Adjusting Wacc When Debt Ratios Or Business Risks Change

The WACC formula assumes that the project to be valued will be financed in the same proportions of debt and equity as the firm as a whole. What if that is not true What if the perpetual crusher project supports debt equal to, say, 20 percent of project value, versus 40 percent debt financing for the firm as a whole Moving from 40 to 20 percent debt changes all the elements of the WACC formula except the tax rate.13 Obviously the financing weights change. But the cost 13It could change the tax...

Example Marvin Enterprises Decides To Exploit A New Technology

To illustrate some of the problems involved in predicting economic rents, let us leap forward several years and look at the decision by Marvin Enterprises to exploit a new technology.13 One of the most unexpected developments of these years was the remarkable growth of a completely new industry. By 2023, annual sales of gargle blasters totaled 1.68 billion, or 240 million units. Although it controlled only 10 percent of the market, Marvin Enterprises was among the most exciting growth companies...

Si 192 Using Waccsome Tricks Of The Trade

Sangria had just one asset and two sources of financing. A real company's market value balance sheet has many more entries, for example 6 Several questions immediately arise 1. How does the formula change when there are more than two sources of financing Easy There is one cost for each element. The weight for each element is proportional to its market value. For example, if the capital structure includes both preferred and common shares, D P E WACC rD(1 - Tc) v + rv + rE where rP is investors'...

Nominal And Real Rates Of Interest

If you invest 1,000 in a bank deposit offering an interest rate of 10 percent, the bank promises to pay you 1,100 at the end of the year. But it makes no promises about what the 1,100 will buy. That will depend on the rate of inflation over the year. If the prices of goods and services increase by more than 10 percent, you have lost ground in terms of the goods that you can buy. Several indexes are used to track the general level of prices. The best known is the Consumer Price Index, or CPI,...

Implications of the Pecking Order

The pecking-order theory of corporate financing goes like this.38 1. Firms prefer internal finance. 2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends. 3. Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and other times less. If it is more, the firm pays off debt or invests...

Costs of Distress Vary with Type of Asset

Suppose your firm's only asset is a large downtown hotel, mortgaged to the hilt. The recession hits, occupancy rates fall, and the mortgage payments cannot be met. The lender takes over and sells the hotel to a new owner and operator. You use your firm's stock certificates for wallpaper. What is the cost of bankruptcy In this example, probably very little. The value of the hotel is, of course, much less than you hoped, but that is due to the lack of 25We discuss covenants and the rest of the...

The Rightists

Much of traditional finance literature has advocated high payout ratios. Here, for example, is a statement of the rightist position made by Graham and Dodd in 1951 The considered and continuous verdict of the stock market is overwhelmingly in favor of liberal dividends as against niggardly ones. The common stock investor must take this judgment into account in the valuation of stock for purchase. It is now becoming standard practice to evaluate common stock by applying one multiplier to that...

Share Repurchase

When a firm wants to pay out cash to its shareholders, it usually declares a cash dividend. The alternative is to repurchase its own stock. The reacquired shares may be kept in the company's treasury and resold if the company needs money. There is an important difference in the taxation of dividends and stock repurchases. Dividends are taxed as ordinary income, but stockholders who sell shares back to the firm pay tax only on capital gains realized in the sale. However, the Internal Revenue...

Consumption Betas versus Market Betas

The capital asset pricing model pictures investors as solely concerned with the level and uncertainty of their future wealth. But for most people wealth is not an end in itself. What good is wealth if you can't spend it People invest now to provide future consumption for themselves or for their families and heirs. The most important risks are those that might force a cutback of future consumption. Douglas Breeden has developed a model in which a security's risk is measured by its sensitivity to...

Patterns Of Corporate Financing

Companies invest in long-term assets (mainly property, plant, and equipment) and net working capital. Table 14.1 shows where they get the cash to pay for these investments. You can see that by far the greater part of the money is generated internally. In other words, it comes from cash that the company has set aside as depreciation and from retained earnings (earnings not paid out as dividends).1 Shareholders are happy for companies to plow back this money into the firm, so long as it goes to...

Lesson 4 There Are No Financial Illusions

In an efficient market there are no financial illusions. Investors are unromantically concerned with the firm's cash flows and the portion of those cash flows to which they are entitled. Example Stock Dividends and Splits We can illustrate our fourth lesson by looking at the effect of stock dividends and splits. Every year hundreds of companies increase the number of shares outstanding either by subdividing the existing shares or by distributing more shares as dividends. This does not affect...

The Dividend Controversy

We have seen that a dividend increase indicates management's optimism about earnings and thus affects the stock price. But the jump in stock price that accompanies an unexpected dividend increase would happen eventually anyway as information about future earnings comes out through other channels. We now ask whether the dividend decision changes the value of the stock, rather than simply providing a signal of stock value. One endearing feature of economics is that it can always accommodate not...

