Costs of the general cash offer

Whenever a firm makes a cash offer, it incurs substantial administrative costs. Also, the firm needs to compensate the underwriters by selling them securities below the price that they expect to receive from investors. Figure 14.1 shows the average underwriting spread and administrative costs for several types of security issues in the United States.9 9 These figures do not capture all administrative costs. For example, they do not include management time spent on the issue. Brealey-Myers I IV....

Direct versus indirect costs of bankruptcy

Thus far we have discussed only the direct (that is, legal and administrative) costs of bankruptcy. The indirect costs reflect the difficulties of running a company while it is going through bankruptcy. Management's efforts to prevent further deterioration in the firm's business are often undermined by the delays and legal tangles that go with bankruptcy. When Eastern Airlines entered bankruptcy in 1989, it was in severe financial trouble, but it still had some valuable, profit-making routes...

Determinants of project risk

We have seen that the company cost of capital is the correct discount rate for projects that have the same risk as the company's existing business, but not for those projects that are safer or riskier than the company's average. How do we know whether a project is unusually risky Estimating project risk is never going to be an exact science, but here are two things to bear in mind. First, we saw in Chapter 8 that operating leverage increases the risk of a project. When a large fraction of your...

Example 222 The Bootstrap Game

The position before the merger is set out in the first two columns of Table 22.2. Notice that because Muck and Slurry has relatively poor growth prospects, its stock sells at a lower price-earnings ratio than World Enterprises (line 3). The merger, we assume, produces no economic benefits, so the firms should be worth exactly the same together as apart. The value of World Enterprises after the merger is therefore equal to the sum of the separate values of the two firms (line 6). Since World...

Planners Beware

The Executive Fruit model is still too simple for practical application. You probably have already noticed several ways to improve it. For example, we ignored depreciation of fixed assets. Depreciation is important because it provides a tax shield. If Executive Fruit deducts depreciation before calculating its tax bill, it could plow back more money into new investments and would need to borrow less. We also ignored the fact that there would probably be some interest to pay in 2000 on the new...

The constantgrowth dividend discount model

The dividend discount model requires a forecast of dividends for every year into the future, which poses a bit of a problem for stocks with potentially infinite lives. Unless we want to spend a lifetime forecasting dividends, we must use simplifying assumptions to reduce the number of estimates. The simplest simplification assumes a no-growth perpetuity which works for no-growth common shares. Here's another simplification that finds a good deal of practical use. Suppose forecast dividends grow...

The determinants of option value

The option price must lie between the upper and lower limits in Figure 24.7. In fact, the price will lie on a curved, upward-sloping line like the dashed curve shown in the figure. This line begins its travels where the upper and lower bounds meet (at zero). Then it rises, gradually becoming parallel to the lower bound. This line tells us an important fact about option values given the exercise price, the value of a call option increases as the stock price increases. That should be no surprise....

Prospectus

Of the 800,000 shares of Common Stock offered hereby, 500,000 shares are being sold by the Company and 300,000 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 risk. See Certain Factors. THESE SECURITIES HAVE NOT BEEN APPROVED OR...

Costs of distress vary with type of asset

Suppose your firm's only asset is a large downtown hotel, mortgaged to the hilt. A 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. The stock is worthless and you use the 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 guests, not to...

Mutually exclusive projects and the irr rule

Whereas the NPV rule deals easily with mutually exclusive projects, the IRR rule does not. Because of the potential pitfalls in the use of the IRR rule, our advice is always to base your final decision on the project's net present value.7 7 The other rules we've considered, such as payback or book rate of return, give poor guidance even in the much simpler case of the accept reject decision of a project considered in isolation. They are of no help in choosing among mutually exclusive projects....

What We Do Know The Six Most Important Ideas in Finance

What would you say if you were asked to name the six most important ideas in finance Here is our list. When you wish to know the value of a used car, you look at prices in the secondhand car market. Similarly, when you wish to know the value of a future cash flow, you look at prices quoted in the capital markets, where claims to future cash flows are traded (remember, those highly paid investment bankers are just secondhand cash-flow dealers). If you can buy cash flows for your shareholders at...

Example 212 Credit Scoring

Consider a firm with the following financial ratios EBIT 12 sales 14 market equity 9 total assets ' total assets ' book debt ' retained earnings 4 working capital 12 total assets ' total assets ' (3.3 x .12) + (1.0 x 1.4) + (.6 x .9) + (1.4 x .4) + (1.2 x .12) 3.04 This score is above the cutoff level for predicting bankruptcy, and thus would be considered favorably in terms of evaluating the firm's creditworthiness. see box p. 615. The nearby box describes how statistical scoring systems...

Book Values Liquidation Values and Market Values

Why is PepsiCo selling at 34 per share when the stock of Pfizer, listed below PepsiCo, is priced at 331 i6 And why does it cost 25 to buy one dollar of PepsiCo earnings, while Pfizer is selling at 40 times earnings Do these numbers imply that one stock is a better buy than the other Finding the value of PepsiCo stock may sound like a simple problem. Each year PepsiCo publishes a balance sheet which shows the value of the firm's assets and liabilities. The simplified balance sheet in Table 5.1...

