TABLE 312 Recent Prepackaged Bankruptcies of Large US Firms

The main benefit of prepackaged bankruptcy is that it forces holdouts to accept a bankruptcy reorganization. If a large fraction of a firm's creditors can agree privately to a reorganization plan, the holdout problem may be avoided. It makes a reorganization plan in formal bankruptcy easier to put together.11 A recent study by McConnell, Lease, and Tashjian reports that prepackaged bankruptcies offer many of the advantages of a formal bankruptcy, but they are also more efficient. Their results...

Questions and Problems

30.1 The Lager Brewing Corporation has acquired the Philadelphia Pretzel Company in a vertical merger. Lager Brewing has issued 300,000 in new long-term debt to pay for its purchase. ( 300,000 is the purchase price.) Construct the balance sheet for the new corporation if the merger is treated as a purchase for accounting purposes. The balance sheets shown here represent the assets of both firms at their true market values. Assume these market values are also the book values. PHILADELPHIA...

Indirect Costs of Financial Distress

Impaired Ability to Conduct Business Bankruptcy hampers conduct with customers and suppliers. Sales are frequently lost because of both fear of impaired service and loss of trust. For example, many loyal Chrysler customers switched to other manufacturers when Chrysler skirted insolvency in the 1970s. These buyers questioned whether parts and servicing would be available were Chrysler to fail. Sometimes the taint of impending bankruptcy is enough to drive customers away. For example, gamblers...

Rights

When new shares of common stock are offered to the general public, the proportionate ownership of existing shareholders is likely to be reduced. However, if a preemptive right is contained in the firm's articles of incorporation, the firm must first offer any new issue of common stock to existing shareholders. This assures each owner his or her proportionate owner's share. An issue of common stock to existing stockholders is called a rights offering. Here, each shareholder is issued an option...

Appendix 18A Stock Dividends and Stock Splits

In addition to the cash dividend, companies may issue stock dividends or split their stock. Since stock dividends and stock splits are quite similar, we treat them together. We begin with examples of these two strategies. Next, their benefits and costs to the firm are discussed. Imagine a company with 10,000 shares of stock, each selling at 60. With a stock dividend of 10 percent, each stockholder receives one additional share for each 10 that he or she originally owned. Therefore the total...

The Case of Two Bonds with the Same Maturity but with Different Coupons

The previous example concerned pure discount bonds of different maturities. We now want to see the effect of different coupons on price volatility. To abstract from the effect of differing maturities, we consider two bonds with the same maturity but with different coupons. Value of One-Year Pure Discount Bond Value of Five-Year Pure Discount Bond 16Alternatively, we could have chosen bonds that pay 100 at maturity. Their values would be 90.91 ( 100 1.10) and 62.09 100 (1.10)5 . However, our...

Repurchase of Stock

Instead of paying cash dividends, a firm can rid itself of excess cash by repurchasing shares of its own stock. Recently share repurchase has become an important way of distributing earnings to shareholders.12 The repurchase of stock is a potentially useful adjunct to divi- 12Adam Dunsby, Share Repurchases, Dividends, and Corporate Distribution Policy, unpublished manuscript, The Wharton School, University of Pennsylvania, November 29, 1994, shows a dramatic increase in share repurchase since...

Suggested Readings

The following articles are important for an understanding of how to make short-term financial decisions Sartoris, W. L., and N. C. Hill. Evaluating Credit Policy Alternatives A Present Value Framework. Journal of Financial Research 4 (Spring 1981), p. 1. _A Generalized Cash Flow Approach to Short-Term Financial Decisions. Journal of Finance 38 (May 1983), p. 3. Our treatment of the credit decision owes much to Bierman, H., Jr., and W. H. Hausman. The Credit Granting Decision. Management Science...

Types of Leases

A lease is a contractual agreement between a lessee and lessor. The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor, the owner of the asset. The lessor is either the asset's manufacturer or an independent leasing company. If the lessor is an independent leasing company, it must buy the asset from a manufacturer. Then the lessor delivers the asset to the lessee, and the lease goes into effect. As far as the lessee is...

What We Know and Do Not Know about Dividend Policy

Capital Structure and I 18. Dividend Policy Why I I The McGraw-Hill Corporate Finance, Sixth Dividend Policy Does It Matter Companies, 2002 Chapter 18 Dividend Policy Why Does It Matter 517 TABLE 18.3 Relationship between Dividend Yield and Marginal Tax Rate from Direct Observation of Individual Investors' Portfolios Stockholders in high marginal tax brackets buy securities with low-dividend yield and vice versa. *Lewellen et al. use several alternative methods to...

Financial Planning and Short Term Finance

26 Corporate Financial Models and Long-Term Planning 7S2 27 Short-Term Finance and Planning 746 Financial planning establishes the blueprint for change in a firm. It is necessary because (1) it includes putting forth the firm's goals to motivate the organization and provide benchmarks for performance measurement, (2) the firm's financing and investment decisions are not independent and their interaction must be identified, and (3) the firm must anticipate changing conditions and surprises. Most...

Valuing a Gold Mine

The Woe Is Me gold mine was founded in 1878 on one of the richest veins of gold in the West. Thirty years later, by 1908, the mine had been played out, but occasionally, depending on the price of gold, it is reopened. Currently gold is not actively mined at Woe Is Me, but its stock is still traded on the exchange under the ticker symbol, WOE. WOE has no debt and, with about 20 million outstanding shares, it has a market value (stock price times number of shares outstanding) well above 1...