Venture Capital

On April 1, 2013, George and Mildred Marvin met with Chip Norton in their research lab (which also doubled as a bicycle shed) to celebrate the incorporation of Marvin Enterprises. The three entrepreneurs had raised 100,000 from savings and personal bank loans and had purchased one million shares in the new company. At this zero-stage investment, the company's assets were 90,000 in the bank ( 10,000 had been spent for legal and other expenses of setting up the company), plus the idea for a new...

Taxes And The Radical Left

The left-wing dividend creed is simple Whenever dividends are taxed more heavily than capital gains, firms should pay the lowest cash dividend they can get away with. Available cash should be retained or used to repurchase shares. By shifting their distribution policies in this way, corporations can transmute dividends into capital gains. If this financial alchemy results in lower taxes, it should be welcomed by any taxpaying investor. That is the basic point made by the leftist party when it...

Lesson 3 Read the Entrails

If the market is efficient, prices impound all available information. Therefore, if we can only learn to read the entrails, security prices can tell us a lot about the future. For example, in Chapter 29 we will show how information in a company's financial statements can help the financial manager to estimate the probability of bankruptcy. But the market's assessment of the company's securities can also provide important information about the firm's prospects. Thus, if the company's bonds are...

Dividend IrrelevanceAn Illustration

Consider the case of Rational Demiconductor, which at this moment has the following balance sheet Rational Demiconductor's Balance Sheet (Market Values) Rational Demiconductor's Balance Sheet (Market Values) Rational Demiconductor has 1,000 cash earmarked for a project requiring 1,000 investment. We do not know how attractive the project is, and so we enter it at NPV after the project is undertaken it will be worth 1,000 + NPV. Note that the balance sheet is constructed with market values...

B2 Corporate And Personal Taxes

When personal taxes are introduced, the firm's objective is no longer to minimize the corporate tax bill the firm should try to minimize the present value of all taxes paid on corporate income. All taxes include personal taxes paid by bondholders and stockholders. Figure 18.1 illustrates how corporate and personal taxes are affected by leverage. Depending on the firm's capital structure, a dollar of operating income will 5The last figure would correspond to a 100 percent book debt ratio. But...

The Law of the Conservation of Value

MM's argument that debt policy is irrelevant is an application of an astonishingly simple idea. If we have two streams of cash flow, A and B, then the present value of A + B is equal to the present value of A plus the present value of B. We met this principle of value additivity in our discussion of capital budgeting, where we saw that in perfect capital markets the present value of two assets combined is equal to the sum of their present values considered separately. In the present context we...

Websites

Useful sources of aggregate data on corporate financing for U.S. corporations include www.census.gov csd qfr (balance sheets and income statements) www.federalreserve.gov releases (sources and uses of funds data) Material on the changing capital structure of corporations is provided on http fisher.osu.edu fin resources education credit Sites on corporate governance and shareholder rights include For information on venture capital see www.vnpartners.com primer (a useful primer on venture...

Using the DCF Model to Set Gas and Electricity Prices

The prices charged by local electric and gas utilities are regulated by state commissions. The regulators try to keep consumer prices down but are supposed to allow the utilities to earn a fair rate of return. But what is fair It is usually interpreted as r, the market capitalization rate for the firm's common stock. That is, the fair rate of return on equity for a public utility ought to be the rate offered by securities that have the same risk as the utility's common stock.3 Small variations...

The Taxation of Dividends and Capital Gains

Many of these attempts to measure the effect of dividends are of more historical than current interest, for they look back at the years before 1986 when there was a dramatic difference between the taxation of dividends and capital gains.36 Today, the tax rate on capital gains for most shareholders is 20 percent, while for taxable incomes above 65,550 the tax rate on dividends ranges from 30.5 to 39.1 percent.37 Tax law favors capital gains in another way. Taxes on dividends have to be paid...

Your Questions Answered

Question All these cost of capital formulas which ones do financial managers actually use Answer The after-tax weighted-average cost of capital, most of the time. WACC is estimated for the company, or sometimes for an industry. We recommend industry WACCs when data are available for several closely comparable firms. The firms should have similar assets, operations, business risks, and growth opportunities. Of course, conglomerate companies, with divisions operating in two or more unrelated...

Imperfections and Opportunities

The most serious capital market imperfections are often those created by government. An imperfection which supports a violation of MM's proposition I also cre- 17We return to the topic of security innovation in Section 25.8. CHAPTER 17 Does Debt Policy Matter 481 ates a money-making opportunity. Firms and intermediaries will find some way to reach the clientele of investors frustrated by the imperfection. For many years the United States government imposed a limit on the rate of interest that...

