Richard Brealey, Stewart Myers, Alan Marcus Fundamentals of Corporate
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SEVENTH EDITION Fundamentals of Corporate Finance THE McGRAW-HILL/IRWIN SERIES IN FINANCE, INSURANCE AND REAL ESTATE SEVENTH EDITION Fundamentals of Corporate Finance Richard A. Brealey London Business School Stewart C. Myers Sloan School of Management Massachusetts Institute of Technology Alan J. Marcus Carroll School of Management Boston College OF CORPORATE FINANCE usiness unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2012, 2009, 2007, 2004, 2001, 1999, 1995 by The McGraw-Hill y form or by an v The McGraw-Hill ut not limited to, in any netw United States. 1 2 3 4 5 6 7 8 9 0 QDB/QDB 1 0 9 8 7 6 5 4 3 2 1 ISBN 978-0-07-803464-0 MHID 0-07-803464-7 Vice president Brent Gordon Douglas Reiner editor: Michele Janicek director of development: Ann Development editor II: Karen L. Fisher Robin J. Zwettler director: Brad Parkins Senior manager: Melissa S. Caughlin Sesha Senior project manager: Dana M. Pauley Buyer II: Debra R. Sylvester Designer: Matt Diamond Senior photo coordinator: Keri Johnson Photo researcher: Michelle Buhr Senior project manager: Susan Lombardi project manager: Ron Nelms Typeface: 10.5/12 Times Roman Compositor: Brealey, Richard A. ed. Includes index. ISBN-10: 0-07-803464-7 (alk. paper) HG4026.B6668 2012 658.15—dc22 2011017399 About the Authors Richard A. Brealey Stewart C. Myers Alan J. Marcus vi Preface Fundamentals and Principles of Corporate Finance Organizational Design Routes through the Book Changes in the Seventh Edition Assurance of Learning AACSB Statement ORGANIZATION New and Enhanced Pedagogy WALK-THROUGH Brealey / Myers / Marcus Your guide through the challenging landscape of corporate finance. Chapter Opener CHAPTER Key Terms in the Margin 5.4 Level Cash Flows: Perpetuities and Annuities annuity How to Value Perpetuities perpetuity EXAMPLE 5.8 ▲ Numbered Examples 5 Winning Big at the Lottery PEDAGOGY What makes Brealey/Myers/Marcus such a powerful learning tool? Spreadsheet Solutions Boxes Excel Exhibits Finance in Practice Boxes SPREADSHEET SOLUTIONS Multiple Cash Flows www.mhhe.com/bmm7e. Spreadsheet Questions SPREADSHEET 19.1 FINANCE IN PRACTICE The Hazards of Secured Bank Lending Calculator Boxes and Exercises F I N A N C I A L CA L C U L ATO R An Introduction to Financial Calculators Self-Test Questions Self-Test 5.5 Global Index Global Index A End-of-Chapter Material Summary QUESTIONS QUIZ PRACTICE PROBLEMS CHALLENGE PROBLEMS www.mhhe Quiz, Practice, and Challenge Problems www.mhhe www.mhhe SUMMARY www.mh Excel Problems www.mhhe.com/bmm7e Web Exercises WEB EXERCISES finance.yahoo.com MINICASE www Minicases Supplements For the Instructor Instructor’s Manual Online Support Online Learning Center PowerPoint Presentation System Print and Online Test Bank TM McGraw-Hill Connect ™ Finance Less Managing. More Teaching. Greater Learning. Solutions Manual McGraw-Hill Connect ™ Finance Features DVD Tegrity Campus: Lectures 24/7 McGraw-Hill Customer Care Contact Information Acknowledgments Contents in Brief Part One Introduction 1 2 3 4 Part Two Value 5 6 7 8 9 10 Part Three Risk 11 Part Four Financing 14 Part Five Debt and Payout Policy 16 Part Six Financial Analysis and Planning 18 Part Seven Special Topics 21 12 13 15 17 19 20 22 23 24 Part Eight Conclusion xxii 25 Contents Part One Introduction Chapter 1 Goals and Governance of the Corporation 2 1.1 Chapter 3 Accounting and Finance 3.1 Investment and Financing Decisions 4 6 3.2 The Financing Decision 6 1.3 1.4 What Is a Corporation? 8 3.3 9 3.4 Accounting Practice and Malpractice 66 Goals of the Corporation 11 3.5 Taxes 68 Corporate Governance Corporate Tax Personal Tax 14 Do Managers Really Maximize Value? Questions Careers in Finance 20 1.6 Topics Covered in This Book 23 4.1 Summary 25 Value and Value Added 78 80 How Financial Ratios Help to Understand Value Added 80 Questions 26 Chapter 2 Financial Markets and Institutions 30 4.2 Measuring Market Value and Market Value Added 81 4.3 Economic Value Added and Accounting Rates of Return 84 The Importance of Financial Markets and Institutions 32 Accounting Rates of Return 35 Other Financial Markets 36 Financial Intermediaries 38 4.4 Measuring Efficiency 88 4.5 Analyzing the Return on Assets: The Du Pont System 90 The Du Pont System 40 Total Financing of U.S. Corporations 42 Measuring Financial Leverage 92 4.7 Measuring 43 4.8 43 4.9 Liquidity 44 95 97 Interpreting Financial Ratios 98 4.10 The Role of Financial Ratios—and a Final Note on Transparency 101 The Payment Mechanism 45 Information Provided by Financial Markets 90 4.6 94 Functions of Financial Markets and Intermediaries 43 Risk Transfer and Diversification 86 Problems with EVA and Accounting Rates of Return 87 The Flow of Savings to Corporations 33 Financial Institutions 2.4 71 Chapter 4 Measuring Corporate Performance 23 The Stock Market 68 69 16 19 1.5 2.3 65 Who Is the Financial Manager? 10 The Ethics of Maximizing Value 2.2 60 The Statement of Cash Flows 63 Free Cash Flow Shareholders Want Managers to Maximize Market Value 11 2.1 The Income Statement 59 Profits versus Cash Flow Other Forms of Business Organization 52 54 Book Values and Market Values 57 The Investment (Capital Budgeting) Decision 1.2 The Balance Sheet 45 Transparency 103 The Crisis of 2007–2009 47 Summary 48 Questions Questions Minicase 110 49 105 xxiii Contents Part Two Value Chapter 5 The Time Value of Money 112 7.2 5.1 Future Values and Compound Interest 114 5.2 Present Values 117 Finding the Interest Rate 5.3 Multiple Cash Flows Price and Intrinsic Value 197 Nonconstant Growth Inflation and the Time Value of Money 139 Real or Nominal? 202 205 Market-Value Balance Sheets 138 7.6 139 205 There Are No Free Lunches on Wall Street 206 Method 1: Technical Analysis 206 Method 2: Fundamental Analysis 141 Valuing Real Cash Payments 200 Valuing Growth Stocks Annuities Due 136 Inflation and Interest Rates 199 7.5 133 Real versus Nominal Cash Flows 194 Simplifying the Dividend Discount Model 197 Estimating Expected Rates of Return 127 129 5.6 5.7 192 The Dividend Discount Model with No Growth 197 126 Level Cash Flows: Perpetuities and Annuities 127 Future Value of an Annuity 5.5 7.4 124 Present Value of Multiple Cash Flows How to Value Annuities 191 The Dividend Discount Model 124 How to Value Perpetuities Valuing Common Stocks 191 Valuation by Comparables 123 Future Value of Multiple Cash Flows 5.4 7.3 Market Values, Book Values, and Liquidation Values 189 A Theory to Fit the Facts 143 7.7 144 210 211 Market Anomalies and Behavioral Finance 212 Market Anomalies 212 Summary 144 213 Questions 145 Behavioral Finance 214 Minicase 156 Chapter 6 Valuing Bonds 6.1 Questions 158 The Bond Market 160 Bond Characteristics 6.2 160 Interest Rates and Bond Prices 161 163 Interest Rate Risk 6.3 6.4 165 8.1 8.2 171 172 Using the NPV Rule to Choose among Projects 234 235 Problem 2: The Choice between Longand Short-Lived Equipment 236 177 Problem 3: When to Replace an Old Machine 238 Questions 178 8.3 The Payback Rule Discounted Payback Chapter 7 Valuing Stocks 184 8.4 239 240 The Internal Rate of Return Rule 240 A Closer Look at the Rate of Return Rule Stocks and the Stock Market 186 Reading Stock Market Listings 229 230 Problem 1: The Investment Timing Decision Corporate Bonds and the Risk of Default 174 Summary 178 7.1 228 Valuing Long-Lived Projects Bond Rates of Return 168 Variations in Corporate Bonds Net Present Value A Comment on Risk and Present Value Nominal and Real Rates of Interest 6.6 Chapter 8 Net Present Value and Other Investment Criteria 226 166 6.5 217 Minicase 223 187 241 Calculating the Rate of Return for Long-Lived Projects 241 Contents A Word of Caution 243 Calculating the NPV of Blooper’s Project 243 8.5 248 Capital Rationing Soft Rationing 249 249 Hard Rationing 276 Further Notes and Wrinkles Arising from Blooper’s Project 277 Questions 249 282 Minicase 287 249 8.6 A Last Look 250 Chapter 10 Project Analysis 10.1 How Firms Organize the Investment Process 292 Questions 252 Minicase 258 Stage 1: The Capital Budget Appendix: More on the IRR Rule 259 Exclusive Projects 259 Discount Cash Flows, Not Profits 298 NPV Break-Even Analysis Operating Leverage 298 300 303 10.4 305 The Option to Expand 266 305 A Second Real Option: The Option to Abandon 307 A Third Real Option: The Timing Option Separate Investment and Financing Decisions 271 270 307 Facilities 308 271 Operating Cash Flow Questions 271 Changes in Working Capital 9.3 297 Accounting Break-Even Analysis Discount Nominal Cash Flows by the Nominal Cost of Capital 269 Calculating Cash Flow 295 10.3 Break-Even Analysis 264 Discount Incremental Cash Flows 293 10.2 Some “What-If” Questions 294 Scenario Analysis Identifying Cash Flows 264 Capital Investment 292 Problems and Some Solutions Chapter 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 262 9.2 292 Stage 2: Project Authorizations Using the Modified Internal Rate of Return when there are Multiple IRRs 260 9.1 290 273 309 Minicase 315 An Example: Blooper Industries 274 Cash-Flow Analysis Part Three 274 Risk Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital 316 11.2 319 319 The Historical Record Diversification 330 11.5 Thinking about Risk 334 Message 2: Market Risks Are Macro Risks Using Historical Evidence to Estimate Today’s Cost of Capital 322 Message 3: Risk Can Be Measured 11.3 Measuring Risk 324 A Note on Calculating Variance 333 Message 1: Some Risks Look Big and Dangerous but Really Are Diversifiable 335 319 Variance and Standard Deviation 329 329 Market Risk versus Specific Risk 11.1 Rates of Return: A Review 318 Market Indexes 11.4 Risk and Diversification 324 Questions 327 Measuring the Variation in Stock Returns 327 338 336 336 Contents Use Market Weights, Not Book Weights Chapter 12 Risk, Return, and Capital Budgeting 344 What If There Are Three (or More) Sources of Financing? 378 12.1 Measuring Market Risk 346 Measuring Beta 346 Wrapping Up Geothermal Betas for Dow Chemical and Consolidated Edison 348 Total Risk and Market Risk Portfolio Betas Checking Our Logic 379 379 13.3 Measuring Capital Structure 380 350 13.4 Calculating the Weighted-Average Cost of Capital 382 350 12.2 Risk and Return 352 Why the CAPM Makes Sense The Expected Return on Bonds 354 355 How Well Does the CAPM Work? 356 Using the CAPM to Estimate Expected Returns 359 12.3 Capital Budgeting and Project Risk 359 Company versus Project Risk Determinants of Project Risk 382 The Expected Return on Common Stock 382 The Expected Return on Preferred Stock 383 Adding It All Up 384 Real-Company WACCs 384 13.5 Interpreting the Weighted-Average Cost of Capital 384 359 361 Don’t Add Fudge Factors to Discount Rates 362 When You Can and Can’t Use WACC Some Common Mistakes Questions 363 Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 370 13.1 Geothermal’s Cost of Capital 372 385 What Happens When the Corporate Tax Rate Is Not Zero 387 13.6 Valuing Entire Businesses 387 Calculating the Value of the Concatenator Business 388 13.2 The Weighted-Average Cost of Capital 373 Calculating Company Cost of Capital as a Weighted Average 374 Questions 390 Minicase 394 Financing Chapter 14 Introduction to Corporate Financing 398 Classes of Stock 400 Do Firms Rely Too Heavily on Internal Funds? 403 407 403 Debt Comes in Many Forms 409 Innovation in the Debt Market 414 14.6 Convertible Securities 415 14.3 Common Stock 404 406 407 14.5 Corporate Debt 409 14.2 Are Firms Issuing Too Much Debt? Voting Procedures 14.4 Preferred Stock 407 14.1 Creating Value with Financing Decisions 400 Ownership of the Corporation 384 How Changing Capital Structure Affects Expected Returns 386 Summary 362 Part Four 376 Taxes and the Weighted-Average Cost of Capital 377 Questions 417 Contents Chapter 15 How Corporations Raise Venture Capital and Issue Securities 422 15.3 433 Market Reaction to Stock Issues 15.1 Venture Capital 424 Venture Capital Companies Arranging a Public Issue Part Five Summary 435 427 Other New-Issue Procedures 433 15.4 The Private Placement 434 425 15.2 The Initial Public Offering 426 The Underwriters 431 432 Questions 430 436 Minicase 439 431 Appendix: Hotch Pot’s New-Issue Prospectus 440 Debt and Payout Policy Chapter 16 Debt Policy 444 Chapter 17 Payout Policy 16.1 17.1 How Corporations Pay Out Cash to Shareholders 480 in a Tax-Free Economy MM’s Argument 446 447 Paying Dividends How Borrowing Affects Earnings per Share How Borrowing Affects Risk and Return Debt and the Cost of Equity 448 450 Debt and Taxes at River Cruises 481 17.2 Stock Repurchases 482 Repurchases and Share Valuation How Interest Tax Shields Contribute to the Value of Stockholders’ Equity 456 483 484 17.3 How Do Corporations Decide How Much to Pay Out? 485 Corporate Taxes and the Weighted-Average Cost of Capital 456 The Information Content of Dividends and Repurchases The Implications of Corporate Taxes for Capital Structure 458 486 17.4 The Payout Controversy 487 16.3 Costs of Financial Distress 458 459 Costs of Bankruptcy Vary with Type of Asset Financial Distress without Bankruptcy 461 16.4 Explaining Financing Choices 463 463 488 461 The Assumptions behind Dividend Irrelevance 490 17.5 Why Dividends May Increase Value 491 17.6 Why Dividends May Reduce Value 492 464 465 Taxation of Dividends and Capital Gains under Current Tax Law 493 Summary 494 Questions 468 Questions Minicase 474 Appendix: Bankruptcy Procedures 481 Why Repurchases Are Like Dividends 454 The Two Faces of Financial Slack 480 Limitations on Dividends Stock Dividends and Stock Splits 451 16.2 Capital Structure and Corporate Taxes 454 Bankruptcy Costs 478 494 Minicase 499 475 Contents Part Six Financial Analysis And Planning Chapter 18 Long-Term Financial Planning 502 19.5 543 Evaluating the Plan 18.1 What Is Financial Planning? 504 505 An Improved Model 545 Secured Loans 18.2 Financial Planning Models 506 Percentage of Sales Models 545 Bank Loans Components of a Financial Planning Model 544 19.6 Financial Planning Focuses on the Big Picture 504 Why Build Financial Plans? 543 547 Commercial Paper 506 548 507 508 Questions 18.3 Planners Beware 512 550 Minicase 556 512 The Assumption in Percentage of Sales Models The Role of Financial Planning Models 513 514 18.4 External Financing and Growth 515 Chapter 20 Working Capital Management Summary 519 Terms of Sale Questions 520 Credit Agreements 560 Credit Analysis Minicase 525 Collection Policy 562 562 The Credit Decision 565 569 Chapter 19 Short-Term Financial Planning 526 20.2 Inventory Management 571 19.1 20.3 Cash Management 573 Check Handling and Float 574 and Short-Term Financing 528 Other Payment Systems 19.2 Working Capital 531 Electronic Funds Transfer The Components of Working Capital 531 Working Capital and the Cash Conversion Cycle 536 19.3 Tracing Changes in Cash and Working Capital 537 558 20.1 Accounts Receivable and Credit Policy 560 533 575 576 International Cash Management 578 20.4 Investing Idle Cash: The Money Market 578 Yields on Money Market Investments The International Money Market 580 580 19.4 Cash Budgeting 539 Forecast Sources of Cash Forecast Uses of Cash 539 541 Questions 582 Minicase 588 The Cash Balance 541 Part Seven Special Topics Chapter 21 Mergers, Acquisitions, and Corporate Control 590 Economies of Vertical Integration 21.1 Sensible Motives for Mergers 592 Mergers as a Use for Surplus Funds Economies of Scale 594 594 Combining Complementary Resources 595 595 595 Contents The Cost of Capital for Foreign Investment 636 21.2 Dubious Reasons for Mergers 596 Diversification 596 The Bootstrap Game Avoiding Fudge Factors 596 21.3 The Mechanics of a Merger 598 Questions The Form of Acquisition 598 Mergers, Antitrust Law, and Popular Opposition Mergers Financed by Cash 598 Chapter 23 Options 644 599 Mergers Financed by Stock 638 Minicase 642 21.4 Evaluating Mergers 599 A Warning 636 601 23.1 Calls and Puts 602 646 Selling Calls and Puts Another Warning 602 647 649 21.5 The Market for Corporate Control 602 21.6 Financial Alchemy with Options 603 Some More Option Magic 21.7 Method 2: Takeovers 604 21.8 Method 3: Leveraged Buyouts 607 Barbarians at the Gate? 650 650 23.2 What Determines Option Values? 652 608 Upper and Lower Limits on Option Values 21.9 Method 4: Divestitures, The Determinants of Option Value 610 Option-Valuation Models 21.10 The Benefits and Costs of Mergers 610 23.3 655 657 Options on Real Assets Questions 613 652 652 657 Options on Financial Assets 659 Minicase 616 Chapter 22 International Financial Management 22.1 Foreign Exchange Markets 620 Spot Exchange Rates 620 Forward Exchange Rates 624 Real and Nominal Exchange Rates the Expected Spot Rate Chapter 24 Risk Management 670 The Evidence on Risk Management 22.2 Some Basic Relationships 623 Inflation and Interest Rates 618 662 24.1 Why Hedge? 672 622 Exchange Rates and Inflation Questions 24.2 Reducing Risk with Options 674 626 24.3 Futures Contracts 676 626 629 Interest Rates and Exchange Rates 673 The Mechanics of Futures Trading 677 Commodity and Financial Futures 679 Contracts 680 630 24.5 Swaps 681 22.3 Hedging Exchange Rate Risk 631 Transaction Risk 631 24.6 Innovation in the Derivatives Market 683 Economic Risk 24.7 Is “Derivative” a Four-Letter Word? 684 632 22.4 International Capital Budgeting 633 Net Present Values for Foreign Investments Political Risk 635 633 Questions 686 Contents Part Eight Conclusion Chapter 25 What We Do and Do Not Know about Finance 690 25.1 What We Do Know: The Six Most Important Ideas in Finance 692 Net Present Value (Chapter 5) Efficient Capital Markets (Chapter 7) 692 692 MM’s Irrelevance Propositions (Chapters 16 and 17) 693 693 Agency Theory 696 How Can We Explain Capital Structure? 694 Why Are Financial Systems Prone to Crisis? 25.3 A Final Word 699 Questions 699 Appendix A A-1 Appendix B B Risk and Return—Have We Missed Something? 695 697 What Is the Value of Liquidity? 698 25.2 What We Do Not Know: Nine Unsolved Problems in Finance 694 What Determines Project Risk and Present Value? 694 697 How Can We Resolve the Payout Controversy? How Can We Explain Merger Waves? 692 Risk and Return (Chapters 11 and 12) Are There Important Exceptions to the 696 Credits C-1 Global Index IND Index IND-5 698 697 CHAPTER 1 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 6 7 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T O N E Introduction To grow from small beginnings to a major corporation, FedEx needed to make good investment and financing decisions. T 4 Part One Introduction 1.1 Investment and Financing Decisions as still a sophomore at Y guing that deliv systems were not keeping up with increasing needs for speed and dependability.1 After lea deliv ef founded Federal Express. Like man w the need for an integrated air and ground ge number of points more very system. In 1971, at the age of 27, Smith w million dollars, but this was far from enough. The young compan Dassault Falcon jets, build a central-hub facility, and hire and train pilots, deliv , and of f. company’s shak wn money. In y went liv out of its Memphis hub. By then, the compan vely v ed by a uy the company. (Today ver ex In Nov ved some financial stability when it raised $24.5 million from venture capitalists, investment f vide wnership share. Eventually, venture capitalists inv go deregulation allowed private firms to compete with the Postal very. Federal Express responded by expanding its operations. It acquired seven Boeing 727s, each with about seven times the capacity of the Falcon jets. To pay for these new inv selling shares of stock to the general public in an The new wners of the compan y purchased. From this point on, success followed success, and the company invested heavily to e fedex.com Web site for online package tracking. It opened several new hubs across the United States as well as in Canada, France, the Philippines, and China. In 2007 FedEx (as the company was no orld’s lar planes. FedEx also inv o’s for $2.4 billion in 2004. By 2010, FedEx had about 270,000 employees, annual reveet value of $28 billion. Its name had become a verb—to “FedEx a package” was to ship it ov Even in retrospect, FedEx’s success was hardly a sure thing. Fred Smith’s idea was inspired, but its implementation was complex and dif e good investment decisions. In the beginning, these decisions were constrained by lack of funds. For example, used Falcon jets were the only option, given the young company’s ies. As the company grew, its investment decisions became more complex. Which type of planes should it buy? When should it expand coverage to Europe and Asia? How many operations hubs should it build? 1 Legend has it that Smith received a grade of C on this paper. In fact, he doesn’t remember the grade. Chapter 1 5 Goals and Governance of the Corporation eep up with the increasing package volume and geographic coverage? Which companies should it acquire as it expanded its range of services? e For e w should it raise the money it needed for investment? In the be f w, its range of choices expanded. Ev w questions. Ho w big a w man sell? As the company grew wing money vestors. At each point, it needed ver potential y. The . competitors, b y’ ould hav , but, lik e good inv Let’s widen our discussion. Table 1.1 gives an example of a recent investment and v our are 2 Santander’s VMH’s in P s in Tokyo. We have chosen v TABLE 1.1 Examples of recent investment and financing decisions by major public corporations 2 LVMH (Moët Hennessy Louis V w “Moët Hennessy Louis Vuitton.” ut “LVMH” really is short for 6 Part One Introduction you are likely to be f You have probably traveled on a Boeing jet, shopped at W ven a Ford, for example. T w. W sensible— at least there is nothing ob why The Investment (Capital Budgeting) Decision capital budgeting or capital expenditure (CAPEX) decision Decision to invest in tangible or intangible assets. Investment decisions, such as those shown in Table 1.1, are often called capital budgeting or capital expenditure (CAPEX) decisions. Some of the investments in the table, such as W s new stores or Union P s new locomotives, involve tangible assets—assets that you can touch and kick. Others involve intangible assets, such as research and development (R&D), advertising, and the design of computer software. For e acturers invest billions every year on R&D for ne VMH is estimated to spend Most of the investments in Table 1.1 have long-term consequences. For example, Boeing’ ver 30 years or more. Other investments may pay off in only a few months. For example, with the approach of the Christmas holidays, W stores. ver the following months, the company recovers its investment in these inv The world of b v v y can k v dev v Airbus, has inv w v v v smaller v . v e v wn in Table 1.1. Not all capital investments succeed. orldwide, soaked up $5 billion in inv break even but attracted only a small fraction of that target number. Iridium defaulted y in 1999. for just $25 million. Although the investment in Iridium w ve been rational given what was kno as made. It may have been a good decision thw The Iridium system may have been launched too soon and too ambitiously. (The system surviv y and is .3) avor if vestment analysis and apply them intelligently. We will cover these tools in detail later in this book. The Financing Decision financing decision The form and amount of financing of a firm’s investments. s second main responsibility is to raise the mone requires for its investments and operations. This is the decision. When a y needs to raise money, it can invite investors to put up cash in exchange for a vestors’ cash plus a fixed rate 3 v vestors who took ov yw satellite system. Chapter 1 Goals and Governance of the Corporation vestors, who contribute lenders, that is, debt investors, real assets Assets used to produce goods and services. financial assets Financial claims to the income generated by the firm’s real assets. 7 vestors receive shares of stock and become shareThe inv . In the second case, the investors are The choice between debt capital structure decision. Here “capital” refers Af ” v When s prodvestment in real assets by issuing vests, it acquires real ucts and services. to investors. s real assets and on the income that those assets will produce. cial asset also. It giv s operations can’ y and stake a claim on its real assets. Shares of stock and v securities. The f to borrow. It can issue debt to inv w for 1 year or 20 years. If it borro e the right to pay off the debt all. It can borrow in P ving and promising to repay euros, or it can borrow dollars in New York. (As Table 1.1 shows, LVMH chose to borrow Swiss francs, but it could hav wed euros or dollars instead.) Self-Test 1.1 volved in many other day-to-day acti w up in Table 1.1. For e y to another. Manuf decide how much to invest in inventories of ra Self-Test 1.2 8 Part One Introduction 1.2 What Is a Corporation? corporation A business organized as a separat owned by stockholders. limited liability The owners of a corporation are not personally liable for its obligations. ▲ EXAMPLE 1.1 We hav ” But before going too f ast, we need to offer some basic definitions. A is a distinct, permanent legal entity. Suppose you decide to create a 4 You would work with a la articles of incorporation, ne which set out the purpose of the business and how it is to be financed, managed, and gov ws of the state in which the business is incorporated. For man For example, it can enter into contracts, borrow or lend money, and sue or be sued. It pays its own taxes (but it cannot vote!). so shareholders or stockholders.5 The do not directly o usiness’s real assets (factories, oil wells, stores, etc.). Instead they have indirect o A corporation is legally distinct from the shareholders. Therefore, the shareholders have limited liability and cannot be held personally responsible for the corporation’s debts. When the U.S. financial corporation Lehman Brothers failed in 2008, no one demanded that its stockholders put up more money to cover Lehman’s massive debts. Shareholders can lose their entire investment in a corporation, but no more. Business Organization Suppose you buy a building and open a restaurant. You have invested in the building itself, kitchen equipment, dining-room furnishings, plus various other assets. If you do not incorporate, you own these assets personally, as the sole proprietor of the business. If you have borrowed money from a bank to start the business, then you are personally responsible for this debt. If the business loses money and cannot pay the bank, then the bank can demand that you raise cash by selling other assets—your car or house, for example—in order to repay the loan. But if you incorporate the restaurant business, and then the corporation borrows from the bank, your other assets are shielded from the restaurant’s debts. Of course, incorporation also means that the bank will be more cautious in lending, because the bank will have no recourse to your other assets.6 Notice that if you incorporate your business, you exchange direct ownership of its real assets (the building, kitchen equipment, etc.) for indirect ownership via financial assets (the shares of the new corporation). vately owned by a small group of investors, perhaps the company’s managers and a few backers. In this y is closely held. Eventually, ets such as the New Y wn as public companies. vate hands, and many public companies 4 US ” “Incorporated,” or “Inc.,” as in oup, Inc. v Anonyme”). AG” (“ 5 . 6 t have to ask if your b Chapter 1 9 Goals and Governance of the Corporation may be controlled by just a handful of investors. The latter cate atch Group. v together own the business. An individual may have 100 shares, receive 100 votes, and be entitled to a tiny fraction of the f s income and v sion fund or insurance company may own millions of shares, receive millions of votes, and have a correspondingly large stak s performance. Public shareholders cannot possibly manage or control the corporation directly. y elect a board of directors, monitor their performance. This separation of ownership and control giv tions permanence. Ev ves. Today’ w investors without disrupting the operations of the b ve forever, and in practice they may survive many human lifetimes. One of the oldest corporations is the Hudson’ y, which was formed in 1670 to profit from the fur trade The company still operates as one of Canada’s leading retail chains. wnership and control can also have a downside, for it can open the door for managers and directors to act in their own interests rather than in We return to this problem later in the chapter. and money urdensome for small businesses. s legal machinery. gal entity, it is tax ed again when they receive divi- dends from the compan by b ed just once as personal income.7 Other Forms of Business Organization Corporations do not hav usinesses such as those listed in Table 1.1. You can organize a local plumbing contractor or barber shop as a ger businesses or businesses that aspire to grow. Small “mom-and-pop” businesses are usually organized as sole proprietorships. What about businesses that grow too large for sole ut don’t want to reorganize as corporations? For example, suppose you wish to pool money and e usiness associates. You partnership w deciface unlimited liability. If the b responsible for all the business’s debts. P ve a tax advantage. P pay income taxes. Some b the limited liability adv classif limited partnership, partners are usiness and have unlimy they inv Many states allow 7 giv ve to ships (LLPs) or, equivalently, limited ve limited To av 10 Part One Introduction liability. Another variation on the theme is the professional corporation (PC), which is commonly used by doctors, lawyers, and accountants. In this case, the business has limited liability, but the professionals can still be sued personally, for e malpractice. Most large investment banks such as Morgan Stanle v gre y reor tions. ganization does not work well when ownership is 1.3 Who Is the Financial Manager? chief financial officer (CFO) Sets overall financial strategy. treasurer Responsible for financing, cash management, and relationships with banks and other financial institutions. controller Responsible for budgeting, accounting, and taxes. ving? That simple question can be answered in several ways. W have a chief (CFO), who oversees the w f. As you can see from Figure 1.1, the CFO is deeply involv y and finanxecutiv other top management. inancial v tion and e vestors and the media. Belo treasurer and a controller. s cash, raises ne inv s securities. airs. Thus the treasurer’ whereas the controller ensures that the mone s capital, iciently. Self-Test 1.3 In lar ganizing and supervising the capital budgeting process. However, major capital investment projects are so v eting that managers from these other areas are inevitably drawn into planning and analyzing the projects. involved in capital budgeting too. For this reason we will use the term FIGURE 1.1 Financial managers in large corporations. Chapter 1 Goals and Governance of the Corporation 11 FIGURE 1.2 Flow of cash between investors and the firm’s operations. Key: (1) Cash raised by selling financial assets to investors; (2) cash invested in the firm’s operations; (3) cash generated by the firm’s operations; (4a) cash reinvested; (4b) cash returned to investors. manager to refer to anyone responsible for an inv vely for all the managers drawn into such decisions. Because of the importance of many financial issues, ultimate decisions often rest by la or example, only the board has the legal po dele vestment outlays, but the authority to approv ge inv ver delegated. Now let’s go beyond job titles. What is the essential role of the financial manager? Figure 1.2 gives one answer. The figure traces how mone ws from investors to the corporation and back again to investors. raised from inv The cash could come from banks or from securities sold to inv ets. The cash is then used to pay for the real assets (investment projects) needed for the corporation’s b w 2). Later, as the b w 3). That cash is either reinvested (arrow 4a) or returned to the investors who furnished the mone w 4b ws 4a and 4b is constrained by the promises made when cash w w 1. For example, if the firm borrows money from a bank at arrow 1, it must repay this money plus w 4b. You can see examples of arrows 4a and 4b in Table 1.1. velopment by reinv w 4a). W decided w 4b). It could have chosen instead to pay the money out as additional cash dividends. Notice ho vestors. volv e good investment decisions. On the other hand, he or she deals with financial institutions and other inv ets such as the New York Stock Exchange. W markets in the next chapter. 1.4 Goals of the Corporation Shareholders Want Managers to Maximize Market Value F sity. For example, W ver 300,000 shareholders. There is no way that these vely involved in management; it would be lik New York City by town meetings. Authority has to be delegated. Ho fectively delegate decision making when they all have difDelegation can work only if the shareholders have a common goal. Fortunately there 12 Part One Introduction inancial objectiv the current market value of shareholders’ inv es sense when the shareholders have access to Access giv xibility to manage their own savings and consumption plans, lea cial managers with only one task, to increase market value. For e tion’s roster of shareholders will usually include both risk-av investors. Y xpect the risk-averse to say alue, but don’t touch too many high-risk projects.” Instead, they say, “Risky projects are okay, provided that e too risky for my taste, I’ll adjust my inv e it safer.” For examv such as U.S. gov f y investments increase market v f than they would be if y inv wn. ▲ EXAMPLE 1.2 Value Maximization Fast-Track Wireless shares trade for $20. It has just announced a “bet the company” investment in a high-risk, but potentially revolutionary, WhyFi technology. Investors note the risk of failure but are even more impressed with the technology’s upside. They conclude that the possibility of very high future profits justifies a higher share price. The price goes up to $23. Caspar Milquetoast, eholder, notes the downside risks and decides that it’s time for a change. He sells out to more risk-tolerant investors. But he sells at $23 per share, not $20. Thus he captures the value added by the WhyFi project without having to bear the project’s risks. Those risks are transferred to other investors, who are more risk-tolerant or more optimistic. In a well-functioning stock market, there is always a pool of investors ready to bear downside risks if the upside pot iciently attractive. We know that the upside potential w icient in this case, because Fast-Track st acted investors willing to pay $23 per share. ws, as the following self-test illustrates. Self-Test 1.4 Sometimes you hear managers speak as if the corporation has other goals. For example, they may say that their job is to “maximize profits.” That sounds reasonable. After all, don’t shareholders want their company to be profitable? But taken literally, prof ve. Here are two reasons: current profits by cutting back on outlays for maintenance or staf ut that will not add value unless the outlays were wasteful in the first place. Shareholders will not welcome higher short-term prof Chapter 1 Goals and Governance of the Corporation 2. A compan and inv 13 s dividend vestment. In a free economy a f ve if it pursues goals that reduce the firm’s value. Suppose, for e et share. It aggressively reduces prices to capture new customers, even when this leads to continuing losses. What w As losses mount, it will find it w money, and it may not even have sufficient profits to repay existing debts. Sooner or later, however, outside investors would see an opportunity for easy money. They could b e sv They w ference between the price paid for the f alue it would have under new management. Managers who pursue goals that destroy value often land in early retirement. The natural financial objective of the corporation is to maximize market value. The Investment Trade-Off Okay, let’ e the objectiv et value, or at least adding market value. But why do some inv et value, while others reduce it? The answer is given by Figure 1.3, which sets out the fundamental trade-off for corporate investment decisions. posed inv on hand to finance the project. ahead. If he or she decides not to inv holders, say as an extra dividend. (The investment and di ws in Figure 1.3 ws 2 and 4b in Figure 1.2.) s ownThe v v inv vesting ould v vestment project. If the investve on their o holders would v Figure 1.3 could apply to Union P s decisions to invest in new locomotives. Suppose Union Pacific has cash set aside to buy 20 new locomotives. It could go ahead with the purchase, or it could choose to cancel the investment project and instead pay invest for themselves. Suppose that Union P FIGURE 1.3 The firm can either keep and reinvest cash or return it to investors. (Arrows represent possible cash flows or transfers.) If cash is reinvested, the oppor expected rate of return that shareholders could have obtained by investing in financial assets. s new-locomotiv y as the vestment in the stock market offers a 10% expected rate 14 Opportunity cost of capital Minimum acceptable rate of return on capital investment. Part One Introduction of return. If the new locomotives offer a superior rate of return, say 20%, then Union P ould be happy to let the company keep the cash and invest it in the new locomotives. If the new locomotives offer only a 5% return, then the stockinancial manager should turn the project down. s proposed investments of et (or in other f kets), its shareholders will applaud the investments and the market v will increase. But if the compan et value f y can invest on their own. In our e s new locomotives is 10%. hurdle rate or opportunity cost of capital. It is called an because it depends on the alternative investment opportunities available to inv markets. Whenev vests cash in a new project, its shareholders lose the opportunity to invest the cash on their own. Corporations increase value by accepting all inv Notice that the opportunity cost of capital depends on the risk of the proposed investment project. verse. It’ because shareholders hav y invest on their own. The safest investments, such as U.S. government debt, offer lo Investments with higher e et, for e ver painful losses. (The U.S. stock market fell 38% in 2008, for example.) Other investments are riskier still. For example, high-tech growth stocks ven more v market overall. ets to measure the opportunity cost of capital for the f s investment projects. The e the opportunity cost of capital for safe investments by looking up current interest rates on safe debt securities. F y investments, the opportunity cost of capital has to be estimated. W task in Chapter 11. Self-Test 1.5 The Ethics of Maximizing Value Shareholders want managers to maximize the market value of their shares. But perhaps this begs the question. Is it desirable for managers to act in the selfish interests of their shareholders? Does a focus on enriching the shareholders mean that managers must act as greedy mercenaries riding roughshod over the weak and helpless? Most of this book is dev alue. None of these policies requires gallops over the weak and helpless. In most instances, there is alue) and doing good. The first step Chapter 1 15 Goals and Governance of the Corporation in doing well is doing good by your customers. Here is how Adam Smith put the case in 1776: It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, b wn interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.8 ied customers and loyal emplo orkforce will probably end up with declinalue by b Of course, ethical issues do arise in business as in other walks of life. When the ws and regulations seek to prev laws can help only so much. In business, as in other day-to-day affairs, there are also unwritten rules of behavior. These work because ev ws that such rules are in the general interest. But the w that their air and keeping one’s word are simply good business practices. re e, and each side knows that the other will not renege later if things turn sour. uy a well-known brand in a et, you can be f of the quality of what you are buying. Therefore, honest financial f uild long-term relationships with their customers and to establish a name for fair dealing grity who’s been swimming naked.”9 The tide went out in 2008 and a number of frauds were exposed. One notorious example w f.10 Individuals and institutions invested around $20 billion with Madoff and were told that their investments had grown to $65 billion. That ictitious. (It’s not clear what Madoff did with all this money, but much of it was apparently paid out to early investors in the scheme to create an impression of superior investment performance.) With hindsight, the investors should not have trusted Madof money to him. Madoff’s Ponzi scheme was (we hope) a once-in-a-lifetime event. (Ponzi schemes pop up frequently, but none has approached the scope and duration of Madoff’s.) It was astonishingly unethical, ille xample, at the volving the investment bank Goldman Sachs. Some ers believed that Goldman’ orst on Wall Street. Others see them as simply an e v uyers and sellers. 8 Adam Smith, 1937; first published 1776), p. 14. 9 10 investors unbeliev W e and Causes of the Wealth of Nations (New York: Random House, way vestment company in 1920 that promised vestors in Ne v vided by later investors to pay generous dividends to the original investors, thus promoting W prison sentence. FINANCE IN PRACTICE Goldman Sachs Causes a Rumpus It is not alw w what is ethical behavior y gray or e sive government? Should it emplo veral simple situations that call for an ethically based decision, along with surve Compare your decisions with those of the general public. Self-Test 1.6 Do Managers Really Maximize Value? Owner-managers hav usiness. They work for themselves, reaping the rewards of good work and suf ties of bad work. Their personal well-being is tied to the v In most lar wners, and so managers may be tempted to act in ways that are not in the best interests of shareholders. For example, the verindulge in expense-account dinners. 16 FINANCE IN PRACTICE Things Are Not Always Fair in Love or Economics They might shy away from attractive b in empire-b y are w The yees. Such problems can agents of the owners, may agency agency problems Managers are agents for stockholders, but the managers may act in their own interests rather than maximizing value. have their o . problems. These agency problems can sometimes lead to outrageous behavior. For example, when Dennis Kozlowski, the CEO of Tyco, thre his wife, he charged half of the cost to the company. Conrad Black, the boss of y jet for a trip with his wife to Bora Bora. These of course were e xamples. The agency problems encountered in the normal course of business are less blatant. But agenc ver managers think just a little less hard about spending money that is not their own. y’s net revenue as a pie that is divided among a number of claimants. These include the management and the workforce as well as the lenders and y to establish and maintain the business. The gov- stakeholder Anyone with a financial interest in the firm. stakeholders but their interests may not coincide. All the stakeholders are bound together in a complex web of contracts and underor e contract stating the rate of interest and repayment dates, perhaps placing restrictions on di v rked 17 18 Part One Introduction out personnel policies that establish emplo can’t de ver every possible future ev or e for a fat salary the xpected to w s money on unw xpect managers always to act on behalf of the shareholders? The shareholders can’t spend their lives watching y funds on the latest executive jet. A closer look reveals sev and managers are w w Legal and Regulatory Requirements have a legal duty to act responsibly and in the interests of investors. For example, the for public companies in order to ensure consistency and transparency. ve often been portrayed as passive w Board of Directors pendence. In response to Enron, W y Act, known widely as SOX. SO no w meet in sessions without the CEO present. In addivities, SO s accounting procedures and results. Blockholders ve thousands of individual shareholders, they often also have blockholders, that is, individual investors that hold individuals and families—for example descendants of a founder—other corporations, institutional investors, pension funds, or foundations. When a 5% blockholder calls the CFO, the CFO answers.11 ve become more activ vernance. More chief executives have been forced out in recent years, among them the ucks, AIG, Fannie Mae, and Freddie Mac. Boards outside the United States, which traditionally have been more management-friendly, have also includes the heads of Royal Bank of Scotland, Peugeot Citroen, Lenovo, Swiss Re, and Versace. y of specialists. vestors to buy, hold, Specialist Monitoring or sell the company’ e The vie ving their loans. ve schemes that prout little or nothing if they do not. For example, usiness softw ved total y fraction ($250,000) of that . The lion’ Compensation Plans amount w 11 Ellison’ v v v v wner. For e e in the company y pretty much as he w xtreme ants to. Chapter 1 19 Goals and Governance of the Corporation Those options will be w be highly v alls from its 2010 level but will ver, as founder of Oracle, Ellison holds Ellison would have worked with a different compensation package. But one thing is clear: He has a et value. W holder wealth. But some schemes are not well designed, and in these cases poorly v ge windfall gains. For e Nardelli’s roughly 6-year tenure as CEO of Home Depot, the stock price fell by more val, Lowe’s, more than doubled. as ved a f well compensation package of about . Takeovers The further a company’ pany to b W en over by alls, the easier it is for another comThe old management team is then lik eovers in Chapter 21. v xt election. shareholders will attempt to convince the other shareholders to vote for their slate of candidates to the board. If they succeed, a ne or e felt that the directors of Yahoo! were not acting in shareholders’ interest when they rejected a bid from Microsoft. He therefore invested $67 million in Y muscled himself and two lik Y e the “Wall Street Walk” by selling out and moving on to other investments. The Wall Street Walk can send a po Shareholder Pressure v ment’s reputation and compensation. A lar from stock options, which pay off if the stock price rises but are w f We do not want to leav volved to reconcile personal and corporate interests—to keep everyone w increase the value of the whole pie, not merely the size of each person’s slice. Agency problems are mitigated in practice in several ways: legal and regulatory standards; compensation plans that tie the fortunes of the managers to the fortunes of the firm; monitoring by lenders, stock market analysts, and investors, and ultimately the threat that poor orming managers will be fired. Self-Test 1.7 Corporate Governance Financial mark irms that can inv ves from inv only if investors are protected. This creates the need for a system of corporate 20 One Introduction governance so that mone w to the right firms at the right times. Gov includes well-designed incentives for managers, standards for accounting and disclosure to investors, requirements for boards of directors, and legal sanctions for fraud or self-dealing by management. gov en down. fectively and ethically to deliver v vernance is w . Think, for e viewed at the ved and gre outside investors. That financing was forthcoming because inv pany to invest wisely. In other words, they had f governance, and the shareholder value. orldwide tour of corporate gov be aw v ws, re . The dif y, for example, banks often o agement or strategy of poorly performing companies. (Banks in the United States are prohibited from lar tions.) Large German f ve tw (Aufsichtsrat) and the management board (Vorstand). Half of the supervisory board’s members are elected by emplo ve two boards, one including employee representatives. 1.5 Careers in Finance Well over 1 million people work in the f and many others w We can’t tell you what , but we can give you some idea of the v xperience of a small sample of recent graduates.12 We e ace tw inv Therefore, as a ne cial analyst, you may help to analyze a major new investment project. Or you may y to pay for it, perhaps by ne inancial analysts w term finance, managing collection and investment of the company’ volved in or e s plant and equipment, or they may assist with the purchase and sale of options, futures, and other exotic tools for managing risk. Instead of w The largest employers are banks. Banks collect deposits and usinesses come to deposit cash or to seek a loan. You could also work in the head of to a large corporation. y things in addition to lending money y probably provide a greater v or example, if you work in the ge bank, you may help companies to transfer huge sums of money electronically as wages, tax 12 ut based on the actual e v FINANCE IN PRACTICE Working in Finance Susan Webb, Research Analyst, Mutual Fund Group Albert Rodriguez, European Markets Group, Major New York Bank Richard Gradley, Project Finance, Large Energy Company Sherry Solera, Branch Manager, Regional Bank also buy and sell foreign e of those computer screens in a foreign exchange trading room. Another glamorous vatives group, which helps companies to manage their risk by b This is where the mathematicians and the computer b ve. Investment banks, such as Goldman Sachs or Mor y, help companies sell their securities to investors. They also have lar assist f gers and acquisitions. When f e over y is at stak ve fast. Thus, w v also pay v The insurance industry is another large employer involv s liv , but businesses are also major customers. So, if you work for an insurance company or a large insurance broker Life insurance companies are major lenders to corporations and to investors in commercial real estate. (Life insurance companies deploy the insurance premiums received from policyholders into medium- or long-term loans; banks specialize in shorter-term financing.) So you could end up negotiating a $50 million loan for construction of a new shopping center or investigating the creditworthiness of a family-owned manufacturing company that has applied for a loan to expand production. 21 22 Part One Introduction Then there is the business of “managing money,” that is, deciding which companies’ shares to invest in or how to balance investment in shares with safer securities, such as the bonds (debt securities) issued by the U.S. Treasury. T y from individuals and inv orks with the investment manager to decide which should be bought and sold. Man vestor e ork as a financial analyst in the inv y vest bank that manages money for retirement funds, univ vestment management companies and private individuals to invest in securities. They emplo e the trades. They also employ f decide which to buy or sell. Inv w York, as y of the lar vestment management companies tend to be more scattered. For example, some of the largest insurance y inv ve large businesses outside the United States. Finance is a global business. So you may spend some time w v Tokyo, Hong Kong, or Singapore. w graduates are in the region of $45,000, rather more in a major New York investment bank and somewhat less in a small re Table 1.2 gives you an ard to when you become a senior f . If you would lik logging on to www.careers-in-finance.com. inance, financial planning, insurance, investment banking, money management, and real estate. F vailWe have listed several other useful job Web sites on our book Web site at www.mhhe.com/bmm7e. TABLE 1.2 Representative compensation for jobs in finance Source: Careers-in-Business, LLC.; .careers-in-finance.com, .salary.com. Chapter 1 Goals and Governance of the Corporation 23 1.6 Topics Covered in This Book This book covers investment decisions, then financing decisions, and then a variety of planning issues that require an understanding of both investment and financing. But first there are three further introductory chapters that should be helpful to readers making a first acquaintance with financial management. Chapter 2 is an overview of financial markets and institutions. Chapter 3 reviews the basic concepts of accounting, and Chapter 4 demonstrates the techniques of financial statement analysis. In P ferent aspects of the investment decision. the problem of how to v alue. Nine chapters dev orth y cost may seem excessive, but that problem is not so simple in practice. W w long-liv y assets are valued, and that requireets. For example: • Ho • measured? • • • ets? w can these risks be v v vestors in common stocks reasonably expect to receive? Intelligent capital b other questions about ho Financing decisions occupy P ets work. The two chapters in P y and explain how and when these vers debt policy and dividend policy. We will also ind themselv xcessiv wing, or both. P v We cov cial planning and the management of w Working capital term assets (such as cash, inv y due from customers), net of banks, or other short-term lenders). P vers three important problems that require decisions about both investment and financing. First we look at mergers and acquisitions. usiness at home are present overseas, b aces the additional compligulations imposed by foreign institutions and gov hedge or lay off risks. P w irst to solve an ably f Snippets of History Now let’ sions are made today ets also have an interesting history. Look at the growth of bacteria anticipated the mathematics of compound interest, and continuWe have keyed each of these episodes to the chapter of the book that discusses its topic. FINANCE IN PRACTICE Finance through the Ages SUMMARY QUESTIONS QUIZ www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 2 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T O N E Introduction The façade of the New York Stock Exchange is imposing. I 32 One Introduction 2.1 The Importance of Financial Markets and Institutions In the previous chapter we e v order to survive and prosper. v decisions. But of course those decisions are not made in a vacuum. They are made in a vironment. That environment has two main segments: financial markets and financial institutions. Lar v y need to grow. When they hav y have to invest the cash, for example, in bank accounts or in securities. Let’s take Apple Computer, Inc., as an example. Table 2.1 presents a timeline for tapped by in 2010. The initial investment in Apple stock was $250,000. Apple was also able to ment. Apple w e discuss accounts payable in Chapter 19.) Then, as Apple grew, it was able to obtain sev Apple shares to private venture capital investors. (We discuss venture capital in Chapter 15.) TABLE 2.1 Examples of financing decisions by Apple Computer Chapter 2 Financial Markets and Institutions 33 1 to public investors. There was also a follo Once Apple was a public company, it could raise financing from many sources, and it was able to pay for acquisitions by issuing more shares. We show a few examples in Table 2.1. uted cash to investors by stock repurchases in the early 1990s. But Apple hit a rough patch in 1996 and 1997, and regular dividends were eliminated. The compan w vate investors in order to cov its recovery plan. Apple was generally profitable, despite the rough years, and it wth by plo had cumulated to $37.2 billion by 2010. wn for its product innovations, including the Macintosh computer, the iPod, and the iPad. act, the story of as vital to Apple’s gro . Would we have iMac computers, iPods, or iPads if Apple had been forced to operate in a country with a primitiv initely not. A modern financial system of y different forms, depending on the company’s age, its growth rate, and the nature of its business. For example, Apple relied on v ets. Still later, as the compan xamples given in Table 2.1. But the table does not begin to cov We will encounter many other channels later in the book, and new channels are opening up re . The v e small loans to b orld. 2.2 The Flow of Savings to Corporations The money that corporations invest in real assets comes ultimately from savings by investors. But there can be many stops on the r een savings and corporate investment. The road can pass through financial markets, financial intermediaries, or both. Let’ e Apple in ws in Figure 2.1 sho w of sa holders in this simple setting. There are two possible paths: w v s operations. Reinv additional savings by existing shareholders. The reinvested cash could have been paid out to those shareholders and spent by them on personal consumption. By not ve reinvested their savings in the corporation. Cash retained and reinvested in the firm’s operations is cash saved and invested on behalf of the firm’s shareholders. e out a bank loan, for example. ve raised money by attracting savings accounts. In this case investors’ sa No Apple Computer in 2010. What’ Apple’ venues in 2010 were $65 billion, wed total assets of $75 billion. The scope of Apple’s activities 1 allowed the emplo for Apple. v viously held by Apple employees. Sale of these shares Apple holdings but did not raise additional FINANCE IN PRACTICE Micro Loans has also expanded: It no orldwide. Because of Apple attracts investors’ savings by a v can do so because it is a lar w of sa 2.2. Notice two key dif Figure 2.1 w sa vestors worldwide. Second, the sa FIGURE 2.1 Flow of savings to investment in a closely held corporation. Investors use savings to buy additional shares. Investors also save when the corporation reinvests on their behalf. FIGURE 2.2 Flow of savings to investment for a large, public corporation. Savings come from investors worldwide. The savings may flow through financial markets or financial intermediaries. The corporation also reinvests on shareholders’ behalf. 34 FINANCE IN PRACTICE It’s Not Your Grandfather’s NYSE or both. Suppose, for example, that Bank of w issue vestor b of es that $60,000, along with money raised by the rest of the issue, and Apple. vestor’s sa Apple. Of course our Italian friend’s $60,000 doesn’ ve at Apple in an envelope marked “From L. DaVinci.” Investments by the purchasers of the Bank of America’s stock issue are pooled, not segregated. Sr. DaVinci would own a share of all of Bank of America’s assets, not just one loan to Apple. Nevertheless, investors’ sa wing through the financial mark Apple’s capital investments. The Stock Market financial market Market where securities are issued and traded. primary market Market for the sale of new securities by corporations. A market is a market where securities are issued and traded. or a corporation, the stock mark et. w xpand dramatically. At some point the f organized exchange such as the New Y or IPO. The buyers of the IPO are helping to finance s inv uyers become part-owners of the ailure. (Most investors in the Internet IPOs of w sorely disappointed, b . If only we had bought Apple shares on their IPO day in 1980 . . tion’s IPO is not its last chance to issue shares. For example, Bank of America went ut it could make a ne w. A ne y and wn as a , primary market. But in addition to helping companies raise new ets also allow inv es. For e Apple stock at the same time that Jones inv Apple. The result is simply a transfer 35 36 secondary market Market in which previously issued securities are traded among investors. Part One Introduction of o fect on the company itself. Such purchases and sales of existing securities are known as ansactions, and they take place in the secondary market. y for v y can sell their stock in the secondary market when they need the cash. Stock mark ets, wn the common equity of the firm. Y ture decision as “the choice between debt and equity financing.” es place on the NYSE and on NASDA , high-tech companies. The busi, however, as the box on page 35 explains. No and needs to be f orld. For e Apple’s stock is traded on the NASDAQ mark y on the Deutsche Börse. China T v y, Toyota, Unilever, and over 400 other overseas firms have listed their shares on the NYSE. W Other Financial Markets fixed-income market Market for debt securities. capital market Market for long-term financing. money market Market for short-term financing (less than 1 year). ets. The Apple bond issue in 1994 was a public issue (see Table 2.1). Table 1.1 in the previous chapter also gives examples, including the debt issues by Honda and LVMH. A fe xchanges, but over the counter, ork of banks and securities dealers. Gov ver the counter. A bond is a more complex security than a share of stock. A share is just a proportional ownership claim on the f . Bonds and other debt securities can v , in the degree of protection or collateral offered by the issuer, and in the lev e vel of interest rates. Many can be “called” (repurchased and retired) by the issuing company before the bonds’ stated maturity date. Some bonds can be converted into other securities, usually the stock of the issuing company. You don’t need to master these distinctions now; just be aware that the debt or market is a complicated and challenging place. A corporation must not only decide between debt and equity finance. It must also consider the design of debt. We return to the trading and pricing of debt securities in Chapter 6. The markets for long-term debt and equity are called capital markets. A firm’s capital inancing. Short-term securities are traded in the money markets. “Short term” means less than 1 year. For example, large, creditworthy commercial paper, debt issues with maturities of at most 270 days. Commercial paper is issued in the money market. Self-Test 2.1 FINANCE IN PRACTICE Prediction Markets www.intrade.com www.biz.uiowa.edu/iem The financial manager re examples, with references to the chapters where the • Foreign-exchange markets (Chapter 22). An trade must be able to transfer mone oreign exchange is traded ov largest international banks. • Commodities markets exchanges, such as the New Y Trade. You can b platinum, and so on. • ets. Here are three ork of the ganized , silver, vativ or e date. The option’ can be traded by a dif vative security called a futures contract. 37 38 Part One Introduction vativ e ets where s exposure to v usiness risks. For y may wish to lock in the future price of natu- w materials. Wherever there is uncertainty, investors may be interested in trading, either to specveral ne ets have been created that allow punters to bet on a single event. ets can reveal people’s predictions about the future. Financial Intermediaries financial intermediary An organization that raises money from investors and provides financing for individuals, corporations, or other organizations. mutual fund An investment company that pools the savings of many investors and invests in a por olio of securities. A pro intermediary is an organization that raises money from investors and ganizations. F the road between savings and real investment. Why is a f ferent from a manuf ays, for example, by taking deposits or selling insurance policies. Second, it invests that money in assets, for example, in stocks, bonds, or loans to businesses or individuals. In contrast, a manufacturing company’s main investments are in plant, equipment, or other real assets. W pension funds. Mutual funds raise money by selling shares to investors. The investors’ money is pooled and inv vestors can buy or sell shares in mutual funds as they please, and initial inv Vans Explorer Fund, for e ket value of $10 billion at the end of 2010. An investor in Explorer can increase her stake in the fund’ uying additional shares, and so gain a higher share of 2 s subsequent di vestment.3 The adv ery wealthy, you cannot b iciently. er investors low-cost diversification and professional management. For most investors, it’s mor icient to buy a mutual fund than to assemble a diversified por olio of stocks and bonds. et,” that is, to generate -than-average returns. Whether they can pick winners consistently is another question, which we will address in Chapter 7. In exchange for their services, the fund’s managers take out a management fee. xpenses of running the fund. For Explorer, fees and expenses . This seems reasonable, but watch out: The typical mutual fund charges more than Explorer does. In some cases fees and e . That’s a big bite out of your investment return. 2 ut inv They pay no tax, providing that all income from di this income. 3 Explorer, like most mutual funds, is an open-end w inv uy back e depend on the fund’s net asset value (NAV) on the day of purchase or redemption. Closed-end funds have a ed number of shares traded on an exchange. If you w vest in a closed-end fund, you must b Chapter 2 39 Financial Markets and Institutions Mutual funds are a stop on the road from sa vestment. Suppose w issue of shares by Bank of Again we sho w of savings to inv ws: hedge fund A private investment pool, open to wealthy or institutional investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds. pension fund Fund set up by an employer to provide for employees’ retirement. There are 7,600 mutual funds in the United States. In fact there are more mutual funds than public companies! The funds pursue a wide variety of investment stratevidend payouts. Some specialize in high-tech growth stocks. Some “balanced” funds offer mixtures of stocks gions. For example, the Fidelity Investments mutual fund group sponsors funds for Canada, Japan, China, Europe, and Latin Like mutual funds, hedge funds also pool the sa vestors and invest on their behalf. But they differ from mutual funds in at least two ways. First, because hedge funds usually follow comple v gies, access is wledgeable investors such as pension funds, endowment funds, and wealthy individuals. Don’ vestment b to attract the most talented managers by compensating them with potentially lucrative, ed percentage performance-related fees.4 In contrast, mutual funds usually char of assets under management. Hedge funds follow many different investment strate e a profit by identifying o alued stocks or mark e will not go into fall.)5 “V hedge funds take bets on f volved in merger negotiations, others look for mispricing of conv e positions in currencies and interest rates. Hedge funds manage less money than mutual funds, but they sometimes take v positions and have a lar et. vesting savings. Consider a pension plan set up by a corporation or other organization on behalf of its employees. There are several types of pension plan. ution plan. In this case, a percentage of the employee’s monthly paycheck is contributed to a pension fund. (The emplo ute 5%, for example.) yees are pooled and invested in securities or mutual funds. (Usually the emplo inv gies.) Each employee’ ws over the years as contributions continue and investment income accumulates. The balance in the plan can be used to finance living expenses after retirement. The amount available for retirement depends on the accumulated contrib on the investments.6 4 ge indeed. For example, The Wall Street Journal estimated that hedge fund manager John P 5 v b wner. bought back at a lo as sold for. 6 In a plan, the emplo v the employer invests in the pension plan. s accumulated investment v cov yer must put in more money giving w ge enough to 40 Part One Introduction vestment. They provide professional v They also hav butions are tax-deductible, and inv wn.7 ed until ehicles for savings. Private pension plans held $5.7 trillion in assets in 2010. Self-Test 2.2 Financial Institutions financial institution A bank, insurance company, or similar financial intermediary. Banks and insurance companies are institutions.8 vest savings. Institutions raise ays, for e cies, and they pro e a mutual fund, they not only invest in securities but also loan money directly to individuals, businesses, or other organizations. Commercial Banks States. They v midgets like the Tightwad Bank with some $20 million. States, they are generally not allowed to make equity inv company negotiates a 9-month bank loan for $2.5 million. w of savings is: y and, at the same time, provides a w it as needed. Investment Banks We hav from depositors and other inv 9 Inv Investment banks 7 emplo employer. 8 We may be dra y e loans to businesses and individuals. y do not xcept that the employer inv v A mutual fund - 9 accept deposits and sa uyers. Inv xcept as bridge loans merchant banks. commercial Savings y out mostly to individuals, for example, as mortgage y to b vidueov v Chapter 2 41 Financial Markets and Institutions usually make loans to companies. Instead, they advise and assist companies in raising financing. For example, investment banks stock offerings by purchasing the ne y at a ne to investors. Thus the issuing compan ed price for the new shares, and the investment bank takes responsibility for distrib vestors. W Investment banks also advise on takeovers, mergers, and acquisitions. The inv v vidual and institutional investors. The xchange, commodities, bonds, options, and derivatives. Inv vest their own mone entures. For e v ays, elecorld. gest inv werhouses. They include Goldman Sachs, Morgan Stanley the major commercial banks, including Bank of ve 10 inv Insurance Companies for the financing of business. The and bonds, and they often mak Suppose a compan issue a bond directly to investors, or it could ne company: ve inv The money to make the loan comes mainly from the sale of insurance policies. Say you b y on your home. You pay cash to the insurance compan y) in exchange. You receive no interest payut if a fire does strike, the company is obliged to cover the damages up to the policy limit. vestment. (Of course, vent that you hope to avoid. But if a fire does occur, you are better off getting a return on your investment in insurance than not having insurance at all.) y will issue not just one policy b verages out,” leaving the company with a predictable obligation to its policyholders as a group. Of course the insurance company must charge enough for its policies to cov ve costs, pay policyholders’ claims, and generate a profit for its stockholders. Self-Test 2.3 10 America o ynch, one of the largest inv vestments. 42 Part One Introduction Total Financing of U.S. Corporations Figure 2.3 shows the investors in bonds and other debt securities. vestors—mutual funds, pension funds, insurvidual inv the debt pie. The other slices represent the rest of the world (investors from outside the United States) and v gories. Figure 2.4 sho e a stronger showing, with 36.5% of the total. Pension funds, insurance companies, and mutual funds add up to 48.5% of the total. Remember other companies. The rest-of-the-world slice is 13.3%. The aggre There is $11.4 Figure 2.3 and $21 trillion of equity behind Figure 2.4 ($21,000,000,000,000).11 Chapter 14 revie FIGURE 2.3 Holdings of corporate and foreign bonds, third quarter 2010. The total amount is $11.4 trillion. Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts, Table L.212 ( .federalreserve.gov). FIGURE 2.4 Holdings of corporate equities, third quarter 2010. The total amount is $21.0 trillion. Source: vernors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts, Table L.213 ( .federalreserve.gov). 11 e et value of shares issued by U.S. Chapter 2 43 Financial Markets and Institutions 2.3 Functions of Financial Markets and Intermediaries Financial markets and intermediaries provide financing for business. They channel savings to real investment. 2.2 of this chapter vious. Transporting Cash across Time Individuals need to transport expenditures in time. If you have money now that you wish to save for a rainy day, you can (for example) put the money in a savings account at a bank and withdraw it with interest later. If you don’t have money today, say to buy , you can borrow money from the bank and pay off the loan later inance pro wers y were forced to spend income as it ves. Of course, indi Firms with good inv wing or selling ne y gov Young people sa years into the future by means of a pension fund. They may ev y. viduals or f e out newspaper adv W v is not just a matter of av . Followup is needed. For example, banks don’t just loan money and walk away. They monitor wer to mak wer’s credit stays solid. Risk Transfer and Diversification Financial markets and intermediaries allow investors and businesses to reduce and reallocate risk. Insurance companies are an obvious example. When you buy homeowner’ ire, theft, or accidents. But your policy is not a v y. It div by issuing thousands of policies, and it expects losses to average out over the policies.12 wners. Investors should diversify too. For example, you can buy shares in a mutual fund that holds hundreds of stocks. In fact, you can buy index funds that invest in all the stocks in the popular market indexes. For example, the V x fund holds et index. (The “S&P 500” tracks the performance of the largest U.S. stocks. It is the index most used by professional investors.) If you b x. These risks are averaged out by diversificavel of the stock market as a whole will fall. In fact, we will see in Chapter 11 that inv with market risk, not the specific risks of indi Index mutual funds are one way to invest in widely div w cost. Another route is provided by e of stocks that can be bought or sold in a single trade. s 12 damage thousands of homes at once. reinsurance t always av uy 44 Part One Introduction Poor’ et indexes. v benchmark S&P 500 index was about $94 billion by early-2011. Y uy DIAMONDS, which track the Dow Jones Industrial Average; QUBES or QQQs, which track the NASDAQ 100 inde Vanguard ETFs that track the V Total Stock Market index, which is a bask United States. You can also buy ETFs that track foreign stock markets, bonds, or commodities. ays more efficient than mutual funds. To b , you simply make a trade, just as if you bought or sold shares of stock.13 To invest in an open-ended mutual fund, you have to send money to the fund in exchange for newly vestment, you have to notify the fund, which redeems your shares and sends you a check or credits your account with the fund. Also, many of the larger ETFs charge lower fees than mutual funds. Vanguard’s T . For a $100,000 investment, the fee is only .0007 3 100,000 5 $70. Financial markets provide other mechanisms for sharing risks. For example, a wheat f y are each e est. The farmer w er about high prices. They can both rest easier if the baker can agree with the f uy wheat in the future at a fix ould be dif er and the f e a deal. Fortunately no dating service is needed: Each can trade in commodity markets, the f er as a buyer. Liquidity liquidity T o sell an asset on short notice at close to the market price. vide liquidity, vestment back into cash when needed. Suppose you deposit $5,000 in a savings bank on w deposits to make a 6-month construction loan to a real estate developer The bank can giv thousands of depositors, and other sources of f , it can make an illiquid loan to the developer financed by liquid deposits made by you and other customers. If you lend out your money for 6 months directly to the real estate developer, you will hav ving it 1 month later.14 y are traded more or less et. vestor who puts $60,000 into Bank of ver that money on short notice. (A $60,000 sell order is a drop in the buck olume of Bank of vest . Of course, liquidity is a matter of degree. Foreign exchange markets for major curxceptionally liquid. Bank of America or Deutsche Bank could buy $200 million w ye, with hardly an exchange rates. U.S. T g- 13 ties. ETF issuers mak 14 the real estate dev ve). But ETFs do not have managers wn to index ed bask x or basket. t repay all depositors simultaneously. To do so, it would hav wers. not liquid. wals, with each depositor ed up by the U.S. Chapter 2 45 Financial Markets and Institutions Liquidity is most important when you’ w y all at once, you will probably wn the price to some extent. If you’re patient and don’ vestors with a large, sudden sell order terms. It’s the same problem you may face in selling real estate. A house or condoyou’re not going to get full value. The Payment Mechanism Think how inconvenient life would be if you had to pay for ev suppliers. Checking accounts, credit cards, and electronic transfers allow indi ve payments quickly and safely ov are the obvious pro ut they are not alone. For example, if you buy shares in a mone et mutual fund, your money is pooled with that of other inv Y on this mutual fund investment, just as if you had a bank deposit. Information Provided by Financial Markets ets, you can see w v xpect ets is often essential to a vings. s job Commodity Prices v The catalysts include platinum, which is traded on the New York Mercantile Exchange. acturer of catalytic conv . How much per ounce should the company budget for purchases of platinum in that month? Easy: The company’ et price of platinum on the New Y v as the closv .) The CFO can lock The details of such a trade are covered in Chapter 24. Interest Rates w financing. She considers an issue of 30-year bonds. What will the interest rate on the bonds be? T xisting bonds traded in f ets. The results are shown in Table 2.2. Notice how the interest rate climbs as credit quality deteriorates: gest, safest companies, which are rated Aaa (“triple-A”), The interest rates for Aa, A, and Baa climb to 5.70%, 5.98%, and 6.32%, respectively garded as investment grade, that is, good quality, but the next step do es the investor into TABLE 2.2 Interest rates on long-term corporate bonds, May 2010. The interest rate is lowest for t issuers. The rate rises as credit quality declines. Source: Barclays corporate bond indexes. 46 Part One junk bond Introduction . The interest rate for Ba debt climbs to 7.34%. Single-B companies vestors demand 8.49%. ho the interest rate on ne as a Baa-rated company to raise ne ed-income markets to forecast or example, if Catalytic Concepts can qualify wn in Table 2.2, it should be able Company Values How much was Alaska Air Group w How about Bob Evans Farms, Callaway Golf, Estée Lauder, or GE? Table 2.3 shows the answers. We simply multiply the number of shares outstanding by the price per share in the stock market. Investors valued Alaska Air Group at $2,155 million, GE at $222 billion. Stock prices and company values summarize investors’ collective assessment of how well a company is doing, both its curr ormance and its future prospects. Thus an increase in stock price sends a positive signal from investors to managers.15 That is why top management’ ed to stock prices. A manager who o y’ et value. This reduces agenc y will be motivated to increase the This is one important advantage of going public. A private company can’t use its but the shares will not be v cost of capital Minimum acceptable rate of return on capital investment. et. Cost of Capital Financial managers look to financial markets to measure, or at least estimate, the cost of capital s investment projects. The cost of capital is the minimal acceptable rate of return on the project. Investment projects of y add value; they make both the f inancially. Projects offering rates of return less than the cost of capital subtract value and should not en.16 Thus the hurdle rate for inv the corporation. The e v ets determines the cost of capital. The opportunity cost of capital is generally not a loan from a bank or insurance company. If the compan TABLE 2.3 Calculating the total market values of Alaska Air Group and other companies in Febr (Shares and market values in millions. Ticker symbols in parentheses.) Yahoo! Finance, finance.yahoo.com 15 W t claim that investors’ assessments of v w b W es by investors, for e the gross ov verage, however cial mark . We’ 16 v or e vest in pollution control equipment for a factory. The equipment may not generate a cash return, but may still be worth investing in to meet le ethical obligations. Chapter 2 47 Financial Markets and Institutions inv xpected rate of return that investors can achiev ets at the same lev The e on risk v wing. We introduced the cost of capital in Chapter 1, b We cover the cost of capital in detail in Chapters 11 and 12. Self-Test 2.4 2.4 The Crisis of 2007–2009 y questions, but it settled one question conclusively: Yes, ets and institutions are important. When markets and institutions ceased to operate properly, the world was pushed into a global recession. e and other central banks follo ubble in 2000. ge balance-of-payments surpluses in v This also helped to push down interest rates and contribute to the lax credit. Banks took advantage of this cheap money to expand the supply of subprime mortgages to lo wers. Man ould-be homeowners with low initial payments, offset by significantly higher payments later.17 (Some home buyers were betting on escalating housing prices so that the ed in.) One lender is even said to have adv dubbed its “NINJA” loan—NINJA standing for “No Income, No Job and No Assets.” Most subprime mortgages were then packaged together into mortgage-backed securities vestors who could ge quantities of the loans on their own books or sold them to other banks. The widespread av At that point prices wners began to def ge inv vestments that were held in tw as on the ver y, and the U.S. Federal Reserv JPMorgan Chase. v e over the giant federal mortgage agencies F had invested sev ed securities. Over the next fe ynch and Lehman Brothers were in danger of failing. On September 14, the gov America to take ov However y protection the next day. Two days later the gov insurance company AIG, which had insured huge v ed 17 With a so-called loan month’ homeowner was burdened by an ever as often not even suf ould need to be paid off. v 48 Part One Introduction securities and other bonds against default. The following day, the T veiled its ould be next to fall made banks reluctant to lend to one another, and the interest rate that they charged for such loans rose to 4.6% above the rate on U.S. T ve T than .5%.) , orst setbacks since the Great Depression. Unemployment rose rapidly, and b Few developed economies escaped the crisis. As well as suf in their o ets, man ge investments in U.S. A roll call of all the banks that had to be bailed out by their governments w veral pages, b w members of that unhappy band: the Ro Allied Austria, and West Lb in Germany. Who was responsible for the f e for its policy of easy money. The U.S. government also must take some of the blame for encouraging banks to expand credit for low-income housing. The rating agencies were at fault for pro ard went into default. Last but not least, the bankers themselves were guilty of promoting As we suggested in the last chapter, managers were probably aw gy of originating massiv was likely to end badly. Perhaps they were trying to squeeze in one more fat bonus before the game ended. gely an agency problem—a failure to incenti y gov mountains of debt. By 2010 investors were becoming increasingly concerned about the position of Greece, where for many years gov well ahead of revenues. Greece’s position was complicated by its membership in the y euro club. wing was in euros, the gov v y and could not simply print more euros to service its debt. Investors began to contemplate the possibility of a Greek gov ment def . As we write Attention vernment put up 34 billion euros to take over the SUMMARY QUESTIONS QUIZ www.mhhe.com/bmm7e www.mhhe.com/bmm7e PRACTICE PROBLEMS WEB EXERCISES finance.yahoo.com www.mhhe.com/bmm7e SOLUTIONS TO SELF-TEST QUESTIONS CHAPTER 3 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T O N E Introduction Accounting and finance are not the same, but accounting basics are necessary to understand finance. I 54 One Introduction 3.1 The Balance Sheet ter. company’ pro balance sheet Financial statement that shows the firm’s assets and liabilities at a particular time. vide the investor with information about the . s balance sheet, the income statement, and a 1 ws. We will revie Firms need to raise cash to pay for the many assets used in their businesses. In the process of raising that cash, they also acquire liabilities to those who provide funding. The balance sheet ticular moment. The assets—representing the uses of the funds raised—are listed on the left-hand side of the balance sheet. The liabilities—representing the sources of that funding—are listed on the right. wn as liquid assets. The accountant puts the most liquid assets at the top of the list and works down to the least liquid. Look, for example, at Table 3.1 ws the consolidated balance sheet for Home Depot (HD), at the end of 2009.2 (“Consolidated” simply means that the balance sheet shows the position of Home Depot and any companies it owns.) Y etable securiut had not yet received payment. These payments are due soon and therefore the balance sheet shows the unpaid bills or accounts receivable (or simply receivables The next asset consists of inv These may be (1) ra suppliers, (2) w aiting to be shipped from the w or Home Depot, inv gely of goods in the w ventories would be more skewed toward ra ork in progress. Of course, there are always some items that don’ , other current assets. Up to this point all the assets in Home Depot’ ely to be used or turned into cash in the near future. They are therefore described as current assets. The ne -lived or and include items such as buildings, equipment, and vehicles. alue of Home Depot’ , plant, and This is what the assets originally cost. But they are ely to be w w. For example, suppose the company bought a deliv 2 years ago; that v alue today of the van, b ould be costly and somewhat subjective. Accountants rely instead on depreciation in the v xceptions the or example, in the case of that delivery van the accounalue. So if ould show that accumulated depreciation is 2 3 $5,000 5 $10,000. Net of depreciation the value is only $5,000. Table 3.1 shows that Home Depot’s total accumulated depreciation on alue in the accounts is only $37,345 2 $11,795 5 $25,550 1 In addition, the company pro , which shows how much of the vidends and how much money has been raised by issuing new shares or spent by repurchasing stock. We will not review in detail the statement of shareholders’ equity. 2 We hav Chapter 3 55 Accounting and Finance TABLE 3.1 Note: Column sums subject to rounding error. Source: Derived from Home Depot annual reports. In addition to its tangible assets, Home Depot also has valuable intangible assets, Accountants are generally reluctant to record these intangible assets in the balance sheet unless they can be readily identified and valued. There is, however xception. businesses in the past, it has paid more for their assets than the value sho accounts. wn in Home Depot’ ” Most No where the money to b y’ ws yo . For e . It also o . y wed ve been delivered b wn as accounts payable (or payables . The current liabilities. Home Depot’ $10,363 million. Therefore the difference between the value of Home Depot’ 2 $10,363 5 $3,537 million. wn as Home Depot’s net current assets or net working capital. It roughly measures the company’s potential reservoir of cash. Belo v s long.Y banks and other investors hav Home Depot’ or example, when Home Depot buys goods from its suppliers, it has a liability to pay for them; ws from the bank, it has a liability to repay the loan. ve f s assets. ver after the liabilities have been paid off belongs to the shareholders. wn as the shareholders’ 56 Part One Introduction . For Home Depot the total value of shareholders’ equity amounts to Table 3.1 shows that Home Depot’ investors. A much lar Depot has retained and reinvested in the business on the shareholders’ behalf.3 Finally, ge negative number, 2 This represents the amount that Home Depot has spent on b The money to repurchase them . Figure 3.1 shows ho . There are tw ixed” assets, which may be either tangible or intangible. There are also tw , and long-term liabilities. The difference between the assets and the liabilities represents the amount of the . W equity is what is left over when the liabilities of the f Shareholders’ equity 5 2 total liabilities (3.1) Self-Test 3.1 common-size balance sheet All items in the balance sheet are expressed as a percentage of total assets. common-size balance sheet, which reexpresses all items as a percentage of total assets. Table 3.2 is Home Depot’s common-size balance sheet. w etable s assets than they did in the previous year. There may be good reasons for this, but the manager might wish to By the way, it is easy to obtain the financial statements of almost any publicly traded f vailable on the Web. You also can ey f Y finance.yahoo.com) or Google Finance (finance.google.com). FIGURE 3.1 3 Y y has b ept in the business may have been used to buy new arehouses, and so on. T Home Depot’ etable securities. Chapter 3 Accounting and Finance 57 TABLE 3.2 Note: Column sums subject to rounding error. Source: Home Depot annual report, 2009. Book Values and Market Values e a distinction between the book values et values. alued according to generally accepted accounting principles, GAAP. These state that assets must be sho historical cost adjusted for depreciation. Book v are therefore “backw The or e Home Depot b et the building would sell for $40 million. alue of the building w et v s asset. Or consider a specialized plant that Intel develops for producing special-purpose The book v w chip makes the existing one obsolete. The market value of Intel’s new plant could fall by 50% or more. In this case market value would be less than book value. The difference between book value and market v for others. It is zero in the case of cash but potentially v ed assets where of the assets sho generally accepted accounting principles (GAAP) Procedures for preparing financial statements. book value Value of assets or liabilities according to the balance sheet. the asset ov verning the depreciation of asset values do not et value. et v ed assets usually is much higher than the book value, but sometimes it is less. the accountant simply records the amount of money that you hav . F et value of that promise. For e w, the accounts show a book liability of $1 million. the v 58 One Introduction repaid for sev The accounts still show a liability of $1 million, but how much your debt is worth depends on what happens to interest rates. If interest rates rise after you have issued the debt, lenders may not be prepared to pay as much as all, they may be prepared to pay more than 4 et value of a long-term liability may be higher or lower than the book value. Market values of assets and liabilities do not generally equal their book values. Book values are based on historical or original values. Market values measure current values of assets and liabilities. The difference between book value and market value is likely to be greatest for shareholders’ equity. The book value of equity measures the cash that shareholders hav uted in the past plus the cash that the compan vested in the business on their behalf. But this often bears little resemblance to the total market value that inv , don’t try telling the shareholders that the book value is satisfactory—they won’t want to hear. Shareholdet value of their shares; market value, not book value, holders happy will focus on market values. W market-value balance sheet. Like a conventional balance sheet, a market-value balance sheet lists the s assets, b et v cal cost less depreciation. Similarly, each liability is sho et value. The difference between the market values of assets and liabilities is the market value of the shareholders’ laim. The stock price is simply the market value of shareholders’ y the number of outstanding shares. ▲ EXAMPLE 3.1 Market- versus Book-Value Balance Sheets Jupiter has developed a revolutionary auto production process that enables it to produce cars 20% mor iciently than any rival. It has invested $10 billion in producing its new plant. To finance the investment, Jupiter borrowed $4 billion and raised the remaining funds by selling new shares of stock in the firm. There are currently 100 million shares of stock outstanding. Investors are very excited about Jupiter’s prospects. They believe that the flow of profits from the new plant justifies a stock price of $75. If these are Jupiter’s only assets, the book-value balance sheet immediat er it has made the investment is as follows: BOOK-VALUE BALANCE SHEET FOR JUPITER MOTORS (Figures in billions of dollars) Liabilities and Shareholders’ Equity Assets Auto Plant $10 Debt Shareholders’ equity $4 6 Investors are placing a market value on Jupiter’ share times 100 million shares). We assume that the debt outstanding is worth $4 billion.5 Therefore, if you owned all Jupiter’s shares and all its debt, the value of your investment would be $7.5 1 $4 5 $11.5 billion. In this case you would own the company lock, stock, and barrel and would be entitled to all its cash flows. 4 5 We will show you how changing interest rates affect the market v v Chapter 3 59 Accounting and Finance Because you can buy the entire company for $11.5 billion, the total value of Jupiter’s assets must also be $11.5 billion. In other words, the market value of the assets must be equal to the market value of the liabilities plus the market value of the shareholders’ . We can now draw up the market-value balance sheet as follows: MARKET-VALUE BALANCE SHEET FOR JUPITER MOTORS (Figures in billions of dollars) Liabilities and Shareholders’ Equity Assets Auto Plant $11.5 Debt Shareholders’ equity $4 7.5 Notice that the market value of Jupiter’s plant is $1.5 billion more than the plant cost to build. T erence is due to the superior profits that investors expect the plant to earn. Thus, in contrast to the balance sheet shown in the company’s books, the market-value balance sheet is f ard-looking. It depends on the profits that investors expect the assets to provide. et value generally exceeds book value? It shouldn’t be. ve to raise money to invest in v y believe the projects will be w Y find that shares of stock sell for more than the value shown in the company’s books. Self-Test 3.2 3.2 The Income Statement income statement Financial statement that shows the revenues, expenses, and net income of a firm over a period of time. If Home Depot’ income statement is like a video. It shows how profitable the f past year. Table 3.3. You can see that during 2009 Home Depot sold goods worth $66,176 million and that the total expenses of acquiring and selling these goods were 43,764 1 $15,907 5 $59,671 million. The largest expense item, amounting to $43,764 million, consisted of the cost of goods sold, which included the acquisition cost of its products, the wages of its employees, and other e Almost all the remaining expenses ve expenses such as head of ution. In addition to these out-of-pocket expenses, Home Depot also made a deduction for the value of the plant and equipment used up in producing the goods. In 2009 this charge for depreciation w Thus Home Depot’s earnings before interwere EBIT 5 total revenues 2 costs 2 depreciation 5 66,176 2 59,671 2 1,806 5 $4,699 million 60 Part One Introduction TABLE 3.3 Source: Derived from Home Depot annual report, 2009. As we saw earlier vestment in plant and equipment by wing. In 2009 it paid $676 million of interest on this borrowing. v es. lion. The $2,661 million that was left over after paying interest and taxes belonged to vidends and reinvested the remaining $1,136 million in the business. Presumably, these reinvested funds made the company more valuable. v w ings in Table 3.1 increased by $1,136 million in 2009, from $12,452 million to $13,588 million. However because Home Depot sold some of its treasury stock during the year. common-size income statement All items on the income statement are expressed as a percentage of revenues. prepare a common-size income . In this case, all items are expressed as a percentage of revenues. The last column of Table 3.3 is Home Depot’ income statement. You can see, for e 66.1% of revenues and that selling, general, and administrative expenses absorb a further 24.0%. Profits versus Cash Flow pan 1. Depreciation. o reasons why prof s accountants prepare the income statement, they ut then divides these payments into two xpenditures (such as wages) and capital expenditures (such as the purchase of ne wever purchased, the accountant makes an annual charge for depreciation. ver its forecast life. not deduct the expenditure on new , even though cash is paid out. However does deduct depreciation on assets previously purchased, ev paid out. For example, suppose a $100,000 investment is depreciated by $10,000 a Chapter 3 61 Accounting and Finance year.6 This depreciation is treated as an annual e went out of the door when the asset w or this reason, the noncash expense. To calculate the cash produced by the business, it is necessary to add back the depreciation charge (which is not a cash payment) and to subtract the expenditure on new capital equipment (which is a cash payment). 2. Cash versus accrual accounting. Consider a manufacturer that spends $60 to ut its customers The following diagram sho s cash ws. In period 1 there is a cash of $60. Then, when customers pay their bills in period 3, there is an of $100. 1$100 (collect payment) 1 2 3 Period 2$60 (buy goods) It w w was negative) or that it was e w was positive). looks at when the sale was made (period 2 in our e the revenues and expenses associated with that sale. For our company the income statement would show: Revenue less Cost of goods sold Profit $100 60 $ 40 This practice of matching revenues and expenses is known as accrual accounting. Of course, the accountant cannot ignore the actual timing of the cash expenexpense but as an investment in inv goods are taken out of inventory and sold, the accountant shows a reduction in inv T ws, we need to subtract the investment in inv wn in the balance sheet: Period: Cost of goods sold (income statement) 1 Investment in inventories (balance sheet) 5 Cash paid out 1 2 0 60 60 60 (60) 0 to collect its bills. receivable in the balance sheet is increased to show that the company’s customers owe an extra $100 in unpaid bills. Later, when the customers pay those bills in vable are reduced by $100. Therefore, to go from the 6 W 62 One Introduction revenues sho investment in receivables: ws, we need to subtract the Period: 2 Sales (income statement) 2 Investment in receivables (balance sheet) 5 Cash received W the key points as follows: Cash 3 100 0 100 (100) 0 1100 ut for no low is equal to the cost of goods sold, which is shown in the income statement, plus the change in inventories. The cash that the company receives is equal to the sales shown in the income statement less the change in uncollected bills. ▲ EXAMPLE 3.2 Profits versus Cash Flows Suppose our manufacturer spends a further $80 to produce goods in period 2. It sells these goods in period 3 for $120, but customers do not pay their bills until period 4. The cash flows from these transactions are now as follows: $120 ent) $100 (collect payment) 1 2$60 (buy goods) 2 3 4 Period 2$80 (buy more goods) How do the new tr ect the income statement and the balance sheet? The income statement will match costs with revenues and record the cost of goods sold when the sales are made in periods 1 and 2. T erence between the costs shown in the income statement and the cash flows is recorded as an investment (and later, disinvestment) in inventories. Thus, in period 1 the accountant shows an investment in inventories of $60 just as before. In period 2 these goods are taken out of inventory and sold, but the firm also produces a further $80 of goods. Thus there is a net increase in inventories of $20. As these goods in turn are sold in period 3, inventories are reduced by $80. The following table confirms low in each period is equal to the cost of goods sold that is shown in the income statement plus the change in inventories. Period: Cost of goods sold (income statement) 1 Investment in inventories (balance sheet) 5 Cash paid out 1 0 60 60 2 60 260 1 80 5 20 80 3 80 280 0 The following table provides a similar r erence between the revenues shown in the income statement and the cash inflow: Chapter 3 63 Accounting and Finance Period: Sales (income statement) 2 Investment in receivables (balance sheet) 5 Cash received 2 100 100 0 3 120 2100 1 120 5 20 1100 4 0 2120 1120 In the income statement the accountant records sales of $100 in period 1 and $120 in period 2. The fact that the firm has to wait for payment is recognized in the balance sheet as an investment in receivables. The cash that the company receives is equal to the sales shown in the income statement less the investment in receivables. Self-Test 3.3 3.3 The Statement of Cash Flows cash when it buys ne to the bank and dividends to the shareholders. to keep track of the cash that is coming in and going out. We have seen that the f w can be quite different from its net income. These dif o reasons: 1. The income statement does not recognize capital expenditures as e . Instead, it spreads those expenses over time 2. revenues and expenses are recognized when sales are made, rather than when the cash is received or paid out. statement of cash flows Financial statement that shows the firm’s cash receipts and cash payments over a period of time. The ws sho ations as well as from its inv ws from operw w from operations. usiness activities. Next comes the cash that Home Depot has invested in plant and equipment or in the acquisition of new businesses. acti w debt or stock. W The f w from operations, starts with net income but adjusts that f volv going out. Therefore, it adds back the allowance for depreciation because depreciation w, even though it is treated as an expense in the income statement. An subtracted from net income, since these absorb cash but do not show up in the income statement. Conversely, any additions to added to net income because these release cash. For e vable is added to income, because the collection of payment on pre firm. In addition, Home Depot decreased inv The decrease in inventory levels freed up cash. v w from operations. On the other hand, Home Depot does vities. Table 3.4 64 One Introduction TABLE 3.4 Source: Calculated from data in Tables 3.1 and 3.3. not pay all its bills immediately. These delayed payments show up as payables. In 2009 Home Depot had fe decreased by $36 We have pointed out that depreciation is not a cash payment; it is simply the accountant’ wever uys and pays for new capital equipment. Therefore, these capital e w statement. Y w capital equipment. Notice that (gross) property, plant, and equipment on Home Depot’s balance sheet increased by precisely this amount. On the other hand, Home Depot freed up $141 million by selling off other investments (this amount shows up as the ed assets plus other assets). Total cash used by investments was $981 million. Finally w statement sho vities. Home Depot used 74711,005 5 7 pay di T w inv Therefore, T 7 Y wever, it is usual to include This is because, unlike dividends, interest payments . business e Chapter 3 65 Accounting and Finance In Millions Cash flow from operations 2 Cash flow for new investment 1 Cash provided by new financing 5 Change in cash balance $4,788 2 981 22,905 1 902 Look back at Table 3.1 and you will see that cash accounts on the balance sheet did Self-Test 3.4 Free Cash Flow free cash flow Cash available for distribution to investors after firm pays for new investments or additions to working capital. s activities. It shows ho s day-to-day operations and how much has come from the issue of new stock or debt. It also shows whether this cash was paid out to investors or reinvested in new plant and equipment or w however, you may w w how much cash the company has available for distribution to investors after it has paid for any new capital investment or additions to w s free cash w. ing operations is equal to (EBIT) 2 taxes 1 depreciation Not all of this cash is av net investments in w v s investors, however. As we’ve discussed, ventory or receivables, soak up cash. So orking capital e ed assets, and these investments also use cash. Thus, Free cash ▲ EXAMPLE 3.3 5 EBIT 2 taxes 1 depreciation 2 change in net working capital 2 capital expenditures Free Cash Flow for Home Depot We use both the income statement and the statement of cash flows to compute Home Depot’s free cash flow. From the 2009 income statement, EBIT was $4,699 million, taxes were $1,362 million, and depreciation expense was $1,806 million. From the statement of cash flows (Table 3.4), the change in working capital was 2$321 million (representing a net disinvestment in working capital that released cash), and net capital expenditures were $981 million. Therefore, Home Depot’s free cash flow was Free cash flow 5 $4,699 2 $1,362 1 $1,806 2 (2$321) 2 $981 5 $4,483 million Some of this money was paid out to Home Depot’s investors as interest or dividends. The remainder was used to buy back stock or repay debt. 66 One Introduction 3.4 Accounting Practice and Malpractice y y focuses vestors wait to see whether the company can meet or beat the forecasts. all, even if it is only a cent or two, can be a big disappointment. Investors might judge that if you could not xtra cent or tw ay. Managers complain about this pressure, but do they do an nately e eyed about 400 senior managers.8 Most of the managers said that accounting earnvestors. Most admitted to adjusting their f v vestors . For e in R&D, adv gets. irm’ y can instead Accounting Standards Board (FASB) and its generally accepted accounting principles (GAAP). Yet, inevitably ve room for discretion, and managers e adv way to satisfy investors. In more e y leeway in accounting rules: • Revenue recognition. As we saw abov ways obvious. For example, suppose that you sell goods today but you give the customer the right to ” Hav deliv companies hav or example, in 1997 the head of Sunbeam, “Chainsaw” Al Dunlap, allegedly moved c . Between 1997 and 2001 Xerox also took an overly optimistic view of its revenues. Whenever a customer signed a longy machine, Xerox book as signed instead of spreading them ov • Cookie-jar r W wth, at least until 2008 when it suddenly collapsed in the w e of the meltdo , it emerged in 2003 that Freddie achiev e accounts. Normally, such accounts are intended to allow for the likely impact of events that ailure of customers to pay their bills. But Freddie seemed to “ov e” against such contingencies so that it could “release” those reserves and bolster income in a bad year. Its steady growth was • infamous for its special-purpose vehicles, which allo y, Enron became ge potential companies in which it had an ownership stake. To present a f ve recognized these potential liabilities on its balance sheet. But 8 J ey Accounting and Economics 40 (2005), pp. 3–73. ” Chapter 3 Accounting and Finance 67 ehicles—in the middle of its transactions. The ambiguity of ownership resulting from these technically independent entities led Enron to exclude these liabilities from its own • Mark-to-market accounting. Many assets and liabilities, such as buildings, emplo ven some infrequently traded securities, do not have easily observ cost. But advocates of mark-to-market accounting believ would giv et value of et prices may no longer be indicative of fundamental value. This was a contentious issue in v mark y were allo wns on assets es it irm. ▲ EXAMPLE 3.4 Lehman Brothers’ Repurchase Agreements As the financial crisis of 2007–2009 worsened, Lehman Brothers desperately looked for a way to improve its apparent financial health. It did so using an arcane accounting trick that removed about $50 billion from its balance sheet. The trick was called Repo 105. Lehman sold $50 billion of bonds to several other investment banks with an agreement that it would repurchase those bonds at a slightly higher price within a week or so. This arrangement is thus called a repurchase or “repo” agreement. Everyone knows that a repurchase agreement is not really a sale of the bonds—it is for all intents and purposes a loan, with the higher repurchase price the implicit interest payment. The bonds serve only as collateral—if Lehman defaults on the promised repurchase, it will not get its bonds back. Repurchase agreements are thus commonly, and properly, treated in U.S. law as loans. But in this case Lehman entered into the transaction through its Eur ice, and pledged bonds worth more than 105% of the cash it received. This loophole allowed it to obtain an opinion from a British law firm that the repo could qualify under English law as a true sale of assets. Lehman’s plan was to use the money it received from selling the bonds to pa . Then, er it had filed its quarterly financial reports, it would borrow the funds necessary to repurchase the bonds. But until that time it would look less indebted than it actually was. The firm (barely) follow er of the law but used the discretion allowed to it under accounting practice to paint a misleading picture of its actual condition. By the way, Lehman was not alone in using “window dressing” to pretty up its balance sheet around a quarterly financial report. For example, Bank of America ed to similar (though far smaller) transactions at the end of several fiscal quarters between 2007 and 2009. Investors w act that some companies seem particularly prone to ast and loose with accounting practice. They refer to such companies as having “low-quality” earnings, and the lower v accounting scandals. Firms such as Global Crossing, Qwest Communications, WorldCom, and F And this was not exclusively a U.S. phenomenon. P y, was dubbed “Europe’s FINANCE IN PRACTICE Accounting Convergence? ev v y. Vivendi Unias accused of accounting fraud. In response to these and other scandals, in 2002 Congress passed the SarbanesOxley Act, widely known as SOX. X created the Public Accounting Ov versee the auditing of public companies, and it requires that But managers and investors w SOX and the b ve gone too far. The costs of xible regulations are pushing some corvate ownership. Some blame SOX and onerous re panies hav There is also a vigorous debate ov v w York. v e to v ve been engaged ve lob. The 3.5 Taxes Taxes often hav how corporations and inv Therefore, we should explain ed. Corporate Tax Companies pay tax on their income. Table 3.5 sho w rates of ut for large companies (those with income over 9 Thus for ev When f y are allowed to deduct expenses. These expenses include an allowance for depreciation. However venue 9 68 . Chapter 3 TABLE 3.5 69 Accounting and Finance Corporate tax rates, 2011 TABLE 3.6 Firms A and B both have earnings before interest and taxes (EBIT) of $100 million, but A pays out part of its profits as debt interest. This reduces the corporate tax paid by A. Note: Figur . types of equipment. 