BUSINESS FINANCE
Financial Statements
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Many national governments require public companies to generate financial
statements based on widely accepted accounting rules. In the U.S., these
rules are theGenerally Accepted Accounting Principles (GAAP),
developed by the Financial Accounting Standards Board (FASB), a body that
examines controversial accounting topics and issues standards that, in terms
of their impact on accounting practices, almost have the force of law.
TheSecurities and Exchange Commission (SEC)regulates publicly
traded U.S. companies as well as the nation’s stock and bond markets. It
mandates that companies generate financial statements following
international accounting standards (IAS). In response to the accounting
scandals of 2001 and 2002, the Sarbanes-Oxley Act of 2002 established the
Public Company Accounting Oversight Board (PCAOB), which effectively
gives the SEC authority to oversee the accounting profession’s activities. The
SEC requires four key financial statements: (1) the balance sheet, (2) the
income statement, (3) the statement of retained earnings, and (4) the
statement of cash flows.
TheInternational Financial Reporting Standards (IFRS)are used in
many countries as the regulatory basis for the preparation of financial
statements. They are designed to provide a common global language for
financial reporting, particularly in the European Union, so published financial
information is comparable across international boundaries. In 2008, the SEC
explored the possibility of requiring the use of IFRS in the U.S., which would
have dramatically impacted American financial reporting, but they were not
adopted.
Balance Sheet
A firm’s balance sheet presents a “snapshot” view of the company’s financial
position at a specific moment in time. By definition, a firm’s assets must
equal the combined value of its liabilities and stockholders’ equity. The basic
balance sheet equation isAssets = Liabilities + Stockholders’ Equity.
Thus, creditors and equity investors finance all of a firm’s assets.
The balance sheet consist of three sections that list a firm’s assets and
liabilities as well as the claims of the stockholders. Assets and liabilities
appear in descending order ofliquidity, which is the length of time it takes
to convert accounts into cash during the normal course of business. The
most liquid asset (cash) appears first, and the least liquid (fixed assets)
comes last. Current assets are those that are easy to sell and turn into cash,
while fixed assets are physical assets like buildings and equipment. Assets
include everything that can be used to benefit the business or give the
company the right to receive benefits. Current liabilities are those that must
be paid within one year and include accounts payable, notes payable, and
accrued expenses. Long-term liabilities are due after more than a year and
include deferred taxes and long-term debt. The last entry on the balance
sheet, stockholders’ equity is the owners’ residual share of the business,
including their original investment plus any money the firm has earned and
retained since its inception. Stockholders’ equity includes preferred stock,
common stock, paid-in-capital in excess of par, and retained earnings.
However, the net worth of the firm includes only the common stock, paid-in-
capital in excess of par, and retained earning.
Balance Sheet for Global Petroleum Corporation
The table below presents Global Petroleum Corporation’s balance sheet as of
December 31, 20X1. As is standard practice in annual reports, the table also
shows the prior year’s (20X0) accounts for comparison.
Balance Sheet Assets
Cashandcash equivalentsare assets such as checking account balances
at commercial banks that can be used directly as means of payment.
Marketable securities*represent liquid short-term investments, which
financial analysts view as a form of “near cash.” They include Treasury
notes, commercial paper, and others.
Accounts receivablerepresent the amount customers owe the firm from
sales made on credit.
Inventoriesinclude raw materials, work in process (partially finished
goods), and finished goods held by the firm.
Intangibleassets include items such as patents, trademarks, copyrights, or
mineral rights entitling the company to extract oil and gas on specific
properties.
Gross property, plant, and equipment (PP&E)is the original cost of all
real property, structures, and long-lived equipment owned by the firm.
Net property, plant, and equipment is calculated as Gross PP&Eless
accumulated depreciation – the cumulative expense recorded for the
depreciation of fixed assets since their purchase; this reflects a decline in the
asset’s economic value over time. The one fixed asset that is not depreciated
is land because it seldom declines in value.
It is important to note that the amount shown for Net PP&E is not intended to
reflect the true current value of these assets. The true value cannot be
known unless the assets are sold. Net PP&E on the balance sheet is the
total“book value”of the assets, which is the original cost of the assets less
accumulated depreciation to date. Depreciation is taken according to
standardized formulas and does not reflect the reduction in actual value of
the assets which can vary for many reasons.
Because assets are listed at book value rather than market value (and for
other reasons as well), the Total Assets figure on the balance sheet is not,
and is not intended to be, an accurate indicator of the current value of the
company. Information provided in financial statements must be objective
and verifiable. Since true values for most assets can only be estimated until
they are sold, it is not possible to compile them through objective and
verifiable calculations.
Balance Sheet Liabilities
Liabilitiesare debts that the firm owes to others.Current liabilitiesare
those that are due within one year, while long-term debt liabilities are due
after more than a year, (e.g., bonds, mortgages, long-term loans, etc.).
The current liabilities on the balance sheet include three types of accounts:
1. Accounts Payableare the amounts owed for credit
purchases by the firm.
2. Notes Payableare outstanding short-term loans, typically
from commercial banks.
3. Accrued Expensesare costs that have been incurred by the
firm that have not yet been paid. Examples of accruals
include taxes owed to the government and wages due to
employees.
Accounts payable and accruals are often calledspontaneous
liabilitiesorspontaneous financingbecause they tend to change directly
with changes in sales.
Long-term liabilitiesinclude deferred taxes and long-term debt.
In the U.S. and many other countries, laws permit firms to construct two sets
of financial statements, one for tax purposes and one for reporting to the
public. For example, when a firm purchases a long-lived asset, it can choose
to depreciate the asset rapidly for the purpose of obtaining large, immediate
tax write-offs. When the firm constructs financial statements for release to
the public, however, it may choose a different depreciation method –
perhaps one that results in higher reported earnings in the early years of the
asset’s life. A deferred tax entry is a long-term liability that reflects the
difference between the taxes that firms actually pay and the tax liabilities
they report on their public financial statements.
Long-term debtrepresents debt that matures more than one year in the
future.
Balance Sheet Stockholders’ Equity
Stockholders’ equityis the owners’ residual share of the business
including their original investment plus any money the firm has made and
retained since its inception. This figure does not, and is not intended to,
reflect the current market value of the stock.
The stockholders’ equity section provides information about the claims
against the firm held by investors who own preferred and common shares. It
is reflected in four types of accounts:
1. Preferred Stockshows the total proceeds from the sale of
preferred stock. This form of ownership has preference over
common stock when the firm distributes income and assets.
2. Common Stock(sometimes listed as Common Stock at Par
Value) equals the number of outstanding common shares
multiplied by the par value per share. Par value (often $1) is
an artifact of earlier pre-computer accounting methods used
to track the number of outstanding shares. It has no relation
to the actual value of the shares.
3. Paid-in-capitalin excess of par equals the number of
shares outstanding multiplied by the original selling price of
the shares, net of the par value. The combined value of
common stock and paid-in-capital equals the proceeds the
firm received when it originally sold shares to investors
(including initial public offerings and rights offerings).
4. Retained earningsare the cumulative total of the earnings
that the firm has reinvested in its assets and operations since
its inception. Retained earnings are not a reservoir of
unspent cash. When the retained earnings “vault” is empty,
it is because the firm has already reinvested the earnings in
new assets and/or has paid common stock dividends.
Thetreasury stock*entry records the value of common shares that the firm
currently holds in reserve. Usually, treasury stock appears on the balance
sheet because the firm has reacquired previously issued stock through a
share repurchase program.
Stockholder’s equity is the sum of all of the other amounts in this section. It
is also referred to as thebook value of equity, to distinguish it from the
market value which is not shown on the balance sheet. Stockholder’s equity
is a permanent funding source for the company that never matures and does
not require repayment for as long as the company exists.
Income Statement*
In the vocabulary of accounting, income (also called profit, earnings, or
margin) equals revenue minus expenses. A firm’s income statement,
however, has several measures of “income” appearing at different points:
Gross profit is the first income measure. It is the amount by which sales
revenue exceeds the cost of goods sold (the direct cost of producing or
purchasing the goods sold). Next, a firm deducts from gross profits various
operating expenses, including selling expense, general and administrative
expense, and depreciation expense. The resulting operating profit represents
the profits earned from the sale of products, although this amount does not
include financial and tax costs. Other income, earned on transactions directly
related to producing and/or selling the firm’s products, is added to operating
income to yield earnings before interest and taxes (EBIT). When a firm has
no “other income,” its operating profit and EBIT are equal. Next, the firm
subtracts interest expense – representing the cost of debt financing – from
EBIT to find its pretax income. The final step is to subtract taxes from pretax
income to arrive at net income, or net profits after taxes. Net income is the
proverbial “bottom line” and the single most important accounting number
for both corporate managers and external financial analysts.
The income statement also includes entries which show distributions of net
income. If a firm has preferred stock, it deducts preferred stock dividends
from net income. Net income less preferred stock dividends is earnings
available for common stockholders. Dividing earnings available for common
stockholders by the number of shares of common stock outstanding results
in earnings per share (EPS). Earnings per share represents the amount
earned during the period on each outstanding share of common stock. The
final entry in the income statement is the cash dividend per share (DPS) paid
to common stockholders.
Income Statement for Global Petroleum Corporation
The table below presents Global Petroleum Corporation’s income statement,
which is also called the profit-and-loss statement.
Statement of Retained Earnings*
The third key financial statement reconciles the net income earned during a
given year, and any cash dividends paid, with the change in retained
earnings between the start and end of that year. This statement is primarily
used to see how the firm has made its investment/consumption decision.
Is the firm reinvesting its earnings? If so, how much? Is the firm paying out
its earnings as dividends? It is possible that the dividend payout ratio, the
fraction of current earnings available for common stockholders paid out as
dividends, may decline as well as increase in the course of a firm’s business
practices.
Statement of Retained Earnings for Global Petroleum
Corporation
The table below presents the statement of retained earnings for Global
Petroleum Corporation for the year ended December 31, 20X1. This is how
retained earnings, which appears on the balance sheet, is derived.
Beginning RE + Net income – Dividends paid = Ending
RE
Statement of Cash Flows*
Cash is the lifeblood of a company. Finance emphasizes the importance of
cash flow and its timing because cash is what is required to purchase
inventory, pay bills and labor, and service debt. Running out of cash can
have disastrous consequences for a company, so it is important to forecast
the company’s cash position and to manage its swings.
The statement of cash flows provides a summary of what cash has gone into
and out of a firm because of its operations, investments, and financing
activities during a year. It isolates the firm’s operating, investment, and
financing cash flows and reconciles them with changes in its cash and
marketable securities during the year.
The table below presents the Global Petroleum Corporation’s statement of
cash flows.
Cash Flow Analysis
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The Firm’s Cash Flows*
Although financial managers are interested in the information in the firm’s
accrual-based financial statements, their primary focus is on cash flows.
Without adequate cash to pay obligations on time, to fund operations and
growth, and to compensate owners, the firm will fail. The financial manager
and other interested parties can gain insight into the firm’s cash flows over a
given time period by using some popular measures of cash flow and by
analyzing the firm’s statement of cash flows.
In the process of evaluating a firm’s cash flows, analysts view cash and
marketable securities as perfect substitutes. Both represent a reservoir of
liquidity that increases with cash inflows and decreases with cash outflows.
A firm’s total cash flows can be conveniently divided into:
1. operating flows, which are the cash inflows and outflows
directly related to the production and sale of products or
services;
2. investment flows, which are cash flows associated with the
purchase or sale of fixed assets and business equity;
3. financing flows, which result from debt and equity
financing transactions.
Taking on new debt (short-term or long-term) results in a cash inflow;
repaying existing debt requires a cash outflow. Similarly, the sale of stock
generates a cash inflow; whereas the repurchase of stock or payment of cash
dividends results in a cash outflow. In combination, the operating,
investment, and financing cash flows during a given period affect the firm’s
cash and marketable securities balances.
Free Cash Flow*
Monitoring cash flow is important for the firm’s financial managers and for
outside analysts trying to estimate the firm’s worth. Managers and analysts
track a variety of cash flow measures. Among these, one of the most
important is free cash flow (FCF).
FCF is the amount of cash flow available to investors – the providers of debt
and equity capital. It represents the net amount of cash flow remaining after
the firm has met all operating needs and has made all required payments on
both long-term (fixed) and short-term (current) investments.
Free cash flow for a given period is calculated in two steps. First, we must
examine the firm’s net operating profits after taxes (NOPAT), which is the
firm’s earnings before interest and after taxes:
NOPAT = EBIT x (1-T)
where EBIT is earnings before interest and taxes and T is the corporate tax
rate.
Adding depreciation back into NOPAT yields operating cash flow (OCF), which
is the amount of cash flow generated by the firm’s operations.
OCF = NOPAT + Depreciation = [EBIT x (1-T)] +
Depreciation
Note that because depreciation is a noncash charge, (you don’t write a check
for depreciation), we add it back when determining OCF. Noncash charges –
such as depreciation, amortization, and depletion allowances – are expenses
that appear on the income statement but do not involve an actual outlay of
cash. Almost all firms list depreciation on their income statements, but when
amortization or depletion occur in a firm’s financial statements you would
treat them in a similar manner.
The second step is to convert operating cash flow to free cash flow by
deducting the firm’s change (denoted by the Greek letter Delta, the
“change” symbol ∆) in net investments, fixed assets, and current assets from
operating cash flow.
FCF = OCF − ∆FA *− (∆CA * − ∆AP − ∆Accruals)
∆FA = change in gross fixed assets ∆CA = change in current assets
∆AP = change in accounts payable ∆accruals = change in accrued
expenses
Spontaneouscurrent liability changes occur automatically with changes in
sales. They must, therefore, be deducted from current assets in order to find
the net change in short-term investment for the determination of free cash
flow.
I O
Decrease in any asset Increase in any asset
Increase in any liability Decrease in any liability
Net income (profit after taxes) Net loss
Depreciation and non-cash charges Dividends paid
Sale of common or preferred stock Repurchase or retirement of stock
A decrease in an asset (such as inventory) is an inflow of cash because cash
that has been tied up in the asset is released and can be used for some other
purpose, such as repaying a loan. In contrast, an increase in inventory (or
any other asset) is an outflow of cash because additional inventory ties up
more of the firm’s cash. Logic suggests that if net income is a cash inflow,
then a net loss (negative net profit after taxes) is a cash outflow. The firm
must balance its losses with an inflow of cash from, say, selling off some of
its fixed assets or increasing external borrowing. Can a firm have a net loss
(negative NOPAT) and still have positive operating cash flow? Yes. This can
occur when depreciation and other noncash charges during the period are
greater than the net loss. The statement of cash flows treats net income (or
net losses) and depreciation and other noncash charges as separate entries.
Developing the Statement of Cash Flows
A statement of cash flows can be historical or forward looking. In other
words, it can show how the company has spent money and where it has
received money in the past, or it can be used to predict what funds will be
needed in the future.
Accountants construct the statement of cash flows by using the income
statement for a given year along with the beginning- and end-of-year
balance sheets. The procedure involves classifying balance sheet changes as
inflows or outflows of cash; obtaining income statement data; classifying the
relevant values into operating, investment, and financing cash flows; and
presenting them in the proper format.
A statement of cash flows assigns positive values to all cash inflows and
negative values to all cash outflows. The investment activities aspect of the
statement of cash flows records the increase in gross fixed assets – rather
than net fixed assets – as cash outflow.
The statement includes the categories of operating, investment, and
financing activities. By adding up the total in each category, we obtain the
net increase (decrease) in cash and marketable securities for the year. As a
check, this value should reconcile with the actual yearly change in cash and
marketable securities obtained from the beginning- and end-of-year balance
sheets.
Interpreting the Statement*
The statement of cash flows allows the financial manager and other
interested parties to analyze the firm’s cash flow over time. Unusual changes
in either the major categories of cash flow or in specific items offer clues to
problems a firm may be experiencing. Financial analysts place great
emphasis on cash flows, and because the statement of cash flows provides
the clearest and most complete view of the cash coming in and going out of
a business, this statement is considered by some to be the most important
single financial statement.
Financial managers and analysts can also prepare a statement of cash flows
developed from projected, or pro forma, financial statements. They use this
approach to determine if the firm will need additional external financing or
will generate excess cash that could be reinvested or distributed to
stockholders.
Financial Statements: Notes to Financial
Statements*
Besides the four key financial statements themselves, the “notes” to
financial statements can be extremely useful to financial managers and
analysts. A public company’s financial statements include explanatory notes
keyed to the relevant accounts in the statements. These notes provide
detailed information on the accounting policies, calculations, and
transactions that underlie entries in the financial statements.
Not everything is necessarily reported on the company’s financial
statements. For example, a company could have a lawsuit pending that has
not yet impacted the financial statements. Typically, a company is required
to disclose such potential effects in the notes to its financial statements
which often contain a great deal of valuable information.
Notes typically provide additional information about a firm’s revenue
recognition practices, income taxes, fixed assets, leases, and employee
compensation plans. Professional security analysts find this information
particularly useful, and they routinely scour the notes when evaluating the
firm’s performance and value.
Assessing Financial Performance Using Ratio Analysis
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Financial ratio analysis is the use of ratios to analyze financial statements.
They can be used to determine the company’s strengths and weaknesses, its
historical performance, and its present financial condition. Managers use
ratios to improve the company’s performance. Creditors use ratios to see
whether the firm will be able to repay its debts, while stockholders want to
predict what future dividends and earnings will be.
Assessing a firm’s financial statements is of interest to shareholders,
creditors, and the firm’s own management. A firm often wants to compare its
financial condition to that of similar firms, but doing so can be very tricky.
Company’s can differ in size, location, and other characteristics so there
needs to be a way to put them on an equal footing for comparison. Ratio
analysis provides that capability. It also helps to compare results over time.
Ratio analysis involves calculating and interpreting financial ratios to assess
a firm’s performance and status. To analyze financial statements, we need
relative measures that, in effect, normalize size differences. Effective
analysis of financial statements is thus based on the use of ratios or relative
values.
Different constituents of a firm will focus on different types of financial ratios.
Creditors are primarily interested in ratios that measure the firm’s short-term
liquidity and its ability to make interest and principal payments. A secondary
concern of creditors is profitability; they want assurance that the business is
healthy and will continue to be successful. Present and prospective
shareholders focus on ratios that measure the firm’s current and future
levels of risk and return, because these two dimensions directly affect share
price. The firm’s managers use ratios to generate an overall picture of the
company’s financial health and to monitor its performance from period to
period and examine unexpected changes in order to isolate developing
problems.
One complication of ratio analysis is that a normal ratio in one industry may
be highly unusual in another. For example, the net profit margin ratio
measures the net income generated by each dollar of sales. Net profit
margins vary dramatically across industries. An outstanding net profit margin
in the retail grocery industry would look paltry in the software business.
Therefore, when making subjective judgments about the health of a given
company, analysts usually compare the firm’s ratios against benchmark
firms from the same industry.
First, analysts compare the financial ratios in the current year with previous
years’ ratios and hope to identify trends that will aid in evaluating the firm’s
prospects. In addition, analysts compare the ratios of one company with
those of other “benchmark” firms in the same industry (or to an industry
average obtained from a trade association or third-party provider).
Types of Financial Ratios
L *Ratios •Current Ratio
•Quick (Acid Test) Ratio
A Ratios •Turnover ratios
•Collection/Payment Period
D Ratios •Debt-to-Equity Ratio
•Times Interest Earned (TIE)
P Ratios •Profit Margin
•Return on Assets
M Ratios •Price/Earnings (P/E) Ratio
•Market-to-Book Ratio
Liquidity Ratios
Liquidity ratios measure a firm’s ability to satisfy its short-term obligations as
they come due. Because a common precursor to financial distress or
bankruptcy is low or declining liquidity, liquidity ratios are good leading
indicators of cash flow problems. The two basic measures of liquidity are the
current ratio and the quick (acid-test) ratio.
The current ratio, one of the most commonly cited financial ratios, measures
the firm’s ability to meet its short-term obligations. It is defined as current
assets divided by current liabilities. Global Petroleum’s current ratio for 20X1
is 1.1, computed as follows:
How high should the current ratio be? The answer depends on the type of
business and on the costs and benefits of having too much versus not
enough liquidity. The more predictable a firm’s cash flows, the lower the
acceptable current ratio.
The quick or acid-test ratio is similar to the current ratio except that it
excludes inventory, which is usually the least-liquid current asset. The
generally low liquidity of inventory results from two factors:
1. Many types of inventory cannot be easily sold because they
are partially completed items, special-purpose items, etc;
2. Inventory is typically sold on credit, so it becomes an account
receivable before being converted into cash.
Global Petroleum’s quick ratio for 20X1 is 0.866, computed as follows:
The quick ratio provides a better measure of overall liquidity only when a
firm’s inventory cannot be easily converted into cash. If inventory is liquid,
then the current ratio is the preferred measure.
Activity Ratios*
Activity ratios measure the speed with which the firm converts various
accounts into sales or cash. Analysts use activity ratios as guides to assess
how efficiently the firm manages its assets and its accounts payable.
Inventory turnover*provides a measure of how quickly a firm sells its
goods. The inventory turnover ratio for Global Petroleum for 20X1 is
calculated as follows:
In the numerator, we used cost of goods sold, rather than sales, because
firms value inventory at cost on their balance sheet. In the denominator, we
used an ending inventory balance. If inventories are growing over time or
exhibit seasonal patterns, then analysts sometimes use the average level of
inventory throughout the year, rather than the ending balance, to calculate
this ratio. The resulting turnover of 13.85 indicates that the firm basically
sells out its inventory 13.85 times each year, or slightly more than once each
month. This value is most meaningful when compared with that of other
firms in the same industry or with the firm’s past inventory turnover.
We can easily convert inventory turnover into anaverage age of
inventoryby dividing the turnover figure into 365 (the number of days in a
year). In our example, the average age of inventory is 26.4 days (365/13.85),
meaning that the inventory balance turns over about every 26 days.
Firms use theaverage collection periodoraverage age of accounts
receivablein evaluating credit and collection policies. For Global Petroleum
in 20X1, this measure is computed as follows:
The average collection period is meaningful only in relation to the firm’s
credit terms. For Global Petroleum, it takes 46 days to receive payment from
a credit sale.
Firms use theaverage payment periodto evaluate their payment
performance. This metric measures the average length of time it takes a firm
to pay its suppliers. The average payment period equals the firm’s average
daily purchases divided into the accounts payable balance. For Global
Petroleum in 20X1, the average payment period is computed as follows:
The average payment period is meaningful only in light of the actual credit
terms the firm’s suppliers offer.
Thefixed asset turnover ratiomeasures the efficiency with which a firm
uses its fixed assets. The ratio tells analysts how many dollars of sales the
firm generates per dollar of investment in fixed assets. The fixed asset
turnover ratio is computed as follows:
Fixed Asset Turnover *= *Net Sales / Average Net Fixed Assets
Where average net fixed assets (cost less depreciation) is defined as
(Beginning + Ending)Net Fixed Assets / 2.
As with other ratios, the “normal” level of fixed asset turnover varies widely
from one industry to another.
Thetotal asset turnover ratioindicates the efficiency with which a firm
uses all its assets to generate sales. Like the fixed asset turnover ratio, total
asset turnover indicates how many dollars of sales a firm generates per
dollar of total asset investment. Global Petroleum’s 20X1 total asset turnover
ratio is computed as follows:
All other factors being equal, analysts favor a high turnover ratio because it
indicates that a firm generates more sales (and, ideally, more cash flow for
investors) from a given investment in assets.
When using the fixed asset and total asset turnover ratios, an analyst must
be aware that they are calculated using the historical costs of fixed assets. A
naïve comparison of fixed asset turnover ratios for different firms may lead
an analyst to conclude that one firm operates more efficiently than another
when, in fact, the firm that appears to be more efficient simply has older
(more fully depreciated) assets on its books.
Debt Ratios*
Firms finance their assets from two broad sources, equity and debt. Equity
comes from stockholders, whereas debt comes in many forms from many
different lenders. Firms borrow from suppliers, banks, and investors who buy
publicly traded bonds. Debt ratios measure the extent to which a firm uses
money from creditors rather than from stockholders to finance its operations.
Because creditors’ claims must be satisfied before firms can distribute
earnings to stockholders, current and prospective investors pay close
attention to the debt on the balance sheet. The more indebted the firm, the
higher the probability that it will be unable to satisfy the claims of all its
creditors.
Broadly speaking, there are two types of debt ratios. One type focuses on
balance sheet measures of outstanding debt relative to other sources of
financing. The other type, known ascoverage ratios, focuses more on
income statement measures of the firm’s ability to generate sufficient cash
flow to make scheduled interest and principal payments. Investors and
credit-rating agencies use both types of ratios to assess a firm’s
creditworthiness.
Thedebt ratiomeasures the proportion of total assets financed by the
firm’s creditors. The higher this ratio, the greater is the firm’s reliance on
borrowed money to finance its activities. Global Petroleum’s debt ratio is
55.1%, computed as follows:
A close cousin of the debt ratio is theassets-to-equity (A/E) ratio,
sometimes called theequity multiplier. This ratio is calculated as total
assets divided by common stock equity. For Global Petroleum, the result of
2.24 is computed as follows:
A high equity multiplier indicates high debt and low equity, whereas a low
equity multiplier indicates low debt and high equity.
An alternative measure that focuses solely on the firm’s long-term debt is
thedebt-to-equity ratio. It is calculated as long-term debt divided by
stockholders’ equity as reflected in the following example for Global
Petroleum:
A word of caution: Both the debt ratio and the debt-to-equity ratio use book
values of debt, equity, and assets. Analysts should be aware that the market
values of these variables may differ substantially from book values.
Thetimes interest earnedratio measures the firm’s ability to make
contractual interest payments. It equals earnings before interest and taxes
divided by interest expense. A higher ratio indicates a greater capacity to
meet scheduled payments. Global Petroleum’s ratio of 13.59 indicates that
the firm could experience a substantial decline in earnings and still meet its
interest obligations.
Profitability Ratios*
Several measures of profitability relate a firm’s earnings to its sales, assets,
or equity. Profitability ratios are among the most closely watched and widely
quoted financial ratios. Many firms link employee bonuses to profitability
ratios, and stock prices react sharply to unexpected changes in these
measures.
Thegross profit marginmeasures the percentage of each sales dollar
remaining after the firm has paid for its goods. The higher the gross profit
margin, the better. Global Petroleum’s gross profit margin of 33.7% is
computed as follows:
The operating profit margin measures the percentage of each sales dollar
remaining after deducting all costs and expenses other than interest and
taxes. As with the gross profit margin, the higher the operating profit margin,
the better. This ratio tells analysts what a firm’s bottom line looks like before
deductions for payments to creditors and tax authorities. For Global
Petroleum, it is calculated as shown:
Thenet profit marginmeasures the percentage of each sales dollar
remaining after deducting all costs and expenses including interest, taxes,
and preferred stock dividends. Net profit margins vary widely across
industries, so comparing a company’s figure to industry averages is an
important part of the performance analysis. Global Petroleum’s 20X1 net
profit margin calculation is shown below:
Probably the most closely watched financial ratio is earnings per share (EPS),
which the investing public considers to be a primary indicator of corporate
success. EPS represents the number of dollars earned on behalf of each
outstanding share of common stock during the period. Many firms tie
management bonuses to specific EPS targets. 20X1 EPS is for Global
Petroleum calculated as follows:
EPS is not the same as dividends. The amount of earnings actually
distributed to each shareholder is the dividend per share.