Adjusted PresentValue Approach

The adjusted-present-value (APV) method is best described by the following formula In words, the value of a project to a levered firm (APV) is equal to the value of the project to an unlevered firm (NPV) plus the net present value of the financing side effects (NPVF). One can generally think of four side effects 1. The Tax Subsidy to Debt. This was discussed in Chapter 15, where we pointed out that, for perpetual debt, the value of the tax subsidy is TCB. (TC is the corporate tax rate, and B is...

Call Options

The most common type of option is a call option. A call option gives the owner the right to buy an asset at a fixed price during a particular time period. There is no restriction on the kind of asset, but the most common ones traded on exchanges are options on stocks and bonds. For example, call options on IBM stock can be purchased on the Chicago Board Options Exchange. IBM does not issue (that is, sell) call options on its common stock. Instead, individual investors are the original buyers...

Private Workout or Bankruptcy Which Is Best

A firm that defaults on its debt payments will need to restructure its financial claims.The firm will have two choices formal bankruptcy or private workout. The previous section described two types of formal bankruptcies bankruptcy liquidation and bankruptcy reorganization. This section compares private workouts with bankruptcy reorganizations. Both types of financial restructuring involve exchanging new financial claims for old financial Ross-Westerfield-Jaffe I VIII. Special Topics I 31....

What Is Corporate Financial Planning

Financial planning formulates the method by which financial goals are to be achieved. It has two dimensions a time frame and a level of aggregation. A financial plan is a statement of what is to be done in a future time. The GM board member was right on target when he explained the virtues of financial planning. Most decisions have long lead times, which means they take a long time to implement. In an uncertain world, this requires that decisions be made far in advance of their implementation....

Example

The decision to use a bank cash-management service incorporating lockboxes and concentration banks depends on where a firm's customers are located and the speed of the U.S. postal system. Suppose Atlantic Corporation, located in Philadelphia, is considering a lockbox system. Its collection delay is currently eight days. It does business in the southwestern part of the country (New Mexico, Arizona, and California). The proposed lockbox system will be located in Los Angeles and operated by...

The Benchmark Case An Illustration of the Irrelevance of Dividend Policy

A powerful argument can be made that dividend policy does not matter. This will be illustrated with the Bristol Corporation. Bristol is an all-equity firm that has existed for 10 years. The current financial managers know at the present time (date 0) that the firm will dissolve in one year (date 1). At date 0 the managers are able to forecast cash flows with perfect certainty. The managers know that the firm will receive a cash flow of 10,000 immediately and another 10,000 next year. They...

Minicase US Steels Acquisition of Marathon

In the summer of 1981, Marathon Oil Company commissioned the First Boston Corporation to prepare an analysis of the underlying asset value of Marathon based solely on publicly available information. Before First Boston could complete the study, Mobil Corporation announced a tender offer for Marathon's common equity, thus launching one of the most eventful takeover stories in American corporate history. Ross-Westerfield-Jaffe VIII. Special Topics On October 30,1981, Mobil bid 85 per share for up...

Accounting and Leasing

Before November 1976, a firm could arrange to use an asset through a lease and not disclose the asset or the lease contract on the balance sheet. Lessees needed only to report information on leasing activity in the footnotes of their financial statements. Thus, leasing led to off-balance-sheet financing. In November 1976, the Financial Accounting Standards Board FASB issued its Statement of Financial Accounting Standards No. 13 FAS 13 , Accounting for Leases. Under FAS 13, certain leases are...

The Operating Cycle and the Cash Cycle

Short-term finance is concerned with the firm's short-run operating activities. A typical manufacturing firm's short-run operating activities consist of a sequence of events and decisions Ross-Westerfield-Jaffe VII. Financial Planning and 27. Short-Term Finance The McGraw-Hill Corporate Finance, Sixth Short-Term Finance and Planning Companies, 2002 Chapter 27 Short-Term Finance and Planning 751 FIGURE 27.3 Cash Flow Time Line and the Short-Term Operating Activities of a Typical Manufacturing...

The Black Scholes Model

The preceding example illustrates the duplicating strategy. Unfortunately, a strategy such as this will not work in the real world over, say, a one-year time frame, because there are many more than two possibilities for next year's stock price. However, the number of possibilities is reduced as the time period is shortened. In fact, the assumption that there are only two possibilities for the stock price over the next infinitesimal instant is quite plausible.9 In our opinion, the fundamental...

Defining Cash in Terms of Other Elements

Now we will define cash in terms of the other elements of the balance sheet. The balance sheet equation is Net working capital Fixed assets Long-term debt Equity 27.1 Net working capital is cash plus the other elements of net working capital that is, Net working Other current Current Substituting equation 27.2 into 27.1 yields Other current Current Long-term Fixed Cash - 6 Equity - 27.3 assets liabilities debt assets Long-term Net working capital Fixed Cash Equity - - 27.4 xAs we will learn in...

Appendix 31A Predicting Corporate Bankruptcy The ZScore Model16

Many potential lenders use credit scoring models to assess the creditworthiness of prospective borrowers. The general idea is to find factors that enable the lenders to discriminate between good and bad credit risks. To put it more precisely, lenders want to identify attributes of the borrower that can be used to predict default or bankruptcy. 16Edward I. Altman, Corporate Financial Distress and Bankruptcy, John Wiley amp Sons, N.Y. 1993 , Chapter 3. Ross-Westerfield-Jaffe I VIII. Special...

