The Effects of Stock Repurchases

Suppose a company has some extra cash, perhaps due to the sale of a division, and it plans to use that cash to repurchase stock.12 To keep the example simple, we assume the company has no debt. The current stock price, P0, is 20 and the company has 2 million outstanding shares, n0, for a total market capitalization of 40 million. The company has 5 million in marketable securities (that is, extra cash) from the recent sale of a division. As described in the corporate valuation model of Chapter...

Tale of Two Cash Distributions Dividends versus Stock Repurchases

Suppose a company's current earnings are 400 million, it has 40 million shares of stock, and it pays out 50 percent of its earnings as dividends. Earnings are expected to grow at a constant rate of 5 percent, and the cost of equity is 10 percent. Its current dividend per share is 0.50( 400 40) 5. Using the dividend growth model, the current stock price is p Dp (1 + g) 5(1 + 0.05) 525 0 rs - g rs - g 0.10 - 0.05 0.05 . As the year progresses, the stock should climb in price by 10 percent to...

Selected Additional References and Cases

Firm's best month, when SKI ships equipment to retailers for the holiday season. Interestingly, Barnes' forecasted cash budget indicates that the company's cash holdings will exceed the targeted cash balance every month except for October and November, when shipments will be high but collections will not be coming in until later. Based on the ratios shown earlier, does it appear that SKI's target cash balance is appropriate In addition to possibly lowering the target cash balance, what actions...

Modigliani and Miller No Taxes

Modern capital structure theory began in 1958, when Professors Franco Modigliani and Merton Miller (hereafter MM) published what has been called the most influential finance article ever written.8 MM's study was based on some strong assumptions, including the following 1. There are no brokerage costs. 3. There are no bankruptcy costs. 4. Investors can borrow at the same rate as corporations. 8Franco Modigliani and Merton H. Miller, The Cost of Capital, Corporation Finance, and the Theory of...

Value Based Management

Bell Electronics Inc. has two divisions, Memory and Instruments, with total sales of 1.5 billion and a book value of capital of 1.07 billion. Based on its current stock and bond prices, the company's total market value is about 1.215 billion, giving it an MVA of 145 million, found as 1.215 - 1.070 0.145 billion 145 million. Because it has a positive MVA, Bell has created value for its investors. Even so, management is considering several new strategic plans in its efforts to increase the firm's...

Dividend Reinvestment Plans

During the 1970s, most large companies instituted dividend reinvestment plans (DRIPs), under which stockholders can automatically reinvest their dividends in the stock of the paying corporation.7 Today most larger companies offer DRIPs, and although participation rates vary considerably, about 25 percent of the average firm's shareholders are enrolled. There are two types of DRIPs (1) plans that involve only old stock that is already outstanding and (2) plans that involve newly issued stock. In...

Comparing the Corporate Valuation and Dividend Growth Models

Because the corporate valuation and dividend growth models give the same answer, does it matter which model you choose In general, it does. For example, if you were a financial analyst estimating the value of a mature company whose dividends are expected to grow steadily in the future, it would probably be more efficient to use the dividend growth model. Here you would only need to estimate the growth rate in dividends, not the entire set of pro forma financial statements. However, if a company...

The Dividend Growth Model Applied to Magna Vision

MagnaVision has not yet begun to pay dividends. However, as we saw in Table 12-1, a cash dividend of 0.442 per share is forecasted for 2005. The dividend is expected to grow by about 2.5 percent in 2006, and then at a constant 5 percent rate thereafter. MagnaVision's cost of equity is 14 percent. In this situation, we can apply the noncon-stant dividend growth model as developed earlier in Chapter 5. Figure 12-3 shows that the value of MagnaVision's stock, based on this model, is 3.70 per...

Estimating Shareholder Wealth and Stock Price

Strasburg should now recapitalize, meaning that it should issue debt and use the proceeds to repurchase stock. The shareholder's wealth after the recap, as it is commonly called, would be equal to the payment they receive from the share repurchase plus the remaining value of their equity. To find the remaining value of equity, we need to specify how much debt is issued in the new capital structure. Since we know the percent of debt in the capital structure and the resulting value of the firm,...

International Capital Structures

Companies' capital structures vary among countries. For example, the Organization for Economic Cooperation and Development (OECD) recently reported that, on average, Japanese firms use 85 percent debt to total assets (in book value terms), German firms use 64 percent, and U.S. firms use 55 percent. One problem, however, when interpreting these numbers is that different countries often use very different accounting conventions with regard to (1) reporting assets on a historical- versus a...

Ni

Some calculators use n rather than N. interest rate per period. Some calculators use i or I YR rather than I. payment. This key is used only if the cash flows involve a series of equal, or constant, payments (an annuity). If there are no periodic payments in On some financial calculators, these keys are actually buttons on the face of the calculator, while on others they are shown on a screen after going into the time value of money (TVM) menu. In this chapter, we deal...

Multinational versus Domestic Financial Management

In theory, the concepts and procedures discussed in earlier chapters are valid for both domestic and multinational operations. However, six major factors distinguish financial management in firms operating entirely within a single country from firms that operate globally 1. Different currency denominations. Cash flows in various parts of a multinational corporate system will be denominated in different currencies. Hence, an analysis of exchange rates must be included in all financial analyses....

