Raluca.ibanescu@yahoo.com 127 Principles Of Managerial Finance 13th Edition Text

Principles of Managerial Finance Adelman/Marks Entrepreneurial Finance Andersen Global Derivatives: A Strategic RiskManagement Perspective Bekaert/Hodrick International Financial Management Berk/DeMarzo Corporate Finance* Berk/DeMarzo Corporate Finance: The Core* Berk/DeMarzo/Harford Fundamentals of Corporate Finance* Boakes Reading and Understanding theFinancial Times Brooks Financial Management: CoreConcepts* Copeland/Weston/Shastri Financial Theory and CorporatePolicy Dorfman/Cather Introduction to Risk Management andInsurance Eiteman/Stonehill/Moffett Multinational Business Finance Fabozzi Bond Markets: Analysis and Strategies Fabozzi/Modigliani Capital Markets: Institutions andInstruments Fabozzi/Modigliani/Jones/Ferri Foundations of Financial Markets andInstitutions Finkler Financial Management for Public,Health, and Not-for-ProfitOrganizations Frasca Personal Finance Gitman/Joehnk/Smart Fundamentals of Investing* Gitman/Zutter Principles of Managerial Finance*Gitman/Zutter Principles of Managerial Finance—Brief Edition* Goldsmith Consumer Economics: Issues andBehaviors Haugen The Inefficient Stock Market: WhatPays Off and Why Haugen The New Finance: Overreaction,Complexity, and Uniqueness Holden Excel Modeling and Estimation inCorporate Finance Holden Excel Modeling and Estimation inInvestments Hughes/MacDonald International Banking: Text and Cases Hull Fundamentals of Futures and OptionsMarkets Hull Options, Futures, and OtherDerivatives Hull Risk Management and FinancialInstitutions Keown Personal Finance: Turning Money intoWealth* Keown/Martin/Petty Foundations of Finance: The Logicand Practice of FinancialManagement* Kim/Nofsinger Corporate Governance Madura Personal Finance* Marthinsen Risk Takers: Uses and Abuses ofFinancial Derivatives McDonald Derivatives MarketsMcDonald Fundamentals of Derivatives Markets Mishkin/Eakins Financial Markets and Institutions Moffett/Stonehill/Eiteman Fundamentals of MultinationalFinance Nofsinger Psychology of Investing Ormiston/Fraser Understanding Financial Statements Pennacchi Theory of Asset Pricing Rejda Principles of Risk Management andInsurance Seiler Performing Financial Studies: A Methodological Cookbook Shapiro Capital Budgeting and InvestmentAnalysis Sharpe/Alexander/Bailey Investments Solnik/McLeavey Global Investments Stretcher/Michael Cases in Financial Management Titman/Keown/Martin Financial Management: Principles and Applications* Titman/Martin Valuation: The Art and Science ofCorporate Investment Decisions Van Horne Financial Management and Policy Van Horne/Wachowicz Fundamentals of FinancialManagement Weston/Mitchel/Mulherin Takeovers, Restructuring, and Corporate Governance * denotes titles Log onto www.myfinancelab.com to learn moreThe Prentice Hall Series in Finance Lawrence J. Gitman San Diego State University Chad J. Zutter University of Pittsburgh Prentice Hall Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei TokyoPrinciples of Managerial Finance Thirteenth Edition Editor in Chief: Donna Battista Acquisitions Editor: Tessa O’BrienEditorial Project Managers: Melissa Pellerano and Kerri McQueen Managing Editor: Nancy FentonSenior Production Project Manager: Nancy FreihoferSupplements Editor: Alison EusdenMarketing Assistant: Ian GoldMedia Producer: Nicole SackinMyFinanceLab Content Lead: Miguel LeonarteSenior Manufacturing Buyer: Carol Melville Cover Designer: Anthony GemmellaroCover Image: Stock4B-RF/Getty ImagesImage Permission Coordinator: Rachel YoudelmanPhoto Researcher: Elizabeth AndersonInterior Design, Project Coordination, and Composition: Nesbitt Graphics, Inc. Printer/Binder: R.R. Donnelley, WillardCover Printer: Lehigh PhoenixText Font: 10/12 Sabon Prentice Hall is an imprint ofCredits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text (or on page C1). Microsoft®and Windows®are registered trademarks of the Microsoft Corporation in the U.S.A. and other countries. Screen shots and icons reprinted with permission from the MicrosoftCorporation. This book is not sponsored or endorsed by or affiliated with the MicrosoftCorporation. Copyright © 2012, 2009, 2006, 2003 by Lawrence J. Gitman. All rights reserved. Manufactured in the United States of America. This publication is protected byCopyright, and permission should be obtained from the publisher prior to any prohibited repro-duction, storage in a retrieval system, or transmission in any form or by any means, electronic,mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Rights and ContractsDepartment, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at http://www.pearsoned.com/legal/permission.htm. Many of the designations by manufactures and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of atrademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data Gitman, Lawrence J. Principles of managerial finance/Lawrence J. Gitman, Chad J. Zutter.—13th ed. p. cm.—(The Prentice Hall series in finance) Includes index.ISBN 978-0-13-611946-3 (alk. paper)1. Corporations—Finance. 2. Business enterprises—Finance. I. Zutter, Chad J. II. Title. HG4011.G52 2010658.15—dc22 2010044526 ISBN-13: 978-0-13-611946-3 ISBN-10: 0-13-611946-8 Dedicated to the memory of my mother, Dr. Edith Gitman, who instilled in me the importance of education and hard work. LJG Dedicated to my wonderful wife, Heidi Zutter, who unconditionally supports my every endeavor. CJZ This page intentionally left blank viiOur Proven Teaching and Learning System Users of Principles of Managerial Finance have praised the effectiveness of the book’s Teaching and Learning System, which they hail as one of its hall- marks. The system, driven by a set of carefully developed learning goals, has beenretained and polished in this thirteenth edition. The “walkthrough” on the pagesthat follow illustrates and describes the key elements of the Teaching andLearning System. We encourage both students and instructors to acquaint them-selves at the start of the semester with the many useful features the book offers. SixLearning Goals at the start of the chapter highlight the most important con-cepts and techniques in the chapter. Studentsare reminded to think about the learninggoals while working through the chapter bystrategically placed learning goal icons . Every chapter opens with a feature, titled Why This Chapter Matters to You , that helps motivate student interest by high-lighting both professional and personalbenefits from achieving the chapterlearning goals. Its first part, In Your Professional Life , discusses the intersection of the financetopics covered in the chapter with the con-cerns of other major business disciplines. Itencourages students majoring in accounting,information systems, management, mar-keting, and operations to appreciate howfinancial acumen will help them achievetheir professional goals. The second part, In Your Personal Life , identifies topics in the chapter that willhave particular application to personalfinance. This feature also helps studentsappreciate the tasks performed in a busi-ness setting by pointing out that the tasksare not necessarily different from thosethat are relevant in their personal lives. Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand the relationships between the accounting and finance functions within the firm; how decision makers rely on the financial statements you prepare; why maximizing a firm’s value is not the same as maximizing its profits; and the ethical duty that you have when reporting financial results to investors and otherstakeholders. INFORMATION SYSTEMS You need to understand why financial infor- mation is important to managers in all functional areas; the documenta- tion that firms must produce to comply with various regulations; and how manipulating information for personal gain can get managers into serious trouble. MANAGEMENT You need to understand the various legal forms of a business organization; how to communicate the goal of the firm to employees and other stakeholders; the advantages and disadvantages of the agency relationship between a firm’s managers and its owners; and how compensation systems can align or misalign the interests of managers and investors. MARKETING You need to understand why increasing a firm’s revenues or market share is not always a good thing; how financial managersevaluate aspects of customer relations such as cash and credit manage-ment policies; and why a firm’s brands are an important part of its value to investors. OPERATIONS You need to understand the financial benefits of increasing a firm’s production efficiency; why maximizing profit by cut- ting costs may not increase the firm’s value; and how managers act on behalf of investors when operating a corporation. Many of the principles of manage- rial finance also apply to your per- sonal life. Learning a few simple financial principles can help you manage your own money more effectively.In your personal lifeLearning Goals Define finance and the managerial finance function. Describe the legal forms of business organization. Describe the goal of the firm, and explain why maximizing the value of the firm is an appropriate goal for a business. Describe how the managerial finance function is related to economics and accounting. Identify the primary activities of the financial manager. Describe the nature of the principal–agent relationshipbetween the owners and managers of a corporation, and explain how various corporategovernance mechanisms attempt to manage agency problems.LG6LG5LG4LG3LG2LG11The Role of Managerial Finance 2 Each chapter begins with a short opening vignette that describes a recent real-company eventrelated to the chapter topic. Thesestories raise interest in the chapterby demonstrating its relevance inthe business world. Learning goal icons tie chapter con- tent to the learning goals and appearnext to related text sections and again inthe chapter-end summary, end-of-chapter homework materials, and sup-plements such as the Study Guide, Test Item File, and MyFinanceLab.3In No Hurry to Go Public Facebook founder and chief executive officer Mark Zuckerberg is in no hurry to go public, even though he concedes that it is an inevitable step in the evolution of his firm. The Facebook CEO ison record saying that “we’re going to go public eventually, because that’s the contract that we have with our investors and our employees. . . . [but] we are definitely in no rush.” Nearly all public firms were at one time privately held by relatively few shareholde rs, but at some point the firms’ managers decided to go public. The decision to go public is one of the most important decisions managers can make. Private firms are typically held by fewer shareholders and are subject to less regulation than are public firms. So why do firms go public at all? Often it is to provide an exit strategy for its private investors, gain access to investment capital, establish a market p rice for the firm’s shares, gain public exposure, or all of the above. Going public helps firms grow, but that andother benefits of public ownership must be weighed against the costs of going public. Although taking Facebook public would likely make Zuckerberg one of the richest persons in the world under the age of 30, it would also mean that his firm would become subject to the influences of outside investors and government regulators. A public firm’s managers work for andare responsible to the firm’s investors, and government regulations require firms to provide investors with frequent reports disclosing material information about the firm’s performance. The regulatory demands placed on managers of public firms can sometimes distract managers fr om important aspects of running their businesses. This chapter will highlight the tradeoffs faced by financial managers as they make decisions intended to maximize the value of their firms. Facebook 1.1Finance and Business The field of finance is broad and dynamic. Finance influences everything that firms do, from hiring personnel to building factories to launching new advertisingcampaigns. Because there are important financial dimensions to almost anyaspect of business, there are many financially oriented career opportunities forthose who understand the basic principles of finance described in this textbook.Even if you do not see yourself pursuing a career in finance, you’ll find that anunderstanding of a few key ideas in finance will help make you a smarter con-sumer and a wiser investor with your own money.LG2 LG1 Corporations Acorporation is an entity created by law. A corporation has the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property in its own name. Although only about 20 percent of all U.S. businesses are incorporated, the largest businesses nearly always are; corpora- tions account for nearly 90 percent of total business revenues. Although corpora- tions engage in all types of businesses, manufacturing firms account for thelargest portion of corporate business receipts and net profits. Table 1.1 lists the key strengths and weaknesses of corporations.corporation An entity created by law. stockholders The owners of a corporation, whose ownership, or equity, takes the form of eithercommon stock or preferred stock.For help in study and review, boldfaced key terms and their definitions appear in the margin where they are first intro-duced. These terms are also boldfaced inthe book’s index and appear in the end-of-book glossary. viii Matter of Fact boxes provide inter- esting empirical facts that add back-ground and depth to the materialcovered in the chapter.Matter of fact The P/E multiple approach is a fast and easy way to estimate a stock’s value. However, P/E ratios vary widely over time. In 1980, the average stock had a P/E ratio below 9, but by the year 2000, the ratio had risen above 40. Therefore, analysts using the P/E approach in the 1980s would have come up with much lower estimates of value than analysts using the model 20 years later. In other words, when using this approach to estimate stock values, the estimate will depend more on whether stock market valuations generally are high or low rather than on whether the particular company is doing well or not.Problems with P/E Valuation (7.3) If we simplify Equation 7.3, it can be rewritten as:P0=D0*(1+g)1 (1+rs)1+D0*(1+g)2 (1+rs)2+Á+D0*(1+g)q (1+rs)qIn more depth To read about Deriving the Constant-Growth Model , go to www.myfinancelab.com Fran Abrams wishes to determine how much money she will have at the end of 5 years if she chooses annuity A, the ordinary annuity. She will deposit $1,000 annually, at the end of each of the next 5 years, into a savings account paying 7% annual interest. This situation is dep icted on the following time line:Personal Finance Example 5.73 $1,000 $1,000 $1,000 $1,000 $1,000$1,310.80 1,225.041,144.901,070.00 1,000.00 $5,750.74 Future ValueTime line for future value of an ordinary annuity ($1,000end-of-year deposit, earning 7%, at the end of 5 years)In More Depth boxes point students to additional material,available on MyFinanceLab,intended to further highlight aparticular topic for studentswho want to explore a topic ingreater detail. Personal Finance Examples demon- strate how students can apply manage-rial finance concepts, tools, andtechniques to their personal financialdecisions. Key equations appear in green boxes throughout the text to help readers iden-tify the most important mathematicalrelationships. The variables used in theseequations are, for convenience, printedon the back endpapers of the book. The Equation for Present Value The present value of a future amount can be found mathematically by solving Equation 5.4 for PV.In other words, the present value, PV, of some future amount, FVn, to be received nperiods from now, assuming an interest rate (or opportunity cost) of r, is calculated as follows: (5.7) Note the similarity between this general equation for present value and the equa- tion in the preceding example (Equation 5.6). Let’s use this equation in an example.PV =FVn (1+r)n ixThe nominal interest rates on a number of classes of long-term securities in May 2010 were as follows:Example 6.33 Security Nominal interest rate U.S. Treasury bonds (average) 3.30% Corporate bonds (by risk ratings): High quality (Aaa–Aa) 3.95Medium quality (A–Baa) 4.98Speculative (Ba–C) 8.97 Security Risk premium Corporate bonds (by ratings): High quality (Aaa–Aa)Medium quality (A–Baa)Speculative (Ba–C) 8.97 -3.30 =5.674.98 -3.30 =1.683.95% -3.30% =0.65%Because the U.S. Treasury bond would represent the risk-free, long-term security, we can calculate the risk premium of the other securities by subtracting the risk-free rate, 3.30%, from each nominal rate (yield):Examples are an important component of the book’s learning system. Numberedand clearly set off from the text, theyprovide an immediate and concretedemonstration of how to apply financialconcepts, tools, and techniques. Some Examples demonstrate time-value- of-money techniques. These examplesoften show the use of time lines, equa-tions, financial calculators, and spread-sheets (with cell formulas). Review Questions appear at the end of each major text section. These questions challenge readersto stop and test their understandingof key concepts, tools, techniques,and practices before moving on tothe next section. In Practice boxes offer insights into important topics in managerial finance through the experiences ofreal companies, both large andsmall. There are three categories ofIn Practice boxes: Focus on Ethics boxes in every chapter help readers understand and appreciate important ethicalissues and problems related tomanagerial finance. Focus on Practice boxes take a corporate focus that relates a busi- ness event or situation to a specificfinancial concept or technique. Global Focus boxes look specifi- cally at the managerial finance experiences of international companies. All three types of In Practice boxes end with one or more critical thinking questions to help readers broaden the lesson from the con-tent of the box. 6 REVIEW QUESTIONS 5–14 What effect does compounding interest more frequently than annually have on ( a) future value and ( b) the effective annual rate (EAR)? Why? 5–15 How does the future value of a deposit subject to continuous com- pounding compare to the value obtained by annual compounding? 5–16 Differentiate between a nominal annual rate and an effective annual rate (EAR). Define annual percentage rate (APR) and annual per- centage yield (APY). xfocus on ETHICS If It Seems Too Good to Be True Then It Probably Is For many years, investors around the world clamored to invest with BernardMadoff. Those fortunate enough toinvest with “Bernie” might not have understood his secret trading system, but they were happy with the double-digit returns that they earned. Madoffwas well connected, having been thechairman of the board of directors ofthe NASDAQ Stock Market and a foundin g member of the International Securities Clearing Corporation. His credentials seemed to be impeccable. However, as the old saying goes, if something sounds too good to be true,it probably is. Madoff’s investorslearned this lesson the hard way when, on December 11, 2008, the U.S. Securities and Exchange Commission(SEC) charged Madoff with securitiesfraud. Madoff’s hedge fund, AscotPartne rs, turned out to be a giant Ponzi scheme. Over the years, suspicions were raised about Madoff. Madoff gener-ated high returns year after year, seem-ingly with very little risk. Madoffcredited his complex trading strategy for his investment performance, but other investors employed similar strate-gies with much different results thanMadoff reported. Harry Markopoloswent as far as to submit a report to the SEC three years prior to Madoff’s arrest titled “The World’s Largest Hedge FundIs a Fraud” that detailed his concerns. a On June 29, 2009, Madoff was sentenced to 150 years in prison.Madoff’s investors are still working torecover what they can. Fraudulentaccount statements sent just prior toMadoff’s arrest indicated that investors’accounts contained over $64 billion, inaggregate. Many investors pursuedclaims based on the balance reported in these statements. However, a recent court ruling permits claims up to the dif-ference between the amount an investordeposited with Madoff and the amountthey withdrew. The judge also ruled that investors who managed to with- draw at least their initial investmentbefore the fraud was uncovered are noteligible to recover additional funds.Total out-of-pocket cash losses as a result of Madoff’s fr aud were recently estimated at slightly over $20 billion. 3 What are some hazards of allowing investors to pursue claims based their most recent accounts statements?in practice afocus on PRACTICE Limits on Payback Analysis even more important than discounted cash flow (NPV and IRR)—because itspotlights the risks inherent in lengthy ITprojects. “It should be a hard and fastrule to never take an IT project with a payback period greater than 3 years, unless it’s an infrastructure project youcan’t do without,” Campbell says. Whatever the weaknesses of the payback period method of evaluating capital pr ojects, the simplicity of the method does allow it to be used inconjunction with other, more sophisti- cated measures. It can be used toscreen potential projects and winnowthem down to the few that merit morecareful scrutiny with, for example, net present value (NPV). 3 In your view, if the payback period method is used in conjunction with the NPV method, should it be used before or after the NPV evaluation?in Barrington, Illinois. “The simplicity of computing payback may encourage sloppiness, especially the failure toinclude all costs associated with aninvestment, such as training, mainte- nance, and hardware upgrade costs,” says Douglas Emond, senior vice presi-dent and chief technology officer atEastern Bank in Lynn, Massachusetts.For example, he says, “you may bebringing in a hot new technology, butuh-oh, after implementation you realize that you need a dot-net guru in-house, and you don’t have one.” But the payback method’s emphasis on the short term has a special appealfor IT managers. “That’s because the history of IT projects that take longer than 3 years is disastrous,” saysGardner. Indeed, Ian Cam pbell, chief research officer at Nucleus Research,Inc., in Wellesley, Massachusetts, says payback period is an absolutely essen- tial metric for evaluating IT projects—In tough economic times, the standard for a payback period is often reduced.Chief information officers (CIOs) are apt to reject projects with payback periods of more than 2 years. “Westart with payback period,” says Ron Fijalkowski, CIO at StrategicDistribution, In c., in Bensalem, Pennsylvania. “For sure, if the payback period is over 36 months, it’s not going to get approved. But our rule of thumbis we’d like to see 24 months. And ifit’s close to 12, it’s probably a no-brainer.” While easy to compute and easy to understand, the payback periods sim-plicity brings with it some drawbacks.“Payback gives you an answer that tellsyou a bit about the beginning stage ofa project, but it doesn’t tell you muchabout the full lifetime of the project,”says Chris Gardner, a cofounder ofiValue LLC, an IT valuation consultancyin practice GLOBAL focus An International Flavor to Risk Reduction Earlier in this chapter(see Table 8.5 on page 318), we learned that from1900 through 2009 the U.S. stockmarket produced an average annualnominal return of 9.3 percent, but that return was associated with a relatively high standard deviation: 20.4 percent per year. Could U.S. investors havedone better by diversifying globally? The answer is a qualified yes. Elroy Dimson, Paul Marsh, and MikeStaunton calculated the historical returns on a portfolio that included U.S. stocksas well as stocks from 18 other coun-tries. This diversified portfolio producedreturns that were not quite as high asthe U.S. average, just 8.6 percent per year. However, the globally diversified portfolio was also less volatile, with an annual standard deviation of 17.8 per-cent. Dividing the standard deviation by the annual return produces a coeffi- cient of variation for the globally diversified portfolio of 2.07, slightly lower than the 2.10 coefficient of variation reported for U.S. stocks inTable 8.5. 3 International mutual funds do not include any domestic assets whereas global mutual funds include both foreign and domestic assets. How might this difference affect their correlation with U.S. equity mutual funds?in practice Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton University Press, 2002). Summary FOCUS ON VALUE Time value of money is an important tool that financial managers and other market participants use to assess the effects of proposed actions. Because firmshave long lives and some decisions affect their long-term cash flows, the effectiveapplication of time-value-of-money techniques is extremely important. Thesetechniques enable financial managers to evaluate cash flows occurring at dif-ferent times so as to combine, compare, and evaluate them and link them to thefirm’s overall goal of share price maximization. It will become clear in Chapters 6 and 7 that the application of time value techniques is a key part of the valuedetermination process needed to make intelligent value-creating decisions. REVIEW OF LEARNING GOALS Discuss the role of time value in finance, the use of computational tools, and the basic patterns of cash flow. Financial managers and investors use time- value-of-money techniques when assessing the value of expected cash flow streams. Alternatives can be assessed by either compounding to find future value or discounting to find present value. Financial managers rely primarily onpresent value techniques. Financial calculators, electronic spreadsheets, andfinancial tables can streamline the application of time value techniques. Thecash flow of a firm can be described by its pattern—single amount, annuity, or mixed stream.LG1The end-of-chapter Summary con- sists of two sections. The first sec-tion, Focus on Value , explains how the chapter’s content relates tothe firm’s goal of maximizingowner wealth. The feature helpsreinforce understanding of the linkbetween the financial manager’sactions and share value. The second part of the Summary, theReview of Learning Goals , restates each learning goal and sum-marizes the key material that waspresented to support mastery of thegoal. This review provides studentswith an opportunity to reconcilewhat they have learned with thelearning goal and to confirm theirunderstanding before moving forward. AnOpener-in-Review question at the end of each chapter revisits the openingvignette and asks students to apply alesson from the chapter to that businesssituation. Self-Test Problems , keyed to the learning goals, give readers an opportu-nity to strengthen their understandingof topics by doing a sample problem.For reinforcement, solutions to the Self-Test Problems appear in the appendix atthe back of the book. Warm-Up Exercises follow the Self- Test Problems. These short, numericalexercises give students practice inapplying tools and techniques presentedin the chapter. Opener-in-Review In the chapter opener you learned that it costs Eli Lilly close to $1 billion to bring a new drug to market, and by the time all of the R&D and clinical trials are completed, Lilly may have fewer than 10 years left to sell the drug under patent protection. Assume that the $1 billion cost of bringing a new drug to market is spread out evenly over 10 years, and then 10 years remain for Lilly to recover their investment.How much cash would a new drug have to generate in the last 10 years to justify the $1 billion spent in the first 10 years? Assume that Lilly uses a required rate of return of 10%. Self-Test Problems(Solutions in Appendix) ST5–1 Future values for various compounding frequencies Delia Martin has $10,000 that she can deposit in any of three savings accounts for a 3-year period. Bank A com-pounds interest on an annual basis, bank B compounds interest twice each year, andbank C compounds interest each quarter. All three banks have a stated annual interest rate of 4%. a.What amount would Ms. Martin have at the end of the third year, leaving all interest paid on deposit, in each bank? b.What effective annual rate (EAR ) would she earn in each of the banks? c.On the basis of your findings in parts aand b,which bank should Ms. Martin deal with? Why? d.If a fourth bank (bank D), also with a 4% stated interest rate, compounds interest continuously, how much would Ms. Martin have at the end of the third year? Does this alternative change your recommendation in part c? Explain why or why not.LG2LG5 Warm-Up ExercisesAll problems are available in . E5–1 Assume a firm makes a $2,500 deposit into its money market account. If thisaccount is currently paying 0.7% (yes, that’s right, less than 1%!), what will theaccount balance be after 1 year? E5–2 If Bob and Judy combine their savings of $1,260 and $975, respectively, and depositthis amount into an account that pays 2% annual interest, compounded monthly, what will the account balance be after 4 years? LG2 LG2LG5 xi xiiComprehensive Problems , keyed to the learning goals, are longer and morecomplex than the Warm-Up Exercises.In this section, instructors will find mul-tiple problems that address the impor-tant concepts, tools, and techniques inthe chapter. A short descriptor identifies the essen- tial concept or technique of theproblem. Problems labeled asIntegrative tie together related topics. Personal Finance Problems specifi- cally relate to personal finance situa-tions and Personal Finance Examples ineach chapter. These problems will helpstudents see how they can apply thetools and techniques of managerialfinance in managing their own finances. The last item in the chapter Problems is anEthics Problem . The ethics problem gives students another opportunity tothink about and apply ethics principlesto managerial financial situations. All exercises and problems are available in MyFinanceLab. Every chapter includes a Spreadsheet Exercise . This exercise gives students an opportunity to use Excel ®software to create one or more spreadsheets withwhich to analyze a financial problem.The spreadsheet to be created often ismodeled on a table or Excel screenshotlocated in the chapter. Students canaccess working versions of the Excelscreenshots in MyFinanceLab. AnIntegrative Case at the end of each part of the book challenges stu-dents to use what they have learnedover the course of several chapters. Additional chapter resources, such as Chapter Cases, Group Exercises, CriticalThinking Problems, and numerous onlineresources, intended to provide furthermeans for student learning and assess-ment are available in MyFinanceLab at www.myfinancelab.com .ProblemsAll proble ms are available i n . P5–1 Using a time line The financial mana ger at Starbuck Industries is considerin g an investment that requires an initial outlay of $25,000 and is expected to result in cash inflows of $3,000 at the end of year 1, $6,000 at the end of years 2 and 3, $10,000 at the end of year 4, $8,000 at the end of year 5, and $7,000 at the end of year 6. a.Draw and label a time line depictin g the cash flows associated with Starbuck Industries ’ proposed investment. b.Use arrows to demonstrate, on the time line in part a,how compoundin g to find future value can be used to measure all cash flows at the end of year 6. c.Use arrows to demonstrate, on the time line in part b,how discountin g to find present value can be used to measure all cash flows at time zero. dWhich of the approaches future value orpresent value do financial mana gers LG1 P4–19 Integ rative—P ro forma statements Red Queen Restaurants wishes to prepare financial plans. Use the financial statements on pa ge 155 and the other information provided below to prepare the financial plans.LG5 Personal Finance Problem P5–7 Time value You can deposit $10,000 into an account payin g 9% annual interest either today or exactly 10 years from today. How much better off will you be at theend of 40 years if you decide to make the initial deposit today rather than 10 yearsfrom today?LG2 P5–62 ETHIC S PROBLEM A mana ger at a “Check Into Cash ” business (see Focus on Ethics box on pa ge 192 ) defends his business practice as simply “charging what the market will bear. ”“After all, ” says the mana ger, “we don ’t force people to come in the door. ” How would you respond to this ethical defense of the payday-advance business?LG6 Merit E nterprise Corp. Sara Lehn, chief financial officer of Merit Enterprise Corp., was reviewin g her presentation one last time before her upcomin g meetin g with the board of direc- tors. Merit ’s business had been brisk for the last two years, and the company ’s CEO was pushin g for a dramatic expansion of Merit ’s production capacity. Executin g the CEO ’s plans would require $4 billion in capital in addition to $2 billion in excess cash that the firm had built up. Sara ’s immediate task was to brief the board on options for raisin g the needed $4 billion. Unlike most companies its size, Merit had maintained its status as a private company, financin g its growth by reinvestin g profits and, when necessary, borrowin g from banks. Whether Merit could follow that same strate gy to raise the $4 billion necessary to expand at the pace envisioned by the firm ’s CEO was uncertain, thou gh it seemed unlikely to Sara. She had identified two options for the board to consider:Integrative Case 1 Spreadsheet Exercise You are interested in purchasin g the common stock of Azure Corporation. The firm recently paid a dividend of $3 per share. It expects its earnin gs—and hence its divi- dends—to grow at a rate of 7% for the foreseeable future. Currently, similar-risk stocks have required returns of 10%. Brief Contents Detailed Contents xv About the Authors xxxv Preface xxxvii Supplements to the Thirteenth Edition xlv Acknowledgments xlvii To the Student li Introduction to Managerial Finance 1 1The Role of Managerial Finance 2 2The Financial Market Environment 30 Financial Tools 55 3Financial Statements and Ratio Analysis 56 4Cash Flow and Financial Planning 113 5Time Value of Money 159 Valuation of Securities 219 6Interest Rates and Bond Valuation 220 7Stock Valuation 264 Risk and the Required Rate of Return 307 8Risk and Return 308 9The Cost of Capital 356 Long-Term Investment Decisions 387 10 Capital Budgeting Techniques 388 11 Capital Budgeting Cash Flows 426Part 5Part 4Part 3Part 2Part 112 Risk and Refinements in Capital Budgeting 463 Long-Term Financial Decisions 505 13 Leverage and Capital Structure 506 14 Payout Policy 559 Short-Term Financial Decisions 597 15 Working Capital and Current Assets Management 598 16 Current Liabilities Management 640 Special Topics in Managerial Finance 675 17 Hybrid and Derivative Securities 676 18 Mergers, LBOs, Divestitures, and Business Failure 714 19 International Managerial Finance 757 Appendix A-1 Glossary G-1 Index I-1Part 8Part 7Part 6 xiii This page intentionally left blank Contents About the Authors xxxv Preface xxxvii Supplements to the Thirteenth Edition xlv Acknowledgments xlvii To the Student li 1 The Role of ManagerialFinance page 2 Facebook—In No Hurry To Go Public page 3Finance and Business 4 What is Finance? 4 Career Opportunities in Finance 4 Legal Forms of Business Organization 5 Focus on Practice: Professional Certifications in Finance 5 Why Study Managerial Finance? 9 6REVIEW QUESTIONS 9 Goal of the Firm 10 Maximize Shareholder Wealth 10 Maximize Profit? 11 What About Stakeholders? 13 The Role of Business Ethics 13 6REVIEW QUESTIONS 14 Focus on Ethics: Will Google Live Up to Its Motto? 15 Managerial Finance Function 15 Organization of the Finance Function 16 Relationship to Economics 161.3in practice1.2in practice1.1 Relationship to Accounting 17 Primary Activities of the FinancialManager 19 6REVIEW QUESTIONS 19 Governance and Agency 20 Corporate Governance 20 The Agency Issue 21 6REVIEW QUESTIONS 24 Summary 24 Opener-in-Review 25 Self-Test Problem 25 Warm-Up Exercises 26 Problems 27 Spreadsheet Exercise 291.4Introduction to Managerial Finance 1 Part 1 xv xvi Contents 2 The Financial MarketEnvironment page 30 JPMorgan Chase & Co.— Cut to the Chase page 31Financial Institutions and Markets 32 Financial Institutions 32 Commercial Banks, Investment Banks, and the Shadow Banking System 33 Financial Markets 34 The Relationship Between Institutions and Markets 34 The Money Market 35 The Capital Market 35 Focus on Practice: Berkshire Hathaway—Can Buffett Be Replaced? 37 Focus on Ethics: The Ethics of Insider Trading 40 6REVIEW QUESTIONS 40 The Financial Crisis 41 Financial Institutions and Real Estate Finance 41 Falling Home Prices and DelinquentMortgages 41 Crisis of Confidence in Banks 42 Spillover Effects and the Great Recession 43 6REVIEW QUESTIONS 442.2in practicein practice2.1Regulation of Financial Institutions 44 Regulations Governing Financial Institutions 44 Regulations Governing Financial Markets 45 6REVIEW QUESTIONS 45 Business Taxes 46 Ordinary Income 46 Capital Gains 48 6REVIEW QUESTIONS 49 Summary 49 Opener-in-Review 50 Self-Test Problem 51 Warm-Up Exercises 51 Problems 51 Spreadsheet Exercise 53 Integrative Case 1 Merit Enterprise Corp. 542.42.3 Contents xvii 3 Financial Statements andRatio Analysis page 56 Abercrombie & Fitch— The Value of Casual Luxury page 57The Stockholders’ Report 58 The Letter to Stockholders 58 Global Focus: More Countries Adopt International Financial ReportingStandards 58 The Four Key Financial Statements 59 Focus on Ethics: Taking Earnings Reports at Face Value 59 Notes to the Financial Statements 65 Consolidating International Financial Statements 65 6REVIEW QUESTIONS 66 Using Financial Ratios 67 Interested Parties 67 Types of Ratio Comparisons 67 Cautions About Using Ratio Analysis 70 Categories of Financial Ratios 70 6REVIEW QUESTIONS 70 Liquidity Ratios 71 Current Ratio 71 Quick (Acid-Test) Ratio 72 6REVIEW QUESTIONS 73 Activity Ratios 73 Inventory Turnover 73 Average Collection Period 74 Average Payment Period 75 Total Asset Turnover 75 6REVIEW QUESTION 76 Debt Ratios 76 Debt Ratio 77 Times Interest Earned Ratio 783.53.43.33.2in practicein practice3.1 Fixed-Payment Coverage Ratio 78 6REVIEW QUESTIONS 79 Profitability Ratios 79 Common-Size Income Statements 79 Gross Profit Margin 79 Operating Profit Margin 80 Net Profit Margin 80 Earnings Per Share (EPS) 81 Return on Total Assets (ROA) 81 Return on Common Equity (ROE) 82 6REVIEW QUESTIONS 82 Market Ratios 82 Price/Earnings (P/E) Ratio 82 Market/Book (M/B) Ratio 83 6REVIEW QUESTION 83 A Complete Ratio Analysis 84 Summarizing All Ratios 84 Dupont System of Analysis 85 6REVIEW QUESTIONS 90 Summary 90 Opener-in-Review 92 Self-Test Problems 92 Warm-Up Exercises 93 Problems 94 Spreadsheet Exercise 1103.83.73.6Financial Tools 55 Part 2 xviii Contents 4 Cash Flow and Financial Planning page 113 Apple—Investors Want Apple to Take a Bite Out of its Cash Hoard page 114Analyzing the Firm’s Cash Flow 115 Depreciation 115 Depreciation Methods 116 Developing the Statement of Cash Flows 117 Free Cash Flow 122 Focus on Practice: Free Cash Flow at Cisco Systems 123 6REVIEW QUESTIONS 124 The Financial Planning Process 124 Long-Term (Strategic) Financial Plans 124 Short-Term (Operating) Financial Plans 125 Focus on Ethics: How Much Is a CEO Worth? 125 6REVIEW QUESTIONS 127 Cash Planning: Cash Budgets 127 The Sales Forecast 127 Preparing the Cash Budget 128 Evaluating the Cash Budget 132 Coping with Uncertainty in the Cash Budget 133 Cash Flow within the Month 134 6REVIEW QUESTIONS 1354.3in practice4.2in practice4.1Profit Planning: Pro Forma Statement 135 Preceding Year ’s Financial Statements 135 Sales Forecast 135 6REVIEW QUESTION 135 Preparing the Pro Forma Income Statement 137 Considering Types of Costs and Expenses 137 6REVIEW QUESTIONS 139 Preparing the Pro Forma Balance Sheet 139 6REVIEW QUESTIONS 141 Evaluation of Pro Forma Statements 141 6REVIEW QUESTIONS 141 Summary 142 Opener-in-Review 143 Self-Test Problems 144 Warm-Up Exercises 145 Problems 146 Spreadsheet Exercise 1574.74.64.54.4 Contents xix 5 Time Value of Money page 159 Eli Lilly and Company— Riding the Pipeline page 160The Role of Time Value in Finance 161 Future Value versus Present Value 161 Computational Tools 162 Basic Patterns of Cash Flow 163 6REVIEW QUESTIONS 164 Single Amounts 164 Future Value of a Single Amount 164 Present Value of a Single Amount 168 6REVIEW QUESTIONS 170 Annuities 171 Types of Annuities 171 Finding the Future Value of an Ordinary Annuity 172 Finding the Present Value of an OrdinaryAnnuity 173 Finding the Future Value of an Annuity Due 175 Finding the Present Value of an Annuity Due 176 Finding the Present Value of a Perpetuity 178 6REVIEW QUESTIONS 178 Mixed Streams 178 Future Value of a Mixed Stream 179 Present Value of a Mixed Stream 180 6REVIEW QUESTION 181 Compounding Interest More Frequently Than Annually 181 Semiannual Compounding 181 Quarterly Compounding 1825.55.45.35.25.1 A General Equation for Compounding More Frequently Than Annually 183 Using Computational Tools forCompounding More Frequently ThanAnnually 184 Continuous Compounding 184 Nominal and Effective Annual Rates ofInterest 185 Focus on Ethics: How Fair Is “Check into Cash”? 187 6REVIEW QUESTIONS 187 Special Applications of Time Value 188 Determining Deposits Needed to Accumulate a Future Sum 188 Loan Amortization 189 Focus on Practice: New Century Brings Trouble for Subprime Mortgages 191 Finding Interest or Growth Rates 191 Finding an Unknown Number of Periods 192 6REVIEW QUESTIONS 194 Summary 194 Opener-in-Review 195 Self-Test Problems 196 Warm-Up Exercises 197 Problems 198 Spreadsheet Exercise 214 Integrative Case 2 Track Software, Inc. 215in practice5.6in practice xx Contents 6 Interest Rates and Bond Valuation page 220 The Federal Debt—A Huge Appetite for Money page 221Interest Rates and Required Returns 222 Interest Rate Fundamentals 222 Focus on Practice: I-Bonds Adjust for Inflation 225 Term Structure of Interest Rates 226 Risk Premiums: Issuer and Issue Characteristics 229 6REVIEW QUESTIONS 230 Corporate Bonds 231 Legal Aspects of Corporate Bonds 232 Cost of Bonds to the Issuer 233 General Features of a Bond Issue 233 Bond Yields 234 Bond Prices 234 Bond Ratings 235 Focus on Ethics: Can We Trust the Bond Raters? 236 Common Types of Bonds 236 International Bond Issues 237 6REVIEW QUESTIONS 238in practice6.2in practice6.1Valuation Fundamentals 239 Key Inputs 239 Basic Valuation Model 240 6REVIEW QUESTIONS 241 Bond Valuation 241 Bond Fundamentals 241 Basic Bond Valuation 242 Bond Value Behavior 243 Yield to Maturity (YTM) 247 Semiannual Interest and Bond Values 248 6REVIEW QUESTIONS 249 Summary 250 Opener-in-Review 251 Self-Test Problems 252 Warm-Up Exercises 252 Problems 254 Spreadsheet Exercise 2636.46.3Valuation of Securities 219 Part 3 Contents xxi 7 Stock Valuation page 264 A123 Systems Inc.—Going Green to Find Value page 265Differences between Debt and Equity 266 Voice in Management 266 Claims on Income and Assets 266 Maturity 267 Tax Treatment 267 6REVIEW QUESTION 267 Common and Preferred Stock 267 Common Stock 268 Preferred Stock 271 Issuing Common Stock 272 6REVIEW QUESTIONS 276 Common Stock Valuation 277 Market Efficiency 277 The Efficient-Market Hypothesis 278 Focus on Practice: Understanding Human Behavior Helps UsUnderstand Investor Behavior 279 Basic Common Stock Valuation Equation 279 Free Cash Flow Valuation Model 284in practice7.37.27.1 Other Approaches to Common Stock Valuation 287 Focus on Ethics: Psst—Have You Heard Any Good Quarterly Earnings Forecasts Lately? 288 6REVIEW QUESTIONS 289 Decision Making and Common Stock Value 290 Changes in Expected Dividends 290 Changes in Risk 291 Combined Effect 291 6REVIEW QUESTIONS 292 Summary 292 Opener-in-Review 294 Self-Test Problems 294 Warm-Up Exercises 295 Problems 296 Spreadsheet Exercise 303 Integrative Case 3 Encore International 3047.4in practice xxii Contents 8 Risk and Return page 308 Mutual Funds—Fund ’s Returns Not Even Close to Average page 309Risk and Return Fundamentals 310 Risk Defined 310 Focus on Ethics: If It Seems Too Good to Be True Then It Probably Is 310 Return Defined 311 Risk Preferences 312 6REVIEW QUESTIONS 313 Risk of a Single Asset 313 Risk Assessment 313 Risk Measurement 315 6REVIEW QUESTIONS 320 Risk of a Portfolio 321 Portfolio Return and Standard Deviation 321 Correlation 3238.38.2in practice8.1 Diversification 323 Correlation, Diversification, Risk, and Return 326 International Diversification 327 Global Focus: An International Flavor to Risk Reduction 328 6REVIEW QUESTIONS 328 Risk and Return: The Capital Asset Pricing Model (CAPM) 329 Types of Risk 329 The Model: CAPM 330 6REVIEW QUESTIONS 339 Summary 339 Opener-in-Review 340 Self-Test Problems 341 Warm-Up Exercises 342 Problems 343 Spreadsheet Exercise 3558.4in practiceRisk and the Required Rate of Return 307 Part 4 Contents xxiii 9 The Cost of Capital page 356 General Electric—Falling Short of Expectations page 357Overview of the Cost of Capital 358 The Basic Concept 358 Focus on Ethics: The Ethics of Profit 358 Sources of Long-Term Capital 359 6REVIEW QUESTIONS 360 Cost of Long-Term Debt 360 Net Proceeds 360 Before-Tax Cost of Debt 361 After-Tax Cost of Debt 363 6REVIEW QUESTIONS 364 Cost of Preferred Stock 364 Preferred Stock Dividends 364 Calculating the Cost of Preferred Stock 364 6REVIEW QUESTION 365 Cost of Common Stock 365 Finding the Cost of Common Stock Equity 3659.49.39.2in practice9.1 Cost of Retained Earnings 367 Cost of New Issues of Common Stock 368 6REVIEW QUESTIONS 369 Weighted Average Cost of Capital 369 Calculating Weighted Average Cost of Capital (WACC) 369 Focus on Practice: Uncertain Times Make for an Uncertain Weighted Average Cost of Capital 371 Weighting Schemes 372 6REVIEW QUESTIONS 373 Summary 373 Opener-in-Review 374 Self-Test Problems 374 Warm-Up Exercises 375 Problems 376 Spreadsheet Exercise 383 Integrative Case 4 Eco Plastics Company 385in practice9.5 xxiv Contents 10 Capital Budgeting Techniques page 388 Genco Resources—The Gold Standard for Evaluating Gold Mines page 389Overview of Capital Budgeting 390 Motives for Capital Expenditure 390 Steps in the Process 390 Basic Terminology 391 Capital Budgeting Techniques 392 6REVIEW QUESTION 393 Payback Period 393 Decision Criteria 393 Pros and Cons of Payback Analysis 394 Focus on Practice: Limits on Payback Analysis 395 6REVIEW QUESTIONS 397 Net Present Value (NPV) 397 Decision Criteria 397 NPV and the Profitability Index 399 NPV and Economic Value Added 400 6REVIEW QUESTIONS 40110.3in practice10.210.1Internal Rate of Return (IRR) 401 Decision Criteria 401 Calculating the IRR 402 6REVIEW QUESTIONS 404 Comparing NPV and IRR Techniques 404 Net Present Value Profiles 404 Conflicting Rankings 406 Which Approach Is Better? 409 Focus on Ethics: Nonfinancial Considerations in Project Selection 411 6REVIEW QUESTIONS 411 Summary 412 Opener-in-Review 413 Self-Test Problems 414 Warm-Up Exercises 414 Problems 415 Spreadsheet Exercise 425in practice10.510.4Long-Term Investment Decisions 387 Part 5 Contents xxv 11 Capital Budgeting Cash Flows page 426 ExxonMobil—Maintaining Its Project Inventory page 427Relevant Cash Flows 428 Major Cash Flow Components 428 Focus on Ethics: A Question of Accuracy 428 Expansion versus Replacement Decisions 429 Sunk Costs and Opportunity Costs 429 International Capital Budgeting andLong-Term Investments 430 6REVIEW QUESTIONS 431 Global Focus: Changes May Influence Future Investments in China 432 Finding the Initial Investment 432 Installed Cost of New Asset 433 After-Tax Proceeds from Sale of Old Asset 433 Change in Net Working Capital 436 Calculating the Initial Investment 437 6REVIEW QUESTIONS 438 Finding the Operating Cash Inflows 438 Interpreting the Term After-Tax 43811.311.2in practicein practice11.1 Interpreting the Term Cash Inflows 439 Interpreting the Term Incremental 441 6REVIEW QUESTIONS 443 Finding the Terminal Cash Flow 443 Proceeds from Sale of Assets 443 Taxes on Sale of Assets 443 Change in Net Working Capital 444 6REVIEW QUESTION 445 Summarizing the Relevant Cash Flows 445 6REVIEW QUESTION 447 Summary 447 Opener-in-Review 448 Self-Test Problems 449 Warm-Up Exercises 449 Problems 450 Spreadsheet Exercise 46111.511.4 xxvi Contents 12 Risk and Refinements inCapital Budgeting page 463 BP—Worst Case Scenario page 464Introduction to Risk in Capital Budgeting 465 6REVIEW QUESTION 465 Behavioral Approaches for Dealing with Risk 466 Risk and Cash Inflows 466 Scenario Analysis 467 Simulation 468 Focus on Practice: The Monte Carlo Method: The Forecast Is forLess Uncertainty 470 6REVIEW QUESTIONS 470 International Risk Considerations 470 6REVIEW QUESTION 471 Risk-Adjusted Discount Rates 472 Determining Risk-Adjusted Discount Rates (RADRS) 472 Focus on Ethics: Ethics and the Cost of Capital 475 Applying RADRs 475in practice12.412.3in practice12.212.1 Portfolio Effects 478 RADRs in Practice 478 6REVIEW QUESTIONS 480 Capital Budgeting Refinements 480 Comparing Projects with Unequal Lives 480 Recognizing Real Options 483 Capital Rationing 485 6REVIEW QUESTIONS 487 Summary 488 Opener-in-Review 489 Self-Test Problems 490 Warm-Up Exercises 490 Problems 492 Spreadsheet Exercise 502 Integrative Case 5 Lasting Impressions Company 50312.5 Contents xxvii 13 Leverage and Capital Structure page 506 Genzyme Corp.—Trading Equity for Debt page 507Leverage 508 Breakeven Analysis 509 Operating Leverage 513 Focus on Practice: Adobe’s Leverage 515 Financial Leverage 516 Total Leverage 520 Focus on Ethics: Repo 105 522 6REVIEW QUESTIONS 523 The Firm’s Capital Structure 523 Types of Capital 523 External Assessment of Capital Structure 524 Capital Structure of Non–U.S. Firms 525 Capital Structure Theory 526 Optimal Capital Structure 535 6REVIEW QUESTIONS 536 EBIT–EPS Approach to Capital Structure 537 Presenting a Financing Plan Graphically 53713.313.2in practicein practice13.1 Comparing Alternative Capital Structures 539 Considering Risk in EBIT–EPS Analysis 539 Basic Shortcoming of EBIT–EPS Analysis 540 6REVIEW QUESTION 540 Choosing the Optimal Capital Structure 540 Linkage 540 Estimating Value 541 Maximizing Value versus Maximizing EPS 543 Some Other Important Considerations 543 6REVIEW QUESTIONS 544 Summary 544 Opener-in-Review 546 Self-Test Problems 546 Warm-Up Exercises 547 Problems 548 Spreadsheet Exercise 55813.4Long-Term Financial Decisions 505 Part 6 xxviii Contents 14 Payout Policy page 559 Best Buy—Payback Time page 560The Basics of Payout Policy 561 Elements of Payout Policy 561 Trends in Earnings and Dividends 562 Trends in Dividends and Share Repurchases 563 Focus on Ethics: Are Buybacks Really a Bargain? 564 6REVIEW QUESTIONS 565 The Mechanics of Payout Policy 565 Cash Dividend Payment Procedures 565 Share Repurchase Procedures 567 Tax Treatment of Dividends andRepurchases 568 Focus on Practice: Capital Gains and Dividend Tax TreatmentExtended to 2010 569 Dividend Reinvestment Plans 570 Stock Price Reactions to Corporate Payouts 570 6REVIEW QUESTIONS 571 Relevance of Payout Policy 571 Residual Theory of Dividends 571 The Dividend Irrelevance Theory 572 Arguments for Dividend Relevance 573 6REVIEW QUESTIONS 57414.3in practice14.2in practice14.1Factors Affecting Dividend Policy 574 Legal Constraints 574 Contractual Constraints 576 Growth Prospects 576 Owner Considerations 576 Market Considerations 576 6REVIEW QUESTION 577 Types of Dividend Policies 577 Constant-Payout-Ratio Dividend Policy 577 Regular Dividend Policy 578 Low-Regular-and-Extra Dividend Policy 579 6REVIEW QUESTION 579 Other Forms of Dividends 579 Stock Dividends 579 Stock Splits 581 6REVIEW QUESTIONS 583 Summary 583 Opener-in-Review 584 Self-Test Problems 585 Warm-Up Exercises 585 Problems 586 Spreadsheet Exercise 593 Integrative Case 6 O’Grady Apparel Company 59414.614.514.4 Contents xxix 15 Working Capital and Current AssetsManagement page 598 Cytec Industries—Focusing on Working Capital page 599Net Working Capital Fundamentals 600 Working Capital Management 600 Net Working Capital 601 Trade-Off between Profitability and Risk 601 6REVIEW QUESTIONS 603 Cash Conversion Cycle 603 Calculating the Cash Conversion Cycle 604 Funding Requirements of the CashConversion Cycle 605 Strategies for Managing the CashConversion Cycle 607 6REVIEW QUESTIONS 608 Inventory Management 608 Differing Viewpoints about Inventory Level 608 Common Techniques for ManagingInventory 609 Focus on Practice: RFID: The Wave of the Future 613 International Inventory Management 614 6REVIEW QUESTIONS 614in practice15.315.215.1Accounts Receivable Management 615 Credit Selection and Standards 615 Credit Terms 619 Credit Monitoring 622 6REVIEW QUESTIONS 623 Management of Receipts and Disbursements 624 Float 624 Speeding Up Collections 625 Slowing Down Payments 625 Focus on Ethics: Stretching Accounts Payable—Is It a Good Policy? 626 Cash Concentration 626 Zero-Balance Accounts 627 Investing in Marketable Securities 629 6REVIEW QUESTIONS 630 Summary 630 Opener-in-Review 632 Self-Test Problems 632 Warm-Up Exercises 633 Problems 634 Spreadsheet Exercise 639in practice15.515.4Short-Term Financial Decisions 597 Part 7 xxx Contents 16 Current Liabilities Management page 640 Memorial Sloan-Kettering Cancer Center—Reducing Accounts Payable Expensespage 641Spontaneous Liabilities 642 Accounts Payable Management 642 Accruals 647 Focus on Ethics: Accruals Management 647 6REVIEW QUESTIONS 648 Unsecured Sources of Short-Term Loans 648 Bank Loans 648 Commercial Paper 654 Focus on Practice: The Ebb and Flow of Commercial Paper 654 International Loans 655 6REVIEW QUESTIONS 656in practice16.2in practice16.1Secured Sources of Short-Term Loans 657 Characteristics of Secured Short-Term Loans 657 Use of Accounts Receivable as Collateral 658 Use of Inventory as Collateral 660 6REVIEW QUESTIONS 662 Summary 662 Opener-in-Review 663 Self-Test Problems 664 Warm-Up Exercises 664 Problems 665 Spreadsheet Exercise 671 Integrative Case 7 Casa de Diseño 67216.3 Contents xxxi 17 Hybrid and DerivativeSecurities page 676 Boeing— ”We ’ll Buy It, You Fly It ” page 677Overview of Hybrids and Derivatives 678 6REVIEW QUESTION 678 Leasing 678 Types of Leases 678 Leasing Arrangements 679 Focus on Practice: Leases to Airlines End on a Sour Note 680 Lease-versus-Purchase Decision 681 Effects of Leasing on Future Financing 685 Advantages and Disadvantages of Leasing 686 6REVIEW QUESTIONS 687 Convertible Securities 687 Types of Convertible Securities 687 General Features of Convertibles 688 Financing with Convertibles 689 Determining the Value of a Convertible Bond 691 6REVIEW QUESTIONS 693 Stock Purchase Warrants 693 Key Characteristics 69317.417.3in practice17.217.1 Implied Price of an Attached Warrant 694 Values of Warrants 695 6REVIEW QUESTIONS 697 Options 698 Calls and Puts 698 Options Markets 698 Options Trading 699 Role of Call and Put Options in Fund Raising 700 Focus on Ethics: Options Backdating 701 Hedging Foreign-Currency Exposures with Options 701 6REVIEW QUESTIONS 702 Summary 702 Opener-in-Review 704 Self-Test Problems 705 Warm-Up Exercises 705 Problems 706 Spreadsheet Exercise 712in practice17.5Special Topics in Managerial Finance 675 Part 8 xxxii Contents 18 Mergers, LBOs, Divestitures, andBusiness Failure page 714 IMS Health, Inc.—Creating Value by Going Private page 715Merger Fundamentals 716 Terminology 716 Motives for Merging 718 Types of Mergers 720 6REVIEW QUESTIONS 721 LBOs and Divestitures 721 Leveraged Buyouts (LBOs) 721 Divestitures 722 6REVIEW QUESTIONS 723 Analyzing and Negotiating Mergers 723 Valuing the Target Company 724 Stock Swap Transactions 726 Merger Negotiation Process 731 Holding Companies 733 International Mergers 735 6REVIEW QUESTIONS 736 Global Focus: International Mergers 737 Business Failure Fundamentals 737 Types of Business Failure 73718.4in practice18.318.218.1 Major Causes of Business Failure 738 Focus on Ethics: Too Big to Fail? 739 Voluntary Settlements 739 6REVIEW QUESTIONS 740 Reorganization and Liquidation in Bankruptcy 741 Bankruptcy Legislation 741 Reorganization in Bankruptcy (Chapter 11) 742 Liquidation in Bankruptcy (Chapter 7) 744 6REVIEW QUESTIONS 744 Summary 745 Opener-in-Review 747 Self-Test Problems 748 Warm-Up Exercises 748 Problems 749 Spreadsheet Exercise 75518.5in practice Contents xxxiii 19 International ManagerialFinance page 757 General Electric—Establishing a Presence in China page758The Multinational Company and Its Environment 759 Key Trading Blocs 759 GATT and the WTO 761 Legal Forms of Business Organization 761 Taxes 762 Financial Markets 764 6REVIEW QUESTIONS 765 Financial Statements 765 Subsidiary Characterization andFunctional Currency 766 Translation of Individual Accounts 766 6REVIEW QUESTION 767 Risk 767 Exchange Rate Risks 767 Political Risks 773 6REVIEW QUESTIONS 774 Focus on Ethics: Chiquita’s Slippery Situation 775 Long-Term Investment and Financing Decisions 775 Foreign Direct Investment 775 Investment Cash Flows and Decisions 776 Capital Structure 77719.4in practice19.319.219.1 Global Focus: Take an Overseas Assignment to Take a Step Up theCorporate Ladder 778 Long-Term Debt 779 Equity Capital 780 6REVIEW QUESTIONS 781 Short-Term Financial Decisions 781 Cash Management 783 Credit and Inventory Management 786 6REVIEW QUESTIONS 787 Mergers and Joint Ventures 787 6REVIEW QUESTION 788 Summary 788 Opener-in-Review 790 Self-Test Problems 790 Warm-Up Exercises 791 Problems 791 Spreadsheet Exercise 794 Integrative Case 8 Organic Solutions 79519.619.5in practice Appendix A-1 Glossary G-1 Index I-1 This page intentionally left blank About the Authors Lawrence J. Gitman is an emeritus professor of finance at San Diego State University. Dr. Gitman has pub-lished more than 50 articles in scholarly journals as well astextbooks covering undergraduate- and graduate-level cor-porate finance, investments, personal finance, and introduc-tion to business. Dr. Gitman is past president of theAcademy of Financial Services, the San Diego Chapter of theFinancial Executives Institute, the Midwest FinanceAssociation, and the FMA National Honor Society. Dr.Gitman served as Vice-President of Financial Education ofthe Financial Management Association, as a director of theSan Diego MIT Enterprise Forum, and on the CFP ®Board of Standards. He received his B.S.I.M. from Purdue University,his M.B.A. from the University of Dayton, and his Ph.D.from the University of Cincinnati. He and his wife have twochildren and live in La Jolla, California, where he is an avidbicyclist, having twice competed in the coast-to-coast RaceAcross America. Chad J. Zutter is an associate professor of finance at the University of Pittsburgh. Dr. Zutter recently won the JensenPrize for the best paper published in the Journal of Financial Economics and has also won a best paper award from the Journal of Corporate Finance . His research has a practical, applied focus and has been the subject of feature stories in, among other prominent outlets, The Economist and CFO Magazine . His papers have been cited in arguments before the U.S. Supreme Court and in consultation with companies suchas Google and Intel. Dr. Zutter has also won teaching awardsat Indiana University and the University of Pittsburgh. Hereceived his B.B.A. from the University of Texas at Arlingtonand his Ph.D. from Indiana University. He and his wife havefour children and live in Pittsburgh, Pennsylvania. Prior to hiscareer in academics, Dr. Zutter was a submariner in the U.S.Navy. xxxv This page intentionally left blank xxxviiPreface The desire to write Principles of Managerial Finance came from the experience of teaching the introductory managerial finance course. Those who have taught the introductory course many times can appreciate the difficulties thatsome students have absorbing and applying financial concepts. Students want abook that speaks to them in plain English and a book that ties concepts to reality.These students want more than just description—they also want demonstrationof concepts, tools, and techniques. This book is written with the needs of studentsin mind, and it effectively delivers the resources that students need to succeed inthe introductory finance course. Courses and students have changed since the first edition of this book, but the goals of the text have not changed. The conversational tone and wide use ofexamples set off in the text still characterize Principles of Managerial Finance . Building on those strengths, 13 editions, numerous translations, and well overhalf a million U.S. users, Principles has evolved based on feedback from both instructors and students, from adopters, nonadopters, and practitioners. In this edition, Chad Zutter of the University of Pittsburgh joins the author team. A recent recipient of the Jensen Prize for the best paper published in theJournal of Financial Economics , Chad brings a fresh perspective to Principles . Larry and Chad have worked together to incorporate contemporary thinking andpedagogy with the classic topics that Gitman users have come to expect. NEW TO THE THIRTEENTH EDITION As we made plans to publish the thirteenth edition, we carefully assessed marketfeedback about content changes that would better meet the needs of instructorsteaching the course. The chapter sequence is similar to the prior edition, but there are some note- worthy changes. The thirteenth edition contains 19 chapters divided into eightparts. Each part is introduced by a brief overview, which is intended to give stu-dents an advance sense for the collective value of the chapters included in thepart. In Part 1, a new Chapter 2 expands coverage of financial markets and insti- tutions, with particular emphasis on the recent financial crisis and recession. Thischapter not only explores the root causes and consequences of the financial crisis,but it also discusses the changing regulatory landscape within which financialinstitutions and markets function. Part 2 contains three chapters in the same order in which they appeared in the twelfth edition. These chapters focus on basic financial skills such as financialstatement analysis, cash flow analysis, and time-value-of-money calculations. Part 3 focuses on bond and stock valuation. We moved these two chapters forward in this edition, just ahead of the risk and return chapter, to provide stu-dents with exposure to basic material on bonds and stocks that is easier to graspthan some of the more theoretical concepts in the next part. Part 4 contains the risk and return chapter as well as the chapter on the cost of capital, which we have moved forward to lead into Part 5 on capital budg-eting. We also moved up the chapter on the cost of capital so that it followsdirectly on the heels of the risk and return material. We believe that this makesthe subsequent discussion of capital budgeting topics more meaningful becausestudents will already have an idea of where a project “hurdle rate” comes from. Part 5 contains three chapters on various capital budgeting topics. A change from the last edition here is that we present capital budgeting methods before thechapter on capital budgeting cash flows. Parts 6, 7, and 8 contain the same seven chapters in the same order that appeared in the latter part of the twelfth edition. These chapters cover topics suchas capital structure, payout policy, working capital management, derivatives,mergers, and international finance. Details about the revisions made to thesechapters appear below. Although the text content is sequential, instructors can assign almost any chapter as a self-contained unit, enabling instructors to customize the text to var-ious teaching strategies and course lengths. A number of new topics have been added at appropriate places, and new fea- tures appear in each chapter. The Matter of Fact feature provides additional detailand interesting empirical facts that help students understand the practical implica-tions of financial concepts. For students who want to explore particular topicsmore deeply on their own, the In More Depth feature, available on MyFinanceLab,offers a guide for further study. In addition, as the detailed list shows, the chapter-opening vignettes and In Practice boxes have been replaced or heavily revised: Forexample, three-quarters of the chapter-opening vignettes are new, focusing on com-panies such as Facebook, Abercrombie & Fitch, and Best Buy that have studentappeal, and more than half of the Focus on Ethics boxes are new. Also new to thisedition are Opener-in-Review questions, which appear at the end of each chapter. The following chapter-by-chapter list details several of the notable content changes in the thirteenth edition. Chapter 1 The Role of Managerial Finance •Revised opening vignette discusses Facebook’s possible IPO. •New Focus on Practice box discusses professional certifications in finance. •New Matter of Fact feature provides statistics on the number of businesses and the revenues they generate by legal form of organization. •Sections on financial markets and business taxes have been moved to a new,expanded Chapter 2. •Coverage of the difference between cash flow and profit as part of the discus-sion surrounding the goal of the firm has been revised. •New Focus on Ethics box highlights the ethical issues that Google facedduring its expansion to China. •Coverage of agency issues has been substantially revised, and a new Matterof Fact feature provides data on the link between pay and performance forseveral prominent firms. Chapter 2 The Financial Market Environment •This new chapter focuses on financial markets and institutions as well as the recent financial crisis. •New opening vignette traces JP Morgan’s performance during the crisis.xxxviii Preface •New section provides coverage of commercial banks, investment banks, and the shadow banking system. •New Focus on Ethics box is related to the Martha Stewart insider tradingscandal. •New section has been added on causes and consequences of financial crisis. •Coverage of regulatory issues has been updated. Chapter 3 Financial Statements and Ratio Analysis •New opening vignette has been added (financial results, Abercrombie & Fitch). •New Global Focus box covers International Financial Reporting Standards(IFRS). •New Focus on Ethics box describes ethical issues related to corporate earn-ings reports. •New table shows values of key ratios for several prominent firms and therelated industry averages. Five related Matter of Fact features explain whycertain ratio values vary systematically across industries. Chapter 4 Cash Flow and Financial Planning •New opening vignette highlights Apple’s huge cash hoard. •New Matter of Fact box illustrates where Apple’s cash flow comes from. •New Focus on Practice box dissects a recent earnings report by Cisco Systems to explore the firm’s underlying cash generation. •Discussion of alternative cash flow measures has been revised. •New In More Depth feature (on MyFinanceLab) discusses the value of usingregression analysis to estimate fixed costs. Chapter 5 Time Value of Money •New In More Depth feature (on MyFinanceLab) shows how the firm Royalty Pharma makes lump-sum payments to acquire royalty streams from otherfirms. •References to financial tables and interest rate factors have been eliminated. •Coverage of calculations using Excel has been expanded. •New Matter of Fact feature describes a Kansas truck driver’s choice to take alump-sum payment rather than an annuity due after winning the lottery. •The Focus on Ethics box on subprime loans has been revised. Chapter 6 Interest Rates and Bond Valuation •Opening vignette (U.S. Treasury, public debt) has been updated. •New Matter of Fact feature highlights a 2008 U.S. Treasury auction in which bill returns briefly turned negative. •Discussion of factors that influence interest rates, particularly inflation, hasbeen substantially revised. •New In More Depth feature (on MyFinanceLab) points students to an ani-mation on the Web that illustrates historical yield curve behavior. •Major revisions have been made to coverage of the term structure of interestrates. •Focus on Ethics box on the performance of rating agencies during the finan-cial crisis has been revised.Preface xxxix Chapter 7 Stock Valuation •New opening vignette has been added about A123 Systems Inc., a company that uses nanotechnology to make more powerful batteries for electric cars. •New In More Depth feature (on MyFinanceLab) discusses the U.S. bank-ruptcy process. •New Matter of Fact box describes how assets are divided in bankruptcy. •New In More Depth feature (on MyFinanceLab) discusses the hierarchy ofthe efficient market hypothesis. •New In More Depth feature (on MyFinanceLab) illustrates the derivation ofthe constant-growth model. •New Matter of Fact box describes how P/E ratios fluctuate over time. Chapter 8 Risk and Return •New opening vignette has been added about a mutual fund that ranked near the bottom and then at the top of all mutual funds in consecutive years. •New Focus on Ethics box features Bernie Madoff. •New numerical examples have data drawn from the real world. •Historical returns on U.S. stocks, bonds, and bills have been updated. •Discussion of investor risk preferences has been substantially revised. •New Matter of Fact feature discusses Nicholas Taleb’s Black Swan . •New Matter of Fact box compares historical returns on large stocks versus small stocks. •New Global Focus box features data on international diversification. Chapter 9 The Cost of Capital •New opening vignette focuses on General Electric. •New Focus on Ethics box deals with Merck’s handling of Vioxx. •New In More Depth feature (on MyFinanceLab) discusses changes in the weighted average cost of capital. •New Matter of Fact box presents a more comprehensive cost of retainedearnings. •New Focus on Practice feature focuses on WACC’s susceptibility to the 2008financial crisis and the 2009 great recession. •New integrative case for Part 4 has been added. Chapter 10 Capital Budgeting Techniques •New opening vignette describes techniques used by Genco Resources to eval- uate a proposal to expand its mining operations. •New In More Depth feature (on MyFinanceLab) discusses the AccountingRate of Return method. •Substantially revised opening section discusses the capital budgeting process. •Coverage of profitability index approach has been expanded. •Coverage of economic value added has been expanded. •New Matter of Fact box provides evidence on the extent to which firms usedifferent capital budgeting methods. Chapter 11 Capital Budgeting Cash Flows •Opening vignette (project costs at ExxonMobil) has been updated. •New Matter of Fact box provides statistics on foreign direct investment in the United States.xl Preface •Global Focus box (foreign direct investment in China) has been updated. •Focus on Ethics box (accuracy of cash flow estimates) has been updated. •Two new Integrative Problems have been added. Chapter 12 Risk and Refinements in Capital Budgeting •New opening vignette discusses BP oil spill. •New In More Depth feature (on MyFinanceLab) directs students to a Crystal Ball simulation of a mining investment on the Internet. •New Matter of Fact box provides evidence on the frequency with whichfirms make adjustments to their investment analysis to account for currencyrisk. •New Focus on Ethics box discusses the implications of the BP oil spill on thefirm’s cost of capital. Chapter 13 Leverage and Capital Structure •New opening vignette discuss the value created by Genzyme when it added debt to its capital structure in response to a proxy fight with Carl Icahn. •Substantially revised opening section discusses the nature and risks ofleverage. •Revised Focus on Practice box calculates Adobe’s operating leverage. •New Focus on Ethics box discusses Lehman Brothers’ use of off–balancesheet transactions to understate its leverage. •New Matter of Fact box offers data on the use of financial leverage by firmsin different countries. •New In More Depth feature (on MyFinanceLab) explains why capital struc-ture does not affect firm value in perfect markets. •Major revisions have been made to the discussion of the pecking order andsignaling theories of capital structure. Chapter 14 Payout Policy •New chapter title reflects broader focus on payout policy, including share repurchases as opposed to a narrow focus on dividends. •Revised opening vignette covers Best Buy’s dividend and share repurchaseprograms. •New opening section discusses long-term trends in earnings, dividends, andrepurchases. •New Matter of Fact box describes Procter & Gamble’s long dividend history. •New figure shows relative frequency of firms increasing and decreasing divi-dends over time. •New examples have real-world data. •Extensive new discussion of share repurchase programs and procedures hasbeen added. •New discussion covers effects of dividend and share repurchase decisions onfirm value. •New In More Depth feature (on MyFinanceLab) explains the conditionsunder which dividend policy has no impact on firm value. •Extensive revisions have been made to discussions of alternative dividendtheories and a brief introduction to the new catering theory of dividends hasbeen added.Preface xli Chapter 15 Working Capital and Current Assets Management •New opening vignette focuses on working capital at Cytec Industries. •New figure shows the yearly median working capital values for all U.S.-listed manufacturing companies. •Updated example for calculating the cash conversion cycle uses real data forIBM. •Updated Focus on Practice box discusses Walmart’s use of RFID. •New In More Depth feature (on MyFinanceLab) discusses accounts receiv-able financing. •New Matter of Fact box cites finding from a survey of CFOs regarding thevalue they place on working capital management. Chapter 16 Current Liabilities Management •Updated opening vignette covers reducing accounts payable expenses at Memorial Sloan-Kettering. •Revised in-chapter examples use real data for Hewlett-Packard. •Focus on Practice box (commercial paper) has been updated. •New Focus on Ethics box discusses the accounting fraud case againstDiebold Inc. •Two new Matter of Fact boxes have been added, one on lending limits andthe other on quasi-factoring. •Several In More Depth features (on MyFinanceLab) have been added,including one that discusses floating inventory liens. Chapter 17 Hybrid and Derivative Securities •New opening vignette discusses airlines sale-leaseback transactions. •New Matter of Fact feature provides recent data on the size of the convert- ibles market. •Major revisions to options coverage include a Matter of Fact box thatdescribes the decline in trading volume during the financial crisis and anotherone outlining some popular options trading strategies. •Updated Focus on Ethics box discusses the options backdating scandal. Chapter 18 Mergers, LBOs, Divestitures, and Business Failure •New opening vignette on creating value by going private has been added. •New In More Depth (on MyFinanceLab) discusses prioritizing claims in liquidation. •Global Focus box (News Corp acquisitions) has been updated. •New Focus on Ethics box discusses General Motors and the “too big to fail”policy. •New Matter of Fact box provides statistics on the ten largest U.S. bankruptcies. Chapter 19 International Managerial Finance •Opening vignette (GE’s business in China) has been updated. •Two new Matter of Fact boxes have been added, one on diversifying opera- tions and the other on adjusting discount rates. •Global Focus box (overseas assignments) has been updated. •New Focus on Ethics box discusses Chiquita’s policy of paying protectionmoney in Colombia.xlii Preface THE THIRTEENTH EDITION Like the previous editions, the thirteenth edition incorporates a proven learning system, which integrates pedagogy with concepts and practical applications. Itconcentrates on the knowledge that is needed to make keen financial decisions inan increasingly competitive business environment. The strong pedagogy and gen-erous use of examples—including personal finance examples—make the text aneasily accessible resource for in-class learning or out-of-class learning, such asonline courses and self-study programs. ORGANIZATION The text’s organization conceptually links the firm’s actions and its value, asdetermined in the financial market. Each major decision area is presented interms of both risk and return factors and their potential impact on owners’wealth. A Focus on Value element at the end of each chapter helps reinforce thestudent’s understanding of the link between the financial manager’s actions andthe firm’s share value. In organizing each chapter, we have adhered to a managerial decision- making perspective, relating decisions to the firm’s overall goal of wealth maxi-mization. Once a particular concept has been developed, its application isillustrated by an example—a hallmark feature of this book. These examplesdemonstrate, and solidify in the student’s thought, financial decision-making con-siderations and their consequences. INTERNATIONAL CONSIDERATIONS We live in a world where international considerations cannot be divorced from thestudy of business in general and finance in particular. As in prior editions, discus-sions of international dimensions of chapter topics are integrated throughout thebook. International material is integrated into learning goals and end-of-chaptermaterials. In addition, for those who want to spend more time addressing thetopic, a separate chapter on international managerial finance concludes the book. PERSONAL FINANCE LINKAGES The thirteenth edition contains several features designed to help students see thevalue of applying financial principles and techniques in their personal lives. At thestart of each chapter, the feature titled Why This Chapter Matters to You helps motivate student interest by discussing how the topic of the chapter relates to theconcerns of other major business disciplines and to personal finance. Within thechapter, Personal Finance Examples explicitly link the concepts, tools, and tech-niques of each chapter to personal finance applications. Throughout the homeworkmaterial, the book provides numerous personal finance problems. The purpose ofthese personal finance materials is to demonstrate to students the usefulness ofmanagerial finance knowledge in both business and personal financial dealings. ETHICAL ISSUES The need for ethics in business remains as important as ever. Students need to under-stand the ethical issues that financial managers face as they attempt to maximizePreface xliii shareholder value and to solve business problems. Thus, every chapter includes an In Practice box that focuses on current ethical issues. HOMEWORK OPPORTUNITIES Of course, practice is essential for students’ learning of managerial finance con-cepts, tools, and techniques. To meet that need, the book offers a rich and variedmenu of homework assignments: short, numerical Warm-Up Exercises; a com-prehensive set of Problems, including more than one problem for each importantconcept or technique and personal finance problems; an Ethics Problem for eachchapter; a Spreadsheet Exercise; and, at the end of each part of the book, anIntegrative Case. In addition, the end-of-chapter problems are available in algo-rithmic form in . These materials (see pages xi through xii for detaileddescriptions) offer students solid learning opportunities, and they offer instruc-tors opportunities to expand and enrich the classroom environment. MyFinanceLab This fully integrated online homework system gives students the hands-on prac-tice and tutorial help they need to learn finance efficiently. There are ampleopportunities for online practice and assessment that is automatically graded inMyFinanceLab ( www.myfinancelab.com ). Chapter Cases with automatically graded assessment are also provided in MyFinanceLab. These cases have students apply the concepts they have learnedto a more complex and realistic situation. These cases help strengthen practicalapplication of financial tools and techniques. MyFinanceLab also has Group Exercises where students can work together in the context of an ongoing company. Each group creates a company and fol-lows it through the various managerial finance topics and business activities pre-sented in the textbook. MyFinanceLab provides Critical Thinking Problems , which require students to apply the various finance concepts and managerial techniques presented in thetextbook. These are rigorous problems that are designed to test a student’s abilityto understand the financial management situation, apply the necessary manage-rial finance concepts, and find the value-maximizing solution. An online glossary, digital flashcards, financial calculator tutorials, videos, Spreadsheet Use examples from the text in Excel, and numerous other premiumresources are available in MyFinanceLab. From classroom to boardroom, the thirteenth edition of Principles of Managerial Finance can help users get to where they want to be. We believe that it is the best edition yet—more relevant, more accurate, and more effective than ever.We hope you agree that Principles of Managerial Finance, Thirteenth Edition, is the most effective introductory managerial finance text for your students. Lawrence J. Gitman La Jolla, California Chad J. Zutter Pittsburgh, Pennsylvaniaxliv Preface Supplements to the Thirteenth Edition ThePrinciples of Managerial Finance Teaching and Learning System includes a variety of useful supplements for teachers and for students. TEACHING TOOLS FOR INSTRUCTORS The key teaching tools available to instructors are the Instructor’s Manual, testing materials, and PowerPoint Lecture Presentations. Instructor’s Manual Revised by Thomas Krueger, Texas A&M University– Kingsville and accuracy-checked by Gordon Stringer, University of Colorado,Colorado Springs. This comprehensive resource pulls together the teaching tools so that instructors can use the textbook easily and effectively in the classroom.Each chapter provides an overview of key topics and detailed answers and solu-tions to all review questions, Opener-in-Review questions, Warm-Up Exercises,end-of-chapter problems, and chapter cases, plus suggested answers to all criticalthinking questions in chapter boxes, Ethics Problems, and Group Exercises. Atthe end of the manual are practice quizzes and solutions. The completeInstructor’s Manual, including Spreadsheet Exercises, is available online at the Instructor’s Resource Center ( www.pearsonhighered.com/irc ). Test Item File Revised by Shannon Donovan, Bridgewater State University. Thoroughly revised to accommodate changes in the text, the Test Item File consists of a mix of true/false, multiple-choice, and essay questions. Each testquestion includes identifiers for type of question, skill tested by learning goal,and key topic tested plus, where appropriate, the formula(s) or equation(s)used in deriving the answer. TheTest Item File is also available in Test Generator Software (TestGen) for either Windows or Macintosh. The Test Item File andTestGen are avail- able online at the Instructor’s Resource Center ( www.pearsonhighered.com/irc ). xlvPowerPoint Lecture Presentation Revised by Thomas Boulton, Miami University. This presentation combines lecture notes with all of the art from the textbook. The PowerPoint Lecture Presentation is available online at the Instructor’s Resource Center ( www.pearsonhighered.com/irc ). LEARNING TOOLS FOR STUDENTS Beyond the book itself, students have access to valuable resources, such asMyFinanceLab and the Study Guide, that if taken advantage of can help ensure their success. MyFinanceLab MyFinanceLab opens the door to a powerful Web-based diag- nostic testing and tutorial system designed specifically for the Gitman/Zutter,Principles of Managerial Finance textbooks. With MyFinanceLab, instructors can create, edit, and assign online homework and test and track all student workin the online gradebook. MyFinanceLab allows students to take practice tests corre-lated to the textbook and receive a customized study plan based on the test results. Most end-of-chapter problems are available in MyFinanceLab, and because the problems have algorithmically generated values, no student will have the samehomework as another; there is an unlimited opportunity for practice and testing.Students get the help they need, when they need it, from the robust tutorialoptions, including “View an Example” and “Help Me Solve This,” which breaksthe problem into its steps and links to the relevant textbook page. This fully integrated online homework system gives students the hands-on practice and tutorial help they need to learn finance efficiently. There are ampleopportunities for online practice and assessment that is automatically graded inMyFinanceLab ( www.myfinancelab.com ). Advanced reporting features in MyFinanceLab also allow you to easily report on AACSB accreditation and assessment in just a few clicks. Chapter Cases with automatically graded assessment are also provided in MyFinanceLab. These cases have students apply the concepts they have learnedto a more complex and realistic situation. These cases help strengthen practicalapplication of financial tools and techniques. MyFinanceLab also has Group Exercises where students can work together in the context of an ongoing company. Each group creates a company and fol-lows it through the various managerial finance topics and business activities pre-sented in the textbook. MyFinanceLab provides Critical Thinking Problems, which require students to apply the various finance concepts and managerial techniques presented in thetextbook. These are rigorous problems that are designed to test a student’s abilityto understand the financial management situation, apply the necessary manage-rial finance concepts, and find the value-maximizing solution. An online glossary, digital flashcards, financial calculator tutorials, videos, Spreadsheet Use examples from the text in Excel, and numerous other premiumresources are available in MyFinanceLab. Students can use MyFinanceLab with no instructor intervention. However, to take advantage of the full capabilities of MyFinanceLab, including assigninghomework and tracking student progress in the automated gradebook, instruc-tors will want to set up their class. To view a demo of MyFinanceLab or torequest instructor access go to www.myfinancelab.com . Study Guide Revised by Shannon Donovan, Bridgewater State University. The Study Guide is an integral component of the Principles of Managerial Finance Teaching and Learning System. It offers many tools for studying finance. Eachchapter contains the following features: chapter summary enumerated bylearning goals; topical chapter outline, also broken down by learning goals forquick review; sample problem solutions; study tips and a full sample exam withthe answers at the end of the chapter. A financial dictionary of key terms islocated at the end of the Study Guide, along with an appendix with tips on using financial calculators.xlvi Supplements to the Thirteenth Edition Acknowledgments TO OUR COLLEAGUES, FRIENDS, AND FAMILY Prentice Hall sought the advice of a great many excellent reviewers, all of whom influenced the revisions of this book. The following individuals providedextremely thoughtful and useful comments for the preparation of the thirteenthedition: Johnny C. Chan, Western Kentucky University Kent Cofoid, Seminole Community College Shannon Donovan, Bridgewater State University Suk Hun Lee, Loyola University Chicago Hao Lin, California State University–Sacramento Larry Lynch, Roanoke College Alvin Nishimoto, Hawaii Pacific University William Sawatski, Southwestern College Steven R. Scheff, Florida Gulf Coast University Michael Schellenger, University of Wisconsin, Oshkosh Gordon M. Stringer, University of Colorado–Colorado Springs Barry Uze, University of Southwestern Louisiana Sam Veraldi, Duke University John Zietlow, Malone University Our special thanks go to the following individuals who analyzed the manu- script in previous editions: Saul W. Adelman M. Fall AininaGary A. Anderson Ronald F. Anderson James M. Andre Gene L. Andrusco Antonio Apap David A. Arbeit Allen Arkins Saul H. Auslander Peter W. Bacon Richard E. Ball Thomas Bankston Alexander Barges Charles Barngrover Michael Becker Omar Benkato Scott BesleyDouglas S. BibleCharles W. Blackwell Russell L. Block Calvin M. BoardmanPaul BolsterRobert J. BondiJeffrey A. Born Jerry D. Boswell Denis O. Boudreaux Kenneth J. BoudreauxWayne BoyetRon BraswellChristopher Brown William Brunsen Samuel B. BulmashFrancis E. CandaOmer CareyPatrick A. Casabona Robert Chatfield K. C. ChenRoger G. ClarkeTerrence M. ClauretieMark Cockalingam Boyd D. Collier Thomas CookMaurice P. CorriganMike CuddDonnie L. Daniel Prabir Datta Joel J. DautenLee E. Davis Irv DeGrawRichard F. DeMongPeter A. DeVito James P. D’Mello R. Gordon Dippel Carleton Donchess Thomas W. Donohue Vincent R. Driscoll Betty A. Driver Lorna Dotts David R. Durst Dwayne O. Eberhardt Ronald L. Ehresman Ted Ellis F. Barney English Greg Filbeck Ross A. Flaherty Rich Fortin Timothy J. Gallagher George W. Gallinger Sharon Garrison Gerald D. Gay Deborah Giarusso xlvii xlviii Acknowledgments R. H. Gilmer Anthony J. Giovino Michael Giuliano Philip W. Glasgo Jeffrey W. Glazer Joel Gold Ron B. Goldfarb Dennis W. Goodwin David A. Gordon J. Charles Granicz C. Ramon Griffin Reynolds Griffith Arthur Guarino Lewell F. Gunter Melvin W. Harju John E. HarperPhil Harrington George F. Harris George T. Harris John D. Harris Mary Hartman R. Stevenson Hawkey Roger G. Hehman Harvey Heinowitz Glenn Henderson Russell H. Hereth Kathleen T. Hevert J. Lawrence Hexter Douglas A. Hibbert Roger P. Hill Linda C. Hittle James Hoban Hugh A. HobsonKeith Howe Kenneth M. Huggins Jerry G. HuntMahmood Islam James F. Jackson Stanley Jacobs Dale W. Janowsky Jeannette R. Jesinger Nalina Jeypalan Timothy E. Johnson Roger Juchau Ashok K. Kapoor Daniel J. Kaufman Jr. Joseph K. Kiely Terrance E. Kingston Raj K. Kohli Thomas M. Krueger Lawrence Kryzanowski Harry R. Kuniansky Richard E. La Near William R. Lane James Larsen Rick LeCompte B. E. Lee Scott Lee Michael A. Lenarcic A. Joseph Lerro Thomas J. Liesz Alan Lines Christopher K. Ma James C. Ma Dilip B. Madan Judy Maese James Mallet Inayat Mangla Bala Maniam Timothy A. Manuel Brian Maris Daniel S. Marrone William H. Marsh John F. Marshall Linda J. Martin Stanley A. Martin Charles E. Maxwell Timothy Hoyt McCaughey Lee McClain Jay Meiselman Vincent A. Mercurio Joseph Messina John B. Mitchell Daniel F. Mohan Charles Mohundro Gene P. Morris Edward A. Moses Tarun K. Mukherjee William T. Murphy Randy Myers Lance Nail Donald A. Nast Vivian F. Nazar G. Newbould Charles Ngassam Gary NoreikoDennis T. OfficerKathleen J. OldfatherKathleen F. Oppenheimer Richard M. Osborne Jerome S. OsteryoungPrasad PadmanabahnRoger R. PalmerDon B. Panton John Park Ronda S. PaulBruce C. PayneGerald W. PerrittGladys E. Perry Stanley Piascik Gregory PierceMary L. PiotrowskiD. Anthony PlathJerry B. Poe Gerald A. PogueSuzanne Polley Ronald S. PretekinFran QuinnRich Ravichandran David RayoneWalter J. Reinhart Jack H. ReubensBenedicte ReyesWilliam B. Riley Jr. Ron Rizzuto Gayle A. RussellPatricia A. RyanMurray SabrinKanwal S. Sachedeva R. Daniel Sadlier Hadi SalavitabarGary Sanger Mukunthan Santhanakrishnan William L. Sartoris Michael Schinski Tom SchmidtCarl J. SchwendimanCarl Schweser Jim Scott John W. SettleRichard A. Shick A. M. SibleySandeep Singh Surendra S. Singhvi Stacy SirmansBarry D. SmithGerald SmolenIra Smolowitz Jean Snavely Joseph V. StanfordJohn A. StockerLester B. Strickler Elizabeth Strock Donald H. Stuhlman Sankar Sundarrajan Philip R. Swensen S. Tabriztchi John C. Talbott Gary Tallman Harry Tamule Richard W. Taylor Acknowledgments xlix Rolf K. Tedefalk Richard Teweles Kenneth J. Thygerson Robert D. Tollen Emery A. Trahan Pieter A. VandenbergNikhil P. Varaiya Oscar Varela Kenneth J. Venuto James A. Verbrugge Ronald P. Volpe John M. Wachowicz Jr. Faye (Hefei) Wang William H. Weber III Herbert Weinraub Jonathan B. Welch Grant J. Wells Larry R. White Peter WichertC. Don Wiggins Howard A. WilliamsRichard E. WilliamsGlenn A. Wilt Jr.Bernard J. WingerTony R. Wingler I. R. WoodsJohn C. WoodsRobert J. WrightRichard H. YanowSeung J. YoonCharles W. YoungPhilip J. YoungJoe W. ZemanJ. Kenton ZumwaltTom Zwirlein A special thanks goes to Thomas J. Boulton of Miami University for his work on the Focus on Ethics boxes and to Alan Wolk of the University of Georgia foraccuracy checking the quantitative content in the textbook. We are pleased by andproud of all their efforts. No textbook would be complete, let alone usable, if not for the accompanying instructor and student supplements. We are grateful to the following individualsfor their work creating, revising, and accuracy checking all of the valuableinstructor and student resources that support the use of Principles: Thomas Krueger of Texas A&M University–Kingsville for updating the Instructor’s Manual, Gordon Stringer of University of Colorado–Colorado Springs for accu- racy checking the Instructor’s Manual , Thomas J. Boulton of Miami University for revising the PowerPoint Lecture Presentation , and Shannon Donovan of Bridgewater State University for revising the Test Item File and the Study Guide. A hearty round of applause also goes to the publishing team assembled by Prentice Hall—including Donna Battista, Tessa O’Brien, Kerri McQueen, MelissaPellerano, Nancy Freihofer, Alison Eusden, Nicole Sackin, Miguel Leonarte, andothers who worked on the book—for the inspiration and the perspiration thatdefine teamwork. Also, special thanks to the formidable Prentice Hall sales forcein finance, whose ongoing efforts keep the business fun! Finally, and most important, many thanks to our families for patiently pro- viding support, understanding, and good humor throughout the revision process.To them we will be forever grateful. Lawrence J. Gitman La Jolla, California Chad J. Zutter Pittsburgh, Pennsylvania This page intentionally left blank To the Student Because you have a good many options for getting your assigned reading mate- rials we appreciate your choosing this textbook as the best means for learning in your managerial finance course. You should not be disappointed. In writingthis edition, we have been mindful of students and careful to maintain a studentfocus. The learning system in this book has been used by many of your predecessors in the course and has been proven effective. It integrates various learning toolswith the concepts, tools, techniques, and practical applications you will need tolearn about managerial finance. We have worked hard to present in a clear andinteresting way the information you will need. This book is loaded with featuresdesigned to motivate your study of finance and to help you learn the course mate-rial. Go to pages vii–xii (“Our Proven Teaching and Learning System”) for anoverview and walkthrough of those features. Notice that the book includesPersonal Finance Examples (and related end-of-chapter problems) that show howto apply managerial finance concepts and tools to your personal financial life. About some of the specific features: First, pay attention to the learning goals, which will help you focus on what material you need to learn, where you can findit in the chapter, and whether you’ve mastered it by the end of the chapter. Second, avoid the temptation to rush past the Review Questions at the end of each major text section. Pausing briefly to test your understanding of the sectioncontent will help you cement your understanding. Give yourself an honest assess-ment. If some details are fuzzy, go back (even briefly) and review anything thatstill seems unclear. Third, look for (or make) opportunities to talk with classmates or friends about what you are reading and learning in the course. Talking about the con-cepts and techniques of finance demonstrates how much you’ve learned, uncoversthings you haven’t yet understood fully, and gives you valuable practice for classand (eventually) the business world. While you’re talking, don’t neglect to discussthe issues raised in the Focus on Ethics boxes, which look at some of the oppor-tunities to do right (or not) that business people face. MyFinanceLab opens the door to a powerful Web-based diagnostic testing and tutorial system designed for this text. MyFinanceLab allows you to takepractice exams correlated to the textbook and receive a customized study planbased on your results. The assignment Problems in MyFinanceLab, based on theeven-numbered end-of-chapter Problems in the book, have algorithmically gener-ated values. Thus, the numbers in your homework will differ from those of yourclassmates, and there is an unlimited opportunity for practice and testing. Youcan get the help you need, when you need it, from the robust tutorial options,including “View an Example” and “Help Me Solve This,” which breaks theproblem into steps and links to the relevant textbook page. li Given today’s rapidly changing technology, who knows what might be avail- able next? We are striving to keep pace with your needs and interests, and wouldlike to hear your ideas for improving the teaching and learning of finance. We wish you all the best in this course and in your academic and professional careers. Lawrence J. Gitman La Jolla, California Chad J. Zutter Pittsburgh, Pennsylvanialii To the Student 11 PartIntroduction to Managerial Finance 1The Role of Managerial Finance 2The Financial Market Environment INTEGRATIVE CASE 1 Merit Enterprise Corp. Part 1 of Principles of Managerial Finance discusses the role that financial managers play in businesses and the financial market environment in which firms operate. We argue that the goal of managers should be to maximize the value of the firm and by doing so maximize the wealth of its owners. Financial managers act on behalf of the firm ’s owners by making operating and investment decisions whose benefits exceed their costs. These decisions create wealth for shareholders.Maximizing shareholder wealth is important because firms operate in a highlycompetitive financial market environment that offers shareholders many alternatives for investing their funds. To raise the financial resources necessary to fund the firm ’s ongoing operations and future investment opportunities, managers have to delivervalue to the firm ’s investors. Without smart financial managers and access to financial markets, firms are unlikely to survive, let alone achieve the long-term goal ofmaximizing the value of the firm.Chapters in This Part Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand the relationships between the accounting and finance functions within the firm; how decision makersrely on the financial statements you prepare; why maximizing a firm ’s value is not the same as maximizing its profits; and the ethical duty that you have when reporting financial results to investors and otherstakeholders. INFORMATION SYSTEMS You need to understand why financial infor- mation is important to managers in all functional areas; the documenta-tion that firms must produce to comply with various regulations; andhow manipulating information for personal gain can get managers intoserious trouble. MANAGEMENT You need to understand the various legal forms of a business organization; how to communicate the goal of the firm toemployees and other stakeholders; the advantages and disadvantagesof the agency relationship between a firm ’s managers and its owners; and how compensation systems can align or misalign the interests ofmanagers and investors. MARKETING You need to understand why increasing a firm ’s revenues or market share is not always a good thing; how financial managersevaluate aspects of customer relations such as cash and credit manage-ment policies; and why a firm ’s brands are an important part of its value to investors. OPERATIONS You need to understand the financial benefits of increasing a firm ’s production efficiency; why maximizing profit by cut- ting costs may not increase the firm ’s value; and how managers act on behalf of investors when operating a corporation. Many of the principles of manage- rial finance also apply to your per- sonal life. Learning a few simple financial principles can help youmanage your own money more effectively. In your personal lifeLearning Goals Define finance and the managerial finance function. Describe the legal forms of business organization. Describe the goal of the firm, and explain why maximizing the valueof the firm is an appropriate goalfor a business. Describe how the managerial finance function is related to economics and accounting. Identify the primary activities of the financial manager. Describe the nature of the principal–agent relationshipbetween the owners andmanagers of a corporation, andexplain how various corporategovernance mechanisms attemptto manage agency problems.LG6LG5LG4LG3LG2LG11The Role of Managerial Finance 2 3In No Hurry to Go Public Facebook founder and chief executive officer Mark Zuckerberg is in no hurry to go public, even though he concedes that it is an inevitable step in the evolution of his firm. The Facebook CEO ison record saying that “we ’re going to go public eventually, because that ’s the contract that we have with our investors and our employees. . . . [but] we are definitely in no rush. ” Nearly all public firms were at one time privately held by relatively few shareholders, but at some point thefirms ’ managers decided to go public. The decision to go public is one of the most important decisions managers can make. Private firms are typically held by fewer shareholders and are subject to less regulation than are public firms. So why do firms go public at all ? Often it is to provide an exit strategy for its private investors, gain access to investment capital, establish a market price for the firm ’s shares, gain public exposure, or all of the above. Going public helps firms grow, but that andother benefits of public ownership must be weighed against the costs of going public. Although taking Facebook public would likely make Zuckerberg one of the richest persons in the world under the age of 30, it would also mean that his firm would become subject to the influences of outside investors and government regulators. A public firm ’s managers work for and are responsible to the firm ’s investors, and government regulations require firms to provide investors with frequent reports disclosing material information about the firm ’s performance. The regulatory demands placed on managers of public firms can sometimes distract managers fromimportant aspects of running their businesses. This chapter will highlight the tradeoffs faced by financial managers as they make decisions intended to maximize the value of their firms. Facebook 4 PART 1 Introduction to Managerial Finance 1.1Finance and Business The field of finance is broad and dynamic. Finance influences everything that firms do, from hiring personnel to building factories to launching new advertisingcampaigns. Because there are important financial dimensions to almost anyaspect of business, there are many financially oriented career opportunities forthose who understand the basic principles of finance described in this textbook.Even if you do not see yourself pursuing a career in finance, you’ll find that anunderstanding of a few key ideas in finance will help make you a smarter con-sumer and a wiser investor with your own money. WHAT IS FINANCE? Finance can be defined as the science and art of managing money. At the personal level, finance is concerned with individuals’ decisions about how much of theirearnings they spend, how much they save, and how they invest their savings. In abusiness context, finance involves the same types of decisions: how firms raisemoney from investors, how firms invest money in an attempt to earn a profit, andhow they decide whether to reinvest profits in the business or distribute themback to investors. The keys to good financial decisions are much the same forbusinesses and individuals, which is why most students will benefit from anunderstanding of finance regardless of the career path they plan to follow.Learning the techniques of good financial analysis will not only help you makebetter financial decisions as a consumer, but it will also help you understand thefinancial consequences of the important business decisions you will face nomatter what career path you follow. CAREER OPPORTUNITIES IN FINANCE Careers in finance typically fall into one of two broad categories: (1) financialservices and (2) managerial finance. Workers in both areas rely on a commonanalytical “tool kit,” but the types of problems to which that tool kit is appliedvary a great deal from one career path to the other. Financial Services Financial services is the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and governments. Itinvolves a variety of interesting career opportunities within the areas of banking,personal financial planning, investments, real estate, and insurance. Managerial Finance Managerial finance is concerned with the duties of the financial manager working in a business. Financial managers administer the financial affairs of all types of businesses—private and public, large and small, profit seeking and notfor profit. They perform such varied tasks as developing a financial plan orbudget, extending credit to customers, evaluating proposed large expenditures, andraising money to fund the firm’s operations. In recent years, a number of factorshave increased the importance and complexity of the financial manager’s duties.These factors include the recent global financial crisis and subsequent responsesLG2 LG1 finance The science and art of managing money. financial services The area of finance concerned with the design and delivery ofadvice and financial productsto individuals, businesses, andgovernments. managerial finance Concerns the duties of the financial manager in a business. by regulators, increased competition, and technological change. For example, globalization has led U.S. corporations to increase their transactions in othercountries, and foreign corporations have done likewise in the United States. Thesechanges increase demand for financial experts who can manage cash flows in dif-ferent currencies and protect against the risks that arise from international trans-actions. These changes increase the finance function’s complexity, but they alsocreate opportunities for a more rewarding career. The increasing complexity of thefinancial manager’s duties has increased the popularity of a variety of professionalcertification programs outlined in the Focus on Practice box below. Financial managers today actively develop and implement corporate strategies aimed athelping the firm grow and improving its competitive position. As a result, manycorporate presidents and chief executive officers (CEOs) rose to the top of theirorganizations by first demonstrating excellence in the finance function. LEGAL FORMS OF BUSINESS ORGANIZATION One of the most basic decisions that all businesses confront is how to choose alegal form of organization. This decision has very important financial implica-tions because how a business is organized legally influences the risks that theCHAPTER 1 The Role of Managerial Finance 5 financial manager Actively manages the financial affairs of all types of businesses, whether private or public, large or small, profit seeking or not for profit. focus on PRACTICE Professional Certifications in Finance in a wide range of fields. Their certifications include the CharteredPortfolio Manager, Chartered AssetManager, Certified Risk Analyst,Certified Cost Accountant, CertifiedCredit Analyst, and many other pro-grams. See the AAFM website forcomplete details on all of theAAFM educational programs. Professional Certifications in Accounting —Most professionals in the field of managerial financeneed to know a great deal aboutaccounting to succeed in their jobs.Professional certifications inaccounting include the CertifiedPublic Accountant (CPA), CertifiedManagement Accountant (CMA),Certified Internal Auditor (CIA), andmany other programs. 3 Why do employers value having employees with professional certifi- cations?Certified Treasury Professional (CTP)—The CTP program requires students to pass a single exam thatis focused on the knowledge andskills needed for those working in acorporate treasury department. Theprogram emphasizes topics such asliquidity and working capital man-agement, payment transfer systems, capital structure, managing relation- ships with financial service providers,and monitoring and controllingfinancial risks. Certified Financial Planner (CFP) — To obtain CFP status, students mustpass a 10-hour exam covering awide range of topics related to per-sonal financial planning. The CFPprogram also requires 3 years offull-time relevant experience. Theprogram focuses primarily on skillsrelevant for advising individuals indeveloping their personal financialplans. American Academy of Financial Management (AAFM) —The AAFM administers a host of certificationprograms for financial professionalsTo be successful in finance and just about any other field, you need to continueyour education beyond your undergrad-uate degree. For some people thatmeans getting an MBA, but there aremany other ways to advance your edu-cation and enhance your credentialswithout getting a graduate degree. Infinance, there are a variety of profes-sional certification programs that arewidely recognized in the field. Chartered Financial Analyst (CFA) —Offered by the CFA Institute, the CFA program is agraduate-level course of studyfocused primarily on the investmentsside of finance. To earn the CFACharter, students must pass a seriesof three exams, usually over a 3-year period, and have 48 monthsof professional experience. Althoughthis program appeals primarily tothose who work in the investmentsfield, the skills developed in theCFA program are useful in a variety of corporate finance jobs as well. in practice firm’s owners must bear, how the firm can raise money, and how the firm’s profits will be taxed. The three most common legal forms of business organization arethesole proprietorship, thepartnership, and the corporation. More businesses are organized as sole proprietorships than any other legal form. However, thelargest businesses are almost always organized as corporations. Even so, eachtype of organization has its advantages and disadvantages. Sole Proprietorships Asole proprietorship is a business owned by one person who operates it for his or her own profit. About 73 percent of all businesses are sole proprietorships.The typical sole proprietorship is small, such as a bike shop, personal trainer, orplumber. The majority of sole proprietorships operate in the wholesale, retail,service, and construction industries. Typically, the owner (proprietor), along with a few employees, operates the proprietorship. The proprietor raises capital from personal resources or by bor-rowing, and he or she is responsible for all business decisions. As a result, thisform of organization appeals to entrepreneurs who enjoy working independently. A major drawback to the sole proprietorship is unlimited liability, which means that liabilities of the business are the entrepreneur’s responsibility, andcreditors can make claims against the entrepreneur’s personal assets if the busi-ness fails to pay its debts. The key strengths and weaknesses of sole proprietor-ships are summarized in Table 1.1. Partnerships Apartnership consists of two or more owners doing business together for profit. Partnerships account for about 7 percent of all businesses, and they are typicallylarger than sole proprietorships. Partnerships are common in the finance, insur-ance, and real estate industries. Public accounting and law partnerships oftenhave large numbers of partners. Most partnerships are established by a written contract known as articles of partnership. In a general (orregular )partnership, all partners have unlimited lia- bility, and each partner is legally liable for allof the debts of the partnership. Table 1.1 summarizes the strengths and weaknesses of partnerships.6 PART 1 Introduction to Managerial Finance sole proprietorship A business owned by one person and operated for his or her own profit. unlimited liability The condition of a soleproprietorship (or generalpartnership), giving creditorsthe right to make claimsagainst the owner’s personalassets to recover debts owedby the business. partnership A business owned by two ormore people and operated forprofit. articles of partnership The written contract used toformally establish a businesspartnership. Matter of fact Although there are vastly more sole proprietorships than there are partnerships and corpo- rations combined, they generate the lowest level of receipts. In total, sole proprietorships generated more than $969 billion in receipts, but this number hardly compares to the more than $17 trillion in receipts generated by corporations.BizStats.com Total Receipts by Type of U.S. Firm Sole proprietorships Partnerships Corporations Number of firms (millions) 17.6 1.8 4.8 Percentage of all firms 73% 7% 20%Total receipts ($ billions) 969 1,142 17,324Percentage of all receipts 5% 6% 89%BizStats.com Total Receipts by Type of U.S. Firm Corporations Acorporation is an entity created by law. A corporation has the legal powers of an individual in that it can sue and be sued, make and be party to contracts, andacquire property in its own name. Although only about 20 percent of all U.S.businesses are incorporated, the largest businesses nearly always are; corpora-tions account for nearly 90 percent of total business revenues. Although corpora-tions engage in all types of businesses, manufacturing firms account for thelargest portion of corporate business receipts and net profits. Table 1.1 lists thekey strengths and weaknesses of corporations. The owners of a corporation are its stockholders, whose ownership, or equity, takes the form of either common stock or preferred stock. Unlike the owners of sole proprietorships or partnerships, stockholders of a corporationenjoy limited liability, meaning that they are not personally liable for the firm’s debts. Their losses are limited to the amount they invested in the firm when theypurchased shares of stock. In Chapter 7 you will learn more about common andpreferred stock, but for now it is enough to say that common stock is the purest and most basic form of corporate ownership. Stockholders expect to earn aCHAPTER 1 The Role of Managerial Finance 7 corporation An entity created by law.Strengths and Weaknesses of the Common Legal Forms of Business Organization Sole proprietorship Partnership Corporation StrengthsTABLE 1.1 • Owner receives all profits (and sustains all losses) • Low organizational costs• Income included and taxed on proprietor’s personal tax return • Independence• Secrecy• Ease of dissolution• Can raise more funds than sole proprietorships • Borrowing power enhanced by more owners • More available brain power and managerial skill • Income included and taxed on partner’s personal tax return• Owners have limited liability, which guarantees that theycannot lose more than theyinvested • Can achieve large size via sale of ownership (stock) • Ownership (stock) is readily transferable • Long life of firm• Can hire professional managers• Has better access to financing • Owner has unlimited liability — total wealth can be taken tosatisfy debts • Limited fund-raising power tends to inhibit growth • Proprietor must be jack-of-all- trades • Difficult to give employees long- run career opportunities • Lacks continuity when proprietor dies• Owners have unlimited liability and may have to cover debts ofother partners • Partnership is dissolved when a partner dies • Difficult to liquidate or transfer partnership• Taxes generally higher because corporate income is taxed, anddividends paid to owners arealso taxed at a maximum 15%rate • More expensive to organize than other business forms • Subject to greater government regulation • Lacks secrecy because regulations require firms todisclose financial resultsWeaknesses stockholders The owners of a corporation, whose ownership, or equity, takes the form of eithercommon stock or preferredstock. common stock The purest and most basic formof corporate ownership.limited liability A legal provision that limits stockholders’ liability for a corporation’s debt to theamount they initially invested inthe firm by purchasing stock. return by receiving dividends —periodic distributions of cash—or by realizing gains through increases in share price. Because the money to pay dividends gen-erally comes from the profits that a firm earns, stockholders are sometimesreferred to as residual claimants, meaning that stockholders are paid last—after employees, suppliers, tax authorities, and lenders receive what they are owed. Ifthe firm does not generate enough cash to pay everyone else, there is nothingavailable for stockholders. As noted in the upper portion of Figure 1.1, control of the corporation func- tions a little like a democracy. The stockholders (owners) vote periodically toelect members of the board of directors and to decide other issues such as amending the corporate charter. The board of directors is typically responsible for approving strategic goals and plans, setting general policy, guiding corporateaffairs, and approving major expenditures. Most importantly, the board decideswhen to hire or fire top managers and establishes compensation packages for themost senior executives. The board consists of “inside” directors, such as key cor-porate executives, and “outside” or “independent” directors, such as executivesfrom other companies, major shareholders, and national or community leaders.Outside directors for major corporations receive compensation in the form ofcash, stock, and stock options. This compensation often totals $100,000 per yearor more.8 PART 1 Introduction to Managerial Finance dividends Periodic distributions of cash to the stockholders of a firm. Financial Planning and Fund-Raising ManagerCash ManagerPension Fund ManagerCapital Expenditure ManagerCredit ManagerForeign Exchange Manager Corporate Accounting ManagerFinancial Accounting ManagerTax ManagerTreasurerVice President ManufacturingVice President Human ResourcesVice President Finance (CFO)President (CEO)Board of Directors Owners ManagersStockholders elect hires Vice President MarketingVice President Information Technology Controller Cost Accounting ManagerFIGURE 1.1 Corporate Organization The general organizationof a corporation and the finance function (which is shown in yellow)board of directors Group elected by the firm’s stockholders and typicallyresponsible for approvingstrategic goals and plans,setting general policy, guidingcorporate affairs, andapproving major expenditures. Thepresident or chief executive officer (CEO) is responsible for managing day-to-day operations and carrying out the policies established by the board ofdirectors. The CEO reports periodically to the firm’s directors. It is important to note the division between owners and managers in a large corporation, as shown by the dashed horizontal line in Figure 1.1. This separa-tion and some of the issues surrounding it will be addressed in the discussion ofthe agency issue later in this chapter. Other Limited Liability Organizations A number of other organizational forms provide owners with limited liability. The most popular are limited partnership (LP), S corporation (S corp), limited lia- bility company (LLC), andlimited liability partnership (LLP) . Each represents a specialized form or blending of the characteristics of the organizational formsdescribed previously. What they have in common is that their owners enjoy lim-ited liability, and they typically have fewer than 100 owners. WHY STUDY MANAGERIAL FINANCE? An understanding of the concepts, techniques, and practices presentedthroughout this text will fully acquaint you with the financial manager’s activitiesand decisions. Because the consequences of most business decisions are measuredin financial terms, the financial manager plays a key operational role. People inall areas of responsibility—accounting, information systems, management, mar-keting, operations, and so forth—need a basic awareness of finance so they willunderstand how to quantify the consequences of their actions. OK, so you’re not planning to major in finance! You still will need to under- stand how financial managers think to improve your chance of success in yourchosen business career. Managers in the firm, regardless of their job descriptions,usually have to provide financial justification for the resources they need to dotheir job. Whether you are hiring new workers, negotiating an advertisingbudget, or upgrading the technology used in a manufacturing process, under-standing the financial aspects of your actions will help you gain the resources youneed to be successful. The “Why This Chapter Matters to You” section that appearson each chapter opening page should help you understand the importance ofeach chapter in both your professional and personal life. As you study this text, you will learn about the career opportunities in man- agerial finance, which are briefly described in Table 1.2 on page 10. Although this text focuses on publicly held profit-seeking firms, the principles presented here areequally applicable to private and not-for-profit organizations. The decision- making principles developed in this text can also be applied to personal financialdecisions. We hope that this first exposure to the exciting field of finance will pro-vide the foundation and initiative for further study and possibly even a futurecareer. 6REVIEW QUESTIONS 1–1What is finance? Explain how this field affects all of the activities in which businesses engage. 1–2What is the financial services area of finance? Describe the field of managerial finance.CHAPTER 1 The Role of Managerial Finance 9 president or chief executive officer (CEO) Corporate official responsible for managing the firm’s day-to-day operations and carryingout the policies established bythe board of directors. limited partnership (LP) S corporation (S corp) limited liability company (LLC) limited liability partnership (LLP) See “In More Depth” feature. In more depth To read about Other Limited Liability Organizations , go to www.myfinancelab.com 1–3Which legal form of business organization is most common? Which form is dominant in terms of business revenues? 1–4Describe the roles and the basic relationships among the major partiesin a corporation—stockholders, board of directors, and managers. Howare corporate owners rewarded for the risks they take? 1–5Briefly name and describe some organizational forms other than corpo-rations that provide owners with limited liability. 1–6Why is the study of managerial finance important to your professionallife regardless of the specific area of responsibility you may have withinthe business firm? Why is it important to your personal life?10 PART 1 Introduction to Managerial Finance Career Opportunities in Managerial Finance Position Description Financial analyst Prepares the firm’s financial plans and budgets. Other duties include financial forecasting, performing financial comparisons, and working closely with accounting. Capital expenditures manager Evaluates and recommends proposed long-term investments. May be involved in the financial aspects of implementing approved investments. Project finance manager Arranges financing for approved long-term investments. Coordinates consultants, investment bankers, and legal counsel. Cash manager Maintains and controls the firm’s daily cash balances. Frequently manages the firm’s cash collection and disbursement activities and short-term investments andcoordinates short-term borrowing and banking relationships. Credit analyst/manager Administers the firm’s credit policy by evaluating credit applications, extending credit, and monitoring and collecting accounts receivable. Pension fund manager Oversees or manages the assets and liabilities of the employees’ pension fund.Foreign exchange manager Manages specific foreign operations and the firm’s exposure to fluctuations in exchange rates.TABLE 1.2 1.2Goal of the Firm What goal should managers pursue? There is no shortage of possible answers to this question. Some might argue that managers should focus entirely on satisfyingcustomers. Progress toward this goal could be measured by the market shareattained by each of the firm’s products. Others suggest that managers must firstinspire and motivate employees; in that case, employee turnover might be the keysuccess metric to watch. Clearly the goal that managers select will affect many ofthe decisions that they make, so choosing an objective is a critical determinant ofhow businesses operate. MAXIMIZE SHAREHOLDER WEALTH Finance teaches that managers’ primary goal should be to maximize the wealth ofthe firm’s owners—the stockholders. The simplest and best measure of stock-holder wealth is the firm’s share price, so most textbooks (ours included) instructLG3 managers to take actions that increase the firm’s share price. A common miscon- ception is that when firms strive to make their shareholders happy, they do so atthe expense of other constituencies such as customers, employees, or suppliers.This line of thinking ignores the fact that in most cases, to enrich shareholders,managers must first satisfy the demands of these other interest groups. Recall thatdividends that stockholders receive ultimately come from the firm’s profits. It isunlikely that a firm whose customers are unhappy with its products, whoseemployees are looking for jobs at other firms, or whose suppliers are reluctant toship raw materials will make shareholders rich because such a firm will likely beless profitable in the long run than one that better manages its relations withthese stakeholder groups. Therefore, we argue that the goal of the firm, and also of managers, should beto maximize the wealth of the owners for whom it is being operated, or equivalently, to maximize the stock price. This goal translates into a straightfor-ward decision rule for managers— only take actions that are expected to increase the share price. Although that goal sounds simple, implementing it is not always easy. To determine whether a particular course of action will increase or decreasea firm’s share price, managers have to assess what return (that is, cash inflows net of cash outflows) the action will bring and how risky that return might be.Figure 1.2 depicts this process. In fact, we can say that the key variables that managers must consider when making business decisions are return (cash flows)and risk . MAXIMIZE PROFIT? It might seem intuitive that maximizing a firm’s share price is equivalent to max- imizing its profits, but that is not always correct. Corporations commonly measure profits in terms of earnings per share (EPS), which represent the amount earned during the period on behalf of each outstanding share of common stock. EPS are calculated by dividing the period’stotal earnings available for the firm’s common stockholders by the number ofshares of common stock outstanding.CHAPTER 1 The Role of Managerial Finance 11 Financial ManagerReturn? Risk?Financial Decision Alternative or ActionAccept RejectYesIncrease Share Price? NoFIGURE 1.2 Share Price Maximization Financial decisions andshare priceearnings per share (EPS) The amount earned during the period on behalf of eachoutstanding share of commonstock, calculated by dividingthe period’s total earningsavailable for the firm’scommon stockholders by the number of shares of common stock outstanding. Nick Dukakis, the financial manager of Neptune Manufacturing, a producer of marine engine components, is choosing between two investments, Rotor andValve. The following table shows the EPS that each investment is expected tohave over its 3-year life. In terms of the profit maximization goal, Valve would be preferred over Rotor because it results in higher total earnings per share over the 3-year period ($3.00 EPS compared with $2.80 EPS). But does profit maximization lead to the highest possible share price? For at least three reasons the answer is often no. First, timing is important. An invest-ment that provides a lower profit in the short run may be preferable to one thatearns a higher profit in the long run. Second, profits and cash flows are not iden-tical. The profit that a firm reports is simply an estimate of how it is doing, anestimate that is influenced by many different accounting choices that firms makewhen assembling their financial reports. Cash flow is a more straightforwardmeasure of the money flowing into and out of the company. Companies have topay their bills with cash, not earnings, so cash flow is what matters most to finan-cial managers. Third, risk matters a great deal. A firm that earns a low but reli-able profit might be more valuable than another firm with profits that fluctuate agreat deal (and therefore can be very high or very low at different times). Timing Because the firm can earn a return on funds it receives, the receipt of funds sooner rather than later is preferred. In our example, in spite of the fact that the total earnings from Rotor are smaller than those from Valve, Rotor provides muchgreater earnings per share in the first year. The larger returns in year 1 could bereinvested to provide greater future earnings. Cash Flows Profits do notnecessarily result in cash flows available to the stockholders. There is no guarantee that the board of directors will increase dividends when profitsincrease. In addition, the accounting assumptions and techniques that a firmadopts can sometimes allow a firm to show a positive profit even when its cashoutflows exceed its cash inflows. Furthermore, higher earnings do not necessarily translate into a higher stock price. Only when earnings increases are accompanied by increased future cashflows is a higher stock price expected. For example, a firm with a high-qualityproduct sold in a very competitive market could increase its earnings by signifi-cantly reducing its equipment maintenance expenditures. The firm’s expenseswould be reduced, thereby increasing its profits. But if the reduced maintenanceExample 1.1312 PART 1 Introduction to Managerial Finance Earnings per share (EPS) Investment Year 1 Year 2 Year 3 Total for years 1, 2, and 3 Rotor $1.40 $1.00 $0.40 $2.80 Valve 0.60 1.00 1.40 3.00 results in lower product quality, the firm may impair its competitive position, and its stock price could drop as many well-informed investors sell the stock in antic-ipation of lower future cash flows. In this case, the earnings increase was accom-panied by lower future cash flows and therefore a lower stock price. Risk Profit maximization also fails to account for risk—the chance that actual out- comes may differ from those expected. A basic premise in managerial finance isthat a trade-off exists between return (cash flow) and risk. Return and risk are, in fact, the key determinants of share price, which represents the wealth of theowners in the firm. Cash flow and risk affect share price differently: Holding risk fixed, higher cash flow is generally associated with a higher share price. In contrast, holding cashflow fixed, higher risk tends to result in a lower share price because the stock-holders do not like risk. For example, Apple’s CEO, Steve Jobs, took a leave ofabsence to battle a serious health issue, and the firm’s stock suffered as a result.This occurred not because of any near-term cash flow reduction but in response tothe firm’s increased risk—there’s a chance that the firm’s lack of near-term leader-ship could result in reduced future cash flows. Simply put, the increased riskreduced the firm’s share price. In general, stockholders are risk averse —that is, they must be compensated for bearing risk. In other words, investors expect to earnhigher returns on riskier investments, and they will accept lower returns on rela-tively safe investments. The key point, which will be fully developed in Chapter 5,is that differences in risk can significantly affect the value of different investments. WHAT ABOUT STAKEHOLDERS? Although maximization of shareholder wealth is the primary goal, many firmsbroaden their focus to include the interests of stakeholders as well as share- holders. Stakeholders are groups such as employees, customers, suppliers, credi- tors, owners, and others who have a direct economic link to the firm. A firmwith a stakeholder focus consciously avoids actions that would prove detri- mental to stakeholders. The goal is not to maximize stakeholder well-being butto preserve it. The stakeholder view does not alter the goal of maximizing shareholder wealth. Such a view is often considered part of the firm’s “social responsibility.”It is expected to provide long-run benefit to shareholders by maintaining positiverelationships with stakeholders. Such relationships should minimize stakeholderturnover, conflicts, and litigation. Clearly, the firm can better achieve its goal ofshareholder wealth maximization by fostering cooperation with its other stake-holders, rather than conflict with them. THE ROLE OF BUSINESS ETHICS Business ethics are the standards of conduct or moral judgment that apply to per- sons engaged in commerce. Violations of these standards in finance involve avariety of actions: “creative accounting,” earnings management, misleadingfinancial forecasts, insider trading, fraud, excessive executive compensation,options backdating, bribery, and kickbacks. The financial press has reportedmany such violations in recent years, involving such well-known companies asCHAPTER 1 The Role of Managerial Finance 13 risk The chance that actual outcomes may differ from thoseexpected. risk averse Requiring compensation tobear risk. stakeholders Groups such as employees,customers, suppliers, creditors,owners, and others who havea direct economic link to thefirm. business ethics Standards of conduct or moraljudgment that apply to personsengaged in commerce. Apple and Bank of America. As a result, the financial community is developing and enforcing ethical standards. The goal of these ethical standards is to motivatebusiness and market participants to adhere to both the letter and the spirit oflaws and regulations concerned with business and professional practice. Mostbusiness leaders believe businesses actually strengthen their competitive positionsby maintaining high ethical standards. Considering Ethics Robert A. Cooke, a noted ethicist, suggests that the following questions be usedto assess the ethical viability of a proposed action. 1 1. Is the action arbitrary or capricious? Does it unfairly single out an individual or group? 2. Does the action violate the moral or legal rights of any individual or group? 3. Does the action conform to accepted moral standards?4. Are there alternative courses of action that are less likely to cause actual or potential harm? Clearly, considering such questions before taking an action can help to ensure its ethical viability. Today, many firms are addressing the issue of ethics by establishing corpo- rate ethics policies. The Focus on Ethics box provides an example of ethics poli- cies at Google. A major impetus toward the development of ethics policies hasbeen the Sarbanes-Oxley Act of 2002. Frequently, employees are required to signa formal pledge to uphold the firm’s ethics policies. Such policies typically applyto employee actions in dealing with all corporate stakeholders, including thepublic. Ethics and Share Price An effective ethics program can enhance corporate value by producing a numberof positive benefits. It can reduce potential litigation and judgment costs, main-tain a positive corporate image, build shareholder confidence, and gain the loy-alty, commitment, and respect of the firm’s stakeholders. Such actions, bymaintaining and enhancing cash flow and reducing perceived risk, can positivelyaffect the firm’s share price. Ethical behavior is therefore viewed as necessary for achieving the firm’s goal of owner wealth maximization. 6REVIEW QUESTIONS 1–7What is the goal of the firm and, therefore, of all managers and employees? Discuss how one measures achievement of this goal. 1–8For what three basic reasons is profit maximization inconsistent with wealth maximization?14 PART 1 Introduction to Managerial Finance 1. Robert A. Cooke, “Business Ethics: A Perspective,” in Arthur Andersen Cases on Business Ethics (Chicago: Arthur Andersen, September 1991), pp. 2 and 5. 1–9What is risk? Why must risk as well as return be considered by the financial manager who is evaluating a decision alternative or action? 1–10 Describe the role of corporate ethics policies and guidelines, and dis-cuss the relationship that is believed to exist between ethics and shareprice.CHAPTER 1 The Role of Managerial Finance 15 focus on ETHICS Will Google Live Up to Its Motto? Google offers an inter- esting case study on value maximization and corporateethics. In 2004, Google ’s founders pro- vided “An Owner ’s Manual ” for share- holders, which stated that “Google is not a conventional company ” and that the company ’s ultimate goal “is to develop services that significantly improve the lives of as many people aspossible. ”The founders stressed that it was not enough for Google to run asuccessful business but that they want to use the company to make the world a better place. The “Owner ’s Manual ” also unveiled Google ’s corporate motto, “Don ’t Be Evil. ” The motto is intended to convey Google ’s willing- ness to do the right thing even when doing so requires the firm to sacrifice inthe short run. Google ’s approach does not appear to be limiting its ability to maximize value—the company ’s share price increased from $100 to approxi-mately $500 in 6 years.in practiceGoogle ’s business goal is “instantly delivering relevant information on anytopic ” to the world. However, when the company launched its search engine inChina in early 2006, it agreed to theChinese government ’s request to censor search results. Some observers felt thatthe opportunity to gain access to the vast Chinese market led Google to compromise its principles. In January 2010, Google announced that the Gmail accounts ofChinese human-rights activists and a number of technology, financial, and defense companies had been hacked.The company threatened to pull out ofChina unless an agreement on uncen-sored search results could be reached. Two months later, Google began rout- ing Chinese web searches to theiruncensored servers in Hong Kong, amove that was cheered by activists and human-rights groups, but criticized by the Chinese government. In the shortterm, Google ’s shareholders suffered.During the first quarter of 2010, Google ’s share price declined by 8.5 percent, compared to an increase of45.2 percent for Google ’s main rival in China, Baidu.com. Google ’s founders seemed to antici- pate the current situation in the firm ’s “Owner ’s Manual. ” According to the firm, “If opportunities arise that might cause us to sacrifice short-term resultsbut are in the best long-term interest of our shareholders, we will take those opportunities. We have the fortitude todo this. We would request that ourshareholders take the long-term view. ” It remains to be seen whether Google ’s short-term sacrifice will benefit share- holders in the long run. 3 Is the goal of maximization of shareholder wealth necessarily ethical or unethical? 3How can Google justify its actions in the short run to its long-run investors? Source: 2004 Founders ’ IPO Letter, http://investor.google.com/corporate/2004/ipo-founders-letter.html 1.3Managerial Finance Function People in all areas of responsibility within the firm must interact with finance per- sonnel and procedures to get their jobs done. For financial personnel to makeuseful forecasts and decisions, they must be willing and able to talk to individualsin other areas of the firm. For example, when considering a new product, thefinancial manager needs to obtain sales forecasts, pricing guidelines, and adver-tising and promotion budget estimates from marketing personnel. The manage-rial finance function can be broadly described by considering its role within theLG5 LG4 organization, its relationship to economics and accounting, and the primary activities of the financial manager. ORGANIZATION OF THE FINANCE FUNCTION The size and importance of the managerial finance function depend on the size ofthe firm. In small firms, the finance function is generally performed by theaccounting department. As a firm grows, the finance function typically evolvesinto a separate department linked directly to the company president or CEOthrough the chief financial officer (CFO). The lower portion of the organizationalchart in Figure 1.1 on page 8 shows the structure of the finance function in a typ-ical medium- to large-size firm. Reporting to the CFO are the treasurer and the controller. The treasurer (the chief financial manager) typically manages the firm’s cash, investing surplusfunds when available and securing outside financing when needed. The treasureralso oversees a firm’s pension plans and manages critical risks related to move-ments in foreign currency values, interest rates, and commodity prices. Thecontroller (the chief accountant) typically handles the accounting activities, such as corporate accounting, tax management, financial accounting, and cost accounting.The treasurer’s focus tends to be more external, whereas the controller’s focus ismore internal. If international sales or purchases are important to a firm, it may well employ one or more finance professionals whose job is to monitor and managethe firm’s exposure to loss from currency fluctuations. A trained financial man-ager can “hedge,” or protect against such a loss, at a reasonable cost by using avariety of financial instruments. These foreign exchange managers typically report to the firm’s treasurer. RELATIONSHIP TO ECONOMICS The field of finance is closely related to economics. Financial managers mustunderstand the economic framework and be alert to the consequences of varyinglevels of economic activity and changes in economic policy. They must also beable to use economic theories as guidelines for efficient business operation.Examples include supply-and-demand analysis, profit-maximizing strategies, andprice theory. The primary economic principle used in managerial finance ismarginal cost–benefit analysis, the principle that financial decisions should be made and actions taken only when the added benefits exceed the added costs.Nearly all financial decisions ultimately come down to an assessment of theirmarginal benefits and marginal costs. Jamie Teng is a financial manager for Nord Department Stores, a large chain ofupscale department stores operating primarily in the western United States. She iscurrently trying to decide whether to replace one of the firm’s computer serverswith a new, more sophisticated one that would both speed processing and handlea larger volume of transactions. The new computer would require a cash outlayof $8,000, and the old computer could be sold to net $2,000. The total benefitsfrom the new server (measured in today’s dollars) would be $10,000. The bene-fits over a similar time period from the old computer (measured in today’s Example 1.2316 PART 1 Introduction to Managerial Finance treasurer The firm’s chief financial manager, who manages thefirm’s cash, oversees itspension plans, and manageskey risks. controller The firm’s chief accountant,who is responsible for thefirm’s accounting activities,such as corporate accounting,tax management, financial accounting, and cost accounting. foreign exchange manager The manager responsible formanaging and monitoring thefirm’s exposure to loss fromcurrency fluctuations. marginal cost–benefit analysis Economic principle that states that financial decisions shouldbe made and actions takenonly when the added benefitsexceed the added costs. dollars) would be $3,000. Applying marginal cost–benefit analysis, Jamie organ- izes the data as follows: Because the marginal (added) benefits of $7,000 exceed the marginal (added) costs of $6,000, Jamie recommends that the firm purchase the new computer toreplace the old one. The firm will experience a net benefit of $1,000 as a result of this action. RELATIONSHIP TO ACCOUNTING The firm’s finance and accounting activities are closely related and generallyoverlap. In small firms accountants often carry out the finance function, and inlarge firms financial analysts often help compile accounting information.However, there are two basic differences between finance and accounting; one isrelated to the emphasis on cash flows and the other to decision making. Emphasis on Cash Flows The accountant’s primary function is to develop and report data for measuringthe performance of the firm, assess its financial position, comply with and filereports required by securities regulators, and file and pay taxes. Using generallyaccepted accounting principles, the accountant prepares financial statements thatrecognize revenue at the time of sale (whether payment has been received or not)and recognize expenses when they are incurred. This approach is referred to astheaccrual basis. The financial manager, on the other hand, places primary emphasis on cash flows, the intake and outgo of cash. He or she maintains the firm’s solvency by planning the cash flows necessary to satisfy its obligations and to acquire assetsneeded to achieve the firm’s goals. The financial manager uses this cash basis to recognize the revenues and expenses only with respect to actual inflows and out-flows of cash. Whether a firm earns a profit or experiences a loss, it must have a sufficient flow of cash to meet its obligations as they come due. Nassau Corporation, a small yacht dealer, sold one yacht for $100,000 in the cal-endar year just ended. Nassau originally purchased the yacht for $80,000.Although the firm paid in full for the yacht during the year, at year-end it has yetto collect the $100,000 from the customer. The accounting view and the financial Example 1.33CHAPTER 1 The Role of Managerial Finance 17 Benefits with new computer $10,000 Less: Benefits with old computer (1) Marginal (added) benefits Cost of new computer $ 8,000Less: Proceeds from sale of old computer (2) Marginal (added) costsNet benefit [(1) 2(2)] $ 1,000 $ 6,0002,000$ 7,0003,000 accrual basis In preparation of financial statements, recognizes revenueat the time of sale andrecognizes expenses when they are incurred. cash basis Recognizes revenues and expenses only with respect toactual inflows and outflows ofcash. view of the firm’s performance during the year are given by the following income and cash flow statements, respectively. In an accounting sense, Nassau Corporation is profitable, but in terms of actual cash flow it is a financial failure. Its lack of cash flow resulted from the uncol-lected accounts receivable of $100,000. Without adequate cash inflows to meet its obligations, the firm will not survive, regardless of its level of profits. As the example shows, accrual accounting data do not fully describe the cir- cumstances of a firm. Thus the financial manager must look beyond financialstatements to obtain insight into existing or developing problems. Of course,accountants are well aware of the importance of cash flows, and financial man-agers use and understand accrual-based financial statements. Nevertheless, thefinancial manager, by concentrating on cash flows, should be able to avoid insol-vency and achieve the firm’s financial goals. Individuals do not use accrual concepts. Rather, they rely solely on cash flows to measure their financial outcomes. Generally, individuals plan, monitor, and assess their financial activities using cash flowsover a given period, typically a month or a year. Ann Bach projects her cash flowsduring October 2012 as follows:Personal Finance Example 1.4318 PART 1 Introduction to Managerial Finance Accounting view Financial view (accrual basis) (cash basis) Nassau Corporation Nassau Corporation income statement cash flow statement for the year ended 12/31 for the year ended 12/31 Sales revenue $100,000 Cash inflow $ 0 Less: Costs Less: Cash outflow Net profit Net cash flow ( ) $80,000 $ 20,00080,000 80,000 Amount Item Inflow Outflow Net pay received $4,400 Rent $1,200Car payment 450Utilities 300Groceries 800Clothes 750Dining out 650Gasoline 260Interest income 220Misc. expense Totals $4,835 $4,620425 Ann subtracts her total outflows of $4,835 from her total inflows of $4,620 and finds that her net cash flow for October will be –$215. To cover the $215 shortfall, Ann will have to either borrow $215 (putting it on a credit card is a form of borrowing) or withdraw $215 from her savings. Or she may decide toreduce her outflows in areas of discretionary spending—for example, clothing purchases, dining out, or areas that make up the $425 of miscellaneous expense. Decision Making The second major difference between finance and accounting has to do with deci-sion making. Accountants devote most of their attention to the collection and presentation of financial data. Financial managers evaluate the accounting state- ments, develop additional data, and make decisions on the basis of their assess- ment of the associated returns and risks. Of course, this does not mean thataccountants never make decisions or that financial managers never gather data butrather that the primary focuses of accounting and finance are distinctly different. PRIMARY ACTIVITIES OF THE FINANCIAL MANAGER In addition to ongoing involvement in financial analysis and planning, the finan-cial manager’s primar y activities are making investment and financing decisions. Investment decisions determine what types of assets the firm holds. Financingdecisions determine how the firm raises money to pay for the assets in which itinvests. One way to visualize the difference between a firm’s investment andfinancing decisions is to refer to the balance sheet shown in Figure 1.3. Investmentdecisions generally refer to the items that appear on the left-hand side of the bal-ance sheet, and financing decisions relate to the items on the right-hand side. Keep in mind, though, that financial managers make these decisions based ontheir impact on the value of the firm, not on the accounting principles used toconstruct a balance sheet. 6REVIEW QUESTIONS 1–11 In what financial activities does a corporate treasurer engage? 1–12 What is the primary economic principle used in managerial finance? 1–13 What are the major differences between accounting and finance withrespect to emphasis on cash flows and decision making? 