FUNDAMENTALS OF

Corporate Finance SECOND EDITION

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FUNDAMENTALS OF

Corporate Finance SECOND EDITION

Jonathan Berk

Peter DeMarzo

Jarrad Harford

STANFORD UNIVERSITY

STANFORD UNIVERSITY

UNIVERSITY OF WASHINGTON

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 Tokyo

The Prentice Hall Series in Finance Alexander/Sharpe/Bailey Fundamentals of Investments

Gitman/Joehnk Fundamentals of Investing*

Megginson Corporate Finance Theory

Bear/Moldonado-Bear Free Markets, Finance, Ethics, and Law

Gitman/Madura Introduction to Finance

Melvin International Money and Finance

Berk/DeMarzo Corporate Finance*

Guthrie/Lemon Mathematics of Interest Rates and Finance

Berk/DeMarzo Corporate Finance: The Core*

Mishkin/Eakins Financial Markets and Institutions

Haugen The Inefficient Stock Market: What Pays Off and Why

Moffett Cases in International Finance

Haugen Modern Investment Theory

Moffett/Stonehill/Eiteman Fundamentals of Multinational Finance

Haugen The New Finance: Overreaction, Complexity, and Uniqueness

Nofsinger Psychology of Investing

Berk/DeMarzo/Harford Fundamentals of Corporate Finance* Bierman/Smidt The Capital Budgeting Decision: Economic Analysis of Investment Projects Bodie/Merton/Cleeton Financial Economics Click/Coval The Theory and Practice of International Financial Management

Holden Excel Modeling and Estimation in the Fundamentals of Corporate Finance

Copeland/Weston/Shastri Financial Theory and Corporate Policy

Holden Excel Modeling and Estimation in the Fundamentals of Investments

Cox/Rubinstein Options Markets

Holden Excel Modeling and Estimation in Investments

Dietrich Financial Services and Financial Institutions: Value Creation in Theory and Practice

Holden Excel Modeling and Estimation in Corporate Finance

Dorfman Introduction to Risk Management and Insurance

Hughes/MacDonald International Banking: Text and Cases

Dufey/Giddy Cases in International Finance Eakins Finance in .learn Eiteman/Stonehill/Moffett Multinational Business Finance Emery/Finnerty/Stowe Corporate Financial Management Fabozzi Bond Markets: Analysis and Strategies Fabozzi/Modigliani Capital Markets: Institutions and Instruments Fabozzi/Modigliani/Jones/Ferri Foundations of Financial Markets and Institutions Finkler Financial Management for Public, Health, and Not-for-Profit Organizations Francis/Ibbotson Investments: A Global Perspective Fraser/Ormiston Understanding Financial Statements Geisst Investment Banking in the Financial System Gitman Principles of Managerial Finance* Gitman Principles of Managerial Finance––Brief Edition*

*denotes

Hull Fundamentals of Futures and Options Markets Hull Options, Futures, and Other Derivatives Hull Risk Management and Financial Institutions Keown Personal Finance: Turning Money into Wealth Keown/Martin/Petty/Scott Financial Management: Principles and Applications Keown/Martin/Petty/Scott Foundations of Finance: The Logic and Practice of Financial Management

Ogden/Jen/O'Connor Advanced Corporate Finance Pennacchi Theory of Asset Pricing Rejda Principles of Risk Management and Insurance Schoenebeck Interpreting and Analyzing Financial Statements Scott/Martin/Petty/Keown/Thatcher Cases in Finance Seiler Performing Financial Studies: A Methodological Cookbook Shapiro Capital Budgeting and Investment Analysis Sharpe/Alexander/Bailey Investments Solnik/McLeavey Global Investments Stretcher/Michael Cases in Financial Management Titman/Martin Valuation: The Art and Science of Corporate Investment Decisions

Kim/Nofsinger Corporate Governance

Trivoli Personal Portfolio Management: Fundamentals and Strategies

Levy/Post Investments

Van Horne Financial Management and Policy

Madura Personal Finance

Van Horne Financial Market Rates and Flows

Marthinsen Risk Takers: Uses and Abuses of Financial Derivatives

Van Horne/Wachowicz Fundamentals of Financial Management

May/May/Andrew Effective Writing: A Handbook for Finance People

Vaughn Financial Planning for the Entrepreneur

McDonald Derivatives Markets

Weston/Mitchel/Mulherin Takeovers, Restructuring, and Corporate Governance

McDonald Fundamentals of Derivatives Markets

Winger/Frasca Personal Finance

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To Rebecca, Natasha, and Hannah for the love and for being there. —J. B.

To Kaui, Pono, Koa, and Kai for all the love and laughter. —P. D.

To Katrina, Evan, and Cole for your love and support. —J. H.

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10 9 8 7 6 5 4 3 2 1

ISBN 10: ISBN 13:

0-132-14823-4 978-0-13-214823-8

Brief Contents PART 1

Introduction CHAPTER 1 CHAPTER 2

PART 2

Corporate Finance and the Financial Manager 2 Introduction to Financial Statement Analysis 23

Interest Rates and Valuing Cash Flows CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER

PART 3

1

3 4 5 6 7

61

Time Value of Money: An Introduction 62 Time Value of Money: Valuing Cash Flow Streams Interest Rates 117 Bonds 144 Stock Valuation 182

Valuation and the Firm

83

209

CHAPTER 8 Investment Decision Rules 210 CHAPTER 9 Fundamentals of Capital Budgeting 247 CHAPTER 10 Stock Valuation: A Second Look 282

PART 4

Risk and Return

315

CHAPTER 11 Risk and Return in Capital Markets 316 CHAPTER 12 Systematic Risk and the Equity Risk Premium CHAPTER 13 The Cost of Capital 381

PART 5

Long-Term Financing

409

CHAPTER 14 Raising Equity Capital CHAPTER 15 Debt Financing 438

PART 6

345

410

Capital Structure and Payout Policy

459

CHAPTER 16 Capital Structure 460 CHAPTER 17 Payout Policy 498

PART 7

Financial Planning and Forecasting

533

CHAPTER 18 Financial Modeling and Pro Forma Analysis CHAPTER 19 Working Capital Management 564 CHAPTER 20 Short-Term Financial Planning 591

PART 8

Special Topics

534

621

CHAPTER 21 Option Applications and Corporate Finance CHAPTER 22 Mergers and Acquisitions 648 CHAPTER 23 International Corporate Finance 679

622

vii

Detailed Contents PART 1 CHAPTER 1

Introduction

1

Corporate Finance and the Financial Manager 2 Q INTERVIEW WITH Leslie Tillquist, PA Consulting Group 3

1.1 Why Study Finance? 4 1.2 The Four Types of Firms 4 Sole Proprietorships 5 Partnerships 5 Limited Liability Companies 6 Corporations 6 Tax Implications for Corporate Entities 7 1.3 The Financial Manager 9 Q Corporate Taxation Around the World 9 Making Investment Decisions 10 Making Financing Decisions 10 Managing Short-Term Cash Needs 10 The Goal of the Financial Manager 11 1.4 The Financial Manager’s Place in the Corporation 11 The Corporate Management Team 11 Ethics and Incentives in Corporations 12 1.5 The Stock Market 14 The Largest Stock Markets 14 Primary Versus Secondary Markets 14 Physical Stock Markets 15 Over-the-Counter Stock Markets 15 Q NYSE, AMEX, DJIA, S&P 500: Awash in Acronyms 16 Listing Standards 16 Other Financial Markets 17 1.6 Financial Institutions 17 The Financial Cycle 17 Types of Financial Institutions 18 Role of Financial Institutions 18 Summary 19 Q Problems 21

CHAPTER 2

viii

Introduction to Financial Statement Analysis 23 Q INTERVIEW WITH Hiral Tolia, CBIZ Valuation Group, LLC 24

2.1 Firms’ Disclosure of Financial Information 25 Preparation of Financial Statements 25 Types of Financial Statements 25 Q International Financial Reporting Standards 26 2.2 The Balance Sheet 26 Assets 27 Liabilities 28 Stockholders’ Equity 28 2.3 Balance Sheet Analysis 30 Market-to-Book Ratio 30 Debt-Equity Ratio 30 Enterprise Value 31 Other Balance Sheet Information 32 2.4 The Income Statement 33 Earnings Calculations 33 2.5 Income Statement Analysis 35 Profitability Ratios 35 Asset Efficiency 36 Working Capital Ratios 36 EBITDA 37 Leverage Ratios 37 Investment Returns 37 The DuPont Identity 38 Valuation Ratios 39 Q COMMON MISTAKE Mismatched Ratios 40 2.6 The Statement of Cash Flows 42 Operating Activity 42 Investment Activity 44 Financing Activity 44 2.7 Other Financial Statement Information 45 Management Discussion and Analysis 45 Statement of Stockholders’ Equity 46 Notes to the Financial Statements 46 2.8 Financial Reporting in Practice 46 Enron 46 The Sarbanes-Oxley Act 47 Q Practitioner INTERVIEW WITH Sue Frieden, Ernst & Young 48 The Financial Statements: A Useful Starting Point 49 Summary 49 Q Critical Thinking 52 Q Problems 52 Q Data Case 58

Detailed Contents

PART 2 CHAPTER 3

Interest Rates and Valuing Cash Flows 61 Time Value of Money: An Introduction 62 Q INTERVIEW WITH Nicole Wickswat, Intel Corporation 63

3.1 Cost-Benefit Analysis 64 Role of the Financial Manager 64 Quantifying Costs and Benefits 64 Q When Competitive Market Prices Are Not Available 66

Q COMMON MISTAKE Discounting One Too Many Times 92 4.3 Annuities 92 Present Value of an Annuity 92 Future Value of an Annuity 95 4.4 Growing Cash Flows 96 Growing Perpetuity 96 Growing Annuity 98 4.5 Solving for Variables Other Than Present Value or Future Value 99 Solving for the Cash Flows 100 Rate of Return 102 Solving for the Number of Periods 104

3.2 Market Prices and the Valuation Principle 66 The Valuation Principle 67 Why There Can Be Only One Competitive Price for a Good 67 Q Your Personal Financial Decisions 68

Summary 106 Q Critical Thinking 108 Q Problems 108 Q Data Case 113 CHAPTER 4 APPENDIX Using a Financial Calculator 114 Specifying Decimal Places 114 Toggling Between the Beginning and End of a Period 114 Set the Number of Periods per Year 114 General TVM Buttons 114 Solving for the Future Value of an Annuity (Example 4.5) 115 Solving for the Rate of Return 115

3.3 The Time Value of Money and Interest Rates 68 The Time Value of Money 69 The Interest Rate: Converting Cash Across Time 70 Timelines 72 3.4 Valuing Cash Flows at Different Points in Time 73 Rule 1: Comparing and Combining Values 73 Q COMMON MISTAKE Summing Cash Flows Across Time 74 Rule 2: Compounding 74 Q Rule of 72 76 Rule 3: Discounting 76 Q Using a Financial Calculator 78 Summary 78 Q Critical Thinking 80 Q Problems 80

CHAPTER 4

Time Value of Money: Valuing Cash Flow Streams 83 Q INTERVIEW WITH Gregory Goin, McFee Financial Group 84

4.1 Valuing a Stream of Cash Flows 85 Applying the Rules of Valuing Cash Flows to a Cash Flow Stream 85 Q Using a Financial Calculator: Solving for Present and Future Values of Cash Flow Streams 88 4.2 Perpetuities 89 Perpetuities 89 Q Historical Examples of Perpetuities 91

ix

CHAPTER 5

Interest Rates

117

Q INTERVIEW WITH Jason Moore, Bradford & Marzec, LLC 118 5.1 Interest Rate Quotes and Adjustments 119 The Effective Annual Rate 119 Adjusting the Discount Rate to Different Time Periods 120 Annual Percentage Rates 121 Q COMMON MISTAKE Using the EAR in the Annuity Formula 122 5.2 Application: Discount Rates and Loans 124 Computing Loan Payments 124 Computing the Outstanding Loan Balance 126 5.3 The Determinants of Interest Rates 127 Inflation and Real Versus Nominal Rates 127 Investment and Interest Rate Policy 128 Q How Is Inflation Actually Calculated? 130 The Yield Curve and Discount Rates 130 Q Practitioner INTERVIEW WITH Frederic S. Mishkin, Columbia University 132 Q COMMON MISTAKE Using the Annuity Formula When Discount Rates Vary 133 The Yield Curve and the Economy 133

x

Detailed Contents 5.4 The Opportunity Cost of Capital 136 Q Interest Rates, Discount Rates, and the Cost of Capital 137 Summary 138 Q Critical Thinking 139 Q Problems 140

CHAPTER 6

Bonds

144

Q INTERVIEW WITH Andrew DeWitt, PIMCO 145 6.1 Bond Terminology 146 6.2 Zero-Coupon Bonds 147 Zero-Coupon Bond Cash Flows 148 Yield to Maturity of a Zero-Coupon Bond 148 Risk-Free Interest Rates 149 6.3 Coupon Bonds 151 Coupon Bond Cash Flows 151 Q The U.S. Treasury Market 152 Yield to Maturity of a Coupon Bond 152 Q Finding Bond Prices on the Web 154 Coupon Bond Price Quotes 155 6.4 Why Bond Prices Change 156 Interest Rate Changes and Bond Prices 156 Time and Bond Prices 158 Interest Rate Risk and Bond Prices 160 Q Clean and Dirty Prices for Coupon Bonds 162 Bond Prices in Practice 163 6.5 Corporate Bonds 164 Credit Risk 164 Q Practitioner INTERVIEW WITH Lisa Black, Teachers Insurance and Annuity Association 165 Corporate Bond Yields 166 Bond Ratings 166 Corporate Yield Curves 166 Q The Credit Crisis and Bond Yields 168 Summary 170 Q Critical Thinking 171 Q Problems 172 Q Data Case 175 CHAPTER 6 APPENDIX A Solving for the Yield to Maturity of a Bond Using a Financial Calculator 177 CHAPTER 6 APPENDIX B The Yield Curve and the Law of One Price 178

CHAPTER 7

Stock Valuation

182

Q INTERVIEW WITH Christopher Ellis-Ferrara, AllianceBernstein 183 7.1 Stock Basics 184 Stock Market Reporting: Stock Quotes 184

Common Stock 185 Preferred Stock 186 7.2 The Mechanics of Stock Trades 187 7.3 The Dividend-Discount Model 188 A One-Year Investor 188 Dividend Yields, Capital Gains, and Total Returns 189 A Multiyear Investor 190 Dividend-Discount Model Equation 191 7.4 Estimating Dividends in the Dividend-Discount Model 192 Constant Dividend Growth 192 Dividends Versus Investment and Growth 193 Changing Growth Rates 195 Q COMMON MISTAKE Forgetting to “Grow” This Year’s Dividend 196 Value Drivers and the Dividend-Discount Model 198 7.5 Limitations of the Dividend-Discount Model 198 Uncertain Dividend Forecasts 198 Non-Dividend-Paying Stocks 199 7.6 Share Repurchases and the Total Payout Model 200 7.7 Putting It All Together 201 Summary 202 Q Critical Thinking 204 Q Problems 204 PART 2 INTEGRATIVE CASE 207

PART 3

Valuation and the Firm

CHAPTER 8

Investment Decision Rules

209 210

Q INTERVIEW WITH Scott Ladner, Parsons Brinckerhoff 211 8.1 The NPV Decision Rule 212 Net Present Value 212 The NPV Decision Rule 213 8.2 Using the NPV Rule 214 Organizing the Cash Flows and Computing the NPV 214 The NPV Profile 215 Measuring Sensitivity with IRR 216 Alternative Rules Versus the NPV Rule 216 8.3 Alternative Decision Rules 216 Q USING EXCEL Computing NPV and IRR 217 The Payback Rule 218 The Internal Rate of Return Rule 219 Q COMMON MISTAKE IRR Versus the IRR Rule 223

Detailed Contents Break-Even Analysis 267 Q Practitioner INTERVIEW WITH David Holland, Sports and Entertainment Solutions 268 Scenario Analysis 269

Modified Internal Rate of Return 223 Q Why Do Rules Other Than the NPV Rule Persist? 224 8.4 Choosing Between Projects 226 Differences in Scale 227 Q Practitioner INTERVIEW WITH Dick Grannis, QUALCOMM 230 Timing of the Cash Flows 231 8.5 Evaluating Projects with Different Lives 232 Important Considerations When Using the Equivalent Annual Annuity 234

xi

9.6 Real Options in Capital Budgeting 270 Option to Delay 270 Option to Expand 270 Option to Abandon 270 Summary 271 Q Critical Thinking 273 Q Problems 273 Q Data Case 279

8.6 Choosing Among Projects When Resources Are Limited 235 Evaluating Projects with Different Resource Requirements 235

CHAPTER 9 APPENDIX MACRS Depreciation 280

8.7 Putting It All Together 238 Summary 239 Q Critical Thinking 240 Q Problems 241 Q Data Case 246

CHAPTER 9

Fundamentals of Capital Budgeting 247 Q INTERVIEW WITH Kelly Cox, Boeing Corporation 248

9.1 The Capital Budgeting Process 249 9.2 Forecasting Incremental Earnings 250 Operating Expenses Versus Capital Expenditures 250 Incremental Revenue and Cost Estimates 251 Taxes 252 Incremental Earnings Forecast 252 9.3 Determining Incremental Free Cash Flow 254 Converting from Earnings to Free Cash Flow 255 Calculating Free Cash Flow Directly 258 Calculating the NPV 259 9.4 Other Effects on Incremental Free Cash Flows 260 Opportunity Costs 260 Q COMMON MISTAKE The Opportunity Cost of an Idle Asset 260 Project Externalities 260 Sunk Costs 261 Q COMMON MISTAKE The Sunk Cost Fallacy 261 Adjusting Free Cash Flow 262 Replacement Decisions 264 9.5 Analyzing the Project 265 Sensitivity Analysis 265

CHAPTER 10

Stock Valuation: A Second Look 282 Q INTERVIEW WITH David Mandell, William Blair & Company 283

10.1 The Discounted Free Cash Flow Model 284 Valuing the Enterprise 284 Implementing the Model 285 Connection to Capital Budgeting 286 10.2 Valuation Based on Comparable Firms 288 Valuation Multiples 288 Limitations of Multiples 293 Comparison with Discounted Cash Flow Methods 294 Stock Valuation Techniques: The Final Word 294 Q Practitioner INTERVIEW WITH Marilyn Fedak, AllianceBernstein 295 10.3 Information, Competition, and Stock Prices 296 Information in Stock Prices 296 Competition and Efficient Markets 298 Forms of Market Efficiency 298 Lessons for Investors and Corporate Managers 300 The Efficient Markets Hypothesis Versus No Arbitrage 301 10.4 Individual Biases and Trading 302 Excessive Trading and Overconfidence 302 Hanging On to Losers and the Disposition Effect 302 Investor Attention, Mood, and Experience 303 Summary 305 Q Critical Thinking 306 Q Problems 306 Q Data Case 310 PART 3 INTEGRATIVE CASE 312

xii

Detailed Contents

PART 4 CHAPTER 11

Risk and Return

Computing a Portfolio’s Variance and Standard Deviation 354 The Volatility of a Large Portfolio 356 Q NOBEL PRIZE Harry Markowitz 357

315

Risk and Return in Capital Markets 316 Q INTERVIEW WITH Sunita S. Mohanty, Absolute Return for Kids 317

11.1 A First Look at Risk and Return 318 11.2 Historical Risks and Returns of Stocks 320 Computing Historical Returns 321 Average Annual Returns 323 Q Arithmetic Average Returns Versus Compound Annual Returns 325 The Variance and Volatility of Returns 326 Q COMMON MISTAKE Mistakes When Computing Standard Deviation 328 Q USING EXCEL Computing the Standard Deviation of Historical Returns 328 The Normal Distribution 329 11.3 The Historical Tradeoff Between Risk and Return 331 The Returns of Large Portfolios 331 The Returns of Individual Stocks 332 11.4 Common Versus Independent Risk 332 Theft Versus Earthquake Insurance: An Example 332 Types of Risk 333

12.3 Measuring Systematic Risk 358 Role of the Market Portfolio 358 Stock Market Indexes as the Market Portfolio 359 Market Risk and Beta 359 Q Index Funds 360 Q COMMON MISTAKE Mixing Standard Deviation and Beta 362 Estimating Beta from Historical Returns 363 Q USING EXCEL Calculating a Stock’s Beta 365 12.4 Putting It All Together: The Capital Asset Pricing Model 366 The CAPM Equation Relating Risk to Expected Return 366 Q Why Not Estimate Expected Returns Directly? 367 Q NOBEL PRIZE William Sharpe The Security Market Line 368 The CAPM and Portfolios 370 Summary of the Capital Asset Pricing Model 371 The Big Picture 371 Summary 372 Q Critical Thinking 373 Q Problems 373

11.5 Diversification in Stock Portfolios 334 Unsystematic Versus Systematic Risk 334 Diversifiable Risk and the Risk Premium 337 The Importance of Systematic Risk 337 Q COMMON MISTAKE A Fallacy of Long-Run Diversification 339 Summary 339 Q Critical Thinking 341 Q Problems 342

CHAPTER 12

Systematic Risk and the Equity Risk Premium 345 Q INTERVIEW WITH Alexander Morgan, Pantheon Ventures 346

12.1 The Expected Return of a Portfolio 347 Portfolio Weights 347 Portfolio Returns 347 Expected Portfolio Return 349 12.2 The Volatility of a Portfolio 350 Diversifying Risks 350 Measuring Stocks’ Co-movement: Correlation 352 Q USING EXCEL Calculating the Correlation Between Two Sets of Returns 354

CHAPTER 12 APPENDIX Alternative Models of Systematic Risk 378

CHAPTER 13

The Cost of Capital

381

Q INTERVIEW WITH John Drum, KPMG LLP 382 13.1 A First Look at the Weighted Average Cost of Capital 383 The Firm’s Capital Structure 383 Opportunity Cost and the Overall Cost of Capital 384 Weighted Averages and the Overall Cost of Capital 384 Weighted Average Cost of Capital Calculations 384 13.2 The Firm’s Costs of Debt and Equity Capital 386 Cost of Debt Capital 386 Q COMMON MISTAKE Using the Coupon Rate as the Cost of Debt 387

Detailed Contents Cost of Preferred Stock Capital 388 Cost of Common Stock Capital 388 13.3 A Second Look at the Weighted Average Cost of Capital 390 WACC Equation 391 Weighted Average Cost of Capital in Practice 391 Methods in Practice 392 13.4 Using the WACC to Value a Project 394 Key Assumptions 394 WACC Method Application: Extending the Life of a DuPont Facility 395 Summary of the WACC Method 396 13.5 Project-Based Costs of Capital 396 Cost of Capital for a New Acquisition 397 Divisional Costs of Capital 397 Q Practitioner INTERVIEW WITH Shelagh Glaser, Intel 398 13.6 When Raising External Capital Is Costly 399 Summary 401 Q Critical Thinking 402 Q Problems 403 Q Data Case 406 PART 4 INTEGRATIVE CASE 408

PART 5 CHAPTER 14

Long-Term Financing Raising Equity Capital

409

14.4 Raising Additional Capital: The Seasoned Equity Offering 429 SEO Process 429 SEO Price Reaction 431 SEO Costs 432 Summary 433 Q Critical Thinking 434 Q Problems 434

CHAPTER 15

14.3 IPO Puzzles 425 Underpriced IPOs 425 “Hot” and “Cold” IPO Markets 427 Q 2008–2009: A Very Cold IPO Market 427 High Cost of Issuing an IPO 428 Poor Post-IPO Long-Run Stock Performance 429

438

15.1 Corporate Debt 440 Private Debt 440 Q Debt Financing at Hertz: Bank Loans 440 Q Debt Financing at Hertz: Private Placements 441 Public Debt 441 Q Debt Financing at Hertz: Public Debt 443 15.2 Bond Covenants 445 Types of Covenants 445 Advantages of Covenants 445 Application: Hertz’s Covenants 446 15.3 Repayment Provisions 446 Call Provisions 446 Sinking Funds 449 Convertible Provisions 449 Summary 452 Q Critical Thinking 453 Q Problems 453

Q INTERVIEW WITH Sandra Pfeiler, Goldman Sachs 411

14.2 Taking Your Firm Public: The Initial Public Offering 416 Advantages and Disadvantages of Going Public 416 Primary and Secondary IPO Offerings 417 Other IPO Types 422 Q Google’s IPO 425

Debt Financing

Q INTERVIEW WITH Eric Hassberger, Strategic Hotels & Resorts 439

410

14.1 Equity Financing for Private Companies 412 Sources of Funding 412 Securities and Valuation 414 Exiting an Investment in a Private Company 416

xiii

CHAPTER 15 APPENDIX Using a Financial Calculator to Calculate Yield to Call 455 PART 5 INTEGRATIVE CASE 456

PART 6 CHAPTER 16

Capital Structure and Payout Policy 459 Capital Structure

460

Q INTERVIEW WITH Christopher Cvijic, Morgan Stanley 461 16.1 Capital Structure Choices 462 Capital Structure Choices Across Industries 462 Capital Structure Choices Within Industries 462 16.2 Capital Structure in Perfect Capital Markets 464 Application: Financing a New Business 465 Leverage and Firm Value 466

xiv

Detailed Contents Q COMMON MISTAKE Repurchases and the Supply of Shares 506 Alternative Policy 3: High Dividend (Equity Issue) 506 Modigliani-Miller and Dividend Policy Irrelevance 507 Q COMMON MISTAKE The Bird in the Hand Fallacy 508 Dividend Policy with Perfect Capital Markets 508

The Effect of Leverage on Risk and Return 467 Homemade Leverage 469 Leverage and the Cost of Capital 469 Q COMMON MISTAKE Capital Structure Fallacies 470 MM and the Real World 472 Q NOBEL PRIZE Franco Modigliani and Merton Miller 472 16.3 Debt and Taxes 473 The Interest Tax Deduction and Firm Value 473 Value of the Interest Tax Shield 474 The Interest Tax Shield with Permanent Debt 476 Leverage and the WACC with Taxes 477 Debt and Taxes: The Bottom Line 477 16.4 The Costs of Bankruptcy and Financial Distress 479 Direct Costs of Bankruptcy 479 Q Bankruptcy Can Be Expensive 479 Indirect Costs of Financial Distress 479 16.5 Optimal Capital Structure: The Tradeoff Theory 480 Differences Across Firms 481 Optimal Leverage 481 16.6 Additional Consequences of Leverage: Agency Costs and Information 482 Agency Costs 483 Q Airlines Use Financial Distress to Their Advantage 483 Q Financial Distress and Rolling the Dice, Literally 484 Debt and Information 485

17.3 The Tax Disadvantage of Dividends 509 Taxes on Dividends and Capital Gains 509 Optimal Dividend Policy with Taxes 509 Tax Differences Across Investors 512 17.4 Payout Versus Retention of Cash 514 Retaining Cash with Perfect Capital Markets 514 Retaining Cash with Imperfect Capital Markets 515 17.5 Signaling with Payout Policy 518 Dividend Smoothing 518 Dividend Signaling 519 Q Royal & SunAlliance’s Dividend Cut 520 Signaling and Share Repurchases 520 Q Practitioner INTERVIEW WITH John Connors, Microsoft (Retired) 521 17.6 Stock Dividends, Splits, and Spin-Offs 522 Stock Dividends and Splits 522 Q Berkshire Hathaway’s A and B Shares 523 Spin-Offs 523 17.7 Advice for the Financial Manager 524 Summary 525 Q Critical Thinking 527 Q Problems 527 Q Data Case 529

16.7 Capital Structure: Putting It All Together 487 Summary 488 Q Critical Thinking 490 Q Problems 490 CHAPTER 16 APPENDIX The Bankruptcy Code 497

CHAPTER 17

Payout Policy

498

Q INTERVIEW WITH Nitin Garg, Intuit 499 17.1 Cash Distributions to Shareholders 500 Dividends 501 Share Repurchases 502 17.2 Dividends Versus Share Repurchases in a Perfect Capital Market 503 Alternative Policy 1: Pay a Dividend with Excess Cash 504 Alternative Policy 2: Share Repurchase (No Dividend) 504

PART 6 INTEGRATIVE CASE 531

PART 7 CHAPTER 18

Financial Planning and Forecasting 533 Financial Modeling and Pro Forma Analysis 534 Q INTERVIEW WITH David Hollon, Goldman Sachs 535

18.1 Goals of Long-Term Financial Planning 536 Identify Important Linkages 536 Analyze the Impact of Potential Business Plans 536 Plan for Future Funding Needs 536 18.2 Forecasting Financial Statements: The Percent of Sales Method 537

Detailed Contents Percent of Sales Method 537 Pro Forma Income Statement 538 Pro Forma Balance Sheet 539 Q COMMON MISTAKE Confusing Stockholders’ Equity with Retained Earnings 540 Making the Balance Sheet Balance: Net New Financing 540 Choosing a Forecast Target 542 18.3 Forecasting a Planned Expansion 542 KMS Designs’ Expansion: Financing Needs 543 KMS Designs’ Expansion: Pro Forma Income Statement 544 Q COMMON MISTAKE Treating Forecasts as Fact 546 Forecasting the Balance Sheet 546 18.4 Growth and Firm Value 547 Sustainable Growth Rate and External Financing 548 18.5 Valuing the Expansion 551 Forecasting Free Cash Flows 551 Q COMMON MISTAKE Confusing Total and Incremental Net Working Capital 553 KMS Designs’ Expansion: Effect on Firm Value 553 Optimal Timing and the Option to Delay 556 Summary 557 Q Critical Thinking 558 Q Problems 558 CHAPTER 18 APPENDIX The Balance Sheet and Statement of Cash Flows 562

CHAPTER 19

Working Capital Management 564 Q INTERVIEW WITH Waleed Husain, Comcast 565

19.1 Overview of Working Capital 566 The Cash Cycle 566 Working Capital Needs by Industry 568 Firm Value and Working Capital 569 19.2 Trade Credit 570 Trade Credit Terms 571 Trade Credit and Market Frictions 571 Q COMMON MISTAKE Using APR Instead of EAR to Compute the Cost of Trade Credit 572 Managing Float 573 19.3 Receivables Management 574 Determining the Credit Policy 574 Q The 5 C’s of Credit 574 Monitoring Accounts Receivable 576

xv

19.4 Payables Management 578 Determining Accounts Payable Days Outstanding 578 Stretching Accounts Payable 579 19.5 Inventory Management 580 Benefits of Holding Inventory 580 Costs of Holding Inventory 581 Q Inventory Management Adds to the Bottom Line at Gap 581 19.6 Cash Management 582 Motivation for Holding Cash 582 Alternative Investments 582 Q Cash Balances 584 Summary 584 Q Critical Thinking 586 Q Problems 586 Q Data Case 589

CHAPTER 20

Short-Term Financial Planning

591

Q INTERVIEW WITH Teresa Wendt, Lockheed Martin 592 20.1 Forecasting Short-Term Financing Needs 593 Application: Springfield Snowboards, Inc. 593 Negative Cash Flow Shocks 594 Positive Cash Flow Shocks 594 Seasonalities 595 The Cash Budget 596 20.2 The Matching Principle 598 Permanent Working Capital 598 Temporary Working Capital 598 Permanent Versus Temporary Working Capital 598 Financing Policy Choices 599 20.3 Short-Term Financing with Bank Loans 601 Single, End-of-Period Payment Loan 601 Line of Credit 601 Bridge Loan 602 Common Loan Stipulations and Fees 602 20.4 Short-Term Financing with Commercial Paper 604 Q Short-Term Financing and the Financial Crisis of the Fall of 2008 604 20.5 Short-Term Financing with Secured Financing 606 Accounts Receivable as Collateral 606 Q A Seventeenth-Century Financing Solution 606 Inventory as Collateral 607 20.6 Putting It All Together: Creating a Short-Term Financial Plan 609 Summary 610 Q Critical Thinking 611 Q Problems 612 PART 7 INTEGRATIVE CASE 616

xvi

Detailed Contents

PART 8 CHAPTER 21

Special Topics

621

Option Applications and Corporate Finance 622 Q INTERVIEW WITH Deniz Gulunay, BP 623

21.1 Option Basics 624 Option Contracts 624 Stock Option Quotations 625 Options on Other Financial Securities 627 Q Options Are for More Than Just Stocks 627 21.2 Option Payoffs at Expiration 627 The Long Position in an Option Contract 628 The Short Position in an Option Contract 629 Profits for Holding an Option to Expiration 631 Returns for Holding an Option to Expiration 633 21.3 Factors Affecting Option Prices 634 Strike Price and Stock Price 634 Option Prices and the Exercise Date 634 Option Prices and the Risk-Free Rate 635 Option Prices and Volatility 635 21.4 The Black-Scholes Option Pricing Formula 636 21.5 Put-Call Parity 638 Portfolio Insurance 638

22.4 The Takeover Process 659 Valuation 659 The Offer 660 Merger “Arbitrage” 662 Tax and Accounting Issues 663 Board and Shareholder Approval 664 22.5 Takeover Defenses 665 Poison Pills 665 Staggered Boards 666 White Knights 667 Golden Parachutes 667 Recapitalization 667 Other Defensive Strategies 667 Regulatory Approval 668 Q Weyerhaeuser’s Hostile Bid for Willamette Industries 668 22.6 Who Gets the Value Added from a Takeover? 669 The Free Rider Problem 669 Toeholds 670 The Leveraged Buyout 670 Q The Leveraged Buyout of RJR-Nabisco by KKR 672 The Freezeout Merger 673 Competition 673 Summary 674 Q Critical Thinking 676 Q Problems 676

21.6 Options and Corporate Finance 641 Summary 643 Q Critical Thinking 644 Q Problems 644 Q Data Case 646

CHAPTER 22

Mergers and Acquisitions

648

Q INTERVIEW WITH Kyle Finegan, Croft & Bender LLC 649 22.1 Background and Historical Trends 650 Merger Waves 650 Types of Mergers 652 22.2 Market Reaction to a Takeover 652 22.3 Reasons to Acquire 653 Economies of Scale and Scope 653 Vertical Integration 654 Expertise 654 Monopoly Gains 654 Efficiency Gains 655 Tax Savings from Operating Losses 655 Diversification 656 Earnings Growth 657 Managerial Motives to Merge 658

CHAPTER 23

International Corporate Finance 679 Q INTERVIEW WITH Rob Harvey, Cisco Systems 680

23.1 Foreign Exchange 681 The Foreign Exchange Market 682 Exchange Rates 683 23.2 Exchange Rate Risk 683 Exchange Rate Fluctuations 684 Hedging with Forward Contracts 686 Cash-and-Carry and the Pricing of Currency Forwards 687 Hedging Exchange Rate Risk with Options 691 23.3 Internationally Integrated Capital Markets 692 Q COMMON MISTAKE Forgetting to Flip the Exchange Rate 694 23.4 Valuation of Foreign Currency Cash Flows 694 Application: Ityesi, Inc. 695

Detailed Contents The Law of One Price as a Robustness Check 697 23.5 Valuation and International Taxation 698 A Single Foreign Project with Immediate Repatriation of Earnings 699 Multiple Foreign Projects and Deferral of Earnings Repatriation 699 23.6 Internationally Segmented Capital Markets 700 Differential Access to Markets 700 Macro-Level Distortions 700 Implications of Internationally Segmented Capital Markets 701 23.7 Capital Budgeting with Exchange Rate Risk 703 Application: Ityesi, Inc. 703 Conclusion 705 Summary 705 Q Critical Thinking 707 Q Problems 707 Q Data Case 711

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CHAPTERS ON THE WEB These Web Chapters are on MyFinanceLab at www.myfinancelab.com

Leasing WEB CHAPTER 2 Insurance and Risk Management WEB CHAPTER 3 Corporate Governance WEB CHAPTER 1

About the Authors Jonathan Berk

is the A.P. Giannini Professor of Finance at the Graduate School of Business, Stanford University, and is a Research Associate at the National Bureau of Economic Research. Prior to Stanford, he was the Sylvan Coleman Professor of Finance at the Haas School of Business at the University of California, Berkeley, where he taught the introductory Corporate Finance course. Before earning his PhD from Yale University, he worked as an associate at Goldman Sachs, where his education in finance really began. His research has won a number of awards including the TIAA-CREF Paul A. Samuelson Award, the Smith Breeden Prize, Best Paper of the Year in The Review of Financial Studies, and the FAME Research Prize. His paper “A Critique of Jonathan Berk, Peter DeMarzo, and Jarrad Harford Size-Related Anomalies” was selected as one of the two best papers ever published in The Review of Financial Studies. In recognition of his influence on the practice of finance, he has received the Bernstein-Fabozzi/Jacobs Levy Award, the Graham and Dodd Award of Excellence, and the Roger F. Murray Prize. He served as an Associate Editor of the Journal of Finance for eight years and is currently an Advisory Editor at the journal. Born in Johannesburg, South Africa, Professor Berk is married, has two daughters, and is an avid skier and biker.

Peter DeMarzo is the Mizuho Financial Group Professor of Finance and Senior Associate Dean for Academic Affairs at Stanford Graduate School of Business. He is also a Research Associate at the National Bureau of Economic Research. He currently teaches MBA and PhD courses in Corporate Finance and Financial Modeling. Prior to Stanford, he taught at the Haas School of Business and the Kellogg Graduate School of Management, and he was a National Fellow at the Hoover Institution. Professor DeMarzo received the Sloan Teaching Excellence Award at Stanford in 2004 and 2006 and the Earl F. Cheit Outstanding Teaching Award at the University of California, Berkeley, in 1998. Professor DeMarzo has served as an Associate Editor for The Review of Financial Studies, Financial Management, and the B.E. Journals in Economic Analysis and Policy, as well as a Director of the American Finance Association. He is currently President of the Western Finance Association. Professor DeMarzo has received numerous awards for his research including the Western Finance Association Corporate Finance Award and the Barclays Global Investors/Michael Brennan Best Paper Award from The Review of Financial Studies. Professor DeMarzo was born in Whitestone, New York, is married, and has three sons. He and his family enjoy hiking, biking, and skiing.

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About the Authors

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Jarrad Harford is the Marion B. Ingersoll Professor of Finance at the University of Washington. Prior to Washington, Professor Harford taught at the Lundquist College of Business at the University of Oregon. He received his PhD in Finance with a minor in Organizations and Markets from the University of Rochester. Professor Harford has taught the core undergraduate finance course, Business Finance, for over thirteen years, as well as an elective in Mergers and Acquisitions, and “Finance for Non-financial Executives” in the executive education program. He has won numerous awards for his teaching, including the UW Finance Professor of the Year (2010), Interfraternity Council Excellence in Teaching Award (2007 and 2008), ISMBA Excellence in Teaching Award (2006), and the Wells Fargo Faculty Award for Undergraduate Teaching (2005). He is also the Faculty Director of the UW Business School Undergraduate Honors Program. Professor Harford serves as an Associate Editor for The Journal of Financial Economics, Journal of Financial and Quantitative Analysis, and Journal of Corporate Finance. Professor Harford was born in State College, Pennsylvania, is married, and has two sons. He and his family enjoy traveling, hiking, and skiing.

Bridging Theory and Practice Study Aids with a Practical Focus

EXAMPLE 7.1

To be successful, students need to master the core concepts and learn to identify and solve problems that today’s practitioners face.

Stock Prices and Returns

Suppose you expect Longs Drug Stores to pay an annual dividend of $0.56 per share in the coming year and to trade for $45.50 per share at the end of the year. If investments with equivalent risk to Longs’ stock have an expected return of 6.80%, what is the most you would pay today for Longs’ stock? What dividend yield and capital gain rate would you expect at this price?

Solution

Q The Valuation Principle is presented as the foundation of all financial decision making: The central idea is that a firm should take projects or make investments that increase the value of the firm. The tools of finance determine the impact of a project or investment on the firm’s value by comparing the costs and benefits in equivalent terms. The Valuation Principle is first introduced in Chapter 3, revisited in the part openers, and integrated throughout the text. Q Guided Problem Solutions (GPS) are Examples that accompany every important concept using a consistent problem-solving methodology that breaks the solution process into three steps: Plan, Execute, and Evaluate. This approach aids student comprehension, enhances their ability to model the solution process when tackling problems on their own, and demonstrates the importance of interpreting the mathematical solution.

Problem

◗ Plan

We can use Eq. 7.1 to solve for the beginning price we would pay now 1 P0 2 given our expectations about dividends 1 Div1 = $0.56 2 and future price 1 P1 = $45.50 2 and the return we need to expect to earn to be willing to invest 1 rE = 0.068 2 . We can then use Eq. 7.2 to calculate the dividend yield and capital gain rate. ◗ Execute Using Eq. 7.1, we have P0 =

Div1 + P1 $0.56 + $45.50 = $43.13 = 1 + rE 1.0680

Referring to Eq. 7.2, we see that at this price, Longs’ dividend yield is Div1/P0 = 0.56/43.13 = 1.30%. The expected capital gain is $45.50 - $43.13 = $2.37 per share, for a capital gain rate of 2.37/43.13 = 5.50%. ◗ Evaluate At a price of $43.13, Longs’ expected total return is 1.30% + 5.50% = 6.80%, which is equal to its equity cost of capital (the return being paid by investments with equivalent risk to Longs’). This amount is the most we would be willing to pay for Longs’ stock. If we paid more, our expected return would be less than 6.8% and we would rather invest elsewhere.

Personal Finance

EXAMPLE 4.4

Q Personal Finance GPS Examples showcase the use of financial analysis in everyday life by setting problems in scenarios such as purchasing a new car or house, and saving for retirement.

Present Value of a Lottery Prize Annuity

Problem You are the lucky winner of the $30 million state lottery. You can take your prize money either as (a) 30 payments of $1 million per year (starting today), or (b) $15 million paid today. If the interest rate is 8%, which option should you take?

Solution ◗ Plan Option (a) provides $30 million in prize money but paid over time. To evaluate it correctly, we must convert it to a present value. Here is the timeline: 0

1

2

29 ...

$1 million

$1 million

$1 million

$1 million

Because the first payment starts today, the last payment will occur in 29 years (for a total of 30 payments).2 The $1 million at date 0 is already stated in present value terms, but we need to compute the present value of the remaining payments. Fortunately, this case looks like a 29-year annuity of $1 million per year, so we can use the annuity formula. ◗ Execute

Q Common Mistake boxes alert students to frequently made mistakes stemming from misunderstanding core concepts and calculations—in the classroom and in the field.

COMMON MISTAKE

We use the annuity formula: PV 1 [email protected] annuity of +1 million at 8% annual interest 2 = +1 million *

= +1 million * 11.16 = +11.16 million today

Summing Cash Flows Across Time

Once you understand the time value of money, our first rule may seem straightforward. However, it is very common, especially for those who have not studied finance, to violate this rule, simply treating all cash flows as comparable regardless of when they are received. One example is in sports contracts. In 2007, Alex Rodriguez and the New York Yankees were negotiating what was repeatedly referred to as a “$275 million” contract. The $275 million comes from simply adding up all

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1 1 ≤ ¢1 0.08 1.0829

the payments Rodriguez would receive over the ten years of the contract and an additional ten years of deferred payments— treating dollars received in 20 years the same as dollars received today. The same thing occurred when David Beckham signed a “$250 million” contract with the LA Galaxy soccer team.

Applications That Reflect Real Practice Applications That Reflect Real Practice INTERVIEW WITH

Nicole Wickswat Intel Corporation

Fundamentals of Corporate Finance features actual companies and practitioners in the field.

“As a Senior Strategic Analyst in Intel Corporation’s Data Center Group, I strive to uphold the company’s finance charter by being ‘a full partner in business decisions to maximize shareholder value,’” says Nicole Wickswat, a 2006 graduate of the University of Oregon’s Business Honors Program with a degree in finance. “I work on a team with engineers and marketing people, helping them develop products for data center and cloud computer environments that are competitive, financially feasible, and provide the required return.” Nicole analyzes the potential financial impact of her group’s business decisions, evaluating the return to Intel on current and proposed products and making recommendations to management on whether they continue to add value. “A good investment decision should be aligned with the strategic objectives of the business,” she says. “We want the benefits to outweigh the associated costs, and we also take into account product launch timing and a project’s incremental financial value. Then we take a comprehensive view of the decision on the company as a whole, assessing the impact a decision would have on other products and/or groups.” Intel uses present value calculations within all business groups to compare the present values of costs and benefits that happen at different points in time. This gives management a consistent metric to compare different investments and projects, set priorities, and make tradeoffs where necessary to allocate funds to the optimal investments. The analysis continues throughout the product life cycle. “We assess the competitive landscape and determine whether the cost of adding or removing specific product features will benefit us in terms of increased market segment share, volume, and/or average selling price. We also look at whether adding the product feature negatively affects other groups or products and, if so, incorporate that into the analysis.” Nicole’s analysis helps the Data Center Group establish product cost targets that are aligned with long-term profitability goals. “These cost targets play a key role in product development decisions because they put pressure on engineers to design with profitability in mind and encourage us to get the most value out of the product line.”

INTERVIEW WITH

University of Oregon, 2006

“A good investment decision should be aligned with the strategic objectives of the business.”

Shelagh Glaser Shelagh Glaser is the

Finance Director for Intel’s Mobility Group, which provides solutions for the mobile computing market. Prior to that she was Group Controller for Sales & Marketing and co-Group Controller for Digital Enterprise Group. QUESTION: Does Intel set the discount rate at the corporate or project level? ANSWER: We typically set the discount rate at the corporate level. As

a company, Intel makes a broad set of products that sell into similar markets, so one hurdle rate makes sense for our core business. To justify an investment, every project has to earn or exceed that level of return for our shareholders.

We may use a different discount rate for mergers and acquisitions. For example, recently we’ve done more software acquisitions. That industry is very different from semiconductors and has different risk factors, so we take those considerations into account to set the hurdle rate.

Q Chapter-Opening Interviews with recent college graduates now working in the field of finance underscore the relevance of these concepts to students who are encountering them for the first time.

Q Practitioner Interviews from notable professionals featured in many chapters highlight leaders in the field and address the effects of the financial crisis.

QUESTION: How does Intel compute the cost of capital for new investment opportunities? ANSWER: We reexamine our weighted average cost of capital (WACC) each year to see that we have the right inputs and if any have changed: What is the current market risk premium? Are we using the right risk-free rate? How should we weight historical

The Credit Crisis and Bond Yields The financial crisis that engulfed the world’s economies in 2008 originated as a credit crisis that first emerged in August 2007. At that time, problems in the mortgage market had led to the bankruptcy of several large mortgage lenders. The default of these firms, and the downgrading of many of the bonds backed by mortgages these firms had made, caused many investors to reassess the risk of other bonds in their portfolios. As perceptions of risk increased, and investors attempted to move into safer U.S. Treasury securities, the prices of corporate bonds fell and so their credit spreads rose relative to Treasuries, as shown in Figure 6.7. Panel A of the figure shows

the yield spreads for long-term corporate bonds, where we can see that spreads of even the highest-rated Aaa bonds increased dramatically, from a typical level of 0.5% to over 2% by the fall of 2008. Panel B shows a similar pattern for the rate banks had to pay on short-term loans compared to the yields of short-term Treasury bills. This increase in borrowing costs made it more costly for firms to raise the capital needed for new investment, slowing economic growth. The decline in these spreads in early 2009 was viewed by many as an important first step in mitigating the ongoing impact of the financial crisis on the rest of the economy.

Q General Interest boxes highlight timely material from financial publications that shed light on business problems and real-company practices.

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Teaching Every Student to Think Finance Simplified Presentation of Mathematics

notation

Because one of the hardest parts of learning finance for non-majors is mastering the jargon, math, and non-standardized notation, Fundamentals of Corporate Finance systematically uses: Q Notation Boxes. Each chapter begins with a Notation box that defines the variables and the acronyms used in the chapter and serves as a “legend” for students’ reference.

C

cash flow

Cn

cash flow at date n

FV

future value

FVn

future value on date n

g

growth rate

Chapter 4 APPENDIX

Q Numbered and Labeled Equations. The first time a full equation is given in notation form it is numbered. Key equations are titled and revisited in the summary and in end papers.

N

date of the last cash flow in a stream of cash flows

P

initial principal or deposit, or equivalent present value

PV

present value

r

interest rate or rate of return

Using a Financial Calculator

Specifying Decimal Places Make sure you have plenty of decimal places displayed! HP-10BII DISP

4

TI BAII Plus Professional

Q Timelines. Introduced in Chapter 3, timelines are emphasized as the important first step in solving every problem that involves cash flow.

2ND

4

ENTER

Toggling Between the Beginning and End of a Period You should always make sure that your calculator is in end-of-period mode. HP-10BII

Q Financial Calculator instructions, including a box in Chapter 4 on solving for future and present values, and appendices to Chapters 4, 6, and 15 with keystrokes for HP-10BII and TI BAII Plus Professional, highlight this problem-solving tool. Q Spreadsheet Tables. Select tables are available on MyFinanceLab as Excel files, enabling students to change inputs and manipulate the underlying calculations.

•

MAR TI BAII Plus Professional 2ND

TABLE 18.2 KMS Designs’ Pro Forma Income Statement for 2011

Q Using Excel boxes describe Excel techniques and include screenshots to serve as a guide for students using this technology.

PMT

1 2 3 4 5 6 7 8 9 10 11

Year Income Statement ($000s) Sales Costs Except Depreciation EBITDA Depreciation EBIT Interest Expense (net) Pretax Income Income Tax (35%) Net Income

2010

2011

Calculation

74,889 88,369 74,889 1.18 58,413 68,928 78% of Sales 16,476 19,441 Lines 3 4 5,492 6,480 7.333% of Sales 10,984 12,961 Lines 5 6 306 306 Remains the same 10,678 12,655 Lines 7 8 4,429 35% of Line 9 3,737 8,226 Lines 9 10 6,941

USING EXCEL

Here we discuss how to use Microsoft Excel to solve for NPV and IRR. We also identify some pitfalls to avoid when using Excel.

Computing NPV and IRR

Excel’s NPV function has the format NPV (rate, value1, value2, . . . ), where “rate” is the interest rate per period used to discount the cash flows, and “value1”, “value2”, etc., are the cash flows (or ranges of cash flows). The NPV function computes the present value of the cash flows assuming the first cash flow occurs at date 1. Therefore, if a project’s first cash flow occurs at date 0, we cannot use the NPV function by itself to compute the NPV. We can use the NPV function to compute the present value of the cash flows from date 1 onward, and then we must add the date 0 cash flow to that result to calculate the NPV. The screenshot below shows the difference. The first NPV calculation (outlined in blue) is correct: we used the NPV function for all of the cash flows occurring at time 1 and later and then added on the first cash flow occurring at time 0 since it is already in present value. The second calculation (outlined in green) is incorrect: we used the NPV function for all of the cash flows, but the function assumed that the first cash flow occurs in period 1 instead of immediately.

NPV Function: Leaving Out Date 0

NPV Function: Ignoring Blank Cells Another pitfall with the NPV function is that cash flows that are left blank are treated differently from cash flows that are equal to zero. If the cash flow is left blank, both the cash flow and the period are ignored. For example, the second set of cash flows below is equivalent to the first—we have simply left the cash flow for date 2 blank instead of entering a “0.” However, the NPV function ignores the blank cell at date 2 and assumes the cash flow is 10 at date 1 and 110 at date 2, which is clearly not what is intended and

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Practice Finance to Learn Finance Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

MyFinanceLab Study Plan 4.1

4.1 Valuing a Stream of Cash Flows ◗ The present value of a cash flow stream is: C1 C2 CN + + g + PV = C0 + (4.3) 11 + r2 11 + r22 11 + r2N 4.2 Perpetuities ◗ A perpetuity is a stream of equal cash flows C paid every period, forever. The present value of a perpetuity is: PV 1 C in perpetuity 2 =

C r

Online Practice Opportunities

consol, p. 89 perpetuity, p. 89

MyFinanceLab Study Plan 4.2

(4.4)

4.3 Annuities annuity, p. 92 ◗ An annuity is a stream of equal cash flows C paid every period for N periods. The present value of an annuity is: 1 1 C * a1 (4.5) b r 11 + r2N ◗ The future value of an annuity at the end of the annuity is: 1 C * 1 11 + r2N - 12 (4.6) r

MyFinanceLab Study Plan 4.3 Interactive Annuity Calculator Financial Calculator Tutorials: Calculating the Present Value of an Annuity and Solving for the Future Value of an Annuity

Working problems is the proven way to cement and demonstrate an understanding of finance. Q Concept Check questions at the end of each section enable students to test their understanding and target areas in which they need further review. Q End-of-chapter problems written personally by Jonathan Berk, Peter DeMarzo, and Jarrad Harford offer instructors the opportunity to assign first-rate materials to students for homework and practice with the confidence that the problems are consistent with the chapter content. All end-of-chapter problems are available in MyFinanceLab, the fully integrated homework and tutorial system. Both the problems and solutions, which were also written by the authors, have been class-tested and accuracy checked to ensure quality. Excel icons indicate the availability of instructor solutions and student templates in the Textbook Resources tab of MyFinanceLab.

End-of-Chapter Materials Reinforce Learning Testing understanding of central concepts is crucial to learning finance. Q MyFinanceLab Chapter Summary presents the key points and conclusions from each chapter, provides a list of key terms with page numbers, and indicates online practice opportunities. Q Data Cases present in-depth scenarios in a business setting with questions designed to guide students’ analysis. Many questions involve the use of Internet resources. Q Integrative Cases occur at the end of most parts and present a capstone extended problem for each part with a scenario and data for students to analyze based on that subset of chapters.

Data Case

Assume today is August 1, 2010. Natasha Kingery is 30 years old and has a Bachelor of Science degree in computer science. She is currently employed as a Tier 2 field service representative for a telephony corporation located in Seattle, Washington, and earns $38,000 a year that she anticipates will grow at 3% per year. Natasha hopes to retire at age 65 and has just begun to think about the future. Natasha has $75,000 that she recently inherited from her aunt. She invested this money in ten-year Treasury bonds. She is considering whether she should further her education and would use her inheritance to pay for it. She has investigated a couple of options and is asking for your help as a financial planning intern to determine the financial consequences associated with each option. Natasha has already been accepted to two programs and could start either one soon. One alternative that Natasha is considering is attaining a certification in network design. This certification would automatically promote her to a Tier 3 field service representative in her company. The base salary for a Tier 3 representative is $10,000 more than the salary of a Tier 2 representative, and she anticipates that this salary differential will grow at a rate of 3% a year for as long as she keeps working. The certification program requires the completion of 20 Web-based courses and a score of 80% or better on an exam at the end of the course work. She has learned that the average amount of time necessary to finish the program is one year. The total cost of the program is $5,000, due when she

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Preface Finance professors are united by their commitment to shaping future generations of financial professionals as well as instilling financial awareness and skills in non-majors. Our goal with Fundamentals of Corporate Finance is to provide an accessible presentation for both finance and non-finance majors. We know from experience that countless undergraduate students have felt that corporate finance is challenging. It is tempting to make finance seem accessible by de-emphasizing the core principles and instead concentrating on the results. In our over 45 years of combined teaching experience, we have found that emphasizing the core concepts in finance—which are clear and intuitive at heart—is what makes the subject matter accessible. What makes the subject challenging is that it is often difficult for a novice to distinguish between these core ideas and other intuitively appealing approaches that, if used in financial decision making, will lead to incorrect decisions. The 2007–2009 financial crisis was fueled in part by many practitioners’ poor decision making when they did not understand—or chose to ignore—the core concepts that underlie finance and the pedagogy in this book. With this point in mind, we present finance as one unified whole based on two simple, powerful ideas: (1) valuation drives decision making—the firm should take projects for which the value of the benefits exceeds the value of the costs, and (2) in a competitive market, market prices (rather than individual preferences) determine values. We combine these two ideas with what we call the Valuation Principle, and from it we establish all of the key ideas in corporate finance.

New to This Edition In general terms, in our work on the second edition we took great care to update all text discussions and figures, tables, and facts to reflect key developments in the field and to provide the clearest presentation possible. Specific highlights include the following: Q Reorganized Flow of Topics in Chapters 3 and 4. Mastering the tools for discounting

cash flows is central to students’ success in the introductory course. As always, mastery comes with practice and by approaching complex topics in manageable units. We begin our step-by-step look at the time value of money in Chapter 3, which provides intuition for time value concepts, introduces the Valuation Principle, and presents rules for valuing cash flows. Chapter 4 addresses cash flow valuation for multi-period investments. Q New Two-Pronged Approach to Stock Valuation. Immediately following bond valuation, Chapter 7 opens with key background coverage of stock quotes and the mechanics of stock trades and then presents the dividend-discount model. We delay the discussion of the discounted cash flow model until after we have covered capital budgeting. In Chapter 10, we introduce the discounted cash flow model by building on concepts already developed in the capital budgeting chapters. Chapter 10 also discusses market efficiency and includes a new discussion of investor behavior. Q New and Updated Interviews. A number of new and updated practitioner and recent graduate interviews support the book’s practical perspective and incorporate timely xxiv

Preface

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viewpoints related to the recent financial crisis. Our popular interviews with highlevel practitioners incorporate an “inside” perspective on the financial crisis of 2007–2009 and include new interviews with Frederic S. Mishkin, former Federal Reserve Board governor; David Holland, Senior Vice President and Treasurer of Cisco; and Shelagh Glaser, Director for Intel’s Mobility Group. Q Expanded Special Topics Section. The new mergers and acquisitions chapter looks at

the overall market for takeovers, motivations for pursuing acquisitions, and the typical process. Additional chapters now available online—leasing, insurance and risk management, and corporate governance—allow professors to choose favorite topics. Q New Problems and MyFinanceLab Upgrade. We added 100 new problems to the

Second Edition, once again personally writing and solving each one. In addition, every single problem is available in MyFinanceLab, the groundbreaking homework and tutorial system that accompanies the book. The system recognizes typical mistakes and provides immediate feedback, allowing the student to learn instantaneously from the mistake.