Inventory Management

As with most other aspects of finance, inventory management in a multinational setting is similar to but more complex than for a purely domestic firm. First, there is the matter of the physical location of inventories. For example, where should Exxon Mobil keep its stockpiles of crude oil and refined products It has refineries and marketing centers located worldwide, and one alternative is to keep items concentrated in a few strategic spots from which they can then be shipped as needs arise....

Summary of Factors Influencing Dividend Policy

In earlier sections, we described both the major theories of investor preference and some issues concerning the effects of dividend policy on the value of a firm. We also discussed the residual dividend model for setting a firm's long-run target payout ratio. In this section, we discuss several other factors that affect the dividend decision. These factors may be grouped into four broad categories (1) constraints on dividend payments, (2) investment opportunities, (3) availability and cost of...

Tax Preference Theory

There are three tax-related reasons for thinking that investors might prefer a low dividend payout to a high payout (1) Recall from Chapter 9 that long-term capital gains are taxed at a maximum rate of 20 percent, whereas dividends are taxed at effective rates that go up to 39.1 percent. Therefore, wealthy investors (who own most of the stock and receive most of the dividends) might prefer to have companies retain and plow earnings back into the business. Earnings growth would presumably lead...

Provisions to Prevent Managerial Entrenchment

Suppose a company has a weak board of directors and strong anti-takeover provisions in its corporate charter, causing senior managers to feel that there is little chance that they will be removed. In this case, management is said to be entrenched. Such a company faces a high risk of being poorly run, because entrenched managers are able to act in their own interests rather than in those of shareholders. For example, they can spend company money on such perquisites as lavish offices, memberships...

The Income Statement

Table 9-2 gives the 2002 and 2001 income statements for MicroDrive. Net sales are shown at the top of each statement, after which various costs are subtracted to obtain the net income available to common shareholders, which is generally referred to simply as net income. These costs include operating costs, interest costs, and taxes. A report on earnings and dividends per share is given at the bottom of the income statement. Earnings per share (EPS) is called the bottom line, denoting that of...

Summary

This chapter described techniques for forecasting financial statements, which is a crucial part of the financial planning process. As we will see throughout the rest of the book, both investors and corporations regularly use forecasting techniques to help value a company's stock, to estimate the benefits of potential projects, and to estimate how changes in capital structure, dividend policy, and working capital policy will influence shareholder value. The key concepts covered are listed below...

Effects of Dividend Policy on rs

The effects of dividend policy on rs may be considered in terms of four factors (1) stockholders' desire for current versus future income, (2) perceived riskiness of dividends versus capital gains, (3) the tax advantage of capital gains over dividends, and (4) the information content of dividends (signaling). Since we discussed each of these factors in detail earlier, we need only note here that the importance of each factor in terms of its effect on rs varies from firm to firm depending on the...

Spreadsheet Problem

BUILD A MODEL MULTINATIONAL FINANCIAL MANAGEMENT Start with the partial model in the file Ch 15 P14 Build a Model.xls from the textbook's web site. Yohe Telecommunications is a multinational corporation that produces and distributes telecommunications technology. Although its corporate headquarters are located in Maitland, Florida, Yohe usually must buy its raw materials in several different foreign countries using several different foreign currencies. The matter is further complicated because...

Estimating the Value of Operations

Tables 12-1 and 12-2 contain the actual 2002 and projected 2003 to 2006 financial statements for MagnaVision Inc., which produces optical systems for use in medical photography. (See Chapter 11 for more details on how to project financial statements.) Growth has been rapid in the past, but the market is becoming saturated, so the sales growth rate is expected to decline from 21 percent in 2003 to a sustainable rate of 5 percent in 2006 and beyond. Profit margins are expected to improve as the...

Clientele Effect

As we indicated earlier, different groups, or clienteles, of stockholders prefer different dividend payout policies. For example, retired individuals, pension funds, and university endowment funds generally prefer cash income, so they may want the firm to pay out a high percentage of its earnings. Such investors are often in low or even zero tax brackets, so taxes are of no concern. On the other hand, stockholders in their peak earning years might prefer reinvestment, because they have less...

Conservative Approach

Panel c of Figure 16-2 has the dashed line above the line designating permanent NOWC, indicating that long-term sources are being used to finance all permanent operating asset requirements and also to meet some of the seasonal needs. In this situation, the firm uses a small amount of short-term debt to meet its peak requirements, but it also meets a part of its seasonal needs by storing liquidity in the form of marketable securities. The humps above the dashed line represent short-term...

Market Multiple Analysis

Another method of stock valuation is market multiple analysis, which applies a market-determined multiple to net income, earnings per share, sales, book value, or, for businesses such as cable TV or cellular telephone systems, the number of subscribers. While the discounted dividend method applies valuation concepts in a precise manner, focusing on expected cash flows, market multiple analysis is more judgmental. To illustrate the concept, suppose that a company's forecasted earnings per share...

Distributions to Shareholders Dividends and Repurchases

A profitable company regularly faces three important questions. (1) How much of its free cash flow should it pass on to shareholders (2) Should it provide this cash to stockholders by raising the dividend or by repurchasing stock (3) Should it maintain a stable, consistent payment policy, or should it let the payments vary as conditions change In this chapter we will discuss the issues that affect a firm's cash distribution policy. As we will see, most firms establish a policy that considers...

