Exchange Rates

The exchange rate is the number of units of a given currency that can be purchased for one unit of another country's currency the exchange rate tells us about the relative value of any two currencies. The exchange rate can be quoted in term of the number of units of the domestic currency relative to a unit of the foreign currency (referred to as a direct quotation), or in terms of the number of units of the foreign currency relative to a unit of the domestic currency (referred to as an indirect...

Questions

Explain why a corporation would issue preferred stock rather than a debt security or common shares. 2. Why would a corporate treasurer prefer to buy preferred shares of another corporation rather than a bond or common shares 3. Suppose the Multi-Facet Corporation issues a convertible callable sinking fund preferred stock. a. From the perspective of the issuer, which of these features contributes to financing flexibility b. From the perspective of the investor, which features contribute to the...

Dividend Policy

A dividend policy is a firm's decision about the payment of cash dividends to shareholders. Looking at the dividends per share and the dividend payout at a point in time doesn't tell us much about the firm's dividend policy. We generally need somewhat more information than one quarter's or one year's dividend. If we look at dividends over a longer period, we can begin to get a better picture of the firm's dividend policy. There are several basic ways of describing a firm's dividend policy...

Mplications of Global Market Integration for Funding Costs

As explained above, a firm may seek funds outside its local capital market with the expectation of doing so at a lower cost than if its funds are raised in its own capital market. Whether this is possible depends on the degree of integration of capital markets. At the two extremes, the world capital markets can be classified as either completely segmented or completely integrated. In the case of a completely segmented capital market, investors in one country are not permitted to invest in the...

Using Cash Flow Information

The analysis of cash flows provides information that can be used along with other financial data to help the analyst assess the financial condition of a company. Consider the cash flow to debt ratio calculated using three different measures of cash flow EBITDA, free cash flow, and cash flow from operations from the statement of cash flows each compared with long-term debt, as shown in Exhibit 24.8 for Weirton Steel. This example illustrates the need to understand the differences among the cash...

Financial Distress and Capital Structure

The relationship between financial distress and capital structure is simple As more debt financing is used, fixed legal obligations increase interest and principal payments , and the ability of the firm to satisfy these increasing fixed payments decreases. Therefore, as more debt financing is used, the probability of financial distress and then bankruptcy increases. For a given decrease in operating earnings, a firm that uses debt to a greater extent in its capital structure that is, a firm...

The Cost of Capital

In Chapters 8 through 10, we discussed and practiced techniques for valuing assets and weighing risk and return. These are all topics we will apply in Part Three of this book, when we turn to the methods and techniques used in making decisions about actual projects capital budgeting. In this chapter, we focus on a crucial element in both valuation and capital budgeting the cost of capital. The cost of capital is the return that must be provided for the use of an investor's funds. If the funds...

Unused Tax Shields

The value of a tax shield depends on whether the firm can use an interest expense deduction. In general, if a firm has deductions that exceed income, 5 Equity income consists of dividends and capital appreciation. Under the present U.S. tax system capital appreciation is taxed more favorably meaning lower rates than interest income since 1 capital appreciation is not taxed until realized for example, when shares of stock sold and 2 at times, a portion of the realized capital gain has been...

Depreciation for Tax Purposes

For accounting purposes, a firm can select a method of depreciation based on a number of factors, including the expected rate of physical depreciation of its asset and the effect on reported income. For federal income tax purposes, however, businesses are limited by law with regard to both the depreciation method and the period of time over which an asset can be depreciated. The current depreciation tax laws are the result of an ongoing trend to create more uniformity in depreciation methods...

Stand Alone versus Market Risk

If we have some idea of the uncertainty associated with a project's future cash flows its possible outcomes and the probabilities associated with these outcomes, we will have a measure of the risk of the project. But this is the project's risk in isolation from the firm's other projects, also referred to as the project's total risk, or stand-alone risk. Because most firms have many assets, the stand-alone risk of a project under consideration may not be the relevant risk for analyzing the...