1–14 What are the two primary activities of the financial manager that arerelated to the firm’s balance sheet?CHAPTER 1 The Role of Managerial Finance 19 Fixed AssetsLong-Term FundsCurrent Assets Making InvestmentDecisionsMaking FinancingDecisionsCurrent LiabilitiesBalance SheetFIGURE 1.3 Financial Activities Primary activities of thefinancial manager 20 PART 1 Introduction to Managerial Finance 1.4Governance and Agency As noted earlier, the majority of owners of a corporation are normally distinct from its managers. Nevertheless, managers are entrusted to only take actions ormake decisions that are in the best interests of the firm’s owners, its shareholders.In most cases, if managers fail to act on the behalf of the shareholders, they willalso fail to achieve the goal of maximizing shareholder wealth. To help ensurethat managers act in ways that are consistent with the interests of shareholdersand mindful of obligations to other stakeholders, firms aim to establish soundcorporate governance practices. CORPORATE GOVERNANCE Corporate governance refers to the rules, processes, and laws by which compa- nies are operated, controlled, and regulated. It defines the rights and responsibil-ities of the corporate participants such as the shareholders, board of directors,officers and managers, and other stakeholders, as well as the rules and proce-dures for making corporate decisions. A well-defined corporate governance struc-ture is intended to benefit all corporate stakeholders by ensuring that the firm isrun in a lawful and ethical fashion, in accordance with best practices, and subjectto all corporate regulations. A firm’s corporate governance is influenced by both internal factors such as the shareholders, board of directors, and officers as well as external forces suchas clients, creditors, suppliers, competitors, and government regulations. The cor-porate organization, depicted in Figure 1.1 on page 8, helps to shape a firm’s cor-porate governance structure. In particular, the stockholders elect a board ofdirectors, who in turn hire officers or managers to operate the firm in a mannerconsistent with the goals, plans, and policies established and monitored by theboard on behalf of the shareholders. Individual versus Institutional Investors To better understand the role that shareholders play in shaping a firm’s corporategovernance, it is helpful to differentiate between the two broad classes ofowners—individuals and institutions. Generally, individual investors own rela- tively small quantities of shares and as a result do not typically have sufficientmeans to directly influence a firm’s corporate governance. In order to influence thefirm, individual investors often find it necessary to act as a group by voting collec-tively on corporate matters. The most important corporate matter individualinvestors vote on is the election of the firm’s board of directors. The corporateboard’s first responsibility is to the shareholders. The board not only sets policiesthat specify ethical practices and provide for the protection of stakeholder inter-ests, but it also monitors managerial decision making on behalf of investors. Although they also benefit from the presence of the board of directors, insti- tutional investors have advantages over individual investors when it comes toinfluencing the corporate governance of a firm. Institutional investors are invest- ment professionals that are paid to manage and hold large quantities of securitieson behalf of individuals, businesses, and governments. Institutional investorsinclude banks, insurance companies, mutual funds, and pension funds. Unlikeindividual investors, institutional investors often monitor and directly influence acorporate governance The rules, processes, and laws by which companies areoperated, controlled, andregulated. individual investors Investors who own relativelysmall quantities of shares so asto meet personal investmentgoals. institutional investors Investment professionals, suchas banks, insurancecompanies, mutual funds, andpension funds, that are paid tomanage and hold largequantities of securities onbehalf of others.LG6 firm’s corporate governance by exerting pressure on management to perform or communicating their concerns to the firm’s board. These large investors can alsothreaten to exercise their voting rights or liquidate their holdings if the boarddoes not respond positively to their concerns. Because individual and institu-tional investors share the same goal, individual investors benefit from the share-holder activism of institutional investors. Government Regulation Unlike the impact that clients, creditors, suppliers, or competitors can have on aparticular firm’s corporate governance, government regulation generally shapesthe corporate governance of all firms. During the past decade, corporate gover-nance has received increased attention due to several high-profile corporate scan-dals involving abuse of corporate power and, in some cases, alleged criminalactivity by corporate officers. The misdeeds derived from two main types ofissues: (1) false disclosures in financial reporting and other material informationreleases and (2) undisclosed conflicts of interest between corporations and theiranalysts, auditors, and attorneys and between corporate directors, officers, andshareholders. Asserting that an integral part of an effective corporate governanceregime is provisions for civil or criminal prosecution of individuals who conductunethical or illegal acts in the name of the firm, in July 2002 the U.S. Congresspassed the Sarbanes-Oxley Act of 2002 (commonly called SOX ). Sarbanes-Oxley is intended to eliminate many of the disclosure and conflict of interest problems that can arise when corporate managers are not held person-ally accountable for their firm’s financial decisions and disclosures. SOX accom-plished the following: established an oversight board to monitor the accountingindustry; tightened audit regulations and controls; toughened penalties againstexecutives who commit corporate fraud; strengthened accounting disclosurerequirements and ethical guidelines for corporate officers; established corporateboard structure and membership guidelines; established guidelines with regard toanalyst conflicts of interest; mandated instant disclosure of stock sales by corpo-rate executives; and increased securities regulation authority and budgets forauditors and investigators. THE AGENCY ISSUE We know that the duty of the financial manager is to maximize the wealth of thefirm’s owners. Shareholders give managers decision-making authority over thefirm; thus managers can be viewed as the agents of the firm’s shareholders. Technically, any manager who owns less than 100 percent of the firm is an agentacting on behalf of other owners. This separation of owners and managers isshown by the dashed horizontal line in Figure 1.1 on page 8, and it is representa-tive of the classic principal–agent relationship, where the shareholders are the principals. In general, a contract is used to specify the terms of a principal–agentrelationship. This arrangement works well when the agent makes decisions thatare in the principal’s best interest but doesn’t work well when the interests of theprincipal and agent differ. In theory, most financial managers would agree with the goal of share- holder wealth maximization. In reality, however, managers are also concernedwith their personal wealth, job security, and fringe benefits. Such concerns maycause managers to make decisions that are not consistent with shareholderCHAPTER 1 The Role of Managerial Finance 21 Sarbanes-Oxley Act of 2002 (SOX) An act aimed at eliminating corporate disclosure andconflict of interest problems.Contains provisions aboutcorporate financial disclosuresand the relationships amongcorporations, analysts, auditors, attorneys, directors, officers, and shareholders. principal–agent relationship An arrangement in which anagent acts on the behalf of aprincipal. For example,shareholders of a company(principals) elect management(agents) to act on their behalf. wealth maximization. For example, financial managers may be reluctant or unwilling to take more than moderate risk if they perceive that taking too muchrisk might jeopardize their job or reduce their personal wealth. The Agency Problem An important theme of corporate governance is to ensure the accountability ofmanagers in an organization through mechanisms that try to reduce or eliminatethe principal–agent problem; however, when these mechanisms fail agency prob-lems arise. Agency problems arise when managers deviate from the goal of maxi- mization of shareholder wealth by placing their personal goals ahead of the goalsof shareholders. These problems in turn give rise to agency costs. Agency costs are costs borne by shareholders due to the presence or avoidance of agency problems,and in either case represent a loss of shareholder wealth. For example, share-holders incur agency costs when managers fail to make the best investment deci-sion or when managers have to be monitored to ensure that the best investmentdecision is made, because either situation is likely to result in a lower stock price. Management Compensation Plans In addition to the roles played by corporate boards, institutional investors, andgovernment regulations, corporate governance can be strengthened by ensuringthat managers’ interests are aligned with those of shareholders. A commonapproach is to structure management compensation to correspond with firm per- formance. In addition to combating agency problems, the resulting performance-based compensation packages allow firms to compete for and hire the bestmanagers available. The two key types of managerial compensation plans areincentive plans and performance plans. Incentive plans tie management compensation to share price. One incentive plan grants stock options to management. If the firm’s stock price rises over time, managers will be rewarded by being able to purchase stock at the market price ineffect at the time of the grant and then to resell the shares at the prevailing highermarket price. Many firms also offer performance plans that tie management compensation to performance measures such as earnings per share (EPS) or growth in EPS.Compensation under these plans is often in the form of performance shares orcash bonuses. Performance shares are shares of stock given to management as a result of meeting the stated performance goals, whereas cash bonuses are cash payments tied to the achievement of certain performance goals. The execution of many compensation plans has been closely scrutinized in light of the past decade’s corporate scandals and financial woes. Both individualand institutional stockholders, as well as the Securities and Exchange Commission(SEC) and other government entities, continue to publicly question the appropri-ateness of the multimillion-dollar compensation packages that many corporateexecutives receive. The total compensation in 2009 for the chief executive officersof the 500 biggest U.S. companies is considerable. For example, the three highest-paid CEOs in 2009 were (1) H. Lawrence Culp Jr. of Danaher Corp., who earned$141.36 million; (2) Lawrence J. Ellison of Oracle Corp., who earned $130.23million; and (3) Aubrey K. McClendon of Chesapeake Energy Corp., who earned22 PART 1 Introduction to Managerial Finance agency problems Problems that arise when managers place personal goalsahead of the goals ofshareholders. agency costs Costs arising from agencyproblems that are borne byshareholders and represent aloss of shareholder wealth.In more depth To read about Agency Problems , go to www.myfinancelab.com incentive plans Management compensation plans that tie managementcompensation to share price;one example involves thegranting of stock options. stock options Options extended by the firmthat allow management tobenefit from increases in stockprices over time. performance plans Plans that tie managementcompensation to measuressuch as EPS or growth in EPS. Performance shares and/or cash bonuses are used as compensation under theseplans. performance shares Shares of stock given tomanagement for meetingstated performance goals. cash bonuses Cash paid to management forachieving certain performancegoals. $114.29 million. Tenth on the same list is Jen-Hsun Huang of NVIDIA Corp., who earned $31.40 million. Most studies have failed to find a strong relationship between the perform- ance that companies achieve and the compensation that CEOs receive. Duringthe past few years, publicity surrounding these large compensation packages(without corresponding performance) has driven down executive compensation.Contributing to this publicity is the SEC requirement that publicly traded compa-nies disclose to shareholders and others the amount of compensation to theirCEO, CFO, three other highest-paid executives, and directors; the method usedto determine it; and a narrative discussion regarding the underlying compensation policies. At the same time, new compensation plans that better link managers’ per-formance to their compensation are being developed and implemented. As evi-dence of this trend, consider that the average total compensation for the top threeCEOs in 2009 was down slightly more than 69 percent from the average for thetop three CEOs in 2006. The average in 2006 was $421.13 million versus anaverage of $128.63 million in 2009. The Threat of Takeover When a firm’s internal corporate governance structure is unable to keep agencyproblems in check, it is likely that rival managers will try to gain control of thefirm. Because agency problems represent a misuse of the firm’s resources andimpose agency costs on the firm’s shareholders, the firm’s stock is generallydepressed, making the firm an attractive takeover target. The threat of takeover by another firm that believes it can enhance the troubled firm’s value by restruc-turing its management, operations, and financing can provide a strong source ofexternal corporate governance. The constant threat of a takeover tends to moti-vate management to act in the best interests of the firm’s owners.CHAPTER 1 The Role of Managerial Finance 23 Matter of fact Aquick check of the most recent Forbes.com reporting of CEO performance versus pay for the top 500 U.S. companies reveals that the highest-paid CEOs are not nec- essarily the best-performing CEOs. In fact, the total compensation of the top three per-forming CEOs is less than 4 percent of the total compensation for the top-paid CEOs, allof whom have performances ranked 82nd or worse.Forbes.com CEO Performance versus Pay Efficiency Chief executive Compensation ranking officer Company Compensation rank 1st Jeffery H. Boyd Priceline.com $7.49 mil. 135th 2nd Jeffrey P. Bezos Amazon.com $1.28 mil. 463rd 3rd Leonard Bell Alexion Pharmaceuticals $4.26 mil. 286th 90th H. Lawrence Culp Jr. Danaher Corp. $141.36 mil. 1st 82nd Lawrence J. Ellison Oracle Corp. $130.23 mil. 2nd 163rd Aubrey K. McClendon Chesapeake Energy Corp. $114.29 mil. 3rdForbes.com CEO Performance vs. Pay Unconstrained, managers may have other goals in addition to share price maximization, but much of the evidence suggests that share price maximiza-tion—the focus of this book—is the primary goal of most firms. 6REVIEW QUESTIONS 1–15 What is corporate governance? How has the Sarbanes-Oxley Act of 2002 affected it? Explain. 1–16 Define agency problems, and describe how they give rise to agency costs. Explain how a firm’s corporate governance structure can help avoid agency problems. 1–17 How can the firm structure management compensation to minimize agency problems? What is the current view with regard to the execution ofmany compensation plans? 1–18 How do market forces—both shareholder activism and the threat oftakeover—act to prevent or minimize the agency problem? What role do institutional investors play in shareholder activism?24 PART 1 Introduction to Managerial Finance Summary FOCUS ON VALUE Chapter 1 established the primary goal of the firm —to maximize the wealth of the owners for whom the firm is being operated. For public companies, value at any time is reflected in the stock price. Therefore, management should actonly on those opportunities that are expected to create value for owners byincreasing the stock price. Doing this requires management to consider thereturns (magnitude and timing of cash flows), the risk of each proposed action,and their combined effect on value. REVIEW OF LEARNING GOALS Define finance and the managerial finance function. Finance is the sci- ence and art of managing money. It affects virtually all aspects of business.Managerial finance is concerned with the duties of the financial manager working in a business. Financial managers administer the financial affairs of alltypes of businesses—private and public, large and small, profit seeking and notfor profit. They perform such varied tasks as developing a financial plan orbudget, extending credit to customers, evaluating proposed large expenditures,and raising money to fund the firm’s operations. Describe the legal forms of business organization. The legal forms of business organization are the sole proprietorship, the partnership, and the cor-poration. The corporation is dominant in terms of business receipts, and itsowners are its common and preferred stockholders. Stockholders expect to earna return by receiving dividends or by realizing gains through increases in shareprice. LG2LG1 Describe the goal of the firm, and explain why maximizing the value of the firm is an appropriate goal for a business. The goal of the firm is to maxi- mize its value and therefore the wealth of its shareholders. Maximizing the valueof the firm means running the business in the interest of those who own it—theshareholders. Because shareholders are paid after other stakeholders, it is generally necessary to satisfy the interests of other stakeholders to enrich shareholders. Describe how the managerial finance function is related to economics and accounting. All areas of responsibility within a firm interact with finance personnel and procedures. The financial manager must understand the economicenvironment and rely heavily on the economic principle of marginal cost–benefitanalysis to make financial decisions. Financial managers use accounting but con-centrate on cash flows and decision making. Identify the primary activities of the financial manager. The primary activities of the financial manager, in addition to ongoing involvement in finan-cial analysis and planning, are making investment decisions and makingfinancing decisions. Describe the nature of the principal–agent relationship between the owners and managers of a corporation, and explain how various corporate gov-ernance mechanisms attempt to manage agency problems. This separation of owners and managers of the typical firm is representative of the classic principal–agent relationship, where the shareholders are the principals and man-agers are the agents. This arrangement works well when the agent makes deci-sions that are in the principal’s best interest but can lead to agency problemswhen the interests of the principal and agent differ. A firm’s corporate gover-nance structure is intended to help ensure that managers act in the best interestsof the firm’s shareholders, and other stakeholders, and it is usually influenced byboth internal and external factors. LG6LG5LG4LG3CHAPTER 1 The Role of Managerial Finance 25 Self-Test Problem(Solution in Appendix) ST1–1 Emphasis on Cash Flows Worldwide Rugs is a rug importer located in the United States that resells its import products to local retailers. Last year Worldwide Rugs imported $2.5 million worth of rugs from around the world, all of which were paidLG4Opener-in-Review In the chapter opener you read about Facebook and its founder’s reluctance to go public. If Zuckerberg is expected to remain the CEO of Facebook after theIPO, why would he be worried about going public? for prior to shipping. On receipt of the rugs, the importer immediately resold them to local retailers for $3 million. To allow its retail clients time to resell the rugs,Worldwide Rugs sells to retailers on credit. Prior to the end of its business year,Worldwide Rugs collected 85% of its outstanding accounts receivable.a.What is the accounting profit that Worldwide Rugs generated for the year? b.Did Worldwide Rugs have a successful year from an accounting perspective? c.What is the financial cash flow that Worldwide Rugs generated for the year? d.Did Worldwide Rugs have a successful year from a financial perspective? e.If the current pattern persists, what is your expectation for the future success of Worldwide Rugs?26 PART 1 Introduction to Managerial Finance Warm-Up ExercisesAll problems are available in . E1–1 Ann and Jack have been partners for several years. Their firm, A & J Tax Preparation, has been very successful, as the pair agree on most business-related questions. One disagreement, however, concerns the legal form of their business. Ann has tried for the past 2 years to get Jack to agree to incorporate. She believesthat there is no downside to incorporating and sees only benefits. Jack strongly disagrees; he thinks that the business should remain a partnership forever. First, take Ann’s side, and explain the positive side to incorporating the busi- ness. Next, take Jack’s side, and state the advantages to remaining a partnership. Lastly, what information would you want if you were asked to make the decision forAnn and Jack? E1–2 The end-of-year parties at Yearling, Inc., are known for their extravagance.Management provides the best food and entertainment to thank the employees fortheir hard work. During the planning for this year’s bash, a disagreement broke outbetween the treasurer’s staff and the controller’s staff. The treasurer’s staff contendedthat the firm was running low on cash and might have trouble paying its bills overthe coming months; they requested that cuts be made to the budget for the party.The controller’s staff felt that any cuts were unwarranted as the firm continued to be very profitable. Can both sides be right? Explain your answer. E1–3 You have been made treasurer for a day at AIMCO, Inc. AIMCO develops tech-nology for video conferencing. A manager of the satellite division has asked you to authorize a capital expenditure in the amount of $10,000. The manager states that this expenditure is necessary to continue a long-running project designed to use satellites to allow video conferencing anywhere on the planet. The manager admits that the satellite concept has been surpassed by recent technological advances intelephony, but he feels that AIMCO should continue the project. His reasoning is based on the fact that $2.5 million has already been spent over the past 15 years on this project. Although the project has little chance to be viable, the manager believes it would be a shame to waste the money and time already spent. Usemarginal cost–benefit analysis to make your decision regarding whether you should authorize the $10,000 expenditure to continue the project. LG2 LG4 LG5 E1–4 Recently, some branches of Donut Shop, Inc., have dropped the practice of allowing employees to accept tips. Customers who once said, “Keep the change,” now haveto get used to waiting for their nickels. Management even instituted a policy ofrequiring that the change be thrown out if a customer drives off without it. As a fre-quent customer who gets coffee and doughnuts for the office, you notice that thelines are longer and that more mistakes are being made in your order. Explain why tips could be viewed as similar to stock options and why the delays and incorrect orders could represent a case of agency costs. If tips are gone forever, how could Donut Shop reduce these agency costs?CHAPTER 1 The Role of Managerial Finance 27 LG6 ProblemsAll problems are available in . P1–1 Liability comparisons Merideth Harper has invested $25,000 in Southwest Development Company. The firm has recently declared bankruptcy and has $60,000 in unpaid debts. Explain the nature of payments, if any, by Ms. Harper in each of the following situations.a.Southwest Development Company is a sole proprietorship owned by Ms. Harper. b.Southwest Development Company is a 50–50 partnership of Ms. Harper and Christopher Black. c.Southwest Development Company is a corporation . P1–2 Accrual income versus cash flow for a period Thomas Book Sales, Inc., supplies textbooks to college and university bookstores. The books are shipped with a pro- viso that they must be paid for within 30 days but can be returned for a full refund credit within 90 days. In 2009, Thomas shipped and billed book titles totaling$760,000. Collections, net of return credits, during the year totaled $690,000. The company spent $300,000 acquiring the books that it shipped. a.Using accrual accounting and the preceding values, show the firm’s net profit for the past year. b.Using cash accounting and the preceding values, show the firm’s net cash flow for the past year. c.Which of these statements is more useful to the financial manager? Why? Personal Finance Problem P1–3 Cash flows It is typical for Jane to plan, monitor, and assess her financial position using cash flows over a given period, typically a month. Jane has a savings account, and her bank loans money at 6% per year while it offers short-term investment ratesof 5%. Jane’s cash flows during August were as follows: LG2 LG4 LG4 Item Cash inflow Cash outflow Clothes $1,000 Interest received $ 450Dining out 500Groceries 800Salary 4,500Auto payment 355Utilities 280Mortgage 1,200Gas 222 a.Determine Jane’s total cash inflows and cash outflows. b.Determine the net cash flow for the month of August. c.If there is a shortage, what are a few options open to Jane? d.If there is a surplus, what would be a prudent strategy for her to follow? P1–4 Marginal cost–benefit analysis and the goal of the firm Ken Allen, capital budg- eting analyst for Bally Gears, Inc., has been asked to evaluate a proposal. The man-ager of the automotive division believes that replacing the robotics used on theheavy truck gear line will produce total benefits of $560,000 (in today’s dollars)over the next 5 years. The existing robotics would produce benefits of $400,000(also in today’s dollars) over that same time period. An initial cash investment of$220,000 would be required to install the new equipment. The manager estimatesthat the existing robotics can be sold for $70,000. Show how Ken will applymarginal cost–benefit analysis techniques to determine the following: a.The marginal (added) benefits of the proposed new robotics. b.The marginal (added) cost of the proposed new robotics. c.The net benefit of the proposed new robotics. d.What should Ken Allen recommend that the company do? Why? e.What factors besides the costs and benefits should be considered before the final decision is made? P1–5 Identifying agency problems, costs, and resolutions Explain why each of the fol- lowing situations is an agency problem and what costs to the firm might result from it. Suggest how the problem might be dealt with short of firing the individual(s) involved.a.The front desk receptionist routinely takes an extra 20 minutes of lunch time to run personal errands. b.Division managers are padding cost estimates so as to show short-term efficiency gains when the costs come in lower than the estimates. c.The firm’s chief executive officer has had secret talks with a competitor about the possibility of a merger in which she would become the CEO of the combined firms. d.A branch manager lays off experienced full-time employees and staffs customer service positions with part-time or temporary workers to lower employment costs and raise this year’s branch profit. The manager’s bonus is based on profitability. P1–6 ETHICS PROBLEM What does it mean to say that managers should maximize shareholder wealth “subject to ethical constraints”? What ethical considerations might enter into decisions that result in cash flow and stock price effects that are lessthan they might otherwise have been?28 PART 1 Introduction to Managerial Finance LG5LG3 LG6 LG3 CHAPTER 1 The Role of Managerial Finance 29 Spreadsheet Exercise Assume that Monsanto Corporation is considering the renovation and/or replace- ment of some of its older and outdated carpet-manufacturing equipment. Its objectiveis to improve the efficiency of operations in terms of both speed and reduction in thenumber of defects. The company’s finance department has compiled pertinent data that will allow it to conduct a marginal cost–benefit analysis for the proposed equip- ment replacement. The cash outlay for new equipment would be approximately $600,000. The net book value of the old equipment and its potential net selling price add up to $250,000. The total benefits from the new equipment (measured in today’s dollars) would be $900,000. The benefits of the old equipment over a similar period of time (measured in today’s dollars) would be $300,000. TO DO Create a spreadsheet to conduct a marginal cost–benefit analysis for Monsanto Corporation, and determine the following: a.The marginal (added) benefits of the proposed new equipment. b.The marginal (added) cost of the proposed new equipment. c.The net benefit of the proposed new equipment. d.What would you recommend that the firm do? Why? Visit www.myfinancelab.com forChapter C ase:Assessing the Go al of Sports Products, Inc., Group Exercises, and numerous online resources. Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand how business income is taxed and the difference between average and marginal tax rates. INFORMATION SYSTEMS You need to understand how information flows between the firm and financial markets. MANAGEMENT You need to understand why healthy financial institu- tions are an integral part of a healthy economy and how a crisis in thefinancial sector can spread and affect almost any type of business. MARKETING You need to understand why it is important for firms to communicate about their operating results with external investors andhow regulations constrain the types of communication that occur. OPERATIONS You need to understand why external financing is, for most firms, an essential aspect of ongoing operations. Making financial transactions will be a regular occurrence throughout your entire life. These transactions may be as simple as depositing yourpaycheck in a bank or as complex as deciding how to allocate themoney you save for retirement among different investment options.Many of these transactions have important tax consequences, whichvary over time and from one type of transaction to another. The contentin this chapter will help you make better decisions when you engage inany of these transactions.In your personal lifeLearning Goals Understand the role that financial institutions play in managerialfinance. Contrast the functions of financial institutions and financial markets. Describe the differences between the capital markets and themoney markets. Explain the root causes of the 2008 financial crisis and recession. Understand the major regulations and regulatory bodies that affectfinancial institutions and markets. Discuss business taxes and their importance in financial decisions. LG6LG5LG4LG3LG2LG12The Financial Market Environment 30 31Cut to the Chase Since the recession of the early 1990s, business had been booming for JPMorgan Chase, one of the leading investment banking firms on Wall Street.After hitting a low of roughly $2 per share in October 1990, Chase stock went on a tear, rising at a rate of about 21 percent per year and hitting the $50 rangeby April 2007. The bank ’s investors enjoyed increasing dividend payments along with the rising stock price. JPMorgan Chase increased its dividend payout from $0.0833 per share inDecember 1990 to $0.38 per share in July 2007, an increase of more than 350 percent. Trouble was brewing, however. In the summer of 2007, data began to emerge that prices of single-family homes were falling in many U.S. cities and homeowners were starting to defaulton their mortgages. Rumors swirled that JPMorgan and other banks held large investments insecurities tied to residential mortgages. On September 15, 2008, the venerable investment banking firm, Lehman Brothers, filed for bankruptcy, and JPMorgan shares fell 10 percent in a single day. Bad news about the economy and the financial sector continued through the fall,and Chase ’s stock hit a low point on November 21 near $20, losing more than half its value in roughly 18 months. All of this prompted JPMorgan management to make two difficult decisions. The first was to accept a $25 billion “investment ” (some referred to it as a bailout) from the U.S. Treasury on October 28, 2008. The second was to cut its quarterly dividend by almost 87 percent, from $0.38 to $0.05 per share. These decisions, combined with a slowly improving economy,helped JPMorgan survive the 2008 financial crisis and the subsequent recession. By the summer of 2009, JPMorgan Chase repaid the $25 billion (with interest) that it had received from the government, and the bank ’s stock had recovered most of the value that it had lost. JPMorgan Chase & Co. 32 PART 1 Introduction to Managerial Finance 2.1Financial Institutions and Markets Most successful firms have ongoing needs for funds. They can obtain funds from external sources in three ways. The first source is through a financial institution that accepts savings and transfers them to those that need funds. A second sourceis through financial markets, organized forums in which the suppliers and demanders of various types of funds can make transactions. A third source isthrough private placement. Because of the unstructured nature of private place- ments, here we focus primarily on the role of financial institutions and financialmarkets in facilitating business financing. FINANCIAL INSTITUTIONS Financial institutions serve as intermediaries by channeling the savings of individ- uals, businesses, and governments into loans or investments. Many financialinstitutions directly or indirectly pay savers interest on deposited funds; othersprovide services for a fee (for example, checking accounts for which customerspay service charges). Some financial institutions accept customers’ savingsdeposits and lend this money to other customers or to firms; others invest customers’ savings in earning assets such as real estate or stocks and bonds; andsome do both. Financial institutions are required by the government to operatewithin established regulatory guidelines. Key Customers of Financial Institutions For financial institutions, the key suppliers of funds and the key demanders offunds are individuals, businesses, and governments. The savings that individualconsumers place in financial institutions provide these institutions with a largeportion of their funds. Individuals not only supply funds to financial institutionsbut also demand funds from them in the form of loans. However, individuals as agroup are the net suppliers for financial institutions: They save more money than they borrow. Business firms also deposit some of their funds in financial institutions, pri- marily in checking accounts with various commercial banks. Like individuals,firms borrow funds from these institutions, but firms are net demanders of funds: They borrow more money than they save. Governments maintain deposits of temporarily idle funds, certain tax pay- ments, and Social Security payments in commercial banks. They do not borrowfunds directly from financial institutions, although by selling their debt securities to various institutions, governments indirectly borrow from them. The govern-ment, like business firms, is typically a net demander of funds: It typically bor- rows more than it saves. We’ve all heard about the federal budget deficit. Major Financial Institutions The major financial institutions in the U.S. economy are commercial banks, sav-ings and loans, credit unions, savings banks, insurance companies, mutual funds,and pension funds. These institutions attract funds from individuals, businesses,and governments, combine them, and make loans available to individuals andbusinesses.LG3LG2LG1 financial institution An intermediary that channels the savings of individuals,businesses, and governmentsinto loans or investments. COMMERCIAL BANKS, INVESTMENT BANKS, AND THE SHADOW BANKING SYSTEM Commercial banks are among the most important financial institutions in the economy because they provide savers with a secure place to invest funds and theyoffer both individuals and companies loans to finance investments, such as thepurchase of a new home or the expansion of a business. Investment banks are institutions that (1) assist companies in raising capital, (2) advise firms on majortransactions such as mergers or financial restructurings, and (3) engage in tradingand market making activities. The traditional business model of a commercial bank—taking in and paying interest on deposits and investing or lending those funds back out at higherinterest rates—works to the extent that depositors believe that their investmentsare secure. Since the 1930s, the U.S. government has given some assurance todepositors that their money is safe by providing deposit insurance (currently upto $250,000 per depositor). Deposit insurance was put in place in response to thebanking runs or panics that were part of the Great Depression. The same act ofCongress that introduced deposit insurance, the Glass-Steagall Act, also created a separation between commercial banks and investment banks, meaning that aninstitution engaged in taking in deposits could not also engage in the somewhatriskier activities of securities underwriting and trading. Commercial and investment banks remained essentially separate for more than 50 years, but in the late 1990s Glass-Steagall was repealed. Companies that had for-merly engaged only in the traditional activities of a commercial bank began com-peting with investment banks for underwriting and other services. In addition, the1990s witnessed tremendous growth in what has come to be known as the shadowbanking system. The shadow banking system describes a group of institutions that engage in lending activities, much like traditional banks, but these institutions donot accept deposits and are therefore not subject to the same regulations as tradi-tional banks. 1For example, an institution such as a pension fund might have excess cash to invest, and a large corporation might need short-term financing to cover sea-sonal cash flow needs. A business like Lehman Brothers acted as an intermediarybetween these two parties, helping to facilitate a loan, and thereby became part ofthe shadow banking system. In March 2010, Treasury Secretary Timothy Geithnernoted that at its peak the shadow banking system financed roughly $8 trillion inassets and was roughly as large as the traditional banking system.CHAPTER 2 The Financial Market Environment 33 commercial banks Institutions that provide savers with a secure place to investtheir funds and that offer loansto individual and businessborrowers. investment banks Institutions that assistcompanies in raising capital,advise firms on majortransactions such as mergers orfinancial restructurings, andengage in trading and marketmaking activities. Glass-Steagall Act An act of Congress in 1933that created the federal depositinsurance program andseparated the activities ofcommercial and investmentbanks. 1. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 in response to the finan- cial crisis and recession of 2008–2009. This legislation will likely have a dramatic impact on the regulation of both traditional and shadow banking institutions, but it is too early to tell exactly what the new law’s effects will be. In the wake of the law’s passage, many commentators suggested that the law did not exercise enough oversight of theshadow banking system to prevent a financial meltdown similar to the one that motivated the law’s enactment.shadow banking system A group of institutions that engage in lending activities,much like traditional banks, butdo not accept deposits andtherefore are not subject to thesame regulations as traditionalbanks. Matter of fact The U.S. banking industry has been going through a long period of consolidation. According to the FDIC, the number of commercial banks in the United States declined from 11,463 in 1992 to 8,012 at the end of 2009, a decline of 30 percent. The decline is concentrated among small community banks, which larger institutions have been acquiring at a rapid pace.Consolidation in the U.S. Banking Industry FINANCIAL MARKETS Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. Whereas the loans made by financial institutionsare granted without the direct knowledge of the suppliers of funds (savers), sup-pliers in the financial markets know where their funds are being lent or invested.The two key financial markets are the money market and the capital market.Transactions in short-term debt instruments, or marketable securities, take placein the money market. Long-term securities—bonds and stocks—are traded in the capital market. To raise money, firms can use either private placements or public offerings. A private placement involves the sale of a new security directly to an investor or group of investors, such as an insurance company or pension fund. Most firms,however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public. When a company or government entity sells stocks or bonds to investors and receives cash in return, it is said to have sold securities in the primary market. After the primary market transaction occurs, any further trading in the security does notinvolve the issuer directly, and the issuer receives no additional money from thesesubsequent transactions. Once the securities begin to trade between investors, theybecome part of the secondary market. On large stock exchanges, billions of shares may trade between buyers and sellers on a single day, and these are all secondarymarket transactions. Money flows from the investors buying stocks to the investorsselling them, and the company whose stock is being traded is largely unaffected bythe transactions. The primary market is the one in which “new” securities are sold.The secondary market can be viewed as a “preowned” securities market. THE RELATIONSHIP BETWEEN INSTITUTIONS AND MARKETS Financial institutions actively participate in the financial markets as both sup-pliers and demanders of funds. Figure 2.1 depicts the general flow of fundsthrough and between financial institutions and financial markets as well as the34 PART 1 Introduction to Managerial Finance financial markets Forums in which suppliers of funds and demanders of fundscan transact business directly. private placement The sale of a new securitydirectly to an investor or groupof investors. public offering The sale of either bonds orstocks to the general public. primary market Financial market in whichsecurities are initially issued;the only market in which theissuer is directly involved in thetransaction. secondary market Financial market in whichpreowned securities (those thatare not new issues) are traded. Private PlacementSuppliers of FundsDemanders of FundsFinancial Institutions Financial MarketsFundsDeposits/Shares FundsLoans SecuritiesSecurities Securities SecuritiesFunds Funds FundsFundsFIGURE 2.1 Flow of Funds Flow of funds for financialinstitutions and markets mechanics of private placement transactions. Domestic or foreign individuals, busi- nesses, and governments may supply and demand funds. We next briefly discuss themoney market, including its international equivalent—the Eurocurrency market. We then end this section with a discussion of the capital market, which is of keyimportance to the firm. THE MONEY MARKET Themoney market is created by a financial relationship between suppliers and demanders of short-term funds (funds with maturities of one year or less). The money market exists because some individuals, businesses, governments, andfinancial institutions have temporarily idle funds that they wish to invest in a rel-atively safe, interest-bearing asset. At the same time, other individuals, busi-nesses, governments, and financial institutions find themselves in need ofseasonal or temporary financing. The money market brings together these sup-pliers and demanders of short-term funds. Most money market transactions are made in marketable securities — short-term debt instruments, such as U.S. Treasury bills, commercial paper, andnegotiable certificates of deposit issued by government, business, and financialinstitutions, respectively. Investors generally consider marketable securities to beamong the least risky investments available. Marketable securities are describedin Chapter 15. The international equivalent of the domestic money market is called the Eurocurrency market. This is a market for short-term bank deposits denominated in U.S. dollars or other major currencies. Eurocurrency deposits arise when a cor-poration or individual makes a bank deposit in a currency other than the localcurrency of the country where the bank is located. If, for example, a multina-tional corporation were to deposit U.S. dollars in a London bank, this wouldcreate a Eurodollar deposit (a dollar deposit at a bank in Europe). Nearly allEurodollar deposits are time deposits. This means that the bank would promise to repay the deposit, with interest, at a fixed date in the future—say, in 6 months.During the interim, the bank is free to lend this dollar deposit to creditworthycorporate or government borrowers. If the bank cannot find a borrower on itsown, it may lend the deposit to another international bank. THE CAPITAL MARKET Thecapital market is a market that enables suppliers and demanders of long-term funds to make transactions. Included are securities issues of business and govern- ment. The backbone of the capital market is formed by the broker and dealermarkets that provide a forum for bond and stock transactions. International cap-ital markets also exist. Key Securities Traded: Bonds and Stocks The key capital market securities are bonds (long-term debt) and both common stock andpreferred stock (equity, or ownership). Bonds are long-term debt instruments used by business and government to raise large sums of money, generally from a diverse group of lenders. Corporate bonds typically pay interest semiannually (every 6 months) at a stated coupon interest rate. They have an initial maturity of from 10 to 30 years, and a par,orCHAPTER 2 The Financial Market Environment 35 money market A financial relationship created between suppliers anddemanders of short-term funds. marketable securities Short-term debt instruments, such as U.S. Treasury bills, commercial paper, andnegotiable certificates ofdeposit issued by government,business, and financialinstitutions, respectively. Eurocurrency market International equivalent of the domestic money market. capital market A market that enables suppliers and demanders of long-term funds to make transactions. bond Long-term debt instrument usedby business and government toraise large sums of money,generally from a diverse groupof lenders. face, value of $l,000 that must be repaid at maturity. Bonds are described in detail in Chapter 7. Lakeview Industries, a major microprocessor manufacturer, has issued a 9%coupon interest rate, 20-year bond with a $1,000 par value that pays interestsemiannually. Investors who buy this bond receive the contractual right to $90annual interest (9% coupon interest rate par value) distributed as $45at the end of each 6 months for 20 years, plus the $1,000 par value at the end of year 20. As noted earlier, shares of common stock are units of ownership, or equity, in a corporation. Common stockholders earn a return by receiving dividends—periodic distributions of cash—or by realizing increases in share price. Preferred stock is a special form of ownership that has features of both a bond and common stock. Preferred stockholders are promised a fixed periodic dividendthat must be paid prior to payment of any dividends to common stockholders. Inother words, preferred stock has “preference” over common stock. Preferredstock and common stock are described in detail in Chapter 8. See the Focus on Practice box for the story of one legendary stock price and the equally legendary man who brought it about. Broker Markets and Dealer Markets By far the vast majority of trades made by individual investors take place in thesecondary market. When you look at the secondary market on the basis of how securities are traded, you will find you can essentially divide the market into two segments: broker markets and dealer markets. The key difference between broker and dealer markets is a technical point dealing with the way trades are executed. That is, when a trade occurs in a broker market, the two sides to the transaction, the buyer and the seller, are brought together and the trade takes place at that point: Party A sells his or her securitiesdirectly to the buyer, Party B. In a sense, with the help of a broker, the securities effectively change hands on the floor of the exchange. The broker market consistsof national and regional securities exchanges, which are organizations that pro- vide a marketplace in which firms can raise funds through the sale of new securi-ties and purchasers can resell securities. In contrast, when trades are made in a dealer market, the buyer and the seller are never brought together directly. Instead, market makers execute the buy/sell orders. Market makers are securities dealers who “make markets” by offering to buy or sell certain securities at stated prices. Essentially, two separate trades aremade: Party A sells his or her securities (in, say, Dell) to a dealer, and Party B buyshis or her securities (in Dell) from another, or possibly even the same, dealer.Thus, there is always a dealer ( market maker ) on one side of a dealer–market transaction. The dealer market is made up of both the Nasdaq market, an all- electronic trading platform used to execute securities trades, and the over- the-counter (OTC) market, where smaller, unlisted securities are traded. Broker Markets If you are like most people, when you think of the “stock market” the first name to come to mind is the New York Stock Exchange, knowncurrently as the NYSE Euronext after a series of mergers that expanded the(1/2 *$90)*$1,000 Example 2.1336 PART 1 Introduction to Managerial Finance preferred stock A special form of ownership having a fixed periodicdividend that must be paidprior to payment of anydividends to commonstockholders. broker market The securities exchanges onwhich the two sides of atransaction, the buyer andseller, are brought together totrade securities. securities exchanges Organizations that provide themarketplace in which firms canraise funds through the sale ofnew securities and purchaserscan resell securities. dealer market The market in which the buyerand seller are not broughttogether directly but insteadhave their orders executed bysecurities dealers that “makemarkets” in the given security. market makers Securities dealers who “makemarkets” by offering to buy orsell certain securities at statedprices. Nasdaq market An all-electronic tradingplatform used to executesecurities trades. over-the-counter (OTC) market Market where smaller, unlisted securities are traded. CHAPTER 2 The Financial Market Environment 37 focus on PRACTICE Berkshire Hathaway—Can Buffett Be Replaced? In early 1980, investors could buy one share of Berkshire Hathaway ClassA common stock (stock symbol: BRKA)for $285. That may have seemedexpensive at the time, but by September2010 the price of just one share had climbed to $125,000. The wizard behind such phenomenal growth inshareholder value is the chairman ofBerkshire Hathaway, Warren Buffett,nicknamed the Oracle of Omaha. With his partner, Vice-Chairman Charlie Munger, Buffett runs a largeconglomerate of dozens of subsidiarieswith 222,000 employees and morethan $112 billion in annual revenues. He makes it look easy. In his words, “I’ve taken the easy route, just sitting back and working through great man-agers who run their own shows. Myonly tasks are to cheer them on, sculpt and harden our corporate culture, and make major capital-allocation deci-sions. Our managers have returned thistrust by working hard and effectively. ” ain practiceBuffett ’s style of corporate leader- ship seems rather laid back, but behind that “aw-shucks ” manner is one of the best analytical minds in business. Hebelieves in aligning managerial incen-tives with performance. Berkshireemploys many different incentive arrangements, with their terms depend- ing on such elements as the economicpotential or capital intensity of a CEO ’s business. Whatever the compensationarrangement, Buffett tries to keep it both simple and fair. Buffett himself receives an annual salary of $100,000—notmuch in this age of supersized CEOcompensation packages. Listed formany years among the world ’s wealthi- est people, Buffett has donated most of his Berkshire stock to the Bill andMelinda Gates Foundation. Berkshire ’s annual report is a must- read for many investors due to the pop- ularity of Buffett ’s annual letter to shareholders with his homespun take onsuch topics as investing, corporate gov-ernance, and corporate leadership.Shareholder meetings in Omaha, Nebraska, have turned into cultlikegatherings, with thousands traveling tolisten to Buffett answer questions fromshareholders. One question that has been firmly answered is the question of Mr. Buffett ’s ability to create share- holder value. The next question that needs to be answered is whether Berkshire Hathaway can successfully replace Buffett (age 80) and Munger (age 86).In October 2010, Berkshire hiredhedge fund manager Todd Combs tohandle a significant portion of the firm ’s investments. Berkshire shareholders hope that Buffett ’s special wisdom applies as well to identifying new man-agerial talent as it does to makingstrategic investment decisions. 3 The share price of BRKA has never been split. Why might the company refuse to split its shares to make them more affordable to average investors? exchange’s global reach. In point of fact, the NYSE Euronext is the dominant broker market. The American Stock Exchange (AMEX), which is anothernational exchange, and several so-called regional exchanges are also broker mar- kets. These exchanges account for about 60 percent of the total dollar volume of all shares traded in the U.S. stock market. In broker markets all the trading takesplace on centralized trading floors. Most exchanges are modeled after the New York Stock Exchange. For a firm’s securities to be listed for trading on a stock exchange, a firm must file anapplication for listing and meet a number of requirements. For example, to be eli-gible for listing on the NYSE, a firm must have at least 400 stockholders owning100 or more shares; a minimum of 1.1 million shares of publicly held stock out-standing; pretax earnings of at least $10 million over the previous 3 years, with atleast $2 million in the previous 2 years; and a minimum market value of publicshares of $100 million. Clearly, only large, widely held firms are candidates forNYSE listing. Once placed, an order to buy or sell on the NYSE can be executed in minutes, thanks to sophisticated telecommunication devices. New Internet-based bro-kerage systems enable investors to place their buy and sell orders electronically.aBerkshire Hathaway, Inc., “Letter to Shareholders of Berkshire Hathaway, Inc., ” 2006 Annual Report, p. 4. Information on publicly traded securities is reported in various media, both print, such as the Wall Street Journal, and electronic, such as MSN Money (www.moneycentral.msn.com ). Dealer Markets One of the key features of the dealer market is that it has no centralized trading floors. Instead, it is made up of a large number of market makers who are linked together via a mass-telecommunications network. Each market maker is actually a securities dealer who makes a market in one or more securities by offering to buy or sell them at stated bid/ask prices. The bid price andask price represent, respectively, the highest price offered to purchase a given security and the lowest price at which the security is offered for sale. Ineffect, an investor pays the ask price when buying securities and receives the bidprice when selling them. As described earlier, the dealer market is made up of both the Nasdaq market and the over-the-counter (OTC) market, which together account for about 40 percent of all shares traded in the U.S. market—with the Nasdaqaccounting for the overwhelming majority of those trades. (As an aside, theprimary market is also a dealer market because all new issues are sold to the investing public by securities dealers, acting on behalf of the investmentbanker.) The largest dealer market consists of a select group of stocks that are listed and traded on the National Association of Securities Dealers Automated Quotation System, typically referred to as Nasdaq . Founded in 1971, Nasdaq had its origins in the OTC market but is today considered a totally separate entity that’s no longer a part of the OTC market. In fact, in 2006 Nasdaq was formally recognized by the SEC as a “listed exchange,” essentially giving it the same statureand prestige as the NYSE. International Capital Markets Although U.S. capital markets are by far the world’s largest, there are importantdebt and equity markets outside the United States. In the Eurobond market, cor- porations and governments typically issue bonds denominated in dollars and sellthem to investors located outside the United States. A U.S. corporation might, forexample, issue dollar-denominated bonds that would be purchased by investorsin Belgium, Germany, or Switzerland. Through the Eurobond market, issuingfirms and governments can tap a much larger pool of investors than would begenerally available in the local market.38 PART 1 Introduction to Managerial Finance bid price The highest price offered to purchase a security. ask price The lowest price at which asecurity is offered for sale. Matter of fact According to the World Federation of Exchanges, the largest stock market in the world, as measured by the total market value of securities listed on that market, is the NYSE Euronext, with listed securities worth more than $11.8 trillion in the United States and $2.9 trillion in Europe. Next largest is the London Stock Exchange, with securities valued at £1.7 trillion, which is equivalent to $2.8 trillion given the exchange rate between pounds and dol- lars prevailing at the end of 2009.NYSE Euronext is the World’s Largest Stock ExchangeEurobond market The market in which corporations and governmentstypically issue bondsdenominated in dollars and sell them to investors located outside the United States. Theforeign bond market is an international market for long-term debt secu- rities. A foreign bond is a bond issued by a foreign corporation or government that is denominated in the investor’s home currency and sold in the investor’shome market. A bond issued by a U.S. company that is denominated in Swissfrancs and sold in Switzerland is a foreign bond. Although the foreign bondmarket is smaller than the Eurobond market, many issuers have found it to be anattractive way of tapping debt markets around the world. Finally, the international equity market allows corporations to sell blocks of shares to investors in a number of different countries simultaneously. This marketenables corporations to raise far larger amounts of capital than they could in anysingle market. International equity sales have been indispensable to governmentsthat have sold state-owned companies to private investors. The Role of Capital Markets From a firm’s perspective, the role of a capital market is to be a liquid marketwhere firms can interact with investors to obtain valuable external financingresources. From investors’ perspectives, the role of a capital market is to be anefficient market that allocates funds to their most productive uses. This is espe- cially true for securities that are actively traded in broker or dealer markets,where the competition among wealth-maximizing investors determines and pub-licizes prices that are believed to be close to their true value. The price of an individual security is determined by the interaction between buyers and sellers in the market. If the market is efficient, the price of a stock isan unbiased estimate of its true value, and changes in the price reflect new infor-mation that investors learn about and act on. For example, suppose a certainstock currently trades at $40 per share. If this company announces that sales of anew product have been higher than expected, investors will raise their estimate ofwhat the stock is truly worth. At $40, the stock is a relative bargain, so there willtemporarily be more buyers than sellers wanting to trade the stock, and its pricewill have to rise to restore equilibrium in the market. The more efficient themarket is, the more rapidly this whole process works. In theory, even informationknown only to insiders may become incorporated in stock prices as the Focus on Ethics box on page 40 explains. Not everyone agrees that prices in financial markets are as efficient as described in the preceding paragraph. Advocates of behavioral finance, an emerging field that blends ideas from finance and psychology, argue that stockprices and prices of other securities can deviate from their true values forextended periods. These people point to episodes such as the huge run-up andsubsequent collapse of the prices of Internet stocks in the late 1990s and thefailure of markets to accurately assess the risk of mortgage-backed securities inthe more recent financial crisis as examples of the principle that stock pricessometimes can be wildly inaccurate measures of value. Just how efficient are the prices in financial markets? That is a question that will be debated for a long time. It is clear that prices do move in response to newinformation, and for most investors and corporate managers the best advice isprobably to be cautious when betting against the market. Identifying securitiesthat the market has over- or undervalued is extremely difficult, and very fewpeople have demonstrated an ability to bet against the market correctly for anextended time.CHAPTER 2 The Financial Market Environment 39 foreign bond A bond that is issued by a foreign corporation or government and is denominated in the investor’s home currency and sold in theinvestor’s home market. international equity market A market that allows corporations to sell blocks of shares to investors in a number of different countries simultaneously. efficient market A market that allocates fundsto their most productive uses as a result of competition among wealth-maximizing investors and that determines and publicizes prices that are believed to be close to their true value. In more depth To read about The Efficient Markets Hypothesis , go to www.myfinancelab.com 6REVIEW QUESTIONS 2–1Who are the key participants in the transactions of financial institu- tions? Who are net suppliers, and who are net demanders? 2–2What role do financial markets play in our economy? What are primary and secondary markets? What relationship exists between financial institutions and financial markets? 2–3What is the money market? What is the Eurocurrency market? 2–4What is the capital market? What are the primary securities traded in it? 2–5What are broker markets? What are dealer markets? How do they differ? 2–6Briefly describe the international capital markets, particularly the Eurobond market and the international equity market. 2–7What are efficient markets? What determines the price of an individual security in such a market?40 PART 1 Introduction to Managerial Finance focus on ETHICS The Ethics of Insider Trading On December 27, 2001, Martha Stewart sold nearly 4,000 shares in ImCloneSystems stock. The following day, the Food and Drug Administration deliv-ered some bad news regardingImClone ’s cancer drug, Erbitux, and ImClone ’s stock price dropped substan- tially. It appeared that Martha Stewart had picked the right time to sell. Martha Stewart was not the only ImClone shareholder who was selling.The company ’s founder, Sam Waksal, also tried to sell his stock (brokers refused to execute the sales), as did hisdaughter. The U.S. Securities andExchange Commission and the FederalBureau of Investigation were soon look- ing into the transactions. Sam Waksal ultimately received an 87-month prisonsentence and $3 million in fines forinsider trading and tax evasion. Martha Stewart was convicted of conspiracy, obstruction, and making false state-ments to federal investigators andserved 5 months in jail, 5 months ofhome confinement, and 2 years of pro- bation and paid a $30,000 fine. In addition, she was forced to resign aschairman and CEO of the companyshe had founded, Martha Stewart Living Omnimedia. On the day of herconviction, the company ’s shares lost 23 percent of their value. Laws prohibiting insider trading were established in the United States in the 1930s. These laws are designed to ensure that all investors have access torelevant information on the same terms.However, many market participantsbelieve that insider trading should be permitted. Their argument is rooted in the efficient-market hypothesis (EMH).According to the EMH, stock pricesfully reflect all publicly available infor-mation. Of course, a significant amount of information about every company is not publicly available. Thus, stockprices may not accurately reflect all thatis known about a company. Those who argue for allowing insider trading believe that market prices influence the allocation ofresources among companies. Firms with higher stock prices find it easier to raise capital, for example. Therefore, it is important that market prices reflectas much information as possible. Ad-vocates of allowing insider tradingargue that investors would quickly convert inside information into publicly available information if insider tradingwere permitted. If, for example, SamWaksal had been permitted to sell his stock after learning of the FDA ’s deci- sion, market participants might view hisactions and come to the judgment thatImClone ’s prospects had dimmed. Of course, the other necessary condition is that outsiders can observe the stock market transactions of insiders. Interestingly, Eugene Fama, who is viewed by many as the father of theefficient-market hypothesis, does not believe that insider trading should be permitted. aFama believes that allowing insider trading creates a moral hazard problem. For example, if insiders are allowed to trade on proprietary infor-mation, they may have the incentive tohold back information for their personalgain. 3 If efficiency is the goal of financial markets, is allowing or disallowing insider trading more unethical? 3Does allowing insider trading cre- ate an ethical dilemma for insiders?in practice awww.dimensional.com/famafrench/2010/04/qa-is-insider-trading-beneficial.html CHAPTER 2 The Financial Market Environment 41 2.2The Financial Crisis In the summer and fall of 2008, the U.S. financial system, and financial systems around the world, appeared to be on the verge of collapse. Troubles in the finan-cial sector spread to other industries, and a severe global recession ensued. In thissection, we outline some of the main causes and consequences of that crisis. FINANCIAL INSTITUTIONS AND REAL ESTATE FINANCE In the classic film It’s a Wonderful Life, the central character is George Bailey, who runs a financial institution called the Bailey Building and Loan Association.In a key scene in that movie, a bank run is about to occur and depositors demandthat George return the money that they invested in the Building and Loan.George pleads with one man to keep his funds at the bank, saying: You’re thinking of this place all wrong, as if I have the money back in a safe. The money’s not here. Your money is in Joe’s house. That’s right next to yours—and then the Kennedy house, and Mrs. Maklin’s house, and a hundred others. You’re lending them the money to build, and then they’re going to pay it back to you as best theycan. What are you going to do, foreclose on them? This scene offers a relatively realistic portrayal of the role that financial insti- tutions played in allocating credit for investments in residential real estate formany years. Local banks took deposits and made loans to local borrowers.However, since the 1970s, a process called securitization has changed the waythat mortgage finance works. Securitization refers to the process of pooling mort- gages or other types of loans and then selling claims or securities against that poolin a secondary market. These securities, called mortgage-backed securities, can be purchased by individual investors, pension funds, mutual funds, or virtually anyother investor. As homeowners repay their loans, those payments eventuallymake their way into the hands of investors who hold the mortgage-backed secu-rities. Therefore, a primary risk associated with mortgage-backed securities isthat homeowners may not be able to, or may choose not to, repay their loans.Banks today still lend money to individuals who want to build or purchase newhomes, but they typically bundle those loans together and sell them to organiza-tions that securitize them and pass them on to investors all over the world. FALLING HOME PRICES AND DELINQUENT MORTGAGES Prior to the 2008 financial crisis, most investors viewed mortgage-backed securi-ties as relatively safe investments. Figure 2.2 on page 42 illustrates one of the mainreasons for this view. The figure shows the behavior of the Standard & Poor’sCase-Shiller Index, a barometer of home prices in ten major U.S. cities, in eachmonth from January 1987 to February 2010. Historically, declines in the indexwere relatively infrequent, and between July 1995 and April 2006 the index rosecontinuously without posting even a single monthly decline. When house pricesare rising, the gap between what a borrower owes on a home and what the homeis worth widens. Lenders will allow borrowers who have difficulty making pay-ments on their mortgages to tap this built-up home equity to refinance their loansand lower their payments. Therefore, rising home prices helped keep mortgagedefault rates low from the mid-1990s thr ough 2006. Investing in real estate and mortgage-backed securities seemed to involve very little risk during this period.securitization The process of pooling mortgages or other types ofloans and then selling claimsor securities against that poolin the secondary market. mortgage-backed securities Securities that represent claimson the cash flows generated bya pool of mortgages.LG4 In part because real estate investments appeared to be relatively safe, lenders began relaxing their standards for borrowers. This led to tremendous growth in acategory of loans called subprime mortgages. Subprime mortgages are mortgageloans made to borrowers with lower incomes and poorer credit histories as com-pared to “prime” borrowers. Often, loans granted to subprime borrowers haveadjustable, rather than fixed, interest rates. This makes subprime borrowers par-ticularly vulnerable if interest rates rise, and many of these borrowers (andlenders) assumed that rising home prices would allow borrowers to refinance theirloans if they had difficulties making payments. Partly through the growth of sub-prime mortgages, banks and other financial institutions gradually increased theirinvestments in real estate loans. In the year 2000, real estate loans accounted forless than 40 percent of the total loan portfolios of large banks. By 2007, real estateloans grew to more than half of all loans made by large banks, and the fraction ofthese loans in the subprime category increased as well. Unfortunately, as Figure 2.2 shows, home prices fell almost without interrup- tion from May 2006 through May 2009. Over that three-year period, homeprices fell on average by more than 30 percent. Not surprisingly, when home-owners had difficulty making their mortgage payments, refinancing was nolonger an option, and delinquency rates and foreclosures began to climb. By2009, nearly 25 percent of subprime borrowers were behind schedule on theirmortgage payments. Some borrowers, recognizing that the value of their homeswas far less than the amount they owed on their mortgages, simply walked awayfrom their homes and let lenders repossess them. CRISIS OF CONFIDENCE IN BANKS With delinquency rates rising, the value of mortgage-backed securities began tofall, and so too did the fortunes of financial institutions that had invested heavilyin real estate assets. In March 2008, the Federal Reserve provided financing forthe acquisition (that is, the rescue) of Bear Stearns by JPMorgan Chase. Later thatyear, Lehman Brothers filed for bankruptcy. Throughout 2008 and 2009, theFederal Reserve, the Bush administration, and finally the Obama administrationtook unprecedented steps to try to shore up the banking sector and stimulate theeconomy, but these measures could not completely avert the crisis.42 PART 1 Introduction to Managerial Finance Jan. 1987 Feb. 2010 Time250 200150100 50 0Index Value 1987 ’89 ’91 ’93 ’95 ’97 ’99 ’01 ’03 ’05 ’07 2009FIGURE 2.2 Housing Values Standard & Poor’s Case-Shiller Home Price Index, January 1987 through February 2010 Figure 2.3 shows the behavior of the Standard & Poor’s Banking Index, an index that tracks bank stocks. Bank stocks fell 81 percent between January 2008and March 2009, and the number of bank failures skyrocketed. According to theFederal Deposit Insurance Corporation (FDIC), only three banks failed in 2007.In 2008 that number rose by a factor of eight to 25 failed banks, and the numberincreased nearly six times to 140 failures in 2009. While the economy began torecover in 2010, bank failures continued at a rapid pace, with 139 institutionsfailing in the first 10 months of that year. SPILLOVER EFFECTS AND THE GREAT RECESSION As banks came under intense financial pressure in 2008, they began to tightentheir lending standards and dramatically reduced the quantity of loans they made.In the aftermath of the Lehman Brothers bankruptcy, lending in the money marketcontracted very sharply. Corporations who had relied on the money market as asource of short-term funding found that they could no longer raise money in thismarket or could do so only at extraordinarily high rates. As a consequence, businesses began to hoard cash and cut back on expendi- tures, and economic activity contracted. Gross domestic product (GDP) declinedin five out of six quarters starting in the first quarter of 2008, and the economyshed more than 8 million jobs in 2008–2009 as the unemployment rate reached10 percent. Congress passed an $862 billion stimulus package to try to revive theeconomy, and the Federal Reserve pushed short-term interest rates close to 0 per-cent. By late 2009 and early 2010, there were signs that a gradual economicrecovery had begun, but the job market remained stagnant, and most forecastscalled for anemic economic growth. Perhaps the most important lesson from this episode is how important finan- cial institutions are to a modern economy. By some measures, the 2008–2009recession was the worst experienced in the United States since the GreatDepression. Indeed, there many parallels between those two economic contrac-tions. Both were preceded by a period of rapid economic growth, rising stockprices, and movements by banks into new lines of business, and both involved aCHAPTER 2 The Financial Market Environment 43 Time250300350 200 150100 50 0Index Value Jan. 1 2008July 1 2008Jan. 1 2009July 1 2009Jan. 1 2010May 17 2010FIGURE 2.3 Bank Stock Values Standard & Poor’s BankingIndex, January 1, 2008 through May 17, 2010 major crisis in the financial sector. Recessions associated with a banking crisis tend to be more severe than other recessions because so many businesses rely oncredit to operate. When financial institutions contract borrowing, activity in mostother industries slows down too. 6REVIEW QUESTIONS 2–8What is securitization, and how does it facilitate investment in real estate assets? 2–9What is a mortgage-backed security? What is the basic risk associated with mortgage-backed securities? 2–10 How do rising home prices contribute to low mortgage delinquencies? 2–11 Why do falling home prices create an incentive for homeowners todefault on their mortgages even if they can afford to make the monthlypayments? 2–12 Why does a crisis in the financial sector spill over into other industries?44 PART 1 Introduction to Managerial Finance 2.3Regulation of Financial Institutions and Markets The previous section discussed just how vulnerable modern economies are when financial institutions are in a state of crisis. Partly to avoid these types of prob-lems, governments typically regulate financial institutions and markets as muchor more than almost any other sector in the economy. This section provides anoverview of the financial regulatory landscape in the United States. REGULATIONS GOVERNING FINANCIAL INSTITUTIONS As mentioned in the previous section, Congress passed the Glass-Steagall Act in1933 during the depths of the Great Depression. The early 1930s witnessed aseries of banking panics that caused almost one-third of the nation’s banks to fail.Troubles within the banking sector and other factors contributed to the worsteconomic contraction in U.S. history, in which industrial production fell by morethan 50 percent, the unemployment rate peaked at almost 25 percent, and stockprices dropped roughly 86 percent. The Glass-Steagall Act attempted to calm thepublic’s fears about the banking industry by establishing the Federal Deposit Insurance Corporation (FDIC), which provided deposit insurance, effectively guaranteeing that individuals would not lose their money if they held it in a bankthat failed. The FDIC was also charged with examining banks on a regular basisto ensure that they were “safe and sound.” The Glass-Steagall Act also prohibitedinstitutions that took deposits from engaging in activities such as securitiesunderwriting and trading, thereby effectively separating commercial banks frominvestment banks. Over time, U.S. financial institutions faced competitive pressures from both domestic and foreign businesses that engaged in facilitating loans or making Federal Deposit Insurance Corporation (FDIC) An agency created by the Glass-Steagall Act thatprovides insurance for depositsat banks and monitors banks toensure their safety andsoundness.LG5 loans directly. Because these competitors either did not accept deposits or were located outside the United States, they were not subject to the same regulations asdomestic banks. As a result, domestic banks began to lose market share in theircore businesses. Pressure mounted to repeal the Glass-Steagall Act to enable U.S.banks to compete more effectively, and in 1999 Congress enacted and PresidentClinton signed the Gramm-Leach-Bliley Act, which allows commercial banks, investment banks, and insurance companies to consolidate and compete for busi-ness in a wider range of activities. In the aftermath of the recent financial crisis and recession, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010.In print, the new law runs for hundreds of pages and calls for the creation of sev-eral new agencies including the Financial Stability Oversight Council, the Officeof Financial Research, and the Bureau of Consumer Financial Protection. The actalso realigns the duties of several existing agencies and requires existing and newagencies to report to Congress regularly. As this book was going to press, the var-ious agencies affected or created by the new law were writing rules specifyinghow the new law’s provisions would be implemented, so exactly how the new leg-islation will affect financial institutions and markets remains unclear. REGULATIONS GOVERNING FINANCIAL MARKETS Two other pieces of legislation were passed during the Great Depression that hadan enormous impact on the regulation of financial markets. The Securities Act of 1933 imposed new regulations governing the sale of new securities. That is, the 1933 act was intended to regulate activity in the primary market in which securi-ties are initially issued to the public. The act was designed to insure that thesellers of new securities provided extensive disclosures to the potential buyers ofthose securities. TheSecurities Exchange Act of 1934 regulates the secondary trading of secu- rities such as stocks and bonds. The Securities Exchange Act of 1934 also createdtheSecurities and Exchange Commission (SEC), which is the primary agency responsible for enforcing federal securities laws. In addition to the one-time dis-closures required of security issuers by the Securities Act of 1933, the SecuritiesExchange Act of 1934 requires ongoing disclosure by companies whose securitiestrade in secondary markets. Companies must make a 10-Q filing every quarterand a 10-K filing annually. The 10-Q and 10-K forms contain detailed informa-tion about the financial performance of the firm during the relevant period.Today, these forms are available online through the SEC’s website known asEDGAR (Electronic Data Gathering, Analysis, and Retrieval). The 1934 act alsoimposes limits on the extent to which corporate “insiders,” such as senior man-agers, can trade in their firm’s securities. 6REVIEW QUESTIONS 2–13 Why do you think so many pieces of important legislation related to financial markets and institutions were passed during the GreatDepression? 2–14 What different aspects of financial markets do the Securities Act of 1933 and the Securities Exchange Act of 1934 regulate?CHAPTER 2 The Financial Market Environment 45 Gramm-Leach-Bliley Act An act that allows business combinations (that is, mergers)between commercial banks,investment banks, andinsurance companies, and thuspermits these institutions tocompete in markets that prior regulations prohibited them from entering. Securities Act of 1933 An act that regulates the saleof securities to the public via the primary market. Securities Exchange Act of 1934 An act that regulates the trading of securities such as stocks and bonds in the secondary market. Securities and Exchange Commission (SEC) The primary government agency responsible forenforcing federal securitieslaws. 46 PART 1 Introduction to Managerial Finance 2.4Business Taxes Taxes are a fact of life, and businesses, like individuals, must pay taxes on income. The income of sole proprietorships and partnerships is taxed as the income of theindividual owners; corporate income is subject to corporate taxes. Regardless of their legal form, all businesses can earn two types of income, ordinary and capital gains. Under current law, these two types of income aretreated differently in the taxation of individuals; they are not treated differentlyfor entities subject to corporate taxes. However, frequent amendments are madeto the tax code, particularly as economic conditions change and when party con-trol of the legislative and executive branches of government shifts. ORDINARY INCOME Theordinary income of a corporation is income earned through the sale of goods or services. Ordinary income in 2010 was taxed subject to the rates depicted inthe corporate tax rate schedule in Table 2.1. Webster Manufacturing, Inc., a small manufacturer of kitchen knives, has before-tax earnings of $250,000. The tax on these earnings can be found by using thetax rate schedule in Table 2.1: From a financial point of view, it is important to understand the difference between average and marginal tax rates, the treatment of interest and dividendincome, and the effects of tax deductibility. Marginal versus Average Tax Rates Themarginal tax rate represents the rate at which the next dollar of income is taxed. In the current corporate tax structure, the marginal tax rate is 15 percent=$22,250 +$58,500 =$80,750=$22,250 +(0.39 *$150,000)Total taxes due =$22,250 +30.39 *($250,000 -$100,000) 4Example 2.23ordinary income Income earned through the sale of a firm’s goods or services. Corporate Tax Rate Schedule Tax calculation Range of taxable income Base tax (Marginal rate amount over base bracket) $ 0 to $ 50,000 $ 0 (15% amount over $ 0) 50,000 to 75,000 7,500 (25 amount over 50,000)75,000 to 100,000 13,750 (34 amount over 75,000) 100,000 to 335,000 22,250 (39 amount over 100,000)335,000 to 10,000,000 113,900 (34 amount over 335,000) 10,000,000 to 15,000,000 3,400,000 (35 amount over 10,000,000)15,000,000 to 18,333,333 5,150,000 (38 amount over 15,000,000) Over 18,333,333 6,416,667 (35 amount over 18,333,333) * +* +* +* +* +* +* +* +: /H11545TABLE 2.1marginal tax rate The rate at which additional income is taxed.LG6 if the firm earns less than $50,000. If a firm earns more than $50,000 but less than $75,000, the marginal tax rate is 25 percent. As a firm’s income rises, themarginal tax rate that it faces changes as shown in Table 2.1. In the exampleabove, if Webster Manufacturing’s earnings increase to $250,001, the last $1 inincome would be taxed at the marginal rate of 39 percent. Theaverage tax rate paid on the firm’s ordinary income can be calculated by dividing its taxes by its taxable income. For most firms, the average tax ratedoes not equal the marginal tax rate because tax rates change with incomelevels. In the example above, Webster Manufacturing’s marginal tax rate is 39 percent, but its average tax rate is 32.3 percent . For very large corporations with earnings in the hundreds of millions or even billions of dollars, the average tax rate is very close to the 35 percent mar-ginal rate in the top bracket because most of the firm’s income is taxed at that rate. In most of the business decisions that managers make, it’s the marginal tax rate that really matters . To keep matters simple, the examples in this text will use aflat 40 percent tax rate . That means that both the average tax rate and the mar- ginal tax rate equal 40 percent. Interest and Dividend Income In the process of determining taxable income, any interest received by the corpo- ration is included as ordinary income. Dividends, on the other hand, are treateddifferently. This different treatment moderates the effect of double taxation, which occurs when the already once-taxed earnings of a corporation are distrib-uted as cash dividends to stockholders, who must pay taxes on dividends up to amaximum rate of 15 percent. Dividends that the firm receives on common andpreferred stock held in other corporations are subject to a 70 percent exclusionfor tax purposes. 2The dividend exclusion in effect eliminates most of the poten- tial tax liability from the dividends received by the second and any subsequentcorporations. Tax-Deductible Expenses In calculating their taxes, corporations are allowed to deduct operatingexpenses, as well as interest expense. The tax deductibility of these expensesreduces their after-tax cost. The following example illustrates the benefit of taxdeductibility. Two companies, Debt Co. and No-Debt Co., both expect in the coming year tohave earnings before interest and taxes of $200,000. During the year, Debt Co.will have to pay $30,000 in interest. No-Debt Co. has no debt and therefore will Example 2.33($80,750 ,$250,000)CHAPTER 2 The Financial Market Environment 47 2. The 70 percent exclusion applies if the firm receiving dividends owns less than 20 percent of the shares of the firm paying the dividends. The exclusion is 80 percent if the corporation owns between 20 percent and 80 percent of the stock in the corporation paying it dividends; 100 percent of the dividends received are excluded if it owns more than 80 percent of the corporation paying it dividends. For convenience, we are assuming here that the ownership interestin the dividend-paying corporation is less than 20 percent.average tax rate A firm’s taxes divided by its taxable income. double taxation Situation that occurs whenafter-tax corporate earningsare distributed as cashdividends to stockholders, whothen must pay personal taxeson the dividend amount. Debt Co. had $30,000 more interest expense than No-Debt Co., but Debt Co.’s earnings after taxes are only $18,000 less than those of No-Debt Co. This differ-ence is attributable to the fact that Debt Co.’s $30,000 interest expense deductionprovided a tax savings of $12,000 ($68,000 for Debt Co. versus $80,000 for No-Debt Co.). This amount can be calculated directly by multiplying the tax rateby the amount of interest expense . Similarly, the $18,000 after-tax cost of the interest expense can be calculated directly by multiplying 1 minus the tax rate by the amount of interest expense . The tax deductibility of expenses reduces their actual (after-tax) cost to the firm as long as the firm is profitable. If a firm experiences a net loss in a givenyear, its tax liability is already zero. Even in this case, losses in one year can beused to offset taxes paid on profits in prior years, and in some cases losses can be“carried forward” to offset income and lower taxes in subsequent years. Notethat both for accounting and tax purposes interest is a tax-deductible expense, whereas dividends are not. Because dividends are not tax deductible, their after- tax cost is equal to the amount of the dividend. Thus a $30,000 cash dividend hasan after-tax cost of $30,000. CAPITAL GAINS If a firm sells a capital asset (such as stock held as an investment) for more than itpaid for the asset, the difference between the sale price and purchase price iscalled a capital gain. For corporations, capital gains are added to ordinary corpo- rate income and taxed at the regular corporate rates. Ross Company, a manufacturer of pharmaceuticals, has pretax operating earn-ings of $500,000 and has just sold for $150,000 an asset that was purchased 2 years ago for $125,000. Because the asset was sold for more than its initial pur-chase price, there is a capital gain of $25,000 ($150,000 sale price $125,000initial purchase price). The corporation’s taxable income will total $525,000($500,000 ordinary income plus $25,000 capital gain). Multiplying their taxable income by 40% produces Ross Company’s tax liability of $210,000.-Example 2.43$18,000 43(1-0.40) *$30,000 =(0.40 *$30,000 =$12,000)48 PART 1 Introduction to Managerial Finance Debt Co. No-Debt Co. Earnings before interest and taxes $200,000 $200,000 Less: Interest expense Earnings before taxes $170,000 $200,000 Less: Taxes (40%) Earnings after taxes Difference in earnings after taxes $18,000$120,000 $102,00080,000 68,0000 30,000 i capital gain The amount by which the sale price of an asset exceeds theasset’s purchase price.have no interest expense. Calculation of the earnings after taxes for these two firms is as follows: 6REVIEW QUESTIONS 2–15 Describe the tax treatment of ordinary income and that of capital gains. What is the difference between the average tax rate and the marginal tax rate? 2–16 How does the tax treatment of dividend income by the corporation moderate the effects of double taxation? 2–17 What benefit results from the tax deductibility of certain corporate expenses?CHAPTER 2 The Financial Market Environment 49 Summary THE ROLE OF FINANCIAL INSTITUTIONS AND MARKETS Chapter 2 described why financial institutions and markets are an integral part of managerial finance. Companies cannot get started or survive without raisingcapital, and financial institutions and markets give firms access to the moneythey need to grow. As we have seen in recent years, however, financial marketscan be quite turbulent, and when large financial institutions get into trouble,access to capital is reduced and firms throughout the economy suffer as a result.Taxes are an important part of this story as well because the rules governing howbusiness income is taxed shape the incentives of firms to make new investments. REVIEW OF LEARNING GOALS Understand the role that financial institutions play in managerial finance. Financial institutions bring net suppliers of funds and net demanders together to help translate the savings of individuals, businesses, and govern-ments into loans and other types of investments. The net suppliers of funds aregenerally individuals or households who save more money than they borrow.Businesses and governments are generally net demanders of funds, meaning thatthey borrow more money than they save. Contrast the functions of financial institutions and financial markets. Both financial institutions and financial markets help businesses raise the moneythat they need to fund new investments for growth. Financial institutions collectthe savings of individuals and channel those funds to borrowers such as busi-nesses and governments. Financial markets provide a forum in which savers andborrowers can transact business directly. Businesses and governments issue debtand equity securities directly to the public in the primary market. Subsequenttrading of these securities between investors occurs in the secondary market. Describe the differences between the capital markets and the money markets. In the money market, savers who want a temporary place to deposit funds where they can earn interest interact with borrowers who have a short-term need for funds. Marketable securities including Treasury bills, commercialpaper, and other instruments are the primary securities traded in the moneymarket. The Eurocurrency market is the international equivalent of the domesticmoney market. LG3LG2LG1 In contrast, the capital market is the forum in which savers and borrowers interact on a long-term basis. Firms issue either debt (bonds) or equity (stock)securities in the capital market. Once issued, these securities trade on secondarymarkets that are either broker markets or dealer markets. An important func-tion of the capital market is to determine the underlying value of the securitiesissued by businesses. In an efficient market, the price of a security is an unbiasedestimate of its true value. Explain the root causes of the 2008 financial crisis and recession. The financial crisis was caused by several factors related to investments in real estate.Financial institutions lowered their standards for lending to prospective home-owners, and institutions also invested heavily in mortgage-backed securities.When home prices fell and mortgage delinquencies rose, the value of the mort-gage-backed securities held by banks plummeted, causing some banks to fail andmany others to restrict the flow of credit to business. That in turn contributed toa severe recession in the United States and abroad. Understand the major regulations and regulatory bodies that affect financial institutions and markets. The Glass-Steagall Act created the FDIC and imposed a separation between commercial and investment banks. The act wasdesigned to limit the risks that banks could take and to protect depositors. Morerecently, the Gramm-Leach-Bliley Act essentially repealed the elements of Glass-Steagall pertaining to the separation of commercial and investment banks. Afterthe recent financial crisis, much debate has occurred regarding the proper regu-lation of large financial institutions. The Securities Act of 1933 and the Securities Exchange Act of 1934 are the major pieces of legislation shaping the regulation of financial markets. The 1933act focuses on regulating the sale of securities in the primary market, whereasthe 1934 act deals with regulations governing transactions in the secondarymarket. The 1934 act also created the Securities and Exchange Commission, the primary body responsible for enforcing federal securities laws. Discuss business taxes and their importance in financial decisions. Corporate income is subject to corporate taxes. Corporate tax rates apply to both ordinary income (after deduction of allowable expenses) and capitalgains. The average tax rate paid by a corporation ranges from 15 to 35 percent.Corporate taxpayers can reduce their taxes through certain provisions in the taxcode: dividend income exclusions and tax-deductible expenses. A capital gainoccurs when an asset is sold for more than its initial purchase price; gains areadded to ordinary corporate income and taxed at regular corporate tax rates.(For convenience, we assume a 40 percent marginal tax rate in this book.) LG6LG5LG450 PART 1 Introduction to Managerial Finance Opener-in-Review In the chapter opener you read about JPMorgan’s tumultuous ride through the 2008 financial crisis, and in the chapter itself you learned about capital marketefficiency. What role do you think market efficiency (or inefficiency) played inthe 10 percent fall of JPMorgan’s share price in a single day? CHAPTER 2 The Financial Market Environment 51 Self-Test Problem(Solution in Appendix) ST2–1 Corporate taxes Montgomery Enterprises, Inc., had operating earnings of $280,000 for the year just ended. During the year the firm sold stock that it held inanother company for $180,000, which was $30,000 above its original purchaseprice of $150,000, paid 1 year earlier.a.What is the amount, if any, of capital gains realized during the year? b.How much total taxable income did the firm earn during the year? c.Use the corporate tax rate schedule given in Table 2.1 to calculate the firm’s total taxes due. d.Calculate both the average tax rate and the marginal tax rate on the basis of your findings.LG6 Warm-Up ExercisesAll problems are available in . E2–1 What does it mean to say that individuals as a group are net suppliers of funds for financial institutions? What do you think the consequences might be in financial markets if individuals consumed more of their incomes and thereby reduced thesupply of funds available to financial institutions? E2–2 You are the chief financial officer (CFO) of Gaga Enterprises, an edgy fashion design firm. Your firm needs $10 million to expand production. How do you think the process of raising this money will vary if you raise it with the help of a financialinstitution versus raising it directly in the financial markets? E2–3 For what kinds of needs do you a think firm would issue securities in the money market versus the capital market? E2–4 Your broker calls to offer you the investment opportunity of a lifetime, the chance toinvest in mortgage-backed securities. The broker explains that these securities are entitled to the principal and interest payments received from a pool of residentialmortgages. List some of the questions you would ask your broker to assess the risk of this investment opportunity. E2–5 Reston, Inc., has asked your corporation, Pruro, Inc., for financial assistance. As along-time customer of Reston, your firm has decided to give that assistance. The question you are debating is whether Pruro should take Reston stock with a 5%annual dividend or a promissory note paying 5% annual interest. Assuming payment is guaranteed and the dollar amounts for annual interest and dividend income are identical, which option will result in greater after-tax incomefor the first year? LG1 LG3 LG4 LG6LG2 ProblemsAll problems are available in . P2–1 Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclusive distributor of a major line of sporting goods. During 2010 the firm earned $92,500 before taxes. a.Calculate the firm’s tax liability using the corporate tax rate schedule given in Table 2.1. b.How much are Tantor Supply’s 2010 after-tax earnings? LG6 52 PART 1 Introduction to Managerial Finance LG6 LG6 LG6 LG6 LG6 LG6c.What was the firm’s average tax rate, based on your findings in part a? d.What is the firm’s marginal tax rate, based on your findings in part a? P2–2 Average corporate tax rates Using the corporate tax rate schedule given in Table 2.1, perform the following: a.Calculate the tax liability, after-tax earnings, and average tax rates for the fol- lowing levels of corporate earnings before taxes: $10,000; $80,000; $300,000; $500,000; $1.5 million; $10 million; and $20 million. b.Plot the average tax rates (measured on the yaxis) against the pretax income levels (measured on the xaxis). What generalization can be made concerning the relationship between these variables? P2–3 Marginal corporate tax rates Using the corporate tax rate schedule given in Table 2.1, perform the following:a.Find the marginal tax rate for the following levels of corporate earnings before taxes: $15,000; $60,000; $90,000; $200,000; $400,000; $1 million; and $20 million. b.Plot the marginal tax rates (measured on the yaxis) against the pretax income levels (measured on the xaxis). Explain the relationship between these variables. P2–4 Interest versus dividend income During the year just ended, Shering Distributors, Inc., had pretax earnings from operations of $490,000. In addition, during the year it received $20,000 in income from interest on bonds it held in Zig Manufacturingand received $20,000 in income from dividends on its 5% common stock holding in Tank Industries, Inc. Shering is in the 40% tax bracket and is eligible for a 70% dividend exclusion on its Tank Industries stock. a.Calculate the firm’s tax on its operating earnings only. b.Find the tax and the after-tax amount attributable to the interest income from Zig Manufacturing bonds. c.Find the tax and the after-tax amount attributable to the dividend income from the Tank Industries, Inc., common stock. d.Compare, contrast, and discuss the after-tax amounts resulting from the interest income and dividend income calculated in parts bandc. e.What is the firm’s total tax liability for the year? P2–5 Interest versus dividend expense Michaels Corporation expects earnings before interest and taxes to be $40,000 for the current period. Assuming an ordinary tax rate of 40%, compute the firm’s earnings after taxes and earnings available forcommon stockholders (earnings after taxes and preferred stock dividends, if any) under the following conditions: a.The firm pays $10,000 in interest. b.The firm pays $10,000 in preferred stock dividends. P2–6 Capital gains taxes Perkins Manufacturing is considering the sale of two nondepre- ciable assets, X and Y. Asset X was purchased for $2,000 and will be sold today for $2,250. Asset Y was purchased for $30,000 and will be sold today for $35,000. Thefirm is subject to a 40% tax rate on capital gains. a.Calculate the amount of capital gain, if any, realized on each of the assets. b.Calculate the tax on the sale of each asset. P2–7 Capital gains taxes The following table contains purchase and sale prices for the nondepreciable capital assets of a major corporation. The firm paid taxes of 40% oncapital gains. a.Determine the amount of capital gain realized on each of the five assets. b.Calculate the amount of tax paid on each of the assets. P2–8 ETHICS PROBLEM The Securities Exchange Act of 1934 limits, but does not pro- hibit, corporate insiders from trading in their own firm’s shares. What ethical issues might arise when a corporate insider wants to buy or sell shares in the firm where heor she works?CHAPTER 2 The Financial Market Environment 53 LG5Asset Purchase price Sale price A $ 3,000 $ 3,400 B 12,000 12,000 C 62,000 80,000 D 41,000 45,000 E 16,500 18,000 Spreadsheet Exercise Hemingway Corporation is considering expanding its operations to boost its income, but before making a final decision they have asked you to calculate the corporate tax consequences of their decision. Currently Hemingway generates before-tax yearly income of $200,000 and has no debt outstanding. Expanding operations would allowHemingway to increase before-tax yearly income to $350,000. Hemingway can useeither cash reserves or debt to finance its expansion. If Hemingway uses debt, it willhave yearly interest expense of $70,000. TO DO Create a spreadsheet to conduct a tax analysis for Hemingway Corporation and determine the following: a.What is Hemingway’s current annual corporate tax liability? b.What is Hemingway’s current average tax rate? c.If Hemingway finances its expansion using cash reserves, what will be its new corporate tax liability and average tax rate? d.If Hemingway finances its expansion using debt, what will be its new corporate tax liability and average tax rate? e.What would you recommend that the firm do? Why? Visit www.myfinancelab.com forChapter C ase:The Pros and Cons of Being Publicly Listed, Group Exercises, and numerous online resources. Merit Enterprise Corp. Sara Lehn, chief financial officer of Merit Enterprise Corp., was reviewing her presentation one last time before her upcoming meeting with the board of direc- tors. Merit’s business had been brisk for the last two years, and the company’s CEO was pushing for a dramatic expansion of Merit’s production capacity. Executing the CEO’s plans would require $4 billion in capital in addition to $2 billion in excess cash that the firm had built up. Sara’s immediate task was to brief the board on options for raising the needed $4 billion. Unlike most companies its size, Merit had maintained its status as a private company, financing its growth by reinvesting profits and, when necessary, borrowing from banks. Whether Merit could follow that same strategy to raise the $4 billionnecessary to expand at the pace envisioned by the firm’s CEO was uncertain, thoughit seemed unlikely to Sara. She had identified two options for the board to consider: Option 1: Merit could approach JPMorgan Chase, a bank that had served Merit well for many years with seasonal credit lines as well as medium-term loans. Lehnbelieved that JPMorgan was unlikely to make a $4 billion loan to Merit on its own,but it could probably gather a group of banks together to make a loan of this magni-tude. However, the banks would undoubtedly demand that Merit limit further bor-rowing and provide JPMorgan with periodic financial disclosures so that they couldmonitor Merit’s financial condition as it expanded its operations. Option 2: Merit could convert to public ownership, issuing stock to the public in the primary market. With Merit’s excellent financial performance in recent years, Sara thought that its stock could command a high price in the market and that manyinvestors would want to participate in any stock offering that Merit conducted. Becoming a public company would also allow Merit, for the first time, to offer employees compensation in the form of stock or stock options, thereby creatingstronger incentives for employees to help the firm succeed. On the other hand, Saraknew that public companies faced extensive disclosure requirements and other regu-lations that Merit had never had to confront as a private firm. Furthermore, with stock trading in the secondary market, who knew what kind of individuals or insti- tutions might wind up holding a large chunk of Merit stock? TO DO a.Discuss the pros and cons of option 1, and prioritize your thoughts. What are the most positive aspects of this option, and what are the biggest drawbacks? b.Do the same for option 2. c.Which option do you think Sara should recommend to the board and why? 54Integrative Case 1 552 Part Financial Tools 3Financial Statements and Ratio Analysis 4Cash Flow and Financial Planning 5Time Value of Money INTEGRATIVE CASE 2 Track Software, Inc.Chapters in This Part In Part 2 you will learn about some of the basic analytical tools that financial managers use almost every day. Chapter 3 reviews the main financial statements that are the primary means by which firms communicate with investors, analysts, andthe rest of the business community. Chapter 3 also illustrates some simple tools thatmanagers use to analyze the information contained in financial statements to identifyand diagnose financial problems. Firms create financial statements using the accrual principles of accounting, but in finance it is cash flow that really matters. Chapter 4 shows how to use financialstatements to determine how much cash flow a firm is generating and how it isspending that cash flow. Chapter 4 also explains how firms develop short-term andlong-term financial plans. Managers have to decide whether the up-front costs of investments are justified by the subsequent cash that those investments are likely to produce. Chapter 5 illustratestechniques that firms use to evaluate these sorts of trade-offs. Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand the stockholders ’ report and preparation of the four key financial statements; how firms consolidateinternational financial statements; and how to calculate and interpretfinancial ratios for decision making. INFORMATION SYSTEMS You need to understand what data are included in the firm ’s financial statements to design systems that will supply such data to those who prepare the statements and to those inthe firm who use the data for ratio calculations. MANAGEMENT You need to understand what parties are interested in the stockholders ’ report and why; how the financial statements will be analyzed by those both inside and outside the firm to assess variousaspects of performance; the caution that should be exercised in usingfinancial ratio analysis; and how the financial statements affect thevalue of the firm. MARKETING You need to understand the effects your decisions will have on the financial statements, particularly the income statement andthe statement of cash flows, and how analysis of ratios, especiallythose involving sales figures, will affect the firm ’s decisions about levels of inventory, credit policies, and pricing decisions. OPERATIONS You need to understand how the costs of operations are reflected in the firm ’s financial statements and how analysis of ratios, particularly those involving assets, cost of goods sold, or inventory,may affect requests for new equipment or facilities. A routine step in personal financial planning is to prepare and analyze personal financial statements, so that you can monitor progress towardyour financial goals. Also, you need to understand and analyze corpo-rate financial statements to build and monitor your investment portfolio. In your personal lifeLearning Goals Review the contents of the stockholders ’ report and the procedures for consolidatinginternational financial statements. Understand who uses financial ratios and how. Use ratios to analyze a firm ’s liquidity and activity. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm ’s debt. Use ratios to analyze a firm ’s profitability and its market value. Use a summary of financial ratios and the DuPont system of analysisto perform a complete ratioanalysis. LG6LG5LG4LG3LG2LG13Financial Statements and Ratio Analysis 56 57The Value of Casual Luxury AMay 15, 2010, post on an investment website, Motley Fool, provided a valuation analysis for clothing retailer Abercrombie & Fitch. Abercrombie ’s stock price had been trending down for several weeks, and given that recent months had only just seen the end of one of the worst recessions in two generations,Motley Fool analysts did not expect the firm ’s financial condition to be particularly impressive. However, they noted that Abercrombie ’s current ratio was a healthy 2.79, and its quick ratio was also strong at 1.79. Furthermore, analysts noted that Abercrombie ’s receivables collection period had quick- ened to 43 days in the prior year, and they concluded their report with a relatively positive out- look for the stock. Just a few days later, Abercrombie & Fitch announced that it would scale back planned overseas store openings, the markets where it had been enjoying the most rapid growth. In addi- tion, the company reported that its gross profit margin declined in the most recent quarter. Markets responded to this information by sending Abercrombie stock down 7 percent on that day. Valuing the shares of a company is a difficult task. Analysts try to simplify that task by drawing data from financial reports produced by the company and calculating a variety of financial ratios using those data. These ratios help analysts answer questions such as, Does thefirm have enough liquidity to pay the bills that will come due in the short term ? and, How effec- tively does the firm collect cash from its customers ? In this chapter, you will learn about the main financial statements that analysts rely on for this type of analysis, and you will see how informa-tion from those statements can be used to assess the overall performance of a company. Abercrombie & Fitch 58 PART 2 Financial Tools 3.1The Stockholders’ Report Every corporation has many and varied uses for the standardized records and reports of its financial activities. Periodically, reports must be prepared for regu-lators, creditors (lenders), owners, and management. The guidelines used to pre-pare and maintain financial records and reports are known as generally accepted accounting principles (GAAP). These accounting practices and procedures are authorized by the accounting profession’s rule-setting body, the Financial Accounting Standards Board (FASB). In addition, the Sarbanes-Oxley Act of 2002, enacted in an effort to eliminate the many disclosure and conflict-of-interest problems of corporations, establishedthePublic Company Accounting Oversight Board (PCAOB), a not-for-profit cor- poration that oversees auditors of public corporations. The PCAOB is chargedwith protecting the interests of investors and furthering the public interest in thepreparation of informative, fair, and independent audit reports. The expectationis that it will instill confidence in investors with regard to the accuracy of theaudited financial statements of public companies. Publicly owned corporations with more than $5 million in assets and 500 or more stockholders are required by the Securities and Exchange Commission(SEC)—the federal regulatory body that governs the sale and listing of securities—to provide their stockholders with an annual stockholders’ report. The stock- holders’ report summarizes and documents the firm’s financial activities duringthe past year. It begins with a letter to the stockholders from the firm’s presidentand/or chairman of the board. THE LETTER TO STOCKHOLDERS Theletter to stockholders is the primary communication from management. It describes the events that are considered to have had the greatest effect on the firmgenerally accepted accounting principles (GAAP) The practice and procedure guidelines used to prepare andmaintain financial records andreports; authorized by the Financial Accounting Standards Board (FASB). Financial Accounting Standards Board (FASB) The accounting profession’s rule-setting body, whichauthorizes generally accepted accounting principles (GAAP). Public Company Accounting Oversight Board (PCAOB) A not-for-profit corporation established by the Sarbanes- Oxley Act of 2002 to protect the interests of investors andfurther the public interest in thepreparation of informative, fair,and independent audit reports. GLOBAL focus More Countries Adopt International Financial Reporting Standards In the United States, public companies are required to report financial results using GAAP. However, accounting standards vary around the world, and that makescomparing the financial results of firmslocated in different countries quite chal-lenging. In recent years, many countries have adopted a system of accounting principles known as InternationalFinancial Reporting Standards (IFRS),which are established by an independ-ent standards-setting body known as the International Accounting StandardsBoard (IASB). These standards are designed with the goal of making financial statements everywhere under-standable, reliable, comparable, and accurate. More than 80 countries now require listed firms to comply with IFRS,and dozens more permit or requirefirms to follow IFRS to some degree. Why hasn ’t the United States fol- lowed the global trend of IFRS adop- tion ? Some argue that GAAP is still the “gold standard, ” and a movement to IFRS would lower the overall quality offinancial reporting made by U.S. firms.It is true that IFRS generally requires less detail than GAAP. Even so, the Securities and Exchange Commissionhas expressed its view that U.S.investors will benefit as GAAP and IFRSconverge though there is no expecta- tion that firms in the United States will be required to switch to IFRS in thenear future. 3 What costs and benefits might be associated with a switch to IFRS in the United States?in practiceLG1 during the year. It also typically discusses management philosophy, corporate governance issues, strategies, and actions, as well as plans for the coming year. THE FOUR KEY FINANCIAL STATEMENTS The four key financial statements required by the SEC for reporting to share-holders are (1) the income statement, (2) the balance sheet, (3) the statement ofstockholders’ equity, and (4) the statement of cash flows. The financial state-ments from the 2012 stockholders’ report of Bartlett Company, a manufacturerof metal fasteners, are presented and briefly discussed in this section. Most likely,you have studied these four financial statements in an accounting course, so thepurpose of looking at them here is to refresh your memory of the basics, ratherthan provide an exhaustive review. Income Statement Theincome statement provides a financial summary of the firm’s operating results during a specified period. Most common are income statements covering a 1-yearperiod ending at a specified date, ordinarily December 31 of the calendar year.CHAPTER 3 Financial Statements and Ratio Analysis 59 stockholders’ report Annual report that publicly owned corporations mustprovide to stockholders; itsummarizes and documents the firm’s financial activitiesduring the past year. letter to stockholders Typically, the first element of the annual stockholders’report and the primarycommunication frommanagement. focus on ETHICS Taking Earnings Reports at Face Value Near the end of each quarter, Wall Street ’s much anticipated “earnings season ” arrives. During earnings season, manycompanies unveil their quarterly per-formance. Interest is high, as media outlets rush to report the latest announcements, analysts slice and dicethe numbers, and investors buy and sellbased on the news. The most antici- pated performance metric for most com- panies is earnings per share (EPS),which is typically compared to the esti-mates of the analysts that cover a firm.Firms that beat analyst estimates often see their share prices jump, while those that miss estimates, by even a smallamount, tend to suffer price declines. Many investors are aware of the pitfalls of judging firms based on reported earnings. Specifically, the complexity of financial reports makes iteasy for managers to mislead investors.Sometimes, the methods used to mis-lead investors are within the rules,albeit not the spirit, of acceptable accounting practices. Other times, firmsbreak the rules to make their numbers. The practice of manipulating earnings to mislead investors is known as earn-ings management. Some firms are notorious for consis- tently beating analysts ’ estimates. For example, for one 10-year period(1995–2004), General Electric Co.(GE) beat Wall Street earnings esti-mates every quarter, often by only a penny or two per share. However, in 2009, the U.S. Securities andExchange Commission (SEC) fined GE$50 million for improper accountingpractices, including recording sales that had not yet occurred. When GE went back to correct the problems identifiedby the SEC, they found that net earn-ings between 2001 and 2007 were atotal of $280 million lower than origi- nally reported. In one of his famous letters to the shareholders of Berskshire Hathaway,Warren Buffett offers three bits of advice regarding financial reporting. a First, he warns that weak visible accounting practices are typically a sign of bigger problems. Second, hesuggests that, when you can ’t under- stand management, the reason is prob-ably that management doesn ’t want you to understand them. Third, he warns that investors should be suspi-cious of projections because earningsand growth do not typically progress in an orderly fashion. Finally, Buffett notes that “Managers that always promise to ‘make the numbers ’ will at some point be tempted to make up the numbers. ” 3Why might financial managers be tempted to manage earnings? 3Is it unethical for managers to manage earnings if they disclose their activities to investors?in practice awww.berkshirehathaway.com/letters/2002pdf.pdfincome statement Provides a financial summary of the firm’s operating resultsduring a specified period. 60 PART 2 Financial Tools Many large firms, however, operate on a 12-month financial cycle, or fiscal year, that ends at a time other than December 31. In addition, monthly income state-ments are typically prepared for use by management, and quarterly statementsmust be made available to the stockholders of publicly owned corporations. Table 3.1 presents Bartlett Company’s income statements for the years ended December 31, 2012 and 2011. The 2012 statement begins with sales revenue — the total dollar amount of sales during the period—from which the cost of goods sold is deducted. The resulting gross profit of $986,000 represents the amount remaining to satisfy operating, financial, and tax costs. Next, operating expenses, which include selling expense, general and administrative expense, lease expense,and depreciation expense, are deducted from gross profits. The resultingoperating profits of $418,000 represent the profits earned from producing and selling products; this amount does not consider financial and tax costs.(Operating profit is often called earnings before interest and taxes, orEBIT. ) Next, the financial cost— interest expense —is subtracted from operating profits Bartlett Company Income Statements ($000) For the years ended December 31 2012 2011 Sales revenue $3,074 $2,567 Less: Cost of goods sold Gross profits Less: Operating expenses Selling expenseGeneral and administrative expenses 194 187Lease expense a35 35 Depreciation expense Total operating expense Operating profits Less: Interest expense Net profits before taxes Less: Taxes Net profits after taxes Less: Preferred stock dividends Earnings available for common stockholders Earnings per share (EPS)b Dividend per share (DPS)c aLease expense is shown here as a separate item rather than being included as part of interest expense, as specified by the FASB for financial reporting purposes. The approach used here is consistent with tax reporting rather than financial reporting procedures. bCalculated by dividing the earnings available for common stockholders by the number of shares of common stock outstanding—76,262 in 2012 and 76,244 in 2011. Earnings per share in 2012: ; in 2011: . cCalculated by dividing the dollar amount of dividends paid to common stockholders by the number of shares of common stock outstanding. Dividends per share in 2012: ; in 2011: . $57,183 ,76,244 =$0.75$98,000 ,76,262 =$1.29$138,000 ,76,244 =$1.81 $2.90$221,000 ,76,262 =$0.75 $1.29$1.81 $2.90$ 138 $2 2 110 10$ 148 $2 3 164 94$ 212 $3 2 591 93$ 303 $4 1 8$ 553 $5 6 8223 239$ 108 $1 0 0$ 856 $9 8 61,711 2,088TABLE 3.1 CHAPTER 3 Financial Statements and Ratio Analysis 61 to find net profits (orearnings )before taxes . After subtracting $93,000 in 2012 interest, Bartlett Company had $325,000 of net profits before taxes. Next, taxes are calculated at the appropriate tax rates and deducted to deter- mine net profits (orearnings )after taxes. Bartlett Company’s net profits after taxes for 2012 were $231,000. Any preferred stock dividends must be subtractedfrom net profits after taxes to arrive at earnings available for common stock- holders. This is the amount earned by the firm on behalf of the common stock- holders during the period. Dividing earnings available for common stockholders by the number of shares of common stock outstanding results in earnings per share (EPS). EPS represent the number of dollars earned during the period on behalf of each outstanding share ofcommon stock. In 2012, Bartlett Company earned $221,000 for its common stock-holders, which represents $2.90 for each outstanding share. The actual cash dividend per share (DPS), which is the dollar amount of cash distributed during the period on behalf of each outstanding share of common stock, paid in 2012 was $1.29. Jan and Jon Smith, a mid-30s married couple with no children, prepared a personal income and expense statement, which is similar to a corporate income statement. A condensed version of their income andexpense statement follows. Personal Finance Example 3.13dividend per share (DPS) The dollar amount of cash distributed during the periodon behalf of each outstandingshare of common stock. Jan and Jon Smith’s Income and Expense Statement for the Year Ended December 31, 2012 Income Salaries $72,725 Interest received 195Dividends received (1) Total income Expenses Mortgage payments $16,864 Auto loan payments 2,520Utilities 2,470Home repairs and maintenance 1,050Food 5,825Car expense 2,265Health care and insurance 1,505Clothes, shoes, accessories 1,700Insurance 1,380Taxes 16,430Appliance and furniture payments 1,250Recreation and entertainment 4,630Tuition and books for Jan 1,400Personal care and other items (2) Total expenses(3) Cash surplus (or deficit) [(1) (2)] $11,336 -$61,7042,415$73,040120 During the year, the Smiths had total income of $73,040 and total expenses of $61,704, which left them with a cash surplus of $11,336. They can use the sur- plus to increase their savings and investments. Balance Sheet Thebalance sheet presents a summary statement of the firm’s financial position at a given time. The statement balances the firm’s assets (what it owns) against its financing, which can be either debt (what it owes) or equity (what was provided by owners). Bartlett Company’s balance sheets as of December 31 of 2012 and2011 are presented in Table 3.2. They show a variety of asset, liability (debt), andequity accounts. An important distinction is made between short-term and long-term assets and liabilities. The current assets andcurrent liabilities areshort-term assets and liabilities. This means that they are expected to be converted into cash (currentassets) or paid (current liabilities) within 1 year or less. All other assets and lia-bilities, along with stockholders’ equity, which is assumed to have an infinite life,are considered long-term, orfixed, because they are expected to remain on the firm’s books for more than 1 year. As is customary, the assets are listed from the most liquid— cash—down to the least liquid. Marketable securities are very liquid short-term investments, such as U.S. Treasury bills or certificates of deposit, held by the firm. Because they arehighly liquid, marketable securities are viewed as a form of cash (“near cash”).Accounts receivable represent the total monies owed the firm by its customers on credit sales. Inventories include raw materials, work in process (partially finished goods), and finished goods held by the firm. The entry for gross fixed assets is the original cost of all fixed (long-term) assets owned by the firm. 1Net fixed assets rep- resent the difference betw een gross fixed assets and accumulated depreciation — the total expense recorded for the depreciation of fixed assets. The net value offixed assets is called their book value. Like assets, the liabilities and equity accounts are listed from short-term to long-term. Current liabilities include accounts payable, amounts owed for credit purchases by the firm; notes payable, outstanding short-term loans, typically from commercial banks; and accruals, amounts owed for services for which a bill may not or will not be received. Examples of accruals include taxes due the gov-ernment and wages due employees. Long-term debt represents debt for which payment is not due in the current year. Stockholders’ equity represents the owners’ claims on the firm. The preferred stock entry shows the historical pro- ceeds from the sale of preferred stock ($200,000 for Bartlett Company). Next, the amount paid by the original purchasers of common stock is shown by two entries, common stock and paid-in capital in excess of par on commonstock. The common stock entry is the par value of common stock. Paid-in capital in excess of par represents the amount of proceeds in excess of the par value received from the original sale of common stock. The sum of the common stockand paid-in capital accounts divided by the number of shares outstanding representsthe original price per share received by the firm on a single issue of common stock.62 PART 2 Financial Tools 1. For convenience the term fixed assets is used throughout this text to refer to what, in a strict accounting sense, is captioned “property, plant, and equipment.” This simplification of terminology permits certain financial concepts to be more easily developed.long-term debt Debt for which payment is not due in the current year.balance sheet Summary statement of thefirm’s financial position at agiven point in time. current assets Short-term assets, expected tobe converted into cash within 1 year or less. current liabilities Short-term liabilities, expectedto be paid within 1 year orless. paid-in capital in excess of par The amount of proceeds in excess of the par valuereceived from the original sale of common stock. CHAPTER 3 Financial Statements and Ratio Analysis 63 Bartlett Company Balance Sheets ($000) December 31 Assets 2012 2011 Cash Marketable securities 68 51Accounts receivable 503 365Inventories Total current assets Land and buildings $2,072 $1,903Machinery and equipment 1,866 1,693Furniture and fixtures 358 316Vehicles 275 314Other (includes financial leases) Total gross fixed assets (at cost) a$4,669 $4,322 Less: Accumulated depreciation Net fixed assetsTotal assets Liabilities and Stockholders’ Equity Accounts payable Notes payable 79 99Accruals Total current liabilities Long-term debt (includes financial leases) b Total liabilities Preferred stock—cumulative 5%, $100 par, 2,000 shares authorized and issuedc Common stock—$2.50 par, 100,000 shares authorized, shares issued and outstanding in 2012: 76,262; in 2011: 76,244 191 190 Paid-in capital in excess of par on common stock 428 418Retained earnings Total stockholders’ equityTotal liabilities and stockholders’ equity aIn 2012, the firm has a 6-year financial lease requiring annual beginning-of-year payments of $35,000. Four years of the lease have yet to run. bAnnual principal repayments on a portion of the firm’s total outstanding debt amount to $71,000. cThe annual preferred stock dividend would be $5 per share , or a total of $10,000 annually . ($5 per share *2,000 shares)(5% *$100 par)$3,270 $3,597$1,820 $1,9541,012 1,135$2 0 0 $ 200$1,450 $1,643967 1,023$4 8 3 $ 620114 159$2 7 0 $ 382$3,270 $3,597$2,266 $2,3742,056 2,29596 98$1,004 $1,223300 289$2 8 8 $ 363TABLE 3.2 Bartlett Company therefore received about $8.12 per share from the sale of its common stock. Finally, retained earnings represent the cumulative total of all earnings, net of dividends, that have been retained and reinvested in the firm since its inception. Itis important to recognize that retained earnings are not cash but rather have beenutilized to finance the firm’s assets. Bartlett Company’s balance sheets in Table 3.2 show that the firm’s total assets increased from $3,270,000 in 2011 to $3,597,000 in 2012. The $327,000increase was due primarily to the $219,000 increase in current assets. The assetincrease, in turn, appears to have been financed primarily by an increase of$193,000 in total liabilities. Better insight into these changes can be derived fromthe statement of cash flows, which we will discuss shortly. The following personal balance sheet for Jan and Jon Smith— the couple introduced earlier, who are married, in their mid- 30s, and have no children—is similar to a corporate balance sheet. Personal Finance Example 3.23$428,000 paid-in capital in excess of par) ,76,262 shares 43($191,000 par +64 PART 2 Financial Tools retained earnings The cumulative total of all earnings, net of dividends, that have been retained andreinvested in the firm since itsinception. Jan and Jon Smith’s Balance Sheet: December 31, 2012 Assets Liabilities and Net Worth Cash on hand Credit card balances Checking accounts 575 Utility bills 120Savings accounts 760 Medical bills 75Money market funds Other current liabilities Total liquid assets Total current liabilities Stocks and bonds Real estate mortgageMutual funds 1,500 Auto loans 4,250Retirement funds, IRA Education loan 3,800 Total investments Personal loan 4,000 Real estate $120,000 Furniture loanCars 14,000 Total long-term liabilitiesHousehold furnishings 3,700 Total liabilitiesJewelry and artwork Net worth (N/W) Total personal property $139,200 Total liabilitiesTotal assets and net worth $147,175 $147,17541,420 1,500$105,755$104,850800$5 , 7 5 02,000$ 92,000 $2 , 2 5 0$9 0 5 $2 , 2 2 545 800$6 6 5 $9 0 The Smiths have total assets of $147,175 and total liabilities of $105,755. Personal net worth (N/W) is a “plug figure”—the difference between total assets and total liabilities—which in the case of Jan and Jon Smith is $41,420. Statement of Retained Earnings Thestatement of retained earnings is an abbreviated form of the statement of stockholders’ equity. Unlike the statement of stockholders’ equity, which shows all equity account transactions that occurred during a given year, the statement of retained earnings reconciles the net income earned during a given year, and anystatement of stockholders’ equity Shows all equity account transactions that occurred during a given year. statement of retained earnings Reconciles the net income earned during a given year,and any cash dividends paid,with the change in retainedearnings between the start and the end of that year. An abbreviated form of the statement of stockholders’ equity. cash dividends paid, with the change in retained earnings between the start and the end of that year. Table 3.3 presents this statement for Bartlett Company forthe year ended December 31, 2012. The statement shows that the companybegan the year with $1,012,000 in retained earnings and had net profits aftertaxes of $231,000, from which it paid a total of $108,000 in dividends, resultingin year-end retained earnings of $1,135,000. Thus the net increase for BartlettCompany was $123,000 ($231,000 net profits after taxes minus $108,000 individends) during 2012. Statement of Cash Flows Thestatement of cash flows is a summary of the cash flows over the period of concern. The statement provides insight into the firm’s operating, investment,and financing cash flows and reconciles them with changes in its cash and mar-ketable securities during the period. Bartlett Company’s statement of cash flowsfor the year ended December 31, 2012, is presented in Table 3.4 (see page 66).Further insight into this statement is included in the discussion of cash flow inChapter 4. NOTES TO THE FINANCIAL STATEMENTS Included with published financial statements are explanatory notes keyed to therelevant accounts in the statements. These notes to the financial statements pro- vide detailed information on the accounting policies, procedures, calculations,and transactions underlying entries in the financial statements. Common issuesaddressed by these notes include revenue recognition, income taxes, breakdownsof fixed asset accounts, debt and lease terms, and contingencies. Since passage ofSarbanes-Oxley, notes to the financial statements have also included some detailsabout compliance with that law. Professional securities analysts use the data inthe statements and notes to develop estimates of the value of securities that thefirm issues, and these estimates influence the actions of investors and thereforethe firm’s share value. CONSOLIDATING INTERNATIONAL FINANCIAL STATEMENTS So far, we’ve discussed financial statements involving only one currency, theU.S. dollar. The issue of how to consolidate a company’s foreign and domesticfinancial statements has bedeviled the accounting profession for many years.CHAPTER 3 Financial Statements and Ratio Analysis 65 Bartlett Company Statement of Retained Earnings ($000) for the Year Ended December 31, 2012 Retained earnings balance (January 1, 2012) $1,012 Plus: Net profits after taxes (for 2012) 231Less: Cash dividends (paid during 2012) Preferred stock 10Common stockTotal dividends paidRetained earnings balance (December 31, 2012) $1,135 $1 0 898TABLE 3.3 statement of cash flows Provides a summary of the firm’s operating, investment,and financing cash flows andreconciles them with changesin its cash and marketablesecurities during the period. notes to the financial statements Explanatory notes keyed to relevant accounts in thestatements; they providedetailed information on the accounting policies,procedures, calculations, andtransactions underlying entriesin the financial statements. The current policy is described in Financial Accounting Standards Board (FASB) Standard No. 52, which mandates that U.S.–based companies translate their foreign-currency-denominated assets and liabilities into dollars, for consoli-dation with the parent company’s financial statements. This is done by using atechnique called the current rate (translation) method, under which all of a U.S. parent company’s foreign-currency-denominated assets and liabilities are con-verted into dollar values using the exchange rate prevailing at the fiscal yearending date (the current rate). Income statement items are treated similarly.Equity accounts, on the other hand, are translated into dollars by using theexchange rate that prevailed when the parent’s equity investment was made (thehistorical rate). Retained earnings are adjusted to reflect each year’s operatingprofits or losses. 6REVIEW QUESTIONS 3–1What roles do GAAP, the FASB, and the PCAOB play in the financial reporting activities of public companies? 3–2Describe the purpose of each of the four major financial statements.66 PART 2 Financial Tools Bartlett Company Statement of Cash Flows ($000) for the Year Ended December 31, 2012 Cash Flow from Operating Activities Net profits after taxes $231Depreciation 239Increase in accounts receivable ( ) a Decrease in inventories 11Increase in accounts payable 112Increase in accruals Cash provided by operating activities $500 Cash Flow from Investment ActivitiesIncrease in gross fixed assets ( 347)Change in equity investments in other firms Cash provided by investment activities ( ) Cash Flow from Financing ActivitiesDecrease in notes payable ( )Increase in long-term debts 56Changes in stockholders’ equity b11 Dividends paid ( ) Cash provided by financing activities ( )Net increase in cash and marketable securities aAs is customary, parentheses are used to denote a negative number, which in this case is a cash outflow. bRetained earnings are excluded here because their change is actually reflected in the combination of the “net profits after taxes” and “dividends paid” entries.$9 2$6 110820$347045138TABLE 3.4 Financial Accounting Standards Board (FASB)Standard No. 52 Mandates that U.S.–based companies translate theirforeign-currency-denominatedassets and liabilities intodollars, for consolidation withthe parent company’s financialstatements. This is done byusing the current rate (translation) method. current rate (translation) method Technique used by U.S.–based companies to translate theirforeign-currency-denominatedassets and liabilities intodollars, for consolidation withthe parent company’s financialstatements, using the year-end(current) exchange rate. 3–3Why are the notes to the financial statements important to professional securities analysts? 3–4How is the current rate (translation) method used to consolidate a firm’s foreign and domestic financial statements?CHAPTER 3 Financial Statements and Ratio Analysis 67 3.2Using Financial Ratios The information contained in the four basic financial statements is of major sig- nificance to a variety of interested parties who regularly need to have relativemeasures of the company’s performance. Relative is the key word here, because the analysis of financial statements is based on the use of ratios orrelative values. Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance. The basic inputs to ratio analysisare the firm’s income statement and balance sheet. INTERESTED PARTIES Ratio analysis of a firm’s financial statements is of interest to shareholders, credi-tors, and the firm’s own management. Both current and prospective shareholdersare interested in the firm’s current and future level of risk and return, which directlyaffect share price. The firm’s creditors are interested primarily in the short-term liq-uidity of the company and its ability to make interest and principal payments. Asecondary concern of creditors is the firm’s profitability; they want assurance thatthe business is healthy. Management, like stockholders, is concerned with allaspects of the firm’s financial situation, and it attempts to produce financial ratiosthat will be considered favorable by both owners and creditors. In addition, man-agement uses ratios to monitor the firm’s performance from period to period. TYPES OF RATIO COMPARISONS Ratio analysis is not merely the calculation of a given ratio. More important istheinterpretation of the ratio value. A meaningful basis for comparison is needed to answer such questions as “Is it too high or too low?” and “Is it good or bad?”Two types of ratio comparisons can be made, cross-sectional and time-series. Cross-Sectional Analysis Cross-sectional analysis involves the comparison of different firms’ financial ratios at the same point in time. Analysts are often interested in how well a firmhas performed in relation to other firms in its industry. Frequently, a firm willcompare its ratio values to those of a key competitor or group of competitors thatit wishes to emulate. This type of cross-sectional analysis, called benchmarking, has become very popular. Comparison to industry averages is also popular. These figures can be found in the Almanac of Business and Industrial Financial Ratios, Dun & Bradstreet’s Industry Norms and Key Business Ratios, RMA Annual Statement Studies, ValueLine, and industry sources. It is also possible to derive financial ratios for yourself using financial information reported in financial databases, such as Compustat.Table 3.5 illustrates a brief cross-sectional ratio analysis by comparing severalratio analysis Involves methods of calculating and interpreting financialratios to analyze and monitorthe firm’s performance. cross-sectional analysis Comparison of different firms’financial ratios at the samepoint in time; involves comparing the firm’s ratios to those of other firms in itsindustry or to industryaverages. benchmarking A type of cross-sectional analysis in which the firm’s ratio values are compared tothose of a key competitor orgroup of competitors that itwishes to emulate.LG2 ratios as of early 2010 for two select firms to each other and the median value for their particular industry. Analysts have to be very careful when drawing conclusions from ratio compar- isons. It’s tempting to assume that if one ratio for a particular firm is above theindustry norm, this is a sign that the firm is performing well, at least along the dimen-sion measured by that ratio. However, ratios may be above or below the industrynorm for both positive and negative reasons, and it is necessary to determine whya firm’s performance differs from its industry peers. Thus, ratio analysis on its own is probably most useful in highlighting areas for further investigation . In early 2013, Mary Boyle, the chief financial analyst at Caldwell Manufacturing, a producer of heat exchangers, gathered data on the firm’s financial performanceduring 2012, the year just ended. She calculated a variety of ratios and obtainedindustry averages. She was especially interested in inventory turnover, whichreflects the speed with which the firm moves its inventory from raw materialsthrough production into finished goods and to the customer as a completed sale.Generally, higher values of this ratio are preferred, because they indicate a quickerturnover of inventory and more efficient inventory management. CaldwellManufacturing’s calculated inventory turnover for 2012 and the industry averageinventory turnover were as follows:Example 3.3368 PART 2 Financial Tools Financial Ratios for Select Firms and Their Industry Median Valuesa Average collection Total Net profit Return on Return on Current Quick Inventory period asset margin total assets Common ratio ratio turnover (days) turnover Debt ratio (%) (%) Equity (%) Dell 1.3 1.2 40.5 58.9 1.6 0.8 2.7 4.3 25.4 Hewlett-Packard 1.2 1.1 13.8 80.6 1.0 0.6 6.7 6.7 18.9 Computers 2.5 2.1 5.8 61.3 0.9 0.4 3.1 2.2 2.6 Home Depot 1.3 0.4 4.3 5.3 1.6 0.5 4.0 6.5 13.7 Lowe’s 1.3 0.2 3.7 0.0 1.4 0.4 3.7 5.4 9.3 Building Materials 2.8 0.8 3.7 5.3 1.6 0.3 4.0 6.5 13.7 Kroger 1.0 0.3 12.0 4.3 3.3 0.8 0.1 0.3 1.4 Whole Foods Market 1.3 1.0 25.6 7.0 3.6 0.4 2.3 8.0 14.5 Grocery Stores 1.3 0.7 11.1 7.5 2.4 0.6 2.1 3.1 9.8 Sears 1.3 0.3 3.7 5.4 1.8 0.6 0.5 0.9 2.6 Wal-Mart 0.9 0.3 9.0 3.7 2.4 0.6 3.5 8.4 20.3 Merchandise Stores 1.7 0.6 4.1 3.7 2.3 0.5 1.5 4.9 10.8 aThe data used to calculate these ratios are drawn from the Compustat North American database.- – -TABLE 3.5 Inventory Turnover, 2012 Caldwell Manufacturing 14.8 Industry average 9.7 Mary’s initial reaction to these data was that the firm had managed its inven- tory significantly better than the average firm in the industry. The turnover was nearly 53% faster than the industry average. On reflection, however, she realizedthat a very high inventory turnover could be a sign that the firm is not holdingenough inventories. The consequence of low inventory could be excessive stock-outs (insufficient inventory to meet customer needs). Discussions with people inthe manufacturing and marketing departments did, in fact, uncover such a problem:Inventories during the year were extremely low, the result of numerous produc-tion delays that hindered the firm’s ability to meet demand and resulted in dis-gruntled customers and lost sales. A ratio that initially appeared to reflectextremely efficient inventory management was actually the symptom of a major problem. Time-Series Analysis Time-series analysis evaluates performance over time. Comparison of current to past performance, using ratios, enables analysts to assess the firm’s progress.Developing trends can be seen by using multiyear comparisons. Any significantyear-to-year changes may be symptomatic of a problem, especially if the sametrend is not an industry-wide phenomenon. Combined Analysis The most informative approach to ratio analysis combines cross-sectional andtime-series analyses. A combined view makes it possible to assess the trend in thebehavior of the ratio in relation to the trend for the industry. Figure 3.1 depictsthis type of approach using the average collection period ratio of BartlettCompany, over the years 2009–2012. This ratio reflects the average amount oftime (in days) it takes the firm to collect bills, and lower values of this ratio gen-erally are preferred. The figure quickly discloses that (1) Bartlett’s effectiveness incollecting its receivables is poor in comparison to the industry, and (2) Bartlett’strend is toward longer collection periods. Clearly, Bartlett needs to shorten itscollection period.CHAPTER 3 Financial Statements and Ratio Analysis 69Average Collection Period (days)70 60504030 2009 2010 2011 2012IndustryBartlett YearFIGURE 3.1 Combined Analysis Combined cross-sectionaland time-series view of Bartlett Company’s average collection period,2009–2012time-series analysis Evaluation of the firm’s financial performance overtime using financial ratioanalysis. CAUTIONS ABOUT USING RATIO ANALYSIS Before discussing specific ratios, we should consider the following cautions about their use: 1. Ratios that reveal large deviations from the norm merely indicate the possi- bility of a problem. Additional analysis is typically needed to determine whether there is a problem and to isolate the causes of the problem. 2. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. However, if an analysis is con- cerned only with certain specific aspects of a firm’s financial position, one or two ratios may suffice. 3. The ratios being compared should be calculated using financial statements dated at the same point in time during the year. If they are not, the effects ofseasonality may produce erroneous conclusions and decisions. 4. It is preferable to use audited financial statements for ratio analysis. If they have not been audited, the data in them may not reflect the firm’s true finan-cial condition. 5. The financial data being compared should have been developed in the same way. The use of differing accounting treatments—especially relative to inven-tory and depreciation—can distort the results of ratio comparisons, regard-less of whether cross-sectional or time-series analysis is used. 6. Results can be distorted by inflation, which can cause the book values of inven- tory and depreciable assets to differ greatly from their replacement values.Additionally, inventory costs and depreciation write-offs can differ from theirtrue values, thereby distorting profits. Without adjustment, inflation tends tocause older firms (older assets) to appear more efficient and profitable thannewer firms (newer assets). Clearly, in using ratios, you must be careful whencomparing older to newer firms or a firm to itself over a long period of time. CATEGORIES OF FINANCIAL RATIOS Financial ratios can be divided for convenience into five basic categories: liq-uidity, activity, debt, profitability, and market ratios. Liquidity, activity, and debtratios primarily measure risk. Profitability ratios measure return. Market ratioscapture both risk and return. As a rule, the inputs necessary for an effective financial analysis include, at a minimum, the income statement and the balance sheet. We will use the 2012 and2011 income statements and balance sheets for Bartlett Company, presented ear-lier in Tables 3.1 and 3.2, to demonstrate ratio calculations. Note, however, thatthe ratios presented in the remainder of this chapter can be applied to almost anycompany. Of course, many companies in different industries use ratios that focuson aspects peculiar to their industry. 6REVIEW QUESTIONS 3–5With regard to financial ratio analysis, how do the viewpoints held by the firm’s present and prospective shareholders, creditors, and manage-ment differ? 3–6What is the difference between cross-sectional and time-series ratio analysis? What is benchmarking? 3–7What types of deviations from the norm should the analyst pay primary attention to when performing cross-sectional ratio analysis? Why?70 PART 2 Financial Tools In more depth To read about Perils of Ratio Analysis , go to www.myfinancelab.com 3–8Why is it preferable to compare ratios calculated using financial state- ments that are dated at the same point in time during the year?CHAPTER 3 Financial Statements and Ratio Analysis 71 3.3Liquidity Ratios Theliquidity of a firm is measured by its ability to satisfy its short-term obliga- tions as they come due. Liquidity refers to the solvency of the firm’s overall finan- cial position—the ease with which it can pay its bills. Because a commonprecursor to financial distress and bankruptcy is low or declining liquidity, theseratios can provide early signs of cash flow problems and impending businessfailure. Clearly it is desirable that a firm is able to pay its bills, so having enoughliquidity for day-to-day operations is important. However, liquid assets, like cashheld at banks and marketable securities, do not earn a particularly high rate ofreturn, so shareholders will not want a firm to overinvest in liquidity. Firms have to balance the need for safety that liquidity provides against the low returns thatliquid assets generate for investors. The two basic measures of liquidity are thecurrent ratio and the quick (acid-test) ratio. CURRENT RATIO Thecurrent ratio, one of the most commonly cited financial ratios, measures the firm’s ability to meet its short-term obligations. It is expressed as follows: The current ratio for Bartlett Company in 2012 is A higher current ratio indicates a greater degree of liquidity. How much liq- uidity a firm needs depends on a variety of factors, including the firm’s size, itsaccess to short-term financing sources like bank credit lines, and the volatility ofits business. For example, a grocery store whose revenues are relatively pre-dictable may not need as much liquidity as a manufacturing firm who facessudden and unexpected shifts in demand for its products. The more predictable afirm’s cash flows, the lower the acceptable current ratio. Because BartlettCompany is in a business with a relatively predictable annual cash flow, its cur-rent ratio of 1.97 should be quite acceptable.