Questions

16-1 Define each of the following terms a. Working capital net working capital net operating working capital b. Inventory conversion period receivables collection period payables deferral period cash conversion cycle c. Relaxed NOWC policy restricted NOWC policy moderate NOWC policy d. Transactions balance compensating balance precautionary balance e. Cash budget target cash balance g. Account receivable days sales outstanding aging schedule h. Credit policy credit period credit standards...

Financial Analysis on the Internet

A wide range of valuable financial information is available on the Internet. With just a couple of clicks, an investor can easily find the key financial statements for most publicly traded companies. Say, for example, you are thinking about buying Disney stock, and you are looking for financial information regarding the company's recent performance. Here's a partial but by no means a complete list of places you can go to get started One source is Yahoo's finance web site, http finance....

Setting the Target Payout Ratio The Residual Dividend Model5

When deciding how much cash to distribute to stockholders, two points should be kept in mind 1 The overriding objective is to maximize shareholder value, and 2 the firm's cash flows really belong to its shareholders, so management should refrain from retaining income unless they can reinvest it to produce returns higher than shareholders could themselves earn by investing the cash in investments of equal risk. On the other hand, recall from Chapter 6 that internal equity retained earnings is...

Multinational or Global Corporations

The textbook's web site contains an Excel file that will guide you through the chapter's calculations. The file for this chapter is Ch 15 Tool Kit.xls, and we encourage you to open the file and follow along as you read the chapter. The term multinational, or global, corporation is used to describe a firm that operates in an integrated fashion in a number of countries. During the past 20 years, a new and fundamentally different form of international commercial activity has developed, and this...

Trade Off Theory

Trade Off Theory Capital

MM's results also depend on the assumption that there are no bankruptcy costs. However, in practice bankruptcy can be quite costly. Firms in bankruptcy have very high legal and accounting expenses, and they also have a hard time retaining customers, suppliers, and employees. Moreover, bankruptcy often forces a firm to liquidate or sell assets for less than they would be worth if the firm were to continue operating. For example, if a steel manufacturer goes out of business, it might be hard to...

Using Debt Financing to Constrain Managers

Agency problems may arise if managers and shareholders have different objectives. Such conflicts are particularly likely when the firm's managers have too much cash at their disposal. Managers often use excess cash to finance pet projects or for perquisites such as nicer offices, corporate jets, and sky boxes at sports arenas, all of which may do little to maximize stock prices. Even worse, managers might be tempted to pay too much for an acquisition, something that could cost shareholders...

Uses and Limitations of Ratio Analysis

To find quick information about a company, link to http www.marketguide. com. Here you can find company profiles, stock price and share information, and several key ratios. As noted earlier, ratio analysis is used by three main groups 1 managers, who employ ratios to help analyze, control, and thus improve their firms' operations 2 credit analysts, including bank loan officers and bond rating analysts, who analyze ratios to help ascertain a company's ability to pay its debts and 3 stock...

NPV Profiles

See Ch 07 Tool Kit.xls for A graph that plots a project's NPV against the cost of capital rates is defined as all calculations. the project's net present value profile profiles for Projects L and S are shown in Figure 7-4. To construct NPV profiles, first note that at a zero cost of capital, the NPV is simply the total of the project's undiscounted cash flows. Thus, at a zero cost of capital NPVS 300, and NPVL 400. These values are plotted as the vertical axis intercepts in Figure 7-4. Next, we...

Dividends versus Capital Gains What Do Investors Prefer

An excellent source of recent dividend news for major corporations is available at the web site of Corporate Financials Online at http www.cfonews. com scs. By clicking the down arrow of the News Category box to the left of the screen, students may select Dividends to receive a list of companies with dividend news. Click on any company, and you will see its latest dividend news. When deciding how much cash to distribute to stockholders, financial managers must keep in mind that the firm's...

Multinational Capital Budgeting

Up to now, we have discussed the general environment in which multinational firms operate. In the remainder of the chapter, we will see how international factors affect key corporate decisions. We begin with capital budgeting. Although the same basic principles of capital budgeting analysis apply to both foreign and domestic operations, there are some key differences. First, cash flow estimation is more complex for overseas investments. Most multinational firms set up separate subsidiaries in...

The Cash Budget

The cash budget shows the firm's projected cash inflows and outflows over some specified period. Generally, firms use a monthly cash budget forecasted over the next year, plus a more detailed daily or weekly cash budget for the coming month. The monthly cash budgets are used for planning purposes, and the daily or weekly budgets for actual cash control. The cash budget provides more detailed information concerning a firm's future cash flows than do the forecasted financial statements. In...

Capital Structure Decisions

For updates on a company's ratio, go to http finance. yahoo.com, enter the ticker symbol for a stock quote, and select Profile after the quote comes up. Click on Ratio Comparisons on the left side of the Profile sheet for updates on the sector ratio. A company can obtain long-term financing in the form of equity, debt, or some combination. The accompanying table shows the long-term debt ratios for different business sectors and selected individual companies within those industries.1 There are...

Operating Working Capital Policies

Table 16-1 shows three alternative policies regarding the total amount of net operating working capital carried. The first row illustrates a relaxed working capital policy, where relatively large amounts of cash and inventories are carried, where sales are stimulated by the use of a credit policy that provides liberal financing to customers and a corresponding high level of receivables, and where a company doesn't take advantage of credit provided by accruals and accounts payable. Conversely,...

