁnd the value of i. Simply input the CF values into the cash ﬂow register and then press the IRR key. IRR stands for “internal rate of return,” which is the percentage return on an investment. We will defer further discussion of this calculation for now, but we will take it up later, in our discussion of capital budgeting methods in Chapter 7.8 Give two examples of ﬁnancial decisions that would typically involve uneven cash ﬂows. (Hint: Think about a bond or a stock that you plan to hold for ﬁve years.) What is meant by the term “terminal value”?

Growing Annuities Normally, an annuity is deﬁned as a series of constant payments to be received over a speciﬁed number of periods. However, the term growing annuity is used to describe a series of payments that is growing at a constant rate for a speciﬁed number of periods. The most common application of growing annuities is in the area of ﬁnancial planning, where someone wants to maintain a constant real, or inﬂationadjusted, income over some speciﬁed number of years. For example, suppose a 65-year-old person is contemplating retirement, expects to live for another 20 years, 8

To obtain an IRR solution, at least one of the cash ﬂows must have a negative sign, indicating that it is an investment. Since none of the CFs in our example were negative, the cash ﬂow stream has no IRR. However, had we input a cost for CF0, say, $1,000, we could have obtained an IRR, which would be the rate of return earned on the $1,000 investment. Here IRR would be 13.96 percent.

81

Time Value of Money Semiannual and Other Compounding Periods

83

has $1 million of investment funds, expects to earn 10 percent on the investments, expects inﬂation to average 5 percent per year, and wants to withdraw a constant real amount per year. What is the maximum amount that he or she can withdraw at the end of each year? We explain in the spreadsheet model for this chapter, Ch 02 Tool Kit.xls that the problem can be solved in three ways. (1) Use the real rate of return for I in a ﬁnancial calculator. (2) Use a relatively complicated formula. Or (3) use a spreadsheet model, with Excel’s Goal Seek feature used to ﬁnd the maximum withdrawal that will leave a zero balance in the account at the end of 20 years. The ﬁnancial calculator approach is the easiest to use, but the spreadsheet model provides the clearest picture of what is happening. Also, the spreadsheet approach can be adapted to ﬁnd other parameters of the general model, such as the maximum number of years a given constant income can be provided by the initial portfolio. To implement the calculator approach, ﬁrst calculate the expected real rate of return as follows, where rr is the real rate and rnom is the nominal rate of return: Real rate rr [(1 rnom)/(1 Inflation)] 1.0 [1.10/1.05] 1.0 4.761905%. Now, with a ﬁnancial calculator, input N 20, I 4.761905, PV 1000000, and FV 0, and then press PMT to get the answer, $78,630.64. Thus, a portfolio worth $1 million will provide 20 annual payments with a current dollar value of $78,630.64 under the stated assumptions. The actual payments will be growing at 5 percent per year to offset inﬂation. The (nominal) value of the portfolio will be growing at ﬁrst and then declining, and it will hit zero at the end of the 20th year. The Ch 02 Tool Kit.xls shows all this in both tabular and graphic form.9 Differentiate between a “regular” and a growing annuity. What three methods can be used to deal with growing annuities?

Semiannual and Other Compounding Periods In almost all of our examples thus far, we have assumed that interest is compounded once a year, or annually. This is called annual compounding. Suppose, however, that you put $100 into a bank which states that it pays a 6 percent annual interest rate but that interest is credited each six months. This is called semiannual compounding. How much would you have accumulated at the end of one year, two years, or some other period under semiannual compounding? Note that virtually all bonds pay interest semiannually, most stocks pay dividends quarterly, and most mortgages, student loans, and auto loans require monthly payments. Therefore, it is essential that you understand how to deal with nonannual compounding.

Types of Interest Rates Compounding involves three types of interest rates: nominal rates, iNom; periodic rates, iPER; and effective annual rates, EAR or EFF%. 9

The formula used to ﬁnd the payment is shown below. Other formulas can be developed to solve for n and other terms, but they are even more complex. PVIF of a Growing Annuity PVIFGA [1 [(1 g)/(1 i)]n]/[(i g)/(1 g)] 12.72. Payment PMT PV/PVIFGA $1,000,000/12.72 $78,630.64.

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Time Value of Money 84

CHAPTER 2

Time Value of Money

1. Nominal, or quoted, rate.10 This is the rate that is quoted by banks, brokers, and other ﬁnancial institutions. So, if you talk with a banker, broker, mortgage lender, auto ﬁnance company, or student loan ofﬁcer about rates, the nominal rate is the one he or she will normally quote you. However, to be meaningful, the quoted nominal rate must also include the number of compounding periods per year. For example, a bank might offer 6 percent, compounded quarterly, on CDs, or a mutual fund might offer 5 percent, compounded monthly, on its money market account. The nominal rate on loans to consumers is also called the Annual Percentage Rate (APR). For example, if a credit card issuer quotes an annual rate of 18 percent, this is the APR. Note that the nominal rate is never shown on a time line, and it is never used as an input in a ﬁnancial calculator, unless compounding occurs only once a year. If more frequent compounding occurs, you should use the periodic rate as discussed below. 2. Periodic rate, iPER. This is the rate charged by a lender or paid by a borrower each period. It can be a rate per year, per six-month period, per quarter, per month, per day, or per any other time interval. For example, a bank might charge 1.5 percent per month on its credit card loans, or a ﬁnance company might charge 3 percent per quarter on installment loans. We ﬁnd the periodic rate as follows: Periodic rate, iPER i Nom/m,

(2-10)

Nominal annual rate i Nom (Periodic rate)(m).

(2-11)

which implies that

Here i Nom is the nominal annual rate and m is the number of compounding periods per year. To illustrate, consider a ﬁnance company loan at 3 percent per quarter: Nominal annual rate iNom (Periodic rate)(m) (3%)(4) 12%, or Periodic rate i Nom/m 12%/4 3% per quarter. If there is only one payment per year, or if interest is added only once a year, then m 1, and the periodic rate is equal to the nominal rate. The periodic rate is the rate that is generally shown on time lines and used in calculations.11 To illustrate use of the periodic rate, suppose you invest $100 in an 10

The term nominal rate as it is used here has a different meaning than the way it was used in Chapter 1. There, nominal interest rates referred to stated market rates as opposed to real (zero inﬂation) rates. In this chapter, the term nominal rate means the stated, or quoted, annual rate as opposed to the effective annual rate, which we explain later. In both cases, though, nominal means stated, or quoted, as opposed to some adjusted rate. 11 The only exception is in situations where (1) annuities are involved and (2) the payment periods do not correspond to the compounding periods. If an annuity is involved and if its payment periods do not correspond to the compounding periods—for example, if you are making quarterly payments into a bank account to build up a speciﬁed future sum, but the bank pays interest on a daily basis—then the calculations are more complicated. For such problems, one can proceed in two alternative ways. (1) Determine the periodic (daily) interest rate by dividing the nominal rate by 360 (or 365 if the bank uses a 365-day year), then compound each payment over the exact number of days from the payment date to the terminal point, and then sum the compounded payments to ﬁnd the future value of the annuity. This is what would generally be done in the real world, because with a computer, it would be a simple process. (2) Calculate the EAR, as deﬁned on the next page, based on daily compounding, then ﬁnd the corresponding nominal rate based on quarterly compounding (because the annuity payments are made quarterly), then ﬁnd the quarterly periodic rate, and then use that rate with standard annuity procedures. The second procedure is faster with a calculator, but hard to explain and generally not used in practice given the ready availability of computers.

83

Time Value of Money Semiannual and Other Compounding Periods

85

account that pays a nominal rate of 12 percent, compounded quarterly. How much would you have after two years? For compounding more frequently than annually, we use the following modiﬁcation of Equation 2-1: iNom mn b . m

FVn PV(1 iPER)Number of periods PV a1

(2-12)

Time Line and Equation: 0 3% 1

2

3

4

5

6

7

100

8

Quarters

FV ?

FVn = PV(l iPER)Number of periods. 1. NUMERICAL SOLUTION

Using Equation 2–12,

FV = $l00 (1 0.03)8 = $126.68.

2. FINANCIAL CALCULATOR SOLUTION

Inputs:

8

3

–100

0

126.68

Output:

Input N 2 4 8, I 12/4 3, PV –100, and PMT 0, and then press the FV key to get FV $126.68.

3. SPREADSHEET SOLUTION

A spreadsheet could be developed as we did earlier in the chapter in our discussion of the future value of a lump sum. Rows would be set up to show the interest rate, time, cash ﬂow, and future value of the lump sum. The interest rate used in the spreadsheet would be the periodic interest rate (i Nom/m) and the number of time periods shown would be (m)(n). 3. Effective (or equivalent) annual rate (EAR). This is the annual rate that produces the same result as if we had compounded at a given periodic rate m times per year. The EAR, also called EFF% (for effective percentage), is found as follows: EAR (or EFF%) a1

i Nom m b 1.0. m

(2-13)

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You could also use the interest conversion feature of a ﬁnancial calculator.12 In the EAR equation, iNom/m is the periodic rate, and m is the number of periods per year. For example, suppose you could borrow using either a credit card that charges 1 percent per month or a bank loan with a 12 percent quoted nominal interest rate that is compounded quarterly. Which should you choose? To answer this question, the cost rate of each alternative must be expressed as an EAR: Credit card loan: EAR Bank loan: EAR

(1 0.01)12 1.0 (1.01)12 1.0 1.126825 1.0 0.126825 12.6825%. (1 0.03)4 1.0 (1.03)4 1.0 1.125509 1.0 0.125509 12.5509%.

Thus, the credit card loan is slightly more costly than the bank loan. This result should have been intuitive to you—both loans have the same 12 percent nominal rate, yet you would have to make monthly payments on the credit card versus quarterly payments under the bank loan. The EAR rate is not used in calculations. However, it should be used to compare the effective cost or rate of return on loans or investments when payment periods differ, as in the credit card versus bank loan example.

The Result of Frequent Compounding Suppose you plan to invest $100 for ﬁve years at a nominal annual rate of 10 percent. What will happen to the future value of your investment if interest is compounded more frequently than once a year? Because interest will be earned on interest more often, you might expect the future value to increase as the frequency of compounding increases. Similarly, you might also expect the effective annual rate to increase with more frequent compounding. As Table 2-1 shows, you would be correct—the future value and EAR do in fact increase as the frequency of compounding increases. Notice

12

Most ﬁnancial calculators are programmed to ﬁnd the EAR or, given the EAR, to ﬁnd the nominal rate. This is called “interest rate conversion,” and you simply enter the nominal rate and the number of compounding periods per year and then press the EFF% key to ﬁnd the effective annual rate.

TABLE 2-1

Frequency of Compounding

Annual Semiannual Quarterly Monthly Dailyc a

The Inpact of Frequent Compounding Nominal Annual Rate

Effective Annual Rate (EAR)a

Future Value of $100 Invested for 5 Yearsb

10% 10 10 10 10

10.000% 10.250 10.381 10.471 10.516

$161.05 162.89 163.86 164.53 164.86

The EAR is calculated using Equation 2-13. The future value is calculated using Equation 2-12. c The daily calculations assume 365 days per year. b

85

Time Value of Money Fractional Time Periods

87

Using the Internet for Personal Financial Planning

People continually face important ﬁnancial decisions that require an understanding of the time value of money. Should we buy or lease a car? How much and how soon do we need to save for our children’s education? What size house can we afford? Should we reﬁnance our home mortgage? How much must we save in order to retire comfortably? The answers to these questions are often complicated, and they depend on a number of factors, such as housing and education costs, interest rates, inﬂation, expected family income, and stock market returns. Hopefully, after completing this chapter, you will have a better idea of how to answer such questions. Moreover, there are a number of online resources available to help with ﬁnancial planning. A good place to start is http://www.smartmoney.com. Smartmoney is a personal ﬁnance magazine produced by the publishers of The Wall Street Journal. If you go to Smartmoney’s web site you will ﬁnd a section entitled “Tools.” This

section has a number of ﬁnancial calculators, spreadsheets, and descriptive materials that cover a wide range of personal ﬁnance issues. Another good place to look is Quicken’s web site, http://www.quicken.com. Here you will ﬁnd several interesting sections that deal with a variety of personal ﬁnance issues. Within these sections you will ﬁnd background articles plus spreadsheets and calculators that you can use to analyze your own situation. Finally, http://www.ﬁnancialengines.com is a great place to visit if you are focusing speciﬁcally on retirement planning. This web site, developed by Nobel Prize–winning ﬁnancial economist William Sharpe, considers a wide range of alternative scenarios that might occur. This approach, which enables you to see a full range of potential outcomes, is much better than some of the more basic online calculators that give you simple answers to complicated questions.

that the biggest increases in FV and EAR occur when compounding goes from annual to semiannual, and that moving from monthly to daily compounding has a relatively small impact. Although Table 2-1 shows daily compounding as the smallest interval, it is possible to compound even more frequently. At the limit, one can have continuous compounding. This is explained in the Chapter 2 Web Extension, available on the textbook’s web site. Deﬁne the nominal (or quoted) rate, the periodic rate, and the effective annual rate. Which rate should be shown on time lines and used in calculations? What changes must you make in your calculations to determine the future value of an amount that is being compounded at 8 percent semiannually versus one being compounded annually at 8 percent? Why is semiannual compounding better than annual compounding from a saver’s standpoint? What about a borrower’s standpoint?

Fractional Time Periods In all the examples used thus far in the chapter, we have assumed that payments occur at either the beginning or the end of periods, but not at some date within a period. However, we often encounter situations that require compounding or discounting over fractional periods. For example, suppose you deposited $100 in a bank that adds interest to your account daily, that is, uses daily compounding, and pays a nominal rate

86

Time Value of Money 88

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Time Value of Money

of 10 percent with a 360-day year. How much will be in your account after nine months? The answer is $107.79:13 Periodic rate iPER 0.10/360 0.00027778 per day. Number of days 0.75(360) 270. Ending amount $100(1.00027778)270 $107.79. Now suppose you borrow $100 from a bank that charges 10 percent per year “simple interest,” which means annual rather than daily compounding, but you borrow the $100 for only 270 days. How much interest would you have to pay for the use of $100 for 270 days? Here we would calculate a daily interest rate, iPER, as above, but multiply by 270 rather than use it as an exponent: Interest owed $100(0.00027778)(270) $7.50 interest charged. You would owe the bank a total of $107.50 after 270 days. This is the procedure most banks actually use to calculate interest on loans, except that they generally require you to pay the interest on a monthly basis rather than after 270 days. Finally, let’s consider a somewhat different situation. Say an Internet access ﬁrm had 100 customers at the end of 2002, and its customer base is expected to grow steadily at the rate of 10 percent per year. What is the estimated customer base nine months into the new year? This problem would be set up exactly like the bank account with daily compounding, and the estimate would be 107.79 customers, rounded to 108. The most important thing in problems like these, as in all time value problems, is to be careful! Think about what is involved in a logical, systematic manner, draw a time line if it would help you visualize the situation, and then apply the appropriate equations.

Amortized Loans One of the most important applications of compound interest involves loans that are paid off in installments over time. Included are automobile loans, home mortgage loans, student loans, and most business loans other than very short-term loans and long-term bonds. If a loan is to be repaid in equal periodic amounts (monthly, quarterly, or annually), it is said to be an amortized loan.14 Table 2-2 illustrates the amortization process. A ﬁrm borrows $1,000, and the loan is to be repaid in three equal payments at the end of each of the next three years. (In this case, there is only one payment per year, so years periods and the stated rate periodic rate.) The lender charges a 6 percent interest rate on the loan balance that is outstanding at the beginning of each year. The ﬁrst task is to determine the amount the ﬁrm must repay each year, or the constant annual payment. To ﬁnd this amount, recognize that the $1,000 represents the present value of an annuity of PMT dollars per year for three years, discounted at 6 percent:

13

Here we assumed a 360-day year, and we also assumed that the nine months all have 30 days. This convention is often used. However, some contracts specify that actual days be used. Computers (and many ﬁnancial calculators) have a built-in calendar, and if you input the beginning and ending dates, the computer or calculator would tell you the exact number of days, taking account of 30-day months, 31-day months, and 28- or 29-day months. 14 The word amortized comes from the Latin mors, meaning “death,” so an amortized loan is one that is “killed off” over time.

87

Time Value of Money Amortized Loans TABLE 2-2

Year

Beginning Amount (1)

1 2 3

$1,000.00 685.89 352.93

89

Loan Amortization Schedule, 6 Percent Interest Rate

Payment (2)

Interesta (3)

Repayment of Principalb (2) (3) (4)

Remaining Balance (1) (4) (5)

$ 374.11 374.11 374.11 $1,122.33

$ 60.00 41.15 21.18 $122.33

$ 314.11 332.96 352.93 $1,000.00

$685.89 352.93 0.00

a Interest is calculated by multiplying the loan balance at the beginning of the year by the interest rate. Therefore, interest in Year 1 is $1,000(0.06) $60; in Year 2 it is $685.89(0.06) $41.15; and in Year 3 it is $352.93(0.06) $21.18. b Repayment of principal is equal to the payment of $374.11 minus the interest charge for each year.

Time Line: 0

6%

1,000

1

2

3

PMT

PMT

PMT

Equation: The same general equation used to ﬁnd the PV of an ordinary annuity is shown below: 1 2 n 1 1 1 b PMTa b PMTa b 1i 1i 1i n t 1 PMT a a b t1 1 i (2-5) 1 1 (1 i)n ¢ ° PMT i PMT(PVIFAi,n) .

PVAn PMTa

1. NUMERICAL SOLUTION

We know the PV, the interest rate, and the number of periods. The only unknown variable is the payment: 3 t 1 $1,000 PMT a a b t1 1 0.06 1 1 (1 0.06)3 ¢ ° PMT . 0.06

Using Equation 2-5a, we can solve the equation for the payment: 1 (1 0.06)3 ¢ ° $1,000 PMT PMT(2.6730) 0.06 PMT $1,000/2.6730 $374.11. 1

(2-5a)

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Time Value of Money 90

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Time Value of Money 2. FINANCIAL CALCULATOR SOLUTION

Inputs:

3

Output:

6

1000

0

374.11

Enter N 3, I 6, PV 1000, and FV 0, and then press the PMT key to ﬁnd PMT $374.11. 3. SPREADSHEET SOLUTION

See Ch 02 Tool Kit.xls for details.

The spreadsheet is ideal for developing amortization tables. The setup is similar to Table 2–2, but you would want to include “input” cells for the interest rate, principal value, and the length of the loan. This would make the spreadsheet ﬂexible in the sense that the loan terms could be changed and a new amortization table would be recalculated instantly. Then use the function wizard to ﬁnd the payment. If you had I 6% in B1, N 3 in B2, and PV 1000 in B3, then the function PMT(B1, B2, B3) would return a result of $374.11. Therefore, the ﬁrm must pay the lender $374.11 at the end of each of the next three years, and the percentage cost to the borrower, which is also the rate of return to the lender, will be 6 percent. Each payment consists partly of interest and partly of repayment of principal. This breakdown is given in the amortization schedule shown in Table 2–2. The interest component is largest in the ﬁrst year, and it declines as the outstanding balance of the loan decreases. For tax purposes, a business borrower or homeowner reports the interest component shown in Column 3 as a deductible cost each year, while the lender reports this same amount as taxable income. Financial calculators are programmed to calculate amortization tables—you simply enter the input data, and then press one key to get each entry in Table 2–2. If you have a ﬁnancial calculator, it is worthwhile to read the appropriate section of the calculator manual and learn how to use its amortization feature. As we show in the model for this chapter, with a spreadsheet such as Excel it is easy to set up and print out a full amortization schedule. To construct an amortization schedule, how do you determine the amount of the periodic payments? How do you determine the amount of each payment that goes to interest and to principal?

Summary Most ﬁnancial decisions involve situations in which someone pays money at one point in time and receives money at some later time. Dollars paid or received at two different points in time are different, and this difference is recognized and accounted for by time value of money (TVM) analysis. We summarize below the types of TVM analysis and the key concepts covered in this chapter, using the data

89

Time Value of Money Summary Illustration for Chapter Summary (i 4%, Annual Compounding)

4%

2

3

1,000

1,000

↑    

↑      ↑             

961.50 924.60 889.00 Present value 2,775.10

1

↑           

0

Years

1,000.00 1,040.00 1,081.60

↑                

FIGURE 2-3

91

Future value 3,121.60

shown in Figure 2-3 to illustrate the various points. Refer to the ﬁgure constantly, and try to ﬁnd in it an example of the points covered as you go through this summary. 䊉

䊉

Compounding is the process of determining the future value (FV) of a cash ﬂow or a series of cash ﬂows. The compounded amount, or future value, is equal to the beginning amount plus the interest earned. Future value: FVn PV(1 i)n PV(FVIFi,n). (single payment) Example: $1,000 compounded for 1 year at 4 percent: FV1 $1,000(1.04)1 $1,040.

䊉

䊉

Discounting is the process of ﬁnding the present value (PV) of a future cash ﬂow or a series of cash ﬂows; discounting is the reciprocal, or reverse, of compounding. n FVn 1 b FV a FVn(PVIFi,n). Present value: PV n (1 i)n 1i (single payment) Example: $1,000 discounted back for 2 years at 4 percent: PV

䊉

䊉

$1,000 (1.04)2

$1,000 a

1 2 b $1,000(0.9246) $924.60. 1.04

An annuity is deﬁned as a series of equal periodic payments (PMT) for a speciﬁed number of periods. Future value: (annuity)

FVAn PMT(1 i)n1 PMT(1 i)n2 PMT(1 i)n3 PMT(1 i)0 n

PMT a (1 i)nt t1

(1 i)n 1 b i PMT(FVIFA i,n).

PMTa

Example: FVA of 3 payments of $1,000 when i 4%: FVA3 $1,000(3.1216) $3,121.60.

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Time Value of Money 92

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Time Value of Money

䊉

PMT PMT PMT Present value: PVAn 1 2 (1 i)n (1 i) (1 i) (annuity) n 1 t PMT a c d 1i t1 1 1 (1 i)n ¢ ° PMT i PMT(PVIFAi,n).

Example: PVA of 3 payments of $1,000 when i 4% per period: PVA3 $1,000(2.7751) $2,775.10. 䊉

䊉

An annuity whose payments occur at the end of each period is called an ordinary annuity. The formulas above are for ordinary annuities. If each payment occurs at the beginning of the period rather than at the end, then we have an annuity due. In Figure 2-3, the payments would be shown at Years 0, 1, and 2 rather than at Years 1, 2, and 3. The PV of each payment would be larger, because each payment would be discounted back one year less, so the PV of the annuity would also be larger. Similarly, the FV of the annuity due would also be larger because each payment would be compounded for an extra year. The following formulas can be used to convert the PV and FV of an ordinary annuity to an annuity due: PVA (annuity due) PVA of an ordinary annuity (1 i). FVA (annuity due) FVA of an ordinary annuity (1 i). Example: PVA of 3 beginning-of-year payments of $1,000 when i 4%: PVA (annuity due) $1,000(2.7751)(1.04) $2,886.10. Example: FVA of 3 beginning-of-year payments of $1,000 when i 4%: FVA (annuity due) $1,000(3.1216)(1.04) $3,246.46.

䊉

If the time line in Figure 2-3 were extended out forever so that the $1,000 payments went on forever, we would have a perpetuity whose value could be found as follows: Value of perpetuity

䊉

䊉

䊉

$1,000 PMT $25,000. i 0.04

If the cash ﬂows in Figure 2-3 were unequal, we could not use the annuity formulas. To ﬁnd the PV or FV of an uneven series, ﬁnd the PV or FV of each individual cash ﬂow and then sum them. Note, though, that if some of the cash ﬂows constitute an annuity, then the annuity formula can be used to calculate the present value of that part of the cash ﬂow stream. Financial calculators have built-in programs that perform all of the operations discussed in this chapter. It would be useful for you to buy such a calculator and to learn how to use it. Spreadsheet programs are especially useful for problems with many uneven cash ﬂows. They are also very useful if you want to solve a problem repeatedly with dif-

91

Time Value of Money Summary

䊉

䊉

䊉

93

ferent inputs. See Ch 02 Tool Kit.xls on the textbook’s web site that accompanies this text for spreadsheet models of the topics covered in this chapter. TVM calculations generally involve equations that have four variables, and if you know three of the values, you (or your calculator) can solve for the fourth. If you know the cash ﬂows and the PV (or FV) of a cash ﬂow stream, you can determine the interest rate. For example, in the Figure 2-3 illustration, if you were given the information that a loan called for 3 payments of $1,000 each, and that the loan had a value today of PV $2,775.10, then you could ﬁnd the interest rate that caused the sum of the PVs of the payments to equal $2,775.10. Since we are dealing with an annuity, you could proceed as follows: With a ﬁnancial calculator, enter N 3, PV 2775.10, PMT 1000, FV 0, and then press the I key to ﬁnd I 4%. Thus far in this section we have assumed that payments are made, and interest is earned, annually. However, many contracts call for more frequent payments; for example, mortgage and auto loans call for monthly payments, and most bonds pay interest semiannually. Similarly, most banks compute interest daily. When compounding occurs more frequently than once a year, this fact must be recognized. We can use the Figure 2-3 example to illustrate semiannual compounding. First, recognize that the 4 percent stated rate is a nominal rate that must be converted to a periodic rate, and the number of years must be converted to periods: iPER Stated rate/Periods per year 4%/2 2%. Periods Years Periods per year 3 2 6.

䊉

The periodic rate and number of periods would be used for calculations and shown on time lines. If the $1,000 per-year payments were actually payable as $500 each 6 months, you would simply redraw Figure 2-3 to show 6 payments of $500 each, but you would also use a periodic interest rate of 4%/2 2% for determining the PV or FV of the payments. If we are comparing the costs of loans that require payments more than once a year, or the rates of return on investments that pay interest more frequently, then the comparisons should be based on equivalent (or effective) rates of return using this formula: Effective annual rate EAR (or EFF%) a1

i Nom m b 1.0. m

For semiannual compounding, the effective annual rate is 4.04 percent: a1 䊉

0.04 2 b 1.0 (1.02)2 1.0 1.0404 1.0 0.0404 4.04% . 2

The general equation for ﬁnding the future value for any number of compounding periods per year is: FVn PV a1

i Nom mn b , m

where i Nom quoted interest rate. m number of compounding periods per year. n number of years.

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Time Value of Money 94

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Time Value of Money 䊉

An amortized loan is one that is paid off in equal payments over a speciﬁed period. An amortization schedule shows how much of each payment constitutes interest, how much is used to reduce the principal, and the unpaid balance at each point in time.

The concepts covered in this chapter will be used throughout the remainder of the book. For example, in Chapters 4 and 5, we apply present value concepts to ﬁnd the values of bonds and stocks, and we see that the market prices of securities are established by determining the present values of the cash ﬂows they are expected to provide. In later chapters, the same basic concepts are applied to corporate decisions involving expenditures on capital assets, to the types of capital that should be used to pay for assets, and so forth.

Questions 2–1

Deﬁne each of the following terms: a. PV; i; INT; FVn; PVA n; FVA n; PMT; m; i Nom b. FVIFi,n; PVIFi,n; FVIFA i,n; PVIFA i,n c. Opportunity cost rate d. Annuity; lump sum payment; cash ﬂow; uneven cash ﬂow stream e. Ordinary (deferred) annuity; annuity due f. Perpetuity; consol g. Outﬂow; inﬂow; time line; terminal value h. Compounding; discounting i. Annual, semiannual, quarterly, monthly, and daily compounding j. Effective annual rate (EAR); nominal (quoted) interest rate; APR; periodic rate k. Amortization schedule; principal versus interest component of a payment; amortized loan

2–2

What is an opportunity cost rate? How is this rate used in discounted cash ﬂow analysis, and where is it shown on a time line? Is the opportunity rate a single number which is used in all situations?

2–3

An annuity is deﬁned as a series of payments of a ﬁxed amount for a speciﬁc number of periods. Thus, $100 a year for 10 years is an annuity, but $100 in Year 1, $200 in Year 2, and $400 in Years 3 through 10 does not constitute an annuity. However, the second series contains an annuity. Is this statement true or false?

2–4

If a ﬁrm’s earnings per share grew from $1 to $2 over a 10-year period, the total growth would be 100 percent, but the annual growth rate would be less than 10 percent. True or false? Explain.

2–5

Would you rather have a savings account that pays 5 percent interest compounded semiannually or one that pays 5 percent interest compounded daily? Explain.

Self-Test Problems ST–1 FUTURE VALUE

(Solutions Appear in Appendix A)

Assume that one year from now, you will deposit $1,000 into a savings account that pays 8 percent. a. If the bank compounds interest annually, how much will you have in your account four years from now? b. What would your balance four years from now be if the bank used quarterly compounding rather than annual compounding? c. Suppose you deposited the $1,000 in 4 payments of $250 each at Year 1, Year 2, Year 3, and Year 4. How much would you have in your account at Year 4, based on 8 percent annual compounding? d. Suppose you deposited 4 equal payments in your account at Year 1, Year 2, Year 3, and Year 4. Assuming an 8 percent interest rate, how large would each of your payments have to be for you to obtain the same ending balance as you calculated in part a?

93

Time Value of Money Problems ST–2 TIME VALUE OF MONEY

ST–3 EFFECTIVE ANNUAL RATES

95

Assume that you will need $1,000 four years from now. Your bank compounds interest at an 8 percent annual rate. a. How much must you deposit one year from now to have a balance of $1,000 four years from now? b. If you want to make equal payments at Years 1 through 4, to accumulate the $1,000, how large must each of the 4 payments be? c. If your father were to offer either to make the payments calculated in part b ($221.92) or to give you a lump sum of $750 one year from now, which would you choose? d. If you have only $750 one year from now, what interest rate, compounded annually, would you have to earn to have the necessary $1,000 four years from now? e. Suppose you can deposit only $186.29 each at Years 1 through 4, but you still need $1,000 at Year 4. What interest rate, with annual compounding, must you seek out to achieve your goal? f. To help you reach your $1,000 goal, your father offers to give you $400 one year from now. You will get a part-time job and make 6 additional payments of equal amounts each 6 months thereafter. If all of this money is deposited in a bank which pays 8 percent, compounded semiannually, how large must each of the 6 payments be? g. What is the effective annual rate being paid by the bank in part f? Bank A pays 8 percent interest, compounded quarterly, on its money market account. The managers of Bank B want its money market account to equal Bank A’s effective annual rate, but interest is to be compounded on a monthly basis. What nominal, or quoted, rate must Bank B set?

Problems 2–1 PRESENT AND FUTURE VALUES FOR DIFFERENT PERIODS

2–2 PRESENT AND FUTURE VALUES FOR DIFFERENT INTEREST RATES

2–3 TIME FOR A LUMP SUM TO DOUBLE

Find the following values, using the equations, and then work the problems using a ﬁnancial calculator to check your answers. Disregard rounding differences. (Hint: If you are using a ﬁnancial calculator, you can enter the known values and then press the appropriate key to ﬁnd the unknown variable. Then, without clearing the TVM register, you can “override” the variable which changes by simply entering a new value for it and then pressing the key for the unknown variable to obtain the second answer. This procedure can be used in parts b and d, and in many other situations, to see how changes in input variables affect the output variable.) a. An initial $500 compounded for 1 year at 6 percent. b. An initial $500 compounded for 2 years at 6 percent. c. The present value of $500 due in 1 year at a discount rate of 6 percent. d. The present value of $500 due in 2 years at a discount rate of 6 percent. Use equations and a ﬁnancial calculator to ﬁnd the following values. See the hint for Problem 2-1. a. An initial $500 compounded for 10 years at 6 percent. b. An initial $500 compounded for 10 years at 12 percent. c. The present value of $500 due in 10 years at a 6 percent discount rate. d. The present value of $1,552.90 due in 10 years at a 12 percent discount rate and at a 6 percent rate. Give a verbal deﬁnition of the term present value, and illustrate it using a time line with data from this problem. As a part of your answer, explain why present values are dependent upon interest rates. To the closest year, how long will it take $200 to double if it is deposited and earns the following rates? [Notes: (1) See the hint for Problem 2-1. (2) This problem cannot be solved exactly with some ﬁnancial calculators. For example, if you enter PV 200, PMT 0, FV 400, and I 7 in an HP-12C, and then press the N key, you will get 11 years for part a. The correct answer is 10.2448 years, which rounds to 10, but the calculator rounds up. However, the HP10B and HP-17B give the correct answer.] a. 7 percent. b. 10 percent. c. 18 percent. d. 100 percent.

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Time Value of Money 2–4

FUTURE VALUE OF AN ANNUITY

2–5 PRESENT VALUE OF AN ANNUITY

2–6 UNEVEN CASH FLOW STREAM

Find the future value of the following annuities. The ﬁrst payment in these annuities is made at the end of Year 1; that is, they are ordinary annuities. (Note: See the hint to Problem 2-1. Also, note that you can leave values in the TVM register, switch to “BEG,” press FV, and ﬁnd the FV of the annuity due.) a. $400 per year for 10 years at 10 percent. b. $200 per year for 5 years at 5 percent. c. $400 per year for 5 years at 0 percent. d. Now rework parts a, b, and c assuming that payments are made at the beginning of each year; that is, they are annuities due. Find the present value of the following ordinary annuities (see note to Problem 2-4): a. $400 per year for 10 years at 10 percent. b. $200 per year for 5 years at 5 percent. c. $400 per year for 5 years at 0 percent. d. Now rework parts a, b, and c assuming that payments are made at the beginning of each year; that is, they are annuities due. a. Find the present values of the following cash ﬂow streams. The appropriate interest rate is 8 percent. (Hint: It is fairly easy to work this problem dealing with the individual cash ﬂows. However, if you have a ﬁnancial calculator, read the section of the manual that describes how to enter cash ﬂows such as the ones in this problem. This will take a little time, but the investment will pay huge dividends throughout the course. Note, if you do work with the cash ﬂow register, then you must enter CF0 0.) Year

Cash Stream A

Cash Stream B

1 2 3 4 5

$100 400 400 400 300

$300 400 400 400 100

b. What is the value of each cash ﬂow stream at a 0 percent interest rate? 2–7 EFFECTIVE RATE OF INTEREST

2–8 FUTURE VALUE FOR VARIOUS COMPOUNDING PERIODS

2–9 PRESENT VALUE FOR VARIOUS COMPOUNDING PERIODS

2–10 FUTURE VALUE OF AN ANNUITY FOR VARIOUS COMPOUNDING PERIODS

Find the interest rates, or rates of return, on each of the following: a. You borrow $700 and promise to pay back $749 at the end of 1 year. b. You lend $700 and receive a promise to be paid $749 at the end of 1 year. c. You borrow $85,000 and promise to pay back $201,229 at the end of 10 years. d. You borrow $9,000 and promise to make payments of $2,684.80 per year for 5 years. Find the amount to which $500 will grow under each of the following conditions: a. 12 percent compounded annually for 5 years. b. 12 percent compounded semiannually for 5 years. c. 12 percent compounded quarterly for 5 years. d. 12 percent compounded monthly for 5 years. Find the present value of $500 due in the future under each of the following conditions: a. 12 percent nominal rate, semiannual compounding, discounted back 5 years. b. 12 percent nominal rate, quarterly compounding, discounted back 5 years. c. 12 percent nominal rate, monthly compounding, discounted back 1 year. Find the future values of the following ordinary annuities: a. FV of $400 each 6 months for 5 years at a nominal rate of 12 percent, compounded semiannually. b. FV of $200 each 3 months for 5 years at a nominal rate of 12 percent, compounded quarterly. c. The annuities described in parts a and b have the same amount of money paid into them during the 5-year period and both earn interest at the same nominal rate, yet the annuity in part b earns $101.60 more than the one in part a over the 5 years. Why does this occur?

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Time Value of Money Problems 2–11 EFFECTIVE VERSUS NOMINAL INTEREST RATES

2–12 AMORTIZATION SCHEDULE

2–13 GROWTH RATES

2–14 EXPECTED RATE OF RETURN

2–15 EFFECTIVE RATE OF INTEREST

2–16 REQUIRED LUMP SUM PAYMENT

2–17 REPAYING A LOAN

2–18 REACHING A FINANCIAL GOAL

2-19 PRESENT VALUE OF A PERPETUITY

2–20 PV AND EFFECTIVE ANNUAL RATE

97

Universal Bank pays 7 percent interest, compounded annually, on time deposits. Regional Bank pays 6 percent interest, compounded quarterly. a. Based on effective interest rates, in which bank would you prefer to deposit your money? b. Could your choice of banks be inﬂuenced by the fact that you might want to withdraw your funds during the year as opposed to at the end of the year? In answering this question, assume that funds must be left on deposit during the entire compounding period in order for you to receive any interest. a. Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at the end of each of the next 5 years. The interest rate is 10 percent. b. How large must each annual payment be if the loan is for $50,000? Assume that the interest rate remains at 10 percent and that the loan is paid off over 5 years. c. How large must each payment be if the loan is for $50,000, the interest rate is 10 percent, and the loan is paid off in equal installments at the end of each of the next 10 years? This loan is for the same amount as the loan in part b, but the payments are spread out over twice as many periods. Why are these payments not half as large as the payments on the loan in part b? Hanebury Corporation’s current sales were $12 million. Sales were $6 million 5 years earlier. a. To the nearest percentage point, at what rate have sales been growing? b. Suppose someone calculated the sales growth for Hanebury Corporation in part a as follows: “Sales doubled in 5 years. This represents a growth of 100 percent in 5 years, so, dividing 100 percent by 5, we ﬁnd the growth rate to be 20 percent per year.” Explain what is wrong with this calculation. Washington-Paciﬁc invests $4 million to clear a tract of land and to set out some young pine trees. The trees will mature in 10 years, at which time Washington-Paciﬁc plans to sell the forest at an expected price of $8 million. What is Washington-Paciﬁc’s expected rate of return? A mortgage company offers to lend you $85,000; the loan calls for payments of $8,273.59 per year for 30 years. What interest rate is the mortgage company charging you? To complete your last year in business school and then go through law school, you will need $10,000 per year for 4 years, starting next year (that is, you will need to withdraw the ﬁrst $10,000 one year from today). Your rich uncle offers to put you through school, and he will deposit in a bank paying 7 percent interest a sum of money that is sufﬁcient to provide the four payments of $10,000 each. His deposit will be made today. a. How large must the deposit be? b. How much will be in the account immediately after you make the ﬁrst withdrawal? After the last withdrawal? While Mary Corens was a student at the University of Tennessee, she borrowed $12,000 in student loans at an annual interest rate of 9 percent. If Mary repays $1,500 per year, how long, to the nearest year, will it take her to repay the loan? You need to accumulate $10,000. To do so, you plan to make deposits of $1,250 per year, with the ﬁrst payment being made a year from today, in a bank account which pays 12 percent annual interest. Your last deposit will be less than $1,250 if less is needed to round out to $10,000. How many years will it take you to reach your $10,000 goal, and how large will the last deposit be? What is the present value of a perpetuity of $100 per year if the appropriate discount rate is 7 percent? If interest rates in general were to double and the appropriate discount rate rose to 14 percent, what would happen to the present value of the perpetuity? Assume that you inherited some money. A friend of yours is working as an unpaid intern at a local brokerage ﬁrm, and her boss is selling some securities that call for four payments, $50 at the end of each of the next 3 years, plus a payment of $1,050 at the end of Year 4. Your friend says she can get you some of these securities at a cost of $900 each. Your money is now invested in a bank that pays an 8 percent nominal (quoted) interest rate but with quarterly compounding. You regard

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Time Value of Money the securities as being just as safe, and as liquid, as your bank deposit, so your required effective annual rate of return on the securities is the same as that on your bank deposit. You must calculate the value of the securities to decide whether they are a good investment. What is their present value to you? 2–21

LOAN AMORTIZATION

2–22 LOAN AMORTIZATION

2–23 NONANNUAL COMPOUNDING

2–24 NOMINAL RATE OF RETURN

2–25 REQUIRED ANNUITY PAYMENTS

Assume that your aunt sold her house on December 31 and that she took a mortgage in the amount of $10,000 as part of the payment. The mortgage has a quoted (or nominal) interest rate of 10 percent, but it calls for payments every 6 months, beginning on June 30, and the mortgage is to be amortized over 10 years. Now, 1 year later, your aunt must inform the IRS and the person who bought the house of the interest that was included in the two payments made during the year. (This interest will be income to your aunt and a deduction to the buyer of the house.) To the closest dollar, what is the total amount of interest that was paid during the ﬁrst year? Your company is planning to borrow $1,000,000 on a 5-year, 15%, annual payment, fully amortized term loan. What fraction of the payment made at the end of the second year will represent repayment of principal? a. It is now January 1, 2002. You plan to make 5 deposits of $100 each, one every 6 months, with the ﬁrst payment being made today. If the bank pays a nominal interest rate of 12 percent but uses semiannual compounding, how much will be in your account after 10 years? b. You must make a payment of $1,432.02 ten years from today. To prepare for this payment, you will make 5 equal deposits, beginning today and for the next 4 quarters, in a bank that pays a nominal interest rate of 12 percent, quarterly compounding. How large must each of the 5 payments be? Anne Lockwood, manager of Oaks Mall Jewelry, wants to sell on credit, giving customers 3 months in which to pay. However, Anne will have to borrow from her bank to carry the accounts payable. The bank will charge a nominal 15 percent, but with monthly compounding. Anne wants to quote a nominal rate to her customers (all of whom are expected to pay on time) which will exactly cover her ﬁnancing costs. What nominal annual rate should she quote to her credit customers? Assume that your father is now 50 years old, that he plans to retire in 10 years, and that he expects to live for 25 years after he retires, that is, until he is 85. He wants a ﬁxed retirement income that has the same purchasing power at the time he retires as $40,000 has today (he realizes that the real value of his retirement income will decline year by year after he retires). His retirement income will begin the day he retires, 10 years from today, and he will then get 24 additional annual payments. Inﬂation is expected to be 5 percent per year from today forward; he currently has $100,000 saved up; and he expects to earn a return on his savings of 8 percent per year, annual compounding. To the nearest dollar, how much must he save during each of the next 10 years (with deposits being made at the end of each year) to meet his retirement goal?

Spreadsheet Problem 2–26 BUILD A MODEL: THE TIME VALUE OF MONEY

Start with the partial model in the ﬁle Ch 02 P26 Build a Model.xls from the textbook’s web site. Answer the following questions, using a spreadsheet model to do the calculations. a. Find the FV of $1,000 invested to earn 10 percent after 5 years. Answer this question by using a math formula and also by using the Excel function wizard. b. Now create a table that shows the FV at 0 percent, 5 percent, and 20 percent for 0, 1, 2, 3, 4, and 5 years. Then create a graph with years on the horizontal axis and FV on the vertical axis to display your results. c. Find the PV of $1,000 due in 5 years if the discount rate is 10 percent. Again, work the problem with a formula and also by using the function wizard. d. A security has a cost of $1,000 and will return $2,000 after 5 years. What rate of return does the security provide? e. Suppose California’s population is 30 million people, and its population is expected to grow by 2 percent per year. How long would it take for the population to double? f. Find the PV of an annuity that pays $1,000 at the end of each of the next 5 years if the interest rate is 15 percent. Then ﬁnd the FV of that same annuity.

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Time Value of Money Mini Case

99

g. How would the PV and FV of the annuity change if it were an annuity due rather than an ordinary annuity? h. What would the FV and the PV for parts a and c be if the interest rate were 10 percent with semiannual compounding rather than 10 percent with annual compounding? i. Find the PV and the FV of an investment that makes the following end-of-year payments. The interest rate is 8 percent. Year

Payment

1 2 3

$100 200 400

j. Suppose you bought a house and took out a mortgage for $50,000. The interest rate is 8 percent, and you must amortize the loan over 10 years with equal end-of-year payments. Set up an amortization schedule that shows the annual payments and the amount of each payment that goes to pay off the principal and the amount that constitutes interest expense to the borrower and interest income to the lender. (1) Create a graph that shows how the payments are divided between interest and principal repayment over time. (2) Suppose the loan called for 10 years of monthly payments, with the same original amount and the same nominal interest rate. What would the amortization schedule show now?

See Ch 02 Show.ppt and Ch 02 Mini Case.xls.

Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the bank’s evaluation process, you have been asked to take an examination that covers several ﬁnancial analysis techniques. The ﬁrst section of the test addresses discounted cash ﬂow analysis. See how you would do by answering the following questions. a. Draw time lines for (a) a $100 lump sum cash ﬂow at the end of Year 2, (b) an ordinary annuity of $100 per year for 3 years, and (c) an uneven cash ﬂow stream of $50, $100, $75, and $50 at the end of Years 0 through 3. b. (1) What is the future value of an initial $100 after 3 years if it is invested in an account paying 10 percent annual interest? (2) What is the present value of $100 to be received in 3 years if the appropriate interest rate is 10 percent? c. We sometimes need to ﬁnd how long it will take a sum of money (or anything else) to grow to some speciﬁed amount. For example, if a company’s sales are growing at a rate of 20 percent per year, how long will it take sales to double? d. If you want an investment to double in three years, what interest rate must it earn? e. What is the difference between an ordinary annuity and an annuity due? What type of annuity is shown below? How would you change it to the other type of annuity?

0

1

2

3

100

100

100

f. (1) What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate is 10 percent? (2) What is the present value of the annuity? (3) What would the future and present values be if the annuity were an annuity due? g. What is the present value of the following uneven cash ﬂow stream? The appropriate interest rate is 10 percent, compounded annually.

0

1

2

3

0

100

300

300

4 Years 50

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h. (1) Deﬁne (a) the stated, or quoted, or nominal rate (iNom) and (b) the periodic rate (iPER). (2) Will the future value be larger or smaller if we compound an initial amount more often than annually, for example, every 6 months, or semiannually, holding the stated interest rate constant? Why? (3) What is the future value of $100 after 5 years under 12 percent annual compounding? Semiannual compounding? Quarterly compounding? Monthly compounding? Daily compounding? (4) What is the effective annual rate (EAR)? What is the EAR for a nominal rate of 12 percent, compounded semiannually? Compounded quarterly? Compounded monthly? Compounded daily? i. Will the effective annual rate ever be equal to the nominal (quoted) rate? j. (1) Construct an amortization schedule for a $1,000, 10 percent annual rate loan with 3 equal installments. (2) What is the annual interest expense for the borrower, and the annual interest income for the lender, during Year 2? k. Suppose on January 1 you deposit $100 in an account that pays a nominal, or quoted, interest rate of 11.33463 percent, with interest added (compounded) daily. How much will you have in your account on October 1, or after 9 months? l. (1) What is the value at the end of Year 3 of the following cash ﬂow stream if the quoted interest rate is 10 percent, compounded semiannually?

0

1

2

0

100

100

3 Years 100

(2) What is the PV of the same stream? (3) Is the stream an annuity? (4) An important rule is that you should never show a nominal rate on a time line or use it in calculations unless what condition holds? (Hint: Think of annual compounding, when iNom EAR iPer.) What would be wrong with your answer to Questions l (1) and l (2) if you used the nominal rate (10%) rather than the periodic rate (iNom/2 10%/2 5%)? m. Suppose someone offered to sell you a note calling for the payment of $1,000 ﬁfteen months from today. They offer to sell it to you for $850. You have $850 in a bank time deposit which pays a 6.76649 percent nominal rate with daily compounding, which is a 7 percent effective annual interest rate, and you plan to leave the money in the bank unless you buy the note. The note is not risky—you are sure it will be paid on schedule. Should you buy the note? Check the decision in three ways: (1) by comparing your future value if you buy the note versus leaving your money in the bank, (2) by comparing the PV of the note with your current bank account, and (3) by comparing the EAR on the note versus that of the bank account.

Selected Additional References For a more complete discussion of the mathematics of ﬁnance, see Atkins, Allen B., and Edward A. Dyl, “The Lotto Jackpot: The Lump Sum versus the Annuity,” Financial Practice and Education, Fall/Winter 1995, 107–111. Lindley, James T., “Compounding Issues Revisited,” Financial Practice and Education, Fall 1993, 127–129. Shao, Lawrence P., and Stephen P. Shao, Mathematics for Management and Finance (Cincinnati, OH: SouthWestern, 1997).

To learn more about using ﬁnancial calculators, see the manual which came with your calculator or see White, Mark A., Financial Analysis with an Electronic Calculator, 2nd ed. (Chicago: Irwin, 1995). , “Financial Problem Solving with an Electronic Calculator: Texas Instruments’ BA II Plus,” Financial Practice and Education, Fall 1993, 123–126.

Risk and Return

33

S

kill or luck? That’s the question The Wall Street Journal’s Investment Dartboard Contest sought to answer by pitting the stock-picking ability of professional analysts against both amateurs and stocks chosen by throwing darts at tables of stock listings. Here’s how the contest worked. The Wall Street Journal (WSJ) picked four professional analysts, and each of those pros formed a portfolio by picking four stocks. The stocks must be traded on the NYSE, AMEX, or Nasdaq; have a market capitalization of at least $50 million and a stock price of at least $2; and have average daily trades of at least $100,000. Amateurs could enter the contest by e-mailing their pick of a single stock to the WSJ, which then picked four amateurs at random and combined their choices to make a four-stock portfolio. Finally, a group of WSJ editors threw four darts at the stock tables. At the beginning of the contest, the WSJ announced the pros’ picks, and at the end of six months, the paper announced the results. The top two pros were invited back for another six months. The WSJ actually had six separate contests running simultaneously, with a new one beginning each month; since 1990 there have been 142 completed contests. The pros have beaten the darts 87 times and lost 55 times. The pros also beat the Dow Jones Industrial Average in 54 percent of the contests. However, the pros have an average sixmonth portfolio return of 10.2 percent, much higher than the DJIA six-month average of 5.6 percent and the darts’ return of only 3.5 percent. In 30 six-month contests, the readers lost an average of 4 percent, while the pros posted an average gain of 7.2 percent. Do these results mean that skill is more important than luck when it comes to investing in stocks? Not necessarily, according to Burton Malkiel, an economics professor at Princeton and the author of the widely read book, A Random Walk Down Wall Street. Since the dart-selected portfolios consist of randomly chosen stocks, they should have betas that average close to 1.0, and hence be of average risk. However, the pros have consistently picked high-beta stocks. Because we have enjoyed a bull market during the last decade, one would expect high-beta stocks to outperform the market. Therefore, according to Malkiel, the pros’ performance could be due to a rising market rather than superior analytical skills. The WSJ ended the contest in 2002, so we won’t know for sure whether Malkiel was right or wrong.

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In this chapter, we start from the basic premise that investors like returns and dislike risk. Therefore, people will invest in risky assets only if they expect to receive higher returns. We deﬁne precisely what the term risk means as it relates to investments. We The textbook’s web site examine procedures managers use to measure risk, and we discuss the relationship becontains an Excel ﬁle that tween risk and return. In Chapters 4 and 5, we extend these relationships to show how will guide you through the risk and return interact to determine security prices. Managers must understand these chapter’s calculations. The ﬁle for this chapter is Ch 03 concepts and think about them as they plan the actions that will shape their ﬁrms’ fuTool Kit.xls, and we encour- tures. age you to open the ﬁle and As you will see, risk can be measured in different ways, and different conclusions follow along as you read the about an asset’s risk can be reached depending on the measure used. Risk analysis can chapter. be confusing, but it will help if you remember the following: 1. All ﬁnancial assets are expected to produce cash ﬂows, and the risk of an asset is judged in terms of the risk of its cash ﬂows. 2. The risk of an asset can be considered in two ways: (1) on a stand-alone basis, where the asset’s cash ﬂows are analyzed by themselves, or (2) in a portfolio context, where the cash ﬂows from a number of assets are combined and then the consolidated cash ﬂows are analyzed.1 There is an important difference between stand-alone and portfolio risk, and an asset that has a great deal of risk if held by itself may be much less risky if it is held as part of a larger portfolio. 3. In a portfolio context, an asset’s risk can be divided into two components: (a) diversiﬁable risk, which can be diversiﬁed away and thus is of little concern to diversiﬁed investors, and (b) market risk, which reﬂects the risk of a general stock market decline and which cannot be eliminated by diversiﬁcation, does concern investors. Only market risk is relevant—diversiﬁable risk is irrelevant to rational investors because it can be eliminated. 4. An asset with a high degree of relevant (market) risk must provide a relatively high expected rate of return to attract investors. Investors in general are averse to risk, so they will not buy risky assets unless those assets have high expected returns. 5. In this chapter, we focus on ﬁnancial assets such as stocks and bonds, but the concepts discussed here also apply to physical assets such as computers, trucks, or even whole plants.

Investment Returns With most investments, an individual or business spends money today with the expectation of earning even more money in the future. The concept of return provides investors with a convenient way of expressing the ﬁnancial performance of an investment. To illustrate, suppose you buy 10 shares of a stock for $1,000. The stock pays no dividends, but at the end of one year, you sell the stock for $1,100. What is the return on your $1,000 investment? One way of expressing an investment return is in dollar terms. The dollar return is simply the total dollars received from the investment less the amount invested: Dollar return ⫽ Amount received ⫺ Amount invested ⫽ $1,100 ⫺ $1,000 ⫽ $100. 1

A portfolio is a collection of investment securities. If you owned some General Motors stock, some Exxon Mobil stock, and some IBM stock, you would be holding a three-stock portfolio. Because diversiﬁcation lowers risk, most stocks are held in portfolios.

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Risk and Return Stand-Alone Risk

103

If at the end of the year you had sold the stock for only $900, your dollar return would have been ⫺$100. Although expressing returns in dollars is easy, two problems arise: (1) To make a meaningful judgment about the return, you need to know the scale (size) of the investment; a $100 return on a $100 investment is a good return (assuming the investment is held for one year), but a $100 return on a $10,000 investment would be a poor return. (2) You also need to know the timing of the return; a $100 return on a $100 investment is a very good return if it occurs after one year, but the same dollar return after 20 years would not be very good. The solution to the scale and timing problems is to express investment results as rates of return, or percentage returns. For example, the rate of return on the 1-year stock investment, when $1,100 is received after one year, is 10 percent: Amount received ⫺ Amount invested Amount invested Dollar return $100 ⫽ ⫽ Amount invested $1,000 ⫽ 0.10 ⫽ 10%.

Rate of return ⫽

The rate of return calculation “standardizes” the return by considering the return per unit of investment. In this example, the return of 0.10, or 10 percent, indicates that each dollar invested will earn 0.10($1.00) ⫽ $0.10. If the rate of return had been negative, this would indicate that the original investment was not even recovered. For example, selling the stock for only $900 results in a minus 10 percent rate of return, which means that each invested dollar lost 10 cents. Note also that a $10 return on a $100 investment produces a 10 percent rate of return, while a $10 return on a $1,000 investment results in a rate of return of only 1 percent. Thus, the percentage return takes account of the size of the investment. Expressing rates of return on an annual basis, which is typically done in practice, solves the timing problem. A $10 return after one year on a $100 investment results in a 10 percent annual rate of return, while a $10 return after ﬁve years yields only a 1.9 percent annual rate of return. Although we illustrated return concepts with one outﬂow and one inﬂow, rate of return concepts can easily be applied in situations where multiple cash ﬂows occur over time. For example, when Intel makes an investment in new chip-making technology, the investment is made over several years and the resulting inﬂows occur over even more years. For now, it is sufﬁcient to recognize that the rate of return solves the two major problems associated with dollar returns—size and timing. Therefore, the rate of return is the most common measure of investment performance. Differentiate between dollar return and rate of return. Why is the rate of return superior to the dollar return in terms of accounting for the size of investment and the timing of cash ﬂows?

Stand-Alone Risk Risk is deﬁned in Webster’s as “a hazard; a peril; exposure to loss or injury.” Thus, risk refers to the chance that some unfavorable event will occur. If you engage in skydiving, you are taking a chance with your life—skydiving is risky. If you bet on the

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Risk and Return

horses, you are risking your money. If you invest in speculative stocks (or, really, any stock), you are taking a risk in the hope of making an appreciable return. An asset’s risk can be analyzed in two ways: (1) on a stand-alone basis, where the asset is considered in isolation, and (2) on a portfolio basis, where the asset is held as one of a number of assets in a portfolio. Thus, an asset’s stand-alone risk is the risk an investor would face if he or she held only this one asset. Obviously, most assets are held in portfolios, but it is necessary to understand stand-alone risk in order to understand risk in a portfolio context. To illustrate the risk of ﬁnancial assets, suppose an investor buys $100,000 of short-term Treasury bills with an expected return of 5 percent. In this case, the rate of return on the investment, 5 percent, can be estimated quite precisely, and the investment is deﬁned as being essentially risk free. However, if the $100,000 were invested in the stock of a company just being organized to prospect for oil in the mid-Atlantic, then the investment’s return could not be estimated precisely. One might analyze the situation and conclude that the expected rate of return, in a statistical sense, is 20 percent, but the investor should recognize that the actual rate of return could range from, say, ⫹1,000 percent to ⫺100 percent. Because there is a signiﬁcant danger of actually earning much less than the expected return, the stock would be relatively risky. No investment should be undertaken unless the expected rate of return is high enough to compensate the investor for the perceived risk of the investment. In our example, it is clear that few if any investors would be willing to buy the oil company’s stock if its expected return were the same as that of the T-bill. Risky assets rarely produce their expected rates of return—generally, risky assets earn either more or less than was originally expected. Indeed, if assets always produced their expected returns, they would not be risky. Investment risk, then, is related to the probability of actually earning a low or negative return—the greater the chance of a low or negative return, the riskier the investment. However, risk can be deﬁned more precisely, and we do so in the next section.

Probability Distributions An event’s probability is deﬁned as the chance that the event will occur. For example, a weather forecaster might state, “There is a 40 percent chance of rain today and a 60 percent chance that it will not rain.” If all possible events, or outcomes, are listed, and if a probability is assigned to each event, the listing is called a probability distribution. For our weather forecast, we could set up the following probability distribution: Outcome (1)

Probability (2)

Rain No rain

0.4 ⫽ 40% 0.6 ⫽ 60 1.0 ⫽ 100%

The possible outcomes are listed in Column 1, while the probabilities of these outcomes, expressed both as decimals and as percentages, are given in Column 2. Notice that the probabilities must sum to 1.0, or 100 percent. Probabilities can also be assigned to the possible outcomes (or returns) from an investment. If you buy a bond, you expect to receive interest on the bond plus a return of your original investment, and those payments will provide you with a rate of return on your investment. The possible outcomes from this investment are (1) that the issuer will make the required payments or (2) that the issuer will default on the payments. The higher the probability of default, the riskier the bond, and the higher the

103

Risk and Return Stand-Alone Risk TABLE 3-1

105

Probability Distributions for Martin Products and U.S. Water Rate of Return on Stock if This Demand Occurs

Demand for the Company’s Products

Probability of This Demand Occurring

Strong Normal Weak

0.3 0.4 0.3 1.0

Martin Products

U.S. Water

100% 15 (70)

20% 15 10

risk, the higher the required rate of return. If you invest in a stock instead of buying a bond, you will again expect to earn a return on your money. A stock’s return will come from dividends plus capital gains. Again, the riskier the stock—which means the higher the probability that the ﬁrm will fail to perform as you expected—the higher the expected return must be to induce you to invest in the stock. With this in mind, consider the possible rates of return (dividend yield plus capital gain or loss) that you might earn next year on a $10,000 investment in the stock of either Martin Products Inc. or U.S. Water Company. Martin manufactures and distributes routers and equipment for the rapidly growing data transmission industry. Because it faces intense competition, its new products may or may not be competitive in the marketplace, so its future earnings cannot be predicted very well. Indeed, some new company could develop better products and literally bankrupt Martin. U.S. Water, on the other hand, supplies an essential service, and because it has city franchises that protect it from competition, its sales and proﬁts are relatively stable and predictable. The rate-of-return probability distributions for the two companies are shown in Table 3-1. There is a 30 percent chance of strong demand, in which case both companies will have high earnings, pay high dividends, and enjoy capital gains. There is a 40 percent probability of normal demand and moderate returns, and there is a 30 percent probability of weak demand, which will mean low earnings and dividends as well as capital losses. Notice, however, that Martin Products’ rate of return could vary far more widely than that of U.S. Water. There is a fairly high probability that the value of Martin’s stock will drop substantially, resulting in a 70 percent loss, while there is no chance of a loss for U.S. Water.2

Expected Rate of Return If we multiply each possible outcome by its probability of occurrence and then sum these products, as in Table 3-2, we have a weighted average of outcomes. The weights are the probabilities, and the weighted average is the expected rate of return, rˆ , called “r-hat.”3 The expected rates of return for both Martin Products and U.S. Water are shown in Table 3-2 to be 15 percent. This type of table is known as a payoff matrix.

2

It is, of course, completely unrealistic to think that any stock has no chance of a loss. Only in hypothetical examples could this occur. To illustrate, the price of Columbia Gas’s stock dropped from $34.50 to $20.00 in just three hours a few years ago. All investors were reminded that any stock is exposed to some risk of loss, and those investors who bought Columbia Gas learned that lesson the hard way. 3 In Chapters 4 and 5, we will use rd and rs to signify the returns on bonds and stocks, respectively. However, this distinction is unnecessary in this chapter, so we just use the general term, r, to signify the expected return on an investment.

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Risk and Return 106

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Risk and Return TABLE 3-2

Calculation of Expected Rates of Return: Payoff Matrix Martin Products

Demand for the Company’s Products (1)

Probability of This Demand Occurring (2)

Rate of Return if This Demand Occurs (3)

Strong Normal Weak

0.3 0.4 0.3 1.0

100% 15 (70)

Product: (2) ⫻ (3) ⫽ (4)

U.S. Water Rate of Return if This Demand Occurs (5)

30% 6 (21) rˆ ⫽ 15%

20% 15 10

Product: (2) ⫻ (5) ⫽ (6)

6% 6 3 rˆ ⫽ 15%

The expected rate of return calculation can also be expressed as an equation that does the same thing as the payoff matrix table:4 Expected rate of return ⫽ rˆ ⫽ P1r1 ⫹ P2r2 ⫹ ⭈ ⭈ ⭈ ⫹ Pnrn n

⫽ a Piri.

(3-1)

i⫽1

Here ri is the ith possible outcome, Pi is the probability of the ith outcome, and n is the number of possible outcomes. Thus, rˆ is a weighted average of the possible outcomes (the ri values), with each outcome’s weight being its probability of occurrence. Using the data for Martin Products, we obtain its expected rate of return as follows: rˆ ⫽ P1(r1) ⫹ P2(r2) ⫹ P3(r3) ⫽ 0.3(100%) ⫹ 0.4(15%) ⫹ 0.3(⫺70%) ⫽ 15%. U.S. Water’s expected rate of return is also 15 percent: rˆ ⫽ 0.3(20%) ⫹ 0.4(15%) ⫹ 0.3(10%) ⫽ 15%. We can graph the rates of return to obtain a picture of the variability of possible outcomes; this is shown in the Figure 3-1 bar charts. The height of each bar signiﬁes the probability that a given outcome will occur. The range of probable returns for Martin Products is from ⫺70 to ⫹100 percent, with an expected return of 15 percent. The expected return for U.S. Water is also 15 percent, but its range is much narrower. Thus far, we have assumed that only three situations can exist: strong, normal, and weak demand. Actually, of course, demand could range from a deep depression to a fantastic boom, and there are an unlimited number of possibilities in between. Suppose we had the time and patience to assign a probability to each possible level of demand (with the sum of the probabilities still equaling 1.0) and to assign a rate of return to each stock for each level of demand. We would have a table similar to Table 3-1, except that it would have many more entries in each column. This table could be used to 4

The second form of the equation is simply a shorthand expression in which sigma (⌺) means “sum up,” or add the values of n factors. If i ⫽ 1, then Piri ⫽ P1r1; if i ⫽ 2, then Piri ⫽ P2r2; and so on until i ⫽ n, the n

last possible outcome. The symbol a in Equation 3-1 simply says, “Go through the following process: i⫽1

First, let i ⫽ 1 and ﬁnd the ﬁrst product; then let i ⫽ 2 and ﬁnd the second product; then continue until each individual product up to i ⫽ n has been found, and then add these individual products to ﬁnd the expected rate of return.”

105

Risk and Return Stand-Alone Risk FIGURE 3-1

–70

Probability Distributions of Martin Products’ and U.S. Water’s Rates of Return

a. Martin Products

b. U.S. Water

Probability of Occurrence 0.4

Probability of Occurrence 0.4

0.3

0.3

0.2

0.2

0.1

0.1

0

107

15

100

Expected Rate of Return

Rate of Return (%)

0 10

15

20

Rate of Return (%)

Expected Rate of Return

calculate expected rates of return as shown previously, and the probabilities and outcomes could be approximated by continuous curves such as those presented in Figure 3-2. Here we have changed the assumptions so that there is essentially a zero probability that Martin Products’ return will be less than ⫺70 percent or more than 100 percent, or that U.S. Water’s return will be less than 10 percent or more than 20 percent, but virtually any return within these limits is possible. The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will be close to the expected value, and, consequently, the less likely it is that the actual return will end up far below the expected return. Thus, the tighter the probability distribution, the lower the risk assigned to a stock. Since U.S. Water has a relatively tight probability distribution, its actual return is likely to be closer to its 15 percent expected return than is that of Martin Products.

Measuring Stand-Alone Risk: The Standard Deviation Risk is a difﬁcult concept to grasp, and a great deal of controversy has surrounded attempts to deﬁne and measure it. However, a common deﬁnition, and one that is satisfactory for many purposes, is stated in terms of probability distributions such as those presented in Figure 3-2: The tighter the probability distribution of expected future returns, the smaller the risk of a given investment. According to this deﬁnition, U.S. Water is less risky than Martin Products because there is a smaller chance that its actual return will end up far below its expected return. To be most useful, any measure of risk should have a deﬁnite value—we need a measure of the tightness of the probability distribution. One such measure is the standard deviation, the symbol for which is ␴, pronounced “sigma.” The smaller the standard deviation, the tighter the probability distribution, and, accordingly, the lower

106

Risk and Return 108

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Risk and Return FIGURE 3-2

Continuous Probability Distributions of Martin Products’ and U.S. Water’s Rates of Return Probability Density

U.S. Water

Martin Products –70

0

15

100 Rate of Return (%)

Expected Rate of Return

Note: The assumptions regarding the probabilities of various outcomes have been changed from those in Figure 3-1. There the probability of obtaining exactly 15 percent was 40 percent; here it is much smaller because there are many possible outcomes instead of just three. With continuous distributions, it is more appropriate to ask what the probability is of obtaining at least some speciﬁed rate of return than to ask what the probability is of obtaining exactly that rate. This topic is covered in detail in statistics courses.

the riskiness of the stock. To calculate the standard deviation, we proceed as shown in Table 3-3, taking the following steps: 1. Calculate the expected rate of return: n

Expected rate of return ⫽ rˆ ⫽ a Piri. i⫽1

For Martin, we previously found rˆ ⫽ 15%. 2. Subtract the expected rate of return (rˆ ) from each possible outcome (ri) to obtain a set of deviations about rˆ as shown in Column 1 of Table 3-3: Deviationi ⫽ ri ⫺ rˆ.

TABLE 3-3 ri ⫺ rˆ (1)

100 ⫺ 15 ⫽ 85 15 ⫺ 15 ⫽ 0 ⫺70 ⫺ 15 ⫽ ⫺85

Calculating Martin Products’ Standard Deviation (ri ⫺ rˆ )2 (2)

(ri ⫺ rˆ )2Pi (3)

7,225 0 7,225

(7,225)(0.3) ⫽ 2,167.5 (0)(0.4) ⫽ 0.0 (7,225)(0.3) ⫽ 2,167.5 Variance ⫽ ␴2 ⫽ 4,335.0

Standard deviation ⫽ ␴ ⫽ 2␴2 ⫽ 24,335 ⫽ 65.84%.

107

Risk and Return Stand-Alone Risk

109

3. Square each deviation, then multiply the result by the probability of occurrence for its related outcome, and then sum these products to obtain the variance of the probability distribution as shown in Columns 2 and 3 of the table: n 2 Variance ⫽ ␴2 ⫽ a (ri ⫺ rˆ ) Pi.

(3-2)

i⫽1

4. Finally, ﬁnd the square root of the variance to obtain the standard deviation: n 2 Standard deviation ⫽ ␴ ⫽ B a (ri ⫺ rˆ ) Pi.

(3-3)

i⫽1

Thus, the standard deviation is essentially a weighted average of the deviations from the expected value, and it provides an idea of how far above or below the expected value the actual value is likely to be. Martin’s standard deviation is seen in Table 3-3 to be ␴ ⫽ 65.84%. Using these same procedures, we ﬁnd U.S. Water’s standard deviation to be 3.87 percent. Martin Products has the larger standard deviation, which indicates a greater variation of returns and thus a greater chance that the expected return will not be realized. Therefore, Martin Products is a riskier investment than U.S. Water when held alone. If a probability distribution is normal, the actual return will be within ⫾1 standard deviation of the expected return 68.26 percent of the time. Figure 3-3 illustrates this point, and it also shows the situation for ⫾2␴ and ⫾3␴. For Martin Products, r ⫽ 15% and ␴ ⫽ 65.84%, whereas rˆ ⫽ 15% and ␴ ⫽ 3.87% for U.S. Water. Thus, if

FIGURE 3-3

Probability Ranges for a Normal Distribution

For more discussion of probability distributions, see the Chapter 3 Web Extension on the textbook’s web site at http://ehrhardt. swcollege.com.

68.26%

95.46% 99.74% –3 σ

–2σ

–1 σ

rˆ

+1 σ

+2 σ

+3 σ

Notes: a. The area under the normal curve always equals 1.0, or 100 percent. Thus, the areas under any pair of normal curves drawn on the same scale, whether they are peaked or ﬂat, must be equal. b. Half of the area under a normal curve is to the left of the mean, indicating that there is a 50 percent probability that the actual outcome will be less than the mean, and half is to the right of r,ˆ indicating a 50 percent probability that it will be greater than the mean. c. Of the area under the curve, 68.26 percent is within ⫾1␴ of the mean, indicating that the probability is 68.26 percent that the actual outcome will be within the range rˆ ⫺ 1␴ to rˆ ⫹ 1␴. d. Procedures exist for ﬁnding the probability of other ranges. These procedures are covered in statistics courses. e. For a normal distribution, the larger the value of ␴, the greater the probability that the actual outcome will vary widely from, and hence perhaps be far below, the expected, or most likely, outcome. Since the probability of having the actual result turn out to be far below the expected result is one deﬁnition of risk, and since ␴ measures this probability, we can use ␴ as a measure of risk. This deﬁnition may not be a good one, however, if we are dealing with an asset held in a diversiﬁed portfolio. This point is covered later in the chapter.

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Risk and Return 110

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Risk and Return

the two distributions were normal, there would be a 68.26 percent probability that Martin’s actual return would be in the range of 15 ⫾ 65.84 percent, or from ⫺50.84 to 80.84 percent. For U.S. Water, the 68.26 percent range is 15 ⫾ 3.87 percent, or from 11.13 to 18.87 percent. With such a small ␴, there is only a small probability that U.S. Water’s return would be signiﬁcantly less than expected, so the stock is not very risky. For the average ﬁrm listed on the New York Stock Exchange, ␴ has generally been in the range of 35 to 40 percent in recent years.

Using Historical Data to Measure Risk In the previous example, we described the procedure for ﬁnding the mean and standard deviation when the data are in the form of a known probability distribution. If only sample returns data over some past period are available, the standard deviation of returns can be estimated using this formula: n 2 a (rt ⫺ r Avg)

Estimated ␴ ⫽ S ⫽

t⫽1

R

n⫺1

(3-3a)

Here rt (“r bar t”) denotes the past realized rate of return in Period t, and rAvg is the average annual return earned during the last n years. Here is an example: Year

rt

2000 2001 2002

15% ⫺5 20

(15 ⫺ 5 ⫹ 20) ⫽ 10.0%. 3 (15 ⫺ 10)2 ⫹ (⫺5 ⫺ 10)2 ⫹ (20 ⫺ 10)2 Estimated ␴ (or S) ⫽ 3⫺1 B 350 ⫽ ⫽ 13.2%. B 2 rAvg ⫽

The historical ␴ is often used as an estimate of the future ␴. Much less often, and generally incorrectly, rAvg for some past period is used as an estimate of rˆ, the expected future return. Because past variability is likely to be repeated, S may be a good estimate of future risk. But it is much less reasonable to expect that the past level of return (which could have been as high as ⫹100% or as low as ⫺50%) is the best expectation of what investors think will happen in the future.5

Measuring Stand-Alone Risk: The Coefﬁcient of Variation If a choice has to be made between two investments that have the same expected returns but different standard deviations, most people would choose the one with the lower standard deviation and, therefore, the lower risk. Similarly, given a choice between two investments with the same risk (standard deviation) but different expected

5

Equation 3-3a is built into all ﬁnancial calculators, and it is very easy to use. We simply enter the rates of return and press the key marked S (or Sx) to get the standard deviation. Note, though, that calculators have no built-in formula for ﬁnding S where unequal probabilities are involved; there you must go through the process outlined in Table 3-3 and Equation 3-3. The same situation holds for computer spreadsheet programs.

109

Risk and Return Stand-Alone Risk

111

returns, investors would generally prefer the investment with the higher expected return. To most people, this is common sense—return is “good,” risk is “bad,” and consequently investors want as much return and as little risk as possible. But how do we choose between two investments if one has the higher expected return but the other the lower standard deviation? To help answer this question, we often use another measure of risk, the coefﬁcient of variation (CV), which is the standard deviation divided by the expected return: Coefficient of variation ⫽ CV ⫽

␴ . rˆ

(3-4)

The coefﬁcient of variation shows the risk per unit of return, and it provides a more meaningful basis for comparison when the expected returns on two alternatives are not the same. Since U.S. Water and Martin Products have the same expected return, the coefﬁcient of variation is not necessary in this case. The ﬁrm with the larger standard deviation, Martin, must have the larger coefﬁcient of variation when the means are equal. In fact, the coefﬁcient of variation for Martin is 65.84/15 ⫽ 4.39 and that for U.S. Water is 3.87/15 ⫽ 0.26. Thus, Martin is almost 17 times riskier than U.S. Water on the basis of this criterion. For a case where the coefﬁcient of variation is necessary, consider Projects X and Y in Figure 3-4. These projects have different expected rates of return and different standard deviations. Project X has a 60 percent expected rate of return and a 15 percent standard deviation, while Project Y has an 8 percent expected return but only a 3 percent standard deviation. Is Project X riskier, on a relative basis, because it has the larger standard deviation? If we calculate the coefﬁcients of variation for these two projects, we ﬁnd that Project X has a coefﬁcient of variation of 15/60 ⫽ 0.25, and Project Y has a coefﬁcient of variation of 3/8 ⫽ 0.375. Thus, we see that Project Y actually has more risk per unit of return than Project X, in spite of the fact that X’s standard deviation is larger. Therefore, even though Project Y has the lower standard deviation, according to the coefﬁcient of variation it is riskier than Project X. Project Y has the smaller standard deviation, hence the more peaked probability distribution, but it is clear from the graph that the chances of a really low return are higher for Y than for X because X’s expected return is so high. Because the coefﬁcient

FIGURE 3-4

Comparison of Probability Distributions and Rates of Return for Projects X and Y

Probability Density Project Y

Project X

0

8

60

Expected Rate of Return (%)

110

Risk and Return 112

CHAPTER 3

Risk and Return

of variation captures the effects of both risk and return, it is a better measure for evaluating risk in situations where investments have substantially different expected returns.

Risk Aversion and Required Returns Suppose you have worked hard and saved $1 million, which you now plan to invest. You can buy a 5 percent U.S. Treasury security, and at the end of one year you will have a sure $1.05 million, which is your original investment plus $50,000 in interest. Alternatively, you can buy stock in R&D Enterprises. If R&D’s research programs are successful, your stock will increase in value to $2.1 million. However, if the research is a failure, the value of your stock will go to zero, and you will be penniless. You regard R&D’s chances of success or failure as being 50-50, so the expected value of the stock investment is 0.5($0) ⫹ 0.5($2,100,000) ⫽ $1,050,000. Subtracting the $1 million cost of the stock leaves an expected proﬁt of $50,000, or an expected (but risky) 5 percent rate of return: Expected rate of return ⫽

Expected ending value ⫺ Cost

Cost $1,050,000 ⫺ $1,000,000 ⫽ $1,000,000 $50,000 ⫽ ⫽ 5%. $1,000,000

Thus, you have a choice between a sure $50,000 proﬁt (representing a 5 percent rate of return) on the Treasury security and a risky expected $50,000 proﬁt (also representing a 5 percent expected rate of return) on the R&D Enterprises stock. Which one would you choose? If you choose the less risky investment, you are risk averse. Most investors are indeed risk averse, and certainly the average investor is risk averse with regard to his or her “serious money.” Because this is a well-documented fact, we shall assume risk aversion throughout the remainder of the book. What are the implications of risk aversion for security prices and rates of return? The answer is that, other things held constant, the higher a security’s risk, the lower its price and the higher its required return. To see how risk aversion affects security prices, look back at Figure 3-2 and consider again U.S. Water and Martin Products stocks. Suppose each stock sold for $100 per share and each had an expected rate of return of 15 percent. Investors are averse to risk, so under these conditions there would be a general preference for U.S. Water. People with money to invest would bid for U.S. Water rather than Martin stock, and Martin’s stockholders would start selling their stock and using the money to buy U.S. Water. Buying pressure would drive up U.S. Water’s stock, and selling pressure would simultaneously cause Martin’s price to decline. These price changes, in turn, would cause changes in the expected rates of return on the two securities. Suppose, for example, that U.S. Water’s stock price was bid up from $100 to $150, whereas Martin’s stock price declined from $100 to $75. This would cause U.S. Water’s expected return to fall to 10 percent, while Martin’s expected return would rise to 20 percent. The difference in returns, 20% ⫺ 10% ⫽ 10%, is a risk premium, RP, which represents the additional compensation investors require for assuming the additional risk of Martin stock. This example demonstrates a very important principle: In a market dominated by risk-averse investors, riskier securities must have higher expected returns, as estimated by the marginal investor, than less risky securities. If this situation does not exist, buying and selling in the market will force it to occur. We will consider the question of how much higher the returns on risky securities must be later in the chapter, after we see how diversiﬁcation

111

Risk and Return Stand-Alone Risk

113

The Trade-Off between Risk and Return

ments. For T-bills, however, the standard deviation needs to be interpreted carefully. Note that the table shows that Treasury bills have a positive standard deviation, which indicates some risk. However, if you invested in a one-year Treasury bill and held it for the full year, your realized return would be the same regardless of what happened to the economy that year, and thus the standard deviation of your return would be zero. So, why does the table show a 3.2 percent standard deviation for T-bills, which indicates some risk? In fact, a T-bill is riskless if you hold it for one year, but if you invest in a rolling portfolio of one-year T-bills and hold the portfolio for a number of years, your investment income will vary depending on what happens to the level of interest rates in each year. So, while you can be sure of the return you will earn on a T-bill in a given year, you cannot be sure of the return you will earn on a portfolio of T-bills over a period of time.

The table accompanying this box summarizes the historical trade-off between risk and return for different classes of investments from 1926 through 2000. As the table shows, those assets that produced the highest average returns also had the highest standard deviations and the widest ranges of returns. For example, small-company stocks had the highest average annual return, 17.3 percent, but their standard deviation of returns, 33.4 percent, was also the highest. By contrast, U.S. Treasury bills had the lowest standard deviation, 3.2 percent, but they also had the lowest average return, 3.9 percent. When deciding among alternative investments, one needs to be aware of the trade-off between risk and return. While there is certainly no guarantee that history will repeat itself, returns observed over a long period in the past are a good starting point for estimating investments’ returns in the future. Likewise, the standard deviations of past returns provide useful insights into the risks of different invest-

Distribution of Realized Returns, 1926–2000

Average return Standard deviation Excess return over T-bondsa

SmallCompany Stocks

LargeCompany Stocks

Long-Term Corporate Bonds

Long-Term Government Bonds

U.S. Treasury Bills

Inﬂation

17.3%

13.0%

6.0%

5.7%

3.9%

3.2%

33.4

20.2

8.7

9.4

3.2

4.4

11.6

7.3

0.3

a The excess return over T-bonds is called the “historical risk premium.” If and only if investors expect returns in the future that are similar to returns earned in the past, the excess return will also be the current risk premium that is reﬂected in security prices.

Source: Based on Stocks, Bonds, Bills, and Inﬂation: Valuation Edition 2001 Yearbook (Chicago: Ibbotson Associates, 2001).

affects the way risk should be measured. Then, in Chapters 4 and 5, we will see how risk-adjusted rates of return affect the prices investors are willing to pay for different securities. What does “investment risk” mean? Set up an illustrative probability distribution for an investment. What is a payoff matrix? Which of the two stocks graphed in Figure 3-2 is less risky? Why? How does one calculate the standard deviation? Which is a better measure of risk if assets have different expected returns: (1) the standard deviation or (2) the coefﬁcient of variation? Why? Explain the following statement: “Most investors are risk averse.” How does risk aversion affect rates of return?

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Risk and Return 114

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Risk and Return

Risk in a Portfolio Context In the preceding section, we considered the risk of assets held in isolation. Now we analyze the risk of assets held in portfolios. As we shall see, an asset held as part of a portfolio is less risky than the same asset held in isolation. Accordingly, most ﬁnancial assets are actually held as parts of portfolios. Banks, pension funds, insurance companies, mutual funds, and other ﬁnancial institutions are required by law to hold diversiﬁed portfolios. Even individual investors—at least those whose security holdings constitute a signiﬁcant part of their total wealth—generally hold portfolios, not the stock of only one ﬁrm. This being the case, from an investor’s standpoint the fact that a particular stock goes up or down is not very important; what is important is the return on his or her portfolio, and the portfolio’s risk. Logically, then, the risk and return of an individual security should be analyzed in terms of how that security affects the risk and return of the portfolios in which it is held. To illustrate, Pay Up Inc. is a collection agency company that operates nationwide through 37 ofﬁces. The company is not well known, its stock is not very liquid, its earnings have ﬂuctuated quite a bit in the past, and it doesn’t pay a dividend. All this suggests that Pay Up is risky and that the required rate of return on its stock, r, should be relatively high. However, Pay Up’s required rate of return in 2002, and all other years, was quite low in relation to those of most other companies. This indicates that investors regard Pay Up as being a low-risk company in spite of its uncertain proﬁts. The reason for this counterintuitive fact has to do with diversiﬁcation and its effect on risk. Pay Up’s earnings rise during recessions, whereas most other companies’ earnings tend to decline when the economy slumps. It’s like ﬁre insurance—it pays off when other things go badly. Therefore, adding Pay Up to a portfolio of “normal” stocks tends to stabilize returns on the entire portfolio, thus making the portfolio less risky.

Portfolio Returns The expected return on a portfolio, rˆ p, is simply the weighted average of the expected returns on the individual assets in the portfolio, with the weights being the fraction of the total portfolio invested in each asset: rˆ p ⫽ w1rˆ 1 ⫹ w2rˆ 2 ⫹ ⭈ ⭈ ⭈ ⫹ wn rˆ n

(3-5)

n

⫽ a wi rˆi. i⫽1

Here the rˆ i’s are the expected returns on the individual stocks, the wi’s are the weights, and there are n stocks in the portfolio. Note (1) that wi is the fraction of the portfolio’s dollar value invested in Stock i (that is, the value of the investment in Stock i divided by the total value of the portfolio) and (2) that the wi’s must sum to 1.0. Assume that in August 2002, a security analyst estimated that the following returns could be expected on the stocks of four large companies: Expected Return, rˆ

Microsoft General Electric Pﬁzer Coca-Cola

12.0% 11.5 10.0 9.5

If we formed a $100,000 portfolio, investing $25,000 in each stock, the expected portfolio return would be 10.75 percent:

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Risk and Return Risk in a Portfolio Context

115

rˆ p ⫽ w1rˆ 1 ⫹ w2rˆ 2 ⫹ w3rˆ 3 ⫹ w4rˆ 4 ⫽ 0.25(12%) ⫹ 0.25(11.5%) ⫹ 0.25(10%) ⫹ 0.25(9.5%) ⫽ 10.75%. Of course, after the fact and a year later, the actual realized rates of return, r, on the individual stocks—the ri, or “r-bar,” values—will almost certainly be different from their expected values, so rp will be different from rˆ p ⫽ 10.75%. For example, CocaCola might double and provide a return of ⫹100%, whereas Microsoft might have a terrible year, fall sharply, and have a return of ⫺75%. Note, though, that those two events would be somewhat offsetting, so the portfolio’s return might still be close to its expected return, even though the individual stocks’ actual returns were far from their expected returns.

Portfolio Risk As we just saw, the expected return on a portfolio is simply the weighted average of the expected returns on the individual assets in the portfolio. However, unlike returns, the risk of a portfolio, ␴p, is generally not the weighted average of the standard deviations of the individual assets in the portfolio; the portfolio’s risk will almost always be smaller than the weighted average of the assets’ ␴’s. In fact, it is theoretically possible to combine stocks that are individually quite risky as measured by their standard deviations to form a portfolio that is completely riskless, with ␴p ⫽ 0. To illustrate the effect of combining assets, consider the situation in Figure 3-5. The bottom section gives data on rates of return for Stocks W and M individually, and also for a portfolio invested 50 percent in each stock. The three top graphs show plots of the data in a time series format, and the lower graphs show the probability distributions of returns, assuming that the future is expected to be like the past. The two stocks would be quite risky if they were held in isolation, but when they are combined to form Portfolio WM, they are not risky at all. (Note: These stocks are called W and M because the graphs of their returns in Figure 3-5 resemble a W and an M.) The reason Stocks W and M can be combined to form a riskless portfolio is that their returns move countercyclically to each other—when W’s returns fall, those of M rise, and vice versa. The tendency of two variables to move together is called correlation, and the correlation coefﬁcient measures this tendency.6 The symbol for the correlation coefﬁcient is the Greek letter rho, ␳ (pronounced roe). In statistical terms, we say that the returns on Stocks W and M are perfectly negatively correlated, with ␳ ⫽ ⫺1.0. The opposite of perfect negative correlation, with ␳ ⫽ ⫺1.0, is perfect positive correlation, with ␳ ⫽ ⫹1.0. Returns on two perfectly positively correlated stocks (M and

6 The correlation coefﬁcient, ␳, can range from ⫹1.0, denoting that the two variables move up and down in perfect synchronization, to ⫺1.0, denoting that the variables always move in exactly opposite directions. A correlation coefﬁcient of zero indicates that the two variables are not related to each other—that is, changes in one variable are independent of changes in the other. The correlation is called R when it is estimated using historical data. Here is the formula to estimate the correlation between stocks i and j ( ri,t is the actual return for stock i in period t and rAvgi is the average return during the period; similar notation is used for stock j):

n

a ( ri,t ⫺ rAvgi ) (rj,t ⫺ rAvgj )

R⫽

t⫽1 n

a Bt⫽1

.

n

(ri,t ⫺ rAvgi ) a (rj,t ⫺ rAvgj ) 2

2

t⫽1

Fortunately, it is easy to calculate correlation coefﬁcients with a ﬁnancial calculator. Simply enter the returns on the two stocks and then press a key labeled “r.” In Excel, use the CORREL function.

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FIGURE 3-5

Rate of Return Distributions for Two Perfectly Negatively Correlated Stocks (␳ ⫽ ⫺1.0) and for Portfolio WM

a. Rates of Return _

_

Stock W

r W(%)

_

Stock M

r M(%)

25

25

25

15

15

15

0

2002

–10

Portfolio WM

r p (%)

0

2002

–10

0

2002

–10

b. Probability Distributions of Returns Probability Density

Probability Density Stock W

0

15

Probability Density Stock M

Percent

0

rˆW

15

Percent

rˆM

Portfolio WM

0

15

Percent

rˆP

Year

Stock W (rw)

Stock M (rM)

Portfolio WM (rp)

1998 1999 2000 2001 2002 Average return Standard deviation

40.0% (10.0) 35.0 (5.0) 15.0 15.0% 22.6%

(10.0)% 40.0 (5.0) 35.0 15.0 15.0% 22.6%

15.0% 15.0 15.0 15.0 15.0 15.0% 0.0%

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117

M⬘) would move up and down together, and a portfolio consisting of two such stocks would be exactly as risky as each individual stock. This point is illustrated in Figure 3-6, where we see that the portfolio’s standard deviation is equal to that of the individual stocks. Thus, diversiﬁcation does nothing to reduce risk if the portfolio consists of perfectly positively correlated stocks. Figures 3-5 and 3-6 demonstrate that when stocks are perfectly negatively correlated (␳ ⫽ ⫺1.0), all risk can be diversiﬁed away, but when stocks are perfectly positively correlated (␳ ⫽ ⫹1.0), diversiﬁcation does no good whatsoever. In reality, most stocks are positively correlated, but not perfectly so. On average, the correlation coefﬁcient for the returns on two randomly selected stocks would be about ⫹0.6, and for most pairs of stocks, ␳ would lie in the range of ⫹0.5 to ⫹0.7. Under such conditions, combining stocks into portfolios reduces risk but does not eliminate it completely. Figure 3-7 illustrates this point with two stocks whose correlation coefﬁcient is ␳ ⫽ ⫹0.67. The portfolio’s average return is 15 percent, which is exactly the same as the average return for each of the two stocks, but its standard deviation is 20.6 percent, which is less than the standard deviation of either stock. Thus, the portfolio’s risk is not an average of the risks of its individual stocks—diversiﬁcation has reduced, but not eliminated, risk. From these two-stock portfolio examples, we have seen that in one extreme case (␳ ⫽ ⫺1.0), risk can be completely eliminated, while in the other extreme case (␳ ⫽ ⫹1.0), diversiﬁcation does nothing to limit risk. The real world lies between these extremes, so in general combining two stocks into a portfolio reduces, but does not eliminate, the risk inherent in the individual stocks. What would happen if we included more than two stocks in the portfolio? As a rule, the risk of a portfolio will decline as the number of stocks in the portfolio increases. If we added enough partially correlated stocks, could we completely eliminate risk? In general, the answer is no, but the extent to which adding stocks to a portfolio reduces its risk depends on the degree of correlation among the stocks: The smaller the positive correlation coefﬁcients, the lower the risk in a large portfolio. If we could ﬁnd a set of stocks whose correlations were ⫺1.0, all risk could be eliminated. In the real world, where the correlations among the individual stocks are generally positive but less than ⫹1.0, some, but not all, risk can be eliminated. To test your understanding, would you expect to ﬁnd higher correlations between the returns on two companies in the same or in different industries? For example, would the correlation of returns on Ford’s and General Motors’ stocks be higher, or would the correlation coefﬁcient be higher between either Ford or GM and AT&T, and how would those correlations affect the risk of portfolios containing them? Answer: Ford’s and GM’s returns have a correlation coefﬁcient of about 0.9 with one another because both are affected by auto sales, but their correlation is only about 0.6 with AT&T. Implications: A two-stock portfolio consisting of Ford and GM would be less well diversiﬁed than a two-stock portfolio consisting of Ford or GM, plus AT&T. Thus, to minimize risk, portfolios should be diversiﬁed across industries. Before leaving this section we should issue a warning—in the real world, it is impossible to ﬁnd stocks like W and M, whose returns are expected to be perfectly negatively correlated. Therefore, it is impossible to form completely riskless stock portfolios. Diversiﬁcation can reduce risk, but it cannot eliminate it. The real world is closer to the situation depicted in Figure 3-7.

Diversiﬁable Risk versus Market Risk As noted above, it is difﬁcult if not impossible to ﬁnd stocks whose expected returns are negatively correlated—most stocks tend to do well when the national economy is

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FIGURE 3-6

Rate of Return Distributions for Two Perfectly Positively Correlated Stocks (␳ ⫽ ⫹1.0) and for Portfolio MM⬘

a. Rates of Return _

_

Stock M

r M(%)

_

Stock M´

r M (%)

r p (%)

25

25

25

15

15

15

0

2002

–10

0

2002

Portfolio MM´

0

2002

–10

–10

b. Probability Distributions of Returns Probability Density

0

Probability Density

15

Percent

0

rˆM

15

Probability Density

Percent

rˆM´

0

15 rˆP

Year

Stock M ( rM)

Stock M⬘ ( rM⬘)

Portfolio MM⬘ ( rp)

1998 1999 2000 2001 2002 Average return Standard deviation

(10.0%) 40.0 (5.0) 35.0 15.0 15.0% 22.6%

(10.0%) 40.0 (5.0) 35.0 15.0 15.0% 22.6%

(10.0%) 40.0 (5.0) 35.0 15.0 15.0% 22.6%

Percent

117

Risk and Return Risk in a Portfolio Context FIGURE 3-7

119

Rate of Return Distributions for Two Partially Correlated Stocks (␳ ⫽ ⫹0.67) and for Portfolio WY

a. Rates of Return _

r W(%)

_

Stock W

_

Stock Y

r Y (%)

r p (%)

25

25

25

15

15

15

0

2002

0

2002

b. Probability Distribution of Returns

0

2002

–15

–15

–15

Portfolio WY

Probability Density Portfolio WY

Stocks W and Y

0 15

Percent

rˆ p

Year

Stock W ( rw)

Stock Y ( rY)

1998 1999 2000 2001 2002 Average return Standard deviation

40.0% (10.0) 35.0 (5.0) 15.0 15.0% 22.6%

28.0% 20.0 41.0 (17.0) 3.0 15.0% 22.6%

Portfolio WY ( rp)

34.0% 5.0 38.0 (11.0) 9.0 15.0% 20.6%

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strong and badly when it is weak.7 Thus, even very large portfolios end up with a substantial amount of risk, but not as much risk as if all the money were invested in only one stock. To see more precisely how portfolio size affects portfolio risk, consider Figure 3-8, which shows how portfolio risk is affected by forming larger and larger portfolios of randomly selected New York Stock Exchange (NYSE) stocks. Standard deviations are plotted for an average one-stock portfolio, a two-stock portfolio, and so on, up to a portfolio consisting of all 2,000-plus common stocks that were listed on the NYSE at the time the data were graphed. The graph illustrates that, in general, the riskiness of a portfolio consisting of large-company stocks tends to decline and to approach some limit as the size of the portfolio increases. According to data accumulated in recent years, ␴1, the standard deviation of a one-stock portfolio (or an average stock), is approximately 35 percent. A portfolio consisting of all stocks, which is called the market portfolio, would have a standard deviation, ␴M, of about 20.1 percent, which is shown as the horizontal dashed line in Figure 3-8. 7

It is not too hard to ﬁnd a few stocks that happened to have risen because of a particular set of circumstances in the past while most other stocks were declining, but it is much harder to ﬁnd stocks that could logically be expected to go up in the future when other stocks are falling. However, note that derivative securities (options) can be created with correlations that are close to ⫺1.0 with stocks. Such derivatives can be bought and used as “portfolio insurance.”

FIGURE 3-8

Effects of Portfolio Size on Portfolio Risk for Average Stocks

Portfolio Risk, σ p (%) 35

30 Diversifiable Risk 25

σM = 20.1

15 Portfolio's StandAlone Risk: Declines 10 as Stocks Are Added

Minimum Attainable Risk in a Portfolio of Average Stocks Portfolio's Market Risk: Remains Constant

5

0

1

10

20

30

40

2,000+ Number of Stocks in the Portfolio

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Risk and Return Risk in a Portfolio Context

121

Thus, almost half of the riskiness inherent in an average individual stock can be eliminated if the stock is held in a reasonably well-diversiﬁed portfolio, which is one containing 40 or more stocks in a number of different industries. Some risk always remains, however, so it is virtually impossible to diversify away the effects of broad stock market movements that affect almost all stocks. The part of a stock’s risk that can be eliminated is called diversiﬁable risk, while the part that cannot be eliminated is called market risk.8 The fact that a large part of the risk of any individual stock can be eliminated is vitally important, because rational investors will eliminate it and thus render it irrelevant. Diversiﬁable risk is caused by such random events as lawsuits, strikes, successful and unsuccessful marketing programs, winning or losing a major contract, and other events that are unique to a particular ﬁrm. Because these events are random, their effects on a portfolio can be eliminated by diversiﬁcation—bad events in one ﬁrm will be offset by good events in another. Market risk, on the other hand, stems from factors that systematically affect most ﬁrms: war, inﬂation, recessions, and high interest rates. Since most stocks are negatively affected by these factors, market risk cannot be eliminated by diversiﬁcation. We know that investors demand a premium for bearing risk; that is, the higher the risk of a security, the higher its expected return must be to induce investors to buy (or to hold) it. However, if investors are primarily concerned with the risk of their portfolios rather than the risk of the individual securities in the portfolio, how should the risk of an individual stock be measured? One answer is provided by the Capital Asset Pricing Model (CAPM), an important tool used to analyze the relationship between risk and rates of return.9 The primary conclusion of the CAPM is this: The relevant risk of an individual stock is its contribution to the risk of a well-diversiﬁed portfolio. In other words, the risk of General Electric’s stock to a doctor who has a portfolio of 40 stocks or to a trust ofﬁcer managing a 150-stock portfolio is the contribution the GE stock makes to the portfolio’s riskiness. The stock might be quite risky if held by itself, but if half of its risk can be eliminated by diversiﬁcation, then its relevant risk, which is its contribution to the portfolio’s risk, is much smaller than its stand-alone risk. A simple example will help make this point clear. Suppose you are offered the chance to ﬂip a coin once. If a head comes up, you win $20,000, but if a tail comes up, you lose $16,000. This is a good bet—the expected return is 0.5($20,000) ⫹ 0.5(⫺$16,000) ⫽ $2,000. However, it is a highly risky proposition, because you have a 50 percent chance of losing $16,000. Thus, you might well refuse to make the bet. Alternatively, suppose you were offered the chance to ﬂip a coin 100 times, and you would win $200 for each head but lose $160 for each tail. It is theoretically possible that you would ﬂip all heads and win $20,000, and it is also theoretically possible that you would ﬂip all tails and lose $16,000, but the chances are very high that you would actually ﬂip about 50 heads and about 50 tails, winning a net of about $2,000. Although each individual ﬂip is a risky bet, collectively you have a low-risk proposition because most of the risk has been diversiﬁed away. This is the idea behind holding portfolios of stocks rather than just one stock, except that with stocks all of the risk

8

Diversiﬁable risk is also known as company-speciﬁc, or unsystematic, risk. Market risk is also known as nondiversiﬁable, or systematic, or beta, risk; it is the risk that remains after diversiﬁcation. 9 Indeed, the 1990 Nobel Prize was awarded to the developers of the CAPM, Professors Harry Markowitz and William F. Sharpe. The CAPM is a relatively complex subject, and only its basic elements are presented in this chapter. The basic concepts of the CAPM were developed speciﬁcally for common stocks, and, therefore, the theory is examined ﬁrst in this context. However, it has become common practice to extend CAPM concepts to capital budgeting and to speak of ﬁrms having “portfolios of tangible assets and projects.”

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The Beneﬁts of Diversifying Overseas

The size of the global stock market has grown steadily over the last several decades, and it passed the $15 trillion mark during 1995. U.S. stocks account for approximately 41 percent of this total, whereas the Japanese and European markets constitute roughly 25 and 26 percent, respectively. The rest of the world makes up the remaining 8 percent. Although the U.S. equity market has long been the world’s biggest, its share of the world total has decreased over time. The expanding universe of securities available internationally suggests the possibility of achieving a better riskreturn trade-off than could be obtained by investing solely in U.S. securities. So, investing overseas might lower risk and simultaneously increase expected returns. The potential beneﬁts of diversiﬁcation are due to the facts that the correlation between the returns on U.S. and international securities is fairly low, and returns in developing nations are often quite high. Figure 3-8, presented earlier, demonstrated that an investor can signiﬁcantly reduce the risk of his or her portfolio by holding a large number of stocks. The ﬁgure accompanying this box suggests that investors may be able to reduce risk even further by holding a large portfolio of stocks from all around the world, given the fact that the returns of domestic and international stocks are not perfectly correlated. Despite the apparent beneﬁts from investing overseas, the typical U.S. investor still dedicates less than 10 percent of his or her portfolio to foreign stocks—even though for-

eign stocks represent roughly 60 percent of the worldwide equity market. Researchers and practitioners alike have struggled to understand this reluctance to invest overseas. One explanation is that investors prefer domestic stocks because they have lower transaction costs. However, this explanation is not completely convincing, given that recent studies have found that investors buy and sell their overseas stocks more frequently than they trade their domestic stocks. Other explanations for the domestic bias focus on the additional risks from investing overseas (for example, exchange rate risk) or suggest that the typical U.S. investor is uninformed about international investments and/or views international investments as being extremely risky or uncertain. More recently, other analysts have argued that as world capital markets have become more integrated, the correlation of returns between different countries has increased, and hence the beneﬁts from international diversiﬁcation have declined. A third explanation is that U.S. corporations are themselves investing more internationally, hence U.S. investors are de facto obtaining international diversiﬁcation. Whatever the reason for the general reluctance to hold international assets, it is a safe bet that in the years ahead U.S. investors will shift more and more of their assets to overseas investments. Source: Kenneth Kasa, “Measuring the Gains from International Portfolio Diversiﬁcation,” Federal Reserve Bank of San Francisco Weekly Letter, Number 94-14, April 8, 1994.

Portfolio Risk, σp (%)

U.S. Stocks U.S. and International Stocks

Number of Stocks in the Portfolio

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Risk and Return Risk in a Portfolio Context

123

cannot be eliminated by diversiﬁcation—those risks related to broad, systematic changes in the stock market will remain. Are all stocks equally risky in the sense that adding them to a well-diversiﬁed portfolio would have the same effect on the portfolio’s riskiness? The answer is no. Different stocks will affect the portfolio differently, so different securities have different degrees of relevant risk. How can the relevant risk of an individual stock be measured? As we have seen, all risk except that related to broad market movements can, and presumably will, be diversiﬁed away. After all, why accept risk that can be easily eliminated? The risk that remains after diversifying is market risk, or the risk that is inherent in the market, and it can be measured by the degree to which a given stock tends to move up or down with the market. In the next section, we develop a measure of a stock’s market risk, and then, in a later section, we introduce an equation for determining the required rate of return on a stock, given its market risk.

The Concept of Beta As we noted above, the primary conclusion of the CAPM is that the relevant risk of an individual stock is the amount of risk the stock contributes to a well-diversiﬁed portfolio. The benchmark for a well-diversiﬁed stock portfolio is the market portfolio, which is a portfolio containing all stocks. Therefore, the relevant risk of an individual stock, which is called its beta coefﬁcient, is deﬁned under the CAPM as the amount of risk that the stock contributes to the market portfolio. In CAPM terminology, ␳iM is the correlation between the ith stock’s expected return and the expected return on the market, ␴i is the standard deviation of the ith stock’s expected return, and ␴M is the standard deviation of the market’s expected return. In the literature on the CAPM, it is proved that the beta coefﬁcient of the ith stock, denoted by bi, can be found as follows: bi ⫽ a

␴i b␳ . ␴M iM

(3-6)

This tells us that a stock with a high standard deviation, ␴i, will tend to have a high beta. This makes sense, because if all other things are equal, a stock with high standalone risk will contribute a lot of risk to the portfolio. Note too that a stock with a high correlation with the market, ␳iM, will also have a large beta, hence be risky. This also makes sense, because a high correlation means that diversiﬁcation is not helping much, hence the stock contributes a lot of risk to the portfolio. Calculators and spreadsheets use Equation 3-6 to calculate beta, but there is another way. Suppose you plotted the stock’s returns on the y-axis of a graph and the market portfolio’s returns on the x-axis, as shown in Figure 3-9. The tendency of a stock to move up and down with the market is reﬂected in its beta coefﬁcient. An average-risk stock is deﬁned as one that tends to move up and down in step with the general market as measured by some index such as the Dow Jones Industrials, the S&P 500, or the New York Stock Exchange Index. Such a stock will, by deﬁnition, be assigned a beta, b, of 1.0, which indicates that, in general, if the market moves up by 10 percent, the stock will also move up by 10 percent, while if the market falls by 10 percent, the stock will likewise fall by 10 percent. A portfolio of such b ⫽ 1.0 stocks will move up and down with the broad market indexes, and it will be just as risky as the indexes. If b ⫽ 0.5, the stock is only half as volatile as the market—it will rise and fall only half as much—and a portfolio of such stocks will be half as risky as a portfolio of b ⫽ 1.0 stocks. On the other hand, if b ⫽ 2.0, the stock is twice as volatile as an average stock, so a portfolio of such stocks will be twice as risky as an average portfolio. The value of such a portfolio could double—or halve—in a short time, and if you held such a portfolio, you could quickly go from millionaire to pauper.

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Risk and Return FIGURE 3-9

Relative Volatility of Stocks H, A, and L _

Return on Stock i, r i (%)

Stock H, High Risk: b = 2.0

30 Stock A, Average Risk: b = 1.0 20 Stock L, Low Risk: b = 0.5 X

10

– 20

–10

0

10

20

30 _

Return on the Market, rM (%) –10

– 20

– 30

Year

rH

rA

rL

rM

2000 2001 2002

10% 30 (30)

10% 20 (10)

10% 15 0

10% 20 (10)

Note: These three stocks plot exactly on their regression lines. This indicates that they are exposed only to market risk. Mutual funds that concentrate on stocks with betas of 2, 1, and 0.5 would have patterns similar to those shown in the graph.

Figure 3-9 graphs the relative volatility of three stocks. The data below the graph assume that in 2000 the “market,” deﬁned as a portfolio consisting of all stocks, had a total return (dividend yield plus capital gains yield) of rM ⫽ 10%, and Stocks H, A, and L (for High, Average, and Low risk) also all had returns of 10 percent. In 2001, the market went up sharply, and the return on the market portfolio was rM ⫽ 20%. Returns on the three stocks also went up: H soared to 30 percent; A went up to 20 percent, the same as the market; and L only went up to 15 percent. Now suppose the market dropped in 2002, and the market return was r M ⫽ ⫺10%. The three stocks’ returns also fell, H plunging to ⫺30 percent, A falling to ⫺10 percent, and L going down to rL ⫽ 0%. Thus, the three stocks all moved in the same direction as the market, but H was by far the most volatile; A was just as volatile as the market; and L was less volatile. Beta measures a stock’s volatility relative to an average stock, which by deﬁnition has b ⫽ 1.0. As we noted above, a stock’s beta can be calculated by plotting a line like those

123

Risk and Return Risk in a Portfolio Context

125

in Figure 3-9. The slopes of the lines show how each stock moves in response to a movement in the general market—indeed, the slope coefﬁcient of such a “regression line” is deﬁned as a beta coefﬁcient. (Procedures for actually calculating betas are described later in this chapter.) Most stocks have betas in the range of 0.50 to 1.50, and the average for all stocks is 1.0 by deﬁnition. Theoretically, it is possible for a stock to have a negative beta. In this case, the stock’s returns would tend to rise whenever the returns on other stocks fall. In practice, very few stocks have a negative beta. Keep in mind that a stock in a given period may move counter to the overall market, even though the stock’s beta is positive. If a stock has a positive beta, we would expect its return to increase whenever the overall stock market rises. However, company-speciﬁc factors may cause the stock’s realized return to decline, even though the market’s return is positive. If a stock whose beta is greater than 1.0 is added to a b ⫽ 1.0 portfolio, then the portfolio’s beta, and consequently its risk, will increase. Conversely, if a stock whose beta is less than 1.0 is added to a b ⫽ 1.0 portfolio, the portfolio’s beta and risk will decline. Thus, since a stock’s beta measures its contribution to the risk of a portfolio, beta is the theoretically correct measure of the stock’s risk. The preceding analysis of risk in a portfolio context is part of the Capital Asset Pricing Model (CAPM), and we can summarize our discussion to this point as follows: 1. A stock’s risk consists of two components, market risk and diversiﬁable risk. 2. Diversiﬁable risk can be eliminated by diversiﬁcation, and most investors do indeed diversify, either by holding large portfolios or by purchasing shares in a mutual fund. We are left, then, with market risk, which is caused by general movements in the stock market and which reﬂects the fact that most stocks are systematically affected by events like war, recessions, and inﬂation. Market risk is the only relevant risk to a rational, diversiﬁed investor because such an investor would eliminate diversiﬁable risk. 3. Investors must be compensated for bearing risk—the greater the risk of a stock, the higher its required return. However, compensation is required only for risk that cannot be eliminated by diversiﬁcation. If risk premiums existed on stocks due to diversiﬁable risk, well-diversiﬁed investors would start buying those securities (which would not be especially risky to such investors) and bidding up their prices, and the stocks’ ﬁnal (equilibrium) expected returns would reﬂect only nondiversiﬁable market risk. If this point is not clear, an example may help clarify it. Suppose half of Stock A’s risk is market risk (it occurs because Stock A moves up and down with the market), while the other half of A’s risk is diversiﬁable. You hold only Stock A, so you are exposed to all of its risk. As compensation for bearing so much risk, you want a risk premium of 10 percent over the 7 percent T-bond rate. Thus, your required return is rA ⫽ 7% ⫹ 10% ⫽ 17%. But suppose other investors, including your professor, are well diversiﬁed; they also hold Stock A, but they have eliminated its diversiﬁable risk and thus are exposed to only half as much risk as you. Therefore, their risk premium will be only half as large as yours, and their required rate of return will be rA ⫽ 7% ⫹ 5% ⫽ 12%. If the stock were yielding more than 12 percent in the market, diversiﬁed investors, including your professor, would buy it. If it were yielding 17 percent, you would be willing to buy it, but well-diversiﬁed investors would bid its price up and drive its yield down, hence you could not buy it at a price low enough to provide you with a 17 percent return. In the end, you would have to accept a 12 percent return or else keep your money in the bank. Thus, risk premiums in a market populated by rational, diversiﬁed investors reﬂect only market risk.

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4. The market risk of a stock is measured by its beta coefﬁcient, which is an index of the stock’s relative volatility. Some benchmark betas follow: b ⫽ 0.5: Stock is only half as volatile, or risky, as an average stock. b ⫽ 1.0: Stock is of average risk. b ⫽ 2.0: Stock is twice as risky as an average stock. 5. A portfolio consisting of low-beta securities will itself have a low beta, because the beta of a portfolio is a weighted average of its individual securities’ betas: bp ⫽ w1b1 ⫹ w2b2 ⫹ ⭈ ⭈ ⭈ ⫹ wnbn n

⫽ a wibi.

(3-7)

i⫽1

Here bp is the beta of the portfolio, and it shows how volatile the portfolio is in relation to the market; wi is the fraction of the portfolio invested in the ith stock; and bi is the beta coefﬁcient of the ith stock. For example, if an investor holds a $100,000 portfolio consisting of $33,333.33 invested in each of three stocks, and if each of the stocks has a beta of 0.7, then the portfolio’s beta will be bp ⫽ 0.7: bp ⫽ 0.3333(0.7) ⫹ 0.3333(0.7) ⫹ 0.3333(0.7) ⫽ 0.7. Such a portfolio will be less risky than the market, so it should experience relatively narrow price swings and have relatively small rate-of-return ﬂuctuations. In terms of Figure 3-9, the slope of its regression line would be 0.7, which is less than that for a portfolio of average stocks. Now suppose one of the existing stocks is sold and replaced by a stock with bi ⫽ 2.0. This action will increase the beta of the portfolio from bp1 ⫽ 0.7 to bp2 ⫽ 1.13: bp2 ⫽ 0.3333(0.7) ⫹ 0.3333(0.7) ⫹ 0.3333(2.0) ⫽ 1.13. Had a stock with bi ⫽ 0.2 been added, the portfolio beta would have declined from 0.7 to 0.53. Adding a low-beta stock, therefore, would reduce the risk of the portfolio. Consequently, adding new stocks to a portfolio can change the riskiness of that portfolio. 6. Since a stock’s beta coefﬁcient determines how the stock affects the risk of a diversiﬁed portfolio, beta is the most relevant measure of any stock’s risk. Explain the following statement: “An asset held as part of a portfolio is generally less risky than the same asset held in isolation.” What is meant by perfect positive correlation, perfect negative correlation, and zero correlation? In general, can the risk of a portfolio be reduced to zero by increasing the number of stocks in the portfolio? Explain. What is an average-risk stock? What will be its beta? Why is beta the theoretically correct measure of a stock’s risk? If you plotted the returns on a particular stock versus those on the Dow Jones Index over the past ﬁve years, what would the slope of the regression line you obtained indicate about the stock’s market risk?

125

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127

Calculating Beta Coefﬁcients The CAPM is an ex ante model, which means that all of the variables represent beforethe-fact, expected values. In particular, the beta coefﬁcient used by investors should reﬂect the expected volatility of a given stock’s return versus the return on the market during some future period. However, people generally calculate betas using data from some past period, and then assume that the stock’s relative volatility will be the same in the future as it was in the past. Table 3-4 shows the betas for some well-known companies, as calculated by two different ﬁnancial organizations, Bloomberg and Yahoo!Finance. Notice that their estimates of beta usually differ, because they calculate beta in slightly different ways.10 Given these differences, many analysts choose to calculate their own betas. To illustrate how betas are calculated, consider Figure 3-10. The data at the bottom of the ﬁgure show the historical realized returns for Stock J and for the market over the last ﬁve years. The data points have been plotted on the scatter diagram, and a regression line has been drawn. If all the data points had fallen on a straight line, as they did in Figure 3-9, it would be easy to draw an accurate line. If they do not, as in Figure 3-10, then you must ﬁt the line either “by eye” as an approximation, with a calculator, or with a computer. Recall what the term regression line, or regression equation, means: The equation Y ⫽ a ⫹ bX ⫹ e is the standard form of a simple linear regression. It states that the dependent variable, Y, is equal to a constant, a, plus b times X, where b is the slope coefﬁcient and X is the independent variable, plus an error term, e. Thus, the rate of return on the stock during a given time period (Y) depends on what happens to the general stock market, which is measured by X ⫽ rM. Once the data have been plotted and the regression line has been drawn on graph paper, we can estimate its intercept and slope, the a and b values in Y ⫽ a ⫹ bX. The intercept, a, is simply the point where the line cuts the vertical axis. The slope coefﬁcient, b, can be estimated by the “rise-over-run” method. This involves calculating the 10

Many other organizations provide estimates of beta, including Merrill Lynch and Value Line.

To see updated estimates, go to http://www. bloomberg.com, and enter the ticker symbol for a Stock Quote. Beta is shown in the section on Fundamentals. Or go to http://ﬁnance. yahoo.com and enter the ticker symbol. When the page with results comes up, select Proﬁle in the section called More Info. When this page comes up, scroll down until you see beta in the section called Price and Volume.

TABLE 3-4

Beta Coefﬁcients for Some Actual Companies

Stock (Ticker Symbol)

Amazon.com (AMZN) Cisco Systems (CSCO) Dell computers (DELL) Merrill Lynch (MER) General Electric (GE) Microsoft Corp. (MSFT) Energen Corp. (EGN) Empire District Electric (EDE) Coca-Cola (KO) Procter & Gamble (PG) Heinz (HNZ)

Beta: Bloomberg

Beta: Yahoo!Finance

1.76 1.70 1.39 1.38 1.18 1.09 0.72 0.57 0.54 0.54 0.26

3.39 1.89 2.24 1.57 1.18 1.82 0.26 –0.12 0.66 0.29 0.45

Sources: http://www.bloomberg.com and http://ﬁnance.yahoo.com.

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Risk and Return FIGURE 3-10

Calculating Beta Coefﬁcients

Historic Realized_ Returns on Stock J, rJ (%) Year 1

40

30

Year 5

_

_

rJ = aJ + bJ rM + _eJ = –8.9% + 1.6 rM + eJ 20 Year 3 10 Year 4

7.1

–10

0

10

aJ = Intercept = – 8.9%

Historic Realized Returns _ on the Market, rM (%) ∆ rJ = 8.9% + 7.1% = 16% 20

30

_

–10 _

∆ r M = 10%

_

bJ =

Rise ∆r 16 = _J = = 1.6 Run ∆ r M 10

–20 Year 2 Year

Market ( rM)

Stock J ( rJ)

1 2 3 4 5 Average r

23.8% (7.2) 6.6 20.5 30.6 14.9%

38.6% (24.7) 12.3 8.2 40.1 14.9%

␴ r¯

15.1%

26.5%

amount by which rJ increases for a given increase in rM. For example, we observe in Figure 3-10 that rJ increases from ⫺8.9 to ⫹7.1 percent (the rise) when rM increases from 0 to 10.0 percent (the run). Thus, b, the beta coefﬁcient, can be measured as follows: b ⫽ Beta ⫽

7.1 ⫺ (⫺8.9) Rise DY 16.0 ⫽ ⫽ ⫽ ⫽ 1.6. Run DX 10.0 ⫺ 0.0 10.0

Note that rise over run is a ratio, and it would be the same if measured using any two arbitrarily selected points on the line. The regression line equation enables us to predict a rate of return for Stock J, given a value of rM. For example, if rM ⫽ 15%, we would predict rJ ⫽ ⫺8.9% ⫹ 1.6(15%) ⫽ 15.1%. However, the actual return would probably differ from the predicted return. This deviation is the error term, eJ, for the year, and it varies randomly from year to year depending on company-speciﬁc factors. Note, though,

127

Risk and Return Calculating Beta Coefﬁcients

129

that the higher the correlation coefﬁcient, the closer the points lie to the regression line, and the smaller the errors. In actual practice, one would use the least squares method for ﬁnding the regression coefﬁcients a and b. This procedure minimizes the squared values of the error terms, and it is discussed in statistics courses. However, the least squares value of beta can be obtained quite easily with a ﬁnancial calculator.11 Although it is possible to calculate beta coefﬁcients with a calculator, they are usually calculated with a computer, either with a statistical software program or a spreadsheet program. The ﬁle Ch 03 Tool Kit.xls on your textbook’s web site shows an application in which the beta coefﬁcient for Wal-Mart Stores is calculated using Excel’s regression function. The ﬁrst step in a regression analysis is compiling the data. Most analysts use four to ﬁve years of monthly data, although some use 52 weeks of weekly data. We decided to use four years of monthly data, so we began by downloading 49 months of stock prices for Wal-Mart from the Yahoo!Finance web site. We used the S&P 500 Index as the market portfolio because most analysts use this index. Table 3-5 shows a portion of this data; the full data set is in the ﬁle Ch 03 Tool Kit.xls on your textbook’s web site. The second step is to convert the stock prices into rates of return. For example, to ﬁnd the August 2001 return, we ﬁnd the percentage change from the previous month: –14.0% ⫽ –0.140 ⫽ ($47.976 – $55.814)/$55.814.12 We also ﬁnd the percent change of the S&P 500 Index level, and use this as the market return. For example, in August 2001 this is –3.5% ⫽ –0.035 ⫽ (1,294.0 ⫺ 1,341.0 )/1,341.0. As Table 3-5 shows, Wal-Mart stock had an average annual return of 31.4 percent during this four-year period, while the market had an average annual return of 6.9 percent. As we noted before, it is usually unreasonable to think that the future expected return for a stock will equal its average historical return over a relatively short period, such as four years. However, we might well expect past volatility to be a reasonable estimate of future volatility, at least during the next couple of years. Note that the standard deviation for Wal-Mart’s return during this period was 34.5 percent versus 18.7 percent for the market. Thus, the market’s volatility is about half that of Wal-Mart. This is what we would expect, since the market is a well-diversiﬁed portfolio, in which much risk has been diversiﬁed away. The correlation between Wal-Mart’s stock returns and the market returns is about 27.4 percent, which is a little lower than the correlation for an average stock. Figure 3-11 shows a plot of Wal-Mart’s stock returns against the market returns. As you will notice if you look in the ﬁle Ch 03 Tool Kit.xls, we used the Excel Chart feature to add a trend line and to display the equation and R2 value on the chart itself. Alternatively, we could have used the Excel regression analysis feature, which would have provided more detailed data. Figure 3-11 shows that Wal-Mart’s beta is about 0.51, as shown by the slope coefﬁcient in the regression equation displayed on the chart. This means that Wal-Mart’s 11

For an explanation of calculating beta with a ﬁnancial calculator, see the Chapter 3 Web Extension on the textbook’s web site, http://ehrhardt.swcollege.com. 12 For example, suppose the stock price is $100 in July, the company has a 2-for-1 split, and the actual price is then $60 in August. The reported adjusted price for August would be $60, but the reported price for July would be lowered to $50 to reﬂect the stock split. This gives an accurate stock return of 20 percent: ($60 ⫺ $50)/$50 ⫽ 20%, the same as if there had not been a split, in which case the return would have been ($120 ⫺ $100)/$100 ⫽ 20%. Or suppose the actual price in September were $50, the company paid a $10 dividend, and the actual price in October was $60. Shareholders have earned a return of ($60 ⫹ $10 ⫺ $50)/$50 ⫽ 40%. Yahoo reports an adjusted price of $60 for October, and an adjusted price of $42.857 for September, which gives a return of ($60 – $42.857)/$42.857 = 40%. Again, the percent change in the adjusted price accurately reﬂects the actual return.

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Risk and Return TABLE 3-5

Check out http://ﬁnance. yahoo.com for Wal-Mart using its ticker symbol of WMT. You can also download data for the S&P 500 index using its symbol of ^SPI.

Stock Return Data for Wal-Mart Stores

Date

August 2001 July 2001 June 2001 May 2001 . . . . . . October 1997 September 1997 August 1997 Average (annual)

Market Level (S&P 500 Index)

Market Return

Wal-Mart Adjusted Stock Pricea

Wal-Mart Return

1,294.0 1,341.0 1,386.8 1,424.2 . . . . . . 994.0 1,057.3 1,049.4

–3.5% –3.3 –2.6 –13.9 . . . . . . ⫺6.0 0.8 NA

47.976 55.814 48.725 51.596 . . . . . . 17.153 17.950 17.368

–14.0% 14.5 –5.6 0.0 . . . . . . –4.4 3.4 NA

6.9%

31.4%

Standard deviation (annual)

18.7%

34.5%

Correlation between Wal-Mart and the market

27.4%

a

Yahoo actually adjusts the stock prices to reﬂect any stock splits or dividend payments.

beta is about half the 1.0 average beta. Thus, Wal-Mart moves up and down by roughly half the percent as the market. Note, however, that the points are not clustered very tightly around the regression line. Sometimes Wal-Mart does much better than the market, while at other times it does much worse. The R2 value shown in the chart measures the degree of dispersion about the regression line. Statistically speaking, it measures the percentage of the variance that is explained by the regression equation. An R2 of 1.0 indicates that all points lie exactly on the line, hence that all of the variance of the y-variable is explained by the x-variable. Wal-Mart’s R2 is about 0.08, which is a little lower than most individual stocks. This indicates that about 8 percent of the variance in Wal-Mart’s returns is explained by the market returns. If we had done a similar analysis for portfolios of 50 randomly selected stocks, then the points would on average have been clustered tightly around the regression line, and the R2 would have averaged over 0.9. Finally, note that the intercept shown in the regression equation on the chart is about 2 percent. Since the regression equation is based on monthly data, this means that over this period Wal-Mart’s stock earned 2 percent more per month than an average stock as a result of factors other than a general increase in stock prices. What types of data are needed to calculate a beta coefﬁcient for an actual company? What does the R2 measure? What is the R2 for a typical company?

The Relationship between Risk and Rates of Return In the preceding section, we saw that under the CAPM theory, beta is the appropriate measure of a stock’s relevant risk. Now we must specify the relationship between risk and return: For a given level of risk as measured by beta, what rate of return should

129

Risk and Return The Relationship between Risk and Rates of Return FIGURE 3-11

131

Calculating a Beta Coefﬁcient for Wal-Mart Stores Historic Realized Returns _ on Wal-Mart, rj (%) 30

_

rj = 2.32% + 0.506 rM R2 = 0.0752 20

10

-30

-20

-10

0

-10

10

20

30

Historic Realized Returns _ on the Market, rM (%)

-20

-30

investors require to compensate them for bearing that risk? To begin, let us deﬁne the following terms: rˆi ⫽ expected rate of return on the ith stock. ri ⫽ required rate of return on the ith stock. Note that if rˆi is less than ri, you would not purchase this stock, or you would sell it if you owned it. If rˆi were greater than ri, you would want to buy the stock, because it looks like a bargain. You would be indifferent if rˆi ⫽ ri. r ⫽ realized, after-the-fact return. One obviously does not know what r will be at the time he or she is considering the purchase of a stock. rRF ⫽ risk-free rate of return. In this context, rRF is generally measured by the return on long-term U.S. Treasury bonds. bi ⫽ beta coefﬁcient of the ith stock. The beta of an average stock is bA ⫽ 1.0.

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Risk and Return

rM ⫽ required rate of return on a portfolio consisting of all stocks, which is called the market portfolio. rM is also the required rate of return on an average (bA ⫽ 1.0) stock. RPM ⫽ (rM ⫺ rRF) ⫽ risk premium on “the market,” and also on an average (b ⫽ 1.0) stock. This is the additional return over the risk-free rate required to compensate an average investor for assuming an average amount of risk. Average risk means a stock whose bi ⫽ bA ⫽ 1.0. RPi ⫽ (rM ⫺ rRF)bi ⫽ (RPM)bi ⫽ risk premium on the ith stock. The stock’s risk premium will be less than, equal to, or greater than the premium on an average stock, RPM, depending on whether its beta is less than, equal to, or greater than 1.0. If bi ⫽ bA ⫽ 1.0, then RPi ⫽ RPM. The market risk premium, RPM, shows the premium investors require for bearing the risk of an average stock, and it depends on the degree of risk aversion that investors on average have.13 Let us assume that at the current time, Treasury bonds yield rRF ⫽ 6% and an average share of stock has a required return of rM ⫽ 11%. Therefore, the market risk premium is 5 percent: RPM ⫽ rM ⫺ rRF ⫽ 11% ⫺ 6% ⫽ 5%. It follows that if one stock were twice as risky as another, its risk premium would be twice as high, while if its risk were only half as much, its risk premium would be half as large. Further, we can measure a stock’s relative riskiness by its beta coefﬁcient. Therefore, the risk premium for the ith stock is: Risk premium for Stock i ⫽ RPi ⫽ (RPM)bi

(3-8)

If we know the market risk premium, RPM, and the stock’s risk as measured by its beta coefﬁcient, bi, we can ﬁnd the stock’s risk premium as the product (RPM)bi. For example, if bi ⫽ 0.5 and RPM ⫽ 5%, then RPi is 2.5 percent: RPi ⫽ (5%)(0.5) ⫽ 2.5%. As the discussion in Chapter 1 implied, the required return for any investment can be expressed in general terms as Required return ⫽ Risk-free return ⫹ Premium for risk. Here the risk-free return includes a premium for expected inflation, and we assume that the assets under consideration have similar maturities and liquidity. Under these conditions, the relationship between the required return and risk is called the Security Market Line (SML)

It should be noted that the risk premium of an average stock, rM ⫺ rRF, cannot be measured with great precision because it is impossible to obtain precise values for the expected future return on the market, rM. However, empirical studies suggest that where long-term U.S. Treasury bonds are used to measure rRF and where rM is an estimate of the expected (not historical) return on the S&P 500 Industrial Stocks, the market risk premium varies somewhat from year to year, and it has generally ranged from 4 to 6 percent during the last 20 years. 13

131

Risk and Return The Relationship between Risk and Rates of Return FIGURE 3-12

133

The Security Market Line (SML)

Required Rate of Return (%)

SML: ri = rRF + (RPM ) bi = 6% + (5%) bi

rH = 16

rL = 8.5

Safe Stock’s Risk Premium: 2.5%

rRF = 6

Relatively Risky Stock’s Risk Premium: 10%

Market Risk Premium: 5%. Applies Also to an Average Stock, and Is the Slope Coefficient in the SML Equation

rM = rA = 11

Risk-Free Rate, rRF

0

0.5

SML Equation:

1.0

1.5

2.0

Risk, b i

Required return Risk-free Market risk Stock i’s ⫽ ⫹¢ ≤¢ ≤ on Stock i rate premium beta (3-9) ri ⫽ rRF ⫹ (rM ⫺ rRF)bi ⫽ rRF ⫹ (RPM)bi

The required return for Stock i can be written as follows: ri ⫽ 6% ⫹ (11% ⫺ 6%)(0.5) ⫽ 6% ⫹ 5%(0.5) ⫽ 8.5%. If some other Stock j were riskier than Stock i and had bj ⫽ 2.0, then its required rate of return would be 16 percent: rj ⫽ 6% ⫹ (5%)2.0 ⫽ 16%. An average stock, with b ⫽ 1.0, would have a required return of 11 percent, the same as the market return: rA ⫽ 6% ⫹ (5%)1.0 ⫽ 11% ⫽ rM. As noted above, Equation 3-9 is called the Security Market Line (SML) equation, and it is often expressed in graph form, as in Figure 3-12, which shows the SML when rRF ⫽ 6% and rM ⫽ 11%. Note the following points: 1. Required rates of return are shown on the vertical axis, while risk as measured by beta is shown on the horizontal axis. This graph is quite different from the one shown in Figure 3-9, where the returns on individual stocks were plotted on the

132

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Risk and Return

vertical axis and returns on the market index were shown on the horizontal axis. The slopes of the three lines in Figure 3-9 were used to calculate the three stocks’ betas, and those betas were then plotted as points on the horizontal axis of Figure 3-12. 2. Riskless securities have bi ⫽ 0; therefore, rRF appears as the vertical axis intercept in Figure 3-12. If we could construct a portfolio that had a beta of zero, it would have an expected return equal to the risk-free rate. 3. The slope of the SML (5% in Figure 3-12) reﬂects the degree of risk aversion in the economy—the greater the average investor’s aversion to risk, then (a) the steeper the slope of the line, (b) the greater the risk premium for all stocks, and (c) the higher the required rate of return on all stocks.14 These points are discussed further in a later section. 4. The values we worked out for stocks with bi ⫽ 0.5, bi ⫽ 1.0, and bi ⫽ 2.0 agree with the values shown on the graph for rL, rA, and rH. Both the Security Market Line and a company’s position on it change over time due to changes in interest rates, investors’ aversion to risk, and individual companies’ betas. Such changes are discussed in the following sections.

14

Students sometimes confuse beta with the slope of the SML. This is a mistake. The slope of any straight line is equal to the “rise” divided by the “run,” or (Y1 ⫺ Y0)/(X1 ⫺ X0). Consider Figure 3-12. If we let Y ⫽ r and X ⫽ beta, and we go from the origin to b ⫽ 1.0, we see that the slope is (rM ⫺ rRF)/(bM ⫺ bRF) ⫽ (11% ⫺ 6%)/(1 ⫺ 0) ⫽ 5%. Thus, the slope of the SML is equal to (rM ⫺ rRF), the market risk premium. In Figure 3-12, ri ⫽ 6% ⫹ 5%bi, so an increase of beta from 1.0 to 2.0 would produce a 5 percentage point increase in ri.

FIGURE 3-13

Shift in the SML Caused by an Increase in Inﬂation

Required Rate of Return (%)

SML2 = 8% + 5%(bi) SML1 = 6% + 5%(bi)

rM2 = 13 rM1 = 11

rRF2 = 8 Increase in Anticipated Inflation, ∆ IP = 2% rRF1 = 6 Original IP = 3% r* = 3 Real Risk-Free Rate of Return, r* 0

0.5

1.0

1.5

2.0

Risk, b i

133

Risk and Return The Relationship between Risk and Rates of Return

135

The Impact of Inﬂation As we learned in Chapter 1, interest amounts to “rent” on borrowed money, or the price of money. Thus, rRF is the price of money to a riskless borrower. We also learned that the risk-free rate as measured by the rate on U.S. Treasury securities is called the nominal, or quoted, rate, and it consists of two elements: (1) a real inflationfree rate of return, r*, and (2) an inflation premium, IP, equal to the anticipated rate of inflation.15 Thus, rRF ⫽ r* ⫹ IP. The real rate on long-term Treasury bonds has historically ranged from 2 to 4 percent, with a mean of about 3 percent. Therefore, if no inflation were expected, long-term Treasury bonds would yield about 3 percent. However, as the expected rate of inflation increases, a premium must be added to the real risk-free rate of return to compensate investors for the loss of purchasing power that results from inflation. Therefore, the 6 percent rRF shown in Figure 3-12 might be thought of as consisting of a 3 percent real risk-free rate of return plus a 3 percent inflation premium: rRF ⫽ r* ⫹ IP ⫽ 3% ⫹ 3% ⫽ 6%. If the expected inﬂation rate rose by 2 percent, to 3% ⫹ 2% ⫽ 5%, this would cause rRF to rise to 8 percent. Such a change is shown in Figure 3-13. Notice that under the CAPM, the increase in rRF leads to an equal increase in the rate of return on all risky assets, because the same inﬂation premium is built into the required rate of return of both riskless and risky assets.16 For example, the rate of return on an average stock, rM, increases from 11 to 13 percent. Other risky securities’ returns also rise by two percentage points. The discussion above also applies to any change in the nominal risk-free interest rate, whether it is caused by a change in expected inﬂation or in the real interest rate. The key point to remember is that a change in rRF will not necessarily cause a change in the market risk premium, which is the required return on the market, rM, minus the risk-free rate, rRF. In other words, as rRF changes, so may the required return on the market, keeping the market risk premium stable. Think of a sailboat ﬂoating in a harbor. The distance from the ocean ﬂoor to the ocean surface is like the risk-free rate, and it moves up and down with the tides. The distance from the top of the ship’s mast to the ocean ﬂoor is like the required market return: it, too, moves up and down with the tides. But the distance from the mast-top to the ocean surface is like the market risk premium—it generally stays the same, even though tides move the ship up and down. In other words, a change in the risk-free rate also causes a change in the required market return, rM, resulting in a relatively stable market risk premium, rM ⫺ rRF.

Changes in Risk Aversion The slope of the Security Market Line reﬂects the extent to which investors are averse to risk—the steeper the slope of the line, the greater the average investor’s risk aversion. Suppose investors were indifferent to risk; that is, they were not risk averse. If rRF were 6 percent, then risky assets would also provide an expected return of 6 15

Long-term Treasury bonds also contain a maturity risk premium, MRP. Here we include the MRP in r* to simplify the discussion. 16 Recall that the inﬂation premium for any asset is equal to the average expected rate of inﬂation over the asset’s life. Thus, in this analysis we must assume either that all securities plotted on the SML graph have the same life or else that the expected rate of future inﬂation is constant. It should also be noted that rRF in a CAPM analysis can be proxied by either a long-term rate (the T-bond rate) or a short-term rate (the T-bill rate). Traditionally, the T-bill rate was used, but in recent years there has been a movement toward use of the T-bond rate because there is a closer relationship between T-bond yields and stocks than between T-bill yields and stocks. See Stocks, Bonds, Bills, and Inﬂation: 2001 Valuation Edition Yearbook (Chicago: Ibbotson Associates, 2001) for a discussion.

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Risk and Return

percent, because if there were no risk aversion, there would be no risk premium, and the SML would be plotted as a horizontal line. As risk aversion increases, so does the risk premium, and this causes the slope of the SML to become steeper. Figure 3-14 illustrates an increase in risk aversion. The market risk premium rises from 5 to 7.5 percent, causing rM to rise from rM1 ⫽ 11% to rM2 ⫽ 13.5%. The returns on other risky assets also rise, and the effect of this shift in risk aversion is more pronounced on riskier securities. For example, the required return on a stock with bi ⫽ 0.5 increases by only 1.25 percentage points, from 8.5 to 9.75 percent, whereas that on a stock with bi ⫽ 1.5 increases by 3.75 percentage points, from 13.5 to 17.25 percent.

Changes in a Stock’s Beta Coefﬁcient As we shall see later in the book, a ﬁrm can inﬂuence its market risk, hence its beta, through changes in the composition of its assets and also through its use of debt. A company’s beta can also change as a result of external factors such as increased competition in its industry, the expiration of basic patents, and the like. When such changes occur, the required rate of return also changes, and, as we shall see in Chapter 5, this will affect the ﬁrm’s stock price. For example, consider MicroDrive Inc., with a beta of 1.40. Now suppose some action occurred that caused MicroDrive’s beta to increase from 1.40 to 2.00. If the conditions depicted in Figure 3-12 held, MicroDrive’s required rate of return would increase from 13 to 16 percent: r1 ⫽ rRF ⫹ RPMb1 ⫽ 6% ⫹ (5%)1.40 ⫽ 13%

FIGURE 3-14

Shift in the SML Caused by Increased Risk Aversion SML2 = 6% + 7.5%(bi)

Required Rate of Return (%) 17.25

SML1 = 6% + 5%(bi)

rM2 = 13.5 rM1 = 11 9.75 8.5

New Market Risk Premium, rM2 – rRF = 7.5%

rRF = 6 Original Market Risk Premium, rM1 – rRF = 5%

0

0.5

1.0

1.5

2.0

Risk, b i

135

Risk and Return Physical Assests versus Securities

137

to r2 ⫽ 6% ⫹ (5%)2.0 ⫽ 16%. As we shall see in Chapter 5, this change would have a dramatic effect on MicroDrive’s stock. ˆ the required rate of return Differentiate among the expected rate of return (r), (r), and the realized, after-the-fact return (r-) on a stock. Which would have to be larger to get you to buy the stock, rˆ or r? Would rˆ, r, and -r typically be the same or different for a given company? What are the differences between the relative volatility graph (Figure 3-9), where “betas are made,” and the SML graph (Figure 3-12), where “betas are used”? Discuss both how the graphs are constructed and the information they convey. What happens to the SML graph in Figure 3-12 when inﬂation increases or decreases? What happens to the SML graph when risk aversion increases or decreases? What would the SML look like if investors were indifferent to risk, that is, had zero risk aversion? How can a ﬁrm inﬂuence its market risk as reﬂected in its beta?

Physical Assets versus Securities In a book on ﬁnancial management for business ﬁrms, why do we spend so much time discussing the risk of stocks? Why not begin by looking at the risk of such business assets as plant and equipment? The reason is that, for a management whose primary objective is stock price maximization, the overriding consideration is the risk of the ﬁrm’s stock, and the relevant risk of any physical asset must be measured in terms of its effect on the stock’s risk as seen by investors. For example, suppose Goodyear Tire Company is considering a major investment in a new product, recapped tires. Sales of recaps, hence earnings on the new operation, are highly uncertain, so on a stand-alone basis the new venture appears to be quite risky. However, suppose returns in the recap business are negatively correlated with Goodyear’s regular operations—when times are good and people have plenty of money, they buy new tires, but when times are bad, they tend to buy more recaps. Therefore, returns would be high on regular operations and low on the recap division during good times, but the opposite would occur during recessions. The result might be a pattern like that shown earlier in Figure 3-5 for Stocks W and M. Thus, what appears to be a risky investment when viewed on a stand-alone basis might not be very risky when viewed within the context of the company as a whole. This analysis can be extended to the corporation’s stockholders. Because Goodyear’s stock is owned by diversiﬁed stockholders, the real issue each time management makes an asset investment should be this: How will this investment affect the risk of our stockholders? Again, the stand-alone risk of an individual project may be quite high, but viewed in the context of the project’s effect on stockholders’ risk, it may not be very large. We will address this issue again in Chapter 8, where we examine the effects of capital budgeting on companies’ beta coefﬁcients and thus on stockholders’ risks. Explain the following statement: “The stand-alone risk of an individual project may be quite high, but viewed in the context of a project’s effect on stockholders, the project’s true risk may not be very large.” How would the correlation between returns on a project and returns on the ﬁrm’s other assets affect the project’s risk?

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Some Concerns about Beta and the CAPM The Capital Asset Pricing Model (CAPM) is more than just an abstract theory described in textbooks—it is also widely used by analysts, investors, and corporations. However, despite the CAPM’s intuitive appeal, a number of studies have raised concerns about its validity. In particular, a study by Eugene Fama of the University of Chicago and Kenneth French of Yale cast doubt on the CAPM.17 Fama and French found two variables that are consistently related to stock returns: (1) the ﬁrm’s size and (2) its market/book ratio. After adjusting for other factors, they found that smaller ﬁrms have provided relatively high returns, and that returns are relatively high on stocks with low market/book ratios. At the same time, and contrary to the CAPM, they found no relationship between a stock’s beta and its return. As an alternative to the traditional CAPM, researchers and practitioners have begun to look to more general multi-beta models that expand on the CAPM and address its shortcomings. The multi-beta model is an attractive generalization of the traditional CAPM model’s insight that market risk, or the risk that cannot be diversiﬁed away underlies the pricing of assets. In the multi-beta model, market risk is measured relative to a set of risk factors that determine the behavior of asset returns, whereas the CAPM gauges risk only relative to the market return. It is important to note that the risk factors in the multi-beta model are all nondiversiﬁable sources of risk. Empirical research investigating the relationship between economic risk factors and security returns is ongoing, but it has discovered several risk factors, including the bond default premium, the bond term structure premium, and inﬂation, that affect most securities. Practitioners and academicians have long recognized the limitations of the CAPM, and they are constantly looking for ways to improve it. The multi-beta model is a potential step in that direction. Are there any reasons to question the validity of the CAPM? Explain.

Volatility versus Risk Before closing this chapter, we should note that volatility does not necessarily imply risk. For example, suppose a company’s sales and earnings ﬂuctuate widely from month to month, from year to year, or in some other manner. Does this imply that the company is risky in either the stand-alone or portfolio sense? If the earnings follow seasonal or cyclical patterns, as for an ice cream distributor or a steel company, they can be predicted, hence volatility would not signify much in the way of risk. If the ice cream company’s earnings dropped about as much as they normally did in the winter, this would not concern investors, so the company’s stock price would not be affected. Similarly, if the steel company’s earnings fell during a recession, this would not be a surprise, so the company’s stock price would not fall nearly as much as its earnings. Therefore, earnings volatility does not necessarily imply investment risk. Now consider some other company, say, Wal-Mart. In 1995 Wal-Mart’s earnings declined for the ﬁrst time in its history. That decline worried investors—they were concerned that Wal-Mart’s era of rapid growth had ended. The result was that Wal-Mart’s stock price declined more than its earnings. Again, we conclude that while a downturn in earnings does not necessarily imply risk, it could, depending on conditions.

17

See Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, Vol. 47, 1992, 427–465; and Eugene F. Fama and Kenneth R. French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, Vol. 33, 1993, 3–56.

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139

Now let’s consider stock price volatility as opposed to earnings volatility. Is stock price volatility more likely to imply risk than earnings volatility? The answer is a loud yes! Stock prices vary because investors are uncertain about the future, especially about future earnings. So, if you see a company whose stock price ﬂuctuates relatively widely (which will result in a high beta), you can bet that its future earnings are relatively unpredictable. Thus, biotech companies have less predictable earnings than water companies, biotechs’ stock prices are volatile, and they have relatively high betas. To conclude, keep two points in mind: (1) Earnings volatility does not necessarily signify risk—you have to think about the cause of the volatility before reaching any conclusion as to whether earnings volatility indicates risk. (2) However, stock price volatility does signify risk. Does earnings volatility necessarily imply risk? Explain. Why is stock price volatility more likely to imply risk than earnings volatility?

Summary In this chapter, we described the trade-off between risk and return. We began by discussing how to calculate risk and return for both individual assets and portfolios. In particular, we differentiated between stand-alone risk and risk in a portfolio context, and we explained the beneﬁts of diversiﬁcation. Finally, we developed the CAPM, which explains how risk affects rates of return. In the chapters that follow, we will give you the tools to estimate the required rates of return for bonds, preferred stock, and common stock, and we will explain how ﬁrms use these returns to develop their costs of capital. As you will see, the cost of capital is an important element in the ﬁrm’s capital budgeting process. The key concepts covered in this chapter are listed below. 䊉䊉

䊉

䊉

䊉

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䊉

䊉

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Risk can be deﬁned as the chance that some unfavorable event will occur. The risk of an asset’s cash ﬂows can be considered on a stand-alone basis (each asset by itself) or in a portfolio context, where the investment is combined with other assets and its risk is reduced through diversiﬁcation. Most rational investors hold portfolios of assets, and they are more concerned with the riskiness of their portfolios than with the risk of individual assets. The expected return on an investment is the mean value of its probability distribution of returns. The greater the probability that the actual return will be far below the expected return, the greater the stand-alone risk associated with an asset. The average investor is risk averse, which means that he or she must be compensated for holding risky assets. Therefore, riskier assets have higher required returns than less risky assets. An asset’s risk consists of (1) diversiﬁable risk, which can be eliminated by diversiﬁcation, plus (2) market risk, which cannot be eliminated by diversiﬁcation. The relevant risk of an individual asset is its contribution to the riskiness of a welldiversiﬁed portfolio, which is the asset’s market risk. Since market risk cannot be eliminated by diversiﬁcation, investors must be compensated for bearing it. A stock’s beta coefﬁcient, b, is a measure of its market risk. Beta measures the extent to which the stock’s returns move relative to the market. A high-beta stock is more volatile than an average stock, while a low-beta stock is less volatile than an average stock. An average stock has b ⫽ 1.0. The beta of a portfolio is a weighted average of the betas of the individual securities in the portfolio.

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Risk and Return 䊉

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The Security Market Line (SML) equation shows the relationship between a security’s market risk and its required rate of return. The return required for any security i is equal to the risk-free rate plus the market risk premium times the security’s beta: ri ⫽ rRF ⫹ (RPM)bi. Even though the expected rate of return on a stock is generally equal to its required return, a number of things can happen to cause the required rate of return to change: (1) the risk-free rate can change because of changes in either real rates or anticipated inﬂation, (2) a stock’s beta can change, and (3) investors’ aversion to risk can change. Because returns on assets in different countries are not perfectly correlated, global diversiﬁcation may result in lower risk for multinational companies and globally diversiﬁed portfolios.

In the next two chapters we will see how a security’s expected rate of return affects its value. Then, in the remainder of the book, we will examine ways in which a ﬁrm’s management can inﬂuence a stock’s risk and hence its price.

Questions 3–1

Deﬁne the following terms, using graphs or equations to illustrate your answers wherever feasible: a. Stand-alone risk; risk; probability distribution b. Expected rate of return, rˆ c. Continuous probability distribution d. Standard deviation, ␴; variance, ␴2; coefﬁcient of variation, CV e. Risk aversion; realized rate of return, r f. Risk premium for Stock i, RPi; market risk premium, RPM g. Capital Asset Pricing Model (CAPM) h. Expected return on a portfolio, rˆ p; market portfolio i. Correlation coefﬁcient, ␳; correlation j. Market risk; diversiﬁable risk; relevant risk k. Beta coefﬁcient, b; average stock’s beta, bA l. Security Market Line (SML); SML equation m. Slope of SML as a measure of risk aversion

3–2

The probability distribution of a less risky expected return is more peaked than that of a riskier return. What shape would the probability distribution have for (a) completely certain returns and (b) completely uncertain returns?

3–3

Security A has an expected return of 7 percent, a standard deviation of expected returns of 35 percent, a correlation coefﬁcient with the market of ⫺0.3, and a beta coefﬁcient of ⫺1.5. Security B has an expected return of 12 percent, a standard deviation of returns of 10 percent, a correlation with the market of 0.7, and a beta coefﬁcient of 1.0. Which security is riskier? Why?

3–4

Suppose you owned a portfolio consisting of $250,000 worth of long-term U.S. government bonds. a. Would your portfolio be riskless? b. Now suppose you hold a portfolio consisting of $250,000 worth of 30-day Treasury bills. Every 30 days your bills mature, and you reinvest the principal ($250,000) in a new batch of bills. Assume that you live on the investment income from your portfolio and that you want to maintain a constant standard of living. Is your portfolio truly riskless? c. Can you think of any asset that would be completely riskless? Could someone develop such an asset? Explain.

3–5

If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase more or less than that on a low-beta stock? Explain.

3–6

If a company’s beta were to double, would its expected return double?

3–7

Is it possible to construct a portfolio of stocks which has an expected return equal to the riskfree rate?

139

Risk and Return Problems

Self-Test Problems ST–1 REALIZED RATES OF RETURN

141

(Solutions Appear in Appendix A)

Stocks A and B have the following historical returns: Year

Stock A’s Returns, rA

1998 1999 2000 2001 2002

(18%) 44 (22) 22 34

Stock B’s Returns, rB

(24%) 24 (4) 8 56

a. Calculate the average rate of return for each stock during the period 1998 through 2002. Assume that someone held a portfolio consisting of 50 percent of Stock A and 50 percent of Stock B. What would have been the realized rate of return on the portfolio in each year from 1998 through 2002? What would have been the average return on the portfolio during this period? b. Now calculate the standard deviation of returns for each stock and for the portfolio. Use Equation 3-3a. c. Looking at the annual returns data on the two stocks, would you guess that the correlation coefﬁcient between returns on the two stocks is closer to 0.8 or to ⫺0.8? d. If you added more stocks at random to the portfolio, which of the following is the most accurate statement of what would happen to ␴p? (1) ␴p would remain constant. (2) ␴p would decline to somewhere in the vicinity of 20 percent. (3) ␴p would decline to zero if enough stocks were included. ST–2 BETA AND REQUIRED RATE OF RETURN

ECRI Corporation is a holding company with four main subsidiaries. The percentage of its business coming from each of the subsidiaries, and their respective betas, are as follows: Subsidiary

Percentage of Business

Beta

60% 25 10 5

0.70 0.90 1.30 1.50

Electric utility Cable company Real estate International/special projects

a. What is the holding company’s beta? b. Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent. What is the holding company’s required rate of return? c. ECRI is considering a change in its strategic focus; it will reduce its reliance on the electric utility subsidiary, so the percentage of its business from this subsidiary will be 50 percent. At the same time, ECRI will increase its reliance on the international/special projects division, so the percentage of its business from that subsidiary will rise to 15 percent. What will be the shareholders’ required rate of return if they adopt these changes?

Problems 3–1 EXPECTED RETURN

A stock’s expected return has the following distribution: Demand for the Company’s Products

Weak Below average Average Above average Strong

Probability of this Demand Occurring

0.1 0.2 0.4 0.2 0.1 1.0

Rate of Return if This Demand Occurs

(50%) ( 5) 16 25 60

Calculate the stock’s expected return, standard deviation, and coefﬁcient of variation.

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Risk and Return 3–2

PORTFOLIO BETA

3–3 EXPECTED AND REQUIRED RATES OF RETURN

3–4 REQUIRED RATE OF RETURN

3–5

An individual has $35,000 invested in a stock which has a beta of 0.8 and $40,000 invested in a stock with a beta of 1.4. If these are the only two investments in her portfolio, what is her portfolio’s beta? Assume that the risk-free rate is 5 percent and the market risk premium is 6 percent. What is the expected return for the overall stock market? What is the required rate of return on a stock that has a beta of 1.2? Assume that the risk-free rate is 6 percent and the expected return on the market is 13 percent. What is the required rate of return on a stock that has a beta of 0.7? The market and Stock J have the following probability distributions:

EXPECTED RETURNS

Probability

rM

rJ

0.3 0.4 0.3

15% 9 18

20% 5 12

a. Calculate the expected rates of return for the market and Stock J. b. Calculate the standard deviations for the market and Stock J. c. Calculate the coefﬁcients of variation for the market and Stock J. 3–6 REQUIRED RATE OF RETURN

3–7 REQUIRED RATE OF RETURN

3–8 PORTFOLIO BETA

3–9 PORTFOLIO REQUIRED RETURN

Suppose rRF ⫽ 5%, rM ⫽ 10%, and rA ⫽ 12%. a. Calculate Stock A’s beta. b. If Stock A’s beta were 2.0, what would be A’s new required rate of return? Suppose rRF ⫽ 9%, rM ⫽ 14%, and bi ⫽ 1.3. a. What is ri, the required rate of return on Stock i? b. Now suppose rRF (1) increases to 10 percent or (2) decreases to 8 percent. The slope of the SML remains constant. How would this affect rM and ri? c. Now assume rRF remains at 9 percent but rM (1) increases to 16 percent or (2) falls to 13 percent. The slope of the SML does not remain constant. How would these changes affect ri? Suppose you hold a diversiﬁed portfolio consisting of a $7,500 investment in each of 20 different common stocks. The portfolio beta is equal to 1.12. Now, suppose you have decided to sell one of the stocks in your portfolio with a beta equal to 1.0 for $7,500 and to use these proceeds to buy another stock for your portfolio. Assume the new stock’s beta is equal to 1.75. Calculate your portfolio’s new beta. Suppose you are the money manager of a $4 million investment fund. The fund consists of 4 stocks with the following investments and betas: Stock

Investment

Beta

A B C D

$400,000 600,000 1,000,000 2,000,000

1.50 (0.50) 1.25 0.75

If the market required rate of return is 14 percent and the risk-free rate is 6 percent, what is the fund’s required rate of return? 3–10 PORTFOLIO BETA

You have a $2 million portfolio consisting of a $100,000 investment in each of 20 different stocks. The portfolio has a beta equal to 1.1. You are considering selling $100,000 worth of one stock which has a beta equal to 0.9 and using the proceeds to purchase another stock which has a beta equal to 1.4. What will be the new beta of your portfolio following this transaction?

141

Risk and Return Spreadsheet Problem 3–11 REQUIRED RATE OF RETURN

3–12

143

Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on an average stock is 13 percent, and the risk-free rate of return is 7 percent. By how much does the required return on the riskier stock exceed the required return on the less risky stock? Stocks A and B have the following historical returns:

REALIZED RATES OF RETURN

Year

Stock A’s Returns, rA

Stock B’s Returns, rB

1998 1999 2000 2001 2002

(18.00%) 33.00 15.00 (0.50) 27.00

(14.50%) 21.80 30.50 (7.60) 26.30

a. Calculate the average rate of return for each stock during the period 1998 through 2002. b. Assume that someone held a portfolio consisting of 50 percent of Stock A and 50 percent of Stock B. What would have been the realized rate of return on the portfolio in each year from 1998 through 2002? What would have been the average return on the portfolio during this period? c. Calculate the standard deviation of returns for each stock and for the portfolio. d. Calculate the coefﬁcient of variation for each stock and for the portfolio. e. If you are a risk-averse investor, would you prefer to hold Stock A, Stock B, or the portfolio? Why? 3–13

You have observed the following returns over time:

FINANCIAL CALCULATOR NEEDED; EXPECTED AND REQUIRED RATES OF RETURN

Year

Stock X

Stock Y

Market

1998 1999 2000 2001 2002

14% 19 ⫺16 3 20

13% 7 ⫺5 1 11

12% 10 ⫺12 1 15

Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent. a. What are the betas of Stocks X and Y? b. What are the required rates of return for Stocks X and Y? c. What is the required rate of return for a portfolio consisting of 80 percent of Stock X and 20 percent of Stock Y? d. If Stock X’s expected return is 22 percent, is Stock X under- or overvalued?

Spreadsheet Problem 3–14 BUILD A MODEL: EVALUATING RISK AND RETURN

Start with the partial model in the ﬁle Ch 03 P14 Build a Model.xls from the textbook’s web site. Bartman Industries’ and Reynolds Incorporated’s stock prices and dividends, along with the Market Index, are shown below for the period 1997-2002. The Market data are adjusted to include dividends. Bartman Industries

Reynolds Incorporated

Market Index

Year

Stock Price

Dividend

Stock Price

Dividend

Includes Divs.

2002 2001 2000 1999 1998 1997

$17.250 14.750 16.500 10.750 11.375 7.625

$1.15 1.06 1.00 0.95 0.90 0.85

$48.750 52.300 48.750 57.250 60.000 55.750

$3.00 2.90 2.75 2.50 2.25 2.00

11,663.98 8,785.70 8,679.98 6,434.03 5,602.28 4,705.97

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Risk and Return a. Use the data given to calculate annual returns for Bartman, Reynolds, and the Market Index, and then calculate average returns over the 5-year period. (Hint: Remember, returns are calculated by subtracting the beginning price from the ending price to get the capital gain or loss, adding the dividend to the capital gain or loss, and dividing the result by the beginning price. Assume that dividends are already included in the index. Also, you cannot calculate the rate of return for 1997 because you do not have 1996 data.) b. Calculate the standard deviations of the returns for Bartman, Reynolds, and the Market Index. (Hint: Use the sample standard deviation formula given in the chapter, which corresponds to the STDEV function in Excel.) c. Now calculate the coefﬁcients of variation for Bartman, Reynolds, and the Market Index. d. Construct a scatter diagram graph that shows Bartman’s and Reynolds’ returns on the vertical axis and the Market Index’s returns on the horizontal axis. e. Estimate Bartman’s and Reynolds’ betas by running regressions of their returns against the Index’s returns. Are these betas consistent with your graph? f. The risk-free rate on long-term Treasury bonds is 6.04 percent. Assume that the market risk premium is 5 percent. What is the expected return on the market? Now use the SML equation to calculate the two companies’ required returns. g. If you formed a portfolio that consisted of 50 percent of Bartman stock and 50 percent of Reynolds stock, what would be its beta and its required return? h. Suppose an investor wants to include Bartman Industries’ stock in his or her portfolio. Stocks A, B, and C are currently in the portfolio, and their betas are 0.769, 0.985, and 1.423, respectively. Calculate the new portfolio’s required return if it consists of 25 percent of Bartman, 15 percent of Stock A, 40 percent of Stock B, and 20 percent of Stock C.

See Ch 03 Show.ppt and Ch 03 Mini Case.xls.

Assume that you recently graduated with a major in ﬁnance, and you just landed a job as a ﬁnancial planner with Merrill Finch Inc., a large ﬁnancial services corporation. Your ﬁrst assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of 1 year, you have been instructed to plan for a 1-year holding period. Further, your boss has restricted you to the following investment alternatives, shown with their probabilities and associated outcomes. (Disregard for now the items at the bottom of the data; you will ﬁll in the blanks later.) Returns on Alternative Investments Estimated Rate of Return

State of the Economy

Recession Below average Average Above average Boom rˆ ␴ CV b

Probability

T-Bills

High Tech

0.1 0.2 0.4 0.2 0.1

8.0% 8.0 8.0 8.0 8.0

(22.0%) (2.0) 20.0 35.0 50.0

0.0

Collections

U.S. Rubber

Market Portfolio

28.0% 14.7 0.0 (10.0) (20.0) 1.7% 13.4 7.9 ⫺0.86

10.0%* (10.0) 7.0 45.0 30.0 13.8% 18.8 1.4 0.68

(13.0%) 1.0 15.0 29.0 43.0 15.0% 15.3 1.0

2-Stock Portfolio

3.0% 10.0 15.0

*Note that the estimated returns of U.S. Rubber do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer tires than they would if the economy was stronger. However, if the economy is in a ﬂat-out recession, a large number of consumers who were planning to purchase a new car may choose to wait and instead purchase new tires for the car they currently own. Under these circumstances, we would expect U.S. Rubber’s stock price to be higher if there is a recession than if the economy was just below average.

143

Risk and Return Mini Case

145

Merrill Finch’s economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program which was used to estimate the rate of return on each alternative under each state of the economy. High Tech Inc. is an electronics ﬁrm; Collections Inc. collects past-due debts; and U.S. Rubber manufactures tires and various other rubber and plastics products. Merrill Finch also maintains an “index fund” which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results. Given the situation as described, answer the following questions. a. What are investment returns? What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? b. (1) Why is the T-bill’s return independent of the state of the economy? Do T-bills promise a completely risk-free return? (2) Why are High Tech’s returns expected to move with the economy whereas Collections’ are expected to move counter to the economy? c. Calculate the expected rate of return on each alternative and ﬁll in the blanks on the row for ˆr in the table above. d. You should recognize that basing a decision solely on expected returns is only appropriate for risk-neutral individuals. Because your client, like virtually everyone, is risk averse, the riskiness of each alternative is an important aspect of the decision. One possible measure of risk is the standard deviation of returns. (1) Calculate this value for each alternative, and ﬁll in the blank on the row for ␴ in the table above. (2) What type of risk is measured by the standard deviation? (3) Draw a graph that shows roughly the shape of the probability distributions for High Tech, U.S. Rubber, and T-bills. e. Suppose you suddenly remembered that the coefﬁcient of variation (CV) is generally regarded as being a better measure of stand-alone risk than the standard deviation when the alternatives being considered have widely differing expected returns. Calculate the missing CVs, and ﬁll in the blanks on the row for CV in the table above. Does the CV produce the same risk rankings as the standard deviation? f. Suppose you created a 2-stock portfolio by investing $50,000 in High Tech and $50,000 in Collections. (1) Calculate the expected return ( ˆrp), the standard deviation (␴p), and the coefﬁcient of variation (CVp) for this portfolio and ﬁll in the appropriate blanks in the table above. (2) How does the risk of this 2-stock portfolio compare with the risk of the individual stocks if they were held in isolation? g. Suppose an investor starts with a portfolio consisting of one randomly selected stock. What would happen (1) to the risk and (2) to the expected return of the portfolio as more and more randomly selected stocks were added to the portfolio? What is the implication for investors? Draw a graph of the two portfolios to illustrate your answer. h. (1) Should portfolio effects impact the way investors think about the risk of individual stocks? (2) If you decided to hold a 1-stock portfolio, and consequently were exposed to more risk than diversiﬁed investors, could you expect to be compensated for all of your risk; that is, could you earn a risk premium on that part of your risk that you could have eliminated by diversifying? i. How is market risk measured for individual securities? How are beta coefﬁcients calculated? j. Suppose you have the following historical returns for the stock market and for another company, K. W. Enterprises. Explain how to calculate beta, and use the historical stock returns to calculate the beta for KWE. Interpret your results. Year

1 2 3 4 5 6 7 8 9 10

Market

KWE

25.7% 8.0 ⫺11.0 15.0 32.5 13.7 40.0 10.0 ⫺10.8 ⫺13.1

40.0 ⫺15.0 ⫺15.0 35.0 10.0 30.0 42.0 ⫺10.0 ⫺25.0 25.0

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k. The expected rates of return and the beta coefﬁcients of the alternatives as supplied by Merrill Finch’s computer program are as follows: Security

High Tech Market U.S. Rubber T-bills Collections

Return ( rˆ )

Risk (Beta)

17.4% 15.0 13.8 8.0 1.7

1.29 1.00 0.68 0.00 (0.86)

(1) Do the expected returns appear to be related to each alternative’s market risk? (2) Is it possible to choose among the alternatives on the basis of the information developed thus far? l. (1) Write out the Security Market Line (SML) equation, use it to calculate the required rate of return on each alternative, and then graph the relationship between the expected and required rates of return. (2) How do the expected rates of return compare with the required rates of return? (3) Does the fact that Collections has an expected return that is less than the T-bill rate make any sense? (4) What would be the market risk and the required return of a 50-50 portfolio of High Tech and Collections? Of High Tech and U.S. Rubber? m. (1) Suppose investors raised their inﬂation expectations by 3 percentage points over current estimates as reﬂected in the 8 percent T-bill rate. What effect would higher inﬂation have on the SML and on the returns required on high- and low-risk securities? (2) Suppose instead that investors’ risk aversion increased enough to cause the market risk premium to increase by 3 percentage points. (Inﬂation remains constant.) What effect would this have on the SML and on returns of high- and low-risk securities?

Selected Additional References and Cases Probably the best sources of additional information on probability distributions and single-asset risk measures are statistics textbooks. For example, see Kohler, Heinz, Statistics for Business and Economics (New York: HarperCollins, 1994). Mendenhall, William, Richard L. Schaeffer, and Dennis D. Wackerly, Mathematical Statistics with Applications (Boston: PWS, 1996). Probably the best place to ﬁnd an extension of portfolio theory concepts is one of the investments textbooks. These are some good ones:

Francis, Jack C., Investments: Analysis and Management (New York: McGraw-Hill, 1991). Radcliffe, Robert C., Investment: Concepts, Analysis, and Strategy (New York: HarperCollins, 1994). Reilly, Frank K., and Keith C. Brown, Investment Analysis and Portfolio Management (Fort Worth, TX: The Dryden Press, 1997). The following case from the Cases in Financial Management: series covers many of the concepts discussed in this chapter: Case 2, “Peachtree Securities, Inc. (A).”

Bonds and Their Valuation

44

During the summer of 1999 the future course of interest rates was highly uncertain. Continued strength in the economy and growing fears of inﬂation had led to interest rate increases, and many analysts were concerned that this trend would continue. However, others were forecasting declining rates—they saw no threat from inﬂation, and they were more concerned about the economy running out of gas. Because of this uncertainty, bond investors tended to wait on the sidelines for some deﬁnitive economic news. At the same time, companies were postponing bond issues out of fear that nervous investors would be unwilling to purchase them. One example of all this was Ford Motor, which in June 1999 decided to put a large bond issue on hold. However, after just three weeks, Ford sensed a shift in the investment climate, and it announced plans to sell $8.6 billion of new bonds. As shown in the following table, the Ford issue set a record, surpassing an $8 billion AT&T issue that had taken place a few months earlier. Ford’s $8.6 billion issue actually consisted of four separate bonds. Ford Credit, a subsidiary that provides customer ﬁnancing, borrowed $1.0 billion dollars at a 2-year ﬂoating rate and another $1.8 billion at a 3-year ﬂoating rate. Ford Motor itself borrowed $4 billion as 5-year ﬁxed-rate debt and another $1.8 billion at a 32-year ﬁxed rate. Most analysts agreed that these bonds had limited default risk. Ford held $24 billion in cash, and it had earned a record $2.5 billion during the second quarter of 1999. However, the auto industry faces some inherent risks. When all the risk factors were balanced, the issues all received a single-A rating. Much to the relief of the jittery bond market, the Ford issue was well received. Dave Cosper, Ford Credit’s Treasurer, said “There was a lot of excitement, and demand exceeded our expectations.” The response to the Ford offering revealed that investors had a strong appetite for large bond issues with strong credit ratings. Larger issues are more liquid than smaller ones, and liquidity is particularly important to bond investors when the direction of the overall market is highly uncertain. Anticipating even more demand, Ford is planning to regularly issue large blocks of debt in the global market. Seeing Ford’s success, less than one month later WalMart entered the list of top ten U.S. corporate bond ﬁnancings with a new $5 billion issue. Other large companies have subsequently followed suit. Source: From Gregory Zuckerman, “Ford’s Record Issue May Drive Imitators,” The Wall Street Journal, July 12, 1999, C1. Copyright © 1999 Dow Jones & Co., Inc. Reprinted by permission of Dow Jones & Co., Inc. via Copyright Clearance Center.

149

145

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Bonds and Their Valuation Top Ten U.S. Corporate Bond Financings as of July 1999

Issuer

Date

Ford AT&T RJR Holdings WorldCom Sprint Assoc. Corp. of N. America Norfolk Southern US West Conoco Charter Communications

July 9, 1999 March 23, 1999 May 12, 1989 August 6, 1998 November 10, 1998 October 27, 1998 May 14, 1997 January 16, 1997 April 15, 1999 March 12, 1999

Amount (Billions of Dollars)

$8.60 8.00 6.11 6.10 5.00 4.80 4.30 4.10 4.00 3.58

Source: From Thomson Financial Securities Data, Credit Suisse First Boston as reported in The Wall Street Journal, July 12, 1999, C1. Copyright © 1999 Dow Jones & Co., Inc. Reprinted by permission of Dow Jones & Co., Inc. via Copyright Clearance Center.

If you skim through The Wall Street Journal, you will see references to a wide variety of bonds. This variety may seem confusing, but in actuality just a few characteristics distinguish the various types of bonds. While bonds are often viewed as relatively safe investments, one can certainly lose money on them. Indeed, “riskless” long-term U.S. Treasury bonds declined by more than 20 percent during 1994, and “safe” Mexican government bonds declined by 25 percent on one day, December 27, 1994. More recently, investors in Russian bonds suffered massive losses when Russia defaulted. In each of these cases, investors who had regarded bonds as being riskless, or at least fairly safe, learned a sad lesson. Note, The textbook’s web site though, that it is possible to rack up impressive gains in the bond market. Highcontains an Excel ﬁle that will guide you through the quality corporate bonds in 1995 provided a total return of nearly 21 percent, and in chapter’s calculations. The 1997, U.S. Treasury bonds returned 14.3 percent. ﬁle for this chapter is Ch 04 In this chapter, we will discuss the types of bonds companies and government Tool Kit.xls, and we encouragencies issue, the terms that are contained in bond contracts, the types of risks to age you to open the ﬁle and which both bond investors and issuers are exposed, and procedures for determining follow along as you read the chapter. the values of and rates of return on bonds.

Who Issues Bonds? A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on speciﬁc dates, to the holders of the bond. For example, on January 3, 2003, MicroDrive Inc. borrowed $50 million by issuing $50 million of bonds. For convenience, we assume that MicroDrive sold 50,000 individual bonds for $1,000 each. Actually, it could have sold one $50 million bond, 10 bonds with a $5 million face value, or any other combination that totals to $50 million. In any event, MicroDrive received the $50 million, and in exchange it promised to make annual interest payments and to repay the $50 million on a speciﬁed maturity date. Investors have many choices when investing in bonds, but bonds are classiﬁed into four main types: Treasury, corporate, municipal, and foreign. Each type differs with respect to expected return and degree of risk.

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Treasury bonds, sometimes referred to as government bonds, are issued by the U.S. federal government.1 It is reasonable to assume that the federal government will make good on its promised payments, so these bonds have no default risk. However, Treasury bond prices decline when interest rates rise, so they are not free of all risks. Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury bonds, corporate bonds are exposed to default risk—if the issuing company gets into trouble, it may be unable to make the promised interest and principal payments. Different corporate bonds have different levels of default risk, depending on the issuing company’s characteristics and the terms of the speciﬁc bond. Default risk often is referred to as “credit risk,” and, as we saw in Chapter 1, the larger the default or credit risk, the higher the interest rate the issuer must pay. Municipal bonds, or “munis,” are issued by state and local governments. Like corporate bonds, munis have default risk. However, munis offer one major advantage over all other bonds: As we will explain in Chapter 9, the interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if the holder is a resident of the issuing state. Consequently, municipal bonds carry interest rates that are considerably lower than those on corporate bonds with the same default risk. Foreign bonds are issued by foreign governments or foreign corporations. Foreign corporate bonds are, of course, exposed to default risk, and so are some foreign government bonds. An additional risk exists if the bonds are denominated in a currency other than that of the investor’s home currency. For example, if a U.S. investor purchases a corporate bond denominated in Japanese yen and the yen subsequently falls relative to the dollar, then the investor will lose money, even if the company does not default on its bonds. What is a bond? What are the four main types of bonds? Why are U.S. Treasury bonds not riskless? To what types of risk are investors of foreign bonds exposed?

Key Characteristics of Bonds Although all bonds have some common characteristics, they do not always have the same contractual features. For example, most corporate bonds have provisions for early repayment (call features), but these provisions can be quite different for different bonds. Differences in contractual provisions, and in the underlying strength of the companies backing the bonds, lead to major differences in bonds’ risks, prices, and expected returns. To understand bonds, it is important that you understand the following terms.

Par Value The par value is the stated face value of the bond; for illustrative purposes we generally assume a par value of $1,000, although any multiple of $1,000 (for example, $5,000) can be used. The par value generally represents the amount of money the ﬁrm borrows and promises to repay on the maturity date. 1

The U.S. Treasury actually issues three types of securities: “bills,” “notes,” and “bonds.” A bond makes an equal payment every six months until it matures, at which time it makes an additional lump sum payment. If the maturity at the time of issue is less than 10 years, it is called a note rather than a bond. A T-bill has a maturity of 52 weeks or less at the time of issue, and it makes no payments at all until it matures. Thus, bills are sold initially at a discount to their face, or maturity, value.

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Coupon Interest Rate MicroDrive’s bonds require the company to pay a ﬁxed number of dollars of interest each year (or, more typically, each six months). When this coupon payment, as it is An excellent site for inforcalled, is divided by the par value, the result is the coupon interest rate. For example, mation on many types of bonds is Bonds Online, MicroDrive’s bonds have a $1,000 par value, and they pay $100 in interest each year. which can be found at The bond’s coupon interest is $100, so its coupon interest rate is $100/$1,000 10 http://www.bondsonline. percent. The $100 is the yearly “rent” on the $1,000 loan. This payment, which is com. The site has a great ﬁxed at the time the bond is issued, remains in force during the life of the bond.2 Typdeal of information about corporates, municipals, trea- ically, at the time a bond is issued its coupon payment is set at a level that will enable suries, and bond funds. It in- the bond to be issued at or near its par value. cludes free bond searches, In some cases, a bond’s coupon payment will vary over time. For these ﬂoating through which the user rate bonds, the coupon rate is set for, say, the initial six-month period, after which it speciﬁes the attributes deis adjusted every six months based on some market rate. Some corporate issues are tied sired in a bond and then the to the Treasury bond rate, while other issues are tied to other rates, such as LIBOR. search returns the publicly traded bonds meeting the Many additional provisions can be included in ﬂoating rate issues. For example, some criteria. The site also inare convertible to ﬁxed rate debt, whereas others have upper and lower limits (“caps” cludes a downloadable and “ﬂoors”) on how high or low the rate can go. bond calculator and an exFloating rate debt is popular with investors who are worried about the risk of rising cellent glossary of bond terinterest rates, since the interest paid on such bonds increases whenever market rates minology. rise. This causes the market value of the debt to be stabilized, and it also provides institutional buyers such as banks with income that is better geared to their own obligations. Banks’ deposit costs rise with interest rates, so the income on ﬂoating rate loans that they have made rises at the same time their deposit costs are rising. The savings and loan industry was virtually destroyed as a result of their practice of making ﬁxed rate mortgage loans but borrowing on ﬂoating rate terms. If you are earning 6 percent but paying 10 percent—which they were—you soon go bankrupt—which they did. Moreover, ﬂoating rate debt appeals to corporations that want to issue long-term debt without committing themselves to paying a historically high interest rate for the entire life of the loan. Some bonds pay no coupons at all, but are offered at a substantial discount below their par values and hence provide capital appreciation rather than interest income. These securities are called zero coupon bonds (“zeros”). Other bonds pay some coupon interest, but not enough to be issued at par. In general, any bond originally offered at a price signiﬁcantly below its par value is called an original issue discount (OID) bond. Corporations ﬁrst used zeros in a major way in 1981. In recent years IBM, Alcoa, JCPenney, ITT, Cities Service, GMAC, Lockheed Martin, and even the U.S. Treasury have used zeros to raise billions of dollars.

Maturity Date Bonds generally have a speciﬁed maturity date on which the par value must be repaid. MicroDrive’s bonds, which were issued on January 3, 2003, will mature on January 3, 2018; thus, they had a 15-year maturity at the time they were issued. Most bonds have original maturities (the maturity at the time the bond is issued) ranging from 10 to

2

At one time, bonds literally had a number of small (1/2- by 2-inch), dated coupons attached to them, and on each interest payment date the owner would clip off the coupon for that date and either cash it at his or her bank or mail it to the company’s paying agent, who would then mail back a check for the interest. A 30year, semiannual bond would start with 60 coupons, whereas a 5-year annual payment bond would start with only 5 coupons. Today, new bonds must be registered—no physical coupons are involved, and interest checks are mailed automatically to the registered owners of the bonds. Even so, people continue to use the terms coupon and coupon interest rate when discussing bonds.

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40 years, but any maturity is legally permissible.3 Of course, the effective maturity of a bond declines each year after it has been issued. Thus, MicroDrive’s bonds had a 15year original maturity, but in 2004, a year later, they will have a 14-year maturity, and so on.

Provisions to Call or Redeem Bonds Most corporate bonds contain a call provision, which gives the issuing corporation the right to call the bonds for redemption.4 The call provision generally states that the company must pay the bondholders an amount greater than the par value if they are called. The additional sum, which is termed a call premium, is often set equal to one year’s interest if the bonds are called during the ﬁrst year, and the premium declines at a constant rate of INT/N each year thereafter, where INT annual interest and N original maturity in years. For example, the call premium on a $1,000 par value, 10year, 10 percent bond would generally be $100 if it were called during the ﬁrst year, $90 during the second year (calculated by reducing the $100, or 10 percent, premium by one-tenth), and so on. However, bonds are often not callable until several years (generally 5 to 10) after they were issued. This is known as a deferred call, and the bonds are said to have call protection. Suppose a company sold bonds when interest rates were relatively high. Provided the issue is callable, the company could sell a new issue of low-yielding securities if and when interest rates drop. It could then use the proceeds of the new issue to retire the high-rate issue and thus reduce its interest expense. This process is called a refunding operation. A call provision is valuable to the ﬁrm but potentially detrimental to investors. If interest rates go up, the company will not call the bond, and the investor will be stuck with the original coupon rate on the bond, even though interest rates in the economy have risen sharply. However, if interest rates fall, the company will call the bond and pay off investors, who then must reinvest the proceeds at the current market interest rate, which is lower than the rate they were getting on the original bond. In other words, the investor loses when interest rates go up, but doesn’t reap the gains when rates fall. To induce an investor to take this type of risk, a new issue of callable bonds must provide a higher interest rate than an otherwise similar issue of noncallable bonds. For example, on August 30, 1997, Paciﬁc Timber Company issued bonds yielding 9.5 percent; these bonds were callable immediately. On the same day, Northwest Milling Company sold an issue with similar risk and maturity that yielded 9.2 percent, but these bonds were noncallable for ten years. Investors were willing to accept a 0.3 percent lower interest rate on Northwest’s bonds for the assurance that the 9.2 percent interest rate would be earned for at least ten years. Paciﬁc, on the other hand, had to incur a 0.3 percent higher annual interest rate to obtain the option of calling the bonds in the event of a subsequent decline in rates. Bonds that are redeemable at par at the holder’s option protect investors against a rise in interest rates. If rates rise, the price of a ﬁxed-rate bond declines. However, if holders have the option of turning their bonds in and having them redeemed at par, they are protected against rising rates. Examples of such debt include Transamerica’s $50 million issue of 25-year, 81⁄2 percent bonds. The bonds are not callable by the company, but holders can turn them in for redemption at par ﬁve years after the date 3

In July 1993, Walt Disney Co., attempting to lock in a low interest rate, issued the ﬁrst 100-year bonds to be sold by any borrower in modern times. Soon after, Coca-Cola became the second company to stretch the meaning of “long-term bond” by selling $150 million of 100-year bonds. 4 A majority of municipal bonds also contain call provisions. Although the U.S. Treasury no longer issues callable bonds, some past Treasury issues were callable.

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of issue. If interest rates have risen, holders will turn in the bonds and reinvest the proceeds at a higher rate. This feature enabled Transamerica to sell the bonds with an 81⁄2 percent coupon at a time when other similarly rated bonds had yields of 9 percent. In late 1988, the corporate bond markets were sent into turmoil by the leveraged buyout of RJR Nabisco. RJR’s bonds dropped in value by 20 percent within days of the LBO announcement, and the prices of many other corporate bonds also plunged, because investors feared that a boom in LBOs would load up many companies with excessive debt, leading to lower bond ratings and declining bond prices. All this led to a resurgence of concern about event risk, which is the risk that some sudden event, such as an LBO, will occur and increase the credit risk of the company, hence lowering the ﬁrm’s bond rating and the value of its outstanding bonds. Investors’ concern over event risk meant that those ﬁrms deemed most likely to face events that could harm bondholders had to pay dearly to raise new debt capital, if they could raise it at all. In an attempt to control debt costs, a new type of protective covenant was devised to minimize event risk. This covenant, called a super poison put, enables a bondholder to turn in, or “put” a bond back to the issuer at par in the event of a takeover, merger, or major recapitalization. Poison puts had actually been around since 1986, when the leveraged buyout trend took off. However, the earlier puts proved to be almost worthless because they allowed investors to “put” their bonds back to the issuer at par value only in the event of an unfriendly takeover. But because almost all takeovers are eventually approved by the target ﬁrm’s board, mergers that started as hostile generally ended as friendly. Also, the earlier poison puts failed to protect investors from voluntary recapitalizations, in which a company sells a big issue of bonds to pay a big, one-time dividend to stockholders or to buy back its own stock. The “super” poison puts that were used following the RJR buyout announcement protected against both of these actions. This is a good illustration of how quickly the ﬁnancial community reacts to changes in the marketplace.

Sinking Funds Some bonds also include a sinking fund provision that facilitates the orderly retirement of the bond issue. On rare occasions the ﬁrm may be required to deposit money with a trustee, which invests the funds and then uses the accumulated sum to retire the bonds when they mature. Usually, though, the sinking fund is used to buy back a certain percentage of the issue each year. A failure to meet the sinking fund requirement causes the bond to be thrown into default, which may force the company into bankruptcy. Obviously, a sinking fund can constitute a signiﬁcant cash drain on the ﬁrm. In most cases, the ﬁrm is given the right to handle the sinking fund in either of two ways: 1. The company can call in for redemption (at par value) a certain percentage of the bonds each year; for example, it might be able to call 5 percent of the total original amount of the issue at a price of $1,000 per bond. The bonds are numbered serially, and those called for redemption are determined by a lottery administered by the trustee. 2. The company may buy the required number of bonds on the open market. The ﬁrm will choose the least-cost method. If interest rates have risen, causing bond prices to fall, it will buy bonds in the open market at a discount; if interest rates have fallen, it will call the bonds. Note that a call for sinking fund purposes is quite different from a refunding call as discussed above. A sinking fund call typically requires no call premium, but only a small percentage of the issue is normally callable in any one year.5 5

Some sinking funds require the issuer to pay a call premium.

151

Bonds and Their Valuation Bond Valuation

155

Although sinking funds are designed to protect bondholders by ensuring that an issue is retired in an orderly fashion, you should recognize that sinking funds can work to the detriment of bondholders. For example, suppose the bond carries a 10 percent interest rate, but yields on similar bonds have fallen to 7.5 percent. A sinking fund call at par would require an investor to give up a bond that pays $100 of interest and then to reinvest in a bond that pays only $75 per year. This obviously harms those bondholders whose bonds are called. On balance, however, bonds that have a sinking fund are regarded as being safer than those without such a provision, so at the time they are issued sinking fund bonds have lower coupon rates than otherwise similar bonds without sinking funds.

Other Features Several other types of bonds are used sufﬁciently often to warrant mention. First, convertible bonds are bonds that are convertible into shares of common stock, at a ﬁxed price, at the option of the bondholder. Convertibles have a lower coupon rate than nonconvertible debt, but they offer investors a chance for capital gains in exchange for the lower coupon rate. Bonds issued with warrants are similar to convertibles. Warrants are options that permit the holder to buy stock for a stated price, thereby providing a capital gain if the price of the stock rises. Bonds that are issued with warrants, like convertibles, carry lower coupon rates than straight bonds. Another type of bond is an income bond, which pays interest only if the interest is earned. These securities cannot bankrupt a company, but from an investor’s standpoint they are riskier than “regular” bonds. Yet another bond is the indexed, or purchasing power, bond, which ﬁrst became popular in Brazil, Israel, and a few other countries plagued by high inﬂation rates. The interest rate paid on these bonds is based on an inﬂation index such as the consumer price index, so the interest paid rises automatically when the inﬂation rate rises, thus protecting the bondholders against inﬂation. In January 1997, the U.S. Treasury began issuing indexed bonds, and they currently pay a rate that is roughly 1 to 4 percent plus the rate of inﬂation during the past year. Deﬁne ﬂoating rate bonds and zero coupon bonds. What problem was solved by the introduction of long-term ﬂoating rate debt, and how is the rate on such bonds determined? Why is a call provision advantageous to a bond issuer? When will the issuer initiate a refunding call? Why? What are the two ways a sinking fund can be handled? Which method will be chosen by the ﬁrm if interest rates have risen? If interest rates have fallen? Are securities that provide for a sinking fund regarded as being riskier than those without this type of provision? Explain. What is the difference between a call for sinking fund purposes and a refunding call? Deﬁne convertible bonds, bonds with warrants, income bonds, and indexed bonds. Why do bonds with warrants and convertible bonds have lower coupons than similarly rated bonds that do not have these features?

Bond Valuation The value of any ﬁnancial asset—a stock, a bond, a lease, or even a physical asset such as an apartment building or a piece of machinery—is simply the present value of the cash ﬂows the asset is expected to produce.

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The cash ﬂows from a speciﬁc bond depend on its contractual features as described above. For a standard coupon-bearing bond such as the one issued by MicroDrive, the cash ﬂows consist of interest payments during the 15-year life of the bond, plus the amount borrowed (generally the $1,000 par value) when the bond matures. In the case of a ﬂoating rate bond, the interest payments vary over time. In the case of a zero coupon bond, there are no interest payments, only the face amount when the bond matures. For a “regular” bond with a ﬁxed coupon rate, here is the situation: 0

rd%

Bond’s Value

1

2

3

INT

INT

INT

...

N INT M

Here rd the bond’s market rate of interest 10%. This is the discount rate that is used to calculate the present value of the bond’s cash ﬂows. Note that rd is not the coupon interest rate, and it is equal to the coupon rate only if (as in this case) the bond is selling at par. Generally, most coupon bonds are issued at par, which implies that the coupon rate is set at rd. Thereafter, interest rates as measured by rd will ﬂuctuate, but the coupon rate is ﬁxed, so rd will equal the coupon rate only by chance. We used the term “i” or “I” to designate the interest rate in Chapter 2 because those terms are used on ﬁnancial calculators, but “r,” with the subscript “d” to designate the rate on a debt security, is normally used in ﬁnance.6 N the number of years before the bond matures 15. Note that N declines each year after the bond was issued, so a bond that had a maturity of 15 years when it was issued (original maturity 15) will have N 14 after one year, N 13 after two years, and so on. Note also that at this point we assume that the bond pays interest once a year, or annually, so N is measured in years. Later on, we will deal with semiannual payment bonds, which pay interest each six months. INT dollars of interest paid each year Coupon rate Par value 0.10($1,000) $100. In calculator terminology, INT PMT 100. If the bond had been a semiannual payment bond, the payment would have been $50 each six months. The payment would be zero if MicroDrive had issued zero coupon bonds, and it would vary if the bond was a “ﬂoater.” M the par, or maturity, value of the bond $1,000. This amount must be paid off at maturity. We can now redraw the time line to show the numerical values for all variables except the bond’s value: 0

10%

Bond’s Value

1

2

3

100

100

100

...