OTC Market

The OTC market is called the market for unlisted stocks. As explained previously, technically while there are listing requirements for exchanges, there are also listing requirements for the Nasdaq National and Small Capitalization OTC markets. Nevertheless, exchange traded stocks are called listed, and stocks traded on the OTC markets are called unlisted. There are three parts to the OTC market two under the aegis of NASD the Nasdaq markets and a third market for truly unlisted stocks, the...

The Arbitrage Pricing Model

An alternative to CAPM in relating risk and return is the arbitrage pricing model, which was developed by Stephen Ross. The arbitrage pricing model APM is an asset pricing model that is based on the idea that identical assets in different markets should be priced identically.7 While the CAPM is based on a market portfolio of assets, the APM doesn't mention a market portfolio at all. Instead, the APM states that an asset's returns should compensate the investor for the risk of the asset where...

Practical Problems with the Marginal Cost of Capital

Optimal Capital Budget

Determining the cost of capital appears straightforward Find the cost of each source of capital and weight it by the proportion it will represent in the firm's new capital. But it is not so simple. There are many problems in determining the cost of capital for an individual firm. Consider, for example EXHIBIT 11.7 Determining the Optimal Capital Budget with the Marginal Cost of Capital and the Marginal Efficiency of Investment How do you know what it will cost to raise an additional dollar of...

The Cost of Common Stock

We can estimate the cost of equity using either the DVM or an asset pricing model. An asset pricing model specifies the risk factors that are believed to determine the expected return investors seek from buying a security. We discussed one such model, the capital asset pricing model CAPM in Chapter 10. CAPM specifies that there is only one risk factor, the overall market i.e., market risk that determines the expected return. Other asset pricing models that are discussed in textbooks on...

Corporate Use Of Preferred Stock

Preferred stock is generally considered the Wall Street wallflower. Seldom issued, preferred stock is usually associated with financially troubled firms. Recently, several major U.S. companies issued preferred stock as a source of additional equity capital. Examples of preferred stock issues in the 1990s include Ford Motor Company, RJR Nabisco Holdings, Kmart, and General Motors. These issues did not do much to change preferred stock's image, since these companies issued preferred stock at...

Primary and Secondary Markets

When a security is first issued, it is sold in the primary market. This is the market in which new issues are sold and new capital is raised. So it is the market whose sales directly benefit the issuer of the securities. There are three ways to raise capital in the primary market. The first is the direct sale, in which the investor purchases, say, stock directly from the issuer. Many venture capital firms invest in small, growing businesses in this way. Also, many corporations sell securities...

Variations in the Underwriting Process

Not all deals are underwritten using the traditional syndicate process we have described. Variations in the United States and foreign markets include the bought deal for the underwriting of bonds, the auction process for both stocks and bonds, and a rights offering for underwriting common stock. The mechanics of a bought deal are as follows. The lead manager or a group of managers offers a potential issuer of debt securities a firm bid to purchase a specified amount of the securities. The...

Convertibility

A preferred stock may be exchangeable for common shares called a convertible preferred stock. Such a conversion feature gives the shareholder the right to convert the preferred shares into common shares at a predetermined rate of exchange. Convertible preferred stock specifies the conversion ratio, which is the number of shares of common stock that you get when you exchange a share of preferred stock for common stock. The investor's decision to convert preferred stock into common stock requires...

Differences between Options and Futures Contracts

Notice that, unlike in a futures contract, one party to an option contract is not obligated to transact specifically, the option buyer has the right but not the obligation to transact. The option writer does have the obligation to perform. In the case of a futures contract, both buyer and seller are obligated to perform. Of course, a futures buyer does not pay the seller to accept the obligation, while an option buyer pays the seller an option price. Consequently, the risk reward...