Maturity Matching or Self Liquidating Approach

The maturity matching, or self-liquidating, approach calls for matching asset and liability maturities as shown in Panel a of Figure 16-2. This strategy minimizes the risk that the firm will be unable to pay off its maturing obligations. To illustrate, suppose a company borrows on a one-year basis and uses the funds obtained to build and equip a plant. Cash flows from the plant profits plus depreciation would not be sufficient to pay off the loan at the end of only one year, so the loan would...

Operating Leverage

In physics, leverage implies the use of a lever to raise a heavy object with a small force. In politics, if people have leverage, their smallest word or action can accomplish a lot. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in EBIT. Other things held constant, the higher a firm's fixed costs, the greater its operating leverage. Higher fixed costs are generally associated...

Sensitivity Analysis

Intuitively, we know that many of the variables that determine a project's cash flows could turn out to be different from the values used in the analysis. We also know that a change in a key input variable, such as units sold, will cause the NPV to change. Sensitivity analysis is a technique that indicates how much NPV will change in response to a given change in an input variable, other things held constant. Sensitivity analysis begins with a base-case situation, which is developed using the...

Lumpy Assets

In many industries, technological considerations dictate that if a firm is to be competitive, it must add fixed assets in large, discrete units such assets are often referred to as FIGURE 11-2 Four Possible Ratio Relationships Millions of Dollars b. Economies of Scale Declining Ratios lumpy assets. In the paper industry, for example, there are strong economies of scale in basic paper mill equipment, so when a paper company expands capacity, it must do so in large, lumpy increments. This type of...

Modigliani and Miller The Effect of Corporate Taxes

MM published a follow-up paper in 1963 in which they relaxed the assumption that there are no corporate taxes.10 The Tax Code allows corporations to deduct interest payments as an expense, but dividend payments to stockholders are not deductible. This differential treatment encourages corporations to use debt in their capital structures. This means that interest payments reduce the taxes paid by a corporation, and if a corporation pays less to the government, more of its cash flow is available...

Spreadsheet Problems

Start with the partial model in the file Ch 17 P9 Build a Model.xls from the textbook's web site. Rework Problem 17-1. Then work the next two parts of this problem given below. a. Construct data tables for the exercise value and Black-Scholes option value for this option, and graph this relationship. Include possible stock price values ranging up to 30.00. b. Suppose this call option is purchased today. Draw the profit diagram of this option position at expiration. Start with the partial model...

Assume You Have Been Given The Following Information On Purcell Industries Current Stock Price 15 Exercise Price Of

17-1 Assume you have been given the following information on Purcell Industries BLACK-SCHOLES MODEL Current stock price 15 Exercise price of option 15 Time to maturity of option 6 months Risk-free rate 10 Variance of stock price 0.12 d1 0.32660 Using the Black-Scholes Option Pricing Model, what would be the value of the option 17-2 The exercise price on one of Flanagan Company's options is 15, its exercise value is 22, and options its premium is 5. What are the option's market value and the...

Ability to Service Debt Ebitda Coverage Ratio

The TIE ratio is useful for assessing a company's ability to meet interest charges on its debt, but this ratio has two shortcomings 1 Interest is not the only fixed financial charge companies must also reduce debt on schedule, and many firms lease assets and thus must make lease payments. If they fail to repay debt or meet lease payments, they can be forced into bankruptcy. 2 EBIT does not represent all the cash flow available to service debt, especially if a firm has high depreciation and or...

Dorothy Koehl Recently Leased

Williams amp Sons last year reported sales of 10 million and an inventory turnover ratio of 2. The company is now adopting a new inventory system. If the new system is able to reduce the firm's inventory level and increase the firm's inventory turnover ratio to 5, while maintaining the same level of sales, how much cash will be freed up Medwig Corporation has a DSO of 17 days. The company averages 3,500 in credit sales each day. What is the company's average accounts receivable What is the...

Step 4 Raising the Additional Funds Needed

Based on the forecasted balance sheet, MicroDrive will need 2,200 million of operating assets to support its forecasted 3,300 million of sales. We define required assets as the sum of its forecasted operating assets plus the previous amount of short-term investments. Since MicroDrive had no short-term investments in 2002, its required assets are simply 2,200 million, as shown in Row 19 of Table 11-3. We define the specified sources of financing as the sum of forecasted levels of operating...

Problems

15-1 A currency trader observes that in the spot exchange market, 1 U.S. dollar can be exchanged for CROSS RATES 9 Mexican pesos or for 111.23 Japanese yen. What is the cross-exchange rate between the yen and the peso that is, how many yen would you receive for every peso exchanged 15-2 Six-month T-bills have a nominal rate of 7 percent, while default-free Japanese bonds that ma-INTEREST RATE PARITY ture in 6 months have a nominal rate of 5.5 percent. In the spot exchange market, 1 yen equals...

Using Compensation to Align Managerial and Shareholder Interests

In the preceding section we discussed the stick side of corporate governance. Now we turn to the carrot, managerial compensation. The typical CEO today receives a fixed salary plus a bonus that is zero if the firm's performance is poor but that rises as performance becomes better and better. In 1997, salary for an average executive amounted to about 21 percent of total compensation versus bonuses of about 79 percent. So, performance certainly matters 9 Executive bonuses are based on a number of...