Appendix B Marvins New Issue Prospectus

PROSPECTUS 900,000 Shares Marvin Enterprises Inc. Common Stock .10 par value Of the 900,000 shares of Common Stock offered hereby, 500,000 shares are being sold by the Company and 400,000 shares are being sold by the Selling Stockholders. See Principal and Selling Stockholders. The Company will not receive any of the proceeds from the sale of shares by the Selling Stockholders. Before this offering there has been no public market for the Common Stock. These securities involve a high degree of...

Alternative Tax Systems

In the United States shareholders' returns are taxed twice. They are taxed at the corporate level corporate tax and in the hands of the shareholder income tax or capital gains tax . These two tiers of tax are illustrated in Table 16.2, which shows the after-tax return to the shareholder if the company distributes all its income as dividends. We assume the company earns 100 a share before tax and therefore pays corporate tax of .35 X 100 35. This leaves 65 a share to be paid out as a dividend,...

Three Forms of Market Efficiency

You should see now why prices in competitive markets must follow a random walk. If past price changes could be used to predict future price changes, investors could make easy profits. But in competitive markets easy profits don't last. As investors try to take advantage of the information in past prices, prices adjust immediately until the superior profits from studying past price movements disappear. As a result, all the information in past prices will be reflected in today's stock price, not...

Do Investors Respond Slowly to New Information

Study Bernard And Thomas

We have dwelt on the small-firm effect, but there is no shortage of other puzzles and anomalies. Some of them relate to the short-term behavior of stock prices. For example, returns appear to be higher in January than in other months, they seem to be lower on a Monday than on other days of the week, and most of the daily return comes at the beginning and end of the day. To have any chance of making money from such short-term patterns, you need to be a professional trader, with one eye on the...

Lesson 6 Seen One Stock Seen Them

The elasticity of demand for any article measures the percentage change in the quantity demanded for each percentage addition to the price. If the article has close substitutes, the elasticity will be strongly negative if not, it will be near zero. For example, coffee, which is a staple commodity, has a demand elasticity of about - .2. This means that a 5 percent increase in the price of coffee changes sales by .2 X .05 .01 in other words, it reduces demand by only 1 percent. Consumers are...

Efficient Markets The Evidence

In the years that followed Maurice Kendall's discovery, financial journals were packed with tests of the efficient-market hypothesis. To test the weak form of the hypothesis, researchers measured the profitability of some of the trading rules used by those investors who claim to find patterns in security prices. They also employed statistical tests such as the one that we described when looking for patterns in the returns on Microsoft stock. For example, in Figure 13.4 we have used the same...

Financial Institutions

We have referred to the fact that a large proportion of the company's equity and debt is owned by financial institutions. Since we will be meeting some of these financial institutions in the following chapters, we should introduce them to you here and explain what functions they serve. Financial institutions act as financial intermediaries that gather the savings of many individuals and reinvest them in the financial markets. For example, banks raise money by taking deposits and by selling debt...

An Example Magna Charter

Magna Charter is a new corporation formed by Agnes Magna to provide an executive flying service for the southeastern United States. The founder thinks there will be a ready demand from businesses that cannot justify a full-time company plane but nevertheless need one from time to time. However, the venture is not a sure thing. There is a 40 percent chance that demand in the first year will be low. If it is low, there is a 60 percent chance that it will remain low in subsequent years. On the...

Pitfall 3Mutually Exclusive Projects

Firms often have to choose from among several alternative ways of doing the same job or using the same facility. In other words, they need to choose from among mutually exclusive projects. Here too the IRR rule can be misleading. Consider projects E and F 5Companies sometimes get around the problem of multiple rates of return by discounting the later cash flows back at the cost of capital until there remains only one change in the sign of the cash flows. A modified internal rate of return can...

Market Anomalies and the Financial Manager

The financial manager needs to be confident that, when the firm issues new securities, it can do so at a fair price. There are two reasons that this may not be the case. First, the strong form of the efficient-market hypothesis may not be 100 percent true, so that the financial manager may have information that other investors do not have. Alternatively, investors may have the same information as management, but be slow to react to it. For example, we described above some evidence that new...

How to Value Annuities

An annuity is an asset that pays a fixed sum each year for a specified number of years. The equal-payment house mortgage or installment credit agreement are common examples of annuities. Figure 3.1 illustrates a simple trick for valuing annuities. The first row represents a perpetuity that produces a cash flow of C in each year beginning in year 1. It has a present value of An annuity that makes payments in each of years 1 to t is equal to the difference between two perpetuities. Perpetuity...

