FINANCIAL MANAGEMENT

Study Guide

Financial Management By

Joshua Iversen

About the Author

Joshua Iversen holds a Bachelor’s degree in History from the University of California, Los Angeles. He has worked in the financial services industry since 1988 and is currently the President and Chief Investment Officer of Syzygy Financial LLC. He uses the knowledge gained during his more than 25 years in the industry to write about topics pertaining to finance and investing.

All terms mentioned in this text that are known to be trademarks or service marks have been appropriately capitalized. Use of a term in this text should not be regarded as affecting the validity of any trademark or service mark.

Copyright © 2016 by Penn Foster, Inc.

All rights reserved. No part of the material protected by this copyright may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without permission in writing from the copyright owner.

Requests for permission to make copies of any part of the work should be mailed to Copyright Permissions, Penn Foster, 925 Oak Street, Scranton, Pennsylvania 18515.

Printed in the United States of America

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INSTRUCTIONS TO STUDENTS 1

LESSON ASSIGNMENTS 5

LESSON 1: FINANCIAL MANAGEMENT 7

LESSON 2: KEY FINANCIAL CONCEPTS 37

LESSON 3: CAPITAL MANAGEMENT 151

SELF-CHECK ANSWERS 223

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YOUR STUDY GUIDE Welcome to Financial Management! This study guide is designed to help you make the most of your textbook, Finance: Applications & Theory, Third Edition. Here you’ll find a study plan that includes a useful introduction and a list of your reading assignments. As you work through your study guide and textbook, you’ll learn about important principles of finance. When you finish each lesson in the study guide, you’ll complete a multiple-choice examination. This course provides a basic introduction to the study of finance, including financial institutions, investments, and corporate finance. First, you’ll learn about the essential concepts and analytical tools of financial management, because they’re used in all three areas of study. Then, you’ll explore the key financial concepts underlying these practices. Finally, you’ll learn about the theory and practice of capital management. Note that this study guide isn’t meant to take the place of your textbook. Rather, it’s designed to complement the text material by highlighting essential concepts and clarifying difficult content. In addition, the study guide provides examples and problems to reinforce the textbook readings, as well as assignments and self-checks to help you evaluate your understanding of the material before you complete the examinations.

KNOW YOUR BOOK Finance: Applications & Theory, Third Edition, is the heart of this course. This textbook provides the material you need to know to successfully complete your Financial Management course. Read the material in the text and study it until you’re completely familiar with it. This is the material on which your examinations are based. Before you actually begin reading your assignments, however, become thoroughly familiar with the textbook itself. Refer to it as you read through the following information.

Start your survey of the textbook by turning to the “A Note from the Authors,” beginning on page viii, which describes the key themes of the textbook. Continue your survey on the page

Instructions to Students2

titled “Brief Table of Contents.” Note that the textbook is organized into nine parts. The Table of Contents lists the topics included in each of the nine parts of the textbook. Skim these topics to see what to expect in each chapter. As you use your textbook, take time to study the examples, figures, equations, tables, and other graphics included. These illustrations supplement or amplify the discussion—in fact, many of them are integral parts of the discussion. You’ll also notice that the margins include definitions from the text.

Be sure to review the appendices associated with Chapter 6, 12, 14, and 20. Finally, the index refers you to page numbers and is especially useful for reviewing topics. Each chapter contains viewpoints for both business and personal applications. Learning goals at the start of each chapter are highlighted throughout to emphasize key aspects of the text. Each numbered example has an accompanying video-guided example that you can access by scanning the QR code or by going to the book’s student edition website.

Some of this material is analytical in nature and requires you to understand some mathematical calculations. Example problems in your textbook and study guide help you to master these calculations. Math Coach boxes are included in many chapters to help you complete particular problems. Some of the problems can be completed manually or with the help of tables. However, you’ll find that some calculations are easier to perform with a financial calculator. Your textbook references two inexpensive financial calculators: the Hewlett- Packard 10B II Business Calculator and the Texas Instrument BA II (Plus or Professional). Refer to the Math Coach “Using a Financial Calculator” in Section 4.2 of your textbook for further details and instructions for using common financial buttons. You can also use an electronic spreadsheet such as Microsoft Excel to perform financial calculations if you prefer. The Student Equations Handbook includes all equations from each chapter of your textbook as a quick equation look-up. As you go through each chapter, be sure to complete the “Time Out” questions from each section. The answers to these questions can be found at the end of each chapter.

Instructions to Students 3

COURSE OBJECTIVES When you complete this course, you’ll be able to

n Categorize financial management functions and organizational structure

n Analyze a firm’s financial statements, cash flow values, risks, and returns

n Recommend budgeting policies, planning, structures, and costs for a firm’s capital

A STUDY PLAN This study guide leads you through your assignments. The information, instructions, and advice provide a great approach for building your knowledge in these lessons. You must read this study guide and your textbook carefully, and you should follow the instructions for each assignment.

Complete all work related to each assignment before moving on to the next.

To complete these lessons,

1. Read the short introduction to each assignment in the study guide.

2. Read the required sections in the textbook, and work through the practice problems contained in the assignment.

3. Complete the self-check in the study guide for each assignment, and check your answers against those provided at the back of the study guide.

4. When you’ve finished reading all of the assigned text- book pages for each lesson and you’re sure that you’re comfortable with the material, complete the examination for that lesson.

Each examination contains 20 multiple-choice questions. Take your time as you complete each examination—there’s no time limit. You may go back to your textbook to review material at any time when you’re working on the examination.

Lesson Assignments4

Repeat these steps until all three lessons have been completed. Remember, you may ask your instructor for help whenever you need it. Your instructor can answer your questions, provide additional information, and provide further explanation of your study materials. Your instructor’s guidance and suggestions will be helpful as you progress through your course.

Now, look over the lesson assignments. Then, begin your study of financial management with Lesson 1.

Remember to regularly check your student portal on your student homepage. Your instructor may post additional resources that you can access to enhance your learning experience.

Please note that a computer can’t be used to take proctored exams for this course.

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Lesson 1: Financial Management For: Read in the Read in the study guide: textbook:

Assignment 1 Pages 8–15 Chapter 1

Assignment 2 Pages 16–22 Chapter 19

Assignment 3 Pages 23–36 Chapter 20

Examination 081773 Material in Lesson 1

Lesson 2: Key Financial Concepts For: Read in the Read in the study guide: textbook:

Assignment 4 Pages 38–54 Chapter 2

Assignment 5 Pages 55–74 Chapter 3

Assignment 6 Pages 75–85 Chapter 4

Assignment 7 Pages 86–95 Chapter 5

Assignment 8 Pages 96–111 Chapter 6 and Appendix 6A

Assignment 9 Pages 112–131 Chapters 7 and 8

Assignment 10 Pages 132–138 Chapter 9

Assignment 11 Pages 139–148 Chapter 10

Examination 081774 Material in Lesson 2

Lesson 3: Capital Management For: Read in the Read in the study guide: textbook:

Assignment 12 Pages 150–158 Chapter 11

Assignment 13 Pages 159–164 Chapter 12

Assignment 14 Pages 165–173 Chapter 13

Assignment 15 Pages 174–185 Chapter 14 and Appendix 14A

Assignment 16 Pages 186–192 Chapter 15

Assignment 17 Pages 193–199 Chapter 16

Assignment 18 Pages 200–207 Chapter 17

Assignment 19 Pages 208–219 Chapter 18

Examination 081775 Material in Lesson 3

Instructions to Students6

Note: To access and complete any of the examinations for this study guide, click on the appropriate Take Exam icon on your student portal. You should not have to enter the examination numbers. These numbers are for reference only if you have reason to contact Student CARE.

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Financial Management

INTRODUCTION One of the most important components of any business operation is financial decision making. Business decisions at all levels have some underlying financial implications, either direct or indirect. Financial concepts also arise in the everyday management of personal resources. It’s important, therefore, to understand the basics of finance. For example, the time value of money and the analysis of financial state- ments are basic components of finance used throughout this course and in future finance classes. It’s essential that you take time to master these concepts. As you work your way through this course, you’ll learn the importance of finance to the success of every entity, both personal and professional.

In Lesson 1, you’ll learn some important fundamentals of finance. The lesson also covers issues related to international corporate finance, including a look at international opportunities, issues associated with managing exchange rates, and political risks associated with doing business in a foreign country. The final assignment in the lesson focuses on mergers and acquisitions and an examination of how companies enter into and deal with financial distress.

OBJECTIVES When you complete Lesson 1, you’ll be able to

n Define financial areas, principles, functions, and business organizations

n Analyze international opportunities, risk, and the foreign currency exchange

n Classify various types of mergers, acquisitions, and financial distresses

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ASSIGNMENT 1 Read this assignment. Then read Chapter 1 in your textbook.

The textbook defines finance as the study of applying specific value to things we own, services we use, and decisions we make. Financial management refers to the practice of valuing things from the standpoint of a company or firm. It’s vitally important to a firm’s success and, looked at broadly, can also be applied to other financial decision-making processes such as personal finance.

Cash flow is the process used to pay and receive money. To understand the concept of cash flow, it’s helpful to consider an economy’s participants and their relationship to money. Figure 1.1 in your textbook lists four types of economic participants. Two of the four groups are relevant to our study of financial management:

n Type 2 participants, typically called individual investors, are those who have money to invest but no ideas of their own in which to invest.

n Type 3 participants are sometimes people but more typically corporations with research and development (R&D) departments focused on the development of innovative ideas (or investment firms formed for the purpose of investing in companies of this type). They have viable business ideas but no money of their own to fund these ideas.

By studying how these two groups interact, we can more easily understand how money (capital) flows in the form of capital investments.

Financial markets and financial institutions in most devel- oped countries allow Type 2 and Type 3 participants to work together in a mutually beneficial manner. When investors lend excess capital to companies, those companies can deploy the capital to pay for expansion projects, as shown in Figure 1.2 in the textbook. If these projects are successful, the compa- nies will eventually have enough money to return the original investment along with a profit to their investors. See Figure 1.3 in the textbook.

Lesson 1 9

The amount of capital sent to investors generally doesn’t equal all of the capital earned by a project. Sources of friction include retained earnings—funds a company keeps to pay for ongoing operations—and taxes. Figure 1.4 in the textbook demonstrates the various perspectives involved in the investment of capital. Decisions include

n Determining which investment opportunities fit investors’ risk tolerance and return potential criteria

n Determining how best to distribute the capital

n Deciding which projects to fund, what type of capital to use, and how much earnings from the project should be returned to investors

Subareas of Finance The different methods used and entities involved in financial activity in a particular sector of an economy make up what are called subareas of finance. They include the following categories:

n Investments. This subarea involves the means used to decide what type of securities an investor will buy, the specific firms from which an investor will purchase the securities, and how an investor will be repaid for their investment. The investment process is demonstrated in Figure 1.5 of the textbook.

n Financial management. This subarea focuses on how a firm makes decisions to acquire and use cash (capital) sourced from investors or retained earnings. The financial management process as it applies to investment decisions is outlined in Figure 1.6.

n Financial institutions and markets. These entities make it easier for capital to flow between investors and companies. See Figure 1.7 in your textbook.

n International finance. This subarea of finance deserves a place of its own in the category. Uncertainty relating to future exchange rates, political risk, and changes to business laws globally can add significant complexity to business decisions.

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The Financial Function Cash flows don’t occur immediately, nor are they guaranteed. The uncertainty involved in future cash flows, both as to timing and size, is referred to as risk. For investors, risk involves uncertainty about the return of invested capital. For companies, risk involves uncertainty about their ability to fund and operate business projects. The majority of financial decisions revolve around a comparison of the potential rewards a decision may bring against the risks generated by that decision. When comparing risk and rewards, it helps to determine the current value of cash flows expected to be received in the future. The price of financial assets, like stocks and bonds, depends to a great extent on the expected future cash flows from those investments.

Financial assets are typically categorized by their risk and return characteristics. Commonly recognized asset classes include stocks, bonds, real estate, money market securities, and derivatives. The measure of current cash flows is called present value. Relating expected future cash flows to present cash flows is called the time value of money (TVM). Analyzing TVM involves taking into account both the timing and level of risk associated with any projected cash flows.

The highest ranking financial manager at a company is typically the chief financial officer (CFO). A company’s treasurer and controller usually report to the CFO. In addition to the financial duties of the CFO and the managers that report to the CFO, finance plays a significant role in other areas of most organi- zations. It’s used to provide guidance for long- and short-term decisions as well as provide feedback about financial decisions made by the firm.

Finance is also used in making personal financial decisions such as

n Borrowing money to buy a new car

n Refinancing your home mortgage at a lower rate

n Making credit card or student loan payments

n Saving for retirement

Topics such as calculating risk, return, and time value of money will be further covered in other assignments.

Lesson 1 11

Business Organization There are a number of ways people can choose to structure a business in the United States. Typically, the number of owners is the crucial determinant as to how a business structure is classified. Structure is based on

n Who controls the firm

n Who owns the firm

n What are the owners’ risks

n What access to capital exists

n What are the tax ramifications

Forms of Business The form of a business is significant. For example, there are tax advantages and disadvantages to certain forms of ownership. The majority of businesses are sole proprietorships, owned by a single individual. A sole proprietorship is easy to form and has some tax advantages. However, the primary disadvantage of the sole proprietorship is that the owner has unlimited personal liability. Furthermore, the owner’s liability isn’t limited to his or her investment in the business. Rather, it extends to all personal assets.

A partnership has many of the same features as a sole propri- etorship, although the business has two or more owners. As with the sole proprietorship, each partner (owner) in a general partnership is legally liable for the business’s debts. Thus, the advantages and disadvantages of this form of business are roughly the same as in the sole proprietorship. A limited partnership limits the level of liability for some of the partners. This business arrangement grants one or more partners limited liability for the operations of the business; debts can be extended only to their investment. A limited partnership allows some individuals to invest in the business without bearing personal liability for the firm’s debts. One or more of the partners still maintain full legal liability and control over the business operations.

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A corporation is a legal entity established by the state. The corporation is established as an entity and thus can own assets, collect debt obligations, and pay taxes. The most that individual owners can lose or be liable for is the amount that they’ve invested in the firm. One disadvantage of a corporation is that taxes are due on the corporation’s earnings and also on any dividends paid by the corporation to its shareholders as personal taxes.

A hybrid organization is one that offers both limited personal liability for the owners and passes through the earnings of the firm, allowing them to avoid the double taxation corporations are subject to. This type of structure includes S corporations, limited liability partnerships (LLPs), and limited liability corporations (LLCs). Hybrid status is generally restricted by the U.S. government to firms with a limited number of share- holders or partners in line with the objective of using these forms of organization to encourage small business formation.

Firm Goals While some contend that social responsibility should be favored over maximizing profitability, most financial industry participants and academics tend to believe that maximizing shareholder wealth should be the primary focus of a company’s managers. To do this, the textbook identifies the following factors a manager should evaluate:

n How best to bring additional funds into the firm

n Which projects to invest in

n How best to return the profits from those projects to the owners over time

Agency Theory When one party (the principal) employs another party (the agent) to work for him or her, this is known as an agency relationship. The agent is expected to act in the best inter- ests of the principal. The agency problem describes situations in which the agent works for his or her own best interests

Lesson 1 13

instead of those of the principal. For instance, consider the case of a corporate executive who purchases a luxury vehicle with company funds, when a more practical car would have saved the firm money. To deal with the agency problem, a company can take a variety of approaches:

n Simply ignore the conflicts if the monetary value or effect is negligible.

n Monitor the behavior of managers. Excessive monitoring is likely to be counterproductive but can be done via the process of accounting auditing.

n Take steps to align the personal interests of managers with the owners of a company by using methods such as stock ownership in the company via means such as employee stock option plans (ESOPs).

Corporate Governance Corporate governance is taking steps to monitor managers and align their interests with those of shareholders. Since shareholders don’t typically focus on the daily operations of a company and its managers, other methods are used. For a public corporation, this includes the board of directors, who are appointed to safeguard the interests of shareholders. Monitoring the firm from outside are auditors, investment banks, analysts, and credit rating agencies. These entities help investors judge whether a corporation’s managers are acting in such a manner as to warrant investment in the securities of the firm.

Ethics Ethics has a major role in finance. Financial professionals and corporate managers working in agency relationships are responsible for making decisions on behalf of investors and shareholders. These are known as fiduciary relationships, and any conflict of interest must be resolved in the best interests of the party that the fiduciary agent is working for. Financial institutions (FIs) help others with transactions involving financial assets that take place in financial markets. Figure 1.10 in the textbook shows how they generate profits by taking the role of an intermediary in the markets.

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Markets are subject to the risk of financial contagion as well as risk posed by unethical behavior. The financial crisis that peaked in 2008 and early 2009 was an example of how fear can spread globally in investment markets. The crisis—which arose from problems experienced by defaulting subprime mortgage borrowers in 2006 and 2007—resulted in damage to financial institutions, decreased the availability of credit, and damaged investor confidence. The resulting crisis led to the federal government taking action to stimulate the economy in response to the slowdown in economic activity. As a result, by summer and fall 2009 the domestic economy looked to be starting to recover. However, with lenders and consumers appearing to be more cautious in the wake of the crisis, the process of recovery has been longer and slower than in typical recoveries.

Lesson 1 15

Self-Check 1

At the end of each section of Financial Management, you’ll be asked to pause and check your understanding of what you’ve just read by completing a “Self-Check” exercise. Answering these questions will help you review what you’ve studied so far. Please complete Self-Check 1 now.

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What’s accomplished by the successful application of financial theories?

2. How do investors and companies experience risk?

3. What are some of the most commonly accepted types of asset classes?

4. At most companies, what does a person in a finance position use historical figures and current information to determine?

5. What’s the biggest disadvantage of sole proprietorship relative to other forms of ownership?

6. Why did Adam Smith argue that the actions of individuals pursuing their own interests in an economy tended also to promote the good of the overall community?

7. Why must ethics play a major role in the practice of finance?

8. What’s meant by the term corporate governance?

9. What approaches can a firm use to deal with the agency problem as it relates to the firm’s managers?

10. What factors led to the financial crisis that peaked in fall 2008?

11. Why is a corporation said to be subject to double taxation?

12. How do hybrid organizations avoid double taxation?

13. What are some situations in which you can use finance to help you make good personal financial decisions?

Check your answers with those on page 221.

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ASSIGNMENT 2 Read this assignment. Then read Chapter 19 in your textbook.

Our world today is a globalized one, with many corporations operating all around the world and consumers able to use goods supplied from or manufactured in areas far from where they live. While the United States has the largest economy in the world, other countries such as China and India are experiencing faster growth rates as they attempt to catch up to the major developed world economies. Fast-growing international economies offer business opportunities that many companies are interested in taking advantage of. In doing so, they must be aware of two major factors affecting trade between countries: (1) restrictions on the types of goods that can enter a country and (2) tariffs that consist of fees charged on products transported across borders.

To make it easier for trade between countries to occur, several international trade agreements have been reached over the past two decades. The purpose of these agreements is to lower or eliminate trade restrictions such as product prohibitions and duties, tariffs, and other fees. Recent trade agreements include the

n North American Free Trade Agreement (NAFTA)

n Central America Free Trade Agreement

n Mercosur free-trade zone

In Europe, the European Union (EU) includes 27 members par- ticipating in an open marketplace, allowing easy trading of goods and services across borders. In sum, the economic power of the EU rivals that of the United States. Many countries in the EU also use the euro, a common currency unit. International organizations have been formed to promote free trade globally. The World Trade Organization is one such entity. Located in Switzerland, it consists of 159 signatory countries.

Lesson 1 17

Corporate expansion into other countries involves a variety of activities:

n Simple export and import into a foreign country

n Partnering with a foreign company in one of the following ways:

o Sales subsidiary

o Licensing/franchising

o Joint venture

n Direct capital involvement by establishing direct ownership of a company’s operational assets in a foreign country

Multinational corporations, which produce products and services in multiple countries, invest capital to gain direct ownership of assets. In some cases, such activity is driven by companies discovering that it’s better to manufacture products for sale in a certain country. Capital deployed to operate foreign operations is called foreign direct investment. This type of investment, both by U.S. firms and by firms investing in the United States, has grown substantially in recent years.

Foreign Currency Exchange When conducting international business, a major challenge company managers face is the use of different currencies by foreign countries. To purchase products internationally, U.S. companies must purchase foreign currencies with U.S. currency. The price of one currency as compared with another is called an exchange rate. The price of a currency can be quoted either in domestic units or in units of a foreign currency. An indirect quote details the number of foreign currency units needed to purchase one unit of domestic currency. A direct quote specifies an exchange rate in terms of the amount of domestic currency required to purchase a single unit of foreign currency. A direct quote is equal to the inverse of an indirect quote:

Direct quote 5 1 4 Indirect quote

Let’s look at a problem that illustrates how currency exchange works.

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Example: Brian wants to travel to Australia for a nature tour of the Outback. He determines he will need $3,000 Australian dollars to pay for the trip.

Question: How many U.S. dollars will he need to convert into the required amount of Australian currency?

Solution: If we use the exchange rate of $.9707 shown in Table 19.2 in the textbook, the equation is as follows:

Brian needs $3,091 US$ to convert into $3,000 AU$.

If a U.S. firm wishes to exchange two nondollar currencies, a cross-currency quote is needed. Table 19.3 in the textbook shows an example of cross rates used for this purpose.

When direct quotes and cross rates diverge, arbitrage, a technique focused on buying low and selling high, becomes possible. Arbitrage is used by people seeking to profit by finding mispriced exchange rates through the comparison of direct quote exchange rates between two different currencies, with cross rates calculated in a third currency.

Exchange Rate Risk

While it’s relatively easy for corporations to exchange different currencies, the problem they face when dealing with currencies is that their values change over time. Exchange rate risk refers to the possibility that exchange rates will change in an unfavorable manner over time.

Exchange rates for most major currencies are free to change in accordance with supply and demand factors for a specific currency; this is known as a freely floating regime. Some gov- ernments take steps to influence the exchange rate of their currency by buying or selling the currency to alter supply and demand. This type of currency manipulation is referred to as a managed-floating regime. Another approach is a fixed peg arrangement, typically to a basket composed of world currencies.

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Lesson 1 19

A method used by financial managers to help them lower exchange rate risk to a degree is to use forward exchange rates, which price a currency on some future date rather than using the current, or spot, price. They do this by negotiating an exchange rate for currency that they’ll exchange for months in the future. Table 19.4 in your textbook provides an example of forward exchange rates. Financial managers use the process of hedging to lessen exchange rate risk. They do this by minimizing the foreign currency it’s necessary for their firm to exchange. An alternative strategy is to lock in exchange rates by taking steps to negotiate future currency trades via the use of forward rates. Finally, a financial manager can engage in the use of financial derivatives such as futures contracts, options, and currency swaps to help hedge currency risks.

Types of Parity

The concept of interest rate parity is used to explain the divergence often seen in spot and forward currency rates. The concept holds that the forward rate will be at a level that, taking into account the total return gained from the interest rate and exchange rate changes, the total return between the two countries will be equal. This is the same as saying that the differences between spot and forward rates occur because of the different levels of interest rates in the two countries.

Let’s look at a problem that illustrates how interest rate parity works.

Example: Solve for interest rate parity, using Equation 19–1, the exchange rates in Table 19.4 of the textbook, and six- month interest rates of .25% for the United States and .14% for Switzerland.

Question: What should the forward rate be for the Swiss Franc?

Solution: As the rates in Table 19.4 are indirect quotes, they must first be turned into direct quotes for the spot rate

1 9312

1 0739 .

.= and for the six-month forward rate 1

9284 1 0771

. .= .

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Then rearrange the formula to calculate the following answer

The strengthening of the currency over time indicated by the equation shows that when a foreign interest rate is lower than the domestic one, a currency will strengthen against the foreign currency over time and vice versa if the foreign interest rate is higher.

The concept known as purchasing power parity (PPP) explains the method by which inflation results in exchange rate changes. This idea comes from a concept called the law of one price. The law mandates that identical products will have the same price, adjusting for currency exchange, wherever they’re sold in the world. PPP can be distorted by the effect of transaction costs such as shipping, insurance, and the like. In addition, a large number of products and services aren’t easily transportable, preventing the law from applying to them. While the law isn’t without exceptions, it does help illustrate why exchange rates change as time passes.

Political Risks When operating in foreign jurisdictions, a multinational corporation (MNC) faces other factors that cause uncertainty in addition to the risk of currency fluctuation. Political risk describes the chances that the political decisions or events that occur in a country will have negative effects on the country’s business climate. Such a scenario can result in the MNC’s investment declining in value or, in the worst case, experiencing a complete loss of value. Political risks tend to increase dramatically when a country’s government experiences a violent or rapid regime change.

The textbook identifies several political risks to an MNC’s assets in a foreign country.

n Government seizure of a company’s assets

n Expropriation with minimal compensation (the government demanding specific cash flows)

n Enactment of new taxation

n Limiting or blocking the conversion of local currency to the MNC’s domestic currency

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=. .

. . 3

Lesson 1 21

International Capital Budgeting While opportunities for global investment may arise on a daily basis, such opportunities can involve substantial financial risks. Financial managers can use strategies such as hedging to help minimize some risks. Doing business globally adds complexity to the process of capital budgeting. Estimating future cash flows, which is by no means easy domestically, is made much more difficult when the effects of exchange rate risks are added in. As a result, a high discount rate accounting for added exchange and political risk should be used.

Cash flows generated by a foreign project will be denomi- nated in the foreign currency. However, the discount rate for a project is typically considered from a domestic currency standpoint. A financial manager can use two methods to resolve this issue.

1. Convert incremental currency cash flows to the domestic currency, which necessitates the estimation of exchange rates for each year the project will be in operation. Once this is done, the process of computing regular net present value (NPV) can go ahead.

2. Convert domestic discount rate into an equivalent foreign currency rate. It’s necessary to use different discount rates for the two countries because they’re not likely to experience the same rate of inflation, thus affecting PPP. Adjusting the discount rate to correspond with the difference in inflation rates in the two countries will produce an NPV denoted in the foreign currency. This should then be converted into the domestic currency using the current spot rate.

Both rate methods should deliver the same NPV.

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Self-Check 2

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What’s the purpose of trade agreements such as NAFTA, CAFTA, and the Mercosur free-trade zone?

2. What are the various methods by which firms expand into international markets?

3. What are two strategies multinational corporations use when manufacturing products, and why do they use them?

4. What do arbitrageurs (those who engage in arbitrage) look for when seeking out a profitable currency trade?

5. How do financial managers implement hedging strategies to reduce exchange rate risks?

6. What does the concept of interest rate parity suggest?

7. What factors may prevent the concept of purchasing power parity from exactly reflecting the law of one price?

8. What are some political risks that pertain to the assets and cash flows of multinational corporations?

9. How can a company minimize the impact of political risk?

10. What type of discount rate should be used when analyzing foreign projects and why?

Complete the following problems at the end of Chapter 19.

11. Problem 19–2

12. Problem 19–11

Check your answers with those on page 222.

Lesson 1 23

ASSIGNMENT 3 Read this assignment in your study guide. Then read Chapter 20 in your textbook.

While a corporation as a business structure has the advantage of a potentially unlimited lifespan, this doesn’t necessarily mean that all corporations will continue indefinitely. As circumstances change, a firm may enter into a merger with another firm, thereby losing its identity. Alternately, it may experience financial distress sufficient to cause it to cease operations. However, distress of this type may result in more of a setback rather than a situation in which a company is unable to survive.

Mergers and Acquisitions A merger is defined as a transaction that serves to combine two firms into one firm. An acquisition, by contrast, is an event in which one firm buys another. While these two definitions vary, the phrase “mergers and acquisitions” is often used to refer to both types of transactions. Generally, the purchaser in a merger or acquisition retains its identity while the acquired firm loses its identity as an independent entity, even if its name is retained by the buyer. A consolidation is a type of merger that involves the creation of a totally new firm from the combination of both the buying and selling firms, which no longer exist as individual entities following the consolidation.

The term mergers and acquisitions can be used to refer to a variety of specific financial combinations. This includes horizontal mergers, which involve the combination of two firms that operate in the same industry. One type of horizontal merger is the market extension merger, which is a combination of two companies that sell the same types of products but in different market segments. The formation of a larger firm in this manner can offer the benefits of economies of scale.

A vertical merger occurs when a firm combines with a supplier or distributor. Such mergers are motivated by factors such as the avoidance of fixed costs, eliminating costs incurred in searching for prices, improved contracting, payment

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collection, communication, and planning for inventory. A conglomerate merger refers to a combination of two companies without related products or markets. These types of mergers were quite popular in the 1960s and 1970s as a way of reducing volatility in earnings and cash flows by combining businesses with noncorrelated earnings streams. As it turned out, many of these mergers ended in reduced market values and were later dismantled. Product extension mergers result from the combination of companies that sell products that are different but somewhat related. These mergers are a hybrid type, combining elements of horizontal and conglomerate mergers. They’re motivated by the prospect that the different products the two firms produce can be successfully sold to customers that both firms already have in common.

Motives for Mergers and Acquisitions

The primary motivation driving a merger or acquisition is synergy, the idea that by working with each other the two companies can generate a combined value greater than the sum of each company’s individual value. There are several ways that mergers provide synergy that enhances value: revenue enhancement, cost reduction, tax considerations, lower cost of capital, managers’ personal incentives, and misallocation of capital.

Revenue enhancement. This concept has three parts. To start, buying a firm that operates in a market that’s growing can increase revenues. Second, if the target company’s asset and liability portfolio has credit, interest rate, and liquidity risk characteristics that are different than those of the acquirer, this can add stability to the acquiring firm’s revenue stream. Finally, an opportunity to enhance revenue is provided by expanding into markets that aren’t fully competitive.

Cost reduction. The opportunity to reduce costs through the operational synergy created by economies of scale, scope, or the concept of managerial efficiency is a frequently cited justification for a merger transaction. Economies of scale refer to the ability of a company to reduce or get rid of overlapping resources as a firm grows in size via a merger. Economies of scale are typically present when the average cost of producing goods and services decreases as the firm’s size grows. Figure 20.2 in the textbook provides an example of this process.

Lesson 1 25

Economies of scope refer to the ability of merged firms to synergistically generate savings in cost by the mutual utilization of inputs in the production of multiple products. X-efficiencies refer to cost savings that don’t arise directly from economies of scope or scale—factors such as superior management skills or other hard-to-measure characteristics of management.

Let’s look at a problem that illustrates how economies of scope work.

Example: If a firm that produces hammers merges with a firm that makes wrenches, how does the combined firm’s average cost of production compare with the total average cost of production of two firms that separately produce the same products? For the merged firm, total revenues are $5 million with a cost of $2 million. The firm producing hammers realizes revenue of $2 million with a cost $1 million, and the firm pro- ducing wrenches sees revenue of $3 million and costs of $1.5 million.

Solution: Using Equation 20-1 found in your textbook, you can determine the average cost for the two firms separately producing a single product as follows:

For the hammer company:

ACh 5 TCh 4 Sh 5 1,000,000 4 2,000,000 5 .50 5 50%

For the wrench company:

ACw 5 TCw 4 Sw 5 1,500,000 4 3,000,000 5 .50 5 50%

The total average cost for the two firms is:

TAC 5 2,500,000 4 5,000,000 5 .50 5 50%

For the merged firm the calculation is as follows:

AChw 5 TChw 4 Shw 5 2,000,000 4 5,000,000 5 .40 5 40% < 50%

Taking advantage of the economies of scope involved in producing and marketing two similar products (in this case hammers and wrenches) gives the combined firm a lower total average cost to produce its goods than that of the two firms operating separately, as shown in the figures above.

A merger is considered to enhance the monopoly power of a firm within the industry. Regulators may try to prevent the merger unless it offers the potential for gains in efficiency that are unlikely to be attained by different means. The U.S.

Financial Management26

Department of Justice has taken the lead in recent years in policing mergers and has put forth guidelines relating to the acceptable criteria for allowing mergers. The guidelines are derived from a market-concentration evaluation measure known as the Herfindahl-Hirschman Index (HHI). This index is calculated by taking the percentage market shares attributable to each company in an industry, squaring them, and adding the squared shares. If the HHI as calculated after a potential merger indicates an unduly concentrated market, the merger is more likely to be challenged.

Let’s look at a problem that illustrates how calculating the change in HHI works.

Example: Using the HHI index formula HHI 5 (Market Shares %)2 and Table 20.2, which provides guidelines for acceptable levels of industry concentration following a merger, calculate whether a merger between Manufacturer A and Manufacturer E would meet the criteria for potentially being challenged by the U.S. Department of Justice.

The market in question features seven firms with market shares as follows:

Manufacturer A 5 25%

Manufacturer B 5 21%

Manufacturer C 5 12%

Manufacturer D 5 12%

Manufacturer E 5 9%

Manufacturer F 5 8%

Manufacturer G 5 6%

Solution: Use the HHI formula to determine the concentration level of the industry:

HHI 5 (25)2 1 (21)2 1 (12)2 1 (12)2 1(9)2 1 (8)2 1 (6)2 5 625 1 441 1 144 1 144 1 81 1 64 1 36 5 1,535

After a merger between Manufacturers A and E, the HHI calculation would change to this:

HHI 5 (34)2 1 (21) 2 1 (12) 2 1 (12) 2 1 (8) 2 1 (6) 2 5 1,156 1 441 1 144 1 144 1 64 1 36 5 1,985

Lesson 1 27

With an HHI of 1,535 the industry would be considered moderately concentrated, according to DOJ guidelines. As a result, a change of greater than 100 in the HHI index would be grounds for potentially challenging a merger. The proposed merger would change HHI from 1,535 to 1,985 for a total change of 450 (1,985 – 1,535 5 450). As the change in HHI exceeds the 100-point guideline, the merger would be subject to challenge.

Tax considerations. The opportunity to take advantage of tax gains from an acquisition has motivated many mergers. The textbook mentions a variety of situations that can provide such gains:

n Tax gains from net operating losses: Firms that are profitable and find themselves in a high tax bracket may want to seek out a merger with a firm that has large, accumulated losses. The merger allows the use of the losses of the unprofitable firm to offset the taxes of the firm that’s profitable instead of being carried forward for possible future use.

n Tax gains from unused debt capacity: Mergers that generate increased debt produce tax savings. As interest on debt is tax deductible, the increased leverage caused by higher debt allows merged firms to experience a tax gain.

n Tax gains from surplus funds: A merger can result in a reduction of taxes by causing a reduction in surplus cash.

Lower cost of capital. A merger in many cases can bring about a lower cost of capital as the costs involved in issuing securities benefit from economies of scale. Diversification brought about by a merger can also cause a lower cost of capital because stabilization in the merged firm’s earnings can result in its debt being classified as less risky than before the merger. This can result in lenders providing lower interest rates for the merged firm’s debt.

In addition to the positive motivation of adding synergy to enhance value, mergers also can be negatively motivated.

Managers’ personal incentives. Business decisions may, unfortunately, be based on the personal incentives driving managers instead of economic analysis. As a result, some

Financial Management28

mergers may be based on the desire of managers to receive personal benefits derived from creating and managing a large corporation. This occurs more often in the case of managers who are poorly monitored. Such managers may try to build corporate empires using negative NPV mergers to solidify their position.

Misallocation of capital. When managers of a merged firm engage in a merger to move resources between the merged firms to enable the subsidization of projects with negative NPV that otherwise wouldn’t be accepted, a merger acts to destroy value. This takes place when the managers of a firm hesitate to reduce jobs or keep a losing operation going for other reasons.

Valuing a Merger

Typically, using net present value (NPV) or discounted cash flow (DCF) methods to determine whether a merger is likely to be profitable is the best approach to take.

Let’s look at a problem that illustrates how the NPV of a merger works.

Example: The cash flow in 2015 of a firm targeted for a potential merger is 1.2 million and expected to grow by 5 percent annually for the next three years. It’s estimated that synergies created by the merger will cause the merged firm’s cash flows to grow by an additional $580,000 in the first year after the merger. These cash flows will grow at a rate of 6 percent in the next two years, with all cash flows for the combined firm growing at 2 percent thereafter. The merged firm’s weighted average cost of capital (WACC) going forward is expected to be 8 percent. The owners of the target firm are asking for $11 million to purchase the firm.

Lesson 1 29

Question: Is this merger a positive NPV project for the bidding firm?

Solution:

The table above shows the estimated incremental cash flow for the bidder firm for the first three years after the merger. After this, cash flows are projected to grow at 2 perecent. Therefore, the value of cash flows occurring after year 3 can be calculated as a constant growth rate similar to the one used to value stocks, which will be covered further in Chapter 8 of your textbook. Thus, the value of incremental cash flows starting in year 4 after the merger can be computed by

1. The value of incremental cash flows received starting in year 4 5 incremental cash flow in year 4 divided by (WACC – growth rate) in cash flows after year 3

5

2. To find the present value of the total incremental cash flows, discount the projected cash flows by the WACC. Present value of incremental cash flows from the merger

3. Compute the NPV of the merger by subtracting the price of the target firm from the present value of the cash flows from the merger:

NPV 5 $30.49m -41m = -10.51m

This merger would be worthwhile for the stockholders of the bidding company, as their wealth would increase by $9.53m if the merger goes through.

$ . . . .

$ . 2 041 1 02

08 02 34 697( )

( )2 3

$ . .

$ . .

$ . .

$ . .

$ .1 84 1 08

1 938 1 08

2 041 1 08

34 697 1 08

30 491 2 3 4 m m m m+ + + =

Projected Post-Merger Incremental Cash Flows for Merged Firm (in millions of dollars)

2016 2017 2018

Cash flows from target firm $1.2(1.05) 5$1.26 $1.2(1.05)

2 5$1.323 $1.2(1.05)3 51.389

Cash flows from synergies 5$0.58 $0.58(1.06)

1 5.615 $0.58(1.06)2 5.652

Incremental cash flows $1.84 $1.938 $2.041

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Financial Distress Financial distress can lead to business failure. But financial distress doesn’t necessarily mean the business is doomed to fail. Economic failure, for instance, is a type of financial distress that occurs when the return on a firm’s assets is lower than the cost the firm pays for capital. This means that the company isn’t making a high enough return on its assets to provide payment to those who supplied it with funds.

Another type of distress is technical insolvency, which occurs when the company’s operating cash flows are insufficient to pay the company’s liabilities when they come due. In both cases, a firm can continue to operate as a going concern and can perhaps even thrive again at some point. However, if these issues aren’t dealt with, they can cause dividend cuts, plant closings, work force reductions, and, ultimately, business failure or acquisition or merger with another company.

Various factors that can lead to financial distress are

n A large debt load

n A highly volatile earnings stream

n Poor management

n Fluctuations in the business cycle

n Restrictive monetary policy

Informal Resolutions of Financial Distress

A company experiencing financial distress may seek to informally resolve the issues it faces by seeking a voluntary restructuring of debt agreements; this is most likely to occur if the firm’s financial distress seems to be temporary, motivating the firm’s creditors to cooperate with the firm in the restructuring of its debt obligations so it can return to viability. If, on the other hand, it doesn’t seem likely that the firm will be able to survive its financial distress, the company and its creditors may decide that a liquidation of the firm’s assets should take place. There are various types of informal resolutions.

Lesson 1 31

Restructuring debt agreements. This typically involves making changes to debt agreements involving an extension or composition. An extension is a postponement of the dates on which interest and/or principal payments are due. This allows creditors to eventually receive their full payments without having to force the company into bankruptcy. This approach is generally taken by creditors when they believe it will result in a higher expected payoff than would be the case by forcing the firm into bankruptcy. A composition occurs when creditors voluntarily reduce their claims on the company, accepting a partial payment on their claims. Either the principal amount or the interest rate is reduced, or equity is accepted in exchange for debt reduction.

Informal liquidation of a firm’s assets. If a firm’s creditors decide after analyzing a firm’s situation that it isn’t viable as a going concern, liquidation of the firm takes place. If the liquidation is voluntary, the assets of the firm will be sold and the proceeds used to pay off the company’s creditors. In an assignment, liquidation of the firm’s assets is handled by a third party, known as an assignee or trustee. The assignee seeks to liquidate the assets of the firm, usually via a private sale or public auction. Proceeds are distributed to the firm’s creditors, and any remaining funds are paid to the stockholders. Assignments work best with smaller companies or those not involved in complex liquidation processes. The arrangement can save money compared with a formal bankruptcy process, thus allowing creditors to receive a larger amount of funds from the liquidation process.

Federal Bankruptcy Laws

When a firm that has encountered financial distress is unable to secure agreement on informally restructuring the company or liquidating its assets with its creditors, the creditors can force the firm into bankruptcy. Bankruptcy can lead to either the restructuring or reorganization of a company or its liquidation. The principal law guiding bankruptcies in the United States is the Bankruptcy Reform Act of 1978. Its two main parts are as follows:

1. Chapter 11 provides a plan to reorganize a corporation with the intent to repay the corporation’s creditors to at least some degree. In Chapter 11, a firm facing temporary

Financial Management32

distress is given the chance to operate while the claims of creditors are negotiated in a collective settlement process.