Implications

There are a number of implications associated with the pecking-order theory that are at odds with the trade-off theory. 1. There is no target amount of leverage. According to the trade-off model, each firm balances the benefits of debt, such as the tax shield, with the costs of debt, such as distress costs. The optimal amount of leverage occurs where the marginal benefit of debt equals the marginal cost of debt. By contrast, the pecking-order theory does not imply a target amount of leverage....

The Evidence

The record on the efficient-market hypothesis is extensive, and in large measure it is reassuring to advocates of the efficiency of markets. The studies done by academicians fall into broad categories. First, there is evidence as to whether changes of stock prices are random. Second are event studies. Third is the record of professionally managed investment firms. The random-walk hypothesis, as expressed in equation 13.1 , implies that a stock's price movement in the past is unrelated to its...

Determining the Target Cash Balance

The target cash balance involves a trade-off between the opportunity costs of holding too much cash and the trading costs of holding too little. Figure 28.1 presents the problem graphically. If a firm tries to keep its cash holdings too low, it will find itself selling marketable securities and perhaps later buying marketable securities to replace those sold more frequently than if the cash balance was higher. Thus, trading costs will tend to fall as the cash balance becomes larger. In...

The Different Types of Efficiency

Efficient Capital Markets

In our previous discussion, we assumed that the market responds immediately to all available information. In actuality, certain information may affect stock prices more quickly than other information. To handle differential response rates, researchers separate information into different types. The most common classification system speaks of three types information on past prices, publicly available information, and all information. The effect of these three information sets on prices is...

NPV Analysis of the Leaseversus Buy Decision

The detour leads to a simple method for evaluating leases discount all cash flows at the after-tax interest rate. From the bottom line of Table 21.3, Xomox's incremental cash flows from leasing versus purchasing are Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Net cash flows from lease alternative relative to purchase alternative 10,000 - 2,330 - 2,330 - 2,330 - 2,330 - 2,330 Let us assume that Xomox can either borrow or lend at the interest rate of 7.57575 percent. If the corporate tax rate is 34...

Two State Option Model

Suppose the current market price of a stock is 50 and the stock will either be 60 or 40 at the end of the year. Further, imagine a call option on this stock with a one-year expiration date and a 50 exercise price. Investors can borrow at 10 percent. Our goal is to determine the value of the call. In order to value the call correctly, we need to examine two strategies. The first is to simply buy the call. The second is to a. Buy one-half a share of stock. b....

Preferred Stock

Preferred stock represents equity of a corporation, but it is different from common stock because it has preference over common stock in the payment of dividends and in the assets of the corporation in the event of bankruptcy. Preference means only that the holder of the preferred share must receive a dividend in the case of an ongoing firm before holders of common shares are entitled to anything. Preferred shares have a stated liquidating value, usually 100 per share. The dividend preference...

The Practice of Capital Budgeting

Not all firms use capital budgeting procedures based on discounted cash flows. Some firms use the payback method, and others use the accounting-rate-of-return method. Most studies find that the most frequently used capital budgeting technique for large corporations is either the internal rate of return IRR or the net present value NPV or a combination of both.14 Table 6.4 summarizes the results of a survey of large U.S. multinational firms and shows that over 80 percent of the responding firms...

The Private Equity Market

The previous sections of this chapter assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market. Of course, there are many firms that have not reached this stage and cannot use the public equity market. For start-up firms or firms in financial trouble, the public equity market is often not available. The market for venture capital is part of the private equity market.21 Private placements avoid the costly procedures associated with the...

Empirical Models

The CAPM and the APT by no means exhaust the models and techniques used in practice to measure the expected return on risky assets. Both the CAPM and the APT are risk-based models. They each measure the risk of a security by its beta s on some systematic factor s , and they each argue that the expected excess return must be proportional to the beta s . While we have seen that this is intuitively appealing and has a strong basis in theory, there are alternative approaches. Most of these...

Valuing a StartUp

Ralph Simmons was not your typical MBA student. Since childhood, he had had one ambition, to open a restaurant that sold alligator meat. He went to business school because he realized that, although he knew 101 ways to cook alligators, he didn't have the business skills necessary to run a restaurant. He was extremely focused, with each course at graduate school being important to him only to the extent that it could further his dream. While taking his school's course in entrepreneurship, he...

Corporate Long Term Debt The Basics

Securities issued by corporations may be classified roughly as equity securities and debt securities. The distinction between equity and debt is basic to much of the modern theory and practice of corporate finance. At its crudest level, debt represents something that must be repaid it is the result of borrowing money. When corporations borrow, they promise to make regularly scheduled interest payments and to repay the original amount borrowed that is, the principal . The person or firm making...

Consolidated Rail Corporation

The shares are being sold by the United States Government pursuant to the Conrail Privatization Act. The Company will not receive any proceeds from the sale of the shares. Upon request, a copy of the Prospectus describing these securities and the business of the Company may be obtained within any state from any Underwriter who may legally distribute it within such State. The securities are offered only by means of the Prospectus, and this announcement is neither an offer to sell nor a...