Return on total assets (ROA), often called return on investment (ROI),
measures management’s overall effectiveness in using the firm’s assets to
generate returns to common stockholders. In 20X1, Global Petroleum’s ROA
was 9.9%:
To improve ROA, a firm needs to improve its cost control, for example, by
reducing labor costs, purchases, and overhead; or the company needs to
increase its revenues through higher pricing or changing its product mix or
volumes. The firm might also be able to improve its capacity utilization,
making more use of the same equipment. A firm could also improve its
working capital management, collecting accounts receivable faster or paying
its accounts payable more slowly.
A closely related measure of profitability is the return on common equity
(ROE), which captures the return earned on the common stockholders’
(owners’) investment in the firm. For a firm that uses only common stock to
finance its operations, the ROE and ROA figures will be identical. With debt or
preferred stock on the balance sheet, these ratios will usually differ. When
the firm earns a profit, even after making interest payments to creditors and
paying dividends to preferred stockholders, the firm’s ROE will exceed its
ROA. Conversely, if the firm’s earnings fall short of the amount it must pay to
lenders and preferred stockholders, then the ROE will be less than ROA.
Usually, the use of debt financing increases the value to stockholders unless
a company is taking on more debt than it can reasonably handle.
Global Petroleum’s ROE of 22.1%, calculated below, would be quite high for
most companies.
Financial analysts sometimes conduct a deeper analysis of the ROA and ROE
ratios using theDuPont system. This approach uses both income
statement and balance sheet information to break the ROA and ROE ratios
into component pieces. It highlights the influence of both the net profit
margin and the total asset turnover on a firm’s profitability. In the DuPont
system, the return on total assets equals the product of the net profit margin
and total asset turnover:
ROA = Net profit margin x Total asset turnover x (A/E) =.074 x 1.34
x 2.24 = 0.22
We can push the DuPont system one step further by multiplying the ROA by
the assets-to-equity (A/E) ratio or the equity multiplier to get Return on
Equity (ROE):
ROE = ROA x (A/E) = 0.099 x 2.24 = 0.22
Therefore, ROA can be restated as:
ROA = Net profit margin x Total Asset Turnover = 0.074 x 1.34 =
0.099
DuPont System of Analysis
The advantage of the DuPont system is that it breaks a company’s return on
common equity into three components tied to the financial statements:
Analysts can then study the effect of each of these factors on the overall
return to common stockholders, and managers can focus on strategies to
improve each of these components knowing how they contribute to ROE.
Market Ratios*
Market ratios relate the firm’smarket value, as measured by its current
share price, to certain accounting values. These ratios provide insight into
how investors think the firm is performing, and they also reflect the average
common stockholder’s assessment of the firm’s expected future
performance given information about the past.
Theprice/earnings (P/E)ratio measures the amount investors are
currently willing to pay for each dollar of the firm’s current earnings.
Investors often use the P/E ratio, the most widely quoted market ratio, as a
barometer of a firm’s long-term growth prospects and of investor confidence
in the firm’s future performance. A high P/E ratio indicates investors’ belief
that a firm will achieve rapid earnings growth in the future; hence,
companies with high P/E ratios are referred to as growth stocks. Simply
stated, investors who believe that future earnings are going to be higher
than current earnings are willing to pay more for today’s earnings, and vice
versa. Global Petroleum’s P/E ratio of 14.41, computed below, indicates that
investors are willing to pay $14.41 for each dollar of current earnings per
share at the current share price of $76.25.
The market/book (M/B) ratio provides another assessment of how investors
view the firm’s performance. It relates the market value of the firm’s shares
to their book value. The stocks of firms that investors expect to perform well
in the future – by improving profits, growing market share, launching
successful products, and so forth – typically sell at higher M/B ratios than
firms with less attractive prospects. Firms that investors expect to earn high
returns relative to their risk typically sell at higher M/B multiples than those
expected to earn low returns relative to risk.
To calculate the M/B ratio in our example, we first need to find its book value
per share of common stock as follows:
We then compute the M/B ratio by dividing the book value into the current
price of the firm’s stock:
Investors are currently paying $3.19 for each $1.00 of book value. Clearly,
investors expect this company to continue to grow in the future since they
are willing to pay more than book value for the firm’s shares.
Liquidity ratio-Current Ratio & Quick (Acid Test) Ratio
Activity ratio-Turnover ratios & Collection/Payment Period
Debt ratio-Debt-to-Equity Ratio & Times Interest Earned (TIE)
Profitability ratio-Profit Margin & Return on Assets
Market ratio-Price/Earnings (P/E) Ratio & Market-to-Book Ratio
Overview of the Planning Process
Lesson9of46
Financial Planning*
Financial planning is one of the most important responsibilities of financial
managers. While financial planning is not an exact science and will always
involve uncertainty, a good financial planning process will help ensure that
the uncertainty is managed and that the company has known options for
dealing with contingencies as the arise.
A long-term financial plan begins with strategy. Typically, the senior
management team analyzes the markets in which the firm competes and
tries to identify ways to protect and increase the firm’s competitive
advantage in those markets. For example, a firm that competes by achieving
the lowest production cost in an industry might seek to determine whether it
should make additional investments in manufacturing facilities to achieve
even greater production efficiencies. A risk to this strategy is that market
demand may turn out to be such that the firm’s fixed assets are
underutilized. This type of firm, therefore, will try to forecast market demand
and develop contingency plans for the possibility that the expected demand
does not materialize. If a firm’s competitive advantage derives from the
value of its brand, it might begin by assessing whether new or expanded
marketing programs might increase the value of its brand relative to
competitors.
Financial managers strive to develop and implement effective financial plans
that support, but do not drive, the company’s strategic goals and objectives
while managing risk and uncertainty. In order for the company to function
effectively, it must have adequate funding sources in place based on
effective analysis and comprehensive financial forecasts.
Successful Long-Term Planning
Financial planning, particularly long-term planning, is more an art than a
science because the connection between most financial planning models and
the objective of maximizing shareholder wealth is never precise and is often
tenuous. Long-term planning requires more than paying close attention to a
firm’s existing markets. Even more important is the ability to identify and
prioritize new market opportunities and risks.
Successful long-term planning means asking and answering probing
questions like these:
In what emerging markets might we have a sustainable
competitive advantage?
How can we leverage our competitive strengths across
existing markets in which we currently do not compete?
How can we respond to any threats to our current business?
In which geographic regions should we produce? Where
should we sell?
Can we deploy resources more efficiently by exiting certain
markets and using those resources elsewhere?
As the firm’s senior managers develop answers to these questions, they
construct a strategic plan. This is a multiyear action plan for the major
investments and competitive initiatives that they believe will drive the future
success of the enterprise. A strategic plan is a long-term guide driven by
competitive forces.
The Role of Finance in Long-Term Planning*
Finance plays several roles in long-term planning. First, financial managers
draw on a broad set of skills to assess the likelihood that a given strategic
objective can be achieved. With respect to a major new investment proposal,
their first questions should be “Does this investment make sense?” and “Is
there good reason to expect this proposal to generate wealth for our
shareholders?”
Second, the finance function assesses the feasibility of a strategic action
plan given a firm’s existing and prospective sources of funding. Financial
analysts generally treat expected dividend payments as a factor that limits a
firm’s ability to make new investments. Similarly, if fulfilling strategic
objectives will require a significant increase in leverage, it is the finance
group’s role to communicate this trade-off to the top management team.
Third, finance clearly plays an important control function as firms implement
their strategic plans. Financial analysts prepare and update cash budgets to
make sure that firms do not unknowingly slip into a liquidity crisis.
Fourth, a major contribution of finance to the strategic planning process
involves risk management. The finance function manages risk exposures so
that the firm can take risks for which it has a comparative advantage and
can hedge risks for which it has no advantage. Similarly, more than in any
other functional area, the job of finance is to identify problems that could
develop in the future if the firm’s strategic plans unfold in unexpected ways.
Planning for Growth
Lesson10of46
Sustainable Growth*
Most firms strive to grow over time, and most firms view rapid growth as
preferable to slow growth. Of course, rapid growth does not maximize wealth
for all firms at all times since it’s possible for growth to be detrimental to
shareholders. Assuming that firms seek growth, they can focus on one or a
number of measures of growth. Three of the more popular measurements of
growth are theaccounting return on investment (ROI),economic value
added (EVA®), andgrowth in sales or assets. All of these methods rely
on accounting data and are typically measured on an annual basis. Growth
can also be defined by increases in the firm’s market value, its asset base,
the number of people it employs, or any number of other metrics.
The accounting return on investment (ROI) is the firm’s earnings available for
common stockholders divided by its total assets. As shown earlier, Global
Petroleum’s ROI is 9.9%.
Return on investment measures the firm’s overall effectiveness in using its
assets to generate returns to common stockholders. Firms that use this
metric as a measure of growth attempt to maintain ROI above some
minimum hurdle rate based on the firm’s cost of capital. Thecost of
capital, which will be discussed in more detail later, is the annual
percentage cost of an average dollar of long-term funds employed in the firm
from all sources and given the firms proportional mix of those sources, which
is called its capital structure.
The general assumption is that if ROI is greater than the cost of capital (plus
perhaps a fudge factor), then the firm is earning more on its funds than the
associated costs, and shareholder value will be created. One problem with
this approach is that it compares accounting-based ROI to an economic-
based measure of the return demanded by suppliers of capital. Although use
of this method has practical appeal, its theoretical roots are shallow at best.
Economic value added (EVA®) is the difference between net operating
profits after taxes (NOPAT) and the cost of funds. When applied correctly,
EVA prompts managers to make the same investment decisions that the net
present value (NPV) method directs them to do. NPV will be discussed in
detail later. The cost of funds is found by multiplying the firm’s weighted
average cost of capital (WACC) by the total funds invested (total assets
minus current liabilities).
EVA = NOPAT - [WACC x (Total Assets - Current Liabilities)]
Analysts can apply EVA to individual investments or to the entire firm, but its
use in financial planning tends to focus on the entire firm or entire divisions.
Although widely examined in the financial literature, EVA’s degree of positive
correlation with actual share valuations remains unclear. Most agree that the
measure is conceptually valid but that it is sometimes difficult to implement
because of accrual-based accounting inputs (NOPAT and investment). This
disconnect, coupled with its increased computational complexity, tends to
result in greater planning focus on growth rates.
Firms frequently set planning goals in terms of target growth rates, typically
annual growth in sales or assets. A firm’s growth can be measured by
increases in its market value, its asset base, the number of people it
employs, or any number of other metrics. Most firms define and measure
growth targets in terms of sales as well.
With sales growth in mind, think about what growth means for a firm in
terms of its balance sheet. Increased sales volume probably requires
additional investments in assets including inventories and receivables, and in
fixed assets such as production capacity and office space. In other words,
any increase in sales must be matched by a comparable percentage increase
in assets. Because the balance sheet equation must hold, increases in
liabilities and shareholders’ equity must equal the increase in assets.
Developing the Sustainable Growth Model*
Thesustainable growth modelstarts with a balance sheet identity, adds a
few assumptions, and ultimately derives an expression that determines how
rapidly a firm can grow while maintaining a balance between its outflows
(increases in assets) and inflows (increases in liabilities and equity) of funds.
Specifically, the sustainable growth model assumes the following:
1. The firm’s only form of equity is common stock (E), and it will
not issue new shares of common stock next year.
2. The firm’s total asset turnover ratio, the ratio of sales divided
by total assets (S/A), remains constant.
3. The firm pays out a constant fraction, d, of its earnings as
dividends.
4. The firm maintains a constant assets-to-equity ratio (A/E).
5. The firm’s net profit margin, m, is constant.
Consider a firm that wants to increase sales next period by g percent. If total
assets in the current period equal A and if the asset turnover ratio remains
constant, then assets must increase in the next period by gA. This represents
a change in the left-hand side of the firm’s balance sheet next period – a
change that must be balanced by an equal change on the right-hand side.
Given sales this period of S, a net profit margin (defined as net income
divided by sales) equal to m, and a dividend payout ratio of d, we can
determine the firm’s retained earnings next period:
Retained earnings = S(m)(1 + g)(1 – d)*
The product of S and m yields net profits in the current year. Multiplying this
product by (1 + g) results in next year’s profits; and multiplying this result
by (1 – d) gives next year’s retained earnings. This is the amount by which
the book equity component of the balance sheet will grow.
Next, observe that the ratio of assets to equity (total assets to common stock
equity) equals 1 plus the ratio of total liabilities, L, to shareholders’ equity.
Assuming that the firm maintains a constant assets-to-equity ratio is
equivalent to assuming that the ratio of liabilities to equity remains constant.
Hence, for each dollar of earnings that the company retains, it can borrow an
additional L/E dollars to keep the mix of debt and equity constant. The
increase in liabilities next year simply equals the product of next year’s
retained earnings and the ratio of liabilities to equity:
Increase in liabilities = S(m)(1 + g)(1 - d)(L/E)
Finally, if the increases in assets must match the increase in the sum of
liabilities and equity, then we can write the following equations:
This model is used to derive sustainable growth rate g* that keeps the
sources and uses of funds in balance. Each of the key variables in the
equation affects the sustainable growth rate.
If a firm’s profit margin (m) increases, then the numerator rises and the
denominator falls so g* increases. Therefore, generating higher profits per
dollar of sales provides for a higher growth rate.
Similarly, an increase in the ratio of assets to equity – which can occur only if
the firm is willing to accept greater financial leverage (more debt) – also
increases the sustainable growth rate. Firms willing to borrow more can grow
more rapidly.
If a firm can increase its total asset turnover ratio (S/A), then the inverse
ratio A/S falls and the sustainable growth rate rises. Firms that manage
assets more efficiently and generate higher sales volume per dollar of assets
can achieve more rapid growth.
Finally, a reduction in dividend payouts (d) also tends to increase g*. When
firms retain and reinvest more earnings, they can finance faster growth.
Reducing dividend payouts to increase growth is difficult to achieve in reality
– a firm that cuts its dividend is perceived as a financially troubled firm. Most
dividend paying firms consider the dividend to be fixed payment, even
though legally, the firm is free to change that payment.
Interpreting the Sustainable Growth Model*
It is just as important to understand what the sustainable growth model does
not say as it is to grasp what it does say. The sustainable growth model gives
managers a shorthand projection that ties together growth objectives and
financing needs. It provides hints about the levers that managers must pull
in order to achieve growth beyond the sustainable rate. The model also
identifies some financial benefits of growing more slowly than the
sustainable rate. A firm that expects to grow at a rate less than g* can plan
to reduce leverage or asset turnover, or it can increase dividends; the model
does not say anything about how fast the firm should grow.
This model also highlights tensions that can develop as firms simultaneously
pursue multiple objectives. Compensation issues may further cloud the
evaluation of competing objectives: for example, the compensation of the
vice president of marketing may be tied to generating additional sales
volume, whereas the CFO’s compensation may depend on maintaining the
firm’s credit rating.
The primary advantage of the sustainable growth model is its simple way of
linking together various aspects of financial planning. However, the financial
planning process generally involves more complex projections. These
projections are usually embodied in a set of pro forma income statements
and balance sheets that firms use to provide a benchmark against which to
judge future performance.
Pro Forma Financial Statements
Periodically, firms producepro formafinancial statements, which are
forecasts of what they expect their income statement and balance sheet to
look like a year or two ahead. Occasionally, firms use these statements to
communicate their plans to outside investors. Most of the time, however,
managers construct pro forma financial statements for purposes of internal
planning and control. By making projections of sales volume, profits, fixed
asset requirements, working capital needs, and sources of financing, the firm
can establish goals to which compensation may be tied. The firm can also
predict liquidity requirements with enough lead time to arrange additional
financing when needed.
The process of creating pro forma financial statements varies from firm to
firm, but there are some common elements. Most pro forma statements
begin with a sales forecast which may be derived through either a “top-
down” or “bottom-up” approach.
Top-down sales forecastsrely heavily on macroeconomic and industry
forecasts. Senior managers establish a firm-wide objective for increased
sales; individual divisions or business units receive targets that, in
aggregate, collectively achieve the firm’s overall growth target; division
heads pass down sales targets to product line managers and other smaller-
scale units. The sales targets will vary across units within the division, but
they must add up to achieve the divisional goal.
Bottom-up sales forecastsbegin by assessing demand in the coming year
on a customer-by-customer basis. Managers add up these figures across
sales territories, product lines, and divisions to arrive at the overall sales
forecast for the company. This approach generally does not rely on
mathematical and statistical models.
Not surprisingly, many firms use a blend of these two approaches.
Constructing Pro Forma Statements
Starting with the sales forecast, financial analysts construct pro forma
income statements and balance sheets using a mix of facts and
assumptions. For example, if a firm’s strategic plan calls for major
investments in fixed assets, then the analyst will incorporate those
projections in the forecast of total fixed asset requirements as well as in the
forecast of depreciation expense. In the absence of any specific knowledge
of capital spending plans, an analyst may assume that total fixed assets will
remain at a fixed percentage relative to sales or total assets; this assumption
would, in turn, drive the depreciation line item on the income statement.
Similarly, an analyst can make projections for line items that vary with sales
volume. For example, by assuming a constant gross profit margin, the
analyst can estimate cost of goods sold directly from the sales forecast.
When firms construct pro forma statements by assuming that all items grow
in proportion to sales and by extending that percentage to all income
statement and balance sheet accounts, they are using thepercentage-of-
sales method. This is a good starting point since such balance sheet items
as receivables, inventory, and payables do typically increase with sales,
although not always in a linear fashion.
In constructing pro forma statements, analysts usually leave one line item on
the balance sheet as a plug figure, which is adjusted after making all other
projections. The analyst may make projections for all asset, liability, and
equity accounts except for the cash balance; then, when the projections are
complete, the analyst simply adjusts the cash account to make the balance
sheet balance. Alternatively, the analyst might leave a short-term liability
account open to serve as the plug figure. If this assumed amount of
borrowing on the credit line seems unreasonable, the company may need to
recalculate the other assumptions underlying its planning process.
Estimating External Funds Required
Firms must also estimate the amount ofexternal financing required
(EFR), which is the function of three factors. The first term in the equation
(A/S)ΔS, indicates the additional investment in assets required for a firm if it
plans to maintain its total asset turnover ratio and increase the dollar volume
of sales by ΔS. (Remember that the delta Δ means "change in.")
The second term measures the inflow of funds available to finance this
growth. The inflow represented by this second term assumes that the
relationship between a firm's sales and its spontaneous liabilities (in our
example, accounts payable) remains constant. The third term captures the
additional financing inflows that the firm creates internally through retained
earnings. Thus we have:
Two important points must be remembered. First, shorthand approaches -
such as the sustainable growth model or the equation for determining
external funds required - help managers predict whether they should expect
a scarcity or a surplus of financial resources, given the firm's growth
objectives. Second, firms can construct a more complete picture of their
funding requirements by building pro forma income statements and balance
sheets. Managers can use any of these models to reduce the risk of
experiencing unpleasant financial surprises a year or two ahead.
Planning and Control
Lesson11of46
Short-Term Financing Strategies
Most firms establish growth as one of their long-term objectives, and most
firms, when planning for growth, focus on meeting sales target growth rates.
It is not unusual to observe a distinct upward trend in any company’s
historical sales volume. However, in a single year many firms experience
sharp quarter-to-quarter sales changes due to seasonal factors.
Construction-related businesses generate much higher volume in the
summer than they do in the winter. In contrast, toy companies experience
peak volume in the winter.
Because sales volume tends to fluctuate around a long-term upward trend,
we expect to observe the same pattern when we examine a firm’s total
assets over time. As sales volume grows, so does the firm’s need for current
and fixed assets. During the year, a firm’s investment in current assets will
tend to rise and fall with sales. This seasonal pattern creates temporary cash
surpluses and deficits that the firm must manage. To demonstrate
alternative financing strategies, let us apply what we know to Hershey Foods.
Hershey Foods’ Experience
Hershey’s fiscal year matches the calendar year, so its quarterly income
statements report sales for quarters ending in March, June, September, and
December each year. For Hershey, sales usually peak in the third or fourth
quarter of each year. Sales troughs typically occur in the second quarter.
Hershey’s sales show a consistent pattern of growth and reduced growth in
the quarters identified. Hershey’s total current assets show the same
seasonal pattern (with a lag of one quarter) and the same upward trend of
company’s sales. Hershey builds current assets, mostly inventory and
receivables, during the third and fourth quarters of each year, and it draws
down these items during the first and second quarters.
Because Hershey’s total current assets fluctuate around a long-term upward
trend, we can think of the company’s current assets as containing both a
temporary and a permanent component. The temporary component reflects
the differences between the seasonal peaks and troughs of Hershey’s
business. The permanent component represents the sizeable investment in
current assets that Hershey maintains even during the quarters when
business is slow.
Hershey’s fixed assets do not exhibit the seasonal pattern of sales and
current assets. However, its fixed assets do follow the long-term upward
trend, essentially following the long-term growth in Hershey’s sales.
Financing Strategies
Companies can adopt the following strategies to fund long-term trend and
seasonal fluctuations of sales:
Hershey Foods’ Financing Strategies
What financing strategies might Hershey employ to fund both the long-term
trend and seasonal fluctuations in its total current assets? First, Hershey
might adopt aconservativestrategy, one in which the firm makes sure it
has enough long-term financing to cover its permanent and seasonal
investments in current assets. Using such a strategy, Hershey has a cash
surplus for much of the year, drawing down that surplus only when total
current assets reach their peak during the third and fourth quarters each
year. Hershey will invest its excess cash balances in marketable securities.
We describe this strategy as conservative because it minimizes the risk that
Hershey will experience a liquidity crisis during peak quarters. Hershey will
generally pay higher interest rates on its long-term debt than it would pay if
it were willing to borrow on a short-term basis.
The second strategy that Hershey might adopt is much moreaggressive;
the company relies heavily on short-term borrowing not only to meet the
seasonal peaks each year but also to finance a portion of the long-term
growth in total current assets. During peak quarters, Hershey increases its
short-term borrowings. But even during the first and second quarters, when
business is relatively slow, Hershey continues to finance at least part of its
operations with short-term debt. Hershey uses short-term financing to fund a
portion of its long-term, or permanent, growth in total current assets. With
this strategy, the company takes advantage of short-term interest rates,
which are usually lower than long-term rates. However, if short-term rates
rise, then Hershey will face increased interest expense. The firm also faces a
significant refinancing risk in this strategy. That is, if Hershey’s financial
condition weakens, it may not be able to roll over short-term debt as it had in
the past.
A third strategy is thematchingstrategy. Firms that follow the matching
strategy finance the permanent component of current assets with long-term
financing and finance the temporary or seasonal portion of current assets
with short-term debt. Hershey will increase short-term borrowing during peak
times, and it will repay those loans as it reduces its investment in total
current assets during slow periods. This approach is a middle-of-the-road
approach. If Hershey finances its short-term assets with short-term debt,
then it will have smaller cash surpluses than under the conservative
approach but its borrowing costs will be lower, on average (because short-
term debt is usually lower cost than long-term debt). Short-term debt is safer
for the lender because it is easier to predict interest rates over the short
term and riskier for the borrower because the money might come due before
the firm has earned enough to pay it back. Hershey’s interest costs will be
lower under the matching approach than with the aggressive strategy, but it
will face more exposure to refinancing risk and its interest costs will fluctuate
more from quarter to quarter.
Regardless of which strategy Hershey decides to pursue, the company will
pay careful attention to short-term inflows and outflows of cash. Doing so will
allow the company to invest unanticipated cash surpluses and cover
unexpected deficits. The primary tool for managing cash flow on a short-term
basis is thecash budget. A cash budget is an excellent tool to ensure that
cash disbursements will be in line with cash receipts.
The Cash Budget*
Because it takes cash to operate on a day-to-day basis, firms monitor their
cash inflows and outflows very closely. The primary tool they use for this
purpose is the cash budget.
A cash budget is a statement of the firm’s planned inflows and outflows of
cash. Firms use the cash budget to ensure they will have enough cash
available to meet short-term financial obligations. Any surplus cash
resources can be invested quickly and efficiently. Typically, the cash budget
spans a one-year period with monthly subperiods. Besides the volume of
cash transactions, other factors that determine the frequency with which
firms construct cash budgets include the volatility of prices and sales volume
and the importance of seasonal fluctuations. Running out of cash is an ever-
present threat at small and medium-size companies. Vulnerable companies
include those that are growing rapidly and firms in distress.
As with pro forma financial statements, the key input required to build a cash
budget is the firm’s sales forecast; the financial manager estimates the
monthly cash inflows from cash sales, receivable collections, and other
sources. Naturally, a complete cash budget also contains estimates of cash
outflows; some of these vary directly with sales and some do not. Cash
outlays include purchases of raw materials, labor and other production
expenses, selling expenses, and investments in fixed assets. A cash budget
usually presents projected inflows (cash receipts) first. Next come the
projected outflows (cash disbursements). Finally, the cash budget shows
whether the firm expects a net cash inflow or outflow for the period.
Depending on the firm’s cash balance at the start of the period, the cash
budget will either reveal a need for additional financing or demonstrate that
the firm will have surplus cash to invest in short-term marketable securities.
The Cash Budget Cash Receipts and
Disbursements*
The cash budget also includes cash receipts, all the firm’s cash inflows in a
given period. The most common components of cash receipts are cash sales,
collections of accounts receivable, and other cash receipts. The firm
estimates collections of accounts receivable using the past payment patterns
of its customers.
Cash disbursements, on the other hand, include all outlays of cash by the
firm in the period. The most common cash disbursements are cash
purchases, fixed asset outlays, payments of accounts payable, wages,
interest payments, taxes, and rent and lease payments. Cash disbursements
may also include items such as dividends and share repurchases. It is
important to remember that depreciation and other noncash expenses are
not included in the cash budget. They are not outlays of cash and merely
represent a scheduled write-off of an earlier cash outflow. However,
depreciation does have a cash flow effect through its impact on tax
payments.
We can calculate the firm’s net cash flow by subtracting its cash
disbursements from its cash receipts for each period. By adding the
beginning cash balance to the firm’s net cash flow, we determine the ending
cash balance for each period. When a firm wants to establish a minimum
level for its cash balance, it will subtract the desired minimum cash balance
from the ending cash balance. The result is the required total financing or
the excess cash balance. If the ending cash balance is less than the desired
minimum cash balance, then the firm has a short-term financing need. The
firm meets this need with short-term borrowing, typically notes payable. If
the ending cash balance exceeds the desired minimum cash balance, then
the firm has an excess cash balance that it can invest in short-term
marketable securities.
The Cash Budget Dealing With Uncertainty
Because the cash budget provides only month-end totals, it does not ensure
that the firm has sufficient credit to cover intra-month financing needs. For
example, what if a firm’s disbursements occur before its receipts during a
particular month? In that case, its intra-month borrowing needs will exceed
the monthly totals shown in its cash budget. To ensure sufficient credit, the
firm may forecast its expected receipts and disbursements on a daily basis
and use these estimates, along with its cash budget, when arranging
adequate credit to cover its maximum expected cash deficit.
The monthly cash surpluses and deficits predicted in the budget are affected
by virtually all facets of a firm’s operations. For example, changes in
receivables collection, in payment patterns, or in inventory turnover can
have a dramatic impact on financing needs. Any action that slows collections
from customers or accelerates payments to suppliers will increase monthly
financial deficits (or reduce surpluses). Changes in a firm’s collection or
payment pattern alter the timing and magnitude of its financing needs. A
slowdown (speedup) in collections will increase (reduce) the firm’s short-
term financing needs. Conversely, with regard to payment patterns, a
speedup (slowdown) in payments will likely increase (reduce) the firm’s
financing needs. In that sense, almost any functional area in the firm can
affect, or be affected by, the cash budget.
