Why Diversification Reduces or Eliminates Firm Specific Risk
Why do we distinguish between the different types of risk Risk that affect one of a few firms, i.e., firm specific risk, can be reduced or even eliminated by investors as they hold more diverse portfolios due to two reasons. The first is that each investment in a diversified portfolio is a much smaller percentage of that portfolio. Thus, any risk that increases or reduces the value of only that investment or a small group of investments will have only a small impact on the overall portfolio....
Assessing Investor tax preferences for dividends
As you can see from the discussion above, the tax rate on dividends can vary widely for different investors - individual, pension fund, mutual fund or corporation -receiving the dividends and even for the same investor on different investments. It is difficult therefore to look at a company's investor base and determine their preferences for dividends and capital gains. A simple way to measure the tax disadvantage associated with dividends is to measure the price change on the ex-dividend date...
The Information Problem
Market prices are based upon information, both public and private. In the world of classical theory, information about companies is revealed promptly and truthfully to financial markets. In the real world, there are a few impediments to this process. The first is that information is sometimes suppressed or delayed by firms, especially when it contains bad news. While there is significant anecdotal evidence of this occurrence, the most direct evidence that firms do this comes from studies of...
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All three companies are widely held by institutional investors. To break down the institutional investment, we examined the ten largest investors in each firm at the end of 2002 in Table 8.5, with the percent of the firm's stock held by each (in brackets). Table 3.2 Largest Stockholders in Disney, Aracruz and Deutsche Bank The ten largest investors in Disney are all institutional investors, suggesting that we are on safe grounds assuming that the marginal investor in Disney is likely to be both...
Why is the marginal investor assumed to be diversified
The argument that investors can reduce their exposure to risk by diversifying can be easily made, but risk and return models in finance go further. They argue that the 7 Three stockholders, VCP, Safra and Grupo Lorentzen hold 28 each of the voting shares. marginal investor, who sets prices for investments, is well diversified thus, the only risk that will be priced in the risk as perceived by that investor. The justification that can be offered is a simple one. The risk in an investment will...
Differences in Growth Rates
The growth rates from historical earnings, analyst projections and fundamentals can often be very different. These differences can be best explained by a. As firms become larger, the differences between growth rates will increase. b. Analysts are biased towards making optimistic estimates of growth c. The inputs used to estimate fundamental growth reflect what happened last year rather than what we expect will happen in the future. Illustration 12.2 Growth in Earnings per share Deutsche Bank In...
In Practice Estimating the FCFE at a Financial Service Firm
The standard definition of free cash flows to equity is straightforward to put into practice for most manufacturing firms, since the net capital expenditures, non-cash working capital needs and debt ratio can be estimated from the financial statements. In contrast, the estimation of free cash flows to equity is difficult for financial service firms, due to several reasons. First, estimating net capital expenditures and non-cash working capital for a bank or insurance company is difficult to do,...
Going Public Effect on Optimal Debt Ratio
Assume that Bookscape is planning to make an initial public offering in six months. How would this information change your assessment of the optimal debt ratio a. It will increase the optimal debt ratio because publicly traded firms should be able to borrow more than private businesses b. It will reduce the optimal debt ratio because only market risk counts for a publicly traded firm c. It may increase or decrease the optimal debt ratio, depending on which effect dominates
Optimal Debt Ratios based upon Comparable Firms
The predicted debt ratio from the regression shown above will generally yield (a) a debt ratio similar to the optimal debt ratio from the cost of capital approach (b) a debt ratio higher than the optimal debt ratio from the cost of capital approach (c) a debt ratio lower than the optimal debt ratio from the cost of capital approach (d) any of the above, depending upon Explain. dbtreg.xls There is a dataset on the web that summarizes the latest debt ratio regression across the entire market.
Cash Flow Approach to Analyzing Dividend Policy
Given what firms are returning to their stockholders in the form of dividends or stock buybacks, how do we decide whether they are returning too much or too little In the cash flow approach, we follow four steps. We first measure how much cash is available to be paid out to stockholders after meeting reinvestment needs and compare this amount to the amount actually returned to stockholders. We then have to consider how good existing and new investments in the firm are. Thirdly, based upon the...