Emphasis on Valuation As painful as the financial crisis was, there is a silver lining: with the increasing focus on finance in the news, today’s undergraduate students arrive in the classroom with an interest in finance. We strive to use that natural interest and motivation to overcome their fear of the subject and communicate time-tested core principles. Again, we take what has worked in the classroom and apply it to the text: By providing examples involving familiar companies such as Starbucks and Apple, making consistent use of real-world data, and demonstrating personal finance applications of core concepts, we strive to keep both nonfinance and finance majors engaged. By learning to apply the Valuation Principle, students develop the skills to make the types of comparisons—among loan options, investments, projects, and so on—that turn them into knowledgeable, confident financial consumers and managers. When students see how to apply finance to their personal lives and future careers, they grasp that finance is more than abstract, mathematically based concepts.

Table of Contents Overview Fundamentals of Corporate Finance offers coverage of the major topical areas for introductory-level undergraduate courses. Our focus is on financial decision making related to the corporation’s choice of which investments to make or how to raise the capital required to fund an investment. We designed the book with the need for flexibility and with consideration of time pressures throughout the semester in mind.

Part 1: Introduction Ch. 1: Corporate Finance and the Financial Manager Ch. 2: Introduction to Financial Statement Analysis

Part 2: Interest Rates and Valuing Cash Flows Ch. 3: Time Value of Money: An Introduction Ch. 4: Time Value of Money: Valuing Cash Flow Streams

Introduces the Valuation Principle and time value of money techniques for single-period investments

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Preface Ch. 5: Interest Rates Ch. 6: Bonds Ch. 7: Stock Valuation

Part 3: Valuation and the Firm Ch. 8: Investment Decision Rules Ch. 9: Fundamentals of Capital Budgeting Ch. 10: Stock Valuation: A Second Look

Part 4: Risk and Return Ch. 11: Risk and Return in Capital Markets Ch. 12: Systematic Risk and the Equity Risk Premium Ch. 13: The Cost of Capital

Part 5: Long-Term Financing

Presents how interest rates are quoted and compounding for all frequencies New chapter introduces stocks and presents the dividend discount model as an application of the time value of money Introduces the NPV rule as the “golden rule” against which we evaluate other investment decision rules Provides a clear focus on the distinction between earnings and free cash flow

Ch. 14: Raising Equity Capital Ch. 15: Debt Financing

Builds on capital budgeting material by valuing the ownership claim to the firm’s free cash flows and addresses market efficiency and behavioral finance

Part 6: Capital Structure and Payout Policy

Calculates and uses the firm’s overall costs of capital with the WACC method

Ch. 16: Capital Structure Ch. 17: Payout Policy

Part 7: Financial Planning and Forecasting Ch. 18: Financial Modeling and Pro Forma Analysis Ch. 19: Working Capital Management Ch. 20: Short-Term Financial Planning

Part 8: Special Topics Ch. 21: Option Applications and Corporate Finance Ch. 22: Mergers and Acquisitions Ch. 23: International Corporate Finance

Online Chapters (on MyFinanceLab at www.myfinancelab.com) Leasing Insurance and Risk Management Corporate Governance

These chapters begin with perfect markets and then show how frictions, including agency costs and asymmetric information, can influence financial policy

Makes the critical distinction between sustainable and value-increasing growth in determining the firm’s value

New chapter looks at the overall market for M&A and considers the motivations for and the typical process of a transaction Opportunities for course customization with online-only chapter offerings

A Complete Instructor and Student Support Package MyFinanceLab This fully integrated online homework system gives students the hands-on practice and tutorial help they need to learn finance efficiently. Ample opportunities for online practice and assessment in MyFinanceLab (www.myfinancelab.com) are seamlessly integrated into each chapter and organized by section within the chapter summaries. For more details, see the inside front cover.

Preface

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Videos Video clips available in MyFinanceLab profile well-known firms such as Boeing and Intel through interviews and analysis. The videos focus on core topical areas such as capital budgeting and risk and return.

Solutions Manual The printed Solutions Manual provides students with detailed, accuracy-verified solutions to the problems in the book. The solutions, like the problems, were written by the authors themselves. Spreadsheet solutions in Excel®, which allow the student to see the effect of changes in the input variables on the outcome, are also available to instructors for designated problems at the Instructor Resource Center (www.pearsonhighered.com/irc) and on the Instructor’s Resource CD-ROM.

Study Guide Written by Julie Dahlquist of the University of Texas at San Antonio, the Study Guide provides students with valuable extra practice, offering an in-depth chapter synopsis, answers to the Concept Check questions in the book, additional step-by-step examples following the Guided Problem Solution framework introduced in the text, practice questions and problems, and a self test. To order, visit MyPearsonStore.com.

PowerPoint Presentations The PowerPoint Presentation, authored by Janet Payne and William Chittenden of Texas State University, is available in lecture form and includes art and tables from the book and additional examples. The PowerPoint presentation includes all tables and figures, examples, key terms, and spreadsheet tables from the textbook. All PowerPoint presentations are included on the Instructor’s Resource CD-ROM and are also available for download from the Instructor Resource Center at www.pearsonhighered.com/irc.

Test Item File The Test Item File, edited by Janet Payne and William Chittenden of Texas State University, provides a wealth of accuracy-verified testing material. Each chapter offers a wide variety of true/false, short answer, and multiple-choice questions contributed by Salil Sarkar of the University of Texas at Arlington, Karan Bhanot of the University of Texas at San Antonio, and instructional designer David Stuart. Questions are verified by difficulty level and skill type, and correlated to the chapter topics. Numerical problems include step-by-step solutions. Every question in the Test Item File is available in TestGen® software for both Windows® and Macintosh® computers. This easy-to-use testing software is a valuable test preparation tool that allows professors to view, edit, and add questions. Both the Test Item File and the TestGen computerized test bank are included on the Instructor’s Resource CD-ROM, are available for download from the Instructor Resource Center at www.pearsonhighered.com/irc, and all questions can be assigned via MyFinanceLab.

Instructor’s Manual The Instructor’s Manual was written by Mary R. Brown of the University of Illinois–Chicago, and contains annotated chapter outlines, lecture launchers and questions for further class discussion. It also contains the solutions to the Data Cases and partending case problems, as well as answers to the chapter-ending Critical Thinking questions in the book. As an additional resource to guide instructors with students who

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Preface are planning to take the CFA exam, CFA learning outcomes met in each chapter are listed. A section also details how the end-of-chapter problems map to the accreditation standards set by the Association to Advance Collegiate Schools of Business (AACSB), so that instructors can track students’ mastery of the AACSB standards. The Instructor’s Manual is included on the Instructor’s Resource CD-ROM and is also available for download as Microsoft® Word files or as Adobe® PDF files from the Instructor Resource Center at www.pearsonhighered.com/irc.

Instructor’s Resource CD-ROM The Instructor’s Resource CD-ROM offers the complete set of instructor supplements for Fundamentals of Corporate Finance, Second Edition, including Microsoft® Word and Adobe® PDF files of the Instructor’s Manual, Solutions Manual, and Microsoft® Word files of the Test Item Files; complete PowerPoint® presentations; selected Excel® spreadsheet solutions; and the TestGen® Computerized Test Bank.

Acknowledgments Given the scope of this project, identifying the many people who made it happen is a tall order. This textbook was the product of the expertise and hard work of many talented colleagues. We are especially gratified with the work of those who developed the array of print supplements that accompany the book: Janet Payne and William Chittenden for the question writing on the Test Item File and PowerPoint presentations; Mary R. Brown, for the Instructor’s Manual; Julie Dahlquist, for the Study Guide; James Linck, for serving as advisor for the videos; and our MyFinanceLab content development team, including Carlos Bazan, Shannon Donovan, Michael J. Woodworth, Christopher Kelly, Jody Lotz, and Michael P. Griffin. We’re also deeply appreciative of Marlene Bellamy’s work conducting the lively interviews with recent graduates that open each chapter and Susan White’s contributions to the part-ending cases. Creating a truly error-free text is a challenge we could not have lived up to without our team of expert error checkers. Anand Goel, Robert James, and Timothy Sullivan each subjected the text and problem solutions to their exacting standards. We are indebted to our team of Research Assistants—Nathan Walcott, Jared Stanfield, Miguel Palacios, Rob Schonlau, Alex Paulsen, and Jonathan Kalodimos—for their adept support throughout the writing process. At Prentice Hall, we would like to single out Donna Battista, for her continued leadership and market insight; Tessa O’Brien, for her unparalleled commitment to the project; Rebecca Ferris-Caruso, for her critical eye and uncanny ability to juggle the writing, reviewing, and editing process without missing a beat; and our production team, Nancy Freihofer and Gillian Hall, for expertly managing the transformation of our Word files into a beautiful bound book. We are truly thankful for the indispensable help provided by these and other professionals, including: Elisa Adams, Alison Eusden, Miguel Leonarte, Kerri McQueen, Melissa Pellerano, Nicole Sackin, and Susan Schoenberg. We are indebted to our colleagues for the time and expertise invested as manuscript reviewers, class testers, and focus group participants. We list all of these contributors on the following pages, but want to single out one group, our First Edition editorial board, for special notice: Tom Berry, DePaul University; Elizabeth Booth, Michigan State University; Julie Dahlquist, the University of Texas–San Antonio; Michaël Dewally, Marquette University; Robert M. Donchez, the University of Colorado–Boulder; Belinda Mucklow, the University of Wisconsin–Madison; Coleen Pantalone, Northeastern University; and Susan White, the University of Maryland. We strived to incorporate every contributor’s input and are truly grateful for each comment and suggestion. The book has benefited enormously from this input.

Preface

Reviewers Pankaj Agrrawal, University of Maine Daniel Ahern, California State University–Chico Paul Asabere, Temple University Ajeyo Banerjee, University of Colorado–Denver Tom Berry, DePaul University Karan Bhanot, University of Texas–San Antonio Rafiqul Bhuyan, California State University–San Bernardino Eugene Bland, Texas A&M University–Corpus Christi Matej Blasko, University of Georgia Elizabeth Booth, Michigan State University Mary Brown, University of Illinois–Chicago Bill Brunsen, Eastern New Mexico University David G. Cazier, Brigham Young University–Provo Leo Chan, Delaware State University Cindy Chen, California State University–Long Beach Haiyu Chen, Youngstown State University James F. Cotter, Wake Forest University Vicentiu Covrig, California State University–Northridge Julie Dahlquist, University of Texas–San Antonio Pieter de Jong, University of Texas–Arlington Andrea L. DeMaskey, Villanova University Xiaohui Deng, California State University–Fresno Michaël Dewally, Marquette University Robert M. Donchez, University of Colorado Boulder Gang Dong, Rutgers University Dean Drenk, Montana State University Robert Dubil, University of Utah Hsing Fang, California State University–Los Angeles David O. Fricke, University of North Carolina–Pembroke Scott Fung, California State University–East Bay Sharon Garrison, University of Arizona Rakesh Gupta, Central Queensland University Joseph D. Haley, St. Cloud State University Thomas Hall, Christopher Newport University Karen L. Hamilton, Georgia Southern University Mahfuzul Haque, Indiana State University Edward C. Howell, Northwood University Ping Hsiao, San Francisco State University Xiaoqing Hu, University of Illinois at Chicago Pankaj Jain, University of Memphis Robert James, Babson College Susan Ji, Baruch College, City University of New York Domingo Joaquin, Illinois State University Fred R. Kaen, University of New Hampshire Terrill Keasler, Appalachian State University Howard Keen, Temple University Brett A. King, University of North Alabama

xxix

Daniel Klein, Bowling Green State University Gregory Kuhlemeyer, Carroll University Rose Neng Lai, University of Macau Keith Lam, University of Macau Reinhold P. Lamb, University of North Florida Douglas Lamdin, University of Maryland–Baltimore County Mark J. Laplante, University of Georgia Sie Ting Lau, Nanyang Technological University Richard LeCompte, Wichita State University Adam Y.C. Lei, Midwestern State University Qian Li, Midwestern State University Wei Liu, Texas A&M University Hugh Marble III, University of Vermont James Milanese, University of North Carolina at Greensboro Sunil K. Mohanty, University of St. Thomas Ted Moorman, Northern Illinois University James Morris, University of Colorado–Denver Belinda Mucklow, University of Wisconsin–Madison Rick Nelson, University of Minnesota Tom C. Nelson, University of Colorado–Boulder Anthony C. Ng, Hong Kong Polytechnic University Coleen Pantalone, Northeastern University Daniel Park, Azusa Pacific University Janet Payne, Texas State University Lynn Pi, Hong Kong University of Science and Technology J. Michael Pinegar, Brigham Young University Annette Poulsen, University of Georgia Eric Powers, University of South Carolina Rose M. Prasad, Central Michigan University Shoba Premkumar, Iowa State University Mark K. Pyles, College of Charleston A.A.B. Resing, Hogeschool Van Amsterdam Greg Richey, California State University, San Bernardino David L. Robbins, University of New Mexico Andrew Samwick, Dartmouth College Salil K. Sarkar, University of Texas–Arlington Oliver Schnusenberg, University of North Florida Kenneth Scislaw, University of Alabama–Huntsville Roger Severns, Minnesota State University–Mankato Tatyana Sokolyk, University of Wyoming Andrew C. Spieler, Hofstra University Timothy G. Sullivan, Bentley College Janikan Supanvanij, St. Cloud State University Oranee Tawatnuntachai, Pennsylvania State University–Harrisburg Robert Terpstra, University of Macau Thomas Thomson, University of Texas–San Antonio Olaf J. Thorp, Babson College

xxx

Preface

Emery Trahan, Northeastern University Joe Ueng, University of St. Thomas Mo Vaziri, California State University–San Bernardino Premal P. Vora, Pennsylvania State University–Harrisburg Hefei Wang, University of Illinois–Chicago Gwendolyn Webb, Baruch College Paul M. Weinstock, Ohio State University Susan White, University of Maryland Annie Wong, Western Connecticut State University Zhong-gou Zhou, California State University–Northridge Kermit C. Zieg, Jr., Florida Institute of Technology

Focus Group Participants Anne-Marie Anderson, Lehigh University Sung Bae, Bowling Green State University H. Kent Baker, American University Steven Beach, Radford University Rafiqul Bhuyan, California State University–San Bernardino Deanne Butchey, Florida International University Leo Chan, Delaware State University George Chang, Grand Valley State University Haiwei Chen, California State University–San Bernardino Haiyu Chen, Youngstown State University Massimiliano De Santis, Dartmouth College Jocelyn Evans, College of Charleston Kathleen Fuller, University of Mississippi Xavier Garza Gomez, University of Houston–Victoria William Gentry, Williams College Axel Grossmann, Radford University Pankaj Jain, University of Memphis Zhenhu Jin, Valparaiso University Steve Johnson, University of Northern Iowa Steven Jones, Samford University Yong-Cheol Kim, University of Wisconsin–Milwaukee Robert Kiss, Eastern Michigan University Ann Marie Klingenhagen, DePaul University Thomas J. Krissek, Northeastern Illinois University Olivier Maisondieu Laforge, University of Nebraska–Omaha Douglas Lamdin, University of Maryland–Baltimore County D. Scott Lee, Texas A&M University Stanley A. Martin, University of Colorado–Boulder Jamshid Mehran, Indiana University, South Bend Sunil Mohanty, University of St. Thomas

Karyn L. Neuhauser, State University of New York–Plattsburgh Thomas O’Brien, University of Connecticut Hyuna Park, Minnesota State University–Mankato G. Michael Phillips, California State University–Northridge Wendy Pirie, Valparaiso University Antonio Rodriguez, Texas A&M International University Camelia S. Rotaru, St. Edward’s University Salil Sarkar, University of Texas at Arlington Mark Sunderman, University of Wyoming Chu-Sheng Tai, Texas Southern University Oranee Tawatnuntachai, Pennsylvania State University–Harrisburg Benedict Udemgba, Alcorn State University Rahul Verma, University of Houston–Downtown Angelo P. Vignola, Loyola University–Chicago Premal Vora, Pennsylvania State University–Harrisburg Eric Wehrly, Seattle University Yan A. Xie, University of Michigan–Dearborn Fang Zhao, Siena College Sophie Zong, California State University–Stanislaus

Class Testers Tom Berry, DePaul University Eugene Bland, Texas A&M University–Corpus Christi Charles Blaylock, Murray State University Mary Brown, University of Illinois–Chicago Bill Brunsen, Eastern New Mexico University Sarah Bryant Bower, Shippensburg University of Pennsylvania Alva Wright Butcher, University of Puget Sound David G. Cazier, Brigham Young University–Provo Asim G. Celik, University of Nevada–Reno Michaël Dewally, Marquette University Richard Gaddis, Oklahoma Wesleyan University TeWhan Hahn, Auburn University–Montgomery Matthew Hood, University of Southern Mississippi Zhenhu Jin, Valparaiso University Travis Jones, Florida Gulf Coast University Francis E. Laatsch, Bowling Green State University Diane Lander, Saint Michael’s College Vance Lesseig, Texas State University Frances Maloy, University of Washington Jamshid Mehran, Indiana University–South Bend Belinda Mucklow, University of Wisconsin–Madison Kuo-Chung Tseng, California State University–Fresno Kermit C. Zieg, Jr., Florida Institute of Technology

PART

Introduction

1

Valuation Principle Connection. What is corporate finance? No matter

Chapter 1

what your role in a corporation, an understanding of why and how financial decisions

Corporate Finance and the Financial Manager

are made is essential. The focus of this book is how to make optimal corporate financial decisions. In this part of the book, we lay the foundation for our study of corporate finance. In Chapter 1, we begin by introducing the corporation and related business forms. We then examine the role of financial managers and outside investors in decision making for the firm. To make optimal decisions, a decision maker needs

Chapter 2 Introduction to Financial Statement Analysis

information. As a result, in Chapter 2 we review and analyze an important source of information for corporate decision making—the firm’s accounting statements. These chapters will introduce us to the role and objective of the financial manager and some of the information the financial manager uses in applying the Valuation Principle to make optimal decisions. Then, in the next section of the book, we will introduce and begin applying the Valuation Principle.

1

1

Corporate Finance and the Financial Manager

LEARNING OBJECTIVES Q Grasp the importance of financial information in both your personal and business lives Q Understand the important features of the four main types of firms and see why the advantages of the corporate form have led it to dominate economic activity Q Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the three main types of decisions a financial manager makes

2

Q Know how a corporation is managed and controlled, the financial manager’s place in it, and some of the ethical issues financial managers face Q Understand the importance of financial markets, such as stock markets, to a corporation and the financial manager’s role as liaison to those markets Q Recognize the role that financial institutions play in the financial cycle of the economy

INTERVIEW WITH

Leslie Tillquist PA Consulting Group

Leslie Tillquist, who received a B.S. in Business Administration in Finance and Marketing from the University of Colorado, Boulder in 2007, wasn’t sure what she wanted to do after graduation. “I enjoyed marketing’s focus on understanding human motivations and interactions, but I realized that finance provides a real-world understanding and skill set that leads to incredibly diverse career paths,” she explains. “It is hard to make credible decisions in business or nonprofit organizations without financially supporting and defending them. Understanding financial techniques allows individuals in all careers to pursue opportunities and solve problems in business situations.” She joined the Denver office of PA Consulting Group, Inc., an international consulting firm based in London with offices in more than 35 countries. “I wanted a high-energy, project-based environment where I could interact with the decision makers in a rapidly changing industry and also have the opportunity to work abroad,” she says. Her finance degree gave her that opportunity within PA Consulting’s Global Energy Practice. “Within seven months, I have joined in projects for international banks, government, and a Fortune 500 company. Work has taken me across the United States as well as to England and South Africa.” Her responsibilities include performing financial analysis and energy research that support client business analysis and the resulting strategic recommendations. For example, she uses different metrics to value assets, contracts, and companies, and creates company financial statements used in acquiring financing and evaluating opportunities. Leslie encourages students not to be intimidated by the rigor of finance courses. “They give you essential fundamentals for business analysis in whatever area interests you, as well as the work ethic for further on-the-job learning,” she says. “Although it is sometimes hard to appreciate at the time, finance classes provide the tools you need to resolve complex financial problems—whether your career is in finance or not.” She adds that she was very hesitant to study and work in finance. “I could not be more grateful for the opportunities available to me because I stuck with it. The work pays off immensely when I can communicate ideas eloquently and thoughtfully in business discussions.”

University of Colorado, 2007

“Finance classes provide the tools you need to resolve complex financial problems—whether your career is in finance or not.”

This book focuses on how people in corporations make financial decisions. Despite its name, much of what we discuss in corporate finance applies to the financial decisions made within any organization, including not-for-profit entities such as charities and universities. In this chapter, we introduce the four main types of firms. We stress corporations, however, because they represent 85% of U.S. business revenue. We also highlight the financial manager’s critical role inside any business enterprise. What products to launch, how to pay to develop those products, what profits to keep and how to return profits to investors—all of these decisions and many more fall within corporate finance. The financial manager makes these decisions with the goal of maximizing the value of the business, which is determined in the financial markets. In this chapter and throughout the book, we will focus on this goal, provide you with the tools to make financial management decisions, and show you how the financial markets provide funds to a corporation and produce market prices that are key inputs to any financial manager’s investment analysis.

3

4

Part 1 Introduction

1.1

Why Study Finance? Finance and financial thinking are everywhere in our daily lives. Consider your decision to go to college. You surely weighed alternatives, such as starting a full-time job immediately, and then decided that college provided you with the greatest net benefit. More and more, individuals are taking charge of their personal finances with decisions such as: Q Q Q Q

When to start saving and how much to save for retirement. Whether a car loan or lease is more advantageous. Whether a particular stock is a good investment. How to evaluate the terms of a home mortgage.

Our career paths have become less predictable and more dynamic. In previous generations, it was common to work for one employer your entire career. Today, that would be highly unusual. Most of us will instead change jobs, and possibly even careers, many times. With each new opportunity, we must weigh all the costs and benefits, financial and otherwise. Some financial decisions, such as whether to pay $2.00 for your morning coffee, are simple, but most are more complex. In your business career, you may face questions such as: Q Q Q Q Q

Should your firm launch a new product? Which supplier should your firm choose? Should your firm produce a part of the product or outsource production? Should your firm issue new stock or borrow money instead? How can you raise money for your start-up firm?

In this book, you will learn how all of these decisions in your personal life and inside a business are tied together by one powerful concept, the Valuation Principle. The Valuation Principle shows how to make the costs and benefits of a decision comparable so that we can weigh them properly. Learning to apply the Valuation Principle will give you the skills to make the types of comparisons—among loan options, investments, and projects—that will turn you into a knowledgeable, confident financial consumer and manager. In each chapter you will hear from a former student—someone who opened a book like this one not that long ago—who talks about his or her job and the critical role finance plays in it. From 2007 to 2009 we witnessed a credit freeze, a severe stock market decline, and the failures of well-known financial institutions. Attempts to understand these elements of the crisis, their origins, and how they affect our businesses and personal finances have highlighted the need for learning core financial principles and concepts. Whether you plan to major in finance or simply take this one course, you will find the fundamental financial knowledge gained here to be essential in your personal and business lives.

1.2

The Four Types of Firms We begin our study of corporate finance by examining the types of firms that financial managers run. There are four major types of firms: sole proprietorships, partnerships, limited liability companies, and corporations. We explain each organizational form in turn, but our primary focus is on the most important form—the corporation.

Chapter 1 Corporate Finance and the Financial Manager

5

Sole Proprietorships sole proprietorship A business owned and run by one person.

A sole proprietorship is a business owned and run by one person. Sole proprietorships are usually very small with few, if any, employees. Although they do not account for much sales revenue in the economy, they are the most common type of firm in the world. In 2007, an estimated 71% of businesses in the United States were sole proprietorships, although they generated only 5% of the revenue.1 We now consider the key features of a sole proprietorship. 1. Sole proprietorships have the advantage of being straightforward to set up. Consequently, many new businesses use this organizational form. 2. The principal limitation of a sole proprietorship is that there is no separation between the firm and the owner—the firm can have only one owner who runs the business. If there are other investors, they cannot hold an ownership stake in the firm. 3. The owner has unlimited personal liability for the firm’s debts. That is, if the firm defaults on any debt payment, the lender can (and will) require the owner to repay the loan from personal assets. An owner who cannot afford to repay a loan for which he or she is personably liable must declare personal bankruptcy. 4. The life of a sole proprietorship is limited to the life of the owner. It is also difficult to transfer ownership of a sole proprietorship. For most growing businesses, the disadvantages of a sole proprietorship outweigh the advantages. As soon as the firm reaches the point at which it can borrow without the owner agreeing to be personally liable, the owners typically convert the business into another form. Conversion also has other benefits that we will consider as we discuss the other forms below.

Partnerships partnership A business owned and run by more than one owner.

limited partnership A partnership with two kinds of owners, general partners and limited partners. limited liability When an investor’s liability is limited to her investment.

A partnership is a business owned and run by more than one owner. Key features include the following: 1. All partners are liable for the firm’s debt. That is, a lender can require any partner to repay all the firm’s outstanding debts. 2. The partnership ends in the event of the death or withdrawal of any single partner. 3. Partners can avoid liquidation if the partnership agreement provides for alternatives such as a buyout of a deceased or withdrawn partner. Some old and established businesses remain as partnerships or sole proprietorships. Often these firms are the types of businesses in which the owners’ personal reputations are the basis for the businesses. For example, law firms, medical practices, and accounting firms are frequently organized as partnerships. For such enterprises, the partners’ personal liability increases the confidence of the firm’s clients that the partners will strive to maintain the firm’s reputation. A limited partnership is a partnership with two kinds of owners, general partners and limited partners. In this case, the general partners have the same rights and privileges as partners in any general partnership—they are personally liable for the firm’s debt obligations. Limited partners, however, have limited liability—that is, their liability is limited to their investment. Their private property cannot be seized to pay off the firm’s outstanding debts. Furthermore, the death or withdrawal of a limited partner does not dissolve the 1

U.S. Census Bureau National Data Book.

6

Part 1 Introduction partnership, and a limited partner’s interest is transferable. However, a limited partner has no management authority and cannot legally be involved in the managerial decision making for the business.

Limited Liability Companies limited liability company (LLC) A limited partnership without a general partner.

A limited liability company (LLC) is like a limited partnership but without a general partner. That is, all the owners (referred to as members) have limited liability, but unlike limited partners, they can also run the business (as managing members). The LLC is a relatively new phenomenon in the United States. The first state to pass a statute allowing the creation of an LLC was Wyoming in 1977; the last was Hawaii in 1997. Internationally, companies with limited liability are much older and established. LLCs first rose to prominence in Germany over 100 years ago as a Gesellschaft mit beschränkter Haftung (GmbH) and then in other European and Latin American countries. An LLC is known in France as a Société à responsabilité limitée (SAR), and by similar names in Italy (SRL) and Spain (SL).

Corporations corporation A legally defined, artificial being, separate from its owners.

A corporation is a legally defined, artificial being (a legal entity), separate from its owners. As such, it has many of the legal powers that people have. It can enter into contracts, acquire assets, and incur obligations, and it enjoys protection under the U.S. Constitution against the seizure of its property. Because a corporation is a legal entity separate and distinct from its owners, it is solely responsible for its own obligations. Consequently, the owners of a corporation (or its employees, customers, etc.) are not liable for any obligations the corporation enters into. Similarly, the corporation is not liable for any personal obligations of its owners. In the same way that it is difficult to imagine modern business life without e-mail and cell phones, the corporation revolutionized the economy. On February 2, 1819, the U.S. Supreme Court established the legal precedent that the property of a corporation, similar to that of a person, is private and entitled to protection under the U.S. Constitution.2 This decision led to dramatic growth in the number of U.S. corporations from under 1,000 in 1830 to 50,000 in 1890. Today the corporate structure is ubiquitous, not only in the United States (where they are responsible for 85% of business revenue), but all over the world. Formation of a Corporation. A corporation must be legally formed, which means that the state in which it is incorporated must formally give its consent to the incorporation by chartering it. Setting up a corporation is therefore considerably more costly than setting up a sole proprietorship. The state of Delaware has a particularly attractive legal environment for corporations, so many corporations choose to incorporate there. For jurisdictional purposes, a corporation is a citizen of the state in which it is incorporated. Most firms hire lawyers to create a corporate charter that includes formal articles of incorporation and a set of bylaws. The corporate charter specifies the initial rules that govern how the corporation is run.

stock The ownership or equity of a corporation divided into shares.

Ownership of a Corporation. There is no limit on the number of owners a corporation can have. Because most corporations have many owners, each owner owns only a fraction of the corporation. The entire ownership stake of a corporation is divided into shares known as stock. The collection of all the outstanding shares of a corporation is known as

2

The case was Dartmouth vs. Woodward and the full text of John Marshall’s decision can be found at www.constitution.org/dwebster/dartmouth_decision.htm.

Chapter 1 Corporate Finance and the Financial Manager equity The collection of all the outstanding shares of a corporation. shareholder (also stockholder or equity holder) An owner of a share of stock or equity in a corporation. dividend payments Payments made at the discretion of the corporation to its equity holders.

7

the equity of the corporation. An owner of a share of stock in the corporation is known as a shareholder, stockholder, or equity holder. Shareholders are entitled to dividend payments; that is, payments made at the discretion of the corporation to its equity holders. Shareholders usually receive a share of the dividend payments that is proportional to the amount of stock they own. For example, a shareholder who owns 25% of the firm’s shares would be entitled to 25% of the total dividend payment. An important feature of a corporation is that there is no limitation on who can own its stock. That is, an owner of a corporation need not have any special expertise or qualification. This feature allows free and anonymous trade in the shares of the corporation and provides one of the most important advantages of organizing a firm as a corporation. Corporations can raise substantial amounts of capital because they can sell ownership shares to anonymous outside investors. The availability of outside funding has enabled corporations to dominate the economy. Let’s look at one of the world’s largest firms, Microsoft Corporation, as an example. Microsoft reported annual revenue of $58.4 billion over the 12 months from July 2008 through June 2009. The total value of the company (the wealth in the company the owners collectively owned) as of April 2010 was $267.1 billion. The company employed 93,000 people. Putting these numbers into perspective, treating the sales of $58.4 billion as gross domestic product (GDP) in 2009 would rank Microsoft (just ahead of Ecuador) as the sixty-fifth richest country (out of more than 200).3 Ecuador has almost 13.5 million people, about 145 times as many people as employees at Microsoft. Indeed, if the number of Microsoft employees were used as the “population” of the corporation, Microsoft would rank just above Seychelles as the eighteenth least-populous country on earth!

Tax Implications for Corporate Entities An important difference among the types of corporate organizational forms is the way they are taxed. Because a corporation is a separate legal entity, a corporation’s profits are subject to taxation separate from its owners’ tax obligations. In effect, shareholders of a corporation pay taxes twice. First, the corporation pays tax on its profits, and then when the remaining profits are distributed to the shareholders, the shareholders pay their own personal income tax on this income. This system is sometimes referred to as double taxation.

EXAMPLE 1.1

Problem

Taxation of Corporate Earnings

You are a shareholder in a corporation. The corporation earns $5.00 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend (we make this simplifying assumption, but should note that most corporations retain some of their earnings for reinvestment). The dividend is income to you, so you will then pay taxes on these earnings. The corporate tax rate is 40% and your tax rate on dividend income is 15%. How much of the earnings remains after all taxes are paid?

Solution Q Plan Earnings before taxes: $5.00

Corporate tax rate: 40%

Personal dividend tax rate: 15%

To calculate the corporation’s earnings after taxes, first we subtract the taxes paid at the corporate level from the pre-tax earnings of $5.00. The taxes paid will be 40% (the corporate tax rate) of $5.00. Since all of the after-corporate tax earnings will be paid to you as a dividend, you will pay taxes of 15% on that amount. The amount leftover is what remains after all taxes are paid.

3

World Development Indicators database, April 13, 2010. For quick reference tables on GDP, go to www.worldbank.org/data/quickreference.html.

8

Part 1 Introduction

Q Execute $5.00 per share * 0.40 = $2.00 in taxes at the corporate level, leaving $5.00 - $2.00 = $3.00 in aftercorporate tax earnings per share to distribute. You will pay $3.00 * 0.15 = $0.45 in taxes on that dividend, leaving you with $2.55 from the original $5.00 after all taxes. Q Evaluate As a shareholder, you keep $2.55 of the original $5.00 in earnings; the remaining $2.00 + $0.45 = $2.45 is paid as taxes. Thus, your total effective tax rate is 2.45/5 = 49%. S corporations Those corporations that elect subchapter S tax treatment and are exempted by the U.S. Internal Revenue Service’s tax code from double taxation. C corporations Corporations that have no restrictions on who owns their shares or the number of shareholders; they cannot qualify for subchapter S treatment and are subject to direct taxation.

EXAMPLE 1.2 Taxation of S Corporation Earnings

S Corporations. The corporate organizational structure is the only organizational structure subject to double taxation. However, the U.S. Internal Revenue Code exempts S corporations from double taxation because they elect subchapter S tax treatment. Under subchapter S tax regulations, the firm’s profits (and losses) are not subject to corporate taxes, but instead are allocated directly to shareholders based on their ownership share. The shareholders must include these profits as income on their individual tax returns (even if no money is distributed to them). However, after the shareholders have paid income taxes on these profits, no further tax is due. C Corporations. The government places strict limitations on the qualifications for subchapter S tax treatment. In particular, the shareholders of such corporations must be individuals who are U.S. citizens or residents, and there can be no more than 100 of them. Because most corporations have no restrictions on who owns their shares or the number of shareholders, they cannot qualify for subchapter S treatment. Thus, most corporations are C corporations, which are corporations subject to corporate taxes. Problem Rework Example 1.1, assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 30%.

Solution Q Plan Earnings before taxes: $5.00

Corporate tax rate: 0%

Personal tax rate: 30%

In this case, the corporation pays no taxes. It earned $5.00 per share. In an S corporation, all income is treated as personal income to you, whether or not the corporation chooses to distribute or retain this cash. As a result, you must pay a 30% tax rate on those earnings. Q Execute Your income taxes are 0.30 * $5.00 = $1.50, leaving you with $5.00 - $1.50 = $3.50 in after-tax earnings. Q Evaluate The $1.50 in taxes that you pay is substantially lower than the $2.45 you paid in Example 1.1. As a result, you are left with $3.50 per share after all taxes instead of $2.55. However, note that in a C corporation, you are only taxed when you receive the income as a dividend, whereas in an S corporation, you pay taxes on the income immediately regardless of whether the corporation distributes it as a dividend or reinvests it in the company.

As we have discussed, there are four main types of firms: sole proprietorships, partnerships (general and limited), limited liability companies, and corporations (“S” and “C”). To help you see the differences among them, Table 1.1 compares and contrasts the main characteristics of each.

Chapter 1 Corporate Finance and the Financial Manager

9

Corporate Taxation Around the World In most countries, there is some relief from double taxation. As of August 2010, thirty-one countries make up the Organization for Economic Co-operation and Development (OECD), and of these countries, only Ireland and Switzerland offer no relief from double taxation. The United

States offers no relief on dividend income compared to other sources of income. As of 2010 dividend income is taxed at the investor’s personal income tax rate. A few countries, including Australia, Finland, Mexico, New Zealand, and Norway, offer complete relief by effectively not taxing dividend income.

TABLE 1.1 Number of Owners

Liability for Firm’s Debts

Owners Manage the Firm

Ownership Change Dissolves Firm

Taxation

Sole Proprietorship

One

Yes

Yes

Yes

Personal

Partnership

Unlimited

Yes

Yes

Personal

GP-Yes LP-No

GP-Yes LP-No

Personal

Characteristics of the Different Types of Firms

Limited Partnership

Yes; each partner is liable for the entire amount At least one general GP-Yes partner (GP), no limit LP-No on limited partners (LP)

Limited Liability Unlimited Company

No

Yes

No*

Personal

S Corporation

At most 100

No

No (but they legally may)

No

Personal

C Corporation

Unlimited

No

No (but they legally may)

No

Double

*However, most LLCs require the approval of the other members to transfer your ownership.

Concept Check

1.3

1. What is a limited liability company (LLC)? How does it differ from a limited partnership? 2. What are the advantages and disadvantages of organizing a business as a corporation?

The Financial Manager As of January 2010, Apple, Inc. had just under 906.8 million shares of stock held by 30,476 owners.4 Because there are many owners of a corporation, each of whom can freely trade their stock, it is often not feasible for the owners of a corporation to have direct control of the firm. It falls to the financial manager to make the financial decisions of the business for the stockholders. Within the corporation, the financial manager has three main tasks: 1. Make investment decisions. 2. Make financing decisions. 3. Manage short-term cash needs. We will discuss each of these in turn, along with the financial manager’s overarching goal. 4

Apple, Inc., Notice of 2010 Annual Meeting of Shareholders, January 12, 2010.

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Part 1 Introduction

Making Investment Decisions The financial manager’s most important job is to make the firm’s investment decisions. The financial manager must weigh the costs and benefits of each investment or project and decide which of them qualify as good uses of the money stockholders have invested in the firm. These investment decisions fundamentally shape what the firm does and whether it will add value for its owners. For example, it may seem hard to imagine now, but there was a time when Apple’s financial managers were evaluating whether to invest in the development of the first iPhone. They had to weigh the substantial development and production costs against uncertain future sales. Their analysis indicated that it was a good investment, and the rest is history. In this book, you will learn all the tools necessary to make these investment decisions.

Making Financing Decisions Once the financial manager has decided which investments to make, he or she also decides how to pay for them. Large investments may require the corporation to raise additional money. The financial manager must decide whether to raise more money from new and existing owners by selling more shares of stock (equity) or to borrow the money instead (bonds and other debt). A bond is a security sold by governments and corporations to raise money from investors today in exchange for a promised future payment. It can be viewed as a loan from those investors to the issuer. In this book, we will discuss the characteristics of each source of money and how to decide which one to use in the context of the corporation’s overall mix of debt and equity.

Managing Short-Term Cash Needs The financial manager must ensure that the firm has enough cash on hand to meet its obligations from day to day. This job, also commonly known as managing working capital,5 may seem straightforward, but in a young or growing company, it can mean the difference between success and failure. Even companies with great products require a lot of money to develop and bring those products to market. Consider the costs to Starbucks of launching their VIA instant coffee, which included developing the instant coffee crystals and creating a big marketing campaign around them, or the costs to Boeing of producing the 787—billions of dollars were spent before the first 787 finally left the ground in December 2009. A company typically burns through a significant amount of cash before the sales of the product generate income. The financial manager’s job is to make sure that access to cash does not hinder the firm’s success.

The Goal of the Financial Manager All of these decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of the owners, the stockholders. The stockholders have invested in the corporation, putting their money at risk to become the owners of the corporation. Thus, the financial manager is a caretaker of the stockholders’ money, making decisions in their interests. Many corporations have thousands of owners (shareholders). These shareholders vary from large institutions to small first-time investors, from retirees living off their investments to young employees just starting to save for retirement. Each owner is likely to have different interests and prior5

Working capital refers to things such as cash on hand, inventories, raw materials, loans to suppliers, and payments from customers—the grease that keeps the wheels of production moving. We will discuss working capital in more detail in the next chapter and devote all of Chapter 19 to working capital management.

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ities. Whose interests and priorities determine the goals of the firm? You might be surprised to learn that the interests of shareholders are aligned for many, if not most, important decisions. Regardless of their own personal financial position and stage in life, all the shareholders will agree that they are better off if the value of their investment in the corporation is maximized. For example, suppose the decision concerns whether to develop a new product that will be a profitable investment for the corporation. All shareholders will very likely agree that developing this product is a good idea. Returning to our iPhone example, by October 2010, Apple shares were worth 3 times as much as they were in January 2007, when the first iPhone was introduced. All Apple shareholders at the time of the development of the first iPhone are clearly much better off because of it, whether they have since sold their shares of Apple to pay for retirement, or are still holding those shares in their retirement savings account. Even when all the owners of a corporation agree on the goals of the corporation, these goals must be implemented. In the next section, we discuss the financial manager’s place in the corporation and how owners exert control over the corporation. Shareholder Value Versus Stakeholder Value While the goal of a financial manager is to increase the value of the firm to its shareholders, this responsibility does not imply that the impact of the firm’s decisions on other stakeholders, such as employees or customers, can be ignored. By creating additional value for customers, the firm can raise prices and increase profits. Similarly, if the firm makes decisions that benefit employees (for example,

Concept Check

1.4

increasing their job security), it will be able to offer lower wages or benefit from increased productivity. On the other hand if customers or employees anticipate that the firm is likely to exploit them, they will demand lower prices or higher wages. Thus, to maximize shareholder value, the financial manager must consider the impact of her decision on all stakeholders of the firm.

3. What are the main types of decisions that a financial manager makes? 4. What is the goal of the financial manager?

The Financial Manager’s Place in the Corporation We’ve established that the stockholders own the corporation but rely on financial managers to actively manage the corporation. The board of directors and the management team headed by the chief executive officer possess direct control of the corporation. In this section, we explain how the responsibilities for the corporation are divided between these two entities and describe conflicts that arise between stockholders and the management team.

The Corporate Management Team board of directors A group of people elected by shareholders who have the ultimate decisionmaking authority in the corporation. chief executive officer (CEO) The person charged with running the corporation by instituting the rules and policies set by the board of directors.

The shareholders of a corporation exercise their control by electing a board of directors, a group of people who have the ultimate decision-making authority in the corporation. In most corporations, each share of stock gives a shareholder one vote in the election of the board of directors, so investors with more shares have more influence. When one or two shareholders own a very large proportion of the outstanding stock, these shareholders might either be on the board of directors themselves, or they may have the right to appoint a number of directors. The board of directors makes rules on how the corporation should be run (including how the top managers in the corporation are compensated), sets policy, and monitors the performance of the company. The board of directors delegates most decisions that involve the day-to-day running of the corporation to its management. The chief executive officer (CEO) is charged with running the corporation by instituting the rules and policies set

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Part 1 Introduction by the board of directors. The size of the rest of the management team varies from corporation to corporation. In some corporations, the separation of powers between the board of directors and CEO is not always distinct. In fact, the CEO can also be the chairman of the board of directors. The most senior financial manager is the chief financial officer (CFO), often reporting directly to the CEO. Figure 1.1 presents part of a typical organizational chart for a corporation, highlighting the positions a financial manager may take.

Ethics and Incentives in Corporations A corporation is run by a management team, separate from its owners. How can the owners of a corporation ensure that the management team will implement their goals?

agency problem When managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of those shareholders.

FIGURE 1.1 The Financial Functions Within a Corporation

Agency Problems. Many people claim that because of the separation of ownership and control in a corporation, managers have little incentive to work in the interests of the shareholders when this means working against their own self-interest. Economists call this an agency problem—when managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of those shareholders. Managers face the ethical dilemma of whether to adhere to their responsibility to put the interests of shareholders first, or to do what is in their own personal best interests. This problem is commonly addressed in practice by minimizing the number of decisions managers make that require putting their self-interest against the interests of the shareholders. For example, managers’ compensation contracts are designed to ensure that most decisions in the shareholders’ interest are also in the managers’ interests; shareholders often tie the compensation of top managers to the corporation’s profits or perhaps to its stock price. There is, however, a limitation to this strategy. By tying compensation too closely to performance, the shareholders might be asking managers to take on more risk than they are comfortable taking. As a result, the managers may not make decisions that the shareholders want them to, or it

The board of directors, representing the stockholders, controls the corporation and hires the top management team. A financial manager might hold any of the green-shaded positions, including the Chief Financial Officer (CFO) role. The controller oversees accounting and tax functions. The treasurer oversees more traditional finance functions, such as capital budgeting (making investment decisions), risk management (managing the firm’s exposure to movements in the financial markets), and credit management (managing the terms and policies of any credit the firm extends to its customers).

Board of Directors Chief Executive Officer Chief Financial Officer Controller

Chief Operating Officer

Treasurer Accounting

Capital Budgeting

Tax Department

Risk Management Credit Management

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might be hard to find talented managers willing to accept the job. For example, biotech firms take big risks on drugs that fight cancer, AIDS, and other widespread diseases. The market for a successful drug is huge, but the risk of failure is high. Investors who put only some of their money in biotech may be comfortable with this risk, but a manager who has all of his or her compensation tied to the success of such a drug might opt to develop a less risky drug that has a smaller market. Further potential for conflicts of interest and ethical considerations arise when some stakeholders in the corporation benefit and others lose from a decision. Shareholders and managers are two stakeholders in the corporation, but others include the regular employees and the communities in which the company operates, for example. Managers may decide to take the interests of other stakeholders into account in their decisions, such as keeping a loss-generating factory open because it is the main provider of jobs in a small town, paying above local market wages to factory workers in a developing country, or operating a plant at a higher environmental standard than local law mandates. In some cases, these actions that benefit other stakeholders may also benefit the firm’s shareholders by creating a more dedicated workforce, generating positive publicity with customers, or other indirect effects. In other instances, when these decisions benefit other stakeholders at shareholders’ expense, they represent a form of corporate charity. Indeed, many if not most corporations explicitly donate (on behalf of their shareholders) to local and global causes. Shareholders often approve of such actions, even though they are costly and so reduce their wealth. While it is the manager’s job to make decisions that maximize shareholder value, shareholders—who own the firm—also want the firm’s actions to reflect their moral and ethical values. Of course, shareholders may not have identical preferences in these matters, leading to potential sources of conflict.

hostile takeover A situation in which an individual or organization, sometimes referred to as a corporate raider, purchases a large fraction of a target corporation’s stock and in doing so gets enough votes to replace the target’s board of directors and its CEO.

The CEO’s Performance. Another way shareholders can encourage managers to work in the interests of shareholders is to discipline them if they do not. If shareholders are unhappy with a CEO’s performance, they could, in principle, pressure the board to oust the CEO. Disney’s Michael Eisner, Hewlett-Packard’s Carly Fiorina, and Home Depot’s Robert Nardelli were all forced to resign by their boards. Despite these high-profile examples, directors and top executives are rarely replaced through a grassroots shareholder uprising. Instead, dissatisfied investors often choose to sell their shares. Of course, somebody must be willing to buy the shares from the dissatisfied shareholders. If enough shareholders are dissatisfied, the only way to entice investors to buy (or hold) the shares is to offer them a low price. Similarly, investors who see a well-managed corporation will want to purchase shares, which drives the stock price up. Thus, the stock price of the corporation is a barometer for corporate leaders that continuously gives them feedback on the shareholders’ opinion of their performance. When the stock performs poorly, the board of directors might react by replacing the CEO. In some corporations, however, the senior executives might be entrenched because boards of directors do not have the independence or motivation to replace them. Often the reluctance to fire results when the board is comprised of people who are close friends of the CEO and lack objectivity. In corporations in which the CEO is entrenched and doing a poor job, the expectation of continued poor performance will cause the stock price to be low. Low stock prices create a profit opportunity. In a hostile takeover, an individual or organization—sometimes known as a corporate raider—can purchase a large fraction of the company’s stock and in doing so get enough votes to replace the board of directors and the CEO. With a new superior management team, the stock is a much more attractive investment, which would likely result in a price rise and a profit for the corporate raider and the other shareholders. Although the words “hostile” and “raider” have negative connotations, corporate raiders themselves provide an important service to shareholders. The mere threat of being removed as a result of a hostile takeover is often

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Part 1 Introduction enough to discipline bad managers and motivate boards of directors to make difficult decisions. Consequently, the fact that a corporation’s shares can be publicly traded creates a “market for corporate control” that encourages managers and boards of directors to act in the interests of their shareholders.

Concept Check

5. How do shareholders control a corporation? 6. What types of jobs would a financial manager have in a corporation? 7. What ethical issues could confront a financial manager?

1.5

stock markets (also stock exchanges or bourses) Organized markets on which the shares of many corporations are traded.

primary market When a corporation issues new shares of stock and sells them to investors. secondary market Markets, such as NYSE or NASDAQ, where shares of a corporation are traded between investors without the involvement of the corporation.

In Section 1.3, we established the goal of the financial manager: to maximize the wealth of the owners, the stockholders. The value of the owners’ investments in the corporation is determined by the price of a share of the corporation’s stock. Corporations can be private or public. A private corporation has a limited number of owners and there is no organized market for its shares, making it hard to determine the market price of its shares at any point in time. A public corporation has many owners and its shares trade on an organized market, called a stock market (or stock exchange or bourse). These markets provide liquidity for a company’s shares and determine the market price for those shares. An investment is liquid if it can easily be turned into cash by selling it immediately at a competitive market price. An investor in a public company values the ability to turn his investment into cash easily and quickly by simply selling his shares on one of these markets. In this section, we provide an overview of the functioning of the major stock markets. The analysis and trading by participants in these markets provides an evaluation of the financial managers’ decisions that determines the stock price and provides essential feedback to the managers on their decisions.

The Largest Stock Markets The best known U.S. stock market and one of the largest stock markets in the world is the New York Stock Exchange (NYSE). Billions of dollars of stock are exchanged every day on the NYSE. Other U.S. stock markets include the American Stock Exchange (AMEX), NASDAQ (the National Association of Security Dealers Automated Quotation system), and regional exchanges such as the Midwest Stock Exchange. Most other countries have at least one stock market. Outside the United States, the biggest stock markets are the London Stock Exchange (LSE) and the Tokyo Stock Exchange (TSE). Figure 1.2 ranks the world’s largest stock exchanges by trading volume.

Primary Versus Secondary Markets All of the markets in Figure 1.2 are secondary markets. The primary market refers to a corporation issuing new shares of stock and selling them to investors. After this initial transaction between the corporation and investors, the shares continue to trade in a secondary market between investors without the involvement of the corporation. For example, if you wish to buy 100 shares of Starbucks Coffee, you could place an order on the NASDAQ, where Starbucks trades under the ticker symbol SBUX. You would buy your shares from someone who already held shares of Starbucks, not from Starbucks itself.

Photo by Konstantine Protopapas.

liquid Describes an investment that can easily be turned into cash because it can be sold immediately at a competitive market price.

The Stock Market

Chapter 1 Corporate Finance and the Financial Manager

FIGURE 1.2 Worldwide Stock Markets Ranked by Volume of Trade

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The bar graph shows the 10 biggest stock markets in the world ranked by total value of shares traded on exchange in 2009. NASDAQ OMX NYSE Euronext (US) Shanghai Stock Exchange Tokyo Stock Exchange London Stock Exchange Deutsche Börse NYSE Euronext (Europe) BME Spanish Exchanges Korea Exchanges

market makers Individuals on a stock exchange who match buyers with sellers. specialists Individuals on the trading floor of the NYSE who match buyers with sellers; also called market makers. bid price The price at which a market maker or specialist is willing to buy a security. ask price The price at which a market maker or specialist is willing to sell a security. auction market A market where share prices are set through direct interaction of buyers and sellers. bid-ask spread The amount by which the ask price exceeds the bid price. transaction cost In most markets, an expense such as a broker commission and the bid-ask spread investors must pay in order to trade securities. over-the-counter (OTC) market A market without a physical location, in which dealers are connected by computers and telephones.

Hong Kong Exchanges 0

$5000 $10,000 $15,000 $20,000 $25,000 $30,000 Total Value of Shares Traded in $ Billions

Source: www.world-exchanges.org.

Physical Stock Markets The NYSE is an example of a physical market. It is located at 11 Wall Street in New York City. On the floor of the NYSE, market makers (known on the NYSE as specialists) match buyers and sellers. They post two prices for every stock they make a market in: the price they stand willing to buy the stock at (the bid price) and the price they stand willing to sell the stock for (the ask price). If a customer comes to them wanting to make a trade at these prices, they will honor the price (up to a limited number of shares) and make the trade even if they do not have another customer willing to take the other side of the trade. In this way, they ensure that the market is liquid because customers can always be assured they can trade at the posted prices. The exchange has rules that attempt to ensure that bid and ask prices do not get too far apart and that large price changes take place through a series of small changes, rather than in one big jump. Large investment banks and brokerages buy trading licenses that entitle them to access the floor and trade on the exchange. Because license holders can go to IBM’s trading post, for example, and directly sell IBM shares to the highest bidder or buy IBM shares at the lowest offered price, the exchange is an auction market. Ask prices exceed bid prices. This difference is called the bid-ask spread. Because investors buy at the ask (the higher price) and sell at the bid (the lower price), the bid-ask spread is a transaction cost they have to pay in order to trade. When specialists in a physical market such as the NYSE take the other side of the trade from their customers, this transaction cost accrues to them as a profit. It is the compensation they demand for providing a liquid market by standing ready to honor any quoted price. Investors also pay other forms of transactions costs such as commissions.

Over-the-Counter Stock Markets In today’s technology-driven economy, a stock market does not need to have a physical location. Stock transactions can be made over the phone or by computer network. Consequently, stock markets such as NASDAQ, which are called over-the-counter (OTC) markets, are a collection of dealers or market makers connected by computer networks

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Part 1 Introduction

dealer market A market where dealers buy and sell for their own accounts.

and telephones. An important difference between the NYSE and NASDAQ is that on the NYSE, each stock has only one market maker. On NASDAQ, stocks can and do have multiple market makers who compete with each other. Each market maker must post bid and ask prices in the NASDAQ network, where they can be viewed by all participants. Because investors do not directly interact to set the prices, NASDAQ and other over-the-counter markets are dealer markets. The NASDAQ system posts the best prices first and fills orders accordingly. This process guarantees investors the best possible price at the moment, whether they are buying or selling.

Listing Standards listing standards Outlines of the requirements a company must meet to be traded on the exchange.

Each exchange has its own listing standards, outlines of the requirements a company must meet to be traded on the exchange. These standards usually require that the company have enough shares outstanding for shareholders to have a liquid market and to be of interest to a broad set of investors. The NYSE’s standards are more stringent than those of NASDAQ; traditionally, there has been a certain pride in being listed on the NYSE. Many companies would start on the NASDAQ and then move to the NYSE as they grew. However, NASDAQ has retained many big, successful companies such as Starbucks, Apple, and Microsoft. The two exchanges compete actively over listings of larger companies, and the decision of where to list often comes down to which exchange the company’s board believes will give its stockholders the best execution and liquidity for their trades.

NYSE, AMEX, DJIA, S&P 500: Awash in Acronyms With all of these acronyms floating around, it’s easy to get confused. You may have heard of the “Dow Jones” or “Dow Jones (Industrial) Average” and the “S&P 500” on news reports about the stock markets. The NYSE, AMEX, and NASDAQ are all stock markets where the prices of stocks are determined through trading. However, when commentators talk about whether stocks are up or down in general in a given day, they often refer to the Dow Jones Industrial Average (DJIA) and the Standard and Poor’s 500 (S&P 500). The DJIA and S&P 500 are simply measures of the aggregate price level of collections of pre-selected stocks—30 in the case of the DJIA and 500 in the case of the S&P 500. These stocks were selected by Dow Jones (the publisher of the Wall Street Journal ) or Standard & Poor’s as representative of the overall market. The S&P 500 con-

sists of 500 of the highest-valued U.S. companies. While fewer in number, the 30 stocks in the DJIA include companies such as Microsoft, Wal-Mart, Boeing, and 3M, and are selected to cover the important sectors in the U.S. economy. The table below shows the 30 stocks in the DJIA as of March 2010. Dow Jones editors choose these stocks to reflect the overall U.S. economy. The membership of the index has changed over time to reflect the U.S. economy’s transition from being industrial-driven to being more services and technology based. For example, they added Bank of America and Chevron in 2008 to capture the economy’s move toward financial services and the growing importance of energy. Both the DJIA and S&P 500 include stocks that are traded on the NYSE and stocks that are traded on NASDAQ and so are distinct from the exchanges themselves.

Composition of the Dow Jones Industrial Average (DJIA) 3M Co. Alcoa Inc. American Express Co. AT&T Inc. Bank of America Corp. Boeing Co. Caterpillar Inc. Chevron Corp. Cisco Systems Inc. Coca-Cola Co.

Source: djindexes.com.

E.I. DuPont de Nemours & Co. Exxon Mobil Corp. General Electric Co. Hewlett-Packard Co. Home Depot Inc. Intel Corp. International Business Machines Johnson & Johnson JPMorgan Chase & Co. Kraft Foods Inc.

McDonald’s Corp. Merck & Co. Inc. Microsoft Corp. Pfizer Inc. Procter & Gamble Co. Travelers Cos. Inc. United Technologies Corp. Verizon Communications Inc. Wal-Mart Stores Inc. Walt Disney Co.

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Other Financial Markets Of course, stock markets are not the only financial markets. There are markets to trade practically anything—some of them are physical places like the NYSE and others are purely electronic, like the NASDAQ. Two of the largest financial markets in the world, the bond market and the foreign exchange market, are simply networks of dealers connected by phone and computer. We will discuss these markets in more detail in later chapters (Chapters 6 and 15 for bonds and Chapter 23 for foreign exchange). Commodities like oil, wheat, and soybeans are traded on physical exchanges like the New York Mercantile Exchange. Derivative securities, which are complicated financial products used to hedge risks, are traded in locations like the Chicago Board Options Exchange (discussed in Chapter 21).

Concept Check

1.6 financial institutions Entities that provide financial services, such as taking deposits, managing investments, brokering financial transactions, or making loans.

8. What advantage does a stock market provide to corporate investors? To financial managers? 9. What are the main differences between the NYSE and NASDAQ?

Financial Institutions The spread of the 2008 financial crisis from subprime mortgages to Wall Street to traditional banks and businesses drew everyone’s attention to financial institutions and their role in the economy. In general, financial institutions are entities that provide financial services, such as taking deposits, managing investments, brokering financial transactions, or making loans. In this section, we describe the key types of financial institutions and their functions.

The Financial Cycle Keeping the names and roles of the different types of financial institutions straight can be challenging. It is helpful to think of the basic financial cycle, depicted in Figure 1.3, as context. In the financial cycle, (1) people invest and save their money, (2) that money, through loans and stock, flows to companies who use it to fund growth through new products, generating profits and wages, and (3) the money then flows back to the savers and investors. All financial institutions play a role at some point in this cycle of connecting money with ideas and returning the profits back to the investors.

FIGURE 1.3 The Financial Cycle

This figure depicts the basic financial cycle, which matches funds from savers to companies that have projects requiring funds and then returns the profits from those projects back to the savers.