2. Chapter 7 is the process followed when liquidating a failed firm. This type of bankruptcy is typically used only if reorganizing a firm using Chapter 11 doesn’t seem feasible

Reorganization procedures in bankruptcy. The procedures for reorganizing in bankruptcy are as follows:

n A firm voluntarily files a reorganization petition, or the creditors of the firm file an involuntary petition requesting reorganization.

n At least three creditors (or a single creditor if there are fewer than 12 creditors in total) must file a petition claiming the firm isn’t making payments on its debts.

n A federal judge reviews the petition and, if approved, creditors and shareholders make filings proving their claims. The corporation has 120 days to turn in a plan of reorganization.

n The firm is now the debtor-in-possession and is given the authority to continue running the business.

n Firms that enter Chapter 11 don’t always survive the process. Those that do use the reorganization period to take steps to restructure their business and balance sheet to enable them to emerge from bankruptcy.

Liquidation procedures in bankruptcy. Firms that face a level of financial distress too high to allow for successful reorganization are liquidated through Chapter 7 bankruptcy proceedings. When the bankruptcy courts determine that a reorganization isn’t likely to succeed, the judge selects a trustee-in-bankruptcy to manage the property of the firm and safeguard the creditors’ interests. Trustee’s responsibilities include the following:

n Liquidating the firm’s assets

n Examining the creditor’s claims

n Keeping records

Lesson 1 33

n Disbursing funds

n Furnishing information to involved parties as requested

n Making final reports on the liquidation

Bankruptcy courts have set up a priority of claims, also known as an absolute priority rule, for disbursing funds in a liquidation. The priority order used for distributing funds from asset liquidations is detailed in Section 20.2 under “Liquidation Procedures in Bankruptcy” in your textbook. Priority and secured creditors are paid before unsecured creditors. If the funds are insufficient to pay unsecured creditors in full, the funds are distributed on a pro rata basis.

Predicting Bankruptcy

Market participants such as managers, creditors, and stockholders use a variety of models to gain a broader picture of a firm’s projected viability. Models that use quantitative methods to assess the likelihood of bankruptcy are known as credit-scoring models. Such models use past data, allowing managers to

n Numerically establish which factors are important in explaining bankruptcy risk

n Evaluate the relative degree or importance of these factors

n Improve the pricing of bankruptcy risk

n Screen high-risk firms

The main benefit of credit scoring is that creditors can more accurately predict the performance of a firm without using more resources.

Linear discriminant models. These models classify firms into either high or low bankruptcy risk categories by evaluating their observed financial characteristics. A widely used discrimi- nant model is the Z-score model created by Edward Altman. Z-scores less than 1.81 suggest a high risk of bankruptcy within a year, while Z-scores above 2.99 suggest a low risk over the same time period. Z-scores between 1.81 and 2.99 are inconclusive.

Financial Management34

Let’s look at a problem that illustrates how the Z-score model works.

Example: Consider a company with the following financial ratios:

X1 5 0.1

X2 5 0.2

X3 5 –0.30

X4 5 0.2

X5 5 2.5

Solution: Using Equation 20-4 in the textbook (Z 5 1.2X1 1 1.4X2 1 3.3X3 1 0.6X4 1 1.0X5), we can compute the Z-score as follows:

Z 5 1.2(0.1) 1 1.4(0.2) 1 3.3(-0.30) 1 0.6(0.2) 1 1.0(2.5)

Z 5 .12 1 .28 – .99 1 .12 1 2.5

Z 5 2.03

According to Altman’s Z-score, the bankruptcy risk for this firm over the next year is indeterminate.

Problems with the Z-score model include the following:

n The model typically discriminates between two types of relatively extreme company behavior—becoming bankrupt or not becoming bankrupt. In the real world, there are many gradations between these two extremes, suggesting that more classes should be defined to refine the model.

n The weights used in this model or any credit-scoring model may not remain constant over longer time periods. The explanatory variables used by the scoring model don’t take into account that different ratios specific to the firm may become more relevant when considering bankruptcy risk.

n Models such as this ignore difficult-to-quantify factors such as reputation of the firm and its managers, or macro considerations such as consumer confidence or the direction of monetary policy.

Lesson 1 35

n The lack of a centralized, easy-to-access database on defaulted loans or the results of bankruptcy proceedings makes it harder for creditors to take advantage of credit scoring in regard to larger business loans.

Linear probability and logit models. Linear probability and logit models produce a value corresponding to the probability of bankruptcy. They use factors relating to past repayment experience or bankruptcy to estimate the likelihood of future bankruptcy—known as the probability of default (PD). They sort firms into two classes: those that have experienced default or bankruptcy in the past and those that haven’t. Then, they associate these observations using linear regression to a collection of causal variables based on the firm’s financial information.

Let’s look at a problem that illustrates how a linear probability model works.

Example: A firm you’re analyzing for possible investment has a debt-to-equity ratio of 40% and a sales-to-asset ratio of 1.4. What’s its expected probability of default using the linear probability Equation 20-5 and Example 20-6 in your textbook?

Solution:

PDi 5 0.5 (Debt/Equity) – 0.1 (Sales/Total assets)

PDi 5 0.5(.40) – 0.1(1.4) 5 .2 – .14 5 .06, or 6%

According to the model, the firm has a 6 percent chance of default, or bankruptcy.

The weakness of linear models is that estimating the probability of bankruptcy can produce results outside the 0 to 1 interval. In the logit model, this is dealt with by limiting the scope of bankruptcy probabilities.

Financial Management36

Self-Check 3

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. In a consolidation, what happens to the firms involved?

2. Why does the government regulate horizontal mergers between companies in the same industry?

3. What are the sources of achieving synergy in a merger?

4. How does the concept of economies of scale differ from the concept of economies of scope?

5. How can X-efficiencies bring about cost savings?

6. What’s the Herfindahl-Hirschman Index (HHI) used for?

7. What are some of the tax considerations used to justify mergers?

8. What are two major types of financial distress?

9. What are the main methods of informally resolving financial distress?

10. What are the major methods of dealing with bankruptcy in federal court under the 1978 Bankruptcy Reform Act?

11. What are some credit-scoring methods used to predict bankruptcy, and how do they work?

Complete the following problems at the end of Chapter 20.

12. Problem 20-6

13. Problem 20-7

14. Problem 20-8

Check your answers with those on page 224.

L e

s s

o n

2 L

e s

s o

n 2

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Key Financial Concepts In this lesson, you’ll learn about the key concepts that underlie both personal and business financial activities, such as the time value of money and financial ratios that help you analyze the performance of a company, including return on share- holders’ capital and relation to a company’s liquidity and capital structure.

The time value of money allows you to determine the present and future value of a stream of payments or the rate of return on a project or investment. The principle also extends into the valuation of stocks and bonds, where various related measures are used to determine the price, yield, and return characteristics of these security instruments.

The lesson also covers the characterization of risk and return, which are fundamental factors in the analysis of an investment portfolio.

OBJECTIVES When you complete Lesson 2, you’ll be able to

n Identify a firm’s cash flow using its financial statements

n Analyze financial ratios and their relationships with a firm’s performance

n Calculate the time value of money for single cash flows

n Calculate the time value of money for annuity cash flows

n Compare various types of financial markets and institutions

n Formulate the value of bonds and stocks

n Analyze an investment’s risk and return

n Calculate an investment’s risk and return using various methods

Financial Management38

ASSIGNMENT 4 Read this assignment. Then read Chapter 2 in your textbook.

The duties of a corporate manager include reporting to the public about the company’s financial condition and notable events. One major report corporations release is the annual report, which includes four basic financial statements:

1. The balance sheet

2. The income statement

3. The statement of cash flows

4. The statement of retained earnings

A financial statement provides an accounting-based snapshot detailing a firm’s financial position. Accountants use such statements to provide a picture of what occurred in the past. Financial professionals use them for a different purpose: to help them make inferences about what might happen in the future.

The four statements listed previously offer crucial information to managers, who use them to make financial decisions, and to investors, who use them to help decide whether to make investments in the firm. In this assignment, you’ll learn how improving your understanding of these statements helps provide you with insight into the decision-making process in managerial finance.

Financial statements issued by publicly traded firms are fairly easy to find. They’re typically available in the following locations:

n On the firm’s website

n On the Securities and Exchange Commission (SEC) (www.sec.gov)

n Other financial websites (such as finance.yahoo.com)

Since the SEC doesn’t require financial statements from non- public companies, acquiring in-depth financial information about such firms can be difficult. This ability to keep financial statements private is one reason firms may decide to avoid

Lesson 2 39

going public—having their stock become publicly traded. This assignment covers the major features and uses of the four financial statements listed above. It also focuses on the difference between the accounting-based value, or book value, of a company that’s tracked by these statements and a firm’s true market value, which may differ from the book value. It will also examine the presentation of a firm’s earnings and the manager’s role in preparing the firm’s financial statements.

Balance Sheet A balance sheet is used to report a company’s assets, liabilities, and equity. It displays assets owned by the firm as well as claims on those assets at a particular date. The assets of a firm must be equal to the liabilities and equity used to purchase the assets—these figures must balance out. Assets on a balance sheet are enumerated in descending liquidity order. This means current assets—those assets that are easiest to convert to cash—are listed first, while fixed assets—the least liquid type of assets—are listed last.

Assets

Assets are resources that have economic value and can provide a future benefit to an individual, corporation, or country that owns or controls them.

The two major types of assets include the following categories:

1. Currents assets typically can be converted into cash within a year. They include cash, marketable securities (short-term, low-rate investment securities that a firm holds for the purpose of liquidity), inventory, and accounts receivable.

2. Fixed assets possess a useful life in excess of one year. Fixed assets include net plant and equipment and less tangible items, such as patents and trademarks. The value of net plant and equipment is calculated by determining the difference between gross plant and equipment—the fixed assets’ original value can also be used—and the depreciation that has accumulated on the fixed assets from the time they were purchased. Other long-term assets are also listed net of any amortization.

Financial Management40

Liabilities and Stockholders’ Equity

The funds provided by lenders become liabilities to the company. They’re listed in two categories:

1. Current liabilities are obligations of the firm due within one year, such as accrued wages and taxes, accounts payable, and notes payable.

2. Long-term debts include long-term loans and bonds having a maturity of more than a year.

The difference between the total assets and the total liabilities of a firm is the stockholders’ equity, also known as owners’ equity. A firm’s stockholders’ equity is generated by funds from its preferred and common stock owners. Preferred stock is a form of hybrid security having features of both long-term debt and common stock. It’s similar to common stock because it constitutes an ownership interest in the firm that issued it. However, as with long-term debt, it also pays out a fixed periodic payment, known as a dividend. The ownership claim that’s fundamental in relation to a public or private company is called common stock and paid-in surplus. The proceeds derived from common stock and paid-in surplus are the other component of stockholders’ equity. The reinvestment of cumulative earning is listed on the income statement rather than paid out as dividends to stockholders; these amounts are called retained earnings.

Managing a Balance Sheet Items listed on their company’s balance sheets that managers must monitor include the following:

n The accounting method for fixed asset depreciation

n The level of net working capital

n The liquidity position of the firm

n The method of financing the firm’s assets—equity or debt

n The difference between the book value reported on the balance sheet and the true market value of the firm

Lesson 2 41

Accounting Methods for Fixed Asset Depreciation

Managers can choose the accounting method they use to record depreciation. Depreciation refers to the charge against income reflecting the estimated cost in dollars of the fixed assets belonging to a firm. Two types of depreciation are described:

1. The straight-line method is typically used to report income to a firm’s stockholders.

2. Modified Accelerated Cost Recovery System (MACRS) is normally selected by firms to report their taxes. It accelerates depreciation, resulting in higher depreciation expenses and therefore lower taxes in a project’s early years.

Whichever type of depreciation is chosen, over time the amount of depreciation and, as a result, tax (cash) payments will be the same. However, the MACRS method is often favored by companies because it can defer the payment of taxes.

Net Working Capital

Net working capital is the difference between a company’s current assets and current liabilities. Bondholders and other company stakeholders assess a firm’s net capital level as a way to gauge its capacity to pay its obligations.

Example: XZZ Manufacturing had year-end current liabilities of $12 million in 2013, $14.6 million in 2014, and $17.2 million in 2015. If the firm had current assets in those years of $14 million in 2013, $15.4 million in 2014, and $18.4 million in 2015, what was the firm’s net working capital in each of those years?

Solution: Use the following formula to find the firm’s net working capital:

Net working capital 5 Current assets – Current liabilities

2013: $14 million – $12 million 5 $2 million net working capital

2014: $15.4 million – $14.6 million 5 $0.8 million net working capital

2015: $18.4 million – $17.2 million 5 $1.2 million net working capital

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Liquidity

Firms require cash and other liquid assets to pay bills, including debts as they come due and other expenses. Liquidity has two components: how easy the conversion of an asset to cash is, and to what degree the conversion occurs at a fair market price. Highly liquid assets can quickly be disposed of at fair market value, while illiquid assets—mainly fixed assets such as buildings and equipment—generally can’t be sold quickly unless the price is reduced substantially below fair value.

Liquidity can both benefit and harm a firm. While a high level of liquidity helps a company avoid financial distress, liquid assets such as cash generally don’t provide much in the way of income. Fixed assets, on the other hand, can enable a firm to generate revenue despite being illiquid. As a result, managers must balance the pluses and minuses of holding liquidity on the balance sheet versus acquiring fewer liquid assets in an attempt to increase the firm’s revenue.

Debt versus Equity Financing

Firms can employ financial leverage by using debt securities to fund the firm’s ventures or assets. As debt rises, so does financial leverage, which can increase a firm’s earnings or its losses. If a firm chooses to finance its operations and assets via debt securities—generally bonds—the holders of this debt typically stipulate that they have first claim on a fixed amount of the cash flows generated by the firm. The claims they make are fixed due to the fact that the firm pays only the interest owed to them along with any principal repayment. This contrasts with stockholders who are entitled to claim any cash flows remaining after debt holders have been paid. As a result, if a firm performs well, financial leverage boosts the earnings allotted to shareholders, as the cash flow due to bondholders is fixed.

Financial leverage serves to increase risk. A firm that’s excessively leveraged can experience financial distress and even bankruptcy if the firm’s business suffers. Managers often prefer to use debt to finance the company’s business so they don’t have to give away an excessive portion of the value

Lesson 2 43

of the company. However, they must carefully evaluate their usage of debt when deciding on the company’s capital structure, which refers to the amount of debt compared to equity financing on a firm’s balance sheet. A poor evaluation of what a firm’s capital structure should be can mean the difference between whether a firm stays in business or ends up bankrupt if the firm encounters financial difficulty.

Book Value and Market Value

The book value, otherwise known as historical cost value, shown on a firm’s balance sheet is calculated according to generally accepted accounting principles (GAAP). GAAP requires that assets be displayed on the balance sheet at the acquired price, not the current value of those assets. As a result, book values often diverge widely from the market values— the amount they could be sold for today—attributable to the same assets.

Typically, the book value and market value of a company’s current assets are close, and a firm’s balance sheet displays cash and marketable securities at their current market value. The value of short-term assets such as receivables and inventory, which are usually converted into cash not long after being acquired, is also generally close to their market value. Book value versus market value becomes more of an issue when it comes to ascertaining the value of a company’s fixed assets. Due to the fact that a firm may have acquired a fixed asset many years ago, such as a piece of real property like a factory or headquarters location, the market value of that asset may have changed markedly over time.

Example: Ajax Trucking’s balance sheet shows fixed assets of $18 million. The company’s fixed assets were just appraised at $24 million. The balance sheet also lists current assets at $14 million. Current assets were appraised as worth $14.5 million. Current liabilities’ book value is $7 million, market value is $8 million, and the firm has long-term debt of $18 million. Calculate the book and market values of the firm’s stockholders’ equity. Create the book value and market value balance sheets for Ajax Trucking.

Financial Management44

Solution: The balance sheet identity is

Assets 5 Liabilities 1 Equity

Rearrange the equation:

Equity 5 Assets – Liabilities

As a result, the balance sheets will appear as follows:

Book Value Market Value Book Value Market Value

Assets Liabilities and Equity

Current assets $14m $14.5m

Current liabilities $7m $8.0m

Fixed assets 18m 24.0m

Long-term debt 18m 18.0m

Stockholders’ equity 7m 12.5m

Total $32m $38.5m Total $32m $38.5m

Income Statements While the balance sheet reflects a firm’s financial position at a particular time, the income statement tracks the total revenues a firm generates and the total expenses incurred to produce those revenues over a particular period of time— typically quarterly, semiannually, or annually. The top portion of an income statement displays a firm’s operating income. Subtracting the cost of goods sold, which are the direct costs incurred in the production of the company’s product, from net sales gives you gross profit. The next step is to deduct other operating expenses that include marketing, selling expenses, and general and administrative expenses from gross profits. This determines earnings before interest, taxes, depreciation, and amortization—also known as EBITDA. Next, subtract depreciation and amortization from EBITDA to come up with operating profit, also known as earnings before interest and taxes (EBIT). EBIT amounts to the profit a company earns from selling products without accounting for financing costs or tax considerations.

The bottom portion of an income statement provides a summary of a company’s financial and tax structure. The first step is to subtract interest (the cost of servicing the firm’s debt) from EBIT to determine earnings before taxes (EBT). Because firms have different financial and tax situations, two

Lesson 2 45

firms generating the same operating income may report widely varying net income. This measure, also known as the bottom line, is calculated by subtracting taxes from EBT.

Below net income, a variety of other information related to income and company value is often displayed. These include the following:

n Earnings per share (EPS) 5

n Dividends per share (DPS) 5

n Book value per share (BVPS) 5

n Market value per share (MVPS) 5 Market price of the

firm’s common stock

Debt versus Equity Financing

When firms issue debt in order to finance assets, the debt holders gain first claim to a fixed portion of the firm’s cash flows. When a firm changes its capital structure to take on or reduce debt, it has an effect on the amount of cash flows available to the stockholders. In addition, altering the capital structure to either reduce debt by increasing equity or by decreasing equity to increase debt by buying back shares of stock causes the stockholders’ EPS of a company to change. These are the questions a company’s manager must answer: Will reducing or increasing financial leverage be welcomed by shareholders in view of the increased or decreased earnings per share available to them, and will this increase or decrease the firm’s risk for financial distress and/or bankruptcy?

Example: Consider a company that has EBIT of $940,000. The company uses 2.3 million of debt carrying a 4 percent interest rate and 300,000 shares selling at $5.00 a share to finance its assets. In an effort to lessen the risk that comes with financial leverage, the company is thinking about lowering its debt by $750,000 by selling an extra 150,000 shares of its stock. The company’s tax bracket is 38 percent. As this change in capital structure will have no effect on the firm’s operations, EBIT will continue to be $940,000. Determine the dilution to the company’s EPS from changing its capital structure in this manner.

Net income available to common stockholders Total shares of common sttock outstanding

Common stock dividends paid Number of shares of common stock outtstanding

Common stock Paid-in surplus Retained earnings Number of shares of common stock outstanding

Financial Management46

The change in capital structure would dilute the EPS available for stockholders by $1.75 – $1.21 5 $0.54.

Corporate Income Taxes

A substantial portion of a firm’s earnings is paid in the form of taxes. Taxes can be deferred on profits generated in a specific period. Expenses connected with research and development or mergers can be written off over a fixed number of years. When this is done, the profits the company earns in the current year will be lower than the profits calculated for accounting purposes. This allows the firm to postpone a portion of its tax liability on its current year profit to later years. The U.S. tax code is overseen by Congress and can change in response to trends in the political, economic, or public realms.

When determining their tax liability, companies typically also calculate their average tax rate, which is the percentage of each dollar of taxable income the firm devotes to paying taxes, and their marginal tax rate. Look at Example 2-3 in your textbook to see how to calculate the average tax rate.

Average tax rate 5

Solution:

Tax liability Taxable income

Change Before Capital

Structure Change

After Capital

Structure Change

EBIT $940,000 $940,000

Less: interest ($2,300,000 3 .04) 92,000 ($1,550,000 3 .04) 62,000

EBT 848,000 878,000

Less: taxes (38%) 322,240 333,640

Net income 525,760 544,360

Divided by # of shares 300,000 450,000

EPS $1.75 $1.21

Lesson 2 47

Interest and dividends corporations receive. Corporations are subject to taxes on any interest they receive, with the major exception of interest on state and local government bonds, which is exempt from taxation by the federal government. Another exception deals with corporate ownership of stock in other corporations. In such a case, 70 percent of the dividends paid out by other corporations is free from taxation. The remaining 30 percent will be taxed at the tax rate of the corporation that receives the dividends.

Interest and dividends paid by corporations. When a corporation pays a dividend, it appears on the firm’s income statement as an expense, so interest payments are deducted from operating income when calculating taxable income. However, any dividends corporations pay out to their share- holders aren’t considered tax deductible. This can encourage managers to choose to use debt financing for projects instead of selling more stock. The reason for this is adding debt provides a firm with interest expenses it can deduct for tax purposes. As a result, a firm using primarily equity financing will have higher income and thus pay higher taxes than a debt-financed firm. Consequently, it won’t have as much operating income to pay to its stockholders and bondholders as a firm using more debt. Thus, stockholders may also prefer firms that finance projects primarily using debt. However, as mentioned earlier in this study guide, an increase in the amount of debt on a firm’s balance sheet carries with it risks, which must be balanced when determining the proper balance of debt and equity, also known as the capital structure, for a company.

Example: Imagine that you’re thinking about buying stock in one of two firms, JustDebt, Inc. and JustEquity, Inc., which are in the same industry sector and have operating income of $10.5 million. JustDebt, Inc. finances its $14m in assets with $14m in debt, on which it pays 9 percent interest and no equity. JustEquity, Inc. finances its $14m in assets with no debt and $14m in equity. Each firm pays 32 percent tax on their taxable income. Determine the income that each firm has available to pay its debt and stockholders—its asset funders—and the resulting returns to these asset funders.

Financial Management48

Solution:

JustDebt, Inc. JustEquity, Inc.

Operating income $10.5m $10.5m

Less: interest 1.26m 0.0m

Taxable income $9.24m $10.5m

Less: taxes (32%) 2.96m 3.36m

Net income $6.28m $7.14m

Income available for asset

funders (5 operating income – taxes)

$7.54m $7.14m

Return on asset funders’ investment

$7.54m/$14.00m 5 53.86%

$7.14m/14.00m = 51.00%

By financing all of its assets using debts and receiving associated tax benefits from the interested paid on its debt, JustDebt, Inc. can pay more of the operating income to the debt holders of the assets and the stockholders than JustEquity, Inc.

The Statement of Cash Flows Managers contemplating financial decisions typically need more information than that provided simply by the reports of past performances included in the income and balance state- ments of a firm. One crucial point of distinction between a view that’s accounting-focused and one that’s finance-focused is that a company’s cash flows are usually much more interesting to financial managers and investors than historical data represented by the profit (or loss) displayed on the income statement.

A statement of cash flows details the amounts of cash a company generates and distributes over a specified period of time. Calculating the difference between cash sources and uses of cash is equal to the change experienced in cash and marketable securities shown on the firm’s balance sheet as compared with the previous year’s balance. As such, this statement acts to reconcile noncash balance sheet items along with income statement items to display changes occurring to the cash and marketable securities account listed on the balance

Lesson 2 49

sheet during the period analyzed. The statement of cash flows is important for demonstrating that numbers shown on an income statement don’t necessarily show a firm’s actual cash inflows and outflows over a particular period of time.

GAAP Accounting Principles

GAAP principles must be used by company accountants to prepare company income statements. Procedures mandated by GAAP specify that the firm recognize revenue at the time a sale occurs. However, a company sometimes will receive the cash for a sale either prior to or after the sale takes place. GAAP also requires firms to recognize production and other such expenses on the balance sheet at the time these goods are sold. As a result, the costs associated with selling a product show up on the income statement only when the product is sold. In a manner similar to revenue recognition, often these expenses occur at different points in time—often quite a bit earlier than GAAP rules allow a firm to formally recognize them.

Noncash Income Statement Entries

Income statements include several noncash entries, with depreciation being the largest. This type of expense is used to attempt to calculate the noncash expense realized, as fixed assets deteriorate in value from when they were purchased to the point in time when they need to be replaced. To illustrate the point, consider the purchase of a factory machine for $1M that has an expected useful lifetime of 10 years. While the cash outflow occurs in the year the machine is purchased, for accounting purposes the firm shows an expense of only $100,000 in the first year and for the next nine years the machine is in use. However, the actual cash flow associated with the machine isn’t changed by this accounting convention. $1M was spent in year one to buy it, not the $100,000 expense shown in the income statement.

Cash Sources and Uses

Activities that increase cash are known as cash sources, and those that decrease cash are called cash uses. Figure 2.3 in your textbook provides a list of sources and uses of cash.

Financial Management50

The textbook shows a basic cash flow statement in Figure 2.4 and a more detailed one in Table 2.4. Cash flows from operations consist of the cash inflows and outflows directly resulting from the production and sale of the company’s products. The two types of such cash flows are as follows:

1. Net income—including back depreciation, a noncash expense item (Note: Any other noncash expense, such as amortization, would be added back to the net income and any noncash revenue would be subtracted.)

2. Working capital accounts other than cash and operations-related short-term debt

The top section of the statement of cash flows concisely displays a company’s cash flows caused by and used for the production process.

Cash flows from investing activities are cash inflows and outflows generated by the company’s investment in fixed assets. Cash flows from financing activities are financial transactions involving debt and equity.

Transactions used to raise cash include

n Issuing short-term debt

n Issuing long-term debt

n Issuing stock

Transaction types that use cash include

n Paying dividends

n Paying off debt

n Buying back stock

Net change in cash and marketable securities is the bottom line of the cash flows statement, displaying the sum of all cash flows from

n Operations

n Investing activities

n Financing activities

Lesson 2 51

This sum reconciles to reflect the net change in cash and the marketable securities account found on the balance sheet for the period covered. While a company might report a considerable amount of net income for a given year, it may be that the firm received an amount of cash that was positive, negative, or zero. GAAP accounting rules cause this potential mismatch between what a firm reports as income (or a loss) and what they actually earned (or lost) in the form of cash. The income statement provides accounting-based income, but the statement of cash flows is more reflective of current reality. As a result, managers and investors more often use the statement of cash flows to analyze a firm’s financial condition.

Free Cash Flow A statement of cash flows calculates net cash flow by adding noncash adjustments to net income. But firms must replace or replenish working capital and fixed assets and come up with new products on a continual basis to sustain cash flows over the long term. This means that the managers of a firm must be strategic in their use of the firm’s cash flows. As a result, a firm’s operations can be valued by determining the company’s future expected free cash flows, which are calculated by subtracting the amount of new investment in working capital, fixed assets, and developing new products from after-tax operating income.

Free cash flow consists of the cash subject to distribution to the firm’s investors—including debt holders and stockholders— after taking into account the investments needed to pay for the ongoing operations of the company. The formula for cal- culating free cash flows is displayed in Figure 2.8 of your textbook. To calculate free cash flow, you begin with operating cash flow (OCF). A company generates OCF once they’ve paid the required operating expenses and taxes. The resulting figure, net operating profit after taxes (NOPAT), consists of the net profit a company earns after taxes before accounting for any finance costs. Depreciation, which is a noncash charge, is added back to NOPAT to get total OCF. Other relevant noncash charges, such as amortization and depletion, are also added back. Companies buy physical assets or choose to designate funds for eventually replacing equipment

Financial Management52

to maintain firm operations. This is known as investment in operating capital (IOC) and includes fixed assets, current assets, and spontaneous current liabilities associated with running the business. As a result, the free cash flow measure reveals how a firm’s managers are doing in terms of using the firm’s resources to improve firm performance and, as a result, add to shareholder wealth.

Example: Blue Sky Wind Farms, Inc. had EBIT of $47 million, a tax rate of 35.2 percent (taxes/EBT), and depreciation expense of $12 million. Thus, the company’s operating cash flow (OCF) was

OCF 5 EBIT (1 – Tax Rate) 1 Depreciation 5 $47m (1 – .352) 1 $12m 5 $42.46m

Blue Sky Wind Farm’s gross fixed assets grew from $23 million in 2013 to $84 million in 2014. The current assets of the firm grew by $8 million, and spontaneous current liabilities grew by $11.5 million ($4 million in accrued wages and taxes and $7.5m in accounts payable). As a result, Blue Sky’s operating capital investment for 2014 was

IOC 5 ∆Gross fixed assets 1 ∆Net operating working capital 5 $61 1 ($8m – $11.5) 5 $57.5m

What was Blue Sky Wind Farms, Inc.’s free cash flow for 2014?

Solution:

FCF 5 Operating cash flow – Investment in operating capital 5 $42.46 – $57.5 5 –$15.04m

Blue Sky Wind Farms, Inc. had cash flows of $-15.04m available to pay its stockholders and debtholders.

When a firm has a positive free cash flow, it can distribute funds to investors, but when this figure is zero or negative, as in the above example, no such distributions are possible. Negative free cash flow as a result of operating cash flows that are negative often indicates the company is experiencing operational or managerial issues. Having positive operating cash flows and negative free cash may not be an indication of poor management but an indication of investing heavily in operating capital to foster future growth.

Lesson 2 53

The statement of retained earnings reconciles net income earned and cash dividends paid with the change in retained earnings from the beginning to the end of the period. Retained earnings increase when the common stockholders of a firm allow management to reinvest net income into the company instead of paying it out in the form of dividends. Reinvesting earnings costs less than acquiring capital from sources outside the firm, such as the debt and equity markets; by reinvesting net income in this way the company can use the funds for plant and equipment, inventory, and other assets to increase profit. Because of this, retained earnings are a claim on all of a company’s assets rather than against a specific asset.

Exercising Caution When Evaluating Financial Statements While firms must produce financial statements in accordance with GAAP standards, managers have flexibility in regards to accounting rules. This can result in firms taking steps to “smooth” earnings by overstating or understating them at times. They may do this to demonstrate to investors that a firm’s assets are growing at a steady pace. The process of engineering a company’s earnings in this manner is known as earnings management. Taken to extremes, this practice has led to a number of notorious accounting scandals. This resulted in the Sarbanes-Oxley Act, which Congress enacted in 2002. It mandates that public companies take steps such as requiring that the board of director’s audit committee has the experience necessary to adequately apply GAAP guidelines, and that the company’s senior management signs off on the firm’s financial statements. A firm that doesn’t comply with the Sarbanes-Oxley regulations is subject to being delisted from trading on an exchange.

Financial Management54

Self-Check 4

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What must assets be equal to on a firm’s balance sheet?

2. How can we distinguish between current liabilities and long-term debt?

3. What is liquidity?

4. How is net working capital calculated?

5. If holding liquid assets on its balance sheet lowers a firm’s profits, why do some firms nevertheless maintain more liquidity than that needed to operate the business?

6. What is financial leverage?

7. Why do book values vary widely from market values in many cases?

8. What is EBITDA?

9. How are dividends paid to shareholders and interest on debt paid by corporations treated dif ferently for tax purposes?

Complete the following problems at the end of Chapter 2.

10. Problem 2-2

11. Problem 2-4

12. Problem 2-10

Check your answers with those on page 226.

Lesson 2 55

ASSIGNMENT 5 Read this assignment. Then read Chapter 3 in your textbook.

The primary value of financial statements is that managers, investors, and analysts can use the information they contain to evaluate the financial performance or status of a company. Managers can devise strategies for improving a firm’s performance and, once this takes place, its market value. One method used by managers and finance professionals in the evaluation of financial statements is ratio analysis. This refers to calculating and analyzing a financial ratio to gauge a company’s performance and identify steps that could be taken to improve its performance. In this assignment, you’ll learn to review various financial ratios, explain what they mean, and specify the general trend, whether up or down, that managers and investors like to see in each ratio.

Ratio numbers can mean different things in different situ- ations. Additionally, extreme ratio values, whether high or low, can be a negative indicator for a company. A ratio that appears too good may be detrimental for a company. You’ll also explore how a change in one ratio can change the values of several ratios. Because of this, managers or investors using ratio analysis will often start by looking at trends in a company’s financial ratios over time. They’ll also compare a company’s ratios with the ratios of other companies in the same industry.

Liquidity Ratios A liquidity ratio tracks the relationship between the liquid (current) assets a firm possesses and its current liabilities. The most frequently used liquidity ratios are

n Current ratio 5

n Quick ratio (acid-test ratio) 5

n Cash ratio 5

Current assets Current liabilities

Current assets Inventory Current liabilities

2

Cash and marketable securities Current liabilities

Financial Management56

The current ratio is the broadest liquidity ratio. It tracks the current assets a firm can access in relation to its current liabilities. The quick ratio, or acid-test ratio, takes into account a firm’s capacity to meet short-term obligations without needing to rely on selling inventory. Inventory is typically the least liquid type of current asset, meaning that if a firm must sell inventory to pay its bills, it may be forced to do so at a discount. The cash ratio is designed to test a firm’s ability to meet its short-term obligations without relying on the sale of accounts receivable. As with inventories, selling accounts receivable to raise cash to pay a firm’s bills may force the company to sell the receivables at a discount.

Having sufficient liquidity on its balance sheet to fund its operations is important for a company. Firms with greater liquidity are less likely to experience financial distress than other firms, all else being equal. However, liquidity can be a two-edged sword, given that cash and other short-term assets provide little in the way of yield or return. As you learned previously, fixed assets, while less liquid, usually generate higher returns for a company. High liquidity ratios may indicate that a firm’s management is indecisive or unable to find sufficient opportunities to profitably invest the company’s cash. As with many business decisions, determining how much liquidity a firm should have on its balance sheet requires balancing different objectives: in this case, providing a cushion to help a firm navigate any difficulties as contrasted with acquiring assets that will help it provide attractive returns for its shareholders.

Asset Management Ratios An asset management ratio measures the efficiency with which a company uses its assets—including inventory, accounts receivable, and fixed assets—and manages its accounts payable. Specific asset management ratios enable managers and investors to judge if a firm possesses a reasonable level of a particular type of asset and if the management effectively uses a particular type of asset to create sales.

Lesson 2 57

Inventory Management

These ratios help management evaluate the trade-off between the advantages of holding satisfactory levels of inventory to maintain the production process against the costs associated with keeping large stocks of inventory.

Asset management ratios used most often are

n Inventory turnover 5

n Days’ sales in inventory 5

The inventory turnover ratio tracks dollars from sales created per each dollar of inventory. When managers choose to stress that inventory is held on the balance sheet at cost, they select cost of goods sold as the numerator.

Days’ sales in inventory tracks the number of days inventory is kept before the sale of the final product. A firm typically aims to generate a high level of sales for each dollar of inventory by turning over inventory as rapidly as possible. Higher levels of sales for each dollar of inventory often can imply lower costs for warehousing, monitoring, insurance, and other costs involved in servicing the inventory. Therefore, both high inventory turnover ratios and low days’ sales in inventory ratios are typically indicative of good management.

On the other hand, when inventory turnover ratios are extremely high and days’ sales in inventory are extremely low, it can indicate that a firm isn’t holding enough inventory to keep from running out of the raw materials necessary to maintain the production process. Therefore, this combination of ratio levels can be an indicator of bad management. It should be noted that firms that have superior supply chain relations are often able to keep lower levels of inventory without experiencing a high risk of going out of stock.

Accounts Receivable Management

When deciding the level of accounts receivable to keep on a firm’s balance sheet, a manager must take into account the trade-off between the benefits of increasing sales by providing

Sales or cost of goods sold Inventory

Inventory 365 Sales or cost of goods sold

365 days Inven

3 5

ttory turnover

Financial Management58

customers with better terms, on the one hand, and the drawbacks of having to finance large sums of accounts receivable on the other. Two ratios used for this purpose are

n Accounts receivable turnover 5

n Average collection period (ACP) 5

ACP serves to measure the number of days that accounts receivable are held by the firm before it can collect cash from the customer. This cash is also known as days’ sales outstanding (DSO). Generally speaking, a company aims at producing high levels of sales per each accounts receivable dollar to lower the cost involved in any financing of accounts receivable. Such financing can include interest expense on finance accounts receivable and defaults. A high accounts receivable rate or low ACP is typically indicative of good management. When accounts receivable turnover is very high and ACP very low, however, it can be a sign that a company’s accounts receivable policy is too strict, motivating customers to transact business with competitors. Such a ratio combination can indicate that management isn’t properly managing its accounts receivable policies.

Accounts Payable Management

When determining the level of accounts payable to maintain on the balance sheet, a manager needs to give some thought to the trade-off between taking full advantage of the free financing offered by raw material suppliers against the potential of not having the ability to buy on account. The following ratios are used in the analysis of such situations:

n Accounts payable turnover 5

n Average payment period (APP) 5

Cost of goods sold Accounts payable

Accounts payable 365 days Cost of goods sold

365 days Ac

3 5

ccounts payable turnover

Credit sales Accounts receivable

Accounts receivable 365 days Credit sales

365 days Accou

3 5

nnts receivable turnover

Lesson 2 59

APP measures the days that a company holds account payables prior to payment. Typically, a company prefers to pay for the goods it purchases as slowly as it can. A low accounts pay- able turnover is often a sign of good management, as is a high APP. On the other hand, if an accounts payable turnover ratio is very low and APP is very high, it may indicate that a com- pany is violating or stretching to the limit the credit terms offered by its raw materials suppliers. If this is the case, the companies that supply the firm may take action to prevent it from buying goods on account. In such instances, the combination of very low accounts payable turnover and very high APP might be a sign of bad management by the company.

Fixed Asset and Working Capital Management

These ratios serve to summarize the level of efficiency demonstrated by a company’s overall asset management:

n Fixed asset turnover 5

n Sales to working capital 5

Fixed asset turnover ratio tracks the dollars produced for each dollar of net fixed assets. Sales to working capital ratio provides a measurement of the sales dollars created for each dollar of net working capital. Generally speaking, high levels of sales per dollars of fixed assets and working capital indicate that a firm is being run efficiently. High fixed asset turnover and sales to working capital ratios are typically a sign of good management. In cases in which either of these ratios is extremely high, however, it can indicate that a firm is near its maximum production capacity. If either ratio is extremely high, it may be a sign that a firm’s managers haven’t managed the firm properly and have allowed the firm to get close to maximum capacity without taking steps to accommodate the firm’s growth.

Some things to consider in regards to these ratios: The age of a company’s assets has an effect on its fixed asset turnover ratio, as newer fixed assets will tend to cause a firm to have a lower fixed asset turnover ratio. This doesn’t necessarily mean that such a firm is performing worse than its competitors who have older assets and thus a higher fixed asset turnover ratio. For companies that are expanding, having a lower fixed asset turnover ratio can be a good thing.

Sales Net fixed assets

Sales Working capital

Financial Management60

Total Asset Management

Total asset management ratios are used to gain an overall picture of a company’s performance. Two such ratios are as follows:

n Total asset turnover 5

n Capital intensity 5

A well-managed firm usually generates multiple dollars for each dollar of total assets or needs few dollars of assets for each dollar of sales. As a result, higher total asset turnover and lower capital intensity ratios indicate a more efficient pattern of asset management. If total asset turnover is very high and capital intensity is very low, however, it can indicate the firm has a problem managing its assets.

Let’s look at a problem that solves for the liquidity and management ratios.

Example: Given the balance sheet and income statement below for Acme Widget Manufacturing, Inc., compute the liquidity and asset management ratios for 2015.

Sales Total assets

Total assets Sales

(Continued)

Lesson 2 61

Acme Widget Manufacturing, Inc. Balance Sheet as of December 31, 2015 and 2014

(in millions of dollars)

2015 2014 2015 2014

Assests Liabilities and Equity Current assets Current liabilities

Cash and marketable securities

$33 $30 Accrued wages and taxes

$24 $18

Accounts receivable 84 79 Accounts payable 61 54

Inventory 243 240 Notes payable 89 71

Total $360 $349 Total $174 $143

Fixed assets Long-term debt 283 272

Gross plant and equipment

$411 $388 Total debt 457 415

Less: Depreciation 98 85 Stockholders’ equity

Net plant and equipment

$313 $303 Preferred stock (3 million shares)

$3 $3

Other long-term assets 84 84 Common stock and paid-in surplus (30 million shares)

90 90

Retained earnings 207 228

Total FA $397 $387 Total Equity $300 $321

Total assets $757 $736 Total liabilities and equity

$757 $736

Financial Management62

Income Statement for Widget Manufacturing, Inc. Income Statement for Years Ending December 31, 2015 and 2014

(in millions of dollars)

2015 2014

Net sales (all credit) $ 485 $ 454

Less: Cost of goods sold 287 270

Gross profits $ 198 $ 184

Less: Other operating expenses 43 40

Earnings before interest, taxes, depreciation, and amortization (EBITDA) $ 155 $ 144

Less: Depreciation and amortization 18 15

Earnings before interest and taxes (EBIT) $ 137 $ 129

Less: Interest 24 29

Earnings before taxes (EBT) $ 113 $ 100

Less: Taxes 58 48

Net income $ 55 $ 52

Less: Preferred stock dividends $ 15 $ 15

Net income available to common stockholders $ 40 $ 37

Less: Common stock dividends 10 10

Addition to retained earnings $ 30 $ 27

Per (common) share data:

Earnings per share (EPS) $ 1.33 $ 1.23

Dividends per share (DPS) $ 0.33 $ 0.33

Book value per share (BVPS) $ 9.90 $ 10.60

Market value (price) per share $ 12.25 $ 15.25

Lesson 2 63

Of the three liquidity ratios, only the cash ratio shows Acme Widget Manufacturing, Inc. having less cash on the balance sheet than the industry average and that only by a very small amount. The current ratio and quick ratio show the company having ample cash available to meet current liabilities as they come due compared to the industry average.