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Firm Value (with no growth) 3,343 mil This analysis was based upon the 1995 earnings before interest and taxes of 420 million, and a tax rate of 36.90 . a. Why is the optimal debt ratio for Reebok so high b. What might be some of your concerns in moving to this optimal 20. Timberland Inc., a manufacturer and retailer of footwear and sportswear, is considering is highly levered status. In 1995, the firm had 237 million in market value of debt outstanding, and 11 million shares outstanding at...
Step 4 Interaction between Dividend Policy and Financing Policy
The analysis of dividend policy is further enriched and complicated if we bring in the firm's financing decisions as well. In Chapter 9, we noted that one of the ways a firm can increase leverage over time is by increasing dividends or repurchasing stock at the same time, it can decrease leverage by cutting or not paying dividends. Thus, we cannot decide how much a firm should pay in dividends without determining whether it is under- or over-levered and whether or not it intends to close this...
Temporary Excess Cash
In some cases, firms are tempted to pay or initiate dividends in years in which their operations generate excess cash. Although it is perfectly legitimate to return excess cash to stockholders, firms should also consider their own long-term investment needs. If the excess cash is a temporary phenomenon, resulting from having an unusually good year or a non-recurring action (such as the sale of an asset), and the firm expects cash shortfalls in future years, it may be better off retaining the...
Comparable Firm Approach to Analyzing Dividend Policy
So far, we have examined the dividend policy of a firm by looking at its cash flows and the quality of its investments. There are managers who believe that their dividend policies are judged relative to those of their competitors. This comparable-firm approach to analyzing dividend policy is often used narrowly, by looking at only firms that are similar in size and business mix, for example. As we will illustrate, it can be used more broadly, by looking at the determinants of dividend policy...
Differences in Dividend Policy across Countries
Figures 10.5 to 10.8 showed several trends and patterns in dividend policies at U.S. companies.4 They share some common features with firms in other countries, and there are some differences. As in the United States, dividends in other countries are sticky and follow earnings. However, there are differences in the magnitude of dividend payout ratios across countries. Figure 10.9 shows the proportion of earnings paid out in dividends in the G-7 countries in 1982-84 and again in 1989-91. These...
Dividend Policy at Growth Firms
Assume that you are following a growth firm, whose growth rate has begun easing. Which of the following would you most likely observe in terms of dividend policy at the firm a. An immediate increase of dividends to reflect the lower reinvestment needs. b. No change in dividend policy, and an increase in the cash balance. c. No change in dividend policy, and an increase in acquisitions of other firms Explain. 3 These are growth rates projected by Value Line for firms in April 1999.
Empirical Evidence on Dividend Policy
We observe several interesting patterns when we look at the dividend policies of firms in the United States in the last 50 years. First, dividends tend to lag behind earnings that is, increases in earnings are followed by increases in dividends, and decreases in earnings sometimes by dividend cuts. Second, dividends are sticky because firms are typically reluctant to change dividends in particular, firms avoid cutting dividends even when earnings drop. Third, dividends tend to follow a much...
The Continuum between Debt and Equity
While the distinction between debt and equity is often made in terms of bonds and stocks, its roots lie in the nature of the cash flow claims of each type of financing. The first distinction is that a debt claim entitles the holder to a contracted set of cash flows (usually interest and principal payments), whereas an equity claim entitles the holder to any residual cash flows left over after meeting all other promised claims. While this remains the fundamental difference, other distinctions...
In Practice Estimating Capital Expenditure and Working Capital Needs
Two components go into estimating reinvestments. The first is net capital expenditures, which is the difference between capital expenditures and depreciation. While these numbers can easily be obtained for the current year for any firm in the United States8, they should be used with the following caveats 1. Firms seldom have smooth capital expenditure streams. Firms can go through periods when capital expenditures are very high, followed by periods of relatively light capital expenditures....
Managing Changes in Dividend Policy
In chapter 10, we noted the tendency on the part of investors to buy stocks with dividend policies that meet their specific needs. Thus, investors who want high current cash flows and do not care much about the tax consequences migrate to firms that pay high dividends those who want price appreciation and are concerned about the tax differential hold stock in firms that pay low or no dividends. One consequence of this clientele effect is that changes in dividends, even if entirely justified by...
Length of High Growth Period and Barriers to Entry
Assume that you are analyzing two firms, both of which are enjoying high growth. The first firm is Earthlink Network, an internet service provider, which operates in an environment with few barriers to entry and extraordinary competition. The second firm is Biogen, a biotechnology firm which is enjoying growth from two drugs to which it owns patents for the next decade. Assuming that both firms are well managed, which of the two firms would you expect to have a longer high growth period c. Both...