Money Money

Savers Companies with projects and new ideas

Wages, profits, and interest

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Part 1 Introduction

Types of Financial Institutions Table 1.2 lists the major categories of financial institutions, provides examples of representative firms, and summarizes the institutions’ sources and uses of funds. Financial conglomerates, sometimes referred to as financial services firms, combine more than one type of institution. Examples include Bank of America, JPMorgan Chase, and Deutsche Bank, all of which engage in commercial banking (like Wells Fargo) as well as investment banking. Investment banking refers to the business of advising companies in major financial transactions. Examples include buying and selling companies or divisions, and raising new capital by issuing stock or bonds. Goldman Sachs and Morgan Stanley are financial institutions that are focused on investment banking activities.

Role of Financial Institutions Financial institutions have a role beyond moving funds from those who have extra funds (savers) to those who need funds (borrowers and firms): They also move funds through time. For example, suppose you need a $20,000 car loan. You need $20,000 now, but do not have it. However, you will have it in the future as you earn a salary. The financial institution, in this case a bank or credit union, helps transfer your future salary into funds today by issuing you a loan. Financial institutions also help spread out risk-bearing. Insurance companies essentially pool premiums together from policyholders and pay the claims of those who have an accident, fire, medical need, or die. This process spreads the financial risk of these events out across a large pool of policyholders and the investors in the insurance company. Similarly, mutual funds and pension funds take your savings and spread them out among the stocks and bonds of many different companies, limiting your risk exposure to any one company.

TABLE 1.2 Financial Institutions and Their Roles in the Financial Cycle

Institution Banks and Credit Unions Examples: Wells Fargo, SunTrust

Source of Money Deposits (savings)

Use of Money Loans to people and businesses

Insurance Companies Examples: Liberty Mutual, Allstate

Premiums and investment earnings

Invests mostly in bonds and some stocks, using the investment income to pay claims

Mutual Funds Examples: Vanguard, Fidelity

People’s investments (savings)

Buys stocks, bonds, and other financial instruments on behalf of its investors

Pension Funds Examples: CalPERS, REST

Retirement savings contributed through the workplace

Similar to mutual funds, except with the purpose of providing retirement income

Hedge Funds Examples: Bridgewater, Soros Fund

Investments by wealthy individuals and endowments

Invests in any kind of investment in an attempt to maximize returns

Venture Capital Funds Examples: Kleiner Perkins, Sequoia Capital

Investments by wealthy individuals and endowments

Invests in start-up, entrepreneurial firms

Private Equity Funds Examples: TPG Capital, KKR

Investments by wealthy individuals and endowments

Purchases whole companies by using a small amount of equity and borrowing the rest

Chapter 1 Corporate Finance and the Financial Manager

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While you may have seen coverage of the stock markets and discussion of financial institutions on the news, it is unlikely that you have had any exposure to the finance function within the firm. In this chapter, we provided a sense of what corporate finance is all about, what a financial manager does, and the importance of stock markets and financial institutions. In the coming chapters, you will learn how to make financial management decisions and how to use financial market information. We will explore the tools of financial analysis hand-in-hand with a clear understanding of when to apply them and why they work.

Concept Check

10. What is the basic financial cycle? 11. What are the three main roles financial institutions play?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

Online Practice Opportunities

1.1 Why Study Finance? Q Finance and financial decisions are everywhere in our daily lives. Q Many financial decisions are simple, but others are complex. All are tied together by the Valuation Principle—the foundation for financial decision making—which you will learn in this book. 1.2 The Four Types of Firms Q There are four types of firms in the United States: sole proprietorships, partnerships, limited liability companies, and corporations. Q Firms with unlimited personal liability include sole proprietorships and partnerships. Q Firms with limited liability include limited partnerships, limited liability companies, and corporations. Q A corporation is a legally defined artificial being (a judicial person or legal entity) that has many of the legal powers people have. It can enter into contracts, acquire assets, and incur obligations, and it enjoys protection under the U.S. Constitution against the seizure of its property. Q The shareholders in a C corporation effectively must pay tax twice. The corporation pays tax once and then investors must pay personal tax on any funds that are distributed. S corporations are exempt from the corporate income tax. Q The ownership of a corporation is divided into shares of stock collectively known as equity. Investors in these shares are called shareholders, stockholders, or equity holders.

C corporations, p. 8 corporation, p. 6 dividend payments, p. 7 equity, p. 7 equity holder, p. 7 limited liability, p. 5 limited liability company (LLC), p. 6 limited partnership, p. 5 partnership, p. 5 S corporations, p. 8 shareholder, p. 7 sole proprietorship, p. 5 stock, p. 6 stockholder, p. 7

MyFinanceLab Study Plan 1.2

20 Part 1 Introduction Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where 1.3 The Financial Manager Q The financial manager makes investing, financing, and cash flow management decisions. Q The goal of the financial manager is to maximize the wealth of the shareholders (maximize the stock price).

MyFinanceLab Study Plan 1.3

1.4 The Financial Manager’s Place in the Corporation Q The ownership and control of a corporation are separate. Shareholders exercise their control indirectly through the board of directors.

agency problem, p. 12 board of directors, p. 11 chief executive officer (CEO), p. 11 hostile takeover, p. 13

MyFinanceLab Study Plan 1.4

1.5 The Stock Market Q The shares of public corporations are traded on stock markets. The shares of private corporations do not trade on a stock market. Q When a firm sells shares to investors, that is a primary market. The stock markets, such as NYSE and NASDAQ, are secondary markets where investors trade shares among each other. Q NASDAQ is a dealer market, characterized by market makers trading for their own accounts.

ask price, p. 15 auction market, p. 15 bid-ask spread, p. 15 bid price, p. 15 bourses, p. 14 dealer market, p. 16 liquid, p. 14 listing standards, p. 16 market makers, p. 15 over-the-counter (OTC) market, p. 15 primary market, p. 14 secondary market, p. 14 specialists, p. 15 stock exchange, p. 14 stock market, p. 14 transaction cost, p. 15

MyFinanceLab Study Plan 1.5

1.6 Financial Institutions Q In the basic financial cycle, money flows from savers and investors to companies and entrepreneurs with ideas, and then back to the savers and investors in the form of profits and interest. Q Financial institutions all play some role in this cycle. Q Financial institutions also help move money through time (e.g., loans against future wages) and spread risk across large investor bases.

financial institutions, p. 17

MyFinanceLab Study Plan 1.6

Chapter 1 Corporate Finance and the Financial Manager

Problems

21

All Problems are available in MyFinanceLab. The Four Types of Firms 1. What is the most important difference between a corporation and all other organizational forms? 2. What does the phrase limited liability mean in a corporate context? 3. Which organizational forms give their owners limited liability? 4. What are the main advantages and disadvantages of organizing a firm as a corporation? 5. Explain the difference between an S and a C corporation. 6. You are a shareholder in a C corporation. The corporation earns $2.00 per share before taxes. Once it has paid taxes it will distribute the rest of its earnings to you as a dividend. Assume the corporate tax rate is 40% and the personal tax rate on (both dividend and non-dividend) income is 30%. How much is left for you after all taxes are paid? 7. Repeat Problem 6 assuming the corporation is an S corporation. The Financial Manager 8. What is the most important type of decision that the financial manager makes? 9. Why do all shareholders agree on the same goal for the financial manager? The Financial Manager’s Place in the Corporation 10. Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interests of the owners, rather than in their own interests. What strategies are available to shareholders to help ensure that managers are motivated to act this way? 11. Think back to the last time you ate at an expensive restaurant where you paid the bill. Now think about the last time you ate at a similar restaurant, but your parents paid the bill. Did you order more food (or more expensive food) when your parents paid? Explain how this relates to the agency problem in corporations. 12. Suppose you are considering renting an apartment. You, the renter, can be viewed as an agent while the company that owns the apartment can be viewed as the principal. What agency conflicts do you anticipate? Suppose, instead, that you work for the apartment company. What features would you put into the lease agreement that would give the renter incentives to take good care of the apartment? 13. You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. What is the nature of the agency conflict here and how is it related to ethical considerations?

22

Part 1 Introduction The Stock Market 14. What is the difference between a public and a private corporation? 15. What is the difference between a primary and a secondary market? 16. What are some of the differences between the NYSE and NASDAQ? 17. Explain why the bid-ask spread is a transaction cost. 18. The following quote on Yahoo! stock appeared on April 13, 2010, on Yahoo! Finance:

If you wanted to buy Yahoo!, what price would you pay per share? How much would you receive per share if you wanted to sell Yahoo!? Financial Institutions 19. What is the financial cycle? 20. How do financial institutions help with risk-bearing? 21. What role do investment banks play in the economy? 22. What are some of the similarities and differences among mutual funds, pension funds, and hedge funds?

2

Introduction to Financial Statement Analysis

LEARNING OBJECTIVES Q Know why the disclosure of financial information through financial statements is critical to investors Q Understand the function of the balance sheet Q Use the balance sheet to analyze a firm Q Understand how the income statement is used

Q Interpret a statement of cash flows Q Know what management’s discussion and analysis and the statement of stockholders’ equity are Q Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other financial scandals

Q Analyze a firm through its income statement, including using the DuPont Identity

23

INTERVIEW WITH

Hiral Tolia CBIZ Valuation Group, LLC

As a senior consultant for CBIZ Valuation Group, LLC, in Dallas, Texas, Hiral Tolia works on client projects that focus on determining a company’s value. For example, a privately held company wishing to issue stock to its employees may hire CBIZ to determine its value before setting a stock price. In mergers and acquisitions, a company may need CBIZ to value certain assets owned by the acquired company, as required for financial reporting purposes. Hiral, who received a Bachelor of Engineering in Computer Science in 2003 from the University of Mumbai and an MBA in 2006 from the University of Texas, Arlington, uses the concepts she learned in her various finance classes on a daily basis. “Because we have clients from various industry sectors, we need an in-depth knowledge of each of those market segments. I use financial statement analysis extensively to understand a company’s performance and how it compares to its industry peers.” Analyzing financial statements gives Hiral insight into a company’s current financial position and its performance over time. “This information is useful in making economic decisions, such as to determine a company’s future cash flows, the effect of cyclical trends in the industry on operations over a period of time and in the future, and whether to invest in the company’s securities or recommend them to other investors,” she explains. “Thus, it is important to understand financial statements whether you are an owner of the company, an employee, an investor, or an analyst.” The first step in valuing a company is assessing past performance and determining its current financial position using information contained in the publicly available financial statements. “We use income statements to analyze revenue and expenses and the balance sheets and statement of cash flows to analyze short-term cash flow needs and determine capital expenditures.” One of CBIZ’s valuation methods involves the review of pricing and performance information for public companies in a generally similar industry to the subject company. “Ratio analysis helps to compare the subject company to market participants, so we can apply our valuation models and determine a fair value for the company.”

As we discussed in Chapter 1, anyone with money to invest is a potential investor who can own shares in a corporation. As a result, corporations are often widely held, with investors ranging from individuals who hold one share to large financial institutions that own millions of shares. For example, in 2010 International Business Machines Corporation (IBM) had over 1.3 billion shares outstanding held by over 546,000 stockholders. Although the corporate organizational structure greatly facilitates the firm’s access to investment capital, it also means that stock ownership is most investors’ sole tie to the company. How, then, do investors learn enough about a company to know whether or not they should invest in it? One way firms evaluate their performance and communicate this information to investors is through their financial statements. Financial statements also enable financial managers to assess the success of their own firm and compare it to competitors. Firms regularly issue financial statements to communicate financial information to the investment community. A detailed description of the preparation and analysis of these statements is sufficiently

24

University of Texas, Arlington, 2006

“I use financial statement analysis extensively to understand a company’s performance and how it compares to its industry peers.”

Chapter 2 Introduction to Financial Statement Analysis

25

complicated that to do it justice would require an entire book. In this chapter, we briefly review the subject, emphasizing only the material that investors and corporate financial managers need in order to make the corporate finance decisions we discuss in the text. We review the four main types of financial statements, present examples of these statements for a firm, and discuss where an investor or manager might find various types of information about the company. We also discuss some of the financial ratios used to assess a firm’s performance and value. We close the chapter with a look at financial reporting abuses and the Sarbanes-Oxley regulatory response.

2.1 financial statements Accounting reports issued by a firm quarterly and/or annually that present past performance information and a snapshot of the firm’s assets and the financing of those assets. annual report The yearly summary of business, accompanying or including financial statements, sent by U.S. public companies to their stockholders.

Firms’ Disclosure of Financial Information Financial statements are accounting reports issued by a firm periodically (usually quarterly and annually) that present past performance information and a snapshot of the firm’s assets and the financing of those assets. Public companies in the United States are required to file their financial statements with the U.S. Securities and Exchange Commission (SEC) on a quarterly basis on form 10-Q and annually on form 10-K.1 They must also send an annual report with their financial statements to their shareholders each year. Often, private companies also prepare financial statements, but they usually do not have to disclose these reports to the public. Financial statements are important tools with which investors, financial analysts, and other interested outside parties (such as creditors) obtain information about a corporation. They are also useful for managers within the firm as a source of information for the corporate financial decisions we discussed in the previous chapter. In this section, we examine the guidelines for preparing financial statements and introduce the different types of financial statements.

Preparation of Financial Statements Generally Accepted Accounting Principles (GAAP) A common set of rules and a standard format for public companies to use when they prepare their financial reports. auditor A neutral third party, which corporations are required to hire, that checks a firm’s annual financial statements to ensure they are prepared according to GAAP, and provides evidence to support the reliability of the information.

Reports about a company’s performance must be understandable and accurate. In the United States, the Financial Accounting Standards Board (FASB) establishes Generally Accepted Accounting Principles (GAAP) to provide a common set of rules and a standard format for public companies to use when they prepare their reports. This standardization also makes it easier to compare the financial results of different firms. Investors also need some assurance that the financial statements are prepared accurately. Corporations are required to hire a neutral third party, known as an auditor, to check the annual financial statements, ensure they are prepared according to GAAP, and provide evidence to support the reliability of the information.

Types of Financial Statements Every public company is required to produce four financial statements: the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders’ equity. These financial statements provide investors and creditors with an overview of the firm’s financial performance. In the sections that follow, we take a close look at the content of these financial statements.

1

The Securities and Exchange Commission was established by Congress in 1934 to regulate securities (for example, stocks and bonds) issued to the public and the financial markets (exchanges) on which those securities trade.

26

Part 1 Introduction

International Financial Reporting Standards Generally Accepted Accounting Principles (GAAP) differ among countries. As a result, companies face tremendous accounting complexities when they operate internationally. Investors also face difficulty interpreting financial statements of foreign companies, which discourages them from investing abroad. As companies and capital markets become more global, however, interest in harmonization of accounting standards across countries has increased. The most important harmonization project began in 1973 when representatives of ten countries (including the United States) established the International Accounting Standards Committee. This effort led to the creation of the International Accounting Standards Board (IASB) in 2001, with headquarters in London. Now the IASB has issued a set of International Financial Reporting Standards (IFRS).

Concept Check

2.2 balance sheet A list of a firm’s assets and liabilities that provides a snapshot of the firm’s financial position at a given point in time. assets The cash, inventory, property, plant and equipment, and other investments a company has made. liabilities A firm’s obligations to its creditors. shareholders’ equity, stockholders’ equity An accounting measure of a firm’s net worth that represents the difference between the firm’s assets and its liabilities. common stock and paidin surplus The amount that stockholders have directly invested in the firm through purchasing stock from the company.

The IFRS are taking root throughout the world. The European Union (EU) approved an accounting regulation in 2002 requiring all publicly traded EU companies to follow IFRS in their consolidated financial statements starting in 2005. Many other countries have adopted IFRS for all listed companies, including Australia and several countries in Latin America and Africa. In fact, all major stock exchanges around the world accept IFRS except the United States and Japan, which maintain their local GAAP. Convergence to IFRS in the United States is likely within the near future. In 2008, the SEC eliminated the requirement for foreign firms listing in U.S. markets to reconcile IFRS to U.S. GAAP. In 2010, the SEC further affirmed its support of a single standard, with IFRS as the preferred method. The SEC will study and revisit the issue in 2011, with the possibility of requiring U.S. companies to start reporting according to IFRS as soon as 2015 or 2016.

1. What is the role of an auditor? 2. What are the four financial statements that all public companies must produce?

The Balance Sheet The balance sheet, or statement of financial position,2 lists the firm’s assets and liabilities, providing a snapshot of the firm’s financial position at a given point in time. Table 2.1 shows the balance sheet for a fictitious company, Global Corporation. Notice that the balance sheet is divided into two parts (“sides”) with the assets on the left side and the liabilities on the right side. 1. The assets list the firm’s cash, inventory, property, plant and equipment, and any other investments the company has made. 2. The liabilities show the firm’s obligations to its creditors. 3. Also shown with liabilities on the right side of the balance sheet is the stockholders’ equity. Stockholders’ equity (also shareholders’ equity), the difference between the firm’s assets and liabilities, is an accounting measure of the firm’s net worth. For Global, the stockholders’ equity has two parts: (1) common stock and paid-in surplus, the amount that stockholders have directly invested in the firm through purchasing stock from the company; and (2) retained earnings, which are profits made by the firm, but retained within the firm and reinvested in assets or held as cash. We will take a more detailed look at retained earnings in our discussion of the statement of cash flows later in this chapter. The assets on the left side show how the firm uses its capital (its investments), and the information on the right side summarizes the sources of capital, or how the firm raises the money it needs. Because of the way stockholders’ equity is calculated, the left and right sides must balance: The Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity

(2.1)

2 In IFRS and recent U.S. GAAP pronouncements, the balance sheet is referred to as the statement of financial position.

Chapter 2 Introduction to Financial Statement Analysis

TABLE 2.1 Global Corporation Balance Sheet for 2010 and 2009 ($ millions)

Assets

2010

2009

Current Assets

Liabilities and Stockholders’ Equity

23.2

20.5

Accounts payable

Accounts receivable

18.5

13.2

Notes payable/short-term debt

Inventories

15.3

14.3

57.0

48.0

Long-Term Assets Net property, plant, and equipment Total long-term assets

2010

2009

29.2

26.5

5.5

3.2

34.7

29.7

113.2

78.0

113.2

78.0

147.9

107.7

8.0

8.0

Current Liabilities

Cash

Total current assets

27

Total current liabilities Long-Term Liabilities

113.1

80.9

113.1

80.9

Long-term debt Total long-term liabilities Total Liabilities Stockholders’ Equity Common stock and paid-in surplus

Total Assets

170.1

128.9

Retained earnings

14.2

13.2

Total Stockholders’ Equity

22.2

21.2

170.1

128.9

Total Liabilities and Stockholders’ Equity

retained earnings Profits made by the firm, but retained within the firm and reinvested in assets or held as cash.

In Table 2.1, total assets for 2010 ($170.1 million) are equal to total liabilities ($147.9 million) plus stockholders’ equity ($22.2 million). We now examine the firm’s assets, liabilities, and stockholders’ equity in more detail. Following this, we evaluate the firm’s financial standing by analyzing the information contained in the balance sheet.

current assets Cash or assets that could be converted into cash within one year.

Assets

marketable securities Short-term, low-risk investments that can be easily sold and converted to cash. accounts receivable Amounts owed to a firm by customers who have purchased goods or services on credit. inventories A firm’s raw materials as well as its work-in-progress and finished goods. long-term assets Assets that produce tangible benefits for more than one year.

In Table 2.1, Global’s assets are divided into current and long-term assets. We discuss each in turn. Current Assets. Current assets are either cash or assets that could be converted into cash within one year. This category includes: 1. Cash and other marketable securities, which are short-term, low-risk investments that can be easily sold and converted to cash (such as money market investments, like government debt, that mature within a year); 2. Accounts receivable, which are amounts owed to the firm by customers who have purchased goods or services on credit; 3. Inventories, which are composed of raw materials as well as work-in-progress and finished goods; and 4. Other current assets, which is a catch-all category that includes items such as prepaid expenses (such as rent or insurance). Long-Term Assets. Assets such as real estate or machinery that produce tangible benefits for more than one year are called long-term assets. If Global spends $2 million on new equipment, this $2 million will be included with net property, plant, and equipment under long-term assets on the balance sheet. Because equipment tends to wear out or

28

Part 1 Introduction

depreciation A yearly deduction a firm makes from the value of its fixed assets (other than land) over time, according to a depreciation schedule that depends on an asset’s life span. book value The acquisition cost of an asset less its accumulated depreciation.

become obsolete over time, Global will reduce the value recorded for this equipment through a yearly deduction called depreciation according to a depreciation schedule that depends on an asset’s life span. Depreciation is not an actual cash expense that the firm pays; it is a way of recognizing that buildings and equipment wear out and thus become less valuable the older they get. The book value of an asset is equal to its acquisition cost less accumulated depreciation. The figures for net property, plant, and equipment show the total book value of these assets. Other long-term assets can include such items as property not used in business operations, start-up costs in connection with a new business, trademarks and patents, and property held for sale. The sum of all the firms’ assets is the total assets at the bottom of the left side of the balance sheet in Table 2.1.

Liabilities We now examine the liabilities, shown on the right side of the balance sheet, which are divided into current and long-term liabilities. current liabilities Liabilities that will be satisfied within one year. accounts payable The amounts owed to creditors for products or services purchased with credit. notes payable, shortterm debt Loans that must be repaid in the next year. net working capital The difference between a firm’s current assets and current liabilities that represents the capital available in the short term to run the business.

Current Liabilities. Liabilities that will be satisfied within one year are known as current liabilities. They include: 1. Accounts payable, the amounts owed to suppliers for products or services purchased with credit. 2. Notes payable and short-term debt, loans that must be repaid in the next year. Any repayment of long-term debt that will occur within the next year would also be listed here as current maturities of long-term debt. 3. Accrual items, such as salary or taxes, that are owed but have not yet been paid, and deferred or unearned revenue, which is revenue that has been received for products that have not yet been delivered. The difference between current assets and current liabilities is the firm’s net working capital, the capital available in the short term to run the business. While notes payable and short-term debt are included in current liabilities, they are different from accounts payable and accrual items. Notes payable and short-term debt are related to financing decisions of the firm, while accounts payable and accruals arise from operating decisions of the firm. This distinction is important later when we see that financial managers generally try to keep these two decisions (operating and financing) separate. Net Working Capital = Current Assets - Current Liabilities

long-term debt Any loan or debt obligation with a maturity of more than a year. book value of equity The difference between the book value of a firm’s assets and its liabilities; also called shareholders’ equity and stockholders’ equity, it represents the net worth of a firm from an accounting perspective.

(2.2)

For example, in 2010 Global’s net working capital totaled $22.3 million ($57.0 million in current assets - +34.7 million in current liabilities). Firms with low (or negative) net working capital may face a shortage of funds. In such cases, the liabilities due in the short term exceed the company’s cash and expected payments on receivables. Long-Term Liabilities. Long-term liabilities are liabilities that extend beyond one year. When a firm needs to raise funds to purchase an asset or make an investment, it may borrow those funds through a long-term loan. That loan would appear on the balance sheet as long-term debt, which is any loan or debt obligation with a maturity of more than a year.

Stockholders’ Equity The sum of the current liabilities and long-term liabilities is total liabilities. The difference between the firm’s assets and liabilities is the stockholders’ equity; it is also called the book value of equity or shareholders’ equity. As we stated earlier, it represents the net worth of the firm from an accounting perspective. The two main components are com-

Chapter 2 Introduction to Financial Statement Analysis

market capitalization The total market value of equity; equals the market price per share times the number of shares.

EXAMPLE 2.1 Market Versus Book Value

29

mon stock and paid-in surplus and retained earnings. These two components form the book value of stockholders’ ownership claims, stemming from their direct investment and reinvestment of profits. Ideally, the balance sheet would provide us with an accurate assessment of the true value of the firm’s equity. Unfortunately, this is unlikely to be the case. First, many of the assets listed on the balance sheet are valued based on their historical cost rather than their true value today. For example, an office building is listed on the balance sheet according to its historical cost less its accumulated depreciation. But the actual value of the office building today may be very different than this amount; in fact, if real estate prices went up it will be worth more than the amount the firm paid for it years ago. The same is true for other property, plant, and equipment: The true value today of an asset may be very different from, and even exceed, its book value. A second, and probably more important, problem is that many of the firm’s valuable assets are not captured on the balance sheet. Consider, for example, the expertise of the firm’s employees, the firm’s reputation in the marketplace, the relationships with customers and suppliers, and the quality of the management team. All these assets add to the value of the firm but do not appear on the balance sheet. For these reasons, the book value of equity is an inaccurate assessment of the actual value of the firm’s equity. Thus, it is not surprising that it will often differ substantially from the amount investors are willing to pay for the equity. The total market value of a firm’s equity equals the market price per share times the number of shares, referred to as the company’s market capitalization. The market value of a stock does not depend on the historical cost of the firm’s assets; instead, it depends on what investors expect those assets to produce in the future. To see the difference, think about what happens when a company like Boeing unveils a new plane. Investors’ expectations about future cash flows from selling those planes increase the stock price immediately, elevating the market value of Boeing. However, the revenue from selling the planes will only be reflected in Boeing’s financial statements when it actually sells them. Problem If Global has 3.6 million shares outstanding, and these shares are trading for a price of $10.00 per share, what is Global’s market capitalization? How does the market capitalization compare to Global’s book value of equity?

Solution Q Plan Market capitalization is equal to price per share times shares outstanding. We can find Global’s book value of equity at the bottom of the right side of its balance sheet. Q Execute Global’s market capitalization is (10.00/share) * (3.6 million shares) = $36 million. This market capitalization is significantly higher than Global’s book value of equity of $22.2 million. Q Evaluate Global must have sources of value that do not appear on the balance sheet. These include potential opportunities for growth, the quality of the management team, relationships with suppliers and customers, etc.

Finally, we note that the book value of equity can be negative (liabilities exceed assets), and that a negative book value of equity is not necessarily an indication of poor performance. Successful firms are often able to borrow in excess of the book value of their assets because creditors recognize that the market value of the assets is far higher. For example, in June 2005 Amazon.com had total liabilities of $2.6 billion and a book value of equity of -$64 million. At the same time, the market value of its equity was over $15 billion. Clearly,

30

Part 1 Introduction investors recognized that Amazon’s assets were worth far more than the book value reported on the balance sheet. By 2010, several years of strong growth had brought its book equity to over $5 billion and its market value of equity to more than $50 billion!

Concept Check

2.3 liquidation value The value of a firm after its assets are sold and liabilities paid.

3. What is depreciation designed to capture? 4. The book value of a company’s assets usually does not equal the market value of those assets. What are some reasons for this difference?

Balance Sheet Analysis What can we learn from analyzing a firm’s balance sheet? Although the book value of a firm’s equity is not a good estimate of its true value as an ongoing firm, it is sometimes used as an estimate of the liquidation value of the firm, the value that would be left after its assets were sold and liabilities paid. We can also learn a great deal of useful information from a firm’s balance sheet that goes beyond the book value of the firm’s equity. We now discuss analyzing the balance sheet to assess the firm’s value, its leverage, and its short-term cash needs.

Market-to-Book Ratio market-to-book ratio (price-to-book [P/B] ratio) The ratio of a firm’s market (equity) capitalization to the book value of its stockholders’ equity.

value stocks Firms with low market-to-book ratios. growth stocks Firms with high market-to-book ratios. leverage A measure of the extent to which a firm relies on debt as a source of financing. debt-equity ratio The ratio of a firm’s total amount of short- and long-term debt (including current maturities) to the value of its equity, which may be calculated based on market or book values.

In Example 2.1, we compared the market and book values of Global’s equity. A common way to make this comparison is to compute the market-to-book ratio (also called the price-to-book [P/B] ratio), which is the ratio of a firm’s market capitalization to the book value of stockholders’ equity. [email protected]@Book Ratio =

Market Value of Equity Book Value of Equity

(2.3)

It is one of many financial ratios used to evaluate a firm. The market-to-book ratio for most successful firms substantially exceeds 1, indicating that the value of the firm’s assets when put to use exceeds their historical cost (or liquidation value). The ratio will vary across firms due to differences in fundamental firm characteristics as well as the value added by management. Thus, this ratio is one way a company’s stock price provides feedback to its managers on the market’s assessment of their decisions. In early 2010, AmeriServ Financial, Inc. (ASRV) had a market-to-book ratio of 0.52, a reflection of investors’ assessment that many of AmeriServ’s assets were unlikely to be profitable and were worth less than their book value. Citigroup’s market-to-book ratio of 0.82 tells a similar story. Figure 2.1 shows that at the same time, the average market-tobook ratio for the financial services industry was about 1, and for large U.S. firms it was close to 3. In contrast, consider that Amazon.com, Inc. (AMZN) had a market-to-book ratio of over 11, and the average for technology firms was about 6. Analysts often classify firms with low market-to-book ratios as value stocks, and those with high market-to-book ratios as growth stocks.

Debt-Equity Ratio Another important piece of information that we can learn from a firm’s balance sheet is the firm’s leverage, or the extent to which it relies on debt as a source of financing. The debt-equity ratio is a common ratio used to assess a firm’s leverage that we calculate by dividing the total amount of short- and long-term debt (including current maturities) by the total stockholders’ equity: [email protected] Ratio =

Total Debt Total Equity

(2.4)

Chapter 2 Introduction to Financial Statement Analysis

FIGURE 2.1

31

This figure presents market-to-book ratios of different firms and groups of firms in 2010. Firms that might be classified as value stocks (low market-to-book ratios) are in red and those that might be classified as growth stocks (high market-to-book ratios) are in blue.

Market-to-Book Ratios in 2010

Market-to-Book Ratio

12 10 8 6 4 2 0

AmeriServ

Citigroup

Financial Services

Large U.S. Firms

Tech Stocks

Amazon

Firm or Industry

We can calculate this ratio using either book or market values for equity and debt. From Table 2.1, Global’s debt in 2010 includes notes payable ($5.5 million) and long-term debt ($113.2 million), for a total of $118.7 million. Therefore, using the book value of equity, its book debt-equity ratio is 118.7/22.2 = 5.3. Note the large increase from 2009, when the book debt-equity ratio was only 1 3.2 + 78 2 /21.2 = 3.8. Because of the difficulty interpreting the book value of equity, the book debt-equity ratio is not especially useful. It is more informative to compare the firm’s debt to the market value of its equity. Global’s debt-equity ratio in 2010, using the market value of equity (from Example 2.1), is 118.7/36 = 3.3, which means Global’s debt is a bit more than triple the market value of its equity.3 As we will see later in the text, a firm’s market debt-equity ratio has important consequences for the risk and return of its stock.

Enterprise Value enterprise value The total market value of a firm’s equity and debt, less the value of its cash and marketable securities. It measures the value of the firm’s underlying business.

A firm’s market capitalization measures the market value of the firm’s equity, or the value that remains after the firm has paid its debts. So it includes any cash the firm holds. But what if you are interested in just the value of the business itself? The enterprise value of a firm assesses the value of the underlying business assets, unencumbered by debt and separate from any cash and marketable securities. We compute it as follows: Enterprise Value = Market Value of Equity + Debt - Cash

(2.5)

For example, given its market capitalization from Example 2.1, Global’s enterprise value in 2010 is 36 + 118.7 - 23.2 = +131.5 million. We can interpret the enterprise value as the cost to take over the business. That is, it would cost 36 + 118.7 = +154.7 million to buy all of Global’s equity and pay off its debts. Because we would acquire Global’s $23.2 million in cash (which can be used to pay off Global’s debt), the net cost is only 154.7 - 23.2 = +131.5 million. 3

In this calculation, we have compared the market value of equity to the book value of debt. Strictly speaking, it would be best to use the market value of debt. But because the market value of debt is generally not very different from its book value, this distinction is often ignored in practice.

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Part 1 Introduction

EXAMPLE 2.2 Computing Enterprise Value

Problem In April 2010, H. J. Heinz Co. (HNZ) had a share price of $46.15, 316.2 million shares outstanding, a market-to-book ratio of 7.99, a book debt-equity ratio of 2.64, and cash of $562.3 million. What was Heinz’s market capitalization (its market value of equity)? What was its enterprise value?

Solution Q Plan Share Price Shares Outstanding Market-to-Book Cash Debt-to-Equity (Book)

$46.15 316.2 million 7.99 $562.3 million 2.64

We will solve the problem using Eq. 2.5: Enterprise Value = Market Value of Equity + Debt - Cash. We can compute the market capitalization by multiplying the share price by the shares outstanding. We are given the amount of cash. We are not given the debt directly, but we are given the book debt-to-equity ratio. If we knew the book value of equity, we could use the ratio to infer the value of the debt. Since we can compute the market value of equity (market capitalization) and we have the market-to-book ratio, we can compute the book value of equity, so that is the last piece of information we will need. Q Execute Heinz had a market capitalization of +46.15/share * 316.2 million shares = +14.59 billion. Since Heinz’s [email protected]@book = 7.99 = +14.59 billion/book equity, then book equity = +14.59 billion/7.99 = +1.83 billion. Given that the book equity is $1.83 billion and a book debt-to-equity ratio of 2.64, the total value of Heinz’s debt is +1.83 billion * 2.64 = +4.83 billion. Q Evaluate Thus, Heinz’s enterprise value was 14.59 + 4.83 - 0.5623 = +18.858 billion.

Other Balance Sheet Information current ratio The ratio of current assets to current liabilities. quick ratio The ratio of current assets other than inventory to current liabilities.

Creditors often compare a firm’s current assets and current liabilities to assess whether the firm has sufficient working capital to meet its short-term needs. This comparison is sometimes summarized in the firm’s current ratio, the ratio of current assets to current liabilities, or its quick ratio (“acid-test” ratio), the ratio of current assets other than inventory to current liabilities. A higher current or quick ratio implies less risk of the firm experiencing a cash shortfall in the near future. Current Ratio = Quick Ratio =

Current Assets Current Liabilities

Current Assets - Inventory Current Liabilities

(2.6) (2.7)

Analysts also use the information on the balance sheet to watch for trends that could provide information regarding the firm’s future performance. For example, an unusual increase in inventory could be an indicator that the firm is having difficulty selling its products. Table 2.2 summarizes balance sheet ratios and provides typical values of those ratios during an economic expansion as well as what happened to those ratios during the recent financial crisis and subsequent recession. Many of the recession effects noted here and in future tables are generally short-term in nature because once it is clear that the economy is in a recession, firms take actions to mitigate these effects. The table gives average values for the manufacturing, retail, and service sectors along with the 500 firms in the S&P

Chapter 2 Introduction to Financial Statement Analysis

TABLE 2.2 Balance Sheet Ratios

Ratio

Formula

Manufacturing Retail

Service S&P 500

33

Financial Crisis and Recession

Market Value of Equity Book Value of Equity

2.53

2.40

2.73

2.31

T

Total Debt Book Value of Total Equity

18.9%

31.7%

8.7%

32.4%

c

Market DebtTotal Debt to-Equity Ratio Market Value of Total Equity

7.1%

14.8%

2.5%

13.2%

cc

Current Ratio

Current Assets Current Liabilities

2.31

1.51

1.52

1.47

—

Current Assets - Inventory Current Liabilities

1.59

0.73

1.43

1.14

—

Market-toBook Ratio Book Debt-toEquity Ratio

Quick Ratio

Notes: A “—” in the recession column indicates that any changes in the ratio during the recession were too small to be economically significant or were not broadly felt across sectors. Two arrows indicate a larger move than a single arrow. Source: Standard and Poors’ Compustat.

500 index. The market-to-book ratio is an indicator of potential growth and of managers’ ability to generate value from the firm’s assets above their historical cost. The other ratios measure the financial health of the firm by assessing its leverage (debt-to-equity and equity multiplier) or liquidity (current and quick ratios).

Concept Check

2.4 income statement A list of a firm’s revenues and expenses over a period of time. net income or earnings The last or “bottom” line of a firm’s income statement that is a measure of the firm’s income over a given period of time.

gross profit The third line of an income statement that represents the difference between a firm’s sales revenues and its costs.

5. What does a high debt-to-equity ratio tell you? 6. What is a firm’s enterprise value?

The Income Statement When you want someone to get to the point, you might ask them for the “bottom line.” This expression comes from the income statement. The income statement lists the firm’s revenues and expenses over a period of time. The last or “bottom” line of the income statement shows the firm’s net income, which is a measure of its profitability during the period. The income statement is sometimes called a profit and loss or P&L statement, and the net income is also referred to as the firm’s earnings. In this section, we examine the components of the income statement in detail and introduce ratios we can use to analyze this data.

Earnings Calculations Whereas the balance sheet shows the firm’s assets and liabilities at a given point in time, the income statement shows the flow of revenues and expenses generated by those assets and liabilities between two dates. Table 2.3 shows Global’s income statement for 2010 and 2009. We examine each category on the statement. Gross Profit. The first two lines of the income statement list the revenues from sales of products and the costs incurred to make and sell the products. Note that in accounting, the terms revenues and net sales are equivalent. Net sales is simply gross sales minus any returns, discounts, and allowances. We will simply use the term sales from here forward. The third line is gross profit, the difference between sales revenues and the costs.

34

Part 1 Introduction

TABLE 2.3

GLOBAL CORPORATION Income Statement Year ended December 31 (in $ millions)

Global Corporation’s Income Statement Sheet for 2010 and 2009

2010

2009

186.7

176.1

Cost of sales

-153.4

-147.3

Gross Profit

33.3

28.8

Net sales

-13.5

-13

Research and development

-8.2

-7.6

Depreciation and amortization

-1.2

-1.1

Operating Income

10.4

7.1

Selling, general, and administrative expenses

Other income

—

—

Earnings Before Interest and Taxes (EBIT)

10.4

7.1

Interest income (expense)

-7.7

-4.6

2.7

2.5

-0.7

-0.6

2.0

1.9

Earnings per share:

$0.56

$0.53

Diluted earnings per share:

$0.53

$0.50

Pretax Income Taxes Net Income

operating income A firm’s gross profit less its operating expenses.

EBIT A firm’s earnings before interest and taxes are deducted.

earnings per share (EPS) A firm’s net income divided by the total number of shares outstanding.

Operating Expenses. The next group of items is operating expenses. These are expenses from the ordinary course of running the business that are not directly related to producing the goods or services being sold. They include administrative expenses and overhead, salaries, marketing costs, and research and development expenses. The third type of operating expense, depreciation and amortization (a charge that captures the change in value of acquired assets), represents an estimate of the costs that arise from wear and tear or obsolescence of the firm’s assets.4 It is not an actual cash expense. The firm’s gross profit net of operating expenses is called operating income. Earnings Before Interest and Taxes. We next include other sources of income or expenses that arise from activities that are not the central part of a company’s business. Cash flows from the firm’s financial investments are one example of other income that would be listed here. After we have adjusted for other sources of income or expenses, we have the firm’s earnings before interest and taxes, or EBIT. Pretax and Net Income. From EBIT, we deduct the interest paid on outstanding debt to compute Global’s pretax income, and then we deduct corporate taxes to determine the firm’s net income. Net income represents the total earnings of the firm’s equity holders. It is often reported on a per-share basis as the firm’s earnings per share (EPS), which we compute by dividing net income by the total number of shares outstanding: EPS = 4

Net Income +2.0 million = = +0.56 per share Shares Outstanding 3.6 million shares

(2.8)

Only certain types of amortization are deductible as a pretax expense (e.g., amortization of the cost of an acquired patent). Amortization of goodwill is not a pretax expense and is generally included as an extraordinary item after taxes are deducted.

Chapter 2 Introduction to Financial Statement Analysis stock options The right to buy a certain number of shares of stock by a specific date at a specific price. convertible bonds Corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock. dilution An increase in the total number of shares that will divide a fixed amount of earnings.

Concept Check

2.5 diluted EPS The earnings per share a company would have based on the total number of shares including the effects of all stock options and convertible bonds. gross margin The ratio of gross profit to revenues (sales), it reflects the ability of the company to sell a product for more than the sum of the direct costs of making it.

operating margin The ratio of operating income to revenues, it reveals how much a company has earned from each dollar of sales before deducting interest and taxes.

35

Although Global has only 3.6 million shares outstanding as of the end of 2010 (from Example 2.1), the number of shares outstanding may grow if Global has made commitments that would cause it to issue more shares. Consider these two examples: 1. Suppose Global compensates its employees or executives with stock options that give the holder the right to buy a certain number of shares by a specific date at a specific price. If employees “exercise” these options, the company issues new stock and the number of shares outstanding will grow. 2. The number of shares may also grow if the firm issues convertible bonds, a form of debt that can be converted into shares of common stock. In the cases of stock options and convertible bonds, because there will be more total shares to divide the same earnings, this growth in the number of shares is referred to as dilution. Firms disclose the potential for dilution from options they have awarded by reporting diluted EPS, which shows the earnings per share the company would have if the stock options were exercised. For example, if Global has awarded options for 200,000 shares of stock to its key executives, its diluted EPS is +2.0 million/3.8 million shares = +0.53. 7. What do a firm’s earnings measure? 8. What is dilution?

Income Statement Analysis The income statement provides very useful information regarding the profitability of a firm’s business and how it relates to the value of the firm’s shares. We now discuss several ratios that are often used to evaluate a firm’s performance and value.

Profitability Ratios We introduce three profitability ratios: gross margin, operating margin, and net profit margin. Gross Margin. The gross margin of a firm is the ratio of gross profit to revenues (sales): Gross Margin =

Gross Profit Sales

(2.9)

The gross margin simply reflects the ability of the company to sell a product for more than the sum of the direct costs of making it. All of the firm’s other expenses of doing business (those not directly related to producing the goods sold) must be covered by this margin. In 2010 Global’s gross profit was $33.3 million and its sales were $186.7 million, for a gross margin of 33.3/186.7 = 17.84%. Operating Margin. Because operating income reflects all of the expenses of doing business, another important profitability ratio is the operating margin, the ratio of operating income to revenues: Operating Margin =

Operating Income Sales

(2.10)

The operating margin reveals how much a company earns before interest and taxes from each dollar of sales. Global’s operating margin in 2010 was 10.4/186.7 = 5.57%, an increase from its 2009 operating margin of 7.1/176.1 = 4.03%. By comparing operating margins across firms within an industry, we can assess the relative efficiency of firms’

36

Part 1 Introduction operations. For example, in 2010 American Airlines (AMR) had an operating margin of -5.04% (i.e., they lost 5 cents for each dollar in revenues). However, competitor Southwest Airlines (LUV) had an operating margin of 2.53%. Differences in operating margins can also result from differences in strategy. For example, in 2010, Wal-Mart Stores had an operating margin of 5.87% while high-end retailer Nordstrom had an operating margin of 9.67%. In this case, Wal-Mart’s lower operating margin is not a result of its inefficiency but is part of its strategy of offering lower prices to sell common products in high volume. Indeed, Wal-Mart’s sales were more than 45 times higher than those of Nordstrom.

net profit margin The ratio of net income to revenues, it shows the fraction of each dollar in revenues that is available to equity holders after the firm pays its expenses, plus interest and taxes.

Net Profit Margin. A firm’s net profit margin is the ratio of net income to revenues: Net Profit Margin =

Net Income Sales

(2.11)

The net profit margin shows the fraction of each dollar in revenues that is available to equity holders after the firm pays its expenses, plus interest and taxes. Global’s net profit margin in 2010 was 2.0/186.7 = 1.07%. Differences in net profit margins can be due to differences in efficiency, but they can also result from differences in leverage (the firm’s reliance on debt financing), which determines the amount of interest payments.

Asset Efficiency A financial manager can use the combined information in the firm’s income statement and balance sheet to gauge how efficiently his or her firm is utilizing its assets. A first broad measure of efficiency is asset turnover, the ratio of sales to total assets: Asset Turnover =

Sales Total Assets

(2.12)

Low values of asset turnover indicate that the firm is not generating much revenue (sales) per dollar of assets. In 2010 Global’s $170.1 million in assets generated $186.7 million in sales, for an asset turnover ratio of 1.1 ( = $186.7/$170.1). Since total assets includes assets, such as cash, that are not directly involved in generating sales, Global’s manager might also look at Global’s fixed asset turnover, which is equal to sales divided by fixed assets: Fixed Asset Turnover =

Sales Fixed Assets

(2.13)

Global’s fixed assets in 2010 were $113.1 million worth of property, plant, and equipment, yielding a fixed asset turnover of 1.7 1 = +186.7/+113.1 2 . Low asset turnover ratios indicate that the firm is generating relatively few sales given the amount of assets it employs.

Working Capital Ratios accounts receivable days (average collection period or days sales outstanding) An expression of a firm’s accounts receivable in terms of the number of days’ worth of sales that the accounts receivable represents.

Global’s managers might be further interested in how efficiently they are managing their net working capital. We can express the firm’s accounts receivable in terms of the number of days’ worth of sales that it represents, called the accounts receivable days, average collection period, or days sales outstanding:5 Accounts Receivable Days =

5

Accounts Receivable Average Daily Sales

(2.14)

Accounts receivable days can also be calculated based on the average accounts receivable at the end of the current and prior years.

Chapter 2 Introduction to Financial Statement Analysis accounts payable days An expression of a firm’s accounts payable in terms of the number of days’ worth of cost of goods sold that the accounts payable represents. inventory days An expression of a firm’s inventory in terms of the number of days’ worth or cost of goods sold that the inventory represents. inventory turnover ratio The cost of goods sold divided by either the latest cost of inventory or the average inventory over the year, it shows how efficiently companies turn their inventory into sales.

37

Given average daily sales of +186.7 million/365 = +0.51 million in 2010, Global’s receivables of $18.5 million represent 18.5/0.51 = 36 days¿ worth of sales. In other words, Global takes a little over one month to collect payment from its customers, on average. In 2009, Global’s accounts receivable represented only 27.5 days worth of sales. Although the number of receivable days can fluctuate seasonally, a significant unexplained increase could be a cause for concern (perhaps indicating the firm is doing a poor job collecting from its customers or is trying to boost sales by offering generous credit terms). Similar ratios exist for accounts payable and inventory. Those ratios are called accounts payable days (accounts payable divided by average daily cost of goods sold) and inventory days (inventory divided by average daily cost of goods sold). We can also compute how efficiently firms use inventory. The inventory turnover ratio is equal to the cost of goods sold divided by either the latest cost of inventory or the average inventory over the year. We use the cost of goods sold because that is how inventory costs are reflected on the income statement. It is also common to use sales in the numerator to make the ratio more like the asset turnover ratios. Inventory Turnover =

Cost of Goods Sold Inventory

(2.15)

A normal level for this ratio, similar to the others in this section, can vary substantially for different industries, although a higher level (more dollars of sales per dollar of inventory) is generally better.

EBITDA EBITDA A computation of a firm’s earnings before interest, taxes, depreciation, and amortization are deducted. interest coverage ratio or times interest earned (TIE) ratio An assessment by lenders of a firm’s leverage, it is equal to a measure of earnings divided by interest.

Financial analysts often compute a firm’s earnings before interest, taxes, depreciation, and amortization, or EBITDA. Because depreciation and amortization are not cash expenses for the firm, EBITDA reflects the cash a firm has earned from its operations. Global’s EBITDA in 2010 was 10.4 + 1.2 = +11.6 million.

Leverage Ratios Lenders often assess a firm’s leverage by computing an interest coverage ratio, also known as a times interest earned (TIE) ratio, which is equal to a measure of earnings divided by interest. Financial managers watch these ratios carefully because they assess how easily the firm will be able to cover its interest payments. There is no one accepted measure of earnings for these ratios; it is common to consider operating income, EBIT, or EBITDA as a multiple of the firm’s interest expenses. When this ratio is high, it indicates that the firm is earning much more than is necessary to meet its required interest payments.

Investment Returns return on equity (ROE) The ratio of a firm’s net income to the book value of its equity.

Analysts and financial managers often evaluate the firm’s return on investment by comparing its income to its investment using ratios such as the firm’s return on equity (ROE):6 Return on Equity =

Net Income Book Value of Equity

(2.16)

Global’s ROE in 2010 was 2.0/22.2 = 9.0%. The ROE provides a measure of the return that the firm has earned on its past investments. A high ROE may indicate the firm 6

Because net income is measured over the year, the ROE can also be calculated based on the average book value of equity at the end of the current and prior years.

38

Part 1 Introduction

return on assets (ROA) The ratio of net income to the total book value of the firm’s assets.

DuPont Identity Expresses return on equity as the product of profit margin, asset turnover, and a measure of leverage.

is able to find investment opportunities that are very profitable. Of course, one weakness of this measure is the difficulty in interpreting the book value of equity. Another common measure is the return on assets (ROA), which is net income divided by the total assets. A firm must earn both a positive ROE and ROA to grow.

The DuPont Identity Global’s financial manager will need to know that its ROE is 9%, but that financial manager would also need to understand the drivers of his or her firm’s return on equity. High margins, efficient use of assets, or even simply high leverage could all lead to a higher return on equity. By delving deeper into the sources of return on equity, the financial manager can gain a clear sense of the firm’s financial picture. One common tool for doing so is the DuPont Identity, named for the company that popularized it, which expresses return on equity as the product of profit margin, asset turnover, and a measure of leverage. To understand the DuPont Identity, we start with ROE and decompose it in steps into the drivers identified in the identity. First, we simply multiply ROE by (sales/sales), which is just 1, and rearrange terms: ROE = a

Net Income Sales Net Income Sales ba b = a ba b Total Equity Sales Sales Total Equity

(2.17)

This expression says that ROE can be thought of as net income per dollar of sales (profit margin) times the amount of sales per dollar of equity. For example, Global’s ROE comes from its profit margin of 1.07% multiplied by its sales per dollar of equity 1 186.7/22.2 = 8.41 2 : 1.07% * 8.41 = 9%. We can take the decomposition further by multiplying Eq. 2.17 by (total assets / total assets), which again is just 1, and rearranging the terms: DuPont Identity Net Income Sales Total Assets ROE = a ba ba b Sales Total Equity Total Assets Net Income Sales Total Assets (2.18) = a ba ba b Sales Total Assets Total Equity

equity multiplier A measure of leverage equal to total assets divided by total equity.

This final expression says that ROE is equal to net income per dollar of sales (profit margin) times sales per dollar of assets (asset turnover) times assets per dollar of equity (a measure of leverage called the equity multiplier). Equation 2.18 is the DuPont Identity, expressing return on equity as the product of profit margin, asset turnover, and the equity multiplier. Turning to Global, its equity multiplier is 7.7 1 =170.1/22.2 2 . A financial manager at Global looking for ways to increase ROE could assess the drivers behind its current ROE with the DuPont Identity. With a profit margin of 1.07%, asset turnover of 1.1, and an equity multiplier of 7.7, we have: ROE = 9% = 1 1.07% 2 1 1.1 2 1 7.7 2

This decomposition of ROE shows that leverage is already high (confirmed by the fact that the book debt-to-equity ratio shows that Global’s debt is more than five times its equity). However, Global is operating with only 1% profit margins and relatively low asset turnover. Thus, Global’s managers should focus on utilizing the firm’s existing assets more efficiently and lowering costs to increase the profit margin.7

7

Although the DuPont Identity makes it look like you can increase ROE just by increasing leverage, it is not quite that simple. An increase in leverage will increase your interest expense, decreasing your profit margin.

Chapter 2 Introduction to Financial Statement Analysis

EXAMPLE 2.3 DuPont Analysis

39

Problem The following table contains information about Wal-Mart (WMT) and Nordstrom (JWN). Compute their respective ROEs and then determine how much Wal-Mart would need to increase its profit margin in order to match Nordstrom’s ROE. Profit Margin

Asset Turnover

Equity Multiplier

3.6% 7.7%

2.4 1.7

2.6 2.4

Wal-Mart Nordstrom

Solution Q Plan and Organize The table contains all the relevant information to use the DuPont Identity to compute the ROE. We can compute the ROE of each company by multiplying together its profit margin, asset turnover, and equity multiplier. In order to determine how much Wal-Mart would need to increase its profit margin to match Nordstrom’s ROE, we can set Wal-Mart’s ROE equal to Nordstrom’s, keep its turnover and equity multiplier fixed, and solve for the profit margin. Q Execute Using the DuPont Identity, we have: ROEWMT = 3.6% * 2.4 * 2.6 = 22.5% ROEJWN = 7.7% * 1.7 * 2.4 = 31.4% Now, using Nordstrom’s ROE, but Wal-Mart’s asset turnover and equity multiplier, we can solve for the profit margin that Wal-Mart needs to achieve Nordstrom’s ROE: 31.4% = Margin * 2.4 * 2.6 Margin = 31.4%/6.24 = 5.0% Q Evaluate Wal-Mart would have to increase its profit margin from 3.6% to 5% in order to match Nordstrom’s ROE. It would be able to achieve Nordstrom’s ROE even with a lower profit margin than Nordstrom (5.0% vs. 7.7%) because of its higher turnover and slightly higher leverage.

Valuation Ratios price-earnings ratio (P/E) The ratio of the market value of equity to the firm’s earnings, or its share price to its earnings per share.

PEG ratio The ratio of a firm’s P/E to its expected earnings growth rate.

Analysts and investors use a number of ratios to gauge the market value of the firm. The most important is the firm’s price-earnings ratio (P/E): P/E Ratio =

Market Capitalization Share Price = Net Income Earnings per Share

(2.19)

That is, the P/E ratio is the ratio of the value of equity to the firm’s earnings, either on a total basis or on a per-share basis. Following Eq. 2.19, Global’s P/E ratio in 2010 was 36/2.0 = 10/0.56 = 18. The P/E ratio is a simple measure that is used to assess whether a stock is over- or under-valued, based on the idea that the value of a stock should be proportional to the level of earnings it can generate for its shareholders. P/E ratios can vary widely across industries and tend to be higher for industries with high growth rates. For example, in 2010 the average large U.S. firm had a P/E ratio of about 18. But airlines, which had very low current earnings due to the recession, but the promise of higher future earnings as the economy recovered, had an average P/E ratio of 31. One way to capture the idea that a higher P/E ratio can be justified by a higher growth rate is to compare it to the company’s expected earnings growth rate. For example, if Global’s expected growth rate is 18%, then it would have a P/E to Growth, or PEG ratio, of 1. Some investors consider PEG ratios of 1 or below as indicating the stock is fairly priced, but would question whether the company is potentially overvalued if the PEG is higher than 1.

40

Part 1 Introduction The P/E ratio considers the value of the firm’s equity and so depends on its leverage. Recall that the amount of assets controlled by the equity holders can be increased through the use of leverage. To assess the market value of the underlying business, it is common to consider valuation ratios based on the firm’s enterprise value. Typical ratios include the ratio of enterprise value to revenue, or enterprise value to operating income or EBITDA. These ratios compare the value of the business to its sales, operating profits, or cash flow. Similar to the P/E ratio, managers use these ratios to make intra-industry comparisons of how firms are priced in the market.

COMMON MISTAKE

Mismatched Ratios

When considering valuation (and other) ratios, be sure that the items you are comparing both represent amounts related to the entire firm or that both represent amounts related solely to equity holders. For example, a firm’s share price and market capitalization are values associated with the firm’s equity. Thus, it makes sense to compare them to the firm’s earnings per share or net income, which are amounts to

equity holders after interest has been paid to debt holders. We must be careful, however, if we compare a firm’s market capitalization to its revenues, operating income, or EBITDA. These amounts are related to the whole firm, and both debt and equity holders have a claim to them. Therefore, it is better to compare revenues, operating income, or EBITDA to the enterprise value of the firm, which includes both debt and equity.

The P/E ratio is not useful when the firm’s earnings are negative. In this case, it is common to look at the firm’s enterprise value relative to sales. The risk in doing so, however, is that earnings might be negative because the firm’s underlying business model is fundamentally flawed, as was the case for many Internet firms in the late 1990s.

EXAMPLE 2.4 Computing Profitability and Valuation Ratios

Problem Consider the following data from 2010 for Wal-Mart Stores and Target Corporation ($ billions):

Sales Operating Income Net Income Market Capitalization Cash Debt

Wal-Mart Stores (WMT)

Target Corporation (TGT)

408 24 14 203 8 41

65 5 2 41 2 17

Compare Wal-Mart and Target’s operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales.

Solution Q Plan The table contains all of the raw data, but we need to compute the ratios using the inputs in the table. Operating Margin = Operating Income/Sales Net Profit Margin = Net Income/Sales P/E ratio = Price/Earnings = Market Capitalization/Net Income Enterprise value to operating income = Enterprise Value/Operating Income Enterprise value to sales = Enterprise Value/Sales Q Execute Wal-Mart had an operating margin of 24/408 = 5.9%, a net profit margin of 14/408 = 3.4%, and a P/E ratio of 203/14 = 14.5. Its enterprise value was 203 + 41 - 8 = +236 billion. Its ratio to operating income is 236/24 = 9.8, and its ratio to sales is 236/408 = 0.58.

Chapter 2 Introduction to Financial Statement Analysis

41

Target had an operating margin of 5/65 = 7.7%, a net profit margin of 2/65 = 3.1%, and a P/E ratio of 41/2 = 20.5. Its enterprise value was 41 + 17 - 2 = +56 billion. Its ratio to operating income is 56/5 = 11.2, and its ratio to sales is 56/65 = 0.86. Q Evaluate Despite a slightly lower overall profit margin, Target has higher P/E and enterprise value ratios, suggesting that the market expects greater growth from Target than from Wal-Mart.

Table 2.4 summarizes income statement ratios and provides typical values of those ratios during an economic expansion as well as what happened to them during the Financial Crisis and ensuing recession.