Shortcuts Tables and Calculators

Annuity factor tables simplify the task of valuing annuities. Exhibit 7.8 is a table of future value of annuity factors for interest rates and periods from 1 to 20 and from 1 to 20 payments, respectively. Exhibit 7.9 is the corresponding table for present value of annuity factors. For example, the future value annuity factor from Exhibit 7.8 for five periodic payments and an interest rate of 10 is 6.1051 and the present value annuity factor from Exhibit 7.9 for five periodic payments and an...

Shortcuts Annuities

There are valuation problems that require us to evaluate a series of level cash flows each cash flow is the same amount as the others received at regular intervals. Let's suppose you expect to deposit 2,000 at the end of each of the next four years 2000, 2001, 2002, and 2003 in an account earning 8 compounded interest. How much will you have available at the end of 2003, the fourth year As we just did for the future value of a series of uneven cash flows, we can calculate the future value as of...

Term Structure of interest Rates

One of the factors that we stated affects the risk premium is the maturity of a debt obligation. The relationship between the yield on a bond and its maturity is the term structure of interest rates. The graphic that depicts the relationship between the yield on bonds of the same credit quality but different maturities is known as the yield curve. Market participants have tended to construct yield curves from observations of prices and yields in the Treasury market. Two reasons account for this...

Equity

Equity is the owner's interest in the company. For a corporation, ownership is represented by common stock and preferred stock. Shareholders' equity is also referred to as the book value of equity, since this is the value of equity according to the records in the accounting books. The value of the ownership interest of preferred stock is represented in financial statements as its par value, which is also the dollar value on which dividends are figured. For example, if you own a share of...

Current Assets

Current assets also referred to as circulating capital and working assets are assets that could reasonably be converted into cash within one operating cycle or one year, whichever takes longer. An operating cycle begins when the firm invests cash in the raw materials used to produce its goods or services and ends with the collection of cash for the sale of those same goods or services. For example, if Fictitious manufactures and sells candy products, its operating cycle begins when it purchases...

Maturity Intermediation

In our example of the commercial bank, two things should be noted. First, the maturity of at least a portion of the deposits accepted is typically short term. For example, certain types of deposits are payable upon demand. Others have a specific maturity date, but most are less than two years. Second, the maturity of the loans made by a commercial bank may be considerably longer than two years. In the absence of a commercial bank, the borrower would have to borrow for a shorter term, or find an...

Liquidating a Position

Most futures contracts have settlement dates in the months of March, June, September, or December. This means that at a predetermined time in the contract settlement month the contract stops trading, and a price is determined by the exchange for settlement of the contract. A party to a futures contract has two choices on liquidation of the position. First, the position can be liquidated prior to the settlement date. For this purpose, the party must take an offsetting position in the same...

The Measure of Owners Economic Well Being

The price of a share of stock at any time, or its market value, represents the price that buyers in a free market are willing to pay for it. The market value of shareholders' equity is the value of all owners' interest in the corporation. It is calculated as the product of the market value of one share of stock and the number of shares of stock outstanding Market value of shareholders' equity Market value of a share of stock x Number of shares of stock outstanding The number of shares of stock...

Economic Profit versus Accounting Profit Share Price versus Earnings Per Share

When you studied economics, you saw that the objective of the firm is to maximize profit. In finance, however, the objective is to maximize owners' wealth. Is this a contradiction No. We have simply used different terminology to express the same goal. The difference arises from the distinction between accounting profit and economic profit. Economic profit is the difference between revenues and costs, where costs include both the actual business costs the explicit costs and the implicit costs....

Distinguishing Features Of The Textbook

The text begins with the basic principles and tools, followed by long-term investment and financing decisions. The first two parts lay out the basics Part Three then focuses on the left side of the balance sheet the assets and the Part Four is the right side of the balance sheet the liabilities and equity . Working capital decisions, which are made to support the day-to-day operations of the firm, are discussed in Part Five. Part Six provides the tools for analyzing a firm's...