For the asset management ratios, the result is a mixed bag, with some ratios showing better than average industry performance and some worse.

Ratio Value for Acme Widget Manufacturing, Inc.

Value for the Widget Industry

Liquidity ratios:

Current ratio 5 2.07 times 1.25 times

Quick ratio (acid-test ratio) 5 .67 times .40 times

Cash ratio 5 .19 times .20 times

Asset management ratios:

Inventory turnover 5 2.00 times 2.20 times

Days’ sales in inventory 5 258 days 150 days

Accounts receivable turnover 5 3.75 times 3.75 times

Average collection period (ACP) 5 63 days 80 days

Accounts payable turnover 5 7.95 times 3.20 times

Average payment period (APP) 5 46 days 105 days

Fixed asset turnover 5 1.54 times .75 times

Sales to working capital 5 2.61 times 3.30 times

Total asset turnover 5 .64 times .35 times

Capital intensity 5 1.56 times 2.25 times

Solution: You can solve for these ratios using the equations found either throughout the chapter, the equation summary at the end of the chapter, or in the student equations handbook. Then review and compare how the company would be out- performing or underperforming based on industry standard.

$ $

360 174

m m

$ $

360 174 m $243

m 2

$ $

33 174

m m

$ $

485 243

m m

$ $

343 485

m 365 days m

3

$ $ 315 84

m m

$ $

84 485

m 365 days m

3

$ $ 485 61

m m

$ $

61 485

m 365 days m

3

$ $

482 313

m m

$ $

485 360

m m $174m2

$ $

485 757

m m

$ $

757 485

m m

Financial Management64

Debt Management Ratios The greater the amount of debt a firm carries in relation to its total assets, the higher the firm’s financial leverage. A debt management ratio measures the extent to which the firm makes use of debt as opposed to equity in the financing of its assets, along with how likely the firm is able to pay off its debt. The ratios listed below in separate categories allow investors and managers to evaluate whether a firm’s level of indebtedness seems reasonable when considering its ability to make payments on its debt obligations.

Debt versus Equity Financing

The managers of a firm must decide on the level of debt to place in the firm’s capital structure. The amount of debt used can impact the viability of the firm as an entity over the long haul. In making these decisions, managers must consider the trade-offs between supplying the maximum cash flows possible to the shareholders of the firm compared to the risk that the firm won’t be able to make its debt payments. The following ratios are used to help in evaluating a firm’s capital structure:

n Debt ratio 5

This ratio calculates the percentage of total assets that have been financed using debt.

n Debt-to-equity ratio 5

This ratio measures dollars of debt financing used for each dollar of equity financing.

n Equity multiplier ratio 5

This ratio calculates dollars of assets appearing on the balance sheet in relation to each dollar of equity (or only common stockholders’ equity) financing.

Lower levels of debt, debt-to-equity, or equity multiplier ratios indicate that less debt and more equity was used by a firm for the financing of its assets. Debt financing risks putting the company in financial distress in bad times while increasing cash flows to investors in good times. Similarly, debt holders

Total debt Total assets

Total debt Total equity

Total assets Total equity

or Total assets Common stockholderss’ equity

Lesson 2 65

and stockholders consider equity financing to offer a measure of safety in helping firms weather fluctuations in earning and the value of their assets while maintaining debt service payments.

Coverage Ratios

These ratios measure a firm’s capacity to make payments on its debt obligations. They include the following:

n Times interest earned 5

This ratio measures the dollars of operating earnings a firm has available to satisfy every dollar of interest obligation.

n Fixed-charge coverage 5

This ratio tracks the dollars of operating earnings that can be used to satisfy a company’s interest payments as well as other fixed charges.

n Cash coverage 5

This ratio is used to measure the dollars of operating cash on hand to meet every dollar of interest and other fixed charges owed by the firm.

These ratios help managers and finance professionals decide if a firm has taken on an excessively large debt burden. Higher levels for these ratios represent higher levels of equity as opposed to debt used by the firm to finance its assets. If company debt levels are low, it leads to dilution in the return delivered to stockholders as a result of greater use of equity and not taking full advantage of the fact that interest expense is tax deductible.

Let’s look at a problem that solves for the debt management ratios.

Example: Use the information in the previous example, Acme Widget Manufacturing, Inc.’s balance sheet and income statement, to solve and analyze the debt management ratios for 2015.

EBIT Interest

Earnings available to meet fixed changes Fixed charges

EBIT Depreciation Fixed charges

1

Financial Management66

All the debt-related ratios show that the firm has less balance sheet debt than the average firm in the industry. Additionally, the company has more dollars of operating earnings and cash ready to pay each dollar of interest obligations. This lower level of debt decreases the likelihood that the firm will experience financial distress, but can also serve to lower the opportunity for the firm’s shareholders to receive higher earnings. Thus, the reduced risk of bankruptcy during a downturn is offset by the dilution of returns to shareholders of the firm during good times, which is likely to be seen as a negative by the firm’s common stockholders.

Ratio Value for Acme Widget Manufacturing, Inc.

Value for the Widget Industry

Debt management ratios:

Debt ratio 5 54.42% 65.75%

Debt-to-equity 5 2.52 times 2.25 times

Equity multiplier 5 2.52 times 4.20 times

or 0.46 times 4.10 times

Times interest earned 5 5.71 times 5.10 times

Fixed-charge coverage 5 5.71 times 5.75 times

Cash coverage 5 6.46 times 8.10 times

Solution: Refer to Table 3.1 in the textbook or the chapter equations page at the end of Chapter 3. Then review and compare how the company would be outperforming or underperforming based on industry standard.

$ $

174 757

m $238m m

1

$ $

757 300

m m

$ $

757 300

m m

$ $

137 300

m m $3m2

$ $ 137 24

m m

$ $ 137 24

m m

$ $

137 24

m $18m m

1

Lesson 2 67

Profitability Ratios Profitability ratios demonstrate the combination of the effects of liquidity, asset management, and debt management on a firm’s overall operating results. These ratios are among the most closely followed and most widely known of all financial ratios. They include the following:

n Gross profit margin 5

This ratio calculates the percent of sales remaining after the deduction of costs of goods sold.

n Operating profit margin 5

This ratio calculates the percent of sales remaining when all operating expenses have been deducted.

n Profit margin 5

The profit margin reflects the percentage of sales when all of a firm’s expenses are deducted. This equates to the net profit margin of the firm.

n Basic earnings power 5

This ratio shows the operating return attributable to the assets of a company without taking financial leverage and taxes into account. It calculates the operating profit (EBIT) per dollar of assets held on the balance sheet of the firm.

n Return on assets (ROA) 5

This ratio represents the net income earned per dollar of assets held on the balance sheet of the firm.

n Return on equity (ROE) 5

This equates to the net income earned per dollar of common stockholders’ equity. The value generated by a firm’s ROE is influenced by financial leverage in addition to net income. Greater financial leverage can increase stockholder’s return. However, it can also boost a firm’s chances of experiencing financial distress or even bankruptcy. In general, a high ROE is thought to be a marker of good firm performance. Yet

Net income available to common stockholders Sales

EBIT Total assets

Net income available to common shareholders Total assets

Net income available to common stockholders Common stockholdders' equity

Sales Cost of gold sold Sales

2

EBIT Sales

Financial Management68

if this performance is caused by a high level of financial leverage, it may also indicate a firm that’s subject to a high risk of bankruptcy.

n Dividend payout 5

This ratio reflects the percentage of net income allotted to common stockholders as cash.

In regards to all of these ratios except for the dividend payout ratio, a higher value is associated with a higher value for a firm. However, as with other ratios we’ve discussed, the presence of a high profitability ratio level can be a sign of poor management in other segments of a firm’s business rather than a sign of superior financial management.

Let’s look at a problem that solves for the profitability ratios.

Example: Given the information found in the Acme Widget Manufacturing, Inc. example’s balance sheet and income statement, solve and analyze the profitability ratios for 2015.

Solution: You can solve for these ratios by referring to Table 3.1 in the textbook or the chapter equations page at the end of Chapter 3. Then review and compare how the company would be outperforming or underperforming based on industry standard.

Common stock dividends Net income available to common stockhholders

Ratio Value for Acme Widget Manufacturing, Inc.

Value for the Widget Industry

Profitability ratios:

Gross profit margin 5 40.82% 58.75%

Operating profit margin 5 28.25% 48.66%

Profit margin 5 8.25% 20.25%

Basic earnings power 5 18.10% 23.65%

Return on assets (ROA) 5 5.28% 8.35%

Return on equity (ROE) 5 33.61% 37.55%

Dividend payout 5 25.00% 31.20%

$ $

198 485

m m

$ $

137 485

m m

$ $

40 485

m m

$ $

137 757

m m

$ $

40 757

m m

$ $

10 40

m m

$ $

40 209

m m $90m2

Lesson 2 69

In all cases, profitability ratios show that Acme Widget Manufacturing, Inc. is underperforming the average firm in the industry. As a result, its management will have to analyze the firm’s capital structure and other aspects of its operations to see how its performance can be improved. The firm’s lower debt load compared to the industry average allows its management to consider taking on more debt as a means of improving its performance relative to the shareholder’s investment in the firm.

Market Value Ratios As previously noted, while a high ROE is generally considered a positive indicator of the performance of a firm, if it results from a highly leveraged capital structure, it can be a sign that a firm faces a high risk of bankruptcy. The ROE ratio itself doesn’t reflect such concerns, but the market value of a company’s stock does. Given that stockholders earn returns primarily from increases in the value of a firm’s stock, market value ratios are of tremendous importance to such individuals. Market value ratios work by relating a company’s stock price to the earnings and book value of the company. When a firm is publicly traded, the market value ratios reflect the opinions of investors as to the company’s prospects.

Market-to-book ratio 5

This ratio calculates the amount investors are willing to pay to purchase the company’s stock per each dollar of equity devoted to financing the company’s assets. Market-to-book ratio enables a comparison of the market value for the firm’s equity to its cost historically. Generally speaking, higher market-to-book values indicate better performing firms. When market-to-book value is greater than one, it indicates investors will be paying a premium in excess of book value when they buy equity (stock) in a firm.

This well-known measure of firm performance shows how much investors will pay for each dollar of the firm’s earnings per share of stock purchased. This ratio is frequently used by finance professionals to analyze how a firm’s stock is

Market price per share Book value per share

Financial Management70

performing from a relative financial standpoint. Typically, higher PE ratios indicate better performance. Companies with high PEs are expected to demonstrate high future growth and/ or rapid future increases in dividends. For investors focused on value, high PE ratios indicate greater risk if expected future earnings growth fail to materialize.

Price-earnings (PE) ratio 5

Let’s look at a problem that solves for the market value ratios.

Example: Given the information found in the Acme Widget Manufacturing, Inc. example’s balance sheet and income statement, solve and analyze the market value ratios for 2015.

Solution: You can solve for these ratios by referring to Table 3.1 in the textbook or the chapter equations page at the end of Chapter 3. Then review how the company would be out- performing or underperforming based on industry standard.

Ratio Value for Acme Widget Manufacturing, Inc.

Value for the Widget Industry

Market value ratios:

Market-to-book ratio 5 1.24 times 2.75 times

Price-earnings (PE) ratio 5 9.21 times 7.15 times

The two ratios listed above show that while the firm’s market- to-book ratio shows that the firm is valued well below that of other firms in the industry, this isn’t the case with the firm’s PE ratio. This high PE ratio could be the result of investors expecting changes to be made at the firm to improve its prof- itability. If investors anticipate changes coming at a company, they may at times bid up the company’s share price even before such changes are realized.

DuPont Analysis Managers and finance professionals often use a system popularized by the DuPont Corporation to evaluate company financial performance. The DuPont system of analysis uses

Market price per share Earnings per share

$ . $ . 12 25 9 90

$ . $ . 12 25 1 33

Lesson 2 71

the balance sheet and income statement to divide the return on assets (ROA) and ROE ratios into separate pieces for examination. The series of DuPont equations listed in your textbook are as follows:

ROA 5 Profit margin 3 Total asset turnover

ROE 5 ROA 3 Equity multiplier

ROE 5 Profit margin 3 Total asset turnover 3 Equity multiplier

The presentation of ROE that the system enables gives managers and financial professionals the opportunity to view return on equity as stemming from net profit margin, total asset turnover, and the equity multiplier.

Let’s look at a problem that solves for the DuPont Analysis ratios.

Example: Given the information found in the Acme Widget Manufacturing, Inc. example’s balance sheet and income statement, solve and analyze the DuPont Analysis ratios for 2015.

Ratio Value for Acme Widget Manufacturing, Inc.

Value for the Widget Industry

DuPont analysis ratios:

ROA 5 Profit margin 3 Total asset turnover 8.25% 3.64 times 5 5.28%

20.25% 3.35 times

5 7.09% ROE 5 Profit margin 3 Total asset turnover

3 Equity multiplier

8.25% 3 .64 times 3

2.52 times 5 13.31%

20.25% 3 .35

times 3 4.20 times

5 29.77%

Net income available to common stockholders

Common stockholdders' equity

Net income available to common stockholders

S =

aales Sales

Total assets Total assets

Common stockholders' e 3 3

qquity

Net income available to common stockholders

Total assests

N

=

eet income available to common stockholders

Sales Sales

Tota 3

ll assets

Net income available to common stockholders

Common stockholdders' equity ROA Total assets

Common stockholders' equity = 3

Financial Management72

Solution: You can solve for these ratios by referring to Table 3.1 in the textbook or the chapter equations page at the end of Chapter 3. Then review how the company would be out- performing or underperforming based on industry standard.

The ROA and ROE DuPont analysis ratios show that the company is underperforming industry averages. The management of Acme Widget Manufacturing, Inc. will need to evaluate all areas of the company’s operations, including its capital struc- ture, to see how its performance can be improved. Given its lower-than-average debt burden as compared to the industry average, increasing the company’s leverage may be a means the company can use to increase its ROA and ROE.

Other Ratios Along with the ratios discussed thus far, investors, managers, and finance professionals are also free to calculate alternative ratios by dividing all amounts on the balance sheet by total assets and all amounts found on the income statement by net sales. Performing these calculations, also known as spreading the financial statements, gives what are called common-size financial statements that serve the purpose of correcting for sizes. Such ratios can be useful for picking up on trends and for enabling easy comparisons of balance sheets and income statements among different firms in an industry. Such measures can be helpful to managers of a firm in the strategic planning process.

A firm’s ROA and ROE can be utilized to assess the ability of the firm to grow and of how much market value it has that can be maximized. This is done by computing the two growth measures listed below:

n Internal growth rate 5 , where RR is the company’s earnings retention ratio as calculated using the formula below.

n Retention ratio (RR) 5

Given that a firm will either distribute its net income to stock- holders or reinvest it in the form of retained earnings, the dividend payout ratio and the retention ratio should always add up to one. If a firm relies solely on internal financing to

Addition to retained earnings Net income available to common stockhoolders

ROA RR 1 (ROA RR)

3

2 3

Lesson 2 73

foster asset growth, over time its debt ratio will decline: As asset values grow, the total amount of debt stays constant. This can anger shareholders if the decrease in a firm’s debt ratio as it grows dilutes their returns. As a result, as a firm grows, its managers must attempt to maintain a debt ratio that optimizes both the growth of the firm and the maintenance of an optimal debt ratio. To do this, they finance asset growth using a combination of new debt along with retained earnings. The maximum growth rate achievable in this manner is known as the sustainable growth rate.

Sustainable growth rate 5

Taking steps to maximize the sustainable growth rate helps managers of a company maximize firm value. The textbook indicates four factors firms can use to increase their sustain- able growth rate:

1. The profit margin

2. The total asset turnover

3. Financial leverage

4. Profit retention

Let’s look at a problem that solves for the market value ratios.

Example: Given the information found in the Acme Widget Manufacturing, Inc. example’s balance sheet and income statement, solve and analyze the internal and sustainable growth rates for 2015.

Ratio Value for

Acme Widget Manufacturing, Inc.

Value for the Widget Industry

Internal and sustainable growth rates:

Retention ratio (RR) 5 267.50% 1 2 .3120 5 68.80%

Internal growth rate 5 22.70% 5 5.14%

Sustainable growth rate 5 26.53% 5 25.76%

ROE RR 1 ROE RR

3

32 ( )

$201 $228m $40m 2

. . . .

0528 5250 1 0528 5250

3 2

2 3 2

( ) ( )( )

. . . .

1331 5250 1 1331 5250

3 2

2 3 2

( ) ( )( )

. .

0710 1 0710

3

2 3

.6880 .6880( )

.2977 .6880 1 .2977 .6880

3

32 ( )

Solution: You can solve for these ratios by referring to Table 3.1 in the textbook or the chapter equations page at the end of Chapter 3. Then review how the company would be outperforming or underperforming based on industry standard.

Financial Management74

Once again, Acme Widget Manufacturing, Inc.’s poor performance against the industry average shows up in these ratios. Management will need to thoroughly analyze the company’s operations to see what can be done to improve its performance, including potentially increasing the firm’s debt ratio.

Times Series and Cross-Sectional Analysis To apply ratios in a meaningful way, it helps to evaluate your ratio results in conjunction with a standard or benchmark. Two major kinds of benchmarks are used by finance participants in this regard:

1. Time series analysis–is the performance of a firm over time.

2. Cross-sectional analysis–is the performance of a firm as compared to one or more firms in the same industry.

Analyzing how a firm’s ratios have changed in conjunction with absolute ratio levels provides investors, managers, and finance professionals with information about trends relating to the firm’s financial performance. Focusing on the financial ratios of just one firm provides only a partial picture of a firm’s performance. Most ratio analysis involves cross-sectional analysis in the form of comparing one company’s ratios to those of other industry firms. To most effectively use cross-sectional analysis, it’s vital to compare a firm to other firms that are similar to it in terms of industry, sector, size, and operational approach. This can be hard to do, making cross-sectional analysis a subjective approach.

Applying Caution to the Use of Ratios in Evaluating Firm Performance Analyzing financial ratios enables managers, investors, and financial professionals to gain a better understanding of the factors underlying a firm’s performance. Nevertheless, it should be noted that caution should be taken when reviewing data sourced from financial statements. A number of cautions are listed in Section 3.9 of your textbook. Being aware of these potential issues can help you use ratio analysis to acquire valuable information relating to a firm’s current status, along with hints at its future performance.

Lesson 2 75

Self-Check 5

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What do liquidity ratios measure?

2. How is inventory turnover computed?

3. What does ACP stand for, and how is it determined?

4. What might be indicated by an extremely low accounts payable turnover?

5. Why will a firm with older assets on its balance sheet tend to have a higher fixed asset turnover ratio than a firm that has just replaced its fixed assets?

6. How is the capital intensity ratio calculated?

7. Why are managers’ choices regarding a firm’s capital structure important?

8. What effect does leverage have on a firm’s return to its stockholders and its potential for financial distress?

9. What do market value ratios measure for publicly traded firms?

10. What four factors does a firm’s sustainable growth depend on?

Complete the following problems at the end of Chapter 3.

12. Problem 3-2

13. Problem 3-3

14. Problem 3-11

15. Problem 3-12

Check your answers with those on page 228.

Financial Management76

ASSIGNMENT 6 Read this assignment. Then read Chapter 4 in your textbook.

In both business and personal life, cash flows reflect current and future spending and receipt of cash. In this assignment, you’ll study calculations used for determining the time value of money (TVM). Such calculations can serve as effective tools for making sound financial decisions. Factors to keep in mind when formulating decisions based on the time value of money are as follows:

n Size of the cash flows

n Time between the cash flows

n Rate of return we can earn

The fundamental idea behind the time value of money can be expressed as follows: $1 today has greater worth than $1 to be delivered next year. The degree to which the value of a future sum of money differs from a present one depends on the current interest rate. This assignment explains the concept of the time value of money and gives you the tools necessary to perform an analysis of single cash flows at particular points in time.

Organizing Cash Flows To successfully operate a business, managing the timing of cash flow is imperative. One useful tool for doing so is the timeline, which tracks the size of cash flows over different points in time: monthly, quarterly, or annually. Cash received is known as an inflow and is enumerated as a positive number, while cash that’s spent or paid out is called an outflow, denoted as a negative number. Interest rates are integral to the practice of money management, in both personal and business contexts. Understanding their relation to cash flows, both positive and negative, over time is vital to achieving financial success. A good place to begin learning about these concepts is studying how money grows in value over time.

Lesson 2 77

The Concept of Future Value A cash flow that’s credited to you by your bank in six months on a deposit you’ve made is called a future value. For instance, if you deposited $1,000 with the bank and they credited you with $15 after six months, reflecting an annual interest rate of 3 percent (1,000 3 .03 5 $30, half of which is $15), the $1,015 would be the future value of $1,000 in 6 months at a 3 percent annual interest rate.

Single-Period Future Value

To compute the future value of an amount of money in one year is fairly simple. For example, using the previous scenario, we can calculate the future value as follows:

Value in 1 year 5 Today’s cash flow 1 Interest earned

$1,030 5 $1,000 1 $30

In the equation, 3% is expressed as .03:

$1,000 3 .03 5 $30

This is the same as the following formula:

$1,000 3 (1 1 0.03) 5 $1,030

When using the general form of the future value equation, cash today is called present value, or PV. The future value of a cash flow a year from now, denoted as FV1 with an interest rate of i, is calculated as follows:

Value in 1 year 5 Today’s value 3 (1 1 Interest rate)

FV1 5 PV 3 (1 1 i)

Higher interest rates will, of course, result in higher future values. Your textbook shows this dynamic in Table 4.1.

The Effect of Compounding on Future Value

The process of earning interest on an original deposit and on any earlier interest earned on that deposit is known as compounding. For instance, if you kept your deposit of $1,000 at the bank for another year, it would earn not $30, but $30.90, with the extra $.90 representing interest on the $30 earned the previous year. The calculation would look like this:

$1,000 3 (1 1 .03) 3 (1 1 .03) 5 $1,060.90

Financial Management78

The future value of $1,000 deposited today at 3 percent interest in two years is $1,060.90. The $30 in interest that was earned on the original deposit is called simple interest, while any interest earned above and beyond simple interest over any time period is known as compound interest. The multiyear form of the general future value equation shown above with the future value in year N is as follows:

Future value in N years 5 Present value 3 N years of compounding

FVN 5 PV 3 (1 1 i) N

Using the above equation with the scenario we’ve been working with, we get the following result:

$1,060.90 5 $1,000 3 (1.03)2

While the difference in interest earned due to compounding may be slight over relatively short periods of time, it can become significant over longer periods, as demonstrated in Figures 4.1 and 4.2 in your textbook. Table 4.2 shows how higher interest rates can dramatically impact the power of compounding. Figure 4.3 shows the exponential impact of compound interest rates over time. Because of this, doubling the interest rate you receive on a deposit won’t result in simply doubling the amount of interest you receive. Compounding changes the dynamics of the cash flows so that your money will grow in an exponential, rather than a strictly arithmetic, fashion.

Let’s look at a problem that illustrates how future value works.

Example: Suppose you begin with $100 and deposit it in an account that pays 5 percent annually. How much will you have in the account after one year?

Solution: The calculation is relatively simple. You’ve been given the values of three variables. The present value (PV) is the amount you begin with, which is $100. The number of time periods (N) is 1 year. The interest rate (i) is 5 percent annually. The missing variable that you need to calculate is the future value (FV), which is the value of the investment at the end of one year.

Lesson 2 79

You would use the following equation to calculate the future value of the investment:

FV 5 PV 3 (1 1 i)N

Substitute the known values of PV, i, and N into the equation and solve.

FV 5 $100 3 (1 1 0.05)1

5 $100 3 (1.05)1

5 $100 3 1.05

5 $105

Thus, the value of the $100 investment after 1 year will be $105.

Now, let’s look at a problem that illustrates how future value and compounding works.

Example: Suppose that you deposit $100 into an account that pays 5 percent annually. How much will you have in the account after 5 years?

Solution: In this problem, you’re given the following variables:

PV 5 $100

N 5 5 years

i 5 5% annually

You would again use the following equation to calculate the future value of the investment (FV).

FV 5 PV 3 (1 1 i)N

Substitute the known values of PV, i, and N into the equation and solve.

FV 5 $100 3 (1 1 0.05)5

5 $100 3 (1.05)5

5 $100 3 (1.2763)

5 $127.63

Thus, the value of the $100 investment after 5 years will be $127.63.

Financial Management80

In this example problem, note that the compounding process (the process of earning interest on interest) has produced total interest of $27.63, which is greater than the total simple interest of $25.

Compounding at Different Interest Rates over Time

Interest rates tend to vary over time. Over the past 50 years, banks have credited depositors with rates ranging from the double digits to lower than 1 percent. In the earlier scenario, we examined a bank deposit that earned 3 percent a year for two years. What would the future value of your deposit be if the bank offered to pay 5 percent in the second year?

FVN 5 PV 3 (1 1 iperiod 1) 3 (1 1 iperiod 2) 3 (1 1 iperiod 3) 3 . . . 3 (1 1 iperiod N)

FV2 5 $1,000 3 (1 1 .03) 3 (1 1 .05) 5 $1,081.50

Present Value If you start with a value in the future and are asked to dis- cover the present value, you use a type of calculation known as discounting. Discounting is the process of determining the worth today of an amount you plan to get in the future. While compounding substantially increases a present value in the future, discounting substantially decreases a future value to the present. The formula used for discounting is as follows:

Present value of next period’s cash flow 5

PV FV i

= +( )

1

1

Net period's value One period of discounting

Please refer to the Math Coach, “Using a Financial Calculator” in Section 4.2 of your textbook for step–by–step instructions on how to use the Texas Instrument BA II (Plus or Professional) and the Hewlett–Packard 10B II Business calculators.

Lesson 2 81

Let’s look at another example of discounting.

Example: Suppose you want to know how much money to invest today to reach a future goal of $100. You want to invest the money for one year in an account that pays 4 percent interest annually.

Solution: This calculation is relatively simple. You’ve been given the following three variables:

Future value (FV) 5 $100

Interest rate (i) 5 4% annually

The missing variable that you need to calculate is the present value (PV), which is the amount of money you’ll need to invest today to reach your future goal.

Use the equation above to calculate the present value of the investment, substituting the known values of FV, i, and N into the equation and solve.

Thus, you’ll need to invest $96.15 today to have $100 after one year.

Discounting over Multiple Periods

To discount over multiple periods, we take the opposite of the approach to compounding over multiple periods. The equation for this is as follows:

PV of cash flow made in N years 5

The interest rate can be referred to as the discount rate.

Now, consider the same example over a five-year period.

Example: Suppose you want to know how much money to invest today to reach a future goal of $100. You want to invest the money for five years in an account that pays 4 percent interest annually.

PV FV

i N N= +( )1

Cash flow in year years of discounting

N N

PV = +

=$ ( . )

$ .100 1 0 04

96 15

Financial Management82

Solution: In this problem, you’re given the following three variables.

FV 5 $100

N 5 5 years

i 5 4% annually

Use the formula above to calculate the present value of the investment (PV). Substitute the known values of PV, i, and N into the formula and solve.

5 $82.19, rounded to nearest cent

The process of discounting tells you that you’ll need to invest $82.19 today. After five years of earning 4% interest annually, your investment will have a value of $100.

The use of higher interest rates serves to discount future cash flows much more rapidly, as displayed in Figure 4.4 in your textbook.

Discounting with Multiple Rates

As with compounding, discounting also can be applied using multiple rates. The general formula for doing so is

Present value with different discount rates 5

The Use of Present Value and Future Value When analyzing projects for investment or the composition of a company’s capital structure, managers often find it helpful to move cash flows from their current or projected positions to other points in time. You can do the same. For instance, if you purchase a car with a five-year loan at 9 percent, but later receive an offer to refinance to a three-year loan at 6 percent, it may be worthwhile to consider doing so. While the payments will be higher on a monthly basis, you’ll save on total interest paid for the life of the loan, making it a tempting trade-off if you can afford the higher payment.

PV = ( )

$100

1 0.04 5

�

PV FV i i i i

N= +( ) +( ) +( ) +(1 1 1 1period 1 period 2 period 3 period3 3 3 3 N ))

Lesson 2 83

When steps are taken to move flows to a different point in time, equations relating to both present and future value must be used. Present value equations are utilized to move cash flows back (or earlier) in time, while future value calcu- lations are used to move cash flows forward (or later) in time. By moving cash flows from different periods into the same time frame using present or future value equations, you can more easily compare their values. Table 4.3 in your textbook shows how several cash flows might be moved.

Rule of 72 Albert Einstein is said to have helped popularize compound interest by introducing a simple formula to compute the years needed for an investment to double. This formula is known as the Rule of 72.

Approximate number of years to double an investment 5

The Rule of 72 doesn’t give a precise measurement of the time needed for an investment to double, but rather an approxima- tion. It’s most accurate when lower interest rates are used in the calculation.

Let’s look at a problem that illustrates how the Rule of 72 works.

Example: You deposit money in an account that earns 8 percent interest per year. How many years will it take to double your money?

Solution: Using the Rule of 72, divide 8 into 72.

Number of Years to Double Money 5 5 9 years

Remember this is only a mathematical approximation. It will be more accurate the lower the interest rate. For example, if we use 72 percent as the interest rate, this will give a one- year result. However, we know that it would take 100 percent to actually achieve a one-year goal of doubling your money.

72 Interest rate

72 8

Financial Management84

Compound Interest Rates Knowing the formulas behind calculating the time value of money is useful for situations in which you know the values of two cash flows and want to use those values to determine what the interest rate is.

Example: For instance, if you loaned out $500 and two years later received $800 ($500 in principal plus $300 in interest) in return, what was the rate of interest you received on the loan?

Solution:

To find the answer, we can use time-value equation 4-1 in your textbook.

FVN 5 PV 3 (1 1 i) N

$800 5 $500 3 (1 1 i)2

If we rearrange this equation, we get

$800/$500 5 (1 1i)2, or 1.60 5 (1 1 i)2

To solve for i, the interest rate, you take the square root of both sides of all the equation. To accomplish this, take 1.60 to the 1/2 power using the yx button on your calculator. This results in

1.265 5 (1 1 i), or i 5 .265 5 26.5%

Thus, the $300 return you received on your $500 loan over two years represents a return of 26.5 percent per year.

Loss/Gain Return Asymmetries If you invest $1,000 to purchase a silver coin and it declines in value to $500, the asset has obviously experienced a 50 percent decline in value. However, a 50 percent increase in value isn’t sufficient to return your investment to break even. It will increase the $500 to only $750. It would take a 100 percent return to turn $500 back to $1,000. Another example would be if you purchased a stock for $8 a share and sold it for $6, a 25 percent loss. If you buy a different stock for $6 and it rises in value by 25 percent, the stock would be worth only $7.50. It would require a 33 percent gain in the value of the new stock to cancel out the 25 percent loss.

Lesson 2 85

Solving for Time When you need to calculate the time period required for the accumulation of a specified amount of money, you can use the beginning cash flow, interest rate, and future cash flow (the amount you’ll need) to perform the calculation. Solving for a number of different periods of time is complicated and necessitates the use of natural logarithms. Many people prefer using a financial calculator to solve such equations.

Example: If interest rates are at 6 percent, how long would it take for a $10,000 investment to double?

Solution:

To find the solution using a calculator, input the following values:

I 5 6

PV 5 –10,000

PMT 5 0

FV 5 20,000

CPT N 5 11.8957, or 11.90 years

The answer is 11.90 years, which is close to the number derived from the Rule of 72, which is , or 12.

In Section 4.6, the Math Coach shows how to use Microsoft Excel functions to solve for simple TVM problems.

72 6

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Self-Check 6 Answer the following questions using this study guide and your textbook. Answers will vary

in length.

1. What factors should be considered when making TVM decisions?

2. How would you compute the future value of a sum of money one year from today?

3. If a bank is offering a 5% interest rate on deposits, and a $100 deposit in a bank grows to $110 by the end of year two, is the bank paying simple or compound interest?

4. When moving cash flows from one point to another in time, what’s the present value equation used for?

5. How is the Rule of 72 used to determine the length of time it will take an investment to double?

6. What’s meant by the term return asymmetry when applied to negative returns?

7. How is discounting applied to find the present value of the next period’s cash flow?

8. What happens to the difference between what an investment is worth today and what it’s worth when you’re supposed to receive it as the interest rate increases?

9. What did the famous physicist Albert Einstein reportedly say about compound interest?

10. When companies borrow money to build factories and expand into new locations and markets, what do they expect of the future revenues generated by these activities?

Complete the following problems at the end of Chapter 4.

11. Problem 4-4

12. Problem 4-5

13. Problem 4-11

14. Problem 4-14

15. Problem 4-18

Check your answers with those on page 229.

Lesson 2 87

ASSIGNMENT 7 Read this assignment. Then read Chapter 5 in your textbook.

The previous assignment covered basic time value calcula- tions. Many applications of the time value of money involve multiple cash flows and typically require more complex anal- ysis. This assignment will focus on situations in which many equal payments are required over a period of time.

The Future Value of Multiple Cash Flows In many cases, individuals or businesses will make multiple payments that compound over time—for instance, when pur- chasing a car or saving for retirement. To calculate the total future value of such transactions, you can add together the future value of each separate payment or contribution.

How to Find the Future Value of Multiple Cash Flows

If you make a series of contributions to a savings account at different times, how would you calculate the future value of all the contributions? For example, if you deposited $540 today, $1,000 at the start of the second year, and $800 at the end of the third year, what would be the future value of those deposits at the end of five years, at an interest rate of 4 percent?

Consider that the initial deposit will compound for five years, the second will compound for four, and the third for two. If you calculate the future value of each contribution, you can then add them together to determine the total future value. Starting with the future value equation from Chapter 4 of your textbook, we can determine the future values of the three deposits.

FV5 5 $540 3 (1 1 0.04) 5 1 $1,000 3 (1 1 .04)4 1

$800 3 (1 1 .04)2 5 $2,692.13

The general form of the equation for calculating the future value of multiple inflows or outflows in varying amounts is displayed in Figure 5-1 of your textbook.

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FVA5 5 5 $500 3 5.64 5 $2,819 for 5 years

FVA2 5 5 $500 3 2.06 5 $1,030 for 2 years

5 $2,819 1 $1,030 5 $3,849

The Future Value of Level Cash Flows

If a series of cash flows occur every year in the same amount, they’re known in finance as annuities. An annuity pays out an initial cash flow at the completion of a specified time period (such as at the end of the first year) and then continues to pay out at the same rate until the last year is reached. The formula for determining the future value of an annuity (FVA) is

Future value of an annuity 5 Payment 3 Annuity compounding

The power of compounding affects annuities as it does other forms of investments. Table 5.1 and Figure 5.1 in the textbook show the significant increase in the future value of an annu- ity cash flow when time periods and interest rates increase substantially.

The Future Value of Multiple Annuities

Multiple annuities may occur in both business and personal financial contexts. For instance, if you receive a raise at work, you might decide to increase the amount you’re setting aside in a savings account for retirement at a guaranteed rate of 6 percent over five years.

Example: In such a case, instead of monthly contributions of $1,000 for five years, the monthly payments might rise to $1,500 starting in the fourth year.

Solution: To calculate the future value in this situation, you can calculate each payment stream’s future value individu- ally and then add them together. Use Equation 5-2 in your textbook.

FVA PMT i iN N

5 3 21 1+( )

$500 1 0.06

5 1

0.06 ( )

$500 1 0.06

2 1

0.06 ( )

Lesson 2 89

The Present Value of Multiple Cash Flows While the concept of future value is quite helpful in under- standing the process of creating wealth for the future, present value helps you better evaluate personal and business applications in which multiple cash flows are present.

How to Find the Present Value of Multiple Cash Flows

Earlier, we looked at a series of cash flows over time growing at a 4 percent interest rate to determine their future value. If we take those same three bank deposits and use the equation for calculating present value from Chapter 4 with a 6 percent discount rate, we can add them together to determine the total present value.

Total PV 5 $2,187.68

The general equation for determining the present value of multiple cash flows is listed in Equation 5–3 in your textbook.

The Present Value of Level Cash Flows

Many loans are structured to repay the sum that has been borrowed (present value) via level payments issued each period (the annuity). A lender typically examines the budgets of potential borrowers to gauge the amount they can afford to pay on the loan. The maximum loan amount made available to the borrower will constitute the present value for that annuity payment. The equation used to determine the present value attributed to an annuity is

PV $656.99 5 4 1

1 0 06 490 94 5

1 5 3

. $ .

( ) 

  



  

PV $1,169.86 4 4 1

1 0 06 926 64 5

1 5 3

. $ .

( ) 

  



  

PV $865.28 2 2 1

1 0 06 770 10 5

1 5 3

. $ .

( ) 

  



  

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Present value 5 Payment 3 Annuity discount

Figure 5-2 in the textbook demonstrates that the present value of payments occurring far in the future isn’t very much. It should also be noted that the present values of annuities become less when interest rates rise.

The Present Value of Multiple Annuities

Similar to the method by which you earlier combined annu- ities to determine a total future value, you can also make present value calculations by combining annuities in which changing cash flows are involved.

Example: Consider a professional basketball player who signs a contract promising him the following:

n $54 million over 8 years

n $5 million signing bonus

n $8 million annually in years 1 through 4

n $6 million in years 5 through 7

n $5 million in the last year of the contract

If we use a 7 percent discount rate, what’s the present value of this contract?

Solution: To solve for the present value, we can create three separate annuity cash flows reflecting all three payment periods over the course of the contract.

Total PV 5 $47.77m – $5.25m – $2.80 5 $39.72 million

PVA PMT i iN

N =

− −





   





   

3

1 1 1( )

PV $3m $3m1 11

1 1 0 07 0 07

9346 2 8 .

. . $ .( )





  





  

00 million

PV $8m $8m8 81

1 1 0 07 0 07

5 713 47 .

. . $ .( )





  





  

777 million

PV $2m $2m3 31

1 1 0 07 0 07

2 6243 5 .

. . $ .( )





  





  

225 million

Lesson 2 91

Perpetuities

Perpetuities are a specialized kind of annuity that feature a series of cash flows that never stop—they’re delivered for- ever. Preferred stocks may provide investors with perpetual payments, as do British consols. Equation 5-5 in your text- book shows the calculation used to determine the PV of a perpetuity.

Ordinary Annuities and Annuities Due Many times, cash flows arrive at the start of a period rather than at the end of it. When cash flows come in at the beginning of every period instead of at the end, the annuity is called an annuity due. Thus, a 10-year annuity due would have one payment at the very start of the annuity and nine more payments at the start of each subsequent year, with the final payment at the start of year 9.

Future and Present Value of an Annuity Due While the first nine payments of an ordinary 10-year annuity compound, the last payment doesn’t compound at all. All of the payments of an annuity due, on the other hand, compound. As a result, the formula for calculating the future value of an annuity due is as follows:

Future value of an annuity due 5 Future value of an annuity 3 One year of compounding

FVAN due 5 FVAN 3 (1 1 i)

Let’s look at a problem that illustrates how this equation works.

Example: If the future value of an annuity payment of $500 a year for four years at 8 percent interest is $2,253.06, what’s the future value if such payments were associated with an annuity due?

Solution:

FVAN due 5 $2,253.06 3 (1 1 i)

5 $2,253.06 3 (1 1 0.08)

5 $2,253.06 3 1.08 5 $2,433.30

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When calculating the present value of an annuity due, there’s no need to discount the first payment as it occurs in the present. Therefore, the formula to discover the present value of an annuity due is as follows:

PVAN due 5 PVAN 3 (1 1 i)

Let’s look at a problem that illustrates how this equation works.

Example: Using the same annuity payments and interest as above, what would be the present value of the payments if they constituted an annuity due, given their standard PV of $1,656.06?

Solution:

PVAN due 5 $1,656.06 3 (1 1 i)

5 $1,656.06 3 (1 1 0.08)

5 $1,656.06 3 1.08 5 $1,788.54

Compounding Frequency Often, cash flow TVM analysis necessitates calculations that involve other than annual time periods. For instance, bonds pay interest semiannually, while corporations often pay out dividends quarterly. As a result, compounding frequency must be considered when calculating the future values derived from investments that make payments at other-than- annual intervals.

Effect of Compounding Frequency

A deposit that’s compounded more frequently than annually will grow faster over time, and significantly faster if the time- span is long enough. Table 5.3 in your textbook shows how different compounding frequencies result in different future values. As stated above, the more frequently compounding is performed, the greater the future value will be. Additionally, it should be noted that increases in value from more frequent compounding tend to decrease as frequencies are increased further and further.

Lesson 2 93

EARs and APRs

If you borrow $3,000 on your credit card at a rate of 15 percent, you would expect to pay $450 in simple interest over the course of a year. However, if the loan compounds monthly, you would owe $16,050 at year end. As a result, you’re really paying more than 15 percent interest on the loan—16.08 percent, to be exact. The 15% rate, in this case, would be called the annual percentage rate (APR), and the higher rate of 16.08 percent would be called the effective annual rate (EAR). Lenders offering loans that charge compound interest are mandated by law to inform potential borrowers of a loan’s APR. Example 5–7 in your textbook shows how to convert an APR to an EAR.