Conclusions on Stock Repurchases

When all the pros and cons on stock repurchases have been totaled, where do we stand Our conclusions may be summarized as follows 1. Because of the lower capital gains tax rate and the deferred tax on capital gains, repurchases have a significant tax advantage over dividends as a way to distribute income to stockholders. This advantage is reinforced by the fact that repurchases provide cash to stockholders who want cash while allowing those who do not need current cash to delay its receipt. On...

Ordinary Annuities

If the payments come at the end of each year, then the annuity is an ordinary annuity, and it would be set up as follows The regular time line is shown at the top of the diagram, and the numerical solution values are shown in the left column. The PV of the annuity, PVAn, is 272.32. The general equation used to find the PV of an ordinary annuity is shown below The general equation used to find the PV of an ordinary annuity is shown below The Present Value Interest Factor of an Annuity for i and...

Yield to Call

If you purchased a bond that was callable and the company called it, you would not have the option of holding the bond until it matured. Therefore, the yield to maturity would not be earned. For example, if MicroDrive's 10 percent coupon bonds were callable, and if interest rates fell from 10 percent to 5 percent, then the company could call in the 10 percent bonds, replace them with 5 percent bonds, and save 100 50 50 interest per bond per year. This would be beneficial to the company, but not...

Dividend Irrelevance Theory

It has been argued that dividend policy has no effect on either the price of a firm's stock or its cost of capital. If dividend policy has no significant effects, then it would be irrelevant. The principal proponents of the dividend irrelevance theory are Merton Miller and Franco Modigliani MM .2 They argued that the firm's value is determined only by its basic earning power and its business risk. In other words, MM argued that the value of the firm depends only on the income produced by its...

The AFN Formula

Most firms forecast their capital requirements by constructing pro forma income statements and balance sheets as described above. However, if the ratios are expected to remain constant, then the following formula can be used to forecast financial requirements. Here we apply the formula to MicroDrive based on the 2002 data, not the revised data, as the revised data do not assume constant ratios. The symbols in Equation 11-1 are defined below. The symbols in Equation 11-1 are defined below. A...

The Financial Statements Of Lioi Steel Fabricators Are Shown Below

Costs except depreciation Depreciation Total operating costs Earnings before interest and taxes EBIT Less interest Earnings before taxes Taxes 40 530.0 400.0 30.0 430.0 100.0 23.0 77.0 500.0 380.0 25.0 405.0 95.0 21.0 74.0 29.6 44.4 Marketable securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Common stock Retained earnings Common equity Total liabilities and...

Comparative Ratios and Benchmarking

Ratio analysis involves comparisons a company's ratios are compared with those of other firms in the same industry, that is, with industry average figures. However, like most firms, MicroDrive's managers go one step further they also compare their ratios with those of a smaller set of the leading computer companies. This technique is called benchmarking, and the companies used for the comparison are called benchmark companies. For example, MicroDrive benchmarks against Apex Systems, Ca-blenet,...

Checklist for Capital Structure Decisions

What Optimal Capital Structure

Firms generally consider the following factors when making capital structure decisions 1. Sales stability. A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with unstable sales. Utility companies, because of their stable demand, have historically been able to use more financial leverage than industrial firms. 2. Asset structure. Firms whose assets are suitable as security for loans tend to use debt rather heavily. General-purpose...

Upton Computers Makes Bulk Purchases

Carter Corporation's sales are expected to increase from 5 million in 2002 to 6 million in 2003, or by 20 percent. Its assets totaled 3 million at the end of 2002. Carter is at full capacity, so its assets must grow at the same rate as projected sales. At the end of 2002, current liabilities were 1 million, consisting of 250,000 of accounts payable, 500,000 of notes payable, and 250,000 of accruals. The after-tax profit margin is forecasted to be 5 percent, and the forecasted payout ratio is 70...

Common Stock Valuation

Common stock represents an ownership interest in a corporation, but to the typical investor a share of common stock is simply a piece of paper characterized by two features 1. It entitles its owner to dividends, but only if the company has earnings out of which dividends can be paid, and only if management chooses to pay dividends rather than retaining and reinvesting all the earnings. Whereas a bond contains a promise to pay interest, common stock provides no such promise if you own a stock,...

Provisions to Call or Redeem Bonds

Most corporate bonds contain a call provision, which gives the issuing corporation the right to call the bonds for redemption.4 The call provision generally states that the company must pay the bondholders an amount greater than the par value if they are called. The additional sum, which is termed a call premium, is often set equal to one year's interest if the bonds are called during the first year, and the premium declines at a constant rate of INT N each year thereafter, where INT annual...

Expected Rate of Return

If we multiply each possible outcome by its probability of occurrence and then sum these products, as in Table 3-2, we have a weighted average of outcomes. The weights are the probabilities, and the weighted average is the expected rate of return, T, called r-hat.3 The expected rates of return for both Martin Products and U.S. Water are shown in Table 3-2 to be 15 percent. This type of table is known as a payoff matrix. 2It is, of course, completely unrealistic to think that any stock has no...