$1,223,000 ,$620,000 =1.97Current ratio =Current assets ,Current liabilitiesliquidity A firm’s ability to satisfy its short-term obligations as they come due. current ratio A measure of liquiditycalculated by dividing thefirm’s current assets by itscurrent liabilities. Matter of fact Glance back at the first column of data in Table 3.5 that shows the current ratio for a variety of companies and industries. Notice that the industry with the highest current ratio (that is, most liquidity) is building materials, a business that is notoriously sensitive to business cycle swings. The current ratio for that industry is 2.8, indicating that the typical firm in that business has almost three times as much in current assets as in current liabilities. Two of the largest competitors in that industry, The Home Depot and Lowe’s, operate with a current ratio of 1.3, less than half the industry average. Does this mean that these firms have a liquidity problem? Not necessarily. Large enterprises generally have well-established relationships with banks that can provide lines of credit and other short-term loan products in the event that the firm has a need for liquidity. Smaller firms may not have the same access to credit, and therefore they tend to operate with more liquidity.Determinants of Liquidity NeedsLG3 Individuals, like corporations, can use financial ratios to ana- lyze and monitor their performance. Typically, personal finance ratios are calculated using the personal income and expense statement and per-sonal balance sheet for the period of concern. Here we use these statements, pre-sented in the preceding personal finance examples, to demonstrate calculation ofJan and Jon Smith’s liquidity ratio for calendar year 2012. The personal liquidity ratio is calculated by dividing total liquid assets by total current debt. It indicates the percent of annual debt obligations that an individualcan meet using current liquid assets. The Smiths’ total liquid assets were $2,225.Their total current debts are $21,539 (total current liabilities of payments of loan payments of and furniturepayments of $1,250). Substituting these values into the ratio formula, we get: That ratio indicates that the Smiths can cover only about 10% of their existing 1-year debt obligations with their current liquid assets. Clearly, theSmiths plan to meet these debt obligations from their income, but this ratio sug-gests that their liquid funds do not provide a large cushion. One of their goalsshould probably be to build up a larger fund of liquid assets to meet unexpected expenses. QUICK (ACID-TEST) RATIO Thequick (acid-test) ratio is similar to the current ratio except that it excludes inventory, which is generally the least liquid current asset. The generally low liq-uidity of inventory results from two primary factors: (1) Many types of inventorycannot be easily sold because they are partially completed items, special-purposeitems, and the like; and (2) inventory is typically sold on credit, which means thatit becomes an account receivable before being converted into cash. An additionalproblem with inventory as a liquid asset is that the times when companies facethe most dire need for liquidity, when business is bad, are precisely the timeswhen it is most difficult to convert inventory into cash by selling it. The quickratio is calculated as follows: The quick ratio for Bartlett Company in 2012 is As with the current ratio, the quick ratio level that a firm should strive to achieve depends largely on the nature of the business in which it operates. Thequick ratio provides a better measure of overall liquidity only when a firm’sinventory cannot be easily converted into cash. If inventory is liquid, the currentratio is a preferred measure of overall liquidity.$1,223,000 -$289,000 $620,000=$934,000 $620,000=1.51Quick ratio =Current assets -Inventory Current liabilitiesLiquidity ratio =Total liquid assets Total current debts=$2,225 $21,539=0.1033, or 10.3%$2,520 +appliance $16,864 +auto$905 +mortgagePersonal Finance Example 3.4372 PART 2 Financial Tools quick (acid-test) ratio A measure of liquidity calculated by dividing thefirm’s current assets minusinventory by its currentliabilities. 6REVIEW QUESTIONS 3–9Under what circumstances would the current ratio be the preferred measure of overall firm liquidity? Under what circumstances would thequick ratio be preferred? 3–10 In Table 3.5, most of the specific firms listed have current ratios that fall below the industry average. Why? The exception to this general patternis Whole Foods Market, which competes at the very high end of theretail grocery market. Why might Whole Foods Market operate withgreater-than-average liquidity?CHAPTER 3 Financial Statements and Ratio Analysis 73 Matter of fact Turn again to Table 3.5 and examine the columns listing current and quick ratios for different firms and industries. Notice that Dell has a current ratio of 1.3, and so do The Home Depot and Lowe’s. However, although the quick ratios for The Home Depot and Lowe’s are dramatically lower than their current ratios, for Dell the current and quick ratios have nearly the same value. Why? For many years, Dell operated on a “built-to-order” business model that required them to hold very little inventory. In contrast, all it takes is a trip to your local Home Depot or Lowe’s store to see that the business model in this industry requires a massive investment in inventory, which implies that the quick ratio will be much less than the current ratio for building materials firms.The Importance of Inventories 3.4Activity Ratios Activity ratios measure the speed with which various accounts are converted into sales or cash—inflows or outflows. In a sense, activity ratios measure how efficientlya firm operates along a variety of dimensions such as inventory manage ment, dis- bursements, and collections. A number of ratios are available for measuring theactivity of the most important current accounts, which include inventory, accountsreceivable, and accounts payable. The efficiency with which total assets are used can also be assessed. INVENTORY TURNOVER Inventory turnover commonly measures the activity, or liquidity, of a firm’s inventory. It is calculated as follows: Applying this relationship to Bartlett Company in 2012 yieldsThe resulting turnover is meaningful only when it is compared with that of other firms in the same industry or to the firm’s past inventory turnover. An inventoryturnover of 20 would not be unusual for a grocery store, whose goods are highlyperishable and must be sold quickly, whereas an aircraft manufacturer might turnits inventory just four times per year.$2,088,000 ,$289,000 =7.2Inventory turnover =Cost of goods sold ,Inventoryactivity ratios Measure the speed with which various accounts are convertedinto sales or cash—inflows oroutflows. inventory turnover Measures the activity, orliquidity, of a firm’s inventory.LG3 Another inventory activity ratio measures how many days of inventory the firm has on hand. Inventory turnover can be easily converted into an average age of inventory by dividing it into 365. For Bartlett Company, the average age of inventory in 2012 is 50.7 days (365 7.2). This value can also be viewed as theaverage number of days’ sales in inventory. AVERAGE COLLECTION PERIOD Theaverage collection period, or average age of accounts receivable, is useful in evaluating credit and collection policies. It is arrived at by dividing the averagedaily sales into the accounts receivable balance: 2 The average collection period for Bartlett Company in 2012 is On the average, it takes the firm 59.7 days to collect an account receivable. The average collection period is meaningful only in relation to the firm’s credit terms. If Bartlett Company extends 30-day credit terms to customers, an averagecollection period of 59.7 days may indicate a poorly managed credit or collectiondepartment, or both. It is also possible that the lengthened collection period resultedfrom an intentional relaxation of credit-term enforcement in response to competitivepressures. If the firm had extended 60-day credit terms, the 59.7-day average collec-tion period would be quite acceptable. Clearly, additional information is needed toevaluate the effectiveness of the firm’s credit and collection policies.$503,000 $3,074,000 365=$503,000 $8,422=59.7 days=Accounts receivable Annual sales 365Average collection period =Accounts receivable Average sales per day,74 PART 2 Financial Tools average age of inventory Average number of days’ sales in inventory. 2. The formula as presented assumes, for simplicity, that all sales are made on a credit basis. If this is not the case, average credit sales per day should be substituted for average sales per day.average collection period The average amount of time needed to collect accountsreceivable. Matter of fact Notice in Table 3.5 the vast differences across industries in the average collection periods. Companies in the building materials, grocery, and merchandise store industries collect in just a few days, whereas firms in the computer industry take roughly two months to collect on their sales. The difference is primarily due to the fact that these industries serve very different cus- tomers. Grocery and retail stores serve individuals who pay cash or use credit cards (which to the store are essentially the same as cash). Computer manufacturers sell to retail chains, businesses, and other large organizations that negotiate agreements that allow them to pay for the computers they order well after the sale is made.Who Gets Credit? AVERAGE PAYMENT PERIOD Theaverage payment period, or average age of accounts payable, is calculated in the same manner as the average collection period: The difficulty in calculating this ratio stems from the need to find annual pur- chases,3a value not available in published financial statements. Ordinarily, pur- chases are estimated as a given percentage of cost of goods sold. If we assumethat Bartlett Company’s purchases equaled 70 percent of its cost of goods sold in2012, its average payment period is This figure is meaningful only in relation to the average credit terms extended to the firm. If Bartlett Company’s suppliers have extended, on average, 30-daycredit terms, an analyst would give Bartlett a low credit rating because it wastaking too long to pay its bills. Prospective lenders and suppliers of trade creditare interested in the average payment period because it provides insight into thefirm’s bill-paying patterns. TOTAL ASSET TURNOVER Thetotal asset turnover indicates the efficiency with which the firm uses its assets to generate sales. Total asset turnover is calculated as follows: The value of Bartlett Company’s total asset turnover in 2012 isThis means the company turns over its assets 0.85 times per year. Generally, the higher a firm’s total asset turnover, the more efficiently its assets have been used. This measure is probably of greatest interest to managementbecause it indicates whether the firm’s operations have been financially efficient.$3,074,000 ,$3,597,000 =0.85Total asset turnover =Sales ,Total assets$382,000 0.70 *$2,088,000 365=$382,000 $4,004=95.4 days=Accounts payable Annual purchases 365Average payment period =Accounts payable Average purchases per dayCHAPTER 3 Financial Statements and Ratio Analysis 75 3. Technically, annual credit purchases—rather than annual purchases—should be used in calculating this ratio. For simplicity, this refinement is ignored here.average payment period The average amount of time needed to pay accountspayable. total asset turnover Indicates the efficiency with which the firm uses its assets to generate sales. Matter of fact Observe in Table 3.5 that the grocery business turns over assets faster than any of the other industries listed. That makes sense because inventory is among the most valuable assets held by these firms, and grocery stores have to sell baked goods, dairy products, and produce quickly or throw them away when they spoil. It’s true that some items in a grocery store have a shelf life longer than anyone really wants to know (think Twinkies), but on average a grocery store has to replace its entire inventory in just a few days or weeks, and that contributes to the rapid turnover of the firm’s total assets.Sell It Fast 6REVIEW QUESTION 3–11 To assess the firm’s average collection period and average payment period ratios, what additional information is needed, and why?76 PART 2 Financial Tools 3.5Debt Ratios Thedebt position of a firm indicates the amount of other people’s money being used to generate profits. In general, the financial analyst is most concerned withlong-term debts because these commit the firm to a stream of contractual pay-ments over the long run. The more debt a firm has, the greater its risk of beingunable to meet its contractual debt payments. Because creditors’ claims must besatisfied before the earnings can be distributed to shareholders, current andprospective shareholders pay close attention to the firm’s ability to repay debts.Lenders are also concerned about the firm’s indebtedness. In general, the more debt a firm uses in relation to its total assets, the greater itsfinancial leverage. Financial leverage is the magnification of risk and return through the use of fixed-cost financing, such as debt and preferred stock. Themore fixed-cost debt a firm uses, the greater will be its expected risk and return. Patty Akers is in the process of incorporating her new business. After muchanalysis she determined that an initial investment of $50,000—$20,000 in currentassets and $30,000 in fixed assets—is necessary. These funds can be obtained ineither of two ways. The first is the no-debt plan, under which she would invest the full $50,000 without borrowing. The other alternative, the debt plan, involves investing $25,000 and borrowing the balance of $25,000 at 12% annual interest. Patty expects $30,000 in sales, $18,000 in operating expenses, and a 40% tax rate. Projected balance sheets and income statements associated with the twoplans are summarized in Table 3.6. The no-debt plan results in after-tax profits of$7,200, which represent a 14.4% rate of return on Patty’s $50,000 investment.The debt plan results in $5,400 of after-tax profits, which represent a 21.6% rateof return on Patty’s investment of $25,000. The debt plan provides Patty with ahigher rate of return, but the risk of this plan is also greater, because the annual $3,000 of interest must be paid whether Patty’s business is profitable or not. The example demonstrates that with increased debt comes greater risk as well as higher potential return. Therefore, the greater the financial leverage, the greater the potential risk and return. A detailed discussion of the impact of debton the firm’s risk, return, and value is included in Chapter 12. Here, we empha-size the use of financial debt ratios to assess externally a firm’s debt position. There are two general types of debt measures: measures of the degree of indebtedness and measures of the ability to service debts. The degree of indebted- ness measures the amount of debt relative to other significant balance sheet amounts. A popular measure of the degree of indebtedness is the debt ratio. The second type of debt measure, the ability to service debts, reflects a firm’s ability to make the payments required on a scheduled basis over the life of a debt.Example 3.53financial leverage The magnification of risk and return through the use of fixed- cost financing, such as debt and preferred stock. degree of indebtedness Measures the amount of debt relative to other significant balance sheet amounts. ability to service debts The ability of a firm to make the payments required on a scheduled basis over the life of a debt.LG4 The term to service debts simply means to pay debts on time. The firm’s ability to pay certain fixed charges is measured using coverage ratios. Typically, higher coverage ratios are preferred (especially by the firm’s lenders), but a very highratio might indicate that the firm’s management is too conservative and might beable to earn higher returns by borrowing more. In general, the lower the firm’scoverage ratios, the less certain it is to be able to pay fixed obligations. If a firmis unable to pay these obligations, its creditors may seek immediate repayment,which in most instances would force a firm into bankruptcy. Two popular coverage ratios are the times interest earned ratio and the fixed-payment cov-erage ratio. DEBT RATIO Thedebt ratio measures the proportion of total assets financed by the firm’s cred- itors. The higher this ratio, the greater the amount of other people’s money beingused to generate profits. The ratio is calculated as follows: The debt ratio for Bartlett Company in 2012 isThis value indicates that the company has financed close to half of its assets with debt. The higher this ratio, the greater the firm’s degree of indebtedness and themore financial leverage it has.$1,643,000 ,$3,597,000 =0.457 =45.7%Debt ratio =Total liabilities ,Total assetsCHAPTER 3 Financial Statements and Ratio Analysis 77 coverage ratios Ratios that measure the firm’s ability to pay certain fixed charges. debt ratio Measures the proportion oftotal assets financed by thefirm’s creditors.Financial Statements Associated with Patty’s Alternatives Balance Sheets No-debt plan Debt plan Current assets $20,000 $20,000 Fixed assets Total assets Debt (12% interest) $25,000(1) Equity Total liabilities and equity Income Statements Sales $30,000 $30,000 Less: Operating expenses Operating profits $12,000 $12,000 Less: Interest expense Net profits before taxes $12,000 Less: Taxes (rate 40%) (2) Net profits after taxes Return on equity $5,400 $25,000=21.6%$7,200 $50,000=14.4% 3(2) ,(1)4$ 5,400 $ 7,2003,600 4,800 =$ 9,0003,000 0.12 *$25,000 = 018,000 18,000$50,000 $50,00025,000 50,000$0$50,000 $50,00030,000 30,000TABLE 3.6 TIMES INTEREST EARNED RATIO The times interest earned ratio, sometimes called the interest coverage ratio, measures the firm’s ability to make contractual interest payments. The higher itsvalue, the better able the firm is to fulfill its interest obligations. The timesinterest earned ratio is calculated as follows: The figure for earnings before interest and taxes (EBIT) is the same as that for operating profits shown in the income statement. Applying this ratio to Bartlett Company yields the following 2012 value: The times interest earned ratio for Bartlett Company seems acceptable. A value of at least 3.0—and preferably closer to 5.0—is often suggested. The firm’s earnings beforeinterest and taxes could shrink by as much as 78 percent andthe firm would still be able to pay the $93,000 in interest it owes. Thus it has alarge margin of safety. FIXED-PAYMENT COVERAGE RATIO Thefixed-payment coverage ratio measures the firm’s ability to meet all fixed- payment obligations, such as loan interest and principal, lease payments, and pre-ferred stock dividends. As is true of the times interest earned ratio, the higher thisvalue the better. The formula for the fixed-payment coverage ratio is where Tis the corporate tax rate applicable to the firm’s income. The term 1/(1 T) is included to adjust the after-tax principal and preferred stock dividend pay-ments back to a before-tax equivalent that is consistent with the before-tax valuesof all other terms. Applying the formula to Bartlett Company’s 2012 data yields Because the earnings available are nearly twice as large as its fixed-payment obli- gations, the firm appears safely able to meet the latter. Like the times interest earned ratio, the fixed-payment coverage ratio measures risk. The lower the ratio, the greater the risk to both lenders and owners, and thegreater the ratio, the lower the risk. This ratio allows interested parties to assess thefirm’s ability to meet additional fixed-payment obligations without being driven into bankruptcy.=$453,000 $242,000=1.9=$418,000 +$35,000 $93,000 +$35,000 +5($71,000 +$10,000) *31/(1 -0.29)46Fixed-payment coverage ratio-=Earnings before interest and taxes +Lease payments Interest +Lease payments +5(Principal payments +Preferred stock dividends) *31/(1 -T)46Fixed- paymentcoverageratio3(4.5 -1.0) ,4.54,Time interest earned ratio =$418,000 ,$93,000 =4.5Times interest earned ratio =Earnings before interest and taxes ,taxes78 PART 2 Financial Tools times interest earned ratio Measures the firm’s ability to make contractual interestpayments; sometimes called the interest coverage ratio. fixed-payment coverage ratio Measures the firm’s ability to meet all fixed-paymentobligations. 6REVIEW QUESTIONS 3–12 What is financial leverage? 3–13 What ratio measures the firm’s degree of indebtedness? What ratios assess the firm’s ability to service debts?CHAPTER 3 Financial Statements and Ratio Analysis 79 3.6Profitability Ratios There are many measures of profitability. As a group, these measures enable ana- lysts to evaluate the firm’s profits with respect to a given level of sales, a certainlevel of assets, or the owners’ investment. Without profits, a firm could notattract outside capital. Owners, creditors, and management pay close attention toboosting profits because of the great importance the market places on earnings. COMMON-SIZE INCOME STATEMENTS A useful tool for evaluating profitability in relation to sales is the common-size income statement. Each item on this statement is expressed as a percentage of sales. Common-size income statements are especially useful in comparing per-formance across years because it is easy to see if certain categories of expenses aretrending up or down as a percentage of the total volume of business that the com-pany transacts. Three frequently cited ratios of profitability that come directlyfrom the common-size income statement are (1) the gross profit margin, (2) theoperating profit margin, and (3) the net profit margin. Common-size income statements for 2012 and 2011 for Bartlett Company are presented and evaluated in Table 3.7 on page 80. These statements reveal thatthe firm’s cost of goods sold increased from 66.7 percent of sales in 2011 to 67.9percent in 2012, resulting in a worsening gross profit margin. However, thanks toa decrease in total operating expenses, the firm’s net profit margin rose from 5.4percent of sales in 2011 to 7.2 percent in 2012. The decrease in expenses morethan compensated for the increase in the cost of goods sold. A decrease in thefirm’s 2012 interest expense (3.0 percent of sales versus 3.5 percent in 2011)added to the increase in 2012 profits. GROSS PROFIT MARGIN Thegross profit margin measures the percentage of each sales dollar remaining after the firm has paid for its goods. The higher the gross profit margin, the better(that is, the lower the relative cost of merchandise sold). The gross profit marginis calculated as follows: Bartlett Company’s gross profit margin for 2012 isThis value is labeled (1) on the common-size income statement in Table 3.7.$3,074,000 -$2,088,000 $3,074,000=$986,000 $3,074,000=32.1%Gross profit margin =Sales -Cost of goods sold Sales=Gross profits Salescommon-size income statement An income statement in which each item is expressed as apercentage of sales. gross profit margin Measures the percentage ofeach sales dollar remainingafter the firm has paid for itsgoods.LG5 OPERATING PROFIT MARGIN The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. It represents the “pure profits” earned on eachsales dollar. Operating profits are “pure” because they measure only the profitsearned on operations and ignore interest, taxes, and preferred stock dividends. Ahigh operating profit margin is preferred. The operating profit margin is calcu-lated as follows: Bartlett Company’s operating profit margin for 2012 is This value is labeled (2) on the common-size income statement in Table 3.7. NET PROFIT MARGIN Thenet profit margin measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends,$418,000 $3,074,000=13.6%$418,000 ,$3,074,000 =13.6%Operating profit margin =Operating profits ,Sales80 PART 2 Financial Tools Bartlett Company Common-Size Income Statements For the Years Ended December 31 Evaluationa 2012 2011 2011–2012 Sales revenue 100.0% 100.0% Same Less: Cost of goods sold Worse (1) Gross profit margin % % Worse Less: Operating expenses Selling expense 3.3% 4.2% BetterGeneral and administrative expenses 6.8 6.7 Better Lease expense 1.1 1.3 BetterDepreciation expense Better Total operating expense % % Better (2) Operating profit margin 13.6% 11.8% Better Less: Interest expense Better Net profits before taxes 10.6% 8.3% Better Less: Taxes Worseb Net profits after taxes 7.5% 5.8% Better Less: Preferred stock dividends Better (3) Net profit margin % % Better aSubjective assessments based on data provided. bTaxes as a percentage of sales increased noticeably between 2011 and 2012 because of differing costs and expenses, whereas the average tax rates (taxes net profits before taxes) for 2011 and 2012 remainedabout the same—30% and 29%, respectively.,5.4 7.20.4 0.32.5 3.13.5 3.021.5 18.59.3 7.333.3 32.166.7 67.9TABLE 3.7 operating profit margin Measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted; the “pure profits” earned on each sales dollar. net profit margin Measures the percentage ofeach sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. have been deducted. The higher the firm’s net profit margin, the better. The net profit margin is calculated as follows: Bartlett Company’s net profit margin for 2012 is: This value is labeled (3) on the common-size income statement in Table 3.7. The net profit margin is a commonly cited measure of the firm’s success with respect to earnings on sales. “Good” net profit margins differ considerably acrossindustries. A net profit margin of 1 percent or less would not be unusual for agrocery store, whereas a net profit margin of 10 percent would be low for a retailjewelry store. EARNINGS PER SHARE (EPS) The firm’s earnings per share (EPS) is generally of interest to present or prospec- tive stockholders and management. As we noted earlier, EPS represents thenumber of dollars earned during the period on behalf of each outstanding shareof common stock. Earnings per share is calculated as follows: Bartlett Company’s earnings per share in 2012 is This figure represents the dollar amount earned on behalf of each outstanding share of common stock. The dollar amount of cash actually distributed to each shareholder is the dividend per share (DPS), which, as noted in Bartlett Company’s income statement (Table 3.1), rose to $1.29 in 2012 from $0.75 in 2011. EPS isclosely watched by the investing public and is considered an important indicatorof corporate success. RETURN ON TOTAL ASSETS (ROA) Thereturn on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness of management in generating profits with itsavailable assets. The higher the firm’s return on total assets the better. The returnon total assets is calculated as follows: Bartlett Company’s return on total assets in 2012 is This value indicates that the company earned 6.1 cents on each dollar of asset investment.$221,000 ,$3,597,000 =0.061 =6.1%$221,000 $3,597,000=6.1%ROA =Earnings available for common stockholders ,Total assets$221,000 ,76,262 =$2.90Earnings per share =Earnings available for common stockholders Number of shares of common stock outstanding$221,000 $3,074,000=7.2%$221,000 ,$3,074,000 =0.072 =7.2%Net profit margin =Earnings available for common stockholders ,SalesCHAPTER 3 Financial Statements and Ratio Analysis 81 return on total assets (ROA) Measures the overall effectiveness of management in generating profits with itsavailable assets; also called the return on investment (ROI) . RETURN ON COMMON EQUITY (ROE) Thereturn on common equity (ROE) measures the return earned on the common stockholders’ investment in the firm. Generally, the owners are better off thehigher is this return. Return on common equity is calculated as follows: This ratio for Bartlett Company in 2012 is Note that the value for common stock equity ($1,754,000) was found by sub- tracting the $200,000 of preferred stock equity from the total stockholders’equity of $1,954,000 (see Bartlett Company’s 2012 balance sheet in Table 3.2).The calculated ROE of 12.6 percent indicates that during 2012 Bartlett earned12.6 cents on each dollar of common stock equity. 6REVIEW QUESTIONS 3–14 What three ratios of profitability are found on a common-size income statement? 3–15 What would explain a firm’s having a high gross profit margin and a low net profit margin? 3–16 Which measure of profitability is probably of greatest interest to theinvesting public? Why?$221,000 $1,754,000=12.6%$221,000 ,$1,754,000 =0.126 =12.6%ROE =Earnings available for common stockholders ,Common stock equity82 PART 2 Financial Tools 3.7Market Ratios Market ratios relate the firm’s market value, as measured by its current share price, to certain accounting values. These ratios give insight into how investors inthe marketplace feel the firm is doing in terms of risk and return. They tend toreflect, on a relative basis, the common stockholders’ assessment of all aspects ofthe firm’s past and expected future performance. Here we consider two widelyquoted market ratios, one that focuses on earnings and another that considersbook value. PRICE/EARNINGS (P /E) RATIO Theprice/earnings (P/E) ratio is commonly used to assess the owners’ appraisal of share value. The P/E ratio measures the amount that investors are willing topay for each dollar of a firm’s earnings. The level of this ratio indicates thedegree of confidence that investors have in the firm’s future performance. Thehigher the P/E ratio, the greater the investor confidence. The P/E ratio is calcu-lated as follows: P/E ratio =Market price per share of common stock ,Earnings per sharemarket ratios Relate a firm’s market value, as measured by its current shareprice, to certain accountingvalues. price/earnings (P/E) ratio Measures the amount that investors are willing to pay for each dollar of a firm’searnings; the higher the P/Eratio, the greater the investorconfidence.return on common equity (ROE) Measures the return earned on the common stockholders’investment in the firm. LG5 If Bartlett Company’s common stock at the end of 2012 was selling at $32.25, using the EPS of $2.90, the P/E ratio at year-end 2012 is This figure indicates that investors were paying $11.10 for each $1.00 of earn- ings. The P/E ratio is most informative when applied in cross-sectional analysisusing an industry average P/E ratio or the P/E ratio of a benchmark firm. MARKET /BOOK (M/B) RATIO Themarket/book (M/B) ratio provides an assessment of how investors view the firm’s performance. It relates the market value of the firm’s shares to their book—strict accounting—value. To calculate the firm’s M/B ratio, we first need to findthebook value per share of common stock: Substituting the appropriate values for Bartlett Company from its 2012 balance sheet, we get The formula for the market/book ratio is Substituting Bartlett Company’s end of 2012 common stock price of $32.25 and its $23.00 book value per share of common stock (calculated above) into the M/Bratio formula, we get This M/B ratio means that investors are currently paying $1.40 for each $1.00 of book value of Bartlett Company’s stock. The stocks of firms that are expected to perform well—improve profits, increase their market share, or launch successful products—typically sell athigher M/B ratios than the stocks of firms with less attractive outlooks. Simplystated, firms expected to earn high returns relative to their risk typically sell athigher M/B multiples. Clearly, Bartlett’s future prospects are being viewed favor-ably by investors, who are willing to pay more than their book value for thefirm’s shares. Like P/E ratios, M/B ratios are typically assessed cross-sectionally toget a feel for the firm’s return and risk compared to peer firms. 6REVIEW QUESTION 3–17 How do the price/earnings (P/E) ratio and the market/book (M/B) ratio provide a feel for the firm’s return and risk?$32.25 ,$23.00 =1.40Market>book (M >B) ratio =Market price per share of common stock Book value per share of common stockBook value per share of common stock=$1,754,000 76,262=$23.00Book value per share of common stock=Common stock equity Number of shares of common stock outstanding$32.25 ,$2.90 =11.1CHAPTER 3 Financial Statements and Ratio Analysis 83 market/book (M/B) ratio Provides an assessment of how investors view the firm’sperformance. Firms expectedto earn high returns relative totheir risk typically sell at higherM/B multiples. 84 PART 2 Financial Tools 3.8A Complete Ratio Analysis Analysts frequently wish to take an overall look at the firm’s financial perform- ance and status. Here we consider two popular approaches to a complete ratioanalysis: (1) summarizing all ratios and (2) the DuPont system of analysis. Thesummary analysis approach tends to view all aspects of the firm’s financial activi- ties to isolate key areas of responsibility. The DuPont system acts as a search tech-nique aimed at finding the key areas responsible for the firm’s financial condition. SUMMARIZING ALL RATIOS We can use Bartlett Company’s ratios to perform a complete ratio analysis using both cross-sectional and time-series analysis approaches. The 2012 ratio valuescalculated earlier and the ratio values calculated for 2010 and 2011 for BartlettCompany, along with the industry average ratios for 2012, are summarized inTable 3.8 (see pages 86 and 87), which also shows the formula used to calculateeach ratio. Using these data, we can discuss the five key aspects of Bartlett’s per-formance—liquidity, activity, debt, profitability, and market. Liquidity The overall liquidity of the firm seems to exhibit a reasonably stable trend,having been maintained at a level that is relatively consistent with the industryaverage in 2012. The firm’s liquidity seems to be good. Activity Bartlett Company’s inventory appears to be in good shape. Its inventory manage-ment seems to have improved, and in 2012 it performed at a level above that ofthe industry. The firm may be experiencing some problems with accounts receiv-able. The average collection period seems to have crept up above that of theindustry. Bartlett also appears to be slow in paying its bills; it pays nearly 30 daysslower than the industry average. This could adversely affect the firm’s creditstanding. Although overall liquidity appears to be good, the management ofreceivables and payables should be examined. Bartlett’s total asset turnoverreflects a decline in the efficiency of total asset utilization between 2010 and 2011.Although in 2012 it rose to a level considerably above the industry average, itappears that the pre-2011 level of efficiency has not yet been achieved. Debt Bartlett Company’s indebtedness increased over the 2010–2012 period and iscurrently above the industry average. Although this increase in the debt ratiocould be cause for alarm, the firm’s ability to meet interest and fixed-paymentobligations improved, from 2011 to 2012, to a level that outperforms theindustry. The firm’s increased indebtedness in 2011 apparently caused deteriora-tion in its ability to pay debt adequately. However, Bartlett has evidently improvedits income in 2012 so that it is able to meet its interest and fixed-payment obliga-tions at a level consistent with the average in the industry. In summary, it appears that although 2011 was an off year, the company’s improved ability to pay debtsin 2012 compensates for its increased degree of indebtedness.LG6 CHAPTER 3 Financial Statements and Ratio Analysis 85 Profitability Bartlett’s profitability relative to sales in 2012 was better than the average com- pany in the industry, although it did not match the firm’s 2010 performance.Although the gross profit margin was better in 2011 and 2012 than in 2010, higher levels of operating and interest expenses in 2011 and 2012 appear to havecaused the 2012 netprofit margin to fall below that of 2010. However, Bartlett Company’s 2012 net profit margin is quite favorable when compared to theindustry average. The firm’s earnings per share, return on total assets, and return on common equity behaved much as its net profit margin did over the 2010–2012 period.Bartlett appears to have experienced either a sizable drop in sales between 2010and 2011 or a rapid expansion in assets during that period. The exceptionallyhigh 2012 level of return on common equity suggests that the firm is performingquite well. The firm’s above-average returns—net profit margin, EPS, ROA, andROE—may be attributable to the fact that it is more risky than average. A lookat market ratios is helpful in assessing risk. Market Investors have greater confidence in the firm in 2012 than in the prior 2 years, asreflected in the price/earnings (P/E) ratio of 11.1. However, this ratio is below theindustry average. The P/E ratio suggests that the firm’s risk has declined butremains above that of the average firm in its industry. The firm’s market/book(M/B) ratio has increased over the 2010–2012 period, and in 2012 it exceeds theindustry average. This implies that investors are optimistic about the firm’s futureperformance. The P/E and M/B ratios reflect the firm’s increased profitabilityover the 2010–2012 period: Investors expect to earn high future returns as com-pensation for the firm’s above-average risk. In summary, the firm appears to be growing and has recently undergone an expansion in assets, financed primarily through the use of debt. The 2011–2012period seems to reflect a phase of adjustment and recovery from the rapid growthin assets. Bartlett’s sales, profits, and other performance factors seem to be growingwith the increase in the size of the operation. In addition, the market response tothese accomplishments appears to have been positive. In short, the fir m seems to have done well in 2012. DUPONT SYSTEM OF ANALYSIS TheDuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition. It merges the income statement and balancesheet into two summary measures of profitability, return on total assets (ROA)and return on common equity (ROE). Figure 3.2 (see page 88) depicts the basicDuPont system with Bartlett Company’s 2012 monetary and ratio values. Theupper portion of the chart summarizes the income statement activities; the lowerportion summarizes the balance sheet activities. DuPont Formula The DuPont system first brings together the net profit margin, which measures the firm’s profitability on sales, with its total asset turnover, which indicates howDuPont system of analysis System used to dissect the firm’s financial statements andto assess its financial condition. Summary of Bartlett Company Ratios (2010–2012, Including 2012 Industry Averages) Evaluationd Industry Cross-YearAverage Sectional Time-Series Ratio Formula 2010a2011b2012b2012c2012 2010–2012 Overall Liquidity Current ratio 2.04 2.08 1.97 2.05 OK OK OK Quick (acid-test) ratio 1.32 1.46 1.51 1.43 OK Good Good Activity Inventory turnover 5.1 5.7 7.2 6.6 Good Good Good Average collection period 43.9 days 51.2 days 59.7 days 44.3 days Poor Poor PoorAverage payment period 75.8 days 81.2 days 95.4 days 66.5 days Poor Poor PoorTotal assets turnover 0.94 0.79 0.85 0.75 OK OK OK Debt Debt ratio 36.8% 44.3% 45.7% 40.0% OK OK OK Times interest earned ratio 5.6 3.3 4.5 4.3 Good OK OKFixed-payment coverage ratio 2.4 1.4 1.9 1.5 Good OK Good Profitability Gross profit margin 31.4% 33.3% 32.1% 30.0% OK OK OK Operating profit margin 14.6% 11.8% 13.6% 11.0% Good OK GoodNet profit margin 8.2% 5.4% 7.2% 6.2% Good OK GoodEarnings available for common stockholders SalesOperating profits SalesGross profits SalesEarnings before interest and taxes +Lease payments Int. +Lease pay. +5(Prin. +Pref. div.) *31>(1-T)46Earnings before interest and taxes InterestTotal liabilities Total assetsSales Total assetsAccounts payable Average purchases per dayAccounts receivable Average sales per dayCost of goods sold InventoryCurrent assets -Inventory Current liabilitiesCurrent assets Current liabilitiesTABLE 3.8 86 Evaluationd Industry Cross-YearAverage Sectional Time-Series Ratio Formula 2010a2011b2012b2012c2012 2010–2012 Overall Profitability (cont.) Earnings per share (EPS) $3.26 $1.81 $2.90 $2.26 Good OK Good Return on total assets (ROA) 7.8% 4.2% 6.1% 4.6% Good OK Good Return on common equity (ROE) 13.7% 8.5% 12.6% 8.5% Good OK Good Market Price/earnings (P/E) ratio 10.5 10.0e11.1 12.5 OK OK OK Market/book (M/B) ratio 1.25 0.85e1.40 1.30 OK OK OK aCalculated from data not included in this chapter. bCalculated by using the financial statements presented in Tables 3.1 and 3.2. cObtained from sources not included in this chapter. dSubjective assessments based on data provided. eThe market price per share at the end of 2011 was $18.06.Market price per share of common stock Book value per share of common stockMarket price per share of common stock Earnings per shareEarnings available for common stockholders Common stock equityEarnings available for common stockholders Total assetsEarnings available for common stockholders Number of shares of common stock outstanding 87 88 PART 2 Financial Tools Sales $3,074,000 minus Cost of Goods Sold $2,088,000 minus divided byOperating Expenses $568,000Income Statement minus Interest Expense $93,000 minus Taxes $94,000 minus Preferred Stock Dividends $10,000Earnings Available for Common Stockholders $221,000Net Profit Margin 7.2% Sales $3,074,000 divided bymultiplied by multiplied bySales $3,074,000 Total Asset Turnover 0.85 Common Stock Equity $1,754,000Total Assets $3,597,000Return on Common Equity (ROE) 12.6% plus divided byTotal Liabilities $1,643,000Financial Leverage Multiplier (FLM) 2.06Return on Total Assets (ROA) 6.1% Total Liabilities and Stockholders’ Equity = Total Assets $3,597,000 Stockholders’ Equity $1,954,000Current Assets $1,223,000 plus Net Fixed Assets $2,374,000 Current Liabilities $620,000 plus Long-Term Debt $1,023,000Balance SheetFIGURE 3.2 DuPont System of Analysis The DuPont system of analysis with application to Bartlett Company (2012) efficiently the firm has used its assets to generate sales. In the DuPont formula, the product of these two ratios results in the return on total assets (ROA): Substituting the appropriate formulas into the equation and simplifying results in the formula given earlier, When the 2012 values of the net profit margin and total asset turnover for Bartlett Company, calculated earlier, are substituted into the DuPont formula, theresult is This value is the same as that calculated directly in an earlier section (page 81). The DuPont formula enables the firm to break down its return into profit-on-sales and efficiency-of-asset-use components. Typically, a firm with a low netprofit margin has a high total asset turnover, which results in a reasonably goodreturn on total assets. Often, the opposite situation exists. Modified DuPont Formula The second step in the DuPont system employs the modified DuPont formula. This formula relates the firm’s return on total assets (ROA) to its return on common equity (ROE) . The latter is calculated by multiplying the return on total assets (ROA) by the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity: Substituting the appropriate formulas into the equation and simplifying results in the formula given earlier, Use of the financial leverage multiplier (FLM) to convert the ROA into the ROE reflects the impact of financial leverage on owners’ return. Substituting thevalues for Bartlett Company’s ROA of 6.1 percent, calculated earlier, andBartlett’s FLM of 2.06 ($3,597,000 total assets $1,754,000 common stockequity) into the modified DuPont formula yields The 12.6 percent ROE calculated by using the modified DuPont formula is the same as that calculated directly (page 82). Applying the DuPont System The advantage of the DuPont system is that it allows the firm to break its return onequity into a profit-on-sales component (net profit margin), an efficiency-of-asset-use component (total asset turnover), and a use-of-financial-leverage componentROE =6.1% *2.06 =12.6%,ROE =Earnings available for common stockholders Total assets*Total assets Common stock equity=Earnings available for common stockholders Common stock equityROE =ROA *FLMROA =7.2% *0.85 =6.1%ROA =Earnings available for common stockholders Sales*Sales Total assets=Earnings available for common stockholders Total assetsROA =Net profit margin *Total asset turnoverCHAPTER 3 Financial Statements and Ratio Analysis 89 DuPont formula Multiplies the firm’s net profit margin by its total asset turnover to calculate the firm’s return on total assets (ROA). Matter of fact Dissecting ROA Return to Table 3.5, and examine the total asset turnover figures for Dell and The Home Depot. Both firms turn their assets 1.6 times per year. Now look at the return on assets column. Dell’s ROA is 4.3 percent, but The Home Depot’s is significantly higher at 6.5 percent. If the two firms are equal in terms of the effi- ciency with which they manage their assets (that is, equal asset turns), why is The Home Depot more profitable relative to assets? The answer lies in the DuPont formula. Notice that Home Depot’s net profit margin is 4.0 percent compared to Dell’s 2.7 percent. That drives the superior ROA figures for The Home Depot. modified DuPont formula Relates the firm’s return on total assets (ROA) to its return on common equity (ROE) using the financial leverage multiplier (FLM). financial leverage multiplier (FLM) The ratio of the firm’s total assets to its common stockequity. (financial leverage multiplier). The total return to owners therefore can be ana- lyzed in these important dimensions. The use of the DuPont system of analysis as a diagnostic tool is best explained using Figure 3.2. Beginning with the rightmost value—the ROE—the financialanalyst moves to the left, dissecting and analyzing the inputs to the formula to iso-late the probable cause of the resulting above-average (or below-average) value. For the sake of demonstration, let’s ignore all industry average data in Table 3.8and assume that Bartlett’s ROE of 12.6% is actually below the industry average.Moving to the left in Figure 3.2, we would examine the inputs to the ROE—theROA and the FLM—relative to the industry averages. Let’s assume that the FLMis in line with the industry average, but the ROA is below the industry average.Moving farther to the left, we examine the two inputs to the ROA—the net profitmargin and total asset turnover. Assume that the net profit margin is in line withthe industry average, but the total asset turnover is below the industry average.Moving still farther to the left, we find that whereas the firm’s sales are consistentwith the industry value, Bartlett’s total assets have grown significantly during thepast year. Looking farther to the left, we would review the firm’s activity ratios forcurrent assets. Let’s say that whereas the firm’s inventory turnover is in line with theindustry average, its average collection period is well above the industry average. We can readily trace the possible problem back to its cause: Bartlett’s low ROE is primarily the consequence of slow collections of accounts receivable,which resulted in high levels of receivables and therefore high levels of totalassets. The high total assets slowed Bartlett’s total asset turnover, driving downits ROA, which then drove down its ROE. By using the DuPont system ofanalysis to dissect Bartlett’s overall returns as measured by its ROE, we foundthat slow collections of receivables caused the below-industry-average ROE. Clearly, the firm needs to better manage its credit operations. 6REVIEW QUESTIONS 3–18 Financial ratio analysis is often divided into five areas: liquidity, activity, debt, profitability, andmarket ratios. Differentiate each of these areas of analysis from the others. Which is of the greatest concern to creditors? 3–19 Describe how you would use a large number of ratios to perform a com- plete ratio analysis of the firm. 3–20 What three areas of analysis are combined in the modified DuPont for- mula? Explain how the DuPont system of analysis is used to dissect the firm’s results and isolate their causes.Example 3.6390 PART 2 Financial Tools Summary FOCUS ON VALUE Financial managers review and analyze the firm’s financial statements periodi- cally, both to uncover developing problems and to assess the firm’s progresstoward achieving its goals. These actions are aimed at preserving and creating value for the firm’s owners. Financial ratios enable financial managers to mon- itor the pulse of the firm and its progress toward its strategic goals. Although financial statements and financial ratios rely on accrual concepts, they can pro- vide useful insights into important aspects of risk and return (cash flow) thataffect share price. REVIEW OF LEARNING GOALS Review the contents of the stockholders’ report and the procedures for consolidating international financial statements. The annual stockholders’ report, which publicly owned corporations must provide to stockholders, docu-ments the firm’s financial activities of the past year. It includes the letter to stock-holders and various subjective and factual information. It also contains four keyfinancial statements: the income statement, the balance sheet, the statement ofstockholders’ equity (or its abbreviated form, the statement of retained earnings),and the statement of cash flows. Notes describing the technical aspects of thefinancial statements follow. Financial statements of companies that have opera-tions whose cash flows are denominated in one or more foreign currencies mustbe translated into dollars in accordance with FASB Standard No. 52. Understand who uses financial ratios and how. Ratio analysis enables stockholders, lenders, and the firm’s managers to evaluate the firm’s financialperformance. It can be performed on a cross-sectional or a time-series basis.Benchmarking is a popular type of cross-sectional analysis. Users of ratiosshould understand the cautions that apply to their use. Use ratios to analyze a firm’s liquidity and activity. Liquidity, or the ability of the firm to pay its bills as they come due, can be measured by the cur-rent ratio and the quick (acid-test) ratio. Activity ratios measure the speed withwhich accounts are converted into sales or cash—inflows or outflows. Theactivity of inventory can be measured by its turnover: that of accounts receiv-able by the average collection period and that of accounts payable by theaverage payment period. Total asset turnover measures the efficiency with whichthe firm uses its assets to generate sales. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt. The more debt a firm uses, the greater its financial leverage, which magnifies both risk and return. Financial debt ratiosmeasure both the degree of indebtedness and the ability to service debts. Acommon measure of indebtedness is the debt ratio. The ability to pay fixed chargescan be measured by times interest earned and fixed-payment coverage ratios. Use ratios to analyze a firm’s profitability and its market value. The common-size income statement, which shows each item as a percentage of sales,can be used to determine gross profit margin, operating profit margin, and netprofit margin. Other measures of profitability include earnings per share, returnon total assets, and return on common equity. Market ratios include theprice/earnings ratio and the market/book ratio. Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis. A summary of all ratios can be used to perform a complete ratio analysis using cross-sectional and time-series analysis. The LG6LG5LG4LG3LG2LG1CHAPTER 3 Financial Statements and Ratio Analysis 91 Ratio Too High Too Low Current ratio Inventory turnover Times interest earned Gross profit margin Return on total assets Price/earnings (P/E) ratio ======DuPont system of analysis is a diagnostic tool used to find the key areas respon- sible for the firm’s financial performance. It enables the firm to break the returnon common equity into three components: profit on sales, efficiency of asset use,and use of financial leverage.92 PART 2 Financial Tools Opener-in-Review In the chapter opener you read about how financial analysts gave Abercrombie’s stock a relatively positive outlook based on a current ratio of 2.79, a quick ratioof 1.79, and a receivables collection period of 43 days. Based on what youlearned in this chapter, do you agree with the analysts’ assessment? Explain whyor why not. Self-Test Problems(Solutions in Appendix) ST3–1 Ratio formulas and interpretations Without referring to the text, indicate for each of the following ratios the formula for calculating it and the kinds of problems, if any, the firm may have if that ratio is too high relative to the industry average. Whatif the ratio is too low relative to the industry average? Create a table similar to the one that follows and fill in the empty blocks.LG5LG3LG4 LG5LG3LG4ST3–2 Balance sheet completion using ratios Complete the 2012 balance sheet for O’Keefe Industries using the information that follows it. O’Keefe Industries Balance Sheet December 31, 2012 Assets Liabilities and Stockholders’ Equity Cash $32,720 Accounts payable $120,000 Marketable securities 25,000 Notes payable ________Accounts receivable _______ Accruals 20,000Inventories _______ Total current liabilities ________ Total current assets _______ Long-term debt ________ Net fixed assets _______ Stockholders’ equity $600,000 Total assets $ Total liabilities and stockholders’ equity $ The following financial data for 2012 are also available: 1.Sales totaled $1,800,000. 2.The gross profit margin was 25%. 3.Inventory turnover was 6.0. 4.There are 365 days in the year. 5.The average collection period was 40 days. 6.The current ratio was 1.60. 7.The total asset turnover ratio was 1.20. 8.The debt ratio was 60%.CHAPTER 3 Financial Statements and Ratio Analysis 93 Warm-Up ExercisesAll problems are available in . E3–1 You are a summer intern at the office of a local tax preparer. To test your basic knowledge of financial statements, your manager, who graduated from your alma mater 2 years ago, gives you the following list of accounts and asks you to prepare asimple income statement using those accounts. LG1 Accounts ($000,000) Depreciation 25 General and administrative expenses 22Sales 345Sales expenses 18Cost of goods sold 255Lease expense 4Interest expense 3 a.Arrange the accounts into a well-labeled income statement. Make sure you label and solve for gross profit, operating profit, and net profit before taxes. b.Using a 35% tax rate, calculate taxes paid and net profit after taxes. c.Assuming a dividend of $1.10 per share with 4.25 million shares outstanding, calculate EPS and additions to retained earnings. E3–2 Explain why the income statement can also be called a “profit-and-loss statement.”What exactly does the word balance mean in the title of the balance sheet? Why do we balance the two halves? E3–3 Cooper Industries, Inc., began 2012 with retained earnings of $25.32 million.During the year it paid four quarterly dividends of $0.35 per share to 2.75 millioncommon stockholders. Preferred stockholders, holding 500,000 shares, were paidtwo semiannual dividends of $0.75 per share. The firm had a net profit after taxes of $5.15 million. Prepare the statement of retained earnings for the year ended December 31, 2012. E3–4 Bluestone Metals, Inc., is a metal fabrication firm that manufactures prefabricated metal parts for customers in a variety of industries. The firm’s motto is “If you need it, we can make it.” The CEO of Bluestone recently held a board meeting duringwhich he extolled the virtues of the corporation. The company, he stated confidently,LG1 LG3LG1 had the capability to build any product and could do so using a lean manufacturing model. The firm would soon be profitable, claimed the CEO, because the companyused state-of-the-art technology to build a variety of products while keeping inven-tory levels low. As a business press reporter, you have calculated some ratios to ana-lyze the financial health of the firm. Bluestone’s current ratios and quick ratios forthe past 6 years are shown in the table below:94 PART 2 Financial Tools 2007 2008 2009 2010 2011 2012 Current ratio 1.2 1.4 1.3 1.6 1.8 2.2 Quick ratio 1.1 1.3 1.2 0.8 0.6 0.4 What do you think of the CEO’s claim that the firm is lean and soon to be prof- itable? ( Hint: Is there a possible warning sign in the relationship between the two ratios?) E3–5 If we know that a firm has a net profit margin of 4.5%, total asset turnover of 0.72, and a financial leverage multiplier of 1.43, what is its ROE? What is the advantage to using the DuPont system to calculate ROE over the direct calculation of earningsavailable for common stockholders divided by common stock equity?LG5 ProblemsAll problems are available in . P3–1 Reviewing basic financial statements The income statement for the year ended December 31, 2012, the balance sheets for December 31, 2012 and 2011, and the statement of retained earnings for the year ended December 31, 2012, for Technica,Inc., are given below and on the following page. Briefly discuss the form and infor- mational content of each of these statements. LG1 Technica, Inc. Income Statement for the Year Ended December 31, 2012 Sales revenue $600,000 Less: Cost of goods sold Gross profits Less: Operating expenses General and administrative expenses $ 30,000Depreciation expense Total operating expense Operating profits Less: Interest expense Net profits before taxes Less: Taxes Earnings available for common stockholders Earnings per share (EPS) $2.15$ 42,90027,100$ 70,00010,000$ 80,000$ 60,00030,000$140,000460,000 P3–2 Financial statement account identification Mark each of the accounts listed in the following table as follows: a.In column (1), indicate in which statement—income statement (IS) or balance sheet (BS)—the account belongs. b.In column (2), indicate whether the account is a current asset (CA), current lia- bility (CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue (R), or stockholders’ equity (SE).CHAPTER 3 Financial Statements and Ratio Analysis 95 Technica, Inc. Balance Sheets December 31 Assets 2012 2011 Cash Marketable securities 7,200 8,000Accounts receivable 34,100 42,200Inventories Total current assets Land and buildings $150,000 $150,000Machinery and equipment 200,000 190,000Furniture and fixtures 54,000 50,000Other Total gross fixed assets $415,000 $400,000 Less: Accumulated depreciation Net fixed assetsTotal assets Liabilities and Stockholders’ Equity Accounts payable $ 49,000 Notes payable 13,000 16,000Accruals Total current liabilities Long-term debtCommon stock equity (shares outstanding: 19,500 in 2012 and 20,000 in 2011) $110,200 $120,000 Retained earnings Total stockholders’ equityTotal liabilities and stockholders’ equity $401,200 $408,300$170,200 $183,30050,200 73,100$160,000 $150,000$ 71,000 $ 75,0006,000 5,000$ 57,000$401,200 $408,000$285,000 $270,000115,000 145,00010,000 11,000$116,200 $138,30050,000 82,000$ 16,000 $ 15,000 LG1Technica, Inc. Statement of Retained Earnings for the Year Ended December 31, 2012 Retained earnings balance (January 1, 2012) $50,200 Plus: Net profits after taxes (for 2012) 42,900Less: Cash dividends (paid during 2012) Retained earnings balance (December 31, 2012) $73,100 20,000 P3–3 Income statement preparation On December 31, 2012, Cathy Chen, a self- employed certified public accountant (CPA), completed her first full year in business. During the year, she billed $360,000 for her accounting services. She had twoemployees, a bookkeeper and a clerical assistant. In addition to her monthly salary of $8,000, Ms. Chen paid annual salaries of $48,000 and $36,000 to the book- keeper and the clerical assistant, respectively. Employment taxes and benefit costs for Ms. Chen and her employees totaled $34,600 for the year. Expenses for office supplies, including postage, totaled $10,400 for the year. In addition, Ms. Chenspent $17,000 during the year on tax-deductible travel and entertainment associated with client visits and new business development. Lease payments for the office space rented (a tax-deductible expense) were $2,700 per month. Depreciation expense on the office furniture and fixtures was $15,600 for the year. During the year, Ms. Chen paid interest of $15,000 on the $120,000 borrowed to start the business. She paidan average tax rate of 30% during 2012. a.Prepare an income statement for Cathy Chen, CPA, for the year ended December 31, 2012. b.Evaluate her 2012 financial performance.96 PART 2 Financial Tools LG1(1) (2) Account name Statement Type of account Accounts payable _______ _______ Accounts receivable _______ _______Accruals _______ _______Accumulated depreciation _______ _______Administrative expense _______ _______Buildings _______ _______Cash _______ _______Common stock (at par) _______ _______Cost of goods sold _______ _______Depreciation _______ _______Equipment _______ _______General expense _______ _______Interest expense _______ _______Inventories _______ _______Land _______ _______Long-term debts _______ _______Machinery _______ _______Marketable securities _______ _______Notes payable _______ _______Operating expense _______ _______Paid-in capital in excess of par _______ _______Preferred stock _______ _______Preferred stock dividends _______ _______Retained earnings _______ _______Sales revenue _______ _______Selling expense _______ _______Taxes _______ _______Vehicles _______ _______ Personal Finance Problem P3–4 Income statement preparation Adam and Arin Adams have collected their personal income and expense information and have asked you to put together an income and expense statement for the year ended December 31, 2012. The following informa- tion is received from the Adams family.CHAPTER 3 Financial Statements and Ratio Analysis 97 LG1 Adam’s salary $45,000 Utilities $ 3,200 Arin’s salary 30,000 Groceries 2,200Interest received 500 Medical 1,500Dividends received 150 Property taxes 1,659Auto insurance 600 Income tax, Social Security 13,000Home insurance 750 Clothes and accessories 2,000Auto loan payment 3,300 Gas and auto repair 2,100Mortgage payment 14,000 Entertainment 2,000 a.Create a personal income and expense statement for the period ended December 31, 2012. It should be similar to a corporate income statement. b.Did the Adams family have a cash surplus or cash deficit? c.If the result is a surplus, how can the Adams family use that surplus? P3–5 Calculation of EPS and retained earnings Philagem, Inc., ended 2012 with a net profit before taxes of $218,000. The company is subject to a 40% tax rate and must pay $32,000 in preferred stock dividends before distributing any earnings on the85,000 shares of common stock currently outstanding. a.Calculate Philagem’s 2012 earnings per share (EPS). b.If the firm paid common stock dividends of $0.80 per share, how many dollars would go to retained earnings? P3–6 Balance sheet preparation Use the appropriate items from the following list to pre- pare in good form Owen Davis Company’s balance sheet at December 31, 2012.LG1 LG1 Value ($000) at Value ($000) at Item December 31, 2012 Item December 31, 2012 Accounts payable $ 220 Inventories $ 375 Accounts receivable 450 Land 100Accruals 55 Long-term debts 420Accumulated depreciation 265 Machinery 420Buildings 225 Marketable securities 75Cash 215 Notes payable 475Common stock (at par) 90 Paid-in capital in excessCost of goods sold 2,500 of par 360Depreciation expense 45 Preferred stock 100Equipment 140 Retained earnings 210Furniture and fixtures 170 Sales revenue 3,600General expense 320 Vehicles 25 Personal Finance Problem P3–7 Balance sheet preparation Adam and Arin Adams have collected their personal asset and liability information and have asked you to put together a balance sheet as of December 31, 2012. The following information is received from the Adams family.98 PART 2 Financial Tools LG1 Cash $ 300 Retirement funds, IRA $ 2,000 Checking 3,000 2011 Sebring 15,000Savings 1,200 2010 Jeep 8,000IBM stock 2,000 Money market funds 1,200Auto loan 8,000 Jewelry and artwork 3,000Mortgage 100,000 Net worth 76,500Medical bills payable 250 Household furnishings 4,200Utility bills payable 150 Credit card balance 2,000Real estate 150,000 Personal loan 3,000 a.Create a personal balance sheet as of December 31, 2012. It should be similar to a corporate balance sheet. b.What must the total assets of the Adams family be equal to by December 31, 2012? c.What was their net working capital (NWC) for the year? ( Hint: NWC is the dif- ference between total liquid assets and total current liabilities.) P3–8 Impact of net income on a firm’s balance sheet Conrad Air, Inc., reported net income of $1,365,000 for the year ended December 31, 2013. Show how Conrad’sbalance sheet would change from 2012 to 2013 depending on how Conrad “spent” those earnings as described in the scenarios that appear below.LG1 Conrad Air, Inc. Balance Sheet as of December 31, 2012 Assets Liabilities and Stockholders’ Equity Cash Accounts payable Marketable securities 35,000 Short-term notesAccounts receivable 45,000 Current liabilitiesInventories Long-term debt Current assets Total liabilities Equipment $2,970,000 Common stockBuildings Retained earnings Fixed assets Stockholders’ equityTotal assets Total liabilities and equity $4,900,000 $4,900,000$2,075,000 $4,570,0001,575,000 1,600,000$ 500,000$2,825,000 $ 330,0002,700,000 130,000$ 125,00055,000$ 70,000 $ 120,000 a.Conrad paid no dividends during the year and invested the funds in marketable securities. b.Conrad paid dividends totaling $500,000 and used the balance of the net income to retire (pay off) long-term debt. c.Conrad paid dividends totaling $500,000 and invested the balance of the net income in building a new hangar. d.Conrad paid out all $1,365,000 as dividends to its stockholders. P3–9 Initial sale price of common stock Beck Corporation has one issue of preferred stock and one issue of common stock outstanding. Given Beck’s stockholders’ equityaccount that follows, determine the original price per share at which the firm sold itssingle issue of common stock.CHAPTER 3 Financial Statements and Ratio Analysis 99 LG1 LG1 LG1Stockholders’ Equity ($000) Preferred stock Common stock ($0.75 par, 300,000 shares outstanding) 225 Paid-in capital in excess of par on common stock 2,625 Retained earnings Total stockholders’ equity $3,875900$ 125 P3–10 Statement of retained earnings Hayes Enterprises began 2012 with a retained earn- ings balance of $928,000. During 2012, the firm earned $377,000 after taxes. From this amount, preferred stockholders were paid $47,000 in dividends. At year-end2012, the firm’s retained earnings totaled $1,048,000. The firm had 140,000 shares of common stock outstanding during 2012.a.Prepare a statement of retained earnings for the year ended December 31, 2012, for Hayes Enterprises. ( Note: Be sure to calculate and include the amount of cash dividends paid in 2012.) b.Calculate the firm’s 2012 earnings per share (EPS). c.How large a per-share cash dividend did the firm pay on common stock during 2012? P3–11 Changes in stockholders’ equity Listed are the equity sections of balance sheets for years 2011 and 2012 as reported by Mountain Air Ski Resorts, Inc. The overall value of stockholders’ equity has risen from $2,000,000 to $7,500,000. Use the statements to discover how and why this happened. Mountain Air Ski Resorts, Inc. Balance Sheets (partial) Stockholders’ equity 2011 2012 Common stock ($1.00 par) Authorized—5,000,000 sharesOutstanding—1,500,000 shares 2012 — 500,000 shares 2011 Paid-in capital in excess of par 4,500,000Retained earnings Total stockholders’ equity $7,500,000 $2,000,0001,500,000 1,000,000500,000$ 500,000$1,500,000 The company paid total dividends of $200,000 during fiscal 2012. a.What was Mountain Air’s net income for fiscal 2012? b.How many new shares did the corporation issue and sell during the year? c.At what average price per share did the new stock sold during 2012 sell? d.At what price per share did Mountain Air’s original 500,000 shares sell? P3–12 Ratio comparisons Robert Arias recently inherited a stock portfolio from his uncle. Wishing to learn more about the companies in which he is now invested, Robert per-forms a ratio analysis on each one and decides to compare them to each other. Someof his ratios are listed below.100 PART 2 Financial Tools LG2LG3 LG4LG5 Island Burger Fink Roland Ratio Electric Utility Heaven Software Motors Current ratio 1.10 1.3 6.8 4.5 Quick ratio 0.90 0.82 5.2 3.7Debt ratio 0.68 0.46 0.0 0.35Net profit margin 6.2% 14.3% 28.5% 8.4% Assuming that his uncle was a wise investor who assembled the portfolio with care, Robert finds the wide differences in these ratios confusing. Help him out.a.What problems might Robert encounter in comparing these companies to one another on the basis of their ratios? b.Why might the current and quick ratios for the electric utility and the fast-food stock be so much lower than the same ratios for the other companies? c.Why might it be all right for the electric utility to carry a large amount of debt, but not the software company? d.Why wouldn’t investors invest all of their money in software companies instead of in less profitable companies? (Focus on risk and return.) P3–13 Liquidity management Bauman Company’s total current assets, total current liabil- ities, and inventory for each of the past 4 years follow:LG3 Item 2009 2010 2011 2012 Total current assets $16,950 $21,900 $22,500 $27,000 Total current liabilities 9,000 12,600 12,600 17,400Inventory 6,000 6,900 6,900 7,200 Inventory turnover 2009 2010 2011 2012 Bauman Company 6.3 6.8 7.0 6.4 Industry average 10.6 11.2 10.8 11.0a.Calculate the firm’s current and quick ratios for each year. Compare the resulting time series for these measures of liquidity. b.Comment on the firm’s liquidity over the 2009–2010 period. c.If you were told that Bauman Company’s inventory turnover for each year in the 2009–2012 period and the industry averages were as follows, would this infor-mation support or conflict with your evaluation in part b? Why? Personal Finance Problem P3–14 Liquidity ratio Josh Smith has compiled some of his personal financial data in order to determine his liquidity position. The data are as follows.CHAPTER 3 Financial Statements and Ratio Analysis 101 LG3 Account Amount Cash $3,200 Marketable securities 1,000Checking account 800Credit card payables 1,200Short-term notes payable 900 Month of origin Amounts receivable July $ 3,875 August 2,000September 34,025October 15,100November 52,000December Year-end accounts receivable $300,000 193,000Quarter Inventory 1 $ 400,000 2 800,0003 1,200,0004 200,000a.Calculate Josh’s liquidity ratio . b.Several of Josh’s friends have told him that they have liquidity ratios of about 1.8. How would you analyze Josh’s liquidity relative to his friends? P3–15 Inventory management Wilkins Manufacturing has annual sales of $4 million and a gross profit margin of 40%. Its end-of-quarter inventories areLG3 a.Find the average quarterly inventory and use it to calculate the firm’s inventory turnover and the average age of inventory. b.Assuming that the company is in an industry with an average inventory turnover of 2.0, how would you evaluate the activity of Wilkins’ inventory? P3–16 Accounts receivable management An evaluation of the books of Blair Supply, which follows, gives the end-of-year accounts receivable balance, which is believedto consist of amounts originating in the months indicated. The company had annual sales of $2.4 million. The firm extends 30-day credit terms.LG3 a.Use the year-end total to evaluate the firm’s collection system. b.If 70% of the firm’s sales occur between July and December, would this affect the validity of your conclusion in part a? Explain. P3–17 Interpreting liquidity and activity ratios The new owners of Bluegrass Natural Foods, Inc., have hired you to help them diagnose and cure problems that the com-pany has had in maintaining adequate liquidity. As a first step, you perform a liq-uidity analysis. You then do an analysis of the company’s short-term activity ratios.Your calculations and appropriate industry norms are listed.102 PART 2 Financial Tools LG3 Ratio Bluegrass Industry norm Current ratio 4.5 4.0 Quick ratio 2.0 3.1Inventory turnover 6.0 10.4Average collection period 73 days 52 daysAverage payment period 31 days 40 days Creek Enterprises Income Statement for the Year Ended December 31, 2012 Sales revenue $30,000,000 Less: Cost of goods sold Gross profits Less: Operating expenses Selling expense $ 3,000,000General and administrative expenses 1,800,000Lease expense 200,000Depreciation expense Total operating expense Operating profits $ 3,000,000 Less: Interest expense Net profits before taxes $ 2,000,000 Less: Taxes (rate 40%) Net profits after taxes $ 1,200,000 Less: Preferred stock dividends Earnings available for common stockholders $ 1,100,000 100,000800,000 =1,000,000$ 6,000,0001,000,000$ 9,000,00021,000,000a.What recommendations relative to the amount and the handling of inventory could you make to the new owners? b.What recommendations relative to the amount and the handling of accounts receivable could you make to the new owners? c.What recommendations relative to the amount and the handling of accounts payable could you make to the new owners? d.What results, overall, would you hope your recommendations would achieve? Why might your recommendations not be effective? P3–18 Debt analysis Springfield Bank is evaluating Creek Enterprises, which has requested a $4,000,000 loan, to assess the firm’s financial leverage and financialrisk. On the basis of the debt ratios for Creek, along with the industry averages (see top of page 103) and Creek’s recent financial statements (following), evaluate and recommend appropriate action on the loan request.LG4 P3–19 Common-size statement analysis A common-size income statement for Creek Enterprises’ 2011 operations follows. Using the firm’s 2012 income statement pre-sented in Problem 3–18, develop the 2012 common-size income statement and com-pare it to the 2011 statement. Which areas require further analysis and investigation?CHAPTER 3 Financial Statements and Ratio Analysis 103 Creek Enterprises Balance Sheet December 31, 2012 Assets Liabilities and Stockholders’ Equity Cash $ 1,000,000 Accounts payable $ 8,000,000 Marketable securities 3,000,000 Notes payable 8,000,000Accounts receivable 12,000,000 AccrualsInventories Total current liabilities Total current assets Long-term debt (includes Land and buildings $11,000,000 financial leases) b Machinery and equipment 20,500,000 Preferred stock (25,000 Furniture and fixtures shares, $4 dividend) $ 2,500,000 Gross fixed assets (at cost)a$39,500,000 Common stock (1 million Less: Accumulated depreciation shares at $5 par) 5,000,000 Net fixed assets Paid-in capital in excess of Total assets par value 4,000,000 Retained earnings Total stockholders’ equityTotal liabilities and stockholders’ equity aThe firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three years of the lease have yet to run. bRequired annual principal payments are $800,000.$50,000,000$13,500,0002,000,000$50,000,000$26,500,00013,000,0008,000,000$20,000,000$23,500,000$16,500,000 7,500,000500,000Industry averages Debt ratio 0.51 Times interest earned ratio 7.30 Fixed-payment coverage ratio 1.85 LG5 Creek Enterprises Common-Size Income Statement for the Year Ended December 31, 2011 Sales revenue ($35,000,000) 100.0% Less: Cost of goods sold Gross profits % Less: Operating expenses Selling expense 12.7%General and administrative expenses 6.3Lease expense 0.6Depreciation expense Total operating expense Operating profits 10.9% Less: Interest expense Net profits before taxes 9.4% Less: Taxes (rate 40%) Net profits after taxes 5.6% Less: Preferred stock dividends Earnings available for common stockholders % 5.5 0.13.8 =1.523.23.634.165.9 P3–20 The relationship between financial leverage and profitability Pelican Paper, Inc., and Timberland Forest, Inc., are rivals in the manufacture of craft papers. Somefinancial statement values for each company follow. Use them in a ratio analysis thatcompares the firms’ financial leverage and profitability.104 PART 2 Financial Tools LG5LG4 Item Pelican Paper, Inc. Timberland Forest, Inc. Total assets $10,000,000 $10,000,000 Total equity (all common) 9,000,000 5,000,000Total debt 1,000,000 5,000,000Annual interest 100,000 500,000Total sales 25,000,000 25,000,000EBIT 6,250,000 6,250,000Earnings available for common stockholders 3,690,000 3,450,00 a.Calculate the following debt and coverage ratios for the two companies. Discuss their financial risk and ability to cover the costs in relation to each other. (1)Debt ratio (2)Times interest earned ratio b.Calculate the following profitability ratios for the two companies. Discuss their profitability relative to each other.( 1)Operating profit margin (2)Net profit margin (3)Return on total assets (4)Return on common equity c.In what way has the larger debt of Timberland Forest made it more profitable than Pelican Paper? What are the risks that Timberland’s investors undertakewhen they choose to purchase its stock instead of Pelican’s? P3–21 Ratio proficiency McDougal Printing, Inc., had sales totaling $40,000,000 in fiscal year 2012. Some ratios for the company are listed below. Use this information to determine the dollar values of various income statement and balance sheet accountsas requested.LG6 McDougal Printing, Inc. Year Ended December 31, 2012 Sales $40,000,000 Gross profit margin 80%Operating profit margin 35%Net profit margin 8%Return on total assets 16%Return on common equity 20%Total asset turnover 2Average collection period 62.2 days Calculate values for the following: a.Gross profits b.Cost of goods sold c.Operating profits d.Operating expenses e.Earnings available for common stockholders f.Total assets g.Total common stock equity h.Accounts receivable P3–22 Cross-sectional ratio analysis Use the financial statements below and on page 106 for Fox Manufacturing Company for the year ended December 31, 2012, along withthe industry average ratios below, to:a.Prepare and interpret a complete ratio analysis of the firm’s 2012 operations. b.Summarize your findings and make recommendations.CHAPTER 3 Financial Statements and Ratio Analysis 105 Fox Manufacturing Company Income Statement for the Year Ended December 31, 2012 Sales revenue $600,000 Less: Cost of goods sold Gross profits $140,000 Less: Operating expenses General and administrative expenses $30,000Depreciation expense Total operating expense Operating profits $ 80,000 Less: Interest expense Net profits before taxes $ 70,000 Less: Taxes Net profits after taxes (earnings available for common stockholders) Earnings per share (EPS) $2.15$ 42,90027,10010,00060,00030,000460,000LG6 Ratio Industry average, 2012 Current ratio 2.35 Quick ratio 0.87Inventory turnover a4.55 Average collection perioda35.8 days Total asset turnover 1.09Debt ratio 0.300Times interest earned ratio 12.3Gross profit margin 0.202Operating profit margin 0.135Net profit margin 0.091Return on total assets (ROA) 0.099Return on common equity (ROE) 0.167Earnings per share (EPS) $3.10 aBased on a 365-day year and on end-of-year figures. P3–23 Financial statement analysis The financial statements of Zach Industries for the year ended December 31, 2012, follow.106 PART 2 Financial Tools Fox Manufacturing Company Balance Sheet December 31, 2012 Assets Cash $ 15,000 Marketable securities 7,200Accounts receivable 34,100Inventories Total current assetsNet fixed assetsTotal assets Liabilities and Stockholders’ Equity Accounts payable $ 57,000 Notes payable 13,000Accruals Total current liabilities Long-term debtCommon stock equity (20,000 shares outstanding) $110,200 Retained earnings Total stockholders’ equityTotal liabilities and stockholders’ equity $408,300 $183,30073,100$150,000$ 75,0005,000$408,300270,000$138,30082,000 LG6 Zach Industries Income Statement for the Year Ended December 31, 2012 Sales revenue $160,000 Less: Cost of goods sold Gross profits Less: Operating expenses Selling expense $ 16,000General and administrative expenses 10,000Lease expense 1,000Depreciation expense Total operating expense Operating profits $ 17,000 Less: Interest expense Net profits before taxes $ 10,900 Less: Taxes Net profits after taxes $ 6,540 4,3606,100$ 37,00010,000$ 54,000106,000 a.Use the preceding financial statements to complete the following table. Assume the industry averages given in the table are applicable for both 2011 and 2012.CHAPTER 3 Financial Statements and Ratio Analysis 107 Zach Industries Balance Sheet December 31, 2012 Assets Cash $ 500 Marketable securities 1,000Accounts receivable 25,000Inventories Total current assets Land $ 26,000Buildings and equipment 90,000Less: Accumulated depreciation Net fixed assetsTotal assets Liabilities and Stockholders’ Equity Accounts payable $ 22,000 Notes payable Total current liabilities $ 69,000 Long-term debt 22,950Common stock a31,500 Retained earnings Total liabilities and stockholders’ equity aThe firm’s 3,000 outstanding shares of common stock closed 2012 at a price of $25 per share.$150,00026,55047,000$150,000$ 78,00038,000$ 72,00045,500 Ratio Industry average Actual 2011 Actual 2012 Current ratio 1.80 1.84 ______ Quick ratio 0.70 0.78 ______Inventory turnover a2.50 2.59 ______ Average collection perioda37.5 days 36.5 days ______ Debt ratio 65% 67% ______Times interest earned ratio 3.8 4.0 ______Gross profit margin 38% 40% ______Net profit margin 3.5% 3.6% ______Return on total assets 4.0% 4.0% ______Return on common equity 9.5% 8.0% ______Market/book ratio 1.1 1.2 ______ aBased on a 365-day year and on end-of-year figures. b.Analyze Zach Industries’ financial condition as it is related to (1) liquidity, (2) activity, (3) debt, (4) profitability, and (5) market. Summarize the company’s overall financial condition. P3–24 Integrative—Complete ratio analysis Given the following financial statements (fol- lowing and on page 109), historical ratios, and industry averages, calculate SterlingCompany’s financial ratios for the most recent year. (Assume a 365-day year.)108 PART 2 Financial Tools LG6 Sterling Company Income Statement for the Year Ended December 31, 2012 Sales revenue $10,000,000 Less: Cost of goods sold Gross profits Less: Operating expenses Selling expense $300,000General and administrative expenses 650,000Lease expense 50,000Depreciation expense Total operating expense Operating profits $ 1,300,000 Less: Interest expense Net profits before taxes $ 1,100,000 Less: Taxes (rate 40%) Net profits after taxes $ 660,000 Less: Preferred stock dividends Earnings available for common stockholders Earnings per share (EPS) $3.05$ 610,000 50,000440,000 =200,000$ 1,200,000200,000$ 2,500,0007,500,000 Sterling Company Balance Sheet December 31, 2012 Assets Liabilities and Stockholders’ Equity Cash $ 200,000 Accounts payableb$ 900,000 Marketable securities 50,000 Notes payable 200,000Accounts receivable 800,000 AccrualsInventories Total current liabilities Total current assets Long-term debt (includes Gross fixed assets (at cost) a$12,000,000 financial leases)c Less: Accumulated depreciation Preferred stock (25,000 shares, Net fixed assets $ 9,000,000$2 dividend) $ 1,000,000 Other assets Common stock (200,000 Total assets shares at $3 par)d600,000 Paid-in capital in excess of par value 5,200,000 Retained earnings Total stockholders’ equityTotal liabilities and stockholders’ equity aThe firm has an 8-year financial lease requiring annual beginning-of-year payments of $50,000. Five years of the lease have yet to run. bAnnual credit purchases of $6,200,000 were made during the year. cThe annual principal payment on the long-term debt is $100,000. dOn December 31, 2012, the firm’s common stock closed at $39.50 per share.$12,000,000$ 7,800,0001,000,000$12,000,0001,000,0003,000,000$ 3,000,000$ 2,000,000$ 1,200,000 950,000100,000 P3–25 DuPont system of analysis Use the following ratio information for Johnson International and the industry averages for Johnson’s line of business to: a.Construct the DuPont system of analysis for both Johnson and the industry. b.Evaluate Johnson (and the industry) over the 3-year period. c.Indicate in which areas Johnson requires further analysis. Why?CHAPTER 3 Financial Statements and Ratio Analysis 109 Historical and Industry Average Ratios for Sterling Company Industry average, Ratio Actual 2010 Actual 2011 2012 Current ratio 1.40 1.55 1.85 Quick ratio 1.00 0.92 1.05Inventory turnover 9.52 9.21 8.60Average collection period 45.6 days 36.9 days 35.5 daysAverage payment period 59.3 days 61.6 days 46.4 daysTotal asset turnover 0.74 0.80 0.74Debt ratio 0.20 0.20 0.30Times interest earned ratio 8.2 7.3 8.0Fixed-payment coverage ratio 4.5 4.2 4.2Gross profit margin 0.30 0.27 0.25Operating profit margin 0.12 0.12 0.10Net profit margin 0.062 0.062 0.053Return on total assets (ROA) 0.045 0.050 0.040Return on common equity (ROE) 0.061 0.067 0.066Earnings per share (EPS) $1.75 $2.20 $1.50Price/earnings (P/E) ratio 12.0 10.5 11.2Market/book (M/B) ratio 1.20 1.05 1.10 LG6 Johnson 2010 2011 2012 Financial leverage multiplier 1.75 1.75 1.85 Net profit margin 0.059 0.058 0.049Total asset turnover 2.11 2.18 2.34 Industry Averages Financial leverage multiplier 1.67 1.69 1.64 Net profit margin 0.054 0.047 0.041Total asset turnover 2.05 2.13 2.15 P3–26 Complete ratio analysis, recognizing significant differences Home Health, Inc., has come to Jane Ross for a yearly financial checkup. As a first step, Jane has prepared a complete set of ratios for fiscal years 2011 and 2012. She will use them to look forsignificant changes in the company’s situation from one year to the next.LG6Analyze its overall financial situation from both a cross-sectional and a time-series viewpoint. Break your analysis into evaluations of the firm’s liquidity, activity, debt,profitability, and market. a.To focus on the degree of change, calculate the year-to-year proportional change by subtracting the year 2011 ratio from the year 2012 ratio, then dividing the difference by the year 2011 ratio. Multiply the result by 100. Preserve the posi-tive or negative sign. The result is the percentage change in the ratio from 2011to 2012. Calculate the proportional change for the ratios shown here. b.For any ratio that shows a year-to-year difference of 10% or more, state whether the difference is in the company’s favor or not. c.For the most significant changes (25% or more), look at the other ratios and cite at least one other change that may have contributed to the change in the ratio that you are discussing. P3–27 ETHICS PROBLEM Do some reading in periodicals and/or on the Internet to find out more about the Sarbanes-Oxley Act’s provisions for companies. Select one of those provisions, and indicate why you think financial statements will be more trust-worthy if company financial executives implement this provision of SOX.110 PART 2 Financial Tools Home Health, Inc. Financial Ratios Ratio 2011 2012 Current ratio 3.25 3.00 Quick ratio 2.50 2.20Inventory turnover 12.80 10.30Average collection period 42.6 days 31.4 daysTotal asset turnover 1.40 2.00Debt ratio 0.45 0.62Times interest earned ratio 4.00 3.85Gross profit margin 68% 65%Operating profit margin 14% 16%Net profit margin 8.3% 8.1%Return on total assets 11.6% 16.2%Return on common equity 21.1% 42.6%Price/earnings ratio 10.7 9.8Market/book ratio 1.40 1.25 LG1 Spreadsheet Exercise The income statement and balance sheet are the basic reports that a firm constructs for use by management and for distribution to stockholders, regulatory bodies, and thegeneral public. They are the primary sources of historical financial information aboutthe firm. Dayton Products, Inc., is a moderate-sized manufacturer. The company’smanagement has asked you to perform a detailed financial statement analysis of the firm. The income statements for the years ending December 31, 2012 and 2011, respectively, are presented in the table below. ( Note: Purchases of inventory during 2012 amounted to $109,865.)CHAPTER 3 Financial Statements and Ratio Analysis 111 Annual Income Statements (Values in millions) For the year ended December 31, 2012 December 31, 2011 Sales $178,909 $187,510 Cost of goods sold ? 111,631 Selling, general, and administrative expenses 12,356 12,900Other tax expense 33,572 33,377Depreciation and amortization 12,103 7,944Other income (add to EBIT to arrive at EBT) 3,147 3,323Interest expense 398 293Income tax rate (average) 35.324% 37.945%Dividends paid per share $1.47 $0.91Basic EPS from total operations $1.71 $2.25 Annual Balance Sheets (Values in millions) December 31, 2012 December, 31, 2011 Cash and equivalents $ 7,229 $ 6,547 Receivables 21,163 19,549Inventories 8,068 7,904Other current assets 1,831 1,681Property, plant, and equipment, gross 204,960 187,519Accumulated depreciation and depletion 110,020 97,917Other noncurrent assets 19,413 17,891Accounts payable 13,792 22,862Short-term debt payable 4,093 3,703Other current liabilities 15,290 3,549Long-term debt payable 6,655 7,099Deferred income taxes 16,484 16,359Other noncurrent liabilities 21,733 16,441Retained earnings 74,597 73,161Total common shares outstanding 6.7 billion 6.8 billionYou also have the following balance sheet information as of December 31, 2012 and 2011, respectively. TO DO a.Create a spreadsheet similar to Table 3.1 to model the following: (1)A multiple-step comparative income statement for Dayton, Inc., for theperiods ending December 31, 2012 and 2011. You must calculate the cost of goods sold for the year 2012. ( 2)A common-size income statement for Dayton, Inc., covering the years 2012and 2011. b.Create a spreadsheet similar to Table 3.2 to model the following: ( 1)A detailed, comparative balance sheet for Dayton, Inc., for the years endedDecember 31, 2012 and 2011. ( 2)A common-size balance sheet for Dayton, Inc., covering the years 2012 and 2011. c.Create a spreadsheet similar to Table 3.8 to perform the following analysis: (1)Create a table that reflects both 2012 and 2011 operating ratios for Dayton,Inc., segmented into (a) liquidity, (b) activity, (c) debt, (d) profitability, and (e) market. Assume that the current market price for the stock is $90. ( 2)Compare the 2012 ratios to the 2011 ratios. Indicate whether the results “outperformed the prior year” or “underperformed relative to the prioryear.” Visit www.myfinancelab.com forChapter Case: Assessing Martin Manufacturing’s Current Financial Position, Group Exercises, and numerous online resources. 112 PART 2 Financial Tools 113Learning Goals Understand tax depreciation procedures and the effect ofdepreciation on the firm ’s cash flows. Discuss the firm ’s statement of cash flows, operating cash flow,and free cash flow. Understand the financial planning process, including long-term(strategic) financial plans andshort-term (operating) financialplans. Discuss the cash-planning process and the preparation, evaluation,and use of the cash budget. Explain the simplified procedures used to prepare and evaluate the pro forma income statement and the pro forma balance sheet. Evaluate the simplified approaches to pro formafinancial statement preparationand the common uses of pro forma statements. LG6LG5LG4LG3LG2LG14Cash Flow and Financial Planning Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand how depreciation is used for both tax and financial reporting purposes; how to develop the state-ment of cash flows; the primary focus on cash flows, rather thanaccruals, in financial decision making; and how pro forma financialstatements are used within the firm. INFORMATION SYSTEMS You need to understand the data that must be kept to record depreciation for tax and financial reporting; the infor-mation needed for strategic and operating plans; and what data areneeded as inputs for preparing cash plans and profit plans. MANAGEMENT You need to understand the difference between strategic and operating plans, and the role of each; the importance offocusing on the firm ’s cash flows; and how use of pro forma statements can head off trouble for the firm. MARKETING You need to understand the central role that marketing plays in formulating the firm ’s long-term strategic plans, and the impor- tance of the sales forecast as the key input for both cash planning andprofit planning. OPERATIONS You need to understand how depreciation affects the value of the firm ’s plant assets; how the results of operations are cap- tured in the statement of cash flows; that operations provide key inputsinto the firm ’s short-term financial plans; and the distinction between fixed and variable operating costs. Individuals, like corporations, should focus on cash flow when planning and monitoring finances. You should establish short- and long-term financial goals (destinations) and develop personal financial plans(road maps) that will guide their achievement. Cash flows and financialplans are as important for individuals as for corporations. In your personal life Investors Want Apple to Take a Bite Out of Its Cash Hoard Many people would be surprised to learn that U.S. firms emerged from the worst recession in at least two decades with more cash on their balancesheets than they had before the downturn hit. Non- financial firms in the S&P 500 stock index ended 2009 with $832 billion in cash and short-term mar-ketable securities on hand, an increase of more than 25 percent from 2008 and the highest figure on record. Among the firms with the largest cash hoards were the titans of high technology— Microsoft ($39.7 billion), Cisco Systems ($39.1 billion), Google ($26.5 billion), Oracle ($17.5 billion), and Intel ($16.3 billion). At the top of this list was Apple Inc., with $41.7 billion in cash in early 2010, equivalent to roughly one-fifth of the firm ’s total market value (or $40 of the $200 share price). Is holding that much cash a good thing ? Investors buy Apple shares because they believe that the company will continue to produce great high-tech gadgets and generate high returns as a result, but the money that Apple held in cash earned no more than 1 percent in 2010. Thus, some investorscomplained that Apple should distribute a chunk of its cash via a large dividend or share repur- chase program. Steve Jobs, Apple ’s CEO, responded that distributing cash would not have a lasting impact on the firm ’s value. Instead, he argued that billions in cash could be used to do “big, bold things, ” and he worried, “Who knows what ’s around the next corner ?” The latter statement may be the most revealing for Apple and the other high-tech firms. Having survived a recessionin which cash was hard to come by, many executives appeared to be taking a very conserva- tive posture and holding on to as much cash as they could—just in case. Apple 114 CHAPTER 4 Cash Flow and Financial Planning 115 4.1Analyzing the Firm’s Cash Flow An old saying in finance is “Cash is king.” Cash flow, the lifeblood of the firm, is the primary ingredient in any financial valuation model. Whether an analyst wantsto put a value on an investment that a firm is considering or the objective is to valuethe firm itself, estimating cash flow is central to the valuation process. This chapterexplains where the cash flow numbers used in valuations come from. DEPRECIATION For tax and financial reporting purposes, businesses generally cannot deduct asan expense the full cost of an asset that will be in use for several years. Instead,each year firms are required to charge a portion of the costs of fixed assetsagainst revenues. This allocation of historical cost over time is calleddepreciation. Depreciation deductions, like any other business expenses, reduce the income that a firm reports on its income statement and therefore reduce thetaxes that the firm must pay. However, depreciation deductions are not associ-ated with any cash outlay. That is, when a firm deducts depreciation expense, it isallocating a portion of an asset’s original cost (that the firm has already paid for)as a charge against that year’s income. The net effect is that depreciation deduc- tions increase a firm’s cash flow because they reduce a firm’s tax bill . For tax purposes, the depreciation of business assets is regulated by the Internal Revenue Code. Because the objectives of financial reporting sometimesdiffer from those of tax legislation, firms often use different depreciation methodsfor financial reporting than those required for tax purposes. Keeping two dif-ferent sets of records for these two purposes is legal in the United States. Depreciation for tax purposes is determined by using the modified acceler- ated cost recovery system (MACRS); a variety of depreciation methods are avail- able for financial reporting purposes. All depreciation methods require you toknow an asset’s depreciable value and its depreciable life. Depreciable Value of an Asset Under the basic MACRS procedures, the depreciable value of an asset (theamount to be depreciated) is its fullcost, including outlays for installation. Even if the asset is expected to have some salvage value at the end of its useful life, thefirm can still take depreciation deductions equal to the asset’s full initial cost. Baker Corporation acquired a new machine at a cost of $38,000, with installa-tion costs of $2,000. When the machine is retired from service, Baker expects tosell it for scrap metal and receive $1,000. Regardless of its expected salvagevalue, the depreciable value of the machine is $40,000: $38,000 cost $2,000 installation cost. Depreciable Life of an Asset The time period over which an asset is depreciated is called its depreciable life . The shorter the depreciable life, the larger the annual depreciation deductions+Example 4.13LG2 LG1 depreciation A portion of the costs of fixed assets charged against annualrevenues over time. modified accelerated cost recovery system (MACRS) System used to determine the depreciation of assets for tax purposes. depreciable life Time period over which anasset is depreciated. will be, and the larger will be the tax savings associated with those deductions, all other things being equal. Accordingly, firms generally would like to depreciatetheir assets as rapidly as possible. However, the firm must abide by certainInternal Revenue Service (IRS) requirements for determining depreciable life.These MACRS standards, which apply to both new and used assets, require thetaxpayer to use as an asset’s depreciable life the appropriate MACRS recovery period. There are six MACRS recovery periods—3, 5, 7, 10, 15, and 20 years— excluding real estate. It is customary to refer to the property classes as 3-, 5-, 7-,10-, 15-, and 20-year property. The first four property classes—those routinelyused by business—are defined in Table 4.1. DEPRECIATION METHODS Forfinancial reporting purposes, companies can use a variety of depreciation methods (straight-line, double-declining balance, and sum-of-the-years’-digits).Fortax purposes, assets in the first four MACRS property classes are depreciated by the double-declining balance method, using a half-year convention (meaningthat a half-year’s depreciation is taken in the year the asset is purchased) andswitching to straight-line when advantageous. The approximate percentages (rounded to the nearest whole percent) written off each year for the first fourproperty classes are shown in Table 4.2. Rather than using the percentages in thetable, the firm can either use straight-line depreciation over the asset’s recoveryperiod with the half-year convention or use the alternative depreciation system.For purposes of this text, we will use the MACRS depreciation percentagesbecause they generally provide for the fastest write-off and therefore the best cashflow effects for the profitable firm. Because MACRS requires use of the half-year convention, assets are assumed to be acquired in the middle of the year; therefore, only one-half of the first year’sdepreciation is recovered in the first year. As a result, the final half-year of depre-ciation is recovered in the year immediately following the asset’s stated recoveryperiod. In Table 4.2, the depreciation percentages for an n-year class asset are given for years. For example, a 5-year asset is depreciated over 6 recoveryyears. The application of the tax depreciation percentages given in Table 4.2 canbe demonstrated by a simple example.n+1116 PART 2 Financial Tools recovery period The appropriate depreciable life of a particular asset asdetermined by MACRS.First Four Property Classes under MACRS Property class (recovery period) Definition 3 years Research equipment and certain special tools 5 years Computers, printers, copiers, duplicating equipment, cars, light-duty trucks, qualified technological equipment, and similar assets 7 years Office furniture, fixtures, most manufacturing equipment, railroad track, and single-purpose agricultural and horticultural structures 10 years Equipment used in petroleum refining or in the manufacture of tobacco products and certain food productsTABLE 4.1 Baker Corporation acquired, for an installed cost of $40,000, a machine having a recovery period of 5 years. Using the applicable percentages from Table 4.2,Baker calculates the depreciation in each year as follows:Example 4.23CHAPTER 4 Cash Flow and Financial Planning 117 TABLE 4.2Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes Percentage by recovery yeara Recovery year 3 years 5 years 7 years 10 years 1 33% 20% 14% 10% 24 5 3 2 2 5 1 831 5 1 9 1 8 1 44 7 12 12 1251 2 9 965 9 879 784 69 6 10 6 11 ___ ___ ___ Totals % % % % aThese percentages have been rounded to the nearest whole percent to simplify calculations while retaining realism. To calculate the actual depreciation for tax purposes, be sure to apply the actual unrounded percentages or directly apply double-declining balance depreciation using the half-year convention.100 100 100 1004 Percentages Depreciation Year Cost (from Table 4.2) [(1) (2)] (1) (2) (3) 1 $40,000 20% $ 8,000 2 40,000 32 12,8003 40,000 19 7,6004 40,000 12 4,8005 40,000 12 4,8006 40,000 Totals % $40,000 1002,000 5: Column 3 shows that the full cost of the asset is written off over 6 recovery years. Because financial managers focus primarily on cash flows, only tax deprecia- tion methods will be used throughout this textbook. DEVELOPING THE STATEMENT OF CASH FLOWS Thestatement of cash flows, introduced in Chapter 3, summarizes the firm’s cash flow over a given period. Keep in mind that analysts typically lump cash and marketable securities together when assessing the firm’s liquidity because both cash and marketable securities represent a reservoir of liquidity. That reservoir isincreased by cash inflows anddecreased by cash outflows. Also note that the firm’s cash flows fall into three categories: (1) operating flows, (2) investment flows, and (3) financing flows. The operating flows are cash inflows and outflows directly related to the sale and production of the firm’sproducts and services. Investment flows are cash flows associated with the pur- chase and sale of both fixed assets and equity investments in other firms. Clearly,purchase transactions would result in cash outflows, whereas sales transactionswould generate cash inflows. The financing flows result from debt and equity financing transactions. Incurring either short-term or long-term debt would resultin a corresponding cash inflow; repaying debt would result in an outflow.Similarly, the sale of the company’s stock would result in a cash inflow; the repur-chase of stock or payment of cash dividends would result in an outflow. Classifying Inflows and Outflows of Cash The statement of cash flows, in effect, summarizes the inflows and outflows ofcash during a given period. Table 4.3 classifies the basic inflows (sources) andoutflows (uses) of cash. For example, if a firm’s accounts payable balanceincreased by $1,000 during the year, the change would be an inflow of cash. The change would be an outflow of cash if the firm’s inventory increased by $2,500. A few additional points can be made with respect to the classification scheme in Table 4.3: 1. A decrease in an asset, such as the firm’s cash balance, is an inflow of cash. Why? Because cash that has been tied up in the asset is released and can beused for some other purpose, such as repaying a loan. On the other hand, anincrease in the firm’s cash balance is an outflow of cash because additional cash is being tied up in the firm’s cash balance. The classification of decreases and increases in a firm’s cash balance is difficult for many to grasp. To clarify, imagine that you store all your cash ina bucket. Your cash balance is represented by the amount of cash in thebucket. When you need cash, you withdraw it from the bucket, whichdecreases your cash balance and provides an inflow of cash to you. Conversely, when you have excess cash, you deposit it in the bucket, whichincreases your cash balance and represents an outflow of cash from you. Focus on the movement of funds in and out of your pocket : Clearly, a decrease in cash (from the bucket) is an inflow (to your pocket); an increasein cash (in the bucket) is an outflow (from your pocket).118 PART 2 Financial Tools operating flows Cash flows directly related to sale and production of thefirm’s products and services. investment flows Cash flows associated withpurchase and sale of both fixed assets and equity investments in other firms. financing flows Cash flows that result fromdebt and equity financingtransactions; includeincurrence and repayment ofdebt, cash inflow from the saleof stock, and cash outflows torepurchase stock or pay cashdividends. Matter of fact Apple’s Cash Flows In its 2009 annual report, Apple reported over $10 billion in cash from its operating activities. In the same year, Apple used $17.4 billion in cash to invest in marketable securities and other invest- ments. By comparison, its financing cash flows were negligible, resulting in a cash inflow of about $663 million, mostly from stock issued to employees as part of Apple’s compensation plans. Inflows and Outflows of Cash Inflows (sources) Outflows (uses) Decrease in any asset Increase in any asset Increase in any liability Decrease in any liabilityNet profits after taxes Net lossDepreciation and other Dividends paid noncash charges Sale of stock Repurchase or retirement of stockTABLE 4.3 2. Depreciation (like amortization and depletion) is a noncash charge —an expense that is deducted on the income statement but does not involve anactual outlay of cash. Therefore, when measuring the amount of cash flowgenerated by a firm, we have to add depreciation back to net income or wewill understate the cash that the firm has truly generated. For this reason,depreciation appears as a source of cash in Table 4.3. 3. Because depreciation is treated as a separate cash inflow, only gross rather than netchanges in fixed assets appear on the statement of cash flows. The change in net fixed assets is equal to the change in gross fixed assets minusthe depreciation charge. Therefore, if we treated depreciation as a cash inflowas well as the reduction in net (rather than gross) fixed assets, we would bedouble counting depreciation. 4. Direct entries of changes in retained earnings are not included on the state- ment of cash flows. Instead, entries for items that affect retained earningsappear as net profits or losses after taxes and dividends paid. Preparing the Statement of Cash Flows The statement of cash flows uses data from the income statement, along with thebeginning- and end-of-period balance sheets. The income statement for the yearended December 31, 2012, and the December 31 balance sheets for 2011 and2012 for Baker Corporation are given in Tables 4.4 and 4.5 (see page 120), respec-tively. The statement of cash flows for the year ended December 31, 2012, for BakerCorporation is presented in Table 4.6 (see page 121). Note that all cash inflows as well as net profits after taxes and depreciation are treated as positive values.CHAPTER 4 Cash Flow and Financial Planning 119 noncash charge An expense that is deducted on the income statement but doesnot involve the actual outlay ofcash during the period;includes depreciation,amortization, and depletion. Baker Corporation 2012 Income Statement ($000) Sales revenue $1,700 Less: Cost of goods sold Gross profits Less: Operating expenses Selling, general, and administrative expense $ 230Depreciation expense Total operating expense Earnings before interest and taxes (EBIT) $ 370 Less: Interest expense Net profits before taxes $ 300 Less: Taxes (rate 40%) Net profits after taxes $ 180 Less: Preferred stock dividends Earnings available for common stockholders Earnings per share (EPS) a$1.70 aCalculated by dividing the earnings available for common stockholders by the number of shares of common stock outstanding ($170,000 100,000 shares $1.70 per share).= ,$1 7 010120 =70$3 3 0100$7 0 01,000TABLE 4.4 All cash outflows, any losses, and dividends paid are treated as negative values. The items in each category—operating, investment, and financing—are totaled,and the three totals are added to get the “Net increase (decrease) in cash and mar-ketable securities” for the period. As a check, this value should reconcile with theactual change in cash and marketable securities for the year, which is obtainedfrom the beginning- and end-of-period balance sheets. Interpreting the Statement The statement of cash flows allows the financial manager and other interestedparties to analyze the firm’s cash flow. The manager should pay special attentionboth to the major categories of cash flow and to the individual items of cashinflow and outflow, to assess whether any developments have occurred that arecontrary to the company’s financial policies. In addition, the statement can beused to evaluate progress toward projected goals or to isolate inefficiencies. The120 PART 2 Financial Tools Baker Corporation Balance Sheets ($000) December 31 Assets 2012 2011 Cash and marketable securities $1,000 $ 500 Accounts receivable 400 500Inventories Total current assets Land and buildings $1,200 $1,050Machinery and equipment, furniture and fixtures, vehicles, and other Total gross fixed assets (at cost) $2,500 $2,200 Less: Accumulated depreciation Net fixed assetsTotal assets Liabilities and Stockholders’ Equity Accounts payable $ 700 $ 500 Notes payable 600 700Accruals Total current liabilities $1,400 $1,400 Long-term debt Total liabilities Preferred stock $ 100 $ 100Common stock—$1.20 par, 100,000 shares outstanding in 2012 and 2011 120 120 Paid-in capital in excess of par on common stock 380 380 Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity $2,900 $3,200$1,100 $1,200500 600$1,800 $2,000400 600200 100$2,900 $3,200$1,000 $1,2001,200 1,3001,150 1,300$1,900 $2,000900 600TABLE 4.5 financial manager also can prepare a statement of cash flows developed from projected financial statements to determine whether planned actions are desirablein view of the resulting cash flows. Operating Cash Flow A firm’s operating cash flow (OCF) is the cash flow it generates from its normal operations—producing and selling its output of goodsor services. A variety of definitions of OCF can be found in the financial litera-ture. The definition introduced here excludes the impact of interest on cash flow.We exclude those effects because we want a measure that captures the cash flowgenerated by the firm’s operations, not by how those operations are financed andtaxed. The first step is to calculate net operating profits after taxes (NOPAT), which represent the firm’s earnings before interest and after taxes. Letting T equal the applicable corporate tax rate, NOPAT is calculated as follows: (4.1) To convert NOPAT to operating cash flow (OCF), we merely add back depreciation: (4.2) OCF =NOPAT +DepreciationNOPAT =EBIT *(1-T)CHAPTER 4 Cash Flow and Financial Planning 121 TABLE 4.6Baker Corporation Statement of Cash Flows ($000) for the Year Ended December 31, 2012 Cash Flow from Operating Activities Net profits after taxes $180Depreciation 100Decrease in accounts receivable 100Decrease in inventories 300Increase in accounts payable 200Decrease in accruals ( ) a Cash provided by operating activities $780 Cash Flow from Investment Activities Increase in gross fixed assets ($300)Changes in equity investments in other firms Cash provided by investment activities ( ) Cash Flow from Financing Activities Decrease in notes payable ($100)Increase in long-term debts 200Changes in stockholders’ equity b0 Dividends paid ( ) Cash provided by financing activitiesNet increase in cash and marketable securities aAs is customary, parentheses are used to denote a negative number, which in this case is a cash outflow. bRetained earnings are excluded here, because their change is actually reflected in the combination of the “Net profits after taxes” and “Dividends paid” entries.$500$2 080$3000100 operating cash flow (OCF) The cash flow a firm generates from its normal operations; calculated as net operating profits after taxes (NOPAT) plus depreciation. net operating profits after taxes (NOPAT) A firm’s earnings before interest and after taxes,EBIT (1 T). – * We can substitute the expression for NOPAT from Equation 4.1 into Equation 4.2 to get a single equation for OCF: (4.3) Substituting the values for Baker Corporation from its income statement (Table4.4) into Equation 4.3, we get During 2012, Baker Corporation generated $322,000 of cash flow from pro- ducing and selling its output. Therefore, we can conclude that Baker’s operations are generating positive cash flows. FREE CASH FLOW The firm’s free cash flow (FCF) represents the cash available to investors—the providers of debt (creditors) and equity (owners)—after the firm has met all oper-ating needs and paid for net investments in fixed assets and current assets. Freecash flow can be defined as follows: (4.4) Thenet fixed asset investment (NFAI ) is the net investment that the firm makes in fixed assets and refers to purchases minus sales of fixed assets. You cancalculate the NFAI using Equation 4.5. (4.5) The NFAI is also equal to the change in gross fixed assets from one year to thenext. Using the Baker Corporation’s balance sheets in Table 4.5, we see that its change innet fixed assets between 2011 and 2012 was $200 ($1,200 in 2012 $1,000 in2011). Substituting this value and the $100 of depreciation for 2012 into Equation4.5, we get Baker’s net fixed asset investment (NFAI) for 2012: Baker Corporation therefore invested a net $300,000 in fixed assets during 2012. This amount would, of course, represent a cash outflow to acquire fixed assets during 2012. Looking at Equation 4.5, we can see that if net fixed assets decline by an amount exceeding the depreciation for the period, the NFAI would be negative. A nega-tive NFAI represents a net cash inflow attributable to the fact that the firm sold more assets than it acquired during the year. Thenet current asset investment (NCAI) represents the net investment made by the firm in its current (operating) assets. “Net” refers to the difference betweencurrent assets and the sum of accounts payable and accruals. Notes payable areNFAI =$200 +$100 =$300- + Example 4.43NFAI =Change in net fixed assets +Depreciation- Net current asset investment (NCAI)FCF =OCF -Net fixed asset investment (NFAI)OCF =3$370 *(1.00 -0.40)] +$100 =$222 +$100 =$322Example 4.33OCF =3EBIT *(1-T)4+Depreciation122 PART 2 Financial Tools free cash flow (FCF) The amount of cash flow available to investors (creditorsand owners) after the firm hasmet all operating needs andpaid for investments in netfixed assets and net currentassets. not included in the NCAI calculation because they represent a negotiated creditor claim on the firm’s free cash flow. Equation 4.6 shows the NCAI calculation: (4.6) Looking at the Baker Corporation’s balance sheets for 2011 and 2012 in Table4.5, we see that the change in current assets between 2011 and 2012 is $100($2,000 in 2012 $1,900 in 2011). The difference between Baker’s accountspayable plus accruals of $800 in 2012 ($700 in accounts payable $100 inaccruals) and of $700 in 2011 ($500 in accounts payable $200 in accruals) is $100 ($800 in 2012 $700 in 2011). Substituting into Equation 4.6 the change in current assets and the change in the sum of accounts payable plusaccruals for Baker Corporation, we get its 2012 NCAI: This means that during 2012 Baker Corporation made no investment ($0) in its current assets net of accounts payable and accruals. Now we can substitute Baker Corporation’s 2012 operating cash flow (OCF) of $322, its net fixed asset investment (NFAI) of $300, and its net current assetinvestment (NCAI) of $0 into Equation 4.4 to find its free cash flow (FCF): We can see that during 2012 Baker generated $22,000 of free cash flow, which it can use to pay its investors—creditors (payment of interest) and owners (paymentof dividends). Thus, the firm generated adequate cash flow to cover all of itsoperating costs and investments and had free cash flow available to pay investors.However, Baker’s interest expense in 2012 was $70,000, so the firm is not gener- ating enough FCF to provide a sufficient return to its investors. Clearly, cash flow is the lifeblood of the firm. The Focus on Practice box dis- cusses Cisco System’s free cash flow.FCF =$322 -$300 -$0=$22NCAI =$100 -$100 =$0- +++-+Example 4.53NCAI =Change in current assets -Change in (accounts payable +accruals)CHAPTER 4 Cash Flow and Financial Planning 123 focus on PRACTICE Free Cash Flow at Cisco Systems granted its employees. The analyst com- plained, “Cisco is being run for the ben- efit of its employees and not its public shareholders. ” 3Free cash flow is often consid- ered a more reliable measure of a company’s income than reported earnings. What are some possible ways that corporate accountants might be able to change their earn- ings to portray a more favorable earnings statement?Cisco beat the street ’s forecast, one cent could be attributed to the fact that the quarter was 14 weeks rather than the more typical 13 weeks. Another pennywas attributable to unusual tax gains,and the third was classified with thesomewhat vague label, “other income. ” Other analysts were even more skeptical. One noted that Cisco ’s free cash flow in the prior three quarters had been $6.24 billion, but $5.55 billion of thathad been spent to buy shares to offset dilution from the stock options that CiscoOn May 13, 2010, Cisco Systems issued what at first glance appeared to be afavorable earnings report, saying that they had achieved earnings per share of $0.42 for the most recent quarter,ahead of the expectations of WallStreet experts who had projected EPSof $0.39. Oddly, though, Cisco stock began to fall after the earnings announcement. In subsequent analysis, one analyst observed that of the three cents by whichin practice Source: “Update Cisco Systems (CSCO),” May 13, 2010, http://jubakpicks.com ; Eric Savitz, “Cisco Shares Off Despite Strong FYQ3; Focus on Q4 Guidance,” May 13, 2010, http://blogs.barrons.com . In the next section, we consider various aspects of financial planning for cash flow and profit. 6REVIEW QUESTIONS 4–1Briefly describe the first four modified accelerated cost recovery system (MACRS) property classes and recovery periods. Explain how the depreciation percentages are determined by using the MACRS recoveryperiods. 4–2Describe the overall cash flow through the firm in terms of operating flows, investments flows, and financing flows. 4–3Explain why a decrease in cash is classified as a cash inflow (source) and why an increase in cash is classified as a cash outflow (use) in preparing the statement of cash flows. 4–4Why is depreciation (as well as amortization and depletion) consideredanoncash charge? 4–5Describe the general format of the statement of cash flows. How are cash inflows differentiated from cash outflows on this statement? 4–6Why do we exclude interest expense and taxes from operating cashflow? 4–7From a strict financial perspective, define and differentiate between afirm’s operating cash flow (OCF) and its free cash flow (FCF).124 PART 2 Financial Tools 4.2The Financial Planning Process Financial planning is an important aspect of the firm’s operations because it pro- vides road maps for guiding, coordinating, and controlling the firm’s actions toachieve its objectives. Two key aspects of the financial planning process are cash planning andprofit planning. Cash planning involves preparation of the firm’s cash budget. Profit planning involves preparation of pro forma statements. Boththe cash budget and the pro forma statements are useful for internal financialplanning. They also are routinely required by existing and prospective lenders. Thefinancial planning process begins with long-term, or strategic, financial plans. These, in turn, guide the formulation of short-term, or operating, plans and budgets. Generally, the short-term plans and budgets implement the firm’slong-term strategic objectives. Although the remainder of this chapter places pri-mary emphasis on short-term financial plans and budgets, a few preliminarycomments on long-term financial plans are in order. LONG-TERM (STRATEGIC) FINANCIAL PLANS Long-term (strategic) financial plans lay out a company’s planned financial actions and the anticipated impact of those actions over periods ranging from 2 to 10 years. Five-year strategic plans, which are revised as significant new infor-mation becomes available, are common. Generally, firms that are subject to highdegrees of operating uncertainty, relatively short production cycles, or both, tendto use shorter planning horizons.financial planning process Planning that begins with long- term, or strategic, financial plans that in turn guide theformulation of short-term, or operating, plans and budgets. long-term (strategic) financial plans Plans that lay out a company’s planned financial actions andthe anticipated impact of thoseactions over periods rangingfrom 2 to 10 years.LG3 Long-term financial plans are part of an integrated strategy that, along with production and marketing plans, guides the firm toward strategic goals. Those long-term plans consider proposed outlays for fixed assets, research and developmentactivities, marketing and product development actions, capital structure, and majorsources of financing. Also included would be termination of existing projects,product lines, or lines of business; repayment or retirement of outstanding debts;and any planned acquisitions. Such plans tend to be supported by a series of annualbudgets. The Focus on Ethics box shows how one CEO dramatically reshaped his company’s operating structure, although it later cost him his job. SHORT-TERM (OPERATING) FINANCIAL PLANS Short-term (operating) financial plans specify short-term financial actions and the anticipated impact of those actions. These plans most often cover a 1- to 2-yearperiod. Key inputs include the sales forecast and various forms of operating andfinancial data. Key outputs include a number of operating budgets, the cashbudget, and pro forma financial statements. The entire short-term financial plan-ning process is outlined in Figure 4.1 on page 126. Here we focus solely on cashand profit planning from the financial manager’s perspective.CHAPTER 4 Cash Flow and Financial Planning 125 focus on ETHICS How Much Is a CEO Worth? When Jack Welch retired as chairman and CEO of General Electric in 2000,Robert L. Nardelli was part of a lengthyand well-publicized succession plan- ning saga; he eventually lost the job to Jeff Immelt. Nardelli was quickly hiredby The Home Depot, one of severalcompanies competing for his services,who offered generous incentives for him to come on board. Using the “Six Sigma ” management strategy from GE, Nardelli dramaticallyoverhauled The Home Depot andreplaced its freewheeling entrepre- neurial culture. He changed the de- centralized management structure byeliminating and consolidating divisionexecutives. He also installed processesand streamlined operations, most notably implementing a computerized automated inventory system and central-izing supply orders at the Atlanta head-quarters. Nardelli was credited withdoubling the sales of the chain andimproving its competitive position. Revenue increased from $45.7 billion in 2000 to $81.5 billion in 2005, while profit rose from $2.6 billion to$5.8 billion. However, the company ’s stagnating share price; Nardelli ’s results-driven management style, which turned off both employees and customers; and hiscompensation package eventuallyearned the ire of investors. Despite having received the solid support of The Home Depot ’s board of directors, Nardelli abruptly resigned on January3, 2007. He was not destined forpoverty, as his severance package hadbeen negotiated years earlier when he joined The Home Depot. The total sev- erance package amounted to $210million, including $55.3 million of lifeinsurance coverage, reimbursement of$1.3 million of Nardelli ’s personal taxes related to the life insurance, $50,000 to cover his legal fees,$33.8 million in cash due July 3,2007, an additional $18 million over 4 years for abiding by the terms of thedeal, and the balance of the packagefrom accelerated vesting of stock options. In addition, Nardelli and his family would receive health care bene-fits from the company for the next 3 years. The mammoth payoff for Nardelli ’s departure caused uproar among many shareholder activists because The HomeDepot ’s stock fell 8 percent during his 6-year tenure. Clearly, the mantra of shareholder activists today is, “Ask not what you can do for your company, askwhat your company can do for share-holders. ” The spotlight will no longer be only on what a CEO does, but also on how much the CEO is paid. 3 Do you think shareholder activists would have been as upset with Nardelli’s severance package had The Home Depot’s stock performed much better under his leadership?in practiceshort-term (operating) financial plans Specify short-term financial actions and the anticipatedimpact of those actions. Short-term financial planning begins with the sales forecast. From it, compa- nies develop production plans that take into account lead (preparation) times andinclude estimates of the required raw materials. Using the production plans, thefirm can estimate direct labor requirements, factory overhead outlays, and oper-ating expenses. Once these estimates have been made, the firm can prepare a proforma income statement and cash budget. With these basic inputs, the firm canfinally develop a pro forma balance sheet. The first step in personal financial planning requires you to define your goals. Whereas in a corporation, the goal is to max- imize owner wealth (that is, share price), individuals typically have a number ofmajor goals. Generally personal goals can be short-term (1 year), intermediate-term (2 to 5 years), or long-term (6 or more years). The short- and intermediate-term goalssupport the long-term goals. Clearly, types of long-term personal goals depend onthe individual’s or family’s age, and goals will continue to change with one’s lifesituation. You should set your personal financial goals carefully and realistically. Each goal should be clearly defined and have a priority, time frame, and cost estimate.For example, a college senior’s intermediate-term goal in 2012 might includeearning a master’s degree at a cost of $40,000 by 2014, and his or her long-term goal might be to buy a condominium at a cost of $125,000 by 2016. Throughout the remainder of this chapter, we will concentrate on the key outputs of the short-term financial planning process: the cash budget, the proforma income statement, and the pro forma balance sheet.Personal Finance Example 4.63126 PART 2 Financial Tools Pro Forma Income Statement Pro Forma Balance SheetCurrent- Period Balance SheetCash BudgetProduction PlansSales Forecast Long-Term Financing Plan Fixed Asset Outlay PlanInformation Needed Output for AnalysisFIGURE 4.1 Short-Term Financial PlanningThe short-term (operating) financial planning process 6REVIEW QUESTIONS 4–8What is the financial planning process? Contrast long-term (strategic) financial plans andshort-term (operating) financial plans. 4–9Which three statements result as part of the short-term (operating) financial planning process?CHAPTER 4 Cash Flow and Financial Planning 127 4.3Cash Planning: Cash Budgets Thecash budget, orcash forecast, is a statement of the firm’s planned inflows and outflows of cash. It is used by the firm to estimate its short-term cash require-ments, with particular attention being paid to planning for surplus cash and forcash shortages. Typically, the cash budget is designed to cover a 1-year period, divided into smaller time intervals. The number and type of intervals depend on the nature ofthe business. The more seasonal and uncertain a firm’s cash flows, the greater thenumber of intervals. Because many firms are confronted with a seasonal cashflow pattern, the cash budget is quite often presented on a monthly basis . Firms with stable patterns of cash flow may use quarterly or annual time intervals. THE SALES FORECAST The key input to the short-term financial planning process is the firm’s sales fore- cast. This prediction of the firm’s sales over a given period is ordinarily prepared by the marketing department. On the basis of the sales forecast, the financialmanager estimates the monthly cash flows that will result from projected salesand from outlays related to production, inventory, and sales. The manager alsodetermines the level of fixed assets required and the amount of financing, if any,needed to support the forecast level of sales and production. In practice,obtaining good data is the most difficult aspect of forecasting. The sales forecastmay be based on an analysis of external data, internal data, or a combination ofthe two. Anexternal forecast is based on the relationships observed between the firm’s sales and certain key external economic indicators such as the gross domesticproduct (GDP), new housing starts, consumer confidence, and disposable per-sonal income. Forecasts containing these indicators are readily available. Internal forecasts are based on a consensus of sales forecasts through the firm’s own sales channels. Typically, the firm’s salespeople in the field are asked toestimate how many units of each type of product they expect to sell in the comingyear. These forecasts are collected and totaled by the sales manager, who mayadjust the figures using knowledge of specific markets or of the salesperson’sforecasting ability. Finally, adjustments may be made for additional internal fac-tors, such as production capabilities. Firms generally use a combination of external and internal forecast data to make the final sales forecast. The internal data provide insight into sales expecta-tions, and the external data provide a means of adjusting these expectations totake into account general economic factors. The nature of the firm’s product alsooften affects the mix and types of forecasting methods used.cash budget (cash forecast) A statement of the firm’s planned inflows and outflowsof cash that is used to estimateits short-term cashrequirements. sales forecast The prediction of the firm’ssales over a given period, based on external and/or internal data; used as the keyinput to the short-term financialplanning process. external forecast A sales forecast based on therelationships observed betweenthe firm’s sales and certain keyexternal economic indicators. internal forecast A sales forecast based on abuildup, or consensus, of salesforecasts through the firm’sown sales channels.LG4 PREPARING THE CASH BUDGET The general format of the cash budget is presented in Table 4.7. We will discuss each of its components individually. Cash Receipts Cash receipts include all of a firm’s inflows of cash during a given financial period. The most common components of cash receipts are cash sales, collectionsof accounts receivable, and other cash receipts. Coulson Industries, a defense contractor, is developing a cash budget for October,November, and December. Coulson’s sales in August and September were $100,000and $200,000, respectively. Sales of $400,000, $300,000, and $200,000 have beenforecast for October, November, and December, respectively. Historically, 20% ofthe firm’s sales have been for cash, 50% have generated accounts receivable col-lected after 1 month, and the remaining 30% have generated accounts receivablecollected after 2 months. Bad-debt expenses (uncollectible accounts) have been neg-ligible. In December, the firm will receive a $30,000 dividend from stock in a sub-sidiary. The schedule of expected cash receipts for the company is presented inTable 4.8. It contains the following items: Forecast sales This initial entry is merely informational. It is provided as an aid in calculating other sales-related items. Cash sales The cash sales shown for each month represent 20% of the total sales forecast for that month. Collections of A/R These entries represent the collection of accounts receiv- able (A/R) resulting from sales in earlier months. Lagged 1 month These figures represent sales made in the preceding month that generated accounts receivable collected in the current month.Because 50% of the current month’s sales are collected 1 month later, the col-lections of A/R with a 1-month lag shown for September represent 50% ofthe sales in August, collections for October represent 50% of Septembersales, and so on.Example 4.73128 PART 2 Financial Tools The General Format of the Cash Budget Jan. Feb. . . . Nov. Dec. Cash receipts $XXX $XXG $XXM $XXT Less: Cash disbursements . . . Net cash flow $XXB $XXI $XXO $XXV Add: Beginning cash Ending cash $XXD $XXJ $XXQ $XXW Less: Minimum cash balance . . . Required total financing $XXL $XXSExcess cash balance $XXF $XXZXXY XXR XXK XXEXXQ XXP XXJ XXD XXCXXU XXN XXH XXATABLE 4.7 cash receipts All of a firm’s inflows of cash during a given financial period. Lagged 2 months These figures represent sales made 2 months earlier that generated accounts receivable collected in the current month. Because30% of sales are collected 2 months later, the collections with a 2-month lagshown for October represent 30% of the sales in August, and so on. Other cash receipts These are cash receipts expected from sources other than sales. Interest received, dividends received, proceeds from the sale ofequipment, stock and bond sale proceeds, and lease receipts may show uphere. For Coulson Industries, the only other cash receipt is the $30,000 divi-dend due in December. Total cash receipts This figure represents the total of all the cash receipts listed for each month. For Coulson Industries, we are concerned only with October, November, and December, as shown in Table 4.8. Cash Disbursements Cash disbursements include all outlays of cash by the firm during a given finan- cial period. The most common cash disbursements are Cash purchases Fixed-asset outlays Payments of accounts payable Interest paymentsRent (and lease) payments Cash dividend paymentsWages and salaries Principal payments (loans)Tax payments Repurchases or retirements of stock It is important to recognize that depreciation and other noncash charges are NOT included in the cash budget, because they merely represent a scheduled write-off of an earlier cash outflow. The impact of depreciation, as we noted ear-lier, is reflected in the reduced cash outflow for tax payments. Coulson Industries has gathered the following data needed for the preparation ofa cash disbursements schedule for October, November, and December. Purchases The firm’s purchases represent 70% of sales. Of this amount, 10% is paid in cash, 70% is paid in the month immediately following themonth of purchase, and the remaining 20% is paid 2 months following the month of purchase.Example 4.83CHAPTER 4 Cash Flow and Financial Planning 129 A Schedule of Projected Cash Receipts for Coulson Industries ($000) Aug. Sept. Oct. Nov. Dec. Sales forecast $100 $200 $400 $300 $200 Cash sales (0.20) $20 $40 $ 80 $ 60 $ 40 Collections of A/R: Lagged 1 month (0.50) 50 100 200 150Lagged 2 months (0.30) 30 60 120 Other cash receipts ____ ____ _____ _____ Total cash receipts $340 $320 $210 $90 $2030TABLE 4.8 cash disbursements All outlays of cash by the firm during a given financialperiod. Rent payments Rent of $5,000 will be paid each month. Wages and salaries Fixed salaries for the year are $96,000, or $8,000 per month. In addition, wages are estimated as 10% of monthly sales. Tax payments Taxes of $25,000 must be paid in December. Fixed-asset outlays New machinery costing $130,000 will be purchased and paid for in November. Interest payments An interest payment of $10,000 is due in December. Cash dividend payments Cash dividends of $20,000 will be paid in October. Principal payments (loans) A $20,000 principal payment is due in December. Repurchases or retirements of stock No repurchase or retirement of stock is expected between October and December. The firm’s cash disbursements schedule, using the preceding data, is shown in Table 4.9. Some items in the table are explained in greater detail below. Purchases This entry is merely informational. The figures represent 70% of the forecast sales for each month. They have been included to facilitate cal-culation of the cash purchases and related payments. Cash purchases The cash purchases for each month represent 10% of the month’s purchases. Payments of A/P These entries represent the payment of accounts payable (A/P) resulting from purchases in earlier months. Lagged 1 month These figures represent purchases made in the pre- ceding month that are paid for in the current month. Because 70% of thefirm’s purchases are paid for 1 month later, the payments with a 1-month lagshown for September represent 70% of the August purchases, payments forOctober represent 70% of September purchases, and so on.130 PART 2 Financial Tools TABLE 4.9A Schedule of Projected Cash Disbursements for Coulson Industries ($000) Aug. Sept. Oct. Nov. Dec. Purchases (0.70 sales) $70 $140 $280 $210 $140 Cash purchases (0.10) $7 $14 $ 28 $ 21 $ 14 Payments of A/P: Lagged 1 month (0.70) 49 98 196 147Lagged 2 months (0.20) 14 28 56 Rent payments 5 5 5Wages and salaries 48 38 28Tax payments 25 Fixed-asset outlays 130Interest payments 10Cash dividend payments 20Principal payments _ _ _ ____ _____ _____ Total cash disbursements $305 $418 $213 $63 $720: Lagged 2 months These figures represent purchases made 2 months ear- lier that are paid for in the current month. Because 20% of the firm’s pur-chases are paid for 2 months later, the payments with a 2-month lag forOctober represent 20% of the August purchases, and so on. Wages and salaries These amounts were obtained by adding $8,000 to 10% of the sales in each month. The $8,000 represents the salary component; the rest represents wages. The remaining items on the cash disbursements schedule are self-explanatory. Net Cash Flow, Ending Cash, Financing, and Excess Cash Look back at the general-format cash budget in Table 4.7 on page 128. We haveinputs for the first two entries, and we now continue calculating the firm’s cashneeds. The firm’s net cash flow is found by subtracting the cash disbursements from cash receipts in each period. Then we add beginning cash to the firm’s netcash flow to determine the ending cash for each period. Finally, we subtract the desired minimum cash balance from ending cash to find the required total financing or the excess cash balance. If the ending cash is less than the minimum cash balance, financing is required. Such financing is typ- ically viewed as short-term and is therefore represented by notes payable. If theending cash is greater than the minimum cash balance, excess cash exists. Any excess cash is assumed to be invested in a liquid, short-term, interest-payingvehicle—that is, in marketable securities. Table 4.10 presents Coulson Industries’ cash budget. The company wishes tomaintain, as a reserve for unexpected needs, a minimum cash balance of $25,000.For Coulson Industries to maintain its required $25,000 ending cash balance, itwill need total borrowing of $76,000 in November and $41,000 in December. InOctober the firm will have an excess cash balance of $22,000, which can be held Example 4.93CHAPTER 4 Cash Flow and Financial Planning 131 net cash flow The mathematical difference between the firm’s cashreceipts and its cashdisbursements in each period. ending cash The sum of the firm’s beginningcash and its net cash flow forthe period. required total financing Amount of funds needed by thefirm if the ending cash for theperiod is less than the desiredminimum cash balance;typically represented by notespayable. excess cash balance The (excess) amount availablefor investment by the firm if theperiod’s ending cash is greaterthan the desired minimum cashbalance; assumed to beinvested in marketablesecurities. A Cash Budget for Coulson Industries ($000) Oct. Nov. Dec. Total cash receiptsa$210 $320 $340 Less: Total cash disbursementsb Net cash flow ($ 3) ($ 98) $ 35 Add: Beginning cash ( ) Ending cash $ 47 ($ 51) ($ 16) Less: Minimum cash balance Required total financing (notes payable)c$ 76 $ 41 Excess cash balance (marketable securities)d$ 22 aFrom Table 4.8. bFrom Table 4.9. cValues are placed in this line when the ending cash is less than the desired minimum cash balance. These amounts are typically financed short-term and therefore are represented by notes payable. dValues are placed in this line when the ending cash is greater than the desired minimum cash balance. These amounts are typically assumed to be invested short-term and therefore are represented by marketable securities.25 25 2551 47 50305 418 213TABLE 4.10 in an interest-earning marketable security. The required total financing figures in the cash budget refer to how much will be owed at the end of the month; they do notrepresent the monthly changes in borrowing. The monthly changes in borrowing and in excess cash can be found by fur- ther analyzing the cash budget. In October the $50,000 beginning cash, whichbecomes $47,000 after the $3,000 net cash outflow, results in a $22,000 excesscash balance once the $25,000 minimum cash is deducted. In November the$76,000 of required total financing resulted from the $98,000 net cash outflowless the $22,000 of excess cash from October. The $41,000 of required totalfinancing in December resulted from reducing November’s $76,000 of requiredtotal financing by the $35,000 of net cash inflow during December. Summarizing,thefinancial activities for each month would be as follows: October: Invest the $22,000 excess cash balance in marketable securities. November: Liquidate the $22,000 of marketable securities and borrow $76,000 (notes payable). December: Repay $35,000 of notes payable to leave $41,000 of out- standing required total financing. EVALUATING THE CASH BUDGET The cash budget indicates whether a cash shortage or surplus is expected in each of the months covered by the forecast. Each month’s figure is based on the inter-nally imposed requirement of a minimum cash balance and represents the total balance at the end of the month. At the end of each of the 3 months, Coulson expects the following balances in cash, marketable securities, and notes payable:132 PART 2 Financial Tools End-of-month balance ($000) Account Oct. Nov. Dec. Cash $25 $25 $25 Marketable securities 22 0 0Notes payable 0 76 41 Note that the firm is assumed first to liquidate its marketable securities to meet deficits and then to borrow with notes payable if additional financing is needed.As a result, it will not have marketable securities and notes payable on its booksat the same time. Because it may be necessary to borrow up to $76,000 for the 3-month period, the financial manager should be certain that some arrangementis made to ensure the availability of these funds. Because individuals receive only a finite amount of income (cash inflow) during a given period, they need to prepare budgets to make sure they can cover their expenses (cash outflows) during theperiod. The personal budget is a short-term financial planning report that helps individuals or families achieve short-term financial goals. Personal budgets typi-cally cover a 1-year period, broken into months.Personal Finance Example 4.10 3 A condensed version of a personal budget for the first quarter (3 months) is shown below. CHAPTER 4 Cash Flow and Financial Planning 133 Jan. Feb. Mar. Income Take-home pay $4,775 $4,775 $4,775Investment income ______ ______ (1) Total income Expenses (2) Total expensesCash surplus or deficit ( ) ( )Cumulative cash surplus or deficit ( ) $2,298 $2 3 3 $ 749$2,531 $5 1 6 $ 749 3(1) -(2)4$7,396 $5,291 $4,026$4,865 $4,775 $4,77590 The personal budget shows a cash surplus of $749 in January followed by monthly deficits in February and March of $516 and $2,531, resulting in a cumu-lative deficit of $2,298 through March. Clearly, to cover the deficit, someaction—such as increasing income, reducing expenses, drawing down savings, orborrowing—will be necessary to bring the budget into balance. Borrowing byusing credit can offset a deficit in the short term but can lead to financial trouble if done repeatedly. COPING WITH UNCERTAINTY IN THE CASH BUDGET Aside from careful estimation of cash budget inputs, there are two ways ofcoping with uncertainty in the cash budget. One is to prepare several cashbudgets—based on pessimistic, most likely, and optimistic forecasts. From thisrange of cash flows, the financial manager can determine the amount offinancing necessary to cover the most adverse situation. The use of several cashbudgets, based on differing scenarios, also should give the financial manager asense of the riskiness of the various alternatives. This scenario analysis, or “what if” approach, is often used to analyze cash flows under a variety of circum-stances. Clearly, the use of electronic spreadsheets simplifies the process of per-forming scenario analysis. Table 4.11 presents the summary of Coulson Industries’ cash budget prepared foreach month using pessimistic, most likely, and optimistic estimates of total cashreceipts and disbursements. The most likely estimate is based on the expectedoutcomes presented earlier. During October, Coulson will, at worst, need a maximum of $15,000 of financing and, at best, will have a $62,000 excess cash balance. DuringNovember, its financing requirement will be between $0 and $185,000, or itcould experience an excess cash balance of $5,000. The December projectionsshow maximum borrowing of $190,000 with a possible excess cash balance of$107,000. By considering the extreme values in the pessimistic and optimisticExample 4.11 3 outcomes, Coulson Industries should be better able to plan its cash requirements. For the 3-month period, the peak borrowing requirement under the worst cir-cumstances would be $190,000, which happens to be considerably greater than the most likely estimate of $76,000 for this period. A second and much more sophisticated way of coping with uncertainty in the cash budget is simulation (discussed in Chapter 12). By simulating the occurrence of sales and other uncertain events, the firm can develop a probability distribu-tion of its ending cash flows for each month. The financial decision maker canthen use the probability distribution to determine the amount of financing neededto protect the firm adequately against a cash shortage. CASH FLOW WITHIN THE MONTH Because the cash budget shows cash flows only on a total monthly basis, theinformation provided by the cash budget is not necessarily adequate for ensuringsolvency. A firm must look more closely at its pattern of daily cash receipts andcash disbursements to ensure that adequate cash is available for paying bills asthey come due. The synchronization of cash flows in the cash budget at month-end does not ensure that the firm will be able to meet its daily cash requirements. Because afirm’s cash flows are generally quite variable when viewed on a daily basis, effec-tive cash planning requires a look beyond the cash budget. The financial manager must therefore plan and monitor cash flow more frequently than on a monthlybasis. The greater the variability of cash flows from day to day, the greater theamount of attention required.134 PART 2 Financial Tools A Scenario Analysis of Coulson Industries’ Cash Budget ($000) October November December Pessi- Most Opti- Pessi- Most Opti- Pessi- Most Opti- mistic likely mistic mistic likely mistic mistic likely mistic Total cash receipts $160 $210 $285 $210 $320 $410 $275 $340 $422 Less: Total cash disbursements Net cash flow ($ 40) ($ 3) $ 37 ($170) ($ 98) ($ 57) ($ 5) $ 35 $102 Add: Beginning cash () () Ending cash $ 10 $ 47 $ 87 ($160) ($ 51) $ 30 ($165) ($ 16) $132 Less: Minimum cash balance Required total financing $ 15 $185 $ 76 $190 $ 41 Excess cash balance $ 22 $ 62 $ 5 $10725 25 25 25 25 25 25 25 2530 51 160 87 47 10 50 50 50320 305 280 467 418 380 248 213 200TABLE 4.11 6REVIEW QUESTIONS 4–10 What is the purpose of the cash budget? What role does the sales fore- cast play in its preparation? 4–11 Briefly describe the basic format of the cash budget. 4–12 How can the two “bottom lines” of the cash budget be used to deter- mine the firm’s short-term borrowing and investment requirements? 4–13 What is the cause of uncertainty in the cash budget, and what two tech-niques can be used to cope with this uncertainty?CHAPTER 4 Cash Flow and Financial Planning 135 4.4Profit Planning: Pro Forma Statements Whereas cash planning focuses on forecasting cash flows, profit planning relies on accrual concepts to project the firm’s profit and overall financial position.Shareholders, creditors, and the firm’s management pay close attention to the pro forma statements which are projected income statements and balance sheets. The basic steps in the short-term financial planning process were shown in the flowdiagram of Figure 4.1. The approaches for estimating the pro forma statements areall based on the belief that the financial relationships reflected in the firm’s pastfinancial statements will not change in the coming period. The commonly used sim-plified approaches are presented in subsequent discussions. Two inputs are required for preparing pro forma statements: (1) financial statements for the preceding year and (2) the sales forecast for the coming year. A variety of assumptions must also be made. The company that we will use to illus-trate the simplified approaches to pro forma preparation is Vectra Manufacturing,which manufactures and sells one product. It has two basic product models, Xand Y, which are produced by the same process but require different amounts ofraw material and labor. PRECEDING YEAR’S FINANCIAL STATEMENTS The income statement for the firm’s 2012 operations is given in Table 4.12 on page136. It indicates that Vectra had sales of $100,000, total cost of goods sold of$80,000, net profits before taxes of $9,000, and net profits after taxes of $7,650.The firm paid $4,000 in cash dividends, leaving $3,650 to be transferred to retainedearnings. The firm’s balance sheet for 2012 is given in Table 4.13 on page 136. SALES FORECAST Just as for the cash budget, the key input for pro forma statements is the salesforecast. Vectra Manufacturing’s sales forecast for the coming year (2013), basedon both external and internal data, is presented in Table 4.14 on page 136. Theunit sale prices of the products reflect an increase from $20 to $25 for model X andfrom $40 to $50 for model Y. These increases are necessary to cover anticipatedincreases in costs. 