When firms construct financial plans, they clearly hope to meet the plans’
goals. But the value of planning is not just in attaining established goals.
Rather, its importance derives from the thinking it forces managers to do –
not only about what they expect to occur in the future but also about what
they will do if their expectations are not realized.
Financial Instruments and the Firm's Balance Sheet
Lesson13of46
Assets
Before describing individual financial assets, we must differentiate between
real assets and financial assets, the two general categories into which we
classify assets in the business world. Although any asset generally is
regarded as something that provides value to its owner, a significant
difference exists between how value is provided by a real asset and how it is
provided by a financial asset. A real asset sometimes is called a physical
asset because it typically is a tangible (that is, physically observable) item,
such as a computer, a building, or an inventory item. On the other hand, a
financial asset is intangible because it represents an expectation, or promise,
that future cash flows will be paid to the owner of such an asset.
Different groups of investors prefer different types of financial instruments,
and investors' tastes change over time. Thus, corporations and governments
offer a variety of securities, and they package their security offerings at each
point in time to appeal to the greatest possible number of potential
investors. For the most part, however, a financial asset can be classified as
debt, equity, or a derivative.
A derivative is a contract that derives its value from the performance of an
underlying entity such as asset, an index, or an interest rate. Common
derivatives include forwards, futures, options, and swaps. Some derivatives
can be quite exotic and complicated, such as credit default obligations
(CDOs) that were involved in the 2008-09 financial crisis.
Major Financial Instruments
The table below lists some of the more familiar financial instruments that are
traded in the various financial markets. In the table, these instruments are
arranged in order from those with the shortest maturities to those with the
longest (or no) maturities.
T Financial Assets Issued or Held by Corporations
Treasury Bills Short-term debt obligation backed by the U.S. government
with a maturity of less than one year
Repurchase Agreements
T Financial Assets Issued or Held by Corporations
Contract for a future transaction between two parties to be
concluded on a known deal date
Federal Funds Overnight borrowings between banks and other entities to
maintain their bank reserves at the Federal Reserve
Bankers Acceptances Promised future payment which is accepted and guaranteed
by a bank and drawn on a deposit at the bank
Commercial Papers Unsecured promissory note with a fixed maturity of not
more than 270 days
Eurodollars Time deposits denominated in U.S. dollars at banks outside
of the United States
Negotiable Certificate of Deposit CD with a face value of $100,000 or more, guaranteed by a
bank, that cannot be cashed in before maturity
Money Market Funds Open-ended mutual fund that invests in short-term debt
securities such as U.S. Treasury bills and commercial paper
Treasury Notes and Bonds U.S. Treasury securities with maturities of at least one year
Municipal Bonds Long-term debt issued by a local government or agency,
generally used to finance public projects
Term Loans Loan from a bank for a specific amount that has a specified
repayment schedule
Corporate Bonds Long-term debt issued by a corporation and sold to
investors, backed only by the corporation's ability to pay
Preferred Stock Represents a class of ownership in a corporation with a
higher claim on its assets and earnings than common stock
Common Stock Represents ownership in a corporation with rights to its
assets and earnings after all other claims are satisfied
Financial Instruments and the Firm's Balance
Sheet
A company invests in real assets such as inventories and fixed assets to
generate revenue and returns. At the same time, a corporation issues
financial instruments to raise funds to acquire these assets. In other words,
the company issues financial instruments so that the assets necessary to
produce products or services can be purchased. In addition, firms use
derivatives to hedge, or insure, against a variety of risks.
Table 2 shows a simplified balance sheet for XYZ Corporation. At the end of
20X1, the book value of XYZ's assets was $740 million. These assets were
financed by (1) debt in the form of current liabilities (short term) and bonds
(long term), which totaled $410 million, and (2) equity, which totaled $330
million. During the year, XYZ's investment in total assets increased by $60
million, rising from $680 million at the beginning of 20X1 (end of 20X0) to
$740 million at the end of the year. The company raised the funds needed to
purchase the additional assets by using another $10 million in short-term
debt (current liabilities increased from $220 million to $230 million), by
issuing bonds worth $30 million (long-term debt increased from $150 million
to $180 million), and by retaining $20 million of the income earned during
the year (retained earnings increased from $150 million to $170 million). The
total amount of funds raised during 20X1 was $60 million = ($10 million
increase in short-term debt) + ($30 million increase in long-term debt) +
($20 million increase in retained earnings).
In 20X1, XYZ had total liabilities equal to $410 million, which represented
funds borrowed from such creditors as banks, materials suppliers, and
investors in the firm's bonds. Thus, the company owes its creditors $410
million. Only $230 million is "current," which means that it must be paid
during the year 20X2; the rest is due in future years.
As shown in the common equity section of the balance sheet, XYZ's owners -
its stockholders - have authorized management to issue a total of 75 million
shares, and management actually has issued, or sold, 40 million shares thus
far. Each share has a par value of $1, which is the minimum amount for
which each new share of common stock can be issued.
The company generated $50 million in net income in 20X1. A portion of the
earnings was paid out as dividends to stockholders, and the remainder was
added to retained earnings. Total dividend payments were $30 million, so
$20 million was added to accumulated retained earnings to produce the
$170 million balance shown at year-end 20X1. Thus, XYZ has retained, or
plowed back into the company, a total of $170 million since it began
business. This money belongs to the common stockholders because it
represents funds that could have been paid as dividends in previous years.
Instead, the stockholders "allowed" management to reinvest the $170 million
in the business to grow the firm.
Now consider the $120 million in additional paid-in capital. This account
shows the difference between the stock's par value and the amount that
stockholders paid when they bought newly issued shares of common stock.
For example, when XYZ was formed some years ago, 15 million shares were
issued at par value. The first balance sheet, therefore, showed $0 for paid-in
capital and $15 million in the common stock account. A few years later, to
raise funds for expansion projects, XYZ issued 25 million more shares at a
market price of $5.80 per share – the total value of the issue was $145
million. At that time, the common stock account was increased by $25
million ($1 par value for the 25 million shares issued), and the remainder of
the $145 million stock issued, $120 million, was reported in additional paid-in
capital. XYZ has not issued any more stock since then, so the only change in
the common equity section since that time has occurred in retained
earnings.
As Table 2 shows, XYZ used both debt and equity to raise funds to support
its 20X1 operations. The debt and equity instruments issued by the
company, which were purchased by individuals, other corporations, and
financial institutions, represent some of the financial assets that are traded
in the financial markets.
Debt
Lesson14of46
Debt Features
Simply stated, debt is a loan to a firm, a government, or an individual. Many
types of debt instruments exist: home mortgages, commercial paper, term
loans, bonds, secured and unsecured notes, and marketable and
nonmarketable debt, among others. Each type of debt can be identified by
describing its primary features:
1. Secured or unsecured?
2. Principal repayment value (amount borrowed)
3. Single or multiple cash inflows?
4. Interest rate and type (fixed, variable, or deducted from the
original loan amount)
5. Time to maturity
6. Frequency of payments (single, monthly, quarterly, etc.)
7. Presence of balloon payment? (Is the last payment larger
than the rest?)
8. Amortizing or not? (Does the balance decline over time?)
For example, a $1,000, 10-year, 8 percent corporate bond will most likely
have these features:
1. Is a “general obligation” secured only by the ability of the
company to pay
2. Has a $1,000 principal loan amount
3. Provides a single cash inflow to the issuer
4. Has a fixed 8 percent annual interest rate on the $1000
principal
5. Matures 10 years after issue
6. Requires semi-annual interest payments ($40 per payment =
$80 per year)
7. Has a $1,000 balloon payment at maturity
8. Is not amortizing (balance owed remains at $1,000
throughout its life)
Debtholders have priority over stockholders with regard to distribution of
earnings and liquidation of assets. That is, they must be paid before
stockholders can be paid. Interest on debt is paid before stock dividends are
distributed, and any outstanding debt must be repaid before stockholders
can receive any proceeds from liquidation of the company.
Theprincipal valueof debt represents the amount owed to the lender,
which must be repaid at some point during the life of the debt. For much of
the debt issued by corporations, the principal amount is repaid at maturity.
Consequently, we also refer to the principal value as thematurity value. In
addition, the principal value generally is written on the "face" – that is, the
outside cover – of the debt instrument, so it is sometimes called the face
value.
When the market value of debt is the same as its face value, it is said to be
selling at par; thus the principal amount is also referred to as thepar value.
For most debt, the termspar value,face value, maturity value,
andprincipal valueare used interchangeably to indicate the amount that
must be repaid by the borrower.
In many cases, owners of debt instruments receive periodic payments of
interest, which are computed as a percentage of the principal amount. Some
debts do not pay interest; to generate a positive return for investors, such
financial assets must sell for less than their par, or maturity, values.
Securities that sell for less than their par value are said to be selling at a
discount. Securities that sell at a discount when issued are
calleddiscounted securities.
If an investor holds a discounted security until its maturity date, the dollar
return that he or she earns is the difference between the security's purchase
price and its maturity, or face, value. Most discounted debt securities have
maturities of 1 year or less.
The maturity date represents the date on which the principal amount of a
debt is due. As long as interest has been paid when due, once the principal
amount is repaid, the debt obligation has been satisfied.
Some debt instruments, called installment loans, require the principal
amount to be repaid in regular payments during the life of the loan. In such
cases, the maturity date is the date the last installment payment of principal
is due. The time to maturity varies – some debt has maturity as short as a
few hours, while other debt has no specific maturity.
Debtholders do not have voting rights, so they cannot attain corporate
control. Nevertheless, debtholders can affect the management and the
operations of a firm by placing restrictions on the use of the borrowed funds
as part of the loan agreement.
Short-Term Debt: T-Bills and Repos
Short-term debtgenerally refers to debt with a maturity of 1 year or
less.Treasury bills (T-bills)are discounted securities issued by the U.S.
government to finance operations. When the U.S. Treasury issues T-bills, the
prices are determined by an auction process where interested investors and
investing organizations submit competitive bids for the T-bills offered. T-bills
are issued electronically with face values ranging from $1,000 to $5 million,
and with maturities of 4, 13, 26, or 52 weeks at the time of issue.
Arepurchase agreement (repo)is an arrangement in which one firm sells
some of its financial assets to another firm with a promise to repurchase the
securities at a higher price at a later date. The price at which the securities
will be repurchased is agreed to at the time the repo is arranged. One firm
agrees to sell the securities because it needs funds, whereas the other firm
agrees to purchase the securities because it has excess funds to invest.
Thus, with this arrangement, the repo seller effectively borrows funds from
the repo buyer.
Often the parties involved in repurchase agreements are banks, and the
securities that are sold and repurchased are government securities, such as
T-bills. Although some repos last for days or even weeks, the maturity for
most repurchase agreements is overnight.
Short-Term Debt: Federal Funds
Federal funds, often referred to simply as "fed funds," represent overnight
loans from one bank to another. Banks generally use the fed funds market to
adjust their reserves: banks that need additional funds to meet the reserve
requirements of the Federal Reserve borrow from banks with excess
reserves, and vice versa. The interest rate associated with such debt is
known as the federal funds rate. Federal funds have very short maturities,
often overnight.
Short-Term Debt: Banker’s Acceptances and
Commercial Paper
Abanker’s acceptancemight be best described as a post-dated check.
More accurately, a banker's acceptance is atime draft– an instrument,
issued by a bank, that obligates the bank to pay a specified amount to the
owner of the banker's acceptance at some future date. Generally used in
international trade, a banker's acceptance arrangement is established
between a bank and a firm to ensure the firm's international trading partner
that payment for goods and services essentially is guaranteed at some
future date, which is sufficient time to verify the completion of the
transaction.
Banker's acceptances generally are sold by the original owner before
maturity to raise immediate cash. They are sold at a discount, however,
because they do not pay interest. Banker's acceptances generally have
maturities of 180 days or less.
Commercial paper*is a type of promissory note, or legal IOU, issued by
large, financially sound firms. Like T-bills, commercial paper does not pay
interest, so it must be sold at a discount. The maturity on commercial paper
varies from 1 to 9 months, with an average of about 5 months. Generally,
commercial paper is issued in denominations of $100,000 or more, so few
individuals can afford to directly invest in the commercial paper market.
Instead, commercial paper is sold primarily to other businesses, insurance
companies, pension funds, money market mutual funds, and banks.
Short-Term Debt: Certificate of Deposit and
Eurodollar Deposit
Acertificate of deposit (CD)represents a time deposit at a bank or other
financial institution. Traditional CDs generally earn periodic interest and
must be kept at the institution for a specified time period. To liquidate a
traditional CD prior to maturity, the owner must return it to the issuing
institution, which applies an interest penalty to the amount paid out.
Negotiable CDs, however, can be traded to other investors prior to
maturity because they can be redeemed by whomever owns them at
maturity. Often calledjumbo CDs, these financial assets typically come in
denominations of $1 million to $5 million. They have maturities that range
from a few months to a few years.
AEurodollar depositis a deposit in a bank outside the United States that is
not converted into the currency of the foreign country; instead, it is
denominated in U.S. dollars. Such deposits are not exposed toexchange
rate risk, which is the risk associated with converting dollars into foreign
currencies. Eurodollar deposits earn rates offered by foreign banks and are
not subject to the same regulations imposed on deposits in U.S. banks.
Consequently, the rate that can be earned on Eurodollars is sometimes
considerably greater than the rate that can be earned in the United States.
Short-Term Debt: Money Market Mutual
Funds
Money market mutual funds represent funds that are pooled and managed
by investment companies for the purpose of investing in short-term financial
assets. Investment companies accept money from savers and then use these
funds to buy various types of financial assets.
These funds offer individual investors the ability to indirectly invest in such
short-term securities as T-bills, commercial paper, Eurodollars, and so on,
which they otherwise would not be able to purchase because such
investments either are sold in denominations that are too large or are not
sold to individuals.
Mutual funds reduce risk through diversification among investments and can
achieve economies of scale, which lower costs to investors.
Long-Term Debt: Term Loans
Long-termdebt refers to debt instruments with maturities greater than 1
year. Owners of such debt generally receive periodic payments of interest.
Aterm loanis a contract under which a borrower agrees to make a series of
interest and principal payments on specific dates to the lender. Term loans
usually are negotiated directly between the borrowing firm and a financial
institution, such as a bank, an insurance company, or a pension fund. For this
reason, they are often referred to asprivate debt. Although term loans'
maturities vary from 2 to 30 years, most maturities are in the 3-year to 15-
year range.
Term loans have three major advantages over public debt offerings, such as
corporate bonds: speed, flexibility, and low issuance costs. Because they are
negotiated directly between the lender and the borrower, formal
documentation is minimized.
Another advantage of term loans relates to their future flexibility. If a bond
issue is held by many different bondholders, it is virtually impossible to
obtain permission to alter the terms of the agreement, even though new
economic conditions might make such changes desirable. With a term loan,
however, the borrower generally can sit down with the lender and work out
mutually agreeable modifications to the contract.
The interest rate on a term loan can be either fixed for the life of the loan or
variable. Generally, when interest rates become more volatile, banks and
other lenders are more reluctant to make long-term, fixed-rate loans, so
variable-rate term loans become more common.
Long-Term Debt: Bonds
Abondis a long-term contract under which a borrower agrees to make
payments of interest and principal on specific dates to the bondholder.
The periodic interest payments on bonds are determined by thecoupon
rateand theprincipal, or face, valueof the bond. The coupon rate
represents the total interest paid each year, stated as a percentage of the
bond's face value. It’s called the coupon rate because, for a long time in the
past, bonds were paper documents that had coupons attached to them that
the holder would detach one at a time and redeem at a bank or other
institution when interest payments were due. When electronic records
became the norm, bonds ceased to be issued as paper documents but the
term “coupon rate” continued to be used.
Typically, interest on bonds is paid semiannually (meaning twice as many
payments at half the amount), although bonds that pay interest annually,
quarterly, or monthly also exist.
Some of the more common bonds issued by both governments and
corporations include the following:
1. Government bondsare issued by the U.S. government,
state governments, and local or municipal governments. U.S.
government bonds are issued by the U.S. Treasury and are
called eitherTreasury notesorTreasury bonds. Both
types of debt pay interest semiannually.Municipal bonds,
ormunis, are similar to Treasury bonds, except that they are
issued by state and local governments. The two principal
types of munis are revenue bonds and general obligation
bonds.Revenue bondsare used to raise funds for projects
that generate revenues that contribute to payment of
interest and the repayment of the debt.General
obligationbonds are backed by the government's ability to
tax its citizens; special taxes or tax increases are used to
generate the funds needed to service such bonds.
2. Corporate bondsare issued by businesses called
corporations. Although corporate bonds traditionally have
been issued with maturities of between 20 and 30 years,
bonds with shorter maturities, such as 7 to 10 years, are also
common. Corporate bonds resemble term loans, but a bond
issue generally is advertised, offered to the public, and sold
to many different investors. With bonds, the interest rate
typically remains fixed, although the popularity of floating-
rate bonds has grown during the past couple of decades.
3. With amortgage bond, the corporation pledges certain
assets assecurity, orcollateral, for the bond. To illustrate,
suppose ABC Corp. needed $30 million to build a major
regional distribution center. The company issued bonds in
the amount of $24 million, secured by a mortgage on the
property (the remaining $6 million was financed with stock,
or equity capital). If ABC defaults on the bonds, the
bondholders can foreclose on the property and sell it to
satisfy their claims. At the same time, if ABC so chooses, it
can issue second mortgage bonds secured by the same $30
million facility. In the event of liquidation, the holders of
these second mortgage bonds would have a claim against
the property, but only after the first mortgage bondholders
had been paid off in full. Second mortgages are sometimes
calledjunior mortgagesbecause they are junior in priority
to the claims ofsenior mortgages, or first mortgage
bonds.
4. Adebentureis an unsecured bond. As such, it provides no
lien, or claim, against specific property as security for the
obligation. Therefore, debenture holders are general
creditors whose claims are protected by property not
otherwise pledged as collateral. In practice, the use of
debentures depends on the nature of the firm's assets as
well as its general credit strength.
5. Asubordinated debentureis an unsecured bond that
ranks below, or is "inferior to," other debt with respect to
claims on cash distributions made by the firm. In the event of
bankruptcy, for instance, subordinated debt has claims on
assets only after senior debt has been paid off. Subordinated
debentures might be subordinated either to designated notes
payable (usually bank loans) or to all other debt.
6. Several other types of corporate bonds are used sufficiently
often to merit mention:
1. Income bondspay interest only when the firm has
sufficient income to cover the interest payments. As a
consequence, missing interest payments on these
securities cannot bankrupt a company. From an
investor's standpoint, these bonds are riskier than
"regular" bonds.
2. Putable bondsare bonds that can be turned in and
exchanged for cash at the bondholder's option.
Generally, the option to turn in the bond can be
exercised only if the firm takes some specified action,
such as being acquired by a weaker company or
increasing its outstanding debt by a large amount.
3. Indexed, or purchasing power, bondsare popular
in countries plagued by high rates of inflation. With
such a bond, the interest payment is based on an
inflation index such as the consumer price index. The
interest paid rises automatically when the inflation rate
rises, thereby protecting bondholders against inflation.
4. Floating-rate bondsare similar to indexed bonds
except the coupon rates on these bonds "float" with
market interest rates rather than with the inflation
rate. Thus, when interest rates rise, the coupon rates
will increase, and vice versa. In many cases, limits are
imposed on how high and low (referred to as "caps"
and "collars," respectively) the rates on such debt can
change, both during each period and over the life of
the bond.
7. During the 1980s,original issue discount bonds (OIDs),
commonly referred to aszero coupon bonds, were created.
These securities were offered at substantial discounts below
their par values because they paid little or no coupon
interest. OIDs have since lost their attraction for many
individual investors. For this reason, most OID bonds
currently are held by institutional investors, such as pension
funds and mutual funds, rather than by individual investors.
8. Another innovation from the 1980s is thejunk bond, a high-
risk, high-yield bond often issued to finance a management
buyout (MBO), a merger, or a troubled company. In junk bond
deals, firms generally have significant amounts of debt, so
bondholders must bear as much risk as stockholders
normally would. The yields on these bonds reflect this fact.
The emergence of junk bonds as an important type of debt is
an example of how corporations adjust to and facilitate new
developments in the financial markets.
Bond Contract Features
Lesson15of46
A firm's managers are concerned with both the effective cost of debt and any
restrictions in debt contracts that might limit the firm's future actions.
Investors are concerned with these same factors, but they are on "the
opposite side of the fence" from the firm – that is, investors expect to receive
a positive return, which, in effect, is paid by the corporations that issue
bonds.
As a result, a firm's cost of debt represents the rate of return that
bondholders (investors) earn. The restrictions that are generally included in
the bond contract are intended to help protect investors' funds from
unethical or fraudulent actions that the firm might pursue.
Bondholders have a legitimate fear that once they lend money to a company
and become "locked in" for a period as long as 30 years, the firm will take
some action that is designed to benefit stockholders but harm bondholders.
Bondholders attempt to reduce the potential for financial problems by use of
legal restrictions designed to ensure, insofar as possible, that the company
does nothing to cause the quality of its bonds to deteriorate after they have
been issued.
Anindentureis a legal document that spells out any legal restrictions
associated with the bond as well as the rights of the bondholders (lenders)
and the corporation (bond issuer). Atrustee, usually a bank, is assigned to
represent the bondholders and to guarantee that the terms of the indenture
are carried out.
The indenture might be several hundred pages long, and it
includesrestrictive covenantsthat cover such points as the conditions
under which the issuer can pay off the bonds prior to maturity, the level at
which various financial measures (such as the ability to pay interest) must be
maintained if the company is to sell additional bonds, and restrictions
against the payment of dividends when earnings do not meet certain
specifications.
TheSecurities and Exchange Commissionapproves indentures for
publicly traded bonds and verifies that all indenture provisions have been
met before allowing a company to sell new securities to the public.
Most corporate bonds contain acall provision, which gives the issuing
corporation the right to call the bonds for redemption prior to maturity. A call
provision generally states that the company must pay the bondholders an
amount greater than the par value for the bonds when they are called. This
additional sum, which is termed acall premium, typically equals one year's
interest if the bonds are called during the first year in which a call is
permitted. The premium declines at a constant rate each year thereafter.
Bonds usually are not callable until several years (generally 5 to 10) after
they are issued. Bonds with such deferred calls are said to havecall
protection.
Asinking fundis a provision that facilitates the orderly retirement of a
bond issue. Typically, the sinking fund provision requires the firm to retire a
portion of the bond issue each year. Failure to meet the sinking fund
requirement will throw the bond issue into default, which might force the
company into bankruptcy. In most cases, the firm has the right to handle the
sinking fund in two ways: by randomly calling for redemption (at par value) a
certain percentage of the bonds each year or by purchasing the required
amount of bonds in the open market. The firm will choose the lower cost
method. If interest rates have risen, causing bond prices to fall, the firm will
buy bonds in the open market at a discount; if interest rates have fallen, it
will call the bonds and pay the face value.
Aconversion featurepermits the bondholder (investor) to exchange, or
convert, the bond into shares of common stock at a fixed price. Investors
have greater flexibility with convertible bonds than with straight bonds,
because they can choose whether to hold the company's bond or convert it
into its stock.
Bond Ratings
Lesson16of46
Since the early 1900s, bonds have been assigned quality ratings that reflect
their probability of going into default. The two major rating agencies are
Moody's Investors Service (Moody's) and Standard & Poor's Corporation
(S&P).
The triple-A and double-A bonds are extremely safe. Single-A and triple-B
bonds are strong enough to be calledinvestment-grade bonds; they are
the lowest-rated bonds that many banks and other institutional investors are
permitted by law to hold. Double-B and lower-rated bonds arespeculative,
or*junk bonds; they have a significant probability of going into default, and
many financial institutions are prohibited from buying them.
Bond ratings are based on both qualitative and quantitative factors. Factors
considered by the bond rating agencies include the financial strength of the
company as measured by various ratios, collateral provisions, the seniority of
the debt, restrictive covenants, provisions such as a sinking fund or a
deferred call, litigation possibilities, regulation, and so on. Representatives of
the rating agencies have consistently stated that no precise formula is used
to set a firm's rating; all the factors listed, plus others, are taken into
account, but not in a mathematically precise manner. Statistical studies have
borne out this contention. Indeed, researchers who have tried to predict
bond ratings on the basis of quantitative data have found only limited
success, indicating that the agencies use subjective judgment when
establishing a firm’s rating.
Bond ratings are important to both issuers and investors for several reasons.
First, because a bond's rating serves as an indicator of its default risk, the
rating has a directly measurable influence on the bond's interest rate and
the firm's cost of using such debt. Second, most bonds are purchased by
institutional investors rather than by individuals, and many institutions are
restricted to investment-grade or high-quality securities. Therefore, if its
bonds fall below a BBB rating, a firm will have a difficult time selling new
bonds because many potential purchasers will not be allowed to buy them.
As a result of their higher risk and more restricted market, lower grade bonds
offer higher returns than high-grade bonds. The figure below illustrates this
point. Throughout all 20 years shown on the graph, U.S. government bonds
have the lowest yields, corporate AAA bonds have the next lowest, corporate
BBB bonds (the lowest investment-grade rating) have higher yields, and BB
bonds (the highest non-investment-grade rating and only one grade lower
than BBB) have a much higher yield. The figure also shows that the gaps
between yields on vary over time, indicating that the cost differentials, or
risk premiums, fluctuate from year to year. (The shaded areas on the chart
indicate economic recessions.)
Changes in a firm's bond rating affect both its ability to borrow long-term
capital and the cost of such funds. (The required yield represents the cost of
the funds to the issuing firm.) Rating agencies review outstanding bonds on
a periodic basis, occasionally upgrading or downgrading a bond as a result of
its issuer's changed circumstances.
Stock (Equity)
Lesson17of46
Each corporation issues at least one type of stock, or equity, calledcommon
stock. Some corporations issue more than one type of common stock, and
some issue preferred stock in addition to common stock. As the names
imply, most equity takes the form of common stock, and preferred
shareholders have preference over common shareholders when a firm
distributes funds to stockholders. Dividends, as well as liquidation proceeds
resulting from bankruptcy, are paid to preferred stockholders before
common stockholders receive any payouts.
On the other hand, preferred stockholders generally receive the same
dividend every year, regardless of the company's earnings or growth during
the year, whereas the dividends paid to common stockholders can vary each
year and often depend on current and previous earnings levels and the firm's
plans for growth.
The amount of stock sold by a corporation is reflected in the "owner's
equity" section of its balance sheet.
Preferred Stock: Priority to Assets and
Earnings and Par Value
Preferred stockoften is referred to as ahybrid securitybecause it is
similar to bonds in some respects and similar to common stock in other
respects. The hybrid nature of preferred stock becomes apparent when we
try to classify it in relation to bonds and common stock. Like bonds, preferred
stock has a par, or face, value. Preferred dividends are similar to interest
payments in that they are fixed in amount and must be paid before common
stock dividends can be distributed. If the preferred dividend is not earned,
however, the directors can omit it (or "pass") without throwing the company
into bankruptcy. Thus, although preferred stock has a fixed payment like
bonds, a failure to make this payment will not lead to bankruptcy.