Live Case Study The Trade Off on Dividend Policy
Objective To examine how much cash your firm has returned to its stockholders and in what form (dividends or stock buybacks), and to evaluate whether the trade off favors returning more or less. Has this firm ever paid out dividends If yes, is there a pattern to the dividends over time Given this firm's characteristics today, do you think that this firm should be paying more dividends, less dividends or no dividends at all How much has this company paid in dividends over the last few years How...
Dividend Policy
At the end of each year, every publicly traded company has to decide whether to return cash to its stockholders and, if yes, how much in the form of dividends. The owner of a private company has to make a similar decision about how much cash he plans to withdraw from the business, and how much to reinvest. This is the dividend decision, and we begin this chapter by providing some background on three aspects of dividend policy. One is a purely procedural question about how dividends are set and...
Creating A Replicating Portfolio
The objective in creating a replicating portfolio is to use a combination of risk-free borrowing lending and the underlying asset to create the same cash flows as the option being valued. In the case of the general formulation above, where stock prices can either move up to Su or down to Sd in any time period, the replicating portfolio for a call with a given strike price will involve borrowing B and acquiring A of the underlying asset. Of course, this formulation is of no use if we cannot...
Ways of changing the financing mix
There are four basic paths available to a firm that wants to change its financing mix. One is to change the current financing mix, using new equity to retire debt or new debt to reduce equity this is called recapitalization. The second path is to sell assets and use the proceeds to pay off debt, if the objective is to reduce the debt ratio, or to reduce equity, if the objective is to increase the debt ratio. The third is to use a disproportionately high debt or equity ratio, relative to the...
Framework for Capital Structure Changes
A firm whose actual debt ratio is very different from its optimal has several choices to make. First, it has to decide whether to move towards the optimal or to preserve the status quo. Second, once it decides to move towards the optimal, the firm has to choose between changing its leverage quickly or moving more deliberately. This decision may also be governed by pressure from external sources, such as impatient stockholders or bond ratings agency concerns. Third, if the firm decides to move...
Free Cashflow to Equity Models
In Chapter 11, while developing a framework for analyzing dividend policy we estimated the free cash flow to equity as the cash flow that the firm can afford to pay out as dividends, and contrasted it with the actual dividends. We noted that many firms do not pay out their FCFE as dividends thus, the dividend discount model may not capture their true capacity to generate cash flows for stockholders. A more appropriate model is the free cash flow to equity model. The FCFE is the residual cash...
Firms Dividend Policy Tends To Follow The Life Cycle Of The Firm
In chapter 7, we introduced the link between a firm's place in the life cycle and its financing mix and choices. In particular, we noted five stages in the growth life cycle -start up, rapid expansion, high growth, mature growth and decline. In this section, we will examine the link between a firm's place in the life cycle and its dividend policy. Not surprisingly, firms generally adopt dividend policies that best fit where they are currently in their life cycles. For instance, high-growth...
Dividend policy is a tool for changing financing mix
Dividend policy cannot be analyzed in a vacuum. Firms can use dividend policy as a tool to change their debt ratios, In chapter 9, we examined how firms that want to increase or decrease leverage can do so by changing their dividend policy increasing dividends increases leverage over time, and decreasing dividends reduces leverage. When dividends increase, stockholders sometimes get a bonus in the form of a wealth transfer from lenders to the firm. Lenders would rather have firms accumulate...
Insider Holdings and Leverage
Closely held firms (where managers and insiders hold a substantial portion of the outstanding stock) are less likely to increase leverage quickly than firms with widely dispersed stockholdings. 2 Palepu (1986) notes that one of the variables that seems to predict a takeover is a low debt ratio, in conjunction with poor operating performance. Illustration 9.1 Debt Capacity and Takeovers The Disney acquisition of Capital Cities in 1996, although a friendly acquisition, illustrates some of...