6REVIEW QUESTION 4–14 What is the purpose of pro forma statements? What inputs are required for preparing them using the simplified approaches?pro forma statements Projected, or forecast, income statements and balance sheets.LG5 Vectra Manufacturing’s Income Statement for the Year Ended December 31, 2012 Sales revenue Model X (1,000 units at $20/unit) $ 20,000Model Y (2,000 units at $40/unit) Total sales Less: Cost of goods sold Labor $ 28,500Material A 8,000Material B 5,500Overhead Total cost of goods sold Gross profits $ 20,000 Less: Operating expenses Operating profits $ 10,000 Less: Interest expense Net profits before taxes $ 9,000 Less: Taxes (0.15 $9,000) Net profits after taxes $ 7,650 Less: Common stock dividends To retained earnings $ 3,6504,0001,350 *1,00010,000$ 80,00038,000$100,00080,000TABLE 4.12 Vectra Manufacturing’s Balance Sheet, December 31, 2012 Assets Liabilities and Stockholders’ Equity Cash $ 6,000 Accounts payable $ 7,000 Marketable securities 4,000 Taxes payable 300Accounts receivable 13,000 Notes payable 8,300Inventories Other current liabilities Total current assets $39,000 Total current liabilities $19,000 Net fixed assets Long-term debt Total assets Total liabilities $37,000 Common stock 30,000Retained earnings Total liabilities and stockholders’ equity $90,000 23,000$90,00018,000 51,0003,400 16,000TABLE 4.13 2013 Sales Forecast for Vectra Manufacturing Unit sales Dollar sales Model X 1,500 Model X ($25/unit) $ 37,500Model Y 1,950 Model Y ($50/unit) Total $135,000 97,500TABLE 4.14136 PART 2 Financial Tools CHAPTER 4 Cash Flow and Financial Planning 137 4.5Preparing the Pro Forma Income Statement A simple method for developing a pro forma income statement is the percent-of-sales method. It forecasts sales and then expresses the various income statement items as percentages of projected sales. The percentages used are likely to be the percentagesof sales for those items in the previous year. By using dollar values taken fromVectra’s 2012 income statement (Table 4.12), we find that these percentages are Applying these percentages to the firm’s forecast sales of $135,000 (developed in Table 4.14), we get the 2013 pro forma income statement shown in Table 4.15.We have assumed that Vectra will pay $4,000 in common stock dividends, so theexpected contribution to retained earnings is $6,327. This represents a consider-able increase over $3,650 in the preceding year (see Table 4.12). CONSIDERING TYPES OF COSTS AND EXPENSES The technique that is used to prepare the pro forma income statement in Table4.15 assumes that all the firm’s costs and expenses are variable. That is, for a given percentage increase in sales, the same percentage increase in cost of goodssold, operating expenses, and interest expense would result. For example, asVectra’s sales increased by 35 percent, we assumed that its costs of goods soldalso increased by 35 percent. On the basis of this assumption, the firm’s netprofits before taxes also increased by 35 percent.Interest expense Sales=$1,000 $100,000=1.0%Operating expenses Sales=$10,000 $100,000=10.0%Cost of goods sold Sales=$80,000 $100,000=80.0%percent-of-sales method A simple method for developing the pro formaincome statement; it forecastssales and then expresses thevarious income statement itemsas percentages of projectedsales. A Pro Forma Income Statement, Using the Percent-of-Sales Method, for Vectra Manufacturing for the Year Ended December 31, 2013 Sales revenue $135,000 Less: Cost of goods sold (0.80) Gross profits $ 27,000 Less: Operating expenses (0.10) Operating profits $ 13,500 Less: Interest expense (0.01) Net profits before taxes $ 12,150 Less: Taxes (0.15 $12,150) Net profits after taxes $ 10,327 Less: Common stock dividends To retained earnings $ 6,3274,0001,823 *1,35013,500108,000TABLE 4.15LG5 Because this approach assumes that all costs are variable, it may understate the increase in profits that will occur when sales increase if some of the firm’scosts are fixed. Similarly, if sales decline, the percentage-of-sales method mayoverstate profits if some costs are fixed and do not fall when revenues decline.Therefore, a pro forma income statement constructed using the percentage-of-sales method generally tends to understate profits when sales are increasing and overstate profits when sales are decreasing. The best way to adjust for the pres- ence of fixed costs when preparing a pro forma income statement is to break thefirm’s historical costs and expenses into fixed andvariable components. The potential returns as well as risks resulting from use of fixed (operating and finan-cial) costs to create “leverage” are discussed in Chapter 13. The key point to rec-ognize here is that fixed costs make a firm’s profits more variable than itsrevenues. That is, when both profits and sales are rising, profits tend to increaseat a faster rate, but when profits and sales are in decline, the percentage drop inprofits is often greater than the rate of decline in sales. Vectra Manufacturing’s 2012 actual and 2013 pro forma income statements,broken into fixed and variable cost and expense components, follow: Example 4.12 3138 PART 2 Financial Tools In more depth To read about What Costs Are Fixed? go to www.myfinancelab.com Vectra Manufacturing Income Statements 2012 2013 Actual Pro forma Sales revenue $100,000 $135,000 Less: Cost of goods sold Fixed cost 40,000 40,000Variable cost (0.40 sales)Gross profits Less: Operating expenses Fixed expense $ 5,000 $ 5,000Variable expense (0.05 sales)Operating profits $ 10,000 $ 29,250 Less: Interest expense (all fixed) Net profits before taxes $ 9,000 $ 28,250 Less: Taxes (0.15 net profits before taxes) Net profits after taxes $ 24,012 $7 , 6 5 04,238 1,350 *1,000 1,0006,750 5,000 *$ 41,000 $ 20,00054,000 40,000 * Breaking Vectra’s costs and expenses into fixed and variable components provides a more accurate projection of its pro forma profit. By assuming that all costs are variable (as shown in Table 4.15), we find that projected net profitsbefore taxes would continue to equal 9% of sales (in 2012, $9,000 net profitsbefore taxes $100,000 sales). Therefore, the 2013 net profits before taxeswould have been $12,150 (0.09 $135,000 projected sales) instead of the $28,250 obtained by using the firm’s fixed-cost–variable-cost breakdown. Clearly, when using a simplified approach to prepare a pro forma income statement, we should break down costs and expenses into fixed and variablecomponents.*, 6REVIEW QUESTIONS 4–15 How is the percent-of-sales method used to prepare pro forma income statements? 4–16 Why does the presence of fixed costs cause the percent-of-sales method of pro forma income statement preparation to fail? What is a bettermethod?CHAPTER 4 Cash Flow and Financial Planning 139 4.6Preparing the Pro Forma Balance Sheet A number of simplified approaches are available for preparing the pro forma bal- ance sheet. One involves estimating all balance sheet accounts as a strict per-centage of sales. A better and more popular approach is the judgmental approach, under which the firm estimates the values of certain balance sheet accounts anduses its external financing as a balancing, or “plug,” figure. The judgmentalapproach represents an improved version of the percent-of-sales approach to proforma balance sheet preparation. Because the judgmental approach requires onlyslightly more information and should yield better estimates than the somewhatnaive percent-of-sales approach, it is presented here. To apply the judgmental approach to prepare Vectra Manufacturing’s 2013 pro forma balance sheet, a number of assumptions must be made about levels ofvarious balance sheet accounts: 1. A minimum cash balance of $6,000 is desired. 2. Marketable securities will remain unchanged from their current level of $4,000. 3. Accounts receivable on average represent about 45 days of sales (about 1/8 of a year). Because Vectra’s annual sales are projected to be $135,000, accountsreceivable should average $16,875 (1/8 $135,000). 4. The ending inventory should remain at a level of about $16,000, of which 25 percent (approximately $4,000) should be raw materials and theremaining 75 percent (approximately $12,000) should consist of finishedgoods. 5. A new machine costing $20,000 will be purchased. Total depreciation for the year is $8,000. Adding the $20,000 acquisition to the existing net fixed assetsof $51,000 and subtracting the depreciation of $8,000 yields net fixed as-sets of $63,000. 6. Purchases will represent approximately 30 percent of annual sales, which in this case is approximately $40,500 (0.30 $135,000). The firm estimatesthat it can take 73 days on average to satisfy its accounts payable. Thusaccounts payable should equal one-fifth (73 days 365 days) of the firm’spurchases, or $8,100 (1/5 $40,500). 7. Taxes payable will equal one-fourth of the current year’s tax liability, which equals $455 (one-fourth of the tax liability of $1,823 shown in the pro formaincome statement in Table 4.15). 8. Notes payable will remain unchanged from their current level of $8,300.9. No change in other current liabilities is expected. They remain at the level of the previous year: $3,400.*,** judgmental approach A simplified approach for preparing the pro forma balance sheet under which the firm estimates the values ofcertain balance sheet accountsand uses its external financingas a balancing, or “plug,”figure.LG5 10. The firm’s long-term debt and its common stock will remain unchanged at $18,000 and $30,000, respectively; no issues, retirements, or repurchases ofbonds or stocks are planned. 11. Retained earnings will increase from the beginning level of $23,000 (from the balance sheet dated December 31, 2012, in Table 4.13) to $29,327. Theincrease of $6,327 represents the amount of retained earnings calculated inthe year-end 2013 pro forma income statement in Table 4.15. A 2013 pro forma balance sheet for Vectra Manufacturing based on these assumptions is presented in Table 4.16. A “plug” figure —called the external financing required —of $8,293 is needed to bring the statement into balance. This means that the firm will have to obtain about $8,300 of additional externalfinancing to support the increased sales level of $135,000 for 2013. Apositive value for “external financing required,” like that shown in Table 4.16, means that, based on its plans, the firm will not generate enough internalfinancing to support its forecast growth in assets. To support the forecast level ofoperation, the firm must raise funds externally by using debt and/or equityfinancing or by reducing dividends. Once the form of financing is determined, thepro forma balance sheet is modified to replace “external financing required” withthe planned increases in the debt and/or equity accounts. Anegative value for “external financing required” indicates that, based on its plans, the firm will generate more financing internally than it needs to support itsforecast growth in assets. In this case, funds are available for use in repaying debt,repurchasing stock, or increasing dividends. Once the specific actions are deter-mined, “external financing required” is replaced in the pro forma balance sheetwith the planned reductions in the debt and/or equity accounts. Obviously, besides140 PART 2 Financial Tools external financing required (“plug” figure) Under the judgmental approach for developing a proforma balance sheet, theamount of external financingneeded to bring the statementinto balance. It can be either apositive or a negative value. A Pro Forma Balance Sheet, Using the Judgmental Approach, for Vectra Manufacturing (December 31, 2013) Assets Liabilities and Stockholders’ Equity Cash $ 6,000 Accounts payable $ 8,100 Marketable securities 4,000 Taxes payable 455Accounts receivable 16,875 Notes payable 8,300Inventories Other current liabilities Raw materials $ 4,000 Total current liabilities $ 20,255Finished goods Long-term debt Total inventory Total liabilities $ 38,255Total current assets $ 42,875 Common stock 30,000 Net fixed assets Retained earnings Total assets Total $ 97,582 External financing requireda Total liabilities and stockholders’ equity aThe amount of external financing needed to force the firm’s balance sheet to balance. Because of the nature of the judgmental approach, the balance sheet is not expected to balance without some type of adjustment.$105,8758,293$105,87529,327 63,00016,00018,000 12,0003,400TABLE 4.16 being used to prepare the pro forma balance sheet, the judgmental approach is fre- quently used specifically to estimate the firm’s financing requirements. 6REVIEW QUESTIONS 4–17 Describe the judgmental approach for simplified preparation of the pro forma balance sheet. 4–18 What is the significance of the “plug” figure, external financing required? Differentiate between strategies associated with positive values and with negative values for external financing required.CHAPTER 4 Cash Flow and Financial Planning 141 4.7Evaluation of Pro Forma Statements It is difficult to forecast the many variables involved in preparing pro forma state- ments. As a result, investors, lenders, and managers frequently use the techniquespresented in this chapter to make rough estimates of pro forma financial state-ments. Yet, it is important to recognize the basic weaknesses of these simplifiedapproaches. The weaknesses lie in two assumptions: (1) that the firm’s past finan-cial condition is an accurate indicator of its future; and (2) that certain variables(such as cash, accounts receivable, and inventories) can be forced to take on cer-tain “desired” values. These assumptions cannot be justified solely on the basis oftheir ability to simplify the calculations involved. However, despite their weak-nesses, the simplified approaches to pro forma statement preparation are likely toremain popular because of their relative simplicity. The widespread use of spread-sheets certainly helps to streamline the financial planning process. However pro forma statements are prepared, analysts must understand how to use them to make financial decisions. Both financial managers and lenders canuse pro forma statements to analyze the firm’s inflows and outflows of cash, aswell as its liquidity, activity, debt, profitability, and market value. Various ratioscan be calculated from the pro forma income statement and balance sheet to eval-uate performance. Cash inflows and outflows can be evaluated by preparing apro forma statement of cash flows. After analyzing the pro forma statements, thefinancial manager can take steps to adjust planned operations to achieve short-term financial goals. For example, if projected profits on the pro forma incomestatement are too low, a variety of pricing and/or cost-cutting actions might beinitiated. If the projected level of accounts receivable on the pro forma balancesheet is too high, changes in credit or collection policy may be called for. Proforma statements are therefore of great importance in solidifying the firm’s finan-cial plans for the coming year. 6REVIEW QUESTIONS 4–19 What are the two basic weaknesses of the simplified approaches to preparing pro forma statements? 4–20 What is the financial manager’s objective in evaluating pro forma state- ments?LG6 142 PART 2 Financial Tools Summary FOCUS ON VALUE Cash flow, the lifeblood of the firm, is a key determinant of the value of the firm. The financial manager must plan and manage the firm’s cash flow. Thegoal is to ensure the firm’s solvency and to generate positive cash flow for thefirm’s owners. Both the magnitude and the risk of the cash flows generated onbehalf of the owners determine the firm’s value. To carry out the responsibility to create value for owners, the financial man- ager uses tools such as cash budgets and pro forma financial statements as partof the process of generating positive cash flow. Good financial plans shouldresult in large free cash flows. Clearly, the financial manager must deliberatelyand carefully plan and manage the firm’s cash flows to achieve the firm’s goal ofmaximizing share price. REVIEW OF LEARNING GOALS Understand tax depreciation procedures and the effect of depreciation on the firm’s cash flows. Depreciation is an important factor affecting a firm’s cash flow. An asset’s depreciable value and depreciable life are determined byusing the MACRS standards in the federal tax code. MACRS groups assets(excluding real estate) into six property classes based on length of recoveryperiod. Discuss the firm’s statement of cash flows, operating cash flow, and free cash flow. The statement of cash flows is divided into operating, investment, and financing flows. It reconciles changes in the firm’s cash flows with changesin cash and marketable securities for the period. Interpreting the statement ofcash flows involves both the major categories of cash flow and the individualitems of cash inflow and outflow. From a strict financial point of view, a firm’soperating cash flow is defined to exclude interest. Of greater importance is afirm’s free cash flow, which is the amount of cash flow available to creditors andowners. Understand the financial planning process, including long-term (strategic) financial plans and short-term (operating) financial plans. The two key aspects of the financial planning process are cash planning and profit planning. Cashplanning involves the cash budget or cash forecast. Profit planning relies on thepro forma income statement and balance sheet. Long-term (strategic) financialplans act as a guide for preparing short-term (operating) financial plans. Long-term plans tend to cover periods ranging from 2 to 10 years; short-termplans most often cover a 1- to 2-year period. Discuss the cash-planning process and the preparation, evaluation, and use of the cash budget. The cash-planning process uses the cash budget, based on a sales forecast, to estimate short-term cash surpluses and shortages. Thecash budget is typically prepared for a 1-year period divided into months. It netscash receipts and disbursements for each period to calculate net cash flow. LG4LG3LG2LG1 Ending cash is estimated by adding beginning cash to the net cash flow. By subtracting the desired minimum cash balance from the ending cash, the firmcan determine required total financing or the excess cash balance. To cope withuncertainty in the cash budget, scenario analysis or simulation can be used. A firm must also consider its pattern of daily cash receipts and cash disbursements. Explain the simplified procedures used to prepare and evaluate the pro forma income statement and the pro forma balance sheet. A pro forma income statement can be developed by calculating past percentage relationships between certain cost and expense items and the firm’s sales and then applyingthese percentages to forecasts. Because this approach implies that all costs andexpenses are variable, it tends to understate profits when sales are increasingand to overstate profits when sales are decreasing. This problem can be avoided by breaking down costs and expenses into fixed and variable components. In this case, the fixed components remain unchanged from themost recent year, and the variable costs and expenses are forecast on a percent-of-sales basis. Under the judgmental approach, the values of certain balance sheet accounts are estimated and the firm’s external financing is used as a balancing, or “plug,”figure. A positive value for “external financing required” means that the firmwill not generate enough internal financing to support its forecast growth inassets and will have to raise funds externally or reduce dividends. A negativevalue for “external financing required” indicates that the firm will generatemore financing internally than it needs to support its forecast growth in assetsand funds will be available for use in repaying debt, repurchasing stock, orincreasing dividends. Evaluate the simplified approaches to pro forma financial statement preparation and the common uses of pro forma statements. Simplified approaches for preparing pro forma statements assume that the firm’s pastfinancial condition is an accurate indicator of the future. Pro forma statementsare commonly used to forecast and analyze the firm’s level of profitability andoverall financial performance so that adjustments can be made to planned oper-ations to achieve short-term financial goals. LG6LG5CHAPTER 4 Cash Flow and Financial Planning 143 Opener-in-Review The chapter opener mentions that in 2010, Apple’s stock sold for approximately $200. Apple had just over $40 billion in cash on its balance sheet and just fewerthan 1 billion shares outstanding, so each Apple share represented a claim on$40 of Apple’s cash. Suppose that when Apple invests in the resources necessaryto create new technology products, it expects to earn a 20% rate of return.Suppose also that when it invests its cash, Apple earns just 1%. Given this, whatrate of return should investors expect if they pay $200 to acquire one share ofApple? 144 PART 2 Financial Tools Self-Test Problems(Solutions in Appendix) ST4–1 Depreciation and cash flow A firm expects to have earnings before interest and taxes (EBIT) of $160,000 in each of the next 6 years. It pays annual interest of$15,000. The firm is considering the purchase of an asset that costs $140,000,requires $10,000 in installation cost, and has a recovery period of 5 years. It will bethe firm’s only asset, and the asset’s depreciation is already reflected in its EBIT estimates.a.Calculate the annual depreciation for the asset purchase using the MACRS depreciation percentages in Table 4.2 on page 117. b.Calculate the firm’s operating cash flows for each of the 6 years, using Equation 4.3. Assume that the firm is subject to a 40% tax rate on all the profit that itearns. c.Suppose the firm’s net fixed assets, current assets, accounts payable, and accruals had the following values at the start and end of the final year (year 6). Calculate the firm’s free cash flow (FCF) for that year.LG1LG2 Year 6 Year 6 Account start end Net fixed assets $ 7,500 $ 0 Current assets 90,000 110,000Accounts payable 40,000 45,000Accruals 8,000 7,000 Cash Month Sales disbursements February $500 $400 March 600 300April 400 600May 200 500June 200 200d.Compare and discuss the significance of each value calculated in parts bandc. ST4–2 Cash budget and pro forma balance sheet inputs Jane McDonald, a financial ana- lyst for Carroll Company, has prepared the following sales and cash disbursementestimates for the period February–June of the current year.LG4LG5 McDonald notes that historically, 30% of sales have been for cash. Of credit sales, 70% are collected 1 month after the sale, and the remaining 30% are collected 2 months after the sale. The firm wishes to maintain a minimum ending balance inits cash account of $25. Balances above this amount would be invested in short-term government securities (marketable securities), whereas any deficits would be financed through short-term bank borrowing (notes payable). The beginning cash balance at April 1 is $115. a.Prepare cash budgets for April, May, and June. b.How much financing, if any, at a maximum would Carroll Company require to meet its obligations during this 3-month period? c.A pro forma balance sheet dated at the end of June is to be prepared from the information presented. Give the size of each of the following: cash, notes payable, marketable securities, and accounts receivable. ST4–3 Pro forma income statement Euro Designs, Inc., expects sales during 2013 to rise from the 2012 level of $3.5 million to $3.9 million. Because of a scheduled large loan payment, the interest expense in 2013 is expected to drop to $325,000. Thefirm plans to increase its cash dividend payments during 2013 to $320,000. The company’s year-end 2012 income statement follows.CHAPTER 4 Cash Flow and Financial Planning 145 Euro Designs, Inc. Income Statement for the Year Ended December 31, 2012 Sales revenue $3,500,000 Less: Cost of goods sold Gross profits $1,575,000 Less: Operating expenses Operating profits $1,155,000 Less: Interest expense Net profits before taxes $ 755,000 Less: Taxes (rate 40%) Net profits after taxes $ 453,000 Less: Cash dividends To retained earnings $ 203,000250,000302,000 =400,000420,0001,925,000LG5 a.Use the percent-of-sales method to prepare a 2013 pro forma income statement for Euro Designs, Inc. b.Explain why the statement may underestimate the company’s actual 2013 pro forma income. Warm-Up ExercisesAll problems are available in . E4–1 The installed cost of a new computerized controller was $65,000. Calculate thedepreciation schedule by year assuming a recovery period of 5 years and using the appropriate MACRS depreciation percentages given in Table 4.2 on page 117. E4–2 Classify the following changes in each of the accounts as either an inflow or an outflow of cash. During the year (a) marketable securities increased, (b) land and buildings decreased, (c) accounts payable increased, (d) vehicles decreased, (e) accounts receivable increased, and (f) dividends were paid. E4–3 Determine the operating cash flow (OCF) for Kleczka, Inc., based on the following data. (All values are in thousands of dollars.) During the year the firm had sales of $2,500, cost of goods sold totaled $1,800, operating expenses totaled $300, and depreciation expenses were $200. The firm is in the 35% tax bracket. LG1 LG2 LG2 E4–4 During the year, Xero, Inc., experienced an increase in net fixed assets of $300,000 and had depreciation of $200,000. It also experienced an increase in current assetsof $150,000 and an increase in accounts payable and accruals of $75,000. If oper-ating cash flow (OCF) for the year was $700,000, calculate the firm’s free cash flow (FCF) for the year. E4–5 Rimier Corp. forecasts sales of $650,000 for 2013. Assume the firm has fixed costs of $250,000 and variable costs amounting to 35% of sales. Operating expenses are estimated to include fixed costs of $28,000 and a variable portion equal to 7.5% ofsales. Interest expenses for the coming year are estimated to be $20,000. Estimate Rimier’s net profits before taxes for 2013.146 PART 2 Financial Tools LG2 LG5 ProblemsAll problems are available in . P4–1 Depreciation On March 20, 2012, Norton Systems acquired two new assets. Asset A was research equipment costing $17,000 and having a 3-year recovery period. Asset B was duplicating equipment having an installed cost of $45,000 and a 5-year recovery period. Using the MACRS depreciation percentages in Table 4.2 on page 117, prepare a depreciation schedule for each of these assets. P4–2 Depreciation In early 2012, Sosa Enterprises purchased a new machine for $10,000 to make cork stoppers for wine bottles. The machine has a 3-year recovery period and is expected to have a salvage value of $2,000. Develop a depreciation schedule for this asset using the MACRS depreciation percentages in Table 4.2. P4–3 MACRS depreciation expense and accounting cash flow Pavlovich Instruments, Inc., a maker of precision telescopes, expects to report pretax income of $430,000 this year. The company’s financial manager is considering the timing of a purchase of new computerized lens grinders. The grinders will have an installed cost of$80,000 and a cost recovery period of 5 years. They will be depreciated using the MACRS schedule. a.If the firm purchases the grinders before year-end, what depreciation expense will it be able to claim this year? (Use Table 4.2 on page 117.) b.If the firm reduces its reported income by the amount of the depreciation expense calculated in part a,what tax savings will result? P4–4 Depreciation and accounting cash flow A firm in the third year of depreciating its only asset, which originally cost $180,000 and has a 5-year MACRS recovery period, has gathered the following data relative to the current year’s operations: LG1 LG2 LG1 LG2 LG1LG1 Accruals $ 15,000 Current assets 120,000Interest expense 15,000Sales revenue 400,000Inventory 70,000Total costs before depreciation, interest, and taxes 290,000Tax rate on ordinary income 40% a.Use the relevant data to determine the operating cash flow (see Equation 4.2) for the current year. b.Explain the impact that depreciation, as well as any other noncash charges, has on a firm’s cash flows. P4–5 Classifying inflows and outflows of cash Classify each of the following items as an inflow (I) or an outflow (O) of cash, or as neither (N).CHAPTER 4 Cash Flow and Financial Planning 147 LG2 Item Change ($) Item Change ($) Cash 100 Accounts receivable 700 Accounts payable 1,000 Net profits 600Notes payable 500 Depreciation 100Long-term debt 2,000 Repurchase of stock 600Inventory 200 Cash dividends 800Fixed assets 400 Sale of stock 1,000 + ++ ++ -+ ++ – + P4–6 Finding operating and free cash flows Consider the balance sheets and selected data from the income statement of Keith Corporation that appear below and on the next page.LG2 Keith Corporation Balance Sheets December 31 Assets 2012 2011 Cash $ 1,500 $ 1,000 Marketable securities 1,800 1,200Accounts receivable 2,000 1,800Inventories Total current assets Gross fixed assets $29,500 $28,100Less: Accumulated depreciation Net fixed assetsTotal assets Liabilities and Stockholders’ Equity Accounts payable $ 1,600 $ 1,500 Notes payable 2,800 2,200Accruals Total current liabilities Long-term debt Total liabilities Common stock $10,000 $10,000Retained earnings Total stockholders’ equityTotal liabilities and stockholders’ equity $21,800 $23,000$12,800 $13,4002,800 3,400$ 9,000 $ 9,6005,000 5,000$ 4,000 $ 4,600300 200$21,800 $23,000$15,100 $14,80013,100 14,700$ 6,800 $ 8,2002,800 2,900 a.Calculate the firm’s net operating profit after taxes (NOPAT) for the year ended December 31, 2012, using Equation 4.1. b.Calculate the firm’s operating cash flow (OCF ) for the year ended December 31, 2012, using Equation 4.3. c.Calculate the firm’s free cash flow (FCF) for the year ended December 31, 2012, using Equation 4.5. d.Interpret, compare, and contrast your cash flow estimates in parts bandc. P4–7 Cash receipts A firm has actual sales of $65,000 in April and $60,000 in May. It expects sales of $70,000 in June and $100,000 in July and in August. Assuming that sales are the only source of cash inflows and that half of them are for cash and theremainder are collected evenly over the following 2 months, what are the firm’s expected cash receipts for June, July, and August? P4–8 Cash disbursements schedule Maris Brothers, Inc., needs a cash disbursement schedule for the months of April, May, and June. Use the format of Table 4.9 (on page 130) and the following information in its preparation. Sales: February $500,000; March $500,000; April $560,000; May $610,000; June $650,000; July $650,000 Purchases: Purchases are calculated as 60% of the next month’s sales, 10% of purchases are made in cash, 50% of purchases are paid for 1 month after pur-chase, and the remaining 40% of purchases are paid for 2 months after purchase. Rent: The firm pays rent of $8,000 per month. Wages and salaries: Base wage and salary costs are fixed at $6,000 per month plus a variable cost of 7% of the current month’s sales. Taxes: A tax payment of $54,500 is due in June. Fixed asset outlays: New equipment costing $75,000 will be bought and paid for in April. Interest payments: An interest payment of $30,000 is due in June. Cash dividends: Dividends of $12,500 will be paid in April. Principal repayments and retirements: No principal repayments or retirements are due during these months. P4–9 Cash budget—Basic Grenoble Enterprises had sales of $50,000 in March and $60,000 in April. Forecast sales for May, June, and July are $70,000, $80,000, and $100,000, respectively. The firm has a cash balance of $5,000 on May 1 and wishesto maintain a minimum cash balance of $5,000. Given the following data, prepare and interpret a cash budget for the months of May, June, and July.(1) The firm makes 20% of sales for cash, 60% are collected in the next month, and the remaining 20% are collected in the second month following sale.= = == = =148 PART 2 Financial Tools Keith Corporation Income Statement Data (2012) Depreciation expense $1,600 Earnings before interest and taxes (EBIT) 2,700Interest expense 367Net profits after taxes 1,400Tax rate 40% LG4 LG4 LG4 (2) The firm receives other income of $2,000 per month. (3) The firm’s actual or expected purchases, all made for cash, are $50,000, $70,000, and $80,000 for the months of May through July, respectively. (4) Rent is $3,000 per month. (5) Wages and salaries are 10% of the previous month’s sales. (6) Cash dividends of $3,000 will be paid in June. (7) Payment of principal and interest of $4,000 is due in June. (8) A cash purchase of equipment costing $6,000 is scheduled in July. (9) Taxes of $6,000 are due in June. Personal Finance Problem P4–10 Preparation of cash budget Sam and Suzy Sizeman need to prepare a cash budget for the last quarter of 2013 to make sure they can cover their expenditures duringthe period. Sam and Suzy have been preparing budgets for the past several years andhave been able to establish specific percentages for most of their cash outflows.These percentages are based on their take-home pay (that is, monthly utilities nor-mally run 5% of monthly take-home pay). The information in the following tablecan be used to create their fourth-quarter budget for 2013.CHAPTER 4 Cash Flow and Financial Planning 149 LG4LG4 Income Monthly take-home pay $4,900 Expenses Housing 30%Utilities 5%Food 10%Transportation 7%Medical/dental .5%Clothing for October and November 3%Clothing for December $440Property taxes (November only) 11.5%Appliances 1%Personal care 2%Entertainment for October and November 6%Entertainment for December $1,500Savings 7.5%Other 5%Excess cash 4.5% a.Prepare a quarterly cash budget for Sam and Suzy covering the months October through December 2013. b.Are there individual months that incur a deficit? c.What is the cumulative cash surplus or deficit by the end of December 2013? P4–11 Cash budget—Advanced The actual sales and purchases for Xenocore, Inc., for September and October 2012, along with its forecast sales and purchases for the period November 2012 through April 2013, follow. The firm makes 20% of all sales for cash and collects on 40% of its sales in each of the 2 months following the sale. Other cash inflows are expected to be$12,000 in September and April, $15,000 in January and March, and $27,000 in February. The firm pays cash for 10% of its purchases. It pays for 50% of its pur- chases in the following month and for 40% of its purchases 2 months later. Wages and salaries amount to 20% of the preceding month’s sales. Rent of $20,000 per month must be paid. Interest payments of $10,000 are due in January andApril. A principal payment of $30,000 is also due in April. The firm expects to paycash dividends of $20,000 in January and April. Taxes of $80,000 are due in April. Thefirm also intends to make a $25,000 cash purchase of fixed assets in December.a.Assuming that the firm has a cash balance of $22,000 at the beginning of November, determine the end-of-month cash balances for each month,November through April. b.Assuming that the firm wishes to maintain a $15,000 minimum cash balance, determine the required total financing or excess cash balance for each month, November through April. c.If the firm were requesting a line of credit to cover needed financing for the period November to April, how large would this line have to be? Explain your answer. P4–12 Cash flow concepts The following represent financial transactions that Johnsfield & Co. will be undertaking in the next planning period. For each transaction, check the statement or statements that will be affected immediately.150 PART 2 Financial Tools Year Month Sales Purchases 2012 September $210,000 $120,000 2012 October 250,000 150,0002012 November 170,000 140,0002012 December 160,000 100,0002013 January 140,000 80,0002013 February 180,000 110,0002013 March 200,000 100,0002013 April 250,000 90,000 Statement Pro forma income Pro forma balance Transaction Cash budget statement sheet Cash sale Credit sale Accounts receivable are collected Asset with 5-year life is purchased Depreciation is taken Amortization of goodwill is taken Sale of common stock Retirement of outstanding bonds Fire insurance premium is paid for the next 3 yearsLG4 P4–13 Cash budget—Scenario analysis Trotter Enterprises, Inc., has gathered the fol- lowing data to plan for its cash requirements and short-term investment opportuni-ties for October, November, and December. All amounts are shown in thousands ofdollars.CHAPTER 4 Cash Flow and Financial Planning 151 LG4 LG4 LG5October November December Pessi- Most Opti- Pessi- Most Opti- Pessi- Most Opti- mistic likely mistic mistic likely mistic mistic likely mistic Total cash receipts $260 $342 $462 $200 $287 $366 $191 $294 $353 Total cash disbursements 285 326 421 203 261 313 287 332 315 a.Prepare a scenario analysis of Trotter’s cash budget using –$20,000 as the beginning cash balance for October and a minimum required cash balance of $18,000. b.Use the analysis prepared in part ato predict Trotter’s financing needs and investment opportunities over the months of October, November, and December.Discuss how knowledge of the timing and amounts involved can aid the planning process. P4–14 Multiple cash budgets—Scenario analysis Brownstein, Inc., expects sales of $100,000 during each of the next 3 months. It will make monthly purchases of $60,000 during this time. Wages and salaries are $10,000 per month plus 5% ofsales. Brownstein expects to make a tax payment of $20,000 in the next month and a $15,000 purchase of fixed assets in the second month and to receive $8,000 in cash from the sale of an asset in the third month. All sales and purchases are for cash. Beginning cash and the minimum cash balance are assumed to be zero. a.Construct a cash budget for the next 3 months. b.Brownstein is unsure of the sales levels, but all other figures are certain. If the most pessimistic sales figure is $80,000 per month and the most optimistic is $120,000 per month, what are the monthly minimum and maximum ending cash balances that the firm can expect for each of the 1-month periods? c.Briefly discuss how the financial manager can use the data in parts aandbto plan for financing needs. P4–15 Pro forma income statement The marketing department of Metroline Manufac- turing estimates that its sales in 2013 will be $1.5 million. Interest expense is expected to remain unchanged at $35,000, and the firm plans to pay $70,000 in cash dividends during 2013. Metroline Manufacturing’s income statement for the year ended December 31, 2012, is given on page 152, along with a breakdown ofthe firm’s cost of goods sold and operating expenses into their fixed and variable components. a.Use the percent-of-sales method to prepare a pro forma income statement for the year ended December 31, 2013. b.Usefixed and variable cost data to develop a pro forma income statement for the year ended December 31, 2013. c.Compare and contrast the statements developed in parts aandb.Which state- ment probably provides the better estimate of 2013 income? Explain why. P4–16 Pro forma income statement—Scenario analysis Allen Products, Inc., wants to do a scenario analysis for the coming year. The pessimistic prediction for sales is $900,000; the most likely amount of sales is $1,125,000; and the optimistic predic- tion is $1,280,000. Allen’s income statement for the most recent year follows.152 PART 2 Financial Tools Metroline Manufacturing Income Statement for the Year Ended December 31, 2012 Sales revenue $1,400,000 Less: Cost of goods sold Gross profits $ 490,000 Less: Operating expenses Operating profits $ 370,000 Less: Interest expense Net profits before taxes $ 335,000 Less: Taxes (rate 40%) Net profits after taxes $ 201,000 Less: Cash dividends To retained earnings $ 135,00066,000134,000 =35,000120,000910,000Metroline Manufacturing Breakdown of Costs and Expenses into Fixed and Variable Components for the Year Ended December 31, 2012 Cost of goods sold Fixed cost $210,000Variable costTotal costs Operating expenses Fixed expenses $ 36,000Variable expensesTotal expenses $120,000 84,000$910,000700,000 Allen Products, Inc. Income Statement for the Year Ended December 31, 2012 Sales revenue $937,500 Less: Cost of goods sold Gross profits $515,625 Less: Operating expenses Operating profits $281,250 Less: Interest expense Net profits before taxes $251,250 Less: Taxes (rate 25%) Net profits after taxes $188,43762,813 =30,000234,375421,875LG5 a.Use the percent-of-sales method, the income statement for December 31, 2012, and the sales revenue estimates to develop pessimistic, most likely, and optimistic pro forma income statements for the coming year. b.Explain how the percent-of-sales method could result in an overstatement of profits for the pessimistic case and an understatement of profits for the most likely and optimistic cases. c.Restate the pro forma income statements prepared in part ato incorporate the following assumptions about the 2012 costs: $250,000 of the cost of goods sold is fixed; the rest is variable. $180,000 of the operating expenses is fixed; the rest is variable. All of the interest expense is fixed. d.Compare your findings in part cto your findings in part a.Do your observations confirm your explanation in part b? P4–17 Pro forma balance sheet—Basic Leonard Industries wishes to prepare a pro forma balance sheet for December 31, 2013. The firm expects 2013 sales to total$3,000,000. The following information has been gathered.(1) A minimum cash balance of $50,000 is desired.(2) Marketable securities are expected to remain unchanged.(3) Accounts receivable represent 10% of sales.(4) Inventories represent 12% of sales.(5) A new machine costing $90,000 will be acquired during 2013. Total deprecia- tion for the year will be $32,000. (6) Accounts payable represent 14% of sales.(7) Accruals, other current liabilities, long-term debt, and common stock are expected to remain unchanged. (8) The firm’s net profit margin is 4%, and it expects to pay out $70,000 in cash dividends during 2013. (9) The December 31, 2012, balance sheet follows.CHAPTER 4 Cash Flow and Financial Planning 153 LG5 Leonard Industries Balance Sheet December 31, 2012 Assets Liabilities and Stockholders’ Equity Cash $ 45,000 Accounts payable $ 395,000 Marketable securities 15,000 Accruals 60,000Accounts receivable 255,000 Other current liabilitiesInventories Total current liabilities $ 485,000 Total current assets $ 655,000 Long-term debt Net fixed assets Total liabilities Total assets Common stock 200,000 Retained earnings Total liabilities and stockholders’ equity $1,255,000 220,000$1,255,000$ 835,000 600,000350,000340,00030,000 a.Use the judgmental approach to prepare a pro forma balance sheet dated December 31, 2013, for Leonard Industries. b.How much, if any, additional financing will Leonard Industries require in 2013? Discuss. c.Could Leonard Industries adjust its planned 2013 dividend to avoid the situation described in part b?Explain how. P4–18 Pro forma balance sheet Peabody & Peabody has 2012 sales of $10 million. It wishes to analyze expected performance and financing needs for 2014—2 years ahead. Given the following information, respond to parts aandb. (1) The percents of sales for items that vary directly with sales are as follows: Accounts receivable, 12% Inventory, 18% Accounts payable, 14% Net profit margin, 3% (2) Marketable securities and other current liabilities are expected to remain unchanged.LG5 (3) A minimum cash balance of $480,000 is desired. (4) A new machine costing $650,000 will be acquired in 2013, and equipment costing $850,000 will be purchased in 2014. Total depreciation in 2013 is fore-cast as $290,000, and in 2014 $390,000 of depreciation will be taken. (5) Accruals are expected to rise to $500,000 by the end of 2014. (6) No sale or retirement of long-term debt is expected. (7) No sale or repurchase of common stock is expected. (8) The dividend payout of 50% of net profits is expected to continue. (9) Sales are expected to be $11 million in 2013 and $12 million in 2014. (10) The December 31, 2012, balance sheet follows. 154 PART 2 Financial Tools Peabody & Peabody Balance Sheet December 31, 2012 ($000) Assets Liabilities and Stockholders’ Equity Cash $ 400 Accounts payable $1,400 Marketable securities 200 Accruals 400Accounts receivable 1,200 Other current liabilitiesInventories Total current liabilities $1,880 Total current assets $3,600 Long-term debt Net fixed assets Total liabilities Total assets Common equity Total liabilities and stockholders’ equity $7,600 3,720 $7,600$3,880 4,0002,0001,80080 a.Prepare a pro forma balance sheet dated December 31, 2014. b.Discuss the financing changes suggested by the statement prepared in part a. P4–19 Integrative—Pro forma statements Red Queen Restaurants wishes to prepare financial plans. Use the financial statements on page 155 and the other information provided below to prepare the financial plans. The following financial data are also available: (1) The firm has estimated that its sales for 2013 will be $900,000.(2) The firm expects to pay $35,000 in cash dividends in 2013. (3) The firm wishes to maintain a minimum cash balance of $30,000. (4) Accounts receivable represent approximately 18% of annual sales. (5) The firm’s ending inventory will change directly with changes in sales in 2013. (6) A new machine costing $42,000 will be purchased in 2013. Total depreciation for 2013 will be $17,000. (7) Accounts payable will change directly in response to changes in sales in 2013. (8) Taxes payable will equal one-fourth of the tax liability on the pro forma income statement. (9) Marketable securities, other current liabilities, long-term debt, and common stock will remain unchanged. a.Prepare a pro forma income statement for the year ended December 31, 2013, using the percent-of-sales method. b.Prepare a pro forma balance sheet dated December 31, 2013, using the judgmental approach. c.Analyze these statements, and discuss the resulting external financing required.LG5 P4–20 Integrative—Pro forma statements Provincial Imports, Inc., has assembled past (2012) financial statements (income statement below and balance sheet on page 156) and financial projections for use in preparing financial plans for the coming year (2013).CHAPTER 4 Cash Flow and Financial Planning 155 Red Queen Restaurants Balance Sheet December 31, 2012 Assets Liabilities and Stockholders’ Equity Cash $ 32,000 Accounts payable $100,000 Marketable securities 18,000 Taxes payable 20,000Accounts receivable 150,000 Other current liabilitiesInventories Total current liabilities $125,000 Total current assets $300,000 Long-term debt Net fixed assets Total liabilities Total assets Common stock 150,000 Retained earnings Total liabilities and stockholders’ equity $650,000 175,000$650,000$325,000 350,000200,000100,0005,000Red Queen Restaurants Income Statement for the Year Ended December 31, 2012 Sales revenue $800,000 Less: Cost of goods sold Gross profits $200,000 Less: Operating expenses Net profits before taxes $100,000 Less: Taxes (rate 40%) Net profits after taxes $ 60,000 Less: Cash dividends To retained earnings $ 40,00020,00040,000 =100,000600,000 Provincial Imports, Inc. Income Statement for the Year Ended December 31, 2012 Sales revenue $5,000,000 Less: Cost of goods sold Gross profits $2,250,000 Less: Operating expenses Operating profits $1,400,000 Less: Interest expense Net profits before taxes $1,200,000 Less: Taxes (rate 40%) Net profits after taxes $ 720,000 Less: Cash dividends To retained earnings $ 432,000288,000480,000 =200,000850,0002,750,000LG5 Information related to financial projections for the year 2013:156 PART 2 Financial Tools Provincial Imports, Inc. Balance Sheet December 31, 2012 Assets Liabilities and Stockholders’ Equity Cash $ 200,000 Accounts payable $ 700,000 Marketable securities 225,000 Taxes payable 95,000Accounts receivable 625,000 Notes payable 200,000Inventories Other current liabilities Total current assets $1,600,000 Total current liabilities $1,000,000 Net fixed assets Long-term debt Total assets Total liabilities Common stock 75,000Retained earnings Total liabilities and equity $2,950,000 1,375,000$1,500,000 $2,950,000500,000 1,400,0005,000 500,000 (1) Projected sales are $6,000,000. (2) Cost of goods sold in 2012 includes $1,000,000 in fixed costs. (3) Operating expense in 2012 includes $250,000 in fixed costs.(4) Interest expense will remain unchanged. (5) The firm will pay cash dividends amounting to 40% of net profits after taxes. (6) Cash and inventories will double.(7) Marketable securities, notes payable, long-term debt, and common stock will remain unchanged. (8) Accounts receivable, accounts payable, and other current liabilities will change in direct response to the change in sales. (9) A new computer system costing $356,000 will be purchased during the year. Total depreciation expense for the year will be $110,000. (10) The tax rate will remain at 40%. a.Prepare a pro forma income statement for the year ended December 31, 2013, using the fixed cost data given to improve the accuracy of the percent-of-sales method. b.Prepare a pro forma balance sheet as of December 31, 2013, using the informa- tion given and the judgmental approach. Include a reconciliation of the retained earnings account. c.Analyze these statements, and discuss the resulting external financing required. P4–21 ETHICS PROBLEM The SEC is trying to get companies to notify the investment community more quickly when a “material change” will affect their forthcoming financial results. In what sense might a financial manager be seen as “more ethical”if he or she follows this directive and issues a press release indicating that sales will not be as high as previously anticipated?LG3 CHAPTER 4 Cash Flow and Financial Planning 157 Spreadsheet Exercise You have been assigned the task of putting together a statement for the ACME Company that shows its expected inflows and outflows of cash over the months of July 2013 through December 2013. You have been given the following data for ACME Company: (1) Expected gross sales for May through December, respectively, are $300,000, $290,000, $425,000, $500,000, $600,000, $625,000, $650,000, and $700,000. (2) 12% of the sales in any given month are collected during that month. However, the firm has a credit policy of 3/10 net 30, so factor a 3% discount into thecurrent month’s sales collection. (3) 75% of the sales in any given month are collected during the following month after the sale. (4) 13% of the sales in any given month are collected during the second month fol- lowing the sale. (5) The expected purchases of raw materials in any given month are based on 60% of the expected sales during the following month. (6) The firm pays 100% of its current month’s raw materials purchases in the fol- lowing month. (7) Wages and salaries are paid on a monthly basis and are based on 6% of the current month’s expected sales. (8) Monthly lease payments are 2% of the current month’s expected sales. (9) The monthly advertising expense amounts to 3% of sales. (10) R&D expenditures are expected to be allocated to August, September, and October at the rate of 12% of sales in those months. (11) During December a prepayment of insurance for the following year will be made in the amount of $24,000. (12) During the months of July through December, the firm expects to have miscel- laneous expenditures of $15,000, $20,000, $25,000, $30,000, $35,000, and $40,000, respectively. (13) Taxes will be paid in September in the amount of $40,000 and in December in the amount of $45,000. (14) The beginning cash balance in July is $15,000. (15) The target cash balance is $15,000. TO DO a.Prepare a cash budget for July 2013 through December 2013 by creating a com- bined spreadsheet that incorporates spreadsheets similar to those in Tables 4.8, 4.9, and 4.10. Divide your spreadsheet into three sections: (1) Total cash receipts (2) Total cash disbursements (3) Cash budget covering the period of July through December The cash budget should reflect the following: (1) Beginning and ending monthly cash balances (2) The required total financing in each month required (3) The excess cash balance in each month with excess b.Based on your analysis, briefly describe the outlook for this company over the next 6 months. Discuss its specific obligations and the funds available to meetthem. What could the firm do in the case of a cash deficit? (Where could it getthe money?) What should the firm do if it has a cash surplus? Visit www.myfinancelab.com forChapter Case: Preparing Martin Manufacturing’s 2013 Pro Forma Financial Statements, Group Exercises, and numerous online resources. 158 PART 2 Financial Tools 159Learning Goals Discuss the role of time value in finance, the use of computationaltools, and the basic patterns ofcash flow. Understand the concepts of future value and present value, theircalculation for single amounts,and the relationship betweenthem. Find the future value and the present value of both an ordinaryannuity and an annuity due, andfind the present value of aperpetuity. Calculate both the future value and the present value of a mixedstream of cash flows. Understand the effect that compounding interest morefrequently than annually has onfuture value and on the effectiveannual rate of interest. Describe the procedures involved in (1) determining deposits needed to accumulate a futuresum, (2) loan amortization, (3) finding interest or growthrates, and (4) finding an unknownnumber of periods. LG6LG5LG4LG3LG2LG15Time Value of Money Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand time-value-of-money calcula- tions to account for certain transactions such as loan amortization,lease payments, and bond interest rates. INFORMATION SYSTEMS You need to understand time-value-of-money calculations to design systems that accurately measure and value thefirm ’s cash flows. MANAGEMENT You need to understand time-value-of-money calcula- tions so that you can manage cash receipts and disbursements in away that will enable the firm to receive the greatest value from its cashflows. MARKETING You need to understand time value of money because funding for new programs and products must be justified financiallyusing time-value-of-money techniques. OPERATIONS You need to understand time value of money because the value of investments in new equipment, in new processes, and ininventory will be affected by the time value of money. Time-value-of-money techniques are widely used in personal financial planning. You can use them to calculate the value of savings at givenfuture dates and to estimate the amount you need now to accumulate agiven amount at a future date. You also can apply them to value lump-sum amounts or streams of periodic cash flows and to the interest rateor amount of time needed to achieve a given financial goal. In your personal life 160Riding the Pipeline Companies spend money on new investments if they believe that those investments will later gen- erate enough cash flow to justify the up-front cost. Forpharmaceutical companies like Eli Lilly, the average length of time from the discovery of a new drug until delivery to a patient is 10 to 15 years. After R&D pro-duces a promising lead, a drug is still a long way from being ready for human testing. Researchers must probe further to determine what dosage will be required andat what level it might be toxic to the patient. They also must explore practical issues such as whether Lilly will be able to manufacture the compound on a large scale.The clinical trials themselves can take years. To help recoup its investment, a drug manufacturer can get a 20-year patent that grants the company exclu- sive rights to the new drug. However, with the lengthyresearch and approval process, companies may have fewer than 10 years to sell the drug while the patent is in force. Once patent protection expires, generic drugmanufacturers enter the market with low-priced alterna- tives to the name-brand drug. For Eli Lilly, the cost of bringing a new drug to market runs from $800 million to $1.2 billion. To keep its drug pipeline full, Eli Lilly plows some 20 percent of sales back into the R&D programs on which its future depends. With large cash expenditures occurring years before any cash return, the time value of money is an importantfactor in calculating the economic viability of a new drug. In this chapter, you will learn how todetermine the present value of future cash flows and other time-value-of-money calculations. Eli Lilly and Company CHAPTER 5 Time Value of Money 161 5.1 The Role of Time Value in Finance The time value of money refers to the observation that it is better to receive money sooner than later. Money that you have in hand today can be invested toearn a positive rate of return, producing more money tomorrow. For that reason,a dollar today is worth more than a dollar in the future. In business, managersconstantly face trade-offs in situations where actions that require outflows ofcash today may produce inflows of cash later. Because the cash that comes in thefuture is worth less than the cash that firms spend up front, managers need a setof tools to help them compare cash inflows and outflows that occur at differenttimes. This chapter introduces you to those tools. FUTURE VALUE VERSUS PRESENT VALUE Suppose a firm has an opportunity to spend $15,000 today on some investmentthat will produce $17,000 spread out over the next five years as follows: Year 1 $3,000 Year 2 $5,000Year 3 $4,000Year 4 $3,000Year 5 $2,000 Is this a wise investment? It might seem that the obvious answer is yes because the firm spends $15,000 and receives $17,000. Remember, though, that the value ofthe dollars the firm receives in the future is less than the value of the dollars thatthey spend today. Therefore, it is not clear whether the $17,000 inflows areenough to justify the initial investment. Time-value-of-money analysis helps managers answer questions like these. The basic idea is that managers need a way to compare cash today versus cash inthe future. There are two ways of doing this. One way is to ask the question,What amount of money in the future is equivalent to $15,000 today? In otherwords, what is the future value of $15,000? The other approach asks, What amount today is equivalent to $17,000 paid out over the next 5 years as outlinedabove? In other words, what is the present value of the stream of cash flows coming in the next 5 years? Atime line depicts the cash flows associated with a given investment. It is a horizontal line on which time zero appears at the leftmost end and future periodsare marked from left to right. A time line illustrating our hypothetical investmentproblem appears in Figure 5.1. The cash flows occurring at time zero (today) andIn more depth To read about The Royalty Treatment, go to www.myfinancelab.com –$15,000 $3,000 $5,000 $4,000 $3,000 $2,000 0123 End of Year45FIGURE 5.1 Time Line Time line depicting aninvestment’s cash flowstime line A horizontal line on which time zero appears at the leftmostend and future periods aremarked from left to right; canbe used to depict investmentcash flows.LG1 at the end of each subsequent year are above the line; the negative values repre- sentcash outflows ($15,000 invested today at time zero), and the positive values represent cash inflows ($3,000 inflow in 1 year, $5,000 inflow in 2 years, and so on). To make the right investment decision, managers need to compare the cash flows depicted in Figure 5.1 at a single point in time. Typically, that point is eitherthe end or the beginning of the investment’s life. The future value technique usescompounding to find the future value of each cash flow at the end of the invest- ment’s life and then sums these values to find the investment’s future value. Thisapproach is depicted above the time line in Figure 5.2. The figure shows that thefuture value of each cash flow is measured at the end of the investment’s 5-yearlife. Alternatively, the present value technique uses discounting to find the present value of each cash flow at time zero and then sums these values to find the invest- ment’s value today. Application of this approach is depicted below the time line inFigure 5.2. In practice, when making investment decisions, managers usually adopt the present value approach . COMPUTATIONAL TOOLS Finding present and future values can involve time-consuming calculations. Although you should understand the concepts and mathematics underlying thesecalculations, financial calculators and spreadsheets streamline the application oftime value techniques. Financial Calculators Financial calculators include numerous preprogrammed financial routines. Learning how to use these routines can make present and future values calcula-tions a breeze. We focus primarily on the keys pictured in Figure 5.3. We typically use four of the first five keys shown in the left column, along with the compute ( CPT) key. One of the four keys represents the unknown value being calculated. The keystrokes on162 PART 2 Financial Tools –$15,000 $3,000 $5,000 $4,000 $3,000 $2,000 0123Compounding Discounting45Future Value Present ValueEnd of YearFIGURE 5.2 Compounding and DiscountingTime line showing compounding to find future value and discounting tofind present value CHAPTER 5 Time Value of Money 163 some of the more sophisticated calculators are menu-driven: After you select the appropriate routine, the calculator prompts you to input each value. Regardless,any calculator with the basic future and present value functions can simplifytime-value-of-money calculations. The keystrokes for financial calculators areexplained in the reference guides that accompany them. Once you understand the basic underlying concepts, you probably will want to use a calculator to streamline calculations. With a little practice, you canincrease both the speed and the accuracy of your financial computations.Remember that conceptual understanding of the material is the objective. An ability to solve problems with the aid of a calculator does not necessarily reflectsuch an understanding, so don’t just settle for answers. Work with the materialuntil you are sure you also understand the concepts. Electronic Spreadsheets Like financial calculators, electronic spreadsheets have built-in routines that sim-plify time value calculations. We provide in the text a number of spreadsheetsolutions that identify the cell entries for calculating time values. The value foreach variable is entered in a cell in the spreadsheet, and the calculation is pro-grammed using an equation that links the individual cells. Changing any of theinput variables automatically changes the solution as a result of the equationlinking the cells. BASIC PATTERNS OF CASH FLOW The cash flow—both inflows and outflows—of a firm can be described by its gen-eral pattern. It can be defined as a single amount, an annuity, or a mixed stream. Single amount: A lump-sum amount either currently held or expected at some future date. Examples include $1,000 today and $650 to be received at theend of 10 years. Annuity: A level periodic stream of cash flow. For our purposes, we’ll work primarily with annual cash flows. Examples include either paying out or receiving $800 at the end of each of the next 7 years. Mixed stream: A stream of cash flow that is notan annuity; a stream of unequal periodic cash flows that reflect no particular pattern. Examplesinclude the following two cash flow streams A and B.N — Number of periods I — Interest rate per period PV — Present value PMT — Amount of payment (used only for annuities) FV — Future value CPT — Compute key used to initiate financial calculation once all values are inputN I PMT FVPV CPTFIGURE 5.3 Calculator Keys Important financial keys onthe typical calculator Note that neither cash flow stream has equal, periodic cash flows and that A is a 6-year mixed stream and B is a 4-year mixed stream. In the next three sections of this chapter, we develop the concepts and tech- niques for finding future and present values of single amounts, annuities, andmixed streams, respectively. Detailed demonstrations of these cash flow patternsare included. 6 REVIEW QUESTIONS 5–1What is the difference between future value andpresent value? Which approach is generally preferred by financial managers? Why? 5–2Define and differentiate among the three basic patterns of cash flow:(1) a single amount, (2) an annuity, and (3) a mixed stream.164 PART 2 Financial Tools Mixed cash flow stream End of year A B 1 $ 100 -$5 0 2 800 1003 1,200 804 1,200 -60 5 1,4006 300 5.2 Single Amounts Imagine that at age 25 you began investing $2,000 per year in an investment that earns 5 percent interest. At the end of 40 years, at age 65, you would haveinvested a total of $80,000 (40 years $2,000 per year). How much would youhave accumulated at the end of the fortieth year? $100,000? $150,000?$200,000? No, your $80,000 would have grown to $242,000! Why? Because thetime value of money allowed your investments to generate returns that built oneach other over the 40 years. FUTURE VALUE OF A SINGLE AMOUNT The most basic future value and present value concepts and computations con-cern single amounts, either present or future amounts. We begin by consideringproblems that involve finding the future value of cash that is on hand immedi-ately. Then we will use the underlying concepts to solve problems that determinethe value today of cash that will be received or paid in the future. We often need to find the value at some future date of a given amount of money placed on deposit today. For example, if you deposit $500 today into anaccount that pays 5 percent annual interest, how much would you have in theaccount in 10 years? Future value is the value at a given future date of an amount placed on deposit today and earning interest at a specified rate. The future valuedepends on the rate of interest earned and the length of time the money is left ondeposit. Here we explore the future value of a single amount.* future value The value at a given future date of an amount placed ondeposit today and earninginterest at a specified rate.Found by applying compound interest over a specified period of time.LG2 CHAPTER 5 Time Value of Money 165 The Concept of Future Value We speak of compound interest to indicate that the amount of interest earned on a given deposit has become part of the principal at the end of a specified period. The term principal refers to the amount of money on which the interest is paid. Annual compounding is the most common type. Thefuture value of a present amount is found by applying compound interest over a specified period of time. Savings institutions advertise compound interestreturns at a rate of xpercent, or xpercent interest, compounded annually, semi- annually, quarterly, monthly, weekly, daily, or even continuously. The concept offuture value with annual compounding can be illustrated by a simple example. If Fred Moreno places $100 in a savings account paying 8% interest compounded annually, at the end of 1 year he will have $108 in the account—the initial principal of $100 plus 8% ($8) in interest. Thefuture value at the end of the first year is calculated by using Equation 5.1: Future value at end of year (5.1) If Fred were to leave this money in the account for another year, he would be paid interest at the rate of 8% on the new principal of $108. At the end of thissecond year there would be $116.64 in the account. This amount would repre-sent the principal at the beginning of year 2 ($108) plus 8% of the $108 ($8.64)in interest. The future value at the end of the second year is calculated by usingEquation 5.2: Future value at end of year (5.2) Substituting the expression between the equals signs in Equation 5.1 for the $108 figure in Equation 5.2 gives us Equation 5.3: Future value at end of year (5.3) The equations in the preceding example lead to a more general formula for calculating future value. The Equation for Future Value The basic relationship in Equation 5.3 can be generalized to find the future valueafter any number of periods. We use the following notation for the various inputs: future value at the end of period n initial principal, or present value annual rate of interest paid. (Note: On financial calculators, Iis typically used to represent this rate.) number of periods (typically years) that the money is left on depositn=r=PV =FV n==$116.64=$100 *(1+0.08)22=$100 *(1+0.08) *(1+0.08)=$116.642=$108 *(1+0.08)1=$100 *(1+0.08) =$108Personal Finance Example 5.13compound interest Interest that is earned on a given deposit and has becomepart of the principal at the end of a specified period. principal The amount of money on whichinterest is paid. The general equation for the future value at the end of period nis (5.4) A simple example will illustrate how to apply Equation 5.4. Jane Farber places $800 in a savings account paying 6% interest compounded annually. She wants to know how much money will be in the account at the end of 5 years. Substituting and into Equation 5.4 gives the amount at the end of year 5: This analysis can be depicted on a time line as follows:FV5=$800 *(1+0.06)5=$800 *(1.33823) =$1,070.58n=5 r=0.06,PV =$800,Personal Finance Example 5.23FVn=PV *(1+r)n166 PART 2 Financial Tools PV = $800 012345FV5 = $1,070.58 End of YearTime line for future value of a single amount ($800 initialprincipal, earning 6%, at the end of 5 years) In more depth To read about The Rule of 72, go to www.myfinancelab.com Solving the equation in the preceding example involves raising 1.06 to the fifth power. Using a financial calculator or electronic spreadsheet greatly simplifies thecalculation. In Personal Finance Example 5.2, Jane Farber placed $800 in her savings account at 6% interest compounded annually and wishes to find out how much will be in the account at the end of 5 years. Calculator Use1The financial calculator can be used to calculate the future value directly. First punch in $800 and depress PV;next punch in 5 and depress N;then punch in 6 and depress I(which is equivalent to “ r” in our notation); finally, to calculate the future value, depress CPT and then FV.The future value of $1,070.58 should appear on the calculator display as shown at the left. Onmany calculators, this value will be preceded by a minus sign (–1,070.58). If a minus sign appears on your calculator, ignore it here as well as in all otherPersonal Finance Example 5.33 1. Many calculators allow the user to set the number of payments per year. Most of these calculators are preset for monthly payments—12 payments per year. Because we work primarily with annual payments—one payment per year—it is important to be sure that your calculator is set for one payment per year. And although most calcula- tors are preset to recognize that all payments occur at the end of the period, it is important to make sure that your calculator is correctly set on the END mode. To avoid including previous data in current calculations, always clear all registers of your calculator before inputting values and making each computation. The known values can be punched into the calculator in any order; the order specified in this as well as other demonstrations of calculator use included in this text merely reflects convenience and personal preference.1,070.58800 PV N CPT FVI5 6 SolutionInput Function CHAPTER 5 Time Value of Money 167 “Calculator Use” illustrations in this text.2(Note: In future examples of calculator use, we will use only a display similar to that shown on page 166. If you need areminder of the procedures involved, go back and review this paragraph.) Spreadsheet Use Excel offers a mathematical function that makes the calcula- tion of future values easy. The format of that function is FV(rate,nper,pmt,pv,type). The terms inside the parentheses are inputs that Excel requires to calculatethe future value. The terms rateandnper refer to the interest rate and the number of time periods respectively. The term pvrepresents the lump sum (or present value) that you are investing today. For now, we will ignore the other two inputs,pmtandtype, and enter a value of zero. The future value of the single amount also can be calculated as shown on the following Excel spreadsheet. 2. The calculator differentiates inflows from outflows by preceding the outflows with a negative sign. For example, in the problem just demonstrated, the $800 present value (PV), because it was keyed as a positive number, is con- sidered an inflow. Therefore, the calculated future value (FV) of –1,070.58 is preceded by a minus sign to show that it is the resulting outflow. Had the $800 present value been keyed in as a negative number (–800), the future valueof $1,070.58 would have been displayed as a positive number (1,070.58). Simply stated, the cash flows—present value (PV) and future value (FV)—will have opposite signs.FUTURE VALUE OF A SINGLE AMOUNT Present value Interest rate, pct per year compounded annuallyNumber of yearsFuture value1 2345$800 6% 5 $1,070.58 Entry in Cell B5 is =FV(B3,B4,0,–B2,0) The minus sign appears before B2 because the present value is an outflow (i.e., a deposit made by Jane Farber).AB Changing any of the values in cells B2, B3, or B4 automatically changes the result shown in cell B5 because the formula in that cell links back to the others.As with the calculator, Excel reports cash inflows as positive numbers and cashoutflows as negative numbers. In the example here, we have entered the $800present value as a negative number, which causes Excel to report the future valueas a positive number. Logically, Excel treats the $800 present value as a cash out-flow, as if you are paying for the investment you are making, and it treats thefuture value as a cash inflow when you reap the benefits of your investment 5 years later. A Graphical View of Future Value Remember that we measure future value at the endof the given period. Figure 5.4 (see page 168) illustrates how the future value depends on the interest rate andthe number of periods that money is invested. The figure shows that (1) thehigher the interest rate, the higher the future value, and (2) the longer the periodof time, the higher the future value. Note that for an interest rate of 0 percent, thefuture value always equals the present value ($1.00). But for any interest rategreater than zero, the future value is greater than the present value of $1.00. PRESENT VALUE OF A SINGLE AMOUNT It is often useful to determine the value today of a future amount of money. For example, how much would I have to deposit today into an account paying 7 per-cent annual interest to accumulate $3,000 at the end of 5 years? Present value is the current dollar value of a future amount—the amount of money that wouldhave to be invested today at a given interest rate over a specified period to equalthe future amount. Like future value, the present value depends largely on theinterest rate and the point in time at which the amount is to be received. This sec-tion explores the present value of a single amount. The Concept of Present Value The process of finding present values is often referred to as discounting cash flows. It is concerned with answering the following question: If I can earn rper- cent on my money, what is the most I would be willing to pay now for an oppor-tunity to receive FV ndollars nperiods from today? This process is actually the inverse of compounding interest. Instead of finding the future value of present dollars invested at a given rate, discountingdetermines the present value of a future amount, assuming an opportunity toearn a certain return on the money. This annual rate of return is variouslyreferred to as the discount rate, required return, cost of capital, andopportunity cost. These terms will be used interchangeably in this text. Paul Shorter has an opportunity to receive $300 one year from now. If he can earn 6% on his investments in the normal course of events, what is the most he should pay now for this opportunity? To answerthis question, Paul must determine how many dollars he would have to invest at6% today to have $300 one year from now. Letting PVequal this unknown amount and using the same notation as in the future value discussion, we have (5.5) PV *(1+0.06) =$300Personal Finance Example 5.43168 PART 2 Financial Tools present value The current dollar value of a future amount—the amount of money that would have to be invested today at a giveninterest rate over a specifiedperiod to equal the futureamount.90 807060 30 4050 1020 1 20 4 6 8 10 12 14 16 18 20 22 24 PeriodsFuture Value of One Dollar ($)20% 15% 10% 5% 0%FIGURE 5.4 Future Value Relationship Interest rates, time periods,and future value of one dollar discounting cash flows The process of finding present values; the inverse ofcompounding interest. CHAPTER 5 Time Value of Money 169 Solving Equation 5.5 for PVgives us Equation 5.6: (5.6) The value today (“present value”) of $300 received one year from today, given an interest rate of 6%, is $283.02. That is, investing $283.02 today at 6% would result in $300 at the end of one year. The Equation for Present Value The present value of a future amount can be found mathematically by solvingEquation 5.4 for PV.In other words, the present value, PV, of some future amount, FV n, to be received nperiods from now, assuming an interest rate (or opportunity cost) of r, is calculated as follows: (5.7) Note the similarity between this general equation for present value and the equa- tion in the preceding example (Equation 5.6). Let’s use this equation in an example. Pam Valenti wishes to find the present value of $1,700 that she will receive 8 years from now. Pam’s opportunity cost is 8%. Substituting and into Equation 5.7 yieldsEquation 5.8: (5.8) The following time line shows this analysis.PV =$1,700 (1*0.08)8=$1,700 1.85093=$918.46r=0.08 n=8, FV8=$1,700,Personal Finance Example 5.53PV =FVn (1+r)n=$283.02PV =$300 (1+0.06) PV = $918.460 1 2 3 4 5 6 7 8End of Year FV8 = $1,700Time line for present value of a single amount ($1,700 future amount, discounted at8%, from the end of 8 years) 918.461700 FV N CPT PVI8 8 SolutionInput Function Calculator Use Using the calculator’s financial functions and the inputs shown at the left, you should find the present value to be $918.46. Spreadsheet Use The format of Excel’s present value function is very similar to the future value function covered earlier. The appropriate syntax is PV(rate,nper,pmt,fv,type). The input list inside the parentheses is the same as in Excel’s futurevalue function with one exception. The present value function contains the term A Graphical View of Present Value Remember that present value calculations assume that the future values are meas- ured at the endof the given period. The relationships among the factors in a present value calculation are illustrated in Figure 5.5. The figure clearly showsthat, everything else being equal, (1) the higher the discount rate, the lower thepresent value, and (2) the longer the period of time, the lower the present value.Also note that given a discount rate of 0 percent, the present value always equalsthe future value ($1.00). But for any discount rate greater than zero, the presentvalue is less than the future value of $1.00. 6 REVIEW QUESTIONS 5–3How is the compounding process related to the payment of interest on savings? What is the general equation for future value? 5–4What effect would a decrease in the interest rate have on the future value of a deposit? What effect would an increase in the holding period have on future value? 5–5What is meant by “the present value of a future amount”? What is thegeneral equation for present value?170 PART 2 Financial Tools PRESENT VALUE OF A SINGLE AMOUNT Future value Interest rate, pct per year compounded annuallyNumber of yearsPresent value1 2345$1,700 8% 8 $918.46 Entry in Cell B5 is =–PV(B3,B4,0,B2) The minus sign appears before PV to change the present value to a positive amount.AB fv, which represents the future lump sum payment (or receipt) whose present value you are trying to calculate. The present value of the single future amountalso can be calculated as shown on the following Excel spreadsheet. Periods02468 1 0 1 2 1 4 1 6 1 8 2 0 2 2 2 41.00 0.75 0.500.25Present Value of One Dollar ($)5%0% 15%10% 20%FIGURE 5.5 Present Value Relationship Discount rates, time periods,and present value of one dollar CHAPTER 5 Time Value of Money 171 5–6What effect does increasing the required return have on the present value of a future amount? Why? 5–7How are present value and future value calculations related? 5.3 Annuities How much would you pay today, given that you can earn 7 percent on low-risk investments, to receive a guaranteed $3,000 at the end of each of the next 20 years? How much will you have at the end of 5 years if your employer with-holds and invests $1,000 of your bonus at the end of each of the next 5 years, guaranteeing you a 9 percent annual rate of return? To answer these questions,you need to understand the application of the time value of money to annuities. Anannuity is a stream of equal periodic cash flows, over a specified time period. These cash flows are usually annual but can occur at other intervals, suchas monthly rent or car payments. The cash flows in an annuity can be inflows (the $3,000 received at the end of each of the next 20 years) or outflows (the $1,000 invested at the end of each of the next 5 years). TYPES OF ANNUITIES There are two basic types of annuities. For an ordinary annuity, the cash flow occurs at the endof each period. For an annuity due, the cash flow occurs at the beginning of each period. Fran Abrams is evaluating two annuities. Both are 5-year, $1,000 annuities; annuity A is an ordinary annuity and annuity B is an annuity due. To better understand the difference between these annuities,she has listed their cash flows in Table 5.1. Note that the amount of each annuitytotals $5,000. The two annuities differ only in the timing of their cash flows: Thecash flows are received sooner with the annuity due than with the ordinaryannuity.Personal Finance Example 5.63annuity A stream of equal periodic cash flows over a specifiedtime period. These cash flows can be inflows of returns earned on investments or outflows of funds invested to earn future returns. ordinary annuity An annuity for which the cashflow occurs at the endof each period. annuity due An annuity for which the cashflow occurs at the beginning of each period. Comparison of Ordinary Annuity and Annuity Due Cash Flows ($1,000, 5 Years) Annual cash flows Year Annuity A ( ordinary ) Annuity B ( annuity due ) 0 $ 0 $1,000 1 1,000 1,0002 1,000 1,0003 1,000 1,0004 1,000 1,0005 Totals $5,000 $5,0000 1,000TABLE 5.1LG3 Although the cash flows of both annuities in Table 5.1 total $5,000, the annuity due would have a higher future value than the ordinary annuity becauseeach of its five annual cash flows can earn interest for 1 year more than each ofthe ordinary annuity’s cash flows. In general, as will be demonstrated later in thischapter, the value (present or future) of an annuity due is always greater than the value of an otherwise identical ordinary annuity. Because ordinary annuities are more frequently used in finance, unless other- wise specified, the term annuity is intended throughout this book to refer to ordi- nary annuities. FINDING THE FUTURE VALUE OF AN ORDINARY ANNUITY One way to find the future value of an ordinary annuity is to calculate the futurevalue of each of the individual cash flows and then add up those figures.Fortunately, there are several shortcuts to get to the answer. You can calculate thefuture value of an ordinary annuity that pays an annual cash flow equal to CFby using Equation 5.9: (5.9) As before, in this equation rrepresents the interest rate, and nrepresents the number of payments in the annuity (or equivalently, the number of years overwhich the annuity is spread). The calculations required to find the future value ofan ordinary annuity are illustrated in the following example. Fran Abrams wishes to determine how much money she will have at the end of 5 years if she chooses annuity A, the ordinary annuity. She will deposit $1,000 annually, at the end of each of the next 5 years, into a savings account paying 7% annual interest. This situation is d epicted on the following time line:Personal Finance Example 5.73FVn=CF *e3(1+r)n-14 rf172 PART 2 Financial Tools $1,000 $1,000 $1,000 $1,000 $1,000 012345$1,310.80 1,225.04 1,144.901,070.00 1,000.00 $5,750.74 Future Value End of YearTime line for future value of an ordinary annuity ($1,000end-of-year deposit, earning 7%, at the end of 5 years) As the figure shows, at the end of year 5, Fran will have $5,750.74 in her account. Note that because the deposits are made at the end of the year the first CHAPTER 5 Time Value of Money 173 deposit will earn interest for 4 years, the second for 3 years, and so on. Plugging the relevant values into Equation 5.9 we have (5.10) Calculator Use Using the calculator inputs shown at the left, you can confirm that the future value of the ordinary annuity equals $5,750.74. Spreadsheet Use To calculate the future value of an annuity in Excel, we will use the same future value function that we used to calculate the future value of alump sum, but we will add two new input values. Recall that the future valuefunction’s syntax is FV(rate,nper,pmt,pv,type). We have already explained theterms rate, nper, andpvin this function. The term pmtrefers to the annual pay- ment that the annuity offers. The term type is an input that lets Excel know whether the annuity being valued is an ordinary annuity (in which case the inputvalue for type is 0 or omitted) or an annuity due (in which case the correct input value for typeis 1). In this particular problem, the input value for pvis 0 or omitted because there is no up-front money received. The only cash flows are those thatare part of the annuity stream. The future value of the ordinary annuity can becalculated as shown on the following Excel spreadsheet.FV 5=$1,000 *e3(1+0.07)5-14 0.07f=$5,750.74 5,750.741000 PMT N CPT FVI5 7 SolutionInput Function FUTURE VALUE OF AN ORDINARY ANNUITY Annual payment Annual rate of interest, compounded annuallyNumber of yearsFuture value of an ordinary annuity1 2345$1,000 7% 5 $5,750.74 Entry in Cell B5 is =FV(B3,B4,–B2) The minus sign appears before B2 because the annual payment is a cash outflow.AB FINDING THE PRESENT VALUE OF AN ORDINARY ANNUITY Quite often in finance, there is a need to find the present value of a stream of cash flows to be received in future periods. An annuity is, of course, a stream ofequal periodic cash flows. The method for finding the present value of an ordi-nary annuity is similar to the method just discussed. One approach would be tocalculate the present value of each cash flow in the annuity and then add upthose present values. Alternatively, the algebraic shortcut for finding the presentvalue of an ordinary annuity that makes an annual payment of CFfornyears looks like this: (5.11) Of course the simplest approach is to solve problems like these with a financialcalculator or spreadsheet program.PV n=aCF rb*c1-1 (1+r)nd Braden Company, a small producer of plastic toys, wants to determine the most it should pay to purchase a particular ordinary annuity. The annuity consists ofcash flows of $700 at the end of each year for 5 years. The firm requires theannuity to provide a minimum return of 8%. This situation is depicted on the fol-lowing time line:Example 5.83174 PART 2 Financial Tools Table 5.2 shows one way to find the present value of the annuity—simply calcu- late the present values of all the cash payments using the present value equation(Equation 5.7 on page 169) and sum them. This procedure yields a present valueof $2,794.90. Calculators and spreadsheets offer streamlined methods forarriving at this figure. Calculator Use Using the calculator’s inputs shown at the left, you will find the present value of the ordinary annuity to be $2,794.90. Spreadsheet Use The present value of the ordinary annuity also can be calcu- lated as shown on the Excel spreadsheet on the next page.0 1 2 3 4 5End of Year $700 648.15 600.14 555.68 514.52476.41 $2,794.90$ Present Value$700 $700 $700 $700Time line for present value of an ordinary annuity ($700 end-of-year cash flows, discounted at 8%, over 5 years) Long Method for Finding the Present Value of anOrdinary Annuity Year ( n) Cash flow Present value calculation Present value 1 $700 $ 648.15 2 700 600.143 700 555.684 700 514.525 700 Present value of annuity $2,794.90 476.41700 (1+0.08)5=700 (1+0.08)4=700 (1+0.08)3=700 (1+0.08)2=700 (1+0.08)1=TABLE 5.2 2,794.90700 PMT N CPT PVI5 8 SolutionInput Function CHAPTER 5 Time Value of Money 175 FINDING THE FUTURE VALUE OF AN ANNUITY DUE We now turn our attention to annuities due. Remember that the cash flows of an annuity due occur at the start of the period. In other words, if we are dealing with annual payments, each payment in an annuity due comes one year earlier than itwould in an ordinary annuity. This in turn means that each payment can earn anextra year’s worth of interest, which is why the future value of an annuity dueexceeds the future value of an otherwise identical ordinary annuity. The algebraic shortcut for the future value of an annuity due that makes annual payments of CFfornyears is (5.12) Compare this to Equation 5.9 on page 172, which shows how to calculate the future value of an ordinary annuity. The two equations are nearly identical,but Equation 5.12 has an added term, , at the end. In other words, thevalue obtained from Equation 5.12 will be times greater than the value inEquation 5.9 if the other inputs ( CFandn) are the same, and that makes sense because all the payments in the annuity due earn one more year’s worth ofinterest compared to the ordinary annuity. Recall from an earlier example, illustrated in Table 5.1 on page 171, that Fran Abrams wanted to choose between an ordinary annuity and an annuity due, both offering similar terms except for the timing ofcash flows. We calculated the future value of the ordinary annuity in Example5.7. We now will calculate the future value of the annuity due. Calculator Use Before using your calculator to find the future value of an annuity due, depending on the specific calculator, you must either switch it toBEGIN mode or use the DUE key. Then, using the inputs shown at the left, youwill find the future value of the annuity due to be $6,153.29. ( Note: Because we nearly always assume end-of-period cash flows, be sure to switch your calculator back to END mode when you have completed your annuity-due calculations. ) Spreadsheet Use The future value of the annuity due also can be calculated as shown on the following Excel spreadsheet. Remember that for an annuity due the type input value must be set to 1, and we must also specify the pvinput value as 0 since the inputs are in an ordered series.Personal Finance Example 5.93(1+r)(1+r)FVn=CF *e3(1+r)n-14 rf*(1+r)PRESENT VALUE OF AN ORDINARY ANNUITY Annual payment Annual rate of interest, compounded annuallyNumber of yearsPresent value of an ordinary annuity1 2345$700 8% 5 $2,794.90 Entry in Cell B5 is =PV(B3,B4,–B2) The minus sign appears before B2 because the annual payment is a cash outflow.AB 6,153.291000 PMT N CPT FVI5 7 SolutionInput FunctionNote: Switch calculator to BEGIN mode. Comparison of an Annuity Due with an Ordinary Annuity Future Value The future value of an annuity due is always greater than the future value of an otherwise identical ordinary annuity. We can see this by comparing the futurevalues at the end of year 5 of Fran Abrams’s two annuities: Ordinary annuity $5,750.74 versus Annuity due $6,153.29 Because the cash flow of the annuity due occurs at the beginning of the period rather than at the end (that is, each payment comes one year sooner in theannuity due), its future value is greater. How much greater? It is interesting to cal-culate the percentage difference between the value of the annuity and the value ofthe annuity due: Recall that the interest rate in this example is 7 percent. It is no coincidence that the annuity due is 7 percent more valuable than the annuity. An extra year’sinterest on each of the annuity due’s payments make the annuity due 7 percentmore valuable than the annuity. FINDING THE PRESENT VALUE OF AN ANNUITY DUE We can also find the present value of an annuity due. This calculation can beeasily performed by adjusting the ordinary annuity calculation. Because the cashflows of an annuity due occur at the beginning rather than the end of the period,to find their present value, each annuity due cash flow is discounted back one lessyear than for an ordinary annuity. The algebraic formula for the present value ofan annuity due looks like this: (5.13) Notice the similarity between this equation and Equation 5.11 on page 173.The two equations are identical except that Equation 5.13 has an extra term atthe end, . The reason for this extra term is the same as in the case when wecalculated the future value of the annuity due. In the annuity due, each paymentarrives one year earlier (compared to the annuity), so each payment is worth alittle more—one year’s interest more.(1+r)PV n=aCF rb*c1-1 (1+r)nd*(1+r)($6,153.29 -$5,750.74) ,$5,750.74 =0.07 =7%= =176 PART 2 Financial Tools FUTURE VALUE OF AN ANNUITY DUE Annual payment Annual rate of interest, compounded annuallyNumber of yearsFuture value of an annuity due1 2345$1,000 7% 5 $6,153.29 Entry in Cell B5 is =FV(B3,B4,–B2,0,1) The minus sign appears before B2 because the annual payment is a cash outflow.AB CHAPTER 5 Time Value of Money 177 In Example 5.8 of Braden Company, we found the present value of Braden’s $700, 5-year ordinary annuity discounted at 8% to be $2,794.90. If we nowassume that Braden’s $700 annual cash flow occurs at the start of each year and is thereby an annuity due, we can calculate its present value using a calculator ora spreadsheet. Calculator Use Before using your calculator to find the present value of an annuity due, depending on the specifics of your calculator, you must eitherswitch it to BEGIN mode or use the DUE key. Then, using the inputs shown atthe left, you will find the present value of the annuity due to be $3,018.49 ( Note: Because we nearly always assume end-of-period cash flows, be sure to switch your calculator back to END mode when you have completed your annuity-duecalculations. ) Spreadsheet Use The present value of the annuity due also can be calculated as shown on the following Excel spreadsheet.Example 5.10 3 Matter of fact Kansas truck driver Donald Damon got the surprise of his life when he learned he held the win- ning ticket for the Powerball lottery drawing held November 11, 2009. The advertised lottery jackpot was $96.6 million. Damon could have chosen to collect his prize in 30 annual payments of $3,220,000 (30 $3.22 million $96.6 million), but instead he elected to accept a lump sum payment of $48,367,329.08, roughly half the stated jackpot total.= *Getting Your (Annuity) Due3,018.49700 PMT N CPT PVI5 8 SolutionInput FunctionNote: Switch calculator to BEGIN mode. PRESENT VALUE OF AN ANNUITY DUE Annual payment Annual rate of interest, compounded annuallyNumber of yearsPresent value of an annuity due1 2345$700 8% 5 $3,018.49 Entry in Cell B5 is =PV(B3,B4,–B2,0,1) The minus sign appears before B2 because the annual payment is a cash outflow.AB Comparison of an Annuity Due with an Ordinary Annuity Present Value The present value of an annuity due is always greater than the present value of an otherwise identical ordinary annuity. We can see this by comparing the presentvalues of the Braden Company’s two annuities: Ordinary annuity $2,794.90 versus Annuity due $3,018.49 Because the cash flow of the annuity due occurs at the beginning of the period rather than at the end, its present value is greater. If we calculate the percentagedifference in the values of these two annuities, we will find that the annuity due is8 percent more valuable than the annuity: ($3,018.49 -$2,794.90) ,$2,794.90 =0.08 =8%= = FINDING THE PRESENT VALUE OF A PERPETUITY Aperpetuity is an annuity with an infinite life—in other words, an annuity that never stops providing its holder with a cash flow at the end of each year (forexample, the right to receive $500 at the end of each year forever). It is sometimes necessary to find the present value of a perpetuity. Fortunately, the calculation for the present value of a perpetuity is one of the easiest in all offinance. If a perpetuity pays an annual cash flow of CF, starting one year from now, the present value of the cash flow stream is (5.14) Ross Clark wishes to endow a chair in finance at his alma mater. The university indicated that it requires $200,000 per year to support the chair, and the endowment would earn 10% per year. To deter-mine the amount Ross must give the university to fund the chair, we must deter-mine the present value of a $200,000 perpetuity discounted at 10%. Usingequation 5.14, we can determine that the present value of a perpetuity paying$200,000 per year is $2 million when the interest rate is 10%: In other words, to generate $200,000 every year for an indefinite period requires $2,000,000 today if Ross Clark’s alma mater can earn 10% on its investments. Ifthe university earns 10% interest annually on the $2,000,000, it can withdraw $200,000 per year indefinitely. 6 REVIEW QUESTIONS 5–8What is the difference between an ordinary annuity and an annuity due? Which is more valuable? Why? 5–9What are the most efficient ways to calculate the present value of an ordinary annuity? 5–10 How can the formula for the future value of an annuity be modified tofind the future value of an annuity due? 5–11 How can the formula for the present value of an ordinary annuity bemodified to find the present value of an annuity due? 5–12 What is a perpetuity? Why is the present value of a perpetuity equal to the annual cash payment divided by the interest rate?PV =$200,000 ,0.10 =$2,000,000Personal Finance Example 5.11 3PV =CF ,r178 PART 2 Financial Tools perpetuity An annuity with an infinite life, providing continual annualcash flow. 5.4 Mixed Streams Two basic types of cash flow streams are possible, the annuity and the mixed stream. Whereas an annuity is a pattern of equal periodic cash flows, a mixed stream is a stream of unequal periodic cash flows that reflect no particular pat- tern. Financial managers frequently need to evaluate opportunities that areexpected to provide mixed streams of cash flows. Here we consider both thefuture value and the present value of mixed streams.mixed stream A stream of unequal periodic cash flows that reflect noparticular pattern.LG4 CHAPTER 5 Time Value of Money 179 FUTURE VALUE OF A MIXED STREAM Determining the future value of a mixed stream of cash flows is straightforward. We determine the future value of each cash flow at the specified future date andthen add all the individual future values to find the total future value. Shrell Industries, a cabinet manufacturer, expects to receive the following mixedstream of cash flows over the next 5 years from one of its small customers. Example 5.12 3 End of year Cash flow 1 $11,500 2 14,0003 12,9004 16,0005 18,000 $11,500 $14,000 $12,900 $16,000 $18,000 012345$15,645.62 17,635.97 15,046.5617,280.00 18,000.00 $83,608.15 Future Value End of YearTime line for future value of a mixed stream (end-of-year cash flows, compounded at8% to the end of year 5)If Shrell expects to earn 8% on its investments, how much will it accumulate by the end of year 5 if it immediately invests these cash flows when they arereceived? This situation is depicted on the following time line: Calculator Use You can use your calculator to find the future value of each individual cash flow, as demonstrated earlier (on page 167), and then sum thefuture values to get the future value of the stream. Unfortunately, unless you canprogram your calculator, most calculators lack a function that would allow youto input all of the cash flows, specify the interest rate, and directly calculate the future value of the entire cash flow stream. Had you used your calculator to findthe individual cash flow future values and then summed them, the future value ofShrell Industries’ cash flow stream at the end of year 5 would have been$83,608.15. Spreadsheet Use A relatively simple way to use Excel to calculate the future value of a mixed stream is to use the Excel future value (FV) function discussedon page 167 combined with the net present value (NPV) function (which will bediscussed on page 181). The trick is to use the NPV function to first find thepresent value of the mixed stream and then find the future of this present valueamount. The following Excel spreadsheet illustrates this approach: PRESENT VALUE OF A MIXED STREAM Finding the present value of a mixed stream of cash flows is similar to finding the future value of a mixed stream. We determine the present value of each futureamount and then add all the individual present values together to find the totalpresent value. Frey Company, a shoe manufacturer, has been offered an opportunity to receivethe following mixed stream of cash flows over the next 5 years: Example 5.13 3180 PART 2 Financial Tools FUTURE VALUE OF A MIXED STREAM Interest rate, pct/year Y ear 12345 Future value1 2 3 4567898% Y ear-End Cash Flow $11,500$14,000$12,900$16,000$18,000 $83,608.15 Entry in Cell B9 is =–FV(B2,A8,0,NPV(B2,B4:B8)). The minus sign appears before FV to convert the future value to a positive amount.AB End of year Cash flow 1 $400 2 8003 5004 4005 300 0 1 2 3 4 5End of Year $400 366.97 673.34 386.09 283.37194.98 $1,904.75$ Present Value$800 $500 $400 $300Time line for present value of a mixed stream (end-of-year cash flows, discounted at 9%over the corresponding number of years)If the firm must earn at least 9% on its investments, what is the most it should pay for this opportunity? This situation is depicted on the following time line: CHAPTER 5 Time Value of Money 181 Calculator Use You can use a calculator to find the present value of each indi- vidual cash flow, as demonstrated earlier (on page 169), and then sum the presentvalues, to get the present value of the stream. However, most financial calculatorshave a function that allows you to punch in all cash flows, specify the discount rate, and then directly calculate the present value of the entire cash flow stream.The present value of Frey Company’s cash flow stream found using a calculator is$1,904.75. Spreadsheet Use To calculate the present value of a mixed stream in Excel, we will make use of a new function. The syntax of that function is NPV(rate,value1,value2,value3, . . .). The rate argument is the interest rate, and value1, value2,value3, . . . represent the stream of cash flows. The NPV function assumes that the first payment in the stream arrives one year in the future, and allsubsequent payments arrive at one-year intervals. The present value of the mixedstream of future cash flows can be calculated as shown on the following Excelspreadsheet: PRESENT VALUE OF A MIXED STREAM OF CASH FLOWS Interest rate, pct/year Y ear 12345 Present value1 2 3 4567899% Y ear-End Cash Flow $400$800$500$400$300 $1,904.75 Entry in Cell B9 is =NPV(B2,B4:B8).AB 6 REVIEW QUESTION 5–13 How is the future value of a mixed stream of cash flows calculated? How is the present value of a mixed stream of cash flows calculated? 5.5 Compounding Interest More Frequently Than Annually Interest is often compounded more frequently than once a year. Savings institu- tions compound interest semiannually, quarterly, monthly, weekly, daily, or evencontinuously. This section discusses various issues and techniques related to thesemore frequent compounding intervals. SEMIANNUAL COMPOUNDING Semiannual compounding of interest involves two compounding periods within the year. Instead of the stated interest rate being paid once a year, one-half of thestated interest rate is paid twice a year.semiannual compounding Compounding of interest over two periods within the year.LG5 Fred Moreno has decided to invest $100 in a savings account paying 8% interest compounded semiannually. If he leaves his money in the account for 24 months (2 years), he will be paid 4% interest com-pounded over four periods, each of which is 6 months long. Table 5.3 shows thatat the end of 12 months (1 year) with 8% semiannual compounding, Fred will have $108.16; at the end of 24 months (2 years), he will have $116.99.Personal Finance Example 5.14 3182 PART 2 Financial Tools quarterly compounding Compounding of interest over four periods within the year.TABLE 5.3Future Value from Investing $100 at 8% Interest Compounded Semiannually over 24 Months (2 Years) Period Beginning principal Future value calculation Future value at end of period 6 months $100.00 $104.00 12 months 104.00 108.16 18 months 108.16 112.49 24 months 112.49 116.99 112.49 *(1+0.04) =108.16 *(1+0.04) =104.00 *(1+0.04) =100.00 *(1+0.04) = QUARTERLY COMPOUNDING Quarterly compounding of interest involves four compounding periods within the year. One-fourth of the stated interest rate is paid four times a year. Fred Moreno has found an institution that will pay him 8% interest compounded quarterly. If he leaves his money in this account for 24 months (2 years), he will be paid 2% interest compounded overeight periods, each of which is 3 months long. Table 5.4 shows the amount Fredwill have at the end of each period. At the end of 12 months (1 year), with 8%quarterly compounding, Fred will have $108.24; at the end of 24 months (2 years), he will have $117.17.Personal Finance Example 5.15 3 TABLE 5.4Future Value from Investing $100 at 8% Interest Compounded Quarterly over 24 Months (2 Years) Period Beginning principal Future value calculation Future value at end of period 3 months $100.00 $102.00 6 months 102.00 104.049 months 104.04 106.12 12 months 106.12 108.2415 months 108.24 110.4118 months 110.41 112.6221 months 112.62 114.87 24 months 114.87 117.17 114.87 *(1+0.02) =112.62 *(1+0.02) =110.41 *(1+0.02) =108.24 *(1+0.02) =106.12 *(1+0.02) =104.04 *(1+0.02) =102.00 *(1+0.02) =100.00 *(1+0.02) = CHAPTER 5 Time Value of Money 183 Table 5.5 compares values for Fred Moreno’s $100 at the end of years 1 and 2 given annual, semiannual, and quarterly compounding periods at the 8 percentrate. The table shows that the more frequently interest is compounded, the greater the amount of money accumulated. This is true for any interest rate for any period of time. A GENERAL EQUATION FOR COMPOUNDING MORE FREQUENTLY THAN ANNUALLY The future value formula (Equation 5.4) can be rewritten for use when com- pounding takes place more frequently. If mequals the number of times per year interest is compounded, the formula for the future value of a lump sum becomes (5.15) If , Equation 5.15 reduces to Equation 5.4. Thus, if interest com- pounds annually, Equation 5.15 will provide the same result as Equation 5.4. Thegeneral use of Equation 5.15 can be illustrated with a simple example. The preceding examples calculated the amount that Fred Moreno would have at the end of 2 years if he deposited $100 at 8% interest compounded semiannually and compounded quarterly. For semi-annual compounding, mwould equal 2 in Equation 5.15; for quarterly com- pounding, mwould equal 4. Substituting the appropriate values for semiannual and quarterly compounding into Equation 5.14, we find that 1.For semiannual compounding: 2.For quarterly compounding: These results agree with the values for in Tables 5.5 and 5.6. If the interest were compounded monthly, weekly, or daily, mwould equal 12, 52, or 365, respectively.FV2FV2=$100 *a1+0.08 4b4*2 =$100 *(1+0.02)8=$117.17FV2=$100 *a1+0.08 2b2*2 =$100 *(1+0.04)4=$116.99Personal Finance Example 5.16 3m=1FVn=PV *a1+r mbm*nTABLE 5.5Future Value at the End of Years 1 and 2 from Investing $100 at 8% Interest, Given Various Compounding Periods Compounding period End of year Annual Semiannual Quarterly 1 $108.00 $108.16 $108.24 2 116.64 116.99 117.17 USING COMPUTATIONAL TOOLS FOR COMPOUNDING MORE FREQUENTLY THAN ANNUALLY As before, we can simplify the process of doing the calculations by using a calcu- lator or spreadsheet program. Fred Moreno wished to find the future value of $100 invested at 8% interest compounded both semiannually and quarterly for 2 years. Calculator Use If the calculator were used for the semiannual compounding cal- culation, the number of periods would be 4 and the interest rate would be 4%.The future value of $116.99 will appear on the calculator display as shown at thetop left. For the quarterly compounding case, the number of periods would be 8 and the interest rate would be 2%. The future value of $117.17 will appear on thecalculator display as shown in the second display at the left. Spreadsheet Use The future value of the single amount with semiannual and quarterly compounding also can be calculated as shown on the following Excelspreadsheet:Personal Finance Example 5.17 3184 PART 2 Financial Tools 116.99100 PV N CPT FVI4 4 SolutionInput Function 117.17100 PV N CPT FVI8 2 SolutionInput Function continuous compounding Compounding of interest an infinite number of times per year at intervals of microseconds.FUTURE VALUE OF A SINGLE AMOUNT WITH SEMIANNUAL AND QUARTERL Y COMPOUNDING Present value Interest rate, pct per year compounded semiannuallyNumber of yearsFuture value with semiannual compoundingPresent valueInterest rate, pct per year compounded quarterlyNumber of yearsFuture value with quarterly compounding1 23456789$100 8% 2 $116.99 $100 8% 2 $117.17 Entry in Cell B5 is =FV(B3/2,B4*2,0,–B2,0). Entry in Cell B9 is =FV(B7/4,B8*4,0,–B2,0). The minus sign appears before B2 because the present value is a cash outflow (i.e., a deposit made by Fred Moreno).AB CONTINUOUS COMPOUNDING In the extreme case, interest can be compounded continuously. Continuous com- pounding involves compounding over every nanosecond—the smallest time period imaginable. In this case, min Equation 5.15 would approach infinity. Through the use of calculus, we know that as mapproaches infinity, Equation 5.15 converges to (5.16) where eis the exponential function,3which has a value of approximately 2.7183.FVn=(PV)*(er*n) 3. Most calculators have the exponential function, typically noted by ,built into them. The use of this key is espe- cially helpful in calculating future value when interest is compounded continuously.ex CHAPTER 5 Time Value of Money 185 To find the value at the end of 2 years ( ) of Fred Moreno’s $100 deposit in an account paying 8% annual interest compounded continuously, we can substitute intoEquation 5.16: Calculator Use To find this value using the calculator, you need first to find the value of e 0.16by punching in 0.16 and then pressing 2nd and then exto get 1.1735. Next multiply this value by $100 to get the future value of $117.35 asshown at the left. ( Note: On some calculators, you may not have to press 2nd before pressing e x.) Spreadsheet Use The future value of the single amount with continuous com- pounding of Fred’s deposit also can be calculated as shown on the followingExcel spreadsheet:=$100 *1.1735 =$117.35=$100 *2.7183 0.16FV2 (continuous compounding) =$100 *e0.08 *2(r=0.08)(PV =$100)n=2Personal Finance Example 5.18 3 117.350.16 100ex /H11547 /H115491.1735 SolutionInput Function 2nd FUTURE VALUE OF A SINGLE AMOUNT WITH CONTINUOUS COMPOUNDING Present value Annual rate of interest, compounded continuouslyNumber of yearsFuture value with continuous compounding1 2345$100 8% 2 $117.35 Entry in Cell B5 is =B2*EXP(B3*B4).AB The future value with continuous compounding therefore equals $117.35. As expected, the continuously compounded value is larger than the future value ofinterest compounded semiannually ($116.99) or quarterly ($117.17). In fact, con-tinuous compounding produces a greater future value than any other com- pounding frequency. NOMINAL AND EFFECTIVE ANNUAL RATES OF INTEREST Both businesses and investors need to make objective comparisons of loan costsor investment returns over different compounding periods. To put interest rateson a common basis, so as to allow comparison, we distinguish between nominaland effective annual rates. The nominal, orstated, annual rate is the contractual annual rate of interest charged by a lender or promised by a borrower. Theeffective, ortrue, annual rate (EAR) is the annual rate of interest actually paid or earned. The effective annual rate reflects the effects of compounding frequency,whereas the nominal annual rate does not. Using the notation introduced earlier, we can calculate the effective annual rate, EAR, by substituting values for the nominal annual rate, r, and the com- pounding frequency, m, into Equation 5.17: (5.17) EAR =a1+r mbm -1nominal (stated) annual rate Contractual annual rate of interest charged by a lender or promised by a borrower. effective (true) annual rate (EAR) The annual rate of interest actually paid or earned. We can apply this equation using data from preceding examples. Fred Moreno wishes to find the effective annual rate associated with an 8% nominal annual rate when interest is compounded (1) annually ; (2) semiannually ; and (3) quarterly . Substituting these values into Equation 5.17, we get 1.For annual compounding: 2.For semiannual compounding: 3.For quarterly compounding: These values demonstrate two important points: The first is that nominal and effective annual rates are equivalent for annual compounding. The second is thatthe effective annual rate increases with increasing compounding frequency, up to a limit that occurs with continuous compounding.4 For an EAR example related to the “payday loan” business, with discussion of the ethical issues involved, see the Focus on Ethics box. At the consumer level, “truth-in-lending laws” require disclosure on credit card and loan agreements of the annual percentage rate (APR). The APR is the nominal annual rate found by multiplying the periodic rate by the number of periods in one year. For example, a bank credit card that charges 1.5 percent permonth (the periodic rate) would have an APR of 18 percent (1.5% per month12 months per year). “Truth-in-savings laws,” on the other hand, require banks to quote the annual percentage yield (APY) on their savings products. The APY is the effective annual rate a savings product pays. For example, a savings account that pays 0.5 percent per month would have an APY of 6.17 percent . 3(1.005) 12-14*EAR =a1+0.08 4b4 -1=(1+0.02)4-1=1.0824 -1=0.0824 =8.24%EAR =a1+0.08 2b2 -1=(1+0.04)2-1=1.0816 -1=0.0816 =8.16%EAR =a1+0.08 1b1 -1=(1+0.08)1-1=1+0.08 -1=0.08 =8%(m=4)(m=2) (m=1)(r=0.08)Personal Finance Example 5.19 3186 PART 2 Financial Tools 4. The effective annual rate for this extreme case can be found by using the following equation: (5.17a) For the 8% nominal annual rate , substitution into Equation 5.24a results in an effective annual rate of in the case of continuous compounding. This is the highest effective annual rate attainable with an 8% nominal rate.e0.08-1=1.0833 -1=0.0833 =8.33%(r=0.08)EAR (continuous compounding) =er-1annual percentage rate (APR) Thenominal annual rate of interest, found by multiplyingthe periodic rate by thenumber of periods in one year,that must be disclosed toconsumers on credit cards andloans as a result of “truth-in-lending laws.” annual percentage yield (APY) Theeffective annual rate of interest that must be disclosedto consumers by banks on theirsavings products as a result of“truth-in-savings laws.” CHAPTER 5 Time Value of Money 187 Quoting loan interest rates at their lower nominal annual rate (the APR) and savings interest rates at the higher effective annual rate (the APY) offers twoadvantages: It tends to standardize disclosure to consumers, and it enables finan-cial institutions to quote the most attractive interest rates: low loan rates and highsavings rates. 6 REVIEW QUESTIONS 5–14 What effect does compounding interest more frequently than annuallyhave on ( a) future value and ( b) the effective annual rate (EAR)? Why? 5–15 How does the future value of a deposit subject to continuous com- pounding compare to the value obtained by annual compounding? 5–16 Differentiate between a nominal annual rate and an effective annual rate (EAR). Define annual percentage rate (APR) andannual per- centage yield (APY).aggravating to opponents of the payday-advance industry. A typical feeis $15 for every $100 borrowed.Payday advance companies thatbelong to the Community FinancialServices Association of America(CFSA), an organization dedicated topromoting responsible regulation of the industry, limit their member companies to a maximum of four rollovers of theoriginal amount borrowed. Thus, a bor-rower who rolled over an initial $100loan for the maximum of four times would accumulate a total of $75 in fees all within a 10-week period. Onan annualized basis, the fees wouldamount to a whopping 391 percent. An annual rate of 391 percent is a huge cost in relation to interest charged on home equity loans, personal loans,and even credit cards. However, advo-cates of the payday-advance industry make the following arguments: Most payday loan recipients do so eitherbecause funds are unavailable throughconventional loans or because the pay-day loan averts a penalty or bank fee which is, in itself, onerous. According to Check Into Cash, the cost for $100of overdraft protection is $26.90, acredit card late fee on $100 is $37,and the late/disconnect fee on a $100 utility bill is $46.16. Bankrate.comreports that nonsufficient funds (NSF)fees average $26.90 per occurrence. A payday advance could be use- ful, for example, if you have six out- standing checks at the time you are notified that the first check has beenreturned for insufficient funds and youhave been charged an NSF fee of$26. A payday advance could poten- tially avert subsequent charges of $26 per check for each of the remainingfive checks and allow you time torearrange your finances. When usedjudiciously, a payday advance can be a viable option to meet a short-term cash flow problem despite its high cost.Used unwisely, or by someone whocontinuously relies on a payday loan totry to make ends meet, payday advances can seriously harm one ’s per- sonal finances. 3 The 391 percent mentioned above is an annual nominal rate [15% (365 14)]. Should the 2-week rate (15 percent) be com- pounded to calculate the effective annual interest rate?, *focus on ETHICS How Fair Is “Check Into Cash”? In 1993, the first Check Into Cash location opened in Cleveland,Tennessee. Today there are more than 1,100 Check Into Cash centers amongan estimated 22,000 payday-advancelenders in the United States. There is nodoubt about the demand for such organizations, but the debate continues on the “fairness ” of payday-advance loans. A payday loan is a small, unse- cured, short-term loan ranging from $100 to $1,000 (depending on the state) offered by a payday lender suchas Check Into Cash. A payday loancan solve temporary cash-flow prob-lems without bouncing a check or incur- ring late-payment penalties. To receive a payday advance, borrowers simplywrite a personal post-dated check forthe amount they wish to borrow, plus the payday loan fee. Check Into Cash holds their checks until payday whenthe loans are either paid off in personor the check is presented to the borrow-ers’ bank for payment. Although payday-advance borrow- ers usually pay a flat fee in lieu of inter-est, it is the size of the fee in relation tothe amount borrowed that is particularlyin practice 188 PART 2 Financial Tools 5.6 Special Applications of Time Value Future value and present value techniques have a number of important applica- tions in finance. We’ll study four of them in this section: (1) determining depositsneeded to accumulate a future sum, (2) loan amortization, (3) finding interest orgrowth rates, and (4) finding an unknown number of periods. DETERMINING DEPOSITS NEEDED TO ACCUMULATE A FUTURE SUM Suppose you want to buy a house 5 years from now, and you estimate that an ini- tial down payment of $30,000 will be required at that time. To accumulate the$30,000, you will wish to make equal annual end-of-year deposits into an accountpaying annual interest of 6 percent. The solution to this problem is closely relatedto the process of finding the future value of an annuity. You must determine whatsize annuity will result in a single amount equal to $30,000 at the end of year 5. Earlier in the chapter, Equation 5.9 was provided for the future value of an ordinary annuity that made a payment, CF,each year. In the current problem, we know the future value we want to achieve, $30,000, but we want to solve for theannual cash payment that we’d have to save to achieve that goal. SolvingEquation 5.9 for CFgives the following: (5.18) As a practical matter, to solve problems like this one, analysts nearly always use a calculator or Excel as demonstrated in the following example. As just stated, you want to determine the equal annual end- of-year deposits required to accumulate $30,000 at the end of 5 years, given an interest rate of 6%. Calculator Use Using the calculator inputs shown at the left, you will find the annual deposit amount to be $5,321.89. Thus, if $5,321.89 is deposited at theend of each year for 5 years at 6% interest, there will be $30,000 in the accountat the end of 5 years. Spreadsheet Use In Excel, solving for the annual cash flow that helps you reach the $30,000 means using the payment function. Its syntax is PMT(rate,nper,pv,fv,type). All of the inputs in this function have been discussed previously. The fol-lowing Excel spreadsheet illustrates how to use this function to find the annualpayment required to save $30,000.Personal Finance Example 5.20 3CF =FVn,e3(1+r)n-14 rf 5,321.8930000 FV N CPT PMTI5 6 SolutionInput Function ANNUAL DEPOSITS NEEDED TO ACCUMULATE A FUTURE SUM Future value Number of yearsAnnual rate of interestAnnual deposit1 2345$30,000 5 6% $5,321.89 Entry in Cell B5 is =–PMT(B4,B3,0,B2). The minus sign appears before PMT because the annual deposits are cash outflows.ABLG6 CHAPTER 5 Time Value of Money 189 LOAN AMORTIZATION The term loan amortization refers to the determination of equal periodic loan payments. These payments provide a lender with a specified interest return andrepay the loan principal over a specified period. The loan amortization processinvolves finding the future payments, over the term of the loan, whose presentvalue at the loan interest rate equals the amount of initial principal borrowed.Lenders use a loan amortization schedule to determine these payment amounts and the allocation of each payment to interest and principal. In the case of homemortgages, these tables are used to find the equal monthly payments necessary toamortize, or pay off, the mortgage at a specified interest rate over a 15- to 30-year period. Amortizing a loan actually involves creating an annuity out of a present amount. For example, say you borrow $6,000 at 10 percent and agree to makeequal annual end-of-year payments over 4 years. To find the size of the payments,the lender determines the amount of a 4-year annuity discounted at 10 percentthat has a present value of $6,000. This process is actually the inverse of findingthe present value of an annuity. Earlier in the chapter, Equation 5.11 demonstrated how to find the present value of an ordinary annuity given information about the number of time periods,the interest rate, and the annuity’s periodic payment. We can rearrange that equa-tion to solve for the payment, our objective in this problem: (5.19) As just stated, you want to determine the equal annual end- of-year payments necessary to amortize fully a $6,000, 10% loan over 4 years. Calculator Use Using the calculator inputs shown at the left, you will find the annual payment amount to be $1,892.82. Thus, to repay the interest and prin-cipal on a $6,000, 10%, 4-year loan, equal annual end-of-year payments of$1,892.82 are necessary. The allocation of each loan payment to interest and principal can be seen in columns 3 and 4 of the loan amortization schedule in Table 5.6 on page 190. The portion of each payment that represents interest (column 3) declinesover the repayment period, and the portion going to principal repayment(column 4) increases. This pattern is typical of amortized loans; as the prin-cipal is reduced, the interest component declines, leaving a larger portion ofeach subsequent loan payment to repay principal. Spreadsheet Use The annual payment to repay the loan also can be calculated as shown on the first Excel spreadsheet shown on page 190. The amortizationschedule, shown in Table 5.6, allocating each loan payment to interest andprincipal can be calculated precisely as shown on the second spreadsheet onpage 190.Personal Finance Example 5.21 3CF =(PV *r),c1-1 (1+r)ndloan amortization The determination of the equal periodic loan paymentsnecessary to provide a lenderwith a specified interest returnand to repay the loan principalover a specified period. loan amortization schedule A schedule of equal paymentsto repay a loan. It shows theallocation of each loanpayment to interest andprincipal. 1,892.826000 PV N CPT PMTI4 10 SolutionInput Function To attract buyers who could not immediately afford 15- to 30-year mort- gages of equal annual payments, lenders offered mortgages whose interest ratesadjusted at certain points. The Focus on Practice box discusses how such mort- gages have worked out for some “subprime” borrowers.190 PART 2 Financial Tools TABLE 5.6Loan Amortization Schedule ($6,000 Principal, 10% Interest, 4-Year Repayment Period) Payments Beginning- End-of-year of-year Loan Interest Principal principal principal payment End of-year (1) (2) (3) (4) (5) 1 $6,000.00 $1,892.82 $600.00 $1,292.82 $4,707.18 2 4,707.18 1,892.82 470.72 1,422.10 3,285.083 3,285.08 1,892.82 328.51 1,564.31 1,721.774 1,720.77 1,892.82 172.08 1,720.74 ––– a aBecause of rounding, a slight difference ($0.03) exists between the beginning-of-year-4 principal (in column 1) and the year-4 principal payment (in column 4).[(1)/H11546(4)] [(2)/H11546(3)] [0.10 :(1)] ANNUAL PAYMENT TO REPAY A LOAN Loan principal (present value) Annual rate of interestNumber of yearsAnnual payment1 2345$6,000 10% 4 $1,892.82 Entry in Cell B5 is =–PMT(B3,B4,B2). The minus sign appears before PMT because the annual payments are cash outflows.AB LOAN AMORTIZATION SCHEDULE Y ear 01234Data: Loan principal Annual rate of interest Number of years Annual Payments$6,000 10% 41 2345 6 789 1011 Key Cell Entries Cell B8: =–PMT($D$3,$D$4,$D$2), copy to B9:B11 Cell C8: =–CUMIPMT($D$3,$D$4,$D$2,A8,A8,0), copy to C9:C11 Cell D8: =–CUMPRINC($D$3,$D$4,$D$2,A8,A8,0), copy to D9:D11 Cell E8: =E7–D8, copy to E9:E11 The minus signs appear before the entries in Cells B8, C8, and D8 because these are cash outflows.A Total $1,892.82 $1,892.82$1,892.82$1,892.82B To Interest $600.00 $470.72$328.51$172.07C To Principal $1,292.82 $1,422.11$1,564.32$1,720.75D Y ear-End Principal $6,000.00 4,707.183,285.071,720.75 0.00E CHAPTER 5 Time Value of Money 191 FINDING INTEREST OR GROWTH RATES It is often necessary to calculate the compound annual interest or growth rate (that is, the annual rate of change in values) of a series of cash flows. Examples includefinding the interest rate on a loan, the rate of growth in sales, and the rate of growthin earnings. In doing this, we again make use of Equation 5.4. In this case, we wantto solve for the interest rate (or growth rate) representing the increase in value ofsome investment between two time periods. Solving Equation 5.4 for rwe have (5.20) The simplest situation is one in which an investment’s value has increased over time, and you want to know the annual rate of growth (that is, interest) that isrepresented by the increase in the investment. Ray Noble purchased an investment four years ago for $1,250. Now it is worth $1,520. What compound annual rate of return has Ray earned on this investment? Plugging the appropriate values intoEquation 5.20, we have per year Calculator Use Using the calculator to find the interest or growth rate, we treat the earliest value as a present value, PV,and the latest value as a future value, FV n. (Note: Most calculators require either thePVor the FVvalue to be input as a neg- ative number to calculate an unknown interest or growth rate. That approach isused here.) Using the inputs shown at the left, you will find the interest or growthrate to be 5.01%.r=($1,520 ,$1,250) (1/4)-1=0.0501 =5.01%Personal Finance Example 5.22 3r=aFVn PVb1/n -1As the housing market began to boom at the end of the twentieth century and intothe early twenty-first, the market shareof subprime mortgages climbed fromnear 0 percent in 1997 to about 20 percent of mortgage originations in 2006. Several factors combined tofuel the rapid growth of lending to borrowers with tarnished credit, includ-ing a low interest rate environment,loose underwriting standards, and innovations in mortgage financing such as “affordability programs ” to increase rates of homeownershipamong lower-income borrowers.focus on PRACTICE in practiceNew Century Brings Trouble for Subprime Mortgages option for many subprime borrowers.Instead, borrowers in trouble could tryto convince their lenders to allow a“short sale, ” in which the borrower sells the home for whatever the market willbear, and the lender agrees to acceptthe proceeds from that sale as settle-ment for the mortgage debt. For lendersand borrowers alike, foreclosure is thelast, worst option. 3 As a reaction to problems in the subprime area, lenders tightened lending standards. What effect do you think this had on the housing market?Particularly attractive to new home buyers was the hybrid adjustable ratemortgage (ARM), which featured a lowintroductory interest rate that resetupward after a preset period of time.Interest rates began a steady upwardtrend beginning in late 2004. In2006, some $300 billion worth ofadjustable ARMs were reset to higherrates. In a market with rising home val-ues, a borrower has the option to refi-nance the mortgage, using some of theequity created by the home ’s increasing value to reduce the mortgage payment. But after 2006, home prices started a3-year slide, so refinancing was not an 5.011250 PV FV CPT IN/H115461520 4 SolutionInput Function Another type of interest-rate problem involves finding the interest rate asso- ciated with an annuity, or equal-payment loan. Jan Jacobs can borrow $2,000 to be repaid in equal annual end-of-year amounts of $514.14 for the next 5 years. She wants to find the interest rate on this loan. Calculator Use (Note: Most calculators require either thePMT or the PVvalue to be input as a negative number to calculate an unknown interest rate on anequal-payment loan. That approach is used here.) Using the inputs shown at theleft, you will find the interest rate to be 9.00%. Spreadsheet Use The interest or growth rate for the annuity also can be calcu- lated as shown on the following Excel spreadsheet:Personal Finance Example 5.23 3192 PART 2 Financial Tools INTEREST OR GROWTH RATE– SERIES OF CASH FLOWS Y ear 20082012 Annual growth rateCash Flow $1,250 $1,520 5.01%1 2345 Entry in Cell B5 is =RATE(A4–A3,0,–B3,B4,0). The expression A4–A3 in the entry calculates the number of years of growth. The minus sign appears before B3 because the investment in 2008 is treated as a cash outflow.AB Spreadsheet Use The interest or growth rate for the series of cash flows also can be calculated as shown on the following Excel spreadsheet: 9.00514.14 PMT PV CPT IN/H115462000 5 SolutionInput Function INTEREST OR GROWTH RATE– ANNUITY Present value (loan principal) Number of yearsAnnual paymentsAnnual interest rate1 2345$2,000 5 $514.14 9.00% Entry in Cell B5 is =RATE(B3,B4,–B2). The minus sign appears before B2 because the loan principal is treated as a cash outflow.AB FINDING AN UNKNOWN NUMBER OF PERIODS Sometimes it is necessary to calculate the number of time periods needed to gen- erate a given amount of cash flow from an initial amount. Here we briefly con-sider this calculation for both single amounts and annuities. This simplest case iswhen a person wishes to determine the number of periods, n, it will take for an initial deposit, PV, to grow to a specified future amount, FV n, given a stated interest rate, r. CHAPTER 5 Time Value of Money 193 Ann Bates wishes to determine the number of years it will take for her initial $1,000 deposit, earning 8% annual interest, to grow to equal $2,500. Simply stated, at an 8% annual rate of interest, how manyyears, n,will it take for Ann’s $1,000, PV, to grow to $2,500, FV n? Calculator Use Using the calculator, we treat the initial value as the present value, PV, and the latest value as the future value, FVn.(Note: Most calculators require either thePVor the FVvalue to be input as a negative number to calcu- late an unknown number of periods. That approach is used here.) Using theinputs shown at the left, we find the number of periods to be 11.91 years. Spreadsheet Use The number of years for the present value to grow to a specified future value can be calculated as shown on the following Excel spreadsheet:Personal Finance Example 5.24 3 11.911000 PV FV CPT NI/H115462500 8 SolutionInput Function YEARS FOR A PRESENT VALUE TO GROW TO A SPECIFIED FUTURE VALUE Present value (deposit) Annual rate of interest, compounded annuallyFuture valueNumber of years1 2345$1,000 8% $2,500 11.91 Entry in Cell B5 is =NPER(B3,0,B2,–B4). The minus sign appears before B4 because the future value is treated as a cash outflow.AB Another type of number-of-periods problem involves finding the number of periods associated with an annuity. Occasionally we wish to find the unknown life,n,of an annuity that is intended to achieve a specific objective, such as repaying a loan of a given amount. Bill Smart can borrow $25,000 at an 11% annual interest rate; equal, annual, end-of-year payments of $4,800 are required. He wishes to determine how long it will take to fully repay the loan. In other words,he wishes to determine how many years, n, it will take to repay the $25,000, 11% loan, PV n, if the payments of $4,800 are made at the end of each year. Calculator Use (Note: Most calculators require either thePVor the PMT value to be input as a negative number to calculate an unknown number of periods.That approach is used here.) Using the inputs shown at the left, you will find thenumber of periods to be 8.15 years. This means that after making 8 payments of$4,800, Bill will still have a small outstanding balance. Spreadsheet Use The number of years to pay off the loan also can be calculated as shown on the following Excel spreadsheet:Personal Finance Example 5.25 3 8.15/H115464800 PMT PV CPT NI25000 11 SolutionInput Function YEARS TO PAY OFF A LOAN Annual payment Annual rate of interest, compounded annuallyPresent value (loan principal)Number of years to pay off the loan1 2345$4,800 11% $25,000 8.15 Entry in Cell B5 is =NPER(B3,–B2,B4). The minus sign appears before B2 because the payments are treated as cash outflows.AB 6 REVIEW QUESTIONS 5–17 How can you determine the size of the equal, annual, end-of-period deposits necessary to accumulate a certain future sum at the end of aspecified future period at a given annual interest rate? 5–18 Describe the procedure used to amortize a loan into a series of equalperiodic payments. 5–19 How can you determine the unknown number of periods when youknow the present and future values—single amount or annuity—andthe applicable rate of interest?194 PART 2 Financial Tools Summary FOCUS ON VALUE Time value of money is an important tool that financial managers and other market participants use to assess the effects of proposed actions. Because firmshave long lives and some decisions affect their long-term cash flows, the effectiveapplication of time-value-of-money techniques is extremely important. Thesetechniques enable financial managers to evaluate cash flows occurring at dif-ferent times so as to combine, compare, and evaluate them and link them to thefirm’s overall goal of share price maximization. It will become clear in Chapters 6 and 7 that the application of time value techniques is a key part of the valuedetermination process needed to make intelligent value-creating decisions. REVIEW OF LEARNING GOALS Discuss the role of time value in finance, the use of computational tools, and the basic patterns of cash flow. Financial managers and investors use time- value-of-money techniques when assessing the value of expected cash flowstreams. Alternatives can be assessed by either compounding to find future valueor discounting to find present value. Financial managers rely primarily onpresent value techniques. Financial calculators, electronic spreadsheets, andfinancial tables can streamline the application of time value techniques. Thecash flow of a firm can be described by its pattern—single amount, annuity, ormixed stream. Understand the concepts of future value and present value, their calcula- tion for single amounts, and the relationship between them. Future value (FV) relies on compound interest to measure future amounts. The initial principal ordeposit in one period, along with the interest earned on it, becomes the begin-ning principal of the following period. The present value (PV) of a future amount is the amount of money today that is equivalent to the given future amount, considering the return that can beearned. Present value is the inverse of future value. Find the future value and the present value of both an ordinary annuity and an annuity due, and find the present value of a perpetuity. An annuity is a pattern of equal periodic cash flows. For an ordinary annuity, the cash flows LG3LG2LG1 CHAPTER 5 Time Value of Money 195 occur at the end of the period. For an annuity due, cash flows occur at the beginning of the period. The future or present value of an ordinary annuity can be found by using algebraic equations, a financial calculator, or a spreadsheet program. The valueof an annuity due is always r% greater than the value of an identical annuity. The present value of a perpetuity—an infinite-lived annuity—equals the annualcash payment divided by the discount rate. Calculate both the future value and the present value of a mixed stream of cash flows. A mixed stream of cash flows is a stream of unequal periodic cash flows that reflect no particular pattern. The future value of a mixed stream ofcash flows is the sum of the future values of each individual cash flow. Similarly,the present value of a mixed stream of cash flows is the sum of the presentvalues of the individual cash flows. Understand the effect that compounding interest more frequently than annually has on future value and on the effective annual rate of interest. Interest can be compounded at intervals ranging from annually to daily and even contin-uously. The more often interest is compounded, the larger the future amountthat will be accumulated, and the higher the effective, or true, annual rate(EAR). The annual percentage rate (APR)—a nominal annual rate—is quoted on credit cards and loans. The annual percentage yield (APY)—an effective annualrate—is quoted on savings products. Describe the procedures involved in (1) determining deposits needed to accumulate a future sum, (2) loan amortization, (3) finding interest or growthrates, and (4) finding an unknown number of periods. (1) The periodic deposit to accumulate a given future sum can be found by solving the equation for thefuture value of an annuity for the annual payment. (2) A loan can be amortizedinto equal periodic payments by solving the equation for the present value of anannuity for the periodic payment. (3) Interest or growth rates can be estimatedby finding the unknown interest rate in the equation for the present value of asingle amount or an annuity. (4) The number of periods can be estimated byfinding the unknown number of periods in the equation for the present value ofa single amount or an annuity. LG6LG5LG4 Opener-in-Review In the chapter opener you learned that it costs Eli Lilly close to $1 billion to bring a new drug to market, and by the time all of the R&D and clinical trials are completed,Lilly may have fewer than 10 years left to sell the drug under patent protection. Assume that the $1 billion cost of bringing a new drug to market is spread out evenly over 10 years, and then 10 years remain for Lilly to recover their investment. How much cash would a new drug have to generate in the last 10 years to justify the $1 billion spent in the first 10 years? Assume that Lilly uses a required rate of returnof 10%. 