The Rights Puzzle

Smith calculated the issuance costs from three alternative methods an equity issue with underwriting, a rights issue with standby underwriting, and a pure rights issue.14 The results of his study, which appear in Table 19.10, suggest that a pure rights issue is the cheapest of the three alternatives. The bottom line of the table shows that total costs as a percentage of proceeds is 6.17 percent, 6.05 percent, and 2.45 percent for the three alternatives, respectively. As the body of the table...

Determinants of Beta

The regression analysis approach in the previous section doesn't tell us where beta comes from. The beta of a stock does not come out of thin air. Rather, it is determined by the characteristics of the firm. We consider three factors the cyclical nature of revenues, operating leverage, and financial leverage. The revenues of some firms are quite cyclical. That is, these firms do well in the expansion phase of the business cycle and do poorly in the contraction phase. Empirical evidence suggests...

Bankruptcy Risk or Bankruptcy Cost

As mentioned throughout the previous chapter, debt provides tax benefits to the firm. However, debt puts pressure on the firm, because interest and principal payments are obligations. If these obligations are not met, the firm may risk some sort of financial distress. The ultimate distress is bankruptcy, where ownership of the firm's assets is legally transferred from the stockholders to the bondholders. These debt obligations are fundamentally different from stock obligations. While...

Growing Annuity

Cash flows in business are very likely to grow over time, due either to real growth or to inflation. The growing perpetuity, which assumes an infinite number of cash flows, provides one formula to handle this growth. We now consider a growing annuity, which is a finite 92 Part II Value and Capital Budgeting number of growing cash flows. Because perpetuities of any kind are rare, a formula for a growing annuity would be useful indeed. The formula is13 Formula for Present Value of Growing Annuity...

Resolution of Real World Factors

In the previous sections, we pointed out that the existence of personal taxes favors a low-dividend policy after all positive NPV projects are taken, whereas other factors favor high dividends. The financial profession had hoped that it would be easy to determine which of these sets of factors dominates. Unfortunately, after years of research, no one has been able to conclude which of the two is more important. Thus, the dividend-policy question is not resolved. A discussion of two important...

Summary and Conclusions

The dividend decision is important because it determines the payout received by shareholders and the funds retained by the firm for investment. Dividend policy is usually reflected by the current dividend-to-earnings ratio. This is referred to as the payout ratio. Unfortunately, the optimal payout ratio cannot be determined quantitatively. Rather, one can only indicate qualitatively what factors lead to low- or high-dividend policies. 2. The dividend policy of the firm is irrelevant in a...

Return Statistics

The history of capital-market returns is too complicated to be handled in its undigested form. To use the history we must first find some manageable ways of describing it, dramatically condensing the detailed data into a few simple statements. This is where two important numbers summarizing the history come in. The first and most natural number is some single measure that best describes the past annual returns on the stock market. In other words, what is our best estimate of the return that an...

The Public Issue

The basic steps in a public offering are depicted in Table 19.1. The Securities Act of 1933 sets forth the federal regulation for all new interstate securities issues. The Securities Exchange Act of 1934 is the basis for regulating securities already outstanding. The SEC administers both acts. 1. Management's first step in any issue of securities to the public is to obtain approval from the board of directors. 2. Next, the firm must prepare and file a registration statement with the SEC. This...

Beta and Leverage

Chapter 12 provides the formula for the relationship between the beta of the common stock and leverage of the firm in a world without taxes. We reproduce this formula here As pointed out in Chapter 12, this relationship holds under the assumption that the beta of debt is zero. Ross-Westerfield-Jaffe I IV. Capital Structure and I 17. Valuation and Capital I I The McGraw-Hill Corporate Finance, Sixth Dividend Policy Budgeting for the Levered Companies, 2002 482 Part IV Capital Structure and...

Corporate Strategy and Positive NPV

The intuition behind discounted cash flow analysis is that a project must generate a higher rate of return than the one that can be earned in the capital markets. Only if this is true will a project's NPV be positive. A significant part of corporate strategy analysis is seeking investment opportunities that can produce positive NPV. Simple number crunching in a discounted cash flow analysis can sometimes erroneously lead to a positive NPV calculation. In calculating discounted cash flows, it is...

Agency Costs

When a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies. These conflicts of interest, which are magnified when financial distress is incurred, impose agency costs on the firm. We describe three kinds of selfish strategies that stockholders use to hurt the bondholders and help themselves. These strategies are costly because they will lower the market value of the whole firm. Selfish Investment...

Some Different Types of Bonds

Taggart, The Growing Role of Junk Bonds in Corporate Finance, Journal of Applied Corporate Finance Spring 1988 . Ross-Westerfield-Jaffe I V. Long-Term Financing I 20. Long-Term Debt I I The McGraw-Hill Corporate Finance, Sixth Companies, 2002 The popularity of floating-rate bonds is connected to inflation risk. When inflation is higher than expected, issuers of fixed-rate bonds tend to make gains at the expense of lenders, and when inflation is less than expected, lenders make...

Price Earnings Ratio

We argued earlier that one should not discount earnings in order to determine price per share. Nevertheless, financial analysts frequently relate earnings and price per share, as made evident by their heavy reliance on the price-earnings or P E ratio. Our previous discussion stated that Price per share _ 1 NPVGO EPS r EPS The left-hand side is the formula for the price-earnings ratio. The equation shows that the P E ratio is related to the net present value of growth opportunities. As an...