Some Examples of Growth Opportunities

Stocks like Microsoft, Dell Computer, and Wal-Mart are often described as growth stocks, while those of mature firms like Kellogg, Weyerhaeuser, and Exxon Mobil are regarded as income stocks. Let us check it out. The first column of Table 4.6 6Michael Eisner, the chairman of Walt Disney Productions, made the point this way In school you had to take the test and then be graded. Now we're getting graded, and we haven't taken the test. This was in late 1985, when Disney stock was selling at nearly...

Do Managers Worry Too Much about Book Profitability

Book measures of profitability can be wrong or misleading because 1. Errors occur at different stages of project life. When true depreciation is decelerated, book measures are likely to understate true profitability for new projects and overstate it for old ones. 26Using expected economic depreciation will not generate book ROIs that are exactly right unless realized cash flows exactly match forecasted flows. But we expect forecasts to be right, on average. 27This procedure has been suggested...

The Aircraft Have A Life Span Of Five Years And A Salvage Value Of 1 Million. The Aircraft Owners Do Not Operate The

WARREN BUFFETT ON GROWTH AND PROFITABILITY I thought it would be instructive to go back and look at a couple of industries that transformed this country much earlier in this century automobiles and aviation. Take automobiles first I have here one page, out of 70 in total, of car and truck manufacturers that have operated in this country. At one time, there was a Berkshire car and an Omaha car. Naturally I noticed those. But there was also a telephone book of others. All told, there appear to...

Startling Discovery Price Changes Are Random

As is so often the case with important ideas, the concept of efficient capital markets stemmed from a chance discovery. In 1953 Maurice Kendall, a British statistician, presented a controversial paper to the Royal Statistical Society on the behavior of stock and commodity prices.2 Kendall had expected to find regular price cycles, but to his surprise they did not seem to exist. Each series appeared to be a 'wandering' one, almost as if once a week the Demon of Chance drew a random number . . ....

Combining Stocks into Portfolios

Suppose that you are wondering whether to invest in shares of Coca-Cola or Reebok. You decide that Reebok offers an expected return of 20 percent and CocaCola offers an expected return of 10 percent. After looking back at the past variability of the two stocks, you also decide that the standard deviation of returns is 31.5 percent for Coca-Cola and 58.5 percent for Reebok. Reebok offers the higher expected return, but it is considerably more risky. Now there is no reason to restrict yourself to...

How Diversification Reduces Risk

We can calculate our measures of variability equally well for individual securities and portfolios of securities. Of course, the level of variability over 75 years is less interesting for specific companies than for the market portfolio it is a rare company that faces the same business risks today as it did in 1926. Table 7.3 presents estimated standard deviations for 10 well-known common stocks for a recent five-year period.18 Do these standard deviations look high to you They should. Remember...

Break Even Analysis

When we undertake a sensitivity analysis of a project or when we look at alternative scenarios, we are asking how serious it would be if sales or costs turned out to be worse than we forecasted. Managers sometimes prefer to rephrase this question and ask how bad sales can get before the project begins to lose money. This exercise is known as break-even analysis. In the left-hand portion of Table 10.4 we set out the revenues and costs of the electric scooter project under different assumptions...

Simple Way To Estimate The Capitalization Rate

In Chapter 3 we encountered some simplified versions of the basic present value formula. Let us see whether they offer any insights into stock values. Suppose, for example, that we forecast a constant growth rate for a company's dividends. This does not preclude year-to-year deviations from the trend It means only that expected dividends grow at a constant rate. Such an investment would be just another example of the growing perpetuity that we helped our fickle philanthropist to evaluate in the...

Choosing between Long and Short Lived Equipment

Suppose the firm is forced to choose between two machines, A and B. The two machines are designed differently but have identical capacity and do exactly the same job. Machine A costs 15,000 and will last three years. It costs 5,000 per year to run. Machine B is an economy model costing only 10,000, but it will last only two years and costs 6,000 per year to run. These are real cash flows The costs are forecasted in dollars of constant purchasing power. Because the two machines produce exactly...

Monitoring

Agency costs can be reduced in two ways by monitoring the managers' effort and actions and by giving them the right incentives to maximize value. Monitoring can prevent the more obvious agency costs, such as blatant perks or empire building. It can confirm that the manager is putting sufficient time on the job. But monitoring costs time, effort, and money. Some monitoring is almost always worthwhile, but a limit is soon reached at which an extra dollar spent on monitoring would not return an...

Some More Elaborate Capital Rationing Models

The simplicity of the profitability-index method may sometimes outweigh its limitations. For example, it may not pay to worry about expenditures in subsequent years if you have only a hazy notion of future capital availability or investment opportunities. But there are also circumstances in which the limitations of the profitability-index method are intolerable. For such occasions we need a more general method for solving the capital rationing problem. We begin by restating the problem just...