Preferred stockholders have priority over common stockholders with regard
to earnings and assets. Thus, dividends must be paid on preferred stock
before they can be paid on the common stock, and, in the event of
bankruptcy, the claims of the preferred shareholders must be satisfied
before the common stockholders receive anything. To reinforce these
features, most preferred stocks have coverage requirements similar to those
placed on bonds.
Most preferred stock has a par value or its equivalent under some other
name – for example,liquidation value. The par value is important for two
reasons: (1) it establishes the amount due to the preferred stockholders in
the event of liquidation and (2) the preferred dividend generally is stated as
a percentage of the par value.
Preferred Stock: Cumulative Dividends,
Voting Rights, and Convertibility
Most preferred stock provides forcumulative dividends; that is, any
preferred dividends not paid in previous periods must be paid before
common dividends can be distributed. The cumulative feature acts as a
protective device. If the preferred stock dividends were not cumulative, a
firm could avoid paying preferred and common stock dividends for, say, 10
years, plowing back all of its earnings into the company, and then pay a
huge common stock dividend but only pay the stipulated annual dividend to
the preferred stockholders. Obviously, such an action would effectively void
the preferred position that the preferred stockholders are supposed to enjoy.
The cumulative feature helps prevent such abuses.
Although most preferred stock is not voting stock, preferred stockholders
generally are given the right to vote for directors if the company has not paid
the preferred dividend for a specified period, such as 2 years. For example,
holders of NYSEG preferred stock can elect a majority of the members of the
board of directors if the company misses four consecutive quarterly dividend
payments. This feature motivates management to make every effort to pay
preferred dividends.
Most preferred stock that has been issued in recent years
isconvertibleinto common stock. For example, each share of the Series A
preferred stock issued by Chiquita Brands, a food processor, was convertible
into 2.63 shares of common stock at the option of the preferred
shareholders.
Preferred Stock: Other Provisions
Some other provisions occasionally found in preferred stocks include the
following:
1. Participating:A rare type of preferred stock is one that
participates with the common stock in sharing the firm's
earnings. Participating preferred stocks generally work as
follows: (a) the stated preferred dividend is paid – for
example, $5 per share; (b) the common stock is then entitled
to a dividend in an amount up to the preferred dividend; and
(c) if the common dividend is raised, say to $5.50, the
preferred dividend must likewise be raised to $5.50.
2. Sinking fund:In the past (before the mid-1970s), few
preferred issues had sinking funds. Today, however, most
newly issued preferred stocks have sinking funds that call for
the repurchase and retirement of a given percentage of the
preferred stock each year.
3. Call provision:A call provision gives the issuing corporation
the right to call in the preferred stock for redemption. As in
the case of bonds, call provisions generally state that the
company must pay an amount greater than the par value of
the preferred stock, with the additional sum being dubbed a
call premium.
4. Maturity:Although preferred stock has no specified
maturity date, today most new preferred stock has a sinking
fund and thus an effective maturity date with call provisions.
Common Stock: Dividends
We usually refer to common stockholders as the "owners" of the firm
because investors in common stock have certain rights and privileges
generally associated with property ownership.
Common stockholders can be paid dividends only after the interest on debt
and the preferred dividends are paid. In the event of liquidation resulting
from bankruptcy, common stockholders are last to receive any funds. Thus,
as investors, the common stockholders are "last in line" to receive any cash
distributions from the corporation.
The firm has no obligation, contractual or implied, to pay common stock
dividends. Some firms pay relatively constant dividends from year to year;
other companies do not pay dividends at all. The return that investors
receive when they own a company's common stock is based on both the
change in the stock's market value (capital gain) and the dividend paid by
the company. Some investors prefer current income to future capital gains,
so they invest in firms that pay large dividends; thus their returns are based
primarily on the dividends earned from owning such stocks. These types of
stocks traditionally are calledincome stocks. For example, stocks of utility
companies are typically considered income stocks. On the other hand, some
investors prefer capital gains to current income, so they invest in firms that
pay little or no dividends; thus, their returns are based primarily on the
capital gains earned from owning such stocks. Generally, these types of
firms retain most, if not all, of their earnings each year to help fund growth
opportunities, so their stocks are referred to asgrowth stocks. Microsoft
Corporation is a good example of a growth stock.
Common Stock: Maturity and Voting Rights
Like preferred stock, common stock has no specified maturity – that is, it is
perpetual. At times, however, companies repurchase shares of their common
stock in the financial markets. Stock repurchases might be undertaken when
(1) the firm has excess cash but no "good" investment opportunities, (2) the
price of the firm's stock is undervalued, or (3) management wants to gain
more ownership control of the firm – by repurchasing the stock of other
investors, the percentage owned by management increases.
The common stockholders have the right to elect the firm's directors, who in
turn appoint the officers who manage the business. Stockholders also vote
on shareholders' proposals, mergers, and changes in the firm's charter.
In a small firm, the major stockholder typically assumes the positions of
president and chairperson of the board of directors. In a large, publicly
owned firm, the managers typically own some stock, but their personal
holdings are insufficient to provide voting control. Thus, stockholders can
remove the managers of most publicly owned firms if they decide that a
management team is not effective.
Numerous state and federal laws stipulate how stockholder control is to be
exercised. Corporations must hold an election of directors periodically,
usually once each year, with the vote taken at the annual meeting. In many
firms, one-third of the directors are elected each year for a 3-year term. Each
share of stock normally has one vote, so the owner of 1,000 shares has
1,000 votes. Stockholders of large corporations can appear at the annual
meeting and vote in person, but typically they transfer their right to vote to a
second party by means of an instrument known as a proxy. The
management of large firms always solicits, and thus usually gets,
shareholders' proxies, which is the right to vote those shares for the
shareholder. If earnings are poor and stockholders are dissatisfied, however,
an outside group might solicit the proxies in an effort to overthrow
management and take control of the business. This kind of battle is known as
a proxy fight. The frequency of proxy fights has increased, as have attempts
by one corporation to take over another by purchasing a large amount of the
outstanding stock. This action is called a takeover.
Managers who do not have majority control (more than 50 percent of their
firms' stock) are very concerned about proxy fights and takeovers, and many
attempt to get stockholder approval for changes in their corporate charters
that would make takeovers more difficult. For example, companies have
persuaded their stockholders to agree to the following provisions:
To elect only one-third of the directors each year (rather than electing all
directors each year);
To require 75 percent of the stockholders (rather than 50 percent) to approve a
merger;
To approve a "poison pill" provision that would allow the stockholders of a firm
that is taken over by another firm to buy additional shares at a discounted price.
This provision can dilute the shares held by the acquiring company making the
acquisition unattractive, and, therefore, can ward off hostile takeover attempts.
Common Stock: Preemptive Right
Some common stockholders have the right, called a preemptive right, to
purchase any additional shares sold by the firm. Thepreemptive
rightrequires a firm to offer existing stockholders shares of a new stock
issue in proportion to their ownership holdings before such shares can be
offered to other investors. Most common stock issues do not have
preemptive rights because most states do not require such rights to be
included in corporate charters.
The purpose of the preemptive right is twofold. First, it protects the power of
control of current stock-holders. If not for this safeguard, the management
team of a corporation under criticism from stock-holders could prevent
stockholders from removing the managers from office by issuing a large
number of additional shares and purchasing these shares themselves.
Second, and more importantly, a preemptive right protects stockholders
against thedilution of valuethat would occur if new shares were sold at
relatively low prices.
Types of Common Stock
Although most firms have only one type of common stock, in some instances
classified stock is used to meet the special needs of the company. Generally,
when special classifications of stock are used, one type is designated Class
A, another Class B, and so on. Small, new companies seeking to obtain funds
from outside sources frequently use different types of common stock.
Note that "Class A," "Class B," and so on have no standard meanings. Most
firms have no classified shares, but a firm that does could designate its Class
B shares as founders' shares and its Class A shares as those sold to the
public. Founders’ shares are stock owned by the firm’s founders that has sole
voting rights but generally pays out only restricted dividends for a specified
number of years.
Some companies are so small that their common stocks are not actively
traded; they are owned by only a few people, usually the companies'
managers. Such firms are said to beprivately owned, orclosely
held,corporations, and their stock is calledclosely held stock. In
contrast, the stocks of most larger companies are owned by a large number
of investors, most of whom are not active in management. Such companies
are said to bepublicly owned corporations, and their stock is
calledpublicly held stock.
Derivatives
Lesson18of46
Derivatives: Options
In finance, the termderivativesrefers to financial assets that have values
based on, or derived from, the values of other assets, such as stocks or
bonds. Without the other assets, derivatives would be worthless. Because
the values of derivatives depend on the values of other assets, they can be
rather complex investments.
Anoptionis a contract that gives its holder the right to buy (sell) an asset at
some predetermined price within a specified period of time. "Pure options"
are instruments that are created by outsiders (generally investment firms)
rather than by the firm itself; they are bought and sold primarily by investors
(or speculators).
The most basic types of options include a call and a put. Acall optiongives
the holder the right to purchase, or call in, shares of a stock for purchase at a
predetermined price at any time during the option period. In contrast, aput
optiongives the holder the right to sell, or put out, shares of a stock at a
specified price during the option period. Thetransaction priceestablished
in the option contract - that is, the purchase price for a call and the selling
price for a put – is called thestriking, orexercise,price.
Because options are created by parties outside the firm, such as investment
firms or investors, companies on whose stocks the options are written are
not directly involved in the options markets. Therefore, corporations do not
raise money in the options markets, and option holders neither receive
dividends nor vote for corporate directors (unless they exercise their options
to purchase the stock, which few actually do).
Derivatives: Convertibles
Convertiblesecurities are bonds or preferred stocks that can be exchanged
for, or converted into, common stock at the option of the holder. Conversion
does not bring in additional capital for the issuing firm – rather, debt or
preferred stock is simply replaced by common stock. Of course, this
reduction of debt or preferred stock will strengthen the firm's balance sheet
and make it easier to raise additional capital, but this effect represents a
separate action.
In many cases, a convertible security is issued as a temporary substitute for
common stock when the market price of a firm's stock is depressed but is
expected to improve in the future. If the company wants to ensure that a
convertible security will be converted into common stock once stock prices
rise, the original convertible will include acall provision. The firm will then
call the bond (or preferred stock) when the market price of the common
stock rises to a point where bondholders (preferred stockholders) would
prefer to convert the bonds rather than return the bonds to the firm. When
the conversion takes place, the firm has issued stock. Once the conversion is
made, investors cannot convert back to bonds (preferred stock).
One of the most important provisions of a convertible security is
theconversion ratio, which is defined as the number of shares of stock
that the convertible holder receives upon conversion. Related to the
conversion ratio is the*conversion price, which is the effective price paid
for the common stock obtained by converting a convertible security.
Derivatives: Futures and Swaps
Afutures contractrepresents an arrangement for delivery of an item at
some date in the future; the details of the delivery, including the amount to
be delivered and the price that will be paid at delivery, are specified when
the futures contract is created. Multinational corporations often enter into
futures contracts for foreign currencies used in their transactions. The
futures contract provides the company with insurance against unfavorable
changes in exchange rates – the company has hedged its risk.
Aswapis an agreement to exchange, or swap, cash flows or assets at some
time in the future. For example, firms might agree to exchange interest
payments on outstanding debt. One firm might have fixed-rate debt
outstanding but would prefer to have floating-rate debt, whereas the other
firm might have floating-rate debt outstanding but would prefer to have
fixed-rate debt. Perhaps market conditions make it too costly for each firm to
refinance or convert their present debt into the desired debt.
The firms could, therefore, agree to swap interest payments such that the
firm with the fixed-rate debt pays the variable interest on the floating-rate
debt, and vice versa. As long as the principal amounts of the two debts are
the same, the swap agreement allows the two firms to create the desired
interest payments. Such an arrangement is referred to as a "plain vanilla"
swap because it is a very simple strategy. More complex arrangements
include combination swaps in which multiple items are exchanged; an
example would be a combination interest-rate, exchange-rate swap.
Derivatives: Hedge Funds
Ahedge fundis a relatively new, innovative, and complex investment that
takes many different forms. In simple terms, a hedge fund is a private pool of
funds that is constructed for the purpose of generating a specific range of
returns, no matter what happens in the general stock market. To do so,
hedge fund managers follow complex combinations of investment strategies
that include borrowing large amounts of money and taking a variety of
investment positions in stocks, bonds, options, swaps, and other derivatives.
Because they are "private" and intended for investment-savvy investors,
hedge funds are not subject to the same restrictions, regulations, and
registration requirements as most other investment instruments, including
mutual funds.
Rationale for Different Types of Securities
Lesson19of46
Why do so many different types of securities exist? At least a partial answer
to this question might be seen in the figure below, which depicts the tradeoff
between the risk and expected after-tax return for the various securities
issued by XYZ Products. First, U.S. Treasury bills, which represent the risk-
free rate, are shown for reference. The lowest-risk, long-term securities
offered by XYZ are itsfloating-rate notes. These securities are free of risk
associated with changes in interest rates (interest rate risk), but they are
exposed to some risk of default, or nonpayment by the company. The*first
mortgage bondsare somewhat riskier than the notes (because the bonds
are exposed to interest rate risk), and they sell at a somewhat higher after-
tax return. Thesecond mortgage bondsare even riskier, so they have an
even higher return.Subordinated debentures,*income bonds,
andpreferred stocksare all increasingly risky, and their returns increase
accordingly. XYZ’scommon stock*is the riskiest security it issues, so it has
the highest return.
Why does XYZ issue so many different classes of securities? Why not offer
just one type of bond plus common stock? The answer lies in the fact that
different investors have different risk/return tradeoff preferences. Thus, to
appeal to the broadest possible market, XYZ must offer securities that
attract as many different types of investors as possible. Also, different
securities are more popular at different points in time, and firms tend to
issue whatever is popular at the time they need money.
Which Type of Financial Instrument is Best?
Lesson20of46
Which Financial Instrument Is Best? Issuer’s
Viewpoint
Simply stated, what is best for one individual or firm is not necessarily best
for another individual or firm. To complicate matters, what is best for one
individual or firm when certain market conditions or circumstances exist
might not be best under other market conditions or circumstances. Let’s
consider the circumstances under which firms might prefer to use debt and
equity to raise funds as well as situations in which investors might have a
preference for one of these investments compared to another.
Traditional bonds(as well as many other forms of debt) require fixed
interest payments regardless of the level of operating earnings for a firm.
Thus, a major advantage associated with debt issues is the firm's ability to
limit its financial costs. This ability proves beneficial when the firm prospers
because earnings above the interest payments can be distributed to
stockholders or reinvested in the firm to fund growth opportunities.
Bondholders do not share in the firm's prosperity; only stockholders do.
Unfortunately, debt can be a drawback during times of economic and
financial adversity, as the interest obligation must be paid even if the firm's
operating earnings are low.
Another advantage of using debt financing is that it does not represent
ownership and does not involve voting rights, which means no dilution of
ownership occurs when the firm issues additional debt. Many bond
indentures and other debt contracts, however, contain clauses that restrict
certain actions the firm can make, such as the amount of common stock
dividends that can be paid each year. If the firm violates any of the
contractual provisions, debtholders might force it to liquidate.
Preferred stockhas many of the same characteristics as debt, including a
fixed payment and no voting rights. For these reasons, a firm might consider
issuing preferred stock if prosperous times are expected so that existing
common stockholders do not have to share the prosperity by issuing
additional common shares. Unlike debt, preferred stock does not "legally"
obligate the firm to make payments to stockholders, and it has no maturity
date.
Preferred stock does have a major disadvantage from the issuer's
standpoint: it has a higher cost than debt. The major reason for this higher
cost is taxes: preferred dividends (and common dividends) are not
deductible as a tax expense, whereas interest expense is deductible. This
fact makes the cost of preferred stock much greater than that of bonds.
Common stockoffers several advantages over other forms of financing for
a corporation:
1. Like preferred stock, common stock does not legally obligate
the firm to make payments to stockholders.
2. Common stock carries no fixed maturity date: it never has to
be "repaid" as would a debt issue.
3. The sale of common stock generally increases the
creditworthiness of the firm because common stock cushions
creditors against losses.
4. If a company's prospects look bright, then common stock
often can be sold on better terms than can debt.
Stock appeals to certain groups of investors because it typically carries a
higher expected total return (dividends plus capital gains) than does
preferred stock or debt. It also provides the investor with a means to hedge
against unanticipated inflation because common dividends tend to rise
during inflationary periods.
Disadvantages associated with issuing common stock include the following:
1. The sale of common stock gives some voting rights - and
perhaps even control - to new stockholders. For this reason,
additional equity financing often is avoided by managers who
are concerned about maintaining control of the firm.
2. Common stock gives new owners the right to share in the
income of the firm. Thus, if profits soar, then new
stockholders will share in this bonanza. If debt had been used
under the same circumstances, new investors would have
received only a fixed return, no matter how profitable the
company proved.
3. The costs of underwriting and distributing common stock
usually are higher than those for debt or preferred stock.
4. Like preferred stock, under current tax laws, common stock
dividends are not deductible as an expense for tax purposes.
Convertible securitiescan be used to take advantage of some of the
benefits associated with both debt and equity. Debt with a conversion
feature offers investors greater flexibility by providing them with the
opportunity to ultimately be either a debtholder or a stock-holder. Thus, such
a feature generally allows the firm to sell debt with lower coupon interest
rates and with fewer restrictive covenants. Even though convertibles do not
bring additional funds into the firm at the time of conversion, they are
nevertheless useful features that help the firm achieve "delayed equity
financing" when conversion occurs. Convertibles generally are subordinated
to mortgage bonds, bank loans, and other senior debt, so financing with
these instruments leaves the company's access to "regular" debt
unimpaired.
In addition, convertibles provide a way to sell common stock at prices higher
than those prevailing when the convertible debt was issued. Many
companies actually want to sell common stock and not debt, but they believe
that the prices of their stocks are temporarily depressed so too many shares
would have to be sold to raise a given amount of money. Such firms might
use convertibles if they expect the prices of common stocks to rise
sufficiently in the future to make conversion attractive; when the conversions
take place, the firms have obtained "delayed equity financing" that
eliminates the original debt. Conversely, if the stock price does not increase
sufficiently, and hence conversion does not occur, the company could be
saddled with debt in the face of low earnings, which could prove disastrous.
Convertible securities are useful, but they do have important disadvantages.
While the use of a convertible feature might, in effect, give the issuer the
opportunity to sell common stock at a price higher than it could otherwise,
that same feature could have negative consequences. If the price of the
common stock increases dramatically, the company probably would have
been better off if it had used straight debt (despite its higher interest rate)
and then later sold common stock to repay the debt.
Also, while convertibles typically have a low coupon interest rate, any
advantage of that is lost when conversion occurs.
Which Financial Instrument Is Best?
Investor’s Viewpoint
In designing securities, the financial manager must consider the investor's
point of view. Both debt and preferred stock provide investors with a
steadier, more assured income stream than does common stock. In addition,
debtholders and preferred stockholders have priority over common
stockholders in the event of liquidation.
The primary advantage of debt from an investor's standpoint is that the firm
is legally obligated to make the interest payments. If payments are missed,
debtholders have legal recourse that might include forcing the firm into
bankruptcy in an attempt to recover what is owed.
Many firms find preferred stock a very attractive investment because 70
percent of the preferred dividends received by corporations is not taxable.
For this reason, most preferred stock is owned by corporations. Conversely,
preferred stock might seem somewhat unattractive to investors because
their returns are limited by the fixed dividend payments even though they
still bear some of the ownership risks.
For individual investors (as opposed to corporations), after-tax bond yields
generally are higher than those on preferred stock even though the
preferred stock is the riskier instrument.
From a social viewpoint, common stock is a desirable form of financing
because it makes businesses less vulnerable to the consequences of declines
in sales and earnings. Common stock financing involves no fixed-charge
payments that might force a faltering firm into bankruptcy. From the
standpoint of the economy as a whole, if too many firms used too much debt
then business fluctuations would be amplified and minor recessions could
turn into major depressions. Not long ago, when the level of leveraged (debt-
financed) mergers and buyouts was increasing the proportion of debt used
by firms, the Federal Reserve and other authorities voiced concern over the
possible dangers created by the situation. Congressional leaders, in turn,
debated the wisdom of social controls over corporations' use of debt. Like
most important issues, this one inspires controversy, and the debate centers
around who can better determine an "appropriate" way for firms to raise
funds − corporate managers or government officials.
From an investor's viewpoint,derivativescan be quite complex. Investors
use derivatives either to manage risk associated with their investment
portfolios or to speculate about the direction in which prices will change in
the future.Optionsandfuturesare created by investors; firms do not use
these instruments to raise funds. Both types of derivatives involve two
parties – one on each side of the transaction. In the aggregate, such
derivatives do not create wealth in the financial markets because when an
investor on one side of the transaction gains from a price movement, the
investor on the other side loses an equivalent amount. This is referred to as
a “zero-sum game.”
Financial Instruments in International
Markets: ADRs
For the most part, the financial securities of companies and institutions in
other countries are similar to those in the United States. Some financial
securities have been created specifically to permit investors easier access to
international investments.
Ownership of foreign companies can be traded internationally
throughdepository receipts, which represent shares of the underlying
stocks of foreign companies. In the United States, most foreign stock is
traded throughAmerican depository receipts (ADRs). ADRs are not
foreign stocks; instead they are "certificates" created by organizations such
as banks. The certificates represent ownership in stocks of foreign
companies that are held in trust by a bank located in the country where the
stock is traded.
ADRs provide U.S. investors with the ability to invest in foreign companies
with less complexity and difficulty than might otherwise be possible. The
market values of ADRs move in tandem with the market values of the
underlying stocks that are held in trust.
Financial Instruments in International
Markets: Debt Instruments
Like the U.S. debt markets, the international debt markets offer a variety of
instruments with many different features. Any debt sold outside the country
of the borrower is called international debt. Important types of international
debt include foreign debt and Eurodebt.
Foreign debtis debt sold by a foreign borrower but denominated in the
currency of the country in which the issue is sold. For instance, a Canadian
multinational company might need U.S. dollars to finance the operations of
its subsidiaries in the United States. If it decides to raise the needed capital
in the domestic U.S. bond market, the bond will be underwritten by a
syndicate of U.S. investment firms, denominated in U.S. dollars, and sold to
U.S. investors in accordance with SEC and applicable state regulations.
The termEurodebtis used to designate any debt sold in a country other
than the one in whose currency the debt is denominated. Examples
includeEurobonds, such as a British firm's issue of pound-denominated
bonds sold in France, or Ford Motor Company's dollar-denominated issue
that is sold in Germany.
The institutional arrangements by which Eurobonds are marketed are
different than those for most other bond issues, with the most important
distinction being a far lower level of required disclosure than normally
applies to bonds issued in domestic markets, particularly in the United
States.
Eurobonds appeal to investors for several reasons. Generally, they are issued
in bearer form rather than as registered bonds, so the names and
nationalities of investors are not recorded. Individuals who desire anonymity,
whether for privacy reasons or for tax avoidance, find Eurobonds to their
liking. Similarly, most governments do not withhold taxes on interest
payments associated with Eurobonds.
Some other types of Eurodebt include the following:
Eurocreditsare bank loans that are denominated in the
currency of a country other than that where the lending bank
is located. Many of these loans are very large, so the lending
bank often forms a loan syndicate to help raise the needed
funds and to spread out some of the risk associated with the
loan.
Euro-commercial paper (Euro-CP)is similar to
commercial paper issued in the United States. This short-
term debt instrument is issued by corporations, typically with
a maturity of 1, 3, or 6 months.
Euronotesare medium-term debt issues, typically with
maturities ranging from 1 to 10 years. The general features
of Euronotes closely resemble those of longer term debt
instruments such as bonds. The principal amount is repaid at
maturity, and interest often is paid semiannually. Most
foreign companies use Euronotes just as they would a line of
credit, continuously issuing notes to finance medium-term
needs.
Financial Instruments in International
Markets: Equity Instruments
The equities of foreign companies resemble those of U.S. corporations. The
primary difference between stocks of foreign companies and U.S. companies
is that U.S. regulations provide greater protection of stockholders' rights than
do the regulations of most other countries. In the international markets,
equity generally is referred to as "Euro stock" or "Yankee stock.”
Euro stock is traded in countries other than the home country of the
company, not including the United States. Thus, if the stock of a Japanese
company is sold in Germany, it would be considered a Euro stock.
Yankee stock is issued by foreign companies and traded in the United States.
If a Japanese company sold its stock in the United States, it would be called
Yankee stock in the international markets.
As the financial markets become more global and more sophisticated, the
financial instruments offered both domestically and internationally will
certainly change. Already, foreign companies and governments have
discovered that financial markets in the United States provide excellent
sources of funds because of the great variety of financial outlets found in this
country. As technology improves and regulations that bar or discourage
foreign investment are repealed, the financial markets of other developed
countries will become more prominent, and new, innovative financial
products will emerge.
T Financial Assets Issued or Held by Corporations
Treasury Bills Short-term debt obligation backed by the
U.S. government with a maturity of less
T Financial Assets Issued or Held by Corporations
than one year
Repurchase Agreements Contract for a future transaction between
two parties to be concluded on a known
deal date
Federal Funds
Overnight borrowings between banks and
other entities to maintain their bank
reserves at the Federal Reserve
Bankers Acceptances
Promised future payment which is
accepted and guaranteed by a bank and
drawn on a deposit at the bank
Commercial Papers Unsecured promissory note with a fixed
maturity of not more than 270 days
Eurodollars Time deposits denominated in U.S. dollars
at banks outside of the United States
Negotiable Certificate of Deposit
CD with a face value of $100,000 or more,
guaranteed by a bank, that cannot be
cashed in before maturity
Money Market Funds
Open-ended mutual fund that invests in
short-term debt securities such as U.S.
Treasury bills and commercial paper
Treasury Notes and Bonds U.S. Treasury securities with maturities of
at least one year
Municipal Bonds
Long-term debt issued by a local
government or agency, generally used to
finance public projects
Term Loans Loan from a bank for a specific amount
that has a specified repayment schedule
Corporate Bonds
Long-term debt issued by a corporation
and sold to investors, backed only by the
corporation's ability to pay
Preferred Stock
Represents a class of ownership in a
corporation with a higher claim on its
assets and earnings than common stock
Common Stock
Represents ownership in a corporation with
rights to its assets and earnings after all
other claims are satisfied
Realized Returns (Yields)
Lesson22of46
The primary role of the financial markets is to help bring together borrowers
and lenders by facilitating the flow of funds from those who have surplus
funds (investors) to those who need funds in excess of their current incomes
(borrowers). Savers (investors) and borrowers (issuers of financial assets)
can be individuals, firms, and government units.
In a free economy such as that of the United States, the excess funds of
lenders are allocated to borrowers in the financial markets through a pricing
system that is based on the supply of, and the demand for, funds. This
system is represented by interest rates, or the cost of money, such that
those borrowers who are willing to pay the rates that prevail in the financial
markets are able to use funds provided by others.
Before analyzing the factors that affect interest rates, it will be helpful to
understand how investors earn returns when providing or supplying funds to
borrowers. Whether the investment instrument is debt or equity, the dollar
return earned by an investor can be divided into two categories: (1) income
paid by the issuer of the financial asset and (2) the change in value of the
financial asset in the financial market (capital gains) over some time period.
Thus, the dollar return on a financial asset can be stated as follows:
"Beginning value" represents the market value of the investment at the
beginning of the period and "Ending value" represents its market value at
the end of the period.