Debt Displacement and Lease Valuation

The Basic Concept of Debt Displacement Advanced The previous analysis allows one to calculate the right answer in a simple manner. This clearly must be viewed as an important benefit. However, the analysis has little intuitive appeal. To remedy this, we hope to make lease-buy analysis more intuitive by considering the issue of debt displacement. A firm that purchases equipment will generally issue debt to finance the purchase. The debt becomes a liability of the firm. A lessee incurs a...

Definition of Risk When Investors Hold the Market Portfolio

The previous section states that many investors hold diversified portfolios similar to broad-based indices. This result allows us to be more precise about the risk of a security in the context of a diversified portfolio. Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta of the security. We illustrate beta by an example. Consider the following possible returns on both the stock of Jelco, Inc., and on the market Though the return on the market...

Edison International A Case for High Debt

Edison International is the parent firm of Southern California Edison SCE and five nonutility companies. Southern California Edison is the nation's second largest electric utility in terms of number of customers. SCE currently operates in a highly regulated environment in which it has an obligation to provide electric service to customers in return for a monopoly franchise in Southern California. SCE generated about 90 percent of the total operating revenue for Edison International....

Efficient Market Hypothesis A Summary

Investors are foolish and too stupid to be in the market. All shares of stock have the same expected returns. Investors should throw darts to select stocks. There is no upward trend in stock prices. Prices reflect underlying value. Financial managers cannot time stock and bond sales. Sales of stock and bonds will not depress prices. You cannot cook the books. There are optical illusions, mirages, and apparent patterns in charts of stock market returns. There is some evidence against efficiency...

Long Term Debt A Review

Long-term debt securities are promises by the issuing firm to pay interest and principal on the unpaid balance. The maturity of a long-term debt instrument refers to the length of time the debt remains outstanding with some unpaid balance. Debt securities can be short-term maturities of one year or less or long-term maturities of more than one year .1 Short-term debt is sometimes referred to as unfunded debt and long-term debt as funded debt.2 The two major forms of long-term debt are public...

Expected Return Dividends and Personal Taxes

The material presented so far in this chapter can properly be called a discussion of dividend policy. That is, it is concerned with the level of dividends chosen by a firm. A related, but distinctly different, question is, What is the relationship between the expected return on a security and its dividend yield To answer this question, we consider an extreme situation where dividends are taxed as ordinary income and capital gains are not taxed. Corporate taxes are ignored. Suppose every...

Personal Taxes

So far in the chapter, we have considered corporate taxes only. Unfortunately, the IRS does not let us off that easily. Income to individuals is taxed at marginal rates up to 39.6 percent. To see the effect of personal taxes on capital structure, we have reproduced our Water Products example from Section 15.5 below. As presented above, this example considers corporate but not personal taxes. To treat these personal taxes, we first assume that all earnings after taxes are paid out as dividends....

How Firms Establish Capital Structure

Chapiteau Structure

The theories of capital structure are among the most elegant and sophisticated in the field of finance. Financial economists should and do pat themselves on the back for contributions in this area. However, the practical applications of the theories are less than fully satisfying. Consider that our work on net present value produced an exact formula for evaluating projects. Prescriptions for capital structure under either the trade-off model or the pecking-order theory are vague by comparison....

Recent Trends in Capital Structure

The Federal Reserve System Structure

The previous section of this chapter established that U.S. firms from 1984 to 1990 and after 1993 issued large amounts of new debt to finance the retirement of shares of stock. This pattern of financing suggests the question Did the capital structure of firms change significantly in the 1980s and the mid 1990s Unfortunately there is no precise answer to this important question. If we use book values i.e., balance sheet values the answer would be yes. Figure 14.3 charts the book value of debt to...

Reducing the Cost of Capital

Chapters 9-12 develop the idea that both the expected return on a stock and the cost of capital of the firm are positively related to risk. Recently, a number of academics have argued that expected return and cost of capital are negatively related to liquidity as well.9 In addition, these scholars make the interesting point that, although it is quite difficult to lower the risk of a firm, it is much easier to increase the liquidity of the firm's stock. Therefore, they suggest that a firm can...

Were the Japanese Stock Prices Too High

Japan Stock Bubble

This is the question investors have been asking about the Japanese stock market. As can be seen from the chart below, an investment of one yen, placed in a diversified portfolio of Japanese stocks on the last day of 1969, would have grown to about 18 yen by 1988. By contrast, the tables in Chapter 9 can be used to show that a 1 investment in American stocks would have only risen to under 7 over the same time period. During this time period, the average price-earnings ratio for Japanese stocks...

The NoDividend Firm

Students frequently ask the following questions If the dividend-discount model is correct, why aren't no-dividend stocks selling at zero This is a good question and gets at the goals of the firm. A firm with many growth opportunities is faced with a dilemma. The firm can pay out dividends now, or it can forgo dividends now so that it can make investments that will generate even greater dividends in the future.11 This is often a painful choice, because a strategy of dividend deferment may be...

The Cost of Equity Capital

Security Market Line

Whenever a firm has extra cash, it can take one of two actions. On the one hand, it can pay out the cash immediately as a dividend. On the other hand, the firm can invest extra cash in a project, paying out the future cash flows of the project as dividends. Which procedure would the stockholders prefer If a stockholder can reinvest the dividend in a financial asset a stock or bond with the same risk as that of the project, the stockholders would desire the Ross-Westerfield-Jaffe I III. Risk I...