TABLE 2.4 Income Statement Ratios

Ratio Profitability Ratios Gross margin Operating margin Net Profit margin Leverage Ratio Interest coverage ratio (TIE)

Formula Gross Profit Sales Operating Income Sales Net Income Sales

34.3%

30.8%

50.4%

38.4%

—

8.4%

7.4%

8.7%

19.7%

T

2.0%

2.3%

2.1%

8.7%

TT

Operating Income Interest Expense

4.78

7.16

3.58

12.13

T

7.9%

10.6%

7.9%

15.8%

T

Net Income Total Assets

1.6%

4.3%

1.1%

5.4%

TT

Share Price Earnings per Share

10.0

15.2

9.3

18.0

T*

56.8

6.7

62.5

57.5

—

Investment Return Ratios Net Income Return on equity Book Value of Equity Return on assets Valuation Ratio Price-to-earnings ratio

Manufacturing Retail

Financial Crisis and Service S&P 500 Recession

Efficiency and Working Capital Ratios Accounts Receivable Accounts receivable days Average Daily Sales Fixed asset turnover

Sales Fixed Assets

5.6

6.3

11.8

5.2

—

Total asset turnover

Sales Total Assets

0.9

1.8

0.8

0.7

—

Inventory turnover

Cost of Goods Sold Inventory

4.2

6.5

21.5

6.2

—

Notes: A “—” in the recession column indicates that any changes in the ratio during the recession were too small to be economically significant or were not broadly felt across sectors. Two arrows indicate a larger move than a single arrow. *

Because many firms had losses (negative earnings) during the recession, the P/E ratio was not meaningful and was not calculated. For those that maintained positive earnings, the ratio fell.

Source : Standard and Poors’ Compustat.

42

Part 1 Introduction

Concept Check

2.6

statement of cash flows An accounting statement that shows how a firm has used the cash it earned during a set period.

9. How can a financial manager use the DuPont Identity to assess the firm’s ROE? 10. How do you use the price-earnings (P/E) ratio to gauge the market value of a firm?

The Statement of Cash Flows The income statement provides a measure of the firm’s profit over a given time period. However, it does not indicate the amount of cash the firm has earned. There are two reasons that net income does not correspond to cash earned. First, there are non-cash entries on the income statement, such as depreciation and amortization. Second, certain uses, such as the purchase of a building or expenditures on inventory, and sources of cash, such as the collection of accounts receivable, are not reported on the income statement. The firm’s statement of cash flows utilizes the information from the income statement and balance sheet to determine how much cash the firm has generated, and how that cash has been allocated, during a set period. Cash is important: It is needed to pay bills and maintain operations and is the source of any return of investment for investors. Thus, from the perspective of an investor attempting to value the firm or a financial manager concerned about cash flows (vs. earnings), the statement of cash flows provides what may be the most important information of the four financial statements. The statement of cash flows is divided into three sections: operating activities, investment activities, and financing activities. These sections roughly correspond to the three major jobs of the financial manager. 1. Operating activities starts with net income from the income statement. It then adjusts this number by adding back all non-cash entries related to the firm’s operating activities. 2. Investment activities lists the cash used for investment. 3. Financing activities shows the flow of cash between the firm and its investors. Global’s statement of cash flows is shown in Table 2.5. In this section, we take a close look at each component of the statement of cash flows.

Operating Activity The first section of Global’s statement of cash flows adjusts net income by all non-cash items related to operating activity. For instance, depreciation is deducted when computing net income, but it is not an actual cash expense. Thus, we add it back to net income when determining the amount of cash the firm has generated. Similarly, we add back any other non-cash expenses (for example, deferred taxes). Next, we adjust for changes to net working capital that arise from changes to accounts receivable, accounts payable, or inventory. When a firm sells a product, it records the revenue as income even though it may not receive the cash from that sale immediately. Instead, it may grant the customer credit and let the customer pay in the future. The customer’s obligation adds to the firm’s accounts receivable. We use the following guidelines to adjust for changes in working capital: 1. Accounts receivable: When a sale is recorded as part of net income, but the cash has not yet been received from the customer, we must adjust the cash flows by deducting the increases in accounts receivable. This increase represents additional lending by the firm to its customers and it reduces the cash available to the firm. 2. Accounts payable: We add increases in accounts payable. Accounts payable represents borrowing by the firm from its suppliers. This borrowing increases the cash available to the firm.

Chapter 2 Introduction to Financial Statement Analysis

TABLE 2.5 Global Corporation’s Statement of Cash Flows for 2010 and 2009

43

GLOBAL CORPORATION Statement of Cash Flows Year ended December 31 (in $ millions) Operating activities Net income Depreciation and amortization Cash effect of changes in Accounts receivable Accounts payable Inventory Cash from operating activities Investment activities Capital expenditures Acquisitions and other investing activity Cash from investing activities Financing activities Dividends paid Sale or purchase of stock Increase in short-term borrowing Increase in long-term borrowing Cash from financing activities Change in cash and cash equivalents

2010

2009

2.0 1.2

1.9 1.1

-5.3 2.7

-0.3 -0.5

-1.0 -0.4

-1.0 1.2

-33.4

-4.0

-33.4

-4.0

-1.0 — 2.3 35.2 36.5

-1.0 — 3.0 2.5 4.5

2.7

1.7

3. Inventory: Finally, we deduct increases in inventory. Increases in inventory are not recorded as an expense and do not contribute to net income (the cost of the goods are only included in net income when the goods are actually sold). However, the cost of increasing inventory is a cash expense for the firm and must be deducted. Working capital adjustments address the difference between the time when sales and costs are recorded on the income statement and when the cash actually goes in and out of the firm. For example, Table 2.5 shows that in 2010 we subtracted the $5.3 million increase in accounts receivable from net income as part of the operating cash flow calculation. What happened? From Table 2.3, we see that Global had $10.6 million more in sales in 2010 than in 2009. However, from Table 2.1, we also see that Global’s accounts receivable increased from $13.2 million in 2009 to $18.5 million in 2010. So, even though Global’s sales were up considerably, it has not yet collected all the cash flow for those sales—instead, Global’s customers owe it $5.3 million more at the end of 2010 than they did at the end of 2009. Because the statement of cash flows starts with net income, which includes sales for which Global has not yet been paid, we deduct the additional $5.3 million in sales Global is still owed when computing the actual cash flows it generated. We must make a similar adjustment for inventory. Global does not record the cost of the inventory until it is sold, when it is included in the cost of goods sold. However, when it actually pays for the inventory, cash has flowed out of Global, decreasing operating cash flow. The opposite is true for accounts payable—Global has recorded additional expenses without actually paying for them yet. Those expenses reduce net income, but do not represent cash outflows.

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Part 1 Introduction Finally, we add depreciation to net income before calculating operating cash flow. Depreciation is an accounting adjustment to book value that is an expense, but not a cash outflow. That is, when Global’s property, plant, and equipment depreciate by $1.2 million, it does not literally cost Global $1.2 million in cash flow. Because this is an expense that reduces net income, but not an actual cash outflow, we must add it back to calculate cash flow. We will talk more about depreciation when we do capital budgeting in Chapter 9. All these adjustments mean that cash flows can be very different from net income. Although Global showed positive net income on the income statement, it actually had a negative $0.4 million cash flow from operating activity, in large part because of the increase in accounts receivable.

Investment Activity capital expenditures Purchases of new property, plant, and equipment.

The next section of the statement of cash flows shows the cash required for investment activities. Purchases of new property, plant, and equipment are capital expenditures. Recall that capital expenditures do not appear immediately as expenses on the income statement. Instead, the firm depreciates these assets and deducts depreciation expenses over time. To determine the firm’s cash flow, we already added back depreciation because it is not an actual cash expense. Now, we subtract the actual capital expenditure that the firm made. Similarly, we also deduct other assets purchased or investments made by the firm, such as acquisitions. In Table 2.5, we see that in 2010, Global spent $33.4 million in cash on investing activities.

Financing Activity

retained earnings The difference between a firm’s net income and the amount it spends on dividends. payout ratio The ratio of a firm’s dividends to its net income.

The last section of the statement of cash flows shows the cash flows from financing activities. Dividends paid to shareholders are a cash outflow. Global paid $1 million to its shareholders as dividends in 2010. The difference between a firm’s net income and the amount it spends on dividends is referred to as the firm’s retained earnings for that year: Retained Earnings = Net Income - Dividends

(2.20)

Global retained +2 million - +1 million = +1 million, or 50% of its earnings in 2010. This makes its payout ratio for 2010 equal to 50%. A firm’s payout ratio is the ratio of its dividends to its net income: Payout Ratio =

Dividends Net Income

(2.21)

Also listed under financing activity is any cash the company received from the sale of its own stock, or cash spent buying (repurchasing) its own stock. Global did not issue or repurchase stock during this period. The last items to include in this section result from changes to Global’s short-term and long-term borrowing. Global raised money by issuing debt, so the increases in shortterm and long-term borrowing represent cash inflows. The last line of the statement of cash flows combines the cash flows from these three activities to calculate the overall change in the firm’s cash balance over the period of the statement. In this case, Global had cash inflows of $2.7 million in 2010. By looking at the statement in Table 2.5 as a whole, we can determine that Global chose to borrow (mainly in the form of long-term debt) to cover the cost of its investment and operating activities. Although the firm’s cash balance has increased, Global’s negative operating cash flows and relatively high expenditures on investment activities might give investors some reasons for concern. If this pattern continues, Global will need to continue to borrow to remain in business.

Chapter 2 Introduction to Financial Statement Analysis

EXAMPLE 2.5 The Impact of Depreciation on Cash Flow

45

Problem Suppose Global had an additional $1 million depreciation expense in 2010. If Global’s tax rate on pretax income is 26%, what would be the impact of this expense on Global’s earnings? How would it impact Global’s cash at the end of the year?

Solution Q Plan Depreciation is an operating expense, so Global’s operating income, EBIT, and pretax income would be affected. With a tax rate of 26%, Global’s tax bill will decrease by 26 cents for every dollar that pretax income is reduced. In order to determine how Global’s cash would be impacted, we have to determine the effect of the additional depreciation on cash flows. Recall that depreciation is not an actual cash outflow, even though it is treated as an expense, so the only effect on cash flow is through the reduction in taxes. Q Execute Global’s operating income, EBIT, and pretax income would fall by $1 million because of the $1 million in additional operating expense due to depreciation. This $1 million decrease in pretax income would reduce Global’s tax bill by 26% * +1 million = +0.26 million. Therefore, net income would fall by +1 - +0.26 = +0.74 million. On the statement of cash flows, net income would fall by $0.74 million, but we would add back the additional depreciation of $1 million because it is not a cash expense. Thus, cash from operating activities would rise by - +0.74 + 1 = +0.26 million. Therefore, Global’s cash balance at the end of the year would increase by $0.26 million, the amount of the tax savings that resulted from the additional depreciation deduction. Q Evaluate The increase in cash balance comes completely from the reduction in taxes. Because Global pays $0.26 million less in taxes even though its cash expenses have not increased, it has $0.26 million more in cash at the end of the year.

Concept Check

2.7 management discussion and analysis (MD&A) A preface to the financial statements in which a company’s management discusses the recent year (or quarter), providing a background on the company and any significant events that may have occurred. off-balance sheet transactions Transactions or arrangements that can have a material impact on a firm’s future performance yet do not appear on the balance sheet.

11. Why does a firm’s net income not correspond to cash earned? 12. What are the components of the statement of cash flows?

Other Financial Statement Information The most important elements of a firm’s financial statements are the balance sheet, income statement, and the statement of cash flows, which we have already discussed. Several other pieces of information contained in the financial statements warrant brief mention: the management discussion and analysis, the statement of stockholders’ equity, and notes to the financial statement.

Management Discussion and Analysis The management discussion and analysis (MD&A) is a preface to the financial statements in which the company’s management discusses the recent year (or quarter), providing a background on the company and any significant events that may have occurred. Management may also discuss the coming year, and outline goals and new projects. Management must also discuss any important risks that the firm faces or issues that may affect the firm’s liquidity or resources. Management is also required to disclose any off-balance sheet transactions, which are transactions or arrangements that can have a material impact on the firm’s future performance yet do not appear on the balance sheet. For example, if a firm has made guarantees that it will compensate a buyer for losses related to an asset purchased from the firm, these guarantees represent a potential future liability for the firm that must be disclosed as part of the MD&A.

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Part 1 Introduction

Statement of Stockholders’ Equity statement of stockholders’ equity An accounting statement that breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing new shares versus retained earnings.

Concept Check

2.8

The statement of stockholders’ equity breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing new shares versus retained earnings. Because the book value of stockholders’ equity is not a useful assessment of value for financial purposes, the information contained in the statement of stockholders’ equity is also not particularly insightful, so we do not spend time on the statement here.

Notes to the Financial Statements In addition to the four financial statements, companies provide extensive notes with additional details on the information provided in the statements. For example, the notes document important accounting assumptions that were used in preparing the statements. They often provide information specific to a firm’s subsidiaries or its separate product lines. They show the details of the firm’s stock-based compensation plans for employees and the different types of debt the firm has outstanding. Details of acquisitions, spin-offs, leases, taxes, and risk management activities are also given. The information provided in the notes is often very important to a full interpretation of the firm’s financial statements. 13. Where do off-balance sheet transactions appear in a firm’s financial statements? 14. What information do the notes to financial statements provide?

Financial Reporting in Practice The various financial statements we have examined are of critical importance to investors and financial managers alike. Even with safeguards such as GAAP and auditors, financial reporting abuses unfortunately do take place. We now review one of the most infamous recent examples and offer some concluding thoughts to guide financial managers through the complexities of financial statements.

Enron Enron is the most well-known of the accounting scandals of the early 2000s. Enron started as an operator of natural gas pipelines but evolved into a global trader dealing in a range of products including gas, oil, electricity, and even broadband Internet capacity. A series of events unfolded that led Enron to file what was at the time the largest bankruptcy filing in U.S. history in December 2001. By the end of 2001, the market value of Enron’s shares had fallen by over $60 billion. Interestingly, throughout the 1990s and up to late 2001, Enron was touted as one of the most successful and profitable companies in America. Fortune rated Enron “The Most Innovative Company in America” for six straight years, from 1995 to 2000. But while many aspects of Enron’s business were successful, subsequent investigations suggest that Enron executives had been manipulating Enron’s financial statements to mislead investors and artificially inflate the price of Enron’s stock and to maintain its credit rating. In 2000, for example, 96% of Enron’s reported earnings were the result of accounting manipulation.8 Although the accounting manipulations that Enron used were quite sophisticated, the essence of most of the deceptive transactions was surprisingly simple. Enron sold assets at inflated prices to other firms (or, in many cases, business entities that Enron’s CFO Andrew Fastow had created), together with a promise to buy back those assets at an 8

John R. Kroger, “Enron, Fraud and Securities Reform: An Enron Prosecutor’s Perspective,” University of Colorado Law Review, December 2005, pp. 57–138.

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even higher future price. Thus, Enron was effectively borrowing money, receiving cash today in exchange for a promise to pay more cash in the future. But Enron recorded the incoming cash as revenue and then hid the promises to buy the assets back in a variety of ways.9 In the end, much of their revenue growth and profits in the late 1990s were the result of this type of manipulation.

The Sarbanes-Oxley Act Sarbanes-Oxley Act (SOX) Legislation passed by Congress in 2002, intended to improve the accuracy of financial information given to both boards and to shareholders.

Accurate and up-to-date financial statements are essential to investors evaluating investment opportunities. In 2002, Congress passed the Sarbanes-Oxley Act (SOX). While SOX contains many provisions, the overall intent of the legislation was to improve the accuracy of information given to both boards and to shareholders. SOX attempted to achieve this goal in three ways: (1) by overhauling incentives and independence in the auditing process, (2) by stiffening penalties for providing false information, and (3) by forcing companies to validate their internal financial control processes. Many of the problems at Enron and elsewhere were kept hidden from boards and shareholders until it was too late. In the wake of these scandals, many people felt that the accounting statements of these companies, while often remaining true to the letter of GAAP, did not present an accurate picture of the financial health of a company. Auditing firms are supposed to ensure that a company’s financial statements accurately reflect the financial state of the firm. In reality, most auditors have a long-standing relationship with their audit clients; this extended relationship and the auditors’ desire to keep the lucrative auditing fees make auditors less willing to challenge management. More importantly, perhaps, most accounting firms have developed large and extremely profitable consulting divisions. Obviously, if an audit team refuses to accommodate a request by a client’s management, that client will be less likely to choose the accounting firm’s consulting division for its next consulting contract. SOX addressed this concern by putting strict limits on the amount of non-audit fees (consulting or otherwise) that an accounting firm can earn from the same firm that it audits. It also required that audit partners rotate every five years to limit the likelihood that auditing relationships become too cozy over long periods of time. Finally, SOX called on the SEC to force companies to have audit committees that are dominated by outside directors, and required that at least one outside director have a financial background. SOX also stiffened the criminal penalties for providing false information to shareholders. It required both the CEO and the CFO to personally attest to the accuracy of the financial statements presented to shareholders and to sign a statement to that effect. Penalties for providing false or misleading financial statements were increased under SOX—fines of as much as $5 million and imprisonment of a maximum of 20 years are permitted. Further, CEOs and CFOs must return bonuses or profits from the sale of stock or the exercise of options during any period covered by statements that are later restated. Finally, Section 404 of SOX requires senior management and the boards of public companies to attest to the effectiveness and validity with the process through which funds are allocated and controlled, and outcomes monitored throughout the firm. Section 404 has arguably garnered more attention than any other section in SOX because of the potentially enormous burden it places on every firm to validate its entire financial control system. When the SEC estimated the cost of implementing Section 404, its staff economists put the total cost at $1.24 billion. In 2005, surveys by Financial Executives International and the American Electronics Association predicted that the actual cost

9

In some cases, these promises were called “price risk management liabilities” and hidden with other trading activities; in other cases they were off-balance sheet transactions that were not fully disclosed.

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Part 1 Introduction

INTERVIEW WITH

SUE FRIEDEN

Sue Frieden is Ernst & Young’s Global Managing Partner, Quality & Risk Management. A member of the Global Executive board, she is responsible for every aspect of quality and risk management—employees, services, procedures, and clients.

Do today’s financial statements give the investing public what they need?

QUESTION:

ANSWER: Globally, we

are seeing an effort to provide more forwardlooking information to investors. But fundamental questions remain, such as how fully do investors understand financial statements and how fully do they read them? Research shows that most individual investors don’t rely on financial statements much at all. We need to determine how the financial statement and related reporting models can be improved. To do that we will need a dialogue involving investors, regulators, analysts, auditors, stock exchanges, academics and others to ensure that financial statements and other reporting models are as relevant as they can be.

Ernst & Young is a global organization. How do accounting standards in the U.S. compare to those elsewhere?

QUESTION:

ANSWER: In January of 2005, 100 countries outside the U.S. began the process of adopting new accounting standards (International Financial Reporting Standards) that would in large measure be based on principles rather than rules. As global markets become more complex, we all need to be playing by the same set of rules. As a first step, we need consistency from country to country. There are definite challenges to overcome in reconciling principlebased and rules-based systems, but we are optimistic that these challenges will inevitably get resolved. At the same time, there are efforts underway to ensure that auditing standards are globally consistent. Ultimately, financial statements prepared under global standards and audited under consistent global auditing standards will better serve investors.

What role does the audit firm play in our financial markets, and how has that changed since the collapse of Arthur Andersen?

QUESTION:

ANSWER: The accounting profession has seen unprecedented change in the past few years. The passage of Sarbanes-Oxley and other changes are helping to restore public trust. We’re now engaging on a regular basis with a wider range of stakeholders—companies, boards, policymakers, opinion leaders, investors, and academia. And we’ve had the chance to step back and ask ourselves why we do what we do as accounting professionals, and why it matters. In terms of the services we offer, much of what we do helps companies comply with regulations, guard against undue risks, and implement sound transactions. Part of the value in what we do is providing all stakeholders the basis to understand whether companies are playing by the rules—be they accounting, financial reporting, or tax rules. We help create confidence in financial data. The public may not understand precisely what auditors do or how we do it, but they care that we exist, because it provides them the confidence they so badly need and want.

Accounting standards seem to be shifting from historical cost-based methods to methods that rely on current market values of assets. During the financial crisis, however, many financial institutions complained that “mark-to-market” rules exacerbated their financial difficulties. Do you believe accounting professionals should rethink the wisdom of moving to market-based accounting methods?

QUESTION:

ANSWER:

Fair value accounting can certainly be improved, particularly in light of the difficulty in applying fair value in illiquid markets, which the financial crisis highlighted, and because of some of the anomalies that fair value accounting can produce. But, by and large, fair value accounting provided transparency into reality for investors. It is the most transparent way to reflect the economic reality of prevailing market conditions and provide investors and companies with current financial information on which they can base investment and management decisions. Fair value accounting did not cause the economic crisis; it simply kept a fair scorecard.

Chapter 2 Introduction to Financial Statement Analysis

49

would be between $20 billion and $35 billion.10 The burden of complying with this provision is greater, as a fraction of revenue, for smaller companies. The surveys cited earlier found that multibillion-dollar companies would pay less than 0.05% of their revenues to comply, whereas small companies with less than $20 million in revenues would pay more than 3% of their revenues to comply.

The Financial Statements: A Useful Starting Point In this chapter, we have highlighted the role of the financial statements in informing outside analysts, investors, and the financial managers themselves about the performance, position, and financial condition of the firm. However, especially from the financial manager’s perspective, financial statements are only a starting point. For example, we have emphasized the importance of market values over book values. We have also shown that while much can be learned through ratio analysis, these ratios are only markers that point the financial manager toward areas where the firm is doing well or where he or she needs to focus effort for improvement. No single ratio tells the whole story. However, by studying all of the financial statements and considering ratios that assess profitability, leverage, and efficiency, you should be able to develop a clear sense of the health and performance of the firm. Finally, the usefulness of the financial statements to investors relies on the ethics of those constructing them. However, even in cases of deception, an informed reader of the financial statements could have spotted the warning signs by focusing on the statement of cash flows and carefully reading the notes to the financial statements.

Concept Check

15. Describe the transactions Enron used to increase its reported earnings. 16. What is the Sarbanes-Oxley Act?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

2.1 Firms’ Disclosure of Financial Information Q Financial statements are accounting reports that a firm issues periodically to describe its past performance. Q Investors, financial analysts, managers, and other interested parties, such as creditors, rely on financial statements to obtain reliable information about a corporation. Q The main types of financial statements are the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders’ equity.

annual report, p. 25 auditor, p. 25 financial statements, p. 25 Generally Accepted Accounting Principles (GAAP), p. 25

10

Online Practice Opportunities MyFinanceLab Study Plan 2.1

American Electronics Association, “Sarbanes-Oxley Section 404: The ‘Section’ of Unintended Consequences and Its Impact on Small Business” (2005).

Here is what you know after reading this chapter. MyFinanceLab will help you identify what you know, and 50 Partshould 1 Introduction where to go when you need to practice. 2.2 The Balance Sheet Q The balance sheet shows the current financial position (assets, liabilities, and stockholders’ equity) of the firm at a single point in time. Q The two sides of the balance sheet must balance: Assets = Liabilities + Stockholders¿ Equity (2.1) Q Stockholders’ equity is the book value of the firm’s equity. It differs from the market value of the firm’s equity, its market capitalization, because of the way assets and liabilities are recorded for accounting purposes.

accounts payable, p. 28 MyFinanceLab accounts receivable, p. 27 Study Plan 2.2 assets, p. 26 balance sheet, p. 26 book value, p. 28 book value of equity, p. 28 common stock and paid-in surplus, p. 26 current assets, p. 27 current liabilities, p. 28 depreciation, p. 28 inventories, p. 27 liabilities, p. 26 long-term assets, p. 27 long-term debt, p. 28 market capitalization, p. 29 marketable securities, p. 27 net working capital, p. 28 notes payable, p. 28 retained earnings, p. 26 shareholders’ equity, p. 26 short-term debt, p. 28 stockholders’ equity, p. 26

2.3 Balance Sheet Analysis Q A successful firm’s market-to-book ratio typically exceeds 1. Q A common ratio used to assess a firm’s leverage is: Total Debt [email protected] Ratio = (2.4) Total Equity Q This ratio is most informative when computed using the market value of equity. It indicates the degree of leverage of the firm. Q The enterprise value of a firm is the total value of its underlying business operations: Enterprise Value = Market Value of Equity + Debt - Cash (2.5)

current ratio, p. 32 debt-equity ratio, p. 30 enterprise value, p. 31 growth stocks, p. 30 leverage, p. 30 liquidation value, p. 30 market-to-book ratio (price- to-book [P/B] ratio), p. 30 quick ratio, p. 32 value stocks, p. 30

MyFinanceLab Study Plan 2.3

2.4 The Income Statement Q The income statement reports the firm’s revenues and expenses, and it computes the firm’s bottom line of net income, or earnings. Q Net income is often reported on a per-share basis as the firm’s earnings per share: Earnings per Share (EPS) = Net Income/Shares Outstanding (2.8) Q We compute diluted EPS by adding to the number of shares outstanding the possible increase in the number of shares from the exercise of stock options the firm has awarded.

convertible bonds, p. 35 diluted EPS, p. 35 dilution, p. 35 earnings per share (EPS), p. 34 EBIT, p. 34 gross profit, p. 33 income statement, p. 33 net income or earnings, p. 33 operating income, p. 34 stock options, p. 35

MyFinanceLab Study Plan 2.4

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what Analysis you know, and where Chapter 2 Introduction to Financial Statement 51 to go when you need to practice. 2.5 Income Statement Analysis Q Profitability ratios show the firm’s operating or net income as a fraction of sales, and they are an indication of a firm’s efficiency and its pricing strategy. Q Asset efficiency ratios assess how efficiently the firm is using its assets by showing how many dollars of revenues the firm produces per dollar of assets. Q Working capital ratios express the firm’s working capital as a number of days of sales (for receivables) or cost of sales (for inventory or payables). Q Interest coverage ratios indicate the ratio of the firm’s income or cash flows to its interest expenses, and they are a measure of financial strength. Q Return on investment ratios, such as ROE or ROA, express the firm’s net income as a return on the book value of its equity or total assets. Q Valuation ratios compute market capitalization or enterprise value of the firm relative to its earnings or operating income. Q The P/E ratio computes the value of a share of stock relative to the firm’s EPS. P/E ratios tend to be high for fast-growing firms. Q When comparing valuation ratios, it is important to be sure both the numerator and denominator match in terms of whether they include debt.

accounts payable days, MyFinanceLab p. 37 Study Plan 2.5 accounts receivable days, p. 36 average collection period, days sales outstanding, p. 36 Dupont Identity, p. 38 EBITDA, p. 37 equity multiplier, p. 38 gross margin, p. 35 interest coverage ratio, p. 37 inventory days, p. 37 inventory turnover ratio, p. 37 net profit margin, p. 36 operating margin, p. 35 PEG ratio, p. 39 price-earnings ratio (P/E), p. 39 return on assets (ROA), p. 38 return on equity (ROE), p. 37 times interest earned (TIE) ratio, p. 37

2.6 The Statement of Cash Flows Q The statement of cash flows reports the sources and uses of the firm’s cash. It shows the adjustments to net income for non-cash expenses and changes to net working capital, as well as the cash used (or provided) from investing and financing activities.

capital expenditures, p. 44 payout ratio, p. 44 retained earnings, p. 44 statement of cash flows, p. 42

MyFinanceLab Study Plan 2.6

2.7 Other Financial Statement Information Q The management discussion and analysis section of the financial statement contains management’s overview of the firm’s performance, as well as disclosure of risks the firm faces, including those from offbalance sheet transactions. Q The statement of stockholders’ equity breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing new shares versus retained earnings. It is not particularly useful for financial valuation purposes. Q The notes to a firm’s financial statements generally contain important details regarding the numbers used in the main statements.

management discussion and analysis (MD&A), p. 45 off-balance sheet transactions, p. 45 statement of stockholders’ equity, p. 46

MyFinanceLab Study Plan 2.7

Here is what you know after reading this chapter. MyFinanceLab will help you identify what you know, and where 52 Partshould 1 Introduction to go when you need to practice. 2.8 Financial Reporting in Practice Q Recent accounting scandals have drawn attention to the importance of financial statements. New legislation has increased the penalties for fraud, and tightened the procedures firms must use to ensure that statements are accurate.

Critical Thinking

Sarbanes-Oxley Act (SOX), p. 47

MyFinanceLab Study Plan 2.8

1. Why do firms disclose financial information? 2. Who reads financial statements? List at least three different categories of people. For each category, provide an example of the type of information they might be interested in and discuss why. 3. What is the purpose of the balance sheet? 4. How can you use the balance sheet to assess the health of the firm? 5. What is the purpose of the income statement? 6. How are the balance sheet and the income statement related? 7. What is the DuPont Identity and how can a financial manager use it? 8. How does the statement of cash flows differ from the income statement? 9. Can a firm with positive net income run out of cash? Explain. 10. What can you learn from management’s discussion in the financial statements or the notes to the financial statements? 11. How did accounting fraud contribute to the collapse of Enron?

Problems

All Problems are available in MyFinanceLab. An asterisk * indicates Problems with a higher level of difficulty. Firms’ Disclosure of Financial Information 1. What four financial statements can be found in a firm’s 10-K filing? What checks are there on the accuracy of these statements? 2. What is GAAP and who oversees it? 3. Confirm that you can find the most recent financial statements for Starbucks Corporation (SBUX) using the following sources: a. From the company’s Web page (www.starbucks.com). (Hint: Search for “investor relations.”) b. From the SEC Web site (www.sec.gov). (Hint: Search for company filings in the EDGAR database.) c. From the Yahoo! Finance Web site (finance.yahoo.com). d. From at least one other source. (Hint: Enter “SBUX 10K” at www.bing.com.) The Balance Sheet 4. Consider the following potential events that might have occurred to Global on December 30, 2010. For each one, indicate which line items in Global’s balance sheet

Chapter 2 Introduction to Financial Statement Analysis

53

would be affected and by how much. Also indicate the change to Global’s book value of equity. a. Global used $20 million of its available cash to repay $20 million of its long-term debt. b. A warehouse fire destroyed $5 million worth of uninsured inventory. c. Global used $5 million in cash and $5 million in new long-term debt to purchase a $10 million building. d. A large customer owing $3 million for products it already received declared bankruptcy, leaving no possibility that Global would ever receive payment. e. Global’s engineers discover a new manufacturing process that will cut the cost of its flagship product by over 50%. f. A key competitor announces a radical new pricing policy that will drastically undercut Global’s prices. 5. What was the change in Global’s book value of equity from 2009 to 2010 according to Table 2.1? Does this imply that the market price of Global’s shares increased in 2010? Explain. 6. Use Google Finance (www.google.com/finance) to find the balance sheet data for Qualcomm as of the end of 2009. a. How much did Qualcomm have in cash and short-term investments? b. What were Qualcomm’s total accounts receivable? c. What were Qualcomm’s total assets? d. What were Qualcomm’s total liabilities? How much of this was long-term debt? e. What was the book value of Qualcomm’s equity? 7. Find the annual 10-K report for Peet’s Coffee and Tea (PEET) online, filed for 2008 (filed in early 2009). Answer the following questions from its balance sheet: a. How much cash did Peet’s have at the end of 2008? b. What were Peet’s total assets? c. What were Peet’s total liabilities? How much debt did Peet’s have? d. What was the book value of Peet’s equity? Balance Sheet Analysis 8. In June 2007, General Electric (GE) had a book value of equity of $117 billion, 10.3 billion shares outstanding, and a market price of $38.00 per share. GE also had cash of $16 billion, and total debt of $467 billion. a. What was GE’s market capitalization? What was GE’s market-to-book ratio? b. What was GE’s book debt-equity ratio? What was GE’s market debt-equity ratio? c. What was GE’s enterprise value? 9. In July 2007, Apple had cash of $7.12 billion, current assets of $18.75 billion, and current liabilities of $6.99 billion. It also had inventories of $0.25 billion. a. What was Apple’s current ratio? b. What was Apple’s quick ratio? c. In July 2007, Dell had a quick ratio of 1.25 and a current ratio of 1.30. What can you say about the asset liquidity of Apple relative to Dell? 10. In April 2010, the following information was true about Abercrombie and Fitch (ANF) and The Gap (GPS), both clothing retailers. Values (except price per share) are in millions of dollars.

ANF GPS

Book Equity

Price Per Share

Number of Shares

1,788 4,769

46.67 25.00

88.17 667.42

54

Part 1 Introduction a. What is the market-to-book ratio of each company? b. What conclusions do you draw from comparing the two ratios? The Income Statement and Income Statement Analysis 11. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008. Answer the following questions from the income statement: a. What were Peet’s revenues for 2008? By what percentage did revenues grow from 2007? b. What were Peet’s operating and net profit margins in 2008? How do they compare with its margins in 2007? c. What were Peet’s diluted earnings per share in 2008? What number of shares is this EPS based on? 12. Local Co. has sales of $10 million and cost of sales of $6 million. Its selling, general and administrative expenses are $500,000 and its research and development is $1 million. It has annual depreciation charges of $1 million and a tax rate of 35%. a. What is Local’s gross margin? b. What is Local’s operating margin? c. What is Local’s net profit margin? 13. If Local Co., the company in Problem 12, had an increase in selling expenses of $300,000, how would that affect each of its margins? 14. If Local Co., the company in Problem 12, had interest expense of $800,000, how would that affect each of its margins? 15. Chutes & Co. has interest expense of $1 million and an operating margin of 10% on total sales of $30 million. What is Chutes’ interest coverage ratio? 16. Ladders, Inc. has a net profit margin of 5% on sales of $50 million. It has book value of equity of $40 million and total liabilities with a book value of $30 million. What is Ladders’ ROE? ROA? 17. JPJ Corp has sales of $1 million, accounts receivable of $50,000, total assets of $5 million (of which $3 million are fixed assets), inventory of $150,000, and cost of goods sold of $600,000. What is JPJ’s accounts receivable days? Fixed asset turnover? Total asset turnover? Inventory turnover? 18. If JPJ Corp (the company from the previous question) is able to increase sales by 10% but keep its total and fixed asset growth to only 5%, what will its new asset turnover ratios be? *19. Suppose that in 2010, Global launched an aggressive marketing campaign that boosted sales by 15%. However, their operating margin fell from 5.57% to 4.50%. Suppose that they had no other income, interest expenses were unchanged, and taxes were the same percentage of pretax income as in 2009. a. What was Global’s EBIT in 2010? b. What was Global’s income in 2010? c. If Global’s P/E ratio and number of shares outstanding remained unchanged, what was Global’s share price in 2010? 20. Suppose a firm’s tax rate is 35%. a. What effect would a $10 million operating expense have on this year’s earnings? What effect would it have on next year’s earnings? b. What effect would a $10 million capital expense have on this year’s earnings, if the capital is depreciated at a rate of $2 million per year for five years? What effect would it have on next year’s earnings?

Chapter 2 Introduction to Financial Statement Analysis

55

21. You are analyzing the leverage of two firms and you note the following (all values in millions of dollars): Firm A Firm B

a. b. c. d.

Debt

Book Equity

Market Equity

Operating Income

Interest Expense

500 80

300 35

400 40

100 8

50 7

What is the market debt-to-equity ratio of each firm? What is the book debt-to-equity ratio of each firm? What is the interest coverage ratio of each firm? Which firm will have more difficulty meeting its debt obligations?

22. For 2010, Wal-Mart and Target had the following information (all values are in millions of dollars):

Wal-Mart Target

Sales (Income Statement)

Cost of Goods Sold (Income Statement)

Accounts receivable (Balance Sheet)

Inventory (Balance Sheet)

408,214 65,357

304,657 45,583

4,144 6,966

30,254 7,179

a. What is each company’s accounts receivable days? b. What is each company’s inventory turnover? c. Which company is managing its accounts receivable and inventory more efficiently? *23. Quisco Systems has 6.5 billion shares outstanding and a share price of $18.00. Quisco is considering developing a new networking product in-house at a cost of $500 million. Alternatively, Quisco can acquire a firm that already has the technology for $900 million worth (at the current price) of Quisco stock. Suppose that absent the expense of the new technology, Quisco will have EPS of $0.80. a. Suppose Quisco develops the product in house. What impact would the development cost have on Quisco’s EPS? Assume all costs are incurred this year and are treated as an R&D expense, Quisco’s tax rate is 35%, and the number of shares outstanding is unchanged. b. Suppose Quisco does not develop the product in house but instead acquires the technology. What effect would the acquisition have on Quisco’s EPS this year? (Note that acquisition expenses do not appear directly on the income statement. Assume the acquired firm has no revenues or expenses of its own, so that the only effect on EPS is due to the change in the number of shares outstanding.) c. Which method of acquiring the technology has a smaller impact on earnings? Is this method cheaper? Explain. 24. In January 2009, American Airlines (AMR) had a market capitalization of $1.7 billion, debt of $11.1 billion, and cash of $4.6 billion. American Airlines had revenues of $23.8 billion. British Airways (BABWF) had a market capitalization of $2.2 billion, debt of $4.7 billion, cash of $2.6 billion, and revenues of $13.1 billion. a. Compare the market capitalization-to-revenue ratio (also called the price-to-sales ratio) for American Airlines and British Airways. b. Compare the enterprise value-to-revenue ratio for American Airlines and British Airways. c. Which of these comparisons is more meaningful? Explain. *25. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008 (filed in early 2009). a. Compute Peet’s net profit margin, total asset turnover, and equity multiplier. b. Verify the DuPont Identity for Peet’s ROE. c. If Peet’s managers wanted to increase its ROE by 1 percentage point, how much higher would their asset turnover need to be?

56

Part 1 Introduction 26. Repeat the analysis from parts a and b of the previous problem using Starbucks Corporation (SBUX) instead. Based on the DuPont Identity, what explains the difference between the two firms’ ROEs? 27. Consider a retail firm with a net profit margin of 3.5%, a total asset turnover of 1.8, total assets of $44 million, and a book value of equity of $18 million. a. What is the firm’s current ROE? b. If the firm increased its net profit margin to 4%, what would its ROE be? c. If, in addition, the firm increased its revenues by 20% (while maintaining this higher profit margin and without changing its assets or liabilities), what would its ROE be? The Statement of Cash Flows 28. Find online the 2008 annual 10-K report for Peet’s Coffee and Tea (PEET), filed in early 2009. Answer the following questions from its cash flow statement: a. How much cash did Peet’s generate from operating activities in 2008? b. What was Peet’s depreciation expense in 2008? c. How much cash was invested in new property and equipment (net of any sales) in 2008? d. How much did Peet’s raise from the sale of shares of its stock (net of any purchases) in 2008? 29. See the cash flow statement below for H. J. Heinz (HNZ) (all values in thousands of dollars) (see MyFinanceLab for the data in Excel format): a. What were Heinz’s cumulative earnings over these four quarters? What were its cumulative cash flows from operating activities?

Period Ending

29-Oct-08

30-Jul-08

30-Apr-08

30-Jan-08

228,964

194,062

218,532

75,733 (13,142) (53,218) (111,577) (114,121) (26,574)

74,570 48,826 100,732 201,725 85,028 12,692

73,173 (47,993) (84,711) 39,949 57,681 (2,097)

Total Cash Flow From Operating Activities 227,502 Investing Activities, Cash Flows Provided By or Used In Capital expenditures (82,584) Investments (5,465) Other cashflows from investing activities (108,903)

(13,935)

717,635

254,534

(41,634) 5,465 732

(100,109) (93,153) (58,069)

(69,170) (48,330) 20,652

Total Cash Flows From Investing Activities (196,952) Financing Activities, Cash Flows Provided By or Used In Dividends paid (131,483) Sale purchase of stock 78,774 Net borrowings 515,709 Other cash flows from financing activities (282)

(35,437)

(251,331)

(96,848)

(131,333) 1,210 114,766 2,000

(119,452) (76,807) (283,696) (46,234)

(121,404) (79,288) 64,885 39,763

Net income 276,710 Operating Activities, Cash Flows Provided By or Used In Depreciation 69,997 Adjustments to net income 14,359 Changes In accounts receivables (38,869) Changes in liabilities 82,816 Changes in inventories (195,186) Changes in other operating activities 17,675

Total Cash Flows From Financing Activities Effect of exchange rate changes

462,718 (119,960)

(13,357) (610)

(526,189) 32,807

(96,044) 6,890

Change In Cash and Cash Equivalents

$373,308

(63,339)

(27,078)

$68,532

Chapter 2 Introduction to Financial Statement Analysis

57

b. What fraction of the cash from operating activities was used for investment over the four quarters? c. What fraction of the cash from operating activities was used for financing activities over the four quarters? 30. Suppose your firm receives a $5 million order on the last day of the year. You fill the order with $2 million worth of inventory. The customer picks up the entire order the same day and pays $1 million up front in cash; you also issue a bill for the customer to pay the remaining balance of $4 million within 40 days. Suppose your firm’s tax rate is 0% (i.e., ignore taxes). Determine the consequences of this transaction for each of the following: a. Revenues d. Inventory b. Earnings e. Cash c. Receivables 31. Nokela Industries purchases a $40 million cyclo-converter. The cyclo-converter will be depreciated by $10 million per year over four years, starting this year. Suppose Nokela’s tax rate is 40%. a. What impact will the cost of the purchase have on earnings for each of the next four years? b. What impact will the cost of the purchase have on the firm’s cash flow for the next four years? Other Financial Statement Information 32. The balance sheet information for Clorox Co. (CLX) in 2004–2005 is shown here (all values in thousands of dollars) (see MyFinanceLab for the data in Excel format): Balance Sheet: Assets Current Assets Cash and cash equivalents Net receivables Inventory Other current assets

31-Mar-05

31-Dec-04

30-Sep-04

30-Jun-04

293,000 401,000 374,000 60,000

300,000 362,000 342,000 43,000

255,000 385,000 437,000 53,000

232,000 460,000 306,000 45,000

Total Current Assets Long-term investments Property, plant, and equipment Goodwill Other assets

1,128,000 128,000 979,000 744,000 777,000

1,047,000 97,000 991,000 748,000 827,000

1,130,000 — 995,000 736,000 911,000

1,043,000 200,000 1,052,000 742,000 797,000

Total Assets Liabilities Current Liabilities Accounts payable Short/current long-term debt Other current liabilities

3,756,000

3,710,000

3,772,000

3,834,000

876,000 410,000 —

1,467,000 2,000 —

922,000 173,000 —

980,000 288,000 —

Total Current Liabilities Long-term debt Other liabilities

1,286,000 2,381,000 435,000

1,469,000 2,124,000 574,000

1,095,000 474,000 559,000

1,268,000 475,000 551,000

4,102,000 –346,000 $3,756,000

4,167,000 –457,000 $3,710,000

2,128,000 1,644,000 $3,772,000

2,294,000 1,540,000 $3,834,000

Total Liabilities Total Stockholder Equity Total Liabilities and Stockholder Equity

58

Part 1 Introduction a. What change in the book value of Clorox’s equity took place at the end of 2004? b. Is Clorox’s market-to-book ratio meaningful? Is its book debt-equity ratio meaningful? Explain. c. Find Clorox’s other financial statements from that time online. What was the cause of the change to Clorox’s book value of equity at the end of 2004? d. Does Clorox’s book value of equity in 2005 imply that the firm is unprofitable? Explain. Financial Reporting in Practice 33. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008, filed in early 2009. a. Which auditing firm certified these financial statements? b. Which officers of Peet’s certified the financial statements?

Data Case

This is your second interview with a prestigious brokerage firm for a job as an equity analyst. You survived the morning interviews with the department manager and the vice president of equity. Everything has gone so well that they want to test your ability as an analyst. You are seated in a room with a computer and a list with the names of two companies—Caterpillar (CAT) and Microsoft (MSFT). You have 90 minutes to complete the following tasks: 1. Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from MarketWatch (www.marketwatch .com). Enter each company’s stock symbol and then go to “financials.” Copy and paste the financial statements into Excel. 2. Find historical stock prices for each firm from Yahoo! Finance (finance.yahoo.com). Enter the stock symbol, click on “Historical Prices” in the left column, and enter the proper date range to cover the last day of the month corresponding to the date of each financial statement. Use the closing stock prices (not the adjusted close). To calculate the firm’s market capitalization at each date, multiply the number of shares outstanding (see “Basic Weighted Shares Outstanding” on the income statement) by the firm’s historic stock price. 3. For each of the four years of statements, compute the following ratios for each firm: Valuation Ratios Price-earnings ratio (for EPS use diluted EPS total) Market-to-book ratio Enterprise value-to-EBITDA (For debt, include long-term and short-term debt; for cash, include marketable securities.) Profitability Ratios Operating margin (use operating income after depreciation) Net profit margin Return on equity Financial Strength Ratios Current ratio Book debt–equity ratio Market debt–equity ratio Interest coverage ratio 1 EBIT interest expense 2

Chapter 2 Introduction to Financial Statement Analysis

59

4. Obtain industry averages for each firm from Reuters.com (www.reuters.com/ finance/stocks). Enter the stock symbol at the top of the page in the “Symbol lookup” and then click on the “Financials” button, and then click on “Search”. a. Scroll down to “Valuation Ratios,” and compare each firm’s ratios to the available industry ratios for the most recent year. (Ignore the “Company” column as your calculations will be different.) b. Analyze the performance of each firm versus the industry and comment on any trends in each individual firm’s performance. Identify any strengths or weaknesses you find in each firm. 5. Examine the market-to-book ratios you calculated for each firm. Which, if either, of the two firms can be considered “growth firms” and which, if either, can be considered “value firms”? 6. Compare the valuation ratios across the two firms. How do you interpret the difference between them? 7. Consider the enterprise value of both firms for each of the four years. How have the values of both firms changed over the time period?

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Interest Rates and Valuing Cash Flows

PART

2

Valuation Principle Connection. In this part of the text, we introduce

Chapter 3

the basic tools for making financial decisions. Chapter 3 presents the most important

Time Value of Money: An Introduction

idea in this book, the Valuation Principle. The Valuation Principle states that we can use market prices to determine the value of an investment opportunity to the firm. As we progress through our study of corporate finance, we will demonstrate that the Valuation Principle is the one unifying principle that underlies all of finance and links all the ideas throughout this book. Every day, managers in companies all over the world make financial decisions. These range from relatively minor decisions such as a local hardware store owner’s

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

determination of when to restock inventory, to major decisions such as Starbucks’ 2008 closing of over 600 stores, Microsoft’s 2008 attempt to buy Yahoo!, and Apple’s

Chapter 5

2010 launch of a tablet device called the iPad. What do these far-ranging decisions

Interest Rates

have in common? They all were made by comparing the costs of the action against the value to the firm of the benefits. Specifically, a company’s managers must

Chapter 6

determine what it is worth to the company today to receive the project’s future cash

Bonds

inflows while paying its cash outflows. In Chapter 3, we start to build the tools to undertake this analysis with a central concept in financial economics—the time value of money. In Chapter 4, we explain

Chapter 7

how to value any series of future cash flows and derive a few useful shortcuts for

Stock Valuation

valuing various types of cash flow patterns. Chapter 5 discusses how interest rates are quoted in the market and how to handle interest rates that compound more frequently than once per year. In Chapter 6 we will apply what we have learned about interest rates and the present value of cash flows to the task of valuing bonds. In the last chapter of this section, Chapter 7, we discuss the features of common stocks and learn how to calculate an estimate of their value.

61

Time Value of Money: An Introduction

3

LEARNING OBJECTIVES

notation

62

Q Identify the roles of financial managers and competitive markets in decision making

Q Assess the effect of interest rates on today’s value of future cash flows

Q Understand the Valuation Principle, and how it can be used to identify decisions that increase the value of the firm

Q Calculate the value of distant cash flows in the present and of current cash flows in the future

r

interest rate

C

cash flow

PV

present value

n

number of periods

FV

future value

INTERVIEW WITH

Nicole Wickswat Intel Corporation

“As a Senior Strategic Analyst in Intel Corporation’s Data Center Group, I strive to uphold the company’s finance charter by being ‘a full partner in business decisions to maximize shareholder value,’” says Nicole Wickswat, a 2006 graduate of the University of Oregon’s Business Honors Program with a degree in finance. “I work on a team with engineers and marketing people, helping them develop products for data center and cloud computer environments that are competitive, financially feasible, and provide the required return.” Nicole analyzes the potential financial impact of her group’s business decisions, evaluating the return to Intel on current and proposed products and making recommendations to management on whether they continue to add value. “A good investment decision should be aligned with the strategic objectives of the business,” she says. “We want the benefits to outweigh the associated costs, and we also take into account product launch timing and a project’s incremental financial value. Then we take a comprehensive view of the decision on the company as a whole, assessing the impact a decision would have on other products and/or groups.” Intel uses present value calculations within all business groups to compare the present values of costs and benefits that happen at different points in time. This gives management a consistent metric to compare different investments and projects, set priorities, and make tradeoffs where necessary to allocate funds to the optimal investments. The analysis continues throughout the product life cycle. “We assess the competitive landscape and determine whether the cost of adding or removing specific product features will benefit us in terms of increased market segment share, volume, and/or average selling price. We also look at whether adding the product feature negatively affects other groups or products and, if so, incorporate that into the analysis.” Nicole’s analysis helps the Data Center Group establish product cost targets that are aligned with long-term profitability goals. “These cost targets play a key role in product development decisions because they put pressure on engineers to design with profitability in mind and encourage us to get the most value out of the product line.”

University of Oregon, 2006

“A good investment decision should be aligned with the strategic objectives of the business.”

In 2009, Google decided to directly enter the mobile phone market with its own Android operating system and the Nexus One handset. How did Google’s managers decide this was the right decision for the company? Every decision has future consequences that will affect the value of the firm. These consequences will generally include both benefits and costs. For example, in addition to the up-front cost of developing its own mobile phone and software, Google will also incur ongoing costs associated with future software development for the platform, marketing efforts, and customer support for handset buyers. The benefits to Google include the revenues from the sales as well as the future licensing of its software and the value of having a direct position in the growing mobile market. This decision will increase Google’s value if these benefits outweigh the costs. More generally, a decision is good for the firm’s investors if it increases the firm’s value by providing benefits whose value exceeds the costs. But how do we compare costs and benefits that occur at different points in time, or are in different currencies, or have different risks associated with them? To make a valid comparison, we must use the tools of finance to express all costs and benefits in common terms.

63

64

Part 2 Interest Rates and Valuing Cash Flows We convert all costs and benefits into a common currency and common point of time, such as dollars today. In this chapter, we learn (1) how to use market information to evaluate costs and benefits and (2) why market prices are so important. Then, we will start to build the critical tools relating to the time value of money. These tools will allow you to correctly compare the costs and benefits of a decision no matter when they occur.

3.1

Cost-Benefit Analysis The first step in decision making is to identify the costs and benefits of a decision. In this section, we look at the role of financial managers in evaluating costs and benefits and the tools they use to quantify them.

Role of the Financial Manager A financial manager’s job is to make decisions on behalf of the firm’s investors. Our objective in this book is to explain how to make decisions that increase the value of the firm to its investors. In principal, the idea is simple and intuitive: For good decisions, the benefits exceed the costs. Of course, real-world opportunities are usually complex and the costs and benefits are often difficult to quantify. Quantifying them often means using skills from other management disciplines, as in the following examples: Marketing: to determine the increase in revenues resulting from an advertising campaign Economics: to determine the increase in demand from lowering the price of a product Organizational Behavior: to determine the effect of changes in management structure on productivity Strategy: to determine a competitor’s response to a price increase Operations: to determine production costs after the modernization of a manufacturing plant For the remainder of this text, we will assume we can rely on experts in these areas to provide this information so the costs and benefits associated with a decision have already been identified. With that task done, the financial manager’s job is to compare the costs and benefits and determine the best decision for the value of the firm.

Quantifying Costs and Benefits Any decision in which the value of the benefits exceeds the costs will increase the value of the firm. To evaluate the costs and benefits of a decision, we must value the options in the same terms—cash today. Let’s make this concrete with a simple example. Suppose a jewelry manufacturer has the opportunity to trade 200 ounces of silver for 10 ounces of gold today. An ounce of silver differs in value from an ounce of gold. Consequently, it is incorrect to compare 200 ounces to 10 ounces and conclude that the larger quantity is better. Instead, to compare the cost of the silver and the benefit of the gold, we first need to quantify their values in equivalent terms—cash today. Consider the silver. What is its cash value today? Suppose silver can be bought and sold for a current market price of $10 per ounce. Then the 200 ounces of silver we would give up has a cash value of:1

1 200 ounces of silver 2 * 1 +10/ounce of silver 2 = +2000

1

You might wonder whether commissions and other transactions costs need to be included in this calculation. For now, we will ignore transactions costs, but we will discuss their effect in later chapters.

Chapter 3 Time Value of Money: An Introduction

65

If the current market price for gold is $500 per ounce, then the 10 ounces of gold we would receive has a cash value of

1 10 ounces of gold 2 * 1 +500/ounce of gold 2 = +5000

We have now quantified the decision. The jeweler’s opportunity has a benefit of $5000 and a cost of $2000. The net benefit of the decision is +5000 - +2000 = +3000 today. The net value of the decision is positive, so by accepting the trade, the jewelry firm will be richer by $3000.

EXAMPLE 3.1 Comparing Costs and Benefits

Problem Suppose you work as a customer account manager for an importer of frozen seafood. A customer is willing to purchase 300 pounds of frozen shrimp today for a total price of $1500, including delivery. You can buy frozen shrimp on the wholesale market for $3 per pound today and arrange for delivery at a cost of $100 today. Will taking this opportunity increase the value of the firm?

Solution Q Plan To determine whether this opportunity will increase the value of the firm, we need to evaluate the benefits and the costs using market prices. We have market prices for our costs: Wholesale price of shrimp: $3/pound

Delivery cost: $100

We have a customer offering the following market price for 300 pounds of shrimp delivered: $1500. All that is left is to compare them. Q Execute The benefit of the transaction is $1500 today. The costs are (300 lbs.) * +3/lb. = +900 today for the shrimp, and $100 today for delivery, for a total cost of $1000 today. If you are certain about these costs and benefits, the right decision is obvious: You should seize this opportunity because the firm will gain +1500 - +1000 = +500. Q Evaluate Thus, taking this opportunity contributes $500 to the value of the firm, in the form of cash that can be paid out immediately to the firm’s investors.

competitive market A market in which the good can be bought and sold at the same price.

EXAMPLE 3.2 Competitive Market Prices Determine Value

Role of Competitive Market Prices. Suppose the jeweler works exclusively on silver jewelry or thinks the price of silver should be higher. Should his decision change? The answer is no—he can always make the trade and then buy silver at the current market price. Even if he has no use for the gold, he can immediately sell it for $5000, buy back the 200 ounces of silver at the current market price of $2000, and pocket the remaining $3000. Thus, independent of his own views or preferences, the value of the silver to the jeweler is $2000. Because the jeweler can both buy and sell silver at its current market price, his personal preferences or use for silver and his opinion of the fair price are irrelevant in evaluating the value of this opportunity. This observation highlights an important general principle related to goods trading in a competitive market, a market in which a good can be bought and sold at the same price. Whenever a good trades in a competitive market, that price determines the value of the good. This point is one of the central and most powerful ideas in finance. It will underlie almost every concept we develop throughout the text. Problem You have just won a radio contest and are disappointed to find out that the prize is four tickets to the Def Leppard reunion tour (face value $40 each). Not being a fan of 1980s power rock, you have no intention of going to the show. However, the radio station offers you another option: two tickets to your favorite band’s sold-out show (face value $45 each). You notice that, on eBay, tickets to the Def Leppard show are being

66

Part 2 Interest Rates and Valuing Cash Flows bought and sold for $30 apiece and tickets to your favorite band’s show are being bought and sold at $50 each. What should you do?

Solution Q Plan Market prices, not your personal preferences (or the face value of the tickets), are relevant here: 4 Def Leppard tickets at $30 apiece 2 of your favorite band’s tickets at $50 apiece You need to compare the market value of each option and choose the one with the highest market value. Q Execute The Def Leppard tickets have a total value of +120 (4 * +30) versus the $100 total value of the other 2 tickets (2 * +50). Instead of taking the tickets to your favorite band, you should accept the Def Leppard tickets, sell them on eBay, and use the proceeds to buy 2 tickets to your favorite band’s show. You’ll even have $20 left over to buy a T-shirt. Q Evaluate Even though you prefer your favorite band, you should still take the opportunity to get the Def Leppard tickets instead. As we emphasized earlier, whether this opportunity is attractive depends on its net value using market prices. Because the value of Def Leppard tickets is $20 more than the value of your favorite band’s tickets, the opportunity is appealing.

When Competitive Market Prices Are Not Available Competitive market prices allow us to calculate the value of a decision without worrying about the tastes or opinions of the decision maker. When competitive prices are not available, we can no longer do this. Prices at retail stores, for example, are one-sided: You can buy at the posted price, but you cannot sell the good to the store at that same price. We cannot use these one-sided prices to determine an exact cash value. They determine the maximum value of the good (since it can always be purchased at that price), but an individual may value it for much less depending on his or her preference for the good. Let’s consider an example. It has long been common for banks to try to entice people to open accounts by offering them something free in exchange (it used to be a toaster). In 2007 Key Bank offered college students a free iPod Nano if they

Concept Check

3.2

would open a new checking account and make two deposits. At the time, the retail price of that model of Nano was $199. Because there is no competitive market to trade iPods, the value of the Nano to you depends on whether you were going to buy one or not. If you planned to buy one anyway, then its value to you is $199, the price you would otherwise pay for it. In this case, the value of the bank’s offer is $199. But suppose you do not want or need a Nano. If you were to get it from the bank and then sell it, the value to you of taking the deal would be whatever price you could get for the Nano. For example, if you could sell the Nano for $150 to your friend, then the bank’s offer is worth $150 to you. Thus, depending on your desire to own a new Nano, the bank’s offer is worth somewhere between $150 (you don’t want a Nano) and $199 (you definitely want one).

1. When costs and benefits are in different units or goods, how can we compare them? 2. If crude oil trades in a competitive market, would an oil refiner that has a use for the oil value it differently than another investor would?

Market Prices and the Valuation Principle In the previous examples, the right decisions for the firms were clear because the costs and benefits were easy to evaluate and compare. They were easy to evaluate because we were able to use current market prices to convert them into equivalent cash values. Once we can express costs and benefits in terms of cash today, it is a straightforward process to compare them and determine whether the decision will increase the firm’s value.