15 100 1,000 1,100

The following general equation, written in several forms, can be solved to ﬁnd the value of any bond: 6

The appropriate interest rate on debt securities was discussed in Chapter 1. The bond’s risk, liquidity, and years to maturity, as well as supply and demand conditions in the capital markets, all inﬂuence the interest rate on bonds.

153

Bonds and Their Valuation Bond Valuation

157

INT INT INT M . . . 1 2 N (1 rd) (1 rd) (1 rd) (1 rd)N N INT M a t (1 rd)N t1 (1 rd) (4-1) 1 1 (1 rd)N ¢ ° M INT rd (1 rd)N INT(PVIFArd,N) M(PVIFrd,N).

Bond’s value VB

Inserting values for our particular bond, we have 15 $1,000 $100 VB a t (1.10) (1.10)15 t1 1 1 15 (1.1) ¢ $1,000 ° $100 0.1 (1.1)15 $100(PVIFA10%,15) $1,000(PVIF10%,15).

Note that the cash ﬂows consist of an annuity of N years plus a lump sum payment at the end of Year N, and this fact is reﬂected in Equation 4-1. Further, Equation 4-1 can be solved by the three procedures discussed in Chapter 2: (1) numerically, (2) with a ﬁnancial calculator, and (3) with a spreadsheet. NUMERICAL SOLUTION:

Simply discount each cash ﬂow back to the present and sum these PVs to ﬁnd the bond’s value; see Figure 4-1 for an example. This procedure is not very efﬁcient, especially if the bond has many years to maturity. Alternatively, you could use the formula FIGURE 4-1

Time Line for MicroDrive Inc.’s Bonds, 10% Interest Rate 4 100

5 100

6 100

7 8 100 100

9 100

10 100

11 100

12 100

13 100

14 100

15 100 1,000



↑ ↑                                                  

↑                                            

↑                                        

↑                                     

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1 2 3 Payments 100 100 100 90.91 82.64 75.13 68.30 62.09 56.45 51.32 46.65 42.41 38.55 35.05 31.86 28.97 26.33 23.94 239.39 Present 1,000.00 where rd 10%. Value



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in the third row of Equation 4-1 with a simple or scientiﬁc calculator, although this would still be somewhat cumbersome. FINANCIAL CALCULATOR SOLUTION

In Chapter 2, we worked problems where only four of the ﬁve time value of money (TVM) keys were used. However, all ﬁve keys are used with bonds. Here is the setup: Inputs:

15

10

100

1000

1,000

Output:

Simply input N 15, I rd 10, INT PMT 100, M FV 1000, and then press the PV key to ﬁnd the value of the bond, $1,000. Since the PV is an outﬂow to the investor, it is shown with a negative sign. The calculator is programmed to solve Equation 4-1: It ﬁnds the PV of an annuity of $100 per year for 15 years, discounted at 10 percent, then it ﬁnds the PV of the $1,000 maturity payment, and then it adds these two PVs to ﬁnd the value of the bond. Notice that even though the time line in Figure 4-1 shows a total of $1,100 at Year 15, you should not enter FV 1100! When you entered N 15 and PMT 100, you told the calculator that there is a $100 payment at Year 15. Thus, the FV 1000 accounts for any extra payment at Year 15, above and beyond the $100 payment. SPREADSHEET SOLUTION

Here we want to ﬁnd the PV of the cash ﬂows, so we would use the PV function. Put the cursor on Cell B10, click the function wizard then Financial, PV, and OK. Then ﬁll in the dialog box with Rate 0.1 or F3, Nper 15 or Q5, Pmt 100 or C6, FV 1000 or Q7, and Type 0 or leave it blank. Then, when you click OK, you will get the value of the bond, $1,000. Like the ﬁnancial calculator solution, this is negative because the PMT and FV are positive. An alternative, and in this case somewhat easier procedure given that the time line has been created, is to use the NPV function. Click the function wizard, then FinanA

B

C

D

E

F

G

H

I

J

K

L

M

N

O

P

Q

1 Spreadsheet for bond value calculation 2 3 Coupon rate

Going rate, or yield 10%

10%

4 5 Time

0

6 Interest Pmt

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

100

100

100

100

100

100

100

100

100

100

100

100

100

100

100 1000

7 Maturity Pmt 8 Total CF

100

9 10 PV of CF

1000

100

100

100

100

100

100

100

100

100

100

100

100

100 1100

155

Bonds and Their Valuation Bond Valuation

159

cial, NPV, and OK. Then input Rate 0.1 or F3 and Value 1 C8:Q8. Then click OK to get the answer, $1,000. Note that by changing the interest rate in F3, we can instantly ﬁnd the value of the bond at any other discount rate. Note also that Excel and other spreadsheet software packages provide specialized functions for bond prices. For example, in Excel you could use the function wizard to enter this formula: PRICE(Date(2003,1,3),Date(2018,1,3),10%,10%,100,1,0). The ﬁrst two arguments in the function give the current and maturity dates. The next argument is the bond’s coupon rate, followed by the current market interest rate, or yield. The ﬁfth argument, 100, is the redemption value of the bond at maturity, expressed as a percent of the face value. The sixth argument is the number of payments per year, and the last argument, 0, tells the program to use the U.S. convention for counting days, which is to assume 30 days per month and 360 days per year. This function produces the value 100, which is the current price expressed as a percent of the bond’s par value, which is $1,000. Therefore, you can multiply $1,000 by 100 percent to get the current price, which is $1,000. This function is essential if a bond is being evaluated between coupon payment dates.

Changes in Bond Values over Time At the time a coupon bond is issued, the coupon is generally set at a level that will cause the market price of the bond to equal its par value. If a lower coupon were set, investors would not be willing to pay $1,000 for the bond, while if a higher coupon were set, investors would clamor for the bond and bid its price up over $1,000. Investment bankers can judge quite precisely the coupon rate that will cause a bond to sell at its $1,000 par value. A bond that has just been issued is known as a new issue. (Investment bankers classify a bond as a new issue for about one month after it has ﬁrst been issued. New issues are usually actively traded, and are called “on-the-run” bonds.) Once the bond has been on the market for a while, it is classiﬁed as an outstanding bond, also called a seasoned issue. Newly issued bonds generally sell very close to par, but the prices of seasoned bonds vary widely from par. Except for ﬂoating rate bonds, coupon payments are constant, so when economic conditions change, a bond with a $100 coupon that sold at par when it was issued will sell for more or less than $1,000 thereafter. MicroDrive’s bonds with a 10 percent coupon rate were originally issued at par. If rd remained constant at 10 percent, what would the value of the bond be one year after it was issued? Now the term to maturity is only 14 years—that is, N 14. With a ﬁnancial calculator, just override N 15 with N 14, press the PV key, and you ﬁnd a value of $1,000. If we continued, setting N 13, N 12, and so forth, we would see that the value of the bond will remain at $1,000 as long as the going interest rate remains constant at the coupon rate, 10 percent.7 7

The bond prices quoted by brokers are calculated as described. However, if you bought a bond between interest payment dates, you would have to pay the basic price plus accrued interest. Thus, if you purchased a MicroDrive bond six months after it was issued, your broker would send you an invoice stating that you must pay $1,000 as the basic price of the bond plus $50 interest, representing one-half the annual interest of $100. The seller of the bond would receive $1,050. If you bought the bond the day before its interest payment date, you would pay $1,000 (364/365)($100) $1,099.73. Of course, you would receive an interest payment of $100 at the end of the next day. See Self-Test Problem 1 for a detailed discussion of bond quotations between interest payment dates. Throughout the chapter, we assume that bonds are being evaluated immediately after an interest payment date. The more expensive ﬁnancial calculators such as the HP-17B have a built-in calendar that permits the calculation of exact values between interest payment dates, as do spreadsheet programs.

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Now suppose interest rates in the economy fell after the MicroDrive bonds were issued, and, as a result, rd fell below the coupon rate, decreasing from 10 to 5 percent. Both the coupon interest payments and the maturity value remain constant, but now 5 percent values for PVIF and PVIFA would have to be used in Equation 4-1. The value of the bond at the end of the ﬁrst year would be $1,494.93: VB $100(PVIFA5%,14) $1,000(PVIF5%,14) $100(9.89864) $1,000(0.50507) $989.86 $505.07 $1,494.93. With a ﬁnancial calculator, just change rd I from 10 to 5, and then press the PV key to get the answer, $1,494.93. Thus, if rd fell below the coupon rate, the bond would sell above par, or at a premium. The arithmetic of the bond value increase should be clear, but what is the logic behind it? The fact that rd has fallen to 5 percent means that if you had $1,000 to invest, you could buy new bonds like MicroDrive’s (every day some 10 to 12 companies sell new bonds), except that these new bonds would pay $50 of interest each year rather than $100. Naturally, you would prefer $100 to $50, so you would be willing to pay more than $1,000 for a MicroDrive bond to obtain its higher coupons. All investors would react similarly, and as a result, the MicroDrive bonds would be bid up in price to $1,494.93, at which point they would provide the same rate of return to a potential investor as the new bonds, 5 percent. Assuming that interest rates remain constant at 5 percent for the next 14 years, what would happen to the value of a MicroDrive bond? It would fall gradually from $1,494.93 at present to $1,000 at maturity, when MicroDrive will redeem each bond for $1,000. This point can be illustrated by calculating the value of the bond 1 year later, when it has 13 years remaining to maturity. With a ﬁnancial calculator, merely input the values for N, I, PMT, and FV, now using N 13, and press the PV key to ﬁnd the value of the bond, $1,469.68. Thus, the value of the bond will have fallen from $1,494.93 to $1,469.68, or by $25.25. If you were to calculate the value of the bond at other future dates, the price would continue to fall as the maturity date approached. Note that if you purchased the bond at a price of $1,494.93 and then sold it one year later with rd still at 5 percent, you would have a capital loss of $25.25, or a total return of $100.00 $25.25 $74.75. Your percentage rate of return would consist of an interest yield (also called a current yield) plus a capital gains yield, calculated as follows: Interest, or current, yield $100/$1,494.93 0.0669 6.69% Capital gains yield $25.25/$1,494.93 0.0169 1.69% Total rate of return, or yield $74.75/$1,494.93 0.0500 5.00% Had interest rates risen from 10 to 15 percent during the ﬁrst year after issue rather than fallen from 10 to 5 percent, then you would enter N 14, I 15, PMT 100, and FV 1000, and then press the PV key to ﬁnd the value of the bond, $713.78. In this case, the bond would sell at a discount of $286.22 below its par value: Discount Price Par value $713.78 $1,000.00 $286.22. The total expected future return on the bond would again consist of a current yield and a capital gains yield, but now the capital gains yield would be positive. The total

157

Bonds and Their Valuation Bond Valuation

161

return would be 15 percent. To see this, calculate the price of the bond with 13 years left to maturity, assuming that interest rates remain at 15 percent. With a calculator, enter N 13, I 15, PMT 100, and FV 1000, and then press PV to obtain the bond’s value, $720.84. Note that the capital gain for the year is the difference between the bond’s value at Year 2 (with 13 years remaining) and the bond’s value at Year 1 (with 14 years remaining), or $720.84 $713.78 $7.06. The interest yield, capital gains yield, and total yield are calculated as follows: Interest, or current, yield $100/$713.78 0.1401 14.01% Capital gains yield $7.06/$713.78 0.0099 0.99% Total rate of return, or yield $107.06/$713.78 0.1500 15.00% Figure 4-2 graphs the value of the bond over time, assuming that interest rates in the economy (1) remain constant at 10 percent, (2) fall to 5 percent and then remain constant at that level, or (3) rise to 15 percent and remain constant at that level. Of course, if interest rates do not remain constant, then the price of the bond will ﬂuctuate. However, regardless of what future interest rates do, the bond’s price will approach $1,000 as it nears the maturity date (barring bankruptcy, in which case the bond’s value might fall dramatically). FIGURE 4-2

Time Path of the Value of a 10% Coupon, $1,000 Par Value Bond When Interest Rates Are 5%, 10%, and 15%

Bond Value ($)

Time Path of 10% Coupon Bond's Value When rd Falls to 5% and Remains There (Premium Bond)

1,495

See Ch 04 Tool Kit.xls for details. M = 1,000

Time Path of Bond Value When rd = Coupon Rate = 10% (Par Bond)

M

714 Time Path of 10% Coupon Bond's Value When rd Rises to 15% and Remains There (Discount Bond)

0

1

2

3

4

5

6

7

8

9

10

11

12

13

Year

rd 5%

rd 10%

rd 15%

0 1 . . . 15

— $1,494.93 . . . 1,000

$1,000 1,000 . . . 1,000

— $713.78 . . . 1,000

Note: The curves for 5% and 15% have a slight bow.

14 15 Years

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Bonds and Their Valuation 162

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Bonds and Their Valuation

Figure 4-2 illustrates the following key points: 1. Whenever the going rate of interest, rd, is equal to the coupon rate, a ﬁxed-rate bond will sell at its par value. Normally, the coupon rate is set equal to the going rate when a bond is issued, causing it to sell at par initially. 2. Interest rates do change over time, but the coupon rate remains ﬁxed after the bond has been issued. Whenever the going rate of interest rises above the coupon rate, a ﬁxed-rate bond’s price will fall below its par value. Such a bond is called a discount bond. 3. Whenever the going rate of interest falls below the coupon rate, a ﬁxed-rate bond’s price will rise above its par value. Such a bond is called a premium bond. 4. Thus, an increase in interest rates will cause the prices of outstanding bonds to fall, whereas a decrease in rates will cause bond prices to rise. 5. The market value of a bond will always approach its par value as its maturity date approaches, provided the ﬁrm does not go bankrupt. These points are very important, for they show that bondholders may suffer capital losses or make capital gains, depending on whether interest rates rise or fall after the bond was purchased. And, as we saw in Chapter 1, interest rates do indeed change over time. Explain, verbally, the following equation: N INT M VB a . t (1 r ) (1 rd)N t1 d

What is meant by the terms “new issue” and “seasoned issue”? Explain what happens to the price of a ﬁxed-rate bond if (1) interest rates rise above the bond’s coupon rate or (2) interest rates fall below the bond’s coupon rate. Why do the prices of ﬁxed-rate bonds fall if expectations for inﬂation rise? What is a “discount bond”? A “premium bond”?

Bond Yields If you examine the bond market table of The Wall Street Journal or a price sheet put out by a bond dealer, you will typically see information regarding each bond’s maturity date, price, and coupon interest rate. You will also see the bond’s reported yield. Unlike the coupon interest rate, which is ﬁxed, the bond’s yield varies from day to day depending on current market conditions. Moreover, the yield can be calculated in three different ways, and three “answers” can be obtained. These different yields are described in the following sections.

Yield to Maturity Suppose you were offered a 14-year, 10 percent annual coupon, $1,000 par value bond at a price of $1,494.93. What rate of interest would you earn on your investment if you bought the bond and held it to maturity? This rate is called the bond’s yield to maturity (YTM), and it is the interest rate generally discussed by investors when they talk about rates of return. The yield to maturity is generally the same as the market rate of interest, rd, and to ﬁnd it, all you need to do is solve Equation 4-1 for rd:

159

Bonds and Their Valuation Bond Yields

VB $1,494.93

163

$1,000 $100 $100 . (1 rd)1 (1 rd)14 (1 rd)14

You could substitute values for rd until you ﬁnd a value that “works” and forces the sum of the PVs on the right side of the equal sign to equal $1,494.93. Alternatively, you could substitute values of rd into the third form of Equation 4-1 until you ﬁnd a value that works. Finding rd YTM by trial-and-error would be a tedious, time-consuming process, but as you might guess, it is easy with a ﬁnancial calculator.8 Here is the setup: Inputs:

Output:

1494.93

14

100

1000

5

Simply enter N 14, PV 1494.93, PMT 100, and FV 1000, and then press the I key. The answer, 5 percent, will then appear. The yield to maturity is identical to the total rate of return discussed in the preceding section. The yield to maturity can also be viewed as the bond’s promised rate of return, which is the return that investors will receive if all the promised payments are made. However, the yield to maturity equals the expected rate of return only if (1) the probability of default is zero and (2) the bond cannot be called. If there is some default risk, or if the bond may be called, then there is some probability that the promised payments to maturity will not be received, in which case the calculated yield to maturity will differ from the expected return. The YTM for a bond that sells at par consists entirely of an interest yield, but if the bond sells at a price other than its par value, the YTM will consist of the interest yield plus a positive or negative capital gains yield. Note also that a bond’s yield to maturity changes whenever interest rates in the economy change, and this is almost daily. One who purchases a bond and holds it until it matures will receive the YTM that existed on the purchase date, but the bond’s calculated YTM will change frequently between the purchase date and the maturity date.

Yield to Call If you purchased a bond that was callable and the company called it, you would not have the option of holding the bond until it matured. Therefore, the yield to maturity would not be earned. For example, if MicroDrive’s 10 percent coupon bonds were callable, and if interest rates fell from 10 percent to 5 percent, then the company could call in the 10 percent bonds, replace them with 5 percent bonds, and save $100 $50 $50 interest per bond per year. This would be beneﬁcial to the company, but not to its bondholders. If current interest rates are well below an outstanding bond’s coupon rate, then a callable bond is likely to be called, and investors will estimate its expected rate of return as the yield to call (YTC) rather than as the yield to maturity. To calculate the YTC, solve this equation for rd: N Call price INT Price of bond a . t (1 r ) (1 rd)N t1 d

8

(4-2)

You could also ﬁnd the YTM with a spreadsheet. In Excel, you would use the RATE function for this bond, inputting Nper 14, Pmt 100, Pv 1494.93, Fv 1000, 0 for Type, and leave Guess blank.

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Bonds and Their Valuation

Here N is the number of years until the company can call the bond; call price is the price the company must pay in order to call the bond (it is often set equal to the par value plus one year’s interest); and rd is the YTC. To illustrate, suppose MicroDrive’s bonds had a provision that permitted the company, if it desired, to call the bonds 10 years after the issue date at a price of $1,100. Suppose further that interest rates had fallen, and one year after issuance the going interest rate had declined, causing the price of the bonds to rise to $1,494.93. Here is the time line and the setup for ﬁnding the bond’s YTC with a ﬁnancial calculator: 0

YTC ?

1,494.93

1

2

100

100 1494.93

9

100

8

9

100

100 1,100

1100

4.21 YTC The YTC is 4.21 percent—this is the return you would earn if you bought the bond at a price of $1,494.93 and it was called nine years from today. (The bond could not be called until 10 years after issuance, and one year has gone by, so there are nine years left until the ﬁrst call date.) Do you think MicroDrive will call the bonds when they become callable? MicroDrive’s action would depend on what the going interest rate is when the bonds become callable. If the going rate remains at rd 5%, then MicroDrive could save 10% 5% 5%, or $50 per bond per year, by calling them and replacing the 10 percent bonds with a new 5 percent issue. There would be costs to the company to refund the issue, but the interest savings would probably be worth the cost, so MicroDrive would probably refund the bonds. Therefore, you would probably earn YTC 4.21% rather than YTM 5% if you bought the bonds under the indicated conditions. In the balance of this chapter, we assume that bonds are not callable unless otherwise noted, but some of the end-of-chapter problems deal with yield to call.

Current Yield If you examine brokerage house reports on bonds, you will often see reference to a bond’s current yield. The current yield is the annual interest payment divided by the bond’s current price. For example, if MicroDrive’s bonds with a 10 percent coupon were currently selling at $985, the bond’s current yield would be 10.15 percent ($100/$985). Unlike the yield to maturity, the current yield does not represent the rate of return that investors should expect on the bond. The current yield provides information regarding the amount of cash income that a bond will generate in a given year, but since it does not take account of capital gains or losses that will be realized if the bond is held until maturity (or call), it does not provide an accurate measure of the bond’s total expected return. The fact that the current yield does not provide an accurate measure of a bond’s total return can be illustrated with a zero coupon bond. Since zeros pay no annual income, they always have a current yield of zero. This indicates that the bond will not provide any cash interest income, but since the bond will appreciate in value over time, its total rate of return clearly exceeds zero.

161

Bonds and Their Valuation Bonds with Semiannual Coupons

165

Drinking Your Coupons

In 1996 Chateau Teyssier, an English vineyard, was looking for some cash to purchase some additional vines and to modernize its production facilities. Their solution? With the assistance of a leading underwriter, Matrix Securities, the vineyard issued 375 bonds, each costing 2,650 British pounds. The issue raised nearly 1 million pounds, or roughly $1.5 million. What makes these bonds interesting is that, instead of getting paid with something boring like money, these bonds paid their investors back with wine. Each June until 2002, when the bond matured, investors received their

“coupons.” Between 1997 and 2001, each bond provided six cases of the vineyard’s rose or claret. Starting in 1998 and continuing through maturity in 2002, investors also received four cases of its prestigious Saint Emilion Grand Cru. Then, in 2002, they got their money back. The bonds were not without risk. The vineyard’s owner, Jonathan Malthus, acknowledges that the quality of the wine, “is at the mercy of the gods.” Source: Steven Irvine, “My Wine Is My Bond, and I Drink My Coupons,” Euromoney, July 1996, 7. Reprinted by permission.

Explain the difference between the yield to maturity and the yield to call. How does a bond’s current yield differ from its total return? Could the current yield exceed the total return?

Bonds with Semiannual Coupons Although some bonds pay interest annually, the vast majority actually pay interest semiannually. To evaluate semiannual payment bonds, we must modify the valuation model (Equation 4-1) as follows: 1. Divide the annual coupon interest payment by 2 to determine the dollars of interest paid each six months. 2. Multiply the years to maturity, N, by 2 to determine the number of semiannual periods. 3. Divide the nominal (quoted) interest rate, rd, by 2 to determine the periodic (semiannual) interest rate. By making these changes, we obtain the following equation for ﬁnding the value of a bond that pays interest semiannually: 2N INT/2 M VB a t (1 r /2) (1 rd/2)2N d t1

(4-1a)

To illustrate, assume now that MicroDrive’s bonds pay $50 interest each six months rather than $100 at the end of each year. Thus, each interest payment is only half as large, but there are twice as many of them. The coupon rate is thus “10 percent, semiannual payments.” This is the nominal, or quoted, rate.9 9

In this situation, the nominal coupon rate of “10 percent, semiannually,” is the rate that bond dealers, corporate treasurers, and investors generally would discuss. Of course, the effective annual rate would be higher than 10 percent at the time the bond was issued: EAR EFF% a1

rNom m

m

b 1 a1

0.10 2 b 1 (1.05)2 1 10.25%. 2

Note also that 10 percent with annual payments is different than 10 percent with semiannual payments. Thus, we have assumed a change in effective rates in this section from the situation in the preceding section, where we assumed 10 percent with annual payments.

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When the going (nominal) rate of interest is 5 percent with semiannual compounding, the value of this 15-year bond is found as follows: Inputs:

30

Output:

2.5

50

1000

1,523.26

Enter N 30, r I 2.5, PMT 50, FV 1000, and then press the PV key to obtain the bond’s value, $1,523.26. The value with semiannual interest payments is slightly larger than $1,518.98, the value when interest is paid annually. This higher value occurs because interest payments are received somewhat faster under semiannual compounding. Describe how the annual bond valuation formula is changed to evaluate semiannual coupon bonds. Then, write out the revised formula.

Assessing the Risk of a Bond Interest Rate Risk As we saw in Chapter 1, interest rates go up and down over time, and an increase in interest rates leads to a decline in the value of outstanding bonds. This risk of a decline in bond values due to rising interest rates is called interest rate risk. To illustrate, suppose you bought some 10 percent MicroDrive bonds at a price of $1,000, and interest rates in the following year rose to 15 percent. As we saw earlier, the price of the bonds would fall to $713.78, so you would have a loss of $286.22 per bond.10 Interest rates can and do rise, and rising rates cause a loss of value for bondholders. Thus, people or ﬁrms who invest in bonds are exposed to risk from changing interest rates. One’s exposure to interest rate risk is higher on bonds with long maturities than on those maturing in the near future.11 This point can be demonstrated by showing how the value of a 1-year bond with a 10 percent annual coupon ﬂuctuates with changes in rd, and then comparing these changes with those on a 14-year bond as calculated previously. The 1-year bond’s values at different interest rates are shown below:

10

You would have an accounting (and tax) loss only if you sold the bond; if you held it to maturity, you would not have such a loss. However, even if you did not sell, you would still have suffered a real economic loss in an opportunity cost sense because you would have lost the opportunity to invest at 15 percent and would be stuck with a 10 percent bond in a 15 percent market. In an economic sense, “paper losses” are just as bad as realized accounting losses. 11 Actually, a bond’s maturity and coupon rate both affect interest rate risk. Low coupons mean that most of the bond’s return will come from repayment of principal, whereas on a high coupon bond with the same maturity, more of the cash ﬂows will come in during the early years due to the relatively large coupon payments. A measurement called “duration,” which ﬁnds the average number of years the bond’s PV of cash ﬂows remain outstanding, has been developed to combine maturity and coupons. A zero coupon bond, which has no interest payments and whose payments all come at maturity, has a duration equal to the bond’s maturity. Coupon bonds all have durations that are shorter than maturity, and the higher the coupon rate, the shorter the duration. Bonds with longer duration are exposed to more interest rate risk.

163

Bonds and Their Valuation Assessing the Risk of a Bond

167

Value at rd 5%: Inputs:

1

5

100

1000

1,047.62 1-year bond’s value at rd 5%.

Output: Value at rd 10%: Inputs:

1

10

100

1000

1,000.00 1-year bond’s value at rd 10%.

Output: Value at rd 15%: Inputs:

Output:

1

15

100

1000

956.52 1-year bond’s value at rd 15%.

You would obtain the ﬁrst value with a ﬁnancial calculator by entering N 1, I 5, PMT 100, and FV 1000, and then pressing PV to get $1,047.62. With everything still in your calculator, enter I 10 to override the old I 5, and press PV to ﬁnd the bond’s value at rd I 10; it is $1,000. Then enter I 15 and press the PV key to ﬁnd the last bond value, $956.52. The values of the 1-year and 14-year bonds at several current market interest rates are summarized and plotted in Figure 4-3. Note how much more sensitive the price of the 14-year bond is to changes in interest rates. At a 10 percent interest rate, both the 14-year and the 1-year bonds are valued at $1,000. When rates rise to 15 percent, the 14-year bond falls to $713.78, but the 1-year bond only falls to $956.52. For bonds with similar coupons, this differential sensitivity to changes in interest rates always holds true—the longer the maturity of the bond, the more its price changes in response to a given change in interest rates. Thus, even if the risk of default on two bonds is exactly the same, the one with the longer maturity is exposed to more risk from a rise in interest rates.12 The logical explanation for this difference in interest rate risk is simple. Suppose you bought a 14-year bond that yielded 10 percent, or $100 a year. Now suppose

12

If a 10-year bond were plotted in Figure 4-3, its curve would lie between those of the 14-year bond and the 1-year bond. The curve of a 1-month bond would be almost horizontal, indicating that its price would change very little in response to an interest rate change, but a 100-year bond (or a perpetuity) would have a very steep slope. Also, zero coupon bond prices are quite sensitive to interest rate changes, and the longer the maturity of the zero, the greater its price sensitivity. Therefore, 30-year zero coupon bonds have a huge amount of interest rate risk.

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Bonds and Their Valuation FIGURE 4-3

Value of Long- and Short-Term 10% Annual Coupon Bonds at Different Market Interest Rates

Bond Value ($)

See Ch 04 Tool Kit.xls for details.

2,000

1,500 14-Year Bond

1,000 1-Year Bond

500

0

5

10

15

20 25 Interest Rate, r d (%)

Value of Current Market Interest Rate, rd

1-Year Bond

14-Year Bond

5% 10 15 20 25

$1,047.62 1,000.00 956.52 916.67 880.00

$1,494.93 1,000.00 713.78 538.94 426.39

Note: Bond values were calculated using a ﬁnancial calculator assuming annual, or once-a-year, compounding.

interest rates on comparable-risk bonds rose to 15 percent. You would be stuck with only $100 of interest for the next 14 years. On the other hand, had you bought a 1-year bond, you would have a low return for only 1 year. At the end of the year, you would get your $1,000 back, and you could then reinvest it and receive 15 percent, or $150 per year, for the next 13 years. Thus, interest rate risk reﬂects the length of time one is committed to a given investment. As we just saw, the prices of long-term bonds are more sensitive to changes in interest rates than are short-term bonds. To induce an investor to take this extra risk, long-term bonds must have a higher expected rate of return than short-term bonds. This additional return is the maturity risk premium (MRP), which we discussed in Chapter 1. Therefore, one might expect to see higher yields on long-term than on short-term bonds. Does this actually happen? Generally, the answer is yes. Recall from Chapter 1 that the yield curve usually is upward sloping, which is consistent with the idea that longer maturity bonds must have a higher expected rate of return to compensate for their higher risk.

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169

Reinvestment Rate Risk As we saw in the preceding section, an increase in interest rates will hurt bondholders because it will lead to a decline in the value of a bond portfolio. But can a decrease in interest rates also hurt bondholders? The answer is yes, because if interest rates fall, a bondholder will probably suffer a reduction in his or her income. For example, consider a retiree who has a portfolio of bonds and lives off the income they produce. The bonds, on average, have a coupon rate of 10 percent. Now suppose interest rates decline to 5 percent. Many of the bonds will be called, and as calls occur, the bondholder will have to replace 10 percent bonds with 5 percent bonds. Even bonds that are not callable will mature, and when they do, they will have to be replaced with loweryielding bonds. Thus, our retiree will suffer a reduction of income. The risk of an income decline due to a drop in interest rates is called reinvestment rate risk, and its importance has been demonstrated to all bondholders in recent years as a result of the sharp drop in rates since the mid-1980s. Reinvestment rate risk is obviously high on callable bonds. It is also high on short maturity bonds, because the shorter the maturity of a bond, the fewer the years when the relatively high old interest rate will be earned, and the sooner the funds will have to be reinvested at the new low rate. Thus, retirees whose primary holdings are short-term securities, such as bank CDs and short-term bonds, are hurt badly by a decline in rates, but holders of long-term bonds continue to enjoy their old high rates.

Comparing Interest Rate and Reinvestment Rate Risk Note that interest rate risk relates to the value of the bonds in a portfolio, while reinvestment rate risk relates to the income the portfolio produces. If you hold long-term bonds, you will face interest rate risk, that is, the value of your bonds will decline if interest rates rise, but you will not face much reinvestment rate risk, so your income will be stable. On the other hand, if you hold short-term bonds, you will not be exposed to much interest rate risk, so the value of your portfolio will be stable, but you will be exposed to reinvestment rate risk, and your income will ﬂuctuate with changes in interest rates. We see, then, that no ﬁxed-rate bond can be considered totally riskless—even most Treasury bonds are exposed to both interest rate and reinvestment rate risk.13 One can minimize interest rate risk by holding short-term bonds, or one can minimize reinvestment rate risk by holding long-term bonds, but the actions that lower one type of risk increase the other. Bond portfolio managers try to balance these two risks, but some risk generally remains in any bond. Differentiate between interest rate risk and reinvestment rate risk. To which type of risk are holders of long-term bonds more exposed? Short-term bondholders?

Default Risk Another important risk associated with bonds is default risk. If the issuer defaults, investors receive less than the promised return on the bond. Therefore, investors need to assess a bond’s default risk before making a purchase. Recall from Chapter 1 that

13

Note, though, that indexed Treasury bonds are essentially riskless, but they pay a relatively low real rate. Also, risks have not disappeared—they are simply transferred from bondholders to taxpayers.

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the quoted interest rate includes a default risk premium—the greater the default risk, the higher the bond’s yield to maturity. The default risk on Treasury securities is zero, but default risk can be substantial for corporate and municipal bonds. Suppose two bonds have the same promised cash ﬂows, coupon rate, maturity, liquidity, and inﬂation exposure, but one bond has more default risk than the other. Investors will naturally pay less for the bond with the greater chance of default. As a result, bonds with higher default risk will have higher interest rates: rd r* IP DRP LP MRP. If its default risk changes, this will affect the price of a bond. For example, if the default risk of the MicroDrive bonds increases, the bonds’ price will fall and the yield to maturity (YTM rd) will increase. In this section we consider some issues related to default risk. First, we show that corporations can inﬂuence the default risk of their bonds by changing the type of bonds they issue. Second we discuss bond ratings, which are used to measure default risk. Third, we describe the “junk bond market,” which is the market for bonds with a relatively high probability of default. Finally, we consider bankruptcy and reorganization, which affect how much an investor will recover if a default occurs.

Bond Contract Provisions That Inﬂuence Default Risk Default risk is affected by both the ﬁnancial strength of the issuer and the terms of the bond contract, especially whether collateral has been pledged to secure the bond. Several types of contract provisions are discussed below. Bond Indentures An indenture is a legal document that spells out the rights of both bondholders and the issuing corporation, and a trustee is an ofﬁcial (usually a bank) who represents the bondholders and makes sure the terms of the indenture are carried out. The indenture may be several hundred pages in length, and it will include restrictive covenants that cover such points as the conditions under which the issuer can pay off the bonds prior to maturity, the levels at which certain of the issuer’s ratios must be maintained if the company is to issue additional debt, and restrictions against the payment of dividends unless earnings meet certain speciﬁcations. The trustee is responsible for monitoring the covenants and for taking appropriate action if a violation does occur. What constitutes “appropriate action” varies with the circumstances. It might be that to insist on immediate compliance would result in bankruptcy and possibly large losses on the bonds. In such a case, the trustee might decide that the bondholders would be better served by giving the company a chance to work out its problems and thus avoid forcing it into bankruptcy. The Securities and Exchange Commission (1) approves indentures and (2) makes sure that all indenture provisions are met before allowing a company to sell new securities to the public. Also, it should be noted that the indentures of many larger corporations were actually written in the 1930s or 1940s, and that many issues of new bonds sold since then were covered by the same indenture. The interest rates on the bonds, and perhaps also the maturities, vary depending on market conditions at the time of each issue, but bondholders’ protection as spelled out in the indenture is the same for all bonds of the same type. A ﬁrm will have different indentures for each of the major types of bonds it issues. For example, one indenture will cover its ﬁrst mortgage bonds, another its debentures, and a third its convertible bonds. Mortgage Bonds Under a mortgage bond, the corporation pledges certain assets as security for the bond. To illustrate, in 2002 Billingham Corporation needed $10

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171

million to build a major regional distribution center. Bonds in the amount of $4 million, secured by a ﬁrst mortgage on the property, were issued. (The remaining $6 million was ﬁnanced with equity capital.) If Billingham defaults on the bonds, the bondholders can foreclose on the property and sell it to satisfy their claims. If Billingham chose to, it could issue second mortgage bonds secured by the same $10 million of assets. In the event of liquidation, the holders of these second mortgage bonds would have a claim against the property, but only after the ﬁrst mortgage bondholders had been paid off in full. Thus, second mortgages are sometimes called junior mortgages, because they are junior in priority to the claims of senior mortgages, or ﬁrst mortgage bonds. All mortgage bonds are subject to an indenture. The indentures of many major corporations were written 20, 30, 40, or more years ago. These indentures are generally “open ended,” meaning that new bonds can be issued from time to time under the same indenture. However, the amount of new bonds that can be issued is virtually always limited to a speciﬁed percentage of the ﬁrm’s total “bondable property,” which generally includes all land, plant, and equipment. For example, in the past Savannah Electric Company had provisions in its bond indenture that allowed it to issue ﬁrst mortgage bonds totaling up to 60 percent of its ﬁxed assets. If its ﬁxed assets totaled $1 billion, and if it had $500 million of ﬁrst mortgage bonds outstanding, it could, by the property test, issue another $100 million of bonds (60% of $1 billion $600 million). At times, Savannah Electric was unable to issue any new ﬁrst mortgage bonds because of another indenture provision: its interest coverage ratio (pre-interest income divided by interest expense) was below 2.5, the minimum coverage that it must have in order to sell new bonds. Thus, although Savannah Electric passed the property test, it failed the coverage test, so it could not issue any more ﬁrst mortgage bonds. Savannah Electric then had to ﬁnance with junior bonds. Because ﬁrst mortgage bonds carried lower interest rates, this restriction was costly. Savannah Electric’s neighbor, Georgia Power Company, had more ﬂexibility under its indenture—its interest coverage requirement was only 2.0. In hearings before the Georgia Public Service Commission, it was suggested that Savannah Electric should change its indenture coverage to 2.0 so that it could issue more ﬁrst mortgage bonds. However, this was simply not possible—the holders of the outstanding bonds would have to approve the change, and they would not vote for a change that would seriously weaken their position. Debentures A debenture is an unsecured bond, and as such it provides no lien against speciﬁc property as security for the obligation. Debenture holders are, therefore, general creditors whose claims are protected by property not otherwise pledged. In practice, the use of debentures depends both on the nature of the ﬁrm’s assets and on its general credit strength. Extremely strong companies often use debentures; they simply do not need to put up property as security for their debt. Debentures are also issued by weak companies that have already pledged most of their assets as collateral for mortgage loans. In this latter case, the debentures are quite risky, and they will bear a high interest rate. Subordinated Debentures The term subordinate means “below,” or “inferior to,” and, in the event of bankruptcy, subordinated debt has claims on assets only after senior debt has been paid off. Subordinated debentures may be subordinated either to designated notes payable (usually bank loans) or to all other debt. In the event of liquidation or reorganization, holders of subordinated debentures cannot be paid until all senior debt, as named in the debentures’ indenture, has been paid.

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Development Bonds Some companies may be in a position to beneﬁt from the sale of either development bonds or pollution control bonds. State and local governments may set up both industrial development agencies and pollution control agencies. These agencies are allowed, under certain circumstances, to sell tax-exempt bonds, then to make the proceeds available to corporations for speciﬁc uses deemed (by Congress) to be in the public interest. Thus, an industrial development agency in Florida might sell bonds to provide funds for a paper company to build a plant in the Florida Panhandle, where unemployment is high. Similarly, a Detroit pollution control agency might sell bonds to provide Ford with funds to be used to purchase pollution control equipment. In both cases, the income from the bonds would be tax exempt to the holders, so the bonds would sell at relatively low interest rates. Note, however, that these bonds are guaranteed by the corporation that will use the funds, not by a governmental unit, so their rating reﬂects the credit strength of the corporation using the funds. Municipal Bond Insurance Municipalities can have their bonds insured, which means that an insurance company guarantees to pay the coupon and principal payments should the issuer default. This reduces risk to investors, who will thus accept a lower coupon rate for an insured bond vis-à-vis an uninsured one. Even though the municipality must pay a fee to get its bonds insured, its savings due to the lower coupon rate often makes insurance cost-effective. Keep in mind that the insurers are private companies, and the value added by the insurance depends on the creditworthiness of the insurer. However, the larger ones are strong companies, and their own ratings are AAA. Therefore, the bonds they insure are also rated AAA, regardless of the credit strength of the municipal issuer. Bond ratings are discussed in the next section.

Bond Ratings Since the early 1900s, bonds have been assigned quality ratings that reﬂect their probability of going into default. The three major rating agencies are Moody’s Investors Service (Moody’s), Standard & Poor’s Corporation (S&P), and Fitch Investors Service. Moody’s and S&P’s rating designations are shown in Table 4-1.14 The triple- and double-A bonds are extremely safe. Single-A and triple-B bonds are also strong enough to be called investment grade bonds, and they are the lowest-rated bonds that many banks and other institutional investors are permitted by law to hold. Double-B and lower bonds are speculative, or junk bonds. These bonds have a

14

In the discussion to follow, reference to the S&P code is intended to imply the Moody’s and Fitch’s codes as well. Thus, triple-B bonds mean both BBB and Baa bonds; double-B bonds mean both BB and Ba bonds; and so on.

TABLE 4-1

Moody’s and S&P Bond Ratings Investment Grade

Moody’s S&P

Aaa AAA

Aa AA

A A

Junk Bonds

Baa BBB

Ba BB

B B

Caa CCC

C D

Note: Both Moody’s and S&P use “modiﬁers” for bonds rated below triple-A. S&P uses a plus and minus system; thus, A designates the strongest A-rated bonds and A the weakest. Moody’s uses a 1, 2, or 3 designation, with 1 denoting the strongest and 3 the weakest; thus, within the double-A category, Aa1 is the best, Aa2 is average, and Aa3 is the weakest.

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173

signiﬁcant probability of going into default. A later section discusses junk bonds in more detail. Bond Rating Criteria Bond ratings are based on both qualitative and quantitative factors, some of which are listed below: 1. Various ratios, including the debt ratio, the times-interest-earned ratio, and the EBITDA coverage ratio. The better the ratios, the higher the rating.15 2. Mortgage provisions: Is the bond secured by a mortgage? If it is, and if the property has a high value in relation to the amount of bonded debt, the bond’s rating is enhanced. 3. Subordination provisions: Is the bond subordinated to other debt? If so, it will be rated at least one notch below the rating it would have if it were not subordinated. Conversely, a bond with other debt subordinated to it will have a somewhat higher rating. 4. Guarantee provisions: Some bonds are guaranteed by other ﬁrms. If a weak company’s debt is guaranteed by a strong company (usually the weak company’s parent), the bond will be given the strong company’s rating. 5. Sinking fund: Does the bond have a sinking fund to ensure systematic repayment? This feature is a plus factor to the rating agencies. 6. Maturity: Other things the same, a bond with a shorter maturity will be judged less risky than a longer-term bond, and this will be reﬂected in the ratings. 7. Stability: Are the issuer’s sales and earnings stable? 8. Regulation: Is the issuer regulated, and could an adverse regulatory climate cause the company’s economic position to decline? Regulation is especially important for utilities and telephone companies. 9. Antitrust: Are any antitrust actions pending against the ﬁrm that could erode its position? 10. Overseas operations: What percentage of the ﬁrm’s sales, assets, and proﬁts are from overseas operations, and what is the political climate in the host countries? 11. Environmental factors: Is the ﬁrm likely to face heavy expenditures for pollution control equipment? 12. Product liability: Are the ﬁrm’s products safe? The tobacco companies today are under pressure, and so are their bond ratings. 13. Pension liabilities: Does the ﬁrm have unfunded pension liabilities that could pose a future problem? 14. Labor unrest: Are there potential labor problems on the horizon that could weaken the ﬁrm’s position? As this is written, a number of airlines face this problem, and it has caused their ratings to be lowered. 15. Accounting policies: If a ﬁrm uses relatively conservative accounting policies, its reported earnings will be of “higher quality” than if it uses less conservative procedures. Thus, conservative accounting policies are a plus factor in bond ratings. Representatives of the rating agencies have consistently stated that no precise formula is used to set a ﬁrm’s rating; all the factors listed, plus others, are taken into account, but not in a mathematically precise manner. Nevertheless, as we see in Table 4-2, there is a strong correlation between bond ratings and many of the ratios described in Chapter 10. Not surprisingly, companies with lower debt ratios, higher cash ﬂow to debt, higher returns on capital, higher EBITDA interest coverage ratios, and EBIT interest coverage ratios typically have higher bond ratings.

15

See Chapter 10 for an explanation of these and other ratios.

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TABLE 4-2

Bond Rating Criteria; Three-Year (1998–2000) Median Financial Ratios for Different Bond Rating Classiﬁcations

Ratiosa

EBIT interest coverage (EBIT/Interest) EBITDA interest coverage (EBITDA/Interest) Funds from operations/Total debt Free operating cash ﬂow/Total debt Return on capital Operating income/Sales Long-term debt/Long-term capital Total debt/Total capital

AAA

AA

A

BBB

BB

B

CCC

21.4 26.5 84.2 128.8 34.9 27.0 13.3 22.9

10.1 12.9 25.2 55.4 21.7 22.1 28.2 37.7

6.1 9.1 15.0 43.2 19.4 18.6 33.9 42.5

3.7 5.8 8.5 30.8 13.6 15.4 42.5 48.2

2.1 3.4 2.6 18.8 11.6 15.9 57.2 62.6

0.8 1.8 (3.2) 7.8 6.6 11.9 69.7 74.8

0.1 1.3 (12.9) 1.6 1.0 11.9 68.8 87.7

Note: a See the Source for a detailed deﬁnition of the ratios. Source: Reprinted with permission of Standard & Poor’s, A Division of The McGraw-Hill Companies. http://www.standardandpoors.com/ResourceCenter/RatingsCriteria/CorporateFinance/2001CorporateRatingsCriteria.html.

Importance of Bond Ratings Bond ratings are important both to ﬁrms and to investors. First, because a bond’s rating is an indicator of its default risk, the rating has a direct, measurable inﬂuence on the bond’s interest rate and the ﬁrm’s cost of debt. Second, most bonds are purchased by institutional investors rather than individuals, and many institutions are restricted to investment-grade securities. Thus, if a ﬁrm’s bonds fall below BBB, it will have a difﬁcult time selling new bonds because many potential purchasers will not be allowed to buy them. In addition, the covenants may stipulate that the interest rate is automatically increased if the rating falls below a speciﬁed level. As a result of their higher risk and more restricted market, lower-grade bonds have higher required rates of return, rd, than high-grade bonds. Figure 4-4 illustrates this point. In each of the years shown on the graph, U.S. government bonds have had the lowest yields, AAAs have been next, and BBB bonds have had the highest yields. The ﬁgure also shows that the gaps between yields on the three types of bonds vary over time, indicating that the cost differentials, or risk premiums, ﬂuctuate from year to year. This point is highlighted in Figure 4-5, which gives the yields on the three types of bonds and the risk premiums for AAA and BBB bonds in June 1963 and August 2001.16 Note ﬁrst that the risk-free rate, or vertical axis intercept, rose 1.5 percentage points from 1963 to 2001, primarily reﬂecting the increase in realized and anticipated inﬂation. Second, the slope of the line has increased since 1963, indicating an increase in investors’ risk aversion. Thus, the penalty for having a low credit rating varies over time. Occasionally, as in 1963, the penalty is quite small, but at other times it is large. These slope differences reﬂect investors’ aversion to risk.

16

The term risk premium ought to reﬂect only the difference in expected (and required) returns between two securities that results from differences in their risk. However, the differences between yields to maturity on different types of bonds consist of (1) a true risk premium; (2) a liquidity premium, which reﬂects the fact that U.S. Treasury bonds are more readily marketable than most corporate bonds; (3) a call premium, because most Treasury bonds are not callable whereas corporate bonds are; and (4) an expected loss differential, which reﬂects the probability of loss on the corporate bonds. As an example of the last point, suppose the yield to maturity on a BBB bond was 8.0 percent versus 5.5 percent on government bonds, but there was a 5 percent probability of total default loss on the corporate bond. In this case, the expected return on the BBB bond would be 0.95(8.0%) 0.05(0%) 7.6%, and the risk premium would be 2.1 percent, not the full 2.5 percentage points difference in “promised” yields to maturity. Because of all these points, the risk premiums given in Figure 4-5 overstate somewhat the true (but unmeasurable) theoretical risk premiums.

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Bonds and Their Valuation Default Risk FIGURE 4-4

175

Yields on Selected Long-Term Bonds, 1960–2001

Percent 16

16

14

14

12

12 Corporate BBB

10

8

10

Corporate AAA

8 Wide Spread

Narrow Spread 6

6

U.S. Government

4

4

2

1960

2

1965

1970

1975

1980

1985

1990

1995

2000

Source: Federal Reserve Board, Historical Chart Book, 1983, and Federal Reserve Bulletin: http://www.federalreserve.gov/releases.

Changes in Ratings Changes in a ﬁrm’s bond rating affect both its ability to borrow long-term capital and the cost of that capital. Rating agencies review outstanding bonds on a periodic basis, occasionally upgrading or downgrading a bond as a result of its issuer’s changed circumstances. For example, in October 2001, Standard & Poor’s reported that it had raised the rating on King Pharmaceuticals Inc. to BB from BB due to the “continued success of King Pharmaceuticals’ lead product, the cardiovascular drug Altace, as well as the company’s increasing sales diversity, growing ﬁnancial

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FIGURE 4-5

Relationship between Bond Ratings and Bond Yields, 1963 and 2001 Rate of Return (%) 2001 9.0 8.0 7.0

RPBBB = 2.5%

RPAAA = 1.5%

6.0

1963

5.0

RPBBB = 0.8%

4.0

RPAAA = 0.2%

U.S. Treasury Bonds Long-Term Government Bonds (Default-Free) (1)

June 1963 August 2001

AAA

BBB

Bond Ratings

Risk Premiums

4.0% 5.5

AAA Corporate Bonds (2)

BBB Corporate Bonds (3)

AAA

BBB

(4) (2) (1)

(5) (3) (1)

4.2% 7.0 RPAAA risk premium on AAA bonds. RPBBB risk premium on BBB bonds.

4.8% 8.0

0.2% 1.5

0.8% 2.5

Source: Federal Reserve Bulletin, December 1963, and Federal Reserve Statistical Release, Selected Interest Rates, Historical Data, August, 2001: http://www.federalreserve.gov/releases.

ﬂexibility, and improved ﬁnancial proﬁle.”17 However, S&P also reported that Xerox Corporation’s senior unsecured debt had been downgraded from a BBB to a BB due to expectations of lower operating income in 2001 and 2002.

Junk Bonds Prior to the 1980s, ﬁxed-income investors such as pension funds and insurance companies were generally unwilling to buy risky bonds, so it was almost impossible for risky companies to raise capital in the public bond markets. Then, in the late 1970s, Michael Milken of the investment banking ﬁrm Drexel Burnham Lambert, relying on historical studies that showed that risky bonds yielded more than enough to compensate for their risk, began to convince institutional investors of the merits of purchasing risky debt. Thus was born the “junk bond,” a high-risk, high-yield bond issued to ﬁnance a leveraged buyout, a merger, or a troubled company.18 For example, Public 17

See the Standard & Poor’s web site for this and other changes in ratings: http://www.standardandpoors.com/RatingsActions/RatingsNews/CorporateFinance/index.html. 18 Another type of junk bond is one that was highly rated when it was issued but whose rating has fallen because the issuing corporation has fallen on hard times. Such bonds are called “fallen angels.”

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177

Santa Fe Bonds Finally Mature after 114 Years

In 1995, Santa Fe Paciﬁc Company made the ﬁnal payment on some outstanding bonds that were originally issued in 1881! While the bonds were paid off in full, their history has been anything but routine. Since the bonds were issued in 1881, investors have seen Santa Fe go through two bankruptcy reorganizations, two depressions, several recessions, two world wars, and the collapse of the gold standard. Through it all, the company remained intact, although ironically it did agree to be acquired by Burlington Northern just prior to the bonds’ maturity. When the bonds were issued in 1881, they had a 6 percent coupon. After a promising start, competition in the railroad business, along with the Depression of 1893, dealt a crippling one-two punch to the company’s fortunes. After two bankruptcy reorganizations—and two new management teams—the company got back on its feet, and in 1895 it replaced the original bonds with new 100-year bonds. The new bonds, sanctioned by the Bankruptcy Court, matured in 1995 and carried a 4 percent coupon. However, they also had a wrinkle that was in effect until 1900—the company could skip the coupon payment if, in management’s opinion, earnings were not sufﬁciently high to service the debt. After 1900, the company could no longer just ignore the coupon,

but it did have the option of deferring the payments if management deemed deferral necessary. In the late 1890s, Santa Fe did skip the interest, and the bonds sold at an all-time low of $285 (28.5% of par) in 1896. The bonds reached a peak in 1946, when they sold for $1,312.50 in the strong, low interest rate economy after World War II. Interestingly, the bonds’ principal payment was originally pegged to the price of gold, meaning that the principal received at maturity would increase if the price of gold increased. This type of contract was declared invalid in 1933 by President Roosevelt and Congress, and the decision was upheld by the Supreme Court in a 5–4 vote. If just one Supreme Court justice had gone the other way, then, due to an increase in the price of gold, the bonds would have been worth $18,626 rather than $1,000 when they matured in 1995! In many ways, the saga of the Santa Fe bonds is a testament to the stability of the U.S. ﬁnancial system. On the other hand, it illustrates the many types of risks that investors face when they purchase long-term bonds. Investors in the 100-year bonds issued by Disney and Coca-Cola, among others, should perhaps take note.

Service of New Hampshire ﬁnanced construction of its troubled Seabrook nuclear plant with junk bonds, and junk bonds were used by Ted Turner to ﬁnance the development of CNN and Turner Broadcasting. In junk bond deals, the debt ratio is generally extremely high, so the bondholders must bear as much risk as stockholders normally would. The bonds’ yields reﬂect this fact—a promised return of 25 percent per annum was required to sell some Public Service of New Hampshire bonds. The emergence of junk bonds as an important type of debt is another example of how the investment banking industry adjusts to and facilitates new developments in capital markets. In the 1980s, mergers and takeovers increased dramatically. People like T. Boone Pickens and Henry Kravis thought that certain old-line, established companies were run inefﬁciently and were ﬁnanced too conservatively, and they wanted to take these companies over and restructure them. Michael Milken and his staff at Drexel Burnham Lambert began an active campaign to persuade certain institutions (often S&Ls) to purchase high-yield bonds. Milken developed expertise in putting together deals that were attractive to the institutions yet feasible in the sense that projected cash ﬂows were sufﬁcient to meet the required interest payments. The fact that interest on the bonds was tax deductible, combined with the much higher debt ratios of the restructured ﬁrms, also increased after-tax cash ﬂows and helped make the deals feasible. The development of junk bond ﬁnancing has done much to reshape the U.S. ﬁnancial scene. The existence of these securities contributed to the loss of independence of Gulf Oil and hundreds of other companies, and it led to major shake-ups in such companies as CBS, Union Carbide, and USX (formerly U.S. Steel). It also caused

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Bonds and Their Valuation

Drexel Burnham Lambert to leap from essentially nowhere in the 1970s to become the most proﬁtable investment banking ﬁrm during the 1980s. The phenomenal growth of the junk bond market was impressive, but controversial. In 1989, Drexel Burnham Lambert was forced into bankruptcy, and “junk bond king” Michael Milken, who had earned $500 million two years earlier, was sent to jail. Those events led to the collapse of the junk bond market in the early 1990s. Since then, however, the junk bond market has rebounded, and junk bonds are here to stay as an important form of corporate ﬁnancing.

Bankruptcy and Reorganization During recessions, bankruptcies normally rise, and recent recessions are no exception. The 1991–1992 casualties included Pan Am, Carter Hawley Hale Stores, Continental Airlines, R. H. Macy & Company, Zale Corporation, and McCrory Corporation. The recession beginning in 2001 has already claimed Kmart and Enron, and there will likely be more bankruptcies in 2002 if the economy continues to decline. Because of its importance, a brief discussion of bankruptcy is warranted. When a business becomes insolvent, it does not have enough cash to meet its interest and principal payments. A decision must then be made whether to dissolve the ﬁrm through liquidation or to permit it to reorganize and thus stay alive. These issues are addressed in Chapters 7 and 11 of the federal bankruptcy statutes, and the ﬁnal decision is made by a federal bankruptcy court judge. The decision to force a ﬁrm to liquidate versus permit it to reorganize depends on whether the value of the reorganized ﬁrm is likely to be greater than the value of the ﬁrm’s assets if they are sold off piecemeal. In a reorganization, the ﬁrm’s creditors negotiate with management on the terms of a potential reorganization. The reorganization plan may call for a restructuring of the ﬁrm’s debt, in which case the interest rate may be reduced, the term to maturity lengthened, or some of the debt may be exchanged for equity. The point of the restructuring is to reduce the ﬁnancial charges to a level that the ﬁrm’s cash ﬂows can support. Of course, the common stockholders also have to give up something—they often see their position diluted as a result of additional shares being given to debtholders in exchange for accepting a reduced amount of debt principal and interest. In fact, the original common stockholders often end up with nothing. A trustee may be appointed by the court to oversee the reorganization, but generally the existing management is allowed to retain control. Liquidation occurs if the company is deemed to be too far gone to be saved—if it is worth more dead than alive. If the bankruptcy court orders a liquidation, assets are sold off and the cash obtained is distributed as speciﬁed in Chapter 7 of the Bankruptcy Act. Here is the priority of claims: 1. Secured creditors are entitled to the proceeds from the sale of the speciﬁc property that was used to support their loans. 2. The trustee’s costs of administering and operating the bankrupt ﬁrm are next in line. 3. Expenses incurred after bankruptcy was ﬁled come next. 4. Wages due workers, up to a limit of $2,000 per worker, follow. 5. Claims for unpaid contributions to employee beneﬁt plans are next. This amount, together with wages, cannot exceed $2,000 per worker. 6. Unsecured claims for customer deposits up to $900 per customer are sixth in line. 7. Federal, state, and local taxes due come next. 8. Unfunded pension plan liabilities are next although some limitations exist. 9. General unsecured creditors are ninth on the list. 10. Preferred stockholders come next, up to the par value of their stock. 11. Common stockholders are ﬁnally paid, if anything is left, which is rare.

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179

The key points for you to know are (1) the federal bankruptcy statutes govern both reorganization and liquidation, (2) bankruptcies occur frequently, and (3) a priority of the speciﬁed claims must be followed when distributing the assets of a liquidated ﬁrm. Differentiate between mortgage bonds and debentures. Name the major rating agencies, and list some factors that affect bond ratings. Why are bond ratings important both to ﬁrms and to investors? For what purposes have junk bonds typically been used? Differentiate between a Chapter 7 liquidation and a Chapter 11 reorganization. When would each be used? List the priority of claims for the distribution of a liquidated ﬁrm’s assets.

Bond Markets Corporate bonds are traded primarily in the over-the-counter market. Most bonds are owned by and traded among the large ﬁnancial institutions (for example, life insurance companies, mutual funds, and pension funds, all of which deal in very large blocks of securities), and it is relatively easy for the over-the-counter bond dealers to arrange the transfer of large blocks of bonds among the relatively few holders of the bonds. It would be much more difﬁcult to conduct similar operations in the stock market, with its literally millions of large and small stockholders, so a higher percentage of stock trades occur on the exchanges. Information on bond trades in the over-the-counter market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE and is reported on the bond market page of The Wall Street Journal. Bond data are also available on the Internet, at sites such as http://www.bondsonline. Figure 4-6 reports data for selected bonds of BellSouth Corporation. Note that BellSouth actually had more than ten bond issues outstanding, but Figure 4-6 reports data for only ten bonds. The bonds of BellSouth and other companies can have various denominations, but for convenience we generally think of each bond as having a par value of $1,000—this is how much per bond the company borrowed and how much it must someday repay. However, since other denominations are possible, for trading and reporting purposes bonds are quoted as percentages of par. Looking at the ﬁfth bond listed in the data in Figure 4-6, we see that the bond is of the series that pays a 7 percent coupon, or 0.07($1,000) $70.00 of interest per year. The BellSouth bonds, and most others, pay interest semiannually, so all rates are nominal, not EAR rates. This bond matures and must be repaid on October 1, 2025; it is not shown in the ﬁgure, but this bond was issued in 1995, so it had a 30-year original maturity. The price shown in the last column is expressed as a percentage of par, 106.00 percent, which translates to $1,060.00. This bond has a yield to maturity of 6.501 percent. The bond is not callable, but several others in Figure 4-6 are callable. Note that the eighth bond in Figure 4-6 has a yield to call of only 3.523 percent compared with its yield to maturity of 7.270 percent, indicating that investors expect BellSouth to call the bond prior to maturity. Coupon rates are generally set at levels that reﬂect the “going rate of interest” on the day a bond is issued. If the rates were set lower, investors simply would not buy the bonds at the $1,000 par value, so the company could not borrow the money it needed. Thus, bonds generally sell at their par values on the day they are issued, but their prices ﬂuctuate thereafter as interest rates change.

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Bonds and Their Valuation FIGURE 4-6

Selected Bond Market Data

S&P Bond Rating

Issue Name

Coupon Rate

Maturity Datea

Yield to Maturity

Yield to Callb

Pricec

A A A A Aⴙ A A A A A

BellSouth BellSouth BellSouth BellSouth BellSouth BellSouth BellSouth BellSouth BellSouth BellSouth

6.375 7.000 5.875 7.750 7.000 6.375 7.875 7.875 7.500 7.625

6/15/2004 2/1/2005 1/15/2009 2/15/2010 10/1/2025 6/1/2028 2/15/2030 08-01-2032C 06-15-2033C 05-15-2035C

3.616 4.323 5.242 5.478 6.501 6.453 6.581 7.270 7.014 7.169

NC NC NC NC NC NC NC 3.523 6.290 6.705

106.843 108.031 103.750 114.962 106.000 99.000 116.495 107.375 106.125 105.750

Notes: a C denotes a callable bond. b NC indicates the bond is not callable. c The price is reported as a percentage of par. Source: 10/25/01, http://www.bondsonline.com. At the top of the web page, select the icon for Bond Search, then select the button for Corporate. When the bond-search dialog box appears, type in BellSouth for Issue and click the Find Bonds button. Reprinted by permission.

As shown in Figure 4-7, the BellSouth bonds initially sold at par, but then fell below par in 1996 when interest rates rose. The price rose above par in 1997 and 1998 when interest rates fell, but the price fell again in 1999 and 2000 after increases in interest rates. It rose again in 2001 when interest rates fell. The dashed line in Figure 4-7 FIGURE 4-7

BellSouth 7%, 30-Year Bond: Market Value as Interest Rates Change

Bond Value ($) 1,200

1,100

Actual Price of the 7% Coupon Bond

Bond's Projected Price if Interest Rates Remain Constant from 2001 to 2025

1,000

900

0 1995

2000

2005

2010

2015

2020

Note: The line from 2001 to 2025 appears linear, but it actually has a slight downward curve.

2025 Years

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Bonds and Their Valuation Summary

181

shows the projected price of the bonds, in the unlikely event that interest rates remain constant from 2001 to 2025. Looking at the actual and projected price history of these bonds, we see (1) the inverse relationship between interest rates and bond values and (2) the fact that bond values approach their par values as their maturity date approaches. Why do most bond trades occur in the over-the-counter market? If a bond issue is to be sold at par, how will its coupon rate be determined?

Summary This chapter described the different types of bonds governments and corporations issue, explained how bond prices are established, and discussed how investors estimate the rates of return they can expect to earn. We also discussed the various types of risks that investors face when they buy bonds. It is important to remember that when an investor purchases a company’s bonds, that investor is providing the company with capital. Therefore, when a ﬁrm issues bonds, the return that investors receive represents the cost of debt ﬁnancing for the issuing company. This point is emphasized in Chapter 6, where the ideas developed in this chapter are used to help determine a company’s overall cost of capital, which is a basic component in the capital budgeting process. The key concepts covered are summarized below. 䊉

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A bond is a long-term promissory note issued by a business or governmental unit. The issuer receives money in exchange for promising to make interest payments and to repay the principal on a speciﬁed future date. Some recent innovations in long-term ﬁnancing include zero coupon bonds, which pay no annual interest but that are issued at a discount; ﬂoating rate debt, whose interest payments ﬂuctuate with changes in the general level of interest rates; and junk bonds, which are high-risk, high-yield instruments issued by ﬁrms that use a great deal of ﬁnancial leverage. A call provision gives the issuing corporation the right to redeem the bonds prior to maturity under speciﬁed terms, usually at a price greater than the maturity value (the difference is a call premium). A ﬁrm will typically call a bond if interest rates fall substantially below the coupon rate. A redeemable bond gives the investor the right to sell the bond back to the issuing company at a previously speciﬁed price. This is a useful feature (for investors) if interest rates rise or if the company engages in unanticipated risky activities. A sinking fund is a provision that requires the corporation to retire a portion of the bond issue each year. The purpose of the sinking fund is to provide for the orderly retirement of the issue. A sinking fund typically requires no call premium. The value of a bond is found as the present value of an annuity (the interest payments) plus the present value of a lump sum (the principal). The bond is evaluated at the appropriate periodic interest rate over the number of periods for which interest payments are made. The equation used to ﬁnd the value of an annual coupon bond is: N INT M . VB a t (1 rd)N t1 (1 rd)

An adjustment to the formula must be made if the bond pays interest semiannually: divide INT and rd by 2, and multiply N by 2.

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Bonds and Their Valuation 䊉

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The return earned on a bond held to maturity is deﬁned as the bond’s yield to maturity (YTM). If the bond can be redeemed before maturity, it is callable, and the return investors receive if it is called is deﬁned as the yield to call (YTC). The YTC is found as the present value of the interest payments received while the bond is outstanding plus the present value of the call price (the par value plus a call premium). The longer the maturity of a bond, the more its price will change in response to a given change in interest rates; this is called interest rate risk. However, bonds with short maturities expose investors to high reinvestment rate risk, which is the risk that income from a bond portfolio will decline because cash ﬂows received from bonds will be rolled over at lower interest rates. Corporate and municipal bonds have default risk. If an issuer defaults, investors receive less than the promised return on the bond. Therefore, investors should evaluate a bond’s default risk before making a purchase. There are many different types of bonds with different sets of features. These include convertible bonds, bonds with warrants, income bonds, purchasing power (indexed) bonds, mortgage bonds, debentures, subordinated debentures, junk bonds, development bonds, and insured municipal bonds. The return required on each type of bond is determined by the bond’s riskiness. Bonds are assigned ratings that reﬂect the probability of their going into default. The highest rating is AAA, and they go down to D. The higher a bond’s rating, the lower its risk and therefore its interest rate.

Questions 4–1

Deﬁne each of the following terms: a. Bond; Treasury bond; corporate bond; municipal bond; foreign bond b. Par value; maturity date; coupon payment; coupon interest rate c. Floating rate bond; zero coupon bond; original issue discount bond (OID) d. Call provision; redeemable bond; sinking fund e. Convertible bond; warrant; income bond; indexed, or purchasing power, bond f. Premium bond; discount bond g. Current yield (on a bond); yield to maturity (YTM); yield to call (YTC) h. Reinvestment risk; interest rate risk; default risk i. Indentures; mortgage bond; debenture; subordinated debenture j. Development bond; municipal bond insurance; junk bond; investment-grade bond

4–2

“The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, shortterm bond prices are more sensitive to interest rate changes than are long-term bond prices.” Is this statement true or false? Explain.

4–3

The rate of return you would get if you bought a bond and held it to its maturity date is called the bond’s yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond’s price and to its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bond’s price?

4–4

If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

4–5

A sinking fund can be set up in one of two ways: (1) The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity. (2) The trustee uses the annual payments to retire a portion of the issue each year, either calling a given percentage of the issue by a lottery and paying a speciﬁed price per bond or buying bonds on the open market, whichever is cheaper. Discuss the advantages and disadvantages of each procedure from the viewpoint of both the ﬁrm and its bondholders.

179

Bonds and Their Valuation Problems

Self-Test Problems ST–1 BOND VALUATION

ST–2 SINKING FUND

183

(Solutions Appear in Appendix A)

The Pennington Corporation issued a new series of bonds on January 1, 1979. The bonds were sold at par ($1,000), have a 12 percent coupon, and mature in 30 years, on December 31, 2008. Coupon payments are made semiannually (on June 30 and December 31). a. What was the YTM of Pennington’s bonds on January 1, 1979? b. What was the price of the bond on January 1, 1984, 5 years later, assuming that the level of interest rates had fallen to 10 percent? c. Find the current yield and capital gains yield on the bond on January 1, 1984, given the price as determined in part b. d. On July 1, 2002, Pennington’s bonds sold for $916.42. What was the YTM at that date? e. What were the current yield and capital gains yield on July 1, 2002? f. Now, assume that you purchased an outstanding Pennington bond on March 1, 2002, when the going rate of interest was 15.5 percent. How large a check must you have written to complete the transaction? This is a hard question! (Hint: PVIFA7.75%,13 8.0136 and PVIF7.75%,13 0.3789.) The Vancouver Development Company has just sold a $100 million, 10-year, 12 percent bond issue. A sinking fund will retire the issue over its life. Sinking fund payments are of equal amounts and will be made semiannually, and the proceeds will be used to retire bonds as the payments are made. Bonds can be called at par for sinking fund purposes, or the funds paid into the sinking fund can be used to buy bonds in the open market. a. How large must each semiannual sinking fund payment be? b. What will happen, under the conditions of the problem thus far, to the company’s debt service requirements per year for this issue over time? c. Now suppose Vancouver Development set up its sinking fund so that equal annual amounts, payable at the end of each year, are paid into a sinking fund trust held by a bank, with the proceeds being used to buy government bonds that pay 9 percent interest. The payments, plus accumulated interest, must total $100 million at the end of 10 years, and the proceeds will be used to retire the bonds at that time. How large must the annual sinking fund payment be now? d. What are the annual cash requirements for covering bond service costs under the trusteeship arrangement described in part c? (Note: Interest must be paid on Vancouver’s outstanding bonds but not on bonds that have been retired.) e. What would have to happen to interest rates to cause the company to buy bonds on the open market rather than call them under the original sinking fund plan?

Problems 4–1 BOND VALUATION

4–2 YIELD TO MATURITY; FINANCIAL CALCULATOR NEEDED

4–3 YIELD TO MATURITY AND CALL; FINANCIAL CALCULATOR NEEDED

4–4 CURRENT YIELD

4–5 BOND VALUATION; FINANCIAL CALCULATOR NEEDED

Callaghan Motors’ bonds have 10 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8 percent. The bonds have a yield to maturity of 9 percent. What is the current market price of these bonds? Wilson Wonders’ bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 10 percent. The bonds sell at a price of $850. What is their yield to maturity? Thatcher Corporation’s bonds will mature in 10 years. The bonds have a face value of $1,000 and an 8 percent coupon rate, paid semiannually. The price of the bonds is $1,100. The bonds are callable in 5 years at a call price of $1,050. What is the yield to maturity? What is the yield to call? Heath Foods’ bonds have 7 years remaining to maturity. The bonds have a face value of $1,000 and a yield to maturity of 8 percent. They pay interest annually and have a 9 percent coupon rate. What is their current yield? Nungesser Corporation has issued bonds that have a 9 percent coupon rate, payable semiannually. The bonds mature in 8 years, have a face value of $1,000, and a yield to maturity of 8.5 percent. What is the price of the bonds?

180

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Bonds and Their Valuation 4–6

BOND VALUATION

4–7 YIELD TO MATURITY

4–8 YIELD TO CALL

4–9 BOND YIELDS; FINANCIAL CALCULATOR NEEDED

4–10 YIELD TO MATURITY; FINANCIAL CALCULATOR NEEDED

4–11 CURRENT YIELD; FINANCIAL CALCULATOR NEEDED

4–12 NOMINAL INTEREST RATE

4–13 BOND VALUATION

4–14 INTEREST RATE SENSITIVITY; FINANCIAL CALCULATOR NEEDED

The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual interest plus $1,000 at maturity. Bond L has a maturity of 15 years, and Bond S a maturity of 1 year. a. What will be the value of each of these bonds when the going rate of interest is (1) 5 percent, (2) 8 percent, and (3) 12 percent? Assume that there is only one more interest payment to be made on Bond S. b. Why does the longer-term (15-year) bond ﬂuctuate more when interest rates change than does the shorter-term bond (1-year)? The Heymann Company’s bonds have 4 years remaining to maturity. Interest is paid annually; the bonds have a $1,000 par value; and the coupon interest rate is 9 percent. a. What is the yield to maturity at a current market price of (1) $829 or (2) $1,104? b. Would you pay $829 for one of these bonds if you thought that the appropriate rate of interest was 12 percent—that is, if rd 12%? Explain your answer. Six years ago, The Singleton Company sold a 20-year bond issue with a 14 percent annual coupon rate and a 9 percent call premium. Today, Singleton called the bonds. The bonds originally were sold at their face value of $1,000. Compute the realized rate of return for investors who purchased the bonds when they were issued and who surrender them today in exchange for the call price. A 10-year, 12 percent semiannual coupon bond, with a par value of $1,000, may be called in 4 years at a call price of $1,060. The bond sells for $1,100. (Assume that the bond has just been issued.) a. What is the bond’s yield to maturity? b. What is the bond’s current yield? c. What is the bond’s capital gain or loss yield? d. What is the bond’s yield to call? You just purchased a bond which matures in 5 years. The bond has a face value of $1,000, and has an 8 percent annual coupon. The bond has a current yield of 8.21 percent. What is the bond’s yield to maturity? A bond which matures in 7 years sells for $1,020. The bond has a face value of $1,000 and a yield to maturity of 10.5883 percent. The bond pays coupons semiannually. What is the bond’s current yield? Lloyd Corporation’s 14 percent coupon rate, semiannual payment, $1,000 par value bonds, which mature in 30 years, are callable 5 years from now at a price of $1,050. The bonds sell at a price of $1,353.54, and the yield curve is ﬂat. Assuming that interest rates in the economy are expected to remain at their current level, what is the best estimate of Lloyd’s nominal interest rate on new bonds? Suppose Ford Motor Company sold an issue of bonds with a 10-year maturity, a $1,000 par value, a 10 percent coupon rate, and semiannual interest payments. a. Two years after the bonds were issued, the going rate of interest on bonds such as these fell to 6 percent. At what price would the bonds sell? b. Suppose that, 2 years after the initial offering, the going interest rate had risen to 12 percent. At what price would the bonds sell? c. Suppose that the conditions in part a existed—that is, interest rates fell to 6 percent 2 years after the issue date. Suppose further that the interest rate remained at 6 percent for the next 8 years. What would happen to the price of the Ford Motor Company bonds over time? A bond trader purchased each of the following bonds at a yield to maturity of 8 percent. Immediately after she purchased the bonds, interest rates fell to 7 percent. What is the percentage change in the price of each bond after the decline in interest rates? Fill in the following table: Price @ 8%

10-year, 10% annual coupon 10-year zero 5-year zero 30-year zero $100 perpetuity

Price @ 7%

Percentage Change

181

Bonds and Their Valuation Spreadsheet Problem 4–15 BOND VALUATION; FINANCIAL CALCULATOR NEEDED

185

An investor has two bonds in his portfolio. Each bond matures in 4 years, has a face value of $1,000, and has a yield to maturity equal to 9.6 percent. One bond, Bond C, pays an annual coupon of 10 percent, the other bond, Bond Z, is a zero coupon bond. a. Assuming that the yield to maturity of each bond remains at 9.6 percent over the next 4 years, what will be the price of each of the bonds at the following time periods? Fill in the following table: t

Price of Bond C

Price of Bond Z

0 1 2 3 4

b. Plot the time path of the prices for each of the two bonds.

Spreadsheet Problem 4–16 BUILD A MODEL: BOND VALUATION

See Ch 04 Show.ppt and Ch 04 Mini Case.xls.

Start with the partial model in the ﬁle Ch 04 P16 Build a Model.xls from the textbook’s web site. Rework Problem 4-9. After completing parts a through d, answer the following related questions. e. How would the price of the bond be affected by changing interest rates? (Hint: Conduct a sensitivity analysis of price to changes in the yield to maturity, which is also the going market interest rate for the bond. Assume that the bond will be called if and only if the going rate of interest falls below the coupon rate. That is an oversimpliﬁcation, but assume it anyway for purposes of this problem.) f. Now assume that the date is 10/25/2002. Assume further that our 12 percent, 10-year bond was issued on 7/1/2002, is callable on 7/1/2006 at $1,060, will mature on 6/30/2012, pays interest semiannually (January 1 and July 1), and sells for $1,100. Use your spreadsheet to ﬁnd (1) the bond’s yield to maturity and (2) its yield to call.

Robert Balik and Carol Kiefer are vice-presidents of Mutual of Chicago Insurance Company and codirectors of the company’s pension fund management division. A major new client, the California League of Cities, has requested that Mutual of Chicago present an investment seminar to the mayors of the represented cities, and Balik and Kiefer, who will make the actual presentation, have asked you to help them by answering the following questions. Because the Walt Disney Company operates in one of the league’s cities, you are to work Disney into the presentation. a. What are the key features of a bond? b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? c. How is the value of any asset whose value is based on expected future cash ﬂows determined? d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent? e. (1) What would be the value of the bond described in part d if, just after it had been issued, the expected inﬂation rate rose by 3 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a premium bond? (If you do not have a ﬁnancial calculator, PVIF13%,10 0.2946; PVIFA13%,10 5.4262.) (2) What would happen to the bond’s value if inﬂation fell, and rd declined to 7 percent? Would we now have a premium or a discount bond? (3) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent? (Hint: With a ﬁnancial calculator, enter PMT, I, FV, and N, and then change (override) N to see what happens to the PV as the bond approaches maturity.)

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Bonds and Their Valuation

f. (1) What is the yield to maturity on a 10-year, 9 percent, annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between rd and the bond’s coupon rate? (2) What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.) g. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10-year bond? Why? h. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond? i. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd 13%. (Hint: PVIF6.5%,20 0.2838 and PVIFA6.5%,20 11.0185.) j. Suppose you could buy, for $1,000, either a 10 percent, 10-year, annual payment bond or a 10 percent, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If $1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond? k. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $1,000 is currently selling for $1,135.90, producing a nominal yield to maturity of 8 percent. However, the bond can be called after 5 years for a price of $1,050. (1) What is the bond’s nominal yield to call (YTC)? (2) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why? l. Disney’s bonds were issued with a yield to maturity of 7.5 percent. Does the yield to maturity represent the promised or expected return on the bond? m. Disney’s bonds were rated AA by S&P. Would you consider these bonds investment grade or junk bonds? n. What factors determine a company’s bond rating? o. If this ﬁrm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments?

Selected Additional References and Cases Many investment textbooks cover bond valuation models in depth and detail. Some of the better ones are listed in the Chapter 3 references.

Tse, K. S. Maurice, and Mark A. White, “The Valuation of Semiannual Bonds between Interest Payment Dates: A Correction,” Financial Review, November 1990, 659–662.

For some recent works on valuation, see

The following cases in the Cases in Financial Management series cover many of the valuation concepts contained in Chapter 4.

Bey, Roger P., and J. Markham Collins, “The Relationship between Before- and After-Tax Yields on Financial Assets,” The Financial Review, August 1988, 313–343. Taylor, Richard W., “The Valuation of Semiannual Bonds Between Interest Payment Dates,” The Financial Review, August 1988, 365–368.

Case 3, “Peachtree Securities, Inc. (B);” Case 43, “Swan Davis;” Case 49, “Beatrice Peabody;” and Case 56, “Laura Henderson.”

Stocks and Their Valuation

55

From slightly less than 4000 in early 1995, the Dow surged to 11723 in early 2000. To put this remarkable 7723-point rise in perspective, consider that the Dow ﬁrst reached 1000 in 1965, then took another 22 years to hit 2000, then four more years to reach 3000, and another four to get to 4000 (in 1995). Then, in just over ﬁve years, it reached 11723. Thus, in those ﬁve years investors made almost twice as much in the stock market as they made in the previous 70 years! That bull market made it possible for many people to take early retirement, buy expensive homes, and afford large expenditures such as college tuition. Encouraged by this performance, more and more investors ﬂocked to the market, and today more than 79 million Americans own stock. Moreover, a rising stock market made it easier and cheaper for corporations to raise equity capital, which facilitated economic growth. However, some observers were concerned that many investors did not realize just how risky the stock market can be. There was no guarantee that the market would continue to rise, and even in bull markets some stocks crash and burn. Indeed, several times during 2001 the market fell to below 10000 and surged above 11000. In fact, the market fell all the way to 8236 in the days following the September 11, 2001, terrorist attacks. Note too that while all boats may rise with the tide, the same does not hold for the stock market—regardless of the trend, some individual stocks make huge gains while others suffer substantial losses. For example, in 2001, Lowe’s stock rose more than 108 percent, but during this same period Enron lost nearly 100 percent of its value. While it is difﬁcult to predict prices, we are not completely in the dark when it comes to valuing stocks. After studying this chapter, you should have a reasonably good understanding of the factors that inﬂuence stock prices. With that knowledge— and a little luck—you may be able to ﬁnd the next Lowe’s and avoid future Enrons.

187

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In Chapter 4 we examined bonds. We now turn to common and preferred stock, beginning with some important background material that helps establish a framework for valuing these securities. The textbook’s web site While it is generally easy to predict the cash ﬂows received from bonds, forecastcontains an Excel ﬁle that ing the cash ﬂows on common stocks is much more difﬁcult. However, two fairly will guide you through the straightforward models can be used to help estimate the “true,” or intrinsic, value of a chapter’s calculations. The ﬁle for this chapter is Ch 05 common stock: (1) the dividend growth model, which we describe in this chapter, and Tool Kit.xls, and we encour- (2) the total corporate value model, which we explain in Chapter 12. age you to open the ﬁle and The concepts and models developed here will also be used when we estimate the follow along as you read the cost of capital in Chapter 6. In subsequent chapters, we demonstrate how the cost of chapter. capital is used to help make many important decisions, especially the decision to invest or not invest in new assets. Consequently, it is critically important that you understand the basics of stock valuation.

Legal Rights and Privileges of Common Stockholders The common stockholders are the owners of a corporation, and as such they have certain rights and privileges as discussed in this section.

Control of the Firm Its common stockholders have the right to elect a ﬁrm’s directors, who, in turn, elect the ofﬁcers who manage the business. In a small ﬁrm, the largest stockholder typically assumes the positions of president and chairperson of the board of directors. In a large, publicly owned ﬁrm, the managers typically have some stock, but their personal holdings are generally insufﬁcient to give them voting control. Thus, the managements of most publicly owned ﬁrms can be removed by the stockholders if the management team is not effective. State and federal laws stipulate how stockholder control is to be exercised. First, corporations must hold an election of directors periodically, usually once a year, with the vote taken at the annual meeting. Frequently, one-third of the directors are elected each year for a three-year term. Each share of stock has one vote; thus, the owner of 1,000 shares has 1,000 votes for each director.1 Stockholders can appear at the annual meeting and vote in person, but typically they transfer their right to vote to a second party by means of a proxy. Management always solicits stockholders’ proxies and usually gets them. However, if earnings are poor and stockholders are dissatisﬁed, an outside group may solicit the proxies in an effort to overthrow management and take control of the business. This is known as a proxy ﬁght. Proxy ﬁghts are discussed in detail in Chapter 12.

The Preemptive Right Common stockholders often have the right, called the preemptive right, to purchase any additional shares sold by the ﬁrm. In some states, the preemptive right is automatically included in every corporate charter; in others, it is necessary to insert it speciﬁcally into the charter. 1

In the situation described, a 1,000-share stockholder could cast 1,000 votes for each of three directors if there were three contested seats on the board. An alternative procedure that may be prescribed in the corporate charter calls for cumulative voting. Here the 1,000-share stockholder would get 3,000 votes if there were three vacancies, and he or she could cast all of them for one director. Cumulative voting helps small groups to get representation on the board.

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The preemptive right enables current stockholders to maintain control and prevents a transfer of wealth from current stockholders to new stockholders. If it were not for this safeguard, the management of a corporation could issue a large number of additional shares and purchase these shares itself. Management could thereby seize control of the corporation and steal value from the current stockholders. For example, suppose 1,000 shares of common stock, each with a price of $100, were outstanding, making the total market value of the ﬁrm $100,000. If an additional 1,000 shares were sold at $50 a share, or for $50,000, this would raise the total market value to $150,000. When total market value is divided by new total shares outstanding, a value of $75 a share is obtained. The old stockholders thus lose $25 per share, and the new stockholders have an instant proﬁt of $25 per share. Thus, selling common stock at a price below the market value would dilute its price and transfer wealth from the present stockholders to those who were allowed to purchase the new shares. The preemptive right prevents such occurrences. What is a proxy ﬁght? What are the two primary reasons for the existence of the preemptive right?

Types of Common Stock Although most ﬁrms have only one type of common stock, in some instances classiﬁed stock is used to meet the special needs of the company. Generally, when special classiﬁcations are used, one type is designated Class A, another Class B, and so on. Small, new companies seeking funds from outside sources frequently use different types of common stock. For example, when Genetic Concepts went public recently, its Class A stock was sold to the public and paid a dividend, but this stock had no voting rights for ﬁve years. Its Class B stock, which was retained by the organizers of the company, had full voting rights for ﬁve years, but the legal terms stated that dividends could not be paid on the Class B stock until the company had established its earning power by building up retained earnings to a designated level. The use of classiﬁed stock thus enabled the public to take a position in a conservatively ﬁnanced growth company without sacriﬁcing income, while the founders retained absolute control during the crucial early stages of the ﬁrm’s development. At the same time, outside investors were protected against excessive withdrawals of funds by the original owners. As is often the case in such situations, the Class B stock was called founders’ shares. Note that “Class A,” “Class B,” and so on, have no standard meanings. Most ﬁrms have no classiﬁed shares, but a ﬁrm that does could designate its Class B shares as founders’ shares and its Class A shares as those sold to the public, while another could reverse these designations. Still other ﬁrms could use stock classiﬁcations for entirely different purposes. For example, when General Motors acquired Hughes Aircraft for $5 billion, it paid in part with a new Class H common, GMH, which had limited voting rights and whose dividends were tied to Hughes’s performance as a GM subsidiary. The reasons for the new stock were reported to be (1) that GM wanted to limit voting privileges on the new classiﬁed stock because of management’s concern about a possible takeover and (2) that Hughes employees wanted to be rewarded more directly on Hughes’s own performance than would have been possible through regular GM stock. GM’s deal posed a problem for the NYSE, which had a rule against listing a company’s common stock if the company had any nonvoting common stock outstanding. GM made it clear that it was willing to delist if the NYSE did not change its rules. The NYSE concluded that such arrangements as GM had made were logical and were likely to be made by other companies in the future, so it changed its rules to accommodate GM. In reality, though, the NYSE had little choice. In recent years, the

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Nasdaq market has proven that it can provide a deep, liquid market for common stocks, and the defection of GM would have hurt the NYSE much more than GM. As these examples illustrate, the right to vote is often a distinguishing characteristic between different classes of stock. Suppose two classes of stock differ in but one respect: One class has voting rights but the other does not. As you would expect, the stock with voting rights would be more valuable. In the United States, which has a legal system with fairly strong protection for minority stockholders (that is, noncontrolling stockholders), voting stock typically sells at a price 4 to 6 percent above that of otherwise similar nonvoting stock. Thus, if a stock with no voting rights sold for $50, then one with voting rights would probably sell for $52 to $53. In those countries with legal systems that provide less protection for minority stockholders, the right to vote is far more valuable. For example, voting stock on average sells for 45 percent more than nonvoting stock in Israel, and for 82 percent more in Italy. As we noted above, General Motors created its Class H common stock as a part of its acquisition of Hughes Aircraft. This type of stock, with dividends tied to a particular part of a company, is called tracking stock. It also is called target stock. Although GM used its tracking stock in an acquisition, other companies are attempting to use such stock to increase shareholder value. For example, in 1995 US West had several business areas with very different growth prospects, ranging from slowgrowth local telephone services to high-growth cellular, cable television, and directory services. US West felt that investors were unable to correctly value its highgrowth lines of business, since cash ﬂows from slow-growth and high-growth businesses were mingled. To separate the cash ﬂows and to allow separate valuations, the company issued tracking stocks. Other companies in the telephone industry, such as Sprint, have also issued tracking stock. Similarly, Georgia-Paciﬁc Corp. issued tracking stock for its timber business, and USX Corp. has tracking stocks for its oil, natural gas, and steel divisions. Despite this trend, many analysts are skeptical as to whether tracking stock increases a company’s total market value. Companies still report consolidated ﬁnancial statements for the entire company, and they have considerable leeway in allocating costs and reporting the ﬁnancial results for the various divisions, even those with tracking stock. Thus, a tracking stock is not the same as the stock of an independent, stand-alone company. What are some reasons a company might use classiﬁed stock?

The Market for Common Stock Some companies are so small that their common stocks are not actively traded; they are owned by only a few people, usually the companies’ managers. Such ﬁrms are said to be privately owned, or closely held, corporations, and their stock is called closely held stock. In contrast, the stocks of most larger companies are owned by a large number of investors, most of whom are not active in management. Such companies are called publicly owned corporations, and their stock is called publicly held stock. As we saw in Chapter 1, the stocks of smaller publicly owned ﬁrms are not listed on a physical location exchange or Nasdaq; they trade in the over-the-counter (OTC) market, and the companies and their stocks are said to be unlisted. However, larger publicly owned companies generally apply for listing on a formal exchange, and they and their stocks are said to be listed. Many companies are ﬁrst listed on Nasdaq or on a regional exchange, such as the Paciﬁc Coast or Midwest exchanges. Once they become large enough to be listed on the “Big Board,” many, but by no means all, choose

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Note that http://ﬁnance. yahoo.com provides an easy way to ﬁnd stocks meeting speciﬁed criteria. Under the section on Stock Research, select Stock Screener. To ﬁnd the largest companies in terms of market value, for example, go to the pull-down menu for Market Cap and choose a Minimum of $100 billion. Then click the Find Stocks button at the bottom, and it will return a list of all companies with market capitalizations greater than $100 billion.

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to move to the NYSE. One of the largest companies in the world in terms of market value, Microsoft, trades on the Nasdaq market, as do most other high-tech ﬁrms. A recent study found that institutional investors owned more than 60 percent of all publicly held common stocks. Included are pension plans, mutual funds, foreign investors, insurance companies, and brokerage ﬁrms. These institutions buy and sell relatively actively, so they account for about 75 percent of all transactions. Thus, institutional investors have a heavy inﬂuence on the prices of individual stocks.

Types of Stock Market Transactions We can classify stock market transactions into three distinct types: 1. Trading in the outstanding shares of established, publicly owned companies: the secondary market. MicroDrive Inc., a company we analyze throughout the book, has 50 million shares of stock outstanding. If the owner of 100 shares sells his or her stock, the trade is said to have occurred in the secondary market. Thus, the market for outstanding shares, or used shares, is the secondary market. The company receives no new money when sales occur in this market. 2. Additional shares sold by established, publicly owned companies: the primary market. If MicroDrive decides to sell (or issue) an additional 1 million shares to raise new equity capital, this transaction is said to occur in the primary market.2 3. Initial public offerings by privately held ﬁrms: the IPO market. Several years ago, the Coors Brewing Company, which was owned by the Coors family at the time, decided to sell some stock to raise capital needed for a major expansion program.3 This type of transaction is called going public—whenever stock in a closely held corporation is offered to the public for the ﬁrst time, the company is said to be going public. The market for stock that is just being offered to the public is called the initial public offering (IPO) market. IPOs have received a lot of attention in recent years, primarily because a number of “hot” issues have realized spectacular gains—often in the ﬁrst few minutes of trading. Consider the IPO of Boston Rotisserie Chicken, which has since been renamed Boston Market and acquired by McDonald’s. The company’s underwriter, Merrill Lynch, set an offering price of $20 a share. However, because of intense demand for the issue, the stock’s price rose 75 percent within the ﬁrst two hours of trading. By the end of the ﬁrst day, the stock price had risen by 143 percent, and the company’s end-of-the-day market value was $800 million—which was particularly startling, given that it had recently reported a $5 million loss on only $8.3 million of sales. More recently, shares of the trendy restaurant chain Planet Hollywood rose nearly 50 percent in its ﬁrst day of trading, and when Netscape ﬁrst hit the market, its stock’s price hit $70 a share versus an offering price of only $28 a share.4 Table 5-1 lists the best performing and the worst performing IPOs of 2001, and it shows how they performed from their offering dates through year-end 2001. As 2

MicroDrive has 60 million shares authorized but only 50 million outstanding; thus, it has 10 million authorized but unissued shares. If it had no authorized but unissued shares, management could increase the authorized shares by obtaining stockholders’ approval, which would generally be granted without any arguments. 3 The stock Coors offered to the public was designated Class B, and it was nonvoting. The Coors family retained the founders’ shares, called Class A stock, which carried full voting privileges. The company was large enough to obtain an NYSE listing, but at that time the Exchange had a requirement that listed common stocks must have full voting rights, which precluded Coors from obtaining an NYSE listing. 4 If someone bought Boston Chicken or Planet Hollywood at the initial offering price and sold the shares shortly thereafter, he or she would have done well. A long-term holder would have fared less well—both companies later went bankrupt. Netscape was in serious trouble, but it was sold to AOL in 1998.

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Martha Bodyslams WWF

During the week of October 18, 1999, both Martha Stewart Living Omnimedia Inc. and the World Wrestling Federation (WWF) went public in IPOs. This created a lot of public interest, and it led to media reports comparing the two companies. Both deals attracted strong investor demand, and both were well received. In its ﬁrst day of trading, WWF’s stock closed above $25, an increase of nearly 49 percent above its $17 offering price. Martha Stewart did even better—it closed a little above $37, which was 105 percent above its $18 offering price. This performance led CBS MarketWatch reporter Steve Gelsi to write an online report entitled, “Martha Bodyslams the WWF!”

Both stocks generated a lot of interest, but when the hype died down, astute investors recognized that both stocks have risk. Indeed, one month later, WWF had declined to just above $21, while Martha Stewart had fallen to $28 a share. Many analysts believe that over the long term WWF may have both more upside potential and less risk. However, Martha Stewart has a devoted set of investors, so despite all the uncertainty, the one certainty is that this battle is far from over. Source: Steve Gelsi, “Martha Bodyslams the WWF,” http://cbs. marketwatch.com, October 19, 1999.

the table shows, not all IPOs are as well received as were Netscape and Boston Chicken. Moreover, even if you are able to identify a “hot” issue, it is often difﬁcult to purchase shares in the initial offering. These deals are generally oversubscribed, which means that the demand for shares at the offering price exceeds the number of shares issued. In such instances, investment bankers favor large institutional investors (who are their best customers), and small investors ﬁnd it hard, if not impossible, to get in on the ground ﬂoor. They can buy the stock in the after-market, but evidence suggests that if you do not get in on the ground ﬂoor, the average IPO underperforms the overall market over the longer run.5 Before you conclude that it isn’t fair to let only the best customers have the stock in an initial offering, think about what it takes to become a best customer. Best customers are usually investors who have done lots of business in the past with the investment banking ﬁrm’s brokerage department. In other words, they have paid large sums as commissions in the past, and they are expected to continue doing so in the future. As is so often true, there is no free lunch—most of the investors who get in on the ground ﬂoor of an IPO have in fact paid for this privilege. Finally, it is important to recognize that ﬁrms can go public without raising any additional capital. For example, Ford Motor Company was once owned exclusively by the Ford family. When Henry Ford died, he left a substantial part of his stock to the Ford Foundation. Ford Motor went public when the Foundation later sold some of its stock to the general public, even though the company raised no capital in the transaction. Differentiate between a closely held corporation and a publicly owned corporation. Differentiate between a listed stock and an unlisted stock. Differentiate between primary and secondary markets. What is an IPO?

5

See Jay R. Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance, March 1991, Vol. 46, No. 1, 3–27.

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Initial Public Stock Offerings in 2001 % Change from Offer

Issuer (Business)

Issue Date

Offer Price

3/21/01 11/19/01 6/27/01 2/5/01 12/12/01 7/18/01 7/26/01 6/11/01 4/4/01 10/30/01

$ 7.00 13.00 10.00 21.50 11.00 14.50 12.00 13.50 9.50 15.00

5/2/01 2/5/01 2/8/01 1/25/01 6/7/01 1/10/01 5/17/01 5/22/01 6/12/01 3/15/01

$ 8.00 14.00 8.00 13.00 16.00 4.50 15.00 8.50 18.00 8.00

U.S. Proceeds (millions)

in 1st Day’s Trading

through Dec. 31

26.8 63.1 50.0 98.9 55.0 1,900.2 62.1 310.5 98.3 62.1

14.3% 46.1 12.2 11.6 40.5 4.6 26.3 23.0 6.6 15.0

170.7% 129.2 108.0 91.2 85.6 83.1 77.9 73.3 71.3 68.3

$ 16.0 84.0 8.0 149.5 80.0 5.2 155.3 45.0 144.0 10.0

0.4% 0.0 6.1 33.2 0.4 4.2 39.5 8.6 6.9 0.0

88.9% 79.9 64.9 64.6 62.8 60.4 57.5 55.3 47.2 46.9

The Best Performers Verisity Magma Design Automation Monolithic System Technology Williams Energy Partners Nassda Accenture PDF Solutions Willis Group Holdings Select Medical Odyssey Healthcare

$

The Worst Performers Briazz ATP Oil & Gas Investors Capital Holdings Align Technology Torch Offshore Enterraa Tellium Smith & Wollensky Restaurant General Maritime GMX Resources a

Went public as Westlinks and changed name later

Source: Kate Kelly, “For IPOs, Market Conditions Go from Decent to Downright Inhospitable,” The Wall Street Journal, January 2, 2002, R8. Copyright © 2001 Dow Jones & Co., Inc. Reprinted by permission of Dow Jones & Co. via Copyright Clearance Center.

Common Stock Valuation Common stock represents an ownership interest in a corporation, but to the typical investor a share of common stock is simply a piece of paper characterized by two features: 1. It entitles its owner to dividends, but only if the company has earnings out of which dividends can be paid, and only if management chooses to pay dividends rather than retaining and reinvesting all the earnings. Whereas a bond contains a promise to pay interest, common stock provides no such promise—if you own a stock, you may expect a dividend, but your expectations may not in fact be met. To illustrate, Long Island Lighting Company (LILCO) had paid dividends on its common stock for more than 50 years, and people expected those dividends to continue. However, when the company encountered severe problems a few years ago, it stopped paying dividends. Note, though, that LILCO continued to pay interest on its bonds; if it had not, then it would have been declared bankrupt, and the bondholders could potentially have taken over the company. 2. Stock can be sold at some future date, hopefully at a price greater than the purchase price. If the stock is actually sold at a price above its purchase price, the investor

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will receive a capital gain. Generally, at the time people buy common stocks, they do expect to receive capital gains; otherwise, they would not purchase the stocks. However, after the fact, one can end up with capital losses rather than capital gains. LILCO’s stock price dropped from $17.50 to $3.75 in one year, so the expected capital gain on that stock turned out to be a huge actual capital loss.

Deﬁnitions of Terms Used in Stock Valuation Models Common stocks provide an expected future cash ﬂow stream, and a stock’s value is found in the same manner as the values of other ﬁnancial assets—namely, as the present value of the expected future cash ﬂow stream. The expected cash ﬂows consist of two elements: (1) the dividends expected in each year and (2) the price investors expect to receive when they sell the stock. The expected ﬁnal stock price includes the return of the original investment plus an expected capital gain. We saw in Chapter 1 that managers seek to maximize the values of their ﬁrms’ stocks. A manager’s actions affect both the stream of income to investors and the riskiness of that stream. Therefore, managers need to know how alternative actions are likely to affect stock prices. At this point we develop some models to help show how the value of a share of stock is determined. We begin by deﬁning the following terms: Dt dividend the stockholder expects to receive at the end of Year t. D0 is the most recent dividend, which has already been paid; D1 is the ﬁrst dividend expected, and it will be paid at the end of this year; D2 is the dividend expected at the end of two years; and so forth. D1 represents the ﬁrst cash ﬂow a new purchaser of the stock will receive. Note that D0, the dividend that has just been paid, is known with certainty. However, all future dividends are expected values, so the estimate of Dt may differ among investors.6 P0 actual market price of the stock today. Pˆ t expected price of the stock at the end of each Year t (pronounced “P hat t”). Pˆ 0 is the intrinsic, or fundamental, value of the stock today as seen by the particular investor doing the analysis; Pˆ 1 is the price expected at the end of one year; and so on. Note that Pˆ 0 is the intrinsic value of the stock today based on a particular investor’s estimate of the stock’s expected dividend stream and the riskiness of that stream. Hence, whereas the market price P0 is ﬁxed and is identical for all investors, Pˆ 0 could differ among investors depending on how optimistic they are regarding the company. The caret, or “hat,” is used to indicate that Pˆ t is an esˆ 0, the individual investor’s estimate of the timated value. P intrinsic value today, could be above or below P0, the current stock price, but an investor would buy the stock only if his or her estimate of Pˆ 0 were equal to or greater than P0.

6

Stocks generally pay dividends quarterly, so theoretically we should evaluate them on a quarterly basis. However, in stock valuation, most analysts work on an annual basis because the data generally are not precise enough to warrant reﬁnement to a quarterly model. For additional information on the quarterly model, see Charles M. Linke and J. Kenton Zumwalt, “Estimation Biases in Discounted Cash Flow Analysis of Equity Capital Cost in Rate Regulation,” Financial Management, Autumn 1984, 15–21.

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195

Since there are many investors in the market, there can be many values for Pˆ 0. However, we can think of a group of “average,” or “marginal,” investors whose actions actually determine the market price. For these marginal investors, P0 must equal Pˆ 0; otherwise, a disequilibrium would exist, and buying and selling in the market would change P0 until P0 Pˆ 0 for the marginal investor. g expected growth rate in dividends as predicted by a marginal investor. If dividends are expected to grow at a constant rate, g is also equal to the expected rate of growth in earnings and in the stock’s price. Different investors may use different g’s to evaluate a ﬁrm’s stock, but the market price, P0, is set on the basis of the g estimated by marginal investors. rs minimum acceptable, or required, rate of return on the stock, considering both its riskiness and the returns available on other investments. Again, this term generally relates to marginal investors. The determinants of rs include the real rate of return, expected inﬂation, and risk, as discussed in Chapter 3. rˆ s expected rate of return that an investor who buys the stock expects to receive in the future. rˆ s (pronounced “r hat s”) could be above or below rs, but one would buy the stock only if rˆ s were equal to or greater than rs. r¯s actual, or realized, after-the-fact rate of return, pronounced “r bar s.” You may expect to obtain a return of rˆ s 15 percent if you buy Exxon Mobil today, but if the market goes down, you may end up next year with an actual realized return that is much lower, perhaps even negative. D1/P0 expected dividend yield during the coming year. If the stock is expected to pay a dividend of D1 $1 during the next 12 months, and if its current price is P0 $10, then Pˆ1 P0 the expected dividend yield is $1/$10 0.10 10%. expected capital gains yield during the coming year. If P0 the stock sells for $10 today, and if it is expected to rise to $10.50 at the end of one year, then the expected capital gain is Pˆ 1 P0 $10.50 $10.00 $0.50, and the expected capital gains yield is $0.50/$10 0.05 5%. Expected total return rˆ s expected dividend yield (D1/P0) plus expected capital gains yield [( Pˆ 1 P0)/P0]. In our example, the expected total return rˆ s 10% 5% 15%.

Expected Dividends as the Basis for Stock Values In our discussion of bonds, we found the value of a bond as the present value of interest payments over the life of the bond plus the present value of the bond’s maturity (or par) value: VB

INT INT INT M . (1 rd)1 (1 rd)2 (1 rd)N (1 rd)N

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Stock prices are likewise determined as the present value of a stream of cash ﬂows, and the basic stock valuation equation is similar to the bond valuation equation. What are the cash ﬂows that corporations provide to their stockholders? First, think of yourself as an investor who buys a stock with the intention of holding it (in your family) forever. In this case, all that you (and your heirs) will receive is a stream of dividends, and the value of the stock today is calculated as the present value of an inﬁnite stream of dividends: ˆ 0 PV of expected future dividends Value of stock P D1 D2 D⬁ 1 2 (1 rs)⬁ (1 rs) (1 rs)

(5-1)

⬁

Dt a t. t1 (1 rs) What about the more typical case, where you expect to hold the stock for a ﬁnite period and then sell it—what will be the value of Pˆ 0 in this case? Unless the company is likely to be liquidated or sold and thus to disappear, the value of the stock is again determined by Equation 5-1. To see this, recognize that for any individual investor, the expected cash ﬂows consist of expected dividends plus the expected sale price of the stock. However, the sale price the current investor receives will depend on the dividends some future investor expects. Therefore, for all present and future investors in total, expected cash ﬂows must be based on expected future dividends. Put another way, unless a ﬁrm is liquidated or sold to another concern, the cash ﬂows it provides to its stockholders will consist only of a stream of dividends; therefore, the value of a share of its stock must be established as the present value of that expected dividend stream. The general validity of Equation 5-1 can also be conﬁrmed by asking the following question: Suppose I buy a stock and expect to hold it for one year. I will receive dividends during the year plus the value Pˆ 1 when I sell out at the end of the year. But what will determine the value of Pˆ 1? The answer is that it will be determined as the present value of the dividends expected during Year 2 plus the stock price at the end of that year, which, in turn, will be determined as the present value of another set of future dividends and an even more distant stock price. This process can be continued ad inﬁnitum, and the ultimate result is Equation 5-1.7 Explain the following statement: “Whereas a bond contains a promise to pay interest, a share of common stock typically provides an expectation of, but no promise of, dividends plus capital gains.” What are the two parts of most stocks’ expected total return? How does one calculate the capital gains yield and the dividend yield of a stock?

Constant Growth Stocks Equation 5-1 is a generalized stock valuation model in the sense that the time pattern of Dt can be anything: Dt can be rising, falling, ﬂuctuating randomly, or it can even be zero for several years, and Equation 5-1 will still hold. With a computer spreadsheet 7

We should note that investors periodically lose sight of the long-run nature of stocks as investments and forget that in order to sell a stock at a proﬁt, one must ﬁnd a buyer who will pay the higher price. If you analyze a stock’s value in accordance with Equation 5-1, conclude that the stock’s market price exceeds a reasonable value, and then buy the stock anyway, then you would be following the “bigger fool” theory of investment—you think that you may be a fool to buy the stock at its excessive price, but you also think that when you get ready to sell it, you can ﬁnd someone who is an even bigger fool. The bigger fool theory was widely followed in the spring of 2000, just before the Nasdaq market lost more than one-third of its value.

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197

we can easily use this equation to ﬁnd a stock’s intrinsic value for any pattern of dividends. In practice, the hard part is getting an accurate forecast of the future dividends. However, in many cases, the stream of dividends is expected to grow at a constant rate. If this is the case, Equation 5-1 may be rewritten as follows:8 D0(1 g)1 D0(1 g)2 D0(1 g)⬁ Pˆ 0 (1 rs)⬁ (1 rs)1 (1 rs)2 ⬁ (1 g)t D0 a (1 r )t t1

(5-2)

s

D0(1 g) D1 . rs g rs g

The last term of Equation 5-2 is called the constant growth model, or the Gordon model after Myron J. Gordon, who did much to develop and popularize it. Note that a necessary condition for the derivation of Equation 5-2 is that rs be greater than g. Look back at the second form of Equation 5-2. If g is larger than rs, then (1 g)t/(1 rs)t must always be greater than one. In this case, the second line of Equation 5-2 is the sum of an inﬁnite number of terms, with each term being a number larger than one. Therefore, if the constant g were greater than rs, the resulting stock price would be inﬁnite! Since no company is worth an inﬁnite price, it is impossible to have a constant growth rate that is greater than rs. So, if you try to use the constant growth model in a situation where g is greater than rs, you will violate laws of economics and mathematics, and your results will be both wrong and meaningless.

Illustration of a Constant Growth Stock Assume that MicroDrive just paid a dividend of $1.15 (that is, D0 $1.15). Its stock has a required rate of return, rs, of 13.4 percent, and investors expect the dividend to grow at a constant 8 percent rate in the future. The estimated dividend one year hence would be D1 $1.15(1.08) $1.24; D2 would be $1.34; and the estimated dividend ﬁve years hence would be $1.69: Dt D0(1 g)t $1.15(1.08)5 $1.69. We could use this procedure to estimate each future dividend, and then use Equation 5-1 to determine the current stock value, Pˆ 0. In other words, we could ﬁnd each expected future dividend, calculate its present value, and then sum all the present values to ﬁnd the intrinsic value of the stock. Such a process would be time consuming, but we can take a short cut—just insert the illustrative data into Equation 5-2 to ﬁnd the stock’s intrinsic value, $23: $1.15(1.08) $1.242 Pˆ 0 $23.00 . 0.134 0.08 0.054 The concept underlying the valuation process for a constant growth stock is graphed in Figure 5-1. Dividends are growing at the rate g 8%, but because rs g, the present value of each future dividend is declining. For example, the dividend in Year 1 is D1 D0(1 g)1 $1.15(1.08) $1.242. However, the present value of this dividend, discounted at 13.4 percent, is PV(D1) $1.242/(1.134)1 $1.095. 8

The last term in Equation 5-2 is derived in the Extensions to Chapter 5 of Eugene F. Brigham and Phillip R. Daves, Intermediate Financial Management, 7th ed. (Fort Worth, TX: Harcourt College Publishers, 2002). In essence, Equation 5-2 is the sum of a geometric progression, and the ﬁnal result is the solution value of the progression.

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Stocks and Their Valuation FIGURE 5-1

Present Values of Dividends of a Constant Growth Stock where D0 $1.15, g 8%, rs 13.4%

Dividend ($)

Dollar Amount of Each Dividend = D 0 (1 + g) t

1.15 PV D1 = 1.10 PV of Each Dividend =

D0 (1 + g)t (1 + r s ) t

8

198

ˆ = P 0

∑ PV Dt = Area under PV Curve = $23.00

t=1

0

5

10

15

20 Years

The dividend expected in Year 2 grows to $1.242(1.08) $1.341, but the present value of this dividend falls to $1.043. Continuing, D3 $1.449 and PV(D3) $0.993, and so on. Thus, the expected dividends are growing, but the present value of each successive dividend is declining, because the dividend growth rate (8%) is less than the rate used for discounting the dividends to the present (13.4%). If we summed the present values of each future dividend, this summation would be the value of the stock, Pˆ 0. When g is a constant, this summation is equal to D1/(rs g), as shown in Equation 5-2. Therefore, if we extended the lower step function curve in Figure 5-1 on out to inﬁnity and added up the present values of each future dividend, the summation would be identical to the value given by Equation 5-2, $23.00. Although Equation 5-2 assumes that dividends grow to inﬁnity, most of the value is based on dividends during a relatively short time period. In our example, 70 percent of the value is attributed to the ﬁrst 25 years, 91 percent to the ﬁrst 50 years, and 99.4 percent to the ﬁrst 100 years. So, companies don’t have to live forever for the Gordon growth model to be used.

Dividend and Earnings Growth Growth in dividends occurs primarily as a result of growth in earnings per share (EPS). Earnings growth, in turn, results from a number of factors, including (1) inﬂation, (2) the amount of earnings the company retains and reinvests, and (3) the rate of return the company earns on its equity (ROE). Regarding inﬂation, if output (in units) is stable, but both sales prices and input costs rise at the inﬂation rate, then EPS will also grow at

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199

the inﬂation rate. Even without inﬂation, EPS will also grow as a result of the reinvestment, or plowback, of earnings. If the ﬁrm’s earnings are not all paid out as dividends (that is, if some fraction of earnings is retained), the dollars of investment behind each share will rise over time, which should lead to growth in earnings and dividends. Even though a stock’s value is derived from expected dividends, this does not necessarily mean that corporations can increase their stock prices by simply raising the current dividend. Shareholders care about all dividends, both current and those expected in the future. Moreover, there is a trade-off between current dividends and future dividends. Companies that pay high current dividends necessarily retain and reinvest less of their earnings in the business, and that reduces future earnings and dividends. So, the issue is this: Do shareholders prefer higher current dividends at the cost of lower future dividends, the reverse, or are stockholders indifferent? There is no simple answer to this question. Shareholders prefer to have the company retain earnings, hence pay less current dividends, if it has highly proﬁtable investment opportunities, but they want the company to pay earnings out if investment opportunities are poor. Taxes also play a role—since dividends and capital gains are taxed differently, dividend policy affects investors’ taxes. We will consider dividend policy in detail in Chapter 14.

Do Stock Prices Reﬂect Long-Term or Short-Term Events? Managers often complain that the stock market is shortsighted, and that it cares only about next quarter’s performance. Let’s use the constant growth model to test this assertion. MicroDrive’s most recent dividend was $1.15, and it is expected to grow at a rate of 8 percent per year. Since we know the growth rate, we can forecast the dividends for each of the next ﬁve years and then ﬁnd their present values: PV

D0(1 g)1

(1 rs)1 $1.15(1.08)1

D0(1 g)2

(1 rs)2 $1.15(1.08)2

D0(1 g)3

D0(1 g)4

D0(1 g)5

(1 rs)3 (1 rs)4 (1 rs)5 3 4 $1.15(1.08) $1.15(1.08) $1.15(1.08)5 (1.134)1 (1.134)2 (1.134)3 (1.134)4 (1.134)5 $1.242 $1.341 $1.449 $1.565 $1.690 1 2 3 4 (1.134) (1.134) (1.134) (1.134) (1.134)5 1.095 1.043 0.993 0.946 0.901 ⬇ $5.00.

Recall that MicroDrive’s stock price is $23.00. Therefore, only $5.00, or 22 percent, of the $23.00 stock price is attributable to short-term cash ﬂows. This means that MicroDrive’s managers will have a bigger effect on the stock price if they work to increase long-term cash ﬂows rather than focus on short-term ﬂows. This situation holds for most companies. Indeed, a number of professors and consulting ﬁrms have used actual company data to show that more than 80 percent of a typical company’s stock price is due to cash ﬂows expected more than ﬁve years in the future. This brings up an interesting question. If most of a stock’s value is due to longterm cash ﬂows, why do managers and analysts pay so much attention to quarterly earnings? Part of the answer lies in the information conveyed by short-term earnings. For example, if actual quarterly earnings are lower than expected, not because of fundamental problems but only because a company has increased its R&D expenditures, studies have shown that the stock price probably won’t decline and may actually increase. This makes sense, because R&D should increase future cash ﬂows. On the other hand, if quarterly earnings are lower than expected because customers don’t like the company’s new products, then this new information will have negative implications for future values of g, the long-term growth rate. As we show later in this chapter, even small changes in g can lead to large changes in stock prices. Therefore,

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while the quarterly earnings themselves might not be very important, the information they convey about future prospects can be terribly important. Another reason many managers focus on short-term earnings is that some ﬁrms pay managerial bonuses on the basis of current earnings rather than stock prices (which reﬂect future earnings). For these managers, the concern with quarterly earnings is not due to their effect on stock prices—it’s due to their effect on bonuses.9

When Can the Constant Growth Model Be Used? The constant growth model is often appropriate for mature companies with a stable history of growth. Expected growth rates vary somewhat among companies, but dividend growth for most mature ﬁrms is generally expected to continue in the future at about the same rate as nominal gross domestic product (real GDP plus inﬂation). On this basis, one might expect the dividends of an average, or “normal,” company to grow at a rate of 5 to 8 percent a year. Note too that Equation 5-2 is sufﬁciently general to handle the case of a zero growth stock, where the dividend is expected to remain constant over time. If g 0, Equation 5-2 reduces to Equation 5-3: D Pˆ 0 . rs

(5-3)

This is essentially the same equation as the one we developed in Chapter 2 for a perpetuity, and it is simply the dividend divided by the discount rate. Write out and explain the valuation formula for a constant growth stock. Explain how the formula for a zero growth stock is related to that for a constant growth stock. Are stock prices affected more by long-term or short-term events?

Expected Rate of Return on a Constant Growth Stock We can solve Equation 5-2 for rs, again using the hat to indicate that we are dealing with an expected rate of return:10 Expected rate Expected Expected growth of return dividend rate, or capital yield gains yield D1 rˆ s g. P0

(5-4)

Thus, if you buy a stock for a price P0 $23, and if you expect the stock to pay a dividend D1 $1.242 one year from now and to grow at a constant rate g 8% in the future, then your expected rate of return will be 13.4 percent: rˆ s

$1.242 8% 5.4% 8% 13.4%. $23

9

Many apparent puzzles in ﬁnance can be explained either by managerial compensation systems or by peculiar features of the Tax Code. So, if you can’t explain a ﬁrm’s behavior in terms of economic logic, look to bonuses or taxes as possible explanations. 10

The rs value in Equation 5-2 is a required rate of return, but when we transform to obtain Equation 5-4, we are ﬁnding an expected rate of return. Obviously, the transformation requires that rs rˆ s. This equality holds if the stock market is in equilibrium, a condition that will be discussed later in the chapter.

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201

In this form, we see that rˆ s is the expected total return and that it consists of an expected dividend yield, D1/P0 5.4%, plus an expected growth rate or capital gains yield, g 8%. Suppose this analysis had been conducted on January 1, 2003, so P0 $23 is the January 1, 2003, stock price, and D1 $1.242 is the dividend expected at the end of 2003. What is the expected stock price at the end of 2003? We would again apply Equation 5-2, but this time we would use the year-end dividend, D2 D1 (1 g) $1.242(1.08) $1.3414: D2004 $1.3414 Pˆ 12/31/03 $24.84. rs g 0.134 0.08 Now, note that $24.84 is 8 percent larger than P0, the $23 price on January 1, 2003: $23(1.08) $24.84. Thus, we would expect to make a capital gain of $24.84 $23.00 $1.84 during 2003, which would provide a capital gains yield of 8 percent: Capital gains yield2003

Capital gain Beginning price

$1.84 0.08 8%. $23.00

We could extend the analysis on out, and in each future year the expected capital gains yield would always equal g, the expected dividend growth rate. Continuing, the dividend yield in 2004 could be estimated as follows: Dividend yield2003

D2004 $1.3414 0.054 5.4%. ˆP12/31/03 $24.84

The dividend yield for 2005 could also be calculated, and again it would be 5.4 percent. Thus, for a constant growth stock, the following conditions must hold: The popular Motley Fool web site http://www. fool.com/school/ introductiontovaluation. htm provides a good description of some of the beneﬁts and drawbacks of a few of the more commonly used valuation procedures.

1. 2. 3. 4. 5.

The dividend is expected to grow forever at a constant rate, g. The stock price is expected to grow at this same rate. The expected dividend yield is a constant. The expected capital gains yield is also a constant, and it is equal to g. The expected total rate of return, rˆ s, is equal to the expected dividend yield plus the expected growth rate: rˆ s dividend yield g.

The term expected should be clariﬁed—it means expected in a probabilistic sense, as the “statistically expected” outcome. Thus, if we say the growth rate is expected to remain constant at 8 percent, we mean that the best prediction for the growth rate in any future year is 8 percent, not that we literally expect the growth rate to be exactly 8 percent in each future year. In this sense, the constant growth assumption is a reasonable one for many large, mature companies. What conditions must hold if a stock is to be evaluated using the constant growth model? What does the term “expected” mean when we say expected growth rate?

Valuing Stocks That Have a Nonconstant Growth Rate For many companies, it is inappropriate to assume that dividends will grow at a constant rate. Firms typically go through life cycles. During the early part of their lives, their growth is much faster than that of the economy as a whole; then they match the

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economy’s growth; and ﬁnally their growth is slower than that of the economy.11 Automobile manufacturers in the 1920s, computer software ﬁrms such as Microsoft in the 1990s, and Internet ﬁrms such as AOL in the 2000s are examples of ﬁrms in the early part of the cycle; these ﬁrms are called supernormal, or nonconstant, growth ﬁrms. Figure 5-2 illustrates nonconstant growth and also compares it with normal growth, zero growth, and negative growth.12 In the ﬁgure, the dividends of the supernormal growth ﬁrm are expected to grow at a 30 percent rate for three years, after which the growth rate is expected to fall to 8 percent, the assumed average for the economy. The value of this ﬁrm, like any other, is the present value of its expected future dividends as determined by Equation 5-1. When Dt is growing at a constant rate, we simpliﬁed Equation ˆ D /(r g). In the supernormal case, however, the expected growth 5-1 to P 0 1 s rate is not a constant—it declines at the end of the period of supernormal growth. 11

The concept of life cycles could be broadened to product cycle, which would include both small startup companies and large companies like Procter & Gamble, which periodically introduce new products that give sales and earnings a boost. We should also mention business cycles, which alternately depress and boost sales and proﬁts. The growth rate just after a major new product has been introduced, or just after a ﬁrm emerges from the depths of a recession, is likely to be much higher than the “expected long-run average growth rate,” which is the proper number for a DCF analysis. 12

A negative growth rate indicates a declining company. A mining company whose proﬁts are falling because of a declining ore body is an example. Someone buying such a company would expect its earnings, and consequently its dividends and stock price, to decline each year, and this would lead to capital losses rather than capital gains. Obviously, a declining company’s stock price will be relatively low, and its dividend yield must be high enough to offset the expected capital loss and still produce a competitive total return. Students sometimes argue that they would never be willing to buy a stock whose price was expected to decline. However, if the annual dividends are large enough to more than offset the falling stock price, the stock could still provide a good return.

FIGURE 5-2

Illustrative Dividend Growth Rates

Dividend ($) Normal Growth, 8% End of Supernormal Growth Period

Supernormal Growth, 30% Normal Growth, 8%

1.15

Zero Growth, 0%

Declining Growth, –8% 0

1

2

3

4

5 Years

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Stocks and Their Valuation Valuing Stocks That Have a Nonconstant Growth Rate

203

Because Equation 5-2 requires a constant growth rate, we obviously cannot use it to value stocks that have nonconstant growth. However, assuming that a company currently enjoying supernormal growth will eventually slow down and become a constant growth stock, we can combine Equations 5-1 and 5-2 to form a new formula, Equation 5-5, for valuing it. First, we assume that the dividend will grow at a nonconstant rate (generally a relatively high rate) for N periods, after which it will grow at a constant rate, g. N is often called the terminal date, or horizon date. We can use the constant growth formula, Equation 5-2, to determine what the stock’s horizon, or terminal, value will be N periods from today: D (1 g) ˆ N DN1 N Horizon value P (5-2a) rs g rs g ˆ , is the present value of the dividends during the The stock’s intrinsic value today, P 0 nonconstant growth period plus the present value of the horizon value: (1 rs)

1

D2 (1 rs)

2

DN (1 rs)

N

DN1 (1 rs)

N1

PV of dividends during the nonconstant growth period t 1, N. D1 (1 rs)

D2 (1 rs)

2

DN (1 rs)N

PV of dividends during the constant growth period t N 1, ⬁. ˆN P . (5-5) (1 rs)N         

1

D⬁ . (1 rs)⬁

                      

ˆ0 P

              

D1

                  

Pˆ 0

PV of dividends during the nonconstant growth period t 1, N.

PV of horizon ˆ N: value, P [(DN1)/(rs g)] (1 rs)N.

To implement Equation 5-5, we go through the following three steps: 1. Find the PV of the dividends during the period of nonconstant growth. 2. Find the price of the stock at the end of the nonconstant growth period, at which point it has become a constant growth stock, and discount this price back to the present. 3. Add these two components to ﬁnd the intrinsic value of the stock, Pˆ 0. Figure 5-3 can be used to illustrate the process for valuing nonconstant growth stocks. Here we assume the following ﬁve facts exist: rs stockholders’ required rate of return 13.4%. This rate is used to discount the cash ﬂows. N years of supernormal growth 3. gs rate of growth in both earnings and dividends during the supernormal growth period 30%. This rate is shown directly on the time line. Note: The growth rate during the supernormal growth period could vary from year to year. Also, there could be several different supernormal growth periods, e.g., 30% for three years, then 20% for three years, and then a constant 8%.) gn rate of normal, constant growth after the supernormal period 8%. This rate is also shown on the time line, between Periods 3 and 4. D0 last dividend the company paid $1.15.

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CHAPTER 5

Stocks and Their Valuation FIGURE 5-3 0

Process for Finding the Value of a Supernormal Growth Stock 1

gs 30%

D1 1.4950

D2 1.9435

3

30%

gn 8%

D3 2.5266

4 D4 2.7287

↑                  

↑        

13.4% 13.4% 13.4%

2

Pˆ 3 50.5310 53.0576

↑                       

1.3183 1.5113 36.3838

30%

39.2134 $39.21 Pˆ 0

Notes to Figure 5-3: Step 1. Calculate the dividends expected at the end of each year during the supernormal growth period. Calculate the ﬁrst dividend, D1 D0(1 gs) $1.15(1.30) $1.4950. Here gs is the growth rate during the threeyear supernormal growth period, 30 percent. Show the $1.4950 on the time line as the cash ﬂow at Time 1. Then, calculate D2 D1(1 gs) $1.4950(1.30) $1.9435, and then D3 D2(1 gs) $1.9435(1.30) $2.5266. Show these values on the time line as the cash ﬂows at Time 2 and Time 3. Note that D0 is used only to calculate D1. Step 2. The price of the stock is the PV of dividends from Time 1 to inﬁnity, so in theory we could project each future dividend, with the normal growth rate, gn 8%, used to calculate D4 and subsequent dividends. However, we know that after D3 has been paid, which is at Time 3, the stock becomes a constant growth stock. Therefore, we can use the constant growth formula to ﬁnd Pˆ 3, which is the PV of the dividends from Time 4 to inﬁnity as evaluated at Time 3. First, we determine D4 $2.5266(1.08) $2.7287 for use in the formula, and then we calculate Pˆ 3 as follows: D4 $2.7287 $50.5310. Pˆ 3 rs gn 0.134 0.08 We show this $50.5310 on the time line as a second cash ﬂow at Time 3. The $50.5310 is a Time 3 cash ﬂow in the sense that the owner of the stock could sell it for $50.5310 at Time 3 and also in the sense that $50.5310 is the present value of the dividend cash ﬂows from Time 4 to inﬁnity. Note that the total cash ﬂow at Time 3 consists of the sum of D3 Pˆ 3 $2.5266 $50.5310 $53.0576. Step 3. Now that the cash ﬂows have been placed on the time line, we can discount each cash ﬂow at the required rate of return, rs 13.4%. We could discount each ﬂow by dividing by (1.134)t, where t 1 for Time 1, t 2 for Time 2, and t 3 for Time 3. This produces the PVs shown to the left below the time line, and the sum of the PVs is the value of the supernormal growth stock, $39.21. With a ﬁnancial calculator, you can ﬁnd the PV of the cash ﬂows as shown on the time line with the cash ﬂow (CFLO) register of your calculator. Enter 0 for CF0 because you get no cash ﬂow at Time 0, CF1 1.495, CF2 1.9435, and CF3 2.5266 50.531 53.0576. Then enter I 13.4, and press the NPV key to ﬁnd the value of the stock, $39.21.

The valuation process as diagrammed in Figure 5-3 is explained in the steps set forth below the time line. The value of the supernormal growth stock is calculated to be $39.21. Explain how one would ﬁnd the value of a supernormal growth stock. Explain what is meant by “horizon (terminal) date” and “horizon (terminal) value.”

Market Multiple Analysis Another method of stock valuation is market multiple analysis, which applies a market-determined multiple to net income, earnings per share, sales, book value, or, for businesses such as cable TV or cellular telephone systems, the number of subscribers. While the discounted dividend method applies valuation concepts in a precise manner, focusing on expected cash ﬂows, market multiple analysis is more judgmental. To illustrate the concept, suppose that a company’s forecasted earnings per

201

Stocks and Their Valuation Stock Market Equilibrium

205

share is $7.70 in 2003. The average price per share to earnings per share (P/E) ratio for similar publicly traded companies is 12. To estimate the company’s stock value using the market P/E multiple approach, simply multiply its $7.70 earnings per share by the market multiple of 12 to obtain the value of $7.70(12) $92.40. This is its estimated stock price per share. Note that measures other than net income can be used in the market multiple approach. For example, another commonly used measure is earnings before interest, taxes, depreciation, and amortization (EBITDA). The EBITDA multiple is the total value of a company (the market value of equity plus debt) divided by EBITDA. This multiple is based on total value, since EBITDA measures the entire ﬁrm’s performance. Therefore, it is called an entity multiple. The EBITDA market multiple is the average EBITDA multiple for similar publicly traded companies. Multiplying a company’s EBITDA by the market multiple gives an estimate of the company’s total value. To ﬁnd the company’s estimated stock price per share, subtract debt from total value, and then divide by the number of shares of stock. As noted above, in some businesses such as cable TV and cellular telephone, an important element in the valuation process is the number of customers a company has. For example, telephone companies have been paying about $2,000 per customer when acquiring cellular operators. Managed care companies such as HMOs have applied similar logic in acquisitions, basing their valuations on the number of people insured. Some Internet companies have been valued by the number of “eyeballs,” which is the number of hits on the site. What is market multiple analysis? What is an entity multiple?

Stock Market Equilibrium Recall that ri, the required return on Stock i, can be found using the Security Market Line (SML) equation as it was developed in our discussion of the Capital Asset Pricing Model (CAPM) back in Chapter 3: ri rRF (rM rRF)bi. If the risk-free rate of return is 8 percent, the required return on an average stock is 12 percent, and Stock i has a beta of 2, then the marginal investor will require a return of 16 percent on Stock i: ri 8% (12% 8%) 2.0 16% This 16 percent required return is shown as the point on the SML in Figure 5-4 associated with beta 2.0. The marginal investor will want to buy Stock i if its expected rate of return is more than 16 percent, will want to sell it if the expected rate of return is less than 16 percent, and will be indifferent, hence will hold but not buy or sell, if the expected rate of return is exactly 16 percent. Now suppose the investor’s portfolio contains Stock i, and he or she analyzes the stock’s prospects and concludes that its earnings, dividends, and price can be expected to grow at a constant rate of 5 percent per year. The last dividend was D0 $2.8571, so the next expected dividend is D1 $2.8571(1.05) $3. Our marginal investor observes that the present price of the stock, P0, is $30. Should he or she purchase more of Stock i, sell the stock, or maintain the present position?

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The investor can calculate Stock i’s expected rate of return as follows: D1 $3 rˆ i g 5% 15%. P0 $30 This value is plotted on Figure 5-4 as Point i, which is below the SML. Because the expected rate of return is less than the required return, this marginal investor would want to sell the stock, as would most other holders. However, few people would want to buy at the $30 price, so the present owners would be unable to ﬁnd buyers unless they cut the price of the stock. Thus, the price would decline, and this decline would continue until the price reached $27.27, at which point the stock would be in equilibrium, deﬁned as the price at which the expected rate of return, 16 percent, is equal to the required rate of return: $3 rˆ i 5% 11% 5% 16% ri. $27.27 Had the stock initially sold for less than $27.27, say, at $25, events would have been reversed. Investors would have wanted to buy the stock because its expected rate of return would have exceeded its required rate of return, and buy orders would have driven the stock’s price up to $27.27. To summarize, in equilibrium two related conditions must hold: 1. A stock’s expected rate of return as seen by the marginal investor must equal its required rate of return: rˆ i ri. 2. The actual market price of the stock must equal its intrinsic value as estimated by the marginal investor: P0 Pˆ 0. Of course, some individual investors may believe that rˆ i r and Pˆ 0 P0, hence they would invest most of their funds in the stock, while other investors may have an opposite view and would sell all of their shares. However, it is the marginal investor who establishes the actual market price, and for this investor, we must have rˆ i ri and P0 Pˆ 0. If these conditions do not hold, trading will occur until they do.

FIGURE 5-4

Expected and Required Returns on Stock i

Rate of Return (%) SML: ri = rRF + (rM– rRF) bi r i = 16 r i = 15

>

206

i

rM = 12

r =8 RF

0

1.0

2.0

Risk, bi

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Stocks and Their Valuation Stock Market Equilibrium

207

Changes in Equilibrium Stock Prices Stock prices are not constant—they undergo violent changes at times. For example, on September 17, 2001, the ﬁrst day of trading after the terrorist attacks of September 11, the Dow Jones average dropped 685 points. This was the largest decline ever in the Dow, but not the largest percentage loss, which was 22.6 percent on October 19, 1987. The Dow has also had some spectacular increases. In fact, its ﬁfth largest increase was 368 points on September 24, 2001, shortly after its largest-ever decline. The Dow’s largest increase ever was 499 points on April 16, 2000, and its largest percentage gain of 15.4 percent occurred on March 15, 1933. At the risk of understatement, the stock market is volatile! To see how such changes can occur, assume that Stock i is in equilibrium, selling at a price of $27.27. If all expectations were exactly met, during the next year the price would gradually rise to $28.63, or by 5 percent. However, many different events could occur to cause a change in the equilibrium price. To illustrate, consider again the set of inputs used to develop Stock i’s price of $27.27, along with a new set of assumed input variables: Variable Value

Risk-free rate, rRF Market risk premium, rM rRF Stock i’s beta coefﬁcient, bi Stock i’s expected growth rate, gi D0 Price of Stock i

Original

New

8% 4% 2.0 5% $2.8571 $27.27

7% 3% 1.0 6% $2.8571 ?

Now give yourself a test: How would the change in each variable, by itself, affect the price, and what is your guess as to the new stock price? Every change, taken alone, would lead to an increase in the price. The ﬁrst three changes all lower ri, which declines from 16 to 10 percent: Original ri 8% 4%(2.0) 16%. New ri 7% 3%(1.0) 10%. Using these values, together with the new g value, we ﬁnd that Pˆ 0 rises from $27.27 to $75.71.13 $2.8571(1.05) $3 Original Pˆ 0 $27.27. 0.16 0.05 0.11 ˆ 0 $2.8571(1.06) $3.0285 $75.71. New P 0.10 0.06 0.04 At the new price, the expected and required rates of return are equal:14 rˆ i

$3.0285 6% 10% ri. $75.71

13

A price change of this magnitude is by no means rare. The prices of many stocks double or halve during a year. For example, Ciena, a phone equipment maker, fell by 76.1 percent in 1998 but increased by 183 percent in 2000. 14

It should be obvious by now that actual realized rates of return are not necessarily equal to expected and required returns. Thus, an investor might have expected to receive a return of 15 percent if he or she had bought Ciena stock, but after the fact, the realized return was far above 15 percent in 2000 and was far below in 1998.

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As this example illustrates, even small changes in the size or riskiness of expected future dividends can cause large changes in stock prices. What might cause investors to change their expectations about future dividends? It could be new information about the company, such as preliminary results for an R&D program, initial sales of a new product, or the discovery of harmful side effects from the use of an existing product. Or, new information that will affect many companies could arrive, such as a tightening of interest rates by the Federal Reserve. Given the existence of computers and telecommunications networks, new information hits the market on an almost continuous basis, and it causes frequent and sometimes large changes in stock prices. In other words, ready availability of information causes stock prices to be volatile! If a stock’s price is stable, that probably means that little new information is arriving. But if you think it’s risky to invest in a volatile stock, imagine how risky it would be to invest in a stock that rarely released new information about its sales or operations. It may be bad to see your stock’s price jump around, but it would be a lot worse to see a stable quoted price most of the time but then to see huge moves on the rare days when new information was released. Fortunately, in our economy timely information is readily available, and evidence suggests that stocks, especially those of large companies, adjust rapidly to new information. Consequently, equilibrium ordinarily exists for any given stock, and required and expected returns are generally equal. Stock prices certainly change, sometimes violently and rapidly, but this simply reﬂects changing conditions and expectations. There are, of course, times when a stock appears to react for several months to favorable or unfavorable developments. However, this does not signify a long adjustment period; rather, it simply indicates that as more new pieces of information about the situation become available, the market adjusts to them. The ability of the market to adjust to new information is discussed in the next section.

The Efﬁcient Markets Hypothesis A body of theory called the Efﬁcient Markets Hypothesis (EMH) holds (1) that stocks are always in equilibrium and (2) that it is impossible for an investor to consistently “beat the market.” Essentially, those who believe in the EMH note that there are 100,000 or so full-time, highly trained, professional analysts and traders operating in the market, while there are fewer than 3,000 major stocks. Therefore, if each analyst followed 30 stocks (which is about right, as analysts tend to specialize in the stocks in a speciﬁc industry), there would on average be 1,000 analysts following each stock. Further, these analysts work for organizations such as Citibank, Merrill Lynch, Prudential Insurance, and the like, which have billions of dollars available with which to take advantage of bargains. In addition, as a result of SEC disclosure requirements and electronic information networks, as new information about a stock becomes available, these 1,000 analysts generally receive and evaluate it at about the same time. Therefore, the price of a stock will adjust almost immediately to any new development.

Levels of Market Efﬁciency If markets are efﬁcient, stock prices will rapidly reﬂect all available information. This raises an important question: What types of information are available and, therefore, incorporated into stock prices? Financial theorists have discussed three forms, or levels, of market efﬁciency. Weak-Form Efﬁciency The weak form of the EMH states that all information contained in past price movements is fully reﬂected in current market prices. If this were true, then information about recent trends in stock prices would be of no use in selecting stocks—the fact that a stock has risen for the past three days, for example,

205

Stocks and Their Valuation Stock Market Equilibrium

209

would give us no useful clues as to what it will do today or tomorrow. People who believe that weak-form efﬁciency exists also believe that “tape watchers” and “chartists” are wasting their time.15 For example, after studying the past history of the stock market, a chartist might “discover” the following pattern: If a stock falls three consecutive days, its price typically rises 10 percent the following day. The technician would then conclude that investors could make money by purchasing a stock whose price has fallen three consecutive days. But if this pattern truly existed, wouldn’t other investors also discover it, and if so, why would anyone be willing to sell a stock after it had fallen three consecutive days if he or she knows its price is expected to increase by 10 percent the next day? In other words, if a stock is selling at $40 per share after falling three consecutive days, why would investors sell the stock if they expected it to rise to $44 per share one day later? Those who believe in weak-form efﬁciency argue that if the stock was really likely to rise to $44 tomorrow, its price today would actually rise to somewhere near $44 immediately, thereby eliminating the trading opportunity. Consequently, weak-form efﬁciency implies that any information that comes from past stock prices is rapidly incorporated into the current stock price. Semistrong-Form Efﬁciency The semistrong form of the EMH states that current market prices reﬂect all publicly available information. Therefore, if semistrong-form efﬁciency exists, it would do no good to pore over annual reports or other published data because market prices would have adjusted to any good or bad news contained in such reports back when the news came out. With semistrong-form efﬁciency, investors should expect to earn the returns predicted by the SML, but they should not expect to do any better unless they have either good luck or information that is not publicly available. However, insiders (for example, the presidents of companies) who have information that is not publicly available can earn consistently abnormal returns (returns higher than those predicted by the SML) even under semistrong-form efﬁciency. Another implication of semistrong-form efﬁciency is that whenever information is released to the public, stock prices will respond only if the information is different from what had been expected. If, for example, a company announces a 30 percent increase in earnings, and if that increase is about what analysts had been expecting, the announcement should have little or no effect on the company’s stock price. On the other hand, the stock price would probably fall if analysts had expected earnings to increase by more than 30 percent, but it probably would rise if they had expected a smaller increase. Strong-Form Efﬁciency The strong form of the EMH states that current market prices reﬂect all pertinent information, whether publicly available or privately held. If this form holds, even insiders would ﬁnd it impossible to earn consistently abnormal returns in the stock market.16

Implications of Market Efﬁciency What bearing does the EMH have on ﬁnancial decisions? Since stock prices do seem to reﬂect public information, most stocks appear to be fairly valued. This does not 15

Tape watchers are people who watch the NYSE tape, while chartists plot past patterns of stock price movements. Both are called “technical analysts,” and both believe that they can tell if something is happening to the stock that will cause its price to move up or down in the near future. 16 Several cases of illegal insider trading have made the headlines. These cases involved employees of several major investment banking houses and even an employee of the SEC. In the most famous case, Ivan Boesky admitted to making $50 million by purchasing the stock of ﬁrms he knew were about to merge. He went to jail, and he had to pay a large ﬁne, but he helped disprove the strong-form EMH.

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mean that new developments could not cause a stock’s price to soar or to plummet, but it does mean that stocks in general are neither overvalued nor undervalued—they are fairly priced and in equilibrium. However, there are certainly cases in which corporate insiders have information not known to outsiders. If the EMH is correct, it is a waste of time for most of us to analyze stocks by looking for those that are undervalued. If stock prices already reﬂect all publicly available information, and hence are fairly priced, one can “beat the market” consistently only by luck, and it is difﬁcult, if not impossible, for anyone to consistently outperform the market averages. Empirical tests have shown that the EMH is, in its weak and semistrong forms, valid. However, people such as corporate ofﬁcers, who have inside information, can do better than the averages, and individuals and organizations that are especially good at digging out information on small, new companies also seem to do consistently well. Also, some investors may be able to analyze and react more quickly than others to releases of new information, and these investors may have an advantage over others. However, the buy-sell actions of those investors quickly bring market prices into equilibrium. Therefore, it is generally safe to assume that rˆ i r, that Pˆ 0 P0, and that stocks plot on the SML.17 For a stock to be in equilibrium, what two conditions must hold? What is the Efﬁcient Markets Hypothesis (EMH)? What are the differences among the three forms of the EMH: (1) weak form, (2) semistrong form, and (3) strong form? What are the implications of the EMH for ﬁnancial decisions?

Actual Stock Prices and Returns Our discussion thus far has focused on expected stock prices and expected rates of return. Anyone who has ever invested in the stock market knows that there can be, and there generally are, large differences between expected and realized prices and returns. Figure 5-5 shows how the market value of a portfolio of stocks has moved in recent years, and Figure 5-6 shows how total realized returns on the portfolio have varied from year to year. The market trend has been strongly up, but it has gone up in some years and down in others, and the stocks of individual companies have likewise gone up and

17

Market efﬁciency also has important implications for managerial decisions, especially those pertaining to common stock issues, stock repurchases, and tender offers. Stocks appear to be fairly valued, so decisions based on the premise that a stock is undervalued or overvalued must be approached with caution. However, managers do have better information about their own companies than outsiders, and this information can legally be used to the companies’ (but not the managers’) advantage. We should also note that some Wall Street pros have consistently beaten the market over many years, which is inconsistent with the EMH. An interesting article in the April 3, 1995, issue of Fortune (Terence P. Paré, “Yes, You Can Beat the Market”) argued strongly against the EMH. Paré suggested that each stock has a fundamental value, but when good or bad news about it is announced, most investors fail to interpret that news correctly. As a result, stocks are generally priced above or below their long-term values. Think of a graph with stock price on the vertical axis and years on the horizontal axis. A stock’s fundamental value might be moving up steadily over time as it retains and reinvests earnings. However, its actual price might ﬂuctuate about the intrinsic value line, overreacting to good or bad news and indicating departures from equilibrium. Successful value investors, according to the article, use fundamental analysis to identify stocks’ intrinsic values, and then they buy stocks that are undervalued and sell those that are overvalued. Paré’s argument implies that the market is systematically out of equilibrium and that investors can act on this knowledge to beat the market. That position may turn out to be correct, but it may also be that the superior performance Paré noted simply demonstrates that some people are better at obtaining and interpreting information than others, or have just had a run of good luck.

207

Stocks and Their Valuation Actual Stock Prices and Returns FIGURE 5-5

211

S&P 500 Index, 1967–2001

1,500 1,400 1,300 1,200

1,100 1,000 900 800

700 600 500 400 300 200 100 0 1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000 Years

Source: Data taken from various issues of The Wall Street Journal, “Stock Market Data Bank” section.

down.18 We know from theory that expected returns, as estimated by a marginal investor, are always positive, but in some years, as Figure 5-6 shows, actual returns are negative. Of course, even in bad years some individual companies do well, so “the name of the game” in security analysis is to pick the winners. Financial managers attempt to take actions that will put their companies into the winners’ column, but they don’t 18

If we constructed graphs like Figures 5-5 and 5-6 for individual stocks rather than for a large portfolio, far greater variability would be shown. Also, if we constructed a graph like Figure 5-6 for bonds, it would have the same general shape, but the bars would be smaller, indicating that gains and losses on bonds are generally smaller than those on stocks. Above-average bond returns occur in years when interest rates decline, and losses occur when interest rates rise sharply.

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FIGURE 5-6

S&P 500 Index, Total Returns: Dividend Yield Capital Gain or Loss, 1967–2001

Percent 40 30 20 10 0 –10 –20 –30 1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000 Years

Source: Data taken from various issues of The Wall Street Journal.

always succeed. In subsequent chapters, we will examine the actions that managers can take to increase the odds of their ﬁrms doing relatively well in the marketplace.

Investing in International Stocks As noted in Chapter 3, the U.S. stock market amounts to only about 40 percent of the world stock market, and this is prompting many U.S. investors to hold at least some foreign stocks. Analysts have long touted the beneﬁts of investing overseas, arguing that foreign stocks both improve diversiﬁcation and provide good growth opportunities. For example, after the U.S. stock market rose an average of 17.5 percent a year during the 1980s, many analysts thought that the U.S. market in the 1990s was due for a correction, and they suggested that investors should increase their holdings of foreign stocks. To the surprise of many, however, U.S. stocks outperformed foreign stocks in the 1990s—they gained about 15 percent a year versus only 3 percent for foreign stocks. Figure 5-7 shows how stocks in different countries performed in 2001. The number on the left indicates how stocks in each country performed in terms of its local currency, while the right numbers show how the country’s stocks performed in terms of the U.S. dollar. For example, in 2001 Swiss stocks fell by 22.02 percent, but the Swiss Franc fell by about 7.24 percent versus the U.S. dollar. Therefore, if U.S. investors had bought Swiss stocks, they would have lost 22.02 percent in Swiss Franc terms, but those Swiss Francs would have bought 7.24 percent fewer U.S. dollars, so the effective return would have been 29.26 percent. So, the results of foreign investments depend in part on what happens to the exchange rate. Indeed, when you invest overseas, you are making two bets: (1) that foreign stocks will increase in their local markets and (2) that the currencies in which you will be paid will rise relative to the dollar. Although U.S. stocks have outperformed foreign stocks in recent years, this by no means suggests that investors should avoid foreign stocks. Foreign investments still improve diversiﬁcation, and it is inevitable that there will be years when foreign stocks outperform domestic stocks. When this occurs, U.S. investors will be glad they put some of their money in overseas markets.

FIGURE 5-7

2001 Performance of the Dow Jones Global Stock Indexes

Actual Stock Prices and Returns

Source: “World Markets Stumble, Leaving Investors Cautious,” The Wall Street Journal, January 2, 2002, R21. ©2002 Dow Jones & Company, Inc. Reprinted by permission of Dow Jones & Co. via Copyright Clearance Center.

213

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FIGURE 5-8

Stock Quote for Abbott Labs, October 31, 2001

ABBOTT LABS (NYSE:ABT) - More Info: News, Profile, Research, Insider, Options, Msgs - Trade: Choose Brokerage

Last Trade 4:03PM · 52.98 Day's Range 52.98 - 53.99 52-week Range 42.0000 56.2500

Change -0.80 (-1.49%) Bid N/A

Ask N/A

Earn/Shr P/E 1.08 49.80

Div Date Nov 15

Prev Cls 53.78

Volume 3,478,100

Open 53.50

Avg Vol Ex-Div 3,149,409 Oct 11

Mkt Div/Shr Cap 0.84 82.195B

Yield 1.56

Small: [1d | 5d | 1y | none] Big: [1d | 5d | 3m | 6m | 1y | 2y | 5y | max]

Source: Stock quote for Abbott Labs, 10/31/01. Reprinted by permission. For an update of this quote, go to the web site http://ﬁnance.yahoo.com. Enter the ticker symbol for Abbott Labs, ABT, select Detailed from the pull-down menu, and then click the Get button.

Stock Market Reporting Up until a couple of years ago, the best source of stock quotations was the business section of a daily newspaper, such as The Wall Street Journal. One problem with newspapers, however, is that they are only printed once a day. Now it is possible to get quotes all during the day from a wide variety of Internet sources.19 One of the best is Yahoo!, and Figure 5-8 shows a detailed quote for Abbott Labs. As the ﬁrst row of the quote shows, Abbott Labs is traded on the New York Stock Exchange under the symbol ABT. The ﬁrst row also provides links to additional information. The second row starts with the price of the last trade. For Abbott Labs, this was 4:03 P.M. on October 31, 2001, at a price of $52.98. Note that the price is reported in decimals rather than fractions, reﬂecting a recent change in trading conventions. The second row also reports the closing price from the previous day ($53.78) and the change from the previous closing price to the current price. For Abbott Labs, the price fell by $0.80, which was a 1.49 percent decline. The trading volume during the day was 3,478,100 shares of stock. In other words, almost 3.5 million shares of Abbott Labs’ stock changed hands. Immediately below the daily volume is the average daily volume for the past three months. For Abbott Labs, this was 3.1 million shares, which means that trading on October 31 was a little heavier than usual. The last item in the second row shows that Abbott Labs is scheduled to pay a dividend on November 15. As shown on the last row, the annual dividend is $0.84 per share, so the quarterly dividend payment will be $0.21 per share. The third row shows an ex-dividend date of October 11, meaning that the owner of the stock as of October 10 will receive the dividend, no matter who owns the stock on November 15. In other words, the stock trades without the dividend as of October 11. The last

19

Most free sources actually provide quotes that are delayed by 15 minutes.

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Stocks and Their Valuation Actual Stock Prices and Returns

215

A Nation of Traders

A recent story in Fortune proﬁled the dramatic revolution in the way investors trade stocks. Just a few years ago, the vast majority of investors bought and sold stocks by calling a fullservice broker. The typical broker would execute orders, maintain records, assist with stock selection, and provide guidance regarding long-run asset allocations. These services came at a price—when investors bought stocks, the commissions were often well in excess of $100 a trade. While the full-service broker is far from dead, many are on the ropes. Now large and small investors have online access to the same type of company and market information that brokers provide, and they can trade stocks online at less than $10 a trade. These technological changes, combined with the euphoria surrounding the long-running bull market, have encouraged more and more investors to become actively involved in managing their own investments. They tune in regularly to CNBC, and they keep their computer screens “at the ready” to trade on any new information that hits the market. Online trading is by no means relegated to just a few investors—it now represents a signiﬁcant percentage of all trades that occur. The Fortune article pointed out, for example, that in 1989 only 28 percent of households owned stock,

while 10 years later this percentage had risen to 48 percent. Moreover, in 1999 there were 150 Internet brokerage ﬁrms versus only 5 three years earlier. Virtually nonexistent three years ago, today the percentage of stocks traded online is approximately 12.5 percent, and that number is expected to rise to nearly 30 percent in the next two or three years. Changing technology is encouraging more and more investors to take control of their own ﬁnances. While this trend has lowered traditional brokers’ incomes, it has reduced transaction costs, increased information, and empowered investors. Of course, concerns have been raised about whether individual investors fully understand the risks involved, and whether they have sound strategies in place for long-run investing once the current bull market ends. Good or bad, most observers believe that online trading is here to stay. However, there will surely be a continuing, but changing, need for professional advisors and stockbrokers to work with the many investors who need guidance or who tire of the grind of keeping track of their positions. Source: Andy Serwer, Christine Y. Chen, and Angel Key, “A Nation of Traders,” Fortune (1999), 116–120. Copyright © 1999 Time Inc. All rights reserved. Reprinted by permission.

row also reports a dividend yield of 1.56 percent, which is the dividend divided by the stock price. The third row reports the range of prices for the day and the ﬁrst trade of the day, called the open price. Thus, Abbott Labs opened the day at $53.50, traded as low as $52.98 and as high as $53.99, and ﬁnally closed at $52.98, its low for the day. If Abbott Labs had been listed on Nasdaq, the most recent bid and ask quotes from dealers would have been shown. Because Abbott Labs trades on the NYSE, this data is not available. The bottom row shows the price range of Abbott Labs’ stock during the past year, which was from $42.00 to $56.25. The chart to the right shows the daily prices for the past year, and the links below the chart allow a web user to pick different intervals for data in the chart. The bottom row also reports the earnings per share, based on the earnings in the past 12 months. The ratio of the price per share to the earnings per share, the P/E ratio, is shown on the bottom row. For Abbott Labs, this is 49.80. The total market value of all its stock is called Mkt Cap, and it is $82.195 billion. If a stock is not in equilibrium, explain how ﬁnancial markets adjust to bring it into equilibrium. Explain why expected, required, and realized returns are often different. What are the key beneﬁts of adding foreign stocks to a portfolio? When a U.S. investor purchases foreign stocks, what two things is he or she hoping will happen?

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Preferred Stock Preferred stock is a hybrid—it is similar to bonds in some respects and to common stock in others. The hybrid nature of preferred stock becomes apparent when we try to classify it in relation to bonds and common stock. Like bonds, preferred stock has a par value and a ﬁxed amount of dividends that must be paid before dividends can be paid on the common stock. However, if the preferred dividend is not earned, the directors can omit (or “pass”) it without throwing the company into bankruptcy. So, although preferred stock has a ﬁxed payment like bonds, a failure to make this payment will not lead to bankruptcy. As noted above, a preferred stock entitles its owners to regular, ﬁxed dividend payments. If the payments last forever, the issue is a perpetuity whose value, Vp, is found as follows: Vp

Dp rp

(5-6)

.

Vp is the value of the preferred stock, Dp is the preferred dividend, and rp is the required rate of return. MicroDrive has preferred stock outstanding that pays a dividend of $10 per year. If the required rate of return on this preferred stock is 10 percent, then its value is $100, found by solving Equation 5-6 as follows: Vp

$10.00 $100.00. 0.10

If we know the current price of a preferred stock and its dividend, we can solve for the rate of return as follows: rp

Dp Vp

.

(5-6a)

Some preferred stocks have a stated maturity date, say, 50 years. If MicroDrive’s preferred matured in 50 years, paid a $10 annual dividend, and had a required return of 8 percent, then we could ﬁnd its price as follows: Enter N 50, I 8, PMT 10, and FV 100. Then press PV to ﬁnd the price, Vp $124.47. If rp I 10%, change I 8 to I 10, and ﬁnd P Vp PV $100. If you know the price of a share of preferred stock, you can solve for I to ﬁnd the expected rate of return, rˆ p. Most preferred stocks pay dividends quarterly. This is true for MicroDrive, so we could ﬁnd the effective rate of return on its preferred stock (perpetual or maturing) as follows: EFF% EARp a1

r Nom m 0.10 4 b 1 a1 b 1 10.38%. m 4

If an investor wanted to compare the returns on MicroDrive’s bonds and its preferred stock, it would be best to convert the nominal rates on each security to effective rates and then compare these “equivalent annual rates.” Explain the following statement: “Preferred stock is a hybrid security.” Is the equation used to value preferred stock more like the one used to evaluate a perpetual bond or the one used for common stock?

213

Stocks and Their Valuation Summary

217

Summary Corporate decisions should be analyzed in terms of how alternative courses of action are likely to affect a ﬁrm’s value. However, it is necessary to know how stock prices are established before attempting to measure how a given decision will affect a speciﬁc ﬁrm’s value. This chapter showed how stock values are determined, and also how investors go about estimating the rates of return they expect to earn. The key concepts covered are listed below. 䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

A proxy is a document that gives one person the power to act for another, typically the power to vote shares of common stock. A proxy ﬁght occurs when an outside group solicits stockholders’ proxies in an effort to vote a new management team into ofﬁce. A takeover occurs when a person or group succeeds in ousting a ﬁrm’s management and takes control of the company. Stockholders often have the right to purchase any additional shares sold by the ﬁrm. This right, called the preemptive right, protects the control of the present stockholders and prevents dilution of their value. Although most ﬁrms have only one type of common stock, in some instances classiﬁed stock is used to meet the special needs of the company. One type is founders’ shares. This is stock owned by the ﬁrm’s founders that carries sole voting rights but restricted dividends for a speciﬁed number of years. A closely held corporation is one that is owned by a few individuals who are typically associated with the ﬁrm’s management. A publicly owned corporation is one that is owned by a relatively large number of individuals who are not actively involved in its management. Whenever stock in a closely held corporation is offered to the public for the ﬁrst time, the company is said to be going public. The market for stock that is just being offered to the public is called the initial public offering (IPO) market. The value of a share of stock is calculated as the present value of the stream of dividends the stock is expected to provide in the future. The equation used to ﬁnd the value of a constant growth stock is: Pˆ 0

䊉

䊉

The expected total rate of return from a stock consists of an expected dividend yield plus an expected capital gains yield. For a constant growth ﬁrm, both the expected dividend yield and the expected capital gains yield are constant. The equation for rˆ s, the expected rate of return on a constant growth stock, can be expressed as follows: rˆ s

䊉

䊉

D1 . rs g

D1 g. P0

A zero growth stock is one whose future dividends are not expected to grow at all, while a supernormal growth stock is one whose earnings and dividends are expected to grow much faster than the economy as a whole over some speciﬁed time period and then to grow at the “normal” rate. To ﬁnd the present value of a supernormal growth stock, (1) ﬁnd the dividends expected during the supernormal growth period, (2) ﬁnd the price of the stock at the end of the supernormal growth period, (3) discount the dividends and the projected price back to the present, and (4) sum these PVs to ﬁnd the current value of the stock, Pˆ 0.

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CHAPTER 5

Stocks and Their Valuation 䊉

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The horizon (terminal) date is the date when individual dividend forecasts are no longer made because the dividend growth rate is assumed to be constant. The horizon (terminal) value is the value at the horizon date of all future dividends after that date. The marginal investor is a representative investor whose actions reﬂect the beliefs of those people who are currently trading a stock. It is the marginal investor who determines a stock’s price. Equilibrium is the condition under which the expected return on a security as seen by the marginal investor is just equal to its required return, rˆ r. Also, the stock’s intrinsic value must be equal to its market price, Pˆ 0 P0, and the market price is stable. The Efﬁcient Markets Hypothesis (EMH) holds (1) that stocks are always in equilibrium and (2) that it is impossible for an investor who does not have inside information to consistently “beat the market.” Therefore, according to the EMH, stocks are always fairly valued (Pˆ 0 P0), the required return on a stock is equal to its expected return (r rˆ ), and all stocks’ expected returns plot on the SML. Differences can and do exist between expected and realized returns in the stock and bond markets—only for short-term, risk-free assets are expected and actual (or realized) returns equal. When U.S. investors purchase foreign stocks, they hope (1) that stock prices will increase in the local market and (2) that the foreign currencies will rise relative to the U.S. dollar. Preferred stock is a hybrid security having some characteristics of debt and some of equity. Most preferred stocks are perpetuities, and the value of a share of perpetual preferred stock is found as the dividend divided by the required rate of return: Vp

䊉

Dp rp

.

Maturing preferred stock is evaluated with a formula that is identical in form to the bond value formula.

Questions 5–1

Deﬁne each of the following terms: a. Proxy; proxy ﬁght; takeover; preemptive right; classiﬁed stock; founders’ shares b. Closely held corporation; publicly owned corporation c. Secondary market; primary market; going public; initial public offering (IPO) d. Intrinsic value (Pˆ 0); market price (P0) e. Required rate of return, rs; expected rate of return, rˆ s; actual, or realized, rate of return, rs f. Capital gains yield; dividend yield; expected total return g. Normal, or constant, growth; supernormal, or nonconstant, growth; zero growth stock h. Equilibrium; Efﬁcient Markets Hypothesis (EMH); three forms of EMH i. Preferred stock

5–2

Two investors are evaluating AT&T’s stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the riskiness of the stock. However, one investor normally holds stocks for 2 years, while the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for AT&T’s stock. True or false? Explain.

5–3

A bond that pays interest forever and has no maturity date is a perpetual bond. In what respect is a perpetual bond similar to a no-growth common stock, and to a share of preferred stock?

215

Stocks and Their Valuation Problems

Self-Test Problems ST–1 CONSTANT GROWTH STOCK VALUATION

ST–2 SUPERNORMAL GROWTH STOCK VALUATION

219

(Solutions Appear in Appendix A)

Ewald Company’s current stock price is $36, and its last dividend was $2.40. In view of Ewald’s strong ﬁnancial position and its consequent low risk, its required rate of return is only 12 percent. If dividends are expected to grow at a constant rate, g, in the future, and if rs is expected to remain at 12 percent, what is Ewald’s expected stock price 5 years from now? Snyder Computer Chips Inc. is experiencing a period of rapid growth. Earnings and dividends are expected to grow at a rate of 15 percent during the next 2 years, at 13 percent in the third year, and at a constant rate of 6 percent thereafter. Snyder’s last dividend was $1.15, and the required rate of return on the stock is 12 percent. a. Calculate the value of the stock today. b. Calculate Pˆ 1 and Pˆ 2. c. Calculate the dividend yield and capital gains yield for Years 1, 2, and 3.

Problems 5–1 DPS CALCULATION

5–2 CONSTANT GROWTH VALUATION

5–3 CONSTANT GROWTH VALUATION

5–4 PREFERRED STOCK VALUATION

5–5 SUPERNORMAL GROWTH VALUATION

5–6 CONSTANT GROWTH RATE, G

5–7 CONSTANT GROWTH VALUATION

5–8 PREFERRED STOCK RATE OF RETURN

5–9 DECLINING GROWTH STOCK VALUATION

Warr Corporation just paid a dividend of $1.50 a share (i.e., D0 $1.50). The dividend is expected to grow 5 percent a year for the next 3 years, and then 10 percent a year thereafter. What is the expected dividend per share for each of the next 5 years? Thomas Brothers is expected to pay a $0.50 per share dividend at the end of the year (i.e., D1 $0.50). The dividend is expected to grow at a constant rate of 7 percent a year. The required rate of return on the stock, rs, is 15 percent. What is the value per share of the company’s stock? Harrison Clothiers’ stock currently sells for $20 a share. The stock just paid a dividend of $1.00 a share (i.e., D0 $1.00). The dividend is expected to grow at a constant rate of 10 percent a year. What stock price is expected 1 year from now? What is the required rate of return on the company’s stock? Fee Founders has preferred stock outstanding which pays a dividend of $5 at the end of each year. The preferred stock sells for $60 a share. What is the preferred stock’s required rate of return? A company currently pays a dividend of $2 per share, D0 2. It is estimated that the company’s dividend will grow at a rate of 20 percent per year for the next 2 years, then the dividend will grow at a constant rate of 7 percent thereafter. The company’s stock has a beta equal to 1.2, the risk-free rate is 7.5 percent, and the market risk premium is 4 percent. What would you estimate is the stock’s current price? A stock is trading at $80 per share. The stock is expected to have a year-end dividend of $4 per share (D1 4), which is expected to grow at some constant rate g throughout time. The stock’s required rate of return is 14 percent. If you are an analyst who believes in efﬁcient markets, what would be your forecast of g? You are considering an investment in the common stock of Keller Corp. The stock is expected to pay a dividend of $2 a share at the end of the year (D1 $2.00). The stock has a beta equal to 0.9. The risk-free rate is 5.6 percent, and the market risk premium is 6 percent. The stock’s dividend is expected to grow at some constant rate g. The stock currently sells for $25 a share. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? (That is, what is Pˆ 3?) What will be the nominal rate of return on a preferred stock with a $100 par value, a stated dividend of 8 percent of par, and a current market price of (a) $60, (b) $80, (c) $100, and (d) $140? Martell Mining Company’s ore reserves are being depleted, so its sales are falling. Also, its pit is getting deeper each year, so its costs are rising. As a result, the company’s earnings and dividends are declining at the constant rate of 5 percent per year. If D0 $5 and rs 15%, what is the value of Martell Mining’s stock?

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Stocks and Their Valuation 5–10

RATES OF RETURN AND EQUILIBRIUM

5–11 SUPERNORMAL GROWTH STOCK VALUATION

5–12 SUPERNORMAL GROWTH STOCK VALUATION

5–13 PREFERRED STOCK VALUATION

5–14 CONSTANT GROWTH STOCK VALUATION

5–15 RETURN ON COMMON STOCK

The beta coefﬁcient for Stock C is bC 0.4, whereas that for Stock D is bD 0.5. (Stock D’s beta is negative, indicating that its rate of return rises whenever returns on most other stocks fall. There are very few negative beta stocks, although collection agency stocks are sometimes cited as an example.) a. If the risk-free rate is 9 percent and the expected rate of return on an average stock is 13 percent, what are the required rates of return on Stocks C and D? b. For Stock C, suppose the current price, P0, is $25; the next expected dividend, D1, is $1.50; and the stock’s expected constant growth rate is 4 percent. Is the stock in equilibrium? Explain, and describe what will happen if the stock is not in equilibrium. Assume that the average ﬁrm in your company’s industry is expected to grow at a constant rate of 6 percent and its dividend yield is 7 percent. Your company is about as risky as the average ﬁrm in the industry, but it has just successfully completed some R&D work that leads you to expect that its earnings and dividends will grow at a rate of 50 percent [D1 D0(1 g) D0(1.50)] this year and 25 percent the following year, after which growth should match the 6 percent industry average rate. The last dividend paid (D0) was $1. What is the value per share of your ﬁrm’s stock? Microtech Corporation is expanding rapidly, and it currently needs to retain all of its earnings, hence it does not pay any dividends. However, investors expect Microtech to begin paying dividends, with the ﬁrst dividend of $1.00 coming 3 years from today. The dividend should grow rapidly—at a rate of 50 percent per year—during Years 4 and 5. After Year 5, the company should grow at a constant rate of 8 percent per year. If the required return on the stock is 15 percent, what is the value of the stock today? Ezzell Corporation issued preferred stock with a stated dividend of 10 percent of par. Preferred stock of this type currently yields 8 percent, and the par value is $100. Assume dividends are paid annually. a. What is the value of Ezzell’s preferred stock? b. Suppose interest rate levels rise to the point where the preferred stock now yields 12 percent. What would be the value of Ezzell’s preferred stock? Your broker offers to sell you some shares of Bahnsen & Co. common stock that paid a dividend of $2 yesterday. You expect the dividend to grow at the rate of 5 percent per year for the next 3 years, and, if you buy the stock, you plan to hold it for 3 years and then sell it. a. Find the expected dividend for each of the next 3 years; that is, calculate D1, D2, and D3. Note that D0 $2. b. Given that the appropriate discount rate is 12 percent and that the ﬁrst of these dividend payments will occur 1 year from now, ﬁnd the present value of the dividend stream; that is, calculate the PV of D1, D2, and D3, and then sum these PVs. c. You expect the price of the stock 3 years from now to be $34.73; that is, you expect Pˆ 3 to equal $34.73. Discounted at a 12 percent rate, what is the present value of this expected future stock price? In other words, calculate the PV of $34.73. d. If you plan to buy the stock, hold it for 3 years, and then sell it for $34.73, what is the most you should pay for it? e. Use Equation 5-2 to calculate the present value of this stock. Assume that g 5%, and it is constant. f. Is the value of this stock dependent upon how long you plan to hold it? In other words, if your planned holding period were 2 years or 5 years rather than 3 years, would this affect the value of the stock today, Pˆ 0? You buy a share of The Ludwig Corporation stock for $21.40. You expect it to pay dividends of $1.07, $1.1449, and $1.2250 in Years 1, 2, and 3, respectively, and you expect to sell it at a price of $26.22 at the end of 3 years. a. Calculate the growth rate in dividends. b. Calculate the expected dividend yield. c. Assuming that the calculated growth rate is expected to continue, you can add the dividend yield to the expected growth rate to get the expected total rate of return. What is this stock’s expected total rate of return?

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Stocks and Their Valuation Problems 5–16 CONSTANT GROWTH STOCK VALUATION

5–17 SUPERNORMAL GROWTH STOCK VALUATION

5–18 SUPERNORMAL GROWTH STOCK VALUATION

5–19 EQUILIBRIUM STOCK PRICE

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Investors require a 15 percent rate of return on Levine Company’s stock (rs 15%). a. What will be Levine’s stock value if the previous dividend was D0 $2 and if investors expect dividends to grow at a constant compound annual rate of (1) 5 percent, (2) 0 percent, (3) 5 percent, and (4) 10 percent? b. Using data from part a, what is the Gordon (constant growth) model value for Levine’s stock if the required rate of return is 15 percent and the expected growth rate is (1) 15 percent or (2) 20 percent? Are these reasonable results? Explain. c. Is it reasonable to expect that a constant growth stock would have g rs? Wayne-Martin Electric Inc. (WME) has just developed a solar panel capable of generating 200 percent more electricity than any solar panel currently on the market. As a result, WME is expected to experience a 15 percent annual growth rate for the next 5 years. By the end of 5 years, other ﬁrms will have developed comparable technology, and WME’s growth rate will slow to 5 percent per year indeﬁnitely. Stockholders require a return of 12 percent on WME’s stock. The most recent annual dividend (D0), which was paid yesterday, was $1.75 per share. a. Calculate WME’s expected dividends for t 1, t 2, t 3, t 4, and t 5. b. Calculate the value of the stock today, Pˆ 0. Proceed by ﬁnding the present value of the dividends expected at t 1, t 2, t 3, t 4, and t 5 plus the present value of the stock price which should exist at t 5, Pˆ 5. The Pˆ 5 stock price can be found by using the constant growth equation. Notice that to ﬁnd Pˆ 5, you use the dividend expected at t 6, which is 5 percent greater than the t 5 dividend. c. Calculate the expected dividend yield, D1/P0, the capital gains yield expected during the ﬁrst year, and the expected total return (dividend yield plus capital gains yield) during the ﬁrst year. (Assume that Pˆ 0 P0, and recognize that the capital gains yield is equal to the total return minus the dividend yield.) Also calculate these same three yields for t 5 (e.g., D6/P5). Taussig Technologies Corporation (TTC) has been growing at a rate of 20 percent per year in recent years. This same growth rate is expected to last for another 2 years. a. If D0 $1.60, rs 10%, and gn 6%, what is TTC’s stock worth today? What are its expected dividend yield and capital gains yield at this time? b. Now assume that TTC’s period of supernormal growth is to last another 5 years rather than 2 years. How would this affect its price, dividend yield, and capital gains yield? Answer in words only. c. What will be TTC’s dividend yield and capital gains yield once its period of supernormal growth ends? (Hint: These values will be the same regardless of whether you examine the case of 2 or 5 years of supernormal growth; the calculations are very easy.) d. Of what interest to investors is the changing relationship between dividend yield and capital gains yield over time? The risk-free rate of return, rRF, is 11 percent; the required rate of return on the market, rM, is 14 percent; and Upton Company’s stock has a beta coefﬁcient of 1.5. a. If the dividend expected during the coming year, D1, is $2.25, and if g a constant 5%, at what price should Upton’s stock sell? b. Now, suppose the Federal Reserve Board increases the money supply, causing the risk-free rate to drop to 9 percent and rM to fall to 12 percent. What would this do to the price of the stock? c. In addition to the change in part b, suppose investors’ risk aversion declines; this fact, combined with the decline in rRF, causes rM to fall to 11 percent. At what price would Upton’s stock sell? d. Now, suppose Upton has a change in management. The new group institutes policies that increase the expected constant growth rate to 6 percent. Also, the new management stabilizes sales and proﬁts, and thus causes the beta coefﬁcient to decline from 1.5 to 1.3. Assume that rRF and rM are equal to the values in part c. After all these changes, what is Upton’s new equilibrium price? (Note: D1 goes to $2.27.)

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Spreadsheet Problem 5–20 BUILD A MODEL: SUPERNORMAL GROWTH AND CORPORATE VALUATION

See Ch 05 Show.ppt and Ch 05 Mini Case.xls.

Start with the partial model in the ﬁle Ch 05 P20 Build a Model.xls from the textbook’s web site. Rework Problem 5-18, parts a, b, and c, using a spreadsheet model. For part b, calculate the price, dividend yield, and capital gains yield as called for in the problem.

Robert Balik and Carol Kiefer are senior vice-presidents of the Mutual of Chicago Insurance Company. They are co-directors of the company’s pension fund management division, with Balik having responsibility for ﬁxed income securities (primarily bonds) and Kiefer being responsible for equity investments. A major new client, the California League of Cities, has requested that Mutual of Chicago present an investment seminar to the mayors of the represented cities, and Balik and Kiefer, who will make the actual presentation, have asked you to help them. To illustrate the common stock valuation process, Balik and Kiefer have asked you to analyze the Bon Temps Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. You are to answer the following questions. a. Describe brieﬂy the legal rights and privileges of common stockholders. b. (1) Write out a formula that can be used to value any stock, regardless of its dividend pattern. (2) What is a constant growth stock? How are constant growth stocks valued? (3) What happens if a company has a constant g which exceeds its rs? Will many stocks have expected g rs in the short run (i.e., for the next few years)? In the long run (i.e., forever)? c. Assume that Bon Temps has a beta coefﬁcient of 1.2, that the risk-free rate (the yield on T-bonds) is 7 percent, and that the market risk premium is 5 percent. What is the required rate of return on the ﬁrm’s stock? d. Assume that Bon Temps is a constant growth company whose last dividend (D0, which was paid yesterday) was $2.00 and whose dividend is expected to grow indeﬁnitely at a 6 percent rate. (1) What is the ﬁrm’s expected dividend stream over the next 3 years? (2) What is the ﬁrm’s current stock price? (3) What is the stock’s expected value 1 year from now? (4) What are the expected dividend yield, the capital gains yield, and the total return during the ﬁrst year? e. Now assume that the stock is currently selling at $30.29. What is the expected rate of return on the stock? f. What would the stock price be if its dividends were expected to have zero growth? g. Now assume that Bon Temps is expected to experience supernormal growth of 30 percent for the next 3 years, then to return to its long-run constant growth rate of 6 percent. What is the stock’s value under these conditions? What is its expected dividend yield and capital gains yield in Year 1? In Year 4? h. Is the stock price based more on long-term or short-term expectations? Answer this by ﬁnding the percentage of Bon Temps’ current stock price based on dividends expected more than 3 years in the future. i. Suppose Bon Temps is expected to experience zero growth during the ﬁrst 3 years and then to resume its steady-state growth of 6 percent in the fourth year. What is the stock’s value now? What is its expected dividend yield and its capital gains yield in Year 1? In Year 4? j. Finally, assume that Bon Temps’ earnings and dividends are expected to decline by a constant 6 percent per year, that is, g 6%. Why would anyone be willing to buy such a stock, and at what price should it sell? What would be the dividend yield and capital gains yield in each year?

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Stocks and Their Valuation Selected Additional References and Cases

223

k. What is market multiple analysis? l. Why do stock prices change? Suppose the expected D1 is $2, the growth rate is 5 percent, and rs is 10 percent. Using the constant growth model, what is the price? What is the impact on stock price if g is 4 percent or 6 percent? If rs is 9 percent or 11 percent? m. What does market equilibrium mean? n. If equilibrium does not exist, how will it be established? o. What is the Efﬁcient Markets Hypothesis, what are its three forms, and what are its implications? p. Bon Temps recently issued preferred stock. It pays an annual dividend of $5, and the issue price was $50 per share. What is the expected return to an investor on this preferred stock?

Selected Additional References and Cases Many investment textbooks cover stock valuation models in depth, and some are listed in the Chapter 3 references. For some recent works on valuation, see Bey, Roger P., and J. Markham Collins, “The Relationship between Before- and After-Tax Yields on Financial Assets,” The Financial Review, August 1988, 313–343. Brooks, Robert, and Billy Helms, “An N-Stage, Fractional Period, Quarterly Dividend Discount Model,” Financial Review, November 1990, 651–657.

Copeland, Tom, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed. (New York: John Wiley & Sons, Inc., 2000). The following cases in the Cases in Financial Management series cover many of the valuation concepts contained in this chapter: Case 3, “Peachtree Securities, Inc. (B)”; Case 43, “SwanDavis”; Case 49, Beatrice Peabody”; and Case 101, “TECO Energy.”

66

The Cost of Capital G

eneral Electric has long been recognized as one of the world’s best-managed companies, and it has rewarded its shareholders with outstanding returns. During its corporate life, GE has raised a cumulative $76 billion in capital from its investors, but it has turned that $76 billion investment into a company worth more than $543 billion. Its Market Value Added (MVA), the difference between its market value and the capital investors put up, is a whopping $467 billion! Not surprisingly, GE is always at or near the top of all companies in MVA. When investors provide a corporation with funding, they expect the company to generate an appropriate return on those funds. From the company’s perspective, the investors’ expected return is a cost of using the funds, and it is called the cost of capital. A variety of factors inﬂuence a ﬁrm’s cost of capital. Some, such as the level of interest rates, state and federal tax policies, and the regulatory environment, are outside the ﬁrm’s control. However, the degree of risk in the projects it undertakes and the types of funds it raises are under the company’s control, and both have a profound effect on its cost of capital. GE’s overall cost of capital has been estimated to be about 12.5 percent. Therefore, to satisfy its investors, GE must generate a return on an average project of at least 12.5 percent. Some of GE’s projects are “home grown” in the sense that the company has developed a new product or entered a new geographic market. For example, GE’s aircraft engine division won more than 50 percent of the world’s engine orders for airline passenger jets, and its appliance division recently introduced the Advantium speedcooking oven and the ultra-quiet Triton dishwasher. GE began Lexan® polycarbonate production at a new plastics plant in Cartagena, Spain, and GE Capital expanded in Japan by creating a new life insurance company. Sometimes GE creates completely new lines of business, such as its recent entry into e-commerce. In fact, GE was named “E-Business of the Year” in 2000 by InternetWeek magazine. When GE evaluates potential projects such as these, it must determine whether the return on the capital invested in the project exceeds the cost of that capital. GE also invests by acquiring other companies. In recent years, GE has spent billions annually to acquire hundreds of companies. For example, GE recently acquired Marquette Medical Systems, Stewart & Stevenson's gas turbine division, and Phoenixcor’s commercial equipment leasing portfolio. GE must estimate its expected return on capital, and the cost of capital, for each of these acquisitions, and then make the investment only if the return is greater than the cost. How has GE done with its investments? It has produced a return on capital of 17.2 percent, well above its 12.5 percent estimated cost of capital. With such a large differential, it is no wonder that GE has created a great deal of value for its investors. Sources: Various issues of Fortune; the General Electric web site, http://www.ge.com; and the Stern Stewart & Co. web site, http://www.sternstewart.com.

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Most important business decisions require capital. For example, when Daimler-Benz decided to develop the Mercedes ML 320 sports utility vehicle and to build a plant in Alabama to produce it, Daimler had to estimate the total investment that would be reThe textbook’s web site quired and the cost of the required capital. The expected rate of return exceeded the contains an Excel ﬁle that cost of the capital, so Daimler went ahead with the project. Microsoft had to make a will guide you through the similar decision with Windows XP, Pﬁzer with Viagra, and South-Western when it chapter’s calculations. The ﬁle for this chapter is Ch 06 decided to publish this textbook. Mergers and acquisitions often require enormous amounts of capital. For example, Tool Kit.xls, and we encourage you to open the ﬁle and Vodafone Group, a large telecommunications company in the United Kingdom, spent follow along as you read the $60 billion to acquire AirTouch Communications, a U.S. telecommunications comchapter. pany, in 1999. The resulting company, Vodafone AirTouch, later made a $124 billion offer for Mannesmann, a German company. In both cases, Vodafone estimated the incremental cash ﬂows that would result from the acquisition, then discounted those cash ﬂows at the estimated cost of capital. The resulting values were greater than the targets’ market prices, so Vodafone made the offers. Recent survey evidence indicates that almost half of all large companies have elements in their compensation plans that use the concept of Economic Value Added (EVA). As described in Chapter 9, EVA is the difference between net operating proﬁt after-taxes and a charge for capital, where the capital charge is calculated by multiplying the amount of capital by the cost of capital. Thus, the cost of capital is an increasingly important component of compensation plans. The cost of capital is also a key factor in choosing the mixture of debt and equity used to ﬁnance the ﬁrm. As these examples illustrate, the cost of capital is a critical element in business decisions.1

The Weighted Average Cost of Capital What precisely do the terms “cost of capital” and “weighted average cost of capital” mean? To begin, note that it is possible to ﬁnance a ﬁrm entirely with common equity. However, most ﬁrms employ several types of capital, called capital components, with common and preferred stock, along with debt, being the three most frequently used types. All capital components have one feature in common: The investors who provided the funds expect to receive a return on their investment. If a ﬁrm’s only investors were common stockholders, then the cost of capital would be the required rate of return on equity. However, most ﬁrms employ different types of capital, and, due to differences in risk, these different securities have different required rates of return. The required rate of return on each capital component is called its component cost, and the cost of capital used to analyze capital budgeting decisions should be a weighted average of the various components’ costs. We call this weighted average just that, the weighted average cost of capital, or WACC. Most ﬁrms set target percentages for the different ﬁnancing sources. For example, National Computer Corporation (NCC) plans to raise 30 percent of its required capital as debt, 10 percent as preferred stock, and 60 percent as common equity. This is its target capital structure. We discuss how targets are established in Chapter 13, but for now simply accept NCC’s 30/10/60 debt, preferred, and common percentages as given. 1

The cost of capital is an important factor in the regulation of electric, gas, and telephone companies. These utilities are natural monopolies in the sense that one ﬁrm can supply service at a lower cost than could two or more ﬁrms. Because it has a monopoly, your electric or telephone company could, if it were unregulated, exploit you. Therefore, regulators (1) determine the cost of the capital investors have provided the utility and (2) then set rates designed to permit the company to earn its cost of capital, no more and no less.

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Although NCC and other ﬁrms try to stay close to their target capital structures, they frequently deviate in the short run for several reasons. First, market conditions may be more favorable in one market than another at a particular time. For example, if the stock market is extremely strong, a company may decide to issue common stock. The second, and probably more important, reason for deviations relates to ﬂotation costs, which are the costs that a ﬁrm must incur to issue securities. Flotation costs are addressed in detail later in the chapter, but note that these costs are to a large extent ﬁxed, so they become prohibitively high if small amounts of capital are raised. Thus, it is inefﬁcient and expensive to issue relatively small amounts of debt, preferred stock, and common stock. Therefore, a company might issue common stock one year, debt in the next couple of years, and preferred the following year, thus ﬂuctuating around its target capital structure rather than staying right on it all the time. This situation can cause managers to make a serious error in selecting projects, a process called capital budgeting. To illustrate, assume that NCC is currently at its target capital structure, and it is now considering how to raise capital to ﬁnance next year’s projects. NCC could raise a combination of debt and equity, but to minimize ﬂotation costs it will raise either debt or equity, but not both. Suppose NCC borrows heavily at 8 percent during 2003 to ﬁnance long-term projects that yield 10 percent. In 2004, it has new long-term projects available that yield 13 percent, well above the return on the 2003 projects. However, to return to its target capital structure, it must issue equity, which costs 15.3 percent. Therefore, the company might incorrectly reject these 13 percent projects because they would have to be ﬁnanced with funds costing 15.3percent. However, this entire line of reasoning would be incorrect. Why should a company accept 10 percent long-term projects one year and then reject 13 percent long-term projects the next? Note also that if NCC had reversed the order of its ﬁnancing, raising equity in 2003 and debt in 2004, it would have reversed its decisions, rejecting all projects in 2003 and accepting them all in 2004. Does it make sense to accept or reject projects just because of the more or less arbitrary sequence in which capital is raised? The answer is no. To avoid such errors, managers should view companies as ongoing concerns, and calculate their costs of capital as weighted averages of the various types of funds they use, regardless of the speciﬁc source of ﬁnancing employed in a particular year. The following sections discuss each of the component costs in more detail, and then we show how to combine them to calculate the weighted average cost of capital. What are the three major capital components? What is a component cost? What is a target capital structure? Why should the cost of capital used in capital budgeting be calculated as a weighted average of the various types of funds the ﬁrm generally uses rather than the cost of the speciﬁc ﬁnancing used to fund a particular project?

Cost of Debt, rd(1 ⴚ T) The ﬁrst step in estimating the cost of debt is to determine the rate of return debtholders require, or rd. Although estimating rd is conceptually straightforward, some problems arise in practice. Companies use both ﬁxed and ﬂoating rate debt, straight and convertible debt, and debt with and without sinking funds, and each form has a somewhat different cost. It is unlikely that the ﬁnancial manager will know at the start of a planning period the exact types and amounts of debt that will be used during the period: The type or

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types used will depend on the speciﬁc assets to be ﬁnanced and on capital market conditions as they develop over time. Even so, the ﬁnancial manager does know what types of debt are typical for his or her ﬁrm. For example, NCC typically issues commercial paper to raise short-term money to ﬁnance working capital, and it issues 30year bonds to raise long-term debt used to ﬁnance its capital budgeting projects. Since the WACC is used primarily in capital budgeting, NCC’s treasurer uses the cost of 30year bonds in her WACC estimate. Assume that it is January 2003, and NCC’s treasurer is estimating the WACC for the coming year. How should she calculate the component cost of debt? Most ﬁnancial managers would begin by discussing current and prospective interest rates with their investment bankers. Assume that NCC’s bankers state that a new 30-year, noncallable, straight bond issue would require an 11 percent coupon rate with semiannual payments, and that it would be offered to the public at its $1,000 par value. Therefore, rd is equal to 11 percent.2 Note that the 11 percent is the cost of new, or marginal, debt, and it will probably not be the same as the average rate on NCC’s previously issued debt, which is called the historical, or embedded, rate. The embedded cost is important for some decisions but not for others. For example, the average cost of all the capital raised in the past and still outstanding is used by regulators when they determine the rate of return a public utility should be allowed to earn. However, in ﬁnancial management the WACC is used primarily to make investment decisions, and these decisions hinge on projects’ expected future returns versus the cost of new, or marginal, capital. Thus, for our purposes, the relevant cost is the marginal cost of new debt to be raised during the planning period. Suppose NCC had issued debt in the past, and its bonds are publicly traded. The ﬁnancial staff could use the market price of the bonds to ﬁnd their yield to maturity (or yield to call if the bonds sell at a premium and are likely to be called). The YTM (or YTC) is the rate of return the existing bondholders expect to receive, and it is also a good estimate of rd, the rate of return that new bondholders would require. If NCC had no publicly traded debt, its staff could look at yields on publicly traded debt of similar ﬁrms. This too should provide a reasonable estimate of rd. The required return to debtholders, rd, is not equal to the company’s cost of debt because, since interest payments are deductible, the government in effect pays part of the total cost. As a result, the cost of debt to the ﬁrm is less than the rate of return required by debtholders. The after-tax cost of debt, rd(1 ⫺ T), is used to calculate the weighted average cost of capital, and it is the interest rate on debt, rd, less the tax savings that result because interest is deductible. This is the same as rd multiplied by (1 ⫺ T), where T is the ﬁrm’s marginal tax rate:3 After-tax component cost of debt ⫽ Interest rate ⫺ Tax savings ⫽ rd ⫺ rdT ⫽ rd(1 ⫺ T).