If the financial asset is debt, the income from the investment is the interest
paid by the borrower. If the financial asset is equity, the income from the
investment is the dividend paid by a corporation.
The amount of the capital gains can be negative if the value of the financial
asset decreases during the period it is held.
To determine an investment'syield, we state the dollar return as a
percentage of the dollar amount that was originally invested. Thus, the yield
is computed as follows:
To illustrate the concept of yield, consider the return that you would earn if
you purchased a corporate bond on January 1, 20X0, for $980.00 and sold it
on December 31, 20X0 for $990.25. If the bond paid $100 interest on
December 31, 20X0, the total dollar return on your investment would be
$110.25; this amount includes $100.00 in interest income and $10.25 =
$990.25 - $980.00 in capital gains. Thus the 1-year yield, or percent return,
would be:
In this case, the "cost of money" for such a corporation was essentially 11.25
percent in 20X0 because investors demanded the equivalent of a $110.25
return to invest in $980.
Factors That Affect the Cost of Money
Lesson23of46
Four fundamental factors affect the cost of money: the firm’s production
opportunities, investors’ time preferences for consumption, risk, and
inflation.
To see how these factors operate, imagine an isolated island community
where the people survive by eating fish. They have a stock of fishing gear
that permits them to live reasonably well, but they would like to have more
fish.
Now suppose Mr. Crusoe has a bright idea for a new type of fishnet that
would enable him to increase his daily catch substantially. It would take him
1 year to perfect his design, build his net, and learn how to use it efficiently.
Mr. Crusoe probably would starve before he could put his new net into
operation.
Recognizing this problem, he might suggest to Ms. Robinson, Mr. Friday, and
several others that if they would give him one fish each day for 1 year, he
would return two fish each day during all of the next year. If some-one
accepted the offer, then the fish that Ms. Robinson or one of the others gave
to Mr. Crusoe would constitute savings. These savings would be invested in
the fishnet, and the extra fish the net produced would constitute a return on
the investment.
The attractiveness of Mr. Crusoe's offer for a potential saver would depend in
large part on the saver's time preference for consumption. For example, Ms.
Robinson might be thinking of retirement, and she might be willing to trade
fish today for fish in the future on a one-for-one basis. Mr. Friday might be
unwilling to "lend" a fish today for anything less than three fish next year
because he has a wife and several young children to feed with his current
fish. Mr. Friday is said to have a high time preference for consumption,
whereas Ms. Robinson has a low time preference for consumption.
Also note that if the entire population is living at the subsistence level, time
preferences for current consumption would necessarily be high, aggregate
savings would be low, interest rates would be high, and capital formation
would be difficult.
The risk inherent in the fishnet project, and thus in Mr. Crusoe's ability to
repay the loan, also affects the return required by investors: the higher the
perceived risk, the higher the required rate of return. For example, if Mr.
Crusoe has a history of not always following through with his ideas, Ms.
Robinson, Mr. Friday, and others who are interested in Mr. Crusoe's new
fishnet would consider investment to be fairly risky, and thus they might
provide Mr. Crusoe with one fish each day this year only if he promises to
return four fish each day next year.
Also, a more complex society includes many businesses like Mr. Crusoe's,
many goods other than fish, and many savers like Ms. Robinson and Mr.
Friday. Furthermore, people use money, rather than fish, as a medium of
exchange. When the society uses money, its value in the future, which is
affected by inflation, comes into play. That is, the higher the expected rate of
inflation, the greater the required return (interest).
Interest Rate Levels
Lesson24of46
Funds are allocated among borrowers by interest rates: firms with the most
profitable investment opportunities are willing and able to pay the most for
capital, so they tend to attract it away from less efficient firms or from firms
whose products are not in demand.
Of course, our economy is not completely free in the sense of being
influenced only by market forces. As a result, the federal government
supports agencies that help designated individuals or groups obtain credit on
favorable terms. Among those eligible for this kind of assistance are small
businesses, certain minorities, and firms willing to build facilities in areas
characterized by high unemployment. Even with these government
interventions, most capital in the U.S. economy is allocated through
theprice system.
The figure below shows how supply and demand interact to determine
interest rates in two capital markets. Markets A and B represent two of the
many capital markets in existence. The going interest rate, which we
designate as r for this discussion, initially is 6 percent for the low-risk
securities in Market A. That is, borrowers whose credit is strong enough to
qualify for this market can obtain funds at a cost of 6 percent, and investors
who want to put their money to work without much risk can obtain a 6
percent return. Riskier borrowers must borrow higher-cost funds in Market B.
Investors who are willing to take on more risk invest in Market B expecting to
earn a 9 percent return, but they also realize that they might actually receive
much less (or much more).
If the demand for funds declines, as it typically does during business
recessions, the demand curves wil shift to the left, as shown in demand
curve D2in Market A. The market-clearing, or equilibrium, interest rate in this
example then falls to 5 percent. Similarly, you should be able to visualize
what would happen if the supply of funds tightens: the supply curve,S1,
would shift to the left, which would raise interest rates and lower the level of
borrowing in the economy.
Financial markets are independent. For example, if Markets A and B were in
equilibrium before the demand shifted to D2, in Market A, it means that
investors were willing to accept the higher risk in Market B in exchange for a
3 percent higher return to compensate for the additional risk that is taken.
After the shift to D2, the risk premium would initially increase to 9% - 5% =
4%. In all likelihood, this larger premium would induce some of the lenders in
Market A to shift to Market B, which in turn would case the supply curve in
Market A to shift to the left (or up) and the supply curve in Market B to shift
to the right. The transfer of capital between markets would raise the interest
rate in Market A and lower it in Market B, thereby bringing the risk premium
closer to the original level, 3 percent. For example, when rates on Treasury
securities increase, the rates on corporate bonds and mortgages generally
follow suit.
Many financial markets are found in the United States and throughout the
world. There are markets for short-term debt, long-term debt, home loans,
student loans, business loans, government loans, and so forth. Prices are
established for each type of fund, and these prices change over time as
shifts occur in supply and demand conditions.
The figure below illustrates how long-term and short-term interest rates to
business borrowers have varied since 1962. Notice that short-term interest
rates are especially prone to rise during booms and then fall during
recessions. (The shaded areas of the chart indicate recessions.)
When the economy is expanding, firms need capital, and this demand for
capital pushes rates higher. Inflationary pressures are strongest during
business booms, which also exert upward pressure on rates. Conditions are
reversed during recessions, such as those during 1990-1991 and 2001. In
these periods, slack business reduces the demand for credit, the rate of
inflation falls, and thus interest rates decline.
The Determinants of Market Interest Rates
Lesson25of46
In general, the required (or nominal) interest rate on any security, r, is
composed of a risk-free rate of interest plus a premium that reflects the
riskiness of the security. This relationship can be expressed as follows:
Required rate of return (r) = Risk-free rate + Risk premium
This relationship shows that rational investors must expect greater returns to
be willing to invest in securities with greater risks. Using this relationship, the
interest on debt can be expressed as follows:
Rate of return (r) = Rf*+ [DRP + LP + MRP]
The variables in the equation are defined as follows:
r= the quoted, or nominal, rate of interest on a given security. There are
many different securities, hence many different quoted interest rates.
Rf*= the quoted risk-free rate of return. Theoretically, this rate is the return
associated with an investment that has a guaranteed outcome in the future –
that is, it has no risk.
DRP= Default Risk Premium, which reflects the chance that the borrower –
that is, the issuer of the security – will not pay the debt's interest or principal
on time.
LP= Liquidity Premium, which reflects the fact that some investments are
more easily converted into cash on a short notice at a "reasonable price"
than are other securities. This is also called the marketability premium.
MRP= Maturity Risk Premium, which accounts for the fact that longer-term
bonds experience greater price reactions to particular interest rate changes
than do short-term bonds.
Therisk premiumon a security is the portion of the expected or required
return that exceeds the risk-free rate of return, and thus represents payment
for the risk associated with an investment.Risk Premium = DRP + LP +
MRP.
The nominal, or quoted,risk-free rate,*Rf,*is the interest rate on a security
that has absolutely no risk at all - that is, one that has a guaranteed outcome
in the future regardless of the market conditions. No such security exists in
the real world, and hence there is no observable truly risk-free rate. There is,
however, one security that is free of most risks: a U.S. Treasury bill (T-bill). T-
bills represent the short-term debt of the U.S. government that is extremely
liquid and is free of default risk since it is backed by the full faith and credit
of the U.S. government. Consequently, the rate on T-bills is the most
common proxy for Rf.
The Nominal, or Quoted, Risk-Free Rate of
Interest
The nominal risk-free rate, Rf, is composed of two components: The"real"
risk-free rate, which we will designate asr*, and an adjustment for the
average inflation that is expected during the life of the investment, which we
will designateIP, or theinflation premium. As a result, Rf= r* + IP.
The real risk-free rate of interest, r*, is an economic term defined as the
interest rate that would exist on a security with a guaranteed payoff - that is,
a risk-free security - if inflation is expected to be zero during the investment
period. It can be thought of as the rate of interest that would exist on short-
term U.S. Treasury securities in an inflation-free world. It can also be thought
of as the rate of return that a rational average investor would have to earn
on a 1-year riskless investment in a world with no inflation in order to
purchase the investment.
The real risk-free rate changes over time depending on economic conditions.
It depends especially on (1) the rate of return corporations and other
borrowers are willing to pay to borrow funds, and (2) on people's time
preferences for current vs. future consumption. It is difficult to measure the
real risk-free rate precisely, but for many years it was assumed to fluctuate
in the range of 2 to 4 percent in the United States. However, during several
years after the 2008-09 financial crisis when nominal risk-free rates were
kept close to zero by the Federal Reserve, the real risk-free rate could have
been zero or even negative.
No matter what investments they make, all investors are affected
byinflation. For this reason, the minimum rate earned on any security, no
matter its risk, must include compensation for the loss of purchasing power
that is expected during the life of the investment due to inflation. Thus, in
addition to the portion that represents the increase in real wealth that
investors require to invest their money, Rfmust include a component for the
average inflation, or purchasing power loss, that investors expect in the
future.
If the term risk-free rate is used without either the term real or the term
nominal, people generally mean the quoted (nominal) rate. Therefore, when
we use the term risk-free rate, we mean the nominal risk-free rate, Rf= r* +
IP. Also, we generally use the T-bill rate to approximate the short-term risk-
free rate and the T-bond rate to approximate the long-term risk-free rate. So,
whenever you see the term risk-free rate, assume that we are referring to
either the quoted T-bill rate or to the quoted T-bond rate.
Inflation Premium (IP) and Default Risk
Premium (DRP)
Inflation has a major effect on interest rates because it erodes the
purchasing power of the dollar and lowers the rate of return on investments.
When they lend money, therefore, investors build in an inflation premium (IP)
equal to the average inflation rate expected over the life of the security.
Thus, if the real risk-free rate of interest, r*, is 3 percent, and if inflation is
expected to be 2 percent (and hence IP = 2%) during the next year, then the
quoted rate of interest on 1-year T-bills would be 3% + 2% = 5%. It is
important to note that the rate of inflation built into interest rates is the rate
of inflation expected in the future, not the rate experienced in the past. Note
also that the inflation rate reflected in the quoted interest rate of an
investment is the average inflation expected over the life of the investment.
The risk that a borrower will default on a loan – that is, not pay the interest
or the principal – also affects the market interest rate on a security: the
greater the default risk, the higher the interest rate that lenders charge
(demand). Treasury securities have no default risk because everyone
believes that the U.S. government will pay its debt on time. As a result, U.S.
Treasury securities (bills, notes, and bonds) generally carry the lowest
interest rates on taxable securities in the United States. For corporate bonds,
the better the bond's overall credit rating (AAA is the best), the lower its
default risk, and, consequently, the lower its interest rate. The difference
between the quoted interest rate on a T-bond and that on a corporate bond
with similar maturity, liquidity, and other features is thedefault risk
premium (DRP).
Liquidity Premium (LP)*
Liquiditygenerally is defined as the ability to convert an asset into cash on
short notice and "reasonably" capture the amount initially invested. The
more easily an asset can be converted to cash at a price that substantially
recovers the initial amount invested, the more liquid it is considered. Clearly,
assets have varying degrees of liquidity, depending on the characteristics of
the markets in which they are traded. For instance, such financial assets as
government securities and stocks and bonds trade in extremely active and
efficientsecondary markets, whereas the markets for real estate are much
more restrictive. Also, it generally is easier to convert an asset into cash at a
"good" price the closer the asset's life is to its maturity date. Thus, financial
assets generally are more liquid than real assets, and short-term financial
assets generally are more liquid than long-term financial assets.
Because liquidity is important, investors evaluate liquidity and include
liquidity premiums (LP) when market rates of securities are established.
Although it is difficult to accurately measure liquidity premiums, a differential
of at least two and perhaps four or five percentage points exists between the
least liquid and the most liquid financial assets of similar default risk and
maturity.
Maturity Risk Premium (MRP)
The prices of long-term bonds decline sharply whenever interest rates rise.
Because interest rates can and do occasionally rise, all long-term bonds -
even Treasury bonds - have an element of risk calledinterest rate price
risk. As a general rule, the bonds of any organization have more interest
rate price risk the longer the maturity of the bond. Therefore, the required
interest rate must include amaturity risk premium (MRP), which is higher
the longer the time to maturity. Everything else equal, maturity risk
premiums raise interest rates on long-term bonds relative to those on short-
term bonds.
The MRP, like the other types of premiums, is extremely difficult to measure.
Nevertheless, two things seem clear: (1) the MRP appears to vary over time,
rising when interest rates are more volatile and uncertain, then falling when
interest rates are more stable; and (2) the maturity risk premium on T-bonds
with 20 to 30 years to maturity normally is in the range of one or two
percentage points.
Although long-term bonds are heavily exposed to interest rate price risk,
short-term investments are more vulnerable toreinvestment rate risk.
When short-term investments mature and the proceeds are reinvested, or
"rolled over," a decline in interest rates would necessitate reinvestment at a
lower rate, and hence would lead to a decline in interest income. Although
"investing short" preserves one's principal, the interest income provided by
short-term investments varies from year to year, depending on reinvestment
rates.
The Term Structure of Interest Rates
Lesson26of46
The relationship between long-term and short-term rates, which is known as
theterm structure of interest rates, is important to corporate treasurers,
who must decide whether to borrow by issuing long-term or short-term debt,
and to investors, who must decide whether to buy long-term or short-term
bonds. For these reasons, it is important to understand (1) how long-term
and short-term rates are related and (2) what causes shifts in their relative
positions.
The relationship between long-term and short-term bonds varies, and is
generally dependent on the supply and demand relationship that exists for
these bonds at a particular point in time. Theyield curveprovides a
snapshot of the relationship between short-term and long-term rates, usually
for Treasury securities, on a particular date.
The figure below shows the yield curve at three different dates in the past.
The yield curve changes both in position and in slope over time and is
usually, but not always, upward sloping with longer maturity securities
having higher market yields than shorter maturities. For example, in March
1980, all rates were relatively high, and short-term rates were higher than
long-term rates, so the yield curve on that date was downward sloping
(orinverted yield curve). In July 2003, however, all rates were much lower,
and long-term rates were higher than short-term rates, so the yield curve at
that time was upward sloping. And in July 2007, all rates were higher than in
2003, and short-term and long-term rates did not differ much, so the yield
curve was fairly flat and almost horizontal.
Why Do Yield Curves Differ?
Lesson27of46
Interest rates consist of a risk-free return, Rf, which includes the real risk-free
return (r*) and an adjustment for expected inflation (IP), and a risk premium
that rewards investors for various risks, including default risk (DRP), liquidity
risk (LP), and maturity risk (MRP). Although the real risk-free rate of return,
r*, does change at times, it is generally relatively stable from period to
period. As a result, when interest rates shift to substantially different levels,
it generally is because investors have changed either their expectations
concerning future inflation or their attitudes concerning risk. Because
changes in investor's risk attitudes generally evolve over time (years),
inflation expectations represent an important factor in the determination of
current interest rates, and thus the shape of the yield curve.
To ilustrate how inflation impacts the shape of the yield curve, let's examine
interest rates on U.S. Treasury securities. First, the rate of return on these
securities can be written as follows:
rtreasury*= Rf*+ MRP = r* + IP + MRP
The default risk premium (DRP) and the liquidity premium (LP) are not
included because we generally consider Treasury securities to be extremely
liquid (marketable) and default-free investments. As a result, DRP = 0 and LP
= 0. The maturity risk premium (MRP) is included in the equation because
Treasury securities vary in maturity from as little as a few days to as much
as 30 years.
All else equal, investors generally prefer to hold short-term securities
because such securities are less sensitive to changes in interest rates and
provide greater investment flexibility than longer-term securities. Investors
will, therefore, generally accept lower yields on short-term securities, and
this leads to relatively low short-term rates.
Borrowers, on the other hand, generally prefer long-term debt because short-
term debt exposes them to the risk of having to refinance the debt under
adverse conditions (e.g., higher interest rates). Accordingly, borrowers want
to "lock into" long-term funds, which means they are willing to pay a higher
rate, other things held constant, for long-term funds than for short-term
funds, which also leads to relatively low short-term rates.
Taken together, these two sets of preferences imply that under normal
conditions, a positive maturity risk premium (MRP) exists and the MRP
increases with years to maturity, causing the yield curve to be upward
sloping. In economics, the general theory that supports this conclusion is
referred to as the liquidity preference theory, which simply states that long-
term bonds normally yield more than short -term bonds, all else equal,
primarily because MRP > 0 and MRP increases with time to maturity.
Does the Yield Curve Indicate Future Interest Rates?
Lesson28of46
The yield curve is often used as an aid when forecasting future interest rates
because both investors and borrowers base their current decisions on
expectations regarding which way interest rates will move in the future. The
expectations of the participants in the financial markets - that is, investors
and borrowers - greatly impact interest rates. Theexpectations
theorystates that the yield curve depends on expectations concerning
future inflation rates. Expectations can be used to help forecast interest
rates.
When inflation is expected to increase, the yield curve is upward sloping, and
vice versa. In either case, economists often use the yield curve to form
expectations about the future of the economy. When inflation is high and
expected to decline, the yield curve generally is downward sloping. In many
cases, a downward-sloping yield curve suggests that the economy will
weaken in the future: consumers delay purchases because they expect
prices to decline in the future, borrowers wait to borrow funds because they
believe rates will be lower in the future, and investors provide more funds to
the financial markets in an effort to capture higher current rates. All of these
actions lead to lower long-term rates in the current period.
According to themarket segmentation theorythat has been developed
by economists, the slope of the yield curve depends on supply/demand
conditions in the long-term and short-term markets. The yield curve could at
any given time be flat, upward sloping, or downward sloping and have
humps or dips. Interest rates would be high in a particular segment
compared to other segments when there was a low supply of funds in that
segment relative to demand, and vice versa.
We use Treasury securities to illustrate concepts relating to the shape of the
yield curve. The same concepts apply to corporate bonds. To include
corporate bonds in the illustration, however, we would have to determine the
default risk premium, DRP, and the liquidity premium, LP, associated with
these bonds. In other words, the interest rates on corporate bonds would be
determined using the equation:
r = Rf*+ [DRP + LP +MRP] = [r* + IP] + [DRP + LP + MRP]
DRP > 0 and LP > 0 for corporate bonds, which means that interest rates on
corporate bonds are higher than interest rates on Treasury securities. The
risk-free rate of return for both types of securities is the same, Rf= r* + IP.
But because corporate bonds have default risk, liquidity risk, and maturity
risk, the risk premiums on corporate bonds are greater than the risk
premiums on Treasuries. As a result, if we plotted the yield curves for the
bonds of a particular corporation, the curves would be higher than for
Treasury securities and the height would additionally increase with the risk
level of the corporations.
Other Factors That Influence Interest Rate Levels
Lesson29of46
Other factors also influence both the general level of interest rates and the
shape of the yield curve. The four most important factors areFederal
Reserve policy, the level of thefederal budget deficit, theforeign
trade balance, and thelevel of business activity.
Themoney supplyhas a major effect on both the level of economic activity
and the rate of inflation, and in the United States, the Federal Reserve
controls the money supply. If the Fed wants to control growth in the
economy, it slows growth in the money supply. Such an action initially
causes interest rates to increase and inflation to stabilize. The opposite
effect occurs when the Fed loosens the money supply.
The most important tool used by the Fed to manage the supply of money
isopen market operations, which involve buying or selling U.S. Treasury
securities to change bank reserves. When the Fed wants to increase the
money supply, it purchases government securities from primary dealers who
have established trading relationships with the Federal Reserve. The Fed
pays for the securities by sending funds to the banks where the primary
dealers have accounts. This action increases the deposit balances of the
dealers, which in turn increases the overall reserves of the banking system.
Banks have additional funds to lend, so the money supply increases. The Fed
carries out "normal" open market operations on a continuous basis to
maintain economic activity within defined limits, and it shifts its open market
strategies toward heavier-than-normal buying or selling to make more
substantial adjustments.
If the federal government spends more than it takes in from tax revenues, it
runs adeficit. Deficit spending must be covered either by borrowing or by
printing money. If the government borrows, the added demand for funds
pushes up interest rates. If it prints money, the expectation is that future
inflation will increase, which also drives up interest rates. Thus, the larger
the federal deficit, other things held constant, the higher the level of interest
rates. Whether long-term or short-term rates are affected to a greater extent
depends on how the deficit is financed. Consequently, we cannot generalize
about how deficits will influence the slope of the yield curve.
Businesses and individuals in the United States buy from and sell to people
and firms in other countries. If Americans buy more than we sell (that is, if
Americans import more than we export), the United States is said to be
running aforeign trade deficit. When trade deficits occur, they must be
financed, and the main source of financing is debt. Therefore, the larger the
trade deficit, the more the United States must borrow. As the country
increases its borrowing, interest rates are driven up. Also, foreigners are
willing to hold U.S. debt only if the interest rate on this debt is competitive
with interest rates in other countries. Therefore, if the Federal Reserve
attempts to lower interest rates in the United States, causing U.S. rates to
fall below rates abroad, then foreigners will sell U.S. bonds; this activity will
depress bond prices and cause U.S. interest rates to increase. As a result,
the existence of a deficit trade balance hinders the Fed's ability to combat a
recession by lowering interest rates.
Financial markets in the United States are interdependent in the sense that
when rates in one market increase, investors tend to take their funds out of
other markets to capture the higher rates in the market where the rates first
increased. For example, when interest rates increase significantly in the
bond markets, investors generally sell their stocks and invest the proceeds in
bonds. Of course, borrowers and other users of funds act differently because
they want to use the cheaper source of funds, which would be stocks in this
case. Clearly such actions affect both markets; the additional funds provided
to, and the lower demand for funds in, the bond markets help to decrease
interest rates on bonds, whereas the decrease in funds in the stock markets
help to increase rates on stocks.
International financial markets are similarly interdependent – that is, when
rates are higher in one country than in other countries, businesses tend to
stay away from the high-interest country when seeking to borrow funds,
whereas investors tend to migrate to the high-interest country. As a result,
when interest rates are not "properly aligned," investors and borrowers take
actions that realign the rates, both in domestic financial markets and in
international financial markets.
Business conditions clearly influence interest rates as well. During
recessions, both the demand for money and the rate of inflation tend to fall,
and, at the same time, the Federal Reserve tends to increase the money
supply in an effort to stimulate the economy. As a result, interest rates
typically decline during recessions.
In an attempt to help the U.S. economy recover from the 2008-09 financial
crisis, the Federal Reserve held interest rates at very low levels for several
years and instituted an unconventional policy known asquantitative
easingto stimulate the economy. Quantitative easing increases the money
supply and floods financial institutions with capital to increase liquidity and
promote lending. It also decreases interest rates since the supply of money
increases.
During recessions, short-term rates decline more sharply than do long-term
rates. This situation occurs for two reasons. First, the Fed operates mainly in
the short-term sector, so its intervention has the strongest effect here.
Second, long-term rates reflect the average expected inflation rate over the
next 20 to 30 years. This expectation generally does not change much, even
when the current rate of inflation is low because of a recession.
Interest Rate Levels and Stock Prices
Lesson30of46
Interest rates have two effects on corporate profits. First, because interest is
a cost, the higher the rate of interest, the lower a firm's profits, other things
held constant. Second, interest rates affect the level of economic activity,
and economic activity affects corporate profits.
Interest rates obviously affect stock prices because of their effects on profits.
Perhaps even more important, they influence stock prices because of
competition in the marketplace between stocks and bonds. If interest rates
rise sharply, investors can obtain higher returns in the bond market, which
induces them to sell stocks and transfer funds from the stock market to the
bond market. A massive sale of stocks in response to rising interest rates
obviously would depress stock prices. Of course, the reverse occurs if
interest rates decline.
As interest rates decline, the stock market generally is the "hot" investment.
The Cost of Money as a Determinant of Value
Lesson31of46
The value of an asset is a function of the cash flows that it is expected to
generate in the future and the rate of return at which investors are willing to
provide funds to purchase the investment. We know that many factors,
including conditions in the economy and financial markets, affect the
determination of the expected cash flows and the rate people demand when
investing their funds; thus, the process of determining value can be fairly
complex. In general, when the cost of money increases, the value of an asset
decreases.
The cost of money - that is, interest rates (returns) - affects the prices of
investments. In fact, changes in interest rats can have a significant effect on
the prices of stocks and bonds. In general, when the rates in the financial
markets increase, the prices (values) of financial assets decrease.
The Importance of Capital Budgeting
Lesson33of46
The termcapitalrefers to fixed assets used in production, and abudgetis
a plan that details projected cash inflows and cash outflows during some
future period. Thus, thecapital budgetis an outline of planned
expenditures on fixed assets, andcapital budgetingis the process of
analyzing projects and deciding which are acceptable investments and which
acceptable investments should be purchased.
A number of factors combine to make capital budgeting decisions perhaps
the most important ones that financial managers must make. Capital
budgeting has long-term effects, so the firm loses some decision-making
flexibility when it purchases capital projects.
For example, when a firm invests in an asset with a 15-year economic
(useful) life, its operations are affected for 15 years; the firm is "locked in" by
the capital budgeting decision. Furthermore, because asset expansion is
fundamentally related to expected future sales, a decision to buy a fixed
asset that is expected to last 15 years involves an implicit 15-year sales
forecast.
An error in the forecast of asset requirements can have serious
consequences. That is, investing too much will result in unnecessarily heavy
expenses, whereas investing too little might create inefficient production and
inadequate capacity that result in lost sales.
Timing is also important in capital budgeting. Capital assets must be ready to
come "on line" when they are needed; otherwise, opportunities could be lost.
A firm that forecasts its needs for capital assets in advance will have an
opportunity to purchase and install the assets before they are needed.
Unfortunately, many firms do not order capital goods until they approach full
capacity or must replace worn-out equipment; then the purchases might
come too late, especially if competitors are able to attract the firm's
customers while capital projects are being put on line.
Finally, capital budgeting is important because the acquisition of fixed assets
typically involves substantial expenditures. Before a firm can spend a large
amount of money it must have the funds available, but large amounts of
money are not available automatically. Therefore, a firm contemplating a
major capital expenditure program must arrange its financing well in
advance to ensure that the necessary funds are available.
Because a firm's growth as well as its ability to remain competitive and to
survive depend on a constant flow of ideas for new products, ways to make
existing products better, and ways to produce output more efficiently, a well-
managed firm will go to great lengths to develop good capital budgeting
proposals. And, because some of the capital investment ideas will be good
and others will not, the firm must be able to evaluate the worth of such
projects.