196 PART 2 Financial Tools Self-Test Problems(Solutions in Appendix) ST5–1 Future values for various compounding frequencies Delia Martin has $10,000 that she can deposit in any of three savings accounts for a 3-year period. Bank A com- pounds interest on an annual basis, bank B compounds interest twice each year, andbank C compounds interest each quarter. All three banks have a stated annual interest rate of 4%. a.What amount would Ms. Martin have at the end of the third year, leaving all interest paid on deposit, in each bank? b.What effective annual rate (EAR ) would she earn in each of the banks? c.On the basis of your findings in parts aandb,which bank should Ms. Martin deal with? Why? d.If a fourth bank (bank D), also with a 4% stated interest rate, compounds interest continuously, how much would Ms. Martin have at the end of the thirdyear? Does this alternative change your recommendation in part c? Explain why or why not. ST5–2 Future values of annuities Ramesh Abdul wishes to choose the better of two equally costly cash flow streams: annuity X and annuity Y. X is an annuity due with a cash inflow of $9,000 for each of 6 years. Y is an ordinary annuity with a cash inflow of $10,000 for each of 6 years. Assume that Ramesh can earn 15% on his investments. a.On a purely subjective basis, which annuity do you think is more attractive? Why? b.Find the future value at the end of year 6 for both annuities. c.Use your finding in part bto indicate which annuity is more attractive. Why? Compare your finding to your subjective response in part a. ST5–3 Present values of single amounts and streams You have a choice of accepting either of two 5-year cash flow streams or single amounts. One cash flow stream is an ordi- nary annuity, and the other is a mixed stream. You may accept alternative A or B—either as a cash flow stream or as a single amount. Given the cash flow stream and single amounts associated with each (see the following table), and assuming a 9% opportunity cost, which alternative (A or B) and in which form (cash flow stream orsingle amount) would you prefer?LG2LG5 LG3 LG4LG3LG2 Cash flow stream End of year Alternative A Alternative B 1 $700 $1,100 2 700 9003 700 7004 700 5005 700 300 Single amount At time zero $2,825 $2,800 CHAPTER 5 Time Value of Money 197 ST5–4 Deposits needed to accumulate a future sum Judi Janson wishes to accumulate $8,000 by the end of 5 years by making equal, annual, end-of-year deposits over thenext 5 years. If Judi can earn 7% on her investments, how much must she deposit attheend of each year to meet this goal?LG6 Warm-Up ExercisesAll problems are available in . E5–1 Assume a firm makes a $2,500 deposit into its money market account. If this account is currently paying 0.7% (yes, that’s right, less than 1%!), what will the account balance be after 1 year? E5–2 If Bob and Judy combine their savings of $1,260 and $975, respectively, and deposit this amount into an account that pays 2% annual interest, compounded monthly, what will the account balance be after 4 years? E5–3 Gabrielle just won $2.5 million in the state lottery. She is given the option of receiving a total of $1.3 million now, or she can elect to be paid $100,000 at the end of each of the next 25 years. If Gabrielle can earn 5% annually on her investments, from a strict economic point of view which option should she take? E5–4 Your firm has the option of making an investment in new software that will cost$130,000 today and is estimated to provide the savings shown in the following table over its 5-year life: LG2 LG2LG5 LG3 LG4 Year Savings estimate 1 $35,000 2 50,0003 45,0004 25,0005 15,000 Should the firm make this investment if it requires a minimum annual return of 9% on all investments? E5–5 Joseph is a friend of yours. He has plenty of money but little financial sense. Hereceived a gift of $12,000 for his recent graduation and is looking for a bank in which to deposit the funds. Partners’ Savings Bank offers an account with an annual interestrate of 3% compounded semiannually, while Selwyn’s offers an account with a 2.75% annual interest rate compounded continuously. Calculate the value of the two accounts at the end of one year, and recommend to Joseph which account he should choose. E5–6 Jack and Jill have just had their first child. If college is expected to cost $150,000 per year in 18 years, how much should the couple begin depositing annually at the end of each year to accumulate enough funds to pay the first year’s tuition at thebeginning of the 19th year? Assume that they can earn a 6% annual rate of return on their investment.LG5 LG6 P5–3 Future value You have $100 to invest. If you can earn 12% interest, about how long does it take for your $100 investment to grow to $200? Suppose the interest rate is just half that, at 6%. At half the interest rate, does it take twice as long todouble your money? Why or why not? How long does it take? P5–4 Future values For each of the cases shown in the following table, calculate the future value of the single cash flow deposited today at the end of the deposit period if the interest is compounded annually at the rate specified.198 PART 2 Financial Tools ProblemsAll problems are available in . P5–1 Using a time line The financial manager at Starbuck Industries is considering an investment that requires an initial outlay of $25,000 and is expected to result in cashinflows of $3,000 at the end of year 1, $6,000 at the end of years 2 and 3, $10,000at the end of year 4, $8,000 at the end of year 5, and $7,000 at the end of year 6. a.Draw and label a time line depicting the cash flows associated with Starbuck Industries’ proposed investment. b.Use arrows to demonstrate, on the time line in part a,how compounding to find future value can be used to measure all cash flows at the end of year 6. c.Use arrows to demonstrate, on the time line in part b,how discounting to find present value can be used to measure all cash flows at time zero. d.Which of the approaches— future value orpresent value —do financial managers rely on most often for decision making? Why? P5–2 Future value calculation Without referring to the preprogrammed function on your financial calculator, use the basic formula for future value along with the given interest rate, r,and the number of periods, n, to calculate the future value of $1 in each of the cases shown in the following table. LG1 LG2 LG1 LG2Case Interest rate, r Number of periods, n A 12% 2 B6 3 C9 2 D3 4 Case Single cash flow Interest rate Deposit period (years) A $ 200 5% 20 B 4,500 8 7 C 10,000 9 10 D 25,000 10 12 E 37,000 11 5 F 40,000 12 9 CHAPTER 5 Time Value of Money 199 Personal Finance Problem P5–5 Time value You have $1,500 to invest today at 7% interest compounded annually. a.Find how much you will have accumulated in the account at the end of (1) 3 years, (2) 6 years, and (3) 9 years. b.Use your findings in part ato calculate the amount of interest earned in (1) the first 3 years (years 1 to 3), (2) the second 3 years (years 4 to 6), and (3) the third 3 years (years 7 to 9). c.Compare and contrast your findings in part b.Explain why the amount of interest earned increases in each succeeding 3-year period. Personal Finance Problem P5–6 Time value As part of your financial planning, you wish to purchase a new car exactly 5 years from today. The car you wish to purchase costs $14,000 today, andyour research indicates that its price will increase by 2% to 4% per year over thenext 5 years.a.Estimate the price of the car at the end of 5 years if inflation is (1) 2% per year and (2) 4% per year. b.How much more expensive will the car be if the rate of inflation is 4% rather than 2%? c.Estimate the price of the car if inflation is 2% for the next 2 years and 4% for 3 years after that. Personal Finance Problem P5–7 Time value You can deposit $10,000 into an account paying 9% annual interest either today or exactly 10 years from today. How much better off will you be at theend of 40 years if you decide to make the initial deposit today rather than 10 years from today? Personal Finance Problem P5–8 Time value Misty needs to have $15,000 at the end of 5 years to fulfill her goal of purchasing a small sailboat. She is willing to invest a lump sum today and leave themoney untouched for 5 years until it grows to $15,000, but she wonders what sort of investment return she will need to earn to reach her goal. Use your calculator or spreadsheet to figure out the approximate annually compounded rate of return needed in each of these cases: a.Misty can invest $10,200 today. b.Misty can invest $8,150 today. c.Misty can invest $7,150 today. Personal Finance Problem P5–9 Single-payment loan repayment A person borrows $200 to be repaid in 8 years with 14% annually compounded interest. The loan may be repaid at the end of anyearlier year with no prepayment penalty. a.What amount will be due if the loan is repaid at the end of year 1? b.What is the repayment at the end of year 4? c.What amount is due at the end of the eighth year? P5–10 Present value calculation Without referring to the preprogrammed function on your financial calculator , use the basic formula for present value, along with the given opportunity cost, r, and the number of periods, n, to calculate the present value of $1 in each of the cases shown in the following table.LG2 LG2 LG2 LG2 LG2 LG2 P5–11 Present values For each of the cases shown in the following table, calculate the present value of the cash flow, discounting at the rate given and assuming that the cash flow is received at the end of the period noted.200 PART 2 Financial Tools Case Opportunity cost, r Number of periods, n A2 % 4 B1 0 2 C5 3 D1 3 2 Case Single cash flow Discount rate End of period (years) A $ 7,000 12% 4 B 28,000 8 20 C 10,000 14 12 D 150,000 11 6 E 45,000 20 8 P5–12 Present value concept Answer each of the following questions. a.What single investment made today, earning 12% annual interest, will be worth $6,000 at the end of 6 years? b.What is the present value of $6,000 to be received at the end of 6 years if the dis- count rate is 12%? c.What is the most you would pay today for a promise to repay you $6,000 at the end of 6 years if your opportunity cost is 12%? d.Compare, contrast, and discuss your findings in parts athrough c. Personal Finance Problem P5–13 Time value Jim Nance has been offered an investment that will pay him $500 three years from today. a.If his opportunity cost is 7% compounded annually, what value should he place on this opportunity today? b.What is the most he should pay to purchase this payment today? c.If Jim can purchase this investment for less than the amount calculated in part a, what does that imply about the rate of return that he will earn on the investment? P5–14 Time value An Iowa state savings bond can be converted to $100 at maturity 6 years from purchase. If the state bonds are to be competitive with U.S. savings bonds, which pay 8% annual interest (compounded annually), at what price must the state sell its bonds? Assume no cash payments on savings bonds prior to redemption. Personal Finance Problem P5–15 Time value and discount rates You just won a lottery that promises to pay you $1,000,000 exactly 10 years from today. Because the $1,000,000 payment is guaran- teed by the state in which you live, opportunities exist to sell the claim today for an immediate single cash payment.LG2 LG2 LG2 LG2 LG2 CHAPTER 5 Time Value of Money 201 a.What is the least you will sell your claim for if you can earn the following rates of return on similar-risk investments during the 10-year period? (1) 6%(2) 9% (3) 12% b.Rework part aunder the assumption that the $1,000,000 payment will be received in 15 rather than 10 years. c.On the basis of your findings in parts aandb,discuss the effect of both the size of the rate of return and the time until receipt of payment on the present value of a future sum. Personal Finance Problem P5–16 Time value comparisons of single amounts In exchange for a $20,000 payment today, a well-known company will allow you to choose oneof the alternatives shown in the following table. Your opportunity cost is 11%. Alternative Single amount A $28,500 at end of 3 years B $54,000 at end of 9 years C $160,000 at end of 20 years Investment Price Single cash inflow Year of receipt A $18,000 $30,000 5 B 600 3,000 20 C 3,500 10,000 10 D 1,000 15,000 40a.Find the value today of each alternative. b.Are all the alternatives acceptable—that is, worth $20,000 today? c.Which alternative, if any, will you take? Personal Finance Problem P5–17 Cash flow investment decision Tom Alexander has an opportunity to purchase any of the investments shown in the following table. The purchase price, the amount of the single cash inflow, and its year of receipt are given for each investment. Which purchase recommendations would you make, assuming that Tom can earn 10% on his investments? P5–18 Calculating deposit needed You put $10,000 in an account earning 5%. After 3 years, you make another deposit into the same account. Four years later (that is, 7 years after your original $10,000 deposit), the account balance is $20,000. What was the amount of the deposit at the end of year 3?LG2 LG2 LG2 202 PART 2 Financial Tools Case Amount of annuity Interest rate Deposit period (years) A $ 2,500 8% 10 B 500 12 6 C 30,000 20 5 D 11,500 9 8 E 6,000 14 30 a.Calculate the future value of the annuity assuming that it is (1)An ordinary annuity. (2)An annuity due. b.Compare your findings in parts a(1) and a(2). All else being identical, which type of annuity—ordinary or annuity due—is preferable? Explain why. P5-20 Present value of an annuity Consider the following cases. Case Amount of annuity Interest rate Period (years) A $ 12,000 7% 3 B 55,000 12 15 C 700 20 9 D 140,000 5 7 E 22,500 10 5 a.Calculate the present value of the annuity assuming that it is (1)An ordinary annuity. (2)An annuity due. b.Compare your findings in parts a(1) and a(2). All else being identical, which type of annuity—ordinary or annuity due—is preferable? Explain why. Personal Finance Problem P5–21 Time value—Annuities Marian Kirk wishes to select the better of two 10-year annuities, C and D. Annuity C is an ordinary annuity of $2,500 per year for 10 years. Annuity D is an annuity due of $2,200 per year for 10 years. a.Find the future value of both annuities at the end of year 10, assuming that Marian can earn (1) 10% annual interest and (2) 20% annual interest. b.Use your findings in part ato indicate which annuity has the greater future value at the end of year 10 for both the (1) 10% and (2) 20% interest rates. c.Find the present value of both annuities, assuming that Marian can earn (1) 10% annual interest and (2) 20% annual interest. d.Use your findings in part cto indicate which annuity has the greater present value for both (1) 10% and (2) 20% interest rates. e.Briefly compare, contrast, and explain any differences between your findings using the 10% and 20% interest rates in parts bandd.LG3 LG3LG3P5–19 Future value of an annuity For each case in the accompanying table, answer the questions that follow. CHAPTER 5 Time Value of Money 203 Personal Finance Problem P5–22 Retirement planning Hal Thomas, a 25-year-old college graduate, wishes to retire at age 65. To supplement other sources of retirement income, he can deposit $2,000 each year into a tax-deferred individual retirement arrangement (IRA). The IRA will earn a 10% return over the next 40 years. a.If Hal makes annual end-of-year $2,000 deposits into the IRA, how much will he have accumulated by the end of his sixty-fifth year? b.If Hal decides to wait until age 35 to begin making annual end-of-year $2,000 deposits into the IRA, how much will he have accumulated by the end of his sixty-fifth year? c.Using your findings in parts aandb,discuss the impact of delaying making deposits into the IRA for 10 years (age 25 to age 35) on the amount accumulatedby the end of Hal’s sixty-fifth year. d.Rework parts a, b, andc,assuming that Hal makes all deposits at the beginning, rather than the end, of each year. Discuss the effect of beginning-of-year depositson the future value accumulated by the end of Hal’s sixty-fifth year. Personal Finance Problem P5–23 Value of a retirement annuity An insurance agent is trying to sell you an imme- diate-retirement annuity, which for a single amount paid today will provide you with $12,000 at the end of each year for the next 25 years. You currently earn 9% onlow-risk investments comparable to the retirement annuity. Ignoring taxes, what is the most you would pay for this annuity? Personal Finance Problem P5–24 Funding your retirement You plan to retire in exactly 20 years. Your goal is to create a fund that will allow you to receive $20,000 at the end of each year for the 30 years between retirement and death (a psychic told you would die exactly 30years after you retire). You know that you will be able to earn 11% per year during the 30-year retirement period. a.How large a fund will you need when you retire in 20 years to provide the 30-year, $20,000 retirement annuity? b.How much will you need today as a single amount to provide the fund calculated in part aif you earn only 9% per year during the 20 years preceding retirement? c.What effect would an increase in the rate you can earn both during and prior to retirement have on the values found in parts aandb? Explain. d.Now assume that you will earn 10% from now through the end of your retire- ment. You want to make 20 end-of-year deposits into your retirement account that will fund the 30-year stream of $20,000 annual annuity payments. Howlarge do your annual deposits have to be? Personal Finance Problem P5–25 Value of an annuity versus a single amount Assume that you just won the state lot- tery. Your prize can be taken either in the form of $40,000 at the end of each of the next 25 years (that is, $1,000,000 over 25 years) or as a single amount of $500,000 paid immediately.a.If you expect to be able to earn 5% annually on your investments over the next 25 years, ignoring taxes and other considerations, which alternative should you take? Why?LG3 LG3 LG3LG2 LG3LG2 b.Would your decision in part achange if you could earn 7% rather than 5% on your investments over the next 25 years? Why? c.On a strictly economic basis, at approximately what earnings rate would you be indifferent between the two plans? P5–26 Perpetuities Consider the data in the following table.204 PART 2 Financial Tools Perpetuity Annual amount Discount rate A $ 20,000 8% B 100,000 10 C 3,000 6 D 60,000 5 Cash flow stream Year A B C 1 $ 900 $30,000 $1,200 2 1,000 25,000 1,2003 1,200 20,000 1,0004 10,000 1,9005 5,000Determine the present value of each perpetuity. Personal Finance Problem P5–27 Creating an endowment On completion of her introductory finance course, Marla Lee was so pleased with the amount of useful and interesting knowledge she gainedthat she convinced her parents, who were wealthy alumni of the university she wasattending, to create an endowment. The endowment is to allow three needy studentsto take the introductory finance course each year in perpetuity. The guaranteed annual cost of tuition and books for the course is $600 per student. The endowment will be created by making a single payment to the university. The university expectsto earn exactly 6% per year on these funds. a.How large an initial single payment must Marla’s parents make to the university to fund the endowment? b.What amount would be needed to fund the endowment if the university could earn 9% rather than 6% per year on the funds? P5–28 Value of a mixed stream For each of the mixed streams of cash flows shown in the following table, determine the future value at the end of the final year if deposits are made into an account paying annual interest of 12%, assuming that no withdrawals are made during the period and that the deposits are made:a.At the endof each year. b.At the beginning of each year.LG3 LG3 LG4 CHAPTER 5 Time Value of Money 205 Personal Finance Problem P5–29 Value of a single amount versus a mixed stream Gina Vitale has just contracted to sell a small parcel of land that she inherited a few years ago. The buyer is willing to pay $24,000 at the closing of the transaction or will pay the amounts shown in the following table at the beginning of each of the next 5 years. Because Gina doesn’t really need the money today, she plans to let it accumulate in an account that earns7% annual interest. Given her desire to buy a house at the end of 5 years after closing on the sale of the lot, she decides to choose the payment alternative— $24,000 single amount or the mixed stream of payments in the following table— that provides the higher future value at the end of 5 years. Which alternative will she choose? Cash flow stream Year A B 1 $ 50,000 $ 10,000 2 40,000 20,0003 30,000 30,0004 20,000 40,0005 Totals $150,000 $150,00050,000 10,000P5-30 Value of mixed streams Find the present value of the streams of cash flows shown in the following table. Assume that the firm’s opportunity cost is 12%.Mixed stream Beginning of year Cash flow 1 $ 2,000 2 4,0003 6,0004 8,0005 10,000 AB C Year Cash flow Year Cash flow Year Cash flow 1 -$2,000 1 $10,000 1 -5 $10,000/yr 2 3,000 2–5 5,000/yr 6–10 8,000/yr3 4,000 6 7,0004 6,0005 8,000 P5–31 Present value—Mixed streams Consider the mixed streams of cash flows shown in the following table.LG4 LG4 LG4 a.Find the present value of each stream using a 15% discount rate. b.Compare the calculated present values and discuss them in light of the fact that the undiscounted cash flows total $150,000 in each case. P5–32 Value of a mixed stream Harte Systems, Inc., a maker of electronic surveillance equipment, is considering selling to a well-known hardware chain the rights tomarket its home security system. The proposed deal calls for the hardware chain topay Harte $30,000 and $25,000 at the end of years 1 and 2 and to make annualyear-end payments of $15,000 in years 3 through 9. A final payment to Harte of$10,000 would be due at the end of year 10.a.Lay out the cash flows involved in the offer on a time line. b.If Harte applies a required rate of return of 12% to them, what is the present value of this series of payments? c.A second company has offered Harte an immediate one-time payment of $100,000 for the rights to market the home security system. Which offer should Harte accept? Personal Finance Problem P5–33 Funding budget shortfalls As part of your personal budgeting process, you have determined that in each of the next 5 years you will have budget shortfalls. In other words, you will need the amounts shown in the following table at the end of thegiven year to balance your budget—that is, to make inflows equal outflows. You expect to be able to earn 8% on your investments during the next 5 years and wish to fund the budget shortfalls over the next 5 years with a single amount.206 PART 2 Financial Tools a.How large must the single deposit today into an account paying 8% annual interest be to provide for full coverage of the anticipated budget shortfalls? b.What effect would an increase in your earnings rate have on the amount calcu- lated in part a?Explain. P5–34 Relationship between future value and present value—Mixed stream Using the information in the accompanying table, answer the questions that follow.End of year Budget shortfall 1 $ 5,000 2 4,0003 6,0004 10,0005 3,000 Year ( t) Cash flow 1 $ 800 2 9003 1,0004 1,5005 2,000LG4LG1 LG4 LG4 CHAPTER 5 Time Value of Money 207 a.Determine the present value of the mixed stream of cash flows using a 5% dis- count rate. b.How much would you be willing to pay for an opportunity to buy this stream, assuming that you can at best earn 5% on your investments? c.What effect, if any, would a 7% rather than a 5% opportunity cost have on your analysis? (Explain verbally.) P5–35 Relationship between future value and present value—Mixed stream The table below shows a mixed cash flow stream, except that the cash flow for year 3 ismissing. Year 1 $10,000 Year 2 5,000Year 3Year 4 20,000Year 5 3,000 Suppose that somehow you know that the present value of the entire stream is $32,911.03, and the discount rate is 4%. What is the amount of the missing cashflow in year 3? P5–36 Changing compounding frequency Using annual, semiannual, and quarterly com- pounding periods for each of the following, (1) calculate the future value if $5,000 isdeposited initially, and (2) determine the effective annual rate (EAR ). a.At 12% annual interest for 5 years. b.At 16% annual interest for 6 years. c.At 20% annual interest for 10 years. P5–37 Compounding frequency, time value, and effective annual rates For each of the cases in the following table: a.Calculate the future value at the end of the specified deposit period. b.Determine the effective annual rate, EAR. c.Compare the nominal annual rate, r, to the effective annual rate, EAR. What relationship exists between compounding frequency and the nominal and effec-tive annual rates? Compounding Deposit Amount of Nominal frequency, m period Case initial deposit annual rate, r (times/year) (years) A $ 2,500 6% 2 5 B 50,000 12 6 3 C 1,000 5 1 10 D 20,000 16 4 6LG4 LG5 LG5 Personal Finance Problem P5–39 Compounding frequency and time value You plan to invest $2,000 in an individual retirement arrangement (IRA) today at a nominal annual rate of 8%, which is expected to apply to all future years. a.How much will you have in the account at the end of 10 years if interest is com- pounded (1) annually, (2) semiannually, (3) daily (assume a 365-day year), and (4) continuously? b.What is the effective annual rate, EAR, for each compounding period in part a? c.How much greater will your IRA balance be at the end of 10 years if interest is compounded continuously rather than annually? d.How does the compounding frequency affect the future value and effective annual rate for a given deposit? Explain in terms of your findings in parts athrough c. Personal Finance Problem P5–40 Comparing compounding periods René Levin wishes to determine the future value at the end of 2 years of a $15,000 deposit made today into an account paying a nominal annual rate of 12%. a.Find the future value of René’s deposit, assuming that interest is compounded (1) annually, (2) quarterly, (3) monthly, and (4) continuously. b.Compare your findings in part a, and use them to demonstrate the relationship between compounding frequency and future value. c.What is the maximum future value obtainable given the $15,000 deposit, the 2-year time period, and the 12% nominal annual rate? Use your findings in partato explain. Personal Finance Problem P5-41 Annuities and compounding Janet Boyle intends to deposit $300 per year in a credit union for the next 10 years, and the credit union pays an annual interest rate of 8%. a.Determine the future value that Janet will have at the end of 10 years, given that end-of-period deposits are made and no interest is withdrawn, if (1)$300 is deposited annually and the credit union pays interest annually. (2)$150 is deposited semiannually and the credit union pays interest semiannually. (3)$75 is deposited quarterly and the credit union pays interest quarterly. b.Use your finding in part ato discuss the effect of more frequent deposits and compounding of interest on the future value of an annuity.208 PART 2 Financial Tools Amount of Nominal annual Deposit period Case initial deposit rate, r (years), n A $1,000 9% 2 B 600 10 10 C 4,000 8 7 D 2,500 12 4 LG5 LG5 LG5LG3P5–38 Continuous compounding For each of the cases in the following table, find the future value at the end of the deposit period, assuming that interest is compounded continuously at the given nominal annual rate.LG5 CHAPTER 5 Time Value of Money 209 LG6 Personal Finance Problem P5–43 Creating a retirement fund To supplement your planned retirement in exactly 42 years, you estimate that you need to accumulate $220,000 by the end of 42 years from today. You plan to make equal, annual, end-of-year deposits into an account paying 8% annual interest. a.How large must the annual deposits be to create the $220,000 fund by the end of 42 years? b.If you can afford to deposit only $600 per year into the account, how much will you have accumulated by the end of the forty-second year? Personal Finance Problem P5–44 Accumulating a growing future sum A retirement home at Deer Trail Estates now costs $185,000. Inflation is expected to cause this price to increase at 6% per year over the 20 years before C. L. Donovan retires. How large an equal, annual, end-of- year deposit must be made each year into an account paying an annual interest rate of 10% for Donovan to have the cash needed to purchase a home at retirement? Personal Finance Problem P5–45 Deposits to create a perpetuity You have decided to endow your favorite university with a scholarship. It is expected to cost $6,000 per year to attend the universityinto perpetuity. You expect to give the university the endowment in 10 years andwill accumulate it by making equal annual (end-of-year) deposits into an account. The rate of interest is expected to be 10% for all future time periods. a.How large must the endowment be? b.How much must you deposit at the end of each of the next 10 years to accumu- late the required amount? Personal Finance Problem P5–46 Inflation, time value, and annual deposits While vacationing in Florida, John Kelley saw the vacation home of his dreams. It was listed with a sale price of $200,000. The only catch is that John is 40 years old and plans to continue working until he is 65. Still, he believes that prices generally increase at the overall rate of inflation. John believes that he can earn 9% annually after taxes on his investments. He is willing to invest a fixed amount at the end of each of the next 25 years to fundthe cash purchase of such a house (one that can be purchased today for $200,000) when he retires.Sum to be Accumulation Case accumulated period (years) Interest rate A $ 5,000 3 12% B 100,000 20 7 C 30,000 8 10 D 15,000 12 8 LG6 LG6 LG6LG3 LG6LG3 LG2P5–42 Deposits to accumulate future sums For each of the cases shown in the following table, determine the amount of the equal, annual, end-of-year deposits necessary to accumulate the given sum at the end of the specified period, assuming the stated annual interest rate. Personal Finance Problem P5–48 Loan amortization schedule Joan Messineo borrowed $15,000 at a 14% annual rate of interest to be repaid over 3 years. The loan is amortized into three equal,annual, end-of-year payments. a.Calculate the annual, end-of-year loan payment. b.Prepare a loan amortization schedule showing the interest and principal break- down of each of the three loan payments. c.Explain why the interest portion of each payment declines with the passage of time. P5–49 Loan interest deductions Liz Rogers just closed a $10,000 business loan that is to be repaid in three equal, annual, end-of-year payments. The interest rate on the loanis 13%. As part of her firm’s detailed financial planning, Liz wishes to determine the annual interest deduction attributable to the loan. (Because it is a business loan, the interest portion of each loan payment is tax-deductible to the business.) a.Determine the firm’s annual loan payment. b.Prepare an amortization schedule for the loan. c.How much interest expense will Liz’s firm have in each of the next 3 years as a result of this loan? Personal Finance Problem P5–50 Monthly loan payments Tim Smith is shopping for a used car. He has found one priced at $4,500. The dealer has told Tim that if he can come up with a down pay-ment of $500, the dealer will finance the balance of the price at a 12% annual rate over 2 years (24 months). a.Assuming that Tim accepts the dealer’s offer, what will his monthly (end-of- month) payment amount be? b.Use a financial calculator or spreadsheet to help you figure out what Tim’s monthly payment would be if the dealer were willing to finance the balance of the car price at a 9% annual rate.210 PART 2 Financial Tools a.Inflation is expected to average 5% per year for the next 25 years. What will John’s dream house cost when he retires? b.How much must John invest at the endof each of the next 25 years to have the cash purchase price of the house when he retires? c.If John invests at the beginning instead of at the end of each of the next 25 years, how much must he invest each year? P5–47 Loan payment Determine the equal, annual, end-of-year payment required each year over the life of the loans shown in the following table to repay them fullyduring the stated term of the loan. Loan Principal Interest rate Term of loan (years) A $12,000 8% 3 B 60,000 12 10 C 75,000 10 30 D 4,000 15 5LG6 LG6 LG6 LG6 CHAPTER 5 Time Value of Money 211 a.Calculate the compound annual growth rate between the first and last payment in each stream. b.If year-1 values represent initial deposits in a savings account paying annual interest, what is the annual rate of interest earned on each account? c.Compare and discuss the growth rate and interest rate found in parts aandb, respectively. Personal Finance Problem P5–52 Rate of return Rishi Singh has $1,500 to invest. His investment counselor suggests an investment that pays no stated interest but will return $2,000 at the end of 3 years.a.What annual rate of return will Rishi earn with this investment? b.Rishi is considering another investment, of equal risk, that earns an annual return of 8%. Which investment should he make, and why? Personal Finance Problem P5–53 Rate of return and investment choice Clare Jaccard has $5,000 to invest. Because she is only 25 years old, she is not concerned about the length of the investment’slife. What she is sensitive to is the rate of return she will earn on the investment. With the help of her financial advisor, Clare has isolated four equally risky invest- ments, each providing a single amount at the end of its life, as shown in the fol- lowing table. All of the investments require an initial $5,000 payment.P5–51 Growth rates You are given the series of cash flows shown in the following table. Cash flows Year A B C 1 $500 $1,500 $2,500 2 560 1,550 2,6003 640 1,610 2,6504 720 1,680 2,6505 800 1,760 2,8006 1,850 2,8507 1,950 2,9008 2,0609 2,170 10 2,280 Investment Single amount Investment life (years) A $ 8,400 6 B 15,900 15 C 7,600 4 D 13,000 10 a.Calculate, to the nearest 1%, the rate of return on each of the four investments available to Clare. b.Which investment would you recommend to Clare, given her goal of maximizing the rate of return?LG6 LG6 LG6 P5–54 Rate of return—Annuity What is the rate of return on an investment of $10,606 if the company will receive $2,000 each year for the next 10 years? Personal Finance Problem P5–55 Choosing the best annuity Raina Herzig wishes to choose the best of four immediate-retirement annuities available to her. In each case, in exchange for paying a single premium today, she will receive equal, annual, end-of-year cash benefits for a specified number of years. She considers the annuities to be equallyrisky and is not concerned about their differing lives. Her decision will be basedsolely on the rate of return she will earn on each annuity. The key terms of the fourannuities are shown in the following table.212 PART 2 Financial Tools Annuity Premium paid today Annual benefit Life (years) A $30,000 $3,100 20 B 25,000 3,900 10 C 40,000 4,200 15 D 35,000 4,000 12 Loan Principal Annual payment Term (years) A $5,000 $1,352.81 5 B 5,000 1,543.21 4 C 5,000 2,010.45 3a.Calculate to the nearest 1% the rate of return on each of the four annuities Raina is considering. b.Given Raina’s stated decision criterion, which annuity would you recommend? Personal Finance Problem P5–56 Interest rate for an annuity Anna Waldheim was seriously injured in an indus- trial accident. She sued the responsible parties and was awarded a judgment of $2,000,000. Today, she and her attorney are attending a settlement conference with the defendants. The defendants have made an initial offer of $156,000 per year for 25 years. Anna plans to counteroffer at $255,000 per year for 25 years. Both the offer and the counteroffer have a present value of $2,000,000, the amount of the judgment. Both assume payments at the end of each year.a.What interest rate assumption have the defendants used in their offer (rounded to the nearest whole percent)? b.What interest rate assumption have Anna and her lawyer used in their coun- teroffer (rounded to the nearest whole percent)? c.Anna is willing to settle for an annuity that carries an interest rate assumption of 9%. What annual payment would be acceptable to her? Personal Finance Problem P5–57 Loan rates of interest John Flemming has been shopping for a loan to finance the purchase of a used car. He has found three possibilities that seem attractive andwishes to select the one with the lowest interest rate. The information available with respect to each of the three $5,000 loans is shown in the following table.LG6 LG6 LG6 LG6 CHAPTER 5 Time Value of Money 213 Personal Finance Problem P5–59 Time to accumulate a given sum Manuel Rios wishes to determine how long it will take an initial deposit of $10,000 to double. a.If Manuel earns 10% annual interest on the deposit, how long will it take for him to double his money? b.How long will it take if he earns only 7% annual interest? c.How long will it take if he can earn 12% annual interest? d.Reviewing your findings in parts a, b, andc,indicate what relationship exists between the interest rate and the amount of time it will take Manuel to doublehis money. P5–60 Number of years to provide a given return In each of the following cases, deter- mine the number of years that the given annual end-of-year cash flow must continue to provide the given rate of return on the given initial amount.a.Determine the interest rate associated with each of the loans. b.Which loan should John take? P5–58 Number of years to equal future amount For each of the following cases, deter- mine the number of years it will take for the initial deposit to grow to equal thefuture amount at the given interest rate. Case Initial deposit Future amount Interest rate A $ 300 $ 1,000 7% B 12,000 15,000 5 C 9,000 20,000 10 D 100 500 9 E 7,500 30,000 15 Case Initial amount Annual cash flow Rate of return A $ 1,000 $ 250 11% B 150,000 30,000 15 C 80,000 10,000 10 D 600 275 9 E 17,000 3,500 6 Personal Finance Problem P5–61 Time to repay installment loan Mia Salto wishes to determine how long it will take to repay a loan with initial proceeds of $14,000 where annual end-of-year install- ment payments of $2,450 are required. a.If Mia can borrow at a 12% annual rate of interest, how long will it take for her to repay the loan fully? b.How long will it take if she can borrow at a 9% annual rate? c.How long will it take if she has to pay 15% annual interest? d.Reviewing your answers in parts a, b, andc,describe the general relationship between the interest rate and the amount of time it will take Mia to repay theloan fully.LG6 LG6 LG6 LG6 P5–62 ETHICS PROBLEM A manager at a “Check Into Cash” business (see Focus on Ethics box on page 187) defends his business practice as simply “charging what the market will bear.” “After all,” says the manager, “we don’t force people to come in thedoor.” How would you respond to this ethical defense of the payday-advance business?214 PART 2 Financial Tools LG6 Spreadsheet Exercise At the end of 2012, Uma Corporation was considering undertaking a major long- term project in an effort to remain competitive in its industry. The production and sales departments determined the potential annual cash flow savings that could accrue to the firm if it acts soon. Specifically, they estimate that a mixed stream offuture cash flow savings will occur at the end of the years 2013 through 2018. Theyears 2019 through 2023 will see consecutive and equal cash flow savings at the endof each year. The firm estimates that its discount rate over the first 6 years will be 7%.The expected discount rate over the years 2019 through 2023 will be 11%. The project managers will find the project acceptable if it results in present cash flow savings of at least $860,000. The following cash flow savings data are suppliedto the finance department for analysis. TO DO Create spreadsheets similar to Table 5.2, and then answer the following questions: a.Determine the value (at the beginning of 2013) of the future cash flow savings expected to be generated by this project. b.Based solely on the one criterion set by management, should the firm undertake this specific project? Explain. c.What is the “interest rate risk,” and how might it influence the recommendation made in part b?Explain. Visit www.myfinancelab.com forChapter Case: Funding Jill Moran’s Retirement Annuity, Group Exercises, and numerous online resources. End of year Cash flow savings 2013 $110,000 2014 120,0002015 130,0002016 150,0002017 160,0002018 150,0002019 90,0002020 90,0002021 90,0002022 90,0002023 90,000 215Integrative Case 2 Track Software, Inc. Seven years ago, after 15 years in public accounting, Stanley Booker, CPA, resigned his position as manager of cost systems for Davis, Cohen, and O’Brien Public Accountants and started Track Software, Inc. In the 2 years preceding his departure from Davis, Cohen, and O’Brien, Stanley had spent nights and weekends developing a sophisticated cost-accounting software program that became Track’s initial product offering. As the firm grew, Stanley planned to develop and expand the software product offerings—all of which would be related to streamlining theaccounting processes of medium- to large-sized manufacturers. Although Track experienced losses during its first 2 years of operation—2006 and 2007—its profit has increased steadily from 2008 to the present (2012). Thefirm’s profit history, including dividend payments and contributions to retainedearnings, is summarized in Table 1. Stanley started the firm with a $100,000 investment—his savings of $50,000 as equity and a $50,000 long-term loan from the bank. He had hoped to maintain hisinitial 100 percent ownership in the corporation, but after experiencing a $50,000loss during the first year of operation (2006), he sold 60 percent of the stock to agroup of investors to obtain needed funds. Since then, no other stock transactionshave taken place. Although he owns only 40 percent of the firm, Stanley activelymanages all aspects of its activities; the other stockholders are not active in manage-ment of the firm. The firm’s stock was valued at $4.50 per share in 2011 and at $5.28 per share in 2012. TABLE 1 Track Software, Inc. Profit, Dividends, and Retained Earnings, 2006–2012 Contribution to Net profits after taxes Dividends paid retained earnings [(1) (2)] Year (1) (2) (3) 2006 ($50,000) $ 0 ($50,000) 2007 ( 20,000) 0 ( 20,000)2008 15,000 0 15,0002009 35,000 0 35,0002010 40,000 1,000 39,0002011 43,000 3,000 40,0002012 48,000 5,000 43,000/H11546 216Stanley has just prepared the firm’s 2012 income statement, balance sheet, and statement of retained earnings, shown in Tables 2, 3, and 4, along with the 2011balance sheet. In addition, he has compiled the 2011 ratio values and industryaverage ratio values for 2012, which are applicable to both 2011 and 2012 and aresummarized in Table 5 (on page 218). He is quite pleased to have achieved recordearnings of $48,000 in 2012, but he is concerned about the firm’s cash flows.Specifically, he is finding it more and more difficult to pay the firm’s bills in a timelymanner and generate cash flows to investors—both creditors and owners. To gaininsight into these cash flow problems, Stanley is planning to determine the firm’s2012 operating cash flow (OCF) and free cash flow (FCF). Stanley is further frustrated by the firm’s inability to afford to hire a software developer to complete development of a cost estimation package that is believed to have “blockbuster” sales potential. Stanley began development of this package 2 years ago, but the firm’s growing complexity has forced him to devote more of histime to administrative duties, thereby halting the development of this product.Stanley’s reluctance to fill this position stems from his concern that the added$80,000 per year in salary and benefits for the position would certainly lower the firm’s earnings per share (EPS) over the next couple of years. Although the project’s success is in no way guaranteed, Stanley believes that if the money were spent to hire the software developer, the firm’s sales and earnings would significantly rise once the2- to 3-year development, production, and marketing process was completed. With all of these concerns in mind, Stanley set out to review the various data to develop strategies that would help to ensure a bright future for Track Software. Stanley believed that as part of this process, a thorough ratio analysis of the firm’s 2012 results would provide important additional insights. TABLE 2 Track Software, Inc. Income Statement ($000) for the Year Ended December 31, 2012 Sales revenue $ 1,550 Less: Cost of goods sold Gross profits Less: Operating expenses Selling expense $ 150General and administrative expenses 270Depreciation expense Total operating expense Operating profits (EBIT) $ 89 Less: Interest expense Net profits before taxes $ 60 Less: Taxes (20%) Net profits after taxes $ 48 122943111$5 2 0$1,030 217TABLE 3 Track Software, Inc. Balance Sheet ($000) December 31 Assets 2012 2011 Cash $ 12 $ 31 Marketable securities 66 82Accounts receivable 152 104Inventories Total current assets Gross fixed assets $195 $180Less: Accumulated depreciation Net fixed assetsTotal assets Liabilities and Stockholders’ Equity Accounts payable $136 $126 Notes payable 200 190Accruals Total current liabilities $363 $341 Long-term debt Total liabilities Common stock (50,000 shares outstanding at $0.40 par value) $ 20 $ 20 Paid-in capital in excess of par 30 30Retained earnings Total stockholders’ equityTotal liabilities and stockholders’ equity $490 $553$109 $15259 102$381 $401$4 0 $3 825 27$490 $553$128 $13252 63$362 $421145 191 TABLE 4 Track Software, Inc. Statement of Retained Earnings ($000) for the Year Ended December 31, 2012 Retained earnings balance (January 1, 2012) $ 59 Plus: Net profits after taxes (for 2012) 48Less: Cash dividends on common stock (paid during 2012) Retained earnings balance (December 31, 2012) $1025 TO DO a.(1)On what financial goal does Stanley seem to be focusing? Is it the correct goal? Why or why not? (2)Could a potential agency problem exist in this firm? Explain. b.Calculate the firm’s earnings per share (EPS) for each year, recognizing that the number of shares of common stock outstanding has remained unchanged since the firm’s inception. Comment on the EPS performance in view of your responsein part a. c.Use the financial data presented to determine Track’s operating cash flow (OCF) andfree cash flow (FCF) in 2012. Evaluate your findings in light of Track’s cur- rent cash flow difficulties. d.Analyze the firm’s financial condition in 2012 as it relates to (1) liquidity, (2) activity, (3) debt, (4) profitability, and (5) market, using the financial state-ments provided in Tables 2 and 3 and the ratio data included in Table 5. Be sure to evaluate the firm on both a cross-sectional and a time-series basis. e.What recommendation would you make to Stanley regarding hiring a new soft- ware developer? Relate your recommendation here to your responses in part a. f.Track Software paid $5,000 in dividends in 2012. Suppose an investor approached Stanley about buying 100% of his firm. If this investor believed that by owning the company he could extract $5,000 per year in cash from the com- pany in perpetuity, what do you think the investor would be willing to pay for the firm if the required return on this investment is 10%? g.Suppose that you believed that the FCF generated by Track Software in 2012 could continue forever. You are willing to buy the company in order to receive this perpetual stream of free cash flow. What are you willing to pay if you require a 10% return on your investment? 218TABLE 5 Actual Industry average Ratio 2011 2012 Current ratio 1.06 1.82 Quick ratio 0.63 1.10Inventory turnover 10.40 12.45Average collection period 29.6 days 20.2 daysTotal asset turnover 2.66 3.92Debt ratio 0.78 0.55Times interest earned ratio 3.0 5.6Gross profit margin 32.1% 42.3%Operating profit margin 5.5% 12.4%Net profit margin 3.0% 4.0%Return on total assets (ROA) 8.0% 15.6%Return on common equity (ROE) 36.4% 34.7%Price/earnings (P/E) ratio 5.2 7.1Market/book (M/B) ratio 2.1 2.2 2193 Part Valuation of Securities 6Interest Rates and Bond Valuation 7Stock Valuation INTEGRATIVE CASE 3 Encore InternationalChapters in This Part In Part 2, you learned how to use time-value-of-money tools to compare cash flows at different times. In the next two chapters you ’ll put those tools to practice valuing the two most common types of securities—bonds and stocks. Chapter 6 introduces you to the world of interest rates and bonds. Though bonds are considered to be among the safest investments available, they are not without risk. Theprimary risk that bond investors face is the risk that market interest rates will fluctuate.Those fluctuations cause bond prices to move, and those movements affect the returnsthat bond investors earn. Chapter 6 explains why interest rates vary from one bond toanother and the factors that cause interest rates to move. Chapter 7 focuses on stock valuation. Chapter 7 explains the characteristics of stock that distinguish it from debt and the chapter describes how companies issue stock toinvestors. You ’ll have another chance to practice time-value-of-money techniques as the chapter illustrates how to value stocks by discounting either (1) the dividends thatstockholders receive or (2) the free cash flows that the firm generates over time. Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand interest rates and the various types of bonds to be able to account properly for amortization of bondpremiums and discounts and for bond issues and retirements. INFORMATION SYSTEMS You need to understand the data that is necessary to track bond valuations and bond amortization schedules. MANAGEMENT You need to understand the behavior of interest rates and how they affect the types of funds the firm can raise and the timingand cost of bond issues and retirements. MARKETING You need to understand how the interest rate level and the firm ’s ability to issue bonds may affect the availability of financing for marketing research projects and new-product development. OPERATIONS You need to understand how the interest rate level may affect the firm ’s ability to raise funds to maintain and grow the firm ’s production capacity. Interest rates have a direct impact on personal financial planning. Movements in interest rates occur frequently and affect the returns fromand values of savings and investments. The rate of interest you arecharged on credit cards and loans can have a profound effect on yourpersonal finances. Understanding the basics of interest rates is impor-tant to your personal financial success.In your personal lifeLearning Goals Describe interest rate fundamentals, the term structure ofinterest rates, and risk premiums. Review the legal aspects of bond financing and bond cost. Discuss the general features, yields, prices, ratings, populartypes, and international issues ofcorporate bonds. Understand the key inputs and basic model used in the bond valuation process. Apply the basic valuation model to bonds, and describe the impactof required return and time tomaturity on bond values. Explain yield to maturity (YTM), its calculation, and the procedureused to value bonds that payinterest semiannually. LG6LG5LG4LG3LG2LG16Interest Rates and Bond Valuation 220 221A Huge Appetite for Money Who is the largest debtor in the world ? The U.S. federal government, of course. As of October 6, 2010, the national debt was more than$13 trillion, more than $1 trillion of which accrued in 2009 alone. About half of the outstanding U.S. gov- ernment debt is held by the U.S. Federal Reserve andother U.S. intragovernmental bodies, and another quarter is held by foreign investors. Interest on the national debt is one of the largest items in the federalbudget, totaling $383 billion in 2009. With Congressional Budget Office estimates projecting that from 2010 to 2019 the cumulative deficits will exceed $7 trillion, the federal governmenthas a huge need for outside financing, which dwarfs the capital needs of any corporation. To feed this huge demand, the U.S. Treasury Department can issue T-bills, debt securities that mature in less than 1 year, Treasury notes that mature in 1 to 10 years, Treasury bonds that mature in more than 10 years, and savings bonds. Treasury securities can be purchased atbanks (EE- and I-series savings bonds), at public auctions, and through TreasuryDirect, a Web- based system that allows investors to establish accounts to conduct transactions in Treasury secu- rities online. Despite the government ’s massive past and projected future deficits, U.S. Treasury securities are still regarded as the safest investments in the world. In this chapter, you ’ll learn about the pricing of these and other debt instruments. The Federal Debt 222 PART 3 Valuation of Securities 6.1Interest Rates and Required Returns As noted in Chapter 2, financial institutions and markets create the mechanism through which funds flow between savers (funds suppliers) and borrowers (fundsdemanders). All else being equal, savers would like to earn as much interest aspossible, and borrowers would like to pay as little as possible. The interest rateprevailing in the market at any given time reflects the equilibrium between saversand borrowers. INTEREST RATE FUNDAMENTALS Theinterest rate orrequired return represents the cost of money. It is the com- pensation that a supplier of funds expects and a demander of funds must pay.Usually the term interest rate is applied to debt instruments such as bank loans or bonds, and the term required return is applied to equity investments, such as common stock, that give the investor an ownership stake in the issuer. In fact, themeaning of these two terms is quite similar because, in both cases, the supplier iscompensated for providing funds to the demander. A variety of factors can influence the equilibrium interest rate. One factor is inflation , a rising trend in the prices of most goods and services. Typically, savers demand higher returns (that is, higher interest rates) when inflation is highbecause they want their investments to more than keep pace with rising prices. Asecond factor influencing interest rates is risk. When people perceive that a par-ticular investment is riskier, they will expect a higher return on that investment ascompensation for bearing the risk. A third factor that can affect the interest rateis a liquidity preference among investors. The term liquidity preference refers to the general tendency of investors to prefer short-term securities (that is, securitiesthat are more liquid). If, all other things being equal, investors would prefer tobuy short-term rather than long-term securities, interest rates on short-terminstruments such as Treasury bills will be lower than rates on longer-term securi-ties. Investors will hold these securities, despite the relatively low return that theyoffer, because they meet investors’ preferences for liquidity. inflation A rising trend in the prices of most goods and services.interest rate Usually applied to debtinstruments such as bank loansor bonds; the compensationpaid by the borrower of fundsto the lender; from the borrower’s point of view, the cost of borrowing funds. required return Usually applied to equityinstruments such as commonstock; the cost of fundsobtained by selling an ownership interest. liquidity preference A general tendency for investors to prefer short-term(that is, more liquid) securities. The Real Rate of Interest Imagine a perfect world in which there is no inflation, in which investors have no liquidity preferences, and in which there is no risk. In this world, there would be onecost of money—the real rate of interest . The real rate of interest creates equilibriumreal rate of interest The rate that creates equilibrium between the supply of savingsand the demand for investmentfunds in a perfect world, withoutinflation, where suppliers anddemanders of funds have noliquidity preferences and there isno risk.Matter of fact Near the height of the financial crisis in December 2008, interest rates on Treasury bills briefly turned negative, meaning that investors paid more to the Treasury than the Treasury prom- ised to pay back. Why would anyone put their money into an investment that they know will lose money? Remember that 2008 saw the demise of Lehman Brothers, and fears that other commer- cial banks and investments banks might fail were rampant. Evidently, some investors were willing to pay the U.S. Treasury to keep their money safe for a short time.Fear Turns T-Bill Rates NegativeLG1 between the supply of savings and the demand for funds. It represents the most basic cost of money. Historically, the real rate of interest in the United States hasaveraged about 1 percent per year, but that figure does fluctuate over time. Thissupply–demand relationship is shown in Figure 6.1 by the supply function(labeled S 0) and the demand function (labeled D). An equilibrium between the supply of funds and the demand for funds occurs at a rate of interestr 0*, the real rate of interest. Clearly, the real rate of interest changes with changing economic conditions, tastes, and preferences. To combat a recession, the Board of Governors of theFederal Reserve System might initiate actions to increase the supply of credit inthe economy, causing the supply function in Figure 6.1 to shift to, say, S 1. This could result in a lower real rate of interest, r1*, at equilibrium . With a lower cost of money, firms might find that investments that were previously unat-tractive are now worth undertaking, and as firms hire more workers and spendmore on plant and equipment, the economy begins to expand again. Nominal or Actual Rate of Interest (Return) Thenominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by the demander. Throughout this book, interest rates and required rates of return are nominal rates unless otherwise noted. The nominal rate of interest differs from the real rate of interest, r*, as a result of two factors, inflation and risk. When people save money and invest it, they are sacrificingconsumption today (that is, they are spending less than they could) in return forhigher future consumption. When investors expect inflation to occur, theybelieve that the price of consuming goods and services will be higher in thefuture than in the present. Therefore, they will be reluctant to sacrifice today’sconsumption unless the return they can earn on the money they save (or invest)will be high enough to allow them to purchase the goods and services they desireat a higher future price. That is, investors will demand a higher nominal rate of return if they expect inflation . This higher rate of return is called the expected inflation premium ( IP).(S 1=D)(S0=D)CHAPTER 6 Interest Rates and Bond Valuation 223 Funds Supplied/DemandedReal Rate of Interestr*1r*0 S1 = D S0 = DD S1 S1S0 S0 DFIGURE 6.1 Supply–Demand RelationshipSupply of savings and demand for investment funds nominal rate of interest The actual rate of interest charged by the supplier offunds and paid by thedemander. Similarly, investors generally demand higher rates of return on risky investments as compared to safe ones. Otherwise, there is little incentive for investors to bear theadditional risk. Therefore, investors will demand a higher nominal rate of return on risky investments . This additional rate of return is called the risk premium ( RP). Therefore, the nominal rate of interest for security 1, r 1, is given in Equation 6.1: (6.1) As the horizontal braces below the equation indicate, the nominal rate, r1, can be viewed as having two basic components: a risk-free rate of return, RF,and a risk premium, RP1: (6.2) For the moment, ignore the risk premium, RP1, and focus exclusively on the risk-free rate. Equation 6.1 says that the risk-free rate can be represented as (6.3) The risk-free rate (as shown in Equation 6.3) embodies the real rate of interestplus the expected inflation premium. The inflation premium is driven by investors’expectations about inflation—the more inflation they expect, the higher will bethe inflation premium and the higher will be the nominal interest rate. Three-month U.S. Treasury bills (T-bills ) are short-term IOUs issued by the U.S. Treasury, and they are widely regarded as the safest investments in theworld. They are as close as we can get in the real world to a risk-free investment.To estimate the real rate of interest, analysts typically try to determine what rateof inflation investors expect over the coming 3 months. Next, they subtract the expected inflation rate from the nominal rate on the 3-month T-bill to arrive atthe underlying real rate of interest . For the risk-free asset in Equation 6.3, the real rate of interest, r*, would equal .A simple personal finance example can demonstrate the practical distinction between nominal and real rates of interest. Marilyn Carbo has $10 that she can spend on candy costing $0.25 per piece. She could buy 40 pieces of candy ($10.00 $0.25) today. The nominal rate of interest on a 1-year deposit is currently 7%, andthe expected rate of inflation over the coming year is 4%. Instead of buying the 40 pieces of candy today, Marilyn could invest the $10. After one year she wouldhave $10.70 because she would have earned 7% interest—an additional $0.70 —on her $10 deposit. During that year, inflation would have increased the cost of the candy by 4%—an additional $0.01 —to$0.26 per piece. As a result, at the end of the 1-year period Marilyn would be ableto buy about 41.2 pieces of candy ($10.70 $0.26), or roughly 3% more . The 3% increase in Marilyn’s buying power represents her real rate of return. The nominal rate of return on her investment (7%), is partlyeroded by inflation (4%), so her real return during the year is the difference between the nominal rate and the inflation rate . (7% -4% =3%)(41.2 ,40.0 =1.03),(0.04 *$0.25)(0.07 *$10.00),Personal Finance Example 6.13RF-IPRF=r*+IPr1=RF+RP1risk premiumrisk-free rate, RFr1=r*+IP+RP1224 PART 3 Valuation of Securities The premium for expected inflation in Equation 6.3 represents the average rate of inflation expected over the life of an investment. It is notthe rate of infla- tion experienced over the immediate past, although investors’ inflation expecta-tions are undoubtedly influenced by the rate of inflation that has occurred in therecent past. Even so, the inflation premium reflects the expected rate of inflation.The expected inflation premium changes over time in response to many factors,such as changes in monetary and fiscal policies, currency movements, and inter-national political events. For a discussion of a U.S. debt security whose interestrate is adjusted for inflation, see the Focus on Practice box. Figure 6.2 (see page 226) illustrates the annual movement of the rate of infla- tion and the risk-free rate of return from 1961 through 2009. During this periodthe two rates tended to move in a similar fashion. Note that T-bill rates wereslightly above the inflation rate most of the time, meaning that T-bills generallyoffered a small positive real return. Between 1978 and the early 1980s, inflationand interest rates were quite high, peaking at over 13 percent in 1980–1981.Since then, rates have gradually declined. To combat a severe recession, theFederal Reserve pushed interest rates down to almost 0% in 2009, and for thefirst time in decades, the rate of inflation turned slightly negative (that is, therewas slight deflation that year).CHAPTER 6 Interest Rates and Bond Valuation 225 deflation A general trend of falling prices.focus on PRACTICE I-Bonds Adjust for Inflation refers to a general trend of falling prices, so when deflation occurs, the change in the CPI-U is negative, and the adjustable portion of an I-bond ’s interest also turns negative. For exam-ple, if the fixed-rate component on an I-bond is 2 percent and prices fall 0.5percent (stated equivalently, the inflation rate is –0.5 percent), then the nominal rate on an I-bond will be just 1.5 per-cent (2 percent minus 0.5 percent).Nevertheless, in the past 80 years, peri-ods of deflation have been very rare, whereas inflation has been an almostever-present feature of the economy, so investors are likely to enjoy the inflationprotection that I-bonds offer in the future. 3 What effect do you think the inflation-adjusted interest rate has on the price of an I-bond in compari- son with similar bonds with no allowance for inflation?in this index indicates that inflation has occurred. As the rate of inflation moves up and down, I-bond interest rates adjust (with a short lag). Interest earn-ings are exempt from state and localincome taxes, and are payable onlywhen an investor redeems an I-bond. I-bonds are issued at face value in denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and$10,000. The I-bond is not without its draw- backs. Any redemption within the first 5 years results in a 3-month interestpenalty. Also, you should redeem an I-bond only at the first of the monthbecause none of the interest earned dur-ing a month is included in the redemp- tion value until the first day of the following month. The adjustable-ratefeature of I-bonds can work againstinvestors (that is, it can lower their returns) if deflation occurs. DeflationOne of the disadvan- tages of bonds is that they usually offer a fixed interest rate.Once a bond is issued, its interest ratetypically cannot adjust as expected infla- tion changes. This presents a serious risk to bond investors because if inflationrises while the nominal rate on the bondremains fixed, the real rate of return falls. The U.S. Treasury Department now offers the I-bond, which is an inflation- adjusted savings bond. A Series-I bond earns interest through the application ofa composite rate . The composite rate consists of a fixed rate that remains the same for the life of the bond and an adjustable rate equal to the actual rate of inflation. The adjustable rate changes twice per year and is based on movements in the Consumer PriceIndex for All Urban Consumers (CPI-U).This index tracks the prices of thousandsof goods and services, so an increasein practice TERM STRUCTURE OF INTEREST RATES Theterm structure of interest rates is the relationship between the maturity and rate of return for bonds with similar levels of risk. A graph of this relationship iscalled the yield curve. A quick glance at the yield curve tells analysts how rates vary between short-, medium-, and long-term bonds, but it may also provideinformation on where interest rates and the economy in general are headed in thefuture. Usually, when analysts examine the term structure of interest rates, theyfocus on Treasury securities because these are generally considered to be free ofdefault risk. Yield Curves A bond’s yield to maturity (YTM) (discussed later in this chapter) represents the compound annual rate of return that an investor earns on the bond assuming thatthe bond makes all promised payments and the investor holds the bond to matu-rity. In a yield curve, the yield to maturity is plotted on the vertical axis and timeto maturity is plotted on the horizontal axis. Figure 6.3 shows three yield curvesfor U.S. Treasury securities: one at May 22, 1981, a second at September 29,1989, and a third at May 28, 2010. Observe that both the position and the shape of the yield curves change over time. The yield curve of May 22, 1981, indicates that short-term interest rates atthat time were above longer-term rates. For reasons that a glance at the figuremakes obvious, this curve is described as downward-sloping . Interest rates in May 1981 were also quite high by historical standards, so the overall level of theyield curve is high. Historically, a downward-sloping yield curve, which is oftencalled an inverted yield curve, occurs infrequently and is often a sign that the economy is weakening. Most recessions in the United States have been precededby an inverted yield curve. Usually, short-term interest rates are lower than long-term interest rates, as they were on May 28, 2010. That is, the normal yield curve isupward-sloping . Notice that the May 2010 yield curve lies entirely beneath the other two curves226 PART 3 Valuation of Securities 1961 1966 1971 1991 1986 1981 2001 2006 1996 1976 Year15 10 5Annual Rate (%) a Average annual rate of return on 3-month U.S. Treasury bills. b Annual pecentage change in the consumer price index.T-billsa Inflationb Sources: Data from selected Federal Reserve Bulletins and U.S. Department of Labor Bureau of Labor Statistics.FIGURE 6.2 Impact of Inflation Relationship betweenannual rate of inflation and 3-month U.S. Treasury bill average annual returns,1961–2009 term structure of interest rates The relationship between the maturity and rate of return for bonds with similar levels of risk. yield curve A graphic depiction of the term structure of interest rates. yield to maturity (YTM) Compound annual rate ofreturn earned on a debtsecurity purchased on a givenday and held to maturity. inverted yield curve Adownward-sloping yield curve indicates that short-terminterest rates are generallyhigher than long-term interestrates. normal yield curve Anupward-sloping yield curve indicates that long-term interestrates are generally higher thanshort-term interest rates. shown in Figure 6.3. In other words, interest rates in May 2010 were unusually low, largely because at that time the economy was just beginning to recover froma deep recession and inflation was very low. Sometimes, a flat yield curve, similar to that of September 29, 1989, exists. A flat yield curve simply means that ratesdo not vary much at different maturities. The shape of the yield curve may affect the firm’s financing decisions. A financial manager who faces a downward-sloping yield curve may be tempted torely more heavily on cheaper, long-term financing. However, a risk in followingthis strategy is that interest rates may fall in the future, so long-term rates thatseem cheap today may be relatively expensive tomorrow. Likewise, when theyield curve is upward-sloping, the manager may feel that it is wise to use cheaper,short-term financing. Relying on short-term financing has its own risks. Firmsthat borrow on a short-term basis may see their costs rise if interest rates go up.Even more serious is the risk that a firm may not be able to refinance a short-termloan when it comes due. A variety of factors influence the choice of loan maturity,but the shape of the yield curve is something that managers must consider whenmaking decisions about borrowing short-term versus long-term. Theories of Term Structure Three theories are frequently cited to explain the general shape of the yield curve:the expectations theory, the liquidity preference theory, and the market segmen-tation theory. Expectations Theory One theory of the term structure of interest rates, the expectations theory, suggests that the yield curve reflects investor expectations about future interest rates. According to this theory, when investors expect short-term interest rates to rise in the future (perhaps because investors believe thatinflation will rise in the future), today’s long-term rates will be higher than cur-rent short-term rates, and the yield curve will be upward sloping. The opposite isCHAPTER 6 Interest Rates and Bond Valuation 227 18 16 14 1210 8 64 2 5010 15 20 25 30Yield to Maturity Time to Maturity (years)May 22, 1981 September 29, 1989 May 28, 2010 Data from U.S. Department of the Treasury, Office of Domestic Finance, Office of Debt Mana gement.Sources:FIGURE 6.3 Treasury Yield Curves Yield curves for U.S.Treasury securities: May 22, 1981; September 29, 1989; and May 28, 2010 flat yield curve A yield curve that indicates that interest rates do not varymuch at different maturities. In more depth To read about Yield Curve Animation, go to www.myfinancelab.com expectations theory The theory that the yield curve reflects investor expectationsabout future interest rates; anexpectation of rising interestrates results in an upward-sloping yield curve, and anexpectation of declining ratesresults in a downward-slopingyield curve. true when investors expect declining short-term rates—today’s short-term rates will be higher than current long-term rates, and the yield curve will be inverted. To understand the expectations theory, consider this example. Suppose that the yield curve is flat. The rate on a 1-year Treasury note is 4 percent, and so is the rateon a 2-year Treasury note. Now, consider an investor who has money to place intoa low-risk investment for 2 years. The investor has two options. First, he could pur-chase the 2-year Treasury note and receive a total of 8 percent (ignoring com-pounding) in 2 years. Second, he could invest in the 1-year Treasury earning 4 percent, and then when that security matures, he could reinvest in another 1-yearTreasury note. If the investor wants to maximize his expected return, the decisionbetween the first and second options above depends on whether he expects interestrates to rise, fall, or remain unchanged during the next year. If the investor believes that interest rates will rise, that means next year’s return on a 1-year Treasury note will be greater than 4 percent (that is, greaterthan the 1-year Treasury rate right now). Let’s say the investor believes that theinterest rate on a 1-year note next year will be 5 percent. If the investor expectsrising rates, then his expected return is higher if he follows the second option,buying a 1-year Treasury note now (paying 4 percent) and reinvesting in a newsecurity that pays 5 percent next year. Over 2 years, the investor would expect toearn about 9 percent (ignoring compounding) in interest, compared to just 8 per-cent earned by holding the 2-year bond. If the current 1-year rate is 4 percent and investors generally expect that rate to go up to 5 percent next year, what would the 2-year Treasury note rate have tobe right now to remain competitive? The answer is 4.5 percent. An investor whobuys this security and holds it for 2 years would earn about 9 percent interest(again, ignoring compounding), the same as the expected return from investing intwo consecutive 1-year bonds. In other words, if investors expect interest rates to rise, the 2-year rate today must be higher than the 1-year rate today, and that inturn means that the yield curve must have an upward slope . Suppose that a 5-year Treasury note currently offers a 3% annual return. Investors believe that interest rates are going to decline, and 5 years from now,they expect the rate on a 5-year Treasury note to be 2.5%. According to theexpectations theory, what is the return that a 10-year Treasury note has to offertoday? What does this imply about the slope of the yield curve? Consider an investor who purchases a 5-year note today and plans to reinvest in another 5-year note in the future. Over the 10-year investment horizon, thisinvestor expects to earn about 27.5%, ignoring compounding (that’s 3% per yearfor the first 5 years and 2.5% per year for the next 5 years). To compete with thatreturn, a 10-year bond today could offer 2.75% per year. That is, a bond thatpays 2.75% for each of the next 10 years produces the same 27.5% total returnthat the series of two 5-year notes is expected to produce. Therefore, the 5-yearrate today is 3% and the 10-year rate today is 2.75%, and the yield curve is downward sloping. Liquidity Preference Theory Most of the time, yield curves are upward sloping. According to the expectations theory, this means that investors expectinterest rates to rise. An alternative explanation for the typical upward slope ofthe yield curve is the liquidity preference theory. This theory holds that, all elseExample 6.23228 PART 3 Valuation of Securities liquidity preference theory Theory suggesting that long- term rates are generally higher than short-term rates (hence,the yield curve is upwardsloping) because investorsperceive short-term investmentsto be more liquid and less riskythan long-term investments.Borrowers must offer higherrates on long-term bonds toentice investors away fromtheir preferred short-termsecurities. being equal, investors generally prefer to buy short-term securities, while issuers prefer to sell long-term securities. For investors, short-term securities are attrac-tive because they are highly liquid and their prices are not particularly volatile. 1 Hence, investors will accept somewhat lower rates on short-term bonds becausethey are less risky than long-term bonds. Conversely, when firms or governmentswant to lock in their borrowing costs for a long period of time by selling long-term bonds, those bonds have to offer higher rates to entice investors away fromthe short-term securities that they prefer. Borrowers are willing to pay somewhathigher rates because long-term debt allows them to eliminate or reduce the risk ofnot being able to refinance short-term debts when they come due. Borrowing ona long-term basis also reduces uncertainty about future borrowing costs. Market Segmentation Theory The market segmentation theory suggests that the market for loans is totally segmented on the basis of maturity and thatthe supply of and demand for loans within each segment determine its prevailinginterest rate. In other words, the equilibrium between suppliers and demanders ofshort-term funds, such as seasonal business loans, would determine prevailingshort-term interest rates, and the equilibrium between suppliers and demandersof long-term funds, such as real estate loans, would determine prevailing long-term interest rates. The slope of the yield curve would be determined by the gen-eral relationship between the prevailing rates in each market segment. Simplystated, an upward-sloping yield curve indicates greater borrowing demand rela-tive to the supply of funds in the long-term segment of the debt market relative tothe short-term segment. All three term structure theories have merit. From them we can conclude that at any time the slope of the yield curve is affected by (1) interest rate expecta-tions, (2) liquidity preferences, and (3) the comparative equilibrium of supply anddemand in the short- and long-term market segments. Upward-sloping yieldcurves result from expectations of rising interest rates, lender preferences forshorter-maturity loans, and greater supply of short-term loans than of long-termloans relative to demand. The opposite conditions would result in a downward-sloping yield curve. At any time, the interaction of these three forces determinesthe prevailing slope of the yield curve. RISK PREMIUMS: ISSUER AND ISSUE CHARACTERISTICS So far we have considered only risk-free U.S. Treasury securities. We now rein-troduce the risk premium and assess it in view of risky non-Treasury issues.Recall Equation 6.1: In words, the nominal rate of interest for security 1 ( r 1) is equal to the risk-free rate, consisting of the real rate of interest ( r*) plus the inflation expectationrisk premiumrisk-free rate, RFr1=r*+IP+RP1CHAPTER 6 Interest Rates and Bond Valuation 229 1. Later in this chapter we demonstrate that debt instruments with longer maturities are more sensitive to changing market interest rates. For a given change in market rates, the price or value of longer-term debts will be more signif-icantly changed (up or down) than the price or value of debts with shorter maturities.market segmentation theory Theory suggesting that the market for loans is segmented on the basis of maturity and that the supply of and demandfor loans within each segmentdetermine its prevailing interestrate; the slope of the yieldcurve is determined by thegeneral relationship betweenthe prevailing rates in eachmarket segment. premium ( IP), plus the risk premium ( RP1). The risk premium varies with specific issuer and issue characteristics. The nominal interest rates on a number of classes of long-term securities in May2010 were as follows: Example 6.33230 PART 3 Valuation of Securities Security Nominal interest rate U.S. Treasury bonds (average) 3.30% Corporate bonds (by risk ratings): High quality (Aaa–Aa) 3.95Medium quality (A–Baa) 4.98Speculative (Ba–C) 8.97 Security Risk premium Corporate bonds (by ratings): High quality (Aaa–Aa)Medium quality (A–Baa)Speculative (Ba–C) 8.97 -3.30 =5.674.98 -3.30 =1.683.95% -3.30% =0.65%Because the U.S. Treasury bond would represent the risk-free, long-term security, we can calculate the risk premium of the other securities by subtracting the risk-free rate, 3.30%, from each nominal rate (yield): These risk premiums reflect differing issuer and issue risks. The lower-rated (spec- ulative) corporate issues have a far higher risk premium than that of the higher-rated corporate issues (high quality and medium quality), and that risk premium isthe compensation that investors demand for bearing the higher default risk of lower quality bonds. The risk premium consists of a number of issuer- and issue-related components, including business risk, financial risk, interest rate risk, liquidity risk, and tax risk, aswell as the purely debt-specific risks—default risk, maturity risk, and contractualprovision risk, briefly defined in Table 6.1. In general, the highest risk premiums andtherefore the highest returns result from securities issued by firms with a high risk ofdefault and from long-term maturities that have unfavorable contractual provisions. 6REVIEW QUESTIONS 6–1What is the real rate of interest? Differentiate it from the nominal rate of interest for the risk-free asset, a 3-month U.S. Treasury bill. 6–2What is the term structure of interest rates, and how is it related to the yield curve? 6–3For a given class of similar-risk securities, what does each of the fol- lowing yield curves reflect about interest rates: ( a) downward-sloping; (b) upward-sloping; and ( c) flat? What is the “normal” shape of the yield curve? 6–4Briefly describe the following theories of the general shape of the yieldcurve: ( a) expectations theory; ( b) liquidity preference theory; and (c) market segmentation theory. 6–5List and briefly describe the potential issuer- and issue-related risk components that are embodied in the risk premium. Which are thepurely debt-specific risks?CHAPTER 6 Interest Rates and Bond Valuation 231 Debt-Specific Issuer- and Issue-Related Risk Premium Components Component Description Default risk The possibility that the issuer of debt will not pay the contractual interest or principal as scheduled. The greater theuncertainty as to the borrower’s ability to meet thesepayments, the greater the risk premium. High bond ratingsreflect low default risk, and low bond ratings reflect highdefault risk. Maturity risk The fact that the longer the maturity, the more the value of a security will change in response to a given change in interestrates. If interest rates on otherwise similar-risk securitiessuddenly rise as a result of a change in the money supply, theprices of long-term bonds will decline by more than the pricesof short-term bonds, and vice versa. a Contractual provision risk Conditions that are often included in a debt agreement or a stock issue. Some of these reduce risk, whereas others mayincrease risk. For example, a provision allowing a bond issuerto retire its bonds prior to their maturity under favorableterms increases the bond’s risk. aA detailed discussion of the effects of interest rates on the price or value of bonds and other fixed-income securities is presented later in this chapter.TABLE 6.1 6.2Corporate Bonds Acorporate bond is a long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the futureunder clearly defined terms. Most bonds are issued with maturities of 10 to 30years and with a par value, or face value, of $1,000. The coupon interest rate on a bond represents the percentage of the bond’s par value that will be paid annu-ally, typically in two equal semiannual payments, as interest. The bondholders,who are the lenders, are promised the semiannual interest payments and, atmaturity, repayment of the principal amount.LG2 corporate bond A long-term debt instrument indicating that a corporationhas borrowed a certainamount of money andpromises to repay it in thefuture under clearly definedterms.LG3 LEGAL ASPECTS OF CORPORATE BONDS Certain legal arrangements are required to protect purchasers of bonds. Bondholders are protected primarily through the indenture and the trustee. Bond Indenture Abond indenture is a legal document that specifies both the rights of the bond- holders and the duties of the issuing corporation. Included in the indenture aredescriptions of the amount and timing of all interest and principal payments, variousstandard and restrictive provisions, and, frequently, sinking-fund requirements andsecurity interest provisions. The borrower commonly must (1) maintain satisfactory accounting records in accordance with generally accepted accounting principles (GAAP); (2) periodically supply audited financial statements; (3)pay taxes and other liabilities when due; and (4) maintain all facilities in good working order. Standard Provisions The standard debt provisions in the bond indenture specify certain record-keeping and general business practices that the bond issuermust follow. Restrictive Provisions Bond indentures also normally include certain restrictive covenants, which place operating and financial constraints on the bor- rower. These provisions help protect the bondholder against increases in bor-rower risk. Without them, the borrower could increase the firm’s risk but nothave to pay increased interest to compensate for the increased risk. The most common restrictive covenants do the following: 1. Require a minimum level of liquidity, to ensure against loan default. 2.Prohibit the sale of accounts receivable to generate cash. Selling receivables could cause a long-run cash shortage if proceeds were used to meet currentobligations. 3. Impose fixed-asset restrictions. The borrower must maintain a specified level of fixed assets to guarantee its ability to repay the bonds. 4.Constrain subsequent borrowing. Additional long-term debt may be prohib- ited, or additional borrowing may be subordinated to the original loan. Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied. 5.Limit the firm’s annual cash dividend payments to a specified percentage or amount. Other restrictive covenants are sometimes included in bond indentures. The violation of any standard or restrictive provision by the borrower gives the bondholders the right to demand immediate repayment of the debt.Generally, bondholders evaluate any violation to determine whether it jeopar-dizes the loan. They may then decide to demand immediate repayment, continuethe loan, or alter the terms of the bond indenture. Sinking-Fund Requirements Another common restrictive provision is a sinking-fund requirement. Its objective is to provide for the systematic retirement of bonds prior to their maturity. To carry out this requirement, the corporationmakes semiannual or annual payments that are used to retire bonds by pur-chasing them in the marketplace.232 PART 3 Valuation of Securities coupon interest rate The percentage of a bond’s par value that will be paidannually, typically in two equalsemiannual payments, asinterest. bond indenture A legal document that specifies both the rights of thebondholders and the duties ofthe issuing corporation. standard debt provisions Provisions in a bond indenture specifying certain record-keeping and general businesspractices that the bond issuermust follow; normally, they donot place a burden on afinancially sound business. restrictive covenants Provisions in a bond indenture that place operating andfinancial constraints on theborrower. subordination In a bond indenture, thestipulation that subsequentcreditors agree to wait until allclaims of the senior debt are satisfied. sinking-fund requirement A restrictive provision oftenincluded in a bond indenture,providing for the systematicretirement of bonds prior totheir maturity. Security Interest The bond indenture identifies any collateral pledged against the bond and specifies how it is to be maintained. The protection of bondcollateral is crucial to guarantee the safety of a bond issue. Trustee Atrustee is a third party to a bond indenture . The trustee can be an individual, a corporation, or (most often) a commercial bank trust department. The trustee ispaid to act as a “watchdog” on behalf of the bondholders and can take specifiedactions on behalf of the bondholders if the terms of the indenture are violated. COST OF BONDS TO THE ISSUER The cost of bond financing is generally greater than the issuer would have to payfor short-term borrowing. The major factors that affect the cost, which is the rateof interest paid by the bond issuer, are the bond’s maturity, the size of theoffering, the issuer’s risk, and the basic cost of money. Impact of Bond Maturity Generally, as we noted earlier, long-term debt pays higher interest rates thanshort-term debt. In a practical sense, the longer the maturity of a bond, the lessaccuracy there is in predicting future interest rates, and therefore the greater thebondholders’ risk of giving up an opportunity to lend money at a higher rate. Inaddition, the longer the term, the greater the chance that the issuer might default. Impact of Offering Size The size of the bond offering also affects the interest cost of borrowing but in aninverse manner: Bond flotation and administration costs per dollar borrowed arelikely to decrease with increasing offering size. On the other hand, the risk to thebondholders may increase, because larger offerings result in greater risk of default. Impact of Issuer’s Risk The greater the issuer’s default risk, the higher the interest rate. Some of this risk can be reduced through inclusion of appropriate restrictive provisions in thebond indenture. Clearly, bondholders must be compensated with higher returnsfor taking greater risk. Frequently, bond buyers rely on bond ratings (discussedlater) to determine the issuer’s overall risk. Impact of the Cost of Money The cost of money in the capital market is the basis for determining a bond’scoupon interest rate. Generally, the rate on U.S. Treasury securities of equalmaturity is used as the lowest-risk cost of money. To that basic rate is added a risk premium (as described earlier in this chapter) that reflects the factors mentioned above (maturity, offering size, and issuer’s risk). GENERAL FEATURES OF A BOND ISSUE Three features sometimes included in a corporate bond issue are a conversion fea-ture, a call feature, and stock purchase warrants. These features provide theissuer or the purchaser with certain opportunities for replacing or retiring thebond or supplementing it with some type of equity issue.CHAPTER 6 Interest Rates and Bond Valuation 233 trustee A paid individual, corporation, or commercial bank trustdepartment that acts as thethird party to a bond indenture and can take specified actionson behalf of the bondholders ifthe terms of the indenture areviolated. Convertible bonds offer a conversion feature that allows bondholders to change each bond into a stated number of shares of common stock. Bondholdersconvert their bonds into stock only when the market price of the stock is suchthat conversion will provide a profit for the bondholder. Inclusion of the conver-sion feature by the issuer lowers the interest cost and provides for automatic con-version of the bonds to stock if future stock prices appreciate noticeably. Thecall feature is included in nearly all corporate bond issues. It gives the issuer the opportunity to repurchase bonds prior to maturity. The call price is the stated price at which bonds may be repurchased prior to maturity. Sometimes the call feature can be exercised only during a certain period. As a rule, the call price exceedsthe par value of a bond by an amount equal to 1 year’s interest. For example, a $1,000 bond with a 10 percent coupon interest rate would be callable for around . The amount by which the call price exceeds the bond’s par value is commonly referred to as the call premium. This premium compensates bondholders for having the bond called away from them;to the issuer, it is the cost of calling the bonds. The call feature enables an issuer to call an outstanding bond when interest rates fall and issue a new bond at a lower interest rate. When interest rates rise,the call privilege will not be exercised, except possibly to meet sinking-fund requirements. Of course, to sell a callable bond in the first place, the issuer must pay a higher interest rate than on noncallable bonds of equal risk, to compensatebondholders for the risk of having the bonds called away from them. Bonds occasionally have stock purchase warrants attached as “sweeteners” to make them more attractive to prospective buyers. Stock purchase warrants are instruments that give their holders the right to purchase a certain number ofshares of the issuer’s common stock at a specified price over a certain period oftime. Their inclusion typically enables the issuer to pay a slightly lower couponinterest rate than would otherwise be required. BOND YIELDS Theyield, or rate of return, on a bond is frequently used to assess a bond’s per- formance over a given period of time, typically 1 year. Because there are a numberof ways to measure a bond’s yield, it is important to understand popular yieldmeasures. The three most widely cited bond yields are (1) current yield, (2)yield to maturity (YTM), and (3) yield to call (YTC) . Each of these yields provides a unique measure of the return on a bond. The simplest yield measure is the current yield, the annual interest payment divided by the current price. For example, a $1,000 par value bond with an 8 per-cent coupon interest rate that currently sells for $970 would have a current yieldof . This measure indicates the cash return forthe year from the bond. However, because current yield ignores any change inbond value, it does not measure the total return. As we’ll see later in this chapter,both the yield to maturity and the yield to call measure the total return. BOND PRICES Because most corporate bonds are purchased and held by institutional investors,such as banks, insurance companies, and mutual funds, rather than individualinvestors, bond trading and price data are not readily available to individuals.Table 6.2 includes some assumed current data on the bonds of five companies,noted A through E. Looking at the data for Company C’s bond, which is highlighted8.25%3(0.08 *$1,000) ,$970]$1,100 3$1,000 +(10% *$1,000) 4234 PART 3 Valuation of Securities conversion feature A feature of convertible bonds that allows bondholders to change each bond into a stated number of shares of common stock. call feature A feature included in nearly all corporate bond issues that gives the issuer the opportunity to repurchase bonds at a stated call price prior to maturity. call price The stated price at which abond may be repurchased, by use of a call feature, prior to maturity. call premium The amount by which a bond’s call price exceeds its par value. stock purchase warrants Instruments that give theirholders the right to purchase a certain number of shares of the issuer’s common stock at a specified price over a certainperiod of time. current yield A measure of a bond’s cashreturn for the year; calculated by dividing the bond’s annual interest payment by its current price. in the table, we see that the bond has a coupon interest rate of 7.200 percent and a maturity date of January 15, 2017. These data identify a specific bond issued byCompany C. (The company could have more than a single bond issue outstanding.)The price represents the final price at which the bond traded on the current day. Although most corporate bonds are issued with a par, orface, value of $1,000, all bonds are quoted as a percentage of par . A $1,000-par-value bond quoted at 94.007 is priced at $940.07 ( ). Corporate bondsare quoted in dollars and cents. Thus, Company C’s price of 103.143 for the daywas $1,031.43—that is, The final column of Table 6.2 represents the bond’s yield to maturity (YTM), which is the compound annual rate of return that would be earned on the bond if itwere purchased and held to maturity. (YTM is discussed in detail later in this chapter.) BOND RATINGS Independent agencies such as Moody’s, Fitch, and Standard & Poor’s assessthe riskiness of publicly traded bond issues. These agencies derive their rat-ings by using financial ratio and cash flow analyses to assess the likely pay-ment of bond interest and principal. Table 6.3 summarizes these ratings. For103.143% *$1,000.94.007% *$1,000CHAPTER 6 Interest Rates and Bond Valuation 235 Data on Selected Bonds Company Coupon Maturity Price Yield (YTM) Company A 6.125% Nov. 15, 2011 105.336 4.788% Company B 6.000 Oct. 31, 2036 94.007 6.454 Company C 7.200 Jan. 15, 2014 103.143 6.606Company D 5.150 Jan. 15, 2017 95.140 5.814Company E 5.850 Jan. 14, 2012 100.876 5.631TABLE 6.2 Moody’s and Standard & Poor’s Bond Ratingsa Standard Moody’s Interpretation & Poor’s Interpretation Aaa Prime quality AAA Investment grade Aa High grade AAA Upper medium grade ABaa Medium grade BBBBa Lower medium grade BB Speculative or speculative B B SpeculativeCaa From very speculative CCCCa to near or in default CCC Lowest grade C Income bond D In default aSome ratings may be modified to show relative standing within a major rating category; for example, Moody’s uses numerical modifiers (1, 2, 3), whereas Standard & Poor’s uses plus ( ) and minus ( ) signs. Sources: Moody’s Investors Service, Inc., and Standard & Poor’s Corporation.- +TABLE 6.3 discussion of ethical issues related to the bond-rating agencies, see the Focus on Ethics box. Normally an inverse relationship exists between the quality of a bond and the rate of return that it must provide bondholders: High-quality (high-rated) bondsprovide lower returns than lower-quality (low-rated) bonds. This reflects thelender’s risk–return trade-off. When considering bond financing, the financialmanager must be concerned with the expected ratings of the bond issue, becausethese ratings affect salability and cost. COMMON TYPES OF BONDS Bonds can be classified in a variety of ways. Here we break them into traditionalbonds (the basic types that have been around for years) and contemporary bonds(newer, more innovative types). The traditional types of bonds are summarized interms of their key characteristics and priority of lender’s claim in Table 6.4. Notethat the first three types— debentures, subordinated debentures, and income bonds —are unsecured, whereas the last three— mortgage bonds, collateral trust bonds, andequipment trust certificates —are secured. Table 6.5 (see page 238) describes the key characteristics of five contempo- rary types of bonds: zero- (or low-) coupon bonds, junk bonds, floating-rate bonds, extendible notes, andputable bonds. These bonds can be either unsecured or secured. Changing capital market conditions and investor preferences havespurred further innovations in bond financing in recent years and will probablycontinue to do so.236 PART 3 Valuation of Securities focus on ETHICS Can We Trust the Bond Raters? Moody ’s Investors Service, Standard & Poor ’s, and Fitch Ratings play a crucial role in the financial markets. Thesecredit-rating agencies evaluate andattach ratings to credit instruments (forexample, bonds). Historically, bondsthat received higher ratings were almost always repaid, while lower- rated, more speculative “junk ” bonds experienced much higher default rates.The agencies ’ ratings have a direct impact on firms ’ cost of raising external capital and investors ’ appraisals of fixed-income investments. Recently, the credit-rating agencies have been criticized for their role in thesubprime crisis. The agencies attachedratings to complex securities that did not reflect the true risk of the underlyinginvestments. For example, securitiesbacked by mortgages issued to borrow-ers with bad credit and no documented income often received investment-grade ratings that implied almost zero proba-bility of default. However, when homeprices began to decline in 2006, secu-rities backed by risky mortgages diddefault, including many that had been rated investment grade. It is not entirely clear why the rating agencies assigned such high ratings to these securities. Did the agencies believe that complex financial engineer- ing could create investment-grade secu-rities out of risky mortgage loans ? Didthe agencies understand the securities they were rating ? Were they unduly influenced by the security issuers, who also happened to pay for the ratings ? Apparently, some within the ratingagencies were suspicious. In aDecember, 2006 e-mail exchangebetween colleagues at Standard & Poor ’s, one individual proclaimed, “Let’s hope we are all wealthy and retired bythe time this house of cards falters. ” a 3What ethical issues may arise because the companies that issue bonds pay the rating agencies to rate their bonds?in practice ahttp://oversight.house.gov/images/stories/Hearings/Committee_on_Oversight/E-mail_from_Belinda_Ghetti_to_ Nicole_ Billick_et_al._December_16_2006.pdf debentures subordinated debentures income bonds mortgage bonds collateral trust bonds equipment trust certificates See Table 6.4. zero- (or low-) coupon bonds junk bonds floating-rate bonds extendible notes putable bonds See Table 6.5 on page 238. CHAPTER 6 Interest Rates and Bond Valuation 237 Characteristics and Priority of Lender’s Claim of Traditional Types of Bonds Bond type Characteristics Priority of lender’s claim Unsecured bonds Debentures Unsecured bonds that only creditworthy firms Claims are the same as those of any general can issue. Convertible bonds are normally creditor. May have other unsecured bonds debentures. subordinated to them. Subordinated Claims are not satisfied until those of the Claim is that of a general creditor but not as good debentures creditors holding certain (senior) debts have as a senior debt claim. been fully satisfied. Income bonds Payment of interest is required only when Claim is that of a general creditor. Are not in earnings are available. Commonly issued in default when interest payments are missed, reorganization of a failing firm. because they are contingent only on earnings being available. Secured Bonds Mortgage bonds Secured by real estate or buildings. Claim is on proceeds from sale of mortgaged assets; if not fully satisfied, the lender becomes a general creditor. The first-mortgage claim must be fully satisfied before distribution of proceeds to second- mortgage holders, and so on. A number of mortgages can be issued against the same collateral. Collateral trust Secured by stock and (or) bonds that Claim is on proceeds from stock and (or) bond bonds are owned by the issuer. Collateral value collateral; if not fully satisfied, the lender becomes is generally 25% to 35% greater than a general creditor.bond value. Equipment trust Used to finance “rolling stock”—airplanes, Claim is on proceeds from the sale of the asset; certificates trucks, boats, railroad cars. A trustee buys if proceeds do not satisfy outstanding debt, trust the asset with funds raised through the certificate lenders become general creditors.sale of trust certificates and then leases it to the firm; after making the final scheduled lease payment, the firm receives title to the asset. A type of leasing.TABLE 6.4 INTERNATIONAL BOND ISSUES Companies and governments borrow internationally by issuing bonds in two prin- cipal financial markets: the Eurobond market and the foreign bond market. Bothgive borrowers the opportunity to obtain large amounts of long-term debtfinancing quickly, in the currency of their choice and with flexible repayment terms. AEurobond is issued by an international borrower and sold to investors in countries with currencies other than the currency in which the bond is denomi-nated. An example is a dollar-denominated bond issued by a U.S. corporationand sold to Belgian investors. From the founding of the Eurobond market in the1960s until the mid-1980s, “blue chip” U.S. corporations were the largest singleclass of Eurobond issuers. Some of these companies were able to borrow in thismarket at interest rates below those the U.S. government paid on Treasury bonds.As the market matured, issuers became able to choose the currency in which theyborrowed, and European and Japanese borrowers rose to prominence. In morerecent years, the Eurobond market has become much more balanced in terms ofthe mix of borrowers, total issue volume, and currency of denomination. Eurobond A bond issued by an international borrower andsold to investors in countrieswith currencies other than thecurrency in which the bond isdenominated. In contrast, a foreign bond is issued by a foreign corporation or government and is denominated in the investor’s home currency and sold in the investor’shome market. A Swiss-franc–denominated bond issued in Switzerland by a U.S.company is an example of a foreign bond. The three largest foreign-bond marketsare Japan, Switzerland, and the United States. 6REVIEW QUESTIONS 6–6What are typical maturities, denominations, and interest payments of a corporate bond? What mechanisms protect bondholders? 6–7Differentiate between standard debt provisions andrestrictive covenants included in a bond indenture. What are the consequences if a bond issuer violates any of these covenants? 6–8How is the cost of bond financing typically related to the cost of short-term borrowing? In addition to a bond’s maturity, what other majorfactors affect its cost to the issuer? 6–9What is a conversion feature? Acall feature? What are stock purchase warrants? 6–10 What is the current yield for a bond? How are bond prices quoted? How are bonds rated, and why? 6–11 Compare the basic characteristics of Eurobonds andforeign bonds.238 PART 3 Valuation of Securities Characteristics of Contemporary Types of Bonds Bond type Characteristicsa Zero- (or low-) Issued with no (zero) or a very low coupon (stated interest) rate and sold at a large discount from par. coupon bonds A significant portion (or all) of the investor’s return comes from gain in value (that is, par value minus purchase price). Generally callable at par value. Because the issuer can annually deduct the current year’s interest accrual without having to pay the interest until the bond matures (or is called), its cash flow each year is increased by the amount of the tax shield provided by the interest deduction. Junk bonds Debt rated Ba or lower by Moody’s or BB or lower by Standard & Poor’s. Commonly used by rapidly growing firms to obtain growth capital, most often as a way to finance mergers and takeovers. High-risk bonds with high yields—often yielding 2% to 3% more than the best-quality corporate debt. Floating-rate bonds Stated interest rate is adjusted periodically within stated limits in response to changes in specified money market or capital market rates. Popular when future inflation and interest rates are uncertain. Tend tosell at close to par because of the automatic adjustment to changing market conditions. Some issuesprovide for annual redemption at par at the option of the bondholder. Extendible notes Short maturities, typically 1 to 5 years, that can be renewed for a similar period at the option of holders. Similar to a floating-rate bond. An issue might be a series of 3-year renewable notes over a period of 15 years; every 3 years, the notes could be extended for another 3 years, at a new ratecompetitive with market interest rates at the time of renewal. Putable bonds Bonds that can be redeemed at par (typically, $1,000) at the option of their holder either at specific dates after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specifiedactions, such as being acquired, acquiring another company, or issuing a large amount of additional debt. In return for its conferring the right to “put the bond” at specified times or when the firm takes certain actions, the bond’s yield is lower than that of a nonputable bond. aThe claims of lenders (that is, bondholders) against issuers of each of these types of bonds vary, depending on the bonds’ othe r features. Each of these bonds can be unsecured or secured.TABLE 6.5 foreign bond A bond that is issued by a foreign corporation or gov-ernment and is denominated in the investor’s home currencyand sold in the investor’s home market. CHAPTER 6 Interest Rates and Bond Valuation 239 6.3Valuation Fundamentals Valuation is the process that links risk and return to determine the worth of an asset. It is a relatively simple process that can be applied to expected streams of benefits from bonds, stocks, income properties, oil wells, and so on. To determinean asset’s worth at a given point in time, a financial manager uses the time-value-of-money techniques presented in Chapter 5 and the concepts of risk and returnthat we will develop in Chapter 8. KEY INPUTS There are three key inputs to the valuation process: (1) cash flows (returns), (2) timing, and (3) a measure of risk, which determines the required return. Eachis described below. Cash Flows (Returns) The value of any asset depends on the cash flow(s) it is expected to provide over the ownership period. To have value, an asset does not have to provide an annualcash flow; it can provide an intermittent cash flow or even a single cash flow overthe period. Celia Sargent wishes to estimate the value of three assets she is considering investing in: common stock in Michaels Enterprises, an interest in an oil well, and an original painting by a well-known artist. Her cashflow estimates for each are as follows: Stock in Michaels Enterprises Expect to receive cash dividends of $300 per year indefinitely. Oil well Expect to receive cash flow of $2,000 at the end of year 1, $4,000 at the end of year 2, and $10,000 at the end of year 4, when the well is to besold. Original painting Expect to be able to sell the painting in 5 years for $85,000. With these cash flow estimates, Celia has taken the first step toward placing a value on each of the assets. Timing In addition to making cash flow estimates, we must know the timing of the cash flows.2For example, Celia expects the cash flows of $2,000, $4,000, and $10,000 for the oil well to occur at the ends of years 1, 2, and 4, respectively. Thecombination of the cash flow and its timing fully defines the return expected fromthe asset.Personal Finance Example 6.43valuation The process that links risk and return to determine the worthof an asset. 2. Although cash flows can occur at any time during a year, for computational convenience as well as custom, we will assume they occur at the end of the year unless otherwise noted.LG4 Risk and Required Return The level of risk associated with a given cash flow can significantly affect its value. In general, the greater the risk of (or the less certain) a cash flow, the lowerits value. Greater risk can be incorporated into a valuation analysis by using ahigher required return or discount rate. The higher the risk, the greater therequired return, and the lower the risk, the less the required return. Let’s return to Celia Sargent’s task of placing a value on the original painting and consider two scenarios. Scenario 1—Certainty A major art gallery has contracted to buy the painting for $85,000 at the end of 5 years. Because this is considered a cer-tain situation, Celia views this asset as “money in the bank.” She thus woulduse the prevailing risk-free rate of 3% as the required return when calculatingthe value of the painting. Scenario 2—High risk The values of original paintings by this artist have fluctuated widely over the past 10 years. Although Celia expects to be able tosell the painting for $85,000, she realizes that its sale price in 5 years couldrange between $30,000 and $140,000. Because of the high uncertainty sur-rounding the painting’s value, Celia believes that a 15% required return isappropriate. These two estimates of the appropriate required return illustrate how this rate captures risk. The often subjective nature of such estimates is also evident. BASIC VALUATION MODEL Simply stated, the value of any asset is the present value of all future cash flows it is expected to provide over the relevant time period. The time period can be any length, even infinity. The value of an asset is therefore determined by discountingthe expected cash flows back to their present value, using the required returncommensurate with the asset’s risk as the appropriate discount rate. Using thepresent value techniques explained in Chapter 5, we can express the value of anyasset at time zero, V 0, as (6.4) where We can use Equation 6.4 to determine the value of any asset. Celia Sargent uses Equation 6.4 to calculate the value of each asset. She values Michaels Enterprises stock using Equation 5.14 on page 178, which says that the present value of a perpetuity equals the annualPersonal Finance Example 6.63n=relevant time periodr=appropriate required return (discount rate)CFt=cash flow expected at the end of year tV0=value of the asset at time zeroV0=CF1 (1+r)1+CF2 (1+r)2+Á+CFn (1+r)nPersonal Finance Example 6.53240 PART 3 Valuation of Securities payment divided by the required return. In the case of Michaels stock, the annual cash flow is $300, and Celia decides that a 12% discount rate is appropriate for thisinvestment. Therefore, her estimate of the value of Michaels Enterprises stock is Next, Celia values the oil well investment, which she believes is the most risky of the three investments. Using a 20% required return, Celia estimates theoil well’s value to be Finally, Celia estimates the value of the painting by discounting the expected $85,000 lump sum payment in 5 years at 15%: Note that, regardless of the pattern of the expected cash flow from an asset, the basic valuation equation can be used to determine its value. 6REVIEW QUESTIONS 6–12 Why is it important for financial managers to understand the valuation process? 6–13 What are the three key inputs to the valuation process? 6–14 Does the valuation process apply only to assets that provide an annual cash flow? Explain. 6–15 Define and specify the general equation for the value of any asset, V0.$85,000 ,(1+0.15)5=$42,260.02$2,000 (1+0.20)1+$4,000 (1+0.20)2+$10,000 (1+0.20)4=$9,266.98$300 ,0.12 =$2,500CHAPTER 6 Interest Rates and Bond Valuation 241 6.4Bond Valuation The basic valuation equation can be customized for use in valuing specific securi- ties: bonds, common stock, and preferred stock. We describe bond valuation inthis chapter, and valuation of common stock and preferred stock in Chapter 7. BOND FUNDAMENTALS As noted earlier in this chapter, bonds are long-term debt instruments used by business and government to raise large sums of money, typically from a diversegroup of lenders. Most corporate bonds pay interest semiannually (every 6 months) at a stated coupon interest rate, have an initial maturity of 10 to 30 years, and have a par value, orface value, of $1,000 that must be repaid at maturity. Mills Company, a large defense contractor, on January 1, 2013, issued a 10% coupon interest rate, 10-year bond with a $1,000 par value that pays interestannually. Investors who buy this bond receive the contractual right to two cashflows: (1) $100 annual interest (10% coupon interest rate $1,000 par value)distributed at the end of each year and (2) the $1,000 par value at the end of the tenth year.*Example 6.73LG5LG6 We will use data for Mills’s bond issue to look at basic bond valuation. BASIC BOND VALUATION The value of a bond is the present value of the payments its issuer is contractually obligated to make, from the current time until it matures. The basic model for thevalue, B 0, of a bond is given by Equation 6.5: (6.5) where We can calculate bond value by using Equation 6.5 and a financial calculator or by using a spreadsheet. Tim Sanchez wishes to determine the current value of the Mills Company bond. Assuming that interest on the Mills Company bond issue is paid annually and that the required return is equal to the bond’s coupon interest rate, and years. The computations involved in finding the bond value are depicted graphi- cally on the following time line.n=10 M=$1,000, rd=10%, I=$100,Personal Finance Example 6.83rd=required return on the bondM=par value in dollarsn=number of years to maturityI=annual interest paid in dollarsB0=value of the bond at time zeroB0=I*can t=11 (1+rd)td+M*c1 (1+rd)nd242 PART 3 Valuation of Securities Time line for bond valuation (MillsCompany’s 10% couponinterest rate, 10-yearmaturity, $1,000 par,January 1, 2013, issuedate, paying annualinterest, and requiredreturn of 10%) 385.54$614.46$1002013 $1002014 $1002015 $1002016 $1002017 $1002018 $1002019 $1002020 $1002021 $100 $1,0002022End of Year B0 = $1,000.00 Calculator Use Using the Mills Company’s inputs shown at the left, you should find the bond value to be exactly $1,000. Note that the calculated bond value is equal to its par value; this will always be the case when the required return isequal to the coupon interest rate. 3 Spreadsheet Use The value of the Mills Company bond also can be calculated as shown in the following Excel spreadsheet.CHAPTER 6 Interest Rates and Bond Valuation 243 3. Note that because bonds pay interest in arrears, the prices at which they are quoted and traded reflect their value plus any accrued interest. For example, a $1,000 par value, 10% coupon bond paying interest semiannually and having a calculated value of $900 would pay interest of $50 at the end of each 6-month period. If it is now 3 monthssince the beginning of the interest period, three-sixths of the $50 interest, or $25 (that is, 3/6 $50), would be accrued. The bond would therefore be quoted at $925—its $900 value plus the $25 in accrued interest. For conven- ience, throughout this book, bond values will always be assumed to be calculated at the beginning of the interest period, thereby avoiding the need to consider accrued interest.*1,00010 N I CPT PVPMT10 100 FV 1000 SolutionInput Function BOND VALUE, ANNUAL INTEREST, REQUIRED RETURN = COUPON INTEREST RATE Annual interest payment Coupon interest rateNumber of years to maturityPar valueBond value1 23456$100 10% 10 $1,000 $1,000.00 Entry in Cell B6 is =PV(B3,B4,B2,B5,0) Note that Excel will return a negative $1000 as the price that must be paid to acquire this bond.AB BOND VALUE BEHAVIOR In practice, the value of a bond in the marketplace is rarely equal to its par value. In the bond data (see Table 6.2 on page 235), you can see that the prices of bondsoften differ from their par values of 100 (100 percent of par, or $1,000). Somebonds are valued below par (current price below 100), and others are valuedabove par (current price above 100). A variety of forces in the economy, as wellas the passage of time, tend to affect value. Although these external forces are inno way controlled by bond issuers or investors, it is useful to understand theimpact that required return and time to maturity have on bond value. Required Returns and Bond Values Whenever the required return on a bond differs from the bond’s coupon interestrate, the bond’s value will differ from its par value. The required return is likelyto differ from the coupon interest rate because either (1) economic conditionshave changed, causing a shift in the basic cost of long-term funds; or (2) the firm’srisk has changed. Increases in the basic cost of long-term funds or in risk willraise the required return; decreases in the cost of funds or in risk will lower therequired return. Regardless of the exact cause, what is important is the relationship between the required return and the coupon interest rate: When the required return isgreater than the coupon interest rate, the bond value, B 0, will be less than its par value, M. In this case, the bond is said to sell at a discount, which will equal . When the required return falls below the coupon interest rate, the bond value will be greater than par. In this situation, the bond is said to sell at apremium, which will equal . The preceding example showed that when the required return equaled the coupon interest rate, the bond’s value equaled its $1,000 par value. If for thesame bond the required return were to rise to 12% or fall to 8%, its value in eachcase could be found using Equation 6.5 or as follows. Calculator Use Using the inputs shown at the left for the two different required returns, you will find the value of the bond to be below or above par. At a 12%required return, the bond would sell at a discount of $113.00 ($1,000 par value $887.00 value). At the 8% required return, the bond would sell for apremium of $134.20 ($1,134.20 value $1,000 par value). The results of these calculations for Mills Company’s bond values are summarized in Table 6.6 andgraphically depicted in Figure 6.4. The inverse relationship between bond valueand required return is clearly shown in the figure. Spreadsheet Use The values for the Mills Company bond at required returns of 12% and 8% also can be calculated as shown in the following Excel spreadsheet.Once this spreadsheet has been configured you can compare bond values for anytwo required returns by simply changing the input values.– Example 6.93B0-MM-B0244 PART 3 Valuation of Securities discount The amount by which a bond sells at a value that is less thanits par value. premium The amount by which a bondsells at a value that is greaterthan its par value. 887.0010 N I CPT PVPMT12 100 FV 1000 SolutionInput Function 1,134.2010 N I CPT PVPMT8 100 FV 1000 SolutionInput Function BOND VALUE, ANNUAL INTEREST, REQUIRED RETURN NOT EQUAL TO COUPON INTEREST RATE Annual interest payment Coupon interest rateAnnual required returnNumber of years to maturityPar valueBond value1 234567$100 10%12% 10 $1,000 $887.00 Entry in Cell B7 is =PV(B4,B5,B2,B6,0) Note that the bond trades at a discount (i.e., below par) because the bond’s coupon rate is below investors’ required return. Entry in Cell C7 is =PV(C4,C5,C2,C6,0) Note that the bond trades at a premium because the bond’s coupon rate is above investors’ required return.AB $100 10% 8% 10 $1,000 $1,134.20C Time to Maturity and Bond Values Whenever the required return is different from the coupon interest rate, the amount of time to maturity affects bond value. An additional factor is whetherrequired returns are constant or change over the life of the bond. Constant Required Returns When the required return is different from the coupon interest rate and is constant until maturity, the value of the bond will approach its par value as the passage of time moves the bond’s value closer tomaturity. (Of course, when the required return equals the coupon interest rate, the bond’s value will remain at par until it matures.) Figure 6.5 depicts the behavior of the bond values calculated earlier and pre-sented in Table 6.6 for Mills Company’s 10% coupon interest rate bond payingannual interest and having 10 years to maturity. Each of the three required Example 6.10 3CHAPTER 6 Interest Rates and Bond Valuation 245 Bond Values for Various Required Returns (Mills Company’s 10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1, 2013, Issue Date, Paying Annual Interest) Required return, rd Bond value, B0 Status 12% $ 887.00 Discount 10 1,000.00 Par value 8 1,134.20 PremiumTABLE 6.6 1,400 1,3001,2001,1001,000 900800 700 2 0 4 6 8 10 12 14 16 Required Return, rd (%)8871,134 Par DiscountPremiumMarket Value of Bond, B0 ($)FIGURE 6.4 Bond Values and Required ReturnsBond values and requiredreturns (Mills Company’s10% coupon interest rate,10-year maturity, $1,000par, January 1, 2013, issuedate, paying annualinterest) returns—12%, 10%, and 8%—is assumed to remain constant over the 10 years to the bond’s maturity. The bond’s value at both 12% and 8% approaches andultimately equals the bond’s $1,000 par value at its maturity, as the discount (at 12%) or premium (at 8%) declines with the passage of time. Changing Required Returns The chance that interest rates will change and thereby change the required return and bond value is called interest rate risk.4 Bondholders are typically more concerned with rising interest rates because a rise in interest rates, and therefore in the required return, causes a decrease in bondvalue. The shorter the amount of time until a bond’s maturity, the less responsiveis its market value to a given change in the required return. In other words, short maturities have less interest rate risk than long maturities when all other features(coupon interest rate, par value, and interest payment frequency) are the same.This is because of the mathematics of time value; the present values of short-termcash flows change far less than the present values of longer-term cash flows inresponse to a given change in the discount rate (required return). The effect of changing required returns on bonds with differing maturities can beillustrated by using Mills Company’s bond and Figure 6.5. If the required returnrises from 10% to 12% when the bond has 8 years to maturity (see the dashedline at 8 years), the bond’s value decreases from $1,000 to $901—a 9.9%decrease. If the same change in required return had occurred with only 3 years to Example 6.11 3246 PART 3 Valuation of Securities 1 0 98765432101,000 901952 8871,0521,1151,134 Time to Maturity (years)Market Value of Bond, B0($) Premium Bond, Required Return, rd = 8% Par-Value Bond, Required Return, rd= 10% Discount Bond, Required Return, rd = 12%MFIGURE 6.5 Time to Maturity and Bond ValuesRelationship among time tomaturity, required returns,and bond values (MillsCompany’s 10% couponinterest rate, 10-yearmaturity, $1,000 par,January 1, 2013, issuedate, paying annualinterest) 4. A more robust measure of a bond’s response to interest rate changes is duration . Duration measures the sensitivity of a bond’s prices to changing interest rates. It incorporates both the interest rate (coupon rate) and the time tomaturity into a single statistic. Duration is simply a weighted average of the maturity of the present values of all thecontractual cash flows yet to be paid by the bond. Duration is stated in years, so a bond with a 5-year duration willdecrease in value by 5 percent if interest rates rise by 1 percent or will increase in value by 5 percent if interest ratesfall by 1 percent.interest rate risk The chance that interest rates will change and thereby change the required return and bond value. Rising rates, which result in decreasing bond values, are of greatest concern. maturity (see the dashed line at 3 years), the bond’s value would have dropped to just $952—only a 4.8% decrease. Similar types of responses can be seen for thechange in bond value associated with decreases in required returns. The shorterthe time to maturity, the less the impact on bond value caused by a given change in the required return. YIELD TO MATURITY (YTM) When investors evaluate bonds, they commonly consider yield to maturity(YTM). This is the compound annual rate of return earned on a debt securitypurchased on a given day and held to maturity. (The measure assumes, of course,that the issuer makes all scheduled interest and principal payments as promised.) 5 The yield to maturity on a bond with a current price equal to its par value (thatis, ) will always equal the coupon interest rate. When the bond value dif-fers from par, the yield to maturity will differ from the coupon interest rate. Assuming that interest is paid annually, the yield to maturity on a bond can be found by solving Equation 6.5 for r d. In other words, the current value, the annual interest, the par value, and the number of years to maturity are known,and the required return must be found. The required return is the bond’s yield tomaturity. The YTM can be found by using a financial calculator, by using anExcel spreadsheet, or by trial and error. The calculator provides accurate YTMvalues with minimum effort. Earl Washington wishes to find the YTM on Mills Company’s bond. The bond currently sells for $1,080, has a 10% coupon interest rate and $1,000 par value, pays interest annually, and has 10 years tomaturity. Calculator Use Most calculators require either the present value ( B 0in this case) or the future values ( IandMin this case) to be input as negative numbers to calculate yield to maturity. That approach is employed here. Using the inputsshown at the left, you should find the YTM to be 8.766%. Spreadsheet Use The yield to maturity of Mills Company’s bond also can be calculated as shown in the following Excel spreadsheet. First, enter all the bond’scash flows. Notice that you begin with the bond’s price as an outflow (a negativenumber). In other words, an investor has to pay the price up front to receive thecash flows over the next 10 years. Next, use Excel’s internal rate of return func- tion. This function calculates the discount rate that makes the present value of aseries of cash flows equal to zero. In this case, when the present value of all cashflows is zero, the present value of the inflows (interest and principal) equals thepresent value of the outflows (the bond’s initial price). In other words, theinternal rate of return function is giving us the bond’s YTM, the discount ratethat equates the bond’s price to the present value of its cash flows.Personal Finance Example 6.12 3B0=MCHAPTER 6 Interest Rates and Bond Valuation 247 5. Many bonds have a call feature, which means they may not reach maturity if the issuer, after a specified time period, calls them back. Because the call feature typically cannot be exercised until a specific future date, investors often calculate the yield to call (YTC) . The yield to call represents the rate of return that investors earn if they buy a callable bond at a specific price and hold it until it is called back and they receive the call price, which would be set above the bond’s par value. Here our focus is solely on the more general measure of yield to maturity.8.76610 N PV CPT IPMT–1080 100 FV 1000 SolutionInput Function SEMIANNUAL INTEREST AND BOND VALUES The procedure used to value bonds paying interest semiannually is similar to that shown in Chapter 5 for compounding interest more frequently than annually,except that here we need to find present value instead of future value. It involves 1. Converting annual interest, I, to semiannual interest by dividing Iby 2. 2. Converting the number of years to maturity, n, to the number of 6-month periods to maturity by multiplying nby 2. 3. Converting the required stated (rather than effective) 6annual return for similar-risk bonds that also pay semiannual interest from an annual rate, rd, to a semiannual rate by dividing rdby 2. Substituting these three changes into Equation 6.5 yields (6.6) B0=I 2*Ca2n t=11 a1+rd 2btS+M*C1 a1+rd 2b2nS248 PART 3 Valuation of Securities YIELD TO MATURITY , ANNUAL INTERESTA Cash Flow 8.766%0 123456 7 89 10Y ear YTM($1,080) $100$100$100$100$100$100$100$100$100 $1,100 Entry in Cell B14 is =IRR(B3:B13)1 23456789 1011121314B 6. As we noted in Chapter 5, the effective annual rate of interest, EAR, for stated interest rate r, when interest is paid semiannually ( m 2), can be found by using Equation 5.17: For example, a bond with a 12% required stated annual return, rd, that pays semiannual interest would have an effective annual rate of Because most bonds pay semiannual interest at semiannual rates equal to 50 percent of the stated annual rate, their effective annual rates are generally higher than their stated annual rates.EAR =a1+0.12 2b2 -1=(1.06)2-1=1.1236 -1=0.1236 =12.36%EAR =a1+r 2b2 -1= Assuming that the Mills Company bond pays interest semiannually and that the required stated annual return, rd, is 12% for similar-risk bonds that also pay semiannual interest, substituting these values into Equation 6.6 yields Calculator Use In using a calculator to find bond value when interest is paid semiannually, we must double the number of periods and divide both the requiredstated annual return and the annual interest by 2. For the Mills Company bond,we would use 20 periods (2 10 years), a required return of 6% (12% 2), andan interest payment of $50 ($100 2). Using these inputs, you should find thebond value with semiannual interest to be $885.30, as shown at the left. Spreadsheet Use The value of the Mills Company bond paying semiannual interest at a required return of 12% also can be calculated as shown in the fol-lowing Excel spreadsheet.,, *B 0=$100 2*Ca20 t=11 a1+0.12 2btS+$1,000 *C1 a1+0.12 2b20S=$885.30Example 6.13 3CHAPTER 6 Interest Rates and Bond Valuation 249 885.3020 N I CPT PVPMT6 50 FV 1000 SolutionInput Function BOND VALUE, SEMIANNUAL INTEREST Semiannual interest payment Semiannual required returnNumber of periods to maturityPar valueBond value1 23456$50 6% 20 $1,000 $885.30 Entry in Cell B6 is =PV(B3,B4,B2,B5,0) Note that Excel will produce a negative value for the bond’s priceAB Comparing this result with the $887.00 value found earlier for annual com- pounding, we can see that the bond’s value is lower when semiannual interest ispaid. This will always occur when the bond sells at a discount. For bonds selling at a premium, the opposite will occur: The value with semiannual interest will begreater than with annual interest. 6REVIEW QUESTIONS 6–16 What basic procedure is used to value a bond that pays annual interest? Semiannual interest? 6–17 What relationship between the required return and the coupon interest rate will cause a bond to sell at a discount? At a premium? At its par value? 6–18 If the required return on a bond differs from its coupon interest rate,describe the behavior of the bond value over time as the bond movestoward maturity. 6–19 As a risk-averse investor, would you prefer bonds with short or long periods until maturity? Why? 6–20 What is a bond’s yield to maturity (YTM )?Briefly describe the use of a financial calculator and the use of an Excel spreadsheet for finding YTM.250 PART 3 Valuation of Securities Summary FOCUS ON VALUE Interest rates and required returns embody the real cost of money, inflationary expectations, and issuer and issue risk. They reflect the level of return requiredby market participants as compensation for the risk perceived in a specific secu-rity or asset investment. Because these returns are affected by economic expecta-tions, they vary as a function of time, typically rising for longer-term maturities.The yield curve reflects such market expectations at any point in time. The value of an asset can be found by calculating the present value of its expected cash flows, using the required return as the discount rate. Bonds arethe easiest financial assets to value; both the amounts and the timing of theircash flows are contractual and, therefore, known with certainty (at least forhigh-grade bonds). The financial manager needs to understand how to applyvaluation techniques to bonds, stocks, and tangible assets (as we will demon-strate in the following chapters) to make decisions that are consistent with thefirm’s share price maximization goal. REVIEW OF LEARNING GOALS Describe interest rate fundamentals, the term structure of interest rates, and risk premiums. The flow of funds between savers and borrowers is regu- lated by the interest rate or required return. In a perfect, inflation-free, certainworld there would be one cost of money—the real rate of interest. The nominalor actual interest rate is the sum of the risk-free rate and a risk premiumreflecting issuer and issue characteristics. The risk-free rate is the real rate ofinterest plus an inflation premium. For any class of similar-risk bonds, the term structure of interest rates reflects the relationship between the interest rate or rate of return and the timeto maturity. Yield curves can be downward sloping (inverted), upward sloping(normal), or flat. The expectations theory, liquidity preference theory, andmarket segmentation theory are cited to explain the shape of the yield curve.Risk premiums for non-Treasury debt issues result from business risk, financialrisk, interest rate risk, liquidity risk, tax risk, default risk, maturity risk, andcontractual provision risk. Review the legal aspects of bond financing and bond cost. Corporate bonds are long-term debt instruments indicating that a corporation has borrowed an amount that it promises to repay in the future under clearlydefined terms. Most bonds are issued with maturities of 10 to 30 years and apar value of $1,000. The bond indenture, enforced by a trustee, states all conditions of the bond issue. It contains both standard debt provisions and LG2LG1 restrictive covenants, which may include a sinking-fund requirement and/or a security interest. The cost of a bond to an issuer depends on its maturity,offering size, and issuer risk and on the basic cost of money. Discuss the general features, yields, prices, ratings, popular types, and international issues of corporate bonds. A bond issue may include a conversion feature, a call feature, or stock purchase warrants. The yield, or rate of return,on a bond can be measured by its current yield, yield to maturity (YTM), oryield to call (YTC). Bond prices are typically reported along with their coupon,maturity date, and yield to maturity (YTM). Bond ratings by independent agenciesindicate the risk of a bond issue. Various types of traditional and contemporarybonds are available. Eurobonds and foreign bonds enable established creditworthycompanies and governments to borrow large amounts internationally. Understand the key inputs and basic model used in the valuation process. Key inputs to the valuation process include cash flows (returns), timing, and risk and the required return. The value of any asset is equal to the presentvalue of all future cash flows it is expected to provide over the relevant time period. Apply the basic valuation model to bonds, and describe the impact of required return and time to maturity on bond values. The value of a bond is the present value of its interest payments plus the present value of its par value. Thediscount rate used to determine bond value is the required return, which maydiffer from the bond’s coupon interest rate. A bond can sell at a discount, at par,or at a premium, depending on whether the required return is greater than,equal to, or less than its coupon interest rate. The amount of time to maturityaffects bond values. The value of a bond will approach its par value as the bondmoves closer to maturity. The chance that interest rates will change and therebychange the required return and bond value is called interest rate risk. Theshorter the amount of time until a bond’s maturity, the less responsive is itsmarket value to a given change in the required return. Explain yield to maturity (YTM), its calculation, and the procedure used to value bonds that pay interest semiannually. Yield to maturity is the rate of return investors earn if they buy a bond at a specific price and hold it untilmaturity. YTM can be calculated by using a financial calculator or by using anExcel spreadsheet. Bonds that pay interest semiannually are valued by using thesame procedure used to value bonds paying annual interest, except that theinterest payments are one-half of the annual interest payments, the number ofperiods is twice the number of years to maturity, and the required return is one-half of the stated annual required return on similar-risk bonds. LG6LG5LG4LG3CHAPTER 6 Interest Rates and Bond Valuation 251 Opener-in-Review In the chapter opener you learned that the United States government had more than $13 trillion in debt outstanding in the form of Treasury bills, notes,and bonds in 2010. From time to time, the Treasury changes the mix of securities that it issues to finance government debt, issuing more bills than bonds or vice versa. a.With short-term interest rates near 0 percent in 2010, suppose the Treasury decided to replace maturing notes and bonds by issuing new Treasury bills, thus shortening the average maturity of U.S. debt outstanding. Discuss the pros and cons of this strategy. b.The average maturity of outstanding U.S. Treasury debt is about 5 years. Suppose a newly issued 5-year Treasury note has a coupon rate of 2 percent and sells at par. What happens to the value of this bond if the inflation rate rises 1 percentage point, causing the yield-to-maturity on the 5-year note to jump to 3 percent shortly after it is issued? c.Assume that the “average” Treasury security outstanding has the features described in part b. If total U.S. debt is $13 trillion and an increase in inflation causes yields on Treasury securities to increase by 1 percentage point, by how much would the market value of the outstanding debt fall? What does this sug-gest about the incentives of government policy makers to pursue policies thatcould lead to higher inflation?252 PART 3 Valuation of Securities Self-Test Problems(Solutions in Appendix) ST6–1 Bond valuation Lahey Industries has outstanding a $1,000 par-value bond with an 8% coupon interest rate. The bond has 12 years remaining to its maturity date. a.If interest is paid annually, find the value of the bond when the required return is (1) 7%, (2) 8%, and (3) 10%. b.Indicate for each case in part awhether the bond is selling at a discount, at a pre- mium, or at its par value. c.Using the 10% required return, find the bond’s value when interest is paid semi- annually. ST6–2 Bond yields Elliot Enterprises’ bonds currently sell for $1,150, have an 11% coupon interest rate and a $1,000 par value, pay interest annually, and have 18 years to maturity. a.Calculate the bonds’ current yield . b.Calculate the bonds’ yield to maturity (YTM) . c.Compare the YTM calculated in part bto the bonds’ coupon interest rate and current yield (calculated in part a). Use a comparison of the bonds’ current price and par value to explain these differences.LG6 LG5 LG6 LG3 Warm-Up ExercisesAll problems are available in . E6–1 The risk-free rate on T-bills recently was 1.23%. If the real rate of interest is estimatedto be 0.80%, what was the expected level of inflation? E6–2 The yields for Treasuries with differing maturities on a recent day were as shown inthe table on page 253.a.Use the information to plot a yield curve for this date. b.If the expectations hypothesis is true, approximately what rate of return do investors expect a 5-year Treasury note to pay 5 years from now? LG1 LG1 c.If the expectations hypothesis is true, approximately (ignoring compounding) what rate of return do investors expect a 1-year Treasury security to pay starting2 years from now? d.Is it possible that even though the yield curve slopes up in this problem, investors do not expect rising interest rates? Explain. E6–3 The yields for Treasuries with differing maturities, including an estimate of the real rate of interest, on a recent day were as shown in the following table:CHAPTER 6 Interest Rates and Bond Valuation 253 Maturity Yield 3 months 1.41% 6 months 1.712 years 2.683 years 3.015 years 3.7010 years 4.5130 years 5.25 Rating class Nominal interest rate AAA 5.12% BBB 5.78B 7.82Maturity Yield Real rate of interest 3 months 1.41% 0.80% 6 months 1.71 0.802 years 2.68 0.803 years 3.01 0.805 years 3.70 0.8010 years 4.51 0.8030 years 5.25 0.80LG1 Use the information in the preceding table to calculate the inflation expectation for each maturity. E6–4 Recently, the annual inflation rate measured by the Consumer Price Index (CPI) wasforecast to be 3.3%. How could a T-bill have had a negative real rate of return over the same period? How could it have had a zero real rate of return? What minimumrate of return must the T-bill have earned to meet your requirement of a 2% real rate of return? E6–5 Calculate the risk premium for each of the following rating classes of long-term securities, assuming that the yield to maturity (YTM) for comparable Treasuries is 4.51%.LG1 LG1 E6–6 You have two assets and must calculate their values today based on their different payment streams and appropriate required returns. Asset 1 has a required return of15% and will produce a stream of $500 at the end of each year indefinitely. Asset 2has a required return of 10% and will produce an end-of-year cash flow of $1,200in the first year, $1,500 in the second year, and $850 in its third and final year. E6–7 A bond with 5 years to maturity and a coupon rate of 6% has a par, or face, valueof $20,000. Interest is paid annually. If you required a return of 8% on this bond,what is the value of this bond to you? E6–8 Assume a 5-year Treasury bond has a coupon rate of 4.5%.a.Give examples of required rates of return that would make the bond sell at a discount, at a premium, and at par. b.If this bond’s par value is $10,000, calculate the differing values for this bond given the required rates you chose in part a.254 PART 3 Valuation of Securities LG4 LG5 LG5 ProblemsAll problems are available in . P6–1 Interest rate fundamentals: The real rate of return Carl Foster, a trainee at an investment banking firm, is trying to get an idea of what real rate of return investors are expecting in today’s marketplace. He has looked up the rate paid on 3-monthU.S. Treasury bills and found it to be 5.5%. He has decided to use the rate of change in the Consumer Price Index as a proxy for the inflationary expectations of investors. That annualized rate now stands at 3%. On the basis of the information that Carl has collected, what estimate can he make of the real rate of return? P6–2 Real rate of interest To estimate the real rate of interest, the economics division of Mountain Banks—a major bank holding company—has gathered the data summa- rized in the following table. Because there is a high likelihood that new tax legisla-tion will be passed in the near future, current data as well as data reflecting the probable impact of passage of the legislation on the demand for funds are also LG1 LG1 With passage Currently of tax legislation Amount of funds Interest rate Interest rate Interest rate supplied/demanded required by required by required by ($ billion) funds suppliers funds demanders funds demanders $ 1 2% 7% 9% 53 6 8 10 4 4 720 6 3 650 7 2 4 100 9 1 3 included in the table. ( Note: The proposed legislation will not affect the supply schedule of funds. Assume a perfect world in which inflation is expected to be zero, funds suppliers and demanders have no liquidity preference, and all outcomes are certain.)a.Draw the supply curve and the demand curve for funds using the current data. (Note: Unlike the functions in Figure 6.1 on page 223, the functions here will not appear as straight lines.) b.Using your graph, label and note the real rate of interest using the current data. c.Add to the graph drawn in part athe new demand curve expected in the event that the proposed tax legislation is passed. d.What is the new real rate of interest? Compare and analyze this finding in light of your analysis in part b. Personal Finance Problem P6–3 Real and nominal rates of interest Zane Perelli currently has $100 that he can spend today on polo shirts costing $25 each. Alternatively, he could invest the $100 in a risk-free U.S. Treasury security that is expected to earn a 9% nominal rate ofinterest. The consensus forecast of leading economists is a 5% rate of inflation over the coming year. a.How many polo shirts can Zane purchase today? b.How much money will Zane have at the end of 1 year if he forgoes purchasing the polo shirts today? c.How much would you expect the polo shirts to cost at the end of 1 year in light of the expected inflation? d.Use your findings in parts bandcto determine how many polo shirts (fractions are OK) Zane can purchase at the end of 1 year. In percentage terms, how many more or fewer polo shirts can Zane buy at the end of 1 year? e.What is Zane’s real rate of return over the year? How is it related to the per- centage change in Zane’s buying power found in part d? Explain. P6–4 Yield curve A firm wishing to evaluate interest rate behavior has gathered yield data on five U.S. Treasury securities, each having a different maturity and all meas- ured at the same point in time. The summarized data follow.CHAPTER 6 Interest Rates and Bond Valuation 255 LG1 LG1 U.S. Treasury security Time to maturity Yield A 1 year 12.6% B 10 years 11.2 C 6 months 13.0 D 20 years 11.0 E 5 years 11.4 a.Draw the yield curve associated with these data. b.Describe the resulting yield curve in part a,and explain the general expectations embodied in it. P6–5 Nominal interest rates and yield curves A recent study of inflationary expectations has revealed that the consensus among economic forecasters yields the followingLG1 a.If the real rate of interest is currently 2.5%, find the nominal rate of interest on each of the following U.S. Treasury issues: 20-year bond, 3-month bill, 2-year note, and 5-year bond. b.If the real rate of interest suddenly dropped to 2% without any change in infla- tionary expectations, what effect, if any, would this have on your answers in parta?Explain. c.Using your findings in part a,draw a yield curve for U.S. Treasury securities. Describe the general shape and expectations reflected by the curve. d.What would a follower of the liquidity preference theory say about how the preferences of lenders and borrowers tend to affect the shape of the yield curve drawn in part c?Illustrate that effect by placing on your graph a dotted line that approximates the yield curve without the effect of liquidity preference. e.What would a follower of the market segmentation theory say about the supply and demand for long-term loans versus the supply and demand for short-term loans given the yield curve constructed for part cof this problem? P6–6 Nominal and real rates and yield curves A firm wishing to evaluate interest rate behavior has gathered data on the nominal rate of interest and on inflationary expectations for five U.S. Treasury securities, each having a different maturity and each measured at a different point in time during the year just ended. ( Note: Assume that the risk that future interest rate movements will affect longer maturities more than shorter maturities is zero; that is, there is no maturity risk. ) These data are summarized in the following table.LG1256 PART 3 Valuation of Securities Average annual Period rate of inflation 3 months 5% 2 years 65 years 810 years 8.520 years 9 U.S. Treasury Nominal rate Inflationary security Point in time Maturity of interest expectation A Jan. 7 2 years 12.6% 9.5% B Mar. 12 10 years 11.2 8.2 C May 30 6 months 13.0 10.0 D Aug. 15 20 years 11.0 8.1 E Dec. 30 5 years 11.4 8.3average annual rates of inflation expected over the periods noted. ( Note: Assume that the risk that future interest rate movements will affect longer maturities morethan shorter maturities is zero; that is, there is no maturity risk. ) a.Using the preceding data, find the real rate of interest at each point in time. b.Describe the behavior of the real rate of interest over the year. What forces might be responsible for such behavior? c.Draw the yield curve associated with these data, assuming that the nominal rates were measured at the same point in time. d.Describe the resulting yield curve in part c,and explain the general expectations embodied in it. P6–7 Term structure of interest rates The following yield data for a number of highest- quality corporate bonds existed at each of the three points in time noted.CHAPTER 6 Interest Rates and Bond Valuation 257 LG1 Yield Time to maturity (years) 5 years ago 2 years ago Today 1 9.1% 14.6% 9.3% 3 9.2 12.8 9.85 9.3 12.2 10.9 10 9.5 10.9 12.615 9.4 10.7 12.720 9.3 10.5 12.930 9.4 10.5 13.5 a.On the same set of axes, draw the yield curve at each of the three given times. b.Label each curve in part awith its general shape (downward-sloping, upward- sloping, flat). c.Describe the general interest rate expectation existing at each of the three times. d.Examine the data from 5 years ago. According to the expectations theory, what approximate return did investors expect a 5-year bond to pay as of today? P6–8 Risk-free rate and risk premiums The real rate of interest is currently 3%; the inflation expectation and risk premiums for a number of securities follow. Inflation expectation Security Premium Risk premium A6 %3 % B9 2 C8 2 D5 4 E1 1 1 a.Find the risk-free rate of interest ,RF, that is applicable to each security. b.Although not noted, what factor must be the cause of the differing risk-free rates found in part a? c.Find the nominal rate of interest for each security.LG1 a.If the real rate of interest is currently 2%, find the risk-free rate of interest appli- cable to each security. b.Find the total risk premium attributable to each security’s issuer and issue char- acteristics. c.Calculate the nominal rate of interest for each security. Compare and discuss your findings. P6–10 Bond interest payments before and after taxes Charter Corp. has issued 2,500 debentures with a total principal value of $2,500,000. The bonds have a coupon interest rate of 7%.a.What dollar amount of interest per bond can an investor expect to receive each year from Charter? b.What is Charter’s total interest expense per year associated with this bond issue? c.Assuming that Charter is in a 35% corporate tax bracket, what is the company’s net after-tax interest cost associated with this bond issue? P6–11 Bond prices and yields Assume that the Financial Management Corporation’s $1,000-par-value bond had a 5.700% coupon, matured on May 15, 2020, had a current price quote of 97.708, and had a yield to maturity (YTM) of 6.034%. Giventhis information, answer the following questions: a.What was the dollar price of the bond? b.What is the bond’s current yield? c.Is the bond selling at par, at a discount, or at a premium? Why? d.Compare the bond’s current yield calculated in part bto its YTM and explain why they differ. Personal Finance Problem P6–12 Valuation fundamentals Imagine that you are trying to evaluate the economics of purchasing an automobile. You expect the car to provide annual after-tax cash bene- fits of $1,200 at the end of each year and assume that you can sell the car for after-tax proceeds of $5,000 at the end of the planned 5-year ownership period. All funds for purchasing the car will be drawn from your savings, which are currently earning 6% after taxes. a.Identify the cash flows, their timing, and the required return applicable to valuing the car. b.What is the maximum price you would be willing to pay to acquire the car? Explain.P6–9 Risk premiums Eleanor Burns is attempting to find the nominal rate of interest for each of two securities—A and B—issued by different firms at the same point in time.She has gathered the following data:258 PART 3 Valuation of Securities LG2 LG4 LG4LG1 Characteristic Security A Security B Time to maturity 3 years 15 years Inflation expectation premium 9.0% 7.0%Risk premium for: Liquidity risk 1.0% 1.0%Default risk 1.0% 2.0%Maturity risk 0.5% 1.5%Other risk 0.5% 1.5% Personal Finance Problem P6–14 Asset valuation and risk Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $3,000 per year at the end of years 1 through 4 and $15,000 at the end of year 5. Her research indicates that she must earn 10% on low-risk assets, 15% on average-risk assets, and 22% on high-risk assets.a.Determine what is the most Laura should pay for the asset if it is classified as (1) low-risk, (2) average-risk, and (3) high-risk. b.Suppose Laura is unable to assess the risk of the asset and wants to be certain she’s making a good deal. On the basis of your findings in part a,what is the most she should pay? Why? c.All else being the same, what effect does increasing risk have on the value of an asset? Explain in light of your findings in part a. P6–15 Basic bond valuation Complex Systems has an outstanding issue of $1,000-par- value bonds with a 12% coupon interest rate. The issue pays interest annually and has 16 years remaining to its maturity date. a.If bonds of similar risk are currently earning a 10% rate of return, how much should the Complex Systems bond sell for today? b.Describe the twopossible reasons why the rate on similar-risk bonds is below the coupon interest rate on the Complex Systems bond. c.If the required return were at 12% instead of 10%, what would the current value of Complex Systems’ bond be? Contrast this finding with your findings in part a and discuss.CHAPTER 6 Interest Rates and Bond Valuation 259 Cash flow Asset End of year Amount Appropriate required return A 1 $ 5,000 18% 2 5,0003 5,000 B 1 through $ 300 15% C 1 $ 0 16% 2030405 35,000 D 1 through 5 $ 1,500 12% 6 8,500 E 1 $ 2,000 14% 2 3,0003 5,0004 7,0005 4,0006 1,000q LG4 LG5P6–13 Valuation of assets Using the information provided in the following table, find the value of each asset.LG4 P6–16 Bond valuation—Annual interest Calculate the value of each of the bonds shown in the following table, all of which pay interest annually.260 PART 3 Valuation of Securities LG5 Bond Par value Coupon interest rate Years to maturity Required return A $1,000 14% 20 12% B 1,000 8 16 8C 100 10 8 13D 500 16 13 18E 1,000 12 10 10 P6–17 Bond value and changing required returns Midland Utilities has outstanding a bond issue that will mature to its $1,000 par value in 12 years. The bond has a coupon interest rate of 11% and pays interest annually. a.Find the value of the bond if the required return is (1) 11%, (2) 15%, and (3) 8%. b.Plot your findings in part aon a set of “required return ( xaxis)–market value of bond ( yaxis)” axes. c.Use your findings in parts aandbto discuss the relationship between the coupon interest rate on a bond and the required return and the market value of the bond relative to its par value. d.What twopossible reasons could cause the required return to differ from the coupon interest rate? P6–18 Bond value and time—Constant required returns Pecos Manufacturing has just issued a 15-year, 12% coupon interest rate, $1,000-par bond that pays interest annually. The required return is currently 14%, and the company is certain it will remain at 14% until the bond matures in 15 years.a.Assuming that the required return does remain at 14% until maturity, find the value of the bond with (1) 15 years, (2) 12 years, (3) 9 years, (4) 6 years, (5) 3 years, and (6) 1 year to maturity. b.Plot your findings on a set of “time to maturity ( xaxis)–market value of bond (yaxis)” axes constructed similarly to Figure 6.5 on page 246. c.All else remaining the same, when the required return differs from the coupon interest rate and is assumed to be constant to maturity, what happens to the bond value as time moves toward maturity? Explain in light of the graph in partb. Personal Finance Problem P6–19 Bond value and time—Changing required returns Lynn Parsons is considering investing in either of two outstanding bonds. The bonds both have $1,000 par values and 11% coupon interest rates and pay annual interest. Bond A has exactly 5 years to maturity, and bond B has 15 years to maturity. a.Calculate the value of bond A if the required return is (1) 8%, (2) 11%, and (3) 14%. b.Calculate the value of bond B if the required return is (1) 8%, (2) 11%, and (3) 14%.LG5 LG5 LG5 c.From your findings in parts aandb,complete the following table, and discuss the relationship between time to maturity and changing required returns.CHAPTER 6 Interest Rates and Bond Valuation 261 Required return Value of bond A Value of bond B 8% ? ? 11 ? ?14 ? ? Bond Par value Coupon interest rate Years to maturity Current value A $1,000 9% 8 $ 820 B 1,000 12 16 1,000 C 500 12 12 560 D 1,000 15 10 1,120 E 1,000 5 3 900Bond Coupon interest rate Yield to maturity Price A 6% 10% _________ B 8 8 _________C 9 7 _________D 7 9 _________E 12 10 _________d.If Lynn wanted to minimize interest rate risk, which bond should she purchase? Why? P6–20 Yield to maturity The relationship between a bond’s yield to maturity and coupon interest rate can be used to predict its pricing level. For each of the bonds listed,state whether the price of the bond will be at a premium to par, at par, or at a discount to par.LG6 P6–21 Yield to maturity The Salem Company bond currently sells for $955, has a 12% coupon interest rate and a $1,000 par value, pays interest annually, and has 15 years to maturity.a.Calculate the yield to maturity (YTM ) on this bond. b.Explain the relationship that exists between the coupon interest rate and yield to maturity and the par value and market value of a bond. P6–22 Yield to maturity Each of the bonds shown in the following table pays interest annually.LG6 LG6 a.Calculate the yield to maturity (YTM ) for each bond. b.What relationship exists between the coupon interest rate and yield to maturity and the par value and market value of a bond? Explain. Personal Finance Problem P6–23 Bond valuation and yield to maturity Mark Goldsmith’s broker has shown him two bonds. Each has a maturity of 5 years, a par value of $1,000, and a yield to maturity of 12%. Bond A has a coupon interest rate of 6% paid annually. Bond B has a coupon interest rate of 14% paid annually. a.Calculate the selling price for each of the bonds. b.Mark has $20,000 to invest. Judging on the basis of the price of the bonds, how many of either one could Mark purchase if he were to choose it over the other? (Mark cannot really purchase a fraction of a bond, but for purposes of this ques- tion, pretend that he can.) c.Calculate the yearly interest income of each bond on the basis of its coupon rate and the number of bonds that Mark could buy with his $20,000. d.Assume that Mark will reinvest the interest payments as they are paid (at the end of each year) and that his rate of return on the reinvestment is only 10%. Foreach bond, calculate the value of the principal payment plus the value of Mark’s reinvestment account at the end of the 5 years. e.Why are the two values calculated in part ddifferent? If Mark were worried that he would earn less than the 12% yield to maturity on the reinvested interest pay-ments, which of these two bonds would be a better choice? P6–24 Bond valuation—Semiannual interest Find the value of a bond maturing in 6 years, with a $1,000 par value and a coupon interest rate of 10% (5% paid semi- annually) if the required return on similar-risk bonds is 14% annual interest (7% paid semiannually). P6–25 Bond valuation—Semiannual interest Calculate the value of each of the bonds shown in the following table, all of which pay interest semiannually.262 PART 3 Valuation of Securities LG5 LG2 LG6 LG6 LG6 Coupon Years to Required stated Bond Par value interest rate maturity annual return A $1,000 10% 12 8% B 1,000 12 20 12C 500 12 5 14D 1,000 14 10 10E 100 6 4 14 P6–26 Bond valuation—Quarterly interest Calculate the value of a $5,000-par-value bond paying quarterly interest at an annual coupon interest rate of 10% and having 10 years until maturity if the required return on similar-risk bonds is currently a12% annual rate paid quarterly. P6–27 ETHICS PROBLEM Bond rating agencies have invested significant sums of money in an effort to determine which quantitative and nonquantitative factors best predict bond defaults. Furthermore, some of the raters invest time and money to meet pri-vately with corporate personnel to get nonpublic information that is used in assigning the issue’s bond rating. To recoup those costs, some bond rating agencies have tied their ratings to the purchase of additional services. Do you believe that this is an acceptable practice? Defend your position.LG6 LG1 CHAPTER 6 Interest Rates and Bond Valuation 263 Spreadsheet Exercise CSM Corporation has a bond issue outstanding at the end of 2012. The bond has 15 years remaining to maturity and carries a coupon interest rate of 6%. Interest on the bond is compounded on a semiannual basis. The par value of the CSM bond is $1,000 and it is currently selling for $874.42. TO DO Create a spreadsheet similar to the Excel spreadsheet examples located in the chapterfor yield to maturity and semiannual interest to model the following: a.Create a spreadsheet similar to the Excel spreadsheet examples located in the chapter to solve for the yield to maturity. b.Create a spreadsheet similar to the Excel spreadsheet examples located in the chapter to solve for the price of the bond if the yield to maturity is 2% higher. c.Create a spreadsheet similar to the Excel spreadsheet examples located in the chapter to solve for the price of the bond if the yield to maturity is 2% lower. d.What can you summarize about the relationship between the price of the bond, the par value, the yield to maturity, and the coupon rate? Visit www.myfinancelab.com forChapter Case: Evaluating Annie Hegg’s Proposed Investment in Atilier Industries Bonds, Group Exercises, and other numerous resources. Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand the difference between debt and equity in terms of tax treatment; the ownership claims of capitalproviders, including venture capitalists and stockholders; and the differences between book value per share and other market-based valuations. INFORMATION SYSTEMS You need to understand the procedures used to issue common stock, the information needed to value stock,how to collect and process the necessary information from each func-tional area, and how to disseminate information to investors. MANAGEMENT You need to understand the difference between debt and equity capital, the rights and claims of stockholders, the process ofissuing common stock, and the effects each functional area has on thevalue of the firm ’s stock. MARKETING You need to understand that the firm ’s ideas for products and services will greatly affect investors ’ beliefs regarding the likely success of the firm ’s projects; projects that are viewed as more likely to succeed are also viewed as more valuable and therefore lead to ahigher stock value. OPERATIONS You need to understand that the evaluations of venture capitalists and other would-be investors will in part depend on the effi-ciency of the firm ’s operations; more cost-efficient operations lead to better growth prospects and, therefore, higher stock valuations. At some point, you are likely to hold stocks as an asset in your retirement program. You may want to estimate a stock ’s value. If the stock is selling below its estimated value, you may buy the stock; if its marketprice is above its value, you may sell it. Some individuals rely on finan-cial advisors to make such buy or sell recommendations. Regardless ofhow you approach investment decisions, it will be helpful for you tounderstand how stocks are valued. In your personal lifeLearning Goals Differentiate between debt and equity. Discuss the features of both common and preferred stock. Describe the process of issuing common stock, including venturecapital, going public, and theinvestment banker. Understand the concept of market efficiency and basic stock valuation using zero-growth, constant-growth, and variable-growth models. Discuss the free cash flow valuation model and the bookvalue, liquidation value, andprice/earnings (P/E) multiple approaches. Explain the relationships among financial decisions, return, risk,and the firm ’s value. LG6LG5LG4LG3LG2LG17Stock Valuation 264 265Going Green to Find Value One of the most “hotly ” debated topics of our day has been the issue of global warming and the benefitsand costs of lower emissions. Many companies are investing in radical new technologies with the hope of capital-izing on the going green movement. On September 24, 2009, A123 Systems Inc. raised $378 million in its initial public offering (IPO) of common stock. A123, whose shares trade on the Nasdaq stock exchange, uses a patented nanotechnology developed at the MassachusettsInstitute of Technology to produce more powerful and longer-lasting lithium ion batteries that go in products ranging from cordless hand tools to electric vehicles. Even though A123 reported a loss of $40.7 million on revenue of just $42.9 million in the first half of 2009, investors wel-comed the IPO, boosting the share price 50 percent on the first day of trading. Excitement about A123 ’s prospects was fueled in part by major investments in the com- pany from a few high-profile companies including General Electric, Qualcomm, and Motorola. Furthermore, the company secured almost $250 million in grants from the federal government aspart of the American Recovery and Reinvestment Act of 2009, a bill passed by Congress designed to help the U.S. economy emerge from a deep recession. Some likely customers of A123 also received stimulus funds, including electric car makers Tesla Motors and FiskerAutomotive. In the weeks following the IPO, A123 ’s stock price was as high as $28 per share, but by the middle of 2010 it was trading below $10 a share. A123 is not a stock for the faint of heart. In the long run, A123 ’s stock price will depend on its ability to generate positive cash flows and convince the market of its ability to do so into the future. A123 Systems Inc. 266 PART 3 Valuation of Securities 7.1Differences between Debt and Equity Although debt and equity capital are both sources of external financing used by firms, they are very different in several important respects. Most importantly,debt financing is obtained from creditors, and equity financing is obtained frominvestors who then become part owners of the firm. Creditors (lenders ordebtholders) have a legal right to be repaid, whereas investors have only anexpectation of being repaid. Debt includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments. Equity consists of funds provided by the firm’s owners (investors or stockholders) and isrepaid subject to the firm’s performance. A firm can obtain equity eitherinternally, by retaining earnings rather than paying them out as dividends to its stockholders, or externally, by selling common or preferred stock. The key differ- ences between debt and equity capital are summarized in Table 7.1 and discussedin the following pages. VOICE IN MANAGEMENT Unlike creditors, holders of equity (stockholders) are owners of the firm. Stockholdersgenerally have voting rights that permit them to select the firm’s directors and voteon special issues. In contrast, debtholders do not receive voting privileges butinstead rely on the firm’s contractual obligations to them to be their voice. CLAIMS ON INCOME AND ASSETS Equityholders’ claims on income and assets are secondary to the claims of credi-tors. Their claims on income cannot be paid until the claims of all creditors, including both interest and scheduled principal payments, have been satisfied.After satisfying creditor’s claims, the firm’s board of directors decides whether todistribute dividends to the owners.debt Includes all borrowing incurred by a firm, including bonds,and is repaid according to a fixed schedule of payments. equity Funds provided by the firm’s owners (investors orstockholders) that are repaidsubject to the firm’sperformance. Equityholders’ claims on assets also are secondary to the claims of creditors. If the firm fails, its assets are sold, and the proceeds are distributed in this order:secured creditors, unsecured creditors, and equityholders. Because equityholdersare the last to receive any distribution of assets, they expect greater returns fromtheir investment in the firm’s stock than the returns creditors require on the firm’sMatter of fact According to the U.S. Securities and Exchange Commission, in bankruptcy assets are divided up as follows: 1.Secured creditors: Secured bank loans or secured bonds are paid first. 2.Unsecured creditors: Unsecured bank loans or unsecured bonds, suppliers, or customers have the next claim. 3.Equityholders: Equityholders or the owners of the company have the last claim on assets, and they may not receive anything if the secured and unsecured creditors’ claims are not fully repaid.How Are Assets Divided in Bankruptcy? In more depth To read about The Bankruptcy Process , go to www.myfinancelab.com LG1 borrowings. The higher rate of return expected by equityholders leads to a higher cost of equity financing relative to the cost of debt financing for the firm. MATURITY Unlike debt, equity is a permanent form of financing for the firm. It does not “mature,” so repayment is not required. Because equity is liquidated only duringbankruptcy proceedings, stockholders must recognize that, although a readymarket may exist for their shares, the price that can be realized may fluctuate.This fluctuation of the market price of equity makes the overall returns to a firm’sstockholders even more risky. TAX TREATMENT Interest payments to debtholders are treated as tax-deductible expenses by theissuing firm, whereas dividend payments to a firm’s stockholders are not taxdeductible. The tax deductibility of interest lowers the corporation’s cost of debtfinancing, further causing it to be lower than the cost of equity financing. 6REVIEW QUESTION 7–1What are the key differences between debt andequity?CHAPTER 7 Stock Valuation 267 Key Differences between Debt and Equity Type of capital Characteristic Debt Equity Voice in managementaNo Yes Claims on income and assets Senior to equity Subordinate to debtMaturity Stated NoneTax treatment Interest deduction No deduction aDebtholders do not have voting rights, but instead they rely on the firm’s contractual obligations to them to be their voice.TABLE 7.1 7.2Common and Preferred Stock A firm can obtain equity capital by selling either common or preferred stock. All corporations initially issue common stock to raise equity capital. Some of thesefirms later issue either additional common stock or preferred stock to raise moreequity capital. Although both common and preferred stock are forms of equitycapital, preferred stock has some similarities to debt that significantly differen-tiate it from common stock. Here we first consider the features of both commonand preferred stock and then describe the process of issuing common stock,including the use of venture capital.LG3 LG2 COMMON STOCK The true owners of a corporate business are the common stockholders. Common stockholders are sometimes referred to as residual owners because they receive what is left—the residual—after all other claims on the firm’s income and assetshave been satisfied. They are assured of only one thing: that they cannot lose anymore than they have invested in the firm. As a result of this generally uncertainposition, common stockholders expect to be compensated with adequate divi-dends and, ultimately, capital gains. Ownership The common stock of a firm can be privately owned by private investors or publicly owned by public investors. Private companies are often closely owned by an indi- vidual investor or a small group of private investors (such as a family). Public com-panies are widely owned by many unrelated individual or institutional investors. The shares of privately owned firms, which are typically small corporations, are gen-erally not traded; if the shares are traded, the transactions are among privateinvestors and often require the firm’s consent. Large corporations, which are empha-sized in the following discussions, are publicly owned, and their shares are generallyactively traded in the broker or dealer markets described in Chapter 2. Par Value The market value of common stock is completely unrelated to its par value. Thepar value of common stock is an arbitrary value established for legal purposes in the firm’s corporate charter and is generally set quite low, often an amount of $1or less. Recall that when a firm sells new shares of common stock, the par valueof the shares sold is recorded in the capital section of the balance sheet as part ofcommon stock. One benefit of this recording is that at any time the total numberof shares of common stock outstanding can be found by dividing the book valueof common stock by the par value. Setting a low par value is advantageous in states where certain corporate taxes are based on the par value of stock. A low par value is also beneficial in states thathave laws against selling stock at a discount to par. For example, a companywhose common stock has a par value of $20 per share would be unable to issuestock if investors are unwilling to pay more than $16 per share. Preemptive Rights Thepreemptive right allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued, thus protecting themfrom dilution of their ownership. A dilution of ownership is a reduction in each previous shareholder’s fractional ownership resulting from the issuance ofadditional shares of common stock. Preemptive rights allow preexisting share- holders to maintain their preissuance voting control and protects them againstthe dilution of earnings. Preexisting shareholders experience a dilution of earn- ings when their claim on the firm’s earnings is diminished as a result of new shares being issued. In a rights offering, the firm grants rights to its shareholders. These financial instruments allow stockholders to purchase additional shares at a price belowthe market price, in direct proportion to their number of owned shares. In these268 PART 3 Valuation of Securities privately owned (stock) The common stock of a firm is owned by private investors; this stock is not publicly traded. publicly owned (stock) The common stock of a firm isowned by public investors; this stock is publicly traded. closely owned (stock) The common stock of a firm is owned by an individual or a small group of investors (such as a family); these are usually privately owned companies. widely owned (stock) The common stock of a firm is owned by many unrelated individual or institutional investors. par-value common stock An arbitrary value established for legal purposes in the firm’s corporate charter and which can be used to find the total number of shares outstanding by dividing it into the book value of common stock. preemptive right Allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued, thus protecting them from dilution of their ownership. dilution of ownership A reduction in each previousshareholder’s fractional ownership resulting from the issuance of additional shares of common stock. dilution of earnings A reduction in each previous shareholder’s fractional claim on the firm’s earnings resulting from the issuance of additional shares of common stock. rights Financial instruments that allow stockholders to purchase additional shares at a price below the market price, in direct proportion to their number of owned shares. situations, rights are an important financing tool without which shareholders would run the risk of losing their proportionate control of the corporation. Fromthe firm’s viewpoint, the use of rights offerings to raise new equity capital may beless costly than a public offering of stock. Authorized, Outstanding, and Issued Shares A firm’s corporate charter indicates how many authorized shares it can issue. The firm cannot sell more shares than the charter authorizes without obtainingapproval through a shareholder vote. To avoid later having to amend the charter,firms generally attempt to authorize more shares than they initially plan to issue. Authorized shares become outstanding shares when they are issued or sold to investors. If the firm repurchases any of its outstanding shares, these shares are recorded as treasury stock and are no longer considered to be outstanding shares. Issued shares are the shares of common stock that have been put into circulation; they represent the sum of outstanding shares andtreasury stock . Golden Enterprises, a producer of medical pumps, has the following stock- holders’ equity account on December 31: Stockholders’ EquityCommon stock—$0.80 par value: Authorized 35,000,000 shares; issued 15,000,000 shares $ 12,000,000 Paid-in capital in excess of par 63,000,000Retained earnings $106,000,000 Less: Cost of treasury stock (1,000,000 shares) Total stockholders’ equity How many shares of additional common stock can Golden sell without gaining approval from its shareholders? The firm has 35 million authorizedshares, 15 million issued shares, and 1 million shares of treasury stock. Thus 14million shares are outstanding (15 million issued shares minus 1 million shares oftreasury stock), and Golden can issue 21 million additional shares (35 millionauthorized shares minus 14 million outstanding shares) without seeking share-holder approval. This total includes the treasury shares currently held, which the firm can reissue to the public without obtaining shareholder approval. Voting Rights Generally, each share of common stock entitles its holder to one vote in the elec-tion of directors and on special issues. Votes are generally assignable and may becast at the annual stockholders’ meeting. Because most small stockholders do not attend the annual meeting to vote, they may sign a proxy statement transferring their votes to another party. The solicitation of proxies from shareholders is closely controlled by the Securitiesand Exchange Commission to ensure that proxies are not being solicited on the$102,000,000 4,000,00031,000,000Example 7.13CHAPTER 7 Stock Valuation 269 authorized shares Shares of common stock that a firm’s corporate charter allowsit to issue. outstanding shares Issued shares of common stockheld by investors, including bothprivate and public investors. treasury stock Issued shares of common stockheld by the firm; often theseshares have been repurchasedby the firm. issued shares Shares of common stock thathave been put into circulation;the sum of outstanding shares andtreasury stock . proxy statement A statement transferring thevotes of a stockholder toanother party. basis of false or misleading information. Existing management generally receives the stockholders’ proxies because it is able to solicit them at company expense. Occasionally, when the firm is widely owned, outsiders may wage a proxy battle to unseat the existing management and gain control of the firm. To win a cor- porate election, votes from a majority of the shares voted are required. However, theodds of an outside group winning a proxy battle are generally slim. In recent years, many firms have issued two or more classes of common stock with unequal voting rights. A firm can use different classes of stock as a defenseagainst a hostile takeover in which an outside group, without management sup- port, tries to gain voting control of the firm by buying its shares in the market-place. Supervoting shares , which have multiple votes per share, allow “insiders” to maintain control against an outside group whose shares have only one voteeach. At other times, a class of nonvoting common stock is issued when the firm wishes to raise capital through the sale of common stock but does not want togive up its voting control. When different classes of common stock are issued on the basis of unequal voting rights, class A common typically—but not universally—has one vote pershare, and class B common has supervoting rights. In most cases, the multipleshare classes are equal with respect to all other aspects of ownership, althoughthere are some exceptions to this general rule. In particular, there is usually nodifference in the distribution of earnings (dividends) and assets. Treasury stock,which is held within the corporation, generally does not have voting rights, does notearn dividends, and does not have a claim on assets in liquidation. Dividends The payment of dividends to the firm’s shareholders is at the discretion of the company’s board of directors. Most corporations that pay dividends pay themquarterly. Dividends may be paid in cash, stock, or merchandise. Cash dividendsare the most common, mer chandise dividends the least. Common stockholders are not promised a dividend, but they come to expect certain payments on the basis of the historical dividend pattern of the firm.Before firms pay dividends to common stockholders, they must pay any past duedividends owed to preferred stockholders. The firm’s ability to pay dividends canbe affected by restrictive debt covenants designed to ensure that the firm canrepay its creditors. Since passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, many firms now pay larger dividends to shareholders, who are subject to a max-imum tax rate of 15 percent on dividends rather than the maximum tax rate of39 percent in effect prior to passage of the act. Because of the importance of thedividend decision to the growth and valuation of the firm, dividends are dis-cussed in greater detail in Chapter 14. International Stock Issues Although the international market for common stock is not as large as the inter-national market for bonds, cross-border issuance and trading of common stockhave increased dramatically in the past 30 years. Some corporations issue stock in foreign markets. For example, the stock of General Electric trades in Frankfurt, London, Paris, and Tokyo; the stocks of TimeWarner and Microsoft trade in Frankfurt and London; and the stock of McDonalds270 PART 3 Valuation of Securities proxy battle The attempt by a nonmanagement group to gaincontrol of the management of afirm by soliciting a sufficientnumber of proxy votes. supervoting shares Stock that carries with itmultiple votes per share ratherthan the single vote per sharetypically given on regularshares of common stock. nonvoting common stock Common stock that carries novoting rights; issued when thefirm wishes to raise capitalthrough the sale of commonstock but does not want to giveup its voting control. trades in Frankfurt, London, and Paris. The Frankfurt, London, and Tokyo mar- kets are the most popular. Issuing stock internationally broadens the ownershipbase and helps a company to integrate into the local business environment.Having locally traded stock can facilitate corporate acquisitions because sharescan be used as an acceptable method of payment. Foreign corporations have also discovered the benefits of trading their stock in the United States. The disclosure and reporting requirements mandated by theU.S. Securities and Exchange Commission have historically discouraged all butthe largest foreign firms from directly listing their shares on the New York StockExchange or the American Stock Exchange. As an alternative, most foreign companies choose to tap the U.S. market through American depositary shares (ADSs). These are dollar-denominated receipts for the stocks of foreign companies that are held by a U.S. financial insti-tution overseas. They serve as backing for American depositary receipts (ADRs), which are securities that permit U.S. investors to hold shares of non-U.S. compa-nies and trade them in U.S. markets. Because ADRs are issued, in dollars, to U.S.investors, they are subject to U.S. securities laws. At the same time, they giveinvestors the opportunity to diversify their portfolios internationally. PREFERRED STOCK Preferred stock gives its holders certain privileges that make them senior to common stockholders. Preferred stockholders are promised a fixed periodic divi-dend, which is stated either as a percentage or as a dollar amount. How the divi-dend is specified depends on whether the preferred stock has a par value . Par-value preferred stock has a stated face value, and its annual dividend is spec- ified as a percentage of this value. No-par preferred stock has no stated face value, but its annual dividend is stated in dollars. Preferred stock is most oftenissued by public utilities, by acquiring firms in merger transactions, and by firmsthat are experiencing losses and need additional financing. Basic Rights of Preferred Stockholders The basic rights of preferred stockholders are somewhat stronger than the rightsof common stockholders. Preferred stock is often considered quasi-debt because, much like interest on debt, it specifies a fixed periodic payment (dividend).Preferred stock is unlike debt in that it has no maturity date. Because they have afixed claim on the firm’s income that takes precedence over the claim of commonstockholders, preferred stockholders are exposed to less risk. Preferred stockholders are also given preference over common stockholders in the liquidation of assets in a legally bankrupt firm, although they must “stand in line” behind creditors. The amount of the claim of preferred stockholders in liqui-dation is normally equal to the par or stated value of the preferred stock. Preferredstockholders are not normally given a voting right, although preferred stock- holders are sometimes allowed to elect one member of the board of directors. Features of Preferred Stock A preferred stock issue generally includes a number of features, which, alongwith the stock’s par value, the amount of dividend payments, the dividend pay-ment dates, and any restrictive covenants, are specified in an agreement similar toabond indenture.CHAPTER 7 Stock Valuation 271 American depositary shares (ADSs) Dollar-denominated receipts for the stocks of foreigncompanies that are held by aU.S. financial institutionoverseas. American depositary receipts (ADRs) Securities, backed by American depositary shares (ADSs), that permit U.S. investors to hold shares of non-U.S. companies and tradethem in U.S. markets. par-value preferred stock Preferred stock with a statedface value that is used with thespecified dividend percentageto determine the annual dollardividend. no-par preferred stock Preferred stock with no statedface value but with a statedannual dollar dividend. Restrictive Covenants The restrictive covenants in a preferred stock issue focus on ensuring the firm’s continued existence and regular payment of the divi-dend. These covenants include provisions about passing dividends, the sale of seniorsecurities, mergers, sales of assets, minimum liquidity requirements, and repurchasesof common stock. The violation of preferred stock covenants usually permits pre-ferred stockholders either to obtain representation on the firm’s board of directorsor to force the retirement of their stock at or above its par or stated value. Cumulation Most preferred stock is cumulative with respect to any divi- dends passed. That is, all dividends in arrears, along with the current dividend,must be paid before dividends can be paid to common stockholders. If preferredstock is noncumulative, passed (unpaid) dividends do not accumulate. In this case, only the current dividend must be paid before dividends can be paid tocommon stockholders. Because the common stockholders can receive dividendsonly after the dividend claims of preferred stockholders have been satisfied, it isin the firm’s best interest to pay preferred dividends when they are due. Other Features Preferred stock can be callable orconvertible . Preferred stock with a callable feature allows the issuer to retire outstanding shares within a certain period of time at a specified price. The call price is normally set abovethe initial issuance price, but it may decrease as time passes. Making preferredstock callable provides the issuer with a way to bring the fixed-payment commit-ment of the preferred issue to an end if conditions make it desirable to do so. Preferred stock with a conversion feature allows holders to change each share into a stated number of shares of common stock, usually anytime after a prede-termined date. The conversion ratio can be fixed, or the number of shares ofcommon stock that the preferred stock can be exchanged for changes throughtime according to a predetermined formula. ISSUING COMMON STOCK Because of the high risk associated with a business startup, a firm’s initialfinancing typically comes from its founders in the form of a common stockinvestment. Until the founders have made an equity investment, it is highlyunlikely that others will contribute either equity or debt capital. Early-stageinvestors in the firm’s equity, as well as lenders who provide debt capital, want tobe assured that they are taking no more risk than the founders. In addition, theywant confirmation that the founders are confident enough in their vision for thefirm that they are willing to risk their own money. Typically, the initial nonfounder financing for business startups with attrac- tive growth prospects comes from private equity investors. Then, as the firmestablishes the viability of its product or service offering and begins to generaterevenues, cash flow, and profits, it will often “go public” by issuing shares ofcommon stock to a much broader group of investors. Before we consider the initial public sale of equity, let’s discuss some of the key aspects of early-stage equity financing in firms that have attractive growth prospects. Venture Capital The initial external equity financing privately raised by firms, typically early-stage firms with attractive growth prospects, is called venture capital. Those who272 PART 3 Valuation of Securities cumulative (preferred stock) Preferred stock for which all passed (unpaid) dividends inarrears, along with the currentdividend, must be paid beforedividends can be paid tocommon stockholders. noncumulative (preferred stock) Preferred stock for which passed (unpaid) dividends donot accumulate. callable feature (preferred stock) A feature of callable preferred stock that allows the issuer to retire the shares within a certain period of time and at a specified price. conversion feature (preferred stock) A feature of convertible preferred stock that allows holders to change each shareinto a stated number of sharesof common stock. venture capital Privately raised external equitycapital used to fund early-stage firms with attractivegrowth prospects. provide venture capital are known as venture capitalists (VCs). They typically are formal business entities that maintain strong oversight over the firms they investin and that have clearly defined exit strategies. Less visible early-stage investorscalled angel capitalists (orangels ) tend to be investors who do not actually operate as a business; they are often wealthy individual investors who are willingto invest in promising early-stage companies in exchange for a portion of thefirm’s equity. Although angels play a major role in early-stage equity financing,we will focus on VCs because of their more formal structure and greater publicvisibility. Organization and Investment Stages Venture capital investors tend to be organized in one of four basic ways, as described in Table 7.2. The VC limited partnership is by far the dominant structure. These funds have as their sole objec- tive to earn high returns, rather than to obtain access to the companies in order tosell or buy other products or services. VCs can invest in early-stage companies, later-stage companies, or buyouts and acquisitions. Generally, about 40 to 50 percent of VC investments aredevoted to early-stage companies (for startup funding and expansion) and a sim-ilar percentage to later-stage companies (for marketing, production expansion,and preparation for public offering); the remaining 5 to 10 percent are devoted tothe buyout or acquisition of other companies. Generally, VCs look for compoundannual rates of return ranging from 20 to 50 percent or more, depending on boththe development stage and the attributes of each company. Earlier-stage invest-ments tend to demand higher returns than later-stage investments because of thehigher risk associated with the earlier stages of a firm’s growth. Deal Structure and Pricing Regardless of the development stage, venture capital investments are made under a legal contract that clearly allocates respon-sibilities and ownership interests between existing owners (founders) and the VCfund or limited partnership. The terms of the agreement will depend on numerousCHAPTER 7 Stock Valuation 273 venture capitalists (VCs) Providers of venture capital; typically, formal businesses thatmaintain strong oversight overthe firms they invest in and thathave clearly defined exitstrategies. angel capitalists (angels) Wealthy individual investorswho do not operate as abusiness but invest inpromising early-stagecompanies in exchange for aportion of the firm’s equity. Organization of Venture Capital Investors Organization Description Small business investment Corporations chartered by the federal government that can companies (SBICs) borrow at attractive rates from the U.S. Treasury and use the funds to make venture capital investments in privatecompanies. Financial VC funds Subsidiaries of financial institutions, particularly banks, set up to help young firms grow and, it is hoped, become majorcustomers of the institution. Corporate VC funds Firms, sometimes subsidiaries, established by nonfinancial firms, typically to gain access to new technologies that thecorporation can access to further its own growth. VC limited partnerships Limited partnerships organized by professional VC firms, which serve as the general partner and organize, invest, andmanage the partnership using the limited partners’ funds;the professional VCs ultimately liquidate the partnershipand distribute the proceeds to all partners.TABLE 7.2 factors related to the founders; the business structure, stage of development, and outlook; and other market and timing issues. The specific financial terms will, ofcourse, depend on the value of the enterprise, the amount of funding, and the per-ceived risk. To control the VC’s risk, various covenants are included in the agree-ment, and the actual funding may be pegged to the achievement of measurable milestones. The VC will negotiate numerous other provisions into the contract, both to ensure the firm’s success and to control its risk exposure. The contractwill have an explicit exit strategy for the VC that may be tied both to measurablemilestones and to time. The amount of equity to which the VC is entitled will, of course, depend on the value of the firm, the terms of the contract, the exit terms, and the minimumcompound annual rate of return required by the VC on its investment. Althougheach VC investment is unique and no standard contract exists, the transactionwill be structured to provide the VC with a high rate of return that is consistentwith the typically high risk of such transactions. The exit strategy of most VCinvestments is to take the firm public through an initial public offering. Going Public When a firm wishes to sell its stock in the primary market, it has three alterna-tives. It can make (1) a public offering, in which it offers its shares for sale to the general public; (2) a rights offering, in which new shares are sold to existing stockholders; or (3) a private placement, in which the firm sells new securities directly to an investor or group of investors. Here we focus on public offerings,particularly the initial public offering (IPO), which is the first public sale of a firm’s stock. IPOs are typically made by small, rapidly growing companies thateither require additional capital to continue expanding or have met a milestonefor going public that was established in a contract signed earlier in order toobtain VC funding. To go public, the firm must first obtain the approval of its current share- holders, the investors who own its privately issued stock. Next, the company’sauditors and lawyers must certify that all documents for the company are legiti-mate. The company then finds an investment bank willing to underwrite the offering. This underwriter is responsible for promoting the stock and facilitatingthe sale of the company’s IPO shares. The underwriter often brings in otherinvestment banking firms as participants. We’ll discuss the role of the investmentbanker in more detail in the next section. The company files a registration statement with the SEC. One portion of the registration statement is called the prospectus. It describes the key aspects of the issue, the issuer, and its management and financial position. During the waitingperiod between the statement’s filing and its approval, prospective investors canreceive a preliminary prospectus. This preliminary version is called a red herring, because a notice printed in red on the front cover indicates the tentative nature ofthe offer. The cover of the preliminary prospectus describing the 2010 stock issueof Convio, Inc., is shown in Figure 7.1. Note the red herring printed across thetop of the page. After the SEC approves the registration statement, the investment community can begin analyzing the company’s prospects. However, from the time it files untilat least one month after the IPO is complete, the company must observe a quiet period, during which there are restrictions on what company officials may say274 PART 3 Valuation of Securities initial public offering (IPO) The first public sale of a firm’s stock. prospectus A portion of a securityregistration statement thatdescribes the key aspects of the issue, the issuer, and itsmanagement and financialposition. red herring A preliminary prospectus made available to prospectiveinvestors during the waitingperiod between the registrationstatement’s filing with the SECand its approval. about the company. The purpose of the quiet period is to make sure that all potential investors have access to the same information about the company—theinformation presented in the preliminary prospectus—and not to any unpub-lished data that might give them an unfair advantage. The investment bankers and company executives promote the company’s stock offering through a road show, a series of presentations to potential investors around the country and sometimes overseas. In addition to providing investorswith information about the new issue, road show sessions help the investmentbankers gauge the demand for the offering and set an expected pricing range. Afterthe underwriter sets terms and prices the issue, the SEC must approve the offering. The Investment Banker’s Role Most public offerings are made with the assistance of an investment banker. The investment banker is a financial intermediary (such as Morgan Stanley orGoldman Sachs) that specializes in selling new security issues and advising firmswith regard to major financial transactions. The main activity of the investmentbanker is underwriting. This process involves purchasing the security issue from the issuing corporation at an agreed-on price and bearing the risk of reselling it tothe public at a profit. The investment banker also provides the issuer with adviceabout pricing and other important aspects of the issue.CHAPTER 7 Stock Valuation 275 The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the reg istration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. SUBJECT TO COMPLETION. DATED APRIL 23, 2010. IPO PRELIMINARY PROSPECTUS 5,132,728 Shares Common Stock $ per share Convio, Inc. is selling 3,636,364 shares of our common stock and the selling stockholders identified in this prospectus are sell ing additional 1,496,364 shares. We will not receive any of the proceeds from the sale of the shares being sold by the selling stockholders. We have granted the underwri ters a 30-day option to purchase up to an additional 769,909 shares from us to cover over-allotments, if any. This is an initial public offering of our common stock. We currently expect the initial public offering price to be between $10. 00 and $12.00 per share. We have applied for the listing of our common stock on the NASDAQ Global Market under the symbol „CNVO.” INVESTING IN OUR COMMON STOCK INVOLVES RISKS. SEE „RISK FACTORS” BEGINNING ON PAGE 10 Per Share Total Initial public offering price $ $ Underwriting discount $ $Proceeds, before expenses, to Convio $ $ Proceeds, before expenses, to the selling stockholders $ $ Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securiti es or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense. Thomas Weisel Partners LLC Piper Jaffray William Blair & Company JMP Securities Pacific Crest Securities The date of this prospectus is , 2010.FIGURE 7.1 Cover of a Preliminary Prospectus for a StockIssueSome of the key factorsrelated to the 2010common stock issue byConvio, Inc., are sum-marized on the cover of thepreliminar y prospectus. The disclaimer printed in redacross the top of the pageis what gives thepreliminary prospectus its“red herring” name. investment banker Financial intermediary that specializes in selling new security issues and advising firms with regard to major financial transactions. underwriting The role of the investment banker in bearing the risk of reselling, at a profit, the securities purchased from an issuing corporation at an agreed-on price.Source: SEC filing Form S-1/A, Convio, Inc., filed April 26, 2010, p. 4. In the case of very large security issues, the investment banker brings in other bankers as partners to form an underwriting syndicate. The syndicate shares the financial risk associated with buying the entire issue from the issuer and resellingthe new securities to the public. The originating investment banker and the syndi-cate members put together a selling group, normally made up of themselves and a large number of brokerage firms. Each member of the selling group accepts theresponsibility for selling a certain portion of the issue and is paid a commission on thesecurities it sells. The selling process for a large security issue is depicted in Figure 7.2. Compensation for underwriting and selling services typically comes in the form of a discount on the sale price of the securities. For example, an investmentbanker may pay the issuing firm $24 per share for stock that will be sold for $26per share. The investment banker may then sell the shares to members of theselling group for $25.25 per share. In this case, the original investment bankerearns $1.25 per share ($25.25 sale price minus $24 purchase price). The membersof the selling group earn 75 cents for each share they sell ($26 sale price minus$25.25 purchase price). Although some primary security offerings are directlyplaced by the issuer, the majority of new issues are sold through public offeringvia the mechanism just described. 6REVIEW QUESTIONS 7–2What risks do common stockholders take that other suppliers of capital do not? 7–3How does a rights offering protect a firm’s stockholders against the dilution of ownership?276 PART 3 Valuation of Securities Investment BankerInvestment BankerInvestment BankerIssuing Corporation Underwriting Syndicate Selling GroupOriginating Investment Banker Purchasers of SecuritiesInvestment BankerFIGURE 7.2 The Selling Process for a Large Security IssueThe investment banker hired by the issuing corporation may form an underwritingsyndicate. The underwritingsyndicate buys the entiresecurity issue from theissuing corporation at an agreed-on price. The underwriters then have theopportunity (and bear therisk) of reselling the issue tothe public at a profit. Boththe originating investmentbanker and the othersyndicate members puttogether a selling group tosell the issue on a commission basis to investors. underwriting syndicate A group of other bankers formed by an investmentbanker to share the financialrisk associated with underwriting new securities. selling group A large number of brokeragefirms that join the originatinginvestment banker(s); eachaccepts responsibility forselling a certain portion of anew security issue on acommission basis. 7–4Explain the relationships among authorized shares, outstanding shares, treasury stock, and issued shares. 7–5What are the advantages to both U.S.-based and foreign corporations ofissuing stock outside their home markets? What are American deposi- tary receipts (ADRs)? What are American depositary shares (ADSs)? 7–6What claims do preferred stockholders have with respect to distribution of earnings (dividends) and assets? 7–7Explain the cumulative feature of preferred stock. What is the purpose of a call feature in a preferred stock issue? 7–8What is the difference between a venture capitalist (VC) and an angel capitalist (angel)? 7–9What are the four ways that VCs are most commonly organized? Howare their deals structured and priced? 7–10 What general procedures must a private firm follow to go public via aninitial public offerin g(IPO)? 7–11 What role does an investment banker play in a public offering? Describe an underwriting syndicate.CHAPTER 7 Stock Valuation 277 7.3Common Stock Valuation Common stockholders expect to be rewarded through periodic cash dividends and an increasing share value. Some of these investors decide which stocks to buyand sell based on a plan to maintain a broadly diversified portfolio. Otherinvestors have a more speculative motive for trading. They try to spot companieswhose shares are undervalued —meaning that the true value of the shares is greater than the current market price. These investors buy shares that they believeto be undervalued and sell shares that they think are overvalued (that is, the market price is greater than the true value). Regardless of one’s motive fortrading, understanding how to value common stocks is an important part of theinvestment process. Stock valuation is also an important tool for financial managers—how can they work to maximize the stock price without understanding the factorsthat determine the value of the stock? In this section, we will describe specificstock valuation techniques. First, we will consider the relationship betweenmarket efficiency and stock valuation. MARKET EFFICIENCY Economically rational buyers and sellers use their assessment of an asset’s riskand return to determine its value. To a buyer, the asset’s value represents the max-imum purchase price, and to a seller it represents the minimum sale price. In com-petitive markets with many active participants, such as the New York StockExchange, the interactions of many buyers and sellers result in an equilibriumprice—the market value —for each security. This price reflects the collective actions that buyers and sellers take on the basis of all available information.Buyers and sellers digest new information quickly as it becomes available and,through their purchase and sale activities, create a new market equilibrium price.Because the flow of new information is almost constant, stock prices fluctuate,continuously moving toward a new equilibrium that reflects the most recentinformation available. This general concept is known as market efficiency .LG5 LG4 THE EFFICIENT-MARKET HYPOTHESIS As noted in Chapter 2, active broker and dealer markets, such as the New York Stock Exchange and the Nasdaq market, are efficient —they are made up of many rational investors who react quickly and objectively to new information. Theefficient-market hypothesis (EMH), which is the basic theory describing the behavior of such a “perfect” market, specifically states that 1. Securities are typically in equilibrium, which means that they are fairly priced and that their expected returns equal their required returns. 2. At any point in time, security prices fully reflect all information available about the firm and its securities, and these prices react swiftly to new information. 3. Because stocks are fully and fairly priced, investors need not waste their time trying to find mispriced (undervalued or overvalued) securities. Not all market participants are believers in the efficient-market hypothesis. Some feel that it is worthwhile to search for undervalued or overvalued securitiesand to trade them to profit from market inefficiencies. Others argue that it ismere luck that would allow market participants to anticipate new informationcorrectly and as a result earn abnormal returns —that is, actual returns greater than average market returns. They believe it is unlikely that market participantscanover the long run earn abnormal returns. Contrary to this belief, some well- known investors such as Warren Buffett and Bill Gross have over the long run consistently earned abnormal returns on their portfolios. It is unclear whethertheir success is the result of their superior ability to anticipate new information orof some form of market inefficiency. The Behavioral Finance Challenge Although considerable evidence supports the concept of market efficiency, agrowing body of academic evidence has begun to cast doubt on the validity ofthis notion. The research documents various anomalies —outcomes that are incon- sistent with efficient markets—in stock returns. A number of academics and prac-titioners have also recognized that emotions and other subjective factors play arole in investment decisions. This focus on investor behavior has resulted in a significant body of research, collectively referred to as behavioral finance. Advocates of behavioral finance are commonly referred to as “behaviorists.” Daniel Kahneman was awarded the2002 Nobel Prize in economics for his work in behavioral finance, specifically forintegrating insights from psychology and economics. Ongoing research into thepsychological factors that can affect investor behavior and the resulting effects onstock prices will likely result in growing acceptance of behavioral finance. TheFocus on Practice box further explains some of the findings of behavioral finance. While challenges to the efficient market hypothesis, such as those presented by advocates of behavioral finance, are interesting and worthy of study, in this text wegenerally take the position that markets are efficient . This means that the terms expected return andrequired return will be used interchangeably because they should be equal in an efficient market. In other words, we will operate under theassumption that a stock’s market price at any point in time is the best estimate of itsvalue. We’re now ready to look closely at the mechanics of common stock valuation.278 PART 3 Valuation of Securities efficient-market hypothesis (EMH) Theory describing the behavior of an assumed “perfect”market in which (1) securitiesare in equilibrium, (2) securityprices fully reflect all availableinformation and react swiftly to new information, and (3), because stocks are fully and fairly priced, investors need not waste time looking formispriced securities. behavioral finance A growing body of researchthat focuses on investorbehavior and its impact oninvestment decisions and stockprices. Advocates arecommonly referred to as “behaviorists.”In more depth To read about The Hierarchy of the Efficient-Market Hypothesis , go to www.myfinancelab.com BASIC COMMON STOCK VALUATION EQUATION Like the value of a bond, which we discussed in Chapter 6, the value of a share of common stock is equal to the present value of all future cash flows (dividends)that it is expected to provide. Although a stockholder can earn capital gains by selling stock at a price above that originally paid, what the buyer really pays foris the right to all future dividends. What about stocks that do not currently paydividends? Such stocks have a value attributable to a future dividend stream or tothe proceeds from the sale of the company. Therefore, from a valuation view- point, future dividends are relevant.CHAPTER 7 Stock Valuation 279 focus on PRACTICE Understanding Human Behavior Helps Us Understand Investor Behavior Other investor behaviors are prospect theory and anchoring. According to prospect theory , people express a differ- ent degree of emotion toward gains thanlosses. Individuals are stressed more by prospective losses than they arebuoyed by the prospect of equal gains. Anchoring is the tendency of investors to place more value on recent information.People tend to give too much credence to recent market opinions and events and mistakenly extrapolate recent trends thatdiffer from historical, long-term averagesand probabilities. Anchoring is a partial explanation for the longevity of some bullmarkets. Most stock-valuation techniques require that all relevant information be available to properly determine a stock ’s value and potential for future gain. Behavioral finance may explainthe connection between valuation andan investor ’s actions based on that valuation. 3 Theories of behavioral finance can apply to other areas of human behavior in addition to investing. Think of a situation in which you may have demonstrated one of these behaviors. Share your situation with a classmate.embarrassment about losing money on a popular stock than about losing moneyon an unknown or unpopular stock. People have a tendency to place particular events into mental accounts , and the difference between these com-partments sometimes influences behav- ior more than the events themselves. Researchers have asked people the fol-lowing question: “Would you purchase a $20 ticket at the local theater if yourealize after you get there that you have lost a $20 bill ?” Roughly 88 per- cent of people would do so. Underanother scenario, people were askedwhether they would buy a second $20ticket if they arrived at the theater and realized that they had left at home a ticket purchased in advance for $20.Only 40 percent of respondents wouldbuy another. In both scenarios the per- son is out $40, but mental accounting leads to a different outcome. In invest-ing, compartmentalization is best illus-trated by the hesitation to sell aninvestment that once had monstrous gains and now has a modest gain. During bull markets, people get accus-tomed to paper gains. When a marketcorrection deflates investors ’ net worth, they are hesitant to sell, causing them to wait for the return of that gain.Market anomalies are patterns inconsistent with the efficient market hypothesis.Behavioral finance has a number of theories to help explain how human emotions influence people in theirinvestment decision-making processes. Regret theory deals with the emo- tional reaction people experience afterrealizing they have made an error in judgment. When deciding whether to sell a stock, investors become emotion-ally affected by the price at whichthey purchased the stock. A sale at a loss would confirm that the investor miscalculated the value of the stock when it was purchased. The correctapproach when considering whether tosell a stock is, “Would I buy this stock today if it were already liquidated ?” If the answer is “no, ” it is time to sell. Regret theory also holds true forinvestors who passed up buying astock that now is selling at a much higher price. Again, the correct approach is to value the stock todaywithout regard to its prior value. Herding is another market behavior affecting investor decisions. Some investors rationalize their decision to buy certain stocks with “everyone else is doing it. ” Investors may feel lessin practice The basic valuation model for common stock is given in Equation 7.1: (7.1) where The equation can be simplified somewhat by redefining each year’s dividend, Dt, in terms of anticipated growth. We will consider three models here: zero growth,constant growth, and variable growth. Zero-Growth Model The simplest approach to dividend valuation, the zero-growth model, assumes a con- stant, nongrowing dividend stream. In terms of the notation already introduced, When we let D1represent the amount of the annual dividend, Equation 7.1 under zero growth reduces to (7.2) The equation shows that with zero growth, the value of a share of stock would equalthe present value of a perpetuity of D 1dollars discounted at a rate rs. (Perpetuities were introduced in Chapter 5; see Equation 5.14 and the related discussion.) Chuck Swimmer estimates that the dividend of Denham Company, an established textile producer, is expected to remain constant at $3 per share indefinitely. If his required return on its stock is 15%, the stock’s value is per share. Preferred Stock Valuation Because preferred stock typically provides its holders with a fixed annual dividend over its assumed infinite life, Equation 7.2 can be used to find the value of preferred stock. The value of preferred stock can be estimated by substituting the stated dividend on the preferred stock for D1and the required return for rsin Equation 7.2. For example, a preferred stock paying a $5 stated annual dividend and having a required return of 13 percent wouldhave a value of per share. Constant-Growth Model The most widely cited dividend valuation approach, the constant-growth model, assumes that dividends will grow at a constant rate, but a rate that is less than the$38.46 ($5 ,0.13)$20 ($3 ,0.15)Personal Finance Example 7.23D1 rsD1*aq t=11 (1+rs)t=D1*1 rs= P0=D1=D2=Á=Dqrs=required return on common stockDt=per-share dividend expected at the end of year tP0=value today of common stockP0=D1 (1+rs)1+D2 (1+rs)2+Á+Dq (1+rs)q280 PART 3 Valuation of Securities zero-growth model An approach to dividend valuation that assumes aconstant, nongrowing dividendstream. constant-growth model A widely cited dividendvaluation approach thatassumes that dividends will grow at a constant rate, but a rate that is less than therequired return. required return. (The assumption that the constant rate of growth, g, is less than the required return, rs,is a necessary mathematical condition for deriving this model.1) By letting D0represent the most recent dividend, we can rewrite Equation 7.1 as follows: (7.3) If we simplify Equation 7.3, it can be rewritten as: (7.4) The constant-growth model in Equation 7.4 is commonly called the Gordon growth model. An example will show how it works. Lamar Company, a small cosmetics company, from 2007 through 2012 paid the following per-share dividends:Example 7.33P0=D1 rs-gP0=D0*(1+g)1 (1+rs)1+D0*(1+g)2 (1+rs)2+Á+D0*(1+g)q (1+rs)qCHAPTER 7 Stock Valuation 281 1. Another assumption of the constant-growth model as presented is that earnings and dividends grow at the same rate. This assumption is true only in cases in which a firm pays out a fixed percentage of its earnings each year (has a fixed payout ratio). In the case of a declining industry, a negative growth rate (g 0%) might exist. In such a case,the constant-growth model, as well as the variable-growth model presented in the next section, remains fully appli- cable to the valuation process.6Gordon growth model A common name for the constant-growth model that is widely cited in dividendvaluation.In more depth To read about Deriving the Constant-Growth Model , go to www.myfinancelab.com Year Dividend per share 2012 $1.40 2011 1.292010 1.202009 1.122008 1.052007 1.00 We assume that the historical annual growth rate of dividends is an accurate esti- mate of the future constant annual rate of dividend growth, g.To find the histor- ical annual growth rate of dividends, we must solve the following for g: $1.00 $1.40=1 (1+g)5D2007 D2012=1 (1+g)5D2012 =D2007 *(1+g)5 Using a financial calculator or a spreadsheet, we find that the historical annual growth rate of Lamar Company dividends equals 7%.2The company estimates that its dividend in 2013, D1, will equal $1.50 (about 7% more than the last div- idend). The required return, rs, is 15%. By substituting these values into Equation 7.4, we find the value of the stock to be Assuming that the values of D1,rs, and gare accurately estimated, Lamar Com- pany’s stock value is $18.75 per share. Variable-Growth Model The zero- and constant-growth common stock models do not allow for any shift in expected growth rates. Because future growth rates might shift up or downbecause of changing business conditions, it is useful to consider a variable-growth model that allows for a change in the dividend growth rate. 3We will assume that a single shift in growth rates occurs at the end of year N, and we will use g1to represent the initial growth rate and g2for the growth rate after the shift. To determine the value of a share of stock in the case of variable growth, we use afour-step procedure: Step 1 Find the value of the cash dividends at the end of each year, D t, during the initial growth period, years 1 through N.This step may require adjusting the most recent dividend, D0, using the initial growth rate, g1, to calculate the dividend amount for each year. Therefore, for the first N years, Step 2 Find the present value of the dividends expected during the initial growth period. Using the notation presented earlier, we can give this value as Step 3 Find the value of the stock at the end of the initial growth period, , which is the present value of all dividends expected from year to infinity, assuming a constant dividend growth rate, g 2. This value is found by applying the constant-growth model (Equation 7.4) to the dividends expected from year to infinity. N+1N+1PN=(DN+1)/(rs-g2)aN t=1D0*(1+g1)t (1+rs)t =aN t=1Dt (1+rs)tDt=D0*(1+g1)tP0=$1.50 0.15 -0.07=$1.50 0.08=$18.75 per share282 PART 3 Valuation of Securities 2. A financial calculator can be used. ( Note: Most calculators require either thePVorFVvalue to be input as a neg- ative number to calculate an unknown interest or growth rate. That approach is used here.) Using the inputs shown at the left, you should find the growth rate to be 6.96%, which we round to 7%. An electronic spreadsheet could also be used to make this computation. Given space considerations, we have for- gone that computational aid here. 3. More than one change in the growth rate can be incorporated into the model, but to simplify the discussion we will consider only a single growth-rate change. The number of variable-growth valuation models is technically unlimited, but concern over all possible shifts in growth is unlikely to yield much more accuracy than a simpler model.6.961.00 PV FV IN–1.40 5 CPT SolutionInput Function variable-growth model A dividend valuation approach that allows for a change in thedividend growth rate. The present value of PNwould represent the value today of all dividends that are expected to be received from year to infinity. This valuecan be represented by Step 4 Add the present value components found in Steps 2 and 3 to find the value of the stock, P 0, given in Equation 7.5: (7.5) Present value of Present value of dividends price of stock during initial at end of initial growth period growth period The following example illustrates the application of these steps to a variable- growth situation with only one change in growth rate. Victoria Robb is considering purchasing the common stock of Warren Industries, a rapidly growing boat manufacturer. She finds that the firm’s most recent (2012) annual dividend payment was $1.50 pershare. Victoria estimates that these dividends will increase at a 10% annual rate,g 1, over the next 3 years (2013, 2014, and 2015) because of the introduction of a hot new boat. At the end of the 3 years (the end of 2015), she expects the firm’smature product line to result in a slowing of the dividend growth rate to 5% peryear, g 2, for the foreseeable future. Victoria’s required return, rs, is 15%. To esti- mate the current (end-of-2012) value of Warren’s common stock, , sheapplies the four-step procedure to these data. Step 1 The value of the cash dividends in each of the next 3 years is calculated in columns 1, 2, and 3 of Table 7.3. The 2013, 2014, and 2015 dividendsare $1.65, $1.82, and $2.00, respectively.P 0=P2012Personal Finance Example 7.43P0=aN t=1D0*(1+g1)t (1+rs)t +c1 (1+rs)N*DN+1 rs-g2d1 (1+rs)N*DN+1 rs-g2N+1CHAPTER 7 Stock Valuation 283 TABLE 7.3Calculation of Present Value of Warren Industries Dividends (2013–2015) Present value Dt of dividends End of t year (1) (2) (3) (4) (5) 1 2013 $1.50 1.100 $1.65 1.150 $1.43 2 2014 1.50 1.210 1.82 1.323 1.373 2015 1.50 1.331 2.00 1.521 Sum of present value of dividends =a3 t=1D0*(1+g1)t (1+rs)t=$4.121.323(3)/H11548(4)4 (1/H11545rs)t3(1) :(2)4 (1/H11545g1)tD0/H11549D2012 Step 2 The present value of the three dividends expected during the 2013–2015 initial growth period is calculated in columns 3, 4, and 5 of Table 7.3.The sum of the present values of the three dividends is $4.12. Step 3 The value of the stock at the end of the initial growth period can be found by first calculating : By using , a 15% required return, and a 5% dividend growth rate, the value of the stock at the end of 2015 is calculated as follows: Finally, in Step 3, the share value of $21 at the end of 2015 must be con- verted into a present (end-of-2012) value. Using the 15% requiredreturn, we get Step 4 Adding the present value of the initial dividend stream (found in Step 2) to the present value of the stock at the end of the initial growth period(found in Step 3) as specified in Equation 7.5, the current (end-of-2012)value of Warren Industries stock is: Victoria’s calculations indicate that the stock is currently worth $17.93 per share. FREE CASH FLOW VALUATION MODEL As an alternative to the dividend valuation models presented earlier in this chapter, a firm’s value can be estimated by using its projected free cash flows (FCFs ). This approach is appealing when one is valuing firms that have no divi- dend history or are startups or when one is valuing an operating unit or divisionof a larger public company. Although dividend valuation models are widely usedand accepted, in these situations it is preferable to use a more general free cashflow valuation model. Thefree cash flow valuation model is based on the same basic premise as div- idend valuation models: The value of a share of common stock is the presentvalue of all future cash flows it is expected to provide over an infinite timehorizon. However, in the free cash flow valuation model, instead of valuing thefirm’s expected dividends, we value the firm’s expected free cash flows, defined in Equation 4.4 (on page 122). They represent the amount of cash flow available toinvestors—the providers of debt (creditors) and equity (owners)—after all otherobligations have been met. The free cash flow valuation model estimates the value of the entire company by finding the present value of its expected free cash flows discounted at itsP 2012 =$4.12 +$13.81 =$17.93 per shareP2015 (1+rs)3=$21 (1+0.15)3=$13.81P2015 =D2016 rs-g2=$2.10 0.15 -0.05=$2.10 0.10=$21.00D2016 =$2.10D2016 =D2015 *(1+0.05) =$2.00 *(1.05) =$2.10DN+1=D2016(N=2015)284 PART 3 Valuation of Securities free cash flow valuation model A model that determines the value of an entire company as the present value of itsexpected free cash flows discounted at the firm’s weighted average cost of capital, which is its expected average future cost of fundsover the long run. weighted average cost of capital, which is its expected average future cost of funds (we’ll say more about this in Chapter 9), as specified in Equation 7.6: (7.6) where Note the similarity between Equations 7.6 and 7.1, the general stock valuation equation. Because the value of the entire company, VC, is the market value of the entire enterprise (that is, of all assets), to find common stock value, VS, we must sub- tract the market value of all of the firm’s debt, VD, and the market value of pre- ferred stock, VP, from VC: (7.7) Because it is difficult to forecast a firm’s free cash flow, specific annual cash flows are typically forecast for only about 5 years, beyond which a constantgrowth rate is assumed. Here we assume that the first 5 years of free cash flowsare explicitly forecast and that a constant rate of free cash flow growth occursbeyond the end of year 5 to infinity. This model is methodologically similar to thevariable-growth model presented earlier. Its application is best demonstrated withan example. Dewhurst, Inc., wishes to determine the value of its stock by using the free cashflow valuation model. To apply the model, the firm’s CFO developed the datagiven in Table 7.4. Application of the model can be performed in four steps. Step 1 Calculate the present value of the free cash flow occurring from the end of 2018 to infinity, measured at the beginning of 2018 (that is, at the endof 2017). Because a constant rate of growth in FCF is forecast beyond2017, we can use the constant-growth dividend valuation modelExample 7.53VS=VC-VD-VPra=the firm’s weighted average cost of capitalFCF t=free cash flow expected at the end of year tVC=value of the entire companyVC=FCF 1 (1+ra)1+FCF 2 (1+ra)2+Á+FCF q (1+ra)qCHAPTER 7 Stock Valuation 285 Dewhurst, Inc.’s, Data for the Free Cash Flow Valuation Model Free cash flow Year ( t)( FCF t) Other data 2013 $400,000 Growth rate of FCF, beyond 2017 to infinity, 2014 450,000 Weighted average cost of capital, ra9% 2015 520,000 Market value of all debt, VD $3,100,000 2016 560,000 Market value of preferred stock, VP$800,000 2017 600,000 Number of shares of common stock outstanding 300,000 ====gFCF =3%TABLE 7.4 (Equation 7.4) to calculate the value of the free cash flows from the end of 2018 to infinity: Note that to calculate the FCF in 2018, we had to increase the 2017 FCF value of $600,000 by the 3% FCF growth rate, gFCF. Step 2 Add the present value of the FCF from 2018 to infinity, which is measured at the end of 2017, to the 2017 FCF value to get the total FCF in 2017. Step 3 Find the sum of the present values of the FCFs for 2013 through 2017 to determine the value of the entire company, VC.This calculation is shown in Table 7.5.Total FCF 2017 =$600,000 +$10,300,000 =$10,900,000=$618,000 0.06=$10,300,000=$600,000 *(1+0.03) 0.09 -0.03Value of FCF 2018:q=FCF 2018 ra-gFCF286 PART 3 Valuation of Securities Calculation of the Value of the Entire Company for Dewhurst, Inc. Present value of FCF t FCF t Year ( t) (1) (2) (3) 2013 $ 400,000 1.090 $ 366,972 2014 450,000 1.188 378,7882015 520,000 1.295 401,5442016 560,000 1.412 396,6012017 10,900,000 a1.539 Value of entire company, b aThis amount is the sum of the FCF 2017of $600,000 from Table 7.4 and the $10,300,000 value of the calculated in Step 1. bThis value of the entire company is based on the rounded values that appear in the table. The precise value found without rounding is $8,628,234.FCF 2018:qVC=$8,626,4267,082,521[(1)/H11548(2)] (1/H11545ra)tTABLE 7.5 Step 4 Calculate the value of the common stock using Equation 7.7. Substituting into Equation 7.7 the value of the entire company, VC, calculated in Step 3, and the market values of debt, VD, and preferred stock, VP, given in Table 7.4, yields the value of the common stock, VS: The value of Dewhurst’s common stock is therefore estimated to be $4,726,426. By dividing this total by the 300,000 shares of commonstock that the firm has outstanding, we get a common stock value of $15.76 per share . ($4,726,426 ,300,000)VS=$8,626,426 -$3,100,000 -$800,000 =$4,726,426 It should now be clear that the free cash flow valuation model is consistent with the dividend valuation models presented earlier. The appeal of this approach isits focus on the free cash flow estimates rather than on forecasted dividends, whichare far more difficult to estimate given that they are paid at the discretion of thefirm’s board. The more general nature of the free cash flow model is responsible forits growing popularity, particularly with CFOs and other financial managers. OTHER APPROACHES TO COMMON STOCK VALUATION Many other approaches to common stock valuation exist. The more popularapproaches include book value, liquidation value, and some type of price/earnings multiple. Book Value Book value per share is simply the amount per share of common stock that would be received if all of the firm’s assets were sold for their exact book (accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders. This method lacks sophisti-cation and can be criticized on the basis of its reliance on historical balance sheetdata. It ignores the firm’s expected earnings potential and generally lacks any truerelationship to the firm’s value in the marketplace. Let us look at an example. At year-end 2012, Lamar Company’s balance sheet shows total assets of $6 million,total liabilities (including preferred stock) of $4.5 million, and 100,000 shares ofcommon stock outstanding. Its book value per share therefore would be Because this value assumes that assets could be sold for their book value, it may not represent the minimum price at which shares are valued in the marketplace.As a matter of fact, although most stocks sell above book value, it is not unusualto find stocks selling below book value when investors believe either that assets are overvalued or that the firm’s liabilities are understated. Liquidation Value Liquidation value per share is the actual amount per share of common stock that would be received if all of the firm’s assets were sold for their market value, liabili- ties (including preferred stock) were paid, and any remaining money were dividedamong the common stockholders. This measure is more realistic than book value—because it is based on the current market value of the firm’s assets—but it still failsto consider the earning power of those assets. An example will illustrate. Lamar Company found on investigation that it could obtain only $5.25 million ifit sold its assets today. The firm’s liquidation value per share therefore would be Ignoring liquidation expenses, this amount would be the firm’s minimum value.$5,250,000 -$4,500,000 100,000 shares=$7.50 per shareExample 7.73$6,000,000 -$4,500,000 100,000 shares=$15 per shareExample 7.63CHAPTER 7 Stock Valuation 287 book value per share The amount per share of common stock that would be received if all of the firm’sassets were sold for their exact book (accounting) value and the proceeds remaining afterpaying all liabilities (includingpreferred stock) were dividedamong the common stockholders. liquidation value per share Theactual amount per share of common stock that would bereceived if all of the firm’sassets were sold for their market value, liabilities (including preferred stock)were paid, and any remainingmoney were divided amongthe common stockholders. Price/Earnings (P/E) Multiples The price/earnings (P/E)ratio, introduced in Chapter 3, reflects the amount investors are willing to pay for each dollar of earnings. The average P/E ratio in aparticular industry can be used as a guide to a firm’s value—if it is assumed thatinvestors value the earnings of that firm in the same way they do the “average”firm in the industry. The price/earnings multiple approach is a popular technique used to estimate the firm’s share value; it is calculated by multiplying the firm’sexpected earnings per share (EPS) by the average price/earnings (P/E) ratio for theindustry. The average P/E ratio for the industry can be obtained from a sourcesuch as Standard & Poor’s Industrial Ratios. The P/E ratio valuation technique is a simple method of determining a stock’s value and can be quickly calculated after firms make earnings announcements,which accounts for its popularity. Naturally, this has increased the demand formore frequent announcements or “guidance” regarding future earnings. Somefirms feel that pre-earnings guidance creates additional costs and can lead to ethical issues, as discussed in the Focus on Ethics box below.288 PART 3 Valuation of Securities price/earnings multiple approach A popular technique used to estimate the firm’s share value;calculated by multiplying the firm’s expected earnings per share (EPS) by the averageprice/earnings (P/E) ratio forthe industry. focus on ETHICS Psst—Have You Heard Any Good Quarterly Earnings Forecasts Lately? Corporate managers have long complained about the pressure to focus on the shortterm, and now business groups are coming to their defense. “The focus on the short term is a huge problem, ” says William Donaldson, former chairman ofthe Securities and Exchange Commission. “With all of the attention paid to quarterly performance, managers aretaking their eyes off long-term strategicgoals. ” Donaldson, the U.S. Chamber of Commerce, and others believe that the best way to focus companies towardlong-term goals is to do away with thepractice of giving quarterly earningsguidance. In March 2007 the CFA Centre for Financial Market Integrity and the Business Roundtable Institute forCorporate Ethics proposed a templatefor quarterly earnings reports thatwould, in their view, obviate the need for earnings guidance. Meanwhile, many companies are hesitant to give up issuing quarterlyguidance. The practice of issuing earnings forecasts began in the early 1980s, a few years after the SEC ’s decision to allow companies to includeforward-looking projections, providedthey were accompanied by appropri- ate cautionary language. The result was what former SEC chairman ArthurLevitt once called a “game of winks and nods. ” Companies used earnings guidance to lower analysts ’ estimates; when the actual numbers came in higher, their stock prices jumped. Thepractice reached a fever pitch duringthe late 1990s when companies that missed the consensus earnings esti- mate, even by just a penny, saw theirstock prices tumble. One of the first companies to stop issuing earnings guidance was Gillette, in 2001. Others that abandoned quar- terly guidance were Coca-Cola, Intel,and McDonald ’s. It became a trend. By 2005, just 61 percent of companieswere offering quarterly projections to the public; according to the NationalInvestor Relations Institute, the number declined to 52 percent in 2006. Not everyone agrees with eliminat- ing quarterly guidance. A survey con- ducted by New York University ’s Stern School of Business finance professorBaruch Lev, along with University ofFlorida professors Joel Houston and Jennifer Tucker, showed that companies that ended quarterly guidance reapedalmost no benefit from doing so. Theirstudy found no evidence that guidancestoppers increased capital investments or research and development. So when should companies give up earningsguidance ? According to Lev, they should do so only when they are notvery good at predicting their earnings. “If you are not better than others at fore- casting, then don ’t bother, ” he says. 3 What temptations might managers face if they have provided earnings guidance to investors and later find it difficult to meet the expectations that they helped create?in practice The use of P/E multiples is especially helpful in valuing firms that are not publicly traded, but analysts use this approach for public companies too. In anycase, the price/earnings multiple approach is considered superior to the use ofbook or liquidation values because it considers expected earnings. An example will demonstrate the use of price/earnings multiples. Ann Perrier plans to use the price/earnings multiple approach to estimate the value of Lamar Company’s stock, which she currently holds in her retirement account. She estimates that Lamar Companywill earn $2.60 per share next year (2013). This expectation is based on ananalysis of the firm’s historical earnings trend and of expected economic andindustry conditions. She finds the price/earnings (P/E) ratio for firms in the sameindustry to average 7. Multiplying Lamar’s expected earnings per share (EPS) of$2.60 by this ratio gives her a value for the firm’s shares of $18.20, assuming that investors will continue to value the average firm at 7 times its earnings. So how much is Lamar Company’s stock really worth? That’s a trick ques- tion because there’s no one right answer. It is important to recognize that theanswer depends on the assumptions made and the techniques used. Professionalsecurities analysts typically use a variety of models and techniques to valuestocks. For example, an analyst might use the constant-growth model, liquidationvalue, and a price/earnings (P/E) multiple to estimate the worth of a given stock.If the analyst feels comfortable with his or her estimates, the stock would bevalued at no more than the largest estimate. Of course, should the firm’s esti-mated liquidation value per share exceed its “going concern” value per share,estimated by using one of the valuation models (zero-, constant-, or variable-growth or free cash flow) or the P/E multiple approach, the firm would be viewedas being “worth more dead than alive.” In such an event, the firm would lack suf-ficient earning power to justify its existence and should probably be liquidated.Personal Finance Example 7.83CHAPTER 7 Stock Valuation 289 Matter of fact The P/E multiple approach is a fast and easy way to estimate a stock’s value. However, P/E ratios vary widely over time. In 1980, the average stock had a P/E ratio below 9, but by the year 2000, the ratio had risen above 40. Therefore, analysts using the P/E approach in the 1980s would have come up with much lower estimates of value than analysts using the model 20 years later. In other words, when using this approach to estimate stock values, the estimate will depend more on whether stock market valuations generally are high or low rather than on whether the particular company is doing well or not.Problems with P/E Valuation 6REVIEW QUESTIONS 7–12 Describe the events that occur in an efficient market in response to new information that causes the expected return to exceed the requiredreturn. What happens to the market value? 7–13 What does the efficient-market hypothesis (EMH) say about (a)securities prices, (b)their reaction to new information, and (c)investor opportunities to profit? What is the behavioral finance challenge to this hypothesis? 7–14 Describe, compare, and contrast the following common stock dividend valuation models: (a)zero-growth, (b)constant-growth, and (c)variable- growth. 7–15 Describe the free cash flow valuation model and explain how it differs from the dividend valuation models. What is the appeal of this model? 7–16 Explain each of the three other approaches to common stock valuation:(a)book value, (b)liquidation value, and (c)price/earnings (P/E) multi- ples. Which of these is considered the best?290 PART 3 Valuation of Securities 7.4Decision Making and Common Stock Value Valuation equations measure the stock value at a point in time based on expected return and risk. Any decisions of the financial manager that affect these variablescan cause the value of the firm to change. Figure 7.3 depicts the relationshipamong financial decisions, return, risk, and stock value. CHANGES IN EXPECTED DIVIDENDS Assuming that economic conditions remain stable, any management action thatwould cause current and prospective stockholders to raise their dividend expecta-tions should increase the firm’s value. In Equation 7.4, we can see that P 0will increase for any increase in D1org. Any action of the financial manager that will increase the level of expected dividends without changing risk (the requiredreturn) should be undertaken, because it will positively affect owners’ wealth. Using the constant-growth model in an earlier example (on pages 281 and 282),we found Lamar Company to have a share value of $18.75. On the followingday, the firm announced a major technological breakthrough that would revolu-tionize its industry. Current and prospective stockholders would not be expectedto adjust their required return of 15%, but they would expect that future divi-dends will increase. Specifically, they expect that although the dividend next year,D 1, will remain at $1.50, the expected rate of growth thereafter will increase from 7% to 9%. If we substitute and intoEquation 7.4, the resulting share value is . Theincreased value therefore resulted from the higher expected future dividends reflected in the increase in the growth rate.$253$1.50 ,(0.15 -0.09)4g=0.09 D1=$1.50, rs=0.15,Example 7.93 Decision Action by Financial ManagerEffect on Stock Value P0 =rs – gEffect on 1. Expected Return Measured by ExpectedDividends, D 1,D2, …, Dn, and Expected DividendGrowth, g. 2. Risk Measured by the Required Return, r s.D1FIGURE 7.3 Decision Making and Stock Value Financial decisions, return,risk, and stock valueLG6 CHANGES IN RISK Although the required return, rs, is the focus of Chapters 8 and 9, at this point we can consider its fundamental components. Any measure of required return con-sists of two components, a risk-free rate and a risk premium. We expressed thisrelationship as Equation 6.1 in the previous chapter, which we repeat here interms of r s: risk-free risk rate, RFpremium In the next chapter you will learn that the real challenge in finding the required return is determining the appropriate risk premium. In Chapters 8 and 9 we willdiscuss how investors and managers can estimate the risk premium for any par-ticular asset. For now, recognize that r srepresents the minimum return that the firm’s stock must provide to shareholders to compensate them for bearing therisk of holding the firm’s equity. Any action taken by the financial manager that increases the risk share- holders must bear will also increase the risk premium required by shareholders,and hence the required return. Additionally, the required return can be affectedby changes in the risk free rate—even if the risk premium remains constant. Forexample, if the risk-free rate increases due to a shift in government policy, thenthe required return goes up too. In Equation 7.1, we can see that an increase inthe required return, r s, will reduce share value, P0, and a decrease in the required return will increase share value. Thus, any action of the financial manager thatincreases risk contributes to a reduction in value, and any action that decreasesrisk contributes to an increase in value. Assume that Lamar Company’s 15% required return resulted from a risk-freerate of 9% and a risk premium of 6%. With this return, the firm’s share valuewas calculated in an earlier example (on pages 280 and 281) to be $18.75. Now imagine that the financial manager makes a decision that, without changing expected dividends, causes the firm’s risk premium to increase to 7%.Assuming that the risk-free rate remains at 9%, the new required return on Lamar stock will be 16% (9% 7%) , substituting and into the valuation equation (Equation 7.3), results in a new share value of . As expected, raising the required return,without any corresponding increase in expected dividends, causes the firm’s stockvalue to decline. Clearly, the financial manager’s action was not in the owners’ best interest. COMBINED EFFECT A financial decision rarely affects dividends and risk independently; most deci-sions affect both factors often in the same direction. As firms take on more risk,their shareholders expect to see higher dividends. The net effect on value dependson the relative size of the changes in these two variables.$16.67 3$1.50 ,(0.16 -0.07)4g=0.07D 1=$1.50, rs=0.16, +Example 7.10 3rs=r*+IP+RPsCHAPTER 7 Stock Valuation 291 If we assume that the two changes illustrated for Lamar Company in the pre- ceding examples occur simultaneously, the key variable values would be and . Substituting into the valuation model, we obtain a share price of . The net result of thedecision, which increased dividend growth ( g, from 7% to 9%) as well as required return ( r s, from 15% to 16%), is positive. The share price increased from $18.75 to $21.43. Even with the combined effects, the decision appears to be in the best interest of the firm’s owners because it increases their wealth. 6REVIEW QUESTIONS 7–17 Explain the linkages among financial decisions, return, risk, and stock value. 7–18 Assuming that all other variables remain unchanged, what impact would each of the following have on stock price? (a)The firm’s risk pre- mium increases. (b)The firm’s required return decreases. (c)The divi- dend expected next year decreases. (d)The rate of growth in dividends is expected to increase.$21.43 3$1.50 ,(0.16 -0.09)4g=0.09 D1=$1.50, rs=0.16,Example 7.11 3292 PART 3 Valuation of Securities Summary FOCUS ON VALUE The price of each share of a firm’s common stock is the value of each ownership interest. Although common stockholders typically have voting rights, whichindirectly give them a say in management, their most significant right is theirclaim on the residual cash flows of the firm. This claim is subordinate to thoseof vendors, employees, customers, lenders, the government (for taxes), and pre-ferred stockholders. The value of the common stockholders’ claim is embodiedin the future cash flows they are entitled to receive. The present value of thoseexpected cash flows is the firm’s share value. To determine this present value, forecast cash flows are discounted at a rate that reflects their risk. Riskier cash flows are discounted at higher rates, resultingin lower present values than less risky expected cash flows, which are discountedat lower rates. The value of the firm’s common stock is therefore driven by itsexpected cash flows (returns) and risk (certainty of the expected cash flows). In pursuing the firm’s goal of maximizing the stock price, the financial man- ager must carefully consider the balance of return and risk associated with eachproposal and must undertake only those actions that create value for owners. By focusing on value creation and by managing and monitoring the firm’s cashflows and risk, the financial manager should be able to achieve the firm’s goal ofshare price maximization. REVIEW OF LEARNING GOALS Differentiate between debt and equity. Holders of equity capital (common and preferred stock) are owners of the firm. Typically, only commonstockholders have a voice in management. Equityholders’ claims on income andLG1 assets are secondary to creditors’ claims, there is no maturity date, and divi- dends paid to stockholders are not tax deductible. Discuss the features of both common and preferred stock. The common stock of a firm can be privately owned, closely owned, or publicly owned. It canbe sold with or without a par value. Preemptive rights allow common stock-holders to avoid dilution of ownership when new shares are issued. Not allshares authorized in the corporate charter are outstanding. If a firm has treasurystock, it will have issued more shares than are outstanding. Some firms have twoor more classes of common stock that differ mainly in having unequal votingrights. Proxies transfer voting rights from one party to another. The decision topay dividends to common stockholders is made by the firm’s board of directors.Firms can issue stock in foreign markets. The stock of many foreign corpora-tions is traded in U.S. markets in the form of American depositary receipts(ADRs), which are backed by American depositary shares (ADSs). Preferred stockholders have preference over common stockholders with respect to the distribution of earnings and assets. They do not normally havevoting privileges. Preferred stock issues may have certain restrictive covenants,cumulative dividends, a call feature, and a conversion feature. Describe the process of issuing common stock, including venture capital, going public, and the investment banker. The initial nonfounder financing for business startups with attractive growth prospects typically comes from privateequity investors. These investors can be either angel capitalists or venture capi-talists (VCs). VCs usually invest in both early-stage and later-stage companiesthat they hope to take public so as to cash out their investments. The first public issue of a firm’s stock is called an initial public offering (IPO). The company selects an investment banker to advise it and to sell thesecurities. The lead investment banker may form a selling syndicate with otherinvestment bankers. The IPO process includes getting SEC approval, promotingthe offering to investors, and pricing the issue. Understand the concept of market efficiency and basic stock valuation using zero-growth, constant-growth, and variable-growth models. Market effi- ciency assumes that the quick reactions of rational investors to new informa-tion cause the market value of common stock to adjust upward or downwardquickly. The efficient-market hypothesis (EMH) suggests that securities are fairly priced, that they reflect fully all publicly available information, and thatinvestors should therefore not waste time trying to find and capitalize on mis-priced securities. Behavioral finance advocates challenge this hypothesis byarguing that emotion and other factors play a role in investment decisions. The value of a share of stock is the present value of all future dividends it is expected to provide over an infinite time horizon. Three dividend growthmodels—zero-growth, constant-growth, and variable-growth—can be consid-ered in common stock valuation. The most widely cited model is the constant-growth model. Discuss the free cash flow valuation model and the book value, liquida- tion value, and price/earnings (P/E) multiple approaches. The free cash flow valuation model values firms that have no dividend history, startups, or an operating unit or division of a larger public company. The model finds the value LG5LG4LG3LG2CHAPTER 7 Stock Valuation 293 of the entire company by discounting the firm’s expected free cash flow at its weighted average cost of capital. The common stock value is found by sub-tracting the market values of the firm’s debt and preferred stock from the valueof the entire company. Book value per share is the amount per share of common stock that would be received if all of the firm’s assets were sold for their exact book (accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders. Liquidation value pershare is the actual amount per share of common stock that would be received if all of the firm’s assets were sold for their market value, liabilities (including preferred stock) were paid, and the remaining money were divided among thecommon stockholders. The price/earnings (P/E) multiple approach estimatesstock value by multiplying the firm’s expected earnings per share (EPS) by theaverage price/earnings (P/E) ratio for the industry. Explain the relationships among financial decisions, return, risk, and the firm’s value. In a stable economy, any action of the financial manager that increases the level of expected dividends without changing risk should increaseshare value; any action that reduces the level of expected dividends withoutchanging risk should reduce share value. Similarly, any action that increases risk (required return) will reduce share value; any action that reduces risk willincrease share value. An assessment of the combined effect of return and risk on stock value must be part of the financial decision-making process. LG6294 PART 3 Valuation of Securities Opener-in-Review A123 shares were originally offered for sale at a price of $13.50. Three months later, the stock traded for about $18. What return did investors earn over thisperiod? On November 10, 2009, A123 reported its 3rd quarter financial results.From November 9 to November 11, the firm’s stock price fell from $17.85 to$16.88. Given that A123 has 102 million shares outstanding, what were thedollar and percentage losses that shareholders endured in the days surroundingthe earnings release? Over the same three days (November 9–11), the Nasdaqstock index moved up 0.6%. How does this influence your thinking aboutA123’s stock performance around this time? Self-Test Problems(Solutions in Appendix) ST7–1 Common stock valuation Perry Motors’ common stock just paid its annual dividend of $1.80 per share. The required return on the common stock is 12%. Estimate the value of the common stock under each of the following assumptionsabout the dividend: a.Dividends are expected to grow at an annual rate of 0% to infinity. b.Dividends are expected to grow at a constant annual rate of 5% to infinity. c.Dividends are expected to grow at an annual rate of 5% for each of the next 3 years, followed by a constant annual growth rate of 4% in years 4 to infinity.LG4 ST7–2 Free cash flow valuation Erwin Footwear wishes to assess the value of its Active Shoe Division. This division has debt with a market value of $12,500,000 and nopreferred stock. Its weighted average cost of capital is 10%. The Active ShoeDivision’s estimated free cash flow each year from 2013 through 2016 is given in the following table. Beyond 2016 to infinity, the firm expects its free cash flow to grow at 4% annually.CHAPTER 7 Stock Valuation 295 LG5 Year ( t) Free cash flow ( FCF t) 2013 $ 800,000 2014 1,200,0002015 1,400,0002016 1,500,000 a.Use the free cash flow valuation model to estimate the value of Erwin’s entire Active Shoe Division. b.Use your finding in part aalong with the data provided above to find this divi- sion’s common stock value. c.If the Active Shoe Division as a public company will have 500,000 shares outstanding, use your finding in part bto calculate its value per share. Warm-Up ExercisesAll problems are available in . E7–1 A balance sheet balances assets with their sources of debt and equity financing. If a corporation has assets equal to $5.2 million and a debt ratio of 75.0%, how muchdebt does the corporation have on its books? E7–2 Angina, Inc., has 5 million shares outstanding. The firm is considering issuing anadditional 1 million shares. After selling these shares at their $20 per share offering price and netting 95% of the sale proceeds, the firm is obligated by an earlier agree- ment to sell an additional 250,000 shares at 90% of the offering price. In total, how much cash will the firm net from these stock sales? E7–3 Figurate Industries has 750,000 shares of cumulative preferred stock outstanding. It has passed the last three quarterly dividends of $2.50 per share and now (at the end of the current quarter) wishes to distribute a total of $12 million to its shareholders. If Figurate has 3 million shares of common stock outstanding, how large a per-share common stock dividend will it be able to pay? E7–4 Today the common stock of Gresham Technology closed at $24.60 per share, down $0.35 from yesterday. If the company has 4.6 million shares outstanding and annual earnings of $11.2 million, what is its P/E ratio today? What was its P/E ratio yes- terday? E7–5 Stacker Weight Loss currently pays an annual year-end dividend of $1.20 per share.It plans to increase this dividend by 5% next year and maintain it at the new level for the foreseeable future. If the required return on this firm’s stock is 8%, what is the value of Stacker’s stock? LG1 LG2 LG2 LG3 LG4 E7–6 Brash Corporation initiated a new corporate strategy that fixes its annual dividend at $2.25 per share forever. If the risk-free rate is 4.5% and the risk premium onBrash’s stock is 10.8%, what is the value of Brash’s stock?296 PART 3 Valuation of Securities LG6 ProblemsAll problems are available in . P7–1 Authorized and available shares Aspin Corporation’s charter authorizes issuance of 2,000,000 shares of common stock. Currently, 1,400,000 shares are outstanding, and 100,000 shares are being held as treasury stock. The firm wishes to raise $48,000,000 for a plant expansion. Discussions with its investment bankers indicatethat the sale of new common stock will net the firm $60 per share.a.What is the maximum number of new shares of common stock that the firm can sell without receiving further authorization from shareholders? b.Judging on the basis of the data given and your finding in part a,will the firm be able to raise the needed funds without receiving further authorization? c.What must the firm do to obtain authorization to issue more than the number of shares found in part a? P7–2 Preferred dividends Slater Lamp Manufacturing has an outstanding issue of pre- ferred stock with an $80 par value and an 11% annual dividend. a.What is the annual dollar dividend? If it is paid quarterly, how much will be paid each quarter? b.If the preferred stock is noncumulative and the board of directors has passed the preferred dividend for the last 3 quarters, how much must be paid to preferred stockholders in the current quarter before dividends are paid to common stock- holders? c.If the preferred stock is cumulative and the board of directors has passed the pre- ferred dividend for the last 3 quarters, how much must be paid to preferred stockholders in the current quarter before dividends are paid to common stock-holders? P7–3 Preferred dividends In each case in the following table, how many dollars of pre- ferred dividends per share must be paid to preferred stockholders in the current period before common stock dividends are paid? LG2 LG2 LG2 LG2Dividend per Periods of Case Type Par value share per period dividends passed A Cumulative $ 80 $ 5 2 B Noncumulative 110 8% 3 C Noncumulative 100 $11 1 D Cumulative 60 8.5% 4 E Cumulative 90 9% 0 P7–4 Convertible preferred stock Valerian Corp. convertible preferred stock has a fixed conversion ratio of 5 common shares per 1 share of preferred stock. The preferred stock pays a dividend of $10.00 per share per year. The common stock currently sells for $20.00 per share and pays a dividend of $1.00 per share per year.a.Judging on the basis of the conversion ratio and the price of the common shares, what is the current conversion value of each preferred share? b.If the preferred shares are selling at $96.00 each, should an investor convert the preferred shares to common shares? c.What factors might cause an investor not to convert from preferred to common stock? Personal Finance Problem P7–5 Common stock valuation—Zero growth Scotto Manufacturing is a mature firm in the machine tool component industry. The firm’s most recent common stock divi-dend was $2.40 per share. Because of its maturity as well as its stable sales and earn-ings, the firm’s management feels that dividends will remain at the current level forthe foreseeable future.a.If the required return is 12%, what will be the value of Scotto’s common stock? b.If the firm’s risk as perceived by market participants suddenly increases, causing the required return to rise to 20%, what will be the common stock value? c.Judging on the basis of your findings in parts aandb,what impact does risk have on value? Explain. Personal Finance Problem P7–6 Common stock value—Zero growth Kelsey Drums, Inc., is a well-established sup- plier of fine percussion instruments to orchestras all over the United States. The company’s class A common stock has paid a dividend of $5.00 per share per year for the last 15 years. Management expects to continue to pay at that amount for the foreseeable future. Sally Talbot purchased 100 shares of Kelsey class A common 10 years ago at a time when the required rate of return for the stock was 16%. She wants to sell her shares today. The current required rate of return for the stock is 12%. How much capital gain or loss will Sally have on her shares? P7–7 Preferred stock valuation Jones Design wishes to estimate the value of its out- standing preferred stock. The preferred issue has an $80 par value and pays an annual dividend of $6.40 per share. Similar-risk preferred stocks are currentlyearning a 9.3% annual rate of return. a.What is the market value of the outstanding preferred stock? b.If an investor purchases the preferred stock at the value calculated in part a,how much does she gain or lose per share if she sells the stock when the required return on similar-risk preferred stocks has risen to 10.5%? Explain. P7–8 Common stock value—Constant growth Use the constant-growth model (Gordon growth model) to find the value of each firm shown in the following table.CHAPTER 7 Stock Valuation 297 LG4 LG4 LG4 LG4 Firm Dividend expected next year Dividend growth rate Required return A $1.20 8% 13% B 4.00 5 15 C 0.65 10 14 D 6.00 8 9 E 2.25 8 20 P7–9 Common stock value—Constant growth McCracken Roofing, Inc., common stock paid a dividend of $1.20 per share last year. The company expects earnings and divi-dends to grow at a rate of 5% per year for the foreseeable future.a.What required rate of return for this stock would result in a price per share of $28? b.If McCracken expects both earnings and dividends to grow at an annual rate of 10%, what required rate of return would result in a price per share of $28? Personal Finance Problem P7–10 Common stock value—Constant growth Elk County Telephone has paid the divi- dends shown in the following table over the past 6 years.298 PART 3 Valuation of Securities LG4 LG4 Year Dividend per share 2012 $2.87 2011 2.762010 2.602009 2.462008 2.372007 2.25 The firm’s dividend per share next year is expected to be $3.02. a.If you can earn 13% on similar-risk investments, what is the most you would be willing to pay per share? b.If you can earn only 10% on similar-risk investments, what is the most you would be willing to pay per share? c.Compare and contrast your findings in parts aandb,and discuss the impact of changing risk on share value. P7–11 Common stock value—Variable growth Newman Manufacturing is considering a cash purchase of the stock of Grips Tool. During the year just completed, Grips earned $4.25 per share and paid cash dividends of $2.55 per share .Grips’ earnings and dividends are expected to grow at 25% per year for the next 3 years, after which they are expected to grow at 10% per year to infinity. What is the maximum price per share that Newman should pay for Grips if it has a required return of 15% on investments with risk characteristics similar to those of Grips? Personal Finance Problem P7–12 Common stock value—Variable growth Home Place Hotels, Inc., is entering into a 3-year remodeling and expansion project. The construction will have a limiting effect on earnings during that time, but when it is complete, it should allow the com-pany to enjoy much improved growth in earnings and dividends. Last year, the com- pany paid a dividend of $3.40. It expects zero growth in the next year. In years 2 and 3, 5% growth is expected, and in year 4, 15% growth. In year 5 and thereafter, growth should be a constant 10% per year. What is the maximum price per share that an investor who requires a return of 14% should pay for Home Place Hotelscommon stock?(D 0=$2.55)LG4 LG4 P7–13 Common stock value—Variable growth Lawrence Industries’ most recent annual dividend was $1.80 per share , and the firm’s required return is 11%.Find the market value of Lawrence’s shares when:a.Dividends are expected to grow at 8% annually for 3 years, followed by a 5% constant annual growth rate in years 4 to infinity. b.Dividends are expected to grow at 8% annually for 3 years, followed by a 0% constant annual growth rate in years 4 to infinity. c.Dividends are expected to grow at 8% annually for 3 years, followed by a 10% constant annual growth rate in years 4 to infinity. Personal Finance Problem P7–14 Common stock value—All growth models You are evaluating the potential pur- chase of a small business currently generating $42,500 of after-tax cash flow . On the basis of a review of similar-risk investment opportunities, you must earn an 18% rate of return on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm’s value using several possible assumptions about the growth rate of cash flows. a.What is the firm’s value if cash flows are expected to grow at an annual rate of 0% from now to infinity? b.What is the firm’s value if cash flows are expected to grow at a constant annual rate of 7% from now to infinity? c.What is the firm’s value if cash flows are expected to grow at an annual rate of 12% for the first 2 years, followed by a constant annual rate of 7% from year 3 to infinity? P7–15 Free cash flow valuation Nabor Industries is considering going public but is unsure of a fair offering price for the company. Before hiring an investment banker to assist in making the public offering, managers at Nabor have decided to make their ownestimate of the firm’s common stock value. The firm’s CFO has gathered data for performing the valuation using the free cash flow valuation model. The firm’s weighted average cost of capital is 11%, and it has $1,500,000 of debt at market value and $400,000 of preferred stock at its assumed market value. The estimated free cash flows over the next 5 years, 2013 through 2017, are givenbelow. Beyond 2017 to infinity, the firm expects its free cash flow to grow by 3% annually.(D 0=$42,500)(D0=$1.80)CHAPTER 7 Stock Valuation 299 Year ( t) Free cash flow ( FCF t) 2013 $200,000 2014 250,0002015 310,0002016 350,0002017 390,000LG4 LG4 LG5 a.Estimate the value of Nabor Industries’ entire company by using the free cash flow valuation model. b.Use your finding in part a,along with the data provided above, to find Nabor Industries’ common stock value. c.If the firm plans to issue 200,000 shares of common stock, what is its estimated value per share? Personal Finance Problem P7–16 Using the free cash flow valuation model to price an IPO Assume that you have an opportunity to buy the stock of CoolTech, Inc., an IPO being offered for $12.50 per share. Although you are very much interested in owning the company, you are con- cerned about whether it is fairly priced. To determine the value of the shares, you have decided to apply the free cash flow valuation model to the firm’s financial datathat you’ve developed from a variety of data sources. The key values you have com- piled are summarized in the following table.300 PART 3 Valuation of Securities LG5 Gallinas Industries Balance Sheet December 31 Assets Liabilities and Stockholders’ Equity Cash $ 40,000 Accounts payable $100,000 Marketable securities 60,000 Notes payable 30,000Accounts receivable 120,000 Accrued wagesInventories Total current liabilities Total current assets Long-term debt Land and buildings (net) $150,000 Preferred stock $ 80,000Machinery and equipment Common stock (10,000 shares) 260,000 Total fixed assets (net) Retained earningsTotal assets Total liabilities and stockholders’ equity $780,000 $780,000100,000 $400,000250,000$180,000 $380,000$160,000 160,00030,000Free cash flow Year ( t) FCF t Other data 2013 $ 700,000 Growth rate of FCF, beyond 2013 to infinity 2% 2014 800,000 Weighted average cost of capital 8%2015 950,000 Market value of all debt $2,700,0002016 1,100,000 Market value of preferred stock $1,000,000 Number of shares of common stock outstanding 1,100,000 ===== a.Use the free cash flow valuation model to estimate CoolTech’s common stock value per share. b.Judging on the basis of your finding in part aand the stock’s offering price, should you buy the stock? c.On further analysis, you find that the growth rate in FCF beyond 2016 will be 3% rather than 2%. What effect would this finding have on your responses in parts aandb? P7–17 Book and liquidation value The balance sheet for Gallinas Industries is as follows. Additional information with respect to the firm is available: (1) Preferred stock can be liquidated at book value. (2) Accounts receivable and inventories can be liquidated at 90% of book value.(3) The firm has 10,000 shares of common stock outstanding. (4) All interest and dividends are currently paid up.LG5 (5) Land and buildings can be liquidated at 130% of book value. (6) Machinery and equipment can be liquidated at 70% of book value.(7) Cash and marketable securities can be liquidated at book value. Given this information, answer the following: a.What is Gallinas Industries’ book value per share? b.What is its liquidation value per share? c.Compare, contrast, and discuss the values found in parts aandb. P7–18 Valuation with price/earnings multiples For each of the firms shown in the fol- lowing table, use the data given to estimate its common stock value employing price/earnings (P/E) multiples.CHAPTER 7 Stock Valuation 301 LG5 Firm Expected EPS Price/earnings multiple A $3.00 6.2 B 4.50 10.0 C 1.80 12.6 D 2.40 8.9 E 5.10 15.0 P7–19 Management action and stock value REH Corporation’s most recent dividend was $3 per share, its expected annual rate of dividend growth is 5%, and the requiredreturn is now 15%. A variety of proposals are being considered by management to redirect the firm’s activities. Determine the impact on share price for each of the fol- lowing proposed actions, and indicate the best alternative.a.Do nothing, which will leave the key financial variables unchanged. b.Invest in a new machine that will increase the dividend growth rate to 6% and lower the required return to 14%. c.Eliminate an unprofitable product line, which will increase the dividend growth rate to 7% and raise the required return to 17%. d.Merge with another firm, which will reduce the growth rate to 4% and raise the required return to 16%. e.Acquire a subsidiary operation from another manufacturer. The acquisition should increase the dividend growth rate to 8% and increase the required return to 17%. P7–20 Integrative—Risk and Valuation Given the following information for the stock of Foster Company, calculate the risk premium on its common stock. Current price per share of common $50.00 Expected dividend per share next year $ 3.00Constant annual dividend growth rate 9% Risk-free rate of return 7% P7–21 Integrative—Risk and valuation Giant Enterprises’ stock has a required return of 14.8%. The company, which plans to pay a dividend of $2.60 per share in the coming year, anticipates that its future dividends will increase at an annual rate LG6 LG6LG4 LG6LG4 consistent with that experienced over the 2006–2012 period, when the following dividends were paid:302 PART 3 Valuation of Securities Year Dividend per share 2012 $2.45 2011 2.282010 2.102009 1.952008 1.822007 1.802006 1.73 Year Dividend per share 2012 $3.44 2011 3.282010 3.152009 2.902008 2.752007 2.45a.If the risk-free rate is 10%, what is the risk premium on Giant’s stock? b.Using the constant-growth model ,estimate the value of Giant’s stock. c.Explain what effect, if any, a decrease in the risk premium would have on the value of Giant’s stock. P7–22 Integrative—Risk and Valuation Hamlin Steel Company wishes to determine the value of Craft Foundry, a firm that it is considering acquiring for cash. Hamlin wishes to determine the applicable discount rate to use as an input to the constant-growth valuation model. Craft’s stock is not publicly traded. After studying the required returns of firms similar to Craft that are publicly traded, Hamlin believes that an appropriate risk premium on Craft stock is about 5%. The risk-free rate is currently 9%. Craft’s dividend per share for each of the past 6 years is shown in the following table.LG6LG4 a.Given that Craft is expected to pay a dividend of $3.68 next year, determine the maximum cash price that Hamlin should pay for each share of Craft. b.Describe the effect on the resulting value of Craft of: (1) A decrease in its dividend growth rate of 2% from that exhibited over the 2007–2012 period. (2) A decrease in its risk premium to 4%. P7–23 ETHICS PROBLEM Melissa is trying to value Generic Utility, Inc.’s, stock, which is clearly not growing at all. Generic declared and paid a $5 dividend last year. The required rate of return for utility stocks is 11%, but Melissa is unsure about thefinancial reporting integrity of Generic’s finance team. She decides to add an extraLG4 1% “credibility” risk premium to the required return as part of her valuation analysis.a.What is the value of Generic’s stock, assuming that the financials are trust- worthy? b.What is the value of Generic’s stock, assuming that Melissa includes the extra 1% “credibility” risk premium? c.What is the difference between the values found in parts aandb,and how might one interpret that difference?CHAPTER 7 Stock Valuation 303 Spreadsheet Exercise You are interested in purchasing the common stock of Azure Corporation. The firm recently paid a dividend of $3 per share. It expects its earnings—and hence its divi- dends—to grow at a rate of 7% for the foreseeable future. Currently, similar-riskstocks have required returns of 10%. TO DO a.Given the data above, calculate the present value of this security. Use the con- stant-growth model (Equation 7.4) to find the stock value. b.One year later, your broker offers to sell you additional shares of Azure at $73. The most recent dividend paid was $3.21, and the expected growth rate for earn- ings remains at 7%. If you determine that the appropriate risk premium is 6.74% and you observe that the risk-free rate, RF,is currently 5.25%, what is the firm’s current required return, rAzure? c.Applying Equation 7.4, determine the value of the stock using the new dividend and required return from part b. d.Given your calculation in part c,would you buy the additional shares from your broker at $73 per share? Explain. e.Given your calculation in part c,would you sell your old shares for $73? Explain. Visit www.myfinancelab.com forChapter Case: Assessing the Impact of Suarez Manufacturing’s Proposed Risky Investment on Its Stock Value, Group Exercises, and numerous online resources. Encore International In the world of trendsetting fashion, instinct and marketing savvy are prerequisites to success. Jordan Ellis had both. During 2012, his international casual-wear com- pany, Encore, rocketed to $300 million in sales after 10 years in business. His fashion line covered the young woman from head to toe with hats, sweaters, dresses, blouses, skirts, pants, sweatshirts, socks, and shoes. In Manhattan, there was an Encore shop every five or six blocks, each featuring a different color. Some shops showed the entire line in mauve, and others featured it in canary yellow. Encore had made it. The company’s historical growth was so spectacular that no one could have predicted it. However, securities analysts speculated that Encore could not keep up the pace. They warned that competition is fierce in the fashionindustry and that the firm might encounter little or no growth in the future. Theyestimated that stockholders also should expect no growth in future dividends. Contrary to the conservative securities analysts, Jordan Ellis felt that the com- pany could maintain a constant annual growth rate in dividends per share of 6% inthe future, or possibly 8% for the next 2 years and 6% thereafter. Ellis based hisestimates on an established long-term expansion plan into European and LatinAmerican markets. Venturing into these markets was expected to cause the risk ofthe firm, as measured by the risk premium on its stock, to increase immediately from8.8% to 10%. Currently, the risk-free rate is 6%. In preparing the long-term financial plan, Encore’s chief financial officer has assigned a junior financial analyst, Marc Scott, to evaluate the firm’s current stock price. He has asked Marc to consider the conservative predictions of the securitiesanalysts and the aggressive predictions of the company founder, Jordan Ellis. Marc has compiled these 2012 financial data to aid his analysis: 304Integrative Case 3 Data item 2012 value Earnings per share (EPS) $6.25 Price per share of common stock $40.00Book value of common stock equity $60,000,000Total common shares outstanding 2,500,000Common stock dividend per share $4.00 TO DO a.What is the firm’s current book value per share? b.What is the firm’s current P/E ratio? c.(1)What is the current required return for Encore stock? (2)What will be the new required return for Encore stock assuming that they expand into European and Latin American markets as planned? d.If the securities analysts are correct and there is no growth in future dividends, what will be the value per share of the Encore stock? ( Note: Use the new required return on the company’s stock here.) 305e.(1)If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the firm maintains a constant annual 6% growth rate in future dividends? ( Note: Continue to use the new required return here.) (2)If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the firm maintains a constant annual 8% growth rate in divi- dends per share over the next 2 years and 6% thereafter? f.Compare the current (2012) price of the stock and the stock values found in parts a, d, ande.Discuss why these values may differ. Which valuation method do you believe most clearly represents the true value of the Encore stock? This page intentionally left blank 3074 PartRisk and the Required Rate of Return 8Risk and Return 9The Cost of Capital INTEGRATIVE CASE 4 Eco Plastics CompanyChapters in This Part Most people intuitively understand the principle that risk and return are linked. After all, as the old saying goes, “Nothing ventured, nothing gained. ” In the next two chapters, we ’ll explore how investors and financial managers quantify the notion of risk and how they determine how much additional return is appropriatecompensation for taking extra risk. Chapter 8 lays the groundwork, defining the terms riskandreturn and explaining why investors think about risk in different ways depending on whether they want to understand the risk of a specific investment or the risk of a broad portfolio ofinvestments. Perhaps the most famous and widely applied theory in all of finance, theCapital Asset Pricing Model (or CAPM), is introduced here. The CAPM tells investorsand managers alike what return they should expect given the risk of the asset they wantto invest in. Chapter 9 applies these lessons in a managerial finance setting. Firms raise money from two broad sources, owners and lenders. Owners provide equity financing, andlenders provide debt. To maximize the value of the firm, managers have to satisfy bothgroups, and doing so means earning returns high enough to meet investors ’ expectations. Chapter 9 ’s focus is on the cost of capital or, more precisely, the weighted average cost of capital (WACC). The WACC tells managers exactly whatkind of return their investments in plant and equipment, advertising, and humanresources have to earn if the firm is to satisfy its investors. Essentially, the WACC is ahurdle rate, the minimum acceptable return that a firm should earn on any investmentthat it makes. Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand the relationship between risk and return because of the effect that riskier projects will have on thefirm ’s financial statements. INFORMATION SYSTEMS You need to understand how to do scenario and correlation analyses to build decision packages that help manage-ment analyze the risk and return of various business opportunities. MANAGEMENT You need to understand the relationship between risk and return and how to measure that relationship to evaluate data thatcome from finance personnel and translate those data into decisionsthat increase the value of the firm. MARKETING You need to understand that although higher-risk projects may produce higher returns, they may not be the best choice for thefirm if they produce erratic financial results and fail to maximize firmvalue. OPERATIONS You need to understand why investments in plant, equip- ment, and systems need to be evaluated in light of their impact on thefirm ’s risk and return, which together will affect the firm ’s value. The tradeoff between risk and return enters into numerous personal finan- cial decisions. You will use risk and return concepts when you investyour savings, buy real estate, finance major purchases, purchase insur-ance, invest in securities, and implement retirement plans. Although riskand return are difficult to measure precisely, you can get a feel for themand make decisions based on the trade-offs between risk and return inlight of your personal disposition toward risk. In your personal lifeLearning Goals Understand the meaning and fundamentals of risk, return, andrisk preferences. Describe procedures for assessing and measuring the risk of a singleasset. Discuss the measurement of return and standard deviation for aportfolio and the concept ofcorrelation. Understand the risk and return characteristics of a portfolio interms of correlation anddiversification and the impact ofinternational assets on a portfolio. Review the two types of risk and the derivation and role of beta in measuring the relevant risk of both a security and a portfolio. Explain the capital asset pricing model (CAPM), its relationship tothe security market line (SML),and the major forces causing shifts in the SML. LG6LG5LG4LG3LG2LG18Risk and Return 308 309Fund’s Returns Not Even Close to Average For most investors, 2008 was a miser- able year. In the United States the Standard & Poor ’s 500 stock index, a barometer of the overall market, fell 37.2 percent. Returns were even worse in manyother countries. The Morgan StanleyEurope, Australasia, and Far East (EAFE) Index dropped 45 percent, wiping out the previous fiveyears worth of gains. For Deryck Noble-Nesbitt, manager of the Close Special Situations Fundin the United Kingdom, 2008 was close to a career-ending catastrophe. The Close Fund, whichinvests in small companies, lost nearly 60 percent of its value that year and ranked in the bottom2 percent of all funds in its category. That performance followed a loss of nearly 5 percent in2007, so the Close Fund was on a two-year losing streak going into 2009. What a difference a year makes. In 2009, the Close Fund earned a return of 247 per- cent and ranked first among all funds specializing in small stocks. An investor who put £1,000in the fund at the beginning of 2007 would have had roughly £1,411 by December 31,2009, far ahead of what investors in most other funds would have earned over the sameperiod. However, the first five months of 2010 were unkind to the Close Fund as it experiencedanother 5 percent loss, once again falling in the bottom 3 percent of all funds in the small stockcategory. The experience of the Close Special Situations Fund illustrates two key points. First, invest- ments with high returns tend to be associated with high risk. Small stocks as a category, and therecent performance of the Close Fund, clearly demonstrate that principle. In fact, investors oughtto be suspicious of investment opportunities that appear to offer high returns without also havinghigh risk. (See the Focus on Ethics box on page 310.) Second, predicting how any particular fund or investment will perform in any given period is difficult. In three consecutive years, theClose Fund ranked near the bottom, at the very top, and then near the bottom again of its peergroup. Together, these two points suggest that investors must be very mindful of risk and should diversify their investments. This chapter explains how to put that advice into action. Mutual Funds 310 PART 4 Risk and the Required Rate of Return 8.1Risk and Return Fundamentals In most important business decisions there are two key financial considerations: risk and return. Each financial decision presents certain risk and return characteristics,and the combination of these characteristics can increase or decrease a firm’s shareprice. Analysts use different methods to quantify risk, depending on whether theyare looking at a single asset or a portfolio —a collection, or group, of assets. We will look at both, beginning with the risk of a single asset. First, though, it is importantto introduce some fundamental ideas about risk, return, and risk preferences. RISK DEFINED In the most basic sense, riskis a measure of the uncertainty surrounding the return that an investment will earn. Investments whose returns are more uncer-tain are generally viewed as being riskier. More formally, the term riskis used interchangeably with uncertainty to refer to the variability of returns associated with a given asset. A $1,000 government bond that guarantees its holder $5 interest after 30 days has no risk, because there is no variability associated withthe return. A $1,000 investment in a firm’s common stock, the value of whichover the same 30 days may move up or down a great deal, is very risky because ofthe high variability of its return.LG1 portfolio A collection, or group, of assets. risk A measure of the uncertainty surrounding the return that aninvestment will earn or, moreformally, the variability of returns associated with a given asset. focus on ETHICS If It Seems Too Good to Be True Then It Probably Is For many years, investors around the world clamored to invest with BernardMadoff. Those fortunate enough toinvest with “Bernie ” might not have understood his secret trading system,but they were happy with the double- digit returns that they earned. Madoffwas well connected, having been thechairman of the board of directors of the NASDAQ Stock Market and a founding member of the InternationalSecurities Clearing Corporation. Hiscredentials seemed to be impeccable. However, as the old saying goes, if something sounds too good to be true, it probably is. Madoff ’s investors learned this lesson the hard way when,on December 11, 2008, the U.S.Securities and Exchange Commission (SEC) charged Madoff with securitiesfraud. Madoff ’s hedge fund, Ascot Partners, turned out to be a giant Ponzi scheme. Over the years, suspicions were raised about Madoff. Madoff gener-ated high returns year after year, seem-ingly with very little risk. Madoff credited his complex trading strategy for his investment performance, butother investors employed similar strate-gies with much different results than Madoff reported. Harry Markopolos went as far as to submit a report to theSEC three years prior to Madoff ’s arrest titled “The World ’s Largest Hedge Fund Is a Fraud ” that detailed his concerns. a On June 29, 2009, Madoff was sentenced to 150 years in prison. Madoff ’s investors are still working to recover what they can. Fraudulentaccount statements sent just prior toMadoff ’s arrest indicated that investors ’ accounts contained over $64 billion, inaggregate. Many investors pursued claims based on the balance reported in these statements. However, a recentcourt ruling permits claims up to the dif-ference between the amount an investordeposited with Madoff and the amount they withdrew. The judge also ruled that investors who managed to with-draw at least their initial investmentbefore the fraud was uncovered are noteligible to recover additional funds. Total out-of-pocket cash losses as a result of Madoff ’s fraud were recently estimated at slightly over $20 billion. 3 What are some hazards of allowing investors to pursue claims based on their most recent account statements?in practice awww.sec.gov/news/studies/2009/oig-509/exhibit-0293.pdf RETURN DEFINED Obviously, if we are going to assess risk on the basis of variability of return, we need to be certain we know what return is and how to measure it. The total rate of return is the total gain or loss experienced on an investment over a given period. Mathematically, an investment’s total return is the sum of any cash distri-butions (for example, dividends or interest payments) plus the change in theinvestment’s value, divided by the beginning-of-period value. The expression forcalculating the total rate of return earned on any asset over period t,r t, is com- monly defined as (8.1) where The return, rt, reflects the combined effect of cash flow, Ct, and changes in value, , over the period.1 Equation 8.1 is used to determine the rate of return over a time period as short as 1 day or as long as 10 years or more. However, in most cases, tis 1 year, andrtherefore represents an annual rate of return. Robin wishes to determine the return on two stocks that she owned during 2009, Apple Inc. and Wal-Mart. At the beginning of the year, Apple stock traded for$90.75 per share, and Wal-Mart was valued at $55.33. During the year, Applepaid no dividends, but Wal-Mart shareholders received dividends of $1.09 pershare. At the end of the year, Apple stock was worth $210.73 and Wal-Mart soldfor $52.84. Substituting into Equation 8.1, we can calculate the annual rate ofreturn, r,for each stock. Robin made money on Apple and lost money on Wal-Mart in 2009, but notice that her losses on Wal-Mart would have been greater had it not been for the div-idends that she received on her Wal-Mart shares. When calculating the total rateof return, it is important to take into account the effects of both cash disburse- ments and changes in the price of the investment during the year.Wal-Mart: ($1.09 +$52.84 -$55.33) ,$55.33 =-2.5%Apple: ($0 +$210.73 -$90.75) ,$90.75 =132.2%Example 8.13Pt-Pt-1Pt-1=price (value) of asset at time t-1Pt=price (value) of asset at time tt-1 to tCt=cash (flow) received from the asset investment in the time periodrt=actual, expected, or required rate of return during period trt=Ct+Pt-Pt-1 Pt-1CHAPTER 8 Risk and Return 311 1. This expression does not imply that an investor necessarily buys the asset at time and sells it at time t. Rather, it represents the increase (or decrease) in wealth that the investor has experienced during the period by holding a particular investment. If the investor sells the asset at time t, we say that the investor has realized the return on the investment. If the investor continues to hold the investment, we say that the return is unrealized .t-1total rate of return The total gain or loss experienced on an investmentover a given period of time;calculated by dividing theasset’s cash distributions duringthe period, plus change in value, by its beginning-of- period investment value. Investment returns vary both over time and between different types of invest- ments. By averaging historical returns over a long period of time, we can focus onthe differences in returns that different kinds of investments tend to generate.Table 8.1 shows both the nominal and real average annual rates of return from1900 to 2009 for three different types of investments: Treasury bills, Treasurybonds, and common stocks. Although bills and bonds are both issued by the U.S.government and are therefore viewed as relatively safe investments, bills havematurities of 1 year or less, while bonds have maturities ranging up to 30 years.Consequently, the interest rate risk associated with Treasury bonds is muchhigher than with bills. Over the last 109 years, bills earned the lowest returns, just3.9 percent per year on average in nominal returns and only 0.9 percent annuallyin real terms. The latter number means that average Treasury bill returns barelyexceeded the average rate of inflation. Bond returns were higher, 5.0 percent innominal terms and 1.9 percent in real terms. Clearly, though, stocks outshinedthe other types of investments, earning average annual nominal returns of 9.3 percent and average real returns of 6.2 percent. In light of these statistics, you might wonder, “Why would anyone invest in bonds or bills if the returns on stocks are so much higher?” The answer, as you willsoon see, is that stocks are much riskier than either bonds or bills and that risk leadssome investors to prefer the safer, albeit lower, returns on Treasury securities. RISK PREFERENCES Different people react to risk in different ways. Economists use three categories todescribe how investors respond to risk. The first category, and the one that describes the behavior of most people most of the time , is called risk aversion. A person who is a risk-averse investor prefers less risky over more risky invest- ments, holding the rate of return fixed. A risk-averse investor who believes thattwo different investments have the same expected return will choose the invest-ment whose returns are more certain. Stated another way, when choosingbetween two investments, a risk-averse investor will not make the riskier invest- ment unless it offers a higher expected return to compensate the investor forbearing the additional risk . A second attitude toward risk is called risk neutrality. An investor who is risk neutral chooses investments based solely on their expected returns, disregarding the risks. When choosing between two investments, a risk-neutral investor will always choose the investment with the higher expected return regardless of itsrisk.312 PART 4 Risk and the Required Rate of Return Historical Returns on Selected Investments (1900–2009) TABLE 8.1 Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002).Investment Average nominal return Average real return Treasury bills 3.9% 0.9% Treasury bonds 5.0 1.9Common stocks 9.3 6.2 In more depth To read about Inflation and Returns , go to www.myfinancelab.com risk averse The attitude toward risk in which investors would requirean increased return ascompensation for an increasein risk. risk neutral The attitude toward risk inwhich investors choose theinvestment with the higherreturn regardless of its risk. Finally, a risk-seeking investor is one who prefers investments with higher risk and may even sacrifice some expected return when choosing a riskier invest-ment. By design, the average person who buys a lottery ticket or gambles in acasino loses money. After all, state governments and casinos make money off ofthese endeavors, so individuals lose on average. This implies that the expectedreturn on these activities is negative. Yet people do buy lottery tickets and visitcasinos, and in doing so they exhibit risk-seeking behavior. 6REVIEW QUESTIONS 8–1What is riskin the context of financial decision making? 8–2Define return, and describe how to find the rate of return on an investment. 8–3Compare the following risk preferences: (a)risk averse, (b)risk neutral, and(c)risk seeking. Which is most common among financial managers?CHAPTER 8 Risk and Return 313 risk seeking The attitude toward risk in which investors preferinvestments with greater riskeven if they have lowerexpected returns. 8.2Risk of a Single Asset In this section we refine our understanding of risk. Surprisingly, the concept of risk changes when the focus shifts from the risk of a single asset held in isolationto the risk of a portfolio of assets. Here, we examine different statistical methodsto quantify risk, and next we apply those methods to portfolios. RISK ASSESSMENT The notion that risk is somehow connected to uncertainty is intuitive. The moreuncertain you are about how an investment will perform, the riskier that invest-ment seems. Scenario analysis provides a simple way to quantify that intuition,and probability distributions offer an even more sophisticated way to analyze therisk of an investment. Scenario Analysis Scenario analysis uses several possible alternative outcomes (scenarios) to obtain a sense of the variability of returns.2One common method involves considering pessimistic (worst), most likely (expected), and optimistic (best) outcomes andthe returns associated with them for a given asset. In this one measure of aninvestment’s risk is the range of possible outcomes. The range is found by sub- tracting the return associated with the pessimistic outcome from the return asso-ciated with the optimistic outcome. The greater the range, the more variability, orrisk, the asset is said to have. Norman Company, a manufacturer of custom golf equipment, wants to choose thebetter of two investments, A and B. Each requires an initial outlay of $10,000, andeach has a most likely annual rate of return of 15%. Management has estimated Example 8.23LG2 2. The term scenario analysis is intentionally used in a general rather than a technically correct fashion here to sim- plify this discussion. A more technical and precise definition and discussion of this technique and of sensitivity analysis are presented in Chapter 12.scenario analysis An approach for assessing risk that uses several possiblealternative outcomes(scenarios) to obtain a sense ofthe variability among returns. range A measure of an asset’s risk,which is found by subtractingthe return associated with thepessimistic (worst) outcomefrom the return associated withthe optimistic (best) outcome. returns associated with each investment’s pessimistic andoptimistic outcomes. The three estimates for each asset, along with its range, are given in Table 8.2. Asset Aappears to be less risky than asset B; its range of 4% (17% minus 13%) is less thanthe range of 16% (23% minus 7%) for asset B. The risk-averse decision makerwould prefer asset A over asset B, because A offers the same most likely return as B (15%) with lower risk (smaller range). It’s not unusual for financial managers to think about the best and worst pos- sible outcomes when they are in the early stages of analyzing a new investmentproject. No matter how great the intuitive appeal of this approach, looking at therange of outcomes that an investment might produce is a very unsophisticatedway of measuring its risk. More sophisticated methods require some basic statis-tical tools. Probability Distributions Probability distributions provide a more quantitative insight into an asset’s risk.Theprobability of a given outcome is its chance of occurring. An outcome with an 80 percent probability of occurrence would be expected to occur 8 out of 10times. An outcome with a probability of 100 percent is certain to occur.Outcomes with a probability of zero will never occur.314 PART 4 Risk and the Required Rate of Return Assets A and B Asset A Asset B Initial investment $10,000 $10,000 Annual rate of return Pessimistic 13% 7%Most likely 15% 15%Optimistic 17% 23% Range 4% 16%TABLE 8.2 probability Thechance that a given outcome will occur. Matter of fact Is it ever possible to know for sure that a particular outcome can never happen, that the chance of it occurring is 0 percent? In the 2007 best seller, The Black Swan: The Impact of the Highly Improbable , Nassim Nicholas Taleb argues that seemingly improbable or even impossible events are more likely to occur than most people believe, especially in the area of finance. The book’s title refers to the fact that for many years, people believed that all swans were white until a black variety was discovered in Australia. Taleb reportedly earned a large fortune during the 2007–2008 financial crisis by betting that financial markets would plummet.Beware of the Black Swan Norman Company’s past estimates indicate that the probabilities of the pes- simistic, most likely, and optimistic outcomes are 25%, 50%, and 25%, respec-tively. Note that the sum of these probabilities must equal 100%; that is, they must be based on all the alternatives considered.Example 8.33 Aprobability distribution is a model that relates probabilities to the associated outcomes. The simplest type of probability distribution is the bar chart . The bar charts for Norman Company’s assets A and B are shown in Figure 8.1. Althoughboth assets have the same average return, the range of return is much greater, ormore dispersed, for asset B than for asset A—16 percent versus 4 percent. Most investments have more than two or three possible outcomes. In fact, the number of possible outcomes in most cases is practically infinite. If we knewall the possible outcomes and associated probabilities, we could develop acontinuous probability distribution. This type of distribution can be thought of as a bar chart for a very large number of outcomes. Figure 8.2 presents continuousprobability distributions for assets C and D. Note that although the two assetshave the same average return (15 percent), the distribution of returns for asset Dhas much greater dispersion than the distribution for asset C. Apparently, asset D is more risky than asset C. RISK MEASUREMENT In addition to considering the range of returns that an investment might produce, the risk of an asset can be measured quantitatively by using statistics. The mostcommon statistical measure used to describe an investment’s risk is its standarddeviation.CHAPTER 8 Risk and Return 315 51 9 13 17 21 25.50 .25Probability of OccurrenceReturn (%) Probability of OccurrenceAsset A 51 9 13 17 21 25.50 .25 Return (%)Asset BFIGURE 8.1 Bar Charts Bar charts for asset A’s andasset B’s returns probability distribution A model that relates probabilities to the associatedoutcomes. bar chart The simplest type of probabilitydistribution; shows only alimited number of outcomesand associated probabilities for a given event. continuous probability distribution A probability distribution showing all the possibleoutcomes and associatedprobabilities for a given event. 50 7 9 1 11 31 51 71 92 12 32 5Probability Density Return (%)Asset DAsset CFIGURE 8.2 Continuous Probability DistributionsContinuous probabilitydistributions for asset C’s and asset D’s returns Standard Deviation Thestandard deviation, r,measures the dispersion of an investment’s return around the expected return. Theexpected return, , is the average return that an investment is expected to produce over time. For an investment that has jdif- ferent possible returns, the expected return is calculated as follows:3 (8.2) where The expected values of returns for Norman Company’s assets A and B are pre-sented in Table 8.3. Column 1 gives the Pr j’s and column 2 gives the rj’s. In each casenequals 3. The expected value for each asset’s return is 15%.Example 8.43n=number of outcomes consideredPrj=probability of occurrence of the jth outcomerj=return for the jth outcomer=an j=1rj*PrjrS316 PART 4 Risk and the Required Rate of Return 3. The formula for finding the expected value of return, , when all of the outcomes, , are known andtheir related probabilities are equal, is a simple arithmetic average: (8.2a) where nis the number of observations.r=an j=1rj nrj rexpected value of a return ( ) The average return that an investment is expected toproduce over time.rstandard deviation ( ) The most common statisticalindicator of an asset’s risk; it measures the dispersionaround the expected value.Sr Expected Values of Returns for Assets A and B Weighted value Possible Probability Returns [(1) (2)] outcomes (1) (2) (3) Asset A Pessimistic 0.25 13% 3.25% Most likely 0.50 15 7.50Optimistic 17 Total Expected return % Asset B Pessimistic 0.25 7% 1.75% Most likely 0.50 15 7.50Optimistic 23 Total Expected return % 15.00 1.005.75 0.2515.00 1.004.25 0.25:TABLE 8.3 CHAPTER 8 Risk and Return 317 4. In practice, analysts rarely know the full range of possible investment outcomes and their probabilities. In these cases, analysts use historical data to estimate the standard deviation. The formula that applies in this situation is (8.3a) sr=aan j=1(rj-r)2 n-1TABLE 8.4The Calculation of the Standard Deviation of the Returns for Assets A and Ba jr j rj (rj )2Prj (rj )2Prj Asset A 1 13% 15% 2% 4% .25 1% 2 15 15 0 0 .50 03 17 15 2 4 .25 Asset B 1 7% 15% 8% 64% .25 16% 2 15 15 0 0 .50 03 23 15 8 64 .25 aCalculations in this table are made in percentage form rather than decimal form—for example, 13% rather than 0.13. As a result, some of the intermediate computations may appear to be inconsistent with those that would result from using decimal form. Regardless, the resulting standard deviations are correct and identicalto those that would result from using decimal rather than percentage form.srB=Ba3 j=1(rj-r)2*Prj=232% =5.66%a3 j=1(rj-r)2*Prj=32%16-srA=Ba3 j=1(rj-r)2*Prj=22% =1.41%a3 j=1(rj-r)2*Prj=2%1-: /H11546r /H11546r /H11546r rThe expression for the standard deviation of returns, r, is4 (8.3) In general, the higher the standard deviation, the greater the risk. Table 8.4 presents the standard deviations for Norman Company’s assets A and B, based on the earlier data. The standard deviation for asset A is 1.41%, and thestandard deviation for asset B is 5.66%. The higher risk of asset B is clearlyreflected in its higher standard deviation.Example 8.53sr=Aan j=1(rj-r)2*Prjs Historical Returns and Risk We can now use the standard deviation as a measure of risk to assess the historical (1900–2009) investment return data inTable 8.1. Table 8.5 repeats the historical nominal average returns in column 1and shows the standard deviations associated with each of them in column 2. Aclose relationship can be seen between the investment returns and the standarddeviations: Investments with higher returns have higher standard deviations. Forexample, stocks have the highest average return at 9.3 percent, which is morethan double the average return on Treasury bills. At the same time, stocks aremuch more volatile, with a standard deviation of 20.4 percent, more than fourtimes greater than the standard deviation of Treasury bills. Because higher stan-dard deviations are associated with greater risk, the historical data confirm theexistence of a positive relationship between risk and return. That relationshipreflects risk aversion by market participants, who require higher returns as com- pensation for greater risk. The historical data in columns 1 and 2 of Table 8.5clearly show that during the 1900–2009 period, investors were, on average,rewarded with higher returns on higher-risk investments.318 PART 4 Risk and the Required Rate of Return Matter of fact Table 8.5 shows that stocks are riskier than bonds, but are some stocks riskier than others? The answer is emphatically yes. A recent study examined the historical returns of large stocks and small stocks and found that the average annual return on large stocks from 1926 through 2009 was 11.8 percent, while small stocks earned 16.7 percent per year on average. The higher returns on small stocks came with a cost, however. The standard deviation of small stock returns was a whopping 32.8 percent, whereas the standard deviation on large stocks was just 20.5 percent.All Stocks Are Not Created EqualHistorical Returns and Standard Deviations on Selected Investments (1900–2009) TABLE 8.5 Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002).Investment Average nominal return Standard deviation Coefficient of variation Treasury bills 3.9% 4.7% 1.21 Treasury bonds 5.0 10.2 2.04Common stocks 9.3 20.4 2.19 Normal Distribution Anormal probability distribution, depicted in Figure 8.3, resembles a symmetrical “bell-shaped” curve. The symmetry of the curve meansthat half the probability is associated with the values to the left of the peak andhalf with the values to the right. As noted on the figure, for normal probabilitydistributions, 68 percent of the possible outcomes will lie between /H110061 standard deviation from the expected value, 95 percent of all outcomes will lie between /H110062 standard deviations from the expected value, and 99 percent of all outcomes willlie between /H110063 standard deviations from the expected value.normal probability distribution A symmetrical probability distribution whose shaperesembles a “bell-shaped”curve. Using the data in Table 8.5 and assuming that the probability distributions of returns for common stocks and bonds are normal, we can surmise that 68% of thepossible outcomes would have a return ranging between 11.1% and 29.7% forstocks and between 5.2% and 15.2% for bonds; 95% of the possible return out-comes would range between 31.5% and 50.1% for stocks and between 15.4%and 25.4% for bonds. The greater risk of stocks is clearly reflected in their much wider range of possible returns for each level of confidence (68% or 95%). Coefficient of Variation—Trading Off Risk and Return Thecoefficient of variation, CV,is a measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns. Equation 8.4gives the expression for the coefficient of variation: (8.4) A higher coefficient of variation means that an investment has more volatility rel-ative to its expected return. Because investors prefer higher returns and less risk,intuitively one might expect investors to gravitate towards investments with alow coefficient of variation. However, this logic doesn’t always apply for reasonsthat will emerge in the next section. For now, consider the coefficients of varia-tion in column 3 of Table 8.5. That table reveals that Treasury bills have thelowest coefficient of variation and therefore the lowest risk relative to theirreturn. Does this mean that investors should load up on Treasury bills and divestthemselves of stocks? Not necessarily. When the standard deviations (from Table 8.4) and the expected returns (fromTable 8.3) for assets A and B are substituted into Equation 8.4, the coefficients ofvariation for A and B are 0.094 (1.41% 15%) and 0.377 (5.66% 15%),respectively. Asset B has the higher coefficient of variation and is therefore morerisky than asset A—which we already know from the standard deviation.(Because both assets have the same expected return, the coefficient of variation has not provided any new information.), ,Example 8.73CV =sr r- –Example 8.63CHAPTER 8 Risk and Return 319 95% 99% 0 Return (%)Probability Density –3σr–2σr–1σrr +1σr+2σr+3σr68%FIGURE 8.3 Bell-Shaped Curve Normal probabilitydistribution, with ranges coefficient of variation ( CV) A measure of relative dispersion that is useful incomparing the risks of assetswith differing expected returns. Marilyn Ansbro is reviewing stocks for inclusion in her invest- ment portfolio. The stock she wishes to analyze is Danhaus Industries, Inc. (DII), a diversified manufacturer of pet products. One of her keyconcerns is risk; as a rule she will invest only in stocks with a coefficient of varia-tion below 0.75. She has gathered price and dividend data (shown in the accom-panying table) for DII over the past 3 years, 2010–2012, and assumes that eachyear’s return is equally probable.Personal Finance Example 8.83320 PART 4 Risk and the Required Rate of Return Stock Price Year Beginning End Dividend paid 2010 $35.00 $36.50 $3.50 2011 36.50 34.50 3.502012 34.50 35.00 4.00 Year Returns 2010 20112012 3$4.00 +($35.00 -$34.50) 4,$34.50 =$4.50 ,$34.50 =13.0%3$3.50 +($34.50 -$36.50) 4,$36.50 =$1.50 ,$36.50 =4.1%3$3.50 +($36.50 -$35.00) 4,$35.00 =$5.00 ,$35.00 =14.3%Substituting the price and dividend data for each year into Equation 8.1, we get: Substituting into Equation 8.2a, given that the returns are equally probable, we get the average return, : Substituting the average return and annual returns into Equation 8.3a, we get the standard deviation, r2010–2012 : Finally, substituting the standard deviation of returns and the average return into Equation 8.4, we get the coefficient of variation, CV: Because the coefficient of variation of returns on the DII stock over the 2010–2012 period of 0.53 is well below Marilyn’s maximum coefficient of varia- tion of 0.75, she concludes that the DII stock would be an acceptable investment. 6REVIEW QUESTIONS 8–4Explain how the range is used in scenario analysis. 8–5What does a plot of the probability distribution of outcomes show a decision maker about an asset’s risk?CV =5.6% ,10.5% =0.53=2(14.44% +40.96% +6.25%) ,2=230.825% =5.6%sr2010–201 =23(14.3% -10.5%)2+(4.1% -10.5%)2+(13.0% -10.5%)24,(3-1)sr2010–2012 =(14.3% +4.1% +13.0%) ,3=10.5%r2010–2012 8–6What relationship exists between the size of the standard deviation and the degree of asset risk? 8–7What does the coefficient of variation reveal about an investment’s risk that the standard deviation does not?CHAPTER 8 Risk and Return 321 8.3Risk of a Portfolio In real-world situations, the risk of any single investment would not be viewed independently of other assets. New investments must be considered in light oftheir impact on the risk and return of an investor’s portfolio of assets. The finan- cial manager’s goal is to create an efficient portfolio, one that provides the max- imum return for a given level of risk. We therefore need a way to measure thereturn and the standard deviation of a portfolio of assets. As part of that analysis,we will look at the statistical concept of correlation, which underlies the process of diversification that is used to develop an efficient portfolio. PORTFOLIO RETURN AND STANDARD DEVIATION Thereturn on a portfolio is a weighted average of the returns on the individual assets from which it is formed. We can use Equation 8.5 to find the portfolioreturn, r p: (8.5) where Of course, , which means that 100 percent of the portfolio’s assets must be included in this computation. James purchases 100 shares of Wal-Mart at a price of $55 per share, so his totalinvestment in Wal-Mart is $5,500. He also buys 100 shares of Cisco Systems at$25 per share, so the total investment in Cisco stock is $2,500. Combining thesetwo holdings, James’s total portfolio is worth $8,000. Of the total, 68.75% isinvested in Wal-Mart ($5,500 $8,000) and 31.25% is invested in Cisco Systems ($2,500 $8,000). Thus, w10.6875, w20.3125, and . Thestandard deviation of a portfolio’s returns is found by applying the for- mula for the standard deviation of a single asset. Specifically, Equation 8.3 isused when the probabilities of the returns are known, and Equation 8.3a (fromfootnote 4) is applied when analysts use historical data to estimate the standarddeviation.w 1+w2=1.0 = = ,,Example 8.93gn j=1wj=1rj=return on asset jwj=proportion of the portfolio’s total dollar value represented by asset jrp=(w1*r1)+(w2*r2)+Á+ (wn*rn)=an j=1wj*rjLG4 LG3 efficient portfolio A portfolio that maximizes return for a given level of risk. Assume that we wish to determine the expected value and standard deviation of returns for portfolio XY, created by combining equal portions (50% each) ofassets X and Y. The forecasted returns of assets X and Y for each of the next 5years (2013–2017) are given in columns 1 and 2, respectively, in part A of Table8.6. In column 3, the weights of 50% for both assets X and Y along with theirrespective returns from columns 1 and 2 are substituted into Equation 8.5.Column 4 shows the results of the calculation—an expected portfolio return of12% for each year, 2013 to 2017. Furthermore, as shown in part B of Table 8.6, the expected value of these portfolio returns over the 5-year period is also 12% (calculated by usingEquation 8.2a, in footnote 3). In part C of Table 8.6, portfolio XY’s standarddeviation is calculated to be 0% (using Equation 8.3a, in footnote 4). This valueshould not be surprising because the portfolio return each year is the same— 12%. Portfolio returns do not vary through time.Example 8.10 3322 PART 4 Risk and the Required Rate of Return Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY A. Expected Portfolio Returns Forecasted return Expected portfolio Asset X Asset Y Portfolio return calculationareturn, rp Year (1) (2) (3) (4) 2013 8% 16% 12% 2014 10 14 122015 12 12 122016 14 10 122017 16 8 12 B. Expected Value of Portfolio Returns, 2013–2017b C. Standard Deviation of Expected Portfolio Returnsc aUsing Equation 8.5. bUsing Equation 8.2a found in footnote 3. cUsing Equation 8.3a found in footnote 4.