(6-1)

2 The effective annual rate is (1 ⫹ 0.11/2)2 ⫺ 1 ⫽ 11.3%, but NCC and most other companies use nominal rates for all component costs. 3 The federal tax rate for most corporations is 35 percent. However, most corporations are also subject to state income taxes, so the marginal tax rate on most corporate income is about 40 percent. For illustrative purposes, we assume that the effective federal-plus-state tax rate on marginal income is 40 percent. The effective tax rate is zero for a ﬁrm with such large current or past losses that it does not pay taxes. In this situation the after-tax cost of debt is equal to the pre-tax interest rate.

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Therefore, if NCC can borrow at an interest rate of 11 percent, and if it has a marginal federal-plus-state tax rate of 40 percent, then its after-tax cost of debt is 6.6 percent: rd(1 ⫺ T) ⫽ 11%(1.0 ⫺ 0.4) ⫽ 11%(0.6) ⫽ 6.6%. Flotation costs are usually fairly small for most debt issues, and so most analysts ignore them when estimating the cost of debt. Later in the chapter we show how to incorporate ﬂotation costs for those cases in which they are signiﬁcant. Why is the after-tax cost of debt rather than the before-tax cost used to calculate the weighted average cost of capital? Is the relevant cost of debt the interest rate on already outstanding debt or that on new debt? Why?

Cost of Preferred Stock, rps A number of ﬁrms, including NCC, use preferred stock as part of their permanent ﬁnancing mix. Preferred dividends are not tax deductible. Therefore, the company bears their full cost, and no tax adjustment is used when calculating the cost of preferred stock. Note too that while some preferreds are issued without a stated maturity date, today most have a sinking fund that effectively limits their life. Finally, although it is not mandatory that preferred dividends be paid, ﬁrms generally have every intention of doing so, because otherwise (1) they cannot pay dividends on their common stock, (2) they will ﬁnd it difﬁcult to raise additional funds in the capital markets, and (3) in some cases preferred stockholders can take control of the ﬁrm. The component cost of preferred stock used to calculate the weighted average cost of capital, rps, is the preferred dividend, Dps, divided by the net issuing price, Pn, which is the price the ﬁrm receives after deducting ﬂotation costs: Component cost of preferred stock ⫽ rps ⫽

Dps Pn

.

(6-2)

Flotation costs are higher for preferred stock than for debt, hence they are incorporated into the formula for preferred stocks’ costs. To illustrate the calculation, assume that NCC has preferred stock that pays a $10 dividend per share and sells for $100 per share. If NCC issued new shares of preferred, it would incur an underwriting (or ﬂotation) cost of 2.5 percent, or $2.50 per share, so it would net $97.50 per share. Therefore, NCC’s cost of preferred stock is 10.3 percent: rps ⫽ $10/$97.50 ⫽ 10.3%. Does the component cost of preferred stock include or exclude ﬂotation costs? Explain. Why is no tax adjustment made to the cost of preferred stock?

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Cost of Common Stock, rs Companies can raise common equity in two ways: (1) directly by issuing new shares and (2) indirectly by retaining earnings. If new shares are issued, what rate of return must the company earn to satisfy the new stockholders? In Chapter 3, we saw that investors require a return of rs. However, a company must earn more than rs on new external equity to provide this rate of return to investors because there are commissions and fees, called ﬂotation costs, when a ﬁrm issues new equity. Few mature ﬁrms issue new shares of common stock.4 In fact, less than 2 percent of all new corporate funds come from the external equity market. There are three reasons for this: 1. Flotation costs can be quite high, as we show later in this chapter. 2. Investors perceive issuing equity as a negative signal with respect to the true value of the company’s stock. Investors believe that managers have superior knowledge about companies’ future prospects, and that managers are most likely to issue new stock when they think the current stock price is higher than the true value. Therefore, if a mature company announces plans to issue additional shares, this typically causes its stock price to decline. 3. An increase in the supply of stock will put pressure on the stock’s price, forcing the company to sell the new stock at a lower price than existed before the new issue was announced. Therefore, we assume that the companies in the following examples do not plan to issue new shares.5 Does new equity capital raised indirectly by retaining earnings have a cost? The answer is a resounding yes. If some of its earnings are retained, then stockholders will incur an opportunity cost—the earnings could have been paid out as dividends (or used to repurchase stock), in which case stockholders could then have reinvested the money in other investments. Thus, the ﬁrm should earn on its reinvested earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk. What rate of return can stockholders expect to earn on equivalent-risk investments? The answer is rs, because they expect to earn that return by simply buying the stock of the ﬁrm in question or that of a similar ﬁrm. Therefore, rs is the cost of common equity raised internally by retaining earnings. If a company cannot earn at least rs on reinvested earnings, then it should pass those earnings on to its stockholders and let them invest the money themselves in assets that do provide rs. Whereas debt and preferred stock are contractual obligations that have easily determined costs, it is more difﬁcult to estimate rs. However, we can employ the principles described in Chapters 3 and 5 to produce reasonably good cost of equity estimates. Three methods typically are used: (1) the Capital Asset Pricing Model (CAPM), (2) the discounted cash ﬂow (DCF) method, and (3) the bond-yield-plusrisk-premium approach. These methods are not mutually exclusive—no method dominates the others, and all are subject to error when used in practice. Therefore, when

4

A few companies issue new shares through new-stock dividend reinvestment plans, which we discuss in Chapter 14. Also, quite a few companies sell stock to their employees, and companies occasionally issue stock to ﬁnance huge projects or mergers. 5 There are times when companies should issue stock in spite of these problems, hence we discuss stock issues later in the chapter.

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faced with the task of estimating a company’s cost of equity, we generally use all three methods and then choose among them on the basis of our conﬁdence in the data used for each in the speciﬁc case at hand. What are the two sources of equity capital? Why do most established ﬁrms not issue additional shares of common equity? Explain why there is a cost to using retained earnings; that is, why aren’t retained earnings a free source of capital?

The CAPM Approach To estimate the cost of common stock using the Capital Asset Pricing Model (CAPM) as discussed in Chapter 3, we proceed as follows: Step 1. Estimate the risk-free rate, rRF. Step 2. Estimate the current expected market risk premium, RPM.6 Step 3. Estimate the stock’s beta coefﬁcient, bi, and use it as an index of the stock’s risk. The i signiﬁes the ith company’s beta. Step 4. Substitute the preceding values into the CAPM equation to estimate the required rate of return on the stock in question: rs ⫽ rRF ⫹ (RPM)bi.

(6-3)

Equation 6-3 shows that the CAPM estimate of rs begins with the risk-free rate, rRF, to which is added a risk premium set equal to the risk premium on the market, RPM, scaled up or down to reﬂect the particular stock’s risk as measured by its beta coefﬁcient. The following sections explain how to implement the four-step process.

Estimating the Risk-Free Rate The starting point for the CAPM cost of equity estimate is rRF, the risk-free rate. There is really no such thing as a truly riskless asset in the U.S. economy. Treasury securities are essentially free of default risk, but nonindexed long-term T-bonds will suffer capital losses if interest rates rise, and a portfolio of short-term T-bills will provide a volatile earnings stream because the rate earned on T-bills varies over time. Since we cannot in practice ﬁnd a truly riskless rate upon which to base the CAPM, what rate should we use? A recent survey of highly regarded companies shows that about two-thirds of the companies use the rate on long-term Treasury bonds.7 We agree with their choice, and here are our reasons: 1. Common stocks are long-term securities, and although a particular stockholder may not have a long investment horizon, most stockholders do invest on a longterm basis. Therefore, it is reasonable to think that stock returns embody longterm inﬂation expectations similar to those reﬂected in bonds rather than the short-term expectations in bills.

6

Recall from Chapter 3 that the market risk premium is the expected market return minus the risk-free rate. See Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, “Best Practices in Estimating the Cost of Capital: Survey and Synthesis,” Financial Practice and Education, Spring/Summer 1998, 13–28. 7

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2. Treasury bill rates are more volatile than are Treasury bond rates and, most experts agree, more volatile than rs. 3. In theory, the CAPM is supposed to measure the expected return over a particular holding period. When it is used to estimate the cost of equity for a project, the theoretically correct holding period is the life of the project. Since many projects have To ﬁnd the rate on a T-bond, long lives, the holding period for the CAPM also should be long. Therefore, the go to http://www. rate on a long-term T-bond is a logical choice for the risk-free rate. federalreserve.gov. Select ”Research and Data,” then select ”Statistics: Releases and Historical Data.” Click on the ”Daily Update” for H.15, ”Selected Interest Rates.”

In light of the preceding discussion, we believe that the cost of common equity is more closely related to Treasury bond rates than to T-bill rates. This leads us to favor T-bonds as the base rate, or rRF, in a CAPM cost of equity analysis. T-bond rates can be found in The Wall Street Journal or the Federal Reserve Bulletin. Generally, we use the yield on a 10-year T-bond as the proxy for the risk-free rate.

Estimating the Market Risk Premium The market risk premium, RPM, is the expected market return minus the risk-free rate, rM ⫺ rRF. It can be estimated on the basis of (1) historical data or (2) forwardlooking data. Historical Risk Premium A very complete and accurate historical risk premium study, updated annually, is available for a fee from Ibbotson Associates, who examine market data over long periods of time to ﬁnd the average annual rates of return on stocks, T-bills, T-bonds, and a set of high-grade corporate bonds.8 For example, Table 6-1 summarizes some results from their 2001 study, which covers the period 1926–2000. Table 6-1 shows that the historical risk premium of stocks over long-term T-bonds is about 7.3 percent when using the arithmetic average and about 5.7 percent when using the geometric average. This leads to the question of which average to use. Keep in mind that the logic behind using historical risk premiums to estimate the current risk premium is the basic assumption that the future will resemble the past. If this assumption is reasonable, then the annual arithmetic average is the theoretically correct predictor for next year’s risk premium. On the other hand, the geometric average is a better predictor of the risk premium over a longer future interval, say, the next 20 years. However, it is not at all clear that the future will be like the past. For example, the choice of the beginning and ending periods can have a major effect on the calculated risk premiums. Ibbotson Associates used the longest period available to them, but had their data begun some years earlier or later, or ended earlier, their results would have been very different. In fact, using data for the past 30 or 40 years, the arithmetic average market risk premium has ranged from 5 to 6 percent, which is quite different than the 7.3 percent over the last 75 years. Note too that using periods as short as 5 to 10 years can lead to bizarre results. Indeed, over many periods the Ibbotson data would indicate negative risk premiums, which would lead to the conclusion that Treasury securities have a higher required return than common stocks. That, of course, is contrary to both ﬁnancial theory and common sense. All this suggests that historical risk premiums should be approached with caution. As one businessman muttered after listening to a professor give a lecture on the CAPM, “Beware of academicians bearing gifts!” 8

See Stocks, Bonds, Bills and Inﬂation: 2001 Yearbook (Chicago: Ibbotson Associates, 2001). Also, note that Ibbotson now recommends using the T-bond rate as the proxy for the risk-free rate when using the CAPM. Before 1988, Ibbotson recommended that T-bills be used.

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The Cost of Capital TABLE 6-1

Selected Ibbotson Associates Data, 1926–2000 Arithmetic Meana

Geometric Meana

13.0% 5.7

11.0% 5.3

7.3%

5.7%

Average Rates of Return Common stocks Long-term government bonds Implied Risk Premiums Common stocks over T-bonds

a Ibbotson Associates calculates average returns in two ways: (1) by taking each of the annual holding period returns and deriving the arithmetic average of these annual returns and (2) by ﬁnding the compound annual rate of return over the whole period, which amounts to a geometric average.

Forward-Looking Risk Premiums An alternative to the historical risk premium is to estimate a forward-looking, or ex ante, risk premium. The most common approach is to use the discounted cash ﬂow (DCF) model to estimate the expected market rate of return, rˆ M ⫽ rM, and then calculate RPM as rM ⫺ rRF. This procedure recognizes that if markets are in equilibrium, the expected rate of return on the market is also its required rate of return, so when we estimate rˆ M, we are also estimating rM: D1 Required Expected ⫽ rˆ M ⫽ ⫹ g ⫽ rRF ⫹ RPM ⫽ rM ⫽ . rate of return rate of return P0 In words, the required return on the market is the sum of the expected dividend yield plus the expected growth rate. Note that the expected dividend yield, D1/P0, can be found using the current dividend yield and the expected growth rate: D1/P0 ⫽ D0(1 ⫹ Go to http://ﬁnance.yahoo. g)/P0. Therefore, to estimate the required return on the market, all you need are esticom, enter the ticker symmates of the current dividend yield and the expected growth rate in dividends. Several bol for any company, select data sources report the current dividend yield on the market, as measured by the S&P “Research” from the pull 500. For example, Yahoo! reports a current dividend yield of 1.78 percent for the S&P down menu, and then click Get. Included with the other 500. Yahoo! also reports a 9.03 percent annual growth rate of dividends for the S&P research on this page are 500 during the past ﬁve years. However, we need the expected future growth in diviforecasts of growth rates in dends, not the past growth rate. earnings for the next ﬁve To the best of our knowledge, there are no free sources that report analysts’ estiyears for the company, the mates of the expected future dividend growth rates for the S&P 500. Although we industry, and the sector. Secan't ﬁnd the S&P 500's expected dividend growth rate, there are sources that report lect “Proﬁle” from the menu at the top of the page. the S&P 500's expected earnings growth rate. For example, Yahoo! reports a 13.03 Scroll down the resulting percent estimate for the S&P 500's expected annualized earnings growth rate. page until you see on the Given these data limitations, there are two practical approaches for estimating left side of the page the the forward-looking risk premium. First, you could use the current dividend yield heading “More from Marand assume that the future growth rate in dividends will be similar to the past ketGuide,” and then select “Ratio Comparisons.” This ﬁve-year growth rate in dividends. Using this approach, the required return on the page provides current valmarket is ues for the dividend yield of the company, industry, sector, and the S&P 500.

rM ⫽ c

D0 (1 ⫹ g) d ⫹ g P0 ⫽ [0.0178(1 ⫹ 0.0903)] ⫹ 0.0903 ⫽ 0.01097 ⫽ 10.97%.

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233

Given a current 10-year T-bond rate of around 4.24 percent, the estimated forward-looking risk premium from this approach is about 10.97 ⫺ 4.24 ⫽ 6.73 percent. The second approach is to assume the forecasted earnings growth rate will equal the dividend growth rate.9 Using this growth estimate, you could estimate the required return on the market and the forward-looking risk premium as shown above. In recent years, estimates of the forward-looking risk premium have usually ranged from 4.5 to 6.5 percent, depending on the date of the estimate and the data sources used by the analyst. Our View on the Market Risk Premium After reading the previous sections, you might well be confused about the correct market risk premium, since the different approaches give different results. Using the historical Ibbotson data over the last 75 years, it appears that the market risk premium is somewhere between 5.7 and 7.3 percent, depending on whether you use an arithmetic average or a geometric average. However, in the past 30 to 40 years, the historical premium has been in the range of 5 to 6 percent. Using the forward-looking approach, it appears that the market risk premium is somewhere in the area of 4.5 to 6.5 percent. To further muddy the waters, the previously cited survey indicates that 37 percent of responding companies use a market risk premium of 5 to 6 percent, 15 percent use a premium provided by their ﬁnancial advisors (who typically make a recommendation of about 7 percent), and 11 percent use a premium in the range of 4 to 4.5 percent. Moreover, it has been toward the low end of the range when interest rates were high and toward the high end when rates were low. Here is our opinion. The risk premium is driven primarily by investors’ attitudes toward risk, and there are good reasons to believe that investors are less risk averse today than 50 years ago. The advent of pension plans, Social Security, health insurance, and disability insurance means that people today can take more chances with their investments, which should make them less risk averse. Also, many households have dual incomes, which also allow investors to take more chances. Finally, the historical average return on the market as Ibbotson measures it is probably too high due to a survivorship bias. Putting it all together, we conclude that the true risk premium in 2002 is almost certainly lower than the long-term historical average of more than 7 percent. But how much lower is the current premium? In our consulting, we typically use a risk premium of 5.5 percent, but we would have a hard time arguing with someone who used a risk premium in the range of 4.5 to 6.5 percent. The bottom line is that there is no way to prove that a particular risk premium is either right or wrong, although we are extremely doubtful that the premium market is less than 4 percent or greater than 7 percent.

Estimating Beta Recall from Chapter 3 that beta is usually estimated as the slope coefﬁcient in a regression, with the company’s stock returns on the y-axis and market returns on the x-axis. The resulting beta is called the historical beta, since it is based on historical data. Although this approach is conceptually straightforward, complications quickly arise in practice. To ﬁnd an estimate of beta, go to http://www. bloomberg. com, enter the ticker symbol for a stock quote, and click ”go.”

9

In theory, the constant growth rate for sales, earnings, and dividends ought to be equal. However, this has not been true for past growth rates. For example, the S&P 500 has had past ﬁve-year annual average growth rates of 15.17 percent for sales, 17.49 percent for earnings per share, and 9.03 percent for dividends. Thus, an analyst must use judgment when using the forecasted growth rate in earnings to estimate the forecasted growth rate in dividends.

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First, there is no theoretical guidance as to the correct holding period over which to measure returns. The returns for a company can be calculated using daily, weekly, or monthly time periods, and the resulting estimates of beta will differ. Beta is also sensitive to the number of observations used in the regression. With too few observations, the regression loses statistical power, but with too many, the “true” beta may have changed during the sample period. In practice, it is common to use either four to ﬁve years of monthly returns or one to two years of weekly returns. Second, the market return should, theoretically, reﬂect every asset, even the human capital being built by students. In practice, however, it is common to use only an index of common stocks such as the S&P 500, the NYSE Composite, or the Wilshire 5000. Even though these indexes are highly correlated with one another, using different indexes in the regression will often result in different estimates of beta. Third, some organizations modify the calculated historical beta in order to produce what they deem to be a more accurate estimate of the “true” beta, where the true beta is the one that reﬂects the risk perceptions of the marginal investor. One modiﬁcation, called an adjusted beta, attempts to correct a possible statistical bias by adjusting the historical beta to make it closer to the average beta of 1.0. Another modiﬁcation, called a fundamental beta, incorporates information about the company, such as changes in its product lines and capital structure. Fourth, even the best estimates of beta for an individual company are statistically imprecise. The average company has an estimated beta of 1.0, but the 95 percent conﬁdence interval ranges from about 0.6 to 1.4. For example, if your regression produces an estimated beta of 1.0, then you can be 95 percent sure that the true beta is in the range of 0.6 to 1.4. So, you should always bear in mind that while the estimated beta is useful when calculating the required return on stock, it is not absolutely correct. Therefore, managers and ﬁnancial analysts must learn to live with some uncertainty when estimating the cost of capital.

An Illustration of the CAPM Approach To illustrate the CAPM approach for NCC, assume that rRF ⫽ 8%, RPM ⫽ 6%, and bi ⫽ 1.1, indicating that NCC is somewhat riskier than average. Therefore, NCC’s cost of equity is 14.6 percent: rs ⫽ 8% ⫹ (6%)(1.1) ⫽ 8% ⫹ 6.6% ⫽ 14.6%.

(6-3a)

It should be noted that although the CAPM approach appears to yield an accurate, precise estimate of rs, it is hard to know the correct estimates of the inputs required to make it operational because (1) it is hard to estimate the beta that investors expect the company to have in the future, and (2) it is difﬁcult to estimate the market risk premium. Despite these difﬁculties, surveys indicate that CAPM is the preferred choice for the vast majority of companies. What is generally considered to be the most appropriate estimate of the riskfree rate, the yield on a short-term T-bill or the yield on a long-term T-bond? Explain the two methods for estimating the market risk premium, that is, the historical data approach and the forward-looking approach. What are some of the problems encountered when estimating beta?

231

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The Cost of Capital Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach

235

Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach In Chapter 5, we saw that if dividends are expected to grow at a constant rate, then the price of a stock is P0 ⫽

D1 . rs ⫺ g

(6-4)

Here P0 is the current price of the stock; D1 is the dividend expected to be paid at the end of Year 1 and rs is the required rate of return. We can solve for rs to obtain the required rate of return on common equity, which for the marginal investor is also equal to the expected rate of return: rs ⫽ rˆs ⫽

D1 ⫹ Expected g. P0

(6-5)

Thus, investors expect to receive a dividend yield, D1/P0, plus a capital gain, g, for a total expected return of rˆ s. In equilibrium this expected return is also equal to the required return, rs. This method of estimating the cost of equity is called the discounted cash ﬂow, or DCF, method. Henceforth, we will assume that equilibrium exists, hence rs ⫽ rˆ s, so we can use the terms rs and rˆ s interchangeably.

Estimating Inputs for the DCF Approach Three inputs are required to use the DCF approach: the current stock price, the current dividend, and the expected growth in dividends. Of these inputs, the growth rate is by far the most difﬁcult to estimate. The following sections describe the most commonly used approaches for estimating the growth rate: (1) historical growth rates, (2) the retention growth model, and (3) analysts’ forecasts. Historical Growth Rates First, if earnings and dividend growth rates have been relatively stable in the past, and if investors expect these trends to continue, then the past realized growth rate may be used as an estimate of the expected future growth rate. We explain several different methods for estimating historical growth in the Web Extension to this chapter, found on the textbook’s web site; the spreadsheet in the ﬁle Ch 06 Tool Kit.xls shows the calculations. For NCC, these different methods produce estimates of historical growth ranging from 4.6 percent to 11.0 percent, with most estimates fairly close to 7 percent. As the Ch 06 Tool Kit.xls shows, one can take a given set of historical data and, depending on the years and the calculation method used, obtain a large number of quite different growth rates. Now recall our purpose in making these calculations: We are seeking the future dividend growth rate that investors expect, and we reasoned that, if past growth rates have been stable, then investors might base future expectations on past trends. This is a reasonable proposition, but, unfortunately, we rarely ﬁnd much historical stability. Therefore, the use of historical growth rates in a DCF analysis must be applied with judgment, and also be used (if at all) in conjunction with other growth estimation methods as discussed next. Retention Growth Model Most ﬁrms pay out some of their net income as dividends and reinvest, or retain, the rest. The payout ratio is the percent of net income that the ﬁrm pays out as a dividend, deﬁned as total dividends divided by net income; see Chapter 10 for more details on ratios. The retention ratio is the complement of

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the payout ratio: Retention ration ⫽ (1 ⫺ Payout ratio). ROE is the return on equity, deﬁned as net income available for common stockholders divided by common equity. Although we don’t prove it here, you should ﬁnd it reasonable that the growth rate of a ﬁrm will depend on the amount of net income that it retains and the rate it earns on the retentions. Using this logic, we can write the retention growth model: g ⫽ ROE (Retention ratio).

(6-6)

Equation 6-6 produces a constant growth rate, but when we use it we are, by implication, making four important assumptions: (1) We expect the payout rate, and thus the retention rate, to remain constant; (2) we expect the return on equity on new investment to remain constant; (3) the ﬁrm is not expected to issue new common stock, or, if it does, we expect this new stock to be sold at a price equal to its book value; and (4) future projects are expected to have the same degree of risk as the ﬁrm’s existing assets. NCC has had an average return on equity of about 14.5 percent over the past 15 years. The ROE has been relatively steady, but even so it has ranged from a low of 11.0 percent to a high of 17.6 percent. In addition, NCC’s dividend payout rate has averaged 0.52 over the past 15 years, so its retention rate has averaged 1.0 ⫺ 0.52 ⫽ 0.48. Using Equation 6-6, we estimate g to be 7 percent: g ⫽ 14.5% (0.48) ⫽ 7%.

For example, see http://www.zacks.com, http://www.thomsonfn. com, or http://www. ﬁnance.yahoo.com.

Analysts’ Forecasts A third technique calls for using security analysts’ forecasts. Analysts publish growth rate estimates for most of the larger publicly owned companies. For example, Value Line provides such forecasts on 1,700 companies, and all of the larger brokerage houses provide similar forecasts. Further, several companies compile analysts’ forecasts on a regular basis and provide summary information such as the median and range of forecasts on widely followed companies. These growth rate summaries, such as the ones compiled by Zack’s or by Thomson Financial Network, can be found on the Internet. However, these forecasts often involve nonconstant growth. For example, some analysts were forecasting that NCC would have a 10.4 percent annual growth rate in earnings and dividends over the next ﬁve years, but a growth rate beyond that of 6.5 percent. This nonconstant growth forecast can be used to develop a proxy constant growth rate. Computer simulations indicate that dividends beyond Year 50 contribute very little to the value of any stock—the present value of dividends beyond Year 50 is virtually zero, so for practical purposes, we can ignore anything beyond 50 years. If we consider only a 50-year horizon, we can develop a weighted average growth rate and use it as a constant growth rate for cost of capital purposes. In the NCC case, we assumed a growth rate of 10.4 percent for 5 years followed by a growth rate of 6.5 percent for 45 years. We weight the short-term growth by 5/50 ⫽ 10% and the long-term growth by 45/50 ⫽ 90%. This produces an average growth rate of 0.10(10.4%) ⫹ 0.90(6.5%) ⫽ 6.9%. Rather than convert nonconstant growth estimates into an approximate average growth rate, it is possible to use the nonconstant growth estimates to directly estimate the required return on common stock. See the Web Extension to this chapter for an explanation of this approach; all calculations are in the ﬁle Ch 06 Tool Kit.xls.

Illustration of the Discounted Cash Flow Approach To illustrate the DCF approach, suppose NCC’s stock sells for $32; its next expected dividend is $2.40; and its expected growth rate is 7 percent. NCC’s expected and required rate of return, hence its cost of common stock, would then be 14.5 percent:

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The Cost of Capital Comparison of the CAPM, DCF, and Bond-Yeild-plus-Risk-Premium Methods

237

$2.40 ⫹ 7.0% $32.00 ⫽ 7.5% ⫹ 7.0% ⫽ 14.5%.

rˆs ⫽ rs ⫽

Evaluating the Methods for Estimating Growth Note that the DCF approach expresses the cost of common equity as the dividend yield (the expected dividend divided by the current price) and the growth rate. The dividend yield can be estimated with a high degree of certainty, but the growth estimate causes uncertainty as to the DCF cost estimate. We discussed three methods: (1) historical growth rates, (2) retention growth model, and (3) analysts’ forecasts. Of these three methods, studies have shown that analysts’ forecasts usually represent the best source of growth rate data for DCF cost of capital estimates.10

Bond-Yield-plus-Risk-Premium Approach Some analysts use a subjective, ad hoc procedure to estimate a ﬁrm’s cost of common equity: they simply add a judgmental risk premium of 3 to 5 percentage points to the interest rate on the ﬁrm’s own long-term debt. It is logical to think that ﬁrms with risky, low-rated, and consequently high-interest-rate debt will also have risky, highcost equity, and the procedure of basing the cost of equity on a readily observable debt cost utilizes this logic. For example, if an extremely strong ﬁrm such as BellSouth had bonds which yielded 8 percent, its cost of equity might be estimated as follows: rs ⫽ Bond yield ⫹ Risk premium ⫽ 8% ⫹ 4% ⫽ 12%. The bonds of NCC, a riskier company, have a yield of 10.4 percent, making its estimated cost of equity 14.4 percent: rs ⫽ 11% ⫹ 4% ⫽ 15%. Because the 4 percent risk premium is a judgmental estimate, the estimated value of rs is also judgmental. Empirical work suggests that the risk premium over a ﬁrm’s own bond yield has generally ranged from 3 to 5 percentage points, so this method is not likely to produce a precise cost of equity. However, it can get us “into the right ballpark.” What is the reasoning behind the bond-yield-plus-risk-premium approach?

Comparison of the CAPM, DCF, and Bond-Yield-plus-Risk-Premium Methods We have discussed three methods for estimating the required return on common stock. For NCC, the CAPM estimate is 14.6 percent, the DCF constant growth estimate is 14.5 percent, and the bond-yield-plus-risk-premium is 14.4 percent. The

10

See Robert Harris, “Using Analysts’ Growth Rate Forecasts to Estimate Shareholder Required Rates of Return,” Financial Management, Spring 1986, 58–67. Analysts’ forecasts are the best predictors of actual future growth, and also the growth rate investors say they use in valuing stocks.

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overall average of these three methods is (14.6% ⫹ 14.5% ⫹ 14.4%)/3 ⫽ 14.5%. These results are unusually consistent, so it would make little difference which one we used. However, if the methods produced widely varied estimates, then a ﬁnancial analyst would have to use his or her judgment as to the relative merits of each estimate and then choose the estimate that seemed most reasonable under the circumstances. Recent surveys found that the CAPM approach is by far the most widely used method. Although most ﬁrms use more than one method, almost 74 percent of respondents in one survey, and 85 percent in the other, used the CAPM.11 This is in sharp contrast to a 1982 survey, which found that only 30 percent of respondents used the CAPM.12 Approximately 16 percent now use the DCF approach, down from 31 percent in 1982. The bond-yield-plus-risk-premium is used primarily by companies that are not publicly traded. People experienced in estimating the cost of equity recognize that both careful analysis and sound judgment are required. It would be nice to pretend that judgment is unnecessary and to specify an easy, precise way of determining the exact cost of equity capital. Unfortunately, this is not possible—ﬁnance is in large part a matter of judgment, and we simply must face that fact. Which approach is used most often by businesses today?

Composite, or Weighted Average, Cost of Capital, WACC As we shall see in Chapter 13, each ﬁrm has an optimal capital structure, deﬁned as that mix of debt, preferred, and common equity that causes its stock price to be maximized. Therefore, a value-maximizing ﬁrm will establish a target (optimal) capital structure and then raise new capital in a manner that will keep the actual capital structure on target over time. In this chapter, we assume that the ﬁrm has identiﬁed its optimal capital structure, that it uses this optimum as the target, and that it ﬁnances so as to remain constantly on target. How the target is established will be examined in Chapter 13. The target proportions of debt, preferred stock, and common equity, along with the component costs of capital, are used to calculate the ﬁrm’s WACC. To illustrate, suppose NCC has a target capital structure calling for 30 percent debt, 10 percent preferred stock, and 60 percent common equity. Its before-tax cost of debt, rd, is 11 percent; its after-tax cost of debt is rd(1 ⫺ T) ⫽ 11%(0.6) ⫽ 6.6%; its cost of preferred stock, rps, is 10.3 percent; its cost of common equity, rs, is 14.5 percent; its marginal tax rate is 40 percent; and all of its new equity will come from retained earnings. We can calculate NCC’s weighted average cost of capital, WACC, as follows:

11

See John R. Graham and Campbell Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics, Vol. 60, no. 1, 2001, and the paper cited in Footnote 7. Interestingly, a growing number of ﬁrms (about 34 percent) also are using CAPM-type models with more than one factor. Of these ﬁrms, over 40 percent include factors for interest-rate risk, foreign exchange risk, and business cycle risk (proxied by gross domestic product). More than 20 percent of these ﬁrms include a factor for inﬂation, size, and exposure to particular commodity prices. Less than 20 percent of these ﬁrms make adjustments due to distress factors, book-to-market ratios, or momentum factors. 12 See Lawrence J. Gitman and Vincent Mecurio, “Cost of Capital Techniques Used by Major U.S. Firms: Survey Analysis of Fortune’s 1000, Financial Management, Vol. 14, 1982, 21–29.

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The Cost of Capital Composite, or Weighted Average, Cost of Capital, WACC

239

WACC Estimates for Some Large U.S. Corporations

Our table presents some recent WACC estimates as calculated by Stern Stewart & Company for a sample of corporations, along with their debt ratios. These estimates suggest that a typical company has a WACC somewhere in the 7 to 13 percent range and that WACCs vary considerably depending on (1) the company’s risk and (2) the amount of debt it uses. Companies in riskier businesses, such as Intel, presumably have higher costs of common equity. Moreover, they tend not to use as much debt. These two factors, in combination, result in higher WACCs than those of companies that operate in more stable businesses, such as BellSouth. We will discuss the effects of capital structure on WACC in more detail in Chapter 13. Note that riskier companies may also have the potential for producing higher returns, and what really matters to shareholders is whether a company is able to generate returns in excess of its cost of capital. Source: Various issues of Fortune, the General Electric web site, http://www.ge.com, and the Stern Stewart & Co. web site, http://www. sternstewart.com.

Companya

General Electric (GE) Coca-Cola (KO) Intel (INTC) Motorola (MOT) Wal-Mart (WMT) Walt Disney (DIS) AT&T (T) Exxon Mobil (XOM) H.J. Heinz (HNZ) BellSouth (BLS)

WACCb

Book Value Debt Ratioc

12.5 12.3 12.2 11.7 11.0 9.3 9.2 8.2 7.8 7.4

60.2% 11.5 2.9 31.5 36.3 31.0 23.1 9.1 75.4 42.2

Notes: a Ticker symbols are shown in parentheses. b Values are from http://www.sternstewart.com, The 2000 Stern Stewart Performance 1000. c This is Long-term debt/(Long-term debt ⫹ Equity), obtained from http://yahoo.marketguide.com.

WACC ⫽ wdrd(1 ⫺ T) ⫹ wpsrps ⫹ wcers

(6-7)

⫽ 0.3(11.0%)(0.6) ⫹ 0.1(10.3%) ⫹ 0.6(14.5%) ⫽ 11.7%. Here wd, wps, and wce are the weights used for debt, preferred, and common equity, respectively. Every dollar of new capital that NCC obtains will on average consist of 30 cents of debt with an after-tax cost of 6.6 percent, 10 cents of preferred stock with a cost of 10.3 percent, and 60 cents of common equity with a cost of 14.5 percent. The average cost of each whole dollar, the WACC, is 11.7 percent. Two points should be noted. First, the WACC is the weighted average cost of each new, or marginal, dollar of capital—it is not the average cost of all dollars raised in the past. We are primarily interested in obtaining a cost of capital to use in discounting future cash ﬂows, and for this purpose the cost of the new money that will be invested is the relevant cost. On average, each of these new dollars will consist of some debt, some preferred, and some common equity. Second, the percentages of each capital component, called weights, could be based on (1) accounting values as shown on the balance sheet (book values), (2) current market values of the capital components, or (3) management’s target capital structure, which is presumably an estimate of the ﬁrm’s optimal capital structure. The correct weights are those based on the ﬁrm’s target capital structure, since this is the best estimate of how the ﬁrm will, on average, raise money in the future. Recent survey evidence indicates that the majority of ﬁrms do base their weights on target capital structures, and that the target structures reﬂect market values.

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How does one calculate the weighted average cost of capital? Write out the equation. On what should the weights be based?

Factors That Affect the Weighted Average Cost of Capital The cost of capital is affected by a number of factors. Some are beyond the ﬁrm’s control, but others are inﬂuenced by its ﬁnancing and investment policies.

Factors the Firm Cannot Control The three most important factors that are beyond a ﬁrm’s direct control are (1) the level of interest rates, (2) the market risk premium, and (3) tax rates. The Level of Interest Rates If interest rates in the economy rise, the cost of debt increases because ﬁrms will have to pay bondholders a higher interest rate to obtain debt capital. Also, recall from our discussion of the CAPM that higher interest rates also increase the costs of common and preferred equity. During the 1990s, interest rates in the United States declined signiﬁcantly. This reduced the cost of both debt and equity capital for all ﬁrms, which encouraged additional investment. Lower interest rates also enabled U.S. ﬁrms to compete more effectively with German and Japanese ﬁrms, which in the past had enjoyed relatively low costs of capital. Market Risk Premium The perceived risk inherent in stocks, along with investors’ aversion to risk, determine the market risk premium. Individual ﬁrms have no control over this factor, but it affects the cost of equity and, through a substitution effect, the cost of debt, and thus the WACC. Tax Rates Tax rates, which are largely beyond the control of an individual ﬁrm (although ﬁrms do lobby for more favorable tax treatment), have an important effect on the cost of capital. Tax rates are used in the calculation of the cost of debt as used in the WACC, and there are other less obvious ways in which tax policy affects the cost of capital. For example, lowering the capital gains tax rate relative to the rate on ordinary income would make stocks more attractive, which would reduce the cost of equity relative to that of debt. That would, as we will see in Chapter 13, lead to a change in a ﬁrm’s optimal capital structure toward less debt and more equity.

Factors the Firm Can Control A ﬁrm can affect its cost of capital through (1) its capital structure policy, (2) its dividend policy, and (3) its investment (capital budgeting) policy. Capital Structure Policy In this chapter, we assume that a ﬁrm has a given target capital structure, and we use weights based on that target structure to calculate the WACC. It is clear, though, that a ﬁrm can change its capital structure, and such a change can affect its cost of capital. First, beta is a function of ﬁnancial leverage, so capital structure affects the cost of equity. Second, the after-tax cost of debt is lower than the cost of equity. Therefore, if the ﬁrm decides to use more debt and less common equity, this change in the weights in the WACC equation will tend to lower the WACC. However, an increase in the use of debt will increase the riskiness of both the debt and the equity, and increases in component costs will tend to offset the effects of

237

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The Cost of Capital Adjusting the Cost of Capital for Risk

241

Global Variations in the Cost of Capital

For U.S. ﬁrms to be competitive with foreign companies, they must have a cost of capital no greater than that faced by their international competitors. In the past, many experts argued that U.S. ﬁrms were at a disadvantage. In particular, Japanese ﬁrms enjoyed a very low cost of capital, which lowered their total costs and thus made it hard for U.S. ﬁrms to compete. Recent events, however, have considerably narrowed cost of capital differences between U.S. and Japanese ﬁrms. In particular, the U.S. stock market has outperformed the Japanese market in the last decade, which has made it easier and cheaper for U.S. ﬁrms to raise equity capital.

As capital markets become increasingly integrated, crosscountry differences in the cost of capital are disappearing. Today, most large corporations raise capital throughout the world, hence we are moving toward one global capital market rather than distinct capital markets in each country. Although government policies and market conditions can affect the cost of capital within a given country, this primarily affects smaller ﬁrms that do not have access to global capital markets, and even these differences are becoming less important as time goes by. What matters most is the risk of the individual ﬁrm, not the market in which it raises capital.

the change in the weights. In Chapter 13 we will discuss this in more depth, and we will demonstrate that a ﬁrm’s optimal capital structure is the one that minimizes its cost of capital. Dividend Policy As we shall see in Chapter 14, the percentage of earnings paid out in dividends may affect a stock’s required rate of return, rs. Also, if a ﬁrm’s payout ratio is so high that it must issue new stock to fund its capital budget, this will force it to incur ﬂotation costs, and this too will affect its cost of capital. This second point is discussed in detail later in this chapter and also in Chapter 14. Investment Policy When we estimate the cost of capital, we use as the starting point the required rates of return on the ﬁrm’s outstanding stock and bonds. Those rates reﬂect the risk of the ﬁrm’s existing assets. Therefore, we have implicitly been assuming that new capital will be invested in assets and with the same degree of risk as existing assets. This assumption is generally correct, as most ﬁrms do invest in assets similar to those they currently use. However, it would be incorrect if a ﬁrm dramatically changed its investment policy. For example, if a ﬁrm invests in an entirely new line of business, its marginal cost of capital should reﬂect the riskiness of that new business. To illustrate, Time Warner’s merger with AOL undoubtedly increased its risk and cost of capital. What three factors that affect the cost of capital are generally beyond the ﬁrm’s control? What three policies under the ﬁrm’s control are likely to affect its cost of capital? Explain how a change in interest rates in the economy would affect each component of the weighted average cost of capital.

Adjusting the Cost of Capital for Risk As we have calculated it, the cost of capital reﬂects the average risk and overall capital structure of the entire ﬁrm. But what if a ﬁrm has divisions in several business lines that differ in risk? Or what if a company is considering a project that is much riskier

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than its typical project? It doesn’t make sense for a company to use its overall cost of capital to discount divisional or project-speciﬁc cash ﬂows that don’t have the same risk as the company’s average cash ﬂows. The following sections explain how to adjust the cost of capital for divisions and for speciﬁc projects.

The Divisional Cost of Capital Consider Starlight Sandwich Shops, a company with two divisions—a bakery operation and a chain of cafes. The bakery division is low risk and has a 10 percent cost of capital. The cafe division is riskier and has a 14 percent cost of capital. Each division is approximately the same size, so Starlight’s overall cost of capital is 12 percent. The bakery manager has a project with an 11 percent expected rate of return, and the cafe division manager has a project with a 13 percent expected return. Should these projects be accepted or rejected? Starlight can create value if it accepts the bakery’s project, since its rate of return is greater than its cost of capital (11% ⬎ 10%), but the cafe project’s rate of return is less than its cost of capital (13% ⬍ 14%), so it should be rejected. However, if one simply compared the two projects’ returns with Starlight’s 12 percent overall cost of capital, then the bakery’s value-adding project would be rejected while the cafe’s value-destroying project would be accepted. Many ﬁrms use the CAPM to estimate the cost of capital for speciﬁc divisions. To begin, recall that the Security Market Line equation expresses the risk/return relationship as follows: rs ⫽ rRF ⫹ (RPM)bi. As an example, consider the case of Huron Steel Company, an integrated steel producer operating in the Great Lakes region. For simplicity, assume that Huron has only one division and uses only equity capital, so its cost of equity is also its corporate cost of capital, or WACC. Huron’s beta ⫽ b ⫽ 1.1; rRF ⫽ 7%; and RPM ⫽ 6%. Thus, Huron’s cost of equity is 13.6 percent: rs ⫽ 7% ⫹ (6%)1.1 ⫽ 13.6%. This suggests that investors should be willing to give Huron money to invest in average-risk projects if the company expects to earn 13.6 percent or more on this money. By average risk we mean projects having risk similar to the ﬁrm’s existing division. Now suppose Huron creates a new transportation division consisting of a ﬂeet of barges to haul iron ore, and barge operations have betas of 1.5 rather than 1.1. The barge division, with b ⫽ 1.5, has a 16.0 percent cost of capital: rBarge ⫽ 7% ⫹ (6%)1.5 ⫽ 16.0%. On the other hand, if Huron adds a low-risk division, such as a new distribution center with a beta of only 0.5, its divisional cost of capital would be 10 percent: rCenter ⫽ 7% ⫹ (6%)0.5 ⫽ 10.0%. A ﬁrm itself may be regarded as a “portfolio of assets,” and since the beta of a portfolio is a weighted average of the betas of its individual assets, adding the barge and distribution center divisions will change Huron’s overall beta. The exact value of the new beta would depend on the relative size of the investment in the new divisions versus Huron’s original steel operations. If 70 percent of Huron’s total value ends up in the steel division, 20 percent in the barge division, and 10 percent in the distribution center, then its new corporate beta would be New beta ⫽ 0.7(1.1) ⫹ 0.2(1.5) ⫹ 0.1(0.5) ⫽ 1.12.

239

240

The Cost of Capital Adjusting the Cost of Capital for Risk

243

Thus, investors in Huron’s stock would have a required return of: RHuron ⫽ 7% ⫹ (6%)1.12 ⫽ 13.72%. Even though the investors require an overall return of 13.72 percent, they would expect a return of at least 13.6 percent from the steel division, 16.0 percent from the barge division, and 10.0 percent from the distribution center. Figure 6-1 gives a graphic summary of these concepts as applied to Huron Steel. Note the following points: 1. The SML is the same Security Market Line that we discussed in Chapter 3. It shows how investors are willing to make trade-offs between risk as measured by beta and expected returns. The higher the beta risk, the higher the rate of return needed to compensate investors for bearing this risk. The SML speciﬁes the nature of this relationship. 2. Huron Steel initially has a beta of 1.1, so its required rate of return on average-risk investments in its original steel operations is 13.6 percent. 3. High-risk investments such as the barge line require higher rates of return, whereas low-risk investments such as the distribution center require lower rates of return. 4. If the expected rate of return on a given capital project lies above the SML, the expected rate of return on the project is more than enough to compensate for its risk, and the project should be accepted. Conversely, if the project’s rate of return lies below the SML, it should be rejected. Thus, Project M in Figure 6-1 is acceptable, whereas Project N should be rejected. N has a higher expected return than M, but the differential is not enough to offset its much higher risk. 5. For simplicity, the Huron Steel illustration is based on the assumption that the company used no debt ﬁnancing, which allows us to use the SML to plot the company’s cost of capital. The basic concepts presented in the Huron illustration also

FIGURE 6-1

Using the Security Market Line for Divisions

Rate of Return (%) Acceptance Region Barge Division

SML = r RF + (RPMRF )b = 7% + (6%)b

rBarge = 16.0 N

rSteel = 13.6

Rejection Region

M Steel Division

rCenter = 10.0 r RF = 7.0

0

Distribution Center Division

0.5

1.1

1.5

2.0

Risk (b)

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hold for companies that use debt ﬁnancing. When debt ﬁnancing is used, the division’s cost of equity must be combined with the division’s cost of debt and target capital structure to obtain the division’s overall cost of capital. Based on the CAPM, how would one ﬁnd the cost of capital for a low-risk division, and for a high-risk division? Explain why you should accept a given capital project if its expected rate of return lies above the SML and reject it if its expected return is below the SML.

Techniques for Measuring Divisional Betas In Chapter 3 we discussed the estimation of betas for stocks and indicated the difﬁculties in estimating beta. The estimation of divisional betas is much more difﬁcult, and more fraught with uncertainty. However, two approaches have been used to estimate individual assets’ betas—the pure play method and the accounting beta method.

The Pure Play Method In the pure play method, the company tries to ﬁnd several single-product companies in the same line of business as the division being evaluated, and it then averages those companies’ betas to determine the cost of capital for its own division. For example, suppose Huron could ﬁnd three existing single-product ﬁrms that operate barges, and suppose also that Huron’s management believes its barge division would be subject to the same risks as those ﬁrms. Huron could then determine the betas of those ﬁrms, average them, and use this average beta as a proxy for the barge division’s beta.13 The pure play approach can only be used for major assets such as whole divisions, and even then it is frequently difﬁcult to implement because it is often impossible to ﬁnd pure play proxy ﬁrms. However, when IBM was considering going into personal computers, it was able to obtain data on Apple Computer and several other essentially pure play personal computer companies. This is often the case when a ﬁrm considers a major investment outside its primary ﬁeld.

The Accounting Beta Method As noted above, it may be impossible to ﬁnd single-product, publicly traded ﬁrms suitable for the pure play approach. If that is the case, we may be able to use the accounting beta method. Betas normally are found by regressing the returns of a particular company’s stock against returns on a stock market index. However, we could run a regression of the division’s accounting return on assets against the average return on assets for a large sample of companies, such as those included in the S&P 500. Betas determined in this way (that is, by using accounting data rather than stock market data) are called accounting betas.

13

If the pure play ﬁrms employ different capital structures than that of Huron, this fact must be dealt with by adjusting the beta coefﬁcients. See Chapter 13 for a discussion of this aspect of the pure play method. For a technique that can be used when pure play ﬁrms are not available, see Yatin Bhagwat and Michael Ehrhardt, “A Full Information Approach for Estimating Divisional Betas,” Financial Management, Summer 1991, 60–69.

241

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The Cost of Capital Estimating the Cost of Capital for Individual Projects

245

Accounting betas for a totally new project can be calculated only after the project has been accepted, placed in operation, and begun to generate output and accounting results—too late for the capital budgeting decision. However, to the extent management thinks a given project is similar to other projects the ﬁrm has undertaken in the past, the similar project’s accounting beta can be used as a proxy for that of the project in question. In practice, accounting betas are normally calculated for divisions or other large units, not for single assets, and divisional betas are then used for the division’s projects. Describe the pure play and the accounting beta methods for estimating divisional betas.

Estimating the Cost of Capital for Individual Projects Although it is intuitively clear that riskier projects have a higher cost of capital, it is difﬁcult to estimate project risk. First, note that three separate and distinct types of risk can be identiﬁed: 1. Stand-alone risk is the project’s risk disregarding the fact that it is but one asset within the ﬁrm’s portfolio of assets and that the ﬁrm is but one stock in a typical investor’s portfolio of stocks. Stand-alone risk is measured by the variability of the project’s expected returns. It is a correct measure of risk only for one-asset ﬁrms whose stockholders own only that stock. 2. Corporate, or within-ﬁrm, risk is the project’s risk to the corporation, giving consideration to the fact that the project represents only one of the ﬁrm’s portfolio of assets, hence that some of its risk effects will be diversiﬁed away. Corporate risk is measured by the project’s effect on uncertainty about the ﬁrm’s future earnings. 3. Market, or beta, risk is the riskiness of the project as seen by a well-diversiﬁed stockholder who recognizes that the project is only one of the ﬁrm’s assets and that the ﬁrm’s stock is but one part of his or her total portfolio. Market risk is measured by the project’s effect on the ﬁrm’s beta coefﬁcient. Taking on a project with a high degree of either stand-alone or corporate risk will not necessarily affect the ﬁrm’s beta. However, if the project has highly uncertain returns, and if those returns are highly correlated with returns on the ﬁrm’s other assets and with most other assets in the economy, then the project will have a high degree of all types of risk. For example, suppose General Motors decides to undertake a major expansion to build electric autos. GM is not sure how its technology will work on a mass production basis, so there is much risk in the venture—its stand-alone risk is high. Management also estimates that the project will do best if the economy is strong, for then people will have more money to spend on the new autos. This means that the project will tend to do well if GM’s other divisions are doing well and will tend to do badly if other divisions are doing badly. This being the case, the project will also have high corporate risk. Finally, since GM’s proﬁts are highly correlated with those of most other ﬁrms, the project’s beta will also be high. Thus, this project will be risky under all three deﬁnitions of risk. Of the three measures, market risk is theoretically the most relevant because of its direct effect on stock prices. Unfortunately, the market risk for a project is also the most difﬁcult to estimate. In practice, most decision makers consider all three risk measures in a judgmental manner.

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The ﬁrst step is to determine the divisional cost of capital, and then to group divisional projects into subjective risk categories. Then, using the divisional WACC as a starting point, risk-adjusted costs of capital are developed for each category. For example, a ﬁrm might establish three risk classes—high, average, and low—then assign average-risk projects the divisional cost of capital, higher-risk projects an aboveaverage cost, and lower-risk projects a below-average cost. Thus, if a division’s WACC were 10 percent, its managers might use 10 percent to evaluate average-risk projects in the division, 12 percent for high-risk projects, and 8 percent for low-risk projects. While this approach is better than not risk adjusting at all, these risk adjustments are necessarily subjective and somewhat arbitrary. Unfortunately, given the data, there is no completely satisfactory way to specify exactly how much higher or lower we should go in setting risk-adjusted costs of capital. What are the three types of project risk? Which type of risk is theoretically the most relevant? Why? Describe a procedure ﬁrms can use to develop costs of capital for projects with differing degrees of risk.

Adjusting the Cost of Capital for Flotation Costs Most debt is privately placed, and most equity is raised internally as retained earnings. In these cases, there are no ﬂotation costs, hence the component costs of debt and equity should be estimated as discussed earlier. However, if companies issue debt or new stock to the public, then ﬂotation costs can become important. In the following sections, we explain how to estimate the component costs of publicly issued debt and stock, and we show how these new component costs affect the marginal cost of capital. Axis Goods Inc., a retailer of trendy sportswear, has a target capital structure of 45 percent debt, 2 percent preferred stock, and 53 percent common stock. Its common stock sells for $23, the next expected dividend is $1.24, and the expected constant growth rate is 8 percent. Based on the constant growth DCF model, Axis’ cost of common equity is rs ⫽ 13.4% when the equity is raised as retained earnings. Axis’ cost of preferred stock is 10.3 percent, based on the method discussed in the chapter, which incorporates ﬂotation costs. In the following sections, we examine the effects of ﬂotation costs on the component costs of debt and common stock, and on the marginal cost of capital.

Flotation Costs and the Component Cost of Debt Axis can issue a 30-year, $1,000 par value bond with an interest rate of 10 percent, paid annually. Here T ⫽ 40%, so the after-tax component cost of debt is rd ⫽ (1.0 ⫺ 0.4)10% ⫽ 6.0%. However, if Axis must incur ﬂotation costs, F, of 1 percent of the value of the issue, then this formula must be used to ﬁnd the after-tax cost of debt: N

M(1 ⫺ F) ⫽ a

t⫽1

INT(1 ⫺ T) M ⫹ . t (1 ⫹ rd) (1 ⫹ rd)N

(6-8)

Here M is the bond’s par value, F is the ﬂotation percentage, N is the bond’s maturity, T is the ﬁrm’s tax rate, INT is the dollars of interest per period, and rd is the

243

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The Cost of Capital Adjusting the Cost of Capital for Flotation Costs

247

after-tax cost of debt adjusted for ﬂotation. With a ﬁnancial calculator, enter N ⫽ 30, PV ⫽ ⫺990, PMT ⫽ 60, and FV ⫽ 1000. Solving for I, we ﬁnd I ⫽ rd(1 ⫺ T) ⫽ 6.07%, which is the after-tax component cost of debt. Note that the 6.07 percent theoretically correct after-tax cost of debt is quite close to the original 6.00 percent aftertax cost, so in this instance adjusting for ﬂotation doesn’t make much difference. However, the ﬂotation adjustment would be higher if F were larger or if the bond’s life were shorter. For example, if F were 10 percent rather than 1 percent, then the ﬂotation-adjusted rd(1 ⫺ T) would have been 6.79 percent. With N at 1 year rather than 30 years, and F still equal to 1 percent, then rd(1 ⫺ T) ⫽ 7.07%. Finally, if F ⫽ 10% and N ⫽ 1, then rd(1 ⫺ T) ⫽ 17.78%. In all of these cases the differential would be too high to ignore.14

Cost of Newly Issued Common Stock, or External Equity, re The cost of new common equity, re, or external equity, is higher than the cost of equity raised internally by reinvesting earnings, rs, because of ﬂotation costs involved in issuing new common stock. What rate of return must be earned on funds raised by selling new stock to make issuing stock worthwhile? To put it another way, what is the cost of new common stock? The answer for a constant growth stock is found by applying this formula: re ⫽

D1 ⫹ g. P0 (1 ⫺ F)

(6-9)

Here F is the percentage ﬂotation cost incurred in selling the new stock, so P0(1 ⫺ F) is the net price per share received by the company. Assuming that Axis has a ﬂotation cost of 10 percent, its cost of new outside equity is computed as follows: $1.24 ⫹ 8.0% $23(1 ⫺ 0.10) $1.24 ⫽ ⫹ 8.0% $20.70 ⫽ 6.0% ⫹ 8.0% ⫽ 14.0%.

re ⫽

Investors require a return of rs ⫽ 13.4% on the stock.15 However, because of ﬂotation costs the company must earn more than 13.4 percent on the net funds obtained by selling stock if investors are to receive a 13.4 percent return on the money they put up. Speciﬁcally, if the ﬁrm earns 14 percent on funds obtained by issuing new stock, then earnings per share will remain at the previously expected level, the ﬁrm’s expected dividend can be maintained, and, as a result, the price per share will not decline. If the ﬁrm earns less than 14 percent, then earnings, dividends, and growth will fall below expectations, causing the stock price to decline. If the ﬁrm earns more than 14 percent, the stock price will rise. As we noted earlier, most analysts use the CAPM to estimate the cost of equity. Suppose the CAPM cost of equity for Axis is 13.8 percent. How could the analyst

14

Strictly speaking, the after-tax cost of debt should reﬂect the expected cost of debt. While Axis’ bonds have a promised return of 10 percent, there is some chance of default, so its bondholders’ expected return (and consequently Axis’ cost) is a bit less than 10 percent. However, for a relatively strong company such as Axis, this difference is quite small. $1.24 15 If there were no ﬂotation costs, rs = + 8.0% = 13.4%. $23

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The Cost of Capital TABLE 6-2

Average Flotation Costs for Debt and Equity

Amount of Capital Raised (Millions of Dollars)

Average Flotation Cost for Common Stock (% of Total Capital Raised)

Average Flotation Cost for New Debt (% of Total Capital Raised)

2–9.99 10–19.99 20–39.99 40–59.99 60–79.99 80–99.99 100–199.99 200–499.99 500 and up

13.28 8.72 6.93 5.87 5.18 4.73 4.22 3.47 3.15

4.39 2.76 2.42 2.32 2.34 2.16 2.31 2.19 1.64

Source: Inmoo Lee, Scott Lochhead, Jay Ritter, and Quanshui Zhao, “The Costs of Raising Capital,” The Journal of Financial Research, Vol. XIX, No. 1, Spring 1996, 59–74. Reprinted with permission.

incorporate ﬂotation costs? In the example above, application of the DCF methodology gives a cost of equity of 13.4 percent if ﬂotation costs are ignored and a cost of equity of 14.0 percent if ﬂotation costs are included. Therefore, ﬂotation costs add 0.6 percentage point to the cost of equity (14.0 ⫺ 13.4 ⫽ 0.6). To incorporate ﬂotation costs into the CAPM estimate, you would add the 0.6 percentage point to the 13.8 percent CAPM estimate, resulting in a 14.4 percent estimated cost of external equity. As an alternative, you could ﬁnd the average of the CAPM, DCF, and bond-yieldplus-risk-premium costs of equity ignoring ﬂotation costs, and then add to it the 0.6 percentage point due to ﬂotation costs.

How Much Does It Cost to Raise External Capital? A recent study provides some insights into how much it costs U.S. corporations to raise external capital. Using information from the Securities Data Company, they found the average ﬂotation cost for debt and equity issued in the 1990s as presented in Table 6-2. The common stock ﬂotation costs are for non-IPOs. Costs associated with IPOs are even higher—about 17 percent of gross proceeds for common equity if the amount raised is less than $10 million and about 6 percent if more than $500 million is raised. The data include both utility and nonutility companies. If utilities were excluded, ﬂotation costs would be even higher. What are ﬂotation costs? Are ﬂotation costs higher for debt or equity?

Some Problem Areas in Cost of Capital A number of difﬁcult issues relating to the cost of capital either have not been mentioned or were glossed over in this chapter. These topics are beyond the scope of this text, but they deserve some mention both to alert you to potential dangers and to provide you with a preview of some of the matters dealt with in advanced courses.

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1. Privately owned ﬁrms. Our discussion of the cost of equity was related primarily to publicly owned corporations, and we concentrated on the rate of return required by public stockholders. However, there is a serious question about how one should measure the cost of equity for a ﬁrm whose stock is not traded. Tax issues are also especially important in these cases. As a general rule, the same principles of cost of capital estimation apply to both privately held and publicly owned ﬁrms, but the problems of obtaining input data are somewhat different for each. 2. Small businesses. Small businesses are generally privately owned, making it difﬁcult to estimate their cost of equity. 3. Measurement problems. One cannot overemphasize the practical difﬁculties encountered when estimating the cost of equity. It is very difﬁcult to obtain good input data for the CAPM, for g in the formula rs ⫽ D1/P0 ⫹ g, and for the risk premium in the formula rs ⫽ Bond yield ⫹ Risk premium. As a result, we can never be sure just how accurate our estimated cost of capital is. 4. Costs of capital for projects of differing riskiness. As we will see in Chapter 8, it is difﬁcult to measure projects’ risks, hence to assign risk-adjusted discount rates to capital budgeting projects of differing degrees of riskiness. 5. Capital structure weights. In this chapter, we simply took as given the target capital structure and used this target to obtain the weights used to calculate WACC. As we shall see in Chapter 13, establishing the target capital structure is a major task in itself. Although this list of problems may appear formidable, the state of the art in cost of capital estimation is really not in bad shape. The procedures outlined in this chapter can be used to obtain cost of capital estimates that are sufﬁciently accurate for practical purposes, and the problems listed here merely indicate the desirability of reﬁnements. The reﬁnements are not unimportant, but the problems we have identiﬁed do not invalidate the usefulness of the procedures outlined in the chapter. Identify some problem areas in cost of capital analysis. Do these problems invalidate the cost of capital procedures discussed in the chapter?

Four Mistakes to Avoid We often see managers and students make the following mistakes when estimating the cost of capital. Although we have discussed these errors previously at separate places in the chapter, they are worth repeating here: 1. Never use the coupon rate on a ﬁrm’s existing debt as the pre-tax cost of debt. The relevant pre-tax cost of debt is the interest rate the ﬁrm would pay if it issued debt today. 2. When estimating the market risk premium for the CAPM method, never use the historical average return on stocks in conjunction with the current riskfree rate. The historical average return on common stocks has been about 13 percent, the historical return on long-term Treasury bonds about 5.5 percent, and the difference between them, which is the historical risk premium, is 7.5 percent. The current risk premium is found as the difference between an estimate of the current expected rate of return on common stocks and the current expected yield on T-bonds. To illustrate, suppose an estimate of the future return on common stock is 10 percent, and the current rate on long-term T-bonds is 4 percent. This implies that you expect

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To ﬁnd the current S&P 500 market to book ratio, go to yahoo.marketguide.com, get the stock quote for any company, and select ratio comparison.

to earn 10 percent if you buy stock today and 4 percent if you buy bonds. Therefore, this implies a current market risk premium of 10% ⫺ 4% ⫽ 6%. A case could be made for using either the historical or the current risk premium, but it would be wrong to take the historical rate of return on the market, 13 percent, subtract from it the current 4 percent rate on T-bonds, and then use 13% ⫺ 4% ⫽ 9% as the risk premium. 3. Never use the book value of equity when estimating the capital structure weights for the WACC. Your ﬁrst choice should be to use the target capital structure to determine the weights. If you are an outside analyst and do not know the target weights, it is better to estimate weights based on the current market values of the capital components than on their book values. This is especially true for equity. For example, the stock of an average S&P 500 ﬁrm in 2001 had a market value that was about 5.64 times its book value, and in general, stocks’ market values are rarely close to their book values. If the company’s debt is not publicly traded, then it is reasonable to use the book value of debt to estimate the weights, since book and market values of debt, especially short-term debt, are usually close to one another. To summarize, if you don’t know the target weights, then use market values of equity rather than book values to obtain the weights used to calculate WACC. 4. Always remember that capital components are funds that come from investors. If it’s not from an investor, then it’s not a capital component. Sometimes the argument is made that accounts payable and accruals are sources of funding and should be included in the calculation of the WACC. However, these accounts are due to operating relationships with suppliers and employees, and they are deducted when determining the investment requirement for a project. Therefore, they should not be included in the WACC. Of course, they are not ignored in either corporate valuation or capital budgeting. As we show in Chapter 9, current liabilities do affect cash ﬂow, hence have an effect on corporate valuation. Moreover, in Chapter 8 we show that the same is true for capital budgeting, namely, that current liabilities affect the cash ﬂows of a project, but not its WACC.16 What are four common mistakes people make when estimating the WACC?

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The cost of capital used in capital budgeting is a weighted average of the types of capital the ﬁrm uses, typically debt, preferred stock, and common equity. The component cost of debt is the after-tax cost of new debt. It is found by multiplying the cost of new debt by (1 ⫺ T), where T is the ﬁrm’s marginal tax rate: rd(1 ⫺ T).

The same reasoning could be applied to other items on the balance sheet, such as deferred taxes. The existence of deferred taxes means that the government has collected less in taxes than a company would owe if the same depreciation and amortization rates were used for taxes as for stockholder reporting. In this sense, the government is “making a loan to the company.” However, the deferred tax account is not a source of funds from investors, hence it is not considered to be a capital component. Moreover, the cash ﬂows that are used in capital budgeting and in corporate valuation reﬂect the actual taxes that the company must pay, not the “normalized” taxes it might report on its income statement. In other words, the correct adjustment for the deferred tax account is made in the cash ﬂows, not in the WACC.

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The component cost of preferred stock is calculated as the preferred dividend divided by the net issuing price, where the net issuing price is the price the ﬁrm receives after deducting ﬂotation costs: rps ⫽ Dps/Pn. The cost of common equity, rs, is also called the cost of common stock. It is the rate of return required by the ﬁrm’s stockholders, and it can be estimated by three methods: (1) the CAPM approach, (2) the dividend-yield-plus-growth-rate, or DCF, approach, and (3) the bond-yield-plus-risk-premium approach. To use the CAPM approach, one (1) estimates the ﬁrm’s beta, (2) multiplies this beta by the market risk premium to determine the ﬁrm’s risk premium, and (3) adds the ﬁrm’s risk premium to the risk-free rate to obtain the cost of common stock: rs ⫽ rRF ⫹ (RPM)bi. The best proxy for the risk-free rate is the yield on long-term T-bonds. To use the dividend-yield-plus-growth-rate approach, which is also called the discounted cash ﬂow (DCF) approach, one adds the ﬁrm’s expected growth rate to its expected dividend yield: rs ⫽ D1/P0 ⫹ g. The growth rate can be estimated from historical earnings and dividends or by use of the retention growth model, g ⫽ (1 ⫺ Payout)(Return on equity), or it can be based on analysts’ forecasts. The bond-yield-plus-risk-premium approach calls for adding a risk premium of from 3 to 5 percentage points to the ﬁrm’s interest rate on long-term debt: rs ⫽ Bond yield ⫹ RP. Each ﬁrm has a target capital structure, deﬁned as that mix of debt, preferred stock, and common equity that minimizes its weighted average cost of capital (WACC): WACC ⫽ wdrd (1 ⫺ T) ⫹ wpsrps ⫹ wcers.

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Various factors affect a ﬁrm’s cost of capital. Some of these factors are determined by the ﬁnancial environment, but the ﬁrm inﬂuences others through its ﬁnancing, investment, and dividend policies. Ideally, the cost of capital for each project should reﬂect the risk of the project itself, not the risks associated with the ﬁrm’s average project as reﬂected in its composite WACC. Failing to adjust for differences in project risk would lead a ﬁrm to accept too many value-destroying risky projects and reject too many value-adding safe ones. Over time, the ﬁrm would become more risky, its WACC would increase, and its shareholder value would decline. A project’s stand-alone risk is the risk the project would have if it were the ﬁrm’s only asset and if stockholders held only that one stock. Stand-alone risk is measured by the variability of the asset’s expected returns. Corporate, or within-ﬁrm, risk reﬂects the effects of a project on the ﬁrm’s risk, and it is measured by the project’s effect on the ﬁrm’s earnings variability. Market, or beta, risk reﬂects the effects of a project on the riskiness of stockholders, assuming they hold diversiﬁed portfolios. Market risk is measured by the project’s effect on the ﬁrm’s beta coefﬁcient. Most decision makers consider all three risk measures in a judgmental manner and then classify projects into subjective risk categories. Using the composite WACC as a starting point, risk-adjusted costs of capital are developed for each category. The risk-adjusted cost of capital is the cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital. Firms may be able to use the CAPM to estimate the cost of capital for speciﬁc projects or divisions. However, estimating betas for projects is difﬁcult. The pure play and accounting beta methods can sometimes be used to estimate betas for large projects or for divisions.

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Companies generally hire an investment banker to assist them when they issue common stock, preferred stock, or bonds. In return for a fee, the investment banker helps the company with the terms, price, and sale of the issue. The banker’s fees are often referred to as ﬂotation costs. The total cost of capital should include not only the required return paid to investors but also the ﬂotation fees paid to the investment banker for marketing the issue. When calculating the cost of new common stock, the DCF approach can be adapted to account for ﬂotation costs. For a constant growth stock, this cost can be expressed as: re ⫽ D1/[P0(1 ⫺ F)] ⫹ g. Note that ﬂotation costs cause re to be greater than rs. Flotation cost adjustments can also be made for debt. The bond’s issue price is reduced for ﬂotation expenses and then used to solve for the after-tax yield to maturity. The three equity cost estimating techniques discussed in this chapter have serious limitations when applied to small ﬁrms, thus increasing the need for the smallbusiness manager to use judgment.

The cost of capital as developed in this chapter is used in the following chapters to determine the value of a corporation and to evaluate capital budgeting projects. In addition, we will extend the concepts developed here in Chapter 13, where we consider the effect of the capital structure on the cost of capital.

Questions 6–1

Deﬁne each of the following terms: a. Weighted average cost of capital, WACC; after-tax cost of debt, rd(1 ⫺ T) b. Cost of preferred stock, rps; cost of common equity or cost of common stock, rs c. Target capital structure d. Flotation cost, F; cost of new external common equity, re

6–2

In what sense is the WACC an average cost? A marginal cost?

6–3

How would each of the following affect a ﬁrm’s cost of debt, rd(1 ⫺ T); its cost of equity, rs; and its weighted average cost of capital, WACC? Indicate by a plus (⫹), a minus (⫺), or a zero (0) if the factor would raise, lower, or have an indeterminate effect on the item in question. Assume other things are held constant. Be prepared to justify your answer, but recognize that several of the parts probably have no single correct answer; these questions are designed to stimulate thought and discussion. Effect on rd(1 ⫺ T)

rs

WACC

a. b. c. d.

The corporate tax rate is lowered. The Federal Reserve tightens credit. The ﬁrm uses more debt. The ﬁrm doubles the amount of capital it raises during the year. e. The ﬁrm expands into a risky new area. f. Investors become more risk averse.

6–4

Distinguish between beta (or market) risk, within-ﬁrm (or corporate) risk, and stand-alone risk for a potential project. Of the three measures, which is theoretically the most relevant, and why?

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The Cost of Capital Problems 6–5

Suppose a ﬁrm estimates its cost of capital for the coming year to be 10 percent. What might be reasonable costs of capital for average-risk, high-risk, and low-risk projects?

Self-Test Problem ST–1 WACC

253

(Solution Appears in Appendix A)

Longstreet Communications Inc. (LCI) has the following capital structure, which it considers to be optimal: debt ⫽ 25%, preferred stock ⫽ 15%, and common stock ⫽ 60%. LCI’s tax rate is 40 percent and investors expect earnings and dividends to grow at a constant rate of 9 percent in the future. LCI paid a dividend of $3.60 per share last year (D0), and its stock currently sells at a price of $60 per share. Treasury bonds yield 11 percent; an average stock has a 14 percent expected rate of return; and LCI’s beta is 1.51. These terms would apply to new security offerings: Preferred: New preferred could be sold to the public at a price of $100 per share, with a dividend of $11. Flotation costs of $5 per share would be incurred. Debt:

Debt could be sold at an interest rate of 12 percent.

a. Find the component costs of debt, preferred stock, and common stock. Assume LCI does not have to issue any additional shares of common stock. b. What is the WACC?

Problems 6–1 COST OF EQUITY

6–2 COST OF PREFERRED STOCK

6–3 COST OF EQUITY

6–4 AFTER-TAX COST OF DEBT

6–5 AFTER-TAX COST OF DEBT

6–6 COST OF PREFERRED STOCK

6–7 AFTER-TAX COST OF DEBT

David Ortiz Motors has a target capital structure of 40 percent debt and 60 percent equity. The yield to maturity on the company’s outstanding bonds is 9 percent, and the company’s tax rate is 40 percent. Ortiz’s CFO has calculated the company’s WACC as 9.96 percent. What is the company’s cost of equity capital? Tunney Industries can issue perpetual preferred stock at a price of $50 a share. The issue is expected to pay a constant annual dividend of $3.80 a share. The ﬂotation cost on the issue is estimated to be 5 percent. What is the company’s cost of preferred stock, rps? Javits & Sons’ common stock is currently trading at $30 a share. The stock is expected to pay a dividend of $3.00 a share at the end of the year (D1 ⫽ $3.00), and the dividend is expected to grow at a constant rate of 5 percent a year. What is the cost of common equity? Calculate the after-tax cost of debt under each of the following conditions: a. Interest rate, 13 percent; tax rate, 0 percent. b. Interest rate, 13 percent; tax rate, 20 percent. c. Interest rate, 13 percent; tax rate, 35 percent. The Heuser Company’s currently outstanding 10 percent coupon bonds have a yield to maturity of 12 percent. Heuser believes it could issue at par new bonds that would provide a similar yield to maturity. If its marginal tax rate is 35 percent, what is Heuser’s after-tax cost of debt? Trivoli Industries plans to issue some $100 par preferred stock with an 11 percent dividend. The stock is selling on the market for $97.00, and Trivoli must pay ﬂotation costs of 5 percent of the market price. What is the cost of the preferred stock for Trivoli? A company’s 6 percent coupon rate, semiannual payment, $1,000 par value bond which matures in 30 years sells at a price of $515.16. The company’s federal-plus-state tax rate is 40 percent. What is the ﬁrm’s component cost of debt for purposes of calculating the WACC? (Hint: Base your answer on the nominal rate.)

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The Cost of Capital 6–8

COST OF EQUITY

6–9 COST OF EQUITY

6–10 CALCULATION OF G AND EPS

6–11 WACC ESTIMATION

The earnings, dividends, and stock price of Carpetto Technologies Inc. are expected to grow at 7 percent per year in the future. Carpetto’s common stock sells for $23 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 at the end of the current year. a. Using the discounted cash ﬂow approach, what is its cost of equity? b. If the ﬁrm’s beta is 1.6, the risk-free rate is 9 percent, and the expected return on the market is 13 percent, what will be the ﬁrm’s cost of equity using the CAPM approach? c. If the ﬁrm’s bonds earn a return of 12 percent, what will rs be using the bond-yield-plus-riskpremium approach? (Hint: Use the midpoint of the risk premium range.) d. On the basis of the results of parts a through c, what would you estimate Carpetto’s cost of equity to be? The Bouchard Company’s EPS was $6.50 in 2002 and $4.42 in 1997. The company pays out 40 percent of its earnings as dividends, and the stock sells for $36. a. Calculate the past growth rate in earnings. (Hint: This is a 5-year growth period.) b. Calculate the next expected dividend per share, D1. (D0 ⫽ 0.4($6.50) ⫽ $2.60.) Assume that the past growth rate will continue. c. What is the cost of equity, rs, for the Bouchard Company? Sidman Products’ stock is currently selling for $60 a share. The ﬁrm is expected to earn $5.40 per share this year and to pay a year-end dividend of $3.60. a. If investors require a 9 percent return, what rate of growth must be expected for Sidman? b. If Sidman reinvests earnings in projects whose average return is equal to the stock’s expected rate of return, what will be next year’s EPS? [Hint: g ⫽ REO ( Retention ratio).] On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The ﬁrm’s present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt.

Debt Common equity Total capital

$30,000,000 30,000,000 $60,000,000

New bonds will have an 8 percent coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. Stockholders’ required rate of return is estimated to be 12 percent, consisting of a dividend yield of 4 percent and an expected constant growth rate of 8 percent. (The next expected dividend is $1.20, so $1.20/$30 ⫽ 4%.) The marginal corporate tax rate is 40 percent. a. To maintain the present capital structure, how much of the new investment must be ﬁnanced by common equity? b. Assume that there is sufﬁcient cash ﬂow such that Tysseland can maintain its target capital structure without issuing additional shares of equity. What is the WACC? c. Suppose now that there is not enough internal cash ﬂow and the ﬁrm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC? 6–12

Suppose the Schoof Company has this book value balance sheet:

MARKET VALUE CAPITAL STRUCTURE

Current assets Fixed assets

Total assets

$30,000,000 50,000,000

$80,000,000

Current liabilities Long-term debt Common equity Common stock (1 million shares) Retained earnings Total claims

$10,000,000 30,000,000 1,000,000 39,000,000 $80,000,000

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The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10 percent, the same as the rate on new bank loans. The long-term debt consists of 30,000 bonds, each of which has a par value of $1,000, carries an annual coupon interest rate of 6 percent, and matures in 20 years. The going rate of interest on new long-term debt, rd, is 10 percent, and this is the present yield to maturity on the bonds. The common stock sells at a price of $60 per share. Calculate the ﬁrm’s market value capital structure. 6–13 WACC ESTIMATION

A summary of the balance sheet of Travellers Inn Inc. (TII), a company which was formed by merging a number of regional motel chains and which hopes to rival Holiday Inn on the national scene, is shown in the table: Travellers Inn: December 31, 2002 (Millions of Dollars) Cash Accounts receivable Inventories Current assets Net ﬁxed assets

Total assets

$ 10 20 20 $ 50 50

$100

Accounts payable Accruals Short-term debt Current liabilities Long-term debt Preferred stock Common equity Common stock Retained earnings Total common equity Total liabilities and equity

$ 10 10 5 $ 25 30 5 $ 10 30 $ 40 $100

These facts are also given for TII: (1) Short-term debt consists of bank loans that currently cost 10 percent, with interest payable quarterly. These loans are used to ﬁnance receivables and inventories on a seasonal basis, so in the off-season, bank loans are zero. (2) The long-term debt consists of 20-year, semiannual payment mortgage bonds with a coupon rate of 8 percent. Currently, these bonds provide a yield to investors of rd ⫽ 12%. If new bonds were sold, they would yield investors 12 percent. (3) TII’s perpetual preferred stock has a $100 par value, pays a quarterly dividend of $2, and has a yield to investors of 11 percent. New perpetual preferred would have to provide the same yield to investors, and the company would incur a 5 percent ﬂotation cost to sell it. (4) The company has 4 million shares of common stock outstanding. P0 ⫽ $20, but the stock has recently traded in a range of $17 to $23. D0 ⫽ $1 and EPS0 ⫽ $2. ROE based on average equity was 24 percent in 2002, but management expects to increase this return on equity to 30 percent; however, security analysts are not aware of management’s optimism in this regard. (5) Betas, as reported by security analysts, range from 1.3 to 1.7; the T-bond rate is 10 percent; and RPM is estimated by various brokerage houses to be in the range of 4.5 to 5.5 percent. Brokerage house reports forecast growth rates in the range of 10 to 15 percent over the foreseeable future. However, some analysts do not explicitly forecast growth rates, but they indicate to their clients that they expect TII’s historical trends as shown in the table below to continue. (6) At a recent conference, TII’s ﬁnancial vice-president polled some pension fund investment managers on the minimum rate of return they would have to expect on TII’s common to make them willing to buy the common rather than TII bonds, when the bonds yielded 12 percent. The responses suggested a risk premium over TII bonds of 4 to 6 percentage points. (7) TII is in the 40 percent federal-plus-state tax bracket. (8) TII’s principal investment banker, Henry, Kaufman & Company, predicts a decline in interest rates, with rd falling to 10 percent and the T-bond rate to 8 percent, although Henry,

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The Cost of Capital Kaufman & Company acknowledges that an increase in the expected inﬂation rate could lead to an increase rather than a decrease in rates. (9) Here is the historical record of EPS and DPS: Year

EPS

DPS

Year

EPS

DPS

1988 1989 1990 1991 1992 1993 1994 1995

$0.09 ⫺0.20 0.40 0.52 0.10 0.57 0.61 0.70

$0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

1996 1997 1998 1999 2000 2001 2002

$0.78 0.80 1.20 0.95 1.30 1.60 2.00

$0.00 0.00 0.20 0.40 0.60 0.80 1.00

Assume that you are a recently hired ﬁnancial analyst, and your boss, the treasurer, has asked you to estimate the company’s WACC; assume no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects which are in the same risk class as the ﬁrm’s average assets now on books. 6–14 FLOTATION COSTS AND THE COST OF EQUITY

6–15 FLOTATION COSTS AND THE COST OF DEBT

Rework Problem 6-3, assuming that new stock will be issued. The stock will be issued for $30 and the ﬂotation cost is 10 percent of the issue proceeds. The expected dividend and growth remain at $3.00 per share and 5 percent, respectively. Suppose a company will issue new 20-year debt with a par value of $1,000 and a coupon rate of 9 percent, paid annually. The tax rate is 40 percent. If the ﬂotation cost is 2 percent of the issue proceeds, what is the after-tax cost of debt?

Spreadsheet Problem 6–16 BUILD A MODEL: WACC

Start with the partial model in the ﬁle Ch 06 P16 Build a Model.xls from the textbook’s web site. The stock of Gao Computing sells for $55, and last year’s dividend was $2.10. A ﬂotation cost of 10 percent would be required to issue new common stock. Gao’s preferred stock pays a dividend of $3.30 per share, and new preferred could be sold at a price to net the company $30 per share. Security analysts are projecting that the common dividend will grow at a rate of 7 percent a year. The ﬁrm can also issue additional long-term debt at an interest rate (or before-tax cost) of 10 percent, and its marginal tax rate is 35 percent. The market risk premium is 6 percent, the risk-free rate is 6.5 percent, and Gao’s beta is 0.83. In its cost of capital calculations, Gao uses a target capital structure with 45 percent debt, 5 percent preferred stock, and 50 percent common equity. a. Calculate the cost of each capital component (that is, the after-tax cost of debt), the cost of preferred stock (including ﬂotation costs), and the cost of equity (ignoring ﬂotation costs) with the DCF method and the CAPM method. b. Calculate the cost of new stock using the DCF model. c. What is the cost of new common stock, based on the CAPM? (Hint: Find the difference between re and rs as determined by the DCF method and add that differential to the CAPM value for rs.) d. Assuming that Gao will not issue new equity and will continue to use the same target capital structure, what is the company’s WACC? e. Suppose Gao is evaluating three projects with the following characteristics: (1) Each project has a cost of $1 million. They will all be ﬁnanced using the target mix of long-term debt, preferred stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for the project. All equity will come from retained earnings.

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(2) Equity invested in Project A would have a beta of 0.5 and an expected return of 9.0 percent. (3) Equity invested in Project B would have a beta of 1.0 and an expected return of 10.0 percent. (4) Equity invested in Project C would have a beta of 2.0 and an expected return of 11.0 percent. f. Analyze the company’s situation and explain why each project should be accepted or rejected.

See Ch 06 Show.ppt and Ch 06 Mini Case.xls.

During the last few years, Cox Technologies has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Jerry Lee, the ﬁnancial vice-president. Your ﬁrst task is to estimate Cox’s cost of capital. Lee has provided you with the following data, which he believes may be relevant to your task: (1) The ﬁrm’s tax rate is 40 percent. (2) The current price of Cox’s 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Cox does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no ﬂotation cost. (3) The current price of the ﬁrm’s 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. Cox would incur ﬂotation costs of $2.00 per share on a new issue. (4) Cox’s common stock is currently selling at $50 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future. Cox’s beta is 1.2, the yield on T-bonds is 7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-plus-risk-premium approach, the ﬁrm uses a 4 percentage point risk premium. (5) Cox’s target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity. To structure the task somewhat, Lee has asked you to answer the following questions. a. (1) What sources of capital should be included when you estimate Cox’s weighted average cost of capital (WACC)? (2) Should the component costs be ﬁgured on a before-tax or an after-tax basis? (3) Should the costs be historical (embedded) costs or new (marginal) costs? b. What is the market interest rate on Cox’s debt and its component cost of debt? c. (1) What is the ﬁrm’s cost of preferred stock? (2) Cox’s preferred stock is riskier to investors than its debt, yet the preferred’s yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.) d. (1) What are the two primary ways companies raise common equity? (2) Why is there a cost associated with reinvested earnings? (3) Cox doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Cox’s estimated cost of equity? e. (1) What is the estimated cost of equity using the discounted cash ﬂow (DCF) approach? (2) Suppose the ﬁrm has historically earned 15 percent on equity (ROE) and retained 35 percent of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5 percent growth rate given earlier? (3) Could the DCF method be applied if the growth rate was not constant? How? f. What is the cost of equity based on the bond-yield-plus-risk-premium method? g. What is your ﬁnal estimate for the cost of equity, rs? h. What is Cox’s weighted average cost of capital (WACC)?

The Cost of Capital 258

CHAPTER 6

The Cost of Capital

i. What factors inﬂuence a company’s WACC? j. Should the company use the composite WACC as the hurdle rate for each of its divisions? k. What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta? 1. Cox is interested in establishing a new division, which will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that stand-alone ﬁrms involved in similar projects have on average the following characteristics: 䊉 Their capital structure is 10 percent debt and 90 percent common equity. 䊉 Their cost of debt is typically 12 percent. 䊉 The beta is 1.7. Given this information, what would your estimate be for the division’s cost of capital? m. What are three types of project risk? How is each type of risk used? n. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reinvesting earnings. o. (1) Cox estimates that if it issues new common stock, the ﬂotation cost will be 15 percent. Cox incorporates the ﬂotation costs into the DCF approach. What is the estimated cost of newly issued common stock, taking into account the ﬂotation cost? (2) Suppose Cox issues 30-year debt with a par value of $1,000 and a coupon rate of 10 percent, paid annually. If ﬂotation costs are 2 percent, what is the after-tax cost of debt for the new bond issue? p. What four common mistakes in estimating the WACC should Cox avoid?

Selected Additional References and Cases For a comprehensive treatment of the cost of capital, see Ehrhardt, Michael C., The Search for Value: Measuring the Company’s Cost of Capital (Boston: Harvard Business School Press, 1994). The following articles provide some valuable insights into the CAPM approach to estimating the cost of equity: Amihud, Yakov, and Haim Mendelson, “Liquidity and Cost of Capital: Implications for Corporate Management,” Journal of Applied Corporate Finance, Fall 1989, 65–73. Boudreaux, Kenneth J., and Hugh W. Long; John R. Ezzell and R. Burr Porter; Moshe Ben Horim; and Alan C. Shapiro, “The Weighted Average Cost of Capital: A Discussion,” Financial Management, Summer 1979, 7–23. Bowman, Robert G., “The Theoretical Relationship between Systematic Risk and Financial (Accounting) Variables,” Journal of Finance, June 1979, 617–630. Brigham, Eugene F., Dilip K. Shome, and Steve R. Vinson, “The Risk Premium Approach to Measuring a Utility’s Cost of Equity,” Financial Management, Spring 1985, 33–45. Chen, Andrew, “Recent Developments in the Cost of Debt Capital,” Journal of Finance, June 1978, 863–883. Chen, Carl R., “Time-Series Analysis of Beta Stationarity and Its Determinants: A Case of Public Utilities,” Financial Management, Autumn 1982, 64–70.

Cooley, Philip L., “A Review of the Use of Beta in Regulatory Proceedings,” Financial Management, Winter 1981, 75–81. Harris, Robert S., and Felecia C. Marston, “Estimating Shareholder Risk Premia Using Analysts’ Growth Forecasts,” Financial Management, Summer 1992, 63–70. Nantell, Timothy J., and C. Robert Carlson, “The Cost of Capital as a Weighted Average,” Journal of Finance, December 1975, 1343–1355. Siegal, Jeremy J., “The Application of DCF Methodology for Determining the Cost of Equity Capital,” Financial Management, Spring 1985, 46–53. Taggart, Robert A., Jr., “Consistent Valuation and Cost of Capital Expressions with Corporate and Personal Taxes,” Financial Management, Autumn 1991, 8–20. Timme, Stephen G., and Peter C. Eisemann, “On the Use of Consensus Forecasts of Growth in the Constant Growth Model: The Case of Electric Utilities,” Financial Management, Winter 1989, 23–35. The following cases in the Cases in Financial Management series cover concepts related to the cost of capital: Case 4A, “West Coast Semiconductor;” Case 4B, “Ace Repair;” Case 4C, “Premier Paint & Body;” Case 6, “Randolph Corporation;” and Case 57, “Auto Hut.”

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77

I

n 1970, the Adolph Coors Company was a small brewer serving a regional market. But due to its quality products and aggressive marketing, by 1990 Coors had risen to the number three brand in the U.S. beer market. During this high-growth phase, the corporate emphasis was on marketing, technology, engineering, and capacity additions. When investing in new equipment or factories, Coors always went “the Cadillac route,” with little scrutiny of proposed projects. In effect, their motto was “If you build it, they will come.” Indeed, for two decades consumers did switch to Coors. However, the brewing industry began to experience major problems in the 1990s. Many consumers were drawn to wine, causing growth in beer sales to fall below 1 percent per year. In addition, large numbers of microbreweries opened, providing beer drinkers with an alternative to the national brands. These events proved particularly painful to Coors, whose lack of ﬁnancial discipline had led to a frivolous use of capital and thus to a high-cost infrastructure. In February 1995, Coors hired a new CFO, Timothy Wolf, who soon learned that Coors had a low return on invested capital, negative free cash ﬂow, and an unreliable planning/forecasting process. Wolf quickly created an in-house education program to teach managers and engineers how to conduct a rational project analysis. Even more important, he began to shift the corporate culture from a focus on undisciplined growth and high-technology engineering to creating shareholder value. This new focus was put to the test in 1996, when Coors reexamined its plans for a major new bottle-washing facility in Virginia. Using the capital budgeting processes established by Wolf, the project team was able to reduce the cost of the investment by 25 percent. They also implemented design changes that led to lower operating costs. Under Wolf’s guidance, Coors has steadily improved both its return on invested capital and its free cash ﬂow. Financial analysts are impressed with Wolf’s efforts. Skip Carpenter of Donaldson, Lufkin & Jenrette says, “From a ﬁnancial perspective, there’s absolutely no question Coors is better positioned to deal with the difﬁculties of the beer industry.”1 Investors seem to agree, as Coors’ stock price has climbed from about $14 per share when Wolf joined to over $52 per share in mid-2001, an annualized average gain of more than 24 percent.

1

See an article by Stephen Barr, “Coors’s New Brew,” CFO, March 1998, 91–93.

259

257

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The Basics of Capital Budgeting: Evaluating Cash Flows

This chapter’s focus is on capital budgeting, the process of evaluating speciﬁc investment decisions. Here the term capital refers to operating assets used in production, while a budget is a plan that details projected cash ﬂows during some future period. Thus, the capital budget is an outline of planned investments in operating assets, and capital budgeting is the whole process of analyzing projects and deciding which ones to include in the capital budget. Our treatment of capital budgeting is divided into three chapters. This chapter The textbook’s web site provides an overview of the capital budgeting process and explains the basic techcontains an Excel ﬁle that will guide you through the niques used to evaluate cash ﬂows. Chapter 8 then explains how to estimate a project’s chapter’s calculations. The cash ﬂows and risk. Finally, some projects provide managers with opportunities to reﬁle for this chapter is Ch 07 act to changing market conditions. These opportunities, called “real options,” are deTool Kit.xls, and we encourage you to open the ﬁle and scribed in Chapter 17. As you read this chapter, think about Coors and how it uses capital budgeting to follow along as you read the chapter. create value for shareholders.

Overview of Capital Budgeting Capital budgeting is perhaps the most important task faced by ﬁnancial managers and their staffs. First, a ﬁrm’s capital budgeting decisions deﬁne its strategic direction, because moves into new products, services, or markets must be preceded by capital expenditures. Second, the results of capital budgeting decisions continue for many years, reducing ﬂexibility. Third, poor capital budgeting can have serious ﬁnancial consequences. If the ﬁrm invests too much, it will incur unnecessarily high depreciation and other expenses. On the other hand, if it does not invest enough, its equipment and computer software may not be sufﬁciently modern to enable it to produce competitively. Also, if it has inadequate capacity, it may lose market share to rival ﬁrms, and regaining lost customers requires heavy selling expenses, price reductions, or product improvements, all of which are costly. The same general concepts that are used in security valuation are also involved in capital budgeting. However, whereas a set of stocks and bonds exists in the securities market, and investors select from this set, capital budgeting projects are created by the ﬁrm. For example, a sales representative may report that customers are asking for a particular product that the company does not now produce. The sales manager then discusses the idea with the marketing research group to determine the size of the market for the proposed product. If it appears that a signiﬁcant market does exist, cost accountants and engineers will be asked to estimate production costs. If they conclude that the product can be produced and sold at a sufﬁcient proﬁt, the project will be undertaken. A ﬁrm’s growth, and even its ability to remain competitive and to survive, depends on a constant ﬂow of ideas for new products, for ways to make existing products better, and for ways to operate at a lower cost. Accordingly, a well-managed ﬁrm will go to great lengths to encourage good capital budgeting proposals from its employees. If a ﬁrm has capable and imaginative executives and employees, and if its incentive system is working properly, many ideas for capital investment will be advanced. Some ideas will be good ones, but others will not. Therefore, companies must screen projects for those that add value, the primary topic of this chapter. Why are capital budgeting decisions so important? What are some ways ﬁrms get ideas for capital projects?

259

The Basics of Capital Budgeting: Evaluating Cash Flows Project Classiﬁcations

261

Project Classiﬁcations Analyzing capital expenditure proposals is not a costless operation—beneﬁts can be gained, but analysis does have a cost. For certain types of projects, a relatively detailed analysis may be warranted; for others, simpler procedures should be used. Accordingly, ﬁrms generally categorize projects and then analyze those in each category somewhat differently: 1. Replacement: maintenance of business. Replacement of worn-out or damaged equipment is necessary if the ﬁrm is to continue in business. The only issues here are (a) should this operation be continued and (b) should we continue to use the same production processes? If the answers are yes, maintenance decisions are normally made without an elaborate decision process. 2. Replacement: cost reduction. These projects lower the costs of labor, materials, and other inputs such as electricity by replacing serviceable but less efﬁcient equipment. These decisions are discretionary, and require a detailed analysis. 3. Expansion of existing products or markets. Expenditures to increase output of existing products, or to expand retail outlets or distribution facilities in markets now being served, are included here. These decisions are more complex because they require an explicit forecast of growth in demand, so a more detailed analysis is required. Also, the ﬁnal decision is generally made at a higher level within the ﬁrm. 4. Expansion into new products or markets. These projects involve strategic decisions that could change the fundamental nature of the business, and they normally require the expenditure of large sums with delayed paybacks. Invariably, a detailed analysis is required, and the ﬁnal decision is generally made at the very top—by the board of directors as a part of the ﬁrm’s strategic plan. 5. Safety and/or environmental projects. Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms are called mandatory investments, and they often involve nonrevenue-producing projects. How they are handled depends on their size, with small ones being treated much like the Category 1 projects described above. 6. Research and development. The expected cash ﬂows from R & D are often too uncertain to warrant a standard discounted cash ﬂow (DCF) analysis. Instead, decision tree analysis and the real options approach discussed in Chapter 17 are often used. 7. Long-term contracts. Companies often make long-term contractual arrangements to provide products or services to speciﬁc customers. For example, IBM has signed agreements to handle computer services for other companies for periods of 5 to 10 years. There may or may not be much up-front investment, but costs and revenues will accrue over multiple years, and a DCF analysis should be performed before the contract is signed. In general, relatively simple calculations and only a few supporting documents are required for replacement decisions, especially maintenance-type investments in profitable plants. A more detailed analysis is required for cost-reduction replacements, for expansion of existing product lines, and especially for investments in new products or areas. Also, within each category projects are classiﬁed by their dollar costs: Larger investments require increasingly detailed analysis and approval at a higher level within the ﬁrm. Thus, a plant manager may be authorized to approve maintenance expenditures up to $10,000 on the basis of a relatively unsophisticated analysis, but the full board of directors may have to approve decisions that involve either amounts over $1 million or expansions into new products or markets.

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The Basics of Capital Budgeting: Evaluating Cash Flows

Note that the term “assets” encompasses more than buildings and equipment. Computer software that a ﬁrm develops to help it buy supplies and materials more efﬁciently, or to communicate with customers, is also an asset, as is a customer base like the one AOL developed by sending out millions of free CDs to potential customers. All of these are “intangible” as opposed to “tangible” assets, but decisions to invest in them are analyzed in the same way as decisions related to tangible assets. Keep this in mind as you go through the remainder of the chapter. Identify the major project classiﬁcation categories, and explain how they are used.

Capital Budgeting Decision Rules Six key methods are used to rank projects and to decide whether or not they should be accepted for inclusion in the capital budget: (1) payback, (2) discounted payback, (3) net present value (NPV), (4) internal rate of return (IRR), (5) modiﬁed internal rate of return (MIRR), and (6) proﬁtability index (PI). We will explain how each ranking criterion is calculated, and then we will evaluate how well each performs in terms of identifying those projects that will maximize the ﬁrm’s stock price. The ﬁrst, and most difﬁcult, step in project analysis is estimating the relevant cash ﬂows, a step that Chapter 8 explains in detail. Our present focus is on the different decision rules, so we provide the cash ﬂows used in this chapter, starting with the expected cash ﬂows of Project S and L in Figure 7–1. These projects are equally risky, and the cash ﬂows for each year, CFt, reﬂect purchase cost, investments in working capital, taxes, depreciation, and salvage values. Finally, we assume that all cash ﬂows occur at the end of the designated year. Incidentally, the S stands for short and the L for long: Project S is a short-term project in the sense that its cash inﬂows come in sooner than L’s. FIGURE 7-1

Net Cash Flows for Projects S and L Expected After-Tax Net Cash Flows, CFt

Project S:

Project L:

a

Year (t)

Project S

Project L

0a 1 2 3 4

($1,000) 500 400 300 100

($1,000) 100 300 400 600

0

1

2

3

4

1,000

500

400

300

100

0

1

2

3

4

1,000

100

300

400

600

CF0 represents the cash ﬂow experienced at the project’s inception.

261

The Basics of Capital Budgeting: Evaluating Cash Flows Capital Budgeting Decision Rules

263

Payback Period The payback period, deﬁned as the expected number of years required to recover the original investment, was the ﬁrst formal method used to evaluate capital budgeting projects. The payback calculation is diagrammed in Figure 7-2, and it is explained below for Project S. The cumulative cash ﬂow at t 0 is just the initial cost of $1,000. At Year 1 the cumulative cash ﬂow is the previous cumulative of $1,000 plus the Year 1 cash ﬂow of $500: $1,000 $500 $500. Similarly, the cumulative for Year 2 is the previous cumulative of –$500 plus the Year 2 inﬂow of $400, resulting in –$100. We see that by the end of Year 3 the cumulative inﬂows have more than recovered the initial outﬂow. Thus, the payback occurred during the third year. If the $300 of inﬂows comes in evenly during Year 3, then the exact payback period can be found as follows: PaybackS Year before full recovery

Unrecovered cost at start of year Cash flow during year

$100 2 2.33 years. $300 Applying the same procedure to Project L, we ﬁnd PaybackL 3.33 years. The shorter the payback period, the better. Therefore, if the ﬁrm required a payback of three years or less, Project S would be accepted but Project L would be rejected. If the projects were mutually exclusive, S would be ranked over L because S has the shorter payback. Mutually exclusive means that if one project is taken on, the other must be rejected. For example, the installation of a conveyor-belt system in a warehouse and the purchase of a ﬂeet of forklifts for the same warehouse would be mutually exclusive projects—accepting one implies rejection of the other. Independent projects are projects whose cash ﬂows don’t affect one another.

Discounted Payback Period Some ﬁrms use a variant of the regular payback, the discounted payback period, which is similar to the regular payback period except that the expected cash ﬂows are discounted by the project’s cost of capital. Thus, the discounted payback period is deﬁned as the number of years required to recover the investment from discounted net cash ﬂows. Figure 7-3 contains the discounted net cash ﬂows for Projects S and L,

FIGURE 7-2

Payback Period for Projects S and L

Project S: Net cash ﬂow Cumulative NCF PaybackS 2.33 years. Project L: Net cash ﬂow Cumulative NCF PaybackL 3.33 years.

0 1,000 1,000 0 1,000 1,000

1 500 500 1 100 900

2 400 100 2 300 600

3

4

300 200

100 300

3

4

400 200

600 400

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The Basics of Capital Budgeting: Evaluating Cash Flows 264

CHAPTER 7

The Basics of Capital Budgeting: Evaluating Cash Flows FIGURE 7-3

Projects S and L: Discounted Payback Period

Project S: Net cash ﬂow Discounted NCF (at 10%) Cumulative discounted NCF PaybackS 2.95 years. Project L: Net cash ﬂow Discounted NCF (at 10%) Cumulative discounted NCF PaybackL 3.88 years.

0 1,000 1,000 1,000 0 1,000 1,000 1,000

1 500 455 545 1 100 91 909

2 400 331 214 2 300 248 661

3

4

300 225 11

100 68 79

3

4

400 301 360

600 410 50

assuming both projects have a cost of capital of 10 percent. To construct Figure 7-3, each cash inﬂow is divided by (1 r)t (1.10)t, where t is the year in which the cash ﬂow occurs and r is the project’s cost of capital. After three years, Project S will have generated $1,011 in discounted cash inﬂows. Because the cost is $1,000, the discounted payback is just under three years, or, to be precise, 2 ($214/$225) 2.95 years. Project L’s discounted payback is 3.88 years: Discounted paybackS 2.0 $214/$225 2.95 years. Discounted paybackL 3.0 $360/$410 3.88 years. For Projects S and L, the rankings are the same regardless of which payback method is used; that is, Project S is preferred to Project L, and Project S would still be selected if the ﬁrm were to require a discounted payback of three years or less. Often, however, the regular and the discounted paybacks produce conﬂicting rankings.

Evaluating Payback and Discounted Payback Note that the payback is a type of “breakeven” calculation in the sense that if cash ﬂows come in at the expected rate until the payback year, then the project will break even. However, the regular payback does not consider the cost of capital—no cost for the debt or equity used to undertake the project is reﬂected in the cash ﬂows or the calculation. The discounted payback does consider capital costs—it shows the breakeven year after covering debt and equity costs. An important drawback of both the payback and discounted payback methods is that they ignore cash ﬂows that are paid or received after the payback period. For example, suppose Project L had an additional cash ﬂow of $5,000 at Year 5. Common sense suggests that Project L would be more valuable than Project S, yet its payback and discounted payback make it look worse than Project S. Consequently, both payback methods have serious deﬁciencies.2 Although the payback methods have serious faults as ranking criteria, they do provide information on how long funds will be tied up in a project. Thus, the shorter the payback period, other things held constant, the greater the project’s liquidity. Also, since 2

Another capital budgeting technique that was once used widely is the accounting rate of return (ARR), which examines a project’s contribution to the ﬁrm’s net income. Very few companies still use the ARR, and it really has no redeeming features, so we will not discuss it.

263

The Basics of Capital Budgeting: Evaluating Cash Flows Capital Budgeting Decision Rules

265

cash ﬂows expected in the distant future are generally riskier than near-term cash ﬂows, the payback is often used as an indicator of a project’s riskiness.

Net Present Value (NPV) As the ﬂaws in the payback were recognized, people began to search for ways to improve the effectiveness of project evaluations. One such method is the net present value (NPV) method, which relies on discounted cash ﬂow (DCF) techniques. To implement this approach, we proceed as follows: 1. Find the present value of each cash ﬂow, including all inﬂows and outﬂows, discounted at the project’s cost of capital. 2. Sum these discounted cash ﬂows; this sum is deﬁned as the project’s NPV. 3. If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen. The equation for the NPV is as follows: NPV CF0

CF1 (1 r)

1

CF2 (1 r)

2

...

CFn (1 r)n (7-1)

n

CFt a . (1 r)t t0

Here CFt is the expected net cash ﬂow at Period t, r is the project’s cost of capital, and n is its life. Cash outﬂows (expenditures such as the cost of buying equipment or building factories) are treated as negative cash ﬂows. In evaluating Projects S and L, only CF0 is negative, but for many large projects such as the Alaska Pipeline, an electric generating plant, or a new Boeing jet aircraft, outﬂows occur for several years before operations begin and cash ﬂows turn positive. At a 10 percent cost of capital, Project S’s NPV is $78.82: r 10% 1

4

400

300

100

↑             

↑    

500

3

↑                   

1,000.00 454.55 330.58 225.39 68.30 Net Present Value 78.82 Cash Flows

2

↑                         

0

By a similar process, we ﬁnd NPVL $49.18. On this basis, both projects should be accepted if they are independent, but S should be chosen over L if they are mutually exclusive. It is not hard to calculate the NPV as was done in the time line by using Equation 7-1 and a regular calculator. However, it is more efﬁcient to use a ﬁnancial calculator. Different calculators are set up somewhat differently, but they all have a section of memory called the “cash ﬂow register” that is used for uneven cash ﬂows such as those in Projects S and L (as opposed to equal annuity cash ﬂows). A solution process for Equation 7-1 is literally programmed into ﬁnancial calculators, and all you have to do is enter the cash ﬂows (being sure to observe the signs), along with the value of r I. At that point, you have (in your calculator) this equation: NPVS 1,000

500 400 300 100 . (1.10)1 (1.10)2 (1.10)3 (1.10)4

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The Basics of Capital Budgeting: Evaluating Cash Flows

Note that the equation has one unknown, NPV. Now all you need to do is to ask the calculator to solve the equation for you, which you do by pressing the NPV button (and, on some calculators, the “compute” button). The answer, 78.82, will appear on the screen.3 Most projects last for more than four years, and, as you will see in Chapter 8, we must go through a number of steps to develop the estimated cash ﬂows. Therefore, ﬁnancial analysts generally use spreadsheets when dealing with capital budgeting projects. For Project S, this spreadsheet could be used (disregard for now the IRR on Row 6; we discuss it in the next section): A

B

C

1

Project S

2

r

3

Time

4

Cash ﬂow

5

NPV

$78.82

6

IRR

14.5%

D

E

F

10% 1

2

3

4

5

1000

500

400

300

100

In Excel, the formula in Cell B5 is: ⴝB4ⴙNPV(B2,C4:F4), and it results in a value of $78.82.4 For a simple problem such as this, setting up a spreadsheet may not seem worth the trouble. However, in real-world problems there will be a number of 3

The Technology Supplement for this text explains commonly used calculator applications for a variety of calculators. The steps for two popular calculators, the HP-10B and the HP-17B, are shown below. HP-10B: (1) Clear the memory. (2) Enter CF0 as follows: 1000 / CFj . (3) Enter CF1 as follows: 500 CFj . (4) Repeat the process to enter the other cash ﬂows. Note that CF 0, CF 1, and so forth, ﬂash on the screen as you press the CFj button. If you hold the button down, CF 0 and so forth, will remain on the screen until you release it. (5) Once the CFs have been entered, enter r I 10%: 10 I/YR . (6) Now that all of the inputs have been entered, you can press NPV to get the answer, NPV $78.82. (7) If a cash ﬂow is repeated for several years, you can avoid having to enter the CFs for each year. For example, if the $500 cash ﬂow for Year 1 had also been the CF for Years 2 through 10, making 10 of these $500 cash ﬂows, then after entering 500 CFj the ﬁrst time, you could enter 10 Nj . This would automatically enter 10 CFs of 500. HP-17B: (1) Go to the cash ﬂow (CFLO) menu, clear if FLOW(0) ? does not appear on the screen. (2) Enter CF0 as follows: 1000 / INPUT . (3) Enter CF1 as follows: 500 INPUT . (4) Now, the calculator will ask you if the 500 is for Period 1 only or if it is also used for several following periods. Since it is only used for Period 1, press INPUT to answer “1.” Alternatively, you could press EXIT and then #T? to turn off the prompt for the remainder of the problem. For some problems, you will want to use the repeat feature. (5) Enter the remaining CFs, being sure to turn off the prompt or else to specify “1” for each entry. (6) Once the CFs have all been entered, press EXIT and then CALC . (7) Now enter r I 10% as follows: 10 I% . (8) Now press NPV to get the answer, NPV $78.82. 4

You could click the function wizard, fx, then Financial, then NPV, and then OK. Then insert B2 as the rate and C4:F4 as “Value 1,” which is the cash ﬂow range. Then click OK, and edit the equation by adding B4. Note that you cannot enter the –$1,000 cost as part of the NPV range because the Excel NPV function assumes that the ﬁrst cash ﬂow in the range occurs at t 1.

265

The Basics of Capital Budgeting: Evaluating Cash Flows Capital Budgeting Decision Rules

See Ch 07 Tool Kit.xls.

267

rows above our cash ﬂow line, starting with expected sales, then deducting various costs and taxes, and ending up with the cash ﬂows shown on Row 4. Moreover, once a spreadsheet has been set up, it is easy to change input values to see what would happen under different conditions. For example, we could see what would happen if lower sales caused all cash ﬂows to decline by $15, or if the cost of capital rose to 10.5 percent. Using Excel, it is easy to make such changes and then see the effects on NPV.

Rationale for the NPV Method The rationale for the NPV method is straightforward. An NPV of zero signiﬁes that the project’s cash ﬂows are exactly sufﬁcient to repay the invested capital and to provide the required rate of return on that capital. If a project has a positive NPV, then it is generating more cash than is needed to service the debt and to provide the required return to shareholders, and this excess cash accrues solely to the ﬁrm’s stockholders. Therefore, if a ﬁrm takes on a project with a positive NPV, the wealth of the stockholders increases. In our example, shareholders’ wealth would increase by $78.82 if the ﬁrm takes on Project S, but by only $49.18 if it takes on Project L. Viewed in this manner, it is easy to see why S is preferred to L, and it is also easy to see the logic of the NPV approach.5 There is also a direct relationship between NPV and EVA (economic value added, as discussed in Chapter 9)—NPV is equal to the present value of the project’s future EVAs. Therefore, accepting positive NPV projects should result in a positive EVA and a positive MVA (market value added, or the excess of the ﬁrm’s market value over its book value). So, a reward system that compensates managers for producing positive EVA will lead to the use of NPV for making capital budgeting decisions.

Internal Rate of Return (IRR) In Chapter 4 we presented procedures for ﬁnding the yield to maturity, or rate of return, on a bond—if you invest in a bond, hold it to maturity, and receive all of the promised cash ﬂows, you will earn the YTM on the money you invested. Exactly the same concepts are employed in capital budgeting when the internal rate of return (IRR) method is used. The IRR is deﬁned as the discount rate that equates the present value of a project’s expected cash inﬂows to the present value of the project’s costs: PV(Inflows) PV(Investment costs), or, equivalently, the IRR is the rate that forces the NPV to equal zero: CF0

CF1 (1 IRR)

1

CF2 (1 IRR)

2

. . .

CFn 0 (1 IRR)n

n CFt NPV a 0. (1 IRR)t t0

5

(7-2)

This description of the process is somewhat oversimpliﬁed. Both analysts and investors anticipate that ﬁrms will identify and accept positive NPV projects, and current stock prices reﬂect these expectations. Thus, stock prices react to announcements of new capital projects only to the extent that such projects were not already expected.

266

The Basics of Capital Budgeting: Evaluating Cash Flows The Basics of Capital Budgeting: Evaluating Cash Flows

For our Project S, here is the time line setup: 0

Sum of PVs for CF1–4 Net Present Value 1,000

  1,000   

2

3

4

500

400

300

100

↑            

Cash Flows 1,000

1

↑   

IRR

↑                   

CHAPTER 7

↑                         

268

0

400 300 100 500 0. (1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4

Thus, we have an equation with one unknown, IRR, and we need to solve for IRR. Although it is easy to ﬁnd the NPV without a ﬁnancial calculator, this is not true of the IRR. If the cash ﬂows are constant from year to year, then we have an annuity, and we can use annuity formulas as discussed in Chapter 2 to ﬁnd the IRR. However, if the cash ﬂows are not constant, as is generally the case in capital budgeting, then it is difﬁcult to ﬁnd the IRR without a ﬁnancial calculator. Without a calculator, you must solve Equation 7-2 by trial-and-error—try some discount rate and see if the equation solves to zero, and if it does not, try a different discount rate, and continue until you ﬁnd the rate that forces the equation to equal zero. The discount rate that causes the equation (and the NPV) to equal zero is deﬁned as the IRR. For a realistic project with a fairly long life, the trial-and-error approach is a tedious, timeconsuming task. Fortunately, it is easy to ﬁnd IRRs with a ﬁnancial calculator. You follow procedures almost identical to those used to ﬁnd the NPV. First, you enter the cash ﬂows as shown on the preceding time line into the calculator’s cash ﬂow register. In effect, you have entered the cash ﬂows into the equation shown below the time line. Note that we have one unknown, IRR, which is the discount rate that forces the equation to equal zero. The calculator has been programmed to solve for the IRR, and you activate this program by pressing the button labeled “IRR.” Then the calculator solves for IRR and displays it on the screen. Here are the IRRs for Projects S and L as found with a ﬁnancial calculator:6 IRRS 14.5%. IRRL 11.8%. It is also easy to ﬁnd the IRR using the same spreadsheet we used for the NPV. With Excel, we simply enter this formula in Cell B6: ⴝIRR(B4:F4). For Project S, the result is 14.5 percent.7

6

To ﬁnd the IRR with an HP-10B or HP-17B, repeat the steps given in Footnote 3. Then, with an HP-10B,

press press

IRR/YR , and, after a pause, 14.49, Project S’s IRR, will appear. With the HP-17B, simply IRR%

to get the IRR. With both calculators, you would generally want to get both the NPV

and the IRR before clearing the cash ﬂow register. The Technology Supplement explains how to ﬁnd IRR with several other calculators. 7 Note that the full range is speciﬁed, because Excel’s IRR function assumes that the ﬁrst cash ﬂow (the negative $1,000) occurs at t 0. Also you can use the function wizard if you don’t have the formula memorized.

267

The Basics of Capital Budgeting: Evaluating Cash Flows Comparison of the NPV and IRR Methods

269

If both projects have a cost of capital, or hurdle rate, of 10 percent, then the internal rate of return rule indicates that if the projects are independent, both should be accepted—they are both expected to earn more than the cost of the capital needed to ﬁnance them. If they are mutually exclusive, S ranks higher and should be accepted, so L should be rejected. If the cost of capital is above 14.5 percent, both projects should be rejected. Notice that the internal rate of return formula, Equation 7-2, is simply the NPV formula, Equation 7-1, solved for the particular discount rate that forces the NPV to equal zero. Thus, the same basic equation is used for both methods, but in the NPV method the discount rate, r, is speciﬁed and the NPV is found, whereas in the IRR method the NPV is speciﬁed to equal zero, and the interest rate that forces this equality (the IRR) is calculated. Mathematically, the NPV and IRR methods will always lead to the same accept/ reject decisions for independent projects. This occurs because if NPV is positive, IRR must exceed r. However, NPV and IRR can give conﬂicting rankings for mutually exclusive projects. This point will be discussed in more detail in a later section.

Rationale for the IRR Method Why is the particular discount rate that equates a project’s cost with the present value of its receipts (the IRR) so special? The reason is based on this logic: (1) The IRR on a project is its expected rate of return. (2) If the internal rate of return exceeds the cost of the funds used to ﬁnance the project, a surplus will remain after paying for the capital, and this surplus will accrue to the ﬁrm’s stockholders. (3) Therefore, taking on a project whose IRR exceeds its cost of capital increases shareholders’ wealth. On the other hand, if the internal rate of return is less than the cost of capital, then taking on the project will impose a cost on current stockholders. It is this “breakeven” characteristic that makes the IRR useful in evaluating capital projects. What four capital budgeting ranking methods were discussed in this section? Describe each method, and give the rationale for its use. What two methods always lead to the same accept/reject decision for independent projects? What two pieces of information does the payback period convey that are not conveyed by the other methods?

Comparison of the NPV and IRR Methods In many respects the NPV method is better than IRR, so it is tempting to explain NPV only, to state that it should be used to select projects, and to go on to the next topic. However, the IRR is familiar to many corporate executives, it is widely entrenched in industry, and it does have some virtues. Therefore, it is important for you to understand the IRR method but also to be able to explain why, at times, a project with a lower IRR may be preferable to a mutually exclusive alternative with a higher IRR.

NPV Proﬁles See Ch 07 Tool Kit.xls for all calculations.

A graph that plots a project’s NPV against the cost of capital rates is deﬁned as the project’s net present value proﬁle; proﬁles for Projects L and S are shown in

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CHAPTER 7

The Basics of Capital Budgeting: Evaluating Cash Flows

Figure 7-4. To construct NPV proﬁles, ﬁrst note that at a zero cost of capital, the NPV is simply the total of the project’s undiscounted cash ﬂows. Thus, at a zero cost of capital NPVS $300, and NPVL $400. These values are plotted as the vertical axis intercepts in Figure 7-4. Next, we calculate the projects’ NPVs at three costs of capital, 5, 10, and 15 percent, and plot these values. The four points plotted on our graph for each project are shown at the bottom of the ﬁgure. Recall that the IRR is deﬁned as the discount rate at which a project’s NPV equals zero. Therefore, the point where its net present value proﬁle crosses the horizontal axis indicates a project’s internal rate of return. Since we calculated IRRS and IRRL in an earlier section, we can conﬁrm the validity of the graph. When we plot a curve through the data points, we have the net present value proﬁles. NPV proﬁles can be very useful in project analysis, and we will use them often in the remainder of the chapter.

NPV Rankings Depend on the Cost of Capital Figure 7-4 shows that the NPV proﬁles of both Project L and Project S decline as the cost of capital increases. But notice in the ﬁgure that Project L has the higher NPV at a low cost of capital, while Project S has the higher NPV if the cost of capital is greater than the 7.2 percent crossover rate. Notice also that Project L’s NPV is “more sensitive” to changes in the cost of capital than is NPVS; that is, Project L’s net present value proﬁle has the steeper slope, indicating that a given change in r has a greater effect on NPVL than on NPVS. Recall that a long-term bond has greater sensitivity to interest rates than a shortterm bond. Similarly, if a project has most of its cash ﬂows coming in the early years, its NPV will not decline very much if the cost of capital increases, but a project whose cash ﬂows come later will be severely penalized by high capital costs. Accordingly, Project L, which has its largest cash ﬂows in the later years, is hurt badly if the cost of capital is high, while Project S, which has relatively rapid cash ﬂows, is affected less by high capital costs. Therefore, Project L’s NPV proﬁle has the steeper slope.

Evaluating Independent Projects If an independent project is being evaluated, then the NPV and IRR criteria always lead to the same accept/reject decision: if NPV says accept, IRR also says accept. To see why this is so, assume that Projects L and S are independent, look at Figure 7-4, and notice (1) that the IRR criterion for acceptance for either project is that the project’s cost of capital is less than (or to the left of) the IRR and (2) that whenever a project’s cost of capital is less than its IRR, its NPV is positive. Thus, at any cost of capital less than 11.8 percent, Project L will be acceptable by both the NPV and the IRR criteria, while both methods reject Project L if the cost of capital is greater than 11.8 percent. Project S—and all other independent projects under consideration—could be analyzed similarly, and it will always turn out that if the IRR method says accept, then so will the NPV method.

Evaluating Mutually Exclusive Projects Now assume that Projects S and L are mutually exclusive rather than independent. That is, we can choose either Project S or Project L, or we can reject both, but we cannot accept both projects. Notice in Figure 7-4 that as long as the cost of capital is greater than the crossover rate of 7.2 percent, then (1) NPVS is larger than NPVL and

269

The Basics of Capital Budgeting: Evaluating Cash Flows Comparison of the NPV and IRR Methods FIGURE 7-4

271

Net Present Value Proﬁles: NPVs of Projects S and L at Different Costs of Capital

Net Present Value ($)

See Ch 07 Tool Kit.xls.

400

Project L's Net Present Value Profile

300

200 Crossover Rate = 7.2% 100

Project S's Net Present Value Profile IRRS = 14.5%

0

5

7.2

10

Cost of Capital (%) 15

IRR L = 11.8% –100

Cost of Capital

0% 5 10 15

NPVS

NPVL

$300.00 180.42 78.82 (8.33)

$400.00 206.50 49.18 (80.14)

(2) IRRS exceeds IRRL. Therefore, if r is greater than the crossover rate of 7.2 percent, the two methods both lead to the selection of Project S. However, if the cost of capital is less than the crossover rate, the NPV method ranks Project L higher, but the IRR method indicates that Project S is better. Thus, a conﬂict exists if the cost of capital is less than the crossover rate.8 NPV says choose mutually exclusive L, while IRR says take S. Which is correct? Logic suggests that the NPV method is better, because it selects the project that adds the most to shareholder wealth. But what causes the conﬂicting recommendations? Two basic conditions can cause NPV proﬁles to cross, and thus conﬂicts to arise between NPV and IRR: (1) when project size (or scale) differences exist, meaning that the

8

The crossover rate is easy to calculate. Simply go back to Figure 7-1, where we set forth the two projects’ cash ﬂows, and calculate the difference in those ﬂows in each year. The differences are CFS CFL $0, $400, $100, $100, and $500, respectively. Enter these values in the cash ﬂow register of a ﬁnancial calculator, press the IRR button, and the crossover rate, 7.17% 艐 7.2%, appears. Be sure to enter CF0 0 or else you will not get the correct answer.

270

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The Basics of Capital Budgeting: Evaluating Cash Flows

cost of one project is larger than that of the other, or (2) when timing differences exist, meaning that the timing of cash ﬂows from the two projects differs such that most of the cash ﬂows from one project come in the early years while most of the cash ﬂows from the other project come in the later years, as occurred with our Projects L and S. When either size or timing differences occur, the ﬁrm will have different amounts of funds to invest in the various years, depending on which of the two mutually exclusive projects it chooses. For example, if one project costs more than the other, then the ﬁrm will have more money at t 0 to invest elsewhere if it selects the smaller project. Similarly, for projects of equal size, the one with the larger early cash inﬂows—in our example, Project S—provides more funds for reinvestment in the early years. Given this situation, the rate of return at which differential cash ﬂows can be invested is a critical issue. The key to resolving conﬂicts between mutually exclusive projects is this: How useful is it to generate cash ﬂows sooner rather than later? The value of early cash ﬂows depends on the return we can earn on those cash ﬂows, that is, the rate at which we can reinvest them. The NPV method implicitly assumes that the rate at which cash ﬂows can be reinvested is the cost of capital, whereas the IRR method assumes that the ﬁrm can reinvest at the IRR. These assumptions are inherent in the mathematics of the discounting process. The cash ﬂows may actually be withdrawn as dividends by the stockholders and spent on beer and pizza, but the NPV method still assumes that cash ﬂows can be reinvested at the cost of capital, while the IRR method assumes reinvestment at the project’s IRR. Which is the better assumption—that cash ﬂows can be reinvested at the cost of capital, or that they can be reinvested at the project’s IRR? The best assumption is that projects’ cash ﬂows can be reinvested at the cost of capital, which means that the NPV method is more reliable. We should reiterate that, when projects are independent, the NPV and IRR methods both lead to exactly the same accept/reject decision. However, when evaluating mutually exclusive projects, especially those that differ in scale and/or timing, the NPV method should be used.

Multiple IRRs There is another reason the IRR approach may not be reliable—when projects have nonnormal cash ﬂows. A project has normal cash ﬂows if it has one or more cash outﬂows (costs) followed by a series of cash inﬂows. Notice that normal cash ﬂows have only one change in sign—they begin as negative cash ﬂows, change to positive cash ﬂows, and then remain positive.9 Nonnormal cash ﬂows occur when there is more than one change in sign. For example, a project may begin with negative cash ﬂows, switch to positive cash ﬂows, and then switch back to negative cash ﬂows. This cash ﬂow stream has two sign changes—negative to positive and then positive to negative—so it is a nonnormal cash ﬂow. Projects with nonnormal cash ﬂows can actually have two or more IRRs, or multiple IRRs! To see this, consider the equation that one solves to ﬁnd a project’s IRR: n

CFt a (1 IRR)t 0.

(7-2)

t0

9

Normal cash ﬂows can also begin with positive cash ﬂows, switch to negative cash ﬂows, and then remain negative. The key is that there is only one change in sign.

271

The Basics of Capital Budgeting: Evaluating Cash Flows Comparison of the NPV and IRR Methods

273

Notice that Equation 7-2 is a polynomial of degree n, so it has n different roots, or solutions. All except one of the roots are imaginary numbers when investments have normal cash ﬂows (one or more cash outﬂows followed by cash inﬂows), so in the normal case, only one value of IRR appears. However, the possibility of multiple real roots, hence multiple IRRs, arises when the project has nonnormal cash ﬂows (negative net cash ﬂows occur during some year after the project has been placed in operation). To illustrate, suppose a ﬁrm is considering the expenditure of $1.6 million to develop a strip mine (Project M). The mine will produce a cash ﬂow of $10 million at the end of Year 1. Then, at the end of Year 2, $10 million must be expended to restore the land to its original condition. Therefore, the project’s expected net cash ﬂows are as follows (in millions of dollars): Expected Net Cash Flows Year 0

End of Year 1

End of Year 2

$1.6

$10

$10

These values can be substituted into Equation 7-2 to derive the IRR for the investment: NPV

$1.6 million $10 million $10 million 0. 0 1 (1 IRR) (1 IRR) (1 IRR)2

When solved, we ﬁnd that NPV 0 when IRR 25% and also when IRR 400%.10 Therefore, the IRR of the investment is both 25 and 400 percent. This relationship is depicted graphically in Figure 7-5. Note that no dilemma would arise if the NPV method were used; we would simply use Equation 7-1, ﬁnd the NPV, and use this to evaluate the project. If Project M’s cost of capital were 10 percent, then its NPV would be $0.77 million, and the project should be rejected. If r were between 25 and 400 percent, the NPV would be positive. The example illustrates how multiple IRRs can arise when a project has nonnormal cash ﬂows. In contrast, the NPV criterion can easily be applied, and this method leads to conceptually correct capital budgeting decisions.

10

If you attempted to ﬁnd the IRR of Project M with many ﬁnancial calculators, you would get an error message. This same message would be given for all projects with multiple IRRs. However, you can still ﬁnd Project M’s IRRs by ﬁrst calculating NPVs using several different values for r and then plotting the NPV proﬁle. The intersections with the X-axis give a rough idea of the IRR values. Finally, you can use trial-anderror to ﬁnd the exact values of r that force NPV 0. Note, too, that some calculators, including the HP-10B and 17B, can ﬁnd the IRR. At the error message, key in a guess, store it, and press the IRR key. With the HP-10B, type 10 STO IRR, and the answer, 25.00, appears. If you enter as your guess a cost of capital less than the one at which NPV in Figure 7-5 is maximized (about 100%), the lower IRR, 25%, is displayed. If you guess a high rate, say, 150, the higher IRR is shown. The IRR function in spreadsheets also begins its trial-and-error search for a solution with an initial guess. If you omit the initial guess, the Excel default starting point is 10 percent. Now suppose the values 1.6, 10, and 10 were in Cells A1:C1. You could use this Excel formula: ⴝIRR(A1:C1,10%), where 10 percent is the initial guess, and it would produce a result of 25 percent. If you used a guess of 150 percent, you would have this formula: ⴝIRR(A1:C1,150%), and it would produce a result of 400 percent.

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CHAPTER 7

The Basics of Capital Budgeting: Evaluating Cash Flows FIGURE 7-5

NPV Proﬁle for Project M

NPV (Millions of Dollars) 1.5 NPV = –$1.6 + $10 – $10 (1 + r) (1 + r)2

1.0

IRR2 = 400%

0.5

0

100

200

300

400

500

Cost of Capital (%)

IRR1 = 25%

–0.5

–1.0

–1.5

Describe how NPV proﬁles are constructed, and deﬁne the crossover rate. How does the “reinvestment rate” assumption differ between the NPV and IRR methods? If a conﬂict exists, should the capital budgeting decision be made on the basis of the NPV or the IRR ranking? Why? Explain the difference between normal and nonnormal cash ﬂows, and their relationship to the “multiple IRR problem.”

Modiﬁed Internal Rate of Return (MIRR) In spite of a strong academic preference for NPV, surveys indicate that many executives prefer IRR over NPV. Apparently, managers ﬁnd it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV. Given this fact, can we devise a percentage evaluator that is better than the regular IRR? The answer is yes—we can modify the IRR and make it a better indicator of relative profitability, hence better for use in capital budgeting. The new measure is called the modiﬁed IRR, or MIRR, and it is deﬁned as follows: n nt a CIFt(1 r) COFt t0 t a (1 MIRR)n t0 (1 r) n

Terminal value PV of costs . (1 MIRR)n

(7-2a)

PV of terminal value Here COF refers to cash outﬂows (negative numbers), or the cost of the project, and CIF refers to cash inﬂows (positive numbers). The left term is simply the PV of the

273

The Basics of Capital Budgeting: Evaluating Cash Flows Modiﬁed Internal Rate of Return (MIRR)

275

investment outlays when discounted at the cost of capital, and the numerator of the right term is the compounded future value of the inﬂows, assuming that the cash inﬂows are reinvested at the cost of capital. The compounded future value of the cash inﬂows is also called the terminal value, or TV. The discount rate that forces the PV of the TV to equal the PV of the costs is deﬁned as the MIRR.11 We can illustrate the calculation with Project S: 0

2

3

4

500

400

300

100.00

r 10%

330.00 484.00 665.50 Terminal Value (TV) 1,579.50

↑                       

r 10%

↑              

r 10%

↑    

1,000 ↓ PV of costs12 1,000 Cash Flows

1

1,000 0

MIRR 12.1%

↑                                

PV of TV NPV

Using the cash ﬂows as set out on the time line, ﬁrst ﬁnd the terminal value by compounding each cash inﬂow at the 10 percent cost of capital. Then enter N 4, PV 1000, PMT 0, FV 1579.5, and then press the I button to ﬁnd MIRRS 12.1%. Similarly, we ﬁnd MIRRL 11.3%.13 The modiﬁed IRR has a signiﬁcant advantage over the regular IRR. MIRR assumes that cash ﬂows from all projects are reinvested at the cost of capital, while the regular IRR assumes that the cash ﬂows from each project are reinvested at the project’s own IRR. Since reinvestment at the cost of capital is generally more correct, the modiﬁed IRR is a better indicator of a project’s true proﬁtability. The MIRR also eliminates the multiple IRR problem. To illustrate, with r 10%, Project M (the strip mine project) has MIRR 5.6% versus its 10 percent cost of capital, so it should be rejected. This is consistent with the decision based on the NPV method, because at r 10%, NPV $0.77 million. 11

There are several alternative deﬁnitions for the MIRR. The differences primarily relate to whether negative cash ﬂows that occur after positive cash ﬂows begin should be compounded and treated as part of the TV or discounted and treated as a cost. A related issue is whether negative and positive ﬂows in a given year should be netted or treated separately. For a complete discussion, see William R. McDaniel, Daniel E. McCarty, and Kenneth A. Jessell, “Discounted Cash Flow with Explicit Reinvestment Rates: Tutorial and Extension,” The Financial Review, August 1988, 369–385; and David M. Shull, “Interpreting Rates of Return: A Modiﬁed Rate of Return Approach,” Financial Practice and Education, Fall 1993, 67–71

In this example, the only negative cash ﬂow occurs at t 0, so the PV of costs is equal to CF0. With some calculators, including the HP-17B, you could enter the cash inﬂows in the cash ﬂow register (being sure to enter CF0 0), enter I 10, and then press the NFV key to ﬁnd TVS 1,579.50. The HP-10B does not have an NFV key, but you can still use the cash ﬂow register to ﬁnd TV. Enter the cash inﬂows in the cash ﬂow register (with CF0 0), then enter I 10, then press NPV to ﬁnd the PV of the inﬂows, which is 1,078.82. Now, with the regular time value keys, enter N 4, I 10, PV 1078.82, PMT 0, and press FV to ﬁnd TVS 1,579.50. Similar procedures can be used with other ﬁnancial calculators. Most spreadsheets have a function for ﬁnding the MIRR. Refer back to our spreadsheet for Project S, with cash ﬂows of 1,000, 500, 400, 300, and 100 in Cells B4:F4. You could use the Excel function wizard to set up the following formula: ⴝMIRR(B4:F4,10%,10%). Here the ﬁrst 10 percent is the cost of capital used for discounting, and the second one is the rate used for compounding, or the reinvestment rate. In our deﬁnition of the MIRR, we assume that reinvestment is at the cost of capital, so we enter 10 percent twice. The result is an MIRR of 12.1 percent. 12

13

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Is MIRR as good as NPV for choosing between mutually exclusive projects? If two projects are of equal size and have the same life, then NPV and MIRR will always lead to the same decision. Thus, for any set of projects like our Projects S and L, if NPVS NPVL, then MIRRS MIRRL, and the kinds of conﬂicts we encountered between NPV and the regular IRR will not occur. Also, if the projects are of equal size, but differ in lives, the MIRR will always lead to the same decision as the NPV if the MIRRs are both calculated using as the terminal year the life of the longer project. (Just ﬁll in zeros for the shorter project’s missing cash ﬂows.) However, if the projects differ in size, then conﬂicts can still occur. For example, if we were choosing between a large project and a small mutually exclusive one, then we might ﬁnd NPVL NPVS, but MIRRS MIRRL. Our conclusion is that the MIRR is superior to the regular IRR as an indicator of a project’s “true” rate of return, or “expected long-term rate of return,” but the NPV method is still the best way to choose among competing projects because it provides the best indication of how much each project will add to the value of the ﬁrm. Describe how the modiﬁed IRR (MIRR) is calculated. What are the primary differences between the MIRR and the regular IRR? What condition can cause the MIRR and NPV methods to produce conﬂicting rankings?

Proﬁtability Index Another method used to evaluate projects is the proﬁtability index (PI): n CFt a (1 r)t PV of future cash flows t1 PI . Initial cost CF0

(7-3)

Here CFt represents the expected future cash ﬂows, and CF0 represents the initial cost. The PI shows the relative proﬁtability of any project, or the present value per dollar of initial cost. The PI for Project S, based on a 10 percent cost of capital, is 1.079: PIS

$1,078.82 1.079. $1,000

Thus, on a present value basis, Project S is expected to produce $1.079 for each $1 of investment. Project L, with a PI of 1.049, should produce $1.049 for each dollar invested. A project is acceptable if its PI is greater than 1.0, and the higher the PI, the higher the project’s ranking. Therefore, both S and L would be accepted by the PI criterion if they were independent, and S would be ranked ahead of L if they were mutually exclusive. Mathematically, the NPV, IRR, MIRR, and PI methods will always lead to the same accept/reject decisions for independent projects: If a project’s NPV is positive, its IRR and MIRR will always exceed r, and its PI will always be greater than 1.0. However, these methods can give conﬂicting rankings for mutually exclusive projects. This point is discussed in more detail in the next section. Explain how the PI is calculated. What does it measure?

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Conclusions on Capital Budgeting Methods We have discussed six capital budgeting decision methods, comparing the methods with one another, and highlighting their relative strengths and weaknesses. In the process, we probably created the impression that “sophisticated” ﬁrms should use only one method in the decision process, NPV. However, virtually all capital budgeting decisions are analyzed by computer, so it is easy to calculate and list all the decision measures: payback and discounted payback, NPV, IRR, modiﬁed IRR (MIRR), and proﬁtability index (PI). In making the accept/reject decision, most large, sophisticated ﬁrms calculate and consider all of the measures, because each one provides decision makers with a somewhat different piece of relevant information. Payback and discounted payback provide an indication of both the risk and the liquidity of a project—a long payback means (1) that the investment dollars will be locked up for many years, hence the project is relatively illiquid, and (2) that the project’s cash ﬂows must be forecasted far out into the future, hence the project is probably quite risky. A good analogy for this is the bond valuation process. An investor should never compare the yields to maturity on two bonds without also considering their terms to maturity, because a bond’s riskiness is affected by its maturity. NPV is important because it gives a direct measure of the dollar beneﬁt of the project to shareholders. Therefore, we regard NPV as the best single measure of profitability. IRR also measures proﬁtability, but here it is expressed as a percentage rate of return, which many decision makers prefer. Further, IRR contains information concerning a project’s “safety margin.” To illustrate, consider the following two projects: Project S (for small) costs $10,000 and is expected to return $16,500 at the end of one year, while Project L (for large) costs $100,000 and has an expected payoff of $115,500 after one year. At a 10 percent cost of capital, both projects have an NPV of $5,000, so by the NPV rule we should be indifferent between them. However, Project S has a much larger margin for error. Even if its realized cash inﬂow were 39 percent below the $16,500 forecast, the ﬁrm would still recover its $10,000 investment. On the other hand, if Project L’s inﬂows fell by only 13 percent from the forecasted $115,500, the ﬁrm would not recover its investment. Further, if no inﬂows were generated at all, the ﬁrm would lose only $10,000 with Project S, but $100,000 if it took on Project L. The NPV provides no information about either of these factors—the “safety margin” inherent in the cash ﬂow forecasts or the amount of capital at risk. However, the IRR does provide “safety margin” information—Project S’s IRR is a whopping 65 percent, while Project L’s IRR is only 15.5 percent. As a result, the realized return could fall substantially for Project S, and it would still make money. The modiﬁed IRR has all the virtues of the IRR, but (1) it incorporates a better reinvestment rate assumption, and (2) it avoids the multiple rate of return problem. The PI measures proﬁtability relative to the cost of a project—it shows the “bang per buck.” Like the IRR, it gives an indication of the project’s risk, because a high PI means that cash ﬂows could fall quite a bit and the project would still be proﬁtable. The different measures provide different types of information to decision makers. Since it is easy to calculate all of them, all should be considered in the decision process. For any speciﬁc decision, more weight might be given to one measure than another, but it would be foolish to ignore the information provided by any of the methods. Just as it would be foolish to ignore these capital budgeting methods, it would also be foolish to make decisions based solely on them. One cannot know at Time 0 the exact cost of future capital, or the exact future cash ﬂows. These inputs are simply estimates, and if they turn out to be incorrect, then so will be the calculated NPVs and IRRs. Thus, quantitative methods provide valuable information, but they should not be used as

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the sole criteria for accept/reject decisions in the capital budgeting process. Rather, managers should use quantitative methods in the decision-making process but also consider the likelihood that actual results will differ from the forecasts. Qualitative factors, such as the chances of a tax increase, or a war, or a major product liability suit, should also be considered. In summary, quantitative methods such as NPV and IRR should be considered as an aid to informed decisions but not as a substitute for sound managerial judgment. In this same vein, managers should ask sharp questions about any project that has a large NPV, a high IRR, or a high PI. In a perfectly competitive economy, there would be no positive NPV projects—all companies would have the same opportunities, and competition would quickly eliminate any positive NPV. Therefore, positive NPV projects must be predicated on some imperfection in the marketplace, and the longer the life of the project, the longer that imperfection must last. Therefore, managers should be able to identify the imperfection and explain why it will persist before accepting that a project will really have a positive NPV. Valid explanations might include patents or proprietary technology, which is how pharmaceutical and software ﬁrms create positive NPV projects. Hoechst’s Allegra® allergy medicine and Microsoft’s Windows XP® operating system are examples. Companies can also create positive NPV by being the ﬁrst entrant into a new market or by creating new products that meet some previously unidentiﬁed consumer needs. The Post-it® notes invented by 3M is an example. Similarly, Dell developed procedures for direct sales of microcomputers, and in the process created projects with enormous NPV. Also, companies such as Southwest Airlines have managed to train and motivate their workers better than their competitors, and this has led to positive NPV projects. In all of these cases, the companies developed some source of competitive advantage, and that advantage resulted in positive NPV projects. This discussion suggests three things: (1) If you can’t identify the reason a project has a positive projected NPV, then its actual NPV will probably not be positive. (2) Positive NPV projects don’t just happen—they result from hard work to develop some competitive advantage. At the risk of oversimpliﬁcation, the primary job of a manager is to ﬁnd and develop areas of competitive advantage. (3) Some competitive advantages last longer than others, with their durability depending on competitors’ ability to replicate them. Patents, the control of scarce resources, or large size in an industry where strong economies of scale exist can keep competitors at bay. However, it is relatively easy to replicate nonpatentable features on products. The bottom line is that managers should strive to develop nonreplicatible sources of competitive advantage, and if such an advantage cannot be demonstrated, then you should question projects with high NPV, especially if they have long lives. Describe the advantages and disadvantages of the six capital budgeting methods discussed in this chapter. Should capital budgeting decisions be made solely on the basis of a project’s NPV? What are some possible reasons that a project might have a large NPV?

Business Practices The ﬁndings of a 1993 survey of the capital budgeting methods used by the Fortune 500 industrial companies are shown below:14 14

Harold Bierman, “Capital Budgeting in 1993: A Survey,” Financial Management, Autumn 1993, 24.

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279

1. Every responding ﬁrm used some type of DCF method. In 1955, a similar study reported that only 4 percent of large companies used a DCF method. Thus, large ﬁrms’ usage of DCF methodology increased dramatically in the last half of the 20th century. 2. The payback period was used by 84 percent of Bierman’s surveyed companies. However, no company used it as the primary method, and most companies gave the greatest weight to a DCF method. In 1955, surveys similar to Bierman’s found that payback was the most important method. 3. In 1993, 99 percent of the Fortune 500 companies used IRR, while 85 percent used NPV. Thus, most ﬁrms actually used both methods. 4. Ninety-three percent of Bierman’s companies calculated a weighted average cost of capital as part of their capital budgeting process. A few companies apparently used the same WACC for all projects, but 73 percent adjusted the corporate WACC to account for project risk, and 23 percent made adjustments to reﬂect divisional risk. 5. An examination of surveys done by other authors led Bierman to conclude that there has been a strong trend toward the acceptance of academic recommendations, at least by large companies. A second 1993 study, conducted by Joe Walker, Richard Burns, and Chad Denson (WBD), focused on small companies.15 WBD began by noting the same trend toward the use of DCF that Bierman cited, but they reported that only 21 percent of small companies used DCF versus 100 percent for Bierman’s large companies. WBD also noted that within their sample, the smaller the ﬁrm, the smaller the likelihood that DCF would be used. The focal point of the WBD study was why small companies use DCF so much less frequently than large ﬁrms. The three most frequently cited reasons, according to the survey, were (1) small ﬁrms’ preoccupation with liquidity, which is best indicated by payback, (2) a lack of familiarity with DCF methods, and (3) a belief that small project sizes make DCF not worth the effort. The general conclusion one can reach from these studies is that large ﬁrms should and do use the procedures we recommend, and that managers of small ﬁrms, especially managers with aspirations for future growth, should at least understand DCF procedures well enough to make rational decisions about using or not using them. Moreover, as computer technology makes it easier and less expensive for small ﬁrms to use DCF methods, and as more and more of their competitors begin using these methods, survival will necessitate increased DCF usage. What general considerations can be reached from these studies?

The Post-Audit An important aspect of the capital budgeting process is the post-audit, which involves (1) comparing actual results with those predicted by the project’s sponsors and (2) explaining why any differences occurred. For example, many ﬁrms require that the operating divisions send a monthly report for the ﬁrst six months after a project goes into operation, and a quarterly report thereafter, until the project’s results are up to

15

Joe Walker, Richard Burns, and Chad Denson, “Why Small Manufacturing Firms Shun DCF,” Journal of Small Business Finance, 1993, 233–249.

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Techniques Firms Use to Evaluate Corporate Projects

Professors John Graham and Campbell Harvey of Duke University recently surveyed 392 chief ﬁnancial ofﬁcers (CFOs) about their companies’ corporate practices. Of those ﬁrms, 26 percent had sales less than $100 million, 32 percent had sales between $100 million and $1 billion, and 42 percent exceeded $1 billion. The CFOs were asked to indicate what approaches they used to estimate the cost of equity: 73.5 percent used the Capital Asset Pricing Model (CAPM), 34.3 percent used a multi-beta version of the CAPM, and 15.7 percent used the dividend discount model. The CFOs also used a variety of risk adjustment techniques, but most still used a single hurdle rate to evaluate all corporate projects. The CFOs were also asked about the capital budgeting techniques they used. Most used NPV (74.9 percent) and IRR (75.7 percent) to evaluate projects, but many (56.7 per-

cent) also used the payback approach. These results conﬁrm that most ﬁrms use more than one approach to evaluate projects. The survey also found important differences between the practices of small ﬁrms (less than $1 billion in sales) and large ﬁrms (more than $1 billion in sales). Consistent with the earlier studies by Bierman and by Walker, Burns, and Denson (WBD) described in the text, Graham and Harvey found that smaller ﬁrms are more likely to rely on the payback approach, while larger ﬁrms are more likely to rely on NPV and/or IRR. Source: From John R. Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics, Vol. 60, no. 2–3, 2001, 187–243. Copyright © 2001. Reprinted with permission from Elsevier Science.

expectations. From then on, reports on the operation are reviewed on a regular basis like those of other operations. The post-audit has three main purposes: 1. Improve forecasts. When decision makers are forced to compare their projections to actual outcomes, there is a tendency for estimates to improve. Conscious or unconscious biases are observed and eliminated; new forecasting methods are sought as the need for them becomes apparent; and people simply tend to do everything better, including forecasting, if they know that their actions are being monitored. 2. Improve operations. Businesses are run by people, and people can perform at higher or lower levels of efﬁciency. When a divisional team has made a forecast about an investment, its members are, in a sense, putting their reputations on the line and will strive to improve operations if they are evaluated with post-audits. In a discussion related to this point, one executive made this statement: “You academicians worry only about making good decisions. In business, we also worry about making decisions good.” 3. Identify termination opportunities. Although the decision to undertake a project may be the correct one based on information at hand, things don’t always turn out as expected. The post-audit can help identify projects that should be terminated because they have lost their economic viability. The results of post-audits often conclude that (1) the actual NPVs of most cost reduction projects exceed their expected NPVs by a slight amount, (2) expansion projects generally fall short of their expected NPVs by a slight amount, and (3) new product and new market projects often fall short by relatively large amounts. Thus, biases seem to exist, and companies that understand them can build in corrections and thus design better capital budgeting programs. Our observations of businesses and governmental units suggest that the best-run and most successful organizations put great emphasis on post-audits. Accordingly, we regard the post-audit as being one of the most important elements in a good capital budgeting system.

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What is done in the post-audit? Identify several purposes of the post-audit.

Special Applications of Cash Flow Evaluation Misapplication of the NPV method can lead to errors when two mutually exclusive projects have unequal lives. There are also situations in which an asset should not be operated for its full life. The following sections explain how to evaluate cash ﬂows in these situations.

Comparing Projects with Unequal Lives Note that a replacement decision involves comparing two mutually exclusive projects: retaining the old asset versus buying a new one. When choosing between two mutually exclusive alternatives with signiﬁcantly different lives, an adjustment is necessary. We now discuss two procedures—(1) the replacement chain method and (2) the equivalent annual annuity method—to illustrate the problem and to show how to deal with it. Suppose a company is planning to modernize its production facilities, and it is considering either a conveyor system (Project C) or some forklift trucks (Project F) for moving materials. Figure 7-6 shows both the expected net cash ﬂows and the NPVs for these two mutually exclusive alternatives. We see that Project C, when discounted at the ﬁrm’s 11.5 percent cost of capital, has the higher NPV and thus appears to be the better project. Although the NPV shown in Figure 7-6 suggests that Project C should be selected, this analysis is incomplete, and the decision to choose Project C is actually incorrect. If we choose Project F, we will have an opportunity to make a similar investment in three years, and if cost and revenue conditions continue at the Figure 7-6 levels, this second investment will also be proﬁtable. However, if we choose Project C, we cannot make this second investment. Two different approaches can be used to correctly compare Projects C and F. The ﬁrst is the equivalent annual annuity FIGURE 7-6

Expected Net Cash Flows for Projects C and F

Project C: 0

11.5%

40,000

1

2

3

4

5

6

8,000

14,000

13,000

12,000

11,000

10,000

NPVC at 11.5% $7,165; IRR 17.5%. Project F: 0 20,000

11.5%

1

2

3

7,000

13,000

12,000

NPVF at 11.5% $5,391; IRR 25.2%.

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(EAA) approach, and the second is the replacement chain (common life) approach. Both methods are theoretically correct, but the replacement chain approach is the most widely used method in practice because it is very easy to apply using spreadsheets and because it enables analysts to incorporate a variety of assumptions regarding future inﬂation and efﬁciency gains. For those reasons, we focus here upon the replacement chain approach. However, we provide a full description of the EAA approach on the Web Extension to this chapter, and the Ch 07 Tool Kit.xls illustrates the application of both methods. The key to the replacement chain approach is to analyze both projects using a common life. In this example, we will ﬁnd the NPV of Project F over a six-year period, and then compare this extended NPV with Project C’s NPV over the same six years. The NPV for Project C as calculated in Figure 7-6 is already over the six-year common life. For Project F, however, we must add in a second project to extend the overall life of the combined projects to six years. Here we assume (1) that Project F’s cost and annual cash inﬂows will not change if the project is repeated in three years and (2) that the cost of capital will remain at 11.5 percent: 0

1

2

7,000

13,000

11.5%

20,000

3 12,000 20,000 8,000

4

5

6

7,000

13,000

12,000

NPV at 11.5% $9,281; IRR 25.2%. The NPV of this extended Project F is $9,281, and its IRR is 25.2 percent. (The IRR of two Project Fs is the same as the IRR for one Project F.) Since the $9,281 extended NPV of Project F over the six-year common life is greater than the $7,165 NPV of Project C, Project F should be selected.16 When should we worry about unequal life analysis? The unequal life issue (1) does not arise for independent projects, but (2) it can arise if mutually exclusive projects with signiﬁcantly different lives are being compared. However, even for mutually exclusive projects, it is not always appropriate to extend the analysis to a common life. This should only be done if there is a high probability that the projects will actually be repeated at the end of their initial lives. We should note several potentially serious weaknesses inherent in this type of analysis: (1) If inﬂation is expected, then replacement equipment will have a higher price. Moreover, both sales prices and operating costs will probably change. Thus, the static conditions built into the analysis would be invalid. (2) Replacements that occur down the road would probably employ new technology, which in turn might change the cash ﬂows. (3) It is difﬁcult enough to estimate the lives of most projects, and even more so to estimate the lives of a series of projects.

16

Alternatively, we could recognize that the value of the cash ﬂow stream of two consecutive Project Fs can be summarized by two NPVs: one at Year 0 representing the value of the initial project, and one at Year 3 representing the value of the replication project: 0

11.5%

5,391

1

2

3

4

5

6

5,391

NPV $9,281. Ignoring rounding differences, the present value of these two cash ﬂows, when discounted at 11.5 percent, is again $9,281.

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In view of these problems, no experienced ﬁnancial analyst would be too concerned about comparing mutually exclusive projects with lives of, say, eight years and ten years. Given all the uncertainties in the estimation process, such projects would, for all practical purposes, be assumed to have the same life. Still, it is important to recognize that a problem exists if mutually exclusive projects have substantially different lives. When we encounter such problems in practice, we use a computer spreadsheet and build expected inﬂation and/or possible efﬁciency gains directly into the cash ﬂow estimates, and then use the replacement chain approach. The cash ﬂow estimation is a bit more complicated, but the concepts involved are exactly the same as in our example.

Economic Life versus Physical Life Projects are normally analyzed under the assumption that the ﬁrm will operate the asset over its full physical life. However, this may not be the best course of action—it may be best to terminate a project before the end of its potential life, and this possibility can materially affect the project’s estimated proﬁtability. The situation in Table 7-1 can be used to illustrate this concept and its effects on capital budgeting. The salvage values listed in the third column are after taxes, and they have been estimated for each year of Project A’s life. Using a 10 percent cost of capital, the expected NPV based on three years of operating cash ﬂows and the zero abandonment (salvage) value is $14.12: 0

1

2

3

$2,000

$2,000

$1,750 0

10%

($4,800)

NPV $4,800 $2,000/(1.10)1 $2,000/(1.10)2 $1,750/(1.10)3 $14.12. Thus, Project A would not be accepted if we assume that it will be operated over its full three-year life. However, what would its NPV be if the project were terminated after two years? In this case, we would receive operating cash ﬂows in Years 1 and 2, plus the salvage value at the end of Year 2, and the project’s NPV would be $34.71: 0 ($4,800)

1

2

$2,000

$2,000 1,650

10%

NPV $4,800 $2,000/(1.10)1 $2,000/(1.10)2 $1,650/(1.10)2 $34.71. Thus, Project A would be proﬁtable if we operate it for two years and then dispose of it. To complete the analysis, note that if the project were terminated after one year, its NPV would be $254.55. Thus, the optimal life for this project is two years. TABLE 7-1

Project A: Investment, Operating, and Salvage Cash Flows

Year (t)

Initial (Year 0) Investment and After-tax Operating Cash Flows

Net Salvage Value at End of Year t

0 1 2 3

($4,800) 2,000 2,000 1,750

$4,800 3,000 1,650 0

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This type of analysis can be used to determine a project’s economic life, which is the life that maximizes the NPV and thus maximizes shareholder wealth. For Project A, the economic life is two years versus the three-year physical, or engineering, life. Note that this analysis was based on the expected cash ﬂows and the expected salvage values, and it should always be conducted as a part of the capital budgeting evaluation if salvage values are relatively high. Brieﬂy describe the replacement chain (common life) approach. Deﬁne the economic life of a project (as opposed to its physical life).

The Optimal Capital Budget The optimal capital budget is the set of projects that maximizes the value of the ﬁrm. Finance theory states that all projects with positive NPVs should be accepted, and the optimal capital budget consists of these positive NPV projects. However, two complications arise in practice: (1) an increasing marginal cost of capital and (2) capital rationing.

An Increasing Marginal Cost of Capital The cost of capital may depend on the size of the capital budget. As we discussed in Chapter 6, the ﬂotation costs associated with issuing new equity or public debt can be quite high. This means that the cost of capital jumps upward after a company invests all of its internally generated cash and must sell new common stock. In addition, investors often perceive extremely large capital investments to be riskier, which may also drive up the cost of capital as the size of the capital budget increases. As a result, a project might have a positive NPV if it is part of a “normal size” capital budget, but the same project might have a negative NPV if it is part of an unusually large capital budget. Fortunately, this problem occurs very rarely for most ﬁrms, and it is unusual for an established ﬁrm to require new outside equity. Still, the Web Extension for this chapter on the textbook’s web site contains a more detailed discussion of this problem and shows how to deal with the existence of an increasing marginal cost of capital.

Capital Rationing Armbrister Pyrotechnics, a manufacturer of ﬁreworks and lasers for light shows, has identiﬁed 40 potential independent projects, with 15 having a positive NPV based on the ﬁrm’s 12 percent cost of capital. The total cost of implementing these 15 projects is $75 million. Based on ﬁnance theory, the optimal capital budget is $75 million, and Armbrister should accept the 15 projects with positive NPVs. However, Armbrister’s management has imposed a limit of $50 million for capital expenditures during the upcoming year. Due to this restriction, the company must forego a number of valueadding projects. This is an example of capital rationing, deﬁned as a situation in which a ﬁrm limits its capital expenditures to less than the amount required to fund the optimal capital budget. Despite being at odds with ﬁnance theory, this practice is quite common.

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Why would any company forego value-adding projects? Here are some potential explanations, along with some suggestions for better ways to handle these situations: 1. Reluctance to issue new stock. Many ﬁrms are extremely reluctant to issue new stock, so all of their capital expenditures must be funded out of debt and internally generated cash. Also, most ﬁrms try to stay near their target capital structure, and, combined with the limit on equity, this limits the amount of debt that can be added during any one year. The result can be a serious constraint on the amount of funds available for investment in new projects. This reluctance to issue new stock could be based on some sound reasons: (a) ﬂotation costs can be very expensive; (b) investors might perceive new stock offerings as a signal that the company’s equity is overvalued; and (c) the company might have to reveal sensitive strategic information to investors, thereby reducing some of its competitive advantages. To avoid these costs, many companies simply limit their capital expenditures. However, rather than placing a somewhat artiﬁcial limit on capital expenditures, a company might be better off explicitly incorporating the costs of raising external capital into its cost of capital. If there still are positive NPV projects even using this higher cost of capital, then the company should go ahead and raise external equity and accept the projects. See the Web Extension for this chapter on the textbook’s web site for more details concerning an increasing marginal cost of capital. 2. Constraints on nonmonetary resources. Sometimes a ﬁrm simply does not have the necessary managerial, marketing, or engineering talent to immediately accept all positive NPV projects. In other words, the potential projects are not really independent, because the ﬁrm cannot accept them all. To avoid potential problems due to spreading existing talent too thinly, many ﬁrms simply limit the capital budget to a size that can be accommodated by their current personnel. A better solution might be to employ a technique called linear programming. Each potential project has an expected NPV, and each potential project requires a certain level of support by different types of employees. A linear program can identify the set of projects that maximizes NPV, subject to the constraint that the total amount of support required for these projects does not exceed the available resources.17 3. Controlling estimation bias. Many managers become overly optimistic when estimating the cash ﬂows for a project. Some ﬁrms try to control this estimation bias by requiring managers to use an unrealistically high cost of capital. Others try to control the bias by limiting the size of the capital budget. Neither solution is generally effective since managers quickly learn the rules of the game and then increase their own estimates of project cash ﬂows, which might have been biased upward to begin with. A better solution is to implement a post-audit program and to link the accuracy of forecasts to the compensation of the managers who initiated the projects. What factors can lead to an increasing marginal cost of capital? How might this affect capital budgeting? What is capital rationing? What are three explanations for capital rationing? How might ﬁrms handle these situations?

17

See Stephen P. Bradley and Sherwood C. Frey, Jr., “Equivalent Mathematical Programming Models of Pure Capital Rationing,” Journal of Financial and Quantitative Analysis, June 1978, 345–361.

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The Basics of Capital Budgeting: Evaluating Cash Flows

Summary This chapter has described six techniques (payback, discounted payback, NPV, IRR, MIRR, and PI) that are used in capital budgeting analysis. Each approach provides a different piece of information, so in this age of computers, managers often look at all of them when evaluating projects. However, NPV is the best single measure, and almost all ﬁrms now use NPV. The key concepts covered in this chapter are listed below: 䊉

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Capital budgeting is the process of analyzing potential projects. Capital budgeting decisions are probably the most important ones managers must make. The payback period is deﬁned as the number of years required to recover a project’s cost. The regular payback method ignores cash ﬂows beyond the payback period, and it does not consider the time value of money. The payback does, however, provide an indication of a project’s risk and liquidity, because it shows how long the invested capital will be “at risk.” The discounted payback method is similar to the regular payback method except that it discounts cash ﬂows at the project’s cost of capital. It considers the time value of money, but it ignores cash ﬂows beyond the payback period. The net present value (NPV) method discounts all cash ﬂows at the project’s cost of capital and then sums those cash ﬂows. The project should be accepted if the NPV is positive. The internal rate of return (IRR) is deﬁned as the discount rate that forces a project’s NPV to equal zero. The project should be accepted if the IRR is greater than the cost of capital. The NPV and IRR methods make the same accept/reject decisions for independent projects, but if projects are mutually exclusive, then ranking conﬂicts can arise. If conﬂicts arise, the NPV method should be used. The NPV and IRR methods are both superior to the payback, but NPV is superior to IRR. The NPV method assumes that cash ﬂows will be reinvested at the ﬁrm’s cost of capital, while the IRR method assumes reinvestment at the project’s IRR. Reinvestment at the cost of capital is generally a better assumption because it is closer to reality. The modiﬁed IRR (MIRR) method corrects some of the problems with the regular IRR. MIRR involves ﬁnding the terminal value (TV) of the cash inﬂows, compounded at the ﬁrm’s cost of capital, and then determining the discount rate that forces the present value of the TV to equal the present value of the outﬂows. The proﬁtability index (PI) shows the dollars of present value divided by the initial cost, so it measures relative proﬁtability. Sophisticated managers consider all of the project evaluation measures because each measure provides a useful piece of information. The post-audit is a key element of capital budgeting. By comparing actual results with predicted results and then determining why differences occurred, decision makers can improve both their operations and their forecasts of projects’ outcomes. Small ﬁrms tend to use the payback method rather than a discounted cash ﬂow method. This may be rational, because (1) the cost of conducting a DCF analysis may outweigh the beneﬁts for the project being considered, (2) the ﬁrm’s cost of capital cannot be estimated accurately, or (3) the small-business owner may be considering nonmonetary goals. If mutually exclusive projects have unequal lives, it may be necessary to adjust the analysis to put the projects on an equal life basis. This can be done using the replacement chain (common life) approach.

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The Basics of Capital Budgeting: Evaluating Cash Flows Self-Test Problem 䊉

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287

A project’s true value may be greater than the NPV based on its physical life if it can be terminated at the end of its economic life. Flotation costs and increased riskiness associated with unusually large expansion programs can cause the marginal cost of capital to rise as the size of the capital budget increases. Capital rationing occurs when management places a constraint on the size of the ﬁrm’s capital budget during a particular period.

Questions 7–1

Deﬁne each of the following terms: a. Capital budgeting; regular payback period; discounted payback period b. Independent projects; mutually exclusive projects c. DCF techniques; net present value (NPV) method; internal rate of return (IRR) method d. Modiﬁed internal rate of return (MIRR) method; proﬁtability index e. NPV proﬁle; crossover rate f. Nonnormal cash ﬂow projects; normal cash ﬂow projects; multiple IRRs g. Hurdle rate; reinvestment rate assumption; post-audit h. Replacement chain; economic life; capital rationing

7–2

How is a project classiﬁcation scheme (for example, replacement, expansion into new markets, and so forth) used in the capital budgeting process?

7–3

Explain why the NPV of a relatively long-term project, deﬁned as one for which a high percentage of its cash ﬂows are expected in the distant future, is more sensitive to changes in the cost of capital than is the NPV of a short-term project.

7–4

Explain why, if two mutually exclusive projects are being compared, the short-term project might have the higher ranking under the NPV criterion if the cost of capital is high, but the long-term project might be deemed better if the cost of capital is low. Would changes in the cost of capital ever cause a change in the IRR ranking of two such projects?

7–5

In what sense is a reinvestment rate assumption embodied in the NPV, IRR, and MIRR methods? What is the assumed reinvestment rate of each method?

7–6

Suppose a ﬁrm is considering two mutually exclusive projects. One has a life of 6 years and the other a life of 10 years. Would the failure to employ some type of replacement chain analysis bias an NPV analysis against one of the projects? Explain.

Self-Test Problem ST–1 PROJECT ANALYSIS

(Solution Appears in Appendix A)

You are a ﬁnancial analyst for the Hittle Company. The director of capital budgeting has asked you to analyze two proposed capital investments, Projects X and Y. Each project has a cost of $10,000, and the cost of capital for each project is 12 percent. The projects’ expected net cash ﬂows are as follows: Expected Net Cash Flows Year

Project X

Project Y

0 1 2 3 4

($10,000) 6,500 3,000 3,000 1,000

($10,000) 3,500 3,500 3,500 3,500

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The Basics of Capital Budgeting: Evaluating Cash Flows a. Calculate each project’s payback period, net present value (NPV), internal rate of return (IRR), and modiﬁed internal rate of return (MIRR). b. Which project or projects should be accepted if they are independent? c. Which project should be accepted if they are mutually exclusive? d. How might a change in the cost of capital produce a conﬂict between the NPV and IRR rankings of these two projects? Would this conﬂict exist if r were 5%? (Hint: Plot the NPV proﬁles.) e. Why does the conﬂict exist?

Problems 7–1 DECISION METHODS

7–2 NPV

Project K has a cost of $52,125, its expected net cash inﬂows are $12,000 per year for 8 years, and its cost of capital is 12 percent. (Hint: Begin by constructing a time line.) a. What is the project’s payback period (to the closest year)? b. What is the project’s discounted payback period? c. What is the project’s NPV? d. What is the project’s IRR? e. What is the project’s MIRR? Your division is considering two investment projects, each of which requires an up-front expenditure of $15 million. You estimate that the investments will produce the following net cash ﬂows: Year

Project A

Project B

1 2 3

$ 5,000,000 10,000,000 20,000,000

$20,000,000 10,000,000 6,000,000

What are the two projects’ net present values, assuming the cost of capital is 10 percent? 5 percent? 15 percent? 7–3 NPVS, IRRS, AND MIRRS FOR INDEPENDENT PROJECTS

Edelman Engineering is considering including two pieces of equipment, a truck and an overhead pulley system, in this year’s capital budget. The projects are independent. The cash outlay for the truck is $17,100, and that for the pulley system is $22,430. The ﬁrm’s cost of capital is 14 percent. After-tax cash ﬂows, including depreciation, are as follows: Year

Truck

Pulley

1 2 3 4 5

$5,100 5,100 5,100 5,100 5,100

$7,500 7,500 7,500 7,500 7,500

Calculate the IRR, the NPV, and the MIRR for each project, and indicate the correct accept/reject decision for each. 7–4 NPVS AND IRRS FOR MUTUALLY EXCLUSIVE PROJECTS

B. Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving materials in its factory. Since both forklifts perform the same function, the ﬁrm will choose only one. (They are mutually exclusive investments.) The electric-powered truck will cost more, but it will be less expensive to operate; it will cost $22,000, whereas the gas-powered truck will cost $17,500. The cost of capital that applies to both investments is 12 percent. The life for both types of truck is estimated to be 6 years, during which time the net cash ﬂows for the electric-powered truck will be $6,290 per year and those for the gas-powered truck will be

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The Basics of Capital Budgeting: Evaluating Cash Flows Problems

289

$5,000 per year. Annual net cash ﬂows include depreciation expenses. Calculate the NPV and IRR for each type of truck, and decide which to recommend. 7–5 CAPITAL BUDGETING METHODS

7–6 MIRR AND NPV

Project S has a cost of $10,000 and is expected to produce beneﬁts (cash ﬂows) of $3,000 per year for 5 years. Project L costs $25,000 and is expected to produce cash ﬂows of $7,400 per year for 5 years. Calculate the two projects’ NPVs, IRRs, MIRRs, and PIs, assuming a cost of capital of 12 percent. Which project would be selected, assuming they are mutually exclusive, using each ranking method? Which should actually be selected? Your company is considering two mutually exclusive projects, X and Y, whose costs and cash ﬂows are shown below: Year

0 1 2 3 4

X

($1,000) 100 300 400 700

Y

($1,000) 1,000 100 50 50

The projects are equally risky, and their cost of capital is 12 percent. You must make a recommendation, and you must base it on the modiﬁed IRR (MIRR). What is the MIRR of the better project? 7–7 NPV AND IRR ANALYSIS

7–8 NPV AND IRR ANALYSIS

After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation must decide whether to mine the deposit. The most cost-effective method of mining gold is sulfuric acid extraction, a process that results in environmental damage. To go ahead with the extraction, CTC must spend $900,000 for new mining equipment and pay $165,000 for its installation. The gold mined will net the ﬁrm an estimated $350,000 each year over the 5-year life of the vein. CTC’s cost of capital is 14 percent. For the purposes of this problem, assume that the cash inﬂows occur at the end of the year. a. What is the NPV and IRR of this project? b. Should this project be undertaken, ignoring environmental concerns? c. How should environmental effects be considered when evaluating this, or any other, project? How might these effects change your decision in part b? Cummings Products Company is considering two mutually exclusive investments. The projects’ expected net cash ﬂows are as follows:

Expected Net Cash Flows Year

Project A

Project B

0 1 2 3 4 5 6

($300) (387) (193) (100) 600 600 850

($405) 134 134 134 134 134 134

7

(180)

0

a. Construct NPV proﬁles for Projects A and B. b. What is each project’s IRR?

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The Basics of Capital Budgeting: Evaluating Cash Flows c. If you were told that each project’s cost of capital was 10 percent, which project should be selected? If the cost of capital was 17 percent, what would be the proper choice? d. What is each project’s MIRR at a cost of capital of 10 percent? At 17%? (Hint: Consider Period 7 as the end of Project B’s life.) e. What is the crossover rate, and what is its signiﬁcance? 7–9

TIMING DIFFERENCES

7–10 SCALE DIFFERENCES

7–11 MULTIPLE RATES OF RETURN

7–12 PRESENT VALUE OF COSTS

The Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on property for which it has mineral rights. Both plans call for the expenditure of $10,000,000 to drill development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash ﬂow at t 1 of $12,000,000, while under Plan B, cash ﬂows will be $1,750,000 per year for 20 years. a. What are the annual incremental cash ﬂows that will be available to Ewert Exploration if it undertakes Plan B rather than Plan A? (Hint: Subtract Plan A’s ﬂows from B’s.) b. If the ﬁrm accepts Plan A, then invests the extra cash generated at the end of Year 1, what rate of return (reinvestment rate) would cause the cash ﬂows from reinvestment to equal the cash ﬂows from Plan B? c. Suppose a company has a cost of capital of 10 percent. Is it logical to assume that it would take on all available independent projects (of average risk) with returns greater than 10 percent? Further, if all available projects with returns greater than 10 percent have been taken, would this mean that cash ﬂows from past investments would have an opportunity cost of only 10 percent, because all the ﬁrm could do with these cash ﬂows would be to replace money that has a cost of 10 percent? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project’s cash ﬂows? d. Construct NPV proﬁles for Plans A and B, identify each project’s IRR, and indicate the crossover rate of return. The Pinkerton Publishing Company is considering two mutually exclusive expansion plans. Plan A calls for the expenditure of $50 million on a large-scale, integrated plant which will provide an expected cash ﬂow stream of $8 million per year for 20 years. Plan B calls for the expenditure of $15 million to build a somewhat less efﬁcient, more labor-intensive plant which has an expected cash ﬂow stream of $3.4 million per year for 20 years. The ﬁrm’s cost of capital is 10 percent. a. Calculate each project’s NPV and IRR. b. Set up a Project by showing the cash ﬂows that will exist if the ﬁrm goes with the large plant rather than the smaller plant. What are the NPV and the IRR for this Project ? c. Graph the NPV proﬁles for Plan A, Plan B, and Project . d. Give a logical explanation, based on reinvestment rates and opportunity costs, as to why the NPV method is better than the IRR method when the ﬁrm’s cost of capital is constant at some value such as 10 percent. The Ulmer Uranium Company is deciding whether or not it should open a strip mine, the net cost of which is $4.4 million. Net cash inﬂows are expected to be $27.7 million, all coming at the end of Year 1. The land must be returned to its natural state at a cost of $25 million, payable at the end of Year 2. a. Plot the project’s NPV proﬁle. b. Should the project be accepted if r 8%? If r 14%? Explain your reasoning. c. Can you think of some other capital budgeting situations where negative cash ﬂows during or at the end of the project’s life might lead to multiple IRRs? d. What is the project’s MIRR at r 8%? At r 14%? Does the MIRR method lead to the same accept/reject decision as the NPV method? The Aubey Coffee Company is evaluating the within-plant distribution system for its new roasting, grinding, and packing plant. The two alternatives are (1) a conveyor system with a high initial cost, but low annual operating costs, and (2) several forklift trucks, which cost less, but have considerably higher operating costs. The decision to construct the plant has already been made, and the choice here will have no effect on the overall revenues of the project. The cost of capital for the plant is 8 percent, and the projects’ expected net costs are listed in the table:

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The Basics of Capital Budgeting: Evaluating Cash Flows Problems

291

Expected Net Cost Year

Conveyor

Forklift

0 1 2 3 4 5

($500,000) (120,000) (120,000) (120,000) (120,000) (120,000)

($200,000) (160,000) (160,000) (160,000) (160,000) (160,000)

a. What is the IRR of each alternative? b. What is the present value of costs of each alternative? Which method should be chosen? 7–13 PAYBACK, NPV, AND MIRR

Your division is considering two investment projects, each of which requires an up-front expenditure of $25 million. You estimate that the cost of capital is 10 percent and that the investments will produce the following after-tax cash ﬂows (in millions of dollars): Year

Project A

Project B

1 2 3 4

5 10 15 20

20 10 8 6

a. What is the regular payback period for each of the projects? b. What is the discounted payback period for each of the projects? c. If the two projects are independent and the cost of capital is 10 percent, which project or projects should the ﬁrm undertake? d. If the two projects are mutually exclusive and the cost of capital is 5 percent, which project should the ﬁrm undertake? e. If the two projects are mutually exclusive and the cost of capital is 15 percent, which project should the ﬁrm undertake? f. What is the crossover rate? g. If the cost of capital is 10 percent, what is the modiﬁed IRR (MIRR) of each project? 7–14 UNEQUAL LIVES

7–15 UNEQUAL LIVES

7–16 UNEQUAL LIVES

Shao Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will cost $100 million, and will produce net cash ﬂows of $30 million per year. Plane B has a life of 10 years, will cost $132 million, and will produce net cash ﬂows of $25 million per year. Shao plans to serve the route for 10 years. Inﬂation in operating costs, airplane costs, and fares is expected to be zero, and the company’s cost of capital is 12 percent. By how much would the value of the company increase if it accepted the better project (plane)? The Perez Company has the opportunity to invest in one of two mutually exclusive machines which will produce a product it will need for the foreseeable future. Machine A costs $10 million but realizes after-tax inﬂows of $4 million per year for 4 years. After 4 years, the machine must be replaced. Machine B costs $15 million and realizes after-tax inﬂows of $3.5 million per year for 8 years, after which it must be replaced. Assume that machine prices are not expected to rise because inﬂation will be offset by cheaper components used in the machines. If the cost of capital is 10 percent, which machine should the company use? Filkins Fabric Company is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: Machine 190-3, which has a cost of $190,000, a 3-year expected life, and after-tax cash ﬂows (labor savings and depreciation) of $87,000 per year; and Machine 360-6, which has a cost of $360,000, a 6-year life, and after-tax cash ﬂows of $98,300 per year. Knitting machine prices are not expected to rise, because inﬂation will be offset by

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The Basics of Capital Budgeting: Evaluating Cash Flows cheaper components (microprocessors) used in the machines. Assume that Filkins’ cost of capital is 14 percent. Should the ﬁrm replace its old knitting machine, and, if so, which new machine should it use? 7–17

ECONOMIC LIFE

The Scampini Supplies Company recently purchased a new delivery truck. The new truck cost $22,500, and it is expected to generate net after-tax operating cash ﬂows, including depreciation, of $6,250 per year. The truck has a 5-year expected life. The expected salvage values after tax adjustments for the truck are given below. The company’s cost of capital is 10 percent. Year

Annual Operating Cash Flow

Salvage Value

0 1 2 3 4 5

($22,500) 6,250 6,250 6,250 6,250 6,250

$22,500 17,500 14,000 11,000 5,000 0

a. Should the ﬁrm operate the truck until the end of its 5-year physical life, or, if not, what is its optimal economic life? b. Would the introduction of salvage values, in addition to operating cash ﬂows, ever reduce the expected NPV and/or IRR of a project?

Spreadsheet Problem 7–18 BUILD A MODEL: CAPITAL BUDGETING TOOLS

Start with the partial model in the ﬁle Ch 07 P18 Build a Model.xls from the textbook’s web site. Gardial Fisheries is considering two mutually exclusive investments. The projects’ expected net cash ﬂows are as follows: Expected Net Cash Flows Year

Project A

Project B

0 1 2 3 4 5 6 7

($375) (387) (193) (100) 600 600 850 (180)

($405) 134 134 134 134 134 134 0

a. If you were told that each project’s cost of capital was 12 percent, which project should be selected? If the cost of capital was 18 percent, what would be the proper choice? b. Construct NPV proﬁles for Projects A and B. c. What is each project’s IRR? d. What is the crossover rate, and what is its signiﬁcance? e. What is each project’s MIRR at a cost of capital of 12 percent? At r 18%? (Hint: Consider Period 7 as the end of Project B’s life.) f. What is the regular payback period for these two projects? g. At a cost of capital of 12 percent, what is the discounted payback period for these two projects?

291

The Basics of Capital Budgeting: Evaluating Cash Flows Mini Case

See Ch 07 Show.ppt and Ch 07 Mini Case.xls.

293

Assume that you recently went to work for Axis Components Company, a supplier of auto repair parts used in the after-market with products from GM, Ford, and other auto makers. Your boss, the chief ﬁnancial ofﬁcer (CFO), has just handed you the estimated cash ﬂows for two proposed projects. Project L involves adding a new item to the ﬁrm’s ignition system line; it would take some time to build up the market for this product, so the cash inﬂows would increase over time. Project S involves an add-on to an existing line, and its cash ﬂows would decrease over time. Both projects have 3-year lives, because Axis is planning to introduce entirely new models after 3 years. Here are the projects’ net cash ﬂows (in thousands of dollars): Expected Net Cash Flow Year

Project L

Project S

0 1 2 3

($100) 10 60 80

($100) 70 50 20

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash ﬂows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics which are similar to the ﬁrm’s average project. Axis’s weighted average cost of capital is 10 percent. You must now determine whether one or both of the projects should be accepted. a. What is capital budgeting? b. What is the difference between independent and mutually exclusive projects? c. (1) What is the payback period? Find the paybacks for Projects L and S. (2) What is the rationale for the payback method? According to the payback criterion, which project or projects should be accepted if the ﬁrm’s maximum acceptable payback is 2 years, and if Projects L and S are independent? If they are mutually exclusive? (3) What is the difference between the regular and discounted payback periods? (4) What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? d. (1) Deﬁne the term net present value (NPV). What is each project’s NPV? (2) What is the rationale behind the NPV method? According to NPV, which project or projects should be accepted if they are independent? Mutually exclusive? (3) Would the NPVs change if the cost of capital changed? e. (1) Deﬁne the term internal rate of return (IRR). What is each project’s IRR? (2) How is the IRR on a project related to the YTM on a bond? (3) What is the logic behind the IRR method? According to IRR, which projects should be accepted if they are independent? Mutually exclusive? (4) Would the projects’ IRRs change if the cost of capital changed? f. (1) Draw NPV proﬁles for Projects L and S. At what discount rate do the proﬁles cross? (2) Look at your NPV proﬁle graph without referring to the actual NPVs and IRRs. Which project or projects should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6 percent? g. (1) What is the underlying cause of ranking conﬂicts between NPV and IRR? (2) What is the “reinvestment rate assumption,” and how does it affect the NPV versus IRR conﬂict? (3) Which method is the best? Why? h. (1) Deﬁne the term modiﬁed IRR (MIRR). Find the MIRRs for Projects L and S. (2) What are the MIRR’s advantages and disadvantages vis-à-vis the regular IRR? What are the MIRR’s advantages and disadvantages vis-à-vis the NPV? i. As a separate project (Project P), the ﬁrm is considering sponsoring a pavilion at the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5

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million of incremental cash inﬂows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project P’s expected net cash ﬂows look like this (in millions of dollars): Year

Net Cash Flows

0 1 2

($0.8) 5.0 (5.0)

The project is estimated to be of average risk, so its cost of capital is 10 percent. (1) What are normal and nonnormal cash ﬂows? (2) What is Project P’s NPV? What is its IRR? Its MIRR? (3) Draw Project P’s NPV proﬁle. Does Project P have normal or nonnormal cash ﬂows? Should this project be accepted? j. In an unrelated analysis, Axis must choose between the following two mutually exclusive projects: Expected Net Cash Flow Year

Project S

Project L

0 1 2 3 4

($100,000) 60,000 60,000 — —

($100,000) 33,500 33,500 33,500 33,500

The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have a 10 percent cost of capital. (1) What is each project’s initial NPV without replication? (2) Now apply the replacement chain approach to determine the projects’ extended NPVs. Which project should be chosen? (3) Now assume that the cost to replicate Project S in 2 years will increase to $105,000 because of inﬂationary pressures. How should the analysis be handled now, and which project should be chosen? k. Axis is also considering another project which has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the project’s estimated cash ﬂows:

Year

Initial Investment and Operating Cash Flows

End-of-Year Net Salvage Value

0 1 2 3

($5,000) 2,100 2,000 1,750

$5,000 3,100 2,000 0

Using the 10 percent cost of capital, what is the project’s NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the project’s optimal (economic) life? l. After examining all the potential projects, the CFO discovers that there are many more projects this year with positive NPVs than in a normal year. What two problems might this extra large capital budget cause?

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Selected Additional References and Cases For an in-depth treatment of capital budgeting techniques, see Bierman, Harold, Jr., and Seymour Smidt, The Capital Budgeting Decision (New York: Macmillan, 1993). Levy, Haim, and Marshall Sarnat, Capital Investment and Financial Decisions (Englewood Cliffs, NJ: Prentice-Hall, 1994). Seitz, Neil E., and Mitch Ellison, Capital Budgeting and Long-Term Financing Decisions (Fort Worth, TX: The Dryden Press, 1995). The following articles present interesting comparisons of four different approaches to ﬁnding NPV: Brick, Ivan E., and Daniel G. Weaver, “A Comparison of Capital Budgeting Techniques in Identifying Proﬁtable Investments,” Financial Management, Winter 1984, 29–39. Greenﬁeld, Robert L., Maury R. Randall, and John C. Woods, “Financial Leverage and Use of the Net Present Value Investment Criterion,” Financial Management, Autumn 1983, 40–44. These articles are related directly to the topics in this chapter: Bacon, Peter W., “The Evaluation of Mutually Exclusive Investments,” Financial Management, Summer 1977, 55–58. Chaney, Paul K., “Moral Hazard and Capital Budgeting,” Journal of Financial Research, Summer 1989, 113–128. Miller, Edward M., “Safety Margins and Capital Budgeting Criteria,” Managerial Finance, Number 2/3, 1988, 1–8. Woods, John C., and Maury R. Randall, “The Net Present Value of Future Investment Opportunities: Its Impact on Shareholder Wealth and Implications for Capital Budgeting Theory,” Financial Management, Summer 1989, 85–92.

For some articles that discuss the capital budgeting methods actually used in practice, see Kim, Suk H., Trevor Crick, and Seung H. Kim, “Do Executives Practice What Academics Preach?” Management Accounting, November 1986, 49–52. Mukherjee, Tarun K., “Capital Budgeting Surveys: The Past and the Future,” Review of Business and Economic Research, Spring 1987, 37–56. ———, “The Capital Budgeting Process of Large U.S. Firms: An Analysis of Capital Budgeting Manuals,” Managerial Finance, Number 2/3, 1988, 28–35. Ross, Marc, “Capital Budgeting Practices of Twelve Large Manufacturers,” Financial Management, Winter 1986, 15–22. Runyan, L. R., “Capital Expenditure Decision Making in Small Firms,” Journal of Business Research, September 1983, 389–397. Weaver, Samuel C., Donald Peters, Roger Cason, and Joe Daleiden, “Capital Budgeting,” Financial Management, Spring 1989, 10–17. Additional capital budgeting references are provided in Chapters 8 and 17. For a case that focuses on capital budgeting decision methods, see Case 11, “Chicago Valve Company,” in the Cases in Financial Management series.

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Cash Flow Estimation and Risk Analysis Home Depot Inc. grew phenomenally during the 1990s, and it shows no sign of slowing down. At the beginning of 1990, it had 118 stores and annual sales of $2.8 billion. By the end of 1999, it had more than 900 stores, and its sales were $37 billion. The company continues to open stores at a rate of about two per week, and it opened another 200 stores in ﬁscal 2001. The stock has more than matched the sales growth—a $10,000 investment in 1990 would now be worth about $220,000! It costs Home Depot, on average, $16 million to purchase land, construct a new store, and stock it with inventory. (The inventory costs about $5 million, but about $2 million of this is ﬁnanced through accounts payable.) Each new store thus represents a major capital expenditure, so the company must use capital budgeting techniques to determine if a potential store’s expected cash ﬂows are sufﬁcient to cover its costs. Home Depot uses information from its existing stores to forecast new stores’ expected cash ﬂows. Thus far, its forecasts have been outstanding, but there are always risks that must be considered. First, sales might be less than projected if the economy weakens. Second, some of Home Depot’s customers might in the future bypass it altogether and buy directly from manufacturers through the Internet. Third, new stores could “cannibalize,” that is, take sales away from, existing stores. This last point was made in the July 16, 1999, issue of Value Line: The retailer has picked the “low-hanging fruit;” it has already entered the most attractive markets. To avoid “cannibalization”—which occurs when duplicative stores are located too closely together—the company is developing complementary formats. For example, Home Depot is beginning to roll out its Expo Design Center chain, which offers one-stop sales and service for kitchen and bath and other remodeling and renovation work . . .

The decision to expand requires a detailed assessment of the forecasted cash ﬂows, including the risk that the forecasted level of sales might not be realized. In this chapter, we describe techniques for estimating a project’s cash ﬂows and their associated risk. Companies such as Home Depot use these techniques on a regular basis to evaluate capital budgeting decisions.

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The basic principles of capital budgeting were covered in Chapter 7. Given a project’s expected cash ﬂows, it is easy to calculate its payback, discounted payback, NPV, IRR, MIRR, and PI. Unfortunately, cash ﬂows are rarely just given—rather, managers must estimate them based on information collected from sources both inside and outside the company. Moreover, uncertainty surrounds the cash ﬂow estimates, and some projects are riskier than others. In the ﬁrst part of the chapter, we develop procedures for estimating the cash ﬂows associated with capital budgeting projects. Then, in the second part, we discuss techniques used to measure and take account of project risk.

Estimating Cash Flows The most important, but also the most difﬁcult, step in capital budgeting is estimating projects’ cash ﬂows—the investment outlays and the annual net cash ﬂows after a project goes into operation. Many variables are involved, and many individuals and The textbook’s web site departments participate in the process. For example, the forecasts of unit sales and contains an Excel ﬁle that sales prices are normally made by the marketing group, based on their knowledge of will guide you through the price elasticity, advertising effects, the state of the economy, competitors’ reactions, chapter’s calculations. The ﬁle for this chapter is Ch 08 and trends in consumers’ tastes. Similarly, the capital outlays associated with a new Tool Kit.xls, and we encour- product are generally obtained from the engineering and product development staffs, age you to open the ﬁle and while operating costs are estimated by cost accountants, production experts, personnel follow along as you read the specialists, purchasing agents, and so forth. chapter. It is difﬁcult to forecast the costs and revenues associated with a large, complex project, so forecast errors can be quite large. For example, when several major oil companies decided to build the Alaska Pipeline, the original cost estimates were in the neighborhood of $700 million, but the ﬁnal cost was closer to $7 billion. Similar (or even worse) miscalculations are common in forecasts of product design costs, such as the costs to develop a new personal computer. Further, as difﬁcult as plant and equipment costs are to estimate, sales revenues and operating costs over the project’s life are even more uncertain. Just ask Polaroid, which recently ﬁled for bankruptcy, or any of the now-defunct dot-com companies. A proper analysis includes (1) obtaining information from various departments such as engineering and marketing, (2) ensuring that everyone involved with the forecast uses a consistent set of economic assumptions, and (3) making sure that no biases are inherent in the forecasts. This last point is extremely important, because some managers become emotionally involved with pet projects, and others seek to build empires. Both problems cause cash ﬂow forecast biases which make bad projects look good—on paper. It is almost impossible to overstate the problems one can encounter in cash ﬂow forecasts. It is also difﬁcult to overstate the importance of these forecasts. Still, observing the principles discussed in the next several sections will help minimize forecasting errors. What is the most important step in a capital budgeting analysis? What departments are involved in estimating a project’s cash ﬂows? What steps does a proper analysis include?