The Public Issue of Bonds

The general procedures followed for a public issue of bonds are the same as those for stocks, as described in the previous chapter. First, the offering must be approved by the board of directors. Sometimes a vote of stockholders is also required. Second, a registration statement is prepared for review by the Securities and Exchange Commission. Third, if accepted, the registration statement becomes effective 20 days later, and the securities are sold. However, the registration statement for a...

Maximizing Firm Value versus Maximizing Stockholder Interests

The following example illustrates that the capital structure that maximizes the value of the firm is the one that financial managers should choose for the shareholders. Suppose the market value of the J. J. Sprint Company is 1,000. The company currently has no debt, and each of J. J. Sprint's 100 shares of stock sells for 10. A company such as J.J. Sprint with no debt is called an unlevered company. Further suppose that J. J. Sprint plans to borrow 500 and pay the 500 proceeds to shareholders...

Expected Return and Variance

Suppose financial analysts believe that there are four equally likely states of the economy depression, recession, normal, and boom times. The returns on the Supertech Company are expected to follow the economy closely, while the returns on the Slowpoke Company are not. The return predictions are as follows Supertech Returns Slowpoke Returns Variance can be calculated in four steps. An additional step is needed to calculate standard deviation. The calculations are presented in Table 10.1. The...

Taxes

The previous part of this chapter showed that firm value is unrelated to debt in a world without taxes. We now show that, in the presence of corporate taxes, the firm's value is positively related to its debt. The basic intuition can be seen from a pie chart, such as the one in Figure 15.4. Consider the all-equity firm on the left. Here, both equityholders and the IRS have claims on the firm. The value of the all-equity firm is, of course, that part of the pie owned by the equityholders. The...

Standard Method of Cash Dividend Payment

The decision whether or not to pay a dividend rests in the hands of the board of directors of the corporation. A dividend is distributable to shareholders of record on a specific date. When a dividend has been declared, it becomes a liability of the firm and cannot be easily rescinded by the corporation. The amount of the dividend is expressed as dollars per share dividend per share , as a percentage of the market price dividend yield , or as a percentage of earnings per share dividend payout ....

Different Types of Dividends

The term dividend usually refers to a cash distribution of earnings. If a distribution is made from sources other than current or accumulated retained earnings, the term distribution rather than dividend is used. However, it is acceptable to refer to a distribution from earnings as a dividend and a distribution from capital as a liquidating dividend. More generally, any direct payment by the corporation to the shareholders may be considered part of dividend policy. The most common type of...

Where Does g Come From

The previous discussion on stocks assumed that dividends grow at the rate g. We now want to estimate this rate of growth. Consider a business whose earnings next year are expected to be the same as earnings this year unless a net investment is made. This situation is likely to occur, because net investment is equal to gross, or total, investment less depreciation. A net investment of zero occurs when total investment equals depreciation. If total investment is equal to depreciation, the firm's...

Capital Structure and Dividend Policy

13 Corporate-Financing Decisions and Efficient Capital Markets 339 14 Long-Term Financing An Introduction 371 15 Capital Structure Basic Concepts 390 16 Capital Structure Limits to the Use of Debt 422 17 Valuation and Capital Budgeting for the Levered Firm 468 18 Dividend Policy Why Does It Matter 495 Part II discussed the capital budgeting decisions of the firm. We argued that the objective of the firm should be to create value from its capital budgeting decisions. To do this the firm must...

Capital Structure Example

Suppose we are analyzing a new product that will sell an expected 10 units a year in perpetuity at 10 net cash flow. In other words, we expect that cash flows will be 100 per year. At the end of the first year we will learn more about the economic viability of the new product. Specifically, we will know if the project will be a success or a failure. If the product is a success, unit sales will be revised to 20 and if the product is a failure, unit sales will be 0. Success and failure are...

In Spite Of The Theoretical Argument That Dividend Policy Should Be Irrelevant The Fact Remains That Many Investors

Clienteles 515 Date of payment 497 Date of record 496 Declaration date 496 Ex-dividend date 496 Homemade dividends 501 Information-content effect 514 Regular cash dividends 495 Stock dividend 496 Stock split 496 Ross-Westerfield-Jaffe IV. Capital Structure and Corporate Finance, Sixth Dividend Policy Edition 1S. Dividend Policy Why Does It Matter Chapter 18 Dividend Policy Why Does It Matter The breakthrough in the theory of dividend policy is contained in Miller, M., and F. Modigliani....

In Their Own Words

Apple Eps And Dividend After 2002

Thornley on Why Qualcomm Pays No Dividends Qualcomm has consistently been able to generate for its shareholders a significantly higher return than the shareholders could get from being paid a dividend. It has no excess cash for dividends. If Qualcomm paid a dividend, our shareholders would view it very negatively. Qualcomm would be saying, We have run out of good profit opportunities. Our shareholders don't like dividends as much as they like the capital gains from Qualcomm's growth...

The Three Methods of Capital Budgeting with Leverage

Adjusted-Present-Value APV Method Additional effects of debt - Initial investment UCFt The project's cash flow at date t to the equityholders of an unlevered firm r0 Cost of capital for project in an unlevered firm - Initial investment - Amount borrowed LCFt The project's cash flow at date t to the equityholders of a levered firm rS Cost of equity capital with leverage 3. Weighted-Average-Cost-of-Capital WACC Method rWACC Weighted average cost of capital Notes 1. The middle term in the APV...