=B0% 4=0%=B0% +0% +0% +0% +0% 4srp=B(12% -12%)2+(12% -12%)2+(12% -12%)2+(12% -12%)2+(12% -12%)2 5-1rp=12% +12% +12% +12% +12% 5=60% 5=12%(0.50 *16%) +(0.50 *8%) =(0.50 *14%) +(0.50 *10%) =(0.50 *12%) +(0.50 *12%) =(0.50 *10%) +(0.50 *14%) =(0.50 *8%) +(0.50 *16%) =TABLE 8.6 CORRELATION Correlation is a statistical measure of the relationship between any two series of numbers. The numbers may represent data of any kind, from returns to testscores. If two series tend to vary in the same direction, they are positively corre- lated. If the series vary in opposite directions, they are negatively correlated. For example, suppose we gathered data on the retail price and weight of new cars. Itis likely that we would find that larger cars cost more than smaller ones, so wewould say that among new cars weight and price are positively correlated. If wealso measured the fuel efficiency of these vehicles (as measured by the number ofmiles they can travel per gallon of gasoline), we would find that lighter cars aremore fuel efficient than heavier cars. In that case, we would say that fueleconomy and vehicle weight are negatively correlated. 5 The degree of correlation is measured by the correlation coefficient, which ranges from for perfectly positively correlated series to for perfectly nega- tively correlated series. These two extremes are depicted for series M and N in Figure 8.4. The perfectly positively correlated series move exactly togetherwithout exception; the perfectly negatively correlated series move in exactlyopposite directions. DIVERSIFICATION The concept of correlation is essential to developing an efficient portfolio. Toreduce overall risk, it is best to diversify by combining, or adding to the portfolio, assets that have the lowest possible correlation. Combining assets that have a lowcorrelation with each other can reduce the overall variability of a portfolio’sreturns. Figure 8.5 (see page 324) shows the returns that two assets, F and G,earn over time. Both assets earn the same average or expected return, butnote that when F’s return is above average, the return on G is below average andvice versa. In other words, returns on F and G are negatively correlated, andwhen these two assets are combined in a portfolio, the risk of that portfolio fallswithout reducing the average return (that is, the portfolio’s average return is also ). r r,-1 +1CHAPTER 8 Risk and Return 323 5. Note here that we are talking about general tendencies. For instance, a large hybrid SUV might have better fuel economy than a smaller sedan powered by a conventional gas engine. This does not change the fact that the general tendency is for lighter cars to achieve better fuel economy.correlation A statistical measure of the relationship between any twoseries of numbers. positively correlated Describes two series that movein the same direction. negatively correlated Describes two series that movein opposite directions. correlation coefficient A measure of the degree ofcorrelation between two series. perfectly positively correlated Describes two positively correlated series that have a correlation coefficient of 1.+ perfectly negatively correlated Describes two negatively correlated series that have a correlation coefficient of 1.- Perfectly Positively Correlated Perfectly Negatively CorrelatedReturn ReturnN M MN Time TimeFIGURE 8.4 Correlations The correlation between series M and series N For risk-averse investors, this is very good news. They get rid of something that they don’t like (risk) without having to sacrifice what they do like (return). Evenif assets are positively correlated, the lower the correlation between them, thegreater the risk reduction that can be achieved through diversification. Some assets are uncorrelated —that is, there is no interaction between their returns. Combining uncorrelated assets can reduce risk, not as effectively ascombining negatively correlated assets but more effectively than combining pos-itively correlated assets. The correlation coefficient for uncorrelated assets is close to zero and acts as the midpoint between perfect positive and perfect nega- tive correlation. The creation of a portfolio that combines two assets with perfectly positively correlated returns results in overall portfolio risk that at minimum equals that ofthe least risky asset and at maximum equals that of the most risky asset.However, a portfolio combining two assets with less than perfectly positive cor-relation canreduce total risk to a level below that of either of the components. For example, assume that you buy stock in a company that manufacturesmachine tools. The business is very cyclical, so the stock will do well when the economy is expanding, and it will do poorly during a recession. If you boughtshares in another machine-tool company, with sales positively correlated withthose of your firm, the combined portfolio would still be cyclical and risk wouldnot be reduced a great deal. Alternatively, however, you could buy stock in a dis-count retailer, whose sales are countercyclical. It typically performs worse during economic expansions than it does during recessions (when consumers are tryingto save money on every purchase). A portfolio that contained both of these stocksmight be less volatile than either stock on its own. Table 8.7 presents the forecasted returns from three different assets—X, Y, andZ—over the next 5 years, along with their expected values and standard devia-tions. Each of the assets has an expected return of 12% and a standard deviationof 3.16%. The assets therefore have equal return and equal risk. The return pat-terns of assets X and Y are perfectly negatively correlated. When X enjoys itshighest return, Y experiences its lowest return, and vice versa. The returns ofassets X and Z are perfectly positively correlated. They move in precisely thesame direction, so when the return on X is high, so is the return on Z. ( Note: TheExample 8.11 3324 PART 4 Risk and the Required Rate of Return Return Return ReturnAsset F Asset GPortfolio of Assets F and G Time Time Timer rFIGURE 8.5 Diversification Combining negativelycorrelated assets to reduce, or diversify, risk uncorrelated Describes two series that lack any interaction and thereforehave a correlation coefficient close to zero. returns for X and Z are identical.)6Now let’s consider what happens when we combine these assets in different ways to form portfolios. Portfolio XY Portfolio XY (shown in Table 8.7) is created by combining equal portions of assets X and Y, the perfectly negatively correlated assets. (Calculationof portfolio XY’s annual returns, the expected portfolio return, and the standarddeviation of returns was demonstrated in Table 8.6 on page 322.) The risk in thisportfolio, as reflected by its standard deviation, is reduced to 0%, whereas theexpected return remains at 12%. Thus, the combination results in the completeelimination of risk because in each and every year the portfolio earns a 12%return. 7Whenever assets are perfectly negatively correlated, some combination of the two assets exists such that the resulting portfolio’s returns are risk free. Portfolio XZ Portfolio XZ (shown in Table 8.7) is created by combining equal portions of assets X and Z, the perfectly positively correlated assets. Individually,assets X and Z have the same standard deviation, 3.16%, and because theyCHAPTER 8 Risk and Return 325 TABLE 8.7Forecasted Returns, Expected Values, and Standard Deviations for Assets X, Y, and Z and Portfolios XY and XZ Assets Portfolios XYaXZb Year X Y Z (50% X 50% Y) (50% X 50% Z) 2013 8% 16% 8% 12% 8% 2014 10 14 10 12 102015 12 12 12 12 122016 14 10 14 12 142017 16 8 16 12 16 Statistics: c Expected value 12% 12% 12% 12% 12% Standard deviationd3.16% 3.16% 3.16% 0% 3.16% aPortfolio XY, which consists of 50 percent of asset X and 50 percent of asset Y, illustrates perfect negative correlation because these two return streams behave in completely opposite fashion over the 5-year period. Its return values shown here were calculated in part A of Table 8.6. bPortfolio XZ, which consists of 50 percent of asset X and 50 percent of asset Z, illustrates perfect positive correlation because these two return streams behave identically over the 5-year period. Its return values were calculated by using the same method demonstrated for portfolio XY in part A of Table 8.6. cBecause the probabilities associated with the returns are not given, the general equations, Equation 8.2a in footnote 3 and Equ ation 8.3a in footnote 4, were used to calculate expected values and standard deviations, respectively. Calculation of the expected value and standard deviation for portfolio XY is demonstrated in parts B and C, respectively, of Table 8.6. dThe portfolio standard deviations can be directly calculated from the standard deviations of the component assets with the foll owing formula: where w1andw2are the proportions of component assets 1 and 2, 1and 2are the standard deviations of component assets 1 and 2, and c1,2is the correlation coefficient between the returns of component assets 1 and 2.sssrp=2w2 1s21+w2 2s22+2w1w2c1,2s1s2/H11545 /H11545 6. Identical return streams are used in this example to permit clear illustration of the concepts, but it is notnecessary for return streams to be identical for them to be perfectly positively correlated. Any return streams that move exactly together—regardless of the relative magnitude of the returns—are perfectly positively correlated. 7. Perfect negative correlation means that the ups and downs experienced by one asset are exactly offset by move- ments in the other asset. Therefore, the portfolio return does not vary over time. always move together, combining them in a portfolio does nothing to reduce risk—the portfolio standard deviation is also 3.16%. As was the case with port-folio XY, the expected return of portfolio XZ is 12%. Because both of these port-folios provide the same expected return, but portfolio XY achieves that expectedreturn with no risk, portfolio XY is clearly preferred by risk-averse investors over portfolio XZ. CORRELATION, DIVERSIFICATION, RISK, AND RETURN In general, the lower the correlation between asset returns, the greater the riskreduction that investors can achieve by diversifying. The following example illus-trates how correlation influences the risk of a portfolio but not the portfolio’sexpected return. Consider two assets—Lo and Hi—with the characteristics described in the tablebelow: Example 8.12 3326 PART 4 Risk and the Required Rate of Return Expected Risk (standard Asset return, deviation), Lo 6% 3% Hi 8 8S r Clearly, asset Lo offers a lower return than Hi does, but Lo is also less risky than Hi. It is natural to think that a portfolio combining Lo and Hi would offer areturn that is between 6% and 8% and that the portfolio’s risk would also fallbetween the risk of Lo and Hi (between 3% and 8%). That intuition is onlypartly correct. The performance of a portfolio consisting of assets Lo and Hi depends not only on the expected return and standard deviation of each asset (given above),but also on how the returns on the two assets are correlated. We will illustrate theresults of three specific scenarios: (1) returns on Lo and Hi are perfectly positivelycorrelated, (2) returns on Lo and Hi are uncorrelated, and (3) returns on Lo andHi are perfectly negatively correlated. The results of the analysis appear in Figure 8.6. Whether the correlation between Lo and Hi is , 0, or , a portfolio of those two assets must have anexpected return between 6% and 8%. That is why the line segments at left inFigure 8.6 all range between 6% and 8%. However, the standard deviation of aportfolio depends critically on the correlation between Lo and Hi. Only when Loand Hi are perfectly positively correlated can it be said that the portfolio standarddeviation must fall between 3% (Lo’s standard deviation) and 8% (Hi’s standarddeviation). As the correlation between Lo and Hi becomes weaker (that is, as thecorrelation coefficient falls), investors may find that they can form portfolios ofLo and Hi with standard deviations that are even less than 3% (that is, portfoliosthat are less risky than holding asset Lo by itself). That is why the line segmentsat right in Figure 8.6 vary. In the special case when Lo and Hi are perfectly nega-tively correlated, it is possible to diversify away all of the risk and form a port- folio that is risk free.-1 +1 INTERNATIONAL DIVERSIFICATION One excellent practical example of portfolio diversification involves including foreign assets in a portfolio. The inclusion of assets from countries with businesscycles that are not highly correlated with the U.S. business cycle reduces the port-folio’s responsiveness to market movements. The ups and the downs of differentmarkets around the world offset each other, at least to some extent, and the resultis a portfolio that is less risky than one invested entirely in the U.S. market. Returns from International Diversification Over long periods, internationally diversified portfolios tend to perform better(meaning that they earn higher returns relative to the risks taken) than purelydomestic portfolios. However, over shorter periods such as a year or two, interna-tionally diversified portfolios may perform better or worse than domestic portfolios.For example, consider what happens when the U.S. economy is performing rela-tively poorly and the dollar is depreciating in value against most foreign currencies.At such times, the dollar returns to U.S. investors on a portfolio of foreign assets canbe very attractive. However, international diversification can yield subpar returns,particularly when the dollar is appreciating in value relative to other currencies.When the U.S. currency appreciates, the dollar value of a foreign-currency-denominated portfolio of assets declines. Even if this portfolio yields a satisfactoryreturn in foreign currency, the return to U.S. investors will be reduced when foreignprofits are translated into dollars. Subpar local currency portfolio returns, coupledwith an appreciating dollar, can yield truly dismal dollar returns to U.S. investors. Overall, though, the logic of international portfolio diversification assumes that these fluctuations in currency values and relative performance will averageout over long periods. Compared to similar, purely domestic portfolios, an inter-nationally diversified portfolio will tend to yield a comparable return at a lowerlevel of risk. Risks of International Diversification In addition to the risk induced by currency fluctuations, several other financialrisks are unique to international investing. Most important is political risk, whichCHAPTER 8 Risk and Return 327 056789 0123456789Ranges of Return Coefficient Ranges of Risk +1 (Perfect positive) 0 (Uncorrelated) –1 (Perfect negative) rLorHi Portfolio Return (%) (rp)+1 0 –1 σrLoσrHi Portfolio Risk (%) (σrp)FIGURE 8.6 Possible Correlations Range of portfolio return ( ) and risk ( ) for combinations of assets Lo and Hi for variouscorrelation coefficientss rprp political risk Risk that arises from the possibility that a hostgovernment will take actionsharmful to foreign investors orthat political turmoil willendanger investments. arises from the possibility that a host government will take actions harmful to foreign investors or that political turmoil will endanger investments. Politicalrisks are particularly acute in developing countries, where unstable or ideologi-cally motivated governments may attempt to block return of profits by foreigninvestors or even seize (nationalize) their assets in the host country. For example,reflecting President Chavez’s desire to broaden the country’s socialist revolution,Venezuela issued a list of priority goods for import that excluded a large per-centage of the necessary inputs to the automobile production process. As a result,Toyota halted auto production in Venezuela, and three other auto manufacturerstemporarily closed or deeply cut their production there. Chavez also has forcedmost foreign energy firms to reduce their stakes and give up control of oil projectsin Venezuela. For more discussion of reducing risk through international diversification, see the Global Focus box above. 6REVIEW QUESTIONS 8–8What is an efficient portfolio? How can the return and standard devia- tion of a portfolio be determined? 8–9Why is the correlation between asset returns important? How does diversification allow risky assets to be combined so that the risk of theportfolio is less than the risk of the individual assets in it? 8–10 How does international diversification enhance risk reduction? Whenmight international diversification result in subpar returns? What arepolitical risks, and how do they affect international diversification?328 PART 4 Risk and the Required Rate of Return GLOBAL focus An International Flavor to Risk Reduction Earlier in this chapter (see Table 8.5 on page 318), we learned that from1900 through 2009 the U.S. stock market produced an average annualnominal return of 9.3 percent, but thatreturn was associated with a relativelyhigh standard deviation: 20.4 percent per year. Could U.S. investors have done better by diversifying globally ? The answer is a qualified yes. ElroyDimson, Paul Marsh, and MikeStaunton calculated the historical returns on a portfolio that included U.S. stocksas well as stocks from 18 other coun-tries. This diversified portfolio produced returns that were not quite as high as the U.S. average, just 8.6 percent peryear. However, the globally diversifiedportfolio was also less volatile, with anannual standard deviation of 17.8 per-cent. Dividing the standard deviation by the annual return produces a coeffi- cient of variation for the globally diversified portfolio of 2.07, slightly lower than the 2.10 coefficient of variation reported for U.S. stocks inTable 8.5. 3 International mutual funds do not include any domestic assets whereas global mutual funds include both foreign and domestic assets. How might this difference affect their correlation with U.S. equity mutual funds?in practice Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton University Press, 2002). CHAPTER 8 Risk and Return 329 8.4Risk and Return: The Capital Asset Pricing Model (CAPM) Thus far we have observed a tendency for riskier investments to earn higher returns, and we have learned that investors can reduce risk through diversifica-tion. Now we want to quantify the relationship between risk and return. In otherwords, we want to measure how much additional return an investor should expectfrom taking a little extra risk. The classic theory that links risk and return for allassets is the capital asset pricing model (CAPM). We will use the CAPM to under- stand the basic risk–return tradeoffs involved in all types of financial decisions. TYPES OF RISK In the last section we saw that the standard deviation of a portfolio is often lessthan the standard deviation of the individual assets in the portfolio. That’s thepower of diversification. To see this more clearly, consider what happens to therisk of a portfolio consisting of a single security (asset), to which we add securi-ties randomly selected from, say, the population of all actively traded securities.Using the standard deviation of return, rp, to measure the total portfolio risk, Figure 8.7 depicts the behavior of the total portfolio risk ( yaxis) as more securi- ties are added ( xaxis). With the addition of securities, the total portfolio risk declines, as a result of diversification, and tends to approach a lower limit. Thetotal risk of a security can be viewed as consisting of two parts: (8.6) Diversifiable risk (sometimes called unsystematic risk ) represents the portion of an asset’s risk that is associated with random causes that can be eliminatedthrough diversification. It is attributable to firm-specific events, such as strikes,lawsuits, regulatory actions, or the loss of a key account. Figure 8.7 shows thatdiversifiable risk gradually disappears as the number of stocks in the portfolioincreases. Nondiversifiable risk (also called systematic risk ) is attributable toTotal security risk =Nondiversifiable risk +Diversifiable risksLG6 LG5 capital asset pricing model (CAPM) The basic theory that links risk and return for all assets. total risk The combination of a security’s nondiversifiable risk and diversifiable risk. diversifiable risk The portion of an asset’s riskthat is attributable to firm-specific, random causes; canbe eliminated throughdiversification. Also called unsystematic risk. nondiversifiable risk The relevant portion of anasset’s risk attributable tomarket factors that affect allfirms; cannot be eliminatedthrough diversification. Alsocalled systematic risk . Nondiversifiable RiskTotal RiskDiversifiable RiskPortfolio Risk, σrP 1 5 10 15 20 25 Number of Securities (Assets) in PortfolioFIGURE 8.7 Risk Reduction Portfolio risk anddiversification market factors that affect all firms; it cannot be eliminated through diversifica- tion. Factors such as war, inflation, the overall state of the economy, internationalincidents, and political events account for nondiversifiable risk. In Figure 8.7,nondiversifiable risk is represented by the horizontal black line below which theblue curve can never go, no matter how diversified the portfolio becomes. Because any investor can easily create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is nondiversifiable risk. Any investor or firm therefore must be concerned solely with nondiversifiable risk.The measurement of nondiversifiable risk is thus of primary importance inselecting assets with the most desired risk–return characteristics. THE MODEL: CAPM The capital asset pricing model (CAPM) links nondiversifiable risk to expectedreturns. We will discuss the model in five sections. The first section deals with thebeta coefficient, which is a measure of nondiversifiable risk. The second sectionpresents an equation of the model itself, and the third section graphically describesthe relationship between risk and return. The fourth section discusses the effects ofchanges in inflationary expectations and risk aversion on the relationship betweenrisk and return. The fifth section offers some comments on the CAPM. Beta Coefficient Thebeta coefficient, b,is a relative measure of nondiversifiable risk. It is an index of the degree of movement of an asset’s return in response to a change in themarket return. An asset’s historical returns are used in finding the asset’s beta coefficient. The market return is the return on the market portfolio of all traded securities. The Standard & Poor’s 500 Stock Composite Index or some similar stock index is commonly used as the market return. Betas for actively tradedstocks can be obtained from a variety of sources, but you should understand howthey are derived and interpreted and how they are applied to portfolios. Deriving Beta from Return Data An asset’s historical returns are used in finding the asset’s beta coefficient. Figure 8.8 plots the relationship between thereturns of two assets—R and S—and the market return. Note that the horizontal(x) axis measures the historical market returns and that the vertical ( y) axis meas- ures the individual asset’s historical returns. The first step in deriving betainvolves plotting the coordinates for the market return and asset returns fromvarious points in time. Such annual “market return–asset return” coordinates areshown for asset S only for the years 2005 through 2012. For example, in 2012, asset S’s return was 20 percent when the market return was 10 percent. By use ofstatistical techniques, the “characteristic line” that best explains the relationshipbetween the asset return and the market return coordinates is fit to the datapoints. 8The slope of this line is beta. The beta for asset R is about 0.80, and that for asset S is about 1.30. Asset S’s higher beta (steeper characteristic line slope)indicates that its return is more responsive to changing market returns. Therefore asset S is more risky than asset R .330 PART 4 Risk and the Required Rate of Return beta coefficient ( b) A relative measure of nondiversifiable risk. An index of the degree of movement ofan asset’s return in response toa change in the market return. market return The return on the marketportfolio of all tradedsecurities. 8. The empirical measurement of beta is approached by using least-squares regression analysis . Interpreting Betas The beta coefficient for the entire market equals 1.0. All other betas are viewed in relation to this value. Asset betas may be positive or neg-ative, but positive betas are the norm. The majority of beta coefficients fall between0.5 and 2.0. The return of a stock that is half as responsive as the market should change by 0.5 percent for each 1 percent change in the return of the marketportfolio. A stock that is twice as responsive as the market should expe-rience a 2 percent change in its return for each 1 percent change in the return of themarket portfolio. Table 8.8 provides various beta values and their interpretations.Beta coefficients for actively traded stocks can be obtained from published sourcessuch as Value Line Investment Survey, via the Internet, or through brokerage firms. Betas for some selected stocks are given in Table 8.9.(b=2.0)(b=0.5)CHAPTER 8 Risk and Return 331 –20 –1035 3025 20 15 10 5 –15–10 –20 –25 –30–510015 20 25 30 35 (2008)(2007)(2006) (2011)(2010) (2012) (2005)(2009) bR = slope = .80bS = slope = 1.30 Asset RAsset S Market Return (%) Characteristic Line S Characteristic Line RAsset Return (%) aAll data points shown are associated with asset S. No data points are shown for asset R. FIGURE 8.8 Beta Derivationa Graphical derivation of beta for assets R and S Selected Beta Coefficients and Their Interpretations Beta Comment Interpretation 2.0 Move in same Twice as responsive as the market 1.0 direction as Same response as the market0.5 market Only half as responsive as the market 0 Unaffected by market movement Move in opposite Only half as responsive as the market direction to Same response as the marketmarket Twice as responsive as the market -2.0-1.0-0.5TABLE 8.8 Portfolio Betas The beta of a portfolio can be easily estimated by using the betas of the individual assets it includes. Letting wjrepresent the proportion of the portfolio’s total dollar value represented by asset j, and letting bjequal the beta of asset j, we can use Equation 8.7 to find the portfolio beta, bp: (8.7) Of course, , which means that 100 percent of the portfolio’s assets must be included in this computation. Portfolio betas are interpreted in the same way as the betas of individual assets. They indicate the degree of responsiveness of the portfolio’s return to changes in the market return. For example, when the market return increases by10 percent, a portfolio with a beta of 0.75 will experience a 7.5 percent increasein its return ; a portfolio with a beta of 1.25 will experience a 12.5 percent increase in its return . Clearly, a portfolio containingmostly low-beta assets will have a low beta, and one containing mostly high-betaassets will have a high beta. Mario Austino, an individual investor, wishes to assess the risk of two small portfolios he is considering—V and W. Both port- folios contain five assets, with the proportions and betas shown in Table 8.10.The betas for the two portfolios, b VandbW, can be calculated by substituting data from the table into Equation 8.7: =0.080 +0.100 +0.130 +0.075 +0.525 =0.91bW=(0.10 *.80) +(0.10 *1.00) +(0.20 *.65) +(0.10 *.75) +(0.50 *1.05)=0.165 +0.300 +0.260 +0.220 +0.250 =1.195 L1.20bV=(0.10 *1.65) +(0.30 *1.00) +(0.20 *1.30) +(0.20 *1.10) +(0.20 *1.25)Personal Finance Example 8.13 3(1.25 *10%)(0.75 *10%)gn j=1wj=1bp=(w1*b1)+(w2*b2)+Á +(wn*bn)=an j=1wj*bj332 PART 4 Risk and the Required Rate of Return Beta Coefficients for Selected Stocks (June 7, 2010) TABLE 8.9 Source: www.finance.yahoo.comStock Beta Stock Beta Amazon.com 0.99 JP Morgan Chase & Co. 1.16 Anheuser-Busch 1.00 Bank of America 2.58Ford Motor 2.72 Microsoft 0.99Disney 1.25 Nike, Inc. 0.92eBay 1.75 PepsiCo, Inc. 0.57ExxonMobil Corp. 0.37 Qualcomm 0.89Gap (The), Inc. 1.31 Sempra Energy 0.60General Electric 1.68 Wal-Mart Stores 0.29Intel 1.12 Xerox 1.50Int’l Business Machines 0.68 Yahoo! Inc. 0.92 Portfolio V’s beta is about 1.20, and portfolio W’s is 0.91. These values make sense because portfolio V contains relatively high-beta assets, and portfolio Wcontains relatively low-beta assets. Mario’s calculations show that portfolio V’sreturns are more responsive to changes in market returns and are therefore morerisky than portfolio W’s. He must now decide which, if either, portfolio he feels comfortable adding to his existing investments. The Equation Using the beta coefficient to measure nondiversifiable risk, the capital asset pricing model (CAPM) is given in Equation 8.8: (8.8) where on a U.S. Treasury bill The CAPM can be divided into two parts: (1) the risk-free rate of return, RF, which is the required return on a risk-free asset, typically a 3-month U.S. Treasury bill (T-bill), a short-term IOU issued by the U.S. Treasury, and (2) the risk premium. These are, respectively, the two elements on either side of the plus sign in Equation 8.8. The ( rm RF) portion of the risk premium is called the market risk premium because it represents the premium the investor must receive for taking the average amount of risk associated with holding the marketportfolio of assets. Historical Risk Premiums Using the historical return data for stocks, bonds, and Treasury bills for the 1900–2009 period shown in Table 8.1, we can calculate the risk premiums for each investment category. The calcula-tion (consistent with Equation 8.8) involves merely subtracting the historical -r m=market return; return on the market portfolio of assetsbj=beta coefficient or index of nondiversifiable risk for asset jRF=risk-free rate of return, commonly measured by the returnrj=required return on asset jrj=RF+3bj*(rm-RF)4CHAPTER 8 Risk and Return 333 Mario Austino’s Portfolios V and W Portfolio V Portfolio W Asset Proportion Beta Proportion Beta 1 0.10 1.65 0.10 0.80 2 0.30 1.00 0.10 1.003 0.20 1.30 0.20 0.654 0.20 1.10 0.10 0.755 1.25 1.05 Totals 1.00 1.000.50 0.20TABLE 8.10 risk-free rate of return, ( RF) The required return on a risk- free asset, typically a 3-month U.S. Treasury bill. U.S. Treasury bills (T-bills) Short-term IOUs issued by theU.S. Treasury; considered the risk-free asset. U.S. Treasury bill’s average return from the historical average return for a given investment:334 PART 4 Risk and the Required Rate of Return Investment Risk premiuma Stocks Treasury bonds aReturn values obtained from Table 8.1.5.0 -3.9 =1.19.3% -3.9% =5.4% Reviewing the risk premiums calculated above, we can see that the risk pre- mium is higher for stocks than for bonds. This outcome makes sense intuitivelybecause stocks are riskier than bonds (equity is riskier than debt). Benjamin Corporation, a growing computer software developer, wishes to deter-mine the required return on an asset Z, which has a beta of 1.5. The risk-free rateof return is 7%; the return on the market portfolio of assets is 11%. Substituting , and into the capital asset pricing model given in Equation 8.8 yields a required return of The market risk premium of when adjusted for the asset’s index of risk (beta) of 1.5, results in a risk premium of 6% (1.5 4%). That risk premium, when added to the 7% risk-free rate, results in a 13% required return. Other things being equal, the higher the beta, the higher the required return, and the lower the beta, the lower the required return. The Graph: The Security Market Line (SML) When the capital asset pricing model (Equation 8.8) is depicted graphically, it iscalled the security market line (SML). The SML will, in fact, be a straight line. It reflects the required return in the marketplace for each level of nondiversifiablerisk (beta). In the graph, risk as measured by beta, b, is plotted on the xaxis, and required returns, r, are plotted on the yaxis. The risk–return trade-off is clearly represented by the SML. In the preceding example for Benjamin Corporation, the risk-free rate, RF, was 7%, and the market return, rm, was 11%. The SML can be plotted by using the two sets of coordinates for the betas associated with RFandrm, and bm(that is, ,9; and . Figure 8.9 presents the resulting security market line. As traditionally shown, the security market line inbm=1.0,rm=11%) RF=7% bRF=0bRFExample 8.15 3*4% (11% -7%),rZ=7% +31.5 *(11% -7%)4=7% +6% =13%rm=11% bZ=1.5,RF=7%Example 8.14 3 9. Because RFis the rate of return on a risk-free asset, the beta associated with the risk-free asset, , would equal 0. The zero beta on the risk-free asset reflects not only its absence of risk but also that the asset’s return is unaffectedby movements in the market return.b RFsecurity market line (SML) The depiction of the capital asset pricing model (CAPM ) as a graph that reflects therequired return in themarketplace for each level ofnondiversifiable risk (beta). Figure 8.9 presents the required return associated with all positive betas. The market risk premium of 4% of 7%) has been highlighted. For abeta for asset Z, b Z, of 1.5, its corresponding required return, rZ, is 13%. Also shown in the figure is asset Z’s risk premium of 6% ( rZof of 7%). It should be clear that for assets with betas greater than 1, the risk premium isgreater than that for the market; for assets with betas less than 1, the risk pre- mium is less than that for the market. Shifts in the Security Market Line The security market line is not stable over time, and shifts in the security marketline can result in a change in required return. The position and slope of the SMLare affected by two major forces—inflationary expectations and risk aversion—which are analyzed next. 10 Changes in Inflationary Expectations Changes in inflationary expectations affect the risk-free rate of return, RF.The equation for the risk-free rate of return is (8.9) This equation shows that, assuming a constant real rate of interest, r*,changes in inflationary expectations, reflected in an inflation premium, IP, will result in corresponding changes in the risk-free rate. Therefore, a change in inflationaryRF=r*+IP13% -RF(rm of 11% -RFCHAPTER 8 Risk and Return 335Required Return, r (%)17 15 rZ = 13 rm = 11 9 RF = 7 5 3 1 .5 0 1.0 1.5 2.0Market RiskPremium (4%)Asset Z’s RiskPremium(6%)SML b RFbmbZ Nondiversifiable Risk, bFIGURE 8.9 Security Market Line Security market line (SML)with Benjamin Corporation’s asset Z data shown 10. A firm’s beta can change over time as a result of changes in the firm’s asset mix, in its financing mix, or in external factors not within management’s control, such as earthquakes, toxic spills, and so on. expectations that results from events such as international trade embargoes or major changes in Federal Reserve policy will result in a shift in the SML. Becausethe risk-free rate is a basic component of all rates of return, any change in R Fwill be reflected in allrequired rates of return. Changes in inflationary expectations result in parallel shifts in the SML in direct response to the magnitude and direction of the change. This effect can bestbe illustrated by an example. In the preceding example, using the CAPM, the required return for asset Z, rZ, was found to be 13%. Assuming that the risk-free rate of 7% includes a 2% real rate ofinterest, r*, and a 5% inflation premium, IP, then Equation 8.9 confirms that Now assume that recent economic events have resulted in an increase of 3% in inflationary expectations, raising the inflation premium to 8% ( IP 1). As a result, all returns likewise rise by 3%. In this case, the new returns (noted by sub-script 1) are Substituting these values, along with asset Z’s beta ( b Z) of 1.5, into the CAPM (Equation 8.8), we find that asset Z’s new required return ( ) can be calculated: Comparing of 16% to rZof 13%, we see that the change of 3% in asset Z’s required return exactly equals the change in the inflation premium. The same 3%increase results for all assets. Figure 8.10 depicts the situation just described. It shows that the 3% increase in inflationary expectations results in a parallel shift upward of 3% in the SML.Clearly, the required returns on all assets rise by 3%. Note that the rise in theinflation premium from 5% to 8% ( IPtoIP 1) causes the risk-free rate to rise from 7% to 10% ( RFto ) and the market return to increase from 11% to 14% (rmto ). The security market line therefore shifts upward by 3% (SML to SML 1), causing the required return on all risky assets, such as asset Z, to rise by 3%. The important lesson here is that a given change in inflationary expectations will be fully reflected in a corresponding change in the returns of all assets, as reflected graphically in a parallel shift of the SML. Changes in Risk Aversion The slope of the security market line reflects the general risk preferences of investors in the marketplace. As discussed earlier, mostinvestors are risk averse —they require increased returns for increased risk. This positive relationship between risk and return is graphically represented by theSML, which depicts the relationship between nondiversifiable risk as measuredby beta ( xaxis) and the required return ( yaxis). The slope of the SML reflects the degree of risk aversion: the steeper its slope, the greater the degree of risk aver- sion because a higher level of return will be required for each level of risk as measured by beta. In other words, risk premiums increase with increasing risk avoidance.r m1RF1rZ1rZ1=10% +31.5 *(14% -10%)4=10% +6% =16%rZ1rm1=14% (rises from 11% to 14%)RF1=10% (rises from 7% to 10%)RF=2% +5% =7%Example 8.16 3336 PART 4 Risk and the Required Rate of Return Changes in risk aversion, and therefore shifts in the SML, result from changing preferences of investors, which generally result from economic, polit-ical, and social events. Examples of events that increase risk aversion include a stock market crash, assassination of a key political leader, and the outbreak ofwar. In general, widely shared expectations of hard times ahead tend to causeinvestors to become more risk averse, requiring higher returns as compensationfor accepting a given level of risk. The impact of increased risk aversion on theSML can best be demonstrated by an example. In the preceding examples, the SML in Figure 8.9 reflected a risk-free rate ( RF) of 7%, a market return ( rm) of 11%, a market risk premium ( rmRF) of 4%, and a required return on asset Z ( rZ) of 13% with a beta ( bZ) of 1.5. Assume that recent economic events have made investors more risk-averse, causing a new highermarket return ( ) of 14%. Graphically, this change would cause the SML topivot upward as shown in Figure 8.11, causing a new market risk premium ( ) of 7%. As a result, the required return on all risky assets will increase.For asset Z, with a beta of 1.5, the new required return ( ) can be calculated byusing the CAPM (Equation 8.8): This value can be seen on the new security market line (SML 1) in Figure 8.11. Note that although asset Z’s risk, as measured by beta, did not change, itsrequired return has increased because of the increased risk aversion reflected inthe market risk premium. To summarize, greater risk aversion results in higher required returns for each level of risk. Similarly, a reduction in risk aversion causes the required return for each level of risk to decline.rZ1=7% +31.5 *(14% -7%)4=7% +10.5% =17.5%rZ1rm1-RFrm1-Example 8.17 3CHAPTER 8 Risk and Return 337Required Return, r (%)17 rZ1 = 16 15 rm1 = 14 rZ = 13 rm = 11 RF1 = 10 9 RF = 7 5 3 1 .5 0 1.0 1.5 2.0SML bRFbmbZ Nondiversifiable Risk, bSML1 IPInc. inIP IP1 r*FIGURE 8.10 Inflation Shifts SML Impact of increasedinflationary expectations on the SML Some Comments on the CAPM The capital asset pricing model generally relies on historical data. The betas may or may not actually reflect the future variability of returns. Therefore, the required returns specified by the model can be viewed only as rough approxima-tions. Users of betas commonly make subjective adjustments to the historicallydetermined betas to reflect their expectations of the future. The CAPM was developed to explain the behavior of security prices and pro- vide a mechanism whereby investors could assess the impact of a proposed secu-rity investment on their portfolio’s overall risk and return. It is based on anassumed efficient market with the following characteristics: many small investors,all having the same information and expectations with respect to securities; norestrictions on investment, no taxes, and no transaction costs; and rationalinvestors, who view securities similarly and are risk averse, preferring higherreturns and lower risk. Although the perfect world described in the preceding paragraph appears to be unrealistic, studies have provided support for the existence of the expecta-tional relationship described by the CAPM in active markets such as the NewYork Stock Exchange. The CAPM also sees widespread use in corporations thatuse the model to assess the required returns that their shareholders demand (andtherefore, the returns that the firm’s managers need to achieve when they investshareholders’ money).338 PART 4 Risk and the Required Rate of Return Required Return, r (%)171921 15 rm1 = 14 rZ = 13 rm = 11 9 RF = 7 5 31 .5 0 1.0 1.5 2.0SML bRFbmbZ Nondiversifiable Risk, bSML1 rZ1 = 17.5 New Market Risk Premium rm1– RF = 7% Initial Market Risk Premium rm– RF = 4%FIGURE 8.11 Risk Aversion Shifts SML Impact of increased riskaversion on the SML In more depth To read about CAPM Survives Criticism , go to www.myfinancelab.com 6REVIEW QUESTIONS 8–11 How are total risk, nondiversifiable risk, and diversifiable risk related? Why is nondiversifiable risk the only relevant risk? 8–12 What risk does betameasure? How can you find the beta of a portfolio? 8–13 Explain the meaning of each variable in the capital asset pricing model (CAPM) equation. What is the security market line (SML)? 8–14 What impact would the following changes have on the security market line and therefore on the required return for a given level of risk? (a)An increase in inflationary expectations. (b)Investors become lessrisk- averse.CHAPTER 8 Risk and Return 339 Summary FOCUS ON VALUE A firm’s risk and expected return directly affect its share price. Risk and return are the two key determinants of the firm’s value. It is therefore the financial man-ager’s responsibility to assess carefully the risk and return of all major decisionsto ensure that the expected returns justify the level of risk being introduced. The financial manager can expect to achieve the firm’s goal of increasing its share price (and thereby benefiting its owners) by taking only those actions that earn returns at least commensurate with their risk. Clearly, financial managersneed to recognize, measure, and evaluate risk–return trade-offs to ensure thattheir decisions contribute to the creation of value for owners. REVIEW OF LEARNING GOALS Understand the meaning and fundamentals of risk, return, and risk pref- erences. Risk is a measure of the uncertainty surrounding the return that an investment will produce. The total rate of return is the sum of cash distribu-tions, such as interest or dividends, plus the change in the asset’s value over agiven period, divided by the investment’s beginning-of-period value. Investmentreturns vary both over time and between different types of investments.Investors may be risk averse, risk neutral, or risk seeking. Most financial deci-sion makers are risk averse. A risk averse decision maker requires a higherexpected return on a more risky investment alternative. Describe procedures for assessing and measuring the risk of a single asset. The risk of a single asset is measured in much the same way as the risk of a portfolio of assets. Scenario analysis and probability distributions can be usedto assess risk. The range, the standard deviation, and the coefficient of variationcan be used to measure risk quantitatively. Discuss the measurement of return and standard deviation for a port- folio and the concept of correlation. The return of a portfolio is calculated as the weighted average of returns on the individual assets from which it is formed.The portfolio standard deviation is found by using the formula for the standarddeviation of a single asset. LG3LG2LG1 Correlation—the statistical relationship between any two series of num- bers—can be positively correlated, negatively correlated, or uncorrelated. At theextremes, the series can be perfectly positively correlated or perfectly negativelycorrelated. Understand the risk and return characteristics of a portfolio in terms of correlation and diversification and the impact of international assets on a port-folio. Diversification involves combining assets with low correlation to reduce the risk of the portfolio. The range of risk in a two-asset portfolio depends on thecorrelation between the two assets. If they are perfectly positively correlated, theportfolio’s risk will be between the individual assets’ risks. If they are perfectlynegatively correlated, the portfolio’s risk will be between the risk of the morerisky asset and zero. International diversification can further reduce a portfolio’s risk. Foreign assets have the risk of currency fluctuation and political risks. Review the two types of risk and the derivation and role of beta in meas- uring the relevant risk of both a security and a portfolio. The total risk of a security consists of nondiversifiable and diversifiable risk. Diversifiable risk can be elimi-nated through diversification. Nondiversifiable risk is the only relevant risk.Nondiversifiable risk is measured by the beta coefficient, which is a relativemeasure of the relationship between an asset’s return and the market return. Beta isderived by finding the slope of the “characteristic line” that best explains the his-torical relationship between the asset’s return and the market return. The beta of aportfolio is a weighted average of the betas of the individual assets that it includes. Explain the capital asset pricing model (CAPM), its relationship to the security market line (SML), and the major forces causing shifts in the SML. The CAPM uses beta to relate an asset’s risk relative to the market to the asset’srequired return. The graphical depiction of the CAPM is SML, which shifts overtime in response to changing inflationary expectations and/or changes ininvestor risk aversion. Changes in inflationary expectations result in parallelshifts in the SML. Increasing risk aversion results in a steepening in the slope ofthe SML. Decreasing risk aversion reduces the slope of the SML. Although it hassome shortcomings, the CAPM provides a useful conceptual framework forevaluating and linking risk and return. LG6LG5LG4340 PART 4 Risk and the Required Rate of Return Opener-in-Review The table below shows the annual returns in each year from 2007 through 2009 of the Close Special Situations Fund (a British fund specializing in small stocks),and the Financial Times Stock Index (FTSE), an index that tracks the perform-ance of the 100 largest companies on the U.K. stock market: Year Close Fund FTSE 2007 4.8% 2.1% 2008 57.3% 30.9%2009 246.9% 22.1%- – For both the Close Fund and the FTSE, calculate the average annual return and its standard deviation. What are the general patterns that you see?Provide one reason that the performance of the FTSE differs from that of the Close Fund.CHAPTER 8 Risk and Return 341 Self-Test Problems(Solutions in Appendix) ST8–1 Portfolio analysis You have been asked for your advice in selecting a portfolio of assets and have been given the following data:LG4LG3 Expected return Year Asset A Asset B Asset C 2013 12% 16% 12% 2014 14 14 142015 16 12 16 You have been told that you can create two portfolios—one consisting of assets A and B and the other consisting of assets A and C—by investing equal proportions (50%) in each of the two component assets. a.What is the expected return for each asset over the 3-year period? b.What is the standard deviation for each asset’s return? c.What is the expected return for each of the two portfolios? d.How would you characterize the correlations of returns of the two assets making up each of the two portfolios identified in part c? e.What is the standard deviation for each portfolio? f.Which portfolio do you recommend? Why? ST8–2 Beta and CAPM Currently under consideration is an investment with a beta, b,o f 1.50. At this time, the risk-free rate of return, RF, is 7%, and the return on the market portfolio of assets, rm, is 10%. You believe that this investment will earn an annual rate of return of 11%. a.If the return on the market portfolio were to increase by 10%, what would you expect to happen to the investment’s return ?What if the market return were to decline by 10%? b.Use the capital asset pricing model (CAPM) to find the required return on this investment. c.On the basis of your calculation in part b,would you recommend this invest- ment? Why or why not? d.Assume that as a result of investors becoming less risk-averse, the market return drops by 1% to 9%. What impact would this change have on your responses in parts bandc?LG6LG5 342 PART 4 Risk and the Required Rate of Return Stock Portfolio weight Beta Alpha 20% 1.15 Centauri 10 0.85Zen 15 1.60Wren 20 1.35Yukos 35 1.85 E8–6 a.Calculate the required rate of return for an asset that has a beta of 1.8, given a risk-free rate of 5% and a market return of 10%. b.If investors have become more risk-averse due to recent geopolitical events, and the market return rises to 13%, what is the required rate of return for the same asset? c.Use your findings in part ato graph the initial security market line (SML), and then use your findings in part bto graph (on the same set of axes) the shift in the SML.LG6Warm-Up ExercisesAll problems are available in . E8–1 An analyst predicted last year that the stock of Logistics, Inc., would offer a totalreturn of at least 10% in the coming year. At the beginning of the year, the firm hada stock market value of $10 million. At the end of the year, it had a market value of$12 million even though it experienced a loss, or negative net income, of $2.5 mil- lion. Did the analyst’s prediction prove correct? Explain using the values for total annual return. E8–2 Four analysts cover the stock of Fluorine Chemical. One forecasts a 5% return forthe coming year. A second expects the return to be negative 5%. A third predicts a 10% return. A fourth expects a 3% return in the coming year. You are relatively confident that the return will be positive but not large, so you arbitrarily assignprobabilities of being correct of 35%, 5%, 20%, and 40%, respectively, to the analysts’ forecasts. Given these probabilities, what is Fluorine Chemical’s expected return for the coming year? E8–3 The expected annual returns are 15% for investment 1 and 12% for investment 2. The standard deviation of the first investment’s return is 10%; the second invest- ment’s return has a standard deviation of 5%. Which investment is less risky based solely on standard deviation ? Which investment is less risky based on coefficient of variation ? Which is a better measure given that the expected returns of the two investments are not the same? E8–4 Your portfolio has three asset classes. U.S. government T-bills account for 45% ofthe portfolio, large-company stocks constitute another 40%, and small-company stocks make up the remaining 15%. If the expected returns are 3.8% for the T-bills, 12.3% for the large-company stocks, and 17.4% for the small-company stocks, what is the expected return of the portfolio? E8–5 You wish to calculate the risk level of your portfolio based on its beta. The five stocks in the portfolio with their respective weights and betas are shown in the accompanying table. Calculate the beta of your portfolio. LG1 LG2 LG2 LG3 LG5 CHAPTER 8 Risk and Return 343 ProblemsAll problems are available in . P8–1 Rate of return Douglas Keel, a financial analyst for Orange Industries, wishes to estimate the rate of return for two similar-risk investments, X and Y. Douglas’sresearch indicates that the immediate past returns will serve as reasonable estimatesof future returns. A year earlier, investment X had a market value of $20,000;investment Y had a market value of $55,000. During the year, investment X gener- ated cash flow of $1,500 and investment Y generated cash flow of $6,800. The cur- rent market values of investments X and Y are $21,000 and $55,000, respectively. a.Calculate the expected rate of return on investments X and Y using the most recent year’s data. b.Assuming that the two investments are equally risky, which one should Douglas recommend? Why? P8–2 Return calculations For each of the investments shown in the following table, cal- culate the rate of return earned over the unspecified time period. LG1 LG1 LG1Cash flow Beginning-of- End-of- Investment during period period value period value A $ 800 $ 1,100 $ 100 B 15,000 120,000 118,000C 7,000 45,000 48,000D 80 600 500E 1,500 12,500 12,400- P8–3 Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Sharon will evaluate each of these investments to decide whether they are superior to investments that her company already has in place, which have an expected return of 12% and a stan-dard deviation of 6%. The expected returns and standard deviations of the invest-ments are as follows: Expected Standard Investment return deviation X 14% 7% Y1 2 8Z1 0 9 a.If Sharon were risk neutral, which investments would she select? Explain why. b.If she were risk averse, which investments would she select? Why? c.If she were risk seeking, which investments would she select? Why? d.Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why? P8–4 Risk analysis Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are being considered. After investigating the possible outcomes, the company made the estimates shown in the following table.LG2 344 PART 4 Risk and the Required Rate of Return Expansion A Expansion B Initial investment $12,000 $12,000 Annual rate of return Pessimistic 16% 10%Most likely 20% 20%Optimistic 24% 30% a.Determine the range of the rates of return for each of the two projects. b.Which project is less risky? Why? c.If you were making the investment decision, which one would you choose? Why? What does this imply about your feelings toward risk? d.Assume that expansion B’s most likely outcome is 21% per year and that all other facts remain the same. Does this change your answer to part c?Why? P8–5 Risk and probability Micro-Pub, Inc., is considering the purchase of one of two microfilm cameras, R and S. Both should provide benefits over a 10-year period, andeach requires an initial investment of $4,000. Management has constructed theaccompanying table of estimates of rates of return and probabilities for pessimistic,most likely, and optimistic results.a.Determine the range for the rate of return for each of the two cameras. b.Determine the expected value of return for each camera. c.Purchase of which camera is riskier? Why?LG2 LG2Camera R Camera S Amount Probability Amount Probability Initial investment $4,000 1.00 $4,000 1.00 Annual rate of return Pessimistic 20% 0.25 15% 0.20Most likely 25% 0.50 25% 0.55Optimistic 30% 0.25 35% 0.25 P8–6 Bar charts and risk Swan’s Sportswear is considering bringing out a line of designer jeans. Currently, it is negotiating with two different well-known designers. Because of the highly competitive nature of the industry, the two lines of jeans havebeen given code names. After market research, the firm has established the expecta- tions shown in the following table about the annual rates of return: Annual rate of return Market acceptance Probability Line J Line K Very poor 0.05 0.0075 0.010 Poor 0.15 0.0125 0.025Average 0.60 0.0850 0.080Good 0.15 0.1475 0.135Excellent 0.05 0.1625 0.150 Use the table to: a.Construct a bar chart for each line’s annual rate of return. b.Calculate the expected value of return for each line. c.Evaluate the relative riskiness for each jean line’s rate of return using the bar charts. P8–7 Coefficient of variation Metal Manufacturing has isolated four alternatives for meeting its need for increased production capacity. The following table summarizes data gathered relative to each of these alternatives.CHAPTER 8 Risk and Return 345 LG2 LG2 LG2Expected Standard deviation Alternative return of return A 20% 7.0% B 22 9.5C 19 6.0D 16 5.5 Expected Standard Project return Range deviation A 12.0% 4.0% 2.9% B 12.5 5.0 3.2 C 13.0 6.0 3.5 D 12.8 4.5 3.0a.Calculate the coefficient of variation for each alternative. b.If the firm wishes to minimize risk, which alternative do you recommend? Why? P8–8 Standard deviation versus coefficient of variation as measures of risk Greengage, Inc., a successful nursery, is considering several expansion projects. All of the alternatives promise to produce an acceptable return. Data on four possible projectsfollow. a.Which project is least risky, judging on the basis of range? b.Which project has the lowest standard deviation? Explain why standard devia- tion may not be an entirely appropriate measure of risk for purposes of this com- parison. c.Calculate the coefficient of variation for each project. Which project do you think Greengage’s owners should choose? Explain why. Personal Finance Problem P8–9 Rate of return, standard deviation, coefficient of variation Mike is searching for a stock to include in his current stock portfolio. He is interested in Hi-Tech Inc.; he has been impressed with the company’s computer products and believes Hi-Tech isan innovative market player. However, Mike realizes that any time you consider a technology stock, risk is a major concern. The rule he follows is to include onlysecurities with a coefficient of variation of returns below 0.90.LG1 Mike has obtained the following price information for the period 2009 through 2012. Hi-Tech stock, being growth-oriented, did not pay any dividends during these4 years.346 PART 4 Risk and the Required Rate of Return Stock price Year Beginning End 2009 $14.36 $21.55 2010 21.55 64.782011 64.78 72.382012 72.38 91.80 a.Calculate the rate of return for each year, 2009 through 2012, for Hi-Tech stock. b.Assume that each year’s return is equally probable, and calculate the average return over this time period. c.Calculate the standard deviation of returns over the past 4 years. ( Hint: Treat these data as a sample.) d.Based on bandcdetermine the coefficient of variation of returns for the security. e.Given the calculation in dwhat should be Mike’s decision regarding the inclusion of Hi-Tech stock in his portfolio? P8–10 Assessing return and risk Swift Manufacturing must choose between two asset pur- chases. The annual rate of return and the related probabilities given in the followingtable summarize the firm’s analysis to this point. Project 257 Project 432 Rate of return Probability Rate of return Probability 10% 0.01 10% 0.05 10 0.04 15 0.1020 0.05 20 0.1030 0.10 25 0.1540 0.15 30 0.2045 0.30 35 0.1550 0.15 40 0.1060 0.10 45 0.1070 0.05 50 0.0580 0.04 100 0.01- a.For each project, compute: (1) The range of possible rates of return. (2) The expected return.(3) The standard deviation of the returns. (4) The coefficient of variation of the returns. b.Construct a bar chart of each distribution of rates of return. c.Which project would you consider less risky? Why?LG2 P8–11 Integrative—Expected return, standard deviation, and coefficient of variation Three assets—F, G, and H—are currently being considered by Perth Industries. The proba-bility distributions of expected returns for these assets are shown in the following table.CHAPTER 8 Risk and Return 347 LG2 Asset F Asset G Asset H j Prj Return, rj Prj Return, rj Prj Return, rj 1 0.10 40% 0.40 35% 0.10 40% 2 0.20 10 0.30 10 0.20 20 3 0.40 0 0.30 20 0.40 104 0.20 5 0.20 05 0.10 10 0.10 20 – – a.Calculate the expected value of return, for each of the three assets. Which pro- vides the largest expected return? b.Calculate the standard deviation, r, for each of the three assets’ returns. Which appears to have the greatest risk? c.Calculate the coefficient of variation, CV, for each of the three assets’ returns. Which appears to have the greatest relative risk? P8–12 Normal probability distribution Assuming that the rates of return associated with a given asset investment are normally distributed; that the expected return, is 18.9%; and that the coefficient of variation, CV, is 0.75; answer the following questions: a.Find the standard deviation of returns, r. b.Calculate the range of expected return outcomes associated with the following probabilities of occurrence: (1) 68%, (2) 95%, (3) 99%. c.Draw the probability distribution associated with your findings in parts aandb. Personal Finance Problem P8–13 Portfolio return and standard deviation Jamie Wong is considering building an investment portfolio containing two stocks, L and M. Stock L will represent 40% of the dollar value of the portfolio, and stock M will account for the other 60%. The expected returns over the next 6 years, 2013–2018, for each of these stocks are shown in the following table.sr,sr, Expected return Year Stock L Stock M 2013 14% 20% 2014 14 182015 16 162016 17 142017 17 122018 19 10LG2 LG3 a.Calculate the expected portfolio return, rp, for each of the 6 years. b.Calculate the expected value of portfolio returns, , over the 6-year period. c.Calculate the standard deviation of expected portfolio returns, over the 6-year period. d.How would you characterize the correlation of returns of the two stocks L and M? e.Discuss any benefits of diversification achieved by Jamie through creation of the portfolio. P8–14 Portfolio analysis You have been given the expected return data shown in the first table on three assets—F, G, and H—over the period 2013–2016.srp,rp348 PART 4 Risk and the Required Rate of Return LG3 LG4Expected return Year Asset F Asset G Asset H 2013 16% 17% 14% 2014 17 16 152015 18 15 162016 19 14 17 Using these assets, you have isolated the three investment alternatives shown in the following table. Alternative Investment 1 100% of asset F 2 50% of asset F and 50% of asset G3 50% of asset F and 50% of asset H Expected Risk (standard Asset return, deviation), V8 % 5 % W1 3 1 0Sr ra.Calculate the expected return over the 4-year period for each of the three alternatives. b.Calculate the standard deviation of returns over the 4-year period for each of the three alternatives. c.Use your findings in parts aandbto calculate the coefficient of variation for each of the three alternatives. d.On the basis of your findings, which of the three investment alternatives do you recommend? Why? P8–15 Correlation, risk, and return Matt Peters wishes to evaluate the risk and return behaviors associated with various combinations of assets V and W under threeassumed degrees of correlation: perfect positive, uncorrelated, and perfect negative. The expected returns and standard deviations calculated for each of the assets are shown in the following table. a.If the returns of assets V and W are perfectly positively correlated (correlation coefficient ), describe the range of (1) expected return and (2) risk associ- ated with all possible portfolio combinations. b.If the returns of assets V and W are uncorrelated (correlation coefficient 0), describe the approximate range of (1) expected return and (2) risk associated with all possible portfolio combinations. c.If the returns of assets V and W are perfectly negatively correlated (correlation coefficient ), describe the range of (1) expected return and (2) risk associ- ated with all possible portfolio combinations. Personal Finance Problem P8–16 International investment returns Joe Martinez, a U.S. citizen living in Brownsville, Texas, invested in the common stock of Telmex, a Mexican corporation. He pur- chased 1,000 shares at 20.50 pesos per share. Twelve months later, he sold them at24.75 pesos per share. He received no dividends during that time. a.What was Joe’s investment return (in percentage terms) for the year, on the basis of the peso value of the shares? b.The exchange rate for pesos was 9.21 pesos per US$1.00 at the time of the pur- chase. At the time of the sale, the exchange rate was 9.85 pesos per US$1.00.Translate the purchase and sale prices into US$. c.Calculate Joe’s investment return on the basis of the US$ value of the shares. d.Explain why the two returns are different. Which one is more important to Joe? Why? P8–17 Total, nondiversifiable, and diversifiable risk David Talbot randomly selected securi- ties from all those listed on the New York Stock Exchange for his portfolio. He began with a single security and added securities one by one until a total of 20 securities wereheld in the portfolio. After each security was added, David calculated the portfolio standard deviation, .The calculated values are shown in the following table.s rp=-1==+1CHAPTER 8 Risk and Return 349 LG4 LG5LG1 Number of Portfolio Number of Portfolio securities risk, securities risk, 1 14.50% 11 7.00% 2 13.30 12 6.803 12.20 13 6.704 11.20 14 6.655 10.30 15 6.606 9.50 16 6.567 8.80 17 6.528 8.20 18 6.509 7.70 19 6.48 10 7.30 20 6.47s rpsrp a.Plot the data from the table above on a graph that has the number of securities on the x-axis and the portfolio standard deviation on the y-axis. b.Divide the total portfolio risk in the graph into its nondiversifiable and diversifiable risk components, and label each of these on the graph. c.Describe which of the two risk components is the relevant risk, and explain why it is relevant. How much of this risk exists in David Talbot’s portfolio? P8–18 Graphical derivation of beta A firm wishes to estimate graphically the betas for two assets, A and B. It has gathered the return data shown in the following table forthe market portfolio and for both assets over the last 10 years, 2003–2012.350 PART 4 Risk and the Required Rate of Return LG5 LG5Actual return Year Market portfolio Asset A Asset B 2003 6% 11% 16% 2004 2 8 112005 13 4 102006 4 3 32007 8 0 32008 16 19 302009 10 14 222010 15 18 292011 8 12 192012 13 17 26- – – – a.On a set of “market return ( xaxis)–asset return ( yaxis)” axes, use the data given to draw the characteristic line for asset A and for asset B. b.Use the characteristic lines from part ato estimate the betas for assets A and B. c.Use the betas found in part bto comment on the relative risks of assets A and B. P8–19 Graphical derivation and interpreting beta You are analyzing the performance of two stocks. The first, shown in Panel A, is Cyclical Industries Incorporated. Cyclical –20 –3070 6050 40 30 2010 –30–20 –40 –50–1020 10030Return on CyclicalIndustriesStockReturn on Overall Market Panel A–10 –20 –10 –3070 6050 40 30 2010 –30–20 –40 –50–1020 10030Return on BiotechCuresStockReturn on Overall Market Panel B Industries makes machine tools and other heavy equipment, the demand for which rises and falls closely with the overall state of the economy. The second stock, shownin Panel B, is Biotech Cures Corporation. Biotech Cures uses biotechnology todevelop new pharmaceutical compounds to treat incurable diseases. Biotech’s for-tunes are driven largely by the success or failure of its scientists to discover new andeffective drugs. Each data point on the graph shows the monthly return on the stockof interest and the monthly return on the overall stock market. The lines drawnthrough the data points represent the characteristic lines for each security.a.Which stock do you think has a higher standard deviation? Why? b.Which stock do you think has a higher beta? Why? c.Which stock do you think is riskier? What does the answer to this question depend on? P8–20 Interpreting beta A firm wishes to assess the impact of changes in the market return on an asset that has a beta of 1.20.a.If the market return increased by 15%, what impact would this change be expected to have on the asset’s return? b.If the market return decreased by 8%, what impact would this change be expected to have on the asset’s return? c.If the market return did not change, what impact, if any, would be expected on the asset’s return? d.Would this asset be considered more or less risky than the market? Explain. P8–21 Betas Answer the questions below for assets A to D shown in the table.CHAPTER 8 Risk and Return 351 Asset Beta A 0.50 B 1.60 C 0.20 D 0.90- a.What impact would a 10% increase in the market return be expected to have on each asset’s return? b.What impact would a 10% decrease in the market return be expected to have on each asset’s return? c.If you believed that the market return would increase in the near future, which asset would you prefer? Why? d.If you believed that the market return would decrease in the near future, which asset would you prefer? Why? Personal Finance Problem P8–22 Betas and risk rankings You are considering three stocks—A, B, and C—for pos- sible inclusion in your investment portfolio. Stock A has a beta of 0.80, stock B hasa beta of 1.40, and stock C has a beta of 0.30. a.Rank these stocks from the most risky to the least risky. b.If the return on the market portfolio increased by 12%, what change would you expect in the return for each of the stocks? c.If the return on the market portfolio decreased by 5%, what change would you expect in the return for each of the stocks?-LG5 LG5 LG5 d.If you felt that the stock market was getting ready to experience a significant decline, which stock would you probably add to your portfolio? Why? e.If you anticipated a major stock market rally, which stock would you add to your portfolio? Why? Personal Finance Problem P8–23 Portfolio betas Rose Berry is attempting to evaluate two possible portfolios, which consist of the same five assets held in different proportions. She is particularly interested in using beta to compare the risks of the portfolios, so she has gatheredthe data shown in the following table.352 PART 4 Risk and the Required Rate of Return Portfolio weights Asset Asset beta Portfolio A Portfolio B 1 1.30 10% 30% 2 0.70 30 103 1.25 10 204 1.10 10 205 0.90 Totals 100 % 100%20 40 a.Calculate the betas for portfolios A and B. b.Compare the risks of these portfolios to the market as well as to each other. Which portfolio is more risky? P8–24 Capital asset pricing model (CAPM) For each of the cases shown in the following table, use the capital asset pricing model to find the required return.LG6 LG5Risk-free Market Case rate, RF return, rm Beta, b A 5% 8% 1.30 B 8 13 0.90C 9 12 0.20D 10 15 1.00E 6 10 0.60- Personal Finance Problem P8–25 Beta coefficients and the capital asset pricing model Katherine Wilson is wondering how much risk she must undertake to generate an acceptable return on her portfolio. The risk-free return currently is 5%. The return on the overall stock market is 16%. Use the CAPM to calculate how high the beta coefficient of Katherine’s portfolio would have to be to achieve each of the following expected portfolio returns. a.10% b.15% c.18% d.20% e.Katherine is risk averse. What is the highest return she can expect if she is unwilling to take more than an average risk?LG6LG5 P8–26 Manipulating CAPM Use the basic equation for the capital asset pricing model (CAPM) to work each of the following problems.a.Find the required return for an asset with a beta of 0.90 when the risk-free rate and market return are 8% and 12%, respectively. b.Find the risk-free rate for a firm with a required return of 15% and a beta of 1.25 when the market return is 14%. c.Find the market return for an asset with a required return of 16% and a beta of 1.10 when the risk-free rate is 9%. d.Find the beta for an asset with a required return of 15% when the risk-free rate and market return are 10% and 12.5%, respectively. Personal Finance Problem P8–27 Portfolio return and beta Jamie Peters invested $100,000 to set up the following portfolio one year ago:CHAPTER 8 Risk and Return 353 LG6 Asset Cost Beta at purchase Yearly income Value today A $20,000 0.80 $1,600 $20,000 B 35,000 0.95 1,400 36,000 C 30,000 1.50 — 34,500 D 15,000 1.25 375 16,500 a.Calculate the portfolio beta on the basis of the original cost figures. b.Calculate the percentage return of each asset in the portfolio for the year. c.Calculate the percentage return of the portfolio on the basis of original cost, using income and gains during the year. d.At the time Jamie made his investments, investors were estimating that the market return for the coming year would be 10%. The estimate of the risk-free rate of return averaged 4% for the coming year. Calculate an expected rate of return for each stock on the basis of its beta and the expectations of market and risk-free returns. e.On the basis of the actual results, explain how each stock in the portfolio per- formed relative to those CAPM-generated expectations of performance. What factors could explain these differences? P8–28 Security market line (SML) Assume that the risk-free rate, RF, is currently 9% and that the market return, rm, is currently 13%. a.Draw the security market line (SML) on a set of “nondiversifiable risk (xaxis)–required return ( yaxis)” axes. b.Calculate and label the market risk premium on the axes in part a. c.Given the previous data, calculate the required return on asset A having a beta of 0.80 and asset B having a beta of 1.30. d.Draw in the betas and required returns from part cfor assets A and B on the axes in part a.Label the risk premium associated with each of these assets, and discuss them. P8–29 Shifts in the security market line Assume that the risk-free rate, RF, is currently 8%, the market return, rm, is 12%, and asset A has a beta, bA, of 1.10. a.Draw the security market line (SML) on a set of “nondiversifiable risk ( xaxis)– required return ( yaxis)” axes. b.Use the CAPM to calculate the required return, rA, on asset A, and depict asset A’s beta and required return on the SML drawn in part a.LG3 LG1 LG5LG6 LG6 LG6 c.Assume that as a result of recent economic events, inflationary expectations have declined by 2%, lowering RFandrmto 6% and 10%, respectively. Draw the new SML on the axes in part a,and calculate and show the new required return for asset A. d.Assume that as a result of recent events, investors have become more risk averse, causing the market return to rise by 1%, to 13%. Ignoring the shift in part c, draw the new SML on the same set of axes that you used before, and calculate and show the new required return for asset A. e.From the previous changes, what conclusions can be drawn about the impact of (1) decreased inflationary expectations and (2) increased risk aversion on the required returns of risky assets? P8–30 Integrative—Risk, return, and CAPM Wolff Enterprises must consider several investment projects, A through E, using the capital asset pricing model (CAPM) and its graphical representation, the security market line (SML). Relevant information ispresented in the following table.354 PART 4 Risk and the Required Rate of Return Item Rate of return Beta, b Risk-free asset 9% 0.00 Market portfolio 14 1.00Project A — 1.50Project B — 0.75Project C — 2.00Project D — 0.00Project E — 0.50 – a.Calculate (1) the required rate of return and (2) the risk premium for each project, given its level of nondiversifiable risk. b.Use your findings in part ato draw the security market line (required return rela- tive to nondiversifiable risk). c.Discuss the relative nondiversifiable risk of projects A through E. d.Assume that recent economic events have caused investors to become less risk- averse, causing the market return to decline by 2%, to 12%. Calculate the new required returns for assets A through E, and draw the new security market lineon the same set of axes that you used in part b. e.Compare your findings in parts aandbwith those in part d.What conclusion can you draw about the impact of a decline in investor risk aversion on therequired returns of risky assets? P8–31 ETHICS PROBLEM Risk is a major concern of almost all investors. When share- holders invest their money in a firm, they expect managers to take risks with those funds. What do you think are the ethical limits that managers should observe whentaking risks with other people’s money?LG6 LG1 CHAPTER 8 Risk and Return 355 Year Stock A Stock B Stock C 2013 10% 10% 12% 2014 13 11 142015 15 8 102016 14 12 112017 16 10 92018 14 15 92019 12 15 10Spreadsheet Exercise Jane is considering investing in three different stocks or creating three distinct two- stock portfolios. Jane considers herself to be a rather conservative investor. She is ableto obtain forecasted returns for the three securities for the years 2013 through 2019.The data are as follows: In any of the possible two-stock portfolios, the weight of each stock in the portfolio will be 50%. The three possible portfolio combinations are AB, AC, and BC. TO DO Create a spreadsheet similar to Tables 8.6 and 8.7 to answer the following: a.Calculate the expected return for each individual stock. b.Calculate the standard deviation for each individual stock. c.Calculate the expected returns for portfolio AB, AC, and BC. d.Calculate the standard deviations for portfolios AB, AC, and BC. e.Would you recommend that Jane invest in the single stock A or the portfolio con- sisting of stocks A and B? Explain your answer from a risk–return viewpoint. f.Would you recommend that Jane invest in the single stock B or the portfolio con- sisting of stocks B and C? Explain your answer from a risk–return viewpoint. Visit www.myfinancelab.com forChapter Case: Analyzing Risk and Return on Chargers Products’ Investments, Group Exercises, and numerous online resources. Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand the various sources of capital and how their costs are calculated to provide the data necessary todetermine the firm ’s overall cost of capital. INFORMATION SYSTEMS You need to understand the various sources of capital and how their costs are calculated to develop systems thatwill estimate the costs of those sources of capital, as well as the overallcost of capital. MANAGEMENT You need to understand the cost of capital to select long-term investments after assessing their acceptability and relativerankings. MARKETING You need to understand the firm ’s cost of capital because proposed projects must earn returns in excess of it to be acceptable. OPERATIONS You need to understand the firm ’s cost of capital to assess the economic viability of investments in plant and equipmentneeded to improve or grow the firm ’s capacity. Knowing your personal cost of cap- italwill allow you to make informed decisions about your personal consuming, borrowing, and investing.Managing your personal wealth is a lot like managing the wealth of abusiness—you need to understand the trade-offs between consumingwealth and growing wealth and how growing wealth can be accomplished by investing your own monies or borrowed monies.Understanding the cost of capital concepts will allow you to makebetter long-term decisions and maximize the value of your personalwealth.In your personal lifeLearning Goals Understand the basic concept and sources of capital associated withthe cost of capital. Explain what is meant by the marginal cost of capital. Determine the cost of long-term debt, and explain why the after-tax cost of debt is the relevantcost of debt. Determine the cost of preferred stock. Calculate the cost of common stock equity, and convert it intothe cost of retained earnings andthe cost of new issues of commonstock. Calculate the weighted average cost of capital (WACC), anddiscuss alternative weightingschemes. LG6LG5LG4LG3LG2LG19The Cost of Capital 356 357Falling Short of Expectations For years, General Electric was perhaps the most admired company in the world. From 1990 through 2000, its stock rose more than 800 percent,making it one of the world ’s most valuable companies and earning its long-time CEO, Jack Welch, the title of “Manager of the Century ” from Fortune magazine. GE ’s stock price peaked in August 2000 at $60.50. Since then, however, GE stock has lost its luster, fallingby roughly 50 percent and trailing far behind benchmarks such as the Standard & Poor ’s 500 Stock Index. In 2009, GE cut its dividend for the first time since the Great Depression and lost its coveted AAA credit rating. Why did GE perform so poorly ? A simple answer is that GE ’s business investments failed to earn a return sufficient to meet the expectations of investors. When a firm ’s operating results disappoint investors, its stock price will fall as investors sell their shares and move to a moreattractive investment. As one expert explained, “GE has been destroying shareholder capital for years. Their cost of capital is about 5 percent, and their return on assets is about 1 percent. That mathematic equation can ’t remain too much longer. ” 1 For companies to succeed, their investments have to earn a rate of return that exceeds investors ’ expectations. But how do companies know what investors expect ? The answer is that companies have to measure their cost of capital. Read on to learn how firms do that. General Electric 1. Pros Say, December 15, 2009, cnbc.com, www.cnbc.com/id/34440926 . 358 PART 4 Risk and the Required Rate of Return 9.1Overview of the Cost of Capital Chapter 1 established that the goal of the firm is to maximize shareholder wealth, and it told us that financial managers achieve this goal by investing in risky proj-ects that add value to the firm. In this chapter, you will learn about the cost ofcapital, which is the rate of return that financial managers use to evaluate all pos-sible investment opportunities to determine which ones to invest in on behalf ofthe firm’s shareholders. The cost of capital represents the firm’s cost of financing and is the minimum rate of return that a project must earn to increase firm value.In particular, the cost of capital refers to the cost of the next dollar of financingnecessary to finance a new investment opportunity. Investments with a rate ofreturn above the cost of capital will increase the value of the firm, and projectswith a rate of return below the cost of capital will decrease firm value. The cost of capital is an extremely important financial concept. It acts as a major link between the firm’s long-term investment decisions and the wealth of the firm’sowners as determined by the market value of their shares. Financial managers areethically bound to invest only in projects that they expect to exceed the cost of cap-ital; see the Focus on Ethics box for more discussion of this responsibility. THE BASIC CONCEPT A firm’s cost of capital is estimated at a given point in time and reflects the expected average future cost of funds over the long run. Although firms typically raiseLG2 LG1 cost of capital Represents the firm’s cost of financing and is the minimumrate of return that a projectmust earn to increase firmvalue. focus on ETHICS The Ethics of Profit Business Week once referred to Peter Drucker as “The Man Who Invented Management. ” In his role as writer and management consultant, Druckerstressed the importance of ethics tobusiness leaders. He believed that it was the ethical responsibility of a busi- ness to earn a profit. In his mind, prof-itable businesses create opportunities,while unprofitable ones waste society ’s resources. Drucker once said, “Profit is not the explanation, cause, or rationaleof business behavior and business deci-sions, but rather the test of their validity.If archangels instead of businessmen sat in directors ’ chairs, they would still have to be concerned with profitability,despite their total lack of personal inter-est in making profits. ” a But what happens when businesses abandon ethics for profits ? ConsiderMerck ’s experience with the drug, Vioxx. Introduced in 1999, Vioxx wasan immediate success, quickly reaching$2.5 billion in annual sales. However, a Merck study launched in 1999 even- tually found that patients who tookVioxx suffered from an increased risk ofheart attacks and strokes. Despite therisks, Merck continued to market and sell Vioxx. By the time Vioxx was with- drawn from the market, an estimated20 million Americans had taken thedrug, 88,000 had suffered Vioxx-related heart attacks, and 38,000 had died. News of the 2004 Vioxx with- drawal hit Merck ’s stock hard. The company ’s shares fell 27 percent on the day of the announcement, slashing $27 billion off the firm ’s market capital- ization. Moody ’s, Standard & Poor ’s, and Fitch cut Merck ’s credit ratings,costing the firm its coveted AAA rating. The company ’s bottom line also suf- fered, as net income fell 21 percent inthe final three months of 2004. The recall dealt a major blow to Merck ’s reputation. The company was criticized for aggressively marketing Vioxx despite its serious side effects.Questions were also raised about theresearch reports Merck had submittedin support of the drug. Lawsuits fol- lowed. In 2008, Merck agreed to fund a $4.85 billion settlement to resolveapproximately 50,000 Vioxx-relatedlawsuits. The company had alsoincurred $1.53 billion in legal costs by the time of the settlement. 3 The Vioxx recall increased Merck’s cost of capital. What effect would an increased cost of capital have on a firm’s future investments?in practice aPeter F. Drucker, The Essential Drucker (New York: Collins Business Essentials, 2001). money in lumps, the cost of capital reflects the entirety of the firm’s financing activ- ities. For example, if a firm raises funds with debt (borrowing) today and at somefuture point sells common stock to raise additional financing, then the respectivecosts of both forms of capital should be reflected in the firm’s cost of capital. Mostfirms attempt to maintain an optimal mix of debt and equity financing. In practice,this mix is commonly a range, such as 40 percent to 50 percent debt, rather than apoint, such as 55 percent debt. This range is called a target capital structure —a topic that will be addressed in Chapter 13. Here, it is sufficient to say that althoughfirms raise money in lumps, they tend toward some desired mix of financing. To capture all of the relevant financing costs, assuming some desired mix of financing, we need to look at the overall cost of capital rather than just the cost of any single source of financing. A firm is currently faced with an investment opportunity. Assume the following: Best project available today Least costly financing source available Because it can earn 7% on the investment of funds costing only 6%, the firm undertakes the opportunity. Imagine that 1 week later a new investment opportu- nity is available: Best project available 1 week later Least costly financing source available In this instance, the firm rejects the opportunity because the 14% financing cost is greater than the 12% expected return. What if instead the firm used a combined cost of financing? By weighting the cost of each source of financing by its relative proportion in the firm’s target cap- ital structure, the firm can obtain a weighted average cost of capital . Assuming that a 50–50 mix of debt and equity is targeted, the weighted average cost herewould be . With this averagecost of financing, the first opportunity would have been rejected (7% expectedreturn 10% weighted average cost), and the second would have been accepted (12% expected return 10% weighted average cost). SOURCES OF LONG-TERM CAPITAL In this chapter, our concern is only with the long-term sources of capital available to a firm because these are the sources that supply the financing necessary to supportthe firm’s capital budgeting activities. Capital budgeting is the process of eval uating7610% 3(0.50 *6% debt) +(0.50 *14% equity) 4Equity =14% Expected Return =12%Life =20 yearsCost =$100,000Debt =6% Expected Return =7%Life =20 yearsCost =$100,000Example 9.13CHAPTER 9 The Cost of Capital 359 and selecting long-term investments. This process is intended to achieve the firm’s goal of maximizing shareholders’ wealth. Although the entire capital budgetingprocess is discussed throughout Part 5, at this point it is sufficient to say that cap-ital budgeting activities are chief among the responsibilities of financial managersand that they cannot be carried out without knowing the appropriate cost of cap-ital with which to judge the firm’s investment opportunities. There are four basic sources of long-term capital for firms: long-term debt, pre- ferred stock, common stock, and retained earnings. All entries on the right-handside of the balance sheet, other than current liabilities, represent these sources:360 PART 4 Risk and the Required Rate of Return Balance Sheet Long-term debt Assets Stockholders’ equity Preferred stock Common stock equity Common stock Retained earningsCurrent liabilities Sources of long-term capital Not every firm will use all of these sources of financing, but most firms will have some mix of funds from these sources in their capital structures. Although a firm’sexisting mix of financing sources may reflect its target capital structure, it is ulti-mately the marginal cost of capital necessary to raise the next marginal dollar offinancing that is relevant for evaluating the firm’s future investment opportunities. 6REVIEW QUESTIONS 9–1What is the cost of capital? 9–2What role does the cost of capital play in the firm’s long-term invest- ment decisions? How does it relate to the firm’s ability to maximizeshareholder wealth? 9–3What does the firm’s capital structure represent? 9–4What are the typical sources of long-term capital available to the firm? 9.2Cost of Long-Term Debt The cost of long-term debt is the financing cost associated with new funds raised through long-term borrowing. Typically, the funds are raised through the sale ofcorporate bonds. NET PROCEEDS The net proceeds from the sale of a bond, or any security, are the funds that the firm receives from the sale. The total proceeds are reduced by the flotation costs,LG3 cost of long-term debt The financing cost associated with new funds raised throughlong-term borrowing. net proceeds Funds actually received by thefirm from the sale of a security. which represent the total costs of issuing and selling securities. These costs apply to all public offerings of securities—debt, preferred stock, and common stock.They include two components: (1) underwriting costs —compensation earned by investment bankers for selling the security—and (2) administrative costs —issuer expenses such as legal, accounting, and printing. Duchess Corporation, a major hardware manufacturer, is contemplating selling$10 million worth of 20-year, 9% coupon (stated annual interest rate) bonds, each with a par value of $1,000. Because bonds with similar risk earn returnsgreater than 9%, the firm must sell the bonds for $980 to compensate for thelower coupon interest rate. The flotation costs are 2% of the par value of thebond (0.02 $1,000), or $20. The net proceeds to the firm from the sale of each bond are therefore $960 ($980 minus $20). BEFORE-TAX COST OF DEBT The before-tax cost of debt, rd, is simply the rate of return the firm must pay on new borrowing. A firm’s before-tax cost of debt for bonds can be found in any ofthree ways: quotation, calculation, or approximation. Using Market Quotations A relatively quick method for finding the before-tax cost of debt is to observe theyield to maturity (YTM) on the firm’s existing bonds or bonds of similar risk issued by other companies. The market price of existing bonds reflects the rate ofreturn required by the market. For example, if the market requires a YTM of 9.7percent for a similar-risk bond, then this value can be used as the before-tax costof debt, r d, for new bonds. Bond yields are widely reported by sources such as The Wall Street Journal . Calculating the Cost This approach finds the before-tax cost of debt by calculating the YTM generated by the bond cash flows. From the issuer’s point of view, this value is the cost to maturity of the cash flows associated with the debt. The cost to maturity can be calculated by using a financial calculator or an electronic spreadsheet. It repre-sents the annual before-tax percentage cost of the debt. In the preceding example, $960 were the net proceeds of a 20-year bond with a$1,000 par value and 9% coupon interest rate. The calculation of the annual costis quite simple. The cash flow pattern associated with this bond’s sales consists ofan initial inflow (the net proceeds) followed by a series of annual outlays (theinterest payments). In the final year, when the debt is retired, an outlay repre-senting the repayment of the principal also occurs. The cash flows associatedwith Duchess Corporation’s bond issue are as follows:Example 9.33*Example 9.23CHAPTER 9 The Cost of Capital 361 flotation costs The total costs of issuing and selling a security. End of year(s) Cash flow 0 $ 960 1–20 $ 90 20 $1,000 – The initial $960 inflow is followed by annual interest outflows of $90 (9% coupon interest rate $1,000 par value) over the 20-year life of the bond. Inyear 20, an outflow of $1,000 (the repayment of the principal) occurs. We candetermine the cost of debt by finding the YTM, which is the discount rate thatequates the present value of the bond outflows to the initial inflow. Calculator Use (Note: Most calculators require either the present value [net proceeds] or the future value [annual interest payments and repayment of prin-cipal] to be input as negative numbers when we calculate yield to maturity. Thatapproach is used here.) Using the calculator and the inputs shown at the left, youshould find the before-tax cost of debt (yield to maturity) to be 9.452%. Spreadsheet Use The before-tax cost of debt on the Duchess Corporation bond can be calculated using an Excel spreadsheet. The following Excel spreadsheetshows that by referencing the cells containing the bond’s net proceeds, couponpayment, years to maturity, and par value as part of Excel’s RATE function youcan quickly determine that the appropriate before-tax cost of debt for DuchessCorporation’s bond is 9.452%.* 362 PART 4 Risk and the Required Rate of Return 9.452PV PMT CPT IFV–90 –1000 SolutionInput Function N 96020 FINDING THE YTM ON A 20-YEAR BOND Net proceeds from sale of bond Coupon paymentY ears to maturityPar value (principal)Before-tax cost of debt1 23456$960 $90 20 $1,000 9.452% Entry in Cell B6 is =RATE(B4,–B3,B2,–B5). A minus sign appears before B3 and B5 because coupon payment and par value are treated as cash outflows.AB Although you may not recognize it, both the calculator and the Excel function are using trial-and-error to find the bond’s YTM—they just do it faster than you can. Approximating the Cost Although not as precise as using a calculator, there is a method for quickly approx- imating the before-tax cost of debt. The before-tax cost of debt, rd, for a bond with a $1,000 par value can be approximated by using the following equation: (9.1) where n=number of years to the bond’s maturity Nd=net proceeds from the sale of debt (bond) I=annual interest in dollarsrd=I+$1,000 -Nd n Nd+$1,000 2 Substituting the appropriate values from the Duchess Corporation example into the approximation formula given in Equation 9.1, we get: This approximate value of before-tax cost of debt is close to the 9.452%, but it lacks the precision of the value derived using the calculator or spreadsheet. AFTER-TAX COST OF DEBT Unlike the dividends paid to equityholders, the interest payments paid to bond- holders are tax deductable for the firm, so the interest expense on debt reducesthe firm’s taxable income and, therefore, the firm’s tax liability. To find the firm’snetcost of debt, we must account for the tax savings created by debt and solve for the cost of long-term debt on an after-tax basis. The after-tax cost of debt, r i, can be found by multiplying the before-tax cost, rd, by 1 minus the tax rate, T, as stated in the following equation: (9.2) Duchess Corporation has a 40% tax rate. Using the 9.452% before-tax debt costcalculated above, and applying Equation 9.2, we find an after-tax cost of debt of Typically, the cost of long-term debt for a given firm is less than the cost of preferred or common stock, partly because of the tax deductibility of interest. Kait and Kasim Sullivan, a married couple in the 28% federal income-tax bracket, wish to borrow $60,000 to pay for a new luxury car. To finance the purchase, they can either borrow the $60,000through the auto dealer at an annual interest rate of 6.0%, or they can take a$60,000 second mortgage on their home. The best annual rate they can get onthe second mortgage is 7.2%. They already have qualified for both of the loansbeing considered. If they borrow from the auto dealer, the interest on this “consumer loan” will not be deductible for federal tax purposes. However, the interest on the secondmortgage would be tax deductible because the tax law allows individuals todeduct interest paid on a home mortgage. To choose the least-cost financing, theSullivans calculated the after-tax cost of both sources of long-term debt. Becauseinterest on the auto loan is nottax deductible, its after-tax cost equals its statedPersonal Finance Example 9.635.67% [9.452% *(1-0.40)].Example 9.53ri=rd*(1-T) =$92 $980=0.09388 or 9.388 % rd=$90 +$1,000 -$960 20 $960 +$1,000 2=$90 +$2 $980Example 9.43CHAPTER 9 The Cost of Capital 363 cost of 6.0%. Because the interest on the second mortgage istax deductible, its after-tax cost can be found using Equation 9.2: Because the 5.2% after-tax cost of the second mortgage is less than the 6.0% cost of the auto loan, the Sullivans should use the second mortgage to finance the auto purchase. 6REVIEW QUESTIONS 9–5What are the net proceeds from the sale of a bond? What are flotation costs, and how do they affect a bond’s net proceeds? 9–6What methods can be used to find the before-tax cost of debt? 9–7How is the before-tax cost of debt converted into the after-tax cost? 7.2% *(1-0.28) =7.2% *0.72 =5.2% After-tax cost of debt =Before-tax cost of debt *(1-Tax rate)364 PART 4 Risk and the Required Rate of Return 9.3Cost of Preferred Stock Preferred stock represents a special type of ownership interest in the firm. It gives preferred stockholders the right to receive their stated dividends before the firm can distribute any earnings to common stockholders. The key characteristics ofpreferred stock were described in Chapter 7. However, the one aspect of pre-ferred stock that requires review is dividends. PREFERRED STOCK DIVIDENDS Most preferred stock dividends are stated as a dollar amount: “xdollars per year.” When dividends are stated this way, the stock is often referred to as “ x-dollar pre- ferred stock.” Thus a “$4 preferred stock” is expected to pay preferred stockholders$4 in dividends each year on each share of preferred stock owned. Sometimes preferred stock dividends are stated as an annual percentage rate. This rate represents the percentage of the stock’s par, or face, value that equals the annual dividend. For instance, an 8 percent preferred stock with a $50 par value would be expected to pay an annual dividend of $4 per share Before the cost of preferred stock is calculated, any divi- dends stated as percentages should be converted to annual dollar dividends. CALCULATING THE COST OF PREFERRED STOCK The cost of preferred stock, rp,is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of the preferred stock. The net proceeds repre-sent the amount of money to be received minus any flotation costs. Equation 9.3gives the cost of preferred stock, r p, in terms of the annual dollar dividend, Dp, and the net proceeds from the sale of the stock, Np: (9.3) rp=Dp Np(0.08 *$50 par =$4).LG4 cost of preferred stock, rp The ratio of the preferred stock dividend to the firm’s net proceeds from the sale of preferred stock. Duchess Corporation is contemplating issuance of a 10% preferred stock that they expect to sell for $87 per share. The cost of issuing and selling the stock willbe $5 per share. The first step in finding the cost of the stock is to calculate thedollar amount of the annual preferred dividend, which is The net proceeds per share from the proposed sale of stock equals the sale priceminus the flotation costs Substituting the annual dividend,D p, of $8.70 and the net proceeds, Np, of $82 into Equation 9.3 gives the cost of preferred stock, The cost of Duchess’s preferred stock (10.6%) is much greater than the cost of its long-term debt (5.67%). This difference exists both because the cost oflong-term debt (the interest) is tax deductible and because preferred stock isriskier than long-term debt. 6REVIEW QUESTION 9–8How would you calculate the cost of preferred stock?10.6% ($8.70 ,$82).($87 -$5=$82).$8.70 (0.10 *$87).Example 9.73CHAPTER 9 The Cost of Capital 365 9.4Cost of Common Stock The cost of common stock is the return required on the stock by investors in the marketplace. There are two forms of common stock financing: (1) retained earn-ings and (2) new issues of common stock. As a first step in finding each of thesecosts, we must estimate the cost of common stock equity. FINDING THE COST OF COMMON STOCK EQUITY The cost of common stock equity, rs,is the rate at which investors discount the expected common stock dividends of the firm to determine its share value. Two tech-niques are used to measure the cost of common stock equity. One relies on the con-stant-growth valuation model, the other on the capital asset pricing model (CAPM). Using the Constant-Growth Valuation (Gordon Growth) Model In Chapter 7 we found the value of a share of stock to be equal to the presentvalue of all future dividends, which in one model were assumed to grow at a con-stant annual rate over an infinite time horizon. This is the constant-growth valu- ation model, also known as the Gordon growth model. The key expression derived for this model was presented as Equation 7.4 and is restated here: (9.4) where g=constant rate of growth in dividends rs=required return on common stock D1=per-share dividend expected at the end of year 1 P0=value of common stockP0=D1 rs-gLG5 cost of common stock equity, rs The rate at which investors discount the expecteddividends of the firm to determine its share value.In more depth To read about Subjective Techniques, go to www.myfinancelab.com constant-growth valuation (Gordon growth) model Assumes that the value of a share of stock equals thepresent value of all futuredividends (assumed to grow ata constant rate) that it isexpected to provide over aninfinite time horizon. Solving Equation 9.4 for rsresults in the following expression for the cost of common stock equity: (9.5) Equation 9.5 indicates that the cost of common stock equity can be found bydividing the dividend expected at the end of year 1 by the current market price ofthe stock (the “dividend yield”) and adding the expected growth rate (the “cap-ital gains yield”). Duchess Corporation wishes to determine its cost of common stock equity, rs. The market price, P0, of its common stock is $50 per share. The firm expects to pay a dividend, D1, of $4 at the end of the coming year, 2013. The dividends paid on the outstanding stock over the past 6 years (2007 through 2012) were as follows:Example 9.83rs=D1 P0+g366 PART 4 Risk and the Required Rate of Return Year Dividend 2012 $3.80 2011 3.622010 3.472009 3.332008 3.122007 2.97 Using a financial calculator or electronic spreadsheet, in conjunction with the tech- nique described for finding growth rates in Chapter 5, we can calculate the annualrate at which dividends have grown, g, from 2007 to 2012. It turns out to be approximately 5% (more precisely, it is 5.05%). Substituting and into Equation 9.5 yields the cost of common stock equity: The 13.0% cost of common stock equity represents the return required by existing shareholders on their investment. If the actual return is less than that, shareholders are likely to begin selling their stock. Using the Capital Asset Pricing Model (CAPM) Recall from Chapter 8 that the capital asset pricing model (CAPM) describes the relationship between the required return, rs, and the nondiversifiable risk of the firm as measured by the beta coefficient, b.The basic CAPM is: (9.6) where rm=market return; return on the market portfolio of assets RF=risk-free rate of returnrs=RF+3b*(rm-RF)4rs=$4 $50+0.05 =0.08 +0.05 =0.130 or 13.0 %g=5%D1=$4, P0=$50, capital asset pricing model (CAPM) Describes the relationship between the required return, rs, and the nondiversifiable risk ofthe firm as measured by thebeta coefficient, b. Using the CAPM indicates that the cost of common stock equity is the return required by investors as compensation for the firm’s nondiversifiable risk, meas-ured by beta. Duchess Corporation now wishes to calculate its cost of common stock equity, rs, by using the CAPM. The firm’s investment advisors and its own analysts indicatethat the risk-free rate, R F, equals 7%; the firm’s beta, b, equals 1.5; and the market return, rm, equals 11%. Substituting these values into Equation 9.6, the company estimates the cost of common stock equity, rs, to be: The 13.0% cost of common stock equity represents the required return of investors in Duchess Corporation common stock. It is the same as that found by using the constant-growth valuation model. Comparing Constant-Growth and CAPM Techniques The CAPM technique differs from the constant-growth valuation model in that itdirectly considers the firm’s risk, as reflected by beta, in determining the required return or cost of common stock equity. The constant-growth model does not lookat risk; it uses the market price, P 0, as a reflection of the expected risk–return preference of investors in the marketplace. The constant-growth valuation andCAPM techniques for finding r sare theoretically equivalent, though in practice estimates from the two methods do not always agree. The two methods can pro-duce different estimates because they require (as inputs) estimates of other quan-tities, such as the expected dividend growth rate or the firm’s beta. Another difference is that when the constant-growth valuation model is used to find the cost of common stock equity, it can easily be adjusted for flotation costs tofind the cost of new common stock; the CAPM does not provide a simple adjust-ment mechanism. The difficulty in adjusting the cost of common stock equity cal-culated by using the CAPM occurs because in its common form the model does not include the market price, P 0, a variable needed to make such an adjustment. Although the CAPM has a stronger theoretical foundation, the computational appeal of the traditional constant-growth valuation model justifies its usethroughout this text to measure financing costs of common stock. As a practicalmatter, analysts might want to estimate the cost of equity using both approaches andthen take an average of the results to arrive at a final estimate of the cost of equity. COST OF RETAINED EARNINGS As you know, dividends are paid out of a firm’s earnings. Their payment, made incash to common stockholders, reduces the firm’s retained earnings. Suppose afirm needs common stock equity financing of a certain amount. It has twochoices relative to retained earnings: It can issue additional common stock in thatamount and still pay dividends to stockholders out of retained earnings, or it canincrease common stock equity by retaining the earnings (not paying the cash divi-dends) in the needed amount. In a strict accounting sense, the retention of earningsincreases common stock equity in the same way that the sale of additional shares ofcommon stock does. Thus the cost of retained earnings, r r,to the firm is the same as the cost of an equivalent fully subscribed issue of additional common stock.rs=7.0% +31.5 *(11.0% -7.0%)4=7.0% +6.0% =13.0%Example 9.93CHAPTER 9 The Cost of Capital 367 cost of retained earnings, rr The same as the cost of an equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity, rs. Stockholders find the firm’s retention of earnings acceptable only if they expect that it will earn at least their required return on the reinvested funds. Viewing retained earnings as a fully subscribed issue of additional common stock, we can set the firm’s cost of retained earnings, rr, equal to the cost of common stock equity as given by Equations 9.5 and 9.6. (9.7) It is not necessary to adjust the cost of retained earnings for flotation costs becauseby retaining earnings the firm “raises” equity capital without incurring these costs. The cost of retained earnings for Duchess Corporation was actually calculated inthe preceding examples: It is equal to the cost of common stock equity. Thus r r equals 13.0%. As we will show in the next section, the cost of retained earnings is always lower than the cost of a new issue of common stock because it entails no flotation costs.Example 9.10 3rr=rs368 PART 4 Risk and the Required Rate of Return Matter of fact In the United States and most other countries, firms rely more heavily on retained earnings than any other financing source. For example, a 2010 survey of CEOs by the Australian Industry Group and Deloitte reported that the vast majority of Australian firms see retained earnings as their mostimportant source of finance. Almost 65% of CEOs surveyed said that retained earnings was their most preferred source of financing, with bank debt coming in as a distant second choice. 2Retained Earnings, the Preferred Source of Financing COST OF NEW ISSUES OF COMMON STOCK Our purpose in finding the firm’s overall cost of capital is to determine the after- tax cost of new funds required for financing projects. The cost of a new issue of common stock, rn,is determined by calculating the cost of common stock, net of underpricing and associated flotation costs. Normally, when new shares are issuedthey are underpriced —sold at a discount relative to the current market price, P 0. Underpricing is the difference between the market price and the issue price, whichis the price paid by the primary market investors discussed in Chapter 2. We can use the constant-growth valuation model expression for the cost of existing common stock, r s, as a starting point. If we let Nnrepresent the net pro- ceeds from the sale of new common stock after subtracting underpricing andflotation costs, the cost of the new issue, r n, can be expressed as follows:3 (9.8) rn=D1 Nn+g 2. Australian Industry Group and Deloitte, National CEO Survey: Growth Strategies for Business, Report, October 2010. 3. An alternative, but computationally less straightforward, form of this equation is (9.8a) where frepresents the percentage reduction in current market price expected as a result of underpricing and flota- tion costs. Simply stated, Nnin Equation 9.8 is equivalent to in Equation 9.8a. For convenience, Equation 9.8 is used to define the cost of a new issue of common stock, rn.P0*(1-f)rn=D1 P0*(1-f)+gcost of a new issue of common stock, rn The cost of common stock, net of underpricing and associatedflotation costs. underpriced Stock sold at a price below itscurrent market price, P0. The net proceeds from sale of new common stock, Nn, will be less than the current market price, P0. Therefore, the cost of new issues, rn, will always be greater than the cost of existing issues, rs, which is equal to the cost of retained earnings, rr. The cost of new common stock is normally greater than any other long-term financing cost. In the constant-growth valuation example, we found Duchess Corporation’s costof common stock equity, r s, to be 13%, using the following values: an expected dividend, D1, of $4; a current market price, P0, of $50; and an expected growth rate of dividends, g,of 5%. To determine its cost of new common stock, rn, Duchess Corporation has estimated that on average, new shares can be sold for $47. The $3-per-shareunderpricing is due to the competitive nature of the market. A second cost asso-ciated with a new issue is flotation costs of $2.50 per share that would be paid toissue and sell the new shares. The total underpricing and flotation costs per shareare therefore $5.50. Subtracting the $5.50-per-share underpricing and flotation cost from the cur- rent $50 share price results in expected net proceeds of $44.50 per share ($50.00minus $5.50). Substituting and into Equation 9.8results in a cost of new common stock, r n, as follows: Duchess Corporation’s cost of new common stock is therefore 14.0%. This is the value to be used in subsequent calculations of the firm’s overall cost of capital. 6REVIEW QUESTIONS 9–9What premise about share value underlies the constant-growth valua- tion (Gordon growth) model that is used to measure the cost of commonstock equity, r s? 9–10 How do the constant-growth valuation model and capital asset pricing model methods for finding the cost of common stock differ? 9–11 Why is the cost of financing a project with retained earnings less thanthe cost of financing it with a new issue of common stock?r n=$4.00 $44.50+0.05 =0.09 +0.05 =0.140 or 14.0 %g=5% D1=$4, Nn=$44.50,Example 9.11 3CHAPTER 9 The Cost of Capital 369 9.5Weighted Average Cost of Capital Now that we have calculated the cost of specific sources of financing, we can determine the overall cost of capital. As noted earlier, the weighted average cost of capital (WACC), ra,reflects the expected average future cost of capital over the long run. It is found by weighting the cost of each specific type of capital by itsproportion in the firm’s capital structure. CALCULATING WEIGHTED AVERAGE COST OF CAPITAL (WACC) Calculating the weighted average cost of capital (WACC) is straightforward:Multiply the individual cost of each form of financing by its proportion in theLG6 weighted average cost of capital (WACC), ra Reflects the expected average future cost of capital over thelong run; found by weightingthe cost of each specific type ofcapital by its proportion in thefirm’s capital structure. firm’s capital structure and sum the weighted values. As an equation, the weighted average cost of capital, ra, can be specified as follows: (9.9) where Three important points should be noted in Equation 9.9: 1. For computational convenience, it is best to convert the weights into decimal form and leave the individual costs in percentage terms. 2.The weights must be nonnegative and sum to 1.0. Simply stated, WACC must account for all financing costs within the firm’s capital structure. 3. The firm’s common stock equity weight, ws, is multiplied by either the cost of retained earnings, rr, or the cost of new common stock, rn. Which cost is used depends on whether the firm’s common stock equity will be financed usingretained earnings, r r, or new common stock, rn. In earlier examples, we found the costs of the various types of capital for Duchess Corporation to be as follows: The company uses the following weights in calculating its weighted average cost of capital: Cost of new common stock, rn=14.0% Cost of retained earnings, rr=13.0% Cost of preferred stock, rp=10.6% Cost of debt, ri=5.6%Example 9.12 3 wi+wp+ws=1.0 ws=proportion of common stock equity in capital structure wp=proportion of preferred stock in capital structure wi=proportion of long-term debt in capital structurera=(wi*ri)+(wp*rp)+(ws*rr or n)370 PART 4 Risk and the Required Rate of Return Source of capital Weight Long-term debt 40% Preferred stock 10Common stock equity Total % 10050 Because the firm expects to have a sizable amount of retained earnings avail- able ($300,000), it plans to use its cost of retained earnings, rr, as the cost of common stock equity. Duchess Corporation’s weighted average cost of capital iscalculated in Table 9.1. The resulting weighted average cost of capital forDuchess is 9.8%. Assuming an unchanged risk level, the firm should accept all projects that will earn a return greater than 9.8%. CHAPTER 9 The Cost of Capital 371 Calculation of the Weighted Average Cost of Capital for Duchess Corporation Weighted cost Weight Cost [(1) (2)] Source of capital (1) (2) (3) Long-term debt 0.40 5.6% 2.2% Preferred stock 0.10 10.6 1.1Common stock equity 13.0 Totals 1.00 WACC 9.8 % =6.5 0.50:TABLE 9.1 focus on PRACTICE Uncertain Times Make for an Uncertain Weighted Average Cost of Capital on those projects that have immediate returns, ” Mr. Domanico is quoted saying.a Part of Caraustar ’s motivation for implementing this two-prongedapproach was to account for the exces-sively large spread between short- and long-term debt rates that emerged dur- ing the financial market crisis. Mr.Domanico reported that during the cri-sis Caraustar could borrow short-term funds at the lower of Prime plus 4 per- cent or LIBOR plus 5 percent—whereeither rate was reasonable for makingshort-term investment decisions.Alternatively, long-term investment deci- sions were being required to clear Caraustar ’s long-term cost-of-capital cal- culation accounting for borrowing ratesin excess of 12 percent. 3 Why don’t firms generally use both short- and long-run weighted average costs of capital?inaccessible, and the great recession saw Treasury bond yields fall to historiclows, making cost of equity projectionsappear unreasonably low. With these key components in flux, it is exceedingly difficult, if not impossible, for firms to get a handle on a cost of long-term capital. According to CFO Magazine, at least one firm resorted to a two-pronged approach for determining itscost of capital during the uncertain times. Ron Domanico is the chief finan- cial officer (CFO) at CaraustarIndustries, Inc., and he reported that hiscompany dealt with the cost-of-capital uncertainty by abandoning the conven- tional one-size-fits-all approach. “In the past, we had one cost of capital thatwe applied to all our investment deci-sions . . . today that ’s not the case. We have a short-term cost of capital we apply to short-term opportunities, and a longer-term cost of capital we apply tolonger-term opportunities . . . and thereality is that the longer-term cost is so high that it has forced us to focus onlyAs U.S. financial mar- kets experienced and recovered from the 2008 financial crisis and 2009 “great recession, ” firms struggled to keep track of their weighted average cost of capital. The individual component costs weremoving rapidly in response to thefinancial market turmoil. Volatile finan- cial markets can make otherwise man- ageable cost-of-capital calculations exceedingly complex and inherentlyerror prone—possibly wreaking havoc with investment decisions. If a firm underestimates its cost of capital it risks making investments that are not economically justified, and if a firm overestimates its financing costs itrisks foregoing value-maximizing investments. Although the WACC computation does not change when marketsbecome unstable, the uncertainty sur-rounding the components that comprisethe WACC increases dramatically. The financial crisis pushed credit costs to a point where long-term debt was largelyin practice aRandy Myers, “A Losing Formula ” (May 2009), www.cfo.com/article.cfm/13522582/c_13526469 . WEIGHTING SCHEMES Firms can calculate weights on the basis of either book value or market value using either historical or target proportions. Book Value versus Market Value Book value weights use accounting values to measure the proportion of each type of capital in the firm’s financial structure. Market value weights measure the propor- tion of each type of capital at its market value. Market value weights are appealingbecause the market values of securities closely approximate the actual dollars to bereceived from their sale. Moreover, because firms calculate the costs of the varioustypes of capital by using prevailing market prices, it seems reasonable to use marketvalue weights. In addition, the long-term investment cash flows to which the cost ofcapital is applied are estimated in terms of current as well as future market values.Market value weights are clearly preferred over book value weights. Historical versus Target Historical weights can be either book or market value weights based on actual capital structure proportions. For example, past or current book value propor-tions would constitute a form of historical weighting, as would past or currentmarket value proportions. Such a weighting scheme would therefore be based onreal—rather than desired—proportions. Target weights, which can also be based on either book or market values, reflect the firm’s desired capital structure proportions. Firms using target weights establish such proportions on the basis of the “optimal” capital structure theywish to achieve. (The development of these proportions and the optimal structureare discussed in detail in Chapter 13.) When one considers the somewhat approximate nature of the calculation of weighted average cost of capital, the choice of weights may not be critical.However, from a strictly theoretical point of view, the preferred weighting scheme is target market value proportions, and we assume these throughout this chapter. Chuck Solis currently has three loans outstanding, all of which mature in exactly 6 years and can be repaid without penalty any time prior to maturity. The outstanding balances and annual interest rates onthese loans are noted in the following table.Personal Finance Example 9.13 3372 PART 4 Risk and the Required Rate of Return historical weights Either book or market value weights based on actual capital structure proportions. target weights Either book or market valueweights based on desired capital structure proportions.book value weights Weights that use accountingvalues to measure theproportion of each type ofcapital in the firm’s financialstructure. market value weights Weights that use market valuesto measure the proportion ofeach type of capital in thefirm’s financial structure. In more depth To read about Changes in the Weighted Average Cost of Capital, go to www.myfinancelab.com Outstanding Annual Loan balance interest rate 1 $26,000 9.6% 2 9,000 10.63 45,000 7.4 After a thorough search, Chuck found a lender who would loan him $80,000 for 6 years at an annual interest rate of 9.2% on the condition that the loan proceedsbe used to fully repay the three outstanding loans, which combined have an out-standing balance of . Chuck wishes to choose the least costly alternative: (1) to do nothing or (2) to borrow the $80,000 and pay off all three loans. He calculates the weighted$80,000 ($26,000 +$9,000 +$45,000) average cost of his current debt by weighting each debt’s annual interest cost by the proportion of the $80,000 total it represents and then summing the threeweighted values as follows: Weighted average Given that the weighted average cost of the $80,000 of current debt of 8.5% is below the 9.2% cost of the new $80,000 loan, Chuck should do nothing, and just continue to pay off the three loans as originally scheduled. 6REVIEW QUESTIONS 9–12 What is the weighted average cost of capital (WACC), and how is it cal- culated? 9–13 What is the relationship between the firm’s target capital structure and theweighted average cost of capital (WACC)? 9–14 Describe the logic underlying the use of target weights to calculate the WACC, and compare and contrast this approach with the use ofhistorical weights . What is the preferred weighting scheme?=3.12% +1.19% +4.16% =8.47% L8.5 %=(.3250 *9.6%) +(.1125 *10.6%) +(.5625 *7.4%)*10.6%4+3($45,000 ,$80,000) *7.4%4cost of current debt =3($26,000 ,$80,000) *9.6%4+3($9,000 ,$80,000)CHAPTER 9 The Cost of Capital 373 Summary FOCUS ON VALUE The cost of capital is an extremely important rate of return, particularly in cap- ital budgeting decisions. It is the expected average future cost to the firm offunds over the long run. Because the cost of capital is the pivotal rate of returnused in the investment decision process, its accuracy can significantly affect thequality of these decisions. Underestimation of the cost of capital can make poor projects look attractive; overestimation can make good projects look unattractive. By applying the tech-niques presented in this chapter to estimate the firm’s cost of capital, the financialmanager will improve the likelihood that the firm’s long-term decisions will beconsistent with the firm’s overall goal of maximizing stock price (owner wealth). REVIEW OF LEARNING GOALS Understand the basic concept and sources of capital associated with the cost of capital. The cost of capital is the minimum rate of return that a firm must earn on its investments to grow firm value. A weighted average cost of capitalshould be used to find the expected average future cost of funds over the longrun. The individual costs of the basic sources of capital (long-term debt, pre-ferred stock, retained earnings, and common stock) can be calculated separately. Explain what is meant by the marginal cost of capital. The relevant cost of capital for a firm is the marginal cost of capital necessary to raise the next LG2LG1 marginal dollar of financing to fund the firm’s future investment opportunities. A firm’s future investment opportunities in expectation will be required toexceed the firm’s cost of capital. Determine the cost of long-term debt, and explain why the after-tax cost of debt is the relevant cost of debt. The before-tax cost of long-term debt can be found by using cost quotations, calculations (either by calculator or spread-sheet), or an approximation. The after-tax cost of debt is calculated by multi-plying the before-tax cost of debt by 1 minus the tax rate. The after-tax cost ofdebt is the relevant cost of debt because it is the lowest possible cost of debt forthe firm due to the deductibility of interest expenses. Determine the cost of preferred stock. The cost of preferred stock is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale ofpreferred stock. Calculate the cost of common stock equity, and convert it into the cost of retained earnings and the cost of new issues of common stock. The cost of common stock equity can be calculated by using the constant-growth valuation(Gordon growth) model or the CAPM. The cost of retained earnings is equal tothe cost of common stock equity. An adjustment in the cost of common stockequity to reflect underpricing and flotation costs is necessary to find the cost ofnew issues of common stock. Calculate the weighted average cost of capital (WACC), and discuss alternative weighting schemes. The firm’s WACC reflects the expected average future cost of funds over the long run. It combines the costs of specific types ofcapital after weighting each of them by its proportion. The theoretically pre-ferred approach uses target weights based on market values. LG6LG5LG4LG3374 PART 4 Risk and the Required Rate of Return Opener-in-Review The chapter opener claimed that GE’s cost of capital in late 2009 was about 5%. Suppose that GE could use $1 billion to make an investment that wouldgenerate positive cash flow of $60 million every year in perpetuity. At a 5 per-cent discount rate, what would be the value of this cash flow to investors? Howmuch would such an investment add to GE’s market value? Now suppose thatthe investment actually produces just $10 million per year in perpetuity (orabout 1 percent per year relative to the cost of the investment). What is thevalue of this investment to shareholders, and by how much would GE’s marketvalue fall because of this investment? Self-Test Problem(Solutions in Appendix) ST9–1 Individual costs and WACC Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in the 40% tax bracket. Current investigation has gathered the following data: Debt The firm can raise debt by selling $1,000-par-value, 10% coupon interest rate, 10-year bonds on which annual interest payments will be made. To sell theLG3LG4 LG5LG6 issue, an average discount of $30 per bond must be given. The firm must also pay flotation costs of $20 per bond. Preferred stock The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par value. The cost of issuing and selling the preferred stock isexpected to be $4 per share. Common stock The firm’s common stock is currently selling for $80 per share. The firm expects to pay cash dividends of $6 per share next year. The firm’s divi-dends have been growing at an annual rate of 6%, and this rate is expected tocontinue in the future. The stock will have to be underpriced by $4 per share,and flotation costs are expected to amount to $4 per share. Retained earnings The firm expects to have $225,000 of retained earnings available in the coming year. Once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. a.Calculate the individual cost of each source of financing. (Round to the nearest 0.1%.) b.Calculate the firm’s weighted average cost of capital using the weights shown in the following table, which are based on the firm’s target capital structure propor- tions. (Round to the nearest 0.1%.)CHAPTER 9 The Cost of Capital 375 Source of capital Weight Long-term debt 40% Preferred stock 15Common stock equity Total % 10045 c.In which, if any, of the investments shown in the following table do you recom- mend that the firm invest? Explain your answer. How much new financing is required? Investment Expected rate Initial opportunity of return investment A 11.2% $100,000 B 9.7 500,000 C 12.9 150,000 D 16.5 200,000 E 11.8 450,000 F 10.1 600,000 G 10.5 300,000 Warm-Up ExercisesAll problems are available in . E9–1 A firm raises capital by selling $20,000 worth of debt with flotation costs equal to 2% of its par value. If the debt matures in 10 years and has a coupon interest rate of 8%, what is the bond’s YTM? LG3 E9–2 Your firm, People’s Consulting Group, has been asked to consult on a potential pre- ferred stock offering by Brave New World. This 15% preferred stock issue would besold at its par value of $35 per share. Flotation costs would total $3 per share.Calculate the cost of this preferred stock. E9–3 Duke Energy has been paying dividends steadily for 20 years. During that time, divi-dends have grown at a compound annual rate of 7%. If Duke Energy’s current stockprice is $78 and the firm plans to pay a dividend of $6.50 next year, what is Duke’scost of common stock equity ? E9–4 Weekend Warriors, Inc., has 35% debt and 65% equity in its capital structure. The firm’s estimated after-tax cost of debt is 8% and its estimated cost of equity is 13%.Determine the firm’s weighted average cost of capital (WACC) . E9–5 Oxy Corporation uses debt, preferred stock, and common stock to raise capital. The firm’s capital structure targets the following proportions: debt, 55%; preferredstock, 10%; and common stock, 35%. If the cost of debt is 6.7%, preferred stock costs 9.2%, and common stock costs 10.6%, what is Oxy’s weighted average cost of capital (WACC) ?376 PART 4 Risk and the Required Rate of Return LG4 LG5 LG6 LG6 ProblemsAll problems are available in . P9–1 Concept of cost of capital Wren Manufacturing is in the process of analyzing its investment decision-making procedures. The two projects evaluated by the firm during the past month were projects 263 and 264. The basic variables surroundingeach project analysis and the resulting decision actions are summarized in the fol- lowing table. LG1 Basic variables Project 263 Project 264 Cost $64,000 $58,000 Life 15 years 15 yearsExpected return 8% 15%Least-cost financing Source Debt EquityCost (after-tax) 7% 16% Decision Action Invest Don’t investReason 8% 7% cost 15% 16% cost 6 7 a.Evaluate the firm’s decision-making procedures, and explain why the acceptance of project 263 and rejection of project 264 may not be in the owners’ best interest. b.If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table. c.If the firm had used the weighted average cost calculated in part b,what actions would have been indicated relative to projects 263 and 264? d.Compare and contrast the firm’s actions with your findings in part c.Which deci- sion method seems more appropriate? Explain why. P9–2 Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30per bond will be incurred in this process. The firm is in the 40% tax bracket. a.Find the net proceeds from sale of the bond, N d. b.Show the cash flows from the firm’s point of view over the maturity of the bond. c.Calculate the before-tax and after-tax costs of debt. d.Use the approximation formula to estimate the before-tax and after-tax costs of debt. e.Compare and contrast the costs of debt calculated in parts cand d.Which approach do you prefer? Why? Personal Finance Problem P9–3 Before-tax cost of debt and after-tax cost of debt David Abbot is interested in purchasing a bond issued by Sony. He has obtained the following information on the security:CHAPTER 9 The Cost of Capital 377 Sony bond Par value $1,000 Coupon interest rate 6% Tax bracket 20% Cost $ 930 Years to maturity 10LG3 LG3 LG3 LG3Answer the following questions. a.Calculate the before-tax cost of the Sony bond. b.Calculate the after-tax cost of the Sony bond given David’s tax bracket. P9–4 Cost of debt using the approximation formula For each of the following $1,000-par- value bonds, assuming annual interest payment and a 40% tax rate, calculate the after-tax cost to maturity using the approximation formula. Discount ( ) or Coupon Bond Life (years) Underwriting fee premium ( ) interest rate A 20 $25 $20 9% B1 6 4 0 1 0 1 0 C1 5 3 0 1 5 1 2 D 25 15 Par 9 E2 2 2 0 6 0 1 1 –+-/H11545/H11546 P9–5 The cost of debt Gronseth Drywall Systems, Inc., is in discussions with its invest- ment bankers regarding the issuance of new bonds. The investment banker has informed the firm that different maturities will carry different coupon rates and sell at different prices. The firm must choose among several alternatives. In each case,the bonds will have a $1,000 par value and flotation costs will be $30 per bond. The company is taxed at a rate of 40%. Calculate the after-tax cost of financing with each of the following alternatives. Personal Finance Problem P9–6 After-tax cost of debt Rick and Stacy Stark, a married couple, are interested in pur- chasing their first boat. They have decided to borrow the boat’s purchase price of $100,000. The family is in the 28% federal income tax bracket. There are two choices for the Stark family: They can borrow the money from the boat dealer at an annual interest rate of 8%, or they could take out a $100,000 second mortgage on their home. Currently, home equity loans are at rates of 9.2%. There is no problemsecuring either of these two alternative financing choices. Rick and Stacy learn that if they borrow from the boat dealership, the interest will not be tax deductible. However, the interest on the second mortgage will qualify as being tax deductible on their federal income tax return.a.Calculate the after-tax cost of borrowing from the boat dealership. b.Calculate the after-tax cost of borrowing through a second mortgage on their home. c.Which source of borrowing is less costly for the Stark family? P9–7 Cost of preferred stock Taylor Systems has just issued preferred stock. The stock has a 12% annual dividend and a $100 par value and was sold at $97.50 per share. In addition, flotation costs of $2.50 per share must be paid. a.Calculate the cost of the preferred stock. b.If the firm sells the preferred stock with a 10% annual dividend and nets $90.00 after flotation costs, what is its cost? P9–8 Cost of preferred stock Determine the cost for each of the following preferred stocks.378 PART 4 Risk and the Required Rate of Return Coupon Time to Premium or Alternative rate maturity (years) discount A 9% 16 $250 B7 5 5 0 C 6 7 par D 5 10 75 – Preferred stock Par value Sale price Flotation cost Annual dividend A $100 $101 $9.00 11% B 40 38 $3.50 8% C 35 37 $4.00 $5.00 D 30 26 5% of par $3.00 E 20 20 $2.50 9% P9–9 Cost of common stock equity—CAPM J&M Corporation common stock has a beta, b, of 1.2. The risk-free rate is 6%, and the market return is 11%. a.Determine the risk premium on J&M common stock. b.Determine the required return that J&M common stock should provide. c.Determine J&M’s cost of common stock equity using the CAPM.LG3 LG4 LG4 LG5 P9–10 Cost of common stock equity Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently selling for $57.50. The firm expects to paya $3.40 dividend at the end of the year (2013). The dividends for the past 5 yearsare shown in the following table.CHAPTER 9 The Cost of Capital 379 LG5 LG5Year Dividend 2012 $3.10 2011 2.922010 2.602009 2.302008 2.12 After underpricing and flotation costs, the firm expects to net $52 per share on a new issue. a.Determine the growth rate of dividends from 2008 to 2012. b.Determine the net proceeds, Nn, that the firm will actually receive. c.Using the constant-growth valuation model, determine the cost of retained earn- ings, r r. d.Using the constant-growth valuation model, determine the cost of new common stock, r n. P9–11 Retained earnings versus new common stock Using the data for each firm shown in the following table, calculate the cost of retained earnings and the cost of new common stock using the constant-growth valuation model. Projected Current market Dividend dividend per Underpricing Flotation cost Firm price per share growth rate share next year per share per share A $50.00 8% $2.25 $2.00 $1.00 B 20.00 4 1.00 0.50 1.50C 42.50 6 2.00 1.00 2.00D 19.00 2 2.10 1.30 1.70 P9–12 The effect of tax rate on WACC Equity Lighting Corp. wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% commonstock. The cost of financing with retained earnings is 14%, the cost of preferred stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts atoc. a.Tax rate 40% b.Tax rate 35% c.Tax rate 25% d.Describe the relationship between changes in the rate of taxation and the weighted average cost of capital.===LG4LG3 LG6LG5 P9–13 WACC—Book weights Ridge Tool has on its books the amounts and specific (after-tax) costs shown in the following table for each source of capital.380 PART 4 Risk and the Required Rate of Return LG6 Source of capital Book value Individual cost Long-term debt $700,000 5.3% Preferred stock 50,000 12.0Common stock equity 650,000 16.0 Source of capital Book value Market value After-tax cost Long-term debt $4,000,000 $3,840,000 6.0% Preferred stock 40,000 60,000 13.0Common stock equity 17.0 Totals $6,900,000 $5,100,0003,000,000 1,060,000 Target market Source of capital value weight Long-term debt 30% Preferred stock 15Common stock equity Total % 10055a.Calculate the firm’s weighted average cost of capital using book value weights . b.Explain how the firm can use this cost in the investment decision-making process. P9–14 WACC—Book weights and market weights Webster Company has compiled the information shown in the following table. a.Calculate the weighted average cost of capital using book value weights. b.Calculate the weighted average cost of capital using market value weights. c.Compare the answers obtained in parts aand b.Explain the differences. P9–15 WACC and target weights After careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market value weights shown in the following table. The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated to be 13.5%; the cost of retained earnings is estimated to be 16.0%; and the cost ofnew common stock is estimated to be 18.0%. All of these are after-tax rates. The company’s debt represents 25%, the preferred stock represents 10%, and the common stock equity represents 65% of total capital on the basis of the market values of the three components. The company expects to have a significant amountof retained earnings available and does not expect to sell any new common stock.LG6 LG6 a.Calculate the weighted average cost of capital on the basis of historical market value weights. b.Calculate the weighted average cost of capital on the basis of target market value weights. c.Compare the answers obtained in parts aandb.Explain the differences. P9–16 Cost of capital Edna Recording Studios, Inc., reported earnings available to common stock of $4,200,000 last year. From those earnings, the company paid a dividend of $1.26 on each of its 1,000,000 common shares outstanding. The capitalstructure of the company includes 40% debt, 10% preferred stock, and 50% common stock. It is taxed at a rate of 40%. a.If the market price of the common stock is $40 and dividends are expected to grow at a rate of 6% per year for the foreseeable future, what is the company’s cost of retained earnings financing? b.If underpricing and flotation costs on new shares of common stock amount to $7.00 per share, what is the company’s cost of new common stock financing? c.The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share. Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing? d.The company can issue $1,000-par-value, 10% coupon, 5-year bonds that can be sold for $1,200 each. Flotation costs would amount to $25.00 per bond. Use theestimation formula to figure the approximate cost of debt financing. e.What is the WACC? P9–17 Calculation of individual costs and WACC Dillon Labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost is to be measured by using the fol-lowing weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm’s tax rate is 40%. Debt The firm can sell for $980 a 10-year, $1,000-par-value bond paying annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond. Preferred stock Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters. Common stock The firm’s common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2013) is $4. Its dividend payments, which have been approximately 60% of earnings per sharein each of the past 5 years, were as shown in the following table.CHAPTER 9 The Cost of Capital 381 LG4LG3 LG6LG5 Year Dividend 2012 $3.75 2011 3.502010 3.302009 3.152008 2.85LG4LG3 LG6LG5 It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend paymentsare expected to continue at 60% of earnings. (Assume that .)a.Calculate the after-tax cost of debt. b.Calculate the cost of preferred stock. c.Calculate the cost of common stock. d.Calculate the WACC for Dillon Labs. Personal Finance Problem P9–18 Weighted average cost of capital John Dough has just been awarded his degree in business. He has three education loans outstanding. They all mature in 5 years andcan be repaid without penalty any time before maturity. The amounts owed on eachloan and the annual interest rate associated with each loan are given in the followingtable.r r=rs382 PART 4 Risk and the Required Rate of Return Annual Loan Balance due interest rate 1 $20,000 6% 2 12,000 93 32,000 5 John can also combine the total of his three debts (that is, $64,000) and create a consolidated loan from his bank. His bank will charge a 7.2% annual interest rate for a period of 5 years. Should John do nothing (leave the three individual loans as is) or create a con- solidated loan (the $64,000 question)? P9–19 Calculation of individual costs and WACC Lang Enterprises is interested in meas- uring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40% tax bracket. Debt The firm can raise debt by selling $1,000-par-value, 8% coupon interest rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond would have to be given. The firm alsomust pay flotation costs of $30 per bond. Preferred stock The firm can sell 8% preferred stock at its $95-per-share par value. The cost of issuing and selling the preferred stock is expected to be $5 per share. Preferred stock can be sold under these terms. Common stock The firm’s common stock is currently selling for $90 per share. The firm expects to pay cash dividends of $7 per share next year. The firm’s divi- dends have been growing at an annual rate of 6%, and this growth is expected tocontinue into the future. The stock must be underpriced by $7 per share, and flotation costs are expected to amount to $5 per share. The firm can sell new common stock under these terms. Retained earnings When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available $100,000 of retained earnings in the coming year; once these retained earningsLG6 LG4LG3 LG6LG5 are exhausted, the firm will use new common stock as the form of common stock equity financing. a.Calculate the after-tax cost of debt. b.Calculate the cost of preferred stock. c.Calculate the cost of common stock. d.Calculate the firm’s weighted average cost of capital using the capital structure weights shown in the following table. (Round answer to the nearest 0.1%.)CHAPTER 9 The Cost of Capital 383 Source of capital Weight Long-term debt 30% Preferred stock 20Common stock equity Total % 10050 P9–20 Weighted average cost of capital American Exploration, Inc., a natural gas pro- ducer, is trying to decide whether to revise its target capital structure. Currently it targets a 50–50 mix of debt and equity, but it is considering a target capital structurewith 70% debt. American Exploration currently has 6% after-tax cost of debt and a12% cost of common stock. The company does not have any preferred stock out-standing. a.What is American Exploration’s current WACC? b.Assuming that its cost of debt and equity remain unchanged, what will be American Exploration’s WACC under the revised target capital structure? c.Do you think shareholders are affected by the increase in debt to 70%? If so, how are they affected? Are their common stock claims riskier now? d.Suppose that in response to the increase in debt, American Exploration’s share- holders increase their required return so that cost of common equity is 16%. What will its new WACC be in this case? e.What does your answer in part bsuggest about the tradeoff between financing with debt versus equity? P9–21 ETHICS PROBLEM During the 1990s, General Electric put together a long string of consecutive quarters in which the firm managed to meet or beat the earnings fore- casts of Wall Street stock analysts. Some skeptics wondered if GE “managed” earn- ings to meet Wall Street’s expectations, meaning that GE used accounting gimmicks to conceal the true volatility in its business. How do you think GE’s long run of meeting or beating earnings forecasts affected its cost of capital? If investors learn that GE’s performance was achieved largely through accounting gimmicks, how doyou think they would respond? Spreadsheet Exercise Nova Corporation is interested in measuring the cost of each specific type of capitalas well as the weighted average cost of capital. Historically, the firm has raised capital in the following manner: LG6 LG1 The tax rate of the firm is currently 40%. The needed financial information and data are as follows: Debt Nova can raise debt by selling $1,000-par-value, 6.5% coupon interest rate, 10-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $20 per bond needs to be given. There is an associ-ated flotation cost of 2% of par value. Preferred stock Preferred stock can be sold under the following terms: The security has a par value of $100 per share, the annual dividend rate is 6% of the par value, and the flotation cost is expected to be $4 per share. The preferred stock is expected to sell for $102 before cost considerations. Common stock The current price of Nova’s common stock is $35 per share. The cash dividend is expected to be $3.25 per share next year. The firm’s divi- dends have grown at an annual rate of 5%, and it is expected that the dividend will continue at this rate for the foreseeable future. The flotation costs are expected to be approximately $2 per share. Nova can sell new common stock under these terms. Retained earnings The firm expects to have available $100,000 of retained earnings in the coming year. Once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. (Note: When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners.) TO DO Create a spreadsheet to answer the following questions: a.Calculate the after-tax cost of debt. b.Calculate the cost of preferred stock. c.Calculate the cost of retained earnings. d.Calculate the cost of new common stock. e.Calculate the firm’s weighted average cost of capital using retained earnings and the capital structure weights shown in the table above. f.Calculate the firm’s weighted average cost of capital using new common stock and the capital structure weights shown in the table above. Visit www.myfinancelab.com forChapter Case: Making Star Products’ Financing/Investment Decision, Group Exercises, and numerous online resources. 384 PART 4 Risk and the Required Rate of Return Source of capital Weight Long-term debt 35% Preferred stock 12Common stock equity 53 385Integrative Case 4 Eco Plastics Company Since its inception, Eco Plastics Company has been revolutionizing plastic and trying to do its part to save the environment. Eco’s founder, Marion Cosby, developed a biodegradable plastic that her company is marketing to manufacturing companies throughout the southeastern United States. After operating as a private company for six years, Eco went public in 2009 and is listed on the Nasdaq stock exchange. As the chief financial officer of a young company with lots of investment oppor- tunities, Eco’s CFO closely monitors the firm’s cost of capital. The CFO keeps tabs on each of the individual costs of Eco’s three main financing sources: long-term debt, preferred stock, and common stock. The target capital structure for ECO is given by the weights in the following table: Source of capital Weight Long-term debt 30% Preferred stock 20Common stock equity Total % 10050 At the present time, Eco can raise debt by selling 20-year bonds with a $1,000 par value and a 10.5% annual coupon interest rate. Eco’s corporate tax rate is 40%, and its bonds generally require an average discount of $45 per bond and flotationcosts of $32 per bond when being sold. Eco’s outstanding preferred stock pays a 9% dividend and has a $95-per-share par value. The cost of issuing and selling addi- tional preferred stock is expected to be $7 per share. Because Eco is a young firm that requires lots of cash to grow it does not currently pay a dividend to common stock holders. To track the cost of common stock the CFO uses the capital assetpricing model (CAPM). The CFO and the firm’s investment advisors believe that the appropriate risk-free rate is 4% and that the market’s expected return equals 13%. Using data from 2009 through 2012, Eco’s CFO estimates the firm’s beta to be 1.3. Although Eco’s current target capital structure includes 20% preferred stock, the company is considering using debt financing to retire the outstanding preferredstock, thus shifting their target capital structure to 50% long-term debt and 50% common stock. If Eco shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to 1.5. TO DO a.Calculate Eco’s current after-tax cost of long-term debt. b.Calculate Eco’s current cost of preferred stock. c.Calculate Eco’s current cost of common stock. d.Calculate Eco’s current weighted average cost capital. e.