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Identifying the Relevant Cash Flows The ﬁrst step in capital budgeting is to identify the relevant cash ﬂows, deﬁned as the speciﬁc set of cash ﬂows that should be considered in the decision at hand. Analysts often make errors in estimating cash ﬂows, but two cardinal rules can help you minimize mistakes: (1) Capital budgeting decisions must be based on cash ﬂows, not accounting income. (2) Only incremental cash ﬂows are relevant. Free cash ﬂow is the cash ﬂow available for distribution to investors. In a nutshell, the relevant cash ﬂow for a project is the additional free cash ﬂow that the company can expect if it implements the project. It is the cash ﬂow above and beyond what the company could expect if it doesn’t implement the project. The following sections discuss the relevant cash ﬂows in more detail.

Project Cash Flow versus Accounting Income Free cash ﬂow is calculated as follows:1 Net operating Change in net Gross fixed asset Free cash flow ⫽ profit after taxes ⫹ Depreciation ⫺ ⫺ operating expenditures (NOPAT) working capital ⌬ Operating current assets ⫺ Gross fixed asset ⫺c d. ⫽ EBIT(1 ⫺ T) ⫹ Depreciation ⫺ ⌬ Operating current liabilities expenditures Just as a ﬁrm’s value depends on its free cash ﬂows, so does the value of a project. We illustrate the estimation of project cash ﬂow later in the chapter with a comprehensive example, but it is important for you to understand that project cash ﬂow differs from accounting income. Costs of Fixed Assets Most projects require assets, and asset purchases represent negative cash ﬂows. Even though the acquisition of assets results in a cash outﬂow, accountants do not show the purchase of ﬁxed assets as a deduction from accounting income. Instead, they deduct a depreciation expense each year throughout the life of the asset. Note that the full cost of ﬁxed assets includes any shipping and installation costs. When a ﬁrm acquires ﬁxed assets, it often must incur substantial costs for shipping and installing the equipment. These charges are added to the price of the equipment when the project’s cost is being determined. Then, the full cost of the equipment, including shipping and installation costs, is used as the depreciable basis when depreciation charges are being calculated. For example, if a company bought a computer with an invoice price of $100,000 and paid another $10,000 for shipping and installation, then the full cost of the computer (and its depreciable basis) would be $110,000. Note too that ﬁxed assets can often be sold at the end of a project’s life. If this is the case, then the after-tax cash proceeds represent a positive cash ﬂow. We will illustrate both depreciation and cash ﬂow from asset sales later in the chapter.

1

Chapter 9 explains the calculation of free cash ﬂow. Note that EBIT stands for earnings before interest and taxes, and it is also called pre-tax operating proﬁt.

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Noncash Charges In calculating net income, accountants usually subtract depreciation from revenues. So, while accountants do not subtract the purchase price of ﬁxed assets when calculating accounting income, they do subtract a charge each year for depreciation. Depreciation shelters income from taxation, and this has an impact on cash ﬂow, but depreciation itself is not a cash ﬂow. Therefore, depreciation must be added to NOPAT when estimating a project’s cash ﬂow. Changes in Net Operating Working Capital Normally, additional inventories are required to support a new operation, and expanded sales tie up additional funds in accounts receivable. However, payables and accruals increase as a result of the expansion, and this reduces the cash needed to ﬁnance inventories and receivables. The difference between the required increase in operating current assets and the increase in operating current liabilities is the change in net operating working capital. If this change is positive, as it generally is for expansion projects, then additional ﬁnancing, over and above the cost of the ﬁxed assets, will be needed. Toward the end of a project’s life, inventories will be used but not replaced, and receivables will be collected without corresponding replacements. As these changes occur, the ﬁrm will receive cash inﬂows, and as a result, the investment in net operating working capital will be returned by the end of the project’s life. Interest Expenses Are Not Included in Project Cash Flows Recall from Chapter 7 that we discount a project’s cash ﬂows by its cost of capital, and that the cost of capital is a weighted average (WACC) of the costs of debt, preferred stock, and common equity, adjusted for the project’s risk. Moreover, the WACC is the rate of return necessary to satisfy all of the ﬁrm’s investors—debtholders and stockholders. In other words, the project generates cash ﬂows that are available for all investors, and we ﬁnd the value of the project by discounting those cash ﬂows at the average rate required by all investors. Therefore, we do not subtract interest when estimating a project’s cash ﬂows. If you did not take our advice and instead were to subtract interest (or interest plus principal payments), then you would be calculating the cash ﬂows available only for equity investors, which should be discounted at the rate of return required by equity investors. One problem with this approach, though, is that you must adjust the amount of debt each year by exactly the right amount. If you were extremely careful doing this, then you should get the correct result. However, this is a very complicated process, and we do not recommend that you try it. Here is one ﬁnal caution: If you did subtract interest, you would deﬁnitely be wrong to discount that cash ﬂow, which is available only for equity holders, at the project’s WACC, since the project’s WACC is the average rate expected by all investors, not just the equity investors. Note that this differs from the procedures used to calculate accounting income. Accountants measure the proﬁt available for stockholders, so interest expenses are subtracted. However, project cash ﬂow is the cash ﬂow available for all investors, bondholders as well as stockholders, so interest expenses are not subtracted. This is completely analogous to the procedures used in the corporate valuation model of Chapter 12, where the company’s free cash ﬂows are discounted at the WACC. Therefore, you should not subtract interest expenses when ﬁnding a project’s cash ﬂows.

Incremental Cash Flows In evaluating a project, we focus on those cash ﬂows that occur if and only if we accept the project. These cash ﬂows, called incremental cash ﬂows, represent the change in

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the ﬁrm’s total cash ﬂow that occurs as a direct result of accepting the project. Three special problems in determining incremental cash ﬂows are discussed next. Sunk Costs A sunk cost is an outlay that has already occurred, hence is not affected by the decision under consideration. Since sunk costs are not incremental costs, they should not be included in the analysis. To illustrate, in 2002, Northeast BankCorp was considering the establishment of a branch ofﬁce in a newly developed section of Boston. To help with its evaluation, Northeast had, back in 2001, hired a consulting ﬁrm to perform a site analysis; the cost was $100,000, and this amount was expensed for tax purposes in 2001. Is this 2001 expenditure a relevant cost with respect to the 2002 capital budgeting decision? The answer is no—the $100,000 is a sunk cost, and it will not affect Northeast’s future cash ﬂows regardless of whether or not the new branch is built. It often turns out that a particular project has a negative NPV if all the associated costs, including sunk costs, are considered. However, on an incremental basis, the project may be a good one because the future incremental cash ﬂows are large enough to produce a positive NPV on the incremental investment. Opportunity Costs A second potential problem relates to opportunity costs, which are cash ﬂows that could be generated from an asset the ﬁrm already owns provided it is not used for the project in question. To illustrate, Northeast BankCorp already owns a piece of land that is suitable for the branch location. When evaluating the prospective branch, should the cost of the land be disregarded because no additional cash outlay would be required? The answer is no, because there is an opportunity cost inherent in the use of the property. In this case, the land could be sold to yield $150,000 after taxes. Use of the site for the branch would require forgoing this inﬂow, so the $150,000 must be charged as an opportunity cost against the project. Note that the proper land cost in this example is the $150,000 market-determined value, irrespective of whether Northeast originally paid $50,000 or $500,000 for the property. (What Northeast paid would, of course, have an effect on taxes, hence on the after-tax opportunity cost.) Effects on Other Parts of the Firm: Externalities The third potential problem involves the effects of a project on other parts of the ﬁrm, which economists call externalities. For example, some of Northeast’s customers who would use the new branch are already banking with Northeast’s downtown ofﬁce. The loans and deposits, hence proﬁts, generated by these customers would not be new to the bank; rather, they would represent a transfer from the main ofﬁce to the branch. Thus, the net income produced by these customers should not be treated as incremental income in the capital budgeting decision. On the other hand, having a suburban branch would help the bank attract new business to its downtown ofﬁce, because some people like to be able to bank both close to home and close to work. In this case, the additional income that would actually ﬂow to the downtown ofﬁce should be attributed to the branch. Although they are often difﬁcult to quantify, externalities (which can be either positive or negative) should be considered. When a new project takes sales from an existing product, this is often called cannibalization. Naturally, ﬁrms do not like to cannibalize their existing products, but it often turns out that if they do not, someone else will. To illustrate, IBM for years refused to provide full support for its PC division because it did not want to steal sales from its highly proﬁtable mainframe business. That turned out to be a huge strategic error, because it allowed Intel, Microsoft, Dell, and others to become dominant forces in the computer industry. Therefore, when considering externalities, the full implications of the proposed new project should be taken into account.

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A few young ﬁrms, including Dell Computer, have been successful selling their products only over the Internet. Many ﬁrms, however, had established retail channels long before the Internet became a reality. For these ﬁrms, the decision to begin selling directly to consumers over the Internet is not a simple one. For example, Nautica Enterprises Inc. is an international company that designs, sources, markets, and distributes sportswear. Nautica sells its products to traditional retailers such as Saks Fifth Avenue and Parisian, who then sell to consumers. If Nautica opens its own online Internet store, it could potentially increase its proﬁt margin by avoiding the substantial markup added by dealers. However, Internet sales would probably cannibalize sales through its retailer network. Even worse, retailers might react adversely to Nautica’s Internet sales by redirecting the marketing effort and display space they now provide Nautica to other brands that do not compete over the Internet. Nautica, and many other producers, must determine whether the new proﬁts from Internet sales will compensate for lost proﬁts from existing channels. Thus far, Nautica has decided to stay with its traditional retailers. Rather than focusing narrowly on the project at hand, analysts must anticipate the project’s impact on the rest of the ﬁrm, which requires imagination and creative thinking. As the IBM and Nautica examples illustrate, it is critical to identify and account for all externalities when evaluating a proposed project.

Timing of Cash Flow We must account properly for the timing of cash ﬂows. Accounting income statements are for periods such as years or months, so they do not reﬂect exactly when during the period cash revenues or expenses occur. Because of the time value of money, capital budgeting cash ﬂows should in theory be analyzed exactly as they occur. Of course, there must be a compromise between accuracy and feasibility. A time line with daily cash ﬂows would in theory be most accurate, but daily cash ﬂow estimates would be costly to construct, unwieldy to use, and probably no more accurate than annual cash ﬂow estimates because we simply cannot forecast well enough to warrant this degree of detail. Therefore, in most cases, we simply assume that all cash ﬂows occur at the end of every year. However, for some projects, it may be useful to assume that cash ﬂows occur at mid-year, or even quarterly or monthly. Why should companies use project cash ﬂow rather than accounting income when ﬁnding the NPV of a project? How do shipping and installation costs affect the depreciable basis? What is the most common noncash charge that must be added back when ﬁnding project cash ﬂows? What is net operating working capital, and how does it affect a project’s costs in capital budgeting? Explain the following terms: incremental cash ﬂow, sunk cost, opportunity cost, externality, and cannibalization.

Tax Effects Taxes have a major effect on cash ﬂows, and in many cases tax effects will make or break a project. Therefore, it is critical that taxes be dealt with correctly. Our tax laws are extremely complex, and they are subject to interpretation and to change. You can

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get assistance from your ﬁrm’s accountants and tax lawyers, but even so, you should have a working knowledge of the current tax laws and their effects on cash ﬂows.

An Overview of Depreciation Suppose a ﬁrm buys a milling machine for $100,000 and uses it for ﬁve years, after which it is scrapped. The cost of the goods produced by the machine must include a charge for the machine, and this charge is called depreciation. In the following sections, we review some of the depreciation concepts covered in accounting courses. Companies often calculate depreciation one way when ﬁguring taxes and another way when reporting income to investors: many use the straight-line method for stockholder reporting (or “book” purposes), but they use the fastest rate permitted by law for tax purposes. Under the straight-line method used for stockholder reporting, one normally takes the cost of the asset, subtracts its estimated salvage value, and divides the net amount by the asset’s useful economic life. For an asset with a 5-year life, which costs $100,000 and has a $12,500 salvage value, the annual straight-line depreciation charge is ($100,000 ⫺ $12,500)/5 ⫽ $17,500. Note, however, as we discuss later, that salvage value is not considered for tax depreciation purposes. For tax purposes, Congress changes the permissible tax depreciation methods from time to time. Prior to 1954, the straight-line method was required for tax purposes, but in 1954 accelerated methods (double-declining balance and sum-of-years’digits) were permitted. Then, in 1981, the old accelerated methods were replaced by a simpler procedure known as the Accelerated Cost Recovery System (ACRS). The ACRS system was changed again in 1986 as a part of the Tax Reform Act, and it is now known as the Modiﬁed Accelerated Cost Recovery System (MACRS); a 1993 tax law made further changes in this area. Note that U.S. tax laws are very complicated, and in this text we can only provide an overview of MACRS designed to give you a basic understanding of the impact of depreciation on capital budgeting decisions. Further, the tax laws change so often that the numbers we present may be outdated before the book is even published. Thus, when dealing with tax depreciation in real-world situations, current Internal Revenue Service (IRS) publications or individuals with expertise in tax matters should be consulted.

Tax Depreciation Life For tax purposes, the entire cost of an asset is expensed over its depreciable life. Historically, an asset’s depreciable life was set equal to its estimated useful economic life; it was intended that an asset would be fully depreciated at approximately the same time that it reached the end of its useful economic life. However, MACRS totally abandoned that practice and set simple guidelines that created several classes of assets, each with a more-or-less arbitrarily prescribed life called a recovery period or class life. The MACRS class lives bear only a rough relationship to assets’ expected useful economic lives. A major effect of the MACRS system has been to shorten the depreciable lives of assets, thus giving businesses larger tax deductions early in the assets’ lives, thereby increasing the present value of the cash ﬂows. Table 8-1 describes the types of property that ﬁt into the different class life groups, and Table 8-2 sets forth the MACRS recovery allowance percentages (depreciation rates) for selected classes of investment property. Consider Table 8-1, which gives the MACRS class life and the types of assets that fall into each category. Property in the 27.5- and 39-year categories (real estate) must

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Major Classes and Asset Lives for MACRS

Class

Type of Property

3-year 5-year

Certain special manufacturing tools Automobiles, light-duty trucks, computers, and certain special manufacturing equipment Most industrial equipment, ofﬁce furniture, and ﬁxtures Certain longer-lived types of equipment Residential rental real property such as apartment buildings All nonresidential real property, including commercial and industrial buildings

7-year 10-year 27.5-year 39-year

TABLE 8-2

Recovery Allowance Percentage for Personal Property Class of Investment

Ownership Year

1 2 3 4 5 6 7 8 9 10 11

3-Year

5-Year

7-Year

33% 45 15 7

20% 32 19 12 11 6

14% 25 17 13 9 9 9 4

100%

100%

100%

10-Year

10% 18 14 12 9 7 7 7 7 6 3 100%

Notes: a. We developed these recovery allowance percentages based on the 200 percent declining balance method prescribed by MACRS, with a switch to straight-line depreciation at some point in the asset’s life. For example, consider the 5-year recovery allowance percentages. The straight line percentage would be 20 percent per year, so the 200 percent declining balance multiplier is 2.0(20%) ⫽ 40% ⫽ 0.4. However, because the half-year convention applies, the MACRS percentage for Year 1 is 20 percent. For Year 2, there is 80 percent of the depreciable basis remaining to be depreciated, so the recovery allowance percentage is 0.40(80%) ⫽ 32%. In Year 3, 20% ⫹ 32% ⫽ 52% of the depreciation has been taken, leaving 48%, so the percentage is 0.4(48%) 艐 19%. In Year 4, the percentage is 0.4(29%) 艐 12%. After 4 years, straight-line depreciation exceeds the declining balance depreciation, so a switch is made to straight-line (this is permitted under the law). However, the half-year convention must also be applied at the end of the class life, and the remaining 17 percent of depreciation must be taken (amortized) over 1.5 years. Thus, the percentage in Year 5 is 17%/1.5 艐 11%, and in Year 6, 17% ⫺ 11% ⫽ 6%. Although the tax tables carry the allowance percentages out to two decimal places, we have rounded to the nearest whole number for ease of illustration. b. Residential rental property (apartments) is depreciated over a 27.5-year life, whereas commercial and industrial structures are depreciated over 39 years. In both cases, straight-line depreciation must be used. The depreciation allowance for the ﬁrst year is based, pro rata, on the month the asset was placed in service, with the remainder of the ﬁrst year’s depreciation being taken in the 28th or 40th year. A half-month convention is assumed; that is, an asset placed in service in February would receive 10.5 months of depreciation in the ﬁrst year.

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be depreciated by the straight-line method, but 3-, 5-, 7-, and 10-year property (personal property) can be depreciated either by the accelerated method set forth in Table 8-2 or by the straight-line method.2 As we saw earlier in the chapter, higher depreciation expenses result in lower taxes in the early years, hence a higher present value of cash ﬂows. Therefore, since a ﬁrm has the choice of using straight-line rates or the accelerated rates shown in Table 8-2, most elect to use the accelerated rates. The yearly recovery allowance, or depreciation expense, is determined by multiplying each asset’s depreciable basis by the applicable recovery percentage shown in Table 8-2. Calculations are discussed in the following sections. Half-Year Convention Under MACRS, the assumption is generally made that property is placed in service in the middle of the ﬁrst year. Thus, for 3-year class life property, the recovery period begins in the middle of the year the asset is placed in service and ends three years later. The effect of the half-year convention is to extend the recovery period out one more year, so 3-year class life property is depreciated over four calendar years, 5-year property is depreciated over six calendar years, and so on. This convention is incorporated into Table 8-2’s recovery allowance percentages.3 Depreciable Basis The depreciable basis is a critical element of MACRS because each year’s allowance (depreciation expense) depends jointly on the asset’s depreciable basis and its MACRS class life. The depreciable basis under MACRS is equal to the purchase price of the asset plus any shipping and installation costs. The basis is not adjusted for salvage value (which is the estimated market value of the asset at the end of its useful life) regardless of whether accelerated or straight-line depreciation is taken. Sale of a Depreciable Asset If a depreciable asset is sold, the sale price (actual salvage value) minus the then-existing undepreciated book value is added to operating income and taxed at the ﬁrm’s marginal tax rate. For example, suppose a ﬁrm buys a 5-year class life asset for $100,000 and sells it at the end of the fourth year for $25,000. The asset’s book value is equal to $100,000(0.11 ⫹ 0.06) ⫽ $100,000(0.17) ⫽ $17,000. Therefore, $25,000 ⫺ $17,000 ⫽ $8,000 is added to the ﬁrm’s operating income and is taxed. Depreciation Illustration Assume that Stango Food Products buys a $150,000 machine that falls into the MACRS 5-year class life and places it into service on March 15, 2003. Stango must pay an additional $30,000 for delivery and installation. Salvage value is not considered, so the machine’s depreciable basis is $180,000. (Delivery and installation charges are included in the depreciable basis rather than expensed in the year incurred.) Each year’s recovery allowance (tax depreciation expense) is 2

As a beneﬁt to very small companies, the Tax Code also permits companies to expense, which is equivalent to depreciating over one year, up to $24,000 of equipment for 2001; see IRS Publication 946 for details. Thus, if a small company bought one asset worth up to $24,000, it could write the asset off in the year it was acquired. This is called “Section 179 expensing.” We shall disregard this provision throughout the book. 3 The half-year convention also applies if the straight-line alternative is used, with half of one year’s depreciation taken in the ﬁrst year, a full year’s depreciation taken in each of the remaining years of the asset’s class life, and the remaining half-year’s depreciation taken in the year following the end of the class life. You should recognize that virtually all companies have computerized depreciation systems. Each asset’s depreciation pattern is programmed into the system at the time of its acquisition, and the computer aggregates the depreciation allowances for all assets when the accountants close the books and prepare ﬁnancial statements and tax returns.

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determined by multiplying the depreciable basis by the applicable recovery allowance percentage. Thus, the depreciation expense for 2003 is 0.20($180,000) ⫽ $36,000, and for 2004 it is 0.32($180,000) ⫽ $57,600. Similarly, the depreciation expense is $34,200 for 2005, $21,600 for 2006, $19,800 for 2007, and $10,800 for 2008. The total depreciation expense over the six-year recovery period is $180,000, which is equal to the depreciable basis of the machine. As noted above, most ﬁrms use straight-line depreciation for stockholder reporting purposes but MACRS for tax purposes. In this case, for capital budgeting purposes MACRS should be used. In capital budgeting, we are concerned with cash ﬂows, not reported income. Since MACRS depreciation is used for taxes, this type of depreciation must be used to determine the taxes that will be assessed against a particular project. Only if the depreciation method used for tax purposes is also used for capital budgeting analysis will we obtain an accurate cash ﬂow estimate. What do the acronyms ACRS and MACRS stand for? Brieﬂy describe the tax depreciation system under MACRS. How does the sale of a depreciable asset affect a ﬁrm’s cash ﬂows?

Evaluating Capital Budgeting Projects

For more discussion on replacement analysis decisions, refer to the Chapter 8 Web Extension on the web site, http://ehrhardt. swcollege.com. Also, the ﬁle Ch 08 Tool Kit.xls, provides an example of replacement analysis.

Up to now, we have discussed several important aspects of cash ﬂow analysis, but we have not seen how they affect capital budgeting decisions. Conceptually, capital budgeting is straightforward: A potential project creates value for the ﬁrm’s shareholders if and only if the net present value of the incremental cash ﬂows from the project is positive. In practice, however, estimating these cash ﬂows can be difﬁcult. Incremental cash ﬂows are affected by whether the project is an expansion project or replacement project. A new expansion project is deﬁned as one where the ﬁrm invests in new assets to increase sales. Here the incremental cash ﬂows are simply the project’s cash inﬂows and outﬂows. In effect, the company is comparing what its value would be with and without the proposed project. By contrast, a replacement project occurs when the ﬁrm replaces an existing asset with a new one. In this case, the incremental cash ﬂows are the ﬁrm’s additional inﬂows and outﬂows that result from investing in the new project. In a replacement analysis, the company is comparing its value if it takes on the new project to its value if it continues to use the existing asset. Despite these differences, the basic principles for evaluating expansion and replacement projects are the same. In each case, the cash ﬂows typically include the following items: 1. Initial investment outlay. This includes the cost of the ﬁxed assets associated with the project plus any initial investment in net operating working capital (NOWC), such as raw materials. 2. Annual project cash ﬂow. The operating cash ﬂow is the net operating proﬁt after taxes (NOPAT) plus depreciation. Recall (a) that depreciation is added back because it is a noncash expense and (b) that ﬁnancing costs (including interest expenses) are not subtracted because they are accounted for when the cash ﬂow is discounted at the cost of capital. In addition, many projects have levels of NOWC that change during the project’s life. For example, as sales increase, more NOWC is required, and as sales fall, less NOWC is needed. The cash ﬂows associated with

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annual increases or reductions in NOWC must be included when calculating the project’s annual cash ﬂow. 3. Terminal year cash ﬂow. At the end of the project’s life, some extra cash ﬂow is usually generated from the salvage value of the ﬁxed assets, adjusted for taxes if the assets are not sold at their book value. Any return of net operating working capital not already accounted for in the annual cash ﬂow must also be added to the terminal year cash ﬂow. The classiﬁcation of cash ﬂows isn’t always as distinct as we have indicated. For example, in some projects the acquisition of ﬁxed assets is phased in throughout the project’s life, and for other projects some ﬁxed assets are sold off at times other than the terminal year. The important thing to remember is to include all cash ﬂows in your analysis, no matter how you classify them. For each year of the project’s life, the net cash ﬂow is determined as the sum of the cash ﬂows from each of the categories. These annual net cash ﬂows are then plotted on a time line and used to calculate the project’s NPV and IRR. We will illustrate the principles of capital budgeting analysis by examining a new project being considered by Regency Integrated Chips (RIC), a large Nashville-based technology company. RIC’s research and development department has been applying its expertise in microprocessor technology to develop a small computer designed to control home appliances. Once programmed, the computer will automatically control the heating and air-conditioning systems, security system, hot water heater, and even small appliances such as a coffee maker. By increasing a home’s energy efﬁciency, the computer can cut costs enough to pay for itself within a few years. Developments have now reached the stage where a decision must be made about whether or not to go forward with full-scale production. RIC’s marketing vice-president believes that annual sales would be 20,000 units if the units were priced at $3,000 each, so annual sales are estimated at $60 million. RIC expects no growth in sales, and it believes that the unit price will rise by 2 percent each year. The engineering department has reported that the project will require additional manufacturing space, and RIC currently has an option to purchase an existing building, at a cost of $12 million, which would meet this need. The building would be bought and paid for on December 31, 2003, and for depreciation purposes it would fall into the MACRS 39-year class. The necessary equipment would be purchased and installed in late 2003, and it would also be paid for on December 31, 2003. The equipment would fall into the MACRS 5-year class, and it would cost $8 million, including transportation and installation. The project’s estimated economic life is four years. At the end of that time, the building is expected to have a market value of $7.5 million and a book value of $10.908 million, whereas the equipment would have a market value of $2 million and a book value of $1.36 million. The production department has estimated that variable manufacturing costs would be $2,100 per unit, and that ﬁxed overhead costs, excluding depreciation, would be $8 million a year. They expect variable costs to rise by 2 percent per year, and ﬁxed costs to rise by 1 percent per year. Depreciation expenses would be determined in accordance with MACRS rates. RIC’s marginal federal-plus-state tax rate is 40 percent; its cost of capital is 12 percent; and, for capital budgeting purposes, the company’s policy is to assume that operating cash ﬂows occur at the end of each year. Because the plant would begin operations on January 1, 2004, the ﬁrst operating cash ﬂows would occur on December 31, 2004.

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Several other points should be noted: (1) RIC is a relatively large corporation, with sales of more than $4 billion, and it takes on many investments each year. Thus, if the computer control project does not work out, it will not bankrupt the company— management can afford to take a chance on the computer control project. (2) If the project is accepted, the company will be contractually obligated to operate it for its full four-year life. Management must make this commitment to its component suppliers. (3) Returns on this project would be positively correlated with returns on RIC’s other projects and also with the stock market—the project should do well if other parts of the ﬁrm and the general economy are strong. Assume that you have been assigned to conduct the capital budgeting analysis. For now, assume that the project has the same risk as an average project, and use the corporate weighted average cost of capital, 12 percent.

Analysis of the Cash Flows

See Ch 08 Tool Kit.xls for Table 8-3 details.

Capital projects can be analyzed using a calculator, paper, and a pencil, or with a spreadsheet program such as Excel. Either way, you must set the analysis up as shown in Table 8-3 and go through the steps outlined in Parts 1 through 5 of the table. For exam purposes, you will probably have to work problems with a calculator. However, for reasons that will become obvious as you go through the chapter, in practice spreadsheets are virtually always used. Still, the steps involved in a capital budgeting analysis are the same whether you use a calculator or a computer. Table 8-3, a printout from the web site ﬁle Ch 08 Tool Kit.xls, is divided into ﬁve parts: (1) Input Data, (2) Depreciation Schedule, (3) Net Salvage Values, (4) Projected Net Cash Flows, and (5) Key Output. There are also two extensions, Parts 6 and 7, that deal with risk analysis and which we will discuss later in the chapter when we cover sensitivity and scenario analyses. Note also that the table shows row and column indicators, so cells in the table have designations such as “Cell D33,” which is the location of the cost of the building, found in Part 1, Input Data. The ﬁrst row shown is Row 31; the ﬁrst 30 rows contain information about the model that we omitted from the text. Finally, the numbers in the printed table are rounded from the actual numbers in the spreadsheet. Part 1, the Input Data section, provides the basic data used in the analysis. The inputs are really “assumptions”—thus, in the analysis we assume that 20,000 units can be sold at a price of $3 per unit.4 Some of the inputs are known with near certainty—for example, the 40 percent tax rate is not likely to change. Others are more speculative— units sold and the variable cost percentage are in this category. Obviously, if sales or costs are different from the assumed levels, then proﬁts and cash ﬂows, hence NPV and IRR, will differ from their projected levels. Later in the chapter, we discuss how changes in the inputs affect the results. Part 2, which calculates depreciation over the project’s four-year life, is divided into two sections, one for the building and one for the equipment. The ﬁrst row in each section (Rows 44 and 48) gives the yearly depreciation rates as taken from Table 8-2. The second row in each section (Rows 45 and 49) gives the dollars of depreciation, found as the rate times the asset’s depreciable basis, which, in this example, is the initial cost. The third row (Rows 46 and 50) shows the book value at the end of Year 4, found by subtracting the accumulated depreciation from the depreciable basis.

4

Recall that the sales price is actually $3,000, but for convenience we show all dollars in thousands.

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TABLE 8-3

Analysis of a New (Expansion) Project Parts 1 and 2

Part 3 estimates the cash ﬂows the ﬁrm will realize when it disposes of the assets. Row 57 shows the salvage value, which is the sales price the company expects to receive when it sells the assets four years hence. Row 58 shows the book values at the end of Year 4; these values were calculated in Part 2. Row 59 shows the expected gain or loss, deﬁned as the difference between the sale price and the book value. As explained in notes c and d to Table 8-3, gains and losses are treated as ordinary income, not capital gains or losses.5 Therefore, gains result in tax liabilities, and losses produce tax credits, that are equal to the gain or loss times the 40 percent tax rate. Taxes paid and tax credits are shown on Row 60. Row 61 shows the after-tax cash ﬂow the company expects when it disposes of the asset, found as the 5

Note again that if an asset is sold for exactly its book value, there will be no gain or loss, hence no tax liability or credit. However, if an asset is sold for other than its book value, a gain or loss will be created. For example, RIC’s building will have a book value of $10,908, but the company only expects to realize $7,500 when it is sold. This would result in a loss of $3,408. This indicates that the building should have been depreciated at a faster rate—only if depreciation had been $3,408 larger would the book and market values have been equal. So, the Tax Code stipulates that losses on the sale of operating assets can be used to reduce ordinary income, just as depreciation reduces income. On the other hand, if an asset is sold for more than its book value, as is the case for the equipment, then this signiﬁes that the depreciation rates were too high, so the gain is called “depreciation recapture” by the IRS and is taxed as ordinary income.

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Cash Flow Estimation and Risk Analysis Evaluating Capital Budgeting Projects TABLE 8-3

309

Analysis of a New (Expansion) Project Part 3

expected sale price minus the tax liability or plus the credit. Thus, the ﬁrm expects to net $8,863 from the sale of the building and $1,744 from the equipment, for a total of $10,607. Next, in Part 4, we use the information developed in Parts 1, 2, and 3 to ﬁnd the projected cash ﬂows over the project’s life. Five periods are shown, from Year 0 (2003) to Year 4 (2007). The cash outlays required at Year 0 are the negative numbers in Column E for 2003, and their sum, ⫺$26,000, is shown at the bottom in cell E105. Then, in the next four columns, we calculate the operating cash ﬂows. We begin with sales revenues, found as the product of units sold and the sales price. Next, we subtract variable costs, which were assumed to be $2.10 per unit. We then deduct ﬁxed operating costs and depreciation to obtain taxable operating income, or EBIT. When taxes (at a 40 percent rate) are subtracted, we are left with net operating proﬁt after taxes, or NOPAT. Note, though, that we are seeking cash ﬂows, not accounting income. Thus, depreciation must be added back. RIC must purchase raw materials and replenish them each year as they are used. In Part 1 we assume that RIC must have an amount of NOWC on hand equal to 10 percent of the upcoming year’s sales. For example, sales in Year 1 are $60,000, so RIC must have $6,000 in NOWC at Year 0, as shown in Cell E97. Because RIC had no NOWC prior to Year 0, it must make a $6,000 investment in NOWC at Year 0, as shown in Cell E98. Sales increase to $61,200 in Year 2, so RIC must have $6,120 of NOWC at Year 1. Because it already had $6,000 in NOWC on hand, its net investment at Year 1 is just $120, shown in Cell F98. Note that RIC will have no sales after Year 4, so it will require no NOWC at Year 4. Thus, it has a positive cash ﬂow of $6,367 at Year 4 as working capital is sold but not replaced.

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TABLE 8-3

Analysis of a New (Expansion) Project Part 4

When the project’s life ends, the company will receive the “Salvage Cash Flows” as shown in the column for Year 4 in the lower part of the table. When the company disposes of the building and equipment at the end of Year 4, it will receive cash as estimated back in Part 3 of the table. Thus, the total salvage cash ﬂow amounts to $10,607 as shown on Row 103. When we sum the subtotals in Part 4, we obtain the net cash ﬂows shown on Row 105. Those cash ﬂows constitute a cash ﬂow time line, and they are then evaluated in Part 5 of Table 8-3.

Making the Decision Part 5 of the table shows the standard evaluation criteria—NPV, IRR, MIRR, and payback—based on the cash ﬂows shown on Row 105. The NPV is positive, the IRR and MIRR both exceed the 12 percent cost of capital, and the payback indicates that the project will return the invested funds in 3.22 years. Therefore, on the basis of the analysis thus far, it appears that the project should be accepted. Note, though, that we

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Cash Flow Estimation and Risk Analysis Adjusting for Inﬂation TABLE 8-3

311

Analysis of a New (Expansion) Project Part 5

have been assuming that the project is about as risky as the company’s average project. If the project were judged to be riskier than average, it would be necessary to increase the cost of capital, which might cause the NPV to become negative and the IRR and MIRR to drop below the then-higher WACC. Therefore, we cannot make a ﬁnal decision until we evaluate the project’s risk, the topic of a later section. What three types of cash ﬂows must be considered when evaluating a proposed project?

Adjusting for Inﬂation Inﬂation is a fact of life in the United States and most other nations, so it must be considered in any sound capital budgeting analysis.6

Inﬂation-Induced Bias Note that in the absence of inﬂation, the real rate, rr, would be equal to the nominal rate, rn. Moreover, the real and nominal expected net cash ﬂows—RCFt and NCFt—would also be equal. Remember that real interest rates and cash ﬂows do not include inﬂation effects, while nominal rates and ﬂows do reﬂect the effects of inﬂation. In particular, an inﬂation premium, IP, is built into all nominal market interest rates. Suppose the expected rate of inﬂation is positive, and we expect all of the project’s cash ﬂows—including those related to depreciation—to rise at the rate i. Further, assume that this same inﬂation rate, i, is built into the market cost of capital as an inﬂation premium, IP ⫽ i. In this situation, the nominal net cash ﬂow, NCFt, will increase annually at the rate of i percent, producing this result: NCFt ⫽ RCFt(1 ⫹ i)t. 6

For some articles on this subject, see Philip L. Cooley, Rodney L. Roenfeldt, and It-Keong Chew, “Capital Budgeting Procedures under Inﬂation,” Financial Management, Winter 1975, 18–27; and “Cooley, Roenfeldt, and Chew vs. Findlay and Frankle,” Financial Management, Autumn 1976, 83–90.

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For example, if we expected a net cash ﬂow of $100 in Year 5 in the absence of inﬂation, then with a 5 percent annual rate of inﬂation, NCF5 ⫽ $100(1.05)5 ⫽ $127.63. In general, the cost of capital used as the discount rate in capital budgeting analysis is based on the market-determined costs of debt and equity, so it is a nominal rate. To convert a real interest rate to a nominal rate when the inﬂation rate is i, we use this formula: (1 ⫹ rn) ⫽ (1 ⫹ rr)(1 ⫹ i). For example, if the real cost of capital is 7 percent and the inﬂation rate is 5 percent, then 1 ⫹ rn ⫽ (1.07)(1.05) ⫽ 1.1235, so rn ⫽ 12.35%.7 Now if net cash ﬂows increase at the rate of i percent per year, and if this same inﬂation premium is built into the ﬁrm’s cost of capital, then the NPV would be calculated as follows: n n RCFt(1 ⫹ i)t NCFt NPV (with inflation) ⫽ a t ⫽ a t t. t⫽0 (1 ⫹ rn) t⫽0 (1 ⫹ rr) (1 ⫹ i)

(8-1)

Since the (1 ⫹ i)t terms in the numerator and denominator cancel, we are left with: n RCFt NPV ⫽ a t. t⫽0 (1 ⫹ rr)

Thus, if all costs and also the sales price, hence annual cash ﬂows, are expected to rise at the same inﬂation rate that investors have built into the cost of capital, then the inﬂation-adjusted NPV as determined using Equation 8-1 is the same whether you discount nominal cash ﬂows at a nominal rate or real cash ﬂows at a real rate. For example, the PV of a real $100 at Year 5 at a real rate of 7 percent is $71.30 ⫽ $100/(1.07)5. The PV of a nominal $127.63 at Year 5 at a nominal rate of 12.35 percent is also $71.30 ⫽ $127.63/(1.1235)5. However, some analysts mistakenly use base year, or constant (unadjusted), dollars throughout the analysis—say, 2003 dollars if the analysis is done in 2003—along with a cost of capital as determined in the marketplace as we described in Chapter 6. This is wrong: If the cost of capital includes an inﬂation premium, as it typically does, but the cash ﬂows are all stated in constant (unadjusted) dollars, then the calculated NPV will be lower than the true NPV. The denominator will reﬂect inﬂation, but the numerator will not, and this will produce a downward-biased NPV.

Making the Inﬂation Adjustment There are two ways to adjust for inﬂation. First, all project cash ﬂows can be expressed as real (unadjusted) ﬂows, with no consideration of inﬂation, and then the cost of capital can be adjusted to a real rate by removing the inﬂation premiums from the component costs. This approach is simple in theory, but to produce an unbiased NPV it requires (1) that all project cash ﬂows, including depreciation, be affected identically by inﬂation, and (2) that this rate of increase equals the inﬂation rate built into investors’ required returns. Since these assumptions do not necessarily hold in practice, this method is not commonly used.

7

To focus on inﬂation effects, we have simpliﬁed the situation somewhat. The actual project cost of capital is made up of debt and equity components, both of which are affected by inﬂation, but only the debt component is adjusted for tax effects. Thus, the relationship between nominal and real costs of capital is more complex than indicated in our discussion here.

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The second method involves leaving the cost of capital in its nominal form, and then adjusting the individual cash ﬂows to reﬂect expected inﬂation. This is what we did earlier in our RIC example as summarized in Table 8-3. There we assumed that sales prices and variable costs would increase at a rate of 2 percent per year, ﬁxed costs would increase by 1 percent per year, and that depreciation charges would not be affected by inﬂation. One should always build inﬂation into the cash ﬂow analysis, with the speciﬁc adjustment reﬂecting as accurately as possible the most likely set of circumstances. With a spreadsheet, it is easy to make the adjustments. Our conclusions about inﬂation may be summarized as follows. First, inﬂation is critically important, for it can and does have major effects on businesses. Therefore, it must be recognized and dealt with. Second, the most effective way of dealing with inﬂation in capital budgeting analyses is to build inﬂation estimates into each cash ﬂow element, using the best available information on how each element will be affected. Third, since we cannot estimate future inﬂation rates with precision, errors are bound to be made. Thus, inﬂation adds to the uncertainty, or riskiness, of capital budgeting as well as to its complexity. What is the best way of handling inﬂation, and how does this procedure eliminate the potential bias?

Project Risk Analysis: Techniques for Measuring Stand-Alone Risk Recall from Chapter 6 that there are three distinct types of risk: stand-alone risk, corporate risk, and market risk. Why should a project’s stand-alone risk be important to anyone? In theory, this type of risk should be of little or no concern. However, it is actually of great importance for two reasons: 1. It is easier to estimate a project’s stand-alone risk than its corporate risk, and it is far easier to measure stand-alone risk than market risk. 2. In the vast majority of cases, all three types of risk are highly correlated—if the general economy does well, so will the ﬁrm, and if the ﬁrm does well, so will most of its projects. Because of this high correlation, stand-alone risk is generally a good proxy for hard-to-measure corporate and market risk. The starting point for analyzing a project’s stand-alone risk involves determining the uncertainty inherent in its cash ﬂows. To illustrate what is involved, consider again Regency Integrated Chips’ appliance control computer project that we discussed above. Many of the key inputs shown in Part 1 of Table 8-3 are subject to uncertainty. For example, sales were projected at 20,000 units to be sold at a net price of $3,000 per unit. However, actual unit sales will almost certainly be somewhat higher or lower than 20,000, and the sales price will probably turn out to be different from the projected $3,000 per unit. In effect, the sales quantity and price estimates are really expected values based on probability distributions, as are many of the other values that were shown in Part 1 of Table 8-3. The distributions could be relatively “tight,” reﬂecting small standard deviations and low risk, or they could be “wide,” denoting a great deal of uncertainty about the actual value of the variable in question and thus a high degree of stand-alone risk. The nature of the individual cash ﬂow distributions, and their correlations with one another, determine the nature of the NPV probability distribution and, thus, the project’s stand-alone risk. In the following sections, we discuss three techniques for

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assessing a project’s stand-alone risk: (1) sensitivity analysis, (2) scenario analysis, and (3) Monte Carlo simulation.

Sensitivity Analysis Intuitively, we know that many of the variables that determine a project’s cash ﬂows could turn out to be different from the values used in the analysis. We also know that a change in a key input variable, such as units sold, will cause the NPV to change. Sensitivity analysis is a technique that indicates how much NPV will change in response to a given change in an input variable, other things held constant. Sensitivity analysis begins with a base-case situation, which is developed using the expected values for each input. To illustrate, consider the data given back in Table 8-3, where projected cash ﬂows for RIC’s computer project were shown. The values used to develop the table, including unit sales, sales price, ﬁxed costs, and variable costs, are all most likely, or base-case, values, and the resulting $5.809 million NPV shown in Table 8-3 is called the base-case NPV. Now we ask a series of “what if” questions: “What if unit sales fall 15 percent below the most likely level?” “What if the sales price per unit falls?” “What if variable costs are $2.50 per unit rather than the expected $2.10?” Sensitivity analysis is designed to provide decision makers with answers to questions such as these. In a sensitivity analysis, each variable is changed by several percentage points above and below the expected value, holding all other variables constant. Then a new NPV is calculated using each of these values. Finally, the set of NPVs is plotted to show how sensitive NPV is to changes in each variable. Figure 8-1 shows the computer project’s sensitivity graphs for six of the input variables. The table below the graph gives the NPVs that were used to construct the graph. The slopes of the lines in the graph show how sensitive NPV is to changes in each of the inputs: the steeper the slope, the more sensitive the NPV is to a change in the variable. From the ﬁgure and the table, we see that the project’s NPV is very sensitive to changes in the sales price and variable costs, fairly sensitive to changes in the growth rate and units sold, and not very sensitive to changes in either ﬁxed costs or the cost of capital. If we were comparing two projects, the one with the steeper sensitivity lines would be riskier, because for that project a relatively small error in estimating a variable such as unit sales would produce a large error in the project’s expected NPV. Thus, sensitivity analysis can provide useful insights into the riskiness of a project. Before we move on, we should note that spreadsheet computer programs such as Excel are ideally suited for sensitivity analysis. We used the Data Table feature in the ﬁle Ch 08 Tool Kit.xls, on the textbook’s web site, to generate the table used for Figure 8-1. To conduct such an analysis by hand would be extremely time consuming.

Scenario Analysis Although sensitivity analysis is probably the most widely used risk analysis technique, it does have limitations. For example, we saw earlier that the computer project’s NPV is highly sensitive to changes in the sales price and the variable cost per unit. Those sensitivities suggest that the project is risky. Suppose, however, that Home Depot or Circuit City was anxious to get the new computer product and would sign a contract to purchase 20,000 units per year for four years at $3,000 per unit. Moreover, suppose Intel would agree to provide the principal component at a price that would ensure that the variable cost per unit would not exceed $2,200. Under these conditions, there would be a low probability of high or low sales prices and input costs, so the project would not be at all risky in spite of its sensitivity to those variables.

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Evaluating Risk: Sensitivity Analysis (Dollars in Thousands)

NPV ($) 40,000

Sales price

30,000 Growth rate 20,000 Units sold

10,000

WACC 0

Fixed cost

–10,000

Variable cost

–20,000

–30,000 –30

0

–15

15 30 Deviation from Base-Case Value (%)

NPV at Different Deviations from Base Deviation from Base Case

Sales Price

Variable Cost/Unit

Growth Rate

Year 1 Units Sold

Fixed Cost

WACC

⫺30% ⫺15 0 15 30

($27,223) (10,707) 5,809 22,326 38,842

$29,404 17,607 5,809 (5,988) (17,785)

($ 4,923) (115) 5,809 12,987 21,556

($ 3,628) 1,091 5,809 10,528 15,247

$10,243 8,026 5,809 3,593 1,376

$9,030 7,362 5,809 4,363 3,014

Range

$66,064

$47,189

$26,479

$18,875

$8,867

$6,016

We see, then, that we need to extend sensitivity analysis to deal with the probability distributions of the inputs. In addition, it would be useful to vary more than one variable at a time so we could see the combined effects of changes in the variables. Scenario analysis provides these extensions—it brings in the probabilities of changes in the key variables, and it allows us to change more than one variable at a time. In a scenario analysis, the ﬁnancial analyst begins with the base case, or most likely set of values for the input variables. Then, he or she asks marketing, engineering, and other operating managers to specify a worst-case scenario (low unit sales, low sales price, high variable costs, and so on) and a best-case scenario. Often, the best case and worst case are set so as to have a 25 percent probability of conditions being that good or bad, and a 50 percent probability is assigned to the base-case conditions. Obviously, conditions could actually take on other values, but parameters such as these are useful to get people focused on the central issues in risk analysis. The best-case, base-case, and worst-case values for RIC’s computer project are shown in Table 8-4, along with a plot of the data. If the product is highly successful, then

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TABLE 8-4

Scenario

Scenario Analysis (Dollars in Thousands) Sales Price

Probability

Best case Base case Worst case

25% 50 25

Unit Sales

Variable Costs

Growth Rate

NPV

$3.90 26,000 $1.47 30% 3.00 20,000 2.10 0 2.10 14,000 2.73 ⫺30 Expected NPV ⫽ Standard deviation ⫽ Coefﬁcient of variation ⫽ Standard deviation/Expected NPV ⫽

$146,180 5,809 (37,257) $30,135 $69,267 2.30

Probability Graph Probability (%) 50

25

(37,257)

146,180

30,135

0

NPV ($)

5,809 Most likely

Mean of distribution = Expected value

Note: The scenario analysis calculations were performed in the Excel model, Ch 08 Tool Kit.xls.

See Ch 08 Tool Kit.xls for a scenario analysis using Excel’s Scenario Manager.

the combination of a high sales price, low production costs, high ﬁrst year sales, and a strong growth rate in future sales will result in a very high NPV, $146 million. However, if things turn out badly, then the NPV would be ⫺$37 million. The graphs show a very wide range of possibilities, indicating that this is indeed a very risky project. If the bad conditions materialize, this will not bankrupt the company—this is just one project for a large company. Still, losing $37 million would certainly not help the stock price or the career of the project’s manager. The scenario probabilities and NPVs constitute a probability distribution of returns like those we dealt with in Chapter 3, except that the returns are measured in dollars instead of percentages (rates of return). The expected NPV (in thousands of dollars) is $30,135:8 n

Expected NPV ⫽ a Pi(NPVi) i⫽1

⫽ 0.25($146,180) ⫹ 0.50($5,809) ⫹ 0.25(⫺$37,257) ⫽ $30,135.

8

Note that the expected NPV, $30,135, is not the same as the base-case NPV, $5,809 (in thousands). This is because the two uncertain variables, sales volume and sales price, are multiplied together to obtain dollar sales, and this process causes the NPV distribution to be skewed to the right. A big number times another big number produces a very big number, which, in turn, causes the average, or expected value, to increase.

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Capital Budgeting Practices in the Asia/Paciﬁc Region

A recent survey of executives in Australia, Hong Kong, Indonesia, Malaysia, the Philippines, and Singapore asked several questions about their companies’ capital budgeting practices. The study yielded some interesting results, which are summarized here.

Techniques for Evaluating Corporate Projects Consistent with evidence on U.S. companies, most companies in this region evaluate projects using IRR, NPV, and payback. IRR use ranged from 86 percent (in Hong Kong) to 96 percent (in Australia). NPV use ranged from 81 percent (in the Philippines) to 96 percent (in Australia). Payback use ranged from 81 percent (in Indonesia) to 100 percent (in Hong Kong and the Philippines).

Techniques for Estimating the Cost of Equity Capital Recall from Chapter 6 that three basic approaches can be used to estimate the cost of equity: CAPM, dividend yield plus growth rate (DCF), and cost of debt plus a risk pre-

mium. The use of these methods varied considerably from country to country (see Table A). We noted in Chapter 7 that the CAPM is used most often by U.S. ﬁrms. (See the box in Chapter 7 entitled, “Techniques Firms Use to Evaluate Corporate Projects”.) Except for Australia, this is not the case for Asian/ Paciﬁc ﬁrms, who instead more often use the other two approaches.

Techniques for Assessing Risk Finally, ﬁrms in these six countries rely heavily on scenario and sensitivity analyses to assess project risk. They also use decision trees and Monte Carlo simulation, but less frequently than the other techniques (see Table B). Source: From George W. Kester et al., “Capital Budgeting Practices in the Asia-Paciﬁc Region: Australia, Hong Kong, Indonesia, Malaysia, Philippines, and Singapore,” Financial Practice and Education, vol. 9, no. 1, Spring/Summer 1999, 25–33. Reprinted by permission of Financial Management Association International, University of South Florida.

TABLE A Method

CAPM Dividend yield plus growth rate Cost of debt plus risk premium

Australia

Hong Kong

Indonesia

Malaysia

Philippines

Singapore

72.7% 16.4 10.9

26.9% 53.8 23.1

0.0% 33.3 53.4

6.2% 50.0 37.5

24.1% 34.5 58.6

17.0% 42.6 42.6

Australia

Hong Kong

Indonesia

Malaysia

Philippines

Singapore

96% 100 44 38

100% 100 58 35

94% 88 50 25

80% 83 37 9

97% 94 33 24

90% 79 46 35

TABLE B Risk Assessment Technique

Scenario analysis Sensitivity analysis Decision tree analysis Monte Carlo simulation

The standard deviation of the NPV is $69,267 (in thousands of dollars): n

␴NPV ⫽

a Pi(NPVi ⫺ Expected NPV) B i⫽1

2

0.25($146,180 ⫺ $30,135)2 ⫹ 0.50($5,809 ⫺ $30,135)2 B ⫹ 0.25(⫺$37,257 ⫺ $30,135)2 ⫽ $69,267. ⫽

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High-Tech CFOs

Recent developments in technology have made it easier for corporations to utilize complex risk analysis techniques. New software and higher-powered computers enable ﬁnancial managers to process large amounts of information, so technically astute ﬁnance people can consider a broad range of scenarios using computers to estimate the effects of changes in sales, operating costs, interest rates, the overall economy, and even the weather. Given such analysis, ﬁnancial managers can make better decisions as to which course of action is most likely to maximize shareholder wealth. Risk analysis can also take account of the correlation between various types of risk. For example, if interest rates and currencies tend to move together in a particular way, this tendency can be incorporated into the model. This can enable ﬁnancial managers to make better estimates of the likelihood and effect of “worst-case” outcomes. While this type of risk analysis is undeniably useful, it is only as good as the information and assumptions used in the

models. Also, risk models frequently involve complex calculations, and they generate output that requires ﬁnancial managers to have a fair amount of mathematical sophistication. However, technology is helping to solve these problems, and new programs have been developed to present risk analysis in an intuitive way. For example, Andrew Lo, an MIT ﬁnance professor, has developed a program that summarizes the risk, return, and liquidity proﬁles of various strategies using a new data visualization process that enables complicated relationships to be plotted along three-dimensional graphs that are easy to interpret. While some old-guard CFOs may bristle at these new approaches, younger and more computer-savvy CFOs are likely to embrace them. As Lo puts it: “The videogame generation just loves these 3-D tools.” Source: “The CFO Goes 3-D: Higher Math and Savvy Software Are Crucial,” reprinted from October 28, 1996 issue of Business Week by special permission, copyright © 1996 by The McGraw-Hill Companies, Inc.

Finally, the project’s coefﬁcient of variation is: CVNPV ⫽

␴NPV $69,267 ⫽ ⫽ 2.30. E(NPV) $30,135

The project’s coefﬁcient of variation can be compared with the coefﬁcient of variation of RIC’s “average” project to get an idea of the relative riskiness of the proposed project. RIC’s existing projects, on average, have a coefﬁcient of variation of about 1.0, so, on the basis of this stand-alone risk measure, we conclude that the project is much riskier than an “average” project. Scenario analysis provides useful information about a project’s stand-alone risk. However, it is limited in that it considers only a few discrete outcomes (NPVs), even though there are an inﬁnite number of possibilities. We describe a more complete method of assessing a project’s stand-alone risk in the next section.

Monte Carlo Simulation Monte Carlo simulation ties together sensitivities and probability distributions. It grew out of work in the Manhattan Project to build the ﬁrst atomic bomb, and was so named because it utilized the mathematics of casino gambling. While Monte Carlo simulation is considerably more complex than scenario analysis, simulation software packages make this process manageable. Many of these packages are included as add-ons to spreadsheet programs such as Microsoft Excel. In a simulation analysis, the computer begins by picking at random a value for each variable—sales in units, the sales price, the variable cost per unit, and so on.

317

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319

Then those values are combined, and the project’s NPV is calculated and stored in the computer’s memory. Next, a second set of input values is selected at random, and a second NPV is calculated. This process is repeated perhaps 1,000 times, generating 1,000 NPVs. The mean and standard deviation of the set of NPVs is determined. The mean, or average value, is used as a measure of the project’s expected NPV, and the standard deviation (or coefﬁcient of variation) is used as a measure of risk. Using this procedure, we conducted a simulation analysis of RIC’s proposed project. As in our scenario analysis, we simpliﬁed the illustration by specifying the distributions for only four key variables: (1) sales price, (2) variable cost, (3) Year 1 units sold, and (4) growth rate. We assumed that sales price can be represented by a continuous normal distribution with an expected value of $3.00 and a standard deviation of $0.35. Recall from Chapter 3 that there is about a 68 percent chance that the actual price will be within one standard deviation of the expected price, which results in a range of $2.65 to $3.35. Put another way, there is only a 32 percent chance that the price will fall outside the indicated range. Note too that there is less than a 1 percent chance that the actual price will be more than three standard deviations of the expected price, which gives us a range of $1.95 to $4.05. Therefore, the sales price is very unlikely to be less than $1.95 or more than $4.05. RIC has existing labor contracts and strong relationships with some of its suppliers, which makes the variable cost less uncertain. In the simulation we assumed that the variable cost can be described by a triangular distribution, with a lower bound of $1.40, a most likely value of $2.10, and an upper bound of $2.50. Note that this is not a symmetric distribution. The lower bound is $0.70 less than the most likely value, but the upper bound is only $0.40 higher than the most likely value. This is because RIC has an active risk management program under which it hedges against increases in the prices of the commodities used in its production processes. The net effect is that RIC’s hedging activities reduce its exposure to price increases but still allow it to take advantage of falling prices. Based on preliminary purchase agreements with major customers, RIC is certain that sales in the ﬁrst year will be at least 15,000 units. The marketing department believes the most likely demand will be 20,000 units, but it is possible that demand will be much higher. The plant can produce a maximum of 30,000 units in the ﬁrst year, although production can be expanded in subsequent years if there is higher than expected demand. Therefore, we represented Year 1 unit sales with a triangular distribution with a lower bound of 15,000 units, a most likely value of 20,000 units, and an upper bound of 30,000 units. The marketing department anticipates no growth in unit sales after the ﬁrst year, but it recognizes that actual sales growth could be either positive or negative. Moreover, actual growth is likely to be positively correlated with units sold in the ﬁrst year, which means that if demand is higher than expected in the ﬁrst year, then growth will probably be higher than expected in subsequent years. We represented growth with a normal distribution having an expected value of 0 percent and a standard deviation of 15 percent. We also speciﬁed the correlation between Year 1 unit sales and growth in sales to be 0.65. We used these inputs and the model from Ch 08 Tool Kit.xls to conduct the simulation analysis. If you want to do the simulation yourself, you should ﬁrst read the instructions in the ﬁle Explanation of Simulation.doc. This explains how to install an Excel add-in, Simtools.xla, which is necessary to run the simulation. After you have installed Simtools.xla, you can run the simulation analysis, which is in a separate

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spreadsheet, Ch 08 Tool Kit Simulation.xls.9 All three ﬁles are included on the textbook’s web site. Using this model, we simulated 1,000 outcomes for the capital budgeting project. Table 8-5 presents selected results from the simulation. After running the simulation, the ﬁrst thing to do is to ensure that the results are consistent with our assumptions. The resulting mean and standard deviation of sales price are $3.01 and $0.35, respectively, which are virtually identical to our assumptions. Similarly, the resulting mean of ⫺0.4 percent and standard deviation of 14.8 percent for growth are very close to our assumed distribution. The maximum for variable cost is $2.47, which is just under our speciﬁed maximum of $2.50, and the minimum is $1.40, which is equal to our speciﬁed minimum. Unit sales have a maximum of 29,741 and a minimum of 15,149, both of which are consistent with our assumptions. Finally, the resulting correlation between unit sales and growth is 0.664, which is very close to our assumed correlation of 0.65. Therefore, the results of the simulation are consistent with our assumptions. Table 8-5 also reports summary statistics for the project’s NPV. The mean is $13,867, which suggests that the project should be accepted. However, the range of outcomes is quite large, from a loss of $49,550 to a gain of $124,091, so the project is clearly risky. The standard deviation of $22,643 indicates that losses could easily occur, and this is consistent with this wide range of possible outcomes.10 The coefﬁcient of variation is 1.63, which is large compared with most of RIC’s 9

We are grateful to Professor Roger Myerson of Northwestern University for making Simtool.xla available to us. Note too that there are a number of commercially available simulation programs that can be used with Excel, including @Risk and Crystal Ball. Many universities and companies have such a program installed on their networks, and they can also be installed on PCs. 10 Note that the standard deviation of NPV in the simulation is much smaller than the standard deviation in the scenario analysis. In the scenario analysis, we assumed that all of the poor outcomes would occur together in the worst-case scenario, and all of the positive outcomes would occur together in the best-case scenario. In other words, we implicitly assumed that all of the risky variables were perfectly positively correlated. In the simulation, we assumed that the variables were independent, with the exception of the correlation between unit sales and growth. The independence of variables in the simulation reduces the range of outcomes. For example, in the simulation, sometimes the sales price is high, but the sales growth is low. In the scenario analysis, a high sales price is always coupled with high growth. Because the scenario analysis’s assumption of perfect correlation is unlikely, simulation may provide a better estimate of project risk. However, if the standard deviations and correlations used as inputs in the simulation are not estimated accurately, then the simulation output will likewise be inaccurate. Remember the terms GIGO, or “garbage in, garbage out,” and SWAG, or “scientiﬁc wild a_ _ guess”!

TABLE 8-5

Summary of Simulation Results (Thousands of Dollars) Risky Inputs

Mean Standard deviation Maximum Minimum Median Probability of NPV ⬎ 0 Coefﬁcient of variation

Output

Sales Price

Variable Cost

Unit Sales

Growth

NPV

$3.01 0.35 4.00 1.92

$2.00 0.23 2.47 1.40

21,662 3,201 29,741 15,149

⫺0.4% 14.8 42.7 ⫺51.5

$13,867 22,643 124,091 ⫺49,550 10,607 72.8% 1.63

319

320

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321

NPV Probability Distribution Probability

–70,000

0

70,000

140,000

210,000 NPV ($)

other projects. Table 8-5 also reports a median NPV of $10,607, which means that half the time the project will have an NPV greater than $10,607. The table also reports that 72.8 percent of the time we would expect the project to have a positive NPV. A picture is worth a thousand words, and Figure 8-2 shows the probability distribution of the outcomes. Note that the distribution of outcomes is skewed to the right. As the ﬁgure shows, the potential downside losses are not as large as the potential upside gains. Our conclusion is that this is a very risky project, as indicated by the coefﬁcient of variation, but it does have a positive expected NPV and the potential to be a home run. List two reasons why, in practice, a project’s stand-alone risk is important. Differentiate between sensitivity and scenario analyses. What advantage does scenario analysis have over sensitivity analysis? What is Monte Carlo simulation?

Project Risk Conclusions We have discussed the three types of risk normally considered in capital budgeting analysis—stand-alone risk, within-ﬁrm (or corporate) risk, and market risk—and we have discussed ways of assessing each. However, two important questions remain: (1) Should ﬁrms be concerned with stand-alone or corporate risk in their capital budgeting decisions, and (2) what do we do when the stand-alone, within-ﬁrm, and market risk assessments lead to different conclusions?

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These questions do not have easy answers. From a theoretical standpoint, welldiversiﬁed investors should be concerned only with market risk, managers should be concerned only with stock price maximization, and this should lead to the conclusion that market (beta) risk ought to be given virtually all the weight in capital budgeting decisions. However, if investors are not well diversiﬁed, if the CAPM does not operate exactly as theory says it should, or if measurement problems keep managers from having conﬁdence in the CAPM approach in capital budgeting, it may be appropriate to give stand-alone and corporate risk more weight than ﬁnancial theory suggests. Note also that the CAPM ignores bankruptcy costs, even though such costs can be substantial, and the probability of bankruptcy depends on a ﬁrm’s corporate risk, not on its beta risk. Therefore, even well-diversiﬁed investors should want a ﬁrm’s management to give at least some consideration to a project’s corporate risk instead of concentrating entirely on market risk. Although it would be nice to reconcile these problems and to measure project risk on some absolute scale, the best we can do in practice is to estimate project risk in a somewhat nebulous, relative sense. For example, we can generally say with a fair degree of conﬁdence that a particular project has more or less stand-alone risk than the ﬁrm’s average project. Then, assuming that stand-alone and corporate risk are highly correlated (which is typical), the project’s stand-alone risk will be a good measure of its corporate risk. Finally, assuming that market risk and corporate risk are highly correlated (as is true for most companies), a project with more corporate risk than average will also have more market risk, and vice versa for projects with low corporate risk.11 In theory, should a ﬁrm be concerned with stand-alone and corporate risk? Should the ﬁrm be concerned with these risks in practice? If a project’s stand-alone, corporate, and market risk are highly correlated, would this make the task of measuring risk easier or harder? Explain.

Incorporating Project Risk into Capital Budgeting As we described in Chapter 6, many ﬁrms calculate a cost of capital for each division, based on the division’s market risk and capital structure. This is the ﬁrst step toward incorporating risk analysis into capital budgeting decisions, but it is limited because it only encompasses market risk. Rather than directly estimating the corporate risk of a project, the risk management departments at many ﬁrms regularly assess the entire ﬁrm’s likelihood of ﬁnancial distress, based on current and proposed projects.12 In other words, they assess a ﬁrm’s corporate risk, given its portfolio of projects. This screening process will identify those projects that signiﬁcantly increase corporate risk. Suppose a proposed project doesn’t signiﬁcantly affect a ﬁrm’s likelihood of ﬁnancial distress, but it does have greater stand-alone risk than the typical project in a division. Two methods are used to incorporate this project risk into capital budgeting. One is called the certainty equivalent approach. Here every cash inﬂow that is not known with certainty is scaled down, and the riskier the ﬂow, the lower its certainty equivalent value. Chapter 17 Web Extension explains the certainty equivalent approach in more detail. The other method, and the one we focus on here, is the risk-adjusted 11

For example, see M. Chapman Findlay III, Arthur E. Gooding, and Wallace Q. Weaver, Jr., “On the Relevant Risk for Determining Capital Expenditure Hurdle Rates,” Financial Management, Winter 1976, 9–16. 12 These processes also measure the magnitude of the losses, which is often called value at risk.

321

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323

discount rate approach, under which differential project risk is dealt with by changing the discount rate. Average-risk projects are discounted at the ﬁrm’s average cost of capital, higher-risk projects are discounted at a higher cost of capital, and lower-risk projects are discounted at a rate below the ﬁrm’s average cost of capital. Unfortunately, there is no good way of specifying exactly how much higher or lower these discount rates should be. Given the present state of the art, risk adjustments are necessarily judgmental and somewhat arbitrary. How are risk-adjusted discount rates used to incorporate project risk into the capital budget decision process?

Managing Risk through Phased Decisions: Decision Trees Up to this point we have focused primarily on techniques for estimating a project’s stand-alone risk. Although this is an integral part of capital budgeting, managers are generally more interested in reducing risk than in measuring it. For example, sometimes projects can be structured so that expenditures do not have to be made all at one time, but, rather, can be made in stages over a period of years. This reduces risk by giving managers the opportunity to reevaluate decisions using new information and then either investing additional funds or terminating the project. Such projects can be evaluated using decision trees.

The Basic Decision Tree For example, suppose United Robotics is considering the production of an industrial robot for the television manufacturing industry. The net investment for this project can be broken down into stages, as set forth in Figure 8-3: Stage 1. At t ⫽ 0, which in this case is sometime in the near future, conduct a $500,000 study of the market potential for robots in television assembly lines. Stage 2. If it appears that a sizable market does exist, then at t ⫽ 1 spend $1,000,000 to design and build a prototype robot. This robot would then be evaluated by television engineers, and their reactions would determine whether the ﬁrm should proceed with the project. Stage 3. If reaction to the prototype robot is good, then at t ⫽ 2 build a production plant at a net cost of $10,000,000. If this stage were reached, the project would generate either high, medium, or low net cash ﬂows over the following four years. Stage 4. At t ⫽ 3 market acceptance will be known. If demand is low, the ﬁrm will terminate the project and avoid the negative cash ﬂows in Years 4 and 5. A decision tree such as the one in Figure 8-3 can be used to analyze such multistage, or sequential, decisions. Here we assume that one year goes by between decisions. Each circle represents a decision point, and it is called a decision node. The dollar value to the left of each decision node represents the net investment required at that decision point, and the cash ﬂows shown under t ⫽ 3 to t ⫽ 5 represent the cash inﬂows if the project is pushed on to completion. Each diagonal line represents a branch of the decision tree, and each branch has an estimated probability. For example, if the ﬁrm decides to “go” with the project at Decision Point 1, it will spend $500,000 on a marketing study. Management estimates that there is a 0.8 probability

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FIGURE 8–3

United Robotics: Decision Tree Analysis (Thousands of Dollars) Time

t=1

t=2

0. 8

➀

0.4

($500)

➁

2 0.

Stop

Stop

t=4

t=5

Joint Probability

NPV

Product: Prob. ⴛ NPV

$18,000

$18,000

$18,000

0.144

$25, 635

$3,691

$8,000

$8,000

$8,000

0.192

$6,149

$1,181

0.144

($10,883)

($1,567)

0.320

(1,397)

(447)

0.200

(500)

(100)

0.4

➂ 3 0.

($1,000)

0.6

($10,000)

t=3

0.3

t=0

($2,000) ④

Stop

1.000

Expected NPV = $2,758 ␴ = $10,584

that the study will produce favorable results, leading to the decision to move on to Stage 2, and a 0.2 probability that the marketing study will produce negative results, indicating that the project should be canceled after Stage 1. If the project is canceled, the cost to the company will be the $500,000 for the initial marketing study, and it will be a loss. If the marketing study yields positive results, then United Robotics will spend $1,000,000 on the prototype robot at Decision Point 2. Management estimates (before even making the initial $500,000 investment) that there is a 60 percent probability that the television engineers will ﬁnd the robot useful and a 40 percent probability that they will not like it. If the engineers like the robot, the ﬁrm will spend the ﬁnal $10,000,000 to build the plant and go into production. If the engineers do not like the prototype, the project will be dropped. If the ﬁrm does go into production, the operating cash ﬂows over the project’s four-year life will depend on how well the market accepts the ﬁnal product. There is a 30 percent chance that acceptance will be quite good and net cash ﬂows will be $18 million per year, a 40 percent probability of $8 million each year, and a 30 percent chance of losing $2 million. These cash ﬂows are shown under Years 3 through 5. In summary, the decision tree in Figure 8-3 deﬁnes the decision nodes and the branches that leave the nodes. There are two types of nodes, decision nodes and outcome nodes. Decision nodes are the points at which management can respond to new information. The ﬁrst decision node is at t ⫽ 1, after the company has completed the marketing study (Decision Point 1 in Figure 8-3). The second decision node is at t ⫽ 2, after the company has completed the prototype study (Decision Point 2 in Figure 8-3). The outcome nodes show the possible results if a particular decision is taken. There is one relevant outcome node (Decision Point 3 in Figure 8-3), the one occurring at t ⫽ 3, and its branches show the possible cash ﬂows if the company goes ahead with the industrial robot project. There is one more decision node, Decision Point 4, at which United Robotics terminates the project if acceptance is low. Note that the decision tree also shows the probabilities of moving into each branch that leaves a node. The column of joint probabilities in Figure 8-3 gives the probability of occurrence of each branch, hence of each NPV. Each joint probability is obtained by multiplying together all probabilities on a particular branch. For example, the probability that the

323

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325

company will, if Stage 1 is undertaken, move through Stages 2 and 3, and that a strong demand will produce $18,000,000 of inﬂows, is (0.8)(0.6)(0.3) ⫽ 0.144 ⫽ 14.4%. The company has a cost of capital of 11.5 percent, and management assumes initially that the project is of average risk. The NPV of the top (most favorable) branch as shown in the next to last column is $25,635 (in thousands of dollars): NPV ⫽ ⫺$500 ⫺ ⫽ $25,635.

$1,000 (1.115)1

⫺

$10,000 (1.115)2

⫹

$18,000 (1.115)3

⫹

$18,000 (1.115)4

⫹

$18,000 (1.115)5

The NPVs for other branches were calculated similarly. The last column in Figure 8-3 gives the product of the NPV for each branch times the joint probability of that branch, and the sum of these products is the project’s expected NPV. Based on the expectations set forth in Figure 8-3 and a cost of capital of 11.5 percent, the project’s expected NPV is $2.758 million. As this example shows, decision tree analysis requires managers to explicitly articulate the types of risk a project faces and to develop responses to potential scenarios. Note also that our example could be extended to cover many other types of decisions, and could even be incorporated into a simulation analysis. All in all, decision tree analysis is a valuable tool for analyzing project risk. A relatively new area of capital budgeting is called real options analysis. We discuss this in much more detail in Chapter 17, but a real option exists any time a manager has an opportunity to alter a project in response to changing market conditions. Chapter 17 shows several methods for evaluating real options, including the use of decision tree analysis.13 What is a decision tree? A branch? A node?

Summary Throughout the book, we have indicated that the value of any asset depends on the amount, timing, and riskiness of the cash ﬂows it produces. In this chapter, we developed a framework for analyzing a project’s cash ﬂows and risk. The key concepts covered are listed below. 䊉 The most important (and most difﬁcult) step in analyzing a capital budgeting project is estimating the incremental after-tax cash ﬂows the project will produce. 䊉 Project cash ﬂow is different from accounting income. Project cash ﬂow reﬂects: (1) cash outlays for ﬁxed assets, (2) the tax shield provided by depreciation, and (3) cash ﬂows due to changes in net operating working capital. Project cash ﬂow does not include interest payments. 䊉 In determining incremental cash ﬂows, opportunity costs (the cash ﬂows forgone by using an asset) must be included, but sunk costs (cash outlays that have 13

In the United Robotics example we glossed over an important issue, namely, the appropriate cost of capital for the project. Adding decision nodes to a project clearly changes its risk, so we would expect the cost of capital for a project with few decision nodes to have a different risk than one with many nodes. If this were so, we would expect the projects to have different costs of capital. In fact, we might expect the cost of capital to change over time as the project moves to different stages, since the stages themselves differ in risk. We discuss these issues in more detail in Chapter 17.

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䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

been made and that cannot be recouped) are not included. Any externalities (effects of a project on other parts of the ﬁrm) should also be reﬂected in the analysis. Cannibalization occurs when a new project leads to a reduction in sales of an existing product. Tax laws affect cash ﬂow analysis in two ways: (1) They reduce operating cash ﬂows, and (2) they determine the depreciation expense that can be taken in each year. Capital projects often require additional investments in net operating working capital (NOWC). The incremental cash ﬂows from a typical project can be classiﬁed into three categories: (1) initial investment outlay, (2) operating cash ﬂows over the project’s life, and (3) terminal year cash ﬂows. Inﬂation effects must be considered in project analysis. The best procedure is to build expected inﬂation into the cash ﬂow estimates. Since stockholders are generally diversiﬁed, market risk is theoretically the most relevant measure of risk. Market, or beta, risk is important because beta affects the cost of capital, which, in turn, affects stock prices. Corporate risk is important because it inﬂuences the ﬁrm’s ability to use low-cost debt, to maintain smooth operations over time, and to avoid crises that might consume management’s energy and disrupt its employees, customers, suppliers, and community. Sensitivity analysis is a technique that shows how much a project’s NPV will change in response to a given change in an input variable such as sales, other things held constant. Scenario analysis is a risk analysis technique in which the best- and worst-case NPVs are compared with the project’s expected NPV. Monte Carlo simulation is a risk analysis technique that uses a computer to simulate future events and thus to estimate the proﬁtability and riskiness of a project. The risk-adjusted discount rate, or project cost of capital, is the rate used to evaluate a particular project. It is based on the corporate WACC, which is increased for projects that are riskier than the ﬁrm’s average project but decreased for less risky projects. Decision tree analysis shows how different decisions in a project’s life affect its value.

Questions 8–1

Deﬁne each of the following terms: a. Cash ﬂow; accounting income b. Incremental cash ﬂow; sunk cost; opportunity cost c. Net operating working capital changes; salvage value d. Real rate of return, rr, versus nominal rate of return, rn e. Sensitivity analysis; scenario analysis; Monte Carlo simulation analysis f. Risk-adjusted discount rate; project cost of capital

8–2

Operating cash ﬂows, rather than accounting proﬁts, are listed in Table 8-3. What is the basis for this emphasis on cash ﬂows as opposed to net income?

8–3

Why is it true, in general, that a failure to adjust expected cash ﬂows for expected inﬂation biases the calculated NPV downward?

8–4

Explain why sunk costs should not be included in a capital budgeting analysis, but opportunity costs and externalities should be included.

8–5

Explain how net operating working capital is recovered at the end of a project’s life, and why it is included in a capital budgeting analysis.

8–6

Deﬁne (a) simulation analysis, (b) scenario analysis, and (c) sensitivity analysis.

325

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Cash Flow Estimation and Risk Analysis Problems

Self-Test Problems ST–1 NEW PROJECT ANALYSIS

ST–2 CORPORATE RISK ANALYSIS

327

(Solutions Appear in Appendix A)

You have been asked by the president of the Farr Construction Company to evaluate the proposed acquisition of a new earth mover. The mover’s basic price is $50,000, and it would cost another $10,000 to modify it for special use. Assume that the mover falls into the MACRS 3-year class, it would be sold after 3 years for $20,000, and it would require an increase in net working capital (spare parts inventory) of $2,000. The earth mover would have no effect on revenues, but it is expected to save the ﬁrm $20,000 per year in before-tax operating costs, mainly labor. The ﬁrm’s marginal federal-plus-state tax rate is 40 percent. a. What is the net cost of the earth mover? (That is, what are the Year 0 cash ﬂows?) b. What are the operating cash ﬂows in Years 1, 2, and 3? c. What are the additional (nonoperating) cash ﬂows in Year 3? d. If the project’s cost of capital is 10 percent, should the earth mover be purchased? The staff of Porter Manufacturing has estimated the following net after-tax cash ﬂows and probabilities for a new manufacturing process: Net After-Tax Cash Flows Year

P ⴝ 0.2

P ⴝ 0.6

P ⴝ 0.2

0 1 2 3 4 5 5*

($100,000) 20,000 20,000 20,000 20,000 20,000 0

($100,000) 30,000 30,000 30,000 30,000 30,000 20,000

($100,000) 40,000 40,000 40,000 40,000 40,000 30,000

Line 0 gives the cost of the process, Lines 1 through 5 give operating cash ﬂows, and Line 5* contains the estimated salvage values. Porter’s cost of capital for an average-risk project is 10 percent. a. Assume that the project has average risk. Find the project’s expected NPV. (Hint: Use expected values for the net cash ﬂow in each year.) b. Find the best-case and worst-case NPVs. What is the probability of occurrence of the worst case if the cash ﬂows are perfectly dependent (perfectly positively correlated) over time? If they are independent over time? c. Assume that all the cash ﬂows are perfectly positively correlated, that is, there are only three possible cash ﬂow streams over time: (1) the worst case, (2) the most likely, or base, case, and (3) the best case, with probabilities of 0.2, 0.6, and 0.2, respectively. These cases are represented by each of the columns in the table. Find the expected NPV, its standard deviation, and its coefﬁcient of variation.

Problems 8–1 INVESTMENT OUTLAY

8–2 OPERATING CASH FLOW

Johnson Industries is considering an expansion project. The necessary equipment could be purchased for $9 million, and the project would also require an initial $3 million investment in net operating working capital. The company’s tax rate is 40 percent. What is the project’s initial investment outlay? Nixon Communications is trying to estimate the ﬁrst-year operating cash ﬂow (at t ⫽ 1) for a proposed project. The ﬁnancial staff has collected the following information: Projected sales Operating costs (not including depreciation) Depreciation Interest expense

$10 million $7 million $2 million $2 million

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Cash Flow Estimation and Risk Analysis The company faces a 40 percent tax rate. What is the project’s operating cash ﬂow for the ﬁrst year (t ⫽ 1)? 8–3

NET SALVAGE VALUE

8–4 NEW PROJECT ANALYSIS

8–5 NEW PROJECT ANALYSIS

8–6 INFLATION ADJUSTMENTS

8–7 SCENARIO ANALYSIS

Carter Air Lines is now in the terminal year of a project. The equipment originally cost $20 million, of which 80 percent has been depreciated. Carter can sell the used equipment today to another airline for $5 million, and its tax rate is 40 percent. What is the equipment’s after-tax net salvage value? The Campbell Company is evaluating the proposed acquisition of a new milling machine. The machine’s base price is $108,000, and it would cost another $12,500 to modify it for special use by your ﬁrm. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The machine would require an increase in net working capital (inventory) of $5,500. The milling machine would have no effect on revenues, but it is expected to save the ﬁrm $44,000 per year in before-tax operating costs, mainly labor. Campbell’s marginal tax rate is 35 percent. a. What is the net cost of the machine for capital budgeting purposes? (That is, what is the Year 0 net cash ﬂow?) b. What are the net operating cash ﬂows in Years 1, 2, and 3? c. What is the terminal year cash ﬂow? d. If the project’s cost of capital is 12 percent, should the machine be purchased? You have been asked by the president of your company to evaluate the proposed acquisition of a new spectrometer for the ﬁrm’s R&D department. The equipment’s basic price is $70,000, and it would cost another $15,000 to modify it for special use by your ﬁrm. The spectrometer, which falls into the MACRS 3-year class, would be sold after 3 years for $30,000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $4,000. The spectrometer would have no effect on revenues, but it is expected to save the ﬁrm $25,000 per year in before-tax operating costs, mainly labor. The ﬁrm’s marginal federal-plus-state tax rate is 40 percent. a. What is the net cost of the spectrometer? (That is, what is the Year 0 net cash ﬂow?) b. What are the net operating cash ﬂows in Years 1, 2, and 3? c. What is the additional (nonoperating) cash ﬂow in Year 3? d. If the project’s cost of capital is 10 percent, should the spectrometer be purchased? The Rodriguez Company is considering an average-risk investment in a mineral water spring project that has a cost of $150,000. The project will produce 1,000 cases of mineral water per year indeﬁnitely. The current sales price is $138 per case, and the current cost per case (all variable) is $105. The ﬁrm is taxed at a rate of 34 percent. Both prices and costs are expected to rise at a rate of 6 percent per year. The ﬁrm uses only equity, and it has a cost of capital of 15 percent. Assume that cash ﬂows consist only of after-tax proﬁts, since the spring has an indeﬁnite life and will not be depreciated. a. Should the ﬁrm accept the project? (Hint: The project is a perpetuity, so you must use the formula for a perpetuity to ﬁnd its NPV.) b. If total costs consisted of a fixed cost of $10,000 per year and variable costs of $95 per unit, and if only the variable costs were expected to increase with inflation, would this make the project better or worse? Continue with the assumption that the sales price will rise with inflation. Shao Industries is considering a proposed project for its capital budget. The company estimates that the project’s NPV is $12 million. This estimate assumes that the economy and market conditions will be average over the next few years. The company’s CFO, however, forecasts that there is only a 50 percent chance that the economy will be average. Recognizing this uncertainty, she has also performed the following scenario analysis: Economic Scenario

Recession Below average Average Above average Boom

Probability of Outcome

NPV

0.05 0.20 0.50 0.20 0.05

($70 million) (25 million) 12 million 20 million 30 million

What is the project’s expected NPV, its standard deviation, and its coefﬁcient of variation?

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Cash Flow Estimation and Risk Analysis Problems 8–8 RISKY CASH FLOWS

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The Bartram-Pulley Company (BPC) must decide between two mutually exclusive investment projects. Each project costs $6,750 and has an expected life of 3 years. Annual net cash ﬂows from each project begin 1 year after the initial investment is made and have the following probability distributions: Project A

Project B

Probability

Net Cash Flows

Probability

0.2 0.6 0.2

$6,000 6,750 7,500

0.2 0.6 0.2

Net Cash Flows

$

0 6,750 18,000

BPC has decided to evaluate the riskier project at a 12 percent rate and the less risky project at a 10 percent rate. a. What is the expected value of the annual net cash ﬂows from each project? What is the coefﬁcient of variation (CV)? (Hint: ␴B ⫽ $5,798 and CVB ⫽ 0.76.) b. What is the risk-adjusted NPV of each project? c. If it were known that Project B was negatively correlated with other cash ﬂows of the ﬁrm whereas Project A was positively correlated, how would this knowledge affect the decision? If Project B’s cash ﬂows were negatively correlated with gross domestic product (GDP), would that inﬂuence your assessment of its risk? 8–9 SIMULATION

Singleton Supplies Corporation (SSC) manufactures medical products for hospitals, clinics, and nursing homes. SSC may introduce a new type of X-ray scanner designed to identify certain types of cancers in their early stages. There are a number of uncertainties about the proposed project, but the following data are believed to be reasonably accurate.

Developmental costs

Project life

Sales in units

Sales price

Cost per unit (excluding developmental costs)

Probability

Value

Random Numbers

0.3 0.4 0.3 0.2 0.6 0.2 0.2 0.6 0.2 0.1 0.8 0.1 0.3 0.4 0.3

$2,000,000 4,000,000 6,000,000 3 years 8 years 13 years 100 200 300 $13,000 13,500 14,000 $5,000 6,000 7,000

00–29 30–69 70–99 00–19 20–79 80–99 00–19 20–79 80–99 00–09 10–89 90–99 00–29 30–69 70–99

SSC uses a cost of capital of 15 percent to analyze average-risk projects, 12 percent for low-risk projects, and 18 percent for high-risk projects. These risk adjustments reﬂect primarily the uncertainty about each project’s NPV and IRR as measured by the coefﬁcients of variation of NPV and IRR. SSC is in the 40 percent federal-plus-state income tax bracket. a. What is the expected IRR for the X-ray scanner project? Base your answer on the expected values of the variables. Also, assume the after-tax “proﬁts” ﬁgure you develop is equal to annual cash ﬂows. All facilities are leased, so depreciation may be disregarded. Can you determine the value of ␴IRR short of actual simulation or a fairly complex statistical analysis? b. Assume that SSC uses a 15 percent cost of capital for this project. What is the project’s NPV? Could you estimate ␴NPV without either simulation or a complex statistical analysis?

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Cash Flow Estimation and Risk Analysis c. Show the process by which a computer would perform a simulation analysis for this project. Use the random numbers 44, 17, 16, 58, 1; 79, 83, 86; and 19, 62, 6 to illustrate the process with the ﬁrst computer run. Actually calculate the ﬁrst-run NPV and IRR. Assume that the cash ﬂows for each year are independent of cash ﬂows for other years. Also, assume that the computer operates as follows: (1) A developmental cost and a project life are estimated for the ﬁrst run. (2) Next, sales volume, sales price, and cost per unit are estimated and used to derive a cash ﬂow for the ﬁrst year. (3) Then, the next three random numbers are used to estimate sales volume, sales price, and cost per unit for the second year, hence the cash ﬂow for the second year. (4) Cash ﬂows for other years are developed similarly, on out to the ﬁrst run’s estimated life. (5) With the developmental cost and the cash ﬂow stream established, NPV and IRR for the ﬁrst run are derived and stored in the computer’s memory. (6) The process is repeated to generate perhaps 500 other NPVs and IRRs. (7) Frequency distributions for NPV and IRR are plotted by the computer, and the distributions’ means and standard deviations are calculated. 8–10

SEQUENTIAL DECISIONS

The Yoran Yacht Company (YYC), a prominent sailboat builder in Newport, may design a new 30-foot sailboat based on the “winged” keels ﬁrst introduced on the 12-meter yachts that raced for the America’s Cup. First, YYC would have to invest $10,000 at t ⫽ 0 for the design and model tank testing of the new boat. YYC’s managers believe that there is a 60 percent probability that this phase will be successful and the project will continue. If Stage 1 is not successful, the project will be abandoned with zero salvage value. The next stage, if undertaken, would consist of making the molds and producing two prototype boats. This would cost $500,000 at t ⫽ 1. If the boats test well, YYC would go into production. If they do not, the molds and prototypes could be sold for $100,000. The managers estimate that the probability is 80 percent that the boats will pass testing, and that Stage 3 will be undertaken. Stage 3 consists of converting an unused production line to produce the new design. This would cost $1,000,000 at t ⫽ 2. If the economy is strong at this point, the net value of sales would be $3,000,000, while if the economy is weak, the net value would be $1,500,000. Both net values occur at t ⫽ 3, and each state of the economy has a probability of 0.5. YYC’s corporate cost of capital is 12 percent. a. Assume that this project has average risk. Construct a decision tree and determine the project’s expected NPV. b. Find the project’s standard deviation of NPV and coefﬁcient of variation (CV) of NPV. If YYC’s average project had a CV of between 1.0 and 2.0, would this project be of high, low, or average stand-alone risk?

Spreadsheet Problem 8–11 BUILD A MODEL: ISSUES IN CAPITAL BUDGETING

Start with the partial model in the ﬁle Ch 08 P11 Build a Model.xls from the textbook’s web site. Webmasters.com has developed a powerful new server that would be used for corporations’ Internet activities. It would cost $10 million to buy the equipment necessary to manufacture the server, and it would require net operating working capital equal to 10 percent of sales. The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After the ﬁrst year the sales price and variable costs will increase at the inﬂation rate of 3 percent. The company’s ﬁxed costs would be $1 million per year and would increase with inﬂation. It would take 1 year to buy the required equipment and set up operations, and the server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the project’s returns are expected to be highly correlated with returns on the ﬁrm’s other assets. The ﬁrm believes it could sell 1,000 units per year. The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the project’s 4-year life is $500,000.

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Webmasters’ federal-plus-state tax rate is 40 percent. Its cost of capital is 10 percent for average-risk projects, deﬁned as projects with a coefﬁcient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with a WACC of 8 percent, and high-risk projects at 13 percent. a. Develop a spreadsheet model and use it to ﬁnd the project’s NPV, IRR, and payback. b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables’ values at 10 percent and 20 percent above and below their base-case values. Include a graph in your analysis. c. Now conduct a scenario analysis. Assume that there is a 25 percent probability that “bestcase” conditions, with each of the variables discussed in part b being 20 percent better than its base-case value, will occur. There is a 25 percent probability of “worst-case” conditions, with the variables 20 percent worse than base, and a 50 percent probability of base-case conditions. d. If the project appears to be more or less risky than an average project, ﬁnd its risk-adjusted NPV, IRR, and payback. e. On the basis of information in the problem, would you recommend that the project be accepted?

See Ch 08 Show.ppt and Ch 08 Mini Case.xls.

John Crockett Furniture Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Joan Samuels, a recently graduated MBA. The production line would be set up in unused space in Crockett’s main plant. The machinery’s invoice price would be approximately $200,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Crockett has obtained a special tax ruling that places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $25,000 after 4 years of use. The new line would generate incremental sales of 1,250 units per year for 4 years at an incremental cost of $100 per unit in the ﬁrst year, excluding depreciation. Each unit can be sold for $200 in the ﬁrst year. The sales price and cost are both expected to increase by 3 percent per year due to inﬂation. Further, to handle the new line, the ﬁrm’s net operating working capital would have to increase by an amount equal to 12 percent of sales revenues. The ﬁrm’s tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent. a. Deﬁne “incremental cash ﬂow.” (1) Should you subtract interest expense or dividends when calculating project cash ﬂow? (2) Suppose the ﬁrm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. (3) Now assume that the plant space could be leased out to another ﬁrm at $25,000 per year. Should this be included in the analysis? If so, how? (4) Finally, assume that the new product line is expected to decrease sales of the ﬁrm’s other lines by $50,000 per year. Should this be considered in the analysis? If so, how? b. Disregard the assumptions in part a. What is Crockett’s depreciable basis? What are the annual depreciation expenses? c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inﬂation when estimating cash ﬂows? d. Construct annual incremental operating cash ﬂow statements. e. Estimate the required net operating working capital for each year and the cash ﬂow due to investments in net operating working capital. f. Calculate the after-tax salvage cash ﬂow. g. Calculate the net cash ﬂows for each year. Based on these cash ﬂows, what are the project’s NPV, IRR, MIRR, and payback? Do these indicators suggest that the project should be undertaken?

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Cash Flow Estimation and Risk Analysis

h. What does the term “risk” mean in the context of capital budgeting; to what extent can risk be quantiﬁed; and when risk is quantiﬁed, is the quantiﬁcation based primarily on statistical analysis of historical data or on subjective, judgmental estimates? i. (1) What are the three types of risk that are relevant in capital budgeting? (2) How is each of these risk types measured, and how do they relate to one another? (3) How is each type of risk used in the capital budgeting process? j. (1) What is sensitivity analysis? (2) Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume that each of these variables can vary from its base-case, or expected, value by ⫾ 10, 20, and 30 percent. Include a sensitivity diagram, and discuss the results. (3) What is the primary weakness of sensitivity analysis? What is its primary usefulness? k. Assume that Joan Samuels is conﬁdent of her estimates of all the variables that affect the project’s cash ﬂows except unit sales and sales price. If product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,600 units and a unit price of $240. Joan believes that there is a 25 percent chance of poor acceptance, a 25 percent chance of excellent acceptance, and a 50 percent chance of average acceptance (the base case). (1) What is scenario analysis? (2) What is the worst-case NPV? The best-case NPV? (3) Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to ﬁnd the project’s expected NPV, standard deviation, and coefﬁcient of variation. l. Are there problems with scenario analysis? Deﬁne simulation analysis, and discuss its principal advantages and disadvantages. m. (1) Assume that Crockett’s average project has a coefﬁcient of variation in the range of 0.2 to 0.4. Would the new furniture line be classiﬁed as high risk, average risk, or low risk? What type of risk is being measured here? (2) Crockett typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Should the new furniture line be accepted? (3) Are there any subjective risk factors that should be considered before the ﬁnal decision is made?

Selected Additional References and Cases Several articles have been written regarding the implications of the Accelerated Cost Recovery System (ACRS). Among them are the following:

Mehta, Dileep R., Michael D. Curley, and Hung-Gay Fung, “Inﬂation, Cost of Capital, and Capital Budgeting Procedures,” Financial Management, Winter 1984, 48–54.

Angell, Robert J., and Tony R. Wingler, “A Note on Expensing versus Depreciating Under the Accelerated Cost Recovery System,” Financial Management, Winter 1982, 34–35.

Rappaport, Alfred, and Robert A. Taggart, Jr., “Evaluation of Capital Expenditure Proposals Under Inﬂation,” Financial Management, Spring 1982, 5–13.

McCarty, Daniel E., and William R. McDaniel, “A Note on Expensing versus Depreciating Under the Accelerated Cost Recovery System: Comment,” Financial Management, Summer 1983, 37–39. Three additional papers on the effect of inﬂation on capital budgeting are the following: Bailey, Andrew D., and Daniel L. Jensen, “General Price Level Adjustments in the Capital Budgeting Decision,” Financial Management, Spring 1977, 26–32.

The following articles pertain to other topics in this chapter: Kroll, Yoram, “On the Differences between Accrual Accounting Figures and Cash Flows: The Case of Working Capital,” Financial Management, Spring 1985, 75–82. Mukherjee, Tarun K., “Reducing the Uncertainty-Induced Bias in Capital Budgeting Decisions—A Hurdle Rate Approach,” Journal of Business Finance & Accounting, September 1991, 747–753.

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Cash Flow Estimation and Risk Analysis Selected Additional References and Cases The literature on risk analysis in capital budgeting is vast; here is a small but useful selection of additional references that bear directly on the topics covered in this chapter: Ang, James S., and Wilbur G. Lewellen, “Risk Adjustment in Capital Investment Project Evaluations,” Financial Management, Summer 1982, 5–14. Bower, Richard S., and Jeffrey M. Jenks, “Divisional Screening Rates,” Financial Management, Autumn 1975, 42–49. Butler, J. S., and Barry Schachter, “The Investment Decision: Estimation Risk and Risk Adjusted Discount Rates,” Financial Management, Winter 1989, 13–22. Gup, Benton E., and S. W. Norwood III, “Divisional Cost of Capital: A Practical Approach,” Financial Management, Spring 1982, 20–24. Weaver, Samuel C., Peter J. Clemmens III, Jack A. Gunn, and Bruce D. Danneburg, “Divisional Hurdle Rates and the Cost of Capital,” Financial Management, Spring 1989, 18–25.

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The Cases in Financial Management series contains the following cases that focus on capital budgeting under uncertainty: Case 12, “Indian River Citrus Company (A),” Case 12A, “Cranﬁeld, Inc. (A),” Case 14, “Robert Montoya, Inc.” focus on cash ﬂow estimation. Case 13, “Indian River Citrus (B),” Case 13A, “Cranﬁeld, Inc. (B),” Case 13B, “Tasty Foods (B),” Case 13C, “Heavenly Foods,” and Case 15, “Robert Montoya, Inc. (B),” illustrate project risk analysis. Case 58, “Universal Corporation,” is a comprehensive case that illustrates Chapters 13 and 14, as do Cases 47 and 48, “The Western Company (A and B).”

Financial Statements, Cash Flow, and Taxes

99

Suppose you are a small investor who knows a little about ﬁnance and accounting. Could you compete successfully against large institutional investors with armies of analysts, high-powered computers, and state-of-the-art trading strategies? The answer, according to one Wall Street legend, is a resounding yes! Peter Lynch, who had an outstanding track record as manager of the $10 billion Fidelity Magellan fund and then went on to become the best-selling author of One Up on Wall Street and Beating the Street, has long argued that small investors can beat the market by using common sense and information available to all of us as we go about our day-to-day lives. For example, a college student may be more adept at scouting out the new and interesting products that will become tomorrow’s success stories than is an investment banker who works 75 hours a week in a New York ofﬁce. Parents of young children are likely to know which baby foods will succeed, or which diapers are best. Couch potatoes may have the best feel for which tortilla chips have the brightest future, or whether a new remote control is worth its price. The trick is to ﬁnd a product that will boom, yet whose manufacturer’s stock is undervalued. If this sounds too easy, you are right. Lynch argues that once you have discovered a good product, there is still much homework to be done. This involves combing through the vast amount of ﬁnancial information provided by companies. It also requires taking a closer and more critical look at how the company conducts its business—Lynch refers to this as “kicking the tires.” To illustrate his point, Lynch relates his experience with Dunkin’ Donuts. As a consumer, Lynch was impressed with the quality of the product. This impression led him to take a closer look at the company’s ﬁnancial statements and operations. He liked what he saw, and Dunkin’ Donuts became one of his all-time best investments. The next two chapters discuss what ﬁnancial statements are and how they are analyzed. Once you have identiﬁed a good product as a possible investment, the principles discussed in these chapters will help you “kick the tires.”

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Financial Statements, Cash Flow, and Taxes

A manager’s primary goal is to maximize the value of his or her ﬁrm’s stock. Value is based on the stream of cash ﬂows the ﬁrm will generate in the future. But how does an investor go about estimating future cash ﬂows, and how does a manager decide which actions are most likely to increase cash ﬂows? The answers to both questions lie in a study of the ﬁnancial statements that publicly traded ﬁrms must provide to investors. Here “investors” include both institutions (banks, insurance companies, pension funds, and the like) and individuals. Thus, this chapter begins with a discussion of what the basic ﬁnancial statements are, how they are used, and what kinds of ﬁnancial information users need. The value of any business asset—whether it is a ﬁnancial asset such as a stock or a bond, or a real (physical) asset such as land, buildings, and equipment—depends on the usable, after-tax cash ﬂows the asset is expected to produce. Therefore, the chapter also explains the difference between accounting income and cash ﬂow. Finally, since it The textbook's web site is after-tax cash ﬂow that is important, the chapter provides an overview of the federal contains an Excel ﬁle that income tax system. will guide you through the Much of the material in this chapter reviews concepts covered in basic accounting chapter’s calculations. The courses. However, the information is important enough to go over again. Accounting ﬁle for this chapter is Ch 09 is used to “keep score,” and if a ﬁrm’s managers do not know the score, they won’t Tool Kit.xls, and we encourage you to open the ﬁle and know if their actions are appropriate. If you took midterm exams but were not told follow along as you read the how you were doing, you would have a difﬁcult time improving your grades. The chapter. same thing holds in business. If a ﬁrm’s managers—whether they are in marketing, personnel, production, or ﬁnance—do not understand ﬁnancial statements, they will not be able to judge the effects of their actions, and the ﬁrm will not be successful. Although only accountants need to know how to make ﬁnancial statements, everyone involved with business needs to know how to interpret them.

Financial Statements and Reports Of the various reports corporations issue to their stockholders, the annual report is probably the most important. Two types of information are given in this report. First, there is a verbal section, often presented as a letter from the chairman, that describes the ﬁrm’s operating results during the past year and discusses new developments that For an excellent example of will affect future operations. Second, the annual report presents four basic ﬁnancial a corporate annual report, statements—the balance sheet, the income statement, the statement of retained earnings, take a look at 3M’s annual and the statement of cash ﬂows. Taken together, these statements give an accounting picreport found at http:// www.mmm.com. Search for ture of the ﬁrm’s operations and ﬁnancial position. Detailed data are provided for the “annual report” to ﬁnd the two or three most recent years, along with historical summaries of key operating stalatest report. A source for 1 links to the annual reports of tistics for the past ﬁve or ten years. The quantitative and verbal materials are equally important. The ﬁnancial statemany companies is www. ments report what has actually happened to assets, earnings, and dividends over the past annualreportservice.com. few years, whereas the verbal statements attempt to explain why things turned out the way they did. For illustrative purposes, we use data on MicroDrive Inc., a producer of disk drives for microcomputers. Formed in 1982, MicroDrive has grown steadily and has earned a reputation for being one of the best ﬁrms in the microcomputer components industry. MicroDrive’s earnings dropped a bit in 2002, to $113.5 million versus $117.8 1

Firms also provide quarterly reports, but these are much less comprehensive. In addition, larger ﬁrms ﬁle even more detailed statements, giving breakdowns for each major division or subsidiary, with the Securities and Exchange Commission (SEC). These reports, called 10-K reports, are made available to stockholders upon request to a company’s corporate secretary. Finally, see http://www.edgarscan.com for an online source of these reports, available in spreadsheets.

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million in 2001. Management reported that the decline resulted from a three-month strike that kept the ﬁrm from fully utilizing a new plant that had been ﬁnanced mostly with debt. However, management went on to paint a more optimistic picture for the future, stating that full operations had been resumed, that several new products had been introduced, and that 2003 proﬁts were expected to rise sharply. Of course, the proﬁt increase may not occur, and analysts should compare management’s past statements with subsequent results when judging the credibility of the projected improvement. In any event, the information contained in an annual report is used by investors to help form expectations about future earnings and dividends. Therefore, the annual report is obviously of great interest to investors. What is the annual report, and what two types of information are given in it? Why is the annual report of great interest to investors? What four types of ﬁnancial statements are typically included in the annual report?

The Balance Sheet The left-hand side of MicroDrive’s year-end 2002 and 2001 balance sheets, which are given in Table 9-1, shows the ﬁrm’s assets, while the right-hand side shows the liabilities and equity, or the claims against these assets. The assets are listed in order of their “liquidity,” or the length of time it typically takes to convert them to cash. The claims are listed in the order in which they must be paid: Accounts payable must generally be paid within 30 days, notes payable within 90 days, and so on, down to the stockholders’ equity accounts, which represent ownership and need never be “paid off.” Some additional points about the balance sheet are worth noting:

See Ch 09 Tool Kit.xls for details.

TABLE 9-1 Assets

1. Cash versus other assets. Although the assets are all stated in terms of dollars, only cash represents actual money. Note, though, that some types of marketable securities have a very short time until maturity and can also be converted very quickly into cash at prices close to their book values. These securities are called

MicroDrive Inc.: December 31 Balance Sheets (Millions of Dollars) 2002

2001

Cash and equivalents Short-term investments Accounts receivable Inventories Total current assets Net plant and equipment

$

10 0 375 615 $ 1,000 1,000

$

15 65 315 415 $ 810 870

Total assets

$ 2,000

$1,680

Liabilities and Equity

Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Preferred stock (400,000 shares) Common stock (50,000,000 shares) Retained earnings Total common equity Total liabilities and equity

2002

$

60 110 140 $ 310 754 $ 1,064 40 130 766 $ 896 $ 2,000

2001

$

30 60 130 $ 220 580 $ 800 40 130 710 $ 840 $1,680

Note: The bonds have a sinking fund requirement of $20 million a year. Sinking funds are discussed in Chapter 4, but in brief, a sinking fund simply involves the repayment of long-term debt. Thus, MicroDrive was required to pay off $20 million of its mortgage bonds during 2002. The current portion of the long-term debt is included in notes payable here, although in a more detailed balance sheet it would be shown as a separate item under current liabilities.

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Financial Statements, Cash Flow, and Taxes

“cash equivalents,” and they are included with cash. Other types of marketable securities have a longer time until maturity, and their market values are less predictable. These securities are classiﬁed as “short-term investments.” Receivables are bills others owe MicroDrive, while inventories show the dollars the company has invested in raw materials, work-in-process, and ﬁnished goods available for sale. Finally, net plant and equipment reﬂect the amount of money MicroDrive paid for its ﬁxed assets when it acquired those assets in the past, less accumulated depreciation. With $10 million of cash, MicroDrive can write checks for a total of $10 million (versus current liabilities of $310 million due within a year). The noncash assets should produce cash over time, but they do not represent cash in hand, and the amount of cash they would bring if they were sold today could be higher or lower than the values at which they are carried on the books. 2. Liabilities versus stockholders’ equity. The claims against assets are of two types—liabilities (or money the company owes) and the stockholders’ ownership position.2 The common stockholders’ equity, or net worth, is a residual. For example, at the end of 2002, Common stockholders’ equity. $2,000,000,000 $1,064,000,000 P$40,000,000 sto$896,000,000.

$2,0Assets

$1,Liabilities

Preferred stock

Suppose assets decline in value; for example, suppose some of the accounts receivable are written off as bad debts. Liabilities and preferred stock remain constant, so the value of the common stockholders’ equity must decline. Therefore, the risk of asset value ﬂuctuations is borne primarily by the common stockholders. Note, however, that if asset values rise (perhaps because of inﬂation), these beneﬁts will accrue exclusively to the common stockholders. 3. Preferred versus common stock. Preferred stock is a hybrid, or a cross between common stock and debt. In the event of bankruptcy, preferred stock ranks below debt but above common stock. Also, the preferred dividend is ﬁxed, so preferred stockholders do not beneﬁt if the company’s earnings grow. Finally, many ﬁrms do not use any preferred stock, and those that do generally do not use much of it. Therefore, when the term “equity” is used in ﬁnance, we generally mean “common equity” unless the word “total” is included. 4. Breakdown of the common equity accounts. The common equity section is divided into two accounts—“common stock” and “retained earnings.” The retained earnings account is built up over time as the ﬁrm “saves” a part of its earnings rather than paying all earnings out as dividends. The common stock account arises from the issuance of stock to raise capital, as discussed in Chapter 5. The breakdown of the common equity accounts is important for some purposes but not for others. For example, a potential stockholder would want to know whether the company actually earned the funds reported in its equity accounts or whether the funds came mainly from selling stock. A potential creditor, on the other hand, would be more interested in the total equity the owners have in the ﬁrm and would be less concerned with the source of the equity. In the remainder of this chapter, we generally aggregate the two common equity accounts and call this sum equity, common equity, or net worth.

2

One could divide liabilities into (1) debts owed to someone and (2) other items, such as deferred taxes, reserves, and so on. Because we do not make this distinction, the terms debt and liabilities are often used synonymously.

337

Financial Statements, Cash Flow, and Taxes The Income Statement

341

5. Inventory accounting. MicroDrive uses the FIFO (ﬁrst-in, ﬁrst-out) method to determine the inventory value shown on its balance sheet ($615 million). It could have used the LIFO (last-in, ﬁrst-out) method. During a period of rising prices, by taking out old, low-cost inventory and leaving in new, high-cost items, FIFO will produce a higher balance sheet inventory value but a lower cost of goods sold on the income statement. (This is strictly accounting; companies actually use older items ﬁrst.) Since MicroDrive uses FIFO, and since inﬂation has been occurring, (a) its balance sheet inventories are higher than they would have been had it used LIFO, (b) its cost of goods sold is lower than it would have been under LIFO, and (c) its reported proﬁts are therefore higher. In MicroDrive’s case, if the company had elected to switch to LIFO in 2002, its balance sheet ﬁgure for inventories would have been $585,000,000 rather than $615,000,000, and its earnings (which will be discussed in the next section) would have been reduced by $18,000,000. Thus, the inventory valuation method can have a signiﬁcant effect on ﬁnancial statements. This is important when an analyst is comparing different companies. 6. Depreciation methods. Most companies prepare two sets of ﬁnancial statements— one for tax purposes and one for reporting to stockholders. Generally, they use the most accelerated method permitted under the law to calculate depreciation for tax purposes, but they use straight line, which results in a lower depreciation charge, for stockholder reporting. However, MicroDrive has elected to use rapid depreciation for both stockholder reporting and tax purposes. Had MicroDrive elected to use straight line depreciation for stockholder reporting, its 2002 depreciation expense would have been $25,000,000 less, so the $1 billion shown for “net plant” on its balance sheet would have been $25,000,000 higher. Its net income and its retained earnings would also have been higher. 7. The time dimension. The balance sheet may be thought of as a snapshot of the ﬁrm’s ﬁnancial position at a point in time—for example, on December 31, 2001. Thus, on December 31, 2001, MicroDrive had $15 million of cash and marketable securities, but this account had been reduced to $10 million by the end of 2002. The balance sheet changes every day as inventories are increased or decreased, as ﬁxed assets are added or retired, as bank loans are increased or decreased, and so on. Companies whose businesses are seasonal have especially large changes in their balance sheets. For example, most retailers have large inventories just before Christmas but low inventories and high accounts receivable just after Christmas. Therefore, ﬁrms’ balance sheets change over the year, depending on when the statement is constructed. What is the balance sheet, and what information does it provide? How is the order of the information shown on the balance sheet determined? Why might a company’s December 31 balance sheet differ from its June 30 balance sheet?

The Income Statement Table 9-2 gives the 2002 and 2001 income statements for MicroDrive. Net sales are shown at the top of each statement, after which various costs are subtracted to obtain the net income available to common shareholders, which is generally referred to simply as net income. These costs include operating costs, interest costs, and taxes. A report on earnings and dividends per share is given at the bottom of the income statement. Earnings per share (EPS) is called “the bottom line,” denoting that of all the items on the income statement, EPS is the most important. MicroDrive earned

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TABLE 9-2

MicroDrive Inc.: Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per-Share Data)

Net sales Operating costs excluding depreciation and amortization Earnings before interest, taxes, depreciation, and amortization (EBITDA) Depreciation Amortization Depreciation and amortization Earnings before interest and taxes (EBIT, or operating income) Less interest Earnings before taxes (EBT) Taxes (40%) Net income before preferred dividends Preferred dividends Net income Common dividends Addition to retained earnings

2002

2001

$3,000.0 2,616.2 $ 383.8 100.0 0.0 $ 100.0 $ 283.8 88.0 $ 195.8 78.3 $ 117.5 4.0 $ 113.5 $ 57.5 $ 56.0

$2,850.0 2,497.0 $ 353.0 90.0 0.0 $ 90.0 $ 263.0 60.0 $ 203.0 81.2 $ 121.8 4.0 $ 117.8 $ 53.0 $ 64.8

$23.00 $ 2.27 $ 1.15 $17.92 $ 4.27

$26.00 $ 2.36 $ 1.06 $16.80 $ 4.16

Per-Share Data Common stock price Earnings per share (EPS)a Dividends per share (DPS)a Book value per share (BVPS)a Cash ﬂow per share (CFPS)a a

There are 50,000,000 shares of common stock outstanding. Note that EPS is based on earnings after preferred dividends—that is, on net income available to common stockholders. Calculations of EPS, DPS, BVPS, and CFPS for 2002 are as follows: Earnings per share EPS Dividends per share DPS

$113,500,000 Net income $2.27. 50,000,00 Common shares outstanding

Dividends paid to common stockholders

Book value per share BVPS Cash flow per share CFPS

See Ch 09 Tool Kit.xls for details.

Common shares outstanding Total common equity Common shares outstanding

$896,000,000 $17.92. 50,000,000

Net income Depreciation Amortization Common shares outstanding

$57,500,000 $1.15. 50,000,000

$213,500,000 $4.27. 50,000,000

$2.27 per share in 2002, down from $2.36 in 2001, but it still raised the dividend from $1.06 to $1.15.3 Taking a closer look at the income statement, we see that depreciation and amortization are important components of total operating costs. Depreciation and amortization are similar in that both represent allocations of the costs of assets over their useful lives; however, there are some important distinctions. Recall from accounting that

3

After December 15, 1997, companies have had to report “comprehensive income” as well as net income. Comprehensive income is equal to net income plus several comprehensive income items. One example of comprehensive income is the unrealized gain or loss that occurs when a marketable security, classiﬁed as available for sale, is marked-to-market. For our purposes in this introductory ﬁnance text, we will assume that there are no comprehensive income items, so we will present only basic income statements throughout the text.

339

Financial Statements, Cash Flow, and Taxes Statement of Retained Earnings

343

depreciation is an annual charge against income that reﬂects the estimated dollar cost of the capital equipment used up in the production process. Depreciation applies to tangible assets, such as plant and equipment, whereas amortization applies to intangible assets such as patents, copyrights, trademarks, and goodwill. Some companies use amortization to write off research and development costs, or the accounting goodwill that is recorded when one ﬁrm purchases another for more than its book value. Because they are similar, depreciation and amortization are often lumped together on the income statement. Managers, security analysts, and bank loan ofﬁcers often calculate EBITDA, which is deﬁned as earnings before interest, taxes, depreciation, and amortization. MicroDrive currently has no amortization charges, so the depreciation and amortization on its income statement comes solely from depreciation. In 2002, MicroDrive’s EBITDA was $383.8 million. Subtracting the $100 million of depreciation expense from its EBITDA leaves the company with $283.8 million in operating income (EBIT). After subtracting $88 million in interest expense and $78.3 million in taxes, we obtain net income before preferred dividends of $117.5 million. Finally, we subtract $4 million of preferred dividends, which leaves MicroDrive with $113.5 million of net income available to common stockholders. When analysts refer to a company’s net income, they generally mean net income available to common shareholders. Likewise, throughout this book unless otherwise indicated, net income means net income available to common stockholders. While the balance sheet can be thought of as a snapshot in time, the income statement reports on operations over a period of time, for example, during the calendar year 2002. During 2002 MicroDrive had sales of $3 billion, and its net income available to common stockholders was $113.5 million. Income statements can cover any period of time, but they are usually prepared monthly, quarterly, or annually. Of course, sales, costs, and proﬁts will be larger the longer the reporting period, and the sum of the last 12 monthly (or four quarterly) income statements should equal the values shown on the annual income statement. For planning and control purposes, management generally forecasts monthly (or perhaps quarterly) income statements, and it then compares actual results to the budgeted statements. If revenues are below and costs above the forecasted levels, then management should take corrective steps before the problem becomes too serious. What is an income statement, and what information does it provide? Why is earnings per share called “the bottom line”? Differentiate between amortization and depreciation. What is EBITDA? Regarding the time period reported, how does the income statement differ from the balance sheet?

Statement of Retained Earnings Changes in retained earnings between balance sheet dates are reported in the statement of retained earnings. Table 9-3 shows that MicroDrive began the year with $710 million of retained earnings, earned $113.5 million during 2002, paid out $57.5 million in common dividends, and plowed $56 million back into the business. Thus, the balance sheet item “Retained earnings” increased from $710 million at the end of 2001 to $766 million at the end of 2002.

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Financial Statements, Cash Flow, and Taxes TABLE 9-3

See Ch 09 Tool Kit.xls for details.

MicroDrive Inc.: Statement of Retained Earnings for Year Ending December 31, 2002 (Millions of Dollars)

Balance of retained earnings, December 31, 2001 Add: Net income, 2002 Less: Dividends to common stockholders Balance of retained earnings, December 31, 2002

$ 710.0 113.5 (57.5)a $766.0

a

Here, and throughout the book, parentheses are used to denote negative numbers.

Note that “Retained earnings” represents a claim against assets, not assets per se. Moreover, ﬁrms retain earnings primarily to expand the business, and this means investing in plant and equipment, in inventories, and so on, not piling up cash in a bank account. Changes in retained earnings occur because common stockholders allow the ﬁrm to reinvest funds that otherwise could be distributed as dividends. Thus, retained earnings as reported on the balance sheet do not represent cash and are not “available” for the payment of dividends or anything else.4 What is the statement of retained earnings, and what information does it provide? Why do changes in retained earnings occur? Explain why the following statement is true: “Retained earnings as reported on the balance sheet do not represent cash and are not ‘available’ for the payment of dividends or anything else.”

Net Cash Flow Many ﬁnancial analysts focus on net cash ﬂow. A business’s net cash ﬂow generally differs from its accounting proﬁt because some of the revenues and expenses listed on the income statement were not paid in cash during the year. The relationship between net cash ﬂow and net income can be expressed as follows: Net cash flow Net income Noncash revenues Noncash charges. (9-1) The primary examples of noncash charges are depreciation and amortization. These items reduce net income but are not paid out in cash, so we add them back to net income when calculating net cash ﬂow. Another example of a noncash charge is deferred taxes. In some instances, companies are allowed to defer tax payments to a later date even though the tax payment is reported as an expense on the income statement. Therefore, deferred tax payments would be added to net income when calculating net cash ﬂow.5 At

4 The amount reported in the retained earnings account is not an indication of the amount of cash the ﬁrm has. Cash (as of the balance sheet date) is found in the cash account, an asset account. A positive number in the retained earnings account indicates only that in the past the ﬁrm has earned some income, but its dividends have been less than its earnings. Even though a company reports record earnings and shows an increase in the retained earnings account, it still may be short of cash. The same situation holds for individuals. You might own a new BMW (no loan), lots of clothes, and an expensive stereo, hence have a high net worth, but if you had only 23 cents in your pocket plus $5 in your checking account, you would still be short of cash. 5 Deferred taxes may arise, for example, if a company uses accelerated depreciation for tax purposes but straight-line depreciation for reporting its ﬁnancial statements to investors.

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Financial Statements, Cash Flow, and Taxes Net Cash Flow

345

Financial Analysis on the Internet

A wide range of valuable ﬁnancial information is available on the Internet. With just a couple of clicks, an investor can easily ﬁnd the key ﬁnancial statements for most publicly traded companies. Say, for example, you are thinking about buying Disney stock, and you are looking for ﬁnancial information regarding the company’s recent performance. Here’s a partial (but by no means a complete) list of places you can go to get started:

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䊉䊉

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One source is Yahoo’s ﬁnance web site, http://ﬁnance. yahoo.com.a Here you will ﬁnd updated market information along with links to a variety of interesting research sites. Enter a stock’s ticker symbol, click on Get Quotes, and you will see the stock’s current price, along with recent news about the company. Click on Proﬁle (under More Info) and you will ﬁnd a report on the company’s key ﬁnancial ratios. Links to the company’s income statement, balance sheet, and statement of cash ﬂows can also be found. The Yahoo site also has a list of insider transactions, so you can tell if a company’s CEO and other key insiders are buying or selling their company’s stock. In addition, there is a message board where investors share opinions about the company, and there is a link to the company’s ﬁlings with the Securities and Exchange Commission (SEC). Note that, in most cases, a more complete list of the SEC ﬁlings can be found at http://www.sec.gov, or http://www. edgar-online.com or http://www.edgarscan.com. Other sources for up-to-date market information are http://www.thomsonfn.com, http://money.cnn.com, http://www.bloomberg.com, and http://www.cbs. marketwatch.com. Each also has an area where you can obtain stock quotes along with company ﬁnancials, links to Wall Street research, and links to SEC ﬁlings.

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Another good source is http://www.quicken.com. Enter the ticker symbol in the area labeled quotes and research. The site will take you to an area where you can ﬁnd a link to the company’s ﬁnancial statements, along with analysts’ earnings estimates and SEC ﬁlings. This site also has a section where you can estimate the stock’s intrinsic value. (In Chapter 5 we discuss various methods for calculating intrinsic value.) If you are looking for charts of key accounting variables (for example, sales, inventory, depreciation and amortization, and reported earnings), along with the ﬁnancial statements, take a look at http://www.smartmoney.com. Another good place to look is http://www. marketguide.com. Here you ﬁnd links to analysts’ research reports along with the key ﬁnancial statements. Two other places to consider: http://www.hoovers.com and http://www.zacks.com. Each has free research available along with more detailed information provided to subscribers.

Once you have accumulated all of this information, you may be looking for sites that provide opinions regarding the direction of the overall market and views regarding individual stocks. Two popular sites in this category are The Motley Fool’s web site, http://www.fool.com, and the web site for The Street.com, http://www.thestreet.com. Keep in mind that this list is just a small subset of the information available online. You should also realize that a lot of these sites change their content over time, and new and interesting sites are always being added to the Internet. a A quick way to change an address is to highlight the portion of the address that is different and type in the appropriate letters of the new address. Once you’re ﬁnished just press Enter.

the same time, some revenues may not be collected in cash during the year, and these items must be subtracted from net income when calculating net cash ﬂow. Typically, depreciation and amortization are by far the largest noncash items, and in many cases the other noncash items roughly net out to zero. For this reason, many analysts assume that net cash ﬂow equals net income plus depreciation and amortization: Net cash flow Net income Depreciation and amortization.

(9-2)

To keep things simple, we will generally assume that Equation 9-2 holds. However, you should remember that Equation 9-2 will not accurately reﬂect net cash ﬂow in those instances where there are signiﬁcant noncash items beyond depreciation and amortization. We can illustrate Equation 9-2 with 2002 data for MicroDrive taken from Table 9-2: Net cash flow $113.5 $100.0 $213.5 million.

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Financial Statements, Cash Flow, and Taxes

To illustrate depreciation’s effect, suppose a machine with a life of ﬁve years and a zero expected salvage value was purchased in 2001 for $100,000 and placed into service in 2002. This $100,000 cost is not expensed in the purchase year; rather, it is charged against production over the machine’s ﬁve-year depreciable life. If the depreciation expense were not taken, proﬁts would be overstated, and taxes would be too high. So, the annual depreciation charge is deducted from sales revenues, along with such other costs as labor and raw materials, to determine income. However, because the $100,000 was actually expended back in 2001, the depreciation charged against income in 2002 and subsequent years is not a cash outlay, as are labor or raw materials charges. Depreciation is a noncash charge, so it must be added back to net income to obtain the net cash ﬂow. If we assume that all other noncash items (including amortization) sum to zero, then net cash ﬂow is simply equal to net income plus depreciation. Differentiate between net cash ﬂow and accounting proﬁt. In accounting, the emphasis is on net income. What is emphasized in ﬁnance, and why is that item emphasized? Assuming that depreciation is its only noncash cost, how can someone calculate a business’s net cash ﬂow?

Statement of Cash Flows Even if a company reports a large net income during a year, the amount of cash reported on its year-end balance sheet may be the same or even lower than its beginning cash. The reason is that its net income can be used in a variety of ways, not just kept as cash in the bank. For example, the ﬁrm may use its net income to pay dividends, to increase inventories, to ﬁnance accounts receivable, to invest in ﬁxed assets, to reduce debt, or to buy back common stock. Indeed, the company’s cash position as reported on its balance sheet is affected by a great many factors, including the following: 1. Net income before preferred dividends. Other things held constant, a positive net income will lead to more cash in the bank. However, as we discuss below, other things generally are not held constant. 2. Noncash adjustments to net income. To calculate cash ﬂow, it is necessary to adjust net income to reﬂect noncash revenues and expenses, such as depreciation and deferred taxes, as shown above in the calculation of net cash ﬂow. 3. Changes in working capital. Increases in current assets other than cash, such as inventories and accounts receivable, decrease cash, whereas decreases in these accounts increase cash. For example, if inventories are to increase, the ﬁrm must use some of its cash to acquire the additional inventory. Conversely, if inventories decrease, this generally means the ﬁrm is selling inventories and not replacing all of them, hence generating cash. On the other hand, if payables increase, the ﬁrm has received additional credit from its suppliers, which saves cash, but if payables decrease, this means it has used cash to pay off its suppliers. Therefore, increases in current liabilities such as accounts payable increase cash, whereas decreases in current liabilities decrease cash. 4. Fixed assets. If a company invests in ﬁxed assets, this will reduce its cash position. On the other hand, if it sells some ﬁxed assets this will increase cash. 5. Security transactions and dividend payments. If a company issues stock or bonds during the year, the funds raised will increase its cash position. On the other hand, if the company uses cash to buy back outstanding stock or to pay off debt, or if it pays dividends to its shareholders, this will reduce cash.

343

Financial Statements, Cash Flow, and Taxes Statement of Cash Flows

347

Each of the above factors is reﬂected in the statement of cash ﬂows, which summarizes the changes in a company’s cash position. The statement separates activities into three categories, plus a summary section: 1. Operating activities, which includes net income, depreciation, and changes in current assets and liabilities other than cash, short-term investments, and shortterm debt. 2. Investing activities, which includes investments in or sales of ﬁxed assets. 3. Financing activities, which includes raising cash by selling short-term investments or by issuing short-term debt, long-term debt, or stock. Also, because both dividends paid and cash used to buy back outstanding stock or bonds reduce the company’s cash, such transactions are included here. Accounting texts explain how to prepare the statement of cash ﬂows, but the statement is used to help answer questions such as these: Is the ﬁrm generating enough cash to purchase the additional assets required for growth? Is the ﬁrm generating any extra cash that can be used to repay debt or to invest in new products? Such information is useful both for managers and investors, so the statement of cash ﬂows is an important part of the annual report. Financial managers generally use this statement, along with the cash budget, when forecasting their companies’ cash positions. This issue is considered in more detail in Chapter 11. Table 9-4 shows MicroDrive’s statement of cash ﬂows as it would appear in the company’s annual report. The top section shows cash generated by and used in operations—for MicroDrive, operations provided net cash ﬂows of minus $2.5 million. This subtotal, the minus $2.5 million net cash ﬂow provided by operating activities, is in many respects the most important ﬁgure in any of the ﬁnancial statements. Proﬁts as reported on the income statement can be “doctored” by such tactics as depreciating assets too slowly, not recognizing bad debts promptly, and the like. However, it is far more difﬁcult to simultaneously doctor proﬁts and the working capital accounts. Therefore, it is not uncommon for a company to report positive net income right up to the day it declares bankruptcy. In such cases, however, the net cash ﬂow from operations almost always began to deteriorate much earlier, and analysts who kept an eye on cash ﬂow could have predicted trouble. Therefore, if you are ever analyzing a company and are pressed for time, look ﬁrst at the trend in net cash ﬂow provided by operating activities, because it will tell you more than any other number. The second section shows long-term ﬁxed-asset investing activities. MicroDrive purchased ﬁxed assets totaling $230 million; this was the only long-term investment it made during 2002. The third section, ﬁnancing activities, includes borrowing from banks (notes payable), selling new bonds, and paying dividends on common and preferred stock. MicroDrive raised $289 million by borrowing and by selling off its short-term investments, but it paid $61.5 million in preferred and common dividends. Therefore, its net inﬂow of funds from ﬁnancing activities was $227.5 million. In the summary, where all of these sources and uses of cash are totaled, we see that MicroDrive’s cash outﬂows exceeded its cash inﬂows by $5 million during 2002; that is, its net change in cash was a negative $5 million. MicroDrive’s statement of cash ﬂows should be worrisome to its managers and to outside analysts. The company had a $2.5 million cash shortfall from operations, it spent an additional $230 million on new ﬁxed assets, and it paid out another $61.5 million in dividends. It covered these cash outlays by borrowing heavily and by selling $65 million of short-term investments. Obviously, this situation cannot continue year after year, so something will have to be done. Later in the chapter we will consider some of the actions MicroDrive’s ﬁnancial staff might recommend to ease the cash ﬂow problem.

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Financial Statements, Cash Flow, and Taxes TABLE 9-4

MicroDrive Inc.: Statement of Cash Flows for 2002 (Millions of Dollars) Cash Provided or Used

See Ch 09 Tool Kit.xls for details.

Operating Activities Net income before preferred dividends Adjustments: Noncash adjustments: Depreciationa Due to changes in working capital:b Increase in accounts receivable Increase in inventories Increase in accounts payable Increase in accruals Net cash provided by operating activities

$117.5

100.0 (60.0) (200.0) 30.0 10.0 ($ 2.5)

Long-Term Investing Activities Cash used to acquire ﬁxed assetsc

($230.0)

Financing Activities Sale of short-term investments Increase in notes payable Increase in bonds outstanding Payment of preferred and common dividends Net cash provided by ﬁnancing activities

$ 65.0 50.0 174.0 (61.5) 227.5

Summary Net change in cash Cash at beginning of year Cash at end of year

($

5.0) 15.0 $ 10.0

a Depreciation is a noncash expense that was deducted when calculating net income. It must be added back to show the correct cash ﬂow from operations. b An increase in a current asset decreases cash. An increase in a current liability increases cash. For example, inventories increased by $200 million, so that reduced cash by a like amount. c The net increase in ﬁxed assets is $130 million; however, this net amount is after a deduction for the year’s depreciation expense. Depreciation expense would have to be added back to ﬁnd the increase in gross ﬁxed assets. From the company’s income statement, we see that the 2002 depreciation expense is $100 million; thus, expenditures on ﬁxed assets were actually $230 million.

What is the statement of cash ﬂows, and what types of questions does it answer? Identify and brieﬂy explain the three different categories of activities shown in the statement of cash ﬂows.

Modifying Accounting Data for Managerial Decisions Thus far in the chapter we have focused on ﬁnancial statements as they are presented in the annual report. However, these statements are designed more for use by creditors and tax collectors than for managers and stock analysts. Therefore, certain modiﬁcations

345

Financial Statements, Cash Flow, and Taxes Modifying Accounting Data for Managerial Decisions

349

are needed for use in corporate decision making. In the following sections we discuss how ﬁnancial analysts combine stock prices and accounting data to make the statements more useful.

Operating Assets and Operating Capital Different ﬁrms have different ﬁnancial structures, different tax situations, and different amounts of nonoperating assets. These differences affect traditional accounting measures such as the rate of return on equity. They can cause two ﬁrms, or two divisions within a single ﬁrm, that actually have similar operations to appear to be operated with different efﬁciency. This is important, because if managerial compensation systems are to function properly, operating managers must be judged and compensated for those things that are under their control, not on the basis of things outside their control. Therefore, to judge managerial performance, we need to compare managers’ ability to generate operating income (or EBIT) with the operating assets under their control. The ﬁrst step in modifying the traditional accounting framework is to divide total assets into two categories, operating assets, which consist of the assets necessary to operate the business, and nonoperating assets, which would include cash and shortterm investments above the level required for normal operations, investments in subsidiaries, land held for future use, and the like. Moreover, operating assets are further divided into operating current assets, such as inventory, and long-term operating assets, such as plant and equipment. Obviously, if a manager can generate a given amount of proﬁt and cash ﬂow with a relatively small investment in operating assets, that reduces the amount of capital investors must put up and thus increases the rate of return on that capital. Most capital used in a business is supplied by investors—stockholders, bondholders, and lenders such as banks. Investors must be paid for the use of their money, with payment coming as interest in the case of debt and as dividends plus capital gains in the case of stock. So, if a company buys more assets than it actually needs, and thus raises too much capital, then its capital costs will be unnecessarily high. Must all of the capital used to acquire assets be obtained from investors? The answer is no, because some of the funds are provided as a normal consequence of operations. For example, some funds will come from suppliers and be reported as accounts payable, while other funds will come as accrued wages and accrued taxes, which amount to short-term loans from workers and tax authorities. Such funds are called operating current liabilities. Therefore, if a ﬁrm needs $100 million of assets, but it has $10 million of accounts payable and another $10 million of accrued wages and taxes, then its investor-supplied capital would be only $80 million. Those current assets used in operations are called operating working capital, and operating working capital less operating current liabilities is called net operating working capital. Therefore, net operating working capital is the working capital acquired with investor-supplied funds. Here is the deﬁnition in equation form: Net operating working capital Operating current assets Operating current liabilities.

(9-3)

Now think about how these concepts can be used in practice. First, all companies must carry some cash to “grease the wheels” of their operations. Companies continuously receive checks from customers and write checks to suppliers, employees, and so on. Because inﬂows and outﬂows do not coincide perfectly, a company must keep some cash in its bank account. In other words, some cash is required to conduct operations. The same is true for most other current assets, such as inventory and accounts receivable, which are required for normal operations. However, any shortterm securities the ﬁrm holds generally result from investment decisions made by the

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treasurer, and they are not used in the core operations. Therefore, short-term investments are normally excluded when calculating net operating working capital.6 Some current liabilities—especially accounts payable and accruals—arise in the normal course of operations. Moreover, each dollar of such current liabilities is a dollar that the company does not have to raise from investors to acquire current assets. Therefore, to calculate net operating working capital, we deduct these operating current liabilities from the operating current assets. Other current liabilities that charge interest, such as notes payable to banks, are treated as investor-supplied capital and thus are not deducted when calculating net working capital. If you are ever uncertain about an item, ask yourself whether it is a natural consequence of operations or if it is a discretionary choice, such as a particular method of ﬁnancing, or an investment in a ﬁnancial asset. If it is discretionary, it is not an operating asset or liability. We can apply these deﬁnitions to MicroDrive, using the balance sheet data given in Table 9-1. Here is the net operating working capital for 2002: Net operating working capital (Cash Accounts receivable Inventories) (Accounts payable Accruals) ($10 $375 $615) ($60 $140) $800 million. MicroDrive’s total operating capital at year-end 2002 was Total operating capital (Net operating working capital) (Operating long-term assets)

(9-4)

$800 $1,000 $1,800 million. Note that MicroDrive’s only operating long-term assets are net plant and equipment. Now note that MicroDrive’s net operating working capital a year earlier, at yearend 2001, was Net operating working capital ($15 $315 $415) ($30 $130) $585 million. Adding the $870 million of ﬁxed assets, its total operating capital at year-end 2001 was Total operating capital $585 $870 $1,455 million. Notice that we have deﬁned operating capital as the sum of net operating working capital and operating long-term assets. In other words, our deﬁnition is in terms of assets. However, the term “capital” is also commonly used to denote funds provided by investors, such as notes payable, long-term bonds, preferred stock, and common stock. For MicroDrive, the total capital provided by investors at year-end 2001 was $60 $580 $40 $840 $1,520 million. Of this amount, $65 million was tied up in short-term investments, which are not directly related to MicroDrive’s operations. Therefore, only $1,520 $65 $1,455 million of investor-supplied capital was used in operations. Notice that this is exactly the same value as calculated above. This 6

If the marketable securities are held as a substitute for cash, and therefore reduce the cash requirements, then they may be classiﬁed as part of operating working capital. Generally, though, large holdings of marketable securities are held as a reserve for some contingency or else as a temporary “parking place” for funds prior to an acquisition, a major capital investment program, or the like.

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shows that we can calculate operating capital either from the operating assets or from the investor-supplied funds. We usually base our calculations upon operating assets since it is possible to perform this calculation for a division, whereas it is not possible to do so using the deﬁnition based on investor-supplied capital. MicroDrive increased its operating capital to $1,800 from $1,455 million, or by $345 million, during 2002. Furthermore, most of this increase went into working capital, which rose from $585 to $800 million, or by $215 million. This 37 percent increase in net operating working capital versus a sales increase of only 5 percent (from $2,850 to $3,000 million) should set off warning bells in your head: Why did MicroDrive tie up so much additional cash in working capital? Is the company gearing up for a big increase in sales, or are inventories not moving and receivables not being collected? We will address these questions in detail in the next chapter.

Net Operating Proﬁt after Taxes (NOPAT) If two companies have different amounts of debt, hence different amounts of interest charges, they could have identical operating performances but different net incomes— the one with more debt would have a lower net income. Net income is certainly important, but it does not always reﬂect the true performance of a company's operations or the effectiveness of its operating managers. A better measurement for comparing managers’ performance is net operating proﬁt after taxes, or NOPAT, which is the amount of proﬁt a company would generate if it had no debt and held no ﬁnancial assets. NOPAT is deﬁned as follows:7 NOPAT EBIT(1 Tax rate).

(9-5)

Using data from the income statements of Table 9-2, MicroDrive’s 2002 NOPAT is found to be NOPAT $283.8(1 0.4) $283.8(0.6) $170.3 million. In 2002 MicroDrive generated an after-tax operating proﬁt of $170.3 million. This was actually a little better than the 2001 NOPAT of $263(0.6) $157.8 million. However, the income statements in Table 9-2 show that MicroDrive’s earnings per share declined from 2001 to 2002. This decrease in EPS was caused by an increase in interest expense, and not by a decrease in operating proﬁt. Moreover, the balance sheets in Table 9-1 show that debt increased from 2001 to 2002. But why did MicroDrive increase its debt? As we just saw, its investment in operating capital increased dramatically during 2002, and that increase was ﬁnanced primarily with debt.

Free Cash Flow Earlier in this chapter, we deﬁned net cash ﬂow as net income plus noncash adjustments, which typically means net income plus depreciation. Note, though, that cash ﬂows cannot be maintained over time unless depreciated ﬁxed assets are replaced, so management is not completely free to use its cash ﬂows however it chooses. Therefore, we now deﬁne another term, free cash ﬂow (FCF), which is the cash ﬂow For ﬁrms with a more complicated tax situation, it is better to deﬁne NOPAT as follows: NOPAT (Net income before preferred dividends) (Net interest expense)(1 Tax rate). Also, if ﬁrms are able to defer paying some of their taxes, perhaps by the use of accelerated depreciation, then NOPAT should be adjusted to reﬂect the taxes that the company actually paid on its operating income. The Copeland et al. and Stewart books listed in the references at the end of the chapter explain in detail these and other adjustments. 7

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actually available for distribution to investors after the company has made all the investments in ﬁxed assets and working capital necessary to sustain ongoing operations. When you studied income statements in accounting, the emphasis was probably on the ﬁrm’s net income, which is its accounting proﬁt. However, the value of a company’s operations is determined by the stream of cash ﬂows that the operations will generate now and in the future. To be more speciﬁc, the value of operations depends on all the future expected free cash ﬂows (FCF), deﬁned as after-tax operating proﬁt minus the amount of new investment in working capital and ﬁxed assets necessary to sustain the business. Thus, free cash ﬂow represents the cash that is actually available for distribution to investors. Therefore, the way for managers to make their companies more valuable is to increase their free cash ﬂow.

Calculating Free Cash Flow As shown earlier in the chapter, MicroDrive had $1,455 million of operating assets (and operating capital) at the end of 2001, but $1,800 million at the end of 2002. Therefore, during 2002, it made a net investment in operating assets of Net investment in operating assets $1,800 $1,455 $345 million. Net ﬁxed assets rose from $870 to $1,000 million, or by $130 million. However, MicroDrive reported $100 million of depreciation, so its gross investment in ﬁxed assets was $130 $100 $230 million for the year. With this background, we ﬁnd the gross investment in operating assets as follows: Gross investment Net investment Depreciation

(9-6)

$345 $100 $445 million. As shown earlier in the chapter, MicroDrive had a 2002 NOPAT of $170.3 million. MicroDrive’s free cash ﬂow in 2002 was FCF (NOPAT Depreciation) Gross investment in operating assets (9-7) ($170.3 $100) $445 $174.7 million. An algebraically equivalent equation is FCF NOPAT Net investment in operating assets

(9-7a)

$170.3 $345 $174.7 million. The two equations are equivalent because depreciation is added to both NOPAT and net investment in Equation 9-7a to arrive at Equation 9-7. We usually use Equation 9-7a, because it saves us this step.

The Uses of FCF Recall that free cash ﬂow (FCF) is the amount of cash that is available for distribution to all investors, including both shareholders and debtholders. There are ﬁve good uses for FCF: 1. Pay interest to debtholders, keeping in mind that the net cost to the company is the after-tax interest expense. 2. Repay debtholders, that is, pay off some of the debt. 3. Pay dividends to shareholders. 4. Repurchase stock from shareholders. 5. Buy marketable securities or other nonoperating assets.

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Recall that the company does not have to use FCF to acquire operating assets, since by deﬁnition FCF already takes into account the purchase of all operating assets needed to support growth. Unfortunately, there is evidence to suggest that some companies with high FCF tend to make unnecessary investments that don’t add value, such as paying too much to acquire some other company. Thus, high FCF can cause waste if managers fail to act in the best interest of shareholders. This is called an agency cost, since managers are hired as agents to act on behalf of stockholders. We discuss agency costs and ways to control them in Chapter 12, where we discuss value-based management and corporate governance, and in Chapter 13, where we discuss the choice of capital structure. In practice, most companies combine these ﬁve uses in such a way that the net total is equal to FCF. For example, a company might pay interest and dividends, issue new debt, and also sell some of its marketable securities. Some of these activities are cash outﬂows (for example, paying interest and dividends) and some are cash inﬂows (for example, issuing debt and selling marketable securities), but the net cash ﬂow from these ﬁve activities is equal to FCF.

FCF and Corporate Value FCF is the amount of cash available for distribution to investors, and, as a result, the value of a company depends on its expected future FCFs. Subsequent chapters will develop the tools needed to forecast FCFs, to evaluate their risk, and to calculate the value of a company given the size and risk of its expected cash ﬂows. Chapter 12 ties all this together with a model that is used to calculate the value of a company. Even though you do not yet have the tools to apply the model, it’s important that you understand this basic concept: FCF is the cash available for distribution to investors. Therefore, the value of a ﬁrm is primarily dependent on its expected future FCFs.

Evaluating FCF, NOPAT, and Operating Capital Even though MicroDrive had a positive NOPAT, its very high investment in operating assets resulted in a negative free cash ﬂow. Because free cash ﬂow is what is available for distribution to investors, not only was there nothing for investors, but investors actually had to provide additional money to keep the business going. Investors provided most of this new money as debt. Is a negative free cash ﬂow always bad? The answer is, “Not necessarily. It depends on why the free cash ﬂow was negative.” If FCF was negative because NOPAT was negative, that is a bad sign, because then the company is probably experiencing operating problems. However, many high-growth companies have positive NOPAT but negative free cash ﬂow because they are making large investments in operating assets to support growth. There is nothing wrong with proﬁtable growth, even if it causes negative cash ﬂows. One way to determine whether growth is proﬁtable is by examining the return on invested capital (ROIC), which is the ratio of NOPAT to total operating capital. If the ROIC exceeds the rate of return required by investors, then a negative free cash ﬂow caused by high growth is nothing to worry about. Chapter 12 discusses this in detail. To calculate the ROIC, we ﬁrst calculate NOPAT and operating capital. The return on invested capital (ROIC) is a performance measure that indicates how much NOPAT is generated by each dollar of operating capital: ROIC

NOPAT . Operating capital

(9-8)

If ROIC is greater than the rate of return investors require, which is the weighted average cost of capital (WACC), then the ﬁrm is adding value.

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As noted earlier, a negative current FCF is not necessarily bad, provided it is due to high growth. For example, Home Depot has negative FCF due to its rapid growth, but it also has a very high ROIC, and this high ROIC results in a high market value for the stock. MicroDrive had an ROIC in 2002 of 9.46 percent ($170.3/$1,800 0.0946). Is this enough to cover its cost of capital? We’ll answer that question in the next section. What is net operating working capital? Why does it exclude most short-term investments and also notes payable? What is total operating capital, or, equivalently, total operating assets? Why is it important for managers to calculate a company’s capital requirements? What is NOPAT? Why might it be a better performance measure than net income? What is free cash ﬂow? Why is free cash ﬂow the most important determinant of a ﬁrm’s value?

MVA and EVA Neither traditional accounting data nor the modiﬁed data discussed in the preceding section bring in stock prices, even though the primary goal of management is to maximize the ﬁrm’s stock price. Financial analysts have therefore developed two new performance measures, MVA, or Market Value Added, and EVA, or Economic Value Added. These concepts are discussed in this section.8

Market Value Added (MVA) The primary goal of most ﬁrms is to maximize shareholders’ wealth. This goal obviously beneﬁts shareholders, but it also helps to ensure that scarce resources are allocated efﬁciently, which beneﬁts the economy. Shareholder wealth is maximized by maximizing the difference between the market value of the ﬁrm’s stock and the amount of equity capital that was supplied by shareholders. This difference is called the Market Value Added (MVA): MVA Market value of stock Equity capital supplied by shareholders (Shares outstanding)(Stock price) Total common equity. (9-9) To illustrate, consider Coca-Cola. In late 2001, its total market equity value was $123.5 billion, while its balance sheet showed that stockholders had put up only $10.4 billion. Thus, Coca-Cola’s MVA was $123.5 $10.4 $113.1 billion. This $113.1 For an updated estimate of billion represents the difference between the money that Coca-Cola’s stockholders Coca-Cola’s MVA, go to have invested in the corporation since its founding—including retained earnings— http://ﬁnance.yahoo.com, versus the cash they could get if they sold the business. The higher its MVA, the betenter KO, pick Detailed for ter the job management is doing for the ﬁrm’s shareholders. the quote, and click Get. Sometimes MVA is deﬁned as the total market value of the company minus the toThis shows the market value of equity, called Mkt Cap. To tal amount of investor-supplied capital: get the book value of equity, select Research, then Financials, and then Balance Sheet.

MVA Total market value Total capital (Market value of stock Market value of debt) Total Capital. (9-9a)

8

The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-founders of the consulting ﬁrm Stern Stewart & Company. Stern Stewart copyrighted the terms “EVA” and “MVA,” so other consulting ﬁrms have given other names to these values. Still, EVA and MVA are the terms most commonly used in practice.

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For most companies, the total amount of investor-supplied capital is the sum of equity, debt, and preferred stock. We can calculate the total amount of investor-supplied capital directly from their reported values in the ﬁnancial statements. The total market value of a company is the sum of the market values of common equity, debt, and preferred stock. It is easy to ﬁnd the market value of equity, since stock prices are readily available, but it is not always easy to ﬁnd the market value of debt. Hence, many analysts use the value of debt that is reported in the ﬁnancial statements, or the debt’s book value, as an estimate of its market value. For Coca-Cola, the total amount of reported debt was $6.9 billion, and Coca-Cola had no preferred stock. Using this as an estimate of the market value of debt, Coke’s total market value was $123.5 $6.9 $130.4 billion. The total amount of investorsupplied funds was $10.4 $6.9 $17.3 billion. Using these total values, the MVA was $130.4 $17.3 $113.1 billion. Note that this is the same answer that we got using the previous deﬁnition of MVA. Both methods will give the same results if the market value of debt is approximately equal to its book value.

Economic Value Added (EVA) If you want to read more about EVA and MVA, surf over to http://www. sternstewart.com and learn about it from the people who invented it, Stern Stewart & Co.

Whereas MVA measures the effects of managerial actions since the very inception of a company, Economic Value Added (EVA) focuses on managerial effectiveness in a given year. The EVA basic formula is as follows: EVA Net operating proﬁt after taxes (NOPAT) After-tax dollar cost of capital used to support operations

(9-10)

EBIT(1 Corporate tax rate) (Operating capital)(WACC). Operating capital is the sum of the interest-bearing debt, preferred stock, and common equity used to acquire the company’s net operating assets, that is, its net operating working capital plus net plant and equipment. Operating assets by deﬁnition equals the capital used to buy operating assets. We can also calculate EVA in terms of ROIC: EVA (Operating capital)(ROIC WACC).

(9-10a)

As this equation shows, a ﬁrm adds value—that is, has a positive EVA—if its ROIC is greater than its WACC. If WACC exceeds ROIC, then new investments in operating capital will reduce the ﬁrm’s value. EVA is an estimate of a business’s true economic proﬁt for the year, and it differs sharply from accounting proﬁt.9 EVA represents the residual income that remains after the cost of all capital, including equity capital, has been deducted, whereas accounting proﬁt is determined without imposing a charge for equity capital. As we discussed in Chapter 6, equity capital has a cost, because funds provided by shareholders could have been invested elsewhere, where they would have earned a return. Shareholders give up the opportunity to invest elsewhere when they provide capital to the ﬁrm. The return they could earn elsewhere in investments of equal risk represents the cost of equity capital. This cost is an opportunity cost rather than an accounting cost, but it is quite real nevertheless. Note that when calculating EVA we do not add back depreciation. Although it is not a cash expense, depreciation is a cost, and it is therefore deducted when determining 9

The most important reason EVA differs from accounting proﬁt is that the cost of equity capital is deducted when EVA is calculated. Other factors that could lead to differences include adjustments that might be made to depreciation, to research and development costs, to inventory valuations, and so on. These other adjustments also can affect the calculation of investor supplied capital, which affects both EVA and MVA. See Stewart, The Quest for Value, listed in the Selected Additional References at the end of the chapter.

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both net income and EVA. Our calculation of EVA assumes that the true economic depreciation of the company’s ﬁxed assets exactly equals the depreciation used for accounting and tax purposes. If this were not the case, adjustments would have to be made to obtain a more accurate measure of EVA. EVA measures the extent to which the ﬁrm has added to shareholder value. Therefore, if managers focus on EVA, this will help to ensure that they operate in a manner that is consistent with maximizing shareholder wealth. Note too that EVA can be determined for divisions as well as for the company as a whole, so it provides a useful basis for determining managerial performance at all levels. Consequently, EVA is being used by an increasing number of ﬁrms as the primary basis for determining managerial compensation. Table 9-5 shows how MicroDrive’s MVA and EVA are calculated. The stock price was $23 per share at year-end 2002, down from $26 per share at the end of 2001. Its WACC, which is the percentage after-tax cost of capital, was 10.8 percent in 2001 and 11.0 percent in 2002, and its tax rate was 40 percent. Other data in Table 9-5 were given in the basic ﬁnancial statements provided earlier in the chapter. Note ﬁrst that the lower stock price and the higher book value of equity (due to retaining earnings during 2002) combined to reduce the MVA. The 2002 MVA is still positive, but $460 $254 $206 million of stockholders’ value was lost during 2002. EVA for 2001 was just barely positive, and in 2002 it was negative. Operating income (NOPAT) rose, but EVA still declined, primarily because the amount of capital rose more sharply than NOPAT—by about 26 percent versus 8 percent—and the cost of this increased capital pulled EVA down. Recall also that net income fell somewhat from 2001 to 2002, but not nearly so dramatically as the decline in EVA. Net income does not reﬂect the amount of equity TABLE 9-5

MVA and EVA for MicroDrive (Millions of Dollars) 2002

See Ch 09 Tool Kit.xls for details.

2001

MVA Calculation Price per share Number of shares (millions) Market value of equity Book value of equity MVA Market value Book value

$

23.0 50.0 $1,150.0 $ 896.0 $ 254.0

$

26.0 50.0 $1,300.0 $ 840.0 $ 460.0

$ 283.8 40% $ 170.3 $1,800.0 11.0% $ 198.0 ($27.7) 9.46% (1.54%) ($27.7)

$ 263.0 40% $ 157.8 $1,455.0 10.8% $ 157.1 $ 0.70 10.85% 0.05% $ 0.7

EVA Calculation EBIT Tax rate NOPAT EBIT(1 T) Total investor-supplied operating capitala After-tax cost of capital, WACC (%) Dollar cost of capital Capital (WACC) EVA NOPAT Capital cost ROIC NOPAT/Operating capital ROIC Cost of capital ROIC WACC EVA (Operating capital)(ROIC WACC)

a Investor-supplied operating capital equals the sum of notes payable, long-term debt, preferred stock, and common equity, less short-term investments. It could also be calculated as total liabilities and equity minus accounts payable, accruals, and short-term investments. It is also equal to net operating working capital plus operating longterm assets.

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capital employed, but EVA does. Because of this omission, net income is not as useful as EVA for setting corporate goals and measuring managerial performance. We will have more to say about both MVA and EVA later in the book, but we can close this section with two observations. First, there is a relationship between MVA and EVA, but it is not a direct one. If a company has a history of negative EVAs, then its MVA will probably be negative, and vice versa if it has a history of positive EVAs. However, the stock price, which is the key ingredient in the MVA calculation, depends more on expected future performance than on historical performance. Therefore, a company with a history of negative EVAs could have a positive MVA, provided investors expect a turnaround in the future. The second observation is that when EVAs or MVAs are used to evaluate managerial performance as part of an incentive compensation program, EVA is the measure that is typically used. The reasons are (1) EVA shows the value added during a given year, whereas MVA reﬂects performance over the company’s entire life, perhaps even including times before the current managers were born, and (2) EVA can be applied to individual divisions or other units of a large corporation, whereas MVA must be applied to the entire corporation. Deﬁne the terms “Market Value Added (MVA)” and “Economic Value Added (EVA).” How does EVA differ from accounting proﬁt?

The Federal Income Tax System The value of any ﬁnancial asset (including stocks, bonds, and mortgages), as well as most real assets such as plants or even entire ﬁrms, depends on the stream of cash ﬂows produced by the asset. Cash ﬂows from an asset consist of usable income plus depreciation, and usable income means income after taxes. Our tax laws can be changed by Congress, and in recent years changes have occurred frequently. Indeed, a major change has occurred, on average, every three to four years since 1913, when our federal income tax system began. Further, certain A web site explaining fedparts of our tax system are tied to the inﬂation rate, so changes occur automatically eral tax law is http://www. each year, depending on the rate of inﬂation during the previous year. Therefore, altaxsites.com. From this though this section will give you a good background on the basic nature of our tax syshome page one can visit tem, you should consult current rate schedules and other data published by the Interother sites that provide summaries of recent tax leg- nal Revenue Service (available in U.S. post ofﬁces and on the Web) before you ﬁle islation or current informayour personal or business tax returns. tion on corporate and indiCurrently (early 2002), federal income tax rates for individuals go up to 39.6 pervidual tax rates. The ofﬁcial cent, and, when Social Security, Medicare, and state and city income taxes are ingovernment site is http:// cluded, the marginal tax rate on an individual’s income can easily exceed 50 percent. www.irs.gov. Business income is also taxed heavily. The income from partnerships and proprietorships is reported by the individual owners as personal income and, consequently, is taxed at federal-plus-state rates going up to 50 percent or more. Corporate proﬁts are subject to federal income tax rates of up to 39 percent, plus state income taxes. Furthermore, corporations pay taxes and then distribute after-tax income to their stockholders as dividends, which are also taxed. So, corporate income is really subject to double taxation. Because of the magnitude of the tax bite, taxes play a critical role in many ﬁnancial decisions. As this text is being written, Congress and the administration are debating the merits of different changes in the tax laws. Even in the unlikely event that no explicit changes are made in the tax laws, changes will still occur because certain aspects of the tax calculation are tied to the inﬂation rate. Thus, by the time you read this chapter,

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tax rates and other factors will almost certainly be different from those we provide. Still, if you understand this section, you will understand the basics of our tax system, and you will know how to operate under the revised tax code. Taxes are so complicated that university law schools offer master’s degrees in taxation to lawyers, many of whom are also CPAs. In a ﬁeld complicated enough to warrant such detailed study, only the highlights can be covered in a book such as this. This is really enough, though, because business managers and investors should and do rely on tax specialists rather than trusting their own limited knowledge. Still, it is important to know the basic elements of the tax system as a starting point for discussions with tax experts.

Individual Income Taxes Individuals pay taxes on wages and salaries, on investment income (dividends, interest, and proﬁts from the sale of securities), and on the proﬁts of proprietorships and partnerships. Our tax rates are progressive—that is, the higher one’s income, the larger the percentage paid in taxes. Table 9-6 gives the tax rates for single individuals and married couples ﬁling joint returns under the rate schedules that were in effect for the 2001 tax year. 1. Taxable income is deﬁned as gross income less a set of exemptions and deductions that are spelled out in the instructions to the tax forms individuals must ﬁle. When ﬁling a tax return in 2002 for the tax year 2001, each taxpayer receives an exemption of $2,900 for each dependent, including the taxpayer, which reduces taxable income. However, this exemption is indexed to rise with inﬂation, and the exemption is phased out (taken away) for high-income taxpayers. Also, certain expenses including mortgage interest paid, state and local income taxes, and charitable contributions, can be deducted and thus be used to reduce taxable income, but again, high-income taxpayers lose most of these deductions. 2. The marginal tax rate is deﬁned as the tax rate on the last unit of income. Marginal rates begin at 15 percent and rise to 39.1 percent. Note, though, that when consideration is given to the phase-out of exemptions and deductions, to Social Security and Medicare taxes, and to state taxes, the marginal tax rate can exceed 50 percent. 3. One can calculate average tax rates from the data in Table 9-6. For example, if Jill Smith, a single individual, had taxable income of $35,000, her tax bill would be $4,057.50 ($35,000 $27,050)(0.275) $6,243.75. Her average tax rate would be $6,243.75/$35,000 17.8% versus a marginal rate of 27.5 percent. If Jill received a raise of $1,000, bringing her income to $36,000, she would have to pay $275 of it as taxes, so her after-tax raise would be $725. In addition, her Social Security and Medicare taxes would increase by $76.50, which would cut her net raise to $648.50. Taxes on Dividend and Interest Income Dividend and interest income received by individuals is added to their other income and thus is taxed at rates going up to about 50 percent.10 Because corporations pay dividends out of earnings that have already been taxed, there is double taxation of corporate income—income is ﬁrst taxed at the corporate rate, and when what is left is paid out as dividends, it is taxed again at the personal rate.

10

You do not pay Social Security and Medicare taxes on interest, dividends, and capital gains, only on earned income, but state taxes are generally imposed on dividends, interest, and capital gains.

355

Financial Statements, Cash Flow, and Taxes The Federal Income Tax System TABLE 9-6

Individual Tax Rates for the 2001 Tax Year

INDIVIDUAL TAX TABLE FOR THE

See Ch 09 Tool Kit.xls for details.

If an Individual’s Taxable Income Is Between: (1) (2)

$

0 27,050 65,550 136,750 297,350

$ 27,050 65,550 136,750 297,350 and up

2001 TAX YEAR He/She Pays This Amount on the Base of the Bracket (3)

$

0.00 4,057.50 14,645.00 36,361.00 93,374.00

MARRIED (JOINT RETURN) TAX TABLE FOR THE

If a Couple’s Taxable Income Is Between: (1)

$

0 45,200 109,250 166,500 297,350

(2)

$ 45,200 109,250 166,500 297,350 and up

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Average Tax Rate at Top of Bracket (5)

15.0% 27.5 30.5 35.5 39.1

15.0% 22.3 26.6 31.4 39.1

2001 TAX YEAR

It Pays This Amount on the Base of the Bracket (3)

$

Plus This Percentage on the Excess Over the Base (4)

0.00 6,780.00 24,393.75 41,855.00 88,306.75

Plus This Percentage on the Excess Over the Base (4)

Average Tax Rate at Top of Bracket (5)

15.0% 27.5 30.5 35.5 39.1

15.0% 22.3 25.1 29.7 39.1

Notes: a. These are the tax rates for the 2001 tax year. The income ranges at which each tax rate takes effect, as well as the ranges for the additional taxes discussed below, are indexed with inﬂation each year, so they will change from those shown in the table. b. The average tax rate approaches 39.1 percent as taxable income rises without limit. At $1 million of taxable income, the average tax rates for single individuals and married couples ﬁling joint returns are 36.8 percent and 36.3 percent, respectively, while at $10 million they are 38.9 and 38.8 percent, respectively. c. In 2001, a personal exemption of $2,900 per person or dependent could be deducted from gross income to determine taxable income. Thus, a husband and wife with two children would have a 2001 exemption of 4 $2,900 $11,600. The amount of the exemption is scheduled to increase with inﬂation. However, if gross income exceeds certain limits ($199,450 for joint returns and $132,950 for single individuals in 2001), the exemption is phased out, and this has the effect of raising the effective tax rate on incomes over the speciﬁed limit by about 0.5 percent per family member, or 2.0 percent for a family of four. In addition, taxpayers can claim itemized deductions for charitable contributions and certain other items, but these deductions are reduced if the gross income exceeds $132,950 (for both single individuals and joint returns), and this raises the effective tax rate for high-income taxpayers by another 1 percent or so. The combined effect of the loss of exemptions and the reduction of itemized deductions is about 3 percent, so the marginal federal tax rate for high-income individuals goes up to about 42.1 percent. In addition, there is the Social Security tax, which amounts to 6.2 percent (12.4 percent for a self-employed person) on up to $80,400 of earned income, plus a 1.45 percent Medicare payroll tax (2.9 percent for self-employed individuals) on all earned income. Finally, older high-income taxpayers who receive Social Security payments must pay taxes on 85 percent of their Social Security receipts, up from 50 percent in 1994. All of this pushes the effective tax rate up even further. d. The Tax Relief Act of 2001 made major changes in the Tax Code, including reducing tax rates and creating a new bracket (at $6,000 for individuals and $12,000 for married couples) with a 10 percent tax rate. Rather than include this bracket on the 2001 tax schedules, most taxpayers in 2001 received a rebate ($300 for individuals, $600 for couples) to reﬂect the beneﬁt of the new bracket. The new bracket will appear on tax schedules after 2001.

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It should be noted that under U.S. tax laws, interest on most state and local government bonds, called municipals or “munis,” is not subject to federal income taxes. Thus, investors get to keep all of the interest received from most municipal bonds but only a fraction of the interest received from bonds issued by corporations or by the U.S. government. This means that a lower-yielding muni can provide the same aftertax return as a higher-yielding corporate bond. For example, a taxpayer in the 39.1 percent marginal tax bracket who could buy a muni that yielded 5.5 percent would have to receive a before-tax yield of 9.03 percent on a corporate or U.S. Treasury bond to have the same after-tax income: Yield on muni Equivalent pre-tax yield on taxable bond 1 Marginal tax rate

5.5% 9.03% . 1 0.391

If we know the yield on the taxable bond, we can use the following equation to ﬁnd the equivalent yield on a muni: Pre-tax yield Equivalent yield on muni £ on taxable ≥(1 Marginal tax rate) bond 9.03%(1 0.391) 5.5%. The exemption from federal taxes stems from the separation of federal and state powers, and its primary effect is to help state and local governments borrow at lower rates than they otherwise could. Munis always yield less than corporate bonds with similar risk, maturity, and liquidity. Because of this, it would make no sense for someone in a zero or very low tax bracket to buy munis. Therefore, most munis are owned by high-bracket investors. Capital Gains versus Ordinary Income Assets such as stocks, bonds, and real estate are deﬁned as capital assets. If you buy a capital asset and later sell it for more than your purchase price, the proﬁt is called a capital gain; if you suffer a loss, it is called a capital loss. An asset sold within one year of the time it was purchased produces a short-term gain or loss and one held for more than a year produces a long-term gain or loss. Thus, if you buy 100 shares of Disney stock for $42 per share and sell it for $52 per share, you make a capital gain of 100 $10, or $1,000. However, if you sell the stock for $32 per share, you will have a $1,000 capital loss. Depending on how long you held the stock, you will have a short-term or long-term gain or loss.11 If you sell the stock for exactly $42 per share, you make neither a gain nor a loss; you simply get your $4,200 back, and no tax is due. Short-term capital gains are added to such ordinary income as wages, dividends, and interest and are then taxed at the same rate as ordinary income. However, longterm capital gains are taxed differently. The top rate on long-term gains for most situations is 20 percent. Thus, if in 2001 you were in the 39.1 percent tax bracket, we congratulate you. Any short-term gains you earned would be taxed just like ordinary income, but your long-term gains would be taxed at 20 percent. Thus, capital gains on

11

If you have a net capital loss (capital losses exceed capital gains) for the year, you can currently deduct only up to $3,000 of this loss against your other income (for example, salary, interest, and dividends). This $3,000 loss limitation is not applicable to losses on the sale of business assets, which by deﬁnition are not capital assets.

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Financial Statements, Cash Flow, and Taxes The Federal Income Tax System

361

assets held for more than 12 months are better than ordinary income for many people because the tax bite is smaller.12 Capital gains tax rates have varied over time, but they have generally been lower than rates on ordinary income. The reason is simple—Congress wants the economy to grow, for growth we need investment in productive assets, and low capital gains tax rates encourage investment. To see why, suppose you owned a company that earned $1 million after corporate taxes. Because it is your company, you could have it pay out the entire $1 million proﬁt as dividends, or you could have it retain and reinvest all or part of the income to expand the business. If it paid dividends, they would be taxable to you at a rate of 39.1 percent. However, if the company reinvests its income, that reinvestment should cause the company’s earnings and stock price to increase. Then, if you wait for one year and one day and then sell some of your stock at a now-higher price, you will have earned a capital gain, but it will be taxed at only 20 percent. Further, you can postpone the capital gains tax indeﬁnitely by simply not selling the stock. It should be clear that the lower tax rate on capital gains encourages investment. The owners of small businesses will want to reinvest income to get capital gains, as will stockholders in large corporations. Individuals with money to invest will understand the tax advantages associated with investing in newly formed companies versus buying bonds, so new ventures will have an easier time attracting equity capital. All in all, lower capital gains tax rates stimulate capital formation and investment.13

Corporate Income Taxes The corporate tax structure, shown in Table 9-7, is relatively simple. To illustrate, if a ﬁrm had $65,000 of taxable income, its tax bill would be Taxes $7,500 0.25($15,000) $7,500 $3,750 $11,250, and its average tax rate would be $11,250/$65,000 17.3%. Note that corporate income above $18,333,333 has an average and marginal tax rate of 35 percent.14 12

For assets acquired after December 31, 2000, and held for more than ﬁve years, the capital gains rate is 18 percent. This rate is only 8 percent if you are in the 15 percent bracket. The Tax Code governing capital gains is very complex, and we have illustrated only the most common provision. 13

Fifty percent of any capital gains on the newly issued stock of certain small companies is excluded from taxation, provided the small-company stock is held for ﬁve years or longer. The remaining 50 percent of the gain is taxed at a rate of 20 percent for most taxpayers. Thus, if one bought newly issued stock from a qualifying small company and held it for at least ﬁve years, any capital gains would be taxed at a maximum rate of 10 percent for most taxpayers. This provision was designed to help small businesses attract equity capital. 14 Prior to 1987, many large, proﬁtable corporations such as General Electric and Boeing paid no income taxes. The reasons for this were as follows: (1) expenses, especially depreciation, were deﬁned differently for calculating taxable income than for reporting earnings to stockholders, so some companies reported positive proﬁts to stockholders but losses—hence no taxes—to the Internal Revenue Service; and (2) some companies that did have tax liabilities used various tax credits to offset taxes that would otherwise have been payable. This situation was effectively eliminated in 1987. The principal method used to eliminate this situation is the Alternative Minimum Tax (AMT). Under the AMT, both corporate and individual taxpayers must ﬁgure their taxes in two ways, the “regular” way and the AMT way, and then pay the higher of the two. The AMT is calculated as follows: (1) Figure your regular taxes. (2) Take your taxable income under the regular method and then add back certain items, especially income on certain municipal bonds, depreciation in excess of straight line depreciation, certain research and drilling costs, itemized or standard deductions (for individuals), and a number of other items. (3) The income determined in (2) is deﬁned as AMT income, and it must then be multiplied by the AMT tax rate to determine the tax due under the AMT system. An individual or corporation must then pay the higher of the regular tax or the AMT tax. In 2001, there were two AMT tax rates for individuals (26 percent and 28 percent, depending on the level of AMT income and ﬁling status). Most corporations have an AMT of 20 percent. However, there is no AMT for very small companies, deﬁned as those that have had average sales of less than $7.5 million for the last three years.

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TABLE 9-7

Corporate Tax Rates as of January 2001 It Pays This Amount on the Base of the Bracket

If a Corporation’s Taxable Income Is

Up to $50,000 $50,000–$75,000 $75,000–$100,000 $100,000–$335,000 $335,000–$10,000,000 $10,000,000–$15,000,000 $15,000,000–$18,333,333 Over $18,333,333

See Ch 09 Tool Kit.xls for details.

$

0 7,500 13,750 22,250 113,900 3,400,000 5,150,000 6,416,667

Plus This Percentage on the Excess over the Base

Average Tax Rate at Top of Bracket

15% 25 34 39 34 35 38 35

15.0% 18.3 22.3 34.0 34.0 34.3 35.0 35.0

Interest and Dividend Income Received by a Corporation Interest income received by a corporation is taxed as ordinary income at regular corporate tax rates. However, 70 percent of the dividends received by one corporation from another is excluded from taxable income, while the remaining 30 percent is taxed at the ordinary tax rate.15 Thus, a corporation earning more than $18,333,333 and paying a 35 percent marginal tax rate would pay only (0.30)(0.35) 0.105 10.5% of its dividend income as taxes, so its effective tax rate on dividends received would be 10.5 percent. If this ﬁrm had $10,000 in pre-tax dividend income, its after-tax dividend income would be $8,950: After-tax Before-tax income Taxes income Before-tax income (Before-tax income)(Effective tax rate) Before-tax income(1 Effective tax rate) $10,000[1 (0.30)(0.35)] $10,000(1 0.105) $10,000(0.895) $8,950. If the corporation pays its own after-tax income out to its stockholders as dividends, the income is ultimately subjected to triple taxation: (1) the original corporation is ﬁrst taxed, (2) the second corporation is then taxed on the dividends it received, and (3) the individuals who receive the ﬁnal dividends are taxed again. This is the reason for the 70 percent exclusion on intercorporate dividends. If a corporation has surplus funds that can be invested in marketable securities, the tax factor favors investment in stocks, which pay dividends, rather than in bonds, which pay interest. For example, suppose GE had $100,000 to invest, and it could buy either bonds that paid interest of $8,000 per year or preferred stock that paid dividends of $7,000. GE is in the 35 percent tax bracket; therefore, its tax on the interest, if it bought bonds, would be 0.35($8,000) $2,800, and its after-tax income would be $5,200. If it bought preferred (or common) stock, its tax would be 0.35[(0.30)($7,000)] $735, and

15

The size of the dividend exclusion actually depends on the degree of ownership. Corporations that own less than 20 percent of the stock of the dividend-paying company can exclude 70 percent of the dividends received; ﬁrms that own more than 20 percent but less than 80 percent can exclude 80 percent of the dividends; and ﬁrms that own more than 80 percent can exclude the entire dividend payment. We will, in general, assume a 70 percent dividend exclusion.

359

Financial Statements, Cash Flow, and Taxes The Federal Income Tax System TABLE 9-8

See Ch 09 Tool Kit.xls for details.

363

Returns to Investors under Bond and Stock Financing

Sales Operating costs Earnings before interest and taxes (EBIT) Interest Taxable income Federal-plus-state taxes (40%) After-tax income Income to investors Rate of return on $10 million of assets

Use Bonds (1)

Use Stock (2)

$ 5,000,000 3,500,000 $1,500,000 1,500,000 $ 0 0 $ 0 $1,500,000 15.0%

$ 5,000,000 3,500,000 $1,500,000 0 $1,500,000 600,000 $ 900,000 $ 900,000 9.0%

its after-tax income would be $6,265. Other factors might lead GE to invest in bonds, but the tax factor certainly favors stock investments when the investor is a corporation.16 Interest and Dividends Paid by a Corporation A ﬁrm’s operations can be ﬁnanced with either debt or equity capital. If it uses debt, it must pay interest on this debt, whereas if it uses equity, it is expected to pay dividends to the equity investors (stockholders). The interest paid by a corporation is deducted from its operating income to obtain its taxable income, but dividends paid are not deductible. Therefore, a ﬁrm needs $1 of pre-tax income to pay $1 of interest, but if it is in the 40 percent federal-plus-state tax bracket, it must earn $1.67 of pre-tax income to pay $1 of dividends: $1 $1 Pre-tax income needed $1.67. to pay $1 of dividends 1 Tax rate 0.60 Working backward, if a company has $1.67 in pre-tax income, it must pay $0.67 in taxes [(0.4)($1.67) $0.67]. This leaves it with after-tax income of $1.00. Table 9-8 shows the situation for a ﬁrm with $10 million of assets, sales of $5 million, and $1.5 million of earnings before interest and taxes (EBIT). As shown in Column 1, if the ﬁrm were ﬁnanced entirely by bonds, and if it made interest payments of $1.5 million, its taxable income would be zero, taxes would be zero, and its investors would receive the entire $1.5 million. (The term investors includes both stockholders and bondholders.) However, as shown in Column 2, if the ﬁrm had no debt and was therefore ﬁnanced only by stock, all of the $1.5 million of EBIT would be taxable income to the corporation, the tax would be $1,500,000(0.40) $600,000, and investors would receive only $0.9 million versus $1.5 million under debt ﬁnancing. The rate of return to investors on their $10 million investment is therefore much higher if debt is used.

16

This illustration demonstrates why corporations favor investing in lower-yielding preferred stocks over higher-yielding bonds. When tax consequences are considered, the yield on the preferred stock, [1 0.35(0.30)](7.0%) 6.265%, is higher than the yield on the bond, (1 0.35)(8.0%) 5.200%. Also, note that corporations are restricted in their use of borrowed funds to purchase other ﬁrms’ preferred or common stocks. Without such restrictions, ﬁrms could engage in tax arbitrage, whereby the interest on borrowed funds reduces taxable income on a dollar-for-dollar basis, but taxable income is increased by only $0.30 per dollar of dividend income. Thus, current tax laws reduce the 70 percent dividend exclusion in proportion to the amount of borrowed funds used to purchase the stock.

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Of course, it is generally not possible to ﬁnance exclusively with debt capital, and the risk of doing so would offset the beneﬁts of the higher expected income. Still, the fact that interest is a deductible expense has a profound effect on the way businesses are ﬁnanced—our corporate tax system favors debt ﬁnancing over equity ﬁnancing. This point is discussed in more detail in Chapters 6 and 13. Corporate Capital Gains Before 1987, corporate long-term capital gains were taxed at lower rates than corporate ordinary income, so the situation was similar for corporations and individuals. Under current law, however, corporations’ capital gains are taxed at the same rates as their operating income. Corporate Loss Carry-Back and Carry-Forward Ordinary corporate operating losses can be carried back (carry-back) to each of the preceding 2 years and forward (carry-forward) for the next 20 years and used to offset taxable income in those years. For example, an operating loss in 2003 could be carried back and used to reduce taxable income in 2001 and 2002, and forward, if necessary, and used in 2004, 2005, and so on, to the year 2023. The loss is typically applied ﬁrst to the earliest year, then to the next earliest year, and so on, until losses have been used up or the 20-year carryforward limit has been reached. To illustrate, suppose Apex Corporation had $2 million of pre-tax proﬁts (taxable income) in 2001 and 2002, and then, in 2003, Apex lost $12 million. Also, assume that Apex’s federal-plus-state tax rate is 40 percent. As shown in Table 9-9, the company would use the carry-back feature to recompute its taxes for 2001, using $2 million of the 2003 operating losses to reduce the 2001 pre-tax proﬁt to zero. This would permit it to recover the taxes paid in 2001. Therefore, in 2003 Apex would receive a refund of its 2001 taxes because of the loss experienced in 2003. Because $10 million of the unrecovered losses would still be available, Apex would repeat this procedure for 2002. Thus, in 2003 the company would pay zero taxes for 2003 and also would receive a refund for taxes paid in 2001 and 2002. Apex would still have $8 million of unrecovered losses to carry forward, subject to the 20-year limit. This $8 million could be used to offset taxable income. The purpose of this loss treatment is to avoid penalizing corporations whose incomes ﬂuctuate substantially from year to year. Improper Accumulation to Avoid Payment of Dividends Corporations could refrain from paying dividends and thus permit their stockholders to avoid personal income taxes on dividends. To prevent this, the Tax Code contains an improper TABLE 9-9

Apex Corporation: Calculation of Loss Carry-Back and CarryForward for 2001–2002 Using a $12 Million 2003 Loss 2001

See Ch 09 Tool Kit.xls for details.

Original taxable income $2,000,000 Carry-back credit 2,000,000 Adjusted proﬁt $ 0 Taxes previously paid (40%) 800,000 Difference Tax refund $ 800,000 Total refund check received in 2003: $800,000 $800,000 $1,600,000 Amount of loss carry-forward available for use in 2004–2023: 2003 loss Carry-back losses used Carry-forward losses still available

2002

$ 2,000,000 2,000,000 $ 0 800,000 $ 800,000

$12,000,000 4,000,000 $ 8,000,000

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365

Tax Havens

Many multinational corporations have found an interesting but controversial way to reduce their tax burdens: By shifting some of their operations to countries with low or nonexistent taxes, they can signiﬁcantly reduce their total tax bills. Over the years, several countries have passed tax laws that make the countries tax havens designed to attract foreign investment. Notable examples include the Bahamas, Grand Cayman, and the Netherlands Antilles. Rupert Murdoch, chairman of global media giant News Corporation, has in some years paid virtually no taxes on his U.S. businesses, despite the fact that these businesses represent roughly 70 percent of his total operating proﬁt. How has Murdoch been able to reduce his tax burden? By shifting proﬁts to a News Corp. subsidiary that is incorporated in the Netherlands Antilles. As Murdoch puts it, “Moving assets around like that is one of the advantages of being global.”

To learn more about tax havens, check out http://www.escapeartist. com for an in-depth analysis into tax havens, including country proﬁles and indexes of offshore banks and foreign markets.

While activities such as Murdoch’s are legal, some have questioned their ethics. Clearly, shareholders want corporations to take legal steps to reduce taxes. Indeed, many argue that managers have a ﬁduciary responsibility to take such actions whenever they are cost effective. Moreover, citizens of the various tax havens beneﬁt from foreign investment. Who loses? Obviously, the United States loses tax revenue whenever a domestic corporation establishes a subsidiary in a tax haven. Ultimately, this loss of tax revenue either reduces services or raises the tax burden on other corporations and individuals. Nevertheless, even the U.S. government is itself somewhat ambivalent about the establishment of off-shore subsidiaries—it does not like to lose tax revenues, but it does like to encourage foreign investment.

accumulation provision that states that earnings accumulated by a corporation are subject to penalty rates if the purpose of the accumulation is to enable stockholders to avoid personal income taxes. A cumulative total of $250,000 (the balance sheet item “retained earnings”) is by law exempted from the improper accumulation tax for most corporations. This is a beneﬁt primarily to small corporations. The improper accumulation penalty applies only if the retained earnings in excess of $250,000 are shown by the IRS to be unnecessary to meet the reasonable needs of the business. A great many companies do indeed have legitimate reasons for retaining more than $250,000 of earnings. For example, earnings may be retained and used to pay off debt, to ﬁnance growth, or to provide the corporation with a cushion against possible cash drains caused by losses. How much a ﬁrm should be allowed to accumulate for uncertain contingencies is a matter of judgment. We shall consider this matter again in Chapter 14, which deals with corporate dividend policy. Consolidated Corporate Tax Returns If a corporation owns 80 percent or more of another corporation’s stock, it can aggregate income and ﬁle one consolidated tax return; thus, the losses of one company can be used to offset the proﬁts of another. (Similarly, one division’s losses can be used to offset another division’s proﬁts.) No business ever wants to incur losses (you can go broke losing $1 to save 35¢ in taxes), but tax offsets do help make it more feasible for large, multidivisional corporations to undertake risky new ventures or ventures that will suffer losses during a developmental period.

Taxation of Small Businesses: S Corporations The Tax Code provides that small businesses that meet certain restrictions as spelled out in the code may be set up as corporations and thus receive the beneﬁts of the corporate form of organization—especially limited liability—yet still be taxed as proprietorships or partnerships rather than as corporations. These corporations are called

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S corporations. (“Regular” corporations are called C corporations.) If a corporation elects S corporation status for tax purposes, all of the business’s income is reported as personal income by its stockholders, on a pro rata basis, and thus is taxed at the rates that apply to individuals. This is an important beneﬁt to the owners of small corporations in which all or most of the income earned each year will be distributed as dividends, because then the income is taxed only once, at the individual level. Explain what is meant by this statement: “Our tax rates are progressive.” Are tax rates progressive for all income ranges? Explain the difference between marginal tax rates and average tax rates. What is a “municipal bond,” and how are these bonds taxed? What are capital gains and losses, and how are they taxed relative to ordinary income? How does the federal income tax system treat dividends received by a corporation versus those received by an individual? Why is this distinction made? What is the difference in the tax treatment of interest and dividends paid by a corporation? Does this factor favor debt or equity ﬁnancing? Brieﬂy explain how tax loss carry-back and carry-forward procedures work.

Summary The primary purposes of this chapter were (1) to describe the basic ﬁnancial statements, (2) to present some background information on cash ﬂows, and (3) to provide an overview of the federal income tax system. The key concepts covered are listed below. 䊉

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The four basic statements contained in the annual report are the balance sheet, the income statement, the statement of retained earnings, and the statement of cash ﬂows. Investors use the information provided in these statements to form expectations about the future levels of earnings and dividends, and about the ﬁrm’s riskiness. The balance sheet shows assets on the left-hand side and liabilities and equity, or claims against assets, on the right-hand side. (Sometimes assets are shown at the top and claims at the bottom of the balance sheet.) The balance sheet may be thought of as a snapshot of the ﬁrm’s ﬁnancial position at a particular point in time. The income statement reports the results of operations over a period of time, and it shows earnings per share as its “bottom line.” The statement of retained earnings shows the change in retained earnings between balance sheet dates. Retained earnings represent a claim against assets, not assets per se. The statement of cash ﬂows reports the effect of operating, investing, and ﬁnancing activities on cash ﬂows over an accounting period. Net cash ﬂow differs from accounting proﬁt because some of the revenues and expenses reﬂected in accounting proﬁts may not have been received or paid out in cash during the year. Depreciation is typically the largest noncash item, so net cash ﬂow is often expressed as net income plus depreciation. Investors are at least as interested in a ﬁrm’s projected net cash ﬂow as in reported earnings because it is cash, not paper proﬁt, that is paid out as dividends and plowed back into the business to produce growth. Operating current assets are the current assets that are used to support operations, such as cash, inventory, and accounts receivable. They do not include shortterm investments.

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367

Operating current liabilities are the current liabilities that occur as a natural consequence of operations, such as accounts payable and accruals. They do not include notes payable or any other short-term debts that charge interest. Net operating working capital is the difference between operating current assets and operating current liabilities. Thus, it is the working capital acquired with investor-supplied funds. Operating long-term assets are the long-term assets used to support operations, such as net plant and equipment. They do not include any long-term investments that pay interest or dividends. Total operating assets (or capital), or just operating assets (or capital), is the sum of net operating working capital and operating long-term assets. It is the total amount of capital needed to run the business. NOPAT is net operating proﬁt after taxes. It is the after-tax proﬁt a company would have if it had no debt and no investments in nonoperating assets. Because it excludes the effects of ﬁnancial decisions, it is a better measure of operating performance than is net income. Free cash ﬂow (FCF) is the amount of cash ﬂow remaining after a company makes the asset investments necessary to support operations. In other words, FCF is the amount of cash ﬂow available for distribution to investors, so the value of a company is directly related to its ability to generate free cash ﬂow. It is deﬁned as NOPAT minus the net investment in operating capital. Market Value Added (MVA) represents the difference between the total market value of a ﬁrm and the total amount of investor-supplied capital. If the market values of debt and preferred stock equal their values as reported on the ﬁnancial statements, then MVA is the difference between the market value of a ﬁrm’s stock and the amount of equity its shareholders have supplied. Economic Value Added (EVA) is the difference between after-tax operating proﬁt and the total dollar cost of capital, including the cost of equity capital. EVA is an estimate of the value created by management during the year, and it differs substantially from accounting proﬁt because no charge for the use of equity capital is reﬂected in accounting proﬁt. The value of any asset depends on the stream of after-tax cash ﬂows it produces. Tax rates and other aspects of our tax system are changed by Congress every year or so. In the United States, tax rates are progressive—the higher one’s income, the larger the percentage paid in taxes. Assets such as stocks, bonds, and real estate are deﬁned as capital assets. If a capital asset is sold for more than its cost, the proﬁt is called a capital gain. If the asset is sold for a loss, it is called a capital loss. Assets held for more than a year provide long-term gains or losses. Operating income paid out as dividends is subject to double taxation: the income is ﬁrst taxed at the corporate level, and then shareholders must pay personal taxes on their dividends. Interest income received by a corporation is taxed as ordinary income; however, 70 percent of the dividends received by one corporation from another are excluded from taxable income. The reason for this exclusion is that corporate dividend income is ultimately subjected to triple taxation. Because interest paid by a corporation is a deductible expense while dividends are not, our tax system favors debt over equity ﬁnancing. Ordinary corporate operating losses can be carried back to each of the preceding 2 years and forward for the next 20 years and used to offset taxable income in those years.

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CHAPTER 9

Financial Statements, Cash Flow, and Taxes 䊉

S corporations are small businesses that have the limited-liability beneﬁts of the corporate form of organization yet are taxed as a partnership or a proprietorship.

Questions 9–1

Deﬁne each of the following terms: a. Annual report; balance sheet; income statement b. Common stockholders’ equity, or net worth; retained earnings c. Statement of retained earnings; statement of cash ﬂows d. Depreciation; amortization; EBITDA e. Operating current assets; operating current liabilities; net operating working capital; operating capital f. Accounting proﬁt; net cash ﬂow; NOPAT; free cash ﬂow g. Market Value Added; Economic Value Added h. Progressive tax; taxable income; marginal and average tax rates i. Capital gain or loss; tax loss carry-back and carry-forward; j. Improper accumulation; S corporation

9–2

What four statements are contained in most annual reports?

9–3

If a “typical” ﬁrm reports $20 million of retained earnings on its balance sheet, could its directors declare a $20 million cash dividend without any qualms whatsoever?

9–4

Explain the following statement: “While the balance sheet can be thought of as a snapshot of the ﬁrm’s ﬁnancial position at a point in time, the income statement reports on operations over a period of time.”

9–5

What is operating capital, and why is it important?

9–6

Explain the difference between NOPAT and net income. Which is a better measure of the performance of a company’s operations?

9–7

What is free cash ﬂow? Why is it the most important measure of cash ﬂow?

9–8

What does double taxation of corporate income mean?

9–9

If you were starting a business, what tax considerations might cause you to prefer to set it up as a proprietorship or a partnership rather than as a corporation?

Self-Test Problems ST–1 NET INCOME, CASH FLOW, AND EVA

ST–2 EFFECT OF FORM OF ORGANIZATION ON TAXES

(Solutions Appear in Appendix A)

Last year Rattner Robotics had $5,000,000 in operating income (EBIT). The company had a net depreciation expense of $1,000,000 and an interest expense of $1,000,000; its corporate tax rate was 40 percent. The company has $14,000,000 in non-interest-earning current assets and $4,000,000 in non-interest-bearing current liabilities; it has $15,000,000 in net plant and equipment. It estimates that it has an after-tax cost of capital of 10 percent. Assume that Rattner’s only noncash item was depreciation. a. What was the company’s net income for the year? b. What was the company’s net cash ﬂow? c. What was the company’s net operating proﬁt after taxes (NOPAT)? d. If capital in the previous year was $24,000,000, what was the company’s free cash ﬂow (FCF) for the year? e. What was the company’s Economic Value Added (EVA)? Mary Henderson is planning to start a new business, MH Enterprises, and she must decide whether to incorporate or to do business as a sole proprietorship. Under either form, Henderson will initially own 100 percent of the ﬁrm, and tax considerations are important to her. She plans to ﬁnance the ﬁrm’s expected growth by drawing a salary just sufﬁcient for her family living expenses, which she estimates will be about $40,000, and by retaining all other income in

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the business. Assume that as a married woman with one child, she ﬁles a joint return. She has income tax exemptions of 3 $2,900 $8,700, and she estimates that her itemized deductions for each of the 3 years will be $9,400. She expects MH Enterprises to grow and to earn income of $52,700 in 2003, $90,000 in 2004, and $150,000 in 2005. Which form of business organization will allow Henderson to pay the lowest taxes (and retain the most income) during the period from 2003 to 2005? Assume that the tax rates given in the chapter are applicable for all future years. (Social Security taxes would also have to be paid, but ignore them.)