Project Classifications
Lesson34of46
Capital budgeting decisions generally are termed either replacement
decisions or expansion decisions. Replacement decisions involve determining
whether capital projects should be purchased to take the place of (replace)
existing assets that might be worn out, damaged, or obsolete. Replacement
projects are necessary to maintain or improve profitable operations using
existing production levels. On the other hand, if a firm is considering whether
to increase operations by adding capital projects to existing assets so as to
produce either more of its existing products or entirely new products,
expansion decisions are made.
Some capital budgeting decisions involve independent projects, whereas
others involve mutually exclusive projects. Independent projects are projects
whose cash flows are not affected by any other projects, so the acceptance
of one project does not affect the acceptance of other projects. As a result,
all independent projects can be purchased if they all are acceptable. For
example, if Cengage Learning, which publishes textbooks, decided to
purchase the ABC television network, it still could publish a new textbook.
Conversely, if a capital budgeting decision involves mutually exclusive
projects, then accepting one project means that other projects must be
rejected. Only one mutually exclusive project can be purchased, even if all of
them are acceptable. For example, imagine that Alldome Sports, Ltd. has a
parcel of land on which it wants to build either a children's amusement park
or a domed baseball stadium. The land is not large enough for both
alternatives, so if Alldome chooses to build the amusement park, it could not
build the stadium, and vice versa.
Steps in the Valuation Process
Lesson35of46
Capital budgeting decisions involve the valuation of assets or projects. Not
surprisingly, then, capital budgeting involves the same steps used in general
asset valuation. These steps can be summarized as follows:
Determine the relevant components of the initial
investment outlay for the asset or project.
Estimate the future cash flows expected to be
generated by the asset or project.
Evaluate the riskiness of the projected cash flows to
determine the appropriate rate of return to use for
computing the present value of the estimated cash
flows.
Compute the discounted present value of the expected
cash flows using the firm’s cost of capital as the
discount rate.
Compare the discounted present value of the expected
future cash flows with the initial investment, or cost,
that is required to acquire the asset. Alternatively, the
expected rate of return on the project can be
calculated and compared with the firm's required rate
of return.
If a firm invests in a project with a present value greater than its cost, the
value of the firm will increase. A very direct link therefore exists between
capital budgeting and stock values: the more effective the firm's capital
budgeting procedures, the higher the price of its stock.
Estimating a Project’s Cash Flows
Lesson36of46
Before we can compute a project's value, we must estimate the cash flows -
both current and future - associated with it. Cash flow estimation is the most
important, and perhaps the most difficult, step in the analysis of a capital
project. The process of cash flow estimation is problematic because it is
difficult to accurately forecast the costs and revenues associated with large,
complex projects or projects that are expected to affect operations for long
periods of time.
Many variables are involved in cash flow estimation, and many individuals
and departments participate in the process. For example, the marketing
group typically makes the forecasts of unit sales and prices, the engineering
and product development staffs determine the capital outlays associated
with a new product, and cost accountants, production experts, and other
personnel estimate the operation costs.
When all of the information about a project is collected, financial managers
use these data to create estimates of its cash flows – theinvestment
outlaysand thenet cash flowsexpected after the project is purchased.
Although estimating the cash flows can be rather difficult, two cardinal rules
can help financial analysts avoid making mistakes:
1. Capital budgeting decisions must be based on after-tax cash
flows and not accounting income.
2. Onlyincremental cash flows*are relevant to the analysis to
accept or reject a project.
Capital budgeting analysis relies onafter-tax cash flowsrather than
accounting profits because it is cash that pays the bills and can be invested
in capital projects, not profits. Cash flows and accounting profits can be very
different since some of the items included in the income statement are not
cash flows (such as depreciation and accruals). Although accounting profits
are important for some purposes, cash flows have greater relevance for the
purposes of valuing an asset. Cash flows can be reinvested to create value,
whereas profits cannot.
Incremental cash flowsare those that occur as a direct result of accepting
the project. To determine whether a specific cash flow is considered
relevant, we must determine whether it is affected by the purchase of the
project. Cash flows that will change because the project is purchased are
incremental cash flows that should be included in the capital budgeting
evaluation. Cash flows that will not be changed by the purchase of the
project are not relevant to the particular capital budgeting decision.
Incremental Cash Flows
Identifying the relevant cash flows for a project is not always as simple as it
seems. Notable problems in determining incremental cash flows include the
following:
Sunk costsare outlays that have been committed or that
already have occurred which will not change if the project is
purchased. They cannot be recovered regardless of whether
the project is accepted or rejected. Because they are not
affected by the decision under consideration, they should not
be included in the cash flow analysis.
Opportunity costsare the cash flows that could be
generated from assets that the firm already owns if they are
not used for the project in question.
Externalitiesare effects that a project will have on other
parts of the firm. Although they often are difficult to quantify,
externalities must be estimated so that they are not
mistakenly included as new (incremental) cash flows in the
capital budgeting analysis.
Shipping and installation costsfor project components
are important to include in the project cost because they
require cash payments. In addition, for depreciable assets,
the total amount that can be depreciated (known as the
depreciable basis) includes the purchase price and any
additional expenditures required to make the asset
operational, including shipping and installation. Although
depreciation is a noncash expense (cash is not needed to pay
the depreciation expense each year), depreciation affects the
taxable income of a firm. In this way, it affects the amount of
taxes paid by the firm, which is a cash flow.
Inflationshould be recognized in capital budgeting
decisions. If expected inflation is not built into the
determination of expected cash flows, then the asset's
calculated value and expected rate of return will be incorrect.
That is, both of these values will be artificially low. It is easy
to avoid inflation bias: simply build inflationary expectations
into the cash flows used in the capital budgeting analysis.
The firm does not have to adjust its required rate of return
(weighted average cost of capital, WACC) to account for
inflation expectations because investors include such
expectations when establishing the rate at which they are
willing to permit the firm to use their funds. In other words,
investors decide the rates at which a firm can raise funds in
the capital markets, and these rates include an inflation
premium.
Identifying Incremental (Relevant) Cash
Flows
Generally, when we identify the incremental cash flows associated with a
capital project, we separate them according to when they occur during the
life of the project. In most cases, we can classify a project's incremental cash
flows into one of three categories:
1. Cash flows that occur only at the start of the project's
life- time Period 0 - which represent the amounts that are
initially invested in the project.
2. Cash flows that continue throughout the project's life-
time Periods 1 through n - which represent changes in the
firm's operating cash flows that are associated with investing
in the project.
3. Cash flows that occur only at the end, or the
termination, of the project- time Period n - which
represent the amounts that are associated with the disposal,
or termination, of the project at the end of its life.
Initial Investment Outlay
The initial investment outlay refers to the incremental cash flows that occur
only at the start of a project's life,CF0. It includes such cash flows as the
purchase price of the new project and shipping and installation costs. If the
capital budgeting decision is a replacement decision, then the initial
investment also must take into account the cash flows associated with the
disposal of the old, or replaced, asset; this amount includes any cash
received or paid to scrap the old asset and any tax effects associated with its
disposal.
In many cases, the addition or replacement of a capital asset also affects the
firm's short-term assets and liabilities, which are known as theworking
capitalaccounts. For example, additional inventories might be required to
support a new operation, and increased inventory purchases will increase
accounts payable. The difference between the required increase in current
assets and the increase in current liabilities is thechange in net working
capital. If this change is positive (as it generally is for expansion projects),
then additional financing, over and above the cost of the project, is needed
to fund the increase.
Thus, the change in net working capital that results from the acceptance of a
project is an incremental cash flow that must be considered in the capital
budgeting analysis. Because the change in net working capital requirements
occurs at the start of the project's life, this incremental cash flow must be
included as part of the initial investment outlay.
Incremental Operating Cash Flow
Incremental operating cash flows are the changes in day-to-day operating
cash flows that result from the purchase of a capital project. They occur
throughout the life of the project, continuing to affect the firm's cash flows
until the firm disposes of the asset. In most cases, we can compute the
incremental operating cash flows for each year directly by using the
following equation:
* Incremental operating CFt*= ΔCash revenuest–ΔCash expensest–
ΔTaxest
* * * * * * * * * * * * * * * * * * * * * * * * * *= ΔNOIt*x (1 – T) + ΔDeprt
* * * * * * * * * * * * * * * * * * * * * * * * * *= (ΔSt–ΔOCt–ΔDeprt) x (1 – T) + ΔDeprt
* * * * * * * * * * * * * * * * * * * * * * * * * *= (ΔSt–ΔOCt) x (1 – T) + T (ΔDeprt)
Where:
Δ = The Greek letter delta indicates the change in something.
ΔNOIt= NOIt,accept–NOIt,reject= The change in net operating
income in Period t that results from accepting the capital
project; the subscript accept indicates the firm's operations
that would exist if the project is accepted, and the subscript
reject indicates the level of operations that would exist if the
project is rejected (the existing situation without the project).
ΔDeprt= Deprt,accept–Deprt,reject= The change in depreciation
expense in Period t that results from accepting the project.
ΔSt= St,accept–St,reject= The change in sales revenues in Period t
that results from accepting the project.
ΔOCt= OCt,accept–OCt,reject= The change in operating costs,
excluding depreciation, in Period t that results from
accepting the project.
T = Marginal tax rate.
Incremental Operating Cash Flow and
Terminal Cash Flow
Previously we have emphasized thatdepreciationis a noncash expense.
We include the change in depreciation expense when computing incremental
operating cash flows because when depreciation changes, both taxable
income and hence the amount of income taxes paid change and the amount
of taxes paid is a cash flow. When identifying the relevant cash flows, the
effects of financing the new project are omitted. Instead, financing effects,
such as interest charges, are reflected in the cost of capital (required return)
that is used to evaluate the attractiveness of a project. For this reason,
financing effects should not be included in the cash flows.
Theterminal cash flowoccurs at the end of the life of the project. It is
associated with (1) the final disposal of the project and (2) the return of the
firm's operations to their state prior to the project's acceptance.
Consequently, the terminal cash flow includes the salvage value, which could
be either positive (selling the asset) or negative (paying for its removal), and
the tax effects of the disposition of the project.
Because we assume that the firm returns to the operating level that existed
prior to the acceptance of the project, anychanges in net working capital
that occurred at the beginning of the project's life will be reversed at the
end of its life. For example, as an expansion project's life approaches
termination, we assume that inventories will be sold off and not replaced; the
firm will therefore receive an end-of-project cash inflow equal to the net
working capital requirement, or cash outflow, that occurred when the project
was begun.
Cash Flow Estimation and the Evaluation
Process
Anexpansion projectcalls for the firm to invest in new assets in an effort
to increase sales. The first step in the analysis is to summarize the initial
investment outlays required for the project. The next step is to estimate the
cash flows that will occur once production begins. The final cash flow
component that must be computed is the terminal cash flow.
At some point, all companies must make decisions about replacing existing
assets. Identifying the incremental cash flows is more complicated with
areplacement projectthan with an expansion project because the cash
flows from both the new asset and old asset must be considered. The net
difference between the “new” and “old” cash flows must be taken into
account because a replacement decision involves comparing two mutually
exclusive projects – that is, retaining the old asset versus buying a new one.
If the new asset replaces the old asset, then the new cash flows replace the
old cash flows.
Capital Budgeting Evaluation Techniques
Lesson37of46
After we estimate the cash flows that are expected to be generated by a
project, we must determine whether purchasing the project is desirable. That
is, we need to evaluate how the project's purchase will affect the value of the
firm. The three most popular methods used by businesses to evaluate capital
budgeting projects are (1)net present value (NPV), (2)internal rate of
return (IRR), and (3)payback period (PB).
We can determine the acceptability of a capital budgeting project by
computing its value and comparing the result to the purchase price. The
value of an asset can be determined by computing the discounted present
value of the cash flows it is expected to generate during its life. If we
subtract the purchase price of the asset from (or add a negative cash flow)
the discounted present value of its expected future cash flows, the result is
the net dollar value, or net benefit that accrues to the firm if the asset is
purchased. This net benefit is called the asset'snet present value (NPV).
The NPV shows by how much a firm's value, and thus stockholders' wealth,
will increase if a capital budgeting project is purchased.
Capital Budgeting Evaluation Techniques
(NPV)
If the estimated NPV for a project is positive, then it is an acceptable
investment because the value of the company will be increased. If the NPV is
negative, then the project should be rejected because it will decrease the
value of the company if it is undertaken. An NPV of zero would indicate that
the project will have no effect on the value of the company.
NPV is a discounted cash flow technique that uses time value of money
concepts. Use the following equation to compute NPV:
Here CFtis the expected net cash flow at Period t, and r is the rate of return
required by the firm to invest in this project - typically the weighted average
cost of capital (WACC) for the firm.
Cash outflows (expenditures on the project, such as the cost of buying
equipment or building factories) are treated as negative cash flows. CF0is
therefore usually a negative number.
Capital Budgeting Evaluation Techniques
(IRR)
Theinternal rate of return (IRR)is the rate of return the firm expects to
earn if a project is purchased and held for its economic (useful) life. The IRR
is defined as the discount rate that equates the present value of a project’s
expected cash flows to the initial amount invested.
As long as the project’s IRR is greater than the rate of return required by the
firm for such an investment (r), then the project is acceptable. An IRR greater
than r also means that NPV is positive, so the two measures will produce the
same decision to accept.
We can use the following equation to solve for a project's IRR:
Although it is fairly easy to find the NPV without a financial calculator, the
same is not true of the IRR. Without a financial calculator, you must solve the
equation by trial and error - that is, you must try different discount rates until
you find the one that forces NPV equal to $0. This discount rate is the IRR.
Fortunately, it is easy to find IRRs with a financial calculator. See the
instructions for your particular calculator to compute an IRR.
All spreadsheet programs provide an IRR function to compute the IRR for a
series of cash flows. In Microsoft Excel and most other spreadsheet
programs, that function is
= IRR(values,[guess])
wherevaluesis the range of cells that contain the cash flows with the first
cell being the negative initial outlay, andguessis an optional estimate of the
IRR. The guess input is a holdover from the early days of spreadsheets when
computing power was low and the guess was needed to speed up the
calculation, but it is no longer needed.
One important caveat concerning IRR is thatthe project’s cash flows
must only change sign one time during its life. That is the usual case
with a project that has a cash outflow at t=0 and expected positive cash
inflows throughout the rest of its life. The project could even have more than
one year of negative cash flows in the beginning as long as the sign of the
cash flows changes from negative to positive only once. If the sign of the
cash flows changes more than once during the project’s life, then the IRR
isnot unique, and there are in fact multiple IRRs for the project − one for
each sign change. In that case, none of the IRRs has meaning (since a
project can’t have more than one expected rate of return) so IRR cannot be
used to evaluate such projects. This situation will be discussed more later in
this section.
Another important caveat concerning IRR is that it implies aconstant
reinvestment ratefor the cash flows of the project. The IRR for a project
will be its average annual rate of return over its life only if all of its cash flows
can be reinvested in other projects that on average have the same IRRs. If a
project has a particularly high IRR, it will be difficult to find other projects
with high IRRs to fulfill this reinvestment rate assumption. If a project has a
particularly low IRR, it will be easy to find other projects with higher IRRs for
the reinvestment of cash flows. Due to the constant reinvestment rate
assumption, IRR tends to understate the relative worth of low IRR projects
and it tends to overstate the relative worth of high IRR projects. This problem
will also be discussed more later in this section.
Why is a project acceptable if its IRR is greater than its required rate of
return? Because the IRR on a project is the rate of return that the project is
expected to generate, and if this return exceeds the cost of the funds used
to finance the project, a surplus remains after paying for the funds. This
surplus accrues to the firm's stockholders. Therefore, taking on a project
whose IRR exceeds its required rate of return, or cost of funds, increases
stockholders’ wealth. On the other hand, if the IRR is less than the cost of
funds, then taking on the project imposes a cost on current stockholders that
decreases wealth.
Also, note that (1) the IRR is the rate of return that will be earned by anyone
who purchases the project and (2) the IRR is dependent on the project's cash
flow characteristics – that is, the amounts and the timing of the cash flows –
not the firm's required rate of return. As a result, the IRR of a particular
project is the same for all firms, regardless of their particular required rates
of return. A project might be acceptable to one firm, but not acceptable to
another firm.
Comparison of the NPV and IRR Methods
Lesson38of46
We generally measure wealth in dollars, so the NPV method should be used
to accomplish the goal of maximizing shareholders' wealth. In reality, using
the IRR method could lead to investment decisions that increase, but do not
maximize, wealth. While most corporate executives are familiar with the
meaning of IRR, it is entrenched in the corporate world, and it does have
some of the virtues of NPV. For these reasons, it is important to understand
the IRR method and be prepared to explain why a project with a lower IRR
might sometimes be preferable to one with a higher IRR.
A graph that shows a project's NPV at various discount rates (required rates
of return) is termed the project'snet present value (NPV) profile. The
figure below shows the NPV profiles for Projects S and L. To construct the
profiles, we calculate the projects' NPVs at various discount rates – say, 0, 5,
10, and 15 percent – and then plot these values.
Because the IRR is defined as the discount rate at which a project's NPV
equals $0, the point where its NPV profile crosses the X axis indicates a
project's internal rate of return. Note that firms with different required rates
of return can use the NPV profile to determine whether a project is
acceptable. To determine a project's NPV using the NPV profile, simply locate
the appropriate required rate of return on the graph and then identify the
NPV that corresponds to that rate.
The figure shows that the NPV profiles for Projects S and L decline as the
discount rate (required rate of return) increases. Notice, however, that
Project L has a higher NPV at low discount rates, whereas Project S has a
higher NPV at high discount rates. According to the graph, NPVS= NPVL=
$267 when the discount rate equals 8.1%. We call this point thecrossover
ratebecause below this rate NPVS< NPVL, and above this rate, NPVS> NPVL;
but, NPVS= NPVL, and thus cross over, at 8.1%.
The figure also indicates that Project L's NPV profile has the steeper slope,
indicating that a given change in r has a larger effect on NPVLthan on NPVS.
Project L is more sensitive to changes in r because the cash flows from
Project L are received later than those from Project S. As a general rule, the
impact of an increase on the discount rate is much greater on distant cash
flows than on near-term cash flows. Consequently, if most of its cash flows
come in the early years, a project's NPV will not be lowered very much if the
required rate of return increases.
Conversely, a project whose cash flows come later will be severely penalized
by high required rates of return. Accordingly, Project L, which has its largest
cash flows in the later years, is hurt badly when the required rate of return is
high, whereas Project S, which has relatively rapid cash flows, is affected less
by high discount rates.
Independent Projects
Note that the IRR formula is simply the NPV formula solved for the particular
discount rate that forces the NPV to equal zero. Thus, the same basic
equation is used for both methods.
Mathematically, the NPV and IRR methods will always lead to the same
accept/reject decisions for independent projects: If a project's NPV is
positive, its IRR will exceed r; if NPV is negative, r will exceed the IRR.
In every case, if a project is acceptable using the IRR method, then the NPV
method also will show it is acceptable.
Mutually Exclusive Projects
If Projects S and L are mutually exclusive rather than independent, then only
one project can be purchased. If you use IRR to make the decision as to
which project is better, you would choose Project S because IRRS= 13.1% >
IRRL = 11.4%. If you use NPV to make the decision, you might reach a
different conclusion depending on the firm's required rate of return. Note
from the figure above that the required rate of return is less than the
crossover rate of 8.1%, NPVL> NPVS, but NPVS> NPVLif the required rate of
return is greater than 8.1%. As a result of using the NPV technique, Project L
would be preferred if the firm's required rate of return is less than 8.1%, but
Project S would be preferred if the firm's required rate of return is greater
than 8.1%.
As long as the firm's required rate of return is greater than 8.1%, using either
NPV or IRR will result in the same decision - that is, Project S should be
purchased - because NPVS> NPVLand IRRS> IRRL. On the other hand, if the
firm's required rate of return is less than 8.1%, a person who uses NPV will
reach a different conclusion as to which project should be purchased than
will a person who uses IRR. The person who uses NPV will choose Project L
because NPVL> NPVS, whereas the person who uses IRR will choose Project S
because IRRS> IRRL. Thus in the case where the required rate of return is
less than 8.1%, a conflict exists. Which capital budgeting technique should
be used to choose the better project? Logic suggests that the NPV method is
better because it selects the project that adds more to shareholder wealth.
Two basic conditions can cause NPV profiles to cross and thus lead to
conflicts between NPV and IRR: (1) when project size (or scale) differences
exist, meaning that the cost of one project is much larger than that of the
other or (2) when timing differences exist, meaning that the timing of cash
flows from the two projects differs such that most of the cash flows from one
project come in the early years and most of the cash flows from the other
project come in the later years, as occurs with Projects S and L.
When size or timing differences occur, the firm will have different amounts of
funds to invest in the various years, depending on which of the two mutually
exclusive projects it chooses. For example, if one project costs more than the
other, then the firm will have more money at t = 0 to invest elsewhere if it
selects the smaller project. Similarly, for projects of equal size, the one with
the larger early cash inflows provides more funds for reinvestment in the
early years. Given this situation, the rate of return at which differential cash
flows can be invested is an important consideration.
The critical issue in resolving conflicts between mutually exclusive projects is
this: How useful is it to generate cash flows earlier rather than later? The
value of early cash flows depends on the rate at which we can reinvest these
cash flows. The NPV method implicitly assumes that the rate at which cash
flows can be reinvested is the required rate of return, r, whereas the IRR
method implies that the firm has the opportunity to reinvest at the project's
IRR. The cash flows can actually be withdrawn as dividends by the
stockholders and spent on pizza, but the NPV method still assumes that cash
flows could be reinvested at the required rate of return, whereas the IRR
method assumes reinvestment at the project's IRR.
Which is the better assumption – that cash flows can be reinvested at the
firm's required rate of return or that they can be reinvested at the project's
IRR? To reinvest at the IRR associated with a capital project, the firm must be
able to reinvest the project's cash flows in another project with an identical
IRR. Such projects generally do not continue to exist, or it is not feasible to
reinvest in such projects, because competition in the investment markets
drives their prices up and their IRRs down.
On the other hand, at the very least, a firm could repurchase the bonds and
stock it has issued to raise capital budgeting funds and thus repay some of
its investors, which would be the same as investing at its required rate of
return. Thus, we conclude the more realistic reinvestment rate assumption is
that the firm's opportunity cost is its required rate of return, which is implicit
in the NPV method. This, in turn, leads us to prefer the NPV method, at least
for firms willing and able to obtain new funds at a cost reasonably close to
their current cost of funds.
When projects are independent, the NPV and IRR methods both provide
exactly the same accept/reject decision. However, when evaluating mutually
exclusive projects, especially those that differ in scale or timing, the NPV
method should be used to determine which project should be purchased.
Cash Flow Patterns and Multiple IRRs
Lesson39of46
A project has a conventional cash flow pattern if it has cash outflows (costs)
in one or more consecutive periods at the beginning of its life followed by a
series of cash inflows during its life.
If, however, a project has a large cash outflow at the beginning of its life and
then another cash outflow either sometime during or at the end of its life,
then it has an unconventional cash flow pattern.
Projects with unconventional cash flow patterns present unique difficulties
when the IRR method is used, including the possibility ofmultiple IRRs.
There exists an IRR solution for each time the direction of the cash flows
associated with a project is interrupted – that is, inflows change to outflows.
Modified Internal Rate of Return
Lesson40of46
Despite strong academic preference for NPV, surveys indicate that many
business executives prefer IRR over NPV. It seems that many managers find
it intuitively more appealing to analyze investments in terms of percentage
rates than dollars of NPV. But the IRR method assumes the cash flows from
the project are reinvested at a rate of return equal to the IRR, which we
generally view as unrealistic.
Fortunately, we can modify the IRR and make it a better indicator of relative
profitability, and hence a better evaluation tool for use in capital budgeting.
This "modified" return is call themodified IRR, orMIRR, and it is defined as
follows:
COFrefers to cash outflows (all negative numbers) andCIFrefers to cash
inflows (all positive numbers) associated with a project. The left term is
simply the present value (PV) of the investment outlays (cash outflows) when
discounted at the firm's required rate of return, r, and the numerator of the
right terms is the future value of the cash inflows, assuming that these
inflows are reinvested at the firm's required rate of return. The future value
of the cash inflows is also called theterminal value, orTV. The discount
rate that forces the PV of the TV to equal the PV of the costs is defined as the
MIRR.
The modified IRR has a significant advantage over the traditional IRR
measure. MIRR assumes that cash flows are reinvested at the required rate
of return, whereas the traditional IRR measure assumes that cash flows are
reinvested at the project's own IRR. Because reinvestment at the required
rate of return (cost of funds) generally is more correct, the MIRR is a better
indicator of a project's true profitability. MIRR also solves the multiple IRR
problem.
Is MIRR as good as NPV for choosing between mutually exclusive projects? If
two projects are of equal size and have the same life, then NPV and MIRR will
always lead to the same project selection decision. Thus, for any projects like
our projects S and L, if NPVS> NPVL, then MIRRS> MIRRL, and the kinds of
conflicts we encountered between NPV and the traditional IRR will not occur.
Also, if the projects are of equal size, but have different lives, the MIRR will
always lead to the same decision as the NPV if the MIRRs for both projects
are calculated using as the terminal year the life of the longer project. If the
projects differ in size, however, then conflicts can still occur. For example, if
we were choosing between a large project and a small mutually exclusive
one, then we might find NPVLarge> NPVSmalland MIRRLarge> MIRRSmall.
Our conclusion is that the MIRR is superior to the regular IRR as an indicator
of a project's "true" rate of return, or "expected long-term rate of return," but
the NPV method is still better for choosing among competing projects that
differ in size because it provides a better indicator of the extent to which
each project will increase the value of the firm; thus, NPV is still the
recommended approach.
Conclusions on the Capital Budgeting Decision Methods
Lesson41of46
Capital Budgeting Evaluation Techniques −
Payback Period (PB)
Many managers like to know how long it will take a project to repay its initial
investment (cost) from the cash flows it is expected to generate in the
future. Thus, many firms compute a project's traditional payback period (PB),
which is defined as the expected number of years required to recover the
original investment (the cost of the asset).
Payback is the simplest and, as far as we know, the oldest formal method
used to evaluate capital budgeting projects. To compute a project's payback
period, simply add up the expected cash flows for each year until the
cumulative value equals the amount that is initially invested. The total
amount of time, including the fraction of a year if appropriate, that it takes to
recapture the original amount invested is the payback period.
The exact payback period can be found using the following formula:
Using payback to make capital budgeting decisions is based on the concept
that it is better to recover the cost of (investment in) a project sooner rather
than later. As a general rule, a project is considered acceptable if its payback
is less than the maximum cost recovery time established by the firm.
The payback method is simple, which explains why it traditionally has been
one of the most popular capital budgeting techniques. But, because payback
ignores the time value of money, relying solely on this method could lead to
incorrect decisions - at least if our goal is to maximize value. If a project has
a payback of three years, we know how quickly the initial investment will be
covered by the expected cash flows, but this information does not provide
any indication of whether the return on the project is sufficient to cover the
cost of the invested funds. In addition, when payback is used, the cash flows
beyond the payback period are ignored.
Capital Budgeting Evaluation Techniques −
Discounted Payback Period (DPB)
To correct for the fact that the traditional payback method does not consider
the time value of money, we can compute the discounted payback period
(DPB) − which is the length of time it takes for a project's discounted cash
flows to repay the cost of the investment.