Levels of Market Efficiency

If markets are efficient, stock prices will rapidly reflect all available information. This raises an important question What types of information are available and, therefore, incorporated into stock prices Financial theorists have discussed three forms, or levels, of market efficiency. Weak-Form Efficiency The weak form of the EMH states that all information contained in past price movements is fully reflected in current market prices. If this were true, then information about recent trends...

Versus Securities

In a book on financial management for business firms, why do we spend so much time discussing the risk of stocks Why not begin by looking at the risk of such business assets as plant and equipment The reason is that, for a management whose primary objective is stock price maximization, the overriding consideration is the risk of the firm's stock, and the relevant risk of any physical asset must be measured in terms of its effect on the stock's risk as seen by investors. For example, suppose...

Investment Returns

With most investments, an individual or business spends money today with the expectation of earning even more money in the future. The concept of return provides investors with a convenient way of expressing the financial performance of an investment. To illustrate, suppose you buy 10 shares of a stock for 1,000. The stock pays no dividends, but at the end of one year, you sell the stock for 1,100. What is the return on your 1,000 investment One way of expressing an investment return is in...

Scenario Analysis

Scenario Analysis Tool

Although sensitivity analysis is probably the most widely used risk analysis technique, it does have limitations. For example, we saw earlier that the computer project's NPV is highly sensitive to changes in the sales price and the variable cost per unit. Those sensitivities suggest that the project is risky. Suppose, however, that Home Depot or Circuit City was anxious to get the new computer product and would sign a contract to purchase 20,000 units per year for four years at 3,000 per unit....

Step 3 Forecast the Balance Sheet

Before going into the details of forecasting balance sheets, let's take a look at the big picture. First, a company must have assets to support the sales as forecasted on the income statement, and if sales are growing, then assets typically must also grow. Second, if assets are to grow, then the company must obtain funds to purchase the new assets. Third, the needed funds can come from internal sources, mainly as reinvested earnings, or externally, from the sale of short-term investments, from...

Strategic Plans

Strategic plans usually begin with a statement of the overall corporate purpose. Most companies are very clear about their corporate purpose Our mission is to maximize shareowner value over time. This corporate purpose is increasingly common for U.S. companies, but that has not always been the case. For example, Varian Associates, Inc., a New York Stock Exchange company with sales of almost 2 billion, was, in 1990, regarded as one of the most technologically advanced electronics companies....

Types of Stock Market Transactions

We can classify stock market transactions into three distinct types 1. Trading in the outstanding shares of established, publicly owned companies the secondary market. MicroDrive Inc., a company we analyze throughout the book, has 50 million shares of stock outstanding. If the owner of 100 shares sells his or her stock, the trade is said to have occurred in the secondary market. Thus, the market for outstanding shares, or used shares, is the secondary market. The company receives no new money...

Changes in Bond Values over Time

At the time a coupon bond is issued, the coupon is generally set at a level that will cause the market price of the bond to equal its par value. If a lower coupon were set, investors would not be willing to pay 1,000 for the bond, while if a higher coupon were set, investors would clamor for the bond and bid its price up over 1,000. Investment bankers can judge quite precisely the coupon rate that will cause a bond to sell at its 1,000 par value. A bond that has just been issued is known as a...

Analysis of the Cash Flows

Capital projects can be analyzed using a calculator, paper, and a pencil, or with a spreadsheet program such as Excel. Either way, you must set the analysis up as shown in Table 8-3 and go through the steps outlined in Parts 1 through 5 of the table. For exam purposes, you will probably have to work problems with a calculator. However, for reasons that will become obvious as you go through the chapter, in practice spreadsheets are virtually always used. Still, the steps involved in a capital...

Conclusions on Capital Budgeting Methods

We have discussed six capital budgeting decision methods, comparing the methods with one another, and highlighting their relative strengths and weaknesses. In the process, we probably created the impression that sophisticated firms should use only one method in the decision process, NPV. However, virtually all capital budgeting decisions are analyzed by computer, so it is easy to calculate and list all the decision measures payback and discounted payback, NPV, IRR, modified IRR MIRR , and...

The Financial Plan

The financial planning process can be broken down into these steps 1. Project financial statements and use these projections to analyze the effects of the operating plan on projected profits and financial ratios. The projections can also be used to monitor operations after the plan has been finalized and put into effect. Rapid awareness of deviations from the plan is essential in a good control system, which, in turn, is essential to corporate success in a changing world. 2. Determine the funds...

Incremental Cash Flows

In evaluating a project, we focus on those cash flows that occur if and only if we accept the project. These cash flows, called incremental cash flows, represent the change in the firm's total cash flow that occurs as a direct result of accepting the project. Three special problems in determining incremental cash flows are discussed next. Sunk Costs A sunk cost is an outlay that has already occurred, hence is not affected by the decision under consideration. Since sunk costs are not incremental...

Changes in Equilibrium Stock Prices

Stock prices are not constant they undergo violent changes at times. For example, on September 17, 2001, the first day of trading after the terrorist attacks of September 11, the Dow Jones average dropped 685 points. This was the largest decline ever in the Dow, but not the largest percentage loss, which was 22.6 percent on October 19, 1987. The Dow has also had some spectacular increases. In fact, its fifth largest increase was 368 points on September 24, 2001, shortly after its largest-ever...