Problems Note: By the time this book is published, Congress might have changed rates and/or other provisions of current tax law—as noted in the chapter, such changes occur fairly often. Work all problems on the assumption that the information in the chapter is applicable. 9–1 PERSONAL AFTER-TAX YIELD

9–2 PERSONAL TAXES

9–3 PERSONAL AFTER-TAX YIELD

9–4 CORPORATE TAX LIABILITY

9–5 CORPORATE TAX LIABILITY

9–6 CORPORATE AFTER-TAX YIELD

9-7 CASH FLOW

9–8 INCOME AND CASH FLOW ANALYSIS

9-9 FREE CASH FLOW

An investor recently purchased a corporate bond which yields 9 percent. The investor is in the 36 percent tax bracket. What is the bond’s after-tax yield? Joe and Jane Keller are a married couple who ﬁle a joint income tax return. The couple’s taxable income was $97,000. Ignoring exemptions and deductions, how much federal taxes did they owe? Use the tax tables given in the chapter. Corporate bonds issued by Johnson Corporation currently yield 8 percent. Municipal bonds of equal risk currently yield 6 percent. At what tax rate would an investor be indifferent between these two bonds? The Talley Corporation had a taxable income of $365,000 from operations after all operating costs but before (1) interest charges of $50,000, (2) dividends received of $15,000, (3) dividends paid of $25,000, and (4) income taxes. What is the ﬁrm’s income tax liability and its after-tax income? What are the company’s marginal and average tax rates on taxable income? The Wendt Corporation had $10.5 million of taxable income from operations in 2001. a. What is the company’s federal income tax bill for the year? b. Assume the ﬁrm receives an additional $1 million of interest income from some bonds it owns. What is the tax on this interest income? c. Now assume that Wendt does not receive the interest income but does receive an additional $1 million as dividends on some stock it owns. What is the tax on this dividend income? The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing between AT&T bonds, which yield 7.5 percent, state of Florida muni bonds, which yield 5 percent, and AT&T preferred stock, with a dividend yield of 6 percent. Shrieves’ corporate tax rate is 35 percent, and 70 percent of the dividends received are tax exempt. Assuming that the investments are equally risky and that Shrieves chooses strictly on the basis of after-tax returns, which security should be selected? What is the after-tax rate of return on the highestyielding security? The Klaven Corporation has operating income (EBIT) of $750,000. The company’s depreciation expense is $200,000. Klaven is 100 percent equity ﬁnanced, and it faces a 40 percent tax rate. What is the company’s net income? What is its net cash ﬂow? The Menendez Corporation expects to have sales of $12 million in 2002. Costs other than depreciation are expected to be 75 percent of sales, and depreciation is expected to be $1.5 million. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. Menendez’s federal-plus-state tax rate is 40 percent. a. Set up an income statement. What is Menendez’s expected net cash ﬂow? b. Suppose Congress changed the tax laws so that Menendez’s depreciation expenses doubled. No changes in operations occurred. What would happen to reported proﬁt and to net cash ﬂow? c. Now suppose that Congress, instead of doubling Menendez’s depreciation, reduced it by 50 percent. How would proﬁt and net cash ﬂow be affected? d. If this were your company, would you prefer Congress to cause your depreciation expense to be doubled or halved? Why? You have just obtained ﬁnancial information for the past 2 years for Powell Panther Corporation. Answer the following questions.

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CHAPTER 9

Financial Statements, Cash Flow, and Taxes a. b. c. d. e.

What is the net operating proﬁt after taxes (NOPAT) for 2002? What are the amounts of net operating working capital for 2001 and 2002? What are the amounts of total operating capital for 2001 and 2002? What is the free cash ﬂow for 2002? How can you explain the large increase in dividends in 2002?

Powell Panther Corporation: Income Statements for Year Ending December 31 (Millions of Dollars)

Sales Operating costs excluding depreciation Depreciation Earnings before interest and taxes Less interest Earnings before taxes Taxes (40%) Net income available to common stockholders Common dividends

2002

2001

$1,200.0 1,020.0 30.0 $ 150.0 21.7 $ 128.3 51.3 $ 77.0 60.5

$1,000.0 850.0 25.0 $ 125.0 20.2 $ 104.8 41.9 $ 62.9 4.4

Powell Panther Corporation: Balance Sheets as of December 31 (Millions of Dollars) 2002

2001

$ 12.0 0.0 180.0 180.0 $372.0 300.0 $672.0

$ 10.0 0.0 150.0 200.0 $360.0 250.0 $610.0

$108.0 67.0 72.0 $247.0 150.0 $397.0 50.0 225.0 $275.0 $672.0

$ 90.0 51.5 60.0 $201.5 150.0 $351.5 50.0 208.5 $258.5 $610.0

Assets Cash and equivalents Short-term investments Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock (50 million shares) Retained earnings Common equity Total liabilities and equity

9-10 LOSS CARRY-BACK, CARRY-FORWARD

9-11 FORM OF ORGANIZATION

The Herrmann Company has made $150,000 before taxes during each of the last 15 years, and it expects to make $150,000 a year before taxes in the future. However, in 2002 the ﬁrm incurred a loss of $650,000. The ﬁrm will claim a tax credit at the time it ﬁles its 2002 income tax return, and it will receive a check from the U.S. Treasury. Show how it calculates this credit, and then indicate the ﬁrm’s tax liability for each of the next 5 years. Assume a 40 percent tax rate on all income to ease the calculations. Susan Visscher has operated her small restaurant as a sole proprietorship for several years, but projected changes in her business’s income have led her to consider incorporating. Visscher is

367

Financial Statements, Cash Flow, and Taxes Spreadsheet Problems

371

married and has two children. Her family’s only income, an annual salary of $52,000, is from operating the business. (The business actually earns more than $52,000, but Susan reinvests the additional earnings in the business.) She itemizes deductions, and she is able to deduct $8,200. She can claim four personal exemptions. (Assume the personal exemption remains at $2,900.) Of course, her actual taxable income, if she does not incorporate, would be higher by the amount of reinvested income. Visscher estimates that her business earnings before salary and taxes for the period 2003 to 2005 will be: Year

Earnings before Salary and Taxes

2003 2004 2005

$ 70,000 95,000 $110,000

a. What would her total taxes (corporate plus personal) be in each year under (1) A non-S corporate form of organization? (2003 tax $7,530.) (2) A proprietorship? (2003 tax $8,355.50.) b. Should Visscher incorporate? Discuss. 9-12 PERSONAL TAXES

Mary Jarvis, a single individual, has this situation for the year 2002: salary of $82,000; dividend income of $12,000; interest on Disney bonds of $5,000; interest on state of Florida municipal bonds of $10,000; proceeds of $22,000 from the sale of Disney stock purchased in 1985 at a cost of $9,000; and proceeds of $22,000 from the November 2002 sale of Disney stock purchased in October 2001 at a cost of $21,000. Jarvis gets one exemption ($2,900), and she has allowable itemized deductions of $7,100; these amounts will be deducted from her gross income to determine her taxable income. a. What is Jarvis’s federal tax liability? b. What are her marginal and average tax rates? c. If she had $5,000 to invest and was offered a choice of either state of Florida bonds with a yield of 6 percent or more Disney bonds with a yield of 8 percent, which should she choose, and why? d. At what marginal tax rate would Jarvis be indifferent in her choice between the Florida and Disney bonds?

Spreadsheet Problems 9-13 BUILD A MODEL: FINANCIAL STATEMENTS, EVA, AND MVA

Start with the partial model in the ﬁle Ch 09 P13 Build a Model.xls from the textbook’s web site. Cumberland Industries’ 2001 and 2002 balance sheets (in thousands of dollars) are shown below and in the partial model in the ﬁle:

Cash Short-term investments Accounts receivable Inventories Total current assets Net ﬁxed assets Total assets Accounts payable Accruals Notes payable Total current liabilities Long-term debt Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity

2002

2001

$ 91,450 $ 11,400 103,365 38,444 $244,659 67,165 $311,824 $ 30,761 30,477 16,717 $ 77,955 76,264 $154,219 100,000 57,605 $157,605 $311,824

$ 74,625 $ 15,100 85,527 34,982 $210,234 42,436 $252,670 $ 23,109 22,656 14,217 $ 59,982 63,914 $123,896 90,000 38,774 $128,774 $252,670

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CHAPTER 9

Financial Statements, Cash Flow, and Taxes a. The company’s sales for 2002 were $455,150,000, and EBITDA was 15 percent of sales. Furthermore, depreciation amounted to 11 percent of net ﬁxed assets, interest charges were $8,575,000, the state-plus-federal corporate tax rate was 40 percent, and Cumberland pays 40 percent of its net income out in dividends. Given this information, construct Cumberland’s 2002 income statement. (Hint: Start with the partial model in the ﬁle.) b. Next, construct the ﬁrm’s statement of retained earnings for the year ending December 31, 2002, and then its 2002 statement of cash ﬂows. c. Calculate net operating working capital, total operating capital, net operating proﬁt after taxes, and free cash ﬂow for 2002. d. Calculate the ﬁrm’s EVA and MVA for 2002. Assume that Cumberland had 10 million shares outstanding, that the year-end closing stock price was $17.25 per share, and its after-tax cost of capital was 12 percent.

See Ch 09 Show.ppt for a PowerPoint presentation of the Mini Case and Ch 09 Mini Case.xls for detailed calculations.

Donna Jamison, a 1998 graduate of the University of Tennessee with four years of banking experience, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of electronic calculators. The company doubled its plant capacity, opened new sales ofﬁces outside its home territory, and launched an expensive advertising campaign. Computron’s results were not satisfactory, to put it mildly. Its board of directors, which consisted of its president and vice-president plus its major stockholders (who were all local businesspeople), was most upset when directors learned how the expansion was going. Suppliers were being paid late and were unhappy, and the bank was complaining about the deteriorating situation and threatening to cut off credit. As a result, Al Watkins, Computron’s president, was informed that changes would have to be made, and quickly, or he would be ﬁred. Also, at the board’s insistence Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired banker who was Computron’s chairman and largest stockholder. Campo agreed to give up a few of his golﬁng days and to help nurse the company back to health, with Jamison’s help. Jamison began by gathering ﬁnancial statements and other data. BALANCE SHEETS

2001

2002

Assets Cash Short-term investments Accounts receivable Inventories Total current assets Gross ﬁxed assets Less: Accumulated depreciation Net ﬁxed assets Total assets

$

9,000 48,600 351,200 715,200 $1,124,000 491,000 146,200 $ 344,800 $1,468,800

$

7,282 20,000 632,160 1,287,360 $1,946,802 1,202,950 263,160 $ 939,790 $2,886,592

Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term debt Common stock (100,000 shares) Retained earnings Total equity Total liabilities and equity

2001

2002

$ 145,600 200,000 136,000 $ 481,600 323,432 460,000 203,768 $ 663,768 $1,468,800

$ 324,000 720,000 284,960 $1,328,960 1,000,000 460,000 97,632 $ 557,632 $2,886,592

369

Financial Statements, Cash Flow, and Taxes Mini Case

2001

2002

$3,432,000 2,864,000 340,000 18,900 $3,222,900 $ 209,100 62,500 $ 146,600 58,640 $ 87,960

$5,834,400 4,980,000 720,000 116,960 $5,816,960 $ 17,440 176,000 $ (158,560) (63,424) $ (95,136)

INCOME STATEMENTS

Sales Cost of goods sold Other expenses Depreciation Total operating costs EBIT Interest expense EBT Taxes (40%) Net income OTHER DATA:

2001

Stock price Shares outstanding EPS DPS Tax rate

8.50 100,000 $ 0.880 $ 0.220 40%

$

6.00 100,000 $ (0.951) $ 0.110 40%

2002

Balance of retained earnings, 12/31/2001 Add: Net income, 2002 Less: Dividends paid, 2002 Balance of retained earnings, 12/31/2002 STATEMENT OF CASH FLOWS,

2002

$

STATEMENT OF RETAINED EARNINGS,

373

$ 203,768 (95,136) (11,000) $ 97,632

2002

Operating Activities Net Income Adjustments: Noncash adjustments: Depreciation Changes in working capital: Change in accounts receivable Change in inventories Change in accounts payable Change in accruals Net cash provided by operating activities

($

95,136)

116,960 (280,960) (572,160) 178,400 148,960 ($ 503,936)

Long-Term Investing Activities Cash used to acquire ﬁxed assets

($ 711,950)

Financing Activities Change in short term investments Change in notes payable Change in long-term debt Change in common stock Payment of cash dividends Net cash provided by ﬁnancing activities

$

28,600 520,000 676,568 — (11,000) $1,214,168

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Financial Statements, Cash Flow, and Taxes 374

CHAPTER 9

Financial Statements, Cash Flow, and Taxes

Summary Net change in cash Cash at beginning of year Cash at end of year

($ $

1,718) 9,000 7,282

Assume that you are Jamison’s assistant, and you must help her answer the following questions for Campo. a. What effect did the expansion have on sales and net income? What effect did the expansion have on the asset side of the balance sheet? What effect did it have on liabilities and equity? b. What do you conclude from the statement of cash ﬂows? c. What is free cash ﬂow? Why is it important? What are the ﬁve uses of FCF? d. What are operating current assets? What are operating current liabilities? How much net operating working capital and total operating capital does Computron have? e. What are Computron’s net operating proﬁt after taxes (NOPAT) and free cash ﬂow (FCF)? f. Calculate Computron’s return on invested capital. Computron has a 10 percent cost of capital (WACC). Do you think Computron’s growth added value? g. Jamison also has asked you to estimate Computron’s EVA. She estimates that the after-tax cost of capital was 10 percent in both years. h. What happened to Computron’s market value added (MVA)? i. Assume that a corporation has $100,000 of taxable income from operations plus $5,000 of interest income and $10,000 of dividend income. What is the company’s tax liability? j. Working with Jamison has required you to put in a lot of overtime, so you have had very little time to spend on your private ﬁnances. It’s now April 1, and you have only two weeks left to ﬁle your income tax return. You have managed to get all the information together that you will need to complete your return. Computron paid you a salary of $45,000, and you received $3,000 in dividends from common stock that you own. You are single, so your personal exemption is $2,900, and your itemized deductions are $7,100. (1) On the basis of the information above and the individual tax rate schedule shown in this chapter, what is your tax liability? (2) What are your marginal and average tax rates? k. Assume that after paying your personal income tax as calculated in part j, you have $5,000 to invest. You have narrowed your investment choices down to California bonds with a yield of 7 percent or equally risky Exxon Mobil bonds with a yield of 10 percent. Which one should you choose and why? At what marginal tax rate would you be indifferent to the choice between California and Exxon Mobil bonds?

Selected Additional References The effects of alternative accounting policies on ﬁnancial statements are discussed in the investment textbooks referenced in Chapter 3 and also in the many excellent texts on ﬁnancial statement analysis. For example, see Fraser, Lyn M., and Aileen Ormiston, Understanding Financial Statements (Englewood Cliffs, NJ: Prentice-Hall, 2001). For an excellent treatment of the relationship between free cash ﬂows and the value of a company, see Copeland, Tom, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies (New York: John Wiley & Sons, Inc., 2001). Stewart, G. Bennett, The Quest for Value (New York: Harper Collins, 1991).

The following articles provide additional information on the effect of corporate taxes on business behavior: Angell, Robert J., and Tony Wingler, “A Note on Expensing versus Depreciating under the Accelerated Cost Recovery System,” Financial Management, Winter 1982, 34–35. McCarty, Daniel E., and William R. McDaniel, “A Note on Expensing versus Depreciating under the Accelerated Cost Recovery System: Comment,” Financial Management, Summer 1983, 37–39. For a good reference guide to tax issues, see Federal Tax Course (Englewood Cliffs, NJ: Prentice-Hall, published annually).

Analysis of Financial Statements

10 10

On May 19, 1999, Dell Computer Corp. announced that its ﬁrst quarter earnings were 42 percent higher than those reported one year earlier. This dramatic increase in earnings was roughly in line with Wall Street projections. Nevertheless, Dell’s stock fell nearly $4 a share immediately after the announcement. At ﬁrst glance, the market’s response appears puzzling. However, analysts zeroed in on the fact that Dell’s proﬁt margin in the ﬁrst quarter had fallen considerably. In recent months the computer business had become a lot more competitive, and this increased competition had pushed down computer prices. Dell’s earnings report indicated that lower prices for consumers had lowered margins for Dell’s shareholders. Still, Dell stockholders have done fantastically well over the past ten years. A $10,000 investment in Dell in early 1991 would be worth over $1 million today. So, while Dell’s increased earnings might suggest that the stock will continue to do well, the lower margins raised concerns that earnings growth in the years ahead might be lower than previously expected. Wall Street’s response to Dell’s announced earnings brings home several important points. First, investors and others outside the company use reported earnings and other ﬁnancial statement data to determine a company’s value. Second, analysts are primarily concerned about future performance—past performance is useful only to the extent that it provides information about the company’s future. Finally, analysts go beyond reported proﬁts—they dig into the ﬁnancial statements. So, while many people regard ﬁnancial statements as “just accounting,” they are really much more. As you will see in this chapter, the statements provide a wealth of information that is used by managers, investors, lenders, customers, suppliers, and regulators. An analysis of its statements can highlight a company’s strengths and shortcomings, and this information can be used by management to improve performance and by others to predict future results. Financial analysis can be used to predict how such strategic decisions as the sale of a division, a major marketing program, or expanding a plant are likely to affect future ﬁnancial performance.

375

371

372

Analysis of Financial Statements 376

CHAPTER 10

Analysis of Financial Statements

The primary goal of ﬁnancial managers is to maximize the stock price, not accounting measures such as net income or EPS. However, accounting data do inﬂuence stock prices, and to understand why a company is performing the way it is and to forecast where it is heading, one needs to evaluate the accounting statements. Chapter 9 described the primary ﬁnancial statements and showed how they change as a ﬁrm’s operations undergo change. Now, in Chapter 10, we show how ﬁnancial statements are used by managers to improve performance, by lenders to evaluate the likelihood of collecting on loans, and by stockholders to forecast earnings, dividends, free cash ﬂow, and stock prices. If management is to maximize a ﬁrm’s value, it must take advantage of the ﬁrm’s The textbook’s web site strengths and correct its weaknesses. Financial statement analysis involves (1) comparcontains an Excel ﬁle that will guide you through the ing the ﬁrm’s performance with that of other ﬁrms in the same industry and (2) evaluchapter’s calculations. The ating trends in the ﬁrm’s ﬁnancial position over time. These studies help managers ﬁle for this chapter is Ch 10 identify deﬁciencies and then take actions to improve performance. In this chapter, we Tool Kit.xls, and we encourage you to open the ﬁle and focus on how ﬁnancial managers (and investors) evaluate a ﬁrm’s current ﬁnancial pofollow along as you read the sition. Then, in the remaining chapters, we examine the types of actions managers can chapter. take to improve future performance and thus increase a ﬁrm’s stock price.

Ratio Analysis Financial statements report both on a ﬁrm’s position at a point in time and on its operations over some past period. However, the real value of ﬁnancial statements lies in the fact that they can be used to help predict future earnings, dividends, and free cash ﬂow. From an investor’s standpoint, predicting the future is what ﬁnancial statement analysis is all about, while from management’s standpoint, ﬁnancial statement analysis is useful both to help anticipate future conditions and, more important, as a starting point for planning actions that will improve the ﬁrm’s future performance. Financial ratios are designed to help evaluate ﬁnancial statements. For example, Firm A might have debt of $5,248,760 and interest charges of $419,900, while Firm B might have debt of $52,647,980 and interest charges of $3,948,600. Which company is stronger? The burden of these debts, and the companies’ ability to repay them, can best be evaluated by comparing (1) each ﬁrm’s debt to its assets and (2) the interest it must pay to the income it has available for payment of interest. Such comparisons are made by ratio analysis. We will calculate the Year 2002 ﬁnancial ratios for MicroDrive Inc., using data from the balance sheets and income statements given in Tables 9-1 and 9-2 back in Chapter 9. We will also evaluate the ratios in relation to the industry averages. Note that dollar amounts are in millions.

Liquidity Ratios A liquid asset is one that trades in an active market and hence can be quickly converted to cash at the going market price, and a ﬁrm’s “liquidity ratios” deal with this question: Will the ﬁrm be able to pay off its debts as they come due over the next year or so? As shown in Table 9-1 in Chapter 9, MicroDrive has current liabilities of $310 million that must be paid off within the coming year. Will it have trouble satisfying those obligations? A full liquidity analysis requires the use of cash budgets, but by relating the amount of cash and other current assets to current obligations, ratio analysis provides a quick, easy-to-use measure of liquidity. Two commonly used liquidity ratios are discussed in this section.

373

Analysis of Financial Statements Liquidity Ratios

377

Ability to Meet Short-Term Obligations: The Current Ratio The current ratio is calculated by dividing current assets by current liabilities: Current ratio ⫽

Current assets Current liabilities

$1,000 ⫽ 3.2 times. $310 Industry average ⫽ 4.2 times. ⫽

Current assets normally include cash, marketable securities, accounts receivable, and inventories. Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses (principally wages). MicroDrive has a lower current ratio than the average for its industry. Is this good or bad? Sometimes the answer depends on who is asking the question. For example, suppose a supplier is trying to decide whether to extend credit to MicroDrive. In general, creditors like to see a high current ratio. If a company is getting into ﬁnancial difﬁculty, it will begin paying its bills (accounts payable) more slowly, borrowing from its bank, and so on, so its current liabilities will be increasing. If current liabilities are rising faster than current assets, the current ratio will fall, and this could spell trouble. Because the current ratio provides the best single indicator of the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash fairly quickly, it is the most commonly used measure of short-term solvency. MicroDrive’s current ratio is well below the average for its industry, 4.2, so its liquidity position is relatively weak. Still, since current assets are scheduled to be converted to cash in the near future, it is likely that they could be liquidated at close to their stated value. With a current ratio of 3.2, MicroDrive could liquidate current assets at only 31 percent of book value and still pay off current creditors in full.1 Now consider the current ratio from the perspective of a shareholder. A high current ratio could mean that the company has a lot of money tied up in nonproductive assets, such as excess cash or marketable securities, or in inventory. In fact, it was Chrysler’s buildup of marketable securities that led to a confrontation between management and Kirk Kerkorian, who owned 15 percent of Chrysler’s stock. Kerkorian and Lee Iacocca, Chrysler’s former CEO, said that funds should be reinvested in the company’s operations or else returned to shareholders. Chrysler’s management disagreed, arguing that funds were needed to weather possible future economic downturns. While the situation was not resolved to the complete satisfaction of Kerkorian and Iacocca, Chrysler did reduce its security holdings, and its stock rose. Although industry average ﬁgures are discussed later in some detail, it should be noted that an industry average is not a magic number that all ﬁrms should strive to maintain—in fact, some very well-managed ﬁrms will be above the average while other good ﬁrms will be below it. However, if a ﬁrm’s ratios are far removed from the averages for its industry, this is a red ﬂag, and analysts should be concerned about why the variance occurs. For example, suppose a low current ratio is traced to low inventories. Is this a competitive advantage resulting from the ﬁrm’s mastery of just-in-time inventory management, or an Achilles heel that is causing the ﬁrm to miss shipments and lose sales? Ratio analysis doesn’t answer such questions, but it does point to areas of potential concern. 1/3.2 ⫽ 0.31, or 31 percent. Note that 0.31($1,000) ⫽ $310, the amount of current liabilities.

1

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Quick, or Acid Test, Ratio The quick, or acid test, ratio is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities: Quick, or acid test, ratio ⫽

Current assets ⫺ Inventories Current liabilities

$385 ⫽ 1.2 times. $310 Industry average ⫽ 2.1 times. ⫽

Inventories are typically the least liquid of a ﬁrm’s current assets, hence they are the current assets on which losses are most likely to occur in a bankruptcy. Therefore, a measure of the ﬁrm’s ability to pay off short-term obligations without relying on the sale of inventories is important. The industry average quick ratio is 2.1, so MicroDrive’s 1.2 ratio is low in comparison with other ﬁrms in its industry. Still, if the accounts receivable can be collected, the company can pay off its current liabilities without having to liquidate its inventory. Identify two ratios that are used to analyze a ﬁrm’s liquidity position, and write out their equations. What are the characteristics of a liquid asset? Give some examples. Which current asset is typically the least liquid?

Asset Management Ratios The second group of ratios, the asset management ratios, measure how effectively the ﬁrm is managing its assets. These ratios are designed to answer this question: Does the total amount of each type of asset as reported on the balance sheet seem reasonable, too high, or too low in view of current and projected sales levels? If a company has excessive investments in assets, then its operating assets and capital will be unduly high, which will reduce its free cash ﬂow and its stock price. On the other hand, if a company does not have enough assets, it will lose sales, which will hurt proﬁtability, free cash ﬂow, and the stock price. Therefore, it is important to have the right amount invested in assets. Ratios that analyze the different types of assets are described in this section.

Evaluating Inventories: The Inventory Turnover Ratio The inventory turnover ratio is deﬁned as sales divided by inventories: Inventory turnover ratio ⫽

Sales Inventories

$3,000 ⫽ 4.9 times. $615 Industry average ⫽ 9.0 times. ⫽

As a rough approximation, each item of MicroDrive’s inventory is sold out and restocked, or “turned over,” 4.9 times per year. “Turnover” is a term that originated many years ago with the old Yankee peddler, who would load up his wagon with goods, then go off to peddle his wares. The merchandise was called “working capital” because it was what he actually sold, or “turned over,” to produce his profits, whereas

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his “turnover” was the number of trips he took each year. Annual sales divided by inventory equaled turnover, or trips per year. If he made 10 trips per year, stocked 100 pans, and made a gross profit of $5 per pan, his annual gross profit would be (100)($5)(10) ⫽ $5,000. If he went faster and made 20 trips per year, his gross profit would double, other things held constant. So, his turnover directly affected his profits. MicroDrive’s turnover of 4.9 times is much lower than the industry average of 9 times. This suggests that MicroDrive is holding too much inventory. Excess inventory is, of course, unproductive, and it represents an investment with a low or zero rate of return. MicroDrive’s low inventory turnover ratio also makes us question the current ratio. With such a low turnover, we must wonder whether the ﬁrm is actually holding obsolete goods not worth their stated value.2 Note that sales occur over the entire year, whereas the inventory ﬁgure is for one point in time. For this reason, it is better to use an average inventory measure.3 If the ﬁrm’s business is highly seasonal, or if there has been a strong upward or downward sales trend during the year, it is especially useful to make some such adjustment. To maintain comparability with industry averages, however, we did not use the average inventory ﬁgure.

Evaluating Receivables: The Days Sales Outstanding Days sales outstanding (DSO), also called the “average collection period” (ACP), is used to appraise accounts receivable, and it is calculated by dividing accounts receivable by average daily sales to ﬁnd the number of days’ sales that are tied up in receivables. Thus, the DSO represents the average length of time that the ﬁrm must wait after making a sale before receiving cash, which is the average collection period. MicroDrive has 46 days sales outstanding, well above the 36-day industry average: DSO ⫽

Days Receivables Receivables sales ⫽ ⫽ Average sales per day Annual sales/365 outstanding ⫽

$375 $375 ⫽ ⫽ 45.6 days ⬇ 46 days. $3,000/365 $8.219 Industry average ⫽ 36 days.

Note that in this calculation we assumed a 365-day year. This convention is followed by most in the ﬁnancial community. However, a few analysts use a 360-day year. If MicroDrive had calculated its DSO using a 360-day year, its DSO would have been 45 days.4

2

A problem arises calculating and analyzing the inventory turnover ratio. Sales are stated at market prices, so if inventories are carried at cost, as they generally are, the calculated turnover overstates the true turnover ratio. Therefore, it would be more appropriate to use cost of goods sold in place of sales in the formula’s numerator. However, established compilers of ﬁnancial ratio statistics such as Dun & Bradstreet use the ratio of sales to inventories carried at cost. To develop a ﬁgure that can be compared with those published by Dun & Bradstreet and similar organizations, it is necessary to measure inventory turnover with sales in the numerator, as we do here. 3 Preferably, the average inventory value should be calculated by summing the monthly ﬁgures during the year and dividing by 12. If monthly data are not available, one can add the beginning and ending ﬁgures and divide by 2. Both methods adjust for growth but not for seasonal effects. 4 It would be better to use average receivables, either an average of the monthly ﬁgures or (Beginning receivables ⫹ Ending receivables)/2 ⫽ ($315 ⫹ $375)/2 ⫽ $345 in the formula. Had the annual average receivables been used, MicroDrive’s DSO on a 365-day basis would have been $345.00/$8.219 ⫽ 42 days. The 42-day ﬁgure is the more accurate one, but because the industry average was based on year-end receivables, we used 46 days for our comparison. The DSO is discussed further in Chapter 16.

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The DSO can also be evaluated by comparison with the terms on which the ﬁrm sells its goods. For example, MicroDrive’s sales terms call for payment within 30 days, so the fact that 45 days’ sales, not 30 days’, are outstanding indicates that customers, on the average, are not paying their bills on time. This deprives MicroDrive of funds that it could use to invest in productive assets. Moreover, in some instances the fact that a customer is paying late may signal that the customer is in ﬁnancial trouble, in which case MicroDrive may have a hard time ever collecting the receivable. Therefore, if the trend in DSO over the past few years has been rising, but the credit policy has not been changed, this would be strong evidence that steps should be taken to expedite the collection of accounts receivable.

Evaluating Fixed Assets: The Fixed Assets Turnover Ratio The ﬁxed assets turnover ratio measures how effectively the ﬁrm uses its plant and equipment. It is the ratio of sales to net ﬁxed assets: Fixed assets turnover ratio ⫽

Sales Net fixed assets

$3,000 ⫽ 3.0 times. $1,000 Industry average ⫽ 3.0 times. ⫽

MicroDrive’s ratio of 3.0 times is equal to the industry average, indicating that the ﬁrm is using its ﬁxed assets about as intensively as are other ﬁrms in its industry. Therefore, Micro Drive seems to have about the right amount of ﬁxed assets in relation to other ﬁrms. A potential problem can exist when interpreting the ﬁxed assets turnover ratio. Recall from accounting that ﬁxed assets reﬂect the historical costs of the assets. Inﬂation has caused the value of many assets that were purchased in the past to be seriously understated. Therefore, if we were comparing an old ﬁrm that had acquired many of its ﬁxed assets years ago at low prices with a new company that had acquired its ﬁxed assets only recently, we would probably ﬁnd that the old ﬁrm had the higher ﬁxed assets turnover ratio. However, this would be more reﬂective of the difﬁculty accountants have in dealing with inﬂation than of any inefﬁciency on the part of the new ﬁrm. The accounting profession is trying to devise ways to make ﬁnancial statements reﬂect current values rather than historical values. If balance sheets were actually stated on a current value basis, this would help us make better comparisons, but at the moment the problem still exists. Because ﬁnancial analysts typically do not have the data necessary to make adjustments, they simply recognize that a problem exists and deal with it judgmentally. In MicroDrive’s case, the issue is not a serious one because all ﬁrms in the industry have been expanding at about the same rate, hence the balance sheets of the comparison ﬁrms are reasonably comparable.5

Evaluating Total Assets: The Total Assets Turnover Ratio The ﬁnal asset management ratio, the total assets turnover ratio, measures the turnover of all the ﬁrm’s assets; it is calculated by dividing sales by total assets: Total assets turnover ratio ⫽

Sales Total assets

$3,000 ⫽ 1.5 times. $2,000 Industry average ⫽ 1.8 times. ⫽

5

See FASB #89, Financial Reporting and Changing Prices (December 1986), for a discussion of the effects of inﬂation on ﬁnancial statements.

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MicroDrive’s ratio is somewhat below the industry average, indicating that the company is not generating a sufﬁcient volume of business given its total asset investment. Sales should be increased, some assets should be sold, or a combination of these steps should be taken. Identify four ratios that are used to measure how effectively a ﬁrm is managing its assets, and write out their equations. How might rapid growth distort the inventory turnover ratio? What potential problem might arise when comparing different ﬁrms’ ﬁxed assets turnover ratios?

Debt Management Ratios The extent to which a ﬁrm uses debt ﬁnancing, or ﬁnancial leverage, has three important implications: (1) By raising funds through debt, stockholders can maintain control of a ﬁrm without increasing their investment. (2) If the ﬁrm earns more on investments ﬁnanced with borrowed funds than it pays in interest, then its shareholders’ returns are magniﬁed, or “leveraged,” but their risks are also magniﬁed. (3) Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, so the higher the proportion of funding supplied by stockholders, the less risk creditors face. Chapter 13 explains the ﬁrst two points in detail, while the following ratios examine leverage from a creditor’s point of view.

How the Firm Is Financed: Total Liabilities to Total Assets The ratio of total liabilities to total assets is called the debt ratio, or sometimes the total debt ratio. It measures the percentage of funds provided by sources other than equity: Debt ratio ⫽ ⫽

Total liabilities Total assets $1,064 $310 ⫹ $754 ⫽ ⫽ 53.2%. $2,000 $2,000 Industry average ⫽ 40.0%.

Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors’ losses in the event of liquidation. Stockholders, on the other hand, may want more leverage because it magniﬁes expected earnings. MicroDrive’s debt ratio is 53.2 percent, which means that its creditors have supplied more than half the total ﬁnancing. As we will discuss in Chapter 13, a variety of factors determine a company’s optimal debt ratio. Nevertheless, the fact that MicroDrive’s debt ratio exceeds the industry average raises a red ﬂag and may make it costly for MicroDrive to borrow additional funds without ﬁrst raising more equity capital. Creditors may be reluctant to lend the ﬁrm more money, and management would probably be subjecting the ﬁrm to the risk of bankruptcy if it increased the debt ratio by borrowing additional funds. If you use a debt ratio that you did not calculate yourself, be sure to ﬁnd out how the ratio was deﬁned. Some sources provide the ratio of long-term debt to total assets,

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and some provide the ratio of debt to equity, so be sure to check the source’s deﬁnition.6

Ability to Pay Interest: Times Interest Earned The times-interest-earned (TIE) ratio is determined by dividing earnings before interest and taxes (EBIT in Table 9-2) by the interest charges: Times-interest-earned (TIE) ratio ⫽

EBIT Interest charges

$283.8 ⫽ 3.2 times. $88 Industry average ⫽ 6.0 times. ⫽

The TIE ratio measures the extent to which operating income can decline before the ﬁrm is unable to meet its annual interest costs. Failure to meet this obligation can bring legal action by the ﬁrm’s creditors, possibly resulting in bankruptcy. Note that earnings before interest and taxes, rather than net income, is used in the numerator. Because interest is paid with pre-tax dollars, the ﬁrm’s ability to pay current interest is not affected by taxes. MicroDrive’s interest is covered 3.2 times. Since the industry average is 6 times, MicroDrive is covering its interest charges by a relatively low margin of safety. Thus, the TIE ratio reinforces the conclusion from our analysis of the debt ratio that MicroDrive would face difﬁculties if it attempted to borrow additional funds.

Ability to Service Debt: EBITDA Coverage Ratio The TIE ratio is useful for assessing a company’s ability to meet interest charges on its debt, but this ratio has two shortcomings: (1) Interest is not the only ﬁxed ﬁnancial charge—companies must also reduce debt on schedule, and many ﬁrms lease assets and thus must make lease payments. If they fail to repay debt or meet lease payments, they can be forced into bankruptcy. (2) EBIT does not represent all the cash ﬂow available to service debt, especially if a ﬁrm has high depreciation and/or amortization charges. To account for these deﬁciencies, bankers and others have developed the EBITDA coverage ratio, deﬁned as follows:7 EBITDA coverage ratio ⫽ ⫽

6

EBITDA ⫹ Lease payments Interest ⫹ Principal payments ⫹ Lease payments $283.8 ⫹ $100 ⫹ $28 $411.8 ⫽ ⫽ 3.0 times. $88 ⫹ $20 ⫹ $28 $136 Industry average ⫽ 4.3 times.

The debt-to-assets (D/A) and debt-to-equity (D/E) ratios are simply transformations of each other: D/A D/E D/E ⫽ , and D/A ⫽ . 1 ⫺ D/A 1 ⫹ D/E 7 Different analysts deﬁne the EBITDA coverage ratio in different ways. For example, some would omit the lease payment information, and others would “gross up” principal payments by dividing them by (1 ⫺ T) because these payments are not tax deductions, hence must be made with after-tax cash ﬂows. We included lease payments because, for many ﬁrms, they are quite important, and failing to make them can lead to bankruptcy just as surely as can failure to make payments on “regular” debt. We did not gross up principal payments because, if a company is in ﬁnancial difﬁculty, its tax rate will probably be zero, hence the gross up is not necessary whenever the ratio is really important.

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MicroDrive had $283.8 million of operating income (EBIT), presumably all cash. Noncash charges of $100 million for depreciation and amortization (the DA part of EBITDA) were deducted in the calculation of EBIT, so they must be added back to ﬁnd the cash ﬂow available to service debt. Also, lease payments of $28 million were deducted before getting the $283.8 million of EBIT.8 That $28 million was available to meet ﬁnancial charges, hence it must be added back, bringing the total available to cover ﬁxed ﬁnancial charges to $411.8 million. Fixed ﬁnancial charges consisted of $88 million of interest, $20 million of sinking fund payments, and $28 million for lease payments, for a total of $136 million.9 Therefore, MicroDrive covered its ﬁxed ﬁnancial charges by 3.0 times. However, if operating income declines, the coverage will fall, and operating income certainly can decline. Moreover, MicroDrive’s ratio is well below the industry average, so again, the company seems to have a relatively high level of debt. The EBITDA coverage ratio is most useful for relatively short-term lenders such as banks, which rarely make loans (except real estate-backed loans) for longer than about ﬁve years. Over a relatively short period, depreciation-generated funds can be used to service debt. Over a longer time, those funds must be reinvested to maintain the plant and equipment or else the company cannot remain in business. Therefore, banks and other relatively short-term lenders focus on the EBITDA coverage ratio, whereas long-term bondholders focus on the TIE ratio. How does the use of ﬁnancial leverage affect current stockholders’ control position? In what way do taxes inﬂuence a ﬁrm’s willingness to ﬁnance with debt? In what way does the use of debt involve a risk-versus-return trade-off? Explain the following statement: “Analysts look at both balance sheet and income statement ratios when appraising a ﬁrm’s ﬁnancial condition.” Name three ratios that are used to measure the extent to which a ﬁrm uses ﬁnancial leverage, and write out their equations.

Proﬁtability Ratios Proﬁtability is the net result of a number of policies and decisions. The ratios examined thus far provide useful clues as to the effectiveness of a ﬁrm’s operations, but the proﬁtability ratios go on to show the combined effects of liquidity, asset management, and debt on operating results.

8

Lease payments are included in the numerator because, unlike interest, they were deducted when EBITDA was calculated. We want to ﬁnd all the funds that were available to service debt, so lease payments must be added to the EBIT and DA to ﬁnd the funds that could be used to service debt and meet lease payments. To illustrate this, suppose EBIT before lease payments was $100, lease payments were $100, and DA was zero. After lease payments, EBIT would be $100 ⫺ $100 ⫽ $0. Yet lease payments of $100 were made, so obviously there was cash to make those payments. The available cash was the reported EBIT of $0 plus the $100 of lease payments. 9 A sinking fund is a required annual payment designed to reduce the balance of a bond or preferred stock issue. A sinking fund payment is like the principal repayment portion of the payment on an amortized loan, but sinking funds are used for publicly traded bond issues, whereas amortization payments are used for bank loans and other private loans.

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International Accounting Differences Create Headaches for Investors You must be a good ﬁnancial detective to analyze ﬁnancial statements, especially if the company operates overseas. Despite attempts to standardize accounting practices, there are many differences in the way ﬁnancial information is reported in different countries, and these differences create headaches for investors trying to make cross-border company comparisons. A study by two Rider College accounting professors demonstrated that huge differences can exist. The professors developed a computer model to evaluate the net income of a hypothetical but typical company operating in different countries. Applying the standard accounting practices of each country, the hypothetical company would have reported net income of $34,600 in the United States, $260,600 in the United Kingdom, and $240,600 in Australia. Such variances occur for a number of reasons. In most countries, including the United States, an asset’s balance sheet value is reported at original cost less any accumulated

depreciation. However, in some countries, asset values are adjusted to reﬂect current market prices. Also, inventory valuation methods vary from country to country, as does the treatment of goodwill. Other differences arise from the treatment of leases, research and development costs, and pension plans. These differences arise from a variety of legal, historical, cultural, and economic factors. For example, in Germany and Japan large banks are the key source of both debt and equity capital, whereas in the United States public capital markets are most important. As a result, U.S. corporations disclose a great deal of information to the public, while German and Japanese corporations use very conservative accounting practices that appeal to the banks. Source: From “All Accountants Soon May Speak the Same Language,” The Wall Street Journal, August 29, 1995, A15. Copyright © 1995 by Dow Jones & Co., Inc. Reprinted by permission of Dow Jones & Co., Inc. via Copyright Clearance Center.

Proﬁt Margin on Sales The proﬁt margin on sales, calculated by dividing net income by sales, gives the proﬁt per dollar of sales: Net income available to Profit margin common stockholders ⫽ on sales Sales $113.5 ⫽ 3.8%. $3,000 Industry average ⫽ 5.0%. ⫽

MicroDrive’s proﬁt margin is below the industry average of 5 percent. This sub-par result occurs because costs are too high. High costs, in turn, generally occur because of inefﬁcient operations. However, MicroDrive’s low proﬁt margin is also a result of its heavy use of debt. Recall that net income is income after interest. Therefore, if two ﬁrms have identical operations in the sense that their sales, operating costs, and EBIT are the same, but if one ﬁrm uses more debt than the other, it will have higher interest charges. Those interest charges will pull net income down, and since sales are constant, the result will be a relatively low proﬁt margin. In such a case, the low proﬁt margin would not indicate an operating problem— rather, it would indicate a difference in ﬁnancing strategies. Thus, the ﬁrm with the low proﬁt margin might end up with a higher rate of return on its stockholders’ investment due to its use of ﬁnancial leverage. We will see exactly how proﬁt margins and the use of debt interact to affect the return on stockholder’s equity later in the chapter, when we examine the Du Pont model.

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Basic Earning Power (BEP) The basic earning power (BEP) ratio is calculated by dividing earnings before interest and taxes (EBIT) by total assets: Basic earning power ratio (BEP) ⫽

EBIT Total assets

$283.8 ⫽ 14.2%. $2,000 Industry average ⫽ 17.2%. ⫽

This ratio shows the raw earning power of the ﬁrm’s assets, before the inﬂuence of taxes and leverage, and it is useful for comparing ﬁrms with different tax situations and different degrees of ﬁnancial leverage. Because of its low turnover ratios and low proﬁt margin on sales, MicroDrive is not getting as high a return on its assets as is the average company in its industry.10

Return on Total Assets The ratio of net income to total assets measures the return on total assets (ROA) after interest and taxes: Net income available to Return on common stockholders ⫽ ROA ⫽ total assets Total assets $113.5 ⫽ 5.7%. $2,000 Industry average ⫽ 9.0%. ⫽

MicroDrive’s 5.7 percent return is well below the 9 percent average for the industry. This low return results from (1) the company’s low basic earning power plus (2) high interest costs resulting from its above-average use of debt, both of which cause its net income to be relatively low.

Return on Common Equity Ultimately, the most important, or “bottom line,” accounting ratio is the ratio of net income to common equity, which measures the return on common equity (ROE): Net income available to Return on common stockholders ⫽ ROE ⫽ common equity Common equity $113.5 ⫽ 12.7%. $896 Industry average ⫽ 15.0%. ⫽

10

Notice that EBIT is earned throughout the year, whereas the total assets ﬁgure is an end-of-the-year number. Therefore, it would be conceptually better to calculate this ratio as EBIT/Average assets ⫽ EBIT/[(Beginning assets ⫹ Ending assets)/2]. We have not made this adjustment because the published ratios used for comparative purposes do not include it. However, when we construct our own comparative ratios, we do make the adjustment. Incidentally, the same adjustment would also be appropriate for the next two ratios, ROA and ROE.

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Stockholders invest to get a return on their money, and this ratio tells how well they are doing in an accounting sense. MicroDrive’s 12.7 percent return is below the 15 percent industry average, but not as far below as the return on total assets. This somewhat better result is due to the company’s greater use of debt, a point that is analyzed in detail later in the chapter. Identify and write out the equations for four ratios that show the combined effects of liquidity, asset management, and debt management on proﬁtability. Why is the basic earning power ratio useful? Why does the use of debt lower the ROA? What does ROE measure? Since interest expense lowers proﬁts, does using debt lower ROE?

Market Value Ratios A ﬁnal group of ratios, the market value ratios, relates the ﬁrm’s stock price to its earnings, cash ﬂow, and book value per share. These ratios give management an indication of what investors think of the company’s past performance and future prospects. If the liquidity, asset management, debt management, and proﬁtability ratios all look good, then the market value ratios will be high, and the stock price will probably be as high as can be expected.

Price/Earnings Ratio The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported proﬁts. MicroDrive’s stock sells for $23, so with an EPS of $2.27 its P/E ratio is 10.1: Price/earnings (P/E) ratio ⫽

Price per share Earnings per share

$23.00 ⫽ 10.1 times. $2.27 Industry average ⫽ 12.5 times. ⫽

P/E ratios are higher for ﬁrms with strong growth prospects, other things held constant, but they are lower for riskier ﬁrms. Because MicroDrive’s P/E ratio is below the average, this suggests that the company is regarded as being somewhat riskier than most, as having poorer growth prospects, or both.

Price/Cash Flow Ratio In some industries, stock price is tied more closely to cash ﬂow rather than net income. Consequently, investors often look at the price/cash ﬂow ratio: Price/cash flow ⫽

Price per share Cash flow per share

$23.00 ⫽ 5.4 times. $4.27 Industry average ⫽ 6.8 times. ⫽

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The calculation for cash ﬂow per share was shown in Chapter 9, but just to refresh your memory, cash ﬂow per share is calculated as net income plus depreciation and amortization divided by common shares outstanding. MicroDrive’s price/cash ﬂow ratio is also below the industry average, once again suggesting that its growth prospects are below average, its risk is above average, or both. Note that some analysts look at multiples beyond just the price/earnings and the price/cash ﬂow ratios. For example, depending on the industry, some may look at measures such as price/sales, price/customers, or price/EBITDA per share. Ultimately, though, value depends on free cash ﬂows, so if these “exotic” ratios do not forecast future free cash ﬂow, they may turn out to be misleading. This was true in the case of the dot-com retailers before they crashed and burned in 2000, costing investors many billions.

Market/Book Ratio The ratio of a stock’s market price to its book value gives another indication of how investors regard the company. Companies with relatively high rates of return on equity generally sell at higher multiples of book value than those with low returns. First, we ﬁnd MicroDrive’s book value per share: Book value per share ⫽ ⫽

Common equity Shares outstanding $896 ⫽ $17.92. 50

Now we divide the market price by the book value to get a market/book (M/B) ratio of 1.3 times: Market/book ratio ⫽ M/B ⫽

Market price per share Book value per share

$23.00 ⫽ 1.3 times. $17.92 Industry average ⫽ 1.7 times. ⫽

See Ch 10 Tool Kit.xls for details.

Investors are willing to pay relatively little for a dollar of MicroDrive’s book value. The average company in the S&P 500 had a market/book ratio of about 5.62 in late 2001. Since M/B ratios typically exceed 1.0, this means that investors are willing to pay more for stocks than their accounting book values. The book value is a record of the past, showing the cumulative amount that stockholders have invested, either directly by purchasing newly issued shares or indirectly through retaining earnings. In contrast, the market price is forward-looking, incorporating investors’ expectations of future cash ﬂows. For example, in late 2001 American Airlines had a market/book ratio of only 0.45, reﬂecting the crisis in the airlines industry caused by the terrorist attacks earlier in the year, whereas Dell Computer’s market/book ratio was over 13, indicating that investors expect Dell’s past successes to continue. Table 10-1 summarizes MicroDrive’s ﬁnancial ratios. As the table indicates, the company has many problems.

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TABLE 10-1

Ratio

MicroDrive Inc.: Summary of Financial Ratios (Millions of Dollars)

Formula for Calculation

Calculation

Current assets Current liabilities Current assets ⫺ Inventories Current liabilities

$1,000 $310 $385 $310

Sales Inventories Receivables Annual sales/365 Sales Net fixed assets Sales Total assets

$3,000 $615 $375 $8.219 $3,000 $1,000 $3,000 $2,000

Total liabilities Total assets Earnings before interest and taxes (EBIT)

Ratio

Industry Average

Comment

Liquidity Current Quick, or acid test

⫽ 3.2⫻

4.2⫻

Poor

⫽ 1.2⫻

2.1⫻

Poor

⫽ 4.9⫻

9.0⫻

Poor

36 days

Poor

Asset Management Inventory turnover Days sales outstanding (DSO) Fixed assets turnover Total assets turnover

⫽ 46 days ⫽ 3.0⫻

3.0⫻

OK

⫽ 1.5⫻

1.8⫻

Somewhat low

$1,064 $2,000

⫽ 53.2%

40.0%

High (risky)

$283.8 $88

⫽ 3.2⫻

6.0⫻

Low (risky)

$411.8 $136

⫽ 3.0⫻

4.3⫻

Low (risky)

$113.5 $3,000

⫽ 3.8%

5.0%

Poor

⫽ 14.2%

17.2%

Poor

⫽ 5.7%

9.0%

Poor

⫽ 12.7%

15.0%

Poor

$23.00 $2.27

⫽ 10.1⫻

12.5⫻

Low

$23.00 $4.27

⫽ 5.4⫻

6.8⫻

Low

$23.00 $17.92

⫽ 1.3⫻

1.7⫻

Low

Debt Management Debt ratio Times-interestearned (TIE) EBITDA coverage

Interest charges EBITDA ⫹ Lease payments Interest ⫹ Principal payments ⫹ Lease payments

Proﬁtability Proﬁt margin on sales Basic earning power (BEP) Return on total assets (ROA) Return on common equity (ROE)

Net income available to common stockholders Sales Earnings before interest and taxes (EBIT) Total assets Net income available to common stockholders Total assets Net income available to common stockholders Common equity

$283.8 $2,000 $113.5 $2,000 $113.5 $896

Market Value Price/earnings (P/E) Price/cash ﬂow Market/book (M/B)

Price per share Earnings per share Price per share Cash flow per share Market price per share Book value per share

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Describe three ratios that relate a ﬁrm’s stock price to its earnings, cash ﬂow, and book value per share, and write out their equations. How do market value ratios reﬂect what investors think about a stock’s risk and expected rate of return? What does the price/earnings (P/E) ratio show? If one ﬁrm’s P/E ratio is lower than that of another, what are some factors that might explain the difference? How is book value per share calculated? Explain why book values often deviate from market values.

Trend Analysis, Common Size Analysis, and Percent Change Analysis It is important to analyze trends in ratios as well as their absolute levels, for trends give clues as to whether a ﬁrm’s ﬁnancial condition is likely to improve or to deteriorate. To do a trend analysis, one simply plots a ratio over time, as shown in Figure 10-1. This graph shows that MicroDrive’s rate of return on common equity has been declining since 1999, even though the industry average has been relatively stable. All the other ratios could be analyzed similarly. Common size analysis and percent change analysis are two other techniques that can be used to identify trends in ﬁnancial statements. Common size analysis is also useful in comparative analysis, and some sources of industry data, such as Robert Morris Associates, are presented exclusively in common size form. In a common size analysis, all income statement items are divided by sales, and all balance sheet items are divided by total assets. Thus, a common size income statement shows each item as a percentage of sales, and a common size balance sheet shows each item as a percentage of total assets. The advantage of common size analysis is that it facilitates comparisons of balance sheets and income statements over time and across companies.

FIGURE 10-1

Rate of Return on Common Equity, 1998–2002

ROE (%) 16

Industry

14

MicroDrive

12 10

1998

1999

2000

2001

2002

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Table 10-2 contains MicroDrive’s 2001 and 2002 common size income statements, along with the composite statement for the industry. (Note: Rounding may cause addition/subtraction differences in Tables 10-2 and 10-3.) MicroDrive’s operating costs are slightly above average, as are its interest expenses, but its taxes are relatively low because of its low EBIT. The net effect of all these forces is a relatively low proﬁt margin. Table 10-3 shows MicroDrive’s common size balance sheets, along with the industry average. Its accounts receivable are signiﬁcantly higher than the industry average, its inventories are signiﬁcantly higher, and it uses far more ﬁxed charge capital (debt and preferred) than the average ﬁrm. A ﬁnal technique used to help analyze a ﬁrm’s ﬁnancial statements is percentage change analysis. In this type of analysis, growth rates are calculated for all income statement items and balance sheet accounts. To illustrate, Table 10-4 contains MicroDrive’s income statement percentage change analysis for 2002. Sales increased at a 5.3 percent rate during 2002, while total operating costs increased at a slower 5.0 percent rate, leading to 7.9 percent growth in EBIT. The fact that sales increased faster than operating costs is positive, but this “good news” was offset by a 46.7 percent increase in interest expense. The signiﬁcant growth in interest expense caused growth in both earnings before taxes and net income to be negative. Thus, the percentage change analysis points out that the decrease in reported income in 2002 resulted almost exclusively from an increase in interest expense. This conclusion could be reached by analyzing dollar amounts, but percentage change analysis simpliﬁes the task. The same type of analysis applied to the balance sheets would show that assets grew at a 19.0 percent rate, largely because inventories grew at a whopping 48.2 percent rate. With only a 5.3 percent growth in sales, the extreme growth in inventories should be of great concern to MicroDrive’s managers. The conclusions reached in common size and percentage change analyses generally parallel those derived from ratio analysis. However, occasionally a serious deﬁciency is highlighted by only one of the three analytical techniques. Also, it is often useful to have all three and to drive home to management, in slightly different ways, the need to take corrective actions. Thus, a thorough ﬁnancial statement analysis will

TABLE 10-2

See Ch 10 Tool Kit.xls for details.

MicroDrive Inc.: Common Size Income Statements

Net sales Costs excluding depreciation Depreciation Total operating costs Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes (40%) Net income before preferred dividends Preferred dividends Net income available to common stockholders (proﬁt margin)

2001

2002

2002 Industry Composite

100.0% 87.6 3.2 90.8% 9.2% 2.1 7.1% 2.8 4.3% 0.1 4.1%

100.0% 87.2 3.3 90.5% 9.5% 2.9 6.5% 2.6 3.9% 0.1 3.8%

100.0% 87.6 2.8 90.4% 9.6% 1.3 8.3% 3.3 5.0% 0.0 5.0%

387

Analysis of Financial Statements Trend Analysis, Common Size Analysis, and Percent Change Analysis TABLE 10-3

391

MicroDrive Inc.: Common Size Balance Sheets

2001

2002

2002 Industry Composite

0.9% 3.9 18.8 24.7 48.2% 51.8 100.0%

0.5% 0.0 18.8 30.8 50.0% 50.0 100.0%

3.2% 0.0 17.8 19.8 40.8% 59.2 100.0%

1.8% 3.6 7.7 13.1% 34.5 47.6% 2.4 50.0 100.0%

3.0% 5.5 7.0 15.5% 37.7 53.2% 2.0 44.8 100.0%

1.8% 4.4 3.6 9.8% 30.2 40.0% 0.0 60.0 100.0%

Assets Cash and equivalents Short-term investments Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Preferred equity Common equity Total liabilities and equity

include ratio, percentage change, and common size analyses, as well as a Du Pont analysis as described next. How does one do a trend analysis? What important information does a trend analysis provide? What is common size analysis? What is percent change analysis? TABLE 10-4

See Ch 10 Tool Kit.xls for details.

MicroDrive Inc.: Income Statement Percentage Change Analysis (Millions of Dollars)

Net sales Costs excluding depreciation Depreciation Total operating costs Earnings before interest and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes (40%) Net income before preferred dividends Preferred dividends Net income available to common stockholders

2001

2002

Percent Change

$2,850 $2,497 90 $2,587 $ 263 60 $ 203 81 $ 122 4 $ 118

$3,000.0 $2,616.2 100.0 $2,716.2 $ 283.8 88.0 $ 195.8 78.3 $ 117.5 4.0 $ 113.5

5.3% 4.8% 11.1 5.0% 7.9% 46.7 (3.5%) (3.3) (3.7%) 0 (3.8%)

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Tying the Ratios Together: The Du Pont Chart and Equation Table 10-1 summarized MicroDrive’s ratios, and now Figure 10-2 shows how the return on equity is affected by asset turnover, the proﬁt margin, and leverage. The chart depicted in Figure 10-2 is called a modiﬁed Du Pont chart because that company’s managers developed this approach for evaluating performance. Working from the bottom up, the left-hand side of the chart develops the proﬁt margin on sales. The various expense items are listed and then summed to obtain MicroDrive’s total cost, which is subtracted from sales to obtain the company’s net income. When we divide net income by sales, we ﬁnd that 3.8 percent of each sales dollar is left over for stockholders. If the proﬁt margin is low or trending down, one can examine the individual expense items to identify and then correct problems. The right-hand side of Figure 10-2 lists the various categories of assets, totals them, and then divides sales by total assets to ﬁnd the number of times MicroDrive “turns its assets over” each year. The company’s total assets turnover ratio is 1.5 times. The proﬁt margin times the total assets turnover is called the Du Pont equation, and it gives the rate of return on assets (ROA): ROA ⫽ Profit margin ⫻ Total assets turnover Net income Sales ⫽ ⫻ Sales Total assets

(10-1)

⫽ 3.8% ⫻ 1.5 ⫽ 5.7%.

FIGURE 10-2

Modiﬁed Du Pont Chart for MicroDrive Inc. (Millions of Dollars)

Return on Equity 12.7%

Return on Assets 5.7%

Profit Margin: Earnings as a Percent of Sales 3.8%

Multiplied by

Multiplied by

Total Assets Turnover 1.5

Sales $3,000

Divided into

Net Income $113.5

Sales $3,000

Divided by

Total Costs $2,886.5

Subtracted from

Sales $3,000

Fixed Assets $1,000

Added to

Other Operating Costs $2,616.2 (Labor, overhead, etc.)

Interest plus Preferred Dividends $92

Depreciation $100

Taxes $78.3

Assets/Equity = $2,000/$896 = 2.23

Total Assets $2,000

Current Assets $1,000

Cash and Marketable Securities $10

Accounts Receivable $375

Inventories $615

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Analysis of Financial Statements Tying the Ratios Together: The Du Pont Chart and Equation

393

MicroDrive made 3.8 percent, or 3.8 cents, on each dollar of sales, and its assets were “turned over” 1.5 times during the year. Therefore, the company earned a return of 5.7 percent on its assets. If the company were ﬁnanced only with common equity, the rate of return on assets (ROA) and the return on equity (ROE) would be the same because the total assets would equal the common equity: ROA ⫽

Net income Net income ⫽ ⫽ ROE. Total assets Common equity

This equality holds if and only if Total assets ⫽ Common equity, that is, if the company uses no debt. MicroDrive does use debt, so its common equity is less than total assets. Therefore, the return to the common stockholders (ROE) must be greater than the ROA of 5.7 percent. To ﬁnd the ROE, multiply the rate of return on assets (ROA) by the equity multiplier, which is the ratio of assets to common equity: Equity multiplier ⫽

Total assets . Common equity

Firms that use a large amount of debt ﬁnancing (a lot of leverage) will necessarily have a high equity multiplier—the more the debt, the less the equity, hence the higher the equity multiplier. For example, if a ﬁrm has $1,000 of assets and is ﬁnanced with $800, or 80 percent debt, then its equity will be $200, and its equity multiplier will be $1,000/$200 ⫽ 5. Had it used only $200 of debt, then its equity would have been $800, and its equity multiplier would have been only $1,000/$800 ⫽ 1.25.11 MicroDrive’s return on equity (ROE) depends on its ROA and its use of leverage:12 ROE ⫽ ROA ⫻ Equity multiplier Net income Total assets ⫽ ⫻ Total assets Common equity

(10-2)

⫽ 5.7% ⫻ $2,000/$896 ⫽ 5.7% ⫻ 2.23 ⫽ 12.7%. Now we can combine Equations 10-1 and 10-2 to form the extended Du Pont equation, which shows how the proﬁt margin, the assets turnover ratio, and the equity multiplier combine to determine the ROE: ROE ⫽ (Profit margin)(Total assets turnover)(Equity multiplier) Net income Sales Total assets ⫽ (10-3) ⫻ ⫻ . Sales Total assets Common equity

11

Expressed algebraically,

D A⫺E A E 1 ⫽ ⫽ ⫺ ⫽1⫺ . A A A A Equity multiplier Here D is debt, E is equity, A is total assets, and A/E is the equity multiplier. This equation ignores preferred stock. Debt ratio ⫽

12

Note that we could also ﬁnd the ROE by “grossing up” the ROA, that is, by dividing the ROA by the common equity fraction: ROE ⫽ ROA/Equity fraction ⫽ 5.7%/0.448 ⫽ 12.7%. The two procedures are algebraically equivalent.

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For MicroDrive, we have ROE ⫽ (3.8%)(1.5)(2.23) ⫽ 12.7%. The 12.7 percent rate of return could, of course, be calculated directly: both Sales and Total assets cancel, leaving Net income/Common equity ⫽ $113.5/$896 ⫽ 12.7%. However, the Du Pont equation shows how the proﬁt margin, the total assets turnover, and the use of debt interact to determine the return on equity. The insights provided by the Du Pont model are valuable, and it can be used for “quick and dirty” estimates of the impact that operating changes have on returns. For example, holding all else equal, if MicroDrive can drive up its ratio of sales/total assets to 1.8, then its ROE will improve to (3.8%)(1.8)(2.23) ⫽ 15.25%. For more a complete “what if” analysis, most companies use a forecasting model such as the one described in the next chapter. Explain how the extended, or modiﬁed, Du Pont equation and chart can be used to reveal the basic determinants of ROE. What is the equity multiplier?

Comparative Ratios and “Benchmarking” Ratio analysis involves comparisons—a company’s ratios are compared with those of other ﬁrms in the same industry, that is, with industry average ﬁgures. However, like most ﬁrms, MicroDrive’s managers go one step further—they also compare their ratios with those of a smaller set of the leading computer companies. This technique is called benchmarking, and the companies used for the comparison are called benchmark companies. For example, MicroDrive benchmarks against Apex Systems, Cablenet, Carter Controls, BMR Corporation, Magnetic Sciences, and Luxor Corporation. MicroDrive’s management considers these to be the best-managed companies with operations similar to its own. Here is the comparison of MicroDrive’s ROE versus those of the benchmark ﬁrms:

ROE

Cablenet Carter BMR Magnetic Sciences Luxor MicroDrive Apex

28% 26 22 19 16 13 9

Similar comparisons are made for the other key ratios, and this procedure allows management to see, on a company-by-company basis, how it stacks up against its major competitors. Many companies also benchmark various parts of their overall operation against top companies, whether they are in the same industry or not. For example, MicroDrive has a division that sells hard drives directly to consumers through catalogs and the Internet. This division’s shipping department benchmarks against L.L. Bean, even

391

Analysis of Financial Statements Comparative Ratios and “Benchmarking”

395

though they are in different industries, because L.L. Bean’s shipping department is one of the best. MicroDrive wants its own shippers to strive to match L.L. Bean’s record for on-time shipments. Comparative ratios are available from a number of sources, including Value Line, Dun and Bradstreet (D&B), and the Annual Statement Studies published by Robert Morris Associates, which is the national association of bank loan ofﬁcers. Table 10-5 reports selected ratios from Market Guide, available through Yahoo!. Each data-supplying organization uses a somewhat different set of ratios designed for its own purposes. For example, D&B deals mainly with small ﬁrms, many of which are proprietorships, and it sells its services primarily to banks and other lenders. Therefore, D&B is concerned largely with the creditor’s viewpoint, and its ratios emphasize current assets and liabilities, not market value ratios. So, when you select a comparative data source, you should be sure that your emphasis is similar to that of the agency whose ratios you plan to use. Additionally, there are often deﬁnitional differences in the ratios presented by different sources, so before using a source, be sure to verify the exact deﬁnitions of the ratios to ensure consistency with your own work. Differentiate between trend analysis and comparative ratio analysis. Why is it useful to do a comparative ratio analysis? What is benchmarking?

TABLE 10-5

Comparative Ratios for Dell Computer Corporation, the Computer Hardware Industry, the Technology Sector, and the S&P 500

Ratio

P/E ratio Market to book Price to tangible book Price to cash ﬂow Net proﬁt margin Quick ratio Current ratio Long-term debt to equity Total debt to equity Interest coverage (TIE)c Return on assets Return on equity Inventory turnover Asset turnover

Dell

Computer Hardware Industrya

Technology Sectorb

S&P 500

48.49 13.57 13.57 40.55 4.51 1.05 1.23 0.11 0.11 — 4.51 25.69 69.40 2.45

30.75 7.95 7.97 27.52 5.54 1.07 1.48 0.51 0.73 16.04 5.54 25.04 21.71 1.37

45.11 5.59 7.24 33.58 4.38 2.32 2.88 0.23 0.29 6.78 4.38 7.01 10.90 0.76

30.39 5.62 8.48 21.06 8.69 1.14 1.69 0.68 0.94 8.53 8.69 17.38 10.45 0.98

a The computer hardware industry is comprised of 50 ﬁrms, including IBM, Dell, Sun Microsystems, HewlettPackard, Hitachi, and Compaq. b The technology sector contains 11 industries, including communications equipment, computer hardware, computer networks, semiconductors, and software and programming. c Dell had more interest income than interest expense.

Source: Multex.com, accessed through Yahoo!.

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Ratio Analysis in the Internet Age

A great source for comparative ratios is http://ﬁnance. yahoo.com. On this web page is a ﬁeld to enter a company’s ticker symbol. Do this and click the “Get Quotes” button. This brings up a table with the stock quote and some additional links. Select “Proﬁle,” which brings up a page with detailed information on the company. About halfway down the

left side is a section called “More from Market Guide.” Select the item “Ratio Comparisons.” This brings up a detailed ratio analysis for the company and includes comparative ratios for other companies in the same sector, the same industry, and the S&P 500.

Uses and Limitations of Ratio Analysis

To ﬁnd quick information about a company, link to http://www.marketguide. com. Here you can ﬁnd company proﬁles, stock price and share information, and several key ratios.

As noted earlier, ratio analysis is used by three main groups: (1) managers, who employ ratios to help analyze, control, and thus improve their ﬁrms’ operations; (2) credit analysts, including bank loan ofﬁcers and bond rating analysts, who analyze ratios to help ascertain a company’s ability to pay its debts; and (3) stock analysts, who are interested in a company’s efﬁciency, risk, and growth prospects. In later chapters we will look more closely at the basic factors that underlie each ratio, which will give you a better idea about how to interpret and use ratios. Note, though, that while ratio analysis can provide useful information concerning a company’s operations and ﬁnancial condition, it does have limitations that necessitate care and judgment. Some potential problems are listed below: 1. Many large ﬁrms operate different divisions in different industries, and for such companies it is difﬁcult to develop a meaningful set of industry averages. Therefore, ratio analysis is more useful for small, narrowly focused ﬁrms than for large, multidivisional ones. 2. Most ﬁrms want to be better than average, so merely attaining average performance is not necessarily good. As a target for high-level performance, it is best to focus on the industry leaders’ ratios. Benchmarking helps in this regard. 3. Inﬂation may have badly distorted ﬁrms’ balance sheets—recorded values are often substantially different from “true” values. Further, because inﬂation affects both depreciation charges and inventory costs, proﬁts are also affected. Thus, a ratio analysis for one ﬁrm over time, or a comparative analysis of ﬁrms of different ages, must be interpreted with judgment. 4. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a food processor will be radically different if the balance sheet ﬁgure used for inventory is the one just before versus just after the close of the canning season. This problem can be minimized by using monthly averages for inventory (and receivables) when calculating turnover ratios. 5. Firms can employ “window dressing” techniques to make their ﬁnancial statements look stronger. To illustrate, a Chicago builder borrowed on a two-year basis in late December. Because the loan was for more than one year, it was not included in current liabilities. The builder held the proceeds of the loan as cash. This improved his current and quick ratios, and made his year-end balance sheet look stronger. However, the improvement was strictly window dressing; a week later the builder paid off the loan and the balance sheet was back at the old level.

393

Analysis of Financial Statements Problems with ROE

397

6. Different accounting practices can distort comparisons. As noted earlier, inventory valuation and depreciation methods can affect ﬁnancial statements and thus distort comparisons among ﬁrms. Also, if one ﬁrm leases a substantial amount of its productive equipment, then its assets may appear low relative to sales because leased assets often do not appear on the balance sheet. At the same time, the liability associated with the lease obligation may not be shown as a debt. Therefore, leasing can artiﬁcially improve both the turnover and the debt ratios. 7. It is difﬁcult to generalize about whether a particular ratio is “good” or “bad.” For example, a high current ratio may indicate a strong liquidity position, which is good, or excessive cash, which is bad (because excess cash in the bank is a nonearning asset). Similarly, a high ﬁxed assets turnover ratio may denote either that a ﬁrm uses its assets efﬁciently or that it is undercapitalized and cannot afford to buy enough assets. 8. A ﬁrm may have some ratios that look “good” and others that look “bad,” making it difﬁcult to tell whether the company is, on balance, strong or weak. However, statistical procedures can be used to analyze the net effects of a set of ratios. Many banks and other lending organizations use discriminant analysis, a statistical technique, to analyze ﬁrms’ ﬁnancial ratios, and then classify the ﬁrms according to their probability of getting into ﬁnancial trouble. Ratio analysis is useful, but analysts should be aware of these problems and make adjustments as necessary. Ratio analysis conducted in a mechanical, unthinking manner is dangerous, but used intelligently and with good judgment, it can provide useful insights into a ﬁrm’s operations. Your judgment in interpreting a set of ratios is bound to be weak at this point, but it will improve as you go through the remainder of the book.

List three types of users of ratio analysis. Would the different users emphasize the same or different types of ratios? List several potential problems with ratio analysis.

Problems with ROE In Chapter 1 we said that managers should strive to maximize shareholder wealth. If a ﬁrm takes steps to improve its ROE, does this mean that shareholder wealth will also increase? Not necessarily, for despite its widespread use and the fact that ROE and shareholder wealth are often highly correlated, serious problems can arise when ﬁrms use ROE as the sole measure of performance. First, ROE does not consider risk. While shareholders clearly care about returns, they also care about risk. Second, ROE does not consider the amount of invested capital. For example, suppose a company has $1 invested in Project A, which has an ROE of 50 percent, and $1 million invested in Project B, which has a 40 percent ROE. Project A has a higher ROE, but because it is so small, it does little to enhance shareholder wealth. Project B, on the other hand, has the lower ROE, but it adds much more to shareholder value. A project’s return must be combined with its risk and size to determine its effect on shareholder value. To the extent that ROE focuses only on rate of return, increasing

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ROE may in some cases be inconsistent with increasing shareholder wealth. Chapter 12 provides a more detailed description of the relationship between ratios and shareholder value. If a ﬁrm takes steps to improve its ROE, does this mean that shareholder wealth will also increase? Explain.

Looking Beyond the Numbers Hopefully, working through this chapter has helped your understanding of ﬁnancial statements and improved your ability to interpret accounting numbers. These important and basic skills are necessary when making business decisions, evaluating performance, and forecasting likely future developments. Students might want to Sound ﬁnancial analysis involves more than just calculating numbers—good analyrefer to AAII’s educational web site at http://www.aaii. sis requires that certain qualitative factors be considered when evaluating a company. com. The site provides inThese factors, as summarized by the American Association of Individual Investors formation on investing ba(AAII), include the following: sics, ﬁnancial planning, portfolio management, and the like, so individuals can manage their own assets more effectively.

1. Are the company’s revenues tied to one key customer? If so, the company’s performance may decline dramatically if the customer goes elsewhere. On the other hand, if the relationship is ﬁrmly entrenched, this might actually stabilize sales. 2. To what extent are the company’s revenues tied to one key product? Companies that rely on a single product may be more efﬁcient and focused, but a lack of diversiﬁcation increases risk. If revenues come from several different products, the overall bottom line will be less affected by a drop in the demand for any one product. 3. To what extent does the company rely on a single supplier? Depending on a single supplier may lead to unanticipated shortages and thus to lower proﬁts. 4. What percentage of the company’s business is generated overseas? Companies with a large percentage of overseas business are often able to realize higher growth and larger proﬁt margins. However, ﬁrms with large overseas operations also ﬁnd that the value of their operations depends in large part on the value of the local currency. Thus, ﬂuctuations in currency markets create additional risks for ﬁrms with large overseas operations. In addition, the political stability of the region is important. 5. Competition. Generally, increased competition lowers prices and proﬁt margins. In forecasting future performance, it is important to assess both the likely actions of the current competition and the likelihood of new competitors in the future. 6. Future prospects. Does the company invest heavily in research and development? If so, its future prospects may depend critically on the success of new products in the pipeline. For example, the market’s assessment of a computer company depends on how next year’s products are shaping up. Likewise, investors in pharmaceutical companies are interested in knowing whether the company has developed any potential blockbuster drugs that are doing well in the required tests. 7. Legal and regulatory environment. Changes in laws and regulations have important implications for many industries. For example, when forecasting the future of tobacco companies, it is crucial to factor in the effects of proposed regulations and pending or likely lawsuits. Likewise, when assessing banks, telecommunications ﬁrms, and electric utilities, analysts need to forecast both the extent to which

395

Analysis of Financial Statements Questions

399

these industries will be regulated in the years ahead, and the ability of individual ﬁrms to respond to changes in regulation. What are some qualitative factors analysts should consider when evaluating a company’s likely future ﬁnancial performance?

Summary The primary purpose of this chapter was to discuss techniques used by investors and managers to analyze ﬁnancial statements. The key concepts covered are listed below. 䊉 Financial statement analysis generally begins with a set of ﬁnancial ratios designed to reveal a company’s strengths and weaknesses as compared with other companies in the same industry, and to show whether its ﬁnancial position has been improving or deteriorating over time. 䊉 Liquidity ratios show the relationship of a ﬁrm’s current assets to its current liabilities, and thus its ability to meet maturing debts. Two commonly used liquidity ratios are the current ratio and the quick, or acid test, ratio. 䊉 Asset management ratios measure how effectively a ﬁrm is managing its assets. These ratios include inventory turnover, days sales outstanding, ﬁxed assets turnover, and total assets turnover. 䊉 Debt management ratios reveal (1) the extent to which the ﬁrm is ﬁnanced with debt and (2) its likelihood of defaulting on its debt obligations. They include the debt ratio, times-interest-earned ratio, and EBITDA coverage ratio. 䊉 Proﬁtability ratios show the combined effects of liquidity, asset management, and debt management policies on operating results. They include the proﬁt margin on sales, the basic earning power ratio, the return on total assets, and the return on common equity. 䊉 Market value ratios relate the ﬁrm’s stock price to its earnings, cash ﬂow, and book value per share, thus giving management an indication of what investors think of the company’s past performance and future prospects. These include the price/earnings ratio, price/cash ﬂow ratio, and the market/book ratio. 䊉 Trend analysis, where one plots a ratio over time, is important, because it reveals whether the ﬁrm’s condition has been improving or deteriorating over time. 䊉 The Du Pont system is designed to show how the proﬁt margin on sales, the assets turnover ratio, and the use of debt interact to determine the rate of return on equity. The ﬁrm’s management can use the Du Pont system to analyze ways of improving performance. 䊉 Benchmarking is the process of comparing a particular company with a group of “benchmark” companies. 䊉 ROE is important, but it does not take account of either the amount of investment or risk. Ratio analysis has limitations, but used with care and judgment, it can be very helpful.

Questions 10–1

Deﬁne each of the following terms: a. Liquidity ratios: current ratio; quick, or acid test, ratio b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO); ﬁxed assets turnover ratio; total assets turnover ratio

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Analysis of Financial Statements c. Financial leverage: debt ratio; times-interest-earned (TIE) ratio; coverage ratio d. Proﬁtability ratios: proﬁt margin on sales; basic earning power (BEP) ratio; return on total assets (ROA); return on common equity (ROE) e. Market value ratios: price/earnings (P/E) ratio; price/cash ﬂow ratio; market/book (M/B) ratio; book value per share f. Trend analysis; comparative ratio analysis; benchmarking g. Du Pont chart; Du Pont equation h. “Window dressing”; seasonal effects on ratios

10–2

Financial ratio analysis is conducted by four groups of analysts: managers, equity investors, long-term creditors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios?

10–3

Over the past year, M. D. Ryngaert & Co. has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the company’s sales, quick ratio, and ﬁxed assets turnover ratio have remained constant. What explains these changes?

10–4

Proﬁt margins and turnover ratios vary from one industry to another. What differences would you expect to ﬁnd between a grocery chain such as Safeway and a steel company? Think particularly about the turnover ratios, the proﬁt margin, and the Du Pont equation.

10–5

How might (a) seasonal factors and (b) different growth rates distort a comparative ratio analysis? Give some examples. How might these problems be alleviated?

10–6

Why is it sometimes misleading to compare a company’s ﬁnancial ratios with other ﬁrms that operate in the same industry?

Self-Test Problems (Solutions Appear in Appendix A) ST–1 DEBT RATIO

ST–2

K. Billingsworth & Co. had earnings per share of $4 last year, and it paid a $2 dividend. Total retained earnings increased by $12 million during the year, while book value per share at year-end was $40. Billingsworth has no preferred stock, and no new common stock was issued during the year. If Billingsworth’s year-end debt (which equals its total liabilities) was $120 million, what was the company’s year-end debt/assets ratio? The following data apply to A.L. Kaiser & Company (millions of dollars):

RATIO ANALYSIS

Cash and marketable securities Fixed assets Sales Net income Quick ratio Current ratio DSO ROE

$100.00 $283.50 $1,000.00 $50.00 2.0⫻ 3.0⫻ 40.55 days 12%

Kaiser has no preferred stock—only common equity, current liabilities, and long-term debt. a. Find Kaiser’s (1) accounts receivable (A/R), (2) current liabilities, (3) current assets, (4) total assets, (5) ROA, (6) common equity, and (7) long-term debt. b. In part a, you should have found Kaiser’s accounts receivable (A/R) ⫽ $111.1 million. If Kaiser could reduce its DSO from 40.55 days to 30.4 days while holding other things constant, how much cash would it generate? If this cash were used to buy back common stock (at book value), thus reducing the amount of common equity, how would this affect (1) the ROE, (2) the ROA, and (3) the total debt/ total assets ratio?

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Analysis of Financial Statements Problems

401

Problems 10–1 LIQUIDITY RATIOS

10–2 DAYS SALES OUTSTANDING

10–3 DEBT RATIO

10–4 DU PONT ANALYSIS

10–5

Ace Industries has current assets equal to $3 million. The company’s current ratio is 1.5, and its quick ratio is 1.0. What is the ﬁrm’s level of current liabilities? What is the ﬁrm’s level of inventories? Baker Brothers has a DSO of 40 days. The company’s average daily sales are $20,000. What is the level of its accounts receivable? Assume there are 365 days in a year. Bartley Barstools has an equity multiplier of 2.4. The company’s assets are ﬁnanced with some combination of long-term debt and common equity. What is the company’s debt ratio? Doublewide Dealers has an ROA of 10 percent, a 2 percent proﬁt margin, and a return on equity equal to 15 percent. What is the company’s total assets turnover? What is the ﬁrm’s equity multiplier? Assume you are given the following relationships for the Brauer Corporation:

RATIO CALCULATIONS

Sales/total assets Return on assets (ROA) Return on equity (ROE)

1.5⫻ 3% 5%

Calculate Brauer’s proﬁt margin and debt ratio. 10–6 LIQUIDITY RATIOS

10–7 RATIO CALCULATIONS

10–8 TIMES-INTEREST-EARNED RATIO

10–9 RATIO ANALYSIS

The Petry Company has $1,312,500 in current assets and $525,000 in current liabilities. Its initial inventory level is $375,000, and it will raise funds as additional notes payable and use them to increase inventory. How much can Petry’s short-term debt (notes payable) increase without pushing its current ratio below 2.0? What will be the ﬁrm’s quick ratio after Petry has raised the maximum amount of short-term funds? The Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0, an inventory turnover of 6 times, total current assets of $810,000, and cash and marketable securities of $120,000. What were Kretovich’s annual sales and its DSO? Assume a 365-day year. The H.R. Pickett Corporation has $500,000 of debt outstanding, and it pays an interest rate of 10 percent annually. Pickett’s annual sales are $2 million, its average tax rate is 30 percent, and its net proﬁt margin on sales is 5 percent. If the company does not maintain a TIE ratio of at least 5 times, its bank will refuse to renew the loan, and bankruptcy will result. What is Pickett’s TIE ratio? Data for Barry Computer Company and its industry averages follow. a. Calculate the indicated ratios for Barry. b. Construct the extended Du Pont equation for both Barry and the industry. c. Outline Barry’s strengths and weaknesses as revealed by your analysis. d. Suppose Barry had doubled its sales as well as its inventories, accounts receivable, and common equity during 2002. How would that information affect the validity of your ratio analysis? (Hint: Think about averages and the effects of rapid growth on ratios if averages are not used. No calculations are needed.) Barry Computer Company: Balance Sheet as of December 31, 2002 (In Thousands) Cash Receivables Inventories Total current assets Net ﬁxed assets

$ 77,500 336,000 241,500 $655,000 292,500

Total assets

$947,500

Accounts payable Notes payable Other current liabilities Total current liabilities Long-term debt Common equity Total liabilities and equity

$129,000 84,000 117,000 $330,000 256,500 361,000 $947,500

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Analysis of Financial Statements Barry Computer Company: Income Statement for Year Ended December 31, 2002 (In Thousands) Sales Cost of goods sold Selling, general, and administrative expenses Earnings before interest and taxes (EBIT) Interest expense Earnings before taxes (EBT) Federal and state income taxes (40%) Net income Ratio

$1,607,500 1,392,500 145,000 $ 70,000 24,500 $ 45,500 18,200 $ 27,300 Barry

Current assets/current liabilities Days sales outstandinga Sales/inventory Sales/ﬁxed assets Sales/total assets Net income/sales Net income/total assets Net income/common equity Total debt/total assets

Industry Average

2.0⫻ 35 days 6.7⫻ 12.1⫻ 3.0⫻ 1.2% 3.6% 9.0% 60.0%

a

Calculation is based on a 365-day year.

10–10 BALANCE SHEET ANALYSIS

Complete the balance sheet and sales information in the table that follows for Hoffmeister Industries using the following ﬁnancial data: Debt ratio: 50% Quick ratio: 0.80⫻ Total assets turnover: 1.5⫻ Days sales outstanding: 36.5 daysa Gross proﬁt margin on sales: (Sales ⫺ Cost of goods sold)/Sales ⫽ 25% Inventory turnover ratio: 5⫻ a

Calculation is based on a 365-day year.

BALANCE SHEET

Cash Accounts receivable Inventories Fixed assets Total assets Sales

10–11 RATIO ANALYSIS

$300,000

Accounts payable Long-term debt Common stock Retained earnings Total liabilities and equity

60,000 97,500

Cost of goods sold

The Corrigan Corporation’s forecasted 2003 ﬁnancial statements follow, along with some industry average ratios. a. Calculate Corrigan’s 2003 forecasted ratios, compare them with the industry average data, and comment brieﬂy on Corrigan’s projected strengths and weaknesses. b. What do you think would happen to Corrigan’s ratios if the company initiated cost-cutting measures that allowed it to hold lower levels of inventory and substantially decreased the cost of goods sold? No calculations are necessary. Think about which ratios would be affected by changes in these two accounts.

399

Analysis of Financial Statements Problems Corrigan Corporation: Forecasted Balance Sheet as of December 31, 2003 Cash Accounts receivable Inventories Total current assets Fixed assets Total assets Accounts and notes payable Accruals Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

$

72,000 439,000 894,000 $1,405,000 431,000 $1,836,000 $ 432,000 170,000 $ 602,000 404,290 575,000 254,710 $1,836,000

Corrigan Corporation: Forecasted Income Statement for 2003 Sales Cost of goods sold Selling, general, and administrative expenses Depreciation Earnings before taxes (EBT) Taxes (40%) Net income

$ 4,290,000 3,580,000 370,320 159,000 $ 180,680 72,272 $ 108,408

Per-Share Data EPS Cash dividends per share P/E ratio Market price (average) Number of shares outstanding

$4.71 $0.95 5⫻ $23.57 23,000

Industry Financial Ratios (2003)a Quick ratio Current ratio Inventory turnoverb Days sales outstandingc Fixed assets turnoverb Total assets turnoverb Return on assets Return on equity Debt ratio Proﬁt margin on sales P/E ratio P/cash ﬂow ratio

a

Industry average ratios have been constant for the past 4 years. Based on year-end balance sheet ﬁgures. c Calculation is based on a 365-day year. b

1.0⫻ 2.7⫻ 7.0⫻ 32 days 13.0⫻ 2.6⫻ 9.1% 18.2% 50.0% 3.5% 6.0⫻ 3.5⫻

403

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Spreadsheet Problem 10–12 BUILD A MODEL: RATIO ANALYSIS

See Ch 10 Show.ppt for a PowerPoint presentation of the Mini Case and Ch 10 Mini Case.xls for detailed calculations.

Start with the partial model in the ﬁle Ch 10 P12 Build a Model.xls from the textbook’s web site. This problem requires you to further analyze the ﬁnancial data given for Cumberland Industries in the Build a Model problem for Chapter 9. Cumberland Industries’ common stock has increased in price from $14.75 to $17.25 from the end of 2001 to the end of 2002, and its shares outstanding increased from 9 to 10 million shares during that same period. Cumberland has annual lease payments of $75,000 (which is included in operating costs on the income statement), but no sinking fund payments are required. Now answer the following questions. Using Cumberland’s ﬁnancial statements as given in the Chapter 9 Build a Model problem, perform a ratio analysis for 2001 and 2002. Consider its liquidity, asset management, debt management, proﬁtability, and market value ratios. a. Has Cumberland’s liquidity position improved or worsened? Explain. b. Has Cumberland’s ability to manage its assets improved or worsened? Explain. c. How has Cumberland’s proﬁtability changed during the last year? d. Perform an extended Du Pont analysis for Cumberland for 2001 and 2002. e. Perform a common size analysis. What has happened to the composition (that is, percentage in each category) of assets and liabilities? f. Perform a percent change analysis. What does this tell you about the change in proﬁtability and asset utilization?

The ﬁrst part of the case, presented in Chapter 9, discussed the situation that Computron Industries was in after an expansion program. Thus far, sales have not been up to the forecasted level, costs have been higher than were projected, and a large loss occurred in 2002, rather than the expected proﬁt. As a result, its managers, directors, and investors are concerned about the ﬁrm’s survival. Donna Jamison was brought in as assistant to Fred Campo, Computron’s chairman, who had the task of getting the company back into a sound ﬁnancial position. Computron’s 2001 and 2002 balance sheets and income statements, together with projections for 2003, are shown in the following tables. Also, the tables show the 2001 and 2002 ﬁnancial ratios, along with industry average data. The 2003 projected ﬁnancial statement data represent Jamison’s and Campo’s best guess for 2003 results, assuming that some new ﬁnancing is arranged to get the company “over the hump.” BALANCE SHEETS

2001

2002

2003E

Assets Cash Short-term investments Accounts receivable Inventories Total current assets Gross ﬁxed assets Less: Accumulated depreciation Net ﬁxed assets Total assets NOTE:

$

9,000 48,600 351,200 715,200 $1,124,000 491,000 146,200 $ 344,800 $1,468,800

“E” indicates estimated. The 2003 data are forecasts.

$

7,282 20,000 632,160 1,287,360 $1,946,802 1,202,950 263,160 $ 939,790 $2,886,592

$

14,000 71,632 878,000 1,716,480 $2,680,112 1,220,000 383,160 $ 836,840 $3,516,952

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Analysis of Financial Statements Mini Case

405

2001

2002

2003E

$ 145,600 200,000 136,000 $ 481,600 323,432 460,000 203,768 $ 663,768 $1,468,800

$ 324,000 720,000 284,960 $1,328,960 1,000,000 460,000 97,632 $ 557,632 $2,886,592

$ 359,800 300,000 380,000 $1,039,800 500,000 1,680,936 296,216 $1,977,152 $3,516,952

Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term debt Common stock (100,000 shares) Retained earnings Total equity Total liabilities and equity NOTE:

“E” indicates estimated. The 2003 data are forecasts.

INCOME STATEMENTS

2001

Sales Cost of goods sold Other expenses Depreciation Total operating costs EBIT Interest expense EBT Taxes (40%) Net income

$3,432,000 2,864,000 340,000 18,900 $3,222,900 $ 209,100 62,500 $ 146,600 58,640 $ 87,960

2002

$5,834,400 4,980,000 720,000 116,960 $5,816,960 $ 17,440 176,000 ($ 158,560) (63,424) ($ 95,136)

2003E

$7,035,600 5,800,000 612,960 120,000 $6,532,960 $ 502,640 80,000 $ 422,640 169,056 $ 253,548

2001

2002

2003E

$8.50 100,000 $0.880 $0.220 40% $6.638 $40,000

$6.00 100,000 ($0.951) 0.110 40% $5.576 $40,000

$12.17 250,000 $1.014 0.220 40% $7.909 $40,000

Other Data Stock price Shares outstanding EPS DPS Tax rate Book value per share Lease payments NOTE:

“E” indicates estimated. The 2003 data are forecasts.

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Analysis of Financial Statements

RATIO ANALYSIS

Current Quick Inventory turnover Days sales outstanding Fixed assets turnover Total assets turnover Debt ratio TIE EBITDA coverage Proﬁt margin Basic earning power ROA ROE Price/earnings (P/E) Price/cash ﬂow Market/book NOTE:

2001

2002

2003E

2.3⫻ 0.8⫻ 4.8⫻ 37.3 10.0⫻ 2.3⫻ 54.8% 3.3⫻ 2.6⫻ 2.6% 14.2% 6.0% 13.3% 9.7⫻ 8.0⫻ 1.3⫻

1.5⫻ 0.5⫻ 4.5⫻ 39.6 6.2⫻ 2.0⫻ 80.7% 0.1⫻ 0.8⫻ ⫺1.6% 0.6% ⫺3.3% ⫺17.1% ⫺6.3⫻ 27.5⫻ 1.1⫻

— — — — — — — — — — — — — — — —

Industry Average

2.7⫻ 1.0⫻ 6.1⫻ 32.0 7.0⫻ 2.5⫻ 50.0% 6.2⫻ 8.0⫻ 3.6% 17.8% 9.0% 17.9% 16.2⫻ 7.6⫻ 2.9⫻

“E” indicates estimated. The 2003 data are forecasts.

Jamison examined monthly data for 2002 (not given in the case), and she detected an improving pattern during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned to a small proﬁt by December. Thus, the annual data looked somewhat worse than ﬁnal monthly data. Also, it appears to be taking longer for the advertising program to get the message across, for the new sales ofﬁces to generate sales, and for the new manufacturing facilities to operate efﬁciently. In other words, the lags between spending money and deriving beneﬁts were longer than Computron’s managers had anticipated. For these reasons, Jamison and Campo see hope for the company—provided it can survive in the short run. Jamison must prepare an analysis of where the company is now, what it must do to regain its ﬁnancial health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or no answers. a. Why are ratios useful? What are the ﬁve major categories of ratios? b. Calculate the 2003 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company’s liquidity position in 2001, 2002, and as projected for 2003? We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysts have an equal interest in the liquidity ratios? c. Calculate the 2003 inventory turnover, days sales outstanding (DSO), ﬁxed assets turnover, and total assets turnover. How does Computron’s utilization of assets stack up against other ﬁrms in its industry? d. Calculate the 2003 debt, times-interest-earned, and EBITDA coverage ratios. How does Computron compare with the industry with respect to ﬁnancial leverage? What can you conclude from these ratios? e. Calculate the 2003 proﬁt margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios? f. Calculate the 2003 price/earnings ratio, price/cash ﬂow ratio, and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?

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Analysis of Financial Statements Selected Additional References and Cases

407

g. Perform a common size analysis and percent change analysis. What do these analyses tell you about Computron? h. Use the extended Du Pont equation to provide a summary and overview of Computron’s ﬁnancial condition as projected for 2003. What are the ﬁrm’s major strengths and weaknesses? i. What are some potential problems and limitations of ﬁnancial ratio analysis? j. What are some qualitative factors analysts should consider when evaluating a company’s likely future ﬁnancial performance?

Selected Additional References and Cases The effects of alternative accounting policies on both ﬁnancial statements and ratios based on these statements are discussed in the books referenced in Chapter 9. For further information on the relative usefulness of various ﬁnancial ratios, see Chen, Kung H., and Thomas A. Shimerda, “An Empirical Analysis of Useful Financial Ratios,” Financial Management, Spring 1981, 51–60. Considerable work has been done to establish the relationship between bond ratings and ﬁnancial ratios. For one example, see Belkaoui, Ahmed, Industrial Bonds and the Rating Process (London: Quorum Books, 1983). For sources of ratios and common size statements, see the following: Dun & Bradstreet, Key Business Ratios (New York: Updated annually).

Financial Research Associates, Financial Studies of the Small Business (Arlington, VA: Updated annually). Robert Morris Associates, Annual Statement Studies (Philadelphia: Updated annually). The following cases from the Cases in Financial Management series focus on ﬁnancial analysis: Case 35, “Mark X Company (A),” which illustrates the use of ratio analysis in the evaluation of a ﬁrm’s existing and potential ﬁnancial positions. Case 36, “Garden State Container Corporation,” which is similar in content to Case 35. Case 36A, “Safe Packaging Corporation,” which updates Case 36.

11 11

Financial Planning and Forecasting Financial Statements Many

managers compare ﬁnancial planning with having a root canal: timeconsuming and painful. Even worse, they are left with nagging doubts that the results might not be very reliable. According to a recent survey of ﬁnance professionals, only 45 percent are satisﬁed with their current planning process, and 90 percent believe it is too cumbersome. Nevertheless, 71 percent of the ﬁnance professionals believe longterm strategic planning is the single most critical activity for future success. What’s wrong with the current planning process? First, it’s too slow. The process typically starts in July and ends in December. Given the ever-shortening life cycles of many products, plans are often out of date before they are completed. Second, it requires a considerable amount of managerial effort. On average, ﬁve full-time ﬁnance employees plus eight full-time nonﬁnance employees each spend four person-months on planning, equivalent to 4.33 person-years. The process begins with data acquisition, including sales revenues, costs, inventories, batch sizes, defect rates, the number of repeat customers, product mix by customertype, and hours of employee-training. Unfortunately, only 24 percent of companies currently have a uniﬁed planning and reporting system—most have stand-alone software packages and spreadsheets that vary from division to division, making data acquisition time-consuming and error-ﬁlled. The next step is setting targets for growth and ﬁnancial results. Instead of basing targets on analysis, they are often set through negotiation between staff managers who make the budgets and line managers who must execute them. Fully 66 percent of managers believe planning is inﬂuenced more by politics than strategy. Given the importance of ﬁnancial planning, it’s not surprising that many companies are reengineering their processes, with plenty of help from consulting ﬁrms and software vendors. With information technology that standardizes data, links data throughout the company, and pulls it directly into the planning process, many companies are dramatically shortening the planning cycle. For example, Sprint replaced annual budgets with quarterly reviews, and Nationwide Financial Services reduced its budget cycle from four months to a few weeks. Similar revolutions are occurring in forecasting, with analysis replacing politics. A recent survey reported that 81 percent of companies use trend-based projections, 41 percent use activity based management (i. e., linking ﬁnancial forecasts to nonﬁnancial data), and 22 percent use simulations. As a result of better data, better forecasting techniques, and shorter planning cycles, many companies now have more accurate and useful ﬁnancial plans.

Sources: Fritz McCormick, “Fewer and Fewer Beans,” CFO, October 1999, 18; Susan Arterian, “Sprint Retools the Budget Process,” CFO, September 1997, 88–91; Russ Banham, “The Revolution in Planning,” CFO, August 1999, 46–56; and Cathy Lazere, “All Together Now,” CFO, February 1998, 28–36.

408

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Financial Planning and Forecasting Financial Statements Overview of Financial Planning

409

Chapters 9 and 10 described what ﬁnancial statements are and showed how both managers and investors analyze them to evaluate a ﬁrm’s past performance. While this is clearly important, it is even more important to look ahead and to anticipate what is likely to happen in the future. So, both managers and investors need to understand how to forecast future results. Managers make pro forma, or projected, ﬁnancial statements and then use them in four ways: (1) By looking at projected statements, they can assess whether the ﬁrm’s anticipated performance is in line with the ﬁrm’s own general targets and with investors’ expectations. For example, if the projected ﬁnancial statements indicate that the forecasted return on equity is well below the industry average, managers should investigate the cause and then seek a remedy. (2) Pro forma statements can be used to estimate the effect of proposed operating changes. Therefore, ﬁnancial managers spend a The textbook’s web site lot of time doing “what if” analyses. (3) Managers use pro forma statements to anticicontains an Excel ﬁle that pate the ﬁrm’s future ﬁnancing needs. (4) Projected ﬁnancial statements are used to estiwill guide you through the mate future free cash ﬂows, which determine the company’s overall value. Thus, manchapter’s calculations. The ﬁle for this chapter is Ch 11 agers forecast free cash ﬂows under different operating plans, forecast their capital Tool Kit.xls and we encour- requirements, and then choose the plan that maximizes shareholder value. Security anage you to open the ﬁle and alysts make the same types of projections, forecasting future earnings, cash ﬂows, and follow along as you read the stock prices. chapter. We will have more to say about managers’ and investors’ use of projections in Chapter 12, when we discuss corporate valuation and value-based management. First, though, in this chapter we explain how to create and use pro forma ﬁnancial statements. We begin with an overview of the planning process.

Overview of Financial Planning Our primary objective in this book is to explain what managers can do to make their companies more valuable. Managers must understand how investors determine the values of stocks and bonds if they are to identify, evaluate, and implement projects that meet or exceed investor expectations. However, value creation is impossible unless the company has a well-articulated plan. As Yogi Berra once said, “You’ve got to be careful if you don’t know where you’re going, because you might not get there.”

Strategic Plans Strategic plans usually begin with a statement of the overall corporate purpose. Most companies are very clear about their corporate purpose: “Our mission is to maximize shareowner value over time.” This corporate purpose is increasingly common for U.S. companies, but that has not always been the case. For example, Varian Associates, Inc., a New York Stock Exchange company with sales of almost $2 billion, was, in 1990, regarded as one of the most technologically advanced electronics companies. However, Varian’s management was more concerned with developing new technology than with marketing it, and its stock price was lower than it had been ten years earlier. Some of the larger stockholders were intensely unhappy with the state of affairs, and management was faced with the threat of a proxy ﬁght or forced merger. In 1991, management announced a change in policy and stated that it would, in the future, emphasize both technological excellence and proﬁtability, rather than focusing primarily on technology. Earnings improved dramatically, and the stock price rose from $6.75 to more than $60 within four years of that change in corporate purpose.

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A corporate focus on creating wealth for the company’s owners is not yet as common abroad as it is in the United States. For example, Veba AG, one of Germany’s largest companies, created a stir in 1996 when it stated in its annual report that “Our commitment is to create value for you, our shareholders.” This was quite different from the usual German model, in which companies have representatives from labor on their boards of directors and which explicitly state their commitments to a variety of stakeholders. As one might expect, Veba’s stock has consistently outperformed the average German stock. As the trend in international investing continues, more and more non-U.S. companies are adopting a corporate purpose similar to that of Varian and Veba. Its corporate scope deﬁnes a ﬁrm’s lines of business and geographic area of operations. For example, Coca-Cola limits its products to soft drinks, but on a global scale. Pepsi-Cola recently followed Coke’s lead—it restricted its scope by spinning off its food service businesses. Several recent studies have found that the market tends to value focused ﬁrms more highly than diversiﬁed ﬁrms.1 The steel industry provides a study in contrasts. USX Corporation (formerly U.S. Steel) has diversiﬁed widely while Nucor Corporation (the second largest steel company) has stuck closely to the basic steel business. Here is Nucor’s position: We are a manufacturing company producing primarily steel products. Nucor’s major strength is constructing plants economically and operating them efﬁciently.

During the last decade, an investment in Nucor’s stock has increased by more than 8 percent per year, while an investment in USX has decreased by more than 6 percent per year. Many factors caused these results, but scope and focus certainly played an important role. The corporate purpose states the general philosophy of the business, but it does not provide managers with operational objectives. The statement of corporate objectives sets forth speciﬁc goals to guide management. Most organizations have both qualitative and quantitative objectives. A typical quantitative objective might be attaining a 50 percent market share, a 20 percent ROE, a 10 percent earnings growth rate, or a $100 million economic value added (EVA). Once a ﬁrm has deﬁned its purpose, scope, and objectives, it must develop a strategy for achieving its goals. Corporate strategies are broad approaches rather than detailed plans. For example, one airline may have a strategy of offering no-frills service between a limited number of cities, while another’s strategy may be to offer “staterooms in the sky.” Any such strategy should be both attainable and compatible with the ﬁrm’s purpose, scope, and objectives.

Operating Plans Operating plans provide detailed implementation guidance, based on the stated corporate strategy, to help meet the corporate objectives. These plans can be developed for any time horizon, but most companies use a ﬁve-year horizon. A ﬁve-year plan is most detailed for the ﬁrst year, with each succeeding year’s plan becoming less speciﬁc. The plan explains in considerable detail who is responsible for each particular function, when speciﬁc tasks are to be accomplished, sales and proﬁt targets, and the like.

1

See, for example, Philip G. Berger and Eli Ofek, “Diversiﬁcation’s Effect on Firm Value,” Journal of Financial Economics, Vol. 37, No. 1, 39–66 (1995); and Larry Lang and René Stulz, “Tobin’s Q, Corporate Diversiﬁcation, and Firm Performance,” Journal of Political Economy, Vol. 102, Issue 6, 1248–1280 (1994).

407

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Financial Planning and Forecasting Financial Statements Sales Forecast

411

It should be noted that large, multidivisional companies such as General Electric break down their operating plans by divisions. Thus, each division has its own goals, mission, and plan for meeting its objectives, and these plans are then consolidated to form the corporate plan.

The Financial Plan The ﬁnancial planning process can be broken down into these steps: 1. Project ﬁnancial statements and use these projections to analyze the effects of the operating plan on projected proﬁts and ﬁnancial ratios. The projections can also be used to monitor operations after the plan has been ﬁnalized and put into effect. Rapid awareness of deviations from the plan is essential in a good control system, which, in turn, is essential to corporate success in a changing world. 2. Determine the funds needed to support the ﬁve-year plan. This includes funds for plant and equipment as well as for inventories and receivables, R&D programs, and major advertising campaigns. 3. Forecast funds availability over the next ﬁve years. This involves estimating the funds to be generated internally as well as those to be obtained from external sources. Any constraints on operating plans imposed by ﬁnancial restrictions must be incorporated into the plan. Constraints include restrictions on the debt ratio, the current ratio, and the coverage ratios. 4. Establish a performance-based management compensation system. It is critically important that ﬁrms reward managers for doing what stockholders want them to do—maximize share prices. In the remainder of this chapter, we explain how to create a ﬁnancial plan, including its three key components: (1) the sales forecast, (2) pro forma ﬁnancial statements, and (3) the external ﬁnancing plan. We discuss compensation in Chapter 12. What are four ways that managers use pro forma statements? Brieﬂy explain the following terms: (1) corporate purpose, (2) corporate scope, (3) corporate objectives, and (4) corporate strategies. Brieﬂy describe the contents of an operating plan. What are the four steps of the ﬁnancial planning process?

Sales Forecast

See Ch 11 Tool Kit.xls for details.

The sales forecast generally starts with a review of sales during the past ﬁve to ten years, expressed in a graph such as that in Figure 11-1. The ﬁrst part of the graph shows ﬁve years of historical sales for MicroDrive. The graph could have contained 10 years of sales data, but MicroDrive typically focuses on sales ﬁgures for the latest ﬁve years because the ﬁrm’s studies have shown that its future growth is more closely related to recent events than to the distant past. Entire courses are devoted to forecasting sales, so we can only touch on the basic elements here. However, forecasting the future sales growth rate always begins with a look at past growth. Techniques for estimating the past growth rate range from the very simple to the quite complex. For example, the average of MicroDrive’s recent annual growth rates is 10.3 percent. However, the compound growth rate from 1998 to 2002 is the solution value for g in the equation $2,058 (1 g)4 $3,000,

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MicroDrive Inc.: 2002 Sales Projection (Millions of Dollars)

Net Sales ($)

3,000 Regression Line 2,000

1,000

0 1998

1999

2000

Year

Sales

1998 1999 2000 2001 2002

$2,058 2,534 2,472 2,850 3,000

2001

2002

2003

Annual Growth Rate

23.1% 2.4 15.3 5.3 Average 10.3%

and it can be found by solving the equation or with a ﬁnancial calculator, entering N 4, PV 2058, PMT 0, FV 3000, and then pressing I to get g 9.9 percent. The preceding approaches are simple, but both can be poor representations of past growth. First, the averaging procedure generally produces numbers that are too high. To illustrate why, suppose sales grew by 100 percent one year and then fell by 50 percent the next year. There would actually be zero growth over the two years, but the calculated average growth rate would be 25 percent. Similarly, the point-to-point procedure is not reliable because if either the beginning or ending year is an “outlier” in the sense of being above or below the trend line shown in Figure 11-1, then the calculated growth rate will not be representative of past growth. The solution to these problems is to use a regression approach, where a curve is ﬁtted to the historic sales data and then the slope of that curve is used to measure historic growth. If we expect a constant growth rate (as opposed to a constant dollar amount, which would mean a declining growth rate), then the regression should be based on the natural log of sales, not sales itself. With a spreadsheet, this is not a difﬁcult calculation, but by far the easiest way to calculate the growth rate is with Excel’s LOGEST function. Simply type the years and sales into a spreadsheet, click fx on the menu bar, select Statistical functions, and then choose the LOGEST function. Highlight the sales range for the Y variable and the years range for X in the function dialog box, and then click OK. The result will be 1 g, so you ﬁnish by subtracting 1 to get the growth rate. For MicroDrive, the growth rate is 9.1 percent.2 2 These approaches are demonstrated in the Ch 11 Tool Kit.xls. Also, the Chapter 6 Web Extension illustrates these approaches when estimating dividend growth rates.

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413

Although it is useful to calculate the past growth rate in sales, much more is involved in estimating future sales. Future sales will depend on the economy (both domestic and global), the industry’s prospects, the company’s current product line, proposed products that are in the pipeline, and marketing campaigns. When MicroDrive incorporated these issues into its analysis, the expected growth for the upcoming year was estimated to be 10 percent. If the sales forecast is off, the consequences can be serious. First, if the market expands by more than MicroDrive has prepared, the company will not be able to meet demand. Its customers will end up buying competitors’ products, and MicroDrive will lose market share. On the other hand, if its projections are overly optimistic, MicroDrive could end up with too much plant, equipment, and inventory. That would mean low turnover ratios, high costs for depreciation and storage, and write-offs of obsolete inventory. All of this would result in low proﬁts, a low rate of return on equity, low free cash ﬂows, and a depressed stock price. If MicroDrive had ﬁnanced an unnecessary expansion with debt, high interest charges would compound its problems. Thus, an accurate sales forecast is critical to the ﬁrm’s wellbeing.3 List some factors that should be considered when developing a sales forecast. Explain why an accurate sales forecast is critical to proﬁtability.

Financial Statement Forecasting: The Percent of Sales Method Once sales have been forecasted, we must forecast future balance sheets and income statements. The most commonly used technique is the percent of sales method, which begins with the sales forecast, expressed as an annual growth rate in dollar sales revenues. Many items on the income statement and balance sheets are assumed to increase proportionally with sales, with their values for a particular year estimated as percentages of the forecasted sales for that year. The remaining items on the forecasted statements—items that are not tied directly to sales—depend on the company’s dividend policy and its relative use of debt and equity ﬁnancing. In the following sections we explain the percent of sales method and use it to forecast MicroDrive’s ﬁnancial statements.

Step 1. Analyze the Historical Ratios The ﬁrst step is to analyze the historical ratios. This differs somewhat from the ratio analysis of Chapter 10, since the objective here is to forecast the future, or pro forma, ﬁnancial statements. The percent of sales method assumes that costs in a given year will be some speciﬁed percentage of that year’s sales. Thus, we begin our analysis by calculating the ratio of costs to sales for several past years. We illustrate the method using only two years of data for MicroDrive, but a thorough analysis should have at least ﬁve years of historical data. Table 11-1 shows MicroDrive’s ratio of cost to sales for the past two years for MicroDrive. In 2001, MicroDrive had an 87.6 percent ratio

3

A sales forecast is actually the expected value of a probability distribution, so there are many possible levels of sales. Because any sales forecast is subject to uncertainty, ﬁnancial planners are just as interested in the degree of uncertainty inherent in the sales forecast, as measured by the standard deviation, as in the expected level of sales.

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Financial Planning and Forecasting Financial Statements TABLE 11-1

See Ch 11 Tool Kit.xls for details.

Historical Ratios for MicroDrive Inc.

Costs to sales Depreciation to net plant and equipment Cash to sales Accounts receivable to sales Inventory to sales Net plant and equipment to sales Accounts payable to sales Accruals to sales

Actual 2001

Actual 2002

Historical Average

Industry Average

87.6% 10.3 0.5 11.1 14.6 30.5 1.1 4.6

87.2% 10.0 0.3 12.5 20.5 33.3 2.0 4.7

87.4% 10.2 0.4 11.8 17.5 31.9 1.5 4.6

87.1% 10.2 1.0 10.0 11.1 33.3 1.0 2.0

of cost to sales, and the ratio dropped to 87.2 percent in 2002. The table also shows the historical average, which in this case is the average of the two prior years. The last column shows the ratio of cost to sales for the industry composite, which is the sum of the ﬁnancial statements for all ﬁrms in the industry. Note that MicroDrive has improved its cost/sales ratio, but it still is higher than the industry average. The table also shows the ratio of depreciation to net plant and equipment. Because depreciation depends on the asset base, it is more reasonable to forecast depreciation as a percent of net plant and equipment rather than of sales. Many other items on MicroDrive’s balance sheets will also increase with sales. The company writes and deposits checks every day. Because managers don’t know exactly when all of the checks will clear, they can’t predict exactly what the balance in their checking accounts will be on any given day. Therefore, they must maintain a balance of cash and cash equivalents (such as very short-term marketable securities) to avoid overdrawing their accounts. We discuss the issue of cash management in Chapter 16, but for now we simply assume that the cash required to support the company’s operations is proportional to its sales. Table 11-1 shows the ratio of cash to sale for the past two years, as well as the historical average and the industry composite ratio. All of the remaining pro forma balance sheet ratios, which we discuss below, also are shown in Table 11-1. Unless a company changes its credit policy or has a change in its customer base, accounts receivable should be proportional to sales. Furthermore, as sales increase, ﬁrms generally must carry more inventories. Chapter 16 discusses inventory management in detail, but for now we assume that inventory will also be proportional to sales. It might be reasonable to assume that cash, accounts receivable, and inventories will be proportional to sales, but will the amount of net plant and equipment go up and down as sales go up and down? The correct answer could be either yes or no. When companies acquire plant and equipment, they often install more capacity than they currently need due to economies of scale in building capacity. For example, it was economically better for GM to build its Tennessee Saturn plant with a capacity of about 320,000 cars per year than to build a plant with a capacity equal to the initial projected sales of 50,000 and then add capacity as sales expanded. Saturn’s sales were far below 320,000 units for the ﬁrst few years of production, so it was possible to increase sales during those years without increasing plant and equipment. Moreover, even if a plant is operating at its maximum rated capacity, most companies can produce additional units by reducing downtime for scheduled maintenance, by running machinery at a higher than optimal speed, or by adding a second or third shift. Therefore, at least in the short run, companies may not have a very close relationship between sales and net plant and equipment.

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415

However, some companies do have a ﬁxed relationship between sales and plant and equipment, even in the short term. For example, new stores in many retail chains achieve the same sales during their ﬁrst year as the chain’s existing stores. The only way such retailers can grow (beyond inﬂation) is by adding new stores. Such companies therefore have a strong proportional relationship between ﬁxed assets and sales. Finally, in the long term there is a strong relationship between sales and net plant and equipment for virtually all companies: Few companies can continue to increase sales unless they eventually add capacity. Therefore, as a ﬁrst approximation it is reasonable to assume that the long-term ratio of net plant and equipment to sales will be constant. For the ﬁrst years in a forecast, managers generally build in the actual planned expenditures on plant and equipment. If those estimates are not available, it is generally best to assume a constant ratio of net plant and equipment to sales. Some items on the liability side of the balance sheet can be expected to increase spontaneously with sales, producing what are called spontaneously generated funds. The two primary types of spontaneous funds are accounts payable and accruals. Regarding payables, as sales increase, so will purchases of raw materials, and those larger purchases will spontaneously lead to a higher level of accounts payable. Similarly, more sales will require more labor, while higher sales normally result in higher taxable income and thus taxes. Therefore, accrued wages and taxes both increase. All of the historical ratios are shown in Table 11-1. Using these ratios, along with the industry composite ratios and a knowledge of MicroDrive’s operating plans and industry trends, its managers are ready to begin forecasting the projected, or pro forma, ﬁnancial statements.

Step 2. Forecast the Income Statement In this section we explain how to forecast the income statement, and in the following section we forecast the balance sheet. Although we cover these topics in two separate sections, the forecasted ﬁnancial statements are actually integrated with one another and with the previous year’s statements. For example, the income statement item “depreciation” depends on net plant and equipment, which is a balance sheet item, and “retained earnings,” which is a balance sheet item, depends on the previous year’s retained earnings, the forecasted net income, and the ﬁrm’s dividend policy. Keep this interrelatedness in mind as you go through the forecast. Forecast Sales Table 11-2 shows the forecasted income statement. Management forecasts that sales will grow by 10 percent. Thus, forecasted sales, shown in Row 1, Column 3, is the product of $3,000 million prior year’s sales and (1 g), or $3,000(1.1) $3,300 million.

See Ch 11 Tool Kit.xls for all calculations.

Forecast Earnings before Interest and Taxes (EBIT) Table 11-1 shows that MicroDrive’s ratio of costs to sales for the most recent year was 87.2 percent ($2,616/$3,000 0.872). Thus, to get a dollar of sales, MicroDrive had to incur 87.2 cents of costs. Initially, we assume that the cost structure will remain unchanged. Later on, we explore the impact of changes in the cost structure, but for now we assume that forecasted costs will equal 87.2 percent of forecasted sales. See Row 2 of Table 11-2. The most recent ratio of depreciation to net plant and equipment, shown in Table 11-1, was 10 percent ($100/$1,000 0.10), and MicroDrive’s managers believe this is a good estimate of future depreciation rates. As we show later in Table 11-3 on page 420, the forecasted net plant and equipment is $1,100 million. Therefore, forecasted depreciation is 0.10($1,100) $110 million. Notice how a balance sheet item, net plant and equipment, affects the charge for depreciation, which is an income statement item.

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TABLE 11-2

MicroDrive Inc.: Actual and Projected Income Statements (Millions of Dollars Except for Per Share Data) Actual 2002 (1)

1. Sales 2. Costs except depreciation 3. Depreciation expense 4. Total operating costs 5. EBIT 6. Less Interest 7. Earnings before taxes (EBT) 8. Taxes (40%) 9. NI before preferred dividends 10. Preferred dividends 11. NI available to common

$3,000.0 2,616.2 100.0 $2,716.2 $ 283.8 88.0 $ 195.8 78.3 $ 117.5 4.0 $ 113.5

12. Shares of common equity 13. Dividends per share 14. Dividends to common 15. Additions to retained earnings

$ $ $

50.0 1.15 57.5 56.0

Forecast Basis (2)

110% 2002 Sales 87.2% 2003 Sales 10% 2003 Net plant

(See text for explanation)

Dividend rate 2002 preferred

108% 2002 DPS 2003 DPS Number of shares

Forecast for 2003 (3)

$3,300.0 2,877.6 110.0 $2,987.6 $ 312.4 92.8 $ 219.6 87.8 $ 131.8 4.0 $ 127.8 $ $ $

50.0 1.25 62.5 65.3

Total operating costs, shown on Row 4, are the sum of costs of goods sold plus depreciation, and EBIT is then found by subtraction. Forecast Interest Expense How should we forecast the interest charges? The actual net interest expense is the sum of the ﬁrm’s daily interest charges less its daily interest income, if any, from short-term investments. Most companies have a variety of different debt obligations with different ﬁxed interest rates and/or ﬂoating interest rates. For example, bonds issued in different years generally have different ﬁxed rates, while most bank loans have rates that vary with interest rates in the economy. Given this situation, it is impossible to forecast the exact interest expense for the upcoming year, so we make two simplifying assumptions. Assumption 1. Specifying the Balance of Debt for Computing Interest Expense As noted above, interest on bank loans is calculated daily, based on the amount of debt at the beginning of the day, while bond interest depends on the amount of bonds outstanding. If all of the debt remained constant all during the year, the correct balance to use when forecasting the annual interest expense would be the amount of debt at the beginning of the year, which is the same as the debt shown on the balance sheets at the end of the previous year. But how should you forecast the annual interest expense if debt is expected to change during the year, which is typical for most companies? One option would be to base the interest expense on the debt balance shown at the end of the forecasted year, but this has two disadvantages. First, this would charge a full year’s interest on the additional debt, which would imply that the debt was put in place on January 1. Because this is usually not true, that forecast would overstate the most likely interest expense. Second, this assumption causes circularity in the spreadsheet. We discuss this in detail in the Web Extension to this chapter, but the short explanation is that additional debt causes additional interest expense, which reduces the addition to retained earnings, which in turn requires the ﬁrm to issue additional debt, which causes still more interest expense, and the cycle keeps repeating. This is called ﬁnancing feedback. Spreadsheets can deal with this problem (see the Web Extension to this chapter), but it adds complexity to the model that might not be worth the beneﬁts.

413

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417

A similar approach would be to base the interest expense on the average of the debt at the beginning and end of the year. This approach would produce the correct interest expense only if debt were added evenly throughout the year, which is a big assumption. In addition, it also results in a circular model with all its complexity. A third approach, which we illustrate below, works well for most situations. We base the interest expense on the amount of debt at the beginning of the year as shown on the last balance sheet. However, since this will underestimate the true interest expense if debt increases throughout the year, as it usually does for most companies, we use an interest rate that is about 0.5 percent higher than the rate we actually expect. This approach provides reasonably accurate forecasts without greatly increasing the model’s complexity. Keep in mind, though, that this simple approach might not work well in all situations, so see the Web Extension to this chapter if you want to implement the more complex modeling technique. Assumption 2. Specifying Interest Rates As noted earlier, most ﬁrms pay different interest rates on their different loans. Rather than trying to specify the rate on each separate debt issue, we usually specify only two rates, one for short-term notes payable and one for long-term bonds. The interest rate on short-term debt usually ﬂoats, and because the best estimate of future rates is generally the current rate, it is most reasonable to apply the current market rate to short-term loans. For MicroDrive, the appropriate short-term rate is about 8.5 percent, which we rounded up to 9 percent because we are going to apply it to the debt at the beginning of the year. Most companies’ long-term debt consists of several different bond issues with different interest rates. During the course of the year, some of this debt may be paid off, and some new long-term debt may be added. Rather than try to estimate the interest expense for each particular issue, we apply a single interest rate to the total amount of long-term debt. This rate is an average of the rates on the currently outstanding long-term bonds and the rate that is expected on any new long-term debt. The average rate on MicroDrive’s existing long-term bonds is about 10 percent, and it would have to pay about 10.5 percent on new long-term bonds. The average rate on old and new bonds would be somewhere between 10 and 10.5 percent, which we round up to 11 percent because we are going to apply it to the debt at the beginning of the year, as explained above. Calculating Interest Expense The forecasted interest expense is the net interest paid on short-term ﬁnancing plus the interest on long-term bonds. We estimate the net interest on short-term ﬁnancing by ﬁrst ﬁnding the interest expense on notes payable and then subtracting any interest income from short-term investments. We base interest charges on the amount of short-term debt at the beginning of the year (which is the debt at the end of the previous year), and we note that MicroDrive had no short-term investments. Therefore, MicroDrive’s net short-term interest is 0.09($110) 0.09($0) $9.9 million. The interest on long-term bonds is 0.11($754.0) $82.94, rounded to $82.9 million. Therefore, the total interest expense is $9.9 $82.9 $92.8 million. Completing the Income Statement Earnings before taxes (EBT) is calculated by subtracting interest from EBIT, and then we deduct taxes calculated at a 40 percent rate. The resulting net income before preferred dividends for 2003, which is $131.8 million, is shown on Row 9 of Table 11-2. MicroDrive’s preferred stock pays a dividend of 10 percent. Based on the amount of preferred stock at the beginning of the year, the preferred dividends are equal to 0.10($40) $4 million. Thus, MicroDrive’s forecasted net income available to common stock is $127.8 million, shown in Row 11. Row 12 shows the number of shares of common stock, and Row 13 shows the most recent dividend per share, $1.15. MicroDrive does not plan to issue any new shares,

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but it does plan to increase the dividend by 8 percent, resulting in a forecasted dividend of 1.08($1.15) $1.242, rounded up to $1.25 per share. With 50 million shares, the total forecasted dividend is 50($1.25) $62.5 million. The forecasted addition to retained earnings is equal to the net income available to common stockholders minus the total dividends: $127.8 $62.5 $65.3 million, as shown on Row 15.

Step 3. Forecast the Balance Sheet Before going into the details of forecasting balance sheets, let’s take a look at the big picture. First, a company must have assets to support the sales as forecasted on the income statement, and if sales are growing, then assets typically must also grow. Second, if assets are to grow, then the company must obtain funds to purchase the new assets. Third, the needed funds can come from internal sources, mainly as reinvested earnings, or externally, from the sale of short-term investments, from new loans (either notes payable or long-term bonds), from new stock issues, or by increasing operating current liabilities, mainly accounts payable or accruals. Here are the steps: (1) Determine the amount of new assets needed to support the forecasted sales, (2) determine the amount of internal funds that will be available, and (3) plan to raise any required additional ﬁnancing. This sounds simple, but the devil is in the details. Let’s start with the assets required to support sales. Notice that these consist of operating current assets plus operating long-term assets. The percent of sales approach assumes initially that each class of assets is proportional to sales, so we can forecast all of the assets on MicroDrive’s balance sheet except for short-term investments, which is a nonoperating asset. Many ﬁrms use short-term investments as a temporary repository for any extra cash, or as a “slush fund” for use in times when operating cash ﬂows are lower than expected. We’ll show how to forecast the ﬁnal level of short-term investments shortly, but for now we assume that MicroDrive plans to maintain its current level of short-term investments. The liability side of the balance sheet is a little trickier because it involves both operating effects driven by the sales and costs forecasts and ﬁnancial effects that result from management’s ﬁnancial policy decisions. The percent of sales method is based on the assumption that accounts payable and accruals are both proportional to sales, so given the sales forecast we can forecast operating current liabilities. Forecasting the other liability and equity items is more complicated, because these are affected by the ﬁrm’s ﬁnancial policies, which can vary widely. We explain one fairly typical set of ﬁnancial policies below, and we go through the calculations in detail in the chapter spreadsheet model, Chapter 11 Tool Kit.xls. However, there are many other possible policies. The Web Extension to this chapter describes a procedure that can be used to develop a model to ﬁt any set of ﬁnancial policies. First, as we explain in Chapter 13, most mature companies rarely issue new common stock, so the forecast for common stock is usually the previous year’s common stock. Second, most ﬁrms grow their dividends at a fairly steady rate, which allows us to forecast dividend payments; see Chapter 14 for a discussion of dividend policy. Subtracting forecasted dividends from forecasted net income gives the addition to retained earnings, which allows us to specify the forecasted amount of total common equity. Third, most ﬁrms do not use preferred stock, and those that do issue it infrequently. Therefore, we assume that the forecasted preferred stock is equal to last year’s preferred stock. Fourth, issuing more long-term bonds is a major event for most ﬁrms, and it often requires approval from the board of directors. Chapter 13 discusses long-term debt ﬁnancing in detail, but for now we simply assume that MicroDrive will not issue any new long-term debt, at least in the initial forecast.

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419

Fifth, many ﬁrms use short-term bank loans, shown on the balance sheet as notes payable, as a ﬁnancial “shock absorber.” When extra funding is needed, they draw down their lines of credit, thus increasing notes payable, until their short-term debt has risen to an unacceptably high level, at which point they arrange long-term ﬁnancing. When they secure the long-term ﬁnancing, they pay off some of their short-term debt to bring it down to an acceptable level. We will explain how to forecast the ﬁnal level of notes payable shortly, but initially we assume that MicroDrive will simply maintain its current level of notes payable. At this point, all of the items on the liability and equity side of the balance sheet have been speciﬁed. If we were extraordinarily lucky, the sources of ﬁnancing would exactly equal the required assets. In this case, we would have exactly enough ﬁnancing to acquire the assets needed to support the forecasted level of sales. But in all our years of forecasting, we have never had this happen, and you probably won’t be any luckier. Therefore, we deﬁne the term additional funds needed (AFN) as the required assets minus the speciﬁed sources of ﬁnancing. If the required additional ﬁnancing is positive, then we need to raise additional funds, and we “plug” this amount into the balance sheet as additional notes payable. For example, suppose the required assets equal $2,500 million and the speciﬁed sources of ﬁnancing total $2,400 million. The required additional ﬁnancing is $2,500 $2,400 $100 million. We assume that the ﬁrm would raise this $100 million as notes payable, thus increasing the old notes payable by $100 million. If the AFN were negative, this would mean that we are forecasting having more capital than we need. Initially, we assume that any extra funds will be used to purchase additional short-term investments, so we would “plug” the amount (the absolute value of the AFN) into short-term investments on the asset side of the balance sheet. For example, suppose the required assets equal only $2,200 million and the speciﬁed sources of ﬁnancing total $2,400 million. The required additional ﬁnancing is $2,200 $2,400 $200 million. Thus, the ﬁrm would have an extra $200 million that it could use to purchase short-term investments. Notice that total assets would now equal $2,200 $200 $2,400 million, which is exactly equal to the total sources of ﬁnancing. Before we apply this model to MicroDrive, a couple of points are worth noting. First, ﬁnancial policies are not etched in stone. For example, if the forecast is for a very large need for ﬁnancing, the ﬁrm might decide to issue more long-term debt or equity rather than ﬁnance the entire shortfall with notes payable. Similarly, a company with negative required additional ﬁnancing might decide to use the funds to pay a special dividend, to pay off some of its debt, or even to buy back some of its stock. As we discuss, managers generally go over the initial forecast and then go back and make changes to the plan. Financial planning is truly an iterative process—managers formulate a plan, analyze the results, modify either the operating plan or their ﬁnancial policies, observe the new results, and repeat the process until they are comfortable with the forecast. Second, the plug approach that we outlined speciﬁes the additional amount of either notes payable or short-term investments, but not both. If the AFN is positive, we assume that the ﬁrm will add to notes payable but leave short-term investments at their current level. If the AFN is negative, it will add to short-term investments but not to notes payable. Now let’s apply these concepts to MicroDrive. Forecast Operating Assets As noted earlier, MicroDrive’s assets must increase if sales are to increase. The company’s most recent ratio of cash to sales was approximately 0.33 percent ($10/$3,000 0.003333), and its management believes this ratio should remain constant. Therefore, the forecasted cash balance, shown in Row 1 of Table 11-3 is 0.003333($3,300) $11 million. The ratio of accounts receivable to sales was $375/$3,000 0.125 12.5 percent. For now we assume that the credit policy and customers’ paying patterns will remain

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TABLE 11-3

MicroDrive Inc.: Actual and Projected Balance Sheets (Millions of Dollars) Actual 2002 (1)

Forecast Basis (2)

Forecast for 2003 (3)

Assets 1. Cash 2. Short-term investments 3. Accounts receivable 4. Inventories 5. Total current assets 6. Net plant and equipment 7. Total assets

10.0 0.0 375.0 615.0 $1,000.0 1,000.0 $2,000.0

0.33% 2003 Sales Previous plus “plug” if needed 12.50% 2003 Sales 20.50% 2003 Sales

$

2.00% 2003 Sales 4.67% 2003 Sales Previous plus “plug” if needed

$

33.33% 2003 Sales

$

11.0 0.0 412.5 676.5 $1,100.0 1,100.0 $2,200.0

Liabilities and Equity 8. Accounts payable 9. Accruals 10. Notes payable 11. Total current liabilities 12. Long-term bonds 13. Total liabilities 14. Preferred stock 15. Common stock 16. Retained earnings 17. Total common equity 18. Total liabilities and equity

60.0 140.0 110.0 $ 310.0 754.0 $1,064.0 40.0 130.0 766.0 896.0 $2,000.0

19. Required assetsa 20. Speciﬁed sources of ﬁnancingb 21. Additional funds needed (AFN) 22. Required additional notes payable 23. Additional short-term investments

Same: no new issue Same: no new issue Same: no new issue 2002 RE 2003 Additions to RE

$

66.0 154.0 224.7 $ 444.7 754.0 $1,198.7 40.0 130.0 831.3 961.3 $2,200.0

$2,200.0 2,085.3 $ 114.7 $ 114.7 0.0

a

Required assets include all of the forecasted operating assets, plus short-term investments from the previous year. Speciﬁed sources of ﬁnancing include forecasted operating current liabilities, forecasted long-term bonds, forecasted preferred stock, forecasted common equity, and the amount of notes payable from the previous year.

b

constant, so the forecast for accounts receivable is 0.125($3,300) $412.5 million, as shown in Row 3. The most recent inventory to sales ratio was $615/$3,000 0.205 20.5 percent. Assuming no change in MicroDrive’s inventory policy, the forecasted inventory is 0.205($3,300) $676.5 million, as shown in Row 4. The ratio of net plant and equipment to sales was $1,000/$3,000 0.3333 33.33 percent. MicroDrive’s net plant and equipment have grown fairly steadily in the past, and its managers expect steady future growth. Therefore, they forecast that they will need net plant and equipment of 0.3333($3,300) $1,100 million. Next, we make the temporary assumption that short-term investments will remain at their current level. We will return to this point after we forecast the rest of the balance sheet. Forecast Operating Current Liabilities As noted earlier, operating current liabilities are called spontaneously generated funds because they increase automatically, as sales increase. MicroDrive’s most recent ratio of accounts payable to sales was

417

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421

$60/$3,000 0.02 2 percent. Assuming that the payables policy will not change, the forecasted level of accounts payable is 0.02($3,300) $66 million as shown in Row 8. The most recent ratio of accruals to sales was $140/$3,000 0.0467 4.67 percent. There is no reason to expect a change in this ratio, so the forecasted level of accruals is 0.0467($3,300) $154 million. Forecast Items Determined by Financial Policy Decisions In its initial ﬁnancial plan, MicroDrive kept long-term debt at the 2002 level, as shown in Row 12. The company’s policy is to not issue any additional shares of preferred or common stock barring extraordinary circumstances. Therefore, its forecasts for preferred and common stock, shown in Rows 14 and 15, are the 2002 levels. MicroDrive plans to increase its dividend per share by about 8 percent per year. As shown in Row 15 in Table 11-2, this policy, when combined with the forecasted level of net income, results in a $65.3 million addition to retained earnings. On the balance sheet, the forecasted level of retained earnings is equal to the 2002 retained earnings plus the forecasted addition to retained earnings, or $766.0 $65.3 $831.3 million. Again, note that we make the temporary assumption that notes payable remain at their 2002 level.

Step 4. Raising the Additional Funds Needed Based on the forecasted balance sheet, MicroDrive will need $2,200 million of operating assets to support its forecasted $3,300 million of sales. We deﬁne required assets as the sum of its forecasted operating assets plus the previous amount of short-term investments. Since MicroDrive had no short-term investments in 2002, its required assets are simply $2,200 million, as shown in Row 19 of Table 11-3. We deﬁne the speciﬁed sources of ﬁnancing as the sum of forecasted levels of operating current liabilities, long-term debt, preferred stock, and common equity, plus notes payable carried over from the previous year: Accounts payable Accruals Notes payable (carryover) Long-term bonds Preferred stock Common stock Retained earnings Total

$

66.0 154.0 110.0 754.0 40.0 130.0 831.3

$2,085.3

Based on its required assets and speciﬁed sources of ﬁnancing, MicroDrive’s AFN is $2,200 $2,085.3 $114.7 million, as shown in Rows 19, 20, and 21 of Table 113. Because the AFN is positive, MicroDrive needs $114.7 million of additional ﬁnancing, and its initial ﬁnancial policy is to obtain these funds as notes payable. Therefore, we add $114.7 million into notes payable (Row 10 of Table 11-3), bringing the forecasted total to $110 $114.7 $224.7 million. Because we added notes payable, we don’t add any short-term investment, and so this completes the initial forecast. Now it is time to analyze the plan and consider potential changes.

Analysis of the Forecast The 2003 forecast as developed above is only the ﬁrst part of MicroDrive’s total forecasting process. We must next examine the projected statements and determine whether

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See Ch 11 Tool Kit.xls for details.

TABLE 11-4

the forecast meets the ﬁnancial targets as set forth in the ﬁve-year ﬁnancial plan. If the statements do not meet the targets, then elements of the forecast must be changed. Table 11-4 shows MicroDrive’s most recent actual ratios, its projected ratios, and the latest industry average ratios. (The table also shows a “Revised Forecast” in the third column, which we will discuss later. Disregard the revised data for now.) The ﬁrm’s ﬁnancial condition at the close of 2002 was weak, with many ratios being well below the industry averages. For example, MicroDrive’s current ratio, based on Column 1 of Table 11-4, was only 3.2 versus 4.2 for an average competitor. The “Inputs” section shown on the top three rows of the table provides data on three of the model’s key drivers: (1) costs (excluding depreciation) as a percentage of sales, (2) accounts receivable as a percentage of sales, and (3) inventory as a percentage of sales. The preliminary forecast in Column 2 assumes these variables remain constant. While MicroDrive’s cost-to-sales ratio is only slightly worse than the industry average, its ratios of accounts receivable to sales and inventory to sales are signiﬁcantly higher than those of its competitors. Its investment in inventories and receivables is too high, causing its returns on assets, equity, and invested capital as shown in the lower part of the table to be too low. Therefore, MicroDrive should make operational changes designed to reduce its current assets. The “Ratios” section of Table 11-4 provides more details regarding the ﬁrm’s weaknesses. MicroDrive’s asset management ratios are much worse than the industry averages. For example, its total assets turnover ratio is 1.5 versus an industry average of 1.8. Its poor asset management ratios drag down the return on invested capital (9.5 Model Inputs, AFN, and Key Ratios (Millions of Dollars)

Actual 2002 (1)

Preliminary Forecast for 2003 (2)

Revised Forecast for 2003 (3)

Industry Average 2002 (4)

86.0% 11.8 16.7

87.1% 10.0 11.1

Model Inputs Costs (excluding depreciation) as percentage of sales Accounts receivable as percentage of sales Inventory as percentage of sales

87.2% 12.5 20.5

87.2% 12.5 20.5

Model Outputs NOPAT (net operating proﬁt after taxes) Net operating working capital Total operating capital Free cash ﬂow (FCF) AFN

$170.3 $800.0 $1,800.0 ($174.7)

$187.4 $880.0 $1,980.0 $7.5 $114.7

$211.2 $731.5 $1,831.5 $179.7 ($57.5)

Ratios Current ratio Inventory turnover Days sales outstanding Total assets turnover Debt ratio Proﬁt margin Return on assets Return on equity Return on invested capital (NOPAT/Total operating capital)

3.2 4.9 45.6 1.5 53.2% 3.8% 5.7% 12.7% 9.5%

2.5 4.9 45.6 1.5 54.5% 3.9% 5.8% 13.3% 9.5%

3.1 6.0 43.1 1.6 51.4% 4.6% 7.2% 15.4% 11.5%

4.2 9.0 36.0 1.8 40.0% 5.0% 9.0% 15.0% 11.4%

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percent for MicroDrive versus 11.4 percent for the industry average). Furthermore, MicroDrive must carry more than the average amount of debt to support its excessive assets, and the extra interest expense reduces its proﬁt margin to 3.9 percent versus 5.0 percent for the industry. Much of the debt is short term, and this results in a current ratio of 2.5 versus the 4.2 industry average. These problems will persist unless management takes action to improve things. After reviewing its preliminary forecast, management decided to take three steps to improve its ﬁnancial condition: (1) It decided to lay off some workers and close certain operations. It forecasted that these steps would lower operating costs (excluding depreciation) from the current 87.2 to 86 percent of sales as shown in Column 3 of Table 11-4. (2) By screening credit customers more closely and being more aggressive in collecting past-due accounts, the company believes it can reduce the ratio of accounts receivable to sales from 12.5 to 11.8 percent. (3) Finally, management thinks it can reduce the inventory-to-sales ratio from 20.5 to 16.7 percent through the use of tighter inventory controls.4 These projected operational changes were then used to create a revised set of forecasted statements for 2003. We do not show the new ﬁnancial statements, but the revised ratios are shown in the third column of Table 11-4. You can see the details in the chapter spreadsheet model, Ch 11 Tool Kit.xls. Here are the highlights of the revised forecast: 1. The reduction in operating costs improved the 2003 NOPAT, or net operating proﬁt after taxes, by $23.8 million. Even more impressive, the improvements in the receivables policy and in inventory management reduced receivables and inventories by $148.5 million. The net result of the increase in NOPAT and the reduction of operating current assets was a very large increase in free cash ﬂow for 2003, from a previously estimated $7.5 million to $179.7 million. 2. The proﬁt margin improved to 4.6 percent. However, the ﬁrm’s proﬁt margin still lagged the industry average because its high debt ratio results in higher-thanaverage interest payments. 3. The increase in the proﬁt margin resulted in an increase in projected retained earnings. More importantly, by tightening inventory controls and reducing the days sales outstanding, MicroDrive projected a reduction in inventories and receivables. Taken together, these actions resulted in a negative AFN of $57.5 million, which means that MicroDrive would actually generate $57.5 million more from internal operations and its ﬁnancing plan than it needs for new assets. Under its current ﬁnancial policy, MicroDrive would have $110 million in notes payable (the amount it carried over from the previous year) and $57.5 million in short-term investments. (Note: MicroDrive’s managers considered using the $57.5 million to pay down some of the debt but decided instead to keep it as a liquid asset, which gives them the ﬂexibility to quickly fund any new projects created by their R&D department.) The net effect is a signiﬁcant reduction in MicroDrive’s debt ratio, although it is still above the industry average. 4. These actions would also raise the rate of return on assets from 5.8 to 7.2 percent, and they would boost the return on equity from 12.5 to 15.4 percent, which is even higher than the industry average. Although MicroDrive’s managers believed that the revised forecast is achievable, they were not sure of this. Accordingly, they wanted to know how variations in sales would affect the forecast. Therefore, they ran a spreadsheet model using several

4

We will discuss receivables and inventory management in detail in Chapter 16.

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different sales growth rates, and analyzed the results to see how the ratios would change under different growth scenarios. To illustrate, if the sales growth rate increased from 10 to 20 percent, the AFN would change dramatically, from a $57.5 million surplus to an $89.8 million shortfall because more assets would be required to ﬁnance the additional sales. The spreadsheet model was also used to evaluate dividend policy. If MicroDrive decided to reduce its dividend growth rate, then additional funds would be generated, and those funds could be invested in plant, equipment, and inventories; used to reduce debt; or used to repurchase stock. We see, then, that forecasting is an iterative process. For planning purposes, the ﬁnancial staff develops a preliminary forecast based on a continuation of past policies and trends. This provides a starting point, or “baseline” forecast. Next, the projections are modiﬁed to see what effects alternative operating plans would have on the ﬁrm’s earnings and ﬁnancial condition. This results in a revised forecast. Then alternative operating plans are examined under different sales growth scenarios, and the model is used to evaluate both dividend policy and capital structure decisions. Finally, the projected statements can be used to estimate the effect of different plans on MicroDrive’s stock price. This is called value-based management, and is covered in Chapter 12. What is the AFN, and how is the percent of sales method used to estimate it? Why do accounts payable and accruals provide “spontaneous funds” to a growing ﬁrm?

The AFN Formula Most ﬁrms forecast their capital requirements by constructing pro forma income statements and balance sheets as described above. However, if the ratios are expected to remain constant, then the following formula can be used to forecast ﬁnancial requirements. Here we apply the formula to MicroDrive based on the 2002 data, not the revised data, as the revised data do not assume constant ratios. Additional funds needed AFN

Required increase in assets (A*/S0)S

Spontaneous increase in liabilities (L*/S0)S

Increase in retained earnings MS1(RR).

(11-1)

The symbols in Equation 11-1 are deﬁned below. AFN additional funds needed. A* assets that are tied directly to sales, hence must increase if sales are to increase. Note that A designates total assets and A* designates those assets that must increase if sales are to increase. When the ﬁrm is operating at full capacity, as is the case here, A* A. Often, though, A* and A are not equal, and either the equation must be modiﬁed or we must use the projected ﬁnancial statement method. S0 sales during the last year. A*/S0 percentage of required assets to sales, which also shows the required dollar increase in assets per $1 increase in sales. A*/S0 $2,000/$3,000 0.6667 for MicroDrive. Thus, for every $1 increase in sales, assets must increase by about 67 cents.

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Financial Planning and Forecasting Financial Statements The AFN Formula

425

L* liabilities that increase spontaneously. L* is normally much less than total liabilities (L). Spontaneous liabilities include accounts payable and accruals, but not bank loans and bonds. L*/S0 liabilities that increase spontaneously as a percentage of sales, or spontaneously generated ﬁnancing per $1 increase in sales. L*/S0 ($60 $140)/$3,000 0.0667 for MicroDrive. Thus, every $1 increase in sales generates about 7 cents of spontaneous ﬁnancing. S1 total sales projected for next year. Note that S0 designates last year’s sales, and S1 $3,300 million for MicroDrive. S change in sales S1 S0 $3,300 million $3,000 million $300 million for MicroDrive. M proﬁt margin, or proﬁt per $1 of sales. M $114/$3,000 0.0380 for MicroDrive. So, MicroDrive earns 3.8 cents on each dollar of sales. RR retention ratio, which is the percentage of net income that is retained. For MicroDrive, RR $56/$114 0.491. RR is also equal to 1 payout ratio, since the retention ratio and the payout ratio must total to 1.0 100%. Inserting values for MicroDrive into Equation 11-1, we ﬁnd the additional funds needed to be $118 million: AFN £

Required Spontaneous Increase asset § £ liability § £ in retained § increase increase earnings

0.667(S) 0.067(S) 0.038(S1)(0.491) 0.667($300 million) 0.067($300 million) 0.038($3,300 million)(0.491) $200 million $20 million $62 million $118 million. To increase sales by $300 million, the formula suggests that MicroDrive must increase assets by $200 million. The $200 million of new assets must be ﬁnanced in some manner. Of the total, $20 million will come from a spontaneous increase in liabilities, while another $62 million will be obtained from retained earnings. The remaining $118 million must be raised from external sources. This value is an approximation, but it is only slightly different from the AFN ﬁgure ($114.7 million) we developed in Table 11-3. The AFN equation shows that external ﬁnancing requirements depend on ﬁve key factors: 䊉

䊉

䊉

䊉

䊉

Sales growth (⌬S). Rapidly growing companies require large increases in assets, and more external ﬁnancing, other things held constant. Capital intensity (A*/S0). The amount of assets required per dollar of sales, A*/S0 in Equation 11-1, is called the capital intensity ratio. This ratio has a major effect on capital requirements. Companies with higher assets-to-sales ratios require more assets for a given increase in sales, hence a greater need for external ﬁnancing. Spontaneous liabilities-to-sales ratio (L*/S0). Companies that spontaneously generate a large amount of liabilities from accounts payable and accruals will have a relatively lower need for external ﬁnancing. Proﬁt margin (M). The higher the proﬁt margin, the larger the net income available to support increases in assets, hence the lower the need for external ﬁnancing. Retention ratio (RR). Companies that retain more of their earnings as opposed to paying them out as dividends will generate more retained earnings and thus have less need for external ﬁnancing.

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Note that Equation 11-1 provides an accurate forecast only for companies whose ratios are all expected to remain constant. It is useful to obtain a quick “back of the envelope” estimate of external ﬁnancing requirements for nonconstant ratio companies, but in the planning process one should calculate the actual additional funds needed by the projected ﬁnancial statement method. If all ratios are expected to remain constant, a formula can be used to forecast AFN. Give the formula and brieﬂy explain it. How do the following factors affect external capital requirements: (1) retention ratio, (2) capital intensity, (3) proﬁt margin, and (4) dividend payout ratio?

Forecasting Financial Requirements When the Balance Sheet Ratios Are Subject to Change Both the AFN formula and the projected ﬁnancial statement method as we initially used it assume that the ratios of assets and liabilities to sales (A*/S0 and L*/S0) remain constant over time. This, in turn, requires the assumption that each “spontaneous” asset and liability item increases at the same rate as sales. In graph form, this implies the type of relationship shown in Panel a of Figure 11-2, a relationship that is (1) linear and (2) passes through the origin. Under those conditions, if the company’s sales increase from $200 million to $400 million, or by 100 percent, inventory will also increase by 100 percent, from $100 million to $200 million. The assumption of constant ratios and identical growth rates is appropriate at times, but there are times when it is incorrect. Three such conditions are described in the following sections.

Economies of Scale There are economies of scale in the use of many kinds of assets, and when economies occur, the ratios are likely to change over time as the size of the ﬁrm increases. For example, retailers often need to maintain base stocks of different inventory items, even if current sales are quite low. As sales expand, inventories may then grow less rapidly than sales, so the ratio of inventory to sales (I/S) declines. This situation is depicted in Panel b of Figure 11-2. Here we see that the inventory/sales ratio is 1.5, or 150 percent, when sales are $200 million, but the ratio declines to 1.0 when sales climb to $400 million. The relationship in Panel b is linear, but nonlinear relationships often exist. Indeed, if the ﬁrm uses one popular model for establishing inventory levels (the EOQ model), its inventories will rise with the square root of sales. This situation is shown in Panel c of Figure 11-2, which shows a curved line whose slope decreases at higher sales levels. In this situation, very large increases in sales would require very little additional inventory. See the Web Extension to this chapter for more on forecasting when variables are not proportional to sales.

Lumpy Assets In many industries, technological considerations dictate that if a ﬁrm is to be competitive, it must add ﬁxed assets in large, discrete units; such assets are often referred to as

423

424

Financial Planning and Forecasting Financial Statements Forecasting Financial Requirements FIGURE 11-2

427

Four Possible Ratio Relationships (Millions of Dollars)

a. Constant Ratios

b. Economies of Scale; Declining Ratios

Inventory ($)

Inventory ($)

I/S I/S 200

300

100

0

400

100/200 = 0.50 = 50% 200

200/400 = 0.50 = 50%

300/200 = 1.50 = 150%

Base Stock

400 Sales ($)

c. Curvilinear Relationship

200

0

400/400 = 1.00 = 100%

400 Sales ($)

d. Lumpy Assets Fixed Assets ($)

Inventory ($)

300

FA/S Capacity

I/S

225

424 150

300

75

0

200

400 Sales ($)

0

Excess Capacity (Temporary)

A B

50 100

200

300

Sales ($)

lumpy assets. In the paper industry, for example, there are strong economies of scale in basic paper mill equipment, so when a paper company expands capacity, it must do so in large, lumpy increments. This type of situation is depicted in Panel d of Figure 11-2. Here we assume that the minimum economically efﬁcient plant has a cost of $75 million, and that such a plant can produce enough output to reach a sales level of $100 million. If the ﬁrm is to be competitive, it simply must have at least $75 million of ﬁxed assets. Lumpy assets have a major effect on the ﬁxed assets/sales (FA/S) ratio at different sales levels and, consequently, on ﬁnancial requirements. At Point A in Panel d, which represents a sales level of $50 million, the ﬁxed assets are $75 million, so the ratio FA/S $75/$50 1.5. Sales can expand by $50 million, out to $100 million, with no additions to ﬁxed assets. At that point, represented by Point B, the ratio FA/S $75/$100 0.75. However, since the ﬁrm is operating at capacity (sales of $100 million), even a small increase in sales would require a doubling of plant

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capacity, so a small projected sales increase would bring with it a very large ﬁnancial requirement.5

Excess Capacity Adjustments Consider again the MicroDrive example set forth in Tables 11-2 and 11-3, but now assume that excess capacity exists in ﬁxed assets. Speciﬁcally, assume that ﬁxed assets in 2002 were being utilized to only 96 percent of capacity. If ﬁxed assets had been used to full capacity, 2002 sales could have been as high as $3,125 million versus the $3,000 million in actual sales: Full Actual sales capacity Percentage of capacity sales at which fixed assets were operated

(11-2)

$3,000 million $3,125 million. 0.96

This suggests that MicroDrive’s target ﬁxed assets/sales ratio should be 32 percent rather than 33.3 percent: Target fixed assets/Sales

Actual fixed assets Full capacity sales

(11-3)

$1,000 0.32 32%. $3,125

Therefore, if sales are to increase to $3,300 million, then ﬁxed assets would have to increase to $1,056 million: Required level (Target fixed assets/Sales)(Projected sales) of fixed assets

(11-4)

0.32($3,300) $1,056 million. We previously forecasted that MicroDrive would need to increase ﬁxed assets at the same rate as sales, or by 10 percent. That meant an increase from $1,000 million to $1,100 million, or by $100 million. Now we see that the actual required increase is only from $1,000 million to $1,056 million, or by $56 million. Thus, the capacityadjusted forecast is $100 million $56 million $44 million less than the earlier forecast. With a smaller ﬁxed asset requirement, the projected AFN would decline from an estimated $118 million to $118 million $44 million $74 million. Note also that when excess capacity exists, sales can grow to the capacity sales as determined above with no increase whatever in ﬁxed assets, but sales beyond that level will require ﬁxed asset additions as calculated in our example. The same situation 5

Several other points should be noted about Panel d of Figure 11-4. First, if the ﬁrm is operating at a sales level of $100 million or less, any expansion that calls for a sales increase above $100 million would require a doubling of the ﬁrm’s ﬁxed assets. A much smaller percentage increase would be involved if the ﬁrm were large enough to be operating a number of plants. Second, ﬁrms generally go to multiple shifts and take other actions to minimize the need for new ﬁxed asset capacity as they approach Point B. However, these efforts can only go so far, and eventually a ﬁxed asset expansion will be required. Third, ﬁrms often make arrangements to share excess capacity with other ﬁrms in their industry. For example, the situation in the electric utility industry is very much like that depicted in Panel d. However, electric companies often build jointly owned plants, or else they “take turns” building plants, and then they buy power from or sell power to other utilities to avoid building new plants that would be underutilized.

425

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Financial Planning and Forecasting Financial Statements Questions

429

could occur with respect to inventories, and the required additions would be determined in exactly the same manner as for ﬁxed assets. Theoretically, the same situation could occur with other types of assets, but as a practical matter excess capacity normally exists only with respect to ﬁxed assets and inventories. Explain how economies of scale and lumpy asset acquisition affect ﬁnancial forecasting. If excess capacity exists, how will that affect the AFN?

Summary This chapter described techniques for forecasting ﬁnancial statements, which is a crucial part of the ﬁnancial planning process. As we will see throughout the rest of the book, both investors and corporations regularly use forecasting techniques to help value a company’s stock, to estimate the beneﬁts of potential projects, and to estimate how changes in capital structure, dividend policy, and working capital policy will inﬂuence shareholder value. The key concepts covered are listed below: 䊉

䊉

䊉

䊉

䊉

䊉

Financial forecasting generally begins with a forecast of the ﬁrm’s sales, in terms of both units and dollars. Either the projected, or pro forma, ﬁnancial statement method or the AFN formula method can be used to forecast ﬁnancial requirements. The ﬁnancial statement method is more reliable, and it also provides ratios that can be used to evaluate alternative business plans. A ﬁrm can determine its additional funds needed (AFN) by estimating the amount of new assets necessary to support the forecasted level of sales and then subtracting from that amount the spontaneous funds that will be generated from operations. The ﬁrm can then plan how to raise the AFN most efﬁciently. The higher a ﬁrm’s sales growth rate, the greater will be its need for additional ﬁnancing. Similarly, the smaller its retention ratio, the greater its need for additional funds. Adjustments must be made if economies of scale exist in the use of assets, if excess capacity exists, or if assets must be added in lumpy increments. Linear regression and excess capacity adjustments can be used to forecast asset requirements in situations where assets are not expected to grow at the same rate as sales.

The type of forecasting described in this chapter is important for several reasons. First, if the projected operating results are unsatisfactory, management can “go back to the drawing board,” reformulate its plans, and develop more reasonable targets for the coming year. Second, it is possible that the funds required to meet the sales forecast simply cannot be obtained. If so, it is obviously better to know this in advance and to scale back the projected level of operations than to suddenly run out of cash and have operations grind to a halt. And third, even if the required funds can be raised, it is desirable to plan for their acquisition well in advance.

Questions 11–1

Deﬁne each of the following terms: a. Operating plan; ﬁnancial plan; sales forecast b. Pro forma ﬁnancial statement; percent of sales method c. Spontaneously generated funds

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Financial Planning and Forecasting Financial Statements d. Additional funds needed (AFN); AFN formula; capital intensity ratio e. Lumpy assets

11–2

Certain liability and net worth items generally increase spontaneously with increases in sales. Put a check (冪) by those items that typically increase spontaneously: Accounts payable Notes payable to banks Accrued wages Accrued taxes

11–3

Mortgage bonds Common stock Retained earnings

The following equation can, under certain assumptions, be used to forecast ﬁnancial requirements: AFN (A*/S0)(S) (L*/S0)(S) MS1(RR). Under what conditions does the equation give satisfactory predictions, and when should it not be used?

11–4

Suppose a ﬁrm makes the following policy changes. If the change means that external, nonspontaneous ﬁnancial requirements (AFN) will increase, indicate this by a (); indicate a decrease by a (); and indicate indeterminate or no effect by a (0). Think in terms of the immediate, short-run effect on funds requirements. a. The dividend payout ratio is increased. b. The ﬁrm decides to pay all suppliers on delivery, rather than after a 30-day delay, to take advantage of discounts for rapid payment. c. The ﬁrm begins to sell on credit (previously all sales had been on a cash basis). d. The ﬁrm’s proﬁt margin is eroded by increased competition; sales are steady.

Self-Test Problems ST–1 GROWTH RATE

ST–2 ADDITIONAL FUNDS NEEDED

ST–3

(Solutions Appear in Appendix A)

Weatherford Industries Inc. has the following ratios: A*/S0 1.6; L*/S0 0.4; proﬁt margin 0.10; and dividend payout ratio 0.45, or 45 percent. Sales last year were $100 million. Assuming that these ratios will remain constant, use the AFN formula to determine the maximum growth rate Weatherford can achieve without having to employ nonspontaneous external funds. Suppose Weatherford’s ﬁnancial consultants report (1) that the inventory turnover ratio is sales/inventory 3 times versus an industry average of 4 times and (2) that Weatherford could reduce inventories and thus raise its turnover to 4 without affecting sales, the proﬁt margin, or the other asset turnover ratios. Under these conditions, use the AFN formula to determine the amount of additional funds Weatherford would require during each of the next 2 years if sales grew at a rate of 20 percent per year. Van Auken Lumber’s 2002 ﬁnancial statements are shown below.

EXCESS CAPACITY

Van Auken Lumber: Balance Sheet as of December 31, 2002 (Thousands of Dollars) Cash Receivables Inventories Total current assets Net ﬁxed assets

Total assets

$ 1,800 10,800 12,600 $25,200 21,600

$46,800

Accounts payable Notes payable Accruals Total current liabilities Mortgage bonds Common stock Retained earnings Total liabilities and equity

$ 7,200 3,472 2,520 $13,192 5,000 2,000 26,608 $46,800

427

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Financial Planning and Forecasting Financial Statements Problems

431

Van Auken Lumber: Income Statement for December 31, 2002 (Thousands of Dollars) Sales Operating costs Earnings before interest and taxes Interest Earnings before taxes Taxes (40%) Net income Dividends (60%) Addition to retained earnings

$36,000 30,783 $ 5,217 1,017 $ 4,200 1,680 $ 2,520 $ 1,512 $ 1,008

a. Assume that the company was operating at full capacity in 2002 with regard to all items except ﬁxed assets; ﬁxed assets in 2002 were being utilized to only 75 percent of capacity. By what percentage could 2003 sales increase over 2002 sales without the need for an increase in ﬁxed assets? b. Now suppose 2003 sales increase by 25 percent over 2002 sales. How much additional external capital will be required? Assume that Van Auken cannot sell any ﬁxed assets. (Hint: Use the percent of sales method to develop a pro forma balance sheet and income statement as in Tables 11-2 and 11-3.) Assume that any required ﬁnancing is borrowed as notes payable. Use a 12 percent interest rate for all debt at the beginning of the year to forecast interest expense (cash does not earn interest), and use a pro forma income statement to determine the addition to retained earnings. (Another hint: Notes payable $6,021.)

Problems Carter Corporation’s sales are expected to increase from $5 million in 2002 to $6 million in 2003, or by 20 percent. Its assets totaled $3 million at the end of 2002. Carter is at full capacity, so its assets must grow at the same rate as projected sales. At the end of 2002, current liabilities were $1 million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accruals. The after-tax proﬁt margin is forecasted to be 5 percent, and the forecasted payout ratio is 70 percent. Use this information to answer Problems 11-1, 11-2, and 11-3. 11–1

Use the AFN formula to forecast Carter’s additional funds needed for the coming year.

AFN FORMULA

11–2 AFN FORMULA

11–3 AFN FORMULA

11–4 SALES INCREASE

What would the additional funds needed be if the company’s year-end 2002 assets had been $4 million? Assume that all other numbers are the same. Why is this AFN different from the one you found in Problem 11-1? Is the company’s “capital intensity” the same or different? Return to the assumption that the company had $3 million in assets at the end of 2002, but now assume that the company pays no dividends. Under these assumptions, what would be the additional funds needed for the coming year? Why is this AFN different from the one you found in Problem 11-1? Pierce Furnishings generated $2.0 million in sales during 2002, and its year-end total assets were $1.5 million. Also, at year-end 2002, current liabilities were $500,000, consisting of $200,000 of notes payable, $200,000 of accounts payable, and $100,000 of accruals. Looking ahead to 2003, the company estimates that its assets must increase by 75 cents for every $1 increase in sales. Pierce’s proﬁt margin is 5 percent, and its payout ratio is 60 percent. How large a sales increase can the company achieve without having to raise funds externally?

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11–5 PRO FORMA STATEMENTS AND RATIOS

Upton Computers makes bulk purchases of small computers, stocks them in conveniently located warehouses, and ships them to its chain of retail stores. Upton’s balance sheet as of December 31, 2002, is shown here (millions of dollars): Cash Receivables Inventories Total current assets Net ﬁxed assets

Total assets

$

3.5 26.0 58.0 $ 87.5 35.0

$122.5

Accounts payable Notes payable Accruals Total current liabilities Mortgage loan Common stock Retained earnings Total liabilities and equity

$

9.0 18.0 8.5 $ 35.5 6.0 15.0 66.0 $122.5

Sales for 2002 were $350 million, while net income for the year was $10.5 million. Upton paid dividends of $4.2 million to common stockholders. The ﬁrm is operating at full capacity. Assume that all ratios remain constant. a. If sales are projected to increase by $70 million, or 20 percent, during 2003, use the AFN equation to determine Upton’s projected external capital requirements. b. Construct Upton’s pro forma balance sheet for December 31, 2003. Assume that all external capital requirements are met by bank loans and are reﬂected in notes payable. Assume Upton’s proﬁt margin and dividend payout ratio remain constant. 11–6

Stevens Textile’s 2002 ﬁnancial statements are shown below.

ADDITIONAL FUNDS NEEDED

Stevens Textile: Balance Sheet as of December 31, 2002 (Thousands of Dollars) Cash Receivables Inventories Total current assets Net ﬁxed assets

Total assets

$ 1,080 6,480 9,000 $16,560 12,600

$29,160

Accounts payable Accruals Notes payable Total current liabilities Mortgage bonds Common stock Retained earnings Total liabilities and equity

Stevens Textile: Income Statement for December 31, 2002 (Thousands of Dollars) Sales Operating costs Earnings before interest and taxes Interest Earnings before taxes Taxes (40%) Net income

$36,000 32,440 $ 3,560 460 $ 3,100 1,240 $ 1,860

Dividends (45%) Addition to retained earnings

$ 837 $ 1,023

$ 4,320 2,880 2,100 $ 9,300 3,500 3,500 12,860 $29,160

429

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Financial Planning and Forecasting Financial Statements Problems

433

a. Suppose 2003 sales are projected to increase by 15 percent over 2002 sales. Determine the additional funds needed. Assume that the company was operating at full capacity in 2002, that it cannot sell off any of its ﬁxed assets, and that any required ﬁnancing will be borrowed as notes payable. Also, assume that assets, spontaneous liabilities, and operating costs are expected to increase by the same percentage as sales. Use the percent of sales method to develop a pro forma balance sheet and income statement for December 31, 2003. Use an interest rate of 10 percent on the balance of debt at the beginning of the year to compute interest (cash pays no interest). Use the pro forma income statement to determine the addition to retained earnings. 11–7

Garlington Technologies Inc.’s 2002 ﬁnancial statements are shown below.

ADDITIONAL FUNDS NEEDED

Garlington Technologies Inc.: Balance Sheet as of December 31, 2002 Cash Receivables Inventories Total current assets Fixed assets Total assets

$ 180,000 360,000 720,000 $1,260,000 1,440,000 $2,700,000

Accounts payable Notes payable Accruals Total current liabilities Common stock Retained earnings Total liabilities and equity

$ 360,000 156,000 180,000 $ 696,000 1,800,000 204,000 $2,700,000

Garlington Technologies Inc.: Income Statement for December 31, 2002 Sales Operating costs EBIT Interest EBT Taxes (40%) Net income

$3,600,000 3,279,720 $ 320,280 18,280 $ 302,000 120,800 $ 181,200

Dividends

$ 108,000

a. Suppose that in 2003 sales increase by 10 percent over 2002 sales and that 2003 dividends will increase to $112,000. Construct the pro forma ﬁnancial statements using the percent of sales method. Assume the ﬁrm operated at full capacity in 2002. Use an interest rate of 13 percent on the debt balance at the beginning of the year. Assume dividends will grow by 3 percent and that the AFN will be in the form of notes payable. 11–8 LONG-TERM FINANCING NEEDED

At year-end 2002, total assets for Bertin Inc. were $1.2 million and accounts payable were $375,000. Sales, which in 2002 were $2.5 million, are expected to increase by 25 percent in 2003. Total assets and accounts payable are proportional to sales and that relationship will be maintained. Bertin typically uses no current liabilities other than accounts payable. Common stock amounted to $425,000 in 2002, and retained earnings were $295,000. Bertin plans to sell new common stock in the amount of $75,000. The ﬁrm’s proﬁt margin on sales is 6 percent; 40 percent of earnings will be paid out as dividends. a. What was Bertin’s total debt in 2002? b. How much new, long-term debt ﬁnancing will be needed in 2003? (Hint: AFN New stock New long-term debt.) Do not consider any ﬁnancing feedback effects.

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11–9 ADDITIONAL FUNDS NEEDED

The Booth Company’s sales are forecasted to increase from $1,000 in 2002 to $2,000 in 2003. Here is the December 31, 2002, balance sheet: Cash Accounts receivable Inventories Net ﬁxed assets

Total assets

$ 100 200 200 500

$1,000

Accounts payable Notes payable Accruals Long-term debt Common stock Retained earnings Total liabilities and equity

$

50 150 50 400 100 250 $1,000

Booth’s ﬁxed assets were used to only 50 percent of capacity during 2002, but its current assets were at their proper levels. All assets except ﬁxed assets increase at the same rate as sales, and ﬁxed assets would also increase at the same rate if the current excess capacity did not exist. Booth’s after-tax proﬁt margin is forecasted to be 5 percent, and its payout ratio will be 60 percent. What is Booth’s additional funds needed (AFN) for the coming year?

Spreadsheet Problem 11–10 BUILD A MODEL: FORECASTING FINANCIAL STATEMENTS

Start with the partial model in the ﬁle Ch 11 P10 Build a Model.xls from the textbook’s web site. Cumberland Industries’ ﬁnancial planners must forecast the company’s ﬁnancial results for the coming year. The forecast will be based on the percent of sales method, and any additional funds needed will be obtained by using a mix of notes payable, long-term debt, and common stock. No preferred stock will be issued. Data for the problem, including Cumberland Industries’ balance sheet and income statement, can be found in the spreadsheet problem for Chapter 9. Use these data to answer the following questions. a. Cumberland Industries has had the following sales since 1997. Assuming the historical trend continues, what will sales be in 2003? Year

Sales

1997 1998 1999 2000 2001 2002

$129,215,000 180,901,000 235,252,000 294,065,000 396,692,000 455,150,000

Base your forecast on a spreadsheet regression analysis of the 1997–2002 sales. By what percentage are sales predicted to increase in 2003 over 2002? Is the sales growth rate increasing or decreasing? b. Cumberland’s management believes that the ﬁrm will actually experience a 20 percent increase in sales during 2003. Construct the 2003 pro forma ﬁnancial statements. Cumberland will not issue any new stock or long-term bonds. Assume Cumberland will carry forward its current amounts of short-term investments and notes payable, prior to calculating AFN. Assume that any additional funds needed (AFN) will be raised as notes payable (if AFN is negative, Cumberland will purchase additional short-term investments). Use an interest rate of 9 percent for short-term debt (and for the interest income on short-term investments) and a rate of 11 percent for long-term debt. No interest is earned on cash. Use the beginning of year debt balances to calculate net interest expense. Assume dividends grow at an 8 percent rate. c. Now create a graph that shows the sensitivity of AFN to the sales growth rate. To make this graph, compare the AFN at sales growth rates of 5, 10, 15, 20, 25, and 30 percent. d. Calculate net operating working capital (NOWC), total operating capital, NOPAT, and operating cash ﬂow (OCF) for 2002 and 2003. Also, calculate the free cash ﬂow (FCF) for 2003. e. Suppose Cumberland can reduce its inventory to sales ratio to 5 percent and its cost to sales ratio to 83 percent. What happens to AFN and FCF?

431

432

Financial Planning and Forecasting Financial Statements Mini Case

435

Sue Wilson, the new ﬁnancial manager of Northwest Chemicals (NWC), an Oregon producer of specialized chemicals for use in fruit orchards, must prepare a ﬁnancial forecast for 2003. NWC’s 2002 sales were $2 billion, and the marketing department is forecasting a 25 percent increase for 2003. Sue thinks the company was operating at full capacity in 2002, but she is not sure about this. The 2002 ﬁnancial statements, plus some other data, are shown below.

A.

2002 BALANCE SHEET (MILLIONS OF DOLLARS) Percent of Sales

Cash and securities Accounts receivable Inventories Total current assets Net ﬁxed assets Total assets

B.

$

20 240 240 $ 500 500 $1,000

1% 12% 12% 25%

Percent of Sales

Accounts payable and accruals Notes payable Total current liabilities Long-term debt Common stock

$ 100 100 $ 200 100 500

Retained earnings Total liabilities and equity

200 $1,000

5%

2002 INCOME STATEMENT (MILLIONS OF DOLLARS) Percent of Sales

Sales Cost of goods sold (COGS) Sales, general, and administrative costs (SGA) Earnings before interest and taxes Interest Earnings before taxes Taxes (40%) Net income Dividends (40%) Addition to retained earnings

$2,000.00 1,200.00 700.00 $ 100.00 10.00 $ 90.00 36.00 $ 54.00 21.60 $ 32.40

60% 35%

C. KEY RATIOS

NWC

Proﬁt margin Return on equity Days sales outstanding (365 days) Inventory turnover Fixed assets turnover Debt/assets Times interest earned Current ratio Return on invested capital (NOPAT/ Operating capital)

2.70 7.71 43.80 days 8.33 4.00 30.00% 10 2.50 6.67%

Industry

4.00 15.60 32.00 days 11.00 5.00 36.00% 9.40 3.00 14.00%

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See Ch 11 Show.ppt for a PowerPoint presentation of the Mini Case and Ch 11 Mini Case.xls for detailed calculations.

Assume that you were recently hired as Wilson’s assistant, and your ﬁrst major task is to help her develop the forecast. She asked you to begin by answering the following set of questions. a. Describe three ways that pro forma statements are used in ﬁnancial planning. b. Explain the steps in ﬁnancial forecasting. c. Assume (1) that NWC was operating at full capacity in 2002 with respect to all assets, (2) that all assets must grow proportionally with sales, (3) that accounts payable and accruals will also grow in proportion to sales, and (4) that the 2002 proﬁt margin and dividend payout will be maintained. Under these conditions, what will the company’s ﬁnancial requirements be for the coming year? Use the AFN equation to answer this question. d. How would changes in these items affect the AFN: (1) sales increase? (2) the dividend payout ratio increases? (3) the proﬁt margin increases? (4) the capital intensity ratio increases? and (5) NWC begins paying its suppliers sooner? (Consider each item separately and hold all other things constant.) e. Brieﬂy explain how to forecast ﬁnancial statements using the percent of sales approach. Be sure to explain how to forecast interest expenses. f. Now estimate the 2003 ﬁnancial requirements using the percent of sales approach. Assume (1) that each type of asset, as well as payables, accruals, and ﬁxed and variable costs, will be the same percent of sales in 2003 as in 2002; (2) that the payout ratio is held constant at 40 percent; (3) that external funds needed are ﬁnanced 50 percent by notes payable and 50 percent by long-term debt (no new common stock will be issued); (4) that all debt carries an interest rate of 10 percent; and (5) interest expenses should be based on the balance of debt at the beginning of the year. g. Why does the percent of sales approach produce a somewhat different AFN than the equation approach? Which method provides the more accurate forecast? h. Calculate NWC’s forecasted ratios, and compare them with the company’s 2002 ratios and with the industry averages. Calculate NWC’s forecasted free cash ﬂow and return on invested capital (ROIC). i. Based on comparisons between NWC’s days sales outstanding (DSO) and inventory turnover ratios with the industry average ﬁgures, does it appear that NWC is operating efﬁciently with respect to its inventory and accounts receivable? Suppose NWC were able to bring these ratios into line with the industry averages and reduce its SGA/Sales ratio to 33 percent. What effect would this have on its AFN and its ﬁnancial ratios? What effect would this have on free cash ﬂow and ROIC? j. Suppose you now learn that NWC’s 2002 receivables and inventories were in line with required levels, given the ﬁrm’s credit and inventory policies, but that excess capacity existed with regard to ﬁxed assets. Speciﬁcally, ﬁxed assets were operated at only 75 percent of capacity. (1) What level of sales could have existed in 2002 with the available ﬁxed assets? (2) How would the existence of excess capacity in ﬁxed assets affect the additional funds needed during 2003? k. The relationship between sales and the various types of assets is important in ﬁnancial forecasting. The percent of sales approach, under the assumption that each asset item grows at the same rate as sales, leads to an AFN forecast that is reasonably close to the forecast using the AFN equation. Explain how each of the following factors would affect the accuracy of ﬁnancial forecasts based on the AFN equation: (1) economies of scale in the use of assets and (2) lumpy assets.

433

434

Financial Planning and Forecasting Financial Statements Selected Additional References and Cases

437

Selected Additional References and Cases The heart of successful ﬁnancial planning is the sales forecast. On this key subject, see

The Cases in Financial Management series contains the following applicable cases:

Hirschey, Mark, and James L. Pappas, Managerial Economics (Fort Worth, TX: The Dryden Press, 1996).

Case 37, “Space-Age Materials, Inc.,” Case 38, “Automated Banking Management, Inc.,” Case 38A, “Expert Systems,” Case 38B, “Medical Management Systems, Inc.,” and Case 63, “Dental Records, Inc.,” which all focus on using the percent of sales forecasting method to forecast future ﬁnancing requirements.

Computer modeling is becoming increasingly important. For general references, see Francis, Jack Clark, and Dexter R. Rowell, “A Simultaneous Equation Model of the Firm for Financial Analysis and Planning,” Financial Management, Spring 1978, 29–44. For an article on control, see Bierman, Harold, “Beyond Cash Flow ROI,” Midland Corporate Finance Journal, Winter 1988, 36–39.

12 12

Corporate Valuation, Value-Based Management, and Corporate Governance I

f you had invested $1,000 in the NYSE Composite Index at the beginning of the 1990s, your investment would have grown to $3,010, resulting in an 11 percent annual rate of return. Had you put the $1,000 in Berkshire Hathaway, you would now have $9,551, which is a 17.8 percent annual return. And if you had been really smart (or lucky) and invested in Dell, you would now have $497,510, which translates into a whopping 76.6 percent annual return! Berkshire Hathaway and Dell compete in very different industries and have very different strategies, yet both beat the market by sharing an operating philosophy: They created value for shareholders by focusing on the free cash ﬂows of their underlying businesses. When this focus is applied systematically throughout a company, it is called value-based management, which is the central theme of this chapter. Berkshire Hathaway’s primary strategy has been to grow through acquisitions. Warren Buffett, Berkshire’s CEO, wrote in a recent letter to shareholders that he seeks to own “businesses that generate cash and consistently earn above-average returns on their capital.” When evaluating a potential acquisition, Buffett says he compares its purchase price with its “intrinsic value,” which he deﬁnes as “the discounted value of the cash that can be taken out of a business during its remaining life.” Thus, Buffett’s growth strategy is governed by the principles of value-based management. Instead of growing primarily through acquisitions, Dell has chosen to grow “organically” by expanding its existing businesses and developing new products and markets. For most companies, rapid growth in sales requires rapid growth in operating capital, which reduces free cash ﬂow. But Dell is relentless in minimizing the amount of operating capital required to support sales. During the last ﬁve years, Dell’s sales grew by 43 percent per year. However, Dell actually reduced its operating capital, largely because of reductions in inventory as a result of its produce-to-order strategy and increases in its accounts payable. Dell also increased its net operating proﬁt after taxes (NOPAT) faster than sales, 47 percent for NOPAT versus 43 percent per year for sales. Thus, Dell has excelled at improving three primary drivers of valuebased management: (1) Its sales growth rate was a huge 43 percent. (2) Its proﬁt margin rose from a good NOPAT-to-sales ratio of 5.1 percent to an excellent ratio of 5.8 percent. (3) Its capital requirements were held in check as a result of lowering the capital-to-sales ratio from 11.4 percent to virtually nothing. Sources: Various annual reports of Berkshire Hathaway Inc. and Dell Computers.

438

435

436

Corporate Valuation, Value-Based Management, and Corporate Governance Overview of Corporate Valuation

439

As we have emphasized throughout the book, maximizing shareholder value should be management’s primary objective. However, to maximize value, managers need a tool for estimating the effects of alternative strategies. In this chapter, we develop and illustrate such a tool—the corporate valuation model, which is the present value of expected future free cash ﬂows, discounted at the weighted average cost of capital. In a sense, the corporate valuation model is the culmination of all the material covered thus far, because it pulls together ﬁnancial statements, cash ﬂows, ﬁnancial projections, time value of money, risk, and the cost of capital. Companies practice value-based management by systematically using the corporate valuation model to guide their decisions.

Overview of Corporate Valuation

The textbook’s web site contains an Excel ﬁle that will guide you through the chapter’s calculations. The ﬁle for this chapter is Ch 12 Tool Kit.xls, and we encourage you to open the ﬁle and follow along as you read the chapter.

As stated earlier, managers should evaluate the effects of alternative strategies on their ﬁrms’ values. This really means forecasting ﬁnancial statements under alternative strategies, ﬁnding the present value of each strategy’s cash ﬂow stream, and then choosing the strategy that provides the maximum value. The ﬁnancial statements should be projected using the techniques and procedures discussed in Chapter 11, and the discount rate should be the risk-adjusted cost of capital as discussed in Chapter 6. But what model should managers use to discount the cash ﬂows? One possibility is the dividend growth model from Chapter 5. However, that model is often unsuitable for managerial purposes. For example, suppose a startup company is formed to develop and market a new product. Its managers will focus on product development, marketing, and raising capital. They will probably be thinking about an eventual IPO, or perhaps the sale of the company to a larger ﬁrm—Cisco, Microsoft, Intel, IBM, or other industry leaders that buy hundreds of successful new companies each year. For the managers of such a startup, the decision to initiate dividend payments in the foreseeable future will be totally off the radar screen. Thus, the dividend growth model is not useful for valuing most startup companies. Also, many established ﬁrms, including giants such as Microsoft, pay no dividends. Investors may expect them to pay dividends some time in the future, but when, and how much? As long as internal opportunities and acquisitions are so attractive, the initiation of dividends will be postponed, and this makes the dividend growth model of little use. Finally, the dividend growth model often is of limited use for internal management purposes even for a dividend-paying company. If the ﬁrm consisted of just one big asset, and that asset produced all of the cash ﬂows used to pay dividends, then alternative strategies could be judged through the use of the dividend growth model. However, most ﬁrms have several different divisions with many assets, so the corporation’s value depends on the cash ﬂows from many different assets, and on the actions of many managers. These managers need a way to measure the effects of their decisions on corporate value, but the discounted dividend model isn’t very useful because individual divisions don’t pay dividends. Fortunately, the corporate valuation model does not depend on dividends, and it can be applied to divisions and subunits as well as to the entire ﬁrm. Another important aspect of value-based management is the concept of corporate governance. The corporate valuation model shows how corporate decisions affect stockholders. However, corporate decisions are made by managers, not stockholders, and maximizing shareholder wealth is not the same as individual managers maximizing their own “satisfaction.”1 Thus, a key aspect of value-based 1

A distinction is sometimes made between “executives” and “managers,” with executives being corporate ofﬁcers and others members of the top management team. We do not make that distinction in this book—all people with important decision-making powers are designated as “managers.”

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management is making sure that managers focus on the goal of stockholder wealth maximization. The set of rules and procedures used to motivate managers falls under the general heading of corporate governance. At the risk of oversimpliﬁcation, it involves two primary mechanisms: “sticks” and “carrots.” The sticks make it easier to replace a poorly performing CEO. They include (1) provisions in the corporate charter that affect the likelihood of a takeover and (2) the composition of the board of directors. The corporate charter may make it relatively easy for a takeover to occur, so that a poorly performing CEO can be replaced; or the charter may make a takeover more difﬁcult, in which case poor managers can continue to perform poorly. The board of directors can consist of strong outsiders, who will likely monitor the CEO’s performance closely and replace him or her if things are not going well, or of friends and colleagues of the CEO, who are willing to let things slide. The carrot involves the type of managerial compensation plan the company uses. If managerial compensation is linked to the ﬁrm’s stock price, then managers are more likely to focus on shareholder wealth maximization than if their compensation is just a ﬁxed salary. This chapter discusses the corporate valuation model, value-based management, and corporate governance, beginning with the corporate valuation model. Why is the corporate valuation model applicable in more circumstances than the dividend growth model? What is value-based management? What is corporate governance?

The Corporate Valuation Model Corporate assets are of two types: operating and nonoperating. Operating assets, in turn, take two forms: assets-in-place and growth options. Assets-in-place include such tangible assets as land, buildings, machines, and inventory, plus intangible assets such as patents, customer lists, reputation, and general know-how. Growth options are opportunities to expand that arise from the ﬁrm’s current operating knowledge, experience, and other resources. The assets-in-place provide an expected stream of cash ﬂows, and so do the growth options. To illustrate, Wal-Mart owns stores, inventory, and other tangible assets, it has a well-known name and reputation, and it has a lot of business know-how. These assets produce current sales and cash ﬂows, and they also provide opportunities for new investments that will produce additional cash ﬂows in the future. Similarly, Merck owns manufacturing plants, patents, and other real assets, and it has a knowledge base that facilitates the development of new drugs and thus new cash ﬂow streams. Most companies also own some nonoperating assets, which come in two forms. The ﬁrst is a marketable securities portfolio over and above the cash needed to operate the business. For example, Ford Motor Company’s automotive operation had about $6.9 billion in marketable securities as of late 2001, and this was in addition to $6.1 billion in cash. Second, Ford also had $2.7 billion of investments in other businesses, which were reported on the asset side of the balance sheet as “Equity in Net Assets of Afﬁliated Companies.” So, in total Ford had $6.9 $2.7 $9.6 billion of nonoperating assets, compared with its $87.6 billion of automotive assets, or 11 percent of the total. For most companies, the percentage is even lower. For example, Wal-Mart’s percentage of nonoperating assets was only 1 percent, which is more typical.

437

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Corporate Valuation, Value-Based Management, and Corporate Governance The Corporate Valuation Model

441

We see, then, that for most companies operating assets are far more important than nonoperating assets. Moreover, companies can inﬂuence the values of their operating assets, but the values of nonoperating assets are largely out of their direct control. Therefore, value-based management, hence this chapter, focuses on operating assets.

Estimating the Value of Operations

See Ch 12 Tool Kit.xls for details.

TABLE 12-1

Tables 12-1 and 12-2 contain the actual 2002 and projected 2003 to 2006 ﬁnancial statements for MagnaVision Inc., which produces optical systems for use in medical photography. (See Chapter 11 for more details on how to project ﬁnancial statements.) Growth has been rapid in the past, but the market is becoming saturated, so the sales growth rate is expected to decline from 21 percent in 2003 to a sustainable rate of 5 percent in 2006 and beyond. Proﬁt margins are expected to improve as the production process becomes more efﬁcient and because MagnaVision will no longer be incurring marketing costs associated with the introduction of a major product. All items on the ﬁnancial statements are projected to grow at a 5 percent rate after 2006. Note that the company does not pay a dividend, but it is expected to start paying out about 75 percent of its earnings beginning in 2005. (Chapter 14 explains in more detail how companies decide how much to pay out in dividends.) Recall that free cash ﬂow (FCF) is the cash from operations that is actually available for distribution to investors, including stockholders, bondholders, and preferred stockholders. The value of operations is the present value of the free cash ﬂows the ﬁrm is expected to generate out into the future. Therefore, MagnaVision’s value can be calculated as the present value of its expected future free cash ﬂows from operations, discounted at its weighted average cost of capital, WACC, plus the value of its MagnaVision Inc.: Income Statements (Millions of Dollars Except for Per Share Data) Actual

Projected

2002

2003

2004b

2005

2006

Net sales Costs (except depreciation) Depreciation Total operating costs Earnings before interest and taxes (EBIT) Less: Net interesta Earnings before taxes Taxes (40%) Net income before preferred dividends Preferred dividends Net income available for common dividends

$700.0 $599.0 28.0 $627.0 $ 73.0 13.0 $ 60.0 24.0 $ 36.0 6.0 $ 30.0

$850.0 $734.0 31.0 $765.0 $ 85.0 15.0 $ 70.0 28.0 $ 42.0 7.0 $ 35.0

$1,000.0 $ 911.0 34.0 $ 945.0 $ 55.0 16.0 $ 39.0 15.6 $ 23.4 7.4 $ 16.0

$1,100.0 $ 935.0 36.0 $ 971.0 $ 129.0 17.0 $ 112.0 44.8 $ 67.2 8.0 $ 59.2

$1,155.0 $ 982.0 38.0 $1,020.0 $ 135.0 19.0 $ 116.0 46.4 $ 69.6 8.3 $ 61.3

Common dividends Addition to retained earnings

— $ 30.0

— $ 35.0

$

$ $

$ $

100 —

100 —

Number of shares Dividends per share

— 16.0 100 —

44.2 15.0 100 $0.442

45.3 16.0 100 $0.453

Notes: a “Net interest” is interest paid on debt less interest earned on marketable securities. Both items could be shown separately on the income statements, but for this example we combine them and show net interest. MagnaVision pays more interest than it earns, hence its net interest is subtracted. b Net income is projected to decline in 2004. This is due to the projected cost for a one-time marketing program in that year.

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TABLE 12-2

MagnaVision Inc.: Balance Sheets (Millions of Dollars) Actual

Projected

2002

2003

2004

2005

2006

Assets Cash Marketable securitiesa Accounts receivable Inventories Total current assets Net plant and equipment Total assets

$

17.0 63.0 85.0 170.0 $ 335.0 279.0 $ 614.0

$

20.0 70.0 100.0 200.0 $ 390.0 310.0 $ 700.0

$ 22.0 80.0 110.0 220.0 $ 432.0 341.0 $ 773.0

$

23.0 84.0 116.0 231.0 $ 454.0 358.0 $ 812.0

$ 24.0 88.0 121.0 243.0 $ 476.0 376.0 $ 852.0

$

$

$ 22.0 160.0 55.0 $ 237.0 $ 160.0 80.0 200.0 96.0 $ 296.0 $ 773.0

$

$ 24.0 176.0 61.0 $ 261.0 $ 176.0 88.0 200.0 127.0 $ 327.0 $ 852.0

Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Preferred stock Common stockb Retained earnings Common equity Total liabilities and equity

$ $

$ $

17.0 123.0 43.0 183.0 124.0 62.0 200.0 45.0 245.0 614.0

$ $

$ $

20.0 140.0 50.0 210.0 140.0 70.0 200.0 80.0 280.0 700.0

$ $

$ $

23.0 168.0 58.0 249.0 168.0 84.0 200.0 111.0 311.0 812.0

Notes: a All assets except marketable securities are operating assets required to support sales. The marketable securities are ﬁnancial assets not required in operations. b Par plus paid-in capital.

nonoperating assets. Here is the equation for the value of operations, which is the ﬁrm’s value as a going concern: Value of operations Vop PV of expected future free cash ﬂow FCF1 FCF2 FCF⬁ 1 2 (1 WACC)⬁ (1 WACC) (1 WACC) ⬁ FCFt a t. t1 (1 WACC)

(12-1)

MagnaVision’s cost of capital is 10.84 percent. To ﬁnd its value of operations as a going concern, we use an approach similar to the nonconstant dividend growth model, proceeding as follows: 1. Assume that the ﬁrm will experience nonconstant growth for N years, after which it will grow at some constant rate. 2. Calculate the expected free cash ﬂow for each of the N nonconstant growth years. 3. Recognize that after Year N growth will be constant, so we can use the constant growth formula to ﬁnd the ﬁrm’s value at Year N. This is the sum of the PVs for year N 1 and all subsequent years, discounted back to Year N. 4. Find the PV of the free cash ﬂows for each of the N nonconstant growth years. Also, ﬁnd the PV of the ﬁrm’s value at Year N.