The Option to Abandon

If the option to expand has value, what about the decision to bail out Projects don't just go on until assets expire of old age. The decision to terminate a project is usually taken by management, not by nature. Once the project is no longer profitable, the company will cut its losses and exercise its option to abandon the Some assets are easier to bail out of than others. Tangible assets are usually easier to sell than intangible ones. It helps to have active secondhand markets, which really...

Pros and Cons of EVA

EVA, economic profit, and other residual income measures are clearly better than earnings or earnings growth for measuring performance. A plant or division that's generating lots of EVA should generate accolades 17It can be shown that compensation plans that are linked to economic value added can induce a manager to choose the efficient investment level. See W. P. Rogerson, International Cost Allocation and Managerial Incentives A Theory Explaining the Use of Economic...

The Link Between Stock Price And Earnings Per Share

Investors often use the terms growth stocks and income stocks. They buy growth stocks primarily for the expectation of capital gains, and they are interested in the future growth of earnings rather than in next year's dividends. On the other hand, they buy income stocks primarily for the cash dividends. Let us see whether these distinctions make sense. Imagine first the case of a company that does not grow at all. It does not plow back any earnings and simply produces a constant stream of...

Waldo County

Waldo County, the well-known real estate developer, worked long hours, and he expected his staff to do the same. So George Probit was not surprised to receive a call from the boss just as George was about to leave for a long summer's weekend. Mr. County's success had been built on a remarkable instinct for a good site. He would exclaim Location Location Location at some point in every planning meeting. Yet finance was not his strong suit. On this occasion he wanted George to go over the figures...

Operating Leverage and Break Even Points

Break-even charts like Figure 10.1 help managers appreciate operating leverage, that is, project exposure to fixed costs. Remember from Section 9.5 that high operating leverage means high risk, other things equal, of course. The electric scooter project had low fixed costs, only 3 billion against projected revenues of 37.5 billion. But suppose Otobai now considers a different production technology with lower variable costs of only 120,000 per unit versus 300,000 per unit but higher fixed costs...

Decision Trees and Monte Carlo Simulation

We have said that any cash-flow forecast rests on assumptions about future investment and operating strategy. Think back to the Monte Carlo simulation model that we constructed for Otobai's electric scooter project. What strategy was that based on We don't know. Inevitably Otobai will face decisions about pricing, production, expansion, and abandonment, but the model builder's assumptions about these decisions are buried in the model's equations. The model builder may have implicitly identified...

Calculating PVs and NPVs

You have some bad news about your office building venture the one described at the start of Chapter 2 . The contractor says that construction will take two years instead of one and requests payment on the following schedule 1. A 100,000 down payment now. Note that the land, worth 50,000, must also be committed now. 2. A 100,000 progress payment after one year. 3. A final payment of 100,000 when the building is ready for occupancy at the end of the second year. Your real estate adviser maintains...

Diversification And Value Additivity

We have seen that diversification reduces risk and, therefore, makes sense for investors. But does it also make sense for the firm Is a diversified firm more attractive to investors than an undiversified one If it is, we have an extremely disturbing result. If diversification is an appropriate corporate objective, each project has to be analyzed as a potential addition to the firm's portfolio of assets. The value of the diversified package would be greater than the sum of the parts. So present...

Another Look At Risk And Discounted Cash Flow

In practical capital budgeting, a single discount rate is usually applied to all future cash flows. For example, the financial manager might use the capital asset pricing model to estimate the cost of capital and then use this figure to discount each year's expected cash flow. Among other things, the use of a constant discount rate assumes that project risk does not change.22 We know that this can't be strictly true, for the risks to which companies are exposed are constantly shifting. We are...

When You Cannot Use a Single Risk Adjusted Discount Rate for Long Lived Assets

Sometimes you will encounter problems where risk does change as time passes, and the use of a single risk-adjusted discount rate will then get you into trouble. For example, later in the book we will look at how options are valued. Because an option's risk is continually changing, the certainty-equivalent method needs to be used. Here is a disguised, simplified, and somewhat exaggerated version of an actual project proposal that one of the authors was asked to analyze. The scientists at...

How Individual Securities Affect Portfolio Risk

We presented earlier some data on the variability of 10 individual U.S. securities. Amazon.com had the highest standard deviation and Exxon Mobil had the lowest. If you had held Amazon on its own, the spread of possible returns would have been six times greater than if you had held Exxon Mobil on its own. But that is not a very interesting fact. Wise investors don't put all their eggs into just one basket They reduce their risk by diversification. They are therefore interested in the effect...

Some Warnings about Constant Growth Formulas

The simple constant-growth DCF formula is an extremely useful rule of thumb, but no more than that. Naive trust in the formula has led many financial analysts to silly conclusions. We have stressed the difficulty of estimating r by analysis of one stock only. Try to use a large sample of equivalent-risk securities. Even that may not work, but at least it gives the analyst a fighting chance, because the inevitable errors in estimating r for a single security tend to balance out across a broad...