Chapter 3 Time Value of Money: An Introduction

67

The Valuation Principle Our discussion so far establishes competitive market prices as the way to evaluate the costs and benefits of a decision in terms of cash today. Once we do this, it is a simple matter to determine the best decision for the firm. The best decision makes the firm and its investors wealthier, because the value of its benefits exceeds the value of its costs. We call this idea the Valuation Principle: The Valuation Principle: The value of a commodity or an asset to the firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using those market prices. When the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm. The Valuation Principle provides the basis for decision making throughout this text. In the remainder of this chapter, we apply it to decisions whose costs and benefits occur at different points in time.

EXAMPLE 3.3 Applying the Valuation Principle

Problem You are the operations manager at your firm. Due to a pre-existing contract, you have the opportunity to acquire 200 barrels of oil and 3000 pounds of copper for a total of $25,000. The current market price of oil is $90 per barrel and for copper is $3.50 per pound. You are not sure that you need all the oil and copper, so you are wondering whether you should take this opportunity. How valuable is it? Would your decision change if you believed the value of oil or copper would plummet over the next month?

Solution Q Plan We need to quantify the costs and benefits using market prices. We are comparing $25,000 with: 200 barrels of oil at $90 per barrel 3000 pounds of copper at $3.50 per pound Q Execute Using the competitive market prices we have: (200 barrels of oil) * (+90/barrel today) = +18,000 today (3000 pounds of copper) * (+3.50/pound today) = +10,500 today The value of the opportunity is the value of the oil plus the value of the copper less the cost of the opportunity, or +18,000 + +10,500 - +25,000 = +3500 today. Because the value is positive, we should take it. This value depends only on the current market prices for oil and copper. If we do not need all of the oil and copper, we can sell the excess at current market prices. Even if we thought the value of oil or copper was about to plummet, the value of this investment would be unchanged. (We can always exchange them for dollars immediately at the current market prices.) Q Evaluate Since we are transacting today, only the current prices in a competitive market matter. Our own use for or opinion about the future prospects of oil or copper do not alter the value of the decision today. This decision is good for the firm and will increase its value by $3500.

Why There Can Be Only One Competitive Price for a Good The Valuation Principle and finance in general rely on using a competitive market price to value a cost or benefit. We cannot have two different competitive market prices for the same good—otherwise we would arrive at two different values. Fortunately, powerful market forces keep competitive prices the same. To illustrate, imagine what you would do

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Law of One Price In competitive markets, securities with the same cash flows must have the same price. arbitrage The practice of buying and selling equivalent goods to take advantage of a price difference. arbitrage opportunity Any situation in which it is possible to make a profit without taking any risk or making any investment.

if you saw gold simultaneously trading for two different prices. You and everyone else who noticed the difference would buy at the low price and sell at the high price for as many ounces of gold as possible, making instant risk-free profits. The flood of buy and sell orders would push the two prices together until the profit was eliminated. These forces establish the Law of One Price, which states that in competitive markets, the same good or securities must have the same price. More generally, securities that produce exactly the same cash flows must have the same price. In general, the practice of buying and selling equivalent goods in different markets to take advantage of a price difference is known as arbitrage. We refer to any situation in which it is possible to make a profit without taking any risk or making any investment as an arbitrage opportunity. Because an arbitrage opportunity’s benefits are more valuable than its costs, whenever an arbitrage opportunity appears in financial markets, investors will race to take advantage of it and their trades will eliminate the opportunity. Retail stores often quote different prices for the same item in different countries. Here, we compare prices for the iPod Shuffle as of April 2010. The price in the local currency and converted to U.S. dollars is listed. Of course, these prices are not examples of competitive market prices, because you can only buy the iPod at these prices. Hence they do not present an arbitrage opportunity. Even if shipping were free, you could buy as many Shuffles as you could get your hands on in Hong Kong but you would not necessarily be able to sell them in São Paulo for a profit. City

Local Cost

US$ Cost

HK$448 $58 Hong Kong New York $59 $59 Tokyo ¥5800 $62 London £46 $71 Melbourne A$79 $73 Frankfurt :55 $75 Brussels :55 $75 Paris :59 $80 Rome :61 $83 São Paulo R$259 $147 Sources: Apple.com for prices and Citibank for exchange rates.

Your Personal Financial Decisions While the focus of this text is on the decisions a financial manager makes in a business setting, you will soon see that concepts and skills you will learn here apply to personal decisions as well. As a normal part of life we all make decisions that trade off benefits and costs across time. Going to college, purchasing this book, saving for a new car or

Concept Check

3.3

house down payment, taking out a car loan or home loan, buying shares of stock, and deciding between jobs are just a few examples of decisions you have faced or could face in the near future. As you read through this book, you will see that the Valuation Principle is the foundation of all financial decision making—whether in a business or in a personal context.

3. How do investors’ profit motives keep competitive market prices correct? 4. How do we determine whether a decision increases the value of the firm?

The Time Value of Money and Interest Rates Unlike the examples presented so far, most financial decisions have costs and benefits that occur at different points in time. For example, typical investment projects incur costs up

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front and provide benefits in the future. In this section, we show how to account for this time difference when using the Valuation Principle to make a decision.

The Time Value of Money Consider a firm’s investment opportunity with the following cash flows: Cost: $100,000 today Benefit: $105,000 in one year

time value of money The difference in value between money received today and money received in the future; also, the observation that two cash flows at two different points in time have different values.

FIGURE 3.1 Converting Between Dollars Today and Gold or Dollars in the Future

Both are expressed in dollar terms. Are the cost and benefit directly comparable? No. Calculating the project’s net value as +105,000 - +100,000 = +5000 is incorrect because it ignores the timing of the costs and benefits. That is, it treats money today as equivalent to money in one year. Just like silver and gold, money today and money tomorrow are not the same thing. We compare them just like we did with silver and gold—using competitive market prices. But in the case of money, what is the price? It is the interest rate, the price for exchanging money today for money in a year. We can use the interest rate to determine values in the same way we used competitive market prices. In general, a dollar received today is worth more than a dollar received in one year: If you have $1 today, you can invest it now and have more money in the future. For example, if you deposit it in a bank account paying 10% interest, you will have $1.10 at the end of one year. We call the difference in value between money today and money in the future the time value of money. Today

One Year

$100,000

$105,000

$1.00

$1.10

Figure 3.1 illustrates how we use competitive market prices and interest rates to convert between dollars today and other goods, or dollars in the future. Once we quantify all the costs and benefits of an investment in terms of dollars today, we can rely on the Valuation Principle to determine whether the investment will increase the firm’s value.

We can convert dollars today to different goods or points in time by using the competitive market price or interest rate. Once values are in equivalent terms, we can use the Valuation Principle to make a decision.

Gold Price ($/oz) Ounces of Gold Today Gold Price ($/oz)

Dollars Today

with interest Dollars in One Year before interest

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The Interest Rate: Converting Cash Across Time

interest rate The rate at which money can be borrowed or lent over a given period. interest rate factor One plus the interest rate, it is the rate of exchange between dollars today and dollars in the future. It has units of “$ in the future/$ today.”

We now develop the tools needed to value our $100,000 investment opportunity correctly. By depositing money into a savings account, we can convert money today into money in the future with no risk. Similarly, by borrowing money from the bank, we can exchange money in the future for money today. The rate at which we can exchange money today for money in the future is determined by the current interest rate. In the same way that an exchange rate allows us to convert money from one currency to another, the interest rate allows us to convert money from one point in time to another. In essence, an interest rate is like an exchange rate across time: It tells us the market price today of money in the future. Suppose the current annual interest rate is 10%. By investing $1 today we can convert this $1 into $1.10 in one year. Similarly, by borrowing at this rate, we can exchange $1.10 in one year for $1 today. More generally, we define the interest rate, r, for a given period as the interest rate at which money can be borrowed or lent over that period. In our example, the interest rate is 10% and we can exchange 1 dollar today for 1 1 + .10 2 dollars in one year. In general, we can exchange 1 dollar today for 1 1 + r 2 dollars in one year, and vice versa. We refer to 1 1 + r 2 as the interest rate factor for cash flows; it defines how we convert cash flows across time, and has units of “$ in one year/$ today.” Like other market prices, the interest rate ultimately depends on supply and demand. In particular, the interest rate equates the supply of savings to the demand for borrowing. But regardless of how it is determined, once we know the interest rate, we can apply the Valuation Principle and use it to evaluate other decisions in which costs and benefits are separated in time. Value of $100,000 Investment in One Year. Let’s reevaluate the investment we considered earlier, this time taking into account the time value of money. If the interest rate is 10%, we can express the cost of the investment as: Cost = 1 +100,000 today 2 * 1 1.10 dollars in one year/1 dollar today 2 = +110,000 in one year Think of this amount as the opportunity cost of spending $100,000 today: The firm gives up the $110,000 it would have had in one year if it had left the money in the bank. Alternatively, by borrowing the $100,000 from the same bank, the firm would owe $110,000 in one year.

Investment Bank

Today

One Year

$100,000 $100,000

$105,000 $110,000

We have used a market price, the interest rate, to put both the costs and benefits in terms of “dollars in one year,” so now we can use the Valuation Principle to compare them and compute the investment’s net value by subtracting the cost of the investment from the benefit in one year: +105,000 - +110,000 = - +5000 in one year In other words, the firm could earn $5000 more in one year by putting the $100,000 in the bank rather than making this investment. Because the net value is negative, we should reject the investment: If we took it, the firm would be $5000 poorer in one year than if we didn’t.

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Value of $100,000 Investment Today. The preceding calculation expressed the value of the costs and benefits in terms of dollars in one year. Alternatively, we can use the interest rate factor to convert to dollars today. Consider the benefit of $105,000 in one year. What is the equivalent amount in terms of dollars today? That is, how much would we need to have in the bank today so we end up with $105,000 in the bank in one year? We find this amount by dividing $105,000 by the interest rate factor: Benefit = 1 +105,000 in one year 2 1 +1.10 in one year/+1 today 2 = +95,454.55 today

This is also the amount the bank would lend to us today if we promised to repay $105,000 in one year.2 Thus, it is the competitive market price at which we can “buy” or “sell” $105,000 in one year. Today Value of Cost Today Value of Benefit Today

One Year

$100,000 $95,454.55

$105,000 105,000 1.10

Now we are ready to compute the net value of the investment by subtracting the cost from the benefit: +95,454.55 - +100,000 = - +4,545.45 today Because this net value is calculated in terms of dollars today (in the present), it is typically called the net present value. We will formally introduce this concept in Chapter 8. Once again, the negative result indicates that we should reject the investment. Taking the investment would make the firm $4,545.45 poorer today because it gave up $100,000 for something worth only $95,454.55. Present Versus Future Value. This calculation demonstrates that our decision is the same whether we express the value of the investment in terms of dollars in one year or dollars today: We should reject the investment. Indeed, if we convert from dollars today to dollars in one year, present value (PV) The value of a cost or benefit computed in terms of cash today. future value (FV) The value of a cash flow that is moved forward in time.

discount factor The value today of a dollar received in the future. discount rate The appropriate rate to discount a cash flow to determine its value at an earlier time.

1 - +4545.45 today 2 * 1 +1.10 in one year/+1 today 2 = - +5000 in one year

we see that the two results are equivalent, but expressed as values at different points in time. When we express the value in terms of dollars today, we call it the present value (PV) of the investment. If we express it in terms of dollars in the future, we call it the future value (FV) of the investment. Discount Factors and Rates. In the preceding calculation, we can interpret 1 1 = = 0.90909 1 + r 1.10 as the price today of $1 in one year. In other words, for just under 91 cents, you can “buy” $1 to be delivered in one year. Note that the value is less than $1—money in the future is worth less today, so its price reflects a discount. Because it provides the discount at which we can purchase money in the future, the amount 1/ 1 1 + r 2 is called the oneyear discount factor. The interest rate is also referred to as the discount rate for an investment. 2

We are assuming the bank is willing to lend at the same 10% interest rate, which would be the case if there were no risk associated with the cash flow.

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EXAMPLE 3.4 Comparing Revenues at Different Points in Time

Problem The launch of Sony’s PlayStation 3 was delayed until November 2006, giving Microsoft’s Xbox 360 a full year on the market without competition. Imagine that it is November 2005 and you are the marketing manager for the PlayStation. You estimate that if PlayStation 3 were ready to be launched immediately, you could sell $2 billion worth of the console in its first year. However, if your launch is delayed a year, you believe that Microsoft’s head start will reduce your first-year sales by 20%. If the interest rate is 8%, what is the cost of a delay of the first year’s revenues in terms of dollars in 2005?

Solution Q Plan Revenues if released today: $2 billion

Revenue decrease if delayed: 20%

Interest rate: 8%

We need to compute the revenues if the launch is delayed and compare them to the revenues from launching today. However, in order to make a fair comparison, we need to convert the future revenues of the PlayStation if they are delayed into an equivalent present value of those revenues today. Q Execute If the launch is delayed to 2006, revenues will drop by 20% of $2 billion, or $400 million, to $1.6 billion. To compare this amount to revenues of $2 billion if launched in 2005, we must convert it using the interest rate of 8%: +1.6 billion in 2006 (+1.08 in 2006/+1 in 2005) = +1.481 billion in 2005 Therefore, the cost of a delay of one year is +2 billion - +1.481 billion = +0.519 billion (+519 million). Q Evaluate Delaying the project for one year was equivalent to giving up $519 million in cash. In this example, we focused only on the effect on the first year’s revenues. However, delaying the launch delays the entire revenue stream by one year, so the total cost would be calculated in the same way by summing the cost of delay for each year of revenues.

Timelines timeline A linear representation of the timing of (potential) cash flows.

Our visual representation of the cost and benefit of the $100,000 investment in this section is an example of a timeline, a linear representation of the timing of the expected cash flows. Timelines are an important first step in organizing and then solving a financial problem. We use them throughout this text. Constructing a Timeline. To understand how to construct a timeline, assume a friend owes you money. He has agreed to repay the loan by making two payments of $10,000 at the end of each of the next two years. We represent this information on a timeline as follows: Year 1

Year 2

Date 0 Cash Flow $0 Today

1

2

$10,000

$10,000

End Year 1

Begin Year 2

Identifying Dates on a Timeline. To track cash flows, we interpret each point on the timeline as a specific date. The space between date 0 and date 1 represents the first year of the loan. Date 0 is today, the beginning of the first year, and date 1 is the end of the first year. The $10,000 cash flow below date 1 is the payment you will receive at the end of the first year. Similarly, date 1 is the beginning of the second year, date 2 is the end of the

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second year, and the $10,000 cash flow below date 2 is the payment you will receive at the end of the second year. Note that date 1 signifies both the end of year 1 and the beginning of year 2, which makes sense since those dates are effectively the same point in time.3 Distinguishing Cash Inflows from Outflows. In this example, both cash flows are inflows. In many cases, however, a financial decision will include inflows and outflows. To differentiate between the two types of cash flows, we assign a different sign to each: Inflows (cash flows received) are positive cash flows, whereas outflows (cash flows paid out) are negative cash flows. To illustrate, suppose you have agreed to lend your brother $10,000 today. Your brother has agreed to repay this loan with interest by making payments of $6000 at the end of each of the next two years. The timeline is: Year 1 Date

0

Cash Flow $10,000

Year 2 1

2

$6000

$6000

Notice that the first cash flow at date 0 (today) is represented as –$10,000 because it is an outflow. The subsequent cash flows of $6000 are positive because they are inflows. Representing Various Time Periods. So far, we have used timelines to show the cash flows that occur at the end of each year. Actually, timelines can represent cash flows that take place at any point in time. For example, if you pay rent each month, you could use a timeline such as the one in our first example to represent two rental payments, but you would replace the “year” label with “month.” Many of the timelines included in this chapter are simple. Consequently, you may feel that it is not worth the time or trouble to construct them. As you progress to more difficult problems, however, you will find that timelines identify events in a transaction or investment that are easy to overlook. If you fail to recognize these cash flows, you will make flawed financial decisions. Therefore, approach every problem by drawing the timeline as we do in this chapter and the next.

Concept Check

3.4

5. How is an interest rate like a price? 6. Is the value today of money to be received in one year higher when interest rates are high or when interest rates are low?

Valuing Cash Flows at Different Points in Time The example of the $100,000 investment in the previous section laid the groundwork for how we will compare cash flows that happen at different points in time. In this section, we will generalize from the example by introducing three important rules central to financial decision making that allow us to compare or combine values across time.

Rule 1: Comparing and Combining Values Our first rule is that it is only possible to compare or combine values at the same point in time. This rule restates a conclusion from the last section: Only cash flows in the same

3

That is, there is no real time difference between a cash flow paid at 11:59 P.M. on December 31 and one paid at 12:01 A.M. on January 1, although there may be some other differences such as taxation, which we will overlook for now.

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Part 2 Interest Rates and Valuing Cash Flows units can be compared or combined. A dollar today and a dollar in one year are not equivalent. Having money now is more valuable than having money in the future; if you have the money today you can earn interest on it.

COMMON MISTAKE

Summing Cash Flows Across Time the payments Rodriguez would receive over the ten years of the contract and an additional ten years of deferred payments— treating dollars received in 20 years the same as dollars received today. The same thing occurred when David Beckham signed a “$250 million” contract with the LA Galaxy soccer team.

Once you understand the time value of money, our first rule may seem straightforward. However, it is very common, especially for those who have not studied finance, to violate this rule, simply treating all cash flows as comparable regardless of when they are received. One example is in sports contracts. In 2007, Alex Rodriguez and the New York Yankees were negotiating what was repeatedly referred to as a “$275 million” contract. The $275 million comes from simply adding up all

To compare or combine cash flows that occur at different points in time, you first need to convert the cash flows into the same units by moving them to the same point in time. The next two rules show how to move the cash flows on the timeline.

Rule 2: Compounding Suppose we have $1000 today, and we wish to determine the equivalent amount in one year’s time. If the current market interest rate is 10%, we saw in the last section that we can use that rate as an exchange rate, meaning the rate at which we exchange money today for money in one year, to move the cash flow forward in time. That is:

1 +1000 today 2 * 1 +1.10 in one year/+1 today 2 = +1100 in one year

compounding Computing the return on an investment over a long horizon by multiplying the return factors associated with each intervening period.

In general, if the market interest rate for the year is r, then we multiply by the interest rate factor, 1 1 + r 2 , to move the cash flow from the beginning to the end of the year. We multiply by 1 1 + r 2 because at the end of the year you will have 1 1 * your original investment 2 plus interest in the amount of 1 r * your original investment 2 . This process of moving forward along the timeline to determine a cash flow’s value in the future (its future value) is known as compounding. Our second rule stipulates that to calculate a cash flow’s future value, you must compound it. We can apply this rule repeatedly. Suppose we want to know how much the $1000 is worth in two years’ time. If the interest rate for year 2 is also 10%, then we convert as we just did:

1 +1100 in one year 2 * 1 +1.10 in two years/+1 in one year 2 = +1210 in two years

Let’s represent this calculation on a timeline: 0 $1000

1 1.10

$1100

2 1.10

$1210

Chapter 3 Time Value of Money: An Introduction

FIGURE 3.2 The Composition of Interest over Time

Given a 10% interest rate, all of the cash flows—$1000 at date 0, $1100 at date 1, and $1210 at date 2—are equivalent. They have the same value but are expressed in different units (different points in time). An arrow that points to the right indicates that the value is being moved forward in time—that is, compounded. In the preceding example, $1210 is the future value of $1000 two years from today. Note that the value grows as we move the cash flow further in the future. In the last section, we defined the time value of money as the difference in value between money today and money in the future. Here, we can say that $1210 in two years is the equivalent amount to $1000 today. The reason money is more valuable to you today is that you have opportunities to invest it. As in this example, by having money sooner, you can invest it (here at a 10% return) so that it will grow to a larger amount of money in the future. Note also that the equivalent amount grows by $100 the first year, but by $110 the second year. In the second year, we earn interest on our original $1000, plus we earn interest on the $100 interest we received in the first year. This effect of earning interest on both the original principal plus the accumulated interest, so that you are earning “interest on interest,” is known as compound interest. Figure 3.2 shows how over time the amount of money you earn from interest on interest grows so that it will eventually exceed the amount of money that you earn as interest on your original deposit.

This bar graph shows how the account balance and the composition of the interest changes over time when an investor starts with an original deposit of $1000, represented by the red area, in an account earning 10% interest over a 20-year period. Note that the turquoise area representing interest on interest grows, and by year 15 has become larger than the interest on the original deposit, shown in green. By year 20, the interest on interest the investor earned is $3727.50, while the interest earned on the original $1000 is $2000.

$8000 7000 6000

Total Future Value

compound interest The effect of earning “interest on interest.”

75

Interest on interest

5000 4000 3000

Interest on the original $1000

2000 1000

Original $1000 0

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year

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Part 2 Interest Rates and Valuing Cash Flows How does the future value change in the third year? Continuing to use the same approach, we compound the cash flow a third time. Assuming the competitive market interest rate is fixed at 10%, we get: +1000 * 1 1.10 2 * 1 1.10 2 * 1 1.10 2 = +1000 * 1 1.10 2 3 = +1331

In general, to compute a cash flow C’s value n periods into the future, we must compound it by the n intervening interest rate factors. If the interest rate r is constant, this calculation yields: Future Value of a Cash Flow FVn = C * 1 1 + r 2 * 1 1 + r 2 * g * 1 1 + r 2 = C * 1 1 + r 2 n (3.1) ('''''''')''''''''* n times

Rule of 72

Another way to think about the effect of compounding is to consider how long it will take your money to double given different interest rates. Suppose you want to know how many years it will take for $1 to grow to a future value of $2. You want the number of years, n, to solve: FVn = +1 * 1 1 + r 2 n = +2

If you solve this formula for different interest rates, you will find

the following approximation: Years to double ⬇ 72 (interest rate in percent) This simple “Rule of 72” is fairly accurate (that is, within one year of the exact doubling time) for interest rates higher than 2%. For example, if the interest rate is 9%, the doubling time should be about 72 9 = 8 years. Indeed, 1.098 = 1.99! So, given a 9% interest rate, your money will approximately double every 8 years.

Rule 3: Discounting The third rule describes how to put a value today on a cash flow that comes in the future. Suppose you would like to compute the value today of $1000 that you anticipate receiving in one year. If the current market interest rate is 10%, you can compute this value by converting units as we did in the last section:

1 +1000 in one year 2 1 +1.10 in one year/+1 today 2 = +909.09 today

discounting Finding the equivalent value today of a future cash flow by multiplying by a discount factor, or equivalently, dividing by 1 plus the discount rate.

That is, to move the cash flow back along the timeline, we divide it by the interest rate factor, 1 1 + r 2 , where r is the interest rate. This process of finding the equivalent value today of a future cash flow is known as discounting. Our third rule stipulates that to calculate the value of a future cash flow at an earlier point in time, we must discount it. Suppose that you anticipate receiving the $1000 two years from today rather than in one year. If the interest rate for both years is 10%, you can prepare the following timeline: 0 $826.45

1 1.10

$909.09

2 1.10

$1000

When the interest rate is 10%, all of the cash flows—$826.45 at date 0, $909.09 at date 1, and $1000 at date 2—are equivalent. They represent the same value in different units (different points in time). The arrow points to the left to indicate that the value is being moved backward in time or discounted. Note that the value decreases the further in the future is the original cash flow. The value of a future cash flow at an earlier point on the timeline is its present value at the earlier point in time. That is, $826.45 is the present value at date 0 of $1000 in two years. Recall from earlier that the present value is the “do-it-yourself ” price to produce a

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future cash flow. Thus, if we invested $826.45 today for two years at 10% interest, we would have a future value of $1000, using the second rule of valuing cash flows: 0

1

$826.45

1.10

2

$909.09

1.10

$1000

Suppose the $1000 were three years away and you wanted to compute the present value. Again, if the interest rate is 10%, we have: 0 $751.31

1 1.10

2 1.10

3 1.10

$1000

That is, the present value today of a cash flow of $1000 in three years is given by:

+1000 1 1.10 2 1 1.10 2 1 1.10 2 = +1000 1 1.10 2 3 = +751.31

In general, to compute the present value of a cash flow C that comes n periods from now, we must discount it by the n intervening interest rate factors. If the interest rate r is constant, this yields: Present Value of a Cash Flow C PV = C 1 1 + r 2 n = 11 + r2n Personal Finance

EXAMPLE 3.5 Present Value of a Single Future Cash Flow

(3.2)

Problem You are considering investing in a savings bond that will pay $15,000 in ten years. If the competitive market interest rate is fixed at 6% per year, what is the bond worth today?

Solution Q Plan First, set up your timeline. The cash flows for this bond are represented by the following timeline:

0

1

2

9

10

... $15,000 Thus, the bond is worth $15,000 in ten years. To determine the value today, we compute the present value using Equation 3.2 and our interest rate of 6%. Q Execute PV =

15,000 = +8375.92 today 1.0610

Q Evaluate The bond is worth much less today than its final payoff because of the time value of money.

As we’ve seen in this section, we can compare cash flows at different points in time as long as we follow the Three Rules of Valuing Cash Flows, summarized in Table 3.1. Armed with these three rules, a financial manager can compare an investment’s costs and benefits that are spread out over time and apply the Valuation Principle to make the right decision. In the next chapter, we will show you how to apply these rules to situations involving multiple cash flows at different points in time.

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TABLE 3.1 The Three Rules of Valuing Cash Flows

Rule

Formula

1: Only values at the same point in time can be compared or combined.

None

2: To calculate a cash flow’s future value, we must compound it.

Future value of a cash flow: FVn = C * (1 + r )n

3: To calculate the present value of a future cash flow, we must discount it.

Present value of a cash flow: PV = C (1 + r )n =

C (1 + r )n

Using a Financial Calculator Financial calculators are programmed to perform most present and future value calculations. However, we recommend that you develop an understanding of the formulas before using the shortcuts. We provide a more extensive discussion of financial calculators on page 88 and in the appendix to Chapter 4, but we’ll cover the relevant functions for this chapter here. To use financial calculator functions, you always enter the known values first and then the calculator solves for the unknown. To answer Example 3.5 with a financial calculator, do the following:

Concept Calculator Key Enter

Interest Rate per Period I/Y 6

Number of Periods N 10

Recurring Payments PMT 0

Future Value FV 15000

Because you are solving for the present value (PV), press the PV key last (on an HP calculator), or press CPT then the PV key on a TI calculator. The calculator will return -8375.92. Note that the calculator balances inflows with outflows, so because the FV is positive (an inflow), it returns the PV as a negative (an outflow). If you were solving for the future value instead, you would enter:

N 10 And finally, on an HP press the

Concept Check

FV

I/Y 6 key or on a TI, press

PV 8375.92 CPT

PMT 0

and then the

FV

key.

7. Can you compare or combine cash flows at different times? 8. What do you need to know to compute a cash flow’s present or future value?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

Online Practice Opportunities

3.1 Cost-Benefit Analysis Q To evaluate a decision, we must value the incremental costs and benefits associated with that decision. A good decision is one for which the value of the benefits exceeds the value of the costs.

competitive market, p. 65

MyFinanceLab Study Plan 3.1

Chapter 3 Time Value of Money: An Introduction

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Q To compare costs and benefits that occur at different points in time we must put all costs and benefits in common terms. Typically, we convert costs and benefits into cash today. Q A competitive market is one in which a good can be bought and sold at the same price. We use prices from competitive markets to determine the cash value of a good. 3.2 Market Prices and the Valuation Principle Q Arbitrage is the process of trading to take advantage of equivalent goods that have different prices in different competitive markets. Q If equivalent goods or securities trade simultaneously in different competitive markets, they will trade for the same price in each market. This is equivalent to saying that no arbitrage opportunities should exist. Q The Valuation Principle states that the value of a commodity or an asset to the firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using those market prices. When the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm.

arbitrage, p. 68 arbitrage opportunity, p. 68 Law of One Price, p. 68 Valuation Principle, p. 67

MyFinanceLab Study Plan 3.2

3.3 The Time Value of Money and Interest Rates Q The time value of money is the difference in value between money today and money in the future. Q The rate at which we can exchange money today for money in the future by borrowing or investing is the current market interest rate. Q The present value (PV) of a cash flow is its value in terms of cash today. Q Timelines are a critical first step in organizing the cash flows in a financial problem.

discount factor, p. 71 discount rate, p. 71 future value (FV), p. 71 interest rate, p. 70 interest rate factor, p. 70 present value (PV), p. 71 time value of money, p. 69 timeline, p. 72

MyFinanceLab Study Plan 3.3

3.4 Valuing Cash Flows at Different Points in Time Q There are three rules of valuing cash flows: a. Only cash flows that occur at the same point in time can be compared or combined. b. To calculate a cash flow’s future value, you must compound it. c. To calculate a cash flow’s present value, you must discount it. Q The future value in n years of a cash flow C today is: (3.1) C * 11 + r2n Q The present value today of a cash flow C received in n years is: C 11 + r2n (3.2)

compounding, p. 74 compound interest, p. 75 discounting, p. 76

MyFinanceLab Study Plan 3.4 Financial Calculator Tutorials: Calculating the Future Value of a Lump Sum and Solving for the Present Value of a Single Future Cash Flow

80

Part 2 Interest Rates and Valuing Cash Flows

Critical Thinking

1. What makes an investment decision a good one? 2. How important are our personal preferences in valuing an investment decision? 3. Why are market prices useful to a financial manager? 4. Why is arbitrage important to competitive market prices? 5. How does the Valuation Principle help a financial manager make decisions? 6. Can we directly compare dollar amounts received at different points in time? 7. Why is a cash flow in the future worth less than the same amount today? 8. What is a discount rate? 9. What is compound interest? 10. What is the intuition behind the geometric growth in interest?

Problems

All Problems are available in MyFinanceLab. An asterisk * indicates Problems with a higher level of difficulty. Cost-Benefit Analysis 1. Honda Motor Company is considering offering a $2000 rebate on its minivan, lowering the vehicle’s price from $30,000 to $28,000. The marketing group estimates that this rebate will increase sales over the next year from 40,000 to 55,000 vehicles. Suppose Honda’s profit margin with the rebate is $6000 per vehicle. If the change in sales is the only consequence of this decision, what are its costs and benefits? Is it a good idea? 2. You are an international shrimp trader. A food producer in the Czech Republic offers to pay you 2 million Czech koruna today in exchange for a year’s supply of frozen shrimp. Your Thai supplier will provide you with the same supply for 3 million Thai baht today. If the current competitive market exchange rates are 25.50 koruna per dollar and 41.25 baht per dollar, what is the value of this exchange to you? 3. Suppose your employer offers you a choice between a $5000 bonus and 100 shares of the company’s stock. Whichever one you choose will be awarded today. The stock is currently trading for $63 per share. a. Suppose that if you receive the stock bonus, you are free to trade it. Which form of the bonus should you choose? What is its value? b. Suppose that if you receive the stock bonus, you are required to hold it for at least one year. What can you say about the value of the stock bonus now? What will your decision depend on? 4. Suppose Big Bank offers an interest rate of 5.5% on both savings and loans, and Bank Enn offers an interest rate of 6% on both savings and loans. a. What profit opportunity is available? b. Which bank would experience a surge in the demand for loans? Which bank would receive a surge in deposits? c. What would you expect to happen to the interest rates the two banks are offering? 5. If the cost of buying a CD and ripping the tracks to your iPod (including your time) is $25, what is the most Apple could charge on iTunes for a whole 15-track CD? 6. Some companies cross-list their shares, meaning that their stock trades on more than one stock exchange. For example, Research In Motion, the maker of BlackBerry

Chapter 3 Time Value of Money: An Introduction

81

mobile devices, trades on both the Toronto Stock Exchange and NASDAQ. If its price in Toronto is 50 Canadian dollars per share and anyone can exchange Canadian dollars for U.S. dollars at the rate of US$0.95 per C$1.00, what must RIM’s price be on NASDAQ? Market Prices and the Valuation Principle 7. Bubba is a shrimp farmer. In an ironic twist, Bubba is allergic to shellfish, so he cannot eat any shrimp. Each day he has a one-ton supply of shrimp. The market price of shrimp is $10,000 per ton. a. What is the value of a ton of shrimp to him? b. Would this value change if he were not allergic to shrimp? Why or why not? 8. Brett has almond orchards, but he is sick of almonds and prefers to eat walnuts instead. The owner of the walnut orchard next door has offered to swap this year’s crop with him. Assume he produces 1000 tons of almonds and his neighbor produces 800 tons of walnuts. If the market price of almonds is $100 per ton and the market price of walnuts is $110 per ton: a. Should he make the exchange? b. Does it matter whether he prefers almonds or walnuts? Why or why not? The Time Value of Money and Interest Rates 9. You have $100 and a bank is offering 5% interest on deposits. If you deposit the money in the bank, how much will you have in one year? 10. You expect to have $1000 in one year. A bank is offering loans at 6% interest per year. How much can you borrow today? 11. A friend asks to borrow $55 from you and in return will pay you $58 in one year. If your bank is offering a 6% interest rate on deposits and loans: a. How much would you have in one year if you deposited the $55 instead? b. How much money could you borrow today if you pay the bank $58 in one year? c. Should you loan the money to your friend or deposit it in the bank? 12. You plan to borrow $1000 from a bank. In exchange for $1000 today, you promise to pay $1080 in one year. What does the cash flow timeline look like from your perspective? What does it look like from the bank’s perspective? Valuing Cash Flows at Different Points in Time 13. Suppose the interest rate is 4%. a. Having $200 today is equivalent to having what amount in one year? b. Having $200 in one year is equivalent to having what amount today? c. Which would you prefer, $200 today or $200 in one year? Does your answer depend on when you need the money? Why or why not? 14. Consider the following alternatives: i. $100 received in one year ii. $200 received in 5 years iii. $300 received in 10 years a. Rank the alternatives from most valuable to least valuable if the interest rate is 10% per year. b. What is your ranking if the interest rate is only 5% per year? c. What is your ranking if the interest rate is 20% per year?

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Part 2 Interest Rates and Valuing Cash Flows *15. Suppose you invest $1000 in an account paying 8% interest per year. a. What is the balance in the account after 3 years? How much of this balance corresponds to “interest on interest”? b. What is the balance in the account after 25 years? How much of this balance corresponds to “interest on interest”? 16. Calculate the future value of $2000 in a. 5 years at an interest rate of 5% per year. b. 10 years at an interest rate of 5% per year. c. 5 years at an interest rate of 10% per year. *d. Why is the amount of interest earned in part (a) less than half the amount of interest earned in part (b)? 17. What is the present value of $10,000 received a. 12 years from today when the interest rate is 4% per year? b. 20 years from today when the interest rate is 8% per year? c. 6 years from today when the interest rate is 2% per year? 18. Your brother has offered to give you either $5000 today or $10,000 in 10 years. If the interest rate is 7% per year, which option is preferable? 19. Your cousin is currently 12 years old. She will be going to college in 6 years. Your aunt and uncle would like to have $100,000 in a savings account to fund her education at that time. If the account promises to pay a fixed interest rate of 4% per year, how much money do they need to put into the account today to ensure that they will have $100,000 in 6 years? 20. Your mom is thinking of retiring. Her retirement plan will pay her either $250,000 immediately on retirement or $350,000 five years after the date of her retirement. Which alternative should she choose if the interest rate is a. 0% per year? b. 8% per year? c. 20% per year? 21. You are planning to invest $5000 in an account earning 9% per year for retirement. a. If you put the $5000 in an account at age 23, and withdraw it 42 years later, how much will you have? b. If you wait 10 years before making the deposit, so that it stays in the account for only 32 years, how much will you have at the end? *22. Your grandfather put some money in an account for you on the day you were born. You are now 18 years old and are allowed to withdraw the money for the first time. The account currently has $3996 in it and pays an 8% interest rate. a. How much money would be in the account if you left the money there until your twenty-fifth birthday? b. What if you left the money until your sixty-fifth birthday? c. How much money did your grandfather originally put in the account?

Time Value of Money: Valuing Cash Flow Streams

4

LEARNING OBJECTIVES Q Value a series of many cash flows Q Value a perpetual series of regular cash flows called a perpetuity Q Value a common set of regular cash flows called an annuity

notation

C

cash flow

Cn

cash flow at date n

FV

future value

FVn

future value on date n

g

growth rate

Q Value both perpetuities and annuities when the cash flows grow at a constant rate Q Compute the number of periods, cash flow, or rate of return of a loan or investment

N

date of the last cash flow in a stream of cash flows

P

initial principal or deposit, or equivalent present value

PV

present value

r

interest rate or rate of return

83

INTERVIEW WITH

Gregory Goin McFee Financial Group

After receiving his degree in finance and marketing from Iowa State University in 2010, Gregory Goin joined McFee Financial Group in Minneapolis, Minnesota, a private wealth management firm. As Manager of Private Client Relations, he assists in reviewing client investment portfolios, researching new investment opportunities, and preparing client presentations. “We help our clients set goals and develop appropriate investment strategies to achieve them, including bonds, dividend-paying stocks, or stocks in companies with high growth potential,” he says. The financial plan McFee proposes takes into account the client’s age, risk tolerance, how much he or she needs for each goal, and the timeframe to accumulate the funds. “The key is to invest regularly and to reinvest the income so that your money grows even faster, thanks to compounding and time value of money.” One of the tools Greg uses to develop an investment plan for a client is time value of money (TVM). “TVM illustrates the profound impact that compounding has on your ability to achieve your future financial goals,” he says. “It tells you how much to save to reach those goals and also the impact of different rates of return. Assume that you want to buy a house in seven years and need a down payment of $35,000. TVM calculations show you how much to save each month: If you earn 5% a year on your funds, it’s about $350 a month; 7%, $325; 3%, $375.” In today’s volatile market environment, rates of return on securities are much harder to predict. “This has changed people’s view on financial planning, because the assumption of long-term savings now is a return of money (capital preservation) versus a return on money,” says Greg. Most investment professionals agree that future returns will not approach historical returns, so investors must lower their expectations. “When the actual rates of return you can earn are lower than you projected, you must invest more to reach your financial targets. This may require making lifestyle changes and lowering your standard of living to achieve financial independence.” With TVM, Greg can help McFee’s clients find realistic savings plans that will achieve their goals.

As we discussed in Chapter 3, to evaluate a project a financial manager must compare its costs and benefits. In most cases, the cash flows in financial investments involve more than one future period. Thus, the financial manager is faced with the task of trading off a known upfront cost against a series of uncertain future benefits. We learned to value those costs and benefits by computing their cash value today—their present values. In financial management, as well as your personal finances, you will need to evaluate series of cash flows occurring across time. In this chapter, we build on the tools we developed in Chapter 3 to value any series of cash flows. We will develop shortcuts for valuing annuities, perpetuities, and other special cases of assets with cash flows that follow regular patterns. In Chapter 5, we will learn how interest rates are quoted and determined. Once we understand how interest rates are quoted, it will be straightforward to extend the tools of this chapter to cash flows that occur more frequently than once per year.

84

Iowa State University, 2010

“Time value of money tells you how much to save to reach your future financial goals, and also the impact of different rates of return.”

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

4.1 stream of cash flows A series of cash flows lasting several periods.

85

Valuing a Stream of Cash Flows We refer to a series of cash flows lasting several periods as a stream of cash flows. As with single cash flows, we can represent a stream of cash flows on a timeline. In this chapter we will continue to use timelines and the rules of cash flow valuation introduced in Chapter 3 to organize and then solve financial problems.

Applying the Rules of Valuing Cash Flows to a Cash Flow Stream Most investment opportunities have multiple cash flows that occur at different points in time. In Chapter 3, we learned the rules to value such cash flows: Rule 1: Only values at the same point in time can be compared or combined. Rule 2: To calculate a cash flow’s future value, we must compound it using Eq. 3.1 from Chapter 3. (4.1) FVn = C * 1 1 + r 2 n Rule 3: To calculate the present value of a future cash flow, we must discount it using Eq. 3.2 of Chapter 3. C PV = C 1 1 + r 2 n = (4.2) 11 + r2n The rules of cash flow valuation allow us to compare and combine cash flows that occur at different points in time. Suppose we plan to save $1000 today and $1000 at the end of each of the next two years. If we earn a fixed 10% interest rate on our savings, how much will we have three years from today? Again, we start with a timeline: 0

1

2

3

$1000

$1000

$1000

?

The timeline shows the three deposits we plan to make. We need to compute their value at the end of three years. We can use the cash flow valuation rules in a number of ways to solve this problem. First, we can take the deposit at date 0 and move it forward to date 1. Because it is then in the same time period as the date 1 deposit, we can combine the two amounts to find out the total in the bank on date 1: 0

1

2

3

$1000

$1000

$1000

?

1.10

$1100 $2100

Using the first two rules, we find that our total savings on date 1 will be $2100. Continuing in this fashion, we can solve the problem as follows: 0

1

2

$1000

$1000

$1000

1.10

3

$1100 $2100 1.10

$2310 $3310 1.10

$3641

Part 2 Interest Rates and Valuing Cash Flows The total amount we will have in the bank at the end of three years is $3641. This amount is the future value of our $1000 savings deposits. Another approach to the problem is to compute the future value in year 3 of each cash flow separately. Once all three amounts are in year 3 dollars, we can then combine them. 0

1

$1000

2

1.10

$1000

3

1.10

1.10

1.10

1.10

$1000

$1331 $1210 $1100 $3641

1.10

Both calculations give the same future value of $3641. As long as we follow the rules, we get the same result. The order in which we apply the rules does not matter. The calculation we choose depends on which is more convenient for the problem at hand. Now we formalize this approach by deriving a general formula for valuing a stream of cash flows. Consider a stream of cash flows: C0 at date 0, C1 at date 1, and so on, up to CN at date N. We represent this cash flow stream on a timeline as follows: 0

1

2

N ...

C0

C1

C2

CN

Using the rules of cash flow valuation, we compute the present value of this cash flow stream in two steps. First, we compute the present value of each individual cash flow. Then, once the cash flows are in common units of dollars today, we can combine them. For a given interest rate r, we represent this process on the timeline as follows: 1

0

2

N ...

C0

C2

C1

C1 —–—– (1 r)

CN

(1 r)

C2 —–—— (1 r)2

(1 r)2

...

86

CN (1 r)N

————–—

C0

(1 r)N

C1 C2 CN —–—— —–—— . . . ———–—— (1 r) (1 r) 2 (1 r)N

This timeline provides the general formula for the present value of a cash flow stream: PV = C0 +

C1 C2 CN + + g + 11 + r2 11 + r22 11 + r2N

(4.3)

That is, the present value of the cash flow stream is the sum of the present values of each cash flow. Recall from Chapter 3 that we defined the present value as the dollar amount you would need to invest today to produce the single cash flow in the future. The same

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

87

idea holds in this context. The present value is the amount you need to invest today to generate the cash flows stream C0 , C1 , p , CN . That is, receiving those cash flows is equivalent to having their present value in the bank today. Personal Finance

EXAMPLE 4.1 Present Value of a Stream of Cash Flows

Problem You have just graduated and need money to buy a new car. Your rich Uncle Henry will lend you the money so long as you agree to pay him back within four years, and you offer to pay him the rate of interest that he would otherwise get by putting his money in a savings account. Based on your earnings and living expenses, you think you will be able to pay him $5000 in one year, and then $8000 each year for the next three years. If Uncle Henry would otherwise earn 6% per year on his savings, how much can you borrow from him?

Solution Q Plan The cash flows you can promise Uncle Henry are as follows: 0

1

2

3

4

$5000

$8000

$8000

$8000

How much money should Uncle Henry be willing to give you today in return for your promise of these payments? He should be willing to give you an amount that is equivalent to these payments in present value terms. This is the amount of money that it would take him to produce these same cash flows. We will (1) solve the problem using Equation 4.3 and then (2) verify our answer by calculating the future value of this amount. Q Execute 1. We can calculate the PV as follows: 5000 8000 8000 8000 + + + 1.06 1.062 1.063 1.064 = 4716.98 + 7119.97 + 6716.95 + 6336.75

PV =

= +24,890.65 Now suppose that Uncle Henry gives you the money, and then deposits your payments to him in the bank each year. How much will he have four years from now? We need to compute the future value of the annual deposits. One way to do so is to compute the bank balance each year: 0

1

2

3

4

$5000

$8000

$8000

$8000

1.06

$5300 $13,300

1.06

$14,098 $22,098

1.06

$23,423.88 $31,423.88

2. To verify our answer, suppose your uncle kept his $24,890.65 in the bank today earning 6% interest. In four years he would have: FV = +24,890.65 * 1 1.06 2 4 = +31,423.87 in 4 years

We get the same answer both ways (within a penny, which is because of rounding). Q Evaluate Thus, Uncle Henry should be willing to lend you $24,890.65 in exchange for your promised payments. This amount is less than the total you will pay him 1 +5000 + +8000 + +8000 + +8000 = +29,000 2 due to the time value of money.

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Part 2 Interest Rates and Valuing Cash Flows Example 4.1 illustrates that if you want to compute the future value of a stream of cash flows, you can do it directly (the first approach used in Example 4.1), or you can first compute the present value and then move it to the future (the second approach). As always, we use Eq. 4.1 to calculate the future value of any present value. Because we obey the rules of valuing cash flows in both cases, we get the same result.

Using a Financial Calculator: Solving for Present and Future Values of Cash Flow Streams So far, we have used formulas to compute present values and future values of cash flow streams. As we discussed at the end of Chapter 3, both financial calculators and spreadsheets have these formulas pre-programmed to quicken the process. In this box, we focus on financial calculators, but spreadsheets such as Excel have very similar shortcut functions. Financial calculators have a set of functions that perform the calculations that finance professionals do most often. The functions are all based on the following timeline, which among other things can handle most types of loans: 0

1

2

NPER ...

PV

PMT

PMT FV

PMT

There are a total of five variables: number of periods (N or NPER ), present value (PV ), cash flow or “payment” (PMT ), future value (FV ), and the interest rate, denoted I/Y. Each function takes four of these variables as inputs and returns the value of the fifth one that ensures that the sum of the present value of the cash flows is zero. By setting the recurring payments equal to 0, you could compute present and future values of single cash flows such as we have done above using Equations 4.2 and 4.1. In the examples in Sections 4.2 through 4.4, we will calculate cash flows using the [PMT] button. The best way to learn to use a financial calculator is by practicing. We present one example below. We will also show the calculator buttons for any additional examples in this chapter that can be solved with financial calculator functions. Finally, the appendix to this chapter contains step-by-step instructions for using the two most popular financial calculators. Example Suppose you plan to invest $20,000 in an account paying 8% interest. You will invest an additional $1000 at the end of each year for 15 years. How much will you have in the account in 15 years? We represent this problem with the following timeline: 0

1

2 ...

PV $20,000

PMT $1000

NPER 15

$1000

FV ?

To compute the solution, we enter the four variables we know, N = 15, I/Y = 8, PV = -20,000, PMT = - +1000, and solve for the one we want to determine: FV. Specifically, for the HP-10BII or TI-BAII Plus calculators: 1. 2. 3. 4. 5.

Enter 15 and press the [N] button. Enter 8 and press the [I/Y] button ([I/YR] for the HP calculator). Enter -20,000 and press the [PV] button. Enter -$1000 and press the [PMT] button. Press the [FV] button (for the Texas Instruments calculator, press [CPT] and then [FV]).

Given: Solve for:

N 15

I/Y 8

PV 20,000

PMT 1000

FV 90,595.50

Excel Formula: FV(0.08,15,1000,20000) The calculator then shows a future value of $90,595.50. Note that we entered PV and PMT as negative numbers (the amounts we are putting into the bank), and FV is shown as a positive number (the amount we can take out of the bank). It is important to use signs correctly to indicate the direction in which the money is flowing when using the calculator functions. You will see more examples of getting the sign of the cash flows correct throughout the chapter. Excel has the same functions, but it calls “N,” “NPER” and “I/Y,” “RATE”. Also, it is important to note that you enter an interest rate of 8% as “8” in a financial calculator, but as “0.08” in Excel.

Chapter 4 Time Value of Money: Valuing Cash Flow Streams Personal Finance

EXAMPLE 4.2 Computing the Future Value

89

Problem Let’s revisit the savings plan we considered earlier: We plan to save $1000 today and at the end of each of the next two years. At a fixed 10% interest rate, how much will we have in the bank three years from today?

Solution Q Plan We’ll start with the timeline for this savings plan: 0

1

2

3

$1000

$1000

$1000

?

Let’s solve this problem in a different way than we did in the text, while still following the rules we established. First we’ll compute the present value of the cash flows. Then we’ll compute its value three years later (its future value). Q Execute There are several ways to calculate the present value of the cash flows. Here, we treat each cash flow separately and then combine the present values. 0 1 2 3

$1000 $909.09 $826.45 $2735.54

$1000

$1000

?

1.10 1.102

Saving $2735.54 today is equivalent to saving $1000 per year for three years. Now let’s compute future value in year 3 of that $2735.54: 0

1

2

3

$2735.54 1.103

$3641

Q Evaluate This answer of $3641 is precisely the same result we found earlier. As long as we apply the three rules of valuing cash flows, we will always get the correct answer.

Concept Check

4.2

perpetuity A stream of equal cash flows that occurs at regular intervals and lasts forever. consol A bond that promises its owner a fixed cash flow every year, forever.

1. How do you calculate the present value of a cash flow stream? 2. How do you calculate the future value of a cash flow stream?

Perpetuities The formulas we have developed so far allow us to compute the present or future value of any cash flow stream. In this section and the next one, we consider two types of cash flow streams, perpetuities and annuities, and learn shortcuts for valuing them. These shortcuts are possible because the cash flows follow a regular pattern.

Perpetuities A perpetuity is a stream of equal cash flows that occur at regular intervals and last forever. One example is the British government bond called a consol (or perpetual bond ). Consol bonds promise the owner a fixed cash flow every year, forever.

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Part 2 Interest Rates and Valuing Cash Flows Here is the timeline for a perpetuity: 0

1

2

3 ...

C

C

C

Note from the timeline that the first cash flow does not occur immediately; it arrives at the end of the first period. This timing is sometimes referred to as payment in arrears and is a standard convention in loan payment calculations and elsewhere, so we adopt it throughout this text. Using the formula for the present value, the present value of a perpetuity with payment C and interest rate r is given by: C C C + + + g PV = 11 + r2 11 + r22 11 + r23 Notice that all the cash flows (C in the formula) are the same because the cash flow for a perpetuity is constant. Also, because the first cash flow is in one period, there is no cash flow at time 0 1 C0 = 0 2 . To find the value of a perpetuity by discounting one cash flow at a time would take forever—literally! You might wonder how, even with a shortcut, the sum of an infinite number of positive terms could be finite. The answer is that the cash flows in the future are discounted for an ever-increasing number of periods, so their contribution to the sum eventually becomes negligible. To derive the shortcut, we calculate the value of a perpetuity by creating our own perpetuity. The Valuation Principle tells us that the value of a perpetuity must be the same as the cost we incurred to create our own identical perpetuity. To illustrate, suppose you could invest $100 in a bank account paying 5% interest per year forever. At the end of one year, you will have $105 in the bank—your original $100 plus $5 in interest. Suppose you withdraw the $5 interest and reinvest the $100 for a second year. Again, you will have $105 after one year, and you can withdraw $5 and reinvest $100 for another year. By doing this year after year, you can withdraw $5 every year in perpetuity: 0

1

2

3 ...

$100

$105 $100

$105 $100

$105 $100

$5

$5

$5

By investing $100 in the bank today, you can, in effect, create a perpetuity paying $5 per year. Because the bank will “sell” us (allow us to create) the perpetuity for $100, the present value of the $5 per year in perpetuity is this “do-it-yourself” cost of $100. Now let’s generalize this argument. Suppose we invest an amount P in a bank account with an interest rate r. Every year we can withdraw the interest we have earned, C = r * P, leaving the principal, P, in the bank. Because our cost for creating the perpetuity is only the initial investment of principal (P), the value of receiving C in perpetuity is therefore the upfront cost P. Rearranging C = r * P to solve for P we have P = C/r. Therefore: Present Value of a Perpetuity PV 1 C in perpetuity 2 =

C r

(4.4)

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

91

C C By depositing the amount today, we can withdraw interest of * r = C each period r r in perpetuity. Note the logic of our argument. To determine the present value of a cash flow stream, we computed the “do-it-yourself” cost of creating those same cash flows at the bank. This is an extremely useful and powerful approach—and is much simpler and faster than summing those infinite terms!1

Historical Examples of Perpetuities Perpetual bonds were some of the first bonds ever issued. The oldest perpetuities that are still making interest payments were issued by the Hoogheemraadschap Lekdijk Bovendams, a seventeenthcentury Dutch water board responsible for upkeep of the local dikes. The oldest bond dates from 1624. Two finance professors at Yale University, William Goetzmann and Geert Rouwenhorst, personally verified that these bonds continue to pay interest. On behalf of Yale, they purchased one of these bonds on July 1, 2003, and collected 26 years of back interest. On its issue date in 1648, this bond originally paid interest in Carolus guilders.

Personal FInance

Over the next 355 years, the currency of payment changed to Flemish pounds, Dutch guilders, and most recently euros. Recently, the bond was paying interest of :11.34 annually. Although the Dutch bonds are the oldest perpetuities still in existence, the first perpetuities date from much earlier times. For example, cencus agreements and rentes, which were forms of perpetuities and annuities, were issued in the twelfth century in Italy, France, and Spain. They were initially designed to circumvent the usury laws of the Catholic Church: Because they did not require the repayment of principal, in the eyes of the church they were not considered loans.

Problem

EXAMPLE 4.3

You want to endow an annual graduation party at your alma mater. You want the event to be a memorable one, so you budget $30,000 per year forever for the party. If the university earns 8% per year on its investments, and if the first party is in one year’s time, how much will you need to donate to endow the party?

Endowing a Perpetuity

Solution Q Plan The timeline of the cash flows you want to provide is: 0 1

2

3 ...

$30,000

$30,000

$30,000

This is a standard perpetuity of $30,000 per year. The funding you would need to give the university in perpetuity is the present value of this cash flow stream. Q Execute Use the formula for a perpetuity: PV = C/r = +30,000/0.08 = +375,000 today Q Evaluate If you donate $375,000 today, and if the university invests it at 8% per year forever, then the graduates will have $30,000 every year for their graduation party.

1

Another mathematical derivation of this result exists (see the online appendix), but it is less intuitive.

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Part 2 Interest Rates and Valuing Cash Flows

COMMON MISTAKE

Discounting One Too Many Times flows occur regularly. From the perspective of date 1, this is a perpetuity, and we can apply the formula. From the preceding calculation, we know we need $375,000 on date 1 to have enough to start the parties on date 2. We rewrite the timeline as follows: 0 1 2 3 ... $375,000 $30,000 $30,000

The perpetuity formula assumes that the first payment occurs at the end of the first period (at date 1). Sometimes perpetuities have cash flows that start later. In this case, we can adapt the perpetuity formula to compute the present value, but we need to do so carefully to avoid a common mistake. To illustrate, consider the graduation party described in Example 4.3. Rather than starting in one year, suppose the first party will be held two years from today. How would this delay change the amount of the donation required? Now the timeline looks like this: 0 1 2 3 ... $30,000 $30,000

Our goal can now be restated more simply: How much do we need to invest today to have $375,000 in one year? This is a simple present value calculation: PV = +375,000/1.08 = +347,222 today A common mistake is to discount the $375,000 twice because the first party is in two periods. Remember—the present value formula for the perpetuity already discounts the cash flows to one period prior to the first cash flow. Keep in mind that this common mistake may be made with perpetuities, annuities, and all the other special cases discussed in this chapter. All these formulas discount the cash flows to one period prior to the first cash flow.

We need to determine the present value of these cash flows, as it tells us the amount of money needed in the bank today to finance the future parties. We cannot apply the perpetuity formula directly, however, because these cash flows are not exactly a perpetuity as we defined it. Specifically, the cash flow in the first period is “missing.” But consider the situation on date 1— at that point, the first party is one period away and then the cash

Concept Check

4.3 annuity A stream of equal cash flows arriving at a regular interval and ending after specified time period.

3. What are some examples of perpetuities? 4. What is the intuition behind the fact that an infinite stream of cash flows has a finite present value?

Annuities An annuity is a stream consisting of a fixed number of equal cash flows paid at regular intervals. So the difference between an annuity and a perpetuity is that an annuity ends after some fixed number of payments whereas a perpetuity continues forever. Most car loans, mortgages, and some bonds are annuities. We represent the cash flows of an annuity on a timeline as follows: 0

1

2

N ...

C

C

C

Note that just as with the perpetuity, we adopt the convention that the first payment takes place at date 1, one period from today. The present value of an N-period annuity with payment C and interest rate r is: PV =

C C C C + + + g + 11 + r2 11 + r22 11 + r23 11 + r2N

Present Value of an Annuity To find a simpler formula, we use the same approach we followed with the perpetuity: find a way to create your own annuity. To illustrate, suppose you invest $100 in a bank account paying 5% interest. At the end of one year, you will have $105 in the bank—your original $100 plus $5 in interest. Using the same strategy as you did for calculating the value of a perpetuity, suppose you withdraw the $5 interest and reinvest the $100 for a second year. Once again you will have $105 after one year. You can repeat the process, withdrawing $5

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

93

and reinvesting $100, every year. For a perpetuity, you left the principal in the bank forever. Alternatively, you might decide after 20 years to close the account and withdraw the principal. In that case, your cash flows will look like this: 0

1

2

20 ...

$100

$105 $100

$105 $100

$105

$5

$5

$5 $100

With your initial $100 investment, you have created a 20-year annuity of $5 per year, plus you will receive an extra $100 at the end of 20 years. The Valuation Principle’s Law of One Price tells us that things that produce exactly the same cash flows must have the same value. Because it only took an initial investment of $100 to create the cash flows on the timeline, the present value of these cash flows is $100, or: +100 = PV 1 [email protected] annuity of +5 per year 2 + PV 1 +100 in 20 years 2

So if we invest $100 now, we can receive $5 per year for 20 years as well as $100 in the 20th year, representing the following cash flows: 0

1

2

20 ...