439

440

Corporate Valuation, Value-Based Management, and Corporate Governance The Corporate Valuation Model

443

5. Now sum all the PVs, those of the annual free cash ﬂows during the nonconstant period plus the PV of the Year N value, to ﬁnd the ﬁrm’s value of operations. Table 12-3 calculates free cash ﬂow for each year, using procedures discussed in Chapter 9. Line 1, with data for 2002 from the balance sheets in Table 12-2, shows the required net operating working capital, or operating current assets minus operating current liabilities, for 2002: Required net Cash Accounts operating ° Accounts receivable ¢ ° payable ¢ working capital Inventories Accruals ($17.00 $85.00 $170.00) ($17.00 $43.00) $212.00. Line 2 shows required net plant and equipment, and Line 3, which is the sum of Lines 1 and 2, shows the required net operating assets, also called net operating capital. For 2002, net operating capital is $212 $279 $491 million. Line 4 shows the required net annual addition to operating assets, found as the change in net operating assets from the previous year. For 2003, the required net investment in operating assets is $560 $491 $69 million. Line 5 shows NOPAT, or net operating proﬁt after taxes. Note that EBIT is operating earnings before taxes, while NOPAT is operating earnings after taxes. Therefore, NOPAT EBIT(1 T). With 2003 EBIT of $85 as shown in Table 12-1 and a tax rate of 40 percent, NOPAT as projected for 2003 is $51 million: NOPAT EBIT(1 T) $85(1.0 0.4) $51 million. Although MagnaVision’s operating assets are projected to produce $51 million of after-tax proﬁts in 2003, the company must invest $69 million in new assets in 2003 to support its growth plan. Therefore, the free cash ﬂow for 2003, shown on Line 7, is a negative $18 million: Free cash ﬂow (FCF) $51 $69 $18 million.

TABLE 12-3

Calculating MagnaVision’s Expected Free Cash Flow (Millions of Dollars) Actual

Projected

2002

2003

2004

2005

2006

$212.00 279.00 $491.00

$250.00 310.00 $560.00

$275.00 341.00 $616.00

$289.00 358.00 $647.00

$303.00 376.00 $679.00

69.00

56.00

31.00

32.00

$ 51.00 69.00 ($ 18.00)

$ 33.00 56.00 ($ 23.00)

$ 77.40 31.00 $ 46.40

$ 81.00 32.00 $ 49.00

Calculation of Free Cash Flow 1. 2. 3. 4.

Required net operating working capital Required net plant and equipment Required net operating capital Required net new investment in operating capital change in net operating capital from previous year

5. NOPAT [Net operating proﬁt after taxes EBIT (1 Tax rate)] 6. Less: Required investment in operating capital 7. Free cash ﬂow

Note: NOPAT declines in 2004 because of a marketing expenditure projected for that year. See Note b in Table 12-1.

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This negative free cash ﬂow in the early years is typical for young, high-growth companies. Even though net operating proﬁt after taxes (NOPAT) is positive in all years, free cash ﬂow is negative because of the need to invest in operating assets. The negative free cash ﬂow means the company will have to obtain new funds from investors, and the balance sheets in Table 12-2 show that notes payable, long-term bonds, and preferred stock all increase from 2002 to 2003. Stockholders will also help fund MagnaVision’s growth—they will receive no dividends until 2005, so all of the net income from 2003 and 2004 will be reinvested. However, as growth slows, free cash ﬂow will become positive, and MagnaVision plans to use some of its FCF to pay dividends beginning in 2005.2 A variant of the constant growth dividend model is shown below as Equation 12-2. This equation can be used to ﬁnd the value of MagnaVision’s operations at time N, when its free cash ﬂows stabilize and begin to grow at a constant rate. This is the value of all FCFs beyond time N, discounted back to time N, which is 2006 for MagnaVision. Vop(at time N)

⬁

a

FCFt

(1 WACC)tN FCFN(1 g) FCFN1 . WACC g WACC g tN1

(12-2)

Based on a 10.84 percent cost of capital, $49 million of free cash ﬂow in 2006, and a 5 percent growth rate, the value of MagnaVision’s operations as of December 31, 2006, is forecasted to be $880.99 million: Vop(12/31/06)

FCF12/31/06(1 g) WACC g

FCF12/31/07 WACC g

(12-2a)

$49(1 0.05) $51.45 $880.99. 0.1084 0.05 0.1084 0.05

This $880.99 million ﬁgure is called the company’s terminal, or horizon, value, because it is the value at the end of the forecast period. It is also sometimes called a continuing value. In any case, it is the amount that MagnaVision could expect to receive if it sold its operating assets on December 31, 2006. Figure 12-1 shows the free cash ﬂow for each year during the nonconstant growth period, along with the horizon value of operations in 2006. To ﬁnd the value of operations as of “today,” December 31, 2002, we ﬁnd the PV of each annual cash ﬂow in Figure 12-1, discounting at the 10.84 percent cost of capital. The sum of the PVs is approximately $615 million, and it represents an estimate of the price MagnaVision could expect to receive if it sold its operating assets today, December 31, 2002.

Estimating the Price per Share The total value of any company is the value of its operations plus the value of its nonoperating assets.3 As the December 31, 2002, balance sheet in Table 12-2 shows, MagnaVision had $63 million of marketable securities on that date. Unlike operating assets, we do not have to calculate a present value for marketable securities because short-term ﬁnancial assets as reported on the balance sheet are at, or close to, 2

MagnaVision plans to increase its debt and preferred stock each year so as to maintain a constant capital structure. We discuss capital structure in detail in Chapter 13. 3 The total value also includes the value of growth options not associated with assets-in-place, but MagnaVision has none. Chapter 17 describes such growth options in detail.

441

Corporate Valuation, Value-Based Management, and Corporate Governance The Corporate Valuation Model FIGURE 12-1

12/31/02

445

Process for Finding the Value of Operations for a Nonconstant Growth Company

12/31/03

12/31/04

12/31/05

12/31/06

12/31/07

g 5%

↑↑                

23.00

46.40

49.00

Vop(2006) 880.99

10.84%

10.84% 10.84%

51.45 51.45 0.1084 0.05

↑                     

$16.24 18.72 34.07 616.16

18.00 10.84%

↑                           

442

929.99

$615.27 Vop(12/31/02)

their market value. Therefore, MagnaVision’s total value on December 31, 2002, is $615.27 $63.00 $678.27 million. If the company’s total value on December 31, 2002, is $678.27 million, what is the value of its common equity? First, the sum of notes payable and long-term debt is $123 $124 $247 million, and these securities have the ﬁrst claim on assets and income. Accounts payable and accruals were netted out earlier when calculating free cash ﬂow, so they have been accounted for. However, the preferred stock has a claim of $62 million, and it also ranks above the common. Therefore, the value left for common stockholders is $678.27 $247 $62 $369.27 million. Figure 12-2 is a bar chart that provides a breakdown of MagnaVision’s value. The left bar shows the company’s total value as the sum of its nonoperating assets plus its FIGURE 12-2

MagnaVision’s Value as of December 31, 2002

Dollars (Millions) 700 Nonoperating Assets = $63

Market Value Added (MVA) = $124

600 Market Value of Equity = $369

500

400

300

Value of Operations = $615

Book Value of Equity = $245

Preferred Stock = $62

Preferred Stock = $62

Debt = $247

Debt = $247

Market Value: Claims

Book Value: Claims

200

100

0

Market Value: Sources

Corporate Valuation, Value-Based Management, and Corporate Governance 446

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Corporate Valuation, Value-Based Management, and Corporate Governance

going concern value. Next, the middle bar shows the claim of each class of investors on that total value. Debtholders have the highest priority claim, and MagnaVision owes $123 million on notes payable and $124 million on long-term bonds, for a total of $247 million. The preferred stockholders have the next claim, $62 million. The remaining value belongs to the common equity, and it amounts to $678.27 $247.00 $62.00 $369.27 million.4 Finally, the bar on the right side divides the market value of the equity into the book value, which represents the actual investment stockholders have made, and the additional market value added by management (MVA). Table 12-4 summarizes the calculations used to ﬁnd MagnaVision’s stock value. There are 100 million shares outstanding, and their total value is $369.27 million. Therefore, the value of a single share is $369.27/100 $3.69.

The Dividend Growth Model Applied to MagnaVision MagnaVision has not yet begun to pay dividends. However, as we saw in Table 12-1, a cash dividend of $0.442 per share is forecasted for 2005. The dividend is expected to grow by about 2.5 percent in 2006, and then at a constant 5 percent rate thereafter. MagnaVision’s cost of equity is 14 percent. In this situation, we can apply the nonconstant dividend growth model as developed earlier in Chapter 5. Figure 12-3 shows that the value of MagnaVision’s stock, based on this model, is $3.70 per share, which is the same as the value found using the corporate valuation model except for a rounding difference.

Comparing the Corporate Valuation and Dividend Growth Models Because the corporate valuation and dividend growth models give the same answer, does it matter which model you choose? In general, it does. For example, if you were a ﬁnancial analyst estimating the value of a mature company whose dividends are expected to grow steadily in the future, it would probably be more efﬁcient to use the dividend growth model. Here you would only need to estimate the growth rate in dividends, not the entire set of pro forma ﬁnancial statements. However, if a company is paying a dividend but is still in the high-growth stage of its life cycle, you would need to project the future ﬁnancial statements before you

4

Rather than subtracting the book values of debt and preferred stock, it would be better to subtract their market values. In most cases, including this one, the book values of ﬁxed income securities are close to their market values, and when this is true, one can simply work with book values.

TABLE 12-4

Finding the Value of MagnaVision’s Stock (Millions of Dollars Except for Per Share Data)

1. 2. 3. 4.

Value of operations (present value of free cash ﬂows) Plus value of nonoperating assets Total market value of the ﬁrm Less: Value of debt Value of preferred stock 5. Value of common equity 6. Divide by number of shares 7. Value per share

$615.27 63.00 $678.27 247.00 62.00 $369.27 100.00 $3.69

443

Corporate Valuation, Value-Based Management, and Corporate Governance Value-Based Management FIGURE 12-3

12/31/02

12/31/03

12/31/04

12/31/05

12/31/06

g 2.5% D2004 0

↑↑                

D2003 0 14%

D2005 0.442

14%

14% 14%

12/31/07 g 5%

D2006 0.453

D2007 0.476

P2006 5.285

0.476 0.14 0.05

↑                     

$0.0000 0.0000 0.2983 3.3974

447

Using the DCF Dividend Model to Find MagnaVision’s Stock Value

↑                             

444

5.738

$3.6957 ⬇ $3.70 P12/31/02

could make a reasonable estimate of future dividends. Then, because you would have already estimated future ﬁnancial statements, it would be a toss-up as to whether the corporate valuation model or the dividend growth model would be easier to apply. Intel, which pays a dividend of about 8 cents versus earnings of about $0.54, is an example of a company to which you could apply either model. Now suppose you were trying to estimate the value of a company that has never paid a dividend, such as Microsoft, or a new ﬁrm that is about to go public, or a division that GE or some other large company is planning to sell. In all of these situations, you would have no choice: You would have to estimate future ﬁnancial statements and use the corporate valuation model. Actually, even if a company is paying steady dividends, much can be learned from the corporate valuation model, hence many analysts today use it for all types of valuations. The process of projecting the future ﬁnancial statements can reveal quite a bit about the company’s operations and ﬁnancing needs. Also, such an analysis can provide insights into actions that might be taken to increase the company’s value. This is value-based management, which we discuss in the next section. Give some examples of assets-in-place, growth options, and nonoperating assets. Write out the equation for the value of operations. What is the terminal, or horizon, value? Why is it also called the continuing value? Explain how to estimate the price per share using the corporate valuation model.

Value-Based Management

See Ch 12 Tool Kit.xls for details.

Bell Electronics Inc. has two divisions, Memory and Instruments, with total sales of $1.5 billion and a book value of capital of $1.07 billion. Based on its current stock and bond prices, the company’s total market value is about $1.215 billion, giving it an MVA of $145 million, found as $1.215 $1.070 $0.145 billion $145 million. Because it has a positive MVA, Bell has created value for its investors. Even so, management is considering several new strategic plans in its efforts to increase the ﬁrm’s value. All of the assets are used in operations.

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The Memory Division produces memory chips for such handheld electronic devices as cellular phones and PDAs (personal digital assistants), while the Instruments Division produces devices for measuring and controlling sewage and water treatment facilities. Table 12-5 shows the latest ﬁnancial results for the two divisions and for the company as a whole. As Table 12-5 shows, Bell Memory is the larger of the two divisions, with higher sales and more operating capital. Bell Memory is also more proﬁtable, with a NOPAT/Sales ratio of 7.9 percent versus 7.2 percent for Bell Instruments. This year, as in other recent years, the focus of the initial strategic planning sessions was on the Memory division. Bell Memory has grown rapidly because of the phenomenal growth in consumer electronics, and this division rocketed past Instruments several years ago. Although Memory’s growth had tapered off, senior management generally agreed that this division would receive the lion’s share of corporate attention and resources because it is larger, more proﬁtable, and, frankly, more exciting. After all, Bell Memory is associated with the glamorous market for telecommunications and personal electronic devices, whereas Bell Instruments is associated with sewage and sludge. The ﬁnancial assumptions and projections associated with the preliminary strategic plans for the two divisions are shown in Tables 12-6 and 12-7. Based on the initial strategic plans, each division is projected to have 5 percent annual growth for the next ﬁve years and thereafter. The strategic plans also assume that the cost structures of the two divisions will remain unchanged from the current year, 2002. Only partial ﬁnancial projections are shown in Tables 12-6 and 12-7, but when Bell’s management decides on a ﬁnal strategic plan, it will develop complete ﬁnancial statements for the company as a whole and use them to determine ﬁnancing requirements, as described in Chapter 11. To evaluate the plans, Bell’s management applied the corporate valuation model to each division, thus valuing them using the free cash ﬂow valuation technique. Each division has a WACC of 10.5 percent, and Table 12-8 shows the results. The three key items are NOPAT, the required investment in operating capital, and the resulting free cash ﬂows for each year. In addition, the table shows each division’s horizon value of operations at 2007, which is the end of the ﬁve years of explicit forecasts, calculated with Equation 12-2. The value of operations at 2002 is the present value of the free cash ﬂows and the horizon value, discounted at the weighted average cost of capital. As expected, Bell Memory has the greater value of operations, $709.6 million versus $505.5 million for Bell Instruments. However, the managers were surprised to see that Bell Memory’s market value added (MVA) is negative: $709.6 value of operations $870.0 required operating capital $160.4 million. In contrast, Bell Instruments’ MVA is positive: $505.5 value of operations $200 operating capital $305.5 million.

TABLE 12-5

Financial Results for Bell Electronics Inc. (Millions of Dollars)

Sales Operating capital Earnings before interest and taxes (EBIT) Net operating proﬁt after taxes (NOPAT) Operating proﬁtability (NOPAT/Sales)

Division 1: Bell Memory

Division 2: Bell Instruments

Total Company

$1,000.0 870.0 131.0 78.6 7.9%

$500.0 200.0 60.0 36.0 7.2%

$1,500.0 1,070.0 191.0 114.6 7.6%

445

446

Corporate Valuation, Value-Based Management, and Corporate Governance Value-Based Management TABLE 12-6

449

Initial Projections for the Bell Memory Division (Millions of Dollars, Except for Percentages) Actual

Projected

2002

2003

2004

2005

2006

2007

81% 10 1 8 30 59 5 6 40

5% 81 10 1 8 30 59 5 6 40

5% 81 10 1 8 30 59 5 6 40

5% 81 10 1 8 30 59 5 6 40

5% 81 10 1 8 30 59 5 6 40

5% 81 10 1 8 30 59 5 6 40

$1,000.0 810.0 59.0 $ 869.0 $ 131.0

$1,050.0 850.5 62.0 $ 912.5 $ 137.6

$1,102.5 893.0 65.0 $ 958.1 $ 144.4

$1,157.6 937.7 68.3 $1,006.0 $ 151.6

$1,215.5 984.6 71.7 $1,056.3 $ 159.2

$1,276.3 1,033.8 75.3 $1,109.1 $ 167.2

Cash Accounts receivable Inventories Operating current assets

$ 10.0 80.0 300.0 $390.0

$ 10.5 84.0 315.0 $409.5

$ 11.0 88.2 330.8 $430.0

$ 11.6 92.6 347.3 $451.5

$ 12.2 97.2 364.7 $474.0

$ 12.8 102.1 382.9 $497.7

Net plant and equipment

$590.0

$619.5

$650.5

$683.0

$717.1

$753.0

$ 50.0 60.0 $110.0

$ 52.5 63.0 $115.5

$ 55.1 66.2 $121.3

$ 57.9 69.5 $127.3

$ 60.8 72.9 $133.7

$ 63.8 76.6 $140.4

PANEL A: INPUTS

Sales growth rate Costs/sales Depreciation/net plant Cash/sales Accounts receivable/sales Inventories/sales Net plant/sales Accounts payable/sales Accruals/sales Tax rate PANEL B: PARTIAL INCOME STATEMENT

Net sales Costs (except depreciation) Depreciation Total operating costs EBIT PANEL C: PARTIAL BALANCE SHEETS

Operating Assets

Operating Liabilities Accounts payable Accruals Operating current liabilities

A second strategic planning meeting was called to address this unexpected result. In it, Bell Memory’s managers proposed a $20 million marketing campaign to boost their sales growth rate from 5 to 6 percent. They argued that because Bell Memory is so proﬁtable, its value would be much higher if they could push up sales. Before accepting this proposal, though, the proposed changes were run through the valuation model. The managers changed the Bell Memory division’s growth rate from 5 to 6 percent; see the ﬁle Ch 12 Tool Kit.xls on the textbook’s web site for details. To their surprise, the division’s value of operations fell to $691.5, and its MVA also declined, from $160.4 million to $178.5 million. Although Bell Memory was proﬁtable, increasing its sales growth actually reduced its value!

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TABLE 12-7

Initial Projections for the Bell Instruments Division (Millions of Dollars) Actual

Projected

2002

2003

2004

2005

2006

2007

85% 10 1 5 15 30 5 6 40

5% 85 10 1 5 15 30 5 6 40

5% 85 10 1 5 15 30 5 6 40

5% 85 10 1 5 15 30 5 6 40

5% 85 10 1 5 15 30 5 6 40

5% 85 10 1 5 15 30 5 6 40

$500.0 $425.0 15.0 $440.0 $ 60.0

$525.0 $446.3 15.8 $462.0 $ 63.0

$551.3 $468.6 16.5 $485.1 $ 66.2

$578.8 $492.0 17.4 $509.4 $ 69.5

$607.8 $516.6 18.2 $534.8 $ 72.9

$638.1 $542.4 19.1 $561.6 $ 76.6

Cash Accounts receivable Inventories Operating current assets

$

5.0 25.0 75.0 $105.0

$

5.3 26.3 78.8 $110.3

$

5.5 27.6 82.7 $115.8

$

5.8 28.9 86.8 $121.6

$

6.1 30.4 91.2 $127.6

$

Net plant and equipment

$150.0

$157.5

$165.4

$173.6

$182.3

$191.4

$25.0 30.0 $55.0

$26.3 31.5 $57.8

$27.6 33.1 $60.6

$28.9 34.7 $63.7

$30.4 36.5 $66.9

$31.9 38.3 $70.2

PANEL A: INPUTS

Sales growth rate Costs/sales Depreciation/net plant Cash/sales Accounts receivable/sales Inventories/sales Net plant/sales Accounts payable/sales Accruals/sales Tax rate PANEL B: PARTIAL INCOME STATEMENT

Net sales Costs (except depreciation) Depreciation Total operating costs EBIT PANEL C: PARTIAL BALANCE SHEETS

Operating Assets 6.4 31.9 95.7 $134.0

Operating Liabilities Accounts payable Accruals Operating current liabilities

To better understand these results, we can express the ﬁrm’s value in terms of four fundamental wealth drivers: g growth in sales OP Operating proﬁtability (OP) NOPAT/Sales CR Capital requirements (CR) Operating capital/Sales WACC Weighted average cost of capital How do these drivers affect the value of a ﬁrm? First, the sales growth rate generally, but not always, has a positive effect on value, provided the company is proﬁtable

447

448

Corporate Valuation, Value-Based Management, and Corporate Governance Value-Based Management TABLE 12-8

451

Initial FCF Valuation of Each Division (Millions of Dollars)

PANEL A: FCF VALUATION OF THE BELL MEMORY DIVISION

Actual

Projected

2002

2003

$280.0 590.0 $870.0

$294.0 619.5 $913.5

$78.6

$43.5 $82.5 $39.0

2004

2005

2006

2007

$ 324.1 683.0 $1,007.1

$ 340.3 717.1 $1,057.5

$ 357.4 753.0 $1,110.4

Calculation of FCF Net operating working capital Net plant Net operating capital Investment in operating capital NOPAT Free cash ﬂow Growth in FCF

$308.7 650.5 $959.2 $45.7 $86.7 $41.0 5.0%

$48.0 $91.0 $43.0 5.0%

$50.4 $95.5 $45.2 5.0%

$52.9 $100.3 $47.4 5.0%

Value of Operations Horizon value Value of operations Divisional MVA (Value of operations capital)

$905.7 $709.6 ($160.4)

PANEL B: FCF VALUATION OF THE BELL INSTRUMENTS DIVISION

Calculation of FCF Net operating working capital Net plant Net operating capital Investment in operating capital NOPAT Free cash ﬂow Growth in FCF

$ 50.0 150.0 $200.0

$ 52.5 157.5 $210.0

$36.0

$10.0 $37.8 $27.8

$ 55.1 165.4 $220.5 $10.5 $39.7 $29.2 5.0%

$ 57.9 173.6 $231.5 $11.0 $41.7 $30.6 5.0%

$ 60.8 182.3 $243.1 $11.6 $43.8 $32.2 5.0%

$ 63.8 191.4 $255.3 $12.2 $45.9 $33.8 5.0%

Value of Operations Horizon value Value of operations Divisional MVA (Value of operations capital)

$645.1 $505.5 $305.5

Notes: The WACC is 10.5 percent for each division. The horizon value (HV) at 2007 is calculated using Equation 12-2, the constant growth formula for free cash ﬂows: HV2007 [FCF2007 (1 g)]/(WACC g). The value of operations is the present value of the horizon value and the free cash ﬂows discounted at the WACC, calculated in a manner similar to Figure 12-1. See the ﬁle Ch 12 Tool Kit.xls on the textbook’s web site for details.

enough. However, the effect can be negative if growth requires a great deal of capital, and the cost of that capital is high. Second, operating proﬁtability, which measures the after-tax proﬁt per dollar of sales, always has a positive effect—the higher the better. Third, the capital requirements ratio, which measures how much operating capital is needed to generate a dollar of sales, also has a consistent effect—the lower the CR the better, since a low CR means that the company can generate new sales with smaller amounts of new capital. Finally, the fourth factor, the WACC, also has a consistent effect—the lower it is, the higher the ﬁrm’s value.

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Another important metric in the corporate valuation model is the expected return on invested capital (EROIC), deﬁned as the expected NOPAT for the coming year divided by the amount of operating capital at the beginning of the year (which is the end of the preceding year). Thus, EROIC represents the expected return on the capital that has already been invested. To illustrate, the EROIC of the Bell Memory division for 2007, the last year in the forecast period, is: EROIC2007

$100.3(1.05) NOPAT2008 9.5%. Capital2007 $1,110.4

To see exactly how the four value drivers and expected ROIC determine value for a constant growth ﬁrm, we can start with Equation 12-2, Vop(at time N)

FCFN1 , WACC g

(12-2)

and rewrite it in terms of the value drivers: Vop(at time N) CapitalN c

SalesN (1 g) WACC g

d c OP WACCa

CR b d. 1g

(12-3)

Equation 12-3 shows that the value of operations can be divided into two components: (1) the dollars of operating capital that investors have provided and (2) the additional value that management has added or subtracted, which is equivalent to MVA. Note that the ﬁrst bracket of Equation 12-3 shows the present value of growing sales, discounted at the WACC. This would be the MVA of a ﬁrm that has no costs and that never needs to invest additional capital. But ﬁrms do have costs and capital requirements, and their effect is shown in the second bracket. Here we see that, holding g constant, MVA will improve if operating proﬁtability (OP) increases, capital requirements (CR) decrease, or WACC decreases. Note that an increase in growth will not necessarily increase value. OP could be positive, but if CR is quite high, meaning that a lot of new capital is needed to support a given increase in sales, then the second bracket can be negative. In this situation, growth causes the term in the ﬁrst bracket to increase, but it is being multiplied by a negative term in the second bracket, and the net result will be a decrease in MVA. We can also rewrite Equation 12-2 in terms of EROIC: Vop(at time N) CapitalN

CapitalN(EROICN WACC) WACC g

.

(12-4)

Equation 12-4 also breaks value into two components, the value of capital and the MVA, shown in the second term. This term shows that value depends on the spread between the expected return on invested capital, EROIC, and WACC. If EROIC is greater than WACC, then the return on capital is greater than the return investors expect, and management is adding value. In this case, an increase in the growth rate causes value to go up. If EROIC is exactly equal to WACC, then the ﬁrm is, in an economic sense, “breaking even.” It has positive accounting proﬁts and cash ﬂow, but these cash ﬂows are just sufﬁcient to satisfy investors, causing value to exactly equal the amount of capital that has been provided. If EROIC is less than WACC, the term in brackets is negative, management is destroying value, and growth is harmful. Here the faster the growth rate is, the lower the ﬁrm’s value. We should also note that the insights from Equations 12-3 and 12-4 apply to all ﬁrms, but the equations themselves can only be applied to relatively stable ﬁrms whose growth has leveled out at a constant rate. For example, Home Depot has been growing at more than 20 percent per year, so we cannot apply Equations 12-3 and 12-4 directly (although we can always apply Equation 12-1). Home Depot’s

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Who Is Creating Wealth?

A recent article in Fortune demonstrates the relationship between wealth creation as measured by Market Value Added (MVA) and the spread between the return on invested capital (ROIC) and the cost of capital (WACC). The accompanying table shows that companies such as Microsoft and Intel have created enormous MVA by having a large spread between ROIC and WACC, even though they employ relatively small amounts of capital. On the other hand, Wal-Mart and Citigroup created extraordinary MVA with a relatively small spread between ROIC and WACC MVA (billions of dollars)

because they are earning that spread on a large amount of capital. Cisco has a small spread and low capital base, but very strong growth prospects, which explains its large MVA. The table also shows some companies with negative MVAs. Note that all of them have a negative spread: Their return on capital is less than investors expect. These negative MVAs cannot be attributed solely to industry conditions. Several pairs of wealth creators and destroyers are in the same industries: WalMart versus Kmart, Burlington Northern Santa Fe versus CSX, GE versus Raytheon, and Citigroup versus BankOne. Capital (billions of dollars)

ROIC

WACC

$502 389 378 177 281 113 1

$76 20 24 54 30 75 20

17.2% 51.8 13.7 14.3 30.6 14.3 8.2

12.5% 12.6 12.8 11.0 12.0 12.8 8.1

$ 1 5 7 9

$18 27 20 46

4.0% 5.3 4.8 8.5

7.0% 7.9 7.7 12.0

Wealth Creators General Electric (GE) Microsoft (MSFT) Cisco Systems (CSCO) Wal-Mart Stores (WMT) Intel (INTC) Citigroup (C) Burlington Northern Santa Fe (BNI) Wealth Destroyers CXS (CSX) Raytheon (RTN) Kmart (KM) BankOne Corporation (ONE)

Sources: Geoffrey Colvin, “America’s Best and Worst Wealth Creators,” Fortune, December 18, 2000, 207–216; and http://www.sternstewart.com.

NOPAT/sales ratio is 5.6 percent, which is excellent for its industry, but even though it is proﬁtable, it has negative free cash ﬂows. This is because Home Depot is still in its high-growth phase, which requires enormous investments in operating capital. When we forecast out to the point where Home Depot’s sales growth slows due to market saturation, its free cash ﬂows become very large and positive, which explains its high MVA of $148 billion. Note also that Home Depot currently has an expected ROIC of 19.6 percent versus a WACC of only 10.5 percent. This large spread contributes to its $148 billion MVA. Table 12-9 shows the value drivers for Bell’s two divisions, measured at 2007, the end of the forecast period. We report these for the end of the forecast period because ratios can change during the forecast period due to input changes. By the end of the forecast period, however, all inputs and ratios should be stable. Table 12-9 shows that both divisions have the same growth rate and the same WACC. Bell Memory is more proﬁtable, but it also has much higher capital requirements. The result is that Bell Memory’s expected ROIC is only 9.5 percent, well

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Corporate Valuation, Value-Based Management, and Corporate Governance TABLE 12-9

Bell Electronics’ Forecasted Value Drivers for 2007 Division 1: Bell Memory

Growth, g Proﬁtability (NOPAT2007/Sales2007) Capital requirement (Capital2007/Sales2007) WACC Expected return on invested capital, EROIC (NOPAT2007(1 g)/Capital2007)

Division 2: Bell Instruments

5.0%

5.0%

7.9

7.2

87.0 10.5

40.0 10.5

9.5

18.9

below its 10.5 percent WACC. Thus, growth doesn’t help Bell Memory—indeed, it lowers the division’s value. Based on this analysis, Bell Memory’s managers decided not to request funds for a marketing campaign. Instead, they developed a plan to reduce capital requirements. The new plan called for spending $50 million on an integrated supply chain information system that would allow them to cut their inventories/sales ratio from 30 percent to 20 percent and also reduce the net plant/sales ratio from 59 percent to 50 percent. Table 12-10 shows operating results based on this new plan. The value of operations increases from $709.6 million to $1.1574 billion, or by $447.8 million. Because this is well over the $50 million required to implement the plan, top management decided to approve the plan. Note also that MVA becomes positive at $287.4 million, and the divisional expected ROIC rises to 13.0 percent, well over the 10.5 percent WACC. Bell Instruments’ managers also used the valuation model to assess changes in plans for their division. Given their high expected ROIC, the Instruments Division proposed (1) an aggressive marketing campaign and (2) an increase in inventories that TABLE 12-10

Comparison of the Preliminary and Final Plans (Millions of Dollars) Bell Memory Preliminary

Bell Instruments

Final

Preliminary

Final

Inputs Sales growth rate, g Inventories/sales Net plant/sales

5% 30 59

5% 20 50

5% 15 30

6% 16 30

Results EROIC (2007)a Invested (operating) capital (2007)a Current value of operations (2002)b Current MVA (2002)b

9.5% $1,110.4 $709.6 ($160.4)

13.0% $867.9 $1,157.4 $287.4

18.9% $255.3 $505.5 $305.5

18.6% $274.3 $570.1 $370.1

Notes: a We report EROIC and capital for the end of the forecast period because ratios can change during the forecast period if inputs change during the forecast period. By the end of the forecast period, however, all inputs and ratios should be stable. b We report the value of operations and the MVA as of the current date, 2002, because we want to see the effect that the proposed plans have on the current value of the divisions.

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Value-Based Management in Practice

The corporate valuation model, in which free cash ﬂows are discounted at the weighted average cost of capital to determine the value of the company, lies at the heart of valuebased management. Therefore, before adopting value-based management, managers would be wise to ask if the corporate valuation model produces results that are consistent with actual market values. The answer, according to a study by Copeland, Koller, and Murrin of the consulting ﬁrm McKinsey & Company, is a resounding yes. They applied the model to 35 companies and found a 0.94 correlation between the model’s estimated values and the actual market values. Additional evidence of the model’s usefulness was provided by McCafferty’s recent survey, in which CFOs rated the corporate valuation model as the most important technique for estimating the value of a potential acquisition. Finally, a recent Fortune article described how much corporations are paying consultants to help them implement the model. Marakon Associates, a leading advocate of valuebased management, prides itself on having a single-minded view that a company should have one, and only one, goal—to increase shareholder wealth. It often takes Marakon several years to fully implement a value-based management system at a company. One reason for the lengthy implementation period is that Marakon breaks the company into segments to

determine where value is currently being created or destroyed. These segments might be divisions, product lines, customers, or even channels of distribution. “Deep drilling,” as they call this process, is arduous and time-consuming, and it requires a great deal of data and analysis. Also, and perhaps even more important, full implementation requires both a change in corporate culture and the creation of an “organization’s collective ability to out-think its rivals.” In other words, the skill-set to use value-based management must permeate the entire company. Although Marakon is a relatively small ﬁrm, with only 275 consultants versus almost 5,000 for McKinsey, it generates about $475,000 in revenue per consultant, which ties them with McKinsey as the most expensive consulting company. Note, though, that its rates seem to be justiﬁed. During the last ﬁve years, Marakon’s client companies have created an additional $68 billion of wealth versus what they would have created had they matched their industry peers’ results. Sources: Thomas A. Stewart, “Marakon Runners,” Fortune, September 28, 1998, 153–158; Joseph McCafferty, “What Acquiring Minds Want to Know,” CFO, February, 1999, 1; Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies (New York: John Wiley & Sons, 1994), 83.

would allow faster delivery and fewer stock-outs. Together, these changes would boost the growth rate from 5 to 6 percent. The direct cost to implement the plan was $20 million, but there was also an indirect cost in that signiﬁcantly more inventories would have to be carried. Indeed, the ratio of inventories to sales was forecasted to increase from 15 to 16 percent. Should Instruments’ new plan be implemented? Table 12-10 shows the forecasted results. The capital requirements associated with the increased inventory caused the expected ROIC to fall from 18.9 to 18.6 percent, but (1) the 18.6 percent return greatly exceeded the 10.5 percent WACC, and (2) the spread between 18.6 percent and 10.5 percent would be earned on additional capital. This caused the forecasted value of operations to increase from $505.5 to $570.1 million, or by $64.6 million. An 18.6 percent return on $274.3 million of capital is more valuable than an 18.9 percent return on $255.3 million of capital.5 You, or one of Bell’s stockholders, would surely rather have an asset that provides a 50 percent return on an investment of $1,000 than one that provides a 100 percent return on an investment of $1. Therefore, the new plan should be accepted, even though it lowers the Instruments Division’s expected ROIC. 5

A potential ﬂy in the ointment is the possibility that Bell has a compensation plan based on rates of return and not on changes in wealth. In such a plan, which is fairly typical, the managers might reject the new proposed strategic plan if it lowers ROIC and, hence, their bonuses, even though the plan is good for the company’s stockholders. We discuss the effect of compensation plans in more detail later in the chapter.

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Sometimes companies focus on their proﬁtability and growth, without giving adequate consideration to their capital requirements. This is a big mistake—all the wealth creation drivers must be taken into account, not just growth. Fortunately for Bell’s investors, the revised plan was accepted. However, as this example illustrates, it is easy for a company to mistakenly focus only on proﬁtability and growth. They are important, but so are the other value drivers—capital requirements and the weighted average cost of capital. Value-based management explicitly includes the effects of all the value drivers because it uses the corporate valuation model, and they are all embodied in the model. What are the four value drivers? How is it possible that sales growth would decrease the value of a proﬁtable ﬁrm?

Corporate Governance and Shareholder Wealth Shareholders want companies to hire managers who are able and willing to take whatever legal and ethical actions they can to maximize stock prices. This obviously requires managers with technical competence, but it also requires managers who are willing to put forth the extra effort necessary to identify and implement value-adding See the web pages of CalPERS (the California Pub- activities. However, managers are people, and people have both personal and corporate goals. Logically, therefore, managers can be expected to act in their own selflic Employees’ Retirement System), http://www. interests, and if their self-interests are not aligned with those of stockholders, then calpers.org, and TIAAcorporate value will not be maximized. Managers may spend too much time golﬁng, CREF (Teachers Insurance lunching, surﬁng the net, and so forth, rather than focusing on corporate tasks, and and Annuity Associationthey may also use corporate resources on activities that beneﬁt themselves rather than College Retirement Equity Fund), http://www.tiaa.org, shareholders. So, a key aspect of value-based management is to motivate executives for excellent discussions of and other managers to actually take the actions required under value-based manageshareholder-friendly corpoment. rate governance. This section deals with corporate governance, which is deﬁned as the set of rules and procedures that ensure that managers do indeed employ the principles of valuebased management. The essence of corporate governance is to make sure that the key shareholder objective—wealth maximization—is implemented. Most corporate governance provisions come in two forms, sticks and carrots. The primary stick is the threat of removal, either as a decision by the board of directors or as the result of a hostile takeover. If a ﬁrm’s managers are maximizing the value of the resources entrusted to them, they need not fear the loss of their jobs. On the other hand, if managers are not maximizing value, they may well be removed, by their own boards of directors, by dissident stockholders, or by other companies seeking to proﬁt by installing a better management team. The main carrot is compensation. If compensation is strictly in the form of salary, then managers will have less incentive to focus on their ﬁrms’ values than if compensation is somehow linked to their ﬁrms’ performance, especially stock price performance. We discuss different types of motivational devices in the following subsections.

Provisions to Prevent Managerial Entrenchment Suppose a company has a weak board of directors and strong anti-takeover provisions in its corporate charter, causing senior managers to feel that there is little chance that

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they will be removed. In this case, management is said to be entrenched. Such a company faces a high risk of being poorly run, because entrenched managers are able to act in their own interests rather than in those of shareholders. For example, they can spend company money on such perquisites as lavish ofﬁces, memberships at country clubs, and corporate jets. Because these perks are not actually cash payments to the managers, they are called nonpecuniary beneﬁts. Also, entrenched managers are often reluctant to reduce ﬁxed costs by closing or selling off redundant plants, laying off employees whose services are no longer needed, and abandoning projects that show little promise of future proﬁts. Managers often hate to admit mistakes, and they are also reluctant to lay off people, especially old friends and colleagues, even when these actions really should be taken. Entrenchment also enables managers to acquire other companies at too high a price, as well as to accept projects that make the company larger but that have negative MVAs. These actions occur because managerial prestige and salary are associated with larger size, and they result in things that are bad for stockholders but good for the senior executives. Note, though, that if a ﬁrm has a strong board, dominated by shareholder-oriented people such as Warren Buffett, or if its charter does not make it too difﬁcult for an outside group to seize control and oust a poorly performing management, then such value-destroying actions are minimized. Barriers to Hostile Takeovers Hostile takeovers usually occur when managers have not been willing or able to maximize the proﬁt potential of the resources under their control. In such a situation, another company can acquire the poorly performing ﬁrm, replace its managers, increase free cash ﬂow, and improve MVA. The following paragraphs describe some provisions that can be included in a corporate charter to make it harder for poorly performing managers to remain in control.6 A shareholder-friendly charter should ban targeted share repurchases, also known as greenmail. For example, suppose a company’s stock is selling for $20 per share. Now a hostile bidder, who plans to replace management if the takeover is successful, buys 5 percent of the company’s stock at the $20 price.7 The raider then makes an offer to purchase the remainder of the stock for $30 per share. The company might offer to buy back the bidder’s stock at a price of say $35 per share. This is called a targeted share repurchase, since the stock will be purchased only from the bidder and not from any other shareholders. Because the bidder paid only $20 per share for the stock, he or she would be making a quick proﬁt of $15 per share, which could easily total several hundred million dollars. As a part of the deal, the raider would sign a document promising not to attempt to take over the company for a speciﬁed number of years, hence the buyback also is called greenmail. Greenmail

6

Some states have laws that go further than others to protect management. This is one reason that many companies are incorporated in Delaware. Some companies have even shifted their state of incorporation to Delaware because their managers felt that a hostile takeover attempt was likely. Note that a “shareholderfriendly charter” could and would waive the company’s rights to strong anti-takeover protection, even if the state allows it. 7 Someone can, under the law, acquire up to ﬁve percent of a ﬁrm’s stock without announcing the acquisition. Once the ﬁve-percent limit has been hit, the acquirer must “announce” the acquisition by ﬁling a report with the SEC, and the report must list not only the acquirer’s position but also his or her intentions, e.g., a passive investment or a takeover. These reports are monitored closely, so as soon as one is ﬁled, management is alerted to the imminent danger of a takeover.

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hurts shareholders in two ways. First, they are left with $20 stock when they could have received $30 per share. Second, the company purchased stock from the bidder at $35 per share, which represents a direct loss by the remaining shareholders of $15 for each repurchased share. Managers who buy back stock in targeted repurchases typically argue that their ﬁrms are worth more than the raiders offered, and that in time the “true value” will be revealed in the form of a much higher stock price. This situation might be true if a company were in the process of restructuring itself, or if new products with high potential were in the pipeline. But if the old management had been in power for a long time, and if it had a history of making empty promises, then one should question whether the true purpose of the buyback was to protect stockholders or management. Another aspect of a stockholder-friendly charter is that it does not contain a shareholder rights provision, better described as a poison pill. These provisions give the shareholders of target ﬁrms the right to buy a speciﬁed number of shares in the company at a very low price if an outside group or ﬁrm acquires a speciﬁed percentage of the ﬁrm’s stock. Therefore, if a potential acquirer tries to take over a company, its other shareholders will be entitled to purchase additional shares of stock at a bargain price, thus seriously diluting the holdings of the raider. For this reason, these clauses are called poison pills, because if they are in the charter, the acquirer will end up swallowing a poison pill if the acquisition is successful. Obviously, the existence of a poison pill makes a takeover more difﬁcult, and this helps to entrench management. A third management entrenchment tool is a restricted voting rights provision, which automatically deprives a shareholder of voting rights if the shareholder owns more than a speciﬁed amount of stock. The board can grant voting rights to such a shareholder, but this is unlikely if the shareholder plans to take over the company. Effective Monitoring by a Strong Board of Directors High compensation and prestige go with a position on the board of a major company, so board seats are prized possessions. Board members typically want to retain their positions, and they are grateful to whoever helped get them on the board. This situation has important implications for corporate governance as it affects stockholders. First, note that 30 years ago a ﬁrm’s CEO was in all likelihood also the chairman of its board. Moreover, many of the other board members were “insiders,” that is, people who held managerial positions within the company, such as the CFO. The CEO, who could remove them from their inside position if they raised objections to his policies, generally nominated them to the board. Even outside board members usually had strong connections with the CEO through personal friendships, consulting or other fee-generating activities, or interlocking boards of directors, where Company A’s CEO sits on Company B’s board and B’s CEO sits on A’s board. In these situations, even the outside directors are not truly independent and impartial. Under an “old boy network” board as described above, the CEO had a much more protected position than is typical today. Now most boards are comprised primarily of outsiders who are not beholden to the CEO, which makes it much more likely that an ineffective CEO will be removed. Also, in the earlier period board members were compensated in the form of salary, whereas today directors are generally given stock or options, so an ineffective management team costs the directors money. The changes in director compensation, together with directors’ greater

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independence, have done much to improve the way boards monitor managerial performance and react to poor results.8 Why have these changes occurred? The primary reason has to do with a shift in the ownership of common stocks. Prior to the 1960s, most stock was owned by a large number of individual investors, each of whom owned a diversiﬁed portfolio of stocks. Because these individuals had just a small amount of any given company’s stock, they could do little to inﬂuence its operations. Also, with just a small investment, it was not cost effective for them to monitor companies closely. Indeed, if a stockholder was dissatisﬁed, he or she would typically just “vote with his feet,” that is, sell his or her stock. This situation began to change as institutional investors such as pension and mutual funds gained control of a larger and larger share of investment capital, and as they then acquired a larger and larger percentage of all outstanding stock. Given their large holdings, it makes sense for institutional investors to monitor management, and they have the clout to inﬂuence the board. In some cases, they have actually elected their own representatives to the board. For example, when TIAA-CREF, a huge private pension fund, became frustrated with the performance and leadership of Furr’s/ Bishop, a cafeteria chain, the fund led a ﬁght that ousted the entire board and then elected a new board, which consisted only of outsiders. In general, activist investors with large stakes in companies have been good for all shareholders. They have searched for ﬁrms with poor proﬁtability, then replaced management with new teams that are well-versed in value-based management techniques, and thereby improved proﬁtability. Not surprisingly, stock prices usually rise when the news comes out that a well-known activist investor has taken a major position in an underperforming company. Note that activist investors can improve performance even if they don’t go so far as to take over a ﬁrm. More often, they get a few people on the board, those people point out the ﬁrm’s problems, and then the other board members change their attitudes and become less tolerant when they realize that the management team is not following the dictates of value-based management. Moreover, the ﬁrm’s top managers recognize what will happen if they don’t whip the company into shape, and they go about doing just that. As power has shifted from CEOs to boards as a whole, there has been a tendency to replace insiders with strong, independent outsiders. Today, the typical board has about one-third insiders and two-thirds outsiders, and most outsiders are truly independent. Moreover, they are compensated primarily with stock rather than a straight salary. All of this has clearly decreased the patience of boards with poorly performing CEOs, and within the past several years the CEOs of Procter & Gamble, Coca-Cola,

8

Note that boards can be elected by either cumulative or noncumulative voting. Under cumulative voting, each shareholder is given a number of votes equal to his or her shares times the number of board seats up for election. For example, the holder of 100 shares of stock will receive 1,000 votes if 10 seats are to be ﬁlled. Then, the shareholder can distribute his or her votes however he or she sees ﬁt. One hundred votes could be cast for each of 10 candidates, or all 1,000 votes could be cast for one candidate. If noncumulative voting is used, our illustrative stockholder cannot concentrate his or her votes—no more than 100 votes can be cast for any one candidate. With noncumulative voting, if management controls 51 percent of the shares, they can ﬁll every seat on the board—dissident stockholders cannot put a representative on the board. With cumulative voting, however, if 10 seats are to be ﬁlled, dissidents can elect a representative, provided they have 10 percent plus one share of the stock. Note also that bylaws specify whether the entire board is to be elected annually or if directors are to have staggered terms, with, say, one-third of the seats to be ﬁlled each year and directors to serve three-year terms. With staggered terms, fewer seats come up each year, making it harder for dissidents to gain representation on the board.

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GM, IBM, Mattel, Campbell Soup, and Xerox, to name just a few, have been removed. This would have been unheard of 30 years ago.

Using Compensation to Align Managerial and Shareholder Interests In the preceding section we discussed the stick side of corporate governance. Now we turn to the carrot, managerial compensation. The typical CEO today receives a ﬁxed salary plus a bonus that is zero if the ﬁrm’s performance is poor but that rises as performance becomes better and better. In 1997, salary for an average executive amounted to about 21 percent of total compensation versus bonuses of about 79 percent. So, performance certainly matters!9 Executive bonuses are based on a number of criteria, some reﬂecting short-term, or very recent, performance and others reﬂecting performance over a longer period. Bonuses also reﬂect internal operating statistics as well as stock prices, which reﬂect both internal operations and general stock market movements. On average, short-run operating factors such as this year’s growth in earnings per share account for about 34 percent of the bonus, 20 percent is based on longer-term operating performance such as earnings growth over the last three years, and the remaining 46 percent is linked to the company’s stock price. Bonuses can be paid in cash, in stock, or in options to buy stock. Moreover, they can be paid immediately after the relevant period (immediate vesting) or be awarded in stages over a number of years (deferred vesting). To illustrate deferred vesting, an executive might be awarded 10,000 shares of stock, but at the rate of 2,000 per year for each of the next ﬁve years, provided he or she is still with the company on each payment date. Stock Options The majority of stock-based compensation is in the form of options. Chapter 17 discusses option valuation in detail, but we discuss here how a standard stock option compensation plan works. Suppose IBM decides to grant an option to an employee, allowing him or her to purchase a speciﬁed number of IBM shares at a ﬁxed price, called the exercise price, regardless of the actual price of the stock. The exercise price is usually set equal to the current stock price at the time the option is granted. Thus, if IBM’s current price were $100, then the option would have an exercise price of $100. Options usually cannot be exercised until after some speciﬁed period (the vesting period), which is usually one to ﬁve years. Moreover, they have an expiration date, usually 10 years after issue. For our IBM example, assume that the vesting period is 3 years and the expiration date is 10 years. Thus, the employee can exercise the option 3 years after issue or wait as long as 10 years. Of course, the employee would not exercise unless IBM’s stock is above the $100 exercise price, and if the price never rose above $100, the option would expire unexercised. However, if the stock price were above $100 on the expiration date, the option would surely be exercised. Suppose the stock price had grown to $134 after ﬁve years, at which point the employee decided to exercise the option. He or she would buy stock from IBM for $100, so IBM would get only $100 for stock worth $134. The employee would (probably) sell the stock the same day he or she exercised the option, hence would receive in cash the $34 difference between the $134 stock price and the $100 exercise price. People often time the exercise of options to the purchase of a new home or some other large expenditure. Let’s suppose the employee is actually a senior executive and the grant was for 1 million shares. In this case, the executive would receive $34 for each share, or a total of $34 million. Keep in mind that this is in addition to an annual salary and other 9

See Thomas A. Stewart, “CEO Pay: Mom Wouldn’t Approve,” Fortune, March 31, 1997, 119–120.

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bonuses. The logic behind employee options is that they motivate people to work harder and smarter, thus making the company more valuable and beneﬁting shareholders. But take a closer look at this example. If the risk-free rate is 6.5 percent, the market risk premium is 6 percent, and IBM’s beta is 1.09, then the expected return, based on the CAPM, is 13 percent [6.5% 1.09(6%) 13%]. IBM’s dividend yield is only 0.4 percent, so the expected annual price appreciation must be around 12.6 percent (13% 0.4% 12.6%). Now note that if IBM’s stock price grew from $100 to $134 over ﬁve years, that would translate to an annual growth rate of only 6 percent, not the 12.6 percent shareholders expected. Thus, the executive would receive $34 million for helping run a company that performed below shareholders’ expectations. As this example illustrates, standard stock options do not necessarily link executives’ wealth with that of shareholders. As a result, companies today are experimenting with different types of compensation plans, with different vesting periods and different measures of performance.10 Employee Stock Ownership Plans (ESOPs) Studies show that 90 percent of the employees who receive stock under option plans sell the stock as soon as they exercise their options, so the plans motivate employees only for a limited period.11 Moreover, many companies limit their stock option plans to key managers and executives. To help provide long-term productivity gains, and also to help improve retirement incomes for all employees, Congress authorized the use of Employee Stock Ownership Plans (ESOPs). Today about 8,500 privately held companies and 1,500 publicly held ﬁrms have ESOPs, and more are being created every day. Typically, the ESOP’s major asset is shares of the common stock of the company that created it, and of the 10,000 total ESOPs, about 2,500 of them actually own a majority of their company’s stock.12 To illustrate how an ESOP works, consider Gallagher & Abbott Inc. (G&A), a Knoxville, Tennessee, construction company. G&A’s simpliﬁed balance sheet is shown below. G&A’s Balance Sheet Prior to ESOP (millions of dollars) Assets

Cash Other Total

Liabilities and Equity

$ 10 190 $200

Debt Equity (1 million shares) Total

$100 100 $200

Now G&A creates an ESOP, which is a new legal entity. The company issues 500,000 shares of new stock at $100 per share, or $50 million in total, which it sells to the ESOP. G&A’s employees are the ESOP’s stockholders, and each employee receives an

10

It should be noted that the empirical literature listed in the end-of-chapter references shows that the correlation between executive compensation and corporate performance is mixed. Some studies suggest that the type of compensation plan used affects company performance, while others suggest little if any effect. Note also that just as “all ships rise in a rising tide,” so too do most stocks rise in a bull market such as the one during the 1990s. In a strong market, even the stocks of companies whose performance ranks in the bottom 10 percent of their peer group can rise and thus trigger handsome executive bonuses. This situation is leading to compensation plans that are based on relative as opposed to absolute stock price performance. For example, some compensation plans have indexed options, whose exercise prices depend on the performance of the market or of a subset of competitors. 11 See Gary Laufman, “To Have and Have Not,” CFO, March 1998, 58–66. 12 See Eugene Pilotte, “Employee Stock Ownership Plans, Management Motives, and Shareholder Wealth: A Review of the Evidence,” Journal of Financial Education, Spring 1997, 41–46; and Daniel Eisenberg, “No ESOP Fable,” Time, May 10, 1999, 95.

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Corporate Valuation, Value-Based Management, and Corporate Governance

International Corporate Governance

Corporate governance includes the following factors: (1) the likelihood that a poorly performing ﬁrm can be taken over; (2) whether the board of directors is dominated by insiders or outsiders; (3) the extent to which most of the stock is held by a few large “blockholders” versus many small shareholders; and (4) the size and form of executive compensation. A recent study compared Germany, Japan, and the United States. First, note from the accompanying table that the threat of a takeover serves as a stick in the United States but not in Japan or Germany. This threat, which reduces management entrenchment, should beneﬁt shareholders in the United States relative to the other two countries. Second, German and Japanese boards are larger than those in the United States, and Japanese boards consist primarily of insiders versus German and American boards, which have similar inside/outside mixes. It should be noted, though, that the boards of most large German corporations include representatives of labor, whereas U.S. boards represent just shareholders. Thus, it would appear that U.S. boards, with a higher percentage of outsiders, would have interests most closely aligned with those of shareholders. German and Japanese ﬁrms are also more likely to be controlled by large blocks of stock than in the United States. Although pension and mutual funds, as well as other institutional investors, are increasingly important in the United States, block ownership is still less than in Germany and Japan. In both Germany and Japan, banks often own large blocks of stock, something that is not permitted by law in the United States, and corporations also own large blocks of stock in other corporations. In Japan, combinations of companies, called keiretsus, have cross-ownership of stock among the member companies, and these interlocking blocks distort the deﬁnition of an outside board member. For example, when the performance of a company in a keiretsu deteriorates, new directors are often appointed from the staffs of other members of the keiretsu. Such appointees might be

classiﬁed ofﬁcially as insiders, but they represent interests other than those of the troubled company’s CEO. In general, large blockholders are better able to monitor management than are small investors, so one might expect the blockholder factor to favor German and Japanese shareholders. However, these blockholders have other relationships with the company that might be detrimental to outside shareholders. For example, if one company buys from another, they might use transfer pricing to shift wealth to a favored company, or a company might be forced to buy from a sister company in spite of the availability of lower-cost resources from outside the group. Executive compensation packages differ dramatically across the three countries, with U.S. executives receiving by far the highest compensation. However, compensation plans are remarkably similar in terms of how sensitive total compensation is to corporate performance. Which country’s system of corporate governance is best from the standpoint of a shareholder whose goal is stock price maximization? There is no deﬁnitive answer. U.S. stocks have had the best performance in recent years. Moreover, German and Japanese companies are slowly moving toward the U.S. system with respect to size of compensation, and compensation plans in all three countries are being linked ever stronger to performance. At the same time, though, U.S. companies are moving toward the others in the sense of having larger ownership blocks, and since those blocks are primarily held by pension and mutual funds rather than banks and related corporations, they better represent the interests of shareholders. Source: Steven N. Kaplan, “Top Executive Incentives in Germany, Japan, and the USA: A Comparison,” in Executive Compensation and Shareholder Value, Jennifer Carpenter and David Yermack, eds. (Boston: Kluwer Academic Publishers, 1999), 3–12.

International Characteristics of Corporate Governance Germany

Threat of a takeover Board of directors Size of board Percent insiders Percent outsiders Are large blocks of stock typically owned by A controlling family? Another corporation? A bank? Executive compensation Amount of compensation Sensitivity to performance

Japan

United States

Moderate

Low

High

26 27% 73%

21 91% 9%

14 33% 67%

Yes Yes Yes

No Yes Yes

No No No

Moderate Low to moderate

Low Low to moderate

Large Low to moderate

459

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Corporate Valuation, Value-Based Management, and Corporate Governance Corporate Governance and Shareholder Wealth

463

ownership interest based on the size of his or her salary and years of service. The ESOP borrows the $50 million to buy the newly issued stock.13 Financial institutions are willing to lend the ESOP the money because G&A signs a guarantee for the loan. Here is the company’s new balance sheet: G&A’s Balance Sheet after the ESOP (millions of dollars) Assets

Cash Other Total

Liabilities and Equity

$ 60 190 $250

a

Debt Equity (1.5 mil. shares) Total

$100 150 $250

a The company has guaranteed the ESOP’s loan, and it has promised to make payments to the ESOP sufﬁcient to retire the loan, but this does not show up on the balance sheet.

The company now has an additional $50 million of cash and $50 million more of book equity, but it has a de facto liability due to its guarantee of the ESOP’s debt. It could use the cash to ﬁnance an expansion, but many companies use the cash to repurchase their own common stock, so we assume that G&A will do likewise. The company’s new balance sheets, and that of the ESOP, are shown below: G&A’s Balance Sheet after the ESOP and Share Repurchase (millions of dollars) Assets

Liabilities and Equity

Cash Other

$ 10 $190

Total

$200

Debt Equity (1.5 mil. shares) Treasury stock Total

$100 150 (50) $200

ESOP’s Initial Balance Sheet (millions of dollars) Assets

Liabilities and Equity

G&A Stock

$50

Total

$50

Debt Equity Total

$50 0 $50

Note that while the company’s balance sheet looks exactly as it did initially, there is really a huge difference—the footnote that discloses that the company has guaranteed the ESOP’s debt, hence that it has an off-balance-sheet liability of $50 million. Moreover, because the ESOP has no equity, the guarantee is very real indeed. Finally, note that operating assets have not been increased at all, but the total debt outstanding and supported by those assets has increased by $50 million.14 13

Our description is somewhat simpliﬁed. Technically, the stock would be placed in a suspense account and then be allocated to employees as the debt is repaid. 14 We assumed that the company used the $50 million paid to it by the ESOP to repurchase common stock and thus to increase its de facto debt. It could have used the $50 million to retire debt, in which case its true debt ratio would remain unchanged, or it could have used the money to support an expansion.

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Corporate Valuation, Value-Based Management, and Corporate Governance

If this were the whole story, there would be no reason to have an ESOP. However, G&A has promised to make payments to the ESOP in sufﬁcient amounts to enable the ESOP to pay interest and principal charges on the debt so as to amortize the debt over 15 years. Thus, after 15 years the debt will be paid off, and the ESOP’s equity holders, who are the employees, will have equity with a book value of $50 million and a market value that could be much higher if G&A’s stock increases, as it should over time. Then, as employees retire, the ESOP will distribute a pro rata amount of the G&A stock to each employee, who can then use it as a part of his or her retirement plan. An ESOP is clearly beneﬁcial for employees, but why would a company want to establish one? There are ﬁve primary reasons: 1. Congress passed the enabling legislation in hopes of enhancing employees’ productivity and thus making the economy more efﬁcient. In theory, if an employee has equity in the enterprise, he or she will work harder and smarter. Note too that if employees are more productive and creative, this will beneﬁt outside shareholders, because productivity enhancements that beneﬁt ESOP shareholders also beneﬁt outside shareholders. 2. The ESOP represents additional compensation to employees, because in our example there is a $50 million (or more) transfer of wealth from existing shareholders to employees over the 15-year period. Presumably, if the ESOP were not created, then some other form of compensation would have been required, and that alternative compensation might not have the secondary beneﬁt of enhancing productivity. Note too that the ESOP’s payments to employees (as opposed to the payment by the company) come primarily at retirement, and Congress wanted to boost retirement incomes. 3. Depending on when an employee’s rights to the ESOP are vested, the ESOP may help the ﬁrm retain employees. 4. There are also strong tax incentives to encourage a company to form an ESOP. First, Congress decreed that in cases where the ESOP owns 50 percent or more of the company’s common stock, the ﬁnancial institutions that lend money to ESOPs can exclude from taxable income 50 percent of the interest they receive on the loan. This improves the ﬁnancial institutions’ after-tax returns, making them willing to lend to ESOPs at below-market rates. Therefore, a company that establishes an ESOP can borrow through the ESOP at a lower rate than would otherwise be available—in our example, the $50 million of debt would be at a reduced rate. There is also a second tax advantage. If the company were to borrow directly, it could deduct interest but not principal payments from its taxable income. However, companies typically make the required payments to their ESOPs in the form of cash dividends. Dividends are not normally deductible from taxable income, but cash dividends paid on ESOP stock are deductible if the dividends are paid to plan participants or are used to repay the loan. Thus, companies whose ESOPs own 50 percent of their stock can in effect borrow on ESOP loans at subsidized rates and then deduct both the interest and principal payments made on the loans. American Airlines and Publix Supermarkets are two of the many ﬁrms that have used ESOPs to obtain this beneﬁt, along with motivating employees by giving them an equity interest in the enterprise. 5. A less desirable use of ESOPs is to help companies avoid being acquired by another company. The company’s CEO, or someone appointed by the CEO, typically acts as trustee for its ESOP, and the trustee is supposed to vote the ESOP’s shares according to the will of the plan participants. Moreover, the participants, who are the company’s employees, usually oppose takeovers because they frequently involve labor cutbacks. Therefore, if an ESOP owns a signiﬁcant percentage of the

461

462

Corporate Valuation, Value-Based Management, and Corporate Governance Summary

465

company’s shares, then management has a powerful tool for warding off takeovers. This is not good for outside stockholders. Are ESOPs good for a company’s shareholders? In theory, ESOPs motivate employees by providing them with an ownership interest. That should increase productivity and thereby enhance stock values. Moreover, tax incentives mitigate the costs associated with some ESOPs. However, an ESOP can be used to help entrench management, and that could hurt stockholders. How do the pros and cons balance out? The empirical evidence is not entirely clear, but certain ﬁndings are worth noting. First, if an ESOP is established to help defend against a takeover, then the ﬁrm’s stock price typically falls when plans for the ESOP are announced. The market does not like the prospect of entrenching management and having to give up the premium normally associated with a takeover. However, if the ESOP is established for tax purposes and/or to motivate employees, the stock price generally goes up at the time of the announcement. In these cases, the company typically has a subsequent improvement in sales per employee and other long-term performance measures, which stimulates the stock price. Indeed, a recent study showed that companies with ESOPs enjoyed a 26 percent average annual stock return versus a return of only 19 percent for peer companies without ESOPs.15 Therefore, it appears that ESOPs, if used appropriately, can be a powerful tool to help create shareholder value. What are two primary forms of corporate governance (that is, the carrot and the stick)? What are three provisions in many corporate charters that deter takeovers? Describe brieﬂy how a typical stock option plan works. What are ESOPs? What are some of their advantages and disadvantages?

Summary Corporate assets consist of operating assets and ﬁnancial, or nonoperating, assets. Operating assets take two forms: assets-in-place and growth options. Assets-in-place, include the land, buildings, machines, and inventory that the ﬁrm uses in its operations to produce products and services. Growth options refer to opportunities the ﬁrm has to increase sales. They include opportunities arising from R&D expenditures, customer relationships, and the like. Financial, or nonoperating, assets are distinguished from operating assets and include items such as investments in marketable securities and noncontrolling interests in the stock of other companies. The value of nonoperating assets is usually close to the ﬁgure reported on the balance sheet. The value of operations is the present value of all the future free cash ﬂows expected from operations when discounted at the weighted average cost of capital:

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䊉

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⬁ FCFt Vop(at time 0) a t. t1 (1 WACC)

15

See Daniel Eisenberg, “No ESOP Fable,” Time, May 10, 1999, 95.

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Corporate Valuation, Value-Based Management, and Corporate Governance 䊉

The terminal, or horizon, value, is the value of operations at the end of the explicit forecast period. It is also called the continuing value, and it is equal to the present value of all free cash ﬂows beyond the forecast period, discounted back to the end of the forecast period at the weighted average cost of capital: Continuing value Vop(at time N)

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䊉

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䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

䊉

FCFN (1 g) FCFN1 . WACC g WACC g

The corporate valuation model can be used to calculate the total value of a company by ﬁnding the value of operations plus the value of nonoperating assets. The value of equity is the total value of the company minus the value of the debt and preferred stock. The price per share is the total value of the equity divided by the number of shares. Value-based management involves the systematic use of the corporate valuation model to evaluate a company’s potential decisions. The four value drivers are (1) the growth rate in sales (g), (2) operating proﬁtability (OP), which is measured by the ratio of NOPAT to sales, (3) capital requirements (CR) as measured by the ratio of operating capital to sales, and (4) the weighted average cost of capital (WACC). Expected return on invested capital (EROIC) is equal to expected NOPAT divided by the amount of capital that is available at the beginning of the year. A company creates value when the spread between expected ROIC and WACC is positive, i.e., when EROIC WACC 0. Corporate governance involves the manner in which shareholders’ objectives are implemented, and it is reﬂected in a company’s policies and actions. The two primary mechanisms used in corporate governance are: (1) the threat of removal of a poorly performing CEO and (2) the type of plan used to compensate executives and managers. Poorly performing managers can be removed either by a takeover or by the company’s own board of directors. Provisions in the corporate charter affect the difﬁculty of a successful takeover, and the composition of the board of directors affects the likelihood of a manager being removed by the board. Managerial entrenchment is most likely when a company has a weak board of directors coupled with strong anti-takeover provisions in its corporate charter. In this situation, the likelihood that badly performing senior managers will be ﬁred is low. Nonpecuniary beneﬁts are noncash perks such as lavish ofﬁces, memberships at country clubs, corporate jets, foreign junkets, and the like. Some of these expenditures may be cost effective, but others are wasteful and simply reduce proﬁts. Such fat is almost always cut after a hostile takeover. Targeted share repurchases, also known as greenmail, occur when a company buys back stock from a potential acquiror at a higher-than-fair-market price. In return, the potential acquiror agrees not to attempt to take over the company. Shareholder rights provisions, also known as poison pills, allow existing shareholders to purchase additional shares of stock at a lower than market value if a potential acquiror purchases a controlling stake in the company. A restricted voting rights provision automatically deprives a shareholder of voting rights if the shareholder owns more than a speciﬁed amount of stock. Interlocking boards of directors occur when the CEO of Company A sits on the board of Company B, and B’s CEO sits on A’s board. A stock option provides for the purchase of a share of stock at a ﬁxed price, called the exercise price, no matter what the actual price of the stock is. Stock options have an expiration date, after which they cannot be exercised.

463

464

Corporate Valuation, Value-Based Management, and Corporate Governance Problems 䊉

467

An Employee Stock Ownership Plan, or ESOP, is a plan that facilitates employees’ ownership of stock in the company for which they work.

Questions 12–1

Deﬁne each of the following terms: a. Assets-in-place; growth options; nonoperating assets b. Net operating working capital; operating capital; NOPAT; free cash ﬂow c. Value of operations; horizon value; corporate valuation model d. Value-based management; value drivers; ROIC e. Managerial entrenchment; nonpecuniary beneﬁts f. Greenmail; poison pills; restricted voting rights g. Stock option; ESOP

12–2

Explain how to use the corporate valuation model to ﬁnd the price per share of common equity.

12–3

Explain how it is possible for sales growth to decrease the value of a proﬁtable company.

12–4

What are some actions an entrenched management might take that would harm shareholders?

12–5

How is it possible for an employee stock option to be valuable even if the ﬁrm’s stock price fails to meet shareholders’ expectations?

Self-Test Problem ST–1 CORPORATE VALUATION

(Solution Appears in Appendix A)

Watkins Inc. has never paid a dividend, and when it might begin paying dividends is unknown. Its current free cash ﬂow is $100,000, and this FCF is expected to grow at a constant 7 percent rate. The weighted average cost of capital is WACC 11%. Watkins currently holds $325,000 of nonoperating marketable securities. Its long-term debt is $1,000,000, but it has never issued preferred stock. a. Calculate Watkins’ value of operations. b. Calculate the company’s total value. c. Calculate the value of its common equity.

Problems 12–1 FREE CASH FLOW

Use the following income statements and balance sheets to calculate Garnet Inc.’s free cash ﬂow for 2003. Garnet Inc. INCOME STATEMENT

Net sales Costs (except depreciation) Depreciation Total operating costs Earnings before interest and taxes (EBIT) Less interest Earnings before taxes Taxes (40%) Net income

2003

2002

$530.0 400.0 30.0 $430.0 100.0 23.0 77.0 30.8 $ 46.2

$500.0 380.0 25.0 $405.0 95.0 21.0 74.0 29.6 $ 44.4

465

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Corporate Valuation, Value-Based Management, and Corporate Governance BALANCE SHEET

2003

2002

$ 28.0 69.0 84.0 112.0 $293.0 281.0 $574.0

$ 27.0 66.0 80.0 106.0 $279.0 265.0 $544.0

$ 56.0 138.0 28.0 $222.0 $173.0 100.0 79.0 $179.0 $574.0

$ 52.0 130.0 28.0 $210.0 $164.0 100.0 70.0 $170.0 $544.0

Assets Cash Marketable securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Common stock Retained earnings Common equity Total liabilities and equity

12–2 VALUE OF OPERATIONS

12–3 VALUE OF OPERATIONS

12–4 CORPORATE VALUATION

EMC Corporation has never paid a dividend. Its current free cash ﬂow is $400,000 and is expected to grow at a constant rate of 5 percent. The weighted average cost of capital is WACC 12%. Calculate EMC’s value of operations. Brooks Enterprises has never paid a dividend. Free cash ﬂow is projected to be $80,000 and $100,000 for the next 2 years, respectively, and after the second year it is expected to grow at a constant rate of 8 percent. The company’s weighted average cost of capital is WACC 12%. a. What is the terminal, or horizon, value of operations? (Hint: Find the value of all free cash ﬂows beyond Year 2 discounted back to Year 2.) b. Calculate the value of Brooks’ operations. Dozier Corporation is a fast-growing supplier of ofﬁce products. Analysts project the following free cash ﬂows (FCFs) during the next 3 years, after which FCF is expected to grow at a constant 7 percent rate. Dozier’s cost of capital is WACC 13%. Time Free cash ﬂow ($ millions)

1 $20

2 $30

3 $40

a. What is Dozier’s terminal, or horizon, value? (Hint: Find the value of all free cash ﬂows beyond Year 3 discounted back to Year 3.) b. What is the current value of operations for Dozier? c. Suppose Dozier has $10 million in marketable securities, $100 million in debt, and 10 million shares of stock. What is the price per share? 12–5 HORIZON VALUE

Current and projected free cash ﬂows for Radell Global Operations are shown below. Growth is expected to be constant after 2004. The weighted average cost of capital is 11 percent. What is the horizon, or continuing, value? Projected

Free cash ﬂow (millions of dollars)

Actual 2002

2003

2004

2005

$606.82

$667.50

$707.55

$750.00

466

Corporate Valuation, Value-Based Management, and Corporate Governance Problems 12–6 MVA

12–7 HORIZON VALUE

12–8 VALUE OF EQUITY

469

A company has capital of $200,000,000. It has an expected ROIC of 9 percent, forecasted constant growth of 5 percent, and a WACC of 10 percent. What is its value of operations? What is its MVA? (Hint: Use Equation 12-4.) You are given the following forecasted information for the year 2006: Sales $300,000,000; Operating proﬁtability (OP) 6%; Capital requirements (CR) 43%; Growth (g) 5%; and the weighted average cost of capital (WACC) 9.8%. If these values remain constant, what is the horizon value (that is, the 2006 value of operations)? (Hint: Use Equation 12-3.) The balance sheets of Hutter Amalgamated are shown below. If the 12/31/2002 value of operations is $756 million, what is the 12/31/2002 value of equity?

Balance Sheets, December 31, 2002 (Millions of Dollars) Assets

12–9 PRICE PER SHARE

Liabilities and Equity

Cash Marketable securities Accounts receivable Inventories Total current assets Net plant and equipment

$ 20.0 77.0 100.0 200.0 $397.0 279.0

Total assets

$676.0

Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Preferred stock Common stock (par plus PIC) Retained earnings Common equity Total liabilities and equity

$ 19.0 151.0 51.0 $221.0 190.0 $ 76.0 $100.0 89.0 $189.0 $676.0

The balance sheets of Roop Industries are shown below. The 12/31/2002 value of operations is $651 million and there are 10 million shares of common equity. What is the price per share?

Balance Sheets, December 31, 2002 (Millions of Dollars) Assets

Liabilities and Equity

Cash Marketable securities Accounts receivable Inventories Total current assets Net plant and equipment

$ 20.0 47.0 100.0 200.0 $367.0 279.0

Total assets

$646.0

Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Preferred stock Common stock (par plus PIC) Retained earnings Common equity Total liabilities and equity

$ 19.0 65.0 51.0 $135.0 131.0 $ 33.0 $160.0 187.0 $347.0 $646.0

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Corporate Valuation, Value-Based Management, and Corporate Governance

12–10 CORPORATE VALUATION

The ﬁnancial statements of Lioi Steel Fabricators are shown below, with the actual results for 2002 and the projections for 2003. Free cash ﬂow is expected to grow at a 6 percent rate after 2003. The weighted average cost of capital is 11 percent. a. If operating capital as of 12/31/2002 is $502.2 million, what is the free cash ﬂow for 12/31/2003? b. What is the horizon value as of 12/31/2003? c. What is the value of operations as of 12/31/2002? d. What is the total value of the company as of 12/31/2002? e. What is the price per share for 12/31/2002?

Income Statement for the Year Ending December 31 (Millions of Dollars Except for Per Share Data) Actual 2002

Projected 2003

Net sales Costs (except depreciation) Depreciation Total operating costs Earnings before interest and tax Less interest Earnings before taxes Taxes (40%) Net income before preferred dividends Preferred dividends Net income avail. for common dividends

$500.0 360.0 37.5 $397.5 $102.5 13.9 $ 88.6 35.4 $ 53.2 6.0 $ 47.2

$530.0 381.6 39.8 $421.4 108.6 16.0 $ 92.6 37.0 $ 55.6 7.4 $ 48.2

Common dividends Addition to retained earnings

$ 40.8 $ 6.4

$ 29.7 $ 18.5

Number of shares Dividends per share

$

10 4.08

$

10 2.97

Balance Sheets for December 31 (Millions of Dollars) Actual 2002

Projected 2003

Assets Cash Marketable securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets

$

5.3 49.9 53.0 106.0 $214.2 375.0 $589.2

$

5.6 51.9 56.2 112.4 $226.1 397.5 $623.6

468

Corporate Valuation, Value-Based Management, and Corporate Governance Spreadsheet Problem Actual 2002

471

Projected 2003

Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Preferred stock Common stock (par plus PIC) Retained earnings Common equity Total liabilities and equity

$

9.6 69.9 27.5 $107.0 140.8 $ 35.0 $160.0 146.4 $306.4 $589.2

$ 11.2 74.1 28.1 $113.4 148.2 $ 37.1 $160.0 164.9 $324.9 $623.6

Spreadsheet Problem 12–11 BUILD A MODEL: CORPORATE VALUATION

Start with the partial model in the ﬁle Ch 12 P11 Build a Model.xls from the textbook’s web site. The Henley Corporation is a privately held company specializing in lawn care products and services. The most recent ﬁnancial statements are shown below.

Income Statement for the Year Ending December 31 (Millions of Dollars Except for Per Share Data) 2002

Net sales Costs (except depreciation) Depreciation Total operating costs Earnings before interest and taxes Less interest Earnings before taxes Taxes (40%) Net income before preferred dividends Preferred dividends Net income avail. for common dividends

$800.0 576.0 60.0 636.0 164.0 32.0 132.0 52.8 79.2 1.4 $ 77.9

Common dividends Addition to retained earnings Number of shares (in millions) Dividends per share

$ 31.1 $ 46.7 10 $ 3.11

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CHAPTER 12

Corporate Valuation, Value-Based Management, and Corporate Governance Balance Sheets for December 31 (Millions of Dollars) Assets

Liabilities and Equity

2002

Cash Marketable Securities Accounts receivable Inventories Total current assets Net plant and equipment

$

8.0 20.0 80.0 160.0 $268.0 600.0

Total assets

$868.0

2002

Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Preferred stock Common stock (par plus PIC) Retained earnings Common equity Total liabilities and equity

$ 16.0 40.0 40.0 $ 96.0 300.0 $ 15.0 $257.0 200.0 $457.0 $868.0

The ratios and selected information for the current and projected years are shown below. Projected

Sales growth rate Costs/sales Depreciation/net PPE Cash/sales Accounts receivable/sales Inventories/sales Net PPE/sales Accounts payable/sales Accruals/sales Tax rate Weighted average cost of capital (WACC)

Actual 2002

2003

2004

2005

72% 10 1 10 20 75 2 5 40

15% 72 10 1 10 20 75 2 5 40

10% 72 10 1 10 20 75 2 5 40

6% 72 10 1 10 20 75 2 5 40

6% 72 10 1 10 20 75 2 5 40

10.5

10.5

10.5

10.5

10.5

2006

a. Forecast the parts of the income statement and balance sheets necessary to calculate free cash ﬂow. b. Calculate free cash ﬂow for each projected year. Also calculate the growth rates of free cash ﬂow each year to ensure that there is constant growth (that is, the same as the constant growth rate in sales) by the end of the forecast period. c. Calculate operating proﬁtability (OP NOPAT/Sales), capital requirements (CR Operating capital/Sales), and expected return on invested capital (EROIC Expected NOPAT/Operating capital at beginning of year). Based on the spread between expected ROIC and WACC, do you think that the company will have a positive market value added (MVA Market value of company Book value of company Value of operations Operating capital)? d. Calculate the value of operations and MVA. (Hint: First calculate the horizon value at the end of the forecast period, which is equal to the value of operations at the end of the forecast period. Assume that growth beyond the horizon is 6 percent.) e. Calculate the price per share of common equity as of 12/31/2002.

470

Corporate Valuation, Value-Based Management, and Corporate Governance Mini Case

See Ch 12 Show.ppt and Ch 12 Mini Case.xls.

473

You have been hired as a consultant to Kulpa Fishing Supplies (KFS), a company that is seeking to increase its value. KFS has asked you to estimate the value of two privately held companies that KFS is considering acquiring. But ﬁrst, the senior management of KFS would like for you to explain how to value companies that don’t pay any dividends. You have structured your presentation around the following questions: a. List the two types of assets that companies own. b. What are assets-in-place? How can their value be estimated? c. What are nonoperating assets? How can their value be estimated? d. What is the total value of a corporation? Who has claims on this value? e. The ﬁrst acquisition target is a privately held company in a mature industry. The company currently has free cash ﬂow of $20 million. Its WACC is 10 percent and it is expected to grow at a constant rate of 5 percent. The company has marketable securities of $100 million. It is ﬁnanced with $200 million of debt, $50 million of preferred stock, and $210 million of book equity. (1) What is its value of operations? (2) What is its total corporate value? What is its value of equity? (3) What is its MVA (MVA Total corporate value total book value)? f. The second acquisition target is a privately held company in a growing industry. The target has recently borrowed $40 million to ﬁnance its expansion; it has no other debt or preferred stock. It pays no dividends and currently has no marketable securities. KFS expects the company to produce free cash ﬂows of $5 million in 1 year, $10 million in 2 years, and $20 million in 3 years. After 3 years, free cash ﬂow will grow at a rate of 6 percent. Its WACC is 10 percent and it currently has 10 million shares of stock. (1) What is its horizon value (that is, its value of operations at Year 3)? What is its current value of operations (that is, at time zero)? (2) What is its value of equity on a price per share basis? g. KFS is also interested in applying value-based management to its own divisions. Explain what value-based management is. h. What are the four value drivers? How does each of them affect value? i. What is expected return on invested capital (EROIC)? Why is the spread between expected ROIC and WACC so important? j. KFS has two divisions. Both have current sales of $1,000, current expected growth of 5 percent, and a WACC of 10 percent. Division A has high proﬁtability (OP 6%) but high capital requirements (CR 78%). Division B has low proﬁtability (OP 4%) but low capital requirements (CR 27%). What is the MVA of each division, based on the current growth of 5 percent? What is the MVA of each division if growth is 6 percent? k. What is the expected ROIC of each division for 5 percent growth and for 6 percent growth? How is this related to MVA? l. The managers at KFS have heard that corporate governance can affect shareholder value. List for them the two primary mechanisms of corporate governance. m. Why is entrenched management potentially harmful to shareholders? n. List three provisions in the corporate charter that affect takeovers. o. Explain the difference between insiders and outsiders on the board of directors. What are interlocking boards? p. What is a stock option in a compensation plan?

Corporate Valuation, Value-Based Management, and Corporate Governance 474

CHAPTER 12

Corporate Valuation, Value-Based Management, and Corporate Governance

Selected Additional References For explanations of corporate valuation and value-based management, see

Stewart, G. Bennett, The Quest for Value (New York: Harper Collins, 1991).

Copeland, Tom, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed., (New York: John Wiley & Sons, Inc., 2000). Martin, John D., and J. William Petty, Value Based Management: The Corporate Response to the Shareholder Revolution (Boston: Harvard Business School Press, 2000). McTaggart, James M., Peter W. Kontes, and Michael C. Mankins, The Value Imperative (New York: The Free Press, 1994).

For additional discussions of corporate governance, see Carpenter, Jennifer, and David Yermack, Editors, Executive Compensation and Shareholder Value (Boston: Kluwer Academic Publishers, 1999). For more on EVA and performance, see Peterson, Pamela P., and David R. Peterson, Company Performance and Measures of Value Added (The Research Foundation of the Institute of Chartered Financial Analysts, 1996).

471

Capital Structure Decisions

13 13

A

company can obtain long-term ﬁnancing in the form of equity, debt, or some combination. The accompanying table shows the long-term debt ratios for different business sectors and selected individual companies within those industries.1 There are obvious differences between sectors’ average debt ratios, with Technology having a very low average ratio (18.7 percent) and others, such as Consumer Cyclical (72.1 percent), having much higher ratios. But notice that within each sector some companies have very low levels of debt, while others have very high levels. For example, the average debt ratio for Consumer/Noncyclical is 46.8 percent, but Starbucks has no longterm debt versus Kellogg’s 86.9 percent. Why do we see such variation across companies and business sectors, and can a company make itself more valuable through its choice of debt ratio? Keep these questions in mind as you read the chapter. Sector and Company Technology Agilent Technologies Inc. (A) IKON Ofﬁce Solutions (IKN) Energy Exxon Mobil Corporation (XOM) Chesapeake Energy Corp. (CHK) Health care Patterson Dental Company (PDCO) HCA Inc. (HCA) Transportation Roadway Corporation (ROAD) Continental Airlines, Inc. (CAL) Basic materials Anglo American PLC (AAUK) Kaiser Aluminum Corp. (KLU) Capital goods Winnebago Industries (WGO) Caterpillar Inc. (CAT) Consumer/noncyclical Starbucks Corporation (SBUX) Kellogg Company (K) Conglomerates Minnesota Mining & Manufacturing (MMM) TRW, Inc. (TRW) Utilities Reliant Resources, Inc. (RRI) CMS Energy Corp. (CMS) Services Administaff, Inc. (ASF) Allied Waste Industries (AW) Consumer/cyclical Callaway Golf Company (ELY) Black & Decker Corp. (BDK)

For updates on a company’s ratio, go to http://ﬁnance. yahoo.com, enter the ticker symbol for a stock quote, and select Proﬁle after the quote comes up. Click on Ratio Comparisons (on the left side of the Proﬁle sheet) for updates on the sector ratio.

Long-Term Debt Ratio 18.7% 0.0% 59.3 29.6 9.1 70.2 32.0 0.0 58.5 39.8 0.0 74.9 45.7 0.0 84.4 45.9 0.0 68.1 46.8 0.0 86.9 54.3 16.7 66.8 60.9 12.3 73.0 63.0 0.0 84.3 72.1 0.0 60.8

1

The long-term debt ratio is the percent of total long-term ﬁnancing that comes from debt: (Long-term debt)/(Long-term debt ⫹ Equity). The ticker symbol is in parenthesis.

477

473

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A s seen in Chapters 11 and 12, all ﬁrms need operating capital to support their sales. To acquire that operating capital, funds must be raised, usually as a combination of equity and debt. The mixture of debt and equity that a ﬁrm uses is called its capital The textbook’s web site structure. Although a ﬁrm’s actual levels of debt and equity may vary somewhat over contains an Excel ﬁle that time, most seek to keep their ﬁnancing mix close to a target capital structure. The will guide you through the capital structure decisions include a ﬁrm’s choice of a target capital structure, the chapter’s calculations. The ﬁle for this chapter is Ch 13 average maturity of its debt, and the speciﬁc source of ﬁnancing it chooses at any parTool Kit.xls, and we encour- ticular time it raises new funding. Similar to operating decisions, managers should age you to open the ﬁle and make capital structure decisions designed to maximize the ﬁrm’s value. follow along as you read the chapter.

A Preview of Capital Structure Issues Recall from Chapter 12 that the value of a ﬁrm is the present value of its expected future free cash ﬂow (FCFs), discounted at its weighted average cost of capital (WACC):2 ⬁ FCFt V⫽ a t. t⫽1 (1 ⫹ WACC)

(13-1)

The WACC depends on the percentages of debt and equity (wd and we), the cost of debt (rd), the cost of stock (rs), and the corporate tax rate (T): WACC ⫽ wd (1 ⫺ T)rd ⫹ Wers .

(13-2)

As these equations show, the only way that any decision can change a ﬁrm’s value is if it affects either free cash ﬂows or the cost of capital. We discuss below some of the ways that a higher proportion of debt can affect WACC and/or FCF.

Debt Increases the Cost of Stock, rs Debtholders have a prior claim on the company’s cash ﬂows relative to shareholders, who are entitled only to any residual cash ﬂow after debtholders have been paid. As we show later in a numerical example, the “ﬁxed” claim of the debtholders causes the “residual” claim of the stockholders to become less certain, and this increases the cost of stock, rs.

Debt Reduces the Taxes a Company Pays Imagine that a company’s cash ﬂows are a pie, and three different groups get pieces of the pie. The ﬁrst piece goes to the government in the form of taxes, the second goes to debtholders, and the third to shareholders. Companies can deduct interest expenses when calculating taxable income, which reduces the government’s piece of the pie and leaves more pie available to debtholders and investors. This beneﬁcial impact of taxes reduces the after-tax cost of debt, as shown in Equation 13-2 above.

The Risk of Bankruptcy Increases the Cost of Debt, rd As debt increases, the probability of ﬁnancial distress, or even bankruptcy, goes up. With higher bankruptcy risk, debtholders will insist on a higher promised return, which increases the pre-tax cost of debt, rd.

2

For simplicity, we assume that the ﬁrm has no nonoperating assets.

475

Capital Structure Decisions A Preview of Capital Structure Issues

479

The Net Effect on the Weighted Average Cost of Capital As Equation 13-2 shows, the WACC is a weighted average of relatively low-cost debt and high-cost equity. If we increase the proportion of debt, then the weight of low-cost debt (wd) increases and the weight of high-cost equity (we) decreases. If all else remained the same, then the WACC would fall and the value of the ﬁrm in Equation 13-1 would increase. But the previous paragraphs show that all else doesn’t remain the same: both rd and rs increase. While it should be clear that changing the capital structure affects all the variables in the WACC equation, it’s not easy to say whether those changes increase the WACC, decrease it, or balance out exactly and leave the WACC unchanged. We’ll return to this issue later, when we discuss capital structure theory.

Bankruptcy Risk Reduces Free Cash Flow As the risk of bankruptcy increases, some customers may choose to buy from another company, which hurts sales. This, in turn, decreases net operating proﬁt after taxes (NOPAT), thus reducing FCF. Financial distress also hurts the productivity of workers and managers, as they spend more time worrying about their next job rather than their current job. Again, this reduces NOPAT and FCF. Finally, suppliers tighten their credit standards, which reduces accounts payable and causes net operating working capital to increase, thus reducing FCF. Therefore, the risk of bankruptcy can decrease FCF and reduce the value of the ﬁrm.

Bankruptcy Risk Affects Agency Costs Higher levels of debt may affect the behavior of managers in two opposing ways. First, when times are good, managers may waste cash ﬂow on perquisites and nonnecessary expenditures. This is an agency cost, as described in Chapter 12. The good news is that the threat of bankruptcy reduces such wasteful spending, which increases FCF. But the bad news is that a manager may become gun-shy and reject positive NPV projects if they are risky. From the stockholder’s point of view it would be unfortunate if a risky project caused the company to go into bankruptcy, but note that other companies in the stockholder’s portfolio may be taking on risky projects that turn out successfully. Since most stockholders are well diversiﬁed, they can afford for a manager to take on risky but positive NPV projects. But a manager’s reputation and wealth are generally tied to a single company, so the project may be unacceptably risky from the manager’s point of view. Thus, high debt can cause managers to forego positive NPV projects unless they are extremely safe. This is called the underinvestment problem, and it is another type of agency cost. Notice that debt can reduce one aspect of agency costs (wasteful spending) but may increase another (underinvestment), so the net effect on value isn’t clear.

Issuing Equity Conveys a Signal to the Marketplace Managers are in a better position to forecast a company’s free cash ﬂow than are investors, and academics call this informational asymmetry. Suppose a company’s stock price is $50 per share. If managers are willing to issue new stock at $50 per share, investors reason that no one would sell anything for less than its true value. Therefore, the true value of the shares as seen by the managers with their superior information must be less than $50. Thus, investors perceive an equity issue as a negative signal, and this usually causes the stock price to fall.3 3

An exception to this rule is any situation with little informational asymmetry, such as a regulated utility. Also, some companies, such as startups or high-tech ventures, are unable to issue debt and so simply must issue equity; we discuss this later in the chapter.

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Brieﬂy describe some ways in which the capital structure decision can affect the WACC and FCF.

Business and Financial Risk In Chapter 3, when we examined risk from the viewpoint of a stock investor, we distinguished between market risk, which is measured by the ﬁrm’s beta coefﬁcient, and stand-alone risk, which includes both market risk and an element of risk that can be eliminated by diversiﬁcation. Now we introduce two new dimensions of risk: (1) business risk, or the riskiness of the ﬁrm’s stock if it uses no debt, and (2) ﬁnancial risk, which is the additional risk placed on the common stockholders as a result of the ﬁrm’s decision to use debt.4 Conceptually, the ﬁrm has a certain amount of risk inherent in its operations: this is its business risk. If it uses debt, then, in effect, it partitions its investors into two groups and concentrates most of its business risk on one class of investors—the common stockholders. However, the common stockholders will demand compensation for assuming more risk and thus require a higher rate of return. In this section, we examine business and ﬁnancial risk within a stand-alone risk framework, which ignores the beneﬁts of stockholder diversiﬁcation.

Business Risk Business risk in a stand-alone sense is a function of the uncertainty inherent in projections of a ﬁrm’s return on invested capital (ROIC), deﬁned as follows: Net income to After-tax ⫹ common stockholders interest payments EBIT (1 ⫺ T) NOPAT ⫽ ⫽ . ROIC ⫽ Capital Capital Capital Here NOPAT is net operating proﬁt after taxes and capital is the sum of the ﬁrm’s debt and common equity, which is numerically equivalent to our deﬁnition of operating capital in Chapter 9. Business risk can be measured by the standard deviation of its ROIC, ␴ROIC. To illustrate, consider Strasburg Electronics Company, a debt-free (unlevered) ﬁrm. Figure 13-1 gives some clues about the company’s business risk. The top graph shows the trend in ROIC from 1992 through 2002; this graph gives both security analysts and Strasburg’s management an idea of the degree to which ROIC has varied in the past and might vary in the future. The lower graph shows the beginning-of-year subjectively estimated probability distribution of Strasburg’s ROIC for 2002, based on the trend line in the top section of Figure 13-1. As both graphs indicate, Strasburg’s actual ROIC in 2002 was only 8 percent, well below the expected value of 12 percent—2002 was a bad year. Business risk depends on a number of factors, as described below: 1. Demand variability. The more stable the demand for a ﬁrm’s products, other things held constant, the lower its business risk. 2. Sales price variability. Firms whose products are sold in highly volatile markets are exposed to more business risk than similar ﬁrms whose output prices are more stable. 4

Preferred stock also adds to ﬁnancial risk. To simplify matters, we concentrate on debt and common equity in this chapter.

477

Capital Structure Decisions Business and Financial Risk FIGURE 13-1

481

Strasburg Electronics: Trend in ROIC, 1992–2002, and Subjective Probability Distribution of ROIC, 2002

a. Trend in Return on Invested Capital (ROIC) ROIC (%) 2002 ROIC as Projected at Beginning of Year = 12%

20

10 Actual 2002 ROIC 0 1994

1996

1998

2000

2002

– 10

b. Subjective Probability Distribution of ROIC for 2002 Probability Density

0 Actual ROIC

8

12

ROIC (%) Expected ROIC

3. Input cost variability. Firms whose input costs are highly uncertain are exposed to a high degree of business risk. 4. Ability to adjust output prices for changes in input costs. Some ﬁrms are better able than others to raise their own output prices when input costs rise. The greater the ability to adjust output prices to reﬂect cost conditions, the lower the business risk. 5. Ability to develop new products in a timely, cost-effective manner. Firms in such high-tech industries as drugs and computers depend on a constant stream of new products. The faster its products become obsolete, the greater a ﬁrm’s business risk. 6. Foreign risk exposure. Firms that generate a high percentage of their earnings overseas are subject to earnings declines due to exchange rate ﬂuctuations. Also, if a ﬁrm operates in a politically unstable area, it may be subject to political risks. See Chapter 15 for a further discussion. 7. The extent to which costs are ﬁxed: operating leverage. If a high percentage of its costs are ﬁxed, hence do not decline when demand falls, then the ﬁrm is exposed to a relatively high degree of business risk. This factor is called operating leverage, and it is discussed at length in the next section. Each of these factors is determined partly by the ﬁrm’s industry characteristics, but each of them is also controllable to some extent by management. For example, most

478

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ﬁrms can, through their marketing policies, take actions to stabilize both unit sales and sales prices. However, this stabilization may require spending a great deal on advertising and/or price concessions to get commitments from customers to purchase ﬁxed quantities at ﬁxed prices in the future. Similarly, ﬁrms such as Strasburg Electronics can reduce the volatility of future input costs by negotiating long-term labor and materials supply contracts, but they may have to pay prices above the current spot price to obtain these contracts. Many ﬁrms are also using hedging techniques to reduce business risk.

Operating Leverage

See Ch 13 Tool Kit.xls for detailed calculations.

In physics, leverage implies the use of a lever to raise a heavy object with a small force. In politics, if people have leverage, their smallest word or action can accomplish a lot. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in EBIT. Other things held constant, the higher a ﬁrm’s ﬁxed costs, the greater its operating leverage. Higher ﬁxed costs are generally associated with more highly automated, capital intensive ﬁrms and industries. However, businesses that employ highly skilled workers who must be retained and paid even during recessions also have relatively high ﬁxed costs, as do ﬁrms with high product development costs, because the amortization of development costs is an element of ﬁxed costs. Figure 13-2 illustrates the concept of operating leverage by comparing the results that Strasburg could expect if it used different degrees of operating leverage. Plan A calls for a relatively small amount of ﬁxed costs, $20,000. Here the ﬁrm would not have much automated equipment, so its depreciation, maintenance, property taxes, and so on would be low. However, the total operating costs line has a relatively steep slope, indicating that variable costs per unit are higher than they would be if the ﬁrm used more operating leverage. Plan B calls for a higher level of ﬁxed costs, $60,000. Here the ﬁrm uses automated equipment (with which one operator can turn out a few or many units at the same labor cost) to a much larger extent. The breakeven point is higher under Plan B—breakeven occurs at 60,000 units under Plan B versus only 40,000 units under Plan A. We can calculate the breakeven quantity by recognizing that operating breakeven occurs when earnings before interest and taxes (EBIT) ⫽ 0:5 EBIT ⫽ PQ ⫺ VQ ⫺ F ⫽ 0.

(13-3)

Here P is average sales price per unit of output, Q is units of output, V is variable cost per unit, and F is ﬁxed operating costs. If we solve for the breakeven quantity, QBE, we get this expression: QBE ⫽

F . P⫺V

(13-3a)

Thus for Plan A, QBE ⫽

5

$20,000 ⫽ 40,000 units, $2.00 ⫺ $1.50

This deﬁnition of breakeven does not include any ﬁxed ﬁnancial costs because Strasburg is an unlevered ﬁrm. If there were ﬁxed ﬁnancial costs, the ﬁrm would suffer an accounting loss at the operating breakeven point. We will introduce ﬁnancial costs shortly.

479

Capital Structure Decisions Business and Financial Risk FIGURE 13-2

Illustration of Operating Leverage

Plan A: Low Operating Leverage

Plan B: High Operating Leverage Sales Revenues

Revenues and Costs (Thousands of Dollars) 240

Revenues and Costs (Thousands of Dollars) 240

Positive EBIT

200

160 Negative EBIT

80

Total Operating Costs

0

120

40

Total Operating Costs

Negative EBIT

Breakeven Point (EBIT = 0) Fixed Costs

40

Fixed Costs 20

Positive EBIT

80

Breakeven Point (EBIT = 0)

40

60 80 100 120 Sales (Thousands of Units)

0

Price Variable costs Fixed costs Capital Tax rate

20

40

60 80 100 120 Sales (Thousands of Units)

Plan A

Plan B

$2.00 $1.50 $20,000 $200,000 40%

$2.00 $1.00 $60,000 $200,000 40%

Plan A

Demand

Probability

Units Sold

Sales Revenues

200

160 120

483

Dollar Sales

Operating Costs

Plan B

Net Pre-Tax Operating Operating Proﬁt after Proﬁts Taxes (EBIT) (NOPAT) ROIC

Operating Costs

Net Pre-Tax Operating Operating Proﬁt after Proﬁts Taxes (EBIT) (NOPAT)

ROIC

Terrible

0.05

0

0

$ 20,000

⫺6.0%

$ 60,000

($ 60,000)

($36,000)

⫺18.0%

Poor

0.20

40,000

80,000

80,000

0

0

0.0

100,000

(20,000)

(12,000)

⫺6.0

Normal

0.50

100,000

200,000

170,000

30,000

18,000

9.0

160,000

40,000

24,000

12.0

Good

0.20

160,000

320,000

260,000

60,000

36,000

18.0

220,000

100,000

60,000

30.0

Wonderful

0.05

200,000

400,000

320,000

80,000

48,000

24.0%

260,000

140,000

84,000

42.0

100,000

$200,000

$170,000

$30,000

$18,000

9.0%

$160,000

$ 40,000

$24,000

Expected value: Standard deviation: Coefﬁcient of variation:

$

($20,000)

($12,000)

12.0%

$24,698

7.4%

$ 49,396

14.8%

0.82

0.82

1.23

1.23

Notes: a. Operating costs ⫽ Variable costs ⫹ Fixed costs. b. The federal-plus-state tax rate is 40 percent, so NOPAT ⫽ EBIT(1 ⫺ Tax rate) ⫽ EBIT(0.6). c. ROIC ⫽ NOPAT/Capital. d. The breakeven sales level for Plan B is not shown in the table, but it is 60,000 units or $120,000. e. The expected values, standard deviations, and coefﬁcients of variation were found using the procedures discussed in Chapter 3.

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and for Plan B, QBE ⫽

$60,000 ⫽ 60,000 units. $2.00 ⫺ $1.00

How does operating leverage affect business risk? Other things held constant, the higher a ﬁrm’s operating leverage, the higher its business risk. The data in Figure 13-2 conﬁrm this, as shown in the much riskier EBIT of Plan A versus Plan B. The range of possible EBITs under Plan A is from ⫺$20,000 if demand is terrible to $80,000 if demand is wonderful, for a total range of $100,000. For Plan B, EBIT goes from ⫺$60,000 to $140,000, a total range of $200,000. In addition, the standard deviation of EBIT for Plan A is $24,698 versus $49,396 for Plan B. Notice that even though Plan B is riskier, it also has a higher expected EBIT, $40,000 versus the $30,000 expected EBIT of Plan A. For the rest of this analysis, we assume that Strasburg decided to go ahead with Plan B because they believe that the higher expected return is sufﬁcient to compensate for the higher risk. To a large extent, operating leverage is determined by technology. Electric utilities, telephone companies, airlines, steel mills, and chemical companies simply must have large investments in ﬁxed assets; this results in high ﬁxed costs and operating leverage. Similarly, drug, auto, computer, and other companies must spend heavily to develop new products, and product-development costs increase operating leverage. Grocery stores, on the other hand, generally have signiﬁcantly lower ﬁxed costs, hence lower operating leverage. Although industry factors do exert a major inﬂuence, all ﬁrms have some control over their operating leverage. For example, an electric utility can expand its generating capacity by building either a gas-ﬁred or a coal-ﬁred plant. The coal plant would require a larger investment and would have higher ﬁxed costs, but its variable operating costs would be relatively low. The gas-ﬁred plant, on the other hand, would require a smaller investment and would have lower ﬁxed costs, but the variable costs (for gas) would be high. Thus, by its capital budgeting decisions, a utility (or any other company) can inﬂuence its operating leverage, hence its business risk.6

Financial Risk Financial risk is the additional risk placed on the common stockholders as a result of the decision to ﬁnance with debt. Conceptually, stockholders face a certain amount of risk that is inherent in a ﬁrm’s operations—this is its business risk, which is deﬁned as the uncertainty inherent in projections of future operating income. If a ﬁrm uses debt (ﬁnancial leverage), this concentrates the business risk on common stockholders. To illustrate, suppose ten people decide to form a corporation to manufacture disk drives. There is a certain amount of business risk in the operation. If the ﬁrm is capitalized only with common equity, and if each person buys 10 percent of the stock, then each investor shares equally in the business risk. However, suppose the ﬁrm is capitalized with 50 percent debt and 50 percent equity, with ﬁve of the investors putting up their capital as debt and the other ﬁve putting up their money as equity. In this case, the ﬁve investors who put up the equity will have to bear all of the business risk, so the common stock will be twice as risky as it would have been had the ﬁrm been ﬁnanced only with equity. Thus, the use of debt, or ﬁnancial leverage, concentrates the ﬁrm’s business risk on its stockholders. This concentration of

6

See the Web Extension to this chapter for additional discussion of the degree of operating leverage.

481

Capital Structure Decisions Business and Financial Risk

See Ch 13 Tool Kit.xls for detailed calculations.

485

business risk occurs because debtholders, who receive ﬁxed interest payments, bear none of the business risk. To illustrate the concentration of business risk, we can extend the Strasburg Electronics example. To date, the company has never used debt, but the treasurer is now considering a possible change in the capital structure. For now, assume that only two ﬁnancing choices are being considered—remaining at zero debt, or shifting to $100,000 debt and $100,000 book equity. First, focus on Section I of Table 13-1, which assumes that Strasburg uses no debt. Since debt is zero, interest is also zero, hence pre-tax income is equal to EBIT. Taxes at 40 percent are deducted to obtain net income, which is then divided by the $200,000 of book equity to calculate ROE. Note that Strasburg receives a tax credit if the demand is either terrible or poor (which are the two scenarios where net income is negative). Here we assume that Strasburg’s losses can be carried back to offset income earned in the prior year. The ROE at each sales level is then multiplied by the probability of that sales level to calculate the 12 percent expected ROE. Note that this 12 percent is the same as we found in Figure 13-2 for Plan B, since ROE is equal to ROIC if a ﬁrm has no debt. Now let’s look at the situation if Strasburg decides to use $100,000 of debt ﬁnancing, shown in Section II of Table 13-1, with the debt costing 10 percent. Demand will not be affected, nor will operating costs, hence the EBIT columns are the same for the zero debt and $100,000 debt cases. However, the company will now have $100,000 of debt with a cost of 10 percent, hence its interest expense will be $10,000. This interest must be paid regardless of the state of the economy—if it is not paid, the company will be forced into bankruptcy, and stockholders will probably be wiped out. Therefore, we show a $10,000 cost in Column 4 as a ﬁxed number for all demand conditions. Column 5 shows pre-tax income, Column 6 the applicable taxes, and Column 7 the resulting net income. When the net income ﬁgures are divided by the book equity —which will now be only $100,000 because $100,000 of the $200,000 total requirement was obtained as debt—we ﬁnd the ROEs under each demand state. If demand is terrible and sales are zero, then a very large loss will be incurred, and the ROE will be ⫺42.0 percent. However, if demand is wonderful, then ROE will be 78.0 percent. The probability-weighted average is the expected ROE, which is 18.0 percent if the company uses $100,000 of debt. Typically, ﬁnancing with debt increases the expected rate of return for an investment, but debt also increases the riskiness of the investment to the common stockholders. This situation holds with our example—ﬁnancial leverage raises the expected ROE from 12 percent to 18 percent, but it also increases the risk of the investment as seen by the increase in the standard deviation from 14.8 percent to 29.6 percent and the increase in the coefﬁcient of variation from 1.23 to 1.65.7 We see, then, that using leverage has both good and bad effects: higher leverage increases expected ROE, but it also increases risk. The next section discusses how this trade-off between risk and return affects the value of the ﬁrm. What is business risk, and how can it be measured? What are some determinants of business risk? How does operating leverage affect business risk? What is ﬁnancial risk, and how does it arise? Explain this statement: “Using leverage has both good and bad effects.”

7

See Chapter 3 for a review of procedures for calculating the standard deviation and coefﬁcient of variation. Recall that the advantage of the coefﬁcient of variation is that it permits better comparisons when the expected values of ROEs vary, as they do here for the two capital structures.

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TABLE 13-1

SECTION

Effects of Financial Leverage: Strasburg Electronics Financed with Zero Debt or with $100,000 of Debt

I. ZERO DEBT

Debt Book equity

Demand for Product (1)

Terrible Poor Normal Good Wonderful

0 $200,000

Probability (2)

EBIT (3)

Interest (4)

Pre-Tax Income (5)

Taxes (40%) (6)

Net Income (7)

ROE (8)

0.05 0.20 0.50 0.20 0.05

($ 60,000) (20,000) 40,000 100,000 $140,000

$0 0 0 0 $0

($ 60,000) (20,000) 40,000 100,000 $140,000

($24,000) (8,000) 16,000 40,000 $56,000

($36,000) (12,000) 24,000 60,000 $84,000

⫺18.0 % ⫺6.0 12.0 30.0 ⫺42.0

$ 40,000

$0

$ 40,000

$16,000

$24,000

12.0 % 14.8 % 1.23

Expected value: Standard deviation: Coefﬁcient of variation:

Assumptions: 1. In terms of its operating leverage, Strasburg has chosen Plan B. The probability distribution and EBITs are obtained from Figure 13-2. 2. Sales and operating costs, hence EBIT, are not affected by the ﬁnancing decision. Therefore, EBIT under both ﬁnancing plans is identical, and it is taken from the EBIT column for Plan B in Figure 13-2. 3. All losses can be carried back to offset income in the prior year.

Capital Structure Theory In the previous section, we showed how capital structure choices affect a ﬁrm’s ROE and its risk. For a number of reasons, we would expect capital structures to vary considerably across industries. For example, pharmaceutical companies generally have very different capital structures than airline companies. Moreover, capital structures vary among ﬁrms within a given industry. What factors explain these differences? In an attempt to answer this question, academics and practitioners have developed a number of theories, and the theories have been subjected to many empirical tests. The following sections examine several of these theories.

Modigliani and Miller: No Taxes Modern capital structure theory began in 1958, when Professors Franco Modigliani and Merton Miller (hereafter MM) published what has been called the most inﬂuential ﬁnance article ever written.8 MM’s study was based on some strong assumptions, including the following: 1. 2. 3. 4.

8

There are no brokerage costs. There are no taxes. There are no bankruptcy costs. Investors can borrow at the same rate as corporations.

Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review, June 1958. Modigliani and Miller both won Nobel Prizes for their work.

483

Capital Structure Decisions Capital Structure Theory TABLE 13-1

SECTION

487

Continued

II. 100,000 OF DEBT

Debt Book equity Interest rate Demand for Product (1)

$100,000 $100,000 10% Probability (2)

EBIT (3)

Interest (4)

Pre-Tax Income (5)

Taxes (40%) (6)

Net Income (7)

ROE (8)

0.05 0.20 0.50 0.20 0.05

($ 60,000) (20,000) 40,000 100,000 $140,000

$10,000 10,000 10,000 10,000 $10,000

($ 70,000) (30,000) 30,000 90,000 $130,000

($28,000) (12,000) 12,000 36,000 $52,000

($42,000) (18,000) 18,000 54,000 $78,000

⫺42.0 % ⫺18.0 18.0 54.0 ⫺78.0

$ 40,000

$10,000

$ 30,000

$12,000

$18,000

18.0 % 29.6 % 1.65

Terrible Poor Normal Good Wonderful Expected value: Standard deviation: Coefﬁcient of variation:

5. All investors have the same information as management about the ﬁrm’s future investment opportunities. 6. EBIT is not affected by the use of debt. If these assumptions hold true, MM proved that a ﬁrm’s value is unaffected by its capital structure, hence the following situation must exist: VL ⫽ VU ⫽ SL ⫹ D.

(13-4)

Here VL is the value of a levered ﬁrm, which is equal to VU, the value of an identical but unlevered ﬁrm. SL is the value of the levered ﬁrm’s stock, and D is the value of its debt. Recall that the WACC is a combination of the cost of debt and the relatively higher cost of equity, rs. As leverage increases, more weight is given to low-cost debt, but equity gets riskier, driving up rs. Under MM’s assumptions, rs increases by exactly enough to keep the WACC constant. Put another way, if MM’s assumptions are correct, it does not matter how a ﬁrm ﬁnances its operations, so capital structure decisions would be irrelevant. Despite the fact that some of these assumptions are obviously unrealistic, MM’s irrelevance result is extremely important. By indicating the conditions under which capital structure is irrelevant, MM also provided us with clues about what is required for capital structure to be relevant and hence to affect a ﬁrm’s value. MM’s work marked the beginning of modern capital structure research, and subsequent research has focused on relaxing the MM assumptions in order to develop a more realistic theory of capital structure. Another extremely important aspect of MM’s work was their thought process. To make a long story short, they imagined two portfolios. The ﬁrst contained all the equity of the unlevered ﬁrm, and it generated cash ﬂows in the form of dividends. The second portfolio contained all the levered ﬁrm’s stock and debt, so its cash ﬂows were

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Yogi Berra on the M&M Proposition

When a waitress asked Yogi Berra (Baseball Hall of Fame catcher for the New York Yankees) whether he wanted his pizza cut into four pieces or eight, Yogi replied: “Better make it four. I don’t think I can eat eight.”a Yogi’s quip helps convey the basic insight of Modigliani and Miller. The firm’s choice of leverage “slices” the distribution of future cash flows in a way that is like slicing a pizza. MM recognized that if you fix a company’s investment activities, it’s like fixing the size of the pizza; no information costs means that everyone sees the same pizza; no taxes means the IRS gets none of the pie; and no “contracting costs” means nothing sticks to the knife.

So, just as the substance of Yogi’s meal is unaffected by whether the pizza is sliced into four pieces or eight, the economic substance of the firm is unaffected by whether the liability side of the balance sheet is sliced to include more or less debt, at least under the MM assumptions.

a

Lee Green, Sportswit (New York: Fawcett Crest, 1984), 228.

Source: “Yogi Berra on the M&M Proposition,” Journal of Applied Corporate Finance, Vol. 7, no. 4, Winter 1995, 6. Reprinted by permission of Stern Stewart Management.

the levered ﬁrm’s dividends and interest payments. Under MM’s assumptions, the cash ﬂows of the two portfolios would be identical. They then concluded that if two portfolios produce the same cash ﬂows, then they must have the same value.9 As we show in Chapter 17, this simple idea changed the entire ﬁnancial world because it led to the development of options and derivatives. Thus, their paper’s approach was just as important as its conclusions.

Modigliani and Miller: The Effect of Corporate Taxes MM published a follow-up paper in 1963 in which they relaxed the assumption that there are no corporate taxes.10 The Tax Code allows corporations to deduct interest payments as an expense, but dividend payments to stockholders are not deductible. This differential treatment encourages corporations to use debt in their capital structures. This means that interest payments reduce the taxes paid by a corporation, and if a corporation pays less to the government, more of its cash ﬂow is available for its investors. In other words, the tax deductibility of the interest payments shields the ﬁrm’s pre-tax income. As in their earlier paper, MM introduced a second important way of looking at the effect of capital structure: The value of a levered ﬁrm is the value of an otherwise identical unlevered ﬁrm plus the value of any “side effects.” While others expanded on this idea, the only side effect MM considered was the tax shield: VL ⫽ VU ⫹ Value of side effects ⫽ VU ⫹ PV of tax shield.

(13-5)

Under their assumptions, they showed that the present value of the tax shield is equal to the corporate tax rate, T, multiplied by the amount of debt, D: 9

They actually showed that if the values of the two portfolios differed, then an investor could engage in riskless arbitrage: The investor could create a trading strategy (buying one portfolio and selling the other) that had no risk, required none of the investor’s own cash, and resulted in a positive cash ﬂow for the investor. This would be such a desirable strategy that everyone would try to implement it. But if everyone tries to buy the same portfolio, its price will be driven up by market demand, and if everyone tries to sell a portfolio, its price will be driven down. The net result of the trading activity would be to change the portfolios’ values until they were equal and no more arbitrage was possible. 10 Franco Modigliani and Merton H. Miller, “Corporate Income Taxes and the Cost of Capital: A Correction,” American Economic Review 53, June 1963, 433–443.

485

Capital Structure Decisions Capital Structure Theory

VL ⫽ VU ⫹ TD.

489

(13-6)

With a tax rate of about 40 percent, this implies that every dollar of debt adds about 40 cents of value to the ﬁrm, and this leads to the conclusion that the optimal capital structure is virtually 100 percent debt. MM also showed that the cost of equity, rs, increases as leverage increases, but that it doesn’t increase quite as fast as it would if there were no taxes. As a result, under MM with corporate taxes the WACC falls as debt is added.

Miller: The Effect of Corporate and Personal Taxes Merton Miller (this time without Modigliani) later brought in the effects of personal taxes.11 He noted that all of the income from bonds is generally interest, which is taxed as personal income at rates (Td ) going up to 39.1 percent, while income from stocks generally comes partly from dividends and partly from capital gains. Further, long-term capital gains are taxed at a rate of 20 percent, and this tax is deferred until the stock is sold and the gain realized. If stock is held until the owner dies, no capital gains tax whatever must be paid. So, on average, returns on stocks are taxed at lower effective rates (Ts ) than returns on debt. Because of the tax situation, Miller argued that investors are willing to accept relatively low before-tax returns on stock relative to the before-tax returns on bonds. (The situation here is similar to that with tax-exempt municipal bonds as discussed in Chapter 4 and preferred stocks held by corporate investors as discussed in Chapter 5.) For example, an investor might require a return of 10 percent on Strasburg’s bonds, and if stock income were taxed at the same rate as bond income, the required rate of return on Strasburg’s stock might be 16 percent because of the stock’s greater risk. However, in view of the favorable treatment of income on the stock, investors might be willing to accept a before-tax return of only 14 percent on the stock. Thus, as Miller pointed out, (1) the deductibility of interest favors the use of debt ﬁnancing, but (2) the more favorable tax treatment of income from stock lowers the required rate of return on stock and thus favors the use of equity ﬁnancing. Miller showed that the net impact of corporate and personal taxes is given by this equation: VL ⫽ VU ⫹ c 1 ⫺

(1 ⫺ Tc)(1 ⫺ Ts) d D. (1 ⫺ Td)

(13-7)

Here Tc is the corporate tax rate, Ts is the personal tax rate on income from stocks, and Td is the tax rate on income from debt. Miller argued that the marginal tax rates on stock and debt balance out in such a way that the bracketed term in Equation 13-7 is zero, so VL ⫽ VU, but most observers believe that there is still a tax advantage to debt. For example, with a 40 percent marginal corporate tax rate, a 30 percent marginal rate on debt, and a 12 percent marginal rate on stock, the advantage of debt ﬁnancing is: (1 ⫺ 0.40)(1 ⫺ 0.12) dD (1 ⫺ 0.30) ⫽ VU ⫹ 0.25D.

VL ⫽ VU ⫹ c 1 ⫺

(13-7a)

11 Merton H. Miller, “Debt and Taxes,” Journal of Finance 32, May 1977, 261–275. Miller was president of the American Finance Association, and he delivered the paper as his presidential address.

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Thus it appears as though the presence of personal taxes reduces but does not completely eliminate the advantage of debt ﬁnancing.

Trade-Off Theory MM’s results also depend on the assumption that there are no bankruptcy costs. However, in practice bankruptcy can be quite costly. Firms in bankruptcy have very high legal and accounting expenses, and they also have a hard time retaining customers, suppliers, and employees. Moreover, bankruptcy often forces a ﬁrm to liquidate or sell assets for less than they would be worth if the ﬁrm were to continue operating. For example, if a steel manufacturer goes out of business, it might be hard to ﬁnd buyers for the company’s blast furnaces, even though they were quite expensive. Assets such as plant and equipment are often illiquid because they are conﬁgured to a company’s individual needs and also because they are difﬁcult to disassemble and move. Note, too, that the threat of bankruptcy, not just bankruptcy per se, produces these problems. Key employees jump ship, suppliers refuse to grant credit, customers seek more stable suppliers, and lenders demand higher interest rates and impose more restrictive loan covenants if potential bankruptcy looms. Bankruptcy-related problems are most likely to arise when a ﬁrm includes a great deal of debt in its capital structure. Therefore, bankruptcy costs discourage ﬁrms from pushing their use of debt to excessive levels. Bankruptcy-related costs have two components: (1) the probability of ﬁnancial distress and (2) the costs that would be incurred given that ﬁnancial distress occurs. Firms whose earnings are more volatile, all else equal, face a greater chance of bankruptcy and, therefore, should use less debt than more stable ﬁrms. This is consistent with our earlier point that ﬁrms with high operating leverage, and thus greater business risk, should limit their use of ﬁnancial leverage. Likewise, ﬁrms that would face high costs in the event of ﬁnancial distress should rely less heavily on debt. For example, ﬁrms whose assets are illiquid and thus would have to be sold at “ﬁre sale” prices should limit their use of debt ﬁnancing. The preceding arguments led to the development of what is called “the trade-off theory of leverage,” in which ﬁrms trade off the beneﬁts of debt ﬁnancing (favorable corporate tax treatment) against the higher interest rates and bankruptcy costs. In essence, the trade-off theory says that the value of a levered ﬁrm is equal to the value of an unlevered ﬁrm plus the value of any side effects, which include the tax shield and the expected costs due to ﬁnancial distress. A summary of the trade-off theory is expressed graphically in Figure 13-3. Here are some observations about the ﬁgure: 1. Under the assumptions of the Modigliani-Miller with-corporate-taxes paper, a ﬁrm’s value will be maximized if it uses virtually 100 percent debt, and the line labeled “MM Result Incorporating the Effects of Corporate Taxation” in Figure 13-3 expresses the relationship between value and debt under their assumptions. 2. There is some threshold level of debt, labeled D1 in Figure 13-3, below which the probability of bankruptcy is so low as to be immaterial. Beyond D1, however, bankruptcy-related costs become increasingly important, and they reduce the tax beneﬁts of debt at an increasing rate. In the range from D1 to D2, bankruptcyrelated costs reduce but do not completely offset the tax beneﬁts of debt, so the stock price rises (but at a decreasing rate) as the debt ratio increases. However, beyond D2, bankruptcy-related costs exceed the tax beneﬁts, so from this point on increasing the debt ratio lowers the value of the stock. Therefore, D2 is the optimal capital structure. Of course, D1 and D2 vary from ﬁrm to ﬁrm, depending on their business risks and bankruptcy costs.

487

Capital Structure Decisions Capital Structure Theory FIGURE 13-3

491

Effect of Leverage on Value

Value

MM Result Incorporating the Effects of Corporate Taxation: Value if There Were No Bankruptcy-Related Costs

Value Added by Debt Tax Shelter Benefits

Value Reduced by Bankruptcy-Related Costs Actual Value

Value with Zero Debt = $20

Value if the Firm Used No Financial Leverage

0

D1

D2

Leverage

Threshold Debt Level Optimal Capital Structure: Where Bankruptcy Marginal Tax Shelter Benefits = Costs Become Material Marginal Bankruptcy-Related Costs

3. While theory and empirical work support the general shape of the curve in Figure 13-3, this graph must be taken as an approximation, not as a precisely deﬁned function.

Signaling Theory MM assumed that investors have the same information about a ﬁrm’s prospects as its managers—this is called symmetric information. However, in fact managers often have better information than outside investors. This is called asymmetric information, and it has an important effect on the optimal capital structure. To see why, consider two situations, one in which the company’s managers know that its prospects are extremely positive (Firm P) and one in which the managers know that the future looks negative (Firm N). Suppose, for example, that Firm P’s R&D labs have just discovered a nonpatentable cure for the common cold. They want to keep the new product a secret as long as possible to delay competitors’ entry into the market. New plants must be built to make the new product, so capital must be raised. How should Firm P’s management raise the needed capital? If it sells stock, then, when proﬁts from the new product start ﬂowing in, the price of the stock would rise sharply, and the purchasers of the new stock would make a bonanza. The current stockholders (including the managers) would also do well, but not as well as they would have done if the company had not sold stock before the price increased, because then they would not have had to share the beneﬁts of the new product with the new stockholders. Therefore, one would expect a ﬁrm with very positive prospects to try to avoid selling stock and, rather, to raise any required new capital by other means, including using debt beyond the normal target capital structure.12

12

It would be illegal for Firm P’s managers to personally purchase more shares on the basis of their inside knowledge of the new product. They could be sent to jail if they did.

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Now let’s consider Firm N. Suppose its managers have information that new orders are off sharply because a competitor has installed new technology that has improved its products’ quality. Firm N must upgrade its own facilities, at a high cost, just to maintain its current sales. As a result, its return on investment will fall (but not by as much as if it took no action, which would lead to a 100 percent loss through bankruptcy). How should Firm N raise the needed capital? Here the situation is just the reverse of that facing Firm P, which did not want to sell stock so as to avoid having to share the beneﬁts of future developments. A ﬁrm with negative prospects would want to sell stock, which would mean bringing in new investors to share the losses!13 The conclusion from all this is that ﬁrms with extremely bright prospects prefer not to ﬁnance through new stock offerings, whereas ﬁrms with poor prospects like to ﬁnance with outside equity. How should you, as an investor, react to this conclusion? You ought to say, “If I see that a company plans to issue new stock, this should worry me because I know that management would not want to issue stock if future prospects looked good. However, management would want to issue stock if things looked bad. Therefore, I should lower my estimate of the ﬁrm’s value, other things held constant, if it plans to issue new stock.” If you gave the above answer, your views would be consistent with those of sophisticated portfolio managers. In a nutshell, the announcement of a stock offering is generally taken as a signal that the ﬁrm’s prospects as seen by its management are not bright. Conversely, a debt offering is taken as a positive signal. Notice that Firm N’s managers cannot make a false signal to investors by mimicking Firm P and issuing debt. With its unfavorable future prospects, issuing debt could soon force Firm N into bankruptcy. Given the resulting damage to the personal wealth and reputations of N’s managers, they cannot afford to mimic Firm P. All of this suggests that when a ﬁrm announces a new stock offering, more often than not the price of its stock will decline. Empirical studies have shown that this situation does indeed exist.14 What are the implications of all this for capital structure decisions? Because issuing stock emits a negative signal and thus tends to depress the stock price, even if the company’s prospects are bright, it should, in normal times, maintain a reserve borrowing capacity that can be used in the event that some especially good investment opportunity comes along. This means that ﬁrms should, in normal times, use more equity and less debt than is suggested by the tax beneﬁt/bankruptcy cost trade-off model expressed in Figure 13-3. Finally, the presence of asymmetric information may cause a ﬁrm to raise capital according to a pecking order. In this situation a ﬁrm ﬁrst raises capital internally by reinvesting its net income and selling off its short-term marketable securities. When that supply of funds has been exhausted, the ﬁrm will issue debt and perhaps preferred stock. Only as a last resort will the ﬁrm issue common stock.

Using Debt Financing to Constrain Managers Agency problems may arise if managers and shareholders have different objectives. Such conﬂicts are particularly likely when the ﬁrm’s managers have too much cash at their disposal. Managers often use excess cash to ﬁnance pet projects or for perquisites such as nicer ofﬁces, corporate jets, and sky boxes at sports arenas, all of which may do little to maximize stock prices. Even worse, managers might be tempted to pay too much for an acquisition, something that could cost shareholders hundreds of millions.

13

Of course, Firm N would have to make certain disclosures when it offered new shares to the public, but it might be able to meet the legal requirements without fully disclosing management’s worst fears. 14 Paul Asquith and David W. Mullins, Jr., “The Impact of Initiating Dividend Payments on Shareholders’ Wealth,” Journal of Business, January 1983, 77–96.

489

Capital Structure Decisions Capital Structure Theory

493

By contrast, managers with limited “excess cash ﬂow” are less able to make wasteful expenditures. Firms can reduce excess cash ﬂow in a variety of ways. One way is to funnel some of it back to shareholders through higher dividends or stock repurchases. Another alternative is to shift the capital structure toward more debt in the hope that higher debt service requirements will force managers to be more disciplined. If debt is not serviced as required, the ﬁrm will be forced into bankruptcy, in which case its managers would likely lose their jobs. Therefore, a manager is less likely to buy an expensive new corporate jet if the ﬁrm has large debt service requirements that could cost the manager his or her job. In short, high levels of debt bond the cash ﬂow, since much of it is precommitted to servicing the debt. A leveraged buyout (LBO) is one way to bond cash ﬂow. In an LBO debt is used to ﬁnance the purchase of a company’s shares, after which the ﬁrm “goes private.” Many leveraged buyouts, which were especially common during the late 1980s, were designed speciﬁcally to reduce corporate waste. As noted, high debt payments force managers to conserve cash by eliminating unnecessary expenditures. Of course, increasing debt and reducing the available cash ﬂow has its downside: It increases the risk of bankruptcy. One professor has argued that adding debt to a ﬁrm’s capital structure is like putting a dagger into the steering wheel of a car.15 The dagger— which points toward your stomach—motivates you to drive more carefully, but you may get stabbed if someone runs into you, even if you are being careful. The analogy applies to corporations in the following sense: Higher debt forces managers to be more careful with shareholders’ money, but even well-run ﬁrms could face bankruptcy (get stabbed) if some event beyond their control such as a war, an earthquake, a strike, or a recession occurs. To complete the analogy, the capital structure decision comes down to deciding how big a dagger stockholders should use to keep managers in line. Finally, too much debt may overconstrain managers. A large portion of a manager’s personal wealth and reputation are tied to a single company, so managers are not well diversiﬁed. When faced with a positive NPV project that is risky, a manager may decide that it’s not worth taking on the risk, even when well-diversiﬁed stockholders would ﬁnd the risk acceptable. This is called the underinvestment problem. The more debt the ﬁrm has, the greater the likelihood of ﬁnancial distress, and thus the greater the likelihood that managers will forego risky projects even if they have positive NPVs.

Debt and the Investment Opportunity Set Bankruptcy and ﬁnancial distress are costly, and, as noted above, this can discourage highly leveraged ﬁrms from undertaking risky new investments. If potential new investments, although risky, have positive net present values, then high levels of debt can be doubly costly—the expected ﬁnancial distress and bankruptcy costs are high, and the ﬁrm loses potential value by not making some potentially proﬁtable investments. On the other hand, if a ﬁrm has very few proﬁtable investment opportunities, then high levels of debt can keep managers from wasting money by investing in poor projects. For such companies, increases in the debt ratio can increase the value of the ﬁrm. Thus, in addition to the tax, signaling, bankruptcy, and managerial constraint effects discussed earlier, the ﬁrm’s optimal capital structure is related to its set of investment opportunities. Firms with many proﬁtable opportunities should maintain their ability to invest by using low levels of debt, which is also consistent with maintaining

15

Ben Bernake, “Is There Too Much Corporate Debt?” Federal Reserve Bank of Philadelphia Business Review, September/October 1989, 3–13.

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reserve borrowing capacity. Firms with few proﬁtable investment opportunities should use high levels of debt and thus have substantial interest payments, which means imposing managerial constraint through debt.16 If you ﬁnd our discussion of capital structure theory imprecise and somewhat dissatisfying, you are not alone. In truth, no one knows how to identify precisely a ﬁrm’s optimal capital structure, or how to measure the effects of capital structure on stock prices and the cost of capital. In practice, capital structure decisions must be made using a combination of judgment and numerical analysis as shown in the next section. Why does MM theory with corporate taxes lead to 100 percent debt? Explain how “asymmetric information” and “signals” affect capital structure decisions. What is meant by reserve borrowing capacity, and why is it important to ﬁrms? How can the use of debt serve to discipline managers?

Estimating the Optimal Capital Structure Managers should choose the capital structure that maximizes shareholders’ wealth. The basic approach is to consider a trial capital structure, based on the market values of the debt and equity, and then estimate the wealth of the shareholders under this capital structure. This approach is repeated until an optimal capital structure is identiﬁed. There are ﬁve steps for the analysis of each potential capital structure: (1) Estimate the interest rate the ﬁrm will pay. (2) Estimate the cost of equity. (3) Estimate the weighted average cost of capital. (4) Estimate the free cash ﬂows and their present value, which is the value of the ﬁrm. (5) Deduct the value of the debt to ﬁnd the shareholders’ wealth, which we want to maximize. The following sections explain each of these steps, using the company we considered earlier, Strasburg Electronics.

1. Estimating the Cost of Debt The CFO asked Strasburg’s investment bankers to estimate the cost of debt at different capital structures. The investment bankers began by analyzing industry conditions and prospects. They appraised Strasburg’s business risk, based on its past ﬁnancial statements and its current technology and customer base. The bankers also projected pro forma statements under various capital structures and analyzed such key ratios as the current ratio and the times-interest-earned ratio. Finally, they factored in current conditions in the ﬁnancial markets, including interest rates paid by ﬁrms in Strasburg’s industry. Based on their analysis and judgment, they estimated interest rates at various capital structures as shown in Table 13-2, starting with an 8 percent cost of debt if 10 percent or less of its capital is obtained as debt. Notice that the cost of debt goes up as leverage and the threat of bankruptcy increase.

2. Estimating the Cost of Equity, rs An increase in the debt ratio also increases the risk faced by shareholders, and this has an effect on the cost of equity, rs. Recall from Chapter 3 that a stock’s beta is the relevant measure of risk for diversiﬁed investors. Moreover, it has been demonstrated, 16

Michael J. Barclay and Clifford W. Smith, Jr., “The Capital Structure Puzzle: Another Look at the Evidence,” Journal of Applied Corporate Finance, Vol. 12, no. 1, Spring 1999, 8–20.

491

Capital Structure Decisions Estimating the Optimal Capital Structure

495

Taking a Look at Global Capital Structures

To what extent does capital structure vary across different countries? The following table, which is taken from a recent study by Raghuram Rajan and Luigi Zingales, both of the University of Chicago, shows the median debt ratios of ﬁrms in the largest industrial countries. Rajan and Zingales also show that there is considerable variation in capital structure among ﬁrms within each of the seven countries. However, they also show that capital structures for the ﬁrms in each country are generally determined by a similar set of factors: ﬁrm size, proﬁtability, market-tobook ratio, and the ratio of ﬁxed assets to total assets. All in all, the Rajan-Zingales study suggests that the points developed in this chapter apply to ﬁrms all around the world.

Median Percentage of Debt to Total Assets in Different Countries Country

Book Value Debt Ratio

Canada France Germany Italy Japan United Kingdom United States

32% 18 11 21 21 10 25

Source: Raghuram G. Rajan and Luigi Zingales, “What Do We Know about Capital Structure? Some Evidence from International Data,” The Journal of Finance, Vol. 50, no. 5, December 1995, 1421-1460. Used with permission.

both theoretically and empirically, that beta increases with ﬁnancial leverage. Indeed, Robert Hamada developed the following equation to specify the effect of ﬁnancial leverage on beta:17 b ⫽ bU[1 ⫹ (1 ⫺ T)(D/S)].

(13-8)

The Hamada equation shows how increases in the market value debt/equity ratio increase beta. Here bU is the ﬁrm’s unlevered beta coefﬁcient, that is, the beta it would have if it has no debt. In that case, beta would depend entirely upon business risk and thus be a measure of the ﬁrm’s “basic business risk.”

17

See Robert S. Hamada, “Portfolio Analysis, Market Equilibrium, and Corporation Finance,” Journal of Finance, March 1969, 13–31. Note that Thomas Conine and Maurry Tamarkin extended Hamada’s work to include risky debt. See “Divisional Cost of Capital Estimation: Adjusting for Leverage,” Financial Management, Spring 1985, 54–58.

TABLE 13-2

The Cost of Debt for Strasburg Electronics with Different Capital Structures

Percent Financed with Debt (wd)

0% 10 20 30 40 50 60 Note: The capital structure weights are based on market values.

Cost of Debt (rd)

8.0% 8.0 8.1 8.5 9.0 11.0 14.0

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Note that beta is the only variable that can be inﬂuenced by management in the CAPM cost of equity equation, rs ⫽ (rRF ⫹ RPM)b. The risk-free rate and market risk premium are determined by market forces that are beyond the ﬁrm’s control. However, b is affected (1) by the ﬁrm’s operating decisions as discussed earlier in the chapter, which affect bU, and (2) by its capital structure decisions as reﬂected in its D/S ratio. As a starting point, a ﬁrm can take its current beta, tax rate, and debt/equity ratio and calculate its unlevered beta, bU, by simply transforming Equation 13-8 as follows: bU ⫽ b/[1 ⫹ (1 ⫺ T)(D/S)].

(13-8a)

Then, once bU is determined, the Hamada equation can be used to estimate how changes in the debt/equity ratio would affect the leveraged beta, b, and thus the cost of equity, rs. We can apply the procedure to Strasburg Electronics. First, the risk-free rate of return, rRF, is 6 percent, and the market risk premium, RPM, is 6 percent. Next, we need the unlevered beta, bU. Because Strasburg has no debt, its D/S ⫽ 0. Therefore, its current beta of 1.0 is also its unlevered beta, hence bU ⫽ 1.0. Therefore, Strasburg’s current cost of equity is 12 percent: rs ⫽ rRF ⫹ RPM(b) ⫽ 6% ⫹ (6%)(1.0) ⫽ 6% ⫹ 6% ⫽ 12%. The ﬁrst 6 percent is the risk-free rate, the second the risk premium. Because Strasburg currently uses no debt, it has no ﬁnancial risk. Therefore, its 6 percent risk premium reﬂects only its business risk. If Strasburg changes its capital structure by adding debt, this would increase the risk stockholders bear. That, in turn, would result in an additional risk premium. Conceptually, this situation would exist: rs ⫽ rRF ⫹ Premium for business risk ⫹ Premium for ﬁnancial risk. Column 4 of Table 13-3 shows Strasburg’s estimated beta for the capital structures under consideration. Figure 13-4 (using data calculated in Column 5 of Table 13-3) graphs Strasburg’s required return on equity at different debt ratios. As the ﬁgure shows, rs consists of the 6 percent risk-free rate, a constant 6 percent premium for business risk, and a premium for ﬁnancial risk that starts at zero but rises at an increasing rate as the debt ratio increases.

3. Estimating the Weighted Average Cost of Capital, WACC Column 6 of Table 13-3 shows Strasburg’s weighted average cost of capital, WACC, at different capital structures. Currently, it has no debt, so its capital structure is 100 percent equity, and at this point WACC ⫽ rs ⫽ 12%. As Strasburg begins to use lowercost debt, the WACC declines. However, as the debt ratio increases, the costs of both debt and equity rise, at ﬁrst slowly but then at a faster and faster rate. Eventually, the increasing costs of the two components offset the fact that more low-cost debt is being used. At 40 percent debt, the WACC hits a minimum of 10.8 percent, and after that it rises with further increases in the debt ratio. Note too that even though the component cost of equity is always higher than that of debt, using only lower-cost debt would not maximize value because of the feedback effects on the costs of debt and equity. If Strasburg were to issue more than 40 percent debt, it would then be relying more on the cheaper source of capital, but this lower cost would be more than offset by the fact that using more debt would raise the costs of both debt and equity.

493

Capital Structure Decisions Estimating the Optimal Capital Structure TABLE 13-3 Percent Financed with Debt, wd (1)

0% 10 20 30 40 50 60

497

Strasburg’s Optimal Capital Structure

Market Debt/Equity, D/S (2)a

0.00% 11.11 25.00 42.86 66.67 100.00 150.00

After-Tax Cost of Debt, (1 ⫺ T) rd (3)b

Estimated Beta, b (4)c

Cost of Equity, rs (5)d

WACC (6)e

Value of Firm, V (7)f

4.80% 4.80 4.86 5.10 5.40 6.60 8.40

1.00 1.07 1.15 1.26 1.40 1.60 1.90

12.0% 12.4 12.9 13.5 14.4 15.6 17.4

12.00% 11.64 11.29 11.01 10.80 11.10 12.00

$200,000 206,186 212,540 217,984 222,222 216,216 200,000

Notes: a The D/S ratio is calculated as: D/S ⫽ wd/(1 ⫺ wd). b The interest rates are shown in Table 13-2, and the tax rate is 40 percent. c The beta is estimated using Hamada’s formula in Equation 13-8. d The cost of equity is estimated using the CAPM formula: rs ⫽ rRF ⫹ (RPM)b, where the risk free rate is 6 percent and the market risk premium is 6 percent. e The weighted average cost of capital is calculated using Equation 13-2: WACC ⫽ wers ⫹ wdrd (1 ⫺ T), where we ⫽ (1 ⫺ wd). f The value of the ﬁrm is calculated using the free cash ﬂow valuation formula in Equation 13-1, modiﬁed to reﬂect the fact that since Strasburg has zero growth, V ⫽ FCF / WACC. Strasburg has zero growth, so it requires no investment in capital and its FCF is equal to its NOPAT. Using the EBIT shown in Table 13-1: FCF ⫽ NOPAT ⫹ Investment in capital ⫽ EBIT (1 ⫺ T) ⫹ 0 ⫽ $40,000 (1 ⫺ 0.4) ⫽ $24,000.

4. Estimating the Firm’s Value We can estimate Strasburg’s value using Equation 13-1. Because Strasburg has zero growth, we can use the constant growth version of Equation 13-1: V⫽

FCF . WACC

(13-1a)

Recall that FCF is net operating proﬁt after taxes (NOPAT) minus the required net investment in capital. Table 13-1 shows that Strasburg has an expected EBIT of $40,000. With a tax rate of 40 percent, its expected NOPAT is $24,000 ⫽ $40,000 (1 ⫺ 0.40). Since Strasburg has zero growth, its future net investments in operating assets will be zero, so its expected FCF is equal to NOPAT. With zero debt, Strasburg has a WACC of 12 percent (shown in Column 6 of Table 13-3) and a value of V⫽

$24,000 FCF ⫽ ⫽ $200,000. WACC 0.12

Column 7 of Table 13-3 shows Strasburg’s value at different capital structures.18 Notice that the maximum value of $222,222 occurs at a capital structure with 40 percent debt, which is also the capital structure that minimizes the WACC.

18

In this analysis we assume that Strasburg’s expected EBIT and FCF are constant for the various capital structures. In a more reﬁned analysis we might try to estimate any possible declines in FCF at high levels of debt in the capital structure as the threat of bankruptcy becomes imminent.

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CHAPTER 13

Capital Structure Decisions FIGURE 13-4

Strasburg’s Required Rate of Return on Equity at Different Debt Levels

Required Return on Equity (%) 18

rs

16 Premium for Financial Risk

14 12 10

Premium for Business Risk

8 rRF = 6

rRF Risk-Free Rate: Time Value of Money Plus Expected Inflation

4 2

0

10

20

30

40

50

60

Percent Financed with Debt (%)

5. Estimating Shareholder Wealth and Stock Price Strasburg should now recapitalize, meaning that it should issue debt and use the proceeds to repurchase stock. The shareholder’s wealth after the recap, as it is commonly called, would be equal to the payment they receive from the share repurchase plus the remaining value of their equity. To ﬁnd the remaining value of equity, we need to specify how much debt is issued in the new capital structure. Since we know the percent of debt in the capital structure and the resulting value of the ﬁrm, we can ﬁnd the dollar value of debt as follows: D ⫽ wdV . For example, at the optimal capital structure of 40 percent debt, the dollar value of debt is about $88,889 ⫽ 0.40($222,222). The market value of the remaining equity, S, is equal to the total value minus the value of the debt. At the optimal capital structure, the market value of equity is $133,333 ⫽ $222,222 ⫺ $88,889. Column 4 in Table 13-4 shows the market value of equity under the various capital structures. Notice that the value of equity declines as the percent ﬁnanced with debt increases. At ﬁrst glance, it looks like increasing leverage hurts shareholders. But keep in mind that the shareholders also receive cash equal to the amount of new debt when the company repurchases the stock: Cash raised by issuing debt ⫽ D ⫺ D0.

495

Capital Structure Decisions Estimating the Optimal Capital Structure TABLE 13-4

499

Strasburg’s Stock Price and Earnings per Share

Percent Financed with Debt, wd (1)

Value of Firm, V (2)a

Market Value of Debt, (D) (3)b

Market Value of Equity, S (4)c

0% 10 20 30 40 50 60

$200,000 206,186 212,540 217,984 222,222 216,216 200,000

$0 20,619 42,508 65,395 88,889 108,108 120,000

$200,000 185,567 170,032 152,589 133,333 108,108 80,000

Stock Price, P (5)d

Number of Shares after Repurchase, n (6)e

Net Income, NI (7)f

Earnings per Share, EPS (8)g

$20.00 20.62 21.25 21.80 22.22 21.62 20.00

$10,000 9,000 8,000 7,000 6,000 5,000 4,000

$24,000 23,010 21,934 20,665 19,200 16,865 13,920

$2.40 2.56 2.74 2.95 3.20 3.37 3.48

Notes: a The value of the ﬁrm is taken from Table 13-3. b The value of debt is found by multiplying the percent of the ﬁrm ﬁnanced with debt in Column 1 by the value of the ﬁrm in Column 2. c The value of equity is found by subtracting the value of debt in Column 3 from the total value of the ﬁrm in Column 2. d The number of outstanding shares prior to the recap is n0 ⫽ 10,000. The stock price is P ⫽ [S ⫹ (D ⫺ D0)]/n0 ⫽ [S ⫹ D]/10,000. e The number of shares after the recapitalizations is n ⫽ S/P. f Net income is NI ⫽ (EBIT ⫺ rdD) (I ⫺ T), where EBIT ⫽ $40,000 (taken from Table 13-1), rd comes from Table 13-2, and T ⫽ 40%. g EPS ⫽ NI/n.

Here D0 is the amount of debt the company had before the recap, which for Strasburg was zero. For example, at the optimal capital structure, Strasburg will issue $88,889 in debt and use the proceeds to repurchase stock. Thus, the total wealth of the shareholders after the repurchase will be the cash they receive in the repurchase ($88,889) plus the value of their remaining equity ($133,333), for a total wealth of $222,222. Notice that their total wealth increases from its original level of $200,000 to the new level of $222,222, a gain of $22,222. This is exactly equal to the increase in total value experienced by Strasburg, so the shareholders reap the full rewards of the recapitalization. Prior to the announced recap, Strasburg had a $200,000 market value of equity and 10,000 shares of stock outstanding (n0). Therefore, its stock price prior to the recap was $20 per share ($200,000/10,000 ⫽ $20). To ﬁnd the price per share after the recap, consider the sequence of events. (1) The company announces the recap and issues new debt. (2) The company uses the proceeds from the debt issue to repurchase shares of stock. These events don’t occur exactly simultaneously, so let’s examine each event separately. Strasburg Issues New Debt Strasburg announces its plans to recapitalize, and borrows $88,889. It has not yet repurchased the stock, and so the $88,889 of debt proceeds are temporarily used to purchase short-term investments such as T-bills or other marketable securities. Using the corporate valuation model from Chapter 12, the total corporate value is now equal to the value of operations, calculated by discounting the expected free cash ﬂows by the new WACC, plus the value of any nonoperating assets such as short-term investments. Therefore, Strasburg’s total value after issuing debt but before repurchasing stock is Total corporate value ⫽ Value of operations ⫹ Value of short-term investments ⫽ $222,222 ⫹ $88,889 ⫽ $311,111.

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Recall from Chapter 12 that the value of equity is the total corporate value minus the value of all debt. Therefore, the value of equity after the debt issue but prior to the repurchase, Sp, is Sp ⫽ Value of equity after the debt issue but prior to the repurchase ⫽ Total corporate value ⫺ Value of all debt ⫽ $311,111 ⫺ $88,889 ⫽ $222,222. Although the corporate valuation model will always provide the correct value, there is a quicker and more intuitive way to determine Sp in a recapitalization. Sp reﬂects the wealth of the shareholders under the new capital structure, and, as we noted earlier, this is equal to the value of their equity after completion of the recapitalization plus the cash they receive in the repurchase: Sp ⫽ S ⫹ (D ⫺ D0) ⫽ $133,333 ⫹ ($88,889 ⫺ $0) ⫽ $222,222. This is exactly the same value as calculated above, but it can be computed with fewer steps and is perhaps a little more intuitive. The price per share after issuing debt but prior to repurchasing stock, Pp, is Pp ⫽ Price per share after debt issue but prior to repurchase Value of equity after debt issue but prior to repurchase ⫽ Number of shares outstanding prior to repurchase ⫽ Sp /n0 ⫽ $222,222/10,000 ⫽ $22.22. Strasburg Repurchases Stock What happens to the stock price during the repurchase? The short answer is “nothing.” It is true that the additional debt will change the WACC and the stock price prior to the repurchase, but the subsequent repurchase itself will not affect the stock price.19 To see why this is true, suppose the stock price was lower right before the repurchase than after the repurchase. If this were true, it would be possible for an investor to buy the stock the day before the repurchase and then reap a reward the very next day. Current stockholders would realize this and would refuse to sell the stock unless they were paid the price that is expected immediately after the repurchase. Therefore, the post-repurchase price, P, is equal to the stock price after the debt issue but prior to the repurchase. Using the relationships in the previous section, we can write this as:20 P ⫽ Sp/n0 ⫽ [S ⫹ (D ⫺ D0)]/n0.

(13-9)

Column 5 in Table 13-4 shows the price per share for the various capital structures. Notice that it, too, is maximized at the same capital structure that minimizes the WACC and maximizes the value of the ﬁrm.

19

As we discuss in Chapter 14, a stock repurchase may be a signal of a company’s future prospects, or it may be the way a company “announces” a change in capital structure, and either of those situations could have an impact on estimated free cash ﬂows or WACC. However, neither situation applies to Strasburg. 20 There are other ways to get to Equation 13-9. By deﬁnition, P ⫽ S/n. Since P is also the stock price immediately prior to the repurchase and all debt proceeds are used to repurchase stock, the dollar value of repurchased shares is P(n0 ⫺ n) ⫽ D ⫺ D0. We have two equations (one deﬁning the price per share after the repurchase) and one deﬁning the dollar value of repurchased stock. We have two unknowns, n and P. We can solve for the repurchase price: P ⫽ (S ⫹ D ⫺ D0)/n0.

497

Capital Structure Decisions Estimating the Optimal Capital Structure

501

Strasburg used the entire debt proceeds to repurchase stock, which means the number of repurchased shares is equal to the debt, D, divided by the repurchase price, P. Given 10,000 shares outstanding prior to the repurchase, the number of remaining shares after the repurchase, n, is n ⫽ Number of outstanding shares remaining after the repurchase ⫽ n0 ⫺ (D/P). At the optimal capital structure, Strasburg will repurchase $88.889/$22.22 ⫽ 4,000 shares of stock, leaving 6,000 shares outstanding (see Column 6 of Table 13-4). The expected EBIT is $40,000, from Table 13-1. Using the appropriate interest rate, amount of debt, and tax rate we can calculate the net income (Column 7 in Table 13-4) and the earnings per share (Column 8).

Analyzing the Results We summarize the results graphically in Figure 13-5. Notice that the cost of equity and the cost of debt both increase as debt increases. The WACC initially falls, but the rapidly increasing costs of equity and debt cause WACC to increase when the debt ratio goes above 40 percent. As indicated earlier, the minimum WACC and maximum corporate value occur at the same capital structure. Now look closely at the curve for the value of the ﬁrm, and notice how ﬂat it is around the optimal level of debt. Thus, it doesn’t make a great deal of difference whether Strasburg’s capital structure has 30 percent debt or 50 percent. Also, notice that the maximum value is about 11 percent greater than the value with no debt. Although this example is for a single company, the results are typical: The optimal capital structure can add 10 to 20 percent more value relative to zero debt, and there is a fairly wide region (from about 20 percent debt to 55 percent) over which value changes very little. In the last chapter we looked at value-based management and saw how companies can increase their value by improving their operations. There is good news and bad news regarding this. The good news is that small improvements in operations can lead to huge increases in value. But the bad news is that it’s often very hard to improve operations, especially if the company is already well managed. If instead you seek to increase a ﬁrm’s value by changing its capital structure, we again have good news and bad news. The good news is that changing capital structure is very easy—just call an investment banker and issue debt (or the reverse if the ﬁrm has too much debt). The bad news is that this will add only a relatively small amount of value. Of course, any additional value is better than none, so it’s hard to understand why there are some mature ﬁrms with zero debt. Finally, Figure 13-5 shows that Strasburg’s EPS steadily increases with leverage, while its stock price reaches a maximum and then begins to decline. For some companies there is a capital structure that maximizes EPS, but this is generally not at the same capital structure that maximizes stock price. This is one additional reason we focus on cash ﬂows and value rather than earnings. What happens to the costs of debt and equity when the leverage increases? Explain. Using the Hamada equation, show the effect of ﬁnancial leverage on beta. Using a graph and illustrative data, identify the premiums for ﬁnancial risk and business risk at different debt levels. Do these premiums vary depending on the debt level? Explain. Is expected EPS maximized at the optimal capital structure?

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Capital Structure Decisions FIGURE 13-5

Effects of Capital Structure on Value, Cost of Capital, Stock Price, and EPS

Cost of Capital (%) 20 Cost of Equity 15 WACC 10

After-Tax Cost of Debt

5

0

0

10

20

30 40 50 60 Percent Financed with Debt

Value of Firm ($) 250,000 200,000

150,000 100,000

50,000 0 0

10

20

30 40 50 60 Percent Financed with Debt

Stock Price ($) 25 Price 20

EPS ($) 6

4

15 EPS

10

2

5 0

0

10

20

30

0 40 50 60 Percent Financed with Debt

499

Capital Structure Decisions Checklist for Capital Structure Decisions

503

Checklist for Capital Structure Decisions Firms generally consider the following factors when making capital structure decisions: 1. Sales stability. A ﬁrm whose sales are relatively stable can safely take on more debt and incur higher ﬁxed charges than a company with unstable sales. Utility companies, because of their stable demand, have historically been able to use more ﬁnancial leverage than industrial ﬁrms. 2. Asset structure. Firms whose assets are suitable as security for loans tend to use debt rather heavily. General-purpose assets that can be used by many businesses make good collateral, whereas special-purpose assets do not. Thus, real estate companies are usually highly leveraged, whereas companies involved in technological research are not. 3. Operating leverage. Other things the same, a ﬁrm with less operating leverage is better able to employ ﬁnancial leverage because it will have less business risk. 4. Growth rate. Other things the same, faster-growing ﬁrms must rely more heavily on external capital (see Chapter 11). Further, the flotation costs involved in selling common stock exceed those incurred when selling debt, which encourages rapidly growing ﬁrms to rely more heavily on debt. At the same time, however, these ﬁrms often face greater uncertainty, which tends to reduce their willingness to use debt. 5. Proﬁtability. One often observes that ﬁrms with very high rates of return on investment use relatively little debt. Although there is no theoretical justiﬁcation for this fact, one practical explanation is that very proﬁtable ﬁrms such as Intel, Microsoft, and Coca-Cola simply do not need to do much debt ﬁnancing. Their high rates of return enable them to do most of their ﬁnancing with internally generated funds. 6. Taxes. Interest is a deductible expense, and deductions are most valuable to ﬁrms with high tax rates. Therefore, the higher a ﬁrm’s tax rate, the greater the advantage of debt. 7. Control. The effect of debt versus stock on a management’s control position can inﬂuence capital structure. If management currently has voting control (over 50 percent of the stock) but is not in a position to buy any more stock, it may choose debt for new ﬁnancings. On the other hand, management may decide to use equity if the ﬁrm’s ﬁnancial situation is so weak that the use of debt might subject it to serious risk of default, because if the ﬁrm goes into default, the managers will almost surely lose their jobs. However, if too little debt is used, management runs the risk of a takeover. Thus, control considerations could lead to the use of either debt or equity, because the type of capital that best protects management will vary from situation to situation. In any event, if management is at all insecure, it will consider the control situation. 8. Management attitudes. Because no one can prove that one capital structure will lead to higher stock prices than another, management can exercise its own judgment about the proper capital structure. Some managements tend to be more conservative than others, and thus use less debt than the average ﬁrm in their industry, whereas aggressive managements use more debt in the quest for higher proﬁts. 9. Lender and rating agency attitudes. Regardless of managers’ own analyses of the proper leverage factors for their ﬁrms, lenders’ and rating agencies’ attitudes frequently inﬂuence ﬁnancial structure decisions. In the majority of cases, the corporation discusses its capital structure with lenders and rating agencies and gives much weight to their advice. For example, one large utility was recently told by Moody’s

500

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Capital Structure Decisions

and Standard & Poor’s that its bonds would be downgraded if it issued more debt. This inﬂuenced its decision to ﬁnance its expansion with common equity. 10. Market conditions. Conditions in the stock and bond markets undergo both long- and short-run changes that can have an important bearing on a ﬁrm’s optimal capital structure. For example, during a recent credit crunch, the junk bond market dried up, and there was simply no market at a “reasonable” interest rate for any new long-term bonds rated below triple B. Therefore, low-rated companies in need of capital were forced to go to the stock market or to the short-term debt market, regardless of their target capital structures. When conditions eased, however, these companies sold bonds to get their capital structures back on target. 11. The ﬁrm’s internal condition. A ﬁrm’s own internal condition can also have a bearing on its target capital structure. For example, suppose a ﬁrm has just successfully completed an R&D program, and it forecasts higher earnings in the immediate future. However, the new earnings are not yet anticipated by investors, hence are not reﬂected in the stock price. This company would not want to issue stock—it would prefer to ﬁnance with debt until the higher earnings materialize and are reﬂected in the stock price. Then it could sell an issue of common stock, retire the debt, and return to its target capital structure. This point was discussed earlier in connection with asymmetric information and signaling. 12. Financial ﬂexibility. Firms with proﬁtable investment opportunities need to be able to fund them. An astute corporate treasurer made this statement to the authors: Our company can earn a lot more money from good capital budgeting and operating decisions than from good ﬁnancing decisions. Indeed, we are not sure exactly how ﬁnancing decisions affect our stock price, but we know for sure that having to turn down a promising venture because funds are not available will reduce our long-run proﬁtability. For this reason, my primary goal as treasurer is to always be in a position to raise the capital needed to support operations. We also know that when times are good, we can raise capital with either stocks or bonds, but when times are bad, suppliers of capital are much more willing to make funds available if we give them a secured position, and this means debt. Further, when we sell a new issue of stock, this sends a negative “signal” to investors, so stock sales by a mature company such as ours are not desirable.

Putting all these thoughts together gives rise to the goal of maintaining ﬁnancial ﬂexibility, which, from an operational viewpoint, means maintaining adequate reserve borrowing capacity. Determining an “adequate” reserve borrowing capacity is judgmental, but it clearly depends on the factors discussed in the chapter, including the ﬁrm’s forecasted need for funds, predicted capital market conditions, management’s conﬁdence in its forecasts, and the consequences of a capital shortage. How does sales stability affect the target capital structure? How do the types of assets used affect a ﬁrm’s capital structure? How do taxes affect the target capital structure? How do lender and rating agency attitudes affect capital structure? How does the ﬁrm’s internal condition affect its actual capital structure? What is “ﬁnancial ﬂexibility,” and is it increased or decreased by a high debt ratio?

Summary This chapter examined the effects of ﬁnancial leverage on stock prices, earnings per share, and the cost of capital. The key concepts covered are listed below:

501

Capital Structure Decisions Summary 䊉

䊉

䊉

䊉

䊉

䊉

505

A ﬁrm’s optimal capital structure is that mix of debt and equity that maximizes the stock price. At any point in time, management has a speciﬁc target capital structure in mind, presumably the optimal one, although this target may change over time. Several factors inﬂuence a ﬁrm’s capital structure. These include its (1) business risk, (2) tax position, (3) need for ﬁnancial ﬂexibility, (4) managerial conservatism or aggressiveness, and (5) growth opportunities. Business risk is the riskiness inherent in the ﬁrm’s operations if it uses no debt. A ﬁrm will have little business risk if the demand for its products is stable, if the prices of its inputs and products remain relatively constant, if it can adjust its prices freely if costs increase, and if a high percentage of its costs are variable and hence will decrease if sales decrease. Other things the same, the lower a ﬁrm’s business risk, the higher its optimal debt ratio. Financial leverage is the extent to which ﬁxed-income securities (debt and preferred stock) are used in a ﬁrm’s capital structure. Financial risk is the added risk borne by stockholders as a result of ﬁnancial leverage. Operating leverage is the extent to which ﬁxed costs are used in a ﬁrm’s operations. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in ROIC. Robert Hamada used the underlying assumptions of the CAPM, along with the Modigliani and Miller model, to develop the Hamada equation, which shows the effect of ﬁnancial leverage on beta as follows: b ⫽ bU [1 ⫹ (1 ⫺ T)(D/S)]. Firms can take their current beta, tax rate, and debt/equity ratio to arrive at their unlevered beta, bU, as follows: bU ⫽ b/[1 ⫹ (1 ⫺ T)(D/S)].

䊉

䊉

䊉

Modigliani and Miller and their followers developed a trade-off theory of capital structure. They showed that debt is useful because interest is tax deductible, but also that debt brings with it costs associated with actual or potential bankruptcy. The optimal capital structure strikes a balance between the tax beneﬁts of debt and the costs associated with bankruptcy. An alternative (or, really, complementary) theory of capital structure relates to the signals given to investors by a ﬁrm’s decision to use debt versus stock to raise new capital. A stock issue sets off a negative signal, while using debt is a positive, or at least a neutral, signal. As a result, companies try to avoid having to issue stock by maintaining a reserve borrowing capacity, and this means using less debt in “normal” times than the MM trade-off theory would suggest. A ﬁrm’s owners may decide to use a relatively large amount of debt to constrain the managers. A high debt ratio raises the threat of bankruptcy, which carries a cost but which also forces managers to be more careful and less wasteful with shareholders’ money. Many of the corporate takeovers and leveraged buyouts in recent years were designed to improve efﬁciency by reducing the cash ﬂow available to managers.

Although each ﬁrm has a theoretically optimal capital structure, as a practical matter we cannot estimate it with precision. Accordingly, ﬁnancial executives generally treat the optimal capital structure as a range—for example, 40 to 50 percent debt—rather than as a precise point, such as 45 percent. The concepts discussed in this chapter help managers understand the factors they should consider when they set the target capital structure ranges for their ﬁrms.

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Questions 13–1

Deﬁne each of the following terms: a. Capital structure; business risk; ﬁnancial risk b. Operating leverage; ﬁnancial leverage; breakeven point c. Reserve borrowing capacity

13–2

What term refers to the uncertainty inherent in projections of future ROIC?

13–3

Firms with relatively high nonﬁnancial ﬁxed costs are said to have a high degree of what?

13–4

“One type of leverage affects both EBIT and EPS. The other type affects only EPS.” Explain this statement.

13–5

Why is the following statement true? “Other things being the same, ﬁrms with relatively stable sales are able to carry relatively high debt ratios.”

13–6

Why do public utility companies usually have capital structures that are different from those of retail ﬁrms?

13–7

Why is EBIT generally considered to be independent of ﬁnancial leverage? Why might EBIT actually be inﬂuenced by ﬁnancial leverage at high debt levels?

13–8

If a ﬁrm went from zero debt to successively higher levels of debt, why would you expect its stock price to ﬁrst rise, then hit a peak, and then begin to decline?

Self-Test Problems ST–1 OPTIMAL CAPITAL STRUCTURE

ST–2 HAMADA EQUATION

(Solutions Appear in Appendix A)

The Rogers Company is currently in this situation: (1) EBIT ⫽ $4.7 million; (2) tax rate, T ⫽ 40%; (3) value of debt, D ⫽ $2 million; (4) rd ⫽ 10%; (5) rs ⫽ 15%; (6) shares of stock outstanding, n0 ⫽ 600,000; and stock price, P0 ⫽ $30. The ﬁrm’s market is stable, and it expects no growth, so all earnings are paid out as dividends. The debt consists of perpetual bonds. a. What is the total market value of the ﬁrm’s stock, S, and the ﬁrm’s total market value, V? b. What is the ﬁrm’s weighted average cost of capital? c. Suppose the ﬁrm can increase its debt so that its capital structure has 50 percent debt, based on market values (it will issue debt and buy back stock). At this level of debt, its cost of equity rises to 18.5 percent. Its interest rate on all debt will rise to 12 percent (it will have to call and refund the old debt). What is the WACC under this capital structure? What is the total value? How much debt will it issue, and what is the stock price after the repurchase? How many shares will remain outstanding after the repurchase? Lighter Industrial Corporation (LIC) is considering a large-scale recapitalization. Currently, LIC is ﬁnanced with 25 percent debt and 75 percent equity. LIC is considering increasing its level of debt until it is ﬁnanced with 60 percent debt and 40 percent equity. The beta on its common stock at the current level of debt is 1.5, the risk free rate is 6 percent, the market risk premium is 4 percent, and LIC faces a 40 percent federal-plus-state tax rate. a. What is LIC’s current cost of equity? b. What is LIC’s unlevered beta? c. What will be the new beta and new cost of equity if LIC recapitalizes?

Problems 13–1 OPERATING LEVERAGE AND BREAKEVEN

Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The ﬁrm’s ﬁxed costs, F, are $2 million; 50 earth stations are produced and sold each year; proﬁts total $500,000; and the ﬁrm’s assets (all equity ﬁnanced) are $5 million. The ﬁrm estimates that it can change its production process, adding $4 million to investment and $500,000 to ﬁxed operating costs. This change will (1) reduce variable costs per unit by $10,000 and (2) increase output by

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20 units, but (3) the sales price on all units will have to be lowered to $95,000 to permit sales of the additional output. The ﬁrm has tax loss carry-forwards that cause its tax rate to be zero, its cost of equity is 15 percent, and it uses no debt. a. Should the ﬁrm make the change? b. Would the ﬁrm’s operating leverage increase or decrease if it made the change? What about its breakeven point? c. Would the new situation expose the ﬁrm to more or less business risk than the old one? 13–2

Here are the estimated ROE distributions for Firms A, B, and C:

BUSINESS AND FINANCIAL RISK

Probability

Firm A: ROEA Firm B: ROEB Firm C: ROEC

0.1

0.2

0.4

0.2

0.1

0.0% (2.0) (5.0)

5.0% 5.0 5.0

10.0% 12.0 15.0

15.0% 19.0 25.0

20.0% 26.0 35.0

a. Calculate the expected value and standard deviation for Firm C’s ROE. ROEA ⫽ 10.0%, ␴A ⫽ 5.5%; ROEB ⫽ 12.0%, ␴B ⫽ 7.7%. b. Discuss the relative riskiness of the three ﬁrms’ returns. (Assume that these distributions are expected to remain constant over time.) c. Now suppose all three ﬁrms have the same standard deviation of basic earning power (EBIT/ Total assets), ␴A ⫽ ␴B ⫽ ␴C ⫽ 5.5%. What can we tell about the ﬁnancial risk of each ﬁrm? 13–3 CAPITAL STRUCTURE ANALYSIS

The Rivoli Company has no debt outstanding, and its ﬁnancial position is given by the following data: Assets (book ⫽ market) EBIT Cost of equity, rs Stock price, P0 Shares outstanding, n0 Tax rate, T (federal-plus-state)

$3,000,000 $500,000 10% $15 200,000 40%

The ﬁrm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to capital structure with 30 percent debt based on market values, its cost of equity, rs, will increase to 11 percent to reﬂect the increased risk. Bonds can be sold at a cost, rd, of 7 percent. Rivoli is a no-growth ﬁrm. Hence, all its earnings are paid out as dividends, and earnings are expectationally constant over time. a. What effect would this use of leverage have on the value of the ﬁrm? b. What would be the price of Rivoli’s stock? c. What happens to the ﬁrm’s earnings per share after the recapitalization? d. The $500,000 EBIT given previously is actually the expected value from the following probability distribution: Probability

0.10 0.20 0.40 0.20 0.10

EBIT

($

100,000) 200,000 500,000 800,000 1,100,000

e. Determine the times-interest-earned ratio for each probability. What is the probability of not covering the interest payment at the 30 percent debt level? 13–4 CAPITAL STRUCTURE ANALYSIS

Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10 percent perpetual bonds now selling at par. The

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Capital Structure Decisions company’s EBIT is $13.24 million, and its tax rate is 15 percent. Pettit can change its capital structure by either increasing its debt to 70 percent (based on market values) or decreasing it to 30 percent. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 12 percent coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new 8 percent coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change. The ﬁrm pays out all earnings as dividends; hence, its stock is a zero growth stock. Its current cost of equity, rs, is 14 percent. If it increases leverage, rs will be 16 percent. If it decreases leverage, rs will be 13 percent. What is the ﬁrm’s WACC and total corporate value under each capital structure?

13–5 OPTIMAL CAPITAL STRUCTURE WITH HAMADA

13–6 WACC AND OPTIMAL CAPITAL STRUCTURE

Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8 percent, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero growth ﬁrm and pays out all of its earnings as dividends. EBIT is $14.933 million, and BEA faces a 40 percent federal-plus-state tax rate. The market risk premium is 4 percent, and the risk free rate is 6 percent. BEA is considering increasing its debt level to a capital structure with 40 percent debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 9 percent. BEA has a beta of 1.0. a. What is BEA’s unlevered beta? Use market value D/S when unlevering. b. What are BEA’s new beta and cost of equity if it has 40 percent debt? c. What are BEA's WACC and total value of the ﬁrm with 40 percent debt? Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The ﬁrm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the company’s treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table: Market Debt-to-Value Ratio (wd)

Market Equity-to-Value Ratio (wc)

Market Debt-to-Equity Ratio (D/S)

Bond Rating

Before-Tax Cost of Debt (rd)

0.0 0.2 0.4 0.6 0.8

1.0 0.8 0.6 0.4 0.2

0.00 0.25 0.67 1.50 4.00

A BBB BB C D

7.0% 8.0 10.0 12.0 15.0

Elliott uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free rate is 5 percent, the market risk premium is 6 percent, and its tax rate is 40 percent. Elliott estimates that if it had no debt, its “unlevered” beta, bU, would be 1.2. Based on this information, what is the ﬁrm’s optimal capital structure, and what would the weighted average cost of capital be at the optimal capital structure?

Spreadsheet Problem 13–7 BUILD A MODEL: WACC AND OPTIMAL CAPITAL STRUCTURE

Start with the partial model in the ﬁle Ch 13 P7 Build a Model.xls from the textbook’s web site. Rework Problem 13-6 using a spreadsheet model. After completing the problem as it appears, answer the following related questions. a. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus the debt/ value ratio. b. Would the optimal capital structure change if the unlevered beta changed? To answer this question, do a sensitivity analysis of WACC on bU for different levels of bU.

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Capital Structure Decisions Mini Case

See Ch 13 Show.ppt and Ch 13 Mini Case.xls.

509

Assume you have just been hired as business manager of PizzaPalace, a pizza restaurant located adjacent to campus. The company’s EBIT was $500,000 last year, and since the university’s enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, PizzaPalace plans to pay out all earnings as dividends. The management group owns about 50 percent of the stock, and the stock is traded in the over-thecounter market. The ﬁrm is currently ﬁnanced with all equity; it has 100,000 shares outstanding; and P0 ⫽ $25 per share. When you took your MBA corporate ﬁnance course, your instructor stated that most ﬁrms’ owners would be ﬁnancially better off if the ﬁrms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a ﬁrst step, assume that you obtained from the ﬁrm’s investment banker the following estimated costs of debt for the ﬁrm at different capital structures: Percent Financed with Debt, wd

rd

0% 20 30 40 50

— 8.0% 8.5 10.0 12.0

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium is 6 percent. a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash ﬂows. b. (1) What is business risk? What factors inﬂuence a ﬁrm’s business risk? (2) What is operating leverage, and how does it affect a ﬁrm’s business risk? Show the operating break even point if a company has ﬁxed costs of $200, a sales price of $15, and variable costs of $10. c. Now, to develop an example that can be presented to PizzaPalace’s management to illustrate the effects of ﬁnancial leverage, consider two hypothetical ﬁrms: Firm U, which uses no debt ﬁnancing, and Firm L, which uses $10,000 of 12 percent debt. Both ﬁrms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000. (1) Construct partial income statements, which start with EBIT, for the two ﬁrms. (2) Now calculate ROE for both ﬁrms. (3) What does this example illustrate about the impact of ﬁnancial leverage on ROE? d. Explain the difference between ﬁnancial risk and business risk. e. Now consider the fact that EBIT is not known with certainty, but rather has the following probability distribution: Economic State

Probability

EBIT

Bad Average Good

0.25 0.50 0.25

$2,000 3,000 4,000

Redo the part a analysis for Firms U and L, but add basic earnings power (BEP), return on invested capital (ROIC, deﬁned as NOPAT/Capital ⫽ EBIT (1 ⫺ T)/TA for this company), and the times-interest-earned (TIE) ratio to the outcome measures. Find the values for each ﬁrm in each state of the economy, and then calculate the expected values. Finally, calculate the standard deviations. What does this example illustrate about the impact of debt ﬁnancing on risk and return? f. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

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g. With the above points in mind, now consider the optimal capital structure for PizzaPalace. (1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. (2) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity. (3) Calculate the resulting price per share, the number of shares repurchased, and the remaining shares. h. Considering only the capital structures under analysis, what is PizzaPalace’s optimal capital structure? i. What other factors should managers consider when setting the target capital structure?

Selected Additional References and Cases For an article on signaling, see Baskin, Jonathon, “An Empirical Investigation of the Pecking Order Hypothesis,” Financial Management, Spring 1989, 26–35. For an academic discussion of the issues, see Caks, John, “Corporate Debt Decisions: A New Analytical Framework,” Journal of Finance, December 1978, 1297– 1315. Masulis, Ronald W., “The Impact of Capital Structure Change on Firm Value: Some Estimates,” Journal of Finance, March 1983, 107–126. Piper, Thomas R., and Wolf A. Weinhold, “How Much Debt Is Right for Your Company?” Harvard Business Review, July–August 1982, 106–114. Shalit, Sol S., “On the Mathematics of Financial Leverage,” Financial Management, Spring 1975, 57–66. For some insights into how practicing ﬁnancial managers view the capital structure decision, see Kamath, Ravindra R., “Long-Term Financing Decisions: Views and Practices of Financial Managers of NYSE Firms,” Financial Review, May 1997, 331–356. Norton, Edgar, “Factors Affecting Capital Structure Decisions,” Financial Review, August 1991, 431– 446. Pinegar, J. Michael, and Lisa Wilbricht, “What Managers Think of Capital Structure Theory: A Survey,” Financial Management, Winter 1989, 82–91. Scott, David F., and Dana J. Johnson, “Financing Policies and Practices in Large Corporations,” Financial Management, Summer 1982, 51–59. To learn more about the link between market risk and operating and ﬁnancial leverage, see Callahan, Carolyn M., and Rosanne M. Mohr, “The Determinants of Systematic Risk: A Synthesis,” The Financial Review, May 1989, 157–181. Gahlon, James M., and James A. Gentry, “On the Relationship between Systematic Risk and the Degrees of Operating and Financial Leverage,” Financial Management, Summer 1982, 15–23.

Prezas, Alexandros P., “Effects of Debt on the Degrees of Operating and Financial Leverage,” Financial Management, Summer 1987, 39– 44. Here are some additional articles that relate to this chapter: Easterwood, John C., and Palani-Rajan Kadapakkam, “The Role of Private and Public Debt in Corporate Capital Structures,” Financial Management, Autumn 1991, 49–57. Garvey, Gerald T., “Leveraging the Underinvestment Problem: How High Debt and Management Shareholdings Solve the Agency Costs of Free Cash Flow,” Journal of Financial Research, Summer 1992, 149–166. Harris, Milton, and Artur Raviv, “Capital Structure and the Informational Role of Debt,” Journal of Finance, June 1990, 321–349. Israel, Ronen, “Capital Structure and the Market for Corporate Control: The Defensive Role of Debt Financing,” Journal of Finance, September 1991, 1391–1409. See the following two articles for additional insights into the relationship between industry characteristics and ﬁnancial leverage: Bowen, Robert M., Lane A. Daley, and Charles C. Huber, Jr., “Evidence on the Existence and Determinants of Inter-Industry Differences in Leverage,” Financial Management, Winter 1982, 10–20. Long, Michael, and Ileen Malitz, “The Investment-Financing Nexus: Some Empirical Evidence,” Midland Corporate Finance Journal, Fall 1985, 53–59. For a discussion of the international implications of capital structure, see Rutterford, Janette, “An International Perspective on the Capital Structure Puzzle,” Midland Corporate Finance Journal, Fall 1985, 60–72. The Cases in Financial Management series contains many of the concept we present in Chapter 13. Case 9, “Home Security Systems, Inc.,” Case 10, “Kleen Kar, Inc.,” Case 10A, “Mountain Springs, Inc.,” and Case 10B, “Greta Cosmetics, Inc.,” which present a situation similar to the Strasburg example in the text.

Distributions to Shareholders: Dividends and Repurchases

14 14

A proﬁtable company regularly faces three important questions. (1) How much of its free cash ﬂow should it pass on to shareholders? (2) Should it provide this cash to stockholders by raising the dividend or by repurchasing stock? (3) Should it maintain a stable, consistent payment policy, or should it let the payments vary as conditions change? In this chapter we will discuss the issues that affect a ﬁrm’s cash distribution policy. As we will see, most ﬁrms establish a policy that considers their forecasted cash ﬂows and forecasted capital expenditures, and then try to stick to it. The policy can be changed, but this can cause problems because such changes inconvenience the ﬁrm’s stockholders and send unintended signals, both of which have negative implications for stock prices. Still, economic circumstances do change, and occasionally such changes require ﬁrms to change their dividend policies. One of the most striking examples of a dividend policy change occurred in May 1994, when FPL Group, a utility holding company whose primary subsidiary is Florida Power & Light, announced a cut in its quarterly dividend from $0.62 per share to $0.42. At the same time, FPL stated that it would buy back 10 million of its common shares over the next three years to bolster its stock price.1 Security analysts called the FPL decision a watershed event for the electric utility industry. FPL saw that its circumstances were changing—its core electric business was moving from a regulated monopoly environment to one of increasing competition, and the new environment required a stronger balance sheet and more ﬁnancial ﬂexibility than was consistent with a 90 percent payout policy. What did the market think about FPL’s dividend policy change? The company’s stock price fell by 14 percent the day the announcement was made. In the past, hundreds of dividend cuts followed by sharply lower earnings had conditioned investors to expect the worst when a company reduces its dividend—this is the signaling effect, which is discussed later in the chapter. However, over the next few months, as they understood FPL’s actions better, analysts began to praise the decision and to recommend the stock. As a result, FPL’s stock outperformed the average utility and soon exceeded the preannouncement price. 1

For a complete discussion of the FPL decision, see Dennis Soter, Eugene Brigham, and Paul Evanson, “The Dividend Cut Heard ’Round the World: The Case of FPL,” Journal of Applied Corporate Finance, Spring 1996, 4–15. Also, note that stock repurchases are discussed in a later section of this chapter.

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Successful companies earn income. That income can then be reinvested in operating assets, used to acquire securities, used to retire debt, or distributed to stockholders. If the decision is made to distribute income to stockholders, three key issues arise: The textbook’s web site (1) How much should be distributed? (2) Should the distribution be as cash dividends, contains an Excel ﬁle that or should the cash be passed on to shareholders by buying back some of the stock they will guide you through the hold? (3) How stable should the distribution be; that is, should the funds paid out from chapter’s calculations. The ﬁle for this chapter is Ch 14 year to year be stable and dependable, which stockholders would probably prefer, or Tool Kit.xls, and we encour- be allowed to vary with the ﬁrms’ cash ﬂows and investment requirements, which age you to open the ﬁle and would probably be better from the ﬁrms’ standpoint? These three issues are the prifollow along as you read the mary focus of this chapter, but we also consider two related issues, stock dividends and chapter. stock splits.

Dividends versus Capital Gains: What Do Investors Prefer?

An excellent source of recent dividend news for major corporations is available at the web site of Corporate Financials Online at http://www.cfonews. com/scs. By clicking the down arrow of the “News Category” box to the left of the screen, students may select “Dividends” to receive a list of companies with dividend news. Click on any company, and you will see its latest dividend news.

When deciding how much cash to distribute to stockholders, ﬁnancial managers must keep in mind that the ﬁrm’s objective is to maximize shareholder value. Consequently, the target payout ratio—deﬁned as the percentage of net income to be paid out as cash dividends—should be based in large part on investors’ preferences for dividends versus capital gains: do investors prefer (1) to have the ﬁrm distribute income as cash dividends or (2) to have it either repurchase stock or else plow the earnings back into the business, both of which should result in capital gains? This preference can be considered in terms of the constant growth stock valuation model: Pˆ0 ⫽

D1 . rs ⫺ g

If the company increases the payout ratio, this raises D1. This increase in the numerator, taken alone, would cause the stock price to rise. However, if D1 is raised, then less money will be available for reinvestment, that will cause the expected growth rate to decline, and that will tend to lower the stock’s price. Thus, any change in payout policy will have two opposing effects. Therefore, the ﬁrm’s optimal dividend policy must strike a balance between current dividends and future growth so as to maximize the stock price. In this section we examine three theories of investor preference: (1) the dividend irrelevance theory, (2) the “bird-in-the-hand” theory, and (3) the tax preference theory.

Dividend Irrelevance Theory It has been argued that dividend policy has no effect on either the price of a ﬁrm’s stock or its cost of capital. If dividend policy has no signiﬁcant effects, then it would be irrelevant. The principal proponents of the dividend irrelevance theory are Merton Miller and Franco Modigliani (MM).2 They argued that the ﬁrm’s value is determined only by its basic earning power and its business risk. In other words, MM argued that the value of the ﬁrm depends only on the income produced by its assets, not on how this income is split between dividends and retained earnings. To understand MM’s argument that dividend policy is irrelevant, recognize that any shareholder can in theory construct his or her own dividend policy. For example,

2

Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business, October 1961, 411–433.

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513

if a ﬁrm does not pay dividends, a shareholder who wants a 5 percent dividend can “create” it by selling 5 percent of his or her stock. Conversely, if a company pays a higher dividend than an investor desires, the investor can use the unwanted dividends to buy additional shares of the company’s stock. If investors could buy and sell shares and thus create their own dividend policy without incurring costs, then the ﬁrm’s dividend policy would truly be irrelevant. Note, though, that investors who want additional dividends must incur brokerage costs to sell shares, and investors who do not want dividends must ﬁrst pay taxes on the unwanted dividends and then incur brokerage costs to purchase shares with the after-tax dividends. Because taxes and brokerage costs certainly exist, dividend policy may well be relevant. In developing their dividend theory, MM made a number of assumptions, especially the absence of taxes and brokerage costs. Obviously, taxes and brokerage costs do exist, so the MM irrelevance theory may not be true. However, MM argued (correctly) that all economic theories are based on simplifying assumptions, and that the validity of a theory must be judged by empirical tests, not by the realism of its assumptions. We will discuss empirical tests of MM’s dividend irrelevance theory shortly.

Bird-in-the-Hand Theory: Dividends Are Safer The principal conclusion of MM’s dividend irrelevance theory is that dividend policy does not affect the required rate of return on equity, rs. This conclusion has been hotly debated in academic circles. In particular, Myron Gordon and John Lintner argued that rs decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which are supposed to result from retaining earnings than they are of receiving dividend payments.3 Gordon and Lintner said, in effect, that investors value a dollar of expected dividends more highly than a dollar of expected capital gains because the dividend yield component, D1/P0, is less risky than the g component in the total expected return equation, rs ⫽ D1/P0 ⫹ g. MM disagreed. They argued that rs is independent of dividend policy, which implies that investors are indifferent between D1/P0 and g and, hence, between dividends and capital gains. MM called the Gordon-Lintner argument the bird-in-the-hand fallacy because, in MM’s view, most investors plan to reinvest their dividends in the stock of the same or similar ﬁrms, and, in any event, the riskiness of the ﬁrm’s cash ﬂows to investors in the long run is determined by the riskiness of operating cash ﬂows, not by dividend payout policy.

Tax Preference Theory There are three tax-related reasons for thinking that investors might prefer a low dividend payout to a high payout: (1) Recall from Chapter 9 that long-term capital gains are taxed at a maximum rate of 20 percent, whereas dividends are taxed at effective rates that go up to 39.1 percent. Therefore, wealthy investors (who own most of the stock and receive most of the dividends) might prefer to have companies retain and plow earnings back into the business. Earnings growth would presumably lead to stock price increases, and thus lower-taxed capital gains would be substituted for higher-taxed dividends. (2) Taxes are not paid on the gain until a stock is sold. Due to time value effects, a dollar of taxes paid in the future has a lower effective cost than a dollar paid today. (3) If a stock is held by someone until he or she dies, no capital gains

3

Myron J. Gordon, “Optimal Investment and Financing Policy,” Journal of Finance, May 1963, 264–272; and John Lintner, “Dividends, Earnings, Leverage, Stock Prices, and the Supply of Capital to Corporations,” Review of Economics and Statistics, August 1962, 243–269.

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tax is due at all—the beneﬁciaries who receive the stock can use the stock’s value on the death day as their cost basis and thus completely escape the capital gains tax. Because of these tax advantages, investors may prefer to have companies retain most of their earnings. If so, investors would be willing to pay more for low-payout companies than for otherwise similar high-payout companies.

Using Empirical Evidence to Decide Which Theory Is Best As Figure 14–1 shows, these three theories offer contradictory advice to corporate managers, so which, if any, should we believe? The most logical way to proceed is to test the theories empirically. Many such tests have been conducted, but their results have been unclear. There are two reasons for this: (1) For a valid statistical test, things other than dividend policy must be held constant; that is, the sample companies must differ only in their dividend policies, and (2) we must be able to measure with a high degree of accuracy each ﬁrm’s cost of equity. Neither of these two conditions holds:

FIGURE 14-1

Dividend Irrelevance, Bird-in-the-Hand, and Tax Preference Dividend Theories

Stock Price($) Bird-in-the-Hand P0

MM: Irrelevance

Tax Preference

0

50%

100% Payout

Cost of Equity (%) Tax Preference

rs

MM: Irrelevance Bird-in-the-Hand

0

50%

100% Payout

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515

We cannot ﬁnd a set of publicly owned ﬁrms that differ only in their dividend policies, nor can we obtain precise estimates of the cost of equity. Therefore, no one can establish a clear relationship between dividend policy and the cost of equity. Investors in the aggregate cannot be shown to uniformly prefer either higher or lower dividends. Nevertheless, individual investors do have strong preferences. Some prefer high dividends, while others prefer all capital gains. These differences among individuals help explain why it is difﬁcult to reach any deﬁnitive conclusions regarding the optimal dividend payout. Even so, both evidence and logic suggest that investors prefer ﬁrms that follow a stable, predictable dividend policy (regardless of the payout level). We will consider the issue of dividend stability later in the chapter. What did Modigliani and Miller assume about taxes and brokerage costs when they developed their dividend irrelevance theory? How did the bird-in-the-hand theory get its name? What have been the results of empirical tests of the dividend theories?

Other Dividend Policy Issues Before we discuss how dividend policy is set in practice, we must examine two other theoretical issues that could affect dividend policy: (1) the information content, or signaling, hypothesis and (2) the clientele effect.

Information Content, or Signaling, Hypothesis When MM set forth their dividend irrelevance theory, they assumed that everyone— investors and managers alike—has identical information regarding the ﬁrm’s future earnings and dividends. In reality, however, different investors have different views on both the level of future dividend payments and the uncertainty inherent in those payments, and managers have better information about future prospects than public stockholders. It has been observed that an increase in the dividend is often accompanied by an increase in the price of a stock, while a dividend cut generally leads to a stock price decline. Some have argued that this indicates that investors prefer dividends to capital gains. However, MM argued differently. They noted the well-established fact that corporations are reluctant to cut dividends, hence do not raise dividends unless they anticipate higher earnings in the future. Thus, MM argued that a higher-thanexpected dividend increase is a “signal” to investors that the ﬁrm’s management forecasts good future earnings. Conversely, a dividend reduction, or a smaller-thanexpected increase, is a signal that management is forecasting poor earnings in the future. Thus, MM argued that investors’ reactions to changes in dividend policy do not necessarily show that investors prefer dividends to retained earnings. Rather, they argue that price changes following dividend actions simply indicate that there is an important information, or signaling, content in dividend announcements. Like most other aspects of dividend policy, empirical studies of signaling have had mixed results. There is clearly some information content in dividend announcements. However, it is difﬁcult to tell whether the stock price changes that follow increases or decreases in dividends reﬂect only signaling effects or both signaling and dividend preference. Still, signaling effects should deﬁnitely be considered when a ﬁrm is contemplating a change in dividend policy.