Working capital and the cash conversion cycle

The difference between current assets and current liabilities is known as net working capital, but financial managers often refer to the difference simply (but imprecisely) as working capital. Usually current assets exceed current liabilities that is, firms have positive net working capital. For United States manufacturing companies, current assets are on average 30 percent higher than current liabilities. To see why firms need net working capital, imagine a small company, Simple Souvenirs,...

Net Present Value

In Chapter 3 you learned how to discount future cash payments to find their present value. We now apply these ideas to evaluate a simple investment proposal. Suppose that you are in the real estate business. You are considering construction of an office block. The land would cost 50,000 and construction would cost a further 300,000. You foresee a shortage of office space and predict that a year from now you will be able to sell the building for 400,000. Thus you would be investing 350,000 now...

Is Derivative a Four Letter Word

Our earlier examples of the farmer and the miller showed how derivatives futures, options, or swaps, for example can be used to reduce business risk. However, if you were to copy the farmer and sell wheat futures without an offsetting holding of wheat, you would not be reducing risk you would be speculating. A successful futures market needs speculators who are prepared to take on risk and provide the farmer and the miller with the protection they need. For example, if an excess of farmers...

Growth Stocks and Income Stocks

We often hear investors speak of growth stocks and income stocks. They seem to buy growth stocks primarily in 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 Brealey-Myers I II. Value I 5. Valuing Stocks I I The McGraw-Hill Fundamentals of Corporate Companies, 2001 payout ratio Fraction of earnings paid out as dividends. Fraction of earnings retained by the firm. buy income stocks...

Secured loans

Many short-term loans are unsecured, but sometimes the company may offer assets as security. Since the bank is lending on a short-term basis, the security generally consists of liquid assets such as receivables, inventories, or securities. For example, a firm may decide to borrow short-term money secured by its accounts receivable. When its customers pay their bills, it can use the cash collected to repay the loan. Banks will not usually lend the full value of the assets that are used as...

The Statement of Cash Flows

The firm requires cash when it buys new plant and machinery or when it pays interest to the bank and dividends to the shareholders. Therefore, the financial manager needs to keep track of the cash that is coming in and going out. We have seen that the firm's cash flow can be quite different from its net income. These differences can arise for at least two reasons 1. The income statement does not recognize capital expenditures as expenses in the year that the capital goods are paid for. Instead,...

International Capital Budgeting

KW Corporation is an American firm manufacturing flat-packed kit wardrobes. Its export business has risen to the point that it is considering establishing a small manufacturing operation overseas in Narnia. KW's decision to invest overseas should be based on the same criteria as a decision to invest in the United States that is, the company Brealey-Myers I VIII. Special Topics I 23. International Financial I I The McGraw-Hill needs to forecast the incremental cash flows from the project,...

What Is Financial Planning

Financial planning is a process consisting of 1. Analyzing the investment and financing choices open to the firm. 2. Projecting the future consequences of current decisions. 3. Deciding which alternatives to undertake. 4. Measuring subsequent performance against the goals set forth in the financial plan. Notice that financial planning is not designed to minimize risk. Instead it is a process of deciding which risks to take and which are unnecessary or not worth taking. Firms must plan for both...

Credit decisions with repeat orders

What effect does the possibility of repeat orders have on your credit decision One of the reasons for offering credit today is that you may get yourself a good, regular customer. Cast Iron has been asked to extend credit to a new customer. You can find little information on the firm and you believe that the probability of payment is no better than .8. If you grant credit, the expected profit on this order is Expected profit on initial order p x PV(REV - COST) - (1 - p) x PV(COST) This is the...

Reducing Risk with Options

In the last chapter we introduced you to put and call options. Managers regularly buy options on currencies, interest rates, and commodities to limit their downside risk. Many of these options are traded on options exchanges, but often they are simply private deals between the corporation and a bank. Petrochemical Parfum, Inc., is concerned about potential increases in the price of heavy crude oil, which is one of its major inputs. To protect itself against such increases Petrochemical buys...

Taxes and the weightedaverage cost of capital

Thus far in this section our examples have ignored taxes. Taxes are important because interest payments are deducted from income before tax is calculated. Therefore, the cost to the company of an interest payment is reduced by the amount of this tax saving. The interest rate on Geothermal's debt is rdebt 8 percent. However, with a corporate tax rate of Tc .35, the government bears 35 percent of the cost of the interest payments. The government doesn't send the firm a check for this amount, but...

Simplifying the Dividend Discount Model

The dividend discount model with no growth Consider a company that pays out all its earnings to its common shareholders. Such a company could not grow because it could not reinvest.6 Stockholders might enjoy a generous immediate dividend, but they could forecast no increase in future dividends. The company's stock would offer a perpetual stream of equal cash payments, DIV1 DIV2 . . . DIVt . . 6 We assume it does not raise money by issuing new shares. The dividend discount model says that these...

Example 53 Blue Skies Valued by the Constant Growth Model

Let's apply the constant-growth model to Blue Skies. Assume a dividend has just been paid. The next dividend, to be paid in a year, is forecast at DIV1 3, the growth rate of dividends is g 8 percent, and the discount rate is r 12 percent. Therefore, we solve for the stock value as p DIVi 3 75 Po r - g .12 - .08 75 The constant-growth formula is close to the formula for the present value of a perpetuity. Suppose you forecast no growth in dividends (g 0). Then the dividend stream is a simple...