What do managers believe about dividend policy
Given the pros and cons for paying dividends, and the lack of a consensus on the effect of dividends on value, it is worth considering what managers factor in when they make dividend decisions. Baker, Farrely and Edelman (1985) surveyed managers on their views on dividend policy and reported the level of agreement with a series of statements. Table 10.3 summarizes their findings - Table 10.3 Management Beliefs about Dividend Policy Table 10.3 Management Beliefs about Dividend Policy
Financing Mix and a Firms Life Cycle
Earlier in this chapter, we looked at how a firm's financing choices might change as it makes the transition from a start-up firm to a mature firm to final decline. We could look at how a firm's financing mix changes over the same life cycle. Typically, start-up firms and firms in rapid expansion use debt sparingly in some cases, they use no debt at all. As the growth eases, and as cash flows from existing investments become larger and more predictable, we see firms beginning to use debt. Debt...
Problems
Vernon Enterprises has current after-tax operating income of 100 million and a cost of capital of 10 . The firm earns a return on capital equal to its cost of capital. a. If we assume that the firm is in stable growth, growing 5 a year forever, estimate the firm's reinvestment rate. b. Given this reinvestment rate, estimate the value of the firm. c. What is the value of the firm, if you assume a zero reinvestment rate and no growth 2. Assume, in the previous example with Vernon Enterprises,...
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Estimate the optimal debt ratio, using the cost of capital approach. b. Estimate the optimal debt ratio, using the return differential approach. c. Will the two approaches always give you identical results Why or why not 21. You are trying the evaluate whether United Airlines has any excess debt capacity. In 1995, UAL had 12.2 million shares outstanding at 210 per share, and debt outstanding of approximately 3 billion (book as well as market value). The debt had a rating of B, and carried a...
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Estimate the cost of equity at each level of debt. b. Estimate the return on equity at each level of debt. c. Estimate the optimal debt ratio based upon the differential return. d. Will the value of the firm be maximized at this level of debt. Why or why not 14. Pfizer, one of the largest pharmaceutical companies in the United States, is considering what its debt capacity is. In March 1995, Pfizer had an outstanding market value of equity of 24.27 billion, debt of 2.8 billion and a AAA...
Measures of Dividend Policy
We generally measure the dividends paid by a firm using one of two measures. The first is the dividend yield, which relates the dividend paid to the price of the stock Dividend Yield Annual Dividends per share Price per share The dividend yield is significant because it provides a measure of that component of the total return that comes from dividends, with the balance coming from price appreciation. Expected Return on Stock Dividend Yield + Price Appreciation Some investors also use the...
Normalized Operating Income
A key input that drives the optimal capital structure is the current operating income. If this income is depressed, either because the firm is a cyclical firm or because there are firm-specific factors that are expected to be temporary, the optimal debt ratio that will emerge from the analysis will be much lower than the firm's true optimal. For example, automobile manufacturing firms would have had very low debt ratios if the optimal debt ratios had been computed based upon the operating...
In Practice Using a Probit to Estimate the Probability of Bankruptcy
It is possible to estimate the probability of default using statistical techniques, when there is sufficient data avaialble. For instance, if we have a database that lists all firms that went bankrupt during a period of time, as well as firms that did not go bankrupt during the same period, together with descriptive characteristics on these firms, a probit analysis can be used to estimate the likelihood of bankruptcy as a function of these characteristics. The steps involved in a probit...
In Practice Valuing Warrants
Warrants are long term call options, but standard option pricing models are based upon the assumption that exercising an option does not affect the value of the underlying asset. This may be true for listed options on stocks, but it is not true for warrants, since their exercise increases the number of shares outstanding and brings in fresh cash into the firm, both of which will affect the stock price. The expected negative impact dilution of exercise will make warrants less valuable than...
Sensitivity Analysis
The optimal debt ratio we estimate for a firm is a function of all the inputs that go into the cost of capital computation - the beta of the firm, the riskfree rate, the risk premium and the default spread. It is also, indirectly, a function of the firm's operating income, since interest coverage ratios are based upon this income, and these ratios are used to compute ratings and interest rates. The determinants of the optimal debt ratio for a firm can be divided into variables specific to the...
Following A Financing Hierarchy
There is evidence that firms follow a financing hierarchy retained earnings are the most preferred choice for financing, followed by debt, new equity, common and preferred convertible preferred is the least preferred choice. For instance, in the survey by Pinegar and Wilbricht Table 7.10 , managers were asked to rank six different sources of financing -internal equity, external equity, external debt, preferred stock, and hybrids convertible debt and preferred stock - from most preferred to...