10 The company is also allowed to deduct interest paid to debtholders when calculatut di These di -tax income. Table 3.6 pro how interest payments reduce corporate taxes. The bad ne venues increases taxable es. The good ne xtra dollar of expense reduces taxable income by $1 and therefore reduces taxes by 35 cents. For example, if the f ws money, ev reduces taxes by 35 cents. Self-Test 3.5 y pay 35% of the prof venue Service. But the process doesn’t work in rev fers a loss, the IRS does not simply send it a check for 35% of the loss. However, the f losses back, deduct them from taxable income in earlier years, and claim a refund of past tax ard and deducted from taxable income in the future.11 Personal Tax Table 3.7 sho rate also increases. Notice also that the top personal tax rate is higher than the top corporate rate. 10 If the company assumes a slower rate of depreciation in its income statement than the Internal Revenue Serge sho s life than the actual tax payment. This dif We will tell you more about depreciation allowances in Chapter 9. 11 70 TABLE 3.7 Part One Introduction Personal tax rates, 2011 marginal tax rate Additional taxes owed per dollar of additional income. The tax rates presented in Table 3.7 are mar tax rates. The marginal tax rate is the tax that the individual pays on each extra or example, as a single taxpayer, you w your income is below $8,500, but once income exceeds $8,500, you would pay 15 cents of tax on each e xt $26,000 (ie., 34,500 2 8,500), and 25% of the remaining $5,500: Tax 5 (.10 3 $8,500) 1 (.15 3 $26,000) 1 (.25 3 $5,500) 5 $6,125 average tax rate Total taxes owed divided by total income. The average tax rate is simply the total tax bill divided by total income. In this example it is $6,125/$40,000 5 .153 5 15.3%. Notice that the average rate is below the marginal rate. This is because of the lo Self-Test 3.6 The tax rates in Table 3.7 The treatment of dividend income in the United States leads to what is commonly tax Then, if the company pays a dividend out of this after-tax es on the distribution. The original ed first as corporate income and again as dividend income. Suppose instead that the compan The dollar escapes usiness expense that reduces the firm’s taxable income. Capital gains are also taxed, but only when the gains are realized. Suppose that you bought Bio-technics stock when it was selling for 10 cents a share. Its mark today is $1 a share. As long as you hold on to your stock, there is no tax to pay on your gain. But if you sell, the 90 cents of capital gain is taxed. The marginal tax rate on capital gains for most shareholders is 15%. Financial managers need to w vestment income because tax polic viduals are willing to pay for the company’s stock or bonds. W xt. The tax rates in Table 3.7 apply to indi investors in corporate securities. These institutions often have special tax provisions. For example, pension funds are not taxed on interest or dividend income or on capital gains. L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ www.mhhe.com/bmm7e SUMMARY PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEM WEB EXERCISES finance.yahoo.com www.mhhe.com/bmm7e www.irs.gov moneycentral.msn.com SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e CHAPTER 4 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 6 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T O N E Introduction When managers need to judge a firm's performance, they start with some key financial ratios. I 4.1 Value and Value Added How Financial Ratios Help to Understand Value Added The good ne y are usually easy to calculate. The bad news is that there are so many of them. To make it worse, the ratios are often presented in long lists that seem to require memorization first and understanding maybe later. We can mitigate the bad news by taking a moment to preview what the ratios are measuring and how the ratios connect to the ultimate objective of value added for Shareholder value depends on good investment decisions. evaluates inv veral questions, including: Ho vestments relative to the cost of capital? Ho sured? itability depend on? (We will see that it depends on efficient use vious v av v sold for cash)? xpected setbacks. Figure 4.1 what more detail. The boxes on the left are for investment, the boxes on the right for financing. In each box we have posed a question and given e manager can use to answer the question. For example, the bottom box on the f Figure 4.1 asks about ef iciency are turnover ratios for assets, inventory, and accounts receivable. FIGURE 4.1 An organization chart for financial ratios. The figure shows how common financial ratios and other measures relate to shareholder value. 80 Chapter 4 81 Measuring Corporate Performance The two bottom box verage (the amount of debt financing) is prudent and whether the f . verage include debt ratios, such as the ratio of debt to equity, and interest coverage ratios. quick, and cash ratios. We will explain ho Figure 4.1. For no ws how they relate to the objectiv alue. No irst task is to measure value. We will explain market capitalization, market value added, and the market-to-book ratio. 4.2 Measuring Market Value and Market Value Added Twenty years hav You are well into your w money to Home Depot stock. You could be an investment market capitalization Total market value of , equal to share price times number of shares outstanding. market value added Market capitalization minus book value of . bank Depot’s credit standing. You could be the treasurer or CFO of Home Depot or of one of its competitors. You want to understand Home Depot’s v mance. How w Home Depot’s common stock closed 2009 at a price of $28.72 per share. There were 1,693 million shares outstanding, so Home Depot’s market capitalization or et cap” was $28.72 3 1,693 5 big number, of course, but Home Depot is a big company. Home Depot’ have, ov vested billions in the company. Therefore, you decide to compare Home Depot’s market capitalization to the book value of Home Depot’s equity. The book v ve inv Y duced in Tables 4.1 and 4.2.1 At the end of 2009, the book value of Home Depot’s equity was $19,393 million. Therefore, Home Depot’s market value added, the differet v shareholders have inv as $48,623 2 $19,393 5 $29,230 million. TABLE 4.1 Income statement for Home Depot, 2009 Source: Home Depot annual report, 2009. 1 For conv W The 82 Part One Introduction TABLE 4.2 Home Depot’s Balance Sheet (millions of dollars) Source: Home Depot annual reports. In other w v uted about $19 billion and ended up with shares w They have accumulated nearly $30 billion in et value added. The consultancy firm EVA Dimensions calculates market value added for a large sample of U.S. companies. Table 4.3 shows a few of the firms from EVA’s list. ExxonMobil heads the group. It has created $148.5 billion of wealth for its shareholders. Xerox is near the bottom of the class: The market value of its shares is $9.1 billion less than the amount of shareholders’ money invested in the firm. 83 Chapter 4 TABLE 4.3 Stock-market measures of company performance, July 2010. Companies are ranked by market value added (dollar values in millions). Source: We are grateful to EVA Dimensions for providing these statistics. market-to-book ratio Ratio of market value of equity to book value of equity. Exxon is a large firm. Its managers have lots of assets to work with. A small firm could not hope to create so much extra value. analysts also like to calculate how much value has been added for each dollar that shareholders have invested. To do this, they compute the ratio of market value to book value. For example, Home Depot’s market-to-book ratio at the end of 2009 was2 5 book value of equity 5 $48,623 5 2.5 $19,393 In other words, Home Depot has multiplied the v 2.5 times. Table 4.3 also shows mark much higher market-to-book ratio than Exxon. But Exxon’ ger scale. vestment et value added is Self-Test 4.1 The market-value performance measures in Table 4.3 have three drawbacks. First, the market value of the company’ vestors’ expectations about future performance. Investors pay attention to current profits and investment, of course, but they also avidly forecast investment and growth. Second, market valy risks and ev ager’s control. Thus, market v w well the corporation’s management is performing. Third, you can’t look up the market value of privately owned companies whose shares are not traded. Nor can you observe the market value of divisions or plants that are parts of larger companies. Y et values to satisfy yourself that Home Depot as a whole has performed well, but you can’t use them to drill down to compare the performance of the lumber and home 2 viding stock price by book v 84 Part One Introduction improvement divisions. T W alue added (EVA). . 4.3 Economic Value Added and Accounting Rates of Return w up an income statement, the venues and then deduct operating and other costs. But one important cost is not included: the cost of ys. alue, all costs, including the cost of its capital. vestment. It is an the e cost of capital, because it equals v ets. The inv economic value added (EVA) After-tax operating income minus a charge for the cost of capital employed. Also called residual income. vesting on their own. including the cost of capital, is called the company’s economic value added or EVA. The term “EVA” w w & Co., which did much to develop and promote the concept. EVA is also called residual income. In calculating EVA, it’s customary to take account of all the long-term capital contributed by investors in the corporation. That means including bonds and other longT total capitalization, is the sum of long-term debt and shareholders’ equity. At the end of 2008 Home Depot’s total capitalization amounted to $27,444, the sum . This w tive amount that had been invested by Home Depot’s debt and equity investors. Home Depot’s cost of capital was about 7.5%.3 So we can conv lars by multiplying total capitalization by 7.5%: .075 3 $27,444 5 $2,058 million. To satisfy its debt and equity inv income of $2,058 million. No vestors. In 2009 debt investors received interest income TABLE 4.4 EVA and ROC, July 2010. Companies are ranked by EVA (dollar values in millions) er-tax interest. Note: EVAs do not compute exactly because of rounding in the cost of capital. Source: We are grateful to EVA Dimensions for providing these statistics. 3 v WACC. business. The WA We will explain WACC and how to calculate it in Chapter 13. y’s WACC depends on the risk of its ut with the cost of debt calculated Chapter 4 85 Measuring Corporate Performance The after-tax equivalent, using Home Depot’s 35% tax rate, is 4 Net income to shareholders was $2,661 million. (1 2 .35) 3 676 5 $439 Therefore, Home Depot’s after 1 2,661 5 igure, you can see that the compan 2 2,058 5 more than investors required. This was Home Depot’s EVA or residual income: EVA 5 after-tax interest 1 net income 2 (cost of capital 3 total capitalization) 5 439 1 2,661 2 2,058 5 $1,042 million The sum of Home Depot’s net income and after-tax interest is its after operating income. This is what Home Depot w e interest as a tax-deductible expense. After-tax operating income is what the company w inanced. In that case it would have no (after-tax) interest expense and all operating income w Thus EVA also equals: EVA 5 after-tax operating income 2 (cost of capital 3 total capitalization) 5 3,100 2 2,058 5 $1,042 million Of course Home Depot and its competitors do use debt financing. Nev EVA comparisons are more useful if focused on operating income, which is not affected by interest tax deductions. Table 4.4 shows estimates of EV ge companies. ExxonMobil again heads the list. It earned over $17 billion more than was needed to cover its cost of capital. By contrast, AT&T was a laggard. Although it earned an accounting v as calculated before deducting the cost of capital. After deducting the cost of capital, AT&T made an EVA loss of about $3.8 billion. Notice ho Table 4.4. The v vely safe companies like W Coca-Cola tend to have lo e Xerox and especially Google have high costs of capital. EVA, or residual income, is a better measure of a company’s performance than is accounting income. Accounting income is calculated after deducting all costs except the cost of capital. By contrast, EVA recognizes that companies need to cover their oppor ore they add value. EVA makes the cost of capital visible to operating managers. get: at least the cost of capital on assets employed. A plant or divisional manager can improve EVA by reducing assets. Evaluating performance by EV Therefore, a gro now calculate EVA and tie managers’ compensation to it. Self-Test 4.2 4 irm pays interest, it reduces its will v T , equivalently, we look at after-tax interest payments. This tax saving, or T -tax weighted-average cost of capital (WACC). We will have more to say about these issues in Chapters 13 and 16. 86 Part One Introduction Accounting Rates of Return EVA measures how many dollars a b tal. Other things equal, the more assets the manager has to work with, the greater the ge EVA. The manager of a small division may be highly competent, but if that division has few assets, she is unlik A stakes. s per dollar of assets. OC), OA). book rates of return, because the return on capital (ROC) er-tax operating income as a percentage of long-term capital. Return on Capital (ROC) -tax operating income divided by total capitalization. In 2009 Home Depot’s operating income w shareholders’ equity) of $27,444 million. Therefore its return on capital (ROC) was5 ROC 5 after-tax operating income 3,100 5 5 .113, or 11.3% total capitalization 27,444 R ays. For e vided Home Depot’s operaty’s v . If the additional investment cons operating income, it’s better to divide by the average of the total capitalization at the be .6 Home Depot’s ROC for 2009 would decrease slightly to ROC 5 after-tax operating income 3,100 5 5 .112, or 11.2% ( average total capitalization 27,444 1 28,055) /2 , Home Depot’s cost of capital was about 7.5%. This was the y invested vestors could have e their money in other companies or securities with the same risk as Home Depot’s business. So in 2009 the compan 2 7.5 5 3.7% more than investors required. Think again about how Home Depot creates v invest in new assets or pay out cash to the shareholders, who can then invest the money for themselves in financial markets. When Home Depot invests in a new store or warev v wn. ving up by keeping their money in the compan es its y could obtain for themselv es its investors worse off: They vesting on their own in financial markets. So ant the company to invest only in projects for which the return on capital is at least as great as the cost of capital. The last column in Table 4.4 shows R wn companies. Notice that Google’ ve its cost of capital. Although Google had a higher return on capital than ExxonMobil, it had a lower EVA. This w y than Exxon and so had a higher cost of capital, but also because it had f wer dollars invested than Exxon. 5 sR pretax interest to calculate operating income. OC for companies that use difOC with the after verage cost of capital (WACC). We cover WACC in Chapter 13. 6 Av uilds up ov s conv Chapter 4 87 Measuring Corporate Performance ve companies in Table 4.4 with negative EVAs all have ROCs less than their cost of capital. The spread between R thing as EVA but e return on assets (ROA) er-tax operating income as a percentage of total assets. OA) measures after-tax operat- Return on Assets (ROA) s total assets. T or Home Depot, ROA was 5 after-tax operating income 3,100 5 5 .075, or 7.5% total assets 41,164 Using average total assets, ROA was slightly higher at 7.6%: ROA 5 after-tax operating income 3,100 5 5 .076, or 7.6% ( average total assets 41,164 1 40,877) /2 For both ROA and ROC, we use after-tax operating income, which is calculated by W w profitable the company would hav This what-if calculation is helpful irms with dif The tax deduction for interest is often ignored, however, and operating income is calculated using pretax interest. Some financial analysts take no account of interest payments and measure ROA as net income for shareholders divided by total assets. This calculation is really—we were about to say “stupid,” but don’t w yone. This calcus assets have generated for debt investors. Self-Test 4.3 return on equity (ROE) Net income as a percentage of shareholders’ equity. Return on Equity (ROE) We measure the return on equity (ROE) y have invested. Home Depot had net income . So Home Depot’s ROE was Return on equity 5 ROE 5 2,661 net income 5 5 .150, or 15.0% equity 17,777 Using average equity, ROE was ROE 5 2,661 net income 5 5 .143, or 14.3% ( average equity 17,777 1 19,393) /2 Self-Test 4.4 Problems with EVA and Accounting Rates of Return alue added have some obvious attractions as measures of performance. Unlik et-v y sho and are not affected by all the other things that move stock market prices. Also, they vision. However, 88 Part One Introduction remember that both EV sheet) values for assets. Debt and equity are also book values. As we noted in the last chapter w ev take accounting data at face value. For example, we ignored the f has invested large sums in marketing in order to establish its brand name. This brand ut its value is not shown on the balance sheet. If it were shown, the book v ould increase, and Home Depot w EV Tables 4.3 and 4.4 ea wever, it is impossible to include the value of all assets or to judge how rapidly they depreciate. For example, did Google , because its investment ov and cannot be measured exactly. Remember also that the balance sheet does not sho et values of s assets. y’s books are v any depreciation. Older assets may be grossly undervalued in today’s market condivestments in the past, b you could buy the same assets today at their reported book values. Conversely a low ut it does not always mean that today the assets could be employed better elsewhere. 4.4 Measuring Efficiency We began our analysis of Home Depot by calculating how much value that company has added for its shareholders and ho deducting the cost of the capital that it employs. We e equity, capital, and total assets, which were all impressively high. Our next task is to probe a little deeper to understand the reasons for Home Depot’s success. What factors contrib s ov iciency with which it uses its many types of assets. The asset turnover, or sales-to-assets, ratio shows how w hard the f s assets are w or Home Depot, each dollar of assets produced $1.608 of sales: Asset Turnover Ratio Asset turnover 5 sales 5 66,176 5 1.608 41,164 Lik (sales ov cial managers and analysts often calculate the ratio of sales ov average level of assets over the same period. In this case, Asset turnover 5 66,176 sales 5 5 1.613 (40,877 1 41,164) /2 average total assets ver ratio measures how ef w hard put to use. Belo Inventory Turnover ra of ra w measure usiness is using its entire asset of assets are being xamples. Ef y need in They hold only a relatively small level of inv ver those inv . 89 Chapter 4 The balance sheet shows the cost of inv ished goods will eventually sell for invel of inventories s case, cost of goods sold 43,764 5 5 4.1 inventory at start of year 10,673 5 Another way to express this measure is to look at how many days of output are represented by inventories. This is equal to the level of inv cost of goods sold: Average days in inventory 5 daily cost of goods sold 5 10,673 5 89 days 43,764/365 You could say that on av icient inv ations for 89 days. In Chapter 20 we will see that man ve managed to increase their invenver in recent years. Toyota has been the pioneer in this endeavor. Its justin-time inv vered exactly when they are needed. Toyota now keeps only about one month’ in inv ver its inventory about 12 times a year. Receivables Turnover Receivables are sales for which you have not yet been paid. The receivables turnover ratio measures the f s sales as a multiple of its receivables. For Home Depot, sales 5 5 66,176 5 68 972 , unpaid bills will be a relatively small proportion of v Therefore, a high ratio often indicates sales and the receiv an eff w up on late payers. Sometimes, however, a high ratio may indicate that the f ve credit policy .7 Another way to measure the ef y of the credit operation is by calculating the average length of time for customers to pay their bills. The f ver its receiv s customers pay their bills in about 5.4 days: Average collection period 5 average daily sales 5 972 5 5.4 days 66,176/365 Self-Test 4.5 The receivables turnover ratio and the inv ver ratio may help to highy, but they are not the only possible indicators. For example, a retail chain might compare its sales per square foot with those of its competitors, an airline might look at revenues per passenger-mile, and a law firm might 7 es sense to look only at credit equiv , a low av credit. For e vables turnov , ve a gardless of an 90 Part One Introduction look at revenues per partner. A little thought and common sense should suggest which measures are likely to produce the most helpful insights into your company’s ef y. 4.5 Analyzing the Return on Assets: The Du Pont System We have seen that ev s assets generates $1.61 of sales. But Home Depot’s success depends not only on the efficiency with which it uses its assets to generate sales but also on ho This is measured by Home Depot’ gin. Profit Margin The profit mar way into profits. It is sometimes defined as Profit margin 5 2,661 net income 5 5 .040, or 4.0% sales 66,176 This definition can be misleading. v We would not w simply because it emplo operating profit margin After-tax operating income as a percentage of sales. s lenders. vided between the debtholders and the itable than its rivals gin, it makes sense to add back the after-tax debt interest to net income. This leads us again to after-tax operating income and to the operating pr margin: after-tax operating income sales 2,661 1 (1 2 .35) 3 676 5 5 .047, or 4.7% 66,176 5 The Du Pont System W following equation sho The of v dollar of sales (operating prof gin): after-tax operating income assets after-tax operating income sales 5 3 assets sales c c asset turnover operating profit margin 5 Du Pont formula ROA equals the product of asset turnover and operating profit margin. This breakdown of RO Du Pont formula, after the chemical compan Home Depot’ ves the follo v (4.1) gin is often called the wn of ROA: ROA 5 3 operating profit margin 5 1.61 3 .047 5 .075 e ay to think about a company’s strategy. For ve for high turnover at the expense of a low prof gin Chapter 4 Measuring Corporate Performance 91 (a “W gin even if that results in low ver (a “Bloomingdales strategy”). You would naturally prefer both high profit gin and high turnover, but life isn’t that easy. gin strategy will typically result in lo e tradeoffs between these goals. gy the ould lik ut their ability to do so is limited by competition. The Du Pont formula helps to identify the constraints that ace. Fast-food chains, which have high asset turnover, tend to operate on low gins. Classy hotels have relatively lo ver ratios but tend to compensate with higher margins. ▲ EXAMPLE 4.1 Turnover versus Margin en seek to improve their profit margins by acquiring a supplier. The idea is to capture the supplier’s profit as well as their own. Unfortunately, unless they have some special skill in running the new business, they are likely to find that any gain in profit mar y a decline in asset turnover. A few numbers may help to illustrate this point. Table 4.5 shows the sales, profits, and assets of Admiral Motors and its components supplier, Diana Corporation. Both earn a 10% return on assets, though Admiral has a lower operating profit margin (20% versus Diana’s 25%). Since all of Diana’s output goes to Admiral, Admiral’s management reasons that it would be better to merge the two companies. That way, the merged company would capture the profit margin on both the auto components and the assembled car. T om row of the following table sho ect of the merger. The merged firm does indeed earn the combined profits. Total sales remain at $20 million, however, because all the components produced by Diana are used within the company. With higher profits and unchanged sales, the profit margin increases. Unfortunately, the asset turnover is reduced by the merger since the merged firm has more assets. This ex it of the higher profit margin. The return on assets is unchanged. Figure 4.2 shows evidence of the trade-of v gin. You can see that industries with high average turnover ratios, for e tend to have lower av gins. Conversely gins are typically associated with low turnover. The classic e ater utilities, which hav ver ratios. However, they have extremely lo ginal costs for each unit of additional output The tw ver that result in an ROA of either 3% or 6%. ver, that v fsetting, so for most industries the return on assets lies between 3% and 6%. TABLE 4.5 Merging with suppliers or customers will generally increase the profit margin, by a reduction in asset turnover. 92 FIGURE 4.2 One Introduction Median ROA, profit margin, and asset turnover for 23 industries, 1990–2004 Source: Thomas I. Selling and Clyde P. Stickney, ects of Business Environments and Strategy on a Firm’s Rate of Return on Assets.” Copyright 1989, CFA Institute. Reproduced and republished from Financial Analysts Journal, January–February 1989, pp. 43–52, with permission from the CFA Institute. All rights reserved. Updates courtesy of Professors James Wahlen, Stephen Baginski and Mark Bradshaw. Self-Test 4.6 4.6 Measuring Financial Leverage As Figure 4.1 indicates, shareholder value depends not only on good investment deciW verage and then at measures of liquidity. ws money, it promises to make a series of interest payments and to receiv course, the rev pain. If times are suf pay its debts. entire investment. bad times, it is said to create v that lenders are happ wed heavily may not be able to verage. Leverage ratios measure how much en on. CFOs keep an eye on leverage ratios to ensure s debt. 93 Chapter 4 Debt Ratio Financial leverage is usually measured by the ratio of long-term debt 8 wing but also f For Home Depot, Long-term debt ratio 5 1 equity 5 8,662 5 .31, or 31% 8,662 1 19,393 v Leverage may also be measured by the debt-equity ratio. For Home Depot, Long-term debt-equity ratio 5 long-term debt 8,662 5 5 .45, or 45% equity 19,393 o ratios is moderate for Home Depot, 31% versus 45%. v y 5 9. The long-term debt ratio for the average U.S. manufacturing company is about 30%, but some companies deliberately operate at much higher debt levels. For example, in Chapter 21 we will look at leveraged buyouts (LBOs). Firms that are acquired in a leveraged buyout usually issue lar verage debt ratios of about 90%. Many of et v market value of the company, ues.9 y’ et v y covers its debts, then lenders y back. Thus you would expect to see the debt ratio computed using et values of debt and equity. Y versally. et leverage ratios matter much? Perhaps not; after all, the market value of the f alue of intangible assets generated velopment, adv f training, and so on. These assets are yf gether. wer keep within a maximum debt ratio, the alues and they ignore the intangible Notice also that these measures of lev mak cash, b y is a re Total debt ratio 5 That probably wer, it may be preferable to 21,484 total liabilities 5 5 .53, or 53% total assets 40,877 equity.10 W 5 1.11. Managers sometimes refer loosely to a company’s debt ratio, but we have just seen that the debt ratio may be measured in several different ways. For example, Home Depot has a debt ratio of .31 (the long-term debt ratio) and also .53 (the total debt 8 e re ment is just lik 9 In the case of leased assets, accountants estimate the value of the lease commitments. In the case of long-term debt, they simply show the face value, which can be very different from market value. 10 94 One Introduction ratio). This is not the first time we have come across several w ratio. There is no law stating ho w it has been calculated. inancial Times Interest Earned Ratio verage is the extent to which interest obligations are cov ver interest payments with room to spare. Interest coverage es (EBIT) to interest payments. For Home Depot, Times interest earned 5 4,699 EBIT 5 5 7.0 interest payments 676 ativ tent with coverage ratios as low as 2 or 3. The re to avoid default. The coverage ratio measures ho and hurdler. , however. For e t tell us whether Home Depot is generating enough cash to repay its debt as it becomes due. Cash Coverage Ratio e As we explained in Chapter 3, depreciation is not a cash v o w. We then calculate a cash coverage ratio.11 For Home Depot, Cash coverage ratio 5 EBIT 1 depreciation 4,699 1 1,806 5 5 9.6 interest payments 676 Self-Test 4.7 Leverage and the Return on Equity e interest payments to its lenders. ws instead of issuing equity, it has fewer equityholders to share the remaining profits. Which effect dominates? An extended v wn after-tax operating income net income assets sales net income ROE 5 5 3 3 3 equity equity assets sales after-tax c c c operating income leverage asset operating c ratio profit margin “debt burden” (4.2) 11 . 1 1 5 A cov vered here. Y ves Y Table 4.8 on page 101. Chapter 4 Measuring Corporate Performance 95 Notice that the product of the tw fected by 12 However , which we call the leverage ratio, can be expressed as (equity 1 liabilities)/equity, which equals 1 1 total-debt-to-equity ratio. The last term, which we call the “debt b ” measures the proportion by which interest e Suppose that the f inanced entirely by equity. In this case, both the leverage ws, however, the leverage ratio is greater than 1 its is absorbed by interest). Thus lev . In fact, we will see in Chapter 16 that leverage increases R assets is higher than the interest rate it pays on its debt. Since Home Depot’ on capital e on capital. Self-Test 4.8 4.7 Measuring Liquidity liquidity Access to cash or assets that can be turned into cash on short notice. wer’ verage. You w w whether y can lay its hands on the cash to repay you. That is why credit analysts and bankers look at several measures of liquidity. Liquid assets can be conv quickly and cheaply. Think, for example, what you w ge unexpected bill. You might have some mone v ut you would not f ewise, own assets grees of liquidity. For example, accounts receivable and inventories of As inv pay their bills, mone ws into the f At the other extreme, real estate may be quite illiquid. uyer, negotiate a f Managers have another reason to focus on liquid assets: Their book (balance sheet) values are usually reliable. The book value of a catalytic cracker may be a poor guide alue, but at least you know what cash in the bank is w Liquidity ratios also have some less assets and liabilities are easily changed, measures of liquidity can rapidly become outdated. Y er is worth, b airly sure that it won’t disappear overnight. Cash in the bank can disappear in seconds. Also, assets that seem liquid sometimes have a nasty habit of becoming illiquid. This happened during the subprime mortgage crisis in 2008. Some financial institutions had set up funds known as structured investment vehicles (SIVs) that issued short-term debt backed by residential mortgages. As mortgage default rates began to climb, the market in this debt dried up and dealers became very reluctant to quote a price. 12 Again, we use after 96 One Introduction ve plenty of liquid assets. They know that when the ways a good thing. For e not leave excess cash in their bank accounts. They don’t allow customers to postpone paying their bills, and they don’t leave stocks of ra inished goods littering the w . In other words, high levels of liquidity may indicate sloppy use of capital. Here, EVA can highlight the problem, because it penalizes managers who keep more liquid assets than they really need. Net Working Capital to Total Assets Ratio v v liquid. The dif wn as net working capital. It roughly measures the company’s potential net reservoir of cash. Since current assets usually e orking capital is usually positive. For Home Depot, Net wo 5 13,900 2 10,363 5 $3,537 million Home Depot’s net w as 9% of total assets: Net wo Total assets 5 3,537 5 .09, or 9% 40,877 Current Ratio liabilities: 5 5 13,900 5 1.34 10,363 v pany borro ge sum from the bank and inv or example, suppose that a cometable securities. Cur- capital is unaffected but the current ratio changes. For this reason it is sometimes preferable to net short-term investments against short-term debt when calculating the current ratio. Quick (Acid-Test) Ratio v ything abov rouble typically comes because the f t sell its inv production cost.) Thus managers often exclude inventories and other less liquid comThey focus instead on cash, marketable securities, and bills that customers have not yet paid. This results in the quick ratio: Quick ratio 5 Cash Ratio 1,421 1 964 cash 1 marketable securities 1 receivables 5 5 .23 current liabilities 10,363 A company’ Cash ratio 5 cash 1 et- 5 1,421 5 .14 10,363 A low cash ratio may not matter if the f w on short notice. whether the f wed from the bank or whether it has a guaranteed 97 Chapter 4 of liquidity takes the f w whenever it chooses? None of the standard measures s “reserv wing power” into account. Self-Test 4.9 4.8 Calculating Sustainable Growth Home Depot’s lev cies are safe and sound. But what about the amount vailable for investment and growth? To put it another way, how fast could Home Depot grow? Would its growth be limited by the av The answer to the last question is in principle no. In well-functioning financial markets, a company’s gro ut by limits to good inv y has investment projects that add value, it should be But the window to issue stock may not always be open. For e manager who believes that inv stock at what he or she sees as a depressed price. wing how f w if it relies only on interThe s sustainable growth rate. w mainly by reinv y grow ept in the b the compan w capital. vidends. The proportion of earnings paid out as dividends was, therefore, Payout ratio 5 1,525 5 .57, or 57% 2,661 The remaining 43% of earnings was reinvested and “plowed back” into the business s equity capital.13 Thus, Plowback ratio 5 1 2 payout ratio 5 1 2 .57 5 .43 Home Depot’s return on equity (ROE) was 15%. If it continues to reinvest 43% of y increase by .43 3 .15 5 .065, or 6.5% a year: Sustainable growth rate 5 5 2 dividends equity 2 dividends 3 equity 5 plowback ratio 3 ROE 5 .43 3 .15 5 .065, or 6.5% 13 We assume that payout to shareholders comes as cash dividends only. Companies also pay out cash by repur- net income. We discuss repurchases in Chapter 17. 98 Part One sustainable growth rate The firm’s growth rate if it plows back a constant fraction of earnings, maintains a constant r , and keeps its debt ratio constant. This measure is often known as the sustainable rate of growth. The sustainable gro s long-term debt ratio is held constant. Home Depot could grow its assets at a f wing more and more, but that growth strategy would not be sustainable in the long run. Home Depot’s sustainable growth rate is moderate. But sometimes the formula for sustainable growth will result in crazy values, for example, sustainable growth rates above 30% or even 40%. No company could expect to maintain growth rates like these forever. Often, in such cases, firms are selling products at an early stage of their life-cycle. Competition in these new markets is scarce, return on equity is high, and, with ample opportunities for profitable reinvestment, firms respond with very high plowback ratios. For example, the ROE for computer software firms in 2010 was more than double that of electric utilities. And most software companies 14 paid no dividends at all, but instead plowed all But eventually, as the industry matures, price competition will increase, ROE will decline, and with fe vestment, firms will plow back less of their earnings. As ROE and the plowback ratio both decline, growth also must slow. Introduction 4.9 Interpreting Financial Ratios We have shown ho s Table 4.6.15 Now that you have calculated these measures, you need some w they are high or low or example, if gative v But what about some of our other measures? vel for, say, the ver or profit margin, and if there were, it w y to company. For example, you would not expect a acturer to hav gin as a jeweller or the same levery. All financial ratios must be interpreted in the context of Table 4.7 presents some financial ratios for a sample of industry groups. Notice the large variation across industries. Some of these differences, particularly in profitability measures, may arise from chance; in 2009 the sun shone more kindly on some industries than others. But other dif tal factors. For example, notice the comparatively high debt ratios of food product companies. In comparison, computer and electronic companies tend to borrow far less, and these differences are true in both good times and bad. We pointed out earlier that some businesses are able to generate a high level of sales from relatively few assets. Differences in turnover ratios also tend to be relatively stable. For example, you can see that the asset turnover ratio for beverage and tobacco firms is more than double that for food product companies. But competition ensures that beverage and tobacco firms earn a correspondingly lower margin on their sales. The net effect is that the return on assets in the two industries is broadly similar. 14 Value Line Inv If you would like to see ho spreadsheet available on our Web site at www ey industry group. 15 ve Excel . 99 Chapter 4 TABLE 4.6 Summary of Home Depot’ ormance measures *Authors’ calculation. You can find this spreadsheet at .mhhe.com/bmm7e. TABLE 4.7 Financial ratios f oups, 2009 Source: Authors’ calculations using data from U.S. Department of Commerce, March 2010. Available at .census.gov/econ/qfr/curr erly Financial R . or Manufacturing, Mining and Trade Corporations, 100 Part One Introduction Self-Test 4.10 v s major competitors. Table 4.8 sets out some ke we’s. y respects. For e wever, Home Depot’s ROA is higher v gin. Home Depot relies f vily on debt than Lowe’s. its higher leverage ratios as well as its lower coverage ratios. This greater indebtedness O OE, Home we’s. This is because it pays out a far lar vidends. vidends today, but with lower reinv vidends may grow more slowly.16 It may also be helpful to compare Home Depot’s financial ratios with its own equiv or example, you can see in Figure 4.3 that Home Depot’ w 10% in 2008 FIGURE 4.3 Home Depot financial ratios over time Note: We pointed out earlier in the chapter that there is more than one way to calculate several ratios. Value Line’s figures do not precisely match the values in Table 4.6. Source: Value Line Investment Survey, April 2, 2010. 16 lently, average collection period. W Lowe’ its accounts receiv will generally hav y between the tw v wer receiv gy as well as to emerging b v ver and lo ver or, equivawe’s tends to sell The lesson? ut you 101 Chapter 4 TABLE 4.8 Selected financial measures for Home Depot and Lowe’s, 2009 *Authors’ calculation. before finally stabilizing. W w that ROA 5 asset ver 3 operating profit margin. So what accounted for the fall in ROA? Figure 4.3 shows that the culprit was the gin from 8.6% in 2005 to 5.7% in 2008. Perhaps Home Depot was where it may be useful to look at the e This concludes our canter through Home Depot’ ferent divisions. 4.10 The Role of Financial Ratios—and a Final Note on Transparency ver tw the usiness and finance, it’s a good bet that s drop in on two conversations. Conversation 1 as musing out loud: “Ho e W “I’v w the full cost of the project, the ratio would be about .45. When we took out our last loan from the bank, we agreed that we would not allow our debt ratio to get abov ouldn’t have much leeway to respond to possible emergencies. ve our bonds 102 TABLE 4.9 One Introduction Financial ratios and default risk by rating class, long-term debt Note: EBITDA is earnings before interest, taxes, depreciation, and amortization. Standard & Poor’s and Moody’s, the two largest credit rating agencies, use slightl erent labels for rating classes. For example, S&P’s BBB rating is equivalent to Moody’s Baa, BB is equivalent to Ba, and so on. Source: Corporate Rating Criteria, Standard & Poor’s, 2006. an investment-grade rating. They too look at a company’s leverage when they rate its bonds. I have a table here (Table 4.9), which sho veraged, their bonds receive a lower rating. I don’ w whether the rating agencies would downgrade our bonds if our debt ratio increased to .45, but they might. That wouldn’t please our existing bondholders, and it could raise the cost of any new wing.” “We also need to think about our interest cover, which is be v interest cover would f o times. Sure, we e the new investment, but it could be sev es short of cash.” “Sounds to me as if we should be thinking about a possible equity issue,” concluded the CEO. Conversation 2 The CEO was not in the best of moods after his humiliating defeat at the compan vision: “I see our stock was down again yesterday,” he growled. “It’s now selling below book v ork my socks off for this company; you w ould show a little more gratitude.” “I think I can understand a little of our shareholders’ w ” the financial manager replies. “Just look at our return on assets.” It’s only 6%, well below the cost of ver the cost of the funds that investors provide. Our economic value added is actually negative. Of course, this doesn’ where, but we should y of our divisions should be sold off or the assets redeployed. “In some ways we’re in good shape. We have v s not altogether good news because it also suggests that we may have more w I’v They turn over their inventory 12 times a Also, their customers take an average e 67. If we could just match their performance on these two measures, we would release $300 million that could be paid out to ” w,” said the CEO. “In the meantime I intend to have a word with the production manager about our inv vels and with the credit manager about our collections policy. You’v about whether we should sell off our packaging division. I’ve always w the divisional manager there. Spends too much time practicing his backswing and not enough w ” Chapter 4 103 Measuring Corporate Performance Transparency ve assumed that financial statements are trustworthy. We assumed that accountants are following generally accepted accounting principles (GAAP) and not endorsing misleading numbers. We assumed that managers are not inancial statements or covering up bad ones. When transparent, because outsiders alue and performance. Unfortunately vestors. as in many ways an empty shell. Its stock price was supported more by inv usinesses. The compan wing aggressively special-purpose entities (SPEs) and hiding these debts. Much of the wing was improperly excluded from Enron’ The bad ne , Enron f of its water and broadband business. In November, it recognized its SPE debt retroactively wledged indebtedness debt was do y. y y could hav prospects—its problems would have shown up right away in a f That ould have generated e cies, lenders, and investors. With transparency ve action. But the top management of a troubled and opaque compan price and postpone the discipline of the mark et discipline caught up with y. 2002. y Act (SO y Accounting Ov Among other things, the act set up v y audit; it prohibits y indi y’ statements present a f All this comes at a price. The costs of SOX and the burdens of meeting detailed re vate (versus public) ownership. Some observers also believe that these added re ve hurt the v ets. Despite periodic accounting breakdowns, transparency in the United States and other dev v and critical even in these countries. Take e veloping economies, where SUMMARY www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUIZ www.mhhe.com/bmm7e QUESTIONS PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISE finance.yahoo.com SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e MINICASE TABLE 4.10 TABLE 4.12 www.mhhe.com/bmm7e TABLE 4.11 CHAPTER 5 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 6 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T T W O Value Do you truly understand what these figures mean? C 114 Part Two Value 5.1 Future Values and Compound Interest You have $100 inv of $6: Interest 5 interest rate 3 initial investment 5 .06 3 $100 5 $6 Y ment will gro alue of your investValue of investment after 1 year 5 $100 1 $6 5 $106 Notice that the $100 invested grows by the factor (1 1 .06) 5 y interest rate r, the value of the investment at the end of 1 year is (1 1 r) times the initial investment: 5 initial investment 3 (1 1 r) 5 $100 3 (1.06) 5 $106 What if you leave this money in the bank for a second year? Your balance, now 5 .06 3 $106 5 $6.36 Y alue of your account will grow to $106 1 $6.36 5 $112.36. vestment of $100 increases by a f second year the $106 again increases by a factor of 1.06 to $112.36. Thus the initial $100 investment grows twice by a factor 1.06: 5 $100 3 1.06 3 1.06 5 $100 3 (1.06)2 5 $112.36 If you keep your money invested for a third year, your investment multiplies by future value (FV) Amount to which an investment will grow after earning interest. compound interest Interest earned on interest. simple interest Interest earned only on the original investment; no interest is earned on interest. $100 3 (1.06)3 5 ev v where. , if you invest your $100 for t interest rate of r t will be ut w to $100 3 (1.06)t. For an future value (FV) of your investment Future value (FV) of $100 5 $100 3 (1 1 r)t (5.1) Notice in our e and in the second year is $6.36 (6% of $106). Your income in the second year is higher because you no both vestment and the $6 of vious year compounding or compound interest. In contrast, if the bank calculated the interest only on your original investment, you would be paid simple interest. With simple interest the v of your investment would gro 3 $100 5 $6. Table 5.1 and Figure 5.1 illustrate the mechanics of compound interest. Table 5.1 sho vings have been increased by the previous year’s interest. As a result, your interest income also is higher. Obviously, the higher the rate of interest, the faster your savings will grow. Figure 5.2 shows the balance in your savings account after a giv several interest rates. Even a few percentage points added to the (compound) interest rate can dramatically af or example, after 10 years $100 Chapter 5 The Time Value of Money 115 TABLE 5.1 How your savings grow; the future value of $100 invested to earn 6% with compound interest FIGURE 5.1 A plot of the data in Table 5.1, showing the future values of an investment of $100 earning 6% with compound interest FIGURE 5.2 How an investment of $100 grows with compound interest erent interest rates invested at 10% will grow to $100 3 (1.10)10 5 $259.37. If invested at 5%, it will grow to only $100 3 (1.05)10 5 $162.89. Calculating future values is easy using almost any calculator. If you have the vestment by 1 1 r (1.06 in our example) once vestment. A simpler procedure is to use the power key (the key) on your calculator. For example, to compute (1.06)10, enter 1.06, press the key, enter 10, press 5, and discover that the answer is 1.7908. (Try this!) 116 Two Value TABLE 5.2 An example of a future value table, showing how an investment of $1 grows with compound interest If you don’t have a calculator, you can use a table of future values such as Table 5.2. Let’s use it to work out the future value of a 10-year inv row corresponding to 10 years. Now work along that row until you reach the column for a 6% interest rate. ws that $1 inv ws to $1.7908. Notice that as you move across each row in Table 5.2, the future value of a $1 investment increases, as your funds compound at a higher interest rate. As you move down any column alue also increases, as your funds compound for a lonNow try one more example. If you invest $1 for 20 years at 10% and do not withdraw any money, what will you have at the end? Y Table 5.2 gives future values for only a small selection of years and interest rates. Table A.1 at the end of the book is a bigger version of Table 5.2. It presents the future value of a $1 investment for a wide range of time periods and interest rates. Future value tables are tedious, and as Table 5.2 demonstrates, they sho alor example, suppose that you want to calculate future values using an interest rate of 7.835%. The power key on your calculator will be faster and easier than future value tables. ve is to These are introduced in the next section. ▲ EXAMPLE 5.1 Manhattan Island Almost everyone’s favorite example of the power of compound interest is the puran Island for $24 in 1626 by Peter Minuit. Based on New York real estate prices today, it seems that Minuit got a great deal. But did he? Consider the future value of that $24 if it had been invested for 385 years (2011 minus 1626) at an interest rate of 8% per year: $24 3 (1.08)385 5 $177,157,000,000,000 5 $177.16 trillion Perhaps the deal wasn’t as good as it appeared. The total value of land on Manhattan today is only a fraction of $177.16 trillion. Though entertaining, this analysis is actually somewhat misleading. The 8% interest rate we’ve used to compute future values is high by historical standards. At a 3.5% interest rate, more consistent with historical experience, the future value of the $24 would be dramatically lower, only $24 3 (1.035)385 5 $13,560,000! On the other hand, we have understated the returns to Mr. Minuit and his successors: We have ignored all the rental income that the island’s land has generated over the last three or four centuries. All things considered, if we had been around in 1626, we would have gladly paid $24 for the island. Chapter 5 117 The Time Value of Money The power of compounding is not restricted to money. Foresters try to forecast the compound growth rate of trees, demographers the compound growth rate of population. A social commentator once observed that the number of lawyers in the United States is increasing at a higher compound rate than the population as a whole (3.6% versus .9% in the 1980s) and calculated that in about two centuries there will be more lawyers than people. In all these cases, the principle is the same: Compound growth means that value increases each period by the factor (1 1 growth rate). The value after t periods will equal the initial value times (1 1 growth rate)t. When money is invested at compound interest, the growth rate is the interest rate. Self-Test 5.1 Suppose that Peter Minuit did not become the first New York real estate tycoon but instead had invested his $24 at a 5% interest rate in New Amsterdam Savings Bank. What would have been the balance in his account after 5 years? 50 years? Self-Test 5.2 In 1973 Gordon Moore, one of Intel’s founders, predicted that the number of transistors that could be placed on a single silicon chip would double every 18 months, equivalent to an annual growth of 59% (i.e., 1.591.5 5 2.0). The first microprocessor was built in 1971 and had 2,250 transistors. By 2010 Intel chips contained 2.3 billion transistors, over 1 million times the number of transistors 39 years earlier. What has been the annual compound rate of growth in processing power? How does it compare with the prediction of Moore’s law? 5.2 Present Values present value (PV) Value today of a future cash flow. Money can be invested to earn interest. If you are offered the choice between $100,000 now and $100,000 at the end of the year, you naturally take the money now to get a year’s interest. Financial managers make the same point when they say that money in hand today has a time value or when they quote perhaps the most basic financial principle: A dollar today is worth more than a dollar tomorrow. We have seen that $100 invested for 1 year at 6% will grow to a future value of 100 3 1.06 5 $106. Let’s turn this around: How much do we need to invest now in order to produce $106 at the end of the year? In other words, what is the present value (PV) of the $106 payoff? To calculate future value, we multiply today’s investment by 1 plus the interest rate, .06, or 1.06. To calculate present value, we simply reverse the process and divide the future value by 1.06: Present value 5 PV 5 $106 future value 5 5 $100 1.06 1.06 What is the present value of, say, $112.36 to be received 2 years from now? Again we ask, How much would we need to invest now to produce $112.36 after 2 years? The answer is obviously $100; we’ve already calculated that at 6% $100 grows to $112.36: $100 3 (1.06)2 5 $112.36 However, if we don’t know, or forgot the answer, we just divide future value by (1.06)2: Present value 5 PV 5 $112.36 5 $100 (1.06)2 118 Part Two Value In general, for a future value or payment t periods away, present value is Present value 5 discounted cash flow (DCF) Another term for the present value of a future cash flow. discount rate Interest rate used to compute present values of future cash flows. ▲ EXAMPLE 5.2 future value after t periods ( 1 1 r) t (5.2) To calculate present value, we discounted the future value at the interest rate r. The calculation is therefore termed a discounted cash-flow (DCF) calculation, and the interest rate r is known as the discount rate. In this chapter we will be working through a number of more or less complicated DCF calculations. All of them involve a present value, a discount rate, and one or more future cash flows. If ever a DCF problem leaves you confused and flustered, just pause and write down which of these measures you know and which one you need to calculate. Saving for a Future Purchase Suppose you need $3,000 next year to buy a new computer. The interest rate is 8% per year. How much money should you set aside now in order to pay for the purchase? Just calculate the present value at an 8% interest rate of a $3,000 payment at the end of 1 year. To the nearest dollar, this value is PV 5 $3,000 5 $2,778 1.08 Notice that $2,778 invested for 1 year at 8% will prove just enough to buy your computer: Future value 5 $2,778 3 1.08 5 $3,000 The longer the time before you must make a payment, the less you need to invest today. For example, suppose that you can postpone buying that computer until the end of 2 years. In this case we calculate the present value of the future payment by dividing $3,000 by (1.08)2: PV 5 $3,000 5 $2,572 (1.08)2 Thus you need to invest $2,778 today to provide $3,000 in 1 year but only $2,572 to provide the same $3,000 in 2 years. You now know how to calculate future and present values: To work out how much you will have in the future if you invest for t years at an interest rate r, multiply the initial investment by (1 1 r)t. To find the present value of a future payment, run the process in reverse and divide by (1 1 r)t. Present values are always calculated using compound interest. The ascending lines in Figure 5.2 showed the future value of $1 invested with compound interest. In contrast, present values decline, other things equal, when future cash payments are delayed. The longer you have to wait for money, the less it’s worth today. The descending line in Figure 5.3 shows the present value today of $100 to be received at some future date. Notice how even small variations in the interest rate can have a powerful effect on the value of distant cash flows. At an interest rate of 5%, a payment of $100 in year 20 is worth $37.69 today. If the interest rate increases to 10%, the value of the future payment falls by about 60% to $14.86. The present value formula is sometimes written differently. Instead of dividing the future payment by (1 1 r)t, we could equally well multiply it by 1/(1 1 r)t: PV 5 future payment 1 5 future payment 3 ( 1 1 r) t ( 1 1 r) t Chapter 5 The Time Value of Money 119 FIGURE 5.3 Present value of a future cash flow of $100. Notice that the longer you have to wait for your money, the less it is worth today. discount factor Present value of a $1 future payment. The expression 1/(1 1 r)t is called the discount factor. It measures the present value of $1 receiv t. The simplest w ,b managers sometimes find it convenient to use tables of discount factors. For example, Table 5.3 shows discount factors for a small range of years and interest rates. Table A.2 at the end of the book provides a set of discount f interest rates. Try using Table 5.3 to check our calculations of how much to put aside for that $3,000 computer purchase. If the interest rate is 8%, the present v PV 5 $3,000 3 1 5 $3,000 3 .9259 5 $2,778 1.08 which matches the value we obtained in Example 5.2. Table 5.3 shows that the present value of $1 paid at the end of 2 years is .8573. So the present value of $3,000 is PV 5 $3,000 3 1 5 $3,000 3 .8573 5 $2,572 (1.08)2 as we found in Example 5.2. Notice that as you move along the rows in Table 5.3, moving to higher interest rates, present values decline. As you move down the columns, moving to longer discounting periods, present v e sense?) TABLE 5.3 An example of a present value table, showing the value today of $1 received in the future 120 ▲ EXAMPLE 5.3 Part Two Value Puerto Rico Borrows Some Cash A few years ago, o Rico needed to borrow several billion dollars. It did so by selling IOUs.1 Each IOU was a promise to pa er some number of years. For example, one of those IOUs matured in 2056. The market interest rate on o Rican bonds in 2010 was 6.35%. How much would investors have been prepared to pay for that IOU? Because it matured in 46 years, we calculate its present value by multiplying the $1,000 future payment by the 46-year discount factor: PV 5 $1,000 3 1 (1.0635)46 5 $1,000 3 .0589 5 $58.90 Self-Test 5.3 ▲ EXAMPLE 5.4 Finding the Value of Free Credit Kangaroo Aut ering free credit on a $20,000 car. You pay $8,000 down and then the balance at the end of 2 years. Turtle Motors ne er free credit but will give y . If the interest rate is 10%, which compan ering the better deal? Notice that you pay more in total by buying through Kangaroo, but since part of the payment is postponed, you can keep this money in the bank where it will continue to earn interest. To compar ers, you need to calculate the present value of your payments to Kangaroo. The time line in Figure 5.4 shows the cash payments. The first payment, $8,000, takes place today. The second payment, $12,000, takes place at the end of 2 years. To find its present value, we need to multiply by the 2-year discount factor. The total present value of the payments to Kangaroo is therefore FIGURE 5.4 Drawing a time line can help us to calculate the present value of the payments to Kangaroo Autos. 1 we you. interest or coupon payment. wn as a zero-coupon bond. bonds. , bond investors receive a re as xt chapter. F I N A N C I A L CA L C U L ATO R An Introduction to Financial Calculators FV PV PV 5 $8,000 1 $12,000 3 1 (1.10)2 5 $8,000 1 $9,917.36 5 $17,917.36 Suppose you start with $17,917.36. You make a down payment of $8,000 to Kangaroo Autos and invest the balance of $9,917.36. At an interest rate of 10%, this will grow over 2 years to $9,917.36 3 1.102 5 $12,000, just enough to make the final payment on your automobile. The total cost of $17,917.36 is a better deal than the $19,000 charged by Turtle Motors. 121 SPREADSHEET SOLUTIONS Excel’s Interest Rate Functions SPREADSHEET 5.1 SPREADSHEET 5.2 Now let’s solve Example 5.2 in a spreadsheet. We can type the Excel function 5 PV(rate, nper, pmt, FV) 5 PV(.08, 2, 0, 3000), or we can select the PV function from the pull-down menu of financial functions and fill in our inputs as shown in the dialog box below. Either way, you should get an answer of 2$2,572. (Notice that you don’t type the comma in 3,000 when entering the number in the spreadsheet. If you did, Excel would interpret the entry as two different numbers, 3 followed by zero.) These calculations illustrate how important it is to use present values when comparing alternative patterns of cash payment. You should never compare cash flows occurring at different times without first discounting them to a common date. By calculating present values, we see how much cash must be set aside today to pay future bills. Calculating present and future values can entail a considerable amount of tedious arithmetic. Fortunately, financial calculators and spreadsheets are designed with present value and future value formulas already programmed. They can make your work much easier. The two nearby boxes provide a short introduction to each of these tools. Finding the Interest Rate When we looked at Puerto Rico’s IOUs in Example 5.3, we used the interest rate to compute a fair market price for each IOU. Sometimes, however, you are given the price and have to calculate the interest rate that is being offered. For example, when Puerto Rico borrowed money, it did not announce an interest rate. It simply offered to sell each IOU for $58.90. Thus we know that PV 5 $1,000 3 1 5 $58.90 (1 1 r)46 What is the interest rate? There are several ways to approach this. You might use a table of discount factors. You need to find the interest rate for which the 46-year discount factor 5 .0589. A better approach is to rearrange the equation and use your calculator: $58.90 3 (1 1 r)46 5 $1,000 $1,000 (1 1 r)46 5 5 16.978 $58.90 (1 1 r) 5 (16.978)1/46 5 1.0635 r 5 .0635, or 6.35% 123 124 Part Two Value You can also use a financial calculator or a spreadsheet to find the interest rate. The inputs would be: i ▲ EXAMPLE 5.5 Double Your Money How many times have you heard of an investment adviser who promises to double your money? Is this really an amazing feat? That depends on how long it will take for your money to double. With enough patience, your funds eventually will double even if they earn only a very modest interest rate. Suppose your investment adviser promises to double your money in 8 years. What interest rate is implicitly being promised? The adviser is promising a future value of $2 for every $1 invested today. Therefore, we find the interest rate by solving for r as follows: Future value (FV) 5 PV 3 (1 1 r)t $2 5 $1 3 (1 1 r)8 1 1 r 5 21/8 5 1.0905 r 5 .0905, or 9.05% Self-Test 5.4 5.3 Multiple Cash Flows So f , we have considered problems inv w. This is obviously limiting. Most real-world investments, after all, will involve man ws over time. y payments, you’ stream of Future Value of Multiple Cash Flows Recall the computer you hope to purchase in 2 years (see Example 5.2). Now suppose sav y each year. You might be able to put $1,200 in the bank now w much will you be able to spend on a computer in 2 years? The time line in Figure 5.5 shows how your savings grow. o cash ws into the savings plan. w will hav therefore will grow to $1,200 3 (1.08)2 5 $1,399.68, while the second deposit, which , will be inv w to $1,400 3 (1.08) 5 $1,512. these two amounts, or $2,911.68. Chapter 5 The Time Value of Money 125 FIGURE 5.5 Drawing a time line can help to calculate the future value of your savings. ▲ EXAMPLE 5.6 Even More Savings Suppose that the computer pur or an additional year and that you can make a third deposit of $1,000 at the end of the second year. How much will be available to spend 3 years from now? Again we organize our inputs using a time line as in Figure 5.6. The total cash available will be the sum of the future values of all three deposits. Notice that when we save for 3 years, the first two deposits each have an extra year for interest to compound: $1,200 3 (1.08)3 5 $1,511.65 $1,400 3 (1.08)2 5 1,632.96 $1,000 3 (1.08) 5 1,080.00 Total future value 5 $4,224.61 Our examples show that problems inv ws are simple extenw analysis. To find the value at some future date of a stream of cash flows, calculate what each cash flow will be worth at that future date and then add up these future values. As we will no calculations. FIGURE 5.6 To find the future value of a stream of cash flows, you just calculate the future value of each flow and then add them. orks for present value 126 Part Two Value Present Value of Multiple Cash Flows When we calculate the present v w would be w to w w would be w ▲ EXAMPLE 5.7 w w much that w alues. Cash Up Front versus an Installment Plan Suppose that your auto dealer gives y een paying $15,500 for a used car or entering into an installment plan where you pay $8,000 down today and make payments of $4,000 in each of the next 2 years. Which is the better deal? Before reading this chapter, you might have compared the total payments under the two plans: $15,500 versus $16,000 in the installment plan. Now, however, you know that this comparison is wrong, because it ignores the time value of money. For example, the last installment of $4,000 is less costly to you than paying out $4,000 now. The true cost of that last payment is the present value of $4,000. Assume that the interest rate you can earn on safe investments is 8%. Suppose you choose the installment plan. As the time line in Figure 5.7 illustrates, the present value of the plan’s three cash flows is: Present Value Immediate payment Second payment Third payment Total present value $8,000 5 $4,000/1.08 5 $4,000/(1.08)2 5 5 $ 8,000.00 3,703.70 3,429.36 $15,133.06 Because the present value of the three payments is less than $15,500, the installment plan is in fact the cheaper alternative. The installment plan’s present value is the amount that you would need to invest now to cover the three payments. Let’s check. Here is how your bank balance would change as you make each payment: Year Initial Balance 0 1 2 $ 15,133.06 7,703.70 4,000.00 2 Payment $ 8,000 4,000 4,000 5 Remaining Balance $ 7,133.06 3,703.70 0 1 Interest Earned $ 570.64 296.30 0 5 Balance at Year-End $ 7,703.70 4,000.00 0 If you start with the present value of $15,133.06 in the bank, you could make the first $8,000 pa er 1 year, your savings account would receive an interest payment of $7,133.06 3 .08 5 $570.64, bringing your account to $7,703.70. Similarly, you would make the second $4,000 payment and his sum left in the bank would grow with interest to $4,000, just enough to make the last payment. The present value of a stream of future cash flows is the amount you need to invest today to generate that stream. Self-Test 5.5 Chapter 5 127 The Time Value of Money FIGURE 5.7 To find the present value of a stream of cash flows, you just calculate the present value of each flow and then add them. 5.4 Level Cash Flows: Perpetuities and Annuities Frequently, you may need to v annuity Equally spaced level stream of cash flows, with a finit . perpetuity Stream of level cash payments that never ends. ws. For example, a home e equal monthly payments for the life of the loan. For a 30-year loan, this w loan might require 48 equal monthly payments. Any such sequence of equally spaced, lev ws is called an annuity. If the payment stream lasts forever, it is called a perpetuity. How to Value Perpetuities Some time ago the British gov wn as consols. ords, instead of repaying these loans, the British gov v ver). How might we v vest $100 at an interest rate of 10%. You w 3 $100 5 could withdraw this amount from your investment account each year without ev ning down your balance. In other words, a $100 investment could pro . In general, Cash payment from perpetuity 5 interest rate 3 present value C 5 r 3 PV W ve the present v interest rate r and the cash payment C: PV of perpetuity 5 cash payment C 5 r interest rate , given the (5.3) Suppose some worthy person wishes to endo versity. If the rate of interest is 10% and the aim is to provide $100,000 a year forever amount that must be set aside today is Present value of perpetuity 5 C $100,000 5 $1,000,000 5 r .10 Two w confuse the formula with the present value of a single cash payment. A payment of $1 at the end of 1 year has a present value 1/(1 1 r). alue of 1/r. These are quite different. SPREADSHEET SOLUTIONS Multiple Cash Flows www.mhhe.com/bmm7e. Spreadsheet Questions alue of a regular stream of payments w. Thus our endowment of $1 million would provide the univ w vide the univ she would need to put aside $1,100,000. Sometimes you may need to calculate the v e payments for sev or example, suppose that our philanthropist decides to provide $100,000 a year with the f w. We know that in year 3, this endo end of 1 year wment will be w r. But it is not w w. To find today’s v multiply by the 3-year discount factor. $100,000 3 Self-Test 5.6 128 1 1 1 5 $1,000,000 3 5 $751,315 3 3 r ( 1 1 r) (1.10)3 Chapter 5 129 The Time Value of Money How to Value Annuities Autos for (almost) the last time. Most installment plans call w of xt 3 years. A lev wn as an . . Figure 5.8 sho ws and calculates the present value of each year’ w assuming an interest rate of 10%. You can see that the total present value of the payments is $19,894.82. Y ways v w and finding the total. However, it is usually quick states that if the interest rate is r, then the present value of an annuity that pays C dolt for lev Present value of t annuity factor Present value of a $1 annuity. 5 CB 1 1 R 2 r r ( 1 1 r) t (5.4) The expression in brackets shows the present value of a t t-year annuity factor. Therefore, another way to alue of an annuity is Present value of t 5 payment 3 annuity factor You can use this formula to calculate the present value of the payments to Kangaroo. C r (t) is 3. Therefore, Present value 5 C B 1 1 1 1 R 5 8,000B 2 R 5 $19,894.82 2 t r r ( 1 1 r) .10 .10 (1.10)3 This is e w. If the number of periods is small, there is little to choose between the two methods, but when you are v If you are w Figure 5.9. It sho vestments. Row 1 The investment in the first row pro the end of the first year. We hav of 1/r. FIGURE 5.8 To find the value of an ann , you can calculate the value of each cash flow. It is usually quicker to use the ann ormula. 130 Part Two Value FIGURE 5.9 The value of an ann er een the v o perpetuities. Row 2 Now look at the investment shown in the second row of Figure 5.9. It also pro ut these payments don’ This stream of payments is identical to the payments in row 1, except that the v orth 1/r To alue today, we simply multiply this f actor. Thus PV 5 1 1 1 5 3 r ( ( 1 1 r) 3 r 1 1 r) 3 Row 3 Finally, look at the investment shown in the third row of Figure 5.9. This provides a lev annuity. Y en together, the investments in rows 2 and 3 provide exactly the same cash payments as the investment in row 1. Thus the value of our annuity (row 3) must be equal to the value of the ro alue of the delayed ro 5 1 1 2 r r ( 1 1 r) 3 icult as remembering other people’ valent to the difference , you shouldn’t have any dif . You can use a calculator or spreadsheet to work out annuity factors (we show you ho Table 5.4 is an abridged annuity table (an extended version is shown in Table A.3 at the end of the book). actor for an interest rate of 10%. Compare Table 5.4 with Table 5.3, which presented the present value of a single w. In both tables, present values f v ws to higher discount rates. But in contrast to those in Table 5.3, present values in Table 5.4 increase as we move do longer annuities. TABLE 5.4 An example of an ann able, showing the present value today of $1 a year received for each of t years Chapter 5 131 The Time Value of Money Self-Test 5.7 ▲ EXAMPLE 5.8 Winning Big at the Lottery In A ers from Nebraska pooled their money to buy Powerball lottery tickets and won a record $365 million. We suspect that the winners received unsolicited congratulations, good wishes, and requests for money from dozens of more or less worthy charities, relations, and newly devoted friends. In response, they could fairly point out that the prize wasn’t really worth $365 million. That sum was to be paid in 30 equal annual installments of $12.167 million each. Assuming that the first payment occurred at the end of 1 year, what was the present value of the prize? The interest rate at the time was about 6%. The present value of these payments is simply the sum of the present values of each annual payment. But rather than valuing the payments separately, it is much easier to treat them as a 30-year ann . To value this annuity, we simply multiply $12.167 million by the 30-year annuity factor: PV 5 12.167 3 30-year annuity factor 5 12.167 3 B At an interest rate of 6%, the ann B 1 1 2 R ( r r 1 1 r)30 actor is 1 1 2 R 5 13.7648 .06 .06(1.06)30 (We could also look up the ann actor in Table A.3.) The present value of the cash payments is $12.167 3 13.7648 5 $167.5 million, much less than the muchadvertised prize, but still not a bad day’s haul. L ery operators generally make arrangements for winners with big spending plans to take an equivalent lump sum. In our example the winners could either take the $365 million spread over 30 years or receive $167.5 million up front. Both arrangements have the same present value. ▲ EXAMPLE 5.9 How Much Luxury and Excitement Can $53 Billion Buy? Bill Gates is one of the world’s richest persons, with wealth in 2010 reputed to be about $53 billion. Mr. Gates has devoted a large part of his fortune to the Bill and Melinda Gates Foundation; but suppose that he decides to allocate his entire remaining wealth to a life of luxury and entertainment (L&E). What annual expenditures on L&E could $53 billion support over a 30-year period? Assume that Mr. Gates can invest his funds at 6%. The 30-year, 6% annuity factor is 13.7648. We set the present value of Mr. Gates’s spending stream equal to his total wealth: Present value 5 annual spending 3 annuity factor 53,000,000,000 5 annual spending 3 13.7648 Annual spending 5 3,850,400,000, or about 3.85 billion 132 Part Two Value Using a financial calculator or spreadsheet, the inputs would be: PMT Inputs Compute Excel 30 6 0 253000000000 3,850,392,309 =PMT(rate, nper, PV, FV) =PMT(.06, 30, -53000000000, 0) The answer is identical except for a little rounding error. Warning to Mr. Gates: We haven’t considered inflation. The cost of buying L&E will increase, so $3.85 billion won’t buy as much L&E in 30 years as it will today. More on that later. Self-Test 5.8 ▲ EXAMPLE 5.10 Home Mortgages Sometimes you may need to find the series of cash payments that would provide a given value today. For example, home purchasers typically borrow the bulk of the house price from a lender. The most common loan arrangement is a 30-year loan that is repaid in equal monthly installments. Suppose that a house costs $125,000 and that the buyer puts down 20% of the purchase price, or $25,000, in cash, borrowing the remaining $100,000 from a mortgage lender such as the local savings bank. What is the appropriate monthly mortgage payment? The borrower repays the loan by making monthly payments over the ne years (360 months). The savings bank needs to set these monthly payments so that they have a present value of $100,000. Thus Present value 5 3 360-month annuity factor 5 $100,000 Mortgage payment 5 $100,000 360-month annuity factor Suppose that the interest rate is 1% a month. Then Mortgage payment 5 $100,000 1 1 B 2 R ( .01 .01 1.01)360 5 $100,000 5 $1,028.61 97.218 amortizing loan. “ Table 5.5 illustrates a 4-year amortizing . The annual payment (annuity) that w yourself.) At the end of the f , the interest payment is 10% of $1,000, or $100. So $100 of your first payment is used to pay interest, and the remaining $215.47 is Chapter 5 The Time Value of Money 133 TABLE 5.5 An example of an amortizing loan. If you borrow $1,000 at an interest rate of 10%, you would need to make an annual payment of $315.47 over 4 years to repay the loan with interest. Next year, the outstanding balance is lower, so the interest charge is only $78.45. Therefore, $315.47 2 $78.45 5 Amortization irst, because the amount of the loan has en up in interest. This procedure continues until the last year ing balance on the loan to zero. vely paid off, the fraction of each payment devoted to interest steadily falls ov zation) steadily increases. Figure 5.10 Ev ulk of the monthly payment is interest. Self-Test 5.9 Future Value of an Annuity You are back in savings mode again. This time you are setting aside $3,000 at the end of ev . If your sa , how much will they be w at the end of 4 years? We can answer this question with the help of the time line in Figure 5.11. Y s sa FIGURE 5.10 Mortgage amortization. This figure shows the breakdown of mortgage payments between interest and amortization. Monthly payments within each year are summed, so the figure shows the annual payment on the mortgage. 134 Part Two Value FIGURE 5.11 Calculating the future value of an ordinary annuity of $3,000 a year for 4 years (interest rate 5 8%) vings in year The sum of the future values of the four payments is ($3,000 3 1.083) 1 ($3,000 3 1.082) 1 ($3,000 3 1.08) 1 $3,000 5 $13,518 But w We hav ity W v ws—an annuity. present v e value of a level ws. $3,000 in each of the ne equal to vings is w .Y The present value of this 4-year annuity is therefore PV 5 $3,000 3 1 1 2 R 5 $9,936 5 $3,000 3 B .08 .08(1.08)4 No w much you would have after 4 years if you invested $9,936 today. Simple! Just multiply by (1.08)4: Value at end of year 4 5 $9,936 3 1.084 5 $13,518 We calculated the future v alue and then multiplying by (1 1 r)t. The general formula for the future value of a stream of t years is therefore (FV) of annuity of $1 a year 5 of $1 a year 3 (1 1 r) t (1 1 r) t 2 1 1 1 t 5B 2 t R 3 (1 1 r ) 5 r r r (1 1 r) (5.5) If you need to find the future v ws as in our example, it is a toss-up whether it is quicker to calculate the future v w separately (as we did in Figure 5.11 aced with a stream ws, there is no contest. Y alue of an annuity in Table 5.6 or the more extensive Table A.4 at the end of the book. You can see that in the ro t 5 4 and the r 5 8%, the future v Therefore, the future value of the $3,000 annuity is $3,000 3 4.5061 5 $13,518. In alues. Chapter 5 135 The Time Value of Money TABLE 5.6 An example of a table showing the future value of an investment of $1 a year for each of t years ▲ EXAMPLE 5.11 Saving for Retirement In only 50 more years, you will retire. (That’s right—by the time you retire, the retirement age will be around 70 years. Longevity is not an unmixed blessing.) Have you started saving yet? Suppose you believe you will need to accumulate $500,000 by your retirement date in order to support your desired standard of living. How much savings each year would be necessary to produce $500,000 at the end of 50 years? Let’s say that the interest rate is 10% per year. You need to find how large the annuity in the following figure must be to provide a future value of $500,000: We know that if you were to save $1 each year your funds would accumulate to Future value (FV) of f $1 a year 5 (1.10)50 2 1 (1 1 r)t 2 1 5 r .10 5 $1,163.91 We need to choose C to ensure that C 3 1,163.91 5 $500,000. Thus C 5 $500,000/1,163.91 5 $429.59. This appears to be surprisingly good news. Saving $429.59 a year does not seem to be an extremely demanding savings program. Don’t celebrate yet, however. The news will get worse when we consider the impact of inflation. Self-Test 5.10 136 Part Two Value 5.5 Annuities Due annuity due Level stream of cash flows starting immediately. Remember that our annuity formulas assume that the first cash flow does not occur until the end of the first period. The present value of an annuity is the value today of a stream of payments that starts in one period. Similarly, the future value of an annuity assumes that the first cash flow comes at the end of one period. But in many cases cash payments start immediately. For example, when Kangaroo Autos (see Figure 5.8) sells you a car on credit, it may insist that the first payment be made at the time of the sale. A level stream of payments starting immediately is known as an annuity due. Figure 5.12 depicts the cash-flow streams of an ordinary annuity and an annuity due. Comparing panels a and b, you can see that each of the three cash flows in the annuity due comes one period earlier than the corresponding cash flow of the ordinary annuity. Therefore, each is discounted for one less period, and its present value increases by a factor of (1 1 r). Therefore, Present value of annuity due 5 present value of ordinary annuity 3 (1 1 r) (5.6) Figure 5.12 shows that bringing the Kangaroo loan payments forward by 1 year increases their present value from $19,894.82 (as an ordinary annuity) to $21,884.30 (as an annuity due). Notice that $21,884.30 5 $19,894.82 3 1.10. FIGURE 5.12 The cash payments on the ordinary annuity in panel a start in year 1. The first payment on the annuity due in panel b occurs immediately. The annuity due is therefore more valuable. 3-year ordinary annuity $8,000 $8,000 $8,000 1 2 3 Year 0 Present value 8,000 1.10 5 $7,272.73 8,000 (1.10)2 5 $6,611.57 8,000 (1.10)3 5 $6,010.52 Total $19,894.82 (a) 3-year annuity due $8,000 $8,000 $8,000 0 1 2 Year 3 Present value $8,000.00 8,000 1.10 5 $7,272.73 8,000 (1.10)2 5 $6,611.57 Total $21,884.30 (b) Chapter 5 137 The Time Value of Money By the way, it is easy to deal with annuities due in your calculator or spreadsheets. Your calculator will have a “begin” key, possibly labeled BEG or BGN. If you push that key ginning of each e 1 at the end of a present v the annuity as an annuity due. For example, the present value of Kangaroo Auto’s 3-year as 5PV(rate, nper, PMT, FV) 5PV(.10, 3, 8000, 0) 5 $19,894.82. For an annuity due, we w 5PV(.10, 3, 8000, 0, 1) 5 $21,884.30. Self-Test 5.11 You may also want to calculate the ev w comes immediately w stream is greater, since each w has an extra year to earn interest. For example, at an interest rate of 10%, the future value of an annuity due would be exactly 10% greater than the future value of . More generally, Future value of annuity due 5 ▲ EXAMPLE 5.12 3 ( 1 1 r) (5.7) Future Value of Annuities versus Annuities Due In Example 5.11, we showed that an annual savings stream of $429.59 invested for 50 years at 10% w vings goal of $500,000. Suppose that you put aside the same annual amounts but you invested the money at the beginning rather than the end of each year. Your savings plan now looks as follows: How much would these annual savings provide by the end of year 50? Easy. We know that the future value of an ann o the future value of an ordinary annuity 3 (1 1 r). Therefore, if you make the first of your 50 annual investments immediately, then by the end of the 50 years your retirement savings will be 10% higher, $550,000. 138 Part Two Value 5.6 Effective Annual Interest Rates Thus f v annual interest rates to v annual ws. But interest rates may be quoted for days, months, years, or any convenient interval. How should we compare rates when the periods, such as monthly v Consider your credit card. Suppose you have to pay interest on any unpaid balances at the rate of 1% per month. What is it going to cost you if you neglect to pay off your effective annual interest rate Interest rate that is annualized using compound interest. Don’t be put off because the interest rate is quoted per month rather than per year. The important thing is to maintain consistency between the interest rate and the number of periods. If the interest rate is quoted as a percent per month, then we must define the number of periods in our future value calculation as the number of months. So if w $100 from the credit card company at 1% per month for 12 months, you will need to repay $100 3 (1.01)12 5 $112.68. Thus your debt grows after 1 year to $112.68. v effective annual interest rate, or annually compounded rate, of 12.68%. In general, the effectiv money grows, allo 1 1 effective annual rate 5 (1 1 monthly rate)12 ved ov annual percentage rate (APR) Interest rate that is annualized using simple interest. ve annual rates. This comws for possible alized by multiplying the rate per period by the number of periods in a year. In fact, ws in the United States require that rates be annualized in this manner annual percentage rates (APRs).2 The interest rate on your , the APR on the loan is 12 3 1% 5 12%. If the credit card company quotes an APR of 12%, ho fective annual interest rate? The solution is simple: Step 1. Take the quoted APR and divide by the number of compounding periods in a year to recover the rate per period actually charged. In our example, the interest was calculated monthly. So we divide the interest rate per month: Monthly interest rate 5 12% APR 5 5 1% 12 12 Step 2. Now conv 1 1 effective annual rate 5 (1 1 monthly rate)12 5 (1 1 .01)12 5 1.1268 The effective annual interest rate is .1268, or 12.68%. In general, if an investment is quoted with a given m compounding periods in a year, then $1 will grow to $1 3 (1 1 APR/m)m after 1 year. The effective annual interest rate is (1 1 m)m 2 1. For example, a credit card APR of 12% b ve ective annual interest rate of (1.01)12 2 1 5 .1268, or 12.68%. To summarize: annual rate is the rate at which invested funds will grow over the course of a year. It equals the rate of interest per period compounded for the number of periods in a year. 2 small businesses. ws apply to credit card loans, auto loans, home improv Chapter 5 TABLE 5.7 139 The Time Value of Money These investments all have an APR of 6%, but the more frequently interest is compounded, the ective annual rate of interest. ▲ EXAMPLE 5.13 The Effective Interest Rates on Bank Accounts Back in the 1960s and 1970s federal regulation limited the (APR) interest rates banks could pay on savings accounts. Banks were hungry for depositors, and they searched for ways to increase the ective rate of interest that could be paid within the rules. Their solution was to keep the same APR but to calculate the interest on deposits more frequently. As interest is compounded at shorter and shorter intervals, less time passes before interest can be earned on interest. Therefore, ective annually compounded rate of interest increases. Table 5.7 shows the calculations assuming that the maximum APR that banks could pay was 6%. (Actually, it was a bit less than this, but 6% is a nice round number to use for illustration.) You can see from Table 5.7 how banks were able to incr ective interest rate simply by calculating interest at more frequent intervals. The ultimate step was to assume that interest was paid in a continuous stream rather than at fixed intervals. With 1 year’s continuous compounding, $1 grows to e APR, where e 5 2.718 (a figure that may be familiar to you as the base for natural logarithms). Thus if you deposit ered a continuously compounded rate of 6%, your investment would grow by the end of the year to (2.718).06 5 $1.061837, just a hair’s breadth more than if interest were compounded daily. Self-Test 5.12 5.7 Inflation and the Time Value of Money fers to pay 6% on a sa for ev doesn’t provide an inv you actually lose ground in terms of the goods you can buy. ut it uy. If the value of your Real versus Nominal Cash Flows inflation Rate at which prices as a whole are increasing. Textbooks may become more expensive (sorry) while computers become cheaper. An ov known as . , then goods that cost $1.00 a Chapter 5 ▲ EXAMPLE 5.14 141 The Time Value of Money The Outrageous Price of Gasoline Motorists in 2010, who were paying about $2.80 for a gallon of gasoline, may have looked back longingly to 1981, when they were paying just $1.40 a gallon. But how much had the real price of gasoline changed over this period? Let’s check. In 2010 the consumer price index was about 2.5 times its level in 1981. If the price of gasoline had risen in line with inflation, it would have cost 2.5 3 $1.40 5 $3.50 a gallon in 2010. That was the cost of gasoline in 1981 but measured in terms of 2010 dollars rather than 1981 dollars. Thus over this time period the real price of gasoline actually declined 20%, from $3.50 a gallon to $2.80. Self-Test 5.13 Consider a telephone call to London that currently would cost $5. If the real price of telephone calls does not change in the future, how much will it cost you to make a call to London in 50 years if the inflation rate is 5% (roughly its average over the past 30 years)? What if inflation is 10%? Economists sometimes talk about current or nominal dollars versus constant or real dollars. Current or nominal dollars refer to the actual number of dollars of the day; constant or real dollars refer to the amount of purchasing power. Some expenditures are fixed in nominal terms and therefore decline in real terms when the CPI increases. Suppose you took out a 30-year house mortgage in 1990. The monthly payment was $800. It was still $800 in 2010, even though the CPI increased by a factor of 1.64 over those years (219.2/133.8 5 1.64). What’s the monthly payment for 2010 expressed in real 1990 dollars? The answer is $800/1.64, or $488 per month. The real burden of paying the mortgage was much less in 2010 than in 1990. Self-Test 5.14 If a family spent $250 a week on their typical purchases in 1950, how much would those purchases have cost in 1980? If your salary in 1980 was $30,000 a year, what would be the real value of that salary in terms of 1950 dollars? Use the data in Table 5.8. Inflation and Interest Rates nominal interest rate Rate at which money invested grows. Whenever anyone quotes an interest rate, you can be fairly sure that it is a nominal, not a real, rate. It sets the actual number of dollars you will be paid with no offset for future inflation. If you deposit $1,000 in the bank at a nominal interest rate of 6%, you will have $1,060 at the end of the year. But this does not mean you are 6% better off. Suppose that the inflation rate during the year is also 6%. Then the goods that cost $1,000 last year will now cost $1,000 3 1.06 5 $1,060, so you’ve gained nothing: Real future value of investment 5 5 $1,000 3 (1 1 nominal interest rate) (1 1 inflation rate) $1,000 3 1.06 5 $1,000 1.06 142 Two real interest rate Rate at which the purchasing power of an investment increases. Value In this example, the nominal rate of interest is 6%, but the real interest rate is zero. The real rate of interest is calculated by 1 1 real interest rate 5 1 1 nominal interest rate 11 (5.8) In our e 1.06 51 1.06 Real interest rate 5 0 1 1 real interest rate 5 What if the nominal interest rate is 6% b the real interest rate is 1.06/1.02 2 1 5 of bread is $1, so that $1,000 would buy 1,000 loaves today. If you invest that $1,000 ve $1,060 at the end of the year. However, if the price of loav y will buy you 1,060/1.02 5 1,039 loaves. The real rate of interest is 3.9%. Self-Test 5.15 Here is a useful approximation. The real rate approximately equals the difference 5 Real interest rate < nominal interest rate 2 (5.9) Our e rate of 3.9%. If we round to 4%, the approximation gives the same answer: Real interest rate < nominal interest rate 2 < 6 2 2 5 4% The approximation w When they are not small, throw the approximation away and do it right. ▲ EXAMPLE 5.15 Real and Nominal Rates In the United States in mid-2010, long-term high-grade corporat yield of about 5.1%. If inflation is expected to be about 1%, the real yield is 1 1 real interest rate 5 ered a 1 1 nominal interest rate 1.051 5 5 1.0406 1 1 inflation rate 1.01 Real interest rate 5 .0406, or 4.06% The approximation rule gives a similar value of 5.1 2 1.0 5 4.1%. But the approximation would not have worked in the German hyperinflation of 1922–1923, when the inflation rate was well over 100% per month (at one point you needed 1 million marks to mail a letter), or in Zimbabwe in November 2008, when prices rose an average of 98% per day. 5 The squiggle (≈) means “approximately equal to.” Chapter 5 143 The Time Value of Money Valuing Real Cash Payments w to v learned how to v est rate. For e w much do you need to invest now to produce $100 in a year’s time? Easy! Calculate the present value of $100 by discounting by 10%: PV 5 $100 5 $90.91 1.10 You get exactly the same result if you discount the real payment by the real interest rate. For example, assume that you e ver the ne . The real value of that $100 is therefore only $100/1.07 5 $93.46. In one year’s time your $100 will buy only as much as $93.46 today. interest is only about 3%. We can calculate it exactly from the formula 11 11 Real interest rate 5 .028, or 2.8% 1 1 real interest rate 5 5 1.10 5 1.028 1.07 If we now discount the $93.46 real payment by the 2.8% real interest rate, we have a present value of $90.91, just as before: PV 5 $93.46 5 $90.91 1.028 The two methods should always give the same answer. Remember: Current dollar cash flows must be discounted by the nominal interest rate; real cash flows must be discounted by the real interest rate. ws) is an unforgiv ws and real discount rates (or real rates and nominal w man Self-Test 5.16 ▲ EXAMPLE 5.16 How Inflation Might Affect Bill Gates We showed earlier (Example 5.9) that at an interest rate of 6% Bill Gates could, if he wished, turn his $53 billion wealth into a 30-year ann ear of luxury and excitement (L&E). Unfortunately, L&E expenses inflate just like gasoline and groceries. Thus Mr. Gates would find the purchasing power of that $3.85 billion steadily declining. If he wants the same luxuries in 2040 as in 2010, he’ll have to spend less in 2010 and then increase expenditures in line with inflation. How much should he spend in 2010? Assume the long-run inflation rate is 3%. Mr. Gates needs to calculate a 30-year real annuity. The real interest rat less than 3%: 1 1 real interest rate 5 1 1 nominal interest rate 1 1 inflation rate 5 1.06 5 1.029 1.03 144 Two Value so the real rate is 2.9%. The 30-year ann actor at 2.9% is 19.8562. Therefore, annual spending (in 2010 dollars) should be chosen so that $53,000,000,000 5 annual spending 3 19.8562 Annual spending 5 $2,669,000,000 Mr. Gates could spend that amount on L&E in 1 year’s time and 3% more (in line with inflation) in each subsequent year. This is only about 70% of the value we calculated when we ignored inflation. Life has many disappointments, even for . Self-Test 5.17 Real or Nominal? Any present value calculation done in nominal terms can also be done in real terms, and vice v nominal rates. However ws are easier to deal with. In our example of Bill Gates, the real e ed. In this case, it was w stream is fixed in nominal terms (for example, the payments on a loan), it is easiest to use all nominal quantities. SUMMARY www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISES www.smartmoney.com www.smartmoney.com www.bloomberg.com SOLUTIONS TO SELF-TEST QUESTIONS i www.mhhe.com/bmm7e www.bls.gov/cpi/home.htm PMT PMT www.mhhe.com/bmm7e www.mhhe.com/bmm7e SOLUTIONS TO SPREADSHEET QUESTIONS www.mhhe.com/bmm7e MINICASE CHAPTER 6 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T T W O Value I Bondholders once received a beautifully engraved certificate like this one issued by a railroad. 