Example 52 Valuing Blue Skies Stock

The firm is growing steadily and investors expect both the stock price and the dividend to increase at 8 percent per year. Now consider three investors, Erste, Zweiter, and Dritter. Erste plans to hold Blue Skies for 1 year, Zweiter for 2, and Dritter for 3. Compare their payoffs Remember, we assumed that dividends and stock prices for Blue Skies are expected to grow at a steady 8 percent. Thus DIV2 3 x 1.08 3.24, DIV3 3.24 x 1.08 3.50, and so on. Brealey-Myers I II. Value I 5....

The Du Pont System

Some profitability or efficiency measures can be linked in useful ways. These relationships are often referred to as the Du Pont system, in recognition of the chemical company that popularized them. The first relationship links the return on assets (ROA) with the firm's turnover ratio and its profit margin All firms would like to earn a higher return on their assets, but their ability to do so is limited by competition. If the expected return on assets is fixed by competition, firms face a...

Tracing Changes in Cash and Working Capital

Table 19.3 compares 1999 and 2000 year-end balance sheets for Dynamic Mattress Company. Table 19.4 shows the firm's income statement for 2000. Note that Dynamic's cash balance increases from 4 million to 5 million in 2000. What caused this increase Did the extra cash come from Dynamic Mattress Company's additional long-term borrowing From reinvested earnings From cash released by reducing inventory Or perhaps it came from extra credit extended by Dynamic's suppliers. (Note the increase in...

Components of a financial planning model

A completed financial plan for a large company is a substantial document. A smaller corporation's plan would have the same elements but less detail. For the smallest, youngest businesses, financial plans may be entirely in the financial managers' heads. The basic elements of the plans will be similar, however, for firms of any size. Financial plans include three components inputs, the planning model, and outputs. The relationship among these components is represented in Figure 18.1. Let's look...

The two faces of financial slack

Ready access to cash or debt financing. Other things equal, it's better to be at the top of the pecking order than at the bottom. Firms that have worked down the pecking order and need external equity may end up living with excessive debt or bypassing good investments because shares can't be sold at what managers consider a fair price. In other words, financial slack is valuable. Having financial slack means having cash, marketable securities, readily saleable real assets, and ready access to...

How Dividends Are Paid

In July 1999, Exxon's board of directors met to discuss the company's dividends. The cash dividend company announced a regular quarterly cash dividend of 0.41 per share, making a Payment of cash by the firm total payment for the year of 1.64. The term regular indicates that Exxon expected to to its shareho ders. maintain the payment in the future. If it did not want to give that kind of assurance, it could have declared both a regular and an extra dividend. Investors realize that extra...

The Cost of Bank Loans

Bank loans often extend for several years. Interest payments on these loans are sometimes fixed for the term of the loan but more commonly they are adjusted up or down as the general level of interest rates changes. The interest rate on bank loans of less than a year is almost invariably fixed for the term of the loan. However, you need to be careful when comparing rates on these shorter term bank loans, for the rates may be calculated in different ways. The interest rate on bank loans...

External Financing and Growth

Financial plans force managers to be consistent in their goals for growth, investments, and financing. The nearby box describes how one company was brought to its knees when it did not plan sufficiently for the cash that would be required to support its ambitions. Financial models, such as the one that we have developed for Executive Fruit, can help managers trace through the financial consequences of their growth plans and avoid such disasters. But there is a danger that the complexities of a...

Summary

What are the contents and uses of a financial plan Most firms take financial planning seriously and devote considerable resources to it. The tangible product of the planning process is a financial plan describing the firm's financial strategy and projecting its future consequences by means of pro forma balance sheets, income statements, and statements of sources and uses of funds. The plan establishes financial goals and is a benchmark for evaluating subsequent performance. Usually it also...

Why Dividends May Reduce Firm Value

Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, such financial alchemy should be welcomed by any taxpaying investor. Firms should pay the lowest cash dividend they can get away with. Available cash should be retained and reinvested or used to repurchase shares. Table 16.3 illustrates this. It assumes that dividends are taxed at a combined federal plus state tax rate...

Dubious Reasons for Mergers

The benefits that we have described so far all make economic sense. Other arguments sometimes given for mergers are more dubious. Here are two. We have suggested that the managers of a cash-rich company may prefer to see that cash used for acquisitions. That is why we often see cash-rich firms in stagnant industries merging their way into fresh woods and pastures new. What about diversification as an end in itself It is obvious that diversification reduces risk. Isn't that a gain from merging...

Do firms rely too heavily on internal funds

Gordon Donaldson, in a survey of corporate debt policies, encountered several firms which acknowledged that it was their long-term object to hold to a rate of growth which was consistent with their capacity to generate funds internally. A number of other firms appeared to think less hard about expenditure proposals that could be financed internally.7 At first glance, this behavior doesn't make sense. As we have already noted, retained profits are additional capital invested by shareholders and...