An Argument for Stockholder Wealth Maximization
Let us start off by conceding that all of the alternatives - choosing a different corporate governance system, picking an alternative objective and maximizing stockholder wealth with constraints - have their limitations and lead to problems. The questions then become how each alternative deals with mistakes and how quickly errors get corrected. This is where stock price maximization does better than the alternatives. It is the only one of the three that is self-correcting, in the sense that...
Capital Structure The Optimal Financial
What is the optimal mix of debt and equity for a firm While in the last chapter we looked at the qualitative trade off between debt and equity, we did not develop the tools we need to analyze whether debt should be 0 , 20 , 40 or 60 of capital. Debt is always cheaper than equity, but using debt increases risk in terms of default risk to lenders, and higher earnings volatility for equity investors. Thus, using more debt can increase value for some firms and decrease value for others, and for the...
Internal Rate of Return
The internal rate of return is based on discounted cash flows. Unlike the net present value rule, however, it takes into account the project's scale. It is the discounted cash flow analog to the accounting rates of return. Again, in general terms, the internal rate of return is that discount rate that makes the net Internal Rate of Return IRR The IRR of a project measures the rate of return earned by the project based upon cash flows, allowing for the time value of money. present value of a...
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Set up the linear programming problem, assuming that fractions and multiples of projects cannot be taken. 3. You own a rental building in the city and are interested in replacing the heating system. You are faced with the following alternatives a. A solar heating system, which will cost 12,000 to install and 500 a year to run and will last forever assume that your building will too . b. A gas-heating system, which will cost 5,000 to install and 1000 a year to run and will last 20 years. c. An...
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Source Compustat and Bondsonline.com Source Compustat and Bondsonline.com Now consider a private firm with 10 million in earnings before interest and taxes and 3 million in interest expenses it has an interest coverage ratio of 3.33. Based on this ratio, we would assess a synthetic rating of BB for the firm and attach a default spread of 2.50 to the riskfree rate to come up with a pre-tax cost of debt. By basing the synthetic rating on the interest coverage ratio alone, we run the risk of...
Comparative Analysis of Risk and Return Models
All the risk and return models developed in this chapter have common ingredients. They all assume that only market-wide risk is rewarded, and they derive the expected return as a function of measures of this risk. Figure 3.7 presents a comparison of the different models 12 Adding to the confusion, researchers in recent years have taken to describing proxy models also as multi factor models. Figure 3.7 Competing Models for Risk and Return in Finance The risk in an investment can be measured by...
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In terms of mechanics, we used smoothed historical growth rates in earnings and dividends as our projected growth rates and a two-stage dividend discount model. Looking at these numbers, we would draw the following conclusions. The implied equity premium has seldom been as high as the historical risk premium. Even in 1978, when the implied equity premium peaked, the estimate of 6.50 is well below what many practitioners use as the risk premium in their risk and return models. In fact, the...
Alternatives to Stock Price Maximization
There are obvious problems associated with each of the linkages underlying wealth maximization. Stockholders often have little power over managers, and managers consequently put their interests above those of stockholders. Lenders who do not protect their interests often end up paying a price, when decisions made by firms transfer wealth to stockholders. Information delivered to financial markets is often erroneous, misleading or delayed, and there are significant differences between price and...
Where Do Good Projects Come From
In the process of analyzing new investments in the preceding chapters, we have contended that good projects have a positive net present value and earn an internal rate of return greater than the hurdle rate. While these criteria are certainly valid from a measurement standpoint, they do not address the deeper questions about good projects including the economic conditions that make for a good project and why it is that some firms have a more ready supply of good projects than others. Implicit...
The Real World A Pictorial Representation
We have spent the last few pages chronicling the problems, in the real world, with each of the linkages -- managers and stockholders, stockholders and bondholders, firms and financial markets and firms and society. Figure 2.2 summarizes the problems with each linkage in a pictorial representation. 24 The Balanced Scorecard Translating Strategy into Action, 1996, Robert.S. Kaplan and David P. Norton, Harvard Business School Press. Figure 2.2 Stock Price Maximization in the Real World...
Discount Rates and NPV
In the project described above, the NPV decreased as the discount rate was increased. Is this always the case If no, when might the NPV go up as the discount rate is increased One advantage of the internal rate of return is that it can be used even in cases where the discount rate is unknown. While this is true for the calculation of the IRR, it is not true when the decision maker has to use the IRR to decide whether to take a project or not. At that stage in the process, the internal rate of...