(1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% common stock have on the risk premium for Eco’s common stock? What would be Eco’s new cost of common equity? (2) What would be Eco’s new weighted average cost of capital? (3) Which capital structure—the original one or this one—seems better? Why? This page intentionally left blank 3875 PartLong-Term Investment Decisions 10 Capital Budgeting Techniques 11 Capital Budgeting Cash Flows 12 Risk and Refinements in Capital Budgeting INTEGRATIVE CASE 5 Lasting Impressions Company Probably nothing that financial managers do is more important to the long-term success of a company than making good investment decisions. The term capital budgeting describes the process for evaluating and selecting investment projects. Often, capital expenditures can be very large, such as building a new plant orlaunching a new product line. These endeavors can create enormous value forshareholders, but they can also bankrupt the company. In this section, you ’ll learn how financial managers decide which investment opportunities to pursue. Chapter 10 covers the capital budgeting tools that financial managers and analysts use to evaluate the merits of an investment. Some of these techniques are quite intuitiveand simple to use, such as payback analysis. Other techniques are a little morecomplex, such as the NPV and IRR approaches. In general, the more complextechniques provide more comprehensive evaluations, however, the simpler approachesoften lead to the same value-maximizing decisions. Chapter 11 illustrates how to develop the capital budgeting cash flows that the techniques covered in Chapter 10 require. After studying this chapter, you willunderstand the inputs that are necessary to build the relevant cash flows that arerequired to determine whether a particular investment is likely to create or destroy value for shareholders. Chapter 12 introduces additional techniques for evaluating the risks inherent with capital investment projects. Because of the often huge scale of capital investments andtheir importance to the firm ’s financial well-being, managers invest a tremendous amount of time and energy trying to understand the risks associated with theseprojects.Chapters in This Part Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand capital budgeting techniques to help determine the relevant cash flows associated with proposedcapital expenditures. INFORMATION SYSTEMS You need to understand capital budgeting techniques to design decision modules that help reduce the amount ofwork required to analyze proposed capital expenditures. MANAGEMENT You need to understand capital budgeting techniques to correctly analyze the relevant cash flows of proposed projects anddecide whether to accept or reject them. MARKETING You need to understand capital budgeting techniques to grasp how proposals for new marketing programs, for new products,and for the expansion of existing product lines will be evaluated by thefirm ’s decision makers. OPERATIONS You need to understand capital budgeting techniques to know how proposals for the acquisition of new equipment and plantswill be evaluated by the firm ’s decision makers. You can use the capital budgeting techniques used by financial man- agers to measure either the value of a given asset purchase or its com-pound rate of return. The IRR technique is widely applied in personalfinance to measure both actual and forecast rate of returns on invest-ment securities, real estate, credit card debt, consumer loans, and leases. In your personal lifeLearning Goals Understand the key elements of the capital budgeting process. Calculate, interpret, and evaluate the payback period. Calculate, interpret, and evaluate the net present value (NPV) andeconomic value added (EVA). Calculate, interpret, and evaluate the internal rate of return (IRR). Use net present value profiles to compare NPV and IRRtechniques. Discuss NPV and IRR in terms of conflicting rankings and thetheoretical and practical strengthsof each approach. LG6LG5LG4LG3LG2LG110Capital Budgeting Techniques 388 389The Gold Standard for Evaluating Gold Mines Genco Resources, a Canadian mining firm, announced the results of a feasibility study evalu- ating expansion of the firm ’s operations in Mexico. Specifically, the study examined the merits of opening a new cyanide leach plant that would allow the firm to increase its production by a factor of ten. Cost of theexpansion included $149 million to build the plant, including $40 million in working capital and contingencies required to begin operations. The study estimated cash flows from this investment over its 9-year projected life, assuming prices of silver and gold of $14 and $800 per ounce respectively. Based on those assumptions, the study claimed that the expansion project would pay back the initial cost in 3.6 years, would generate a 20 percent internal rate of return, and would produce a net present value of almost$75 million. Payback, internal rate of return, and net present value are all methods that companies use to evaluate potential investment projects. Each of these techniques has advantages and disad- vantages, but the net present value method has become the gold standard for analyzing invest-ments. This chapter explains why. Genco Resources 390 PART 5 Long-Term Investment Decisions 10.1 Overview of Capital Budgeting Long-term investments represent sizable outlays of funds that commit a firm to some course of action. Consequently, the firm needs procedures to analyze andselect its long-term investments. Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maxi-mizing owners’ wealth. Firms typically make a variety of long-term investments,but the most common is in fixed assets, which include property (land), plant, and equipment. These assets, often referred to as earning assets, generally provide the basis for the firm’s earning power and value. Because firms treat capital budgeting (investment) and financing decisions separately, Chapters 10 through 12 concentrate on fixed-asset acquisition without regard to the specific method of financing used. We begin by discussingthe motives for capital expenditure. MOTIVES FOR CAPITAL EXPENDITURE Acapital expenditure is an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year. An operating expenditure is an outlay resulting in benefits received within 1 year. Fixed-asset outlays are capital expenditures, but not all capital expenditures are classified as fixed assets. A$60,000 outlay for a new machine with a usable life of 15 years is a capitalexpenditure that would appear as a fixed asset on the firm’s balance sheet. A$60,000 outlay for an advertising campaign that is expected to produce benefitsover a long period is also a capital expenditure but would rarely be shown as afixed asset. Companies make capital expenditures for many reasons. The basic motives for capital expenditures are to expand operations, to replace or renew fixed assets, orto obtain some other, less tangible benefit over a long period. STEPS IN THE PROCESS Thecapital budgeting process consists of five distinct but interrelated steps: 1.Proposal generation. Proposals for new investment projects are made at all levels within a business organization and are reviewed by finance personnel.Proposals that require large outlays are more carefully scrutinized than lesscostly ones. 2.Review and analysis. Financial managers perform formal review and analysis to assess the merits of investment proposals. 3.Decision making. Firms typically delegate capital expenditure decision making on the basis of dollar limits. Generally, the board of directors mustauthorize expenditures beyond a certain amount. Often plant managers aregiven authority to make decisions necessary to keep the production linemoving. 4.Implementation. Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases. 5.Follow-up. Results are monitored, and actual costs and benefits are com- pared with those that were expected. Action may be required if actual out-comes differ from projected ones.LG1 capital budgeting The process of evaluating and selecting long-term investmentsthat are consistent with thefirm’s goal of maximizingowners’ wealth. capital expenditure An outlay of funds by the firmthat is expected to producebenefits over a period of time greater than 1 year. operating expenditure An outlay of funds by the firmresulting in benefits received within 1 year. capital budgeting process Five distinct but interrelatedsteps: proposal generation, review and analysis, decision making, implementation, and follow-up. Each step in the process is important. Review and analysis and decision making (Steps 2 and 3) consume the majority of time and effort, however.Follow-up (Step 5) is an important but often ignored step aimed at allowing thefirm to improve the accuracy of its cash flow estimates continuously. Because oftheir fundamental importance, this and the following chapters give primary con-sideration to review and analysis and to decision making. BASIC TERMINOLOGY Before we develop the concepts, techniques, and practices related to the capitalbudgeting process, we need to explain some basic terminology. In addition, wewill present some key assumptions that are used to simplify the discussion in theremainder of this chapter and in Chapters 11 and 12. Independent versus Mutually Exclusive Projects Most investments can be placed into one of two categories: (1) independent proj-ects or (2) mutually exclusive projects. Independent projects are those whose cash flows are unrelated to (or independent of) one another; the acceptance of oneproject does not eliminate the others from further consideration. Mutually exclu- sive projects are those that have the same function and therefore compete with one another. The acceptance of one eliminates from further consideration all other projects that serve a similar function. For example, a firm in need of increased pro-duction capacity could obtain it by (1) expanding its plant, (2) acquiring anothercompany, or (3) contracting with another company for production. Clearly,accepting any one option eliminates the immediate need for either of the others. Unlimited Funds versus Capital Rationing The availability of funds for capital expenditures affects the firm’s decisions. If afirm has unlimited funds for investment (or if it can raise as much money as it needs by borrowing or issuing stock), making capital budgeting decisions is quitesimple: All independent projects that will provide an acceptable return can beaccepted. Typically, though, firms operate under capital rationing instead. This means that they have only a fixed number of dollars available for capital expen-ditures and that numerous projects will compete for these dollars. Procedures fordealing with capital rationing are presented in Chapter 12. The discussions hereand in the following chapter assume unlimited funds. Accept–Reject versus Ranking Approaches Two basic approaches to capital budgeting decisions are available. The accept– reject approach involves evaluating capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion. This approach can be usedwhen the firm has unlimited funds, as a preliminary step when evaluating mutu-ally exclusive projects, or in a situation in which capital must be rationed. Inthese cases, only acceptable projects should be considered. The second method, the ranking approach, involves ranking projects on the basis of some predetermined measure, such as the rate of return. The project withthe highest return is ranked first, and the project with the lowest return is rankedlast. Only acceptable projects should be ranked. Ranking is useful in selecting the“best” of a group of mutually exclusive projects and in evaluating projects with aview of capital rationing.CHAPTER 10 Capital Budgeting Techniques 391 independent projects Projects whose cash flows are unrelated to (or independentof) one another; theacceptance of one does not eliminate the others from further consideration. mutually exclusive projects Projects that compete with oneanother, so that the acceptanceof one eliminates from further consideration all other projectsthat serve a similar function. unlimited funds The financial situation in whicha firm is able to accept allindependent projects thatprovide an acceptable return. capital rationing The financial situation in whicha firm has only a fixed numberof dollars available for capitalexpenditures, and numerousprojects compete for thesedollars. accept–reject approach The evaluation of capital expenditure proposals to determine whether they meetthe firm’s minimum acceptancecriterion. ranking approach The ranking of capitalexpenditure projects on thebasis of some predeterminedmeasure, such as the rate ofreturn. CAPITAL BUDGETING TECHNIQUES Large firms evaluate dozens, perhaps even hundreds, of different ideas for new investments each year. To ensure that the investment projects selected have thebest chance of increasing the value of the firm, financial managers need tools tohelp them evaluate the merits of individual projects and to rank competinginvestments. A number of techniques are available for performing such analyses.The preferred approaches integrate time value procedures, risk and return con-siderations, and valuation concepts to select capital expenditures that are consis-tent with the firm’s goal of maximizing owners’ wealth. This chapter focuses onthe use of these techniques in an environment of certainty. Bennett Company’s Relevant Cash Flows We will use one basic problem to illustrate all the techniques described in thischapter. The problem concerns Bennett Company, a medium-sized metal fabri-cator that is currently contemplating two projects: Project A requires an initialinvestment of $42,000; project B requires an initial investment of $45,000. Theprojected relevant cash flows for the two projects are presented in Table 10.1 anddepicted on the time lines in Figure 10.1. Both projects involve one initial cash392 PART 5 Long-Term Investment Decisions Capital Expenditure Data for Bennett Company Project A Project B Initial investment $42,000 $45,000 Year Operating cash inflows 1 $14,000 $28,000 2 14,000 12,0003 14,000 10,0004 14,000 10,0005 14,000 10,000TABLE 10.1 0 $42,000End of YearProject A$14,000 1$14,000 2$14,000 3$14,000 4$14,000 5 0 $45,000End of YearProject B$28,000 1$12,000 2$10,000 3$10,000 4$10,000 5FIGURE 10.1 Bennett Company’s Projects A and BTime lines depicting the conventional cash flows of projects A and BIn more depth To read about The Accounting Rate of Return, go to www .myfinancelab.com outlay followed by annual cash inflows, a fairly typical pattern for new invest- ments. We begin with a look at the three most popular capital budgeting tech-niques: payback period, net present value, and internal rate of return. 6REVIEW QUESTION 10–1 What is the financial manager’s goal in selecting investment projects for the firm? Define the capital budgeting process and explain how it helpsmanagers achieve their goal.CHAPTER 10 Capital Budgeting Techniques 393 10.2 Payback Period Payback periods are commonly used to evaluate proposed investments. The payback period is the amount of time required for the firm to recover its initial investment in a project, as calculated from cash inflows. In the case of an annuity (such as the Bennett Company’s project A), the payback period can be found bydividing the initial investment by the annual cash inflow. For a mixed stream of cash inflows (such as project B), the yearly cash inflows must be accumulateduntil the initial investment is recovered. Although popular, the payback period isgenerally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money. DECISION CRITERIA When the payback period is used to make accept–reject decisions, the following decision criteria apply: • If the payback period is less than the maximum acceptable payback period, accept the project. • If the payback period is greater than the maximum acceptable payback period, reject the project. The length of the maximum acceptable payback period is determined by manage- ment. This value is set subjectively on the basis of a number of factors, including the type of project (expansion, replacement or renewal, other), the perceived riskof the project, and the perceived relationship between the payback period and theshare value. It is simply a value that management feels, on average, will result invalue-creating investment decisions. We can calculate the payback period for Bennett Company’s projects A and Busing the data in Table 10.1. For project A, which is an annuity, the payback period is 3.0 years ($42,000 initial investment $14,000 annual cash inflow).Because project B generates a mixed stream of cash inflows, the calculation of itspayback period is not as clear-cut. In year 1, the firm will recover $28,000 of its$45,000 initial investment. By the end of year 2, $40,000 ($28,000 from year1 $12,000 from year 2) will have been recovered. At the end of year 3,$50,000 will have been recovered. Only 50% of the year-3 cash inflow of$10,000 is needed to complete the payback of the initial $45,000. The payback period for project B is therefore 2.5 years (2 years 50% of year 3). ++, Example 10.1 3LG2 payback period The amount of time required for a firm to recover its initialinvestment in a project, ascalculated from cash inflows. If Bennett’s maximum acceptable payback period were 2.75 years, project A would be rejected and project B would be accepted. If the maximum acceptable pay-back period were 2.25 years, both projects would be rejected. If the projects were being ranked, B would be preferred over A because it has a shorter payback period. PROS AND CONS OF PAYBACK ANALYSIS Large firms sometimes use the payback approach to evaluate small projects, andsmall firms use it to evaluate most projects. Its popularity results from its computa-tional simplicity and intuitive appeal. By measuring how quickly the firm recoversits initial investment, the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money. Because it can beviewed as a measure of risk exposure, many firms use the payback period as a deci- sion criterion or as a supplement to other decision techniques. The longer the firmmust wait to recover its invested funds, the greater the possibility of a calamity.Hence, the shorter the payback period the lower the firm’s risk exposure. The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number. It cannot be specified in lightof the wealth maximization goal because it is not based on discounting cash flowsto determine whether they add to the firm’s value. Instead, the appropriate pay-back period is simply the maximum acceptable period of time over which man-agement decides that a project’s cash flows must break even (that is, just equal tothe initial investment). The Focus on Practice box offers more information about these time limits in actual practice. Seema Mehdi is considering investing $20,000 to obtain a 5% interest in a rental property. Her good friend and real estate agent, Akbar Ahmed, put the deal together and he conservatively estimates that Seemashould receive between $4,000 and $6,000 per year in cash from her 5% interest inthe property. The deal is structured in a way that forces all investors to maintaintheir investment in the property for at least 10 years. Seema expects to remain in the25% income-tax bracket for quite a while. To be acceptable, Seema requires theinvestment to pay itself back in terms of after-tax cash flows in less than 7 years. Seema’s calculation of the payback period on this deal begins with calcula- tion of the range of annual after-tax cash flow: The after-tax cash flow ranges from $3,000 to $4,500. Dividing the $20,000 ini- tial investment by each of the estimated after-tax cash flows, we get the paybackperiod: Because Seema’s proposed rental property investment will pay itself back between 4.44 and 6.67 years, which is a range below her maximum payback of 7 years, the investment is acceptable.=$20,000 ,$4,500 =4.44 years=$20,000 ,$3,000 =6.67 yearsPayback period =Initial investment ,After-tax cash flow=(1-0.25) *$6,000 =$4,500=(1-0.25) *$4,000 =$3,000After-tax cash flow =(1-tax rate) *Pre-tax cash flowPersonal Finance Example 10.2 3394 PART 5 Long-Term Investment Decisions A second weakness is that this approach fails to take fully into account the time factor in the value of money.1This weakness can be illustrated by an example. DeYarman Enterprises, a small medical appliance manufacturer, is consideringtwo mutually exclusive projects named Gold and Silver. The firm uses only thepayback period to choose projects. The cash flows and payback period for eachproject are given in Table 10.2. Both projects have 3-year payback periods, whichwould suggest that they are equally desirable. But comparison of the pattern ofcash inflows over the first 3 years shows that more of the $50,000 initial invest-ment in project Silver is recovered sooner than is recovered for project Gold. Forexample, in year 1, $40,000 of the $50,000 invested in project Silver is recovered,whereas only $5,000 of the $50,000 investment in project Gold is recovered.Given the time value of money, project Silver would clearly be preferred overExample 10.3 3CHAPTER 10 Capital Budgeting Techniques 395 focus on PRACTICE Limits on Payback Analysis even more important than discounted cash flow (NPV and IRR)—because itspotlights the risks inherent in lengthy ITprojects. “It should be a hard and fast rule to never take an IT project with apayback period greater than 3 years,unless it ’s an infrastructure project you can ’t do without, ” Campbell says. Whatever the weaknesses of the payback period method of evaluatingcapital projects, the simplicity of themethod does allow it to be used inconjunction with other, more sophisti-cated measures. It can be used toscreen potential projects and winnowthem down to the few that merit morecareful scrutiny with, for example, netpresent value (NPV). 3 In your view, if the payback period method is used in conjunction with the NPV method, should it be used before or after the NPV evaluation?in Barrington, Illinois. “The simplicity of computing payback may encouragesloppiness, especially the failure toinclude all costs associated with aninvestment, such as training, mainte-nance, and hardware upgrade costs, ” says Douglas Emond, senior vice presi-dent and chief technology officer atEastern Bank in Lynn, Massachusetts.For example, he says, “you may be bringing in a hot new technology, butuh-oh, after implementation you realizethat you need a .Net guru in-house,and you don ’t have one. ” But the payback method ’s emphasis on the short term has a special appealfor IT managers. “That ’s because the history of IT projects that take longerthan 3 years is disastrous, ” says Gardner. Indeed, Ian Campbell, chiefresearch officer at Nucleus Research,Inc., in Wellesley, Massachusetts, says payback period is an absolutely essen- tial metric for evaluating IT projects—In tough economic times, the standard for a payback period is often reduced.Chief information officers (CIOs) areapt to reject projects with payback periods of more than 2 years. “We start with payback period, ” says Ron Fijalkowski, CIO at StrategicDistribution, Inc., in Bensalem,Pennsylvania. “For sure, if the payback period is over 36 months, it ’s not going to get approved. But our rule of thumbis we ’d like to see 24 months. And if it’s close to 12, it ’s probably a no- brainer. ” While easy to compute and easy to understand, the payback period ’s sim- plicity brings with it some drawbacks. “Payback gives you an answer that tells you a bit about the beginning stage ofa project, but it doesn ’t tell you much about the full lifetime of the project, ” says Chris Gardner, a cofounder ofiValue LLC, an IT valuation consultancyin practice 1. To consider differences in timing explicitly in applying the payback method, the discounted payback period is sometimes used. It is found by first calculating the present value of the cash inflows at the appropriate discount rateand then finding the payback period by using the present value of the cash inflows.Source: Gary Anthes, “ROI Guide: Payback Period, ” Computerworld.com (February 17, 2003), www.computerworld.com/ s/article/78529/ROI_Guide_Payback_Period?taxono . project Gold, in spite of the fact that both have identical 3-year payback periods. The payback approach does not fully account for the time value of money, which, if recognized, would cause project Silver to be preferred over project Gold. A third weakness of payback is its failure to recognize cash flows that occur after the payback period. Rashid Company, a software developer, has two investment opportunities, X and Y. Data for X and Y are given in Table 10.3. The payback period for project X is2 years; for project Y it is 3 years. Strict adherence to the payback approach sug-gests that project X is preferable to project Y. However, if we look beyond thepayback period, we see that project X returns only an additional $1,200 ($1,000in year 3 $100 in year 4 $100 in year 5), whereas project Y returns an addi-tional $7,000 ($4,000 in year 4 $3,000 in year 5). On the basis of this infor-mation, project Y appears preferable to X. The payback approach ignored thecash inflows occurring after the end of the payback period.++ + Example 10.4 3396 PART 5 Long-Term Investment Decisions Relevant Cash Flows and Payback Periods for DeYarman Enterprises’ Projects Project gold Project silver Initial investment $50,000 $50,000 Year Operating cash inflows 1 $ 5,000 $40,000 2 5,000 2,0003 40,000 8,0004 10,000 10,0005 10,000 10,000 Payback period 3 years 3 yearsTABLE 10.2 Calculation of the Payback Period for Rashid Company’s Two Alternative Investment Projects Project X Project Y Initial investment $10,000 $10,000 Year Operating cash inflows 1 $5,000 $3,000 2 5,000 4,0003 1,000 3,0004 100 4,0005 100 3,000 Payback period 2 years 3 yearsTABLE 10.3 6REVIEW QUESTIONS 10–2 What is the payback period? How is it calculated? 10–3 What weaknesses are commonly associated with the use of the payback period to evaluate a proposed investment?CHAPTER 10 Capital Budgeting Techniques 397 10.3 Net Present Value (NPV) The method used by most large companies to evaluate investment projects is called net present value (NPV) . The intuition behind the NPV method is simple. When firms make investments, they are spending money that they obtained, inone form or another, from investors. Investors expect a return on the money thatthey give to firms, so a firm should undertake an investment only if the presentvalue of the cash flow that the investment generates is greater than the cost ofmaking the investment in the first place. Because the NPV method takes into account the time value of investors’ money, it is a more sophisticated capital budg- eting technique than the payback rule .The NPV method discounts the firm’s cash flows at the firm’s cost of capital. This rate—as discussed in Chapter 9—is theminimum return that must be earned on a project to satisfy the firm’s investors.Projects with lower returns fail to meet investors’ expectations and thereforedecrease firm value, and projects with higher returns increase firm value. Thenet present value (NPV) is found by subtracting a project’s initial invest- ment ( CF 0) from the present value of its cash inflows ( CFt) discounted at a rate equal to the firm’s cost of capital ( r). (10.1) When NPV is used, both inflows and outflows are measured in terms of present dollars. For a project that has cash outflows beyond the initial investment, the netpresent value of a project would be found by subtracting the present value of out-flows from the present value of inflows. DECISION CRITERIA When NPV is used to make accept–reject decisions, the decision criteria are asfollows: • If the NPV is greater than $0,accept the project. • If the NPV is less than $0,reject the project. If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and thereforethe wealth of its owners by an amount equal to the NPV. We can illustrate the net present value (NPV) approach by using the BennettCompany data presented in Table 10.1. If the firm has a 10% cost of capital, thenet present values for projects A (an annuity) and B (a mixed stream) can be Example 10.5 3NPV =an t=1CFt (1+r)t-CF0NPV =Present value of cash inflows -Initial investmentLG3 net present value (NPV) A sophisticated capital budgeting technique; found bysubtracting a project’s initialinvestment from the presentvalue of its cash inflowsdiscounted at a rate equal tothe firm’s cost of capital. calculated as shown on the time lines in Figure 10.2. These calculations result in net present values for projects A and B of $11,071 and $10,924, respectively.Both projects are acceptable, because the net present value of each is greater than$0. If the projects were being ranked, however, project A would be consideredsuperior to B, because it has a higher net present value than that of B ($11,071versus $10,924). Calculator Use The preprogrammed NPV function in a financial calculator can be used to simplify the NPV calculation. The keystrokes for project A—theannuity—typically are as shown at left. Note that because project A is an annuity,only its first cash inflow, , is input, followed by its frequency, . The keystrokes for project B—the mixed stream—are as shown on page 397. Because the last three cash inflows for project B are the same , after inputting the first of these cash inflows, CF 3, we merely input its frequency, . The calculated NPVs for projects A and B of $11,071 and $10,924, respec- tively, agree with the NPVs already cited. Spreadsheet Use The NPVs can be calculated as shown on the following Excel spreadsheet.N=310,000)(CF3=CF4=CF5=N=5 CF1=14000398 PART 5 Long-Term Investment Decisions Project A 1 $14,0000 /H11002$42,000 53,071r = 10% NPVA = $11,0712 $14,0003 $14,0004 $14,0005 $14,000 Project BEnd of Year End of Year 1 $28,0000 /H11002$45,000 25,455 $55,9249,917 7,513 6,8306,209 NPV B = $10,924r = 10% r = 10% r = 10%r = 10%r = 10%2 $12,0003 $10,0004 $10,0005 $10,000FIGURE 10.2 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives Time lines depicting the cash flows and NPV calculations for projects A and B 11,071.01–42000 CF 0 CF1 I NPVN14000 5 SolutionInput Function 10Project A NPV AND THE PROFITABILITY INDEX A variation of the NPV rule is called the profitability index (PI). For a project that has an initial cash outflow followed by cash inflows, the profitability index (PI) issimply equal to the present value of cash inflows divided by the initial cash outflow: 2 (10.2) When companies evaluate investment opportunities using the PI, the decision rulethey follow is to invest in the project when the index is greater than 1.0. Whenthe PI is greater than one, that implies that the present value of cash inflows isgreater than the (absolute value of the) initial cash outflow, so a profitability indexgreater than one corresponds to a net present value greater than zero. In otherwords, the NPV and PI methods will always come to the same conclusion regardingwhether a particular investment is worth doing or not. We can refer back to Figure 10.2, which shows the present value of cash inflowsfor projects A and B, to calculate the PI for each of Bennett’s investment options: According to the profitability index, both projects are acceptable (because PI 1.0 for both), which shouldn’t be surprising because we already know that both projects7PI B=$55,924 ,$45,000 =1.24PIA=$53,071 ,$42,000 =1.26Example 10.6 3PI=an t=1CFt (1+r)t CF0CHAPTER 10 Capital Budgeting Techniques 399 10,924.4012000 CF 2 CF3 I NPVN10000 3 SolutionInput Function 10–45000 CF 0 CF1 28000Project B DETERMINING THE NET PRESENT VALUE Y ear 012345 NPVFirm’s cost of capital $ $$$$$$$ $$$$$$(45,000) 28,00012,00010,00010,00010,00010,924(42,000) 14,00014,00014,00014,00014,00011,07110% Y ear-End Cash Flow1 23456789 101112 Entry in Cell B11 is =NPV($C$2,B6:B10)+B5 Copy the entry in Cell B11 to Cell C11. Entry in Cell C12 is =IF(B11>C11,B4,C4).A Project AB Project B Project A Choice of projectC 2. To be a bit more precise, the denominator in Equation 10.2 should be a positive number, so we are taking the absolute value of the initial cash outflow. have positive NPVs. Furthermore, in this particular case, the NPV rule and the PI both indicate that project A is preferred over project B. It is not always true thatthe NPV and PI methods will rank projects in exactly the same order. Differentrankings can occur when alternative projects require initial outlays that have very different magnitudes. NPV AND ECONOMIC VALUE ADDED Economic Value Added (or EVA), a registered trademark of the consulting firmStern Stewart & Co., is another close cousin of the NPV method. Whereas theNPV approach calculates the value of an investment over its entire life, the EVAapproach is typically used to measure an investment’s performance on a year-by-year basis. The EVA method begins the same way that NPV does—by calculatinga project’s net cash flows. However, the EVA approach subtracts from those cashflows a charge that is designed to capture the return that the firm’s investorsdemand on the project. That is, the EVA calculation asks whether a project gen-erates positive cash flows above and beyond what investors demand . If so, then the project is worth undertaking. The EVA method determines whether a project earns a pure economic profit . When accountants say that a firm has earned a profit, they mean that revenuesare greater than expenses. But the term pure economic profit refers to a profit that is higher than expected given the competitive rate of return on a particularline of business. A firm that shows a positive profit on its income statement mayor may not earn a pure economic profit, depending on how large the profit is rel-ative to the capital invested in the business. For instance, in the first quarter of2010, TomTom, the European maker of portable GPS devices, reported a netprofit of 3 million. Does that seem like a large profit? Perhaps not when youconsider that TomTom’s balance sheet showed total assets of over 2.5 billion.In other words, TomTom’s profit represented a return of just 0.0012 percent onthe firm’s assets. That return was below the rate offered on risk-free governmentsecurities in 2010, so it clearly fell below the expectations of TomTom’s investors(who would have expected a higher return as compensation for the risks they weretaking), so the company earned a pure economic loss that quarter. Stated differ- ently, TomTom’s EVA in the first quarter of 2010 was negative. Suppose a certain project costs $1,000,000 up front, but after that it will generatenet cash inflows each year (in perpetuity) of $120,000. To calculate the NPV ofthis project, we would simply discount the cash flows and add them up. If thefirm’s cost of capital is 10%, then the project’s NPV is: 3 To calculate the investment’s economic value added in any particular year, we start with the annual $120,000 cash flow. Next, we assign a charge thataccounts for the return that investors demand on the capital that the firm hasinvested in the project. In this case, the firm invested $1,000,000, and investorsNPV =-$1,000,000 +($120,000 ,0.10) =$200,000Example 10.7 3::400 PART 5 Long-Term Investment Decisions pure economic profit A profit above and beyond the normal competitive rate ofreturn in a line of business. 3. We are using Equation 5.14 to calculate the present value of the perpetual stream of $120,000 cash flows. expect a 10% return. That means that the project’s annual capital charge is $100,000 ($1,000,000 10%), and its EVA is $20,000 per year: In other words, this project earns more than its cost of capital each year, so the project is clearly worth doing. To calculate the EVA for the project over its entirelife, we would simply discount the annual EVA figures using the firm’s cost of cap-ital. In this case, the project produces an annual EVA of $20,000 in perpetuity.Discounting this at 10% gives a project EVA of $200,000 ($20,000 0.10), iden-tical to the NPV. In this example, both the NPV and EVA methods reach the sameconclusion, namely that the project creates $200,000 in value for shareholders. Ifthe cash flows in our example had fluctuated through time rather than remainingfixed at $120,000 per year, an analyst would calculate the investment’s EVAevery year, then discount those figures to the present using the firm’s cost of cap-ital. If the resulting figure is positive, then the project generates a positive EVA and is worth doing. 6REVIEW QUESTIONS 10–4 How is the net present value (NPV) calculated for a project with a conventional cash flow pattern? 10–5 What are the acceptance criteria for NPV? How are they related to the firm’s market value? 10–6 Explain the similarities and differences between NPV, PI, and EVA.,=$120,000 -$100,000 =$20,000EVA =project cash flow -3(cost of capital) *(invested capital) 4*CHAPTER 10 Capital Budgeting Techniques 401 10.4 Internal Rate of Return (IRR) Theinternal rate of return (IRR) is one of the most widely used capital budgeting techniques. Theinternal rate of return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0 (because the present value of cashinflows equals the initial investment). It is the rate of return that the firm will earn ifit invests in the project and receives the given cash inflows. Mathematically, the IRRis the value of rin Equation 10.1 that causes NPV to equal $0. (10.3) (10.3a) DECISION CRITERIA When IRR is used to make accept–reject decisions, the decision criteria are as follows: • If the IRR is greater than the cost of capital, accept the project. • If the IRR is less than the cost of capital, reject the project.an t=1CFt (1+IRR)t=CF0$0=an t=1CFt (1+IRR)t-CF0LG4 internal rate of return (IRR) The discount rate that equates the NPV of an investmentopportunity with $0 (becausethe present value of cashinflows equals the initialinvestment); it is the rate ofreturn that the firm will earn ifit invests in the project andreceives the given cash inflows. These criteria guarantee that the firm will earn at least its required return. Such an outcome should increase the market value of the firm and, therefore, thewealth of its owners. CALCULATING THE IRR Most financial calculators have a preprogrammed IRR function that can be usedto simplify the IRR calculation. With these calculators, you merely punch in allcash flows just as if to calculate NPV and then depress IRR to find the internal rateof return. Computer software, including spreadsheets, is also available for simpli-fying these calculations. All NPV and IRR values presented in this and subsequentchapters are obtained by using these functions on a popular financial calculator. We can demonstrate the internal rate of return (IRR) approach by using the BennettCompany data presented in Table 10.1. Figure 10.3 uses time lines to depict theframework for finding the IRRs for Bennett’s projects A and B. We can see in thefigure that the IRR is the unknown discount rate that causes the NPV to equal $0. Calculator Use To find the IRR using the preprogrammed function in a finan- cial calculator, the keystrokes for each project are the same as those shown onpages 398 and 399 for the NPV calculation, except that the last two NPV key-strokes (punching Iand then NPV ) are replaced by a single IRRkeystroke.Example 10.8 3402 PART 5 Long-Term Investment Decisions 1 $14,0000 /H11002$42,000 42,000IRR? NPVA = $ 0 IRRB = 21.7%IRRA = 19.9%2 $14,0003 $14,0004 $14,0005 $14,000 1 $28,0000 /H11002$45,000 45,000 NPVB = $ 0IRR? IRR? IRR?IRR?IRR?2 $12,0003 $10,0004 $10,0005 $10,000Project A Project BEnd of Year End of YearFIGURE 10.3 Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives Time lines depicting the cash flows and IRR calculations for projects A and B Comparing the IRRs of projects A and B given in Figure 10.3 to Bennett Company’s 10% cost of capital, we can see that both projects are acceptablebecause Comparing the two projects’ IRRs, we would prefer project B over project A because . If these projects are mutually exclu-sive, meaning that we can choose one project or the other but not both, the IRRdecision technique would recommend project B. Spreadsheet Use The internal rate of return also can be calculated as shown on the following Excel spreadsheet.IRR B=21.7% 7IRR A=19.9%IRR B=21.7% 710.0% cost of capitalIRR A=19.9% 710.0% cost of capitalCHAPTER 10 Capital Budgeting Techniques 403 DETERMINING THE INTERNAL RATE OF RETURN Y ear 012345 IRR$ $$$$$$ $$$$$(45,000) 28,00012,00010,00010,00010,000(42,000) 14,00014,00014,00014,00014,000Y ear-End Cash Flow1 23456789 1011 Entry in Cell B10 is =IRR(B4:B9). Copy the entry in Cell B10 to Cell C10. Entry in Cell C11 is =IF(B10>C10,B3,C3).A Project AB Project B 19.9% 21.7% Project B Choice of projectC It is interesting to note in the preceding Example 10.8 that the IRR suggests that project B, which has an IRR of 21.7%, is preferable to project A, whichhas an IRR of 19.9%. This conflicts with the NPV rankings obtained in an ear-lier example. Such conflicts are not unusual. There is no guarantee that NPV and IRR will rank projects in the same order. However, both methods shouldreach the same conclusion about the acceptability or nonacceptability ofprojects. Tony DiLorenzo is evaluating an investment opportunity. He is comfortable with the investment’s level of risk. Based on com- peting investment opportunities, he feels that this investment must earn a min-imum compound annual after-tax return of 9% to be acceptable. Tony’s initialinvestment would be $7,500, and he expects to receive annual after-tax cashflows of $500 per year in each of the first 4 years, followed by $700 per year atthe end of years 5 through 8. He plans to sell the investment at the end of year 8and net $9,000, after taxes.Personal Finance Example 10.9 3 To calculate the investment’s IRR (compound annual return), Tony first sum- marizes the after-tax cash flows as shown in the following table:404 PART 5 Long-Term Investment Decisions Year Cash flow ( or ) 0 $7,500 (Initial investment) 1 5002 5003 5004 5005 7006 7007 7008 9,700 ($700 $9,000) +-/H11545 /H11546 Substituting the after-tax cash flows for years 0 through 8 into a financial calculator or spreadsheet, he finds the investment’s IRR of 9.54%. Given that theexpected IRR of 9.54% exceeds Tony’s required minimum IRR of 9%, the invest- ment is acceptable. 6REVIEW QUESTIONS 10–7 What is the internal rate of return (IRR) on an investment? How is it determined? 10–8 What are the acceptance criteria for IRR? How are they related to the firm’s market value? 10–9 Do the net present value (NPV) and internal rate of return (IRR) alwaysagree with respect to accept–reject decisions? With respect to rankingdecisions? Explain. 10.5 Comparing NPV and IRR Techniques To understand the differences between the NPV and IRR techniques and decisionmakers’ preferences in their use, we need to look at net present value profiles,conflicting rankings, and the question of which approach is better. NET PRESENT VALUE PROFILES Projects can be compared graphically by constructing net present value profiles that depict the project’s NPVs for various discount rates. These profiles are usefulin evaluating and comparing projects, especially when conflicting rankings exist.They are best demonstrated via an example. To prepare net present value profiles for Bennett Company’s two projects, A and B,the first step is to develop a number of “discount rate–net present value” coordi-nates. Three coordinates can be easily obtained for each project; they are at discount Example 10.10 3LG6LG5 net present value profile Graph that depicts a project’s NPVs for various discountrates. rates of 0%, 10% (the cost of capital, r), and the IRR. The net present value at a 0% discount rate is found by merely adding all the cash inflows and subtractingthe initial investment. Using the data in Table 10.1 and Figure 10.1, we get For project A: For project B:The net present values for projects A and B at the 10% cost of capital are $11,071 and $10,924, respectively (from Figure 10.2). Because the IRR is the dis-count rate for which net present value equals zero, the IRRs (from Figure 10.3) of19.9% for project A and 21.7% for project B result in $0 NPVs. The three sets ofcoordinates for each of the projects are summarized in Table 10.4. Plotting the data from Table 10.4 results in the net present value profiles for projects A and B shown in Figure 10.4. The figure reveals three important facts: 1. The IRR of project B is greater than the IRR of project A, so managers using the IRR method to rank projects will always choose B over A if both projectsare acceptable.($28,000 +$12,000 +$10,000 +$10,000 +$10,000) -$45,000 =$25,000($14,000 +$14,000 +$14,000 +$14,000 +$14,000) -$42,000 =$28,000CHAPTER 10 Capital Budgeting Techniques 405 Discount Rate–NPV Coordinates for Projects A and B Net present value Discount rate Project A Project B 0% $28,000 $25,000 10 11,071 10,92419.9 0 —21.7 — 0TABLE 10.4 40 30 20 10 0 –10 –20 5 0 1 01 52 02 53 0AB Discount Rate (%)Project A Project B 10.7% IRRA = 19.9%NPV ($000)IRRB = 21.7%FIGURE 10.4 NPV Profiles Net present value profilesfor Bennett Company’sprojects A and B 2. The NPV of project A is sometimes higher and sometimes lower than the NPV of project B; thus, the NPV method will not consistently rank A above B orvice versa. The NPV ranking will depend on the firm’s cost of capital. 3. When the cost of capital is approximately 10.7%, projects A and B have iden- tical NPVs. The cost of capital for Bennett Company is 10%, and at that rate project A has a higher NPV than project B (the red line is above the blue line in Figure 10.4 whenthe discount rate is 10%). Therefore, the NPV and IRR methods rank the twoprojects differently. If Bennett’s cost of capital were a little higher, say 12%, theNPV method would rank project B over project A and there would be no conflict in the rankings provided by the NPV and IRR approaches. CONFLICTING RANKINGS Ranking different investment opportunities is an important consideration whenprojects are mutually exclusive or when capital rationing is necessary. When proj-ects are mutually exclusive, ranking enables the firm to determine which projectis best from a financial standpoint. When capital rationing is necessary, rankingprojects will provide a logical starting point for determining which group of proj-ects to accept. As we’ll see, conflicting rankings using NPV and IRR result from differences in the reinvestment rate assumption, the timing of each project’s cashflows, and the magnitude of the initial investment. Reinvestment Assumption One underlying cause of conflicting rankings is different implicit assumptionsabout the reinvestment ofintermediate cash inflows —cash inflows received prior to the termination of a project. NPV assumes that intermediate cash inflows arereinvested at the cost of capital, whereas IRR assumes that intermediate cashinflows are reinvested at a rate equal to the project’s IRR. 4These differing assumptions can be demonstrated with an example. A project requiring a $170,000 initial investment is expected to provide operatingcash inflows of $52,000, $78,000, and $100,000 at the end of each of the next 3 years. The NPV of the project (at the firm’s 10% cost of capital) is $16,867 andits IRR is 15%. Clearly, the project is acceptable and cost of capital). Table 10.5 demonstrates calculation of the project’s future value at the end of its 3-year life, assuming both a 10% (its cost ofcapital) and a 15% (its IRR) rate of return. A future value of $248,720 results fromreinvestment at the 10% cost of capital, and a future value of $258,470 resultsfrom reinvestment at the 15% IRR.IRR =15% 710%(NPV =$16,867 7$0 Example 10.11 3406 PART 5 Long-Term Investment Decisions 4. To eliminate the reinvestment rate assumption of the IRR, some practitioners calculate the modified internal rate of return (MIRR) . The MIRR is found by converting each operating cash inflow to its future value measured at the end of the project’s life and then summing the future values of all inflows to get the project’s terminal value . Each future value is found by using the cost of capital, thereby eliminating the reinvestment rate criticism of the tradi-tional IRR. The MIRR represents the discount rate that causes the terminal value just to equal the initial investment. Because it uses the cost of capital as the reinvestment rate the MIRR is generally viewed as a better measure of a pro- ject’s true profitability than the IRR. Although this technique is frequently used in commercial real estate valuationand is a preprogrammed function on some financial calculators, its failure to resolve the issue of conflicting rankingsand its theoretical inferiority to NPV have resulted in the MIRR receiving only limited attention and acceptance in the financial literature.conflicting rankings Conflicts in the ranking given a project by NPV and IRR,resulting from differences in the magnitude and timing of cash flows. intermediate cash inflows Cash inflows received prior tothe termination of a project. If the future value in each case in Table 10.5 were viewed as the return received 3 years from today from the $170,000 initial investment, the cash flowswould be those given in Table 10.6. The NPVs and IRRs in each case are shownbelow the cash flows in Table 10.6. You can see that at the 10% reinvestmentrate, the NPV remains at $16,867; reinvestment at the 15% IRR produces anNPV of $24,418. From this result, it should be clear that the NPV technique assumes reinvest- ment at the cost of capital (10% in this example). (Note that with reinvestment at10%, the IRR would be 13.5%.) On the other hand, the IRR technique assumesan ability to reinvest intermediate cash inflows at the IRR. If reinvestment doesnot occur at this rate, the IRR will differ from 15%. Reinvestment at a rate lowerthan the IRR would result in an IRR lower than that calculated (at 13.5%, forexample, if the reinvestment rate were only 10%). Reinvestment at a rate higherthan the IRR would result in an IRR higher than that calculated.CHAPTER 10 Capital Budgeting Techniques 407 Reinvestment Rate Comparisons for a Projecta Reinvestment rate Operating Number of10% 15% cash years earnings Year inflows interest ( t) Future value Future value 1 $ 52,000 2 $ 62,920 $ 68,770 2 78,000 1 85,800 89,7003 100,000 0 100,000 Future value end of year 3 NPV @ 10% $16,867 IRR 15% aInitial investment in this project is $170,000.==$258,470 $248,720100,000TABLE 10.5 Project Cash Flows after Reinvestment Reinvestment rate 10% 15% Initial investment $170,000 Year Operating cash inflows 1$ 0 $ 0 20 03 248,720 258,470 NPV @ 10% $ 16,867 $ 24,418IRR 13.5% 15.0%TABLE 10.6In more depth To read about Modified Internal Rate of Return, go to www.myfinancelab.com Timing of the Cash Flow Another reason why the IRR and NPV methods may provide different rankings for investment options has to do with differences in the timing of cash flows. Goback to the timelines for investments A and B in Figure 10.1 on page 392. Theup-front investment required by each investment is similar, but after that thetiming of each project’s cash flows is quite different. Project B has a large cashinflow almost immediately (in Year 1), whereas Project A provides cash flowsthat are distributed evenly across time. Because so much of Project B’s cash flowsarrive early in its life (especially compared to the timing for Project A), the NPVof Project B will not be particularly sensitive to changes in the discount rate.Project A’s NPV, on the other hand, will fluctuate more as the discount ratechanges. In essence, Project B is somewhat akin to a short-term bond, whoseprice doesn’t change much when interest rates move, and Project A is more like along-term bond whose price fluctuates a great deal when rates change. You can see this pattern if you review the NPV profiles for projects A and B in Figure 10.4 on page 405. The red line representing project A is considerablysteeper than the blue line representing project B. At very low discount rates,project A has a higher NPV, but as the discount rate increases, the NPV of project Adeclines rapidly. When the discount rate is high enough, the NPV of project Bovertakes that of project A. We can summarize this discussion as follows. Because project A’s cash flows arrive later than project B’s cash flows do, when the firm’s cost of capital is rela-tively low (to be specific, below about 10.7 percent), the NPV method will rankproject A ahead of project B. At a higher cost of capital, the early arrival ofproject B’s cash flows becomes more advantageous, and the NPV method willrank project B over project A. The differences in the timing of cash flows betweenthe two projects does not affect the ranking provided by the IRR method, whichalways puts project B ahead of project A. Table 10.7 illustrates how the conflictin rankings between the NPV and IRR approaches depends on the firm’s cost ofcapital. Magnitude of the Initial Investment Suppose someone offered you the following two investment options. You couldinvest $2 today and receive $3 tomorrow, or you could invest $1,000 today andreceive $1,100 tomorrow. The first investment provides a return (an IRR) of50 percent in just one day, a return that surely would surpass any reasonablehurdle rate. But after making this investment, you’re only better off by $1. On the408 PART 5 Long-Term Investment Decisions Ranking Projects A and B Using IRR and NPV Methods Method Project A Project B IRR ✓ NPV ifr10.7% ✓ ifr10.7% ✓ 76TABLE 10.7 other hand, the second choice offers a return of 10 percent in a single day. That’s far less than the first opportunity, but earning 10 percent in a single day is still avery high return. In addition, if you accept this investment, you will be $100better off tomorrow than you were today. Most people would choose the second option presented above, even though the rate of return on that option (10 percent) is far less than the rate offered bythe first option (50 percent). They reason (correctly) that it is sometimes better toaccept a lower return on a larger investment than to accept a very high return ona small investment. Said differently, most people know that they are better offtaking the investment that pays them a $100 profit in just one day rather than theinvestment that generates just a $1 profit. 5 The preceding example illustrates what is known as the scale (or magnitude) problem. The scale problem occurs when two projects are very different in termsof how much money is required to invest in each project. In these cases, the IRRand NPV methods may rank projects differently. The IRR approach (and the PImethod) may favor small projects with high returns (like the $2 loan that turnsinto $3), whereas the NPV approach favors the investment that makes theinvestor the most money (like the $1,000 investment that yields $1,100 in oneday). In the case of the Bennett Company’s projects, the scale problem is notlikely to be the cause of the conflict in project rankings because the initial invest-ment required to fund each project is quite similar. To summarize, it is important for financial managers to keep an eye out for conflicts in project rankings provided by the NPV and IRR methods, but differ-ences in the magnitude and timing of cash inflows do not guarantee conflicts inranking. In general, the greater the difference between the magnitude and timingof cash inflows, the greater the likelihood of conflicting rankings. Conflicts basedon NPV and IRR can be reconciled computationally; to do so, one creates andanalyzes an incremental project reflecting the difference in cash flows betweenthe two mutually exclusive projects. WHICH APPROACH IS BETTER? Many companies use both the NPV and IRR techniques because current tech-nology makes them easy to calculate. But it is difficult to choose one approachover the other because the theoretical and practical strengths of the approachesdiffer. Clearly, it is wise to evaluate NPV and IRR techniques from both theoret-ical and practical points of view. Theoretical View On a purely theoretical basis, NPV is the better approach to capital budgeting as a result of several factors. Most important, the NPV measures how much wealtha project creates (or destroys if the NPV is negative) for shareholders. Given thatthe financial manager’s objective is to maximize shareholder wealth, the NPVapproach has the clearest link to this objective and, therefore, is the “gold stan-dard” for evaluating investment opportunities.CHAPTER 10 Capital Budgeting Techniques 409 5. Note that the profitability index also provides an incorrect ranking in this example. The first option has a PI of 1.5 ($3 $2), and the second option’s PI equals 1.1 ($1,100 $1,000). Just like the IRR, the PI suggests that the first option is better, but we know that the second option makes more money., , In addition, certain mathematical properties may cause a project with a nonconventional cash flow pattern to have multiple IRRs —more than one IRR.6 Mathematically, the maximum number of realroots to an equation is equal to its number of sign changes. Take an equation like , which has twosign changes in its coefficients—from positive to negative and thenfrom negative to positive . If we factor the equation (remember fac-toring from high school math?), we get , which means that x can equal either 2 or 3—there are two correct values for x. Substitute them back into the equation, and you’ll see that both values work. This same outcome can occur when finding the IRR for projects with non- conventional cash flows, because they have more than one sign change. Clearly,when multiple IRRs occur for nonconventional cash flows, the analyst faces thetime-consuming need to interpret their meanings so as to evaluate the project.The fact that such a challenge does not exist when using NPV enhances its theo-retical superiority. Practical View Evidence suggests that in spite of the theoretical superiority of NPV, financial managers use the IRR approach just as often as the NPV method. The appeal of the IRR technique is due to the general disposition of business people to think interms of rates of return rather than actual dollar returns. Because interest rates, profitability, and so on are most often expressed as annual rates of return, theuse of IRR makes sense to financial decision makers. They tend to find NPV lessintuitive because it does not measure benefits relative to the amount invested. Because a variety of techniques are available for avoiding the pitfalls of the IRR,its widespread use does not imply a lack of sophistication on the part of finan-cial decision makers. Clearly, corporate financial analysts are responsible foridentifying and resolving problems with the IRR before the decision makers useit as a decision technique.(x-2)*(x-3)(+6) (-5x)(-5x) (+x 2)x2-5x+6=0410 PART 5 Long-Term Investment Decisions 6. A conventional cash flow pattern is one in which the up-front cash flow is negative and all subsequent cash flows are positive. A nonconventional pattern occurs if the up-front cash flow is positive and subsequent cash flows are negative (for example, when a firm sells extended warranties and pays benefits later) or when the cash flows oscil-late between positive and negative (as might occur when firms have to reinvest in a project to extend its life). 7. John R. Graham and Campball R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics 60 (2001), pp. 187–243.multiple IRRs More than one IRR resulting from a capital budgetingproject with a nonconventional cash flow pattern; the maximum number of IRRs for aproject is equal to the numberof sign changes in its cashflows. Matter of fact Arecent survey asked chief financial officers (CFOs) what methods they used to evaluate cap- ital investment projects. One interesting finding was that many companies use more than one of the approaches we’ve covered in this chapter. The most popular approaches by far were IRR and NPV, used by 76 percent and 75 percent (respectively) of the CFOs responding to the survey. These techniques enjoy wider use in larger firms, with the payback approach being more common in smaller firms.7Which Methods Do Companies Actually Use? In addition, decision makers should keep in mind that nonfinancial consider- ations may be important elements in project selection, as discussed in the Focus on Ethics box. 6REVIEW QUESTIONS 10–10 How is a net present value profile used to compare projects? What causes conflicts in the ranking of projects via net present value andinternal rate of return? 10–11 Does the assumption concerning the reinvestment of intermediate cash inflow tend to favor NPV or IRR? In practice, which technique is pre-ferred and why?CHAPTER 10 Capital Budgeting Techniques 411 focus on ETHICS Nonfinancial Considerations in Project Selection Corporate ethics codes are often faulted for being “window dressing ”— that is, for having little or no effect on actualbehavior. Financial ethics expert JohnDobson says day-to-day behavior in theworkplace “acculturates ” employees— teaches them that the behavior they see is rational and acceptable in that envi- ronment. The good news is that profes-sional ethics codes, such as thosedeveloped for chartered financial ana-lysts, corporate treasury professionals, and certified financial planners, actu- ally provide sound guidelines forbehavior. These codes, notes Dobson,are based on economically rationalconcepts such as integrity and trustwor- thiness, which guide the decision maker in attempting to increase share-holder wealth. Financial executivesinsist that there should be no separation between an individual ’s personal ethics and his or her business ethics. “It’s a jungle out there ” and “Business is busi- ness ” should not be excuses for engag- ing in unethical behavior.How do ethics codes apply to proj- ect selection and capital budgeting ? For most companies ethical considera-tions are primarily concerned with thereduction of potential risks associatedwith a project. For example, Gateway Computers clearly outlines in its corpo- rate code of ethics the increased regu-latory and procurement laws withwhich an employee must be familiar inorder to sell to the government. The company points out that knowingly sub- mitting a false claim or statement to agovernmental agency could subjectGateway and its employees to signifi-cant monetary civil damages, penal- ties, and even criminal sanctions. Another way to incorporate nonfi- nancial considerations into capital proj-ect evaluation is to take into accountthe likely effect of decisions on non- shareholder parties or stakeholders— employees, customers, the localcommunity, and suppliers. ChipotleMexican Grill ’s “Food with Integrity ” mission is one example. Chipotle ’s phi- losophy is that the company “canalways do better in terms of the food we buy. And when we say better, wemean better in every sense of theword—better tasting, coming from bet- ter sources, better for the environment, better for the animals, and better for thefarmers who raise the animals andgrow the produce. ” a In support of their mission, Chipotle sources meat from animals that are raised humanely, fed a vegetarian diet, and never given antibiotics or hormones.The company favors locally grown pro-duce, organically grown beans, anddairy products made from milk from cows raised in pastures and free of growth hormones. Chipotle ’s efforts have been rewarded, as sales increased bynearly 50 percent from 2007 to 2009.Investors have also profited, as shares that sold for $44 at the company ’s 2006 initial public offering were pricedat over $150 in mid-2010. 3 What are the potential risks to a company of unethical behaviors by employees? What are potential risks to the public and to stakeholders?in practice awww.chipotle.com/html/fwi.aspx 412 PART 5 Long-Term Investment Decisions Summary FOCUS ON VALUE The financial manager must apply appropriate decision techniques to assess whether proposed investment projects create value. Net present value (NPV)and internal rate of return (IRR) are the generally preferred capital budgetingtechniques. Both use the cost of capital as the required return. The appeal ofNPV and IRR stems from the fact that both indicate whether a proposed invest-ment creates or destroys shareholder value. NPV clearly indicates the expected dollar amount of wealth creation from a proposed project, whereas IRR only provides the same accept-or-reject decisionas NPV. As a consequence of some fundamental differences, NPV and IRR donot necessarily rank projects in the same way. NPV is the theoretically preferredapproach. In practice, however, IRR enjoys widespread use because of its intu-itive appeal. Regardless, the application of NPV and IRR to good estimates ofrelevant cash flows should enable the financial manager to recommend projectsthat are consistent with the firm’s goal of maximizing shareholder wealth. REVIEW OF LEARNING GOALS Understand the key elements of the capital budgeting process. Capital budgeting techniques are the tools used to assess project acceptability andranking. Applied to each project’s relevant cash flows, they indicate which cap-ital expenditures are consistent with the firm’s goal of maximizing owners’wealth. Calculate, interpret, and evaluate the payback period. The payback period is the amount of time required for the firm to recover its initial invest-ment, as calculated from cash inflows. Shorter payback periods are preferred.The payback period is relatively easy to calculate, has simple intuitive appeal,considers cash flows, and measures risk exposure. Its weaknesses include lackof linkage to the wealth maximization goal, failure to consider time valueexplicitly, and the fact that it ignores cash flows that occur after the paybackperiod. Calculate, interpret, and evaluate the net present value (NPV) and eco- nomic value added (EVA). Because it gives explicit consideration to the time value of money, NPV is considered a sophisticated capital budgeting technique.NPV measures the amount of value created by a given project; only positiveNPV projects are acceptable. The rate at which cash flows are discounted in calculating NPV is called the discount rate, required return, cost of capital, oropportunity cost. By whatever name, this rate represents the minimum returnthat must be earned on a project to leave the firm’s market value unchanged.The EVA method begins the same way that NPV does—by calculating a pro-ject’s net cash flows. However, the EVA approach subtracts from those cashflows a charge that is designed to capture the return that the firm’s investors LG3LG2LG1 demand on the project. That is, the EVA calculation asks whether a project generates positive cash flows above and beyond what investors demand. If so,then the project is worth undertaking. Calculate, interpret, and evaluate the internal rate of return (IRR). Like NPV, IRR is a sophisticated capital budgeting technique. IRR is the com-pound annual rate of return that the firm will earn by investing in a project andreceiving the given cash inflows. By accepting only those projects with IRRs inexcess of the firm’s cost of capital, the firm should enhance its market value andthe wealth of its owners. Both NPV and IRR yield the same accept–reject deci-sions, but they often provide conflicting rankings. Use net present value profiles to compare NPV and IRR techniques. A net present value profile is a graph that depicts projects’ NPVs for various dis-count rates. The NPV profile is prepared by developing a number of “discountrate–net present value” coordinates (including discount rates of 0 percent, thecost of capital, and the IRR for each project) and then plotting them on thesame set of discount rate–NPV axes. Discuss NPV and IRR in terms of conflicting rankings and the theoret- ical and practical strengths of each approach. Conflicting rankings of projects frequently emerge from NPV and IRR as a result of differences in the reinvest-ment rate assumption, as well as the magnitude and timing of cash flows. NPVassumes reinvestment of intermediate cash inflows at the more conservative costof capital; IRR assumes reinvestment at the project’s IRR. On a purely theo-retical basis, NPV is preferred over IRR because NPV assumes the more con-servative reinvestment rate and does not exhibit the mathematical problem ofmultiple IRRs that often occurs when IRRs are calculated for nonconventionalcash flows. In practice, the IRR is more commonly used because it is consistentwith the general preference of business professionals for rates of return, and cor-porate financial analysts can identify and resolve problems with the IRR beforedecision makers use it. LG6LG5LG4CHAPTER 10 Capital Budgeting Techniques 413 Opener-in-Review The chapter opener described a mining project that had a project NPV of $75 million and an IRR of 20%. a.Based on the facts that the NPV is positive and the IRR is 20%, what can you infer about Genco’s cost of capital? Is it more or less than 20%? b.Expanding the firm’s mining operations in Mexico takes $149 million. Suppose the expansion project will generate a level cash flow (an annuity) for 7 years. If the payback period is 3.6 years, what is the annual cash inflow produced by the expansion project? c.Calculate the NPV and the IRR of the project given your answer to part band a 9% cost of capital for Genco. 414 PART 5 Long-Term Investment Decisions Self-Test Problem(Solutions in Appendix) ST10–1 All techniques with NPV profile—Mutually exclusive projects Fitch Industries is in the process of choosing the better of two equal-risk, mutually exclusive capitalexpenditure projects—M and N. The relevant cash flows for each project are shownin the following table. The firm’s cost of capital is 14%.LG3LG2 LG4LG5LG6 Project M Project N Initial investment ( CF0) $28,500 $27,000 Year ( t) Cash inflows ( CFt) 1 $10,000 $11,000 2 10,000 10,0003 10,000 9,0004 10,000 8,000 a.Calculate each project’s payback period. b.Calculate the net present value (NPV) for each project. c.Calculate the internal rate of return (IRR) for each project. d.Summarize the preferences dictated by each measure you calculated, and indicate which project you would recommend. Explain why. e.Draw the net present value profiles for these projects on the same set of axes, and explain the circumstances under which a conflict in rankings might exist. Warm-Up ExercisesAll problems are available in . E10–1 Elysian Fields, Inc., uses a maximum payback period of 6 years and currently mustchoose between two mutually exclusive projects. Project Hydrogen requires an ini- tial outlay of $25,000; project Helium requires an initial outlay of $35,000. Using the expected cash inflows given for each project in the following table, calculate each project’s payback period . Which project meets Elysian’s standards? LG2 Expected cash inflows Year Hydrogen Helium 1 $6,000 $7,000 2 6,000 7,0003 8,000 8,0004 4,000 5,0005 3,500 5,0006 2,000 4,000 E10–2 Herky Foods is considering acquisition of a new wrapping machine. The initial investment is estimated at $1.25 million, and the machine will have a 5-year lifewith no salvage value. Using a 6% discount rate, determine the net present value (NPV) of the machine given its expected operating cash inflows shown in the following table. Based on the project’s NPV, should Herky make this investment? Terra Firma Initial investment $30,000 $25,000 Year Operating cash inflows 1 $ 7,000 $6,000 2 10,000 9,0003 12,000 9,0004 10,000 8,000LG3 Year Cash inflow 1 $400,000 2 375,0003 300,0004 350,0005 200,000 E10–3 Axis Corp. is considering investment in the best of two mutually exclusive projects. Project Kelvin involves an overhaul of the existing system; it will cost $45,000 and generate cash inflows of $20,000 per year for the next 3 years. Project Thompson involves replacement of the existing system; it will cost $275,000 and generate cash inflows of $60,000 per year for 6 years. Using an 8% cost of capital, calculate each project’s NPV, and make a recommendation based on your findings. E10–4 Billabong Tech uses the internal rate of return (IRR) to select projects. Calculate the IRR for each of the following projects and recommend the best project based on this measure. Project T-Shirt requires an initial investment of $15,000 and generates cash inflows of $8,000 per year for 4 years. Project Board Shorts requires an initialinvestment of $25,000 and produces cash inflows of $12,000 per year for 5 years. E10–5 Cooper Electronics uses NPV profiles to visually evaluate competing projects. Key data for the two projects under consideration are given in the following table. Using these data, graph, on the same set of axes, the NPV profiles for each project using discount rates of 0%, 8%, and the IRR.LG3 LG4 LG5 LG4 LG2CHAPTER 10 Capital Budgeting Techniques 415 ProblemsAll problems are available in . P10–1 Payback period Jordan Enterprises is considering a capital expenditure that requires an initial investment of $42,000 and returns after-tax cash inflows of $7,000 per year for 10 years. The firm has a maximum acceptable payback period of 8 years. a.Determine the payback period for this project. b.Should the company accept the project? Why or why not? P10–2 Payback comparisons Nova Products has a 5-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must choosebetween two alternative ones. The first machine requires an initial investment of$14,000 and generates annual after-tax cash inflows of $3,000 for each of the next 7 years. The second machine requires an initial investment of $21,000 and providesan annual cash inflow after taxes of $4,000 for 20 years.a.Determine the payback period for each machine. b.Comment on the acceptability of the machines, assuming that they are inde- pendent projects. c.Which machine should the firm accept? Why? d.Do the machines in this problem illustrate any of the weaknesses of using pay- back? Discuss. P10–3 Choosing between two projects with acceptable payback periods Shell Camping Gear, Inc., is considering two mutually exclusive projects. Each requires an initialinvestment of $100,000. John Shell, president of the company, has set a maximum payback period of 4 years. The after-tax cash inflows associated with each project are shown in the following table:416 PART 5 Long-Term Investment Decisions LG2 Cash inflows ( CFt) Year Project A Project B 1 $10,000 $40,000 2 20,000 30,0003 30,000 20,0004 40,000 10,0005 20,000 20,000 a.Determine the payback period of each project. b.Because they are mutually exclusive, Shell must choose one. Which should the company invest in? c.Explain why one of the projects is a better choice than the other. Personal Finance Problem P10–4 Long-term investment decision, payback method Bill Williams has the opportunity to invest in project A that costs $9,000 today and promises to pay annual end-of- year payments of $2,200, $2,500, $2,500, $2,000, and $1,800 over the next 5 years. Or, Bill can invest $9,000 in project B that promises to pay annual end-of-year pay-ments of $1,500, $1,500, $1,500, $3,500, and $4,000 over the next 5 years. a.How long will it take for Bill to recoup his initial investment in project A? b.How long will it take for Bill to recoup his initial investment in project B? c.Using the payback period, which project should Bill choose? d.Do you see any problems with his choice? P10–5 NPV Calculate the net present value (NPV) for the following 20-year projects. Comment on the acceptability of each. Assume that the firm has an opportunity cost of 14%. a.Initial investment is $10,000; cash inflows are $2,000 per year. b.Initial investment is $25,000; cash inflows are $3,000 per year. c.Initial investment is $30,000; cash inflows are $5,000 per year.LG2 LG2 LG3 P10–6 NPV for varying costs of capital Dane Cosmetics is evaluating a new fragrance- mixing machine. The machine requires an initial investment of $24,000 and willgenerate after-tax cash inflows of $5,000 per year for 8 years. For each of the costsof capital listed, (1) calculate the net present value (NPV) , (2) indicate whether to accept or reject the machine, and (3) explain your decision. a.The cost of capital is 10%. b.The cost of capital is 12%. c.The cost of capital is 14%. P10–7 Net present value—Independent projects Using a 14% cost of capital, calculate the net present value for each of the independent projects shown in the following table, and indicate whether each is acceptable.CHAPTER 10 Capital Budgeting Techniques 417 Project A Project B Project C Project D Project E Initial investment ( CF0) $26,000 $500,000 $170,000 $950,000 $80,000 Year ( t) Cash inflows ( CFt) 1 $4,000 $100,000 $20,000 $230,000 $ 0 2 4,000 120,000 19,000 230,000 03 4,000 140,000 18,000 230,000 04 4,000 160,000 17,000 230,000 20,0005 4,000 180,000 16,000 230,000 30,0006 4,000 200,000 15,000 230,000 07 4,000 14,000 230,000 50,0008 4,000 13,000 230,000 60,0009 4,000 12,000 70,000 10 4,000 11,000 P10–8 NPV Simes Innovations, Inc., is negotiating to purchase exclusive rights to manu- facture and market a solar-powered toy car. The car’s inventor has offered Simes thechoice of either a one-time payment of $1,500,000 today or a series of five year-end payments of $385,000. a.If Simes has a cost of capital of 9%, which form of payment should it choose? b.What yearly payment would make the two offers identical in value at a cost of capital of 9%? c.Would your answer to part aof this problem be different if the yearly payments were made at the beginning of each year? Show what difference, if any, that change in timing would make to the present value calculation. d.The after-tax cash inflows associated with this purchase are projected to amount to $250,000 per year for 15 years. Will this factor change the firm’s decision about how to fund the initial investment? P10–9 NPV and maximum return A firm can purchase a fixed asset for a $13,000 initial investment. The asset generates an annual after-tax cash inflow of $4,000 for 4 years. a.Determine the net present value (NPV) of the asset, assuming that the firm has a 10% cost of capital. Is the project acceptable? b.Determine the maximum required rate of return (closest whole-percentage rate) that the firm can have and still accept the asset. Discuss this finding in light of your response in part a.LG3 LG3 LG3 LG3 P10–10 NPV—Mutually exclusive projects Hook Industries is considering the replacement of one of its old drill presses. Three alternative replacement presses are under consid-eration. The relevant cash flows associated with each are shown in the followingtable. The firm’s cost of capital is 15%.418 PART 5 Long-Term Investment Decisions LG3 Press A Press B Press C Initial investment ( CF0) $85,000 $60,000 $130,000 Year ( t) Cash inflows ( CFt) 1 $18,000 $12,000 $50,000 2 18,000 14,000 30,0003 18,000 16,000 20,0004 18,000 18,000 20,0005 18,000 20,000 20,0006 18,000 25,000 30,0007 18,000 — 40,0008 18,000 — 50,000 Project A Project B Project C Initial investment ( CF0) $40,000 $40,000 $40,000 Year ( t) Cash inflows ( CFt) 1 $13,000 $ 7,000 $19,000 2 13,000 10,000 16,0003 13,000 13,000 13,0004 13,000 16,000 10,0005 13,000 19,000 7,000a.Calculate the net present value (NPV) of each press. b.Using NPV, evaluate the acceptability of each press. c.Rank the presses from best to worst using NPV. d.Calculate the profitability index (PI) for each press. e.Rank the presses from best to worst using PI. Personal Finance Problem P10–11 Long-term investment decision, NPV method Jenny Jenks has researched the finan- cial pros and cons of entering into an elite MBA program at her state university. The tuition and needed books for a master’s program will have an upfront cost of $100,000. On average, a person with an MBA degree earns an extra $20,000 peryear over a business career of 40 years. Jenny feels that her opportunity cost of cap-ital is 6%. Given her estimates, find the net present value (NPV) of entering this MBA program. Are the benefits of further education worth the associated costs? P10–12 Payback and NPV Neil Corporation has three projects under consideration. The cash flows for each project are shown in the following table. The firm has a 16%cost of capital.LG3 LG3LG2 a.Calculate each project’s payback period. Which project is preferred according to this method? b.Calculate each project’s net present value (NPV) . Which project is preferred according to this method? c.Comment on your findings in parts aandb,and recommend the best project. Explain your recommendation. P10–13 NPV and EVA A project costs $2.5 million up front and will generate cash flows in perpetuity of $240,000. The firm’s cost of capital is 9%. a.Calculate the project’s NPV. b.Calculate the annual EVA in a typical year. c.Calculate the overall project EVA and compare to your answer in part a. P10–14 Internal rate of return For each of the projects shown in the following table, calcu- late the internal rate of return (IRR) . Then indicate, for each project, the maximum cost of capital that the firm could have and still find the IRR acceptable.CHAPTER 10 Capital Budgeting Techniques 419 LG4LG3 Project A Project B Project C Project D Initial investment ( CF0) $90,000 $490,000 $20,000 $240,000 Year ( t) Cash inflows ( CFt) 1 $20,000 $150,000 $7,500 $120,000 2 25,000 150,000 7,500 100,0003 30,000 150,000 7,500 80,0004 35,000 150,000 7,500 60,0005 40,000 — 7,500 — Project X Project Y Initial investment ( CF0) $500,000 $325,000 Year ( t) Cash inflows ( CFt) 1 $100,000 $140,000 2 120,000 120,0003 150,000 95,0004 190,000 70,0005 250,000 50,000P10–15 IRR—Mutually exclusive projects Bell Manufacturing is attempting to choose the better of two mutually exclusive projects for expanding the firm’s warehousecapacity. The relevant cash flows for the projects are shown in the following table. The firm’s cost of capital is 15%.LG4 a.Calculate the IRR to the nearest whole percent for each of the projects. b.Assess the acceptability of each project on the basis of the IRRs found in part a. c.Which project, on this basis, is preferred? Personal Finance Problem P10–16 Long-term investment decision, IRR method Billy and Mandy Jones have $25,000 to invest. On average, they do not make any investment that will not return at least 7.5% per year. They have been approached with an investment opportunity that requires $25,000 upfront and has a payout of $6,000 at the end of each of the next 5 years. Using the internal rate of return (IRR) method and their requirements, determine whether Billy and Mandy should undertake the investment. P10–17 IRR, investment life, and cash inflows Oak Enterprises accepts projects earning more than the firm’s 15% cost of capital. Oak is currently considering a 10-yearproject that provides annual cash inflows of $10,000 and requires an initial invest-ment of $61,450. ( Note: All amounts are after taxes.) a.Determine the IRR of this project. Is it acceptable? b.Assuming that the cash inflows continue to be $10,000 per year, how many additional years would the flows have to continue to make the project acceptable (that is, to make it have an IRR of 15%)? c.With the given life, initial investment, and cost of capital, what is the minimum annual cash inflow that the firm should accept? P10–18 NPV and IRR Benson Designs has prepared the following estimates for a long- term project it is considering. The initial investment is $18,250, and the project is expected to yield after-tax cash inflows of $4,000 per year for 7 years. The firm hasa 10% cost of capital.a.Determine the net present value (NPV) for the project. b.Determine the internal rate of return (IRR) for the project. c.Would you recommend that the firm accept or reject the project? Explain your answer. P10–19 NPV, with rankings Botany Bay, Inc., a maker of casual clothing, is considering four projects. Because of past financial difficulties, the company has a high cost of capital at 15%. Which of these projects would be acceptable under those cost circumstances?420 PART 5 Long-Term Investment Decisions LG4 LG4 Project A Project B Project C Project D Initial investment ( CF0) $50,000 $100,000 $80,000 $180,000 Year ( t) Cash inflows ( CFt) 1 $20,000 $35,000 $20,000 $100,000 2 20,000 50,000 40,000 80,0003 20,000 50,000 60,000 60,000 a.Calculate the NPV of each project, using a cost of capital of 15%. b.Rank acceptable projects by NPV. c.Calculate the IRR of each project, and use it to determine the highest cost of capital at which all of the projects would be acceptable.LG4 LG3 LG4 LG3 P10–20 All techniques, conflicting rankings Nicholson Roofing Materials, Inc., is consid- ering two mutually exclusive projects, each with an initial investment of $150,000.The company’s board of directors has set a maximum 4-year payback requirementand has set its cost of capital at 9%. The cash inflows associated with the two projects are shown in the following table.CHAPTER 10 Capital Budgeting Techniques 421 Cash inflows ( CFt) Year Project A Project B 1 $45,000 $75,000 2 45,000 60,0003 45,000 30,0004 45,000 30,0005 45,000 30,0006 45,000 30,000 a.Calculate the payback period for each project. b.Calculate the NPV of each project at 0%. c.Calculate the NPV of each project at 9%. d.Derive the IRR of each project. e.Rank the projects by each of the techniques used. Make and justify a recommen- dation. P10–21 Payback, NPV, and IRR Rieger International is attempting to evaluate the feasi- bility of investing $95,000 in a piece of equipment that has a 5-year life. The firm has estimated the cash inflows associated with the proposal as shown in the following table. The firm has a 12% cost of capital. Year ( t) Cash inflows ( CFt) 1 $20,000 2 25,0003 30,0004 35,0005 40,000 a.Calculate the payback period for the proposed investment. b.Calculate the net present value (NPV) for the proposed investment. c.Calculate the internal rate of return (IRR) , rounded to the nearest whole percent, for the proposed investment. d.Evaluate the acceptability of the proposed investment using NPV and IRR. What recommendation would you make relative to implementation of the project? Why? P10–22 NPV, IRR, and NPV profiles Thomas Company is considering two mutually exclu- sive projects. The firm, which has a 12% cost of capital, has estimated its cash flows as shown in the following table.LG3 LG4LG2 LG3 LG4LG2 LG4 LG5LG3 a.Calculate the NPV of each project, and assess its acceptability. b.Calculate the IRR for each project, and assess its acceptability. c.Draw the NPV profiles for both projects on the same set of axes. d.Evaluate and discuss the rankings of the two projects on the basis of your find- ings in parts a, b, andc. e.Explain your findings in part din light of the pattern of cash inflows associated with each project. P10–23 All techniques—Decision among mutually exclusive investments Pound Industries is attempting to select the best of three mutually exclusive projects. The initial investment and after-tax cash inflows associated with these projects are shown in thefollowing table.422 PART 5 Long-Term Investment Decisions Project A Project B Initial investment ( CF0) $130,000 $85,000 Year ( t) Cash inflows ( CFt) 1 $25,000 $40,000 2 35,000 35,0003 45,000 30,0004 50,000 10,0005 55,000 5,000 Cash flows Project A Project B Project C Initial investment ( CF0) $60,000 $100,000 $110,000 Cash inflows ( CFt),t1 to 5 $20,000 $ 31,500 $ 32,500=LG3 LG5 LG6LG4LG2 LG3 LG5 LG6LG4LG2a.Calculate the payback period for each project. b.Calculate the net present value (NPV) of each project, assuming that the firm has a cost of capital equal to 13%. c.Calculate the internal rate of return (IRR) for each project. d.Draw the net present value profiles for both projects on the same set of axes, and discuss any conflict in ranking that may exist between NPV and IRR. e.Summarize the preferences dictated by each measure, and indicate which project you would recommend. Explain why. P10–24 All techniques with NPV profile—Mutually exclusive projects Projects A and B, of equal risk, are alternatives for expanding Rosa Company’s capacity. The firm’s cost of capital is 13%. The cash flows for each project are shown in the following table.a.Calculate each project’s payback period . b.Calculate the net present value (NPV) for each project. c.Calculate the internal rate of return (IRR) for each project. d.Draw the net present value profiles for both projects on the same set of axes, and discuss any conflict in ranking that may exist between NPV and IRR. e.Summarize the preferences dictated by each measure, and indicate which project you would recommend. Explain why. P10–25 Integrative—Multiple IRRs Froogle Enterprises is evaluating an unusual invest- ment project. What makes the project unusual is the stream of cash inflows and out- flows shown in the following table:CHAPTER 10 Capital Budgeting Techniques 423 Project A Project B Initial investment ( CF0) $80,000 $50,000 Year ( t) Cash inflows ( CFt) 1 $15,000 $15,000 2 20,000 15,0003 25,000 15,0004 30,000 15,0005 35,000 15,000 Year Cash flow 0 $ 200,000 1 920,0002 1,582,0003 1,205,2004 343,200– a.Why is it difficult to calculate the payback period for this project? b.Calculate the investment’s net present value at each of the following discount rates: 0%, 5%, 10%, 15%, 20%, 25%, 30%, 35%. c.What does your answer to part btell you about this project’s IRR? d.Should Froogle invest in this project if its cost of capital is 5%? What if the cost of capital is 15%? e.In general, when faced with a project like this, how should a firm decide whether to invest in the project or reject it? P10–26 Integrative—Conflicting Rankings The High-Flying Growth Company (HFGC) has been growing very rapidly in recent years, making its shareholders rich in the process. The average annual rate of return on the stock in the last few years has been 20%, andHFGC managers believe that 20% is a reasonable figure for the firm’s cost of capital. To sustain a high growth rate, the HFGC CEO argues that the company must con- tinue to invest in projects that offer the highest rate of return possible. Two projectsare currently under review. The first is an expansion of the firm’s production capacity, and the second project involves introducing one of the firm’s existing products into a new market. Cash flows from each project appear in the following table. a.Calculate the NPV, IRR, and PI for both projects. b.Rank the projects based on their NPVs, IRRs, and PIs. c.Do the rankings in part bagree or not? If not, why not? d.The firm can only afford to undertake one of these investments, and the CEO favors the product introduction because it offers a higher rate of return (that is, a higher IRR) than the plant expansion. What do you think the firm should do? Why?LG6 LG4 LG5LG3 P10–27 ETHICS PROBLEM Gap, Inc., is trying to incorporate human resource and supplier considerations into its management decision making. Here is Gap’s report of find- ings from a recent Social Responsibility Report: Because factory owners sometimes try to hide violations, Gap emphasizes training for factory managers. However, due to regional differences, the training varies from one site to another. The report notes that 10 to 25 percent of workers in China, Taiwan, and Saipan have been harassed and humiliated. Less than half of the facto-ries in sub-Saharan Africa have adequate worker safety regulations and infrastruc- ture. In Mexico, Latin America, and the Caribbean, 25 to 50 percent of the suppliers fail to pay even the minimum wage. Calvert Group, Ltd., a mutual fund family that focuses on “socially responsible investing,” had this to say about the impact of Gap’s report: With revenues of $15.9 billion and over 300,000 employees worldwide, Gap leads the U.S. apparel sector and has contracts with over 3,000 factories globally. Calvert has been in dialogue with Gap for about five years, the last two as part of the Working Group. Gap’s supplier monitoring program focuses on remediation, because its sup- pliers produce for multiple apparel companies and would likely move their capacity to different clients rather than adopt conditions deemed too demanding. About one-third of the factories Gap examined comfortably met Gap’s criteria, another third had barely acceptable conditions, and the final third missed the minimum standards. Gap terminated contracts with 136 factories where it found conditions to be beyondremediation. Increased transparency and disclosure are crucial in measuring a company’s commitment to raising human rights standards and improving the lives of workers. Gap’s report is an important first step in the direction of a model format that othercompanies can adapt. 8 If Gap were to aggressively pursue renegotiations with suppliers, based on this report, what is the likely effect on Gap’s expenses in the next 5 years? In your opinion, what would be the impact on its stock price in the immediate future? After 10 years?424 PART 5 Long-Term Investment Decisions 8.www.calvert.com/news_newsArticle.asp?article=4612&image=cn.gif&keepleftnav=Calvert+NewsLG6 LG1Year Plant expansion Product introduction 0 $3,500,000 $500,000 1 1,500,000 250,0002 2,000,000 350,0003 2,500,000 375,0004 2,750,000 425,000- – CHAPTER 10 Capital Budgeting Techniques 425 Spreadsheet Exercise The Drillago Company is involved in searching for locations in which to drill for oil. The firm’s current project requires an initial investment of $15 million and has anestimated life of 10 years. The expected future cash inflows for the project are asshown in the following table: Year Cash inflows 1 $ 600,000 2 1,000,0003 1,000,0004 2,000,0005 3,000,0006 3,500,0007 4,000,0008 6,000,0009 8,000,000 10 12,000,000 The firm’s current cost of capital is 13%. TO DO Create a spreadsheet to answer the following: a.Calculate the project’s net present value (NPV) . Is the project acceptable under the NPV technique? Explain. b.Calculate the project’s internal rate of return (IRR) . Is the project acceptable under the IRR technique? Explain. c.In this case, did the two methods produce the same results? Generally, is there a preference between the NPV and IRR techniques? Explain. d.Calculate the payback period for the project. If the firm usually accepts projects that have payback periods between 1 and 7 years, is this project acceptable? Visit www.myfinancelab.com forChapter Case: Making Norwich Tool’s Lathe Investment Decision, Group Exercises, and numerous online resources. Why This Chapter Matters to You In your professional life ACCOUNTING You need to understand capital budgeting cash flows to provide revenue, cost, depreciation, and tax data for use both inmonitoring existing projects and in developing cash flows for proposedprojects. INFORMATION SYSTEMS You need to understand capital budgeting cash flows to maintain and facilitate the retrieval of cash flow data forboth completed and existing projects. MANAGEMENT You need to understand capital budgeting cash flows so that you will understand which cash flows are relevant in makingdecisions about proposals for acquiring additional production facilities,for new marketing programs, for new products, and for the expansionof existing product lines. MARKETING You need to understand capital budgeting cash flows so that you can make revenue and cost estimates for proposals for newmarketing programs, for new products, and for the expansion ofexisting product lines. OPERATIONS You need to understand capital budgeting cash flows so that you can make revenue and cost estimates for proposals for theacquisition of new equipment and production facilities. You are not mandated to provide financial statements prepared using GAAP, so you naturally focus on cash flows. When considering amajor outflow of funds (for example, purchase of a house, funding of acollege education), you can project the associated cash flows and usethese estimates to assess the value and affordability of the assets andany associated future outlays. In your personal lifeLearning Goals Discuss the three major cash flow components. Discuss relevant cash flows, expansion versus replacementdecisions, sunk costs andopportunity costs, andinternational capital budgeting. Calculate the initial investment associated with a proposedcapital expenditure. Discuss the tax implications associated with the sale of an oldasset. Find the relevant operating cash inflows associated with aproposed capital expenditure. Determine the terminal cash flow associated with a proposedcapital expenditure. LG6LG5LG4LG3LG2LG111Capital Budgeting Cash Flows 426 427Maintaining Its Project Inventory As the largest publicly traded oil company in the world, ExxonMobil ’s long-term investments are at the heart of its ability to generate shareholderwealth. Its 2009 earnings of more than $19 billion resulted in a 16 percent return on capital invested. Through dividends and share repurchases, ExxonMobilreturned $26 billion to its shareholders in 2009 and more than $150 billion over the previous five years. To maintain its petroleum reserves, ExxonMobil must continually add to its inventory of discovered oil and gas resources. It holds exploration rights to 109 million undeveloped acres in 37 countries. Each year,the company initiates a number of megaprojects thatadd to its exploration rights, locate and “prove ” addi- tional reserves, or increase the productivity of currently producing wells. Total capital and exploration expenditures in 2009 amounted to a record $27 billion. Within the next 5 years, ExxonMobil anticipates investing more than $125 billion. ExxonMobil has partnered with Qatar Petroleum to develop a global-scale petrochemical complex in RasLaffan Industrial City, Qatar. The plant is expected to start up in late 2015, and it will include two 650,000 ton-per-year polyethylene plants, a 1.6 million-ton-per-year steam cracker, and a 700,000 ton-per-year ethylene glycol facility. While Exxon is often able to bring in projects on or under budget, increasing costs could cause some future development projects to go over budget. Drilling and exploration costs are expected to rise. Recent high oil prices have led to a surge in demand for exploration, and thecost of drilling equipment and workers has jumped at least 15 percent a year during the last sev-eral years. Further complicating oil production efforts in the future will be an increase in the use of less-than-suitable oil sources, such as shale oil and tar sands. Like ExxonMobil, every firm must evaluate the costs and returns of projects for expansion, asset replacement or renewal, research and development, advertising, and other areas that require a long-term commitment of funds in expectation of future returns. Chapter 11 explains how to identify the relevant cash outflows and inflows that must be considered in making majorinvestment decisions. ExxonMobil 428 PART 5 Long-Term Investment Decisions 11.1 Relevant Cash Flows Chapter 10 introduced the capital budgeting process and the techniques financial managers use for evaluating and selecting long-term investments. To evaluate invest-ment opportunities, financial managers must determine the relevant cash flows asso- ciated with the project. These are the incremental cash outflows (investment) and inflows (return). Theincremental cash flows represent the additional cash flows— outflows or inflows—expected to result from a proposed capital expenditure. Asnoted in Chapter 4, cash flows rather than accounting figures are used because cashflows directly affect the firm’s ability to pay bills and purchase assets. The nearbyFocus on Ethics box discusses the accuracy of cash flow estimates and cites one reason that even well-estimated deals may not work out as planned. The remainder of this chapter is devoted to the procedures for measuring the relevant cash flows associated with proposed capital expenditures. MAJOR CASH FLOW COMPONENTS The cash flows of any project may include three basic components: (1) an initialinvestment, (2) operating cash inflows, and (3) terminal cash flow. All projects—whether for expansion, replacement or renewal, or some other purpose—have thefirst two components. Some, however, lack the final component, terminal cash flow.LG2LG1 relevant cash flows Theincremental cash outflow (investment) and resulting subsequent inflows associated with a proposed capitalexpenditure. incremental cash flows Theadditional cash flows— outflows or inflows—expectedto result from a proposedcapital expenditure. focus on ETHICS A Question of Accuracy The process of capital budgeting based on projected cash flows has been a part ofthe investment decision process for morethan 40 years. This procedure for evalu- ating investment opportunities works well when cash flows can be estimatedwith certainty, but in real-world corpo-rate practice, many investment decisionsinvolve a high degree of uncertainty. The decision is even more complicated when the project under consideration isthe acquisition of another company orpart of another company. Because estimates of the cash flows from an investment project involve mak- ing assumptions about the future, theymay be subject to considerable error.The problem becomes more compli-cated as the period of time under con- sideration becomes longer and when the project is unique in nature with nocomparables. Other complications mayarise involving accounting for additional(extraordinary) cash flows—for example, the cost of litigation, compliance with tougher environmental standards, or the costs of disposal or recycling of an assetat the completion of the project. All too often, the initial champagne celebration gives way once the final cost of a deal is tallied. In fact, taken as a whole, mergers and acquisitions inrecent years have produced a disheart-ening negative 12 percent return on investment. While the financial data necessary to generate discounted cashflow estimates are ever more readilyavailable, these days more attention isbeing paid to the accuracy of the num- bers. Inspired in part by post-Enron focus on governance and the threat ofshareholder lawsuits, board membershave been pushing corporate managersto make a stronger case for the deals they propose. Says Glenn Gurtcheff, managing director and co-head of mid-dle market M&A for Piper Jaffray & Co.,“They ’re not just taking the company ’s audited and unaudited financial state-ments at face value; they are really div- ing into the numbers and trying to understand not just their accuracy, butwhat they mean in terms of trends. ” If valuation has improved so much, why do analyses show that companies often overpay ? The answer lies in the imperial CEO. Improvements in valuationtechniques can be negated when theprocess deteriorates into a game of tweaking the numbers to justify a deal the CEO wants to do, regardless ofprice. This “make it work ” form of capital budgeting often results in building theempire under the CEO ’s control at the expense of the firm ’s shareholders. 3 What would your options be when faced with the demands of an impe- rial CEO who expects you to “make it work”? Brainstorm several options.in practice Figure 11.1 depicts on a time line the cash flows for a project. The initial investment for the proposed project is $50,000. This is the relevant cash outflow at time zero. The operating cash inflows, which are the incremental after-tax cash inflows resulting from implementation of the project during its life, graduallyincrease from $4,000 in its first year to $10,000 in its tenth and final year. Theterminal cash flow is the after-tax nonoperating cash flow occurring in the final year of the project. It is usually attributable to liquidation of the project. In this caseit is $25,000, received at the end of the project’s 10-year life. Note that the terminalcash flow does notinclude the $10,000 operating cash inflow for year 10. EXPANSION VERSUS REPLACEMENT DECISIONS Developing relevant cash flow estimates is most straightforward in the case of expansion decisions. In this case, the initial investment, operating cash inflows, and terminal cash flow are merely the after-tax cash outflow and inflows associ-ated with the proposed capital expenditure. Identifying relevant cash flows for replacement decisions is more compli- cated, because the firm must identify the incremental cash outflow and inflows that would result from the proposed replacement. The initial investment in thecase of replacement is the difference between the initial investment needed toacquire the new asset and any after-tax cash inflows expected from liquidation ofthe old asset. The operating cash inflows are the difference between the operatingcash inflows from the new asset and those from the old asset. The terminal cashflow is the difference between the after-tax cash flows expected upon terminationof the new and the old assets. These relationships are shown in Figure 11.2. Actually, all capital budgeting decisions can be viewed as replacement deci- sions. Expansion decisions are merely replacement decisions in which all cash flows from the old asset are zero. In light of this fact, this chapter focuses prima- rily on replacement decisions. SUNK COSTS AND OPPORTUNITY COSTS When estimating the relevant cash flows associated with a proposed capitalexpenditure, the firm must recognize any sunk costs and opportunity costs. Thesecosts are easy to mishandle or ignore, particularly when determining a project’sCHAPTER 11 Capital Budgeting Cash Flows 429 0 $50,000Initial InvestmentEnd of Year10$10,000Terminal Cash Flow 9$9,000 8$8,000 7$8,000 6$8,000Operating Cash Inflows 5$7,000 4$7,000 3$6,000 2$5,000 1$4,000$25,000FIGURE 11.1 Cash Flow Components Time line for major cashflow components initial investment The relevant cash outflow for a proposed project at time zero. operating cash inflows The incremental after-tax cashinflows resulting fromimplementation of a projectduring its life. terminal cash flow The after-tax nonoperatingcash flow occurring in the finalyear of a project. It is usuallyattributable to liquidation ofthe project. incremental cash flows. Sunk costs are cash outlays that have already been made (past outlays) and therefore have no effect on the cash flows relevant to the cur-rent decision. As a result, sunk costs should not be included in a project’s incre- mental cash flows. Opportunity costs are cash flows that could be realized from the best alter- native use of an owned asset. They therefore represent cash flows that will not be realized as a result of employing that asset in the proposed project. Because of this, any opportunity costs should be included as cash outflows when one is determining a project’s incremental cash flows. Jankow Equipment is considering renewing its drill press X12, which it purchased3 years earlier for $237,000, by retrofitting it with the computerized controlsystem from an obsolete piece of equipment it owns. The obsolete equipmentcould be sold today for a high bid of $42,000, but without its computerized con-trol system, it would be worth nothing. Jankow is in the process of estimating thelabor and materials costs of retrofitting the system to drill press X12 and the ben-efits expected from the retrofit. The $237,000 cost of drill press X12 is a sunk cost because it represents an earlier cash outlay. It would not be included as a cash out- flow when determining the cash flows relevant to the retrofit decision. AlthoughJankow owns the obsolete piece of equipment, the proposed use of its computer-ized control system represents an opportunity cost of $42,000—the highest price at which it could be sold today. This opportunity cost would be included as a cash outflow associated with using the computerized control system. INTERNATIONAL CAPITAL BUDGETING AND LONG-TERM INVESTMENTS Although the same basic capital budgeting principles are used for domestic and international projects, several additional factors must be addressed in evaluatingforeign investment opportunities. International capital budgeting differs from theExample 11.1 3430 PART 5 Long-Term Investment Decisions Initial investmentInitial investment needed to acquire new assetAfter-tax cash inflows from liquidation of old asset/H11002 /H11005 Operating cash inflowsOperating cash inflows from new assetOperating cash inflows from old asset/H11002 /H11005 Terminal cash flowAfter-tax cash flows from termination of new assetAfter-tax cash flows from termination of old asset/H11002 /H11005FIGURE 11.2 Relevant Cash Flows for Replacement DecisionsCalculation of the three components of relevant cash flows for areplacement decision sunk costs Cash outlays that have already been made (past outlays) andtherefore have no effect on thecash flows relevant to a currentdecision. opportunity costs Cash flows that could be real-ized from the best alternativeuse of an owned asset. domestic version because (1) cash outflows and inflows occur in a foreign cur- rency, and (2) foreign investments entail potentially significant political risk. Bothof these risks can be minimized through careful planning. Companies face both long-term and short-term currency risks related to both the invested capital and the cash flows resulting from it. Long-term currency riskcan be minimized by financing the foreign investment at least partly in the localcapital markets. This step ensures that the project’s revenues, operating costs, andfinancing costs will be in the local currency. Likewise, the dollar value of short-term, local-currency cash flows can be protected by using special securities andstrategies such as futures, forwards, and options market instruments. Political risks can be minimized by using both operating and financial strate- gies. For example, by structuring the investment as a joint venture and selecting awell-connected local partner, the U.S. company can minimize the risk of its oper-ations being seized or harassed. Companies also can protect themselves fromhaving their investment returns blocked by local governments by structuring thefinancing of such investments as debt rather than as equity. Debt-service pay-ments are legally enforceable claims, whereas equity returns (such as dividends)are not. Even if local courts do not support the claims of the U.S. company, thecompany can threaten to pursue its case in U.S. courts. In spite of the preceding difficulties, foreign direct investment (FDI) , which involves the transfer of capital, managerial, and technical assets to a foreigncountry, has surged in recent years. This is evident in the growing market valuesof foreign assets owned by U.S.–based companies and of foreign direct invest-ment in the United States, particularly by British, Canadian, Dutch, German, andJapanese companies. Furthermore, foreign direct investment by U.S. companiesseems to be accelerating. See the Global Focus box on page 432 for a discussion of recent foreign direct investment in China.CHAPTER 11 Capital Budgeting Cash Flows 431 foreign direct investment The transfer of capital, managerial, and technical assets to a foreign country. Matter of fact According to the U.S. Department of Commerce’s Bureau of Economic Analysis (BEA), FDI plays an important role in the U.S. economy. BEA divides FDI into two categories: Greenfield Investment and Mergers and Acquisitions. Greenfield investments create new enterprises and develop or expand production facilities, while Mergers and Acquisitions involve the purchase of an existing enterprise. In 2008 the United States was the world’s largest recipient of FDI, receiving more than $325.3 billion in FDI. This amount was a 37 percent increase from the previous year. Further, the $2.1 trillion worth of FDI in the United States at the end of 2008 is the equivalent of approxi- mately 16 percent of U.S. gross domestic product (GDP).FDI in the United States 6REVIEW QUESTIONS 11–1 Why is it important to evaluate capital budgeting projects on the basis ofincremental cash flows? 11–2 What three components of cash flow may exist for a given project? How can expansion decisions be treated as replacement decisions? Explain. 11–3 What effect do sunk costs andopportunity costs have on a project’s incremental cash flows? 11–4 How can currency risk andpolitical risk be minimized when one is making foreign direct investment?432 PART 5 Long-Term Investment Decisions GLOBAL focus Changes May Influence Future Investments in China Foreign direct invest- ment in China soared in 2009. Not including banks, insur-ance, and securities, foreign direct investment amounted to $90 billion.China ’s economy has surged more than tenfold since 1980, the first year itallowed foreign investments, when money began pouring into factories on China ’s east coast. China ’s trade surplus in 2009 was $196 billion. With a strong foreignexchange surplus, China is no longer desperate for capital from overseas but is now primarily interested in foreignskills and technologies. Prime MinisterWen Jiabao wants to steer investmentstoward the manufacturing of higher- value products and toward less- developed regions. Wen is giving taxbreaks and promising speedyapprovals for investments away from areas in the east, such as Shanghai and the Pearl River Delta.Typical of foreign investors in China is Intel Capital, a subsidiary of Intel Corporation. As of the middle of 2010, Intel Capital ’s portfolio had $200 million invested in 25 Chinese companies. Intel Capital is no beginner at foreign investment; it has investedmore than $4 billion in more than1,000 companies around the world. China allows three types of foreign investments: a wholly foreign-owned enterprise (WFOE) in which the firm is entirely funded with foreign capital; a joint venture in which the foreign part- ner must provide at least 25 percent of initial capital; and a representative office (RO), the most common and eas- ily established entity, which cannot per- form business activities that directly result in profits. Generally an RO is thefirst step in establishing a China pres-ence and includes mechanisms forupgrading to a WFOE or joint venture.As with any foreign investment, investing in China is not without risk.One potential risk facing foreigninvestors in China is that the communistgovernment could decide to nationalize private companies. Many public com- panies in China are firms that wereonce owned by the communist govern-ment, such as China Life InsuranceCompany, and it is always possiblethat the communist government may decide that it wishes to own and con-trol these companies again. The list of governments similar to China ’s that have nationalized private companies isfairly long. While there is no evidence that this will happen in China, it should be considered one of the risks. 3 Although China has been actively campaigning for foreign investment, how do you think having a commu- nist government affects its foreign investment?in practice 11.2 Finding the Initial Investment The term initial investment as used here refers to the relevant cash outflows to be considered when evaluating a prospective capital expenditure. Our discussion ofcapital budgeting will focus on projects with initial investments that occur at time zero—the time at which the expenditure is made. The initial investment is calcu- lated by subtracting all cash inflows occurring at time zero from all cash outflowsoccurring at time zero. The basic format for determining the initial investment is given in Table 11.1. The cash flows that must be considered when determining the initial investmentassociated with a capital expenditure are the installed cost of the new asset, theafter-tax proceeds (if any) from the sale of an old asset, and the change (if any) inLG4LG3 net working capital. Note that if there are no installation costs and the firm is not replacing an existing asset, then the cost (purchase price) of the new asset,adjusted for any change in net working capital, is equal to the initial investment. INSTALLED COST OF NEW ASSET As shown in Table 11.1, the installed cost of the new asset is found by adding thecost of the new asset to its installation costs. The cost of new asset is the net out- flow that its acquisition requires. Usually, we are concerned with the acquisitionof a fixed asset for which a definite purchase price is paid. Installation costs are any added costs that are necessary to place an asset into operation. The InternalRevenue Service (IRS) requires the firm to add installation costs to the purchaseprice of an asset to determine its depreciable value, which is expensed over aperiod of years. The installed cost of new asset, calculated by adding the cost of new asset to its installation costs, equals its depreciable value. AFTER-TAX PROCEEDS FROM SALE OF OLD ASSET Table 11.1 shows that the after-tax proceeds from sale of old asset decrease the firm’s initial investment in the new asset. These proceeds are the differencebetween the old asset’s sale proceeds and any applicable taxes or tax refundsrelated to its sale. The proceeds from sale of old asset are the net cash inflows it provides. This amount is net of any costs incurred in the process of removingthe asset. Included in these removal costs arecleanup costs, such as those related to removal and disposal of chemical and nuclear wastes. These costsmay not be trivial. The proceeds from the sale of an old asset are normally subject to some type of tax. 1This tax on sale of old asset depends on the relationship between its sale price and book value and on existing government tax rules.CHAPTER 11 Capital Budgeting Cash Flows 433 The Basic Format for Determining Initial Investment Installed cost of new asset /H11549 Cost of new assetInstallation costs /H11546After-tax proceeds from sale of old asset /H11549 Proceeds from sale of old asset /H11007Tax on sale of old asset /H11550Change in net working capital Initial investment+TABLE 11.1 cost of new asset The net outflow necessary to acquire a new asset. installation costs Any added costs that arenecessary to place an assetinto operation. installed cost of new asset Thecost of new asset plus its installation costs; equals the asset’s depreciable value. 1. A brief discussion of the tax treatment of ordinary and capital gains income was presented in Chapter 2. Because corporate capital gains and ordinary income are taxed at the same rate, for convenience, we do not differentiatebetween them in the following discussions.after-tax proceeds from sale of old asset The difference between the old asset’s sale proceeds and anyapplicable taxes or tax refundsrelated to its sale. proceeds from sale of old asset The cash inflows, net of any removal orcleanup costs, resulting from the sale of an existing asset. tax on sale of old asset Tax that depends on therelationship between the oldasset’s sale price and book value and on existing government tax rules. Book Value Thebook value of an asset is its strict accounting value. It can be calculated by using the following equation: (11.1) Hudson Industries, a small electronics company, 2 years ago acquired a machinetool with an installed cost of $100,000. The asset was being depreciated underMACRS using a 5-year recovery period. Table 4.2 (on page 117) shows thatunder MACRS for a 5-year recovery period, 20% and 32% of the installed costwould be depreciated in years 1 and 2, respectively. In other words, 52%(20% 32%) of the $100,000 cost, or $52,000 (0.52 $100,000), would rep-resent the accumulated depreciation at the end of year 2. Substituting intoEquation 11.1, we get The book value of Hudson’s asset at the end of year 2 is therefore $48,000. Basic Tax Rules Three potential tax situations can occur when a firm sells an asset. These situa-tions depend on the relationship between the asset’s sale price and its book value.The two key forms of taxable income and their associated tax treatments aredefined and summarized in Table 11.2. The assumed tax rates used throughoutthis text are noted in the final column. There are three possible tax situations.The asset may be sold (1) for more than its book value, (2) for its book value, or(3) for less than its book value. An example will illustrate. The old asset purchased 2 years ago for $100,000 by Hudson Industries has acurrent book value of $48,000. What will happen if the firm now decides to sellthe asset and replace it? The tax consequences depend on the sale price.Figure 11.3 depicts the taxable income resulting from four possible sale prices in light of the asset’s initial purchase price of $100,000 and its current book value ofExample 11.3 3Book value =$100,000 -$52,000 =$48,000* +Example 11.2 3Book value =Installed cost of asset -Accumulated depreciation434 PART 5 Long-Term Investment Decisions book value The strict accounting value of an asset, calculated by subtractingits accumulated depreciationfrom its installed cost. Tax Treatment on Sales of Assets Form of Assumed taxable income Definition Tax treatment tax rate Gain on sale of asset Portion of the sale price that is All gains above book value are taxed 40% greater than book value. as ordinary income. Loss on sale of asset Amount by which sale price is If the asset is depreciable and used 40% of loss less than book value. in business, loss is deducted is a tax savings from ordinary income. If the asset is notdepreciable or is not 40% of loss used in business, loss is deductible only is a tax savingsagainst capital gains.TABLE 11.2 $48,000. The taxable consequences of each of these sale prices are described in the following paragraphs. The sale of the asset for more than its book value If Hudson sells the old asset for $110,000, it realizes a gain of $62,000 ($110,000 $48,000). Technicallythis gain is made up of two parts—a capital gain and recaptured depreciation, which is the portion of the sale price that is above book value and below the ini-tial purchase price. For Hudson, the capital gain is $10,000 ($110,000 saleprice $100,000 initial purchase price); recaptured depreciation is $52,000 (the$100,000 initial purchase price $48,000 book value). Both the $10,000 capital gain and the $52,000 recaptured depreciation are shown under the $110,000 sale price in Figure 11.3. The total gain above bookvalue of $62,000 is taxed as ordinary income at the 40% rate, resulting in taxesof $24,800 (0.40 $62,000). These taxes should be used in calculating the ini-tial investment in the new asset, using the format in Table 11.1. In effect, thetaxes raise the amount of the firm’s initial investment in the new asset by reducingthe proceeds from the sale of the old asset. If Hudson instead sells the old asset for $70,000, it experiences a gain above book value (in the form of recaptured depreciation ) of $22,000 ($70,000 $48,000), as shown under the $70,000 sale price in Figure 11.3. This gain is taxed as ordinaryincome. Because the firm is assumed to be in the 40% tax bracket, the taxes on the$22,000 gain are $8,800 (0.40 $22,000). This amount in taxes should be usedin calculating the initial investment in the new asset.*-*–CHAPTER 11 Capital Budgeting Cash Flows 435 Initial Purchase Price Book Value$100,000 $70,000 $48,000 $30,000 $0$110,000Capital Gain Gain ($62,000)$110,000 $70,000 $48,000Sale Price $30,000 Gain ($22,000)No Gain or LossLoss($18,000)RecapturedDepreciation LossFIGURE 11.3 Taxable Income from Sale of Asset Taxable income from sale of asset at various sale prices for Hudson Industries recaptured depreciation The portion of an asset’s sale price that is above its bookvalue and below its initialpurchase price. The sale of the asset for its book value If the asset is sold for $48,000, its book value, the firm breaks even. There is no gain or loss, as shown under the $48,000sale price in Figure 11.3. Because no tax results from selling an asset for its book value, there is no tax effect on the initial investment in the new asset. The sale of the asset for less than its book value If Hudson sells the asset for $30,000, it experiences a loss of $18,000 ($48,000 $30,000), as shown under the$30,000 sale price in Figure 11.3. If this is a depreciable asset used in the business,the firm may use the loss to offset ordinary operating income. If the asset is not depreciable or is notused in the business, the firm can use the loss only to offset cap- ital gains. In either case, the loss will save the firm $7,200 (0.40 $18,000) intaxes. And, if current operating earnings or capital gains are not sufficient to offset the loss, the firm may be able to apply these losses to prior or future years’ taxes. CHANGE IN NET WORKING CAPITAL Net working capital is the difference between the firm’s current assets and its cur- rent liabilities. This topic is treated in depth in Chapter 15; at this point it isimportant to note that changes in net working capital often accompany capitalexpenditure decisions. If a firm acquires new machinery to expand its level ofoperations, it will experience an increase in levels of cash, accounts receivable,inventories, accounts payable, and accruals. These increases result from the needfor more cash to support expanded operations, more accounts receivable andinventories to support increased sales, and more accounts payable and accruals tosupport increased outlays made to meet expanded product demand. As noted inChapter 4, increases in cash, accounts receivable, and inventories are outflows of cash, whereas increases in accounts payable and accruals are inflows of cash. The difference between the change in current assets and the change in current liabilities is the change in net working capital. Generally, current assets increase by more than current liabilities, resulting in an increased investment in networking capital. This increased investment is treated as an initial outflow. 2If the change in net working capital were negative, it would be shown as an initialinflow. The change in net working capital—regardless of whether it is an increaseor a decrease— is not taxable because it merely involves a net buildup or net reduction of current accounts. Danson Company, a metal products manufacturer, is contemplating expandingits operations. Financial analysts expect that the changes in current accountssummarized in Table 11.3 will occur and will be maintained over the life of theexpansion. Current assets are expected to increase by $22,000, and current lia-bilities are expected to increase by $9,000, resulting in a $13,000 increase in networking capital. In this case, the change will represent an increased net workingcapital investment and will be treated as a cash outflow in calculating the initialinvestment.Example 11.4 3*-436 PART 5 Long-Term Investment Decisions net working capital The difference between the firm’s current assets and its current liabilities. 2. When changes in net working capital apply to the initial investment associated with a proposed capital expendi- ture, they are for convenience assumed to be instantaneous and thereby occurring at time zero. In practice, thechange in net working capital will frequently occur over a period of months as the capital expenditure is imple-mented.change in net working capital The difference between a change in current assets and a change in current liabilities. CALCULATING THE INITIAL INVESTMENT A variety of tax and other considerations enter into the initial investment calcula- tion. The following example illustrates calculation of the initial investmentaccording to the format in Table 11.1. 3 Powell Corporation, a large, diversified manufacturer of aircraft components, istrying to determine the initial investment required to replace an old machine witha new, more sophisticated model. The proposed machine’s purchase price is$380,000, and an additional $20,000 will be necessary to install it. It will bedepreciated under MACRS using a 5-year recovery period. The present (old)machine was purchased 3 years ago at a cost of $240,000 and was being depreci-ated under MACRS using a 5-year recovery period. The firm has found a buyerwilling to pay $280,000 for the present machine and to remove it at the buyer’sexpense. The firm expects that a $35,000 increase in current assets and an$18,000 increase in current liabilities will accompany the replacement; thesechanges will result in a $17,000 ($35,000 $18,000) increase in net working capital. The firm pays taxes at a rate of 40%. The only component of the initial investment calculation that is difficult to obtain is taxes. The book value of the present machine can be found byusing the depreciation percentages from Table 4.2 (on page 117) of 20%,32%, and 19% for years 1, 2, and 3, r espectively. The resulting book value is $69,600 . A gainof $210,400 is realized on the sale. The total taxes on the gain are $84,160 . These taxes must be subtracted from the $280,000sale price of the present machine to calculate the after-tax proceeds from its sale.(0.40 *$210,400)($280,000 -$69,600)($240,000 -3(0.20 +0.32 +0.19) *$240,000 4)- Example 11.5 3CHAPTER 11 Capital Budgeting Cash Flows 437 Calculation of Change in Net Working Capital for Danson Company Current account Change in balance Cash $ 4,000 Accounts receivable 10,000Inventories (1) Current assets $22,000 Accounts payable $ 7,000Accruals (2) Current liabilitiesChange in net working capital [(1) (2)] +$13,000 /H11546+9,000+2,000+++8,000++TABLE 11.3 3. Throughout the discussions of capital budgeting, all assets evaluated as candidates for replacement are assumed to be depreciable assets that are directly used in the business, so any losses on the sale of these assets can be applied against ordinary operating income. The decisions are also structured to ensure that the usable life remaining on the old asset is just equal to the life of the new asset; this assumption enables us to avoid the problem of unequal lives,which is discussed in Chapter 12. Substituting the relevant amounts into the format in Table 11.1 results in an initial investment of $221,160, which represents the net cash outflow required attime zero. Installed cost of proposed machine Cost of proposed machine $380,000 Installation costs Total installed cost—proposed (depreciable value) $400,000 After-tax proceeds from sale of present machine Proceeds from sale of present machine $280,000 Tax on sale of present machine Total after-tax proceeds—present 195,840 Change in net working capital Initial investment 6REVIEW QUESTIONS 11–5 Explain how each of the following inputs is used to calculate the initial investment: (a)cost of new asset, (b)installation costs, (c)proceeds from sale of old asset, (d)tax on sale of old asset, and (e)change in net working capital. 11–6 How is the book value of an asset calculated? What are the two key forms of taxable income? 11–7 What three tax situations may result from the sale of an asset that isbeing replaced? 11–8 Referring to the basic format for calculating initial investment, explainhow a firm would determine the depreciable value of the new asset.$221,16017,000 /H1154584,160 -/H1154620,000 +438 PART 5 Long-Term Investment Decisions 11.3 Finding the Operating Cash Inflows The benefits expected from a capital expenditure or “project” are embodied in its operating cash inflows, which are incremental after-tax cash inflows. In this sec- tion, we use the income statement format to develop clear definitions of the termsafter-tax, cash inflows, andincremental. INTERPRETING THE TERM AFTER-TAX Benefits expected to result from proposed capital expenditures must be measured on an after-tax basis because the firm will not have the use of any benefits until it has satisfied the government’s tax claims. These claims depend on the firm’s tax-able income, so deducting taxes before making comparisons between proposed investments is necessary for consistency when evaluating capital expenditurealternatives.LG5 INTERPRETING THE TERM CASH INFLOWS All benefits expected from a proposed project must be measured on a cash flow basis. Cash inflows represent dollars that can be spent, not merely “accounting profits.” There is a simple technique for converting after-tax net profits intooperating cash inflows. The basic calculation requires adding depreciation andany other noncash charges (amortization and depletion) deducted as expenses on the firm’s income statement back to net profits after taxes. Because deprecia-tion is commonly found on income statements, it is the only noncash charge weconsider. Powell Corporation’s estimates of its revenue and expenses (excluding deprecia-tion and interest), with and without the proposed new machine described inExample 11.5, are given in Table 11.4. Note that both the expected usable life of theproposed machine and the remaining usable life of the present machine are 5 years.The amount to be depreciated with the proposed machine is calculated by sum-ming the purchase price of $380,000 and the installation costs of $20,000. Theproposed machine is to be depreciated under MACRS using a 5-year recoveryperiod. 4The resulting depreciation on this machine for each of the 6 years, as well as the remaining 3 years of depreciation (years 4, 5, and 6) on the presentmachine, are calculated in Table 11.5 (see page 440). 5 Theoperating cash inflows each year can be calculated by using the income statement format shown in Table 11.6 (see page 440). Note that we excludeinterest because we are focusing purely on the “investment decision.” The interestis relevant to the “financing decision,” which is separately considered. Because weexclude interest expense, “earnings before interest and taxes” (EBIT) is equivalentto “net profits before taxes,” and the calculation of “operating cash inflow” inExample 11.6 3CHAPTER 11 Capital Budgeting Cash Flows 439 4. As noted in Chapter 4, it takes years to depreciate an n-year class asset under current tax law. Therefore, MACRS percentages are given for each of 6 years for use in depreciating an asset with a 5-year recovery period. 5. It is important to recognize that, although both machines will provide 5 years of use, the proposed new machine will be depreciated over the 6-year period, whereas the present machine, as noted in the preceding example, has beendepreciated over 3 years and therefore has remaining only its final 3 years (years 4, 5, and 6) of depreciation (12%, 12%, and 5%, respectively, under MACRS).n+1Powell Corporation’s Revenue and Expenses (Excluding Depreciation and Interest) for Proposed and Present Machines With proposed machine With present machine Expenses Expenses Revenue (excl. depr. and int.) Revenue (excl. depr. and int.) Year (1) (2) Year (1) (2) 1 $2,520,000 $2,300,000 1 $2,200,000 $1,990,000 2 2,520,000 2,300,000 2 2,300,000 2,110,0003 2,520,000 2,300,000 3 2,400,000 2,230,0004 2,520,000 2,300,000 4 2,400,000 2,250,0005 2,520,000 2,300,000 5 2,250,000 2,120,000TABLE 11.4 Table 11.6 is equivalent to “operating cash flow (OCF)” (defined in Equation 4.3, on page 122). Simply stated, the income statement format calculates OCF. Substituting the data from Tables 11.4 and 11.5 into this format and assuming a 40% tax rate, we get Table 11.7. It demonstrates the calculation of operatingcash inflows for each year for both the proposed and the present machine. Becausethe proposed machine is depreciated over 6 years, the analysis must be performed440 PART 5 Long-Term Investment Decisions Depreciation Expense for Proposed and Present Machines for Powell Corporation Applicable MACRS depreciation Depreciation Cost percentages (from Table 4.2) [(1) (2)] Year (1) (2) (3) With proposed machine 1 $400,000 20% $ 80,000 2 400,000 32 128,0003 400,000 19 76,0004 400,000 12 48,0005 400,000 12 48,0006 400,000 Totals With present machine 1 $240,000 12% (year-4 depreciation) $28,800 2 240,000 12 (year-5 depreciation) 28,8003 240,000 5 (year-6 depreciation) 12,0004 0 5 0 6 Total a aThe total $69,600 represents the book value of the present machine at the end of the third year, as calculated in Example 11.5.$69,6000$400,000 100%20,000 5:TABLE 11.5 Because the present machine is at the end of the third year of its cost recovery at the time the analysis is performed, it has only the final 3 years of depreciation (as noted above) still applicable. Calculation of Operating Cash Inflows Using the Income Statement Format Revenue Expenses (excluding depreciation and interest) Earnings before depreciation, interest, and taxes (EBDIT) Depreciation Earnings before interest and taxes (EBIT) Taxes (rate T) Net operating profit after taxes DepreciationOperating cash inflows (same as OCF in Equation 4.3)+3NOPAT =EBIT *(1-T)4= –TABLE 11.6 over the 6-year period to capture fully the tax effect of its year-6 depreciation. The resulting operating cash inflows are shown in the final row of Table 11.7 for eachmachine. The $8,000 year-6 operating cash inflow for the proposed machine results solely from the tax benefit of its year-6 depreciation deduction.6 INTERPRETING THE TERM INCREMENTAL The final step in estimating the operating cash inflows for a proposed replacementproject is to calculate the incremental (relevant) cash inflows. Incremental operating cash inflows are needed because our concern is only with the change in operating cash inflows that result from the proposed project. Clearly, if this were an expansionproject, the project’s cash flows would be the incremental cash flows.CHAPTER 11 Capital Budgeting Cash Flows 441 Calculation of Operating Cash Inflows for Powell Corporation’s Proposed and Present Machines Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 With proposed machine Revenuea$2,520,000 $2,520,000 $2,520,000 $2,520,000 $2,520,000 $ 0 /H11002Expenses (excluding depreciation and interest)b Earnings before depreciation, interest, and taxes $ 220,000 $ 220,000 $ 220,000 $ 220,000 $ 220,000 $ 0 /H11002Depreciationc Earnings before interest and taxes $ 140,000 $ 92,000 $ 144,000 $ 172,000 $ 172,000 /H11002Taxes (rate, T 40%) Net operating profit after taxes $ 84,000 $ 55,200 $ 86,400 $ 103,200 $ 103,200 /H11001Depreciationc Operating cash inflows With present machine Revenuea$2,200,000 $2,300,000 $2,400,000 $2,400,000 $2,250,000 $ 0 /H11002Expenses (excluding depreciation and interest)b Earnings before depreciation, interest, and taxes $ 210,000 $ 190,000 $ 170,000 $ 150,000 $ 130,000 $ 0 /H11002Depreciationc Earnings before interest and taxes $ 181,200 $ 161,200 $ 158,000 $ 150,000 $ 130,000 $ 0 /H11002Taxes (rate, T 40%) Net operating profit after taxes $ 108,720 $ 96,720 $ 94,800 $ 90,000 $ 78,000 $ 0 /H11001Depreciationc Operating cash inflows aFrom column 1 of Table 11.4. bFrom column 2 of Table 11.4. cFrom column 3 of Table 11.5.$0 $ 78,000 $ 90,000 $ 106,800 $ 125,520 $ 137,5200 0 0 12,000 28,800 28,8000 52,000 60,000 63,200 64,480 72,480 =0 0 0 12,000 28,800 28,8000 2,120,000 2,250,000 2,230,000 2,110,000 1,990,000$8 , 0 0 0 $ 151,200 $ 151,200 $ 162,400 $ 183,200 $ 164,00020,000 48,000 48,000 76,000 128,000 80,000-$12,000-8,000 68,800 68,800 57,600 36,800 56,000 =-$20,00020,000 48,000 48,000 76,000 128,000 80,0000 2,300,000 2,300,000 2,300,000 2,300,000 2,300,000TABLE 11.7 6. Although here we have calculated the year-6 operating cash inflow for the proposed machine, this cash flow will later be eliminated as a result of the assumed sale of the machine at the end of year 5. Table 11.8 demonstrates the calculation of Powell Corporation’s incremental (rel- evant) operating cash inflows for each year. The estimates of operating cash inflows developed in Table 11.7 appear in columns 1 and 2. Column 2 values rep-resent the amount of operating cash inflows that Powell Corporation will receiveif it does not replace the present machine. If the proposed machine replaces thepresent machine, the firm’s operating cash inflows for each year will be thoseshown in column 1. Subtracting the present machine’s operating cash inflowsfrom the proposed machine’s operating cash inflows, we get the incrementaloperating cash inflows for each year, shown in column 3. These cash flows repre-sent the amounts by which each respective year’s cash inflows will increase as aresult of the replacement. For example, in year 1, Powell Corporation’s cashinflows would increase by $26,480 if the proposed project were undertaken.Clearly, these are the relevant inflows to be considered when evaluating the bene- fits of making a capital expenditure for the proposed machine.7Example 11.7 3442 PART 5 Long-Term Investment Decisions Incremental (Relevant) Operating Cash Inflows for Powell Corporation Operating cash inflows Incremental (relevant) Proposed machineaPresent machinea[(1) (2)] Year (1) (2) (3) 1 $164,000 $137,520 $26,480 2 183,200 125,520 57,6803 162,400 106,800 55,6004 151,200 90,000 61,2005 151,200 78,000 73,2006 8,000 0 8,000 aFrom final row for respective machine in Table 11.7./H11546TABLE 11.8 7. The following equation can be used to calculate more directly the incremental cash inflow in year t,ICI t. where change in earnings before depreciation, interest, and taxes [revenues expenses (excl. depr. and int.)] in year t change in depreciation expense in year t firm’s marginal tax rate Applying this formula to the Powell Corporation data given in Tables 11.4 and 11.5 for year 3, we get the following values of variables: Substituting into the equation yields The $55,600 of incremental cash inflow for year 3 is the same value as that calculated for year 3 in column 3 of Table 11.8.=$30,000 +$25,600 =$55,600ICI3=3$50,000 *(1-0.40)4+($64,000 *0.40)T=0.40¢D3=$76,000 -$12,000 =$64,000=$220,000 -$170,000 =$50,000¢EBDIT 3=($2,520,000 -$2,300,000) -($2,400,000 -$2,230,000)T=¢Dt=- ¢EBDIT t=ICIt=3¢EBDIT t*(1-T)4+(¢Dt*T) 6REVIEW QUESTIONS 11–9 How does depreciation enter into the calculation of operating cash inflows? How does the income statement format in Table 11.6 relate toEquation 4.3 (on page 122) for finding operating cash flow (OCF)? 11–10 How are the incremental (relevant) operating cash inflows that are asso- ciated with a replacement decision calculated?CHAPTER 11 Capital Budgeting Cash Flows 443 11.4 Finding the Terminal Cash Flow Terminal cash flow is the cash flow resulting from termination and liquidation of a project at the end of its economic life. It represents the after-tax cash flow,exclusive of operating cash inflows, that occurs in the final year of the project.When it applies, this flow can significantly affect the capital expenditure decision.Terminal cash flow can be calculated for replacement projects by using the basicformat presented in Table 11.9. PROCEEDS FROM SALE OF ASSETS The proceeds from sale of the new and the old asset, often called “salvage value,”represent the amount net of any removal or cleanup costs expected on termina- tion of the project. For replacement projects, proceeds from both the new assetand the old asset must be considered. For expansion and renewal types of capitalexpenditures, the proceeds from the old asset are zero. Of course, it is not unusualfor the value of an asset to be zero at the termination of a project. TAXES ON SALE OF ASSETS When the investment being analyzed involves replacing an old asset with a newone, there are two key elements in finding the terminal cash flow. First, at the endof the project’s life, the firm will dispose of the new asset, so the after-tax pro-ceeds from selling the new asset represent a cash inflow. However, remember thatif the firm had not replaced the old asset, the firm would have received proceedsfrom disposal of the old asset at the end of the project (rather than counting thoseproceeds up front as part of the initial investment). Therefore, we must count as acash outflow the after-tax proceeds that the firm would have received from disposalof the old asset. Taxes come into play whenever an asset is sold for a value dif-ferent from its book value. If the net proceeds from the sale are expected to exceedLG6 The Basic Format for Determining Terminal Cash Flow After-tax proceeds from sale of new asset /H11549 Proceeds from sale of new asset /H11007Tax on sale of new asset /H11546After-tax proceeds from sale of old asset /H11549 Proceeds from sale of old asset /H11007Tax on sale of old asset /H11550Change in net working capital Terminal cash flowTABLE 11.9 book value, a tax payment shown as an outflow (deduction from sale proceeds) will occur. When the net proceeds from the sale are less than book value, a tax rebate shown as a cash inflow (addition to sale proceeds) will result. For assets sold to net exactly book value, no taxes will be due. CHANGE IN NET WORKING CAPITAL When we calculated the initial investment, we took into account any change innet working capital that is attributable to the new asset. Now, when we calculatethe terminal cash flow, the change in net working capital represents the reversionof any initial net working capital investment. Most often, this will show up as acash inflow due to the reduction in net working capital; with termination of theproject, the need for the increased net working capital investment is assumed toend. 8Because the net working capital investment is in no way consumed, the amount recovered at termination will equal the amount shown in the calculationof the initial investment. Tax considerations are not involved. Calculating the terminal cash flow involves the same procedures as those used to find the initial investment. In the following example, the terminal cashflow is calculated for a replacement decision. Continuing with the Powell Corporation example, assume that the firm expectsto be able to liquidate the new machine at the end of its 5-year usable life to net$50,000 after paying removal and cleanup costs. Had it not been replaced by thenew machine, the old machine would have been liquidated at the end of the 5 yearsto net $10,000. The firm expects to recover its $17,000 net working capitalinvestment upon termination of the project. The firm pays taxes at a rate of 40%. From the analysis of the operating cash inflows presented earlier, we can see that the proposed (new) machine will have a book value of $20,000 (equal to theyear-6 depreciation) at the end of 5 years. The present (old) machine would havebeen fully depreciated and therefore would have a book value of zero at the endof the 5 years. Because the sale price of $50,000 for the proposed (new) machineis below its initial installed cost of $400,000 but greater than its book value of$20,000, taxes will have to be paid only on the recaptured depreciation of$30,000 ($50,000 sale proceeds $20,000 book value). Applying the ordinarytax rate of 40% to this $30,000 results in a tax of $12,000 (0.40 $30,000) onthe sale of the proposed machine. Its after-tax sale proceeds would thereforeequal $38,000 ($50,000 sale proceeds $12,000 taxes). Because the oldmachine would have been sold for $10,000 at termination, which is less than itsoriginal purchase price of $240,000 and above its book value of zero, it wouldhave experienced a taxable gain of $10,000 ($10,000 sale price $0 bookvalue). Applying the 40% tax rate to the $10,000 gain, the firm would haveowed a tax of $4,000 (0.40 $10,000) on the sale of the old machine at the endof year 5. Its after-tax sale proceeds from the old machine would have equalled$6,000 ($10,000 sale price $4,000 taxes). Substituting the appropriate valuesinto the format in Table 11.9 results in the terminal cash inflow of $49,000.-*–*- Example 11.8 3444 PART 5 Long-Term Investment Decisions 8. As noted earlier, the change in net working capital is for convenience assumed to occur instantaneously—in this case, on termination of the project. After-tax proceeds from sale of proposed machine Proceeds from sale of proposed machine $50,000 /H11002Tax on sale of proposed machine Total after-tax proceeds—proposed $38,000 /H11546 After-tax proceeds from sale of present machine Proceeds from sale of present machine $10,000 /H11002Tax on sale of present machine Total after-tax proceeds—present 6,000 /H11545 Change in net working capital Terminal cash flow 6REVIEW QUESTION 11–11 Explain how the terminal cash flow is calculated for replacement projects.$49,00017,0004,00012,000CHAPTER 11 Capital Budgeting Cash Flows 445 11.5 Summarizing the Relevant Cash Flows The initial investment, operating cash inflows, and terminal cash flow together represent a project’s relevant cash flows. These cash flows can be viewed as the incremental after-tax cash flows attributable to the proposed project. They repre-sent, in a cash flow sense, how much better or worse off the firm will be if itchooses to implement the proposal. The relevant cash flows for Powell Corporation’s proposed replacement expendi-ture can be shown graphically, on a time line. Note that because the new asset is assumed to be sold at the end of its 5-year usable life, the year-6 incrementaloperating cash inflow calculated in Table 11.8 has no relevance; the terminal cashflow effectively replaces this value in the analysis.Example 11.9 3LG5 LG3 LG6 0 $221,160End of Year5$122,200 Total Cash Flow73,200 Operating Cash Inflow49,000$ Terminal Cash Flow 4$61,200 3$55,600 2$57,680 1$26,480Time line for Powell Corporation’s relevant cashflows with the proposed machine With these cash flow estimates in hand, a financial manager could then cal- culate the investment’s NPV or IRR using the techniques covered in Chapter 10. After receiving a sizable bonus from her employer, Tina Talor is contemplating the purchase of a new car. She feels that by estimating and analyzing its cash flows she could make a more rational decisionabout whether to make this large purchase. Tina’s cash flow estimates for the carpurchase are as follows: Negotiated price of new car $23,500 Taxes and fees on new car purchase $ 1,650Proceeds from sale of old car $ 9,750Estimated value of new car in 3 years $10,500Estimated value of old car in 3 years $ 5,700Estimated annual repair costs on new car 0 (in warranty)Estimated annual repair costs on old car $ 400 Using the cash flow estimates, Tina calculates the initial investment, oper- ating cash inflows, terminal cash flow, and a summary of all cash flows for thecar purchase. Initial Investment Total cost of new car Cost of car $23,500 /H11001Taxes and fees $25,150 /H11002Proceeds from sale of old car Initial investment $15,400 Operating Cash Inflows Year 1 Year 2 Year 3 Cost of repairs on new car $ 0 $ 0 $ 0 /H11002Cost of repairs on old car Operating cash inflows (savings) $400 $400 $400 Terminal Cash Flow—End of Year 3 Proceeds from sale of new car $10,500 /H11002Proceeds from sale of old car Terminal cash flow $ 4,800 Summary of Cash Flows End of Year Cash Flow 0 /H11002$15,400 1 /H11001 400 2 /H11001 400 3 /H110015,200 ($400 $4,800) The cash flows associated with Tina’s car purchase decision reflect her net costs of the new car over the assumed 3-year ownership period, but they ignore+5,700 400 400 4009,7501,650Personal Finance Example 11.10 3446 PART 5 Long-Term Investment Decisions the many intangible benefits of owning a car. Whereas the fuel cost and basic transportation service provided are assumed to be the same with the new car aswith the old car, Tina will have to decide if the cost of moving up to a new car can be justified in terms of intangibles, such as luxury and prestige. 6REVIEW QUESTION 11–12 Diagram and describe the three components of the relevant cash flows for a capital budgeting project.CHAPTER 11 Capital Budgeting Cash Flows 447 Summary FOCUS ON VALUE A key responsibility of financial managers is to review and analyze proposed investment decisions to make sure that the firm undertakes only those that con-tribute positively to the value of the firm. Utilizing a variety of tools and tech-niques, financial managers estimate the cash flows that a proposed investmentwill generate and then apply decision techniques to assess the investment’simpact on the firm’s value. The most difficult and important aspect of this cap-ital budgeting process is developing good estimates of the relevant cash flows. The relevant cash flows are the incremental after-tax cash flows resulting from a proposed investment. These estimates represent the cash flow benefitsthat are likely to accrue to the firm as a result of implementing the investment.By applying to the cash flows decision techniques that capture the time value ofmoney and risk factors, the financial manager can estimate how the investmentwill affect the firm’s share price. Consistent application of capital budgeting pro-cedures to proposed long-term investments should therefore allow the firm tomaximize its stock price. REVIEW OF LEARNING GOALS Discuss the three major cash flow components. The three major cash flow components of any project can include: (1) an initial investment, (2) oper-ating cash inflows, and (3) terminal cash flow. The initial investment occurs attime zero, the operating cash inflows occur during the project life, and the ter- minal cash flow occurs at the end of the project. Discuss relevant cash flows, expansion versus replacement decisions, sunk costs and opportunity costs, and international capital budgeting. The rele- vant cash flows for capital budgeting decisions are the initial investment, theoperating cash inflows, and the terminal cash flow. For replacement decisions,these flows are the difference between the cash flows of the new asset and theold asset. Expansion decisions are viewed as replacement decisions in which allcash flows from the old asset are zero. When estimating relevant cash flows,ignore sunk costs and include opportunity costs as cash outflows. In interna-tional capital budgeting, currency risks and political risks can be minimizedthrough careful planning.LG2LG1