Comparison of the Apv Fte and WACC Approaches

Capital-budgeting techniques in the early chapters of this text applied to all-equity firms. Capital budgeting for the levered firm could not be handled early in the book because the effects of debt on firm value were deferred until the previous two chapters. We learned there that debt increases firm value through tax benefits but decreases value through bankruptcy and related costs. In this chapter we provide three approaches to capital budgeting for the levered firm. The...

Integration of Tax Effects and Financial Distress Costs

Modigliani and Miller argue that the firm's value rises with leverage in the presence of corporate taxes. Because this implies that all firms should choose maximum debt, the theory does not predict the behavior of firms in the real world. Other authors have suggested that bankruptcy and related costs reduce the value of the levered firm. The integration of tax effects and distress costs appears in Figure 16.1. The diagonal straight line in the figure represents the value of the firm in a world...

Real World Factors Favoring a High Dividend Policy

In a previous section, we pointed out that dividends are taxed at the personal level. This implies that financial managers will seek out ways to reduce dividends, though a complete elimination of dividends would be unlikely for firms with strong cash flow. We also pointed out that share repurchase is a way financial managers can convey many of the same benefits of a dividend without the tax disadvantage. In this section, we consider reasons why a firm might pay its shareholders high dividends,...

Appendix 17A The Adjusted PresentValue Approach to Valuing Leveraged Buyouts8

A leveraged buyout LBO is the acquisition by a small group of equity investors of a public or private company financed primarily with debt. The equityholders service the heavy interest and principal payments with cash from operations and or asset sales. The shareholders generally hope to reverse the LBO within three to seven years by way of a public offering or sale of the company to another firm. A buyout is therefore likely to be successful only if the firm generates enough cash to serve the...

Patterns of Financing

Firms use cash flow for capital spending and net working capital. Historically, U.S. firms have spent about 80 percent of cash flow on capital spending and 20 percent on net working capital. Table 14.1 summarizes the patterns of long-term financing for U.S. industrial firms from 1979 to 1999. Here we observe internal financing, debt financing, and external equity financing as a percentage of total financing. For example, in 1999 capital spending by U.S. industrial firms was 859.9 billion and...

APV Example

As mentioned earlier in this chapter, firms generally set a target debt-to-equity ratio, allowing the use of WACC and FTE for capital budgeting. APV does not work as well here. However, as we also mentioned earlier, APV is the preferred approach when there are side benefits and side costs to debt. Because the analysis here can be tricky, we now devote an entire section to an example where, in addition to the tax subsidy to debt, both flotation costs and interest subsidies come into play....

Taxes Issuance Costs and Dividends

The model we used to determine the level of dividends assumed that there were no taxes, no transactions costs, and no uncertainty. It concluded that dividend policy is irrelevant. Although this model helps us to grasp some fundamentals of dividend policy, it ignores many factors that exist in reality. It is now time to investigate these real-world considerations. We first examine the effect of taxes on the level of a firm's dividends. Cash dividends received are taxed as ordinary income....

Capital Budgeting When the Discount Rate Must Be Estimated

The previous sections of this chapter introduced APV, FTE, and WACC the three basic approaches to valuing a levered firm. However, one important detail remains. The example in Sections 17.1 through 17.3 assumed a discount rate. We now want to show how this rate is determined for real-world firms with leverage, with an application to the three preceding approaches. The example in this section brings together the work in Chapters 9-12 on the discount rate for unlevered firms with that in Chapter...

The Capital Structure Question and the Pie Theory

How should a firm choose its debt-equity ratio We call our approach to the capital-structure question the pie model. If you are wondering why we chose this name, just take a look at Figure 15.1. The pie in question is the sum of the financial claims of the firm, debt and equity in this case. We define the value of the firm to be this sum. Hence, the value of the firm, V, is where B is the market value of the debt and S is the market value of the equity. Figure 15.1 presents two possible ways of...

Rules of the Pecking Order

For expository purposes, we have oversimplified by comparing equity to riskless debt. Managers cannot use special knowledge of their firm to determine if this type of debt is mispriced, because the price of riskless debt is determined solely by the marketwide interest rate. However, in reality, corporate debt has the possibility of default. Thus, just as managers have a tendency to issue equity when they think it is overvalued, managers also have a tendency to issue debt when they think it is...

The Miller Model

Valuation under Personal and Corporate Taxes The previous example calculated cash flows for the two plans under personal and corporate taxes. However, we have made no attempt to determine firm value so far. It can be shown that the value of the levered firm can be expressed in terms of an unlevered firm as32 Tb is the personal tax rate on ordinary income, such as interest, and TS is the personal tax rate on equity distributions. If we set Tb TS, 16.1 reduces to EBIT - B X 1 - Tc X 1 - Ts rBB X...

Protective Covenants

Because the stockholders must pay higher interest rates as insurance against their own selfish strategies, they frequently make agreements with bondholders in hopes of lower rates. These agreements, called protective covenants, are incorporated as part of the loan document or indenture between stockholders and bondholders. The covenants must be taken seriously since a broken covenant can lead to default. Protective covenants can be classified into two types negative covenants and positive...

Common Stock

The term common stock has no precise meaning. It usually is applied to stock that has no special preference either in dividends or in bankruptcy. A description of the common stock of Anheuser-Busch in 1996 is presented below. ANHEUSER-BUSCH Common Stock and Other Shareholders' Equity December 31,1999 in millions Common stock, 1 par value, authorized 1.6 billion shares, issued 716.1 million shares Capital in excess of par value Retained earnings Treasury stock, at cost Other ESOP debt guarantee...