Unlike the traditional payback computation, the discounted payback
computation considers the time value of money. Using the discounted
payback method, a project should be accepted when its discounted payback
is less than its expected life. When a project's discounted payback is less
than its life, the present value of the future cash flows the project is
expected to generate exceeds the initial cost of the asset – that is, NPV > 0 –
and the project will create value for the firm and its shareholders.
Conclusions on the Capital Budgeting
Decision Methods
We compared the NPV and IRR methods to highlight their relative strengths
and weaknesses for evaluating capital projects, and in the process we
probably created the impression that "sophisticated" firms should use only
one method in the decision process - NPV. However, because virtually all
capital budgeting decisions are analyzed by computer, it is easy to calculate
and list all the decision measures: traditional payback, discounted payback,
NPV, IRR, and MIRR. In making the accept/reject decision, most large,
sophisticated firms calculate and consider multiple measures because each
provides decision makers with a somewhat different piece of relevant
information. In fact, a recent survey revealed that approximately 75 percent
of the respondent firms "always or almost always" use the NPV methods,
about the same percent use the IRR method, and nearly 57 percent use the
payback period approach to evaluate capital budgeting projects. These
results show that firms do indeed use more than one technique to evaluate
capital budgeting projects.
Traditional payback and discounted payback provide information about both
the risk and the liquidity of a project. A long payback means (1) that the
investment dollars will be locked up for many years, hence the project is
relatively illiquid, and (2) that the project's cash flows must be forecast far
out into the future, hence the project is probably quite risky. A good analogy
for this is the bond valuation process. An investor should never compare the
yields to maturity on two bonds without considering their terms to maturity
because a bond's riskiness is influenced by its maturity.
NPV is important because it gives a direct measure of the dollar benefit (on a
present value basis) to the firm's shareholders, so we regard NPV as the best
single measure of profitability.
IRR also measures profitability, but it is expressed as a percentage rate of
return which many decision makers, especially nonfinancial managers, seem
to prefer. Further, IRR contains information concerning a project's "safety
margin," which is not inherent in NPV.
All capital budgeting methods that consider the time value of money – that
is, NPV, IRR, MIRR, and discounted payback – provide the same accept/reject
decisions, but there could be ranking conflicts that might lead to different
decisions about which project to purchase when they are mutually exclusive
depending on which capital budgeting technique is used.
In summary, the different methods provide different types of information.
Because it is easy to calculate them, all should be considered in the decision
process. For any specific decision, more weight might be given to one
method than another, but it would be foolish to ignore the information
provided by any of the methods.
Incorporating Risk in Capital Budgeting Analysis
Lesson42of46
To this point, we have assumed that the capital budgeting projects being
evaluated have the same risk as the projects that the firm currently
possesses, because such projects can be evaluated using the firm's average
required rate of return (its WACC).
In the real world, three types of project risk need to be considered to
determine whether the required rate of return used to evaluate a project
should be different than the firm's WACC:
The project’s ownstand-alone risk, or the risk it exhibits when evaluated alone
rather than as part of a combination, or portfolio, of assets
Thecorporate, orwithin-firm,risk, which is the effect a project has on the
total (overall) riskiness of the company
Thebeta, ormarket,risk, which is the project's risk assessed from the
standpoint of a stockholder who holds a well-diversified portfolio
Stand-Alone Risk
Astand-alone riskis the risk an asset would have if it were a firm’s only
asset. It is measured by the variability of the asset’s expected returns. When
we compute a project's NPV, we use cash flows that are forecasted by
management. Unless management has perfect knowledge, the estimation of
the cash flows included in capital budgeting analysts – for example, unit
sales – will be expected values taken from probability distributions that
define the outcomes that management considers viable. Of course,
probability distributions could be relatively "tight," reflecting small standard
deviations and low risk, or "flat,” denoting a great deal of uncertainty, or
high risk. Thus, the nature of the individual cash flow distributions
determines a project's stand-alone risk.
One method used by firms to assess a project's stand-alone risk is scenario
analysis, a risk analysis technique that helps decision makers get an idea of
the range of possible outcomes when a project is purchased. In a scenario
analysis, the financial analyst asks operating managers to pick a "bad" set of
circumstances (low unit sales, low sales price, high costs, and so on) and a
"good" set. The NPVs under the bad and good conditions are then calculated
and compared to the expected, or base case, NPV.
We can use the results of the scenario analysis to determine the expected
NPV, the standard deviation of NPV, and the coefficient of variation. These
measures can then be compared to established goals and benchmarks within
the firm to assess the relative risk of the project.
Corporate (Within-Firm) Risk
To measure corporate, or within-firm, risk, we must determine how the
capital budgeting project is related to the firm's existing assets. Two assets
can be combined to reduce risk if their payoffs move in opposite directions -
that is, when the payoff from one asset falls, the payoff from the other asset
generally rises. In reality, however, it is not easy to find assets with payoffs
that move in opposite directions.
As long as assets are not perfectly positively correlated, we can still achieve
some diversification, or risk reduction, by combining them. Many firms use
this principle to reduce the risk associated with their operations. That is, they
know that adding new projects or new operations that are not highly related
to existing assets can help reduce corporate risk. For example, if Microsoft
acquires a food processing firm or a utility, it would be diversifying, and thus
its overall (within-firm) risk would be expected to decline.
Corporate risk is measured by a project’s effect on the firm’s earnings
variability while it is being held with all of the other projects and assets of
the firm.
Beta (or Market) Risk
The relevant risk of a stock is the risk that remains when it is held with other
stocks in a diversified portfolio because firm-specific risk can be reduced
significantly or eliminated through diversification. We can apply this same
concept to capital budgeting projects, because the firm can be considered as
a composite of all the projects it has undertaken. The relevant risk of a
project, then, can be viewed as the effect that it has on the firm's overall
risk.
This line of reasoning leads to the conclusion that a project’s risk-adjusted
required rate of return can be found by applying the Capital Asset Pricing
Model (CAPM):
rproj*= Rf*+ (rM*- rRF)*βproj
where:
rprojis the risk-adjusted required rate of return for the project
Rfis the risk-free rate, proxied by the rate on Treasury bonds
with a maturity comparable to the expected life of the project
rMis the expected rate of return on the market
βprojis a measure of the risk of the project relative to the other
projects of the firm and while being held with the other
projects of the firm
The major problem with evaluating beta risk is that it is difficult to measure
betas for capital budgeting projects.
One way that a firm can try to measure the beta risk of a project is to find
single-product companies in the same line of business as the project being
evaluated, and then use the average of the betas of those companies to
determine the required rate of return for the proposed project. This
technique is termed the pure play method, and the single-product companies
that are used for comparisons are called pure play firms.
Generally, this method can be used only for major projects such as whole
divisions. Even then, however, it is often difficult to implement because pure
play proxy firms are scarce.
How Project Risk Is Considered in Capital Budgeting Decisions
Lesson43of46
Financial managers would argue that it is difficult to quantify risk in capital
budgeting analysis because it is difficult to develop a specific measure of
project risk. Nevertheless, they would agree that it is possible to evaluate
whether one project is riskier than another in a general sense. Most firms
incorporate project risk in capital budgeting decisions by using the risk-
adjusted discount rate approach.
With this approach, the required rate of return used to evaluate a project is
adjusted if its risk differs substantially from the firm's average risk. That is,
average-risk projects would require an "average" rate of return (the firm's
WACC); above-average-risk projects would require a higher-than-average
rate; and below-average-risk projects would require a lower-than-average
rate.
Multinational Capital Budgeting
Lesson44of46
Although the same basic principles of capital budgeting analysis apply to
both domestic and foreign operations, some key differences need to be
mentioned.
Cash flow estimation generally is much more complex for
overseas investments. Most multinational firms set up a
separate subsidiary in each foreign country in which they
operate, and the relevant cash flows for these subsidiaries
are the dividends and royalties repatriated, or returned, to
the parent company. A foreign government might restrict the
amount of cash that can be repatriated to the parent
company, perhaps to force multinational firms to reinvest
earnings in the host country or to prevent large currency
outflows. The parent corporation cannot use cash flows
blocked in the foreign country to pay current dividends to its
shareholders, nor does it have the flexibility to reinvest cash
flows elsewhere in the world. Therefore, from the perspective
of the parent organization, the cash flows relevant for the
analysis of a foreign investment are the cash flows that the
subsidiary legally can send back to the parent.
Cash flows must be converted into the currency of the parent
company, and thus are subject to future exchange rate
changes. For example, General Motors' German subsidiary
might make a profit of 150 million euro in a year, but the
value of these profits to GM will depend on the dollar/euro
exchange rate when cash flows are repatriated.
Dividends and royalties normally are taxed by both the
foreign and home-country governments.
In addition to the complexities of the cash flow analysis, the rate of return
required for a foreign project might be different than that for an equivalent
domestic project because foreign projects might be more or less risky. A
higher risk could arise from two primary sources:exchange rate
riskandpolitical risk. A lower risk might result from international
diversification.
Exchange rate risk*reflects the inherent uncertainty about the home
currency value of cash flows sent back to the parent. In other words, foreign
projects have an added risk element that relates to what the basic cash flows
will be worth in the parent company's home currency, because actual
exchange rates might differ substantially from expectations
Political riskrefers to any action (or the chance of such action) by a host
government that reduces the value of a company's investment. At one
extreme, it includes the expropriation (seizure) without compensation of the
subsidiary's assets. Less drastic actions might reduce the value of the parent
firm's investment in the foreign subsidiary through the imposition of higher
taxes, tighter repatriation or currency controls, and restrictions on prices
charged. The risk of expropriation of U.S. assets abroad is small in
traditionally friendly and stable countries such as the United Kingdom or
Switzerland. In Latin America and Africa, on the other hand, the risk might be
substantial.
Generally, political risk premiums are not added to the required rate of
return to adjust for this risk. If a company's management is seriously
concerned that a given country might expropriate foreign assets, it simply
will not make significant investments in that country. Expropriation is viewed
as a catastrophic or ruinous event, and managers have been known to be
extraordinarily risk averse when faced with ruinous loss possibilities.
Companies can take three major steps to reduce the potential loss from
expropriation: (1) Finance the subsidiary with local capital. (2) Structure
operations such that the subsidiary has value only as a part of the integrated
corporate system. (3) Obtain insurance against economic losses from
expropriation from a source such as the Overseas Private Investment
Corporation (OPIC). If the third step is taken, insurance premiums would
have to be added to the project’s cost.
A company's balance sheet shows the value of assets, liabilities, and stockholders' equity
a. At the end of the fiscal year.
b. for any given period of time
c. at a specific point in time.
d. over an annual period.
-On a balance sheet, retained earnings are not "unspent cash" because
a. they have been paid out to common stockholders.
b. they have an arbitrarily assigned value.
c. they are always changing.
d. they have been used to finance the firm's assets.
Retained earningsare the cumulative total of the earnings that the
firm has reinvested in its assets and operations since its inception.
Retained earnings are not a reservoir of unspent cash. When the
retained earnings “vault” is empty, it is because the firm has already
reinvested the earnings in new assets and/or has paid common stock
dividends.
-For both managers and external financial analysts, blank______ is the single most important
accounting number found on the income statement.
a. net income (net profit after tax)
b. earnings before interest and taxes (EBIT)
c. earnings available for common stockholders
d. operating profit
Net income is the proverbial “bottom line” and the single most
important accounting number for both corporate managers and
external financial analysts.
-Earnings per share (EPS) is calculated by
a. dividing pretax income by the number of shares of common stock outstanding.
b. dividing the dividends paid by the number of shares of common stock outstanding.
c. dividing earnings available for common stockholders by the number of shares of common
stock outstanding.
d. dividing net profits after tax by the total number of preferred and common stock shares
outstanding.
-Net working capital
a. is a measure of a firm's overall liquidity.
b. is defined as total assets minus current liabilities.
c. reflects decreasing firm solvency as it increases
d. all of the above
-Why is the quick ratio a more appropriate measure of liquidity than the current ratio for a large-
airplane manufacturer?
a. It recognizes the contribution of all assets so that analysts can see how "quickly" a firm
can satisfy its short-term obligations.
b. It excludes inventory from the numerator of the ratio because it is difficult to convert
inventory to cash and most sales are made on a credit basis.
c. It recognizes that parts can be quickly converted to cash.
d. It is not more appropriate. The current ratio would provide better information in this
situation.
The quick ratio provides a better measure of overall liquidity only when
a firm’s inventory cannot be easily converted into cash. If inventory is
liquid, then the current ratio is the preferred measure.
-The one fixed asset that is not depreciated is blank________.
a. cash.
b. inventories.
c. equipment.
d. land.
The one fixed asset that is not depreciated is land because it seldom
declines in value.
-Return on total assets (ROA) is equal to blank_________.
a. Net profit margin x total asset turnover.
b. the product of the components of the DuPont System.
c. earnings available for common stockholders / total assets.
d. all of the above.
ROA = Net profit margin x Total asset turnover x (A/E) =.074 x 1.34
x 2.24 = 0.22
In the DuPont system, the return on total assets equals the product of the
net profit margin and total asset turnover:
-When a firm has no "other income," its operating profit and blank_____ are equal.
a. Net income
b. net profit after taxes
c. EPS
d. EBIT
When a firm has no “other income,” its operating profit and EBIT are equal.
-The firm's blank_______ are primarily interested in ratios that measure the short-term liquidity
of the company and its ability to make principal and interest payments.
a. Board of directors
b. creditors
c. owners
d. financial managers
. Creditors are primarily interested in ratios that measure the firm’s short-
term liquidity and its ability to make interest and principal payments.
-When evaluating financial ratios, analysts typically examine a firm's ratio values
a. compared to firms in other industries
b. compared to the firm's previous years' ratios
c. compared to regional averages
d. compared to firms with similar net profit margins
First, analysts compare the financial ratios in the current year with previous
years’ ratios and hope to identify trends that will aid in evaluating the firm’s
prospects.
________ratios would provide the best information regarding total return to common
stockholders.
a. Profitability
b. Activity
c. Liquidity
d. Debt
-The firm's managers use ratios to blank_____________
a. Generate an overall picture of the company's financial health.
b. monitor the firm's performance from period to period.
c. isolate developing problems.
d. all of the above
The firm’s managers use ratios to generate an overall picture of the
company’s financial health and to monitor its performance from period
to period and examine unexpected changes in order to isolate
developing problems.
Managers use ratios to improve the company’s performance. Creditors
use ratios to see whether the firm will be able to repay its debts, while
stockholders want to predict what future dividends and earnings will
be.
-The blank_________ flows result from debt and equity financing transactions.
a. financing
b. operating
c. investment
d. cash
financing flows, which result from debt and equity financing
transactions.
-Which of the following is an inflow of corporate cash?
a. Dividends
b. Increasing treasury stock
c. Depreciation charges
d. Purchasing treasury bills
I
Decrease in any asset
Increase in any liability
Net income (profit after taxes)
Depreciation and non-cash charges
Sale of common or preferred stock
-The bottom-up method for forecasting sales
a. XRelies on the ability of complex statistical models to predict individual unit or regional
sales figures, which are added together and reported to senior managers.
b. relies on the ability of senior managers to determine sales objectives for their company's
product and inform personnel about targets for each business unit.
c. Xrelies on the ability of sales personnel to correctly apply statistical models in order to
obtain firm-wide objectives for increased sales.
d. relies on the ability of sales personnel to assess future demand, usually without the aid of
statistical models.
Bottom-up sales forecastsbegin by assessing demand in the
coming year on a customer-by-customer basis. Managers add up these
figures across sales territories, product lines, and divisions to arrive at
the overall sales forecast for the company. This approach generally
does not rely on mathematical and statistical models.
-Following aggressive financing strategy takes advantage of short-term interest rates but also
increases refinancing risk. Following conservative financing strategy minimizes the risk of a
liquidity crisis, but generally increases borrowing costs. Following matching financing strategy
results in the use of long-term funding for permanent assets and short-term financing for
temporary or seasonal requirements.
a. a conservative; a matching; an aggressive
b. a matching; an aggressive; a conservative
c. a conservative; an aggressive; a matching
d. none of the above
aggressive-takes advantage of short-term interest rates, which are usually
lower than long-term rates. However, if short-term rates rise, then Hershey
will face increased interest expense. The firm also faces a significant
refinancing risk in this strategy.
Conservative-minimizes the risk that Hershey will experience a liquidity
crisis during peak quarters. Hershey will generally pay higher interest rates
on its long-term debt than it would pay if it were willing to borrow on a short-
term basis.
Matching-use of long-term funding for permanent assets & short-term
financing for temp req.
-The sustainable growth model gives managers a kind of shorthand projection that ties together
blank_____ and _____.
a. growth objectives; financial needs
b. external funds required; strategic plan
c. growth objectives; cash receipts
d. the cash budget; strategic plan
The sustainable growth model gives managers a shorthand projection that
ties together growth objectives and financing needs.
-The key input required to build a cash budget is blank________
a. The cash disbursements.
b. the strategic plan.
c. the firm's sales forecast.
d. the sustainable growth model.
the key input required to build a cash budget is the firm’s sales forecast;
-Which of the following are common cash disbursements?
a. Rent and lease payments
b. interest payments and taxes
c. payments of accounts payable and wages
d. all of the above
. The most common cash disbursements are cash purchases, fixed asset
outlays, payments of accounts payable, wages, interest payments, taxes,
and rent and lease payments
-Most pro forma statements begin with a sales forecast. One approach to deriving a sales forecast
is the top-down approach. Top-down sales forecasts rely heavily on
a. macroeconomic and industry forecasts.
b. customer input.
c. forecasts from the sales force.
d. Board of Directors input.
Top-down sales forecastsrely heavily on macroeconomic and industry
forecasts.
-A firm that employs an aggressive strategy to finance assets
a. Will have enough long-term financing to cover both its permanent investment in fixed
and current assets and the additional seasonal investments in current assets.
b. will employ riskier borrowing techniques to finance its short-term assets.
c. will finance a portion of long-term (permanent) growth in assets with short-term
financing.
d. will finance long-term assets with long-term financing and short-term assets with short-
term financing.
Aggressive-But even during the first and second quarters, when business is
relatively slow, Hershey continues to finance at least part of its operations
with short-term debt. Hershey uses short-term financing to fund a portion of
its long-term, or permanent, growth in total current assets.
-A strategic plan is a
a. forecast of the short-term inflows and outflows of a firm.
b. long-term guide driven by competitive forces.
c. projected financial statements typically based on the historical financial relationships
within the firm.
d. short-term financial plan.
A strategic plan is a long-term guide driven by competitive forces.
-A cash budget is
a. a sales forecast that includes the volume of business and various asset and liability
accounts.
b. a pro forma financial statement built upon logic of proportion and risk management.
c. a statement of a firm's planned inflows and outflows of cash used to ensure that a firm
has available cash to meet short-term financial obligations.
d. a measure of assets matched to liabilities and equity.
A cash budget is a statement of the firm’s planned inflows and outflows of
cash. Firms use the cash budget to ensure they will have enough cash
available to meet short-term financial obligations.
A speedup in _____ should _____ a firm's financing needs; whereas, a slowdown in ______
should ______ financing needs for a firm.
a. collections; decrease; payments; increase
b. payments, increase; collections; decrease
c. collections; increase; payments; increase
d. payments; increase; collections; increase
A slowdown (speedup) in collections will increase (reduce) the firm’s
short-term financing needs. Conversely, with regard to payment
patterns, a speedup (slowdown) in payments will likely increase
(reduce) the firm’s financing needs. In that sense, almost any
functional area in the firm can affect, or be affected by, the cash
budget.
-_________are often used as the plug figure in pro forma projection.
a. Gross fixed assets
b. Cash balances
c. Retained earning
d. a and b
In constructing pro forma statements, analysts usually leave one line
item on the balance sheet as a plug figure, which is adjusted after
making all other projections. The analyst may make projections for all
asset, liability, and equity accounts except for the cash balance; then,
when the projections are complete, the analyst simply adjusts the cash
account to make the balance sheet balance. Alternatively, the analyst
might leave a short-term liability account open to serve as the plug
figure. If this assumed amount of borrowing on the credit line seems
unreasonable, the company may need to recalculate the other
assumptions underlying its planning process.
-"Required total financing" figures in a cash budget
a. show the monthly financing activities for a firm.
b. show the monthly change in borrowing for a firm.
c. show the additional amount a firm must borrow at the end of each month.
d. show the amount of excess a firm has to invest at the end of each month.
When a firm wants to establish a minimum level for its cash balance, it will
subtract the desired minimum cash balance from the ending cash balance.
The result is the required total financing or the excess cash balance. If the
ending cash balance is less than the desired minimum cash balance, then
the firm has a short-term financing need. The firm meets this need with
short-term borrowing, typically notes payable. If the ending cash balance
exceeds the desired minimum cash balance, then the firm has an excess
cash balance that it can invest in short-term marketable securities.
-A long-term financial plan begins with blank___________.
a. strategy.
b. pro forma financial statements.
c. matching principals.
d. the sustainable growth model.
A long-term financial plan begins with strategy.
-When generating pro forma statements, most firms rely on a blank__________ approach to
sales forecasts.
a. top-down
b. bottom-up
c. regression
d. blended
Top-down sales forecastsrely heavily on macroeconomic and
industry forecasts. Senior managers establish a firm-wide objective for
increased sales; individual divisions or business units receive targets
that, in aggregate, collectively achieve the firm’s overall growth target;
division heads pass down sales targets to product line managers and
other smaller-scale units. The sales targets will vary across units within
the division, but they must add up to achieve the divisional goal.
Bottom-up sales forecastsbegin by assessing demand in the
coming year on a customer-by-customer basis. Managers add up these
figures across sales territories, product lines, and divisions to arrive at
the overall sales forecast for the company. This approach generally
does not rely on mathematical and statistical models.
Not surprisingly, many firms use a blend of these two approaches.
-Most firms when planning for growth focus on
a. Maintaining ROI over the firm's cost of capital.
b. maximizing Economic Value Added.
c. meeting asset target growth rates.
d. meeting sales target growth rates.
Most firms establish growth as one of their long-term objectives, and most
firms, when planning for growth, focus on meeting sales target growth rates.
-The terms and conditions to which a bond is subject are set forth in its
a. Debenture.
b. Underwriting agreement.
c. Indenture.
d. Restrictive covenants.
Anindentureis a legal document that spells out any legal restrictions
associated with the bond as well as the rights of the bondholders (lenders)
and the corporation (bond issuer).
-The preemptive right is important to shareholders because it
a. Allows management to sell additional shares below the current market price.
b. Protects the current shareholders against dilution of ownership interests.
c. Is included in every corporate charter.
d. Will result in higher dividends per share.
First, it protects the power of control of current stock-holders. If not for this
safeguard, the management team of a corporation under criticism from
stock-holders could prevent stockholders from removing the managers from
office by issuing a large number of additional shares and purchasing these
shares themselves. Second, and more importantly, a preemptive right
protects stockholders against thedilution of valuethat would occur if new
shares were sold at relatively low prices.
-Companies can issue different classes of common stock. Which of the following statements
concerning stock classes is correct?
a. All common stocks fall into one of three classes: A, B, and C.
b. Most firms have several classes of common stock outstanding.
c. All common stock, regardless of class, must have voting rights.
d. None of the above statements is necessarily true.
common stocks, regardless of class, must have the same voting rights.
Some class or classes of common stock are entitled to more votes per share than other
classes.
All common stock, regardless of class, must pay the same dividend.
All firms have several classes of common stock.
-Pure options are instruments that are
a. Created by investors outside the firm.
b. Bought and sold primarily by investors and speculators.
c. Of greater importance to investors than to financial managers.
d. All of the above.
Pure options" are instruments that are created by outsiders
(generally investment firms) rather than by the firm itself; they are
bought and sold primarily by investors (or speculators).
-Your Aunt Agatha purchased a call option a few months ago. Today is the expiration date, so
she must decide whether to exercise the option. Which of the following statements is correct? Do
not consider brokers' commissions in your answer.
a. Aunt Agatha doesn't need to make a decision about exercising the option today; in fact, it
would be better if she waited until after the option expires.
b. Aunt Agatha should exercise the option if the price of the stock is less than the exercise,
or strike, price.
c. Aunt Agatha should exercise the option if the price of the stock is greater than the
exercise, or strike, price.
d. Aunt Agatha should exercise the option, regardless of the current stock price.
The most basic types of options include a call and a put. Acall
optiongives the holder the right to purchase, or call in, shares of a
stock for purchase at a predetermined price at any time during the
option period. In contrast, aput optiongives the holder the right to
sell, or put out, shares of a stock at a specified price during the option
period. Thetransaction priceestablished in the option contract - that
is, the purchase price for a call and the selling price for a put – is called
thestriking, orexercise,price.
-Which of the following are generally considered advantages of term loans over publicly
issued bonds?
a) Lower flotation costs.
b) Speed, or how long it takes to bring the issue to market.
c) Flexibility, or the ability to adjust the bond's terms after it has been issued.
d) All of the above.
Term loans have three major advantages over public debt offerings,
such as corporate bonds: speed, flexibility, and low issuance costs.
Because they are negotiated directly between the lender and the
borrower, formal documentation is minimized.
-Eurodebt is the term used to designate
a. Debt sold by a foreign borrower that is denominated in the currency of the country where
it is sold.
b. European bank loans that are denominated in the new Euro currency.
c. Debt that is denominated in a currency that is different than the currency of the country in
which it is sold.
d. Equity instruments of one country that are sold in another country.
The termEurodebtis used to designate any debt sold in a country
other than the one in whose currency the debt is denominated.
-An American Depository Receipt (ADR) represents
a. Debt sold by a foreign borrower that is denominated in the currency of the country where
it is sold.
b. Certificates representing ownership in stocks of foreign companies that are held in trust
by a bank located in the country the stock is traded.
c. Equity instruments of one country that are sold in another country.
d. The certificates that represent ownership in foreign companies that are sold in the United
States.
ADRs are not foreign stocks; instead they are "certificates" created by
organizations such as banks. The certificates represent ownership in
stocks of foreign companies that are held in trust by a bank located in
the country where the stock is traded.
Which of the following statements is correct?
a. Once a firm declares bankruptcy, it is liquidated by the trustee, who uses the proceeds to
pay bondholders, unpaid wages, taxes, and lawyer fees.
b. XA firm with a sinking fund payment coming due would generally choose to buy back
bonds in the open market, if the price of the bond exceeds the sinking fund call price.
c. Income bonds pay interest only when the amount of the interest is actually earned by the
company. Thus, these securities cannot bankrupt a company and this makes them riskier
to investors than regular bonds.
d. XOne disadvantage of zero-coupon bonds is that issuing firms cannot realize the tax
savings from issuing debt until the bonds mature.
Income bondspay interest only when the firm has sufficient
income to cover the interest payments. As a consequence,
missing interest payments on these securities cannot bankrupt a
company. From an investor's standpoint, these bonds are riskier
than "regular" bonds.
-Which of the following statements concerning common stock and the investment banking
process is false?
a. The preemptive right gives each existing common stockholder the right to purchase his or
her proportionate share of a new stock issue.
b. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the
primary market.
c. Listing a large firm's stock is often considered to be beneficial to stockholders because
the increases in liquidity and status probably outweigh the additional costs to the firm.
d. Stockholders have the right to elect the firm's directors, who in turn select the officers
who manage the business. If stockholders are dissatisfied with management's
performance, an outside group may ask the stockholders to vote for it in an effort to take
control of the business. This action is called a margin call. false
Thepreemptive rightrequires a firm to offer existing stockholders
shares of a new stock issue in proportion to their ownership holdings
before such shares can be offered to other investors. Most common
stock issues do not have preemptive rights because most states do not
require such rights to be included in corporate charters.