6.1 The Bond Market bond Security that obligates the issuer to make specified payments to the bondholder. Gov w money by selling bonds to investors. The market for these bonds is huge. In 2011 public holdings of U.S. gov 1 Companies also raise v ge sums of money by selling bonds. For e wed $17 billion by an issue of bonds. The market for bonds is sophisticated and active. Bond traders frequently make massive trades motivated by tin v e. For e ed interest payment, b may go up or do v w for only a fe ve been a few occasions when bonds hav Bond Characteristics face value Pa of the bond. Also called principal or par value. coupon The interest payments paid to the bondholder. In May 2003 the U.S. gov Treasury bond. It auctioned off to investors $18 billion of 3.625% bonds maturing in 2013. The bonds have a face value principal or par value matures, the bondholder receives an interest payment of 3.625% of the face value, or $36.25. This 3.625% interest payment is called the bond’s coupon. In the old days, most bonds used to hav v claim their payment. When the 3.625% coupon bond matures in 2013, the government must pay the $1,000 face v ferent T buy and sell each of these bonds are sho Web. Table 6.1, which is compiled from The Wall Street Journal’s Web page, shows May 2013 is highlighted. Thus for the 3.625% bond, the asked price vestors need to pay to buy the bond—is shown as 107:01. ace value. Therefore, each bond costs $1,070.3125. An investor who already owns the bond and wishes to sell it would receiv bid price, which is shown as 106:31. Just as the used-car dealer earns a li them, so the bond dealer needs to charge a spread between the bid and the asked price. Notice that the spread for these 3.625% bonds is only 2/32, or about .06% of the bond’s value. Don’ ws the ask . This measures the vestors if they buy the bond at the ask 2013. Y T 1.23%. We will e w this figure was calculated. Self-Test 6.1 1 160 T Chapter 6 161 Valuing Bonds TABLE 6.1 Sample Treasury bond quotes for May 14, 2010 Source: The Wall Street Journal Web site, .wsj.com. FIGURE 6.1 Cash flows to an investor in the 3.625% coupon bond maturing in the year 2013 Y t buy T xchange. Instead, the netw y are prepared to buy and sell. For example, suppose that in 2010 you decide to buy the “3.625s of 2013,” that is, the 3.625% coupon bonds maturing in 2013. You approach a broker who your broker will contact a bond dealer and the trade is done. If you plan to hold your bond until maturity, you can look forw ws shown in Figure 6.1. F payment. Then, when the bond matures in 2013, you receive the $1,000 face value of Self-Test 6.2 6.2 Interest Rates and Bond Prices In Figure 6.1 the bond is the present v ws from your 3.625% Treasury bond. The value of ws. To find this value, you need to dis- The 3.625s were not the only Treasury bonds that matured in 2013. Almost identical bonds maturing at the same time of ould have been willing to hold them. Equally, if they had offered a higher v ould hav 162 Part Two Value their other bonds and buy the 3.625s. In other words, if investors were on their toes, the 3.625s had to offer the same 1.25% rate of interest as similar T You v discussed in Chapter 1. This is the rate that inv in similar securities rather than in this bond. We can now calculate the present value of the 3.625s of 2013 by discounting the ws at 1.25%: $1,036.25 $36.25 $36.25 1 1 ( 1 1 r) ( 1 1 r) 2 ( 1 1 r) 3 $36.25 $1,036.25 $36.25 5 1 5 $1,069.51 1 (1.0125) (1.0125)2 (1.0125)3 PV 5 Bond prices are usually expressed as a percentage of their face value. Thus we can say that your 3.625% Treasury bond is worth 106.951% of face value.2 Did you notice that your bond is like a package of two investments? vides a level stream of coupon payments of $36.25 a year for each of 3 years. The ace value. Therefore, you can use alue the coupon payments and then add on the present value of the final payment of face value: PV 5 PV(coupons) 1 PV(face value) 5 (coupon 3 annuity factor) 1 (face value 3 discount factor) (6.1) 1 1 1 2 R 1 1,000 3 3 ( ) .0125 .0125 1.0125 1.01253 5 $106.09 1 $963.42 5 $1,069.51 5 $36.25 3 B If you need to v , it is usually easiest to value the coupon payments as an annuity and then add on the present value of the Self-Test 6.3 Y The trick is to recognize that the bond provides its owner both (the coupons) and w (the face value). For this bond, the ace value is $1,000. The interest rate is 1.25%. Therefore, the inputs would be PV Inputs Compute 3 1.25 36.25 1000 21069.51 Now compute PV, and you should get an answer of 21069.51, which is the initial cash w required to purchase the bond. F 2 alue of $1,069.51 (106.951%) is a little lo Table 6.1. We discounted at 1.25%, which is rounded up slightly from the ask Also, the bond’ , but $18.125 ev show ho xt example, we’ll Chapter 6 ▲ EXAMPLE 6.1 163 Valuing Bonds Bond Prices and Semiannual Coupon Payments When we valued our Treasury bond, we assumed that interest payments occur annually. This is the case for bonds in many European countries, but in the United States most bonds make coupon payments semiannually. So when you hear that a bond in the United States has a coupon rate of 3.625%, you can generally assume that the bond makes a payment of $36.25/2 5 $18.125 every 6 months. Similarly, when investors in the United States refer to the bond’s interest rate, they usually mean the semiannually compounded interest rate. Thus an interest rate quoted at 1.25% really means that the 6-month rate is 1.25/2 5 .625%.3 The actual cash flows on the Treasury bond are illustrated in Figure 6.2. To value the bond a bit more precisely, we should have discounted the series of semiannual payments by the semiannual rate of interest as follows: PV 5 1 $18.125 $18.125 $18.125 $18.125 1 1 1 (1.00625) (1.00625)4 (1.00625)2 (1.00625)3 $18.125 $1,018.125 1 (1.00625)5 (1.00625)6 5 $1,069.72 Thus, once we allow for the fact that coupon payments are semiannual, the value of the 3.625s is 106.972% of face value, which is slightly higher than the value that we obtained when we assumed annual coupon payments.4 Since semiannual coupon payments just add to the arithmetic, we will stick for the most part to our simplification and assume annual interest payments. How Bond Prices Vary with Interest Rates Figure 6.3 T ho or example, interest rates climbed steeply after 1979 when the Federal Reserve instituted a policy of tight mone W v this with 2008, when nervous inv v T or e vestors demanded an interest rate of 3.625% on 3-year T What would be the price of the T rate of r 5 .03625: PV at 3.625% 5 $1,036.25 $36.25 $36.25 1 5 $1,000.00 1 (1.03625) (1.03625)2 (1.03625)3 the bond sells for its face value. 3 You may hav s APR, vestors. To find the effective rate, we can use a formula that we presented in Section 5.6: Effective annual rate 5 ¢ 1 1 where m is the number of payments each year E 5 ¢1 1 4 payment is receiv received earlier, its present value is higher. 2 m APR ≤ 21 m T .0125 ≤ 2 1 5 1.006252 2 1 5 .01254, or 1.254% 2 164 Part Two Value FIGURE 6.2 Cash flows to an investor in the 3.625% coupon bond maturing in 2013. The bond pays semiannual coupons, so there ar o payments of $18.125 each year. FIGURE 6.3 The interest rate on 10-year U.S. Treasury bonds, 1900-2010 W alued the Treasury bond using an interest rate of 1.25%, which is lower than the coupon rate. In that case the price of the bond was higher than its face value. We then valued it using an interest rate that is equal to the coupon and found that bond price equaled face value. You hav ws are discounted at a rate that is higher than the bond’s coupon rate, the bond is w less than its face value. The following e ▲ EXAMPLE 6.2 Interest Rates and Bond Prices Investors will pay $1,000 for a 3.625%, 3-year Treasury bond when the interest rate is 3.625%. Suppose that the interest rate is higher than the coupon rate at (say) 8%. Now what is the value of the bond? Simple! We just repeat our calculation but with r 5 .08: PV at 8% 5 $36.25 $36.25 $1,036.25 1 1 5 $887.25 (1.08) (1.08)2 (1.08)3 The bond sells for 88.725% of face value. This is a general result. When the market interest rate exceeds the coupon rate, bonds sell for less than face value. When the market interest rate is below the coupon rate, bonds sell for more than face value. Chapter 6 Valuing Bonds 165 FIGURE 6.4 The value of the 3.625% bond falls as interest rates rise. ws, bond investors appear disconsolate. Why? Don’t they lik , look at Figure 6.4, which shows the present value of the 3.625% Treasury bond for or example, imagine yields soar from 1.25% to 8%. Our bond would then be w versely, bondholders hav et interest rates fall. You can see this also from Figure 6.4. For instance, if interest rates fall to .5%, the value of our 3.625% bond would increase to $1,092.82. Figure 6.4 illustrates a fundamental relationship between interest rates and bond prices: When the interest rate rises, the present value of the payments to be received by the bondholder falls and bond prices fall. Conversely, a decline in the interest rate increases the present value of those payments and results in a higher price. Aw coupon rate Annual interest payment as a percentage of face value. payment on the bond interest rate vestors require. The $36.25 coupon payments on our T when the bond is issued. The coupon rate, 3.625%, measures the coupon payment ($36.25) as a percentage of the bond’s face v ed. However, the interest rate changes from day to day. These c ect the present value of the coupon payments but not the payments themselves. Interest Rate Risk interest rate risk The risk in bond prices due to fluctuations in interest rates. We hav ords, bonds exhibit interest rate risk. Bond inv et interest rates will f y are unlucky and the market interest rate rises, the value of their investment falls. A change in interest rates has only a modest impact on the value of near-term cash ws but a much greater impact on the v ws. Therefore any or e es in Figure 6.5. The green line shows how the v , 3.625% coupon bond varies with the interest rate. The blue line shows how the price of a 30-year, 3.625% bond varies. You can see that the 30-year bond is more sensitiv This should bad deal—you could have got a better interest rate if you had waited. However how much worse it would be if the loan had been for 30 years rather than 3 years. The 166 Two Value FIGURE 6.5 Plot of bond prices as a function of the interest rate. The price of long-term bonds is more sensitive to changes in the interest rate than is the price of short-term bonds. v w interest rate. This shows up in a bigger decline in the price of the longer-term bond. Of Figure 6.5. interest rates fall, the longer Self-Test 6.4 6.3 Yield to Maturity Your investment adviser quotes a price for the bond. How do you calculate the rate of return the bond offers? For bonds priced at face value the answer is easy. rate. W ws on your investment: Cash Paid to You in Year: You Pay $1,000 1 2 3 Rate of Return $100 $100 $1,100 10% y ($100/$1,000). In the final year vestment of $1,000. 10%, the same as the coupon rate. No et price of the 3-year bond is $1,136.16. Y are as follows: Cash Paid to You in Year: You Pay 1 2 3 Rate of Return $1,136.16 $100 $100 $1,100 ? ws Chapter 6 167 Valuing Bonds Notice that you are paying out $1,136.16 and receiving an annual income of $100. So 5 .088, or 8.8%. This is sometimes called the bond’s current yield. However, your total y capital gains or losses. v bond’s price must fall. The price today is $1,136.16, but when the bond matures 3 years from now, the bond will sell for its face value, or $1,000. capital loss) of $136.16 is guaranteed, so the overall return over the ne current yield Annual coupon payments divided by bond price. Let us generalize. A bond that is priced above its face value is said to sell at a premium. Investors who b ver the life of the bond, so the return on these bonds is alw A bond w face value sells at a discount. Investors in discount bonds face a capital gain ov greater Because it focuses only on current income and ignores prospective price increases or decreases, the current yield does not measure the bond’s total rate of return. It overstates the return of premium bonds and understates that of discount bonds. yield to maturity Interest rate for which the present value of the bond’s payments equals the price. W change in a bond’s value over its life. The standard measure is called yield to maturity. wing question: At what interest rate The yield to matur ined as the discount w rate that makes the present value of the bond’s payments equal to its price. If you can buy the 3-year bond at face v rate, 10%. W the present value of the bond is equal to its $1,000 face value: PV at 10% 5 ws at 10%, $1,100 $100 $100 1 5 $1,000.00 1 2 (1.10) (1.10) (1.10)3 But suppose the price of the 3-year bond is $1,136.16. In this case the yield to At that discount rate, the bond’s present value equals its actual et price, $1,136.16: PV at 5% 5 ▲ EXAMPLE 6.3 $100 $1,100 $100 1 5 $1,136.16 1 (1.05) (1.05)2 (1.05)3 Calculating Yield to Maturity for the Treasury Bond We found the value of the 3.625% coupon Treasury bond by discounting at a 1.25% interest rate. We could have phrased the question the other way around: If the price of the bond is $1,069.51, what is the bond’s yield to maturity? To calculate the yield, we need to find the discount rate r that solves the following equation: Price 5 $36.25 $36.25 $1,036.25 1 1 5 $1,069.51 (1 1 r) (1 1 r)2 (1 1 r)3 To compute the yield to maturity, most people use either a financial calculator or a spreadsheet. For this bond, the inputs would be: i Inputs Compute 3 21069.51 36.25 1.25 Now compute i, and you should get an answer of 1.25%. 1000 168 Part Two Value income and capital gain. If you buy the bond today and hold it to maturity . Bond investors often refer loosely to a bond’s “yield.” It’s a safe bet that the The only general . You s payments. If the present v ve been too low, so wer PV). Conversely, if PV ▲ EXAMPLE 6.4 Yield to Maturity with Semiannual Coupon Payments Let’s redo Example 6.3, but this time we recognize that the coupons are paid semiannually. Instead of three annual coupon payments of $36.25, the bond makes six semiannual payments of $18.125. Therefore, we can find the semiannual yield to maturity as follows: i Inputs Compute 6 21069.51 18.125 1000 .6284 This yield t , of course, is a 6-month, not an annual, rate. Bond dealers w ualize the semiannual rate by doubling it, so the yield to maturity would be quoted as .628 3 2 5 1.256%. The nearby box shows how to use spreadsheets to find bond prices and yields. Self-Test 6.5 6.4 Bond Rates of Return The yield to maturity is defined as the discount rate that equates the bond’ present v . However, as interest yield to maturity your bond will f rity. Conversely, if rates f higher. This is emphasized in the following example. ▲ EXAMPLE 6.5 , the price of wer than the yield to matu- Rate of Return versus Yield to Maturity On May 15, 2008, the U.S. Treasury sold $9 billion of 4.375% bonds maturing in February 2038. The bonds wer ered a yield to Chapter 6 rate of return Total income per period per dollar invested. 169 Valuing Bonds maturity of 4.60%. This was the return to anyone buying at the issue price and holding the bonds t . In the months following the issue the financial crisis reached its peak. Lehman Brothers filed for bankruptcy with assets of $691 billion, and the government poured money into rescuing Fannie Mae, Freddie Mac, AIG, and a host of banks. As investors rushed to the safety of Treasury bonds, their prices soared. By mid-December the price of the 4.375s of 2038 had reached 138.05% of face value and the yield had fallen to 2.5%. Anyone fortunate enough to have bought the bond at the issue price would have made a capital gain of $1,380.50 2 $963.80 5 $416.70. In addition, on August 15 the bond made its first coupon payment of $21.875 (this is the semiannual payment on the 4.375% coupon bond with a face value of $1,000). Our lucky investor would therefore have earned a 7-month rate of return of 45.5%: Rate of return 5 5 coupon income 1 price change investment $21.875 1 $416.70 5 .455 5 45.5% $963.80 Suddenly, government bonds did not seem quite so boring as before. Self-Test 6.6 Is there any a particular period? Yes: If the bond’s yield to maturity remains unchanged during the period, the bond price changes with time so that the total return on the bond is equal to the yield to maturity. rates fall. Self-Test 6.7 The solid curve in Figure 6.6 ov , 6% coupon bond The ace value. In e in Figure 6.6 sho bond with a 2% coupon that sells at a discount to face v income would pro v w face v ace value, however, and the price gain each et interest rate. SPREADSHEET SOLUTIONS Bond Valuation FIGURE 6.6 How bond prices change as they approach maturity, assuming an unchanged yield. Prices of both premium and discount bonds approach face value as their matur date approaches. 170 6.5 The Yield Curve yield curve Plot of relationship between bond yields to o . When you buy a bond, you b ment of face value. But sometimes it is inconvenient to buy things in packages. For example, perhaps you do not need a regular income and would prefer to buy just the final repayment. That’s not a problem. The T es a single payment. These single-payment bonds are called strips. wn re Web. For example, in May 2010 it would have cost you $962.67 to buy a strip that just paid out $1,000 in May 2013. as 1.28%. In other words, $962.67 3 1.01283 5 $1,000. Bond investors often draw a plot of the relationship between bond yields and matu. This is known as the yield curve. T vide a convenient way to measure this yield curve. For example, if you look at Figure 6.7, you will see that in vided a yield of about 4.6%. In this case, the yield curve sloped 171 172 Part Two Value FIGURE 6.7 Treasury strips are bonds that make a single payment. The yields on Tr ips in May 2010 show that investors received a higher yield on longer-term bonds. upw 5 fer lower e slopes downward. But that raises a question. If long-term bonds offered much higher yields, why didn’t everyone buy them? Who were the (foolish?) investors who put their money T w yields? Even when the yield curve is upward-sloping, inv way from long-term bonds for tw We saw in Figure 6.5 prices are more sensitive to shifting interest rates. vestors don’t lik y will inv y receive a v w, when the bond matures, you can reinvest the proceeds and enjoy whatever rates the bond market offers then. These rates may be high enough to of s relatively lo Thus you often see an upw Self-Test 6.8 Nominal and Real Rates of Interest T v v v y will b or e ,b The real w what T ws: 11 11 Real interest rate 5 .0385 5 3.85% 1 1 real interest rate 5 5 ages. For e 5 1.08 5 1.0385 1.04 v Table 6.1 . Chapter 6 173 Valuing Bonds T You can nail down a real rate of interest by b xed bond, whose payxed bonds have been av many years, but the wn in the United States until 1997 when the U.S. Treasury be x wn as Tr ws on ed, but the nominal Protected Securities, or TIPS.6 x increases. For example, suppose the U.S. T TIPS. The real cash Year 1 Year 2 $30 $1,030 Real cash flows The nominal ws on or example, suppose Then the nominal cash ws would be: Nominal cash flows Year 1 Year 2 $30 3 1.05 5 $31.50 $1,030 3 1.05 3 1.04 5 $1,124.76 real vestment will allow you to buy. T The 1.2% real yield on v v Real interest rates depend on the supply of savings and the demand for new investment. As this supply-demand balance changes, real interest rates change. But they do so gradually. W v ment has issued indexed bonds since 1982. The red line in Figure 6.8 shows that the v w range. FIGURE 6.8 om line shows the real yield on longterm indexed bonds issued by the U.K. government. The top line shows the yield on U.K. government long-term nominal bonds. Notice that the real yield has been much more stable than the nominal yield. 6 x Rev or e ve b x -sev sw .” 174 Part Two Value Suppose that investors revise upw w will this affect interest rates? If investors are concerned about the purchasing power of their money fect the real rate of interest. The nominal interest rate must therefore rise by 1% to compensate inv prospects. The blue line in Figure 6.8 sho dom since 1985. You can see that the nominal rate is much more variable than the real rate. For e vestors were w as about 7 percentage points above the real rate. Notice how low the real interest rate has been recently. By the fall of 2010 the yield on index bonds had fallen below zero. 6.6 Corporate Bonds and the Risk of Default ar has been on U.S. T v the only issuer of bonds. State and local gov w by selling bonds.7 So do y foreign gov w in the United States. issuing their bonds in other countries. For example, they may issue dollar bonds in London that are then sold to investors throughout the world. default (or credit) risk The risk that a bond issuer may default on its bonds. default premium The additional yield on a bond that investors require for bearing credit risk. investment grade Bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s. junk bond Bond with a rating below Baa or BBB. issued by the U.S. Treasury. National governments don’ y just print T ault on its more money.8 So investors rarely w bonds. However inancial dif ties and may default on their bonds. v ws, but in hard times it may pay less. The risk that a bond issuer may default on its obligations is called default risk (or credit risk). Companies need to compensate for this def rate of interest on their bonds. T called the default premium. The greater the chance that the company will get into trouble, the higher the def vestors. vided by Moody’s, Standard & Poor’ Table 6.2 lists the possible bond ratings in declining order of quality. For example, the bonds that receive the highest Moody’ wn as Aaa (or “triple A”) bonds. Then come Aa (“double A”), A, Baa bonds, and so on. Bonds rated Baa and above are called investment grade, while those with a rating of Ba or belo speculative grade, high-yield, or junk bonds.9 Table 6.2 shows how the chances of default v You can see that it is ault. For e bonds have def wever vestment-grade bond 7 municipal bonds enjoy a special tax adv vestors are ex coupon payments on state and local gov As a result, inv wer yields on this debt. 8 But the Therefore, when a foreign gov vestors w vernment may not be able to come up with enough dollars to repay the debt. This w vestors demand on such debt. For example, in 2002, the gentine government defaulted on over $100 billion of debt. In Chapter 2 we saw also ho v s indebtedness caused investors to w v ault on their wings. 9 or example, the most secure A-rated bonds would be rated A1 by Moody’ A1 by Standard & Poor’s. The least secure bonds in this risk class would be rated A3 by Moody’ A2 s. Chapter 6 175 Valuing Bonds TABLE 6.2 Key to Moody’s and Standard & Poor’s bond r bonds are rated triple A, then come double-A bonds, and so on. is do 2001 W e v def Table 6.3 sho most hea aults, the shock waves can be considerable. For example, in May vestment-grade rating. W W y vestment. For low-grade issues, def or s at issue have 10 T you would e T As You can alls off. Investors also prefer liquid bonds that the v uy and sell. So additionally fer lower yields et for vestors found it almost impossible to sell their holdings. Figure 6.9 sho Treasuries since or example, as w TABLE 6.3 Prices and yields of a sample of heavily traded corporate bonds, June 1, 2010 Source: 10 Rating T .wsj.com. s, “Default, T v ” www.standardandpoors.com. FINANCE IN PRACTICE Insuring against Default 6% above the yield on T You might have been tempted by the higher promised yields on the lower-grade bonds. But remember, these bonds do not always keep their promises. By the way ault. xplains how. FIGURE 6.9 Yield spreads een corporate and ear Treasury bonds 176 Chapter 6 ▲ EXAMPLE 6.6 Valuing Bonds 177 Promised versus Expected Yield to Maturity Bad Bet Inc. issued bonds several years ago with a coupon rate (paid annually) of 10% and face value of $1,000. The bonds are due to mature in 6 years. However, the firm is currently in bankruptcy proceedings, the firm has ceased to pay interest, and the bonds sell for only $200. Based on promised cash flow, the yield to maturity on the bond is 63.9%. (On your calculator, set PV 5 2200, FV 5 1,000, PMT 5 100, n 5 6, and compute i.) But this calculation is based on the very unlikely possibility that the firm will resume paying interest and come out of bankruptcy. Suppose that the most lik er 3 years of litigation, during which no interest will be paid, debtholders will receive 27 cents on the dollar—that is, they will receive $270 for each bond with $1,000 face value. In this case the expected return on the bond is 10.5%. (On your calculator, set PV 5 2200, FV 5 270, PMT 5 0, n 5 3, and compute i.) When default is a real possibility, the promised yield can depart considerably from the expected return. Variations in Corporate Bonds T chapter. In other words, the , at which point they also promise to repay the face value. However W ut here are a fe that you may encounter. Zero-Coupon Bonds Corporations sometimes issue zero-coupon bonds. In this case, investors receive $1,000 face value at the maturity date but do not receive a regular coupon payment. In other words, the bond has a coupon rate of zero. The bonds are like T The w face value, and the investor’s return comes from the difference between the purchase price and the payment of face v . Floating-Rate Bonds e et rates. Treasury rate plus 2%. So if the T coupon rate ov coupon rate always approximates current market interest rates. ver time. For s s Conver tible Bonds If you buy a convertible bond, you can choose later to exchange it for a specified number of shares of common stock. For example, a convertible bond that is issued at face value of $1,000 may be conv s stock. Because conv y price appreciation of the company’s stock, investors will accept lower interest rates on convertible bonds. Bond issuers are alw vise new types of bonds that they hope will vestors. Just to giv vor of the inventiveness of f xample of one innovative bond. Managers of life insurance companies agonize about the possibility of a pandemic insurance company €350 million of Axa’s bonds offered a tempting yield, but the bondholders will lose their entire investment if death rates for 2 consecutive years are 10% or more above expectations. www.mhhe.com/bmm7e SUMMARY L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISES www.investopedia.com www.wsj.com finance.yahoo. com www.federalreserve.gov www.mhhe.com/bmm7e SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e CHAPTER 7 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T T W O Value Share prices on the New York Stock Exchange. A 186 Part Two Value 7.1 Stocks and the Stock Market common stock Ownership shares in a publicly held corporation. initial public offering (IPO) ering of stock to the general public. primary offering The corporation sells shares in the firm. primary market Market for the sale of new securities by corporations. secondary market Market in which previously issued securities are traded among investors. In Chapter 1 we saw how FedEx was founded and how it grew and prospered. To fund this growth, FedEx needed capital. Initially, that capital came lar wing, but in 1978 FedEx sold shares of common stock Those inv initial public or IPO, owners of the b y shared in the company’s future successes and setbacks.1 A company’s initial public of raised more capital by selling additional shares. y primary offerings primary market. Owning shares is a risky occupation. For e the misfortune to b vie company RHI Entertainment, you would have lost 95% of your money by the year-end. You can understand, therefore, why investors would be reluctant to b y y forever ge companies xchange so that investors can trade shares among themselves. Exchanges are really markets for secondhand stocks, but they prefer to describe themselves as secondary markets, which sounds more important. The two principal stock markets in the United States are the New York Stock y computer networks ASDAQ.2 called electr that connect traders with each other. All of these markets compete vigorously for the business of traders and just as vigorously tout the advantages of their own trading venue. The volume of trades in these mark or example, ev et value exceeding $70 billion. xchanges in man y, such as the Dar es Salaam exchange in Tanzania, which trades shares in just 10 companies. Others, such as the London, T xt exchanges, , no longer wishes to hold y. She can sell them via a stock exchange to Mr. Brown, who wishes to increase his stake in the f wnership of the f vestor to another. No ne usually will neither care nor even be aw en place.3 Ms. Jones and Mr. Brown do not b es. Instead, each must hire a brokerage f vile transaction for them. Not so long ago, such trades would have involved hands-on negotiation. The broker would hav in the stock or would hav xchange where a specialist in FedEx would have coordinated the transaction. But today the vast majority of trades are executed automatically and electronically, even on the more traditional exchanges. When Ms. Jones and Mr. Brown decide to buy or sell FedEx stock, they need to give their brok y are prepared to transact. , might give her broker a market order to sell 1 We use the terms “shares,” “stock, ” 2 as an acron now is simply known as the NASDAQ market. 3 Ev , FedEx must know to whom it should send dividend checks, b example, if a large investor is b , as we do “shareholders” and Automated Quotation system, but Chapter 7 187 Valuing Stocks FIGURE 7.1 A portion of the limit order book for Federal Express from the NYSE/ Archipelago exchange stock at the best av . Brown might give his broker a price limit at which he is willing to b xecuted , it is recorded in the exchange’s limit order book until it can be executed. Figure 7.1 shows a portion of the limit order book for FedEx from the Archipelet run by the NYSE. The bid prices on the left are the prices (and numbers of shares) at which investors are willing to buy. The Ask column presents offers to sell. The prices are arranged from best to worst, so the highest bids and lowest asks are at the top of the list. The broker might electronically enter Ms. Jones’ et order to sell 100 shares on the Archipelago Exchange, where it would be automatically matched or crossed with the best offer to buy, which at that moment was $83.23 a share. Similarly, a market order to buy would be crossed with the best ask price, $83.27. The bid-ask spread at that moment was therefore 4 cents per share. Reading Stock Market Listings Until recently, you probably would have look The Wall Street Journal wspaper. But those pages contain less and less information about individual stocks, and most inv or example, if you go to finance.yahoo.com, enter FedEx’s ticker symbol, FDX, and ask to “Get Quotes,” you will find recent trading data such as that presented in Figure 7.2.4 August 3 was $83.75 per share, which was $.85 lower than its closing price the previous day, $84.60. The range of , as well as over the previous 52 weeks, is proY v volume over the last 3 months was 3,821,760 shares. Trading as of 9:47 a.m. on this 4 v Wall Street Journal at www.wsj.com or the online edition of et Data tabs). 188 Two Value FIGURE 7.2 Trading information for FedEx 0.85 (1.00%) Source: Yahoo! Finance Web site, finance.yahoo.com P/E ratio Ratio of stock price to earnings per share. s market cap et capitalization) is the total value of its outstanding shares of stock, $26.34 billion. You will frequently venient way to y. . (The abbre theses stands for trailing 12 months.) wn as the price-earnings multiple or, equivalently, ratio, is 83.75/3.76 5 22.24. e et analysts, and we will have much to say about it later in the chapter. The dividend yield tells you how much dividend income you would receive for every $100 invested in the stock. FedEx paid annual dividends of $.48 per share, so its yield was .48/83.75 5 .6%. For ev vested in the stock, you would have received $.60 in dividends. Of course, this would not be the total rate of return on your investment, as you would also hope for some increase in the stock price. The dividend yield is thus much lik ve capital gains or losses. The price at which you can b alues will wax or wane with investors’ perceptions of the prospects for the company. Figure 7.3 sho ver a 6-month period in 2010. The price FIGURE 7.3 hist Share price or FedEx Source: Yahoo! Finance Web site, finance.yahoo.com Chapter 7 189 Valuing Stocks fell by over 25% in just 10 weeks, from $95 at the end of . Why w v denly? And for that matter y willing on August 2 to pay $84.60 a share for FedEx but only $26.25 a share for Microsoft? To answer these questions, we need alue. 7.2 Market Values, Book Values, and Liquidation Values book value Net worth of the firm according to the balance sheet. Finding the value of FedEx stock may sound lik , the compan alue of the f ities. The simplified balance sheet in Table 7.1 shows that in May 2010 the book value of all FedEx’ , inv and so on—was $24,902 million. FedEx’s debt and other liabilities—money that it owes the banks, taxes that are due to be paid, and the lik lion. alue of the assets and the liabilities was $13,811 million. This was the book value s equity.5 Book value records all the mone ve been plowed back on their behalf. Book v . But does the stock price equal book v ut as Table 7.2 shows, its book v as only $43.98. So the shares were worth about 1.9 times book value. This and the other cases shown in Table 7.2 tell us that investors in the stock market do not just buy and sell at book value per share. TABLE 7.1 Note: Shares of stock outstanding: 314 million. Book value of equity (per share): 13,811/314 5 $43.98 TABLE 7.2 Market values versus book values, August 2010 Source: Yahoo! Finance Web site, finance.yahoo.com. 5 ord for stock. vestors. 190 Part Two Value Investors know that accountants don’t even try to estimate market values. The value liquidation value Net proceeds that could be realized by selling the firm’s assets and pa editors. cal”) cost less an allowance for depreciation. But that may not be a good guide to what the f . W liquidation value cash per share a compan ets and paid off all its debts. Wrong again. A successful company ought to be w than liquidation value. The difference between a company’s actual value and its book or liquidation value is often attributed to , which refers to three factors: 1. Extr . A company may hav alue of those assets will be higher than alue. y assets that accountants don’t put on the balance xtremely valuable. Take Johnson & Johnson, a health y. Table 7.2, it sells at 3 times book v Where did all that extra v gely from v eted. These v wn to v don’t put it on the company’s balance sheet. Nev their book v 2. Intangible assets. 3. V e investments. If investors believ y will hav to make v vestments in the future, they will pay more for the company’s stock today. When eBay irst sold its stock to investors in 1998, the book value of shareholders’ equity w Yet 1 day after the issue investors valued the equity at over $6 billion. In part, this dif ver the Internet. But investors also judged that eBay was a growth company. In other words, they were betting that the company’s know-how and brand name would allow it to e e it easier for billion and had a market capitalization of $36 billion. Market price is not the same as book value or liquidation value. Market value, unlike book value and liquidation value, treats the firm as a going concern. ver sell at book or liquidation values. Investors buy shares on the basis of present and future wer. Two key features determine the prof generated by the f vest in lucrativ ▲ EXAMPLE 7.1 Amazon.com and Consolidated Edison Amazon.com, is a growth company. In 2010, its profit was $1,152 million. Yet investors in December 2010 were prepared to pay about 70 times that amount, or $81 billion, for Amazon’s common stock. The value of the stock came from the company’s market position, its highly regarded distribution system, and the promise of new related products that will generate increased future earnings. Amazon was a growth firm, because its market value depended so heavily on intangible assets and the anticipated profit w investments. Contrast this with Consolidated Edison (Con Ed), New Y ea. Con Ed is not a growth company. Its market is limited, and it is e ery deliberate pace. More important, it is a regulated Chapter 7 191 Valuing Stocks , so its returns on present and future investments are constrained. Con Ed’s value derives mostly from the stream of income generated by its existing assets. Therefore, while Amazon shares in 2010 sold for 10.1 times book value, Con Ed shares sold at only about 1.3 times book value. Investors refer to Amazon as a growth stock and Con Ed as an income stock. A few stocks, like Microsoft, offer both income and gro es the stock attractive to investors. In addition, inv y’s ability to inv ably in new ventures that will increase future earnings. Let’ • Book value records what a company has paid for its assets, less a deduction for alue of a business. • Liquidation value is what the company could net by selling its assets and repaying alue of a successful going concern. • Market value is the amount that investors are willing to pay for the shares of the wer of today’s assets and the expected future investments. The next question is, et value? Self-Test 7.1 7.3 Valuing Common Stocks Valuation by Comparables alue a business, the They then e w much investors in these companies This is often called valuation by comparables. Look, for example, at Table 7.3. ws, for some well-kno et value of the equity to the book v et v alue. ws the market-to-book ratio for competing or example, you can see from the second row of the table that the stock of the typical lar alue. If you did not have a mark it would also sell at three times book value. In this case your estimate of J&J’s market price would have been almost spot on. ve would be to look at how much inv The second row of Table 7.3 sho would have gotten a value for the stock of $51, somewhat lo $58.29 in August 2010. 192 Part Two Value TABLE 7.3 Market-to-bookvalue ratios and priceearnings ratios for selected companies and their principal competitors, August 2010. *Figures are median ratios for competing companies. v example, infant f or ve an 1990s, when dot-com companies were growing rapidly and losing lots of money, multiples were often based on the number of subscribers or Web-site visits. Valuation by comparables work wer). However, that is not the case for all the companies shown in Table 7.3. For example, if you had naïvely assumed that Amazon stock would sell ould have been out by a wide mar ably from stock to stock even for f usiness. To unders market value. Price and Intrinsic Value In the previous chapter, we saw that the value of a bond is the present value of its coualue of its final payment of face value. Y ay. Instead of receiving coupon payments, investors may receive dividends; and instead of receiving face value, they will receiv at the time the Consider, for example, an investor who buys a share of Blue Skies Inc. today and plans to sell it in 1 year P1, the expected divis expected cash ver the year DIV1 ws r. Remember have higher discount rates. Then the present v ws the investor will receiv V0 5 intrinsic value Present value of future cash pay om a st . DIV1 1 P1 11r (7.1) We call V0 the intrinsic value alue is just the present value of the cash payoffs anticipated by the investor in the stock. To illustrate, suppose investors expect a cash dividend of $3 over the next year P1 5 $81). If the dis(DIV1 5 $3) and e alue is $75: V0 5 3 1 81 5 $75 1.12 Chapter 7 193 Valuing Stocks Y vestors buy the stock for $75, their expected rate of return will precisely equal the discount rate—in other words, their investment will just compensate them for the opportunity cost of their money. To confirm this, note that the expected rate of return over the next year is the expected dividend plus the expected increase in price, P1 2 P0, all divided by price at the start of the year, P0. If the investor buys the shares for intrinsic value, then P0 5 $75 and Expected return 5 DIV1 1 P1 2 P0 3 1 81 2 75 5 5 .12, or 12% P0 75 ain: 5 expected dividend yield 1 expected capital gain DIV1 P0 3 5 75 5 5 .04 1 1 1 P1 2 P0 P0 81 2 75 75 .08 5 .12, or 12% investors expect. For example, in 2009, as the economy seemed to be emerging from a exceeding 100%. This was almost certainly better than investors expected at the start . At the other e ve energy verage by more than 10%. No inv ould hav ver confuse the actual outcome with the expected outcome. The dream of every investor is to buy shares at a bargain price, that is, a price less than intrinsic value. But in competitive markets, no price other than intrinsic value could survive for long. To see why, imagine that Blue Skies’ current price were above $75. Then the expected rate of return on Blue Skies stock would be lower than that on other securities of equivalent risk. (Check this!) Investors would bail out of Blue Skies stock and move into other securities. In the process they would force down the price of Blue Skies stock. If P 0 were less than $75, Blue Skies stock would offer a higher expected rate of return than equivalentrisk securities. (Check this, too. ) Everyone would rush to buy, forcing the price up to $75. When the stock is priced correctly (that is, price equals present value), the expected rate of return on Blue Skies stock is also the rate of return that investors require to hold the stock. At each point in time all securities of the same risk are priced to offer the same expected rate of return. This is a fundamental characteristic of prices in well-functioning markets. It is also common sense. Equation 7.1 is just a Now we can go be all securities at a given lev e alue: orks for any discount rate r. r as the e P0 5 DIV1 1 P1 11r Thus today’s price will equal the present value of di w we need to tak v P1? w do we estimate the 194 Part Two Value Self-Test 7.2 vidends. Investors in a young, gro y may have to w P0 still applies to such f vidend DIV1 equal to zero. In this case value depends on the subsequent dividends. But let’s be vidends now. We will say more about gro . The Dividend Discount Model dividend discount model Discounted cash-flow model which states that today’s stock price equals the present value of all expected future dividends. s dividend and 1 1 P1, that is, ne next period’s price. Suppose you have forecast the dividend. How do you forecast the price P1? We can answer this question by moving our stock-price equation forw The equation then says that P1 depends on the P2. The second-period s dividend DIV2 price P2 in turn depends on the third period’s dividend DIV3 P3, which depends on DIV4 . . . you can see where this logic is going. xpress a stock’ present value of all This is the dividend discount model: P0 5 present value of (DIV1, DIV2, DIV3, c, DIVt, c) DIV3 DIVt DIV1 DIV2 5 1 1 1 c1 1c ( 1 1 r) 2 ( 1 1 r) 3 ( 1 1 r) t 11r How f wever, f -distant dividends will not hav alues. For example, the present value of $1 received in 30 years using a 10% discount rate is only $.057. Most of the value of established companies comes from dividends to be paid within a person’s w How do we get from the one-period formula P0 5 (DIV1 1 P1)/(1 1 r) to the dividend discount model? We look at increasingly long investment horizons. Let’s consider inv v vestor will v xpects to receive plus the present v ventually sold. Unlike bonds, however ” Moreover, both di vestor, the v e this: P0 5 DIV1 1 P1 11r A 2-year investor would value the stock as P0 5 DIV1 DIV2 1 P2 1 ( 1 1 r) 2 11r vestor would use the formula P0 5 DIV3 1 P3 DIV1 DIV2 1 1 2 ( 1 1 r) ( 1 1 r) 3 11r Chapter 7 195 Valuing Stocks In fact we can look as far out into the future as we lik date H. Then the stock v ould be P0 5 DIV1 DIV2 DIVH 1 PH 1 1 c1 ( 1 1 r) 2 ( 1 1 r) H 11r (7.2) In words, the value of a stock is the present value of the dividends it will pay over the investor’s horizon plus the present value of the expected stock price at the end of that horizon. Does this mean that inv sions about the v v value will be the same. This is because the stock price at the horizon date is determined by expectations of dividends from that date forw Therefore, as long as inv s prospects, they will also agree on its present value. Let’s xample. ▲ EXAMPLE 7.2 Valuing Blue Skies Stock Take Blue Skies. The firm is growing steadily, and investors expect both the stock price and the dividend to increase at 8% per year. Now consider three investors, Erste, Zweiter, and Dritter. Erste plans to hold Blue Skies for 1 year, Zweiter for 2, and er for 3. Compare their pay Year 1 Erste Zweiter DIV1 5 3 P1 5 81 DIV1 5 3 Dr er DIV1 5 3 Year 2 DIV2 5 3.24 P2 5 87.48 DIV2 5 3.24 Year 3 DIV3 5 3.50 P3 5 94.48 Remember, we assumed that dividends and stock prices for Blue Skies are expected to grow at a steady 8%. Thus DIV2 5 $3 3 1.08 5 $3.24, DIV3 5 $3.24 3 1.08 5 $3.50, and so on. Each investor requires the same 12% expected return. So we can calculate present value over Erste’s 1-year horizon: PV 5 DIV1 1 P1 $3 1 $81 5 5 $75 11r 1.12 or Zweiter’s 2-year horizon: PV 5 5 DIV1 DIV2 1 P2 1 11r (1 1 r)2 $3 $3.24 1 $87.48 1 1.12 (1.12)2 5 $2.68 1 $72.32 5 $75 er’s 3-year horizon: PV 5 5 DIV3 1 P3 DIV1 DIV2 1 1 11r (1 1 r)2 (1 1 r)3 $3 $3.24 $3.50 1 $94.48 1 1 1.12 (1.12)2 (1.12)3 5 $2.68 1 $2.58 1 $69.74 5 $75 196 Two Value All agree the stock is worth $75 per share. This illustrates our basic principle: The value of a common stock equals the present value of dividends received out to the investment horizon plus the present value of the forecast stock price at the horizon. Moreover, when you move the horizon date, the stock’s present value should not change. The principle holds for horizons of 1, 3, 10, 20, and 50 years or more. Self-Test 7.3 Look at Table 7.4, which continues the Blue Skies example for v zons, still assuming that the di xpected to increase at a steady 8% compound rate. The expected price increases at the same 8% rate. Each row in the table represents a present v . Note that total present value does not depend on the inv 7.4 presents the same data ws the present value of the di and the present v As the horizon recedes, the dividend alue but the total present value of di ways equals $75. TABLE 7.4 Value of Blue Skies FIGURE 7.4 Skies f Value of Blue erent horizons Chapter 7 197 Valuing Stocks ar away, then we can for price—it has almost no present value—and simply say, Stock price 5 PV(all future dividends per share) This is the dividend discount model. 7.4 Simplifying the Dividend Discount Model The Dividend Discount Model with No Growth ya company could not grow because it could not reinvest.6 vidend, but the ard to higher future dividends. y’s stock would offer a perpetual stream of equal cash payments, DIV1 5 DIV2 5 c5 DIVt 5 c . The dividend discount model says that these no-growth shares should sell for the present v vidends. W w to do that ment by the discount rate. vestors P0 5 DIV1 r Since our compan vidends, di are the same, and we could just as well calculate stock value by Value of a no-growth stock 5 P0 5 where EPS1 represents next year’ loosely say EPS1 r Thus some people ” and calculate value Self-Test 7.4 The Constant-Growth Dividend Discount Model The dividend discount model requires a forecast of dividends for every year into the future, which poses a bit of a problem for stocks with potentially infinite lives. Unless we want to spend a lifetime forecasting dividends, we must use simplifying assumptions to reduce the number of estimates. As we have just seen, the simplest simplification assumes a no-growth perpetuity, which works only for nogrowth shares. Here’ casted dividends gro vidends grow at vidends, we need to forecast only the next dividend and the dividend growth rate. 6 W y by issuing ne 198 Part Two Value Recall Blue Skies Inc. It will pay a $3 dividend in 1 year. If the dividend grows at a constant rate of g 5 .08 (8%) thereafter, then di 5 $3.00 DIV1 5 $3 DIV2 5 $3 3 (1 1 g) 5 $3 3 1.08 5 $3.24 DIV3 5 $3 3 (1 1 g)2 5 $3 3 1.082 5 $3.50 Plug these forecasts of future dividends into the dividend discount model: DIV1(1 1 g) DIV1(1 1 g)2 DIV1(1 1 g)3 c DIV1 1 1 1 1 P0 5 2 3 ( 1 1 r) ( 1 1 r) ( 1 1 r) 4 11r $3 $3.24 $3.50 $3.78 5 1 1 1 1c 2 3 ( ) ( ) ( 1.12 1.12 1.12 1.12)4 5 $2.68 1 $2.58 1 $2.49 1 $2.40 1c constant-growth dividend discount model Version of the dividend discount model in which dividends grow at a constant rate. ▲ EXAMPLE 7.3 than the preceding one as long as the dividend growth rate g is less than the discount rate r. Because the present value of far-distant dividends will be ever closer to zero, the sum of all of these terms is finite despite the fact that an infinite number of dividends will be paid. The sum can be shown to equal P0 5 DIV1 r2g (7.3) This equation is called the constant-growth dividend discount model, or the 7 Gordon growth model Using the Constant-Growth Model to Value Aqua America Aqua America (ticker symbol WTR) is a wat ving parts of 14 states from Maine to Texas. In August 2010 its stock was selling for $19 a share. Since there were 137 million shares outstanding, investors were placing a total value on the stock of 137 million 3 $19 5 $2.6 billion. Can we explain this valuation? In 2010 Aqua America could point to a remarkably consistent growth record. For each of the past 15 years it had steadily increased its dividend payment (see Figure 7.5), and, with one minor hiccup, earnings had also grown steadily. The constant-growth model therefore seems tailor-made for valuing Aqua America’s stock. In 2010 investors were forecasting that in the following year Aqua America would pay a dividend of $.63 (DIV1 5 $.63). The forecast gro as about 3.5% a year over the foreseeable future (we explain later where this figure comes from). If investors required a return of 6.8% from Aqua America’s stock, then the constant-growth model gives a share value in 2010 (P0) of just over $19: P0 5 DIV1 $.63 5 5 $19.09 r2g .068 2 .035 The constant-gro alue of a . Suppose you forecast no growth in dividends (g 5 0). Then the dividend stream is a simple perpetuity aluation formula is P0 5 DIV1/r. This is precisely the formula you used in Self-Test 7.4 to value Moonshine, a no-growth common stock. 7 vidend is assumed to come at the end of the first period and is discounted for a full vidend DIV0, then next year’s dividend will be (1 1 g) times the dividend P0 5 DIV0 3 (1 1 g) DIV1 5 r2g r2g Chapter 7 199 Valuing Stocks FIGURE 7.5 Aqua America's dividends have grown steadily growth in dividends. Notice that as g wever, the constant-gro alid only when g is less than r. If someone forecasts perpetual dividend gro v r, then two things happen: 1. The formula explodes. It gives crazy answers. (Try a numerical example.) 2. Y w the forecast is wrong, because f vidends would have incredibly high present v xample. Calculate the present value of a di 1 5 $.63, r 5 .068, but g 5 .20.) Estimating Expected Rates of Return We argued earlier, in Section 7.3, that in competitiv ets, common stocks with the out what that expected rate of return is? It’s not easy. Consensus estimates of future dividends, stock prices, or overall rates The Wall Street J or reported by TV newscasters. Economists argue about which statistical models give the best estimates. There are nev ve sensible numbers. vidend discount model, which forecasts a constant growth rate g in both future di That means expected capital gains equal g . W wth DIV1 1g P0 5 dividend yield 1 growth rate (7.4) r5 For Aqua growth rate is 3.5%. W vidend is $.63 and the DIV1 1g P0 $.63 5 1 .035 5 .033 1 .035 5 .068, or 6.8% $19.09 r5 200 Two Value Suppose we found another stock with the same risk as Aqua America. It ought to offer the same expected total rate of return even if its immediate dividend or expected growth rate is very different. The required rate of return is not the unique property of Aqua America or any other company; it is set in the worldwide market for common stocks. Aqua America cannot change its value of r by paying higher or lower dividends or by growing faster or slower, unless these changes also affect the risk of the stock. When we use the rule-of-thumb formula, r 5 DIV1/P0 1 g, we are not saying that r, the expected rate of return, is determined by DIV1 or g. It is determined by the rate of return offered by other equally risky stocks. That return determines how much investors are willing to pay for Aqua America’s forecast future dividends: DIV1 1g P0 5r5 expected rate of return offered Given DIV1 g, investors set ▲ EXAMPLE 7.4 so that Aqua adequate expected rate of r Aqua America Gets a Windfall Suppose that a shift in water usage allows Aqua America to generate 5% per year future growth without sacrificing immediate dividends. Will that increase r, the expected rate of return? This is good news for the firm’s stockholders. The stock price will jump to P0 5 But at the new price the st DIV1 $.63 5 5 $35 r2g .068 2 .05 er the same 6.8% expected return: r5 5 DIV1 1g P0 $.63 1 .05 5 .068, or 6.8% $35 Aqua America’s good news is reflected in a higher stock price today, not in a higher expected rate of return in the future. The unchanged expected rate of return corresponds to the firm’s unchanged risk. Self-Test 7.5 Nonconstant Growth Water companies and other utilities tend to have steady rates of gro fore natural candidates for application of the constant-growth model. But many companies gro v wn. Obviously in such cases we can’ wth model to estimate value. However v investment horizon future year by which you expect the company’s growth to settle down. Calculate the present value of dividends from no .F Chapter 7 201 Valuing Stocks alue. Then add up to get the total present value of di P0 5 DIV1 DIV2 DIVH PH 1 1 c1 1 2 H ( 1 1 r) ( 1 1 r) ( 1 1 r) H 11r PV of dividends from at horizon terminal value. ▲ EXAMPLE 7.5 Estimating the Value of McDonald’s Stock In mid-2010 the price of McDonald’s stock was nearly $70. The company earned about $4.50 a share and paid out about 40% of earnings as dividends. Let’s see how we might use the dividend discount model to estimate McDonald’s intrinsic value. Investors in 2010 were optimistic about the prospects for McDonald’s and were forecasting that earnings would grow over the ne ears by 10% a year.8 This growth rate is almost certainly higher than the return, r, that investors required from McDonald’s stock, and it is implausible to suppose that such rapid gro continue indefinitely. Therefore, we cannot use the simple constant-gro ormula to value the shares. Instead, we will break the problem down into three steps: Step 1: Value McDonald’s dividends over the period of rapid gro Step 2: Estimate McDonald’s stock price at the horizon year, when gro should hav wn. Step 3: Calculate the present value of McDonald’s stock by summing the present value of dividends up to the horizon year and the present value of the stock price at the horizon. Step 1: Our first task is to value McDonald’s dividends over the ne ears. If dividends keep pace with the growth in earnings, then forecast earnings and dividends are as follows: Year 1 Earnings Dividends (40% of earnings) 2 3 4 5 4.50 4.95 5.45 5.99 6.59 1.80 1.98 2.18 2.40 2.64 In 2010 investors required a return of about 9% from McDonald’s stock.9 Therefore, the present value of the forecast dividends for years 1 to 5 was: PV of dividends years 1–5 5 $1.80 $1.98 $2.18 $2.40 2.64 1 1 1 1 1.09 (1.09)4 (1.09)5 (1.09)2 (1.09)3 5 $8.41 Step 2: The trickier task is to estimate the price of McDonald’s stock in the horizon year 5. The most lik er year 5 gro wn to a sustainable rate, but to keep life simple, we will assume that in year 6 the gro rate falls immediately to 6% a year.10 Thus the forecast dividend in year 6 is DIV6 5 1.06 3 DIV5 5 1.06 3 2.64 5 $2.80 8 9 The For now and e this v vailable on the Web at . w you how to estimate s 10 We will sho return on these new inv investment. R v y plo vidends will grow by g 5 plowback ratio 3 ard McDonald’s continues to reinv vidends will grow by .6 3 .10 5 .06, or 6%. w 202 Two Value and the expected price at the end of year 5 is P5 5 DIV6 $2.80 5 5 $93.33 r2g .09 2 .06 Step 3: Remember, the value of McDonald’s today is equal to the present value of forecast dividends up to the horizon date plus the present value of the price at the horizon. Thus, P0 5 PV(dividends years 1–5) 1 PV(price in year 5) 5 $8.41 1 $93.33 5 $69.07 1.09 5 A Reality Check Our estimate of McDonald’s value looks reasonable and almost matches McDonald’s actual mark e you nervous to note that your estimate of the terminal price accounts for such a large proportion of the stock’s value? It should. Only v wth be In the case of McDonald’s we know what the mark of 2010, but suppose that you are using the dividend discount model to value a compan uy Blue Skies’ concatenator division. In such cases you do not have the luxury of looking up the market price in The Wall Street J Av serious money. Wise managers, therefore, check that their estimate of value is in the usinesses. For e growth prospects today roughly match those projected for McDonald’s at the investment horizon. You look back at Table 7.3 and discover that their stocks typically sell at Then you can reasonably guess that McDonald’s value in , that is, 18.8 3 $6.59 5 $123.89, some alue that we vidend discount model. application of the valuation by comparables method introduced earlier in the chapter. Self-Test 7.6 7.5 Growth Stocks and Income Stocks W vestors speak of growth stocks and income stocks. They buy growth xpectation of capital gains, and they are interested in the future gro s di y buy income stocks principally for the cash di make sense. Think back once more to Aqua America. It is expected to pay a dividend in 2011 of vidend is expected to grow at a steady rate of 3.5% a $.63 (DIV1 5 year (g 5 .035). If inv (r 5 Aqua America should be P0 5 DIV1 / (r 2 g) 5 .63/ (.068 2 .035) 5 $19.09 Chapter 7 203 Valuing Stocks vidend growth? Let’s check. Aqua OE) Then , matching its av earnings per share in 2011 will be 5 3 return on equity 5 $8.35 3 .11 5 $.919 payout ratio Fraction of earnings paid out as dividends. plowback ratio Fraction of earnings retained by the firm. The forecast dividend in 2011 is DIV1 5 wed back in ne company’s payout ratio .63/.919 5 .686, and its plowback ratio 5 .314. After reinv additional equity per share equal to its plo 2011. W equity. Therefore: ves $.919 2 $.63 5 $.289 vestments. The vidends) is, therefore, vested in the y will start year 2012 with 5 plowback ratio 3 5 plowback ratio 3 3 return on equity] 5 .314 3 [$8.35 3 .11] 5 $.288 T wth rate in book equity we simply divide this increase in equity by the Growth rate 5 5 plowback ratio 3 3 5 plowback ratio 3 5 .314 3 .11 5 .035, or 3.5% If Aqua sustainable growth rate The firm’s growth rate if it plows back a constant fraction of earnings, maintains a constant r , and keeps its debt ratio constant. ws back vidends will also continue to grow by 3.5%. y’s sustainable growth rate, because it is the rate of growth that the company can sustain from reinv verage. (The sustainable growth rate is an old friend from Chapter 4.) If a company earns a constant return on its equity and plows back a constant proportion of earnings, then the gro ate g is g 5 sustainable gro ate 5 retur What if Aqua America did not plow back any equipment? In that case it w forgo any further gro vidends: 3 plowback ratio (7.5) w plant and ut would g 5 sustainable growth rate 5 return on equity 3 plowback ratio 5 .11 3 0 5 0 We could recalculate the value of Aqua y growth: DIV1 EPS1 $.919 5 $13.51 5 5 r2g r .068 Thus, if Aqua America did not reinvest an ould be not $19.09 but $13.51. The $13.51 represents the v already in place. 2 $13.51 5 $5.58) is the net present value of the future investments that Aqua xpected to make. P0 5 FINANCE IN PRACTICE Valuing Growth Opportunities What if the company kept to its policy of reinvesting 31.4% of its profits but the w investments was only 6.8%? In that case the sustainable growth rate would also be lower: g5 5 return on equity 3 plowback ratio 5 .068 3 .314 5 .0214, or 2.14% w figure into our v of $13.51 for Aqua America stock, no different from the value it would have if it chose not to grow at all: P0 5 DIV1 $.63 5 $13.51 5 r2g .068 2 .0214 Plowing earnings back into new inv esult in gro nings and dividends, but it does not add to the current stock price if that money is expected to earn only the return that investors r . Plowing earnings back does add value if investors believe that the reinvested earnings will earn a higher rate of return. present value of growth opportunities (PVGO) Net present value of a firm’s future investments. 204 To repeat, if Aqua America did not reinv alue of its stock w ve from the stream of earnings from the existing assets. The price of its stock would be $13.51. If the company did reinv vestors require, then those new investments w y value. The price of the stock would still be $13.51. F , investors believe that Aqua Amerw investments, somewhat above the 6.8% vestors require. v to pay for the stock. The total value of Aqua America stock is equal to the value of its assets in place plus the present value of its growth opportunities, or PVGO: Value of assets in place 1 Present value of growth opportunities (PVGO) 5 Total value of Aqua America’s stock $13.51 5.58 $19.09 Chapter 7 205 Valuing Stocks The superior prospects of Aqua W 5 20.8. If the company had no gro ould be $13.51/$.919 5 14.7. cator of Aqua’ Does this mean that the f The answer is usually yes. wever ould be only s stock sells v v Af nothing ve an Of course, valuing stocks is always harder in practice than in principle. Forecasting The e Google or value comes largely from growth opportunities rather than assets that are already in place. As the nearby box shows, in these cases there is plenty of room for disagreement about value. Self-Test 7.7 Valuing Growth Stocks We used the dividend discount model to value Aqua value of its gro Aqua as an easy tar as stable and its growth moderate. What about young, y, and rapidly growing companies? These companies usually pay no cash dividividend discount model still works logically—we could project dividends as zero out to some distant date when the firm matures and payout commences. But forecasting f vidends is more easily said than done. In these cases, it’s more helpful to think about the value of a stock as the sum of the value of assets in place plus PVGO, the present value of gro The v s av does not grow, that is, EPS/r. So we can express the value of a growth stock as P0 5 EPS/r 1 PVGO Market-value balance sheet Balance sheet showing market rather than book values of assets, liabilities, and stockholders’ . If you can observe P0 and calculate EPS/r, you can subtract and see how much value investors are assigning to growth. Market-Value Balance Sheets Financial managers are not bound by generally accepted accounting principles. Sometimes they construct a market-value balance sheet to help identify sources of value. Table 7.5 sho 206 Part Two Value TABLE 7.5 A Market-Value Balance Sheet (All entries at current market, not book values.) market-v assets. The market and book v recall that book v amiliar, for e . In contrast, alue, that do not appear at all on the company’s books. The present value of gro GO) never appears on a book balance sheet but belongs on a market-value balance sheet. For successful growth companies like Google, PVGO is f aluable than assets in place. For mature companies like Con Ed, PVGO is relativ et value depends on assets in place. That is why Con Ed is an income stock. The dif et and book values on the asset side of the balance sheet sho et-to-book ratio. aluable future inv 7.6 There Are No Free Lunches on Wall Street We have explained ho ve just given the game away and told you how to mak et? W et, and even highly ind it very dif y consistency. icult to beat the market consistently? Let’s look at two possible ways that you might attempt to do so. Method 1: Technical Analysis technical analysts Invest empt to identify undervalued stocks by searching for erns in past stock prices. Some inv v xploiting patterns in stock prices. These inv wn as technical analysts. Technical analysis sounds plausible. For example, you might hope to beat the market by buying stocks when the ay down. Unfortunately t work. ge price rise in one period may be followed by a further rise in the ne ut it is just as likely to be followed by a fall. Look, for example, at Figure 7.6a. The horizontal axis sho New York Composite Index in one week (5 business days), while the vertical axis shows the return in the follo ferent week ov et rise one week tended to be followed xt week, the points in the chart would plot along an upward-sloping line. But you can see that there was no such tendency; the points are scattered Chapter 7 Valuing Stocks 207 these changes by the coefficient of correlation. In our example, the correlation et movements in successive weeks is 2.022—in other words, effectively zero. Figure 7.6b sho usiness-day) moves. FIGURE 7.6a Each dot shows the returns on the New York Composite Index on two successive weeks between September 1970 and September 2010. The circled dot shows a weekly return of 13.1%, followed by 15.2% in the next w er diagram shows no significant r een returns on successive weeks. FIGURE 7.6b This scatter diagram shows that there is also no r een market returns in successive months. 208 Part Two Value Again you can see that this month’s change in the index gives you almost no clue as to the likely change next month. The correlation between successive monthly changes is 2.004. Financial economists and statisticians who hav vements have concluded that you won’ This seems to be so re et as a whole (as we did in Figure 7.6) or at individual stocks. Prices appear to wander randomly. They are equally likely t er a high or low return on any particular day, regardless of what has occurred on previous days. In other words, prices seem to follow a random walk Security prices change randomly, with no predictable trends or erns. random walk. alk,” consider the following example: Y ven $100 to play a game. At the end of each week a coin is tossed. If it comes up heads, you win 3% of your investment; if it is tails, you lose 2.5%. Therefore, your payoff at the end of the first week is either $103 or $97.50. At the end of the second week the coin is tossed again. Now the possible outcomes are as follows: Heads $103.00 Heads $106.09 Tails $100.43 $100 T Heads $100.43 Tails $ 95.06 This process is a random walk because successive changes in the value of your air coin. That is, the odds of making money each week are the same, re or the pattern of heads or tails in the previous weeks. If a stock’ ws a random w any day, month, or year do not depend at all on the stock’s previous price moves. The ves no useful information about the future—just as a long v xt toss. FIGURE 7.7 One of these charts shows the Standard & Poor’s Index f ear period. The other shows the results of playing our coin-toss game for 5 years. Can you tell which is which? (The answer is given in footnote 11.) Chapter 7 209 Valuing Stocks FIGURE 7.8 Cycles selfdestruct as soon as they are recognized by investors. The stock price instantaneously jumps to the present value of the expected future price. ficult to believ game, then look at the tw ve like our coin-tossing ws the outcome ws the actual performance of the S&P 500 Index for a 5-year period. Can you tell which one is which?11 Does it surprise you that stocks seem to follow a random walk? If so, imagine that it were not the case and that changes in stock prices were expected to persist for several months. Figure 7.8 provides a hypothetical example of such a predictable cycle. Y x was 1,100 and is e xt month. vestors perceive this bonanza? Since stocks are a bar vel, investors will uy and, in so doing, will push up prices. They will stop buying only when Figure 7.7 Thus, as soon as a cycle becomes apparent to investors, they immediately eliminate it by their trading. Don’t confuse randomness in price changes If a stock is f ve only if ne perception of its f level of prices. et Self-Test 7.8 11 Figure 7.7 sho s Inde The botas generated by a series of random numbers. You may be among the 50% of our readers who guess right, but we bet it was just a guess. 210 Part Two Value FIGURE 7.9 The ormance of the stocks of target companies compared with that of the market. The prices of target stocks jump up on the announcement day, but from then on there are no unusual price mov announcement of the takeover empt seems to be fully reflected in the stock price on . Source: Arthur J. Keown and John M. Pinkerton, “Merger Announcements and Insider Trading Activity,” Journal of Finance 36 (September 1981); pp. 855–869. Used with permission of Wiley-Blackwell. Method 2: Fundamental Analysis fundamental analysts Invest empt to b al information, such as ormance and earnings prospects. You may not be able to earn superior returns just by studying past stock prices, but what about other types of information? After all, most investors don’t just look at past stock prices. Instead, they try to gauge a firm’s business prospects by studying the financial and trade press, the company’s financial accounts, the president’s annual statements, and other items of news. These investors are called fundamental analysts, in contrast to technical analysts who focus on past stock price movements. Fundamental analysts are paid to uncover stocks for which price does not equal intrinsic value. If intrinsic value exceeds price, for example, the stock is a bargain and will offer a superior expected return. But what happens if there are many talented and competitive fundamental analysts? If one of them uncovers a stock that appears to be a bargain, it stands to reason that others will as well, and there will be a wave of buying that pushes up the price. In the end, their actions will eliminate the original bargain opportunity. To profit, your insights must be different from those of your competitors, and you must act faster than they can. This is a tall order. To illustrate the challenge facing stock market analysts, look at Figure 7.9, which shows ho ws—the announcement of a takeover. In most takeovers the acquiring compan get company to give up their shares. You can see from Figure 7.9 get compan day that the public becomes aw eover attempt (day 0 in the graph). However wnw made public, it is too late to buy. Researchers have look y other types of news, repurchase existing stock. e superior returns by buying or selling after the announcement. Chapter 7 211 Valuing Stocks A Theory to Fit the Facts efficient market Market in which prices reflect all available information. Economists often refer to the stock market as an market. By this they mean that the competition to find misvalued stocks is intense. So when new information comes out, investors rush to take advantage of it and thereby eliminate any profit opportunities. Professional investors e they say that there are no free lunches on Wall Street. grees of ef y. et, share price changes are alueless. et Figure 7.6, which looked at successiv index, is evidence in fav ficiency. Semistr describes a mark the information contained in past prices but all publicly available information. In such a market it is impossible (or exceptionally difficult) to earn consistently superior returns simply by reading the financial press, studying the company’s financial statements, and so on. Figure 7.9, which looked at the market reaction to merger announcements, was just one piece of evidence in favor of semistrong efficiency. As soon as information about the mergers became public, the stock prices jumped. Finally, str refers to a mark vailable et no investor, howev xpect to earn In f ven professional investors, such as managers of mutual et consistently. Look, for example, at Figure 7.10, which shows the average performance of equity mutual funds over three decades. Y et, but as often as not (in fact, in 24 of the 40 years since 1970) it was the other way ones, and the top-performing managers one year have about an average chance of falling on their face the ne . FIGURE 7.10 Annual returns on the Wilshire 5000 Market Index and equity mutual funds, 1971–2010. The market index provided a higher return than the average mutual fund in 24 of the 40 years. 212 ▲ EXAMPLE 7.6 Two Value Performance of Money Managers Forbes, a widely read investment magazine, publishes annually an “honor roll” of the most consistently successful mutual funds. Suppose that every year starting in 1975, you invested an equal sum in each of these successful funds when Forbes announced its honor roll. You would hav ormed the market in only 5 of the following 16 years, and your average annual return would have been more than 1% below the return on the market.12 y investors have given y simply buy and hold index et. We disy provide maximum diversi- up the search for superior inv funds or e cussed inde w management fees. et” but can’ now invest ov x funds. Self-Test 7.9 7.7 Market Anomalies and Behavioral Finance Market Anomalies Almost without e f et hypothesis was a remarkably good description of reality. But eventually, cracks in its ed with evidence of vestors hav ailed to exploit. We will look at just a few examples. The Earnings Announcement Puzzle In an ef et, a company’s stock price should react instantly at the announcement of unexpectedly good or ws typically outperform the stocks with the w ws. Figure 7.11 shows stock performance following the announcement of une 2001. with the worst news by about 1% per month ov wing the v become aw ves. The New-Issue Puzzle uy. On av wever v e and then held that stock for 5 years. Ov ould hav 12 v w v or verage annual -sized stocks.13 vesting in Equity Mutual Funds 1971 to 1991,” Journal of Finance 50 (June 1995), pp. 549–572. 13 bear s Web page, . Chapter 7 213 Valuing Stocks FIGURE 7.11 Average stock returns over the 6 months following announcements of quarterly earnings. The 10% of stocks with the best earnings news (por olio 10) outperformed those with the worst news (por olio 1) by about 1% per month. Source: Tarun Chordia and Lakshmanan Shivakumar, "Inflation Illusion and Post-Earnings-Announcement Dr Journal of Accounting Research 43 (2005), pp. 521–556. Used with permission of John Wiley and Sons via Copyright Clearance Center, Inc. W t be sure There xplanations. T e, for example, the new-issue puzzle. Most new issues ve involv et v y had just been issued b ve gro poorly ov W Bubbles and Market Efficiency individual stocks may occasionally get out of line. But are there also cases in which prices as a whole can no longer be justified? In the last few decades, we have witnessed several e et bubbles when prices rose to levels hard to reconcile with reasonable outlooks for di Between 1985 and 1989, for e ei inde as down 80% from its peak v . The boom in Japanese stock prices was matched by an even greater explosion in land prices. For example, Ziemba and Schw w hundred acres of land under the Emperor’s Palace in Tokyo, evaluated at neighborhood land prices, was worth as much as all the land in Canada or California.14 But then the real estate bubble also b just 13% of their peak. The dot-com bubble in the United States was almost as dramatic. The technologyheavy NASDAQ stock inde ventual high in March 2000. But then, as rapidly as it began, the boom ended, and by October 2002 the index had fallen 78% from its peak. ve that expected future ws could ever have been suff the case, we have tw xceptions to the theory of ef ets. 14 See W. T. Ziemba and S. L. Schw Invest Japan (Chicago: Prob 214 Two Value But bew w cious. First, most bubbles become ob y have burst. At the time, there often seems to be a plausible e boom, for example, man ers rationalized stock-price gains as w and more profitable economy ven by technological advances. Here’s another conclusion not to jump to: Don’t assume that anyone can know intrinsic value with confidence. Security valuation is intrinsically dif imprecise. Consider this example: Suppose that in September 2010 you wanted to check whether the stocks forming the S&P 500 were fairly priced. you might have used the constant-growth dividend discount model. In 2010, the annual dividends of the 500 companies in the index came to about $228 billion. Suppose investors expected these dividends to grow at a steady rate of 4.0% and that they required a rate of return of 6.3%. Then the value of the stocks in the index would have been PV 5 $228 billion 5 $9,913 billion .063 2 .04 which was roughly their value in September 2010. But what if the dividend growth rate was only 3.5%? Then the value of the stocks would decline to $228 billion 5 $8,143 billion .063 2 .035 In other words, a reduction of just half a percentage point in the expected rate of dividend growth would reduce the value of common stocks by about 18%. Given this sensitivity of value to assumed growth rates, it is easy for investors to justify price run-ups when the bubbles—except of course in retrospect, at which point all bubbles seem to have been obvious. PV 5 Behavioral Finance alues? ve that the vioral psychology 100% of the time. This shows up in two broad areas—their attitudes to risk and the way that they assess probabilities: 1. Attitudes toward risk. Psychologists hav y v small. Losers are liable to re es for having been so foolish. To avoid this unpleasant possibility, individuals will tend to shun those actions that may result in loss. The pain of a loss seems to depend on whether it comes on the heels of earlier losses. Once investors hav y may be even more cautious not to risk a further loss. Conversely, just as gamblers are known to be more willing to take large bets when the vestors may be more prepared to run the et dip after they have e If they do then suffer a small loss, they at least have the consolation of being up on . You can see ho vior could lead to a stock-price bubble. For example, early inv bubble were big winners. They may have stopped w They may have thrown caution to the winds and piled even more investment into ving stock prices f ve fundamental values. The day of reckoning came when investors woke up and realized how far above fundamental value prices had soared. Chapter 7 215 Valuing Stocks 2. Beliefs about probabilities. Most investors do not have a Ph.D. in probability outcomes. Psychologists have found that, when judging the possible future outcomes, individuals commonly look back to what has happened in recent periods and then assume that this is representative of what may occur in the future. The temptation is to project recent e get the lessons or example, an investor who places too much weight on recent events may judge that glamorous growth companies are very likely to continue to grow rapidly, even though v wth cannot persist indefinitely. A second common bias is overconfidence. Most of us believ than-av vers, and most investors think that the -than-average stockpickers. We know that tw e money from the deal; for every winner there must be a loser. But presumably inv . You can see how such behavior may have reinforced the dot-com boom. As the bull market dev vestors rack y became in their views and the more willing they xt month might not be so good. Now it is not difficult to believe that your uncle Harry or aunt Hetty may have become caught up in a scatty whirl of irrational exuberance,15 but why didn’t hardheaded professional investors bail out of the overpriced stocks and force their prices down to fair value? Perhaps they felt that it was too difficult to predict when the boom would end and that their jobs would be at risk if they moved aggressively into cash when others were raking up profits. In this case, sales of stock by the pros were simply not large enough to stem the tide of optimism that was sweeping the market. w far beha of the puzzles and e vents like the dot-com boom. One thing, however, seems clear: It is relativ sight and for psychologists to provide an explanation for them. It is much more difficult for inv v . 15 as coined by , Irrational Exuberance (New York City: Broadway Books, 2001). SUMMARY e www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUIZ PRACTICE PROBLEMS www.mhhe.com/bmm7e QUESTIONS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISES finance.yahoo.com SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e TABLE 7.6 www.mhhe.com/bmm7e MINICASE www.mhhe.com/bmm7e TABLE 7.7 CHAPTER 8 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T T W O Value High tech businesses often require huge investments. T ● ● ● ● ● ● 8.1 Net Present Value value. We now apply these ideas to evaluate a simple investment proposal. Suppose that you are in the real estate business. You are considering construction of ice block. The land w $300,000. Y w you will be able to sell the building for $400,000. Thus you would be investing $350,000 no . Therefore, prows: $400,000 0 Y 1 –$350,000 You should go ahead if the present value of the $400,000 payoff is greater than the investment of $350,000. Assume for the moment that the $400,000 payoff is a sure thing. The of uilding is not the only way to obtain $400,000 a year from now. You could invest in 1-year U.S. T T fer interest of 7%. How much would you have to invest in them in order to receive $400,000 at the end of the year? That’s easy: You would have to invest $400,000 3 1 5 $400,000 3 .9346 5 $373,832 1.07 Let’s assume that as soon as you have purchased the land and laid out the money for construction, you decide to cash in on your project. How much could you sell it for? , investors would be willing to pay at most $373,832 for it now. That’s all it would cost them to get the same $400,000 payoff by investing in gov ways sell your Therefore, at an interest rate of 7%, the present value of the $400,000 payoff from uilding is $373,832. 228 Chapter 8 The $373,832 present v opportunity cost of capital Expected rate of return given up by investing in a project. 229 Net Present Value and Other Investment Criteria uyer and seller. In alue of the prop- erty is also its market price or market value. To calculate present value, we discounted the expected future payoff by the rate of vestment alternatives. The discount rate—7% in our example—is often known as the opportunity cost of . It is called the opportubecause it is the return that is being given up by investing in the project. The building is w off. You committed $350,000, and therefore your net present value (NPV) is $23,832. Net present value is found by subtracting the required initial investment from the present v ws: net present value (NPV) Present value of cash flows minus investment. NPV 5 PV 2 required investment 5 $373,832 2 $350,000 5 $23,832 (8.1) In other w ice development is w es a net ution to value. The net present value rule states that managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value. A Comment on Risk and Present Value In our discussion of the of v w the v completed project. Of course, you will never be certain about the future values of office buildings. The $400,000 represents the best forecast, but it is not a sure thing. Therefore, our initial conclusion about how much investors would pay for the building is premature. Since they could achiev vesting in $373,832 worth of U.S. T y would not buy your building for that amount. You would have to cut your asking price to attract investors’ interest. orth less than a Here we can invoke a basic financial principle: A r safe one. Most investors avoid risk when the wever, the concepts of present v inv fered by a comparable investment. But we have to think of expected expected vestments. Not all investments are equally risky. The office development is riskier than a Treasury note but is probably less risky than investing in a start-up biotech company. Suppose you believe the office development is as risky as an investment in the stock market and that you forecast a 12% rate of return for stock market investments. Then 12% w That is what you are giving up by not investing in comparable securities. You can now recompute NPV: 1 5 $400,000 3 .8929 5 $357,143 1.12 NPV 5 PV 2 $350,000 5 $7,143 PV 5 $400,000 3 If other investors agree with your forecast of a $400,000 payoff and with your orth $357,143 once construction is under way. If you tried to sell for more than that, there w ers, because the property would then offer a lower expected rate of return than the 12% av et. The of uilding still makes a net contribution to value, but it is much smaller than our earlier calculations indicated. 230 Two Value Self-Test 8.1 Valuing Long-Lived Projects The net present v orks for projects of any length. For example, suppose that you are approached by a possible tenant who is prepared to rent your of ed annual rent of $25,000. You would need to expand the reception area -made features. This w vestment to $375,000, but you forecast that after you have collected the third year’s rent the building could be sold for $450,000. w (denoted shown belo selling the building). C3 = $475,000 C1 = $25,000 C2 = $25,000 1 2 0 Y 3 C0 = –$375,000 Notice that the initial investment shows up as a negativ w. w, ws are cerC0, is 2$375,000. For simplicity r 5 7%. Figure 8.1 sho ws and their present values. T present v ws at the 7% opportunity cost of capital: PV 5 5 C3 C2 C1 1 1 2 ( 1 1 r) ( 1 1 r) 3 11r $25,000 $25,000 $475,000 1 1 5 $432,942 2 1.07 1.07 1.073 The net present value of the revised project is NPV 5 $432,942 2 $375,000 5 and renting it for 3 years makes a greater . v s present value, you could calculate NPV directly, as in the following equation, where C0 w required to build the of NPV 5 C0 1 C3 C1 C2 1 1 ( 1 1 r) 2 ( 1 1 r) 3 11r 5 2$375,000 1 $25,000 $25,000 $475,000 1 1 5 $57,942 2 1.07 1.07 1.073 Let’s check that the owners of this project really are better off. Suppose you put up $375,000 of your own money, commit to b uilding, and sign a lease that Chapter 8 231 Net Present Value and Other Investment Criteria FIGURE 8.1 Cash flows and their present values for ice block project. Final cash flow of $475,000 is the sum of the rental income in year 3 plus the forecast sales price for the building. will bring in $25,000 a year for 3 years. Now you can cash in by selling the project to other investors. ws are certain, and the interest rate vestments is 7%, investors will v per 5 $25 $475 $25 1 1 5 $432.94 1.07 1.072 1.073 Thus you can sell the project to outside investors for 1,000 3 $432.94 5 $432,940, which, save for rounding, is exactly the present value we calculated earlier. Your net gain is Net gain 5 $432,942 2 $375,000 5 $57,942 which is the project’s NPV. This equiv value calculation is designed to calculate the v the capital markets. ws to investors in w. In that case we would discount C1 by r1, the discount rate for ws; C2 would be discounted by r2; and so on. Here we assume that the cost of capital is the same re w. We do this for one reason only—simplicity. But we are in good company: W ws from the project. each period’ ▲ EXAMPLE 8.1 Valuing a New Computer System Obsolete Technologies is considering the purchase of a new computer system to help handle its warehouse inventories. The system costs $50,000, is expected to last 4 years, and should reduce the cost of managing inventories by $22,000 a year. The oppor al is 10%. Should Obsolete go ahead? Don’ y the fact that the computer system does not generate any sales. If the expected cost savings are realized, the company’s cash flows will be $22,000 a year higher as a result of buying the computer. Thus we can say that the 232 Two Value computer increases cash flows by $22,000 a year for each of 4 years. To calculate present value, you can discount each of these cash flows by 10%. However, it is smarter to recognize that the cash flows are level, and therefore you can use the annuity formula to calculate the present value: PV 5 cash flow 3 annuity factor 5 $22,000 3 B 1 1 2 R .10 .10(1.10)4 5 $22,000 3 3.1699 5 $69,738 The net present value is NPV 5 2$50,000 1 $69,738 5 $19,738 The project has a positive NPV of $19,738. Undertaking it would increase the value of the firm by that amount. The first tw ws and estimating y, and we will have a lot more to say about them in later chapters. But once you have assembled the data, the calculation of present value and net present value should be routine. Here is another example. ▲ EXAMPLE 8.2 Calculating Eurotunnel’s NPV One of the world’s largest commercial investment projects was construction of the Channel Tunnel by the Anglo-French company Eurotunnel. Here is a chance to put yourself in the shoes of Eurotunnel’s financial manager and find out whether the project looked like it would be a good deal for shareholders. The figures in column C of Table 8.1 are based on the forecasts of construction costs and revenues that the company provided to investors in 1986. The Channel Tunnel project was not a safe investment. Indeed, the prospectus to the Channel Tunnel share issue cautioned investors that the project “involves significant risk and should be regarded at this stage as speculative. If for any reason the Project is abandoned or Eurotunnel is unable to raise the necessary finance, it is lik vestors will lose some or all of their money.” To be induced to invest in the project, investors needed a higher prospective rate of return than they could get on safe government bonds. Suppose investors expected a return of 13% from investments in the capital market that had a degree of risk similar to that of the Channel Tunnel. That was what investors were giving up when they provided the capital for the tunnel. To find the project’s NPV we therefore discount the cash flows in Table 8.1 at 13%. Since the tunnel was expected to take about 7 years to build, there are 7 years of negative cash flows in Table 8.1. To calculate NPV, you just discount all the cash flows, positive and negative, at 13% and sum the results. Call 1986 “year 0,” call 1987 “year 1,” and so on. Then NPV 5 52 1 C1 C2 1 1c (1 1 r)2 11r 2 £17,781 2 1 1 c1 5 £249.8 million 1 2 ( ) (1.13)24 1.13 1.13 We present the calculations in column D. (The nearby box provides additional discussion of how to calculate present values by using spreadsheets.) The net present value of the forecast cash flows is £249.8 million, making the tunnel a worthwhile project, though not by a wide margin, considering the planned investment of SPREADSHEET SOLUTIONS Present Values www.mhhe.com/bmm7e Spreadsheet Questions TABLE 8.1 Forecast cash flows and present values in 1986 for the Channel Tunnel project. The investment at the time appeared to have a positive NPV of £249.8 million. You can find this spreadsheet at .mhhe.com/bmm7e. Note: Cash flow for 2010 includes the value in 2010 of forecast cash flows in all subsequent y . Some of these figures involve guesswork because the prospectus reported accumulated construction costs including interest expenses. Source: Eurotunnel Equity II Prospectus, October 1986. Reprinted with permission. 233 234 Two Value w forees ve. As the law predicted, the tunnel proved much more expensive to build than anticipated in 1986, and the opening was delayed by more than a year. Revenues also were below forecast, and Eurotunnel did not ev Thus, with hindsight, the tunnel was a costly negative-NPV venture. By 2007, Eurotunnel was operaty law and had to be restructured. Eventually, the f as reorganized into a new company called Groupe Eurotunnel. casts. wn Pentagon Law of Lar 8.2 Using the NPV Rule to Choose among Projects So far, the simple projects that we have considered involv e-it-or-leave-it decisions. But almost all real-world decisions entail either-or choices. You could use that vacant lot to b You could build a 7-story of You could heat it with oil or with natural gas. You could build it today or w mutually exclusive. When choosing among mutually exclusive projects, calculate the NPV of each alternative and choose the highest positive-NPV project. ▲ EXAMPLE 8.3 Choosing between Two Projects It has been several years since y ice last upgr ice networking software. Two competing systems have been proposed. Both have an expected useful life of 3 years, at which point it will be time for another upgrade. One proposal is for an expensive, em, which will cost $800,000 and increase firm cash flows by $350,000 a year through increased productivity. The other proposal is for a cheaper, somewhat slower system. This system would cost only $700,000 but would increase cash flows by only $300,000 a year. If the cost of capital is 7%, which is the better option? The following table summarizes the cash flows and the NPVs of the two proposals: In both cases, are systems are worth more than they cost, but the faster system would make the greater contribution to value and therefore should be your preferred choice. o netw did not affect an e. But sometimes the choices that you make today will have an impact on future opportunities. but often challenging, problems: • The investment timing problem. Should you buy a computer now or wait and think about it again ne s investment is competing with possible vestments.) Chapter 8 Net Present Value and Other Investment Criteria 235 • The c Should the company save mone today’s decision would accelerate a later investment in machine replacement.) • The replacement problem. When should e vestment in more modern equipment.) W Problem 1: The Investment Timing Decision In Example 8.1 Obsolete Technologies is contemplating the purchase of a new computer system. The proposed investment has a net present value of almost $20,000, so it vings would easily justify the expense of the system. However, the f tinually f guing that the NPV of the system will be ev . Unfortunately gument for 10 years, and the company is steadily losing b w in her reasoning? This is a problem in investment timing. ve-NPV investment? Investment timing problems all involve choices among mutually exclusive investments. You can either proceed with the project now or do so later. Y t do both. Table 8.2 lays out the basic data for Obsolete. You can see that the cost of the computer is expected to decline from $50,000 today to $45,000 ne The new computer system is expected to last for 4 years from the time it is installed. The present value of the savings at the time of installation is expected to be $70,000. Thus, if Obsolete invests today, it achieves an NPV of $70,000 2 $50,000 5 $20,000; if it invests next year, it will have an NPV of $70,000 2 $45,000 5 $25,000. Isn’t a gain of $25,000 better than one of $20,000? W may prefer to be $20,000 richer today than $25,000 richer next year. Your decision should depend on the cost of capital. Table 8.2 shows the value today (year 0) of those net present values at a 10% cost of capital. For example, you can see that the discounted v 5 $22,700. The financial manager has a point. It is w vestment in the computer: Today’s NPV is higher if she waits a year. But the investment should not be postponed indefinitely. You maximize net present value today by buying the comNotice that you are involved in a trade-off. The sooner you can capture the $70,000 savings the better, but if it costs you less to realize those savings by postponing the investment, it may pay for you to w , the gain from b Since this is less than the cost of capital, this postponement would not make sense. The decision rule for investment timing is to choose the investment date that produces the highest net present value today. Self-Test 8.2 236 Part Two Value TABLE 8.2 Obsolete Technologies: The gain from purchase of a computer is rising, but the NPV today is highest if the computer is purchased in year 3 (figures in thousands of dollars). Problem 2: The Choice between Longand Short-Lived Equipment o machines, A and B. The two machines are designed differently but have identical capacity and do exactly the same job. Machine Machine B is an “economy” model, costing only $10,000, but it will last only 2 years Because the two machines produce exactly the same product, the only way to choose between them is on the basis of cost. Suppose we compute the present value of the costs: Should we tak . All we have sho wer present value of costs? Not necwer total A. But is the annual cost of using B lower than that of A? uy machine A and pay for its operating costs out of her b of the machine. equivalent annual annuity The cash flow per period with the same present value as the cost of buying and operating a machine. viously, the e sure that the present value of these payments equals the present value of the costs of machine A, $25,690. When the discount rate is 6%, the payment stream with such a present v . In other words, the cost of buying and operating machine A over its 3-year life is equivalent to This figure is therefore termed the equivalent annual annuity of operating machine A. Ho w that an annual charge of $9,610 has a present value of $25,690? . So we calculate the value of this annuity and set it equal to $25,690: Equivalent annual annuity 3 5 PV of costs 5 $25,690 Chapter 8 237 Net Present Value and Other Investment Criteria If the cost of capital is 6%, the 3-year annuity factor is 2.6730. So present value of costs Equivalent annual annuity 5 5 (8.2) $25,690 $25,690 5 5 $9,610 3-year annuity factor 2.6730 We see now that machine A is better, because its equivalent annual annuity is less ($9,610 for A versus $11,450 for B). In other w afford to set a lower annual ge for the use of A. We thus have a rule for comparerent lives: Select the machine that has the lowest equivalent annual ann . Think of the equivalent annual annuity as the level annual char 1 The annual to recover the present value of inv charge continues for the life of the equipment. Calculate the equivalent annual annuity by dividing the present value by the annuity factor. ▲ EXAMPLE 8.4 Equivalent Annual Annuity You need a new car. You can either purchase one outright for $15,000 or lease one for 7 years for $3,000 a year. If you buy the car, it will be worth $500 to you in 7 years. The discount rate is 10%. Should you buy or lease? What is the maximum lease payment you would be willing to pay? The present value of the cost of purchasing is PV 5 $15,000 2 $500 5 $14,743 (1.10)7 The equivalent annual cost of purchasing the car is therefore the annuity with this present value: Equivalent annual annuity 3 7-year annuity factor at 10% 5 PV costs of buying 5 $14,743 Equivalent annual annuity 5 $14,743 7- r 5 $14,743 5 $3,028 4.8684 Therefore, the annual lease payment of $3,000 is less than the equivalent annual ann . You should be willing to pay up to $3,028 annually to lease. ▲ EXAMPLE 8.5 Another Equivalent Annual Annuity Low-energy lightbulbs typically cost $3.50, have a life of 9 years, and use about $1.60 of electricity a year. Conventional lightbulbs are cheaper to buy, for they cost only $.50. On the other hand, they last only about a year and use about $6.60 of energy. If the real discount rate is 5%, which product is cheaper to use? 1 We hav vactor. 238 Two Value To answer this question, you need first to convert the initial cost of each bulb to an annual figure and then to add in the annual energy cost.2 The following table sets out the calculations: It seems that a lo 5 $5.03. gy bulb provides an annual saving of about $7.12 2 $2.09 Problem 3: When to Replace an Old Machine ed. In collapse. We usually decide when to replace. For example, we usually replace a car not wn but when it becomes more expensive and troublesome to keep up than a replacement. Here is an example of a replacement problem: Y ves up the ghost. It costs $12,000 per year to operate. You can replace it now with a ne machine no We calculate the NPV of the new machine and its equivalent annual annuity in the following table: ws of the ne valent to an annuity of $13,930 per year. So we can equally well ask whether you would want to replace your old machine, w one costing $13,930 a year. question is posed this way, the answer is obvious. As long as your old machine costs only $12,000 a year, why replace it with a ne Self-Test 8.3 2 Our calculations ignore any environmental costs. Chapter 8 239 Net Present Value and Other Investment Criteria 8.3 The Payback Rule payback period Time until cash flows recover the initial investment in the project. A project with a positive net present value is worth more than it costs. So whenever a v f. These days almost ev vestments, b vestment decisions. W x. As we describe these measures, you will see that payback is no better than a very rough guide to an investment’s w x lead to the same decisions as net present value. We suspect that you hav versations that go something like this: “A w , at the laundromat. So the washing machine should pay for itself in less than 3 years.” You hav A project’s payback period is the length of time before you recover your initial The investment. For the washing machine the payback period w payback rule states that a project should be accepted if its payback period is less than a specified cut iod. For e w t. ut it is easy to see that it can lead to nonsensical decisions. For example, compare projects E and F. Project E ge positive NPV ut a negative NPV ,b . This is because payback does not consider an ve after the payback period. f of 2 or more years would accept both E and F despite the fact that only E would increase shareholder wealth. Cash Flows (dollars) Project C0 C1 C2 E F G 22,000 22,000 22,000 11,000 11,000 0 11,000 11,000 12,000 C3 110,000 0 0 Payback Period, Years NPV at 10% 2 2 2 $7,249 2264 2347 A second problem with payback is that it giv ving before ws are less valuable. For e ut it has an even lower NPV than project F. ve later within the payback period. T f period. If it gardless of project life, it will tend to accept too many shortlived projects and reject too many long-lived ones. ve after the payback Earlier in the chapter we evaluated the Channel Tunnel project. Lar vitably have long payback periods. ws that we 240 Two Value presented in Table 8.1 v that employ the payback rule use a much shorter cutoff period than this. If they used , long-lived projects like the Channel Tunnel wouldn’t have a chance. . But remember that v tic. Today’ vial exercise. Therefore, the payback v We hav y companies continue to use it? Senior managers don’t truly believ ws after the payback vant. It seems more lik ves because the def vely unimportant or because there are some offsetting benefits. Thus managers may point out that payback is the simplest way to communicate an idea of project desirability. Investment decisions require disto have a measure that ev avor quick payback projects even when the projects have lower NPVs because they believe that quicker profits mean quicker promotion. es us back to Chapter 1, where we discussed the need to align the objectives of managers with those of the shareholders. In practice payback is most commonly used when the capital investment is small or . For example, if a project is e ws for 10 years and the payback period is only 2 years, the project in all likelihood has a positive NPV. Discounted Payback Sometimes managers calculate the discounted-payback period. This is the number of alue of prospectiv ws equals or exceeds the initial investment. The discounted-payback measure asks, How long must the project last in order to offer a positive net present value? If the discounted payback meets the company’ The discounted-payantage that it will never accept a negative-NPV project. On the other hand, it still tak ws after the cutoff date, so a company y project with a long discounted-payback y managers simply use the measure as a w These managers don’ the s ability to genws into the distant future. They satisfy themselves that the equipment truly has a long life or that competitors will not enter the market and eat into the project’ ws. Self-Test 8.4 8.4 The Internal Rate of Return Rule Instead of calculating a project’s net present v whether the project’ wer than the opportunity cost of capital. For example, think back to the original proposal to build the of You planned to Chapter 8 241 Net Present Value and Other Investment Criteria inv w of C1 5 $400,000 in 1 year. Therefore, you forecast a profit on the venture of $400,000 2 $350,000 5 project lik vested in the project: profit C1 2 investment $400,000 2 $350,000 5 5 investment investment $350,000 5 .1429, or about 14.3% Rate of return 5 The alternative of investing in a U.S. Treasury note would pro Thus the return on your of This suggests tw project: 3 vestment 1. The NPV rule. Invest in any project that has a positiv ws are discounted at the opportunity cost of capital. 2. The rate of return rule. Inv y project offering a rate of return that is higher An inv NPV of zero will also hav Suppose that the rate of interest on Treasury notes is not 7% but 14.3%. Since your of no ving your money in T notes. The NPV rule also tells you that if the interest rate is 14.3%, the project is evenly C1 $400,000 5 2$350,000 1 50 11r 1.143 The project would make you neither richer nor poorer; it is worth what it costs. Thus ve the same decision on accepting the project. NPV 5 C0 1 A Closer Look at the Rate of Return Rule W w that if the of ws are discounted at a rate of 7%, the project has a net present value of $23,832. If they are discounted at a rate of 14.3%, it has an NPV of zero. In Figure 8.2 the project’s NPV for a v ted. This is often called the NPV pr of the project. Notice tw about Figure 8.2: 1. The project rate of return (in our example, 14.3%) is also the discount rate that The rate of would give the project a zero NPV. This giv return is the discount rate at which NPV equals zero. 2. your project is positiv then NPV is negative. valent. Calculating the Rate of Return for Long-Lived Projects There is no ambiguity in calculating the rate of return for an investment that generates a single payof w do we calculate return when the project prows in sev 3 uilding is risk-free. vestments. 