Example 204 The Optimal Cash Balance

Suppose that you can invest spare cash in U.S. Treasury bills at an interest rate of 8 percent, but every sale of bills costs you 20. Your firm pays out cash at a rate of 105,000 per month, or 1,260,000 per year. Our formula for the initial cash balance tells us that the optimal amount of Treasury bills that you should sell at one time is Thus your firm would sell approximately 25,000 of Treasury bills four times a month about once a week. Its average cash balance will be 25,000 2, or 12,500....

Debt and taxes at river cruises

Debt financing has one important advantage. The interest that the company pays is a tax-deductible expense but equity income is subject to corporate tax. To see the advantage of debt finance, let's look once again at River Cruises. Table 15.5 shows how expected income is reduced if profits are taxed at a rate of 35 percent. The left-hand column sets out the position if River Cruises is financed entirely by equity. The right-hand column shows what happens if the firm issues 500,000 of debt at an...

Example 223 Allied Signal Takes Over AMP

Poison pill Measure taken by a target firm to avoid acquisition for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding. AMP was the world's largest producer of cables for computers and other electronic equipment. Its performance had disappointed investors, and the company was widely viewed as ripe for change in operations and management. AlliedSignal believed that it could make these changes faster and better than...

Internal rate of return

Instead of calculating a project's net present value, companies often prefer to ask whether the project's return is higher or lower than the opportunity cost of capital. For example, think back to the original proposal to build the office block. You planned to invest 350,000 to get back a cash flow of C1 400,000 in 1 year. Therefore, you forecasted a profit on the venture of 400,000 - 350,000 50,000, and a rate of return of , _ , profit C1 - investment 400,000 - 350,000 Rate of return - ----...

Break Even Analysis

Accounting Break Even Analysis Brealey

Break-even analysis Analysis of the level of sales at which the company breaks even. 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 we have misestimated sales or costs. Managers sometimes prefer to rephrase this question and ask how far off the estimates could be before the project begins to lose money. This exercise is known as break-even analysis. For many projects, the make-or-break variable is sales...

How Do Companies Decide on Dividend Payments

What does the board of directors think about when it sets the dividend To help answer this question, John Lintner conducted a classic series of interviews with corporate managers about their dividend policies.8 His description of how dividends are determined can be summarized in four stylized facts 1. Firms have long-run target dividend payout ratios. This ratio is the fraction of earnings paid out as dividends. 2. Managers focus more on dividend changes than on absolute levels. Thus paying a 8...

Example 82 Scenario Analysis

You are worried that Stop and Scoff may decide to build a new store in nearby Salome. That would reduce sales in your Gravenstein store by 15 percent and you might be forced into a price war to keep the remaining business. Prices might be reduced to the point that variable costs equal 82 percent of revenue. Table 8.3 shows that under this Brealey-Myers I II. Value I 8. Project Analysis I I The McGraw-Hill Fundamentals of Corporate Companies, 2001 Scenario analysis, NPV of Finefodder's...

Why Dividends May Increase Firm Value

Most economists believe that MM's conclusions are correct, given their assumptions of perfect and efficient capital markets. However, nobody claims their model is an exact description of the so-called real world. Thus the impact of dividend policy finally boils down to arguments about imperfections and inefficiencies. Those who believe that dividends are good argue that some investors have a natural preference for high-payout stocks. For example, some financial institutions are legally...

Financial distress without bankruptcy

Not every firm that gets into trouble goes bankrupt. As long as the firm can scrape up enough cash to pay the interest on its debt, it may be able to postpone bankruptcy for many years. Eventually the firm may recover, pay off its debt, and escape bankruptcy altogether. A narrow escape from bankruptcy does not mean that costs of financial distress are 7 S. P. Sherman, Bankruptcy's Spreading Blight, Fortune, June 3, 1991, pp. 123-132. 8 G. Andrade and S. N. Kaplan, How Costly Is Financial Not...

Why Dividend Policy Should Not Matter

The first step toward understanding dividend policy is to recognize that the phrase means different things to different people. Therefore, we must start by defining what we mean by it. A firm's decisions about dividends are often intertwined with other financing and investment decisions. Some firms pay low dividends because management is optimistic about the firm's future and wishes to retain earnings for expansion. In this case the dividend is a by-product of the firm's capital budgeting...

Fundamentals and Principles of Corporate Finance

This book is derived in part from its sister text Principles of Corporate Finance. The spirit of the two books is similar. Both apply modern finance to give students a working ability to make financial decisions. However, there are also substantial differences between the two books. First, we provide much more detailed discussion of the principles and mechanics of the time value of money. This material underlies almost all of this text, and we spend a lengthy chapter providing extensive...

Cash Cow International Paid A Regular Quartlery Dividend

How are dividends paid and how do companies decide on dividend payments Dividends come in many forms. The most common is the regular cash dividend, but sometimes companies pay an extra cash dividend, and sometimes they pay a stock dividend. A firm is not free to pay dividends at will. For example, it may have accepted restrictions on dividends as a condition for borrowing money. Most managers seem to have a target dividend payout ratio. But if firms simply applied this target payout rate to...