Annuity Loans In a number of situations, the future and present values of annuities are already known. What’s required to compare them are the amounts they’ll pay out, or the implied interest rate, which is generally the highest rate offered.

Determining the Interest Rate

In a business or personal investment, solving for the implied interest can involve complicated calculations.

Let’s look at a problem that illustrates how to determine an interest rate.

Example: If a company is considering the purchase of a grinding machine for the factory floor for $500,000, and it estimates it will earn $100,000 in profits over the eight-year expected lifetime of the machine, what’s the rate of return on this purchase?

Solution:

To solve the equation with a financial calculator, input the following:

N 5 8

PV 5 –500,000

PMT 5 100,000

FV 5 0

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The resulting interest rate is 11.82 percent. The company can use this rate to decide if the return is high enough to warrant purchasing the machine. If the company’s cost of capital is less than 11.82 percent, purchasing the machine can be justified from a financing standpoint.

Determining Payments on an Amortized Loan

In cases in which a consumer or small business owner knows the amount of money he or she would like to borrow and what the rates are, this information can be used to calculate the actual payments. A loan that has been structured in the form of annuity payments that function to totally satisfy the debt is known as an amortized loan. The formula used to determine the amount of the annuity cash flow of this type of a loan is as follows:

Payment 5 Present value 3 Amortization

Let’s look at a problem that illustrates how you find a payment on an amortized loan.

Example: Bobbie went to SmartTrax Auto Group, Inc. to buy a new car. Most car loans are usually for three to five years. Bobbie decides to get a car that costs $22,000, which includes the taxes, tags, and warranty. The bank offers Bobbie a loan for 5 years and 6 percent APR. What will Bobbie’s monthly payments be for his new car?

Solution: You’ll use an interest rate of 0.50 percent (6%/12 months) and 60 periods (5 years 3 12 months).

If Bobbie decides to purchase this car, his payments will be $1,161.60 each month.

PMT PV i

i

N

N

= −

+



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

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3

1 1 1( )

PMT60 60

22 000 0 05

1 1 1 0 05

22 000 0528= −

+

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= =$ , .

( . )

$ , .3 3 $$ , .1161 60

Lesson 2 95

The level of interest rates and the length of the loan have a major impact on the size of your mortgage payments. Table 5.5 in the textbook displays the monthly payment amounts necessary to fully pay off a mortgage when various levels of interest rates and time periods are taken into account. The table shows that as interest rates decline, monthly mortgage payments decline as well. This explains why there’s usually a push by consumers to investigate the possibility of refinanc- ing their mortgages when interest rates drop.

Amortized Loan Schedule

When making payments on a mortgage or other amortized loan, such as a car loan, you may find it helpful to learn what amount of the debt, the loan principal, is still owed. A loan that’s categorized as interest-only enables a borrower to pay the interest on the loan without making any principal payments to reduce the debt.

Your textbook shows an amortization table in Table 5.6, displaying the effects of payments on the principal amount of a loan over its lifetime. The table demonstrates that early payments on a car loan are used mainly to pay interest instead of reducing principal. Amortization tables are constructed by displaying the principal balance of a loan at the start of each month. From there, the interest owed on the monthly balance is computed. When that’s paid, the rest of the payment is used to reduce the next month’s loan balance. Take a look at the Math Coach on “Using the ANIRT Function in TVM Calculations” of your textbook to see how to preprogram functions to compute the amount of principal paid part way through a mortgage.

It can also be useful to learn the amount of time needed to fully pay off a loan with specified annuity payments. The equation is quite complex, and a financial calculator can come in handy to determine it.

A method to calculate payments for a loan often used in payday lending is known as add-on interest. This method computes the interest amount payable at the start of the loan and then adds that amount to the loan’s principal. The total amount calculated this way is next divided into the number of payments that will be made.

Financial Management96

Self-Check 7 Answer the following questions using this study guide and your textbook. Answers will vary

in length.

1. What are annuities in finance?

2. What does the term FVA denote?

3. How is the future value of multiple annuities determined?

4. What personal applications will the present value concept help most with?

5. How are most loans set up?

6. Why are certain annuities called perpetuities?

7. When do cash flows typically occur in an annuity due?

8. What will be the effect on the end value of a deposit if interest is compounded semiannually rather than annually?

9. How are amortization schedules constructed?

10. How does add-on interest work?

Complete the following problems at the end of Chapter 5.

11. Problem 5-2

12. Problem 5-4

13. Problem 5-6

14. Problem 5-8

15. Problem 5-12

Check your answers with those on page 230.

Lesson 2 97

ASSIGNMENT 8 Read this assignment. Then read Chapter 6 and Appendix 6A in your textbook.

This assignment discusses how funds move throughout the economy and how financial markets function in conjunction with one another. This knowledge can help you make informed decisions as an individual investor, financial professional, or financial manager. This assignment will examine the functioning of financial markets and the financial institutions (FIs) that operate within those markets. We’ll also take a look at how major changes in the services delivered by FIs played a significant role in the devastating financial crisis that started in 2008. In addition, we’ll discuss factors that led to the crisis and cover some of its most serious events and the regulatory reaction to it.

Financial Markets Financial markets serve to manage the process of funds flowing from investors to borrowers and also from investor to investor. Markets are typically categorized by the characteristics of the main financial instruments traded there or by the location of the market. The textbook identifies two main classifications of markets:

1. Primary versus secondary markets

2. Money versus capital markets

Primary Markets versus Secondary Markets

Primary markets offer a means by which those who need funds, such as corporations or various entities of the local, federal, or state governments, can raise those funds by issuing new financial instruments, typically stocks or bonds. Entities that use primary markets to raise funds sell securities to initial fund suppliers (households) on the primary markets. Investment banks arrange the majority of primary market securities sales in the United States. These banks act as intermediaries between the parties issuing the securities (fund demanders) and the investors supplying the funds

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(fund suppliers). The investment banks offer fund demanders a variety of services, such as advice regarding the terms of a securities offering and bringing in investors who may purchase the initial securities offering. This allows firms to engage the expertise of investment banks to help guide them through a process that they likely don’t have significant expertise in, reducing risk for the firm as a result.

Initial sales of securities occur in two ways: through (1) a public offering or (2) a private placement, offered to a small group of accredited investors or financial institutions. When a public offering takes place, an investment bank acts as the underwriter of the security. In private placements, the buyers purchase securities directly from the security issuer.

To protect smaller private investors from a lack of or misleading disclosure, publicly traded securities have to be registered with the Securities and Exchange Commission (SEC). In the case of private placements, no such registration is required. However, privately placed securities can be resold only to financially sophisticated investors with enough knowledge or resources to withstand the risk of such investments. Because of the illiquidity associated with securities that are privately placed, typically only the largest and most experienced institutional investors are willing to purchase and hold such investments without a robust secondary market where they can be traded. Figure 6.1 in your textbook shows a timeline for the exchange of funds in the primary markets.

Stock issued by companies going public for the first time on a primary market are known as initial public offerings (IPOs). A number of prominent firms have raised capital this way in recent decades, including Microsoft, Google, and Apple.

After a firm has issued a financial security to trade in primary markets, the security can then be traded on secondary markets. The American Stock Exchange, New York Stock Exchange, and NASDAQ are prominent examples of secondary markets. Secondary markets also trade financial instruments secured by mortgages and various other assets, foreign exchange, and derivative securities such as futures and options.

Secondary markets allow buyers to locate sellers of secondary market securities that are economic agents needing funds (fund demanders). These markets offer participants a

Lesson 2 99

centralized location where they can purchase or sell a wide variety of securities efficiently, saving them the expense of searching out buyers or sellers by themselves. Figure 6.2 in your textbook illustrates a transfer of funds in the secondary markets. It should be noted that the firm that issued the securities doesn’t participate in trades on the secondary market, and that no money from such trades goes to the company itself.

The benefits offered by secondary markets include liquidity and the ability to diversify holdings for investors. Corporations also gain valuable information about the market value of their securities. They can use this information to gauge the reaction of investors to their use of the funding, both internally and externally, and what the cost might be should they need to raise funds in the markets. Trading volume, which is the number of shares of a security that are bought and sold simultaneously in a given period on the secondary markets, can be quite substantial. Buyers and sellers are matched through an exchange clearinghouse.

Money Markets versus Capital Markets

Distinguishing between exchanges can depend on the maturity ranges—how long it takes for debt issues to come due. Both capital markets and money markets deal in debt (capital markets also deal in stocks). The difference between them is the maturity characteristics of the debt securities being traded.

Money markets trade debt securities or instruments featuring maturities that are equal to or less than a year. These markets enable agents who possess unused short-term funds to lend them to economic agents who are interested in obtaining such funds. Suppliers of funds to these markets participate by buying money market securities, while demanders of funds sell these same securities. Given the limited amount of time during which such securities trade, fluctuation in the prices of such securities is fairly minimal. This low volatility lowers the riskiness of such securities as compared to longer-term instruments. Trading in money market instruments in the United States typically occurs using wire transfer, telephones, and computers rather than at a specific location. As a result, money markets are classified as over-the-counter (OTC) markets.

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Your textbook identifies a variety of money market instruments issued by corporations and government entities, including

n Treasury bills

n Federal funds and repurchase agreements

n Commercial paper

n Negotiable certificates of deposit

n Banker’s acceptances

Definitions for each type of money market security are included in Table 6.1 of your textbook. In Figure 6.4, a graphic representation of the percentages of money market instruments across the United States over three decades is provided.

Capital markets provide a means for parties to trade equity (stocks) and debt (bonds) securities that mature in greater than a year. As a result of their longer maturities, such instruments experience wider variance in price than money market instruments. As a result, they’re usually considered riskier.

Capital market securities include

n U.S. Treasury notes and bonds

n U.S. government agency bonds

n State and local government bonds

n Mortgages and mortgage-backed securities

n Corporate bonds

n Corporate stocks

Capital market securities are defined in Table 6.2 of your textbook, and their proportions in the United States across three decades is graphically represented in Figure 6.5.

Lesson 2 101

Other Markets

Currently, most companies based in the United States engage in operations globally. Astute financial managers realize that movements in foreign markets may have an effect on the profitability of their company. Foreign exchange markets are used to trade currencies either for immediate (known as “spot”) delivery or for delivery at a stated future time. U.S. corporations involved in selling securities or goods in for- eign markets are exposed to foreign exchange risk. This risk stems from the uncertainty about the rate at which cash flow denominated in a foreign currency can be converted to U.S. dollars. Rates for foreign currencies vary on a daily basis, subject to global demand and the available supply of U.S. and foreign currency units.

A financial security—such as an option or futures contract or mortgage-backed security—linked to an underlying security is known as a derivative security. Such securities can be linked to various other securities, such as a stock trading on the capital markets or Australian dollars traded on foreign exchange markets. They typically involve an agreement made by two parties to exchange a specified quantity of a particular asset or cash flow at an agreed-upon price at a predetermined future date. When the value associated with the underlying security changes, it causes the derivative’s value to change as well.

Derivative security contracts have been in existence for centuries. However, securities markets for these instruments grew widely in popularity from the 1970s onward as market participants increasingly used them to help hedge investment risk as well as profit from trends in diverse markets. Contracts of this type typically are highly leveraged, which means that an investor supplies a proportionally small amount of the face value of the derivative contract.

An example of using such a contract to hedge risks consists of a farmer who wants to take advantage of high prices for corn now, but won’t have the actual physical crop harvested for 3 months. The farmer could sell short corn futures at the current price. If prices decline, he could buy back the short contract in 3 months, and the money made on the short trade would make up for the lower price received on selling the

Financial Management102

corn. Alternatively, the farmer could use the actual commodity to satisfy the future contract, which would amount to the same thing: selling the crop at the higher current price rather than the lower price that prevailed three months later.

A similar scenario could apply for a U.S. firm planning to make a purchase overseas in six months. If the firm’s financial managers feel that the foreign currency will rise against the U.S. dollar in that interval, they could hedge against this by purchasing a futures contract in the foreign currency for an amount equal to the planned purchase. Thus, if the currency does strengthen over the next six months, they’ll be able to sell the futures contract to supply the difference between the planned purchase price and the new higher price as a result of currency fluctuation.

Of all the financial security markets, those for derivative securities are the most recent and also potentially the riskiest. This was displayed in the financial crisis that peaked in 2008, when losses on mortgage-based securities held off balance sheets by FIs played a major role in the creating the crisis. When home prices began to fall in later 2006 and 2007, this fostered an increase in defaults, seriously affecting first the mortgage industry and then other areas of the economy. Defaults by mortgage borrows led to steep declines in the value of mortgage-backed securities, leading to financial distress among some of the financial institutions holding such instruments on their balance sheets. These losses amounted to $700 billion globally by early 2009, causing the bankruptcy, acquisition, or government bailout of a number of large FIs and chaos in worldwide financial and economic systems.

Financial Institutions Financial institutions include

n Banks

n Thrifts

n Insurance companies

n Mutual funds

Lesson 2 103

They carry out a variety of crucial functions for securities markets, such as channeling funds from surplus fund holders (those who supply funds) to organizations or individuals who are short of funds (those who demand funds). In essence, FIs offer a cost-effective and efficient method of moving funds into and out of these markets. Another valuable role played by FIs is to spread risk for the benefit of market participants. This helps entrepreneurial activity, as very few individuals or companies could withstand the risk of undertaking the launch of a costly new product themselves. Individual investors who accept risk by purchasing shares in companies that may be subject to substantial fluctuation can, in turn, offset some of this risk by appropriately diversifying their investment portfolios.

To help demonstrate the importance of financial institutions in regard to the proper functioning of financial markets, Figure 6.6 in your textbook displays how funds would flow if FIs weren’t involved. In an economy without FIs, fund flow through markets would very likely be much diminished for the reasons listed below:

n After lending money in return for financial claims, the suppliers of funds would be faced with having to monitor the use of those funds on a continuous basis. This would add substantially to the cost of any investment, as most investors don’t have the personnel or training to perform these tasks.

n While a number of financial claims are long-term in nature, such as mortgages or corporate bonds, many suppliers of funds may not wish to directly hold these securities indefinitely. They may prefer to hold cash for the purpose of liquidity. In a market that isn’t deep (one that’s undeveloped) with a number of buyers available for securities on offer, investors may fear to invest, as they risk not being able to create liquidity from their holdings when desired.

n When buying securities, fund suppliers encounter price risk, which is the risk that when a security is sold the proceeds won’t be sufficient to return an investor’s capital, much less any return on the investment. In an illiquid market, this risk is magnified as transactions costs are likely to increase.

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The impact of various investment-related costs, if seen as excessive, would likely motivate investors to prefer to hold cash. Your textbook identifies these factors as

n Monitoring costs

n Liquidity costs

n Price risk

To mitigate the impact of these factors, the financial system allows financial intermediaries to engage in the indirect trans- fer of funds to the parties that will ultimately use the funds. To better deal with the three risks listed above, suppliers of funds in many cases would rather hold the financial claims of intermediaries such as FIs than the ones issued by those who ultimately make use of the funds. Figure 6.7 in your textbook displays how funds flow in this manner, which is a more accurate representation of the functioning of modern financial markets than shown in Figure 6.6.

As mentioned earlier, when a fund supplier invests in the financial claims of an entity that uses funds, the fund supplier is subject to extensive costs to thoroughly monitor the use of the invested funds. One solution to this dilemma is for a number of small investors to combine their funds in securities issued by FIs. An FI can take these funds or a portion of them and invest in the direct financial claims issued by users of funds. This helps resolve problems such as

n Large FIs, with far more invested in a user of funds than any individual investor, have greater motivation to actively monitor how the invested funds are used.

n The FI generally employs experts to monitor users of funds. Thus, from an economic standpoint, investors select the FI to perform as a designated monitor for their benefit.

Financial intermediaries can provide further liquidity to fund suppliers by serving as asset transformers. They do so by purchasing financial claims issued by funds users (primary securities) and financing such purchases via the sale of financial claims to individual investors and other suppliers of funds as deposits, insurance policies, and other secondary

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securities featuring packages of pools of many claims. These secondary securities in many cases possess greater liquidity than do the primary securities contained within them.

The financial crisis of the late 2000s was a major event that resulted in the reshaping of the financial services indus- try. Regulatory changes in the 1980s and 1990s resulted in increasing financial systemic risk. A major factor driving this was a changing banking model. Banks moved from an originate and hold approach, in which they would keep loans they had originated, to an originate to distribute model, in which they would rapidly sell loans after originating or warehousing them. Figure 6.8 in your textbook shows the significant increase in secondary market trading of bank loans even during the financial crisis. In the traditional originate and hold model, banks are motivated to monitor borrowers even after the loan is made. However, holding such loans exposes a bank to various risks—liquidity, interest rate, and credit risk among them. To minimize these risks and improve risk-return profiles, banks moved to the originate and distribute model. In this model, banks have less need to monitor borrowers’ behavior after a loan is made. Information about credit quality is, to a large degree, offloaded to credit rating agencies and the secondary markets where these loans trade.

In recent years, the growth of shadow banks—nonfinancial firms able to perform certain banking functions—has helped further the originate and distribute banking model. Shadow banking entities include

n Structured investment vehicles (SIVs)

n Special-purpose vehicles (SPVs)

n Asset-backed commercial paper (ABCP) conduits

n Limited-purpose finance companies

n Money-market mutual funds (MMMFs)

n Credit hedge funds

These firms provide loans and leases to borrowers, but unlike the traditional banking process, shadow banking firms use a multistep procedure when nonbank intermediation among

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net savers and net borrowers occurs. A consequence of this trend is the removal of risk from FI’s balance sheets, shifting it to other parts of the financial system. As a result, the need for financial institutions to specialize in the measurement and management of risk lessened.

A factor in FIs moving away from the practice of risk measurement and management was the tremendous boom, often called a “bubble,” that occurred in housing markets after 2001. When the Federal Reserve lowered interest rates in the wake of 9/11, it sparked an upsurge in demand for mortgage, consumer finance, and corporate debt. Some FIs lowered their credit quality standards to accommodate this demand. Some market participants issued adjustable rate mortgages (ARMs) with low “teaser” rates to increase the number of loans they could underwrite. When these loans reset after a few years, it exposed the borrowers to higher rates and, as a result, higher mortgage payments. Because of the new originate-to-distribute banking model, banks could make loans to lower credit-quality borrowers, as most loans were sold off into the secondary markets.

The decline in credit quality of loans coupled with the increase in leverage among corporations and consumers proved problematic when housing prices began to decline in 2006. At the same time, the Federal Reserve was raising rates in an attempt to prevent inflation from getting too high. All of these factors led to mass defaults of subprime mortgages, which provided the spark for the financial conflagration that peaked in the second half of 2008. Appendix 6A: The Financial Crisis: The Failure of Financial Institutions Specialness, found on the textbook’s website, offers an in-depth look at the causes, events, and regulatory changes to the industry that resulted.

To access Appendix 6A:

1. Click on the provided link

2. Select Student Edition

3. Select Appendix 6A from the list of Course–wide Content

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Interest Rates The rates you see displayed by financial markets are actually nominal interest rates, the ones typically referred to by financial news outlets. These rates have a direct effect on the price of most tradeable securities. Because of this, financial managers and investors closely follow financial market trends to try to pick out factors that might influence the future level of interest rates. Changes in interest rates impact investment performance and trigger buy-or-sell decisions for businesses and financial market participants as well. Figure 6.9 in your textbook shows the movement of a variety of important U.S. interest rates in past years.

Factors Influencing Interest Rates for Individual Securities

A number of factors affect nominal interest rates for particular securities, including

n Inflation

n The real risk-free rate

n Default risk

n Liquidity risk

n The security’s term to maturity

n Special provisions regarding the use of funds raised by a particular security issuer

Interest rates are influenced by the actual or expected inflation rate throughout the economy as a whole. Higher rates of actual or expected inflation will lead to higher interest rates. The textbook defines inflation (or the inflation premium, IP) as the increase in the price of a standardized basket of goods and services over a given period of time. Inflation, as measured by the U.S. Department of Commerce, uses the consumer price index (CPI) and the producer price index (PPI). To determine the annual rate of inflation using the CPI between years t and t 1 1, the following formula would apply:

IP = CPI CPI CPI

t + 1 t

t

2 3100

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Interest rates and inflation rates have a positive correlation; when inflation boosts the general price level, it drives investors to demand a higher interest rate. This is because higher inflation rates mean that goods and services will be more expensive in the future, and therefore a higher return is necessary to offset this.

Real Risk-Free Rates

The real risk-free rate is the rate risk-free securities would pay if no inflation was expected over the holding period. Higher real risk-free return rates indicate a higher preference among a society to consume.

The relationship between the real risk-free rates, expected inflation, and nominal risk-free rates, described as the Fisher effect, proposes that nominal risk-free rates have to provide

n Any inflation-related reduction in purchasing power lost on funds lent or principal due

n An additional premium above the expected rate of inflation for forgoing present consumption, which reflects the real risk-free rate issue discussed previously

The following formulas are for calculating the nominal risk- free rate.

i 5 Expected IP 1 RFR

RFR 5 i – Expected IP

Let’s look at a problem that illustrates how the Fisher effect works.

Example: Suppose you have one-year treasury bill rates that in 2010 averaged 5.25 percent, and inflation for the year was 4.85 percent. Investors expected that same inflation rate. Calculate the real risk-free rate for 2010 based on the Fisher effect.

Solution: 5.25% – 4.85% 5 .40%

It should be mentioned that it’s quite difficult to estimate the inflation rate, making the RFR correspondingly difficult to measure. Figure 6.10 displays a chart of how the RFR compares to changes in the CPI over time. When economic slowdowns strike, the T-bill (risk-free rate) is lower than the CPI, making risk-free rates negative.

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Default risk refers to the risk that an issuer of securities might be unable to make payments as promised. Higher default rates lead to security buyers demanding higher interest rates as compensation for the added risk, as compared with purchasing U.S. Treasury securities that are free from default risk. The government can print money to pay its obligations, driving its default risk rate down to almost zero. In Figure 6-4, the textbook provides a formula for determining the difference between quoted interest rates on Treasury securities and other securities with similar features, called a default or credit risk premium. Figure 6-11 shows the risk premiums as determined by credit rating agencies for different categories of bonds over time. The figure demonstrates that default risk premiums tend to increase when the economy contracts and decrease when it expands.

Highly liquid assets can be disposed of at a cost that’s reasonably predictable and with low transaction costs. Interest rates attributable to a security reflect the liquidity of the security on a relative basis, with more liquid securities typically carrying lower interest rates than higher ones (others factors being the same). The added interest due to this risk is known as a liquidity risk premium (LRP). Another type of liquidity risk premium exists when investors are wary of investing in long- term securities, given that their prices are subject to greater fluctuation than the prices of short-term securities as interest rates change.

The party issuing a security may at times attach special provisions or covenants that apply to the security. They serve to affect interest rates on the instruments that have them. The provisions can affect the security, including its

n Taxability

n Convertibility

n Callability

Interest rates are subject to change on a regular basis due to a bond’s term to maturity. This daily or hourly fluctuation in interest rates is known as the term structure of interest rates; it’s also called the yield curve. The yield curve’s shape is derived from the principles underlying the time value of money. Interest rate term structures compare debt securities’

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interest rates based on the time it will take until they mature. Generally speaking, bonds with a longer term to maturity will have higher interest rates than similar bonds of lesser maturity. The addition to the interest rate to compensate for the longer maturity is called the maturity premium (MP).

The most commonly followed yield curve in the United States is the yield curve tracking Treasury securities. In general, the yield curve is positive, as securities with longer terms yield more than securities with shorter terms. However, the MP may invert for short periods of time for various reasons. Equation 6-2 in the textbook provides a formula for computing the influence of factors that have a bearing on the interest rate necessary to compensate investors for the various risks.

Theories That Explain the Shape of Interest Rate Term Structures

Three theories that attempt to explain the yield curve’s shape are

1. The unbiased expectations theory

2. The liquidity premium theory

3. The market segmentation theory

The unbiased expectations theory holds that at any particular time, the shape of the yield curve represents the market’s current expectation of future short-term rates. The idea behind this is that an investor with a five-year time horizon has the choice of purchasing a five-year bond or five one-year bonds over the course of the five years, buying a new one-year bond after the last one matures. Thus, if the market expects future one-year rates to rise, the slope of the yield curve should be positive, as securities with longer-term maturities will need to offer higher yields or investors will just buy one-year bonds in sequence. According to the theory, current long-term interest rates comprise geometric averages of both current interest rates and expectations of the level of future short-term interest rates. Your textbook provides the formulas underlying this relationship in Equations 6-6 and 6-7.

The liquidity premium theory extends the unbiased expectations theory. It claims that investors are willing to hold long-term maturities only if such securities reward investors for the

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uncertainty associated with the future value of the securities. According to this theory, long-term rates are equivalent to geometric averages attributable to current short-term rates and to expectations of short-term rate levels, similar to the unbiased expectations theory. The liquidity premium theory adds to the unbiased expectations theory liquidity risk premiums that increase along with the maturity of the security. Figure 6.14 in the textbook compares both theories in relation to the yield curve.

The market segmentation theory holds that getting investors to purchase securities with maturities different from those they prefer necessitates a higher rate (a maturity premium). They won’t switch from one maturity sector to a different one without compensation for doing so. Figure 6.15 in your text- book shows how such preferences help change the yield curve in response to supply changes in short-term and long-term segments of the bond market.

Forecasting Interest Rates Forecasting interest rates is important to individual investors, public corporations, and finance professionals. The unbiased expectations theory can be used to predict the level of interest rates one year in the future. A rate that’s expected or implied in relation to a short-term security originating at some time in the future is known as a forward rate. By using the equations associated with the unbiased expectations theory, you can determine market expectations for forward rates from the rates that currently exist on spot market securities. The text- book outlines modifications to the equations necessary to serve this purpose in Equations 6-9, 6-10, and 6-11. Example 6-5 shows how these formulas work to estimate the forward rates.

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Self-Check 8

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What’s the difference between primary and secondary markets?

2. What types of securities are featured in money markets?

3. What types of securities are traded on capital markets?

4. What’s a derivative security?

5. What vital functions do financial institutions carry out for securities markets?

6. How did the shift away from risk measurement and management help spark the financial crisis?

7. What are some factors that influence nominal interest rates for a particular security?

8. What does the real risk-free rate measure?

9. What are the three main theories used to explain the shape of the yield curve?

10. What’s a forward rate?

Complete the following problems at the end of Chapter 6.

11. Problem 6-2

12. Problem 6-8

13. Problem 6-20

Check your answers with those on page 232.

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ASSIGNMENT 9 Read this assignment. Then read Chapters 7 and 8 in your textbook.

Bonds and the markets they trade on are essential to a capitalist economy. While stock markets may garner the majority of attention in the popular press, the bond markets are more important as a source of capital for a wide variety of organizations both public and private. In terms of size, the bond market is substantially larger than the stock market, with the total value of all U.S. bonds greater than twice the value of all common stocks in 2012, according to the text- book. This assignment examines the main characteristics of bonds and the price dynamics they’re subject to. As you work through the assignment, you’ll notice that a number of the time-value-of-money principles you’ve studied apply to bond pricing.

Debt is one means businesses can use to procure the funding they need to expand product offerings, start operations, and perform other actions designed to improve their business prospects. The other main source of capital they can use is equity, also known as business ownership. As the majority of individuals lack the time or knowledge to run their own businesses, they can achieve a similar result by purchasing stock in a company for a chance to participate in profits. A major reason investors buy stock is knowing they can sell the stock at any time during the trading day. A properly functioning market is essential to a capitalistic economy. This assignment will discuss stock market functions and methods of valuing stocks.

Characteristics of Bonds A bond is a debt obligation issued by a corporation, the federal government or one of its agencies, or a state or local agency for the purpose of funding projects or operations. Bonds are also called fixed-income securities; their terms provide specific dates and how much investors will receive in interest and principal.

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The structure of a bond is fairly standard. A legal contract known as the indenture agreement details the specific terms, including

n The date the principal will be repaid (called the maturity date)

n The par value, or face value, of each bond, which is the principal loan amount

n The coupon (interest) rate

n A description of any property pledged as collateral

n Steps that the bondholder can take in the event that the issuer fails to pay

Table 7.1 in your textbook describes various bond characteristics. The typical par value (amount an issuer promises to pay) of a bond is $1,000. The lifespan of the bond is complete once the issuer repays this par value to the investor on the date the bond matures. Bonds are generally referred to by their time to maturity—3 years, 8 years, 25 years, and so on. Markets segment groups of bonds using their maturity dates; they include short-term, medium-term, and long-term bonds with maturities ranging from 20 to 30 years, and sometimes longer.

In situations in which interest rates have fallen by several per- centage points, demand arises from a variety of quarters, including homeowners with mortgages and corporate bor- rowers, to refinance debt obligations. In some cases, the indenture contract will allow a bond to be refinanced. The provision that allows this is known as a call feature, which enables an issuer to “call” for the return of the bonds via the repayment of principal prior to the maturity date. As com- pensation for doing so, the issuer adds a call premium to the payment of principal, usually a year of interest payments.

The coupon rate of a bond is used to determine the amount that will be paid to bondholders. This rate shows up on the bond as a percentage of the bond’s par value. Thus, a 6 percent coupon rate on a bond with $1,000 par value would result in payments of $60 in interest per year, generally split into two payments made semiannually. The interest rate is set to match the market interest rates prevailing at the time of issuance. When issued, bonds will usually trade at or near

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their par value. However, this may not be the case if interest rates are exhibiting high volatility at the time. At maturity, bondholders will be paid the par value listed on the bond. Between issuance and maturity, a bond’s price can vary on the secondary market in response to changes in interest rates and to investor expectations about the company’s ability to make the payments. We’ll cover bond pricing in greater detail later in the assignment. Please note that the prices for bonds are quoted as a percent of par value instead of in dollars.

Let’s look at a problem that illustrates bond characteristics.

Example: Suppose you purchased a bond 15 years ago with a maturity time of 30 years. The bond’s coupon rate is 7 percent and currently trades for 110. The par value of this bond is $1,000. Determine the bond’s current time to maturity, semiannual interest payment, and bond price.

Solution:

Time to maturity 5 30 years – 15 years 5 15 years

Annual payment 5 .07 3 $1,000 5 $70, and semiannual payment is $35

Bond price 5 1.10 3 $1,000 5 $1,100

Bond Issuers

At one time, bonds were thought to be rather boring, highly conservative investments. That has changed in recent years as the fixed-income industry has evolved. A number of new kinds of bonds have been issued, some of which are listed in your textbook, including

n TIGRs

n CATs

n COUGRs

n PINEs

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All of the above are debt instruments based on U.S. Treasuries. Innovation in types of bonds notwithstanding, the three main categories of bonds continue to be as follows:

1. U.S. Treasury bonds

2. Corporate bonds

3. Municipal bonds

Treasury bonds. Bonds issued by the U.S. Treasury are backed by the “full-faith-and-credit” of the government of the United States. They’re believed to be some of the safest fixed-income investments available globally. Government agency securities don’t have the same full-faith-and-credit guarantee, but none have ever been allowed to fail by the government. These debt instruments are sold by the federal government via public auctions as a means of financing the public debt. They’re also used by the Federal Reserve System in the process of conducting monetary policy. Treasury securities under one year in maturity are called bills, those between 1 and 10 years are known as Treasury notes, and those from 10–30 years maturity are called Treasury bonds.

Corporate bonds. Bonds issued by corporations enable them to finance investments in inventory, fixed assets such as plants and equipment, Research & Development (R&D), and general growth. A fundamental motivation when creat- ing a corporate financing plan is lowering total capital costs. As a result, as interest rates have dropped in recent years, corporations have tended to favor using bonds over stocks to raise capital. Figure 7.1 in your textbook illustrates this.

Municipal bonds. State and local governments issue debt to finance a wide variety of projects and improvements to existing infrastructure. Projects that serve an entire community such as sewer improvements, schools, courthouses, and so on are typically financed by general obligation bonds, which are repaid through tax revenues. Projects that serve to bene- fit only specific groups such as toll roads, sports arenas, or airports are usually financed by revenue bonds that make payments from user fees. It should be noted that interest payments made to holders of municipal bonds aren’t subject to federal tax or state tax where the bond was issued.

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Other Bonds and Bond-Based Securities

Treasury Inflation-Protected Securities (TIPS) are a popular, recent innovation in bond issuance. This new type of debt security, which is indexed to inflation, was first issued by the Treasury in 1997. As with conventional Treasury bonds, TIPS feature fixed coupon rates. However, the government will adjust the par value of TIPS bonds in conjunction with the rate of inflation using the CPI. When the bond matures, investors get a principal payment adjusted for inflation. So, if inflation is elevated over the bond’s time to maturity, an investor could expect to get a significantly higher principal payment.

U.S. government agency securities are issued to provide reasonably priced financing for activities such as education, farming, and home ownership. Agency bonds support a variety of economic sectors. Since no agency has been allowed by the government to fail, investors consider agency bonds to be quite safe. They generally provide yields only slightly higher than those of Treasury bonds.

Mortgage-backed securities (MBS) are a type of bond invented by agencies of the federal government. They enable Fannie Mae and Freddie Mac to provide either subsidies or mortgage guarantees to individuals who might not otherwise qualify for a mortgage, particularly those buying a home for the first time. The two entities buy home mortgages from banks and other lenders. They combine the loans into diverse portfo- lios and sell them to investors by issuing mortgage-backed securities. This process enables lenders to realize cash from their holdings of existing loans and then make new loans. For many years the process worked well, until the relaxation of credit standards in the late 2000s led to individuals obtain- ing mortgages they couldn’t afford. This helped to spark the financial crisis.

The same procedure for pooling debt has been used by the financial markets in other industries, including credit card debt, auto loans, and equipment leases. Asset-backed securities provide investors with interest and principal payments as consumers pay off their loans. This segment of the financial services industry has been one of the fastest growing ones in recent years.

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When a bond matures, the owner of the bond receives the original principal of the bond, typically $1,000. Some corporate bonds, however, allow the bondholder to choose between a payment of cash or shares of the firm. These convertible bonds are most valuable when the stock of the issuer is higher than the conversion price at which the bond principal can be converted to shares, which is specified at the time the bond is issued. When the stock price is lower than the conversion price, the bondholder will prefer to receive cash instead of stock.

Reading Bond Quotes

Bond quotes are available in publications such as The Wall Street Journal or online, at sources such as Yahoo! Finance (yahoo.finance.com). Table 7.2 shows typical quotes for dif- ferent types of bonds. The bid price is the price at which you can sell the bond, while the ask price is the price at which you can buy. Both bid and ask show up as percentages of the $1,000 par value attributed to the bond. Thus, the amount paid to buy a bond with an asking price of 104.28 would be $1,042.80. A bond selling for higher than the par value is said to be a premium bond.

The ask is higher than the bid in bond quotes, leading to what is called the bid-ask spread. This difference helps compensate the bond dealers who buy and sell to investors for the risk involved in taking the opposite side of such transactions. If a dealer is asking 98.42 for a bond, the total price to buy it would be $984.20. A bond such as this that sells for an amount below its $1,000 par value is known as a discount bond. Bonds of this type will pay out a capital gain to an investor upon maturity equal to the amount below par value the investor paid for the bond. In this case, the capital gain would amount to $1,000 – 984.20, or $15.80.

Several factors are used to determine the coupon rate when issuing bonds, including

n The amount of uncertainty about whether the company will be able to make all payments

n The term of the loan

n The level of interest rates in the overall economy at the time

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Municipal bonds typically feature lower yields relative to Treasuries with comparable maturities because these bonds are exempt from federal income taxes for their purchasers.

Present Value of Bond Cash Flows As bondholders know both the payments of interest they’ll get as well as the payment they’ll receive at par value when the bond matures, they can compute the current price of a bond using time-value-of-money principles. The current price attributed to a bond is equal to the present value of these future cash flows discounted at the prevailing market interest rate.

Zero coupon bonds are the easiest types of bonds to analyze using calculations derived from time value of money. A zero coupon bond doesn’t make ongoing interest payments. These bonds make only one payment—the payment of the par value on the bond’s maturity date. Because of this, such bonds sell at deep discounts relative to their par values.

Bond Prices and Interest Rate Risk When a bond is purchased, the payments it will make for interest due and to redeem par value are fixed and understood by all parties. However, while interest rates in the economy as a whole may change over time, the coupon rate associated with the bond remains unchanged. If general interest rate levels rise, the value of all bonds will fall, and if interest rates fall, the value of all bonds will rise. To understand this phe- nomenon, consider the issuance of a new bond some years after a bond has been issued at a 3 percent rate of interest. Assuming current rates have risen to 5 percent, if the new bond is issued with a maturity profile that matches the old bond, it would be much more attractive to buyers, who would get a 5 percent rather than a 3 percent yield over the same amount of time. Therefore, the old bond won’t sell at par in such cir- cumstances (to yield 3 percent), but would instead trade at a discount sufficient to increase the bond’s yield to one that’s equivalent to other bonds with similar characteristics—in this case, 5 percent.

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The phenomenon of bond prices fluctuating on existing bonds in response to changes in prevailing interest rates is known as interest rate risk. Because of this, when interest rates experience substantial changes over any period of time, bondholders will typically see significant gains or losses on their holdings. Interest rate risk affects short-term bonds less than longer-term ones, and very short-term bonds will fluctuate little or not at all due to changes in interest rates, thus subjecting bondholders to minimal levels of interest rate risk. Long-term bondholders, on the other hand, are subject to high levels of interest rate risk. Table 7.3 in your textbook shows how interest rate risk applies to bonds with various coupons and maturity profiles.

The table shows that bonds possessing coupons with higher rates have higher prices. This is because bondholders tend to prefer larger annuity payments. Additionally, when interest rates rise, bondholders who own bonds with higher coupons are less affected. They can use the large coupon payments they get and reinvest these funds in new bonds offering higher rates. This makes price declines more significant for bonds that have lower coupons due to reinvestment rate risk. As interest rates rise, the cash flows received by bondholders are faced with a higher discount rate, which reduces the value of a bond. Lower coupon bonds provide smaller cash flows, giving their owners less money to purchase new bonds with higher coupons. This dynamic is shown in the 30-year bonds included in Table 7.3.

The maturity of a bond also plays a part in determining its reinvestment risk. As interest rates rise or fall, longer-term bonds will experience greater fluctuations in price than shorter-term bonds. Bonds having longer maturities and lower coupon rates have the greatest interest-rates risk, while bonds with shorter maturities and higher coupons have the lowest interest-rates risk.

Current Yield The yields of bonds express a variety of different rates (also known as yields). The current yield on a bond is easy to calculate but only provides an approximation of the true return offered by the bond. The current yield is measured

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by computing the rate or return that a bondholder earns on an annual basis just from coupon payments alone when the bond is bought at a specified price. It doesn’t track the total return an investor expects to earn from the bond, as it doesn’t take into account capital gains or losses potentially occurring as a result of buying the bond at a price that’s either at a discount or at a premium to par.

Yield to Maturity

A more informational calculation than simple current yield is yield to maturity, which informs bond investors of their expected total return from purchasing a bond and holding it until the bond matures. This calculation is more difficult than the calculation for current yield because it involves deter- mining the internal rate of return of the cash flows paid out by the bond. The formula for doing this is found in textbook Equation 7.2. Note that the inverse relationship applying to bond prices and interest rates also applies to bond prices and yields: As a bond’s price drops, its yield to maturity will rise and vice versa.

Yield to Call

Yield to maturity reflects the assumption that a bond will be held until maturity. However, some bonds have a call feature, which is often invoked by issuers after a large drop in interest rates occurs. Such a feature is good for issuers because it allows them to refinance debt at lower prevailing rates. The formula for computing the price of a bond with a good chance of being called is listed in Example 7-3 in your textbook.

Credit Risk Credit quality risk evaluates the likelihood that a bond issuer will be unable to make payments in a timely manner. This risk is evaluated by independent bond rating agencies who monitor bonds during their lifespan and deliver their judgements in the form of grades or ratings. Table 7.6 in your textbook provides a description of various types of ratings, from the highest to the lowest. Investment grade bonds are considered to be rated AAA, AA, A, or BB. These are the issuers who

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rating agencies believe have the best chances of making all payments as promised. Below-investment grade bonds carry a rating of BB or lower, and are sometimes known as speculative, or junk, bonds. These bonds are thought to feature signifi- cant risk that interest and principal payments won’t be made as promised. A 1 or – may be added to the rating to further refine it. Ratings will have an effect on both the price of a bond and the interest rate investors will receive when pur- chasing the bond.

The ratings given by credit rating agencies can apply to all types of debt issued by a firm. Unsecured corporate bonds, also known as debentures, only feature the backing of the corporation’s reputation and general financial condition. A senior bond features a claim that has priority over junior securities (those that have been issued more recently) if a default or bankruptcy were to occur. As a result, senior bonds have less credit risk than bonds that are junior to them. Certain bonds may be secured with collateral, such as a car loan. If a company offers collateral in the form of real estate or factory equipment, bonds backed by such collateral are known as mortgage bonds or equipment trust certificates, respectively. A bond that’s issued without collateral to back it will, generally speaking, be considered a higher credit risk.