242 Part Two Value FIGURE 8.2 The value of ice project is lower when the discount rate is higher. The project has a positive NPV if the discount rate is less than 14.3%. internal rate of return (IRR) Discount rate at which project NPV 5 0. introduced above—the project rate of return is also the discount rate that gives the project a zero NPV. W y ws. The discount rate that gives the project a zero NPV is known as the project’s , or IRR. It is also termed the discounted cashflow (DCF) rate of return. Let’ vised of ws are as follows: Year: Cash flows 0 1 2 3 2$375,000 1$25,000 1$25,000 1$475,000 ws would have zero NPV. Thus, NPV 5 2$375,000 1 $25,000 $25,000 $475,000 1 1 50 2 (1 1 IRR) (1 1 IRR)3 1 1 IRR There is no simple general method for solving this equation. You have to rely on a little This gives an NPV of $150,000: NPV 5 2$375,000 1 $25,000 $25,000 $475,000 1 1 5 $150,000 2 ( ) (1.0)3 1.0 1.0 With a zero discount rate the NPV is positive. So the IRR must be greater than zero. The ne 2$206,481: NPV 5 2$375,000 1 $25,000 $25,000 $475,000 1 1 5 2$206,481 (1.50)2 (1.50)3 1.50 NPV is now negative. So the IRR must lie somewhere between zero and 50%. In Figure 8.3 we have plotted the net present values for a range of discount rates. You can see that a discount rate of 12.56% gives an NPV of zero. Therefore, the IRR is 12.56%. You can alw Figure 8.3, but it is quick The nearby boxes illustrate how to do so. You can see from Figure 8.3 es sense. Because the NPV profile is downward-sloping, the project has a positive NPV as long as the Chapter 8 243 Net Present Value and Other Investment Criteria FIGURE 8.3 The internal rate of return is the discount rate for which NPV equals zero. opportunity cost of capital is less than the project’s 12.56% IRR. If the opportunity cost of capital is higher than the 12.56% IRR, NPV is negative. Therefore, when we v whether the project has a positive NPV. This w ice project. We conclude that the rate of return rule will give the same answer as the NPV rule as long as the NPV of a project declines smoothly as the discount rate increases.4 The usual agreement between the net present v should not be a surprise. Both are methods of choosing between better off, and both recognize that companies always have a choice: They can invest in a project, or if the project is not suf ve, they can give the money back to vest it for themselv et. Self-Test 8.5 A Word of Caution Some people confuse the internal rate of return on a project with the opportunity cost of capital. Remember that the project IRR measures the profitability of the project. It internal rate of return in the sense that it depends only on the project’s own cash ws. The opportunity cost of capital is the standard for deciding whether to accept the project. It is equal to the return offered by equiv vestments in the capital market. Some Pitfalls with the Internal Rate of Return Rule Many firms use the internal rate of return rule instead of net present value. We think that this is a pity. When used properly, the two rules lead to the same decision, but the rate of return rule has several pitfalls that can trap the unwary. Here are three examples. 4 In Chapter 6 we showed ho A bond’s yield to maturity is simply SPREADSHEET SOLUTIONS Internal Rate of Return Pitfall 1: Lending or Borrowing? to work: The project’s NPV must fall as the discount rate increases. Now consider the following projects: Cash Flows (dollars) Project C0 C1 IRR, % NPV at 10% H I 2100 1100 1150 2150 150 150 1$36.4 2 36.4 Each project has an IRR of 50%. In other w ws at 50%, both projects would have zero NPV. Does this mean that the two projects are equally attractive? Clearly not. In the case of H we are paying out $100 now and getting $150 back at the end of the year. That is better than an w but we hav . That is equiv wing money at 50%. If someone asked you whether 50% was a good rate of interest, you could not answer unless you also knew whether that person was proposing to lend or borrow at that rate. Lending mone country), b wing at 50% is not usually a good deal (unless, of course, you plan y, you want a high borrow, you want a low rate of return. e Figure 8.2 (T Obviously Project I is a fairly obvious trap, but if you want to make sure you don’t fall into it, calculate the project’s NPV. For example, suppose that the cost of capital is 10%. Then the NPV of project H is 1$36.4 and the NPV of project I is 2$36.4. correctly warns us away from a project that is equiv wing money at 50%. When NPV rises as the interest rate rises, the rate of return rule is reversed: A project is acceptable only if its internal rate of return is less than the opportual. Pitfall 2: Mutually Exclusive Projects We have seen that f dom f e-it-or-leave-it projects. Usually they need to choose from a number of mutually exclusiv ves. Given a choice between competing projects, the higher NPV. Would it make sense to just choose the proj, no. Mutually exclusive proj5 ects involve an additional pitf 5 ve considered, payback, giv v xclusive projects. 244 F I N A N C I A L CA L C U L ATO R Using Financial Calculators to Find NPV and IRR Think once more about the two of You initially intended to invest $350,000 in the building and then sell it at the end of the year for $400,000. Under the revised proposal, you planned to invest $375,000, rent out the offices for 3 years at a fixed annual rent of $25,000, and then sell the building for $450,000. The following table sho ws, their IRRs, and their NPVs: vestments; both offer a positive NPV. But the revised pro, vised proposal doesn’t sho The IRR rule seems to say you should go for the initial proposal because it has the higher IRR. If you follow the IRR rule, you have the satisf return; if you use NPV . Figure 8.4 sho ves the wrong signal. NPV of each project for different discount rates. These tw w, is the superior investment. If the cost of capital is lower than 11.72%, then the re 245 246 Part Two Value FIGURE 8.4 The initial pr ers a higher IRR than the revised proposal, but its NPV is lower if the discount rate is less than 11.72%. discount rate, either proposal may be superior. For the 7% cost of capital that we have assumed, the re Now consider the IRR of each proposal. The IRR is simply the discount rate at which NPV equals zero, that is, the discount rate at which the NPV profile crosses the horizontal axis in Figure 8.4. and 12.56% for the revised proposal. However, as you can see from Figure 8.4, the . In our e volv , but the revised proposal had the longer life. enly favored the quick payback project with the high percentage return but the lower NPV. Remember, a high IRR is not an end in itself. You want projects that increase the value of the firm. Projects that earn a good rate of return for a long time often have higher NPVs than those that offer high percentage rates of return but die young. Self-Test 8.6 Pitfall 2a: Mutually Exclusive Projects Involving Different Outlays ves but different outlays. In this case the IRR may mistakenly favor small projects with high rates of return but low NPVs. When you are faced with a straightforward either-or choice, the simple solution is to compare their NPVs. However, if you are determined to use the IRR rule, there is a way to do so. We explain how in the appendix. Chapter 8 247 Net Present Value and Other Investment Criteria Self-Test 8.7 Pitfall 3: Multiple Rates of Return Here is a tricky problem. King Coal The project requires an invest- uilding up to $175 million in years 3 and 4. However, the company is At a 20% opportunity T s project, we have calculated the NPV for various discount rates and plotted the results in Figure 8.5. Y discount rates at which NPV5 0. That is, each of the following statements holds: NPV 5 2210 1 125 175 175 400 $125 1 1 1 2 50 2 3 4 1.03 1.03 1.03 1.03 1.035 NPV 5 2210 1 $125 125 175 175 400 1 1 1 2 50 2 3 4 1.25 1.25 1.25 1.25 1.255 and In other words, the investment has an IRR of both 3% and 25%. The reason for this is ws. y dif w stream.6 FIGURE 8.5 King Coal’s project has two internal rates of return. NPV 5 0 when the discount rate is either 3% or 25%. 6 fewer is no IRR. For e 1, and 1 ect ever have a ne v You may ev ws of 1 t believ 2 248 Part Two Value Is the coal mine worth developing? greater than the cost of capital—won’t help. For e Figure 8.5 gative NPV. It has a positive NPV only if the cost of capital is between 3% and 25%. e King Coal’s f w negative, can sometimes be huge. Phillips Petroleum has estimated that it will need to spend $1 billion to remove its Norwe ver $300 wer plant. These are obvious examples where ws go from positive to negative, but you can probably think of a number of other cases where the company needs to plan for later expenditures. Ships periodically it, hotels may receive a major f Whenev w stream is expected to change sign more than once, the rate of return (MIRR). We explain how to do so in the appendix to this chapter. However, it would be much easier in such cases to abandon the IRR rule and just calculate project NPV. 8.5 The Profitability Index profitability index Ratio of net present value to initial investment. The pr of investment: index measures the net present value of a project per dollar Profitability index 5 net present value initial investment For e (8.3) uilding involved an investx7 was 23,832 5 .068 350,000 Any project with a positive profitability index must also have a positive NPV, so it w Why go to the trouble of calculating the profitability index? The answer is that whenever there is a limit on the amount the company can spend, it makes sense to concentrate on getting the biggest bang for each investment buck. In other words, when there is a shortage of v x. Let us illustrate. aced with the following investment Cash Flows ($ millions) Project J K L C0 C1 C2 210 25 25 130 15 15 15 120 115 NPV at 10% Profitability Index 21 16 12 21/10 5 2.1 16/5 5 3.2 12/5 5 2.4 All three projects are attractive, b million. In that case, you can invest either in project J or in projects K and L, but you can’t inv 7 required inv example, the of uilding’ net present value) to xes calculated belo or x would be PV/investment 5373,832/350,000 5 1.068. Note Chapter 8 Net Present Value and Other Investment Criteria 249 y. In our example, K provested, followed by L. These two projects exactly use up the $10 million budget. Between them the wealth. The alternative of investing in J would have added only $21 million. Capital Rationing capital rationing Limit set on the amount of funds available for investment. Economists use the term capital rationing vailable for inv x can provide a measure of which projects to accept.8 tions can obtain v ge sums of money on fair terms and at short notice. So why does top management sometimes tell subordinates that capital is limited and that they may not e o reasons. Soft Rationing For many f rationing is not imposed by inv ment. For e ager. Y een to e overstate the inv man ” By this we mean that the capital usiness, and as a result you tend to This limit forces you to set your o Even if capital is not rationed, other resources may be. For example, v gro A somewhat rough-and-ready response to this problem is to ration the amount of capital that Hard Rationing Soft rationing should never cost the f vestment become more money and relax the limits it has imposed on capital spending. But what if there is “hard rationing, cannot raise the money it needs? In that case, it may be forced to pass up positive-NPV projects. W may still be interested in net present value, but you now need to select the package of projects that is within the company’s resources and yet gives the highest net present value. x can be useful. Pitfalls of the Profitability Index x is sometimes used to rank projects even when there is no soft or hard capital rationing. In this case the unwary user may be led to favor small projects over larger projects that have higher NPVs. x was designed to select projects with the most bang per buck—the greatest NPV per dollar spent. That’ ve when bucks are limited. When they are not, a bigger bang is always better than a smaller one, even when more b est 8.8 is a xample. 8 other resources are rationed in addition to capital, it isn’t alw x. T ming methods may be used. , or 250 Two Value Self-Test 8.8 8.6 A Last Look We’ve covered several inv wn nuances. If your head is spinning, you might want to take a look at Table 8.3, which gives an overview and , NPV is the gold standard. It is designed to tell you whether an investment will increase the v xclusive investments. aces capital rationing. In this case, there may not be enough cash to take ev positive NPV, and the f x, that is, net present v vested. F w analysis is in f for project evaluation. Table 8.4 pro ge survey of w ways use NPV or IRR to evaluate projects. The dominance of these criteria is even stronger among larger, preantages of discounted cashw methods, however v valuate projects. For example, just ov ways or almost always compute a project’s What e to the chapter TABLE 8.3 A comparison of investment decision rules To some extent, As we noted in the introduction ant to consider some simple ways to describe project Chapter 8 Net Present Value and Other Investment Criteria 251 TABLE 8.4 Capital budgeting techniques used in practice Source: Reprinted from the Journal of Financial Economics, Vol. 60, Issue 2–3, J. R. Graham and C. R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” May 2001, pp. 187–243. © 2001 with permission from Elsevier Science. , even if they present obvious pitfalls. For example, managers talk casually ay that inv stocks. The fact that the verns their decisions. SUMMARY www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS SOLUTIONS TO SELF-TEST QUESTIONS FIGURE 8.6 www.mhhe.com/bmm7e www.mhhe.com/bmm7e SOLUTIONS TO SPREADSHEET QUESTIONS MINICASE www.mhhe.com/bmm7e APPENDIX More on the IRR Rule Using the IRR to Choose between Mutually Exclusive Projects www.mhhe.com/bmm7e Using the Modified Internal Rate of Return when there are Multiple IRRs CHAPTER 9 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T T W O Value A working magnoosium mine. T 9.1 Identifying Cash Flows Discount Cash Flows, Not Profits Up to this point we hav We hav about the problem of what you should discount. The f this: To calculate net present v ws, not accounting W w ho They ws. If the f ge amount of money on a big capital project, you do not , even though a lot of cash is going out the door. Therefore, the accountant does not deduct capital expenditure when calculating the year’s income but, instead, depreciates it over several years. its, but it could get you into trouble when working out net present value. For e investment proposal. It costs $2,000 and is e w of $1,500 You think that the opportunity cost of capital ws as follows: PV 5 $500 $1,500 1 5 $1,776.86 (1.10)2 1.10 The project is w gative NPV: NPV 5 $1,776.86 2 $2,000 5 2$223.14 The project costs $2,000 today, but accountants would not treat that outlay as an xpense. They would depreciate that $2,000 over 2 years and deduct the w to obtain accounting income: Cash inflow Less depreciation Accounting income Year 1 Year 2 1$1,500 2 1,000 1 500 1$ 500 2 1,000 2 500 Thus an accountant would forecast income of $500 in year 1 and an accounting loss of $500 in year 2. Suppose you were giv vely discounted them. Now NPV looks positive: NPV 5 spending mone 264 2$500 $500 1 5 $41.32 (1.10)2 1.10 w that this is nonsense. The project is ob w), and we are simply getting our money W vesting our mone et. Chapter 9 265 Using Discounted Cash-Flow Analysis to Make Investment Decisions The message of the example is this: When calculating NPV, recognize investment expenditures when they occur, not later when they show up as depreciation. Projects are financially attractive because of the cash they generate, either for distribution to shareholders or for reinvestment in the firm. Therefore, the focus of capital budgeting must be on cash flow, not profits. We sa w and accounting profits in Chapter 3. compan or example, an income statement will recognize rev v months. This practice also results in a difference between accounting profits and cash w. w comes later. ▲ EXAMPLE 9.1 Sales before Cash Your firm’s ace computer salesman closed a $500,000 sale on December 15, just in time to count it toward his annual bonus. How did he do it? Well, for one thing he gave the customer 180 days to pay. The income statement will recognize the sale in December, even though cash will not arrive until June. The accountant takes car erence by adding $500,000 to accounts receivable in December and then reducing accounts receivable when the money arrives in June. (The total of accounts receivable is just the sum of all cash due from customers.) You can think of the increase in accounts receivable as an investment—it’s ectively a 180-day loan to the customer—and therefore a cash outflow. That investment is recovered when the customer pays. Thus f en find it convenient to calculate cash flow as follows: December Sales Less investment in accounts receivable Cash flow June $500,000 2500,000 0 Sales Plus recovery of accounts receivable Cash flow 0 1$500,000 $500,000 Note that this procedure gives the correct cash flow of $500,000 in June. It is not alw w the dollars going out. Self-Test 9.1 e away 266 Two Value Discount Incremental Cash Flows A project’s present value depends on the extra ws that it produces. So you need Then forecast ws if you don’t accept the project. T e the difference and you have the extra (or incremental ws produced by the project: Incremental ▲ EXAMPLE 9.2 5 with project 2 without project Launching a New Product Consider the decision by Sony to develop Playstation 4. If successful, the PS4 could lead to several billion dollars in profits. But are these profits all incremental cash flows? Certainly not. Our with-versuswithout principle reminds us that we need also to think about what the cash flows would be without the new system. By launching the new console, Sony will reduce demand for Playstation 3. The incremental cash flows therefore are Cash flow with PS4 (including lower cash flow) from PS3) 2 The trick in capital b project. Here are some things to look out for. cash flow without PS4 (with higher cash flow from PS3) ws from a proposed Include All Indirect Effects The decision to launch a ne w products often damage sales of an existing product. Of w products anyway, usually because they believe that their e en if you don’t go ahead with a ne xisting product line will continue at their present level. Sooner or later they will decline. Sometimes a new project will help the f s existing business. Suppose that you inancial manager of an airline that is considering opening a new short-haul s O’Hare When considered in isolation, the new route may have a negative NPV. But once you allow for the additional business that the ne ery w vestment. To forecast incremental cash flow, you must trace out all indir ects of accepting the project. Some capital investments have very long lives once all indirect ef nized. Consider the introduction of a new jet engine. Engine manufacturers often offer attractive pricing to achiev Also, since airlines prefer to limit the number of dif ves sales w model engine can Forget Sunk Costs The versws. Sunk costs remain the same whether or not you accept the project. Therefore, the ect project NPV. Unfortunately velopment of the T gued that it would be foolish to abandon a project on which nearly $1 billion had already been spent. This Chapter 9 267 Using Discounted Cash-Flow Analysis to Make Investment Decisions w gument, however, because the $1 billion was sunk. The relevant questions were how much more needed to be inv ranted the incremental investment. pect of a satisf This argument too was faulty. The $1 billion was gone, and the decision to continue with the project should have depended vestment. opportunity cost Benefit or cash flow forgone as a result of an action. Include Oppor tunity Costs Resources are almost never free, even when no or example, suppose a ne acturing operation uses land This resource is costly; by using the land, you pass up the opportunity to sell it. There is no out-of-pocket cost, but there is an opportunity cost, that is, the v gone alternative use of the land. This example prompts us to w ersus after” rather than “with versus without.” assign any v wns it both before and after: Before Take Project Firm owns land Cash Flow, Before versus er er Firm still owns land 0 ersus without, is as follows: Before Take Project Firm owns land Before Firm owns land Cash Flow, with Project er Firm still owns land Do Not Take Project 0 Cash Flow, without Project er Firm sells land for $100,000 $100,000 ws with and without the project, you see that $100,000 is given v The oppor ing the land now and therefore is a relevant cash flow for project evaluation. et price.1 However you go ahead with a project to develop Computer Nouveau, pulling your software team off their work on a new operating system that some e so-patiently awaiting. The e to calculate, but you’ ving the software team to Computer Nouveau. net working capital Current assets minus current liabilities. Recognize the Investment in Working Capital Net working capital working capital) is the difference between a company’s short-term assets and its liabilities. receivable (customers’ unpaid bills), and inventories of ra inished you have es that hav ut have not yet been paid). 1 If the v xceed the cost of buying an equiv replace it. 268 Two Value Most projects entail an additional investment in w or example, vest in inventories of raw materials. Then, when you deliv accounts receiv 9.1. It required a $500,000, 6-month investment in accounts receivable.) Next year, as business b ger stock of ra ve even more unpaid bills. Investments in working capital, just like investments in plant and equipment, r lows. W ws.2 Here are the most common mistakes: 1. Forgetting about working capital entirely. We hope that you never fall into that trap. 2. Forgetting that working capital may change during the life of the project. Imagine that you sell $100,000 of goods per year and customers pay on average 6 months late. You will therefore have $50,000 of unpaid bills. Now you increase prices by 10%, so revenues increase to $110,000. If customers continue to pay 6 months late, e an additional investment in w 3. Forgetting that working capital is recovered at the end of the project. comes to an end, inv wn, an ver your investment in w This generates a cash . Remember Terminal Cash Flows The end of a project almost always ws. For e as dedicated to it. Also, as we just mentioned, you may recover some of your investment in w ventories of vable. xpenses to shutting down a project. For e sioning costs of nuclear po v Similarly, when a mine is e vironment may need rehabilitation. ed ov ver the future closure and reclamation costs of its New Me t forget to include these ws. Beware of Allocated Overhead Costs We hav the accountant’s objectiv ways the same as the project analyst’s. A case in point is the allocation of ov . v ut they must be paid for nev s projects, a charge for ov ws says v extra expenses of the project. A project may generate extra overhead costs, but then again it may not. We should be cautious about assuming that the accountant’s allocation of overhead costs represents the incremental cash flow that would be incurred by accepting the project. Self-Test 9.2 2 w why w w, look back to Chapter 3, where we gav xamples. Chapter 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 269 Discount Nominal Cash Flows by the Nominal Cost of Capital Interest rates are usually quoted in nominal of es no promises about what that $106 will buy. vest $100 in a bank deposit . It uy you only 4% more goods at the end of the year than your $100 could buy today. The nominal rate of interest is 6%, but the real rate is about 4%.3 If the discount rate is nominal, consistenc ws be estimated in w some slower. For example, perhaps you have entered into a 5-year fixed-price contract with a supplier v ed in nominal terms. ws at the real interWe sa ws discounted at the real discount rate give e alues as nominal ws discounted at the nominal rate. It should go without saying that you cannot mix and match real and nominal quantities. Real cash flows must be discounted at a real discount rate, nominal cash flows at a nominal rate. Discounting real cash flows at a nominal rate is a big mistake. y may seem like an obvious point, analysts sometimes forget to account for the ef ws. As a result, the This can grossly understate project values. ▲ EXAMPLE 9.3 Cash Flows and Inflation vices is considering moving into a ne ice building. The cost of a 1-year lease is $8,000, paid immediately. This cost will increase in future years at the annual inflation rate of 3%. The firm believes that it will remain in the building for 4 years. What is the present value of its rental costs if the discount rate is 10%? The present value can be obtained by discounting the nominal cash flows at the 10% discount rate as follows: 3 Remember from Chapter 5, Real rate of interest < nom 2 The e 1 1 real rate interest 5 11 11 Therefore, the real interest rate is .0392, or 3.92%. 5 1.06 5 1.0392 1.02 270 Two Value Year Cash Flow 0 1 2 3 8,000 8,000 3 1.03 5 8,240 8,000 3 1.032 5 8,487 8,000 3 1.033 5 8,742 Present Value at 10% Discount Rate 8,000 8,240/1.10 5 7,491 8,487/(1.10)2 5 7,014 8,742/(1.10)3 5 6,568 $29,073 Alternatively, the real discount rate can be calculated as 1.10/1.03 2 1 5 .06796 5 6.796%.4 The present value can then be computed by discounting the real cash flows at the real discount rate as follows: Year Real Cash Flow 0 8,000 1 8,000 2 3 8,000 8,000 Present Value at 6.796% Discount Rate 8,000 8,000/1.06796 5 7,491 8,000/(1.06796) 5 7,014 2 3 8,000/(1.06796) 5 6,568 $29,073 Notice the real cash flow is a constant, since the lease payment increases at the rate of inflation. The present value of each cash flow is the same regardless of the method used to discount it. The sum of the present values is, of course, also identical. Self-Test 9.3 Separate Investment and Financing Decisions w should you treat the proceeds from the debt issue and the interest and principal payments on the debt? Answer: You should neither subtract the debt proceeds from the required investment nor recognize ws. Regardless of the actual financing, you should vie ws as going to them. This procedure focuses exclusively on the project ws ve financing schemes. It, therefore, allo vestment decision from that of the financing decision. First, you ask whether the project has a positive net present v Then you can undertak gy xt. 4 W void confusion from rounding. Such precision is Chapter 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 271 9.2 Calculating Cash Flow It is helpful to think of a project’ (9.1) 5 1 1 W Capital Investment To get a project off the ground, a compan e considerable up-front inv eting, and so on. For example, development of a ne volves e This e gativ w—negative because cash goes out the door. y can either sell the plant and equipment or redeploy the assets elsewhere in the business. This salvage v y taxes if the equipment is sold) represents a positiv w to the wever ws can be negative if wn costs. ▲ EXAMPLE 9.4 Cash Flow from Capital Investment Slick Corporation plans to invest $800 million to develop the Mock4 razor blade. The specialized blade factory will run for 7 years until it is replaced by more advanced technology. At that point the machinery will be sold for $50 million. Taxes of $10 million will be assessed on the sale. The initial cash flow from Slick’s investment is 2$800 million. In year 7, when the firm sells the land and equipment, there will be a net inflow of $50 million 2 $10 million 5 $40 million. Thus, the initial investment involves a negative cash flow, and the salvage value results in a positive flow. Operating Cash Flow w consists of revenues from the sale of the new product less the costs of production and any taxes: 5 revenues 2 costs 2 Undoubtedly, the revenues are expected to outweigh the costs, and therefore operating ve. Many investments do not result in additional revenues; they are simply designed to reduce the costs of the company’s existing operations. For example, a new computer system may provide labor savings, or a new heating system may be more energyef ute to the operating cash w of the f venues but by reducing costs. These cost savings therefore represent a positiv w. ▲ EXAMPLE 9.5 Operating Cash Flow of Cost-Cutting Projects Suppose a new heating system costs $100,000 but reduces heating costs by $30,000 a year. The firm’s tax rate is 35%. The new system does not change rev nues, but, thanks to the cost savings, income increases by $30,000. Therefore, incr mental operating cash flow is: 272 Part Two Value Increase in (revenues less expenses) $30,000 2 Incremental tax at 35% 5 Operating cash flow 2 10,500 1$19,500 Notice that because the cost savings increase profits, the company must pay more tax. The net increase in cash flo er-tax cost savings: (1 2 .35) 3 $30,000 5 $19,500 w. es a deduction for depreciation. ge is an accounting entry y pays, but it is not a cash expense and should not be deducted when calculating operatw. (Remember from our earlier discussion that you want to discount cash When you work out a project’ with depreciation. ays to deal Method 1: Dollars In Minus Dollars Out Take only the items from the ws. cash revenues and subtract cash expenses and taxes paid. You do not, however, subtract a charge for depreciation because this does not involve cash going out the door. Thus, 5 revenues 2 cash expenses 2 taxes (9.2) Method 2: Adjusted Accounting Profits vely, you can start with after-tax accounting profits and add back any depreciation deduction. This gives 5 1 depreciation (9.3) Method 3: Add Back Depreciation Tax Shield Although the depreciation deduction is not a cash e s tax payment, which cer- s tax bracket is 35%, tax payments f depreciation tax shield Reduction in taxes attributable to depreciation. w ving as the depreciation tax shield. It equals the product of the tax rate and the depreciation charge: Depreciation tax shield 5 tax rate 3 depreciation This suggests a third w w. First, calculate net profit, assuming zero depreciation. This is equal to (revenues 2 cash expenses) 3 (1 2 tax rate). No w: 5 (revenues 2 cash expenses) 3 (1 2 1 (tax rate 3 depreciation) The following e w. v ) (9.4) Chapter 9 ▲ EXAMPLE 9.6 Using Discounted Cash-Flow Analysis to Make Investment Decisions 273 Operating Cash Flow A project generates revenues of $1,000, cash expenses of $600, and depreciation charges of $200 in a particular year. The firm’s tax bracket is 35%. Net income is calculated as follows: Revenues 2 Cash expenses 2 Depreciation expense 5 Profit before tax 2 Tax at 35% 5 Net profit 1,000 600 200 200 70 130 Methods 1, 2, and 3 all show that operating cash flow is $330: Method 1: Operating cash flow 5 revenues 2 cash expenses 2 taxes 5 1,000 1 600 2 70 5 330 Method 2: Operating cash flow 5 net profit 1 depreciation 5 130 1 200 5 330 Method 3: Operating cash flow 5 (revenues 2 cash expenses) 3 (1 2 tax rate) 1 (depreciation 3 tax rate) 5 (1,000 2 600) 3 (1 2 .35) 1 (200 3 .35) 5 330 Self-Test 9.4 Changes in Working Capital W y builds up inv w y’s cash is reduced; the reduction in cash irm’s investment in inv , cash is reduced when customw to pay their bills—in this case, the f vestment in accounts receivable. Investment in working capital, just like investment in plant and equipment, represents a negativ w. On the other hand, later in the life of a project, when inv f and accounts receiv s investment in w verts these assets into cash. ▲ EXAMPLE 9.7 Cash Flow from Changes in Working Capital Slick makes an initial (year 0) investment of $10 million in inventories of plastic and steel for its blade plant. Then in year 1 it accumulates an additional $20 million of raw materials. The total level of inventories is now $10 million 1 $20 million 5 $30 million, but the cash expenditure in year 1 is simply the $20 million addition to inventory. The $20 million investment in additional inventory results in a cash flow of 2 $20 million. Notice that the increase in working capital is an investment in the project. Like other investments, a buildup of working capital requires cash. Increases in the level of working capital therefore show up as negative cash flows. Later on, say, in year 5, the company begins planning for the next-generation blade. At this point, it decides to reduce its inventory of raw material from $30 274 Two Value million to $25 million. This reduction in inventory investment frees up $5 million of cash, which is a positive cash flow. Therefore, the cash flows from inventory investment are 2$10 million in year 0, 2$20 million in year 1, and 1$5 million in year 5. These calculations can be summarized in a simple table, as follows: Year: 0 1 2 3 4 5 1. Total working capital, year-end ($ million) 2. Change in working capital ($ million) 3. Cash flow from changes in working capital 10 10 210 30 20 220 30 0 0 30 0 0 30 0 0 25 25 15 In years 0 and 1, there is a net investment in working capital (line 2), corresponding to a negative cash flow (line 3), and an increase in the level of total working capital (line 1). In years 2 to 4, there is no investment in working capital, so its level remains unchanged at $30 million. But in year 5, the firm begins to disinvest in working capital, which provides a positive cash flow. In general: An increase in working capital is an investment and therefore implies a negative cash flow; a decrease in working capital implies a positive cash flow. The cash flow is measured by the change in working capital, not the level of working capital. 9.3 An Example: Blooper Industries No ve e them together into a coherent whole. As the ne ven the forecasts shown in the deposit of high-grade magnoosium ore.5 Y spreadsheet in Table 9.1. We will walk through the lines in the table. Cash-Flow Analysis Investment in Fixed Assets P assumptions. Panel B details investments and disinv ed assets. The project requires an initial investment of $10 million, as shown in cell B14. After 5 years, the ore deposit is e When you sell the equipment, the IRS will check to see whether any taxes are due on the sale. Any dif alue of the equipment will be treated as a taxable gain. W alue of zero. Therefore, the book v will be subject to taxes on the full $2 million proceeds. Your sale of the equipment will land you with an additional tax bill in year 6 of .35 3 $2 5 $.70 The Salvage value 2 tax on gain 5 2 $.70 million 5 $1.30 million This amount is recorded in cell H15. 5 Readers hav stool.” We forget the company, but the blooper really happened. w acts: Magnoosium was w by saying, Chapter 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions TABLE 9.1 Financial projections f 275 s magnoosium mine (figures in thousands of dollars) You can find this spreadsheet at .mhhe.com/bmm7e. Ro ws from inv The entry in each cell equals the after-tax proceeds from asset sales (ro inv ed assets (row 14). Operating Cash Flow ed assets. y expects to be able to sell 750,000 pounds venues of 750,000 3 $20 5 venues by 5%. 5%, and so on. Row 19 in Table 9.1 shows rev The sales forecasts in Table 9.1 straight-line depreciation Constant depreciation for each year of the asset’s accounting life. v That makes sense if the ore should include them in your forecasts. We hav agers who assume a project life of (say) 5 years, even when the xpect rev When ask y explain that forecasting beyond 5 years is too hazardous. We sympathize, but you just have to do your best. Do s life. We assume that the expenses of mining and refining (ro . We also assume for now that the company applies straight-line depreciation to the ver 5 years. 276 Two Value million inv deduction is $2 million. Pretax profit, shown in ro (ro Thus row 21 shows that the annual depreciation venues 2 expenses 2 depreciation). Taxes or e Tax 5 .35 3 3,000 5 1,050, or $1,050,000 Profit after tax (ro The last ro sum of after sum of rows 24 and 21. Changes in Working Capital es. w. W w as the ve). Therefore, row 25 is the Row 28 shows the level of w ut later in the project’s life, the investment in working capital is recovered and the level declines. Row 29 shows the change in w 1 to 4 the change is positiv vestment in w gative; there is a disinvestment as w v w associated with investments in w w 30) is the negative of the change in working capital. Just like investment in plant and equipment, investment in w gative w, and disinvestment produces a positiv w. Total Project Cash Flow T w from inv w. 16, 25, and 30. ws from each ed assets and working capital, w in row 33 is just the sum of rows Calculating the NPV of Blooper’s Project You have no ved (in ro ws from Blooper’s magnoosium mine. Suppose that investors expect a return of 12% from investments in the capital This is the opportunity cost of the shareholders’ money that Blooper is proposing to invest in the project. Therefore, to calculate NPV ws at 12%. Ro v t you can di w by (1 1 r)t or you can mult tiply by a discount factor that is equal to 1/(1 1 r) . Row 34 presents the discount factors for each year, and row 35 calculates the present v w by w (row 33) times the discount factor. ws are discounted and added up, the magnoosium project is seen to offer a positive net present v Now here is a small point that often causes confusion: To calculate the present v w, we divide by (1 1 r) 5 es sense only if all the sales and all the costs occur exactly 365 days, zero hours, w s sales don’ e place on the stroke of midnight on December 31. However udgeting deciws occur at 1-year interv They pretend this for one reason only—simplicity. sometimes little more than intelligent guesses, it may be pointless to inquire how the sales are lik .6 6 of June. v v . late in the year, as the holiday season approaches. v ws are distributed ev w comes Chapter 9 277 Using Discounted Cash-Flow Analysis to Make Investment Decisions Further Notes and Wrinkles Arising from Blooper’s Project Before we leave Blooper and its magnoosium project, we should cover a few extra wrinkles. Forecasting Working Capital magnoosium mine to produce rev But Blooper will not actually receiv Table 9.1 shows that Blooper expects its . We have assumed that, on average, customers pay with a 2-month lag, so that 2/12 of each year’ follo . These unpaid bills show up as accounts receivable. For example, in year 1 Blooper will have accounts receivable of (2/12) 3 15,000 5 $2,500.7 Consider now the mine’s expenses. Blooper must produce the magnoosium before selling it. Each year, Blooper mines magnoosium ore, b . The ore is put into inv , and the accountant does not deduct the cost of its production until it is taken out of inv W s expenses represent an investment in inv . Thus the investment in inv 3 10,000 5 $1,500 in year 0 and at .15 3 $10,500 5 $1,575 in year 1. We can now see ho ves at its forecast of w 0 1 2 3 4 5 1. Receivables (2/12 3 revenues) $ 0 $2,500 $2,625 $2,756 $2,894 $3,039 2. Inventories (.15 3 following year’s expenses) 1,500 1,575 1,654 1,736 1,823 0 3. Working capital (1 1 2) 1,500 4,075 4,279 4,493 4,717 3,039 6 0 0 0 Note: Columns may not sum due to rounding. Notice that w Y ye receivables also fall to zero. e uilds up in years 1 to 4, as sales of magnoosium increase. v . w. For ferent assumptions for w capital. For example, you can adjust the level of receivables and inventories by changing the values in cells B8 and B9. A Fur ther Note on Depreciation We w ws are lik The depreciation tax shield is a case in point, because the Internal Revenue Service lets companies depreciate only the amount of the original investment. For example, if you go back to the IRS to explain vestment and you should be allowed on’t listen. The nominal ed, wer the real value of the depreciation that you can claim. W vestment in mining equipment by $2 million a year. That produced an annual tax shield of 7 For conv s customers pay with a lag, Blooper pays all its bills on ould be recorded as accounts payable. Working capital would be 278 Part Two Value TABLE 9.2 Tax depreciation allowed under the modified accelerated cost recovery system (figures in percent of depreciable investment) Notes: 1. T eciation is lower in the first year because assets are assumed to be in service for 6 months. 2. Real property is depreciated straight-line over 27.5 years for residential property and 39 y or nonresidential property. modified accelerated cost recovery system (MACRS) Depreciation method that allows higher tax deductions in early years and lower deductions later. $2 million 3 .35 5 $.70 million per year for 5 years. These tax shields increase cash ws from operations and therefore increase present value. So if Blooper could get those tax shields sooner y would be w tions, tax law allows them to do just that. It allows accelerated depreciation. wn as the ecovery system, or MACRS. MACRS places assets into one of six classes, each of which has an assumed life. Table 9.2 shows the rate of depreciation that the company can use for each of these classes. Most industrial equipment falls into the 5- and 7-year classes. To keep life simple, we will assume that all of Blooper’ Thus Blooper can depreciate v tion of .32 3 10 5 $3.2 million, and so on.8 How does MA the magnoosium project? Table 9.3 gives the answer. Notice that MACRS does not as before. But MACRS allo , which increases the present value of the depreciation tax shield from $2,523,000 to $2,583,000, an increase of $60,000. Before we recognized MACRS depreciation, we calculated project NPV as $4,223,000. When we recognize MACRS, we should eep two sets of books, one for stockvenue Service. It is common to use straight-line CRS depreciation on the tax books. Only the tax books are relevant in capital budgeting. 8 You might w . also explains why the depreciation allowance is lo This is FINANCE IN PRACTICE MidAmerican’s Wind Power Project www.mhhe.com/bmm7e TABLE 9.3 The switch from straight-line t ear MACRS depreciation increases the value of Blooper’s depreciation tax shield from $2,523,000 to $2,583,000 (figures in thousands of dollars). Note: Column sums subject to rounding error. Self-Test 9.5 es on the More on Salvage Value difference between the sales price and the book value of the asset. The book value in ve charges for depreciation. It is common when figuring tax depreciation to assume a salvage value of zero at the end of the asset’s depreciable life. F wever, positive expected salvage v recognized. For e vestment in mining equipment would be w ould be based on the difference between the investment and the salvage value, that is, $8 million. Straight-line depreciation then would be $1.6 million annually. 279 SPREADSHEET SOLUTIONS The Blooper Spreadsheet Model Spreadsheet Questions L I S T I N G O F E Q U AT I O N S www.mhhe.com/bmm7e SUMMARY www.mhhe.com/bmm7e QUESTIONS QUIZ www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISES finance.yahoo.com SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e SOLUTIONS TO SPREADSHEET QUESTIONS MINICASE www.mhhe.com/bmm7e TABLE 9.4 CHAPTER 10 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T T W O Value When undertaking capital investments, good managers maintain maximum flexibility. I 292 Two Value 10.1 How Firms Organize the Investment Process In the pre w to evaluate a proposed investment such as the w forecasts don’t fall . Promising inv ve to be identified, and they must s strategic goals. To evaluate these opportunities properly w forecasts that have not been skewed to “sell” a project to upper management. Lar facilitate effective communication across dif F vestments are evaluated in two separate stages. Stage 1: The Capital Budget capital budget List of planned investment projects. Once a year, the head of list of the investments that they would like to make.1 a proposed capital budget. This budget is then revie visions and plants to provide a f specialgotiations between the visional management, and there may also be special analyses of major outlays or ventures into ne udget has been approved, it generally remains the basis for planning over the ensuing year. Many investment proposals bubble up from the bottom of the organization. But sometimes the ideas are likely to come from higher up. For example, the managers of plants A and B cannot be e w plant C. We expect divisional management to , divisions 1 and 2 may not be eager to give up their own data processing operations to a large central computer. That proposal would come s strate forts in areas where it has a real competitive advantage. fort, management must also identify declining businesses that should be sold or allowed to run down. s capital inv do udgeting and strategic planning, respectively. The two processes should complement each other vision managers, who do most of the work in bottom-up capital budgeting, may not see the forest for the trees. Strategic planners may hav en view of the forest because they do not look at the trees. Stage 2: Project Authorizations The annual b ws everybody to exchange ideas before attitudes hav ve been made. However, the fact that your pet project has been included in the annual budget doesn’t mean you have At a later stage you will need to draw up a detailed w forecasts, and present value calculations. If your project is large, this proposal may have to ved. category. For e wn: 1. Outlays required by law or company policy, for example, for pollution control equipment. The main 1 plants. vided into several divisions. For e , packaging, and forest products. Each of these divisions may be responsible for a number of Chapter 10 293 Project Analysis west possible cost. The decision is therefore lik ve technologies. 2. Maintenance or cost reduction, such as machine replacement. Engineering analysis ut new machines have to pay their own way. Here the f aces the classical capital budgeting problems described in Chapters 8 and 9. 3. xpansion in existing businesses. Projects in this category are less in technology, and the reactions of competitors. 4. Investment for new products. Projects in this cate ely to depend on gic decisions. w area may not have positive NPVs if considered in isolation, but they may giv aluable option to undertake follow-up projects. More about this later in the chapter. Problems and Some Solutions Valuing capital inv wever brings with it some challenges. udgeting is a cooperative ef Ensuring That Forecasts Are Consistent Inconsistent assumptions often creep into investment proposals. For example, suppose that the manager of the furniture division is b vivision look more attractive than those of the appliance division. To ensure consistency, man gin the capital budgeting process by establishwth in national s busiThese forecasts can then be Eliminating Conflicts of Interest In Chapter 1 we pointed out that while managers w y are also concerned about their own futures. If the ely to be poor investment decisions. For example, new plant managers naturally want to demonstrate good performance right away. So they might propose quick-payback projects even if , man w agers in ways that encourage such behavior ways demands quick results, it is unlikely that plant managers will concentrate only on NPV. Reducing Forecast Bias Someone who is keen to get a project proposal accepted is also lik s cash ws. Such ov or example, think of large public expenditure proposals. How often hav w missile, dam, or highway that actually cost less than w Think back to the Eurotunnel project introduced in Chapter 8. as f higher than initial forecasts. Overoptimism is not altogether bad. Psychologists stress tence. for each project. Sometimes a head of verstate their case. For example, if middle managers believe that success depends on having gest di y will propose large expansion projects that they do not believe have the largest possible net present value. Or if divisions must compete for limited resources, the 294 Two Value those resources. The fault in such cases is top management’s—if lower-lev are not rew alue and contrib alue, it where. v avorite projects. As the proposal travels up the or Thus once a division has screened its own plants’ proposals, the plants in that division unite in competing against outsiders. ice may receive several thousand investment proposals each year, all essentially sales documents presented by united fronts and designed to persuade. The forecasts have been doctored to ensure ve. Since it is dif v an investment proposal, capital inv vely decentralized whatev f to check capital investment proposals. Sor ting the Wheat from the Chaff Senior managers are continually bom- wing that the projects have positive NPVs. How then can managers ensure that only w e the grade? One response of senior managers to this problem of poor information is to impose rigid e vidual plants or divisions. These limits force the subunits to choose The f 2 tainable but as a w Senior managers might also ask some searching questions about why the project has a positive NPV. After all, if the project is so attractive, why hasn’t someone already undertaken it? W itable? Positiv sible only if your company has some competitive advantage. Such an advantage can arise in several ways. Y y enough to et with a new or improved product for which customers will pay Your competitors eventually will enter the market and squeeze out excess profits, b e them sev ve a propriantage that competitors cannot easily match. You may have a contractual advantage such as the distrib region. Or your advantage may be as simple as a good reputation and an established customer list. Analyzing competitive adv ve a negative NPV. If you are the lo product in a growing market, then you should invest to e et. w a negativ have made a e. 10.2 Some “What-If” Questions “What-if ” questions ask what will happen to a project in v or example, what will happen if the economy enters a recession? What if a competitor enters the market? What if costs turn out to be higher than anticipated? You might wonder why one w or instance, suppose your project seems to have a positiv vailable forecasts, in which you have already f ve and negative surWon’ later don’t work out as you had hoped, that is too bad, but you don’t hav 2 W Chapter 10 Project Analysis 295 In fact, what-if analysis is crucial to capital b w estimates are just that—estimates. You often have the opportunity to improve on those or example, if you wish to improve the precision of an estimate of the demand for a product, you v vel production process. But ho w when to k where it is best to dev What-if analysis can help identify the inputs that are most worth refining before you commit to a project. These will be the ones that have the greatest potential to alter project NPV. Moreover e w ws roll in. w where to undertake contingenc Sensitivity Analysis sensitivity analysis ects on project profit changes in sales, costs, and so on. fixed costs Costs that do not depend on the level of output. variable costs Costs that change as the level of output changes. TABLE 10.1 Cash-flow forecasts for Finef s superstore You can find this spreadsheet at .mhhe.com/bmm7e. Uncertainty means that more things can happen than will happen. Therefore, whenever managers are giv w forecast, the and the implications of those possible events. sensitivity analysis. w superstore in Gravenstein, and your staff members hav wn in Table 10.1. To keep the example simple we hav We have also assumed that the entire inv ve neglected the w ve ignored the fact that at the end of the 12 years you could sell off the land and buildings. et are fixed. For e the level of output, you still hav . These costs . Other costs v v , the lower the sales, the less food you need to buy. number of checkouts and reduce the staff needed to restock the shelves. The new superstore’s v Thus variable costs 5 .8125 3 5 The initial inv ov are taxed at a rate of 40%. 296 TABLE 10.2 Two Value Sensitivity analysis for superstore project Given these inputs, we add after w in As an e , you recws constitute an annuity, and therefore you calculate the 12-year annuity factor at a discount rate of 8% (cell C14). The net present v NPV 5 2$5,400,000 1 $780,000 3 12-year annuity factor 5 $478,141 ve net present value. Before you agree to go ahead, however, you want to delve behind these forecasts and identify the key v ails. You seem to hav en account of the important factors that will determine success or failure, but look out for things you may have forgotten. Perhaps there will be delays e costly landscaping. unknown unkno ” as scientists call them. Having found no unk-unks (no doubt you’ w NPV may be affected if you have made a wrong forecast of sales, costs, and so on. To do Table 10.2. Next you see what happens to NPV under the optimistic or pessimistic forecasts for each of these v You recalculate project NPV under these v determine which v . ▲ EXAMPLE 10.1 Sensitivity Analysis The right-hand side of Table 10.2 shows the project’s net present value if the variables are set one at a time to their optimistic and pessimistic values. For example, suppose fixed costs are $1.9 million rather than the forecast $2 million. To find NPV in this case, we simply substitute $1,900,000 in cell C5 of the spreadsheet, and discover that NPV rises to $930,306, a gain of approximately $452,000. The other entries in the three columns on the right in Table 10.2 similarly show how the NPV of the project changes when an input is changed. Your project is by no means a sure thing. The principal uncertainties appear to be sales and variable costs. For example, if sales are only $14 million rather than the forecast $16 million (and all other forecasts are unchanged), then the project has an NPV of 2$1.217 million. If variable costs are 83% of sales (and all other forecasts are unchanged), then the project has an NPV of 2$787,920. Self-Test 10.1 Chapter 10 Project Analysis 297 Value of Information No w the project could be thrown badly of e to see whether it is possible to resolve some of this uncertainty. Perhaps your w ail to attract wns. In that case, additional survey data and vel times may be worthwhile. On the other hand, there is less value to gathering additional information about ed costs. Because the project is marginally profitable ev ed costs, you are unlikely to be in trouble if you hav mated that variable. Limits to Sensitivity Analysis Y fodder’s new superstore is an example of sensitivity analysis. Sensitivity analysis expresses wn variables and then calculates the consequences of misestimating those v actors, ould be most useful, and helps to expose confused or inappropriate forecasts. Of course, there is no law stating which v sitivity analysis. For e rate tax rate, you may wish to look at the ef s NPV. One drawback to sensiti ves somewhat ambiguous results. For example, what exactly does optimistic or pessimistic ferent way from another. T w, after hundreds of projects, hindsight may sho as exceeded twice as often as the other’s; but hindsight won’t help you now while you’re making the investment decision. Another problem with sensiti ely or example, if sales exceed expectations, demand will likely be stronger than you anticipated and your profit margins will be wider. Or, if wages are higher than your forecast, both v ely to be at the upper end of your range. Because of these connections, you cannot push one-at-a-time sensitivity analysis too f alues for total project ws from the information in Table 10.2. Still, it does give a sense of which variables should be most closely monitored. Scenario Analysis scenario analysis Project analysis given a particular combination of assumptions. simulation analysis Estimation of the pr erent possible outcomes, e.g., from an investment project. w their project would fare under dif Scenario analysis allows them to look at ut consistent combinations of v orecasters generally prefer to give an estimate of rev ve some alue. Suppose that you are w f (S&S) may decide to build a new That would reduce sales in your Gravenstein store by 15%, ar to keep the remaining b be reduced to the point that v venue. Table 10.3 shows that both lo gins your new venture would no longer be w A bit more research into S&S’ called for. An e simulation analysis. Here, instead of specifying a relativ veral hunutions specified by the analyst. Each combination of v 298 Part Two Value TABLE 10.3 Scenario analysis comparing NPV of superstore with and without competing store You can find this spreadsheet at .mhhe.com/bmm7e. combination of v ution of outcomes can be Self-Test 10.2 10.3 Break-Even Analysis break-even analysis Analysis of the level of sales at which the project breaks even. e a sensitivity analysis of a project or when you look at alternative ould be if you hav w far off the estimates could be before the project begins to lose money. This ex wn as break-even analysis. For many projects, the make-or-break v olume. Therefore, managers most often focus on the break-even level of sales. However, you might also look at other v ay. Most often, the break-ev , however alue. W ing break-even, show that it can lead you astray, and then show how NPV break-even can be used as an alternative. Accounting Break-Even Analysis The accounting break-even point is the level of sales at which prof equivalently venues equal total costs. As we hav fixed regardless of the level of output. Other costs vary with the level of output. , wing estimates: Sales Variable costs Fixed costs Depreciation $16 million 13 million 2 million 0.45 million Chapter 10 Project Analysis 299 TABLE 10.4 Income statement, break-even sales volume Notice that variable costs are 81.25% of sales. So for each additional dollar of sales, costs increase by only $.8125. We can easily determine how much business the supervoid losses. If the store sells nothing, the income statement will sho ed costs of $2 million and depreciation of $450,000. Thus there will be an accounting loss before tax of $2.45 million. Each dollar of sales reduces this loss by $1.00 2 $.8125 5 $.1875. Therefore, to cov ed costs plus depreciation, you need sales of 2.45 5 $13.067 million. At this sales lev even. More generally, fixed costs including depreciation (10.1) Break-even level of revenues 5 additional profit from each additional dollar of sales Table 10.4 sho Figure 10.1 shows ho ven point is determined. The blue 45-degree line shows the store’s accounting revenues. The dashed cost line shows how costs v with sales. If the store doesn’ ed costs and depreciation amounting to $2.45 million. Each e When sales are $13.067 million, the two lines cross, indicating that costs equal revenues. For lower sales, revenues are less than costs and the project is in the red; for venues e v Is a project that breaks even in accounting terms an acceptable investment? If you , here’s a possibly easier question: Would you be happy about an inv v We hope not. Y ven on such a stock, but a zero return does not compensate you for the time value of money or the risk that you have taken. FIGURE 10.1 Accounting break-even analysis 300 Part Two Value A project that simply breaks even on an accounting basis gives you your money back but does not cover the oppor al tied up in the project. A project that breaks even in accounting terms will surely have a negative NPV. Let’s check this with the superstore project. Suppose that in each year the store has sales of $13.067 million—just enough to break ev What w w? Operating cash 5 profit after tax 1 depreciation 5 0 1 $450,000 5 $450,000 The initial investment is $5.4 million. In each of the ne y back: ves a Total operating cash 5 initial investment 12 3 $450,000 5 $5.4 million But revenues are not suf ment. NPV is negative. of that $5.4 million invest- NPV Break-Even Analysis A manager who calculates an accounting-based measure of break-even may be tempted to think that an igure will help shareholders. But projects that break ev y ailing to cover the costs of capital employed. Managers who accept such projects NPV break-even point Level of sales at which project net present value becomes positive. produce an accounting profit, it is more useful to focus on the point at which NPV switches from negative to positive. NPV break-even point. ws of the superstore project in each year will depend on sales as follows: 1. 2. 3. 4. 5. 6. 7. Variable costs Fixed costs Depreciation Pretax profit Tax (at 40%) Profi er tax Cash flow (3 1 6) 81.25% of sales $2 million $450,000 (.1875 3 sales) 2 $2.45 million .40 3 (.1875 3 sales 2 $2.45 million) .60 3 (.1875 3 sales 2 $2.45 million) $450,000 1 .6 3 (.1875 3 sales 2 $2.45 million) 5 .1125 3 sales 2 $1.02 million 12-year annuity factor. With a discount rate of 8%, the present value of $1 a year for each of 12 years is $7.536. Thus the present v ws is PV( ) 5 7.536 3 (.1125 3 sales 2 The project breaks even in present v ent v break-even occurs when ) vestment. Therefore, ) 5 investment PV( 7.536 3 (.1125 3 sales 2 $1.02 million) 5 $5.4 million .8478 3 sales 2 5 $5.4 million Sales 5 (5.4 1 7.69) /.8478 5 $15.4 million vestment to have a zero NPV. Figure 10.2 is a plot of the present v ws from the superstore as a function of annual sales. The two lines cross when sales are $15.4 million. Chapter 10 FIGURE 10.2 301 Project Analysis NPV break- even analysis This is the point at which the project has zero NPV. As long as sales are greater than this, the present v ws exceeds the present v ws and the project has a positive NPV.3 Self-Test 10.3 ▲ EXAMPLE 10.2 Break-Even Analysis We have said that projects that break even on an accounting basis are really making a loss—they are losing the oppor vestment. Here is a dramatic example. Lophead Aviation is contemplating investment in a new passenger aircraft, code-named the Trinova. Lophead’s financial st ed together the following estimates: 1. The cost of developing the Trinova is forecast at $900 million, and this investment can be depreciated in six equal annual amounts. 2. Production of the plane is expected to take place at a steady annual rate over the following 6 years. 3. The average price of the Trinova is expected to be $15.5 million. 4. Fixed costs are forecast at $175 million a year. 5. Variable costs are forecast at $8.5 million a plane. 6. The tax rate is 50%. 7. The cost of capital is 10%. Lophead’s financial manager has used this information to construct a forecast of the profitability of the Trinova program. This is shown in rows 1 to 7 of Table 10.5 (ignore row 8 for a moment). How many aircr ophead need to sell to break even? The answer depends on what is meant by “break even.” In accounting terms the venture will break even when net profit (row 7 in the table) is zero. In this case, (3.5 3 planes sold) 2 162.5 5 0 Planes sold 5 162.5/3.5 5 46.4 3 present value basis will have a positiv just cover all alue added (EVA) in Chapter 4. ven on a ut zero economic value added. In other words, it will 302 Two Value TABLE 10.5 Forecast profit or production of the Trinova airliner (figures in millions of dollars) Thus Lophead needs to sell about 46 planes a year, or a total of 280 planes over the 6 years to show a profit. With a price of $15.5 million a plane, Lophead will break even in accounting terms with annual revenues of 46.4 3 $15.5 million 5 $719 million. We would have arrived at the same answer if we had used our formula to calculate the break-even level of revenues. Notice that the variable cost of each plane is $8.5 million, which is 54.8% of the $15.5 million sale price. Therefore, each dollar of sales increases pretax profits by $1 2 $.548 5 $.452. Now we use the formula for the accounting break-even point: Break-even revenues 5 5 fixed costs including depreciation additional profit from each additional dollar of sales $325 million 5 $719 million .452 If Lophead sells about 46 planes a year, it will recover its original investment, but it will not earn any return on the capital tied up in the project. Companies that earn a zero return on their capital can expect some unhappy shareholders. Shareholders will be content only if the company’s investments earn at least the cost of the capital invested. True break-even occurs when the projects have zero NPV. How many planes must Lophead sell to break even in terms of net present value? Development of the Trinova costs $900 million. If the cost of capital is 10%, the 6-year ann actor is 4.3553. The last row of Table 10.5 shows that net cash flow (in millions of dollars) in years 1–6 equals (3.5 3 planes sold 2 12.5). We can now find the annual plane sales necessary to break even in terms of NPV: 4.3553(3.5 3 planes sold 2 12.5) 5 900 15.2436 3 planes sold 2 54.44 5 900 Planes sold 5 954.44/15.2436 5 62.6 Thus, while Lophead will break even in terms of accounting profits with sales of 46.4 planes a year (about 280 in total), it needs to sell 62.6 a year (or about 375 in total) to recover the opportunity cost of the capital invested in the project and break even in terms of NPV. Our e anciful, but it is based loosely on reality. In 1971 Lockheed w T . This program w ailure, and it tipped Rolls-Royce (supplier of the T v ving evidence to Congress, Lockheed argued that the T ve and that sales would eventually exceed the break-even point of about 200 aircraft. But in calculating this break-ev v Chapter 10 303 Project Analysis capital inv to reach a zero net present value.4 Self-Test 10.4 Operating Leverage A project’s break-even point depends on both its costs, which do not v sales, and the profit on each extra sale. Managers often face a trade-off between these v or e ed costs. But superet companies sometimes rent stores with contingent rent agreements. This means that the amount of rent the company pays is tied to the level of sales from the store. alls along with sales. The store thus replaces a fixed cost with a variable cost that is link y’s expenses will fall when its sales fall, its break-even point is reduced. ed costs is not all bad. The f gely fixed f w, b operating leverage Degree to which costs are fixed. degree of operating leverage (DOL) Percentage change in profits given a 1% change in sales. Finefodder has a polic yees who will not be laid off except in the most dire circumstances. F val, Stop and Scof uses expensiv ver demand requires e A greater proxpenses are therefore v Suppose that if Finefodder adopted its rival’s policy ed costs in its new superstore would f ut variable costs would rise from 81.25% to 84% of sales. Table 10.6 sho vel of sales, the two policies fare equally its costs fall along with revenue. In a boom the reverse is true, and the store with the ed costs has the advantage. If Finefodder follo y of hiring long-term employees, each e 2 $.8125 5 $.1875. If it uses tempo, an extra dollar of sales increases profits by only $1.00 2 $.84 5 $.16. As a ve high operating leverage. High operating lev We can measure a business’s operating lev for each 1% change in sales. The degree of operating leverage, often abbreviated as DOL, is this measure: DOL 5 percentage change in profits percentage change in sales (10.2) TABLE 10.6 A store with high operating leverage orms relatively badly in a slump but flourishes in a boom (figures in thousands of dollars). 4 sT ven point for the T Application of Financial en ,” Journal of Finance 28 (September 1973), pp. 821–838. 304 Part Two Value For example, Table 10.6 shows that as the store mov y with high Therefore, DOL 5 102.2 5 5.45 18.75 The percentage change in sales is magnified more than fivefold in terms of the percentage impact on profits. Now look at the operating leverage of the store if it uses the policy with lo ed costs but high v As the store moves from normal times to boom, profits Therefore, DOL 5 87.3 5 4.65 18.75 ge percentage ut the degree of operating leverage is lower. In fact, one can show that degree of operating leverage depends on fixed charges (including depreciation) in the following manner:5 DOL 5 1 1 ▲ EXAMPLE 10.3 fixed costs profits (10.3) Operating Leverage Suppose the firm adopts the high-fixed-cost policy. Then fixed costs including depreciation will be 2.00 1 .45 5 $2.45 million. Since the store produces profits of $.55 million at a normal level of sales, DOL should be DOL 5 1 1 fixed costs 2.45 511 5 5.45 profits .55 This value matches the one we obtained by comparing the actual percentage changes in sales and profits. Some companies hav Table 10.7, which shows the av ple of lar A 1% change in sales has on av ed costs than others. Look, for example, at ve relativ ve lo ed costs. ed costs. 6 5 ved as follo its will increase by .01 3 (sales 2 v DOL 5 percentage change in sales 5 100 3 change in profits level of profits 5 5 100 3 costs) 5 .01 3 (profits 1 ed costs). Now /level of profits .01 .01 3 (profits 1 fixed costs) level of profits fixed costs 511 profits 6 Y reason for this conclusion. ery low v ed costs) but use f f xhibiting low operating leverage. But there is a good wer, which have very wer to be brought online xpensive to b wer xpensive energy sources (with high v acilities. Chapter 10 Project Analysis 305 TABLE 10.7 Estimated degree of operating leverage (DOL) for large U.S. companies b Note: DOL is measured as the median ratio of the change in profits to the change in sales for firms in Standard & Poor’s Composite Index, 1998–2008. Notice that operating lev The greater the degree Risk of operating leverage, the greater the sensitivity of profits to v depends on operating leverage. If a large proportion of costs is fixed, a shor all in sales has a magnif ect on profits. We will have more to say about risk in the ne Self-Test 10.5 10.4 Real Options and the Value of Flexibility w (DCF) to v vely they have invested in a new project, they do not simply sit back and w y go badly, the project may . Most tools for project analysis ignore these opportunities. For e w end of your forecasts. It w y to close do ays are more valuable than those that don’t pro xibility. aluable this xibility becomes. The Option to Expand The scientists at MacCaugh have developed a diet whiskey ahead with pilot production and test-marketing. The preliminary phase will take a year and cost $200,000. Management feels that there is only a 50–50 chance that the pilot et tests will be successful. If the uild a $2 million production plant that will generate an e w in perpetuity of $480,000 after taxes. Given an opportunity cost of capital of 12%, project NPV in this case will be 2$2 1 $480,000/.12 5 $2 million. If the tests are not successful, MacCaugh will discontinue the project and the cost of the pilot production will be wasted. Notice that MacCaugh’s e uys a valuable manageThe f ut it has the option to do so depending on the outcome of the tests. If there is some doubt as to whether the project will tak void a e. Therefore, when it proposed the expenditure, MacCaugh’ ment was simply follo w the water temperature (and depth) dive in; if you don’ FINANCE IN PRACTICE FedEx Buys an Option decision tree Diagram of sequential decisions and possible outcomes. When faced with projects like this that involve future decisions, it is often helpful to draw a decision tree as in Figure 10.3. Y y. Each circle represents an outcome revealed by f left-hand square. If it decides to test, then fate will cast the enchanted dice and decide wn, MacCaugh faces a second decision: Should it wind up the project, or should it invest $2 million and start full-scale production? The second-stage decision is obvious: Invest if the tests indicate that NPV is positive gative. So now MacCaugh can move back to consider whether it should invest in the test program. This first-stage decision boils down to a simple problem: Should MacCaugh invest $200,000 now to obtain a 50% At any reasonable discount rate the test program has a positive NPV. Y y other investments that take on added value because of the options they provide to expand in the future. For example: • When designing a f , it can make sense to provide e reduce the future cost of a second production line. • When building a four-lane highway, it may pay to build six-lane bridges so that the road can be conv ves higher than expected. • An airline may acquire an option to buy a ne how Federal Express bought options on the Boeing 777 freighter). In each of these cases you are paying out money today to give you the option to invest in real assets at some time in the future. Managers therefore often refer to such FIGURE 10.3 Decision tree for the diet-whiskey project 306 Chapter 10 Project Analysis 307 options as real options. These options do not show up in the assets that the company lists in its balance sheet, but investors are v ware of their existence. If a company has valuable real options that allow it to inv et value will be higher than the value of its physical assets now in place. We consider the valuation of options in Chapter 23. real options Options to invest in, , or dispose of a capital investment project. A Second Real Option: The Option to Abandon If the option to expand has value, what about the decision to bail out? Projects don’t just go on until assets expire of old age. The decision to terminate a project is usually taken by management, not by nature. Once the project is no longer profitable, the company will cut its losses and exercise its option to abandon the project. T to sell than intangible ones. It helps to have active secondhand markets, which really e ely to be relatively easy to sell. On the other hand, the knowledge accumulated by a software company’s research and development program is a specialized intangible asset and probably would not hav alue. (Some assets, such as old mattresses, even have negative abandonment value; you have to pay wer plants or to reclaim land ▲ EXAMPLE 10.4 Abandonment Option Suppose that the Widgeon Company m o technologies for the manufacture of a new product, a Wankel-engined outboard motor: 1. Technology A uses custom-designed machinery to produce the complex shapes required for Wankel engines at low cost. But if the Wankel engine doesn’t sell, this equipment will be worthless. 2. Technology B uses standard machine tools. Labor costs are much higher, but the tools can easily be sold if the motor doesn’t sell. Technology er in an NPV analysis of the new product, because it is designed to have the lowest possible cost at the planned production volume. Yet you can sense the advantage of technology B’s fle ou are unsure whether the new outboard will sink or swim in the marketplace. Self-Test 10.6 A Third Real Option: The Timing Option Suppose that you have a project that could be a big winner or a big loser. The project’s upside potential outweighs its downside potential, and it has a positive NPV if undertaken today. However, the project is not “now or never.” So should you inv away or wait? It’ . If the project turns out to be a winner, waiting means the ws. But if it turns out to be a loser, it would have been better to w ely demand. Y y project proposal as giving you the option to invest today. You don’t have to exercise that option immediately. Instead, you need to weigh the value of 308 Two Value v velopment of a ne vestment has a small positive NPV. But oil prices are highly volatile, occasionally halving or doubling in the space of a couple be better to wait a little before investing. Our e wn apparently profitable projects. For example, suppose you approach your boss with a proposed project. It involv You explain to him ho fully you have analyzed the project, but nothing seems to convince him that the company should inv wn a positive-NPV project? Faced by such mar es sense to w may hav become clear whether it is really a winner or a loser. In the former case you can go ut if it looks like a loser, the delay will have helped you to av e.7 A Fourth Real Option: Flexible Production Facilities acility. It produces mutton and wool in roughly ed proportions. If the price of mutton suddenly rises and that of wool falls, there is little that the f y manuf y have b xibility to v changes. Since we hav case in which manuf ashion changes hav riously dif ve increasingly invested in computer-controlled vide an option to v void becoming dependent on a single source of raw materials. For e ate than oil-fired ones. Yet many companies prefer to buy boilers that can use either oil v . The reason is ob v ired boiler gives the company a valuable option to e Self-Test 10.7 7 ve-NPV vestment timing problem involves a choice among mutually exclusiv tives. Y uild the project today or next year, but not both. In such cases, we hav choice is the one with the highest NPV. The NPV of the project today, even if positive, may well be less than vestment and keeping alive the option to invest later. SUMMARY www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISE finance.yahoo.com www.mhhe.com/bmm7e SOLUTIONS TO SELF-TEST QUESTIONS MINICASE www.mhhe.com/bmm7e FIGURE 10.4 Chapter 11 335 Message 1: Some Risks Look Big and Dangerous but Really Are Diversifiable Managers confront risks “up close and personal.” They must make decisions about vestments. The failure of such an investment could cost a promotion, bonus, or otherwise steady job. Yet that same inv y to an investor who can stand back and combine it in a div y other assets or securities. ▲ EXAMPLE 11.2 Wildcat Oil Wells You have just been promoted to director of exploration, Western Hemisphere, of MPS Oil. The manager of your exploration team in far aguana has appealed for $20 million e a to drill in an even steamier part of the Costaguanan jungle. The manager thinks there may be an “elephant” field worth $500 million or more hidden there. But the chance of finding it is at best 1 in 10, and yesterday MPS’s CEO sourly commented on the $100 million already “wasted” on Costaguanan exploration. vestment? For you it probably is; you may be a hero if oil is found and a goat otherwise. But MPS drills hundreds of wells worldwide; for the company as a whole, it’s the average success rate ers. Geologic risks (is there oil or not?) should average out. The risk of a worldwide drilling program is much less than the apparent risk of any single wildcat well. Back up one step, and think of the investors who buy MPS stock. The investors may hold other oil companies too, as well as companies producing steel, computers, clothing, cement, and breakfast cereal. They naturally—and realistically— assume that your successes and failures in drilling oil wells will average out with the thousands of independent bets made by the companies in their por olio. Therefore, the risks you face in Cost ect the rate of return they demand for investing in MPS Oil. Diversified investors in MPS stock will be happy if you find that elephant field, but they probably will not notice if you fail and lose your job. In any case, they will not demand a higher average rate of return for worrying about geologic risks in Costaguana. ▲ EXAMPLE 11.3 Fire Insurance Would you be willing to write a $100,000 fire insurance policy on your neighbor’s house? The neighbor is willing to pay you $100 for a year’s protection, and experience shows that the chance of fire damage in a given year is substantially less than 1 in 1,000. But if your neighbor’s house is damaged by fire, you would have to pay up. Few of us have deep enough pockets to insure our neighbors, even if the odds of fire damage are very low. Insur ou think policy by policy. But a large insurance company, which may issue a million policies, is concerned only with average losses, which can be predicted with excellent accuracy. Self-Test 11.6 336 Part Three Risk Message 2: Market Risks Are Macro Risks We have seen that div vidual stocks b v market and the entire economy. These are macroeconomic, or “macro,” factors such as xchange rates, and energy costs. These f fect most f relevant macro risks turn generally fav vestors do well; when the same variables go the other way, investors suffer. You can often assess relative xposures to the business cycle and other macro v The following businesses have substantial macro and mark • Airlines. Because b vel f viduals postpone v v of the business cycle. On the positive side, airline prof b • Machine tool manufacturers. These b xposed to the business cycle. Manufacturing companies that have excess capacity rarely buy new machine tools to expand. During recessions, excess capacity can be quite high. Here, on the other hand, are tw verage macro exposures: • Food companies. Companies selling staples, such as breakf , and dog v • Electric utilities. wer v what across the business cycle, b vel or machine tools. Also, man gulated. Re but also giv Remember, investors holding diversified por olios are mostly concerned with macroeconomic risks. They do not w oeconomic risks peculiar to a particular company or investment project. Micro risks wash out in diversified portfolios. Company managers may worry about both macro and micro risks, but only the for ect the cost of capital. Self-Test 11.7 Message 3: Risk Can Be Measured Delta Airlines clearly has more exposure to macro risks than food companies such as Kellogg or General Mills. These are easy cases. But is IBM stock a riskier investment than ExxonMobil? That’s not an easy question to reason through. We can, however, measure the risk of IBM and ExxonMobil by looking at how their stock We’ve already hinted at how to do this. Remember that diversified investors are concerned with market risks. The movements of the stock market sum up the net effects of all relevant macroeconomic uncertainties. If the mark traded stocks is up in a particular month, we conclude that the net effect of Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital 337 macroeconomic news is positive. Remember, the performance of the market is barely affected by a f vent. These cancel out across thousands of stocks et. How do we measure the risk of a single stock, like IBM or ExxonMobil? We do not re up close to a v s sensiti verall stock market. We will show you how this works in the next chapter. SUMMARY L I S T I N G O F E Q U AT I O N S www.mhhe.com/bmm7e QUESTIONS QUIZ www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e finance.yahoo.com www.fidelity.com SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e WEB EXERCISES www.mhhe.com/bmm7e CHAPTER 12 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T T H R E E Risk I Professor William F. Sharpe receiving the Nobel Prize in Economics. 346 Part Three Risk 12.1 Measuring Market Risk v v market portfolio Por olio of all assets in the economy. In practice a broad stock market index is used to represent the market. macro ev We market , then the net impact of macve. W v verage out when we orld economy— not just stocks but bonds, foreign securities, real estate, and so on. In practice, however e do with index et, such as the Standard & Poor’s Composite Index (the S&P 500).1 Our task here is to define and measure the risk of individual You can probably see where we are headed. Risk depends on exposure to macroeconomic events and can be measured as the sensitivity of a stock’ et portfolio. This sensitivity is called the stock’s beta. Beta is often b. beta ock’s return to the return on the market por olio. Measuring Beta v you had held Do much as they would hav et: v ould have v vestors don’ v Div ggs v vidual stocks but not the v agers talk about “defensive” and “aggressive” stocks. Defensive stocks are not v sensitive to mark ve low betas. In contrast, aggressive et mov v et goes up, it is good to be in aggressive stocks; if it goes down, it is better to be in defensive stocks (and better still to have your money in the bank). Aggressive stocks have high betas, betas greater than 1.0, meaning that their returns tend to respond more than one for one to changes in the return of the overall market. The betas of defensive stocks are less than 1.0. The returns of these stocks v or one with market returns. The average beta of all stocks is—no surprises here—1.0 exactly. Now we’ll show you how betas are measured. ▲ EXAMPLE 12.1 Measuring Beta for Turbot-Charged Seafoods Suppose we look back at the trading history of Turbot-Charged Seafoods and pick out 6 months when the return on the market portfolio was plus or minus 1%. 1 W et indexes in Section 11.2. Chapter 12 Risk, Return, and Capital Budgeting 347 FIGURE 12.1 This figure is a plot of the data presented in the table in Example 12.1. Each point shows the ormance of TurbotCharged Seafoods stock when the overall market is either up or down by 1%. On average, Turbot-Charged moves in the same direction as the market, but not as far. Therefore, Turbot-Charged’s beta is less than 1.0. We can measure beta by the slope of a line fitted to the points in the figure. In this case it is .8. Look at Figure 12.1, where these observations are plotted. We’ve drawn a line through the average performance of Turbot when the market is up or down by 1%. The slope of this line is Turbot’s beta. You can see right away that the beta is .8, because on average Turbot stock gains or loses .8% when the market is up or down by 1%. Notice that a 2-percent erence in the market return (21 to 11) generates on average a 1.6-percent erence for Turbot shareholders (2.8 to 1.8). The ratio, 1.6/2 5 .8, is beta. In 4 months, Turbot’s returns lie above or below the line in Figure 12.1. The distance from the line shows the response of Turbot’s stock returns to news or events that ected Turbot but did not ect the overall market. For example, in month 2, investors in Turbot stock benefited from good macroeconomic news (the market was up 1%) and also from some favorable news specific to Turbot. The market rise gave a boost of .8% to Turbot stock (beta of .8 times the 1% market return). Then firm-specific news gave Turbot stockholders an e a 1% return, for a total return that month of 1.8%. As this example illustrates, we can break down common stock returns into two parts: the part explained by market returns and the firm’s beta, and the part due to news that is specific to the firm. Fluctuations in the first part reflect market risk; fluctuations in the second part reflect specific risk. Of course, div That’s why wise investors, who don’t put all their eggs in one basket, will look to Turbot’ verage beta and call its stock “defensive.” Self-Test 12.1 SPREADSHEET SOLUTIONS Calculating Risk Spreadsheet Questions Real life doesn’t serve up numbers quite as convenient as those in our examples so far. However, the procedure for measuring real companies’ betas is exactly the same: 1. 2. Plot the observations as in Figure 12.1. 3. Fit a line showing the av et. This may sound like a lot of work, but in practice computers do it for you. The nearby box shows how to use the SLOPE function in Excel to calculate a beta. Here o real e Betas for Dow Chemical and Consolidated Edison Each point in Figure 12.2a sho the market index in a different month. For example, the circled point shows that in w Chemical’ et index rose by 8.5%. Notice that more often than not Do 348 Chapter 12 Risk, Return, and Capital Budgeting 349 FIGURE 12.2 (a) Each point in this figure shows the returns on Dow Chemical common stock and the overall market in a particular month between June 2005 and May 2010. Do s beta is the slope of the line fitted to these points. Dow has a v high beta of 2.28. (b) In this plot of 60 months’ returns for Con Ed and the overall market, the slope of the fitted line is much less than Dow’s beta in (a). Con Ed has a relatively low beta of .32. inde et when the index fell. Thus Dow was a relatively aggressive, high-beta stock. 2 The slope of this We have dra line is 2.28. For each e et, Dow’ ved on average an e or each extra 1% f et, Dow’ xtra 2.28%. Thus Dow’s beta was 2.28. Of course, Dow’ The company w ws up in the scatter of points around the line. Sometimes Do w south while the mark ersa. Figure 12.2b sho In contrast to Do as a defensive, low-beta stock. It was not highly sensitive to market movements, usually lagging when the market rose and yet doing better (or less badly) when the market fell. ws that on average an extra 1% change in the inde price of Con Ed stock. Thus ConEd’s beta was .32. Estimates of beta can be accessed easily, for example, at finance.yahoo.com, but Table 12.1, which shows ho et movements hav fected sev lowest beta: Its stock return was .32 times as sensitive as the average stock to market movements. Dow Chemical was near the other e as 2.28 times as sensitive as the av et movements. 2 wn as a regression line. least squares regression. The dependent v v et index, in this case the S&P 500. or w Chemical). The independent 350 Three Risk Total Risk and Market Risk Ford and Do Table 12.1. They were also at the top of Table 11.6, which showed the total variability of the same group of stocks. But et risk. Some of the most variable stocks have belowaverage betas, and vice versa. Consider, for example, Newmont Mining. Newmont is the world’ gest gold producer. The company cites the man y faces as “gold and other metals’ price volatility, increased costs and v v countries in which we operate and gov returns on Newmont’s stock (see T gulation and judicial outcomes.” viation of the When the wmont stock has above-average volatility, it has a relatively low beta. Portfolio Betas Div et risk. The v weighted by the investment in each security. For e two stocks would have a beta as follows: Beta of portfolio 5 ( 1( 3 beta of second stock) 3 beta of first stock) (12.1) vested 50–50 in Dow Chemical and Consolidated Edison would have a beta of (.5 3 2.28) 1 (.5 3 .32) 5 1.30. A well-div e Dow Chemical, would still have a portfolio beta of 2.28. However, most of the individual stocks’ specif ould be diversified away. et risk would remain, and such a ould end up 2.28 times as v et. For e et TABLE 12.1 Betas for selected common stocks, May 2005–April 2010 Note: Betas are calculated from 5 years of monthly data. Chapter 12 Risk, Return, and Capital Budgeting 351 viation of 20%, a fully div viation of 2.28 3 20 5 45.6%. ve in the same direction as the w-beta stocks like Consolidated v et movements. Such a portfolio is .32 times as v et. Of course, on average stocks have a beta of 1.0. v verage beta of 1.0, has the same variability as the et index. et but not as far. A well-div Self-Test 12.2 ▲ EXAMPLE 12.2 How Risky Are Mutual Funds? You don’t have to be wealthy to own a diversified por olio. You can buy shares in one of the more than 8,000 mutual funds in the United States. Investors buy shares of the funds, and the funds use the money to buy por olios of securities. The returns on the portfolios are passed back to the funds’ owners in proportion to their shareholdings. Therefore, the funds act like investment cooperatives, ering even the smallest investors diversification and professional management at low cost. Let’s look at the bet o mutual funds that invest in stocks. Figure 12.3a plots the monthly returns of Vanguard’s Explorer mutual fund and of the S&P index for 5 years ending in April 2010. You can see that the stocks in the Explorer fund had above-average sensitivity to market changes: They had on average a beta of 1.15. If the Explorer fund had no specific risk, its portfolio would have been 1.15 times as variable as the market por olio. But the fund manager wanted to beat the market, not to hold it. So the fund had not diversified away all the specific risk; there is still some scatter about the line in Figure 12.3a. As a result, the variability of the fund was somewhat more than 1.15 times that of the market. FIGURE 12.3a The slope of the fitted line shows that investors in the Vanguard Explorer mutual fund bore market risk greater than that of the S&P 500 por olio. Explor s beta was 1.15. This was the average beta of the individual common stocks held by the fund. Investors also bore some specific risk, however; not er of Explor s returns above and below the f ed line. 352 Part Three Risk FIGURE 12.3b The Vanguard 500 Portfolio is a fully diversified index fund designed to track the ormance of the market. Note the fund’s beta (1.0) and the absence of specific risk. The fund’s returns lie almost precisely on the f ed line relating its returns to those of the S&P 500 por olio. Figure 12.3b shows the same sort of plot for Vanguard’s Index Trust 500 Por olio mutual fund. Notice that this fund has a beta of 1.0 and only a tiny residual of specific risk—the f ed line fits almost exactly because an index fund is designed to track the market as closely as possible. The managers of the fund do not attempt to pick good stocks but just work to achieve full diversification at very low cost. The index fund is fully diversified. Investors in this fund buy the market as a whole and don’t have to worry at all about specific risk. Self-Test 12.3 12.2 Risk and Return market risk premium Risk premium of market por olio erence between market return and return on risk-free Treasury bills. In Chapter 11 we looked at past returns on selected investments. y investment was U.S. T T ed, it is unafet. Thus the beta of Treasury bills is zero. The most y investment that we considered w This has av et risk: Its beta is 1.0. Wise investors don’t run risks just for fun. They are playing with real money and therefore require a higher return from the market portfolio than from Treasury bills. The dif et and the interest rate on bills is termed the market risk premium. Over the past century the average market risk premium has been 7.4% a year. Of course, there is plenty of scope for argument as to ut we will just assume here that the normal risk premium is a nice round 7%, that is, 7% is the additional return that an investor could reasonably expect from investing in the stock market rather than T bills. Chapter 12 353 Risk, Return, and Capital Budgeting FIGURE 12.4 (a) Here we begin the plot of expected rate of return against beta. The first benchmarks are Tr a 5 0) and the market portfolio (beta 5 1.0). We assume a Tr ate of 3% and a market return of 10%. The market risk premium is 10 2 3 5 7%. (b) A por olio split ev een Treasury bills and the market will have beta 5 .5 and an expected return of 6.5% (point portfolio invested 20% in the market and 80% in Treasury bills has beta 5 .2 and an expected rate of return of 4.4% (point e that the expected rate of return on any portfolio mixing Treasury bills and the market lies on a straight line. The risk premium is proportional to the portfolio beta. In Figure 12.4a we hav T and the mark You can see that T v free return; we’ll assume that return is 3%. The mark 3 an assumed e Now, given these two benchmarks, what e vestor vided between T et? Halfway between, of course. Thus in Figure 12.4b we have drawn a straight line through the T xpected market return. ed with an ould have a beta of .5 and an e premium of 3.5% above the T You can calculate this return as follo ference between the rf. This is the expected mark expected mark rm and the T premium: 5 rm 2 rf 5 10% 2 3% 5 7% ve to the market. Therefore, the expected risk premium premium 5 r 2 rf 5 b(rm 2 rf) 3 W mark et is about 7%. With a 3% T ould be 3 1 7 5 10%. xpected 354 Part Three Risk For e Risk 5 b(rm 2 rf) 5 .5 3 7% 5 3.5% The total expected rate of return is the sum of the risk-free rate and the risk premium: 5 1 r 5 rf 1 b(rm 2 rf) 5 3% 1 3.5% 5 6.5% (12.2) You could have calculated the e Expected return 5 r 5 rf 1 b(rm 2 rf) 5 3% 1 (.5 3 7%) 5 6.5% capital asset pricing model (CAPM) Theory of the relationship between risk and return which states that the expected risk premium on an equals its beta times the market risk premium. This basic relationship should hold not only for our portfolios of T market, but for any asset. wn as the capital asset pricing model, or CAPM. The expected rates of return demanded by investors depend on two things: (1) compensation for the time value of money (the risk-free rate rf) and (2) a risk premium, which depends on beta and the market risk premium. Note that the expected rate of return on an asset with b 5 W et r 5 rf 1 b(rm 2 rf) 5 3% 1 (1 3 7%) 5 10% Self-Test 12.4 Why the CAPM Makes Sense The CAPM assumes that the stock market is dominated by well-div vestors et risk. That is reasonable in a stock market where ge institutions and even small fry can diversify at v w cost. The following example shows why in this case the CAPM makes sense. ▲ EXAMPLE 12.3 How Would You Invest $1 Million? Have you ever daydreamed about receiving a $1 million check, ached, from an unknown benefactor? Let’s daydream about how you would invest it. We hav o good candidates: Treasury bills, er an absolutely safe return, and the market por olio (possibly via the Vanguard index fund discussed earlier in this chapter). The market has generated superior returns on average, but those returns have fluctuated a lot. (Look back to Figure 11.4.) So your investment policy is going to depend on your tolerance for risk. If you’re a wimp, you may invest only part of your money in the market portfolio and lend the remainder to the government by buying Treasury bills. Suppose that you invest 20% of your money in the market por olio and put the other 80% in U.S. Treasury bills. Then the beta of your por olio will be a mixture of the beta of the market (bmarket 5 1.0) and the beta of the T-bills (b T-bills 5 0): Chapter 12 355 Risk, Return, and Capital Budgeting Beta of por olio 5 a proportion beta of proportion beta of b 1 a b 3 3 in market market in T-bills T-bills b 5 (.2 3 bmarket) 1 (.8 3 bT-bills) 5 (.2 3 1.0) 1 (.8 3 0) 5 .20 The fraction of funds that you invest in the mark ects your expected return. If you invest your entire million in the market por olio, you earn the full market risk premium. But if you invest only 20% of your money in the market, you earn only 20% of the risk premium. Expected proportion market risk proportion risk premium b1 a b risk premium 5 a 3 3 in market premium in T-bills on T-bills on portfolio 5 (.2 3 expected market risk premium) 1 (.8 3 0) 5 .2 3 expected market risk premium 5 .2 3 7 5 1.4% The expected return on your portfolio is equal to the risk-free interest rate plus the expected risk premium: Expected portfolio return 5 rpor olio 5 3 1 1.4 5 4.4% In Figure 12.4b we show the beta and expected return on this por olio b er Y. The Security Market Line security market line Relationship between expected return and beta. Example 12.3 illustrates a general point: By inv y in the mark wing)4 the balance, you can obtain any combination of risk and expected return along the sloping line in Figure 12.5. This line is generally known as the security market line. Self-Test 12.5 The secur ket line describes the expected returns and risks from investerent fractions of your funds in the market. It also sets a standard for other investments. Investors will be willing to hold other investments only if the er 4 et line extends abov , b 5 2.0? It’s easy, but it’ ves you $2 million inv b 5 1.0. How would you generate a w $1 million and inv .Y w has a beta of 2.0: 5 (proportion in market 3 beta of market) 1 ( b 5 (2 3 b et) 1 (21 3 b ) 5 (2 3 1.0) 1 (21 3 0) 5 2 gativ ay er w 3 beta of loan) wing, not lending money. xpensive as long as you vest strategy? 356 Part Three Risk FIGURE 12.5 The security market line shows how expected rate of return depends on beta. According to the capital asset pricing model, expected rates of return for all securities and all portfolios lie on this line. equally good prospects. Thus the required risk premium for any investment is given by the secur ket line: Risk premium on investment 5 beta 3 expected market risk premium Look back to Figure 12.4b, which suggests that an indi b 5 .5 must offer a 6.5% expected rate of return when T et risk premium is 7%. You can now see why this has to be so. If that stock offered a lower rate of return, nobody would buy even a little of it—they could get 6.5% just by investing 50–50 in T et. And if nobody wants to hold the stock, its price has to drop. A lower price means a better buy for investors, that The price will fall until the stock’s expected rate of return is pushed up to 6.5%. If, on the other hand, our stock offered more than 6.5%, div vestors would want to buy more of it. That would push the price up and the e wn to the levels predicted by the CAPM. This reasoning holds for stocks with any beta. That’s why the CAPM makes sense, and why the e v Self-Test 12.6 How Well Does the CAPM Work? The basic idea behind the capital asset pricing model is that investors expect a rew for both w The greater the w you inv T ve the rate of interest. That’s the reward for waiting. When you invest in risky stocks, you can expect an e is equal to the stock’ Therefore, 5 risk-free interest rate 1 (beta 3 r 5 rf 1 b(rm 2 rf) How well does the CAPM w .5 on average lie halfw ) Chapter 12 Risk, Return, and Capital Budgeting 357 FIGURE 12.6 The capital asset pricing model states that the expected risk premium from any investment should lie on the secur market line. The dots show the actual average risk premium from portfolios with erent betas. The high-beta portfolios generated higher returns, just as predicted by the CAPM. But the high-beta portfolios plotted below the market line and the low-beta portfolios plotted above. A line f ed to the 10 por olio returns would be “flatter” than the secur ket line. Source: This material is reprinted with permission from Institutional Investor, Inc. It originally appeared in the Fall 1993 issue of the Journal of P olio Management 20. It is illegal to make unauthorized copies of this article. For more information please visit www.iijournals.com. All Rights Reserved. rate on T , the e s look back to vestors in low-beta stocks and in high-beta stocks. Imagine that in 1931 ten investors gathered together in a W to establish inv vestor decided to follow a gy. Investor 1 opted to buy the 10% of the New York Stock Exchange stocks with the lowest estimated betas; investor 2 chose the 10% with the next-lowest vestor 10, who proposed to buy the stocks with the highest betas. They also planned that at the end of each year they would reestimate the betas of And so the ality and good wishes. In time the 10 investors all passed away, but their children agreed to meet in early Figure 12.6 shows how they f vestor 1’ y than the market; its beta was only .49. However, investor 1 also realized the lo abov At the other extreme, the beta of investor 10’s portfolio w vestor 1’ vestor 10 was rew v ve the interest rate. So ov As you can see from Figure 12.6 et portfolio ov pro verage return of 11.8% above the interest rate5 and (of course) had a beta of 1.0. et line in Figure 12.6. Since the market provided a risk premium of 11.8%, investor 1’s ve pro vestor 10’ ve given a premium of 18.1%. You can see that, while high-beta stocks performed better than low-beta stocks, the difference was not as great as the CAPM predicts. Figure 12.6 pro v CAPM. For e vested their cash in 1966 rather than 1931, there would have been v beta.6 Does this imply that there has been a fundamental change in the relation between 5 In Figure 12.6 pro v alue-weighted index. Figure 12.6 and the 7.4% premium reported in Table 11.1. 