$100

$5

$5 $100

$5

Rearranging the equation above shows that the cost of a 20-year annuity of $5 per year is $100 minus the present value of $100 in 20 years. PV 1 [email protected] annuity of +5 per year 2 = +100 - PV 1 +100 in 20 years 2 +100 = +100 = +100 - +37.69 = +62.31 1 1.05 2 20 0

1

20

2 ...

$100

$5

$5 $100

$5

Removing the $100 in 20 years and its present value ($37.69) leaves the following cash flows: $62.31

$5

$5

...

$5

So the present value of $5 for 20 years is $62.31. Intuitively, the value of the annuity is the initial investment in the bank account minus the present value of the principal that will be left in the account after 20 years. The $5 we receive every year is the interest on the $100 and can be written as +100 1 .05 2 = +5. Rearranging this equation, we have +100 = +5/.05. If we substitute $5/.05 into our formula above, we can represent the PV of the annuity as a function of its cash flow ($5), the discount rate (5%) and the number of years (20): C N +5 +5 .05 +5 1 PV 1 [email protected] annuity of +5 per year 2 = = ¢1 ≤ .05 .05 1 1.05 2 20 1 1.05 2 20 = +5 *

1 1 ≤ ¢1 .05 1 1.05 2 20 r

94

Part 2 Interest Rates and Valuing Cash Flows This method is very useful because we will most often want to know the PV of the annuity given its cash flow, discount rate, and number of years. We can write this as a general formula for the present value of an annuity of C for N periods: Present Value of an Annuity PV 1 annuity of C for N periods with interest rate r 2 = C * Personal Finance

1 1 ≤ (4.5) ¢1 r 11 + r2N

Problem

EXAMPLE 4.4

You are the lucky winner of the $30 million state lottery. You can take your prize money either as (a) 30 payments of $1 million per year (starting today), or (b) $15 million paid today. If the interest rate is 8%, which option should you take?

Present Value of a Lottery Prize Annuity

Solution Q Plan Option (a) provides $30 million in prize money but paid over time. To evaluate it correctly, we must convert it to a present value. Here is the timeline:

0

1

2

29 ...

$1 million

$1 million

$1 million

$1 million

Because the first payment starts today, the last payment will occur in 29 years (for a total of 30 payments).2 The $1 million at date 0 is already stated in present value terms, but we need to compute the present value of the remaining payments. Fortunately, this case looks like a 29-year annuity of $1 million per year, so we can use the annuity formula. Q Execute We use the annuity formula: PV 1 [email protected] annuity of +1 million at 8% annual interest 2 = +1 million *

1 1 ¢1 ≤ 0.08 1.0829

= +1 million * 11.16 = +11.16 million today Thus, the total present value of the cash flows is +1 million + +11.16 million = +12.16 million. In timeline form: 0 1 2 29 ... $1 million

$1 million

$1 million

$1 million

$11.16 million $12.16 million

Option (b), $15 million upfront, is more valuable—even though the total amount of money paid is half that of option (a). Financial calculators or Excel can handle annuities easily—just enter the cash flow in the annuity as the PMT:

Given: Solve for:

2

N 29

I/Y 8

PV

PMT 1,000,000

FV 0

11,158,406 Excel Formula: PV(RATE,NPER,PMT,FV)PV(0.08,29,1000000,0)

An annuity in which the first payment occurs immediately is sometimes called an annuity due. Throughout this text, we always use the term “annuity” to mean one that is paid in arrears.

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

95

Both the financial calculator and Excel will give you the PV of the 29 payments ($11,158,406, or 11.16 million), to which you must add the first payment of $1 million just as shown. Q Evaluate The reason for the difference is the time value of money. If you have the $15 million today, you can use $1 million immediately and invest the remaining $14 million at an 8% interest rate. This strategy will give you +14 million * 8% = +1.12 million per year in perpetuity! Alternatively, you can spend +15 million - +11.16 million = +3.84 million today, and invest the remaining $11.16 million, which will still allow you to withdraw $1 million each year for the next 29 years before your account is depleted.

Future Value of an Annuity Now that we have derived a simple formula for the present value of an annuity, it is easy to find a simple formula for the future value. If we want to know the value N years in the future, we move the present value N periods forward on the timeline. 0

1

2

20 ...

C PV

C

r

a1

C

C

1 b (1r)N

FV

C

r

1

a1 (1r)N b (1 r)N

As the timeline shows, we compound the present value for N periods at interest rate r: Future Value of an Annuity

FV 1 annuity 2 = PV * 1 1 + r 2 N =

1 C ¢1 ≤ * 11 + r2N r 11 + r2N

= C *

1 1 11 + r2N - 12 r

(4.6)

This formula is useful if we want to know how a savings account will grow over time and the investor deposits the same amount every period. Personal Finance

EXAMPLE 4.5 Retirement Savings Plan Annuity

Problem Ellen is 35 years old and she has decided it is time to plan seriously for her retirement. At the end of each year until she is 65, she will save $10,000 in a retirement account. If the account earns 10% per year, how much will Ellen have in the account at age 65?

Solution Q Plan As always, we begin with a timeline. In this case, it is helpful to keep track of both the dates and Ellen’s age:

35 0

36 1

37 2

65 30 ...

$10,000

$10,000

$10,000

Ellen’s savings plan looks like an annuity of $10,000 per year for 30 years. (Hint : It is easy to become confused when you just look at age, rather than at both dates and age. A common error is to think there are only 65 - 36 = 29 payments. Writing down both dates and age avoids this problem.) To determine the amount Ellen will have in the account at age 65, we’ll need to compute the future value of this annuity.

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Part 2 Interest Rates and Valuing Cash Flows

Q Execute

1 1 1.1030 - 1 2 0.10 = +10,000 * 164.49

FV = +10,000 *

= +1.645 million at age 65 Using a financial calculator or Excel:

Given: Solve for:

N 30

I/Y 10

PV 0

PMT 10,000

FV

1,644,940 Excel Formula: FV(RATE,NPER, PMT, PV)FV(0.10,30,10000,0)

Q Evaluate By investing $10,000 per year for 30 years (a total of $300,000) and earning interest on those investments, the compounding will allow her to retire with $1.645 million.

Concept Check

4.4

5. What are some examples of annuities? 6. What is the difference between an annuity and a perpetuity?

Growing Cash Flows So far, we have considered only cash flow streams that have the same cash flow every period. If, instead, the cash flows are expected to grow at a constant rate in each period, we can also derive a simple formula for the present value of the future stream.

Growing Perpetuity growing perpetuity A stream of cash flows that occurs at regular intervals and grows at a constant rate forever.

A growing perpetuity is a stream of cash flows that occur at regular intervals and grow at a constant rate forever. For example, a growing perpetuity with a first payment of $100 that grows at a rate of 3% has the following timeline: 0

1

2

3

4

$100

$100 1.03 $103

$103 1.03 $106.09

$106.09 1.03 $109.27

...

To derive the formula for the present value of a growing perpetuity, we follow the same logic used for a regular perpetuity: Compute the amount you would need to deposit today to create the perpetuity yourself. In the case of a regular perpetuity, we created a constant payment forever by withdrawing the interest earned each year and reinvesting the principal. To increase the amount we can withdraw each year, the principal that we reinvest each year must grow. We therefore withdraw less than the full amount of interest earned each period, using the remaining interest to increase our principal. Let’s consider a specific case. Suppose you want to create a perpetuity growing at 2%, so you invest $100 in a bank account that pays 5% interest. At the end of one year, you will have $105 in the bank—your original $100 plus $5 in interest. If you withdraw only $3, you will have $102 to reinvest—2% more than the amount you had initially. This amount will then grow to +102 * 1.05 = +107.10 in the following year, and you can withdraw +3 * 1.02 = +3.06, which will leave you with principal of +107.10 - +3.06 = +104.04. Note that +102 * 1.02 = +104.04. That is, both the amount you withdraw and the principal you reinvest grow by 2% each year. On a timeline, these cash flows look like this:

Chapter 4 Time Value of Money: Valuing Cash Flow Streams 0

1

2

97

3 ...

$100

$105 $102

$107.10 $104.04

$3

$3.06 $3 1.02

$109.24 $106.12 $3.12 $3 (1.02)2

By following this strategy, you have created a growing perpetuity that starts at $3 and grows 2% per year. This growing perpetuity must have a present value equal to the cost of $100. We can generalize this argument. If we want to increase the amount we withdraw from the bank each year by g, then the principal in the bank will have to grow by the same factor g. That is, instead of reinvesting P in the second year, we should reinvest P 1 1 + g 2 = P + gP. In order to increase our principal by gP, we need to leave gP of the interest in the account, so of the total interest of rP, we can only withdraw rP - gP = P 1 r - g 2 . We demonstrate this for the first year of our example: Initial amount deposited

$100

P

Interest earned

(.05)($100)

rP

Amount needed to increase principal

(.02)($100)

gP

Amount withdrawn

(.05)($100) - (.02)($100)

rP - gP

= $100(.05 - .02)

= P1r - g2

Denoting our withdrawal as C, we have C = P 1 r - g 2 . Solving this equation for P, the initial amount deposited in the bank account, gives the present value of a growing perpetuity with initial cash flow C:3 Present Value of a Growing Perpetuity C PV 1 growing perpetuity 2 = r - g

(4.7)

To understand intuitively the formula for a growing perpetuity, start with the formula for a perpetuity. In the earlier case, you had to put enough money in the bank to ensure that the interest earned matched the cash flows of the regular perpetuity. In the case of a growing perpetuity, you need to put more than that amount in the bank because you have to finance the growth in the cash flows. How much more? If the bank pays interest at a rate of 5%, then all that is left to take out, if you want to make sure the principal grows 2% per year, is the difference: 5% - 2% = 3%. So instead of the present value of the perpetuity being the first cash flow divided by the interest rate, it is now the first cash flow divided by the difference between the interest rate and the growth rate.

Suppose g r. Then the cash flows grow even faster than they are discounted; each term in the sum of discounted cash flows gets larger, rather than smaller. In this case, the sum is infinite! What does an infinite present value mean? Remember that the present value is the “do-it-yourself” cost of creating the cash flows. An infinite present value means that no matter how much money you start with, it is impossible to reproduce those cash flows on your own. Growing perpetuities of this sort cannot exist in practice because no one would be willing to offer one at any finite price. A promise to pay an amount that forever grew faster than the interest rate is also unlikely to be kept (or believed by any savvy buyer). The only viable growing perpetuities are those where the growth rate is less than the interest rate, so we assume that g 6 r for a growing perpetuity. 3

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Part 2 Interest Rates and Valuing Cash Flows Personal Finance

Problem

EXAMPLE 4.6

In Example 4.3, you planned to donate money to your alma mater to fund an annual $30,000 graduation party. Given an interest rate of 8% per year, the required donation was the present value of:

Endowing a Growing Perpetuity

PV = +30,000/0.08 = +375,000 today Before accepting the money, however, the student association has asked that you increase the donation to account for the effect of inflation on the cost of the party in future years. Although $30,000 is adequate for next year’s party, the students estimate that the party’s cost will rise by 4% per year thereafter. To satisfy their request, how much do you need to donate now?

Solution Q Plan

0

1

2

3

$30,000

$30,000 1.04

$30,000 1.042

...

The cost of the party next year is $30,000, and the cost then increases 4% per year forever. From the timeline, we recognize the form of a growing perpetuity and can value it that way. Q Execute To finance the growing cost, you need to provide the present value today of:

PV = +30,000/ 1 0.08 - 0.04 2 = +750,000 today

Q Evaluate You need to double the size of your gift!

Growing Annuity growing annuity A stream of cash flows, growing at a constant rate and paid at regular intervals, that end afer a specified number of periods.

A growing annuity is a stream of N growing cash flows, paid at regular intervals. It is a growing perpetuity that eventually comes to an end. The following timeline shows a growing annuity with initial cash flow C, growing at rate g every period until period N: 0

1

2

N ...

C

C (1g)

C(1g) N – 1

The conventions used earlier still apply: (1) The first cash flow arrives at the end of the first period, and (2) the first cash flow is before growth. The last cash flow therefore reflects only N - 1 periods of growth. The present value of an N-period growing annuity with initial cash flow C, growth rate g, and interest rate r is given by Present Value of a Growing Annuity PV = C *

1 + g N 1 ¢1 - ¢ ≤ ≤ r - g 1 + r

(4.8)

Because the annuity has only a finite number of terms, Eq. 4.8 also works when g 7 r.4 The process of deriving this simple expression for the present value of a growing annuity is the same as for a regular annuity. Interested readers may consult the online appendix for details.

Eq. 4.8 does not work for g = r. But in that case, growth and discounting cancel out, and the present value is equivalent to receiving all the cash flows at date 1: PV = C * N/ 1 1 + r 2 . 4

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

EXAMPLE 4.7 Retirement Savings with a Growing Annuity

99

Problem In Example 4.5, Ellen considered saving $10,000 per year for her retirement. Although $10,000 is the most she can save in the first year, she expects her salary to increase each year so that she will be able to increase her savings by 5% per year. With this plan, if she earns 10% per year on her savings, how much will Ellen have in the account at age 65?

Solution Q Plan Her new savings plan is represented by the following timeline: 35 0

36 1

37 2

65 30 ...

$10,000

$10,000 (1.05)

$10,000 (1.05)29

This example involves a 30-year growing annuity, with a growth rate of 5%, and an initial cash flow of $10,000. We can use Eq. 4.8 to solve for the present value of this growing annuity. Then we can use Eq. 4.1 to calculate the future value. Q Execute The present value of Ellen’s growing annuity is given by PV = +10,000 *

1.05 30 1 ¢1 - ¢ ≤ ≤ 0.10 - 0.05 1.10

= +10,000 * 15.0463 = +150,463 today Ellen’s proposed savings plan is equivalent to having $150,463 in the bank today. To determine the amount she will have at age 65, we need to move this amount forward 30 years: FV = +150,463 * 1.1030 = +2.625 million in 30 years Q Evaluate Ellen will have $2.625 million at age 65 using the new savings plan. This sum is almost $1 million more than she had without the additional annual increases in savings. Because she is increasing her savings amount each year and the interest on the cumulative increases continues to compound, her final savings is much greater.

Concept Check

4.5

7. How can an infinitely growing stream of cash flows have a finite value? 8. What is an example of a growing perpetuity?

Solving for Variables Other Than Present Value or Future Value So far, we have calculated the present value or future value of a stream of cash flows. Sometimes, however, we know the present value or future value, but do not know one of the variables that so far we have been given as an input. For example, when you take out a loan, you may know the amount you would like to borrow, but may not know the loan payments that will be required to repay it. Or, if you make a deposit into a bank account, you may want to calculate how long it will take before your balance reaches a certain level. In such situations, we use the present and/or future values as inputs, and solve for the variable we are interested in. We examine several special cases in this section.

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Part 2 Interest Rates and Valuing Cash Flows

Solving for the Cash Flows Let’s consider an example where we know the present value of an investment, but do not know the cash flows. The best example is a loan—you know how much you want to borrow (the present value) and you know the interest rate, but you do not know how much you need to repay each year. Suppose you are opening a business that requires an initial investment of $100,000. Your bank manager has agreed to lend you this money. The terms of the loan state that you will make equal annual payments for the next ten years and will pay an interest rate of 8% with the first payment due one year from today. What is your annual payment? From the bank’s perspective, the timeline looks like this: 0

1

2

10 ...

$100,000

+C

+C

+C

The bank will give you $100,000 today in exchange for ten equal payments over the next decade. You need to determine the size of the payment C that the bank will require. For the bank to be willing to lend you $100,000, the loan cash flows must have a present value of $100,000 when evaluated at the bank’s interest rate of 8%. That is: 100,000 = PV 1 [email protected] annuity of C per year, evaluated at the loan rate 2

Using the formula for the present value of an annuity (Eq. 4.5), 100,000 = C *

1 1 ¢1 ≤ = C * 6.71 0.08 1.0810

Solving this equation for C gives: C =

100,000 = +14,903 6.71

You will be required to make ten annual payments of $14,903 in exchange for $100,000 today. We can also solve this problem with a financial calculator or Excel (from your standpoint the $100,000 is positive and the payments are negative):

Given: Solve for:

N 10

I/Y 8

PV 100,000

PMT

FV 0

14,903 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.08,10,100000,0)

In general, when solving for a loan payment, think of the amount borrowed (the loan principal) as the present value of the payments. If the payments of the loan are an annuity, we can solve for the payment of the loan by inverting the annuity formula. Writing the equation for the payments formally for a loan with principal P, requiring N periodic payments of C and interest rate r, we have: Cash flow in an Annuity (Loan Payment) P C = 1 1 ¢1 ≤ r 11 + r2N

(4.9)

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

EXAMPLE 4.8 Computing a Loan Payment

101

Problem Your firm plans to buy a warehouse for $100,000. The bank offers you a 30-year loan with equal annual payments and an interest rate of 8% per year. The bank requires that your firm pay 20% of the purchase price as a down payment, so you can borrow only $80,000. What is the annual loan payment?

Solution Q Plan We start with the timeline (from the bank’s perspective): 0

1

2

30 ...

$80,000

C

C

C

Using Eq. 4.9, we can solve for the loan payment, C, given N = 30, r = 0.08 and P = +80,000. Q Execute Eq. 4.9 gives the following payment (cash flow): C =

P

1 1 ¢1 ≤ r 11 + r2N = +7106.19

=

80,000 1 1 ¢1 ≤ 0.08 1 1.08 2 30

Using a financial calculator or Excel:

Given: Solve for:

N 30

I/Y 8

PV 80,000

PMT

FV 0

7106.19 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.08,30,80000,0)

Q Evaluate Your firm will need to pay $7106.19 each year to repay the loan. The bank is willing to accept these payments because the PV of 30 annual payments of $7106.19 at 8% interest rate per year is exactly equal to the $80,000 it is giving you today.

We can use this same idea to solve for the cash flows when we know the future value rather than the present value. As an example, suppose you have just graduated from college and you decide to be prudent and start saving for a down payment on a house. You would like to have $60,000 saved 10 years from now. If you can earn 7% per year on your savings, how much do you need to save each year to meet your goal? The timeline for this example is: 0

1

2

10 ...

$C

$C

$C $60,000

That is, you plan to save some amount C per year, and then withdraw $60,000 from the bank in ten years. Therefore, we need to find the annuity payment that has a future value of $60,000 in ten years. Use the formula for the future value of an annuity from Eq. 4.6: 60,000 = FV 1 annuity 2 = C *

1 1 1.0710 - 1 2 = C * 13.816 0.07

102

Part 2 Interest Rates and Valuing Cash Flows 60,000 = +4,343. Thus, you need to save $4,343 per year. If you do, then 13.816 at a 7% interest rate your savings will grow to $60,000 in 10 years when you are ready to buy a house. Now let’s solve this problem using a financial calculator or Excel: Therefore, C =

Given: Solve for:

N 10

I/Y 7

PV 0

PMT

FV 60,000

4343 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.07,10,0,60000)

Once again, we find that you need to save $4343 per year for 10 years to accumulate $60,000.

Rate of Return In some situations, you know the cost of an investment opportunity and the expected cash flows from it, but you do not know the rate of return. The rate of return on the investment opportunity is the rate at which the present value of the benefits exactly offsets the cost. For example, suppose you have an investment opportunity that requires a $1000 investment today and will have a $2000 payoff in six years. This would appear on a timeline as: 0

1

2

6 ...

$1000

$2000

One way to analyze this investment is to ask the question: What interest rate, r, would you need so that the present value of what you get is exactly equal to the present value of what you give up? 2000 1000 = 11 + r26 Rearranging this calculation gives the following:

1000 * 1 1 + r 2 6 = 2000

That is, r is the interest rate you would need to earn on your $1000 to have a future value of $2000 in six years. We can solve for r as follows: 1

2000 6 1 + r = a b = 1.1225 1000 Or, r = 0.1225. This rate is the rate of return of this investment opportunity. Making this investment is like earning 12.25% per year on your money for six years. When there are just two cash flows, as in the preceding example, it is straightforward to compute the rate of return. Consider the general case in which you invest an amount P today, and receive FV in N years: P * 1 1 + r 2 N = FV 1 + r = 1 FV/P 2 1/N

That is, we take the total return of the investment over N years, FV/P, and convert it to an equivalent one-year rate by raising it to the power 1/N. Now let’s consider a more sophisticated example. Suppose your firm needs to purchase a new forklift. The dealer gives you two options: (1) a price for the forklift if you pay

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

103

cash and (2) the annual payments if you take out a loan from the dealer. To evaluate the loan that the dealer is offering you, you will want to compare the rate on the loan with the rate that your bank is willing to offer you. Given the loan payment that the dealer quotes, how do you compute the interest rate charged by the dealer? In this case, we need to compute the rate of return of the dealer’s loan. Suppose the cash price of the forklift is $40,000, and the dealer offers financing with no down payment and four annual payments of $15,000. This loan has the following timeline: 0 $40,000

1

2

$15,000

3

$15,000

$15,000

4 $15,000

From the timeline, it is clear that the loan is a four-year annuity with a payment of $15,000 per year and a present value of $40,000. Setting the present value of the cash flows equal to zero requires that the present value of the payments equals the purchase price: 40,000 = 15,000 *

1 1 ¢1 ≤ r 11 + r24

The value of r that solves this equation is the interest rate charged on the loan. Unfortunately, in this case there is no simple way to solve for the interest rate r.5 The only way to solve this equation is to guess at values of r until you find the right one. Start by guessing r = 10%. In this case, the value of the annuity is: 15,000 *

1 1 ¢1 ≤ = 47,548 0.10 1 1.10 2 4

The present value of the payments is too large. To lower it, we need to use a higher interest rate. We guess 20% this time: 15,000 *

1 1 ¢1 ≤ = 38,831 0.20 1 1.20 2 4

Now the present value of the payments is too low, so we must pick a rate between 10% and 20%. We continue to guess until we find the right rate. Let’s try 18.45%: 15,000 *

1 1 ¢1 ≤ = 40,000 0.1845 1 1.1845 2 4

The interest rate charged by the dealer is 18.45%. An easier solution than guessing the rate of return and manually calculating values is to use a spreadsheet or calculator to automate the guessing process. When the cash flows are an annuity, as in this example, we can use a financial calculator or Excel to compute the rate of return. Both solve (with slightly varying notation—recall that I/Y is the discount rate and PMT is the cash flow or payment) the following equation: 0 = PV + PMT *

1 1 FV ¢1 ≤ + N I/Y 1 1 + I/Y 2 1 1 + I/Y 2 N

The equation ensures that the value of investing in the annuity is zero in that the present value of the costs and benefits exactly offset each other. When the unknown variable is the interest rate, it will solve for the interest rate that sets the equation equal to zero. 5

With five or more periods and general cash flows, there is no general formula to solve for r; trial and error (by hand or computer) is the only way to compute it.

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Part 2 Interest Rates and Valuing Cash Flows For this case, you could use a financial calculator or Excel, as follows: Given: Solve for:

N 4

I/Y

PV 40,000

PMT 15,000

FV 0

18.45 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(4,15000,40000,0)

Both the financial calculator and Excel correctly compute a rate of return of 18.45%. Personal Finance

EXAMPLE 4.9 Computing the Rate of Return with a Financial Calculator

Problem Let’s return to the lottery prize in Example 4.4. How high of a rate of return do you need to earn investing on your own in order to prefer the $15 million payout?

Solution Q Plan Recall that the lottery offers you the following deal: take either (a) 30 payments of $1 million per year starting immediately, or (b) a $15 million lump sum payment immediately. The first option is an annuity of 29 payments of $1 million plus an initial $1 million payment.

0

1

2

29 ...

$1 million

$1 million

$1 million

$1 million

We need to solve for the rate of return that makes the two offers equivalent. Anything above that rate of return would make the present value of the annuity lower than the $15 million lump sum payment, and anything below that rate of return would make it greater than the $15 million. Q Execute First, we set the present value of option (a) equal to option (b), which is already in present value since it is an immediate payment of $15 million: +15 million = +1 million + +1 million * +14 million = +1 million *

1 1 ¢1 ≤ r 1 1 + r 2 29

1 1 ¢1 ≤ r 1 1 + r 2 29

Using a financial calculator to solve for r :

N I/Y PV PMT FV Given: 29 14,000,000 1,000,000 0 Solve for: 5.72 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(29,1000000,14000000,0) The rate of return equating the two options is 5.72%. Q Evaluate 5.72% is the rate of return that makes giving up the $15 million payment and taking the 30 installments of $1 million an even trade in terms of present value. If you could earn more than 5.72% investing on your own, then you could take the $15 million, invest it and generate 30 installments that are each more than $1 million. If you could not earn at least 5.72% on your investments, you would be unable to replicate the $1 million installments on your own and would be better off taking the installment plan.

Solving for the Number of Periods In addition to solving for cash flows or the interest rate, we can solve for the amount of time it will take a sum of money to grow to a known value. In this case, the interest rate,

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present value, and future value are all known. We need to compute how long it will take for the present value to grow to the future value. Suppose we invest $10,000 in an account paying 10% interest, and we want to know how long it will take for the amount to grow to $20,000. We want to determine N. 0

1

2

N ...

$10,000

$20,000

In terms of our formulas, we need to find N so that the future value of our investment equals $20,000: FV = +10,000 * 1.10N = +20,000

(4.10)

One approach is to use trial and error to find N, as with the rate of return we calculated earlier. For example, with N = 7 years, FV = +19,487, so it will take longer than 7 years. With N = 8 years, FV = +21,436, so it will take between 7 and 8 years. Alternatively, this problem can be solved on a financial calculator or Excel. In this case, we solve for N: N I/Y PV PMT FV 10 10,000 0 20,000 Given: 7.27 Solve for: Excel Formula: NPER(RATE,PMT,PV,FV)NPER(0.10,0,10000,20000)

It will take about 7.3 years for our savings to grow to $20,000. The problem of solving for the number of periods can also be solved mathematically using logarithms. Personal Finance

EXAMPLE 4.10 Solving for the Number of Periods in a Savings Plan

Problem Let’s return to your savings for a down payment on a house. Imagine that some time has passed and you have $10,050 saved already, and you can now afford to save $5000 per year at the end of each year. Also, interest rates have increased so that you now earn 7.25% per year on your savings. How long will it take you to get to your goal of $60,000?

Solution Q Plan The timeline for this problem is: 0

1

2

N ...

$10,050

$5000

$5000

$5000 $60,000 We need to find N so that the future value of your current savings plus the future value of your planned additional savings (which is an annuity) equals your desired amount. There are two contributors to the future value: the initial lump sum of $10,050 that will continue to earn interest, and the annuity contributions of $5,000 per year that will earn interest as they are contributed. Thus, we need to find the future value of the lump sum plus the future value of the annuity.

Q Execute We can solve this problem using a financial calculator or Excel:

N I/Y PV PMT FV 7.25 10,050 5000 60,000 Given: 7.00 Solve for: Excel Formula: NPER(RATE,PMT,PV,FV)NPER(0.0725,5000,10050,60000)

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Part 2 Interest Rates and Valuing Cash Flows There is also a mathematical solution. We can calculate the future value of the initial cash flow by using Eq. 4.1 and the future value of the annuity using Eq. 4.6: 10,050 * 1.0725N + 5000 *

1 1 1.0725N - 1 2 = 60,000 0.0725

Rearranging the equation to solve for N, 1.0725N =

60,000 * 0.0725 + 5000 = 1.632 10,050 * 0.0725 + 5000

we can then solve for N: N =

ln 1 1.632 2 = 7 years ln 1 1.0725 2

Q Evaluate It will take seven years to save the down payment.

We began this chapter with the goal of further developing the tools a financial manager needs to be able to apply the Valuation Principle by valuing the costs and benefits of a decision. Starting from Chapter 3’s fundamental concept of the time value of money—a dollar today is worth more than a dollar tomorrow—we learned how to calculate the equivalent value of a stream of future cash flows today and today’s cash flows in the future. We then learned some shortcuts for handling common sets of regular cash flows such as those found in perpetuities and loans. As we have seen, the discount rate is a critical input to any of our present value or future value calculations. Throughout this chapter, we have taken the discount rate as given. What determines these discount rates? The Valuation Principle shows us that we must rely on market information to assess the value of cash flows across time. In the next chapter, we will learn the drivers of market interest rates as well as how they are quoted. Understanding interest rate quoting conventions will also allow us to extend the tools we developed in this chapter to situations where the interest rate is compounded more frequently than once per year.

Concept Check

9. How do you calculate the cash flow of an annuity? 10. How do you calculate the rate of return on an investment?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations 4.1 Valuing a Stream of Cash Flows Q The present value of a cash flow stream is: C1 C2 CN PV = C0 + + + g + (4.3) 2 11 + r2 11 + r2 11 + r2N

Terms

Online Practice Opportunities MyFinanceLab Study Plan 4.1

Chapter 4 Time Value of Money: Valuing Cash Flow Streams 4.2 Perpetuities Q A perpetuity is a stream of equal cash flows C paid every period, forever. The present value of a perpetuity is: PV 1 C in perpetuity 2 =

C r

consol, p. 89 perpetuity, p. 89

107

MyFinanceLab Study Plan 4.2

(4.4)

4.3 Annuities annuity, p. 92 Q An annuity is a stream of equal cash flows C paid every period for N periods. The present value of an annuity is: 1 1 C * a1 (4.5) b r 11 + r2N Q The future value of an annuity at the end of the annuity is: 1 C * 1 11 + r2N - 12 (4.6) r

4.4 Growing Cash Flows Q In a growing perpetuity, the cash flows grow at a constant rate g each period. The present value of a growing perpetuity is: C (4.7) r - g

growing annuity, p. 98 growing perpetuity, p. 96

MyFinanceLab Study Plan 4.3 Interactive Annuity Calculator Financial Calculator Tutorials: Calculating the Present Value of an Annuity and Solving for the Future Value of an Annuity MyFinanceLab Study Plan 4.4

Q A growing annuity is like a growing perpetuity, but with an ending point. The present value of a growing annuity is: PV = C *

1 + g N 1 ¢1 - ¢ ≤ ≤ r - g 1 + r

(4.8)

4.5 Solving for Variables Other Than Present Value or Future Value Q The annuity and perpetuity formulas can be used to solve for the annuity payments when either the present value or the future value is known. Q The periodic payment on an N-period loan with principal P and interest rate r is: P C = (4.9) 1 1 ¢1 ≤ r 11 + r2N Q The rate of return of an investment opportunity is the interest rate at which the PV of the benefits of the investment opportunity exactly offset the PV of the costs. Q The annuity formulas can be used to solve for the number of periods it takes to save a fixed amount of money.

MyFinanceLab Study Plan 4.5

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Part 2 Interest Rates and Valuing Cash Flows

Critical Thinking

1. What is the intuition behind the fact that the present value of a stream of cash flows is just the sum of the present values of each individual cash flow? 2. What must be true about a cash flow stream in order for us to be able to use the shortcut formulas? 3. What is the difference between an annuity and a perpetuity? 4. What are some examples of perpetuities? 5. How can a perpetuity have a finite value? 6. What are some examples of annuities? 7. What must be true about the growth rate in order for a growing perpetuity to have a finite value? 8. In what types of situations would it be useful to solve for the number of periods or the rate of return?

Problems

All problems are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Valuing a Stream of Cash Flows 1. You have just taken out a five-year loan from a bank to buy an engagement ring. The ring costs $5000. You plan to put down $1000 and borrow $4000. You will need to make annual payments of $1000 at the end of each year. Show the timeline of the loan from your perspective. How would the timeline differ if you created it from the bank’s perspective? 2. You currently have a one-year-old loan outstanding on your car. You make monthly payments of $300. You have just made a payment. The loan has four years to go (i.e., it had an original term of five years). Show the timeline from your perspective. How would the timeline differ if you created it from the bank’s perspective? 3. You plan to deposit $500 in a bank account now and $300 at the end of one year. If the account earns 3% interest per year, what will the balance be in the account right after you make the second deposit? 4. You have just received a windfall from an investment you made in a friend’s business. She will be paying you $10,000 at the end of this year, $20,000 at the end of the following year, and $30,000 at the end of the year after that (three years from today). The interest rate is 3.5% per year. a. What is the present value of your windfall? b. What is the future value of your windfall in three years (on the date of the last payment)? 5. Suppose you receive $100 at the end of each year for the next three years. a. If the interest rate is 8%, what is the present value of these cash flows? b. What is the future value in three years of the present value you computed in (a)? c. Suppose you deposit the cash flows in a bank account that pays 8% interest per year. What is the balance in the account at the end of each of the next three years (after your deposit is made)? How does the final bank balance compare with your answer in (b)?

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6. You have a loan outstanding. It requires making three annual payments of $1000 each at the end of the next three years. Your bank has offered to allow you to skip making the next two payments in lieu of making one large payment at the end of the loan’s term in three years. If the interest rate on the loan is 5%, what final payment will the bank require you to make so that it is indifferent to the two forms of payment? Perpetuities 7. You want to endow a scholarship that will pay $10,000 per year forever, starting one year from now. If the school’s endowment discount rate is 7%, what amount must you donate to endow the scholarship? 8. How would your answer to Problem 7 change if you endow it now, but it makes the first award to a student 10 years from today? 9. The British government has a consol bond outstanding paying £100 per year forever. Assume the current interest rate is 4% per year. a. What is the value of the bond immediately after a payment is made? b. What is the value of the bond immediately before a payment is made? Annuities 10. What is the present value of $1000 paid at the end of each of the next 100 years if the interest rate is 7% per year? 11. Your grandmother has been putting $1000 into a savings account on every birthday since your first (that is, when you turned one). The account pays an interest rate of 3%. How much money will be in the account immediately after your grandmother makes the deposit on your eighteenth birthday? 12. Assume that your parents wanted to have $160,000 saved for college by your eighteenth birthday and they started saving on your first birthday. They saved the same amount each year on your birthday and earned 8% per year on their investments. a. How much would they have to save each year to reach their goal? b. If they think you will take five years instead of four to graduate and decide to have $200,000 saved just in case, how much more would they have to save each year to reach their new goal? *13. When you purchased your car, you took out a five-year annual-payment loan with an interest rate of 6% per year. The annual payment on the car is $5000. You have just made a payment and have now decided to pay the loan off by repaying the outstanding balance. What is the payoff amount if a. you have owned the car for one year (so there are four years left on the loan)? b. you have owned the car for four years (so there is one year left on the loan)? 14. You figure that the total cost of college will be $100,000 per year 18 years from today. If your discount rate is 8% compounded annually, what is the present value today of 4 years of college costs starting 18 years from today? 15. Assume that Social Security promises you $40,000 per year starting when you retire 45 years from today (the first $40,000 will come 45 years from now). If your discount rate is 7%, compounded annually, and you plan to live for 15 years after retiring (so that you will get a total of 16 payments including the first one), what is the value today of Social Security’s promise? (See MyFinanceLab for the data in Excel Format.)

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Part 2 Interest Rates and Valuing Cash Flows *16. When Alex Rodriguez moved to the Texas Rangers in 2001, he received a lot of attention for his “$252 million” contract (the total of the payments promised was $252 million). Assume the following about the contract: Rodriguez earns $16 million in the first year, $17 million in years 2 through 4, $19 million in years 5 and 6, $23 million in year 7, and $27 million in years 8 through 10. He would also receive his $10 million signing bonus spread equally over the first 5 years ($2 million per year). His deferred payments begin in 2011. The deferred payment amounts total $33 million and are $5 million, then $4 million, then 8 amounts of $3 million (ending in 2020). However, the actual payouts will be different. All of the deferred payments will earn 3% per year until they are paid. For example, the $5 million is deferred from 2001 to 2011, or 10 years, meaning that it will actually be $6.7196 million when paid. Assume that the $4 million payment deferred to 2012 is deferred from 2002 (each payment is deferred 10 years). The contract is a 10-year contract, but each year has a deferred component so that cash flows are paid out over a total of 20 years. The contractual payments, signing bonus, and deferred components are given below. Note that, by contract, the deferred components are not paid in the year they are earned, but instead are paid (plus interest) 10 years later. 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

$16M

$17M

$17M

$17M

$19M

$19M

$23M

$27M

$27M

$27M

$2M

$2M

$2M

$2M

$2M

$4M

$3M

$3M

$3M

$3M

$3M

$3M

$3M

$3M

Deferred $5M

Assume that an appropriate discount rate for A-Rod to apply to the contract payments is 7% per year. a. Calculate the true promised payments under this contract, including the deferred payments with interest. b. Draw a timeline of all of the payments. c. Calculate the present value of the contract. d. Compare the present value of the contract to the quoted value of $252 million. What explains the difference? *17. You are trying to decide how much to save for retirement. Assume you plan to save $5000 per year with the first investment made 1 year from now. You think you can earn 10% per year on your investments and you plan to retire in 43 years, immediately after making your last $5000 investment. a. How much will you have in your retirement account on the day you retire? b. If, instead of investing $5000 per year, you wanted to make one lump-sum investment today for your retirement that will result in the same retirement saving, how much would that lump sum need to be? c. If you hope to live for 20 years in retirement, how much can you withdraw every year in retirement (starting one year after retirement) so that you will just exhaust your savings with the twentieth withdrawal (assume your savings will continue to earn 10% in retirement)? d. If, instead, you decide to withdraw $300,000 per year in retirement (again with the first withdrawal one year after retiring), how many years will it take until you exhaust your savings? e. Assuming the most you can afford to save is $1000 per year, but you want to retire with $1 million in your investment account, how high of a return do you need to earn on your investments?

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Growing Cash Flows 18. A rich relative has bequeathed you a growing perpetuity. The first payment will occur in a year and will be $1000. Each year after that, you will receive a payment on the anniversary of the last payment that is 8% larger than the last payment. This pattern of payments will go on forever. If the interest rate is 12% per year, a. what is today’s value of the bequest? b. what is the value of the bequest immediately after the first payment is made? *19. You are thinking of building a new machine that will save you $1000 in the first year. The machine will then begin to wear out so that the savings decline at a rate of 2% per year forever. What is the present value of the savings if the interest rate is 5% per year? 20. When Alfred Nobel died, he left the majority of his estate to fund five prizes, each to be awarded annually in perpetuity starting one year after he died (the sixth one, in economics, was added later). a. If he wanted the cash award of each of the five prizes to be $45,000 and his estate could earn 7% per year, how much would he need to fund his prizes? b. If he wanted the value of each prize to grow by 4% per year (perhaps to keep up with inflation), how much would he need to leave? Assume that the first amount was still $45,000. c. His heirs were surprised by his will and fought it. If they had been able to keep the amount of money you calculated in (b), and had invested it at 7% per year, how much would they have in 2014, 118 years after he died? 21. You work for a pharmaceutical company that has developed a new drug. The patent on the drug will last 17 years. You expect that the drug’s profits will be $2 million in its first year and that this amount will grow at a rate of 5% per year for the next 17 years. Once the patent expires, other pharmaceutical companies will be able to produce the same drug and competition will likely drive profits to zero. What is the present value of the new drug if the interest rate is 10% per year? 22. A rich aunt has promised you $5000 one year from today. In addition, each year after that, she has promised you a payment (on the anniversary of the last payment) that is 3% larger than the last payment. She will continue to show this generosity for 20 years, giving a total of 20 payments. If the interest rate is 5%, what is her promise worth today? Solving for Variables Other Than Present Value or Future Value 23. You are thinking about buying a savings bond. The bond costs $50 today and will mature in 10 years with a value of $100. What annual interest rate will the bond earn? 24. You have an investment account that started with $1000 ten years ago and which now has grown to $5000. a. What annual rate of return have you earned (you have made no additional contributions to the account)? b. If the savings bond earns 15% per year from now on, what will the account’s value be ten years from now? 25. You have an investment opportunity that requires an initial investment of $5000 today and will pay $6000 in one year. What is the rate of return of this opportunity? 26. You have decided to buy a perpetual bond. The bond makes one payment at the end of every year forever and has an interest rate of 5%. If the bond initially costs $1000, what is the payment every year?

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Part 2 Interest Rates and Valuing Cash Flows 27. You are thinking of purchasing a house. The house costs $350,000. You have $50,000 in cash that you can use as a down payment on the house, but you need to borrow the rest of the purchase price. The bank is offering a 30-year mortgage that requires annual payments and has an interest rate of 7% per year. What will your annual payment be if you sign up for this mortgage? *28. You are thinking about buying a piece of art that costs $50,000. The art dealer is proposing the following deal: He will lend you the money, and you will repay the loan by making the same payment every two years for the next 20 years (i.e., a total of 10 payments). If the interest rate is 4% per year, how much will you have to pay every two years? *29. You would like to buy the house and take the mortgage described in Problem 27. You can afford to pay only $23,500 per year. The bank agrees to allow you to pay this amount each year, yet still borrow $300,000. At the end of the mortgage (in 30 years), you must make a balloon payment; that is, you must repay the remaining balance on the mortgage. How much will this balloon payment be? *30. You are saving for retirement. To live comfortably, you decide you will need to save $2 million by the time you are 65. Today is your twenty-second birthday, and you decide, starting today and continuing on every birthday up to and including your 65th birthday, that you will put the same amount into a savings account. If the interest rate is 5%, how much must you set aside each year to make sure that you will have $2 million in the account on your 65th birthday? 31. You graduate and get a $10,000 check from your grandparents. You decide to save it toward a down payment on a house. You invest it earning 10% per year and you think you will need to have $20,000 saved for the down payment. How long will it be before the $10,000 has grown to $20,000? 32. A local bank is running the following advertisement in the newspaper: “For just $1000 we will pay you $100 forever!” The fine print in the ad says that for a $1000 deposit, the bank will pay $100 every year in perpetuity, starting one year after the deposit is made. What interest rate is the bank advertising (what is the rate of return of this investment)? *33. You are thinking of making an investment in a new plant. The plant will generate revenues of $1 million per year for as long as you maintain it. You expect that the maintenance costs will start at $50,000 per year and will increase 5% per year thereafter. Assume that all revenue and maintenance costs occur at the end of the year. You intend to run the plant as long as it continues to make a positive cash flow (as long as the cash generated by the plant exceeds the maintenance costs). The plant can be built and become operational immediately and the interest rate is 6% per year. a. What is the present value of the revenues? b. What is the present value of the maintenance costs? c. If the plant costs $10 million to build, should you invest in the plant? *34. You have just turned 22 years old, have just received your bachelor’s degree, and have accepted your first job. Now you must decide how much money to put into your retirement plan. The plan works as follows: Every dollar in the plan earns 7% per year. You cannot make withdrawals until you retire on your sixty-fifth birthday. After that point, you can make withdrawals as you see fit. You decide that you will plan to live to 100 and work until you turn 65. You estimate that to live comfortably in retirement, you will need $100,000 per year, starting at the end of the first year of

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retirement and ending on your one-hundredth birthday. You will contribute the same amount to the plan at the end of every year that you work. How much do you need to contribute each year to fund your retirement?

Data Case

Assume today is August 1, 2010. Natasha Kingery is 30 years old and has a Bachelor of Science degree in computer science. She is currently employed as a Tier 2 field service representative for a telephony corporation located in Seattle, Washington, and earns $38,000 a year that she anticipates will grow at 3% per year. Natasha hopes to retire at age 65 and has just begun to think about the future. Natasha has $75,000 that she recently inherited from her aunt. She invested this money in ten-year Treasury bonds. She is considering whether she should further her education and would use her inheritance to pay for it. She has investigated a couple of options and is asking for your help as a financial planning intern to determine the financial consequences associated with each option. Natasha has already been accepted to two programs and could start either one soon. One alternative that Natasha is considering is attaining a certification in network design. This certification would automatically promote her to a Tier 3 field service representative in her company. The base salary for a Tier 3 representative is $10,000 more than the salary of a Tier 2 representative, and she anticipates that this salary differential will grow at a rate of 3% a year for as long as she keeps working. The certification program requires the completion of 20 Web-based courses and a score of 80% or better on an exam at the end of the course work. She has learned that the average amount of time necessary to finish the program is one year. The total cost of the program is $5,000, due when she enrolls in the program. Because she will do all the work for the certification on her own time, Natasha does not expect to lose any income during the certification. Another option is going back to school for an MBA degree. With an MBA degree, Natasha expects to be promoted to a managerial position in her current firm. The managerial position pays $20,000 a year more than her current position. She expects that this salary differential will also grow at a rate of 3% per year for as long as she keeps working. The evening program, which will take three years to complete, costs $25,000 per year, due at the beginning of each of her three years in school. Because she will attend classes in the evening, Natasha doesn’t expect to lose any income while she is earning her MBA if she chooses to undertake the MBA. 1. Determine the interest rate Natasha is currently earning on her inheritance by going to Yahoo! Finance (http://finance.yahoo.com) and clicking on the 10 Yr Bond link in the Market Summary section. Then go to the Historical Prices link and enter the appropriate date, August 2, 2010 (August 1st is a Sunday), to obtain the closing yield or interest rate that she is earning. Use this interest rate as the discount rate for the remainder of this problem. 2. Create a timeline in Excel for her current situation, as well as the certification program and MBA degree options, using the following assumptions: a. Salaries for the year are paid only once, at the end of the year. b. The salary increase becomes effective immediately upon graduating from the MBA program or being certified. That is, because the increases become effective immediately but salaries are paid at the end of the year, the first salary increase will be paid exactly one year after graduation or certification. 3. Calculate the present value of the salary differential for completing the certification program. Subtract the cost of the program to get the value of undertaking the certification program.

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Part 2 Interest Rates and Valuing Cash Flows 4. Calculate the present value of the salary differential for completing the MBA degree. Calculate the present value of the cost of the MBA program. Based on your calculations, determine the value of undertaking the MBA. 5. Based on your answers to Questions 3 and 4, what advice would you give to Natasha? What if the two programs are mutually exclusive? If Natasha undertakes one of the programs, there is no further benefit to undertaking the other program. Would your advice change?

Chapter 4 APPENDIX

Using a Financial Calculator

Specifying Decimal Places Make sure you have plenty of decimal places displayed! HP-10BII DISP

4

TI BAII Plus Professional 2ND

•

4

ENTER

Toggling Between the Beginning and End of a Period You should always make sure that your calculator is in end-of-period mode. HP-10BII MAR

TI BAII Plus Professional 2ND

PMT

Set the Number of Periods per Year To avoid a lot of confusion later, always set your periods per year (P/Y) to 1: HP-10BII PMT

1

TI BAII Plus Professional 2ND I/Y

1

ENTER

PV

PMT

FV

PV

PMT

FV

General TVM Buttons HP-10BII N

I/YR

TI BAII Plus Professional N

I/Y

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Solving for the Future Value of an Annuity (Example 4.5) Ellen is 35 years old, and she has decided it is time to plan seriously for her retirement. At the end of each year until she is 65, she will save $10,000 in a retirement account. If the account earns 10% per year, how much will Ellen have in the account at age 65? [Answer: 1,644,940] HP-10BII

3

0

N

Press [Orange Shift] and then the [C] button to clear all previous entries. Enter the Number of periods.

1

0

I/YR

Enter the market annual interest rate.

1

0

0

0

PV

C

0

0

PMT

FV

Enter the Payment amount per period. Indicate that there is no initial amount in the retirement account. Solve for the Future Value.

TI-BAII Plus Professional 2ND

FV

3

0

N

1

0

I/Y

1

0

0

0

PV

CPT

FV

Press [2ND] and then the [FV] button to clear all previous entries. Enter the Number of periods. Enter the market annual interest rate.

0

0

PMT

Enter the payment amount per period. Indicate that there is no initial amount in the retirement account. Solve for the Future Value.

Solving for the Rate of Return If you have an initial cash outflow of $2000 and one cash inflow per year for the following four years of $1000, $400, $400, and $800, what is the rate of return on the project per year (sometimes called the Internal Rate of Return or IRR on the calculators)? [Answer: 12.12%] HP-10BII C 2

0

0

0

/

1

0

0

0

CF j

4

0

0

CF j

CF j

2 8

0 CST

0

CF j

CF j

Press [Orange Shift] and then the [C] button to clear all previous entries. Enter the initial cash outflow. Enter the first cash inflow. Enter the second cash inflow. Enter the number of consecutive periods the second cash inflow occurs. Enter the fourth cash inflow. Press [Orange Shift] and then the [CST] button to calculate the IRR/year.

116

Part 2 Interest Rates and Valuing Cash Flows TI-BAII Plus Professional Access Cash Flow Worksheet. Press [2ND] and then the [CE/C] button to clear all previous entries.

CF 2ND

CE 円 C

2

0

0

0

/

ENTER

Enter the initial cash outflow.

1

0

0

0

ENTER

4

0

0

ENTER

0

ENTER

Enter the first cash inflow. Leave the frequency of the initial cash inflow at 1 (Default Setting). Enter the second cash inflow. Enter the frequency of the second cash inflow as 2. Enter the fourth cash inflow. Leave the frequency of the fourth cash inflow at 1 (Default Setting). Solve for the IRR.

2 8

IRR

CPT

ENTER 0

5

Interest Rates

LEARNING OBJECTIVES

notation

Q Understand the different ways interest rates are quoted

Q Know how inflation, expectations, and risk combine to determine interest rates

Q Use quoted rates to calculate loan payments and balances

Q See the link between interest rates in the market and a firm’s opportunity cost of capital

APR

annual percentage rate

n

number of periods

APY

annual percentage yield

N

C

cash flow

date of the last cash flow in a stream of cash flows

Cn

cash flow that arrives in period n

PV

present value

EAR

effective annual rate

r

interest rate or discount rate

FV

future value

rn

interest rate or discount rate for an n-year term

m

number of compounding periods per year

117

INTERVIEW WITH

Jason Moore Bradford & Marzec, LLC

Jason Moore graduated in 2004 from the California State University, Long Beach, with a major in business finance. As a fixed-income analyst at Bradford & Marzec, LLC, a Los Angeles-based institutional fixed-income manager with over $4 billion in assets, he pays close attention to interest rate movements. “I perform corporate credit research for basic industries such as metals, mining, chemicals, and forest products, following industry and company news and trends,” Jason explains. Then he formulates an opinion and communicates purchase and sell recommendations to the portfolio managers. One of the trends he watches is inflation, which affects the purchasing power of a given amount of money. When prices increase due to inflation, the value of a given amount of currency declines. Inflation therefore influences the interest rate a lender charges a borrower. “The interest rate charged is often fixed for a long period of time,” says Jason. “Any unexpected change in inflation over that time period affects the purchasing power of those fixed future payments, so all interest rates include an inflation expectation. If inflation increases, the purchasing power of those fixed future payments decreases, and vice versa.” This means that investors’ inflation expectations influence the return they expect to receive when lending money. If they think inflation will rise, they will want a higher interest rate. In addition, investors’ interest rate expectations should be reflected in the length of time an investor is willing to lend funds. “If investors believe that interest rates will rise, they should choose a short-term investment, rather than tie up their money at the current lower interest rate,” he says. “If investors believe interest rates will fall, they should choose a longer-term investment, locking in the current higher interest rate.” When economic activity slows and the financial climate is uncertain, as it was in 2008, investors seek lower-risk investment opportunities. “Lenders evaluate borrowers more closely,” says Jason. “As a consumer currently seeking a loan for education expenses, a car, or a house, your perceived risk of default—not being able to repay the loan—is more important now than it was just a few years ago.”

In Chapters 3 and 4, we explored the mechanics of computing present values and future values given a market interest rate. Recall that an interest rate allows us to convert money at one point in time to another. But how do we determine that interest rate? In this chapter, we consider the factors that affect interest rates and discuss how to determine the appropriate discount rate for a set of cash flows. We begin by looking at the way interest is paid and interest rates are quoted, and we show how to calculate the effective interest paid in one year given different quoting conventions. We then consider some of the main determinants of interest rates—namely, inflation and economic growth. Because interest rates tend to change over time, investors will demand different interest rates for different investment horizons, based on their expectations and the risk involved in longer time horizons.

118

California State University, Long Beach, 2004

“As a consumer currently seeking a loan for education expenses, a car, or a house, your perceived risk of default—not being able to repay the loan—is more important now than it was just a few years ago.”

Chapter 5 Interest Rates

5.1

119

Interest Rate Quotes and Adjustments If you spend some time looking through a newspaper, you will find literally dozens of interest rates discussed and advertised, from savings deposit rates to auto loan rates to interest rates being paid on the government’s debt. Interest rates are clearly central to the functioning of any financial system. To understand interest rates, it’s important to think of interest rates as a price—the price of using money. When you borrow money to buy a car, you are using the bank’s money now to get the car and paying the money back over time. The interest rate on your loan is the price you pay to be able to convert your future loan payments into a car today. Similarly, when you deposit money into a savings account, you are letting the bank use your money until you withdraw it later. The interest the bank pays you on your deposit is the price it pays to have the use of your money (for things like making car loans). Just like any other price, interest rates are set by market forces, in particular the supply of and demand for funds. When the supply (savings) is high and the demand (borrowing) is low, interest rates are low, other things being equal. Additionally, as we discuss later in the chapter, interest rates are also influenced by expected inflation and risk. In order to be able to study and use interest rates, we have to understand how they are quoted. In practice, interest is paid, and interest rates are quoted, in different ways. For example, in mid-2006 ING Direct, an Internet bank, offered savings accounts with an interest rate of 5.25% paid at the end of one year, while New Century Bank offered an interest rate of 5.12%, but with the interest paid on a daily basis. Interest rates can also differ depending on the investment horizon. In January 2004, investors earned only about 1% on one-year risk-free investments, but could earn more than 5% on 15-year risk-free investments. Interest rates can also vary due to risk. For example, the U.S. government is able to borrow at a much lower interest rate than General Motors. Because interest rates may be quoted for different time intervals, such as monthly, semiannual, or annual, it is often necessary to adjust the interest rate to a time period that matches that of our cash flows. We explore these mechanics of interest rates in this section.

The Effective Annual Rate effective annual rate (EAR) or annual percentage yield (APY) The total amount of interest that will be earned at the end of one year.

Interest rates are often reported as an effective annual rate (EAR) or annual percentage yield (APY), which indicates the total amount of interest that will be earned at the end of one year.1 We have used this method of quoting the interest rate thus far in this textbook, and in Chapters 3 and 4 we used the EAR as the discount rate r in our time value of money calculations. For example, with an EAR of 5%, a $100 investment grows to +100 * 1 1 + r 2 = +100 * 1 1.05 2 = +105

in one year. After two years it will grow to:

+100 * 1 1 + r 2 2 = +100 * 1 1.05 2 2 = +110.25

Month: Cash flow:

1

0

1

2

$100

(1.05)

$105

(1.05)

$100

(1.05)2

$110.25

$100

(1.1025)

$110.25

$110.25

The effective annual rate is also referred to as the effective annual yield (EAY).

120

Part 2 Interest Rates and Valuing Cash Flows

Adjusting the Discount Rate to Different Time Periods The preceding example shows that earning an effective annual rate of 5% for two years is equivalent to earning 10.25% in total interest over the entire period: +100 * 1 1.05 2 2 = +100 * 1.1025 = +110.25

In general, by raising the interest rate factor 1 1 + r 2 to the appropriate power, we can compute an equivalent interest rate for a longer time period. We can use the same method to find the equivalent interest rate for periods shorter than one year. In this case, we raise the interest rate factor 1 1 + r 2 to the appropriate fractional power. For example, earning 5% interest in one year is equivalent to receiving

1 1 + r 2 0.5 = 1 1.05 2 0.5 = +1.0247

for each $1 invested every six months (0.5 years). That is, a 5% effective annual rate is equivalent to an interest rate of approximately 2.47% earned every six months. We can verify this result by computing the interest we would earn in one year by investing for two six-month periods at this rate:

1 1 + r 2 2 = 1 1.0247 2 2 = +1.05 1 2

Month:

0

Cash flow:

$1

(1.0247)

$1

(1.0247)2

$1.05

$1

(1.05)

$1.05

1

$1.0247 (1.0247) $1.05

In general, we can convert a discount rate of r for one period to an equivalent discount rate for n periods using the following formula: Equivalent [email protected] Discount Rate = 1 1 + r 2 n - 1

(5.1)

In this formula, n can be larger than 1 (to compute a rate over more than one period) or smaller than 1 (to compute a rate over a fraction of a period). When computing present or future values, you should adjust the discount rate to match the time period of the cash flows. This adjustment is necessary to apply the perpetuity or annuity formulas to non-annual cash flows, as in the following example. Personal Finance

EXAMPLE 5.1 Valuing Monthly Cash Flows

Problem Suppose your bank account pays interest monthly with an effective annual rate of 6%. What amount of interest will you earn each month? If you have no money in the bank today, how much will you need to save at the end of each month to accumulate $100,000 in 10 years?

Solution Q Plan We can use Eq. 5.1 to convert the EAR to a monthly rate, answering the first question. The second question is a future value of an annuity question. It is asking how big a monthly annuity we would have to deposit in order to end up with $100,000 in 10 years. However, in order to do this problem, we need to write the timeline in terms of monthly periods because our cash flows (deposits) will be monthly:

Chapter 5 Interest Rates

Month:

0

1

2

121

120 ...

Cash flow:

C

C

C

That is, we can view the savings plan as a monthly annuity with 10 * 12 = 120 monthly payments. We have the future value of the annuity ($100,000), the length of time (120 months), and we will have the monthly interest rate from the first part of the question. We can then use the future value of an annuity formula (Eq. 4.6) to solve for the monthly deposit. Q Execute

From Eq. 5.1, a 6% EAR is equivalent to earning 1 1.06 2 1/12 - 1 = 0.4868% per month. The exponent in this equation is 1/12 because the period is 1/12th of a year (a month). To determine the amount to save each month to reach the goal of $100,000 in 120 months, we must determine the amount C of the monthly payment that will have a future value of $100,000 in 120 months, given an interest rate of 0.4868% per month. Now that we have all of the inputs in terms of months (monthly payment, monthly interest rate, and total number of months), we use the future value of annuity formula from Chapter 4 to solve this problem: FV 1 annuity 2 = C *

1 3 11 + r2n - 14 r

We solve for the payment C using the equivalent monthly interest rate r = 0.4868%, and n = 120 months: C =

FV 1 annuity 2 1 3 11 + r2n - 14 r

=

+100,000 = +615.47 per month 1 3 1 1.004868 2 120 - 1 4 0.004868

We can also compute this result using a financial calculator or spreadsheet:

N I/Y PV PMT FV Given: 120 0.4868 0 100,000 Solve for: 615.47 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.004868,120,0,100000) Q Evaluate Thus, if we save $615.47 per month and we earn interest monthly at an effective annual rate of 6%, we will have $100,000 in 10 years. Notice that the timing in the annuity formula must be consistent for all of the inputs. In this case, we had a monthly deposit, so we needed to convert our interest rate to a monthly interest rate and then use total number of months (120) instead of years.