To entice investors to buy bonds that feature higher risk, higher yields are required. As result, junk bonds can also be called high-yield bonds. The difference in credit risk between government and corporate bonds is a main reason for the disparity in yields between such bonds. This divergence is displayed in Figure 7.3 in your textbook.

A variety of reasons may cause a company’s bonds to become junk bonds. This can occur when a firm uses an uneconomic level of debt to fund its operations, or when a firm that’s already experiencing difficulties issues such bonds. Alternately, a financially strong firm can issue investment grade bonds that become junk bonds as the company’s prospects worsen over time. A junk bond that was initially issued as an investment grade bond is known as a fallen angel.

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Bond Markets The major part of bond trading volume results from transactions processed in a decentralized over-the-counter market. The majority of trades take place among dealers and sizable financial institutions such as pension funds, mutual funds, and the like. The largest centralized bond market is run by the New York Stock Exchange (NYSE), which focuses mainly on corporate debt trading. Figure 7.4 in your textbook shows the bonds that were traded most actively on a particular day. Figure 7.5 lists major bond indices.

Common Stock Each share of common stock represents an ownership interest in a firm. Common stock has no maturity date. It represents a residual claim, meaning that common stockholders may be paid only after the firm has paid all debt and preferred stock obligations. Also, ownership typically includes the right to vote for a board of directors. While common stockholders are subject to losses, an investor can lose no more than 100 percent of his or her total share. Thus, even though they’re owners, common stockholders face limited liability. The value of common stock is the present value of all expected future cash flows. This is similar to the valuation process for debt and preferred stock.

Expected future cash flows for common stocks are dividends and proceeds from the sale of the stock. These cash flows are less certain than those for bonds and preferred stock, since common stock dividends aren’t necessarily fixed and the sale of the stock is unknown. As owners of the firm, stockholders are classified as residual claimants. As a result, they’re entitled to claim any cash flows or other objects of value once all other claimants have taken receipt of what was owed to them by the firm. The value of a company’s stock is represented by the price of the stock in the marketplace. Stocks issued by firms that are experiencing growth or that pay dividends to their shareholders are valuable. The larger the amount of residual cash flow a company has, the greater the value of the company’s stock.

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Stock Markets Stock markets offer investors greater liquidity than investments such as real estate and collectibles. The best-known stock exchange worldwide is the New York Stock Exchange (NYSE), located in New York City. A large portion of the trading on the NYSE occurs at trading posts staffed by market makers (previously called specialists) who facilitate trading in the stocks associated with their posts. Seventeen trading posts are found on the floor of the exchange. Brokers positioned on the floor’s perimeter function as agents for stock sellers and buyers. Each stock is traded by its ticker symbol rather than its name. For instance, GM is the ticker symbol for General Motors stock. To have its stock listed on the NYSE, a firm must meet various minimum standards. These include

n Total number of stockholders

n Level of trading volume

n Corporate earnings

n Firm size

Other prominent U.S. exchanges include the American Stock Exchange (AMEX), which also employs a market-maker system, and the National Association of Securities Dealers Automated Quotations (NASDAQ). NASDAQ is a purely electronic exchange with no physical trading floor. Instead, NASDAQ relies on a mammoth, computerized electronic trading system. NASDAQ has a larger number of market makers, also known as dealers, than the NYSE. When an investor sends an order to NASDAQ using a stockbroker, the transaction is routed to the dealer offering the best buy or sell price. Market makers maintain their own inventories of the stocks they trade and compete with other dealers to make trades, with a typical company supporting ten dealers actively making a market in its shares.

Following the Stock Market

Table 8.1 in your textbook shows trading volume on the major exchanges on a single day. To track the movement of the stock market, it’s helpful to follow stock indices that track the

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overall market or specific segments of the market. The most commonly known indices in the United States are the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 Index (S&P 500), and the NASDAQ Composite Index.

The S&P 500 uses market capitalization, not just the stock prices of its components to calculate the value of the index. Market capitalization measures the size of a company by calculating the stock price times shares outstanding. While the DJIA is a very well-known index among the public and the press, the broader S&P 500 is seen as a truer performance of the market since it represents companies in all sectors of the economy. The NASDAQ Composite Index calculates the value by market capitalization of all stocks included on NASDAQ. Figure 8.2 in your textbook displays the price levels of these three exchanges from 1980.

Trading Stocks

To trade stocks, an investor must open a stock brokerage account. Broadly speaking, there are two types of brokerage firms: (1) full-service brokerage firms that provide research and advice in investment selections, and (2) discount brokerages that charge much lower commissions but offer no advice. Some firms offer hybrid services whereby a client can receive some advice and pay higher fees or no advice and lower fees.

Orders to buy and sell stocks are routed via a brokerage firm to a market maker on an exchange. The price quote, known as the bid, is defined as the highest price a market maker is offering to pay for a stock. The ask is the lowest price at which a market maker is offering to sell. The difference, or spread, between the bid and ask is the cost an investor must pay to do business on an exchange. This cost serves to compensate the market maker for the risk and effort involved in offering to buy and sell a stock. Stocks with a high volume of trading typically feature lower spreads than the stock of smaller, less well-known companies that trade less often due to liquidity risk.

When buying or selling, investors place a market order, which is filled immediately at the currently prevailing market price. A buy is filled at the current ask, and a sell is filled at the current bid. An advantage of market orders is that they’re filled or executed right away. A disadvantage is that the

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investors don’t know beforehand at what price the trade will be filled. A limit order, on the other hand, allows investors to state the price at which they’d like to buy or sell a stock. If the market price of the stock doesn’t reach that level, the trade won’t be executed.

Basic Stock Valuation Valuing stocks is similar to valuing bonds. However, stock dividend amounts and future prices are subject to change, complicating the process. To calculate today’s value of a stock, we use the following variables and formula:

P0 5 present value today

P1 5 present value of the expected sales price in a year

D1 5 present value of the dividend that will be received in the first year

i 5 the interest rate used to discount the cash flows

Today’s value 5 Present value of next year’s dividend and price

One way to reduce the volatility associated with changing dividend payouts is to make use of a longer holding period in the valuation process. Such a formula would work as follows:

Today’s value 5 Present value of next year’s dividend, the second year’s dividend, and the future price

The formula can be expanded to cover any holding period of n years as follows:

P0 5 Sum of the present value of each payment received

Example 8-1 in your textbook shows you how to value stock using Coca-Cola stock.

P D P i0

1 1

1 =

+ +

P D i

D P i

0 1 2 2

21 1 =

+ +

+

+( )

P D i

D

i

D P

i n n

n0 1 2

21 1 1 =

+ +

+( ) + +

+

+( ) 

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It should be noted that short-term price movement and payment of dividends for stocks can be highly uncertain. As a result, it’s best to take a long-term view of stock valuation. Given the uncertainty involved in predicting the future level, it’s preferable to look at future valuation as a range of prices using reasonable assumptions instead of a single price.

Models for Discounting Dividends

Equation 8-3 in your textbook can be indefinitely extended to receive discounted cash flow from dividends without a future selling price for the stock. In such a case, the value of the stock to an investor is the present value of the future stream of dividends. The calculation to determine this value is displayed in Equation 8-4 in your textbook. This equation displays the general form of the dividend discount model.

To amend the formula to avoid dealing with an infinite amount of numbers, analysts assume that a firm has a constant dividend growth rate, g. The resulting calculation uses a power series that’s simplified to form the constant-growth model, which makes the assumption that the growth rate is less than the discount rate. This model is also sometimes referred to as the Gordon growth model. The resulting equation is as follows:

Stock value 5 Next year’s dividend divided by (Discount rate – Growth rate)

Example 8-2 in your textbook uses the same Coca-Cola stocks but this time uses the constant growth model.

Methods used by investors to estimate the growth of a company include

n Projecting the dividend trend into the future and determining the applied growth rate

n Computing the past growth rate

n Considering a financial analyst’s growth rate predictions

P D g i g

D i g0

0 11= +( )

= 2 2

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Preferred Stock

One case of the constant-growth model considers situations in which the dividend remains the same year after year without growing. This type of case matches the security type known as a preferred stock. Such a stock will have preference over common stock if a firm goes into bankruptcy. This type of stock is owned mainly by corporations instead of individual investors as its dividends aren’t taxable income when paid out to other corporations. (Seventy percent of income received from preferred stock is tax exempt.) A preferred stock doesn’t offer voting rights as common stocks do, preventing a company from controlling another via the ownership of preferred stock. Because the dividend a preferred stock pays is constant, it’s subject to being valued through the constant-growth model using a zero growth rate. This is denoted as P 5 D/i.

While the majority of companies issue only common stock, there are approximately 1,000 preferred stock issues. The dividend yield on preferred stock is greater than that of common stock because preferred stockholders don’t expect to receive a return from capital appreciation in addition to dividend payments as common stockholders do. Common stock also typically trades more frequently than preferred stock does.

As preferred stock dividend rates are fixed, the price of a preferred stock changes due to changes in the discount rate. While preferred stock is classified as equity because of the ownership interest it entails, in practice, it trades like a bond. Preferred stock also will drop when interest rates rise, just as bonds will.

Expected Return

Building stock valuation models necessitates using a discount rate, i. This enables the computing of a figure for the present value associated with the future cash flows. As the discount rate is expected to reflect the level of investment risk, investments subject to higher levels of risk should be analyzed with higher interest rates. One approach to finding the number of return investors expect from a stock involves using the constant-growth rate model. If the current price of a

Lesson 2 129

stock is a fair reflection of its value, the discount rate should equal the stock’s expected return. The following equation is used to determine this:

Dividends can amount to a significant portion of an investor’s profits from investing in stocks. Many investors become excessively enthusiastic about high growth stocks that pay no dividends. As a result, they avoid a solid source of stable returns.

Variable-Growth Techniques In some cases, a company grows at such a rapid rate that using the constant-value model as a means of forecasting the company’s growth isn’t feasible. This is because though a high growth rate may continue for a certain period of time, it isn’t sustainable over the very long term. The constant-growth model doesn’t work when a company has a growth rate in which g > i. Growth rates for firms of this type aren’t expected to be constant, so a variable-growth rate is used to value them. This technique combines Equation 8-3 in your textbook with Equation 8-6. Equation 8-8 in your textbook is the result of this combination.

In computing the variable-growth rate, an investor will choose growth rates for each of the two stages that comprise the analysis. The first growth rate, the higher one, is g1 and reflects the current rate of growth, which is expected to last just a few years. The slower and more sustainable growth rate that the company is expected to achieve in a few years is g2. The initial growth rate is applied over n years, and the second growth rate which applies thereafter continues indefinitely. The application of the variable-growth technique is demonstrated using McDonalds stock in example 8-3 in your textbook.

Expected return Dividend yield + Capital gain= = + =i D P

g1 0

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The P/E Model Another approach to stock valuation is evaluating the relative value of a stock. This compares the valuation of one company’s stock to the value of the stock of other firms to determine whether the stock appears to be priced appropriately. The price-earnings (P/E) ratio is the most commonly used method for comparing valuations in the securities industry. The P/E ratio is determined by the following equation:

To be more precise, this calculation determines what’s known as the trailing P/E ratio and can be listed as P/E0, with the 0 subscript indicating past/trailing earnings. Companies with higher expected earnings growth will typically feature higher P/E ratios than companies that are expected to grow at lower rates. Thus, the value of a stock is closely linked to percep- tions of its chances for success. As a result, many investors favor using a P/E that looks forward rather than one that merely tracks a company’s past performance. A forward P/E ratio is computed by using analyst estimates of what a com- pany’s earnings will be over the next 12 months rather than what they were over the past 12 months.

Experienced investors will compare a firm’s P/E ratio to its expected rate of growth. If a firm has a high P/E and high expected growth rate, it can indicate the stock is fairly priced. The same holds true if the firm has a low P/E ratio and a low expected growth rate. However, stocks of firms with high P/E ratios and low expected growth rates may be seen as potentially overpriced by investors. A number of investors find growth stocks appealing. Yet some are concerned about overpaying for the stocks of such companies. To assess when this is the case, they can use a firm’s P/E ratio to determine how it’s priced relative to its expected growth. On the other hand, some investors look for value stocks, which have low P/Es and are seen as undervalued relative to their true earnings potential.

In certain cases, a P/E ratio may not provide helpful informa- tion for the purposes of relative valuation. This can occur when a firm loses money, resulting in negative earnings. Another such instance can occur when a firm takes a sizable

P E/ = Current stock price Per share earnings for the last 12 2 mmonths

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one-time “write-off” that suppresses earnings for a short time but doesn’t affect the firm’s overall viability. In such cases, a P/E ratio will be negative or large on a temporary basis. As a result, other relative value methods can be used to consider cash flow or book value rather than earnings. The P/CF ratio tracks price divided by cash flow and is a valuable ratio to use in cases in which a firm takes an accounting write-off that has a temporary but dramatic impact on its earnings. The P/B ratio, in which price is divided by book value, is a useful ratio in many situations, especially when a firm is los- ing money and has negative cash flows. Given the stability of a firm’s book value, it’s particularly useful during times when earnings experience a high degree of volatility.

To estimate future stock prices, investors can use the P/E model by multiplying the expected P/E ratio by expected earnings. The following equation provides a means of accom- plishing this and allows investors to estimate a firm’s earnings in year n:

Example 8-4 in your textbook shows how this model is applied to Caterpillar.

P P E E P E E gn n n n n= ( ) = ( ) +( )/ /3 3 30 1

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Self-Check 9 Answer the following questions using this study guide and your textbook. Answers will vary

in length.

1. What are the main features of any bond?

2. What happens to TIPS bonds as their par value changes over time in response to inflation?

3. What are some factors firms consider when they decide what coupon rate to use when originally issuing a bond?

4. How do you determine the present value of a bond?

5. What happens to bond prices when prevailing interest rates in the economy rise?

6. What are some factors that can play a part in determining the market value of a company’s stock?

7. What types of values must be used when investors deal with future stock prices and future dividend payments?

8. Why are dividend yields for preferred stocks higher than for common stocks?

9. What types of firms should the variable-growth rate method be used for?

Complete the following problems at the end of Chapters 7 and 8.

10. Problem 7-1

11. Problem 7-12

12. Problem 8-11

13. Problem 8-14

Check your answers with those on page 233.

Lesson 2 133

ASSIGNMENT 10 Read this assignment. Then read Chapter 9 in your textbook.

While low-risk investments such as Treasury bills or bank savings accounts offer more safety than higher-risk investments such as stocks or long-term bonds, they also offer very low returns. When seeking higher returns, investors realize that they’ll likely have to accept higher risk to achieve their desired returns. However, not all risky investments will end up justi- fying the risk that was taken. Investing in riskier investments should be part of a longer-term strategy for companies and investors. In this assignment, you’ll study how the relation- ship between risk and return plays into finance theory.

Historical Returns By looking at returns from past periods, we can gain a broad understanding of what type of returns might be expected in the future. It’s best to look at historical returns from a long-term perspective, as a return realized in any particular year can be drastically different from average returns.

Returns can be computed in two major ways:

1. Dollar return

2. Percentage return

Dollar return incorporates capital gains or losses and all income paid out by the investment during the period you own it. The calculation for this method is as follows:

Dollar return 5 Capital gain or loss 1 Income 5 (Ending value – Beginning value) 1 Income

Determining percentage return is more efficient than simply calculating the dollar return when the amount invested isn’t the same. You can calculate percentage return as follows:

Percentage return Ending value Beginning value + Income Beginn

= 2 iing value

%3100

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To evaluate performance over time, investors examine average returns. This estimates how an investment has done for longer time periods. The formula to compute this figure is as follows:

Average return 5 Sum of all returns divided by number of returns

This average return is known as the arithmetic average return. While usable for the purpose of statistical analysis, it isn’t suitable for accurately measuring a stock or portfolio’s historical return.

A more accurate means of measuring stock or portfolio performance is the geometric mean return. This is calculated by discovering the equivalent return compounded for N time periods. Your textbook gives the general formula for finding geometric mean return in Equation 9-4.

When considering asset performance across long time periods, stocks have turned in better performance than bonds or cash. Table 9.2 in your textbook displays the performance from these asset classes from 1950 to 2012. While stocks have performed better over longer periods of time, they’ve also exhibited more volatility during short-term periods when compared with other asset classes.

Historical Risks When purchasing a U.S. Treasury bond, you know in advance exactly what the interest and principal payments will be and when they’ll be made. Buying a stock, on the other hand, provides no such advance knowledge as to what type of return it will deliver. Eliminating the uncertainty attached to stock investing by quantitative means is a helpful way to compare risk across various stocks and classes of assets.

= =∑ Return N

tt N

1

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Calculating Volatility Measures In accordance with financial theory, investors are expected to analyze the historical returns attributed to an investment to judge the level of future uncertainty that should be expected. To characterize return volatility, finance participants use a statistical measure of the volatility of returns, called the standard deviation of percentage returns. This figure is referred to as the total risk associated with a security or portfolio.

To determine standard deviation, you first must find the average return for the period. Then, you determine the average degree of deviation in any year from this average by subtracting the return experienced each year from the yearly average. Each deviation is squared and then added up and divided by the number of returns included in the sample minus one. This determines the return variance. You can determine the standard deviation using the following formula:

Standard deviation 5 Square root of the average squared deviation of returns

Example 9-2 uses Mattel and Table 9.3 to show how this equation is used to calculate risk and return.

Larger standard deviations indicate greater return volatility and thus higher risk. Computing the standard deviation by hand is a lengthy process. You can use a spreadsheet or financial calculator to perform the calculations.

Asset Class Risk

Table 9.4 in your textbook displays the standard deviations related to returns for different asset classes. As might be expected, stock market volatility is greater than bond market volatility. While stocks typically make up for this by offering

Table 9.3 in your textbook is incorrect. Download the correct Table 9.3 on the student website by selecting Errata (15.0K).

= =

− =∑ ( )Return Average return

N tt

N 2 1

1

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greater returns over the long term, investors must realize that their higher volatility can lead to large price fluctuations over short periods of time. It should be noted that individual stocks, even of major corporations, often have higher standard deviations than a broad-based index of stocks such as the S&P 500. This doesn’t necessarily mean that these stocks are excessively volatile. Rather, it speaks to the benefit of diversification, or owning small amounts of a wide variety of stocks.

Comparing Risk versus Return

When deciding how much risk to take in seeking higher returns, investors encounter the trade-off between risk and return. A relative means of measuring this relationship is called the coefficient of variation (CoV). The equation used to determine this measure is the standard deviation divided by average return.

Investors will naturally want to get a high return with extremely low risk. A smaller CoV reflects a better risk-reward relationship.

Forming Portfolios Grouping individual stocks into portfolios is an effective way of reducing the risk of owning a few individual stocks. This process of diversification lowers risk by broadening the scope of an investor’s portfolio, either by purchasing mutual funds or ETFs (electronically traded funds) that hold a large amount of individual securities or a security that tracks an index like the S&P 500, with its large basket of stocks.

Risk Reduction Using Diversification

The risk involved in owning a stock has two main components. The first part, firm-specific risk, reflects risks directly related to the company itself as well as those common to the company and its industry peers. The other risk is called market risk,

Coefficient of variation Amount of risk Return

Standard devia 5 5

ttion Average return

Lesson 2 137

the risk common to all firms operating in an economy as it relates to the economy’s strength or weakness at any given time. The equation for computing these risks is as follows:

Total risk 5 Firm-specific risk 1 Market risk

While standard deviation is used to compute total risk, indi- vidual stocks face a number of firm-specific risks. These risks can be minimized by grouping stocks in a diversified portfolio. Firm-specific risk is at times called diversifiable risk.

As more and more stocks are added to a portfolio, the benefits of diversification diminish as firm-specific risk lessens. When a portfolio contains enough stocks to virtually eliminate firm-specific risk, only market risk, which can be referred to as nondiversifiable risk, remains.

Modern Portfolio Theory

Modern portfolio theory as developed by Harry Markowitz in the early 1950s describes how risk reduction happens as securities are combined. It also shows how stocks can be combined to attain a risk level that’s as low as possible with respect to a given expected return. Combining securities in a manner that allows them to reach the highest expected return in relation to a specified risk level is known as an investor’s optimal portfolio. A portfolio that has the highest return possible in relation to every level of risk is referred to as an efficient portfolio, as displayed in Figure 9.3 in the text- book. If all of the efficient portfolios derived from combining groups of securities were shown in a graph, they would form a line connecting the upper side of the bullet shape formed by connecting the dots made by the different efficient portfolios. Adding all available securities to this line forms what’s called the efficient frontier. The shape of this frontier suggests that to attain higher expected return rates, an investor needs to accept higher and higher levels of risk. Your optimal portfolio would be one that’s located on the efficient frontier reflecting the amount of risk you’re willing to withstand.

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How Diversification Works

Diversification works best when securities with different risk characteristics are combined to reduce overall risk. For instance, combining stocks operating in the same industry clearly won’t reduce risk to the degree that doing so with stocks from different industries will. The movement of stocks determines the amount of diversification that combining such stocks supplies. The measure of comovement between stocks is known as correlation. It’s a statistical measurement that falls between –1 and 11. A correlation of 11 indicates that returns from two disparate securities move in exact sync. A correlation value of –1 indicates that the returns stemming from two securities move inversely to each other. Table 9.6 in your textbook shows the level of correlation among various individual stocks and asset classes as a whole. Generally, assets that have low positive correlation when combined together add greater diversification to a portfolio than assets that are highly correlated.

Portfolio Return

The return calculation of a portfolio is determined by com- bining the returns of individual securities in the proportion each security makes up in the portfolio. The calculation is as follows:

Rp 5 (Proportion of portfolio in first stock 3 That stock’s return) 1 (Second stock portion 3 Second stock return) 1 . . .

Example 9-4 shows how portfolio returns are calculated for Disney stock.

= + + + + = =∑( ) ( ) ( ) ... ( )w R w R w R w R w Rn n i it n

1 1 2 2 3 3 13 3 3 3

Lesson 2 139

Self-Check 10 Answer the following questions using this study guide and your textbook. Answers will vary

in length.

1. How is the percentage return on a stock determined?

2. What’s standard deviation, and what does it measure?

3. What’s the coefficient of variation, and how is it calculated?

4. How is total risk calculated?

5. What does market portfolio theory show?

6. What type of relationship between two stocks is most effective at providing diversification?

7. How is a portfolio’s return computed?

8. What does correlation refer to for investment purposes?

9. What’s an efficient portfolio?

10. Why is firm-specific risk sometimes called diversifiable risk?

Complete the following problems at the end of Chapter 9.

11. Problem 9-1

12. Problem 9-13

13. Problem 9-17

Check your answers with those on page 234.

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ASSIGNMENT 11 Read this assignment. Then read Chapter 10 in your textbook.

This assignment covers the methods used by investors to evaluate decisions dealing with risk and reward. While the total risk depends on factors specific to that firm, investors can diversify firm-specific risks by holding a number of firms from the same sector in their portfolios, leaving only market risk. A theory used to identify only market risk within a portfolio expands on modern portfolio theory. This approach is known as the capital asset pricing model (CAPM), which uses a risk measure referred to as beta. CAPM has certain limitations. Other risk-return measures, which will be explored in this assignment, are also worthy of consideration.

Expected Returns While studying risk in historical terms can provide valuable insights, if a firm takes steps to change their business by taking on more risk or by reducing risk, this can change the firm’s risk profile going forward. As a result, both investors and companies often explore various measures of expected return calculations. These calculations take risk measures into account to attempt to estimate the future performance of a stock.

Expected Return and Risk

A firm’s business performance over the next year depends on the skill of the firm’s management, the strategies pursued by the firm, and the quality of its products. However, it can be more difficult to determine how the general economy will perform over the same period. An economist might predict probabilities that the economy will be good or bad. Thus, even if the company is well run, its performance might be poor if the economy is bad. On the other hand, if the economy does well, a well-managed company is likely to turn in a good performance. Considering these factors leads to the concept of expected return, which is computed using p as the probability of a particular return occurring.

Lesson 2 141

Expected return 5 Sum of (Each return 3 Probability of that return) 5

Expected return figures show what average returns will be if economic states follow a specified probabilistic distribution. For instance, an 80/20 probability distribution contends that the economy will be good for 8 out of 10 years, and in recession, in 2 out of 10 years. If company X earns 25 percent during the good years and loses 12 percent during recessions, the average return would be the same as the expected return. This example uses a simplistic formula. Realistic economic forecasts use alternative probability distributions that include a wider variety of possible economic conditions.

Risk may also be characterized using expected return. Using standard deviation as in the last assignment to measure risk for historical returns, you can gauge risk associated with expected returns. The equation used to find the standard deviation of S different economic states is as follows:

Standard deviation 5 Square root of the sum of (Probability of a return 3 Each return’s squared deviation from the average)

Example 10-1 shows how to use these equations to calculate the expected return and risk.

Risk Premiums

Your textbook consistently emphasizes the positive relationship that prevails in regard to expected returns and risk. Expected return on an investment can be divided into two segments: a return that’s risk-free and a contribution that’s risky. The return required by investors to accept a certain level of risk is known as the required return and is computed as follows:

Required return 5 Risk-free rate 1 Risk premium

= ( ) +p p1 1 2 2

2

Return Expected return

Return Expected

3

3

2

2 rreturn( ) +2 

= ( )=∑ pjjs j1 3 Return Expected return 2

2

( ) ( ) ( )

... ( )

p Return p Return p Return

p Return ps s j

1 1 2 2 3 33 3 3

3

+ +

+ + = 33Return j i

s

= ∑

1

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The risk-free rate is the return realized from investing in U.S. government bonds and bills; it’s equal to the real interest rate added to the expected inflation premium. The risk premium is the reward required by investors for taking on risk. As covered previously, the market doesn’t necessarily offer rewards for all risk. As firm-specific risk can be essentially eliminated by diversification, an efficient market doesn’t reward investors for accepting this needless risk. As a result, when looking at risk premiums historically, we choose a portfolio that has no firm-specific risk. Table 10.1 of your textbook shows the market risk premium, which is the reward offered for accepting general stock market risk (also known as unsystematic risk).

Market Risk Investors must determine how much risk they’ll take on to achieve the returns they desire. Attempting to identify a formula that links the required return from a stock to an appropriately measured risk premium is called asset pricing.

The Market Portfolio

The capital asset pricing model, or CAPM, is the most well- known equation for pricing assets. CAPM builds on efficient market theory. The capital market line (CML), which shows investment risk/reward relationships, is used to graph a line showing the efficient frontier from the CML to a tangential point on the efficient frontier. The location of this tangency is known as the market portfolio, which is a representation of all traded assets in the economy. Therefore, it offers the max- imum possible diversification. You can position your optimal portfolio on the line by having a variety of combinations of the risk-free security and the market portfolio. Positioning your investment on the line located to the right of the market port- folio would require investing all of one’s funds in the market portfolio and then borrowing more to invest in the market portfolio. Borrowing money for the purpose of investing is referred to as using financial leverage, which adds to the over- all risk of a portfolio.

Lesson 2 143

Beta

The return of the market portfolio after subtracting the risk-free rate equals the expected average market risk premium. As the market portfolio contains no firm-specific risk, only market risk, you can calculate some level of firm-specific risk for a particular stock or portfolio. Thus, to determine a stock’s riskiness, you subtract market risk from the stock’s standard deviation, which includes all risks to which the stock is subject. To find out how a stock or portfolio fluctuates in relation to the movement of the market portfolio, a measure called beta is used. To find the portion of a firm’s total risk that’s related to the market, multiply the stock’s total risk with its correlation to the market portfolio. The calculation should be scaled to give the market portfolio a beta of 1.

Pstock 3 Pstock, Market 4 Pmarket Stocks that have betas higher than 1 are thought to involve more risk than the market portfolio, while those with betas lower than 1 are believed to feature lower risk.

The Security Market Line Figure 10.2 displays required return compared to beta risk, which is preferred by many investors as a measure for summing up a stock’s levels of risk. The line in Figure 10.2 is known as the security market line (SML), showing how required return is related to risk at any point in time, everything else being equal. SML also demonstrates the risk premium of the market portfolio or of any stock. The SML can be used to quantify how risk and return are related in any stock or portfolio. The following equation results in the CAPM:

Expected return 5 Risk-free rate 1 Beta 3 Market risk premium 5 Rf 1 β(RM – Rf)

Let’s look at a problem that illustrates how CAPM works.

Example: Camila is the CFO of Exports-R-US, Inc. She knows that the risk-free rate is currently at 4.75 percent. She expects the market to earn the company 12 percent this year. George analyzed the firm and believes it will earn 13.75 percent return this year. Beta of the company is 1.4. Should George consider the firm undervalued or overvalued?

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Solution: George computed the shareholders’ required rate of return with CAPM as 4.75% 1 1.4 3 (12% – 4.75%) 5 14.9%

The company is currently undervalued since George believes that it will earn 14.9 percent this year.

Portfolio Beta To determine a stock portfolio’s beta, you take the weighted average of the betas of the portfolio stocks.

βp 5 Sum of the beta of each stock 3 Its weight in the portfolio

Using this equation, you can determine if the addition of a certain stock will add to or diminish the total market risk of the portfolio.

Finding Beta

While CAPM enables a number of applications, its calculation requires knowing a company’s beta. This figure is found in a number of financial outlets. The textbook identifies websites where this data can be found for free:

n MSN Money

n Yahoo! Finance

n Zacks

Compute your own beta by obtaining historical returns for a company and then running a regression of the returns the company has generated as a dependent variable and the return of the market portfolio as an independent variable. The return coefficient that results is the beta.

Shortcomings of Beta

Different betas can be calculated when different benchmarks or parameters are used. This can create questions as to which is the best measure of beta to use. Additionally, a company can alter its risk characteristics by changing its approach to business operations, such as by changing its capital structure in regard to adding debt, or by getting into new businesses.

= = + + + + = = ∑β β β β ββ( ) ( ) ( ) ... ( )w w w w wn n j j j

n

1 1 2 2 3 3 1

� � � �

Lesson 2 145

In such a situation, even if beta accurately measured the firm’s risk in the past, it may not be applicable going forward. The usefulness of beta is linked to its reliability. However, empirical data in this regard isn’t as good as might be hoped for. This is because a firm’s beta doesn’t seem to be very good at predicting its future return. Because the analysis of a firm’s risk-return profile is so crucial, other asset pricing models have been put forward by finance researchers. These models look at factors such as the size of a firm and book-to-market ratios along with beta to measure market risk.

Capital Market Efficiency The relationship between risk and return relies on the assumption that stocks are correctly valued. Your textbook identifies several factors necessary for an efficient market, where investors sell stocks that are overvalued, driving their prices down to a reasonable level, and buy stocks that are undervalued, raising them to a more accurate level. These factors include

n Many buyers and sellers

n No prohibitively high barriers to entry

n Free and readily available information available to all participants

n Low trading or transaction costs

These conditions seem to apply to the major U.S. stock markets, where millions of investors trade each day, with widespread access to cheap trading costs and information about company performance. Some parts of the market, such as exchanges that trade penny stocks, don’t experience the same level of trading activity or availability of information. The prices these stocks trade at may not be fair, and such stocks have been used in fraudulent schemes by unscrupulous stock manipulators.

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Efficient Market Hypothesis

The concept of market efficiency offers a way of understanding the process by which stocks change in price over time. This theory underlies the efficient market hypothesis (EMH), which claims that security prices fully reflect all available information. The EMH questions the nature of the information reflected in a current stock price. Your textbook outlines three fundamental levels of market efficiency that this information can be divided into, including

n Weak-form efficiency: All information derived from trading

n Semistrong-form efficiency: All public information such as financial statements, news, and the like

n Strong-form efficiency: All information reflected by current prices, including privately held information known only by company insiders

Behavioral Finance

Those who believe the market is efficient claim that with hordes of investors looking for overvalued stocks to sell and undervalued stocks to buy, it’s highly likely that few mispriced stocks will be available. Those who argue against the efficient market hypothesis believe that trading decisions can be affected by emotions or other biases, serving to move stocks away from reasonable price levels. When this happens, and stock prices boom to extremely high levels and then subsequently crash, it’s called a stock market bubble. Behavioral finance has, in recent decades, discovered that individuals often act in a manner that can very likely be classified as “irrational.” It may be that capital markets aren’t in every case perfectly rational given that participants may at times make irrational choices. This might be truer in the case of corporate behavior than market behavior, as it would take a large number of investors acting irrationally to sustain a stock’s price above rational levels. Corporate management, on the other hand, may be at risk of overconfidence, which causes individuals to make inaccurate assessments of what’s needed to successfully achieve an objective. Coupled with groupthink, this can lead

Lesson 2 147

corporations to make mistakes such as taking on too much debt or paying too much to acquire a competitor. This, in turn, can affect the stock or bonds of the corporation.

Implications for Financial Managers Financial managers need to understand the risk-return relationship as it applies to a wide number of management decisions they may need to make, such as

n Product mix

n Marketing campaign combination

n Research and development

Managers must also take into account the type of return their stockholders would like to achieve, as this bears on the firm’s ability to raise funds from investors when necessary. Many managers benefit directly from good risk-reward decisions due to corporate incentive programs that award them restricted stock options, executive stock options, or both.

Use of the Constant-Growth Model for Required Return For many years, the CAPM has been used by financial managers as a method of computing shareholders’ required return. With concerns about the accuracy of beta, some finance participants have begun to use a different model for the purpose of calculating required return. The constant-growth model was covered in Assignment 7. The terms of that formula can be rearranged to get the following equation:

i 5 Dividend yield 1 Constant growth

Use of this model implies an assumption that the stock being analyzed is priced efficiently. Its advantage is that it combines current data about a firm with a simple forward estimate to evaluate investors’ current expectations of the return.

= + D P

g1 0

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Solution: Use the CAPM formula from above to calculate the company’s required return for each company. Then compare the two rates.

The CAPM rates for Apple and Lowes are 3.13 percent and 5.11 percent higher than the constant-growth rate model. However, Dell’s CAPM rate is lower than the constant-growth rate by 12.14 percent.

Let’s look at a problem that illustrates how to calculate the required return.

Example: Use the following information to compute the constant-growth model estimate of the required return (CAPM). Then compare those rates to the rates calculated using the constant-growth rate model from Assignment 7. Apple, Lowes, and Dell require returns of 11.50 percent, 12.55 percent, and 14.85 percent, respectively.

Expected Dividend Current Price Analyst Growth Estimate

Apple $2.85 $110.06 12.04%

Lowes 1.85 85.55 15.50

Dell .65 25.55 .30

Apple required return $ $

%

Lowes required

= + =2 85 110 06

1204 14 63. .

. .

rreturn $ $

%

Dell required return $ $

= + =

=

1 85 85 55

1550 17 66

0 53 2

. .

. .

. 22 00

0030 2 71 .

. .+ = %

Lesson 2 149

Self-Check 11

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What does a 60/40 probability distribution for good-recession economic states suggest?

2. How is the required return (the return investors require for the risk they take) computed?

3. What’s meant by financial leverage?

4. What does beta measure?

5. What does the security market line (SML) measure?

6. What does the CAPM provide regarding return?

7. What are some conditions that are necessary for an efficient market?

8. What’s stated by the efficient market hypothesis (EMH)?

9. What happens when a stock market bubble occurs?

10. How is the constant-growth model computed to determine required return?

Complete the following problems at the end of Chapter 10.

11. Problem 10-1

12. Problem 10-7

13. Problem 10-12

14. Problem 10-16

Check your answers with those on page 235.

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Capital Management Understanding the concepts that underlie financial systems is crucial when it comes to deploying and managing capital, both in personal financial planning and in managing the financial affairs of a firm. This lesson will show you how to calculate the cost of capital for a firm and estimate how cash flows impact capital budgeting for projects. You’ll also examine capital budgeting criteria, such as net present value (NPV), used in analyzing project viability. In addition, the lesson covers the principles of working capital management in the context of financial planning. It explores issues relating to a firm’s capital structure, outlining criteria that managers can use to decide the best mix of equity and debt to pursue. Learning the precepts of capital management will enable you to analyze a balance sheet to evaluate the performance of a firm’s management. The various forecasting strategies covered in this lesson will help you understand and formulate approaches to capital structure and capital management for a company going forward.

OBJECTIVES When you complete Lesson 3, you’ll be able to

n Formulate a project’s cost of capital using the weighted- average cost of capital (WACC)

n Calculate cash flows on capital budget projects

n Calculate investment opportunities using various techniques such as net present value (NPV)

n Classify capital management approaches and policies

n Recommend various approaches to financial planning and forecasting

n Identify decisions that affect the capital structure

n Analyze factors affecting the distribution of wealth

n Compare capital funding methods and resources

L e

s s

o n

3 L

e s

s o

n 3

151

ASSIGNMENT 12 Read this assignment. Then read Chapter 11 in your textbook.

This assignment takes a look at the question of how much risk a company should accept when pursuing a particular return level. It examines a firm’s mixing of debt and equity to finance operations as well as its projects and any expansion plans it undertakes. Investors encounter different types of risk when investing in various asset classes such as debt, equity, and preferred stock. Because firms use funds from investors along with other sources of capital to finance themselves, a weighted average of required rates of return must be calculated. This weighted-average cost of capital (WACC) serves a variety of purposes. To find the average rate of return a company must generate from existing operations without changing its capital structure, you can determine WACC using the current capital structure of the firm and its existing component costs. When looking for the required return from a new project to increase a firm’s valuation, you would need to consider the capital structure and component costs of the project.

The WACC Formula and the Component Cost of Equity The equation for weighted-average cost of capital is

WACC 5 Percentage of equity 3 Cost of equity 1 Percentage of preferred stock 3 Cost of preferred stock 1 Percentage of debt 3 After-tax cost of debt

Where

E 5 Market value of equity used in financing the relevant project or firm

P 5 Market value of preferred stock used

D 5 Market value of debt used

= + +

+ + +

+ + +

( )E E P D

i P E P D

i D E P D

i TE P D C3 21

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iE 5 Cost of equity

iP 5 Cost of preferred stock

iD 5 Before-tax cost of debt

TC 5 Appropriate corporate tax rate

The cost of equity in the WACC formula is listed as iE. This can be calculated using the asset pricing model as follows:

iE 5 Rf 1 β(RM – Rf)

Another method for determining cost of equity is to use the constant-growth model to solve for the necessary figure:

When you don’t have access to enough historic data to come up with a good estimation of β, as with a relatively new security, or if you don’t believe that past measures of the stock’s overall risk are likely to be valuable going forward, using CAPM isn’t recommended.

When you believe that constant dividend growth is likely to take place, the constant-growth model is likely appropriate. However, this approach isn’t ideal for stocks that don’t provide constant growth in dividends, as it can lead to the potential for substantial errors.

The CAPM approach should be more accurate in the preponderance of cases. However, in some situations, the constant-growth model may be appropriate to use. Take a look at Example 11-1 in your textbook, which shows how to solve for the cost of equity using both approaches.

E E P D

P E P D

+ + Percentage of financing that's equity

+ + Per

=

= ccentage of financing that's preferred stock

+ + PercentaD

E P D = gge of financing that's debt

i D P

gE = +1 0

Lesson 3 153

Calculating the Component Cost of Preferred Stock and Debt

Preferred stock can be analyzed using a customized constant-growth model, with g equal to zero. The following equation can be used to gain an estimate of the component cost of a preferred stock using an alternate, simpler version of Equation 11-3.

Example 11-1 in your textbook shows the calculation of the cost of preferred stock using this formula.

As debt is tax-deductible, calculating the component cost attributable to debt must be adjusted so it can be converted to an after-tax return rate. Estimating iD requires first finding the yield to maturity (YTM) associated with the company’s existing debt. The equation to do so is

Example 11-3 in your textbook shows the calculation of the cost of debt using this formula.

Once you’ve determined the YTM, you need to convert this number to show the actual cost. This is done using this equation:

YTM 3 (1 – TC)

Selecting Tax Rates

The benefit of the tax deductibility of debt varies in relation to the company’s marginal tax rate. The tax rate that should be used in the WACC is the weighted average associated with the marginal tax rates due to be paid on the taxable income not subject to taxes because of the interest deduction.

i D PP

= 1 0

Solve PV PMT i i

FV i

D N

D D N=

− =

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

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

   

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for iD

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Calculating the Weights

To calculate the weights for the WACC calculation, simply compute the percentages of the funding attributed to equity, preferred stock, and debt. If calculating WACC as it applies to a firm, the funding will include all of the firm’s capital. If for a project, funding is applicable only to financing raised specifically for the project.

Let’s look at a problem that illustrates the calculations of the components used to determine the WACC of a project.

Example: Riverview, Inc.’s common shares are selling for $35.25 per share. They expect to set its next annual dividend at $1.85 per share. If Riverview expects future dividends to grow by 5 percent per year indefinitely, the current risk-free rate is 2 percent. The expected return on the market is 8 percent, and the stock has a beta of 1.5. What should be the firm’s component cost of equity?

Solution: Use the CAPM or the constant-growth model to solve for the firm’s cost of equity.

CAPM Model:

iE 5 Rf 1 β(RM – Rf)

5 0.02 1 1.5(0.08 – 0.02)

5 0.11 or 11%

Constant-Growth Model:

Given these two results, the best estimate for Riverview, Inc. would be 5 10.87%.