What is an investment decision rule
When faced with new investments and projects, firms have to decide whether to invest in them or not. While we have been leading up to this decision over the last few chapters, investment decision rules allow us to formalize the process and specify what condition or conditions need to be met for a project to be acceptable. While we will be looking at a variety of investment decision rules in this section, it is worth keeping in mind what characteristics we would like a good investment decision...
Identifying the Marginal Investor
The marginal investor in a firm is the investor who is most likely to be trading at the margin and therefore has the most influence on the pricing of its equity. In some cases, this may be a large institutional investor, but institutional investors themselves can differ in several ways. The institution may be a taxable mutual fund or a tax-exempt pension fund, may be domestically or internationally diversified, and vary on investment philosophy. In some cases, the marginal investors may be...
Stockholders and Bondholders
The conflict of interests between stockholders and bondholders can lead to actions that transfer wealth to the former from the latter. There are ways in which bondholders can obtain at least partial protection against some of these actions. The most direct way for bondholders to protect themselves is to write in covenants in their bond agreements specifically prohibiting or restricting actions that may be wealth expropriating. Many bond and bank loan agreements have covenants that do the...
A postscript The limits of corporate finance
Corporate finance has come in for more than its share of criticism in the last decade. There are many who argue that the failures of corporate America can be traced to its dependence on stock price maximization. Some of the criticism is justified and based upon the limitations of a single-minded pursuit of stockholder wealth. Some of it, however, is based upon a misunderstanding of what corporate finance is about. Economics was once branded the gospel of Mammon, because of its emphasis on...
Maximize Market Share
In the 1980s, Japanese firms inundated global markets with their products and focused their attention on increasing market share. Their apparent success at converting this market share to profits led other firms, including some in the United States, to also target market share as an objective. In concrete terms, this meant that investments that increased market share more were viewed more favorably than investments that increased them less. Proponents of this objective note that market share is...
Determinants of Bond Ratings
The bond ratings assigned by ratings agencies are primarily based upon publicly available information, though private information conveyed by the firm to the rating agency does play a role. The rating that is assigned to a company's bonds will depend in large part on financial ratios that measure the capacity of the company to meet debt payments and generate stable and predictable cashflows. While a multitude of financial ratios exist, table 3.2 summarizes some of the key ratios that are used...
Problems and Questions
In December 1995, Boise Cascade's stock had a beta of 0.95. The treasury bill rate at the time was 5.8 , and the treasury bond rate was 6.4 . The firm had debt outstanding of 1.7 billion and a market value of equity of 1.5 billion the corporate marginal tax rate was 36 . a. Estimate the expected return on the stock for a short term investor in the company. b. Estimate the expected return on the stock for a long term investor in the company. c. Estimate the cost of equity for the company. 2....
Motivation and Perspective in Analyzing Risk
Why do we need a model that measures risk and estimates expected return A good model for risk and return provides us with the tools to measure the risk in any investment and uses that risk measure to come up with the appropriate expected return on that investment this expected return provides us with the hurdle rate in project analysis. What makes the measurement of risk and expected return so challenging is that it can vary depending upon whose perspective we adopt. When analyzing Disney's...
Hostile Acquisitions Who do they hurt
Given the information presented in this chapter, which of the following groups is likely to be the most likely to be protected by a law banning hostile takeovers a. Stockholders of target companies b. Managers and employees of well-run target companies c. Managers and employees of badly-run target companies Illustration 2.5 Restive Stockholders and Responsive Managers The Disney Case In 1997, Disney was widely perceived as having an imperial CEO in Michael Eisner and a captive board of...
Multifactor Models for risk and return
The arbitrage pricing model's failure to identify specifically the factors in the model may be a strength from a statistical standpoint, but it is a clear weakness from an intuitive standpoint. The solution seems simple Replace the unidentified statistical factors with specified economic factors, and the resultant model should be intuitive while still retaining much of the strength of the arbitrage pricing model. That is precisely what multi-factor models do. Multi-factor models generally are...
Inside Stockholders versus Outside Stockholders
There are companies like Microsoft where a large stockholder Bill Gates may be the on the inside as the manager of the concern. Is it possible that what is in Bill Gates' best interests as an inside stockholder may not be in the interests of a stockholder on the outside a. Yes. Their interests may deviate. b. No. Their interests will not deviate If yes, provide an example of an action that may benefit the inside stockholder but not the outside stockholder. The perceived excesses of many...