Avoid Fudge Factors in Discount Rates

We have defined risk, from the investor's viewpoint, as the standard deviation of portfolio return or the beta of a common stock or other security. But in everyday usage risk simply equals bad outcome. People think of the risks of a project as a list of things that can go wrong. For example, A geologist looking for oil worries about the risk of a dry hole. A pharmaceutical manufacturer worries about the risk that a new drug which cures baldness may not be approved by the Food and Drug...

Example Imcs Fertilizer Project

As the newly appointed financial manager of International Mulch and Compost Company IM amp C , you are about to analyze a proposal for marketing guano as a garden fertilizer. IM amp C's planned advertising campaign features a rustic gentleman who steps out of a vegetable patch singing, All my troubles have guano way. 3 You are given the forecasts shown in Table 6.1. The project requires an investment of 10 million in plant and machinery line 1 . This machinery can be dismantled and sold for net...

Validity And Role Of The Capital Asset Pricing Model

Any economic model is a simplified statement of reality. We need to simplify in order to interpret what is going on around us. But we also need to know how much faith we can place in our model. Let us begin with some matters about which there is broad agreement. First, few people quarrel with the idea that investors require some extra return for taking on risk. That is why common stocks have given on average a higher return than U.S. Treasury bills. Who would want to invest in risky common...

Tests of the Capital Asset Pricing Model

Average Risk Premium 1931 1965

Imagine that in 1931 ten investors gathered together in a Wall Street bar to discuss their portfolios. Each agreed to follow a different investment strategy. Investor 1 opted to buy the 10 percent of New York Stock Exchange stocks with the lowest estimated betas investor 2 chose the 10 percent with the next-lowest betas and so on, up to investor 10, who agreed to buy the stocks with the highest betas. They also undertook that at the end of every year they would reestimate the betas of all NYSE...

Seventyfive Years Of Capital Market History In One Easy Lesson

Capital Market History

Financial analysts are blessed with an enormous quantity of data on security prices and returns. For example, the University of Chicago's Center for Research in Security Prices CRSP has developed a file of prices and dividends for each month since 1926 for every stock that has been listed on the New York Stock Exchange NYSE . Other files give data for stocks that are traded on the American Stock Exchange and the over-the-counter market, data for bonds, for options, and so on. But this is...

Review Of The Basics

Vegetron's chief financial officer CFO is wondering how to analyze a proposed 1 million investment in a new venture called project X. He asks what you think. Your response should be as follows First, forecast the cash flows generated by project X over its economic life. Second, determine the appropriate opportunity cost of capital. This should reflect both the time value of money and the risk involved in project X. Third, use this opportunity cost of capital to discount the future cash flows of...

The Three Factor Model

Treynor Black Model

We noted earlier the research by Fama and French showing that stocks of small firms and those with a high book-to-market ratio have provided above-average returns. This could simply be a coincidence. But there is also evidence that these factors are related to company profitability and therefore may be picking up risk factors that are left out of the simple CAPM.28 If investors do demand an extra return for taking on exposure to these factors, then we have a measure of the expected return that...

Harry Markowitz And The Birth Of Portfolio Theory

Inventory Portfolio Bell Curve

Most of the ideas in Chapter 7 date back to an article written in 1952 by Harry Markowitz.1 Markowitz drew attention to the common practice of portfolio diversification and showed exactly how an investor can reduce the standard deviation of portfolio returns by choosing stocks that do not move exactly together. But Markowitz did not stop there he went on to work out the basic principles of portfolio construction. These principles are the foundation for much of what has been written about the...

How Capital Markets Reconcile Preferences for Current vs Future Consumption

Suppose that you can look forward to a stream of income from your job. Unless you have some way of storing or anticipating this income, you will be compelled to consume it as it arrives. This could be inconvenient or worse. If the bulk of your income comes late in life, the result could be hunger now and gluttony later. This is where the capital market comes in. The capital market allows trade between dollars today and dollars in the future. You can therefore eat moderately both now and in the...

Comment on Risk and Present Value

We made one unrealistic assumption in our discussion of the office development Your real estate adviser cannot be certain about future values of office buildings. The 400,000 represents the best forecast, but it is not a sure thing. If the future value of the building is risky, our calculation of NPV is wrong. Investors could achieve 400,000 with certainty by buying 373,832 worth of United States government securities, so they would not buy your building for that amount. You would have to cut...

Calculating the Present Value of Growth Opportunities for Fledgling Electronics

In our last example both dividends and earnings were expected to grow, but this growth made no net contribution to the stock price. The stock was in this sense an income stock. Be careful not to equate firm performance with the growth in earnings per share. A company that reinvests earnings at below the market capitalization rate may increase earnings but will certainly reduce the share value. Now let us turn to that well-known growth stock, Fledgling Electronics. You may remember that...