Reliable Gearing Currently Is All-equity-financed

What is the goal of the capital structure decision What is the financial manager trying to do The goal is to maximize the overall market value of all the securities issued by the firm. Think of the financial manager as taking all the firm's real assets and selling them to investors as a package of securities. Some financial managers choose the simplest package possible all-equity financing. Others end up issuing dozens of types of debt and equity securities. The financial manager must try to...

Annuities due

Annuity due Level stream of cash flows starting immediately. The perpetuity and annuity formulas assume that the first payment occurs at the end of the period. They tell you the value of a stream of cash payments starting one period hence. However, streams of cash payments often start immediately. For example, Kangaroo Autos in Example 3.8 might have required three annual payments of 4,000 starting immediately. A level stream of payments starting immediately is known as an annuity due. If...

Variance and standard deviation

The third histogram in Figure 9.3 shows the variation in common stock returns. The returns on common stock have been more variable than returns on bonds and Treasury bills. Common stocks have been risky investments. They will almost certainly continue to be risky investments. Investment risk depends on the dispersion or spread of possible outcomes. Sometimes a picture like Figure 9.3 tells you all you need to know about past dispersion. But in general, pictures do not suffice. The financial...

Costs of Financial Distress

Trade Off Theory

Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice. As we will see, financial distress is costly. Investors know that levered firms may run into financial difficulty, and they worry about the costs of financial distress. That worry is reflected in the current market value of the levered firm's securities. Even if the firm is not now in financial distress,...

Risk and Return

In Chapter 9 we looked at past returns on selected investments. The least risky investment was U.S. Treasury bills. Since the return on Treasury bills is fixed, it is unaffected by what happens to the market. Thus the beta of Treasury bills is zero. The most risky investment that we considered was the market portfolio of common stocks. This has average market risk its beta is 1.0. Wise investors don't run risks just for fun. They are playing with real money and therefore require a higher return...

General Cash Offers by Public Companies

Sale of securities by a firm that is already publicly traded. rights issue Issue of securities offered only to current stockholders. After the initial public offering a successful firm will continue to grow and from time to time it will need to raise more money by issuing stock or bonds. An issue of additional stock by a company whose stock already is publicly traded is called a seasoned offering. Any issue of securities needs to be formally approved by the firm's board of directors. If a stock...

Finding the Value of Free Credit

Kangaroo Autos is offering free credit on a 10,000 car. You pay 4,000 down and then the balance at the end of 2 years. Turtle Motors next door does not offer free credit but will give you 500 off the list price. If the interest rate is 10 percent, which company is offering the better deal Notice that you pay more in total by buying through Kangaroo, but, since part of the payment is postponed, you can keep this money in the bank where it will continue to earn interest. To compare the two...

Geothermals Cost of Capital

Jo Ann Cox, a recent graduate of a prestigious eastern business school, poured a third cup of black coffee and tried again to remember what she once knew about project hur- 1 Investors will invest in the firm's securities only if they offer the same expected return as that of other equally risky securities. When securities are properly priced, the return that investors can expect from their investments is therefore also the return that they require. Brealey-Myers I III. Risk I 11. The Cost of...

Example 103 How Would You Invest 1 Million

Have you ever daydreamed about receiving a 1 million check, no strings attached, from an unknown benefactor Let's daydream about how you would invest it. We have two good candidates Treasury bills, which offer an absolutely safe return, and the market portfolio possibly via the Vanguard index fund discussed earlier in this Brealey-Myers I III. Risk I 10. Risk, Return, and I I The McGraw-Hill Fundamentals of Corporate Capital Budgeting Companies, 2001 chapter 10 Risk, Return, and Capital...

Example Blooper Industries

Now that we have examined many of the pieces of a cash-flow analysis, let's try to put them together into a coherent whole. As the newly appointed financial manager of Blooper Industries, you are about to analyze a proposal for mining and selling a small deposit of high-grade magnoosium ore.4 You are given the forecasts shown in Table 7.1. We will walk through the lines in the table. Profit projections for Blooper's magnoosium mine figures in thousands of dollars Note Some entries subject to...

Npv breakeven analysis

Sales Fundamentals Breakeven

Instead of asking how bad sales can get before the project makes an accounting loss, it is more useful to focus on the point at which NPV switches from positive to negative. The cash flows of the project in each year will depend on sales as follows Brealey-Myers I II. Value I 8. Project Analysis I I The McGraw-Hill Fundamentals of Corporate Companies, 2001 .40 x .1875 x sales - 2.45 million .60 x .1875 x sales - 2.45 million 450,000 .60 x .1875 x sales - 2.45 million This cash flow will last...

How Borrowing Affects Value in a Tax Free Economy

It is after the ball game and the pizza man is delivering a pizza to Yogi Berra. Should I cut it into four slices as usual, Yogi asks the pizza man. No, replies Yogi, Cut it into eight I'm hungry tonight. chapter 15 The Capital Structure Decision 425 If you understand why more slices won't sate Yogi's appetite, you will have no difficulty capital structure understanding why a company's choice of capital structure can't increase the underly-Firm's mix of financing. ing value of the cash flows...