Now, let’s suppose that Riverview also has 1.5 million shares of 6% preferred stock outstanding that’s trading at $78 per share. What’s Riverview’s component cost of preferred stock?

i D P

gE = +

+

=

1

0

1 85 32 25

0 05

0 1074 10 74

$ $

or %

. .

.

. .

11% 10.74% 2

1

Lesson 3 155

Solution: You can use a simplified version of the preferred stocks’ component cost equation. Remember that the assumed value of preferred stock is $100, so a 6 percent pre- ferred stock pays $6 a year in dividends.

5

5 0.077 or 7.7%

Example: Riverview, Inc. has a $40,000 debt with 20-year, 7 percent annual coupon bonds outstanding. If the bonds currently sell for 96.5 percent of par and the firm pays an average tax rate of 36.25 percent, what will be the before-tax and after-tax component cost of debt?

Solution: First, estimate iD by using Equation 11-10. You’ll need to solve for the yield to maturity (YTM) on the firm’s existing debt.

5 7.30%

Then, solve for the actual cost the company pays for the YTM.

YTM 3 (1 – TC)

.0730 3 (1 – .3625) 5 .0465 or 4.65%

Example: Given the bond and Riverside’s expected EBIT of approximately $20 million per year, what would be the appropriate tax rate to use in the debt component of Riverview, Inc.’s WACC?

Solution: Solve for the interest payments on the bond.

$40,000 3 $1,000 3 .07 5 $2,800,000 per year

This will result in an earnings before tax (EBIT) of

$20,000,000 – $2,800,000 5 $17,200,000.

Example: Using Table 11.1 (Corporate Tax Rates) and the weighted percentage of 68.45, determine the applicable tax brackets.

$ $

6 78

i D PP

= 1 0

Solve $( . ) . ( ) (

1000 965 70 00 1 1

1 1000 1

20 3 3=

− +





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D ++

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i for i

D D)20

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Solution: The $1,916,000 (68.45% 3 $2,800,000) would fall in the 35 percent tax bracket, while the remaining $884,000, or 31.57 percent ($884,000/$2,800,000) will fall in the 38 percent tax bracket.

TC 5 (.6845 3 .35) 1 (.3157 3 .38)

5 .3595 or 35.95%

Firm WACC and Project WACC When undertaking a new project, a company manager may be able to use previous WACC calculations for the project. This applies if the new project is quite similar to other projects, but not if the new project is substantially different than previous ones.

New products typically represent more risk to common stock- holders than bondholders, since the latter has the senior claim to a firm’s cash flows. Note that this doesn’t necessarily apply if a new product is very large and presents a risk to existing cash flows. If in this instance the product doesn’t work out, bondholders face significant risk as well. Given that most firms tend to grow in increments, most new projects will be riskier for common stockholders, and the risk should, therefore, be accounted for in relation to the firm’s equity.

When a new project changes the risk profile of a company, its stockholders will change the rate of return they require in response to the new level of risk. If no changes have been made to the firm’s capital structure, the changes occurring in its risk profile can be treated as stemming from differences in the company’s business risks attributed to the combination of old and new product lines. The beta of the firm reflects these differences as applied to each product line.

Without previous history in a new product line, a firm can estimate a beta for the product by comparing the beta of other firms involved in the same business. Using an average of these proxy betas allows for a reasonably accurate estimate of the beta for the new project using the following formula:

iE 5 rf 1 βAvg [E(rM) – rf]

Where β

β Avg

jj N

n = =

∑ 1

Lesson 3 157

The average this supplies will be an estimate. Ideally, it will take proxy betas from at least several proxy betas, preferably pure-play proxies of firms whose business activities cover just the business in which the new project takes part. If no pure- play proxies can be found, then you may want to use firms that have significant operations in the business that the new project encompasses. You can then estimate the per- centage of the company’s due to nonrelevant businesses and remove that from the equation to get as relevant a figure as possible.

Finally, the proper corporate tax rate for deriving the WACC of a project must be computed. The formula to calculate a project-specific WACC is:

Look at Example 11-6 in your textbook to see how the components come together to calculate the WACC of a project.

Divisional WACC Calculating a WACC for each new project a firm considers can be highly expensive. Instead, many firms use divisional WACC to consider new projects in different segments of the firm’s business operations.

Using divisional WACC has pros and cons. On the pro side, using firm-wide WACC to evaluate all new products can give an unfair boost to projects that involve more risk and present the opportunity for greater returns, because these use the firm’s cost of capital instead of a more appropriate project- or division-level cost. One way to form divisional WACCs is to evaluate the project’s risk relative to the firm’s existing business operations. If it appears riskier, the firm WACC is adjusted upwards; if less risky, a downward adjustment is applied. While this subjective approach costs less than an objective approach, which calculates the average beta for each

WACC E

E P D iProject

= + +

Project

Project Project Project E, Project

1 P

E P D iProject

Project Project Project P+ + ,, Firm

Project

Project Project Pr 1

D E P D+ + ooject

D, Firm Projecti Tc3 21 ,( )

Financial Management158

division and uses these numbers in the CAPM calculation to determine the iE for each division (and then uses estimates of iE for each division to come up with divisional WACCs), it’s more frequently used because it’s easier to perform.

Flotation Costs

When firms raise outside capital to help fund projects, the costs associated with doing so, such as printing brochures and new stock or bond certificates, must be included in the calculations used to figure project WACC. These flotation costs can either serve to increase the project’s WACC by being included as a percentage of WACC, or you can instead make adjustments to increase the amount of the project’s initial investment. Using the first approach can undershoot the component cost of new equity, while the latter approach is in violation of the separation principle as it applies to capital budgeting, which holds that calculating cash flows is a process that should be separated from financing.

Adjusting the WACC

The first method used to make adjustments for flotation costs involves adjusting the issue price associated with new securities by subtracting the cost of flotation, F, to come up with the net security price. When equity is involved, this is mainly used with the constant-growth model:

If you prefer to use this approach with the cost of equity determined by the CAPM formula instead, adjust it upwards by an equivalent amount.

i D P F

gE = +1 0 2

Lesson 3 159

Self-Check 12

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What does WACC stand for?

2. When might you not want to use CAPM to calculate the component cost of equity?

3. What’s the appropriate tax rate to use in computing WACC?

4. How are the weights used in the WACC formula calculated mathematically?

5. What do pure-plays refer to?

6. Why do large firms often use divisional WACC for new projects?

7. What’s the objective approach to determining divisional WACCs?

8. What are flotation costs?

9. How can the WACC be adjusted to reflect flotation costs as applied to the constant-growth model?

10. How is the component cost of debt calculated?

Complete the following problems at the end of Chapter 11.

11. Problem 11-2

12. Problem 11-4

13. Problem 11-6

14. Problem 11-8

Check your answers with those on page 236.

Financial Management160

ASSIGNMENT 13 Read this assignment. Then read Chapter 12 in your textbook.

To perform an analysis of a capital budgeting project, it’s necessary to estimate the cash outflow the project will need as well as the level of cash inflow it will generate, along with the exact timing of these outflows and inflows. Keeping tabs on these details can be complicated, so this assignment will provide more detailed information than in previous assignments.

To enable the budgeting process to proceed as smoothly as possible, a systematic method for dealing with details is called for. The process you’ll learn to help accomplish this is known as pro forma analysis. The form of this analysis you will use in this assignment estimates the future cash flows that a project is expected to deliver using only those parts of the balance sheet and income statements that are necessary to do so.

Guiding Principles for Cash Flow Estimation When calculating the cash flows expected for a project, consider incremental cash flows expected through the entirety of the firm as the new project gets off the ground. Some changes of this type are easy to recognize, while others are harder to identify and must be watched for diligently.

The types of costs are as follows:

n Opportunity Costs. An opportunity cost exists when a firm has to choose how to allocate scarce investments. Suppose a firm is considering two projects that each require an initial investment of $500,000 to get off the ground. If the firm has only $500,000 for new product development, selecting one of the proposed projects imposes an opportunity cost on the company, and the opportunity the other project represents must be abandoned.

Lesson 3 161

n Sunk Costs. When a company has previously made an expenditure or has obligated itself to make such a pay- ment in the future, whether or not the project involved ever gets off the ground, the expense is called a sunk cost. Sunk costs should not be counted in project cash flows.

If a new product or service will either reduce or increase sales, costs, or the assets needed for existing products and services, such changes are incremental to the project and therefore included when determining project cash flows.

Financing costs, which include dividends paid on stock or interest paid on debt, are never counted as expenses of a project. This is because costs of capital have been previously added as component costs when calculating WACC.

Total Project Cash Flow Free cash flows (FCF) can be used as a variable to measure how much total cash flow is available from a project. There are two key differences from how this measure was used in Assignment 4. First, because we’ll consider potential projects instead of actual operations of a firm, the FCF numbers will be informed guesses rather than historical numbers. Second, FCF will be calculated for potential projects separately instead of considering the firm as a whole. Instead of having to esti- mate the entire set of balance sheets, you’ll have to focus on only a limited subset of pro forma necessary to track the elements on the new project. This will make your job as the manager easier. The hard part will be identifying which parts of the balance sheets are necessary and which aren’t.

Calculating Depreciation

The depreciable basis for real property, according to Internal Revenue Service (IRS) Publication 946, is

n Its cost

n Amounts paid for items such as sales tax

n Freight charges

n Installation and testing fees

Financial Management162

Thus, the depreciable basis for the new project will be calcu- lated using straight-line depreciation.

Calculating Operating Cash Flow and Changes in Gross Fixed Assets

In Assignment 4, operating cash flow was specified as EBIT (1 – Tax rate) 1 Depreciation. As you’ll be building the FCF components yourself rather than getting them from an income statement, it will be helpful to perform this calculation using a “quasi-income statement,” leaving out certain components such as interest deductions. This format gives you space for the expansion of subcategories.

The category of gross fixed assets will generally experience changes in just about every project, as assets are purchased at the start of the project and sold at the end. To calculate the change at the start of the project, we simply add the depreciable basis of the assets. Determining change in gross fixed assets at the termination of a project is more complex. The IRS considers any sale of assets that brings in more than the depreciated book value of the assets as capital gains subject to taxes. Any sale that brings in less than book value is considered to be a taxable loss. Either way, you can figure the after-tax cash flow (ATCF) from such sales using the formula listed below, with TC as the appropriate tax rate.

ATCF 5 Book value 1 (Market value – Book value) 3 (1 – TC)

Calculating Changes in Net Working Capital

Some assumptions can be made in regards to the level of net working capital (NWC) required for the support of a proj- ect. A straightforward method is to assume that NWC is added at the start of the project and subtracted at the end. Such an assumption is likely to be accurate for a project that’s expected to generate steady levels of sales through its expected lifespan.

Depreciation Depreciable basis Ending book value Life of as

5 2

sset

Lesson 3 163

Accelerated Depreciation and the Half-Year Convention The FCF calculation is a simple approach to depreciation calculations. However, the IRS requires that depreciation be calculated using the half-life convention. This means that any machine placed into service during a given period is assumed to be placed into service at midpoint of that period. Table 12.7 shows an excerpt of the straight-line depreciation table with half-year conventions. Keep in mind that there are also midmonth and midquarter conventions as well.

M ACRS Depreciation Calculation

While the IRS allows companies to use the straight-line method and take advantage of the half-year rule to depreciate assets, the majority of businesses benefit from applying accelerated depreciation. This feature allows a company to expense a greater portion of an asset’s cost earlier in the asset’s lifespan.

Section 179 Deductions

Accelerating the asset expensing process further can be done when assets are expensed immediately in the year of their purchase. Most firms are allowed by the IRS to use the Section 179 deduction to immediately expense as much as $500,000 of property that’s placed in service per year. This deduction is aimed at helping small businesses, given the annual limit on its use. Property that can be expensed under Section 179 includes

n Machinery and equipment

n Furniture and fixtures

n Most storage facilities

n Single-purpose agricultural or horticultural structures

n Off-the-shelf computer software

n Certain qualified real property (limited to $250,000 of the $500,000 expensing limit)

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Ineligible property includes

n Buildings and their structural components (unless specifically qualified)

n Income-producing property (investment or rental property)

n Property held by an estate or trust

n Property acquired by gift or inheritance

n Property used in a passive activity

n Property purchased from related parties

n Property used outside of the United States

Choosing Between Alternative Assets with Differing Lives: EAC In situations for which you’re asked to select between two assets that are usable for the same purpose, you can use the two alternative incremental cash flows connected to the two assets and restructure them to compare them to each other.

Revisiting Flotation Costs In addition to accounting for flotation costs as described in the last assignment, you can also adjust the initial cash flow associated with a project to have it include the flotation costs incurred in raising capital for a project along with the required investment in assets. To take this approach, you

1. Compute the weighted average flotation cost, fA, using the firm’s target capital weights:

Where fE, fP, fD are the percentage flotation costs for new equity, preferred stock, and debt.

2. Compute the flotation-adjusted initial investment, CF0, using this formula:

AdjustedCP CF fA

0 0

1 =

−

f E E P D

f P E P D

f D E P D

fA E P D= + + +

+ + +

+ +

Lesson 3 165

Self-Check 13

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What does the phrase pro forma analysis refer to?

2. What are incremental cash flows?

3. What qualifies as a sunk cost?

4. According to the IRS, what constitutes the depreciable basis for real property?

5. What’s the rule for handling negative EBIT?

6. What does the half-year convention mandated by the IRS for calculating deprecation stipulate in regard to placing property in service during a given period?

7. What’s the difference between MACRS and straight-line depreciation?

8. What problem does the EAC technique help resolve?

9. In addition to taking flotation costs into account by adjusting the WACC upwards, what’s another way to account for such costs?

10. What’s a Section 179 deduction?

Check your answers with those on page 237.

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ASSIGNMENT 14 Read this assignment. Then read Chapter 13 in your textbook.

This assignment focuses on weighing net present value and other capital budgeting criteria. After determining the cost of capital that will apply to a project and its projected cash flows, the next step is deciding if the project is worth investing in by analyzing its projected present value. In considering this question, you can use TVM equations, but because capital budgeting involves the purchase of capital equipment that’s less liquid than financial assets such as stocks and bonds, different dynamics apply to such calculations. Real assets such as capital equipment allow companies to create value by making products they can sell to customers; this typically involves, to some degree, the ability to make monop- olistic profits via the long-term ownership of such assets. As a result, the > and < signs are used to indicate the goal of seeking projects that produce profits greater than might be expected (otherwise known as economic profits), even when the risk involved in the project is taken into account.

Capital Budgeting Techniques Your textbook identifies a number of commonly used capital budgeting techniques, including

n NPV (net present value)

n IRR (internal rate of return)

n PB (payback)

n DPB (discounted payback)

n MIRR (modified internal rate of return)

n PI (profitability index)

Net present value (NPV) is the favored technique when performing project analyses. At times, the use of other techniques is favored, either in isolation or in combination with NPV. The textbook lists factors you can use in selecting a capital- budgeting technique:

Lesson 3 167

1. The statistical format you choose

2. The benchmark you compare it to

3. Whether you compute it with TVM

4. Whether non-normal cash flows are a factor

5. What other projects you may or may not have to decide among

Table 13.1 in your textbook outlines how these factors come into consideration when making a choice of capital-budgeting technique.

Choosing a Decision Statistic Format When making a financial decision, managers typically focus on three measurements: currency, time, and rate of return. Dealing with rate or return statistics can be more difficult than the other two measures. Doing so usually necessitates taking into account the ratio between cash inflows and outflows over a project’s lifespan. Using a ratio to summarize activity results in the loss of some valuable information.

Notably, rate-based decision metrics give us a rate of return on each dollar invested but don’t show the amount of the investment that was used to determine the rate. Despite this drawback, such statistics are quite popular with managers, who use them to compare the expected rate a project will earn with interest rates quoted by potential lenders.

Processing Capital Budgeting Decisions Each decision technique needs a process for calculating a decision statistic. In addition, a benchmark for comparing statistics once they’ve been calculated and an outline of the relationship between the decision statistic and benchmark will lead to acceptance of the project. Your textbook lists two processes for capital budgeting. The first process considers one project at a time or a group of independent projects:

1. Compute the statistic.

2. Compare the computed statistic with the benchmark to decide whether to accept or reject the project.

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A different process is used when dealing with projects that are mutually exclusive:

1. Compute the statistic for each project.

2. Have a “runoff” between the mutually exclusive projects, choosing the one with the best statistic.

3. Compare the computed statistic from the runoff winner with the benchmark to decide whether to accept or reject the project.

Payback and Discounted Payback These techniques help answer questions regarding how long it will take to recoup the costs incurred in the development of a project. The payback (PB) statistic is widely used, partly because it’s easy to compute. Equation 13-1 in your textbook shows the formula used to calculate PB. It should be noted that the computation of this figure requires two assumptions:

1. Cash flows are assumed to be normal, with all of the outflows taking place at the start of a product’s lifespan. This approach means that payback wouldn’t be meaningful for nonstandard cash flows.

2. PB isn’t likely to take place in a perfectly round number of time periods. An assumption must be made as to how cash inflows will take place over the year. Usually, cash flows are assumed to come in smoothly over the course of each period, enabling you to count the number of months and days for use in estimating the exact payback statistic.

Refer to Example 13-1 to see how payback is calculated.

Payback Benchmark

A weakness of the payback method is that the benchmark used in this process must be determined for each project, so it involves different values for different projects. An ideal bench- mark for PB should take into account applicable criteria, such as the time period over which investors in the project would like to receive a return of their capital. In practice, however, this benchmark is often selected by managers arbitrarily. Equation 13-2 in your textbook shows the formula used to calculate whether or not to accept or reject a project.

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Discounted Payback Statistic and Benchmark

Another problem with the payback statistic is that it doesn’t take into account the time value of money. To make up for this, a figure often calculated to replace PB is the discounted payback (DPB) statistic. The formula to make this calculation is displayed in Equation 13-3 in your textbook.

While tempting, applying the same benchmark to DPB that was used for PB should only be done with caution, as the DPB statistic will be larger than the PB statistic. DPB takes into account the amount of interest payable until the benchmark is reached. Thus, the DPB is often set to include a longer payback time. See Example 13-2 in your textbook for how to calculate the discounted payback.

Strengths and Weaknesses of Payback and Discounted Payback

While PB is criticized for not accounting for the time value of money, DPB isn’t designed to replace PB but to enhance it by providing further information for use in capital-budgeting analysis. Additionally, both PB and DPB totally ignore cash flows accruing subsequent to the project reaching the payback benchmark aligned with either PB or DPB. This can lead to managers gaining an inaccurate view of the merits of mutually exclusive projects with quite different cash flows once payback has been reached.

The NPV Benchmark Strengths and Weaknesses Using NPV analysis takes into account all product cash flows, including inflows and outflows. Because of this, the assumption is that investment necessary to fund a project has already been taken into consideration. Therefore, an NPV above zero reflects value over and above the investment. As a result, the NPV decision result is as follows:

Accept project if NPV ≥ 0

Reject project if NPV < 0

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Unlike decision statistics that are rate-based, NPV isn’t a ratio. Thus, it can perform just as well with independent projects as it can when it comes to selecting from mutually exclusive projects. For the latter, the project that possesses the highest NPV is the one likeliest to add value to the firm, making it the project management should choose over competing projects. Refer to Example 13-4 to see how to calculate the NPV for a normal set of cash flows and Example 13-5 for the NPV for a non-normal set of cash flows.

Internal Rate of Return and Modified Internal Rate of Return The rate-based capital budgeting technique that has the greatest popularity is the internal rate of return (IRR). This is because when analyzing a project that has normal cash flows and is independent of any other projects, this statistic provides the same decisions as to whether to accept or reject a project as NPV does. NPV equates to the sum of the figure identified as the present value of the cash flows at a specified interest rate (typically the cost of a firm’s capital), while IRR equates to the interest rate that will cause the NPV to equal zero. Equation 13-7 in your textbook demonstrates how to solve for NPV and IRR. Refer to Example 13-6 to see how IRR is calculated.

IRR experiences difficulty as an analytical tool when project cash flows are abnormal or if the measure is being used to decide which mutually exclusive project to choose.

Solving for IRR involves solving the NPV formula to determine the interest rate that makes NPV equal to zero, as shown in Equation 13-8 in your textbook. However, it’s possible to solve for the interest rate that sets NPV so that it equals zero in a direct manner, so some trial-and-error or use of a computer or calculator is involved.

IRR Benchmark

When you’ve calculated IRR, you can contrast this decision statistic with the project’s cost of capital as follows:

Accept project if IRR ≥ Cost of capital

Reject project if IRR < Cost of capital

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The IRR is equivalent to the expected rate of return on a project, while the required rate of return (i) is the rate investors must receive in relation to the projected return of the project, including risk. IRR takes into account the potential for some portion of monopoly-like profits from the use of private assets that allow a company to select projects that have a greater worth than a company pays for them. Only if IRR is higher than i would you want to invest in a project.

A drawback of using IRR is that when cash flows are negative at some point in a project, IRR becomes less useful as a statistic because it can’t differentiate when project cash flows begin and end. As a result, when cash flows are abnormal, you may find more than one valid IRR that results in NPV of zero. This complicates the analysis of a project and may prompt you to choose another decision statistic. Another difficulty with using IRR is that it can lead to reinvestment rate assumptions that are unrealistic. This can occur because IRR makes the assumption that cash inflows, when received, are destined for investment in a project that has earning power identical to the first project. NPV, on the other hand, makes the assumption that the reinvestment rate for cash inflows will be equal to the cost of capital. The NPV assumption seems more logical, as one method of effectively recovering the cost of capital is paying back a company’s capital investors. This option is available to all companies, whereas finding another project that produces the same (likely high) return as the first one seems rather unlikely, or at least difficult to do on a regular basis.

Modified Internal Rate of Return Statistic

This statistic modifies the cash flows to take into account the cost of capital prior to calculating IRR. To do this, use the cost of capital to relocate all the project’s negative cash flows to the date on which the project initially started, and relocate the positive cash flows to the date on which the project is scheduled to terminate. Once this is done, you can take the normal steps to perform the calculation of IRR.

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IRRs, MIRRs, and NPV Profiles with Mutually Exclusive Projects

The MIRR technique for dealing with projects with abnormal cash flows can still encounter difficulties if you use it for the purpose of selecting between mutually exclusive projects. Projects are considered mutually exclusive if management is able to accept only one of the projects. Comparing two such projects with a decision statistic that’s oriented on rates can create problems due to the scale or timing of the cash flows—primarily relating to the amount of the project’s initial investment. Looking over the long term, a large project earning a somewhat lower rate of return might be more advantageous for a company than a smaller one that has a somewhat better rate of return. However, such a distinction isn’t well handled by decision techniques based on rate. Two or more projects are commonly considered to be mutually exclusive if they both target the same market or share a common asset but the company is able to fund only one of them. Another example occurs when the market is able to accept only one product.

Strength and Weaknesses of MIRR

While the MIRR statistic can correct the inaccurate and over-optimistic IRR reinvestment rate assumption, it isn’t able to fix the problems associated with IRR being unable to select the correct mutually exclusive project when dealing with a certain range of rates. MIRR, like IRR and MPV, has a tendency to highlight the rate of return on a per-dollar-invested basis while ignoring the dollar amounts invested for each project. This results from differences in timing and scale of project cash flows.

Profitability Index

The profitability index is another popular decision technique based on rate. Derived from NPV, it has a closer resemblance to that statistic than do IRR or PB/DPB. The equation to cal- culate PI uses the present value assigned to the future cash flows of a project and takes steps to standardize them via the

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process of dividing by initial investment in the project. The resulting statistic could be said to measure “bang per buck invested.” The following calculation is used to determine PI:

The profitability index benchmark is the same as that of NPV:

Accept project if PI ≥ 1

Reject project if PI < 1

As NPV incorporates any required investment in a project, any time that PI is above zero represents the present value of expected economic profits.

PI NPV CF CF

= + 0 0

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Self-Check 14

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What are some capital-budgeting techniques?

2. What is necessary to do with all capital-budgeting decision techniques?

3. How is the payback statistic computed?

4. What should you expect of DPB in relation to the “regular” PB statistic?

5. How does net present value (NPV) measure the expected wealth increase expected from accepting a project?

6. Name a strength of the NPV rule.

7. When does internal rate of return (IRR) run into problems?

8. How do the assumptions concerning what happens with cash inflows once they are returned differ between the NPV and IRR techniques?

9. What can happen when a rate-based decision statistic is used when comparing two mutually exclusive projects?

10. How does the profitability index (PI) standardize the present value of a project’s future cash flows?

Complete the following problems at the end of Chapter 13.

11. Problem 13-4

12. Problem 13-6

13. Problem 13-8

14. Problem 13-10

15. Problem 13-13

Check your answers with those on page 238.

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ASSIGNMENT 15 Read this assignment. Then read Chapter 14 in your textbook.

In this assignment, you’ll learn more about the major issue involved with funding net working capital: the comparison of the cost to a firm of carrying an investment comprising current assets as contrasted with the shortage costs connected with the company not having the proper amount of cash, inventory, or accounts receivable to conduct business. While the ideal method for funding net capital would be to have someone else provide a firm’s net working capital, this usually isn’t realistic. However, it’s possible to shift these costs elsewhere to some degree, and this assignment will cover how that can be done.

The degree to which a firm’s business relies on providing physical goods as opposed to services will determine whether some part of the company’s current assets comes under the control of a department specially organized to control its operations management.

Revisiting the Balance-Sheet Model of the Firm In Assignment 4, you studied the balance sheet of a firm and the fact that current assets, while highly liquid, are typically less profitable than fixed assets. The net working capital portion of current assets is designated to meet a company’s need to maintain its business operations and maximize its profits. While a firm must pay for some net working capital, this doesn’t mean that it should pay for all or even the majority of it. The marginal benefit associated with each dollar used in net working capital should be equal to the marginal opportunity cost of not allocating that dollar to investment in fixed assets that possess positive net present value (NPV).

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The cash cycle of a firm is calculated as follows:

Cash cycle 5 Operating cycle – Average payment period

Aspects of Short-Term Financial Policy To reduce their need for net working capital, firms can

1. Manage their need for current assets

2. Seek to obtain as many current liabilities as economically feasible to fund the current assets that they do need

To decide on optimal levels of investment in each of the current asset types, a compromise must be made in determining the mix of carrying costs and shortage costs. Carrying costs come with having current assets. They’re divided into two main categories:

1. Opportunity costs that come with tying up capital in current assets rather than in fixed assets that are more productive

Tracing Cash and Net Working Capital and the Operating Cycle To follow cash as it moves through a firm’s operations, you must track the operating cycle—which is the time it takes to acquire raw materials, convert them to finished goods, sell those goods, and receive payment—along with the company’s cash cycle.

Net working capital can be thought of as the part of current assets that a company funds over and above assets that are funded by current liabilities. You can also think of the cash cycle as that part of the operating cycle that must be financed by the company. Measuring a firm’s operating cycle uses the following formula:

= +Inventory 365 Cost of goods sold

Accounts receivable 33 3 665 Credit Sales

= Operating cycle Accounts payable 365 Cost of goods sold

2 3

Operating cycle 5 Days’ sale in inventory 1 Average collection period

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2. Explicit costs that are required in the maintenance of current assets’ value

An example of opportunity costs is a clothes retailer being unable to sell all of its summer clothes before winter arrives. Any funds tied up in summer stock can’t be used to buy clothing which would be more likely to sell during the winter. The retailer also needs to pay rent on the store used to sell the clothing and any maintenance associated with its upkeep.

Shortage costs apply when a firm lacks sufficient current assets to take advantage of opportunities. These costs also refer to specific fees that must be paid for the replenishment of a particular type of asset. For instance, suppose a customer will purchase only a certain flavor of ice cream, and the ice cream shop is out of that flavor. The shop will lose that sale to another ice cream shop unless it can purchase the flavor for its stock. When a company purchases more of a particular asset, it will cause carrying costs to go up and short costs to go down. The ideal approach for a company is to choose the point that equates to the lowest cost of an asset—that is, the point at which the carrying costs and shortage costs become equal.

While ideally a company might prefer to use long-term debt and equity for financing long-term (fixed) assets and short- term debt for financing current assets, in reality, net working capital is typically positive. This means that, at the minimum, a certain portion of a firm’s current assets is being financed using long-term debt, equity, or some mixture of the two. Deciding how to finance peaks associated with asset demand through some combination of long-term debt and equity is commonly referred to as flexible financing policy. Such a policy gives a company an excess of cash and marketable securities outside of times when asset demand peaks.

On the other hand, financing troughs of asset demand using long-term debt and equity is known as restrictive financing policy. This requires a company to seek out short-term financing of funds during peak demand times for current assets, and also for demand situations that occur between such times. While to some extent this is the most conservative type of policy, it can be inconvenient for the company in that it requires constant short-term financing.

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Another method is following a compromise financing policy, in which the firm uses long-term debt and equity to finance its average asset-demand level on a seasonally adjusted basis. In this method, the company makes use of short-term and long- term financing on an as-needed basis.

Your textbook outlines several factors that bear on which of these approaches works best, including

n Current and future expected interest rate levels. If a firm expects rates to rise in the future, it may want to lock in fixed rates for a longer time by shifting toward a flexible financing policy. With falling rates, the opposite would hold true.

n The spread between short- and long-term rates. Long- term borrowing usually costs more than short-term financing, but the gap, or spread, between the two terms may be historically small or large, encouraging firms to shift to a more flexible or restrictive policy, respectively.

n Alternative financing availability and costs, discussed in the following sections. Firms with easy and sustained access to alternative sources will want to shift toward more restrictive policies.

The Short-Term Financial Plan A company that doesn’t follow a flexible financing plan will find that it needs to acquire short-term financing from time to time. Such financing includes the following items.

Unsecured Loans

Many businesses turn to banks for commercial loans to help meet their short-term financing needs. If the company is con- sidered creditworthy, the bank may offer a line of credit that the firm can draw from when necessary and pay back during seasonal business changes. A compensating balance refers to a percentage of the money the firm has borrowed (typically 5 to 10 percent) required to be kept on deposit in the company’s bank accounts. If a commitment fee is charged, it’s generally computed using a flat percentage of the credit line.

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Secured Loans

These include asset-based loans that are short-term loans for which a firm’s assets are used as security. Secured loans feature lower interest rates than unsecured loans, meaning that it’s generally best for a company to provide security (or collateral) to back the loan when possible. Such loans can include real estate, accounts receivable, inventory, and equip- ment, although most companies find the use of inventory or accounts receivable preferable for the securing of the loan.

A company’s accounts receivable can be directly sold to a factor, an entity that buys accounts receivable for a discount before they’re due, or assigned. Assignment occurs when a company borrows money and secures the loan by providing a lien on its accounts receivable along with the right of recourse. This is the legal right of debtors associated with the accounts receivable to pursue payment when necessary.

Companies may also use their inventory as a source of loan collateral. The three types of these loans are as follows:

1. A blanket inventory loan, in which the lender receives a lien covering a firm’s entire inventory, but the firm retains its ownership and possession

2. A trust receipt loan, in which the borrower is given possession of the inventory in trust for the firm making the loan. Any proceeds from sales of the inventory are the property of that lender.

3. Field warehousing financing, in which a public ware- house company takes possession and responsibility for supervision of the inventory on behalf of the lender

Other Sources

Other sources of short-term financing include commercial paper and banker’s acceptances. Commercial paper is a type of money-market security issued by banks as well as medium and large corporations. It matures within nine months or less. Given the short-term nature of these obligations and their use solely for current transactions, such debt doesn’t have to register with the SEC. As a result, it’s less expensive than a banker’s acceptance. A banker’s acceptance is a short-term

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promissory note that a corporation issues with an unconditional guarantee (acceptance) from a major bank. The rates for this type of financing are approximately equivalent to those for commercial paper.

Cash Management A cash account is a current asset account similar to the other current assets we’ve covered, such as inventory and accounts receivable. While somewhat more liquid, it isn’t necessarily any more profitable than these other current assets.

Reasons to Hold Cash

There are three main reasons a company may wish to hold cash:

1. Transaction facilitation. A company must pay the wages of its employees, taxes, bills from suppliers, interest on its debt, and stock dividends. Having some cash on hand ensures that these payments can be made without delay.

2. Compensation balances. Some lenders will mandate that a firm keep a percentage of the funds it borrows in its bank account.

3. Investment opportunities. In certain industries, an investment opportunity can come and go rapidly. Having cash available can allow a firm to take advantage of such opportunities.

The Baumol Model for Determining the Target Cash Balance

The Baumol model helps firms minimize opportunity costs related to holding cash as well as the trading costs incurred in the conversion of other assets to cash. This model is used mainly in industries where cash outflows occur at a fairly predictable rate. When this isn’t the case, the model becomes problematic because its assumptions are somewhat unrealistic.

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For example,

n It assumes a company has a constant, predictable cash disbursement rate. This often isn’t the case.

n It assumes no cash will be received over the course of the period being considered, which is usually untrue.

n There’s no allowance for a safety stock of extra cash as a buffer against financial emergency.

The Baumol model assumes that cash starts from a replenishment level, C, and thereafter declines smoothly to zero. Once this happens, the cash can be replenished by the sale of another C’s value of marketable securities, which costs the company a trading expense of F. As a result, the model’s implication is that a company’s cash level follows a cyclical pattern over the course of the year.

If a company can earn an interest rate of i on its marketable securities, maintaining an average cash balance equal to C/2 imposes on the firm an opportunity cost as follows:

If a company is assumed to face an annual cash demand of T, the firm will have to sell marketable securities T/C times over the course of the year, which results in annual trading costs as follows:

The company’s yearly expenses linked to its cash manage- ment policy would thus be as follows:

Solving for a value of C designed to minimize yearly costs, C* yields

Opportunity cost 2

= C i3

Trading cost = T C

F3

Total cost = C i T C

F 2

3 1 3

C TF i

* = 2

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Finding the Target Cash Balance: The Miller-Orr Model

The Miller-Orr model calculates an optimal cash management strategy by assuming daily net cash flows are distributed in a normal fashion, taking into account both cash inflows and outflows. The information needed to compute this model includes

n The lower control limit, L

n The trading cost for marketable securities per transaction, F

n The standard deviation in net daily cash flows, 

n The daily interest rate on marketable securities, iday

The model can be used to demonstrate that the optimal point for the return of cash, Z*, and the upper limit for cash balances, H*, equal

Other Factors That Influence the Target Cash Balance

While the Miller-Orr model is more realistic than the Baumol model in that it includes cash inflows and outflows, it doesn’t take into account significant factors that influence cash management practices that firms pursue. The first factor is that companies also are able to borrow in the short term to satisfy unanticipated cash demands. Second, both models were created when it was more expensive and took more time to buy and sell marketable securities than is the case currently. Finally, neither model takes into account the need for many firms to hold compensating balances in their bank accounts.

Float Control One aspect of good cash management is ensuring that the checks a company receives are cleared in a timely fashion. The time from when a check is written to when it’s cleared, making funds available, is called the float. The checks a firm receives encounter three types of collection float, including

Z F i

L

H Z L day

*

* *

= +

= −

3 4

3 2

2 3



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1. Mail float. The time that the check is on its way to the company, via a postal system or electronic transfer

2. In-house processing float. The time it takes the company to process and deposit the check after it’s received

3. Availability float. The time needed for a check to clear once it’s deposited into the banking system

Companies use a variety of techniques to reduce collection float:

1. A lockbox system refers to geographically separate post office boxes that enable a firm to receive checks more quickly than if all checks were sent to a single location.

2. Concentration banking accelerates collection by having checks sent to geographically remote regional banks and from there transferred to a master bank account.

3. Wire transfers are the fastest means of sending money from local banks into the concentration account.

Disbursement float refers to the delay that occurs between a company sending a payment out and the withdrawal of the funds from the company’s bank account. Two legal methods of increasing this type of float provide for maintaining the availability of the cash to the firm up until the last moment possible:

n Using a zero-balance account. The bank automatically transfers funds out of an interest-bearing account to take care of any checks presented. As these accounts never have extra cash, corporations avoid regulations preventing them from owning checking accounts that bear interest.

n Using drafts. Drafts are similar to checks in appearance, but function differently in that they’re payable by the firm that issues them instead of by the bank. When a draft is presented at the company’s bank for payment, the bank has to present the draft to the firm before it can disburse the funds.

Investing Idle Cash Firms regularly rotate cash into and out of marketable securities for the purpose of at least partially offsetting the opportunity costs that come with having capital stranded

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in current assets. Companies possess surplus cash either because of seasonal changes in cash flow or because they’re preparing for planned expenditures. Firms typically place their cash into money-market securities, including

n Treasury bills

n Federal funds

n Repurchase agreements

n Commercial paper

n Negotiable certificates of deposit

n Banker’s acceptances

Credit Management As with cash management, an optimum credit policy trades the opportunity cost attributable to lost sales with the carrying costs that come with funding accounts receivable and expected costs of default on the accounts receivable.

Credit terms of sale typically include, at a minimum, a

n Credit period

n Cash discount

n Description of the type of credit instrument

Prior to granting credit to a customer, a company may want to perform a credit analysis. This includes systematically examining the ability and willingness of the potential borrower to afford payments for the goods being acquired via credit. The analysis, if thoroughly carried out, will investigate the past credit history of the borrower and its current and forecasted financial condition. This usually involves an examination of the “five Cs”:

1. Capacity

2. Character

3. Capital

4. Collateral

5. Conditions

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The Cash Budget Many firms see their production and sales vary over the course of a year. For example, retailers selling youth-oriented clothing will often see sales surge in the month or two before school starts before returning to lower levels. Whether sales- or production-related, most firms have some seasonality in their operations. This results in times during the year in which a company creates significant cash surpluses and times when large deficits may occur. To prepare for such swings in cash flow, financial managers have to plan ahead to ensure their firms always have sufficient cash on hand. To accomplish this, they use the cash budget.

A cash budget can be used to cover daily, monthly, or quarterly periods of time. The first section of a cash budget covers a projection of sales for the coming year. The greater the seasonality experienced by a company, the more detailed their cash budget should be. Generally, a company with strong seasonality in its business will be well served by the use of a monthly as opposed to a quarterly cash budget.

Tables 14A.1 and 14A.2 in your textbook demonstrate how the cash collection and cash disbursement portions of a cash budget are completed. Once these two elements of the bud- get have been completed, firms can compute net income. Table 14A.3 shows cash flow from net income, which can vary widely depending on the time of year. Even when cash sav- ings from surplus months are taken into account, a firm may easily deplete its cumulative net cash flow (which is displayed below net cash flow on the cash budget) during the course of the year, even if the firm is profitable overall.

In such cases, a firm may need to get a bank loan or line of credit that enables it to ride out the cash deficits it experiences during certain seasonal periods. Failing to plan ahead to deal with such situations can lead to financial stress that harms a firm’s ability to conduct its business and can negatively affect its reputation. A cash budget spreadsheet allows a firm’s managers to engage in what-if analysis to help the firm deal with seasonal fluctuations.

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Self-Check 15

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What’s an opportunity cost?

2. How is a firm’s cash cycle determined?

3. What are two ways by which firms can reduce their net working capital needs?

4. What two general categories do carrying costs associated with having current assets fall into?

5. What does a restrictive financing policy refer to?

6. What are some other sources of short-term financing besides unsecured and secured loans?

7. What are the three primary reasons a company may keep some of its capital tied up in cash?

8. What’s the goal of the Baumol model?

9. What assumption does the Miller-Orr model take in calculating the optimal cash management strategy?

10. What factors are considered in determining a company’s optimal credit policy?

Complete the following problems at the end of Chapter 14.

11. Problem 14-2

12. Problem 14-6

13. Problem 14-8

Check your answers with those on page 240.

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ASSIGNMENT 16 Read this assignment. Then read Chapter 15 in your textbook.

This assignment focuses on the steps necessary to form a financial plan for a company. This includes forecasting future sales and estimating the number and types of assets necessary to support those sales. It also includes finding sources of funding for those assets, both internally and via external sources.

Financial Planning Financial planning is typically thought of in terms of an individual selecting investments toward the attainment of long-term financial objectives. Financial planning for a company involves a similar process but in a more complex environment. Typically, the process involves all of the operating divisions of a company creating pro forma financial statements showing their projected financial condition. Once this is done, the various division pro forma plans are consolidated into a group of master pro forma statements applying to the company as a whole and acting as its financial plan.

The financial plan is a vital element in strategic planning, which is the process of analyzing, implementing, and evaluating all aspects of a company’s operations to assist a firm in meeting its long-term goals. Strategic planning consists of figuring out what a firm hopes to achieve over the next year and beyond, what it can do to realize those achievements, and how it will determine what success looks like.

The various assumptions that underlie a company’s finan- cial plan are usually called the base case, while the projected financial statements that result from it are known as base case projections. These projections help in strategic planning when it comes to setting internal objectives, delivering information to shareholders as well as other stakeholders regarding future expectations, and estimating the company’s funding needs.