6 irst seven investors increased in line with beta. However . ve x is et risk 358 Part Three Risk FIGURE 12.7 The blue line shows the cumulative difference between the returns on small-firm and lar irm stocks from 1926 to September 2010. The orange line shows the cumulative difference between the returns on high-book-tomarket-value stocks and low-book-to-market-value stocks. Source: mba.tuck.dartmouth.edu/pages/faculty/k Kenneth R. French. w h/data_library.html. Used by permission of vestors expected? It is hard to be sure. v et. For example, look at Figure 12.7. The orange line shows the cumula- tive dif gest capitalizations, this is how your wealth would have changed. You can see that small-cap stocks did not always do well, but over the long haul their owners have made v ference between o groups of stocks has been 3.8%. Now look at the blue line in Figure 12.7, which shows the cumulativ alue stocks and gro Value stocks alue et v Growth stocks et. Notice that value stocks have pro wth stocks. Since 1926 the av wth stocks has been 4.9%. with the CAPM, which predicts that beta is the only reason that e fer. If investors expected et ratios, then the simple v What’s going on here? It is hard to say. Defenders of the capital asset pricing model emphasize that it is concerned with expected e only actual returns. xpectations, but they also embody lots of verage investors have receiv y expected. e that in the past smallfirm stocks and value stocks have pro t be sure whether this was simply a coincidence or whether investors have required a higher Such debates have prompted headlines like “Is Beta Dead?” in the business press. It is not the first time that beta has been declared dead, but the CAPM remains the leadve more than one funeral. The CAPM is not the only model of risk and return. It has several brothers and sisters as well as second cousins. However, the CAPM captures in a simple way two veryone agrees that investors require some extra vestors appear to be concerned principally with the market risk that the v . Chapter 12 TABLE 12.2 359 Risk, Return, and Capital Budgeting Expected rates of return Note: Expected return 5 r 5 rf 1 b(rm 2 rf) 5 3% 1 b 3 7%. Using the CAPM to Estimate Expected Returns T vestors are e three numbers—the risk-free interest rate, the expected market risk premium, and beta. Suppose that the interest rate on T et risk premium is about 7%. Now look back to Table 12.1, where we gave you betas of several stocks. Table 12.2 puts these numbers together to give an estimate of the expected s take Dell Computer as an example: Expected return on Dell 5 1 ¢ beta 3 ≤ r 5 3% 1 (1.33 3 7%) 5 12.3% Of our sample of companies, Ford had the highest beta. Investors in Ford required xtra market risk. Table 12.2 suggests that Ford’s e s. 12.3 Capital Budgeting and Project Risk We hav aces a trade-off. It can either buy new plant and equipment vest the money for themselves in the et. y invests the cash, shareholders can’t invest these funds in the capital market. ve up by keeping their money in the company is therefore called the need the compan vestments. We hav vestors could e vestors can buy. company cost of capital Expected rate of return demanded by investors in a company, determined by the average risk of the company’s securities. r, vel of Company versus Project Risk Man company cost of capital v ws on all new projects. Because 360 Three Risk inv y ve a w investment or e e project cost of capital Minimum acceptable expected rate of return on a project given its risk. Table 12.2). According to the company cost of This is a step in the right direction, but we must tak irm has issued securities other than equity.7 Moreover new projects do not hav xisting business. Dell’ investors’ estimate of the risk of the computer hardware business, and its company cost of capital is the return that inv xpansion of its re xpected cash ws by the company cost of capital. But suppose Dell is w project cost of capital. shareholders require from investing in such a business. Self-Test 12.7 The project cost of capital depends on the use to which that capital is put. Therefore, it depends on the risk of the project—not on the risk of the company. If a company invests in a lo low cost of capital. If it inv ws should be discounted at a high cost of capital. Many companies use the company cost of capital as y require on a “typical” capital investment. They then Self-Test 12.8 ▲ EXAMPLE 12.4 Estimating the Opportunity Cost of Capital for a Project Suppose that Dell is contemplating investment in a new project. You have forecast the cash flows on the project and calculated that the internal rate of return is 11%. We assume that Treasur er a return of 3% and that the expected market risk premium is 7%. Should Dell go ahead with the project? To answer this question, you need the oppor al, r. You start with the project’s beta. For example, if the project is a sure thing, its beta is zero and the cost of capital equals the interest rate on Treasury bills: r 5 rf 1 b(rm 2 rf) 5 3 1 (0 3 7) 5 3% 7 Therefore, the Chapter 12 361 Risk, Return, and Capital Budgeting If the pr ers an expected return of 11% when the cost of capital is 3%, Dell should obviously go ahead.8 But if you had compared this project’s return with Dell’s 12.3% company cost of capital, you would have wrongly concluded that it was not worthwhile. Surefire projects rarely occur outside finance texts. So let’s think about the cost of capital if the project has the same risk as the market por olio. In this case beta is 1.0, and the cost of capital is the expected return on the market: r 5 3 1 (1.0 3 7) 5 10% The project appears less attractive than before but still worth doing. lies abov reasonably expect else NPV investment. ve because, as Figure 12.8 shows, its e et line. The project offers a higher return than investors can vestments. Therefore, it is a positive- The security market line provides a standard for project acceptance. If the project’s expected return lies above the security market line, then it is higher than investors could expect to earn by investing their funds in the capital market, and the project is an attractive investment oppor . Determinants of Project Risk We hav that hav y’s existing business but not for those projects y’s average. Ho w whether a y? Estimating project risk is never going to be an exact science, but here are two things to bear in mind. First, we sa v y change in rev ve a Therefore, projects that involv ed costs tend to hav Second, many people intuitiv much of this v v look forward to e ut whether the e it rich is not lik . These investments (like Newmont Mining) hav viation but a low beta. FIGURE 12.8 The expected return of this project is more than the expected return one could earn on stock market investments with the same market risk (beta). Therefore, the project’s expected return lies above the secur market line, and the project should be accepted. 8 fer a lower internal rate W w ones. 362 Three Risk What matters is the strength of the r een the firm’s earnings and the aggregate earnings of all firms. Cyclical businesses, whose revenues and earnings are strongly dependent on the state of the economy, tend to have high betas and a high cost of capital. By contrast, businesses that produce essentials, such as food, beer, and cosmetics, ar ected by the state of the economy. They tend to have low betas and a low cost of capital. Don’t Add Fudge Factors to Discount Rates Risk to an investor arises because an investment adds to the spread of possible portfoTo a diversified investor et risk. But in everyday usage risk ” People think of the “risks” of a project as the things that can go wrong. For example, • • A pharmaceutical manufacturer w reverses balding may not be approved by the F • The o xpropriation. w drug which Administration. orld w Managers sometimes add fudge factors to discount rates to account for w these. v ould not affect the e inv managers fail to giv w forecasts. The e by adding a fudge factor to the discount rate. For example, if a manager is w xploration, he or she may reduce the value of the project by using a higher discount rate. That’s not the w v Then the expected lion. Y ut (.5 3 0) 1 (.5 3 20) 5 $10 Expected cash-flow forecasts should already reflect the probabilities of all possible outcomes, good and bad. If the cash-flow forecasts are prepared properly, the discount rate should reflect only the market risk of the project. It should not be fudged t ors or biases in the cash-flow forecast. SUMMARY www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ www.mhhe.com/bmm7e FIGURE 12.9 PRACTICE PROBLEMS www.mhhe.com/bmm7e FIGURE 12.10 www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISE finance.yahoo.com finance.yahoo.com www.fidelity.com SOLUTIONS TO SELF-TEST QUESTIONS SOLUTIONS TO SPREADSHEET QUESTIONS www.mhhe.com/bmm7e FIGURE 12.11 CHAPTER 13 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T T H R E E Risk Geothermal Corporation was founded to produce electricity from geothermal energy trapped under the earth. I 372 Part Three Risk 13.1 Geothermal’s Cost of Capital Jo Ann Cox, a recent graduate of a prestigious eastern business school, poured a third w about project hurdle rates. Why hadn’t she paid more attention in Finance 101? Why had she sold her finance te Costas valuation of a proposed e s production. She w Thermopolis, whose background was geoxpected a numerical analysis but also expected her to explain it to him. mal energy trapped deep under Nevada. y had pioneered this business and av U.S. government. ve up ener orldy. It w . Now, in 2012, production rights were no longer cheap. The proposed expansion w w of $4.5 . as 4.5/30 5 .15, or 15%, much less s existing assets. However, once the new project was up and running, it w s present business. Jo Ann realized that 15% w would have been better. Fifteen percent might still exceed Geothermal’s cost of capital, that is, exceed the e vestors would demand to invest money in the project. If the cost of capital w xpected xpansion would be a good deal and would generate net v Jo Ann remembered how to calculate the cost of capital for companies that used gument. “I need the expected rate of return investors w s real assets—the wells, pumps, generators, etc. wever et, so I can’ e how risky they hav s common stock. wning the stock means owning the assets, and the e vestors in the stock must also be the cost of capital for the assets.” She jotted down the following identities: of business 5 value of stock Risk of business 5 Rate of return on business 5 rate of return on stock Investors’ required return from business 5 investors’ required return from stock capital structure The mix of long-term debt and equity financing. If there were no company debt, this would be the right discount rate for Geothermal’s expansion plan. Unfortunately, Geothermal had borrowed a substantial amount of money; its stockholders did not have unencumbered ownership of Geothermal’s assets. The expansion project would also justify some e ould have to look at Geothermal’s capital structure—its mix of debt and equity financing—and consider the e vestors. w trading at $20 each. Thus shareholders valued Geothermal’s equity at $20 3 22.65 million 5 $453 million. In addition, the compan et v et value of the company’s debt and equity was therefore $194 1 $453 5 $647 million. Debt was 194/647 5 .3, or 30% of the total. Chapter 13 373 The Weighted-Average Cost of Capital and Company Valuation sw vestors than either its debt or its equity,” Jo Ann verall v s business by adding up the debt and equity.” She sketched a rough balance sheet: Assets Liabilities and Shareholders’ Equity Market v 5v of Geothermal’s existing business $647 Total value $647 Market value of debt Market value of equity Total value $194 453 $647 (30%) (70%) (100%) “Holy Toledo, I’ve got it!” Jo Ann exclaimed. “If I bought all Geothermal, debt as well as equity, I’d own the entire business. That means . . .” She jotted again: Value of business 5 value of portfolio of all the firm’s debt and equity securities Risk of business 5 Rate of return on business 5 rate of return on portfolio Investors’ required return on business (company cost of capital) 5 portfolio “All I have to do is calculate the e irm’s securities. That’s easy. The debt’s yielding 8%, and Fred, that nerdy banker, says that equity investors want 14%. Suppose he’s right. ould contain 30% debt and 70% equity, so . . .” Portfolio return 5 (.3 3 8%) 1 (.7 3 14%) 5 12.2% It was all coming back to her now. y cost of capital is just a weighted average of returns on debt and equity, with weights depending on relative market values of the two securities. “But there’s one more thing. Interest is tax-deductible. If Geothermal pays $1 of s tax bill drops by 35 cents (assuming a 35% tax rate). The net cost is only 65 cents. So the after-tax cost of debt is not 8%, but .65 3 8 5 5.2%. “No verage cost of capital: WACC 5 (.3 3 5.2%) 1 (.7 3 14%) 5 11.4% “Looks like the e a break.” s a good deal. Fifteen’s better than 11.4. But I sure need 13.2 The Weighted-Average Cost of Capital Jo Ann’ vious by now that the choice of volves large capital expenditures or is long-lived. w a major investment in a power station—an investment with both a large capital e y cost of capital is, and what it is used for. We se use it to v it as w assets that hav xpands by investing in av We f v v ets. If vest their money only if it FINANCE IN PRACTICE Choosing the Discount Rate Shortly before the British government began to sell off the electricit y to private investors, controversy er ed ov y’s proposal to b awatt n wer station known as Hinkley Point C. The government ar ation w ersify the ces of electricity generation and r xide and carbon dioxide emissions. Protesters emphasized the dangers of n tacked the proposal as “bizarre, dated and irrelevant.” y held to consider the proposal, opponents pr w vidence that the n ation was also a very high cost option. Their principal witness, Professor Elroy Dimson, ar vernment-owned power company had employ ealistically low fi e for the oppor y cost of capital. Had the compan mor le fi e, the cost of b ating the n ation w ve been higher than that of a comparable station based on f . The reason wh ate was so important was that n ations are expensive to b cheap to operate. If capital is cheap (i.e ate is lo ont cost is less ser . of capital is high, then the high initial cost of n ations Evidence pr constr ed that the ation was £1,527 million (or able nonn clear station was only £895 million. However, power stations ears, and, once b ations cost m o operate than nonn ations. If operated etical capacity, the r n ation w ear, compared with r 68 million a year for the nonn ation. The following table shows the cost advantage of the n wer station at different (r ates. At a ate, which was the fi y the government, the present v as own. Therefore, the e nearly £1 billion lower than that of a station based on fossil . ate of 1 as the fi e favored by Professor Dimson, the position was almost exactly reversed, so the gover ve nearly £1 billion by r wer company permission to b y Point C and relying instead on new f wer stations. Eight years aft y, the proposal to constr kley Point C contin og itish Energy, the privatized electr y, declared that it had no plans to b a new n wer st e. 8 10 12 14 16 18 0.9 0.2 0.1 0.4 0.7 0.9 1.2 Technical Notes: 1. Present v ed at the date that the power station comes into operation. 2. The above tab or simplicity that constr or n stations are spread evenly over the 8 years before the station comes into operation, while the costs for f ations ar o be spread evenly over the 4 years before operation. As a r esent v the costs of the two stations may differ slightly from the more precise estimates pr y Professor Dimson. Adapted from Elroy Dimson, ,V from Elsevier Science. . 175–180. ate for a Power Station,” 989 with permission fer higher rates of return than investors could achieve on their v ets detervestments. y as a y cost of capital in Chapter 12, b whole. W ho or how to adjust it for the tax-deductibility of interest payments. The weighted-average cost of capital formula handles these complications. Calculating Company Cost of Capital as a Weighted Average y cost of capital is ways easy. For e pricing model (CAPM). This would be the expected rate of return investors require on the company’s e xpected return they will require on new investments that do not change the company’s mark 374 Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 375 But most companies issue debt as well as equity. The company cost of capital is a weighted average of the returns demanded b vestors. The weighted average is the expected rate of return investors would demand on a portfolio of all the firm’s outstanding securities. Let’s review Jo Ann Cox’s calculations for Geothermal. To avoid complications, we’ll ignore tax xt two or three pages. et value of Geothermal, which we denote as V, is the sum of the values of the outstanding debt D and the equity E. alue is V 5 D 1 E 5 $194 million 1 $453 million 5 $647 million. Debt accounts for 30% of the v If you held all the shares and all the debt, your investment in Geothermal would be V 5 $647 million. Between them, the debt- and equityholders own all s assets. So V is also the value of these assets—the v s existing business. s equity inv investment in the stock. What rate of return must a new project provide in order that all inv air rate of return? The debtrdebt 5 8%. So each year the f interest of rdebt 3 D 5 .08 3 $194 million 5 $15.52 million. The shareholders, who have invested in a riskier security, require an e requity 5 14% on their investment of $453 million. Thus in order to k y y 5 $63.42 To needs additional income of requity 3 E 5 .14 3 $453 lion 1 $63.42 million 5 $78.94 million. This is equiv rassets 5 78.94/647 5 .122, or 12.2%. Figure 13.1 illustrates the reasoning behind our calculations. The figure shows the vestors. Notice that debtut receive less than 30% of its expected income. On the other hand, the they hav y’s income and also first claim on its assets if the company gets in trouble. Shareholders expect a return of more than 70% of Geothermal’s income because the However, if you buy all s debt and equity, you own its assets lock, You receiv The expected rate of return you’ d require from unencumbered ownership of the business. This rate of return—12.2%, ignoring taxes—is therefore the compan equal-risk expansion of the business. FIGURE 13.1 Geothermal’s debtholders account for 30% of the company’s capital structure, but they get a smaller share of income because their return is guaranteed by the company. Geothermal’s stockholders bear more risk and receive, on average, greater return. Of course, if you buy all the debt , you get all the income. 376 Part Three Risk The bottom line (still ignoring taxes) is Company cost of capital 5 The underlying algebra is simple. Debtholders need income of (rdebt 3 D), and the The total income that is needed equity investors need expected income of (requity 3 The amount of their combined existing investment in the is (rdebt 3 D) 1 (requity 3 y is V. vide the income by the investment: rassets 5 5 total income value of investment (D 3 rdebt) 1 (E 3 requity) V 5 ¢ D E 3 rdebt ≤ 1 ¢ 3 r V V ≤ F rassets 5 (.30 3 8%) 1 (.70 3 14%) 5 12.2% This figure is the e v s assets. Self-Test 13.1 Use Market Weights, Not Book Weights The company cost of capital is the expected rate of return that investors demand from The cost of capital must be based on what the company’ investors are actually willing to pay for the company’s outstanding securities— that is, based on the securities’ market values. Market values usually differ from the values recorded by accountants in the company’s books. The book v y raised in the past from shareholders or reinvested by the f vestors recognize Geothermal’s e et value of equity may be much higher than et values rather than book values. Financial managers use book debt-to-value ratios for v times they unthinkingly look to the book ratios when calculating weights for the company cost of capital. That’s a mistake, because the company cost of capital measures what investors want from the company, and it depends on how they value the company’ That v ws, not on accounting . Book values, while useful for man ve inancings; they don’t generally measure market values accurately. Self-Test 13.2 Assets (book v Debt y 50 Chapter 13 377 The Weighted-Average Cost of Capital and Company Valuation Taxes and the Weighted-Average Cost of Capital So f xamples hav es. When you calculate a project’s NPV, you need ws after That is exactly the approach that we used in Chapter 9, when we valued Blooper’s inv ws before discount rate. It doesn’t work; there is no simple adjustment to the discount rate that ws. Tax debt. The interest payments on this debt are deducted from income before tax is calculated. Therefore, the cost to the company is reduced by the amount of this tax saving. s debt is rdebt 5 8%. However The rate of Tc 5 .35, the gov gov t send the firm a check for this amount, but the income tax that the xpense. -tax cost of debt is only 100 2 35 5 65% of the 8% pretax cost: After-tax cost of debt 5 (1 2 tax rate) 3 pretax cost 5 (1 2 Tc) 3 rdebt 5 (1 2 .35) 3 8% 5 5.2% We can no s cost of capital to recognize the Company cost of capital, after-tax 5 (.3 3 5.2%) 1 (.7 3 14%) 5 11.4% weighted-average cost of capital (WACC) Expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments. Now we’re back to the weighted-average cost of capital, or WACC. The general WACC 5 B D E 3 (1 2 Tc)rdebt R 1 ¢ 3 requity ≤ V V (13.1) Self-Test 13.3 ▲ EXAMPLE 13.1 Weighted-Average Cost of Capital for Dow Chemical In Chapter 12 we showed how the capital asset pricing model can be used to estimate the expected return on Dow Chemical common stock. We will now use this estimate to figure out the company’s weighted-average cost of capital. 378 Part Three Risk Step 1. Calculate the value of each security as a proportion of firm value. The company has outstanding 1,150 million shares, which in mid-2010 had a market value of about $26.50 each. The total market value of Dow’ as E 5 1,150 3 $26.50 5 $30,475 million. The company’s latest balance sheet showed that it had borrowed D 5 $19,152 million. So the total value of Dow’s securities is V 5 D 1 E 5 $19,152 1 $30,475 5 $49,627 million. Debt as a proportion of the total value is D/V 5 $19,152/$49,627 5 .39, and equity as a proportion of the total is $30,475/$49,627 5 .61. Step 2. Determine the required rate of return on each security. In Chapter 12 we estimated that Dow’s shareholders required a return of 19.0%. The average yield on Dow’s debt was about 6.3%. Step 3. Calculate a weighted aver er-tax return on the debt and the r .2 The weighted-average cost of capital is WACC 5 B D E 3 (1 2 Tc)rdebt R 1 ¢ 3 requi ≤ V V 5 3 .39 3 (1 2 .35)6.3% 4 1 (.61 3 19.0%) 5 13.2% Self-Test 13.4 What If There Are Three (or More) Sources of Financing? We hav two classes of securities: debt and equity. Ev securities, our general approach to calculating WACC remains unchanged. We simply calculate the weighted-average after-tax return of each security type. For e Lik dends. Unlike bonds, however ven, usually level, stream of diviThe usiness. Moreover, a failure to come up with the cash to pay the di y. Instead, any unpaid dividends simply cumulate; the common stockholders do not receiv vidends have been paid. Finally, unlik vidends are not considered tax-deductible expenses. How would we calculate WA stock and bonds outstanding? Using P to denote the v ply generalize Equation 13.1 for WACC as follows: WACC 5 B P E D 3 (1 2 Tc)rdebt R 1 ¢ 3 rpreferred ≤ 1 ¢ 3 r V V V 2 (13.1a) v W common stock. ≤ r xpected return on the Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 379 Wrapping Up Geothermal We now turn one last time to Jo want to mak capital. Remember that the proposed e s proposed expansion. We w how to use the weighted-average cost of . w worksheet might look like this:3 Revenue 2 Operating expenses 5 Pretax operating cash flow 2 Tax at 35% After-tax cash flow $10.00 million 2 3.08 6.92 2 2.42 $ 4.50 million s managers and engineers forecast rev all-equity financed. The interest tax shields generated by the project’s actual debt gotten, however. They are accounted for by using the after-tax cost of debt in the weighted-average cost of capital. Project net present v w (which is a perpetuity) at Geothermal’s 11.4% weighted-average cost of capital: NPV 5 230 1 4.5 5 1$9.5 million .114 s owners. Checking Our Logic Any project of ect of ve a positive NPV, assums business. A projxactly 11.4% would just break even; it would generate just enough cash Let’ million and after xpansion had revenues of only $8.34 ws of $3.42 million: Revenue 2 Operating expenses 5 Pretax operating cash flow 2 Tax at 35% After-tax cash flow $8.34 million 2 3.08 5.26 2 1.84 $3.42 million With an inv exactly 11.4%: Rate of 5 3.42 5 .114, or 11.4% 30 and NPV is exactly zero: 3.42 50 .114 s weighted-average cost of capital, we recognized that the company’s debt ratio was 30%. s analysts use the NPV 5 230 1 3 F xample we ignore depreciation, a noncash but tax-deductible expense. (If the project were really 380 Part Three Risk weighted-average cost of capital to evaluate the new project, they are assuming that vestment w to 30% of the investment, or $9 million. vided by the shareholders either in the form of reinv tional shares. The following table shows ho ws would be shared between the debt.W Cash flow before tax and interest 2 Interest payment (.08 3 $9 million) 5 Pretax cash flow 2 Tax at 35% After-tax cash flow v pay tax. Taxes equal .35 3 4.54 5 $1.59 just enough to giv (Note that 2.95/21 5 .14, or 14%.) $5.26 million 2 .72 4.54 2 1.59 $2.95 million y must vestment. v If a project has zero NPV when the expected cash flows are discounted at the weighted-average cost of capital, then the project’s cash flows ar icient to give debtholders and shareholders the returns they require. 13.3 Measuring Capital Structure We have e We will no verage cost of capital. s weightedaverage cost of capital. Your first step is to work out Big Oil’s capital structure. But where do you get the data? Financial managers usually start with the company’s accounts, which show the book value of debt and equity, whereas the weighted-average cost of capital formula calls for their market values. A little work and a dash of judgment are needed to go from one to the other. Table 13.1 shows the debt and equity issued by Big Oil. wed These bonds hav , there alue of $1. But wed back into the f The total book value of the equity shown in the accounts is $100 million 1 $300 million 5 $400 million. wn in Table 13.1 en from Big Oil’s annual accounts and are therefore book v et values are negligible. For example, consider the $200 million that Big Oil owes the ed to the general level of interest rates. Thus if interest rates rise, the rate charged on Big Oil’s loan also rises to TABLE 13.1 The book values of Big Oil’s debt and igures in millions) Bank debt erm bonds (12-y ity Common stock (100 million shares, par v Retained earnings Total 200 100 300 25.0 12.5 37.5 1 Chapter 13 TABLE 13.2 The market values of Big Oil’s debt and igures in millions) The Weighted-Average Cost of Capital and Company Valuation Bank debt erm bonds Total debt Common stock (100 million shar Total 2) 185.7 385.7 1,200.0 381 1 11.7 24.3 75.7 1 maintain the loan’s value. As long as Big Oil is reasonably sure to repay the loan, it is w accept the book v air approximation of its market value. term interest rates have risen to 9%.4 We can calculate the value today of each bond as 3 200 5 $16 follows.5 ment of face v million. All the bond’ ws are discounted back at the current interest rate of 9%: PV 5 16 16 216 16 1 1 1 c1 5 $185.7 2 3 (1.09) (1.09) (1.09)12 1.09 ace value. If you used the book value of Big Oil’s long-term debt rather than its market value, you would be a little bit off in your calculation of the weighted-average cost of capital, b alue of equity rather than its market value. alue of Big Oil’s equity measures the vested on their behalf. But perhaps Big Oil has been able to find projects that were w alue of the assets vestors see great future investment opportuniy. All these considerations determine what inv pay for Big Oil’s common stock. Big Oil’s stock price is $12 a share. Thus the total market value of the stock is Number of shares 3 5 100 million 3 $12 5 In Table 13.2 we show the market values of Big Oil’s debt and equity. You can see that debt accounts for 24.3% of company value (D/V 5 .243) and equity accounts for 75.7% (E/V 5 .757). average cost of capital. Notice that if you looked only at the book values shown in the company accounts, you would mistakenly conclude that debt and equity each accounted for 50% of value. Self-Test 13.5 Debt Preferred stock Common stock Total 4 2.2 2.8 24.2 30.8 1 If Big Oil’ s value using the rate of interest offered by similar bonds. 5 W . 382 Part Three Risk 13.4 Calculating the Weighted-Average Cost of Capital To calculate Big Oil’s weighted-average cost of capital, you first need the rate of return that investors require from each security. The Expected Return on Bonds We kno y does not go belly-up, that is the rate of return investors can expect to earn from holding Big Oil’s bonds. If there is any chance that the f however, the yield to maturity of 9% represents the most fav expected wer than 9%. For most lar y is suf w as a measure of the e w fered on the vestors could expect to receive. The Expected Return on Common Stock Estimates Based on the Capital Asset Pricing Model In the last chapter we showed you how to use the capital asset pricing model to estimate the e The capital asset pricing model tells us that investors demand a higher rate of return from stocks with high betas. on stock 5 interest rate 1 ¢ stock’s 3 beta ≤ Financial managers and economists measure the risk-free rate of interest by the yield on T To measure the expected mark y usually look back at capital mark vestors have received about an extra 7% a year from inv Treasury bills. Yet vidence with considerable humility, for who is to say whether inv v y expected or whether investors today require a higher or lower rew Let’s suppose Big Oil’ rm 2 rf) is 7%. Then the CAPM rate (rf) is 6%, and the e would put Big Oil’s cost of equity at Cost of equity 5 r 5 rf 1 b(rm 2 rf) 5 6% 1 .85(7%) 5 12% Self-Test 13.6 Estimates Based on the Dividend Discount Model Whenever you are given an estimate of the expected return on a common stock, always look for ways to check whether it is reasonable. One check on the estimates provided by the CAPM can be obtained from the dividend discount model (DDM). In Chapter 7 we Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 383 showed you how to use the constant-growth DDM formula to estimate the return that investors expect from different common stocks. Remember the formula: If divixpected to gro g, then the price of the stock is equal to P0 5 where P0 requity is the e provide an estimate of requity: 1 DIV1 requity 2 g is the forecast di W requity 5 , DIV1 1g P0 (13.2) In other words, the e vidend yield (DIV1/P0) plus the e wth rate in dividends (g). This constant-growth dividend discount model is widely used in estimating expected ve a f gro -made for the constant-growth formula. Remember that the constant-gro ormula will get you into trouble if you apply it to firms with very high current rates of gro h gro sustained indefinitely. ver- estimate of the expected return. Beware of False Precision Do not expect estimates of the cost of equity to t know whether the capital asset pricing model fully explains e vidend discount model hold exactly. Even if your formulas were right, the required inputs would be noisy and subject to error. in a band of 2 or 3 percentage points is doing pretty well. In this endeavor it is perfectly okay to conclude that the cost of equity is, say, “about 15%” or “somewhere ”6 Sometimes accuracy can be improved by estimating the cost of equity or WACC for This cuts down the “noise” that plagues single-company estimates. Suppose, for e Ann Cox is able to v s. The average WACC for these three companies would be a valuable check on her estimate of WA Or suppose that Geothermal is contemplating investment in oil refining. For this v s existing WA usiness. It could therefore try to estimate WACC available—most oil companies invest in production and marketing as well as refining— WA ge oil companies could be a useful check or The Expected Return on Preferred Stock alued from the perpetuity formula: of 6 rounding. 5 dividend r ve been done to one or two decimal places just to avoid confusion from 384 Three Risk where r Therefore, we aluation r 5 dividend For e (13.3) vidend of $2 per rpreferred 5 $2/$20 5 simply the dividend yield. Adding It All Up Once you have worked out Big Oil’s capital structure and estimated the expected average cost of capital. Table 13.3 do is plug the data in Table 13.3 into the weighted-av w all you need to E D 3 (1 2 Tc)rdebt R 1 ¢ 3 requity ≤ V V 5 3 .243 3 (1 2 .35) 9% 4 1 (.757 3 12%) 5 10.5% WACC 5 B Suppose that Big Oil needs to ev ness. If the project w xisting busiverage ws. Real-Company WACCs Big Oil is entirely hypothetical. Table 13.4, which gives some estimates of the weighted-av sample of real companies. As you do so, remember that any estimate of the cost of capital for a single company can be way of You should always check 7 13.5 Interpreting the Weighted-Average Cost of Capital When You Can and Can’t Use WACC The weighted-average cost of capital is the rate of return that the firm must expect to earn on its average-risk investments in order to provide a fair expected return to all its secur ictly speaking, the weighted-average cost of capital is an appropriate discount rate only for a project that is a carbon copy TABLE 13.3 Data needed to calculate Big Oil’s weightedaverage cost of capital (dollar figures in millions) Debt Common stock Total 385.7 / / .243 .757 debt y .12, or 1 Note: Corporate tax rate 5 Tc 5 .35. 7 v ord’s WACC is about average despite its v ord use a WACC of 8% when v . y’s The v WACC Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 385 of the firm’s e en it is used as a companywide benchmark discount rate; the benchmark is adjusted upward for unusually r ojects and downward for unusually safe ones. There is a good musical analogy here. Most of us, lacking perfect pitch, need a ey. But anyone relative pitches right. Businesspeople have good intuition about relative ut not about absolute risk or Therefore, they set a company- or industrywide cost of capital verything the company does, but y ventures. Some Common Mistakes One danger with the weighted-average formula is that it tempts people to make logical errors. Think back to your estimate of the cost of capital for Big Oil: E D 3 (1 2 Tc)rdebt R 1 ¢ 3 requity ≤ V V 5 3 .243 3 (1 2 .35) 9% 4 1 (.757 3 12%) 5 10.5% WACC 5 B Now you might be tempted to say to yourself: “Aha! Big Oil has a good credit rating. It could easily push up its debt ratio to 50%. If the interest rate is 9% and the required verage cost of capital would be WACC 5 3 .50 3 (1 2 .35) 9% 4 1 (.50 3 12%) 5 8.9% At a discount rate of 8.9%, we can justify a lot more investment.” wing, the lenders would almost certainly demand a higher rate of interest on the debt. Secwing increased, the risk of the common stock would also increase and There are actually two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, TABLE 13.4 Calculating the weighted-average cost of capital for selected companies Dow Chemical Starb ks Dell Boeing Disney Microsoft ord IBM McDonald’s Newmont Mining Johnson & Johnson Heinz Pfizer ExxonMobil C Consolidated Edison Walmart 19.0 12.5 12.3 12.0 11.1 9.8 20.7 8.3 7.3 7.1 7.0 7.3 7.8 5.9 5.6 5.2 4.7 6.30 6.30 4.60 4.60 4.60 3.50 7.25 4.55 4.65 6.25 3.50 6.25 4.55 3.50 4.60 6.20 4.20 .61 .97 .88 .79 .86 .98 .21 .88 .87 .85 .92 .74 .70 .98 .85 .55 .84 Notes: 1. Expected return on equity is taken from Table 12.2. 2. Interest rate on debt is calculated from yields on similarly rated bonds. 3. D is the book value of the firm’s debt, and E is the market value of equity. 4. WACC 5 (D/V) 3 (1 2 .35) 3 rdebt 1 (E/V) 3 requity. .39 .03 .12 .21 .14 .02 .79 .12 .13 .15 .08 .26 .30 .02 .15 .45 .16 13.2 12.3 11.2 10.1 9.9 9.7 8.0 7.7 6.8 6.7 6.6 6.4 6.4 5.8 5.2 4.7 4.4 386 Part Three Risk because borrowing increases the required return to equity. When you jumped to the conclusion that Big Oil could lower its weighted-average cost of capital to 8.9% by wing more, you were recognizing only the explicit cost of debt and not the implicit cost. Self-Test 13.7 How Changing Capital Structure Affects Expected Returns We will illustrate how changes in capital structure affect expected returns by focusing Tc is zero. , has the following market-value balance sheet: Assets Liabilities and Shareholders’ Equity Assets 5 v existing business mal’s Total value $647 $647 Debt Equity Value $194 453 $647 (30%) (70%) (100%) Geothermal’ average cost of capital is simply the e s assets: WACC 5 rassets 5 (.3 3 8%) 1 (.7 3 14%) 5 12.2% ould expect if you held all Geothermal’ fore o Now think what will happen if Geothermal borrows an additional $97 million and uses the cash to buy back and retire $97 million of its common stock. The revised market-value balance sheet is Assets Assets 5 v existing business Total value Liabilities and Shareholders’ Equity mal’s $647 $647 Debt Equity Value $291 356 $647 (45%) (55%) (100%) ws. Therefore, if investors require a return of 12.2% on the total package of debt and equity before the financing, they must require the same 12.2% return The weighted-average cost of capital is therefore unaffected After all, the required return on debt is lo wing to reduce the weightedaverage cost of capital. y has more debt than before, the debt is Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 387 ely to demand a higher return. Increasing the amount of W What Happens When the Corporate Tax Rate Is Not Zero We have sho capital is unaf es, the weighted-average cost of , taxes can compli8 For the moment, just remember: • The weighted-average cost of capital is the right discount rate for averagerisk capital investments. • The weighted-average cost of capital is the return the company needs to ear er tax in order to satisfy all its security holders. • If the firm increases its debt ratio, both the debt and the equity will become more r . The debtholders and equityholders require a higher return to compensate for the increased risk. 13.6 Valuing Entire Businesses free cash flow Cash flow that is not required for investment in fixed assets or working capital and is therefore available to investors. Investors routinely b uy and sell entire b ter 7 to value Blue Skies’ stock also work for entire businesses? Sure! As long as the company’s debt ratio is expected to remain fairly constant, you can treat the compan ws by the weightedaverage cost of capital. The result is the combined value of the company’s debt and equity. If you w w just the v , you must remember to subtract the value of the debt from the company’s total value. uying Establishment Industry’s concatenator manuf Table 13.5 sets out your forecasts for the ne w 8 shows the e w from operations. This is equal to the e , w, and therefore you need to add it back when calculatw. Row 9 in the table shows the forecast inv and w w less investment expenditures is the amount of cash that the b vestors after paying for all inv wth. This is the concatenator division’s free cash w (row 10 in the table). Notice that the w is negative in the early years. Is that a bad sign? Not really. The business ut because it is growing so fast. Rapid growth is good news, not bad, as long as the b cost of capital on its investments. ws in Table 13.5 did not include a deduction for debt interest. But we will not forget that acquisition of the concatenator b tional debt. We will recognize that f ws by the weighted-av the tax deductibility of its interest payments. 8 doesn’t change the aggre provided vestors. However adjusted formulas showing how WA . Allen, Principles of Corporate Finance, wY vings from deducting v y, w-Hill, 2011). 388 Part Three Risk TABLE 13.5 Forecasts of operating cash flow and investment for the concatenator manufacturing division (thousands of dollars). Rapid expansion means that free cash flow is negative in the early years, because investment outstrips the cash flow from operations. Free cash flow turns positive when gro ws down. 1. Sales 2. Costs 3. Earnings before interest, taxes, depreciation, and amortization (EBITDA) 1 2 4. Depreciation 5. Profit before tax 3 4 6. T 7. Profit after tax 5 6 8. Operating cash flow 4 7 9. Investment in plant and working capital 10. ree cash flow 8 9 1,189 1,070 119 45 74 25.9 48.1 93.1 166.7 73.6 1,421 1,279 1,700 1,530 142 59 83 29.1 54.0 113.0 200.0 87.1 170 76 94 32.9 61.1 137.1 240.0 102.9 2,020 1,818 202 99 103 36.1 67.0 166.0 200.0 34.1 2,391 2,152 239 128 111 38.9 72.2 200.2 160.0 40.2 2,510 2,260 250 136 114 39.9 74.1 210.1 130.6 79.5 Suppose that a sensible capital structure for the concatenator operation is 60% equity and 40% debt.9 You estimate that the required rate of return on the equity is 12% and that the b w at an interest rate of 5%. The weightedaverage cost of capital is therefore E D 3 (1 2 Tc)rdebt R 1 ¢ 3 requity ≤ V V 3 ( ) 4 ( 5 .4 3 1 2 .35 5% 1 .6 3 12%) 5 8.5% WACC 5 B Calculating the Value of the Concatenator Business The value of the concatenator operation is equal to the discounted value of the free alue of the b horizon, also discounted back to the present. That is, PV 5 FCF1 FCF2 FCFH 1 1 c1 1 2 (11WACC)H 11WACC (11WACC) PV ( ) PVH (11WACC)H 1PV (horizon value) usiness will continue to gro ut it’s w year by year to infinity. PVH stands in for the v H 1 1, H 1 2, and so on. . Sometimes the boss tells everybody to s a nice round number. We have pick year because the business is expected to settle down to steady growth of 5% a year from then on. v alue. Let’s try the constant-growth formula that we introduced in Chapter 7: value 5 r2g 9 et-value weights to compute WA 5 79.5 5 $2,271.4 thousand .085 2 .05 present value of the business by debt. Remember book value may be more or less Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 389 We now have all we need to calculate the value of the concatenator business today. W alue: ) PV (business) 5 PV ( –5) 1 PV ( 73.6 87.1 102.9 34.1 40.2 2,271.4 52 2 2 2 1 1 2 3 4 5 (1.085) (1.085) (1.085) (1.085) (1.085)5 1.085 5 Notice that when we use the weighted-average cost of capital to value a company, we y’s debt and equity?” If you need to value the equity alue of any outstanding debt. Suppose that the concatenator b of the overall value of about $1,290,000. Then the equity in the business is w $1,290,000 2 $516,000 5 $774,000. Self-Test 13.8 SUMMARY www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ million 10 million 50 million www.mhhe.com/bmm7e Debt Preferred stock Common stock 8 12 PRACTICE PROBLEMS Earnings before interest, taxes, depreciation, and amortization (EBITDA) Depreciation Pretax profit Investment 80 20 60 12 100 30 70 15 115 35 80 18 120 40 80 20 www.mhhe.com/bmm7e Cash and short-ter A eceivable Inventories Total ities Bonds 3 7 21 y ity 10 years ent yield t ity Preferred stock (par v share) Common stock (par v 0) Additional paid-in stockholders’ y Retained earnings Total 0.0 2.0 .1 9.9 10.0 www.mhhe.com/bmm7e CHALLENGE PROBLEMS WEB EXERCISE finance.yahoo.com www.bondsonline.com SOLUTIONS TO SELF-TEST QUESTIONS Assets Debt V V Assets Debt V V y 40 y 24 www.mhhe.com/bmm7e EBIT Interest expense Taxable income Taxes owed Net income Total income accr MINICASE yholders 0.0 2.0 8.0 2.8 5.2 7.2 0.0 0.0 10.0 3.5 6.5 6.5 www.mhhe.com/bmm7e FIGURE 13.2 www.mhhe.com/bmm7e TABLE 13.6 Working capital Other assets Total Bank loan 360 40 erm debt Preferred stock Common stoc Total 20 etained earnings 80 100 300 1. At year-end 2010, Sea Shore Salt had 10 million common shar anding. 2. The compan eferred shares with book v 00 per share. Each share receives an ann CHAPTER 14 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T F O U R Financing GM and Chrysler went bankrupt, but Ford managed to raise and keep enough financing to survive the recent financial crisis and recession. It’s time to start learning about financing. U 400 Part Four Financing 14.1 Creating Value with Financing Decisions vestment decisions make shareholders wealthier sions. For example, if your compan w at 3% when the going rate is 4%, you hav The problem is that competition in financial markets is more intense than in most product markets. In product markets, companies re ve advantages that allow positive-NPV investments. For e y may have only a fe same line of business in the same geographical area. Or it may be able to capitalize on patents or technology or on customer recognition and loyalty. All this opens up the ind projects with positive NPVs. w protected niches in markets. You can’t patent the design of a new security. Moreover, in these markets you always face fast-moving competilocal, and federal gov and governments that also come to New York, London, or Tok The inv ely, these inv w, you would like to pay less than the going rate of intervestors into ov securities the alues. But what do we mean by true value? True value does not mean ultimate future value—we do not expect inv currently available to investors. W capital markets and showed how dif vestors to obtain consistently supeet all securities are fairly priced given the v v et price can never be a positive-NPV transaction. All this means that it’ e or lose mone strate e mone investors who supply the financing demand f At the same time, it’s harder to lose money because competition among investors prevents any one of them from demanding more than f Just remember as you read the following chapters: There are few free lunches on Wall Street. . . . and few easy answers for the financial manager who must decide which securities to issue. 14.2 Patterns of Corporate Financing internally generated funds Cash reinvested in the firm: depreciation plus earnings not paid out as dividends v They can plo the y from e for example, at Figure 14.1, which shows ho w Chemical have generated cash. In each panel the green line shows the percentage yearly addition to the s capital that was pro The orange line shows the addition that came from ne ws the contribution from internally generated funds vidends1). 1 does not represent a use of cash. noncash expense. xpense ev Chapter 14 Introduction to Corporate Financing 401 FIGURE 14.1 Sources of funds for FedEx and Dow Chemical o examples. Let’s gest source of cash for both companies came financial deficit erence between the cash companies need and the amount generated internally. from plo cash that the company needs is called the . To mak company must either sell new equity or borrow. Neither FedEx nor Do w shares. In fact, as often as not they used cash to buy back shares that had been issued in earlier years. In Figure 14.1 these repurchases show up as negative issues of common stock. (Dow did mak stock in 2009. This is not shown in Figure 14.1.). Instead of issuing equity, both companies have made occasional large new issues of debt, but they have done so for somewhat different reasons. For example, in 2004 o’s for $2.4 billion in cash. To help pay for this purchase, FedEx sold $1.9 billion of short-term debt, called commercial paper. It then issued a 402 Part Four Financing package of 1-, 3-, and 5-year unsecured notes and used the proceeds to pay off the commercial paper. Much of this increased borrowing was also subsequently repaid over the next 4 years. Figure 14.1a shows both the spike in FedEx’s debt issuance in 2004 as well as the negative net debt issues in subsequent years. FedEx’s debt issue was needed to offset a temporary increase in expenditures. In contrast, Dow Chemical’s large debt issues in 2001 and 2002 coincided with a period of operating losses. Thus, the debt issues in those years largely substituted for internal funds. Figure 14.2 shows the net effect of these financing decisions on the debt ratios of the two companies. Debt ratios here are measured in two ways: alternatively using the book value of the equity or its market value. For most of this period FedEx’s steady accumulation of internal funds resulted in a fairly continuous decline in the debt ratio. By contrast, Dow’s periodic large issues of debt to make up for shortfalls in profitability left it with much higher debt ratios. There is nothing particularly remarkable about the financial structure of either FedEx or Dow. For example, some companies, such as Google, rely almost entirely on internal funds and have no debt. Others, such as Ford, are at the opposite extreme. Ford has $147 billion of debt, and the book value of its equity is negative at 2$8 billion.2 Figure 14.3 shows how corporate America as a whole has financed its investments. Notice again the importance of internal funds. Over the 15-year period, internally FIGURE 14.2 Ratio of debt to debt plus equity for FedEx and Dow Chemical (a) FedEx 50 Ratio computed using book values Ratio computed using market values Debt ratio (%) 40 30 20 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 0 1995 10 Year (b) Dow Chemical Ratio computed using book values 70 Ratio computed using market values Debt ratio (%) 60 50 40 30 20 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1994 0 1995 10 Year 2 In other words, Ford’s accumulated losses exceed the total cumulative amount that it has raised from shareholders. Chapter 14 403 Introduction to Corporate Financing FIGURE 14.3 Sources of funds for U.S. nonfinancial corporations, 1995–2010 Source: Board of Governors of the Federal Reserve System, Division of Research and. Statistics, “Flow of Funds Accounts,” Table F.102 at .federalreserve.gov/releases/z1/cur . generated cash cov wing.3 their new cash to buy back stock. The gap was more than gativ Do Firms Rely Too Heavily on Internal Funds? ers w They believe that y if they had to ask inves- tors for it. ing of managers, shareholders, debtholders, and so on. The shareholders and debtholders would like to monitor management to make sure that it is pulling its et v vidual investors to keep check on management, but large financial institutions are specialists in monitoring. So es a public issue of stock or w that they had better hav y want a quiet life, they will avoid going to the capital market to raise money and they will retain suff We do not mean to paint managers as loafers. There are also rational reasons for or example, the costs of issuing new securities voided. Moreover, the announcement of a new equity issue is usually bad news 4 for investors, who w v v ated with equity issues. Are Firms Issuing Too Much Debt? We hav ve on average uy back some of their stock. Has this polic Figure 14.4 pro f 3 The ve on the question. If all U.S. manuould be its ratio . For e w up in 4 Managers hav to them, that is, when the will buy a ne the next chapter. vestors. The outside inv . 404 Part Four Financing FIGURE 14.4 The ratio of debt t or the nonfinancial corporate sector Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, “Flow of Funds Accounts,” Table B.102 at .federalreserve.gov/releases/z1/cur . book values. This is because the market value of equity is substantially greater than book v wever, generally have et debt ratio in increased since 1955.5 2008–2009 as equity v Should we be w y were ely to fall . Undoubtedly GM, , Washington Mutual, and the many other companies that faced insolvency in the recent recession would all hav ways follo ratio is like f , b its as well as risks. So does debt, as we will see in Chapter 16. Self-Test 14.1 14.3 Common Stock We will now look more closely at the different sources of f mon stock. We will stick with our example of Do ge to be owned by one investor. For example, you would need to lay your hands on about $42 billion if you wanted to own the whole of Dow. Dow is owned by about 650,000 different investors, each of whom holds a These inv wn as shareholders, or stockholders. At the end of 2010 Do common stock. Thus, if you were to buy one Do ould own 1/167,000,000, 5 vely Chapter 14 treasury stock Stock that has been repurchased by the company and held in its treasury. issued shares Shares that have been issued by the company. outstanding shares Shares that have been issued by the company and are held by investors. authorized share capital Maximum number of shares that the company ed to issue. par value V wn in the company’s accounts. additional paid-in capital erence between issue price and par value of stock. Also called capital surplus. retained earnings Earnings not paid out as dividends. Introduction to Corporate Financing 405 or about .00000009%, of the company. Of course, a large pension fund might hold many thousands of Do v ve been issued by Dow. The company has also issued a further 5 million shares, which it later bought back from investors. y’s treawn as treasury stock. The shares held by inv issued and outstanding shares. be issued but not outstanding. If Dow wishes to raise more money wever, there is a limit to the number that it can issue without the approv The wn as the authorized share capital—for Dow w has already issued 1.172 billion val. Table 14.1 shows how the investment by Dow’ in the company’s books. wn as its par value. In Dow’s case each share has a par value of $2.50. Thus the total par value of 3 $2.50 per share 5 $2.931 billion. Par value 6 The price at which ne vestors almost always e value. The difference is entered into the company’s accounts as additional paid-in capital, or capital surplus. For e ould increase by 1 million 3 $2.50 5 $2.5 million and additional paid-in capital would increase by 1 million 3 ($20 2 $2.50) 5 $17.5 million. You can see from this example that the funds raised vided between par v as immaterial, so is the allocation alue and additional paid-in capital. Besides buying ne ute ne v vidends are instead plowed back into the company. Table 14.1 shows that the cumulative amount of such retained earnings is $17.736 billion. Dow’s books also show the amount that the company has spent to repurchase its own stock. The repurchase of the 5 million shares cost Dow $.239 billion. This is mone huge sums repurchasing shares. The sum of the par v wn as the net comof the f uted directly by shareholders TABLE 14.1 Book value of common stockholders’ of Dow Chemical, December 31, 2010 (figures in billions) 6 406 Part Four Financing w stock and indirectly when it plo The book value of Dow’s net common equity is $17.839 billion. With 1.167 billion valent to 17.839/1.167 5 et value of Dow’ alue. Evidently investors believe that Dow’s assets are w y originally cost. Self-Test 14.2 Ownership of the Corporation A corporation is o As we saw in Chapter 2, over vidual U.S. inv ganizations. The remainder belongs to financial institutions such as mutual funds, pension funds, and insurance companies. ain in Figure 14.5. own v ver after the lenders have received their entitlement. Usually the compan viw inv these investments will enable the compan vidends in the future. ve the ultimate control over ho y is run. This does not mean that shareholders can do whatever they like. For example, the bank that lends to the company may place restrictions on how much extra borrowing the comy can undertake. However, the contract with the bank can never restrict all the actions that the compan e. The shareholders retain the residual rights of control over these decisions. Occasionally, the compan v e certain actions. For e or to merge with another company. On most other matters, shareholder control boils down to the right to v FIGURE 14.5 Holdings of corporate equities, third quarter, 2010 Board of Governors of the Federal R e System, Division of Research and Statistics, “Flow of Funds Accounts,” table L.213 at .feder ve.go r . Chapter 14 Introduction to Corporate Financing 407 The board of directors usually consists of the company’s top management as well as outside directors, versees the management of the f to vote on such matters as a ne vidend. Most of the time the board will go along with the management, but in crisis situations it can be v or e ailing chief executive. Voting Procedures majority voting Voting system in which each director is voted on separately. cumulative voting Voting system in which all votes that one shareholder is allowed to cast can be cast for one candidate for the board of directors. proxy contest Takeov empt in which outsiders compete with management for shareholders’ votes. majority voting. In this case each director is voted on separately ote for each yo cumulative voting. The directors are then voted on jointly y choose, cast all their votes for just one candidate. For example, suppose that there are five directors to be elected and you o You therefore have a total of 5 3 100 5 500 votes. otes for any one candidate. With a cumulative voting system you can cast all 500 votes for your favorite candidate. Cumulative voting mak That is why minority groups devote so much effort to campaigning for cumulative voting. On many issues a simple majority of the v , but there are some decisions that require a “supermajority” of, say, 75% of those eligible to vote. For example, a supermajority vote is sometimes needed to approve a merger. This makes it dif en over and therefore helps to protect the incumbent management. ote in person or appoint a proxy to vote. The issues on which they are asked to vote are rarely contested, particularly in the case of large publicly traded f , however proxy contests in which outsiders compete with the f se tion. But the odds are stack pay all the costs of presenting their case and obtaining votes. Classes of Stock preferred stock Stock that tak over common stock in regard to dividends. Most companies in the United States issue just one class of common stock. But a few, such as Ford Motor and Google, have issued tw ferent voting rights. For e ut its management does not want to give up its controlling interest. The existing shares could be labeled “class A, oting rights could be issued to outside investors. o classes of stock with That may be a good thing if the controlling shareholders then v . However, you can see the dangers here. If ge block of votes, it may use these votes e, it may exercise its ain a business advantage. 14.4 Preferred Stock net worth Book value of common stockholders’ preferred stock. Usually when investors talk about equity or stock, the But Dow Chemical has also issued 4 million shares of preferred stock, and this too is y’s equity. The sum of Dow’ known as its net worth. 408 Part Four Financing F However situations. Lik with relatively few e ixed payments to the investor, and vergally an equity security. This is because payment of a vidend is within the discretion of the directors. The only obligation is that no di vidend has been paid.7 If the company goes out of b after the debtholders b oting privileges. antage to f that want to raise new mone w shareholders. However, if there is an vide the holder with some voting po Companies cannot deduct preferred dividends when they calculate taxable income. Like common stock dividends, preferred dividends are paid from aftertax income. For most industrial firms this is a serious deterrent to issuing preferred. However, regulated public utilities can take tax payments into account when they negotiate with regulators the rates they charge customers. So they can effectively pass the tax disadvantage of preferred on to the consumer stock also has a particular attraction for banks, for regulators allow banks to lump preferred in with common stock when calculating whether they have sufficient equity capital. Preferred stock does have one tax advantage. If one corporation buys another’s stock, only 30% of the dividends it receiv ed. vidends on vidends rather than capital gains. vest. If it buys a bond, the interest will y’s tax rate of 35%. If it b lik vidends can be viewed as “interest”), but the effective tax rate is only 30% of 35%, .30 3 .35 5 floating-rate preferred Preferred stock paying dividends that vary with short-term interest rates. If you invest your firm’ ant to make sure that when it is time to sell the stock, it won’t have plummeted in value. One ariety preferred stock that pays a fixed dividend is that the preferred’s market prices go up and down as interest rates change (because present values fall when rates rise). So one ingenious banker thought up a wrinkle: Why not link the di interest rates rise and vice versa? The result is known as preferred. If you o w that any change in interest rates will be counterbalanced by a change in the dividend payment, so the value of your investment is protected. Self-Test 14.3 7 ve. In other w vidends that hav Chapter 14 Introduction to Corporate Financing 409 14.5 Corporate Debt w money, companies promise to make re wed). However, corporations have limit . By this we mean that the promise to repay the debt is not always kept. If the company gets into deep water, the company has the right to default on the debt and to hand over the compan s assets to the lenders. y only if the value of the assets is less than the ver of assets is f or example, when P as faced with several thousand creditors all jostling for a better place in the queue. By the time the company had emerged from y 3 years later, it had agreed to mak still under dispute. Because lenders are not re y don’t normally have any voting power. Also, the company’s payments of interest are re Thus interest is paid out of befor income, whereas di -tax income. vernment pro which it does not provide on stock. Debt Comes in Many Forms ety of debt issues. We will w Interest Rate prime rate Benchmark interest rate charged by banks. The interest payment, or coupon, ed ues to pay $100 a year re w interest rates change. You may also encounter zero-coupon bonds. In this case the f e a regular interest payment. es a single payment at maturity. Obviously, investors pay less for zerocoupon bonds. est rate. For example, your firm may be offered a loan at “1 percent over prime.” The prime rate is ge customers with good to excellent credit. (But the largest and most creditw w at less than prime.) The prime rate is adjusted up and down with the general level of interest rates. Floating-rate loans are not alw y are tied to the . This is known as the London ed Rate, or LIBOR. Self-Test 14.4 funded debt Debt with more than 1 year remaining to . Maturity Funded debt is any debt repayable more than 1 year from the date of debt short-term and a 366-day debt long-term (except in leap years). 410 Part Four Financing very conceiv banks hav extreme we f sinking fund Fund established to retire debt before . callable bond Bond that may be repurchased by firm befor specified call price. . For example, ve forever. At the other wing literally overnight. Repayment Provisions regular way, perhaps after an initial grace period. For bonds that are publicly traded, this is done by means of a sinking fund. uy back the bonds. fund, inv wer rate of interest. They know that they are more likely to be repaid if the company sets aside some cash each year than if the . Suppose that a compan ve years later interest rates have fallen to 4%, and the price of the bond has risen dramatically. If you were the company’s treasurer, wouldn’t you like to be able to retire the bonds and issue some new bonds at the lower interest rate? W wn as callable bonds, the company does have the option to buy them back for the call price.8 y will wish to buy the issue back if interest rates fall, and therefore the price of the bond will not rise above the call price. Figure 14.6 shows the risk of a call to the bondholder. The blue line is the value of alue of a bond with the same coupon rate and maturity but callable at $1,060 (i.e., 106% of face value). At v y will call the bonds is negAs rates f bond continues to increase steadily in value, but since the capital appreciation of the the straight bond. A callable bond gives the company the option to retire the bonds early. But some bonds give the investor y loans to Asian companies gave the lenders a repayment option. Consequently, when the Asian crisis struck in 1997, these companies were f FIGURE 14.6 Prices of callable versus straight debt. When interest rates fall, bond prices rise. But the price of the callable bond (orange line) is limited by the call price. 8 is simply to issue another bond at a lower interest rate. wed to call the bond if the purpose Chapter 14 Introduction to Corporate Financing 411 demanding their money back. Needless to say, companies that were already struggling ve did not appreciate this additional burden. Self-Test 14.5 subordinated debt Debt that may be repaid in bankruptcy only after senior debt is paid. secured debt Debt that has first claim on specified collateral in the event of default. Seniority Some debts are subordinated. In the event of default the subordinated s general creditors. The subordinated lender holds a When you lend money to a f the debt agreement says otherwise. However, this does not always put you at the front of the line, for the f v tion of other lenders. That brings us to our ne Security w to buy your home, the sa y will tak default on the loan payments, the S&L can seize your home. w, the loan. collateral, and the debt is said to be secured. In the event of def ve a s assets but only a junior claim on the collateral. Default Risk Seniority and security do not guarantee payment. A debt can be senior and secured but still as risky as a dizzy tightrope walker—it depends on the v s assets. In Chapter 6 we showed how the safety of most corporate bonds can be judged from bond ratings provided by rating agencies such as Moody’s and Standard & Poor’ default. At the other extreme, many speculative-grade (or “junk”) bonds may be teetering on the brink. As you would expect, investors demand a high return from low-rated bonds. We saw e aultfree U.S. T arious rating classes. The lower-rated bonds do in fact offer higher promised yields to maturity. eurodollars Dollars held on deposit in a bank outside the United States. Country and Currency These days capital mark w few national boundy large f w abroad. For example, an American company may choose to finance a ne wing Swiss francs from a Swiss bank, or it may expand its Dutch operation by issuing a bond in Holland. Also many foreign companies come to the United States to borro orld. et centered mainly in London. Banks from all over the world have branches in London. The and BNP P y are there is to collect deposits in the major or example, suppose an Arab sheikh has just received payment in dollars for a large sale of oil to the United States. Rather than depositing the check in the held in a bank outside the United States came to be known as eurodollars. yen held outside Japan were termed euroyen, and so on. , 412 eurobond Bond that is marketed internationally. private placement Sale of securities to a limited number of investors without ering. protective covenant Restriction on a firm to protect bondholders. Part Four Financing y ay that a bank in the United States may relend dollars that have been deposited with it. w w dollars from a bank in London.9 If a f e an issue of long-term bonds, it can choose to do so in the United States. vely vestors in several countries. ve usually been marketed by the London branches y hav wn as eurobonds. A eurobond y other currency. Unfortunately, when the y was established it was called the euro. It is easy, therefore, to confuse a eurobond (a bond that is sold internationally) with a bond that is denominated in euros. Public versus Private Placements yone who wishes to buy, and once they have been issued, they can be freely traded in ets. In a private placement, the issue is sold directly to a small vestment institutions. Privately placed bonds cannot be resold to individuals in the United States and can be resold only to other qualified institutional investors. However, there is increasingly active trading among these investors. We will have more to say about the difference between public issues and private placements in the next chapter. Protective Covenants vestors lend to a company, the w that the y back. But they expect that the company will use their money well and not tak To help ensure this, lenders usually impose a number of conditions, or protective covenants, on companies that borrow from them. ws that the w at a reasonable rate of interest. w in moderation are less likely to get into dif e vent others from pushing ahead of them in the queue if trouble occurs. So they will not allow the company to create ne ers are not suf y impose. Self-Test 14.6 9 Because the Federal Reserv a tax on dollar deposits in the United States. Ov wer slightly lower interest rates. eep interest-free reserv FINANCE IN PRACTICE Marriott Plan Enrages Holders of Its Bonds Strong Covenants May Re-Emerge Price Plunge A Debt by Any Other Name lease Long-term rental agreement. The word debt sounds straightforward, but e identifiable. For example, accounts payable are simply obligations to pay for goods that have already been delivered and are therefore lik or e wing money to buy equipment, many companies lease e a series of payments to the lessor (the owner of the equipment). This is just lik e payments on an outstanding loan. What if the firm can’ e the payments? The lessor can then take back the equipment, which is precisely what w borrowed money from the lessor For e ord f sion plan. That is a debt which the company will eventually need to pay. There is nothing underhanded about these obligations. The wn on the company’s balance sheet as a liability. Sometimes, however, companies go to considerable lengths to ensure that inv w ho y hav wed. For e special-purpose entities (SPEs), which raised cash by a mixture of equity and debt and then used that debt to y. None of this debt sho s balance sheet. 413 414 Part Four Financing ▲ EXAMPLE 14.1 The Terms of Procter & Gamble’s Bond Issue Now that you are familiar with some of the jargon, you might like to look at an example of a bond issue. Table 14.2 is a summary of the terms of a bond issue in 2009 by Procter & Gamble. We have added some explanatory notes. TABLE 14.2 Procter & Gamble’s Debt Issue Innovation in the Debt Market We hav You might think ves you all the choice you need. Yet almost ev advisers dream up new types of debt. Here is one example of a bond that proved popuThe Rise and Fall of Asset-Backed Bonds wing money directly, companies sometimes b ws wn as an asset-backed bond. For e bile loans, student loans, and credit card receivables have all been bundled together and remarketed as asset-backed bonds. However, by f age lending. Suppose your compan uyers of wever, you don’t want to wait until the loans are y now, you can sell mortgage pass-through back uying a share of the payments made by the underlying pool of mortgages. For example, if interest rates f Chapter 14 Introduction to Corporate Financing 415 . That is not generally popular with these holders, for they get their money back just when they don’t w w. sev ferent classes of security wn as collateralized debt obligations (or CDOs). For example, an senior inv , junior By 2007 over half of the new issues of CDOs involved e , senior investors in these CDOs ault on an wever, even market that would lead to widespread defaults v vealed that two of its hedge funds had invested heavily in CDOs that became as rescued with help e, b There is a great v inv As long as you can convince xisting securities, you may be able to create an entirely new one. We can imagine a copper mining company issuorld copper price. We know of no such security, b ws?—it might generate considerable interest among investors. V ve different tastes, levels of wealth, rates of tax, and so on. Why not offer them a choice? Of course, the problem is the expense of designing and marketing ne w security that will appeal to investors, you may be able to issue it on especially favorable terms and thus increase the value of your company. 14.6 Convertible Securities warrant Right to buy shares from a company at a stipulated price before a set date. ▲ EXAMPLE 14.2 We have seen that companies sometimes have the option to repay an issue of bonds . investors have an option. The most dramatic case is provided by a warrant, which is nothing but an option. Companies often issue w Warrants Macaw Bill wishes to make a bond issue, which could include some warrants as a “sweetener.” Each warrant might allow you to purchase one share of Macaw stock at a price of $50 any time during the next 5 years. If Macaw’s st orms well, that option could turn out to be very valuable. For instance, if the stock price at the end of the 5 years is $80, then you pay the company $50 and receive in exchange a share worth $80. Of course, an investment in warrants also has its perils. If the price of Macaw stock fails to rise above $50, then the warrants expire worthless. convertible bond Bond that the holder may exchange for a specified amount of another security A convertible bond gives its owner the option to exchange the bond for a predeterThe conv ny’s share price will zoom up so that the bond can be conv the shares zoom down, there is no obligation to conv , investors v eep the bond or e shares, and therefore a conv that is not convertible. 416 Part Four Financing The convertible is rather like a package of a bond and a w important difference: When the owners of a convertible wish to exercise their options to buy shares, they do not pay cash—they just e stock. Companies may also issue conv vestor receiv ed dividend payments but has the option to exchange y’s common stock. Do v These examples do not e . In f the SUMMARY QUESTIONS QUIZ www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e WEB EXERCISES finance.yahoo.com www.federalreserve.gov/releases/z1/current/data.htm SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e CHAPTER 15 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T F O U R Financing Trading opens on NASDAQ for shares in Google. B 15.1 Venture Capital venture capital Money invested to finance a new firm. 424 You have taken a big step. With a couple of friends, you hav open a number of fast-food outlets, offering innovative combinations of national w mein with Yorkshire ast-food business costs money, but, after pooling your savings and borro ve raised $100,000 and purchased 1 million shares in the new company. zero-stage investment, your company’s assets are $100,000 plus the idea for your new product. That $100,000 is enough to get the business off the ground, b es off, w with funds provided directly by managers or by their friends and f ve using bank loans and reinv vestment, you will probably need v y in return for part of the wn as venture capital, and it is providuals, and investment institutions such as pension funds. y. But it is as hard to convince a v vest in your business as it is to get a first novel published. Y business plan. et, the production method, and the resources—time, money, employees, plant, and equipment—needed for success. It helps if you can point to the f savings in the company, you signal your faith in the business. The venture capital compan ws that the success of a new business depends on the effort its managers put in. y deal so that you have a strong incentive to work hard. For example, if you agree to accept a modest salalue of your investment in the company’s stock), the venture capital company knows you will be committed to w hard. However, if you insist on a watertight employment contract and a fat salary, you won’ enture capital. Y ely to persuade a venture capitalist to give you all at once as much money as you need. Rather, the f xt vince the venture capital company to buy w shares for $.50 each. This will give it one-half o o the v usiness. After this st-stage y’s balance sheet looks like this: Chapter 15 How Corporations Raise Venture Capital and Issue Securities 425 Self-Test 15.1 usiness has grown to the point at which it needs a . This second-stage volve the issue of a nal backers and some by other v financing would then be as follows: The balance sheet after the new Notice that the v wned by you and your friends has no gin to sound like a money machine? It was so only because you have made a success of the business and new investors are uy a share in the business. asn’ ould catch on. If it hadn’t caught on, the v f ve refused to put up more funds. Y vestment, b The second-stage investors hav y. w 3 million shares outstanding, and the second-stage investors hold was w ge investment—must have decided that the company Your one-third share is therefore also w Venture Capital Companies Some young companies grow with the aid of equity investment provided by wealthy indi wn as angel investors. Many others raise capital from specialist venture v nies to invest in, and then work with these companies as they try to grow. In addition, corporate venturers by providing capital to new innovative companies. Most venture capital funds are or v ed v The management company overseeing the investments and, in return, receiv ed fee as well as a share of the Y uy out whole companies and then take them private. The general term for these activities is vesting. V ve investors. They are usually represented on each company’s board of directors, the pany, and they provide ongoing advice. This advice can be very valuable to businesses et. 426 Part Four Financing For ev successful, self-suf come tw enture capital inv ve as enture capital investment. First, don’t shy away from w probability of success. But don’t buy into a business unless chance et. There’s no ward is big if you win. Second, cut your losses; identify losers early, and if you can’ example—don’t throw good mone Very few new businesses make it big, but those that do can be v venture capitalists keep sane by reminding themselves of the success stories—those e Genentech, Intel and FedEx.1 15.2 The Initial Public Offering For man y need more capital than can viduals or venture capitalists. At this point one solution is to sell the business to a lar y entrepreneurs do not ureaucracy and would prefer instead to remain the boss. In this case, the company may choose to raise mone initial public offering (IPO) ering of stock to the general public. A firm is said to go public when it sells its first issue of shares in a gener ering to investors. This first sale of stock is called an initial public , or IPO. An IPO is called a y. It is a of y’ enfer therew investors, v y w cash at the ve involved gov f stock or example, the Japanese government raised $12.6 billion by selling its stock in Nippon Telegraph and Telephone, and the Italian gov y Enel. Even these two issues were dw We hav e an IPO to raise new capital or to enable the existing shareholders to cash out, but there may be other benefits to going public. For example, the company’s stock price provides a readily available yardstick of perforw And, because information about the company becomes more widely av div wing cost. antages to ha ve v for b vately owned. Even in the United States many f vate, unlisted companies. They include some v ge operations, gill, and Levi Strauss. cess in the United States as a one-w verse and vately owned. For a somewhat extreme e y v in 1960. In 1984 the management bought out the company and took it private, and it remained private until 2001, when it had its second public offering. But the experiment did not last long, for 6 years later Aramark was the object of yet another buyout that took the company private once again. 1 F , the successes seem to have outweighed the f v 427 How Corporations Raise Venture Capital and Issue Securities Chapter 15 volv y and at the have become more v to prev WorldCom, b y Act. urden on small public vate ownership. v Arranging a Public Issue underwriter Firm that buys an issue of securities from a company and resells it to the public. Underwriters are investment banking firms that act as financial midwives to a new issue. Usually they play a triple role—first providing the company with procedural and financial advice, then buying the stock, and finally reselling it to the public. A small IPO may hav , but larger issues usually require uy the issue and resell it. spread er een er price and price paid b er. b receiv spread—that is, the wed by the company to sell y won’ happens, the y can for sell as much of the issue as possible b Before any stock can be sold to the public, the company must register the issue with This involv detailed and sometimes cumbersome re , existing b The SEC does not evaluate the wisdom of an inv ut it does check the registration statement for accuracy and completeness. also comply with the “blue-sky” la y seek to y to investors.2 prospectus Formal summary that provides information on an issue of securities. v vestors have jok y read proy would nev y new issue. provides a streamlined version of a possible prospectus for your restaurant business. The compan To gauge how w calculations like those described in Chapter 7. The involv pr y inv . w,” which giv potential investors. These inv y’ yw ely orders. Although inv uy. w that if they w underpricing Issuing securities at an ering price set below the true value of the . xpressions of interest. stock, b ely to be cautious because they will be left with any unsold stock if they overestimate investor demand. fering. Underpricing, they argue, is needed to 2 Sometimes states go be issue w When Apple Computer v vestors in the state. The state relented later, after the vestors ob ” 428 Part Four Financing tempt investors to buy stock and to reduce the cost of marketing the issue to customers. Underpricing represents a cost to the existing owners since the new investors are allowed to buy shares in the firm at a favorable price. Sometimes ne or example, when the prospectus y wever, the enthusi- w asm for eBay’s Web-based auction system w The ne uy eBay; over The experience of eBay is not typical, b wing the sale. For example, one study of more than 12,000 new issues between 1960 and 2009 found an average 3 vestors would have been prepared to pay much more than the ▲ EXAMPLE 15.1 Underpricing of IPOs Suppose an IPO is a secondary issue and the firm’s founders sell part of their holding to investors. Clearly, if the shares are sold for less than their true worth, the founder an opportunity loss. But what if the IPO is a primary issue that raises new cash for the company? Do the founders care whether the shares are sold for less than their market value? The following example illustrates that they do care. Suppose Cosmos.com has 2 million shares outstanding and no ers a further 1 million shares to investors at $50. On the first day of trading the share price jumps to $80, so the shares that the company sold for $50 million are now worth $80 million. The total market capitalization of the company is 3 million 3 $80 5 $240 million. The value of the founders’ shares is equal to the total value of the company less the value of the shares that have been sold to the public—in other words, $240 million 2 $80 million 5 $160 million. The founders might justifiably rejoice at their good fortune. However, if the company had issued shares at a higher price, it would have needed to sell fewer shares to raise the $50 million that it needs and the founders would have retained a larger share of the company. For example, suppose that the outside investors, who put up $50 million, received shares that were wo h only $50 million. In that case the value of the founders’ shares would be $240 million 2 $50 million 5 $190 million. T ect of selling shares below their true value is to transfer $30 million of value from the founders to the investors who buy the new shares. v v only a small share of these hot issues. If it is ov w wn as the winner’s curse.4 ely to receiv xpensiv yone can become wealthy by buyant to buy it and the Y ely to get vestors are unlikely to ge vesverage. 3 vided on Jay Ritter’s home page, bear 4 . alue on the auctioned object. Therealue. W v ve ov v Chapter 15 ▲ EXAMPLE 15.2 How Corporations Raise Venture Capital and Issue Securities 429 Underpricing of IPOs and Investor Returns Suppose that an investor will earn an immediate 10% return on underpriced IPOs and lose 5% on overpriced IPOs. But because of high demand, you may get only half the shares you bid for when the issue is underpriced. Suppose you bid for $1,000 of shares in two issues, one overpriced and the other underpriced. You are awarded the full $1,000 of the overpriced issue but only $500 worth of shares in the underpriced issue. The net gain on y o investments is (.10 3 $500) 2 (.05 3 $1,000) 5 0. Your net profit is zero, despite the fact that, on average, the IPOs are underpriced (10% underpricing versus 5% overpricing). You hav ered the winner’s curse: You “win” a larger allotment of shares when they are overpriced. Self-Test 15.2 flotation costs The costs incurred when a w securities to the public. The costs of a ne costs. Underpricing is not the only act, when people talk about the cost of a new issue, they often think only of the direct costs of the issue. For example, preparation of the registration statement and prospectus involves management, legal counsel, and accountants, as well as underwriters and their advisers. There is also the underwriting spread. (Remember, underwriters make their profit by selling the issue at a higher price than they paid for it.) For most issues between $20 million and $80 million, the spread is 7%. Look at the blue bars (corresponding to IPOs) in Figure 15.1. These show the direct costs of going public. For all b istrative costs are likely to absorb 7% to 8% of the proceeds from the issue. For the gest IPOs, these direct costs may amount to only 5% of the proceeds. v FIGURE 15.1 Total direct costs as a percentage of gross proceeds, 2004–2008. The total direct costs f erings (IPOs), erings (SEOs), convertible bonds, and straight bonds are composed of underwriter spreads and other direct expenses. Source: We are grateful to Nickolay Gantchev for undertaking these calculations, which update tables in Immoo Lee, a er, and Quanshui Zhao, “The Costs of Raising Capital,” Journal of Financial Research 19 (Spring 1996), pp. 59–74. Used with permission. Updates courtesy of Nickolay Gantchev. 430 ▲ EXAMPLE 15.3 Part Four Financing Costs of an IPO The largest U.S. IPO was the $19.7 billion sale of stock by the credit card company Visa in 2008. A syndicate of 45 underwriters acquired a total of 446.6 million Visa shares for $42.768 each and then resold them t ering price of $44. T ers’ spread was therefore $44 2 $42.768 5 $1.232. The firm also paid a total of $45.5 million in legal fees and other costs.5 Therefore, the direct costs of the Visa issue were as follows: The total amount of money raised by the issue was 446.6 million 3 $44 5 $19,650 million. Of this sum 3% was absorbed by direct expenses (that is, 595.7/19,650 5 .030). In addition to these direct costs, there was the cost of underpricing. By the end of the first day’s trading Visa’s stock price had risen to $56.50, so investors valued Visa shares at 446.6 3 $56.50 5 $25,233 million. In other words, Visa sold stock for $25,233 2 $19,650 5 $5,583 less than its market value. This was the cost of underpricing. Managers commonly focus only on the direct costs of an issue. But, when we add in the cost of underpricing, the total cost of the Visa issue as a proportion of the market value of the shares was ($595.7 1 $5,583)/$25,233 5 .24, or 24%. Self-Test 15.3 Other New-Issue Procedures Almost all IPOs in the United States use the bookbuilding method. In other words, uild up a book of likely orders, b y at a discount, and then resell it to investors. This method is in some ways like an auction, since potential buyers indicate how man uy at given prices. However The advantage of the bookbuilding method is that it allows underwriters to give preference to those investors whose bids are most helpful in setfer them a rew ics of the method point to the dangers of allowing the underwriters to decide who is allotted stock. ve way to issue stock is by means of an open auction. In this case, investors are in w many shares they wish to buy. v 5 ve costs. For e y do not include management time spent Chapter 15 431 How Corporations Raise Venture Capital and Issue Securities including the U.S. T of common stock are fairly rare. However, in 2004 Google simultaneously raised eyebro orld’ gest IPO to be sold by auction. The Underwriters We hav new issue from the company, and reselling it to inv the company to make its initial public of viding advice, buying a t just help ver a company Successful underwriting requires considerable e large issue f veral hundred milery red faces. Underwriting in the United States is therefore dominated by the major inv ne gers. They include such giants as Citigroup, JPMorgan, Bank of ynch, and Goldman Sachs. Lar vily involv . Underwriting is not always fun. In fered its shareholders two ne iv y currently held.6 The underwriters to the issue guaranteed that at the end of 8 weeks they would buy any ne ant. At the time of the offer y would not hav , they reckoned without the turbulent market in bank shares that year. The bank’s shareholders w money they were asked to provide would largely go to bailing out the bondholders belo anted shares w Companies get to make only one IPO, b time. W not handle an issue unless they believe the facts have been presented fairly to investors. If a ne ind themselves v or example, in 1999 the softw pany V The next day trading opened at $299 a ut then the price began to sag. W allen belo tled VA Linux investors sued the underwriters for overhyping the issue. VA Linux inv ved. Investment banks soon found themselv vidence emerged that they had deliberately oversold many of the issues that the There w ged that several well-kno ers had eng s seal of approval for a new issue no longer seemed as valuable as it once had. 15.3 General Cash Offers by Public Companies seasoned offering Sale of securities by a firm that is already publicly traded. w time it will need to raise more money by issuing stock or bonds. An issue of additional stock by a compan seasoned . An v 6 wn as a rights issue. W . 432 Part Four Financing If a stock issue requires an increase in the company’ fer to investors at large or by making a rights issue, which is limited to existing shareholders. In the latter case, the company offers the shareholders the opportunity, or right, to buy more shares at an “attractive” price. For example, if the current stock price is $100, the company might offer investors an additional share at $50 for each y hold. Suppose that before the issue an investor has one share worth $100 and $50 in the bank. If the investor takes up the offer of a new share, that vestor’s bank account to the company’s. The investor now has two shares that are a claim on the original assets w on the $50 cash that the company has raised. So the two shares are worth a total of $150, or $75 each. rights issue Issue of securities ered only to current stockholders. ▲ EXAMPLE 15.4 Rights Issues We have already come across one ex er by the British bank HBOS, ers. Let us look more closely at another issue. In May 2010, y National Grid needed to raise over £3 billion. It did so b ering its existing shareholders the right t o new shares for every five that they currently held. The new shares were priced at £3.35 each, some 44% below the preannouncement price of £5.95. Before the issue, National Grid had about 2.5 billion shares outstanding, which were priced at £5.95 each. So investors valued the company at 2.5 3 £5.95 5 £14.875 billion. The new issue increased the total number of shares by (2/5) 3 2.5 billion 5 1 billion and therefore raised 1 billion 3 £3.35 5 £3.35 ect, the issue increased the total value of the company to 14.875 1 3.35 5 £18.225 billion and reduced the value of each share to £18.225/3.5 5 £5.207. Suppose that just before the issue you hold five shares of National Grid valued at 5 3 £5.95 5 £29.75. If you decide to tak er, you would need to lay out 2 3 £3.35 5 £6.70 and the value of your shareholding would increase by exactly £6.70 to 7 3 5 £36.45. You would get what you paid for. stock, but in the United States rights issues are now very rare. We therefore will concentrate on the mechanics of the general cash offer. General Cash Offers and Shelf Registration general cash offer Sale of securities open to all investors by an already-public company. es a general cash offer of debt or equity, it essentially follo This means that it must first register the issue with the SEC and draw up a prospectus.7 Before settling on the issue vestors and build up a book of likely orders. y in turn will of gistration statement ev y issue new securities. Instead, the cov sold to the public with scant additional paperwork, whenev 7 , but as long as these y do not need to be registered with the SEC. Chapter 15 shelf registration A procedure that allows firms to file one registration statement for several issues of the same security. 433 How Corporations Raise Venture Capital and Issue Securities registration is put “on the shelf, ve price. This is called shelf registration—the en do . Suppose that your compan ov approval to issue up to $200 million of debt, but it isn’ required to w y particular w has y. Nor is it gistration statement may . Now you can sit back and issue debt as needed, in bits and pieces if you like. Suppose JPMorgan comes across an insurance company with $10 million ready to inv s a good deal, you say OK and the deal is done, subject to only a little additional paperwork. JPMorgan then resells the bonds to the insurance company than it paid for them. w.” You in ge inv Thus shelf registration offers several advantages: 1. 2. 3. xcessive costs. e advantage of “market conditions” (although any f av et conditions could make a lot more money by quitting and becoming a bond or stock trader instead). 4. The issuing f e sure that underwriters compete for its business. issues. Sometimes they believe the ge issue unusual feature or when the firm believes it needs the inv er’s counsel or stamp of approval on the issue. Thus shelf registration is less often used for issues of common stock than for g Costs of the General Cash Offer v , it incurs substantial administrative costs. Also, price that they expect to receive from investors. Look back at Figure 15.1, which shows the av ve costs for several types of Y v additional compensation for the greater risk they take in buying and reselling equity. Market Reaction to Stock Issues Because stock issues usually throw a sizable number of new shares onto the market, it is widely believed that the issue is v , it is thought, be so severe as to make it almost impossible to raise money. This belief in price pressure implies that a new issue depresses the stock price temalue. However, that view doesn’ ery well with iciency. If the stock price falls solely because of increased supply, then that stock would offer a higher return than comparable stocks and investors would be attracted to it as ants to a picnic. 434 Part Four Financing Economists who have studied ne ve generally found that the announcement of the issue does result in a decline in the stock price. For 8 While this may not sound ov ge fraction of the money raised. Suppose that a company with a market value of equity of $5 billion announces its intention to issue $500 million of additional equity and thereby causes the stock price to drop by 3%. The loss in value is .03 3 $5 billion, or $150 million. That’s 30% of the amount of money raised (.30 3 5 the additional supply? Possibly, b Suppose managers (who hav tors) kno price, it will give the ne ve explanation. vesy sells new stock at this low go the new investment rather than sell shares at too lo o the position is reversed. If the company sells ne xisting shareholders at the expense of the ne ven if the new cash were just put in the bank. Of course inv The ely to issue stock when the v alued, and therefore the stock down accordingly. The tendency for stock prices to decline at the time of an issue may have nothing to do with increased supply. Instead, the stock issue may simply be a signal that well-informed managers believe the market has overpriced the stock.9 15.4 The Private Placement private placement Sale of securities to a limited number of investors without a ering. Whenever a compan es a public of gister the issue with the SEC. It could av vately. ast vate placement, b gely to knowledgeable investors. One disadv v vestor cannot easily resell the security. invest huge sums of mone ed uy unre ge gistered securities among themselves. As you would e vate placement than to make a public issue. ge issues where costs are antage for companies making smaller issues. Another adv vate placement is that the debt contract can be customto change the terms of the debt, it is much simpler to do this with a private placement where only a few inv volved. Therefore, it is not surprising that private placements occup the corporate debt market, namely These are 8 W. Mullins, “Equity Issues and Of ” Journal of Financial W. Masulis and A. N. K ar, “Seasoned Equity vestigation,” Journal of Financial Economics W elson and M. M. P aluation Ef Process,” Journal of Financial Economics 9 This explanation was dev vestment Decisions ve Information That Investors Do Not Have,” Journal of Financial Economics 13 (1984), pp. 187–222. See, for e Economics Of . Chapter 15 How Corporations Raise Venture Capital and Issue Securities 435 ace the highest costs in public issues, that require the most detailed inv W ge, safe, and conv vate or example, in 2005, Berkshire Hathaway, the investment compan W wed $3.75 billion in a private placement. Nev antages of private placement—avoiding registration costs and establishing a direct relationship Of course these advantages are not free. Lenders in private placements have to be y face and for the costs of research and negotiation. They also have to be compensated for holding an asset that is not easily resold. All these f about the dif vate placements and public issues, but a typical yield dif SUMMARY www.mhhe.com/bmm7e QUESTIONS QUIZ PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS finance.yahoo.com www.sec.gov/edgar/searchedgar/webusers.htm bear.cba .ufl.edu/ritter SOLUTIONS TO SELF-TEST QUESTIONS MINICASE www.mhhe.com/bmm7e WEB EXERCISES www.mhhe.com/bmm7e APPENDIX Hotch Pot’s New-Issue PROSPECTUS10 Prospectus Silverman Pinch Inc. April 1, 2012 The Company Use of Proceeds Dividend Policy Certain Factors Substantial Capital Needs Competition Capitalization www.mhhe.com/bmm7e Prospectus Summary www.mhhe.com/bmm7e Selected Financial Data Management’s Analysis of Results of Operations and Financial Condition Business Management Executive Compensation Certain Transactions Lock-Up Agreements Description of Capital Stock Underwriting Legal Matters Legal Proceedings Experts Financial Statements www.mhhe.com/bmm7e Principal and Selling Stockholders CHAPTER 16 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T F I V E Debt and Payout Policy River Cruises is reviewing its capital structure. More debt would increase the expected return on its shares, but would it add value? A 446 Part Five Debt and Payout Policy TABLE 16.1 Median ratios of debt to total capital for a sample of nonfinancial industries, 2009 Note: Debt to total capital ratio 5 D/(D 1 e D and E are the book values of long-term debt and equity. Source: Compustat. 16.1 How Borrowing Affects Value in a Tax-Free Economy v Yogi Berra. “Should I cut it into four slices as usual, Yogi?” asks the pizza man. “No,” replies Yogi, “Cut it into eight; I’m ” capital structure The mix of long-term debt and equity financing. If you understand why more slices won’t sate Yogi’s appetite, you will hav culty understanding when a company’s choice of capital structure does not increase the underlying v Think of a simple balance sheet, with all entries e et values: Assets Liabilities and Stockholders’ Equity Value of cash flows from the firm’s real assets and operations Value of firm Market value of debt Market value of equity Value of firm have to balance!) Therefore, if you add up the market v s real assets and operations. In fact, the v determines the aggregate v ways equal. (Balance sheets s debt and ws from the ws determines the value of the f , by using more debt and less equity financ- ing, overall value should not change. hand side determines how it is sliced. y parts as it likes, but the v ways sum back to the value of the w. (Of course, we have to mak w stream is lost in the slicing. We cannot say “The value of a pizza is independent of how it is sliced” if the slicer is also a nibbler.) The basic idea here (the value of a pizza does not depend on how it is sliced) has v Y v , always referred to as “MM,” showed in 1958 that the v ws are “sliced.” More precisely, Chapter 16 Debt Policy 447 they demonstrated the following proposition: When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix of securities used to finance the company. For example, capital markets have to be “well functioning.” This means that investors can trade securities without restrictions and can borrow or lend on the same ets are eff fairly priced giv vailable to investors. (We discussed market ef y in Chapter 7.) MM’ taxes, and it ignores the costs encountered if a firm borrows too much and lands in financial distress. if other practical complications are encountered. But the best way to start s argument. To keep things as simple as possible, we will ignor . MM’s Argument Cleo, the president of River Cruises, is revie Antony . Table 16.2 sho The company The expected earnings and dividends per share are $1.25, b restructuring Process of changing the firm’s capital structure without changing its real assets. TABLE 16.2 River Cruises is entir inanced. Although it expects to have an income of $125,000 in per , this income is not certain. This table shows the return to the stockholder erent assumptions about operating income. We assume no taxes. or e fall to $.75 in a slump or they could jump to $1.75 in a boom. xpects to produce a lev ings and dividends in perpetuity. No gro xpected xpected di vided 5 .125, or 12.5%. Cleo has come to the conclusion that shareholders w pan . She therefore proposes to issue $500,000 of debt at an interest rate of 10% and to use the proceeds to repurchase This is called a restructuring. Notice that the $500,000 raised by the ne order to repurchase and retire 50,000 shares. Therefore, the assets and investment polic fected. Only the f What would MM say about this ne Operating income is the same, so the v With $500,000 in ne $500,000, that is, 50,000 shares at $10 per share. The total value of the debt and equity 448 Part Five Debt and Payout Policy Since the v orse v The ov alue of River alls from $1 million to $500,000, but shareholders have also received $500,000 in cash. Antony points all this out: “The restructuring doesn’t mak y , Cleo. Why bother? Capital structure doesn’t matter.” Self-Test 16.1 How Borrowing Affects Earnings per Share Cleo is unconvinced. She prepares Table 16.3 and Figure 16.1 to show ho wing Tables 16.2 and 16.3 sho Table 16.3 also sho ersus $1.75) and more “downside” ($.50 versus $.75). The orange line in 16.1 shows ho ould v of the data in Table 16.2. The blue line shows ho y mov data in Table 16.3. Cleo reasons as follo ould v . It is therefore a plot of the use of debt, b increased. We could be heading for a recession but it doesn’t look likely debt issue.” As financial manager, Antony replies as follo wing will increase earnings per share as long as there’s no slump.” But we’re not really doing anything for shareholders that they can’t do on their own. Suppose Riv not w. In that case an inv w $10, and then invest $20 in two shares. Such an investor would put up only $10 of her own money. Table 16.4 shows how the payoffs on this $10 investment v v TABLE 16.3 River Cruises is wondering whether to issue $500,000 of debt at an interest rate of 10% and repurchase 50,000 shares. This table shows the return to the shareholder under erent assumptions about operating income. Returns to shareholders are increased in normal and boom times but fall more in slumps. Chapter 16 Debt Policy 449 FIGUR 16.1 Borrowing increases River Cruises’ earnings per share (EPS) when operating income is greater than $100,000 but reduces it when operating income is less than $100,000. Expected EPS rises from $1.25 to $1.50. operating income. Y vestor would get by buying one share in the compan last two lines of Tables 16.3 and 16.4.) It makes no dif w directly or whether Riv ws on their behalf. Therefore, if River ws, it will not allow investors to do anything that they could not do already, and so it cannot increase the v “W gument in reverse and show that investors also won’t be any worse of vestor who owns two shares in the compan v ws money, there is some wer than before. If that possibility is not to our investor’s taste, he can b y and also invest $10 in the firm’s debt. Table 16.5 shows how the payoff on this investment v ies with Riv You can see that these payof xactly the same as the inv Tables 16.2 and 16.5.) By lending half of his capital (by inv ver Cruises’ debt), the investor exactly offsets the company’ wing. So if Riv ws, it won’t stop investors from doing an y could previously do.” TABLE 16.4 Individual inv e River Cruises’ owing by borrowing on their own. In this example we assume that River Cruises has not restructur wever, the inv or can put up $10 of her own money, w $10 , same rat Table 16.3. n as in TABLE 16.5 Individual investors can also undo the ects of River Cruises’ borrowing. Here the investor buys one share for $10 and lends out $10 more. Compare these rates of return to the original returns of River Cruises in Table 16.2. 