The capital structure decision

How Borrowing Affects Value in a Tax-Free Economy How Borrowing Affects Earnings per Share How Borrowing Affects Risk and Return Debt and the Cost of Equity Capital Structure and Corporate Taxes How Interest Tax Shields Contribute to the Value of Stockholders' Equity Corporate Taxes and the Weighted-Average Cost of Capital The Implications of Corporate Taxes for Capital Structure Direct versus Indirect Costs of Bankruptcy Financial Distress without Bankruptcy Costs of Distress Vary with Type of...

Treasury Bonds Notes Bills

Representative Over-the-Counter quotations based on transactions of 1 million or more. Treasury bond, note and bill quotes are as of mid-afternoon. Colons in bid-and-asked quotes represent 32nds 101 01 means 101 1 32. Net changes in 32nds. n-Treasury note. Treasury bill quotes in hundredths, quoted on terms of a rate of discount. Days to maturity calculated from settlement date. All yields are to maturity and based on the asked quote. Latest 13-week and 26-week bills are boldfaced. For bonds...

Example 43 Calculating Yield to Maturity for the Treasury Bond

We found the value of the 6 percent coupon Treasury bond by discounting at a 5.6 percent interest rate. We could have phrased the question the other way around If the price of the bond is 1,010.77, what return do investors expect We need to find the yield to maturity, in other words, the discount rate r that solves the following equation Price TTr TTr 2 TTr 3 1,010.77 Bond Valuation on a Financial Calculator In Chapter 3 we saw that financial calculators can compute the present values of level...

Measuring Capital Structure

We have explained the formula for calculating the weighted-average cost of capital. We will now look at some of the practical problems in applying that formula. Suppose that the financial manager of Big Oil has asked you to estimate the firm's weighted-average cost of capital. Your first step is to work out Big Oil's capital structure. But where do you get the data Financial managers usually start with the company's accounts, which show the book value of debt and equity, whereas the...

Calculating Eurotunnels NPV

One of the world's largest commercial investment projects was construction of the Channel Tunnel by the Anglo-French company Eurotunnel. Here is a chance to put yourself in the shoes of Eurotunnel's financial manager and find out whether the project looked like a good deal for shareholders. The figures in the column headed cash flow in Table 6.1 are based on the forecasts of construction costs and revenues that the company provided to investors in 1986. The Channel Tunnel project was not a safe...

Book value versus market value

We discussed the distinction between book and market value in Chapters 2 and 5, but it bears repeating. Book value is a backward-looking measure. It tells us how much capital the firm has raised from shareholders in the past. It does not measure the value that investors place on those shares today. The market value of the firm is forward-looking it depends on the future dividends that shareholders expect to receive. Heinz's common equity has a book value of 1,803 million. With 358 million...

Example 64 Choosing between Two Projects

It has been several years since your office last upgraded its office networking software. Two competing systems have been proposed. Both have an expected useful life of 3 years, at which point it will be time for another upgrade. One proposal is for an expensive cutting-edge system, which will cost 800,000 and increase firm cash flows by 350,000 a year through increased productivity. The other proposal is for a cheaper, somewhat slower system. This system would cost only 700,000 but would...

Interpreting the Weighted Average Cost of Capital

We first discussed the company cost of capital in Chapter 10, but at that stage we did not know how to measure the company cost of capital when the firm has issued different types of securities or how to adjust for the tax-deductibility of interest payments. The weighted-average cost of capital formula solves those problems. The weighted-average cost of capital is the rate of return that the firm must expect to earn on its average-risk investments in order to provide a fair expected return to...

Example 55 Estimating the Value of United Bird Seeds Stock

Dawn Chorus, founder and president of United Bird Seed, is wondering whether the company should make its first public sale of common stock and if so at what price. The company's financial plan envisages rapid growth over the next 3 years but only moderate growth afterwards. Forecast earnings and dividends are as follows per share 2.45 3.11 3.78 5 growth thereafter per share_ 1.00 1.20 1.44 5 growth thereafter_ Brealey-Myers I II. Value I 5. Valuing Stocks I I The McGraw-Hill Fundamentals of...

Fill In The Blanks By Choosing The Appropriate Term From The Following List Lease Funded Floating Rate Eurobond

What are the major classes of securities issued by firms to raise capital Companies may raise money from shareholders by issuing more shares. They also raise money indirectly by plowing back cash that could otherwise have been paid out as dividends. Preferred stock offers a fixed dividend but the company has the discretion not to pay it. It can't, however, then pay a dividend on the common stock. Despite its name, preferred stock is not a popular source of finance, but it is useful in special...

What Is an Efficient Market

Stocks Bonds Bills And Inflation

Security prices change randomly, with no predictable trends or patterns. a startling discovery price changes are random As is so often the case with important ideas, the concept of efficient markets was a byproduct of a chance discovery. In 1953 the Royal Statistical Society met in London to discuss a rather unusual paper.1 Its author, Maurice Kendall, was a distinguished statistician, and the subject was the behavior of stock and commodity prices. Kendall had been looking for regular price...