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Forecasting Sales

The Naïve Approach

A simple method of forecasting future sales is to make the assumption that future sales will equal sales from the last observed period. This is often called the naïve approach and is calculated as follows:

E(Salest 1 j) 5 Salest for all j > 0

To see how the naïve approach works, you must investigate the degree of what’s present in its forecasts. A popular statistic for calculating this amount is the mean absolute percentage error (MAPE), shown in your textbook in Equation 15-2. MAPE is used to determine the efficacy of forecasting techniques when they use a single set of historical data to make forecasts about a later historic set of “testing data.” Thus, it provides data on how well a forecasting method would have performed in the past. Of course, this doesn’t guarantee that such a method will work as well going forward. If sales stay reasonably sta- ble for a company over time, the naïve approach can be an appropriate technique for providing such estimations. On the other hand, if it seems likely that sales will change gradually but notably over time, or will be subject to sizable variation from one period to the next, a more sophisticated estimating technique may be appropriate. Refer to Example 15-1 in your textbook to see how to estimate using the naïve approach.

The Average Approach

To improve the accuracy of the naïve approach, which uses only a single period to forecast future sales, you can take the mean of a number of historic observations to help dampen the influence of any one reporting period, which may have been influenced by unique factors that don’t apply at other times. The calculation to do this is given in Equation 15-3 in your textbook. In using this approach, the key question to ask is how far back you should go in calculating average sales. If the sample you’re using is representative of the population, then more observations will be better. However, if the historic data no longer represents the company’s current circumstances, sales from before the time when circumstances changed may

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be “stale,” and not all that useful in projecting sales going for- ward. On the other hand, if no such shift has occurred, the best estimator for future sales is an average taken from all available historical sales data. Refer to Example 15-3 in your textbook to see how to estimate sales using the historic aver- age approach.

Estimating Sales with Systematic Variations

If you examine the sales information in Example 15-3 in your textbook, you’ll see a number of robust patterns, including the following:

1. A quarterly pattern exists in which sales are highest for the third quarter month in every quarter.

2. This pattern is especially noticeable in each year’s fourth quarter, when holiday sales occur.

3. A slight upward trend in sales seems to occur over time.

To forecast future sales as accurately as possible, you must perform adjustments for patterns such as this. A common method used for this purpose is to deseasonalize historic sales figures by dividing the actual sales figures from each month using a seasonal index. Then, you can use seasonal indices and regression metrics to forecast future sales.

Once you’ve deseasonalized sales numbers, you can regress them using the time period to come up with parameters, enabling you to estimate the historic trend. Lastly, you reverse the process, using the regression parameters to forecast monthly sales figures that remain seasonally adjusted for the given period. Afterwards, you can de-adjust them by multiplying them by the respective monthly seasonal index.

External Financing— Additional Funds Needed If there’s an expectation that sales will increase going forward, an increase in assets must occur to support the boost in sales. Some funds to finance this increase will come from increases in liabilities occurring as direct reactions to the higher sales. If a company takes on more raw materials to

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create its products, and the supplier provides it with trade credit, ordering additional materials will increase the amount of accounts payable as well. This corresponding increase in liabilities, known as spontaneous increase, may not be sufficient to finance the need increase in assets by itself. In most cases, a firm will also need to fund some portion of the necessary increase using external capital. This portion is known as the additional funds needed (AFN). It’s calculated as follows:

AFN 5 Necessary increase in assets

– Spontaneous increase in liabilities

– Projected increase in retained earnings

The increase in assets needed is calculated by dividing the assets tied to sales (A*) by the current sales (A0) to determine the capital intensity ratio, and after that multiplying the capital intensity ratio by the forecast sales increase (ΔS):

To compute the spontaneous increase experienced in liabili- ties, you can divide the amount in liabilities linked directly to sales (L*) by current sales to come up with the spontaneous liabilities ratio, and then multiply this ratio by the forecast sales increase:

To calculate the projected increase in retained earnings, multiply the profit margin (M) by the forecasted sales for the coming period (S1), and then multiply this by the retention ratio (RR):

Projected increase in retained earnings 5 M 3 S1 3 RR

AFN with Unused Capacity Assets

If a firm is currently using all of its fixed assets, all assets grow proportionately with sales. However, in most cases, companies have a certain amount of unused capacity available to support the sales increase. In such a case, A* wouldn’t equal total assets but would equal the portion of assets that would have to change to support the projected sales growth. For the majority of firms, this would result in A* being equal to current assets (CA).

Necessary increase in assets = A S

S*

0 3

Spontaneous increase in liabilities = L S

S*

0 3

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AFN with “Lumpy” Assets

When asking why a company would have unused fixed asset capacity, the most common answer is likely that fixed assets generally aren’t infinitely divisible. For instance, you can’t buy one-quarter of a bridge or one-half of a ship and then buy the rest as demand increases. As a result, fixed assets are often said to be “lumpy” because they must be purchased in nondivisible quantities. Making such a purchase will involve planning and financial estimation on the part of a firm. Once the decision to purchase an asset has been made, the necessary increase in fixed assets needed to support the new sales level has to include not just the capital intensity ratio based on current assets, but the totality of the fixed assets that have been purchased.

Forecasting Financial Statements

Several problems may arise when calculating AFN:

n It’s assumed that balance sheet or income statement items that change due to changes in sales do so in the form of a linear sales increase. While this approach may work for many items, it’s not likely to hold true for all. Even when changes do occur with sales, such changes may not be linear.

n Calculations of AFN may account only for what are called first-order effects on the balance sheet and income statement. Such an approach doesn’t take into account the fact that interest on debt, and thus taxes, net income, dividends, and retained earnings, are determined in accordance with how AFN is raised. Because AFN is in part a function of retained earnings, an incomplete picture results unless a process in which retained earnings are also considered a function of AFN is used. To develop an estimate of AFN that’s more realistic, you can build a description of balance and income sheet changes occurring as a result of both projected changes in sales and to changes in various items. To do so, you can use pro forma statements using a spreadsheet program such as Microsoft Excel.

To calculate AFN using pro forma statements, the textbook indicates the following steps:

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1. Identify and compute the balance sheet and income statement items that would logically change, either in direct proportion with sales or indirectly, as a function of those items. (For most firms, this will include all balance sheet and income statement items except notes payable, long-term debt, owners’ equity, and possibly some portion of the fixed assets.)

2. Use amounts for these items adjusted for the impact of the sales change to calculate a first pass at AFN.

3. Determine a strategy for changing the items that don’t vary proportionately with sales. For example, if you assume that externally obtained notes payable, long- term debt, and equity will be used to cover the AFN, you need to specify what relationship should exist between the additions to these accounts. Should you keep the debt-to-equity and short-term to long-term debt ratios constant at their current values, or is there some other strategy that should be pursued? Also, what will be your plug variable—the balance sheet or income statement item that ultimately bears the responsibility of balancing the balance sheet?

4. Allow your spreadsheet program to solve for the value of your plug variable.

Refer to Example 15-7 in your textbook to review the calculation of AFN using pro forma financial statements in Microsoft Excel.

AFN Using Pro Forma Statements Based on Ratio Analysis

In many cases, a portion of the balance sheet and income statement items that have been treated as linear functions of sales might not grow in such a proportional manner. A change in sales could reasonably be considered the result of a change in (1) the fundamental business environment or (2) the company’s policies. As a result, the use of ratios to provide guidance in changing the affected balance sheet or income statement items may be necessary. Refer to Example 15-8 in your textbook to review the calculation of AFN using pro forma financial statements constructed using ratios in Microsoft Excel.

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Self-Check 16

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What’s meant by strategic planning?

2. What’s the naïve approach to estimating a future period’s sales?

3. How can you make adjustments for variable sales patterns using deseasonalization?

4. How are additional funds needed (AFN) computed?

5. Why are fixed assets usually not infinitely divisible?

6. What should a complete calculation of AFN involve?

7. What’s the only feasible way to construct pro forma statements including circular references?

8. What might AFN using pro forma statements gain from including ratio analysis?

9. How is the capital intensity ratio determined?

10. What does mean absolute percentage error (MAPE) measure?

Complete the following problems at the end of Chapter 15.

11. Problem 15-2

12. Problem 15-4

13. Problem 15-6

Check your answers with those on page 241.

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ASSIGNMENT 17 Read this assignment. Then read Chapter 16 in your textbook.

A firm’s capital structure isn’t set in stone. In this assignment, you’ll analyze how and why the financial managers of a company choose to make changes to their firm’s capital structure. When considering such changes, two main factors come into play:

1. Whether interest is tax deductible on debt interest payments

2. To what level increased debt affects the chances of a company either going bankrupt or encountering financial distress

Active versus Passive Changes to Capital Structure The two primary approaches available to firms looking to make changes to their capital structure are as follows:

1. Sell additional claims of a particular type of capital and use the proceeds for the purpose of retiring other types of claims. This strategy is known as active management.

2. Wait until the firm needs to use additional capital to cover its capital-budgeting needs, and at that point sell further claims of the type the firm would like to increase in its capital structure. This is called a strategy of passive management.

Your textbook identifies several factors to consider when selecting between an active and passive management approach, including

n How quickly the firm is growing

n How much the firm faces in flotation costs under the active management approach

n How strongly and how quickly the firm wishes to change the capital structure

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Businesses expected to add substantial assets in the near future are usually best served by the passive management method, as it allows them to change their capital structure fairly quickly without the need to incur additional costs from pursuing active management. Nevertheless, in this assignment, the focus is on actively managing a firm’s capital structure. This enables you to analyze the likely results of making changes to a firm’s capital structure without needing to separate the added impacts of capital-budgeting decisions, which is required when accounting for passive management.

Capital Structure Theory Using debt within the capital structure of a company is known as financial leverage. A basic tool you can use to examine the effect of a number of variables on a company’s choice of optimum capital structure is the Modigliani-Miller (M&M) theorem. This theorem postulates a perfect world with two main propositions:

Proposition I (perfect world): VL 5 VU Where

VU is the value of an unleveraged, or all-equity firm; and

VL is the value of a leveraged firm—in other words, a firm with a capital structure containing debt.

Proposition II (perfect world):

Where

iE,0 is the cost of capital for an all-equity firm; and iE and iD are the costs of equity and debt in a leveraged firm.

Proposition I states that, in a perfect world, the company will have the same worth regardless of its financial structure. Proposition II, which focuses on the cost increase associated with equity capital by considering it as a function of D/E ratio of a company, also incorporates the assertion made by

i i D E i iE E E D= + ( ), ,0 0 2

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Proposition I that capital structure is irrelevant. To demonstrate this, we will combine a few observations from earlier on with some new information as follows:

1. WACC is known to equal iE,0 for an all-equity firm.

2. Given that firms take on projects only if the expected rate of return is equal to or larger than the required (target) rate of return, WACC can be looked at as not just the average rate paid by the company to capital sources. In addition, WACC can be looked at as the minimum average expected return rate from the company’s asset investments that has to be earned if the company expects to repay capital providers.

3. Lastly, the separation principle holds that in a well- functioning capital market, a company’s capital-budgeting decisions are independent of its decisions regarding its capital structure. As a result, making changes to a com- pany’s capital structure in this perfect world wouldn’t affect the projects selected, nor would it affect the mini- mum rate of return considered acceptable as determined by the lower boundary of expected return from those projects. In other words, while the cost associated with equity increases as the amount of debt rises, the WACC remains the same.

As debt is less expensive than equity, a company uses less expensive equity and more relatively cheap debt using a rate that’s just able to offset the effect of the higher cost of equity on WACC. This results in what’s known as Proposition IIa, which is implied but not formally stated by the M&M theorem.

Proposition IIa (perfect world):

which will be constant in

In this proposition, iE increases as D/E increases to compen- sate shareholders for taking on greater and greater residual risk as a result of declines in the number of shareholders. Adding to the amount of debt located in the capital structure increases the EPS level while at the same time increasing the variation (also called risk). This is because stockholders are

WACC i E E D

i D E D

iE E D= = + +

+,0

D E

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the holders of the residual claim to a company’s earnings. Example 16-1 in your textbook shows the impact on expected return and volatility of increasing leverage in a perfect world.

M&M with Corporate Taxes

The value of the M&M propositions isn’t in the ideas behind the theorems as much as it is in what occurs to the proposi- tions when you move away from unrealistic assumptions and get closer to a more realistic approach. One way to do this is relax, to a small degree, the assumptions underlying the prop- ositions and assume the following: Corporations are taxed, corporate debt lasts forever, and interest is tax deductible. This changes the main M&M propositions as follows:

Proposition I (with corporate taxes): VL 5 VU 1 DTC Where

VL is the value of a leveraged firm

VU is the value of an unleveraged firm

D is the level of a perpetual debt firm

TC is the applicable corporate tax rate

Proposition II (with corporate taxes):

Where

iE,0 is the cost of capital

iE and iD are the costs of equity and debt in a leveraged firm

Proposition IIa (with corporate taxes):

which will be decreasing in

Using the M&M theorem in this way allows a firm’s value to increase forever as it takes on more and more debt, as implied by Proposition I. Making these equations somewhat more realistic by adding corporate taxes, managers are now able to maximize the value attributed to the firm by adding as much

i i D E i i TE E E D C= + ( ) ( ), ,0 0 12 3 2

WACC E E D

i D E D

i TE D C= + +

+ ( )12

D E

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debt as they can. The effect of dividends, which are taxable, is to subtract from corporate earnings when they’re paid, whereas debt payments are tax deductible, making them pref- erable from the standpoint of EPS.

However, the effect of adding debt in terms of increasing both EPS volatility and the overall risk of the firm encountering financial distress is unchanged by adding corporate taxes into the equation. Example 16-2 in your textbook shows the impact of leverage on shareholders’ expected return and volatility with corporate taxes.

Choosing to Re-leverage

Given that adding to firm debt boosts both expected cash flows to equity holders as well as the volatility those cash flows are subject to, the question arises, how will investors react to changes in a company’s capital structure? If an investor is unhappy with changes made to the capital structure of a firm (and assuming highly efficient capital markets), he or she can undo any such changes without cost. Example 16-3 in your textbook looks at how the investor might do this.

Break-Even EBIT and EBIT Expectations

We can examine the expected distribution structure of EPS from a different standpoint by solving for a specific expected EPS amount, one that would make investors indifferent about choosing between two proposed capital structures. To accomplish this, you can simply express EPS for each particular capital structure as a function of EBIT and set the two EPS expressions so they equal each other. After that, solve for the EBIT level that solves the equality, which is known as the break-even EBIT. Example 16-5 in your textbook shows how to calculate the break-even EBIT.

M&M with Corporate Taxes and Bankruptcy Relaxing the final M&M unrealistic assumption further by admitting the possibility that a firm may become bankrupt allows you to imply that those who hold debt in the firm will have to consider the possibility that they won’t receive all

Lesson 3 199

the payments they’ve been promised. This provides a more realistic scenario, in which bondholders are asked to take on some risk. In such circumstances, bondholders will ask for greater compensation than they would under “perfect world” assumptions.

The two main types of bankruptcy in the U.S. are as follows:

1. Chapter 7 bankruptcy: This involves the liquidation of a business in which claimants are paid in the order specified below:

o Secured lenders, including bondholders whose bonds provided them with liens on specific assets

o Lawyers, mainly the ones handling the bankruptcy

o Employees

o Government

o Unsecured debt holders

o Equity holders

2. Chapter 11 bankruptcy: This type of bankruptcy is pursued when there’s an attempt to reorganize a firm under court supervision. If a proposed plan of reorganization gains the approval of a large enough majority of the company’s creditors, the firm may emerge from bankruptcy after a time.

Filing for bankruptcy can involve substantial costs, including fees for lawyers, consultants, accountants, and so on. Other costs are incurred when firms simply get close to bankruptcy and enter financial distress. Your textbook iden- tifies groups that begin to act differently when they view firms as financially distressed, including

n Customers, who may decide to purchase goods or services elsewhere

n Suppliers, who may tighten credit due to their concerns about the firm

n Other firms, such as potential partners who are less likely to undertake deals

n Employees of the firm, who may seek out other employment

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Self-Check 17

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What’s a strategy of active management when a firm seeks to change its capital structure?

2. What are some of the factors that influence a firm’s decisions to use an active or passive approach to capital structure changes?

3. What features are assumed in the Modigliani-Miller (M&M) theorem for examining the effect of different variables on a company’s choice of optimal capital structure?

4. What’s stated by the separation theory put forth by Irving Fisher?

5. What do equity holders expect in return for accepting a residual claim on a firm’s future pro- ceeds, thereby taking on a higher level of risk?

6. Where does the value of the M&M theorem lie?

7. What are the two types of bankruptcy for which most firms can file in the United States?

8. What costs occur when a firm enters bankruptcy or financial distress?

9. What constitutes the overinvestment problem?

10. Based on M&M’s theory of optimal capital structure, what are some factors that should have an effect on the capital structure of companies?

Complete the following problems at the end of Chapter 16.

11. Problem 16-2

12. Problem 16-3

13. Problem 16-6

Check your answers with those on page 242.

Lesson 3 201

When a firm gets close enough to bankruptcy that its equity is almost worthless, the equity holders may start to treat it differently as well. The reasons for this are demonstrated in Figures 16.1 through 16.4 in your textbook. Effectively, the value to the equity holders is similar to holding a call option. This gives them the ability to purchase the equity value of the firm by paying off the debt owed to the bondholders.

ASSIGNMENT 18 Read this assignment. Then read Chapter 17 in your textbook.

Prior to this assignment, you’ve studied the investment and financing decisions that firms make. While these decisions are crucial to maximizing the value from a firm’s operations, shareholders are interested not only in how the firm performs but also how they can personally benefit from the firm’s performance. If taxes on all types of distributions were level, deciding when and how to pay out funds to shareholders would be relatively simple. However, the varying treatment of different types of distributions (dividends, capital gains, and interest payments) complicates the matter. This assignment will discuss how firms can most effectively make payments to shareholders of some portion of their earnings.

Dividends versus Capital Gains To illustrate the choice between paying out funds as cash dividends or shares of company stock, the following formula, applicable to a constant-growth stock, can be used:

The amount of the next dividend, defined as D1, is linked to the capital gains rate, g, via the dividend payout ratio, which is calculated as follows:

P D i g0

1= 2

Dividend payout ratio Dividends Net income

=

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If you assume that the capital markets used by firms to raise capital are competitively priced, then a company should retain earnings only insofar as they can invest the funds in projects able to earn a high rate of return. Specifically, that rate should be as high as the rate available if investors were to invest in other firms having similar risk profiles.

Dividend Irrelevance Theorem

The idea that it’s irrelevant whether or not a company pays dividends is taken from another theory credited to Modigliani and Miller, known as the dividend irrelevance theorem. Like their other theories, it’s set in a perfect world with

n No taxes

n No transaction costs (including trading commissions)

n Perfectly efficient markets

n Completely rational investors

The theory holds that if a firm does pay dividends, it will just reduce the value of each share by the amount of cash paid out in the form of dividends. If shareholders prefer not to see the value of their holdings diminished by dividends, they can choose to buy more shares in the company using the dividend proceeds. If a shareholder wants to receive cash from a firm but it doesn’t pay dividends, the shareholder can simply sell some shares to generate the cash that would otherwise come from a dividend.

As with the other M&M theorems, if the “no taxes” assumption is removed, the scenario regarding optimal firm dividend policy changes dramatically. Up until just recently, the higher tax rates on dividends regarding capital gains caused some firms to pursue policies of paying out fewer dividends and holding more retained earnings. However, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) has equalized tax rates in this regard, making dividends more attractive than they were previously. One argument for receiving dividends is the bird-in-the-hand theory. This theory claims that dividends that a firm has made a commitment to paying

Lesson 3 203

aren’t as risky for risk-averse investors as possible future capital gains. However, this theory is dismissed by M&M as the “bird- in-the-hand-fallacy.” They claim that many investors will just reinvest dividends right back into the firm they received them from, and that the long-term riskiness of the cash flows of a firm is decided solely by the risk level of the company’s asset cash flows without reference to its dividend payout policy.

Why Some Investors Favor Capital Gains

Even when capital gains and dividends are taxed at identical rates, some investors would rather have capital gains because these offer greater choice in regard to the timing of cash flows. When a company pays out dividends, all shareholders receive them and thus are subject to tax consequences. On the other hand, if a firm retains earnings and boosts its share price as a result, a shareholder can decide whether to sell shares and be subject to taxes, or hold on to the shares and defer paying taxes on the retained earnings.

Other Dividend Policy Issues Managers don’t like to cut dividends because investors look poorly on such a policy. As a result, firms rarely do this unless they’re in dire straits. At the same time, managers are reluctant to raise dividends unless they’re quite sure that the firm can continue to pay them at the higher level for some time. As a result, when a company announces that it’s increasing its dividend, analysts typically see this as a positive sign regarding the firm’s cash flows and future performance.

The Clientele Effect

The clientele effect describes the different desires among investors regarding the taxability and time frame of payouts from the firm. Investors who prefer a particular dividend policy will invest in those firms that meet their preference, selling their shares if the firm’s policy no longer meets their requirements. If you assumed investors didn’t experience any transaction fees, then changing a firm’s dividend to attract new investors might not have much of an effect. However, as

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transaction costs do apply, if a firm changes its dividend policy to one attractive to investors, it may see increased demand for its stock.

Corporate Control Issues

Companies with shareholders who maintain substantial shares in the firm may discover that those investors can dictate the dividend payout policy they adopt.

Real-World Dividend Policy After considering all of the previously mentioned factors, a reasonable approach for a firm still seems to be paying out as dividends the surplus cash flow that remains once the company has had the chance to invest funds in all prospective projects offering positive net present value:

Dividends 5 Net income – Retained earnings necessary to fund positive NPV Projects

The residual dividend model can also be called the free cash flow theory of dividends. It doesn’t fully explain the real-world dividend policies of some companies, which tend to pay fairly consistent dividends year after year. In addition, managers appear to prefer to pay dividends that rise steadily over time as preferred to those that fluctuate dramatically from period to period. Managers at firms taking such an approach may believe that their investors value the stability of dependable dividends more than they dislike the stress such a policy can place on a company’s cash flows.

To lessen the financial burden that stable dividends can impose on a firm’s cash flows, some companies separate dividends into two classes: ordinary and extraordinary. The firm can set the ordinary dividend rate at a low level to signal the minimum dividend payout investors can expect. Periodically, the firm can add to these small dividend payouts with extraordinary dividends when justified by the firm’s performance. The benefit this provides a firm is the flexibility to pay only the ordinary dividends during times when retained earnings are needed to fund projects.

Lesson 3 205

Logistics of Dividend Payouts From a technical standpoint, dividends aren’t obligations of a firm until it declares them. A company must allow a certain amount of lead time from the time the dividend is announced and the time it’s actually paid. Time must also be allotted to determine the owners of record for each of the firm’s shares as well as to actually mail checks once those owners are identified. This process requires corporations to set up firm dates for the following activities associated with paying a dividend:

n The declaration date is the date on which the board of directors announces that the company will pay a dividend. The dividend is classified as a firm liability on this date. The board announces the record date and a payment date on this date.

n The ex-dividend date is the first day that the company’s shares trade without the dividend attached. Anyone purchasing the stock on or after this date has no claim to receive the dividend.

n The record date is the date on which the firm searches its books to identify the registered owners of record to whom it will send payments.

n The payment date is the date on which payments are sent out.

As you may recall, the share price of a stock should be equal to the present value of its projected payments of future dividends. If dividends were paid out in steady increments at every possible point in time, then dividend payment procedures would likely have little to no impact on a stock’s price. However, given the procedure of paying dividends at specific intervals, it’s implied that the stock will rise as dividend payments get nearer and then fall after the stock goes ex-dividend. For instance, consider a stock that investors expect to pay $1.00 per year dividend with a 10 percent interest rate.

P D i0

1 0 1 10

=

=

=

$

$ .

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Stock Dividends and Stock Splits Along with stock dividends, companies can also choose to distribute additional shares of their stock via either a stock dividend or stock split. While these two approaches use different mechanics, the end result is the same with both: they increase the amount of shares outstanding while leaving unchanged the total market value attributed to owners’ equity. Neither of these will lower a company’s stock price.

Stock Dividends

Companies distribute stock dividends by sending to current shareholders a pro rata number of additional shares of the company’s common stock. For instance, a 10 percent stock dividend would add an additional 10 percent to the number of shares held by each stockholder. As a result, if an investor owned 1,000 shares before the dividend, that investor would own 1,100 after the dividend was paid out.

Stock Splits

When a company performs a stock split, it switches new shares for old shares. Generally, such a split converts each old share into more than one new share, which serves to increase total shares outstanding. A reverse stock split may also occur, in which shareholders trade in more than one share for fewer shares in return. For instance, if an investor owned 500 shares in a firm performing a 3-for-1 stock split, the investor would exchange his or her 500 shares for 1,500 shares. If the company instead performed a 1-for-10 reverse stock split, the investor would receive 50 shares for his or her 500.

The Effect of Splits and Stock Dividends on Stock Prices

A stock dividend or stock split is usually carried out for the purpose of lowering (or raising, in the case of reverse splits) the company’s stock price proportionately. For example, when a company does a 2-for-1 stock split, the stock’s price is likely to trade at roughly one-half of where it was trading prior to

Lesson 3 207

the split. The generally agreed upon reason for firms to pursue this approach is that they prefer to see their shares trade in a certain range. If the price moves out of that range, the firm can move it back into the range using a stock split or dividend. As many investors prefer to trade in round lots of 100 (200, 300, 1,000, 2,000, and so on), a firm may also use this strategy to make it easier for such trades to occur. Look at Example 17-4 in your textbook to explore a stock split versus a stock dividend.

Stock Repurchases Another technique firms use to effect a return of capital to shareholders is carrying out a stock repurchase or buyback. This is most commonly done in the United States via market repurchases of stock on the open market. The firm may or may not publicly announce its intention to buy stock, executing purchases in the same way as any other investor on the open market.

Advantages of Repurchases

When a tax structure has much lower rates on capital gains than on dividends, repurchasing stock offers a company an efficient way to return money to its shareholders. When there’s no such tax advantage, buybacks still allow an investor to defer taxes on the gains related to the buyback by not selling stock right away. Another advantage of stock repurchases is that unlike halts in dividend payments, investors don’t seem to view firms negatively for halting stock buybacks. A stock buyback can also be seen as a positive signal of management’s faith in the company.

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Disadvantages of Purchases

If a shareholder sells shares during a repurchase and the shareholder finds out later that management had information about the company’s prospects that wasn’t revealed publicly, the firm potentially could be subject to litigation. In addition, a stock repurchase plan may act as a negative signal to investors. Some may view it as a sign that the company doesn’t have enough attractive projects available to consume the cash that’s being used to repurchase shares.

Effect of Repurchases on Share Prices

The preponderance of evidence shows that, on average, the advantages of a share repurchase program outweigh the disadvantages.

Lesson 3 209

Self-Check 18

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What’s the dividend irrelevance theorem?

2. Why do some investors favor capital gains over dividends?

3. What’s the clientele effect?

4. What’s the calculation for a dividend policy that involves paying out as dividends any surplus cash flow after a firm has invested in all available positive net value projects?

5. What’s the residual dividend model?

6. What’s announced by a company’s board on the declaration date?

7. What has been demonstrated regarding stock prices and dividend payments?

8. What happens in a stock split?

9. How does a stock repurchase or buyback work?

10. What does the evidence show regarding the advantages and disadvantages of company stock buybacks?

Complete the following problems at the end of Chapter 17.

11. Problem 17-2

12. Problem 17-4

13. Problem 17-6

14. Problem 17-8

Check your answers with those on page 244.

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ASSIGNMENT 19 Read this assignment. Then read Chapter 18 in your textbook.

Firms choose the type of funding they prefer based on their size, the stage of their lifespan, and their prospects for growth. In this assignment, you’ll examine the decisions facing companies when raising capital, when they go public, and when they engage in subsequent debt and equity raises. You’ll also look at the types of securities issued by public firms as well as how investment banks facilitate the process of issuing securities.

Capital Sources for New and Small Firms Typically, new firms and small firms find financing for their business assets by borrowing funds from private or public sources. Suppliers of private capital can be divided into two broad categories: (1) firms that supply financing in return for debt and (2) firms that supply financing in return for equity.

Types of debt financing include funds borrowed from personal savings, from friends or relatives, commercial bank loans from financial institutions, or funding from venture capital firms. Equity financing comprises funds sourced from venture capitalists and, in recent years, crowdfunding, either equity- or rewards-based. Venture capitalists buy equity stakes in firms and receive the same rights and privileges as other owners. Public sources of capital include such government agencies as the U.S. Small Business Administration (SBA), which often offers debt and equity financing.

Now you’ll look at these two types of financing in more detail.

Debt Financing

Financing backed by debt can include personal capital, which typically involves loans from friends and relatives, or external capital—essentially, loans from banks or venture capitalists. In some cases, the wealth of a firm’s owners is directly connected

Lesson 3 211

to the firm’s success. However, most new and small business owners must turn to external sources to borrow capital. These external providers often require that owners invest a substantial portion of their own assets in the business.

Bank loans. Many new and smaller companies use bank loans for a major part of their capital funding. Bank loans, mortgages included, account for more than 60 percent of debt financing and more than 20 percent of the total financing raised by non-publicly traded firms. After the crisis of 2008 and 2009, the lending environment for small firms changed significantly, as major financial institutions found their sur- vival at risk. Demand for loans from small business declined markedly as well. Even as the economy recovered, small business lending continued to suffer. Today, many commercial banks find that small businesses exhibit higher risk profiles than they would like to take on. Some banks have created small-business scoring models similar to those used for ana- lyzing mortgage loans.

Midmarket businesses also rely to a large degree on sourcing capital from banks. Although these firms typically have more developed corporate structures than small businesses, they aren’t traded publicly, which restricts their access to funding from that quarter. Figure 18.1 in your textbook shows the credit process a small or midmarket firm might go through in seeking a bank loan.

Loan commitment agreements. In the past, companies sourced spot loans, which allowed a firm to receive funds right away once the loan was approved by the bank. Today, the majority of business loans are made by allowing firms to take down, or borrow against, lines of credit or loan commitments that have been pre-approved. Loan commitment agreements consist of contractually binding commitments to forward a company a specified maximum amount at a stated interest-rate term. In such agreements, the length of time in which the borrower may draw from the loan is also specified. The bank making the commitment may levy an up-front or facility fee in return for entering into the agreement. In addition, the bank might charge a back-end or commitment fee applicable to any unused balances remaining on the commitment line at the end of its term. Look at Example 18-1 in your textbook to explore how to calculate fees on a loan commitment.

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Fixed-rate versus floating-rate loans. Banks provide loans in two formats. Fixed-rate loans come in the form of fixed-rate commitments. Companies using these loans make interest rate payments over the loan’s lifespan. Floating or variable-rate loans feature a variable rate of interest over the course of the loan’s life. As a result, payments made on such loans may vary as interest rates change. Typically, a floating rate is established at a fixed spread above a benchmark rate, such as LIBOR (London Interbank Offered Rate) or a prime rate. The floating interest rate and spread are stated in the loan contract.

Small Business Administration. As you read previously, the Small Business Administration (SBA) makes loans to qualified small and new companies that are unable to find long-term financing at reasonable rates from private lenders. The SBA’s loan-guarantee program guarantees as much as $3.75 million (amounting to 75 percent of the loan value) at an interest rate that doesn’t exceed 2.75 percent above the prime lending rate. The maturity of such loans can be up to 10 years for working capital purposes and 25 years for loans based on fixed assets. The SBA also offers direct loans to finance real estate, machinery, or equipment via its Certified Development Company Loan Program.

Equity Financing and Expertise

Banks often are wary of lending money to firms with little in the way of assets and operating history. As a result, small and new firms often experience difficulty in obtaining bank loans. This will drive them to seek capital financing from venture capital firms, which in many cases offer business guidance as well as funding to small firms. Venture capital refers to professionally managed pools of money created to finance new firms (start-ups) that may be categorized as high-risk, potentially high-return investments. Venture capital organizations don’t make direct loans to companies but instead purchase equity interests, giving them rights and privileges equal to that of other company equity owners. Typically, venture capital firms don’t operate as passive investors. Instead, they take an active interest in how a company is meeting its financial objectives, helping out with advice and business connections when possible.

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There are a variety of types of venture capital firms, including institutional firms that seek out and provide financing for start-ups with the most promise. Private-sector institutional venture capital firms come in various types, including

n Venture capital limited partnerships. Set up by profes- sional venture capital firms that act as general partners for the entity to manage it and eventually liquidate the equity investments in it

n Financial venture capital firms. Subsidiaries of banks

n Corporate venture capital firms. Subsidiaries of non- financial corporations that specialize in start-up investments in the high-tech sector

The predominant type of venture capital firm is the limited partnership. The federal government, through the SBA, also promotes venture capital in the form of Small Business Investment Companies (SBIC). These are venture capital firms that are set up privately and licensed by the SBA to make equity investments and loans to entrepreneurs to encourage start-up activity and expansion. SBICs are able to access funds from the U.S. Treasury at very low rates compared to those offered in the private sector.

Angel venture capitalists (or angels) are individuals of high net worth who invest in start-ups and small companies. Historically, investors of this type have invested more in small and new firms than institutional venture capital firms have.

When venture capitalists invest, they look for companies that can provide them with the potential to earn very high returns. This makes sense given that they often invest in new, unproven firms that are often considered too risky by commercial banks and investment firms. In addition, venture capitalist firms look for companies that can provide them with an easy exit when the time comes to sell their holdings. As a result of these fairly stringent criteria, venture capital firms reject a high proportion of the funding requests they receive.

Equity Crowdfunding OPOs

Equity crowdfunding is a new fundraising method that small firms and start-ups can use. The practice began with the 2012 JOBS (Jumpstart Our Businesses) Act. Given that

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small businesses produce a large portion of the new jobs in the country, the U.S. Congress hoped to expand the sources of funding small businesses and start-ups could draw from. Equity crowdfunding uses a similar approach to the previously established rewards-based crowdfunding, which enables companies to raise money from investors over the Internet by offering them “rewards.” These rewards typically consist of certain company services or products.

Unlike rewards-based crowdfunding, equity crowdfunding allows companies to offer investors an equity stake in the company. Rules for raising funds via this method have been published by the Security and Exchange Commission in recent years. Some firms have already raised substantial funds under these new regulations.

Choosing to Go Public

Small and new firms that experience success can grow their businesses up to the point where more capital is needed than they’re able to raise on their own. If such a firm doesn’t want to secure additional funding from banks or venture capitalists, the firm may decide to enter into an initial public offering (IPO) of its stock. In such cases, a company allows some of its equity to become publicly traded on stock markets for the first time. There are approximately 200 new IPOs per year in the United States. However, this number fell dramatically in the wake of the 2008 financial crisis and still hasn’t recovered its pre-crisis level.

Equity crowdfunding offerings can be thought of as public offerings in the sense that shares are being sold to the public. As a result, such offerings are sometimes called OPOs (online public offerings). However, while these capital raises do allow companies to sell public shares over the Internet, they’re different from IPOs. For one thing, OPOs don’t automatically list the company’s shares on a publicly traded exchange.

A company raising money via an OPO can register to have its shares traded on a public exchange soon after its offering closes, but this isn’t a required component of the equity crowdfunding process. While the shares purchased in such an offering may

Lesson 3 215

be liquid right away if the offering is done via Title IV of the JOBS Act, unless the stock is listed on an exchange, there may be no active market where the shares can be traded.

When a company decides to go from a private to a public firm, the managers of the company must evaluate the benefits of taking such a step. One benefit of doing so is that it gives the company access to a larger pool of capital than was previously available. For companies traded publicly, the market provides a ready gauge of firm performance via the price of the company’s stock, which can help attract more investors and be used to motivate and compensate firm management. Going public also allows the company owners to diversify their personal wealth outside the firm so that they’re not overly invested in it.

IPOs (and to a lesser degree, OPOs) carry significant costs. Legal and accounting costs must be paid as do the under- writers of the offering, meaning that a fair portion of the funds raised during the process don’t actually go to the firm. The IPO process also typically requires that firm managers spend an extensive amount of time meeting with their investment bankers and potential investors. In addition, the required disclosures a public firm must make may provide a company’s competitors with valuable competitive information. Lastly, there’s reputational risk to a firm if the IPO doesn’t go well.

Two recently developed forms of going public are as follows:

1. Dutch auction IPO. In this form of IPO, a bidding process is used to find the highest price at which the company’s shares can be sold to the public. This process ensures that the price for an initial offering is established at a level at which all shares are sold at a price reflective of market demand. Such a method of allocation allows young and rapidly growing companies the chance to raise as much money as the market can bear. A disadvantage of the Dutch auction process is that if there’s insufficient demand for a company’s shares, it may not be able to raise all the funds it requires.

2. Direct IPO. This form of IPO is conducted via the direct issuance of stock to investors, with no investment bank involved as an intermediary. This can offer significant savings since average IPO underwriter commissions are 13 percent. Such IPOs are exempt from many SEC filing

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requirements and can be completed in a shorter time frame as well. One disadvantage of this process is that a company can raise only a limited amount of funds in 12 months. Additionally, prices are typically lower than if sold through a traditional IPO and shares usually aren’t freely tradeable, so no market price is established.

The Title IV Regulation A1 crowdfunded OPO process offers a compromise of sorts between a full IPO and a direct IPO in that shares are freely tradable once the offering closes. However, as mentioned previously, a company would have to take steps to list its shares on an exchange after the completion of its OPO, as this function isn’t included in the equity crowdfunding process itself. Because such an offering is performed over the Internet on a crowdfunding platform, fees will typically be much less than they would be for a traditional IPO. However, unlike an IPO, this form of OPO has a limit of $50 million as the maximum that can be raised in any one Regulation A1 offering.

Regulatory documentation requirements for Title III Regulation crowdfunded offerings are minimal compared to an IPO or a Title IV Regulation A1 offering. However, such offerings can raise a maximum of only $1 million and, as mentioned previously, shares in such offerings can’t be traded until 12 months have passed.

Public Firms’ Sources of Capital Public firms source the majority of their funding, both debt and equity, from public markets. When it comes to debt financing, there are two main types of debt used by such firms: commercial paper and corporate bonds.

Commercial Paper

Commercial paper is a form of unsecured debt consisting of a short-term promissory note issued by a public firm for the purpose of raising short-term cash. It’s often used as a means of financing working-capital requirements. The market for commercial paper is very large, among the largest of those for money market instruments, with $0.95 trillion outstanding as

Lesson 3 217

of 2013. One reason for its popularity is that firms with strong credit ratings can use commercial paper to borrow at a lower interest rate than a bank would offer.

Commercial paper is sold to investors in two ways: (1) directly from the issuer, using its sales force or (2) indirectly via a broker. If the latter method is used, the price to buyers is usually higher because underwriting costs are involved. Commercial paper is unsecured debt. Therefore, an issuer’s credit rating is very important to buyers. An issuer with a lower-than-prime credit rating may back its offering of commercial paper with a line of credit from a commercial bank to increase its marketability.

Long-Term Debt

Corporate bonds are long-term debt obligations traded in minimum denominations of $1,000. They’re issued by public corporations and usually pay interest on a semiannual basis. The initial sale of corporate bonds typically is performed via a public offering with an investment bank acting as underwriter or by private placement to a small group of investors.

The most common method of selling corporate bonds is to offer them publicly with the help of investment bankers. The investment bank will typically conduct such transactions through a firm commitment underwriting. This involves the bank guaranteeing the company selling the bonds a price for the bonds by purchasing the entire issue from the company at a discount from the par price. The investment bank will then try to resell the bonds at a higher price to investors. In such cases, the bank faces the risk that it won’t be able to resell the bonds at the desired price.

In a process known as a competitive sale, the company issuing the bonds accepts bids from a variety of underwriters and selects the highest bidder. This firm may then use a syndicate of other banks to sell the bonds to the public. A negotiated sale involves a single investment bank obtaining exclusive rights to sell a new issue of bonds via one-to-one negotiation. In such a scenario, the investment bank will provide origination and advisory services to the bond issuers.

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Corporate securities may also be offered via a best efforts underwriting process. In this case, an underwriter provides no guarantee of a firm price to the company selling the bonds, instead acting similarly to a distribution agent and receiving a fee. In this type of offering, the investment bank bears no risk related to mispricing the securities, which it seeks to sell at the highest price it can get on behalf of the issuing firm.

In private placements, a public firm, at times with the help of an investment bank, searches for a large institutional buyer or group of buyers to buy the entire issue. Private placements aren’t required to seek registration with the SEC but must be sold to financially sophisticated investors. Bonds placed privately have historically been highly illiquid securities. However, in 1990 the SEC amended Regulation 144A to allow large investors to trade such securities among themselves. This enabled Rule 144A private placements to be underwritten via the firm commitment method.

Equity Financing Issuing corporate stock or equity is a major source of funds for public companies. Markets in which corporations raise funds via new stock issues are known as primary markets. A sale in a primary market could be an IPO by a firm going public or a seasoned offering from a firm that already has its shares trading in secondary markets. In either case, the proceeds of the sale go to the issuer, and the investors in the primary market get the securities. The majority of primary market securities transactions are sold through investment banks.

Investment banks can engage in primary sales of stocks via a firm commitment underwriting or using the best efforts process. When using a firm commitment, the investment bank buys stock from the issuer for a specific price (known as the bid price or net proceeds) and then resells the stock to investors at higher prices (known as the offer price or gross proceeds). The difference between gross proceeds and net proceeds is referred to as the underwriter’s spread and is used to compensate the investment bank for its expenses and risk in conducting the offering.