450 MM’s proposition I (debtirrelevance proposition) The value of a firm is ected by its capital structure. Part Five Debt and Payout Policy This re-creates MM’s original argument.2 As long as inv w or lend on their o The v must be the same as before. In other words, the value of the firm must be unaffected by its capital structure. This conclusion is widely known as MM’s proposition I. MM debt-irrelevance proposition, because it shows that under ideal conditions s debt policy shouldn’ Self-Test 16.2 How Borrowing Affects Risk and Return Figure 16.2 River Cruises. The upper circles represent f “normal, vance proposition for alue; the lower circles, expected, or Thus if the f raises $500,000 in debt and uses the proceeds to repurchase and retire shares, the remaining shares must be w must stay at $1 million. The two bottom circles in Figure 16.2 are also the same size. But notice that the bottom right circle sho ver They get more than half of the expected income “pie. f? MM say no. operating risk (business risk) Risk in firm’s operating income. financial leverage Debt financing to ects of changes in operating income on the returns to stockholders. Look again at Tables 16.2 and 16.3 regardless of the state of the economy. Therefore, debt f operating risk or, equivalently, the business risk fect operating income, Suppose operating income drops from $125,000 to $75,000. Under all-equity financall by $.50. With 50% debt, there earnings per share by $1. You can see no lever wn as leverage and a The debt increases the uncer, a Tables 16.2 and 16.3.) In other words, the effect of leverage is to double the magnitude of the upside and downside in the return on Riv Whatever the beta of the ould be twice as high afterw 2 W Chapter 16 451 Debt Policy FIGURE 16.2 “Slicing the pie” for River Cruises. The circles on the left assume the company has no debt. The circles on the right reflect the proposed restructuring. The restructuring splits firm value (top circles) 50–50. Shareholders get more than 50% of expected, or “normal,” operating income (bottom circles), but only because they bear financial risk. Note that restructuring ect total firm value or operating income. $1 million equity value $500,000 equity value Equity income = operating income = $125,000 financial risk Risk to shareholders resulting from the use of debt. Debt f W share must double.3 Equity income = $75,000 ect the operating risk but it does add . o absorb the same amount of operating risk, risk per Consider now the implications of MM’ ver vi- dends per share is $1.25. Since inv v xpected dividend di $10. The good news is that after the debt issue, e $1.50. The bad ne v y 5 w doubled. So instead of being 1 5 5 15%. vidends is e 5 $10, e Expected earnings per share Share price Expected return on share Current Structure: All Equity Proposed Structure: Equal Debt and Equity $1.25 $10 12.5% $1.50 $10 15.0% Thus leverage increases the e ut it also increases the The two effects cancel, leaving shareholder value unchanged. Debt and the Cost of Equity ver Cruises’ cost of capital? W 3 leverage. ed costs increase the v vide operating leverage. It is e . irm’s profits. These ixed cost, 452 Part Five Debt and Payout Policy 5 .125, or requity, and also rassets, the e 12.5%. cost of capital for the f s assets. alue, it should es place. Also, by a grand stroke of luck you simultaneously become a billionaire and buy all the outstanding debt and equity of Riv What rate of return should you expect on this investment? Your answer should be 12.5%, because once you own all the debt and equity, you will effectively own all the assets and receive all the operating income. You will indeed get 12.5%. Table 16.3 shows e and a share price that is unchanged at $10. Therefore, the e rdebt 5 .10). Your $1.50/$10 5 .15, or 15% (requity 5 .15). overall return is (.5 3 .10) 1 (.5 3 .15) 5 .125 5 rassets There is obviously a general principle here: rdebt and requity takes you to rassets assets. The formula is rassets 5 (rdebt 3 D/V) 1 (r verage of y’s 3 E/V) where D and E V equals overall alue, the sum of D and E. Remember that D, E, and V are market values, not book values. verage cost of capital (WACC) formula presented in Chapter 13 because at this point we are still ignoring taxes.4 Don’t w , we’ll get to WACC in a moment. First let’s look at the implications of MM’ vance proposition for the cost of equity. MM’ s operating income or the value of its assets. So rassets, the e the package of debt and equity, is unaffected. However, we have just seen that leverage does increase the risk of the equity and the To see how the expected return on equity v lev ws: requity 5 rassets 1 D (rassets 2 rdebt) E (16.1) which in words says that expected expected debtexpected ≥S 2 5 return 1 C equity 3 £ assets on equity on assets ratio debt Expected MM’s proposition II The required rate of return on equity increases as the firm’ atio increases. ▲ EXAMPLE 16.1 This is MM’s proposition II. mon stock of a levered f expressed in market values. Note that requity 5 rassets if the f River Cruises’ Cost of Equity We can check out MM’s proposition II for River Cruises. Before the decision to borrow, requi 5 rassets 5 5 4 expected operating income market value of all securities 125,000 5 .125, or 12.5% 1,000,000 Chapter 16 453 Debt Policy If the firm goes ahead with its plan to borrow, the expected return on assets, rassets, is still 12.5%. So the expected return on equity is requi 5 rassets 1 5 .125 1 D (rassets 2 rdebt) E 500,000 (.125 2 .10) 500,000 5 .15, or 15% We pointed out in Chapter 13 that you can think of a debt issue as having an explicit cost and an implicit cost. The e s debt. But debt also increases financial risk and causes shareholders to demand a higher return on their investment. Once you recognize this implicit cost, debt is no c eturn that investors require on their assets is unaffected by the firm’s borrowing decision. Be sure to remember this point whenever you hear some layperson say “Debt is cheaper than equity.” Self-Test 16.3 The implications of MM’ ws, the e unchanged, but the e wn in Figure 16.3. No matter how , rassets, is age are also changing. More debt means that the cost of equity increases, but at the same time the amount of equity is less. In Figure 16.3 we have drawn the rate of interest on the debt as constant no matter ho ws. That is not wholly realistic. It is true that most large, conservativ w a little more or less without noticeably affecting the interest rate that they pay. But at higher debt levels lenders become concerned that they may not get their money back and they demand higher rates of interest. Figure 16.4 modifies Figure 16.3 to take account of this. Y rows more, the risk of def Proposition II continues to predict that the e FIGURE 16.3 MM’s proposition II with a fixed interest rate on debt. The expected return on River Cruises’ ises in line with the debt-equity ratio. The weighted average of the expected returns on debt and equity is constant, equal to the expected return on assets. 454 Part Five Debt and Payout Policy FIGURE 16.4 MM’s proposition II when debt is not risk-free. As the debtatio increases, debtholders demand a higher expected rate of return to compensate for the risk of default. The expected return on equity increases more slowly when debt is r because the debtholders take on part of the risk. The expected return on the pack , r , remains constant. equity does not change. However, the slope of the requity line now tapers off as D/E increases. y debt be As the f Figures 16.3 and 16.4 wrap up our discussion of MM’s leverage-irrelevance proposition. Because ov v s debt and This result follows from MM’ ets are well functioning and tax w it’ es back into the picture. 16.2 Capital Structure and Corporate Taxes The MM propositions suggest that debt policy should not matter. Yet financial managers do w y, and for good reasons. Now we are ready to see why. If debt policy were completely vant, actual debt ratios would v . Yet almost all airlines, utilities, and real estate development companies rely heavily on debt. And so do many f capital-intensiv are company that is not predominantly equitywth companies seldom use much debt, despite rapid expansion and often heavy requirements for capital. The e ve so f of our discussion. No es. Debt and Taxes at River Cruises antage: The interest that the company pays is a tax-deductible expense, b To see the advantage of debt finance, let’s look once again at River Cruises. Table 16.6 shows how e ed at a rate of 35%. ver Cruises is f equity. The right-hand column shows what happens if the f at an interest rate of 10%. Notice that the combined income of the debtholders and equityholders is higher by vered. deductible. Thus ev es by $.35. The total amount of tax savings is simply .35 3 interest payments. In the case of Riv Chapter 16 455 Debt Policy TABLE 16.6 Since debt interest is tax-deductible, River Cruises’ debtholders and equityholders expect to receive a higher combined income when the firm is leveraged interest tax shield Tax savings resulting fr interest payments. interest tax shield is .35 3 $50,000 5 $17,500 each year. In other words, the “pie” of after-tax income that is shared by debt and equity investors increases by $17,500 relativ v The interest tax shield is a valuable asset. Let’s see how much it could be worth. Suppose that Riv y mature and to keep “rolling ov tax sa . These savings depend only on the corporate tax rate and on the ability of Riv v ely to be small. If we wish to compute the present value of all the future tax sa est tax shields at a relatively low rate. But what rate? The most common assumption is that the risk of the tax shields is the same as that of the interest payments generating them. Thus we discount at 10%, the e v s debt. If the ard to annual savings of $17,500 in perpetuity. Their present value is PV tax shield 5 $17,500 5 $175,000 .10 This is what the tax savings are w v How does company value change? We continue to assume that if the f v pany will be valued at $81,250/.125 5 $650,000.5 s securities increases by the value of the tax shield to $650,000 1 $175,000 5 $825,000. Let us generalize. Tc wed, or rdebt 3 D. The annual tax sa times the interest payment. Therefore, Annual shield 5 3 interest payment 5 Tc 3 (rdebt 3 D) alue: PV shields 5 Tc 3 (rdebt 3 D) annual tax shield 5 5 TcD rdebt rdebt (16.2) 5 TcD) in the rest of the River xample. We do so for simplicity. In fact, the formula almost always overstates the v . es. If that happens, there W 5 as w as zero (see Table 16.2). It is worth only $650,000 es. 456 Part Five Debt and Payout Policy are no taxes for interest to shield. Third, the formula assumes that the amount of debt ed re s more reasonable to assume that the f rebalance ver time to keep its debt ratio more or less ves and its v hard times and value decreases, it can gradually pay down debt to a more comfortable lev ed amounts; they v s performance, and therefore should be discounted at a rate higher than the cost of debt. The simple formula nev Self-Test 16.4 How Interest Tax Shields Contribute to the Value of Stockholders’ Equity MM’ how it is sliced.” The pizza is the firm’s assets, and the slices are the debt and equity claims. If we hold the pizza constant, then a dollar more of debt means a dollar less of equity value. But there is really a third slice—the government’s. MM would still say that the value of the pizza—in this case the company value before taxes—is not changed by slicing. But anything the f vernment’s slice obviously leaves more for the others. One w w money. This reduces s tax bill and increases the cash payments to the investors. The value of their investment goes up by the present value of the tax savings. In a no-tax world, MM’s proposition I states that the v by capital structure. But MM also modified proposition I to recognize corporate taxes: Value of levered firm 5 1 present value of tax shield 5 1 TcD (16.3) Figure 16.5. It implies that borrowing increases firm value and shareholders’ wealth. Corporate Taxes and the Weighted-Average Cost of Capital We have sho v es, debt provides the company with a xplicitly calculate the present v wing policy. gotten, however, because they show up in the discount rate used to evaluate capital investments. Since debt interest is tax-deductible, the government in effect pays 35% of the interest cost. So to keep its investors happy after-tax rate of benefit of debt, the weighted-average cost of capital formula (see Chapter 13 for a review if you need one) becomes D E ≤ 1 requity ¢ ≤ WACC 5 (1 2 Tc)rdebt ¢ D1E D1E Chapter 16 457 Debt Policy FIGURE 16.5 The heavy blue line shows how the interest t ect the market value of the firm. Additional borrowing decreases corporate income tax payments and increases the cash flows available to investors. Thus market value increases. PV tax shield Value if all equity financed Notice that when we allow for the tax advantage of debt, the weighted-average cost of capital depends on the after-tax rate of interest (1 2 Tc) 3 rdebt. ▲ EXAMPLE 16.2 WACC and Debt Policy We can use the weighted-average cost of capital formula to see how leverage ects River Cruises’ cost of capital if the company pays corporate tax. When a company has no debt, the weighted-average cost of capital and the return required by shareholders are identical. In the case of River Cruises the WACC with all-equity financing is 12.5%, and the value of the firm is $650,000. Now let us calculate the weighted-average cost of capital if River Cruises issues $500,000 of permanent debt (D 5 $500,000). Company value increases by PV tax shield 5 $175,000, from $650,000 to $825,000 (meaning that D 1 E 5 $825,000). Therefore the v ust be $825,000 2 $500,000 5 $325,000 (E 5 $325,000). Table 16.6 shows that when River Cruises borrows, the expected equity income is $48,750. So the expected return to shareholders is 48,750/325,000 5 15% (r equity 5 .15). The interest rate is 10% (r debt 5 .10), and the corporate tax rate is 35% (Tc 5 .35). This is all the information we need to see how lever ects River Cruises’ weighted-average cost of capital: WACC 5 (1 2 Tc)rdebt ¢ 5 (1 2 .35).10 ¢ D E ≤ 1 requity ¢ ≤ D1E D1E 325,000 500,000 ≤ 1 .15 ¢ ≤ 5 .0985, or 9.85% 825,000 825,000 We saw earlier that if there are no corporate taxes, the weight verage cost of capit ected by borrowing. But when there are corporate taxes, debt provides the company with a new benefit—the interest tax shield. In this case leverage reduces the weighted-average cost of capital (in River Cruises’ case from 12.5% to 9.85%). Figure 16.6 repeats Figure 16.3 except that now we have allowed f ect of taxes on River Cruises’ cost of capital. You can see that as the company borrows more, the expected r , but the rise is less rapid than in the absence of taxes. T er-tax cost of debt is only 6.5%. As a result, the weighted-average cost of capital declines. For example, if the company has debt of $500,000, wor atio ( 5 1.54. Figure 16.6 shows that with this amount of debt the weighted-average cost of capital is 9.85%, the same figure that we calculated above. 458 Part Five Debt and Payout Policy FIGURE 16.6 Changes in River Cruises’ cost of capital with increased leverage when there are corporate taxes. The after-tax cost of debt is assumed to be constant at (1 2 .35)10% 5 6.5%. With increased borrowing the cost ises, but more slowly than in the no-tax case (see Figure 16.3). The weight verage cost of capital (WACC) declines as the firm borrows more. Again, we must nag and remind you that we have used the simple formula (PV tax shields 5 TcD). The formula assumes that tax shields are fixed, safe, and permanent. But the message from Figure 16.6 still stands even if these assumptions are relaxed.6 Interest tax shields increase firm value and reduce the after-tax WACC. The Implications of Corporate Taxes for Capital Structure wing pro xtreme: w to the hilt. verage cost of capital. MM were not that fanatical about it. No one would e extreme debt ratios. For example, if a f ws heavily, all its operating income es to be paid. There is no wing any more. There may also be some tax disadvantages ve to pay personal income tax on any interest they receive. The top rate of tax on bond interest viv antage that the taxed until the stock is sold. (The delay reduces the present value of the tax payment.) All this suggests that there may come a point at which the tax savings from debt lev ven decline. But it doesn’t e with large tax bills often thrive with little or no debt. There are clearly factors besides tax to consider. One such factor is the lik v 16.3 Costs of Financial Distress en or honored with y. Sometimes it means only skating on thin ice. 6 xpected rate WA however. If you w WACC, check out Chapter 19 in R. A. Brealey, S. C. Myers, and F. Allen, Principles of Corporate Finance, 10th ed. (New Y Irwin), 2011. D/E et-v Figure 16.6. Chapter 16 costs of financial distress Costs arising from bankruptcy or distorted business decisions before bankruptcy. 459 Debt Policy . Inv w that levered f , and they w costs of distress. That w et value of the lev s securities. Even the most blue-chip f w their debt is perceived by investors. The w that the ged a lower rate of interest if the probability of default is minimal, and they are therefore anxious to maintain an investment-grade rating. Ev vestors factor the potential for alue. verall value Overall market value if all-equityPV tax PV costs of 5 1 2 value shield financial distress The present v distress and on the magnitude of the costs encountered if distress occurs. 16.7 shows ho e Riv ut considers mo v At moderate debt levels the pr inancial distress is trivial, ore the tax advantages of debt dominate. But at some point additional borrowing causes the pr inancial distress to increase rapidly and the potential costs of distress begin to take a substantial bite out of firm value. The theoretical optimum is reached when the present value of tax savings from further borro y increases in the present value of costs of distress. trade-off theory Debt levels are chosen to balance interest tax shields against the costs of financial distress. This is called the trade-off theory The theory says that vels to the point where the value of additional interest tax shields is exactly of Now let’ Bankruptcy Costs y is merely a le wing creditors (that is, e ov ault on outstanding debt. If the company cannot pay its debts, the compan ver to wo cause of the decline in the value of the firm. It is the result. In practice, of course, anything involving courts and lawyers cannot be free. The fees involv alue of the FIGURE 16.7 The tr al structure. The curved blue line shows how the market value of the firm at first increases as the firm borrows but finally decreases as the costs of financial distress become more and more important. The optimal capital structure balances the costs of financial distress against the value of the interest tax shields generated by borrowing. PV costs of financial distress PV tax shield Value if all equity financed 460 Part Five Debt and Payout Policy s assets. Creditors end up with what is left after paying the lawyers and other y et value of the alue of these potential costs. It is easy to see how increased lev expected value of the associated costs. et v Creditors foresee the costs and realize that if def y costs y demand compensation in advance fs to et v Self-Test 16.5 y, the Chapter 11. to face the w val of a reorganization plan for who gets what; under the plan each class of creditors needs to give up its claim in exchange for new securities or a mixture of new securities and cash. The challenge is to design a new e the business ves possible to satisfy both demands and the patient emer . Often, however, the proceedings involve costly delays and legal tangles, and the business continues to deteriorate. y costs can add up fast. The f lion in le y. ers are forecast to reach a record $1.5 billion. xceptional cases, for only the largest f ruptcy costs average only about 3% of the v ruptcy.7 ge ones; it seems Thus f ve discussed only the direct (that is, legal and administrative) costs y. The indirect y while it y. y in 1989, it was in severe f ut it still had some v acilities. These assets were more than suf wever, the bankruptcy judge was determined to k , Eastern’s losses continued to pile up. received less than $900 million. The unsuccessful attempt at resuscitation had cost Eastern’s creditors $2.8 billion. We don’ w how much these indirect costs add to the e y. We suspect it is a significant number y proceedings are 7 See, for e A. W y Resolution: Direct Costs and V Journal of Financial Economics 27 (October 1990), pp. 285–314. ” Chapter 16 Debt Policy 461 prolonged. Perhaps the best evidence is the reluctance of creditors to force a f y. In principle, they would be better off to end the agony and seize the assets as soon as possible. But, instead, creditors often overlook defaults in the hope of nursver a dif The v y. w $1,000 and you’ve got a banker. Borrow $10,000,000 and you’v .” Costs of Bankruptcy Vary with Type of Asset Suppose your f ge downtown hotel, mortgaged to the hilt. A recession hits, occupancy rates f The es over and sells the hotel to a new owner and operator. The stock is worthless and you use the f allpaper. y? In this example, probably very little. The value of the hotel is, of course, much less than you hoped, but that is due to the lack of guests, y y does not damage the hotel itself. y gal and court fees, real estate commissions, and the time the lender spends sorting things out. thing is the same, except for the underlying assets. Fledgling is a high-tech going concern, and much of its v v usiness”; its most important assets go down in the elevator and into the parking lot ev y to y should they put up cash which will simply go to pay off the banks? Failure to invest is likely to be much more serious for Fledgling than for a company lik aults on its debt, the lender w to cash in by selling the assets. In fact, if trouble comes, many of those assets may driv ver come back. Some assets, lik y and reorgely unscathed; the values of other assets are likely to be considerably diminished. , where company v velopment. It may also explain the low debt ratios in man Do not think only about whether borrowing labor. is likely to bring trouble. Think also of the value that may be lost if trouble comes. Self-Test 16.6 Financial Distress without Bankruptcy Not ev y for 462 Part Five Debt and Payout Policy many years. Ev altogether. ver y y does not avoided. y may not be paid, potential 8 and employees ws. want it to recover, b e man alities but threatened by squabbling on any specific issue. Financial distress is costly when these conflicts get in the way of running the business. Stockholders are tempted to forsake the usual objective of maximizing the overall market value of the firm and to pursue narrower self-interest instead. They are tempted to play games at the expense of their creditors. These games add to the costs of financial distress. Think of a compan y. It has large debts and large losses. Double-R’s assets have little value, and if its debts were due today, Double-R would default, lea The debtholders would perhaps receive a fe would be left with nothing. xplains why Double-R’s ve value. There could be a strok allo ver. That’s a long shot—unless f v , the stock will be valueless. But the owners have a secret weapon: They control investment and operating strategy. The First Game: Bet the Bank’s Money Suppose Double-R has the opportunity to take a wild gamble. If it does not come of orse off; the company will probably go under anyway. But if the gamble does succeed, there will be more than enough assets to pay off the debt and the surplus will go into the shareholders’ pockets. Y y, but if Double-R does hit the jackpot, the equityholders get most of the loot. This was essentially the situation facing Federal Express while it w ut needed $24,000 for ve to gamble literally. He took s remaining $5,000 and boarded a plane for Las Vegas, where he won $27,000. When asked ho ference did it make? Without the funds for the fuel companies, we couldn’t hav wn ves to tak anyway.” 9 The ef blatant, b vestment strategies are costly for the bondholders y associated with financial distress? Because the temptation to follo gies is strongest when the odds of default are high. ould never invest in Double-R’s lousy gamble, since it would be gambling with its own money, not the bondholders’. s creditors would not be vulnerable to this type of game. The Second Game: Don’t Bet Your Own Money We have just seen how e on risky ects. We will no 8 v y, the U.S. gov by backing the w ehicles. 9 Roger Frock, Changing How the World Does Business, FedEx’s Incredible J oehler Publishers, 2006). s customers The Inside Chapter 16 463 Debt Policy Suppose Double-R uncovers a relatively safe project with a positive NPV nately vestment. Double-R will need to raise this extra cash from its shareholders. Although the project has a positive NPV, the profits may not be suf y. If that is so, all the profy’ y put up. Although it is in the firm’s interest to go ahead with the project, it is not in the owners’ interest, and the project will be passed up. A recent e man ailure, discovered that their shareholders were reluctant to come to the rescue. The shareholders reasoned that any cash that the uted would simply be used to get existing debtholders and the gov These examples illustrate a general point. The value of any inv s stockholders bondholders. ute fresh equity capital even if that means forgoing positive-NPV opportunities. These tw debtholders. fect all lev y in the face. If the pr default is high, managers and stockholders will be tempted to take on excessively r ojects. At the same time, stockholders may refuse to contribute mor al even if the firm has safe, positive-NPV opportunities. Stockholders would rather take money out of the firm than put new money in. y kno w loan covenant Agr een firm and lender requiring the firm to fulfill certain conditions to safeguard the loan. xpense. So to reassure lenders that its loan covenants. For examwing and not to pay excessive dividends. Of ver ev y might ve-NPV course, no amount of f play. F investments and reject negative ones. We do not mean to leav ways succumb to temptation unless restrained. Usually they refrain v , not only because of a sense of f ut also on pragmatic grounds: es a killing today at the expense of a creditor will be coldly received when the time comes w again. Aggressiv wing precisely because they don’t wish to land in distress and be exposed to the temptation to play. Self-Test 16.7 We have now completed our review of the b cov . 16.4 Explaining Financing Choices The Trade-Off Theory troversy about how v 464 Part Five Debt and Payout Policy Thus Figure 16.7 get debt ratios will v have high target ratios. Unprofitable companies with risky, intangible assets ought to . It avoids extreme predictions and rationalizes moderate debt ratios. But what are the facts? Can xplain how companies actually behave? f theory successfully explains many of the industry dif Table 16.1. For example, high-tech gro y and mostly intangible, normally use relativ w heavily because their assets are tangible and relatively safe. f theory cannot explain. It cannot e ve with little debt. Consider, for e s most v velopment. We kno ative capital structures should go together. But Microsoft also has a v w enough to save tens of millions of tax er of concern about possible financial distress. Our e The most ails, for it predicts exactly the reverse. Under the trade-of , high profits should mean more in a higher debt ratio. Self-Test 16.8 A Pecking Order Theory ve theory which could e w less. It is based on asymmetric information w more than outside investors about the prof Thus investors may not be able to assess the true value of a ne They may be especially reluctant to buy ne yw w shares verpriced. Such w ve down 10 If managers know more than outside investors, they will be tempted to time stock issues when their companies’ stock is overpriced—in other words, when v see their companies’ shares as underpriced and decide not to issue. You can see why investors w wn the stock price accordingly. You can also see why are ould view a vely expensive source of financing. 10 W Chapter 16 pecking order theory Firms prefer to issue debt rather than equity if internal finance is icient. Debt Policy 465 All these problems are avoided if the compan vested. But if e inancing is required, the path of least resistance is debt, not equity. Issuing debt seems to hav fect on stock prices. alued and therefore a debt issue is a less w vestors. These observations suggest a pecking order theory like this: 1. vesting internally generated cash does not send adverse signals that could lower the stock price. 2. If e ely than an equity issue to be interpreted by investors as a bad omen. In this story o kinds of equity , and the second is at the bottom. w less; it is not because they have low target debt ratios but because they don’t need outside money y do not have suf v external y that taxes and f actors in the choice of capital structure. However, the theory says that these f ver e ver new issues of common stock. F w investment, and most external financing comes from debt. These aggre .Y ork best for ast-gro vestments. Of course you wouldn’t e xtremely valuable growth opportunities. Such f ve good reasons to issue stock; the wth f The Two Faces of Financial Slack financial slack Ready access to cash or debt financing. ve worked down the pecking order and need e living with excessive debt or bypassing good inv t be sold at what managers consider a fair price. ed about what f y s credit rating. But they place even greater emphasis y has access to funds for pursuing new 11 In other words, they place a high value on projects when the slack. Ha ative y’s debt as a safe investment. y’s v v Therefore, you w v v slack is most v ve-NPV gro That is another reason why gro ativ 11 ey, “The Journal of Financial Economics 61 (2001), pp. 187–243. ” FINANCE IN PRACTICE How Sealed Air’s Change in Capital Structure Acted as a Catalyst to Organizational Change However, there is also a dark side to financial slack. Too much of it may encourage e it easy, expand their perks, or empire-b paid back to stockholders. Michael Jensen has stressed the tendency of managers with w too much cash into mature businesses or ill-advised acquisitions. “The problem,” Jensen says, “is how to motivate managers to disgorge the cash rather than investing it below the cost of capital or wasting it in organizational inef ”12 If that’ pal payments are contractual obligations of the f cash. Perhaps the best debt level would leave just enough cash in the bank, after debt ve-NPV projects, with not a penny left over. We do not recommend this de ut the idea is valid and important. F ve a good effect on managers’ incentives. es the skater concentrate. Likewise, managers of highly lev ely to work harder y spend money. The nearby box tells the story of how Sealed $300 million, using the proceeds of the loan to pay a special cash dividend to shareholders. The net effect w vial level to fully 65% of the 12 M. C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review 26 (May 1986), p. 323. 466 Chapter 16 Debt Policy total v ge sums of money as interest, lea aw ef SUMMARY 467 Air showed great improvements in www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS finance.yahoo.com finance.yahoo.com SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e WEB EXERCISES MINICASE www.mhhe.com/bmm7e www.mhhe.com/bmm7e APPENDIX workout bankruptcy liquidation reorganization Bankruptcy Procedures www.mhhe.com/bmm7e The Choice between Liquidation and Reorganization www.mhhe.com/bmm7e Appendix Questions CHAPTER 17 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T F I V E Debt and Payout Policy In 2010 Union Pacific paid out $600 million in dividends and used $1.2 billion to repurchase stock. S 480 Part Five Debt and Payout Policy 17.1 How Corporations Pay Out Cash to Shareholders o ways. They can pay a cash dividend or repurchase some outstanding shares. Figure 17.1 shows annual repurchases and dividends in the United States since 1980. You can see that stock repurchases were rare before the mid-1980s but have since become f the more active stock repurchasers included W lion), and Microsoft ($8.2 billion). The repurchase champion, however 2009. In 2009, repurchases and dividends in the United States were just about equal, vidends. The no-dividend group includes household names such as Sun Microsystems, Oracle, Amazon, and Google. The no-dividend group also includes companies that used to pay dividends but have f and been forced to cut back dividends to conserve cash. An e ord Motor Company vidends for decades but cut its dividend to zero in 2006. Paying Dividends cash dividend Payment of cash by the firm to its shareholders. In May 2010, Union P s board of directors met and decided to authorize a regular cash dividend of $.33 per share, an increase of $.06 from the pre s vidend of $.27. regular xpected to maintain or increase the dividend in the future. Instead of increasing the regular dividend, they could have kept it at $.27 and authorized a special dividend. Investors realize that special dividends probably won’t be repeated. Some of Union P ve welcomed the cash, but others prevest the dividend in the company. To help these investors, Union P offered an automatic dividend reinvestment plan, or DRIP to this plan, his or her dividends were automatically used to buy additional shares.1 Who receives the Union P vidend? That may seem an obvious question, but s records of who owns its shares are never fully FIGURE 17.1 Dividends and stock repurchases in the United States, 1980–2008 (figures in $ billions). Source: Capital IQ Compustat, www.compustat.com. 1 Often the new shares in an automatic dividend inv v v Chapter 17 481 Payout Policy FIGURE 17.2 The key dates for Union Pacific’s quarterly dividend. ex-dividend Without dividend. Buyer of a st er the ex-dividend date does not receive the most recently declared dividend. Union Pacific declares regular quarterly dividend of $.33 per share. Shares start to trade ex-dividend. Dividend will be paid to shareholders registered on this date. Dividend checks are mailed to shareholders. v who qualify to receive each dividend. Union P ould send a dividend check on July 1 (the payment date) to all shareholders recorded in its books on May 28 (the record date). On May 26, two days before the record date, Union P gan to trade ex-dividend. Inv ve their purchases re vidend. Other things equal, a stock is w vidend. So when a stock “goes ex-dividend,” its price falls by about the amount of the dividend. Figure 17.2 ey dividend dates. same whenever companies pay a dividend (though of course the actual dates will differ). Self-Test 17.1 Limitations on Dividends ute the money as dividends. That would not leav s debts. State la s creditors against excessive dividend payments. For example, most states prohibit a company from paying dividends if doing so would wed to pay a dividend if make the company insolvent.2 it cuts into le Legal capital outstanding shares.3 y wer’ orthiness. We mentioned that F its dividend in 2006. F w heavily very plan. Its loan agreements prohibit dividends. Thus Ford’s get about dividends until the company’ ves and its gotiated. stock dividends and splits Distributions of additional shares to a firm’s stockholders. Stock Dividends and Stock Splits Union P For e 2 3 s dividend was in cash, b enc Where there is no par value, le stock di . ould send wns. ays. In some cases, it just means an inability to meet immediate ed liabilities. 482 Part Five Debt and Payout Policy A stock dividend is v e a stock split. giv ed number of ne or e o-for-one stock split, each investor would receiv held. The investor ends up with two shares rather than one. A two-for-one stock split is therefore like a 100% stock dividend. Both result in a doubling of the number of outstanding shares, but the y’ alue.4 More often than not, however et price of the stock, even though investors are aw y’s business is not affected. Perhaps lo avored by investors, or maybe investors take the decision as a signal of management’ the future.5 ▲ EXAMPLE 17.1 Stock Dividends and Splits Amoeba Products has issued 2 million shares currently selling at $15 each. Thus investors place a total market value on Amoeba of $30 million. The company now declares a 50% stock dividend. This means that each shareholder will receive one new share for ever o shares that are currently held. So the total number of Amoeba shares will increase from 2 million to 3 million. The company’s assets are not changed by this paper transaction and are still worth $30 million. The value of each shar er the stock dividend is therefore $30/3 5 $10. If Amoeba split its stock three for two, ect would be the same.6 In this case two shares would split into three. (Amoeba’ o is “Divide and conquer.”) So each shareholder has 50% more shares with the same total value. Other things equal, share price must decline by a third. 17.2 Stock Repurchases Another way for the f or example, when Union P stock repurchase Firm buys back stock from its shareholders. vidend increase in ver the following 2 years. The company can keep these reacquired shares in its treasury and resell them if it needs money later. exercise stock options. ays to implement a stock repurchase: 1. Open-market repurchase. et, just like any other investor. This is by far the most common 4 b could use a six-for v wn into a more conv vidual investors may favor stocks with lo er. R. Greenwood, and J. Wurgler ”J inance reverse split or e a 1-for-10 rev xchange for ev 5 See E. F. F , M. Jensen, and R. Roll, “The or e stock have above-av . Asquith, P , and K. P Splits,” Accounting Review 6 , say w stock ” vidend is shown on the A split is shown as a . Chapter 17 483 Payout Policy method. There are limits on how many of its o given day ver several months or years. 2. T . fers to b ed price. , the deal is done. 3. Auction. fers declaring how many shares they are prepared to sell at each price, and the f west price at which it can buy the desired 4. Direct negotiation. . which the tar gotiate repurchase of a block of shares from a xamples are greenmail transactions, in eover buys out the hostile bidder. “Greenmail” es the bidder happy to leave the target alone. Why Repurchases Are Like Dividends T A of Table 17.1, which shows the market value of Hewlard Pocket’s assets and liabilities. Shareorth in total $1 million, so the price per share equals $1 million/100,000 5 $10. vidend is paid. Pocket is proposing to pay a di With 100,000 shares outstanding, that amounts to a total payout of $100,000. Panel B shows the effect of this dividend payment. et value of the s assets f price falls to $9. Suppose that before the dividend payment you owned 1,000 shares of Pocket w After the payment you would hav orth $9,000. Rather than paying out $100,000 as a dividend, Pocket could use the cash to buy anel C shows what happens. The firm’s assets fall to $900,000, just as in panel B, b share remains at $10. If you o ould own 1% of the company et, you would still own 1% of the company. Your sales w TABLE 17.1 Cash dividend versus share repurchase. Hewlard Pocket’s marketvalue balance sheet. 484 Part Five Debt and Payout Policy would keep 900 shares w Your position is exactly the same with the share repurchase (panel C of Table 17.1) as with the cash di It’ vidend and a share repurchase are equivalent transallets. reduced by repurchases, however cash is paid out as dividends. Self-Test 17.2 Repurchases and Share Valuation Now here is a question that often causes confusion. We stated in Chapter 7 that the value of a share of stock is equal to the discounted v repurchases, does our simple dividend discount model still hold? The answer is yes, but we need to explain why. w you would value the stock of He et. We’ll suppose that it has just paid a di The stock is ex-dividend. The next dividend is in year 1.7 Pocket is expected to continue to pay annual dividends of orks out to a di alue of this dividend stream is $1/.111 5 $9. Pocket now announces that it will not pay a dividend in year 1 but will instead use the $100,000 it would hav year 2 onward it will resume paying annual dividends of $100,000.8 The new policy does not change the aggregate amount of cash going out to shareholders. Therefore, s check that the dividend discount model continues to give a present value of $9 a share. After the company has repurchased the stock in year 1, the number of outstanding all to 90,000. Therefore, there is no di ut the dividend per share from year 2 onward will be $100,000/90,000 5 $1.11. The present v in year 1 is $1.11/.111 5 $10, and its value in year 0 is $10/1.11 5 $9.9 So our dividend discount model still holds. dividends per share. The only trick is to remember that share repurchases reduce the number of shares and increase future di You can also calculate PV s overall mark on the total cash paid out to both present and future shareholders, and then dividing by 7 W vidends for simplicity. Most cash di Have we cheated by assuming a $100,000 dividend forever? No. but it doesn’t matter. Y 8 . wer, xpectedly well ov xt e Table 17.1 to sho f with $111,000 in repurchases as $111,000 of cash dividends. In f vidends at any level of payout, at least in the simple examples that we’re doing now. Some complications come later in the chapter. 9 checks. Chapter 17 485 Payout Policy 17.3 How Do Corporations Decide How Much to Pay Out? ey asked senior executiv xecutives’ responses. vidend policies. 1. e dividend changes that may have to be reversed, and the wf 2. Managers “smooth” dividends and hate to cut them back. Dividends tend to follow the gro T vidend payouts. 3. Managers focus more on dividend changes than on absolute levels. Thus paying a $2 di inancial decision if last year’s dividend was $1, but it’s no big deal if last year’s dividend was $2. gular dividends sometimes act as though they have a target payout ratio, get ratio does not s di wever. Dividends in that case would be just as volatile as earnings. We know , that dividends are smoothed. target dividend as a percentage of expected or normal or e casts average income of $5 per share over the next 2 or 3 years. If the target payout ratio is 40%, the target dividend is 40% of $5, or $2. get, then the dividend is increased gradually toward the tar all, lea vidend higher get dividend? In this case, the dividend w ,b t cut regular dividends unless the cut is forced by hea Financial managers do not have to choose between cash dividends and repurchases. The ge, mature corporations that pay cash dividends also repurchase re . Man vidends b chase, either regularly or sporadically. dividends but never repurchase is tiny.10 FIGURE 17.3 ey of financial executives suggested that their firms were reluctant to cut the dividend and tried to maintain a smooth series of payments. Source: A. Brav, J. R. . R. nomics 77 (September 2005), pp. 10 ey, and R. Michaely, “Payout Policy in the 21st C ,” J Financial Ecomission of Elsevier Science via Copyright Clearance Center, Inc. v Journal of Financial Economics 87 (March 2008), pp. 582–609. vidends but never vidends and Stock Repurchases,” 486 Part Five Debt and Payout Policy vidends stabilize the dividends. Cash dividends evolve ,e same way. ar more volatile than dividends. The xcess cash, but wither in recessions. Look back at Figure 17.1, and you will see that repurchases fell far more dramatically than dividends in the f The Information Content of Dividends and Repurchases information content of dividends Dividend increases send good news about future cash flow and earnings. Dividend cuts send bad news. vide. Secrecy xt to meaningless. Some say that creative accounting makes the situation in the United States . If transparency is limited, dividends can provide clues about a company’ prospects. vidend, it is putting its mone ut di w cannot back up its dividend payout, it will ultimately have to reduce its investments or turn to investors This can be costly. W therefore, why investors believe in the information content of dividends. vidend increases are good ne en as bad news (stock alls). For example, Healy and Palepu found that the announcement of a company’ verage.11 Such viously good news for investors. The news is good not because inv e dividends.” It is good because announcements of dividend increases send positive signals about future income. Managers don’t increase dividends unless they are confident that income will be high enough to cover the dividend with room to spare. A dividend increase conveys that confidence to investors. A dividend cut, on the other hand, conveys a lack of confidence. Even investors who otherwise prefer lo is unwelcome ne s prospects. xceptions. Not all di vidend ws; if investors are convinced or example, xplains how investors endorsed a drastic di 2009 by J.P. Morgan. Of course, dividend cuts don’t convey bad news when the news is already out and inv vidend cut is coming. ▲ EXAMPLE 17.2 BP’s Dividend Suspension BP announced on June 16, 2010, that it planned to suspend dividends at least through the end of the year. The suspension freed up roughly $7.8 billion in cash, which could be used for the $20 billion compensation fund that BP agreed to set up in the wake of the Gulf oil spill. Yet the announcement of the dividend cut barely moved BP’s stock price. This cut was widely anticipated, so it wasn’t new information. It was a response to a bad event that had already happened and knocked down BP’s stock price. It was not interpreted as a signal of new bad news about BP. ws for investors. But repurchase programs may not be repeated, unlike dividend increases, which imply 11 See P veyed by Dividend Initiations and Omissions,” Journal of Financial Economics 21 (1988), pp. 149–175. FINANCE IN PRACTICE Good News: J.P. Morgan Cuts Its Dividend to a Nickel a longer Therefore, the information content of a repurchase program vidends.12 y have accumulated more cash than they can inv often relieved to see companies paying out the e way vestments. Of course, investors w av gro y suddenly announced a repurchase program because its managers could 17.4 The Payout Controversy s confidence in the f would happen anyway as the information ev Can payout policy itself change the underlying value of the f s common stock, or is it just a signal about underlying value? This can be a dif vestment decisions. Some f w dividends because management is optimistic about the f ings for e s capital budgeting decision. xpenditures largely by wing. wing decision. We wish to isolate payout polic The precise question we should ask is, fect of a change in dividend policy, s capital budgeting and borrowing decisions? Suppose that the firm proposes to increase its dividend. The cash to finance that dividend increase has to come from somewhere. If we fix the f s investment outlays wing, there is only one possible source—an issue of stock or a reduction in stock repurchases. Suppose instead that the f vidend. In that case it would have extra cash. If investment outlays and borro ed, there is only one possible way that this cash can be used—to increase repurchases or reduce een higher or lower stock issues. Thus dividend policy involves a trade-of cash dividends and the issue or repurchase of stock. 12 irm’ y’s stock is w Of vestors, believe that et’s current assessment. et stock repurv ve Signaling Power of Dutch-Auction and Fix ender ”J inance 46 (September 1991), pp. 1243–1271. 487 488 Part Five Debt and Payout Policy o but three opposing points of view. And so it is with payout policy believ vidends increase v ves payout polic ves alue. And in the center there es no difference. Let’ Why Dividends Are Irrelevant in Perfect and Efficient Capital Markets MM’s dividend-irrelevance proposition Under ideal conditions, the value of the firm is ected by dividend policy. v t matinancial mark y also proved that dividend policy doesn’ ets.13 We have already seen the common sense of MM’ gument in Table 17.1, which shows that investors should not care whether a firm distributes cash by dividends or share repurchases. y may matter content of dividends and repurchases but also because of tax e a more thorough look at MM’s dividend-irrelevance proposition. We can illustrate MM’s views about payout policy by considering the Pickwick Paper Company w paper mill. But Pickwick’s directors now propose to use the $100 million to increase the dividend payment. If Pickwick is to continue to build its new mill, that cash needs to ed, the money must come from the sale of new The combination of the dividend payment and the new issue of shares leaves Pickwick and its shareholders in exactly the same position that the All that has happened is that Pickwick has put an extra $100 million in investors’ pockets (the dividend payment) and then taken it out again (the share issue). In other words, Pickwick is simply recycling cash. T es investors better off is lik After Pickwick pays the additional dividend and replaces the cash by selling new yv w have an extra $100 million of cash in their pockets, but they have given up a stak investors who buy the ne The ne million and therefore will demand to receive shares worth value of the compan e in the company falls by this $100 million. Thus the extra di receive just offsets the loss in the v y hold. e an y receive an e vidend payment plus an of ay they could get their hands on the cash. But as long as there are ef ets, the Thus Pickwick’s old shareholders can “cash in” either by persuading the management to pay a higher dividend or by selling some of their shares. In either case there will be the same transfer of value from the old to the investors do not need dividends to convert their shares ne to cash, they will not pay higher prices for firms with higher dividend payouts. In other words, payout policy will have no impact on the value of the firm. This is MM’s argument. The e shareholders better of aper Company sho gument also works in reverse: If inv y reduction in di 13 M. H. Miller and F. Modigliani, “Dividend Policy, Gro e vipurchase of stock. For Valuation of Shares,” Journal of Business Chapter 17 489 Payout Policy e w decides uy back some of the comvidend payments but pany’ they receive $100 million from the sale to the compan Thus MM’ v gument holds both for increases in dividends and for een reductions. As these examples illustrate, payout policy is a tr cash dividends and the issue or repurchase of common stock. In a perfect capital market, the payout decision would have no impact on firm value. These e a stock issue with ev ef vidends They could av lower dividends and retaining more funds in the firm. Man anted cash to repurchase shares. They could instead use the cash to increase the dividend. v ve ignored tax v orld complications. W , but actually be w uys for $100,000 must also be w ords, di v ets. If you’d like another example, look back at Table 17.1 same amount of money to repurchase shares. Pocket’ with one payout policy as the other wever: Lower cash divie were implicitly holding inv wing policy constant.) W ay, too, with higher dividends Again shareholders would not care. ▲ EXAMPLE 17.3 Dividend Irrelevance The columns labeled “Old Dividend Plan” in Table 17.2 show that Consolidated Pasta is currently expected to pay annual dividends of $10 a shar . Shareholders expect a 10% rate of return from Consolidated stock, and therefore the value of each share is PV 5 10 10 10 10 1 1 1 c5 5 $100 (1.10)2 (1.10)3 1.10 .10 Consolidated has issued 1 million shares. So the total forecast dividend payment in each year is 1 million 3 $10 5 $10 million, and the total value of Consolidated Past million 3 $100 5 $100 million. The president, Al Dente, has read that the value of a share depends on the dividends it pays. That suggests an TABLE 17.2 Consolidated Pasta is currently expected to pay a dividend of $10 million in per . However, the president is proposing to pay a one-time bumper dividend of $20 million in year 1. To replace the lost cash, the firm will need to issue more shares, and the dividends that will need to be diverted to the new shareholders will ex ect of the higher dividend in year 1. Note: New shareholders ar 0 million of cash at the end of year 1. Since they require a return of 10%, the total dividends paid to the new shares (starting in year 2) must be 10% of $10 million, or $1 million. 490 Part Five Debt and Payout Policy easy way to keep shareholders happy—increase ne ear’s dividend to $20 per share. That way, he reasons, share price should rise by the present value of the increase in the first-year dividend to a new value of PV 5 20 10 10 10 10 1 1 1 c5 1 5 $109.91 (1.10)2 (1.10)3 1.10 1.10 .10 The president’s heart is obviously in the right place. Unfortunately, his head isn’t. Let’s see why. Consolidated is proposing to pay out an e a $10 million in dividends. It can’t do that and earn the same profits in the future, unless it also replaces the lost cash by an issue of shares. The new shareholders who provide this cash will require a return of 10% on their investment. So Consolidated will need to pay $1 million a year of dividends to the new shareholders ($1 million/$10 million 5 .10, or 10%). This is shown in the last line of Table 17.2. As long as the company replaces the e a cash it pays out, it will continue to earn the same profits and to pay out $10 million of dividends each year from year 2. However, $1 million of this total will be needed t w shareholders, leaving only $9 million (or $9 a share) for the original shareholders. Now recalculate the value of the original shares under the revised dividend plan: PV 5 20 9 9 11 9 1 1 1 c5 1 5 $100 (1.10)2 (1.10)3 1.10 1.10 .10 The value of the shares is unchanged. The extra cash dividend in year 1 is exactly y the reduction of dividends per share in later years. This reduction is necessary because some of the money paid out as dividends in later years is diverted to the new shareholders.14 The Assumptions behind Dividend Irrelevance Man icult to accept the suggestion that dividend polic vant. aced with MM’ gument, they often reply that di ush. It may be true, they say, that the recipient of an extra cash dividend forgoes an equal capital gain, but if the dividend is safe and the capital g , isn’ It’ stabilize dividends but they cannot control stock price. From this it seems a small step to conclude that increased di e the f .15 But the important point is, once again, that as long as investment polic s overall ws are the same regardless of payout policy. all the f e ed by its inv wing policies vidend policy. If we really believed that e cash, then we w v gue that the ne e sense: w 14 will be $9/.10 5 $90. So the ne Table 17.2 ve total di e 15 suggestion? vidend is e ve $10,000,000/$90 5 ve total dividend payments of 111,111 3 $9 5 3 $9 5 and ven more predictable, so a company’s risk would w would you respond to that Chapter 17 491 Payout Policy ut the The uy MM’s ar vance of dividend policy does not assume a world of et. Market efficiency means that the transfers of ownership created by shifts in dividend polic And since the overall value of (old and ne fected, nobody gains or loses. 17.5 Why Dividends May Increase Value MM’s conclusions follo ets. However, nobody claims their model is an exact description of the so-called real world. Thus the impact of payout policy finally boils down to arguments about Those who believe that di preference for high-payout stocks. For e gue that some investors have a natural gally vidend records. T wment funds may prefer high-dividend stocks because di able “income, ” which may not be spent. In addition, there is a natural clientele of investors, including the elderly, who look v be generated from stocks paying no dividends at all; the investors can just sell off a small fraction of their holdings from time to time. But that can be inconvenient and lead to hea Behavioral psychology may also help to explain why some investors prefer to receive regular dividends rather than sell small amounts of stock. W succumb to temptation. Some of us may hanker after fattening foods, while others We could seek to control these cravings by willpower, but es (“cut out chocolate,” or “wine only with meals”). In just the same way, we may welcome the self-discipline that comes from limiting our spending to dividend income. ut it does not follow that you can increase the value of your ve recognized that there is a clientele of investors who w payout stocks. There are natural clienteles for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The highdividend clienteles already have plenty of high-dividend stocks to choose from. Suppose that the CEO of a software company announces at a press conference a plan to enter the market for mint toothpaste. When you ask why, the CEO points out that millions of people buy mint toothpaste. You would doubt the CEO’s business sanity. So why should you believe that because there is a clientele of investors who like high payouts, your company can increase value by manufacturing a high payout? That clientele w Perhaps the most persuasive argument in favor of a high-payout policy is that it prevents managers from wasting funds. Suppose a company has plenty of cash but few profitable inv y will be plowed back into b cases, generous dividends or share repurchases deprive the managers of excess cash alue-oriented investment policy. ution in . By 2004, the company’s inv and investors were, therefore, happ ute its cash mountain. FINANCE IN PRACTICE Microsoft’s Payout Bonanza Self-Test 17.3 17.6 Why Dividends May Reduce Value The low-dividend creed is simple. Companies can conv vidends into capital gains by shifting their dividend policy. If dividends are taxed more heavily than capital vestor should pay the lo y can get aw used to repurchase shares. Table 17.3 illustrates this. It assumes that dividends are taxed at a rate of 40% but ed at only 20%. , and investors demand an expected after-tax vestors expect A to be w . xpected to be only $102.50, but a $10 di same, $112.50. Both stocks of f. Yet B’s stock sells for less than A’s. The reason is obvious: Inv A because its return w-taxed capital gains. 10% e act that B’s pretax . vidend and uses the cash to repurchase stock instead. We saw earlier that a stock repurchase is equivalent to a cash dividend, but now we need to recognize that it is treated differently by the tax TABLE 17.3 ects of a shift in dividend policy when dividends are taxed more heavily than capital gains. The high-payout stock (firm B) must sell at a lower price in order to provide the same er-tax return. 492 Chapter 17 493 Payout Policy y capital vidend, B’s new policy 16 would reduce the tax Self-Test 17.4 Taxation of Dividends and Capital Gains under Current Tax Law If di ed more hea ver pay a cash di uted to stockholders, isn’t share repurchase the best channel for doing so? In the United States, the case for low dividends was strongest before 1986. The top rate of tax on dividends was then 50%, while realized capital gains were taxed at 20%. However, the top rates of tax on both dividends and capital gains were later reduced to v vidends. Late in 2010, Congress agreed to extend these rates through 2012, so at least for the immediate future, the tax case for low dividends has been weakened. There is, however, one w w still favors capital gains. Taxes on dividends hav , but taxes on capital gains can be deferred until 17 The longer they wait, the less capital gains tax the present value of the capital gains tax liability. Thus the rate can be less than the statutory rate. The distinction between dividends and capital gains is less important for pension funds, endo taxes and therefore have no reason to prefer capital gains to dividends or vice versa. Only corporations have a tax reason to prefer dividends. They pay corporate income tax on only 30% of any dividends received.19 Thus the effective tax rate on dividends received by large corporations is 30% of 35% (the marginal rate of corporate income tax), or 10.5%. But they have to pay a 35% tax on the full amount of any 18 y are pretty simple. Capital gains have advantages to many investors, but the antageous than they were 30 or 40 years ago. Consequently, it is less easy today to make con guments in fav . 16 17 v vent tax avoidance by substitution of repurchases for dividends. v vidends and vidends for tax purposes. If the stock is willed to your heirs, capital gains escape taxation altogether. Suppose the discount rate is 6%, and an inv et has a $100 capital gain. If the stock is sold today , the tax due on that $100 gain still will be $15, b , the present value of the tax falls to $15/1.06 5 $14.15. ve tax rate falls to 14.15%. wer the effective tax rate. 19 so company paying the di vidends received. 18 www.mhhe.com/bmm7e SUMMARY QUESTIONS QUIZ PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISES finance.yahoo.com www.earnings.com SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e MINICASE TABLE 17.4 www.mhhe.com/bmm7e TABLE 17.5 TABLE 17.6 CHAPTER 20 LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 2 3 4 5 6 7 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T S I X M Financial Analysis and Planning Amazon's warehouses are stacked with over $3 billion of inventory. 560 Part Six Financial Analysis and Planning 20.1 Accounts Receivable and Credit Policy trade credit Bills awaiting payment from one company to another. consumer credit Bills awaiting payment from final customer to a company. W s accounts receivable. When one company sells goods to another, it does not usually e . The unpaid bills, or trade credit, compose the b vable. The remainder is made up of consumer credit, bills awaiting payment by the final customer. volves the follo ve steps: 1. Y or example, how long will you give customers to pay their bills? W discount for immediate payment? 2. You must decide what evidence you require that the customer owes you money. For e 3. Y ely to pay their bills. This is called credit analysis. 4. You must decide on credit policy. How much credit will you extend to each customer? Ho e on marginally creditw prospects? 5. Finally, you have to collect the money when it becomes due. What do you do about reluctant payers or deadbeats? We discuss these topics in turn. Terms of Sale terms of sale Credit, discount, and payment t ered on a sale. ver you sell goods, you need to set the terms of . For e plying goods to a wide v very (COD). heavy deliv v In many other cases, payment is not made until after deliv , so the buyer receives credit. Each industry seems to have its o ments have a rough logic. For e goods are perishable or quickly resold. When you buy goods on credit, the supplier will state a final payment date. To encourage you to pay before the final date, it is common to of prompt settlement. For example, a manufacturer may require payment within 30 days but offer a 5% discount to customers who pay within 10 days. These terms would be 5 10, net 30 percent discount for early payment number of days that discount is available number of days before payment is due ve a 2% voice date Self-Test 20.1 561 Chapter 20 Working Capital Management For many items that are bought re , it is inconv ment for each deliv . in fact occur at the end of the month (EOM). Thus goods may be sold on terms of 8/10, EOM, net 60. This allo the invoice date. A firm that buys on cr ect borrowing from its supplier. It saves cash today but will have to pay later. This is an implicit loan from the supplier. Of course, if it is free, a loan is always worth having. But if you pass up a cash discount, ve to be v xpensive. For example, a customer who buys on day. The customer obtains an e 30 days after the sale but pays about 3% more for the goods. This is equivalent to borrowing mone . To see why, consider an order of $100. If the aits the full 30 days, it pays $100. The extra 20 days of credit increase the payment by the fraction 3/97 5 .0309, or 3.09%. ged to extend the trade credit is 3.09% per 20 days. There are 365/20 5 , so ve annual rate of interest on the loan is (1.0309)18.25 21 5 .743, or 74.3%. The general formula for calculating the implicit annual interest rate for customers who do not take the cash discount is Effective annual rate 5 ¢ 1 1 365/extra days credit discount ≤ 21 discounted price (20.1) The discount divided by the discounted price is the percentage increase in price paid by a customer who forgoes the discount. In our example, with terms of 3/10, net 30, the percentage increase in price is 3/97 5 .0309, or 3.09%. This is the implicit rate of interest per period. The period of the loan is the number of extra days of credit that you can obtain by forgoing the discount. In our example, this is 20 days. To annualize this rate, we compound the per-period rate by the number of periods in a year. Of course an yond day 30 gains a cheaper loan but damages its reputation for creditw ▲ EXAMPLE 20.1 Trade Credit Rates What is the implied interest rate on the trade credit if the discount for early payment is 5/10, net 60? The cash discount in this case is 5% and customers who choose not to take the discount receive an e a 60 2 10 5 50 days cr ective annual interest is ctive annual rate 5 ¢1 1 5 ¢1 1 365/extra days credit discount ≤ 21 discounted price 5 ≤ 95 /50 In this case the customer who does not tak money at an annual interest rate of 45.4%. Y 2 1 5 .454, or 45.4% ectively borrowing onder why the effective interest rate on trade credit is typically so high. v v discount. Those who don’t are probably strapped for cash. It mak ge 562 Part Six Financial Analysis and Planning Self-Test 20.2 Credit Agreements open account Agreement whereby sales are made with no formal debt contract. ine the amount of any credit but not the nature of the contract. Repetitiv ways made on open account and involve only an implicit contract. There is simply a record in the seller’s books and a receipt signed by the buyer. Sometimes you might w uyer before you deliver commercial draft. This is gon for an order to pay.1 It works as follows: The seller prepares a draft sight dr otherwise, it is known as a time draft. Depending on whether it is a sight or a time draft, the customer either ord “accepted” and a signature. Once accepted, a time draft is like a postdated check and is called a trade acceptance. This trade acceptance is then forwarded to the seller, who holds it until the payment becomes due. If your customer’ y s debt, and the draft is called a banker’s acceptance. er’ verseas trade. They are actively bought and sold in the mone et for shortIf you sell goods to a customer who proves unable to pay, you cannot get your goods back. You simply become a general creditor of the company You can av conditional sale, so that ownership of the goods remains with the seller until full payment is made. The condibought on installment. In this case, if the customer f e the agreed number of payments, then the equipment can be immediately repossessed by the seller. Credit Analysis credit analysis Procedure to determine the likelihood a customer will pay its bills. There are a number of w ely to pay their debts, credit analysis. The most obvious indication is whether they have paid promptly in the past. Prompt payment is usually a good omen, but beware of the If you are dealing with a new customer, you will probably check with a credit agency. Dun & Bradstreet, which is by far the largest of these agencies, provides credit vice, Dun & Bradstreet pro customer. ve had with your customer, b through a credit bureau. Y e a credit check. It will contact the customer’ s average bank balance, access to bank credit, and general reputation. 1 For e a payment. xample of a draft. Whenev e 563 Chapter 20 Working Capital Management In addition to checking with your customer’ e sense to discover what ev s credit xpensive? Not if your customer is a public company. You just look at the Moody’s or Standard & Poor’s rating for the customer’s bonds.2 You irms’ bonds. (Of course , coupon, and so on.) If you don’t wish to rely on the judgment of others, you can do your own homework. Ideally this would involve a detailed analysis of the company’s business prosinancing, b xpensive. concentrate on the company’ ratios. Chapter 4 described ho Numerical Credit Scoring Analyzing credit risk is like detective work. You hav . You must weigh these clues to come up with an overall judgment. When the f gular clientele, the credit manager can easily handle the process informally and mak credit: 1. 2. 3. 4. 5. The customer’s character. The customer’s to pay. The customer’s capital. The collateral provided by the customer.3 The condition of the customer’s business. When the company is dealing directly with consumers or with a large number of small trade accounts, some streamlining is essential. In these cases it may make sense to use a scoring system to prescreen credit applications. If you apply for a credit card or a bank loan, you will probably be asked to complete a questionnaire that pro 4 If you do not make This information is then used to calculate an ov the grade on the score, you are likely to be refused credit or subjected to a more ay f potential customers. Suppose that you are given the task of dev es sense to e s customers. Y v period with those of surviving firms. Figure 20.1 shows what you find. Panel a illusmuch lo O ved. Panel b sho average they also had a high ratio of liabilities to assets, and panel c shows that EBITD es, and depreciation) was low relative to the f w ROA), were more highly leveraged (high ratio of liabilities to assets), and generated relatively little cash (low ratio of EBITDA to liabilities). In each case, these indicators of the f inany approached. William Beaver, Maureen McNichols, and Jung-Wu Rhie studied these f concluded that these v elihood of 2 W For e customer f 3 These bonds can then be seized by the seller if the . 4 data provided by any one of three credit b veloped by F Trans Union, or Equifax. 564 Part Six Financial Analysis and Planning FIGURE 20.1 Financial ratios of failing and nonfailing firms Source: W. H. Beaver, M. F. McNichols, and J.-W. Rhie, “Have Financial Statements Become Less Informative? Evidence from the Ability of Financial Ratios to Predict Bankruptcy,” Review of Accounting Studies 10 (2005), pp. 22. 565 Chapter 20 Working Capital Management y. The chance of f xt year relative to the odds of not failing was best estimated by the following equation:5 Log( ) 5 26.445 2 1.192 3 ROA 1 2.307 3 2.346 3 liabilities assets EBITDA liabilities Av ve been used to develop credit-scoring systems. The model that we have just described uses the technique of hazard analysis. An early, amous Z-score model developed by Edward multiple discriminant analysis s financial ratios could be the impecunious goats.6 combined as follo wn as a Z score:7 market value of equity EBIT sales Z 5 3.3 3 1 1.0 3 1 .6 3 1 total assets total assets total book debt retained earnings 1.4 3 1 1.2 3 total assets total assets Z scores below 2.7 before they went bankZ scores above this level. ▲ EXAMPLE 20.2 The Z-Score Model Consider a firm with the following financial ratios: EBIT 5 .12 Total assets Sales 5 1.4 Total assets Retained earnings Total assets 5 .4 Market value of equity 5 .9 Total book debt Working capital Total assets 5 .12 The firm’s Z score is (3.3 3 .12) 1 (1.0 3 1.4) 1 (.6 3 .9) 1 (1.4 3 .4) 1 (1.2 3 .12) 5 3.04 This score is above the cut vel for predicting bankruptcy, and it would therefore be considered favorably in an evaluation of the firm’s cr orthiness. cut estimates of creditw These assessments can streamline the credit decision and free up labor for other, less mechanical tasks. The Credit Decision You have tak ward an effective credit operation. In other words, you have fixed your terms of sale; you have decided whether to sell on open account 5 See W. H. Beaver, M. F. McNichols, and J.-W. Rhie, “Hav ve? Evidence from the y,” Review of Accounting Studies 10 (2005), pp. 93–122. 6 See E. I. y,” J inance 23 (September 1968), pp. 589–609. 7 es. E. I. y,” J inance 23 (September 1968), pp. 589–609. FINANCE IN PRACTICE Credit Scoring: What Your Lender Won’t Tell You credit policy Standards set to determine the amount and nature of credit to extend to customers. or to ask your customers to sign an IOU; and you have established a procedure for estimating the probability that each customer will pay up. Your next step is to decide on credit policy. If there is no possibility of repeat orders, the credit decision is relatively simple. Figure 20.2 e neither profit nor loss. v credit. If you of it margin on the sale. If the customer defaults, you lose the cost of the goods delivered. The decision t er credit depends on the pr yment. You should grant credit if the expected profit from doing so is greater than the profit from refusing. Suppose that the probability that the customer will pay up is p. If the customer does pay, you receive additional revenues (REV) and you deliver goods that you FIGURE 20.2 If you refuse credit, you make neither profit nor loss. If y er credit, there is a pr p that the customer will pay and you will make REV 2 COST and there is a pr 2 p) that the customer will default and you will lose COST. 566 567 Chapter 20 Working Capital Management alue of REV 2 COST. Unfortunately, you can’t be certain that the customer will pay; there is a probability (1 2 p) of default. Default means you receive nothing but still incur the additional costs of the delivered goods. The expected pr 8 from the two sources of action is therefore as follows: You should grant credit if the e ▲ EXAMPLE 20.3 ve. The Credit Decision Consider the case of the Cast Iron Company. On each nondelinquent sale Cast Iron receives revenues with a present value of $1,200 and incurs costs with a present value of $1,000. Therefore, the company’s expected prof ers credit is p 3 PV(REV 2 COST) 2 (1 2 p) 3 PV(COST) 5 p 3 200 2 (1 2 p) 3 1,000 If the probability of collection is 5/6, Cast Iron can expect to break even: Expected profit 5 5/6 3 200 2 (1 2 5/6) 3 1,000 5 0 Thus Cast Iron’s policy should be to grant credit whenever the chances of collection ar er than 5 out of 6. In this last example, the net present value of granting credit is positive if the probability of collection exceeds 5/6. In general, this break-even probability can be found by setting the net present value of granting credit equal to zero and solving for p. It ven probability is simply the ratio of the present value of costs to revenues: p 3 PV( 2 COST) 2 (1 2 p) 3 PV(COST) 5 0 Break-even probability of collection, then, is p5 PV(COST) PV(REV) ven probability of default is (1 2 p) 5 1 2 PV(COST) /PV(REV) 5 PV(PROFIT) /PV(REV) In other words, the break-even probability of def each sale. If the default probability is lar extend credit. gin on gin, you should not w prof gins should be cautious about granting credit to high-risk customers. Firms with high margins can afford to deal with more doubtful ones. 8 “e v venues. venues generated. Also, while we follow conv As we emphasized in Chapter 1, the manager’s task is to add value, not to 568 Part Six Financial Analysis and Planning Self-Test 20.3 So f of ve ignored the possibility of repeat orders. But one of the reasons for . Suppose Cast Iron has been asked to extend credit to a new customer. Y ve that the probability of payment is no Expected profit on initial order 5 p 3 PV(REV 2 COST) 2 (1 2 p) 3 PV(COST) 5 (.8 3 200) 2 (.2 3 1,000) 5 2$40 You decide to refuse credit. if . But now consider future periods. If the customer does pay up, there will be a reorder next year. Having paid once, the customer will seem less of a risk. For this reason, any repeat order is v Think back to Chapter 10, and you will recognize that the credit decision bears man w, the repeat sales. This option can be v aluable and can tilt the decision tow credit. Even a dubious prospect may w the company will dev . ▲ EXAMPLE 20.4 Credit Decisions with Repeat Orders To illustrate, let’s look at an extreme case. Suppose that if a customer pays up on the first sale, you can be sure you will have a regular and completely reliable customer. In this case, the value of such a customer is not the profit on one order but an entire stream of profits from repeat purchases. For example, suppose that the customer will make one purchase each year from Cast Iron. If the discount rate is 10% and the profit on each order is $200 a year, then the present value of an indefinite stream of business from a good customer is not $200 but $200/.10 5 $2,000. There is a pr p that Cast Iron will secure a good customer with a value of $2,000. There is a pr 2 p) that the customer will default, resulting in a loss of $1,000. So, once we recognize the benefits of securing a good and permanent customer, the expected profit from granting credit is Expected profit 5 (p 3 2,000) 2 (1 2 p) 3 1,000 This is positive for any probability of collection above .33. Thus the break-even probability falls from 5/6 to 1/3. If one sale may lead to profitable repeat sales, the firm should be inclined to grant credit on the initial purchase. Self-Test 20.4 Chapter 20 Working Capital Management 569 Of course, real-life situations are generally far more complex than our simple e y pay late consistently; you get your money, but it costs more to collect and you lose a few months’ interest. And estimating the probability that a customer will pay up is f xact science. Then There may be a good chance that the customer will give you further business, but you can’ w for how long she or he will continue to buy from you. Lik volves a strong dose of judgment. Our e volved rather than as 1. Maximize pr As credit manager your job is not to minimize the number of bad accounts; it is to maximize profits. You are f The best that can happen is that the customer pays promptly; the worst is default. In the one case the f ves the full additional revenues from the sale less the additional costs; in the other it receives nothing and loses the costs. You must weigh the chances of v ied in a liberal credit policy; if it is low y bad debts. 2. Concentrate on the dangerous accounts. You should not expend the same ef analyzing all credit decisions. If an application is small or clear gely routine; if it is large or doubtful, you may do better to move straight to a detailed credit appraisal. Most credit managers don’ e credit decisions on an order-by-order basis. Instead, they set a credit limit for each customer. The sales representative is required to refer the order for approval only if the customer e 3. Look beyond the immediate order. Sometimes it may be w vely elihood that the customer will grow into a regular and reliable buyer ge students even though fe .) New businesses must be prepared to incur more bad debts than established businesses because they hav w-risk customers. This is uilding up a good customer list. Collection Policy It w y don’t, and since you may also “stretch” your payables, from time to time, you can’t altogether blame them. Slow payers impose tw resources in collecting payments. They also force the f vest more in w capital. Recall from Chapter 4 that accounts receiv verage wn as days’ sales in receivables): Accounts receivable 5 daily sales 3 average collection period collection policy Procedures to collect and monitor receivables. aging schedule Classification of accounts receivable by time outstanding. and a greater investment in accounts receivable. That’s why you need a collection policy. The credit manager keeps a record of payment e . In addition, the manager monitors ov wing up a schedule of the aging of receivables. The aging schedule classifies accounts receivable by the length of time the This may look roughly like Table 20.1. The table shows that customer A, for e than a month. Customer Z, however bills that hav 570 Part Six Financial Analysis and Planning TABLE 20.1 An aging schedule of receivables Self-Test 20.5 statement of account w this at interv ax messages. If none of these has an ver to a collection agency or an attorney. Large f eeping, billing, and so on, but the small f wever, it can obtain some scale economies by f factor. The factor sf ies each customer that the factor has purchased the debt (i.e., the trade credit). The factor then takes on the responsibility (and risk) of collecting the bills and pays the invoice value to the client minus a fee of 1% or 2%. Aside from gaining the economies that ge number of manufacturers, factors see many more transactions than any single f creditw . There is alw v y no sooner win ne ters. The collection manager quently paid for. y problem introduced in Chapter 1. Good collection policy balances conflicting goals. The company wants cordial relations with its customers. It also wants them to pay their bills on time. agers who w or e vision of a major pharmaceutical company actually made a b tomer that had been suddenly cut off by its bank. The pharmaceutical company bet that company was right. v y, and became an even more loyal customer. It was a nice e e business loans in this way, but they lend money indirectly whenever they allow a delay in payment. Trade credit can be an e sense for you, the supplier, to continue to e o possible reasons e sense: First, as in the case of our pharmaceutical company, you may 571 Chapter 20 Working Capital Management have more information than the bank about the customer’s business. Second, you need to look be lose some prof usiness.9 20.2 Inventory Management . Inv w matew ventories. For example, they could b , as needed. But then they would pay higher prices for ordering in small lots, and they w vered on time. They can av ,f could do away with inv y expect w gy. A producer with only a small inv orders if demand is unexpectedly high. Moreover ge inv may allow longer v These are called For example, money tied up in inventories does in spillage or obsolescence. e a sensible ventory and the costs. ▲ EXAMPLE 20.5 Inventory Management Here is a simple inventory problem. Akron Wire Products uses 255,000 tons a year of wire rod. Suppose that it orders Q tons at a time from the manufacturer. Just before delivery, its inventories of wire have run down to zero. Just er delivery, it has an inventory of Q tons. Thus, Akron’s inventory of wire rod roughly follo ooth pattern in Figure 20.3. There ar o costs to holding this inventory. First, there are carrying costs, such as the cost of storage, and the cost of the capital that is tied up in inventory. Suppose these costs work out to an annual figure of about $55 per ton. The second type of cost is the order cost. Each order that Akron places with the manufacturer involves a fixed handling and delivery charge of $450. FIGURE 20.3 A simple inventory rule. The company waits until inventories of materials are exhausted and then reorders a constant quantity. 9 ve a greater Theories and Evidence,” Review of Financial Studies 10 (F . For some evidence on rade Credit: 572 Part Six Financial Analysis and Planning FIGURE 20.4 As the inventory order size increases, order costs fall and invent ise. Total costs are minimized when the saving in order costs equals the incr . Here, then, is the kernel of the inventory problem: As Akron increases its order size, the number of orders falls but average inventory rises. Figure 20.4 shows that cost related to the number of orders declines, though at a decreasing rate, while carrying cost related to inventory size rises. It is worth increasing order size as long as the decline in order cost outweighs the rise in carrying cost. The optimal inventory polects ex . In our example, this occurs when the firm places about 250 orders a year (roughly one order every working day) and the size of each order is Q 5 2,043 tons. The optimal order size (2,043 tons in our example) is known as the economic or , or EOQ.10 In the order for Wire, we made several unrealistic assumptions. For instance, most firms do not use up their inventory of raw y would not w of inv • Optimal inv • in inv . • vels involve a trade-of v aiting until they reach some minimum level . • w es sense to place more frequent orders and maintain higher levels of inv will w ger and therefore less frequent orders. • Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal inventory level rises, b . 10 Optimal order size 5 Q 5 In our example, Q 5 Å Å 2 3 sales 3 cost per order 2 3 255,000 3 450 5 2,043 tons. 55 573 Chapter 20 Working Capital Management wer levels of inv y used to. v just-in-time approach System of inventory management that requires minimal inventories of materials and very frequent deliveries by suppliers. Today ay that companies have reduced inv vels is by moving to a just-in-time approach. Just-in-time was pioneered by To Toyota keeps inv y Thus deliv interv . Toyota is able to operate successfully with such low invenes, traf hazards don’ y v Toyota’s example and hav their investment in inventories. Firms are also finding that they can reduce their inv producing their goods to order. For example, Dell Computer discovered that it did not need to k ge stock of f net to specify what features they want on their PC. The computer is then assembled to order and shipped to the customer.11 20.3 Cash Management viduWhy, for example, don’t you e all your cash and inv The answer of course is that cash gives you more than do securities. You can use it to b w York cab drivers to give you change for a $20 bill, but try asking them to split a Treasury bill. When you hav xtra can be extremely useful; when you hav y additional liquidity is not worth much. point where the marginal value of the liquidity is equal to the value of the interest forgone. aces a task like that of the production manager. After all, cash is just another raw material that you need to do b ge “inv of cash. If the cash were invested in securities, it w hand, you can’ s bills. If you had to sell them every time you needed to pay a bill, you could incur hea manager must trade off the cost of keeping an inventory of cash (the lost interest) against the benefits (the saving on transaction costs). For v ge f uying and selling securities are trivial interest rate is 4% per year, or roughly 4/365 5 .011% per day. Then the daily interest 3 $1,000,000 5 $110. Even at a cost of $50 per transaction, which is generous, it pays to buy T w rather than to leave $1 million idle ov A corporation such as W verw of $400,000,000,000/365 5 up buying or selling securities once a day, ev , unless by chance they have only a small positive cash balance at the end of the day. Banks have developed a v ays to help such firms invest idle cash. For example, they may provide sweep programs, 11 These examples of just-in-time and b Isn’t Good Enough,” Ward’s Auto World, World, May 1999, pp. 73–77; “ en from T , “JIT , “Aliv Well,” Ward’s Auto ” The Economist, July 14, 2001, pp. 63–65. 574 Part Six Financial Analysis and Planning surplus funds into a higher-interest account. Why then do these large firms hold any significant amounts of cash in non-interest-bearing accounts? For two reasons: First, cash may be left in accounts to compensate banks for the services they provide. Second, large corporations may have literally hundreds of accounts with dozens of different banks. It is often less expensive to leave idle cash in some of these accounts than to monitor each account daily and make daily transfers between them. One major reason for the proliferation of bank accounts is decentralized management. If you giv airs, you must also giv ve cash. Good cash management nev implies some degree of centralization. You cannot maintain your desired inv wn private pools of cash. v vesting that even in highly decentralized companies there is generally central control over cash balances and bank relations. Check Handling and Float concentration account Customers make payments to a regional collection center, which then transfers funds to an account at a principal bank. lock-box system System whereby customers send payments to a postice box, and a local bank collects and processes checks. T ve been paid with checks. But check handling is a cumbersome and labor-intensiv e several days for a check to clear. Suppose, for example, that you renew your auto insurance by writy. insurance company receives your check and deposits it in its bank account. But this money isn’t available to the company immediately. The company’s bank won’t actually have the mone ves payment. Since the bank has to wait, it makes the insurance company wait too—usually 1 or 2 business days. Until the check has been presented and cleared, that $600 will continue to sit in your bank account. Checks that have been mailed b wn as In our examvided you with an extra $600 in your bank account while the check went y, then to the company’ inally to your own bank. elous invention, but unfortunately it can also work in reverse. Ev you a check, you have to wait several days after depositing it before you may spend the money. However w in the last sev ve helped to speed up collections. wn as “Check 21,” allo es. So fe e bundles of checks from one bank to another. v ge volume of checks have devised a number of ways to ensure that the cash becomes av or e concentration account at one of the company’ o reasons that concentration banking allows the company to gain quicker use of its funds. First, because the s check is likely to be dra reduced. Concentration banking is often combined with a lock-box system. In this case the ice box. The local bank then takes on the administrative chore of emptying the box and depositing the checks in the company’s local deposit account. 575 Chapter 20 Working Capital Management ▲ EXAMPLE 20.6 Lock-Box Systems Suppose that you are thinking of opening a lock box. The local bank shows you a map of mail delivery times. From that and knowledge of your customers’ locations, you come up with the following data: Average number of daily payments to lock box Average size of payment Rate of interest per day Saving in mailing time Saving in processing time 5 150 5 $1,200 5 .02% 5 1.2 days 5 .8 day On this basis, the lock box would reduce collection float by 150 items per day 3 $1,200 per item 3 (1.2 1 .8) days saved 5 $360,000 Invested at .02% per day, that gives a daily return of .0002 3 $360,000 5 $72 The bank’s charge for operating the lock-box system depends on the number of checks processed. Suppose that the bank charges $.26 per check. That works out to 150 3 $.26 5 $39 per day. You are ahead by $72 2 $39 5 $33 per day, plus whatever your firm saves from not having to process the checks itself. Self-Test 20.6 Other Payment Systems ger purchases or set out in Table 20.2. Figure 20.5 compares use of these payment systems around the world. Payment patterns v or example, look at the bottom (blue) portion or Germany fer. By contrast, v , U.S. indi e about 27 billion payments by check. But even in the United States, check writing is steadily giving way to electronic payments. Over 50% of U.S. households now use paid by direct deposit. In f of credit and debit cards continues to grow orld as the market share 576 Part Six Financial Analysis and Planning TABLE 20.2 Small faceto-face purchases are commonly paid for in cash, but here are some of the other ways that you can pay your bills. FIGURE 20.5 How purchases are paid for: Percentage of total volume of cashless transactions. (Data exclude small usage of card-based e-money.) Source: Bank for Inter .bis.or l, December 2009. , “Statistics on Pa ystems in Selected Countries,” the Internet are encouraging the development of new inf just two examples: • ws companies to bill customers and receive payments through the Internet. Already in Finland, two out gard the Internet as the most typical medium for paying bills. • Stored v pretty much as electronic cash. Electronic Funds Transfer As we’ve just noted, throughout the world payments are increasingly being made electronically. The most f ays that mone v . It can do so by direct payment, direct deposit, or wire transfer. Figure 20.6 shows the 577 Chapter 20 Working Capital Management FIGURE 20.6 Methods used by companies to make and receive electronic payments Source: A Treasurer’s Guide to U.S. Cash Management, Association for Financial Professionals, Report of Survey Results, August 2000. xpenditures, such as utility bills, or example, if you hav en out a student loan, you may hav e the payment directly from your bank account each month. The student loan company simply needs to prowing details of each student, the amount to be debited, and the date. The payment then trav Automated Clearing House (ACH) system. You are saved from the chore of writing regular checks, and the ws exactly when the cash is coming in and avoids the labor-intensive process of handling thousands of checks. The ws mone w in the reverse direction. Thus, while a direct payment vides an automatic debit, a direct deposit e bulk payments such as wages or dividends. Again the company pro The bank then debits the company’ the s employees or shareholders. ACH transactions have grown dramatically in recent years. You can see from Table 20.3 that the total value of these transactions in the United States has ov en that of checks. The third method of electronic payment is wire transfer. Most large-value payments Direct payment Automated Clearing House (ACH) An electronic network for cash transfers in the United States. e and .12 CHIPS, the other electronic payment system, is owned by the banks and used mainly for crossborder payments. Wire transfers allow f vement of very large sums of money. For example, suppose bank A wires the Fed to transfer $10 million from its TABLE 20.3 Use of payment systems in the United States, 2009 Source: 12 .federalreserve.gov, .nacha.com, and .chips.org. Fedwire is a real-time, gross settlement system, which means that each transaction over Fedwire is settled indi .W als. 578 Part Six Financial Analysis and Planning A’s account is immediately reduced by $10 million, and bank B’ Table 20.3 shows that although the number of payments by Fedwire and CHIPS is relatively small, the average v alue of payments o systems is ov Thus, while these systems account for a far smaller number of transactions than do checks, the value. These electronic payment systems have several advantages: • Record keeping and routine transactions are easy to automate when money moves electronically. • ery low. For e typically costs about $20, while it costs only a few cents to make each ACH payment. • Float is reduced. For e one plant was paying out about $8 million a month several days early to avoid any risk of late fees if checks were delayed in the mail. The solution was obvious: The ay they could ved exactly on time. International Cash Management ge multinational corporations operating in dozens of different countries, each with its own y A single centralized cash management system is an unattainable ideal for these companies, although the ward it. For example, suppose that you are treasurer of a large multinational company with operations throughout Europe. You could allow the separate businesses to manage their own cash, but that would be costly and w The solution is to set up a re y establishes a local concentration account with a bank in each country. Any surplus cash is swept daily . This cash is then invested in mark that hav Payments can also be made out of the regional center. For example, to pay wages in , the compan inds the least costly way to transfer the cash from the company’ . ge multinationals have sev ,b they use, the less control they have over their cash balances. So development of regional cash management systems favors banks that can offer a worldwide branch network. ford the high costs of setting up computer systems for handling cash payments and receipts in different countries. 20.4 Investing Idle Cash: The Money Market money market Market for short-term financial assets. ve excess funds, they can inv the money market, invest directly in these securities. However a money mark y market investments. et. In fact, however, most instruments in the money market have o advantages for the cash 579 Chapter 20 Working Capital Management manager maturity. V it is f v ault ov inancial strength ov ver the 30-year life of a bond. y are conv Most money market securities are also highly marketable or liquid, meaning that it is easy and cheap to sell the asset for cash. , too, is an attractive feature of vestments until cash is needed. y market are: Tr T vernment and mature The safest and most liquid money mark Commercial paper. wn companies. ge and well- than 2 months. Because there is no active trading in commercial paper, it has low etability. Therefore, it w vestment for a firm that could not hold it until maturity. Both Moody’s and Standard & Poor’s rate comault risk of the issuer. greater than $100,000. Unlik its cannot be withdra The bank pays interest and wever, short-term CDs (with maturities less than 3 months) are activ Repurchase agreements. wn as repos, A gov T investor, with an agreement to repurchase them at a later date at a higher price. es as implicit interest, so the investor in effect is lending money to the dealer, first giving money to the dealer and later getting it back with interest. The bills serve as collateral for the loan: If the dealer fails, and cannot buy back the bill, the investor can keep it. Repurchase agreements are usually very short-term, with maturities of only a few days. Interest rates on short-term loans (loans of less than 1 year) are often quoted on a so-called discount basis. For e . On a discount basis, the rate would be quoted as the discount from face value, in this case 5%. The actual interest rate is a bit higher than this. You pay interest of $5,000 on a $95,000 loan, so the interest rate is $5,000/$95,000 5 .0526, or 5.26%. You should be aw on a discount basis. ▲ EXAMPLE 20.7 Money Market Rates A Treasury bill with face value $100,000 and maturity 6 months is sold for $98,000. The rate on this bill on a discount basis would be quoted as 4%. The actual discount from face value is 2% semiannually, or 4% on an annualized basis. Notice also that money market rates are annualized using simple, not compound, interest. The ective annual rate on this half-year investment can be found by solving 98,000 3 (1 1 r)1/2 5 100,000 which implies that r 5 .0412, or 4.12%. 580 Part Six Financial Analysis and Planning Yields on Money Market Investments e account of def Almost anyy may get into ven today’ trouble ev . T ven companies . They included Lehman Brothers, which defaulted on a record $3 billion of paper. F , such examples are exceptions; in general, the danger of default is less for money mark o reasons for this. First, as we pointed out abov vestments. Even ve for at least the ne well-established companies can borrow in the money market. If you are going to lend money for just a few days, you can’ valuating the Thus, you will consider only blue-chip borrowers. Despite the high quality of money market inv icant differences in yield between corporate and U.S. gov Why is this? One answer is the risk of default. Another is that the investments have different degrees of liquidity, or “moneyness.” Investors like Treasury bills because they are easily verted so quickly and cheaply into cash need to offer relatively high yields. et turmoil investors may place a higher value on having ready access to cash. On these occasions the yield on illiquid securities can increase dramatically. This happened in 2007, when banks across the world revealed huge losses in the their positions, inv ity.” Treasury bills increased to over 100 basis points (1.00%), four times its level at the be . The International Money Market In addition to the domestic money market, there is also an international market for vestments, which is known as the eurodollar mark hav (EMU). The or example, suppose American auto producer buys 1,000 ounces of palladium from Xstrata, the European mining giant. It pays for the purchase with a check for $1.5 million drawn on JPMorgan Chase. Xstrata then deposits the check with its account at Barclays Bank in London. account with JPMorgan Chase. It also has an of deposit. Since that dollar deposit is placed in Europe, it is called a eurodollar deposit.13 Just as there is both a domestic U.S. mone et, so et and a market in London for euroyen. vestment in yen, it can deposit the yen with a bank in Tok e a euroyen deposit in London. Similarly, there is both a domestic money market in the euro area as well as a money market for euros in London. And so on. London ed Rate , the LIBOR interest rate, and they lend euros at the euro interbank offered rate, or Euribor. in the United States and in other countries. For e 13 would still hav www.mhhe.com/bmm7e SUMMARY www.mhhe.com/bmm7e L I S T I N G O F E Q U AT I O N S QUESTIONS QUIZ PRACTICE PROBLEMS www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISES finance.google.com finance.yahoo.com www.wellsfargo.com www.bankofamerica.com www.mhhe.com/bmm7e SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e MINICASE TABLE 20.4 QUESTIONS CHAPTER 21 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 6 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T S E V E N Special Topics Panasonic, a consumer electronics giant, acquired rival Sanyo for around $9 billion. T 592 Seven Special Topics FIGURE 21.1 The number of mergers in the United States, 1962–2009 Source: .mergerstat.com. 21.1 Sensible Motives for Mergers Mer mer horizontal, vertical, or conglomerate. A es place between tw usiness; the merged gers have been of this type. For e ynch and between Wells Fargo and Wachovia. Other gers hav W A vertical merger involves companies at different stages of production. The buyer expands back tow ard in the direction of the ultimate consumer. acturer might b (expanding backward) or a fast-food chain as an outlet for its product (expanding forward). A recent example of a vertical merger is the acquisition of Tele Atlas by its fello Tom Tom. Tom T orld’ gest mak vigation devices, plans to use Tele Atlas’s digital map data to provide real-time updates to its sat-nav systems. TABLE 21.1 Some important recent mergers Chapter 21 Mergers, Acquisitions, and Corporate Control 593 A conglomerate merger involves companies in unrelated lines of business. For y Tata Group is a huge, widely diversif y. In ve been as div Steel, Jaguar Land Rover, and the Ritz Carlton, Boston. No U.S. company is as diverTata, but in the 1960s and 1970s it w unrelated businesses to merge. The number of U.S. conglomerate mergers declined in the 1980s. In f . e Self-Test 21.1 Many mergers and acquisitions are motiv y from combining operations. These mergers create synergies. By this we mean that the two It would be conv gers are more likely to result in syner no such simple generalizations. Many mer e sense nevertheless fail because managers cannot handle the complex task of integrating tw different production processes, pay structures, and accounting methods. Moreover, the v usinesses depends on human orkers, scientists, and engineers. If these people are not happy in their new roles in the mer the best of them will leave. Bew wn in the elev usiness day. Consider the $38 billion merger between Daimler . Although it w bede ov ferent cultures: German management-board members had executiv papers on any number of issues. The t hav orked y for final approval at the top. Then it was set in stone. The vel employees to proceed on their own initiativ waiting for executive-level approval. . . . Cultural integration also was proving to be a slippery commodity. The yawning gap in The xpenses of U.S. workers -side employees thought w York for a half-day meeting, then capping the visit with a fanc xpensive hotel. xtravagance.1 its way through the b w in the towel and announced that veraged-b it was of care liabilities and agreed to inv These observations illustrate the dif ger does achiev 1 Bill Vlasic and Bradley The McGra yee health . ger. gies, but aken for a Ride,” BusinessWeek, June 5, 2000. Reprinted with special per- FINANCE IN PRACTICE Those Elusive Synergies the buyer nev or example, the buyer may overestimate the value of stale inv vating old plant and equipment, or it may overlook the w ve product. With these caveats in mind, we will now consider some possible sources of synergy. Economies of Scale Just as most of us believe that we would be happier if only we were a little richer, so ways seem to believ ould be more competitive if only it were just a little bigger. They hope for economies of scale, that is, the opportunity to spread ed costs across a larger volume of output. vides many examples. As a result of bank re y small, local banks. When these regulations were relaxed, some banks grew by systematically buying up other banks and streamlining their operations. When Bank of New York and ged in 2007, management forecast annual cost savings of $700 million, or ov pated that the merger would allow the two companies to share services and technology and w savings involved senior management. For e o chief f icers before the merger and only one afterward.) Bew verly optimistic predictions of cost savings, however. ger that gies. These economies of scale are the natural goal of horizontal mergers. But they have gers, too. gers have vel management. Economies of Vertical Integration Large companies commonly like to gain as much control and coordination as possible over the production process by expanding back toward the output of the raw material and forward to the ultimate consumer. One way to achieve this is to merge with a supplier or a customer. 