Valuing Common Stocks

The cash payoff to owners of common stocks comes in two forms 1 cash dividends and 2 capital gains or losses. Usually investors expect to get some of each. Suppose that the current price of a share is P0, that the expected price a year from now is P1, and that the expected dividend per share is DIV1. The subscript on P0 denotes time zero, which is today the subscript on P1 denotes time 1, which is 1 year hence. We simplify by assuming that dividends are paid only once a year and that the next...

A comment on risk and present value

In our discussion of the office development we assumed we knew the value of the completed project. Of course, you will never be certain about the future values of office buildings. The 400,000 represents the best forecast, but it is not a sure thing. Therefore, our initial conclusion about how much investors would pay for the building is wrong. Since they could achieve 400,000 risklessly by investing in 373,832 worth of U.S. Treasury bills, they would not buy your building for that amount. You...

Calculating the Weighted Average Cost of Capital

It should be obvious by now that the choice of the discount rate can be crucial, especially when the project involves large capital expendi-see box p. 321. tures or is long-lived. The nearby box describes how a major investment in a power station an investment with both a large capital expenditure and very long life turned on the choice of the discount rate. Think again what the company cost of capital is, and what it is used for. We define Fundamentals of...

If The Expected Return On The Market Portfolio Is Estimated To Be 19 The Risk-free Rate Of Interestt Is

How can you measure and interpret the market risk, or beta, of a security The contribution of a security to the risk of a diversified portfolio depends on its market risk. But not all securities are equally affected by fluctuations in the market. The sensitivity of a stock to market movement is known as beta. Stocks with a beta greater than 1.0 are particularly sensitive to market fluctuations. Those with a beta of less than 1.0 are not so sensitive to such movements. The average beta of all...

What Happens To The Opportunity Cost Of Capital If Investors Become Especially Conservative And Less Willing To Bear

How can one estimate the opportunity cost of capital for an average-risk project Over the past 73 years the return on the Standard amp Poor's Composite Index of common stocks has averaged almost 9.4 percent a year higher than the return on safe Treasury bills. This is the risk premium that investors have received for taking on the risk of investing in stocks. Long-term bonds have offered a higher return than Treasury bills but less than stocks. If the risk premium in the past is a guide to the...

Emperor S Clothes Fashions Can Invest 5 Million In A New Plant For Producing Invisible Makeup. The Plant Has An

What are some of the practical problems of capital budgeting in large corporations For most large corporations there are two stages in the investment process the preparation of the capital budget, which is a list of planned investments, and the authorization process for individual projects. This process is usually a cooperative effort. Investment projects should never be selected through a purely mechanical process. Managers need to ask why a project should have a positive NPV. A positive NPV...

Problems

Find the depreciation charge each year. b. If the sewing machine is sold after 3 years for 20,000, what will be the after-tax proceeds on the sale if the firm's tax bracket is 35 percent 12. Proper Cash Flows. Conference Services Inc. has leased a large office building for 4 million per year. The building is larger than the company needs two of the building's eight stories are almost empty. A manager wants to expand one of her projects, but this will require using one of the empty floors. In...

The Income Statement

If Pepsi's balance sheet resembles a snapshot of the firm at a particular time, its income statement is like a video. It shows how profitable the firm has been during the past year. Look at the summary income statement in Table 2.2. You can see that during 1998 Pepsi sold goods worth 22,348 million and that the total expenses of producing and selling goods was 9,330 291 8,912 18,533 million. The largest expense item, amounting to 9,330 million, consisted of the raw materials, labor, and so on,...

Further notes and wrinkles arising from bloopers project

Before we leave Blooper and its magnoosium project, we should cover a few extra wrinkles. accelerated cost recovery system macrs Depreciation method that allows higher tax deductions in early years and lower deductions later. A Further Note on Depreciation. We warned you earlier not to assume that all cash flows are likely to increase with inflation. The depreciation tax shield is a case in point, because the Internal Revenue Service lets companies depreciate only the amount of the original...

Example 65 Equivalent Annual Cost

You can either purchase one outright for 15,000 or lease one for 7 years for 3,000 a year. If you buy the car, it will be worth 500 to you in 7 years. The discount rate is 10 percent. Should you buy or lease What is the maximum lease you would be willing to pay The present value of the cost of purchasing is The equivalent annual cost of purchasing the car is therefore the annuity with this present value 7-year annuity PV costs Equivalent annual cost x . 14,743 u i i 14,743...

Capital Rationing

A firm maximizes its shareholders' wealth by accepting every project that has a positive net present value. But this assumes that the firm can raise the funds needed to pay for these investments. This is usually a good assumption, particularly for major firms which can raise very large sums of money on fair terms and short notice. Why then does top management sometimes tell subordinates that capital is limited and that they may not exceed a specified amount of capital spending There are two...

Planned Obsolescence Has A Product That Will Be In Vogue For 3 Years At Which Point The Firm Will Close Up Shop And

What information about company stocks is regularly reported in the financial pages of the newspaper Firms that wish to raise new capital may either borrow money or bring new partners into the business by selling shares of common stock. Large companies usually arrange for their stocks to be traded on a stock exchange. The stock listings report the stock's dividend yield, price, and trading volume. How can one calculate the present value of a stock given forecasts of future dividends and future...