We Introduce Borrowing and Lending

Of course, large investment funds can choose from thousands of stocks and thereby achieve a wider choice of risk and return. This choice is represented in Figure 8.6 by the shaded, broken-egg-shaped area. The set of efficient portfolios is again marked by the heavy curved line. Lending and borrowing extend the range of investment possibilities. If you invest in portfolio S and lend or borrow at the risk-free interest rate, rf, you can achieve any point along the straight line from rf through S....

Estimate Cash Flows on an Incremental Basis

The value of a project depends on all the additional cash flows that follow from project acceptance. Here are some things to watch for when you are deciding which cash flows should be included Do Not Confuse Average with Incremental Payoffs Most managers naturally hesitate to throw good money after bad. For example, they are reluctant to invest more money in a losing division. But occasionally you will encounter turnaround opportunities in which the incremental NPV on investment in a loser is...

Using Historical Evidence to Evaluate Todays Cost of Capital

Suppose there is an investment project which you know don't ask how has the same risk as Standard and Poor's Composite Index. We will say that it has the same degree of risk as the market portfolio, although this is speaking somewhat loosely, because the index does not include all risky securities. What rate should you use to discount this project's forecasted cash flows Clearly you should use the currently expected rate of return on the market portfolio that is the return investors would forgo...

Valuing the Concatenator Business

Rumor has it that Establishment Industries is interested in buying your company's concatenator manufacturing operation. Your company is willing to sell if it can get the full value of this rapidly growing business. The problem is to figure out what its true present value is. Table 4.7 gives a forecast of free cash flow FCF for the concatenator business. Free cash flow is the amount of cash that a firm can pay out to investors after paying for Forecasts of free cash flow, in millions, for the...

Why the Discount Factor Declines as Futurity Increases And a Digression on Money Machines

If a dollar tomorrow is worth less than a dollar today, one might suspect that a dollar the day after tomorrow should be worth even less. In other words, the discount factor DF2 should be less than the discount factor DF1. But is this necessarily so, when there is a different interest rate rt for each period Suppose r1 is 20 percent and r2 is 7 percent. Then Apparently the dollar received the day after tomorrow is not necessarily worth less than the dollar received tomorrow. But there is...

Variance and Standard Deviation

The standard statistical measures of spread are variance and standard deviation. The variance of the market return is the expected squared deviation from the expected return. In other words, Variance rm the expected value of rm - rm 2 10The decline in the stock market in 2001 also reduces the long-term average risk premium. The average premium from 1926 to September 2001 is 8.7 percent, .4 percentage points lower than the figure quoted in Table 7.1. 11This range seems to be consistent with...

Arithmetic Averages and Compound Annual Returns

Notice that the average returns shown in Table 7.1 are arithmetic averages. In other words, Ibbotson Associates simply added the 75 annual returns and divided by 75. The arithmetic average is higher than the compound annual return over the period. The 75-year compound annual return for the S amp P index was 11.0 percent.4 The proper uses of arithmetic and compound rates of return from past investments are often misunderstood. Therefore, we call a brief time-out for a clarifying example. Suppose...

New Economy Transport

The New Economy Transport Company NETCO was formed in 1952 to carry cargo and passengers between ports in the Pacific Northwest. By 2002 its fleet had grown to four vessels, one of which was a small dry-cargo vessel, the Vital Spark. The Vital Spark is badly in need of an overhaul. Peter Handy, the finance director, has just been presented with a proposal, which would require the following expenditures Install new engine and associated equipment Replace radar and other electronic equipment...

Separating Investment and Financing Decisions

Our analysis of the guano project takes no notice of how that project is financed. It may be that IM amp C will decide to finance partly by debt, but if it does we will not subtract the debt proceeds from the required investment, nor will we recognize interest and principal payments as cash outflows. We analyze the project as if it were all equity-financed, treating all cash outflows as coming from stockholders and all cash inflows as going to them. We approach the problem in this way so that...

Reeby Sports

Corporate Finance Basics

Ten years ago, in 1993, George Reeby founded a small mail-order company selling high-quality sports equipment. Reeby Sports has grown steadily and been consistently profitable see Table 4.8 . The company has no debt and the equity is valued in the company's books at nearly 41 million Table 4.9 . It is still wholly owned by George Reeby. George is now proposing to take the company public by the sale of 90,000 of his existing shares. The issue would not raise any additional cash for the company,...

Vegetrons CFO Calls Again

The first episode of this story was presented in Section 5.1. Later that afternoon, Vegetron's CFO bursts into your office in a state of anxious confusion. The problem, he explains, is a last-minute proposal for a change in the design of the fermentation tanks that Vegetron will build to extract hydrated zirconium from a stockpile of powdered ore. The CFO has brought a printout Table 5.1 of the forecasted revenues, costs, income, and book rates of return for the standard, low-temperature...