594 Chapter 21 595 Mergers, Acquisitions, and Corporate Control V gration has fallen out of fashion recently. Man icient to outsource many of their activities. For e and 1960s, General Motors was thought to have a cost advantage over its competitors because it produced a greater fraction of its components in-house. By the 1990s Ford antage. They could b suppliers. This w . But it also appears that manufacturers hav gaining power when the amily. In 1998 GM decided to spin off Delphi, its automotiv vision, as a separate company. ge volumes, but it ne s length. Combining Complementary Resources s success. ve a unique product b could dev to mer resources the mer ut it may be quick ve e sense for them to merge. ve faced the loss of patv of promising new compounds. This has prompted an increasing number of acquisior example, in 2008 Eli Lilly acquired ImClone Systems. Lilly ver the company’s earlier market value. But Lilly’s CEO claimed that the acquisition would “broaden Lilly’s eted cancer therapies and boost Lilly’s oncology pipeline with up to geted therapies in Phase III in 2009.” et. Mergers as a Use for Surplus Funds but it has fe v ute the , ener ay. wn shares, it can instead purchase someone else’s. vestment opporgers as a way of deploying their capital. Firms that have excess cash and do not pay it out or redeploy it by acquisition often es targets for takeov y the cash y cash-rich oil companies found themselves threatened by takeover. This was not because their cash was a unique asset. The acquirers w w to make sure it was not frittered away on negative-NPV oil exploration projects. W freemotiv eovers later in the chapter. Eliminating Inefficiencies Cash is not the only asset that can be wasted by poor management. There are always some instances “better management” may simply mean the determination to force y’ ve for such acquisitions has nothing to do with benefits from combining tw Acquisition is simply the mechanism by which a new management team replaces the old one. 596 Seven Special Topics A merger may not be the only way to improve management, but sometimes there is no simple and practical alternativ ge public firms do not usually have much direct If this motive for merger is important, one would expect to observe that acquisitions get f This seems to be the case. For e xecutive is four times 2 The more likely to be replaced in the year after a takeov y studied had generally been poor performers. y of these ger. 21.2 Dubious Reasons for Mergers ve described so far all mak sometimes given for mergers are more dubious. Here are two. guments Diversification We have suggested that the managers of a cash-rich company may prefer to see that cash used for acquisitions. tries mer ay into fresh woods and pastures new. But what about diversification as an end in itself? It is obvious that div t that a gain from merging? gument is that div A buy f versify when A can b versify their o It is f vidual investors to div combine operations. The Bootstrap Game v sev ▲ EXAMPLE 21.1 vive strategy produced To see ho wn conglomerate W The Bootstrap Game The position before the merger is set out in the first two columns of Table 21.2. Notice that because Muck and Slurry has relatively poor growth prospects, its stock sells at a lower price-earnings ratio than World Enterprises (line 3). The merger, we assume, produces no economic benefits, so the firms should be worth exactly the same together as apart. The value of World Ent er the merger is therefore equal to the sum of the separate v o firms (line 6). Since World Enterprises stock is selling for double the price of Muck and Slurry stock (line 2), World Enterprises can acquire the 100,000 Muck and Slurry shares for 50,000 of its own shares. Thus World will have 150,000 shares outst er the merger. World’s total earnings double as a result of the acquisition (line 5), but the number of shares increases by only 50%. Its earnings per share rise from $2.00 to $2.67. We call this a bootstr ect because there is no real gain created by the merger and no incr o firms’ combined value. Since World’s stock price is unchanged b , atio falls (line 3). 2 J T eovers, and Management Turnover,” inance Chapter 21 Mergers, Acquisitions, and Corporate Control 597 TABLE 21.2 Impact of merger on market value and earnings per share of World Enterprises Note: When World Enterprises purchases Muck and Slurry, there are no gains. Therefore, total earnings and total market v ected by the merger. But earnings per share increase. World Enterprises issues only 50,000 of its shares (priced at $40) to acquire the 100,000 Muc es (priced at $20). Before the merger, $1 invested in World Enterprises bought 5 cents of current earnings and rapid gro ospects. On the other hand, $1 invested in Muck and Slurry bought 10 cents of current earnings but slower growth prospects. If the total market value is not altered by the merger, then $1 invested in the merged firm gives World shareholders 6.7 cents of immediate earnings but slower growth than before the merger. Muck and Slurry shareholders get lower immediate earnings but faster growth. Neither side gains or loses provided that everybody understands the deal. Financial manipulators sometimes try to ensure that the market does not understand the deal. Suppose that investors are fooled by the exuberance of the president of World Enterprises and mistake the 33% postmerger increase in earnings per share for sustainable gro y do, the price of World Enterprises stock rises and the shareholders of both companies receive something for nothing. You should now see ho company enjo vestors anticipate rapid growth in future earnings. You achieve this growth not by capital investment, product improvement, or increased operating ef y but by purchasing slow-gro The long-run result will be slower growth and a depressed price-earnings ratio, b increase dramatically. If this fools investors, you may be able to achieve the higher to keep fooling investors, you must continue to expand by merger at the same compound rate. Obviously you cannot do this forever; one day expansion must slow down or stop. all. Buying a firm with a lower P/E ratio can increase earnings per share. But the increase should not result in a higher share price. The short-term increase in earnings y lower future earnings gro Self-Test 21.2 598 Part Seven Special Topics 21.3 The Mechanics of a Merger Buying a company is a much more complicated aff uying a piece of machinery. We are not going to get into the tax or accounting complexities here, but we will describe the dif e and the way that an acquisi- The Form of Acquisition merger Combination of two firms into one, with the acquirer assuming assets and liabilities of the target firm. tender offer Takeover attempt in which outsiders directly er to buy the stock of the firm’s shareholders. acquisition Takeover of a firm by purchase of that firm’s common stock or assets. There are three w . One possibility is to merge two companies into one, in which case the acquiring company assumes all the assets and all the liabilities of the other. The acquired f v y mergers there is a clear acquiring company Sometimes a merger is presented as a “merger of equals,” but even in these cases one s management usually comes out on top. 3 A merger must have the approval of at least 50% of the shareholders of each f Approval is not always guaranteed. For example, when Charles River Laboratories in W price slumped and some major institutional shareholders voiced their opposition to the deal. With a week to go before its shareholders’ meeting, success for CRL w v s stock in exchange for cash, shares, or other securities. xist , but it is now owned by the acquirer. The approval and cooperation ut even if they resist, the acquirer uy shares irm can bypass the tar s management altogether. tender offer. is successful, the buyer obtains control and can, if it chooses, toss out incumbent management. , the tar ut occasionally it sells all xist as an independent entity, b usiness activity. The terminology of mergers and acquisitions (M&A) can be confusing. These phrases are used loosely to refer to an eover. But strictly speaking, merger means the combination of all the assets and liabilities of two The purchase of the stock or assets of another f acquisition. Mergers, Antitrust Law, and Popular Opposition Mergers may be blocked by the federal gov y are thought to be anticompetitiv et power. Thus, when the video-rental giant Blockbuster proposed to mer val Hollywood Video, the Federal Trade ould likely block the deal. In the face of this agement. Companies that do business outside the United States also have to w ws. For e eover bid for Honeywell was block y would have too much power in the aircraft industry. 3 ws sometimes specify a higher percentage. Chapter 21 div F pan Mer Mergers, Acquisitions, and Corporate Control 599 usters will object to a merger but then relent if the companies agree to or instance, when the organic grocer et acquired its closest rival, W ets, the FTC required the comW ven or example, the news in 2005 that Pepsi Cola added his support to opponents of the merger and announced that the French gov ment was drawing up a list of strate ownership. It w gic fwhat it described as “unprecedented political opposition” in Congress. The following year Congress voiced its opposition to the takeov s P&O by the Dubai y, DP World. s ports in the United States were excluded from the deal. 21.4 Evaluating Mergers ven the responsibility for evaluating a proposed merger, you must think wing two questions: 1. Is there an overall economic gain to the merger? In other words, is the merger v Are the tw 2. e my compan f? There is no point in mer other company. vely simple questions is rarely easy can be nearly impossible to quantify, and complex mer valuating mer Mergers Financed by Cash W xample. Your company, Cislunar Foods, is considering acquisition of a smaller food company, Tar T getco’ o companies is given in the left and center columns of Table 21.3. TABLE 21.3 Cislunar Foods is considering an acquisition of Targetco. The merger would increase the companies’ combined earnings by $4 million. Note: Figures in millions except price per share. 600 Seven Special Topics Question 1 Why w Targetco be w ution, and administration. Rev Targetco’s Table 21.3 contains projected revenues, costs, and ger will be $2 million less than the sum of the separate companies’ costs, and revenues will be 4 We will $2 million more. gy to be generated by the merger. ger is the present value of the e v k region. Economic gain 5 PV(increased earnings) 5 4 5 $20 million .20 This additional value is the basic motivation for the merger. Question 2 ger? shareholders? Targetco’s management and shareholders will not consent to the merger unless they receive at least the stand-alone value of their shares. The ne . In this case we are considering a cash offer of $19 per Targetco share, $3 per share ov T ve to pay out $47.5 million, a premium of $7.5 million over T getco’ et v T $7.5 million out of the $20 million gain from the merger. That ought to leave $12.5 . Table 21.4 bottom of the column, where the total market value of the merged f This is ved as follows: Cislunar market value prior to merger Targetco market value Present value of gain to merger Less Cash paid out to Targetco shareholders Postmerger market value $480 million 40 20 247.5 $492.5 million The postmer alue of CisNow let’ The merger mak ger adds $20 million of overall v only $7.5 million of that $20 million overall gain to Targetco’ . You could say that the cost ference between the cash payment and the v rate company: o reasons. First, ger give ving T getco is $7.5 T getco as a sepa- Cost 5 cash paid out 2 Targetco value 5 $47.5 2 40 5 Of course, the T cost. As we’v is the merger’ NPV 5 Their gain is your This 2 cost 5 $20 2 7.5 5 $12.5 million Writing do ger in this way separates the motive for the merger (the economic gain, or value added) from the terms of the merger (the division of the gain between the two merging companies). 4 To k also ignore the interest income that could hav We v ger. Chapter 21 Mergers, Acquisitions, and Corporate Control 601 TABLE 21.4 Financial for er the CislunarTargetco merger column assumes a cash purchase at $19 per Targetco share. The right column assumes Targetco stockholders receive one new Cislunar share for ev ee Targetco shares. Note: Figures in millions except price per share. Self-Test 21.3 Mergers Financed by Stock e its cash for other investments and therefore decides T getco v v T It’s the same merger, but the f The right column of Table 21.4 works out the consequences. bottom of the column. Note that the market v ger is $540 million, $47.5 million higher than in the cash deal, because that cash is kept rather than paid out to Targetco w ve to be issued in exchange for the 2.5 million Targetco shares (a 1-to-3 ratio). Therefore, the price per share is 540/10.833 5 $49.85, which is 60 cents higher than in the cash offer. to pay for the T gain from the merger is the same, but the Tar They ver T getco’s prior market value: Cost 5 value of shares issued 2 Targetco value 5 $41.5 2 40 5 The merger’s NPV to Cislunar’s original shareholders is NPV 5 economic gain 2 cost 5 20 2 1.5 5 $18.5 million Note that Cislunar stock rises by $1.85 from its prior value. The total increase in value for Cislunar’ Evaluating the terms of a mer y when there is an e The target company’s shareholders will retain a stake in the mer ve s shares will be worth after the mer v et v Cislunar and Targetco postmerger, took account of the mer w orked back to the postmerger share price. Only then could we work out the division of the merger gains between the two companies. There is a key distinction between cash and stock for financing mergers. If cash ered, the cost of the mer ected by the size of the merger gains. If stoc ered, the cost depends on the gains because the gains show up in the postmerger share price, and these shares are used to pay for the acquired firm. 602 Seven Special Topics Stock f fects of over Suppose, for e A overestimates B’s v , perhaps because it has overlooked some hidden liability. Thus A makes too generous an offer. Other things equal, A’ offer. With a stock offer, the inevitable bad news about B’s value will f s Self-Test 21.4 A Warning The cost of a mer ver its value as a separate company. If the target is a public company, you can measure its separate v Watch out, though: If investors e get to be acquired, its stock price may overstate the company’ alue. get company’ ve risen in Another Warning Some companies begin their merger analyses with a forecast of the tar s future ws. Any revenue increases or cost reductions attributable to the mer included in the forecasts, which are then discounted back to the present and compared 5 DCF valuation of target including merger benefits 2 cash required for acquisition This is a dangerous procedure. Ev e lar aluing a business. The estimated net gain may come up positive not because the merger makes sense, but simply because the analyst’ w forecasts f get’s potential as a stand-alone business. A better procedure starts get’ et value and changes w that would result from the merger. Always ask why the two firms should be worth more together than apart. Remember, you add value only if you can generate additional economic benef some competitive edge that other firms can’t match and that the target firm’s managers can’t achieve on their own. es sense to keep an eye on the value that investors place on the gains from merging. If A’s stock price f v message that the mer or that A is paying too much for these 21.5 The Market for Corporate Control e the boss, and with good reason. Try b yee, the chief executive of . Chapter 21 Mergers, Acquisitions, and Corporate Control 603 The ownership and management of lar ways separated. s managers. The board of directors, who act as their agents in choosing and monitoring the managers of ve a direct say in v v This system of gov agency costs. Agency costs occur when managers or directors take actions adverse to shareholders’ interests. e such actions may be ever-present, b y forces and constraints w As we pointed out in Chapter 1, managers’ paychecks in lar ways tors tak y may face lawsuits if they don’t—and therefore are reluctant to rubber-stamp obviously bad financial decisions. What What if the board of directors is derelict in moniut These are all questions about the market for corporate control, the mechanisms by e the most of the firm’s resources. Y agement for granted. If it is possible for the v ing management or by reorganizing under new owners, there will be incentives for someone to mak There are four ways to change the management of a firm. These are (1) a successful proxy contest in which a group of stockholders votes in a new group of directors, who then pick a new management team; (2) the purchase of one firm by another in a merger or acquisition; (3) a leveraged buyout of the firm by a private group of investors; and (4) a divestiture, in which a firm either sells part of its operations to another compan irm. We will revie 21.6 Method 1: Proxy Contests Shareholders elect the board of directors to keep watch on management and replace unsatisf -cut. Ownership in lar dispersed. Usually even the largest single shareholder holds only a small fraction of v bers stand for personal relationship with its members. In man v proxy contest Takeover attempt in which outsiders compete with management for shareholders’ votes. Also called proxy fight. When a group of investors believ be replaced, they can launch a proxy contest. A proxy is the right to vote another enough proxies to elect their o in control, management can be replaced and company policy changed. w board is y can cost millions of dollars. Dissidents who engage in them must use their own money, but management can draw on the 604 Seven Special Topics Giv gister their discontent simply by voting against the reelection of existing directors. This can send a powerful signal. y shareholders voted 43% of the shares against the reelection of Michael Eisner, the company’ xt day. In 2010 the SEC adopted a pr e it easier for dissident shareholders to put their o ote. This rule would have greatly reduced the cost of a proxy contest. However, proxy access w This initiative promises to be an ongoing controversy. Institutional shareholders, such as large hedge funds, have become more aggressive ve been able to gain concessions by or example, in 2008 shareholder activist Carl Icahn indicated his intention to put himself forw otes and failed to prevent the reelection of the existing board. Nevertheless, the pressure from Icahn had an effect: Motorola agreed to nominate two ne of y’ vision.5 21.7 Method 2: Takeovers ing in the best interests of inv and make a ves that another company’s management is not actver the heads of that f s management fer and sell their shares, or it may fight the fer or walk away from the deal. If the tender offer is successful, the new owner can then install its own management team. eov often fought. Of course, these battles for corporate control don’t always result in the intended improv xcessive belief in one’s own ability, has led man T , Viv turn Vivendi into “the world’ vider of entertainment, education and personalized services to customers, at any time, and across all distribution vices.” Vivendi entered into a series of major acquisitions, including wned Universal Studios. Messier’s ambitions , moi-même, maitre du monde orld.” Unfortunately, however, prof y, and Messier was ousted.6 ve a near-monopoly on hostile takeovers. That is no longer the case. T eover activity in Europe now exceeds that in the United States, and in recent years some of the most bitterly contested takeovers have involved European companies. For example, Mittal’s $27 billion takeover of fellow steel-producer Arcelor used every defense in the book—including inviting a Russian company to become a leading shareholder. 5 In Chapter 1 we saw that, in the same year board of Y 6 all of Viv Jean-Marie Messier and Vivendi Universal The Man Who Tried to Buy the World: Chapter 21 Mergers, Acquisitions, and Corporate Control 605 Mittal is now based in Europe, but it began operations in Indonesia. This illustrates another change in the mer et: They now include Brazilian, Russian, Indian, and Chinese companies. We have already encountered some of the recent acquisitions of U.S. and British companies by the Indian conglomerate Tata Group. Other e IBM’s personal computer business, which w y Lenovo, and Inco, the Canadian nickel producer, which is now owned by Brazil’s Vale. ger w . We will laws,7 look at one recent contest that illustrates the tactics and weapons employed. ▲ EXAMPLE 21.2 poison pill Measure taken by a target firm to avoid acquisition; for example, the right of existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding. Oracle Bids for PeopleSoft Hostile takeover bids are relatively uncommon in high-tech industries where an acrimonious takeov y cause many of the target’s most valued st o leave. Investors were therefore startled in J are giant Oracle Corp. announced a $5.1 billion cash t er for its rival PeopleSoft. T er price of $16 a share was only a very modest 6% above the recent price of P ock. PeopleSoft’s CEO angrily rejected the bid as dramatically undervaluing the business and accused Oracle of trying to disrupt PeopleSoft’s business and to thwart its recently announced plan to merge with its smaller rival J.D. Edwards & Co. PeopleSoft immediately filed a suit claiming that Oracle’s management had engaged in “acts of unfair trade practices” and had “disrupted PeopleSoft’s customer relationships.” In another suit J.D. Edwards claimed that Oracle had wrongly “int ered with its proposed merger with PeopleSoft” and demanded $1.7 billion in compensatory damages. Oracle’s bid was the opening salv as to last 18 months. Some of the key dat e set out in Table 21.5. P veral defenses at its disposal. First, it had in place a poison pill, which would allow it to flood the market with additional shares if a predator acquired 20% of the stock. Second, the company instituted a customer-assurance progr ered customers money-back guarantees if an acquirer were to reduce customer support. At one point in the takeov ential liability under this program reached nearly $1.6 billion. Third, elections to the P d were staggered, erent directors came up for r erent years. This meant that it would take two annual meetings to replace a majority of PeopleSoft’s board. Oracle not only had to overcome PeopleSoft’s defenses but also had to clear possible antitrust roadblocks. Connecticut’ orney general instituted an antitrust action to block Oracle’s bid, in part to protect his state’s considerable investment in P are, and announced that he was seeking to assemble a coalition of other states and customers as well. Then an investigation of the deal by the U.S. Department of Justice ruled that the deal was anticompetitive. Normally such an objection is enough to kill a deal, but Oracle was persistent and successfully appealed the ruling in a federal court. While these battles were being fought out, Oracle re er four times. It er first to $19.50 and then to $26 a share. Then, ort to put pressure on P eholders, Oracle reduced er to $21 a share, citing a drop of 28% in the price of PeopleSoft’s shares. Six months later it r er again to $24 a share, warning investors that it would walk awa er was not accepted by P s board or a majority of the P eholders. cent of P s shareholders indicated that they wished to er, but before Oracle could gain control of P it still 7 eovers is the Williams Act of 1968. 606 Part Seven Special Topics TABLE 21.5 Some key dates in the Oracle/PeopleSoft takeover battle needed the company to get rid of the poison pill and customer-assurance scheme. That meant putting pressure on PeopleSoft’s management, which had continued to reject every approach. Oracle tried two tactics. First, it initiated a proxy fight to change the composition of P s board. Second, it filed a suit in a Delaware court alleging that PeopleSoft’s management had breached its fiduciar y trying to thwart Oracle’ er and not giving it “due consideration.” The lawsuit asked the court to require that PeopleSoft dismantle its takeover defenses, including the poison-pill plan and the customer-assurance program. P s CEO had at one point said that he “could imagine no price nor combination of price and other conditions to r er.” But with 61% of PeopleSoft’s shareholders wishing to take up Oracle’s lat er, it was becoming less easy for the company to keep saying no, and many observers were starting to question whether P s management was acting in the shareholders’ interest. If management showed itself deaf to shareholders’ interests, the court could well rule in favor of Oracle or disgruntled shareholders might vote to change the composition of the PeopleSoft board. P s directors therefore decided to be less intransigent and testified at the Delaware trial that they would consider negotiating with Oracle if it were t er $26.50 or $27 a share. This was the breakthrough that Oracle was looking for er immediately to $26.50 a share, P ed its defenses, and within a month 97% of PeopleSoft’s shareholders had agreed t er 18 months of punch and counteror P as over. shark repellent Amendment to a company charter made to forestall takeover attempts. xample illustrates some of the stratagems of merger w are. Firms lik en over usually prepare their defenses in advance. Often they will persuade shareholders to agree to shark-repellent . For e y merger must be approved by a of 80% of e the y unappetizing. For example, the poison pill may give e the right to buy the company’ The bidder is not entitled to the discount. Thus the bidder Chapter 21 Mergers, Acquisitions, and Corporate Control 607 resembles Tantalus—as soon as it has acquired 15% of the shares, control is lifted away from its reach. eover defenses. Oracle’s offensive still gained ground, but with great expense and at a v slow pace. But eventually the pressure on PeopleSoft’s management became overas acting in the shareholders’ interests, it risked having the poison pill remov The second reason that the company caved in was the increasing pressure from its shareholders, including some large institutions, who wished to accept Oracle’s offer. 21.8 Method 3: Leveraged Buyouts leveraged buyout (LBO) Acquisition of the firm by a private group using substantial borrowed funds. management buyout (MBO) Acquisition of the firm by its own management in a leveraged buyout. ▲ EXAMPLE 21.3 Leveraged buyouts, or LBOs, o ways. First, a lar w inv on the open market. The remaining equity in the LBO is privately held by a small group of (usually institutional) investors and is known as . When this group is led by the company’s management, the acquisition is called a management buyout (MBO). Many LBOs are in fact MBOs. anted di v main lines of business often lacked top management’s interest and commitment, and di ureaucracy. Many such divisions wered when spun off as MBOs. Their managers, pushed by the need to generate e in the business, found ways to cut costs and compete more effectively. vate-equity activity shifted to buyouts of entire businesses, including large, mature public corporations. The largest, most dramatic, and bestdocumented LBO of them all was the $25 billion takeover of RJR Nabisco in 1988 by Kohlber versies of LBOs are writ large in this case. RJR Nabisco8 On October 28, 1988, the board of directors of RJR Nabisco revealed that Ross Johnson, the company’s chief executiv icer, had formed a group of investors prepared to buy all the firm’s stock for $75 per share in cash and take the company private. Johnson’s group was backed up and advised by Shearson Lehman Hutton, the investment bank subsidiary of American Express. RJR’s share price immediately moved to about $75, handing shareholders a 36% gain over the previous day’s price of $56. At the same time RJR’s bonds fell, since it was clear that existing bondholders would soon have a lot more company. Johnson’ er lifted RJR onto the auction block. Once the company was in play, its board of directors was obliged t ers, which were not long coming. Four days later, a group of investors led by LBO specialists Kohlberg Kravis Roberts bid $90 per share, $79 in cash plus preferred stock valued at $11. The bidding finally closed on November 30, some 32 da er was revealed. In the end it was Johnson’s gr ered $109 per share, er adding $1 per share (roughly $230 million) at the last hour. The KKR bid 8 The Fall of RJR Nabisco (New Y w Barbarians at the Gate: vie with the same title. 608 Seven Special Topics was $81 in cash, convertible subordinated debentures valued at about $10, and preferred shares valued at about $18. Johnson’s group bid $112 in cash and securities. But the RJR board chose KKR. True, Johnson’s gr ered $3 per share more, but its security valuations were viewed as “softer” and perhaps overstated. Also, KKR’s planned asset sales were less drastic; perhaps their plans for managing the business inspired more confidence. Finally, the Johnson group’s proposal contained a management compensation package that seemed e emely generous and had generated an avalanche of bad press. But where did the merger benefits come from? ering $109 per share, about $25 billion in all, for a company that only 33 days previously had been selling for $56 per share? KKR and other bidders were betting on two things. First, they expected to generate billions of additional dollars from interest tax shields, reduced capital expenditures, and sales of assets not strictly necessary to RJR’s core businesses. Asset sales alone were projected to generate $5 billion. Second, they expected to make those core businesses significantly more profitable, mainly b xpenses and bureaucracy. Apparently there was plenty to cut, including the RJR “Air Force,” which at one point operated 10 corporate jets. In the year after KKR took over, new management was installed. This group sold assets and cut back operating expenses and capital spending. There were also lay . As expected, high interest charges meant a net loss of $976 million for 1989, but pretax operating income actually increased, despite extensive asset sales, including the sale of RJR’s European food operations. While management w , prices in the junk bond market were rapidly declining, implying much higher future interest charges for RJR and stricter terms on any refinancing. In mid-1990 KKR made an additional equity investment, and later that year the compan er of cash and new shares in exchange for $753 million of junk bonds. By 1993 the burden of debt had been reduced from $26 billion to $14 billion. For RJR, the world’s largest LBO, it seemed that high debt was a temporary, not permanent, virtue. Barbarians at the Gate? The buyout of RJR crystallized vie et, and the takeover business. For many it exemplified all that w e up established companies, leaving urdens, basically in order to get rich quick. There was plenty of confusion, stupidity, and greed in the LBO business. Not all the people involved were nice. On the other hand, LBOs generated enormous increases in market v or example, the biggest winners in the RJR Nabisco LBO were the company’ W ve come from before veral possibilities. The Junk Bond Markets eovers may have been v ets. With hindsight it seems that investors in junk bonds underestimated the risks of default. Default rates climbed painfully between 1989 and 1991, yields rose dramatically, and new issues Leverage and Taxes As we e wing money saves taxes. But taxes were not the main driving force behind LBOs. The value of interest tax shields was just not big enough to explain the observed g et value. Chapter 21 609 Mergers, Acquisitions, and Corporate Control Of course, if interest tax shields were the main motive for LBOs’ high debt, then LBO managers would not be so concerned to pay off debt. We saw that this was one of s ne Other Stakeholders just someone else’s loss and that no value is generated overall. Therefore, we should look at the total gain to all inv Bondholders are the obvious losers. The debt they thought was well-secured may We noted ho fer was announced. But again, the v ge enough to explain stockholder g Leverage and Incentives Managers and employees of LBOs work harder . They have to generate cash to service the extra debt. Moreover, managers’ personal fortunes are riding on the LBO’s success. They become owners rather than organization men or women. ves, but there is some evidence of improv uyouts verage increases in operating income of 24% over the follo ut not in employved incentives rather ”9 Free Cash Flow eovers is basically that mature firms with a surplus of cash will tend to waste it. theory ve-NPV inv ties should give the cash back to investors through higher dividends or share repurchases. But we see f questionable capital inv w theory predicts that mature, “cash cow” companies will be the most lik gets of LBOs. We can find many e , including RJR Nabisco. The theory says that the gains in market value generated by LBOs are just the present v ws that would otherwise have been frittered away.10 W have mentioned sev v w theory as the sole explanation for LBOs. We v y mistakes and a good many LBOs hav icial. On the y, , Tropicana, Chicago e issue with those who Tribune, Wick wever portray LBOs simply as W corporate America. In many cases LBOs hav The b ger boom of the 1980s even v val management team. as the ability of the bidder to f eover 9 Value,” J inancial Economics 24 (October 1989), pp. 217–254. 10 w theory’ ” d Business Review 67 (September–October 1989), pp. 61–74, and “The Agency Costs of w T eovers,” American Economic Re 76 (May 1986), pp. 323–329. 610 Seven Special Topics ger environment had changed. Many of the obvious targets had disappeared and the battle for RJR . Institutions were reluctant to increase their holdings of junk bonds. Moreover, the market for these bonds had depended to a remarkable extent on one indi en, of the investment x en and his employer were in en was indicted by a grand jury on 98 counts and was subsequently sentenced to jail. Drex y, but by that time the junk bond market was und and the finance for highly leveraged buyouts had largely dried up.11 Finally, in reaction to the perceived excesses of the merger boom, the state le courts be eovers. Eventually, LBO activity began to recover, encouraged by low interest rates and (until August 2007) easy access to debt f gets, hav vate ownership. In addition, for public companies the costs of meeting the requirements of the Sarbanes-Oxley gulations hav vate (rather than public) ownership. 21.9 Method 4: Divestitures, Spin-Offs, and Carve-Outs publicity 2007, F vestiture of assets or entire businesses—can be just as or example, in , for $924 a business the newly independent company. For example, in 2009 Time W investment in AOL. Time W v w company A wn Time W . xcept that shares in the new company are not given to existing stockholders b y to establish a market in the f the remainder of the shares. w the computer company, Palm, w ed and then spun. The most frequent motive for spin-offs is improved ef y. Companies sometimes refer to a b ” By spinning of y can concentrate on its main activity. If each business must stand on its o f from one in order vestments in the other. Moreover, if the tw usiness are independent, it is easy to see the value of each and to reward managers accordingly. 21.10 The Benefits and Costs of Mergers Merger activity comes in waves and is concentrated in a relatively small number of industries. This urge to merge frequently seems to be prompted by deregulation and by Take the merger wave of the 1990s, 11 F en in the dev edator’s Ball: The Junk Bond Raiders and the Man Who Staked Them (New York: Simon and Schuster, 1988). FINANCE IN PRACTICE How Palm Was Carved and Spun for example. Dere of mergers in both industries that has continued to the present. Elsewhere, the decline gers between defense companies the prospective adv ers between such giants as AOL and Time W ution led to merg. on balance. In general, sharee a healthy gain. For example, one study found that follo get company jumped by 16% on average.12 On the other hand, it appears that investors e companies to just about break ev The value uyer plus seller—increased by 1.8%. Of course, these are averxample, have sometimes obtained much higher returns. When Hewlett-Packard won its takeover battle to buy data-storage company 3Par, it s stock. Since buyers roughly break ev there are positive ov gers. But not everybody is convinced. Some believe that investors analyzing mer xpense of long-term prospects. Since we can’ e how companies would have fared in the absence of a merger, . However, several studies of merger activity suggest that mergers do seem to improve real productivity. For example, Healy, Palepu, and Ruback examined 50 large mergers and found an average increase 13 The gue that this gain get f 12 See G. w Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 13 See P , K. P v gers?” Journal of Financial Economics 31 (April 1992), pp. 135–175. The study e ged v verages. 611 612 Seven Special Topics came from generating a higher level of sales from the same assets. There was no e vestments; expenditures on capital equipment and research and development tracked the industry average. y toward mergers, you do not want to look or instance, we hav was at the e venue Service (through the ged interest tax shield). The acquirer’s shareholders may also gain at the expense of the target firm’s employees, who in some cases are laid of e pay cuts after takeovers. fect of acquisition is felt by the managers of companies that are not taken over. For example, one effect of LBOs was that the managers of ev eov , we don’t w whether on balance the threat of merger makes for more active days or more sleepless nights. eover may be a spur to inef ut it is also costly. The companies need to pay for the services provided by the investment bankers, lawyers, and accountants. In addition, mer ge amounts of management time and ef When a compan eover, it can be dif ve as s existing business. Ev xceed these costs, one wonders whether the v ay. For example, are leveraged b e managers work harder? Perhaps the problem lies in the way that man w y of the gains from takeov SUMMARY QUESTIONS QUIZ www.mhhe.com/bmm7e www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISE finance.yahoo.com SOLUTIONS TO SELF-TEST QUESTIONS MINICASE CHAPTER 22 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T S E V E N Special Topics Coca-Cola does business around the world. T 620 Part Seven Special Topics 22.1 Foreign Exchange Markets An American compan xchange its dollars for euros in order to pay for its purchases. Another company e France will probably receive euros, which it then sells in exchange for dollars. Both e use of the foreign exchange mark The foreign exchange mark etplace. All business is conducted via computer terminals and telephone. ge commercial ants to b commercial bank. T ver in the foreign e y changes hands each day. v v wY ver per day olume of the New Y where about $70 billion of stock typically changes hands on any given day. Spot Exchange Rates uy two loaves for a dollar, or he may say that one loaf costs 50 cents. If you ask a foreign e exchange rate Amount of one currency needed to purchase one unit of another. pesos that you can b wn as an indirect quote of the exchange rate. uy 1 peso) is known as a direct quote. Of course, both quotes pro uy 100 pesos , then you can easily calculate that the cost of buying 1 peso is 1/100 5 $.01. v y xactly 100 pesos per U.S. dollar. W veral examples below.) Table 22.1 shows the exchange rate for several actual countries on September 17, 2010. The second column of the table shows the name of the currency and its common abbreviation. For example, the Mexican peso is usually abbreviated as expressed as indirect quotes. Thus the third column of Table 22.1 shows that TABLE 22.1 Exchange rates in September 2010 * Direct quotes (number of U.S. dollars per unit of foreign currency). Other quotes are indirect (units of foreign currency per U.S. dollar). Source: Financial Times, September 17, 2010, available at Chapter 22 621 International Financial Management you could buy 12.8344 Mexican pesos for 1 dollar. This is sometimes written as MXN12.8344 5 USD1. To complicate matters, there are two currencies whose prices are generally expressed as direct quotes. These are the euro and the British pound. For example, you can see that it cost $1.3044 to buy 1 euro. We therefore write the euro exchange rate as USD1.3044 5 EUR1. Self-Test 22.1 ▲ EXAMPLE 22.1 A Yen for Trade How many yen will it cost a Japanese importer to purchase $10,000 worth of oranges from a California farmer? How many dollars will that farmer need in order to buy and import a Japanese tractor priced in Japan at 4.5 million yen? The exchange rate is JPY85.6600 5 USD1. The $10,000 of oranges will require the Japanese importer to come up with 10,000 3 85.66 5 856,600 yen. The tractor will require the American importer to come up with 4,500,000/85.66 5 $52,533. The e spot rate of exchange Exchange rate for an immediate transaction. Table 22.1 y for wn as spot rates of exchange. For example, the spot rate of e 5 ords, it costs 1.71550 Brazilian reals to buy 1 dollar for immediate deliv . Exchange rates are generally quoted against the dollar. For example, Table 22.1 sho uy either 85.66 Japanese yen or 1,160 Korean won. This implies that 85.66 yen are equivalent to 1,160 won and, therefore, that 1 yen is equivalent to 1,160/85.66 5 13.54 won. An exchange rate between tw wn as a cross-rate. In our example, the cross-rate of exchange between the Japanese yen and the South Korean w W13.54 5 JPY1. Cross-rates between any tw ed down by the exchange rate for y versus the U.S. dollar. Otherwise, inv e an easy or example, suppose that a (really stupid) bank quotes a rate of W10 5 JPY1. Here’s what you do: You take $1 and exchange it for 1,160 Korean won, which you then use to buy 1,160/10 5 116 Japanese yen. exchanged back to U.S. dollars for 116/85.66 5 $1.354. You have just taken advantage 1 Of course, in real life you and other investors w time. ould be forced to revise its quote in short order. v . Self-Test 22.2 . so the e y increases in v 1 In practice foreign e y a major cost for small transactions by indi The spread is very small on lar uy and ut it is 622 Part Seven Special Topics y to b y to b y is said to appreciate. depreciate. Self-Test 22.3 v ed e y and seek ed rates seldom last forever. If ev y, ev w the currency to depreciate. When this happens, exchange rates can change dramatically. In December 2001, when Argentina gav ed exchange rate versus the U.S. dollar, the value of the Argentinian peso fell by over 70% in a few months. Forward Exchange Rates Fluctuations in exchange rates can get companies into hot water. For example, suppose you have agreed to b will be deliv (R uys 100 pesos (RUP100 5 USD1). So, if the exchange forward exchange rate Exchange rate for a future transaction. appreciates? For example, suppose that when you come to buy the pesos at the end of the year uys only 80 pesos (RUP80 5 USD1). Then the dollar cost of 5 $1.25 million). You can avoid this exchange rate risk and fix your dollar cost by b d, now to buy pesos at a prespecified price on a future date. This xchange d contract. Suppose you enter into a ard contract with a bank to buy 100 million pesos 12 months from no of RUP105 5 USD1. You don’t pay an w; you simply fix today the price that you will pay in the future. 2 you hand over in exchange $.952 million (100 /105 5 The spot e y today. The exchange rates in Table 22.1 xchange rates. y for delivery at a future date is called the forward exchange rate. The forw xchange rate is not usually the same as the spot rate. In our example 1 dollar bought 100 Ruritanian pesos in the spot market b et. In this case, the peso is said to trade at a forw discount relativ . It’s a discount because pesos are cheaper—more pesos per dollar—if purchased forward rather than spot. If fewer pesos in the forward market, the peso would trade at a forw premium relativ . ard purchase or sale is a made-to-order transaction between you and the bank. It can be for an y, any amount, and any deliv . You could buy, say, 99,999 V There is also an organized mark y for future deliv wn as the currency es et. Futures contracts are highly stanye y v 2 xchange rate is R 5 USD1, then 1 peso will cost you 1/105 5 3 $.00952 5 $.952 million. Chapter 22 International Financial Management 623 easy on futures exchanges—you don’t have to negotiate a one-off contract with a bank. Almost ev futures. We will describe futures markets in greater detail in Chapter 24. Self-Test 22.4 22.2 Some Basic Relationships exchange rates and must be aw exchange rates. She must also recognize that tw rates. To dev needs to understand how e have a lower interest rate than another. To k b consider: ve different interest y, the financial manager y doing inancial manager needs to 1. 2. expected exchange rate at some future date? 3. How do dif s interest rate and the exchange rate? 4. What e the spot rate? These are complex issues, but as a f ward e Figure 22.1. FIGURE 22.1 Some simple theories linking spot and f ard exchange rates, interest rates, and inflation rates fect each ard exchange rate for the peso and ed as shown in 624 Part Seven Special Topics Exchange Rates and Inflation (the two boxes on the right of Figure 22.1). The idea here is simple: If one country suf, then the v y will decline. But let’s slow down and consider why linked. Suppose you notice that gold can be bought in New Y law of one price Theory that prices of goods in all countries should be equal when translated to a common currency. transport of gold, you could be onto a good thing. You b e it on the first plane to Ruritania, where you sell it for 130,000 pesos. e UP100 5 USD1. So you can e 130,000 pesos for 130,000/100 5 $1,300. You hav ounce. Of course, you hav ut there should ver for you. Y its rarely exist, and when they do exist, they don’t last long. price of gold in Ruritania and the price in New York, the price will be forced down in wY This ensures that the dollar price of gold is the same in the two countries. Our conclusion that gold is w y is an example of the law of one price. Just as the price of goods in W Target, so the prices of goods in Ruritania when conv Dollar price of goods in U.S. 5 Number of pesos per dollar , but the same forces push the . Those goods that can wn the price of the domestic product. Those goods that can be produced more cheaply at home will be e w believes that the law of one price holds exactly. Look at Table 22.2, which shows the v You can see that or example, in Norway Big Macs cost almost twice as much as in the United States, but in China the U.S. price.3 TABLE 22.2 Mac hambur countries Price of Big erent “When the Chips Are Down: The Latest Big Mac Index Suggests the Euro Is Still Overvalued,” The Economist, July 22, 2010. 3 ay e with like. urgers Chapter 22 625 International Financial Management This suggests a possible way to make a quick buck. Why don’t you buy a hamburger e it for resale in Norway in dollars is $7.20? The answer, of course, is that the gain would not cover the costs. The law of one price works very well for commodities like gold, where transportation orks f purchasing power parity (PPP) Theory that the cost of erent countries is equal and that exchange rates adjust t lation erentials across countries. W er version of the la w that captures the main idea but allows for exceptions. er version is purchasing power parity, or PPP. PPP states that although some goods, such as Big Macs and haircuts, may cost ferent countries, the overall cost of li . PPP implies that the relative costs of living in two countries will not be affected by will be offset by changes in exchange rates. If purchasing po rates is also your best forecast of the change in the spot rate of exchange. For example, suppose you need a forecast of the exchange rate for the Ruritanian peso. Purchasing po xchange rate for the peso is RUP100 5 USD1. If the cost of living is undle of 6% in Ruritania and 1% in the United States. buy the same quantity of goods as $1.01, and $1 will have the same purchasing power as RUP100 3 (1.06/1.01) 5 R expected exchange rate at the end of the year is RUP105 5 e Look back at the tw es in Figure 22.1. We can no 4 box 11e 5 11 1.06 5 1.05 1.01 equals Expected change in spot exchange rates Expected peso exchange rate 105 5 5 1.05 xchange rate 100 Now we have some helpful advice for the U.S. company doing business in Ruritaxchange rate for Ruritanian pesos, he or she can use the difference in e versus in the United States. 4 Aw indirect e v T v 626 Seven Special Topics Real and Nominal Exchange Rates Financial managers distinguish nominal exchange rates from real exchange rates. Nominal exchange rates tell you how many euros or yen or pounds you can buy for your dollar. Real exchange rates measure the quantity of goods you can b or e alue of the Ruritanian peso declines, you will be able to purchase more pesos for your dollar, but if Ruritania e uy you only the same nominal exchange rate has declined b real exchange rate is unchanged. Purchasing po y change in the nominal exchange rate will be offset by a change in the relativ o countries, leaving the real exchange rate unaffected. Figure 22.2 For e ws that in 2010 one pound (£1) bought only 33% of the . But this decline in the nominal value of the pound w The plot shows that just ov xchange rate was little changed. . Of course, purchasing po term real e . For example, the real value of the pound fell by more than one-quarter between the end of 2007 and the end of 2008. U.S. tourists to Britain found that their dollar bought more than it had in earlier years. Such changes in real exchange rates can be a major headache for an called on to make a long-term forecast of an exchange rate, you probably can’t do much better than to assume that changes in the nominal v y will offset the dif That is the message of purchasing po ity theory. Self-Test 22.5 Inflation and Interest Rates Ruritania. W xplain such a difference? they don’ est rate of 3%, you will hav ix ut y will buy. If you invest $100 for a year at an interould be needed to compen- In our example, the nominal rate of interest is higher in Ruritania than in the United States, b , then the real rates of interest may be much closer than the nominal rates. For example, suppose that the e 1% in the United States and 6% in Ruritania. Then Chapter 22 International Financial Management FIGURE 22.2 Nominal versus real exchange rates in (a) the United Kingdom, (b) France, and (c) Italy. December 1899 5 1. (Values are shown on log scale.) Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002) Updates courtesy of Triumph's authors. 627 628 Part Seven Special Topics Real U.S. interest rate 5 5 1 1 nominal interest rate 21 11 1.03 2 1 5 .0198, or 1.98% 1.01 and 11 21 11 1.081 5 2 1 5 .0198, or 1.98% 1.06 The nominal interest rates in the tw ferent, but the real interest rates are the same. Now you can see why we drew the top two boxes in Figure 22.1: 5 ence in interest rates 1 1 Ruritanian interest rate Expected differ 11e 5 1 1 U.S. interest rate 1.081 1.03 5 1.05 equals rate 1 1 U.S. rate 5 1.06 5 1.05 1.01 If e international Fisher effect Theory that real interest rates in all countries should be equal, with erences in nominal rates reflecting erences in expected inflation. v ferences in the nomferences in e This conclusion is often called the Fisher effect, . As long w unimpeded across national borders, capital mark requires that real y two countries. Just as water always ws downhill, so capital alw wing only when expected returns are the same.5 But it is the real returns that concern investors, not the nominal returns. Tw ve different nominal interest rates but the same expected real interest rate. How similar are real interest rates around the world? It is hard to say, because we e expected wever, in Figure 22.3 we have plotted the av act You can see that the countries with the highest interest rates generally had Self-Test 22.6 5 Here we assume aw y. , pound, euro, Swiss franc, and yen. not acceptable for some dev We hav vestors w ault or e gov y may demand a higher real interest rate on peso loans. Chapter 22 629 International Financial Management FIGURE 22.3 Countries with the highest interest rates generally have the highest inflation. In this diagram each of the 65 points represents the experience of er . The Forward Exchange Rate and the Expected Spot Rate expectations theory of exchange rates Theory that expected spot exchange rate equals the f ard rate. If you buy Ruritanian pesos forw you buy them spot. So the peso is selling at a forw w let us think how this discount may be related to expected changes in spot rates of exchange. The spot rate for the peso is RUP100 5 ard rate is RUP105 5 USD1. Would you sell pesos forw alue? Probably not. You would be tempted to w price (more pesos) in the spot market. If other traders felt the same way, nobody would ould want to buy, so the number of pesos that you et would f expected the peso to f alue, they might be reluctant to buy in order to attract buyers, the number of pesos that you could b the forw et would need to rise.6 Trading would stabilize when the forw adjusts to equal the expected future spot rate. This is the reasoning behind the expectations theory of exchange rates, which xchange rate. Put another way, we can say that the percentage dif s spot rate is equal to the expected percentage change in the spot rate: g of our quadrilateral in Figure 22.1. Difference between forward and spot exchange rates Forward peso exchange rate 105 5 5 1.05 rate 100 equals Expected change in spot exchange rate Expected peso exchange rate 105 5 5 1.05 100 rate 6 forw , you might ven if you e , if a forw ard even if you expected to receive less as a result. uy might be 630 Seven Special Topics The e ve the previous forw all below that on average This prediction is roughly 8 e a long enough average,7 b Because of the exceptions and anomalies, the expectations hypothesis is not much help to foreign e usiness. F exchange exposure, the e fers some reassurance. A company that always covers its foreign exchange commitments by b y in the forw et does not have to pay a premium to avoid e On average, the forw y will equal the eventual spot exchange rate, no better but no worse. Interest Rates and Exchange Rates Now let’s mov av xchange rates, known as covered interest r , almost always works, ev Y vestor with $1 million to invest for 1 year. vest your money in Ruritania or in the United States? The answer seems obvious: Isn’ v v When the loan is repaid at the end of the year, you need to convert your pesos back into U.S. dollars. Of course, you don’t know what the e ,b alue of your pesos by selling them forw ard rate of exchange is suf w, you may do just as well keeping your money in the United States. Let’s check which loan is the better deal: • U.S. dollar loan. The rate of interest on a U.S. dollar loan is 3%. Therefore, at the 3 1.03 5 $1.03 million. • Ruritanian peso loan. UP100 5 USD1. Therefore, you can conv UP100 million. The interest ve R 3 1.081 5 R You don’ w what the e , but that doesn’t matter. You can nail down the rate at which you conv RUP105 5 USD1. will get RUP108.1/105 5 $1.03 million. Thus the two investments offer exactly the same rate of return. They have to, because the “covered” foreign rate, you would have a money machine: You could borrow in the market with the lower rate and lend in the market with the higher rate. 7 times the v ve up return in order to buy sell forw y. ard rate overstates the likely understates the likely spot rate. The over- and v 8 ve studied exchange rates hav ov fall. There is even e rise. F Exchange,” J xaggerate the lik v ely to f Thaler, “Anomalies: Foreign olitical Economy 4 (1990), pp. 179–192. Chapter 22 631 International Financial Management We now hav Figure 22.1: ence in interest rates 11 1.081 interest rate 5 5 1.05 1.03 1 1 U.S. interest rate interest rate parity Theory that f ard premium equals interest rat erential. called interest rate parity. equals Difference between forward and spot exchange rates F ard peso exchange rate 105 5 5 1.05 100 rate wn in tend to ways holds with great precision. whenev You can’t w in a currency with a low nominal rate of interest. If you hedge or “cover” your exchange rate e y.9 If you don’t cover, exchange rate mov antage of a low interest rate. Interest rate parity means that covered interest rates are the same in all major currencies. A f empts to borrow in currencies with low interest rates can profit only by taking a bet on future exchange rates. Self-Test 22.7 22.3 Hedging Exchange Rate Risk Transaction Risk As exchange alue of their revenues or e ful to distinguish two types of exchange rate risk: transaction risk and economic risk. T v wn amount of y. For example, our importer of machinery w RUP100 million at the end of 12 months. If the value of the peso appreciates rapidly ov xpected. T or ev committed to pay, she can buy 1 peso forward. If she buys R ard, v appreciation of the peso. Of course, it is possible that the peso will depreciate v ,10 in ould regret that she did not wait to buy the peso more cheaply 9 A cov y contract. In our e with 8.1% interest to R You therefore would sell R dollar value of your year-end proceeds. 10 By this we mean that the peso f y and hedge the exchange UP100 million, which grows 632 Seven Special Topics et. Unfortunately, you cannot have your cak dollar cost of the machinery Is there any other w xchange rate loss? Think again how cov orks. The f w vert them into pesos today, put the proceeds in a Ruritanian bank deposit, and withdra wing dollars, b et, and leaving them on deposit is e uying pesos forw What is the cost of protection against currency risk? You sometimes hear managers say that it is equal to the difference between the forward rate and today’s spot rate. This is wrong. If our importer did not hedge, she would pay the spot price for pesos when the payment is due at the end of the year. Therefore, the cost of hedging is the difference between the forward rate and the expected spot rate when payment is due. Should companies hedge, or should the tions? We generally vote for hedging. First, it makes life simpler for the f allows it to concentrate on its own business. Second, it does not cost much. (In fact, the cost is zero if the forw xpected spot rate, as our simple theories imply.) Third, the foreign exchange mark icient, at least for the ely case market. Economic Risk Ev wes nor is owed foreign currency, it still may be affected by , for example, the competitive position of foreign auto producers such as Volkswagen and Toyota when the v matically in 2006 and 2007. These f aced a difficult choice between maintaining y, ve against U.S. producers such as Ford and GM. Economic exposure to the exchange rate arises because exchange fect competitive positions. y to undertake operational hedging production closely with sales. For example, 38% of Ford’s sales are outside North America, b y risks v Japanese auto manufacturers have less operational hedging. For example, Toyota produces 63% of its output in Japan b Toyota than for Ford. On the other hand, the Japanese auto companies operate in a wider range of mark They have therefore diversified aw y risks. y risk. Think again of Toyota. It is a net e America and is therefore exposed to a decline in the v . So, in addition to its operational hedging, Toyota also mitigates exchange rate risk by using es. For e ws large amounts in Toyota’s prof Self-Test 22.8 Chapter 22 International Financial Management 633 22.4 International Capital Budgeting Net Present Values for Foreign Investments ve risen to the point that it is considering establishing a small manufacturing and sales operation overseas in Ruritania. Ecsy-Cola’s decision to invest overseas should be based on the same vest in the United States. The company needs to forecast the ws at the opportunity cost of capital, and accept those projects with a positive NPV. Suppose Ecsy-Cola’s Ruritanian facility is expected to generate the following cash ws in Ruritanian pesos: The interest rate in the United States is 3%. Ecsy’ the company requires an additional e 1 10 5 13%. Notice that Ecsy’s opportunity cost of capital is stated in terms of the return on a vestment b ven in pesos. A project that offers a 13% e all f fering the required alue of the peso is expected to decline. Conversely, a project that offers an expected return of less than 13% in pesos may be w is likely to appreciate. You cannot compare the project’s return measured in one currency with the return that you require from investing in another currency. If the oppor of capital is measured as a dollar-denominated return, cash flows should also be forecast in dollars. T Where does this come from? Forw ard exchange rate. ut they can be estimated using interest rate par- ity. For e xchange rate is RUP100 5 USD1 and that the interest rate is 3% in the United States and 8.1% in Ruritania. Thus, the manager sees right away that the peso is likely to sell at a forw . For e forw 1 1 peso interest rate 11 1.081 5 RUP100/USD1 3 5 RUP104.95/USD1 1.03 5 Spot rate in year 0 3 The implied forw similarly, as follows:11 11 W 634 Seven Special Topics ard exchange rates to convert the peso ws into dollars: No capital: .9528 1.1348 1.2976 1.4424 1.5707 1 1 1 1 2 3 4 1.13 1.13 1.13 1.13 1.135 5 $.568 million, or $568,000 NPV 5 23.8 1 ws at 13%, not at the U.S. risk-free interest rate of 3%. ws are risky, so a risk-adjusted interest rate is appropriate. The positive NPV tells the manager that the project is w shareholder wealth by $568,000. not hav xchange ws into dollar equiv ard e y forecast is needed, because the company can hedge its foreign exchange exposure. If it does hedge, for example, by selling pesos forw ws will xchange rates implied by the interest rate differential. In other w ws that we have just calculated. The decision to accept or reject the project therefore is w about the future e What if the management actually expects the peso to appreciate rather than depreciate? Should it use its own forecasts of the future exchange rate instead of the forw e ve, it must be able to stand on its own, based on hedged ws. It would be foolish for xchange rate appreciation. If ould be better y directly rather than use a negative-NPV project to gain e y. (Of course, before it speculates, management ought to think v ves its e ket’s. After all, Ecsy’s comparative advantage is presumably in manuf xchange rate speculation.) Self-Test 22.9 Chapter 22 635 International Financial Management Political Risk So far we have focused on the management of e w political risk. They w v ut managers also vestment is made. Of course, verseas investments. Businesses in ev are exposed to the risk of unanticipated actions by gov the w Consultancy services of w up 12 For example, Table 22.3 is an e cal risk rankings pro verall, while Somalia languishes at the bottom. Some managers dismiss political risk as an act of God, lik quak usiness to reduce political risk. Foreign gov ely to e usiness if it cannot operate without the support of its parent. For example, the foreign American computer softw ould have relatively little value if they were cut off from the know-how of their parents. Such ely to be expropriated than, say, a mining operation that enture. W er mine into a pharmaceutical company, but you may be able to plan your overseas manuf improv vernments. For example, Ford has integrated its overseas operations so that the manufacture of components, subassemblies, and complete automobiles is spread across plants in a number of countries. None of these plants would have much value on its own, and Ford can switch production TABLE 22.3 Political risk scores for a sample of countries - January 2010 Source: PRS Group, “International Country Risk Guide, July 2007,” 12 F (www.duk .prsgroup.com. ey, and T. V ” Financial Analysts J vey) is also a useful source of information on political risk. ey’s Web page 636 Seven Special Topics Multinational corporations have also de eep foreign governments honest. For e inv Tomé silver mine in Costaguana with modern machinery, smelting equipment, and shipping facilities.13 The Costaguanan government agrees to inv e 20% of the silv es. The project’s NPV on these assumptions is quite attractive. But what happens if a new government comes into po w and imposes a 50% tax on “any precious metals exported from the Republic of Costaguana”? Or changes the government’s share of output from 20% to 50%? Or simply takes ov air compensation to be determined in due course by the Minister of Natural Resources of the Republic of Costaguana”? No contract can absolutely restrain sovereign power e these acts as painful as possible for the foreign government. For e ws a large fraction of the required investment from a consortium of major international e sure the guarantee stands only if the Costaguanan government honors its contract. The government will be reluctant to break the contract if doing so causes a default on the loans and undercuts the country’s The Cost of Capital for Foreign Investment We did not say ho project. ved at a 13% dollar discount rate for its Ruritanian verseas investment and the reward that investors , there is no tidy theory of risk and return in xt.14 Remember that the risk of an investment cannot be considered in isolation; it v or example, suppose Ecsy-Cola’s shareholders inv usiness in the United States. They could vie et, though v ven by different forces and therefore a div ets is relatively low, an inv business w vely low-risk project to Ecsy-Cola’ That w y e et.15 Avoiding Fudge Factors We don’ foreign investment. But we disagree with the practice of automatically increasing the domestic cost of capital when foreign investment is considered. inv 13 14 citizens hav and taxes? 15 Tomé mine is described in Joseph Conrad’s Nostromo. ve never been able to agree on y have dif y are subject to different regulations ferent countries. grated w vestors diversify worldwide, re vestors would vie s investment identically. But in reality investors’ portfolios are strongly weighted tow “home bias.” We do not yet have an integrated w et. Chapter 22 International Financial Management 637 because they w xpropriation, foreign e unfavorable tax changes. In other words, they add a fudge factor to the discount rate to of Those managers should leave the discount rate alone and reduce expected cash ws instead. For example, let’s go back to Ecsy-Cola’ w forecast of 100 million Ruritanian pesos in year 1. Now the company gets word of a proposed 100 million peso “incorporation fee” to be imposed in “the first year of operations for all new foreign investments.” The odds that the fee will be imposed are judged at 5%. No expected ut .95 3 100 million 5 95 million pesos. Ecsy should recalculate NPV using this forecast. It should mak s assumptions about political risks out in the open for scrutiny and sensitivity analysis. There may be some discount rate fudge factor that giv ,b ve no practical way of wing what the fudge f lated. Once the adjusted NPV is in hand, the fudge factor is not needed. SUMMARY www.mhhe.com/bmm7e QUESTIONS QUIZ www.mhhe.com/bmm7e PRACTICE PROBLEMS www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe.com/bmm7e WEB EXERCISES www.prsgroup.com SOLUTIONS TO SELF-TEST QUESTIONS MINICASE www.mhhe.com/bmm7e CHAPTER 23 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 R E L A T E D W E B S I T E S F O R T H I S C H A P T E R C A N B E F O U N D A T W W W. M H H E . C O M / B M M 7 E . PA R T S E V E N Special Topics Just another day on the options exchange. W 646 Part Seven Special Topics 23.1 Calls and Puts A call option giv ed exercise price (also called the strike price xpiration date.1 For example, if you buy a call option on Google stock with an e x of $460, you hav . You need not ex xceeds the exercise price. If it does not, the option will be left unexercised and will be valueless. But suppose that when the option expires, Google shares are selling above the exercise price, say, at $520. In this case you will choose to exercise your orth $520. Y call option Right to buy an asset at a specified exercise price on or before the expiration date. you exercise the option. More generally, when the stock price is greater than the exercise price, the payof xercise price. , the value of the call option at expiration is as follows: Stock Price at Expiration Value of Call at Expiration Greater than exercise price Less than exercise price Stock price 2 exercise price Zero Of course, that payof You have to pay for the option. wn as the option premium. Option b exercise later. Your pr equals the ultimate payoff to the call option (which may be zero) minus the initial premium. ▲ EXAMPLE 23.1 Call Options on Google In July 2010 a call option on Google stock with a January 2011 expiration and an exercise price of $460 sold for $42.50. If you bought this call, you gained the right to purchase Google shares for $460 at any time until the option expired the following January. The price of Google stock in July was $460. If the stock price did not rise by January, the call would not be worth exercising and you would lose your investment of $42.50. On the other hand, even a relatively modest rise in the stock price could give you a rich profit on your option. For example, if Google sold for $520 in January, the proceeds from exercising the call would be Proceeds 5 stock price 2 exercise price 5 $520 2 $460 5 $60 and the net profit on the call would be Profit 5 Proceeds 2 original investment 5 $60 2 $42.50 5 $17.50 In 6 months, you would have earned a return of $17.50/$42.50 5 .41, or 41%. put option Right to sell an asset at a specified exercise price on or before the expiration date. Whereas a call option giv uy a share of stock, a put option giv sell it for the exercise price. If you o xercise price, you will not want to exercise your option to sell the shares for the exercise price. The put will be left unex xpire v than the ex uy the share in the market at the low price and then exercise your option to sell it for the exercise price. The put would then be w the difference between the ex 1 European call; x xercised on or before that day , and it is then conventionally known as a wn as an American call. Chapter 23 ▲ EXAMPLE 23.2 647 Options Put Options on Google In July 2010 it cost $41 to buy a put option on Google stock with a January 2011 expiration and an exercise price of $460. Suppose that Google is selling for $400 when the put option expires. Then if you hold the put, you can buy a share of stock in the market for $400 and exercise your right to sell it for $460. The put will be worth $460 2 $400 5 $60. Because you paid $41 for the put originally, your net profit is $60 2 $41 5 $19. As a put buyer, your worry is that the stock price will rise above the $460 exercise price. If that happens, you will let the put option expire worthless and you will lose the $41 that you originally paid for it. In general, the value of the put option at expiration is as follows: Stock Price at Expiration Value of Put at Expiration Greater than exercise price Less than exercise price Zero Exercise price 2 stock price Table 23.1 shows how the v vel of the stock price on the expiration date. You can see that once the stock price is above the ex w the ex dollar decrease in the stock price. Figure 23.1 plots the values of each option on the expiration date. Table 23.2 shows the prices of nine options on Google stock in July 2010. Notice that for an orth more when the exercise price is lower, while puts are worth more when the ex . This makes sense: You would rather have the right to buy at a low price and the right to sell at a high price. Notice also that for an xercise price the longer-dated aluable. es sense. An option that expires in Januves you ev -dated option offers and more. Naturally, you w eep your options open for as long as possible. Self-Test 23.1 Selling Calls and Puts panies themselves but by other investors. If one investor buys an option on Google TABLE 23.1 How the value of a Google option on its expiration date varies with the price of the stock on that date (exercise price 5 $460) 648 Part Seven Special Topics FIGURE 23.1 Values of call options and put options on Google stock on option expiration date (exercise price 5 $460) stock, some other inv gain. We will look now at the position of the investor who sells an option.2 We have already seen that the Google calls that e ex Thus if you sell Google stock, the buyer pays you $42.50. However, in return you promise to sell Google shares at a price of $460 to the call buyer if he decides to exercise his option. The option seller’s obligation to sell Google is just the other side of the coin to the option holder’s right to buy The b to exercise; the seller receives the premium but may be required at a later date to deliver the stock for an ex w the exercise price of $460 when the option e , holders of the call will not exercise their option and you, the seller, will hav liability. However, if the price of Google is greater than $460, it will pay the buyer to exercise and you must give up your shares for $460 each. You lose the difference between the share price and the $460 that you receive from the buyer. Suppose that Google’s stock price turns out to be $520. In this case the buyer will exercise the call option and will pay $460 for stock that can be resold for $520. The buyer therefore has a payoff of $60. Of course, that positive payoff for the buyer means a negative payoff for you the seller, for you are obliged to deliver Google stock w $520 for only $460. nally paid for selling the option. In general, the seller’s loss is the buyer’s gain, and vice versa. Figure 23.2a shows the payoffs to the call option seller Figure 23.1a drawn upside down. The position of an investor who sells the Google put option can be shown in just the same w Figure 23.1b on its head. The put buyer has the right to sell a seller b TABLE 23.2 Examples of options on Google shares in July 2010 when Google stock was selling for $460 2 wn as the writer. Chapter 23 Options 649 FIGURE 23.2 Pay o sellers of call and put options on Google stock (exercise price 5 $460) ve $460 but his payoff will be negativ alls belo The worst thing that can happen to the put seller is for the stock to be w The seller would then be obliged to pay $460 for a w The payoff to the seller would be 2$460. Note that the advantage alw uyer the obligation lies with the seller. Therefore, the buyer must pay the seller to acquire the option. Table 23.3 uyers and sellers of calls and puts. Self-Test 23.2 Payoff Diagrams Are Not Profit Diagrams 23.1 and 23.2 show only possible xpires; they do not account for the initial cost of buying the option or the initial proceeds from selling it. or example, the payoff diagram in 23.1a es purchase of a call look like a sure thing—the payoff is at worst zero, with plenty of upside if Google’s stock price goes abov pr gram in Figure 23.3, which subtracts the $42.50 xpiration. uyer loses money 1 $42.50 5 $502.50. Take another example: The payoff diagram in Figure 23.2b makes selling a put look like a sure loser—the best payof Figure 23.4, which ved by the seller, sho ve $460 2 $41 5 $419. Profit diagrams like those in Figures 23.3 and 23.4 may be helpful to the options beginner, but options e w that you’ve graduated from the on’t draw them either. We will stick to payoff diagrams, because you have to focus on payoffs at expiration to understand options and to value . TABLE 23.3 Rights and obligations of various option positions 650 Part Seven Special Topics FIGURE 23.3 Pay profit for a purchaser of a call option on Google with exercise price of $460 Financial Alchemy with Options e s prospects but you perceive enough risk that a large investment in the stock would cause you sleepless nights. Here is a strate ut also buy a put option on the stock with ex vel of $460, ut you win on your investment in the stock. If the alls, your losses are limited, since the put gives you the right to sell your stock for the $460 exercise price. Thus the value of your stock-plus-put position cannot be less than $460. ay to view your overall position. You hold the stock and the put option. The ultimate value of each component of the portfolio is as follows: Value of stock Value of put option Total value Stock Price < $460 Stock Price ê $460 Stock price $460 2 stock price $460 Stock price 0 Stock price No matter how f alls, the total v all below the $460 exercise price. The value of your position when the option expires is graphed in Figure 23.5. You have downside protection at $460, but still share in an This strategy is called a protective put, because the put option gives protection against losses. Of course, such protection is not free. Look again at Table 23.2 and you will vel of $460 between as the price of a put option with ex xpiration. Some More Option Magic Look again at Figure 23.5, which sho look somewhat f FIGURE 23.4 Pay profit for a seller of a put option on Google with exercise price of $460 T xpiration from holda of Figure 23.2, which shows Chapter 23 651 Options FIGURE 23.5 Payo to protective put strategy. If the ultimate stock price exceeds $460, the put is valueless but you own the stock. If it is less than $460, you can sell the stock for the exercise price. the payoffs from holding a call option on Google stock with an ex The only difference between the tw stock and put option always provides exactly $460 more than the call option. In other words, re v same payof ve strategy of buying a call option plus investing the present value of $460 in a bank deposit. w this second strategy. If the stock price is below $460 when the option expires, your call option will be valueless but you will still have ve $460, you will take your money out of the bank, use it to exercise the call, and own the stock. The followvestment package gives you exactly the same payoffs as you get from holding the stock and a put option: Pay Stock price < $460 Call option Bank deposit paying $460 Total value 0 $460 $460 ation Stock price > $460 Stock price 2 $460 $460 Stock price If you plan to hold each of these packages until the options expire, the packages must . This gives us a fundamental relationship between the value of a call and the value of a put:3 Value of stock 1 value of put 5 value of call 1 This basic relationship between share price, call and put values, and the present value of the exercise price is called . Self-Test 23.3 3 o options hav present value of the ex order to receiv xercise price at expiration. xercise price and e 652 Part Seven Special Topics 23.2 What Determines Option Values? In Table 23.2 we set out the prices of different Google options. But we said nothing about ho et v Upper and Lower Limits on Option Values W w what an option is w xpires. Consider, for example, the option to buy Google stock at $460. If the stock price is belo xpiration date, the call will be worthless; if the stock price is above $460, the call will be w alue xercise price. The relationship is depicted by the heavy Even before expiration, the price of the option can never remain below the heavy orange line in Figure 23.6. For e at $520, it would pay any investor to buy the option, exercise it for an additional $460, and then sell the stock for $520. That would give a “mone $520 2 ($20 1 $460) 5 $40. Money machines can’t last. The demand for options from investors using this strategy w the hea The heavy orange line is therefore a lo et price of the option. Thus Lower limit on value the greater of zero or 5 (stock price 2 exercise price) of call option The diagonal blue line in Figure upper ves a higher final payoff whatever happens. If when the option expires the stock price ends up above the exerless the ex ends up below the ex ut the stock’s owner still has av . Thus the e as follows: Stock Price at Expiration Stock Pay Option Pay Extra Pay om Holding Stock rather than Option Greater than $460 Less than or equal to $460 Stock price Stock price Stock price 2 $460 $0 $460 Stock price The Determinants of Option Value 23.6. In fact, ed, upward-sloping line like the dashed curve shown in the This line begins its trav wer bounds meet (at zero). Then it rises, gradually becoming parallel to the lower bound. This line tells us an act about option values: Given the exercise price, the value of a call option increases as the stock price increases. y when the xercise price and are willing to pay more y.” If you look back at the prices of the Google ve the exercise price. But let us look more carefully at the shape and location of the dashed line. A, B, and C, ed on the dashed line. As we explain Chapter 23 Options 653 FIGURE 23.6 Value of a call before its expiration date (dashed line). The value depends on the stock price. The call is always worth more than its value if exercised now (hea ange line). It is never worth more than the stock price itself (blue line). each point, you will see why the option price has to behave as the dashed line predicts. Point A When the stock is worthless, the option is worthless. A stock price of zero means that there is no possibility the stock will ever have any future value.4 If so, the option is sure to expire unex . Point B When the stoc oaches the stock price less the present value of the exercise price. Notice that the dashed line rep23.6 ev heavy orange line representing the lo The reason is as follows: ventually be exercised. If the stock price is high enough, ex the probability that the stock price will fall below the exercise price before the option expires becomes trivial. If you own an option that you know will be exchanged for a share of stock, you vely own the stock now. t have to pay for the stock (by handing over the exercise price) until later, when formal exercise occurs. In uying the call is equivalent to buying the stock now with v . The value of the call is therefore equal to the stock price less the present value of the exercise price.5 vestors who acquire stock by way of a call option are buying on “installment credit.” They pay the , but they do not pay the exercise price until they actually exercise the option. aluable if interest rates are high and the option has a long maturity. Thus the value of a call option increases with both the rate of interest and the time to expiration. 4 If a stock can be worth something in the future, then investors will pay something for it today, although possibly a very small amount. 5 W vidends until after the option expires. If dividends were paid, you would wn the stock because the option holder misses out on any dividends. 654 Part Seven Special Topics Self-Test 23.4 Point C The option price always exceeds its minimum value (except at expiration or when the stock price is zero). We have seen that the dashed and heavy lines in 23.6 A), but elsewhere the lines diverge; xceed the minimum value given by the heavy orange line. You can see why by examining point C. At point C, the stock price exactly equals the ex The option therefore would be worthless if it expired today. However, suppose that the option will not e w what the stock price will be at the expiration date. There is roughly a 50% chance that it will be higher than the exerwer. The possible payof are therefore: Outcome Pay Stock price rises (50% probability) Stock price falls (50% probability) Stock price 2 exercise price (option is exercised) Zero (option expires worthless) ve payof orst payoff is zero, then the option must be valuable. C exceeds its lower bound, which at point C xceed the lower bound as long as there is time left before expiration. height of the dashed curve (that is, of the difference between actual and lower-bound value) is the likelihood of substantial mov by more than 1% or 2% is not w halve or double is very valuable. For e x xpires. The possible payoffs to the option are as follows: Stock price at expiration Call value at expiration $400 $520 0 $ 60 No The average greater. In this case the payof Stock price at expiration Call value at expiration option is valueless re the option is w ut the volatility is $340 $580 0 $120 . w the exercise price when the option expires, the . However, its of stock price advances. Thus in our example ut it is w Therefore, volatility helps the option holder. Chapter 23 Options 655 TABLE 23.4 What the price of a call option depends on The probability of large stock price changes during the remaining life of an option depends on two things: (1) the v per unit of time and (2) the length of time until the option expires. Other things equal, you would like to hold an option on a volatile stock. Given volatility, you would like to hold an option with a long life ahead of it, since that longer life means that there is more opportunity for the The value of an option increases with both the v xpiration. It’ Therefore, we have summed them up in Table 23.4. Self-Test 23.5 Option-Valuation Models If you want to value an option, you need to go beyond the qualitative statements of Table 23.4 xact option-valuation model—a formula that you can plug alue. Valuing complex options is a high-tech business and well beyond the scope of this book. Our aim here is not to make you into instant option whizzes, but we can illustrate the basics of option valuation by w xample. The trick to option valuation is to f wing and an investment in the stock that exactly replicates the option. The nearby box illustrates a simple version of one of these option-valuation models. This model achiev e on only two values at the expiration date of the option. This assumption is clearly unrealistic, b ge number o values in our example. which showed that ev , you can still replicate an option by a series of levered investments in the stock. The Black-Scholes v ers to value a wide v 6 The box on page 657 in economics for their work on the dev shows you how to set up a Black-Scholes calculator in Excel. Today y ever-more-sophisticated v ets. As computer power continues to increase, these models can be made more complex and increasingly accurate. 6 Fischer Black passed away in 1995. FINANCE IN PRACTICE A Simple Option-Valuation Model TABLE 23.5 Self-Test 23.6 656 SPREADSHEET SOLUTIONS Using the Black-Scholes Formula www.numa.com Spreadsheet Questions 23.3 Spotting the Option In our discussion so far we may have giv to recognize the dif Unfortunately, they rarely come with a lar the problem is to identify the option. W Y options in earlier chapters. uy or sell shares. But once you hav ind that the v v y of these Options on Real Assets In Chapter 10 we pointed out that the capital investment projects that you accept today ve tomorrow. Today’s capital budgeting decisions more v real options Options to invest in, , or dispose of a capital investment project. v t. gy—is more v xible or generates ne If you look out for real options, you’ xible one. real options. v udgeting decision. In Chapter 10 we looked at several ways that companies may b of two types of real options that we introduced in that chapter. 657 FINANCE IN PRACTICE Allegheny Acquires a Real Option The Option to Expand Many capital investment proposals include an option to expand in the future. For instance, some of the world’s largest oil reserves are found , in many cases the cost of e ing oil is higher than the current mark s estimate of the likely price in the future. Yet oil companies hav ves the companies an option. If prices remain below the cost of extraction, the Athabasca sands will remain undeveloped. But if prices rise above the cost of extraction those land purchases could prove very valuable. Thus, ownership giv option—a call option to extract the oil. The Option to Abandon Suppose that you need a ne turboencab You have a choice of designs. If design A is chosen con. Design B is more expensive but you can wait a year A. But suppose that there is some possibility that demand for turboencabulators will fall of s time you will decide the plant is not required. Then design B may be preferable because it giv y time xt 12 months. Y x v mak v wnside exposure. Self-Test 23.7 658 Chapter 23 659 Options Options on Financial Assets vestors to . The y’ ws. However, f issue options to their managers or investors, and these do have a potential impact on ws. Here are a few examples. Executive Stock Options as as dw w and shares w s compensation is unusual, but these days the chief executiv gely with stock options. These stock options are valuable and therefore are an expense just lik wages. The Financial ASB) now requires companies to air value of option grants and to recognize this value when calculating expenses. For example, in fiscal 2010 Oracle granted options to its directors, management, and employees to b y’s stock. Oracle’s accounts showed that according to the Black-Scholes model the total value of these options was $375 million. compensation. There is nothing wrong with that if the options encourage managers to work hard to increase the value of their companies’ stock. However, in recent years gally boosted the value of the stock options that they have given to managers by backdating the grant of their executive stock options. The nearby box discusses the backdating scandal. warrant Right to buy shares from a company at a stipulated price before a set date. Warrants convertible bond Bond that the holder may exchange for a specified amount of . Conver tible Bonds The convertible bond is a close relative of the bondw ws the bondholder to exchange the bond for a given number of Therefore, it is a package of a straight bond and a call option. The exercise price of the call option is the value of the “straight bond” (that is, a bond that is not conv vert if the value of the stock to which the investor is entitled exceeds the value of the straight bond. The owner of a conv s stock. So does the owner of a package of a bond and a w wever ferences, the most important being that a conv s owner must give up the bond to exercise the option. The owner of a package of bonds and w xercises the w eeps the bond. A warrant is a long-term call option on the company’s stock. For examTreasury receiv T buy one share in the bank for $13.30 at an In March 2010 the T vestors for $8.35 each. At that time the price of Bank of America stock was $16.40 a share. So investors who bought the w ould realize a profit if the stock price rose above $13.30 1 $8.35 5 $21.65. W y s bondholders warrants in the reorganized company as part of the settlement. At other times w v y issues a bond, it will occasionally add some w .” Since these warrants are valuable to investors, the than for the bond on its own. Managers sometimes look with delight at this higher price, for the w FINANCE IN PRACTICE The Options Backdating Scandal ▲ EXAMPLE 23.3 Convertible Bonds In March 2009, the giant aluminum company Alcoa issued $575 million of 5.25% convertible bonds maturing in 2014. Each of these bonds can be converted before maturity into 155.49 shares of Alcoa stock. In other words, the owner of the convertible has the option to return the bond to Alcoa and receive 155.49 shares in exchange. The number of shares that are received for each bond is called the bond’s conversion ratio. The conversion ratio of the Alcoa bond is 155.49. In order to receive 155.49 shares of Alcoa stock, you must surrender bonds with a face value of $1,000. Therefore, to receive one share, you have to surrender a face amount of $1,000/155.49 5 $6.43. This figure is called the conversion price. Anybody who originally bought the bond at $1,000 in order to convert it into 155.49 shares paid the equivalent of $6.43 a share. As we write this in July 2010, Alcoa’s stock price is $10.40. So, if investors were obliged to convert their bond today, their investment would be worth 155.49 3 $10.40 5 $1,617. This is the bond’s conversion value. Of course, investors do not need to convert in 2010. They obviously hope that Alcoa’s stock price will zoom up, making conversion even more profitable. But they have the comfort of knowing that if the stock price zooms down, they can choose not to convert and simply hold on to the bond. The value of the bond if it could not be converted is known as its bond value. If Alcoa’s bond could not be converted, it would probably sell in July 2010 for about its face value of $1,000. 660 Chapter 23 661 Options Since the owner of the conv establishes a lo ways has the option not to conv , to the price of a conv orth much. In the extreme case where the f orthless. When the firm does well, conversion value exceeds bond value. In this case the investor would choose to conv alue exceeds conversion value when the firm does poorly vestor would hold on to the bonds if forced to choose. Conv ve to make a now-or-never choice for or against conversion. They can wait and then, with e whatev ve them the highest payoff. Thus a convertible is always worth more than both its bond value and its conversion value (e W v straight bond and an option to b xchange for the straight bond. The v v s mark alue. Self-Test 23.8 callable bond Bond that may be repurchased by the issuer befor specified call price. Callable Bonds Unlike w v ve the investor an option, a callable bond gives an option to the issuer. A company that issues a callable uy the bond back at the stated exercise or “call” price. Therefore, you can think of a callable bond as a package of a straight bond (a bond that is not callable) and a call option held by the issuer. viously attractiv . If interest rates decline and bond prices rise, the compan a fix Therefore, the option to call the bond puts a ceiling on the bond price. y issues a callable bond, inv w The alue of the call option that investors have giv y: Value of callable bond 5 value of straight bond 2 value of the issuer’s call option Self-Test 23.9 www.mhhe.com/bmm7e SUMMARY QUESTIONS QUIZ PRACTICE PROBLEMS www.mhhe.com/bmm7e FIGURE 23.7 FIGURE 23.8 www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e CHALLENGE PROBLEMS www.mhhe .com/bmm7e FIGURE 23.9 www.mhhe.com/bmm7e www.mhhe.com/bmm7e WEB EXERCISES finance.yahoo.com finance.yahoo.com SOLUTIONS TO SELF-TEST QUESTIONS www.mhhe.com/bmm7e www.mhhe.com/bmm7e SOLUTIONS TO EXCEL SPREADSHEET QUESTIONS 673 Chapter 24 Risk Management a 50% decline in profits when the dollar unexpectedly strengthens against other w much of that decrease is due to the exchange rate shift and how much fect of exchange s probably bad management. If it wasn’t protected, you have ea ve been if the xchange rate movements?” Finally, hedging e vents can help focus the operating manager’s attention. We know we shouldn’t w vents outside our control, but most of us do anyway. It’s naive to expect the manager of the e vision not to w e vements if his bottom line and bonus depend on them. The time spent w y hedged itself against such movements. wing questions: • What are the major risks that the company faces and what are the possible consequences? y. • Is the company being paid for taking these risks? void all ut if they can reduce their e compensating rew y can af ger bets when the odds are stacked in their favor. • Can the company take any measures to reduce the pr to limit its impact? For example, most b to prev ire and invest in backup f occur. • Can the company purchase fairly priced insur Insurance companies have some adv , they may be able to ferent insurers. • Can the company use derivatives, such as options or futures, to hedge the risk? In the remainder of this chapter we explain when and how derivatives may be used. The Evidence on Risk Management There are three principal w uildxibility into its operations. For example, a petrochemical plant that is designed to use either oil or natural gas as a feedstock reduces the threat of an unfavorable shift y that reduces the risk of a disaster by test marketing a new product before launching it nationally real options A second way to reduce risk is to buy an insurance polic derivatives Securities whose payo are determined by the values of other financial variables such as prices, exchange rates, or interest rates. known collectively as derivatives, and they include options, futures, and swaps. A survey of the world’ gest companies found that almost all the companies 2 Eighty-five percent employ them to vatives in some w v Risk policies differ. For example, some natural resource companies w hedge their e ander as they may. Explaining why some hedge and others don’t is not easy y had high debt ratios, no debt ratings, and low dividend payouts.3 It seems that for these and to improve 2 3 International Swap Dealers Association (ISDA), “2003 Derivatives Usage Survey,” www.isda.org. G. D. Haushalter, “Financing Policy, Basis Risk and Corporate Hedging,” J 2000), pp. 107–152. inance 674 Seven Special Topics 24.2 Reducing Risk with Options In the last chapter we introduced you to put and call options. Managers re Man v Petrochemical P hea Petrochemical b exercise price of $90. uy xchanges, but often the To protect itself against such increases ve the $90 exercise price when the options expire, Petrochemical will exercise the options and will receive the difference between the oil x alls below the exercise price, the options will expire w The net cost of oil will therefore be: You can see that by b in the oil price while continuing to benef discard its call option and buy its oil at the mark can ex an attractive of the options. Consider now the problem of Onne all, it can wever, it Therefore, options create s; it loses when oil prices fall and Onnex w put options that give it the right to sell oil at an exerall, it will exercise the put. If the et price: If oil prices rise, Onne the payoff of the put option exactly offsets the rev v option. all belo all. As a result, Onnex xercise price of the put Once again, you don’t get something for nothing. The price that Onnex pays for insurance against a fall in the price of oil is the cost of the put option. Similarly, the price that Petrochemical paid for insurance against a rise in the price of oil was the cost of the call option. Options provide protection against adverse price changes for a fee—the option premium. Notice that both Petrochemical and Onnex use options to insure against an adverse move in oil prices. But the options do not remove all uncertainty. For example, Onnex may be able to sell oil for much more than the ex 675 Chapter 24 Risk Management rev 24.1 v As prices f x’ gy. P a shows the xposed to oil s revenue. But, as panel b s exposure. P c sho venues after it buys the put option. F venues are $90,000. But revenues rise $1,000 for ev ve $90. c should be f Think back to the protective In both cases, the put pro alue of the overall position. Self-Test 24.1 FIGURE 24.1 Onnex can buy put options to place a floor on its overall revenues. 676 Seven Special Topics 24.3 Futures Contracts futures contract Exchange-traded promise to buy or sell an asset in the future at a prespecified price. Suppose you are a wheat f . You are optimistic about next year’s wheat crop, but still you can’t sleep. You are w may have f . The cure for insomnia is to sell wheat es. In this case, you agree to deliver so many bushels of wheat in (say) September at a price that is set today. Do not confuse this futures contract with an option, where the holder has a choice whether to make deliv deliv xed selling price. buy est. If she would lik buying wheat futures. In other w e deliv xed today. The miller also does not have an option; if she still holds the futures contract when it matures, she is obliged to take deliv . Let’s suppose the f e a deal. They enter a futures contract. What happens? First, no money changes hands when the contract is initiated.4 The uy wheat at the futures price on a stated e date (the contract maturity date). The f contract is a binding obligation, not an option. Options give the right to buy or sell if b The futures contract requires the f Just remember, no sell and the miller to buy re money changes hands when a futures contract is entered into. The contract is a binding obligation to buy or sell at a fixed price at contract matur . ference between the initial futures price and the ultimate price of the asset when the contract matures. For example, if the futures price is originally $7 and the market price of wheat turns out to be $7.50, the f vers and the miller receives the wheat for a price $.50 below market value. The f ushel as a result of the locked in turns out to exceed the price that could have rity. Conversely, the b et price of the 5 initial futures price 2 ultimate market price 5 ultimate market price 2 initial futures price Now it is easy to see how the f hedge. Consider the f s ov ws: The profits on the futures contract offset the risk surrounding the sales price of wheat and lock in total rev , the miller’s all-in cost xed at the futures price. Any increase in the cost of wheat will be offset by a commensurate increase in the profit realized on the futures contract. 4 Actually y do need not suf gin account. 