Conclusion
While the objective in corporate finance is to maximize firm value, in practice we often adopt the narrower objective of maximizing a firm's stock price. As a measurable and unambiguous measure of a firm's success, stock price offers a clear target for managers in the course of their decision-making. Stock price maximization as the only objective can be problematic when the different players in the firm - stockholders, managers, lenders and society - all have different interests and work at...
Potential Side Costs of Value Maximization
If the objective when making decisions is to maximize firm value, there is a possibility that what is good for the firm may not be good for society. In other words, decisions that are good for the firm, insofar as they increase value, may create social costs. If these costs are large, we can see society paying a high price for value maximization and the objective will have to be modified to allow for these costs. To be fair, however, this is a problem that is likely to persist in any system of...
The Ratings Process
The process of rating a bond starts when a company requests a rating from the ratings agency. This request is usually precipitated by a desire on the part of the company to issue bonds. While ratings are not a legal pre-requisite for bond issues, it is unlikely that investors in the bond market will be willing to buy bonds issued by a company that is not well known and has shown itself to be unwilling to put itself through the rigor of a bond rating process. It is not surprising, therefore,...
Assume You Have All Your Wealth A Million Dollars Invested In The Vanguard 500 Index Fund And That You Expect To Earn
Estimate the average and standard deviation in annual returns in each company b. Estimate the covariance and correlation in returns between the two companies c. Estimate the variance of a portfolio composed, in equal parts, of the two investments 4. You are in a world where there are only two assets, gold and stocks. You are interested in investing your money in one, the other or both assets. Consequently you collect the following data on the returns on the two assets over the last six...
The Dividend Principle
Most businesses would undoubtedly like to have unlimited investment opportunities that yield returns exceeding their hurdle rates, but all businesses grow and mature. As a consequence, every business that thrives reaches a stage in its life when the cash flows generated by existing investments is greater than the funds needed to take on good investments. At that point, this business has to figure out ways to return the excess cash to owners. In private businesses, this may just involve the...
Why Corporate Finance Focuses on Stock Price Maximization
Much of corporate financial theory is centered on stock price maximization as the sole objective when making decisions. This may seem surprising given the potential side costs listed above, but there are three reasons for the focus on stock price maximization in traditional corporate finance. Stock prices are the most observable of all measures that can be used to judge the performance of a publicly traded firm. Unlike earnings or sales, which are updated once every quarter or even once every...
The Financing Principle
Every business, no matter how large and complex it is, is ultimately funded with a mix of borrowed money debt and owner's funds equity . With a publicly trade firm, debt may take the form of bonds and equity is usually common stock. In a private business, debt is more likely to be bank loans and an owner's savings represent equity. While we consider the existing mix of debt and equity and its implications for the minimum acceptable hurdle rate as part of the investment principle, we throw open...
The Effects of Diversification on Venture Capitalist
You are comparing the required returns of two venture capitalists who are interested in investing in the same software firm. One venture capitalist has all of his capital invested in only software firms, whereas the other venture capitalist has invested her capital in small companies in a variety of businesses. Which of these two will have the higher required rate of return The venture capitalist who is invested only in software companies The venture capitalist who is invested in a variety of...
The Investment Principle
Firms have scarce resources that must be allocated among competing needs. The first and foremost function of corporate financial theory is to provide a framework for firms to make this decision wisely. Accordingly, we define investment decisions to include not only those that create revenues and profits such as introducing a new product line or expanding into a new market , but also those that save money such as building a new and more efficient distribution system . Further, we argue that...
The Objective of the Firm
No discipline can develop cohesively over time without a unifying objective. The growth of corporate financial theory can be traced to its choice of a single objective and the development of models built around this objective. The objective in conventional corporate financial theory when making decisions is to maximize the value of your business or firm. Consequently, any decision investment, financial, or dividend that increases the value of a business is considered a 'good' one, whereas one...
Preface For Finance
Let me begin this preface with a confession of a few of my own biases. First, I believe that theory, and the models that flow from it, should provide us with the tools to understand, analyze and solve problems. The test of a model or theory then should not be based upon its elegance but upon its usefulness in problem solving. Second, there is little in corporate financial theory, in my view, that is new and revolutionary. The core principles of corporate finance are common sense ones, and have...