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Dividend Yields Around the World

Dividend yields vary considerably in different stock markets throughout the world. In 1999 in the United States, dividend yields averaged 1.6 percent for the large blue chip stocks in the Dow Jones Industrials, 1.2 percent for a broader sample of stocks in the S&P 500, and 0.3 percent for

World Stock Market (Index)

New Zealand Australia Britain FTSE 100 Hong Kong France Germany Belgium Singapore

Dividend Yield

5.7% 3.1 2.4 2.4 2.1 2.1 2.0 1.7

stocks in the high-tech-dominated Nasdaq. Outside the United States, average dividend yields ranged from 5.7 percent in New Zealand to 0.7 percent in Taiwan. The accompanying table summarizes the dividend picture in 1999.

World Stock Market (Index)

United States (Dow Jones Industrials) Canada (TSE 300) United States (S&P 500) Mexico Japan Nikkei Taiwan United States (Nasdaq)

Dividend Yield

1.6 1.5 1.2 1.1 0.7 0.7 0.3

Source: From Alexandra Eadie, “On the Grid Looking for Dividend Yield Around the World,” The Globe and Mail, June 23, 1999, B16. Eadie’s source was Bloomberg Financial Services. Reprinted with permission from The Globe and Mail.

Clientele Effect As we indicated earlier, different groups, or clienteles, of stockholders prefer different dividend payout policies. For example, retired individuals, pension funds, and university endowment funds generally prefer cash income, so they may want the ﬁrm to pay out a high percentage of its earnings. Such investors are often in low or even zero tax brackets, so taxes are of no concern. On the other hand, stockholders in their peak earning years might prefer reinvestment, because they have less need for current investment income and would simply reinvest dividends received, after ﬁrst paying income taxes on those dividends. If a ﬁrm retains and reinvests income rather than paying dividends, those stockholders who need current income would be disadvantaged. The value of their stock might increase, but they would be forced to go to the trouble and expense of selling off some of their shares to obtain cash. Also, some institutional investors (or trustees for individuals) would be legally precluded from selling stock and then “spending capital.” On the other hand, stockholders who are saving rather than spending dividends might favor the low dividend policy, for the less the ﬁrm pays out in dividends, the less these stockholders will have to pay in current taxes, and the less trouble and expense they will have to go through to reinvest their after-tax dividends. Therefore, investors who want current investment income should own shares in high dividend payout ﬁrms, while investors with no need for current investment income should own shares in low dividend payout ﬁrms. For example, investors seeking high cash income might invest in electric utilities, which averaged a 73 percent payout from 1996 through 2000, while those favoring growth could invest in the semiconductor industry, which paid out only 7 percent during the same time period.

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To the extent that stockholders can switch ﬁrms, a ﬁrm can change from one dividend payout policy to another and then let stockholders who do not like the new policy sell to other investors who do. However, frequent switching would be inefﬁcient because of (1) brokerage costs, (2) the likelihood that stockholders who are selling will have to pay capital gains taxes, and (3) a possible shortage of investors who like the ﬁrm’s newly adopted dividend policy. Thus, management should be hesitant to change its dividend policy, because a change might cause current shareholders to sell their stock, forcing the stock price down. Such a price decline might be temporary, but it might also be permanent—if few new investors are attracted by the new dividend policy, then the stock price would remain depressed. Of course, the new policy might attract an even larger clientele than the ﬁrm had before, in which case the stock price would rise. Evidence from several studies suggests that there is in fact a clientele effect.4 MM and others have argued that one clientele is as good as another, so the existence of a clientele effect does not necessarily imply that one dividend policy is better than any other. MM may be wrong, though, and neither they nor anyone else can prove that the aggregate makeup of investors permits ﬁrms to disregard clientele effects. This issue, like most others in the dividend arena, is still up in the air. Deﬁne (1) information content and (2) the clientele effect, and explain how they affect dividend policy.

Dividend Stability As we noted at the beginning of the chapter, the stability of dividends is also important. Proﬁts and cash ﬂows vary over time, as do investment opportunities. Taken alone, this suggests that corporations should vary their dividends over time, increasing them when cash ﬂows are large and the need for funds is low and lowering them when cash is in short supply relative to investment opportunities. However, many stockholders rely on dividends to meet expenses, and they would be seriously inconvenienced if the dividend stream were unstable. Further, reducing dividends to make funds available for capital investment could send incorrect signals to investors, who might push down the stock price because they interpreted the dividend cut to mean that the company’s future earnings prospects have been diminished. Thus, maximizing its stock price requires a ﬁrm to balance its internal needs for funds against the needs and desires of its stockholders. How should this balance be struck; that is, how stable and dependable should a ﬁrm attempt to make its dividends? It is impossible to give a deﬁnitive answer to this question, but the following points are relevant: 1. Virtually every publicly owned company makes a ﬁve- to ten-year ﬁnancial forecast of earnings and dividends. Such forecasts are never made public—they are used for internal planning purposes only. However, security analysts construct similar forecasts and do make them available to investors; see Value Line for an example. Further, virtually every internal ﬁve- to ten-year corporate forecast we have seen for a “normal” company projects a trend of higher earnings and dividends. Both managers and investors know that economic conditions may cause actual results to differ from forecasted results, but “normal” companies expect to grow.

4

For example, see R. Richardson Pettit, “Taxes, Transactions Costs and the Clientele Effect of Dividends,” The Journal of Financial Economics, December 1977, 419–436.

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2. Years ago, when inﬂation was not persistent, the term “stable dividend policy” meant a policy of paying the same dollar dividend year after year. At one time, AT&T was a prime example of a company with a stable dividend policy—it paid $9 per year ($2.25 per quarter) for 25 straight years. Today, though, most companies and stockholders expect earnings to grow over time as a result of retained earnings and inﬂation. Further, dividends are normally expected to grow more or less in line with earnings. Thus, today a “stable dividend policy” generally means increasing the dividend at a reasonably steady rate. Dividend stability has two components: (1) How dependable is the growth rate, and (2) can we count on at least receiving the current dividend in the future? The most stable policy, from an investor’s standpoint, is that of a ﬁrm whose dividend growth rate is predictable—such a company’s total return (dividend yield plus capital gains yield) would be relatively stable over the long run, and its stock would be a good hedge against inﬂation. The second most stable policy is where stockholders can be reasonably sure that the current dividend will not be reduced—it may not grow at a steady rate, but management will probably be able to avoid cutting the dividend. The least stable situation is where earnings and cash ﬂows are so volatile that investors cannot count on the current dividend in the future. 3. Most observers believe that dividend stability is desirable and that investors prefer stocks that pay more predictable dividends to stocks that pay the same average amount of dividends but in a more erratic manner. This means that the cost of equity will be minimized, and the stock price maximized, if a ﬁrm stabilizes its dividends as much as possible. What does the term “stable dividend policy” mean? What are the two components of dividend stability?

Establishing the Dividend Policy in Practice In the preceding sections we saw that investors may or may not prefer dividends to capital gains, but that they do prefer predictable dividends. Given this situation, how should ﬁrms set their basic dividend policies? For example, how should a company establish the speciﬁc percentage of earnings it will pay out? In this section, we describe how most ﬁrms establish their target payout ratios.

Setting the Target Payout Ratio: The Residual Dividend Model5 When deciding how much cash to distribute to stockholders, two points should be kept in mind: (1) The overriding objective is to maximize shareholder value, and (2) the ﬁrm’s cash ﬂows really belong to its shareholders, so management should refrain from retaining income unless they can reinvest it to produce returns higher than shareholders could themselves earn by investing the cash in investments of equal risk. On the other hand, recall from Chapter 6 that internal equity (retained earnings) is cheaper than external

5

The term “payout ratio” can be interpreted in two ways: (1) the conventional way, where the payout ratio means the percentage of net income paid out as cash dividends, or (2) the percentage of net income distributed to stockholders both through dividends and through share repurchases. In this section, we assume that no repurchases occur. Increasingly, though, ﬁrms are using the residual model to determine “distributions to shareholders” and then making a separate decision as to the form of that distribution. Further, an increasing percentage of the distribution is in the form of share repurchases.

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equity (new common stock). This encourages ﬁrms to retain earnings so as to avoid having to issue new stock. When establishing a dividend policy, one size does not ﬁt all. Some ﬁrms produce a lot of cash but have limited investment opportunities—this is true for ﬁrms in profitable but mature industries where few opportunities for growth exist. Such ﬁrms typically distribute a large percentage of their cash to shareholders, thereby attracting investment clienteles that prefer high dividends. Other ﬁrms generate little or no excess cash but have many good investment opportunities. Such ﬁrms generally distribute little or no cash but enjoy rising earnings and stock prices, thereby attracting investors who prefer capital gains. As Table 14-1 suggests, dividend payouts and dividend yields for large corporations vary considerably. Generally, ﬁrms in stable, cash-producing industries such as utilities, ﬁnancial services, and tobacco pay relatively high dividends, whereas companies in rapidly growing industries such as computer software tend to pay lower dividends. For a given ﬁrm, the optimal payout ratio is a function of four factors: (1) investors’ preferences for dividends versus capital gains, (2) the ﬁrm’s investment opportunities, (3) its target capital structure, and (4) the availability and cost of external capital. The last three elements are combined in what we call the residual dividend model. Under this model a ﬁrm follows these four steps when establishing its target payout ratio: (1) It determines the optimal capital budget; (2) it determines the amount of equity needed to ﬁnance that budget, given its target capital structure; (3) it uses retained earnings to meet equity requirements to the extent possible; and (4) it pays dividends only if more earnings are available than are needed to support the optimal capital budget. The word residual implies “leftover,” and the residual policy implies that dividends are paid out of “leftover” earnings. If a ﬁrm rigidly follows the residual dividend policy, then dividends paid in any given year can be expressed as follows: Dividends ⫽ Net income ⫺ Retained earnings needed to ﬁnance new investments ⫽ Net income ⫺ [(Target equity ratio)(Total capital budget)].

(14-1)

For example, suppose the target equity ratio is 60 percent and the ﬁrm plans to spend $50 million on capital projects. In that case, it would need $50(0.6) ⫽ $30 million of common equity. Then, if its net income were $100 million, its dividends would be $100 ⫺ $30 ⫽ $70 million. So, if the company had $100 million of earnings and a capital budget of $50 million, it would use $30 million of the retained earnings plus $50 ⫺ $30 ⫽ $20 million of new debt to ﬁnance the capital budget, and this would keep its capital structure on target. Note that the amount of equity needed to ﬁnance new investments might exceed the net income; in our example, this would happen if the capital budget were $200 million. In that case, no dividends would be paid, and the company would have to issue new common stock in order to maintain its target capital structure. Most ﬁrms have a target capital structure that calls for at least some debt, so new ﬁnancing is done partly with debt and partly with equity. As long as the ﬁrm ﬁnances with the optimal mix of debt and equity, and provided it uses only internally generated equity (retained earnings), then the marginal cost of each new dollar of capital will be minimized. Internally generated equity is available for ﬁnancing a certain amount of new investment, but beyond that amount, the ﬁrm must turn to more expensive new common stock. At the point where new stock must be sold, the cost of equity, and consequently the marginal cost of capital, rises. To illustrate these points, consider the case of Texas and Western (T&W) Transport Company. T&W’s overall composite cost of capital is 10 percent. However, this

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Distributions to Shareholders: Dividends and Repurchases TABLE 14-1

Dividend Payouts (December 2001)

Company

Industry

Dividend Payout

Dividend Yield

109% 166 62 78 64 83

4.8% 6.4 3.2 6.1 4.6 5.5

13% 28 5 1 0 0

0.6% 0.2 0.3 0.4 0.0 0.0

I. Companies That Pay High Dividends WD-40 Company (WDFC) Empire District Electric (EDE) Rayonier Inc. (RYN) R. J. Reynolds Tobacco (RJR) Union Planters Corp. (UPC) Ingles Markets Inc. (IMKTA)

Household products Electric utility Forest products Tobacco products Regional banks Retail (grocery)

II. Companies That Pay Little or No Dividends Tiffany and Company (TIF) Harley-Davidson Inc. (HDI) Aaron Rents Inc. (RNT) Delta Air Lines Inc. (DAL) Papa John’s Intl. Inc. (PZZA) Microsoft Corp. (MSFT)

Specialty retail Recreational products Rental and leasing Airline Restaurants Software and programming

Source: www.marketguide.com, December 2001.

cost assumes that all new equity comes from retained earnings. If the company must issue new stock, its cost of capital will be higher. T&W has $60 million in net income and a target capital structure of 60 percent equity and 40 percent debt. Provided that it does not pay any cash dividends, T&W could make net investments (investments in addition to asset replacements from depreciation) of $100 million, consisting of $60 million from retained earnings plus $40 million of new debt supported by the retained earnings, at a 10 percent marginal cost of capital. If the capital budget exceeded $100 million, the required equity component would exceed net income, which is of course the maximum amount of retained earnings. In this case, T&W would have to issue new common stock, thereby pushing its cost of capital above 10 percent. At the beginning of its planning period, T&W’s ﬁnancial staff considers all proposed projects for the upcoming period. Independent projects are accepted if their estimated returns exceed the risk-adjusted cost of capital. In choosing among mutually exclusive projects, T&W chooses the project with the highest positive NPV. The capital budget represents the amount of capital that is required to ﬁnance all accepted projects. If T&W follows a strict residual dividend policy, we can see from Table 14-2 that there may be changes in the dividend payout ratio. If T&W forecasts poor investment opportunities, its estimated capital budget will be only $40 million. To maintain the target capital structure, 40 percent of this capital ($16 million) must be raised as debt, and 60 percent ($24 million) must be equity. If it followed a strict residual policy, T&W would retain $24 million of its $60 million earnings to help ﬁnance new investments, then pay out the remaining $36 million as dividends. Under this scenario, the company’s dividend payout ratio would be $36 million/$60 million ⫽ 0.6 ⫽ 60%. By contrast, if the company’s investment opportunities were average, its optimal capital budget would rise to $70 million. Here it would require $42 million of retained earnings, so dividends would be $60 ⫺ $42 ⫽ $18 million, for a payout of $18/$60 ⫽ 30%. Finally, if investment opportunities are good, the capital budget would be $150 million, which would require 0.6($150) ⫽ $90 million of equity. T&W

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Distributions to Shareholders: Dividends and Repurchases Establishing the Dividend Policy in Practice TABLE 14-2

521

T&W’s Dividend Payout Ratio with $60 Million of Net Income When Faced with Different Investment Opportunities (Dollars in Millions) Investment Opportunities Poor

Average

Good

$150

Capital budget

$40

$70

Net income Required equity (0.6 ⫻ Capital budget) Dividends paid (NI ⫺ Required equity) Dividend payout ratio (Dividend/NI)

$60 24 $36 60%

$60 42 $18 30%

$ 60 90 ⫺$ 30a 0%

a

With a $150 million capital budget, T&W would retain all of its earnings and also issue $30 million of new stock.

would retain all of its net income ($60 million), thus pay no dividends. Moreover, since the required equity exceeds the retained earnings, the company would have to issue some new common stock to maintain the target capital structure. Since both investment opportunities and earnings will surely vary from year to year, strict adherence to the residual dividend policy would result in unstable dividends. One year the ﬁrm might pay zero dividends because it needed the money to ﬁnance good investment opportunities, but the next year it might pay a large dividend because investment opportunities were poor and it therefore did not need to retain much. Similarly, ﬂuctuating earnings could also lead to variable dividends, even if investment opportunities were stable. Therefore, following the residual dividend policy rigidly would lead to ﬂuctuating, unstable dividends. Since investors desire stable, dependable dividends, rs would be high, and the stock price low, if the ﬁrm followed the residual model in a strict sense rather than attempting to stabilize its dividends over time. Therefore, ﬁrms should: 1. Estimate earnings and investment opportunities, on average, over the next ﬁve or so years. 2. Use this forecasted information to ﬁnd the average residual model payout ratio and dollars of dividends during the planning period. 3. Then set a target payout ratio based on the average projected data. Thus, ﬁrms should use the residual policy to help set their long-run target payout ratios, but not as a guide to the payout in any one year. Companies use the residual dividend model as discussed above to help understand the determinants of an optimal dividend policy, along with computerized ﬁnancial forecasting models. Most larger corporations forecast their ﬁnancial statements over the next ﬁve to ten years. Information on projected capital expenditures and working capital requirements is entered into the model, along with sales forecasts, proﬁt margins, depreciation, and the other elements required to forecast cash ﬂows. The target capital structure is also speciﬁed, and the model shows the amount of debt and equity that will be required to meet the capital budgeting requirements while maintaining the target capital structure. Then, dividend payments are introduced. Naturally, the higher the payout ratio, the greater the required external equity. Most companies use the model to ﬁnd a dividend pattern over the forecast period (generally ﬁve years) that will provide sufﬁcient equity to support the capital budget without forcing it to sell new common stock or move the capital structure ratios outside the optimal range. Some companies set a very low “regular” dividend and then supplement it with an “extra” dividend when times are good. General Motors, Ford, and other auto companies

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have followed the low-regular-dividend-plus-extras policy in the past. Each company announced a low regular dividend that it was sure could be maintained “through hell or high water,” and stockholders could count on receiving that dividend under all conditions. Then, when times were good and proﬁts and cash ﬂows were high, the companies either paid a specially designated extra dividend or repurchased shares of stock. Investors recognized that the extras might not be maintained in the future, so they did not interpret them as a signal that the companies’ earnings were going up permanently, nor did they take the elimination of the extra as a negative signal. At times, however, companies must make substantial cuts in dividends in order to conserve cash. In October 2000, facing increasing competition, technology changes, a decline in its bond rating, and a cutoff from the commercial paper market, Xerox Corporation rolled back its quarterly dividend from $0.20 per share to $0.05 per share. This was a dividend rate not seen by Xerox shareholders since 1966. In the week prior to the dividend cut, the share price had declined signiﬁcantly in response to an announcement that there would be a loss for the quarter rather than a modest proﬁt, and a warning that a dividend cut was being considered. Xerox took a substantial stock price hit when it conceded that cash ﬂows would not be sufﬁcient to cover the old dividend—the price declined from about $15 to about $8. However, some analysts viewed the cut as a positive action that would preserve cash and maintain Xerox’s ability to service its debt.

Payment Procedures Dividends are normally paid quarterly, and, if conditions permit, the dividend is increased once each year. For example, Katz Corporation paid $0.50 per quarter in 2002, or at an annual rate of $2.00. In common ﬁnancial parlance, we say that in 2002 Katz’s regular quarterly dividend was $0.50, and its annual dividend was $2.00. In late 2002, Katz’s board of directors met, reviewed projections for 2003, and decided to keep the 2003 dividend at $2.00. The directors announced the $2 rate, so stockholders could count on receiving it unless the company experienced unanticipated operating problems. The actual payment procedure is as follows: 1. Declaration date. On the declaration date—say, on November 8—the directors meet and declare the regular dividend, issuing a statement similar to the following: “On November 8, 2002, the directors of Katz Corporation met and declared the regular quarterly dividend of 50 cents per share, payable to holders of record on December 6, payment to be made on January 3, 2003.” For accounting purposes, the declared dividend becomes an actual liability on the declaration date. If a balance sheet were constructed, the amount ($0.50) ⫻ (Number of shares outstanding) would appear as a current liability, and retained earnings would be reduced by a like amount. 2. Holder-of-record date. At the close of business on the holder-of-record date, December 6, the company closes its stock transfer books and makes up a list of shareholders as of that date. If Katz Corporation is notiﬁed of the sales before 5 P.M. on December 6, then the new owner receives the dividend. However, if notiﬁcation is received on or after December 7, the previous owner gets the dividend check. 3. Ex-dividend date. Suppose Jean Buyer buys 100 shares of stock from John Seller on December 3. Will the company be notiﬁed of the transfer in time to list Buyer as the new owner and thus pay the dividend to her? To avoid conﬂict, the securities industry has set up a convention under which the right to the dividend remains with the stock until two business days prior to the holder-of-record date; on the second day before that date, the right to the dividend no longer goes with the shares. The date when the right to the dividend leaves the stock is called the

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ex-dividend date. In this case, the ex-dividend date is two days prior to December 6, or December 4: Dividend goes with stock: Ex-dividend date: Holder-of-record date:

December 3 December 4 December 5 December 6

Therefore, if Buyer is to receive the dividend, she must buy the stock on or before December 3. If she buys it on December 4 or later, Seller will receive the dividend because he will be the ofﬁcial holder of record. Katz’s dividend amounts to $0.50, so the ex-dividend date is important. Barring ﬂuctuations in the stock market, one would normally expect the price of a stock to drop by approximately the amount of the dividend on the ex-dividend date. Thus, if Katz closed at $30.50 on December 3, it would probably open at about $30 on December 4.6 4. Payment date. The company actually mails the checks to the holders of record on January 3, the payment date. Explain the logic of the residual dividend model, the steps a ﬁrm would take to implement it, and why it is more likely to be used to establish a long-run payout target than to set the actual year-by-year payout ratio. How do ﬁrms use planning models to help set dividend policy? Explain the procedures used to actually pay the dividend. Why is the ex-dividend date important to investors?

Dividend Reinvestment Plans During the 1970s, most large companies instituted dividend reinvestment plans (DRIPs), under which stockholders can automatically reinvest their dividends in the stock of the paying corporation.7 Today most larger companies offer DRIPs, and although participation rates vary considerably, about 25 percent of the average ﬁrm’s shareholders are enrolled. There are two types of DRIPs: (1) plans that involve only “old stock” that is already outstanding and (2) plans that involve newly issued stock. In

6

Tax effects cause the price decline on average to be less than the full amount of the dividend. Suppose you were an investor in the 40 percent federal-plus-state tax bracket. If you bought Katz’s stock on December 3, you would receive the dividend, but you would almost immediately pay 40 percent of it out in taxes. Thus, you would want to wait until December 4 to buy the stock if you thought you could get it for $0.50 less per share. Your reaction, and that of others, would inﬂuence stock prices around dividend payment dates. Here is what would happen: 1. Other things held constant, a stock’s price should rise during the quarter, with the daily price increase (for Katz) equal to $0.50/90 ⫽ $0.005556. Therefore, if the price started at $30 just after its last ex-dividend date, it would rise to $30.50 on December 3. 2. In the absence of taxes, the stock’s price would fall to $30 on December 4 and then start up as the next dividend accrual period began. Thus, over time, if everything else were held constant, the stock’s price would follow a sawtooth pattern if it were plotted on a graph. 3. Because of taxes, the stock’s price would neither rise by the full amount of the dividend nor fall by the full dividend amount when it goes ex-dividend. 4. The amount of the rise and subsequent fall would depend on the average investor’s marginal tax rate. 7 See Richard H. Pettway and R. Phil Malone, “Automatic Dividend Reinvestment Plans,” Financial Management, Winter 1973, 11–18, for an old but still excellent discussion of the subject.

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either case, the stockholder must pay taxes on the amount of the dividends, even though stock rather than cash is received. Under both types of DRIPs, stockholders choose between continuing to receive dividend checks or having the company use the dividends to buy more stock in the corporation. Under the “old stock” type of plan, if a stockholder elects reinvestment, a bank, acting as trustee, takes the total funds available for reinvestment, purchases the corporation’s stock on the open market, and allocates the shares purchased to the participating stockholders’ accounts on a pro rata basis. The transactions costs of buying shares (brokerage costs) are low because of volume purchases, so these plans beneﬁt small stockholders who do not need cash dividends for current consumption. The “new stock” type of DRIP uses the reinvested funds to buy newly issued stock, hence these plans raise new capital for the ﬁrm. AT&T, Union Carbide, and many other companies have had new stock plans in effect in recent years, using them to raise substantial amounts of new equity capital. No fees are charged to stockholders, and many companies offer stock at a discount of 3 percent to 5 percent below the actual market price. The companies offer discounts as a trade-off against ﬂotation costs that would have been incurred if new stock had been issued through investment bankers rather than through the dividend reinvestment plans. One interesting aspect of DRIPs is that they are forcing corporations to reexamine their basic dividend policies. A high participation rate in a DRIP suggests that stockholders might be better off if the ﬁrm simply reduced cash dividends, which would save stockholders some personal income taxes. Quite a few ﬁrms are surveying their stockholders to learn more about their preferences and to ﬁnd out how they would react to a change in dividend policy. A more rational approach to basic dividend policy decisions may emerge from this research. Note that companies start or stop using new stock DRIPs depending on their need for equity capital. Thus, both Union Carbide and AT&T recently stopped offering new stock DRIPs with a 5 percent discount because their needs for equity capital declined. Some companies have expanded their DRIPs by moving to “open enrollment,” whereby anyone can purchase the ﬁrm’s stock directly and thus bypass brokers’ commissions. Exxon Mobil not only allows investors to buy their initial shares at no fee but also lets them pick up additional shares through automatic bank account withdrawals. Several plans, including Exxon Mobil’s, offer dividend reinvestment for individual retirement accounts, and some, such as U.S. West, allow participants to invest weekly or monthly rather than on the quarterly dividend schedule. In all of these plans, and many others, stockholders can invest more than the dividends they are foregoing— they simply send a check to the company and buy shares without a brokerage commission. According to First Chicago Trust, which handles the paperwork for 13 million shareholder DRIP accounts, at least half of all DRIPs will offer open enrollment, extra purchases, and other expanded services within the next few years. What are dividend reinvestment plans? What are their advantages and disadvantages from both the stockholders’ and the ﬁrm’s perspectives?

Summary of Factors Inﬂuencing Dividend Policy In earlier sections, we described both the major theories of investor preference and some issues concerning the effects of dividend policy on the value of a ﬁrm. We also discussed the residual dividend model for setting a ﬁrm’s long-run target payout ratio. In this section, we discuss several other factors that affect the dividend decision. These factors may be grouped into four broad categories: (1) constraints on dividend payments, (2) investment opportunities, (3) availability and cost of alternative sources of

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capital, and (4) effects of dividend policy on rs. Each of these categories has several subparts, which we discuss in the following paragraphs.

Constraints 1. Bond indentures. Debt contracts often limit dividend payments to earnings generated after the loan was granted. Also, debt contracts often stipulate that no dividends can be paid unless the current ratio, times-interest-earned ratio, and other safety ratios exceed stated minimums. 2. Preferred stock restrictions. Typically, common dividends cannot be paid if the company has omitted its preferred dividend. The preferred arrearages must be satisﬁed before common dividends can be resumed. 3. Impairment of capital rule. Dividend payments cannot exceed the balance sheet item “retained earnings.” This legal restriction, known as the impairment of capital rule, is designed to protect creditors. Without the rule, a company that is in trouble might distribute most of its assets to stockholders and leave its debtholders out in the cold. (Liquidating dividends can be paid out of capital, but they must be indicated as such, and they must not reduce capital below the limits stated in debt contracts.) 4. Availability of cash. Cash dividends can be paid only with cash, so a shortage of cash in the bank can restrict dividend payments. However, the ability to borrow can offset this factor. 5. Penalty tax on improperly accumulated earnings. To prevent wealthy individuals from using corporations to avoid personal taxes, the Tax Code provides for a special surtax on improperly accumulated income. Thus, if the IRS can demonstrate that a ﬁrm’s dividend payout ratio is being deliberately held down to help its stockholders avoid personal taxes, the ﬁrm is subject to heavy penalties. This factor is generally relevant only to privately owned ﬁrms.

Investment Opportunities 1. Number of proﬁtable investment opportunities. If a ﬁrm expects a large number of proﬁtable investment opportunities, this will lower the target payout ratio, and vice versa if there are few proﬁtable investment opportunities. 2. Possibility of accelerating or delaying projects. The ability to accelerate or postpone projects will permit a ﬁrm to adhere more closely to a stable dividend policy.

Alternative Sources of Capital 1. Cost of selling new stock. If a ﬁrm needs to ﬁnance a given level of investment, it can obtain equity by retaining earnings or by issuing new common stock. If ﬂotation costs (including any negative signaling effects of a stock offering) are high, re will be well above rs, making it better to set a low payout ratio and to ﬁnance through retention rather than through sale of new common stock. On the other hand, a high dividend payout ratio is more feasible for a ﬁrm whose ﬂotation costs are low. Flotation costs differ among ﬁrms—for example, the ﬂotation percentage is generally higher for small ﬁrms, so they tend to set low payout ratios. 2. Ability to substitute debt for equity. A ﬁrm can ﬁnance a given level of investment with either debt or equity. As noted above, low stock ﬂotation costs permit a more ﬂexible dividend policy because equity can be raised either by retaining earnings or by selling new stock. A similar situation holds for debt policy: If the ﬁrm can adjust its debt ratio without raising costs sharply, it can pay the expected dividend, even if earnings ﬂuctuate, by increasing its debt ratio.

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3. Control. If management is concerned about maintaining control, it may be reluctant to sell new stock, hence the company may retain more earnings than it otherwise would. However, if stockholders want higher dividends and a proxy ﬁght looms, then the dividend will be increased.

Effects of Dividend Policy on rs The effects of dividend policy on rs may be considered in terms of four factors: (1) stockholders’ desire for current versus future income, (2) perceived riskiness of dividends versus capital gains, (3) the tax advantage of capital gains over dividends, and (4) the information content of dividends (signaling). Since we discussed each of these factors in detail earlier, we need only note here that the importance of each factor in terms of its effect on rs varies from ﬁrm to ﬁrm depending on the makeup of its current and possible future stockholders. It should be apparent that dividend policy decisions are truly exercises in informed judgment, not decisions that can be quantiﬁed precisely. Even so, to make rational dividend decisions, ﬁnancial managers must take account of all the points discussed in the preceding sections. Identify the four broad sets of factors that affect dividend policy. What constraints affect dividend policy? How do investment opportunities affect dividend policy? How does the availability and cost of outside capital affect dividend policy?

Overview of the Dividend Policy Decision In many ways, our discussion of dividend policy parallels our discussion of capital structure: We presented the relevant theories and issues, and we listed some additional factors that inﬂuence dividend policy, but we did not come up with any hard-and-fast guidelines that managers can follow. You should recognize that dividend policy decisions are exercises in informed judgment, not decisions that can be based on a precise mathematical model. In practice, dividend policy is not an independent decision—the dividend decision is made jointly with capital structure and capital budgeting decisions. The underlying reason for joining these decisions is asymmetric information, which inﬂuences managerial actions in two ways: 1. In general, managers do not want to issue new common stock. First, new common stock involves issuance costs—commissions, fees, and so on—and those costs can be avoided by using retained earnings to ﬁnance equity needs. Second, as we discussed in Chapter 13, asymmetric information causes investors to view new common stock issues as negative signals and thus lowers expectations regarding the ﬁrm’s future prospects. The end result is that the announcement of a new stock issue usually leads to a decrease in the stock price. Considering the total costs involved, including both issuance and asymmetric information costs, managers prefer to use retained earnings as the primary source of new equity. 2. Dividend changes provide signals about managers’ beliefs as to their ﬁrms’ future prospects. Thus, dividend reductions generally have a signiﬁcant negative effect on a ﬁrm’s stock price. Since managers recognize this, they try to set dollar dividends low enough so that there is only a remote chance that the dividend will have to be reduced in the future.

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The effects of asymmetric information suggest that, to the extent possible, managers should avoid both new common stock sales and dividend cuts, because both actions tend to lower stock prices. Thus, in setting dividend policy, managers should begin by considering the ﬁrm’s future investment opportunities relative to its projected internal sources of funds. The target capital structure also plays a part, but because the optimal capital structure is a range, ﬁrms can vary their actual capital structures somewhat from year to year. Since it is best to avoid issuing new common stock, the target long-term payout ratio should be designed to permit the ﬁrm to meet all of its equity capital requirements with retained earnings. In effect, managers should use the residual dividend model to set dividends, but in a long-term framework. Finally, the current dollar dividend should be set so that there is an extremely low probability that the dividend, once set, will ever have to be lowered or omitted. Of course, the dividend decision is made during the planning process, so there is uncertainty about future investment opportunities and operating cash ﬂows. Thus, the actual payout ratio in any year will probably be above or below the ﬁrm’s long-range target. However, the dollar dividend should be maintained, or increased as planned, unless the ﬁrm’s ﬁnancial condition deteriorates to the point where the planned policy simply cannot be maintained. A steady or increasing stream of dividends over the long run signals that the ﬁrm’s ﬁnancial condition is under control. Further, investor uncertainty is decreased by stable dividends, so a steady dividend stream reduces the negative effect of a new stock issue, should one become absolutely necessary. In general, ﬁrms with superior investment opportunities should set lower payouts, hence retain more earnings, than ﬁrms with poor investment opportunities. The degree of uncertainty also inﬂuences the decision. If there is a great deal of uncertainty regarding the forecasts of free cash ﬂows, which are deﬁned here as the ﬁrm’s operating cash ﬂows minus mandatory equity investments, then it is best to be conservative and to set a lower current dollar dividend. Also, ﬁrms with postponable investment opportunities can afford to set a higher dollar dividend, because in times of stress investments can be postponed for a year or two, thus increasing the cash available for dividends. Finally, ﬁrms whose cost of capital is largely unaffected by changes in the debt ratio can also afford to set a higher payout ratio, because they can, in times of stress, more easily issue additional debt to maintain the capital budgeting program without having to cut dividends or issue stock. Firms have only one opportunity to set the dividend payment from scratch. Therefore, today’s dividend decisions are constrained by policies that were set in the past, hence setting a policy for the next ﬁve years necessarily begins with a review of the current situation. Although we have outlined a rational process for managers to use when considering their ﬁrms’ dividend policies, dividend policy still remains one of the most judgmental decisions managers must make. For this reason, dividend policy is always set by the board of directors—the ﬁnancial staff analyzes the situation and makes a recommendation, but the board makes the ﬁnal decision. Describe the dividend policy decision process. Be sure to discuss all the factors that inﬂuence the decision.

Stock Dividends and Stock Splits Stock dividends and stock splits are related to the ﬁrm’s cash dividend policy. The rationale for stock dividends and splits can best be explained through an example. We will use Porter Electronic Controls Inc., a $700 million electronic components

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manufacturer, for this purpose. Since its inception, Porter’s markets have been expanding, and the company has enjoyed growth in sales and earnings. Some of its earnings have been paid out in dividends, but some are also retained each year, causing its earnings per share and stock price to grow. The company began its life with only a few thousand shares outstanding, and, after some years of growth, the stock price was so high that few people could afford to buy a “round lot” of 100 shares. Porter’s CFO thought this limited the demand for the stock and thus kept the total market value of the ﬁrm below what it would have been if more shares, at a lower price, had been outstanding. To correct this situation, Porter “split its stock,” as described in the next section.

Stock Splits Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in ﬁnancial circles that an optimal price range exists for stocks. “Optimal” means that if the price is within this range, the ﬁrm’s value will be maximized. Many observers, including Porter’s management, believe that the best range for most stocks is from $20 to $80 per share. Accordingly, if the price of Porter’s stock rose to $80, management would probably declare a two-for-one stock split, thus doubling the number of shares outstanding, halving the earnings and dividends per share, and thereby lowering the stock price. Each stockholder would have more shares, but each share would be worth less. If the post-split price were $40, Porter’s stockholders would be exactly as well off as before the split. However, if the stock price were to stabilize above $40, stockholders would be better off. Stock splits can be of any size—for example, the stock could be split two-for-one, three-for-one, one-and-a-half-for-one, or in any other way. Sometimes a company will have a reverse split. For example, International Pictures Corp. (IPIX) developed the iPIX computer imaging technology, which allows a user to “walk through” a 360-degree view. Its stock price was in the $30 range prior to the dot-com crash of April 2000, but by August 2001 its price had fallen to $0.20 per share. One of Nasdaq’s listing requirements is that the stock price must be above $1 per share, and Nasdaq was threatening to delist IPIX. To drive its price up, IPIX had a 1:10 reverse stock split before trading began on August 23, 2001, with its shareholders exchanging 10 shares of stock for a single new share. In theory, the stock price should have increased by a factor of 10, but IPIX closed that day at a price of $1.46. Evidently, investors saw the reverse split as a negative signal.

Stock Dividends Stock dividends are similar to stock splits in that they “divide the pie into smaller slices” without affecting the fundamental position of the current stockholders. On a 5 percent stock dividend, the holder of 100 shares would receive an additional 5 shares (without cost); on a 20 percent stock dividend, the same holder would receive 20 new shares; and so on. Again, the total number of shares is increased, so earnings, dividends, and price per share all decline. If a ﬁrm wants to reduce the price of its stock, should it use a stock split or a stock dividend? Stock splits are generally used after a sharp price run-up to produce a large price reduction. Stock dividends used on a regular annual basis will keep the stock price more or less constrained. For example, if a ﬁrm’s earnings and dividends were growing at about 10 percent per year, its stock price would tend to go up at about that same rate, and it would soon be outside the desired trading range. A 10 percent annual stock dividend would maintain the stock price within the optimal trading range. Note, though,

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that small stock dividends create bookkeeping problems and unnecessary expenses, so ﬁrms today use stock splits far more often than stock dividends.8

Effect on Stock Prices If a company splits its stock or declares a stock dividend, will this increase the market value of its stock? Many empirical studies have sought to answer this question. Here is a summary of their ﬁndings. 1. On average, the price of a company’s stock rises shortly after it announces a stock split or dividend. 2. However, these price increases are more the result of the fact that investors take stock splits/dividends as signals of higher future earnings and dividends than of a desire for stock dividends/splits per se. Because only companies whose managements think things look good tend to split their stocks, the announcement of a stock split is taken as a signal that earnings and cash dividends are likely to rise. Thus, the price increases associated with stock splits/dividends are probably the result of signals of favorable prospects for earnings and dividends, not a desire for stock splits/dividends per se. 3. If a company announces a stock split or dividend, its price will tend to rise. However, if during the next few months it does not announce an increase in earnings and dividends, then its stock price will drop back to the earlier level. 4. As we noted earlier, brokerage commissions are generally higher in percentage terms on lower-priced stocks. This means that it is more expensive to trade lowpriced than high-priced stocks, and this, in turn, means that stock splits may reduce the liquidity of a company’s shares. This particular piece of evidence suggests that stock splits/dividends might actually be harmful, although a lower price does mean that more investors can afford to trade in round lots (100 shares), which carry lower commissions than do odd lots (less than 100 shares). What do we conclude from all this? From a purely economic standpoint, stock dividends and splits are just additional pieces of paper. However, they provide management with a relatively low-cost way of signaling that the ﬁrm’s prospects look good. Further, we should note that since few large, publicly owned stocks sell at prices above several hundred dollars, we simply do not know what the effect would be if Microsoft, Xerox, Hewlett-Packard, and other highly successful ﬁrms had never split their stocks, and consequently sold at prices in the thousands or even tens of thousands of dollars. All in all, it probably makes sense to employ stock dividends/splits when a ﬁrm’s prospects are favorable, especially if the price of its stock has gone beyond the normal trading range.9 What are stock dividends and stock splits? How do stock dividends and splits affect stock prices? In what situations should managers consider the use of stock dividends? In what situations should they consider the use of stock splits? 8

Accountants treat stock splits and stock dividends somewhat differently. For example, in a two-for-one stock split, the number of shares outstanding is doubled and the par value is halved, and that is about all there is to it. With a stock dividend, a bookkeeping entry is made transferring “retained earnings” to “common stock.” 9 It is interesting to note that Berkshire Hathaway, which is controlled by billionaire Warren Buffett, one of the most successful ﬁnanciers of the twentieth century, has never had a stock split, and its stock sold on the NYSE for $65,600 per share in November 2000. But, in response to investment trusts that were being formed to sell fractional units of the stock, and thus, in effect, split it, Buffett himself created a new class of Berkshire Hathaway stock (Class B) worth about 1/30 of a Class A (regular) share.

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Stock Repurchases A stock repurchase occurs when a company buys back some of its own outstanding stock.10 Up until the 1980s most stock repurchases were fairly small, but Phillips Petroleum set a record in 1985 when it announced plans to repurchase 81 million of its shares with a market value of $4.1 billion. Texaco, IBM, CBS, Coca-Cola, and dozens of others soon made large repurchases. Indeed, since 1985 large companies have repurchased more shares that they have issued. During the last two decades the amount of cash paid in dividends has steadily declined, while the amount used for repurchases has steadily increased. In fact, since 1995 more cash has been returned to shareholders in repurchases than as dividend payments.11 Interestingly, total distributions have remained relatively stable over the last two decades. Three principal situations lead to stock repurchases. First, a company may decide to increase its leverage by issuing debt and using the proceeds to repurchase stock, as we described in Chapter 13. Second, many ﬁrms have given their employees stock options, and they repurchase stock for use when employees exercise the options. In this case, the number of outstanding shares reverts to its pre-repurchase level after the options are exercised. Third, a company may have excess cash. This may be due to a one-time cash inﬂow, such as the sale of a division, or it may simply be that the company is generating more free cash ﬂow than it needs to service its debt. Stock repurchases are usually made in one of three ways: (1) A publicly owned ﬁrm can buy back its own stock through a broker on the open market. (2) The ﬁrm can make a tender offer, under which it permits stockholders to send in (that is, “tender”) shares in exchange for a speciﬁed price per share. In this case, the ﬁrm generally indicates that it will buy up to a speciﬁed number of shares within a stated time period (usually about two weeks). If more shares are tendered than the company wants to buy, purchases are made on a pro rata basis. (3) The ﬁrm can purchase a block of shares from one large holder on a negotiated basis. This is a targeted stock repurchase as was discussed in Chapter 12.

The Effects of Stock Repurchases Suppose a company has some extra cash, perhaps due to the sale of a division, and it plans to use that cash to repurchase stock.12 To keep the example simple, we assume the company has no debt. The current stock price, P0, is $20 and the company has 2 million outstanding shares, n0, for a total market capitalization of $40 million. The company has $5 million in marketable securities (that is, extra cash) from the recent sale of a division. As described in the corporate valuation model of Chapter 12, the company’s value of operations, Vop, is the present value of its expected future free cash ﬂows, discounted at the WACC.13 Notice that the repurchase will not affect the FCFs or the WACC, so the repurchase doesn’t affect the value of operations. The total value of the company is the

10

The repurchased stock is called “treasury stock,” and is shown as a negative value on the company’s balance sheets. 11 See Gustavo Grullon and David Ikenberry, “What Do We Know about Stock Repurchases?” Journal of Applied Corporate Finance, Spring 2000, 31–51. 12 See Chapter 13 for a description of a stock repurchase as part of a recapitalization. 13 The WACC is based on the company’s capital used in operations and does not include any effects due to the extra cash.

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value of operations plus the value of the extra cash. We can ﬁnd the price per share, P0, by dividing the total value by the number of shares outstanding, n0:

P0 ⫽

Vop ⫹ Extra cash n0

.

(14-2)

We can easily solve this for the value of operations: Vop ⫽ P0(n0) ⫺ Extra cash ⫽ $40 ⫺ $5 ⫽ $35 million Now consider the repurchase. P is the repurchase price and n is the number of shares that will be outstanding after the repurchase. We can multiply the unknown repurchase price by the number of shares that are repurchased, and this must equal the extra cash that is being used in the repurchase: P(n0 ⫺ n) ⫽ Extra cash.

(14-3)

Since the company will have no extra cash after the repurchase, the stock price will be the value of operations divided by the remaining shares of stock:

P⫽

Vop n

.

(14-4)

We know the current price (P0), the current number of shares (n0), and the amount of extra cash. This leaves three remaining unknown variables (P, n, and Vop) and three equations, so we can solve for the unknown variables.14 The solution shows that P ⫽ P0 ⫽ $20. In other words, the repurchase itself does not change the stock price. However, the repurchase does change the number of outstanding shares. Rewriting Equation 14-4,

n⫽

Vop P

⫽

$35 million ⫽ 1.75 million. $20

(14-4a)

As a check, we can see that the total market capitalization before the repurchase was $40 million, $5 million was used to repurchase shares, and the total market capitalization after the repurchase is $35 million ⫽ P(n) ⫽ $20(1.75 million). This should make sense, since the repurchase itself transferred $5 million of corporate assets to the individual shareholders. Notice that the aggregate wealth of the shareholders didn’t change. It was $40 million prior to the repurchase, and it is $40 million afterward ($35 million in stock and $5 million in cash). Notice also that a repurchase of 250,000 shares of stock at a price of $20 equals the $5 million in cash used to repurchase the shares. To summarize, the events leading up to a repurchase (the sale of a division, a recapitalization, or the generation of higher than normal free cash ﬂows) can certainly change the stock price, but the repurchase itself doesn’t change the stock price.

We can rewrite Equation 14-3 as Extra cash ⫽ Pn0 ⫺ Pn and Equation (14-4) as Vop ⫽ Pn. We then substitute these expressions for extra cash and Vop into Equation 14-2 and solve for P, which results in P ⫽ P0.

14

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Distributions to Shareholders: Dividends and Repurchases FIGURE 14-2

Stock Repurchases versus Cash Dividends

Stock Price ($) Firm Repurchases Stock

160

140

120 Firm Pays Dividends 100

0

1

2

3

4

5 Year

A Tale of Two Cash Distributions: Dividends versus Stock Repurchases Suppose a company’s current earnings are $400 million, it has 40 million shares of stock, and it pays out 50 percent of its earnings as dividends. Earnings are expected to grow at a constant rate of 5 percent, and the cost of equity is 10 percent. Its current dividend per share is 0.50($400/40) ⫽ $5. Using the dividend growth model, the current stock price is:

P0 ⫽

D0 (1 ⫹ g) $5(1 ⫹ 0.05) D1 $5.25 ⫽ ⫽ ⫽ ⫽ $105. rs ⫺ g rs ⫺ g 0.10 ⫺ 0.05 0.05

As the year progresses, the stock should climb in price by 10 percent to $115.5, but then fall by the amount of the dividend ($5.25) to $110.25 when the dividend is paid at Year 1.15 This process will be repeated each year, as shown in Figure 14-2. Notice that the shareholders experience a 10 percent total return each year, with 5 percent as a dividend yield and 5 percent as a capital gain. Also, the total expected market value of equity after paying the dividend at the end of Year 1 is the price per share multiplied by the number of shares: S1 ⫽ $110.25(40 million) ⫽ $4,410 million. Suppose the company decides to use 50 percent of its earnings to repurchase stock each year instead of paying dividends. To ﬁnd the current price per share, we discount the total payments to shareholders and divide that by the current number of shares. These payments are exactly equal to the total dividend payments in the original scenario, so the current price is the same for both dividend policies, ignoring any taxes

15

This assumes no tax effects.

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or signaling effects. But what happens when the end of the year arrives? The stock price has grown to $115.50, just as for the cash dividend policy. But unlike the case of cash dividends in which the stock price falls by the amount of the dividend, the price per share doesn’t change when a company repurchases stock, as shown earlier in this section (see Figure 14-2). This means that the total rate of return for a shareholder under the repurchase policy is 10 percent, with a zero dividend yield and a 10 percent capital gain. Year 1 earnings will be $400(1.05) ⫽ $420 million, and the total amount of cash used to repurchase stock is 0.50($420 million) ⫽ $210 million. Using Equation 14-3, we can solve for the number of shares remaining, n, after the repurchase at Year 1: P(n0 ⫺ n) ⫽ Cash purchase $115.5(40 ⫺ n) ⫽ $210 million n ⫽ [$115.5(40) ⫺ $210]/$115.5 ⫽ 38.182 million. The total market value of equity at Year 1, S1, is the price per share multiplied by the number of shares, S1 ⫽ $115.5(38.182 million) ⫽ $4,410 million, which is identical to the market value of equity if the ﬁrm pays dividends instead of repurchasing stock. This example illustrates three key results: (1) Ignoring possible tax effects and signals, the total market value of equity will be the same whether a ﬁrm pays dividends or repurchases stock. (2) The repurchase itself does not change the stock price, although it does reduce the number of outstanding shares. (3) The stock price for a company that repurchases its stock will climb faster than if it pays a dividend, but the total return to the shareholders will be the same.

Advantages of Repurchases The advantages of repurchases are as follows: 1. Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management’s belief that the ﬁrm’s shares are undervalued. 2. The stockholders have a choice when the ﬁrm distributes cash by repurchasing stock—they can sell or not sell. With a cash dividend, on the other hand, stockholders must accept a dividend payment and pay the tax. Thus, those stockholders who need cash can sell back some of their shares, while those who do not want additional cash can simply retain their stock. From a tax standpoint, a repurchase permits both types of stockholders to get what they want. 3. Dividends are “sticky” in the short run because managements are reluctant to raise the dividend if the increase cannot be maintained in the future—managements dislike cutting cash dividends because of the negative signal a cut gives. Hence, if the excess cash ﬂow is thought to be only temporary, management may prefer to make the distribution in the form of a share repurchase rather than to declare an increased cash dividend that cannot be maintained. 4. Companies can use the residual model to set a target cash distribution level, then divide the distribution into a dividend component and a repurchase component. The dividend payout ratio will be relatively low, but the dividend itself will be relatively secure, and it will grow as a result of the declining number of shares outstanding. The company has more ﬂexibility in adjusting the total distribution than it would if the entire distribution were in the form of cash dividends,

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because repurchases can be varied from year to year without giving off adverse signals. This procedure, which is what FPL employed, has much to recommend it, and it is one reason for the dramatic increase in the volume of share repurchases. 5. Repurchases can be used to produce large-scale changes in capital structures. For example, several years ago Consolidated Edison decided to borrow $400 million and use the funds to repurchase some of its common stock. Thus, Con Ed was able to quickly change its capital structure. 6. Companies that use stock options as an important component of employee compensation can repurchase shares and then use those shares when employees exercise their options. This avoids having to issue new shares and thus diluting earnings. Microsoft and other high-tech companies have used this procedure in recent years.

Disadvantages of Repurchases Disadvantages of repurchases include the following: 1. Stockholders may not be indifferent between dividends and capital gains, and the price of the stock might beneﬁt more from cash dividends than from repurchases. Cash dividends are generally dependable, but repurchases are not. 2. The selling stockholders may not be fully aware of all the implications of a repurchase, or they may not have all the pertinent information about the corporation’s present and future activities. However, ﬁrms generally announce repurchase programs before embarking on them to avoid potential stockholder suits. 3. The corporation may pay too much for the repurchased stock, to the disadvantage of remaining stockholders. If the ﬁrm seeks to acquire a relatively large amount of its stock, then the price may be bid above its equilibrium level and then fall after the ﬁrm ceases its repurchase operations.

Conclusions on Stock Repurchases When all the pros and cons on stock repurchases have been totaled, where do we stand? Our conclusions may be summarized as follows: 1. Because of the lower capital gains tax rate and the deferred tax on capital gains, repurchases have a signiﬁcant tax advantage over dividends as a way to distribute income to stockholders. This advantage is reinforced by the fact that repurchases provide cash to stockholders who want cash while allowing those who do not need current cash to delay its receipt. On the other hand, dividends are more dependable and are thus better suited for those who need a steady source of income. 2. Because of signaling effects, companies should not vary their dividends—that would lower investors’ conﬁdence in the company and adversely affect its cost of equity and its stock price. However, cash ﬂows vary over time, as do investment opportunities, so the “proper” dividend in the residual model sense varies. To get around this problem, a company can set its dividend low enough to keep dividend payments from constraining operations and then use repurchases on a more or less regular basis to distribute excess cash. Such a procedure would provide regular, dependable dividends plus additional cash ﬂow to those stockholders who want it. 3. Repurchases are also useful when a ﬁrm wants to make a large shift in its capital structure, wants to distribute cash from a one-time event such as the sale of a division, or wants to obtain shares for use in an employee stock option plan.

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535

Explain how repurchases can (1) help stockholders hold down taxes and (2) help ﬁrms change their capital structures. What are three procedures a ﬁrm can use to repurchase its stock? What are some advantages and disadvantages of stock repurchases? How can stock repurchases help a company operate in accordance with the residual dividend model?

Summary Once a company becomes proﬁtable, it must decide what to do with the cash it generates. It may choose to retain cash and use it either to purchase additional assets or to reduce outstanding debt. Alternatively, it may choose to return the cash to shareholders. Keep in mind that every dollar that management chooses to retain is a dollar that shareholders could have received and invested elsewhere. Therefore, managers should retain earnings if and only if they can invest the money within the ﬁrm and earn more than stockholders could earn outside the ﬁrm. Consequently, high-growth companies with many good projects will tend to retain a high percentage of earnings, whereas mature companies with lots of cash but limited investment opportunities will have generous cash distributions. This basic tendency has a major inﬂuence on ﬁrms’ long-run distribution policies. However, as we saw in this chapter, in any given year several important situations could complicate the long-run policy. Companies with excess cash have to decide whether to pay dividends or repurchase stock. In addition, due to the importance of signaling and the clientele effect, companies generally ﬁnd it desirable to maintain a stable, consistent dividend policy over time. The key concepts covered in this chapter are listed below: 䊉

䊉

䊉

䊉

䊉

䊉

䊉

Dividend policy involves three issues: (1) What fraction of earnings should be distributed? (2) Should the distribution be in the form of cash dividends or stock repurchases? (3) Should the ﬁrm maintain a steady, stable dividend growth rate? The optimal dividend policy strikes a balance between current dividends and future growth so as to maximize the ﬁrm’s stock price. Miller and Modigliani developed the dividend irrelevance theory, which holds that a ﬁrm’s dividend policy has no effect on either the value of its stock or its cost of capital. The bird-in-the-hand theory holds that the ﬁrm’s value will be maximized by a high dividend payout ratio, because investors regard cash dividends as being less risky than potential capital gains. The tax preference theory states that because long-term capital gains are subject to less onerous taxes than dividends, investors prefer to have companies retain earnings rather than pay them out as dividends. Empirical tests of the three theories have been inconclusive. Therefore, academicians cannot tell corporate managers how a given change in dividend policy will affect stock prices and capital costs. Dividend policy should take account of the information content of dividends (signaling) and the clientele effect. The information content, or signaling, effect relates to the fact that investors regard an unexpected dividend change as a signal of management’s forecast of future earnings. The clientele effect suggests that a ﬁrm will attract investors who like the ﬁrm’s dividend payout policy. Both

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䊉

䊉

䊉

䊉

䊉

䊉

䊉

factors should be considered by ﬁrms that are considering a change in dividend policy. In practice, most ﬁrms try to follow a policy of paying a steadily increasing dividend. This policy provides investors with stable, dependable income, and departures from it give investors signals about management’s expectations for future earnings. Most ﬁrms use the residual dividend model to set the long-run target payout ratio at a level that will permit the ﬁrm to meet its equity requirements with retained earnings. A dividend reinvestment plan (DRIP) allows stockholders to have the company automatically use dividends to purchase additional shares. DRIPs are popular because they allow stockholders to acquire additional shares without brokerage fees. Legal constraints, investment opportunities, availability and cost of funds from other sources, and taxes are also considered when ﬁrms establish dividend policies. A stock split increases the number of shares outstanding. Normally, splits reduce the price per share in proportion to the increase in shares because splits merely “divide the pie into smaller slices.” However, ﬁrms generally split their stocks only if (1) the price is quite high and (2) management thinks the future is bright. Therefore, stock splits are often taken as positive signals and thus boost stock prices. A stock dividend is a dividend paid in additional shares rather than in cash. Both stock dividends and splits are used to keep stock prices within an “optimal” trading range. Under a stock repurchase plan, a ﬁrm buys back some of its outstanding stock, thereby decreasing the number of shares, but leaving the stock price unchanged. Repurchases substitute low-taxed capital gains for high-taxed dividends.

Questions 14–1

Deﬁne each of the following terms: a. Optimal dividend policy b. Dividend irrelevance theory; bird-in-the-hand theory; tax preference theory c. Information content, or signaling, hypothesis; clientele effect d. Residual dividend model; extra dividend e. Declaration date; holder-of-record date; ex-dividend date; payment date f. Dividend reinvestment plan (DRIP) g. Stock split; stock dividend; stock repurchase

14–2

How would each of the following changes tend to affect aggregate (that is, the average for all corporations) payout ratios, other things held constant? Explain your answers. a. An increase in the personal income tax rate. b. A liberalization of depreciation for federal income tax purposes—that is, faster tax write-offs. c. A rise in interest rates. d. An increase in corporate proﬁts. e. A decline in investment opportunities. f. Permission for corporations to deduct dividends for tax purposes as they now do interest charges. g. A change in the Tax Code so that both realized and unrealized capital gains in any year were taxed at the same rate as dividends.

14–3

Discuss the pros and cons of having the directors formally announce what a ﬁrm’s dividend policy will be in the future.

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14–4

What is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see your company declare a 100 percent stock dividend or a two-for-one split? Assume that either action is feasible.

14–5

Would it ever be rational for a ﬁrm to borrow money in order to pay dividends? Explain.

14–6

“Executive salaries have been shown to be more closely correlated to the size of the ﬁrm than to its proﬁtability. If a ﬁrm’s board of directors is controlled by management instead of by outside directors, this might result in the ﬁrm’s retaining more earnings than can be justiﬁed from the stockholders’ point of view.” Discuss the statement, being sure (a) to discuss the interrelationships among cost of capital, investment opportunities, and new investment and (b) to explain the implied relationship between dividend policy and stock prices.

14–7

One position expressed in the ﬁnancial literature is that ﬁrms set their dividends as a residual after using income to support new investment. a. Explain what a residual dividend policy implies, illustrating your answer with a table showing how different investment opportunities could lead to different dividend payout ratios. b. Think back to Chapter 13, where we considered the relationship between capital structure and the cost of capital. If the WACC-versus-debt-ratio plot was shaped like a sharp V, would this have a different implication for the importance of setting dividends according to the residual policy than if the plot was shaped like a shallow bowl (or a ﬂattened U)?

14–8

Indicate whether the following statements are true or false. If the statement is false, explain why. a. If a ﬁrm repurchases its stock in the open market, the shareholders who tender the stock are subject to capital gains taxes. b. If you own 100 shares in a company’s stock and the company’s stock splits 2 for 1, you will own 200 shares in the company following the split. c. Some dividend reinvestment plans increase the amount of equity capital available to the ﬁrm. d. The Tax Code encourages companies to pay a large percentage of their net income in the form of dividends. e. If your company has established a clientele of investors who prefer large dividends, the company is unlikely to adopt a residual dividend policy. f. If a ﬁrm follows a residual dividend policy, holding all else constant, its dividend payout will tend to rise whenever the ﬁrm’s investment opportunities improve.

Self-Test Problem ST–1 ALTERNATIVE DIVIDEND POLICIES

(Solution Appears in Appendix A)

Components Manufacturing Corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of $2 par value common stock outstanding. When CMC’s founder, who was also its research director and most successful inventor, retired unexpectedly to the South Paciﬁc in late 2002, CMC was left suddenly and permanently with materially lower growth expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way to replace the founder’s contributions to the ﬁrm. Previously, CMC found it necessary to plow back most of its earnings to ﬁnance growth, which averaged 12 percent per year. Future growth at a 5 percent rate is considered realistic, but that level would call for an increase in the dividend payout. Further, it now appears that new investment projects with at least the 14 percent rate of return required by CMC’s stockholders (rs ⫽ 14%) would amount to only $800,000 for 2003 in comparison to a projected $2,000,000 of net income. If the existing 20 percent dividend payout were continued, retained earnings would be $1.6 million in 2003, but, as noted, investments that yield the 14 percent cost of capital would amount to only $800,000. The one encouraging thing is that the high earnings from existing assets are expected to continue, and net income of $2 million is still expected for 2003. Given the dramatically changed circumstances, CMC’s management is reviewing the ﬁrm’s dividend policy. a. Assuming that the acceptable 2003 investment projects would be ﬁnanced entirely by earnings retained during the year, calculate DPS in 2003, assuming that CMC uses the residual dividend model. b. What payout ratio does your answer to part a imply for 2003?

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Distributions to Shareholders: Dividends and Repurchases c. If a 60 percent payout ratio is maintained for the foreseeable future, what is your estimate of the present market price of the common stock? How does this compare with the market price that should have prevailed under the assumptions existing just before the news about the founder’s retirement? If the two values of P0 are different, comment on why.

Problems 14–1 RESIDUAL DIVIDEND MODEL

14–2 STOCK SPLIT

14–3 EXTERNAL EQUITY FINANCING

14–4 RESIDUAL DIVIDEND POLICY

14–5 DIVIDEND PAYOUT

14–6 STOCK SPLIT

14–7 RESIDUAL DIVIDEND POLICY

Axel Telecommunications has a target capital structure that consists of 70 percent debt and 30 percent equity. The company anticipates that its capital budget for the upcoming year will be $3,000,000. If Axel reports net income of $2,000,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio? Gamma Medical’s stock trades at $90 a share. The company is contemplating a 3-for-2 stock split. Assuming that the stock split will have no effect on the total market value of its equity, what will be the company’s stock price following the stock split? Northern Paciﬁc Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 40 percent with a $10 million investment in plant and machinery. The ﬁrm wants to maintain a 40 percent debt-to-total-assets ratio in its capital structure; it also wants to maintain its past dividend policy of distributing 45 percent of last year’s net income. In 2002, net income was $5 million. How much external equity must Northern Paciﬁc seek at the beginning of 2003 to expand capacity as desired? Petersen Company has a capital budget of $1.2 million. The company wants to maintain a target capital structure which is 60 percent debt and 40 percent equity. The company forecasts that its net income this year will be $600,000. If the company follows a residual dividend policy, what will be its payout ratio? The Wei Corporation expects next year’s net income to be $15 million. The ﬁrm’s debt ratio is currently 40 percent. Wei has $12 million of proﬁtable investment opportunities, and it wishes to maintain its existing debt ratio. According to the residual dividend model, how large should Wei’s dividend payout ratio be next year? After a 5-for-1 stock split, the Strasburg Company paid a dividend of $0.75 per new share, which represents a 9 percent increase over last year’s pre-split dividend. What was last year’s dividend per share? The Welch Company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented below: Project H (high risk): Project M (medium risk): Project L (low risk):

Cost of capital ⫽ 16%; IRR ⫽ 20% Cost of capital ⫽ 12%; IRR ⫽ 10% Cost of capital ⫽ 8%; IRR ⫽ 9%

Note that the projects’ cost of capital varies because the projects have different levels of risk. The company’s optimal capital structure calls for 50 percent debt and 50 percent common equity. Welch expects to have net income of $7,287,500. If Welch bases its dividends on the residual model, what will its payout ratio be? 14–8 ALTERNATIVE DIVIDEND POLICIES

In 2002 the Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. 2002 was a normal year, and for the past 10 years, earnings have grown at a constant rate of 10 percent. However, in 2003, earnings are expected to jump to $14.4 million, and the ﬁrm expects to have proﬁtable investment opportunities of $8.4 million. It is predicted that Keenan will not be able to maintain the 2003 level of earnings growth—the high 2003 earnings level is attributable to an exceptionally proﬁtable new product line introduced that year—and the

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Distributions to Shareholders: Dividends and Repurchases Spreadsheet Problem

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company will return to its previous 10 percent growth rate. Keenan’s target debt ratio is 40 percent. a. Calculate Keenan’s total dividends for 2003 if it follows each of the following policies: (1) Its 2003 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. (2) It continues the 2002 dividend payout ratio. (3) It uses a pure residual dividend policy (40 percent of the $8.4 million investment is ﬁnanced with debt). (4) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy. b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed, but justify your answer. c. Does a 2003 dividend of $9,000,000 seem reasonable in view of your answers to parts a and b? If not, should the dividend be higher or lower? 14–9 ALTERNATIVE DIVIDEND POLICIES

Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3.00 dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain constant for the next several years. The company’s target capital structure is 60 percent equity and 40 percent debt; it has 1,000,000 shares of common equity outstanding; and its net income is $8 million. The company forecasts that it would require $10 million to fund all of its proﬁtable (that is, positive NPV) projects for the upcoming year. a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget? b. If Buena Terra follows the residual dividend model, what will be the company’s dividend per share and payout ratio for the upcoming year? c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be available for the ﬁrm’s capital budget? d. Can the company maintain its current capital structure, maintain the $3.00 DPS, and maintain a $10 million capital budget without having to raise new common stock? e. Suppose that Buena Terra’s management is ﬁrmly opposed to cutting the dividend; that is, it wishes to maintain the $3.00 dividend for the next year. Also assume that the company was committed to funding all proﬁtable projects, and was willing to issue more debt (along with the available retained earnings) to help ﬁnance the company’s capital budget. Assume that the resulting change in capital structure has a minimal impact on the company’s composite cost of capital, so that the capital budget remains at $10 million. What portion of this year’s capital budget would have to be ﬁnanced with debt? f. Suppose once again that Buena Terra’s management wants to maintain the $3.00 DPS. In addition, the company wants to maintain its target capital structure (60 percent equity, 40 percent debt), and maintain its $10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue in order to meet each of its objectives? g. Now consider the case where Buena Terra’s management wants to maintain the $3.00 DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming that the company’s projects are divisible, what will be the company’s capital budget for the next year? h. What actions can a ﬁrm that follows the residual dividend policy take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?

Spreadsheet Problem 14–10 BUILD A MODEL: RESIDUAL DIVIDEND MODEL

Start with the partial model in the ﬁle Ch 14 P10 Build a Model.xls from the textbook’s web site. Rework Problem 14-9, parts a through g, using a spreadsheet model.

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See Ch 14 Show.ppt and Ch 14 Mini Case.xls.

Distributions to Shareholders: Dividends and Repurchases

Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous-casting process. SSC’s founders, Donald Brown and Margo Valencia, had been employed in the research department of a major integrated-steel company, but when that company decided against using the new process (which Brown and Valencia had developed), they decided to strike out on their own. One advantage of the new process was that it required relatively little capital in comparison with the typical steel company, so Brown and Valencia have been able to avoid issuing new stock, and thus they own all of the shares. However, SSC has now reached the stage where outside equity capital is necessary if the ﬁrm is to achieve its growth targets yet still maintain its target capital structure of 60 percent equity and 40 percent debt. Therefore, Brown and Valencia have decided to take the company public. Until now, Brown and Valencia have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the ﬁrm, so dividend policy has not been an issue. However, before talking with potential outside investors, they must decide on a dividend policy. Assume that you were recently hired by Arthur Adamson & Company (AA), a national consulting ﬁrm, which has been asked to help SSC prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions. a. (1) What is meant by the term “dividend policy”? (2) The terms “irrelevance,” “bird-in-the-hand,” and “tax preference” have been used to describe three major theories regarding the way dividend policy affects a ﬁrm’s value. Explain what these terms mean, and brieﬂy describe each theory. (3) What do the three theories indicate regarding the actions management should take with respect to dividend policy? (4) What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend policy? b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on dividend policy. c. (1) Assume that SSC has an $800,000 capital budget planned for the coming year. You have determined that its present capital structure (60 percent equity and 40 percent debt) is optimal, and its net income is forecasted at $600,000. Use the residual dividend model approach to determine SSC’s total dollar dividend and payout ratio. In the process, explain what the residual dividend model is. Then, explain what would happen if net income were forecasted at $400,000, or at $800,000. (2) In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy? (3) What are the advantages and disadvantages of the residual policy? (Hint: Don’t neglect signaling and clientele effects.) d. Describe the series of steps that most ﬁrms take in setting dividend policy in practice. e. What are stock repurchases? Discuss the advantages and disadvantages of a ﬁrm’s repurchasing its own shares. f. What is a dividend reinvestment plan (DRIP), and how does it work? g. What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?

Selected Additional References and Cases Lintner, John, “Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes,” American Economic Review, May 1956, 97–113. The effects of dividend policy on stock prices and capital costs have been examined by many researchers. Hayes, Linda S., “Fresh Evidence That Dividends Don’t Matter,” Fortune, May 4, 1981, 351–354.

Lewellen, Wilbur G., Kenneth L. Stanley, Ronald C. Lease, and Gary G. Schlarbaum, “Some Direct Evidence on the Dividend Clientele Phenomenon,” Journal of Finance, December 1978, 1385–1399. Mukherjee, Tarun, and Larry M. Austin, “An Empirical Investigation of Small Bank Stock Valuation and Dividend Policy,” Financial Management, Spring 1980, 27–31.

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Distributions to Shareholders: Dividends and Repurchases Selected Additional References and Cases On stock dividends and stock splits, see Baker, H. Kent, and Patricia L. Gallagher, “Management’s View of Stock Splits,” Financial Management, Summer 1980, 73–77. Baker, H. Kent, Aaron L. Phillips, and Gary E. Powell, “The Stock Distribution Puzzle: A Synthesis of the Literature on Stock Splits and Stock Dividends,” Financial Practice and Education, Spring/Summer 1995, 24–37. McNichols, Maureen, and Ajay Dravid, “Stock Dividends, Stock Splits, and Signaling,” Journal of Finance, July 1990, 857–879. On repurchases, see Denis, David J., “Defensive Changes in Corporate Payout Policy: Share Repurchases and Special Dividends,” Journal of Finance, December 1990, 1433–1456. Finnerty, Joseph E., “Corporate Stock Issue and Repurchase, Financial Management, Autumn 1975, 62–71. Gay, Gerald D., Jayant R. Kale, and Thomas H. Noe, “Share Repurchase Mechanisms: A Comparative Analysis of Efﬁcacy, Shareholder Wealth and Corporate Control Effects,” Financial Management, Spring 1991, 44–59. Klein, April, and James Rosenfeld, “The Impact of Targeted Share Repurchases on the Wealth of Non-Participating Shareholders,” Journal of Financial Research, Summer 1988, 89–97. Netter, Jeffry M., and Mark L. Mitchell, “Stock-Repurchase Announcements and Insider Transactions after the October 1987 Stock Market Crash,” Financial Management, Autumn 1989, 84–96. Pugh, William, and John S. Jahera, Jr., “Stock Repurchases and Excess Returns: An Empirical Examination,” The Financial Review, February 1990, 127–142. Stewart, Samuel S., Jr., “Should a Corporation Repurchase Its Own Stock?” Journal of Finance, June 1976, 911–921. Wansley, James W., William R. Lane, and Salil Sarkar, “Managements’ View on Share Repurchase and Tender Offer Premiums,” Financial Management, Autumn 1989, 97–110. Woolridge, J. Randall, and Donald R. Chambers, “Reverse Splits and Shareholder Wealth,” Financial Management, Autumn 1983, 5–15. For surveys of managers’ views on dividend policy, see Baker, H. Kent, Gail E. Farrelly, and Richard B. Edelman, “A Survey of Management Views on Dividend Policy,” Financial Management, Autumn 1985, 78–84. Pruitt, Stephen W., and Lawrence J. Gitman, “The Interactions between the Investment, Financing, and Dividend Decisions of Major U.S. Firms,” Financial Review, August 1991, 409–430. Other pertinent articles include Asquith, Paul, and David W. Mullins, Jr., “Signalling with Dividends, Stock Repurchases, and Equity Issues,” Financial Management, Autumn 1986, 27– 44.

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Born, Jeffrey A., “Insider Ownership and Signals—Evidence from Dividend Initiation Announcement Effects,” Financial Management, Spring 1988, 38–45. Brennan, Michael J., and Anjan V. Thakor, “Shareholder Preferences and Dividend Policy,” Journal of Finance, September 1990, 993–1018. Chang, Rosita P., and S. Ghon Rhee, “The Impact of Personal Taxes on Corporate Dividend Policy and Capital Structure Decisions,” Financial Management, Summer 1990, 21–31. DeAngelo, Harry, and Linda DeAngelo, “Dividend Policy and Financial Distress: An Empirical Investigation of Troubled NYSE Firms,” Journal of Finance, December 1990, 1415–1432. DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner, “Dividends and Losses,” Journal of Finance, December 1992, 1837–1863. Dempsey, Stephen J., and Gene Laber, “Effects of Agency and Transactions Costs on Dividend Payout Ratios: Further Evidence of the Agency-Transaction Cost Hypothesis,” Journal of Financial Research, Winter 1992, 317– 321. Fehrs, Donald H., Gary A. Benesh, and David R. Peterson, “Evidence of a Relation between Stock Price Reactions Around Cash Dividend Changes and Yields,” Journal of Financial Research, Summer 1988, 111–123. Ghosh, Chinmoy, and J. Randall Woolridge, “An Analysis of Shareholder Reaction to Dividend Cuts and Omissions,” Journal of Financial Research, Winter 1988, 281–294. Healy, Paul M., and Krishna G. Palepu, “How Investors Interpret Changes in Corporate Financial Policy,” Journal of Applied Corporate Finance, Fall 1989, 59–64. Impson, C. Michael, and Imre Karaﬁath, “A Note on the Stock Market Reaction to Dividend Announcements,” The Financial Review, May 1992, 259–271. Kale, Jayant R., and Thomas H. Noe, “Dividends, Uncertainty, and Underwriting Costs Under Asymmetric Information,” Journal of Financial Research, Winter 1990, 265–277. Manakyan, Herman, and Carolyn Carroll, “An Empirical Examination of the Existence of a Signaling Value Function for Dividends,” Journal of Financial Research, Fall 1990, 201–210. Peterson, David R., and Pamela P. Peterson, “A Further Understanding of Stock Distributions: The Case of Reverse Stock Splits,” Journal of Financial Research, Fall 1992, 189–205. Peterson, Pamela P., David R. Peterson, and Norman H. Moore, “The Adoption of New-Issue Dividend Reinvestment Plans and Shareholder Wealth,” Financial Review, May 1987, 221–232. Talmor, Eli, and Sheridan Titman, “Taxes and Dividend Policy,” Financial Management, Summer 1990, 32–35. Wansley, James W., C. F. Sirmans, James D. Shilling, and Young-jin Lee, “Dividend Change Announcement Effects and Earnings Volatility and Timing,” Journal of Financial Research, Spring 1991, 37–49.

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Woolridge, J. Randall, and Chinmoy Ghosh, “Dividend Cuts: Do They Always Signal Bad News?” Midland Corporate Finance Journal, Summer 1985, 20–32. The following cases in the Cases in Financial Management series focus on the issues contained in this chapter:

Case 19, “Georgia Atlantic Company,” Case 19A, “Floral Fragrance, Inc.,” Case 19B, “Cook Transportation, Inc.,” and Case 20, “Bessemer Steel Products, Inc.,” which illustrate the dividend policy decision. Case 60, “Consolidated Electric,” is a longer and more comprehensive case on dividend policy.

Multinational Financial Management1

15 15

From the end of World War II until the 1970s, the United States dominated the world economy. However, that situation no longer exists. Raw materials, ﬁnished goods, services, and money ﬂow freely across most national boundaries, as do innovative ideas and new technologies. World-class U.S. companies are making breakthroughs in foreign labs, obtaining capital from foreign investors, and putting foreign employees on the fast track to the top. Dozens of top U.S. manufacturers, including Dow Chemical, Colgate-Palmolive, Gillette, Hewlett-Packard, and Xerox, sell more of their products outside the United States than they do at home. Service ﬁrms are not far behind, as Citigroup, Disney, McDonald’s, and AOL Time Warner all receive more than 20 percent of their revenues from foreign sales. The trend is even more pronounced in proﬁts. In recent years, Coca-Cola and many other companies have made more money in the Paciﬁc Rim and Western Europe than in the United States. However, like other companies, Coke has found that global investing also presents unique challenges and risks. Recent weakness in the Asian economy, along with a contamination scare in Belgium, have hurt the bottom line and put Coke on the defensive. Still, most analysts believe that these are only temporary setbacks and that Coke will continue to generate huge proﬁts from its overseas operations in the years ahead. Successful global companies must conduct business in different economies, and they must be sensitive to the many subtleties of different cultures and political systems. Accordingly, they ﬁnd it useful to blend into the foreign landscape to win product acceptance and avoid political problems. At the same time, foreign-based multinationals are arriving on American shores in ever greater numbers. Sweden’s ABB, the Netherlands’ Philips, France’s Thomson, and Japan’s Fujitsu and Honda are all waging campaigns to be identiﬁed as American companies that employ Americans, transfer technology to America, and help the U.S. trade balance. Few Americans know or care that Thomson owns the RCA and General Electric names in consumer electronics, or that Philips owns Magnavox. The emergence of “world companies” raises a host of questions for governments. For example, should domestic ﬁrms be favored, or does it make no difference what a company’s nationality is as long as it provides domestic jobs? Should a company make an effort to keep jobs in its home country, or should it produce where total production costs are lowest? What nation controls the technology developed by a multinational corporation, particularly if the technology can be used in military applications? Must a multinational company adhere to rules imposed in its home country with respect to its operations outside the home country? Keep these questions in mind as you read this chapter. When you ﬁnish it, you should have a better appreciation of both the problems facing governments and the difﬁcult but proﬁtable opportunities facing managers of multinational companies.

1

This chapter was coauthored with Professor Roy Crum of the University of Florida and Subu Venkataraman with Morgan Stanley.

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Managers of multinational companies must deal with a wide range of issues that are not present when a company operates in a single country. In this chapter, we highlight the key differences between multinational and domestic corporations, and we discuss the effect these differences have on the ﬁnancial management of multinational businesses.

Multinational, or Global, Corporations The term multinational, or global, corporation is used to describe a ﬁrm that operates in an integrated fashion in a number of countries. During the past 20 years, a new and fundamentally different form of international commercial activity has developed, and this has greatly increased worldwide economic and political interdependence. Rather than merely buying resources from and selling goods to foreign nations, multiThe textbook’s web site national ﬁrms now make direct investments in fully integrated operations, from contains an Excel ﬁle that will guide you through the extraction of raw materials, through the manufacturing process, to distribution to chapter’s calculations. The consumers throughout the world. Today, multinational corporate networks control a ﬁle for this chapter is Ch 15 large and growing share of the world’s technological, marketing, and productive Tool Kit.xls, and we encourage you to open the ﬁle and resources. Companies, both U.S. and foreign, “go global” for six primary reasons: follow along as you read the chapter.

1. To broaden their markets. After a company has saturated its home market, growth opportunities are often better in foreign markets. Thus, such homegrown ﬁrms as Coca-Cola and McDonald’s are aggressively expanding into overseas markets, and foreign ﬁrms such as Sony and Toshiba now dominate the U.S. consumer electronics market. Also, as products become more complex, and development becomes more expensive, it is necessary to sell more units to cover overhead costs, so larger markets are critical. Thus, movie companies have “gone global” to get the volume necessary to support pictures such as Lord of the Rings. 2. To seek raw materials. Many U.S. oil companies, such as Exxon Mobil, have major subsidiaries around the world to ensure access to the basic resources needed to sustain the companies’ primary business line. 3. To seek new technology. No single nation holds a commanding advantage in all technologies, so companies are scouring the globe for leading scientiﬁc and design ideas. For example, Xerox has introduced more than 80 different ofﬁce copiers in the United States that were engineered and built by its Japanese joint venture, Fuji Xerox. Similarly, versions of the superconcentrated detergent that Procter & Gamble ﬁrst formulated in Japan in response to a rival’s product are now being marketed in Europe and the United States. 4. To seek production efﬁciency. Companies in high-cost countries are shifting production to low-cost regions. For example, GE has production and assembly plants in Mexico, South Korea, and Singapore, and Japanese manufacturers are shifting some of their production to lower-cost countries in the Paciﬁc Rim. BMW, in response to high production costs in Germany, has built assembly plants in the United States. The ability to shift production from country to country has important implications for labor costs in all countries. For example, when Xerox threatened to move its copier rebuilding work to Mexico, its union in Rochester agreed to work rule changes and productivity improvements that kept the operation in the United States. Some multinational companies make decisions almost daily on where to shift production. When Dow Chemical saw European demand for a certain solvent declining, the company scaled back production at a German plant and shifted its production to another chemical that had previously been imported from the United States. Relying on complex computer models for making such decisions, Dow runs its plants at peak capacity and thus keeps capital costs down.

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5. To avoid political and regulatory hurdles. The primary reason Japanese auto companies moved production to the United States was to get around U.S. import quotas. Now Honda, Nissan, Toyota, Mazda, and Mitsubishi are all assembling vehicles in the United States. One of the factors that prompted U.S. pharmaceutical maker SmithKline and Britain’s Beecham to merge was that they wanted to avoid licensing and regulatory delays in their largest markets, Western Europe and the United States. Now SmithKline Beecham can identify itself as an inside player in both Europe and the United States. Similarly, when Germany’s BASF launched biotechnology research at home, it confronted legal and political challenges from the environmentally conscious Green movement. In response, BASF shifted its cancer and immune system research to two laboratories in Boston suburbs. This location is attractive not only because of its large number of engineers and scientists but also because the Boston area has resolved controversies involving safety, animal rights, and the environment. “We decided it would be better to have the laboratories located where we have fewer insecurities about what will happen in the future,” said Rolf-Dieter Acker, BASF’s director of biotechnology research. 6. To diversify. By establishing worldwide production facilities and markets, ﬁrms can cushion the impact of adverse economic trends in any single country. For example, General Motors softened the blow of poor sales in the United States during a recent recession with strong sales by its European subsidiaries. In general, geographic diversiﬁcation works because the economic ups and downs of different countries are not perfectly correlated. Therefore, companies investing overseas beneﬁt from diversiﬁcation in the same way that individuals beneﬁt from investing in a broad portfolio of stocks. Over the past 10 to 15 years, there has been an increasing amount of investment in the United States by foreign corporations, and in foreign nations by U.S. corporations. This trend is shown in Figure 15-1, and it is important because of its implications for eroding the traditional doctrine of independence and self-reliance that has been a hallmark of U.S. policy. Just as U.S. corporations with extensive overseas operations are said to use their economic power to exert substantial economic and political inﬂuence over host governments in many parts of the world, it is feared that foreign corporations are gaining similar sway over U.S. policy. These developments suggest an increasing degree of mutual inﬂuence and interdependence among business enterprises and nations, to which the United States is not immune. The world economy is quite ﬂuid. Here are a few of the recent events that have dramatically changed the international ﬁnancial environment: 1. The disintegration of the former Soviet Union and the movement toward market economies in the newly formed countries have created a vast new market for international commerce. 2. The reuniﬁcation of Germany, coupled with the collapse of communism in Eastern Europe, has created signiﬁcant new opportunities for foreign investment. 3. The European Community and the European Free Trade Association have created a “borderless” region where people, capital, goods, and services move freely among the 19 nations without the burden of tariffs. This consolidation has led to the creation of a single “Eurocurrency” called the “Euro.” 4. The North American Free Trade Agreement (NAFTA) has moved the economies of the United States, Canada, and Mexico much closer together, and made them Interesting reports about more interdependent. the effect of trade on the 5. U.S. bank regulations have been loosened dramatically. One key deregulatory feaU.S. economy can be found ture was the removal of interest rate ceilings, thus allowing banks to attract foreign on the United States Trade deposits by raising rates. Another key feature was the removal of barriers to entry Representative’s home page by foreign banks, which resulted in more cross-border banking transactions. Still, at http://www.ustr.gov.

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FIGURE 15-1

Direct Investment for the United States, 1982–2000

Dollars (Billions) 1,300 1,200 1,100 1,000 900 800 700 600 500 400 300 200 100 0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year U.S. Direct Investment Abroad Foreign Direct Investment in the United States

Source: Maria Borga and Raymond J. Mataloni, Jr., “Direct Investment Positions for 2000, Country and Industry Detail,” Survey of Current Business, July 2001, 16–29. See http://www.bea.doc.gov/bea/pubs.htm for updates.

U.S. commercial and investment banks do not have as much freedom as foreign banks, which has led many U.S. banks to establish subsidiaries in Europe that can offer a wider range of services. All this has increased global competition in the ﬁnancial services industry. What is a multinational corporation? Why do companies “go global”?

Multinational versus Domestic Financial Management In theory, the concepts and procedures discussed in earlier chapters are valid for both domestic and multinational operations. However, six major factors distinguish ﬁnancial management in ﬁrms operating entirely within a single country from ﬁrms that operate globally:

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1. Different currency denominations. Cash ﬂows in various parts of a multinational corporate system will be denominated in different currencies. Hence, an analysis of exchange rates must be included in all ﬁnancial analyses. 2. Economic and legal ramiﬁcations. Each country has its own unique economic and legal systems, and these differences can cause signiﬁcant problems when a corporation tries to coordinate and control its worldwide operations. For example, differences in tax laws among countries can cause a given economic transaction to have strikingly different after-tax consequences, depending on where the transaction occurs. Similarly, differences in legal systems of host nations, such as the Common Law of Great Britain versus the French Civil Law, complicate matters ranging from the simple recording of business transactions to the role played by the judiciary in resolving conﬂicts. Such differences can restrict multinational corporations’ ﬂexibility in deploying resources, and can even make procedures that are required in one part of the company illegal in another part. These differences also make it difﬁcult for executives trained in one country to move easily to another. 3. Language differences. The ability to communicate is critical in all business transactions, and here U.S. citizens are often at a disadvantage because we are generally ﬂuent only in English, while European and Japanese businesspeople are usually ﬂuent in several languages, including English. Thus, they can penetrate our markets more easily than we can penetrate theirs. 4. Cultural differences. Even within geographic regions that are considered relatively homogeneous, different countries have unique cultural heritages that shape values and inﬂuence the conduct of business. Multinational corporations ﬁnd that matters such as deﬁning the appropriate goals of the ﬁrm, attitudes toward risk, dealings with employees, and the ability to curtail unproﬁtable operations vary dramatically from one country to the next. 5. Role of governments. Most ﬁnancial models assume the existence of a competitive marketplace in which the terms of trade are determined by the participants. The government, through its power to establish basic ground rules, is involved in the process, but its role is minimal. Thus, the market provides the primary barometer of success, and it gives the best clues about what must be done to remain competitive. This view of the process is reasonably correct for the United States and Western Europe, but it does not accurately describe the situation in most of the world. Frequently, the terms under which companies compete, the actions that must be taken or avoided, and the terms of trade on various transactions are determined not in the marketplace but by direct negotiation between host governments and multinational corporations. This is essentially a political process, and it must be treated as such. Thus, our traditional ﬁnancial models have to be recast to include political and other noneconomic aspects of the decision. 6. Political risk. A nation is free to place constraints on the transfer of corporate resources and even to expropriate without compensation assets within their boundaries. This is political risk, and it tends to be largely a given rather than a variable that can be changed by negotiation. Political risk varies from country to country, and it must be addressed explicitly in any ﬁnancial analysis. Another aspect of political risk is terrorism against U.S. ﬁrms or executives. For example, U.S. and Japanese executives have been kidnapped and held for ransom—with some killed to prove that the kidnappers were serious—in several South American countries. These six factors complicate ﬁnancial management, and they increase the risks faced by multinational ﬁrms. However, the prospects for high returns, diversiﬁcation beneﬁts, and other factors make it worthwhile for ﬁrms to accept these risks and learn how to manage them.

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The Euro: What You Need to Know

In January 1999, many Europeans began making purchases using a new currency, the euro. This is one result of the Maastricht Treaty, signed in 1992, as part of a decades-long effort to form a tighter economic and monetary union (EMU) in Europe. Eleven countries originally adopted the euro: Belgium, Austria, Finland, France, Luxembourg, Italy, the Netherlands, Germany, Spain, Ireland, and Portugal. (Tip: You can remember them by the phrase BAFFLING SIP). Britain, Switzerland, and the Scandinavian countries chose not to join the union because they did not want to give up control of their currencies. In addition, Greece has now adopted the euro. Euro bills and coins began circulating January 1, 2002. Before then, all cash transactions were made with the country’s national currency, but paperless transactions, such as those with a credit card, could be made in either euros or the

national currency. For example, you could pay for a bottle of French champagne using either francs or euros (with your credit card). After euro bills and coins began circulating, there was a six-month phase-in period, and then all transactions must be made in euros. (You will still have 10 more years to convert remaining bills or coins at a bank at a ﬁxed exchange rate.) The value of the euro will ﬂuctuate relative to other currencies, such as the U.S. dollar. Finally, instead of each country having a central bank to manage its currency, the European Central Bank, located in Frankfurt, Germany, will set interest rates and manage monetary policy for the entire region. Source: From Helene Cooper, “Europe Unites: The Launch of the Euro; The Euro: What You Need to Know,” The Wall Street Journal, January 4, 1999, A5. Copyright © 1999 by Dow Jones & Co., Inc. Reprinted by permission of Dow Jones & Co., Inc. via Copyright Clearance Center.

Identify and brieﬂy discuss six major factors that complicate ﬁnancial management in multinational ﬁrms.

Exchange Rates

The Bloomberg World Currency Values site provides up-to-the-minute foreign currency values versus the U.S. dollar, as well as a cross-currency table similar to that found in The Wall Street Journal for the world’s major currencies. The site can be accessed at http://www.bloomberg. com/markets/fxc.html.

An exchange rate speciﬁes the number of units of a given currency that can be purchased with one unit of another currency. Exchange rates appear daily in the ﬁnancial sections of newspapers, such as The Wall Street Journal, and at ﬁnancial web sites, such as http://www.bloomberg.com. The values shown in Column 1 of Table 15-1 are the number of U.S. dollars required to purchase one unit of foreign currency; this is called a direct quotation. Direct quotations have a dollar sign in their quotation and state the number of dollars per foreign currency, such as dollars per euro. Thus, the direct U.S. dollar quotation for the euro is $0.8894, because one euro could be bought for 88.94 cents. The exchange rates given in Column 2 represent the number of units of foreign currency that can be purchased for one U.S. dollar; these are called indirect quotations. Indirect quotations often begin with the foreign currency’s equivalent to the dollar sign and express the foreign currency per dollar, such as euros per dollar. Thus, the indirect quotation for the euro is €1.1244. (The “€” stands for euro, and it is analogous to the symbol “$.”) Normal practice in currency trading centers is to use the indirect quotations (Column 2) for all currencies other than British pounds and euros, for which the direct quotations are given. Thus we speak of the pound as “selling at 1.4333 dollars, or at $1.4333,” and the euro as “selling at $0.8894.” For all other currencies, say, the Japanese yen, we would quote the dollars as “being at ¥125.54”, where the “¥” stands for yen and is analogous to the symbol “$.” This convention eliminates confusion when comparing quotations from one trading center—say, New York—with those from another—say, London or Zurich.

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Multinational Financial Management Exchange Rates TABLE 15-1

551

Selected Exchange Rates (December 7, 2001) Direct Quotation: U.S. Dollars Required to Buy One Unit of Foreign Currency (1)

British pound Canadian dollar Japanese yen Mexican peso Swiss franc EMU euro

Indirect Quotation: Number of Units of Foreign Currency per U.S. Dollar (2)

$1.4333 0.6348 0.007966 0.1087 0.6027 0.8894

0.6977 1.5752 125.54 9.2015 1.6592 1.1244

Note: Column 1 equals 1.0 divided by Column 2. However, rounding differences do occur. Source: The Wall Street Journal, http://interactive.wsj.com.

We can use the data in Table 15-1 to show how to work with exchange rates. Suppose a tourist ﬂies from New York to London, then to Paris, and then on to Geneva. She then ﬂies to Montreal, and ﬁnally back to New York. Her tour includes lodging, food, and transportation, but she must pay for any other expenses. When she arrives at London’s Heathrow Airport, she goes to the bank to check the foreign exchange listings. The rate she observes for U.S. dollars is $1.4333; this means that £1 will cost $1.4333. Assume that she exchanges $3,000: $3,000 ⫽

$3,000 ⫽ £2,093.07 $1.4333 per pound

and enjoys a week’s vacation in London, ending with £1,000. After traveling to Dover and catching the Hovercraft to Calais on the coast of France, she realizes that she needs to exchange her 1,000 remaining pounds for euros. However, what she sees on the board is the direct quotation for dollars per pound and the direct quotation for dollars per euro. The exchange rate between any two currencies other than dollars is called a cross rate. Cross rates are actually calculated on the basis of various currencies relative to the U.S. dollar. For example, the cross rate between British pounds and euros is computed as follows: Cross rate of euros per pound ⫽

$1.4333 per pound $0.8894 per euro

⫽ 1.6115 euros per pound.

Therefore, for every British pound she would receive 1.6115 euros, so she would receive 1.6115(1,000) ⫽ 1,611.5 euros. She has 800 euros remaining when she ﬁnishes touring in France and arrives in Geneva. She again needs to determine a cross rate, this time between euros and Swiss francs. The quotes she sees, as shown in Table 15-1, are a direct quote for euros ($0.8894 per euro) and an indirect quote for Swiss francs (SFr 1.6592 per dollar). To ﬁnd the cross rate for Swiss francs per euro, she makes the following calculation: Cross rate of Swiss francs per euro ⫽ a

Swiss francs Dollars ba b euro Dollar ⫽ (SFr 1.6592 per dollar)($0.8894 per euro) ⫽ 1.4757 Swiss francs per euro.

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Therefore, for every euro she would receive 1.4757 Swiss francs, so she would receive 1.4757(800) ⫽ 1,180.56 Swiss francs. She has 500 Swiss francs remaining when she leaves Geneva and arrives in Montreal. She again needs to determine a cross rate, this time between Swiss francs and Canadian dollars. The quotes she sees, as shown in Table 15-1, are an indirect quote for Swiss francs (SFr 1.6592 per dollar) and an indirect quote for Canadian dollars (1.5752 Canadian dollars per U.S. dollar). To ﬁnd the cross rate for Swiss francs per euro, she makes the following calculation: a

Canadian dollars b U.S. dollar Cross rate of Swiss francs per euro ⫽ Swiss francs a b U.S. dollar (1.5752 Canadian dollars per U.S dollar) ⫽ (SFr l.6592 per U.S. dollar) ⫽ 0.9494 Canadian dollar per U.S. dollar. Therefore, she would receive 0.9494(500) ⫽ 474.70 Canadian dollars. After leaving Montreal and arriving at New York, she has 100 Canadian dollars remaining. She sees the indirect quote for Canadian dollars and converts the 100 Canadian dollars to U.S. dollars as follows: 100 Canadian dollars ⫽

100 Canadian dollars ⫽ $63.48. 1.5752 Canadian dollars per U.S. dollar

In this example, we made three very strong and generally incorrect assumptions. First, we assumed that our traveler had to calculate all the cross rates. For retail transactions, it is customary to display the cross rates directly instead of a series of dollar rates. Second, we assumed that exchange rates remain constant over time. Actually, exchange rates vary every day, often dramatically. We will have more to say about exchange rate ﬂuctuations in the next section. Finally, we assumed that there were no transactions costs involved in exchanging currencies. In reality, small retail exchange transactions such as those in our example usually involve ﬁxed and/or sliding scale fees that can easily consume 5 or more percent of the transaction amount. However, credit card purchases minimize these fees. Major business publications, such as The Wall Street Journal, and web sites, such as http://www.bloomberg.com, regularly report cross rates among key currencies. A set of cross rates is given in Table 15-2. When examining the table, note the following points: 1. Column 1 gives indirect quotes for dollars, that is, units of a foreign currency that can be bought with one U.S. dollar. Examples: $1 will buy 1.1244 euros or 1.6592 Swiss Francs. Note the consistency with Table 15-1, Column 2. 2. Other columns show number of units of other currencies that can be bought with one pound, one Swiss franc, etc. For example, the euro column shows that 1 euro will buy 1.401 Canadian dollars, 111.66 Japanese yen, or 0.8894 U.S. dollar. 3. The rows show direct quotes, that is, number of units of the currency of the country listed in the left column required to buy one unit of the currency listed in the top row. The bottom row is particularly important for U.S. companies, as it shows the direct quotes for the U.S. dollar. This row is consistent with Column 1 of Table 15-1. 4. Note that the values on the bottom row of Table 15-2 are reciprocals of the corresponding values in the ﬁrst column. For example, the U.K. row in the ﬁrst column shows 0.6977 pound per dollar, and the pound column in the bottom row shows 1/0.6977 ⫽ 1.4333 dollars per pound.

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Multinational Financial Management The International Monetary System TABLE 15-2

Canada Japan Mexico Switzerland United Kingdom Euro United States

553

Key Currency Cross Rates (December 7, 2001) Dollar

Euro

Pound

SFranc

Peso

Yen

CdnDlr

1.5752 125.54 9.2015 1.6592 0.6977 1.1244 —

1.401 111.66 8.1838 1.4757 0.6205 — 0.8894

2.2577 179.94 13.189 2.3781 — 1.6115 1.4333

0.9494 75.663 5.5457 — 0.4205 0.6776 0.6027

0.1712 13.643 — 0.1803 0.0758 0.1222 0.1087

0.0125 — 0.0733 0.0132 0.0056 0.0090 0.0080

— 79.698 5.8415 1.0533 0.4429 0.7138 0.6348

Source: The Wall Street Journal, http://interactive.wsj.com.

5. Now notice, by reading down the euro column, that one euro was worth 1.4757 Swiss francs. This is the same cross rate that we calculated for the U.S. tourist in our example. The tie-in with the dollar ensures that all currencies are related to one another in a consistent manner. If this consistency did not exist, currency traders could proﬁt by buying undervalued and selling overvalued currencies. This process, known as arbitrage, works to bring about an equilibrium wherein the same relationship described earlier would exist. Currency traders are constantly operating in the market, seeking small inconsistencies from which they can proﬁt. The traders’ existence enables the rest of us to assume that currency markets are in equilibrium and that, at any point in time cross rates are all internally consistent. What is an exchange rate? Explain the difference between direct and indirect quotations. What is a cross rate?

The International Monetary System Every nation has a monetary system and a monetary authority. In the United States, the Federal Reserve is our monetary authority, and its task is to hold down inﬂation while promoting economic growth and raising our national standard of living. Moreover, if countries are to trade with one another, we must have some sort of system designed to facilitate payments between nations. From the end of World War II until August 1971, the world was on a ﬁxed exchange rate system administered by the International Monetary Fund (IMF). Under this system, the U.S. dollar was linked to gold ($35 per ounce), and other currencies were then tied to the dollar. Exchange rates between other currencies and the dollar were controlled within narrow limits but then adjusted periodically. For example, in 1964 the British pound was adjusted to $2.80 for £1, with a 1 percent permissible ﬂuctuation about this rate. Fluctuations in exchange rates occur because of changes in the supply of and demand for dollars, pounds, and other currencies. These supply and demand changes have two primary sources. First, changes in the demand for currencies depend on changes in imports and exports of goods and services. For example, U.S. importers must buy British pounds to pay for British goods, whereas British importers must buy U.S. dollars to pay for U.S. goods. If U.S. imports from Great Britain exceeded U.S.

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exports to Great Britain, there would be a greater demand for pounds than for dollars, and this would drive up the price of the pound relative to that of the dollar. In terms of Table 15-1, the dollar cost of a pound might rise from $1.4338 to $2.0000. The U.S. dollar would be said to be depreciating, because a dollar would now be worth fewer pounds, whereas the pound would be appreciating. In this example, the root cause of the change would be the U.S. trade deﬁcit with Great Britain. Of course, if U.S. exports to Great Britain were greater than U.S. imports from Great Britain, Great Britain would have a trade deﬁcit with the United States.2 Changes in the demand for a currency, and the resulting exchange rate ﬂuctuations, also depend on capital movements. For example, suppose interest rates in Great Britain were higher than those in the United States. To take advantage of the high British interest rates, U.S. banks, corporations, and sophisticated individuals would buy pounds with dollars and then use those pounds to purchase high-yielding British securities. This buying of pounds would tend to drive up their price.3 Before August 1971, exchange rate ﬂuctuations were kept within a narrow 1 percent limit by regular intervention of the British government in the market. When the value of the pound was falling, the Bank of England would step in and buy pounds to push up their price, offering gold or foreign currencies in exchange. Conversely, when the pound rate was too high, the Bank of England would sell pounds. The central banks of other countries operated similarly. Devaluations and revaluations occurred only rarely before 1971. They were usually accompanied by severe international ﬁnancial repercussions, partly because nations tended to postpone needed measures until economic pressures had built up to explosive proportions. For this and other reasons, the old international monetary system came to a dramatic end in the early 1970s, when the U.S. dollar, the foundation upon which all other currencies were anchored, was cut loose from the gold standard and, in effect, allowed to “ﬂoat.” The United States and other major trading nations currently operate under a system of ﬂoating exchange rates, whereby currency prices are allowed to seek their own levels without much governmental intervention. However, the central bank of each country does intervene to some extent, buying and selling its currency to smooth out exchange rate ﬂuctuations. Each central bank would like to keep its average exchange rate at a level deemed desirable by its government’s economic policy. This is important, because exchange rates have a profound effect on the levels of imports and exports, which inﬂuence the 2

If the dollar value of the pound moved up from $1.43 to $2.00, this increase in the value of the pound would mean that British goods would now be more expensive in the United States. For example, a box of candy costing £1 in England would rise in price in the United States from about $1.43 to $2.00. Conversely, U.S. goods would become cheaper in England. For example, the British could now buy goods worth $2.00 for £1, whereas before the exchange rate change £1 would buy merchandise worth only $1.43. These price changes would, of course, tend to reduce British exports and increase imports, and this, in turn, would lower the exchange rate, because people in the United States would be buying fewer pounds to pay for English goods. 3 Such capital inﬂows would also tend to drive down British interest rates. If British rates were high in the ﬁrst place because of efforts by the British monetary authorities to curb inﬂation, these international currency ﬂows would tend to thwart that effort. This is one of the reasons domestic and international economies are so closely linked. A good example of this occurred during the summer of 1981. In an effort to curb inﬂation, the Federal Reserve Board pushed U.S. interest rates to record levels. This, in turn, caused a ﬂow of capital from European nations to the United States. The Europeans were suffering from a severe recession and wanted to keep interest rates down in order to stimulate investment, but U.S. policy made this difﬁcult because of international capital ﬂows. Just the opposite occurred in 1992, when the Fed drove short-term rates down to record lows in the United States to promote growth, while Germany and most other European countries pushed their rates higher to combat the inﬂationary pressures of reuniﬁcation. Thus, investment in the United States was dampened as investors moved their money overseas to capture higher interest rates.

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domestic employment. For example, if a country is having a problem with unemployment, its central bank might try to lower interest rates, which would cause capital to ﬂee the country to ﬁnd higher rates, which would lead to the sale of the currency, which would cause a decline in the value of the currency. This would cause its goods to be cheaper in world markets and thus stimulate exports, production, and domestic employment. Conversely, the central bank of a country that is operating at full capacity and experiencing inﬂation might try to raise the value of its currency to reduce exports and increase imports. Under the current ﬂoating rate system, however, such intervention can affect the situation only temporarily, because market forces will prevail in the long run. In the case of the euro, each of the EMU currencies was ﬁxed relative to the euro; however, the value of the euro still ﬂuctuated. The 11 EMU countries turned over control of their monetary policy to the European Central Bank. In 2002, the national currencies of the countries in the EMU began to be phased out, and only the euro will exist. Exchange rate ﬂuctuations can have a profound impact on international monetary transactions. For example, in 1985 it cost Honda Motors 2,380,000 yen to build a particular model in Japan and ship it to the United States. The model carried a U.S. sticker price of $12,000. Since the $12,000 sales price was the equivalent of (238 yen per dollar)($12,000) ⫽ 2,856,000 yen, which was 20 percent above the 2,380,000 yen cost, the automaker had built a 20 percent markup into the U.S. sales price. However, three years later the dollar had depreciated to 128 yen. Now if the model still sold for $12,000, the yen return to Honda would be only (128 yen per dollar)($12,000) ⫽ 1,536,000 yen, and the automaker would be losing about 35 percent on each auto sold. Therefore, the depreciation of the dollar against the yen turned a healthy proﬁt into a huge loss. In fact, for Honda to maintain its 20 percent markup, the model would have to sell in the United States for 2,856,000 yen/128 yen per dollar ⫽ $22,312.50. This situation, which grew even worse, led Honda to build its most popular model, the Accord, in Marysville, Ohio. The inherent volatility of exchange rates under a ﬂoating system increases the uncertainty of the cash ﬂows for a multinational corporation. Because its cash ﬂows are generated in many parts of the world, they are denominated in many different currencies. Since exchange rates can change, the dollar-equivalent value of the company’s consolidated cash ﬂows can also ﬂuctuate. For example, Toyota estimates that each one-yen drop in the dollar reduces the company’s annual net income by about 10 billion yen. This is known as exchange rate risk, and it is a major factor differentiating a global company from a purely domestic one. Concerns about exchange rate risk have led to attempts to stabilize currency movements. Indeed, this concern was one of the motivating factors behind the European consolidation. As we indicated above, each participating country’s currency is now pegged relative to the euro. Countries with pegged exchange rates establish a ﬁxed exchange rate with some major currency, and then the values of the pegged currencies move together over time. Other countries have chosen to peg their currency to the U.S. dollar. For example, Venezuela pegs its currency to the U.S. dollar at a rate of 0.00116 dollar per Bolivar. Its reason for pegging its currency to the dollar is that a large portion of its revenues are linked to its oil exports, which are typically traded in dollars, and its trading partners feel more comfortable dealing with contracts that can, in essence, be stated in dollar terms. Similarly, Kuwait pegs its currency to a composite of currencies that roughly represents the mix of currencies used by its trading partners to purchase its oil. In other instances, currencies are pegged because of traditional ties—for example, Chad, a former French colony, still pegs its currency to the French franc.4

4

The International Monetary Fund reports each year a full listing of exchange rate arrangements in its Annual Report on Exchange Arrangements and Exchange Restrictions.

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Before closing our discussion of the international monetary system, we should note that not all currencies are convertible. A currency is convertible when the nation that issued it allows it to be traded in the currency markets and is willing to redeem it at market rates. This means that, except for limited central bank inﬂuence, the issuing government loses control over the value of its currency. However, a lack of convertibility creates major problems for international trade. For example, consider the situation faced by Pepsico when it wanted to open a chain of Pizza Hut restaurants in the former Soviet Union. The Russian ruble is not convertible, so Pepsico could not take the proﬁts from its restaurants out of the Soviet Union in the form of dollars. There was no mechanism to exchange the rubles it earned in Russia for dollars, so the investment in the Soviet Union was essentially worthless to the U.S. parent. However, Pepsico arranged to use the ruble proﬁt from the restaurants to buy Russian vodka, which it then shipped to the United States and sold for dollars. Pepsico managed to work things out, but lack of convertibility signiﬁcantly inhibits the ability of a country to attract foreign investment. What is the difference between a ﬁxed exchange rate system and a ﬂoating rate system? What are the pros and cons of each system? What are pegged exchange rates? What does it mean to say that the dollar is depreciating with respect to the euro? For a U.S. consumer of European goods, would this be good or bad? How could changes in consumption arrest the decline of the dollar? What is a convertible currency?

Trading in Foreign Exchange Importers, exporters, tourists, and governments buy and sell currencies in the foreign exchange market. For example, when a U.S. trader imports automobiles from Japan, payment will probably be made in Japanese yen. The importer buys yen (through its bank) in the foreign exchange market, much as one buys common stocks on the New York Stock Exchange or pork bellies on the Chicago Mercantile Exchange. However, whereas stock and commodity exchanges have organized trading ﬂoors, the foreign exchange market consists of a network of brokers and banks based in New York, London, Tokyo, and other ﬁnancial centers. Most buy and sell orders are conducted by computer and telephone.5

Spot Rates and Forward Rates The exchange rates shown earlier in Tables 15-1 and 15-2 are known as spot rates, which means the rate paid for delivery of the currency “on the spot” or, in realCurrent currency futures ity, no more than two days after the day of the trade. For most of the world’s major prices are available directly currencies, it is also possible to buy (or sell) currencies for delivery at some agreedfrom the Chicago Mercantile Exchange (CME) on their upon future date, usually 30, 90, or 180 days from the day the transaction is negotiated. This rate is known as the forward exchange rate. web site at http://www. cme.com. The quotes are For example, suppose a U.S. ﬁrm must pay 500 million yen to a Japanese ﬁrm in updated every ten minutes 30 days, and the current spot rate is 125.54 yen per dollar. Unless spot rates change, the throughout the trading session. Updated currency spot U.S. ﬁrm will pay the Japanese ﬁrm the equivalent of $3.983 million (500 million yen and forward rates (from 1 to 12 months) are also provided by the Bank of Montreal Treasury Group at http://www.bmo.com.

5

For a more detailed explanation of exchange rate determination and operations of the foreign exchange market, see Mark Eaker, Frank Fabozzi, and Dwight Grant, International Corporate Finance (Fort Worth, TX: The Dryden Press, 1996).

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Multinational Financial Management Interest Rate Parity TABLE 15-3

557

Selected Spot and Forward Exchange Rates; Indirect Quotation: Number of Units of Foreign Currency per U.S. Dollar (December 7, 2001) Forward Rates

Britain (pound) Canada (dollar) Japan (yen) Switzerland (franc)

Spot Rate

30 Days

90 Days

180 Days

Forward Rate at a Premium or Discount

0.6977 1.5752 125.54 1.6592

0.6989 1.5757 125.339 1.6592

0.7013 1.5761 124.9595 1.6591

0.7048 1.5765 124.335 1.6583

Discount Discount Premium Premium

Notes: a. These are representative quotes as provided by a sample of New York banks. Forward rates for other currencies and for other lengths of time can often be negotiated. b. When it takes more units of a foreign currency to buy one dollar in the future, the value of the foreign currency is less in the forward market than in the spot market, hence the forward rate is at a discount to the spot rate. Source: The Wall Street Journal, http://interactive.wsj.com.

divided by 125.54 yen per dollar) in 30 days. But if the spot rate falls to 100 yen per dollar, for example, the U.S. ﬁrm will have to pay the equivalent of $5 million. The treasurer of the U.S. ﬁrm can avoid this risk by entering into a 30-day forward exchange contract. This contract promises delivery of yen to the U.S. ﬁrm in 30 days at a guaranteed price of 125.339 yen per dollar. No cash changes hands at the time the treasurer signs the forward contract, although the U.S. ﬁrm might have to put some collateral down as a guarantee against default. Because the ﬁrm can use an interest-bearing instrument for the collateral, though, this requirement is not costly. The counterparty to the forward contract must deliver the yen to the U.S. ﬁrm in 30 days, and the U.S. ﬁrm is obligated to purchase the 500 million yen at the previously agreed-upon rate of 125.339 yen per dollar. Therefore, the treasurer of the U.S. ﬁrm is able to lock in a payment equivalent to $3.989 million, no matter what happens to spot rates. This technique is called “hedging.” Forward rates for 30-, 90-, and 180-day delivery, along with the current spot rates for some commonly traded currencies, are given in Table 15-3. If one can obtain more of the foreign currency for a dollar in the forward than in the spot market, the forward currency is less valuable than the spot currency, and the forward currency is said to be selling at a discount. Conversely, since a dollar would buy fewer yen and marks in the forward than in the spot market, the forward yen and marks are selling at a premium. Differentiate between spot and forward exchange rates. Explain what it means for a forward currency to sell at a discount and at a premium.

Interest Rate Parity Market forces determine whether a currency sells at a forward premium or discount, and the general relationship between spot and forward exchange rates is speciﬁed by a concept called “interest rate parity.” Interest rate parity holds that investors should earn the same return on security investments in all countries after adjusting for risk. It recognizes that when you invest in a country other than your home country, you are affected by two forces—returns on the investment itself and changes in the exchange rate. It follows that your overall

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return will be higher than the investment’s stated return if the currency in which your investment is denominated appreciates relative to your home currency. Likewise, your overall return will be lower if the foreign currency you receive declines in value. To illustrate interest rate parity, consider the case of a U.S. investor who can buy default-free 180-day Swiss bonds that promise a 4 percent nominal annual return. The 180-day Swiss interest rate, rf, is 4%/2 ⫽ 2% because 180 days is one-half of a 360-day year. Assume also that the indirect quotation for the spot exchange rate is 1.6592 Swiss francs per dollar, as shown in Table 15-3. Finally, assume that the 180-day forward exchange rate is 1.6583 Swiss francs per dollar, which means that in 180 days the investor can exchange one dollar for 1.6583 Swiss francs. The U.S. investor could receive a 4 percent annualized return denominated in Swiss francs, but if he or she ultimately wants to consume goods in the United States, those Swiss francs must be converted to dollars. The dollar return on the investment depends, therefore, on what happens to exchange rates over the next six months. However, the investor can lock in the dollar return by selling the foreign currency in the forward market. For example, the investor could simultaneously: 1. Convert $1,000 to 1,659.2 Swiss francs in the spot market: $1,000(1.6592 Swiss francs per dollar) ⫽ 1,659.2 Swiss francs. 2. Invest the Swiss francs in a 180-day Swiss bond that has a 4 percent annual return, or a 2 percent semiannual return. This investment will pay 1,659.2(1.02) ⫽ 1,692.38 Swiss francs in 180 days. 3. Agree today to exchange the Swiss francs in 180 days at the rate of 1.6583 Swiss francs per dollar, for a total of (1,692.38 Swiss francs)/(1.6583 Swiss francs per dollar) ⫽ $1,020.55. This investment, therefore, has an expected 180-day return of $20.55/$1,000 ⫽ 2.055%, which translates into a nominal annual return of 2(2.055%) ⫽ 4.11%. In this case, 4 percent of the expected 4.11 percent is coming from the bond itself, and 0.11 percent arises because the market believes the Swiss franc will strengthen relative to the dollar. Note that by locking in the forward rate today, the investor has eliminated all exchange rate risk. And since the Swiss bond is assumed to be default-free, the investor is certain to earn a 4.11 percent annual dollar return. Interest rate parity implies that an investment in the United States with the same risk as the Swiss bond should also have a return of 4.11 percent. We can express interest rate parity by the following equation: Forward exchange rate Spot exchange rate

⫽

(1 ⫹ rh) , (1 ⫹ rf)

(15-1)

Here rh is the periodic interest rate in the home country, rf is the periodic interest rate in the foreign country, and the forward and exchange rates are expressed as direct quotations (that is, dollars per foreign currency). Using Table 15-3, the direct spot quotation is 0.60270 dollar per Swiss franc ⫽ (1/1.6592 Swiss francs per dollar), and the direct 180-day forward quotation is 0.60303 ⫽ (1/1.6583). Using Equation 15-1, we can solve for the equivalent home rate, rh: (1 ⫹ rh) (1 ⫹ rh) 0.60303 ⫽ ⫽ (1 ⫹ rf) (1 ⫹ 0.02) 0.60270 (15-1a) 0.60303 b(1 ⫹ 0.02) ⫽ 1.020558. (1 ⫹ rh) ⫽ a 0.60270

Forward exchange rate Spot exchange rate

⫽

The periodic home interest rate is 2.0558 percent, and the annualized home interest rate is (2.0558%)(2) ⫽ 4.11%, the same value we found above.

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After accounting for exchange rates, interest rate parity states that bonds in the home country and the foreign country must have the same effective rate of return. In this example, the U.S. bond must yield 4.11 percent to provide the same return as the 4 percent Swiss bond. If one bond provides a higher return, investors will sell their low-return bond and ﬂock to the high-return bond. This activity will cause the price of the low-return bond to fall (which pushes up its yield) and the price of the highreturn bond to increase (driving down its yield). This will continue until the two bonds again have the same returns after accounting for exchange rates. In other words, interest rate parity implies that an investment in the United States with the same risk as a Swiss bond should have a dollar value return of 4.11 percent. Solving for rh in Equation 15-1, we indeed ﬁnd that the predicted interest rate in the United States is 4.11 percent. Interest rate parity shows why a particular currency might be at a forward premium or discount. Note that a currency is at a forward premium whenever domestic interest rates are higher than foreign interest rates. Discounts prevail if domestic interest rates are lower than foreign interest rates. If these conditions do not hold, then arbitrage will soon force interest rates back to parity. Brieﬂy explain interest rate parity, illustrating it with an example.

Purchasing Power Parity We have discussed exchange rates in some detail, and we have considered the relationship between spot and forward exchange rates. However, we have not yet addressed the fundamental question: What determines the spot level of exchange rates in each country? While exchange rates are inﬂuenced by a multitude of factors that are difﬁcult to predict, particularly on a day-to-day basis, over the long run market forces work to ensure that similar goods sell for similar prices in different countries after taking exchange rates into account. This relationship is known as “purchasing power parity.” Purchasing power parity (PPP), sometimes referred to as the law of one price, implies that the level of exchange rates adjusts so as to cause identical goods to cost the same amount in different countries. For example, if a pair of tennis shoes costs $150 in the United States and 100 pounds in Britain, PPP implies that the exchange rate be $1.50 per pound. Consumers could purchase the shoes in Britain for 100 pounds, or they could exchange their 100 pounds for $150 and then purchase the same shoes in the United States at the same effective cost, assuming no transaction or transportation costs. Here is the equation for purchasing power parity: Ph ⫽ (Pf)(Spot rate),

(15-2)

or Spot rate ⫽

Ph . Pf

(15-2a)

Here Ph ⫽ the price of the good in the home country ($150, assuming the United States is the home country). Pf ⫽ the price of the good in the foreign country (100 pounds).

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Hungry for a Big Mac? Go to the Philippines!

Purchasing power parity (PPP) implies that the same product will sell for the same price in every country after adjusting for current exchange rates. One problem when testing to see if PPP holds is that it assumes that goods consumed in different countries are of the same quality. For example, if you ﬁnd that a product is more expensive in Switzerland than it is in Canada, one explanation is that PPP fails to hold, but another explanation is that the product sold in Switzerland is of a higher quality and therefore deserves a higher price. One way to test for PPP is to ﬁnd goods that have the same quality worldwide. With this in mind, The Economist magazine occasionally compares the prices of a well-known good whose quality is the same in nearly 120 different countries: the McDonald’s Big Mac hamburger. The table on the next page provides information collected during 2001. The ﬁrst column shows the price of a Big Mac in the local currency. Column 2 calculates the price of the Big Mac in terms of the U.S. dollar—this is obtained by dividing the local price by the actual exchange rate at that time. For example, a Big Mac costs 2.57 euros in the EMU area. Given an exchange rate of 0.88 dollar per euro, this implies that the dollar price of a Big Mac is (2.57 euros)(0.88 dollar per euro) = $2.26. The third column backs out the implied exchange rate that would hold under PPP. This is obtained by dividing the price of the Big Mac in each local currency by its U.S. price.

For example, a Big Mac costs 35.0 rubles in Russia, and $2.54 in the United States. If PPP holds, the exchange rate should be 13.8 rubles per dollar (35.0 rubles/$2.54). Comparing the implied exchange rate to the actual exchange rate in Column 4, we see the extent to which the local currency is under- or overvalued relative to the dollar. Given that the actual exchange rate at the time was 28.9 rubles per dollar, this implies that the ruble was 52 percent undervalued. The evidence suggests that strict PPP does not hold, but the Big Mac test may shed some insights about where exchange rates are headed. Other than a few non-euro European countries, such as Britain, most of the other currencies are undervalued against the dollar. The Big Mac 2001 test suggests that the pound and other non-euro currencies will fall over the next year or so, but that most others will rise. One last beneﬁt of the Big Mac test is that it tells us the cheapest places to ﬁnd a Big Mac. According to the data, if you are looking for a Big Mac, head to the Philippines, and avoid Switzerland.

Source: Based on information contained within “Big MacCurrencies,” The Economist, April 19, 2001 and http://www.economist.com/markets/ Bigmac/Index.cfm.

Note that the spot market exchange rate is expressed as the number of units of home currency that can be exchanged for one unit of foreign currency ($1.50 per pound). PPP assumes that market forces will eliminate situations in which the same product sells at a different price overseas. For example, if the shoes cost $140 in the United States, importers/exporters could purchase them in the United States for $140, sell them for 100 pounds in Britain, exchange the 100 pounds for $150 in the foreign exchange market, and earn a proﬁt of $10 on every pair of shoes. Ultimately, this trading activity would increase the demand for shoes in the United States and thus raise Ph, increase the supply of shoes in Britain and thus reduce Pf, and increase the demand for dollars in the foreign exchange market and thus reduce the spot rate. Each of these actions works to restore PPP. Note that PPP assumes that there are no transportation or transaction costs, or import restrictions, all of which limit the ability to ship goods between countries. In many cases, these assumptions are incorrect, which explains why PPP is often violated. An additional problem for empirical tests of the PPP theorem is that products in different countries are rarely identical. Frequently, there are real or perceived differences in quality, which can lead to price differences in different countries.

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561

Big Mac Prices

United Statesc Argentina Australia Britain Canada China Denmark Euro area Hong Kong Japan Malaysia Mexico Philippines Russia Switzerland

In Local Currency (1)

In Dollars (2)

Implied Exchange Rate Based on PPPa (3)

Actual $ Exchange Rate 4/17/01 (4)

Local Currency Under(⫺)/Over(⫹) Valuationb(%) (5)

$2.54 Peso2.50 A$3.00 £1.99 C$3.33 Yuan9.90 DKr24.75 2.57 HK$10.70 ¥294 M$4.52 Peso21.9 Peso59.00 Ruble35.00 SFr6.30

2.54 2.50 1.52 2.85 2.14 1.20 2.93 2.27 1.37 2.38 1.19 2.36 1.17 1.21 3.65

— 0.98 1.18 1.28d 1.31 3.90 9.74 0.99e 4.21 116 1.78 8.62 23.2 13.8 2.48

— 1.00 1.98 1.43d 1.56 8.28 8.46 0.88e 7.80 124 3.80 9.29 50.3 28.9 1.73

— ⫺2 ⫺40 12 ⫺16 ⫺53 15 ⫺11 ⫺46 ⫺6 ⫺53 ⫺7 ⫺54 ⫺52 44

Notes: a Purchasing power parity: local price divided by price in the United States. b Against dollar. c Average of New York, Chicago, San Francisco, and Atlanta. d Dollars per pound. e Dollars per euro. Source: McDonald’s.

Still, the concepts of interest rate and purchasing power parity are critically important to those engaged in international activities. Companies and investors must anticipate changes in interest rates, inﬂation, and exchange rates, and they often try to hedge the risks of adverse movements in these factors. The parity relationships are extremely useful when anticipating future conditions. What is meant by purchasing power parity? Illustrate it.

Inﬂation, Interest Rates, and Exchange Rates Relative inﬂation rates, or the rates of inﬂation in foreign countries compared with that in the home country, have many implications for multinational ﬁnancial decisions. Obviously, relative inﬂation rates will greatly inﬂuence future production costs at home and abroad. Equally important, inﬂation has a dominant inﬂuence on relative interest rates and exchange rates. Both of these factors inﬂuence decisions by multinational corporations for ﬁnancing their foreign investments, and both have an important effect on the proﬁtability of foreign investments.

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The currencies of countries with higher inﬂation rates than that of the United States by deﬁnition depreciate over time against the dollar. Countries where this has occurred include Mexico and all the South American nations. On the other hand, the currencies of Switzerland and Japan, which have had less inﬂation than the United States, have generally appreciated against the dollar. In fact, a foreign currency will, on average, depreciate or appreciate at a percentage rate approximately equal to the amount by which its inﬂation rate exceeds or is less than the U.S. rate. Relative inﬂation rates also affect interest rates. The interest rate in any country is largely determined by its inﬂation rate. Therefore, countries currently experiencing higher rates of inﬂation than the United States also tend to have higher interest rates. The reverse is true for countries with lower inﬂation rates. It is tempting for a multinational corporation to borrow in countries with the lowest interest rates. However, this is not always a good strategy. Suppose, for example, that interest rates in Switzerland are lower than those in the United States because of Switzerland’s lower inﬂation rate. A U.S. multinational ﬁrm could therefore save interest by borrowing in Switzerland. However, because of relative inﬂation rates, the Swiss franc will probably appreciate in the future, causing the dollar cost of annual interest and principal payments on Swiss debt to rise over time. Thus, the lower interest rate could be more than offset by losses from currency appreciation. Similarly, multinational corporations should not necessarily avoid borrowing in a country such as Brazil, where interest rates have been very high, because future depreciation of the Brazilian cruzeiro could make such borrowing end up being relatively inexpensive. What effects do relative inﬂation rates have on relative interest rates? What happens over time to the currencies of countries with higher inﬂation rates than that of the United States? To those with lower inﬂation rates? Why might a multinational corporation decide to borrow in a country such as Brazil, where interest rates are high, rather than in a country like Switzerland, where interest rates are low?

International Money and Capital Markets One way for U.S. citizens to invest in world markets is to buy the stocks of U.S. multinational corporations that invest directly in foreign countries. Another way is to purchase foreign securities—stocks, bonds, or money market instruments issued by foreign companies. Security investments are known as portfolio investments, and they are distinguished from direct investments in physical assets by U.S. corporations. From World War II through the 1960s, the U.S. capital markets dominated world markets. Today, however, the value of U.S. securities represents less than one-fourth the value of all securities. Given this situation, it is important for both corporate managers and investors to have an understanding of international markets. Moreover, these markets often offer better opportunities for raising or investing capital than are available domestically.

Eurodollar Market A Eurodollar is a U.S. dollar deposited in a bank outside the United States. (Although they are called Eurodollars because they originated in Europe, Eurodollars are really any dollars deposited in any part of the world other than the United States.) The bank in which the deposit is made may be a non-U.S. bank, such as Barclay’s Bank in London; the foreign branch of a U.S. bank, such as Citibank’s Paris branch; or even a foreign branch of a third-country bank, such as Barclay’s Munich branch. Most

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Eurodollar deposits are for $500,000 or more, and they have maturities ranging from overnight to about one year. The major difference between Eurodollar deposits and regular U.S. time deposits is their geographic locations. The two types of deposits do not involve different currencies—in both cases, dollars are on deposit. However, Eurodollars are outside the direct control of the U.S. monetary authorities, so U.S. banking regulations, including reserve requirements and FDIC insurance premiums, do not apply. The absence of these costs means that the interest rate paid on Eurodollar deposits can be higher than domestic U.S. rates on equivalent instruments. Although the dollar is the leading international currency, British pounds, euros, Swiss francs, Japanese yen, and other currencies are also deposited outside their home countries; these Eurocurrencies are handled in exactly the same way as Eurodollars. Eurodollars are borrowed by U.S. and foreign corporations for various purposes, but especially to pay for goods exported from the United States and to invest in U.S. security markets. Also, U.S. dollars are used as an international currency, or international medium of exchange, and many Eurodollars are used for this purpose. It is interesting to note that Eurodollars were actually “invented” by the Soviets in 1946. International merchants did not trust the Soviets or their rubles, so the Soviets bought some dollars (for gold), deposited them in a Paris bank, and then used these dollars to buy goods in the world markets. Others found it convenient to use dollars this same way, and soon the Eurodollar market was in full swing. Eurodollars are usually held in interest-bearing accounts. The interest rate paid on these deposits depends (1) on the bank’s lending rate, as the interest a bank earns on loans determines its willingness and ability to pay interest on deposits, and (2) on rates of return available on U.S. money market instruments. If money market rates in the United States were above Eurodollar deposit rates, these dollars would be sent back and invested in the United States, whereas if Eurodollar deposit rates were signiﬁcantly above U.S. rates, which is more often the case, more dollars would be sent out of the United States to become Eurodollars. Given the existence of the Eurodollar market and the electronic ﬂow of dollars to and from the United States, it is easy to see why interest rates in the United States cannot be insulated from those in other parts of the world. Interest rates on Eurodollar deposits (and loans) are tied to a standard rate known by the acronym LIBOR, which stands for London Interbank Offer Rate. LIBOR is the rate of interest offered by the largest and strongest London banks on dollar deposits of signiﬁcant size. In December 2001, LIBOR rates were just a little above domestic U.S. bank rates on time deposits of the same maturity—1.93 percent for three-month CDs versus 1.78 percent for LIBOR CDs. The Eurodollar market is essentially a shortterm market; most loans and deposits are for less than one year.

International Bond Markets Any bond sold outside the country of the borrower is called an international bond. However, there are two important types of international bonds: foreign bonds and Eurobonds. Foreign bonds are bonds sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. For instance, Northern Telcom (a Canadian company) may need U.S. dollars to ﬁnance the operations of its subsidiaries in the United States. If it decides to raise the needed capital in the United States, the bond will be underwritten by a syndicate of U.S. investment bankers, denominated in U.S. dollars, and sold to U.S. investors in accordance with SEC and applicable state regulations. Except for the foreign origin of the borrower, this bond will be indistinguishable from those issued by equivalent U.S. corporations. Since Northern Telcom is a foreign corporation, however, the bond would be a foreign

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bond. Furthermore, because it is denominated in dollars and sold in the United States under SEC regulations, it is also called a Yankee bond. In contrast, if Northern Telcom issued bonds in Mexico denominated in pesos, it would be a foreign bond, but not a Yankee bond. The term Eurobond is used to designate any bond issued in one country but denominated in the currency of some other country. Examples include a Ford Motor Company issue denominated in dollars and sold in Germany, or a British ﬁrm’s sale of euro-denominated bonds in Switzerland. The institutional arrangements by which Eurobonds are marketed are different than those for most other bond issues, with the most important distinction being a far lower level of required disclosure than is usually found for bonds issued in domestic markets, particularly in the United States. Governments tend to be less strict when regulating securities denominated in foreign currencies, because the bonds’ purchasers are generally more “sophisticated.” The lower disclosure requirements result in lower total transaction costs for Eurobonds. Eurobonds appeal to investors for several reasons. Generally, they are issued in bearer form rather than as registered bonds, so the names and nationalities of investors are not recorded. Individuals who desire anonymity, whether for privacy reasons or for tax avoidance, like Eurobonds. Similarly, most governments do not withhold taxes on interest payments associated with Eurobonds. If the investor requires an effective yield of 10 percent, a Eurobond that is exempt from tax withholding would need a coupon rate of 10 percent. Another type of bond—for instance, a domestic issue subject to a 30 percent withholding tax on interest paid to foreigners—would need a coupon rate of 14.3 percent to yield an after-withholding rate of 10 percent. Investors who desire secrecy would not want to ﬁle for a refund of the tax, so they would prefer to hold the Eurobond. More than half of all Eurobonds are denominated in dollars. Bonds in Japanese yen, German marks, and Dutch guilders account for most of the rest. Although centered in Europe, Eurobonds are truly international. Their underwriting syndicates include investment bankers from all parts of the world, and the bonds are sold to investors not only in Europe but also in such faraway places as Bahrain and Singapore. Up to a few years ago, Eurobonds were issued solely by multinational ﬁrms, by international ﬁnancial institutions, or by national governments. Today, however, the Eurobond market is also being tapped by purely domestic U.S. ﬁrms, because they often ﬁnd that by borrowing overseas they can lower their debt costs.

International Stock Markets New issues of stock are sold in international markets for a variety of reasons. For example, a non-U.S. ﬁrm might sell an equity issue in the United States because it can tap a much larger source of capital than in its home country. Also, a U.S. ﬁrm might tap a foreign market because it wants to create an equity market presence to accompany its operations in that country. Large multinational companies also occasionally issue new stock simultaneously in multiple countries. For example, Alcan Aluminum, a Canadian company, recently issued new stock in Canada, Europe, and the United States simultaneously, using different underwriting syndicates in each market. In addition to new issues, outstanding stocks of large multinational companies are increasingly being listed on multiple international exchanges. For example, CocaCola’s stock is traded on six stock exchanges in the United States, four stock exchanges in Switzerland, and the Frankfurt stock exchange in Germany. Some 500 foreign stocks are listed in the United States—an example here is Royal Dutch Petroleum, which is listed on the NYSE. U.S. investors can also invest in foreign companies through American Depository Receipts (ADRs), which are certiﬁcates representing ownership of foreign stock held in trust. About 1,700 ADRs are now available in the

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565

United States, with most of them traded on the over-the-counter (OTC) market. However, more and more ADRs are being listed on the New York Stock Exchange, including England’s British Airways, Japan’s Honda Motors, and Italy’s Fiat Group. Differentiate between foreign portfolio investments and direct foreign investments. What are Eurodollars? Has the development of the Eurodollar market made it easier or more difﬁcult for the Federal Reserve to control U.S. interest rates? Differentiate between foreign bonds and Eurobonds. Why do Eurobonds appeal to investors?

Multinational Capital Budgeting Up to now, we have discussed the general environment in which multinational ﬁrms operate. In the remainder of the chapter, we will see how international factors affect key corporate decisions. We begin with capital budgeting. Although the same basic principles of capital budgeting analysis apply to both foreign and domestic operations, there are some key differences. First, cash ﬂow estimation is more complex for overseas investments. Most multinational ﬁrms set up separate subsidiaries in each foreign country in which they operate, and the relevant cash ﬂows for the parent company are the dividends and royalties paid by the subsidiaries to the parent. Second, these cash ﬂows must be converted into the parent company’s currency, hence they are subject to exchange rate risk. For example, General Motors’ German subsidiary may make a proﬁt of 100 million euros in 2002, but the value of this proﬁt to GM will depend on the dollar/euro exchange rate: How many dollars will 100 million euros buy? Dividends and royalties are normally taxed by both foreign and home-country governments. Furthermore, a foreign government may restrict the amount of the cash that may be repatriated to the parent company. For example, some governments place a ceiling, stated as a percentage of the company’s net worth, on the amount of cash dividends that a subsidiary can pay to its parent. Such restrictions are normally intended to force multinational ﬁrms to reinvest earnings in the foreign country, although restrictions are sometimes imposed to prevent large currency outﬂows, which might disrupt the exchange rate. Whatever the host country’s motivation for blocking repatriation of proﬁts, the result is that the parent corporation cannot use cash ﬂows blocked in the foreign country to pay dividends to its shareholders or to invest elsewhere in the business. Hence, from the perspective of the parent organization, the cash ﬂows relevant for foreign investment analysis are the cash ﬂows that the subsidiary is actually expected to send back to the parent. The present value of those cash ﬂows is found by applying an appropriate discount rate, and this present value is then compared with the parent’s required investment to determine the project’s NPV. In addition to the complexities of the cash ﬂow analysis, the cost of capital may be different for a foreign project than for an equivalent domestic project, because foreign projects may be more or less risky. A higher risk could arise from two primary sources—(1) exchange rate risk and (2) political risk. A lower risk might result from international diversiﬁcation. Exchange rate risk relates to the value of the basic cash ﬂows in the parent company’s home currency. The foreign currency cash ﬂows to be turned over to the parent must be converted into U.S. dollars by translating them at expected future exchange

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Stock Market Indices Around the World

In Chapter 1, we described the major U.S. stock market indices. As discussed below, similar market indices also exist for each major world ﬁnancial center. The accompanying ﬁgure compares ﬁve of the indices against the U.S. Dow Jones Industrial Average.

Hong Kong (^HSI) In Hong Kong, the primary stock index is the Hang Seng. Created by HSI Services Limited, the Hang Seng index reﬂects the performance of the Hong Kong stock market. It is composed of 33 domestic stocks that account for about 70 percent of the market’s capitalization.

Great Britain (^FTSE) The FT-SE 100 Index (pronounced “footsie”) is the most widely followed indicator of equity investments in Great Britain. It is a value-weighted index composed of the 100 largest companies on the London Stock Exchange whose value is calculated every minute of trading.

Japan (^N225) In Japan, the principal barometer of stock performance is the Nikkei 225 Index. The index’s value, which is calculated

every minute throughout daily trading, consists of a collection of highly liquid equity issues thought to be representative of the Japanese economy.

Chile (^IPSA) The Santiago Stock Exchange has three main share indices: the General Stock Price Index (IGPA), the Selective Stock Price Index (IPSA), and the INTER-10 Index. The IPSA, which reﬂects the price variations of the most active stocks, is composed of 40 of the most actively traded stocks on the exchange.

India (^BSESN) Of the 22 stock exchanges in India, the Bombay Stock Exchange (BSE) is the largest, with more than 6,000 listed stocks and approximately two-thirds of the country’s total trading volume. Established in 1875, the exchange is also the oldest in Asia. Its yardstick is the BSE Sensex, an index of 30 publicly traded Indian stocks that account for one-ﬁfth of the BSE’s market capitalization. Note: For easy access to world indices, see http://ﬁnance.yahoo.com/m2 and use the “ticker” symbols shown in parentheses.

1/93

1/94

Source: Yahoo!, http://ﬁnance.yahoo.com.

1/92

0

100

200

300

400

500

Relative Value (%)

1/95

1/96

1/97

1/98

International Stock Indices—Values Relative to January 1, 1992 (Starting Values ⫽ 100)

1/99

1/00

1/01

Chile

Japan

1/02

India

Great Britain

Hong Kong

United States

Multinational Financial Management

561

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rates. An analysis should be conducted to ascertain the effects of exchange rate variations, and, on the basis of this analysis, an exchange rate risk premium should be added to the domestic cost of capital to reﬂect this risk. It is sometimes possible to hedge against exchange rate ﬂuctuations, but it may not be possible to hedge completely, especially on long-term projects. If hedging is used, the costs of doing so must be subtracted from the project’s cash ﬂows. Political risk refers to potential actions by a host government that would reduce the value of a company’s investment. It includes at one extreme the expropriation without compensation of the subsidiary’s assets, but it also includes less drastic actions that reduce the value of the parent ﬁrm’s investment in the foreign subsidiary, including higher taxes, tighter repatriation or currency controls, and restrictions on prices charged. The risk of expropriation is small in traditionally friendly and stable countries such as Great Britain or Switzerland. However, in Latin America, Africa, the Far East, and Eastern Europe, the risk may be substantial. Past expropriations include those of ITT and Anaconda Copper in Chile, Gulf Oil in Bolivia, Occidental Petroleum in Libya, Enron Corporation in Peru, and the assets of many companies in Iraq, Iran, and Cuba. Note that companies can take several steps to reduce the potential loss from expropriation: (1) ﬁnance the subsidiary with local capital, (2) structure operations so that the subsidiary has value only as a part of the integrated corporate system, and (3) obtain insurance against economic losses from expropriation from a source such as the Overseas Private Investment Corporation (OPIC). In the latter case, insurance premiums would have to be added to the project’s cost. Several organizations rate countries according to different aspects of risk. For example, Transparency International (TI) ranks 91 countries based on perceived corruption, which is an important part of political risk. Table 15-4 shows selected countries. TI rates Finland as the most honest country, while Nigeria and Bangladesh are the lowest two. The United States is tied for ﬁfteenth. List some key differences in capital budgeting as applied to foreign versus domestic operations. What are the relevant cash ﬂows for an international investment—the cash ﬂow produced by the subsidiary in the country where it operates or the cash ﬂows in dollars that it sends to its parent company? Why might the cost of capital for a foreign project differ from that of an equivalent domestic project? Could it be lower? What adjustments might be made to the domestic cost of capital for a foreign investment due to exchange rate risk and political risk?

International Capital Structures Companies’ capital structures vary among countries. For example, the Organization for Economic Cooperation and Development (OECD) recently reported that, on average, Japanese ﬁrms use 85 percent debt to total assets (in book value terms), German ﬁrms use 64 percent, and U.S. ﬁrms use 55 percent. One problem, however, when interpreting these numbers is that different countries often use very different accounting conventions with regard to (1) reporting assets on a historical- versus a replacement-cost basis, (2) the treatment of leased assets, (3) pension plan funding, and (4) capitalizing versus expensing R&D costs. These differences make it difﬁcult to compare capital structures. A study by Raghuram Rajan and Luigi Zingales of the University of Chicago attempted to control for differences in accounting practices. In their study, Rajan and

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Multinational Financial Management International Capital Structures TABLE 15-4

The 2001 Transparency International Corruption Perceptions Index (CPI)

Top-Ranked Countries Rank

1 2 3 4 (Tie) 6 7 8 9 10

569

Country

Bottom-Ranked Countries

2001 CPI Score

Rank

9.9 9.5 9.4 9.2 9.2 9.0 8.9 8.8 8.7 8.6

82 83 84 (Tie)

Finland Denmark New Zealand Iceland Singapore Sweden Canada Netherlands Luxembourg Norway

88 (Tie) 90 91

Country

Tanzania Ukraine Azerbaijan Bolivia Cameroon Kenya Indonesia Uganda Nigeria Bangladesh

2001 CPI Score

2.2 2.1 2.0 2.0 2.0 2.0 1.9 1.9 1.0 0.4

Source: http://www.transparency.org/cpi/2001/cpi2001.html. Reprinted by permission.

Zingales used a database that covered fewer ﬁrms than the OECD but that provided a more complete breakdown of balance sheet data. They concluded that differences in accounting practices can explain much of the cross-country variation in capital structures. Rajan and Zingales’ results are summarized in Table 15-5. There are a number of different ways to measure capital structure. One measure is the average ratio of total liabilities to total assets—this is similar to the measure used by the OECD, and it is reported in Column 1. Based on this measure, German and Japanese ﬁrms appear to be more highly levered than U.S. ﬁrms. However, if you look at Column 2, where capital structure is measured by interest-bearing debt to total assets, it appears that TABLE 15-5

Country

Canada France Germany Italy Japan United Kingdom United States Mean Standard deviation

Median Capital Structures among Large Industrialized Countries (Measured in Terms of Book Value)

Total Liabilities to Total Assets (Unadjusted for Accounting Differences) (1)

Interest-Bearing Debt to Total Assets (Unadjusted for Accounting Differences) (2)

Total Liabilities to Total Assets (Adjusted for Accounting Differences) (3)

Debt to Total Assets (Adjusted for Accounting Differences) (4)

Times-InterestEarned (TIE) Ratio (5)

56% 71 73 70 69 54 58 64% 8%

32% 25 16 27 35 18 27 26% 7%

48% 69 50 68 62 47 52 57% 10%

32% 18 11 21 21 10 25 20% 8%

1.55⫻ 2.64 3.20 1.81 2.46 4.79 2.41 2.69⫻ 1.07⫻

Source: Raghuram Rajan and Luigi Zingales, “What Do We Know about Capital Structure? Some Evidence from International Data,” The Journal of Finance, Vol. 50, no. 5, December 1995, 1421–1460. Used with permission.

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German ﬁrms use less leverage than U.S. and Japanese ﬁrms. What explains this difference? Rajan and Zingales argue that much of this difference is explained by the way German ﬁrms account for pension liabilities. German ﬁrms generally include all pension liabilities (and their offsetting assets) on the balance sheet, whereas ﬁrms in other countries (including the United States) generally “net out” pension assets and liabilities on their balance sheets. To see the importance of this difference, consider a ﬁrm with $10 million in liabilities (not including pension liabilities) and $20 million in assets (not including pension assets). Assume that the ﬁrm has $10 million in pension liabilities that are fully funded by $10 million in pension assets. Therefore, net pension liabilities are zero. If this ﬁrm were in the United States, it would report a ratio of total liabilities to total assets equal to 50 percent ($10 million/$20 million). By contrast, if this ﬁrm operated in Germany, both its pension assets and liabilities would be reported on the balance sheet. The ﬁrm would have $20 million in liabilities and $30 million in assets—or a 67 percent ($20 million/$30 million) ratio of total liabilities to total assets. Total debt is the sum of short-term debt and long-term debt and excludes other liabilities including pension liabilities. Therefore, the measure of total debt to total assets provides a more comparable measure of leverage across different countries. Rajan and Zingales also make a variety of adjustments that attempt to control for other differences in accounting practices. The effect of these adjustments are reported in Columns 3 and 4. Overall, the evidence suggests that companies in Germany and the United Kingdom tend to have less leverage, whereas ﬁrms in Canada appear to have more leverage, relative to ﬁrms in the United States, France, Italy, and Japan. This conclusion is supported by data in the ﬁnal column, which shows the average times-interest-earned ratio for ﬁrms in a number of different countries. Recall from Chapter 10 that the times-interest-earned ratio is the ratio of operating income (EBIT) to interest expense. This measure indicates how much cash the ﬁrm has available to service its interest expense. In general, ﬁrms with more leverage have a lower times-interest-earned ratio. The data indicate that this ratio is highest in the United Kingdom and Germany and lowest in Canada. Do international differences in ﬁnancial leverage exist? Explain.

Multinational Working Capital Management Cash Management The goals of cash management in a multinational corporation are similar to those in a purely domestic corporation: (1) to speed up collections, slow down disbursements, and thus maximize net ﬂoat; (2) to shift cash as rapidly as possible from those parts of the business where it is not needed to those parts where it is needed; and (3) to maximize the risk-adjusted, after-tax rate of return on temporary cash balances. Multinational companies use the same general procedures for achieving these goals as domestic ﬁrms, but because of longer distances and more serious mail delays, such devices as lockbox systems and electronic funds transfers are especially important. Although multinational and domestic corporations have the same objectives and use similar procedures, multinational corporations face a far more complex task. As noted earlier in our discussion of political risk, foreign governments often place

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restrictions on transfers of funds out of the country, so although IBM can transfer money from its Salt Lake City ofﬁce to its New York concentration bank just by pressing a few buttons, a similar transfer from its Buenos Aires ofﬁce is far more complex. Buenos Aires funds are denominated in australs (Argentina’s equivalent of the dollar), so the australs must be converted to dollars before the transfer. If there is a shortage of dollars in Argentina, or if the Argentinean government wants to conserve dollars so they will be available for the purchase of strategic materials, then conversion, hence the transfer, may be blocked. Even if no dollar shortage exists in Argentina, the government may still restrict funds outﬂows if those funds represent proﬁts or depreciation rather than payments for purchased materials or equipment, because many countries, especially those that are less developed, want proﬁts reinvested in the country in order to stimulate economic growth. Once it has been determined what funds can be transferred, the next task is to get those funds to locations where they will earn the highest returns. Whereas domestic corporations tend to think in terms of domestic securities, multinationals are more likely to be aware of investment opportunities all around the world. Most multinational corporations use one or more global concentration banks, located in money centers such as London, New York, Tokyo, Zurich, or Singapore, and their staffs in those cities, working with international bankers, are able to take advantage of the best rates available anywhere in the world.

Credit Management Like most other aspects of ﬁnance, credit management in the multinational corporation is similar to but more complex than that in a purely domestic business. First, granting credit is more risky in an international context because, in addition to the normal risks of default, the multinational corporation must also worry about exchange rate ﬂuctuations between the time a sale is made and the time a receivable is collected. For example, if IBM sold a computer to a Japanese customer for 90 million yen when the exchange rate was 90 yen to the dollar, IBM would obtain 90,000,000/90 ⫽ $1,000,000 for the computer. However, if it sold the computer on terms of net/6 months, and if the yen fell against the dollar so that one dollar would now buy 112.5 yen, IBM would end up realizing only 90,000,000/112.5 ⫽ $800,000 when it collected the receivable. Hedging can reduce this type of risk, but at a cost. Offering credit is generally more important for multinational corporations than for purely domestic ﬁrms for two reasons. First, much U.S. trade is with poorer, lessdeveloped nations, where granting credit is generally a necessary condition for doing business. Second, and in large part as a result of the ﬁrst point, developed nations whose economic health depends on exports often help their manufacturing ﬁrms compete internationally by granting credit to foreign countries. In Japan, for example, the major manufacturing ﬁrms have direct ownership ties with large “trading companies” engaged in international trade, as well as with giant commercial banks. In addition, a government agency, the Ministry of International Trade and Industry (MITI), helps Japanese ﬁrms identify potential export markets and also helps potential customers arrange credit for purchases from Japanese ﬁrms. In effect, the huge Japanese trade surpluses are used to ﬁnance Japanese exports, thus helping to perpetuate their favorable trade balance. The United States has attempted to counter with the ExportImport Bank, which is funded by Congress, but the fact that the United States has a large balance of payments deﬁcit is clear evidence that we have been less successful than others in world markets in recent years. The huge debt that countries such as Korea and Thailand owe U.S. and other international banks is well known, and this situation illustrates how credit policy (by

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banks in this case) can go astray. The banks face a particularly sticky problem with these loans, because if a sovereign nation defaults, the banks cannot lay claim to the assets of the country as they could if a corporate customer defaulted. Note too that although the banks’ loans to foreign governments often get most of the headlines, many U.S. multinational corporations are also in trouble as a result of granting credit to business customers in the same countries where bank loans to governments are on shaky ground. By pointing out the risks in granting credit internationally, we are not suggesting that such credit is bad. Quite the contrary, for the potential gains from international operations far outweigh the risks, at least for companies (and banks) that have the necessary expertise.

Inventory Management As with most other aspects of ﬁnance, inventory management in a multinational setting is similar to but more complex than for a purely domestic ﬁrm. First, there is the matter of the physical location of inventories. For example, where should Exxon Mobil keep its stockpiles of crude oil and reﬁned products? It has reﬁneries and marketing centers located worldwide, and one alternative is to keep items concentrated in a few strategic spots from which they can then be shipped as needs arise. Such a strategy might minimize the total amount of inventories needed and thus might minimize the investment in inventories. Note, though, that consideration will have to be given to potential delays in getting goods from central storage locations to user locations all around the world. Both working stocks and safety stocks would have to be maintained at each user location, as well as at the strategic storage centers. Problems like the Iraqi occupation of Kuwait in 1990 and the subsequent trade embargo, which brought with it the potential for a shutdown of production of about 25 percent of the world’s oil supply, complicate matters further. Exchange rates also inﬂuence inventory policy. If a local currency, say, the Danish krone, were expected to rise in value against the dollar, a U.S. company operating in Denmark would want to increase stocks of local products before the rise in the krone, and vice versa if the krone were expected to fall. Another factor that must be considered is the possibility of import or export quotas or tariffs. For example, Apple Computer Company was buying certain memory chips from Japanese suppliers at a bargain price. Then U.S. chipmakers accused the Japanese of dumping chips in the U.S. market at prices below cost, so they sought to force the Japanese to raise prices.6 That led Apple to increase its chip inventory. Then computer sales slacked off, and Apple ended up with an oversupply of obsolete computer chips. As a result, Apple’s proﬁts were hurt and its stock price fell, demonstrating once more the importance of careful inventory management. As mentioned earlier, another danger in certain countries is the threat of expropriation. If that threat is large, inventory holdings will be minimized, and goods will be brought in only as needed. Similarly, if the operation involves extraction of raw 6

The term “dumping” warrants explanation, because the practice is so potentially important in international markets. Suppose Japanese chipmakers have excess capacity. A particular chip has a variable cost of $25, and its “fully allocated cost,” which is the $25 plus total ﬁxed cost per unit of output, is $40. Now suppose the Japanese ﬁrm can sell chips in the United States at $35 per unit, but if it charges $40, it will not make any sales because U.S. chipmakers sell for $35.50. If the Japanese ﬁrm sells at $35, it will cover variable cost plus make a contribution to ﬁxed overhead, so selling at $35 makes sense. Continuing, if the Japanese ﬁrm can sell in Japan at $40, but U.S. ﬁrms are excluded from Japanese markets by import duties or other barriers, the Japanese will have a huge advantage over U.S. manufacturers. This practice of selling goods at lower prices in foreign markets than at home is called “dumping.” U.S. ﬁrms are required by antitrust laws to offer the same price to all customers and, therefore, cannot engage in dumping.

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materials such as oil or bauxite, processing plants may be moved offshore rather than located close to the production site. Taxes have two effects on multinational inventory management. First, countries often impose property taxes on assets, including inventories, and when this is done, the tax is based on holdings as of a speciﬁc date, say, January 1 or March 1. Such rules make it advantageous for a multinational ﬁrm (1) to schedule production so that inventories are low on the assessment date, and (2) if assessment dates vary among countries in a region, to hold safety stocks in different countries at different times during the year. Finally, multinational ﬁrms may consider the possibility of at-sea storage. Oil, chemical, grain, and other companies that deal in a bulk commodity that must be stored in some type of tank can often buy tankers at a cost not much greater—or perhaps even less, considering land cost—than land-based facilities. Loaded tankers can then be kept at sea or at anchor in some strategic location. This eliminates the danger of expropriation, minimizes the property tax problem, and maximizes ﬂexibility with regard to shipping to areas where needs are greatest or prices highest. This discussion has only scratched the surface of inventory management in the multinational corporation—the task is much more complex than for a purely domestic ﬁrm. However, the greater the degree of complexity, the greater the rewards from superior performance, so if you want challenge along with potentially high rewards, look to the international arena. What are some factors that make cash management especially complicated in a multinational corporation? Why is granting credit especially risky in an international context? Why is inventory management especially important for a multinational ﬁrm?

Summary Over the past two decades, the global economy has become increasingly integrated, and more and more companies generate more and more of their proﬁts from overseas operations. In many respects, the concepts developed in the ﬁrst 14 chapters still apply to multinational ﬁrms. However, multinational companies have more opportunities but also face different risks than do companies that operate only in their home market. The chapter discussed many of the key trends affecting the global markets today, and it described the most important differences between multinational and domestic ﬁnancial management. The key concepts are listed below: 䊉

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International operations are becoming increasingly important to individual ﬁrms and to the national economy. A multinational, or global, corporation is a ﬁrm that operates in an integrated fashion in a number of countries. Companies “go global” for six primary reasons: (1) to expand their markets, (2) to obtain raw materials, (3) to seek new technology, (4) to lower production costs, (5) to avoid trade barriers, and (6) to diversify. Six major factors distinguish ﬁnancial management as practiced by domestic ﬁrms from that practiced by multinational corporations: (1) different currency denominations, (2) different economic and legal structures, (3) languages, (4) cultural differences, (5) role of governments, and (6) political risk. When discussing exchange rates, the number of U.S. dollars required to purchase one unit of a foreign currency is called a direct quotation, while the number of units of foreign currency that can be purchased for one U.S. dollar is an indirect quotation.

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Multinational Financial Management 䊉

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Exchange rate ﬂuctuations make it difﬁcult to estimate the dollars that overseas operations will produce. Prior to August 1971, the world was on a ﬁxed exchange rate system whereby the U.S. dollar was linked to gold, and other currencies were then tied to the dollar. After August 1971, the world monetary system changed to a ﬂoating system under which major world currency rates ﬂoat with market forces, largely unrestricted by governmental intervention. The central bank of each country does operate in the foreign exchange market, buying and selling currencies to smooth out exchange rate ﬂuctuations, but only to a limited extent. The consolidation of the European market has had a profound impact on European exchange rates. The exchange rates for the currencies of each of the participating countries are now ﬁxed relative to the euro. Consequently, the cross rates between the various participating currencies are also ﬁxed. However, the value of the euro continues to ﬂuctuate. Pegged exchange rates occur when a country establishes a ﬁxed exchange rate with a major currency. Consequently, the values of pegged currencies move together over time. A convertible currency is one that may be readily exchanged for other currencies. Spot rates are the rates paid for delivery of currency “on the spot,” while the forward exchange rate is the rate paid for delivery at some agreed-upon future date, usually 30, 90, or 180 days from the day the transaction is negotiated. The forward rate can be at either a premium or a discount to the spot rate. Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk. Purchasing power parity, sometimes referred to as the law of one price, implies that the level of exchange rates adjusts so that identical goods cost the same in different countries. Granting credit is more risky in an international context because, in addition to the normal risks of default, the multinational ﬁrm must worry about exchange rate changes between the time a sale is made and the time a receivable is collected. Credit policy is important for a multinational ﬁrm for two reasons: (1) Much trade is with less-developed nations, and in such situations granting credit is a necessary condition for doing business. (2) The governments of nations such as Japan whose economic health depends upon exports often help their ﬁrms compete by granting credit to foreign customers. Foreign investments are similar to domestic investments, but political risk and exchange rate risk must be considered. Political risk is the risk that the foreign government will take some action that will decrease the value of the investment, while exchange rate risk is the risk of losses due to ﬂuctuations in the value of the dollar relative to the values of foreign currencies. Investments in international capital projects expose ﬁrms to exchange rate risk and political risk. The relevant cash ﬂows in international capital budgeting are the dollars that can be repatriated to the parent company. Eurodollars are U.S. dollars deposited in banks outside the United States. Interest rates on Eurodollars are tied to LIBOR, the London Interbank Offer Rate. U.S. ﬁrms often ﬁnd that they can raise long-term capital at a lower cost outside the United States by selling bonds in the international capital markets. International bonds may be either foreign bonds, which are exactly like regular domestic bonds except that the issuer is a foreign company, or Eurobonds, which are bonds sold in a foreign country but denominated in the currency of the issuing company’s home country.

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Questions 15–1

Deﬁne each of the following terms: a. Multinational corporation b. Exchange rate; ﬁxed exchange rate system; ﬂoating exchange rates c. Trade deﬁcit; devaluation; revaluation d. Exchange rate risk; convertible currency; pegged exchange rates e. Interest rate parity; purchasing power parity f. Spot rate; forward exchange rate; discount on forward rate; premium on forward rate g. Repatriation of earnings; political risk h. Eurodollar; Eurobond; international bond; foreign bond i. The euro

15–2

Under the ﬁxed exchange rate system, what was the currency against which all other currency values were deﬁned? Why?

15–3

Exchange rates ﬂuctuate under both the ﬁxed exchange rate and ﬂoating exchange rate systems. What, then, is the difference between the two systems?

15–4

If the Swiss franc depreciates against the U.S. dollar, can a dollar buy more or fewer Swiss francs as a result?

15–5

If the United States imports more goods from abroad than it exports, foreigners will tend to have a surplus of U.S. dollars. What will this do to the value of the dollar with respect to foreign currencies? What is the corresponding effect on foreign investments in the United States?

15–6

Why do U.S. corporations build manufacturing plants abroad when they could build them at home?

15–7

Should ﬁrms require higher rates of return on foreign projects than on identical projects located at home? Explain.

15–8

What is a Eurodollar? If a French citizen deposits $10,000 in Chase Manhattan Bank in New York, have Eurodollars been created? What if the deposit is made in Barclay’s Bank in London? Chase Manhattan’s Paris branch? Does the existence of the Eurodollar market make the Federal Reserve’s job of controlling U.S. interest rates easier or more difﬁcult? Explain.

15–9

Does interest rate parity imply that interest rates are the same in all countries?

15–10

Why might purchasing power parity fail to hold?

Self-Test Problem ST–1 CROSS RATES

(Solution Appears in Appendix A)

Suppose the exchange rate between U.S. dollars and EMU euros is Euro 0.98 ⫽ $1.00, and the exchange rate between the U.S. dollar and the Canadian dollar is $1.00 ⫽ C$1.50. What is the cross rate of euros to Canadian dollars?

Problems 15–1 CROSS RATES

15–2 INTEREST RATE PARITY

A currency trader observes that in the spot exchange market, 1 U.S. dollar can be exchanged for 9 Mexican pesos or for 111.23 Japanese yen. What is the cross-exchange rate between the yen and the peso; that is, how many yen would you receive for every peso exchanged? Six-month T-bills have a nominal rate of 7 percent, while default-free Japanese bonds that mature in 6 months have a nominal rate of 5.5 percent. In the spot exchange market, 1 yen equals $0.009. If interest rate parity holds, what is the 6-month forward exchange rate?

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15–3 PURCHASING POWER PARITY

15–4 EXCHANGE RATE

15–5 CURRENCY APPRECIATION

15–6 CROSS EXCHANGE RATES

15–7 FOREIGN INVESTMENT ANALYSIS

15–8 EXCHANGE GAINS AND LOSSES

15–9 RESULTS OF EXCHANGE RATE CHANGES

15–10 SPOT AND FORWARD RATES

A television set costs $500 in the United States. The same set costs 550 euros in France. If purchasing power parity holds, what is the spot exchange rate between the euro and the dollar? If British pounds sell for $1.50 (U.S.) per pound, what should dollars sell for in pounds per dollar? Suppose that 1 Swiss franc could be purchased in the foreign exchange market for 60 U.S. cents today. If the franc appreciated 10 percent tomorrow against the dollar, how many francs would a dollar buy tomorrow? Suppose the exchange rate between U.S. dollars and the Swiss franc was SFr1.6 ⫽ $1, and the exchange rate between the dollar and the British pound was £1 ⫽ $1.50. What was the exchange rate between francs and pounds? After all foreign and U.S. taxes, a U.S. corporation expects to receive 3 pounds of dividends per share from a British subsidiary this year. The exchange rate at the end of the year is expected to be $1.60 per pound, and the pound is expected to depreciate 5 percent against the dollar each year for an indeﬁnite period. The dividend (in pounds) is expected to grow at 10 percent a year indeﬁnitely. The parent U.S. corporation owns 10 million shares of the subsidiary. What is the present value in dollars of its equity ownership of the subsidiary? Assume a cost of equity capital of 15 percent for the subsidiary. You are the vice-president of International InfoXchange, headquartered in Chicago, Illinois. All shareholders of the ﬁrm live in the United States. Earlier this month, you obtained a loan of 5 million Canadian dollars from a bank in Toronto to ﬁnance the construction of a new plant in Montreal. At the time the loan was received, the exchange rate was 75 U.S. cents to the Canadian dollar. By the end of the month, it has unexpectedly dropped to 70 cents. Has your company made a gain or loss as a result, and by how much? Early in September 1983, it took 245 Japanese yen to equal $1. More than 17 years later that exchange rate had fallen to 108 yen to $1. Assume the price of a Japanese-manufactured automobile was $8,000 in September 1983 and that its price changes were in direct relation to exchange rates. a. Has the price, in dollars, of the automobile increased or decreased during the 17-year period because of changes in the exchange rate? b. What would the dollar price of the car be, assuming the car’s price changes only with exchange rates? Boisjoly Watch Imports has agreed to purchase 15,000 Swiss watches for 1 million francs at today’s spot rate. The ﬁrm’s ﬁnancial manager, James Desreumaux, has noted the following current spot and forward rates:

Spot 30-day forward 90-day forward 180-day forward

U.S. Dollar/Franc

Franc/U.S. Dollar

1.6590 1.6540 1.6460 1.6400

0.6028 0.6046 0.6075 0.6098

On the same day, Desreumaux agrees to purchase 15,000 more watches in 3 months at the same price of 1 million francs. a. What is the price of the watches, in U.S. dollars, if purchased at today’s spot rate? b. What is the cost, in dollars, of the second 15,000 batch if payment is made in 90 days and the spot rate at that time equals today’s 90-day forward rate? c. If the exchange rate for the Swiss franc is 0.50 to $1 in 90 days, how much will he have to pay for the watches (in dollars)? 15–11 INTEREST RATE PARITY

Assume that interest rate parity holds and that 90-day risk-free securities yield 5 percent in the United States and 5.3 percent in Germany. In the spot market, 1 euro equals $0.80 dollar. a. Is the 90-day forward rate trading at a premium or discount relative to the spot rate? b. What is the 90-day forward rate?

571

Multinational Financial Management Spreadsheet Problem 15–12 INTEREST RATE PARITY

15–13 PURCHASING POWER PARITY

577

Assume that interest rate parity holds. In both the spot market and the 90-day forward market 1 Japanese yen equals 0.0086 dollar. The 90-day risk-free securities yield 4.6 percent in Japan. What is the yield on 90-day risk-free securities in the United States? In the spot market 7.8 pesos can be exchanged for 1 U.S. dollar. A compact disk costs $15 in the United States. If purchasing power parity holds, what should be the price of the same disk in Mexico?

Spreadsheet Problem 15–14 BUILD A MODEL: MULTINATIONAL FINANCIAL MANAGEMENT

Start with the partial model in the ﬁle Ch 15 P14 Build a Model.xls from the textbook’s web site. Yohe Telecommunications is a multinational corporation that produces and distributes telecommunications technology. Although its corporate headquarters are located in Maitland, Florida, Yohe usually must buy its raw materials in several different foreign countries using several different foreign currencies. The matter is further complicated because Yohe usually sells its products in other foreign countries. One product in particular, the SY-20 radio transmitter, draws its principal components, Component X, Component Y, and Component Z, from Germany, Mexico, and England, respectively. Speciﬁcally, Component X costs 84 euros, Component Y costs 650 Mexican pesos, and Component Z costs 105 British pounds. The largest market for the SY-20 is in Japan, where it sells for 38,000 Japanese yen. Naturally, Yohe is intimately concerned with economic conditions that could adversely affect dollar exchange rates. You will ﬁnd Tables 15-1, 15-2, and 15-3 useful for this problem. a. How much, in dollars, does it cost for Yohe to produce the SY-20? What is the dollar sale price of the SY-20? b. What is the dollar proﬁt that Yohe makes on the sale of the SY-20? What is the percentage proﬁt? c. If the U.S. dollar were to weaken by 10 percent against all foreign currencies, what would be the dollar proﬁt for the SY-20? d. If the U.S. dollar were to weaken by 10 percent only against the Japanese yen and remained constant relative to all other foreign currencies, what would be the dollar and percentage proﬁts for the SY-20? e. Using the forward exchange information from Table 15-3, calculate the return on 1-year securities in Germany, if the rate of return on 1-year securities in the U.S. is 4.9 percent. f. Assuming that purchasing power parity (PPP) holds, what would be the sale price of the SY20 if it were sold in England rather than Japan?

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See Ch 15 Show.ppt and Ch 15 Mini Case.xls.

Multinational Financial Management

Citrus Products Inc. is a medium-sized producer of citrus juice drinks with groves in Indian River County, Florida. Until now, the company has conﬁned its operations and sales to the United States, but its CEO, George Gaynor, wants to expand into Europe. The ﬁrst step would be to set up sales subsidiaries in Spain and Sweden, then to set up a production plant in Spain, and, ﬁnally, to distribute the product throughout the European common market. The ﬁrm’s ﬁnancial manager, Ruth Schmidt, is enthusiastic about the plan, but she is worried about the implications of the foreign expansion on the ﬁrm’s ﬁnancial management process. She has asked you, the ﬁrm’s most recently hired ﬁnancial analyst, to develop a 1-hour tutorial package that explains the basics of multinational ﬁnancial management. The tutorial will be presented at the next board of directors meeting. To get you started, Schmidt has supplied you with the following list of questions. a. What is a multinational corporation? Why do ﬁrms expand into other countries? b. What are the six major factors which distinguish multinational ﬁnancial management from ﬁnancial management as practiced by a purely domestic ﬁrm? c. Consider the following illustrative exchange rates. U.S. Dollars Required to Buy One Unit of Foreign Currency

Euro Swedish krona

(1) (2) (3) (4)

d. e. f. g.

h. i. j. k. l.

0.8000 0.1000

Are these currency prices direct quotations or indirect quotations? Calculate the indirect quotations for euros and kronas. What is a cross rate? Calculate the two cross rates between euros and kronas. Assume Citrus Products can produce a liter of orange juice and ship it to Spain for $1.75. If the ﬁrm wants a 50 percent markup on the product, what should the orange juice sell for in Spain? (5) Now, assume Citrus Products begins producing the same liter of orange juice in Spain. The product costs 2.0 euros to produce and ship to Sweden, where it can be sold for 20 kronas. What is the dollar proﬁt on the sale? (6) What is exchange rate risk? Brieﬂy describe the current international monetary system. How does the current system differ from the system that was in place prior to August 1971? What is a convertible currency? What problems arise when a multinational company operates in a country whose currency is not convertible? What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? At a discount? What is interest rate parity? Currently, you can exchange 1 euro for 0.8100 dollar in the 180-day forward market, and the risk-free rate on 180-day securities is 6 percent in the United States and 4 percent in Spain. Does interest rate parity hold? If not, which securities offer the highest expected return? What is purchasing power parity? If grapefruit juice costs $2.00 a liter in the United States and purchasing power parity holds, what should be the price of grapefruit juice in Spain? What impact does relative inﬂation have on interest rates and exchange rates? Brieﬂy discuss the international capital markets. To what extent do average capital structures vary across different countries? What is the impact of multinational operations on each of the following ﬁnancial management topics? (1) Cash management. (2) Capital budgeting decisions. (3) Credit management. (4) Inventory management.

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Selected Additional References and Cases Perhaps the best way to obtain more information on multinational ﬁnancial management is to consult one of the many excellent textbooks on the subject. For example, see Eaker, Mark R., Frank J. Fabozzi, and Dwight Grant, International Corporate Finance (Fort Worth, TX: The Dryden Press, 1996). Levi, Maurice, International Finance (New York: McGrawHill, 1996). Madura, Jeff, International Financial Management (St. Paul: West, 1995). For some articles on multinational ﬁnancial management, see Carre, Herve, and Karen H. Johnson, “Progress Toward a European Monetary Union,” Federal Reserve Bulletin, October 1991, 769–783. Choi, Jongmoo Jay, and Anita Mehra Prasad, “Exchange Risk Sensitivity and Its Determinants: A Firm and Industry Analysis of U.S. Multinationals,” Financial Management, Autumn 1995, 77–88. Frankel, Jeffrey A., “The Japanese Cost of Finance,” Financial Management, Spring 1991, 95–127. Hammer, Jerry A., “Hedging Performance and Hedging Objectives: Tests of New Performance Measures in the Foreign Currency Market,” Journal of Financial Research, Winter 1990, 307–323.

Hunter, William C., and Stephen G. Timme, “A Stochastic Dominance Approach to Evaluating Foreign Exchange Hedging Strategies,” Financial Management, Autumn 1992, 104–112. Kester, George W., Rosita P. Chang, and Kai-Chong Tsui, “Corporate Financial Policy in the Paciﬁc Basin: Hong Kong and Singapore,” Financial Practice and Education, Spring/Summer 1994, 117–127. Lee, Insup, and Steve B. Wyatt, “The Effects of International Joint Ventures on Shareholder Wealth,” Financial Review, November 1990. Mahajan, Arvind, “Pricing Expropriation Risk,” Financial Management, Winter 1990, 77–86. Pauls, B. Dianne, “U.S. Exchange Rate Policy: Bretton Woods to Present,” Federal Reserve Bulletin, November 1990, 891–908. The following case from the Cases in Financial Management: series focuses on multinational capital budgeting: Case 18, “Alaska Oil Corporation.”

16 16

Working Capital Management Dramatic improvements in computer technology and the growth in the Internet have transformed the computer industry. Some companies have succeeded while others have failed. Despite some recent setbacks, Dell Computer has clearly been one that has succeeded: Its sales have grown from roughly $5 billion in 1995 to more than $30 billion in 2000. There are a lot of reasons behind Dell’s remarkable success over the past decade. Perhaps the number one reason is the company’s impressive success in managing its working capital, which is the focus of this chapter. The key to Dell’s success is its ability to build and deliver customized computers very quickly. Traditionally, manufacturers of custom-design products had two choices. They could keep a large supply of inventory on hand to meet customer needs, or they could make their customers wait for weeks while the customized product was being built. Dell uses information technology to revolutionize working capital management. First, it uses information technology to better coordinate with its suppliers. If a supplier wants to do business with Dell, it must link its information system with Dell’s, and provide the necessary components quickly and cheaply. Suppliers that adapt and meet Dell’s demands are rewarded with increased business. Second, Dell uses information technology to collect data that enables it to better customize products for its customers. For example, Dell has been able to capture most of the Ford Motor Company’s PC business by anticipating and quickly ﬁlling its orders. Sound working capital management is necessary if a company wants to compete in the information age, and the lessons taught by Dell extend to other industries. Indeed, Michael Dell, founder and CEO of Dell Computer, recently discussed in an interview with The Wall Street Journal how traditional manufacturers, such as the automobile companies, can use the experience of Dell to improve their operations. The article included Michael Dell’s ﬁve points on how to build a better car: 1. 2. 3. 4.

Use the Internet to lower the costs of linking manufacturers, suppliers, and dealers. Turn over to an outside specialist any operation that isn’t central to the business. Accelerate the pace of change, and get employees conditioned to accept change. Experiment with Internet businesses. Set up trials to see what happens when customers can access information more easily, and in ways they never could before. 5. Think about what could be done with the capital that would be freed up by shedding excessive inventory and other redundant assets. Sources: J. William Gurley and Jane Hodges, “A Dell for Every Industry,” Fortune, October 12, 1998, 167–172; and Gary McWilliams and Joseph B. White, “Dell to Detroit: Get into Gear Online!” The Wall Street Journal, December 1, 1999, B1.

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Working capital management involves two basic questions: (1) What is the appropriate amount of current assets, both in total and for each speciﬁc account, and (2) how should those current assets be ﬁnanced? Note that, sound working capital management goes beyond ﬁnance. Indeed, the ideas for improving working capital manageThe textbook's web site ment often stem from other disciplines. For example, experts in logistics, operations contains an Excel ﬁle that management, and information technology often work with the marketing group to will guide you through the chapter’s calculations. The develop a better way to deliver the ﬁrm’s products. Where ﬁnance comes into play is ﬁle for this chapter is Ch 16 in evaluating the proﬁtability of alternative proposals. In addition, ﬁnancial managers Tool Kit.xls, and we encourdetermine how much cash a company must keep on hand, and how much short-term age you to open the ﬁle and follow along as you read the ﬁnancing it should use. chapter.

Working Capital Terminology We begin our discussion of working capital policy by reviewing some basic deﬁnitions and concepts: 1. Working capital, sometimes called gross working capital, simply refers to current assets used in operations. 2. Net working capital is deﬁned as current assets minus current liabilities. 3. Net operating working capital (NOWC) is deﬁned as operating current assets minus operating current liabilities. Generally, NOWC is equal to cash, accounts receivable, and inventories, less accounts payable and accruals. The term working capital originated with the old Yankee peddler, who would load up his wagon with goods and then go off on his route to peddle his wares. The merchandise was called working capital because it was what he actually sold, or “turned over,” to produce his proﬁts. The wagon and horse were his ﬁxed assets. He generally owned the horse and wagon, so they were ﬁnanced with “equity” capital, but he borrowed the funds to buy the merchandise. These borrowings were called working capital loans, and they had to be repaid after each trip to demonstrate to the bank that the credit was sound. If the peddler was able to repay the loan, then the bank would make another loan, and banks that followed this procedure were said to be employing “sound banking practices.” How did the term “working capital” originate? Differentiate between net working capital and net operating working capital.

The Cash Conversion Cycle As we noted above, the concept of working capital management originated with the old Yankee peddler, who would borrow to buy inventory, sell the inventory to pay off the bank loan, and then repeat the cycle. That concept has been applied to more complex businesses, where it is used to analyze the effectiveness of a ﬁrm’s working capital management. Firms typically follow a cycle in which they purchase inventory, sell goods on credit, and then collect accounts receivable. This cycle is referred to as the cash conversion cycle, and it is discussed in detail in the next section. Sound working capital policy is designed to minimize the time between cash expenditures on materials and the collection of cash on sales.

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An Illustration We can illustrate the process with data from Real Time Computer Corporation (RTC), which in early 2002 introduced a new minicomputer that can perform one billion instructions per second and that will sell for $250,000. RTC expects to sell 40 computers in its ﬁrst year of production. The effects of this new product on RTC’s working capital position were analyzed in terms of the following ﬁve steps: 1. RTC will order and then receive the materials it needs to produce the 40 computers it expects to sell. Because RTC and most other ﬁrms purchase materials on credit, this transaction will create an account payable. However, the purchase will have no immediate cash ﬂow effect. 2. Labor will be used to convert the materials into ﬁnished computers. However, wages will not be fully paid at the time the work is done, so, like accounts payable, accrued wages will also build up. 3. The ﬁnished computers will be sold, but on credit. Therefore, sales will create receivables, not immediate cash inﬂows. 4. At some point before cash comes in, RTC must pay off its accounts payable and accrued wages. This outﬂow must be ﬁnanced. 5. The cycle will be completed when RTC’s receivables have been collected. At that time, the company can pay off the credit that was used to ﬁnance production, and it can then repeat the cycle. The cash conversion cycle model, which focuses on the length of time between when the company makes payments and when it receives cash inﬂows, formalizes the steps outlined above.1 The following terms are used in the model: 1. Inventory conversion period, which is the average time required to convert materials into ﬁnished goods and then to sell those goods. Note that the inventory conversion period is calculated by dividing inventory by sales per day. For example, if average inventories are $2 million and sales are $10 million, then the inventory conversion period is 73 days: Inventory conversion period

Inventory Sales per day

(16-1)

$2,000,000 $10,000,000/365 73 days.

Thus, it takes an average of 73 days to convert materials into ﬁnished goods and then to sell those goods.2 2. Receivables collection period, which is the average length of time required to convert the ﬁrm’s receivables into cash, that is, to collect cash following a sale. The receivables collection period is also called the days sales outstanding (DSO), and it is calculated by dividing accounts receivable by the average credit sales per day. If receivables are $657,534 and sales are $10 million, the receivables collection period is

1

See Verlyn D. Richards and Eugene J. Laughlin, “A Cash Conversion Cycle Approach to Liquidity Analysis,” Financial Management, Spring 1980, 32–38. 2 Some analysts deﬁne the inventory conversion period as inventory divided by daily cost of goods sold. However, most published sources use the formula we show in Equation 16-1. In addition, some analysts use a 360-day year; however, unless stated otherwise, we will base all our calculations on a 365-day year.

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Working Capital Management The Cash Conversion Cycle

Receivables Receivables DSO collection period Sales/365

583

(16-2)

$657,534 24 days. $10,000,000/365

Thus, it takes 24 days after a sale to convert the receivables into cash. 3. Payables deferral period, which is the average length of time between the purchase of materials and labor and the payment of cash for them. For example, if the ﬁrm on average has 30 days to pay for labor and materials, if its cost of goods sold is $8 million per year, and if its accounts payable average $657,534, then its payables deferral period can be calculated as follows: Payables Payables deferral Purchases per day period Payables Cost of goods sold/365

(16-3)

$657,534 $8,000,000/365

30 days. The calculated ﬁgure is consistent with the stated 30-day payment period.3 4. Cash conversion cycle, which nets out the three periods just deﬁned and which therefore equals the length of time between the ﬁrm’s actual cash expenditures to pay for productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receivables). The cash conversion cycle thus equals the average length of time a dollar is tied up in current assets. We can now use these deﬁnitions to analyze the cash conversion cycle. First, the concept is diagrammed in Figure 16-1. Each component is given a number, and the cash conversion cycle can be expressed by this equation: (1) (2) (3) (4) Inventory Receivables Payables Cash conversion collection deferral conversion . period period period cycle

(16-4)

To illustrate, suppose it takes Real Time an average of 73 days to convert raw materials to computers and then to sell them, and another 24 days to collect on receivables. However, 30 days normally elapse between receipt of raw materials and payment for them. Therefore, the cash conversion cycle would be 67 days: Days in cash conversion cycle 73 days 24 days 30 days 67 days. To look at it another way, Cash inﬂow delay Payment delay Net delay (73 days 24 days)

3

30 days

67 days.

Some sources deﬁne the payables deferral period as payables divided by daily sales.

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Working Capital Management FIGURE 16-1

The Cash Conversion Cycle Model

(1) Inventory Conversion Period (73 Days) (3) Payables Deferral Period (30 Days) Receive Raw Materials

Finish Goods and Sell Them

(2) Receivables Collection Period (24 Days) (4) Cash Conversion Cycle (73 24 30 67 Days)

Pay Cash for Purchased Materials

Days Collect Accounts Receivables

Shortening the Cash Conversion Cycle Given these data, RTC knows when it starts producing a computer that it will have to ﬁnance the manufacturing costs for a 67-day period. The ﬁrm’s goal should be to shorten its cash conversion cycle as much as possible without hurting operations. This would increase RTC’s value, because the shorter the cash conversion cycle, the lower the required net operating working capital, and the higher the resulting free cash ﬂow. The cash conversion cycle can be shortened (1) by reducing the inventory conversion period by processing and selling goods more quickly, (2) by reducing the receivables collection period by speeding up collections, or (3) by lengthening the payables deferral period by slowing down the ﬁrm’s own payments. To the extent that these actions can be taken without increasing costs or depressing sales, they should be carried out.

Beneﬁts We can illustrate the beneﬁts of shortening the cash conversion cycle by looking again at Real Time Computer Corporation. Suppose RTC must spend approximately $197,250 on materials and labor to produce one computer, and it takes about nine days to produce a computer. Thus, it must invest $197,250/9 $21,917 for each day’s production. This investment must be ﬁnanced for 67 days — the length of the cash conversion cycle — so the company’s working capital ﬁnancing needs will be 67 $21,917 $1,468,439. If RTC could reduce the cash conversion cycle to 57 days, say, by deferring payment of its accounts payable an additional 10 days, or by speeding up either the production process or the collection of its receivables, it could reduce its working capital ﬁnancing requirements by $219,170. Recall that free cash ﬂow (FCF) is equal to NOPAT minus net investments in operating capital. Therefore, if working capital decreases, FCF increases by that same amount. RTC’s reduction in its cash conversion cycle would lead to an increase in FCF of $219,170. Notice also that reducing the cash conversion cycle reduces the ratio of net operating working capital to sales (NOWC/Sales). If sales stay at the same level, then the reduction in working capital is simply a one-time cash inﬂow. However, if sales are expected to grow, and if the NOWC/Sales ratio remains at its new level, then less working capital will be required to support the additional sales, leading to an increase in projected FCF for each future year.

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The combination of the one-time cash inﬂow and the long-term improvement in working capital can add substantial value to companies. Two professors, Hyun-Han Shin and Luc Soenen, studied more then 2,900 companies during a recent 20-year period and found a strong relationship between a company’s cash conversion cycle and its performance.4 In particular, their results show that for the average company a 10-day improvement in the cash conversion cycle was associated with an increase in pre-tax operating proﬁt from 12.76 to 13.02 percent. They also demonstrated that companies with a cash conversion cycle 10 days shorter than average also had an annual stock return that was 1.7 percentage points higher than that of an average company, even after adjusting for differences in risk. Given results like these, it’s no wonder ﬁrms now place so much emphasis on working capital management! Deﬁne the following terms: inventory conversion period, receivables collection period, and payables deferral period. Give the equation for each term. What is the cash conversion cycle? What is its equation? What should the ﬁrm’s goal be regarding the cash conversion cycle? Explain your answer. What are some actions the ﬁrm can take to shorten its cash conversion cycle?

Alternative Net Operating Working Capital Policies Table 16-1 shows three alternative policies regarding the total amount of net operating working capital carried. The ﬁrst row illustrates a relaxed working capital policy, where relatively large amounts of cash and inventories are carried, where sales are stimulated by the use of a credit policy that provides liberal ﬁnancing to customers and a corresponding high level of receivables, and where a company doesn’t take advantage of credit provided by accruals and accounts payable. Conversely, with the restricted working capital policy, the holdings of cash, inventories, and receivables are minimized, and accruals and payables are maximized. Under the restricted policy, NOWC is turned over more frequently, so each dollar of NOWC is forced to “work harder.” The moderate working capital policy is between the two extremes. Under conditions of certainty — when sales, costs, lead times, payment periods, and so on, are known for sure — all ﬁrms would hold only minimal levels of working capital. Any larger amounts would increase the need for external funding without a corresponding increase in proﬁts, while any smaller holdings would involve late payments to suppliers along with lost sales due to inventory shortages and an overly restrictive credit policy. 4

See Hyun-Han Shin and Luc Soenen, “Efﬁciency of Working Capital Management and Corporate Profitability,” Financial Practice and Education, Fall/Winter 1998, 37–45.

TABLE 16-1

Policy

Relaxed Moderate Restricted

Alternative Net Operating Working Capital (NOWC) Policies (Millions of Dollars) NOWC to Support Sales of $100

$30 23 16

NOWC/ Sales

30% 23 16

Turnover of NOWC

3.3 4.3 6.3

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The Best at Managing Working Capital

What do Boeing, Ford, Gillette, Coca-Cola, Herman Miller, Timberland, Southwest Airlines, and Burlington Northern Santa Fe have in common? Each of these companies leads its industry in CFO magazine’s annual survey of working capital management, which covers 1,000 ﬁrms with sales greater than $500 million. Each company is rated on the number of days to its cash conversion cycle and on its cash conversion efﬁciency (CCE), deﬁned as cash ﬂow from operations divided by sales. According to this survey, the median number of days in the cash conversion cycle is about 57. Burlington Northern Santa Fe (BNSF) has an outstanding cash conversion cycle of 51 days, versus an industry average of 12! BNSF achieved this by reengineering its accounts receivable process, starting with the number of days it takes to submit a bill to customers. In 1997 it had about 50,000 bills on hand each day that had not yet been priced and renderd to customers. By working on its information systems, BNSF was able to

automate much of the process, and it reduced unprocessed bills to about 15,000. BNSF then turned its attention to the number of days it takes a customer to pay. They found that their large customers would receive a batch of bills, but not pay any of them if the customer disputed any single bill in the batch. Working closely with marketing and sales, BNSF was able to greatly reduce the number of disputed bills. The net result of these efforts was a decrease in the days sales outstanding from 50 to 16. When coupled with very little inventory and its own ability to delay payments to its suppliers, BNSF’s cash conversion cycle came in at 51 days. This increased its free cash ﬂow to such an extent that BNSF was able to implement a large stock repurchase program.

Source: Various issues of CFO. For an update, see http://www.cfo.com/ and search for “working capital annual survey.”