Nominal and real rates of interest

In Chapter 3 we drew a distinction between nominal and real rates of interest. The cash flows on the 6 percent Treasury bonds are fixed in nominal terms. Investors are sure to receive an interest payment of 60 each year, but they do not know what that money will buy them. The real interest rate on the Treasury bonds depends on the rate of in- Brealey-Myers I II. Value I 4. Valuing Bonds I I The McGraw-Hill Fundamentals of Corporate Companies, 2001 flation. For example, if the nominal rate of...

Econo-cool Air Conditioners Cost 300 To Purchase Result In Electricity Bills Of 150 Per Year And Last For 5 Years.

What is the net present value of an investment, and how do you calculate it The net present value of a project measures the difference between its value and cost. NPV is therefore the amount that the project will add to shareholder wealth. A company maximizes shareholder wealth by accepting all projects that have a positive NPV. How is the internal rate of return of a project calculated and what must one look out for when using the internal rate of return rule Instead of asking whether a...

Topics Covered in This Book

This book covers investment decisions first, then financing decisions, and then a variety of planning issues that require understanding of both investments and financing. In Parts Two and Three we look at different aspects of the investment decision. The first is the problem of how to value assets, and the second is the link between risk and value. Our discussion of these topics occupies Chapters 3 through 11. Nine chapters devoted to the simple problem of finding real assets that are worth...

The Role of the Financial Manager

To carry on business, companies 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 must be paid for. To obtain the necessary money, the company sells financial assets, or securities.3 These pieces of paper have value because they are claims on the firm's real assets and the cash that those assets will produce. For example, if the...

Future Values and Compound Interest

Compound Interest Future Value Chart

You have 100 invested in a bank account. Suppose banks are currently paying an interest rate of 6 percent per year on deposits. So after a year, your account will earn interest of 6 Brealey-Myers I II. Value I 3. The Time Value of I I The McGraw-Hill Fundamentals of Corporate Money Companies, 2001 chapter 3 The Time Value of Money 59 Amount to which an investment will grow after earning interest. Interest earned only on the original investment no interest is earned on interest. Interest...

Coupon Rate. General Matter S Outstanding Bond Issue Has A Coupon Rate Of 10 And A Current Yield Of 9.6 And It Sells At

What are the differences between the bond's coupon rate, current yield, and yield to maturity A bond is a long-term debt of a government or corporation. When you own a bond, you receive a fixed interest payment each year until the bond matures. This payment is known as Brealey-Myers I II. Value I 4. Valuing Bonds I I The McGraw-Hill Fundamentals of Corporate Companies, 2001 the coupon. The coupon rate is the annual coupon payment expressed as a fraction of the bond's face value. At maturity the...

Example 44 Rate of Return versus Yield to Maturity

Our 6 percent coupon bond with maturity 2002 currently has 3 years left until maturity and sells today for 1,010.77. Its yield to maturity is 5.6 percent. Suppose that by the end of the year, interest rates have fallen and the bond's yield to maturity is now only 4 percent. What will be the bond's rate of return At the end of the year, the bond will have only 2 years to maturity. If investors then demand an interest rate of 4 percent, the value of the bond will be You invested 1,010.77. At the...

The Balance Sheet

We will look first at the balance sheet, which presents a snapshot of the firm's assets and the source of the money that was used to buy those assets. The assets are listed on the left-hand side of the balance sheet. Some assets can be turned more easily into cash than others these are known as liquid assets. The accountant puts the most liquid assets at the top of the list and works down to the least liquid. Look, for example, at the left-hand column of Table 2.1, the balance sheet for...

Goals of the Corporation

Shareholders want managers to maximize market value For small firms, shareholders and management may be one and the same. But for large companies, separation of ownership and management is a practical necessity. For ex- Internet sites for careers in finance Internet sites for careers in finance Extensive salary information, general advice, and industry prospects. Government site with job and qualification profiles, as well as salary data. Go to Publications and Research Papers and then...

South Sea Baubles Has The Following Incomplete Balance Sheet And Income Statement

Taxes often have a major effect on financial decisions. Therefore, we should explain how corporations and investors are taxed. Companies pay tax on their income. Table 2.4 shows that there are special low rates of corporate tax for small companies, but for large companies those with income over 18.33 million the corporate tax rate is 35 percent. Thus for every 100 that the firm earns it pays 35 in corporate tax. When firms calculate taxable income they are allowed to deduct expenses. These...

Organizing a Business

In 1901 pharmacist Charles Walgreen bought the drugstore in which he worked on the South Side of Chicago. Today Walgreen's is the largest drugstore chain in the United States. If, like Charles Walgreen, you start on your own, with no partners or stockhold- chapter 1 The Firm and the Financial Manager 5 Sole owner of a business which has no partners and no shareholders. The proprietor is personally liable for all the firm's obligations. ers, you are said to be a sole proprietor. You bear all the...

Who Is the Financial Manager

In this book we will use the term financial manager to refer to anyone responsible for a significant corporate investment or financing decision. But except in the smallest 8 Mutual funds provide other services. For example, they take care of much of the paperwork of holding shares. Investors also hope that the fund's professional managers will be able to outsmart the market and secure higher returns. The financial managers in large corporations. The financial managers in large corporations....