Lesson 3 219

In many cases, an investment bank will bring together other investment banks to assist in the process of selling a new issue. A group of sellers of this type is known as a syndicate. The lead bank in a syndicate that conducts negotiations with the issuer is called the originating house. When the terms of an issue have been decided upon, each member of the syndicate is allotted a certain number of shares to sell. A syndicate allows investment banks to spread the risk involved in selling shares across a number of banks.

Companies may issue stock initially by offering shares to the general public. New stock can also be issued by way of a private placement. Initial sales of stock require SEC approval as outlined in the Securities Exchange Act of 1934. Registering a stock for sale can require a significant amount of time. Your textbook lists the information that must be included in a registration statement, including

n Information about the issuing firm’s business

n Key provisions and features of the security to be issued

n Risks involved with the security

n The management’s background

The registration statement is designed to provide full disclosure about the company going public and the securities that are being offered. In addition to the registration statement, a preliminary version of the public offering prospectus, known as the red herring prospectus, must be prepared. This document is similar to the registration statement but is given to potential stock buyers. When the SEC approves registration of the issue, it’s replaced by the final prospectus. When the SEC registers the issue, the issuer and its investment bankers set the price to sell shares and send the official prospectus for the issue to all prospective buyers. The prospectus is typically issued on the day after SEC registration. Once it’s issued, the firm can begin selling shares.

As a means of reducing the time and costs involved in registration, the SEC originated a rule in 1982 that allowed for shelf registration, enabling a firm planning to offer multiple issues of stock across a two-year time period to submit a single registration statement (known as a master

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registration statement) that summarizes the firm’s financing plans for those two years. The shares are “shelved” over this time period until the company is ready to issue them. At that point, it files a short-form statement with the SEC and then prices and sells the shares. Once the SEC gives it approval, the sales can usually be priced and offered within a day or two. This allows a firm to quickly raise money if it believes the time is right without having to wait for the full registration process to take place.

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Self-Check 19

Answer the following questions using this study guide and your textbook. Answers will vary in length.

1. What’s a loan commitment agreement?

2. How are the rates for a variable rate loan set?

3. How does the U.S. Small Business Association (SBA) help small and new firms that are seeking financing?

4. How do venture capital firms typically help finance small companies and start-ups?

5. What are angels?

6. Why do successful new and small firms decide to go public?

7. What’s an OPO?

8. What does a firm commitment underwriting of bonds entail?

9. What’s included in a registration statement for an IPO?

10. What are the two types of OPOs?

Complete the following problems at the end of Chapter 18.

11. Problem 18-2

12. Problem 18-4

13. Problem 18-6

14. Problem 18-8

Check your answers with those on page 246.

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NOTES

A n

s w

e r

s A

n s

w e

r s

223

Self-Check 1

1. It helps money flow from individuals who want to improve their financial future to businesses interested in increasing the scale or scope of their business activities.

2. Investors experience risk in relation to the return of their capital. Companies experience risk when it comes to their ability to fund and operate their business projects.

3. Stocks, bonds, money market instruments, real estate, and derivative securities

4. They use it to determine what should happen in the present and the future with the company’s money.

5. Such organizations are subject to unlimited liability for the company’s actions. This places the owners’ personal assets at risk as well as those belonging to the company.

6. Smith believed the invisible hand of the market, operating via competition and the free market, was likely to favor over the long term those activities that were the most beneficial for society.

7. Finance professionals typically manage other people’s money. Doing so creates a fiduciary relationship that allows them to make decisions that either favor the client or benefit themselves, sometimes at the expense of the person or entity they’re managing money for. Ethics are useful to help such professionals determine which decisions are most appropriate in light of their fiduciary duties.

8. Corporate governance refers to the practice of monitoring company managers and aligning their incentives with shareholder goals.

9. The firm can ignore the problem if the amount of money involved is negligible; the firm can monitor the actions of managers, although it should be wary of performing an excessive level of monitoring, which can be counterproductive; it can take steps to make the managers owners in the business to align their interests with the well-being of the company.

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10. Falling home prices and defaults by subprime mortgage borrowers started to affect the whole mortgage industry and other parts of the economy. The collapse of the housing bubble caused severe damage to financial institutions, raising questions about the solvency of many of them. This led to a decrease in the availability of credit in the economy, leading to a full-blown crisis and economic downturn.

11. Income earned by a corporation is taxed first at the corporate level, then taxed again at the individual level when paid out to investors in the form of dividends.

12. Income the organization earns isn’t taxed at the organization level. Instead, it’s passed through to be taxed at the individual level as income to the owners of the organization.

13. Borrowing money to buy a car; refinancing a home mort- gage at a lower rate; making credit card or student loan payments; saving for retirement

Self-Check 2

1. To make it easier for trade to flow between countries by measures such as eliminating trade restrictions and tariffs

2. Import/export; Partnering: sales subsidiary, licensing/ franchising, joint venture; Direct ownership. As a firm moves toward more significant participation in international business activities, it will typically put greater capital at risk for the chance to earn greater rewards.

3. They manufacture products in low-labor-cost countries because it’s less expensive to do so. In some cases, they manufacture products in the countries where they expect to sell the goods because doing so is more efficient.

4. They look for mispricings between currency direct quotes and cross rates that they can profit from.

5. They act to minimize the amount of foreign currency their firm needs to exchange; they take steps to lock in exchange rates by engaging in currency trades that will take place in the future using forward rates; they use financial derivatives such as futures contracts, options, and currency swaps to hedge.

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6. It suggests that forward currency rate will be at a level in which the total return realized (interest rate and changes in interest rate) will be identical between the two countries whose currencies are being compared.

7. Transaction costs, including shipping, storage, insurance, and so on can cause prices in different areas to diverge from the law of one price. Also, for products that aren’t easy to transport, the law of one price may not apply.

8. Government seizure of a company’s assets in the country in question; expropriation with minimal compensation; enacting new taxation; placing limits on or prohibiting the conversion of local currency to the home currency of the MNC

9. By acquiring the capital from inside the country to lessen the necessity of currency exchange. They can also buy country-risk insurance from either private companies or the Overseas Private Investment Corporation sponsored by the U.S. government.

10. A high discount rate should be applied to account for the additional exchange and political risk that the project is subject to.

11. a. 1 Korean won 5 $0.0009, $1 5 1 won / $0.0009 5 1,111.11 won

b. 1 Malaysian ringgit 5 $0.3238, $1 5 1 ringgit / $0.3238 5 3.088 ringgit

c. 1 Thai baht 5 $0.0331, $1 5 1 baht / $0.0331 5 30.211 baht

12. A financial manager has determined that the appropriate discount rate for a foreign project is 12%. However, that discount rate applies in the United States using dollars. What discount rate should be used in the foreign country using the foreign currency? The inflation rate in the United States and in the foreign country is expected to be 3% and 6%, respectively. The discount rate in the foreign country should be 12% 1 (6% − 3%) 5 15%.

Self-Check Answers226

Self-Check 3

1. An entirely new firm is created, and the bidder and target firms are absorbed into this new entity and no longer exist as separate entities.

2. The government regulates them for potential negative effects on competition. By decreasing the number of firms competing in an industry, such mergers can have the effect of encouraging cartel-like behavior in an attempt to receive monopoly profits.

3. Revenue enhancement; cost reduction; tax considerations; lower cost of capital

4. Economies of scale focus on the ability of larger firms to establish a lower cost of production than smaller firms, especially in industries where significant resources are required to develop and manufacture products. Economies of scope relate to the interrelationships different products can have and the combination of factors involved in their production. Economies of scope apply to the ability of merged firms to benefit from synergistic savings via the joint use of inputs in producing multiple products.

5. They do so by bringing superior management skills or other difficult-to-measure factors to the merged company.

6. The HHI is used by the Department of Justice to evaluate whether the post-merger level of the index indicates that the merger could result in excessive concentration in an industry.

7. Tax gains from net operations losses allow profitable firms in high tax brackets to take advantage of the losses of the unprofitable firm to offset future profits. Tax gains from unused debt capacity can allow for taking on greater debt and benefitting from the tax deductibility of this debt. Tax gains from surplus fund apply if the firm uses surplus cash to make acquisitions and avoid taxation as a result.

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8. Economic failure occurs when the return received on a firm’s assets is lower than the cost the firm pays for capital. Technical insolvency occurs when a company’s operating cash flows are insufficient to meet its liabilities as they come due.

9. Restructuring a firm’s debt agreements occurs if the distress is thought to be temporary. This involves an agreement between the firm and its creditors for a vol- untary settlement or workout arrangement regarding debt restructuring. Informal liquidation of a firm’s assets occurs if the firm’s creditors decide after analyzing the firm that liquidation is the only acceptable alternative. Liquidation terminates the firm as a going concern and the proceeds of the liquidation are sent to the firm’s creditors.

10. Chapter 7 and Chapter 11 of the act. In Chapter 7, a firm is liquidated and the proceeds disbursed to its creditors. If any funds remain after that, they go to its shareholders. Chapter 11 is used to reorganize a firm while making some form of repayment to the creditors of the firm.

11. Linear discriminant models sort firms into low or high bankruptcy-risk categories on the basis of their observed financial characteristics. Linear probability and logit models generate a value related to a firm’s expected probability of bankruptcy. They use a firm’s past repayment performance to gauge the probability of default (PD) in the future.

12. The calculation and interpretation of the Altman’s Z-score for this firm is

Z 5 1.2(0.27) 1 1.4(0.37) 1 3.3(0.44) 1 0.6(1.25) 1 1.0(2.75) 5 5.79

According to the Altman’s Z-score, this firm should be placed in the low bankruptcy-risk class.

13. Calculate the pre- and postmerger HHI and the change in the HHI resulting from the merger. According to Department of Justice guidelines, is this merger likely to be challenged?

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The premerger HHI for the market is

HHI 5 (35)2 1 (41)2 1 (24)2 5 1,225 1 1,681 1 576 5 3,482

Thus, the market is highly concentrated according to the Department of Justice guidelines. The postmerger HHI would be

HHI 5 (76)2 1 (24)2 5 5,776 1 576 5 6,352

Thus, the increase or change in the HHI (ΔHHI) post- merger is

ΔHHI 5 6,352 – 3,482 5 2,870

Since the increase is 2,870 points, which is more than the 200-point benchmark defined in the Department of Justice guidelines, the market is heavily concentrated and the merger could be challenged.

14. Calculation of the firm’s expected probability of default, or bankruptcy, is

PDi 5 0.02 (2.75) – 0.01 (1.8) 5 0.0370, or 3.70 percent

Self-Check 4

1. Assets 5 Liabilities 1 Equity

2. Current debt consists of firm obligations due within one year. Long-term debt includes long-term loans and bonds with maturities of more than one year.

3. The time and effort needed to convert assets to cash

4. Net working capital 5 Current assets – Current liabilities

5. Minimal levels of liquidity can increase a firm’s chances of experiencing financial distress.

6. Financial leverage describes the extent to which a company uses debt to finance its activities or projects.

7. Book values are computed using the price at which a company bought an asset. Market forces and inflation can combine to make these values significantly diverge from the original value at purchase over time.

8. Earnings before interest, tax, depreciation, and amortization

Self-Check Answers 229

9. Interest paid on debt is tax deductible, while dividends paid to shareholders are not.

10. Recall the balance sheet identity in Equation 2-1: Assets 5 Liabilities 1 Equity. Rearranging this equation: Equity 5 Assets – Liabilities. Thus, the balance sheets would appear as follows:

11. Use the setup of an income statement in Table 2.2:

Thus,

Earnings per share (EPS) 5 5 $4.30 per share

12. Net change in cash and marketable securities 5 $1,742,000 – $1,615,000 5 $127,000

EBIT $773,500

Interest expense -100,000

EBT $673,500

Taxes -243,500

Net income $430,000

Cash flows from operating activities 5 $10,371,000

Cash flows from investing activities 5 –4,364,000

Cash flows from financing activities 5 –5,880,000

Net change in cash and marketable securities 5 $127,000

Book Value Book Value

Assets Liabilities and Equity

Current assets $435,000 Current liabilities $416,600

Fixed assets 550,800 Long-term debt 341,500

Stockholders’ equity 254,900

Total $985,800 Total $1,013,000

$430 000 100 000

, , shares

Self-Check Answers230

Self-Check 5

1. The relationship between a firm’s current (liquid) assets and its current liabilities

2. Dividing sales or cost of goods sold by inventory

3. Average collection period 5

5

4. The firm may be abusing the credit terms extended to it by its raw materials suppliers, who may at some point revoke the firm’s credit as a result, losing it a source of free financing.

5. Because the newer fixed assets will be listed at the higher market prices they were purchased for, skewing the ratio lower for such firms

6. Total assets divided by sales

7. They affect the firm’s viability as a long-term entity.

8. Leverage magnifies the return to a firm’s stockholders and also increases its potential for financial distress and bankruptcy.

9. They measure what investors think of the company’s future performance and risk.

10. The profit margin; the total asset turnover; financial leverage; profit retention

11. 2015 2014

Current ratio 5 5 1.96 times 5 1.94 times

Quick ratio (acid-test ratio) 5 5 0.91 times 5 0.87 times

Cash ratio5 5 0.17m 5 0.14m

Accounts receivable 365 Credit sales

3 365 days Accounts receivable turnover

$ $

383 195

m m

$ $

340 175

m m

$ $ $

383 206 195 − m

m $ $

$ 340 187

175 − m

m

$ $

34 195

m m

$ $

25 175

m m

Self-Check Answers 231

12.

13. Debt-to-equity 5 5 1.75 5 5 >

Total equity 5 5 14.29m

14. ROE 5 0.18 5 0.1875 3 Total asset turnover 3 2 5 > Total asset turnover 5 0.18/(0.1875 3 2) 5 0.48

Capital intensity ratio 5 1/0.48 times 5 2.08 times

15. ROA 5 0.075 5 (0.12 3 $25m) / Total assets) 5 > Total assets 5 (0.12 3 $25m) / 0.075 5 $40m

Self-Check 6

1. Size of the cash flows; time between the cash flows; rate of return you can earn

2. Value in 1 year 5 Today’s cash flow 1 Interest earned

3. Simple interest, as the 5 percent interest in year two wasn’t compounded by also applying it to the $5 interest earned in year one as well as the original deposit

4. To move cash flows earlier in time

5. 72 is divided by the interest rate on the investment.

6. Generally, only a higher positive return can offset a stated negative return.

7. The next period’s value is divided by one period of discounting.

8. It gets larger.

9. It’s the most powerful force in the universe.

10. They expect them to more than cover the interest payments and repay the loan.

Days’ sales in inventory 5 5 89 days

Inventory turnover 5 5 4.11 times$ $ .

23 5 6

m m

Total debt Total equity

$25m Total equity

$25 1 75

m .

$ . $

5 6 365 23 m

m 3

Self-Check Answers232

11. FVN 5 PV 3 (1 1 i) N

FV1 5 $400 3 (1 1 0.09) 1

5 $400 3 1.09

5 $436

Or N 51, i 5 9, PV 5 −400, PMT 5 0, CPT FV 5 436

12. FVN 5 PV 3 (1 1 i) N

FV8 5 $150 3 (1 1 0.08) 11

5 $150 3 2.3316

5 $349.74

Or N 5 11, i 5 8, PV 5 −150, PMT 5 0, CPT FV 5 349.745

13. PV 5 FV / (1 1 i)N

PV 5 $1,500 / (1 1 0.08)9

5 $1,500 / 1.999005

5 $750.37

Or N 5 9, i 5 8, PMT 5 0, FV 5 −1500, CPT PV 5 750.37

14. PV 5 FV / [(1 1 i) (1 1 j) ]

PV 5 $5,000 / [(1 1 0.08) 3 (1 1 0.07)]

5 $5,000 / [1.08 3 1.07]

5 $5,000 / 1.15560

5 $4,326.76

15. N 5 72 / 12 5 6.00 percent

Self-Check 7

1. Level sets of frequent cash flows

2. The future value of an annuity

3. Compute the future value of each one separately and then add them together.

4. Evaluating loans, such as car and mortgage loans

5. So that the amount borrowed (the present value) is repaid through level payments made every period (the annuity)

Self-Check Answers 233

6. Because payments on these annuities are perpetual

7. At the beginning of each period

8. The end value of such a deposit will be larger if it’s compounded semiannually due to more frequent compounding.

9. By showing the loan’s principal balance at the beginning of the month

10. The amount of interest payable is computed at the beginning of the loan and is then added to the principal of the loan.

11. Using Equation 5-1:

FV7 5 $2,000 3 (1 1 0.08) 6 1 $2,500 3 (1 1 0.08)3

5 $3,173.75 1 $3,149.28 5 $6,323.03

Or N 5 6, i 5 8, PV 5 22000, PMT 5 0, CPT FV 5 3,173.75 and N 5 3, 5 8, PV 5 22500, PMT 5 0, CPT FV 5 3,149.28, then $3,173.75 1 $3,149.28 5 $6,323.03

12. Using Equation 5-1:

FVA6 5 $700 3 5 $700 3 7.7156 5 $5,400.93

Or N 5 6, i 5 10, PV 5 0, PMT 5 –700, CPT FV 5 5,400.93

13. Using Equation 5-3:

PV 5 $2,000 4 (1 1 0.08)1 1 $2,500 4 (1 1 0.08)4

5 $1,851.85 1 $1,837.57 5 $3,689.42

Or N 5 1, i 5 8, PMT 5 0, FV 5 22000, CPT PV 5 1,851.85 and N 5 4, i 5 8, PV 5 22500, PMT 5 0, CPT FV 5 1,837.57, then $1,851.85 1 $1,837.57 5 $3689.42

14. Using Equation 5-4:

PVA6 5 $700 3 5 $700 3 4.355261 5 $3,048.68

Or N 5 4, i 5 10, PMT 5 −700, FV 5 0, CPT PV 5 3,048.68

15. Using Equation 5-7:

PVA6 due 5 $8,500 3 (1 1 0.095) 5 $9,307.50

(1 0.10)61 21 0 10.

1 1 1 0.10 0.10

62 1

Self-Check Answers234

Self-Check 8

1. Primary markets provide a forum for demanders of funds to raise funds by issuing new financial instruments, while secondary markets provide a forum for the trading of financial instruments that have been issued in primary markets.

2. Debt securities or instruments with maturities of one year or less, including treasury bills, federal funds and repurchase agreements, commercial paper, negotiable certificates of deposit, and banker’s acceptances

3. U.S. Treasury notes and bonds, U.S. government agency bonds, state and local government bonds, mortgages and mortgage-backed securities, corporate bonds, corporate stocks

4. A financial security that’s linked to another, underlying security, such as a stock traded in capital markets or British pounds traded in foreign exchange (forex) markets

5. They channel funds from those with surplus funds (suppliers of funds) to those with shortages of funds (demanders of funds).

6. It removed risk from the balance sheets of financial institutions, giving them less incentive to monitor and manage the risk associated with various financial instruments, such as mortgage bonds.

7. Inflation, the real risk-free rate, default risk, liquidity risk, special provisions regarding the use of funds raised by a particular security issuer, the security’s term to maturity

8. Society’s relative time preference to consume today instead of tomorrow

9. The unbiased expectations theory; the liquidity premium theory; the market segmentation theory

10. An expected or implied rate on a short-term security that will originate at some time in the future

11. a. Expected IP 5 i – RFR 5 1.25% – 0.75% 5 0.50%

b. i*j 5 0.50% 1 0.75% 1 1.15% 1.50% 1 1.75% 5 4.65%

Self-Check Answers 235

12. 1R3 5 [(1 1 0.0215)(1 1 0.0265)(1 1 0.0305)] 1/3 – 1 5 2.62%

13. 2f15 [(1 1 1R2) 2/(1 1 1R1)] – 1 5 [(1 1 0.0135)2/(1 1

0.0075)] – 1 5 1.95%

3f15 [(1 1 1R3) 3/(1 1 1R2)2] – 1 5 [(1 1 0.0175)3/(1 1

0.0135)2] – 1 5 2.55%

4f15 [(1 1 1R4) 4/(1 1 1R3)3] – 1 5 [(1 1 0.0190)4/(1 1

0.0175)3] – 1 5 2.35%

Self-Check 9

1. The date the principal will be repaid (maturity date); the par value, which is the face value of each bond, (this is the principal loan amount that must be repaid by the borrower); the coupon (interest) rate; a description of any property that will be pledged as collateral; actions that the bondholder can take if the issuer defaults on a payment of the interest or principal

2. Interest payments also change.

3. The amount of uncertainty about the company’s ability to make payments on the bond; the term of the loan; the level of interest rates in the overall economy at the time

4. Present value of interest payments 1 Present value of par value 5 Present value of bond

5. They fall.

6. The company’s profitability; growth prospects for the future; current market interest rates; conditions in the overall stock market

7. Expected values, not real ones

8. Unlike common stockholders, preferred stockholders should expect a return from dividend payments only.

9. Firms that grow at such a high rate that the constant-growth rate can’t be used to forecast their value.

Self-Check Answers236

10. 3.5% coupon corporate bond (paid semiannually):

0.5 3 0.035 3 $1,000 5 $17.50

4.25% coupon Treasury note: 0.5 3 0.0425 3 $1,000 5 $21.25

Corporate zero coupon bond maturing in 10 years: 0.00 3 $1,000 5 $0

11. Using semiannual compounding:

P 5 5 5 $471.01

Or N 5 40, I 5 1.9, PMT 5 0, FV 5 −1000, CPT PV 5 471.01

12. Use Equation 8-6, noting that for preferred stock, the growth rate g equals zero:

Constant growth model 5 P0 5 5 5 $52.99

13. Use Equation 8-10:

Pn 5 (P/E)n 3 En 5 13.81 3 $3.53 5 $48.75

Self-Check 10

1. Ending value – Beginning value 1 Income divided by Beginning value 3 100% 5 Percentage return

2. A statistical return volatility measure that measures the total risk of a security or portfolio

3. A common relative measure of the trade-off between risk and return; Standard deviation divided by Average return 5 Coefficient of variation

4. Firm-specific risk 1 Market risk 5 Total risk

5. How risk reduction occurs when securities are combined

6. When the stocks are subject to different kinds of events so that their returns differ over time

7. By calculating the returns of the securities in the portfolio and the proportion of the portfolio that’s invested in each security

8. The degree to which two securities move together

PV FV

i N N= +( )1

D g i g

0 11 2

( ) $3 55 0 067 0

. . 2

$1 000

1 038 2

40 ,

.+ 

 

Self-Check Answers 237

9. A portfolio with the highest return possible for each risk level

10. Because you reduce firm-specific risk by the process of combining stocks in a portfolio

11. Dollar return 5 Ending value 5 Beginning value 1 Income

5 ( $106.69 3 200) – ($103.39 3 200) 1 ($0.35 3 200) 5 $730

Percentage return 5 $730 / ($103.39 3 200) 5 3.53%

12. Portfolio return 5 (0.30 3 –1.34%) 1 (0.25 3 7.96%) 1 (0.45 3 0.88%) 5 1.98%

13. Standard deviation 5

5 4.05%

Self-Check 11

1. That the economy will be good in 6 of the next 10 years

2. Required return 5 Risk-free rate 1 Risk premium

3. Borrowing money to invest

4. The movement between a stock or portfolio and the market portfolio

5. How required return relates to risk at any time, everything else being equal

6. It relates the return you should require to take on various levels of market risk

7. Many buyers and sellers; no prohibitively high barriers to entry; free and readily available information accessible by all participants; low trading or transaction costs

8. Security prices fully reflect all available information.

9. A set of stock prices go unnaturally high and subsequently crash down.

10. Required return 5

11. Expected return 5 (0.3 3 40%) 1 (0.4 3 10%) 1 (0.3 3 2 25%) 5 8.5%

D P g

1

0 +

4 11 2 548 3 62 2 906 1 68 2 548 9 25 2 52 2 2. % . % . % . % . % . % . % .2 2 2 2 2( ) + ( ) + ( ) + 448 5 1

2%( ) 2

Self-Check Answers238

12. Hastings’ required return 5 4% 1 0.65 3 (11% 2 4%) 5 8.55%

13. New portfolio beta 5 (0.85 3 1.1) 1 (0.15 3 0.5) 5 1.01

14. Use equation 10.6:

Self-Check 12

1. The weighted-average cost of capital, which measures the average cost per dollar of capital raised

2. In situations in which you don’t have sufficient historic observations to estimate beta, or when you suspect that the past level of the stock’s systemic risk might not be a good indicator of the future

3. The weighted average of the marginal tax rates that would have been paid on the taxable income shielded by the interest deduction

4. You calculate the percentages of the funding that originate from equity, preferred stock, and debt, respectively.

5. Other companies engaged only in a proposed line of business a company intends to start a project in whose betas are used as proxies to estimate the project’s risk

6. They can achieve many of their project-specific WACC calculations with much less time and effort.

7. Computing the average beta per division, using these figures in the CAPM formula to determine iE for each division, and then using divisional estimates of iE to build divisional WACCs

8. The costs of printing new stock or bond certificates, commissions to the underwriters in an offering, government registration fees, and other associated costs

9. Adjust the issue price of new securities by subtracting flotation cost, F, to reflect the net security price. Next, use this net price to calculate the component cost of capital.

i D P

g= + = + =1 0

0 26 57 50

0 095 9 95$ . $ .

. . %

Self-Check Answers 239

10. First, you estimate the before-tax cost of debt, iD, and then adjust this figure to convert it to the after-tax rate of return.

11. Using Equation 11-2:

iE 5 Rf 1 β[RM – Rf]

5 .062 1 0.9[.12 – .062]

5 0.1142, or 11.42%

12. Solving Equation 11-5 for iD:

iD 5 0.052787, or 5.2787% on a semiannual basis

Since the cost of debt is normally quoted on a nominal annual basis, multiply this semiannual rate by 2 to get a quoted component cost of 5.2787% 3 2 5 10.56%.

13. The interest payments on the bonds would total 25,000 3 $1,000 3 0.08 5 $2m, resulting in EBT of $11m – $2m 5 $9m.

Since as taxable income falls from $11m to $9m, the firm is in the 35% tax bracket (from $11m down to $10m) and in the 34% tax bracket (from $10m down to $9m), the weighted average applicable tax rate will be equal to

14. Using Equation 11-4:

Self-Check 13

1. The process of estimating expected future cash flows of a project using only the relevant parts of the balance sheet and income statements

2. The cash flows that are expected to occur throughout the entire firm as a new project comes on board

Solve $ , $ ( ) $ ,1 040 55 1 1

1 1 000 1

60

60= −

+ 



   





   

+ +( )



 3 i

i i D

D D



  



 

  

for iD

TC = −

   + −

  



 



  =

$ $ $

% $ $ $

% .11 10 2

35 10 9 2

34 0 34m m m

m m m

3 3 55 34 50, . %or

i D P

orP = = =1 0

11 96

0 1146 11 46$ $

. , . %

Self-Check Answers240

3. An expense that a firm has already paid or is obligated to be paid by a firm in the future, whether or not a particular project is undertaken

4. Its cost; amounts paid for items such as sales tax; freight charges; installation and testing fees

5. When calculating the cash flows for a single project for a firm, it’s assumed that any loss by the project in a specific period can be applied against assumed before- tax profits made by the rest of the firm in that period.

6. Such property is assumed to be placed in service at the midpoint of that period.

7. MACRS allows for the accelerated depreciation of an asset’s cost by expensing more of that cost earlier in the asset’s life, while straight-line allows for level depreciation over an asset’s lifespan.

8. Choosing between two different assets that can be used for the same purpose

9. Adjusting the project’s initial cash flow so that it will reflect the flotation costs of raising capital for the project as well as the necessary investment in assets

10. A section of the tax code by which by the IRS allows most businesses to immediately expense up to $500,000 of qualified property placed in service each year

Self-Check 14

1. NPV (net present value); IRR (internal rate of return); PR (payback); DPB (discounted payback); MIRR (modified internal rate of return); PI (profitability index)

2. Identify how to calculate a decision statistic; decide on an appropriate benchmark for comparing the calculated statistic; define what relationship between the two will dictate project acceptance.

3. By keeping a running subtotal of the cumulative sum of the flows up to the point that this sum is exactly offset by the initial investment

Self-Check Answers 241

4. That the calculated DPB statistic will always be larger than the “regular” PB statistic because DPB includes the interest you must pay until you reach the benchmark

5. By calculating the difference between the present values of a project’s cash inflows and outflows

6. It works equally well for independent projects and for choosing among mutually exclusive projects.

7. If project cash flows aren’t normal or if you’re using it to decide among mutually exclusive projects

8. IRR assumes that any cash inflows will be reinvested in another project with the same earning power as the first project, while NPV assumes that the inflows will be reinvested at the cost of capital.

9. Problems can arise if the cash flows from the projects exhibit differences in scale or timing.

10. To demonstrate this, we will combine a few observations from earlier on with some new information as follows: To demonstrate this, we will combine a few observations from earlier on with some new information as follows: By simply dividing the future cash flows by the project’s initial investment

11. Using Equation 13-2:

The project should be accepted.

12. Solving Equation 13-3 for N:

This project will achieve payback at time 2 1 $170/$520 5 2.33 years.

13. The NPV for this project is negative, so discounted payback never occurs.

NPV = − + + + +$ , $ , .

$ , .

$ , .

$ , .

10 000 5 000 1 06

6 000 1 06

6 000 1 06

5 000 1 01 2 3 66

10 000 1 06

1 582 564 5+ = 2$ ,

. $ , .

Year 0 1 2 3 4 5

Cash flow -$1,000 $350 $480 $520 $300 $100

Cumulative cash flow

-$1,000 -$650 -$170 $350

Self-Check Answers242

14. The IRR for this project will be the solution to Equation 13-7:

IRR 5 0.21%

Since IRR < i, this project should be rejected.

15. Using Equation 13-10:

Self-Check 15

1. The missed opportunity of using an asset already in use by the firm, or a person already employed by the firm, in a new project

2. Operating cycle – Average payment period 5 Cash cycle

3. They can manage their need for current assets; they can seek to obtain as many current liabilities as economically feasible to fund current assets that they don’t need.

4. The opportunity costs associated with having capital tied up in current assets instead of more productive fixed assets; explicit costs necessary to maintain the value of the current assets

5. A decision to finance the troughs and valleys of asset demand with long-term debt and equity

6. Commercial paper; banker’s acceptances

7. Transaction facilitation; compensating balances; investment opportunities

8. To minimize the sum of the opportunity costs associated with holding cash and the trading costs associated with converting other assets to cash

9. It assumes that daily net cash flows are normally distributed.

0 11000 1

3 350 1

4 180 1

1520 1

2 0 1 2 3= +

+ +

+ +

+ +

+2$ , $ , $ , $ , $ IRR IRR IRR IRR

,,000 1 4+ IRR

NPV = − + + + + +$ , $ .

$ .

$ .

$ .

$ .

1 000 350 1 08

480 1 08

650 1 08

300 1 08

100 11 2 3 4 008

2 540 15

2 540 15 1 000 1 000

3 54

5 =

= + =

$ , .

$ , . $ , $ ,

.PI

Self-Check Answers 243

10. The trade-off of the opportunity cost of lost sales against the carrying costs associated with funding the accounts receivable plus the expected costs of default on the accounts receivable

11. NWC 5 CA – CL 5 ($105,000 1 $203,000 1 $319,000) – ($220,000 1 $65,000 1 $75,000) 5 $267,000.

12. Using Equation 14-2:

Cash cycle 5 Operating cycle – Average payment period

Operating cycle – Cash cycle 5 Average payment period

77 days – 45 days 5 32 days

13. Using Equation 14-2:

Cash cycle 5 Operating cycle – Average payment period

Operating cycle – Cash cycle 5 Average payment period

77 days – 45 days 5 32 days

Payables turnover will be 365 days / 23 days 5 15.87 times

Self-Check 16

1. The process of determining a firm’s objectives over the next year or more, how the firm is going to meet those objectives, and how it will measure whether it meets them or not

2. To assume that they’ll be equal to those of the latest observed period

3. By dividing each month’s actual sales by a seasonal index that’s calculated by dividing the month’s sales by a moving average around that month of annual sales

4. AFN 5 Necessary increase in assets – Spontaneous increase in liabilities – Projected increase in retained earnings

5. Because you can’t buy just a part of them to meet demand. You have to buy the whole asset even if there isn’t sufficient demand at present for its production capacity.

Self-Check Answers244

6. Circular references, where AFN is a function of retained earnings, but where retained earnings is also a function of AFN

7. To use spreadsheet programs such as Microsoft Excel

8. Such ratios can guide you in changing relevant balance sheet or income statement items by highlighting particular underlying relationships between those items.

9. Dividing relevant assets by current sales

10. The efficiency of a forecast developed using one set of historic, observed data on another set that’s held “out of sample” during the formulation of the forecast

11. The latest period observed is 2010, so the naïve estimate for 2014 would be $2,600,000.

12. The average over the historic observation is

5 $2,650,000

13. The necessary increase in assets will be

Necessary increase in assets 5 3 ∆S

5 3 ($8,000,000 – $7,000,000)

5 $1,000,000

The spontaneous increase in liabilities will be

Spontaneous increase in liabilities 5 3 ∆S

5 3 ($8,000,000 – $7,000,000)

5 $357,143

The projected increase in retained earnings 5 M 3 S1 3 RR 5 0.27 3 $8,000,000 3 0.20 5 $432,000

So AFN will be 5 $1,000,000 – $357,143 – $432,000 5 $210,857

Self-Check 17

1. To immediately sell additional claims of one type of capital and use the proceeds to retire other kinds of claims

$ , , $ , , $ , , $ , , $ , ,2 500 000 3 750 000 2 400 000 2 000 000 2 600 000 5

+ + + +

A S

*

0$ , , $ , , 7 000 000 7 000 000

L S

*

0 $ , , $ , ,

2 500 000 7 000 000

Self-Check Answers 245

2. How quickly the firm is growing; how much the firm faces in flotation costs under the active management approach; how strongly and how quickly the firm wishes to change the capital structure

3. No taxes; no chance of bankruptcy; perfectly efficient markets; symmetric information sets for all participants

4. With a well-functioning capital market, the firm’s capital budgeting decisions are separate from its capital structure decisions.

5. They expect a disproportionately large share of the expected return layer.

6. The value lies in examining what happens to the propositions contained in the theorem when the unrealistic assumptions behind them are relaxed and moved closer to what’s seen in real life.

7. Chapter 7, which involves a business liquidation, and Chapter 11, which involves an attempt to allow a firm to reorganize its operations under court supervision

8. Customers may be leery of buying from them; suppliers will be concerned about selling to the company, particularly on credit; other firms will be less likely to offer the firm valuable partnering opportunities; the firm’s better employees may decide to look elsewhere for jobs, causing a loss of efficiency in the firm’s operations.

9. The tendency on the part of stockholders in leveraged firms in which the equity is close to worthless to invest in arguably bad projects because if investments in safe projects were made, the resulting increase would go to the bondholders of the firm

10. Firms facing relatively high tax rates should make more use of debt; firms with stable predictable income streams should be able to make more use of debt than would otherwise be the case.

11.

12.

E E D+

= +

=4 000 000 55 4 000 000 55 17 000 1 000 0 94

93 23, , $ , , $ , $ , .

. %3 3 3 3

D E D+

= +

=17 000 1 000 0 94 4 000 000 55 17 000 1 000 0 94

6, $ , . , , $ , $ , .

.3 3 3 3 3

777%

Self-Check Answers246

The expected EPS will be equal to (0.45 3 –$0.17) 1 (0.55 3 $0.92) 5 $0.43

Using the capital structure weights formulas from Chapter 11, the current capital weights are

The current D/E ratio is 0.4882 / 0.5118 5 0.9538, so Lil John would be contemplating increasing the D/E ratio. To do so, they would have to change their debt ratio to 1.4 / 2.4 5 0.5833, which would require issuing (0.5833 – 0.4882) 3 [($2,000,000 3 $27) 1 (50,000 3 $1,000 3 1.03)] 5 $10,033,050 of new debt and using the proceeds to repurchase stock. Using these numbers, 0.5833 – 0.4882 5 0.0951 3 ($105,500,000) 5 $10,033,050

13. Interest in all states will be equal to 0.12 3 (0.40 3 $150,000,000) 5 $7,200,000, and the number of shares outstanding will be equal to (0.60 3 $150,000,000)/$7 5 12,857,143. The EPS in each state of nature will be as shown:

EPS WITH 40% DEBT

STATE PESSIMISTIC OPTIMISTIC

EBIT $ 5,000,000 $19,000,000

–Interest 7,200,000 7,200,000

EBT –$2,200,000 $11,800,000

–Taxes (@ 0%) 0.00 0.00

Net income –$2,200,000 $11,800,000

EPS –$0.17 $0.92

E E D+

= +

=2 000 000 27 2 000 000 27 50 000 1 000 1 03

0 5118, , $ , , $ , $ , .

. ,3 3 3 3

oor 51 18

50 000 1 000 1 03 2 000 000 27 50 000 1 00

. %

, $ , . , , $ , $ ,

D E D+

= + 3 3

3 3 00 1 03 0 4882 48 82

3 . . ,

. % = or

Self-Check Answers 247

Self-Check 18

1. A theorem derived from M&M’s perfect worlds that states that it doesn’t matter whether a firm pays dividends or not

2. These investors don’t want or need cash and therefore prefer to defer paying taxes on any capital gains derived from growth in a company’s stock price by not selling until they’re ready, and thus not incurring a taxable gain.

3. The tendency among investors to find a payout policy they prefer and to stick with it

4. Dividends 5 Net income – Retained earnings necessary to fund positive NPV projects

5. The policy of a company paying out only funds that are left over after all positive-NPV projects are funded

6. A date of record and a payment date

7. The stock of companies paying dividends tends to increase as the next dividend approaches and then to fall by the present value of that dividend once the stock goes ex-dividend.

8. The firm exchanges new shares for old shares in the firm.

9. The firm buys back shares of its own stock on the stock exchange just like any other investor.

10. On average, the advantages outweigh the disadvantages.

11. Payout ratio 5 $500,000 / $2,000,000 5 0.25

12. If the firm retains 56% of net income, then it pays out

(1 – 0.56) 3 $9,000,000 5 $3,960,000

13. If the firm retains 60% of net income, then it pays out (1 – 0.60) 3 $35,000,000 5 $14,000,000

DPS 5 Common stock dividends paid / Number of shares of common stock outstanding

$14,000,000 / 140,000,000 5 $0.10 per share

14. Since the current value of outstanding shares would be $275,000,000 1 $100,000,000 1 $23,000,000 5 $398,000,000, the stock dividend would involve trans- ferring 0.20 3 $398,000,000 5 $79,600,000 from the retained earnings account into the other two accounts.

Self-Check Answers248

Since this is more than the amount of available retained earnings, the firm would be unable to complete the stock dividend as described.

Self-Check 19

1. A contractual commitment by a bank to loan to a firm a certain maximum amount at specified interest rate terms for a particular length of time, during which the company has the option to take down this loan

2. The interest rate is set at a fixed rate over a benchmark such as the prime rate and varies over time in accordance with changes in the benchmark.

3. The SBA offers a basic loan guarantee for such firms and can guarantee up to $3.75 million (representing 75 percent of loan value) at an interest not to exceed 2.75 percent greater than the prime lending rate.

4. By purchasing equity interests in firms that give the ven- ture capitalist the same rights and privileges as those that accrue to equity investments made by the firm’s owners

5. Wealthy individuals who make equity investments

6. They’ve grown to the point at which they need more capital than they can raise on their own, and they don’t want or need to pay to get additional funds from banks and venture capitalists.

7. An online public offering using the equity crowdfunding process as provided for in the JOBS Act of 2012

8. An investment bank guarantees the issuing firm a price for the newly issued bonds by buying the whole issue at a fixed price and then tries to resell those bonds for a higher price to investors.

9. Information about the issuing firm’s business; the key provisions and features of the security to be issued; the risks involved with the security; management’s background

Self-Check Answers 249

10. Title IV Regulation A1 equity crowdfunding offerings, which allow up to $50 million to be raised and Title III Regulation crowdfunding offerings, which allow up to $1 million to be raised but feature minimal regulatory disclosure

11.

Underwriter’s spread 5 Gross proceeds – Net proceeds

5 $25.50 per share – $23.75 per share 5 $1.75 per share

12. Funds needed 5 $23.75 per share x Number of shares sold 5 $12.5m

Number of shares sold 5 $12.5m / $23.75 per share 5 526,316 shares

13. Underwriter’s fees 5 $191.5m 3 0.05 5 $9.575m

Funds received by Harper’s Dog Pens 5 $191.5m – $9.575m 5 $181.925m

14.

Up-front fee 5 $4.25m 3 0.0075 5 $31,875.00

Back-end fee 5 $4.25m 3 0.0025 3 0.50 5 5,312.50

Total fees 5 $37,187.50

Up-front fee 5 $127,500 3 0.0085 5 $ 1,083.75

Interest 5 $119,000 3 0.0775 5 9,222.50

Back-end fee 5 $8,500 3 0.0035 5 29.75

Total interest and fees 5 $10,336.00