The purpose of the preemptive right is twofold. First, it protects the
power of control of current stock-holders. If not for this safeguard, the
management team of a corporation under criticism from stock-holders
could prevent stockholders from removing the managers from office by
issuing a large number of additional shares and purchasing these
shares themselves. Second, and more importantly, a preemptive right
protects stockholders against thedilution of valuethat would occur if
new shares were sold at relatively low prices.
-Which of the following statements is false?
a. Any bond sold outside the country of the borrower is called an international bond.
b. Foreign bonds and Eurobonds are two important types of international bonds.
c. Foreign bonds are bonds sold by a foreign borrower but denominated in the currency of
the country in which the issue is sold.
d. The term Eurobond specifically applies to any foreign bonds denominated in U.S.
currency. false
Examples includeEurobonds, such as a British firm's issue of pound-
denominated bonds sold in France, or Ford Motor Company's dollar-
denominated issue that is sold in Germany.
-A(n) blank____ is generally obtained from a bank or insurance company and the borrower
agrees to make a series of payments consisting of interest and principal.
a. putable bond
b. bankers acceptance
c. income bond
d. term loan
Aterm loanis a contract under which a borrower agrees to make a series of
interest and principal payments on specific dates to the lender. Term loans
usually are negotiated directly between the borrowing firm and a financial
institution, such as a bank, an insurance company,
-A(n) ____ is a bond that pays no annual interest but is sold at a discount below par, thus
providing compensation to investors in the form of capital appreciation.
a. coupon bond
b. income bond
c. convertible bond
d. zero coupon bond
referred to aszero coupon bonds, were created. These securities
were offered at substantial discounts below their par values because
they paid little or no coupon interest. OIDs have since lost their
attraction for many individual investors. For this reason, most OID
bonds currently are held by institutional investors, such as pension
funds and mutual funds, rather than by individual investors.
-A protective feature on preferred stock that requires preferred dividends previously not paid to
be disbursed before any common stock dividends can be paid is called what?
a. cumulative dividends
b. callable dividends
c. putable dividends
d. historical dividends
Most preferred stock provides forcumulative dividends; that is, any
preferred dividends not paid in previous periods must be paid before
common dividends can be distributed
A ____ is a financial instrument which gives the owner the right but not the obligation to sell
shares of stock at a specified price during a particular time period
a. convertible security
b. call option
c. warrant
d. put option
aput optiongives the holder the right to sell, or put out, shares of a stock
at a specified price during the option period.
-Which of the following is NOT an example of a financial asset?
a. convertible bond
b. certificate of deposit
c. preferred stock
d. inventory
Treasury Bills
Repurchase Agreements
Federal Funds
Bankers Acceptances
Commercial Papers
Eurodollars
Negotiable Certificate of Deposit
Money Market Funds
Treasury Notes and Bonds
Municipal Bonds
Term Loans
Corporate Bonds
Preferred Stock
Common Stock
-Which of the following is NOT a source of equity on a firm’s balance sheet?
a. additional paid-in capital
b. retained earnings
c. common stock
d. property, plant, and equipment
Stockholders’ equity includes preferred stock, common stock, paid-in-
capital in excess of par, and retained earnings. However, the net worth
of the firm includes only the common stock, paid-in-capital in excess of
par, and retained earning.
-A ____ is an agreement between two firms where one firm agrees to sell some of its financial
assets to another and then buy the financial assets back from that firm at a later time
a. buyback
b. call option
c. repurchase agreement
d. put option
Arepurchase agreement (repo)is an arrangement in which one firm sells
some of its financial assets to another firm with a promise to repurchase the
securities at a higher price at a later date.
-Bond ratings of ____ and higher are considered investment grade
a. AAA
b. AA
c. A
d. BBB
BBB bonds (the lowest investment-grade rating)
-Which of the following statements is most correct? Other things held constant,
a. the "liquidity preference theory" would generally lead to an upward sloping yield curve.
b. Xthe "market segmentation theory" would generally lead to an upward sloping yield
curve.
c. Xthe "expectations theory" would generally lead to an upward sloping yield curve.
d. Xthe yield curve under "normal" conditions should be horizontal (i.e., flat.)
-Your uncle would like to restrict his interest rate risk and his default risk, but he still would like
to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle's
criteria?
a. AAA bond with 10 years to maturity.
b. BBB perpetual bond.
c. BBB bond with 10 years to maturity.
d. AAA bond with 5 years to maturity.
-If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury
coupon bond, relative to that on a 1-year T-bond?
a. The yield on the 10-year bond is less than the yield on a 1-year bond.
b. The yield on a 10-year bond will always be higher than the yield on a 1-year bond
because of maturity premiums.
c. It is impossible to tell without knowing the coupon rates of the bonds.
d. The yields on the two bonds are equal.
-An inverted yield curve
a. Exists when short-term rates exceed long-term rates.
b. Exists when long-term rates exceed short-term rates
c. Represents the "normal term structure."
d. Signifies that investors can get higher returns by investing in bonds than by investing in
stocks.
in March 1980, all rates were relatively high, and short-term rates were
higher than long-term rates, so the yield curve on that date was downward
sloping (orinverted yield curve)
-If the expectations theory of the term structure of interest rates is correct, and if the other term
structure theories are invalid, and we observe a downward sloping yield curve, which of the
following is a true statement?
a. Investors expect short-term rates to be constant over time.
b. Investors expect short-term rates to increase in the future.
c. Investors expect short-term rates to decrease in the future.
d. It is impossible to say unless we know whether investors require a positive or negative
maturity risk premium.
Theexpectations theorystates that the yield curve depends on
expectations concerning future inflation rates. Expectations can be
used to help forecast interest rates.
When inflation is expected to increase, the yield curve is upward
sloping, and vice versa. In either case, economists often use the yield
curve to form expectations about the future of the economy. When
inflation is high and expected to decline, the yield curve generally is
downward sloping. In many cases, a downward-sloping yield curve
suggests that the economy will weaken in the future: consumers delay
purchases because they expect prices to decline in the future,
borrowers wait to borrow funds because they believe rates will be
lower in the future, and investors provide more funds to the financial
markets in an effort to capture higher current rates.
-Which of the following statements is most correct?
a. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due
primarily to the fact that the probability of default is higher on long-term bonds than on
short-term bonds.
b. If the maturity risk premium were zero and the rate of inflation were expected to increase
in the future, then the yield curve for U.S. Treasury securities would, other things held
constant, have an upward slope.
c. According to the market segmentation theory of the term structure of interest rates, we
should normally expect the yield curve to have an upward slope.
d. The expectations theory of the term structure of interest rates states that borrowers
generally prefer to borrow on a long-term basis while savers generally prefer to lend on a
short-term basis, and that as a result, the yield curve is normally upward sloping.
-Which of the following statements is correct?
a. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due
primarily to the fact that the probability of default is higher on long-term bonds than on
short-term bonds.
b. Reinvestment rate risk is lower, other things held constant, on long-term than on short-
term bonds.
c. XAccording to the market segmentation theory of the term structure of interest rates, we
should normally expect the yield curve to slope downward.
d. XThe expectations theory of the term structure of interest rates states that borrowers
generally prefer to borrow on a long-term basis while savers generally prefer to lend on a
short-term basis, and that as a result, the yield curve normally is upward sloping.
Theexpectations theorystates that the yield curve depends on
expectations concerning future inflation rates. Expectations can be
used to help forecast interest rates.
When inflation is expected to increase, the yield curve is upward
sloping, and vice versa. In either case, economists often use the yield
curve to form expectations about the future of the economy. When
inflation is high and expected to decline, the yield curve generally is
downward sloping. In many cases, a downward-sloping yield curve
suggests that the economy will weaken in the future: consumers delay
purchases because they expect prices to decline in the future,
borrowers wait to borrow funds because they believe rates will be
lower in the future, and investors provide more funds to the financial
markets in an effort to capture higher current rates.
Although long-term bonds are heavily exposed to interest rate price
risk, short-term investments are more vulnerable toreinvestment
rate risk.
According to themarket segmentation theorythat has been
developed by economists, the slope of the yield curve depends on
supply/demand conditions in the long-term and short-term markets.
The yield curve could at any given time be flat, upward sloping, or
downward sloping and have humps or dips.
-Which of the following is not one of the fundamental factors that affect the cost of money?
a. Production opportunities
b. Time preferences for consumption
c. Exchange rates
d. Risk
Four fundamental factors affect the cost of money: the firm’s
production opportunities, investors’ time preferences for consumption,
risk, and inflation.
-Most experts think that in the United States the real risk-free rate fluctuates between
a. one to two percent.
b. two to four percent.
c. four to seven percent
d. eight to twelve percent
It is difficult to measure the real risk-free rate precisely, but for many years it
was assumed to fluctuate in the range of 2 to 4 percent in the United States.
-Which of the following assets is the most liquid?
a. Stock
b. Treasury bills
c. Corporate bonds
d. Cash
The most liquid asset (cash) appears first, and the least liquid (fixed assets)
comes last.
-During recessions the demand for funds typically blank____.
a. increases
b. stays the same
c. decreases
d. doubles
If the demand for funds declines, as it typically does during business
recessions, the demand curves wil shift to the left
-As the demand for funds increase, the demand curve will shift to the ____ resulting in ____
market clearing interest rate.
a. right; higher
b. left; higher
c. right; lower
d. left; lower
-The ____ premium is compensation for possibility that the borrower will not be able to pay the
debt’s interest and principal on time.
a. inflation risk
b. maturity risk
c. liquidity risk
d. default risk
Default Risk Premium, which reflects the chance that the borrower – that is,
the issuer of the security – will not pay the debt's interest or principal on
time.
-When a project's NPV exceeds zero,
a. The project will also be acceptable using payback criteria.
b. The IRR should be calculated to insure that the project's projected rate of return exceeds
the required rate of return.
c. The project should be accepted without any further consideration, assuming we are
confident that the cash flows and the required rate of return have been properly estimated.
d. Only answers a and c are correct.
-The underlying cause of ranking conflicts between the NPV and IRR methods is differing
a. Initial cost.
b. Reinvestment rate assumption.
c. Cash flow timing.
d. Profitability indices
Two basic conditions can cause NPV profiles to cross and thus lead to
conflicts between NPV and IRR: (1) when project size (or scale)
differences exist, meaning that the cost of one project is much larger
than that of the other or (2) when timing differences exist, meaning
that the timing of cash flows from the two projects differs such that
most of the cash flows from one project come in the early years and
most of the cash flows from the other project come in the later years,
as occurs with Projects S and L.
-Which of the following statements is correct?
a. The NPV method assumes that cash flows will be reinvested at the required rate of return
while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate while
the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the required rate of return
while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider the inflation premium.
but the NPV method still assumes that cash flows could be reinvested
at the required rate of return, whereas the IRR method assumes
reinvestment at the project's IRR.
-Which of the following statements is most correct?
a. Sunk costs should be ignored in capital budgeting.
b. Opportunity costs should be ignored in capital budgeting.
c. Externalities should be ignored in capital budgeting.
d. Answers a, b, and c are all correct.
Sunk costsare outlays that have been committed or that already
have occurred which will not change if the project is purchased. They
cannot be recovered regardless of whether the project is accepted or
rejected. Because they are not affected by the decision under
consideration, they should not be included in the cash flow analysis.
Opportunity costsare the cash flows that could be generated from
assets that the firm already owns if they are not used for the project in
question.
Externalitiesare effects that a project will have on other parts of the
firm. Although they often are difficult to quantify, externalities must be
estimated so that they are not mistakenly included as new (incremental)
cash flows in the capital budgeting analysis.
-Which of the following statements is correct?
a. Capital budgeting analysis for expansion and replacement projects is essentially the same
because the types of cash flows involved are the same.
b. The replacement decision involves an analysis of two independent projects where the
relevant cash flows include the initial investment, additional depreciation, and the
terminal value.
c. The change in working capital for a project is the difference between the required
increase in current assets and the spontaneous increase in current liabilities and is always
positive.
d. The incremental operating cash flow for capital budgeting includes return on invested
capital, which is net income, and return of part of invested capital, which is depreciation.
Incremental cash flowsare those that occur as a direct result of accepting
the project. To determine whether a specific cash flow is considered
relevant, we must determine whether it is affected by the purchase of the
project. Cash flows that will change because the project is purchased are
incremental cash flows that should be included in the capital budgeting
evaluation.
Replacement decisions involve determining whether capital projects
should be purchased to take the place of (replace) existing assets that might
be worn out, damaged, or obsolete.
-Which of the following statements is correct?
a. Capital budgeting analysis for expansion and replacement projects is essentially the same
because the types of cash flows involved are the same.
b. In estimating incremental operating cash flows for the purpose of capital budgeting,
interest payments should not be included since the effects of these payments are already
included in the rate of return the firm is required to earn from its investments.
c. When equipment is sold, companies receive a tax credit as long as the salvage value is
less than the initial cost of the equipment.
d. All of the above answers are correct.
-A firm is considering the purchase of an asset whose risk is greater than the current risk of the
firm, based on any method for assessing risk. In evaluating this asset, the decision maker should
a. Increase the required rate of return used to evaluate the project to reflect the higher risk of
the project.
b. Increase the NPV of the asset to reflect the greater risk.
c. Reject the asset, since its acceptance would increase the risk of the firm.
d. Ignore the risk differential if the asset to be accepted would comprise only a small
fraction of the total assets of the firm.
-Which of the following statements is correct?
a. Because discounted payback takes account of the required rate of return, a project's
discounted payback is normally shorter than its regular payback.
b. The NPV and IRR methods use the same basic equation, but in the NPV method the
discount rate is specified and the equation is solved for NPV, while in the IRR method
the NPV is set equal to zero and the discount rate is found.
c. If the required rate of return is less than the crossover rate for two mutually exclusive
projects' NPV profiles, a NPV/IRR conflict will not occur.
d. If you are choosing between two projects which have the same life, and if their NPV
profiles cross, then the smaller project will probably be the one with the steeper NPV
profile.
-Which of the following statements is correct?
a. Large costs occur at the end of nuclear power plants' lives because these plants have to be
closed down, and shutdown costs are high due to the difficulty of handling radioactive
materials. For this reason, it is possible that a nuclear plant project could have two IRRs.
b. If the Federal Reserve Board lowered interest rates, this would, other things held
constant, tend to favor short-term as opposed to long-term projects.
c. For NPV versus IRR ranking conflicts to occur, the projects under consideration must
have NPV profiles which cross one another. Crossing profiles can occur only if the two
projects differ in the size of the required investment outlay.
d. All of the above statements are false.
-Which of the following rules are essential to successful cash flow estimates, and ultimately, to
successful capital budgeting?
a. The return on invested capital is the only relevant cash flow.
b. Only incremental cash flows are relevant to the accept/reject decision.
c. Total cash flows are relevant to capital budgeting analysis and the accept/reject decision.
d. All of the above are correct.
Although estimating the cash flows can be rather difficult, two cardinal rules
can help financial analysts avoid making mistakes:
1. Capital budgeting decisions must be based on after-tax cash flows and
not accounting income.
2. Onlyincremental cash flows*are relevant to the analysis to
accept or reject a project.
-Which of the following methods involves calculating an average beta for firms in a similar
business and then applying that beta to determine the beta of its own project?
a) Risk premium method.
b) Pure play method.
c) Accounting beta method.
d) CAPM method.
One way that a firm can try to measure the beta risk of a project is to
find single-product companies in the same line of business as the
project being evaluated, and then use the average of the betas of
those companies to determine the required rate of return for the
proposed project. This technique is termed the pure play method, and
the single-product companies that are used for comparisons are called
pure play firms.
-Which of the following statements is correct?
a. Capital budgeting has long-term effects on a firm leading the firm to lose some decision-
making flexibility.
b. Because asset expansion is fundamentally related to future sales, the decision to buy an
asset involves an implicit sales forecast.
c. Timing is important in capital budgeting.
d. All of the above are correct.
-____are decisions about whether to purchase capital projects and add them to existing assets so
as to increase existing operations.
a. Replacement decisions
b. Expansion decisions
c. Independent decisions
d. Mutually exclusive decisions
. On the other hand, if a firm is considering whether to increase operations
by adding capital projects to existing assets so as to produce either more of
its existing products or entirely new products, expansion decisions are
made.
-____projects are a set of projects where the acceptance of one project means that other projects
cannot be accepted.
a. Mutually exclusive
b. Replacement
c. Expansion
Only one mutually exclusive project can be purchased, even if all of them are
acceptable
-A(n) ____ is a cash outlay that already has been incurred and that cannot be recovered
regardless of whether the project is accepted or rejected.
a. sunk cost
b. opportunity cost
c. externality
d. incremental cash flow
Sunk costsare outlays that have been committed or that already
have occurred which will not change if the project is purchased. They
cannot be recovered regardless of whether the project is accepted or
rejected. Because they are not affected by the decision under
consideration, they should not be included in the cash flow analysis.
-Which of the following capital budgeting techniques does not adjust for the riskiness of the cash
flows?
a. IRR
b. NPV
c. MIRR
d. Payback
-Uncertainty regarding the domestic flows that result from converting foreign cash flows is what
type of risk?
a. Repatriation
b. Expropriation
c. Exchange Rate
d. Political
exchange rate risk, which is the risk associated with converting dollars
into foreign currencies.
A company's balance sheet shows the value of assets, liabilities, and stockholders' equity
at a specific point in time.
On a balance sheet, retained earnings are not "unspent cash" because
they have been used to finance the firm's assets.
For both managers and external financial analysts, ______ is the single most important accounting
number found on the income statement.
net income (net profit after tax)
Earnings per share (EPS) is calculated by
dividing earnings available for common stockholders by the number of shares of common stock
outstanding.
Net working capital
is a measure of a firm's overall liquidity.
Why is the quick ratio a more appropriate measure of liquidity than the current ratio for a large-airplane
manufacturer?
It excludes inventory from the numerator of the ratio because it is difficult to convert inventory
to cash and most sales are made on a credit basis.
The one fixed asset that is not depreciated is ________.
land.
Return on total assets (ROA) is equal to _________.
net profit margin x total asset turnover.
the product of the components of the DuPont System.
earnings available for common stockholders / total assets.
all of the above.
When a firm has no "other income," its operating profit and blank_____ are equal.
EBIT
The firm's _______ are primarily interested in ratios that measure the short-term liquidity of the
company and its ability to make principal and interest payments.
creditors
When evaluating financial ratios, analysts typically examine a firm's ratio values
compared to the firm's previous years' ratios
_______ ratios would provide the best information regarding total return to common stockholders.
Profitability
The firm's managers use ratios to ______________.
generate an overall picture of the company's financial health.
monitor the firm's performance from period to period.
isolate developing problems.
all of the above
The _________ flows result from debt and equity financing transactions.
financing
Which of the following is an inflow of corporate cash?
Depreciation charges
The bottom-up method for forecasting sales
relies on the ability of sales personnel to assess future demand, usually without the aid of
statistical models.
Following _______ financing strategy takes advantage of short-term interest rates but also increases
refinancing risk. Following ______ financing strategy minimizes the risk of a liquidity crisis, but generally
increases borrowing costs. Following _______ financing strategy results in the use of long-term funding
for permanent assets and short-term financing for temporary or seasonal requirements.
none of the above
The sustainable growth model gives managers a kind of shorthand projection that ties together
blank_____ and _____.
growth objectives; financial needs
The key input required to build a cash budget is ________.
the firm's sales forecast.
Which of the following are common cash disbursements?
rent and lease payments
interest payments and taxes
payments of accounts payable and wages
all of the above
Most pro forma statements begin with a sales forecast. One approach to deriving a sales forecast is the
top-down approach. Top-down sales forecasts rely heavily on
macroeconomic and industry forecasts.
A firm that employs an aggressive strategy to finance assets
will finance a portion of long-term (permanent) growth in assets with short-term financing.
A strategic plan is a
long-term guide driven by competitive forces.
A cash budget is
a statement of a firm's planned inflows and outflows of cash used to ensure that a firm has
available cash to meet short-term financial obligations.
A speedup in _____ should _____ a firm's financing needs; whereas, a slowdown in ______ should
______ financing needs for a firm.
payments; increase; collections; increase
_________ are often used as the plug figure in pro forma projections.
Cash balances
"Required total financing" figures in a cash budget
show the additional amount a firm must borrow at the end of each month.
A long-term financial plan begins with blank___________.
strategy.
When generating pro forma statements, most firms rely on a __________ approach to sales forecasts.
blended
Most firms when planning for growth focus on
meeting sales target growth rates.
The terms and conditions to which a bond is subject are set forth in its
Indenture.
The preemptive right is important to shareholders because it
Protects the current shareholders against dilution of ownership interests.
Companies can issue different classes of common stock. Which of the following statements concerning
stock classes is correct?
None of the above statements is necessarily true.
Pure options are instruments that are
Created by investors outside the firm.
Bought and sold primarily by investors and speculators.
Of greater importance to investors than to financial managers.
All of the above.
Your Aunt Agatha purchased a call option a few months ago. Today is the expiration date, so she must
decide whether to exercise the option. Which of the following statements is correct? Do not consider
brokers' commissions in your answer.
Aunt Agatha should exercise the option if the price of the stock is greater than the exercise, or
strike, price.
Which of the following are generally considered advantages of term loans over publicly issued bonds?
Lower flotation costs.
Speed, or how long it takes to bring the issue to market.
Flexibility, or the ability to adjust the bond's terms after it has been issued.
All of the above.
Eurodebt is the term used to designate
Debt that is denominated in a currency that is different than the currency of the country in which
it is sold.
An American Depository Receipt (ADR) represents
Certificates representing ownership in stocks of foreign companies that are held in trust by a
bank located in the country the stock is traded.
Which of the following statements is correct?
Income bonds pay interest only when the amount of the interest is actually earned by the
company. Thus, these securities cannot bankrupt a company and this makes them riskier to
investors than regular bonds.
Which of the following statements concerning common stock and the investment banking process is
false?
Stockholders have the right to elect the firm's directors, who in turn select the officers who
manage the business. If stockholders are dissatisfied with management's performance, an
outside group may ask the stockholders to vote for it in an effort to take control of the business.
This action is called a margin call.
Which of the following statements is false?
The term Eurobond specifically applies to any foreign bonds denominated in U.S. currency.
A(n) ____ is generally obtained from a bank or insurance company and the borrower agrees to make a
series of payments consisting of interest and principal.
term loan
A(n) ____ is a bond that pays no annual interest but is sold at a discount below par, thus providing
compensation to investors in the form of capital appreciation.
zero coupon bond
A protective feature on preferred stock that requires preferred dividends previously not paid to be
disbursed before any common stock dividends can be paid is called what?
cumulative dividends
A ____ is a financial instrument which gives the owner the right but not the obligation to sell shares of
stock at a specified price during a particular time period.
put option
Which of the following is NOT an example of a financial asset?
inventory
Which of the following is NOT a source of equity on a firm's balance sheet?
property, plant, and equipment
A ____ is an agreement between two firms where one firm agrees to sell some of its financial assets to
another and then buy the financial assets back from that firm at a later time
repurchase agreement
Bond ratings of ____ and higher are considered investment grade
BBB
Which of the following statements is most correct? Other things held constant,
the "liquidity preference theory" would generally lead to an upward sloping yield curve.
Your uncle would like to restrict his interest rate risk and his default risk, but he still would like to invest
in corporate bonds. Which of the possible bonds listed below best satisfies your uncle's criteria?
AAA bond with 5 years to maturity.
If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond,
relative to that on a 1-year T-bond?
The yield on the 10-year bond is less than the yield on a 1-year bond.
An inverted yield curve
Exists when short-term rates exceed long-term rates.
If the expectations theory of the term structure of interest rates is correct, and if the other term
structure theories are invalid, and we observe a downward sloping yield curve, which of the following is
a true statement?
Investors expect short-term rates to decrease in the future.
Which of the following statements is most correct?
If the maturity risk premium were zero and the rate of inflation were expected to increase in the
future, then the yield curve for U.S. Treasury securities would, other things held constant, have
an upward slope.
Which of the following statements is correct?
Reinvestment rate risk is lower, other things held constant, on long-term than on short-term
bonds.
Which of the following is not one of the fundamental factors that affect the cost of money?
Exchange rates
Most experts think that in the United States the real risk-free rate fluctuates between
two to four percent.
Which of the following assets is the most liquid?
Cash
During recessions the demand for funds typically ____.
decreases
As the demand for funds increase, the demand curve will shift to the ____ resulting in ____ market
clearing interest rate.
right; higher
The ____ premium is compensation for possibility that the borrower will not be able to pay the debt's
interest and principal on time.
default risk
When a project's NPV exceeds zero,
The project should be accepted without any further consideration, assuming we are confident
that the cash flows and the required rate of return have been properly estimated.
The underlying cause of ranking conflicts between the NPV and IRR methods is differing
Reinvestment rate assumption.
Which of the following statements is correct?
The NPV method assumes that cash flows will be reinvested at the required rate of return while
the IRR method assumes reinvestment at the IRR.
Which of the following statements is most correct?
Sunk costs should be ignored in capital budgeting.
Which of the following statements is correct?
The incremental operating cash flow for capital budgeting includes return on invested capital,
which is net income, and return of part of invested capital, which is depreciation.
Which of the following statements is correct?
In estimating incremental operating cash flows for the purpose of capital budgeting, interest
payments should not be included since the effects of these payments are already included in the
rate of return the firm is required to earn from its investments.
A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm,
based on any method for assessing risk. In evaluating this asset, the decision maker should
Increase the required rate of return used to evaluate the project to reflect the higher risk of the
project.
Which of the following statements is correct?
The NPV and IRR methods use the same basic equation, but in the NPV method the discount rate
is specified and the equation is solved for NPV, while in the IRR method the NPV is set equal to
zero and the discount rate is found.
Which of the following statements is correct?
Large costs occur at the end of nuclear power plants' lives because these plants have to be closed
down, and shutdown costs are high due to the difficulty of handling radioactive materials. For
this reason, it is possible that a nuclear plant project could have two IRRs.
Which of the following rules are essential to successful cash flow estimates, and ultimately, to successful
capital budgeting?
Only incremental cash flows are relevant to the accept/reject decision.
Which of the following methods involves calculating an average beta for firms in a similar business and
then applying that beta to determine the beta of its own project?
Pure play method
Which of the following statements is correct?
Capital budgeting has long-term effects on a firm leading the firm to lose some decision-making
flexibility.
Because asset expansion is fundamentally related to future sales, the decision to buy an asset involves
an implicit sales forecast.
Timing is important in capital budgeting.
All of the above are correct.
____ are decisions about whether to purchase capital projects and add them to existing assets so as to
increase existing operations.
Expansion decisions
____ projects are a set of projects where the acceptance of one project means that other projects
cannot be accepted.
Mutually exclusive
A(n) ____ is a cash outlay that already has been incurred and that cannot be recovered regardless of
whether the project is accepted or rejected.
sunk cost
Which of the following capital budgeting techniques does not adjust for the riskiness of the cash flows?
Payback
Uncertainty regarding the domestic flows that result from converting foreign cash flows is what type of
risk?
Exchange Rate