Global Variations in the Cost of Capital

For U.S. firms to be competitive with foreign companies, they must have a cost of capital no greater than that faced by their international competitors. In the past, many experts argued that U.S. firms were at a disadvantage. In particular, Japanese firms enjoyed a very low cost of capital, which lowered their total costs and thus made it hard for U.S. firms to compete. Recent events, however, have considerably narrowed cost of capital differences between U.S. and Japanese firms. In particular,...

The Post Audit

An important aspect of the capital budgeting process is the post-audit, which involves 1 comparing actual results with those predicted by the project's sponsors and 2 explaining why any differences occurred. For example, many firms require that the operating divisions send a monthly report for the first six months after a project goes into operation, and a quarterly report thereafter, until the project's results are up to 15Joe Walker, Richard Burns, and Chad Denson, Why Small Manufacturing...

Economic Value Added EVA

Whereas MVA measures the effects of managerial actions since the very inception of a company, Economic Value Added EVA focuses on managerial effectiveness in a given year. The EVA basic formula is as follows EVA Net operating profit after taxes NOPAT After-tax dollar cost of capital used to support operations 9-10 EBIT 1 Corporate tax rate Operating capital WACC . Operating capital is the sum of the interest-bearing debt, preferred stock, and common equity used to acquire the company's net...

Economic Life versus Physical Life

Projects are normally analyzed under the assumption that the firm will operate the asset over its full physical life. However, this may not be the best course of action it may be best to terminate a project before the end of its potential life, and this possibility can materially affect the project's estimated profitability. The situation in Table 7-1 can be used to illustrate this concept and its effects on capital budgeting. The salvage values listed in the third column are after taxes, and...

Monte Carlo Simulation

Andrew Probability Table

Monte Carlo simulation ties together sensitivities and probability distributions. It grew out of work in the Manhattan Project to build the first atomic bomb, and was so named because it utilized the mathematics of casino gambling. While Monte Carlo simulation is considerably more complex than scenario analysis, simulation software packages make this process manageable. Many of these packages are included as add-ons to spreadsheet programs such as Microsoft Excel. In a simulation analysis, the...

Implications of Market Efficiency

What bearing does the EMH have on financial decisions Since stock prices do seem to reflect public information, most stocks appear to be fairly valued. This does not 15Tape watchers are people who watch the NYSE tape, while chartists plot past patterns of stock price movements. Both are called technical analysts, and both believe that they can tell if something is happening to the stock that will cause its price to move up or down in the near future. 16Several cases of illegal insider trading...

Tying the Ratios Together The Du Pont Chart and Equation

Table 10-1 summarized MicroDrive's ratios, and now Figure 10-2 shows how the return on equity is affected by asset turnover, the profit margin, and leverage. The chart depicted in Figure 10-2 is called a modified Du Pont chart because that company's managers developed this approach for evaluating performance. Working from the bottom up, the left-hand side of the chart develops the profit margin on sales. The various expense items are listed and then summed to obtain MicroDrive's total cost,...

Capital Rationing

Armbrister Pyrotechnics, a manufacturer of fireworks and lasers for light shows, has identified 40 potential independent projects, with 15 having a positive NPV based on the firm's 12 percent cost of capital. The total cost of implementing these 15 projects is 75 million. Based on finance theory, the optimal capital budget is 75 million, and Armbrister should accept the 15 projects with positive NPVs. However, Armbrister's management has imposed a limit of 50 million for capital expenditures...

Incorporating Project Risk into Capital Budgeting

As we described in Chapter 6, many firms calculate a cost of capital for each division, based on the division's market risk and capital structure. This is the first step toward incorporating risk analysis into capital budgeting decisions, but it is limited because it only encompasses market risk. Rather than directly estimating the corporate risk of a project, the risk management departments at many firms regularly assess the entire firm's likelihood of financial distress, based on current and...

Calculate Brauer S Profit Margin And Debt Ratio

Ace Industries has current assets equal to 3 million. The company's current ratio is 1.5, and its quick ratio is 1.0. What is the firm's level of current liabilities What is the firm's level of inventories Baker Brothers has a DSO of 40 days. The company's average daily sales are 20,000. What is the level of its accounts receivable Assume there are 365 days in a year. Bartley Barstools has an equity multiplier of 2.4. The company's assets are financed with some combination of long-term debt and...

Over The Past Year Md Ryngaert

10-1 Define each of the following terms a. Liquidity ratios current ratio quick, or acid test, ratio b. Asset management ratios inventory turnover ratio days sales outstanding DSO fixed assets turnover ratio total assets turnover ratio c. Financial leverage debt ratio times-interest-earned TIE ratio coverage ratio d. Profitability ratios profit margin on sales basic earning power BEP ratio return on total assets ROA return on common equity ROE e. Market value ratios price earnings P E ratio...

Why Is It True In General That A Failure To Adjust Expected Cash Flows For Expected Inflation Biases The Calculated Npv

Throughout the book, we have indicated that the value of any asset depends on the amount, timing, and riskiness of the cash flows it produces. In this chapter, we developed a framework for analyzing a project's cash flows and risk. The key concepts covered are listed below. The most important and most difficult step in analyzing a capital budgeting project is estimating the incremental after-tax cash flows the project will produce. Project cash flow is different from accounting income. Project...