677 Chapter 24 Risk Management Both the f ve The f uying wheat futures.5 ▲ EXAMPLE 24.1 Hedging with Futures Suppose that the farmer originally sold 5,000 bushels of September wheat futures at a price of $7 a bushel. In September, when the futures contract matures, the price of wheat is only $6 a bushel. The farmer buys back the wheat futures at $6 just befor , giving him a profit of $1 a bushel on the sale and subsequent repurchase. At the same time he sells his wheat at the spot price of $6 a bushel. His total receipts are therefore $7 a bushel: You can see that the futures contract has allowed the farmer to lock in total proceeds of $7 a bushel. Figure 24.2 illustrates how the futures contract enabled the farmer in Example 24.1 to hedge his position. Panel a shows how the value of 5,000 bushels of wheat v The v very dollar increase in wheat prices. Panel b is the profit on a futures contract to deliver 5,000 bushels of wheat at a futures price of $7 per bushel. The profit will be zero if the ultimate price The profit on the contract to deliver at $7 rises by $5,000 for every dollar the price of wheat falls below $7. The exposures to the price of wheat depicted in panels a and b obviously cancel out. Panel c shows that the total value of the 5,000 bushels plus the futures position is unaffected by the ultimate price of wheat, and equals $7 3 5,000 5 $35,000. In other words, the farmer has locked in proceeds of $7 per b The Mechanics of Futures Trading In practice the f ould not sign the futures contract face-to-face. Instead, each would go to an organized futures exchange such as the Chicago Board of Trade. Table 24.1 shows the price of wheat futures at the Chicago Board of Trade in August very was about $7 a bushel. Notice that there is a choice of possible deliv xample, you were to sell wheat for deliv in March 2011, you w TABLE 24.1 The price of wheat futures at the Chicago Board of Trade on August 16, 2010 Source: The Chicago Board of Trade Web site, www. cmegroup.com. 5 or e many bushels of wheat he will produce. w for sure how 678 Seven Special Topics FIGURE 24.2 The farmer can use wheat futures to hedge the value of the crop. See Example 24.1. The miller w deliv or example, in the case v ushels of wheat of a Toledo, or Burns Harbor. When you b xed today, but payment is not made until later. However, you will be asked to put up some cash or securities as margin gain. marked to market. This means that each day any prof xchange any losses and receive an or e ver 5,000 bushels of wheat at $7 a bushel. Suppose that the next day the price of wheat futures increases to $7.05 a bushel. The f w has a loss on his sale of 5,000 3 $.05 5 $250 and must pay 679 Chapter 24 Risk Management spot price Price that is paid for immediate delivery. this sum to the exchange. Y uying back his futures position each day and then opening up a new position. Thus after the first day the f ushel and now has an obligation to deliver wheat for $7.05 a bushel. Of course our miller is in the opposite position. The rise in the futures price leaves her with a pr of 5 cents a bushel. The exchange will therefore pay her this profit. In ef w contract to take delivery at $7.05 a bushel. The price of wheat for immediate deliv spot price. When the f e for his wheat may be very different from the spot price. But the future eventually becomes the present. As the date for deliv e a spot The f ait until the futures contract matures and then deliver wheat to the buyer. But in practice such deliv venient for the f .6 Self-Test 24.2 Commodity and Financial Futures We have shown how the f their risk. It is also possible to trade futures in a wide v such as sug , soybean oil, pork bellies, orange juice, crude oil, and copper. Commodity prices can bounce up and down like a bungee jumper. For example, in w or a large user of copper reduces its exposure to mov A number of copper producers have also found that hedging increases their debt capacity y Equinox needed to borro Equinox reduce its e For man use xchange rates have You can es Financial futures are similar to es, but instead of placing an order to e date, you place an order to buy or sell a financial asset at a future date. You can use financial futures to protect yourself against fluctuations in short- and long-term interest rates, exchange rates, and the level of share prices. Figure 24.3 shows the explosive growth of w 6 simply receiv purchase the asset. , you cannot deliver the asset. Table 24.2 uyer 680 Part Seven Special Topics Self-Test 24.3 FIGURE 24.3 Worldwide turnover in futures contracts has expanded sharply. Source: Bank for Inter , .bis.org. TABLE 24.2 Some financial futures contracts Key to abbreviations: CBT Chicago Board of Trade CME Chicago Mercantile Exchange 24.4 Forward Contract Each day billions of dollars of futures contracts are bought and sold. We have seen that contract in Table 24.1), and the contract size is standardized. For example, a contract may call for delivery of 5,000 bushels of wheat, 100 ounces of gold, or 62,500 British forward contract Agreement to buy or sell an asset in the future at an agreed price. able to buy or sell a forward contract. Forward contracts are custom-tailored futures contracts.7 You can write a forward contract with any matur e for delivery of an For e Y to buy yen forw At the end of the 3 months, you pay the agreed sum and take delivery of the yen. 7 ed to market. Thus Chapter 24 Risk Management ▲ EXAMPLE 24.2 681 Forward Contracts Computer Parts Inc. has ordered memory chips from its supplier in Japan. The bill for ¥53 million must be paid on July 27. The company can arrange with its bank today to buy this number of yen forward for delivery on July 27 at a f ard price of ¥110 per dollar. Therefore, on July 27, Computer Parts pays the bank $53 million/ (¥110/$) 5 $481,818 and receives ¥53 million, which it can use to pay its Japanese supplier. By committing f ard to exchange $481,818 for ¥53 million, its dollar costs are locked in. Notice that if the firm had not used the forward contract to hedge and the dollar had depreciated over this period, the firm would have had to pay a greater amount of dollars. For example, if the dollar had depreciated to ¥100/dollar, the firm would have had to exchange $530,000 for the ¥53 million necessary to pay its bill. The firm could have used a futures contract to hedge its foreign exchange exposure, but standardization of futures would not allow for delivery of precisely ¥53 million on precisely July 27. The most active trading in forw ut in recent years ve ard rate agreements that allow them to ance the interest rate at which they borrow or lend. 24.5 Swaps Suppose Computer P bonds to help f w plant. (Recall from Chapter 14 that e interest payments that go up and down with the general level of interest rates. swap Arrangement by two counterparties to exchange one stream of cash flows for another. more volatile, and she would lik s interest expenses. One approach would be to b w issue of xed-rate debt. But it is costly to issue ne uying back the outstanding bonds in the market will result in considerable trading costs. A better approach to hedge out its interest rate e interest rate swap. x that is tied to the level of interest rates. s interest e w from the swap agreement will rise as well, offsetting its exposure. LIBOR, or London Interbank Offer Rate, is the interest rate at which banks borrow interest rate in the swap market.) s interest expense each year therefore equals ould like to transform this obligation into one aps mark xed.” ap agreement to pay 5% on “notional ap dealer and receive payment of the LIBOR rate on counterparties in the swap. 3 $100 million and receives LIBOR 3 $100 million. s net cash payment to the dealer is therefore (.05 2 LIBOR) 3 $100 million. (If LIBOR e ves mone y to the dealer.) Figure 24.4 ws paid by Computer P ap dealer. means that Computer P 682 Part Seven Special Topics FIGURE 24.4 Interest rate swap. Computer Parts currently pays the LIBOR rate on its outstanding bonds (the arrow irm enters a swap to pay a fixed rate of 5% and receive a floating rate of LIBOR, its exposure to LIBOR will cancel low will be a fixed rate of 5%. Table 24.3 shows Computer P s net payments for three possible interest rates. The total payment on the bond-with-swap agreement equals $5 million regardless of the interest rate. The sw xedrate debt with an effective coupon rate of 5%. way its interest rate exposure without actually ha fixed-rate bonds. Swaps offer a much cheaper w ”8 There are many other applications of interest rate swaps. A portfolio manager who ut is w xed rate and receive v rate portfolio (see Self-Test 24.4). Or a pension fund manager might identify some mone xcellent yields compared with other wever, the manager might believe that shortThe fund can receive the interest rate on these high-yielding securities and enter a swap in which it receiv xed rate and wer-yielding money market security. It thus captures the benefit of the advantageous relative yields on its securities but still establishes a portfolio with the fix Self-Test 24.4 yv ap. For example, currency swaps xed y (which also may be tied allo TABLE 24.3 An interest rate swap can transform floatingrate bonds into synthetic fixed-rate bonds. 8 You might wonder what’ wishes to receive x . it by charging a bid-ask xed rate and pay LIBOR. xed rate and receiv xed and equal to .1% of notional principal. ves Chapter 24 Risk Management x 683 These swaps can therefore be used to manage exposure to e ▲ EXAMPLE 24.3 Currency Swaps Suppose that the Possum Company wishes to borrow Swiss francs (SFr) to help finance its European operations. Since Possum is better known in the United States, the financial manager believes that the company can obtain more attractive terms on a dollar loan than on a Swiss franc loan. Therefore, the company borrows $10 million for 5 years at 5% in the United States. At the same time Possum arranges with a swap dealer to trade its futur or Swiss francs. Under this arrangement the dealer agrees to pay P icient dollars to service its dollar loan, and in exchange Possum agrees to make a series of annual payments in Swiss francs to the dealer. Possum’s cash flows are set out in Table 24.4. Line 1 shows that when Possum takes out its dollar loan, it promises to pay annual interest of $.5 million and to repay the $10 million that it has borrowed. Lines 2a and 2b show the cash flows from the swap, assuming that the spot exchange rate for Swiss francs is $1 5 SFr2. Possum hands over to the dealer the $10 million that it borrowed and receives in exchange 2 3 $10 million 5 SFr20 million. In each of the next 4 years the dealer pays Possum $.5 million, which it uses to pay the annual interest on its loan. In year 5 the dealer pays Possum $10.5 million to cover both the final year’s interest and the repayment of the loan. In return for these future dollar receipts, Possum agrees to pay the dealer SFr1.2 million in each of the ne ears and SFr21.2 million in year 5. T ect of Possum’ o steps (line 3) is the conversion of its 5% dollar loan into a 6% Swiss franc loan. The device that makes this possible is the currency swap. Self-Test 24.5 24.6 Innovation in the Derivatives Market Almost every day some new derivative contract seems to be invented. may be just a few private deals between a bank and its customers, but if the contract proves popular, one of the futures exchanges may try to muscle in on the business. Derivativ ace businesses and then design a contract that will allow them to lay off these risks. For example, a major hazge customer will get into dif ault on its debts. Credit default swaps offer a way for the lender to TABLE 24.4 Cash flows from Possum’s dollar loan and currency swap (figures in millions) 684 Seven Special Topics insure against such a default. The pro wer defaults on its debts and in return char We ault swaps in Chapter 6. olatile. W roughly doubled in 2008 and halved in 2009 before surging again in early 2010. The futures exchanges reasoned that both producers and users might welcome a contract vements. Therefore, in July 2010 the New York Mercantile Exchange (part of the CME Group) introduced a futures contract Real estate b uilders w wouldn’t it be nice if they could stop w es against these Well, now they can do so by dealing in real estate futures or options on the participants to protect themselv It seems to be v ficult to predict which new contracts will succeed and which will bomb. By the time you read this, iron ore contracts may have been forgotten, and ev w gro et in vatives. ord. 24.7 Is “Derivative” a Four-Letter Word? xamples of the f wed how derivatives—futures, options, or swaps, for example—can be used to reduce business risk. However, if you were to copy the f fsetting holding of wheat, you would not be reducing risk; you would be speculating. A successful futures market needs speculators who are prepared to tak provide the f y need. For example, if an excess of f ould be forced down until enough speculators were tempted to b uy wheat futures, the reverse will happen. wn in to sell. ving derivatives market, but it can get comor e y, per; its chief trader wn in the business simply as “Mr. Copper,” was lauded for his utions to f its. However, in June 1996 the copper market was battered by the revelation that the man with the Midas touch had managed to hide losses amounting to about $2 billion. Sumitomo has plenty of company. merchant bank, became insolvent. The reason: Nick Leeson, a trader in its Singapore of et index. The same year Daiwa Bank reported that a bond trader in its New York of managed to hide losses over 11 years of $1.1 billion. In 2008 the French bank Societé Generale joined the billion-dollar club when it reported that one of its derivativ ers had lost a record $7.2 billion on unauthorized trades. aged to lose well over $1 billion. matter that is subject to debate. ets to hedge, but it still manas hedging, however, is a vatives? Of course not. But they do illustrate that derivatives need to be used with care. Speculation is foolish unless you have reason to believe that the odds are stacked in your favor. If you ar er informed than the highly paid professionals in banks and other institutions, you should use derivatives for hedging, not for speculation. FINANCE IN PRACTICE Meltdown at Metallgesellschaft SUMMARY www.mhhe.com/bmm7e QUESTIONS QUIZ PRACTICE PROBLEMS www.mhhe.com/bmm7e www.wsj.com CHALLENGE PROBLEM WEB EXERCISES www.cmegroup.com www.mhhe.com/bmm7e www.bis.org SOLUTIONS TO SELF-TEST QUESTIONS FIGURE 24.5 www.mhhe.com/bmm7e CHAPTER 25 PA R T E I G H T Conclusion W Too bad Einstein didn’t tackle the unsolved problems of finance. 692 Eight Conclusion 25.1 What We Do Know: The Six Most Important Ideas in Finance What would you say if you were ask Here is our list. Net Present Value (Chapter 5) et. Similarly w the value of a used car, you look at prices in the second-hand w the v w, you look (remember, those highly paid investment bank w dealers). If you can b ws for your shareholders at a cheaper price than they would hav et, you have increased the value of their investment. This is the simple idea behind net present value (NPV). When we calculate a project’s NPV orth more than it costs. W estimating its v ws would be worth if a claim on v ets. cost of capital—that is, at the e ving the v fer the same e vestors in the project could expect Like most good ideas, the net present v ers, who may have v They giv vious when you think about it. ws thousands of shareholdvels of wealth and attitudes tow gate its operation to a professional manager. alue.” Risk and Return (Chapters 11 and 12) That’s nonsense. If the capital asset pricing model had never been inv ould be essentially the same. The attraction of the model is that it giv vestment. vely simple idea. can diversify away and those that you can’t. The only risks people care about are the ones that they can’t get rid of—the nondiversifiable ones. You can measure the nondiver , or market, vestment by the extent to which the value of the investment is affected by a change in the aggregate value of all the assets in the economy. This is called the beta of the investment. The required return on an asset increases in line with its beta. y people are w iculties of estimating a project’s beta. The , we will have w, b ticated theories will retain the tw • Investors don’t lik • vestors cannot get rid of. Efficient Capital Markets (Chapter 7) v tion and respond rapidly to ne available. This Chapter 25 693 What We Do and Do Not Know about Finance v “av initions of ” licly av Don’ or costs; it doesn’ ficient-market idea. It doesn’t say that there are no taxes t some clever people and some stupid ones. It ets is v y alues of assets on the basis of the best information available to investors. The ef et hypothesis has been extensiv ve revealed several pricing “anomalies, it opportunities with simple investment strategies. We showed you just a few examples of these anomalies in these puzzles. Does this mean that inv ving easy money on the table? Unfortunately for all of us, this body of evidence has not translated into easy money. Superior returns are elusive, and only a few mutual-fund managers have been able to y consistency k MM’s Irrelevance Propositions (Chapters 16 and 17) vance propositions of Modigliani and Miller (MM) imply that you can’t increase v w available to investors. Financing decisions that simply repackage the same ws don’t add value. Financial managers often ask how much their company should borrow. MM’s wing does not alter the total w generated by s assets, it does not af alue. gument to show that dividend policy does alue unless it af w available to present and future shareholders. vidend and gets the cash back by . The same ideas can be run in rev ws doesn’t add value, neither does combining dif w streams. This implies that you can’t increase v o whole companies together unless you thereby increase w. gers solely for diversification. Y v ation of value.” You can’t increase value simply by putting two companies together, nor can you create v w into several pieces, for example, into debt and equity claims. Option Theory (Chapter 23) In ev v versation we often use the word “option” as synonymous with “choice” having a number of options. In f an option ed today w that it is often w b w. We saw in Chapters 10 and 23 that companies are willing to pay e projects that giv xibility. Also, many securities provide the company or the investor with options. For e v ves the owner an option to e y used to. This is y increasingly use options to help limit risk. 694 Eight Conclusion ware that man great f v or examver its salvage value is a put option. v w how to value them. One of the as the discov alue options. We revie value in Chapter 23. Agency Theory fort involving many players, including management, emplo y pull together. F v and ho v v wn as ag . Consider, for e ers. The shareholders (the principals) want managers (their agents irm value. T alue they have added. Moreover interests f en over and they will be turfed out. Although we didn’t allocate a separate chapter to agency theory helped us to think about such questions as these: • How can an entrepreneur persuade venture capital investors to join in his or her • • ine print in bond agreements? (Chapter 16) do they change management’s incentives to maximize company value? (Chapter 21) will, the s job. If after reading this book you really w how to apply them, you hav 25.2 What We Do Not Know: Nine Unsolved Problems in Finance wn is never e could go on forever research. ed problems that seem ripe for productive What Determines Project Risk and Present Value? A good capital investment is one that has a positive NPV. We have talked at some length about how to calculate NPV, but we have given you very little guidance about ho ve-NPV projects, except to say in Chapter 10 that projects have positiv ve advantage. But why do some compaall gains, and when can the created, and planned for? What is their source, and how long do they persist before competition wears them away? V wn about an questions. Here is a related question: vely safe? In Chapter 12 we suggested a fe ferences Chapter 25 695 What We Do and Do Not Know about Finance in operating leverage, for e xtent to which a project’ ws . ut we have as yet no general procedure for estimating project betas. Assessing project risk is . Risk and Return—Have We Missed Something? w ws of value which ” Econor example, the capital asset pricing model is fect of risk on the value of an asset, but prove or disprove conclusively. It appears that av w-beta stocks w. But this could be a problem with the way the tests are conducted and not with the model itself. We also described the puzzling discovery that e alue of the stock to its market value. Of course, these findings could be just a coincidence—an accidental result that is unlikely to be repeated. But if they are not a coincidence, the capital asset pricing model cannot be the whole truth. Perhaps firm size and the book-to-market ratio are related to some other v x xpected returns demanded by investors. But we cannot yet identify v x ve that it matters. Meanwhile, work is proceeding on the theoretical front to relax the simple assumpyou love f e sense for you to b ev ge fraction of your personal wealth and leaves you with a relatively undiv wever hedged against a rise in the price Your hobby will cost you more in a bull market for wine, b e in the chateau will mak . vely undiv We would not expect you to demand a s undiv In general, if two people have different tastes, it may make sense for them to hold different portfolios. You may hedge your consumption needs with an investment in vest in Baskin-Robbins.1 The capital asset pricing model isn’t rich enough to deal with such a world. It assumes that all investors have similar tastes; the “hedging motive” does not enter, and therefore the Merton has e motive.2 If enough investors are attempting to hedge against the same thing, this wever, it is not yet clear who is hedging against what, so the model remains difficult to test. Given the rich possibilities for these extra hedging motives, there are many plausible alternative risk measures beyond beta and many potential competitors to the simple capital asset pricing model. In the meantime, we must recognize the CAPM for what it is: an incomplete but extremely useful w message, that div t matter v 1 2 Asset Pricing Model,” Econometrica 41 (1973), pp. 867–887. 696 Eight Conclusion Are There Important Exceptions to the Efficient-Market Theory? The ef exceptions. ve, but no theory is perfect—there must be xceptions could simply be coincidences, for the more that ely to or example, there is e w moons have been ve that this is anyroughly double those around full moons.3 It seems dif thing other than a chance relationship—fun to read about b inv . We sa believ et is inef vestors have consistently been slo t expect investors never to mak es. If they have been slo interesting to see whether they learn from their mistak ciently in the future. v of human behavior. For e emphasis on recent events when they are predicting the future. We don’t yet know how far such beha vels. ASDAQ Composite Index rose 580% from the beginning of 1995 to its peak in xtreme price mov e aluation techniques. However liable to speculative bubbles, where inv xuberance. No verexcited, but why don’t professional investors bail out of the ov y would do so if it were their own money at stake, but maybe there is something in the way that w ve a full understanding of why asset prices sometimes seem to get so out of line with what fs. Is Management an Off-Balance-Sheet Liability? In Chapter 7, we ar et v alue, alue. For e e here, yet the alue of the fund’s portfolio. Other examples abound. For instance, real estate stocks often appear to sell for less et v et values of et values of their oil reserves. Analysts joked that you could buy oil cheaper on Wall Street than in west Texas. v et v with the value of its underlying assets. alue is harder to measure. One possibility is that gaps between market v alue added of management. Of course, if market value is less than the value of assets, then 3 K. Yuan, L. Zheng, and Q. Zhu, “ v Empirical Finance, 13 (2006), pp. 1–23. ” Journal of Chapter 25 What We Do and Do Not Know about Finance 697 the market seems to view managers’ value added as negative. Perhaps inv w w for their own interests fully e v yees coinv vestors. So far, we know very little about how this coinvestment works. How Can We Explain Capital Structure? Modigliani and Miller’ alue of a ges, and the costs that it incurs. Financing decisions merely affect the w ws are packaged for distribution to investors. What goes into the package is more important than the package itself. Does it really not matter ho ws? We have come across several reasons why it may matter. T . Debt provides a corporate tax shield, and this tax shield may more than compensate for any e the inv y costs. Perhaps dif relativ , none of these possibilities has been either proved relevant or definitely excluded. The upshot of the matter is that we still don’t hav gument on the subject. How Can We Resolve the Payout Controversy? We spent all of Chapter 17 on dividend policy without being able to resolve the dividend controversy. Many people believe di ve they are v s investfected, the payout decision is lar vant. If pressed, we e the middle view, but we can’t be dogmatic about it. whether di when es sense to pay out high or low dividends. Investors in mature f w investment opportunities may welcome the financial discipline imposed by a high dividend payout, The w small high-gro ute cash has changed over the last few decades. An y dividends, while the volume of stock vestment opportunities, b y may help us to understand how that policy affects f alue. How Can We Explain Merger Waves? There are many plausible reasons why two firms might wish to merge. If you single out a particular merger, it is usually possible to think up a reason why that merger could make sense. But that leaves us with a special hypothesis for each merger. What we need is a general hypothesis to explain merger waves. For example, nobody seemed to be merging in 2002, yet only 4 years later, mergers were back in fashion. Why? W ashions. For example, from time to 698 Eight Conclusion speculative ne have been developing new theories of speculative b help to e ashions. What Is the Value of Liquidity? Unlike Treasury bills, cash pays no interest. On the other hand, cash provides more T The value of this liquidity declines as you hold increasing amounts of cash. When you hav extra can be extremely useful; when you hav y additional liquidity is not w , we don’ w to value t say how much cash is enough or ho orking capital management we lar aguely of the need to ensure an “adequate” liquidity reserve. wledge of liquidity would also help us to understand how corporate We already kno lower prices than T . However T ge to be e y will default. It seems likely that the Treaw how to price differences in liquidity, we can’t really say Investors seem to value liquidity much more highly at some times than at others. ind it v w. This hapv rising default lev et. Many banks that had sold these inancial institutions both in the United States and abroad. As the music began to stop, no one w reluctant to quote a price for buying or selling bonds, and banks became w lending to each other. w at .1% above the Federal Reserve’s target interest rate found that they now needed to pay a spread of over 4%—if they could borrow at all. Why Are Financial Systems Prone to Crisis? Financial markets work well most of the time, but we don’t understand why they sometimes shut do vely little advice to managers as to how to respond. cial systems. One moment ev k When the bubbles b deep recession follows. xt moment marW w that ubbles. all, often precipitously, and We need to know what causes them, how they can be prevented, and how they can be managed when they do occur. Crisis prevention will have to incorporate good gov compensation schemes, and ef inancial crises will occup inancial regulators for many years to come. Let’s hope that the . That concludes our list of unsolved problems. We have given you the nine upper- Chapter 25 What We Do and Do Not Know about Finance 699 25.3 A Final Word We titled this chapter “What We Do and Do Not Know about Finance.” We should perhaps have added a third section, “What We Know about Finance but Haven’t Told You.” that we hav ver. Here are some examples: • Investment decisions always hav v w. Sometimes these side ef or instance, if the project allows the company to issue more debt, it may bring with it valuable tax shields. How can companies allo valuating new investment projects? We touched on this issue in Chapter 13 when we showed you how to calculate the weighted-average cost of capital, but there is a huge body wledge about how best to allo aluation. • We stressed in Chapter 14 the wide v raise money. W ut there are others that we largely ignored. Leasing is an example. Companies lease assets rather than buy them because it is conv advantages. A lot is no wn about how to value leases. • Treasurers of large corporations w xchange rates, interest rates, and commodity prices. V ards, and swaps—have been invented to help managers hedge against these risks. Many ve been applied to devising and valuing these new instruments. We only touched on the problem of option valuation and said nothing at all about valuing futures. It’s an exciting area and there is no shortage of books QUESTIONS QUIZ www.mhhe.com/bmm7e www.mhhe.com/bmm7e ANSWERS TO QUIZ www.mhhe.com/bmm7e www.mhhe.com/bmm7e www.mhhe.com/bmm7e APPENDIX A Present Value and Future Value Tables A-1 A-2 Appendix A APPENDIX TABLE A.1 t years = (1 + r)t A-3 Appendix A APPENDIX TABLE A.2 t years = 1/(1 + r)t A-4 Appendix A APPENDIX TABLE A.3 t years = 1/r 2 1/[r (1 + r)t ] Appendix A APPENDIX TABLE A.4 Annuity table: Future value of $1 per year for each of t years 5 [(1 1 r)t 2 1]/r A-5 APPENDIX B Solutions to Selected End-of-Chapter Problems CHAPTER 1 1. CHAPTER 3 1. shares of stock to raise funds; buy or lease a new machine. 2. Liabilities and Shareholders’ Equity Assets Cash $ 10,000 Receivables 22,000 Inventory financial financial real real real financial real financial 12. over defences, it is more likely that managers will act in their own best interest, rather than in the interests of the firm and its 22. yer and the client. 170,000 Total assets 100,000 Shareholders’ equity 145,000 $332,000 Liabilities and shareholders’ equity $332,000 5. a. Taxes 5 $2,575 Average tax rate 5 12.88% Marginal tax rate 5 15% b. Taxes 5 $8,625 Average tax rate 5 17.25% 5 25% c. Taxes 5 $83,897 Average tax rate 5 27.97% 5 33% d. Taxes 5 $1,027,314 Average tax rate 5 34.24% 5 35% 12. Dividends 5 $600,000 13. Total taxes are reduced by $2,000. 27. a. 14. a. Book b. 5 $200,000 value 5 $50,200,000 b. 5 $25.10 Book value per share 5 $0.10 investment unless the expected return on the project is greater than 20%. 32. If you know that you will engage in business with another 15. Sales arise. CHAPTER 2 4. $10,000 Cost of goods sold 6,500 G & A expenses 1,000 Depreciation expense 1,000 EBIT 1,500 Interest expense markets, money market. 500 Taxable income 5. 1,000 Taxes (35%) Net income 10. pare it to $2,500/6 5 $416.67/ounce. 13. a. b. c. d. e. f. $ 17,000 Long-term debt 200,000 Store and property 6. a. b. c. d. e. f. g. h. Accounts payable False False True False False False 18. These funds collect money from small investors and invest Cash 350 $ 650 5 net income 1 depreciation 5 $1,650 18. 20. a. Cash 5 $3.95 million Net income 5 $1.95 million b. CF increases by $0.35 million NI decreases by $0.65 million c. Positive impact. Investors should care more about cash d. tages of mutual funds for individuals are diversification, professional investment management, and record keeping. 23. a. 2010: Equity 5 $890 2 $650 5 $240 2011: Equity 5 $1,040 2 $810 5 $230 B-1 Appendix B b. 2010: NWC 5 $90 2 $50 5 $40 2011: NWC 5 $140 2 $60 5 $80 c. Taxable income 5 $330 Taxes 5 $115.50 d. 5 $174.50 e. Gross investment 5 $450 f. Other current liabilities increased by $45. 25. 27. 5 $1.70 5 $1.52 31. 14. 16. Days’ sales in inventory 5 2 18. a. 5 1.25 b. Cash coverage ratio 5 1.5 c. Fixed payment coverage 5 1.09 20. Total sales 5 $54,750 Asset turnover 5 0.73 ROA 5 3.65% 22. 5 $13.70 CHAPTER 4 1. a. b. c. d. e. f. g. h. i. j. k. l. m. 5 0.42 5 0.65 5 3.75 Cash coverage ratio 5 7.42 ratio 5 0.74 Quick ratio 5 0.52 5 12.64% Inventory 5 19.11 5 19.10 days 5 67.39 days ROE 5 13% ROA 5 6% Payout ratio 5 0.699918 8. a. ROE 5 13.41% after-tax operating income Assets 3 3 Equity assets net income 3 after-tax operating income 13,193 1,223 1 685(1 2 .35) 27,503 3 3 5 9,121 27,503 13,193 1,223 3 5 .129796 5 13% 1,223 1 685(1 2 .35) long-term debt 11. a. Debt-equity ratio 5 b. Ret ty 5 net income average equity c. Operating profit d. Invent e. tu ratio 5 n5 5 after-t cost of goods sold average inventory current assets current liabilities f. Average collection period 5 g. Quick ratio cash 1 5 ing income sales average receivables average daily sales etable securities 1 accounts receivable cu t liabilities Book debt 5 0.5 Book equity Market equity 52 Book equity 0.5 Book debt 5 5 0.25 Market equtiy 2 24. perhaps it pays a higher interest rate on its debt. 26. a. b. United Foods c. d. CHAPTER 5 1. a. b. c. d. $46.32 $21.45 $67.56 $45.64 3. $100 3 (1.04)113 5 $8,409.45 $100 3 (1.08)113 5 $598,252.29 5. PV 5 $548.47 9. PV 5 $796.56 10. a. t 5 23.36 b. t 5 11.91 c. t 5 6.17 11. Effective annual rate a. 12.68% b. 8.24% c. 10.25% 13. n 5 5 52%; EAR 5 67.77% 20. The PV for the quarterback is $11.37 million. The PV for the 24. a. EAR 5 6.78% b. PMT 5 $573.14 5 19.188%; EAR 5 20.97% 30. 34. a. PMT 5 $277.41 b. PMT 5 $247.69 B-2 Appendix B 35. $66,703.25 37. $79,079.37 46. $100 3 e0.10 3 8 5 $222.55 $100 3 e0.08 3 10 5 $222.55 47. n 5 48. value of your receipts is $930.66. This is a good deal. 22. a. b. c. 25. a. b. c. d. 9.89% 8% 6.18% 4.902% 2.885% 0.9434% 20.926% CHAPTER 7 50. r 5 8% 53. a. good deal. b. PV is $771.09. This is a bad deal. 60. $3,230.77 68. a. b. c. d. 5 12% 6. a. 14% b. P0 5 $24 62. $2,964.53 66. a. b. c. 3. a. $66.67 b. $66.67 c. Capital gains yield 5 0 Dividend yield 5 rate 5 3% rate 5 7.12% rate 5 9.18% $79.38 $91.51 Real interest rate 5 4.854% $91.51/(1.04854)3 5 $79.38 11. a. DIV1 5 $1.04 DIV2 5 $1.0816 DIV3 5 $1.1249 b. P0 5 $13 c. P3 5 $14.6237 d. Your payments are: Year 2 Year 3 $1.04 Year 1 $1.0816 $ 1.1249 70. a. $228,107 b. $13,950 DIV 71. Approximately 24 years. Purchasing Power increases by 57.84% Total cash flow $1.04 $1.0816 $15.7486 PV of cash flow $0.9286 $0.8622 $11.2095 Sales price 77. FV 5 $1.188; PV 5 $0.8418 78. $2,653.87 CHAPTER 6 1. a. Coupon rate remains unchanged. b. Price will fall. c. d. 3. Bond 5 $1,333.33 4. Coupon rate 5 8% 5 9.119% 9. Rate of return on both bonds 5 10% 10. a. Price will be $1,000. b. 5 21.82% c. Real 5 24.68% 11. a. Bondholder receives $80 per year. b. Price 5 $1,065.15 c. The bond will sell for $1,136.03. 12. a. 8.971% b. 8% c. 7.18% 16. 20 18. a. Price 5 $641.01 b. r 5 12.87% 19. a. b. 5 5.165% 5 30.61% $14.6237 Sum of PV 5 $13 13. a. P0 5 $31.50 b. P0 5 $45 16. P0 5 $33.33 18. a. (i) g 5 0; P0 5 $40 (ii) g 5 6%; P0 5 $40 (iii) Reinvest 60% of earnings. g 5 9%;P0 5 $40 b. (i) g 5 0; P0 5 $40 PVGO = $0 (ii) g 5 8%; P0 5 $51.43 PVGO 5 $11.43 (iii) g 5 12%; P0 5 $80 PVGO 5 $40 c. the discount rate. 19. a. b. 21. a. b. c. d. e. f. than the discount rate. P0 5 $18.10 DIV1/P0 5 5.52% 6% $35 $10 11.667 5 5 8.333 B-3 Appendix B 23. a. b. 5 33.33/4 5 8.33 25. a. P0 5 $125 b. Assets in place 5 $80 PVGO 5 $45 29. a. b. 5 $800/$200 5 4 ratio 5 ½ 30. a. The equiv wning and operating Econo-cool is $252.53. valent annual cost of Air is $234.21. b. Luxury Air. c. Econo-cool equivalent annual cost is $229.14. Luxury Air equivalent annual cost is $193.72. 33. a. machine is $4,465.82. The old machine costs $5,000 a 30. $16.59 b. If r 5 5 $5,539.68. 41. a. P0 5 $52.806 b. P1 5 $57.143 c. Return 5 0.1200 43. a. Expected 5 8% b. PVGO 5 $16.67 c. P0 5 $106.22 CHAPTER 9 3. $2.3 5. 5 6. CHAPTER 8 Revenue $160,000 Rental costs 1. 3. A 5 $23.85 and NPVB 5 $24.59. Choose B. 5. No. 50,000 Depreciation 10,000 Pretax profit $ 70,000 Taxes (35%) 7. 11. 0.2680 A 5 25.69% B 5 20.69% 24,500 Net income Project B has a payback period of 2 years. $ 45,500 8. Cash 5 $3,300 10. Cash 5 $56,250 11. a. 14. NPV 5 2$197.7. Reject. MACRS(%) Depreciation 1 20.00 $ 8,000 $32,000 2 32.00 12,800 19,200 3 19.20 7,680 11,520 4 11.52 4,608 6,912 5 11.52 4,608 2,304 6 5.76 2,304 0 17. NPV9% 5 $2,139.28 and NPV14% 5 2 11.81%. 20. NPV must be negative. Project Payback A 3 years B 2 years C 3 years b. Only B c. All three projects d. b. 17. Cash 5 $3.7055 million 18. a. Incremental operating CF 5 5 2$4,800 b. NPV 5 2$4,800 1 5 2$9.84 c. NPV 5 $137.09 21. a. b. investment 5 $53,000 Year Cash Flow ($000) A 2$1,010.52 1 20.9 B $3,378.12 2 17.3 C $2,404.55 3 13.7 4 10.1 Project NPV e. False 26. a. If r 5 2%, choose A. b. If r 5 12%, choose B. 27. $22,637.98 29. b. At 5% NPV 5 2$0.443 c. At 20% NPV 5 $0.840 At 40% NPV 5 2$0.634 Book Value (end of year) Year 15. a. r 5 0 implies NPV 5 $15,750. r 5 50% implies NPV 5 $4,250. r 5 100% implies NPV 5 0. b. IRR 5 100% 22. a. 30,000 Variable costs c. NPV 5 2 $4,377.71 d. 5 7.50% 23. NPV 5 2$10,894.31. Don’t buy. 24. $1.891 Choose Do-It-Right. Appendix B 26. NPV 5 2$349,773.33 19. 30. a. $71.75 million b. c. NPV 5 21. a. General Steel b. Club Med 5 31.33% 23. Sassafras is not CHAPTER 10 2. costs 5 $0.50 per burger Fixed costs 5 $2.5 million 5. a. $1.836 million 2$5.509 million b. $544,567 6. a. NPV 5 b. NPV 5 c. NPV 5 d. 5 CHAPTER 12 1. a. False b. False c. False d. e. 3. It is not well diversified. 7. Required return 5 rf 1 b(rm 2 rf) 5 14.75% 9. $1.50 Expected 12. 13. 5 16% 11. a. bA 5 1.2 bD 5 0.75 b. rm 5 12% rA 5 14% rD 5 9% c. r 5 rf 1 b(rm 2 rf) rA 5 13.6% rD 5 10% d. Stock A 15. a. b. $7,578. 16. a. b. c. 18. NPV will be negative. 5 2$25.29 21. DOL 5 1 24. a. Average CF 5 $0 b. Average CF 5 $60,000 15. P1 5 $52.625 27. a. NPV 5 2 b. NPV 5 23. b 5 4/7 5 0.5714 19. $400,000 25. a. False b. c. False d. e. False CHAPTER 11 1. 5 15% Dividend yield 5 5% Capital gains yield 5 10% 26. r 5 rf 1 b(rm 2 rf) 5 12% 3. a. Rate of return 5 0 rate 5 23.85% b. Rate of return 5 5% rate 5 0.96% c. Rate of return 5 10% Real rate 5 5.77% 5. CHAPTER 13 1. 4.88% 4. 13.75% Asset Class Real Rate Treasury bills 0.87% Treasury bonds 2.04% Common stock 8.05% 8. The cost of equity capital is 11.2%. WACC 5 8.74% 11. WACC 5 12.42% 16. 15. Dollars Bonds 17. b. r stock 5 13% r bonds 5 8.4% 5 9.8% 5 3.2% $ 9.36 million Percent 30.3% Preferred stock 1.50 million 4.9 Common stock 20.00 million 64.8 Total $ 30.86 million 100.0% B-5 Appendix B 17. 11.36% 18. 19. a. b. c. d. e. r 5 16% Weighted-average beta 5 0.72 WACC 5 10.56% Discount rate 5 10.56% r 5 18% CHAPTER 14 1. a. b. Outstanding 5 58,000 c. 40,000 3. a. funded b. Eurobond c. subordinated d. sinking fund e. call f. prime rate g. rate h. private placement, public issue i. lease j. k. 6. a. 100 votes b. 1,000 votes 7. a. 200,001 shares b. 80,000 shares 9. 5 $400,000 Additional paid-in capital 5 $1,600,000 Retained 5 $500,000 12. b. The public issue c. terms can be more easily renegotiated. 15. a. $12.5 million b. 17. a. b. c. d. $10 $18.3333 $8.3333 200 CHAPTER 16 4. $280 million 5 10/1.25 5 8 (no leverage) 5 10/1.33 5 7.5 (leveraged) 14. a. Low-debt plan: D/E 5 0.25 High-debt plan: D/E 5 0.67 b. Low-Debt Plan EPS Expected EPS c. EPS 3. a. b. A bond issue c. placements 4. to value. 7. a. 10% b. Average return 5 3.94% c. 10. No 12. 14. a. Net proceeds of public issue 5 $9,770,000 5 $9,970,000 $8.33 $11.25 $15.00 $11.67 Low-Debt High-Debt $10.00 $10.00 22. a. 11.2% b. 3 $800 5 Assets $2,420 1. a. Subsequent issue b. Bond issue c. Bond issue High-Debt Plan $13.75 16. r equity 5 14% deductible expenses. CHAPTER 15 $8.75 Debt Equity $0 $2,420 24. Distorted investment decisions, impeded relations with other firms and creditors. 31. a. b. c. d. CHAPTER 17 1. a. May 7: June 6: June 7: Ex-dividend date June 11: Record date July 2: Payment date b. c. Dividend yield 5 1.11% d. Payout ratio 5 15.79% B-6 Appendix B 2. a. b. c. 13. a. b. 5 $64 5 $64 5 $80, unchanged 15. a. 10. a. No effect on total wealth. b. 5 5.56% 5 8.33% Income Statement Revenue $2,400 $2,100 2,160 1,890 240 210 Cost of goods sold 12. With a repurchase, shareholders will own fewer shares at EBIT Interest expense dividend. Earnings before taxes 14. a. b. Same effect as the stock dividend. State and federal taxes Net income Dividends 16. a. $50; $45 b. $48.50 19. a. b. Balance Sheet A 10.00% 6.500% 9.00% B 10.00 7.725 8.75 C 10.00 8.950 8.50 Corporation Individual B $ 81.25 C $ 62.50 80 68 120 102 40 68 $ 34 20% Growth $ 240 $ 210 Fixed assets 960 840 Total assets $1,200 $1,050 $ 400 $ 400 Liabilities and Shareholders’ Equity Long-term debt Price $100 $ Net working capital Pension A 170 Assets Stock Stock 40 200 80 Retained earnings 18. a. 5 $19.45 b. Before-tax return 5 13.11% c. 5 $20.09 d. Before-tax return 5 14.48% 40 b. 640 634 Total liabilities and shareholders’ equity $1,040 $1,034 Required external financing $ 160 $ Second-Stage Pro Forma Balance Sheet 16 5% Growth Assets Net working capital 23. a. b. 5 $2. If the firm does the repurchase, EPS 5 $2.105. c. 5 9.5. If the stock is 840 Total assets $1,200 $1,050 $ 560 $ 416 Long-term debt CHAPTER 18 6. to output. Costs and assets will increase as a proportion of sales. 9. The balancing item is dividends. Dividends must be $200. 11. a. Internal growth rate 5 10% b. Sustainable growth rate 5 15% $ 210 960 Liabilities and Shareholders’ Equity 5 9.5. 1. a. b. c. d. False e. f. g. False $ 240 Fixed assets Total liabilities and shareholders’ equity 640 634 $1,200 $1,050 17. a. g 5 2.5% b. Issue $1,000 in new debt. c. 1.5% 19. a. b. c. d. 5 10% financing 5 $200,000 5 25% 5 $50,000 21. 5 10% 25. g 5 12% 27. 29. Higher B-7 Appendix B 22. CHAPTER 19 1. a. b. c. d. e. f. Cash Net Working Capital $2 million decline $2 million decline $2,500 increase Unchanged $5,000 decline Unchanged 1. Cash required for operations Unchanged $1 million increase 2. Interest on bank loan Unchanged Unchanged $5 million increase Unchanged 3. Interest on stretched payables 0 0 4. Total cash required $50.00 $15.90 $45 $ 0 First Third Cash requirements $50 $15 0.00 0.90 2$26 0.90 0.8 2$35 0.73 0 2$24.30 2$34.27 Cash raised in quarter 2. a. 5. Bank loan b. 5. $ 0 $ 0 6. Stretched payables 0 15.9 0 0 7. Securities sold 5 0 0 0 $ 0 $ 0 8. Total cash raised 7. a. b. c. d. e. f. Second 9. Of stretched payables 10. Of bank loan $270 2 $252 3 $288 4 $288 18. 0 0.00 0.00 11. Addition to cash balances $ 5 $ 0 $ 0 $ 0 $ 0 $45 $45 $36.6 $45.00 $45.00 $36.60 $2.33 Sources of Cash Sale of marketable securities $ 2 Increase in bank loans 1 Increase in accounts payable 5 Cash from operations: $348 Net income 6 2 $368 Depreciation 2 3 $352 4 $352 Total $16 Uses of Cash Increase in inventories 20. Increase in accounts receivable First Second Third $40 $10 $15 2$14 230 15 229 241 5 Cash at end of period 10 15 214 255 Minimum operating cash balance 30 30 30 30 $20 $15 $44 $85 Cumulative financing required (minimum cash balance minus cash at end of period) 0 34.27 13. 1 1 Net cash inflow (from Problem 18) 8.40 12. 23. Collections Cash at start of period $15.9 Bank loan 16. 1 0 Bank loan Cash conversion cycle increases. Order $15.9 Repayments Cash conversion cycle falls. Cash conversion cycle increases. Cash conversion cycle falls. Cash conversion cycle increases. Quarter $50 Fourth $ 6 3 Investment in fixed assets 6 Dividend paid 1 Total Change in cash balance $16 0 B-8 Appendix B 5 $1,200 PV(COST) 5 $1,000 24. February March April $ 100 $ 110 $ 90 expected profit of a sale to a slow payer is therefore 0.70($1,200 2 $1,000) 2 0.30($1,000) 5 2$160. Expected savings 5 $16. The credit check costs $5, so it is cost effective. Sources of cash Collections on current sales Collections on accounts receivable Total sources of cash 90 100 110 $ 190 $ 210 $ 200 26. CHAPTER 21 Uses of cash Payments of accounts payable $ 30 $ 40 $ 30 Cash purchases 70 80 60 Labor and administrative expenses 30 30 30 Capital expenditures 100 0 0 10 10 10 $ 240 $ 160 $ 130 2$ 50 1$ 50 1$ 70 $ 100 $ 50 $ 100 Taxes, interest, and dividends Total uses of cash Net cash inflow (sources 2 uses) 1 Net cash inflow 250 150 170 5 Cash at end of period $ 50 $ 100 $ 170 1 Minimum operating cash balance $ 100 $ 100 $ 100 5 Cumulative short-term financing required (minimum cash balance minus cash at end of period) 1. a. Economies of scale is a valid reason. b. Diversification is not a valid reason. c. Possibly a valid reason. d. 2. 4. LBO: 5 Poison pill: 3 Tender offer: 4 Shark repellent: 2 6. $ 50 $ 0 2$ 70 12. a. b. c. d. CHAPTER 20 1. a. $10 b. 40 days c. 9.6% 6. Available balance with bank 5 $275,000 8. Extra cash available 5 $22,000. Interest 5 .06 3 $22,000 5 $1,320. 11. a. 20 days b. $1.096 million c. Average days in receivables will fall. 13. a. The e 2$3. Do not extend credit. b. p 5 0.96 c. The present value of a sale is positive, $365.28. d. p 5 0.1935% 14. a. The expected profit of a sale is positive, $90. b. p 5 0.875 20. a. $30,000 b. $6 c. $180 22. Yes 23. Cash balances fall relative to sales. NPV 5 $10,000 SCC will sell for $53.33; SDP will sell for $20. Price 5 $52.63 NPV 5 $7,890 13. a. 4. a. Due lag and pay lag fall. b. Due lag and pay lag increase. c. 19. a. Yes b. Credit should not be advanced. c. 8. a. $6.25 b. $4 c. NPV 5 $2.25 million 5 1 5 Total 5 $200,000 1 $500,000 5 $700,000 Number of shares 5 262,172 5 $9,000,000/262,172 5 $34.33 Price-earnings ratio 5 $34.33/$2.67 5 12.86 b. 0.81 shares c. $567,365 d. 2$567,365 CHAPTER 22 1. a. 76.66 euros; $130.44 b. 100.94 Swiss francs; $99 c. rate will increase. d. U.S. dollar is worth more. 3. a. fx/$ 1 1 rx 5 s 1 1 r$ x/$ b. fx/$ E(sx/$) 5 sx/$ sx/$ c. E(sx/$) 1 1 ix 5 sx/$ 1 1 i$ d. 1 1 r$ 1 1 rx 5 ( ) E 1 1 ix E(1 1 i$) 5 $50. B-9 Appendix B 6. a 6. Advantages: liquidity, no storage costs, no spoilage. 8. holding asset in portfolio. 7. Gold Price 1000 10. a. 4% b. 14% c. 26% a. Revenues Futures contract gain 1400 $1,400,000 80,000 2120,000 2320,000 $1,080,000 $1,080,000 $1,080,000 c. Revenues $1,400,000 18. a. b. c. $1,000,000 $1,200,000 1 Put option payoff 80,000 0 0 2 Put option cost 12,000 12,000 12,000 $1,068,000 $1,188,000 $1,388,000 Total revenues CHAPTER 23 1200 $1,200,000 b. Total revenues 14. 16. Net present value 5 $1,000,000 9. for 1 year at 6%. 1. Payoff Profit 211.20 a. Call option, X 5 430 30 b. Put option, X 5 430 0 211.05 c. Call option, X 5 460 0 222.50 d. Put option, X 5 460 0 222.20 e. Call option, X 5 490 0 210.10 f. Put option, X 5 490 30 2 9.36 11. The futures price for oil is $90 per barrel. Petrochemical will take a long position to hedge its cost of buying oil. Onnex oil. Oil Price ($ per barrel) $80 $90 $100 Cost for Petrochemical: Cash flow to buy 1,000 barrels 5. Figure 23.7a represents a call seller; Figure 23.7b represents a call buyer. 1 Cash flow on long futures position 7. a. b. The value of the stock. Net cost 10. 280,000 290,000 2100,000 210,000 0 10,000 290,000 290,000 290,000 $80,000 $90,000 $100,000 10,000 0 210,000 $90,000 $90,000 $ 90,000 Revenue for Onnex: cise price, whichever is greater. The upper bound is the stock Revenue from 1,000 barrels 14. 1 Cash flow on 16. a. Call option to pursue a project. b. Net revenues 18. Put option with exercise price equal to support price. 20. a. Option to put (sell) the stock to the underwriter. b. 22. deposits owed to bank customers. 12. 24. a. Buy a call option for $3. Exercise the call to purchase stock. Pay the $20 exercise price. Sell the share for $25. of the gold without tying up your money now. The differcompensation for the time value of money. Another way to put it is that the spot price must be lower than the futures b. profit equals $1. opportunity cost of their funds until the futures maturity date. CHAPTER 24 14. 1. diversify away. 4. No another currency. An interest rate swap is an exchange of a Credits CHAPTER 1 Page 3 CHAPTER 10 © The McGraw-Hill Companies, Inc./Jill Braaten, Photographer Page 291 Stockbyte Page 31 Page 317 © Brand X Pictures/ Page 53 Polka Dot Images/ Jupiterimages CHAPTER 12 CHAPTER 3 Page 345 CHAPTER 13 Michael/Corbis Page 79 Page 371 CHAPTER 19 Page 527 The K CHAPTER 20 Page 559 Ingram CHAPTER 4 Page 503 LLC CHAPTER 11 CHAPTER 2 CHAPTER 18 V CHAPTER 21 Page 591 Photodisc/Getty Images Images CHAPTER 5 Page 113 AP CHAPTER 22 vid CHAPTER 6 Page 159 Courtesy of T CHAPTER 7 Page 185 © Alan Schein Photography/ Corbis CHAPTER 8 Page 227 Photodisc/Getty Images CHAPTER 9 Page 263 CHAPTER 14 Page 399 Getty Images CHAPTER 15 Page 423 Page 619 © Reuters New Media Inc./ Corbis CHAPTER 23 Page 645 Getty Images Getty Images CHAPTER 24 CHAPTER 16 Page 445 Page 671 © Corbis © CHAPTER 25 CHAPTER 17 Page 470 Page 691 © © Medioimages/Superstock T C-1 Global Index A C B D E F I G H J N R K L O S M P V U W Y T Z Subject Index Page numbers followed by n refer to notes. A Abandonment option, 307, 658 Abandonment value, 307 Accelerated depreciation, 278 Accounting cash, 61–62 conver gray areas es, 66 mark-to-market accounting, 67 liabilities, 66–67 rev Adobe Systems, 221 Af Inc., 660 After-tax company cost of capital, 377 After-tax cost of debt, 371, 377 After-tax income, 409 di After-tax operating income, 85 calculating, 87 After Agency costs, 603 Agency problems, 48 and board of directors, 18 and compensation plans, 18–19 , 67 et, 67 legal/re requirements, 18 Annuity versus annuity due future value, 137 B er, M., 482n Balance sheet present v v alue, 137 present v Annuity factor, 129 for Bill Gates, 131–132 in lottery winnings, 131 assets on, 189 book vs. market v 57–59, 206 common-size, 56–57 et value excluded, 88 Home Depot, 54–57, 82 future value, A-5 present value, A-4 w, 598–599 main items of, 56 market-value, 205–206 Apple Inc., 34, 35 vidends, 33 ven analysis, 298–300 adjusted, 272 w, 265 and stakeholders, 17–18 and takeovers, 19 Agenc , 694 Agents, 17, 694 Aggressive gro Aggressive stocks, 346 Aging schedule, 569–570 problems with, 87–88 go deregulation, 4 , 87 see Accounting standards, 66 Accounts payable, 532 Accounts payable period definition, 534 estimating, 535 Accounts receivable, 265 on balance sheet, 54 collection period, 569 collections, 539–541 credit policy, 560–571 et risk, 336 negativ , 445n Alaska Air Group, 46 Alcoa, 660, 661 Allegheny Corporation, 658 Allen, F., 387n, 458n Allen, Paul, 423 Vegetable Oil Refining Company, fraud at, 547 Altman, Edw Altria Group, 368, 393, 492 founding of, 423 and Massachusetts law, 427n Aqua 204, 205 window dressing, 67 Balancing item, 507–508 , J., 660 see also Banks and Archipelago Exchange, 35, 187 Asked yield to maturity, 161 Asquith, P., 434n, 482n Asset-back ubbles, 698 Assets on balance sheet, 54–57, 189 y costs, 461 et value, 57–59 leasing vs. buying, 699 liquid, 54, 95–96 et accounting, 67 matching maturities, 529–530 needed by corporations, 3 negative-risk, 332 of pension plans in 2010, 40 ve interest rates, 139 proliferation of, by time deposits, 531 er’s acceptance, 562 48, 329 ed interest rate, 546 line of credit, 545–546 secured loans, 547–548 self-liquidating, 546 67, 176, 431, 546, 586, 592 America w w York, 594 329, 480, 667 level divisions, 534n payment of, 541 types of, 559 Accounts receiv Accounts receivable period definition, 534 estimating, 534 Accrual accounting, 61–62 on income statement, 63 Acid-test ratio, 96 Acquisitions, 598; see also Mergers ve expenses, 541 wer, 189, 192, 221, 524 relative liquidity, 96, 530n ved, 236–238 ver ratio, 88 Chapter 7, 475 America Online, 610 Andrade, G., 611 Angel investors, 425 486 Ann Taylor Stores, 586 Annual percentage rate of bonds, 163n y, 24 ATMs, 576 AT&T, 83, 84, 85 Auction, 428n for stock repurchase, 483 system, 577 Av Average risk, 371 Average tax rate, 70 duration of proceedings, 477 460 Enron, 460 L. , 532 IND-5 IND-6 Subject Index y—Cont. P postpetition creditors, 477 prepackaged, 475n as protection from litigation, 477 recent examples, 476 for selected companies, 359 spreadsheet solutions, 347 of T Bid-ask spread, 187 coupon, 160 expected rate of return, 382 face value, 160 Break-even sales volume, 299 Brealey, R. A., 387n, 458n Brin, Sergey, 423 Bristol Myers Squibb, 410 Brokers, in stock trading, 186–187 Foundation, 131 WorldCom, 175 y costs Black, Fischer, 357, 655, 694 indexed, 173 examples, 460 indirect, 460–461 model, 659 Blockbuster, 598 and v varying by type of assets, 461 y procedures asset liquidation, 475 liquidation vs. reor Bloomingdale strategy, 91 ws, 427 junk bonds, 46, 174–175, 411 Business organizations alue, 160 present value calculation, 162 relativ y problems, 18 v yield curve, 171–174 yield on, 142 yield to maturity, 166–168 Bond valuation, 159 spreadsheet solution, 170–171 Bookb reor workout, 475 Act of 1978, 475 y Act, 18 Bob Ev y, 4, 6, 45, 306, 329, 350, 359, 385 574–575 credit checks by, 562 di inv decisions, 5 Bondholders, 126 with conv Book value, 83 and capital structure, 380–381 and company cost of capital, 376–377 , 88 and debt ratios, 93 equities, 406 es, 412n lock-box system, 574–575 merger activity, 594 Buffett, W Build-to-order production, 573 Bureau of Labor Statistics, 140n losers in LBOs, 609 sole proprietorships, 9 best-case, 504 normal gro Business risk, 450 C Callaway Golf, 46 Call options v Google Inc., 646 v versus market v 189–191 reliability of, 95 et, 36 sweep programs, 573–574 junk bonds, 608–610 size of, 160 versus put options, 646–647 Booms, 330–332 selling, 647–649 Base period, 140 asked yield to maturity, 160, 161 Beaver, William H., 563–565 Bechtel, 426 Before-tax income, 409 Behavioral f w beliefs about probabilities, 215 Behavioral psychology, 491 way, 435, 592 ogi, 446 Best-case plan, 504 alue of, 652–653 value at expiration, 646 calculating, 162 , 170 corporate bonds, 175 cash balance and need for, 541 effect on value debt and cost of equity, discount, 167 premium, 167 Beta(s) T of cyclical businesses, 362 quotations, 175 v Dell Inc., 360 Do 348–349 fate of, 358 measuring, 346–348 Borders Group, 586 wing by Apple Inc., 33 163–165 w vestors, 322 Bonds, 159; see also bonds; Treasury bonds asset-back conv pros and cons, 697 tax disadv Bradshaw Brav, A., 485 Break-even analysis accounting break-even point, 298–300 in credit decision, 567 and economic value added, 301n e at Lockheed, 302–303 net present value, 300–303 sales volume, 298 Call provisions, 645 y, 189, 192, 329, 350, 359, 385, 593 Capacity e Capacity to pay, 563 Capital, 7, 36 Capital asset pricing model, 371 basis of, 356 to calculate company cost of capital, 374–375 critique of, 358 expected return based on, 382 expected vs. actual returns, 358 prediction of risk premium, 357 et line, 355–356 IND-7 Subject Index value and drawbacks, 695 v 358 Capital budget, 292 Capital budgeting, 10–11, 227; see also w, 263–264 w, 265 ws, 266–268 and options, 645 problems and solutions analyze competitive advantage, 294 interest, 292 ensuring consistent forecasts, 292 reducing forecast bias, 293–294 and project risk, 359–362 proposed budget, 292 in strategic planning, 504 what-if questions, 295 Capital budgeting decisions, 6 Allegheny Corporation, 658 and capital rationing, 249 case, 258–259 choosing between two projects, 234 investment timing problem, 234, 235–236 ved equipment, 235, 236–238 xclusive projects, 235 and payout policy, 487 real options option to abandon, 658 option to expand, 658 replacement problem, 235, 238–239 Capital investment projects, 228 decision rules net present v Capital surplus, 405 CAPM; see Capital asset pricing model gill, 426 for long-lived projects, 241–243 pitfalls, 243–248 xclusive, 244–246 net present v selecting ved equipment, 236–238 replacement of equipment, 238–239 timing decision, 235–236 Pentagon La ge Projects, 234 v ved projects new computer system, 231–232 spreadsheet solutions, 233–234 estimating cost of capital from , 322–324 et indexes, 319 ets, 36 I, 447 icient, 692–693 Capital rationing, 249 Capital structure e e-outs, 610 Cash advantage of holding, 530 calculating, 60–61 components, 531 disadv forecasting uses of, 541 liquidity of, 574 mer changes in, 445 and corporate taxes v tracing changes in., 537–539 transported across time, 43 uses of accounts receivable payments, 541 capital expenditures, 541 ve costs, 541 vidends, 541 v Cash before deliv Cash budgeting payment date, 481 record date, 481 regular vs. special, 480 in U.S. 1980–2008, 480 w(s), 263–264; see also ws; w , 599–601 vested, 33 antage, 240–241 steps, 263 vidend date, 481 from bonds, 166–167 from collections, 539–541 calculating, 64–65 v requirements, 541–543 example, 541 minimum operating cash balance, 541 w, 541 changes at Sealed Air Cash coverage ratio, 94 Cash dividends, 479 adv from Apple Inc., 33 date, 123 discounting by real interest rate, 143 equivalent annual annuity, 236–238 expected forecasts, 362 forecasting, 387–388 w, not profits, 264–265 w, 266–270 inv incremental, 266–269 from investment in w capital, 268 level, 127–135 vention, 276n versus net income, 63 from new computer system, 231–232 , 560 v used in practice, 251 Capital e Capital e w, 65 on income statement, 63 w, 64 Capital gain, 193 versus dividends in taxation, 493 Capital gains tax, 70 Capital investment, 271 Capital investment decisions equity, 456 weighted average cost of xpected 539–541 forecasting uses of cash, 541 means of producing, 539 Cash conversion cycle, 533–536 return, 386–387 industry differences, 446, 464 L. A. Gear, 523 accounts receivable period, 534 calculating, 535 estimating accounts payable measuring, 380–381 vable , 464–465 in mergers, 591 net present value analysis, 228–239 v x, 248–250 usinesses, 387–389 ventory period, 534 inventory period, 534 net w production cycle dates, 534 230–231 and payout policy v spreadsheet solution, 233 on TIPS, 173 and value of the firm, 446 w analysis changes in working capital, 276 inv ed assets, 274–275 w, 275–276 w, 276 w estimates, 291 w forecasts, 295 w for new investments, 63–65 IND-8 Subject Index w from operations, 63–65 w, 61 Cash management centralization of, 574 574–575 concentration accounts, 574 , 576–578 reasons for holding cash, 573 Collateral, 411 accounts receiv 547 inv Collateralized debt obligations, 415 Collection policy aging schedule, 569–570 definition, 569 factors for, 570 growth stock, 191, 202–205, 358 holders of, in 2010, 406 income stock, 191, 202–205 incremental risks, 332 405 issued but not outstanding, 405 no-growth dividend discount model, 197 alue, 192–194 Companies; see also countercyclical, 330 credit scoring for, 563–565 e vatives use, 673 fair behavior by, 17 liquidation value, 190 573 types of payment systems, 575–578 Cash on deliv , 560 ws, 61, 62, 541 Cash payments , 127–128 v Cash ratio, 96–97 , 368, 393 593n ing, 66 y, 460 L. A. Gear, 532 y, 475 Character Char v statement of account, 570 Collections of accounts receivable, 539–541 Comcast, 592, 703 Comment, R., 487n see also 48 functions, 40 markets, 186 market value, 189–191 et risk, 346–352 327–329 vestment, 352 net common equity overv and o 2010, 42 holdings of equities 2010, 42 number of, 40 Commercial draft, 562 Commercial paper, 36, 401–402, 531 defaults, 549 definition, 548 , 548 in money market, 579 recent problems with, 549 par value, 405 ets, 37–38, 44 Commodity prices, 45 viation of returns, 328 total risk and market risk, 350 et, et listings, 187–189 risk in mutual funds, 351–352 risks, 320 viation, 334 574 Chevron, 5 Trade, 35, 37, 677 Chicago Board Options Exchange, 645 Common-size income statement, 60 Common stock, 185 35, 684 Chicago T une Company, 609 , 10 CHIPS; see ayment System Chordia, T., 213 593n, 595, 609 staving of y, 462n Cisco Systems, 175, 530 Citicorp, 411 Citigroup, 176, 431 Class ayment System, 577–578 Closed-end fund, 38n, 696 CME Group, 684 y, 83, 84, 85, 473 bid-ask spread, 187 book value, 189–191 classes of, 407 y cost of capital, 374–375 and conv definition, 186 dividend yield, 188 e based on CAPM 382 based on dividend discount model, 382–383 f e 323 e olatility, 330 insolvency, 404 wth rate, 518 investment decisions, 6 inv investments by, 113 leasing vs. buying, 699 line of credit, 545–546 liquidity choice, 530 loan cov tw value stocks, 358 v v aluation case, 332–334 wth dividend discount model, 197–199 dif dividend discount model, et hypothesis, 211–212 paying for investments, 113 payout ratio, 203 plowback ratio, 203 proliferation of bank accounts, 574 reasons for holding cash, 573 203–204 y, 103 Compan after-tax, 377 et value of securities, 376–377 calculated as weighted average, 374–377 calculating, 371 and investors, 376 Company values, 46 Compensation plans for managers, 18–19 ets, 400 Competitive advantage ets, 400 Competitiveness, 6 combined by merger, 595 Compound growth, 24, 117 continuous, 139 effective annual interest rate, 138–139 Compound interest growth stocks, 205 et-v 205–206 present v 118–119 IND-9 Subject Index Concentration accounts, 574 Conditional sales, 562 decision, 563 companies, 175 promised vs. expected yield to , 177 speculativ eliminating, 293 463 Conglomerate merger bootstrap game, 596–597 Consistenc 505 Consolidated balance sheet, 54 Consolidated Edison, 190–191, 206, 329, 346, 348–350, 359, 368, 385, 554 yield on, 142 yield spread vs. T 176 zero-coupon bonds, 177 ays of changing, 591; see also Mark control and value of shareholders’ equity, 456 weighted average cost of 387 e interest deductions, 69 rate v Corporate v Corporations agenc Cost-cutting projects, 271–272 Cost of capital, 31; see also Compan Opportunity cost of capital of c usinesses, 362 , in economic value added, 84–85 ef excluded from income assets needed by, 3 xample, 372–373 investment timing decision, 235 y Constant-growth dividend discount model, 383 closely held, 8 def interest rates, 409 project, 360–361 example, 198 ve covenants, 412 public vs. private placement, 412 repayment provisions, 410 security, 411 required forecasting, 197–198 Consumer credit, 531 Consumer price index, 141–142 subordinated debt, 411 476 s tasks, 10–11 w of savings to, 33–42 goals of and agency problems, 16–19 v value maximization, 11–14 ,8 means of payout RJR Nabisco, 412n , 10 Conversion v Conv direct costs, 429 options on, 645 valuation, 661 Conv Conv conv conv w es, 66 vidence to estimate, 322–323 Cost of debt, after-tax, 377 Cost of equity, 371 f Cost of goods sold, 62 Cost reduction, 392 case, 439–440 conv Alcoa, 661 conversion value, 661 and taxes, 371 general cash of open auctions, 430–431 commercial paper debt ratios, 402 400 32–33 net common equity net w no-dividend group, 480 o payout decisions cash dividend advantages, 486 in context of dividends and ws, 485 get dividend, 485 get payout ratio, 485 vately held, 426 403 y ef eholders, 462 investor assessment, 459 v Counterc Coupon, 160, 509 Coupon rate, 165 ve Cs of, 563 banker’s acceptances, 562 wnership and callable, 410–411, 661 call provisions, 645 Treasury bonds, 174 conv def def v v v agency costs, 603 see also Fraud ault, 176 investment grade, 174–175 liquid, 175 prices vs. T in United States, 25 es debt adv implications of decisions, 458 shareholders, 8 stock betas for, 350 stock issues, 185 tax disadvantage, 9 threat of takeover, 612 open account, 562 sight draft, 562 time draft, 562 Credit analysis, 560 wildly dispersed ownership, 603–604 Cost(s) of general cash offer, 433 of inv of proxy contests, 603–604 563–565 Z-score model, 565 Credit booms, 698 Credit bureaus, 563n IND-10 Subject Index Credit decision bases of 336 Demand deposits, 531, 573 458–463 Cutof usinesses, 362 looking beyond immediate order, 569 y for, 566 with repeat orders, 568 without repeat orders, 566–567 Credit-default swaps, 176, 683–684 , 566 Credit management steps, 560 iciency, 89 Creditors y costs, 460 preference for liquidation, 477 y aging schedule, 569–570 collection policy, 569–571 consumer credit, 560 448–450 Deposit insurance, 44n Depreciation accelerated, 278 D Dangerous accounts, 569 Davidson, S. M., 16 DeAngelo, H., 532 DeAngelo, L., 532 Debit cards, 575–576 Debt; see also verage book value, 88 collateral for, 411 and cost of equity explicit cost, 453 60–61 and cash coverage ratio, 94 w, 64 , estimating, 54 loan covenants, 463 ws, 465–467 as noncash expense, 400n w, 272 ed-rate, 681, 682 implicit cost, 453 402 increase in, 404 issue costs, 433 in trade-of w Depreciation deduction, 272 , 464 wth rate, 518 open account, 562 terms of sale, 560–562 trade credit, 560 Credit rating agencies, 48 return, 450 see also structure in calculating company cost of models, 566 for small businesses, 566 softw , 566 Credit transfer, 576 Debt-to-v Decision making delegated by shareholders, 11–12 for assets with different lives, 237 Debt-equity ratio, 93 for inv net present v , 36, Cumulativ requirements, 541–543 Cumulative voting, 407 y swaps, 682–683 Declaration date, 481 Default over , 549 inv in junk bond market, 608 gin, 90 accounts receivable, 531 cash, 531–532 components, 96 inv , 531 liquidity of, 530n w, 63–64 types of, 559 277–279 Dere go, 4 vatives, 671 credit-default swaps, 683–684 futures contracts, 676–680 innovations, 683–684 iron ore futures, 684 problems caused by Debt-equity trade-off, 459, Debt financing, 7 bonds, 36 68 recovery system, 278 two costs of, 385–386 , 432 Debtholders; see also Bondholders income vs. shareholders, 92 , 375–376 Debt investors, 7 Debt issues, 401 et; see also Bond et; Mone et asset-back collateralized debt obligations, 415 Def Default risk, 102, 159, 411 in money market, 580 Defensive stocks, 346 40n ution pension plans, 39 speculation problem, 684 swaps, 681–683 vatives groups, in banks, 21 vativ et, 37–38 DIAMONDS, 44 Dimon, James, 487 Dimson, Elroy, 319, 320, 321, 324, 325, 327, 328 Direct costs y, 460 Direct debit, 576 Direct deposit, 577 Direct negotiation for stock repurchase, 483 Direct payment, 576, 577 Discount basis interest rate quotes, 579 Discount bonds, 167 price changes, 170 w, 118 by company cost of capital, 360 w, 143 Degree of operating leverage, v Debt policy and net working capital, 96 w, 63–64 in w es, Dell Inc., 191, 329, 350, 359, 573, 593, 616, 667 Delphi, 595 263–264 w vestment, 271 changes in w 273–274 w, 271–273 IND-11 Subject Index case, 287–288 examples 276 depreciation tax shield, 277–279 orking capital, 277 salvage value, 279 ws, 264–268 spreadsheet solution, 280 w methods, 243 w rate of return, 242 ws, 263 Discount factors, 119 present value table, A-2 Discounting w, not profits, 264–265 ws, 266–269 ws, 269–270 ws, 269 Discount rate, 118 w, 143 choosing, 373–374 fudge factors, 362 345 and macro risks, 336 333–334 as reason for merger, 596 to reduce v , 329–330 et risk, 346 Div Dividend cuts, 486, 487 Dividend discount model for common stock valuation, 194–197 constant-growth, 197–199 definition, 194 estimating expected rate of return, 199–200 e 382–383 inv 194–197 required forecasting, 197–198 y measures ver ratio, 88 inv ver, 88–89 receiv ver, 89–90 Ef ets, 400, 692–693 Ef et, 211 Ef et hypothesis, 693 exceptions to, 696 and inv 211–212 and mark , 94–95 E wer, 190 of cyclical businesses, 362 plowback ratio, 203 reinvested, 97 y of, 66 et bubbles, 213–214 212, 213 es, Dividend reinv Dividends, 541 es, , A., 537n Eight O’Clock Coffee, 593n 691 Eisner, Michael, 604 59, 94 w, 65 verage macro risk, 336 compared to repurchases, 483–484 wth, 203–205 ef ef income, 450 impact of merger on, 597 vestment, 479 networks, 186 , 576–578 advantages, 578 , 577–578 w, 192 wildcat oil wells, 335 Div Ef get dividend, 485 get payout ratio, 485 vance proposition, 488–491 payout ratio, 203 242–243 for stock’ Div Dividend policy advantage of cash dividends, 486 cash di es, 492, 493 y low payout policy, 492–493 ws, 485 Microsoft, 491–492 vance proposition, 488–491, 693 in percentage of sales models, 507–508 resolving, 697 stock di 383–384, 408 197–198 stock, 481–482 stock splits, 481 suspended by BP, 486 in U.S. 1980–2008, 480 Dividend yield, 188, 193, 318, 383 ubble, 213, 215, 329, 696 Dow Chemical, 83, 84, 189, 192, 329, 346–350, 359, 385, Eastern y, 460 Eastman K Easy-money policy, 47 eBay, 190, 428 EBIT; see es EBITDA; see es, depreciation, and Economic gain from mergers, 600 Economic order quantity, 572 Economics of v 594–595 Economic v and accounting rates of return, 86–88 ven analysis, 301n as performance measure, 85 problems with, 87–88 weighted av 377–378 Do Average, 44 low in 1932, 321 percentage changes, 1900–2010, 328 Dow Jones Wilshire 500 index, 319 Drex Due lag, 582 w” Al, 66 Economies of scale, gained in mergers, 594 Economists, disagreements among, 695 Economy 330–332 v on bank accounts, 139 of bonds, 163n Eli Lilly, 595 , 18–19, 659 103, 427 y, 460, 477 Equifax, 563n Equipment required by law or policy, 292–293 age value, 279 Equity, 425 book value, 88 general cash offer, 432 wth rate, 517 issue costs, 433 holders of, 406 and leverage ratio, 95 Equity investors, 7 Equity issues, 401 ets, 36 Equiv examples, 237–238 of new equipment, 238 Estée Lauder, 46 European call, 646n IND-12 EVA; see Economic value added EVA Dimensions, 82, 88 Excess funds, 559; see also Idle cash Subject Index Federal Deposit Insurance 426, 462 xpansion, 306 hedging, 679 Ex-dividend date, 481 Executive stock options backdating scandal, 660 calculating, 659 Exercise price, 646–647 Google stock, 648 Expansion option, 305–307, 658 w forecasts, 362 options on callable bonds, 661 conv executive stock options, 659 w v 4–5 386–387 on common stock, 193 based on CAPM, 382 based on dividend discount model, 382–383 false precision, 383 on common stock 1981, 323 y cost of capital, 359–360 vidend discount model, 199–200 from inv return, 228 on preferred stock, 383–384 for selected companies, 359 Expenses, tax-deductible, 68–69 Expiration date, 646, 647 Explicit cost of debt, 385–386, 453 161–166 investment decisions, 4, 5 alue, 246 interest rates, 123–124 operation of, 121 present value calculations, 121 xplaining, 698 Federal funds rate, 546n Federal Reserve System, 415, 699 and Fedwire, 577–578 crisis, 48 tight money policy 1979, 163 Federal Trade Commission and Blockbuster, 598 and Whole F et, 599 Fedwire, 577–578 Fernandez, P., 323n FICO score, 563n Fidelity, 368 Fidelity Investments, 39 Field warehousing, 548 Finance careers in, 20–22 agenc ef ef et, 175 and gov investor fear of default, 698 and mone origin of, 47 et, 580 responsibility for, 48 385, 480, 592 v dividend discount model, 194–202 price and intrinsic value, 192–194 Financial leverage see also Costs of y, 461–463 and capital investment strategies, 462 costs of, 672 ets, 692–693 vance propositions, 693 net present value, 692 , 693–694 unsolved problems 463 ef verage, 460 ef eholders, 462 investor assessment, 459 Financial environment, 32 et f merger waves, 697–698 payout policy, 697 present v 694–695 gro 202–206 technical analysis, 206–210 , 580 f , 694 e yield curve, 171–174 , 166–168 common stock beha ef et hypothesis, 211–212 403n and asset-backed bonds, , 696 wth rate, 515–518 required, 515–516 ExxonMobil, 82–83, 84, 85, 86, vestment criteria bonds def annuity present v 2007–2009, 47 on bonds, 382 hedge funds, 39 factors, 547 measuring, 92–95 cash coverage ratio, 94 debt ratio, 93 Financial managers, 3, 6–7, 503 , 10 controller, 10 essential role of, 11 inv ets, 31 in lar treasurer, 10 use of shelf re ets, 31 et, 36 ets, 36 ets, 37 competition in, 400 w of sa derivatives market, 37–38 694–695 F Face value, 160 and yield to maturity, 167 Factor y, 570 F F F F , Isaac & Company, 563n, 566 ., 482n v valuing liquidity, 698 Finance companies, 545 Finance.yahoo.com, 187 Financial Accounting Board, 66 on option v models, 659 functions div payment mechanism, 45 providing liquidity risk transfer et, 36 w of sa foreign e ets, 37 time, 43 v 32–33 insurance companies, 41 inv pro Financial assets, 38 see Hedging 43 , 44–45 IND-13 Subject Index information provided by on commodity prices, 45 on company values, 46 mone et, 36 et, 37–38 over et, 36 et, 35–36 Financial plan, 503 balancing item, 507–508 depreciation in, 512–513 see also payout ratio, 97 plowback ratio, 97 Fraud; see also role of, 101–102 default risk, 102 y, 103 alue added, 80–81 Financial risk increased by debt, 453 Financial slack and debt policy at L. ve business plans, 504 to av big-picture focus, 504 case, 525 to establish goals, 504 e wth, 515–518 long-term focus, 504 528–531 planning horizon, 504 reasons for contingency planning, 505 forcing consistency, 505 , 505 gic plans, 504 , 532 466–467 v Financial statements; see also 508–512 pro forma, 506, 507 users of, 53 websites for, 56 Financial system, 33 Financing y options, 33–35 composition of, 371 by corporations, 3 debt vs. equity, 7 effects of investment decisions on, 699 of Federal Express, 4–5 508 danger of complexities, 515 and gro improved model, 508–512 by Home Depot, 60 for investment and growth, 97 vance propositions, 693 WACC 378 and v Financing decisions, 3 Apple Inc., 32–33 role of, 514–515 cash payments at different dates, 113 100 case, 110–111 comparisons with past, 100–101 in credit analysis, 563–565 Vegetable Oil y, 547 and payout policy, 487 priv separate from investment decisions, 270 10–11 trade-of value creation with, 400 v Fire insurance, 335 Firm commitment, 427 First Call, 201n compared to investment decisions, 7, 399 conv corporate debt, 409–415 First-stage f Fisher, L., 482n Five Cs of credit, 563 Fixed assets, 56 on balance sheet, 54 investment in, 274–275 Fixed costs, 295 and operating leverage, 303–305 antages, 303 Fixed-income market, 36 Fixed-income securities, 578–579 Fixed-rate debt, 681, 682 Flexible production facilities, 308 , 580 Float reducing, 578 Floating interest rates, 36, 409 Floating-rate bonds, 177, 681, 682 F Forbes, 212 F y, 6, 330, 332–333, 336, 347, 350, 359, 365, 369, 384n, 385, 399, 402, 413, 480, 481, 548–549, 586, 610 inv decisions, 5 Forecast bias, resolving, 293–294 Forecasting ensuring consistency in, 293 at Home Depot ov leverage ratios, 92–94 w, 387–388 ef e by Federal Express, 5 liquidity ratios, 95–97 , 24–25 98, 99 Freddie Mac, 18, 47, 66, 169 w definition, 65, 387 for Home Depot, 65 managers with, 466 motive for takeover, 595 in v usinesses, 388–389 eovers, 609 Free credit, v Frock, Roger, 462n Fudge factors, 362 cross-border, 68 assumption in percentage of sales models, 513–514 components functions, 506 inputs, 506 outputs, 506 consistency between percentage of sales models, 507–508 pitfalls in design, 512–513 inv v uses of cash, 541 Forelle, C., 660 F Funded debt, 409 Futures, 676 Futures contracts characteristics, 676–677 commodity futures, 679–680 definition, 676 for iron ore prices, 684 gin account, 676n gin requirement, 678 et, 678–679 spot price, 679 versus options, 676 real estate, 684 for risk reduction, 676–680 standardized, 680 et 24, 35, 684 New Y 37, 46, 684 ets, 37 requirements for success, 684 Future value of annuity, 133–135 of annuity due, 137 calculating, 115–116 and compound interest, 114–117 definition, 114 ws, 124–125, 128 in present v 117–118 vings, 135 spreadsheet solution, 122–123 Future value tables, 116, 135, A-2, A-5 IND-14 G Gantchev, Nickolay, 429n Gates, Bill, 131–132, 143–144, 423 Genentech, 426, 592 costs of, 433 seasoned of and shelf registration, 432–433 319, 598 Generally accepted accounting Subject Index balance sheet, 54–57 cash coverage ratio, 94 Growth from e 515–518 Gro Gro internal, 517 sustainable, 518 Growth stocks, 191, 358 determining dividend growth, 203–205 reasons for buying, 202 valuing, 205 Gro y, 190–191 Gulf oil spill of 2010, 486 H General Mills, 336 General Motors, 18, 160, 179, 336, 404, 487, 548, 595 cost of capital, 372–373 WACC, 379–380 economic v y measures, 88–90 f 63–64 w, 65 income statement, 59–60 et capitalization, 81 market value added, 81–82 y, 190 y, 350, 359, 385 ey, C. R., 66, 323n, 465n, 485, 530n Haushalter, G. D., 673n Healy, P., 482n, 486, 611 w, 63–64 sustainable growth rate, 97–98 Hone ger, 592 alue, 388–389 Hostile takeovers, 591 e poison pills, 605–607 shark repellent, 606 2010, 42 holdings of equities 2010, 42, 406 founding of, 423 204 Gordon, Myron, 198 Gordon growth model, 198 Government, Troubled Asset Relief Program, 487 Government bonds amount publicly held, 160 maturity, 168–169 sales of, 159 Gradley 485, 530n Grand Union, 476 Greenbacks, 24 Greenmail transactions, 483 Greenspan, Alan, 215n Greenwood, R., 482n problems with derivatives, 684–685 reasons for, 672–673 gy for, 673 aps, 681–683 v ves, 673 v , 699 as zero-sum game, 672 Helyar, J., 607n Hewlett-P Hickey, Robert, 413 gin strategy, 91 High-yield bonds, 174–175 Histogram, 324, 325 Historical cost, 57, 190 v et accounting, 67 Hollywood Videos, 598 Home Depot, 19, 81, 83, 85, 86, 87–88, 90, 91, 93, 94, 95, 96, 97, 98, 100, 101, 106, 107, 368, 393 Index funds, 43 Inde y, 460–461 Individual investments, 113 iciencies, eliminated by mergers, 595–596 base period, 140 and consumer price index, 140 effect on Bill Gates, 143–144 ef w, 269–270 effect on depreciation, 277 , 671 innov vatives, 683–684 versus investor choices, 672 recognizing investment in w w, 268 Indexed bonds Revolution, 173n Households vulture funds, 39 Hedging alue, 190 Goldman Sachs, 10, 15, 21, 41, 175, 431 and housing crisis, 16 and SEC, 16 Goodwill, 55 Google Finance, 56 Google Inc., 37, 83, 84, 85, 86, 88, 205, 206, 368, 402, 480, 646, 647–648, 650–651, 656, 657, 666 w, 60–63 pro forma, 508–512 Income stocks, 191 vidend gro 203–205 reasons for buying, 203 ws allocated overhead costs, 268 forecasting, 266 rates, 172–174 and time value of money I IBES, 201n IBM, 37, 318, 329, 335, 336–337, 350, 359, 385, 480, 593, 602, 616, 667 Idle cash, 574 invested in mone et, 578–580 Illiquid assets, 95 ImClone Systems, 595 Implicit annual interest rate, 561 Implicit cost of debt, 385–386, 453 Income subject to personal tax, 69–70 Income statement real or nominal present value calculations, 144 ws, 139–141 valuing real cash payments, 143–144 xed debt, 25 and interest rates, 142 in U.S. 1900–2010, 140 Information content of dividends, 486–487 Information value in sensitivity analysis, 297 Initial public of Apple Inc., 35–36 Apple IPO and Massachusetts, 427n xpenditures on, 63 bookb xcluded, 84 expense items, 59 Home Depot, 69–70 426 direct costs, 429–430 Federal Express, 4, 186 IND-15 Subject Index information on, 45–46 Google Inc., 204, 423 issue price, 427 Microsoft, 423 et vs. coupon, 164 per period, 561 present v 123–124 ov prospectus, 427 v owned, 426 and SEC re v v and market v Inventories v 70 vestment management composition of, 571 costs of holding, 571 vately Visa, 430 vation by Apple Inc., 33 in derivativ et, 683–684 Insolvency, 404, 481n Installment plan, 126 vestors, 18–19, 42 proxy contests, 604 Insurance companies 174, 269 TED spread, 546 ten-year Treasury bonds, 1900–2009, 164 on trade credit, 561 v Interest rate sw Interest tax shield, 85n, 456–457, 609 as v value of shareholders’ equity, 456 Internal growth rate 2010, 42 holdings of equities in 2010, 42, 406 , 41 , 43 Intangible assets, 3, 6 Internally generated funds, 465 companies relying on, 402 reliance on, 403 Internal rate of return alue, 307 types of, 559 Inv e arehousing, 548 Inv composition of inventories, 571 , 572 319–322 , 352 , 97 just-in-time systems, 573 and production to order, 573 storage costs, 571 Inventory period wing, 159 paying for, 113 estimating, 534 Inv ver v gin, 91 relativ y, 12, 14 Inv Inv alue, 190 inv and economic value added, 537 level divisions, 534n relative liquidity, 530n v and dispersion of possible outcomes, 324 measures of dispersion, 324–325 vestments annuities, 128–130 compound interest, 114–117 costs of, 227 vidends, 113 w of, 34 future value, 190 ver ratio, 88–89 245 for long-lived projects, 241–243 v gies of hedge v 235, 236 v 425, 426, 530 Interest versus coupon rate, 165 simple, 114 tax-deductible, 69 Interest coverage, 94 es, 412n Interest payments, 64n, 509, 541 on before-tax income, 409 f v capital, 243 pitfalls cost of capital, 244 247–248 xclusive projects, investments by, 41 largest, 41 underwriters, 427, 431 underwriting, 41 Investment decisions, 3; see also Capital budgeting xclusive projects and value maximization, 13–14 vestors, 6–7 464 beha attitudes tow inv 215 y laws, 427 verage, 94 decisions, 7 on T Interest rate quotes, 138 Interest rates and bond prices, 126 choices without hedging, 672 and company cost of capital, 376 e v for choosing between mutually exclusive projects, 259–260 f, 13–14 , 24–25 new, 503 and compound interest, 114–117 discount basis quotes, 579 discount rate, 118 discount rate, 241, 242 deceiv differing time horizons, 194–197 div and payout policy, 487 decisions, 270 Internal Rev 274, 277, 612 408 on gov Internet, bill payment by, 575–576 effect of dividend change, ,6 w Investment e fear of default, 698 in initial public of IND-16 Subject Index Investors—Cont. xuberance, 215, 696 ov ycles, 209 required return, 371 senior vs. junior, 415 L valuing liquidity, 698 v wide choice of securities, 319 w Iow ets, 37 IPO; see ailure, 6 358 Lazard, 41 LBO; see Leveraged buyouts Lease, 413 Leasing, 699 Lee, Dorothy K., 413 Le Le Issue costs, 433 405 Issued but not outstanding stock, 405 J J. D. Edwards & Company, 605 JCPenney, 83, 84 Jensen, Michael C., 466, 482n, 609n Jinghua Y 210 Jobs, Steven, 423 Johnson, J., 516, 604n Johnson, Ross, 607–608, 609 Johnson & Johnson, 83, 84, 189, 190, 191, 192, 350, 359, 385, 425 Jorwar, A. N., 434n JPMorgan Chase, 40, 47, 175, 176, 431, 580 dividend cut, 486, 487 Junior investors, 415 et default rates, 608 x 610 eover business, 608 Just-in-time systems, 573 K Kahn, V. M., 566 Kaplan, S., 609 Kellogg, 336 Keown, A., 210 o’s, 4, 401 K Nabisco LBO, 607–608, 609–610 Kolasinski, Adam, 357 Kozlo oods, 592 Liquidation creditor preference for, 477 L. A. Gear, 530 y, 532 Labor costs, 541 A., 611 y, 460, 477, 549 default by, 580 repo agreements, 67 Lev ws alue of annuities, 133–135 valuing annuities, 129–133 v Leveraged buyouts, 93 case, 616 cash co gets, 609 607 decline and recov versus reor alue, 190, 191 Liquid bonds, 175 Liquidity adv of assets, 95 of cash holdings, 574 v T 698 e alue of, 698 measures of, 95–97 of mone et, 579 pro institutions, 44–45 v vehicles, 95 Liquidity ratios cash ratio, 96–97 net w and incentives, 609 et, 608 management buyouts, 607 private equity, 607 M Macro risks; see Mark Madoff, Bernard, 15 Maintenance, 392 Majority voting, 407 e, 32 cost of mer e-outs, 610 div leveraged buyouts, 607–610 proxy contests, 603–604 takeovers, 604–607 assets, 96 quick ratio, 96 Litigation , 609–610 y, 609 , 609 Loss of degree of freedom, 328n Lotteries, 131 Lowe’s, 19, 83, 100, 106 477 malpractice suits, 10 Live Nation, 703 Loan cov , 696–697 replacing, 595–596 uyouts definition, 607 payoff from incentives, 609 adding v agency problems, 16–19 see also dishonest, 103 Lock-box system, 574–575 609–610 and stakeholders, 609 es, 608–609 Leverage ratios cash coverage ratio, 94 debt equity ratio, 93 debt ratio, 93–94 293 ethics of value maximization, 302–303 w, 466 eover, 612 use of WACC, 371 and sustainable growth rate, 98 see also function, 92 times interest earned ratio, 94 Levi Strauss & Company, 426 Liabilities on balance sheet, 54–57, 189 et value, 57–58 Lie, E., 660 Life insurance companies, 20 , 8, 10 v , 465 views of debt policy, 465–467 views on dividends, 485 focus of, 504 xible production advantage of liquidity, 530–531 total capital requirements, 528–530 f Margin account, 676n Marginal tax rates, 70 Mar Marked to market, 678–679 etable securities, 531 decisions, 527 9–10 venture capitalists, 425 Line of credit, 545–546 Liquid assets, 54, 95–96 212, 213 new issue puzzle, 212–213 repayment pro T definition, 81 ved equipment for selected companies, 84 IND-17 Subject Index Mark mechanics of 602–610 agency costs, 603 for selected companies, 189 et value added w, 598–599 return, 248 260 wnership and management, 603 e 598–599 , 598 w et-v 205–206 et vs. coupon rate, 164 o , 702 et accounting, 67 v leveraged buyouts, 607–610 proxy contests, 603–604 takeovers, 604–607 Market index, 319 Market order, 186–187 Mark problems, 413 aul R., 319, 320, 321, 324, 325, 327, 328 e 353–354 Masonite, 609 et line, 355–356 calculating, 353–354 definition, 352 measuring, 382 , 352 et risks, 43, 692 Apple IPO, 427n Massachusetts Bay Colony, 24 MasterCard, 576 Masulis, Ronald W., 434n, 472 , 548 y market, 578–579 matching, 529–530 , 595 recent, 591, 592 RJR Nabisco, 24–25 sensible motives for commercial paper, 579 vernment resources, 595 to create synergies, 593–594 ertical inte 595–596 takeovers, 604–607 in U.S., 1962–2009, 591, 592 vertical, 592 ynch, 25, 41n, 47, 431, 592 Michaely, R., 485 336 measuring betas, 346–349 portfolio betas, 350–352 div see Value maximization McCain, John, 37 McConnell, J. J., 596 McDonald’s, 189, 192, 201–202, 329, 350, 359, 385, 524 McGuire, William W., 660 McNichols, Maureen F., 563–565 v 345 spreadsheet solution, 348 et-to-book ratio, 206 e for selected companies, 191–192 et value, 229 y cost of capital, 376–377 versus book value, 57–59, 189–191 in calculating WACC, company examples, 46 and debt ratios, 93 , 404 e sheet, 88 594 Memorex, 476 Merck & Company, 554, 592 Mergers gulation, 611 wav case, 616 conglomerate, 593 Daimler , 593 versus divestitures, 610 dubious reasons for 693, 696 Money; see also Time value of money greenbacks, 24 in 17th century America, 24 Money management, 22 Mone et, 36 191, 329, 350, 359, 385, 437, 445, 446, 480, 530 cash dividend, 491–492 founding of, 423 MidAmerica Energy, 279 Middle-of-the-road policy for f w convention, 276n elson, W. H., 434n en, Michael, 610 Miller 696, 702 541 Minuit, Peter, 116, 117 Mitchell, M., 611n v 450 MM di vance proposition def definition, 578 578–579 interest rates, 579 liquidity of, 579 recent mark repurchase agreements, 579 T yields, 580 Moody’s Inv 174, 411, 413, 563, 579 Moore, Gordon, 117 Mor y, 10, 21 A. D., 16 alue analysis, 132–133 Motorola, 604 Mullins, D. W., 434n ws future value, 124–125 present v spreadsheet solution, 128 analysis, 565 260 , T., 573n closed end, 38n, 696 consistently successful, 212 versus exchange traded funds, 44 functions, 38–39 holders of corporate bonds in 2010, 42 description, 488–490 MM proposition I, 693 cost of equity, 452 div evaluation of and v 406 impact of merger on, 597 alue, 696 w e aves of, 697–698 v LBOs, 607–610 system, 278 number of, 39 open end, 38n IND-18 Subject Index Mutually exclusive projects, to choose between two projects, 234 O calls and puts, 646–649 on convertible bonds, 645 ferent outlays, 246 , vs. payback rule, 239 liabilities, 66–67 259–260 Myers, S. C., 387n, 434n, 458n value of, 692 valuing long-lived projects, 230–234 Net w see also W capital entries N Najluf, N. S., 434n NASDAQ, 35, 36, 186 number of stocks traded, 319 NASDAQ Composite Index, 696 NASDAQ 100 index, 44 NASDAQ stock index, rise and decline of, 213 Dealers Automated Quotation system, 186n , 703 v Negativ Net asset value, 38n Net income v function of sales, 513–514 Net w New issue puzzle, 212–213 Newmont Mining, 329, 332–333, 350, 351, 359, 365, 385 New products development of, 6 effect on existing products, 266 investment in, 293 Ne New York Mercantile Exchange, 37, 45, 684 New York Stock Exchange, 8–9, 11, 36, 185, 186 changes since 2007, 35 w, 63 Net present v break-even point, 300 examples, 228–229 to measure w negative, 265 negative in accounting break-even analysis, 300 new computer system, 232 of 229 x, 248 vestment e Net present v ven Net present v and IRR, 242–243 Net present v olume, 620 New York Stock Exchange Composite Index, 206–207 New York Stock Exchange stocks, 357 No-di No-growth dividend discount model, 197 No-gro , 197 ws, 139–141, 269–270 Nominal cost of capital, 269–270 Nominal dollars, 141 Nominal interest rate, 141–142, 172–174, 269 Nonconstant growth stocks estimating McDonald’s v 201–202 inv v value of di Nondiversifiable risks, 692 Non-profit organizations to choose among projects inv 235–236 ved equipment, 236–238 replacement of old equipment, 238–29 NPV; see Net present v One-at-a-time sensitivity analysis, 297 Open account, 562 entries , 563–565 ve Cs of credit, 563 Z-score model, 565 versus payoff from holding stock, 652 protective put, 650 , 651 on real assets, 657–658 Open-end fund, 38n Open-mark w, 275–276 of cost-cutting projects, 271–272 dealing with depreciation, 272 example, 273 forecasting, 387–388 Operating income after-tax, 85 calculating, 87 ef uyouts, 609 for risk reduction, 674–675 et, 37–38 , 693–694 xpand, 305–306, 658 aluation models Black-Scholes model, 655, 657, 659 simple model, 656 Option values verage, 303–305, 451n and project risk, 361 gin, 90 Operating risk models for, 655–657 upper and lower limits, 652 659 effect of debt, 450–451 in accounting break-even of holding cash, 573 692; see also Cost of ws, 263 ef estimating, 263 versus internal rate of return, 243 and project risk, 317 445, 459 Option(s) 406 convertible bonds, 659–661 ex ve stock options, 659 w 505 to expand decision tree, 306 e Option Option premium, 646, 648 Options annual volume, 645 backdating scandal, 660 gression, 349n Outputs of f Outside directors, 407 Outsourcing vs. v integration, 595 Ov Overhead costs, 268 Ov Over et, 36 Overv P P P Page, P , 423 P Palm, 611 Pandora, Inc., 438 Partch, M. M., 434n P definition, 9 types of, 9–10 ,9 P alue of bonds, 160 Paulson, John, 39n IND-19 Subject Index P holdings of equities in 2010, 42, 406 y discounted, 239 Positive-NPV projects, 694–695 plausibility, 294 P adv , 240 cutof definition, 239 length of payback periods, 239–240 problems with, 239 reasons for using, 240 Pay lag, 582 Payment date, 481 Payment mechanism, 45 Payment systems checks, 574–575 , 576–578 United States, 576 Payoff on hedging instruments, 671 on options, 649, 650–561 Payof Payout policy, 479 and capital budgeting, 487 case, 499–500 controversy assumptions behind MM ef MM di not taxed, 70 Pension plans assets in 2010, 40 it, 39n, 40n ution, 39 Pensions, 413 ge Projects, 234 PeopleSoft, 605–607 PepsiCo, 189, 192, 473, 599 Percentage of sales models assumptions in, 513–514 Postpetition creditors, 477 its, 413 Po , 131, 137 Po ets, 37 191–192 no-growth, 197 vidends as, 378 present value, 198 v w v 455–456 actor, 119 effect of interest rates, 165 e decisions on, 485–487 average rate, 70 high vs. low implication of tax rates, 493 vestment decisions, 487 ws, 485 on dividend income, 70 121 Petersen, M. A., 571n cash dividends, 480–481 stock di 385, 473, 592, 667 gers, stock splits, 482 v w, 490–491 reasons for dividend value reasons for dividend value increase, 491–492 Payout ratio, 97 definition, 203 595 erton, J., 210 owitz, L., 530–531 ood, 476 and future value, 117–118 in future value of annuity, 134 as intrinsic value, 192 investment timing decision, 235 ws, 126–127, 128 new computer system, 232 Plowback ratio, 97, 518 alue), 160 Principles-based accounting, 68 Priv Privately owned businesses, 426 Private placement, 412 adv and Rule 144a (SED), 434 Probabilities, beliefs about, 215 , 215 Procter & Gamble, 204 debt issue, 414 ycle, 534 , 573 Product life cycle, 98 ve advantages in, 400 Products, sales of new vs. e 266 v w, 60–63, 264–265 determining factors, 190 economic value added, 84 expected, 567 of perpetuities, 127–128, 198 Ponzi scheme, 15 Portfolio betas, 350–352 e macro risks, 336 Portfolios div performance of, 320–322 2010, 42 Prime rate, 509 Plug; see Poison pill, 605–607 Tea, 586 Pension funds def et, 35–36 61–62 , 79 structure definition, 465 e inancing, 465 and company prospects, 205 and mergers, 597 dividends, 408 expected rate of return, 383–384 Present value , 129–130, 136–137 calculating, 117–123 w, 264 , 236 Permanent w requirement, 530n T of gasoline, 141 conv lack of v vileges, 408 and net worth, 407 tax advantage, 408 complications, 513–514 Price(s) of assets, 692 650 spreadsheet solution, 122–123, 233 126–127 of Treasury bonds, 162, 163 using compound interest, 118 Present value of growth et-v 206 Present value tables, 119, A-3, A-4 Present value tax shield, 455 x, 228, 248–250 with capital rationing, 249 pitfalls, 249 positive net present value, 248 inv receiv ver ratio, 88 ver, 88–89 ver, 89–90 , 87 IND-20 gin, 90 versus inv ver, 91 low vs. high, 90–91 for selected industries, 92 Pro forma balance sheet, 507, 508 Pro forma income statement, 507 Pro formas, 506 second-stage, 509–510 Project analysis break-even analysis accounting, 298–300 net present value, 300–303 verage, 303–305 case, 315 inv ve advantage, 294 capital budget, 292 consistent forecasts, 293 interest, 293 Subject Index and capital budgeting, 359–362 v 359–360 and company cost of capital, 359–360 contemplating v 335 336 , 361–362 operating leverage, 361 Q QQQs, 44 QUBES, 44 Quick ratio, 96 xible production facilities, 308 option to abandon, 307, 658 option to expand, 305–307, 658 R timing, 307–308 Real rate of return, 318 693 577n Rates of return, 14; see also and div 322–323 for bonds, 168–171 calculated for bonds, 166–168 in capital mark , 319–322 333–334 ault, 463 with debt-equity mix, 375–376 Receiv ver ratio, 89–90 Recession, 330–332 Recession of 2007–2009, 48 Record date, 481 Re Regression line, 349n Regular dividends, 480 Re 362 estimating, 322–323 estimating cost of capital from , 322–323 Ford Motor Company, 365 Geothermal e government bonds, 1900–2010, 321 histogram, 324, 325 calculating v viation, 324–327 v v 327–329 sensitivity analysis, 295–297 w, 271–273 age value, 279 spreadsheet solution, 280 with zero net present v Real estate bubble, 213 Real estate futures, 684 Real interest rate, 142, 172–174, 269 Real options Alleghen Receivables, 89 aging schedule, 569–570 xible production facilities, 308 option to abandon, 307 option to e timing, 307–308 277–279 and financing, 270 forecasting w identifying, 264–268 allocated overhead costs, 268 ws, 266–268 w, 268 y vs. safe, 694–695 ws, 139–141 selling, 647–649 Puttable bonds, 661 , 208–209, 329–330 273–274 protective put, 650 Rajan, R. G., 571n Rajgopel, S., 66 292–293 reducing forecast bias, 293–294 capacity expansion, 293 maintenance cost reduction, 293 new product investments, 293 outlays required, 292–293 Project betas, 694–695 ws, 263 alue, 276 capital investment, 271 w analysis, 274–276 Real assets, 38 Project cost of capital estimating, 360–361 et line, 361 e Ne Reinsurance, 43n Reinvestment, 33 Relaxed approach to f 529, 530 Rent, contingent, 303 Reorganization v procedures, 475–476 Repayment pro Replacement problem, 235, 238–239 Repurchase agreements ve covenants in mone 47 percentage return, 318 real, 318 ve put, 650 costs of, 603–604 et, 579 transactions, 15 Required e 515–516 capital, 240–241 et risk, 345 at PeopleSoft, 606 T T y Accounting Residual income, 84, 537 323–323 Ov T v Walt Disney Company, 365 v , 167–169 , 651 ve f , 595 y, 529 Ra payof and operating income, 450 IND-21 Subject Index Sa derivatives, 673 evidence on, 673 with forw vings, 135 xpected, 358 e with futures contracts, 676–680 innovations in derivatives, 683–684 on T vatives, reasons for hedging, 672–673 with sw value of tools for, 699 at Home Depot, 87 Home Depot vs. Lowe’s, 100–101 gin, 90 for selected industries, 92 and beta, 353–354 297–298 Schiller Scholes, Myron, 655, 694, 702 Schref Schw Schwed, Fred, 702 Sealed direct costs, 429 et, 36 net present value, 296 one-at-a-time, 297 for project analysis, 295–296 wns, 296 v v wnership and control y problems, 16–19 and agency theory, 694 downside of, 9 and agency theory, 694 y, 477 versus bondholders, 463 x, fering, 426 357n for Home Depot, 85–86 et line, 356 , 517, 518 see also Risk management verage, 94–95 for Home Depot, 87 for software firms, 98 Revenue recognition, 66 Revenues, examples of, 5 Rhie, Jung-Wu, 563–565 y, 660 Rieker, M., 487 Rights issue, 431n, 432 Risk(s) w div hedging, 671 market, 692 mark measurable, 336–337 of New York Stock Exchange stocks, 334 verage, 305 alue, 229 selection of, 671 of v CAPM, 354–359, 692, 695 wing on, investments, 352 et line, 355–356 Risk-averse, 12 Risk-free rate, 354 measuring, 382 Risk-free return on T 353 Second-stage pro formas, 509–510 Secured debt, 411 Secured loans accounts receiv 547 cost of mergers to, 600–601 dele 11–12 dividend reinvestment plan, 479 verage, 451 versus speculation, 684 , 43–44 , Jay, 212n, 428n, 429n hazards of, 548 inv Securities, 7; see also Bonds; , 36 607–608, 609–610, 612 Road shows, 427 Rockefeller, John D., 702 21 Roll, R., 482n Ruback, R., 611 Rules-based accounting, 68 ed-income, 578–579 ed, 47 priv relativ shelf registration, 433 at true value, 400 v iculties, 214 wide choice for investors, 319 Securities and Exchange S Safeway, 593 Sales conditional, 562 credit agreements, 562 of new vs. e 266 on open accounts, 562 Sales-to-assets ratio, 88 Sales volume, 298 break-even, 299 break-even point, 300 Salvage value, 274, 279 Sarbanes-Oxley Act, 18, 103, 427, 610 urden of, 68 Savings capital, 373–374 and ethics of value income vs. debtholders, 92 inv 81–83 ge number of, 9 no-growth stock, 197 o 605–606 proxy contests, 603–604 , 375–376 , 87 verse, 12 654 on private placement, 434 and proxy access, 604 re Rule 144a, 434 et line and project acceptance, 361 Security prices, 692–693 Self-liquidating loans, 546 Selling, Thomas I., 92 y, 211, 693 Senior investors, 415 Sensiti pooled in hedge funds, 39 vidends, 481–482 v 11–14 voting procedures ve voting, 407 proxy contests, 407 Shareholders’ equity on balance sheet, 55–56 book vs. market value, 58 created at Home Depot, 86 vestment decisions, 80–81 maximizing, 79 ed costs, 295 William F., 345, 702 IND-22 Subject Index Shelf registration advantages, 433 v , L., 213 Short sellers, 39 Spin-offs, 610 by 3Com, 611 Staunton, Mike, 320, 321, 324, 325, 327, 328 w y, 84, 537 y A., 593n Stew y, Clyde P., 92 Stock, 7; see also Common stock; Spread, 160, 176, 427 Spreadsheets annuity present v model, 657 bond valuation, 170–171 cash budget, 540 case, 556–557 cash budgeting, 539–543 decisions, 527 future value calculation, 122–123 ws, 128 time horizons, 528 528–530 commercial paper, 548–549 tracing changes in cash and w w line of credit, 545–546 sources commercial paper, 548–549 re secured loans, 547–548 ev e present v 122–123 present v 542–544 Squared deviations, 326 effect of financial distress, 462 in LBOs, 609 relation to companies, 17–18 s, 174–175, 329, 411, 563, 579 s Composite/500 Index, viation, 334 calculating, 326 Consolidated Edison, 346 103, 413–414 , 601–602 Stock di Stock exchanges electronic communications networks, 186 limit order book, 187 NASDAQ, 186 New York Stock Exchange, 186 number of stocks traded, 319 see also entries Stock market, 31 consolidation, 33 crash of 1929, 24, 329 crash of 2007–2009, 24, 322 decline in 2002, 322 decline in 2008, 14 336–337 viation of returns, 328 ucks, 18, 330, 350, 359, 385 b capital requirements, 423 Federal Express, 4 211–212 as equity market, 36 functions, 35–36 venture capital for State laws ws, 427 di Statement of account, 570 w puzzle, 212, 213 new issue puzzle, 212–213 and market risk, 43 , 186 et, 35–36 reaction to stock issues, , 186 et, 36 v 345 ve bubbles, 696, 698 Speculative grade bonds, 174–175 Spinning, 431 211–212 ex-dividend, 481 w, 65 of Home Depot, 63–64 items on, 63–65 Statement of shareholders’ equity, 54n Google Inc., 423 Home Depot, 81 alue, 192–194 liquidation value, 190 Microsoft, 423 aluation models, 655–657 ov par value, 405 and put options, 647 random w reactions to news, 210 wing, 185 in selling calls or puts, 647–649 speculative bubbles, 696 trading range, 482n alue of call option, 652–653 yardstick for performance, 426 Stock repurchase, 405 by Apple Inc., 33 vidends, 483–484 e mark Soft rationing, 249 Sole proprietorships, 9 , 21 Special dividends, 480 Specialist in stock trading, 186 y values, 46 ws, 611 w issues, 433–434 et value, 42n Dow Chemical, 346 , Douglas, 485n Small Business 475n Small b 566 ge-firm stocks, 358 bid-ask spread, 187 et value, 189–191 et, 186 eholders s Depository Simple interest, 114 Simulation analysis, 297–298 defensive, 346 ex factors af measuring v 327–329 mergers f 464 vioral f ws, 233 351–352 versus cash, 573 Sidel, R., 487 aggressive, 346 amount traded in e 319 fect, 486 Apple Inc., 423 v Stock market bubbles, 213–214 Stock market listings, 187–189 Stock options, 426, 660 means of auction, 483 gotiation, 483 greenmail transactions, 483 open-market repurchase, 482–483 tender offer, 483 aluation, 484 in U.S. 1980–2008, 480 Stock splits, 482 Storage costs, 571 275–276 udgeting, 504 IND-23 Subject Index Strategy matched with capital budget, 292 ws, 124 Taxation adv T Treasurer, 10 T of investors, 194–197 504 e, 171–172 yield in May 2010, 172 iciency, 211, 693 Structured investment v Stuyvesant, Peter, 24 Subordinated debt, 411 et, 698 depreciation deduction, 272 depreciation tax shield, 277–279 disadvantage for 415 Time line for future value, 125 T Time value of money annuity due, 136–137 effective annual interest rate, 138–139 future value of annuity, 133–135 future values, 114–117 disadv wing, 458 vidend policy, 492, 493 et accounting, 67 least risky investment, 352 in mone et, 579 320–322 safety of, 320 standard de 328 T auction in 2003, 160 auction sales, 431 and interest rates, 141–142 174 Sunk costs, ignoring, 266–267 on individual income, 70 Sun Microsystems, 480 ger as use for, 595 wth rate, 203–204, 518 calculating, 97 variability in, 98 Swaps credit-def y swaps, 682–683 144 interest rates, 161–166 ws, 139–141 320–322 v vidends, 408 ACC, 377 Tax payments, 541 Tax rates T personal taxes, 70 see also 143–144 ws, 127–135 ws, 124–126, 128 present values, 114–124 Time W , Inc., 175, 610 T TIPS; see T lev maturity, 168–169 real interest rate, 172–173 standard de 328 trading of, 126 , 167 Total capitalization, 84 T interest rate swaps, 681–682 Synergies elusive, 594 mergers to create, 593–594 T Takeovers, 19 case, 616 612 , 609 Oracle and PeopleSoft, 605–607 poison pills, 605–607 by proxy contests, 603–604 shark repellent, 606 tender offer, 604 unsuccessful, 604 Tangible assets, 3, 6 on balance sheet, 54 easy to sell, 307 hea v inv Tar vidend, 485 Tar Target Stores, 536, 624 Taxable income, 70 toxic mortgage-backed T T TED spread, 546 T , 483, 604 10K reports, 54 10Q reports, 54 T w vs. incremental w, 268 T alue, 201 T T cash before deliv , 560 cash on delivery, 560 credit sales, 560–561 due lag, 582 Total capital requirements vel of advantages of liquidity, 530 529–530 permanent working capital requirement, 530 seasonal v T T w, 276 on bonds, 167 yield to maturity as measure of, 168 T et risk, 350 T Trade credit, 531 credit scoring for, 563–565 561 pay lag, 582 Trade-off theory of capital trade credit interest rates, 561 Tesla Motors, 440n Te , R. H., 611 3 Com, 611 Tick , 703 T an y, 536 Tight money policy, 163 Time deposits, 531 T Trading range, 482n Transaction costs, 573 T ef effect on income statement, 62–63 T y, 103 T T World A), 476 T T T Tropicana, 609 Troubled Asset Relief Program, 487 T alue, 400 T inancial transactions, 15 T ws, 138n T U disadvantage, 428 and inv reasons for Underwriters best ef , 433 gest in U.S., 431 road shows, 427 , 431 spinning by, 431 w , 659 IND-24 Subject Index acific, 6, 13–14 dividend dates, 481 dividend reinv inv decisions, 5 V 697 components, 93 destroying, 79 dividends/stock repurchase 1980–2008, 480 dot-com bubble, 213 impact of payout decisions, 489 and liquidation value, 190 market capitalization, 81–84 market-to-book ratio, 83 et vs. asset values, 696–697 mergers 1962–2009, 591, 592 payment systems, 576 ubble, 213 v ,9 Unocal, 599 US Airways Group Inc., 8n U.S. Robotics, 611 V VA Linux, 431 V 191–192, 202 V V see also alue xpiration, 646 400 of entire businesses, 387–389 of no-growth stock, 197 of put option at e of real cash payments, 143–144 Value added Value stocks, 358 V V x, 43 V x fund, 354 V xT V T et index, 44 V V linked to sales, 303 and operating leverage, 303–305 V in sensitivity analysis, 297 Wall Street Journal, 160, 185, 199, 202, 204, 660 et listings, 187 W W W 192, 329, 350, 359, 385, 456, 480, 573, 624 inv decisions, 5 W gy, 91 Walt Disney Company, 329, 350, 359, 365, 385, 604, 703 W Washington Mutual, 404 W iciency, 211, 693 Webb, Susan, 21 Weighted average cost of capital, 84n, 85n, 373–380 accuracy of, 379–380 e function of, 294 sensiti 295–297 Whole F et, 599 Wick Wildcat oil wells, 335 W ets, 599 Wilhelm, W. J., Jr., 16 Williams Act of 1968, 605n Williamson, R., 530–531 Wilshire 5000 Market Index, 211 Window dressing, 67 Wind power project, 279 Winner’s curse, 428 W , 577–578 W additional investment in, 268 version cycle, 533–536 382 273–274 e stock, 382–383 components changing with cycle of operations, 533–534 e stock, 383–384 , 384 using market value, 380–381 y cost of capital, 374–377 case, 394–396 y, forecasting, 277 530n recognizing inv 267–268 tracing changes in, 537–539 V calculating, 327 Dow Chemical, 377–378 Ford Motor Company, 384n V and business plan, 424 Geothermal Corporation, 379–380 V 425–426 V V 504, 505 gration V es, 385–386 corporate taxes, 387 ef 386–387 W 536 accounts receivable credit policy, 560–571 case, 588 cash management, 573–578 inv 571–573 inv et, 578–580 W f managerial use of, 371 V V vestment Survey, 98n ethics of, 14–16 goal of shareholders, 11–14 and investment trade-off, 13–14 agency problems, 16–19 vestment v V V ger, 592 Vlasic, Bill, 593n Voting procedures with common stock, 407 408 V 18–19 le gulatory requirements, 18 W 380–381 multiple sources of capital, 378 y, 384 for selected companies, 385 and taxes, 377–378 valuing entire businesses, 387–389 Weiss, L. A., 460n Wells-Fargo, 586, 592, 703 Wendy’ in, 536–537 Workout, 475 WorldCom, 18, 67, 175, 427 W ven, 423 Wurgler, J., 482n Wyeth, 592 W X WACC; see Weighted average cost eholders, 17–18 takeovers, 19 udgeting, Wachovia, 25, 592, 703 295 83, 84 XTO Energy, 592 IND-25 Subject Index Y Y Y Yield on corporate bonds, 142, 175 on mone et investments corporate vs. gov securities, 580 default risk, 580 et turmoil, 580 Z on TIPS in 2010, 173 Yield curve 168 172–174 upw Yield spread, Treasury vs. corporate bonds, 175–176 Y , 160, 161 168 promised vs. expected, 177 v 168–169 selected corporate bonds, 175 for T Zack’s, 201n Zero-coupon bond, 120n, 177 Zero net present value, 242, 247 ws, 380 Zero-stage investment, 424 Zero-sum game, hedging as, 672 Zhao Quanshui, 429n Ziemba, W. T., 213 Z-score model, 565