However, the picture changes when uncertainty is introduced. Here the ﬁrm requires some minimum amount of cash and inventories based on expected payments, expected sales, expected order lead times, and so on, plus additional holdings, or safety stocks, which enable it to deal with departures from the expected values. Similarly, accounts receivable levels are determined by credit terms, and the tougher the credit terms, the lower the receivables for any given level of sales. With a restricted policy, the ﬁrm would hold minimal safety stocks of cash and inventories, and it would have a tight credit policy even though this meant running the risk of losing sales. A restricted, lean-and-mean working capital policy generally provides the highest expected return on this investment, but it entails the greatest risk, while the reverse is true under a relaxed policy. The moderate policy falls in between the two extremes in terms of expected risk and return. Changing technology can lead to dramatic changes in the optimal working capital policy. For example, if new technology makes it possible for a manufacturer to speed up the production of a given product from 10 days to ﬁve days, then its workin-progress inventory can be cut in half. Similarly, retailers such as Wal-Mart or Home Depot have installed systems under which bar codes on all merchandise are read at the cash register. The information on the sale is electronically transmitted to a computer that maintains a record of the inventory of each item, and the computer automatically transmits orders to suppliers’ computers when stocks fall to prescribed levels. With such a system, inventories will be held at optimal levels; orders will reﬂect exactly what styles, colors, and sizes consumers are buying; and the ﬁrm’s free cash ﬂows will be maximized. Recall that NOWC consists of cash, inventory, and accounts receivable, less accruals and accounts payable. Firms face a fundamental trade-off: Working capital is necessary to conduct business, and the greater the working capital, the smaller the danger of running short, hence the lower the ﬁrm’s operating risk. However, holding working capital is costly — it reduces a ﬁrm’s return on invested capital (ROIC), free

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587

cash ﬂow, and value. The following sections discuss the individual components of NOWC. Identify and explain three alternative working capital policies. What are the principal components of net operating working capital? What are the reasons for not wanting to hold too little working capital? For not wanting to hold too much?

Cash Management Approximately 1.5 percent of the average industrial firm’s assets are held in the form of cash, which is defined as demand deposits plus currency. Cash is often called a “nonearning asset.” It is needed to pay for labor and raw materials, to buy fixed assets, to pay taxes, to service debt, to pay dividends, and so on. However, cash itself (and also most commercial checking accounts) earns no interest. Thus, the goal of the cash manager is to minimize the amount of cash the firm must hold for use in conducting its normal business activities, yet, at the same time, to have sufficient cash (1) to take trade discounts, (2) to maintain its credit rating, and (3) to meet unexpected cash needs. We begin our analysis with a discussion of the reasons for holding cash.

Reasons for Holding Cash Firms hold cash for two primary reasons: 1. Transactions. Cash balances are necessary in business operations. Payments must be made in cash, and receipts are deposited in the cash account. Cash balances associated with routine payments and collections are known as transactions balances. Cash inﬂows and outﬂows are unpredictable, with the degree of predictability varying among ﬁrms and industries. Therefore, ﬁrms need to hold some cash in reserve for random, unforeseen ﬂuctuations in inﬂows and outﬂows. These “safety stocks” are called precautionary balances, and the less predictable the ﬁrm’s cash ﬂows, the larger such balances should be. 2. Compensation to banks for providing loans and services. A bank makes money by lending out funds that have been deposited with it, so the larger its deposits, the better the bank’s profit position. If a bank is providing services to a customer, it may require the customer to leave a minimum balance on deposit to help offset the costs of providing the services. Also, banks may require borrowers to hold deposits at the bank. Both types of deposits are defined as compensating balances. In a 1979 survey, 84.7 percent of responding companies reported that they were required to maintain compensating balances to help pay for bank services.5 Only 13.3 percent reported paying direct fees for banking services. By 1996 those findings were reversed: only 28 percent paid for bank services with compensating balances, while 83 percent paid direct fees.6 So, while the use of compensating balances to pay for services has declined, it is still a reason some companies hold so much cash. 5

See Lawrence J. Gitman, E. A. Moses, and I. T. White, “An Assessment of Corporate Cash Management Practices,” Financial Management, Vol. 14, no. 1, Spring 1979, 32– 41. 6 See Charles E. Maxwell, Lawrence J. Gitman, and Stephanie A. M. Smith, “Working Capital Management and Financial-Service Consumption Preferences of US and Foreign Firms: A Comparison of 1979 and 1996 Preferences,” Financial Practice and Education, Fall/Winter 1998, 46–52.

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In addition to holding cash for transactions, precautionary, and compensating balances, it is essential that the ﬁrm have sufﬁcient cash to take trade discounts. Suppliers frequently offer customers discounts for early payment of bills. As we will see later in this chapter, the cost of not taking discounts is very high, so ﬁrms should have enough cash to permit payment of bills in time to take discounts. Finally, ﬁrms often hold short-term investments in excess of the cash needed to support operations. We discuss short-term investments later in the chapter. Why is cash management important? What are the two primary motives for holding cash?

The Cash Budget

See Ch16 Tool Kit.xls for all calculations.

The cash budget shows the ﬁrm’s projected cash inﬂows and outﬂows over some speciﬁed period. Generally, ﬁrms use a monthly cash budget forecasted over the next year, plus a more detailed daily or weekly cash budget for the coming month. The monthly cash budgets are used for planning purposes, and the daily or weekly budgets for actual cash control. The cash budget provides more detailed information concerning a ﬁrm’s future cash ﬂows than do the forecasted ﬁnancial statements. In Chapter 11, we developed MicroDrive Inc.’s 2003 forecasted ﬁnancial statements. MicroDrive’s projected 2003 sales were $3,300 million, resulting in a net cash ﬂow from operations of $163 million. When all expenditures and ﬁnancing ﬂows are considered, its cash account is projected to increase by $1 million in 2003. Does this mean that it will not have to worry about cash shortages during 2003? To answer this question, we must construct the cash budget for 2003. To simplify the example, we will only consider the cash budget for the last half of 2003. Further, we will not list every cash ﬂow but rather focus on the operating cash ﬂows. Sales peak in September, and all sales are made on terms of 2/10, net 40, meaning that a 2 percent discount is allowed if payment is made within 10 days, and, if the discount is not taken, the full amount is due in 40 days. However, like most companies, MicroDrive ﬁnds that some of its customers delay payment up to 90 days. Experience has shown that payment on 20 percent of dollar sales is made during the month in which the sale is made — these are the discount sales. On 70 percent of sales, payment is made during the month immediately following the month of sale, and on 10 percent of sales, payment is made in the second month following the month of sale. Costs average 70 percent of the sales prices of the ﬁnished products. These purchases are generally made one month before the ﬁrm expects to sell the ﬁnished products, but MicroDrive’s terms with its suppliers allow it to delay payments for 30 days. Accordingly, if July sales are forecasted at $300 million, then purchases during June will amount to $210 million, and this amount will actually be paid in July. Such other cash expenditures as wages and lease payments are also built into the cash budget, and MicroDrive must make estimated tax payments of $30 million on September 15 and $20 million on December 15. Also, a $100 million payment for a new plant must be made in October. Assuming that the target cash balance is $10 million, and that it projects $15 million to be on hand on July 1, 2003, what will its monthly cash surpluses or shortfalls be for the period from July to December? The monthly cash ﬂows are shown in Table 16-2. Section I of the table provides a worksheet for calculating both collections on sales and payments on purchases. Line 1

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Working Capital Management The Cash Budget TABLE 16-2

589

MicroDrive Inc.: Cash Budget (Millions of Dollars) May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

$200

$250

$300

$400

$500

$350

$250

$200

59

78

98

69

49

39

175

210

280

350

245

175

20 $254

25 $313

30 $408

40 $459

50 $344

35 $249

$280

$350

$245

$175

$140

$210

$280

$350

$245

$175

$140

$254

$313

$408

$459

$344

$249

$210 30 15 10

$280 40 15 15

$350 50 15 20 30

$245 40 15 15

$175 30 15 10

$140 30 15 10 20

$265

$350

$465

100 $415

$230

$215

($ 11)

($ 37)

($ 57)

$ 44

$114

$ 34

$ 15

$ 4

($ 33)

($ 90)

($ 46)

$ 68

$ 4 10

($ 33) 10

($ 90) 10

($ 46) 10

$ 68 10

$102 10

($ 43)

($100)

($ 56)

$ 58

$ 92

I. COLLECTIONS AND PURCHASES WORKSHEET

(1) Sales (gross)a Collections (2) During month of sale: (0.2)(0.98)(month’s sales) (3) During ﬁrst month after sale: 0.7(previous month’s sales) (4) During second month after sale: 0.1(sales 2 months ago) (5) Total collections (2 3 4) Purchases (6) 0.7(next month’s sales) (7) Payments (prior month’s purchases)

$210

II. CASH GAIN OR LOSS FOR MONTH

(8) Collections (from Section I) (9) Payments for purchases (from Section I) (10) Wages and salaries (11) Lease payments (12) Other expenses (13) Taxes (14) Payment for plant construction (15) Total payments (16) Net cash gain (loss) during month (Line 8 Line 15) III. LOAN REQUIREMENT OR CASH SURPLUS

(17) Cash at start of month if no borrowing is doneb (18) Cumulative cash: cash at start if no borrowing gain or loss (Line 16 Line 17) (19) Target cash balance (20) Cumulative surplus cash or loans outstanding to maintain $10 target cash balance (Line 18 Line 19)c a

($

6)

Although the budget period is July through December, sales and purchases data for May and June are needed to determine collections and payments during July and August. The amount shown on Line 17 for July, the $15 balance (in millions), is on hand initially. The values shown for each of the following months on Line 17 are equal to the cumulative cash as shown on Line 18 for the preceding month; for example, the $4 shown on Line 17 for August is taken from Line 18 in the July column. c When the target cash balance of $10 (Line 19) is deducted from the cumulative cash balance (Line 18), a resulting negative ﬁgure on Line 20 (shown in parentheses) represents a required loan, whereas a positive ﬁgure represents surplus cash. Loans are required from July through October, and surpluses are expected during November and December. Note also that ﬁrms can borrow or pay off loans on a daily basis, so the $6 borrowed during July would be done on a daily basis, as needed, and during October the $100 loan that existed at the beginning of the month would be reduced daily to the $56 ending balance, which, in turn, would be completely paid off during November. b

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The Great Debate: How Much Cash Is Enough?

“I hate cash on hand,” says Fred Salerno, Bell Atlantic’s CFO. According to a recent survey, Salerno has backed up his talk with actions. When rated on the number of days of operating expenses held in cash (DOEHIC), Bell Atlantic leads its industry with a DOEHIC of 6 days versus an industry average of 27. Put another way, Bell Atlantic has cash holdings equal to only 0.90 percent of sales as compared with an industry median cash/sales ratio of 5.20 percent. A great relationship with its banks is a key to keeping low cash levels. Jim Hopwood, treasurer of Wickes, says, “We have a credit revolver if we ever need it.” The same is true at Haverty Furniture, where CFO Dennis Fink says, “You don’t have to worry about predicting short-term ﬂuctuations in cash ﬂow,” if you have solid bank commitments. Treasurer Wayne Smith of Avery Dennison says that their low cash holdings have reduced their net operating working capital to such an extent that their return on invested capital (ROIC) is 3 percentage points higher than it

would be if their cash holdings were at the industry average. He goes on to say that this adds a lot of economic value to their company. Despite these and other comments about the advantages of low cash holdings, many companies still hold extremely large amounts of cash and marketable securities, including Procter & Gamble ($2.6 billion, 32 days DOEHIC, 7.1 percent cash/sales) and Ford Motor Company ($24 billion, 76 DOEHIC). When asked about the appropriate level of cash holdings, Ford CFO Henry Wallace refused to be pinned down, saying, “There is no answer for a company this size.” However, it is interesting to note that Ford recently completed a huge stock repurchase, reducing its cash by about $10 billion.

Source: S. L. Mintz, “Lean Green Machine,” CFO, July 2000, 76–94.

gives the sales forecast for the period from May through December. (May and June sales are necessary to determine collections for July and August.) Next, Lines 2 through 5 show cash collections. Line 2 shows that 20 percent of the sales during any given month are collected during that month. Customers who pay in the ﬁrst month, however, take the discount, so the cash collected in the month of sale is reduced by 2 percent; for example, collections during July for the $300 million of sales in that month will be 20 percent times sales times 1.0 minus the 2 percent discount (0.20)($300)(0.98) ⬇ $59 million. Line 3 shows the collections on the previous month’s sales, or 70 percent of sales in the preceding month; for example, in July, 70 percent of the $250 million June sales, or $175 million, will be collected. Line 4 gives collections from sales two months earlier, or 10 percent of sales in that month; for example, the July collections for May sales are (0.10)($200) $20 million. The collections during each month are summed and shown on Line 5; thus, the July collections represent 20 percent of July sales (minus the discount) plus 70 percent of June sales plus 10 percent of May sales, or $254 million in total. Next, payments for purchases of raw materials are shown. July sales are forecasted at $300 million, so MicroDrive will purchase $210 million of materials in June (Line 6) and pay for these purchases in July (Line 7). Similarly, MicroDrive will purchase $280 million of materials in July to meet August’s forecasted sales of $400 million. With Section I completed, Section II can be constructed. Cash from collections is shown on Line 8. Lines 9 through 14 list payments made during each month, and these payments are summed on Line 15. The difference between cash receipts and cash payments (Line 8 minus Line 15) is the net cash gain or loss during the month. For July there is a net cash loss of $11 million, as shown on Line 16. In Section III, we ﬁrst determine the cash balance MicroDrive would have at the start of each month, assuming no borrowing is done. This is shown on Line 17.

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MicroDrive will have $15 million on hand on July 1. The beginning cash balance (Line 17) is then added to the net cash gain or loss during the month (Line 16) to obtain the cumulative cash that would be on hand if no ﬁnancing were done (Line 18). At the end of July, MicroDrive forecasts a cumulative cash balance of $4 million in the absence of borrowing. The target cash balance, $10 million, is then subtracted from the cumulative cash balance to determine the ﬁrm’s borrowing requirements, shown in parentheses, or its surplus cash. Because MicroDrive expects to have cumulative cash, as shown on Line 18, of only $4 million in July, it will have to borrow $6 million to bring the cash account up to the target balance of $10 million. Assuming that this amount is indeed borrowed, loans outstanding will total $6 million at the end of July. (MicroDrive did not have any loans outstanding on July 1.) The cash surplus or required loan balance is given on Line 20; a positive value indicates a cash surplus, whereas a negative value indicates a loan requirement. Note that the surplus cash or loan requirement shown on Line 20 is a cumulative amount. MicroDrive must borrow $6 million in July. Then, it has an additional cash shortfall during August of $37 million as reported on Line 16, so its total loan requirement at the end of August is $6 $37 $43 million, as reported on Line 20. MicroDrive’s arrangement with the bank permits it to increase its outstanding loans on a daily basis, up to a prearranged maximum, just as you could increase the amount you owe on a credit card. MicroDrive will use any surplus funds it generates to pay off its loans, and because the loan can be paid down at any time, on a daily basis, the ﬁrm will never have both a cash surplus and an outstanding loan balance. This same procedure is used in the following months. Sales will peak in September, accompanied by increased payments for purchases, wages, and other items. Receipts from sales will also go up, but the ﬁrm will still be left with a $57 million net cash outﬂow during the month. The total loan requirement at the end of September will hit a peak of $100 million, the cumulative cash plus the target cash balance. The $100 million can also be found as the $43 million needed at the end of August plus the $57 million cash deﬁcit for September. Sales, purchases, and payments for past purchases will fall sharply in October, but collections will be the highest of any month because they will reﬂect the high September sales. As a result, MicroDrive will enjoy a healthy $44 million net cash gain during October. This net gain can be used to pay off borrowings, so loans outstanding will decline by $44 million, to $56 million. MicroDrive will have an even larger cash surplus in November, which will permit it to pay off all of its loans. In fact, the company is expected to have $58 million in surplus cash by the month’s end, and another cash surplus in December will swell the excess cash to $92 million. With such a large amount of unneeded funds, MicroDrive’s treasurer will certainly want to invest in interest-bearing securities or to put the funds to use in some other way. We intentionally kept this cash budget simple for illustrative purposes, but here are some potential reﬁnements that you could easily incorporate: (1) Add dividend payments, stock issues, bond sales, interest income, and interest expenses. (2) Create a cash budget to determine weekly, or even daily, cash requirements. (3) Use simulation to estimate the probability distribution for the cash requirements. (4) Allow the target cash balance to vary over time, reﬂecting the seasonal nature of sales and operating activity. What is the purpose of the cash budget? What are the three major sections of a cash budget?

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Cash Management Techniques Most business is conducted by large ﬁrms, many of which operate regionally, nationally, or even globally. They collect cash from many sources and make payments from a number of different cities or even countries. For example, companies such as IBM, General Motors, and Hewlett-Packard have manufacturing plants all around the world, even more sales ofﬁces, and bank accounts in virtually every city where they do business. Their collection points follow sales patterns. Some disbursements are made from local ofﬁces, but most are made in the cities where manufacturing occurs, or else from the home ofﬁce. Thus, a major corporation might have hundreds or even thousands of bank accounts, and since there is no reason to think that inﬂows and outﬂows will balance in each account, a system must be in place to transfer funds from where they come in to where they are needed, to arrange loans to cover net corporate shortfalls, and to invest net corporate surpluses without delay. We discuss the most commonly used techniques for accomplishing these tasks in the following sections.

Cash Flow Synchronization If you as an individual were to receive income once a year, you would probably put it in the bank, draw down your account periodically, and have an average balance for the year equal to about half your annual income. If instead you could arrange to receive income weekly and to pay rent, tuition, and other charges on a weekly basis, and if you were conﬁdent of your forecasted inﬂows and outﬂows, then you could hold a tiny average cash balance. Exactly the same situation holds for businesses—by improving their forecasts and by timing cash receipts to coincide with cash requirements, ﬁrms can hold their transactions balances to a minimum. Recognizing this, utility companies, oil companies, credit card companies, and so on, arrange to bill customers, and to pay their own bills, on regular “billing cycles” throughout the month. This synchronization of cash ﬂows provides cash when it is needed and thus enables ﬁrms to reduce the cash balances needed to support operations.

Speed Up the Check-Clearing Process When a customer writes and mails a check, the funds are not available to the receiving ﬁrm until the check-clearing process has been completed. The bank must ﬁrst make sure that the deposited check is good and the funds are available before it will give cash to the company. In practice, it may take a long time for a ﬁrm to process incoming checks and obtain the use of the money. A check must ﬁrst be delivered through the mail and then be cleared through the banking system before the money can be put to use. Checks received from the customers in distant cities are especially subject to delays because of mail delays and also because more banks are involved. For example, assume that we receive a check and deposit it in our bank. Our bank must send the check to the bank on which it was drawn. Only when this latter bank transfers funds to our bank are the funds available for us to use. Checks are generally cleared through the Federal Reserve System or through a clearinghouse set up by the banks in a particular city. Of course, if the check is deposited in the same bank on which it was drawn, that bank merely transfers funds by bookkeeping entries from one depositor to another. The length of time required for checks to clear is thus a function of the distance between the payer’s and the payee’s bank. In the case of private clearinghouses, clearing can range from one to three days. Checks are generally cleared through the Federal Reserve System in

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about two days, but mail delays can slow down things on each end of the Fed’s involvement in the process.

Using Float Float is deﬁned as the difference between the balance shown in a ﬁrm’s (or individual’s) checkbook and the balance on the bank’s records. Suppose a ﬁrm writes, on average, checks in the amount of $5,000 each day, and it takes six days for these checks to clear and be deducted from the ﬁrm’s bank account. This will cause the ﬁrm’s own checkbook to show a balance $30,000 smaller than the balance on the bank’s records; this difference is called disbursement ﬂoat. Now suppose the ﬁrm also receives checks in the amount of $5,000 daily, but it loses four days while they are being deposited and cleared. This will result in $20,000 of collections ﬂoat. In total, the ﬁrm’s net ﬂoat— the difference between the $30,000 positive disbursement ﬂoat and the $20,000 negative collections ﬂoat—will be $10,000. Delays that cause ﬂoat arise because it takes time for checks (1) to travel through the mail (mail ﬂoat), (2) to be processed by the receiving ﬁrm (processing ﬂoat), and (3) to clear through the banking system (clearing, or availability, ﬂoat). Basically, the size of a ﬁrm’s net ﬂoat is a function of its ability to speed up collections on checks it receives and to slow down collections on checks it writes. Efﬁcient ﬁrms go to great lengths to speed up the processing of incoming checks, thus putting the funds to work faster, and they try to stretch their own payments out as long as possible, sometimes by disbursing checks from banks in remote locations.

Speeding up Receipts Two major techniques are now used both to speed collections and to get funds where they are needed: (1) lockbox plans and (2) payment by wire or automatic debit. Lockboxes A lockbox plan is one of the oldest cash management tools. In a lockbox system, incoming checks are sent to post ofﬁce boxes rather than to corporate headquarters. For example, a ﬁrm headquartered in New York City might have its West Coast customers send their payments to a box in San Francisco, its customers in the Southwest send their checks to Dallas, and so on, rather than having all checks sent to New York City. Several times a day a local bank will collect the contents of the lockbox and deposit the checks into the company’s local account. In fact, some banks even have their lockbox operation located in the same facility as the post ofﬁce. The bank then provides the ﬁrm with a daily record of the receipts collected, usually via an electronic data transmission system in a format that permits on-line updating of the ﬁrm’s accounts receivable records. A lockbox system reduces the time required for a ﬁrm to receive incoming checks, to deposit them, and to get them cleared through the banking system so the funds are available for use. Lockbox services can accelerate the availability of funds by two to ﬁve days over the “regular” system. Payment by Wire or Automatic Debit Firms are increasingly demanding payments of larger bills by wire, or even by automatic electronic debits. Under an electronic debit system, funds are automatically deducted from one account and added to another. This is, of course, the ultimate in a speeded-up collection process, and computer technology is making such a process increasingly feasible and efﬁcient. What is ﬂoat? How do ﬁrms use ﬂoat to increase cash management efﬁciency? What are some methods ﬁrms can use to accelerate receipts?

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Inventory Inventory management techniques are covered in depth in production management courses. Still, since ﬁnancial managers have a responsibility both for raising the capital needed to carry inventory and for the ﬁrm’s overall proﬁtability, we need to cover the ﬁnancial aspects of inventory management here. The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level. Table 16-3 gives a listing of the typical costs associated with inventory, divided into three categories: carrying costs, ordering and receiving costs, and the costs that are incurred if the ﬁrm runs short of inventory. There is always pressure to reduce inventory as part of ﬁrms’ overall costcontainment strategies, and many corporations are taking drastic steps to control inventory costs. For example, Trane Corporation, which makes air conditioners, adopted just-in-time inventory procedures. In the past, Trane produced parts on a steady basis, stored them as inventory, and had them ready whenever the company received an order for a batch of air conditioners. However, the company reached the point where its inventory covered an area equal to three football ﬁelds, and it still sometimes took as long as 15 days to ﬁll an order. To make matters worse, occasionally some of the necessary components simply could not be located, while in other instances the components were located but found to have been damaged from long storage. Then Trane adopted a new inventory policy — it began producing components only after an order is received, and then sending the parts directly from the machines

TABLE 16-3

Costs Associated with Inventory Approximate Annual Cost as a Percentage of Inventory Value

I. CARRYING COSTS

Cost of capital tied up Storage and handling costs Insurance Property taxes Depreciation and obsolescence Total

12.0% 0.5 0.5 1.0 12.0 26.0%

II. ORDERING, SHIPPING, AND RECEIVING COSTS

Cost of placing orders, including production and set-up costs Shipping and handling costs

Varies 2.5%

III. COSTS OF RUNNING SHORT

Loss of sales Loss of customer goodwill Disruption of production schedules

Varies Varies Varies

Note: These costs vary from ﬁrm to ﬁrm, from item to item, and also over time. The ﬁgures shown are U.S. Department of Commerce estimates for an average manufacturing ﬁrm.

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Supply Chain Management

Herman Miller Inc. manufactures a wide variety of ofﬁce furniture, and a typical order from a single customer might require work at ﬁve different plants. Each plant uses components from different suppliers, and each plant works on orders for many customers. Imagine all the coordination that is required. The sales force generates the order, the purchasing department orders components from suppliers, and the suppliers must order materials from their own suppliers. Then, the suppliers ship the components to Herman Miller, the factory builds the product, the different products are gathered together to complete the order, and then the order is shipped to the customer. If one part of that process malfunctions, then the order will be delayed, inventory will pile up, extra costs to expedite the order will be incurred, and the customer’s goodwill will be damaged, which will hurt future sales growth. To prevent such consequences, many companies are turning to a process called supply chain management (SCM). The key element in SCM is sharing information all the way from the point-of-sale at the product’s retailer to the suppliers, and even back to the suppliers’ suppliers. SCM requires special software, but even more important, it requires cooperation between the different companies and depart-

ments in the supply chain. This new culture of open communication is often difﬁcult for many companies — they are reluctant to divulge operating information. For example, EMC Corp., a manufacturer of data storage systems, has become deeply involved in the design processes and ﬁnancial controls of its key suppliers. Many of EMC’s suppliers were initially wary of these new relationships. However, SCM has been a win-win situation, with increases in value for EMC and its suppliers. The same is true at many other companies. After implementing SCM, Herman Miller was able to reduce its days of inventory on hand by a week, and to cut two weeks off of delivery times to customers. Herman Miller was also able to operate its plants at a 20 percent higher volume without additional capital expenditures. Heineken USA can now get beer from its breweries to its customers’ shelves in less than six weeks, compared with 10 to 12 weeks before implementing SCM. As these and other companies have found, SCM increases free cash ﬂows, and that leads to higher stock prices. Sources: Elaine L. Appleton, “Supply Chain Brain,” CFO, July 1997, 51–54; and Kris Frieswick, “Up Close and Virtual,” CFO, April 1998, 87–91.

that make them to the ﬁnal assembly line. The net effect: Inventories fell nearly 40 percent even as sales increased by 30 percent. However, as Table 16-3 indicates, there are costs associated with holding too little inventory, and these costs can be severe. Generally, if a business carries small inventories, it must reorder frequently. This increases ordering costs. Even more important, ﬁrms can miss out on proﬁtable sales, and also suffer a loss of goodwill that can lead to lower future sales. So, it is important to have enough inventory on hand to meet customer demands. Suppose IBM has developed a new line of notebook computers. How much inventory should it produce and have on hand when the marketing campaign is launched? If it fails to produce enough inventory, retailers and customers are likely to be frustrated because they cannot immediately purchase the highly advertised product. Rather than wait, many customers will purchase a notebook computer elsewhere. On the other hand, if IBM has too much inventory, it will incur unnecessarily high carrying costs. In addition, computers become obsolete quickly, so if inventory levels are high but sales are mediocre, the company may have to discount the notebooks to sell them. Apart from reducing the proﬁt margin on this year’s line of computers, these discounts may push down computer prices in general, thereby reducing proﬁt margins on the company’s other products as well. What are the three categories of inventory costs? What are some components of inventory carrying costs? What are some components of inventory ordering costs?

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Receivables Management Firms would, in general, rather sell for cash than on credit, but competitive pressures force most ﬁrms to offer credit. Thus, goods are shipped, inventories are reduced, and an account receivable is created.7 Eventually, the customer will pay the account, at which time (1) the ﬁrm will receive cash and (2) its receivables will decline. Carrying receivables has both direct and indirect costs, but it also has an important beneﬁt — increased sales. Receivables management begins with the credit policy, but a monitoring system is also important. Corrective action is often needed, and the only way to know whether the situation is getting out of hand is with a good receivables control system.

Credit Policy The success or failure of a business depends primarily on the demand for its products— as a rule, the higher its sales, the larger its proﬁts and the higher its stock price. Sales, in turn, depend on a number of factors, some exogenous but others under the ﬁrm’s control. The major controllable determinants of demand are sales prices, product quality, advertising, and the ﬁrm’s credit policy. Credit policy, in turn, consists of these four variables: 1. Credit period, which is the length of time buyers are given to pay for their purchases. For example, credit terms of “2/10, net 30” indicates that buyers may take up to 30 days to pay. 2. Discounts given for early payment, including the discount percentage and how rapidly payment must be made to qualify for the discount. The credit terms “2/10, net 30” allow buyers to take a 2 percent discount if they pay within 10 days. Otherwise, they must pay the full amount within 30 days. 3. Credit standards, which refer to the required ﬁnancial strength of acceptable credit customers. Lower credit standards boost sales, but also increase bad debts. 4. Collection policy, which is measured by its toughness or laxity in attempting to collect on slow-paying accounts. A tough policy may speed up collections, but it might also anger customers, causing them to take their business elsewhere. The credit manager is responsible for administering the ﬁrm’s credit policy. However, because of the pervasive importance of credit, the credit policy itself is normally established by the executive committee, which usually consists of the president plus the vice-presidents of ﬁnance, marketing, and production.

The Accumulation of Receivables The total amount of accounts receivable outstanding at any given time is determined by two factors: (1) the volume of credit sales and (2) the average length of time between sales and collections. For example, suppose Boston Lumber Company (BLC), a wholesale distributor of lumber products, opens a warehouse on January 1 and, starting the ﬁrst day, makes sales of $1,000 each day. For simplicity, we assume that all sales are on credit, and customers are given 10 days to pay. At the end of the ﬁrst

7 Whenever goods are sold on credit, two accounts are created — an asset item entitled accounts receivable appears on the books of the selling ﬁrm, and a liability item called accounts payable appears on the books of the purchaser. At this point, we are analyzing the transaction from the viewpoint of the seller, so we are concentrating on the variables under its control, in this case, the receivables. We will examine the transaction from the viewpoint of the purchaser later in this chapter, where we discuss accounts payable as a source of funds and consider their cost.

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day, accounts receivable will be $1,000; they will rise to $2,000 by the end of the second day; and by January 10, they will have risen to 10($1,000) $10,000. On January 11, another $1,000 will be added to receivables, but payments for sales made on January 1 will reduce receivables by $1,000, so total accounts receivable will remain constant at $10,000. In general, once the ﬁrm’s operations have stabilized, this situation will exist: Accounts Credit sales Length of receivable per day collection period

$1,000

10 days

(16-5) $10,000.

If either credit sales or the collection period changes, such changes will be reﬂected in accounts receivable. Notice that the $10,000 investment in receivables must be ﬁnanced. To illustrate, suppose that when the warehouse opened on January 1, BLC’s shareholders had put up $800 as common stock and used this money to buy the goods sold the ﬁrst day. The $800 of inventory will be sold for $1,000, so BLC’s gross proﬁt on the $800 investment is $200, or 25 percent. In this situation, the beginning balance sheet would be as follows:8 Inventories Total assets

$800 $800

Common stock Total liabilities and equity

$800 $800

At the end of the day, the balance sheet would look like this: Accounts receivable Inventories Total assets

$1,000 0 $1,000

Common stock Retained earnings Total liabilities and equity

$ 800 200 $1,000

To remain in business, BLC must replenish inventories. To do so requires that $800 of goods be purchased, and this requires $800 in cash. Assuming that BLC borrows the $800 from the bank, the balance sheet at the start of the second day will be as follows: Accounts receivable Inventories

$1,000 800

Total assets

$1,800

Notes payable to bank Common stock Retained earnings Total liabilities and equity

$ 800 800 200 $1,800

At the end of the second day, the inventories will have been converted to receivables, and the ﬁrm will have to borrow another $800 to restock for the third day. This process will continue, provided the bank is willing to lend the necessary funds, until the beginning of the 11th day, when the balance sheet reads as follows: Accounts receivable Inventories

$10,000 800

Total assets

$10,800

Notes payable to bank Common stock Retained earnings Total liabilities and equity

$ 8,000 800 2,000 $10,800

From this point on, $1,000 of receivables will be collected every day, and $800 of these funds can be used to purchase new inventories. This example makes it clear (1) that accounts receivable depend jointly on the level of credit sales and the collection period, (2) that any increase in receivables must be 8

Note that the ﬁrm would need other assets such as cash, ﬁxed assets, and a permanent stock of inventory. Also, overhead costs and taxes would have to be deducted, so retained earnings would be less than the ﬁgures shown here. We abstract from these details here so that we may focus on receivables.

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ﬁnanced in some manner, but (3) that the entire amount of receivables does not have to be ﬁnanced because the proﬁt portion ($200 of each $1,000 of sales) does not represent a cash outﬂow. In our example, we assumed bank ﬁnancing, but, as we discuss later in this chapter, there are many alternative ways to ﬁnance current assets.

Monitoring the Receivables Position Investors — both stockholders and bank loan ofﬁcers — should pay close attention to accounts receivable management, for, as we shall see, one can be misled by reported ﬁnancial statements and later suffer serious losses on an investment. When a credit sale is made, the following events occur: (1) Inventories are reduced by the cost of goods sold, (2) accounts receivable are increased by the sales price, and (3) the difference is proﬁt, which is added to retained earnings. If the sale is for cash, then the cash from the sale has actually been received by the ﬁrm, but if the sale is on credit, the ﬁrm will not receive the cash from the sale unless and until the account is collected. Firms have been known to encourage “sales” to very weak customers in order to report high proﬁts. This could boost the ﬁrm’s stock price, at least until credit losses begin to lower earnings, at which time the stock price will fall. Analyses along the lines suggested in the following sections will detect any such questionable practice, as well as any unconscious deterioration in the quality of accounts receivable. Such early detection could help both investors and bankers avoid losses.9 Days Sales Outstanding (DSO) Suppose Super Sets Inc., a television manufacturer, sells 200,000 television sets a year at a price of $198 each. Further, assume that all sales are on credit with the following terms: if payment is made within 10 days, customers will receive a 2 percent discount; otherwise the full amount is due within 30 days. Finally, assume that 70 percent of the customers take discounts and pay on Day 10, while the other 30 percent pay on Day 30. Super Sets’s days sales outstanding (DSO), sometimes called the average collection period (ACP), is 16 days: DSO ACP 0.7(10 days) 0.3(30 days) 16 days. Super Sets’s average daily sales (ADS) is $108,493: ADS

(Units sold)(Sales price) Annual sales 365 365

(16-6)

200,000($198) $39,600,000 $108,493. 365 365

Super Sets’s accounts receivable, assuming a constant, uniform rate of sales throughout the year, will at any point in time be $1,735,888: Receivables (ADS)(DSO)

(16-7)

($108,493)(16) $1,735,888.

9

Accountants are increasingly interested in these matters. Investors have sued several of the major accounting ﬁrms for substantial damages when (1) proﬁts were overstated and (2) it could be shown that the auditors should have conducted an analysis along the lines described here and then reported the results to stockholders in their audit opinion.

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Note also that its DSO, or average collection period, is a measure of the average length of time it takes Super Sets’s customers to pay off their credit purchases, and the DSO is often compared with an industry average DSO. For example, if all television manufacturers sell on the same credit terms, and if the industry average DSO is 25 days versus Super Sets’s 16 days, then Super Sets either has a higher percentage of discount customers or else its credit department is exceptionally good at ensuring prompt payment. Finally, note that if you know both the annual sales and the receivables balance, you can calculate DSO as follows: DSO

$1,735,888 Receivables 16 days . Sales per day $108,493

The DSO can also be compared with the ﬁrm’s own credit terms. For example, suppose Super Sets’s DSO had been averaging 35 days. With a 35-day DSO, some customers would obviously be taking more than 30 days to pay their bills. In fact, if many customers were paying within 10 days to take advantage of the discount, the others must, on average, be taking much longer than 35 days. One way to check this possibility is to use an aging schedule as described in the next section. Aging Schedules An aging schedule breaks down a ﬁrm’s receivables by age of account. Table 16-4 contains the December 31, 2002, aging schedules of two television manufacturers, Super Sets and Wonder Vision. Both ﬁrms offer the same credit terms, and both show the same total receivables. However, Super Sets’s aging schedule indicates that all of its customers pay on time — 70 percent pay on Day 10 while 30 percent pay on Day 30. Wonder Vision’s schedule, which is more typical, shows that many of its customers are not abiding by its credit terms — some 27 percent of its receivables are more than 30 days past due, even though Wonder Vision’s credit terms call for full payment by Day 30. Aging schedules cannot be constructed from the type of summary data reported in ﬁnancial statements; they must be developed from the ﬁrm’s accounts receivable ledger. However, well-run ﬁrms have computerized their accounts receivable records, so it is easy to determine the age of each invoice, to sort electronically by age categories, and thus to generate an aging schedule. Management should constantly monitor both the DSO and the aging schedule to detect trends, to see how the ﬁrm’s collection experience compares with its credit terms, and to see how effectively the credit department is operating in comparison with other firms in the industry. If the DSO starts to lengthen, or if the aging schedule

TABLE 16-4

Aging Schedules Super Sets

Wonder Vision

Age of Account (Days)

Value of Account

Percentage of Total Value

0–10 11–30 31–45 46–60 Over 60 Total receivables

$1,215,122 520,766 0 0 0 $1,735,888

70% 30 0 0 0 100%

Value of Account

$ 815,867 451,331 260,383 173,589 34,718 $1,735,888

Percentage of Total Value

47% 26 15 10 2 100%

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begins to show an increasing percentage of past-due accounts, then the ﬁrm’s credit policy may need to be tightened. Although a change in the DSO or the aging schedule should signal the ﬁrm to investigate its credit policy, a deterioration in either of these measures does not necessarily indicate that the ﬁrm’s credit policy has weakened. In fact, if a ﬁrm experiences sharp seasonal variations, or if it is growing rapidly, then both the aging schedule and the DSO may be distorted. To see this point, note that the DSO is calculated as follows: DSO

Accounts receivable . Sales/365

Since receivables at a given point in time reﬂect sales in the last month or so, but sales as shown in the denominator of the equation are for the last 12 months, a seasonal increase in sales will increase the numerator more than the denominator, hence will raise the DSO. This will occur even if customers are still paying exactly as before. Similar problems arise with the aging schedule if sales ﬂuctuate widely. Therefore, a change in either the DSO or the aging schedule should be taken as a signal to investigate further, but not necessarily as a sign that the ﬁrm’s credit policy has weakened. Explain how a new ﬁrm’s receivables balance is built up over time. Deﬁne days sales outstanding (DSO). What can be learned from it? How is it affected by sales ﬂuctuations? What is an aging schedule? What can be learned from it? How is it affected by sales ﬂuctuations?

Accruals and Accounts Payable (Trade Credit) Recall that net operating working capital is equal to operating current assets minus operating current liabilities. The previous sections discussed the management of operating current assets (cash, inventory, and accounts receivable), and the following sections discuss the two major types of operating current liabilities, accruals and accounts payable.

Accruals Firms generally pay employees on a weekly, biweekly, or monthly basis, so the balance sheet will typically show some accrued wages. Similarly, the ﬁrm’s own estimated income taxes, Social Security and income taxes withheld from employee payrolls, and sales taxes collected are generally paid on a weekly, monthly, or quarterly basis, hence the balance sheet will typically show some accrued taxes along with accrued wages. These accruals increase automatically, or spontaneously, as a ﬁrm’s operations expand. However, a ﬁrm cannot ordinarily control its accruals: The timing of wage payments is set by economic forces and industry custom, while tax payment dates are established by law. Thus, ﬁrms use all the accruals they can, but they have little control over the levels of these accounts.

Accounts Payable (Trade Credit) Firms generally make purchases from other ﬁrms on credit, recording the debt as an account payable. Accounts payable, or trade credit, is the largest single category of operating current liabilities, representing about 40 percent of the current liabilities of the average nonﬁnancial corporation. The percentage is somewhat larger for smaller

595

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Working Capital Management Accruals and Accounts Payable (Trade Credit)

601

ﬁrms: Because small companies often do not qualify for ﬁnancing from other sources, they rely especially heavily on trade credit.10 Trade credit is a “spontaneous” source of ﬁnancing in the sense that it arises from ordinary business transactions. For example, suppose a ﬁrm makes average purchases of $2,000 a day on terms of net 30, meaning that it must pay for goods 30 days after the invoice date. On average, it will owe 30 times $2,000, or $60,000, to its suppliers. If its sales, and consequently its purchases, were to double, then its accounts payable would also double, to $120,000. So, simply by growing, the ﬁrm would spontaneously generate an additional $60,000 of ﬁnancing. Similarly, if the terms under which it bought were extended from 30 to 40 days, its accounts payable would expand from $60,000 to $80,000. Thus, lengthening the credit period, as well as expanding sales and purchases, generates additional ﬁnancing.

The Cost of Trade Credit Firms that sell on credit have a credit policy that includes certain terms of credit. For example, Microchip Electronics sells on terms of 2/10, net 30, meaning that it gives its customers a 2 percent discount if they pay within 10 days of the invoice date, but the full invoice amount is due and payable within 30 days if the discount is not taken. Note that the true price of Microchip’s products is the net price, or 0.98 times the list price, because any customer can purchase an item at that price as long as the customer pays within 10 days. Now consider Personal Computer Company (PCC), which buys its memory chips from Microchip. One commonly used memory chip is listed at $100, so the “true” price to PCC is $98. Now if PCC wants an additional 20 days of credit beyond the 10-day discount period, it must incur a ﬁnance charge of $2 per chip for that credit. Thus, the $100 list price consists of two components: List price $98 true price $2 ﬁnance charge. The question PCC must ask before it turns down the discount to obtain the additional 20 days of credit from Microchip is this: Could we obtain credit under better terms from some other lender, say, a bank? In other words, could 20 days of credit be obtained for less than $2 per chip? PCC buys an average of $11,923,333 of memory chips from Microchip each year at the net, or true, price. This amounts to $11,923,333/365 $32,666.67 per day. For simplicity, assume that Microchip is PCC’s only supplier. If PCC decides not to take the additional trade credit — that is, if it pays on the 10th day and takes the discount— its payables will average 10($32,666.67) $326,667. Thus, PCC will be receiving $326,667 of credit from Microchip. Now suppose PCC decides to take the additional 20 days credit and thus must pay the ﬁnance charge. Since PCC will now pay on the 30th day, its accounts payable will increase to 30($32,666.67) $980,000.11 Microchip will now be supplying PCC with an additional $980,000 $326,667 $653,333 of credit, which PCC could use to

10

In a credit sale, the seller records the transaction as a receivable, the buyer as a payable. We examined accounts receivable as an asset earlier in this chapter. Our focus now is on accounts payable, a liability item. We might also note that if a ﬁrm’s accounts payable exceed its receivables, it is said to be receiving net trade credit, whereas if its receivables exceed its payables, it is extending net trade credit. Smaller ﬁrms frequently receive net credit; larger ﬁrms generally extend it. 11 A question arises here: Should accounts payable reﬂect gross purchases or purchases net of discounts? Generally accepted accounting principles permit either treatment if the difference is not material, but if the discount is material, then the transaction must be recorded net of discounts, or at “true” prices. Then, the higher payment that results from not taking discounts is reported as an additional expense called “discounts lost.” Thus, we show accounts payable net of discounts even if the company does not expect to take discounts.

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build up its cash account, to pay off debt, to expand inventories, or even to extend credit to its own customers, hence increasing its own accounts receivable. The additional trade credit offered by Microchip has a cost — PCC must pay a ﬁnance charge equal to the 2 percent discount it is foregoing. PCC buys $11,923,333 of chips at the true price, and the added ﬁnance charges increase the total cost to $11,923,333/0.98 $12,166,666. Therefore, the annual ﬁnancing cost is $12,166,666 $11,923,333 $243,333. Dividing the $243,333 ﬁnancing cost by the $653,333 of additional credit, we ﬁnd the nominal annual cost rate of the additional trade credit to be 37.2 percent: Nominal annual cost

$243,333 37.2%. $653,333

If PCC can borrow from its bank (or from other sources) at an interest rate less than 37.2 percent, it should take discounts and forgo the additional trade credit. The following equation can be used to calculate the nominal cost, on an annual basis, of not taking discounts, illustrated with terms of 2/10, net 30: Nominal 365 days Discount percent annual Discount Days credit is Discount cost 100 percent outstanding period

(16-8)

2 365 2.04% 18.25 37.2%. 98 20

The numerator of the ﬁrst term, Discount percent, is the cost per dollar of credit, while the denominator in this term, 100 Discount percent, represents the funds made available by not taking the discount. Thus, the ﬁrst term, 2.04%, is the cost per period for the trade credit. The denominator of the second term is the number of days of extra credit obtained by not taking the discount, so the entire second term shows how many times each year the cost is incurred, 18.25 times in this example. The nominal annual cost formula does not take account of compounding, and in effective annual interest terms, the cost of trade credit is even higher. The discount amounts to interest, and with terms of 2/10, net 30, the ﬁrm gains use of the funds for 30 10 20 days, so there are 365/20 18.25 “interest periods” per year. Remember that the ﬁrst term in Equation 16-8, (Discount percent)/(100 Discount percent) 0.02/0.98 0.0204, is the periodic interest rate. This rate is paid 18.25 times each year, so the effective annual cost of trade credit is Effective annual rate (1.0204)18.25 1.0 1.4459 1.0 44.6%. Thus, the 37.2 percent nominal cost calculated with Equation 16-8 understates the true cost. Note, however, that the cost of trade credit can be reduced by paying late. Thus, if PCC could get away with paying in 60 days rather than in the speciﬁed 30 days, then the effective credit period would become 60 10 50 days, the number of times the discount would be lost would fall to 365/50 7.3, and the nominal cost would drop from 37.2 percent to 2.04% 7.3 14.9%. The effective annual rate would drop from 44.6 to 15.9 percent: Effective annual rate (1.0204)7.3 1.0 1.1589 1.0 15.9%. In periods of excess capacity, ﬁrms may be able to get away with deliberately paying late, or stretching accounts payable. However, they will also suffer a variety of problems associated with being branded a “slow payer.” These problems are discussed later in the chapter.

597

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Working Capital Management Alternative Short-Term Financing Policies

603

The costs of the additional trade credit from forgoing discounts under some other purchase terms are shown below: Cost of Additional Credit if the Cash Discount Is Not Taken Credit Terms

Nominal Cost

1/10, net 20 1/10, net 30 2/10, net 20 3/15, net 45

36.9% 18.4 74.5 37.6

Effective Cost

44.3% 20.1 109.0 44.9

As these ﬁgures show, the cost of not taking discounts can be substantial. Incidentally, throughout the chapter, we assume that payments are made either on the last day for taking discounts or on the last day of the credit period, unless otherwise noted. It would be foolish to pay, say, on the 5th day or on the 20th day if the credit terms were 2/10, net 30.12 On the basis of the preceding discussion, trade credit can be divided into two components: (1) free trade credit, which involves credit received during the discount period, and (2) costly trade credit, which involves credit in excess of the free trade credit and whose cost is an implicit one based on the forgone discounts. Firms should always use the free component, but they should use the costly component only after analyzing the cost of this capital to make sure that it is less than the cost of funds that could be obtained from other sources. Under the terms of trade found in most industries, the costly component is relatively expensive, so stronger ﬁrms will avoid using it. What are accruals? How much control do managers have over accruals? What is trade credit? What is the difference between free trade credit and costly trade credit? How does the cost of costly trade credit generally compare with the cost of short-term bank loans?

Alternative Short-Term Financing Policies Up until this point we have focused on the management of net operating working capital. We now turn our attention to decisions involving short-term investments and short-term ﬁnancing. Most businesses experience seasonal and/or cyclical ﬂuctuations. For example, construction ﬁrms have peaks in the spring and summer, retailers peak around Christmas, and the manufacturers who supply both construction companies and retailers follow similar patterns. Similarly, virtually all businesses must build up net operating working capital (NOWC) when the economy is strong, but they then sell off inventories and reduce receivables when the economy slacks off. Still, NOWC rarely drops to

12 A ﬁnancial calculator can also be used to determine the cost of trade credit. If the terms of credit are 2/10, net 30, this implies that for every $100 of goods purchased at the full list price, the customer has the choice of paying the full amount in 30 days or else paying $98 in 10 days. If a customer decides not to take the discount, then it is in effect borrowing $98, the amount it would otherwise have to pay, from Day 11 to Day 30, or for 20 days. It will then have to pay $100, which is the $98 loan plus a $2 ﬁnancing charge, at the end of the 20-day loan period. To calculate the interest rate, enter N 1, PV 98, PMT 0, FV 100, and then press I to obtain 2.04 percent. This is the rate for 20 days. To calculate the effective annual interest rate on a 365-day basis, enter N 20/365 0.05479, PV 98, PMT 0, FV 100, and then press I to obtain 44.6 percent. The 20/365 0.05479, is the fraction of a year the “loan” is outstanding, and the 44.6 percent is the annualized cost of not taking discounts.

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zero — companies have some permanent NOWC, which is the NOWC on hand at the low point of the cycle. Then, as sales increase during the upswing, NOWC must be increased, and the additional NOWC is deﬁned as temporary NOWC. The manner in which the permanent and temporary NOWC are ﬁnanced is called the ﬁrm’s short-term ﬁnancing policy.

Maturity Matching, or “Self-Liquidating,” Approach The maturity matching, or “self-liquidating,” approach calls for matching asset and liability maturities as shown in Panel a of Figure 16-2. This strategy minimizes the risk that the ﬁrm will be unable to pay off its maturing obligations. To illustrate, suppose a company borrows on a one-year basis and uses the funds obtained to build and equip a plant. Cash ﬂows from the plant (proﬁts plus depreciation) would not be sufﬁcient to pay off the loan at the end of only one year, so the loan would have to be renewed. If for some reason the lender refused to renew the loan, then the company would have problems. Had the plant been ﬁnanced with long-term debt, however, the required loan payments would have been better matched with cash ﬂows from proﬁts and depreciation, and the problem of renewal would not have arisen. At the limit, a ﬁrm could attempt to match exactly the maturity structure of its assets and liabilities. Inventory expected to be sold in 30 days could be ﬁnanced with a 30-day bank loan; a machine expected to last for 5 years could be ﬁnanced with a 5-year loan; a 20-year building could be ﬁnanced with a 20-year mortgage bond; and so forth. In practice, ﬁrms don’t actually ﬁnance each speciﬁc asset with a type of capital that has a maturity equal to the asset’s life. However, academic studies do show that most ﬁrms tend to ﬁnance short-term assets from short-term sources and longterm assets from long-term sources.13

Aggressive Approach Panel b of Figure 16-2 illustrates the situation for a relatively aggressive ﬁrm that ﬁnances all of its ﬁxed assets with long-term capital and part of its permanent NOWC with short-term debt. Note that we used the term “relatively” in the title for Panel b because there can be different degrees of aggressiveness. For example, the dashed line in Panel b could have been drawn below the line designating ﬁxed assets, indicating that all of the permanent NOWC and part of the ﬁxed assets were ﬁnanced with short-term credit; this would be a highly aggressive, extremely nonconservative position, and the ﬁrm would be very much subject to dangers from rising interest rates as well as to loan renewal problems. However, short-term debt is often cheaper than long-term debt, and some ﬁrms are willing to sacriﬁce safety for the chance of higher proﬁts.

Conservative Approach Panel c of Figure 16-2 has the dashed line above the line designating permanent NOWC, indicating that long-term sources are being used to ﬁnance all permanent operating asset requirements and also to meet some of the seasonal needs. In this situation, the ﬁrm uses a small amount of short-term debt to meet its peak requirements, but it also meets a part of its seasonal needs by “storing liquidity” in the form of marketable securities. The humps above the dashed line represent short-term ﬁnancing, while the troughs below the dashed line represent short-term investing. Panel c represents a very safe, conservative current asset ﬁnancing policy. 13 For example, see William Beranek, Christopher Cornwell, and Sunho Choi, “External Financing, Liquidity, and Capital Expenditures,” Journal of Financial Research, Summer 1995, 207–222.

599

600

Working Capital Management Alternative Short-Term Financing Policies FIGURE 16-2

Alternative Short-Term Financing Policies a. Moderate Approach (Maturity Matching) Dollars Temporary NOWC

Temporary NOWC

Short-Term Debt

Permanent Level of NOWC

Total Permanent Net Operating Assets

Long-Term Debt plus Equity

Fixed Assets

1

2

3

4

5

6 7 8 Time Period

b. Relatively Aggressive Approach Dollars Temporary NOWC

Short-Term Debt

Permanent Level of NOWC

Long-Term Debt plus Equity

Fixed Assets

1

2

3

4

5

6 7 8 Time Period

c. Conservative Approach Dollars

Short-Term Financing Requirements

Marketable Securities

Permanent Level of NOWC

Fixed Assets

1

2

3

4

5

6 7 8 Time Period

Long-Term Debt plus Equity

605

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What is meant by the term “permanent NOWC”? What is meant by the term “temporary NOWC”? What are three alternative short-term ﬁnancing policies? Is one best?

Short-Term Investments: Marketable Securities Realistically, the management of cash and marketable securities cannot be separated — management of one implies management of the other. In the ﬁrst part of the chapter, we focused on cash management. Now, we turn to marketable securities. Marketable securities typically provide much lower yields than operating assets. For example, recently DaimlerChrysler held approximately a $7 billion portfolio of short-term marketable securities that provided a much lower yield than its operating assets. Why would a company such as DaimlerChrysler have such large holdings of low-yielding assets? In many cases, companies hold marketable securities for the same reasons they hold cash. Although these securities are not the same as cash, in most cases they can be converted to cash on very short notice (often just a few minutes) with a single telephone call. Moreover, while cash and most commercial checking accounts yield nothing, marketable securities provide at least a modest return. For this reason, many ﬁrms hold at least some marketable securities in lieu of larger cash balances, liquidating part of the portfolio to increase the cash account when cash outﬂows exceed inﬂows. In such situations, the marketable securities could be used as a substitute for transactions balances or for precautionary balances. In most cases, the securities are held primarily for precautionary purposes — most ﬁrms prefer to rely on bank credit to make temporary transactions, but they may still hold some liquid assets to guard against a possible shortage of bank credit during difﬁcult times. There are both beneﬁts and costs associated with holding marketable securities. The beneﬁts are twofold: (1) the ﬁrm reduces risk and transactions costs because it won’t have to issue securities or borrow as frequently to raise cash; and (2) it will have ready cash to take advantage of bargain purchases or growth opportunities. Funds held for the second reason are called speculative balances. The primary disadvantage is that the after-tax return on short-term securities is very low. Thus, ﬁrms face a trade-off between beneﬁts and costs. Recent research supports this trade-off hypothesis as an explanation for ﬁrms’ cash holdings.14 Firms with high growth opportunities suffer the most if they don’t have ready cash to quickly take advantage of an opportunity, and the data show that these ﬁrms do hold relatively high levels of marketable securities. Firms with volatile cash ﬂows are the ones most likely to run low on cash, so they tend to hold high levels of cash. In contrast, cash holdings are less important to large ﬁrms with high credit ratings, because they have quick and inexpensive access to capital markets. As expected, such ﬁrms hold relatively low levels of cash. Of course, there will always be outliers such as Ford, which is large, strong, and cash-rich, but volatile ﬁrms with good growth opportunities are still the ones with the most marketable securities, on average. Why might a company hold low-yielding marketable securities when it could earn a much higher return on operating assets?

14

See Tim Opler, Lee Pinkowitz, René Stulz, and Rohan Williamson, “The Determinants and Implications of Corporate Cash Holdings,” Journal of Financial Economics, Vol. 52, 1999, 3– 46.

601

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Working Capital Management Short-Term Bank Loans

607

Short-Term Financing The three possible short-term ﬁnancing policies described earlier were distinguished by the relative amounts of short-term debt used under each policy. The aggressive policy called for the greatest use of short-term debt, while the conservative policy called for the least. Maturity matching fell in between. Although short-term credit is generally riskier than long-term credit, using short-term funds does have some signiﬁcant advantages. The pros and cons of short-term ﬁnancing are considered in this section.

Advantages of Short-Term Financing First, a short-term loan can be obtained much faster than long-term credit. Lenders will insist on a more thorough ﬁnancial examination before extending long-term credit, and the loan agreement will have to be spelled out in considerable detail because a lot can happen during the life of a 10- to 20-year loan. Therefore, if funds are needed in a hurry, the ﬁrm should look to the short-term markets. Second, if its needs for funds are seasonal or cyclical, a ﬁrm may not want to commit itself to long-term debt: (1) Flotation costs are higher for long-term debt than for short-term credit. (2) Although long-term debt can be repaid early, provided the loan agreement includes a prepayment provision, prepayment penalties can be expensive. Accordingly, if a ﬁrm thinks its need for funds will diminish in the near future, it should choose short-term debt. (3) Long-term loan agreements always contain provisions, or covenants, which constrain the ﬁrm’s future actions. Short-term credit agreements are generally less restrictive. Third, the yield curve is normally upward sloping, indicating that interest rates are generally lower on short-term debt. Thus, under normal conditions, interest costs at the time the funds are obtained will be lower if the ﬁrm borrows on a short-term rather than a long-term basis.

Disadvantages of Short-Term Debt Even though short-term rates are often lower than long-term rates, short-term credit is riskier for two reasons: (1) If a ﬁrm borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term credit, its interest expense will ﬂuctuate widely, at times going quite high. For example, the rate banks charge large corporations for short-term debt more than tripled over a two-year period in the 1980s, rising from 6.25 to 21 percent. Many ﬁrms that had borrowed heavily on a short-term basis simply could not meet their rising interest costs, and as a result, bankruptcies hit record levels during that period. (2) If a ﬁrm borrows heavily on a short-term basis, a temporary recession may render it unable to repay this debt. If the borrower is in a weak ﬁnancial position, the lender may not extend the loan, which could force the ﬁrm into bankruptcy. What are the advantages and disadvantages of short-term debt over long-term debt?

Short-Term Bank Loans Loans from commercial banks generally appear on balance sheets as notes payable. A bank’s inﬂuence is actually greater than it appears from the dollar amounts because banks provide nonspontaneous funds. As a ﬁrm’s ﬁnancing needs increase, it requests additional funds from its bank. If the request is denied, the ﬁrm may be forced to

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abandon attractive growth opportunities. The key features of bank loans are discussed in the following paragraphs.

Maturity Although banks do make longer-term loans, the bulk of their lending is on a short-term basis — about two-thirds of all bank loans mature in a year or less. Bank loans to businesses are frequently written as 90-day notes, so the loan must be repaid or renewed at the end of 90 days. Of course, if a borrower’s ﬁnancial position has deteriorated, the bank may refuse to renew the loan. This can mean serious trouble for the borrower.

Promissory Note When a bank loan is approved, the agreement is executed by signing a promissory note. The note speciﬁes (1) the amount borrowed; (2) the interest rate; (3) the repayment schedule, which can call for either a lump sum or a series of installments; (4) any collateral that might have to be put up as security for the loan; and (5) any other terms and conditions to which the bank and the borrower have agreed. When the note is signed, the bank credits the borrower’s checking account with the funds, so on the borrower’s balance sheet both cash and notes payable increase.

Compensating Balances Banks sometimes require borrowers to maintain an average demand deposit (checking account) balance equal to from 10 to 20 percent of the face amount of the loan. This is called a compensating balance, and such balances raise the effective interest rate on the loans. For example, if a ﬁrm needs $80,000 to pay off outstanding obligations, but if it must maintain a 20 percent compensating balance, then it must borrow $100,000 to obtain a usable $80,000. If the stated annual interest rate is 8 percent, the effective cost is actually 10 percent: $8,000 interest divided by $80,000 of usable funds equals 10 percent.15 As we noted earlier in the chapter, recent surveys indicate that compensating balances are much less common now than 20 years ago. In fact, compensating balances are now illegal in many states. Despite this trend, some small banks in states where compensating balances are legal still require their customers to maintain compensating balances.

Informal Line of Credit A line of credit is an informal agreement between a bank and a borrower indicating the maximum credit the bank will extend to the borrower. For example, on December 31, a bank loan ofﬁcer might indicate to a ﬁnancial manager that the bank regards the ﬁrm as being “good” for up to $80,000 during the forthcoming year, provided the borrower’s ﬁnancial condition does not deteriorate. If on January 10 the ﬁnancial manager signs a promissory note for $15,000 for 90 days, this would be called “taking down” $15,000 of the total line of credit. This amount would be credited to the ﬁrm’s checking account at the bank, and before repayment of the $15,000, the ﬁrm could borrow additional amounts up to a total of $80,000 outstanding at any one time. 15

Note, however, that the compensating balance may be set as a minimum monthly average, and if the ﬁrm would maintain this average anyway, the compensating balance requirement would not raise the effective interest rate. Also, note that these loan compensating balances are added to any compensating balances that the ﬁrm’s bank may require for services performed, such as clearing checks.

603

604

Working Capital Management Commercial Paper

609

Revolving Credit Agreement A revolving credit agreement is a formal line of credit often used by large ﬁrms. To illustrate, in 2002 Texas Petroleum Company negotiated a revolving credit agreement for $100 million with a group of banks. The banks were formally committed for four years to lend the ﬁrm up to $100 million if the funds were needed. Texas Petroleum, in turn, paid an annual commitment fee of 1⁄4 of 1 percent on the unused balance of the commitment to compensate the banks for making the commitment. Thus, if Texas Petroleum did not take down any of the $100 million commitment during a year, it would still be required to pay a $250,000 annual fee, normally in monthly installments of $20,833.33. If it borrowed $50 million on the ﬁrst day of the agreement, the unused portion of the line of credit would fall to $50 million, and the annual fee would fall to $125,000. Of course, interest would also have to be paid on the money Texas Petroleum actually borrowed. As a general rule, the interest rate on “revolvers” is pegged to the prime rate, the T-bill rate, or some other market rate, so the cost of the loan varies over time as interest rates change. Texas Petroleum’s rate was set at prime plus 0.5 percentage point. Note that a revolving credit agreement is very similar to an informal line of credit, but with an important difference: The bank has a legal obligation to honor a revolving credit agreement, and it receives a commitment fee. Neither the legal obligation nor the fee exists under the informal line of credit. Often a line of credit will have a clean-up clause that requires the borrower to reduce the loan balance to zero at least once a year. Keep in mind that a line of credit typically is designed to help ﬁnance negative operating cash ﬂows that are incurred as a natural part of a company’s business cycle, not as a source of permanent capital. For example, the total annual operating cash ﬂow of Toys “ R ” Us is normally positive, even though its operating cash ﬂow is negative during the fall as it builds up inventory for the Christmas season. However, Toys “ R ” Us has large positive cash ﬂows in December through February, as it collects on Christmas sales. Their bankers would expect Toys “ R ” Us to use those positive cash ﬂows to pay off balances that had been drawn against their credit lines. Otherwise, Toys “ R ” Us would be using its credit lines as a permanent source of ﬁnancing. Explain how a ﬁrm that expects to need funds during the coming year might make sure the needed funds will be available.

Commercial Paper

For updates on the outstanding balances of commercial paper, go to http:// www.federalreserve.gov/ releases/ and check out the daily releases for Commercial Paper and the weekly releases for Assets and Liabilities of Commercial Banks in the United States.

Commercial paper is a type of unsecured promissory note issued by large, strong ﬁrms and sold primarily to other business ﬁrms, to insurance companies, to pension funds, to money market mutual funds, and to banks. In August 2001, there was approximately $1,434 billion of commercial paper outstanding, versus about $1,062 billion of bank loans. Much of this commercial paper outstanding is issued by ﬁnancial institutions.

Maturity and Cost Maturities of commercial paper generally vary from one day to nine months, with an average of about ﬁve months.16 The interest rate on commercial paper ﬂuctuates with supply and demand conditions — it is determined in the marketplace, varying 16

The maximum maturity without SEC registration is 270 days. Also, commercial paper can only be sold to “sophisticated” investors; otherwise, SEC registration would be required even for maturities of 270 days or less.

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daily as conditions change. Recently, commercial paper rates have ranged from 11⁄2 to 31⁄2 percentage points below the stated prime rate, and up to 1⁄2 of a percentage point above the T-bill rate. For example, in December 2001, the average rate on For current rates, see http:// three-month commercial paper was 1.75 percent, the stated prime rate was 5.0 perwww.federalreserve. cent, and the three-month T-bill rate was 1.68 percent. gov/releases, and look at the Daily Releases for Selected Interest Rates.

Use of Commercial Paper The use of commercial paper is restricted to a comparatively small number of very large concerns that are exceptionally good credit risks. Dealers prefer to handle the paper of ﬁrms whose net worth is $100 million or more and whose annual borrowing exceeds $10 million. One potential problem with commercial paper is that a debtor who is in temporary ﬁnancial difﬁculty may receive little help because commercial paper dealings are generally less personal than are bank relationships. Thus, banks are generally more able and willing to help a good customer weather a temporary storm than is a commercial paper dealer. On the other hand, using commercial paper permits a corporation to tap a wide range of credit sources, including ﬁnancial institutions outside its own area and industrial corporations across the country, and this can reduce interest costs. What is commercial paper? What types of companies can use commercial paper to meet their short-term ﬁnancing needs? How does the cost of commercial paper compare with the cost of short-term bank loans? With the cost of Treasury bills?

Use of Security in Short-Term Financing Thus far, we have not addressed the question of whether or not short-term loans should be secured. Commercial paper is never secured, but other types of loans can be secured if this is deemed necessary or desirable. Other things held constant, it is better to borrow on an unsecured basis, since the bookkeeping costs of secured loans are often high. However, ﬁrms often ﬁnd that they can borrow only if they put up some type of collateral to protect the lender, or that by using security they can borrow at a much lower rate. Several different kinds of collateral can be employed, including marketable stocks or bonds, land or buildings, equipment, inventory, and accounts receivable. Marketable securities make excellent collateral, but few firms that need loans also hold portfolios of stocks and bonds. Similarly, real property (land and buildings) and equipment are good forms of collateral, but they are generally used as security for long-term loans rather than for working capital loans. Therefore, most secured short-term business borrowing involves the use of accounts receivable and inventories as collateral. To understand the use of security, consider the case of a Chicago hardware dealer who wanted to modernize and expand his store. He requested a $200,000 bank loan. After examining his business’s ﬁnancial statements, the bank indicated that it would lend him a maximum of $100,000 and that the effective interest rate would be 12.1 percent. The owner had a substantial personal portfolio of stocks, and he offered to put up $300,000 of high-quality stocks to support the $200,000 loan. The bank then granted the full $200,000 loan, and at the prime rate of 9.5 percent. The store owner might also

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Working Capital Management Summary

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have used his inventories or receivables as security for the loan, but processing costs would have been high.17 For a more detailed discussion of secured ﬁnancing, see the Web Extension to this chapter. What is a secured loan? What are some types of current assets that are pledged as security for shortterm loans?

Summary This chapter discussed working capital management and short-term ﬁnancing. The key concepts covered are listed below. 䊉

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Working capital refers to current assets, and net working capital is deﬁned as current assets minus current liabilities. Net operating working capital is deﬁned as operating current assets minus operating current liabilities. The cash conversion cycle model focuses on the length of time between when the company makes payments and when it receives cash inﬂows. The inventory conversion period is the average time required to convert materials into ﬁnished goods and then to sell those goods. Inventory conversion period Inventory/Sales per day.

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The receivables collection period is the average length of time required to convert the ﬁrm’s receivables into cash, that is, to collect cash following a sale. Receivables collection period DSO Receivables/(Sales/365).

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The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for them. Payables deferral period Payables/Purchases per day.

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The cash conversion cycle equals the length of time between the ﬁrm’s actual cash expenditures to pay for productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receivables). Cash Inventory Receivables Payables conversion conversion collection deferral . cycle period period period

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Under a relaxed working capital policy, a ﬁrm would hold relatively large amounts of each type of current asset. Under a restricted working capital policy, the ﬁrm would hold minimal amounts of these items. The primary goal of cash management is to reduce the amount of cash to the minimum necessary to conduct business.

The term “asset-based ﬁnancing” is often used as a synonym for “secured ﬁnancing.” In recent years, accounts receivable have been used as security for long-term bonds, and this permits corporations to borrow from lenders such as pension funds rather than being restricted to banks and other traditional short-term lenders.

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CHAPTER 16

Working Capital Management 䊉

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The transactions balance is the cash necessary to conduct day-to-day business, whereas the precautionary balance is a cash reserve held to meet random, unforeseen needs. A compensating balance is a minimum checking account balance that a bank requires as compensation either for services provided or as part of a loan agreement. A cash budget is a schedule showing projected cash inﬂows and outﬂows over some period. The cash budget is used to predict cash surpluses and deﬁcits, and it is the primary cash management planning tool. The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level. Inventory costs can be divided into three types: carrying costs, ordering costs, and stock-out costs. In general, carrying costs increase as the level of inventory rises, but ordering costs and stock-out costs decline with larger inventory holdings. When a ﬁrm sells goods to a customer on credit, an account receivable is created. A ﬁrm can use an aging schedule and the days sales outstanding (DSO) to help keep track of its receivables position and to help avoid an increase in bad debts. A ﬁrm’s credit policy consists of four elements: (1) credit period, (2) discounts given for early payment, (3) credit standards, and (4) collection policy. Permanent net operating working capital is the NOWC that the ﬁrm holds even during slack times, whereas temporary NOWC is the additional NOWC needed during seasonal or cyclical peaks. The methods used to ﬁnance permanent and temporary NOWC deﬁne the ﬁrm’s short-term ﬁnancing policy. A moderate approach to short-term ﬁnancing involves matching, to the extent possible, the maturities of assets and liabilities, so that temporary NOWC is ﬁnanced with short-term debt, and permanent NOWC and ﬁxed assets are ﬁnanced with long-term debt or equity. Under an aggressive approach, some permanent NOWC, and perhaps even some ﬁxed assets, are ﬁnanced with short-term debt. A conservative approach would be to use long-term sources to ﬁnance all permanent operating capital and some of the temporary NOWC. The advantages of short-term credit are (1) the speed with which short-term loans can be arranged, (2) increased ﬂexibility, and (3) the fact that short-term interest rates are generally lower than long-term rates. The principal disadvantage of short-term credit is the extra risk the borrower must bear because (1) the lender can demand payment on short notice and (2) the cost of the loan will increase if interest rates rise. Accounts payable, or trade credit, arises spontaneously as a result of credit purchases. Firms should use all the free trade credit they can obtain, but they should use costly trade credit only if it is less expensive than other forms of short-term debt. Suppliers often offer discounts to customers who pay within a stated discount period. The following equation may be used to calculate the nominal cost, on an annual basis, of not taking discounts: 365 days Nominal Discount percent . Discount cost Days credit is Discount 100 percent outstanding period

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Bank loans are an important source of short-term credit. When a bank loan is approved, a promissory note is signed. It speciﬁes: (1) the amount borrowed, (2) the percentage interest rate, (3) the repayment schedule, (4) the collateral, and (5) any other conditions to which the parties have agreed.

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Working Capital Management Questions 䊉

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Banks sometimes require borrowers to maintain compensating balances, which are deposit requirements set at between 10 and 20 percent of the loan amount. Compensating balances raise the effective interest rate on bank loans. A line of credit is an informal agreement between the bank and the borrower indicating the maximum amount of credit the bank will extend to the borrower. A revolving credit agreement is a formal line of credit often used by large ﬁrms; it involves a commitment fee. Commercial paper is unsecured short-term debt issued by large, ﬁnancially strong corporations. Although the cost of commercial paper is lower than the cost of bank loans, it can be used only by large ﬁrms with exceptionally strong credit ratings. Sometimes a borrower will ﬁnd that it is necessary to borrow on a secured basis, in which case the borrower pledges assets such as real estate, securities, equipment, inventories, or accounts receivable as collateral for the loan.

Questions 16–1

Deﬁne each of the following terms: a. Working capital; net working capital; net operating working capital b. Inventory conversion period; receivables collection period; payables deferral period; cash conversion cycle c. Relaxed NOWC policy; restricted NOWC policy; moderate NOWC policy d. Transactions balance; compensating balance; precautionary balance e. Cash budget; target cash balance f. Trade discounts g. Account receivable; days sales outstanding; aging schedule h. Credit policy; credit period; credit standards; collection policy; cash discounts i. Permanent NOWC; temporary NOWC j. Moderate short-term ﬁnancing policy; aggressive short-term ﬁnancing policy; conservative short-term ﬁnancing policy k. Maturity matching, or “self-liquidating,” approach l. Accruals m. Trade credit; stretching accounts payable; free trade credit; costly trade credit n. Promissory note; line of credit; revolving credit agreement o. Commercial paper; secured loan

16–2

What are the two principal reasons for holding cash? Can a ﬁrm estimate its target cash balance by summing the cash held to satisfy each of the two reasons?

16–3

Is it true that when one ﬁrm sells to another on credit, the seller records the transaction as an account receivable while the buyer records it as an account payable and that, disregarding discounts, the receivable typically exceeds the payable by the amount of proﬁt on the sale?

16–4

What are the four elements of a ﬁrm’s credit policy? To what extent can ﬁrms set their own credit policies as opposed to having to accept policies that are dictated by “the competition”?

16–5

What are the advantages of matching the maturities of assets and liabilities? What are the disadvantages?

16–6

From the standpoint of the borrower, is long-term or short-term credit riskier? Explain. Would it ever make sense to borrow on a short-term basis if short-term rates were above long-term rates?

16–7

“Firms can control their accruals within fairly wide limits.” Discuss.

16–8

Is it true that most ﬁrms are able to obtain some free trade credit and that additional trade credit is often available, but at a cost? Explain.

16–9

What kinds of ﬁrms use commercial paper?

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CHAPTER 16

Working Capital Management

Self-Test Problems ST–1 WORKING CAPITAL POLICY

ST–2 CURRENT ASSET FINANCING

(Solutions Appear in Appendix A)

The Calgary Company is attempting to establish a current assets policy. Fixed assets are $600,000, and the ﬁrm plans to maintain a 50 percent debt-to-assets ratio. Calgary has no operating current liabilities. The interest rate is 10 percent on all debt. Three alternative current asset policies are under consideration: 40, 50, and 60 percent of projected sales. The company expects to earn 15 percent before interest and taxes on sales of $3 million. Calgary’s effective federalplus-state tax rate is 40 percent. What is the expected return on equity under each alternative? Vanderheiden Press Inc. and the Herrenhouse Publishing Company had the following balance sheets as of December 31, 2002 (thousands of dollars): Vanderheiden Press

Herrenhouse Publishing

Current assets Fixed assets (net) Total assets

$100,000 100,000 $200,000

$ 80,000 120,000 $200,000

Current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

$ 20,000 80,000 50,000 50,000 $200,000

$ 80,000 20,000 50,000 50,000 $200,000

Earnings before interest and taxes for both ﬁrms are $30 million, and the effective federal-plusstate tax rate is 40 percent. a. What is the return on equity for each firm if the interest rate on current liabilities is 10 percent and the rate on long-term debt is 13 percent? b. Assume that the short-term rate rises to 20 percent. While the rate on new long-term debt rises to 16 percent, the rate on existing long-term debt remains unchanged. What would be the return on equity for Vanderheiden Press and Herrenhouse Publishing under these conditions? c. Which company is in a riskier position? Why?

Problems 16–1 CASH MANAGEMENT

16–2 RECEIVABLES INVESTMENT

16–3

Williams & Sons last year reported sales of $10 million and an inventory turnover ratio of 2. The company is now adopting a new inventory system. If the new system is able to reduce the ﬁrm’s inventory level and increase the ﬁrm’s inventory turnover ratio to 5, while maintaining the same level of sales, how much cash will be freed up? Medwig Corporation has a DSO of 17 days. The company averages $3,500 in credit sales each day. What is the company’s average accounts receivable? What is the nominal and effective cost of trade credit under the credit terms of 3/15, net 30?

COST OF TRADE CREDIT

16–4 COST OF TRADE CREDIT

16–5 ACCOUNTS PAYABLE

16–6 RECEIVABLES INVESTMENT

A large retailer obtains merchandise under the credit terms of 1/15, net 45, but routinely takes 60 days to pay its bills. Given that the retailer is an important customer, suppliers allow the ﬁrm to stretch its credit terms. What is the retailer’s effective cost of trade credit? A chain of appliance stores, APP Corporation, purchases inventory with a net price of $500,000 each day. The company purchases the inventory under the credit terms of 2/15, net 40. APP always takes the discount, but takes the full 15 days to pay its bills. What is the average accounts payable for APP? McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are $912,500. Forty percent of the customers pay on the 10th day and take discounts; the other 60 percent pay, on average, 40 days after their purchases. a. What is the days sales outstanding?

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Working Capital Management Problems

615

b. What is the average amount of receivables? c. What would happen to average receivables if McDowell toughened up on its collection policy with the result that all nondiscount customers paid on the 30th day? 16–7 COST OF TRADE CREDIT

16–8 COST OF TRADE CREDIT

16–9 COST OF TRADE CREDIT

16–10 EFFECTIVE COST OF TRADE CREDIT

16–11 CASH CONVERSION CYCLE

16–12 WORKING CAPITAL CASH FLOW CYCLE

16–13 WORKING CAPITAL POLICY

Calculate the nominal annual cost of nonfree trade credit under each of the following terms. Assume payment is made either on the due date or on the discount date. a. 1/15, net 20. b. 2/10, net 60. c. 3/10, net 45. d. 2/10, net 45. e. 2/15, net 40. a. If a ﬁrm buys under terms of 3/15, net 45, but actually pays on the 20th day and still takes the discount, what is the nominal cost of its nonfree trade credit? b. Does it receive more or less credit than it would if it paid within 15 days? Grunewald Industries sells on terms of 2/10, net 40. Gross sales last year were $4,562,500, and accounts receivable averaged $437,500. Half of Grunewald’s customers paid on the 10th day and took discounts. What are the nominal and effective costs of trade credit to Grunewald’s nondiscount customers? (Hint: Calculate sales/day based on a 365-day year; then get average receivables of discount customers; then ﬁnd the DSO for the nondiscount customers.) The D. J. Masson Corporation needs to raise $500,000 for 1 year to supply working capital to a new store. Masson buys from its suppliers on terms of 3/10, net 90, and it currently pays on the 10th day and takes discounts, but it could forgo discounts, pay on the 90th day, and get the needed $500,000 in the form of costly trade credit. What is the effective annual interest rate of the costly trade credit? The Zocco Corporation has an inventory conversion period of 75 days, a receivables collection period of 38 days, and a payables deferral period of 30 days. a. What is the length of the ﬁrm’s cash conversion cycle? b. If Zocco’s annual sales are $3,421,875 and all sales are on credit, what is the firm’s investment in accounts receivable? c. How many times per year does Zocco turn over its inventory? The Christie Corporation is trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash ﬂow cycle. Christie’s 2002 sales (all on credit) were $150,000, and it earned a net proﬁt of 6 percent, or $9,000. It turned over its inventory 5 times during the year, and its DSO was 36.5 days. The ﬁrm had ﬁxed assets totaling $35,000. Christie’s payables deferral period is 40 days. a. Calculate Christie’s cash conversion cycle. b. Assuming Christie holds negligible amounts of cash and marketable securities, calculate its total assets turnover and ROA. c. Suppose Christie’s managers believe that the inventory turnover can be raised to 7.3 times. What would Christie’s cash conversion cycle, total assets turnover, and ROA have been if the inventory turnover had been 7.3 for 2002? The Rentz Corporation is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the ﬁrm wishes to maintain a 60 percent debt ratio. Rentz’s interest cost is currently 8 percent on both short-term and longer-term debt (which the ﬁrm uses in its permanent structure). Three alternatives regarding the projected current asset level are available to the ﬁrm: (1) a tight policy requiring current assets of only 45 percent of projected sales, (2) a moderate policy of 50 percent of sales in current assets, and (3) a relaxed policy requiring current assets of 60 percent of sales. The ﬁrm expects to generate earnings before interest and taxes at a rate of 12 percent on total sales. a. What is the expected return on equity under each current asset level? (Assume a 40 percent effective federal-plus-state tax rate.)

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CHAPTER 16

Working Capital Management b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption? c. How would the overall riskiness of the ﬁrm vary under each policy?

16–14 CASH BUDGETING

Dorothy Koehl recently leased space in the Southside Mall and opened a new business, Koehl’s Doll Shop. Business has been good, but Koehl has frequently run out of cash. This has necessitated late payment on certain orders, which, in turn, is beginning to cause a problem with suppliers. Koehl plans to borrow from the bank to have cash ready as needed, but ﬁrst she needs a forecast of just how much she must borrow. Accordingly, she has asked you to prepare a cash budget for the critical period around Christmas, when needs will be especially high. Sales are made on a cash basis only. Koehl’s purchases must be paid for during the following month. Koehl pays herself a salary of $4,800 per month, and the rent is $2,000 per month. In addition, she must make a tax payment of $12,000 in December. The current cash on hand (on December 1) is $400, but Koehl has agreed to maintain an average bank balance of $6,000 — this is her target cash balance. (Disregard till cash, which is insigniﬁcant because Koehl keeps only a small amount on hand in order to lessen the chances of robbery.) The estimated sales and purchases for December, January, and February are shown below. Purchases during November amounted to $140,000.

December January February

Sales

Purchases

$160,000 40,000 60,000

$40,000 40,000 40,000

a. Prepare a cash budget for December, January, and February. b. Now, suppose Koehl were to start selling on a credit basis on December 1, giving customers 30 days to pay. All customers accept these terms, and all other facts in the problem are unchanged. What would the company’s loan requirements be at the end of December in this case? (Hint: The calculations required to answer this question are minimal.) 16–15 CASH DISCOUNTS

16–16 TRADE CREDIT VERSUS BANK CREDIT

16–17 BANK FINANCING

Suppose a ﬁrm makes purchases of $3.65 million per year under terms of 2/10, net 30, and takes discounts. a. What is the average amount of accounts payable net of discounts? (Assume that the $3.65 million of purchases is net of discounts — that is, gross purchases are $3,724,490, discounts are $74,490, and net purchases are $3.65 million.) b. Is there a cost of the trade credit the ﬁrm uses? c. If the ﬁrm did not take discounts but it did pay on the due date, what would be its average payables and the cost of this nonfree trade credit? d. What would its cost of not taking discounts be if it could stretch its payments to 40 days? The Thompson Corporation projects an increase in sales from $1.5 million to $2 million, but it needs an additional $300,000 of current assets to support this expansion. Thompson can ﬁnance the expansion by no longer taking discounts, thus increasing accounts payable. Thompson purchases under terms of 2/10, net 30, but it can delay payment for an additional 35 days — paying in 65 days and thus becoming 35 days past due — without a penalty because of its suppliers’ current excess capacity problems. What is the effective, or equivalent, annual cost of the trade credit? The Raattama Corporation had sales of $3.5 million last year, and it earned a 5 percent return, after taxes, on sales. Recently, the company has fallen behind in its accounts payable. Although its terms of purchase are net 30 days, its accounts payable represent 60 days’ purchases. The company’s treasurer is seeking to increase bank borrowings in order to become current in meeting its trade obligations (that is, to have 30 days’ payables outstanding). The company’s balance sheet is as follows (thousands of dollars): Cash Accounts receivable Inventory Current assets

$ 100 300 1,400 $1,800

Accounts payable Bank loans Accruals Current liabilities

$ 600 700 . 200 $1,500

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612

Working Capital Management Spreadsheet Problem Land and buildings Equipment Total assets

600 600 $3,000

Mortgage on real estate Common stock, $0.10 par Retained earnings Total liabilities and equity

617

700 300 500 $3,000

a. How much bank ﬁnancing is needed to eliminate the past-due accounts payable? b. Would you as a bank loan ofﬁcer make the loan? Why or why not?

Spreadsheet Problem 16–18 BUILD A MODEL: CASH BUDGETING

Start with the partial model in the ﬁle Ch 16 P18 Build a Model.xls from the textbook’s web site. Helen Bowers, owner of Helen’s Fashion Designs, is planning to request a line of credit from her bank. She has estimated the following sales forecasts for the ﬁrm for parts of 2003 and 2004: Sales

May 2003 June July August September October November December January 2004

$180,000 180,000 360,000 540,000 720,000 360,000 360,000 90,000 180,000

Labor and Raw Materials

$ 90,000 90,000 126,000 882,000 306,000 234,000 162,000 90,000 NA

Collection estimates obtained from the credit and collection department are as follows: collections within the month of sale, 10 percent; collections the month following the sale, 75 percent; collections the second month following the sale, 15 percent. Payments for labor and raw materials are typically made during the month following the one in which these costs have been incurred. Total labor and raw materials costs are estimated for each month as shown above. General and administrative salaries will amount to approximately $27,000 a month; lease payments under long-term lease contracts will be $9,000 a month; depreciation charges will be $36,000 a month; miscellaneous expenses will be $2,700 a month; income tax payments of $63,000 will be due in both September and December; and a progress payment of $180,000 on a new design studio must be paid in October. Cash on hand on July 1 will amount to $132,000, and a minimum cash balance of $90,000 will be maintained throughout the cash budget period. a. Prepare a monthly cash budget for the last 6 months of 2003. b. Prepare an estimate of the required ﬁnancing (or excess funds) — that is, the amount of money Bowers will need to borrow (or will have available to invest) — for each month during that period. c. Assume that receipts from sales come in uniformly during the month (that is, cash receipts come in at the rate of 1/30 each day), but all outﬂows are paid on the 5th of the month. Will this have an effect on the cash budget — in other words, would the cash budget you have prepared be valid under these assumptions? If not, what can be done to make a valid estimate of peak financing requirements? No calculations are required, although calculations can be used to illustrate the effects. d. Bowers produces on a seasonal basis, just ahead of sales. Without making any calculations, discuss how the company’s current ratio and debt ratio would vary during the year assuming all ﬁnancial requirements were met by short-term bank loans. Could changes in these ratios affect the ﬁrm’s ability to obtain bank credit? e. If its customers began to pay late, this would slow down collections and thus increase the required loan amount. Also, if sales dropped off, this would have an effect on the required loan. Do a sensitivity analysis that shows the effects of these two factors on the maximum loan requirement.

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CHAPTER 16

Working Capital Management

Dan Barnes, ﬁnancial manager of Ski Equipment Inc. (SKI), is excited, but apprehensive. The company’s founder recently sold his 51 percent controlling block of stock to Kent Koren, who is a big fan of EVA (Economic Value Added). EVA is found by taking the after-tax operating proﬁt and then subtracting the dollar cost of all the capital the ﬁrm uses: See Ch 16 Show.ppt and Ch 16 MiniCase.xls.

EVA NOPAT Capital costs EBIT(1 T) WACC(Capital employed). If EVA is positive, then the ﬁrm is creating value. On the other hand, if EVA is negative, the ﬁrm is not covering its cost of capital, and stockholders’ value is being eroded. Koren rewards managers handsomely if they create value, but those whose operations produce negative EVAs are soon looking for work. Koren frequently points out that if a company can generate its current level of sales with less assets, it would need less capital. That would, other things held constant, lower capital costs and increase its EVA. Shortly after he took control of SKI, Kent Koren met with SKI’s senior executives to tell them of his plans for the company. First, he presented some EVA data that convinced everyone that SKI had not been creating value in recent years. He then stated, in no uncertain terms, that this situation must change. He noted that SKI’s designs of skis, boots, and clothing are acclaimed throughout the industry, but something is seriously amiss elsewhere in the company. Costs are too high, prices are too low, or the company employs too much capital, and he wants SKI’s managers to correct the problem or else. Barnes has long felt that SKI’s working capital situation should be studied — the company may have the optimal amounts of cash, securities, receivables, and inventories, but it may also have too much or too little of these items. In the past, the production manager resisted Barnes’ efforts to question his holdings of raw materials inventories, the marketing manager resisted questions about ﬁnished goods, the sales staff resisted questions about credit policy (which affects accounts receivable), and the treasurer did not want to talk about her cash and securities balances. Koren’s speech made it clear that such resistance would no longer be tolerated. Barnes also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered without adversely affecting operations, then less capital would be required, the dollar cost of capital would decline, and EVA would increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, while lower ﬁnished goods inventories might lead to the loss of proﬁtable sales. So, before inventories are changed, it will be necessary to study operating as well as ﬁnancial effects. The situation is the same with regard to cash and receivables. Barnes began collecting the following ratios: SKI

Industry

Current Quick Debt/assets Turnover of cash and securities Days sales outstanding (365-day basis) Inventory turnover Fixed assets turnover Total assets turnover Proﬁt margin on sales Return on equity (ROE)

1.75 0.83 58.76% 16.67 45.63 4.82 11.35 2.08 2.07% 10.45%

2.25 1.20 50.00% 22.22 32.00 7.00 12.00 3.00 3.50% 21.00%

Payables deferral period

30.00

33.00

a. Barnes plans to use the preceding ratios as the starting point for discussions with SKI’s operating executives. He wants everyone to think about the pros and cons of changing each type of current asset and how changes would interact to affect proﬁts and EVA. Based on the data, does SKI seem to be following a relaxed, moderate, or restricted working capital policy?

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614

Working Capital Management Mini Case

Nov

Dec

$71,218

$68,212

Jan

619

Feb

Mar

Apr

$52,475

$42,909

$30,524

I. COLLECTIONS AND PURCHASES WORKSHEET

(1) Sales (gross)

$65,213

Collections (2) During month of sale (0.2)(0.98)(month’s sales) (3) During ﬁrst month after sale (0.7)(previous month’s sales) (4) During second month after sale (0.1)(sales 2 months ago) (5) Total collections (Lines 2 3 4)

12,781.75

10,285.10

47,748.40

45,649.10

7,121.80 $67,651.95

6,821.20 $62,755.40

$36,472.65 44,603.75

$25,945.40 36,472.65

$67,651.95 44,603.75 6,690.56 2,500.00

$62,755.40 36,472.65 5,470.90 2,500.00

$53,794.31

$44,443.55

$13,857.64

$18,311.85

$3,000.00

$16,857.64

16,857.64 1,500.00

35,169.49 1,500.00

$15,357.64

$33,669.49

Purchases (6) (0.85)(forecasted sales 2 months from now) (7) Payments (1-month lag)

$44,603.75

II. CASH GAIN OR LOSS FOR MONTH

(8) (9) (10) (11) (12) (13) (14)

Collections (from Section I) Payments for purchases (from Section I) Wages and salaries Rent Taxes Total payments Net cash gain (loss) during month (Line 8 Line 13)

III. CASH SURPLUS OR LOAN REQUIREMENT

(15) Cash at beginning of month if no borrowing is done (16) Cumulative cash (cash at start, gain or loss Line 14 Line 15) (17) Target cash balance (18) Cumulative surplus cash or loans outstanding to maintain $1,500 target cash balance (Line 16 Line 17)

b. How can one distinguish between a relaxed but rational working capital policy and a situation in which a ﬁrm simply has a lot of current assets because it is inefﬁcient? Does SKI’s working capital policy seem appropriate? c. Calculate the ﬁrm’s cash conversion cycle. Assume a 365 day year. d. What might SKI do to reduce its cash without harming operations? In an attempt to better understand SKI’s cash position, Barnes developed a cash budget. Data for the ﬁrst 2 months of the year are shown above. (Note that Barnes’ preliminary cash budget does not account for interest income or interest expense.) He has the ﬁgures for the other months, but they are not shown. e. Should depreciation expense be explicitly included in the cash budget? Why or why not? f. In his preliminary cash budget, Barnes has assumed that all sales are collected and, thus, that SKI has no bad debts. Is this realistic? If not, how would bad debts be dealt with in a cash budgeting sense? (Hint: Bad debts will affect collections but not purchases.) g. Barnes’ cash budget for the entire year, although not given here, is based heavily on his forecast for monthly sales. Sales are expected to be extremely low between May and September but then increase dramatically in the fall and winter. November is typically the

Working Capital Management 620

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Working Capital Management

firm’s best month, when SKI ships equipment to retailers for the holiday season. Interestingly, Barnes’ forecasted cash budget indicates that the company’s cash holdings will exceed the targeted cash balance every month except for October and November, when shipments will be high but collections will not be coming in until later. Based on the ratios shown earlier, does it appear that SKI’s target cash balance is appropriate? In addition to possibly lowering the target cash balance, what actions might SKI take to better improve its cash management policies, and how might that affect its EVA? h. What reasons might SKI have for maintaining a relatively high amount of cash? i. What are the three categories of inventory costs? If the company takes steps to reduce its inventory, what effect would this have on the various costs of holding inventory? j. Is there any reason to think that SKI may be holding too much inventory? If so, how would that affect EVA and ROE? k. If the company reduces its inventory without adversely affecting sales, what effect should this have on the company’s cash position (1) in the short run and (2) in the long run? Explain in terms of the cash budget and the balance sheet. l. Barnes knows that SKI sells on the same credit terms as other ﬁrms in its industry. Use the ratios presented earlier to explain whether SKI’s customers pay more or less promptly than those of its competitors. If there are differences, does that suggest that SKI should tighten or loosen its credit policy? What four variables make up a ﬁrm’s credit policy, and in what direction should each be changed by SKI? m. Does SKI face any risks if it tightens its credit policy? n. If the company reduces its DSO without seriously affecting sales, what effect would this have on its cash position (1) in the short run and (2) in the long run? Answer in terms of the cash budget and the balance sheet. What effect should this have on EVA in the long run? In addition to improving the management of its current assets, SKI is also reviewing the ways in which it ﬁnances its current assets. With this concern in mind, Dan is also trying to answer the following questions. o. Is it likely that SKI could make signiﬁcantly greater use of accruals? p. Assume that SKI buys on terms of 1/10, net 30, but that it can get away with paying on the 40th day if it chooses not to take discounts. Also, assume that it purchases $506,985 of equipment per year, net of discounts. How much free trade credit can the company get, how much costly trade credit can it get, and what is the percentage cost of the costly credit? Should SKI take discounts? q. SKI tries to match the maturity of its assets and liabilities. Describe how SKI could adopt either a more aggressive or more conservative ﬁnancing policy. r. What are the advantages and disadvantages of using short-term debt as a source of ﬁnancing? s. Would it be feasible for SKI to ﬁnance with commercial paper?

Selected Additional References and Cases Gallinger, George W., and P. Basil Healy, Liquidity Analysis and Management (Reading, MA: Addison-Wesley, 1991). Hill, Ned C., and William L. Sartoris, Short-Term Financial Management (New York: Prentice-Hall, 1995). Maness, Terry S., and John T. Zietlow, Short-Term Financial Management: Text, Cases, and Readings (Minneapolist/St. Paul: West, 1993). The following articles provide more information on short-term ﬁnancial management: Gentry, James A., “State of the Art of Short-Run Financial Management,” Financial Management, Summer 1998, 41–57. Gentry, James A., and Jesus M. De La Garza, “Monitoring Accounts Payables,” Financial Review, November 1990, 559–576.

Gentry, James A., R. Vaidyanathan, and Hei Wai Lee, “A Weighted Cash Conversion Cycle,” Financial Management, Spring 1990, 90–99. Lambrix, R. J., S. S. Singhvi, “Managing the Working Capital Cycle,” Financial Executive, June 1979, 32–41. Mitchell, Karlyn, “The Debt Maturity Choice: An Empirical Investigation,” Journal of Financial Research, Winter 1993, 309–320. For more information on transfers systems, see Summers, Bruce J., “Clearing and Payment Systems: The Role of the Central Bank,” Federal Reserve Bulletin, February 1991, 81–91.

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Working Capital Management Selected Additional References and Cases Wood, John C., and Dolores D. Smith, “Electronic Transfer of Government Beneﬁts,” Federal Reserve Bulletin, April 1991, 204–207. The following articles provide more information on each concentration systems: Stone, Bernell K., and Ned C. Hill, “Cash Transfer Scheduling for Efﬁcient Cash Concentration,” Financial Management, Autumn 1980, 35–43. Stone, Bernell K., and Tom W. Miller, “Daily Cash Forecasting with Multiplicative Models of Cash Flow Patterns,” Financial Management, Winter 1987, 45–54. For more information on marketable securities, see Brown, Keith C., and Scott L. Lummer, “A Reexamination of the Covered Call Option Strategy for Corporate Cash Management,” Financial Management, Summer 1986, 13–17. Kamath, Ravindra R., et al., “Management of Excess Cash: Practices and Developments,” Financial Management, Autumn 1985, 70–77. Zivney, Terry L., and Michael J. Alderson, “Hedged Dividend Capture with Stock Index Options,” Financial Management, Summer 1986, 5–12. The following articles and books provide additional insights into the problems of inventory management: Arvan, L., and L. N. Moses, “Inventory Management and the Theory of the Firm,” American Economic Review, March 1982, 186–193. Brooks, L. D., “Risk-Return Criteria and Optimal Inventory Stocks,” Engineering Economist, Summer 1980, 275–299. Followill, Richard A., Michael Schellenger, and Patrick H. Marchard, “Economic Order Quantities, Volume Discounts, and Wealth Maximization,” The Financial Review, February 1990, 143–152. Kallberg, Jarl G., and Kenneth L. Parkinson, Current Asset Management: Cash, Credit, and Inventory (New York: Wiley, 1984). Articles that address credit policy and receivables management include the following: Atkins, Joseph C., and Yong H. Kim, “Comment and Correction: Opportunity Cost in the Evaluation of Investment in Accounts Receivable,” Financial Management, Winter 1977, 71–74. Ben-Horim, Moshe, and Haim Levy, “Management of Accounts Receivable under Inﬂation,” Financial Management, Spring 1983, 42–48. Dyl, Edward A., “Another Look at the Evaluation of Interest in Accounts Receivable,” Financial Management, Winter 1977, 67–70. Gallinger, George W., and A. James Ifﬂander, “Monitoring Accounts Receivable Using Variance Analysis,” Financial Management, Winter 1986, 69–76. Hill, Ned C., and Kenneth D. Riener, “Determining the Cash Discount in the Firm’s Credit Policy,” Financial Management, Spring 1979, 68–73.

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Kim, Yong H., and Joseph C. Atkins, “Evaluating Investments in Accounts Receivable: A Wealth Maximizing Framework,” Journal of Finance, May 1978, 403–412. Mian, Shehzad L., and Clifford W. Smith, “Extending Trade Credit and Financing Receivables,” Journal of Applied Corporate Finance, Spring 1994, 75–84. Oh, John S., “Opportunity Cost in the Evaluation of Investment in Accounts Receivables,” Financial Management, Summer 1976, 32–36. Roberts, Gordon S., and Jeremy A. Viscione, “Captive Finance Subsidiaries: The Manager’s View” Financial Management, Spring 1981, 36–42. Sachdeva, Kanwal S., and Lawrence J. Gitman, “Accounts Receivable Decisions in a Capital Budgeting Framework,” Financial Management, Winter 1981, 45–49. Walia, Tinclochan S., “Explicit and Implicit Cost of Changes in the Level of Accounts Receivable and the Credit Policy Decision of the Firm,” Financial Management, Winter 1977, 75–78. Weston, J. Fred, and Pham D. Tuan, “Comment on Analysis of Credit Policy Changes,” Financial Management, Winter 1980, 59–63. For more on trade credit, see Adams, Paul D., Steve B. Wyatt, and Yong H. Kim, “A Contingent Claims Analysis of Trade Credit,” Financial Management, Autumn 1992, 104–112. Brosky, John J., The Implicit Cost of Trade Credit and Theory of Optimal Terms of Sale (New York: Credit Research Foundation, 1969). Schwartz, Robert A., “An Economic Analysis of Trade,” Journal of Financial and Quantitative Analysis, September 1974, 643–658. For more on bank lending and commercial credit in general, see Campbell, Tim, S., “A Model of the Market for Lines of Credit,” Journal of Finance, March 1978, 231–243. The following cases from the Cases in Financial Management series focus on the credit policy decision: Case 29, “Ofﬁce Mates, Inc.,” which illustrates how changes in current asset policy affect expected proﬁtability and risk. Case 32, “Alpine Wear, Inc.,” which illustrates the mechanics of the cash budget and the rationale behind its use. Two new cash budgeting cases, Case 32A, “Toy World, Inc.,” and Case 32B, “Sorenson Stove Company,” have been added to the Dryden case set. Case 33, “Upscale Toddlers, Inc.,” which deals with credit policy changes. Case 34, “Texas Rose Company,” which focuses on receivables management. Case 62, “Western Supply Company,” which illustrates the effects of a change in credit policy on corporate profitability and cash ﬂow.

17 17

Option Pricing with Applications to Real Options

Cadence Design Systems, which develops electronic products and services, provides an illustration of a real option. Rather than create all the necessary software itself, Cadence often contracts with specialized software developers. As a part of the license, Cadence must make a royalty payment to the software developer each time it sells a product that contains the software. Many of the software contracts build in a ﬂoor that requires Cadence to make a speciﬁed minimum number of royalty payments, even if actual sales are lower than the ﬂoor. Because the expected demand for Cadence’s products is uncertain, sales may be less than the ﬂoor, causing Cadence to make a large payment without revenue to cover it. Of course, if sales are higher than expected, Cadence must make more royalty payments than expected, but then it would also have high revenues and thus could afford the payments. In negotiating with its software suppliers, Cadence proposed an arrangement that had a relatively low ﬂoor but a higher per-unit royalty. Using a standard NPV analysis, Cadence’s proposal produced a negative NPV. However, option pricing techniques showed that Cadence’s proposed royalty arrangement actually added value. As you read this chapter, think about the ways that option pricing techniques can lead to better decisions. Sources: Peter Coy, “Exploiting Uncertainty: The ‘Real-Option’ Revolution in Decision-Making,” Business Week, June 7, 1999, 118; and S. L. Mintz, “Getting Real,” CFO, November 1999, 52–60.

622

617

618

Option Pricing with Applications to Real Options Financial Options

623

Traditional discounted cash ﬂow (DCF) analysis—where an asset’s cash ﬂows are estimated and then discounted to obtain the asset’s NPV—has been the cornerstone for valuing all types of assets since the 1950s. Accordingly, most of our discussion of capital budgeting has focused on DCF valuation techniques. However, in recent years a growing number of academics and practitioners have demonstrated that DCF valuation techniques do not always tell the complete story about a project’s value, and that rote use of DCF can, at times, lead to incorrect capital budgeting decisions.1 DCF techniques were originally developed to value securities such as stocks and The textbook’s web site bonds. These securities are passive investments—once they have been purchased, contains an Excel ﬁle that most investors have no inﬂuence over the cash ﬂows the assets produce. However, real will guide you through the assets are not passive investments—managerial actions can inﬂuence their results. Furchapter’s calculations. The thermore, investing in a new project often brings with it the potential for increasing ﬁle for this chapter is Ch 17 Tool Kit.xls, and we encour- the ﬁrm’s future opportunities. Opportunities are, in effect, options—the right but not age you to open the ﬁle and the obligation to take some action in the future. As we demonstrate in the next secfollow along as you read the tion, options are valuable, so any project that expands the ﬁrm’s set of opportunities chapter. has positive option value. Similarly, any project that reduces the set of future opportunities destroys option value. A project’s impact on the ﬁrm’s opportunities, or its option value, may not be captured by conventional NPV analysis, so this option value should be considered separately. We begin the chapter with an explanation of ﬁnancial options, after which we build on this foundation to discuss real options.

Financial Options An option is a contract that gives its holder the right to buy (or sell) an asset at some predetermined price within a speciﬁed period of time. All managers should understand option pricing theory, since many projects create opportunities that are in essence options. In addition, ﬁnancial managers must understand option pricing theory when they use derivative securities for risk management or issue hybrid securities such as convertible bonds.

Option Types and Markets There are many types of options and option markets.2 To illustrate how options work, suppose you owned 100 shares of General Computer Corporation (GCC), which on Friday, January 11, 2002, sold for $53.50 per share. You could sell to someone the right to buy your 100 shares at any time during the next four months at a price of, say, $55 per share. The $55 is called the strike, or exercise, price. Such options exist, and they are traded on a number of exchanges, with the Chicago Board Options Exchange (CBOE) being the oldest and the largest. This type of option is deﬁned as a call option, because the buyer has a “call” on 100 shares of stock. The seller of an option is called the option writer. An investor who “writes” call options against stock held in his or her portfolio is said to be selling covered options. Options sold without the stock to back them up are called naked options. When the exercise price exceeds the current stock price, a call option is said to be out-of-the-money. When the exercise price is less than the current price of the stock, the option is in-the-money.

1

For an excellent general discussion of the problems inherent in discounted cash ﬂow valuation techniques as applied to capital budgeting, see Avinash K. Dixit and Robert S. Pindyck, “The Options Approach to Capital Investment,” Harvard Business Review, May–June 1995, 105–115. 2 For an in-depth treatment of options, see Don M. Chance, An Introduction to Derivatives (Fort Worth, TX: The Dryden Press, 1995).

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You can also buy an option that gives you the right to sell a stock at a speciﬁed price within some future period—this is called a put option. For example, suppose you think GCC’s stock price is likely to decline from its current level of $53.50 sometime during the next four months. A put option will give you the right to sell at a ﬁxed price even after the market price declines. You could then buy at the new lower market price, sell at the higher ﬁxed price, and earn a proﬁt. Table 17-1 provides data on GCC’s options. You could buy the four-month May put option for $218.75 ($23⁄16 100). That would give you the right to sell 100 shares (that you would not necessarily own) at a price of $50 per share ($50 is the strike price). Suppose you bought this 100share contract for $218.75 and then GCC’s stock fell to $45. You could buy the stock at $45 and exercise your put option by selling it at $50. Your proﬁt from exercising the option would be ($50 $45)(100) $500. After subtracting the $218.75 you paid for the option, your proﬁt (before taxes and commissions) would be $281.25. Table 17-1 contains an extract from the Listed Options Quotations Table as it would appear the next day in a daily newspaper. Sport World’s February $55 call option sold for $0.50. Thus, for $0.50(100) $50 you could buy options that would give you the right to buy 100 shares of Sport World stock at a price of $55 per share from January until February, or during the next month.3 If the stock price stayed below $55 during that period, you would lose your $50, but if it rose to $65, your $50 investment would increase in value to ($65 $55)(100) $1,000 in less than 30 days. That translates into a very healthy annualized rate of return. Incidentally, if the stock price did go up, you would not actually exercise your options and buy the stock—rather, you would sell the options, which would then have a value of at least $1,000 versus the $50 you paid, to another option buyer or to the original seller. In addition to options on individual stocks, options are also available on several stock indexes such as the NYSE Index and the S&P 100 Index. Index options permit one to hedge (or bet) on a rise or fall in the general market as well as on individual stocks. Option trading is one of the hottest ﬁnancial activities in the United States. The leverage involved makes it possible for speculators with just a few dollars to make a fortune almost overnight. Also, investors with sizable portfolios can sell options against their stocks and earn the value of the option (less brokerage commissions), even if the stock’s price remains constant. Most importantly, though, options can be The Chicago Board used to create hedges that protect the value of an individual stock or portfolio.4 Options Exchange provides Conventional options are generally written for six months or less, but a type of op20-minute delayed quotes tion called a Long-term Equity AnticiPation Security (LEAPS) is different. Like for equity, index, and LEAPS conventional options, LEAPS are listed on exchanges and are available on both indioptions at http://www. cboe.com. vidual stocks and stock indexes. The major difference is that LEAPS are long-term options, having maturities of up to 21⁄2 years. One-year LEAPS cost about twice as much as the matching three-month option, but because of their much longer time to expiration, LEAPS provide buyers with more potential for gains and offer better longterm protection for a portfolio.

3

Actually, the expiration date, which is the last date that the option can be exercised, is the Friday before the third Saturday of the exercise month. Also, note that option contracts are generally written in 100-share multiples. 4

It should be noted that insiders who trade illegally generally buy options rather than stock because the leverage inherent in options increases the proﬁt potential. Note, though, that it is illegal to use insider information for personal gain, and an insider using such information would be taking advantage of the option seller. Insider trading, in addition to being unfair and essentially equivalent to stealing, hurts the economy: Investors lose conﬁdence in the capital markets and raise their required returns because of an increased element of risk, and this raises the cost of capital and thus reduces the level of real investment.

619

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625

Corporations on whose stocks options are written have nothing to do with the option market. Corporations do not raise money in the option market, nor do they have any direct transactions in it. Moreover, option holders do not vote for corporate directors or receive dividends. There have been studies by the SEC and others as to whether option trading stabilizes or destabilizes the stock market, and whether this activity helps or hinders corporations seeking to raise new capital. The studies have not been conclusive, but option trading is here to stay, and many regard it as the most exciting game in town.

Factors That Affect the Value of a Call Option Table 17-1 can provide some insights into call option valuation. First, we see that at least three factors affect a call option’s value: 1. Market price versus strike price. The higher the stock’s market price in relation to the strike price, the higher will be the call option price. Thus, Sport World’s $55 February call option sells for $0.50, whereas U.S. Medical’s $55 February option sells for $4.25. This difference arises because U.S. Medical’s current stock price is $565⁄8 versus only $531⁄8 for Sport World. 2. Level of strike price. The higher the strike price, the lower the call option price. Thus, all of GCC’s call options, regardless of exercise month, decline as the strike price increases. 3. Length of option. The longer the option period, the higher the option price. This occurs because the longer the time before expiration, the greater the chance that the stock price will climb substantially above the exercise price. Thus, option prices increase as the expiration date is lengthened. Other factors that affect option values, especially the volatility of the underlying stock, are discussed in later sections.

Exercise Value versus Option Price How is the actual price of a call option determined in the market? In a later section, we present a widely used model (the Black-Scholes model) for pricing call options, but

TABLE 17-1

January 11, 2002, Listed Options Quotations Calls—Last Quote

Closing Price

Strike Price

February

Puts—Last Quote

March

May

February

March

May

General Computer Corporation (GCC) 531⁄2 531⁄2 531⁄2

50 55 60

41⁄4 15⁄16 5 ⁄16

43⁄4 21⁄16 11 ⁄16

51⁄2 31⁄8 11⁄2

5 ⁄8 25⁄8 65⁄8

13⁄8 r r

23⁄16 41⁄2 8

55

41⁄4

51⁄8

7

21⁄4

33⁄4

r

55

1

11⁄8

r

21⁄8

r

r

U.S. Medical 565⁄8 Sport World 531⁄8

Note: r means not traded on January 11.

⁄2

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ﬁrst it is useful to establish some basic concepts. To begin, we deﬁne a call option’s exercise value as follows:5 Exercise value MAX [Current price of the stock Strike price, 0]. The exercise value is what the option would be worth if it expired immediately. For example, if a stock sells for $50 and its option has a strike price of $20, then you could buy the stock for $20 by exercising the option. You would own a stock worth $50, but you would only have to pay $20. Therefore, the option would be worth $30 if you had to exercise it immediately. The minimum exercise value is zero, because no one would exercise an out-of-the-money option. Figure 17-1 presents some data on Space Technology Inc. (STI), a company that recently went public and whose stock price has ﬂuctuated widely during its short history. The third column in the tabular data shows the exercise values for STI’s call option when the stock was selling at different prices; the fourth column gives the actual market prices for the option; and the ﬁfth column shows the premium of the actual option price over its exercise value. First, notice that the market value of the option is zero when the stock price is zero. This is because a stock price falls to zero only when there is no possibility that the company would ever generate any future cash ﬂows; in other words, the company must be out of business. In such a situation, an option would be worthless. Second, notice that the market price of the option is always greater than or equal to the exercise value. If the option price ever fell below the exercise value, then you could buy the option and immediately exercise it, reaping a riskless proﬁt. Because everyone would try to do this, the price of the option would be driven up until it was at least as high as the exercise value. Third, notice that the market value of the option is greater than zero even when the option is out-of-the-money. For example, the option price is $2 when the stock price is only $10. Depending on the remaining time until expiration and the stock’s volatility, there is a chance that the stock price will rise above $20, so the option has value even if it is out-of-the-money. Fourth, Figure 17-1 shows the value of the option steadily increasing as the stock price increases. This shouldn’t be surprising, since the option’s expected payoff increases along with the stock price. But notice that as the stock price rises, the option price and exercise value begin to converge, causing the premium to get smaller and smaller. This happens because there is virtually no chance that the stock will be out-of-the-money at expiration if the stock price is presently very high. Thus, owning the option is like owning the stock, less the exercise price. Although we don’t show it in Figure 17-1, the market price of the option also converges with the exercise value if the option is about to expire. With expiration close, there isn’t much time for the stock price to change, so the option’s market price curve would be very close to the exercise value for all stock prices. Fifth, an option has more leverage than the stock. For example, if you buy STI’s stock at $20 and a year later it is at $30, you would have a 50 percent rate of return. But if you bought the option instead, its price would go from $8 to $16 versus the stock price increase from $20 to $30. Thus, there is a 100 percent return on the option versus a 50 percent return on the stock. Of course, leverage is a double-edged sword: If the stock price falls to $10, then you would have a 50 percent loss on the stock, but the option price would fall to $2, leaving you with a 75 percent loss. In other words, the option magniﬁes the returns on the stock, for good or ill. Sixth, options typically have considerable upside potential but limited downside risk. To see this, suppose you buy the option for $8 when the stock price is $20. If the

MAX means choose the maximum. For example, MAX[15,0] 15, and MAX[10,0] 0.

5

621

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Option Pricing with Applications to Real Options Financial Options FIGURE 17-1

627

Space Technology Inc.: Option Price and Exercise Value

Option Price and Exercise Value ($) 80

60

40

Market Price of Option

20

Exercise Value of Option Premium

0 20

40

60

80

100

Price of Stock ($) –20

Price of Stock (1)

Strike Price (2)

Exercise Value of Option MAX[(1) ⴚ (2), 0] ⴝ (3)

Market Price of Option (4)

Premium (4) ⴚ (3) ⴝ (5)

$10.00 20.00 21.00 22.00 30.00 40.00 50.00 73.00 98.00

$20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00

$ 0.00 0.00 1.00 2.00 10.00 20.00 30.00 53.00 78.00

$ 2.00 8.00 8.75 9.50 16.00 24.50 33.50 54.50 79.00

$2.00 8.00 7.75 7.50 6.00 4.50 3.50 1.50 1.00

stock price is $28 when the option expires, your net gain would be $0: you gain $28 $20 $8 when you exercise the option, but your original investment was $8. Now suppose the stock price is either $30 or $20 at expiration. If it’s $30, your net gain is $10 $8 $2. If it’s $20, the stock is out-of-the-money, and your net loss is the $8 cost of your investment. Now suppose the stock price is either $50 or $5. If it’s $50, your net gain is $30 $8 $22; if $5, your net loss is still your $8 initial investment. As this example shows, the payoffs from the option aren’t symmetric. The most you can lose is $8, and this happens whether the stock price at expiration is $20, $10, or even $1. On the other hand, every dollar of stock price above $20 yields an extra dollar of payoff from the option, and every dollar above $28 is a dollar of net proﬁt. In addition to the stock price and the exercise price, the price of an option depends on three other factors: (1) the option’s term to maturity, (2) the variability of the stock

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price, and (3) the risk-free rate. We will explain precisely how these factors affect call option prices later, but for now, note these points: 1. The longer a call option has to run, the greater its value and the larger its premium. If an option expires at 4 P.M. today, there is not much chance that the stock price will go up very much, so the option will sell at close to its exercise value and its premium will be small. On the other hand, if the expiration date is a year away, the stock price could rise sharply, pulling the option’s value up with it. 2. An option on an extremely volatile stock is worth more than one on a very stable stock. If the stock price rarely moves, then there is little chance of a large gain on the stock, hence the option will not be worth much. However, if the stock is highly volatile, the option could easily become very valuable. At the same time, losses on options are limited—you can make an unlimited amount, but you can only lose what you paid for the option. Therefore, a large decline in a stock’s price does not have a corresponding bad effect on option holders. As a result of the unlimited upside but limited downside potential, the more volatile a stock, the higher the value of its options. 3. Options may be exercised in the future, and part of a call option’s value depends on the present value of the cost to exercise it. If interest rates are high, then the present value of the cost to exercise is low, which increases the option’s value. Because of Points 1 and 2, a graph such as Figure 17-1 would show that the longer an option’s life, the higher its market price line would be above the exercise value line. Similarly, the more volatile the price of the underlying stock, the higher would be the market price line. We will see precisely how these factors, and also the risk-free rate, affect option values when we discuss the Black-Scholes model. What is an option? A call option? A put option? Deﬁne a call option’s exercise value. Why is the actual market price of a call option usually above its exercise value? What are some factors that affect a call option’s value?

Introduction to Option Pricing Models In the next section, we discuss a widely used option pricing formula, the Black-Scholes model. First, though, we go through a simple example to illustrate basic principles. To begin, note that all option pricing models are based on the concept of a riskless hedge. Here an investor buys some shares and simultaneously sells a call option on the stock. If the stock’s price goes up, the investor will earn a proﬁt, but the holder of the option will exercise it, and that will cost the investor money. Conversely, if the stock goes down, the investor will lose on his or her investment in the stock, but gain from the option (which will expire worthless if the stock price declines). As we demonstrate, it is possible to set things up so that the investor will end up with a riskless position—regardless of what the stock does, the value of the portfolio will remain constant. Thus, a riskless investment will have been created. If an investment is riskless, it must, in equilibrium, yield the riskless rate. If it offered a higher rate of return, arbitrageurs would buy it and in the process push the price up and the rate of return down, and vice versa if it offered less than the riskless rate. Given the price of the stock, its volatility, the option’s exercise price, the life of the option, and the risk-free rate, there is but one price for the option if it is to meet the equilibrium condition, namely, that a portfolio that consists of the stock and the call option will earn the riskless rate. We value a hypothetical option below, and then we use the Black-Scholes model to value options under more realistic conditions.

623

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Option Pricing with Applications to Real Options Introduction to Option Pricing Models

629

1. Assumptions of the example. The stock of Western Cellular, a manufacturer of cell phones, sells for $40 per share. Options exist that permit the holder to buy one share of Western at an exercise price of $35. These options will expire at the end of one year, at which time Western’s stock will be selling at one of two prices, either $30 or $50. Also, the risk-free rate is 8.0 percent. Based on these assumptions, we must ﬁnd the value of the options. 2. Find the range of values at expiration. When the option expires at the end of the year, Western’s stock will sell for either $30 or $50, and here is the situation with regard to the value of the options:

Range

Ending Stock Price

ⴚ

Strike Price Value

ⴝ

$50.00 30.00

$35.00 35.00

$20.00

Ending Option Value

$15.00 0.00 (The option will be worthless. It cannot have a negative value.) $15.00

3. Equalize the range of payoffs for the stock and the option. As shown above, the ranges of payoffs for the stock and the option are $20 and $15. To construct the riskless portfolio, we need to equalize these ranges. We do so by buying 0.75 share and selling one option (or 75 shares and 100 options) to produce the following situation, where the range for both the stock and the option is $15: Ending Stock Price

$50.00 30.00 $20.00

Range

ⴛ

0.75

ⴝ

0.75 0.75

Ending Value of Stock

Ending Value of Option

$37.50 22.50 $15.00

$15.00 0.00 $15.00

4. Create a riskless hedged investment. We can now create a riskless portfolio by buying 0.75 share of the stock and selling one call option. Here is the situation: Ending Stock Price

ⴛ

0.75

ⴝ

Ending Value of Stock in the Portfolio

ⴙ

$50.00 30.00

0.75 0.75

$37.50 22.50

Ending Value of Option in the Portfolio

$15.00 0.00

ⴝ

Ending Total Value of the Portfolio

$22.50 22.50

The stock in the portfolio will have a value of either $22.50 or $37.50, depending on what happens to the price of the stock. The call option that was sold will have no effect on the value of the portfolio if Western’s price falls to $30, because it will then not be exercised—it will expire worthless. However, if the stock price ends at $50, the holder of the option will exercise it, paying the $35 exercise price for stock that would cost $50 on the open market, so in that case, the option would have a cost of $15 to the holder of the portfolio. Now note that the value of the portfolio is $22.50 regardless of whether Western’s stock goes up or down, so the portfolio is riskless. A hedge has been created that protects against both increases or decreases in the price of the stock.

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5. Pricing the call option. To this point, we have not mentioned the price of the call option that was sold to create the riskless hedge. How much should it sell for? Obviously, the seller would like to get a high price, but the buyer would want a low price. What is the fair, or equilibrium, price? To ﬁnd this price, we proceed as follows: a. The value of the portfolio will be $22.50 at the end of the year, regardless of what happens to the price of the stock. This $22.50 is riskless. b. The risk-free rate is 8 percent, so the present value of the riskless $22.50 yearend value is PV $22.50/(1.08) $20.83. c. Since Western’s stock is currently selling for $40, and since the portfolio contains 0.75 share, the cost of the stock in the portfolio is 0.75($40) $30.00. d. If one paid $30 for the stock, and if the present value of the portfolio is $20.83, the option would have to sell for $9.17: Price of option Cost of stock PV of portfolio $30 $20.83 $9.17. If this option sold at a price higher than $9.17, other investors could create riskless portfolios as described above and earn more than the riskless rate. Investors (especially the large investment banking ﬁrms) would create such portfolios—and options—until their price fell to $9.17, at which point the market would be in equilibrium. Conversely, if the options sold for less than $9.17, investors would create an “opposite” portfolio by buying a call option and selling short the stock.6 The resulting supply shortage would drive the price up to $9.17. Thus, investors (or arbitrageurs) would buy and sell in the market until the options were priced at their equilibrium level. Clearly, this example is unrealistic—Western’s stock price could be almost anything after one year, and you could not purchase 0.75 share of stock (but you could do so in effect by buying 75 shares and selling 100 options). Still, the example does illustrate that investors can, in theory, create riskless portfolios by buying stocks and selling call options against those stocks, and the return on such portfolios should be the risk-free rate. If call options are not priced to reﬂect this condition, arbitrageurs will actively trade stocks and options until option prices reﬂect equilibrium conditions. In the next section, we discuss the Black-Scholes Option Pricing Model, which is based on the general premise we developed here—the creation of a riskless portfolio—but which is applicable to “real-world” option pricing because it allows for a complete range of ending stock prices. Describe how a risk-free portfolio can be created using stocks and options. How can such a portfolio be used to help estimate a call option’s value?

6

Suppose an investor (or speculator) does not now own any IBM stock. If the investor anticipates a rise in the stock price and consequently buys IBM stock, he or she is said to have gone long in IBM. On the other hand, if the investor thinks IBM’s stock is likely to fall, he or she could go short, or sell IBM short. Because the short seller has no IBM stock, he or she would have to borrow the shares sold short from a broker. If the stock price falls, the short seller could, later on, buy shares on the open market and pay back the ones borrowed from the broker. The short seller’s proﬁt, before commissions and taxes, would be the difference between the price received from the short sale and the price paid later to purchase the replacement stock.

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The Black-Scholes Option Pricing Model (OPM) The Black-Scholes Option Pricing Model (OPM), developed in 1973, helped give rise to the rapid growth in options trading.7 This model, which has even been programmed into the permanent memories of some hand-held calculators, is widely used by option traders.

OPM Assumptions and Equations In deriving their option pricing model, Fischer Black and Myron Scholes made the following assumptions: 1. The stock underlying the call option provides no dividends or other distributions during the life of the option. 2. There are no transaction costs for buying or selling either the stock or the option. 3. The short-term, risk-free interest rate is known and is constant during the life of the option. 4. Any purchaser of a security may borrow any fraction of the purchase price at the short-term, risk-free interest rate. 5. Short selling is permitted, and the short seller will receive immediately the full cash proceeds of today’s price for a security sold short. 6. The call option can be exercised only on its expiration date. 7. Trading in all securities takes place continuously, and the stock price moves randomly. The derivation of the Black-Scholes model rests on the concept of a riskless hedge such as the one we set up in the last section. By buying shares of a stock and simultaneously selling call options on that stock, an investor can create a risk-free investment position, where gains on the stock will exactly offset losses on the option. This riskless hedged position must earn a rate of return equal to the risk-free rate. Otherwise, an arbitrage opportunity would exist, and people trying to take advantage of this opportunity would drive the price of the option to the equilibrium level as speciﬁed by the Black-Scholes model. The Black-Scholes model consists of the following three equations: V P[N(d1)] Xe rRFt[N(d2)]. ln(P/X) [rRF (2/2)]t d1 . 2t d2 d1 2t.

(17-1) (17-2) (17-3)

Here V current value of the call option. P current price of the underlying stock. N(di) probability that a deviation less than di will occur in a standard normal distribution. Thus, N(d1) and N(d2) represent areas under a standard normal distribution function. X exercise, or strike, price of the option. e 艐 2.7183.

7

See Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, May/June 1973, 637–659.

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rRF risk-free interest rate. t time until the option expires (the option period). ln(P/X) natural logarithm of P/X. 2 variance of the rate of return on the stock. Note that the value of the option is a function of the variables we discussed earlier: (1) P, the stock’s price; (2) t, the option’s time to expiration; (3) X, the strike price; (4) 2, the variance of the underlying stock; and (5) rRF, the risk-free rate. We do not derive the Black-Scholes model—the derivation involves some extremely complicated mathematics that go far beyond the scope of this text. However, it is not difﬁcult to use the model. Under the assumptions set forth previously, if the option price is different from the one found by Equation 17-1, this would provide the opportunity for Robert’s Online Option arbitrage proﬁts, which would force the option price back to the value indicated by the Pricer can be accessed at model.8 As we noted earlier, the Black-Scholes model is widely used by traders, so achttp://www.intrepid.com/ tual option prices conform reasonably well to values derived from the model. ~robertl/option-pricer. Loosely speaking, the ﬁrst term of Equation 17-1, P[N(d1)], can be thought of as html. The site is designed to provide a ﬁnancial service the expected present value of the terminal stock price, given that P X and the option over the Internet to small in- will be exercised. The second term, XerRF t[N(d )], can be thought of as the present 2 vestors for option pricing, value of the exercise price, given that the option will be exercised. However, rather giving anyone a means to than try to ﬁgure out exactly what the equations mean, it is more productive to plug in price option trades without some numbers to see how changes in the inputs affect the value of an option. The folhaving to buy expensive software and hardware. lowing example is also in the ﬁle Ch 17 Tool Kit.xls, on the textbook’s web site.

OPM Illustration The current stock price, P, the exercise price, X, and the time to maturity, t, can all be obtained from a newspaper such as The Wall Street Journal. The risk-free rate, rRF, is the yield on a Treasury bill with a maturity equal to the option expiration date. The annualized variance of stock returns, 2, can be estimated by multiplying the variance of the percentage change in daily stock prices for the past year [that is, the variance of (Pt Pt1)/Pt] by 365 days. Assume that the following information has been obtained: P $20. X $20. t 3 months or 0.25 year. rRF 12% 0.12. 2 0.16. Note that if 2 0.16, then 20.16 0.4. See Ch 17 Tool Kit.xls for all calculations.

Given this information, we can now use the OPM by solving Equations 17-1, 17-2, and 17-3. Since d1 and d2 are required inputs for Equation 17-1, we solve Equations 17-2 and 17-3 ﬁrst: ln($20/$20) [0.12 (0.16/2)](0.25) 0.40(0.50) 0 0.05 0.25. 0.20 d2 d1 0.420.25 0.25 0.20 0.05.

d1

8

Programmed trading, in which stocks are bought and options are sold, or vice versa, is an example of arbitrage between stocks and options.

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Note that N(d1) N(0.25) and N(d2) N(0.05) represent areas under a standard normal distribution function. From the Table in Appendix D, or from the Excel function NORMSDIST, we see that the value d1 0.25 implies a probability of 0.0987 0.5000 0.5987, so N(d1) 0.5987. Similarly, N(d2) 0.5199. We can use those values to solve Equation 17-1: V

$20[N(d1)] $20e(0.12)(0.25)[N(d2)] $20[N(0.25)] $20(0.9704)[N(0.05)] $20(0.5987) $19.41(0.5199) $11.97 $10.09 $1.88.

Thus the value of the option, under the assumed conditions, is $1.88. Suppose the actual option price were $2.25. Arbitrageurs could simultaneously sell the option, buy the underlying stock, and earn a riskless proﬁt. Such trading would occur until the price of the option was driven down to $1.88. The reverse would occur if the option sold for less than $1.88. Thus, investors would be unwilling to pay more than $1.88 for the option, and they could not buy it for less, so $1.88 is the equilibrium value of the option. To see how the ﬁve OPM factors affect the value of the option, consider Table 17-2. Here the top row shows the base-case input values that were used above to illustrate the OPM and the resulting option value, V $1.88. In each of the subsequent rows, the boldfaced factor is increased, while the other four are held constant at their base-case levels. The resulting value of the call option is given in the last column. Now let’s consider the effects of the changes: 1. Current stock price. If the current stock price, P, increases from $20 to $25, the option value increases from $1.88 to $5.81. Thus, the value of the option increases as the stock price increases, but by less than the stock price increase, $3.93 versus $5.00. Note, though, that the percentage increase in the option value, ($5.81 $1.88)/$1.88 209%, far exceeds the percentage increase in the stock price, ($25 $20)/$20 25%. 2. Exercise price. If the exercise price, X, increases from $20 to $25, the value of the option declines. Again, the decrease in the option value is less than the exercise price increase, but the percentage change in the option value, ($0.39 $1.88)/$1.88 79%, exceeds the percentage change in the exercise price, ($25 $20)/$20 25%. 3. Option period. As the time to expiration increases from t 3 months (or 0.25 year) to t 6 months (or 0.50 year), the value of the option increases from $1.88 to $2.81. This occurs because the value of the option depends on the chances for an increase in the price of the underlying stock, and the longer the option has to go, the higher the stock price may climb. Thus, a six-month option is worth more than a three-month option.

TABLE 17-2

Effects of OPM Factors on the Value of a Call Option Input Factors

Case

Base case Increase P by $5 Increase X by $5 Increase t to 6 months Increase rRF to 16% Increase 2 to 0.25

Output

P

X

t

rRF

␴

V

$20 25 20 20 20 20

$20 20 25 20 20 20

0.25 0.25 0.25 0.50 0.25 0.25

12% 12 12 12 16 12

0.16 0.16 0.16 0.16 0.16 0.25

$1.88 5.81 0.39 2.81 1.98 2.27

2

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4. Risk-free rate. As the risk-free rate increases from 12 to 16 percent, the value of the option increases slightly, from $1.88 to $1.98. Equations 17-1, 17-2, and 17-3 suggest that the principal effect of an increase in rRF is to reduce the present value of the exercise price, XerRFt, hence to increase the current value of the option.9 The risk-free rate also plays a role in determining the values of the normal distribution functions N(d1) and N(d2), but this effect is of secondary importance. Indeed, option prices in general are not very sensitive to interest rate changes, at least not to changes within the ranges normally encountered. 5. Variance. As the variance increases from the base case 0.16 to 0.25, the value of the option increases from $1.88 to $2.27. Therefore, the riskier the underlying security, the more valuable the option. This result is logical. First, if you bought an option to buy a stock that sells at its exercise price, and if 2 0, then there would be a zero probability of the stock going up, hence a zero probability of making money on the option. On the other hand, if you bought an option on a high-variance stock, there would be a fairly high probability that the stock would go way up, hence that you would make a large proﬁt on the option. Of course, a high-variance stock could go way down, but as an option holder, your losses would be limited to the price paid for the option—only the right-hand side of the stock’s probability distribution counts. Put another way, an increase in the price of the stock helps option holders more than a decrease hurts them, so the greater the variance, the greater is the value of the option. This makes options on risky stocks more valuable than those on safer, low-variance stocks. Myron Scholes and Robert Merton were awarded the 1997 Nobel Prize in Economics, and Fischer Black would have been a co-recipient had he still been living. Their work provided analytical tools and methodologies that are widely used to solve many types of ﬁnancial problems, not just option pricing. Indeed, the entire ﬁeld of modern risk management is based primarily on their contributions. The next section discusses the application of option pricing to real options. What is the purpose of the Black-Scholes Option Pricing Model? Explain what a “riskless hedge” is and how the riskless hedge concept is used in the Black-Scholes OPM. Describe the effect of a change in each of the following factors on the value of a call option: (1) Stock price. (2) Exercise price. (3) Option life. (4) Risk-free rate. (5) Stock price variance, that is, riskiness of stock.

Introduction to Real Options According to traditional capital budgeting theory, a project’s NPV is the present value of its expected future cash ﬂows, discounted at a rate that reﬂects the riskiness of the expected 9

At this point, you may be wondering why the ﬁrst term in Equation 17-1, P[N(d1)], is not discounted. In fact, it has been, because the current stock price, P, already represents the present value of the expected stock price at expiration. In other words, P is a discounted value, and the discount rate used in the market to determine today’s stock price includes the risk-free rate. Thus, Equation 17-1 can be thought of as the present value of the end-of-option-period spread between the stock price and the strike price, adjusted for the probability that the stock price will be higher than the strike price.

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future cash ﬂows. If the NPV is not positive, then the project should be rejected. Note, however, that traditional capital budgeting theory says nothing about actions that can be taken after the project has been accepted and placed in operation that might cause the cash ﬂows to increase. In other words, traditional capital budgeting theory assumes that a project is like a roulette wheel. A gambler can choose whether or not to spin the wheel, but once the wheel has been spun, there is nothing he or she can do to inﬂuence the outcome. Once the game begins, the outcome depends purely on chance, with no skill involved. Contrast roulette with other games, such as draw poker. Chance plays a role in poker, and it continues to play a role after the initial deal because players receive additional cards throughout the game. However, poker players are able to respond to their opponents’ actions, so skillful players usually win. Capital budgeting decisions have more in common with poker than roulette because (1) chance plays a continuing role throughout the life of the project and (2) managers can respond to changing market conditions and to competitors’ actions. Opportunities to respond to changing circumstances are called managerial options because they give managers a chance to inﬂuence the outcome of a project. They are also called strategic options because they are often associated with large, strategic projects rather than routine maintenance projects. Finally, they are called real options, and they are differentiated from ﬁnancial options, because they involve real, rather than ﬁnancial, assets. The ﬁrst step in valuing projects that have embedded options is to identify the options. Even though no two projects are exactly identical, several types of real options are often present, and managers should always look for them. Even more important, managers should try to create options within projects.

Investment Timing Options Conventional NPV analysis implicitly assumes that projects will either be accepted or rejected, which implies that they will be undertaken now or never. In practice, however, companies sometimes have a third choice—delay the decision until later, when more information is available. Such investment timing options can dramatically affect a project’s estimated proﬁtability and risk. For example, suppose Sony plans to introduce an interactive DVD-TV system, and your company has two alternatives: (1) immediately begin full scale production of game software on DVDs for the new system or (2) delay investment in the project until you get a better idea of the size of the market for interactive DVDs. You would probably prefer delaying implementation. Keep in mind, though, that the option to delay is valuable only if it more than offsets any harm that might come from delaying. For example, if you delay, some other company might establish a loyal customer base that makes it difficult for your company to later enter the market. The option to delay is usually most valuable to firms with proprietary technology, patents, licenses, or other barriers to entry, because these factors lessen the threat of competition. The option to delay is valuable when market demand is uncertain, but it is also valuable during periods of volatile interest rates, since the ability to wait can allow firms to delay raising capital for projects until interest rates are lower.

Growth Options A growth option allows a company to increase its capacity if market conditions are better than expected. There are several types of growth options. One lets a company increase the capacity of an existing product line. A “peaking unit” power plant illustrates this type of growth option. Such units have high variable costs and are used to produce additional power only if demand and therefore prices are high.

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The second type of growth option allows a company to expand into new geographic markets. Many companies are investing in Eastern Europe, Russia, and China even though standard NPV analysis produces negative NPVs. However, if these developing markets really take off, the option to open more facilities could be quite valuable. The third type of growth option is the opportunity to add new products, including complementary products and successive “generations” of the original product. Toshiba probably lost money on its ﬁrst laptop computers, but the manufacturing skills and consumer recognition it gained helped turn subsequent generations of laptops into money makers. In addition, Toshiba used its experience and name recognition in laptops as a springboard into the desktop computer market.

Abandonment Options Many projects contain an abandonment option. When evaluating a potential project, standard DCF analysis assumes that the assets will be used over a speciﬁed economic life. While some projects must be operated over their full economic life, even though market conditions might deteriorate and cause lower than expected cash ﬂows, others can be abandoned. For example, some contracts between automobile manufacturers and their suppliers specify the quantity and price of the parts that must be delivered. If the supplier’s labor costs increase, then the supplier might well lose money on each part it ships. Including the option to abandon in such a contract might be quite valuable. Note too that some projects can be structured so that they provide the option to reduce capacity or temporarily suspend operations. Such options are common in the natural resource industry, including mining, oil, and timber, and they should be reﬂected in the analysis when NPVs are being estimated.

Flexibility Options Many projects offer ﬂexibility options that permit the ﬁrm to alter operations depending on how conditions change during the life of the project. Typically, either inputs or outputs (or both) can be changed. BMW’s Spartanburg, South Carolina, auto assembly plant provides a good example of output ﬂexibility. BMW needed the plant to produce sports coupes. If it built the plant conﬁgured to produce only these vehicles, the construction cost would be minimized. However, the company thought that later on it might want to switch production to some other vehicle type, and that would be difﬁcult if the plant were designed just for coupes. Therefore, BMW decided to spend additional funds to construct a more ﬂexible plant—one that could produce different types of vehicles should demand patterns shift. Sure enough, things did change. Demand for coupes dropped a bit and that for sports utility vehicles soared. But BMW was ready, and the Spartanburg plant is now spewing out hot-selling SUVs. The plant’s cash ﬂows are much higher than they would have been without the ﬂexibility option that BMW “bought” by paying more to build a more ﬂexible plant. Electric power plants provide an example of input ﬂexibility. Utilities can build plants that generate electricity by burning coal, oil, or natural gas. The prices of those fuels change over time, depending on events in the Middle East, changing environmental policies, and weather conditions. Some years ago, virtually all power plants were designed to burn just one type of fuel, because this resulted in the lowest construction cost. However, as fuel cost volatility increased, power companies began to build higher-cost but more ﬂexible plants, especially ones that could switch from oil to gas and back again, depending on relative fuel prices. Name some different types of real options.

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Valuing Real Options How can we estimate the value of a real option? To begin answering this question, consider a simple project consisting of a single risk-free cash ﬂow due one year from today. The pure DCF value of this project is found as follows: Project DCF value

Cash flow . (1 rRF)

The only required inputs are the cash ﬂow, which is known, and the risk-free rate, which can be estimated as the rate on a 52-week Treasury bill. Given these inputs, we can calculate an accurate estimate of the project’s DCF value. In contrast, valuing a real option requires a great deal of judgment, both to formulate the model and to estimate the inputs. This means the “answer” will not be nearly as precise for a real option as for the simple one-period project described above. But does this mean the answer won’t be useful? Deﬁnitely not. For example, the models used by NASA only approximate the centers of gravity for the moon, the earth, and other heavenly bodies, yet even with these “errors” in their models, NASA was able to put a man on the moon. As one professor said, “All models are wrong, but some are still quite useful.” This is especially true for real options. We might not be able to ﬁnd the exact value of a real option, but the value we ﬁnd can be helpful in deciding whether or not to accept the project. Equally as important, the process of looking for and then valuing real options often identiﬁes critical issues that might otherwise go unnoticed. Five possible procedures can be used to deal with real options. Starting with the simplest, these are as follows: 1. Use discounted cash ﬂow (DCF) valuation and ignore any real options by assuming their values are zero. 2. Use DCF valuation and include a qualitative recognition of any real option’s value. 3. Use decision tree analysis. 4. Use a standard model for a ﬁnancial option. 5. Develop a unique, project-speciﬁc model using ﬁnancial engineering techniques. The following sections illustrate these procedures. List the ﬁve possible procedures for dealing with real options.

The Investment Timing Option: An Illustration Murphy Systems is considering a project for a new type of hand-held device that provides wireless Internet connections. The cost of the project is $50 million, but the future cash ﬂows depend on the demand for wireless Internet connections, which is uncertain. Murphy believes there is a 25 percent chance that demand for the new device All calculations for the will be very high, in which case the project will generate cash ﬂows of $33 million analysis of the investment each year for three years. There is a 50 percent chance of average demand, with cash timing option are also shown in Ch 17 Tool Kit.xls. ﬂows of $25 million per year, and a 25 percent chance that demand will be low and annual cash ﬂows will be only $5 million. A preliminary analysis indicates that the project is somewhat riskier than average, so it has been assigned a cost of capital

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of 14 percent versus 12 percent for an average project at Murphy Systems. Here is a summary of the project’s data: Demand

High Average Low Expected annual cash ﬂow

Probability

Annual Cash Flow

0.25 0.50 0.25

$33 million 25 million 5 million $22 million

Project’s cost of capital Life of project Required investment, or cost of project

14% 3 years $50 million

Murphy could accept the project and implement it immediately, but since the company has a patent on the device’s core modules, it can also choose to delay the decision until next year, when more information about demand for the product will be available. The cost will still be $50 million if Murphy waits, and the project will still be expected to generate the indicated cash ﬂows, but each ﬂow will be pushed back one year. However, if Murphy waits, it will know which of the demand conditions, hence which set of cash ﬂows, will exist. If it waits, Murphy will of course make the investment only if demand is sufﬁcient to provide a positive NPV. Note that this real timing option resembles a call option on a stock. A call gives its owner the right to purchase a stock at a ﬁxed exercise price, but only if the stock’s price is higher than the exercise price will the owner exercise the option and buy the stock. Similarly, if Murphy defers implementation, then it will have the right to “purchase” the project by making the investment if the NPV as calculated next year, when new information is available, is positive.

Approach 1. DCF Analysis Ignoring the Timing Option Based on probabilities for the different levels of demand, the expected annual cash ﬂows are $22 million per year: Expected cash ﬂow per year 0.25($33) 0.50($25) 0.25($5) $22 million. Ignoring the investment timing option, the traditional NPV is $1.08 million, found as follows: NPV $50

$22 $22 $22 $1.08. 2 (1 0.14) (1 0.14) (1 0.14)3

Based just on this DCF analysis, Murphy should accept the project. Note, though, that if the expected cash ﬂows had been slightly lower, say, $21.5 million, the NPV would have been negative and the project would have been rejected. Also, note that the project is risky—there is a 25 percent probability that demand will be weak, in which case the NPV would turn out to be a negative $38.4 million.

Approach 2. DCF with a Qualitative Consideration of the Timing Option The discounted cash ﬂow analysis suggests that the project should be accepted, but just barely, and it ignores the existence of a possibly valuable real option. If Murphy implements the project now, it gains an expected (but risky) NPV of $1.08 million. However, accepting now means that it is also giving up the option of waiting to learn more about market demand before making the commitment. Thus, the decision is this: Is the option Murphy would be giving up worth more or less than $1.08 million? If the option is worth

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more than $1.08 million, then Murphy should not give up the option, which means deferring the decision, and vice versa if the option is worth less than $1.08 million. Based on the discussion of ﬁnancial options earlier in the chapter, what qualitative assessment can we make regarding the option’s value? Put another way, without doing any additional calculations, does it appear that Murphy should go forward now or wait? In thinking about this decision, ﬁrst note that the value of an option is higher if the current value of the underlying asset is high relative to its exercise price, other things held constant. For example, a call option with an exercise cost of $50 on a stock with a current price of $50 is worth more than if the price were $20. We will calculate the exact value of Murphy’s underlying asset later, but the DCF analysis does suggest that the underlying asset’s value will be close to the exercise price, so the option should be valuable. We also know that an option’s value is higher the longer its time to expiration. Here the option has a one-year life, which is fairly long for an option, and that too suggests that the option is probably valuable. Finally, we know that the value of an option increases with the risk of the underlying asset. The data used in the DCF analysis indicate that the project is quite risky, which again suggests that the option is valuable. Thus, our qualitative assessment indicates that the option to delay might well be more valuable than the expected NPV of $1.08 if we undertake the project immediately. This is quite subjective, but the qualitative assessment should make Murphy’s management pause, and then go on to make a quantitative assessment of the situation.

Approach 3. Decision Tree Analysis of the Timing Option Part 1 of Figure 17-2 presents a scenario analysis similar to the ones in Chapter 8, except now the cash ﬂows are shown as a decision tree diagram. Each possible outcome is shown as a “branch” on the tree. Each branch shows the cash ﬂows and probability of a scenario, laid out as a time line. Thus, the top line, which gives the payoffs of the high-demand scenario, has positive cash ﬂows of $33 million for the next three years, and its NPV is $26.61 million. The average-demand branch in the middle has an NPV of $8.04 million, while the NPV of the low-demand branch is a negative $38.39 million. Since Murphy will suffer a $38.39 million loss if demand is weak, and since there is a 25 percent probability of weak demand, the project is clearly risky. The expected NPV is the weighted average of the three possible outcomes, with the weight for each outcome being its probability. The sum in the last column in Part 1 shows that the expected NPV is $1.08 million, the same as in the original DCF analysis. Part 1 also shows a standard deviation of $24.02 million for the NPV, and a coefﬁcient of variation, deﬁned as the ratio of standard deviation to the expected NPV, of 22.32, which is quite large. Clearly, the project is quite risky under the analysis thus far. Part 2 is set up similarly to Part 1 except that it shows what happens if Murphy delays the decision and then implements the project only if demand turns out to be high or average. No cost is incurred in 2002—here the only action is to wait. Then, if demand is average or high, Murphy will spend $50 million in 2003 and receive either $33 million or $25 million per year for the following three years. If demand is low, as shown on the bottom branch, Murphy will spend nothing in 2003 and will receive no cash ﬂows in subsequent years. The NPV of the high-demand branch is $23.35 million and that of the average-demand branch is $7.05 million. Because all cash ﬂows under the low-demand scenario are zero, the NPV in this case will also be zero. The expected NPV if Murphy delays the decision is $9.36 million. This analysis shows that the project’s expected NPV will be much higher if Murphy delays than if it invests immediately. Also, since there is no possibility of losing money under the delay option, this decision also lowers the project’s risk. This clearly indicates that the option to wait is valuable, hence that Murphy should wait until 2003 before deciding whether to proceed with the investment.

Option Pricing with Applications to Real Options 640

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Option Pricing with Applications to Real Options

FIGURE 17-2

PART

DCF and Decision Tree Analysis for the Investment Timing Option (Millions of Dollars)

1. SCENARIO ANALYSIS: PROCEED WITH PROJECT TODAY Future Cash Flows

2002

$50

0.25 High 0.50 Average 0.2 5 Low

NPV of This Probability Scenarioc Probability ⴛ NPV

2003

2004

2005

$33

$33

$33

$26.61

0.25

$6.65

$25

$25

$25

$8.04

0.50

$4.02

$5

$5

$5

$38.39

0.25

$9.60

1.00 Expected value of NPVs

$1.08

Standard deviation

$24.02

Coefﬁcient of variation

22.32

NPV of this Scenariod Probability

Probability ⴛ NPV

a

b

PART

2. DECISION TREE ANALYSIS: IMPLEMENT NEXT YEAR ONLY IF OPTIMAL Future Cash Flows

2002

Wait

2003

0.25 High 0.50 Average 0.2 Low 5

2004

2005

2006

$50

$33

$33

$33

$23.35

0.25

$5.84

$50

$25

$25

$25

$7.05

0.50

$3.53

$0

$0

$0

$0

$0.00

0.25 1.00

$0.00

Expected value of NPVs

$9.36

Standard deviationa

$8.57

Coefﬁcient of variation

0.92

b

Notes: a The standard deviation is calculated as explained in Chapter 3. b The coefﬁcient of variation is the standard deviation divided by the expected value. c The WACC is 14 percent. d The NPV in Part 2 is as of 2002. Therefore, each of the project cash ﬂows is discounted back one more year than in Part 1.

Before we conclude the discussion of decision trees, note that we used the same cost of capital, 14 percent, to discount cash ﬂows in the “proceed immediately” scenario analysis in Part 1 and under the “delay one year” scenario in Part 2. However, for three reasons this is not appropriate. First, since there is no possibility of losing money if Murphy delays, the investment under that plan is clearly less risky than if Murphy charges ahead today. Second, the 14 percent cost of capital might be appropriate for risky cash ﬂows, yet the investment in the project in 2003 in Part 2 is known

635

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Option Pricing with Applications to Real Options The Investment Timing Option: An Illustration

641

with certainty. Perhaps, then, we should discount it at the risk-free rate.10 Third, the project’s cash inﬂows (excluding the initial investment) are different in Part 2 than in Part 1 because the low-demand cash ﬂows are eliminated. This suggests that if 14 percent is the appropriate cost of capital in the “proceed immediately” case, some lower rate would be appropriate in the “delay decision” case. In Figure 17-3, Part 1, we repeat the “delay decision” analysis, with one exception. We continue to discount the operating cash ﬂows in years 2004, 2005, and 2006 at the 14 percent WACC, but now we discount the project’s cost back to 2002 at the risk-free rate, 6 percent. This increases the PV of the cost at 2002, and that lowers the NPV from $9.36 million to $6.88 million. Note, though, that we really don’t know the precisely appropriate WACC for the project—the 14 percent we used might be too high or too low for the operating cash ﬂows in 2004, 2005, and 2006.11 Therefore, in Part 2 of Figure 17-3 we show a sensitivity analysis of the NPV where the discount rates used for both the operating cash ﬂows and for the project’s cost vary. This sensitivity analysis shows that under all reasonable WACCs, the NPV of delaying is greater than $1.08 million, the NPV of immediate implementation. This means that the option to wait is more valuable than the $1.08 million resulting from immediate implementation. Therefore, Murphy should wait rather than implement the project immediately.

Approach 4. Valuing the Timing Option with the Black-Scholes Model12 The decision tree approach, coupled with a sensitivity analysis, may provide enough information for a good decision. However, it is often useful to obtain additional insights into the real option’s value, which means using the fourth procedure, an option pricing model. To do this, the analyst must ﬁnd a standard ﬁnancial option that resembles the project’s real option.13 As noted earlier, Murphy’s option to delay the project is similar to a call option on a stock, hence the Black-Scholes option pricing model can be used. This model requires ﬁve inputs: (1) the risk-free rate, (2) the time until the option expires, (3) the exercise price, (4) the current price of the stock, and (5) the variance of the stock’s rate of return. Therefore, we need to estimate values for those ﬁve factors. First, assuming that the rate on a 52-week Treasury bill is 6 percent, this rate can be used as the risk-free rate. Second, Murphy must decide within a year whether or not to implement the project, so there is one year until the option expires. Third, it will cost $50 million to implement the project, so $50 million can be used for the exercise price. Fourth, we need a proxy for the value of the underlying asset, which in Black-Scholes is 10

See Timothy A. Luehrman, “Investment Opportunities as Real Options: Getting Started on the Numbers,” Harvard Business Review, July–August 1998, 51–67, for a more detailed explanation of the rationale for using the risk-free rate to discount the project cost. This paper also provides a discussion of real option valuation. Professor Luehrman also has a follow-up paper that provides an excellent discussion of the ways real options affect strategy. See Timothy A. Luehrman, “Strategy as a Portfolio of Real Options,” Harvard Business Review, September–October 1998, 89–99. 11 The cash inﬂows if we delay might be considered more risky if there is a chance that the delay might cause those ﬂows to decline due to the loss of Murphy’s “ﬁrst mover advantage.” Put another way, we might gain information by waiting, and that could lower risk, but if a delay would enable others to enter and perhaps preempt the market, this could increase risk. In our example, we assumed that Murphy has a patent on critical components of the device, hence that no one could come in and preempt its position in the market. 12 This section is relatively technical, but it can be omitted without loss of continuity. 13 In theory, ﬁnancial option pricing models apply only to assets that are continuously traded in a market. Even though real options usually don’t meet this criterion, ﬁnancial option models often provide a reasonably accurate approximation of the real option’s value.

Option Pricing with Applications to Real Options 642

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Option Pricing with Applications to Real Options

FIGURE 17-3

PART

Decision Tree and Sensitivity Analysis for the Investment Timing Option (Millions of Dollars)

1. DECISION TREE ANALYSIS: IMPLEMENT IN ONE YEAR ONLY IF OPTIMAL (DISCOUNT COST AT THE RISK-FREE RATE

AND OPERATING CASH FLOWS AT THE WACC)

Future Cash Flows 2002

Wait

PART

5 0.2 High 0.50 Average 0.2 Low 5

NPV of This Scenarioc Probability

Probability ⴛ NPV

2003

2004

2005

2006

$50

$33

$33

$33

$20.04

0.25

$5.01

$50

$25

$25

$25

$3.74

0.50

$1.87

$0

$0

$0

$0

$0.00

0.25 1.00

$0.00

Expected value of NPVs

$6.88

Standard deviationa

$7.75

Coefﬁcient of variationb

1.13

2. SENSITIVITY ANALYSIS OF NPV TO CHANGES IN THE COST OF CAPITAL USED TO DISCOUNT COST AND CASH FLOWS

Cost of Capital Used to Discount the 2004–2006 Operating Cash Flows

Cost of Capital Used to Discount the 2003 Cost

8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

$13.11 11.78 10.50 9.27 8.09 6.95 5.85 4.79 3.77 2.78 1.83

$13.46 12.13 10.85 9.62 8.44 7.30 6.20 5.14 4.12 3.13 2.18

$13.80 12.47 11.20 9.97 8.78 7.64 6.54 5.48 4.46 3.47 2.52

$14.14 12.81 11.53 10.30 9.12 7.98 6.88 5.82 4.80 3.81 2.86

$14.47 13.14 11.86 10.64 9.45 8.31 7.21 6.15 5.13 4.14 3.19

$14.79 13.47 12.19 10.96 9.78 8.64 7.54 6.48 5.45 4.46 3.51

$15.11 13.78 12.51 11.28 10.09 8.95 7.85 6.79 5.77 4.78 3.83

Notes: a The standard deviation is calculated as in Chapter 3. b The coefﬁcient of variation is the standard deviation divided by the expected value. c The operating cash ﬂows in years 2004–2006 are discounted at the WACC of 14 percent. The cost in 2003 is discounted at the risk-free rate of 6 percent.

the current price of the stock. Note that a stock’s current price is the present value of its expected future cash ﬂows. For Murphy’s real option, the underlying asset is the project itself, and its current “price” is the present value of its expected future cash ﬂows. Therefore, as a proxy for the stock price we can use the present value of the project’s future cash ﬂows. And ﬁfth, the variance of the project’s expected return can be used to represent the variance of the stock’s return in the Black-Scholes model. Figure 17-4 shows how one can estimate the present value of the project’s cash inﬂows. We need to ﬁnd the current value of the underlying asset, that is, the project.

637

638

Option Pricing with Applications to Real Options The Investment Timing Option: An Illustration FIGURE 17-4

643

Estimating the Input for Stock Price in the Option Analysis of the Investment Timing Option (Millions of Dollars) Future Cash Flows

2002

Wait

2003

0.25 High 0.50 Average 0.2 5 Low

2004

2005

2006

PV of This Scenarioc

$33

$33

$33

$67.21

0.25

$16.80

$25

$25

$25

$50.91

0.50

$25.46

$5

$5

$5

$10.18

0.25 1.00

$2.55

Probability

Probability ⴛ PV

Expected value of PVsd

$44.80

Standard deviationa

$21.07

Coefﬁcient of variationb

0.47

Notes: a The standard deviation is calculated as in Chapter 3. b The coefﬁcient of variation is the standard deviation divided by the expected value. c The WACC is 14 percent. All cash ﬂows in this scenario are discounted back to 2002. d Here we ﬁnd the PV, not the NPV, as the project’s cost is ignored.

For a stock, the current price is the present value of all expected future cash ﬂows, including those that are expected even if we do not exercise the call option. Note also that the exercise price for a call option has no effect on the stock’s current price.14 For our real option, the underlying asset is the delayed project, and its current “price” is the present value of all its future expected cash ﬂows. Just as the price of a stock includes all of its future cash ﬂows, the present value of the project should include all its possible future cash ﬂows. Moreover, since the price of a stock is not affected by the exercise price of a call option, we ignore the project’s “exercise price,” or cost, when we ﬁnd its present value. Figure 17-4 shows the expected cash ﬂows if the project is delayed. The PV of these cash ﬂows as of today (2002) is $44.80 million, and this is the input we should use for the current price in the Black-Scholes model. The last required input is the variance of the project’s return. Three different approaches could be used to estimate this input. First, we could use judgment—an educated guess. Here we would begin by recalling that a company is a portfolio of projects (or assets), with each project having its own risk. Since returns on the company’s stock reﬂect the diversiﬁcation gained by combining many projects, we might expect the variance of the stock’s returns to be lower than the variance of one of its average projects. The variance of an average company’s stock return is about 12 percent, so we might expect the variance for a typical project to be somewhat higher, say, 15 to 25 percent. Companies in the Internet infrastructure industry are riskier than average, so we might subjectively estimate the variance of Murphy’s project to be in the range of 18 percent to 30 percent. 14

The company itself is not involved with traded stock options. However, if the option were a warrant issued by the company, then the exercise price would affect the company’s cash ﬂows, hence its stock price.

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Option Pricing with Applications to Real Options

The second approach, called the direct method, is to estimate the rate of return for each possible outcome and then calculate the variance of those returns. First, Part 1 in Figure 17-5 shows the PV for each possible outcome as of 2003, the time when the option expires. Here we simply ﬁnd the present value of all future operating cash ﬂows discounted back to 2003, using the WACC of 14 percent. The 2003 present value is $76.61 million for high demand, $58.04 million for average demand, and $11.61 million for low demand. Then, in Part 2, we show the percentage return from the current time until the option expires for each scenario, based on the $44.80 million starting “price” of the project in 2002 as calculated in Figure 17-4. If demand is high, we will obtain a return of 71.0 percent: ($76.61 $44.80)/$44.80 0.710 71.0 percent). Similar calculations show returns of 29.5 percent for average demand and 74.1 percent for low demand. The expected percentage return is 14 percent, the standard deviation is 53.6 percent, and the variance is 28.7 percent.15 The third approach for estimating the variance is also based on the scenario data, but the data are used in a different manner. First, we know that demand is not really limited to three scenarios—rather, a wide range of outcomes is possible. Similarly, the stock price at the time a call option expires could take on one of many values. It is reasonable to assume that the value of the project at the time when we must decide on undertaking it behaves similarly to the price of a stock at the time a call option expires. Under this assumption, we can use the expected value and standard deviation of the project’s value to calculate the variance of its rate of return, 2, with this formula:16 2

ln(CV2 1) . t

(17-4)

Here CV is the coefﬁcient of variation of the underlying asset’s price at the time the option expires and t is the time until the option expires. Thus, while the three scenarios are simpliﬁcations of the true condition, where there are an inﬁnite number of possible outcomes, we can still use the scenario data to estimate the variance of the project’s rate of return if it had an inﬁnite number of possible outcomes. For Murphy’s project, this indirect method produces the following estimate of the variance of the project’s return: 2

ln(0.472 1) 0.20 20%. 1

(17-4a)

Which of the three approaches is best? Obviously, they all involve judgment, so an analyst might want to consider all three. In our example, all three methods produce similar estimates, but for illustrative purposes we will simply use 20 percent as our initial estimate for the variance of the project’s rate of return. Part 1 of Figure 17-6 calculates the value of the option to defer investment in the project based on the Black-Scholes model, and the result is $7.04 million. Since this is signiﬁcantly higher than the $1.08 million NPV under immediate implementation, and since the option would be forfeited if Murphy goes ahead right now, we conclude that the company should defer the ﬁnal decision until more information is available.

15

Two points should be made about the percentage return. First, for use in the Black-Scholes model, we need a percentage return calculated as shown, not an IRR return. The IRR is not used in the option pricing approach. Second, the expected return turns out to be 14 percent, the same as the WACC. This is because the 2002 price and the 2003 PVs were all calculated using the 14 percent WACC, and because we are measuring return over only one year. If we measure the compound return over more than one year, then the average return generally will not equal 14 percent. 16 See David C. Shimko, Finance in Continuous Time (Miami, FL: Kolb Publishing Company, 1992), for a more detailed explanation.

639

640

Option Pricing with Applications to Real Options FIGURE 17-5

PART

Estimating the Input for Variance in the Option Analysis of the Investment Timing Option (Millions of Dollars)

1. FIND THE VALUE AND RISK OF FUTURE CASH FLOWS AT THE TIME THE OPTION EXPIRES

2004

2005

PV in 2003 for This 2006 Scenarioc Probability

$33

$33

$33

$76.61

0.25

$19.15

$25

$25

$25

$58.04

0.50

$29.02

$5

$5

$5

$11.61

0.25 1.00

$2.90

Future Cash Flows 2002

Wait

2003

High Average Low

0.25 0.50

0.25

Expected value of PV2003

$51.08

$24.02

Coefﬁcient of variation of PV2003b

0.47

Standard deviation of

PART

Probability ⴛ PV2003

PV2003a

2. DIRECT METHOD: USE THE SCENARIOS TO DIRECTLY ESTIMATE THE VARIANCE OF THE PROJECT’S RETURN

Price2002d

$44.80

0.25 High 0.50 Average 0.25 Low

Probability Probability ⴛ Return2003

PV2003e

Return2003f

$76.61

71.0%

0.25

17.8%

$58.04

29.5%

0.50

14.8%

$11.61

74.1%

0.25

18.5%

1.00 Expected return

14.0%

Standard deviation of returna

53.6%

Variance of return

28.7%

g

PART

3. INDIRECT METHOD: USE THE SCENARIOS TO INDIRECTLY ESTIMATE THE VARIANCE OF THE PROJECT’S RETURN Expected “price” at the time the option expiresh Standard deviation of expected “price” at the time the option expiresi Coefﬁcient of variation (CV) Time (in years) until the option expires (t) Variance of the project’s expected return ln(CV2 1)/t

Notes: a The standard deviation is calculated as explained in Chapter 3. b The coefﬁcient of variation is the standard deviation divided by the expected value. c The WACC is 14 percent. The 2004–2006 cash ﬂows are discounted back to 2003. d The 2002 price is the expected PV from Figure 17-4. e The 2003 PVs are from Part 1. f The returns for each scenario are calculated as (PV2003 Price2002)/Price2002. g The variance of return is the standard deviation squared. h The expected “price” at the time the option expires is taken from Part 1. i The standard deviation of expected “price” at the time the option expires is taken from Part 1.

$51.08 $24.02 0.47 1 20.0%

Option Pricing with Applications to Real Options 646

CHAPTER 17

Option Pricing with Applications to Real Options FIGURE 17-6

PART

Estimating the Value of the Investment Timing Option Using a Standard Financial Option (Millions of Dollars)

1. FIND THE VALUE OF A CALL OPTION USING THE BLACK-SCHOLES MODEL Real Option

rRF t X P 2 d1 d2 N(d1) N(d2) V PART

Risk-free interest rate Time in years until the option expires Cost to implement the project Current value of the project Variance of the project’s rate of return {ln(P/X) [rRF (2/2)]t}/(t1/2) d1 (t1/2)

P[N(d1)] XerRFt[N(d2)]

6% 1 $50.00 $44.80a 20.0%b 0.112 0.33 0.54 0.37 $7.04

2. SENSITIVITY ANALYSIS OF OPTION VALUE TO CHANGES IN VARIANCE

Variance

Option Value

12.0% 14.0 16.0 18.0 20.0 22.0 24.0 26.0 28.0 30.0 32.0

$5.24 5.74 6.20 6.63 7.04 7.42 7.79 8.15 8.49 8.81 9.13

Notes: a The current value of the project is taken from Figure 17-4. b The variance of the project’s rate of return is taken from Part 3 of Figure 17-5.

Note, though, that judgmental estimates were made at many points in the analysis, and it is useful to see how sensitive the final outcome is to certain of the key inputs. Thus, in Part 2 of Figure 17-6 we show the sensitivity of the option’s value to different estimates of the variance. It is comforting to see that for all reasonable estimates of variance, the option to delay remains more valuable than immediate implementation.

Approach 5. Financial Engineering Sometimes an analyst might not be satisﬁed with the results of a decision tree analysis and cannot ﬁnd a standard ﬁnancial option that corresponds to the real option. In such a situation the only alternative is to develop a unique model for the speciﬁc real option being analyzed, which is called ﬁnancial engineering. When ﬁnancial engineering is applied on Wall Street, where it was developed, the result is a newly designed ﬁnancial

641

642

Option Pricing with Applications to Real Options Concluding Thoughts on Real Options

647

Growth Options at Dot-com Companies

In September 2000, several dot-com companies had recently failed, including DEN (Digital Entertainment Network) and Boo.com, an e-tailer of clothing. Other dot-coms had incredible market valuations, such as Yahoo! ($58.2 billion), Amazon.com ($15.5 billion) and America Online ($126.9 billion). What explains these wide variations in values? It’s certainly not the physical assets the companies own, since Yahoo! has enormous value but virtually no physical assets. Based on the corporate valuation model of Chapter 12, we might be tempted to say the differences are explained by free cash ﬂows. Perhaps dot-coms such as Amazon and Yahoo! have large expected future free cash ﬂows, and their high values reﬂect this, but we certainly can’t base that conclusion on their past results. This is where real options come into play. Given its name recognition, infrastructure, and customer base, Amazon is in a position to grow into a variety of businesses, some of which might be very proﬁtable. The same is true for Yahoo! and AOL. In other words, they have many growth options with

very low exercise prices. We know from our discussion of real options that an option is more valuable if the underlying source of risk is very volatile, and it’s hard to imagine anything more volatile than the prospects of proﬁtability in e-commerce. The ﬁeld of e-commerce may end up being so competitive that there is little proﬁt for the participating companies, or it may replace most existing forms of commerce, with the ﬁrst-movers having an enormous advantage. This uncertainty means that a growth option in e-commerce is very valuable. Therefore, companies with many growth options should have high valuations. Note that just being a dot-com company is not enough to create value. DEN and Boo.com had substantial obligations but very few options, which led to their demise. For dot-com companies, the key to high valuations is to create as many growth options as possible. Source: Geoffrey Colvin, “You’re Only as Good as Your Choices,” Fortune, June 12, 2000, 75. Reprinted by permission.

product.17 When it is applied to real options, the result is the value of a project that contains embedded options. Although ﬁnancial engineering was originally developed on Wall Street, many ﬁnancial engineering techniques have been applied to real options during the last ten years. We expect this trend to continue, especially in light of the rapid improvements in computer processing speed and spreadsheet software capabilities. One ﬁnancial engineering technique is called risk-neutral valuation. This technique uses simulation, and we discuss it in the Chapter 17 Web Extension located on the textbook’s web site. Most other ﬁnancial engineering techniques are too complicated for an introductory course in ﬁnancial management, and so we leave a detailed discussion of them to a later course. For illustrative valuations of growth options and abandonment options, see the Chapter 17 Web Extension. The calculations are also shown in Ch 17 Tool Kit.xls, found on the textbook’s web site. What is a decision tree? In a qualitative analysis, what factors affect the value of a real option?

Concluding Thoughts on Real Options We don’t deny that real options can be pretty complicated. Keep in mind, however, that 50 years ago very few companies used NPV because it seemed too complicated. Now NPV is a basic tool used by virtually all companies and taught in all business 17

Financial engineering techniques are widely used for the creation and valuation of derivative securities.

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Option Pricing with Applications to Real Options

schools. A similar, but more rapid, pattern of adoption is occurring with real options. Ten years ago very few companies used real options, but a recent survey of CFOs reported that more than 26 percent of companies now use real option techniques when evaluating projects.18 Just as with NPV, it’s only a matter of time before virtually all companies use real option techniques. We have provided you with some basic tools necessary for evaluating real options, starting with the ability to identify real options and make qualitative assessments regarding a real option’s value. Decision trees are another important tool, since they require an explicit identiﬁcation of the embedded options, which is very important in the decision-making process. However, keep in mind that the decision tree should not use the original project’s cost of capital. Although ﬁnance theory has not yet provided a way to estimate the appropriate cost of capital for a decision tree, sensitivity analysis can identify the effect that different costs of capital have on the project’s value. Many real options can be analyzed using a standard model for an existing ﬁnancial option, such as the Black-Scholes model for calls and puts. There are also other ﬁnancial models for a variety of options. These include the option to exchange one asset for another, the option to purchase the minimum or the maximum of two or more assets, the option on an average of several assets, and even an option on an option.19 In fact, there are entire textbooks that describe even more options.20 Given the large number of standard models for existing ﬁnancial options, it is often possible to ﬁnd a ﬁnancial option that resembles the real option being analyzed. Sometimes there are some real options that don’t resemble any ﬁnancial options. But the good news is that many of these options can be valued using techniques from ﬁnancial engineering. This is frequently the case if there is a traded ﬁnancial asset that matches the risk of the real option. For example, many oil companies use oil futures contracts to price the real options that are embedded in various exploration and leasing strategies. With the explosion in the markets for derivatives, there are now ﬁnancial contracts that span an incredible variety of risks. This means that an ever-increasing number of real options can be valued using these ﬁnancial instruments. Most ﬁnancial engineering techniques are beyond the scope of this book, but we list some useful sources in the references at the end of the chapter. In addition, the Chapter 17 Web Extension describes one particularly useful ﬁnancial engineering technique called risk-neutral valuation. How widely used is real option analysis? What techniques can be used to analyze real options?

Summary In this chapter we discussed some topics that go beyond the simple capital budgeting framework, including the following:

18

See John R. Graham and Cambell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics, 2001, Vol. 60, 187–243. 19 See W. Margrabe, “The Value of an Option to Exchange One Asset for Another,” Journal of Finance, March 1978, 177–186; R. Stulz, “Options on the Minimum or Maximum of Two Risky Assets: Analysis and Applications,” Journal of Financial Economics, 1982, 161–185; H. Johnson, “Options on the Maximum or Minimum of Several Assets,” Journal of Financial and Quantitative Analysis, September 1987, 277–283; P. Ritchken, L. Sankarasubramanian, and A. M. Vijh, “Averaging Options for Capping Total Costs,” Financial Management, Autumn 1990, 35–41; and R. Geske, “The Valuation of Compound Options,” Journal of Financial Economics, March 1979, 63–81. 20

See John C. Hull, Options, Futures, and Other Derivatives, 3rd ed. (Upper Saddle River, NJ: Prentice Hall, 1997).

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Option Pricing with Applications to Real Options Questions 䊉

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Investing in a new project often brings with it a potential increase in the ﬁrm’s future opportunities. Opportunities are, in effect, options—the right but not the obligation to take some future action. A project may have an option value that is not accounted for in a conventional NPV analysis. Any project that expands the ﬁrm’s set of opportunities has positive option value. Financial options are instruments that (1) are created by exchanges rather than ﬁrms, (2) are bought and sold primarily by investors, and (3) are of importance to both investors and ﬁnancial managers. The two primary types of ﬁnancial options are (1) call options, which give the holder the right to purchase a speciﬁed asset at a given price (the exercise, or strike, price) for a given period of time, and (2) put options, which give the holder the right to sell an asset at a given price for a given period of time. A call option’s exercise value is deﬁned as the maximum of zero or the current price of the stock less the strike price. The Black-Scholes Option Pricing Model (OPM) can be used to estimate the value of a call option. Opportunities to respond to changing circumstances are called managerial options because they give managers the option to inﬂuence the outcome of a project. They are also called strategic options because they are often associated with large, strategic projects rather than routine maintenance projects. Finally, they are also called real options because they involve “real,” rather than “ﬁnancial,” assets. Many projects include a variety of embedded options that can dramatically affect the true NPV. Examples of embedded options include (1) “investment timing options” that allow a ﬁrm to delay a project, (2) “growth options” that enable a ﬁrm to manage its capacity in response to changing market conditions, (3) “abandonment options,” and (4) “ﬂexibility” options that allow a ﬁrm to modify its operations over time. An investment timing option involves not only the decision of whether to proceed with a project but also the decision of when to proceed with it. This opportunity to affect a project’s timing can dramatically change its estimated value. A growth option occurs if an investment creates the opportunity to make other potentially proﬁtable investments that would not otherwise be possible. These include: (1) options to expand output, (2) options to enter a new geographical market, and (3) options to introduce complementary products or successive generations of products. The abandonment option is the ability to abandon a project if the operating cash ﬂows and/or abandonment value turn out to be lower than expected. It reduces the riskiness of a project and increases its value. Instead of total abandonment, some options allow a company to reduce capacity or temporarily suspend operations. A ﬂexibility option is the option to modify operations depending on how conditions develop during a project’s life, especially the type of output produced or the inputs used. There are ﬁve possible procedures for valuing real options: (1) DCF analysis only, and ignore the real option; (2) DCF analysis and a qualitative assessment of the real option’s value; (3) decision tree analysis; (4) analysis with a standard model for an existing ﬁnancial option; and (5) ﬁnancial engineering techniques.

Questions 17–1

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Deﬁne each of the following terms: a. Option; call option; put option b. Exercise value; strike price c. Black-Scholes Option Pricing Model d. Real options; managerial options; strategic options; embedded option

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Option Pricing with Applications to Real Options e. Investment timing option; growth option; abandonment option; ﬂexibility option f. Decision trees

17–2

Why do options typically sell at prices higher than their exercise values?

17–3

What factors should a company consider when it decides whether to invest in a project today or to wait until more information becomes available?

17–4

In general, do timing options make it more or less likely that a project will be accepted today?

17–5

If a company has an option to abandon a project, would this tend to make the company more or less likely to accept the project today?

Self-Test Problems ST–1 OPTIONS

ST–2 OPTIONS

(Solutions Appear in Appendix A)

A call option on the stock of Bedrock Boulders has a market price of $7. The stock sells for $30 a share, and the option has an exercise price of $25 a share. a. What is the exercise value of the call option? b. What is the premium on the option? Which of the following events are likely to increase the market value of a call option on a common stock? Explain. a. An increase in the stock’s price. b. An increase in the volatility of the stock price. c. An increase in the risk-free rate. d. A decrease in the time until the option expires.

Problems 17–1

Assume you have been given the following information on Purcell Industries:

BLACK-SCHOLES MODEL

Current stock price $15 Time to maturity of option 6 months Variance of stock price 0.12 d2 0.08165 N(d2) 0.53252

Exercise price of option $15 Risk-free rate 10% d1 0.32660 N(d1) 0.62795

Using the Black-Scholes Option Pricing Model, what would be the value of the option? 17–2 OPTIONS

17–3 INVESTMENT TIMING OPTION: DECISION TREE ANALYSIS

The exercise price on one of Flanagan Company’s options is $15, its exercise value is $22, and its premium is $5. What are the option’s market value and the price of the stock? Kim Hotels is interested in developing a new hotel in Seoul. The company estimates that the hotel would require an initial investment of $20 million. Kim expects that the hotel will produce positive cash ﬂows of $3 million a year at the end of each of the next 20 years. The project’s cost of capital is 13 percent. a. What is the project’s net present value? b. While Kim expects the cash ﬂows to be $3 million a year, it recognizes that the cash ﬂows could, in fact, be much higher or lower, depending on whether the Korean government imposes a large hotel tax. One year from now, Kim will know whether the tax will be imposed. There is a 50 percent chance that the tax will be imposed, in which case the yearly cash ﬂows will be only $2.2 million. At the same time, there is a 50 percent chance that the tax will not be imposed, in which case the yearly cash ﬂows will be $3.8 million. Kim is deciding whether to proceed with the hotel today or to wait 1 year to ﬁnd out whether the tax will be imposed. If Kim waits a year, the initial investment will remain at $20 million. Assume that all cash ﬂows are discounted at 13 percent. Using decision tree analysis, should Kim proceed with the project today or should it wait a year before deciding?

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Option Pricing with Applications to Real Options Problems 17–4 INVESTMENT TIMING OPTION: DECISION TREE ANALYSIS

17–5 INVESTMENT TIMING OPTION: DECISION TREE ANALYSIS

17–6 REAL OPTIONS: DECISION TREE ANALYSIS

17–7 INVESTMENT TIMING OPTION: OPTION ANALYSIS

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The Karns Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project would cost $8 million today. Karns estimates that once drilled, the oil will generate positive net cash ﬂows of $4 million a year at the end of each of the next 4 years. While the company is fairly conﬁdent about its cash ﬂow forecast, it recognizes that if it waits 2 years, it would have more information about the local geology as well as the price of oil. Karns estimates that if it waits 2 years, the project would cost $9 million. Moreover, if it waits 2 years, there is a 90 percent chance that the net cash ﬂows would be $4.2 million a year for 4 years, and there is a 10 percent chance that the cash ﬂows will be $2.2 million a year for 4 years. Assume that all cash ﬂows are discounted at 10 percent. a. If the company chooses to drill today, what is the project’s net present value? b. Using decision tree analysis, would it make sense to wait 2 years before deciding whether to drill? Hart Lumber is considering the purchase of a paper company. Purchasing the company would require an initial investment of $300 million. Hart estimates that the paper company would provide net cash ﬂows of $40 million at the end of each of the next 20 years. The cost of capital for the paper company is 13 percent. a. Should Hart purchase the paper company? b. While Hart’s best guess is that cash ﬂows will be $40 million a year, it recognizes that there is a 50 percent chance the cash ﬂows will be $50 million a year, and a 50 percent chance that the cash ﬂows will be $30 million a year. One year from now, it will ﬁnd out whether the cash ﬂows will be $30 million or $50 million. In addition, Hart also recognizes that if it wanted, it could sell the company at Year 3 for $280 million. Given this additional information, does using decision tree analysis indicate that it makes sense to purchase the paper company? Again, assume that all cash ﬂows are discounted at 13 percent. Utah Enterprises is considering buying a vacant lot that sells for $1.2 million. If the property is purchased, the company’s plan is to spend another $5 million today (t 0) to build a hotel on the property. The after-tax cash ﬂows from the hotel will depend critically on whether the state imposes a tourism tax in this year’s legislative session. If the tax is imposed, the hotel is expected to produce after-tax cash inﬂows of $600,000 at the end of each of the next 15 years. If the tax is not imposed, the hotel is expected to produce after-tax cash inﬂows of $1,200,000 at the end of each of the next 15 years. The project has a 12 percent cost of capital. Assume at the outset that the company does not have the option to delay the project. Use decision tree analysis to answer the following questions. a. What is the project’s expected NPV if the tax is imposed? b. What is the project’s expected NPV if the tax is not imposed? c. Given that there is a 50 percent chance that the tax will be imposed, what is the project’s expected NPV if they proceed with it today? d. While the company does not have an option to delay construction, it does have the option to abandon the project 1 year from now if the tax is imposed. If it abandons the project, it would sell the complete property 1 year from now at an expected price of $6 million. Once the project is abandoned the company would no longer receive any cash inﬂows from it. Assuming that all cash ﬂows are discounted at 12 percent, would the existence of this abandonment option affect the company’s decision to proceed with the project today? e. Finally, assume that there is no option to abandon or delay the project, but that the company has an option to purchase an adjacent property in 1 year at a price of $1.5 million. If the tourism tax is imposed, the net present value of developing this property (as of t 1) is only $300,000 (so it wouldn’t make sense to purchase the property for $1.5 million). However, if the tax is not imposed, the net present value of the future opportunities from developing the property would be $4 million (as of t 1). Thus, under this scenario it would make sense to purchase the property for $1.5 million. Assume that these cash ﬂows are discounted at 12 percent, and the probability that the tax will be imposed is still 50 percent. How much would the company pay today for the option to purchase this property 1 year from now for $1.5 million? Rework Problem 17-3 using the Black-Scholes model to estimate the value of the option. (Hint: Assume the variance of the project’s rate of return is 6.87 percent and the risk-free rate is 8 percent.)

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Option Pricing with Applications to Real Options

17–8 INVESTMENT TIMING OPTION: OPTION ANALYSIS

Rework Problem 17-4 using the Black-Scholes model to estimate the value of the option: The risk-free rate is 6 percent. (Hint: Assume the variance of the project’s rate of return is 1.11 percent.)

Spreadsheet Problems 17–9 BUILD A MODEL: BLACK-SCHOLES MODEL

17–10 BUILD A MODEL: REAL OPTIONS

See Ch 17 Show.ppt and Ch 17 Mini Case.xls.

Start with the partial model in the ﬁle Ch 17 P9 Build a Model.xls from the textbook’s web site. Rework Problem 17-1. Then work the next two parts of this problem given below. a. Construct data tables for the exercise value and Black-Scholes option value for this option, and graph this relationship. Include possible stock price values ranging up to $30.00. b. Suppose this call option is purchased today. Draw the proﬁt diagram of this option position at expiration. Start with the partial model in the ﬁle Ch 17 P10 Build a Model.xls from the textbook’s web site. Bradford Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years. There is a 30 percent probability of good conditions, in which case the project will provide a cash ﬂow of $9 million at the end of each year for 3 years. There is 40 percent probability of medium conditions, in which case the annual cash ﬂows will be $4 million, and there is a 30 percent probability of bad conditions and a cash ﬂow of $1 million per year. BSI uses a 12 percent cost of capital to evaluate projects like this. a. Find the project’s expected present value, NPV, and the coefﬁcient of variation of the present value. b. Now suppose that BSI can abandon the project at the end of the ﬁrst year by selling it for $6 million. BSI will still receive the Year 1 cash ﬂows, but will receive no cash ﬂows in subsequent years. c. Now assume that the project cannot be shut down. However, expertise gained by taking it on will lead to an opportunity at the end of Year 3 to undertake a venture that would have the same cost as the original project, and the new project’s cash ﬂows would follow whichever branch resulted for the original project. In other words, there would be a second $10 million cost at the end of Year 3, and then cash ﬂows of either $9 million, $4 million, or $1 million for the following 3 years. Use decision tree analysis to estimate the value of the project, including the opportunity to implement the new project at Year 3. Assume the $10 million cost at Year 3 is known with certainty and should be discounted at the risk-free rate of 6 percent. d. Now suppose the original (no abandonment and no additional growth) project could be delayed a year. All the cash ﬂows would remain unchanged, but information obtained during that year would tell the company exactly which set of demand conditions existed. Use decision tree analysis to estimate the value of the project if it is delayed by 1 year. (Hint: Discount the $10 million cost at the risk-free rate of 6 percent since it is known with certainty.) e. Go back to part c. Instead of using decision tree analysis, use the Black-Scholes model to estimate the value of the growth option. The risk-free rate is 6 percent, and the variance of the project’s rate of return is 22 percent.

Assume that you have just been hired as a ﬁnancial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. The ﬁrm’s CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on real options. Because no one at Tropical Sweets is familiar with the basics of either ﬁnancial or real options, Yamaguchi has asked you to prepare a brief report that the ﬁrm’s executives could use to gain at least a cursory understanding of the topics. To begin, you gathered some outside materials on the subject and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.

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Option Pricing with Applications to Real Options Mini Case

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a. What is a real option? What is a ﬁnancial option? What is the single most important characteristic of an option? b. Options have a unique set of terminology. Deﬁne the following terms: (1) Call option (2) Put option (3) Exercise price (4) Striking, or strike, price (5) Option price (6) Expiration date (7) Exercise value (8) Covered option (9) Naked option (10) In-the-money call (11) Out-of-the-money call (12) LEAPS c. Consider Tropical Sweets’ call option with a $25 strike price. The following table contains historical values for this option at different stock prices: Stock Price

Call Option Price

$25 30 35 40 45 50

$3.00 7.50 12.00 16.50 21.00 25.50

(1) Create a table which shows (a) stock price, (b) strike price, (c) exercise value, (d) option price, and (e) the premium of option price over exercise value. (2) What happens to the premium of option price over exercise value as the stock price rises? Why? d. In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model (OPM). (1) What assumptions underlie the OPM? (2) Write out the three equations that constitute the model. (3) What is the value of the following call option according to the OPM? Stock price $27.00 Exercise price $25.00 Time to expiration 6 months Risk-free rate 6.0% Stock return variance 0.11

e. What impact does each of the following call option parameters have on the value of a call option? (1) Current stock price (2) Exercise price (3) Option’s term to maturity (4) Risk-free rate (5) Variability of the stock price f. What are some types of real options? g. What are ﬁve possible procedures for analyzing a real option? h. Tropical Sweets is considering a project that will cost $70 million and will generate expected cash ﬂows of $30 million per year for 3 years. The cost of capital for this type of project is 10 percent and the risk-free rate is 6 percent. After discussions with the market-

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Option Pricing with Applications to Real Options

i.

j. k. l.

m. n. o.

ing department, you learn that there is a 30 percent chance of high demand, with future cash ﬂows of $45 million per year. There is a 40 percent chance of average demand, with cash ﬂows of $30 million per year. If demand is low (a 30 percent chance), cash ﬂows will be only $15 million per year. What is the expected NPV? Now suppose this project has an investment timing option, since it can be delayed for a year. The cost will still be $70 million at the end of the year, and the cash ﬂows for the scenarios will still last 3 years. However, Tropical Sweets will know the level of demand, and will implement the project only if it adds value to the company. Perform a qualitative assessment of the investment timing option’s value. Use decision tree analysis to calculate the NPV of the project with the investment timing option. Use a ﬁnancial option pricing model to estimate the value of the investment timing option. Now suppose the cost of the project is $75 million and the project cannot be delayed. But if Tropical Sweets implements the project, then Tropical Sweets will have a growth option. It will have the opportunity to replicate the original project at the end of its life. What is the total expected NPV of the two projects if both are implemented? Tropical Sweets will replicate the original project only if demand is high. Using decision tree analysis, estimate the value of the project with the growth option. Use a ﬁnancial option model to estimate the value of the project with the growth option. What happens to the value of the growth option if the variance of the project’s return is 14.2 percent? What if it is 50 percent? How might this explain the high valuations of many dotcom companies?

Selected Additional References For more information on the derivatives markets, see Chance, Don M., An Introduction to Derivatives (Fort Worth, TX: Dryden Press, 1995). The original Black-Scholes article tested the OPM to see how well predicted prices conformed to market values. For additional empirical tests, see Galai, Dan, “Tests of Market Efﬁciency of the Chicago Board Options Exchange,” Journal of Business, April 1977, 167–197. Gultekin, N. Bulent, Richard J. Rogalski, and Seha M. Tinic, “Option Pricing Model Estimates: Some Empirical Results,” Financial Management, Spring 1982, 58–69.

MacBeth, James D., and Larry J. Merville, “An Empirical Examination of the Black-Scholes Call Option Pricing Model,” Journal of Finance, December 1979, 1173–1186. Here are some references on real options: Amram, Martha, and Nalin Kulatilaka, Real Options: Managing Strategic Investment in an Uncertain World (Boston, MA: Harvard Business School Press, 1999). Trigeorgis, Lenos, Real Options in Capital Investment: Models, Strategies, and Applications (Westport, CT: Praeger, 1995). Trigeorgis, Lenos, Real Options: Managerial Flexibility and Strategy in Resource Allocation (Cambridge, MA: The MIT Press, 1996).

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Five-Minute Mba in Corporate Finance

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