How the Firm Is Financed Total Liabilities to Total Assets

The ratio of total liabilities to total assets is called the debt ratio, or sometimes the total debt ratio. It measures the percentage of funds provided by sources other than equity 310 754 1,064 2,000 2,000 . Industry average 40.0 . Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors' losses in the event of liquidation. Stockholders, on the other hand, may want more leverage because it magnifies expected earnings. MicroDrive's debt ratio is...

Trend Analysis Common Size Analysis and Percent Change Analysis

It is important to analyze trends in ratios as well as their absolute levels, for trends give clues as to whether a firm's financial condition is likely to improve or to deteriorate. To do a trend analysis, one simply plots a ratio over time, as shown in Figure 10-1. This graph shows that MicroDrive's rate of return on common equity has been declining since 1999, even though the industry average has been relatively stable. All the other ratios could be analyzed similarly. Common size analysis...

Project Risk Analysis Techniques for Measuring Stand Alone Risk

Recall from Chapter 6 that there are three distinct types of risk stand-alone risk, corporate risk, and market risk. Why should a project's stand-alone risk be important to anyone In theory, this type of risk should be of little or no concern. However, it is actually of great importance for two reasons 1. It is easier to estimate a project's stand-alone risk than its corporate risk, and it is far easier to measure stand-alone risk than market risk. 2. In the vast majority of cases, all three...

Market Value Added MVA

The primary goal of most firms is to maximize shareholders' wealth. This goal obviously benefits shareholders, but it also helps to ensure that scarce resources are allocated efficiently, which benefits the economy. Shareholder wealth is maximized by maximizing the difference between the market value of the firm's stock and the amount of equity capital that was supplied by shareholders. This difference is called the Market Value Added MVA MVA Market value of stock Equity capital supplied by...

Types of Common Stock

Although most firms have only one type of common stock, in some instances classified stock is used to meet the special needs of the company. Generally, when special classifications are used, one type is designated Class A, another Class B, and so on. Small, new companies seeking funds from outside sources frequently use different types of common stock. For example, when Genetic Concepts went public recently, its Class A stock was sold to the public and paid a dividend, but this stock had no...

Probability Distributions

An event's probability is defined as the chance that the event will occur. For example, a weather forecaster might state, There is a 40 percent chance of rain today and a 60 percent chance that it will not rain. If all possible events, or outcomes, are listed, and if a probability is assigned to each event, the listing is called a probability distribution. For our weather forecast, we could set up the following probability distribution The possible outcomes are listed in Column 1, while the...

Evaluating Fcf Nopat and Operating Capital

Even though MicroDrive had a positive NOPAT, its very high investment in operating assets resulted in a negative free cash flow. Because free cash flow is what is available for distribution to investors, not only was there nothing for investors, but investors actually had to provide additional money to keep the business going. Investors provided most of this new money as debt. Is a negative free cash flow always bad The answer is, Not necessarily. It depends on why the free cash flow was...

Factors the Firm Can Control

A firm can affect its cost of capital through 1 its capital structure policy, 2 its dividend policy, and 3 its investment capital budgeting policy. Capital Structure Policy In this chapter, we assume that a firm has a given target capital structure, and we use weights based on that target structure to calculate the WACC. It is clear, though, that a firm can change its capital structure, and such a change can affect its cost of capital. First, beta is a function of financial leverage, so capital...

Financial Statements Cash Flow and Taxes

Suppose you are a small investor who knows a little about finance and accounting. Could you compete successfully against large institutional investors with armies of analysts, high-powered computers, and state-of-the-art trading strategies The answer, according to one Wall Street legend, is a resounding yes Peter Lynch, who had an outstanding track record as manager of the 10 billion Fidelity Magellan fund and then went on to become the best-selling author of One Up on Wall Street and Beating...

Cost of Common Stock rs

Companies can raise common equity in two ways 1 directly by issuing new shares and 2 indirectly by retaining earnings. If new shares are issued, what rate of return must the company earn to satisfy the new stockholders In Chapter 3, we saw that investors require a return of rs. However, a company must earn more than rs on new external equity to provide this rate of return to investors because there are commissions and fees, called flotation costs, when a firm issues new equity. Few mature firms...

Stand Alone Risk

Risk is defined in Webster's as a hazard a peril exposure to loss or injury. Thus, risk refers to the chance that some unfavorable event will occur. If you engage in skydiving, you are taking a chance with your life skydiving is risky. If you bet on the horses, you are risking your money. If you invest in speculative stocks or, really, any stock , you are taking a risk in the hope of making an appreciable return. An asset's risk can be analyzed in two ways 1 on a stand-alone basis, where the...

Bond Markets

Corporate bonds are traded primarily in the over-the-counter market. Most bonds are owned by and traded among the large financial institutions for example, life insurance companies, mutual funds, and pension funds, all of which deal in very large blocks of securities , and it is relatively easy for the over-the-counter bond dealers to arrange the transfer of large blocks of bonds among the relatively few holders of the bonds. It would be much more difficult to conduct similar operations in the...

Tax Havens

Many multinational corporations have found an interesting but controversial way to reduce their tax burdens By shifting some of their operations to countries with low or nonexistent taxes, they can significantly reduce their total tax bills. Over the years, several countries have passed tax laws that make the countries tax havens designed to attract foreign investment. Notable examples include the Bahamas, Grand Cayman, and the Netherlands Antilles. Rupert Murdoch, chairman of global media...