Uses of Capital Rationing Models

Linear programming models seem tailor-made for solving capital budgeting problems when resources are limited. Why then are they not universally accepted either in theory or in practice One reason is that these models can turn out to be very complex. Second, as with any sophisticated long-range planning tool, there is the general problem of getting good data. It is just not worth applying costly, sophisticated methods to poor data. Furthermore, these models are based on the assumption that all...

How Much Is the Concatenator Business Worth per Share

Suppose the concatenator division is spun off from its parent as an independent company, Concatco, with one million outstanding shares. What would each share sell for We have already calculated the value of Concatco's free cash flow as 18.8 million, using the constant-growth DCF formula to calculate horizon value. If this value is right, and there are one million shares, each share should be worth 18.80. This amount should also be the present value of Concatco's dividends per share although...

Should Managers Look After The Interests Of Shareholders

We have described managers as the agents of the shareholders. But perhaps this begs the question, Is it desirable for managers to act in the selfish interests of their shareholders Does a focus on enriching the shareholders mean that managers must act as greedy mercenaries riding roughshod over the weak and helpless Do they not have wider obligations to their employees, customers, suppliers, and the communities in which the firm is located 8 Most of this book is devoted to financial policies...

Separation Of Ownership And Management

In large businesses separation of ownership and management is a practical necessity. Major corporations may have hundreds of thousands of shareholders. There is no way for all of them to be actively involved in management It would be like running New York City through a series of town meetings for all its citizens. Authority has to be delegated to managers. The separation of ownership and management has clear advantages. It allows share ownership to change without interfering with the operation...

Compounding Intervals and Bond Prices

In calculating the value of the 7 percent Treasury bonds, we made two approximations. First, we assumed that interest payments occurred annually. In practice, 13Early in 2001 the Turkish overnight rate exceeded 20,000 percent. most U.S. bonds make coupon payments semiannually, so that instead of receiving 70 every year, an investor holding 7 percent bonds would receive 35 every half year. Second, yields on U.S. bonds are usually quoted as semiannually compounded yields. In other words, if the...

The Jones Family Incorporated

The Scene Early evening in an ordinary family room in Manhattan. Modern furniture, with old copies of The Wall Street Journal and the Financial Times scattered around. Autographed photos of Alan Greenspan and George Soros are prominently displayed. A picture window reveals a distant view of lights on the Hudson River. John Jones sits at a computer terminal, glumly sipping a glass of chardonnay and trading Japanese yen over the Internet. His wife Marsha enters. Marsha Hi, honey. Glad to be home....

Who Is The Financial Manager

In this book we will use the term financial manager to refer to anyone responsible for a significant investment or financing decision. But only in the smallest firms is a single person responsible for all the decisions discussed in this book. In most cases, responsibility is dispersed. Top management is of course continuously involved in financial decisions. But the engineer who designs a new production facility is also involved The design determines the kind of real assets the firm will hold....

The Role Of The Financial Manager

To carry on business, corporations need an almost endless variety of real assets. Many of these assets are tangible, such as machinery, factories, and offices others are intangible, such as technical expertise, trademarks, and patents. All of them need to be paid for. To obtain the necessary money, the corporation sells claims on its real assets and on the cash those assets will generate. These claims are called financial assets or securities. For example, if the company borrows money from the...

Supplements

In this edition, we have gone to great lengths to ensure that our supplements are equal in quality and authority to the text itself. The Instructor's Manual was extensively revised and updated by C. R. Krishnaswamy of Western Michigan University. It contains an overview of each chapter, teaching tips, learning objectives, challenge areas, key terms, and an annotated outline that provides references to the PowerPoint slides. The Test Bank was also updated by C. R. Krishnaswamy, who included well...

Topics Covered In This Book

We have mentioned how financial managers separate investment and financing decisions Investment decisions typically precede financing decisions. That is also how we have organized this book. Parts 1 through 3 are almost entirely devoted to different aspects of the investment decision. The first topic is how to value assets, the second is the link between risk and value, and the third is the management of the capital investment process. Our discussion of these topics occupies Chapters 2 through...

Gretchen Slemmons

We have a long list of people to thank for their helpful criticism of earlier editions and for assistance in preparing this one. They include Aleijda de Cazen-ove Balsan, John Cox, Kedrum Garrison, Robert Pindyck, and Gretchen Slemmons at MIT Stefania Uccheddu at London Business School Lynda Borucki, Marjorie Fischer, Larry Kolbe, James A. Read, Jr., and Bente Villadsen at The Brattle Group, Inc. John Stonier at Airbus Industries and Alex Tri-antis at the University of Maryland. We would also...