Annual Percentage Rates annual percentage rate (APR) Indicates the amount of interest earned in one year without the effect of compounding. simple interest Interest earned without the effect of compounding.

The most common way to quote interest rates is in terms of an annual percentage rate (APR), which indicates the amount of simple interest earned in one year, that is, the amount of interest earned without the effect of compounding. Because it does not include the effect of compounding, the APR quote is typically less than the actual amount of interest that you will earn. To compute the actual amount that you will earn in one year, you must first convert the APR to an effective annual rate. For example, suppose Granite Bank advertises savings accounts with an interest rate of “6% APR with monthly compounding.” When it quotes a rate this way, Granite Bank really means that you will earn 6%/12 = 0.5% every month. That is, an APR with monthly compounding is actually a way of quoting a monthly interest rate, rather than an annual interest rate. In this case, the actual rate being quoted is 0.5% per month, and

122

Part 2 Interest Rates and Valuing Cash Flows

COMMON MISTAKE

Using the EAR in the Annuity Formula

At this point, many students make the mistake of trying to use the EAR in the annuity formula. The interest rate in the annuity formula must match the frequency of the cash flows. That’s why in Example 5.1 we first converted the EAR into a monthly rate and then used the annuity formula to compute the monthly loan payments. The common mistake in this case would be to use the EAR in the annuity formula to obtain annual cash flows, and then divide those cash flows by 12 to obtain the monthly payments. This process will produce the wrong answer. To see why, consider the timing of the first deposit in Example 5.1. With a monthly rate and monthly payments, the annuity formula

assumes that the first payment will be made one month from now. It then assumes that you will be making 11 more monthly deposits before the end of the first year. Each of those deposits will start earning interest as soon you make it. In contrast, if you use an EAR and calculate an annual cash flow, the formula assumes that you will make your first deposit one year from now, so that you will forgo a whole year of interest before you start earning anything. Thus, you can see that the EAR approach misses the fact that you are making deposits earlier and more often than annually, so you are adding to your interest-earning principal more frequently than once per year.

by convention, the bank states it as an APR by multiplying by 12 months. Because the interest compounds each month, you will actually have +1 * 1 1.005 2 12 = +1.061678

at the end of one year, for an effective annual rate of 6.1678%. The 6.1678% that you earn on your deposit is higher than the quoted 6% APR due to compounding: In later months, you earn interest on the interest paid in earlier months. To summarize, an actual rate of 0.5% per month can be stated in either of the following ways: Q 6% APR, compounded monthly Q EAR of 6.1678%, which is the actual rate earned per year It is important to remember that because the APR does not reflect the true amount you will earn over one year, the APR itself cannot be used as a discount rate. Instead, the APR is a way of quoting the actual interest earned each compounding period: Interest Rate per Compounding Period =

APR m

1 m = number of compounding periods per year 2

(5.2)

Once we have computed the interest earned per compounding period from Eq. 5.2, we can compute the equivalent interest rate for any other time interval using Eq. 5.1. Thus, the effective annual rate corresponding to an APR is given by the following conversion formula: Converting an APR to an EAR 1 + EAR = ¢1 +

APR m ≤ m

1 m = number of compounding periods per year 2

(5.3)

Table 5.1 shows the effective annual rates that correspond to an APR of 6% with different compounding intervals. The EAR increases with the frequency of compounding because of the ability to earn interest on interest sooner. Investments can compound even more frequently than daily. In principle, the compounding interval could be hourly or every second. As a practical matter, compounding more frequently than daily has a negligible impact on the effective annual rate and is rarely observed. When working with APRs, we must first convert the APR to a discount rate per compounding interval using Eq. 5.2, or to an EAR using Eq. 5.3, before evaluating the present or future value of a set of cash flows.

Chapter 5 Interest Rates

TABLE 5.1 Effective Annual Rates for a 6% APR with Different Compounding Periods

Compounding Interval

Effective Annual Rate

Annual Semiannual Monthly Daily

EXAMPLE 5.2 Converting the APR to a Discount Rate

123

¢1 +

0.06 1 ≤ - 1 = 6% 1

¢1 +

0.06 2 ≤ - 1 = 6.09% 2

¢1 +

0.06 12 ≤ - 1 = 6.1678% 12

¢1 +

0.06 365 ≤ - 1 = 6.1831% 365

Problem Your firm is purchasing a new telephone system that will last for four years. You can purchase the system for an upfront cost of $150,000, or you can lease the system from the manufacturer for $4000 paid at the end of each month. The lease price is offered for a 48-month lease with no early termination—you cannot end the lease early. Your firm can borrow at an interest rate of 6% APR with monthly compounding. Should you purchase the system outright or pay $4000 per month?

Solution Q Plan The cost of leasing the system is a 48-month annuity of $4000 per month: Month:

0

1

2

48 ...

Payment: $4000 $4000 $4000 We can compute the present value of the lease cash flows using the annuity formula, but first we need to compute the discount rate that corresponds to a period length of one month. To do so, we convert the borrowing cost of 6% APR with monthly compounding to a monthly discount rate using Eq. 5.2. Once we have a monthly rate, we can use the present value of annuity formula Eq. 4.5 to compute the present value of the monthly payments and compare it to the cost of buying the system.

Q Execute As Eq. 5.2 shows, the 6% APR with monthly compounding really means 6%/12 = 0.5% every month. The 12 comes from the fact that there are 12 monthly compounding periods per year. Now that we have the true rate corresponding to the stated APR, we can use that discount rate in the annuity formula Eq. 4.5 to compute the present value of the monthly payments: PV = 4000 *

1 1 ¢1 ≤ = +170,321.27 0.005 1.00548

Using a financial calculator or spreadsheet:

Given: Solve for:

N 48

I/Y 0.5

PV

PMT 4000

FV 0

170,321.27 Excel Formula: PV(RATE,NPER,PMT,FV)PV(0.005,48,4000,0)

Q Evaluate Thus, paying $4000 per month for 48 months is equivalent to paying a present value of $170,321.27 today. This cost is +170,321.27 - +150,000 = +20,321.27 higher than the cost of purchasing the system, so it is better to pay $150,000 for the system rather than lease it. One way to interpret this result is as follows: At a 6% APR with monthly compounding, by promising to repay $4000 per month your firm can borrow $170,321 today. With this loan it could purchase the phone system and have an additional $20,321 to use for other purposes.

124

Part 2 Interest Rates and Valuing Cash Flows

Concept Check

5.2

1. What is the difference between an EAR and an APR quote? 2. Why can’t the APR be used as a discount rate?

Application: Discount Rates and Loans Now that we have explained how to compute the discount rate from an interest rate quote, let’s apply the concept to solve two common financial problems: calculating a loan payment and calculating the remaining balance on a loan.

Computing Loan Payments amortizing loan A loan on which the borrower makes monthly payments that include interest on the loan plus some part of the loan balance.

Many loans, such as mortgages and car loans, have monthly payments and are quoted in terms of an APR with monthly compounding. These types of loans are amortizing loans, which means that each month you pay interest on the loan plus some part of the loan balance. Each monthly payment is the same, and the loan is fully repaid with the final payment. Typical terms for a new car loan might be “6.75% APR for 60 months.” When the compounding interval for the APR is not stated explicitly, it is equal to the interval between the payments, or one month in this case. Thus, this quote means that the loan will be repaid with 60 equal monthly payments, computed using a 6.75% APR with monthly compounding. It sometimes helps to look at the loan from the bank’s point of view: the bank will give you $30,000 in cash today to use to buy the car. In return, you will give the bank 60 equal payments each month for 60 months, starting one month from now. In order for the bank to be willing to accept this exchange, it must be true that the present value of what you will give the bank, discounted at the loan’s interest rate, is equal to the amount of cash the bank is giving you now. Consider the timeline for a $30,000 car loan with these terms: Month:

0

1

2

60 ...

C

Cash flow: $30,000

C

C

The payment, C, is set so that the present value of the cash flows, evaluated using the loan interest rate, equals the original principal amount of $30,000. In this case, the 6.75% APR with monthly compounding corresponds to a one-month discount rate of 6.75%/12 = 0.5625%. It is important that the discount rate match the frequency of the cash flows—here we have a monthly discount rate and a monthly loan payment, so we can proceed. Because the loan payments are an annuity, we can use Eq. 4.9 to find C: P 30,000 C = = = +590.50 1 1 1 1 ¢1 ≤ ¢1 ≤ r 0.005625 11 + r2N 1 1 + 0.005625 2 60 Alternatively, we can solve for the payment C using a financial calculator or spreadsheet:

Given: Solve for:

N 60

I/Y 0.5625

PV 30,000

PMT

FV 0

590.50 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.005625,60,30000,0)

Your loan payment each month includes interest and repayment of part of the principal, reducing the amount you still owe. Because the loan balance (the amount you still owe) is decreasing each month, the interest that accrues on that balance is decreasing. As a

Chapter 5 Interest Rates

125

result, even though your payment stays the same over the entire 60-month life of the loan, the part of that payment needed to cover interest each month is constantly decreasing and the part left over to reduce the principal further is constantly increasing. We illustrate this effect in panel (a) of Figure 5.1, where we show the proportion of each monthly

FIGURE 5.1 Amortizing Loan

Panel (a) shows how the interest (red) and principal portions (turquoise) of the monthly payment on the $30,000 car loan change over the life of the loan. Panel (b) illustrates the effect on the outstanding balance (principal) of the loan. Note that as the balance decreases, the amount of the payment needed to cover interest on that balance decreases, allowing more of the payment to be used to reduce the principal. Panel (a) $700

Principal Payment Interest Payment

$600 $500 $400 $300 $200 $100 $0

1

4

7

10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 60 Months

Panel (b) $35,000

Principal Outstanding

$30,000 $25,000 $20,000 $15,000 $10,000 $5000 $0

1

4

7

10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 60 Months

126

Part 2 Interest Rates and Valuing Cash Flows loan payment that covers interest (red) and the portion left over to reduce the principal (turquoise). As you can see, $168.75 of your first $590.50 payment is needed just to cover interest accrued over the first month 1 +30,000 * 0.005625 = +168.75 2 . However, this amount steadily decreases so that by the end of the loan, nearly all of your payment is going toward principal. Panel (b) of Figure 5.1 shows the effect of your payments on the loan balance. When you make your first payment of $590.50, $168.75 covers interest on the loan, leaving $421.75 to reduce the principal to +30,000 - +421.75 = +29,578.25. The next month, you owe interest only on the $29,578.25 loan balance, which is $166.38, leaving more of your $590.50 payment to reduce the principal further. This effect continues so that each month more of your payment is available to reduce the principal, causing the principal to decrease rapidly toward the end of the loan as you are taking bigger and bigger chunks out of the balance.

Computing the Outstanding Loan Balance As Figure 5.1 shows, the outstanding balance on an amortizing loan is different each month. The amount you owe at any point in time can be calculated as the present value of your future obligations on the loan. So, the outstanding balance, also called the outstanding principal, is equal to the present value of the remaining future loan payments, again evaluated using the loan interest rate. We calculate the outstanding loan balance by determining the present value of the remaining loan payments using the loan rate as the discount rate. Personal Finance

EXAMPLE 5.3 Computing the Outstanding Loan Balance

Problem Let’s say that you are now three years into your $30,000 car loan from the previous section and you decide to sell the car. When you sell the car, you will need to pay whatever the remaining balance is on your car loan. After 36 months of payments, how much do you still owe on your car loan?

Solution Q Plan We have already determined that the monthly payments on the loan are $590.50. The remaining balance on the loan is the present value of the remaining 2 years, or 24 months, of payments. Thus, we can just use the annuity formula with the monthly rate of 0.5625%, a monthly payment of $590.50, and 24 months remaining. Q Execute Balance with 24 months remaining = +590.50 *

1 1 ¢1 ≤ = +13,222.32 0.005625 1.00562524

Thus, after three years, you owe $13,222.32 on the loan. Using a financial calculator or spreadsheet:

N I/Y PV PMT FV Given: 24 0.5625 590.50 0 Solve for: 13,222.32 Excel Formula: PV(RATE,NPER,PMT,FV)PV(0.005625,24,590.50,0) You could also compute this as the FV of the original loan amount after deducting payments:

N I/Y PV PMT FV Given: 36 0.5625 30,000 590.50 Solve for: 13,222.56 Excel Formula: FV(RATE,NPER,PMT,PV)FV(0.005625,36,590.50,30000)

Chapter 5 Interest Rates

127

The 24 cent difference is due to rounding on the payment amount. Q Evaluate At any point in time, including when you first take out the loan, you can calculate the balance of the loan as the present value of your remaining payments. Recall that when the bank gave you the $30,000 in the first place, it was willing to take 60 monthly payments of $590.50 in return only because the present value of those payments was equivalent to the cash it was giving you. Any time that you want to end the loan, the bank will charge you a lump sum equal to the present value of what it would receive if you continued making your payments as planned. As the second approach shows, the amount you owe can also be thought of as the future value of the original amount borrowed after deducting payments made along the way.

Concept Check

5.3

3. How is the principal repaid in an amortizing loan? 4. Why does the part of your loan payment covering interest change over time?

The Determinants of Interest Rates Now that we understand how interest rates are quoted and used in loans, we turn to a broader question: How are interest rates determined? Fundamentally, interest rates are determined by market forces based on the relative supply and demand of funds. This supply and demand is in turn determined by the willingness of individuals, banks, and firms to borrow, save, and lend. Changes in interest rates affect consumer decisions, such as how much you can borrow for a car loan or mortgage. Because they change the present value of future cash flows, changes in interest rates also have a broad impact on capital budgeting decisions within the firm. In this section, we look at some of the factors that may influence interest rates, such as inflation, current economic activity, and expectations of future growth.

Inflation and Real Versus Nominal Rates

nominal interest rates Interest rates quoted by banks and other financial institutions that indicate the rate at which money will grow if invested for a certain period of time.

real interest rate The rate of growth of purchasing power after adjusting for inflation.

Inflation measures how the purchasing power of a given amount of currency declines due to increasing prices. How many times have you heard the expression, “A dollar just doesn’t buy what it used to”? We’ve all witnessed the steady upward climb of prices—for example, your morning coffee probably costs a little more today than it did five years ago. Inflation affects how we evaluate the interest rates being quoted by banks and other financial institutions. Those interest rates, and the ones we have used for discounting cash flows in this book, are nominal interest rates, which indicate the rate at which your money will grow if invested for a certain period. Of course, if prices in the economy are also increasing due to inflation, the nominal interest rate does not represent the true increase in purchasing power that will result from investing. For example, let’s say that a cup of coffee costs $1 this year. If you have $100, you could buy 100 coffees. Instead, if you put that $100 in a bank account earning 5.06% per year, you will have $105.06 at the end of the year. But how much better off will you really be? That depends on how much prices have increased over the same year. If inflation was 3% over the year, then that cup of coffee would cost 3% more, or $1.03 at the end of the year. Thus, you could take your $105.06 and buy +105.06/+1.03 = 102 coffees, so you’re really only 2% better off. That 2% is your real interest rate: the rate of growth of your purchasing power, after adjusting for inflation. Just as in the example, we can calculate the rate of growth of purchasing power as follows: 1 + Nominal Rate Growth in Purchasing Power = 1 + Real Rate = 1 + Inflation Rate Growth of Money = (5.4) Growth of Prices

128

Part 2 Interest Rates and Valuing Cash Flows We can rearrange Eq. 5.4 to find the following formula for the real interest rate, together with a convenient approximation for the real interest rate when inflation rates are low: The Real Interest Rate Nominal Rate - Inflation Rate Real Rate = ⬇ Nominal Rate - Inflation Rate (5.5) 1 + Inflation Rate That is, the real interest rate is approximately equal to the nominal interest rate less the rate of inflation.2

EXAMPLE 5.4

Problem

Calculating the Real Interest Rate

In the year 2000, short-term U.S. government bond rates were about 5.8% and the rate of inflation was about 3.4%. In 2003, bond rates were about 1% and the rate of inflation was about 1.9%. What was the real interest rate in 2000 and 2003?

Solution Q Plan The bond rates tell us the nominal rates. Given the nominal rates and inflation rates for each year, we can use Eq. 5.5 to calculate the real interest rate. Q Execute Eq. 5.5 says: Real Rate =

Nominal Rate - Inflation Rate 1 + Inflation Rate

Thus, the real interest rate in 2000 was 1 5.8% - 3.4% 2 / 1 1.034 2 = 2.32% (which is approximately equal to the difference between the nominal rate and inflation: 5.8% - 3.4% = 2.4%). In 2003, the real interest rate was 1 1% - 1.9% 2 / 1 1.019 2 = -0.88%. Q Evaluate Note that the real interest rate was negative in 2003, indicating that interest rates, given by the bond rates, were insufficient to keep up with inflation. As a result, investors in U.S. government bonds were able to buy less at the end of the year than they could have purchased at the start of the year.

Figure 5.2 shows the history of nominal interest rates and inflation rates in the United States since 1955. Note that the nominal interest rate tends to move with inflation. Intuitively, individuals’ willingness to save will depend on the growth in purchasing power they can expect (given by the real interest rate). Thus, when the inflation rate is high, a higher nominal interest rate is needed to induce individuals to save. This was evident in the late 1970s and early 1980s when inflation reached double-digits in the United States, and nominal rates increased in response.

Investment and Interest Rate Policy Interest rates affect not only individuals’ propensity to save, but also firms’ incentive to raise capital and invest. Consider an opportunity that requires an upfront investment of 2

The real interest rate should not be used as a discount rate for future cash flows. It can be used as a discount rate only if the cash flows are not the expected cash flows that will be paid, but are the equivalent cash flows before adjusting them for growth due to inflation (in that case, we say the cash flows are in real terms). This approach is error prone, however, so throughout this book we will always forecast cash flows including any growth due to inflation, and discount using nominal interest rates.

Chapter 5 Interest Rates

U.S. Interest Rates and Inflation Rates, 1955–2009

The graph shows U.S. nominal interest rates (in blue) and inflation rates (in red) from 1955–2009. Note that interest rates tend to be high when inflation is high. Interest rates are average three-month Treasury bill rates and inflation rates are based on annual increases in the U.S. Bureau of Labor Statistics’ consumer price index.

Inflation Rate

16.00

Nominal Interest Rate 14.00 12.00 10.00 Rate (%)

FIGURE 5.2

129

8.00 6.00 4.00 2.00 0.00 1960

1970

1980

1990

2000

2010

Year Source: St. Louis Federal Reserve Economic Data (FRED).

$10 million and generates a cash flow of $3 million per year for four years. If the interest rate is 5%, this investment’s benefits have a PV of: 3 3 3 3 PV = + + + = +10.638 million 2 3 1.05 1.05 1.05 1.054 If the interest rate is 9%, the PV falls to PV =

3 3 3 3 + + + = +9.719 million 1.09 1.092 1.093 1.094

and the investment is no longer profitable given its $10 million cost. The reason, of course, is that we are discounting the positive cash flows at a higher rate, which reduces their present value. The cost of $10 million occurs today, however, so its present value is independent of the discount rate. More generally, when the costs of an investment precede the benefits, an increase in the interest rate will make the investment less attractive. All else being equal, higher interest rates will therefore tend to shrink the set of good investments available to firms. The Federal Reserve in the United States and central banks in other countries attempt to use this relationship between interest rates and investment incentives when trying to guide the economy. They will often lower interest rates in an attempt to stimulate investment if the economy is slowing, and they will raise interest rates to reduce investment if the economy is “overheating” and inflation is on the rise.

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How Is Inflation Actually Calculated? Inflation is calculated as the rate of change in the Consumer Price Index (CPI). The CPI measures what it costs each month to purchase a standard set of goods that the average consumer would buy. How controversial can price data be? To gather the price information, data collectors visit stores and gather 80,000 retail price quotes and 5000 housing rent quotes. The data is sent daily to Washington, DC, where analysts at the Bureau of Labor Statistics seek to determine if part of a price change captures a change in quality or inflation. Because this adjustment can be subjective, herein lies the controversy in the CPI calculation. The Wall Street Journal, covering the controversy, reported the following examples: Q A 57-inch television in which the price dropped from $2238.99 to $1909.97. Going over the checklist, the data gatherer in the field discovered the old version had a built-in high-definition tuner. The new one did not. The analyst estimated that the tuner was valued at $513.69. This turned what appeared to be a 14.7% price decrease into a 10.7% increase.

Q A 27-inch television where the price appeared to stay the same, but an analyst determined that the price had declined. The latest model had a flat screen, something that consumers value more than the curved screen in the old model. The newer TV also had a ten-watt stereo, compared with the weaker six-watt stereo in the older model. Critics argue that this quality adjustment most often ends up making a price increase look smaller or even turning it into a decline. Thus, they conclude that the government underestimates the true rate of inflation. Supporters argue that these adjustments are necessary because paying more for a better product is not equivalent to paying more for the same product. This debate is important because many union contracts, for example, have wages linked to inflation, and investors need good inflation data to determine what interest rate to demand. WSJ Source : Aeppel, T., “New and Improved: An Inflation Debate Brews Over Intangibles at the Mall—Critics Say U.S. Plays Down CPI Through Adjustments For Quality, Not Just Price—Value of a TV’s Flat Screen,” 9 May 2005, A1.

The Yield Curve and Discount Rates

term structure The relationship between the investment term and the interest rate. yield curve A plot of bond yields as a function of the bonds’ maturity date. risk-free interest rate The interest rate at which money can be borrowed or lent without risk over a given period.

The interest rates that banks offer on investments or charge on loans depend on the horizon, or term, of the investment or loan. For example, suppose you are willing to put your money in a CD (certificate of deposit)3 that matures in two years (meaning that you cannot get the money back before then without a penalty). The bank will offer you a higher rate of interest for this CD than if you put your money in a statement savings account, where you can withdraw your funds at any time. The relationship between the investment term and the interest rate is called the term structure of interest rates. We can plot this relationship on a graph called the yield curve. Figure 5.3 shows the term structure and corresponding yield curve of U.S. interest rates that were available to investors in November of 2006, 2007, and 2008. In each case, note that the interest rate depends on the horizon, and that the difference between short-term and long-term interest rates was especially pronounced in 2008. The rates plotted are interest rates for U.S. Treasury securities, which are considered to be free of any risk of default (the U.S. government will not default on its loans). Thus, each of these rates is a risk-free interest rate, which is the interest rate at which money can be borrowed or lent without risk over a given period. We can use the term structure to compute the present and future values of a risk-free cash flow over different investment horizons. For example, $100 invested for one year at the one-year interest rate in November 2008 would grow to a future value of +100 * 1.0091 = +100.91

3

A certificate of deposit is a short- or medium-term debt instrument offered by banks. You deposit money in the bank for a stated period of time and normally receive a fixed rate of interest. The rate is higher than it would be on a savings account because you cannot withdraw your money early without paying a penalty.

Chapter 5 Interest Rates

131

FIGURE 5.3 Term Structure of Risk-Free U.S. Interest Rates, November 2006, 2007, and 2008 The figure shows the interest rate available from investing in risk-free U.S. Treasury securities with different investment terms. In each case, the interest rates differ depending on the

0.5 1 2 3 4 5 6 7 8 9 10 15 20

Nov-06 5.23% 4.99% 4.80% 4.72% 4.63% 4.64% 4.65% 4.66% 4.69% 4.70% 4.73% 4.89% 4.87%

6%

Date Nov-07 3.32% 3.16% 3.16% 3.12% 3.34% 3.48% 3.63% 3.79% 3.96% 4.00% 4.18% 4.44% 4.45%

Nov-08 0.47% 0.91% 0.98% 1.26% 1.69% 2.01% 2.49% 2.90% 3.21% 3.38% 3.41% 3.86% 3.87%

November 2006 5%

Interest Rate (EAR)

Term (years)

horizon. For example, in 2008, the interest rate on a 10-year loan (3.41%) was more than three times the rate on a 1-year loan (0.91%).

4% November 2007 3% November 2008 2% 1% 0%

0

2

4

6

8 10 12 Term (Years)

14

16

18

20

(Data from U.S. Treasury securities.)

at the end of one year, and $100 invested for ten years at the ten-year interest rate in November 2008 would grow to:4 +100 * 1 1.0341 2 10 = +139.84

We can apply the same logic when computing the present value of cash flows with different maturities. A risk-free cash flow received in two years should be discounted at the two-year interest rate, and a cash flow received in ten years should be discounted at the ten-year interest rate. In general, a risk-free cash flow of Cn received in n years has the present value PV =

Cn 1 1 + rn 2 n

(5.6)

where rn is the risk-free interest rate for an n-year term. In other words, when computing a present value we must match the term of the cash flow and term of the discount rate. Combining Eq. 5.6 for cash flows in different years leads to the general formula for the present value of a cash flow stream: Present Value of a Cash Flow Stream Using a Term Structure of Discount Rates C1 C2 CN PV = (5.7) + + g + 2 1 + r1 1 1 + r2 2 1 1 + rN 2 N

4

We could also invest for ten years by investing at the one-year interest rate for ten years in a row. However, because we do not know what future interest rates will be, our ultimate payoff would not be risk free.

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Part 2 Interest Rates and Valuing Cash Flows

INTERVIEW WITH

FREDERIC S. MISHKIN

Frederic Mishkin, Alfred Lerner Professor of Banking and Financial Institutions at Columbia University Graduate School of Business, served as a governor of the Federal Reserve Board from 2006 to 2008. QUESTION: What are the main policy instruments used by central banks to control the economy? ANSWER: Short-term interest rates are one of the main policy instru-

ments used by central banks to control the economy. Specifically, central banks like the U.S. Federal Reserve (Fed) will act to lower short-term interest rates in order to stimulate investment if the economy is in a recession. For example, while the economy was slowing down in 2007 and 2008, the Fed cut its short-term interest rate target aggressively, from 5.25% down to 0% by year’s end. The Fed can affect interest rates by changing the amount of liquidity in the financial system. By purchasing U.S. Treasury and federal agency securities or making loans to the financial system, the Fed increases banks available reserves. This expansion of bank’s liquidity increases the availability of credit, thereby lowering interest rates. Similarly, if the Fed sells securities to financial firms, the cash they use to purchase the securities is no longer available to be lent, and this shortage of liquidity raises interest rates.

heating up. Consumers reduce spending when faced with higher interest rates on mortgages, credit cards, and car loans. Likewise, firms cut back on projects when the cost to finance them goes up.

During the 2007–2009 financial crisis, the Fed became concerned about the risk of deflation. Why is deflation a concern?

QUESTION:

ANSWER: The dangers of deflation—or a negative inflation rate— are every bit as serious as the dangers of inflation. Deflation also creates uncertainty about future price levels and makes debt more expensive to repay in terms of goods and services. When borrowers struggle to repay debt or default on their debt obligations, the economy suffers. Deflation also limits the effectiveness of monetary policy. The Federal Reserve can only control nominal interest rates. But investors’ decisions to save or invest are determined by real interest rates, which determine the amount they will actually earn after accounting for inflation. If the inflation rate falls significantly below the nominal interest, then the real interest rate can remain high and offset the Fed’s attempt to stimulate the economy.

QUESTION: We often hear that the Fed is concerned about inflation—why? How does the Fed act to fight inflation?

QUESTION:

Recently, the Fed has been buying long-term Treasury Bonds. Why would the Fed do this?

ANSWER: A primary objective of a central bank is price stability, maintaining a low and stable inflation rate. Getting to the “right” number—an inflation rate that is neither too high nor too low—is one of the key challenges of monetary policy today. High inflation is almost always accompanied by high variability of inflation, making it difficult for consumers, businesses, and government to plan for the future and thus reducing economic efficiency. The Federal Reserve tries to curb inflation by raising interest rates. Higher interest rates constrain demand in the economy, bringing it into balance with supply and preventing inflation from

ANSWER: When traditional monetary policy tools fall short, the Federal Reserve pursues other options. So in 2008–2009, the Fed provided liquidity directly to certain credit markets, lowering interest rates on loans and on securities that have credit risk. The Fed’s purchase on long-term Treasury bonds is another example. In 2009, when short-term rates were close to 0 percent, the Fed bought long-term Treasury bonds. Because of the inverse relationship between bond prices and interest rates, this action lowered long-term interest rates relative to short-term rates.

Note the difference between Eq. 5.7 and Eq. 4.3. Here, we use a different discount rate for each cash flow, based on the rate from the yield curve with the same term. When interest rates are very similar across maturities, we say that the yield curve is flat, because it is close to a flat line. When the yield curve is relatively flat, as it was in November 2006, the distinction of using different rates for each cash flow is relatively minor and is often ignored by discounting using a single “average” interest rate r. But when short-term and long-term interest rates vary widely, as they did in November 2008, Eq. 5.7 should be used. Warning: All of our shortcuts for computing present values (annuity and perpetuity formulas, and financial calculators) are based on discounting all of the cash flows at the same rate. They cannot be used in situations in which cash flows need to be discounted at different rates.

Chapter 5 Interest Rates

EXAMPLE 5.5

133

Problem

Using the Term Structure to Compute Present Values

Compute the present value of a risk-free 5-year annuity of $1000 per year, given the yield curve for November 2008 in Figure 5.3.

Solution Q Plan The timeline of the cash flows of the annuity is:

0

1

2

3

4

5

$1000

$1000

$1000

$1000

$1000

We can use the table next to the yield curve to identify the interest rate corresponding to each length of time: 1, 2, 3, 4, and 5 years. With the cash flows and those interest rates, we can compute the PV. Q Execute From Figure 5.3, we see that the interest rates are: 0.91%, 0.98%, 1.26%, 1.69%, and 2.01%, for terms of 1, 2, 3, 4, and 5 years, respectively. To compute the present value, we discount each cash flow by the corresponding interest rate: PV =

1000 1000 1000 1000 1000 + + + + = +4775 2 3 4 1.0091 1.0098 1.0126 1.0169 1.02015

Q Evaluate The yield curve tells us the market interest rate per year for each different maturity. In order to correctly calculate the PV of cash flows from five different maturities, we need to use the five different interest rates corresponding to those maturities. Note that we cannot use the annuity formula here because the discount rates differ for each cash flow.

COMMON MISTAKE

Using the Annuity Formula When Discount Rates Vary

When computing the present value of an annuity, a common mistake is to use the annuity formula with a single interest rate even though interest rates vary with the investment horizon. For example, we cannot compute the present value of the five-year annuity in Example 5.5 using the five-year interest rate from November 2008: PV Z +1000 *

1 1 ¢1 ≤ = +4712 0.0201 1.02015

If we want to find the single interest rate that we could use to value the annuity, we must first compute the present value of the annuity using Eq. 5.7 and then solve for its rate of return. For the annuity in Example 5.5, we use a financial calculator or spreadsheet to find its rate of return of 1.55%. The rate of return of the annuity is always between the highest and lowest discount rates used to calculate its present value, as is the case in this example.

Given: Solve for:

N 5

I/Y

PV 4775

PMT 1000

FV 0

1.55 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(5,1000,4775,0)

The Yield Curve and the Economy As Figure 5.4 illustrates, the yield curve changes over time. Sometimes, short-term rates are close to long-term rates, and at other times they may be very different. What accounts for the changing shape of the yield curve?

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Part 2 Interest Rates and Valuing Cash Flows

FIGURE 5.4

Yield Curve Shapes example of a steep yield curve is from October 1991. Finally, the green line depicts an inverted yield curve, so called because it slopes downward instead of upward. This happens when shortterm rates are higher than long-term rates as they were in January 1981. We discuss why the shape of the yield curve changes over time in the rest of this section.

0

5

10

20

Years

(a) Normal Yield Curve

federal funds rate The overnight loan rate charged by banks with excess reserves at a Federal Reserve bank (called federal funds ) to banks that need additional funds to meet reserve requirements.

30

16% 14% 12% 10% 8% 6% 4% 2% 0%

Interest Rate

16% 14% 12% 10% 8% 6% 4% 2% 0%

Interest Rate

Interest Rate

The figure shows three different yield curve shapes. The blue line represents a “normal” yield curve. Most of the time the yield curve has this shape—moderately upward sloping. The red line depicts a steep yield curve—note the larger than normal difference between short-term rates (2%) and long-term rates (7%), making the yield curve look steeper than normal. This

0

5

10

20

Years

(b) Steep Yield Curve

30

16% 14% 12% 10% 8% 6% 4% 2% 0%

0

5

10

20

30

Years

(c) Inverted Yield Curve

Interest Rate Determination. The Federal Reserve determines very short-term interest rates through its influence on the federal funds rate, which is the rate at which banks can borrow cash reserves on an overnight basis. All other interest rates on the yield curve are set in the market and are adjusted until the supply of lending matches the demand for borrowing at each loan term. As we shall see in a moment, expectations of future interest rate changes have a major effect on investors’ willingness to lend or borrow for longer terms and, therefore, on the shape of the yield curve. Suppose short-term interest rates are equal to long-term interest rates. If interest rates are expected to rise in the future, investors would not want to make long-term investments. Instead, they could do better by investing on a short-term basis and then reinvesting after interest rates rose. Thus, if interest rates are expected to rise, long-term interest rates will tend to be higher than short-term rates to attract investors. Similarly, if interest rates are expected to fall in the future, then borrowers would not wish to borrow at long-term rates that are equal to short-term rates. They would do better by borrowing on a short-term basis, and then taking out a new loan after rates fall. So, if interest rates are expected to fall, long-term rates will tend to be lower than short-term rates to attract borrowers. Yield Curve Shape. These arguments indicate that the shape of the yield curve will be strongly influenced by interest rate expectations. A sharply increasing (steep) yield curve, with long-term rates much higher than short-term rates, generally indicates that interest rates are expected to rise in the future. A decreasing (inverted ) yield curve, with longterm rates lower than short-term rates, generally signals an expected decline in future interest rates. Because interest rates tend to drop in response to a slowdown in the economy, an inverted yield curve is often interpreted as a negative forecast for economic growth. Indeed, as Figure 5.5 illustrates, each of the last seven recessions in the United States was preceded by a period in which the yield curve was inverted (note the red shaded areas before the gray bars indicating a recession). Conversely, the yield curve tends to be steep (and therefore shaded blue) as the economy comes out of a recession and interest rates are expected to rise.

Chapter 5 Interest Rates

FIGURE 5.5

135

Short-Term Versus Long-Term U.S. Interest Rates and Recessions Research. Note that inverted yield curves tend to precede recessions as determined by the National Bureau of Economic Research. In recessions, interest rates tend to fall, with shortterm rates dropping further. As a result, the yield curve tends to be steep coming out of a recession.

One-year and ten-year U.S. Treasury rates are plotted, with the spread between them shaded in green if the shape of the yield curve is increasing (the one-year rate is below the ten-year rate) and in red if the yield curve is inverted (the one-year rate exceeds the ten-year rate). Gray bars show the dates of U.S. recessions as determined by the National Bureau of Economic

18 10-year Interest Rate 1-year Interest Rate Recession

16

Interest Rate (%)

14 12 10 8 6 4

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

0

1962

2

Year

The normal shape of the yield curve is moderately upward sloping. This would be the case if investors almost always believed that interest rates were going to rise in the future. But that is unlikely, so there have to be other forces at work to cause long-term interest rates normally to be higher than short-term rates. The most commonly cited reason is that long-term loans are riskier than short-term loans. If you make a 30-year loan today and lock in the interest rate, the present value of the payments you receive on the loan is very sensitive to even small changes in market interest rates. This sensitivity is due to the effect of compounding a change in interest rates over a 30-year period. To see this effect, consider the following example.

EXAMPLE 5.6 Long-Term Versus Short-Term Loans

Problem You work for a bank that has just made two loans. In one, you loaned $909.09 today in return for $1000 in one year. In the other, you loaned $909.09 today in return for $15,863.08 in 30 years. The difference between the loan amount and repayment amount is based on an interest rate of 10% per year. Imagine that immediately after you make the loans, news about economic growth is announced that increases inflation expectations, so that the market interest rate for loans like these jumps to 11%. Loans make up a major part of a bank’s assets, so you are naturally concerned about the value of these loans. What is the effect of the interest rate change on the value to the bank of the promised repayment of these loans?

136

Part 2 Interest Rates and Valuing Cash Flows Solution Q Plan Each of these loans has only one repayment cash flow at the end of the loan. They differ only by the time to repayment: Loan Today 1

909.09

1000

Loan Today

1…29

30

909.09

0

15,863.08

The effect on the value of the future repayment to the bank today is just the PV of the loan repayment, calculated at the new market interest rate. Q Execute For the one-year loan: PV =

+1000 = +900.90 1 1.11 2 1

For the 30-year loan: PV =

+15,863.08 = +692.94 1 1.11 2 30

Q Evaluate The value of the one-year loan decreased by +909.09 - +900.90 = +8.19, or 0.9%, but the value of the 30-year loan decreased by +909.09 - +692.94 = +216.15, or almost 24%! The small change in market interest rates, compounded over a longer period, resulted in a much larger change in the present value of the loan repayment. You can see why investors and banks view longer-term loans as being riskier than short-term loans.

In addition to specifying the discount rates for risk-free cash flows that occur at different horizons, it is also a potential leading indicator of future economic growth. Due to these qualities, the yield curve provides extremely important information for a business manager.

Concept Check

5.4

5. What is the difference between a nominal and real interest rate? 6. How are interest rates and the level of investment made by businesses related?

The Opportunity Cost of Capital As we have seen in this chapter, the interest rates we observe in the market will vary based on quoting conventions, the term of the investment, and risk. In this chapter, we have developed the tools to account for these differences and gained some insights into how interest rates are determined. This knowledge will provide the foundation for our study of bonds in the next chapter. In Chapter 3, we argued that the Valuation Principle tells us to use the “market interest rate” to compute present values and evaluate an investment opportunity. But with so many interest rates to choose from, the term “market interest rate” is inherently ambiguous. Therefore, going forward in the textbook, we will base the discount rate that we use to evaluate cash flows on the investor’s opportunity cost of capital (or more simply, the cost of capital), which is the best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted.

Chapter 5 Interest Rates opportunity cost of capital or cost of capital The best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted; the return the investor forgoes on an alternative investment of equivalent risk and term when the investor takes on a new investment.

137

In order to understand the definition of opportunity cost of capital, it helps to think of yourself as a financial manager competing with financial managers at other firms to attract investors’ funds (capital). In order to attract investors to invest in your firm or creditors to lend to your firm, you have to be able to offer them an expected return at least as good as what they could get elsewhere in the market for the same risk and length of investment. Now it is easier to see where the term (opportunity) cost of capital comes from—investors in your firm are giving up the opportunity to invest their funds elsewhere. This is an opportunity cost to them and to overcome it you must offer them a return equal to or better than their opportunity cost of capital. Even if you already have the funds internally in the firm to invest, the logic still applies. You could either return the funds to your shareholders to invest elsewhere, or reinvest them in a new project; however, you should only reinvest them if doing so provides a better return than the shareholders’ other opportunities.

Interest Rates, Discount Rates, and the Cost of Capital By now, you may have noticed that we are using three terms to refer to rates of return. While many people use these three terms interchangeably, they are distinct. Throughout this book, we will use “interest rate” to

mean a quoted rate in the market. A “discount rate” is the appropriate rate for discounting a given cash flow, matched to the frequency of the cash flow. Finally, we use “cost of capital” to indicate the rate of return on an investment of similar risk.

The opportunity cost of capital is the return the investor forgoes when the investor takes on a new investment. For a risk-free project, it will typically correspond to the interest rate on U.S. Treasury securities with a similar term. But the cost of capital is a much more general concept that can be applied to risky investments as well.

EXAMPLE 5.7 The Opportunity Cost of Capital

Problem Suppose a friend offers to borrow $100 from you today and in return pay you $110 one year from today. Looking in the market for other options for investing the $100, you find your best alternative option that you view as equally risky as lending it to your friend. That option has an expected return of 8%. What should you do?

Solution Q Plan Your decision depends on what the opportunity cost is of lending your money to your friend. If you lend her the $100, then you cannot invest it in the alternative with an 8% expected return. Thus, by making the loan, you are giving up the opportunity to invest for an 8% expected return. You can make your decision by using your 8% opportunity cost of capital to value the $110 in one year. Q Execute The value of the $110 in one year is its present value, discounted at 8%: PV =

+110 = +101.85 1 1.08 2 1

The $100 loan is worth $101.85 to you today, so you make the loan. Q Evaluate The Valuation Principle tells us that we can determine the value of an investment by using market prices to value the benefits net of the costs. As this example shows, market prices determine what our best alternative opportunities are, so that we can decide whether an investment is worth the cost.

Chapter 3 introduced the Valuation Principle as a unifying theme in finance. In this and the preceding chapters, we have developed the fundamental tools a financial manager

138

Part 2 Interest Rates and Valuing Cash Flows needs to value cash flows at different points in time. In this last section, we have reiterated the importance of using market information to determine the opportunity cost of capital, which is your discount rate in valuation calculations. In the next chapter, we will study bonds and how they are priced, which provides us with an immediate application of the knowledge we have built so far.

Concept Check

7. What is the opportunity cost of capital? 8. Can you ignore the cost of capital if you already have the funds inside the firm?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

5.1 Interest Rate Quotes and Adjustments Q Just like any other price, interest rates are set by market forces, in particular the supply and demand of funds. Q The effective annual rate (EAR) (or annual percentage yield—APY) indicates the actual amount of interest earned in one year. The EAR can be used as a discount rate for annual cash flows. Q Given an EAR r, the equivalent discount rate for an nyear time interval, where n may be more than one year or less than or equal to one year (a fraction), is:

annual percentage rate (APR), p. 121 annual percentage yield (APY), 119 effective annual rate (EAR), p. 119 simple interest, p. 121

MyFinanceLab Study Plan 5.1

amortizing loan, p. 125

MyFinanceLab Study Plan 5.2

Equivalent n-period Discount Rate = 11 + r2n - 1

(5.1)

Q An annual percentage rate (APR) is a common way of quoting interest rates. The actual interest rate per period is the APR/number of compounding periods per year. APRs cannot be used as discount rates. Q We need to know the compounding interval of an APR to determine the EAR: 1 + EAR = ¢ 1 +

APR m ≤ m

(5.3)

m = number of compounding periods per year. Q For a given APR, the EAR increases with the compounding frequency. 5.2 Application: Discount Rates and Loans Q Loan rates are typically stated as APRs. The outstanding balance of a loan is equal to the present value of the loan cash flows, when evaluated using the actual interest rate per payment interval based on the loan rate. Q In each loan payment on an amortizing loan, you pay interest on the loan plus some part of the loan balance.

Here is what you should know after reading this chapter. MyFinanceLab will help you identify youRates know, and Chapter 5 what Interest where to go when you need to practice. 5.3 The Determinants of Interest Rates Q Quoted interest rates are nominal interest rates, which indicate the rate of growth of the money invested. The real interest rate indicates the rate of growth of one’s purchasing power after adjusting for inflation. Q Given a nominal interest rate and an inflation rate, the real interest rate is: Nominal Rate - Inflation Rate Real Rate = 1 + Inflation Rate ⬇ Real Rate - Inflation Rate (5.5)

federal funds rate, p. 134 nominal interest rates, p. 127 real interest rate, p. 127 risk-free interest rate, p. 130 term structure, p. 130 yield curve, p. 130

MyFinanceLab Study Plan 5.3

(opportunity) cost of capital, p. 136

MyFinanceLab Study Plan 5.4

139

Interactive Yield Curve

Q Nominal interest rates tend to be high when inflation is high and low when inflation is low. Q Higher interest rates tend to reduce the attractiveness of typical investment projects. The U.S. Federal Reserve raises interest rates to moderate investment and combat inflation and lowers interest rates to stimulate investment and economic growth. Q Interest rates differ with the investment horizon according to the term structure of interest rates. The graph plotting interest rates as a function of the horizon is called the yield curve. Q Cash flows should be discounted using the discount rate that is appropriate for their horizon. Thus, the PV of a cash flow stream is: C2 CN C1 (5.7) + + g + PV = 1 + r1 1 1 + r2 2 2 1 1 + rN 2 N Q Annuity and perpetuity formulas cannot be applied when discount rates vary with the horizon. Q The shape of the yield curve tends to vary with investors’ expectations of future economic growth and interest rates. It tends to be inverted prior to recessions and to be steep coming out of a recession. Because investors view long-term loans as riskier, long-term rates are generally higher than short-term rates. 5.4 The Opportunity Cost of Capital Q An investor’s opportunity cost of capital (or simply, the cost of capital) is the best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted.

Critical Thinking

1. Explain how an interest rate is just a price. 2. Why is the EAR for 6% APR, with semiannual compounding, higher than 6%? 3. Why is it so important to match the frequency of the interest rate to the frequency of the cash flows?

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Part 2 Interest Rates and Valuing Cash Flows 4. Why aren’t the payments for a 15-year mortgage twice the payments for a 30-year mortgage at the same rate? 5. What mistake do you make when you discount real cash flows with nominal discount rates? 6. How do changes in inflation expectations impact interest rates? 7. Can the nominal interest rate available to an investor be negative? (Hint: Consider the interest rate earned from saving cash “under the mattress.”) Can the real interest rate be negative? 8. In the early 1980s, inflation was in the double-digits and the yield curve sloped sharply downward. What did the yield curve say about investors’ expectations about future inflation rates? 9. What do we mean when we refer to the “opportunity cost” of capital?

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Interest Rate Quotes and Adjustments 1. Your bank is offering you an account that will pay 20% interest in total for a twoyear deposit. Determine the equivalent discount rate for a period length of a. six months. b. one year. c. one month. 2. You are considering two ways of financing a spring break vacation. You could put it on your credit card, at 15% APR, compounded monthly, or borrow the money from your parents, who want an 8% interest payment every six months. Which is the lower rate? 3. Which do you prefer: a bank account that pays 5% per year (EAR) for three years or a. an account that pays 2.5% every six months for three years? b. an account that pays 7.5% every 18 months for three years? c. an account that pays 0.5% per month for three years? 4. You have been offered a job with an unusual bonus structure. As long as you stay with the firm, you will get an extra $70,000 every seven years, starting seven years from now. What is the present value of this incentive if you plan to work for the company for a total of 42 years and the interest rate is 6% (EAR)? 5. You have found three investment choices for a one-year deposit: 10% APR compounded monthly, 10% APR compounded annually, and 9% APR compounded daily. Compute the EAR for each investment choice. (Assume that there are 365 days in the year.) 6. Your bank account pays interest with an EAR of 5%. What is the APR quote for this account based on semiannual compounding? What is the APR with monthly compounding? 7. Suppose the interest rate is 8% APR with monthly compounding. What is the present value of an annuity that pays $100 every six months for five years? 8. You have been accepted into college. The college guarantees that your tuition will not increase for the four years you attend college. The first $10,000 tuition payment

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is due in six months. After that, the same payment is due every six months until you have made a total of eight payments. The college offers a bank account that allows you to withdraw money every six months and has a fixed APR of 4% (semiannual) guaranteed to remain the same over the next four years. How much money must you deposit today if you intend to make no further deposits and would like to make all the tuition payments from this account, leaving the account empty when the last payment is made? Application: Discount Rates and Loans 9. You make monthly payments on your car loan. It has a quoted APR of 5% (monthly compounding). What percentage of the outstanding principal do you pay in interest each month? 10. Suppose Capital One is advertising a 60-month, 5.99% APR motorcycle loan. If you need to borrow $8000 to purchase your dream Harley-Davidson, what will your monthly payment be? 11. Suppose Oppenheimer Bank is offering a 30-year mortgage with an EAR of 6.80%. If you plan to borrow $150,000, what will your monthly payment be? 12. You have just taken out a $20,000 car loan with a 6% APR, compounded monthly. The loan is for five years. When you make your first payment in one month, how much of the payment will go toward the principal of the loan and how much will go toward interest? *13. You are buying a house and the mortgage company offers to let you pay a “point” (1% of the total amount of the loan) to reduce your APR from 6.5% to 6.25% on your $400,000, 30-year mortgage with monthly payments. If you plan to be in the house for at least five years, should you do it? 14. You have decided to refinance your mortgage. You plan to borrow whatever is outstanding on your current mortgage. The current monthly payment is $2356 and you have made every payment on time. The original term of the mortgage was 30 years, and the mortgage is exactly four years and eight months old. You have just made your monthly payment. The mortgage interest rate is 6.375% (APR). How much do you owe on the mortgage today? *15. You have just sold your house for $1,000,000 in cash. Your mortgage was originally a 30-year mortgage with monthly payments and an initial balance of $800,000. The mortgage is currently exactly 18 1/2 years old, and you have just made a payment. If the interest rate on the mortgage is 5.25% (APR), how much cash will you have from the sale once you pay off the mortgage? 16. You have just purchased a car and taken out a $50,000 loan. The loan has a five-year term with monthly payments and an APR of 6%. a. How much will you pay in interest, and how much will you pay in principal, during the first month, second month, and first year? (Hint: Compute the loan balance after one month, two months, and one year.) b. How much will you pay in interest, and how much will you pay in principal, during the fourth year (i.e., between three and four years from now)? 17. You are thinking about leasing a car. The purchase price of the car is $30,000. The residual value (the amount you could pay to keep the car at the end of the lease) is $15,000 at the end of 36 months. Assume the first lease payment is due one month after you get the car. The interest rate implicit in the lease is 6% APR, compounded monthly. What will your lease payments be for a 36-month lease?

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Part 2 Interest Rates and Valuing Cash Flows *18. You have some extra cash this month and you are considering putting it toward your car loan. Your interest rate is 7%, your loan payments are $600 per month, and you have 36 months left on your loan. If you pay an additional $1000 with your next regular $600 payment (due in one month), how much will it reduce the amount of time left to pay off your loan? *19. You have an outstanding student loan with required payments of $500 per month for the next four years. The interest rate on the loan is 9% APR (monthly). You are considering making an extra payment of $100 today (i.e., you will pay an extra $100 that you are not required to pay). If you are required to continue to make payments of $500 per month until the loan is paid off, what is the amount of your final payment? What effective rate of return (expressed as an APR with monthly compounding) have you earned on the $100? *20. Consider again the setting of Problem 19. Now that you realize your best investment is to prepay your student loan, you decide to prepay as much as you can each month. Looking at your budget, you can afford to pay an extra $250 per month in addition to your required monthly payments of $500, or $750 in total each month. How long will it take you to pay off the loan? *21. If you decide to take the mortgage in Problem 11, Oppenheimer Bank will offer you the following deal: Instead of making the monthly payment you computed in that problem every month, you can make half the payment every two weeks (so that you will make 52/2 = 26 payments per year). How long will it take to pay off the mortgage if the EAR remains the same at 6.80%. *22. Your friend tells you he has a very simple trick for taking one-third off the time it takes to repay your mortgage: Use your Christmas bonus to make an extra payment on January 1 of each year (that is, pay your monthly payment due on that day twice). If you take out your mortgage on July 1, so your first monthly payment is due August 1, and you make an extra payment every January 1, how long will it take to pay off the mortgage? Assume that the mortgage has an original term of 30 years and an APR of 12%. 23. The mortgage on your house is five years old. It required monthly payments of $1402, had an original term of 30 years, and had an interest rate of 10% (APR). In the intervening five years, interest rates have fallen and so you have decided to refinance—that is, you will roll over the outstanding balance into a new mortgage. The new mortgage has a 30-year term, requires monthly payments, and has an interest rate of 6 5/8% (APR). a. What monthly repayments will be required with the new loan? b. If you still want to pay off the mortgage in 25 years, what monthly payment should you make after you refinance? c. Suppose you are willing to continue making monthly payments of $1402. How long will it take you to pay off the mortgage after refinancing? d. Suppose you are willing to continue making monthly payments of $1402, and want to pay off the mortgage in 25 years. How much additional cash can you borrow today as part of the refinancing? 24. You have credit card debt of $25,000 that has an APR (monthly compounding) of 15%. Each month you pay a minimum monthly payment only. You are required to pay only the outstanding interest. You have received an offer in the mail for an otherwise identical credit card with an APR of 12%. After considering all your alternatives, you decide to switch cards, roll over the outstanding balance on the old card into the new card, and borrow additional money as well. How much can you

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borrow today on the new card without changing the minimum monthly payment you will be required to pay? 25. Your firm has taken out a $500,000 loan with 9% APR (compounded monthly) for some commercial property. As is common in commercial real estate, the loan is a 5year loan based on a 15-year amortization. This means that your loan payments will be calculated as if you will take 15 years to pay off the loan, but you actually must do so in 5 years. To do this, you will make 59 equal payments based on the 15-year amortization schedule and then make a final 60th payment to pay the remaining balance. a. What will your monthly payments be? b. What will your final payment be? The Determinants of Interest Rates 26. In 1975, interest rates were 7.85% and the rate of inflation was 12.3% in the United States. What was the real interest rate in 1975? How would the purchasing power of your savings have changed over the year? 27. If the rate of inflation is 5%, what nominal interest rate is necessary for you to earn a 3% real interest rate on your investment? 28. Assume the inflation rate is 3% APR, compounded annually. Would you rather earn a nominal return of 5% APR, compounded semiannually, or a real return of 2% APR, compounded quarterly? 29. You are pleased to see that you have been given a 5% raise this year. However, you read on the Wall Street Journal Web site that inflation over the past year has been 2%. How much better off are you in terms of real purchasing power? 30. What is the shape of the yield curve given in the following term structure? What expectations are investors likely to have about future interest rates? Term

1 year

2 years

3 years

5 years

7 years

10 years

20 years

Rate (EAR, %)

1.99

2.41

2.74

3.32

3.76

4.13

4.93

The Opportunity Cost of Capital 31. You are thinking about investing $5000 in your friend’s landscaping business. Even though you know the investment is risky and you can’t be sure, you expect your investment to be worth $5750 next year. You notice that the rate for one-year Treasury bills is 1%. However, you feel that other investments of equal risk to your friend’s landscape business offer a 10% expected return for the year. What should you do?

6

Bonds

LEARNING OBJECTIVES Q Understand bond terminology

Q Analyze why bond prices change over time

Q Compute the price and yield to maturity of a zero-coupon bond

Q Know how credit risk affects the expected return from holding a corporate bond

Q Compute the price and yield to maturity of a coupon bond

notation

144

CPN

coupon payment on a bond

y

yield to maturity

FV

face value of a bond

YTM

yield to maturity

n

number of periods

YTMn

P

initial price of a bond

yield to maturity on a zero-coupon bond with n periods to maturity

PV

present value

INTERVIEW WITH

Andrew DeWitt PIMCO

PIMCO is a leading global investment management firm with approximately $1.1 trillion in assets under management as of June 30, 2010. The company offers individual and institutional investors bond funds that cover all the major fixed-income (bond-related) strategies in the market, ranging from municipal and high-yield bonds to investment-grade corporate issues. In his position as vice president in PIMCO’s Global Portfolio Associate Hub, Andrew DeWitt oversees the associates who provide support to the portfolio management team. “In layman’s terms, we provide support to the group of people deciding how our strategy and economic outlook will be implemented,” says Andrew, who graduated from Brown University in 2006 with majors in business economics and public- and private-sector organizations. “We serve as intermediaries between all of the parties in bond transactions and assist with almost every aspect of the portfolio management process. For example, we monitor risk metrics for different types of bonds, exposure to foreign currencies, and allocation across industry sectors.” “Considering that the global fixed-income bond market is about two-and-a-half times the size of the equity market, knowing how bonds are priced and sold could help you evaluate almost any investment opportunity,” says Andrew. “Fixed-income investments appeal to investors because bonds generally behave differently from stocks and therefore play an integral role in diversifying an investor’s overall portfolio and enhancing its absolute return potential. During the 2008–2009 financial crisis, we saw record inflows to the fixed-income sector.” Investors must consider many factors when selecting fixed-income securities. “Pension plans in the United States often look to protect their liabilities (the future benefits they will owe workers) by investing in Treasury Inflation-Protected Securities (TIPS), bonds linked to the consumer price index (the standard inflation metric),” Andrew says. “A worker nearing retirement who wants to preserve her savings in a readily accessible vehicle might consider a short-term bond fund that invests primarily in high-rated securities with an average maturity of three to six months.”

Brown University, 2006

“Fixed-income investments appeal to investors because bonds generally behave differently from stocks and . . . diversify an investor’s overall portfolio.”

In this chapter, we introduce bonds and apply our tools for valuing cash flows to them. Bonds are simply loans. When an investor buys a bond from an issuer, the investor is lending money to the bond issuer. Who are the issuers of bonds? Federal and local governments issue bonds to finance long-term projects, and many companies issue bonds as part of their debt financing. Understanding bonds and their pricing is useful for several reasons. First, we can use the prices of risk-free government bonds to determine the risk-free interest rates that produce the yield curves discussed in Chapter 5. As we saw there, the yield curve provides important information for valuing riskfree cash flows and assessing expectations of inflation and economic growth. Second, firms often issue bonds to fund their own investments. The return investors receive on those bonds is one factor determining a firm’s cost of capital. Finally, bonds provide an opportunity to begin our study of how securities are priced in a competitive market. The bond markets are very large and very liquid; there are more than

145

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Part 2 Interest Rates and Valuing Cash Flows $34 trillion of bonds outstanding in the U.S. markets alone.1 Further, the ideas we develop in this chapter will be helpful when we turn to the topic of valuing stocks in Chapter 7. Pricing bonds gives us an opportunity to apply what we’ve learned in the last three chapters about valuing cash flows using competitive market prices. As we explained in Chapter 3, the Valuation Principle implies that the price of a security in a competitive market should be the present value of the cash flows an investor will receive from owning it. Thus, we begin the chapter by evaluating the promised cash flows for different types of bonds. If a bond is risk-free, so that the promised cash flows will be paid with certainty, we can use the Law of One Price to directly relate the return of a bond and its price. We then discuss how and why bond prices change over time. Once we have a firm understanding of the pricing of bonds in the absence of risk, we add the risk of default, where cash flows are not known with certainty. The risk of default and its implications are important considerations for a financial manager who is considering issuing corporate bonds. (In Chapter 15 we will discuss the details of issuing debt financing and cover some additional corporate bond features.)