Efficient Set for Many Securities

Feasible Set Portfolios

The previous discussion concerned two securities. We found that a simple curve sketched out all the possible portfolios. Because investors generally hold more than two securities, we should look at the same graph when more than two securities are held. The shaded area in Figure 10.6 represents the opportunity set or feasible set when many securities are considered. The shaded area represents all the possible combinations of expected return and standard deviation for a portfolio. For example, in...

Interest Rates and Inflation

Suppose that the one-year interest rate that the bank pays is 10 percent. This means that an individual who deposits 1,000 at date 0 will get 1,100 1,000 X 1.10 in one year. While 10 percent may seem like a handsome return, one can only put it in perspective after examining the rate of inflation. Suppose that the rate of inflation is 6 percent over the year and it affects all goods equally. For example, a restaurant that charges 1.00 for a hamburger at date 0 charges 1.06 for the same hamburger...

Qualcomm A Case for Low Debt

Qualcomm is a supplier of digital wireless communications products and services. It is the innovator and implementer of the proprietary code-division multiple access CDMA , a digital wireless technology. CDMA generates licensing fees, royalties, and chip sales. In addition, Qualcomm has a new high-data-rate HDR technology that it expects to transmit data at very high speeds for Internet use and access. Its primary U.S. competitor uses another wireless technology called TDMA. It competes with...

Corporate Strategy and the Stock Market

There should be a connection between the stock market and capital budgeting. If a firm invests in a project that is worth more than its cost, the project will produce positive NPV, and the firm's stock price should go up. However, the popular financial press frequently suggests that the best way for a firm to increase its share price is to report high short-term earnings even if by doing so it cooks the books . As a consequence, it is often said that U.S. firms tend to reduce capital...

Shirking Perquisites and Bad Investments A Note on Agency Cost of Equity

The previous section introduced the static trade-off model, where a rise in debt increases both the tax shield and the costs of distress. We now extend the trade-off model by considering an important agency cost of equity. A discussion of this cost of equity is contained in a well-known quote from Adam Smith.14 The directors of such joint-stock companies, however, being the managers of other people's money than of their own, it cannot well be expected that they should watch over it with the...

Decision Trees

We have considered potential sources of value in NPV analysis. Moreover, we pointed out that there is a connection between the stock market and a firm's capital budgeting decisions. A savvy CEO can learn from the stock market. Now our interest is in coming up with estimates of NPV for a proposed project. A fundamental problem in NPV analysis is dealing with uncertain future outcomes. Furthermore, there is usually a sequence of decisions in NPV project analysis. This section introduces the...

An Analysis of the Project

Investments The investment outlays required for the project are summarized in the top segment of Table 7.1. They consist of three parts 1. The Bowling Ball Machine. The purchase requires a cash outflow of 100,000 at year 0. The firm realizes a cash inflow when the machine is sold in year 5. These cash flows are shown in line 1 of Table 7.1. As indicated in the footnote to the table, taxes are incurred when the asset is sold. 2. The Opportunity Cost of Not Selling the Warehouse. If Baldwin...

Appendix 9A The Historical Market Risk Premium The Very Long

The data in Chapter 9 indicate that the returns on common stock have historically been much higher than the returns on short-term government securities. This phenomenon has bothered economists, since it is difficult to justify why large numbers of rational investors purchase the lower yielding bills and bonds. In 1985 Mehra and Prescott published a very influential paper that showed that the historical returns for common stocks are far too high when compared to the rates of return on short-term...

Free Cash Flow

Any reader of murder mysteries knows that a criminal must have both motive and opportunity. The above discussion was about motive. Managers with only a small ownership interest have an incentive for wasteful behavior. For example, they bear only a small portion of the costs of, say, excessive expense accounts, and reap all of the benefits. Now let's talk about opportunity. A manager can only pad his expense account if the firm has the cash flow to cover it. Thus, we might expect to see more...

Normal Distribution and Its Implications for Standard Deviation

A large enough sample drawn from a normal distribution looks like the bell-shaped curve drawn in Figure 9.10. As you can see, this distribution is symmetric about its mean, not skewed, and it has a much cleaner shape than the actual distribution of yearly returns drawn -y R - R 2 R2 - R 2 R - R 2 R - R 7Several condensed frequency distributions are also in the extreme right column of Table 9.2. 9. Capital Market Theory An Overview Chapter 9 Capital Market Theory An Overview Figure 9.10 The...

Net Present Value and PJ Capital Budgeting

In late 1990, the Boeing Company announced its intention to build the Boeing 777, a commercial airplane that would be able to carry up to 390 passengers and fly 7,600 miles. This was expected to be an enormous undertaking. Analysts believed the up-front investment and research and development expenditures necessary to manufacture the Boeing 777 would be as much as 8 billion. Delivery of the first planes was expected to take place in 1995 and to continue for at least 35 years. Was the Boeing 777...

Description of Efficient Capital Markets

An efficient capital market is one in which stock prices fully reflect available information. To illustrate how an efficient market works, suppose the F-stop Camera Corporation FCC is attempting to develop a camera that will double the speed of the auto-focusing system now available. FCC believes this research has positive NPV. M. Miller, Financial Innovation The Last Twenty Years and the Next, Journal of Financial and Quantitative Analysis December 1986 . However, Peter Tufano, Securities...