6.1 bond certificate States the terms of a bond as well as the amounts and dates of all payments to be made. maturity date The final repayment date of a bond. term The time remaining until the final repayment date of a bond. face value, par value, principal amount The notional amount of a bond used to compute its interest payments. The face value of the bond is generally due at the bond’s maturity. coupons The promised interest payments of a bond, paid periodically until the maturity date of the bond. coupon rate Determines the amount of each coupon payment of a bond. The coupon rate, expressed as an APR, is set by the issuer and stated on the bond certificate.

Bond Terminology Recall from Chapter 1 that a bond is a security sold by governments and corporations to raise money from investors today in exchange for a promised future payment. The terms of the bond are described as part of the bond certificate, which indicates the amounts and dates of all payments to be made. A bond certificate is shown in Figure 6.1. Payments on the bond are made until a final repayment date called the maturity date of the bond. The time remaining until the repayment date is known as the term of the bond. Bonds typically make two types of payments to their holders. The principal or face value (also known as par value or principal amount) of a bond is the notional amount we use to compute the interest payments. Typically, the face value is repaid at maturity. It is generally denominated in standard increments such as $1000. A bond with a $1000 face value, for example, is often referred to as a “$1000 bond.” In addition to the face value, some bonds also promise additional payments called coupons. The bond certificate typically specifies that the coupons will be paid periodically (for example, semiannually) until the maturity date of the bond. As you can see from Figure 6.1, historically, on a payment date the holder of the bond would clip off the next coupon for the next payment and present it for payment. It follows that the interest payments on the bond are called coupon payments. Today, the majority of bonds are registered electronically but the term remains. The amount of each coupon payment is determined by the coupon rate of the bond. This coupon rate is set by the issuer and stated on the bond certificate. By convention, the coupon rate is expressed as an APR, so the amount of each coupon payment, CPN, is: Coupon Payment Coupon Rate * Face Value CPN = Number of Coupon Payments per Year

(6.1)

For example, a “$1000 bond with a 10% coupon rate and semiannual payments” will pay coupon payments of 1 10% * +1000 2 /2 = +50 every six months. Table 6.1 summarizes the bond terminology we have presented thus far.

1

Outstanding U.S. Bond Market Debt, www.sifma.org. December 2009.

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147

FIGURE 6.1 A Bearer Bond and Its Unclipped Coupons Issued by the Elmira and Williamsport Railroad Company for $500

Source: Courtesy Heritage Auctions, Inc. © 1999–2006.

TABLE 6.1 Review of Bond Terminology

Bond Certificate

States the terms of a bond as well as the amounts and dates of all payments to be made.

Coupons

The promised interest payments of a bond. Usually paid semiannually, but the frequency is specified in the bond certificate. They are determined by the coupon rate, which is stated on the bond certificate. The amount paid is equal to: Coupon Rate * Face Value Number of Coupon Payments per Year

Concept Check

6.2 zero-coupon bond A bond that makes only one payment at maturity. Treasury bills Zerocoupon bonds, issued by the U.S. government, with a maturity of up to one year.

Maturity Date

Final repayment date of the bond. Payments continue until this date.

Principal or Face Value

The notional amount used to compute the interest payment. It is usually repaid on the maturity date. Also called par value.

Term

The time remaining until the repayment date.

1. What types of cash flows does a bond buyer receive? 2. How are the periodic coupon payments on a bond determined?

Zero-Coupon Bonds Not all bonds have coupon payments. Bonds without coupons are called zero-coupon bonds. As these are the simplest type of bond, we shall analyze them first. The only cash payment an investor in a zero-coupon bond receives is the face value of the bond on the maturity date. Treasury bills, which are U.S. government bonds with a maturity of up to one year, are zero-coupon bonds. The general name for risk-free zero coupon bonds is “STRIPS,” which is an abbreviation of Separately Tradable Registered Interest and Principal Securities.

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Zero-Coupon Bond Cash Flows There are only two cash flows if we purchase and hold a zero-coupon bond. First, we pay the bond’s current market price at the time we make the purchase. Then, at the maturity date, we receive the bond’s face value. For example, suppose that a one-year, risk-free, zero-coupon bond with a $100,000 face value has an initial price of $96,618.36. If you purchased this bond and held it to maturity, you would have the following cash flows:

discount A price at which bonds trade that is less than their face value. pure discount bonds Zero-coupon bonds.

0

1

$96,618.36

$100,000

Note that although the bond pays no “interest” directly, as an investor you are compensated for the time value of your money by purchasing the bond at a discount to its face value. Recall from Chapter 3 that the present value of a future cash flow is less than the cash flow itself. As a result, prior to its maturity date, the price of a zero-coupon bond is always less than its face value. That is, zero-coupon bonds always trade at a discount (a price lower than the face value), so they are also called pure discount bonds.

Yield to Maturity of a Zero-Coupon Bond

yield to maturity (YTM) The rate of return of an investment in a bond that is held to its maturity date, or the discount rate that sets the present value of the promised bond payments equal to the current market price for the bond.

Now that we understand the cash flows associated with a zero-coupon bond, we can calculate the rate of return of buying a bond and holding it until maturity. Recall from Chapter 4 that we can always find the rate of return of an investment opportunity as the discount rate that equates the present value of the investment to its costs. With a zerocoupon bond, the price is the cost of the bond. So, the rate of return on the zero-coupon bond is the discount rate that makes the present value of the future cash flow received (that is, the bond principal) equal to the cost of the bond. We can extend this concept to a coupon bond: the rate of return is the discount rate at which the present value of all future cash flows from the bond equals the price of the bond. The rate of return of an investment in a bond is given a special name, the yield to maturity (YTM) or just the yield: The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond. Intuitively, the yield to maturity for a zero-coupon bond is the return you will earn as an investor by buying the bond at its current market price, holding the bond to maturity, and receiving the promised face value payment. Let’s determine the yield to maturity of the one-year zero-coupon bond discussed earlier. According to the definition, the yield to maturity of the one-year bond solves the following equation: 96,618.36 =

100,000 1 + YTM1

In this case: 1 + YTM1 =

100,000 = 1.035 96,618.36

That is, the yield to maturity for this bond is 3.5%. Because the bond is risk free, investing in this bond and holding it to maturity is like earning 3.5% interest on your initial investment: +96,618.36 * 1.035 = +100,000

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We can use a similar method to find the yield to maturity for any maturity zero-coupon bond: Yield to Maturity of an n-Year Zero-Coupon Bond Face Value 1/n 1 + YTMn = ¢ ≤ (6.2) Price

The yield to maturity 1 YTMn 2 in Eq. 6.2 is the per-period rate of return for holding the bond from today until maturity on date n.

EXAMPLE 6.1 Yields for Different Maturities

Problem Suppose the following zero-coupon bonds are trading at the prices shown below per $100 face value. Determine the corresponding yield to maturity for each bond. Maturity

1 year

2 years

3 years

4 years

Price

$96.62

$92.45

$87.63

$83.06

Solution Q Plan We can use Eq. 6.2 to solve for the YTM of the bonds. The table gives the prices and number of years to maturity and the face value is $100 per bond. Q Execute Using Eq. 6.2, we have

YTM1 = 1 100/96.62 2 1/1 - 1 = 3.50% YTM2 = 1 100/92.45 2 1/2 - 1 = 4.00% YTM3 = 1 100/87.63 2 1/3 - 1 = 4.50%

YTM4 = 1 100/83.06 2 1/4 - 1 = 4.75% Q Evaluate Solving for the YTM of a zero-coupon bond is the same process we used to solve for the rate of return in Chapter 4. Indeed, the YTM is the rate of return of buying the bond.

Risk-Free Interest Rates

spot interest rates Default-free, zero-coupon yields.

Above, we calculated the yield to maturity of the one-year risk-free bond as 3.5%. But recall that the Valuation Principle’s Law of One Price implies that all one-year risk-free investments must earn this same return of 3.5%. That is, 3.5% must be the competitivemarket risk-free interest rate. More generally, in the last chapter we discussed the competitive market interest rate rn available from today until date n for risk-free cash flows. Recall that we used this interest rate as the cost of capital for a risk-free cash flow that occurs on date n. A default-free zero-coupon bond that matures on date n provides a risk-free return over the same period. So the Law of One Price guarantees that the risk-free interest rate equals the yield to maturity on such a bond. Consequently, we will often refer to the yield to maturity of the appropriate maturity, zero-coupon risk-free bond as the risk-free interest rate. Some financial professionals also use the term spot interest rates to refer to these default-free, zero-coupon yields because these rates are offered “on the spot” at that point in time. In Chapter 5, we introduced the yield curve, which plots the risk-free interest rate for different maturities. These risk-free interest rates correspond to the yields of risk-free zero-coupon bonds. Thus, the yield curve we introduced in Chapter 5 is also referred to

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zero-coupon yield curve A plot of the yield of riskfree zero-coupon bonds (STRIPS) as a function of the bond’s maturity date.

FIGURE 6.2 Zero-Coupon Yield Curve Consistent with the Bond Prices in Example 6.1

as the zero-coupon yield curve. Figure 6.2 illustrates the yield curve consistent with the zero-coupon bond prices in Example 6.1. In the previous example, we used the bond’s price to compute its yield to maturity. But from the definition of the yield to maturity, we can also use a bond’s yield to compute its price. In the case of a zero-coupon bond, the price is simply equal to the present value of the bond’s face value, discounted at the bond’s yield to maturity.

Recall from Chapter 5 that a yield curve simply plots the yield to maturity of investments of different maturities. In this figure, we show the yield curve that would be produced by plotting the yield to maturities determined by the bond prices in Example 6.1. Note that as in this figure, the longer maturities generally have higher yields. 5.50 Longer maturity Higher yield

Yield to Maturity (%)

5.00

4.50

4.00

3.50 Shorter maturity Lower yield 3.00

0

1

2

3

4

5

6

Maturity (years)

EXAMPLE 6.2 Computing the Price of a ZeroCoupon Bond

Problem Given the yield curve shown in Figure 6.2, what is the price of a five-year risk-free zero-coupon bond with a face value of $100?

Solution Q Plan We can compute the bond’s price as the present value of its face amount, where the discount rate is the bond’s yield to maturity. From the yield curve, the yield to maturity for five-year risk-free zero-coupon bonds is 5.0%. Q Execute

P = 100/ 1 1.05 2 5 = 78.35

Q Evaluate We can compute the price of a zero-coupon bond simply by computing the present value of the face amount using the bond’s yield to maturity. Note that the price of the five-year zero-coupon bond is even lower than the price of the other zero-coupon bonds in Example 6.1, because the face amount is the same but we must wait longer to receive it.

Chapter 6 Bonds

Concept Check

6.3 coupon bonds Bonds that pay regular coupon interest payments up to maturity, when the face value is also paid. Treasury notes A type of U.S. Treasury coupon security, currently traded in financial markets, with original maturities from one to ten years. Treasury bonds A type of U.S. Treasury coupon security, currently traded in financial markets, with original maturities of more than ten years.

EXAMPLE 6.3 The Cash Flows of a Coupon Bond or Note

151

3. Why would you want to know the yield to maturity of a bond? 4. What is the relationship between a bond’s price and its yield to maturity?

Coupon Bonds Similar to zero-coupon bonds, coupon bonds pay investors their face value at maturity. In addition, these bonds make regular coupon interest payments. As Table 6.2 indicates, two types of U.S. Treasury coupon securities are currently traded in financial markets: Treasury notes, which have original maturities from one to ten years, and Treasury bonds, which have original maturities of more than ten years. The original maturity is the term of the bond at the time it was originally issued.

TABLE 6.2 Existing U.S. Treasury Securities

Treasury Security

Type

Original Maturity

Bills

Discount

4, 13, and 26 weeks

Notes

Coupon

2, 3, 5, and 10 year

Bonds

Coupon

20 and 30 year

Coupon Bond Cash Flows While an investor’s return on a zero-coupon bond comes from buying it at a discount to its principal value, the return on a coupon bond comes from two sources: (1) any difference between the purchase price and the principal value, and (2) its periodic coupon payments. Before we can compute the yield to maturity of a coupon bond, we need to know all of its cash flows, including the coupon interest payments and when they are paid. In the following example, we take a bond description and translate it into the bond’s cash flows. Problem Assume that it is May 15, 2010 and the U.S. Treasury has just issued securities with a May 2015 maturity, $1000 par value, and a 2.2% coupon rate with semiannual coupons. Since the original maturity is only five years, these would be called “notes” as opposed to “bonds.” The first coupon payment will be paid on November 15, 2010. What cash flows will you receive if you hold this note until maturity?

Solution Q Plan The description of the note should be sufficient to determine all of its cash flows. The phrase “May 2015 maturity, $1000 par value” tells us that this is a note with a face value of $1000 and five years to maturity. The phrase “2.2% coupon rate with semiannual coupons” tells us that the note pays a total of 2.2% of its face value each year in two equal semiannual installments. Finally, we know that the first coupon is paid on November 15, 2010. Q Execute The face value of this note is $1000. Because this note pays coupons semiannually, using Eq. 6.1 you can compute that you will receive a coupon payment every six months of CPN = 1 2.2% * +1000 2 /2 = +11. Here is the timeline based on a six-month period and there are a total of ten cash flows:

May 2010

Nov. 2010

May 2011

Nov. 2011

May 2015 ...

$11

$11

$11

$11 $1000

Note that the last payment occurs five years (ten 6-month periods) from now and is composed of both a coupon payment of $11 and the face value payment of $1000.

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Part 2 Interest Rates and Valuing Cash Flows

Q Evaluate Since a note is just a package of cash flows, we need to know those cash flows in order to value the note. That’s why the description of the note contains all of the information we would need to construct its cash flow timeline.

The U.S. Treasury Market debt outstanding was almost $11.91 trillion. Treasury securities are held by institutional investors such as insurance companies, pension funds and bond mutual funds, individual investors, and even other governmental agencies (such as the Federal Reserve) as shown in the pie chart below. The figures are in billions of dollars (5127 billion is 5.127 trillion).

In most years, the U.S. Federal Government spends more than it takes in through taxes and other revenue sources. To finance this deficit, the U.S. Department of the Treasury issues debt instruments, commonly known as “Treasuries.” The market for Treasury securities is huge and extremely liquid. In 2009, the total amount of public

$196 $503 Federal Reserve and Government Accounts

$5,127

Depository Institutions $3,497

Other Savings Bonds Pension Funds Mutual Funds Foreign State and Local Governments Insurance Companies

$643 $501 $192

$1,051

$199

Source: Treasury Bulletin Ownership of Federal Securities, www.fms.treas.gov/bulletin/index.html, September 2009.

Yield to Maturity of a Coupon Bond Once we have determined the coupon bond’s cash flows, given its market price we can determine its yield to maturity. Recall that the yield to maturity for a bond is the rate of return of investing in the bond and holding it to maturity. This investment has the cash flows shown in the timeline below: 0

1

2

3

N ...

P

CPN

CPN

CPN

CPNFV

Annunity of N payments of CPN Single CF from repayment of Face Value

The yield to maturity of the bond is the single discount rate that equates the present value of the bond’s remaining cash flows to its current price. For zero-coupon bonds, there were only two cash flows. But coupon bonds have many cash flows, complicating

Chapter 6 Bonds

153

the yield to maturity calculation. From the timeline we see that the coupon payments represent an annuity, so the yield to maturity is the interest rate y that solves the following equation: Yield to Maturity of a Coupon Bond Annuity Factor using the YTM (y)

P = CPN *

1 1 a1 b y (1 + y)N

+

Present Value of all of the periodic coupon payments

FV (1 + y)N

(6.3)

Present Value of the Face Value repayment using the YTM ( y)

Unfortunately, unlike zero-coupon bonds, there is no simple formula to solve for the yield to maturity directly. Instead, we need to use either trial and error or, more commonly, a financial calculator or a spreadsheet (both of which we demonstrate in Example 6.4). When we calculate a bond’s yield to maturity by solving Eq. 6.3, the yield we compute will be a rate per coupon interval. However, yields are typically quoted as APRs, so we multiply by the number of coupons per year, thereby converting the answer into an APR quote with the same compounding interval as the coupon rate.

EXAMPLE 6.4 Computing the Yield to Maturity of a Coupon Bond

Problem Consider the five-year, $1000 bond with a 2.2% coupon rate and semiannual coupons described in Example 6.3. If this bond is currently trading for a price of $963.11, what is the bond’s yield to maturity?

Solution Q Plan We worked out the bond’s cash flows in Example 6.3. From the cash flow timeline, we can see that the bond consists of an annuity of ten payments of $11, paid every six months, and one lump-sum payment of $1000 in five years (in ten 6-month periods). We can use Eq. 6.3 to solve for the yield to maturity. However, we must use six-month intervals consistently throughout the equation. Q Execute Because the bond has ten remaining coupon payments, we compute its yield y by solving Eq. 6.3 for this bond: 963.11 = 11 *

1 1000 1 ¢1 ≤ + 10 y 11 + y2 1 1 + y 2 10

We can solve it by trial and error, financial calculator, or a spreadsheet. To use a financial calculator, we enter the price we pay as a negative number for the PV (it is a cash outflow), the coupon payments as the PMT, and the bond’s par value as its FV. Finally, we enter the number of coupon payments remaining (10) as N.

N I/Y PV PMT FV Given: 10 963.11 11 1000 Solve for: 1.50 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(10,11,963.11,1000) Therefore, y = 1.5%. Because the bond pays coupons semiannually, this yield is for a six-month period. We convert it to an APR by multiplying by the number of coupon payments per year. Thus, the bond has a yield to maturity equal to a 3% APR with semiannual compounding. Q Evaluate As the equation shows, the yield to maturity is the discount rate that equates the present value of the bond’s cash flows with its price. Note that the YTM is higher than the coupon rate and the price is lower than the par value. We will discuss why in the next section.

154

Part 2 Interest Rates and Valuing Cash Flows We can also use Eq. 6.3 to compute a bond’s price based on its yield to maturity. We simply discount the cash flows using the yield, as in Example 6.5.

Finding Bond Prices on the Web Unlike the NYSE where many stocks are traded, there is no particular physical location where bonds are traded. Instead, they are traded electronically. Recently, the Financial Industry Regulatory Authority (FINRA) has made an effort to make bond prices more widely available. Their

The bond pays fixed coupons of 8.000% The last trade was at $135.162 per $100 face value, implying a yield to maturity of 4.608% Coupons are paid semiannually in March and September Source: www.finra.org/marketdata, May 25, 2010.

Web site, www.finra.org/marketdata, allows anyone to search for the most recent trades and quotes for bonds. Here we show a screen shot from the Web site displaying the pricing information for one of Proctor and Gamble’s (PG) bonds.

Chapter 6 Bonds

EXAMPLE 6.5 Computing a Bond Price from Its Yield to Maturity

155

Problem Consider again the five-year, $1000 bond with a 2.2% coupon rate and semiannual coupons in Example 6.4. Suppose interest rates drop and the bond’s yield to maturity decreases to 2% (expressed as an APR with semiannual compounding). What price is the bond trading for now? And what is the effective annual yield on this bond?

Solution Q Plan Given the yield, we can compute the price using Eq. 6.3. First, note that a 2% APR is equivalent to a semiannual rate of 1%. Also, recall that the cash flows of this bond are an annuity of ten payments of $11, paid every six months, and one lump-sum cash flow of $1000 (the face value), paid in five years (ten 6-month periods). In Chapter 5 we learned how to compute an effective annual rate from an APR using Eq. 5.3. We do the same here to compute the effective annual yield from the bond’s yield to maturity expressed as an APR. Q Execute Using Eq. 6.3 and the six-month yield of 1%, the bond price must be: P = 11 *

1 1 1000 ¢1 ≤ + = +1009.47 0.01 1.0110 1.0110

We can also use a financial calculator or spreadsheet:

Given: Solve for:

N 10

I/Y 1

PV

PMT 11

FV 1000

1009.47 Excel Formula: PV(RATE,NPER,PMT,FV)PV(.01,10,11,1000)

The effective annual yield corresponding to 1% every six months is:

1 1 + .01 2 2 - 1 = .0201, or 2.01%

Q Evaluate The bond’s price has risen to $1009.47, lowering the return from investing in it from 1.5% to 1% per 6month period. Interest rates have dropped, so the lower return brings the bond’s yield into line with the lower competitive rates being offered for similar risk and maturity elsewhere in the market.

Coupon Bond Price Quotes Because we can convert any price into a yield, and vice versa, prices and yields are often used interchangeably. For example, the bond in Example 6.5 could be quoted as having a yield of 2% or a price of $1009.47 per $1000 face value. Indeed, bond traders generally quote bond yields rather than bond prices. One advantage of quoting the yield to maturity rather than the price is that the yield is independent of the face value of the bond. When prices are quoted in the bond market, they are conventionally quoted per $100 face value. Thus, the bond in Example 6.5 would be quoted as having a price of $100.947 (per $100 face value), which would imply an actual price of $1009.47 given the $1000 face value of the bond.

Concept Check

5. What cash flows does a company pay to investors holding its coupon bonds? 6. What do we need in order to value a coupon bond?

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Part 2 Interest Rates and Valuing Cash Flows

6.4 premium A price at which coupon bonds trade that is greater than their face value. par A price at which coupon bonds trade that is equal to their face value.

Why Bond Prices Change As we mentioned earlier, zero-coupon bonds always trade for a discount—that is, prior to maturity, their price is less than their face value. But as shown in Example 6.4 and Example 6.5, coupon bonds may trade at a discount, or at a premium (a price greater than their face value). In this section, we identify when a bond will trade at a discount or premium, as well as how the bond’s price will change due to the passage of time and fluctuations in interest rates. Most issuers of coupon bonds choose a coupon rate so that the bonds will initially trade at, or very close to, par (that is, at the bond’s face value). For example, the U.S. Treasury sets the coupon rates on its notes and bonds in this way. After the issue date, the market price of a bond generally changes over time for two reasons. First, as time passes, the bond gets closer to its maturity date. Holding fixed the bond’s yield to maturity, the present value of the bond’s remaining cash flows changes as the time to maturity decreases. Second, at any point in time, changes in market interest rates affect the bond’s yield to maturity and its price (the present value of the remaining cash flows). We explore these two effects in the remainder of this section.

Interest Rate Changes and Bond Prices If a bond sells at par (at its face value), the only return investors will earn is from the coupons that the bond pays. Therefore, the bond’s coupon rate will exactly equal its yield to maturity. As interest rates in the economy fluctuate, the yields that investors demand to invest in bonds will also change. Imagine that your company issues a bond when market interest rates imply a YTM of 8%, setting the coupon rate to be 8%. Suppose interest rates then rise so that new bonds have a YTM of 9%. These new bonds would have a coupon rate of 9% and sell for $1000. So, for $1000, the investor would get $90 per year until the bond matured. Your existing bond was issued when rates were lower such that its coupon is fixed at 8%, so it offers payments of $80 per year until maturity. Because its cash flows are lower, the 8% bond must have a lower price than the 9% bond.2 Thus, the price of the 8% bond will fall until the investor is indifferent between buying the 8% bond and buying the 9% bond. Figure 6.3 illustrates the relationship between the bond’s price and its yield to maturity. In our example, the price of the 8% bond will drop to below face value ($1000), so it will be trading at a discount (also called trading below par). If the bond trades at a discount, an investor who buys the bond will earn a return both from receiving the coupons and from receiving a face value that exceeds the price paid for the bond. As a result, if a bond trades at a discount, its yield to maturity will exceed its coupon rate. A bond that pays a coupon can also trade at a premium to its face value (trading above par). Imagine what would have happened in our example if interest rates had gone down to 7% instead of up to 9%. Then, the holder of the existing 8% bond would not part with it for $1000. Instead, its price would have to rise until the yield to maturity from buying it at that price would be 7%. In this case, an investor’s return from the coupons is diminished by receiving a face value less than the price paid for the bond. Thus, a bond trades at a premium whenever its yield to maturity is less than its coupon rate.3 2

Otherwise, if the 8% bond had the same or higher price, there would be an arbitrage opportunity: one could sell the 8% bond and buy the 9% bond, receiving cash today and higher coupons going forward. 3

The terms “discount” and “premium” are simply descriptive and are not meant to imply that you should try to buy bonds at a discount and avoid buying bonds at a premium. In a competitive market, the Law of One Price ensures that all similar bonds are priced to earn the same return. When you buy a bond, the price exactly equals the present value of the bond’s cash flows, so that you earn a fair return, but not an abnormally good (or bad) return.

Chapter 6 Bonds

FIGURE 6.3 A Bond’s Price vs. Its Yield to Maturity

157

At a price of $1000, the 8% semiannual coupon bond offers an 8% YTM. In order for the 8% coupon bond to offer a competitive yield to maturity, its price must fall until its yield to maturity rises to the 9% yield being offered by otherwise similar bonds. In the example depicted here, for a bond with five years left to maturity, its price must fall to $960.44 before investors will be indifferent between buying it and the 9% coupon bond priced at $1000. The curve depicts this bond’s price at yields to maturity between 6% and 10%. $1100 1. Price/YTM of bond when initially released.

$1080 $1060 $1040

2. Price/YTM of bond when interest rates rise, making investors indifferent between it and a 9% coupon bond priced at $1000.

Bond Price

$1020 $1000 $980 $960 $940 $920 $900 6.00%

6.50%

7.00%

7.50%

8.00%

8.50%

9.00%

9.50% 10.00%

Yield to Maturity

This example illustrates a general phenomenon. A higher yield to maturity means that investors demand a higher return for investing. They apply a higher discount rate to the bond’s remaining cash flows, reducing their present value and hence the bond’s price. The reverse holds when interest rates fall. Investors then demand a lower yield to maturity, reducing the discount rate applied to the bond’s cash flows and raising the price. Therefore, as interest rates and bond yields rise, bond prices will fall, and vice versa, so that interest rates and bond prices always move in the opposite direction. Table 6.3 summarizes the relationship between interest rates and bond prices.

TABLE 6.3 Bond Prices Immediately After a Coupon Payment

When the bond price is . . .

greater than the face value

equal to the face value

less than the face value

We say the bond trades . . .

“above par” or “at a premium”

“at par”

“below par” or “at a discount”

This occurs when . . .

Coupon Rate > Yield to Maturity

Coupon Rate = Yield to Maturity

Coupon Rate < Yield to Maturity

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Part 2 Interest Rates and Valuing Cash Flows

EXAMPLE 6.6 Determining the Discount or Premium of a Coupon Bond

Problem Consider three 30-year bonds with annual coupon payments. One bond has a 10% coupon rate, one has a 5% coupon rate, and one has a 3% coupon rate. If the yield to maturity of each bond is 5%, what is the price of each bond per $100 face value? Which bond trades at a premium, which trades at a discount, and which trades at par?

Solution Q Plan From the description of the bonds, we can determine their cash flows. Each bond has 30 years to maturity and pays its coupons annually. Therefore, each bond has an annuity of coupon payments, paid annually for 30 years, and then the face value paid as a lump sum in 30 years. They are all priced so that their yield to maturity is 5%, meaning that 5% is the discount rate that equates the present value of the cash flows to the price of the bond. Therefore, we can use Eq. 6.3 to compute the price of each bond as the PV of its cash flows, discounted at 5%. Q Execute For the 10% coupon bond, the annuity cash flows are $10 per year (10% of each $100 face value). Similarly, the annuity cash flows for the 5% and 3% bonds are $5 and $3 per year. We use a $100 face value for all of the bonds. Using Eq. 6.3 and these cash flows, the bond prices are: P 1 10% coupon 2 = 10 *

1 1 100 ¢1 ≤ + = +176.86 1 trades at a premium 2 0.05 1.0530 1.0530

P 1 5% coupon 2 = 5 * P 1 3% coupon 2 = 3 *

1 1 100 ¢1 ≤ + = +100.00 1 trades at par 2 30 0.05 1.05 1.0530

1 1 100 ¢1 ≤ + = +69.26 1 trades at a discount 2 0.05 1.0530 1.0530

Q Evaluate The prices reveal that when the coupon rate of the bond is higher than its yield to maturity, it trades at a premium. When its coupon rate equals its yield to maturity, it trades at par. When its coupon rate is lower than its yield to maturity, it trades at a discount.

Time and Bond Prices Let’s consider the effect of time on the price of a bond. As the next payment from a bond grows nearer, the price of the bond increases to reflect the increasing present value of that cash flow. Take a bond paying semiannual coupons of $50 and imagine tracking the price of the bond starting on the day after the last coupon payment was made. The price would slowly rise over the following six months as the next $50 coupon payment grows closer and closer. It will peak right before the coupon payment is made, when buying the bond still entitles you to receive the $50 payment immediately. If you buy the bond right after the coupon payment is made, you do not have the right to receive that $50 coupon. The price you are willing to pay for the bond will therefore be $50 less than it was right before the coupon was paid. This pattern—the price slowly rising as a coupon payment nears and then dropping abruptly after the payment is made—continues for the life of the bond. Figure 6.4 illustrates this phenomenon.

Chapter 6 Bonds

FIGURE 6.4 The Effect of Time on Bond Prices

159

The graph illustrates the effects of the passage of time on bond prices when the yield remains constant, in this case 5%. The price of a zero-coupon bond rises smoothly. The prices of the coupon bonds are indicated by the zigzag lines. Notice that the prices rise between coupon payments, but tumble on the coupon date, reflecting the amount of the coupon payment. For each coupon bond, the gray line shows the trend of the bond price just after each coupon is paid.

200

Bond Price (% of Face Value)

180 160

10% Coupon Rate

140 120

5% Coupon Rate

100 80 3% Coupon Rate

60 40 20 0

Zero Coupon 0

5

10

15

20

25

30

Year

EXAMPLE 6.7 The Effect of Time on the Price of a Bond

Problem Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 5%. For a face value of $100, the bond will initially trade for: P 1 30 years to maturity 2 =

100 = +23.14 1.0530

If the bond’s yield to maturity remains at 5%, what will its price be five years later? If you purchased the bond at $23.14 and sold it five years later, what would the rate of return of your investment be?

Solution Q Plan If the bond was originally a 30-year bond and 5 years have passed, then it has 25 years left to maturity. If the yield to maturity does not change, then you can compute the price of the bond with 25 years left exactly as we did for 30 years, but using 25 years of discounting instead of 30. Once you have the price in five years, you can compute the rate of return of your investment just as we did in Chapter 4. The FV is the price in five years, the PV is the initial price ($23.14), and the number of years is 5. Q Execute P 1 25 years to maturity 2 =

100 = +29.53 1.0525

160

Part 2 Interest Rates and Valuing Cash Flows If you purchased the bond for $23.14 and then sold it after five years for $29.53, the rate of return of your investment would be ¢

29.53 1/5 ≤ - 1 = 5.0% 23.14

That is, your return is the same as the yield to maturity of the bond. Q Evaluate Note that the bond price is higher, and hence the discount from its face value is smaller, when there is less time to maturity. The discount shrinks because the yield has not changed, but there is less time until the face value will be received. This example illustrates a more general property for bonds: If a bond’s yield to maturity does not change, then the rate of return of an investment in the bond equals its yield to maturity even if you sell the bond early.

Interest Rate Risk and Bond Prices While the effect of time on bond prices is predictable, unpredictable changes in interest rates will also affect bond prices. Further, bonds with different characteristics will respond differently to changes in interest rates—some bonds will react more strongly than others. We showed in Chapter 5 that investors view long-term loans to be riskier than short-term loans. Because bonds are just loans, the same is true of short- versus long-term bonds.

EXAMPLE 6.8

Problem

The Interest Rate Sensitivity of Bonds

Consider a 10-year coupon bond and a 30-year coupon bond, both with 10% annual coupons. By what percentage will the price of each bond change if its yield to maturity increases from 5% to 6%?

Solution Q Plan We need to compute the price of each bond for each yield to maturity and then calculate the percentage change in the prices. For both bonds, the cash flows are $10 per year for $100 in face value and then the $100 face value repaid at maturity. The only difference is the maturity: 10 years and 30 years. With those cash flows, we can use Eq. 6.3 to compute the prices. Q Execute YTM 5%

6%

10-Year, 10% Annual Coupon Bond

30-Year, 10% Annual Coupon Bond

10 *

1 1 100 ¢1 ≤ + = +138.61 0.05 1.0510 1.0510

10 *

1 1 100 ¢1 ≤ + = +176.86 0.05 1.0530 1.0530

10 *

1 100 1 ¢1 ≤ + = +129.44 0.06 1.0610 1.0610

10 *

1 1 100 ¢1 ≤ + = +155.06 0.06 1.0630 1.0630

The price of the 10-year bond changes by 1 129.44 - 138.61 2 /138.61 = -6.6% if its yield to maturity increases from 5% to 6%. For the 30-year bond, the price change is 1 155.06 - 176.86 2 /176.86 = -12.3%. Q Evaluate The 30-year bond is almost twice as sensitive to a change in the yield than is the 10-year bond. In fact, if we graph the price and yields of the two bonds, we can see that the line for the 30-year bond, shown in blue, is steeper throughout than the green line for the 10-year bond, reflecting its heightened sensitivity to interest rate changes.

Chapter 6 Bonds

190

161

30-year Maturity 10-year Maturity

170

Price

150 130 110 90 70 50

5%

6%

7%

8%

9%

10% 11% 12% 13% 14% 15%

Yield to Maturity

The example illustrates how bonds of different maturity will have different sensitivities to interest rate changes. However, even bonds with the same maturity will differ in interest rate sensitivity if their coupon rates are different. Bonds with higher coupon rates—because they pay higher cash flows upfront—are less sensitive to interest rate changes than otherwise identical bonds with lower coupon rates.4 Table 6.4 summarizes this conclusion.

TABLE 6.4 Bond Prices and Interest Rates

EXAMPLE 6.9

Bond Characteristic

Effect on Interest Rate Risk

Longer term to maturity

Increase

Higher coupon payments

Decrease

Problem

Coupons and Interest Rate Sensitivity

Consider two bonds, each of which pays semiannual coupons and has five years left until maturity. One has a coupon rate of 5% and the other has a coupon rate of 10%, but both currently have a yield to maturity of 8%. By what percentage will the price of each bond change if its yield to maturity decreases from 8% to 7%?

Solution Q Plan As in Example 6.8, we need to compute the price of each bond at 8% and 7% yield to maturities and then compute the percentage change in price. Each bond has ten semiannual coupon payments remaining along with the repayment of par value at maturity. The cash flows per $100 of face value for the first bond are $2.50 every six months and then $100 at maturity. The cash flows per $100 of face value for the second bond are $5 every six months and then $100 at maturity. Since the cash flows are semiannual, the yield to maturity is quoted as a semiannually compounded APR, so we convert the yields to match the frequency of the cash flows by dividing by 2. With semiannual rates of 4% and 3.5%, we can use Eq. 6.3 to compute the prices.

4

The duration of a bond measures its sensitivity to interest rate changes. A full discussion of the concept of duration is beyond the scope of this book.

162

Part 2 Interest Rates and Valuing Cash Flows

Q Execute YTM 8%

7%

5-Year, 5% Coupon Bond

5-Year, 10% Coupon Bond

2.50 *

100 1 1 ¢1 ≤+ = +87.83 10 0.04 1.04 1.0410

5 *

1 1 100 ¢1 ≤+ = +108.11 10 0.04 1.04 1.0410

2.50 *

1 1 100 ≤+ = +91.68 ¢1 0.035 1.03510 1.03510

5 *

1 100 1 ≤+ = +112.47 ¢1 0.035 1.03510 1.03510

The 5% coupon bond’s price changed from $87.83 to $91.68, or 4.4%, but the 10% coupon bond’s price changed from $108.11 to $112.47, or 4.0%. You can calculate the price change very quickly with a financial calculator or spreadsheet. For example, take the 5% coupon bond at 8% YTM (4% per 6 months):

Given: Solve for:

dirty price or invoice price A bond’s actual cash price. clean price A bond’s cash price less an adjustment for accrued interest, the amount of the next coupon payment that has already accrued.

N 10

I/Y 4

PV

PMT 2.50

FV 100

87.83 Excel Formula: PV(RATE,NPER,PMT,FV)PV(.04,10,2.5,100)

With all of the basic bond information entered, you can simply change the I/Y by entering 3.5 and pressing I/Y and then solve for PV again. So, with just a few keystrokes, you will have the new price of $91.68. Q Evaluate The bond with the smaller coupon payments is more sensitive to changes in interest rates. Because its coupons are smaller relative to its par value, a larger fraction of its cash flows are received later. As we learned in Example 6.8, later cash flows are affected more greatly by changes in interest rates, so compared to the 10% coupon bond, the effect of the interest change is greater for the cash flows of the 5% coupon bond.

Clean and Dirty Prices for Coupon Bonds As Figure 6.4 illustrates, coupon bond prices fluctuate around the time of each coupon payment in a sawtooth pattern: The value of the coupon bond rises as the next coupon payment gets closer and then drops after it has been paid. This fluctuation occurs even if there is no change in the bond’s yield to maturity. Bond traders are more concerned about changes in the bond’s price that arise due to changes in the bond’s yield, rather than these predictable patterns around coupon payments. As a result, they often do not quote the price of a bond in terms of its actual cash price, which is also called the dirty price or invoice price of the bond. Instead, bonds are often quoted in terms of a clean price, which is the bond’s cash price less an adjustment for accrued interest, the amount of the next coupon payment that has already accrued: Clean Price = Cash 1 Dirty 2 Price - Accrued Interest

Note that immediately before a coupon payment is made, the accrued interest will equal the full amount of the coupon. Immediately after the coupon payment is made, the accrued interest will be zero. Thus, accrued interest will rise and fall in a sawtooth pattern as each coupon payment passes. If we subtract accrued interest from the bond’s cash price and compute the clean price, the sawtooth pattern is eliminated.

Days Since Last Coupon Payment ≤ Days in Current Coupon Period

Accrued Interest

Accrued Interest = Coupon Amount * ¢

Coupon

0

1

2

Time (Coupon Periods)

3

Chapter 6 Bonds

163

Bond Prices in Practice In actuality, bond prices are subject to the effects of both the passage of time and changes in interest rates. Bond prices converge to the bond’s face value due to the time effect, but simultaneously move up and down due to unpredictable changes in bond yields. Figure 6.5 illustrates this behavior by demonstrating how the price of the 30-year, zero-coupon bond might change over its life. Note that the bond price tends to converge to the face value as the bond approaches the maturity date, but also moves higher when its yield falls and lower when its yield rises.

Panel (a) The Bond’s Yield to Maturity over Time

Yield to Maturity (%)

Yield to Maturity and Bond Price Fluctuations over Time

The graphs illustrate changes in price and yield for a 30-year zero-coupon bond over its life. Panel (a) illustrates the changes in the bond’s yield to maturity (YTM) over its life. In Panel (b), the actual bond price is shown in blue. Because the YTM does not remain constant over the bond’s life, the bond’s price fluctuates as it converges to the face value over time. Also shown is the price if the YTM remained fixed at 4%, 5%, or 6%. Panel (a) shows that the bond’s YTM mostly remained between 4% and 6%. The broken lines in Panel (b) show the price of the bond if its YTM had remained constant at those levels. Note that in all cases, the bond’s price must eventually converge to $100 on its maturity date.

6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0

0

5

10

15

20

25

30

25

30

Year Panel (b) The Bond’s Price over Time (Price +100 on Maturity Date)

100

Actual Bond Price Price with 5% Yield Price with 4% Yield Price with 6% Yield

90 Bond Price (% of Face Value)

FIGURE 6.5

80 70 60 50 40 30 20 10 0

0

5

10

15 Year

20

164

Part 2 Interest Rates and Valuing Cash Flows As the fluctuating price in Figure 6.5 demonstrates, prior to maturity the bond is exposed to interest rate risk. If an investor chooses to sell and the bond’s yield to maturity has decreased, then the investor will receive a high price and earn a high return. If the yield to maturity has increased, the bond price is low at the time of sale and the investor will earn a low return.

Concept Check

6.5 corporate bonds Bonds issued by a corporation.

7. Why do interest rates and bond prices move in opposite directions? 8. If a bond’s yield to maturity does not change, how does its cash price change between coupon payments?

Corporate Bonds In the previous sections, we developed the basics of bond pricing in the context of U.S. Treasury bonds, which have no risk of default. In this section, our focus is on corporate bonds, which are bonds issued by corporations. We will examine the role of default risk in the price and yield to maturity of corporate bonds. As we will see, corporations with higher default risk will need to pay higher coupons to attract buyers to their bonds.

Credit Risk

credit risk The risk of default by the issuer of any bond that is not default free; it is an indication that the bond’s cash flows are not known with certainty.

Table 6.5 lists the interest rates paid by a number of different borrowers in early 2010 for a five-year bond. Why do these interest rates vary so widely? The lowest interest rate is the 2.41% rate paid on U.S. Treasury notes. United States Treasury securities are widely regarded to be risk-free because there is virtually no chance the government will fail to pay the interest and default on these bonds. Thus, as we noted in Section 6.2, when we refer to the “risk-free interest rate,” we mean the rate on U.S. Treasuries. The remaining bonds are all corporate bonds. With corporate bonds, the bond issuer may default—that is, it might not pay back the full amount promised in the bond prospectus. For example, a company with financial difficulties may be unable to fully repay the loan. This risk of default, which is known as the credit risk of the bond, means that the bond’s cash flows are not known with certainty. To compensate for the risk that the firm may default, investors demand a higher interest rate than the rate on U.S. Treasuries.5

TABLE 6.5 Borrower U.S. Government (Treasury Notes) Abbott Laboratories Kraft Foods, Inc. Time Warner, Inc. RadioShack Corp. Goodyear Tire and Rubber Co.

Interest Rates on Five-Year Bonds for Various Borrowers, March 2010

Interest Rate 2.41% 2.65% 3.46% 4.39% 5.84% 8.58%

Credit Spread 0.24% 1.05% 1.98% 3.43% 6.17%

0

1

2

3

4

5

6

Percent

5

Because trading in corporate bonds is much less liquid than trading in Treasuries, part of the increased interest rate is to compensate investors for this lack of liquidity.

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165

The difference between the interest rate of the loan and the Treasury rate will depend on investors’ assessment of the likelihood that the firm will default. For example, investors place a higher probability of default on Goodyear Tire than on Abbott Labs, forcing Goodyear to pay a larger credit spread, which is reflected in a higher interest rate.

INTERVIEW WITH

LISA BLACK

Lisa Black is Managing Director at Teachers Insurance and Annuity Association, a major financial services company. A Chartered Financial Analyst, she oversees a variety of fixed income funds, including money market, intermediate bond, high-yield, emerging market debt, and inflation-linked bond funds.

When many people think about the financial markets, they picture the equity markets. How big and how active are the bond markets compared to the equity markets?

QUESTION:

ANSWER: The

dollar volume of bonds traded daily is about ten times that of equity markets. For example, a single $15 billion issue of ten-year Treasury bonds will sell in one day. The market value of the Barclays Capital U.S. Universal Bond Index of dollardenominated debt as of June 30, 2009, was $13.8 trillion, with the U.S. Aggregate Index (investment-grade debt) accounting for almost 90%. It includes Treasuries, agencies, corporate bonds, and mortgage-backed securities. Other major sectors of the Universal Index include corporate high-yield bonds, Eurodollar bonds, emerging markets, and private placements.

QUESTION:

How do the bond markets operate?

ANSWER: Firms and governments turn to bond markets when they need to borrow money to fund new construction projects, finance acquisitions, and for general corporate purposes. On the other side, institutions like TIAA-CREF, endowments, and foundations have funds to invest. Wall Street investment bankers serve as intermediaries, matching up borrowers with creditors in terms of maturity needs and risk appetite. Because we provide annuities for college professors, for example, we invest money for longer periods of time than an insurance company that needs funds to pay claims. In the institutional world, bond funds typically trade in blocks of bonds ranging from $5 million to $50 million at a time. QUESTION:

What drives changes in the values of Treasury

bonds? ANSWER: The simple answer is that when interest rates rise, bond prices fall. The key is to dig below that reality to see why interest rates rise and fall. A major factor is investors’ expectations for inflation and economic growth. Interest rates generally rise when the expectation is that growth will accelerate, because inflation

won’t be far behind. During the 2008–2009 recession, interest rates dropped as the Federal Reserve injected liquidity into the system. There was also a flight to quality after the bankruptcy of Lehman Brothers. The value of The Reserve Fund fell drastically as its holdings of about $785 million of Lehman’s short-term debt securities became all but worthless. Worried retail and institutional investors sold their money market funds and purchased U.S. Treasury bills and notes to protect their principal. With increased demand, interest rates on risk-free Treasury securities fell sharply. At one point T-bills even had a negative yield.

What impact did the 2008–2009 financial crisis have on the bond market? What changes do you anticipate going forward as a result?

QUESTION:

ANSWER: While the effects of the crisis on equity markets have been widely discussed, the effects on the bond market have been just as profound. Particularly noteworthy is the role governments and central bankers have played—and likely will continue to play—to stabilize financial institutions deemed too big or important to fail. The Fed introduced an unprecedented number of stimulus programs to unfreeze credit markets, including programs to guarantee money funds. The challenge will be how and when the various support programs and financial infusions will end and/or be paid back. In addition, the rating agencies’ role and ratings methodologies will likely be subject to greater scrutiny, both from regulators and investors. In the corporate sector, many borrowers—the automotive industries, for example—could not raise debt financing during the crisis. Credit spreads widened dramatically as investors shunned even AAA- and AA-rated credits. Major institutional investors sat on the sidelines for several months, and the corporate bond newissue market was essentially nonexistent. Not until the federal government announced programs to increase liquidity did institutional investors reenter the market, first buying only the highest credit-quality instruments, such as first mortgage bonds issued by utilities and government-guaranteed mortgage-backed securities. Investors then began to move down the credit-quality chain, selectively focusing on issuers that could weather an economic downturn.

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Part 2 Interest Rates and Valuing Cash Flows

Corporate Bond Yields How does the credit risk of default affect bond prices and yields? The cash flows promised by the bond are the most that bondholders can hope to receive. Due to credit risk, the cash flows that a purchaser of a corporate bond actually expects to receive may be less than that amount. For example, GM struggled financially in 2006 and 2007, substantially increasing the chance that they would default on their bonds, and GM subsequently did in 2009. Realizing this risk, investors in GM bonds incorporated an increased probability that the bond payments would not be made as promised and prices of the bonds fell. Because the yield to maturity of GM’s bonds is computed by comparing the price to the promised cash flows, the yield to maturity increased as the probability of being paid as promised decreased. This example highlights the following general truths: 1. Investors pay less for bonds with credit risk than they would for an otherwise identical default-free bond. 2. Because the yield to maturity for a bond is calculated using the promised cash flows instead of the expected cash flows, the yield of bonds with credit risk will be higher than that of otherwise identical default-free bonds. These two points lead us to an important conclusion: the yield to maturity of a defaultable bond is not equal to the expected return of investing in the bond. The promised cash flows used to determine the yield to maturity are always higher than the expected cash flows investors use to calculate the expected return. As a result, the yield to maturity will always be higher than the expected return of investing in the bond. Moreover, a higher yield to maturity does not necessarily imply that a bond’s expected return is higher.

Bond Ratings investment-grade bonds Bonds in the top four categories of creditworthiness with a low risk of default. speculative bonds, junk bonds, or high-yield bonds Bonds in one of the bottom five categories of creditworthiness (below investment grade) that have a high risk of default. default spread or credit spread The difference between the risk-free interest rate on U.S. Treasury notes and the interest rates on all other loans. The magnitude of the credit spread will depend on investors’ assessment of the likelihood that a particular firm will default.

The probability of default is clearly important to the price you are willing to pay for a corporate bond. How do you assess a firm’s likelihood of default? Several companies rate the creditworthiness of bonds and make this information available to investors. By consulting these ratings, investors can assess the creditworthiness of a particular bond issue. The ratings therefore encourage widespread investor participation and relatively liquid markets. The two best-known bond-rating companies are Standard & Poor’s and Moody’s. Table 6.6 summarizes the rating classes each company uses. Bonds with the highest rating (Aaa or AAA) are judged to be least likely to default. Bonds in the top four categories are often referred to as investment-grade bonds because of their low default risk. Bonds in the bottom five categories are often called speculative bonds, junk bonds, or high-yield bonds because their likelihood of default is high and so they promise higher yields. The rating depends on the risk of bankruptcy as well as the bondholders’ ability to lay claim to the firm’s assets in the event of such a bankruptcy. Thus, debt issues with a low-priority claim in bankruptcy will have a lower rating than issues from the same company that have a high priority in bankruptcy or that are backed by a specific asset such as a building or a plant.

Corporate Yield Curves Just as we can construct a yield curve from risk-free Treasury securities, we can plot a similar yield curve for corporate bonds. Figure 6.6 shows the average yields of U.S. corporate coupon bonds with three different Standard & Poor’s bond ratings: two curves are for investment-grade bonds (AAA and BBB) and one is for junk bonds (B). Figure 6.6 also includes the U.S. (coupon-paying) Treasury yield curve. We refer to the difference between the yields of the corporate bonds and the Treasury yields as the default spread or

Chapter 6 Bonds

TABLE 6.6 Moody’s

167

Bond Ratings and the Number of U.S. Public Firms with Those Ratings at the End of 2009 Standard & Poor’s

Number of Public Firms

Description (Moody’s)

Investment Grade Debt Aaa

AAA

5

Judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as “gilt edged.”

Aa

AA

28

A

A

164

Possess many favorable investment attributes and are considered as upper-mediumgrade obligations. Factors giving security to principal and interest are considered adequate at present, but may not remain that way.

Baa

BBB

399

Are considered as medium-grade obligations (i.e., they are neither highly protected nor poorly secured).

Judged to be of high quality by all standards. Together with the Aaa group, they constitute what are generally known as high-grade bonds.

Speculative Bonds (“Junk Bonds”) Ba

BB

318

Judged to have speculative elements; their future cannot be considered as well assured.

B

B

296

Generally lack characteristics of the desirable investment. Assurance of interest and principal payments over any long period of time may be small.

Caa

CCC

27

Ca

CC

4

Are speculative to a high degree. Such issues are often in default or have other marked shortcomings.

C

C, D

8

Lowest-rated class of bonds, and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing.

Are of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest.

Source: www.moodys.com and S&P Compustat.

Corporate Yield Curves for Various Ratings, March 2010

This figure shows the yield curve for U.S. Treasury securities and yield curves for corporate securities with ratings AA (in red), BBB (in green), and B (in purple). Note how the yield to maturity is higher for the corporate bonds, which have a higher probability of default than the U.S. Treasury securities. 10 9 8 Yield to Maturity (%)

FIGURE 6.6

7 6 5 4 3

U.S. Industrials (B) U.S. Industrials (BBB) U.S. Industrials (AA) U.S. Treasury Yield Curve

2 1 0

0

Source: Bloomberg.

2

4

6

8 10 Years to Maturity

12

14

16

168

Part 2 Interest Rates and Valuing Cash Flows credit spread. This difference can be seen in Figure 6.6 as the distance between the bottom blue line for Treasuries and each of the red, green, and purple lines as default probability increases. Credit spreads fluctuate as perceptions regarding the probability of default change. Note that the credit spread is high for bonds with low ratings and therefore a greater likelihood of default.

EXAMPLE 6.10 Credit Spreads and Bond Prices

Problem Your firm has a credit rating of AA. You notice that the credit spread for 10-year maturity AA debt is 90 basis points (0.90%). Your firm’s ten-year debt has a coupon rate of 5%. You see that new ten-year Treasury notes are being issued at par with a coupon rate of 4.5%. What should the price of your outstanding ten-year bonds be?

Solution Q Plan If the credit spread is 90 basis points, then the yield to maturity (YTM) on your debt should be the YTM on similar Treasuries plus 0.9%. The fact that new ten-year Treasuries are being issued at par with coupons of 4.5% means that with a coupon rate of 4.5%, these notes are selling for $100 per $100 face value. Thus, their YTM is 4.5% and your debt’s YTM should be 4.5% + 0.9% = 5.4%. The cash flows on your bonds are $5 per year for every $100 face value, paid as $2.50 every six months. The six-month rate corresponding to a 5.4% yield is 5.4%/2 = 2.7%. Armed with this information, you can use Eq. 6.3 to compute the price of your bonds. Q Execute 2.50 *

1 1 100 ¢1 ≤ + = +96.94 0.027 1.02720 1.02720

Q Evaluate Your bonds offer a higher coupon (5% vs. 4.5%) than Treasuries of the same maturity, but sell for a lower price ($96.94 vs. $100). The reason is the credit spread. Your firm’s higher probability of default leads investors to demand a higher YTM on your debt. To provide a higher YTM, the purchase price for the debt must be lower. If your debt paid 5.4% coupons, it would sell at $100, the same as the Treasuries. But to get that price, you would have to offer coupons that are 90 basis points higher than those on the Treasuries— exactly enough to offset the credit spread.

The Credit Crisis and Bond Yields The financial crisis that engulfed the world’s economies in 2008 originated as a credit crisis that first emerged in August 2007. At that time, problems in the mortgage market had led to the bankruptcy of several large mortgage lenders. The default of these firms, and the downgrading of many of the bonds backed by mortgages these firms had made, caused many investors to reassess the risk of other bonds in their portfolios. As perceptions of risk increased, and investors attempted to move into safer U.S. Treasury securities, the prices of corporate bonds fell and so their credit spreads rose relative to Treasuries, as shown in Figure 6.7. Panel A of the figure shows

the yield spreads for long-term corporate bonds, where we can see that spreads of even the highest-rated Aaa bonds increased dramatically, from a typical level of 0.5% to over 2% by the fall of 2008. Panel B shows a similar pattern for the rate banks had to pay on short-term loans compared to the yields of short-term Treasury bills. This increase in borrowing costs made it more costly for firms to raise the capital needed for new investment, slowing economic growth. The decline in these spreads in early 2009 was viewed by many as an important first step in mitigating the ongoing impact of the financial crisis on the rest of the economy.

Chapter 6 Bonds

FIGURE 6.7 Yield Spreads and the Financial Crisis

169

Panel A shows the yield spread between long-term (30-year) U.S. corporate and Treasury bonds. Panel B shows the yield spread of short-term loans to major international banks (called LIBOR) and U.S. Treasury bills (also referred to as the Treasury-Eurodollar or “TED” spread). Note the dramatic increase in these spreads beginning in August 2007 and again in September 2008, before beginning to decline in late 2008 and early 2009. Panel A: Yield Spread of Long-Term Corporate Bonds Versus U.S. Treasury Bonds

6

Aaa

A

Baa

Spread (%)

5 4 3 2 1 0 2005

Spread (%)

5

2006

2007

2008

2009

Panel B: Yield Spread of Short-Term Loans to Major International Banks (LIBOR) Versus U.S. Treasury Bonds

4 3 2 1 0 2005

2006

2007

2008

2009

Source: Bloomberg.com.

As we indicated at the beginning of this chapter, the bond market, while less wellknown than the stock markets, is large and important. Because debt is a substantial part of the financing of most corporations, a financial manager needs to understand bonds and how investors price the company’s bonds. In this chapter, we have introduced you to the major types of bonds, how bonds repay investors, and how they are priced. In Chapter 15, we will discuss the bond markets further, including the process a firm goes through to issue debt.

Concept Check

9. What is a junk bond? 10. How will the yield to maturity of a bond vary with the bond’s risk of default?

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Part 2 Interest Rates and Valuing Cash Flows

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

6.1 Bond Terminology Q Bonds pay both coupon and principal or face value payments to investors. By convention, the coupon rate of a bond is expressed as an APR, so the amount of each coupon payment, CPN, is:

bond certificate, p. 146 coupon rate, p. 146 coupons, p. 146 face value, p. 146 maturity date, p. 146 par value, p. 146 principal amount, p. 146 term, p. 146

MyFinanceLab Study Plan 6.1

discount, p. 148 pure discount bond, p. 148 spot interest rates, p. 149 Treasury bills, p. 147 yield to maturity (YTM), p. 148 zero-coupon bond, p. 147 zero-coupon yield curve, p. 150

MyFinanceLab Study Plan 6.2

coupon bonds, p. 151 Treasury bonds, p. 151 Treasury notes, p. 151

MyFinanceLab Study Plan 6.3

CPN =

Coupon Rate * Face Value Number of Coupon Payments per Year

(6.1)

6.2 Zero-Coupon Bonds Q Zero-coupon bonds make no coupon payments, so investors receive only the bond’s face value. Q The rate of return of a bond is called its yield to maturity (or yield). The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond. Q The yield to maturity for a zero-coupon bond is given by: 1 + YTMn = ¢

Face Value 1/n ≤ Price

(6.2)

Financial Calculator Tutorial: Solving for the Yield to Maturity of a Bond

Q The risk-free interest rate for an investment until date n equals the yield to maturity of a risk-free zero-coupon bond that matures on date n. A plot of these rates against maturity is called the zero-coupon yield curve. 6.3 Coupon Bonds Q The yield to maturity for a coupon bond is the discount rate, y, that equates the present value of the bond’s future cash flows with its price: P = CPN *

1 1 FV ¢1 ≤ + y 11 + y2N 11 + y2N

(6.3)

Financial Calculator Tutorial: Bond Valuation with Interest Compounded Semiannually

Chapter 6 Bonds

6.4 Why Bond Prices Change Q A bond will trade at a premium if its coupon rate exceeds its yield to maturity. It will trade at a discount if its coupon rate is less than its yield to maturity. If a bond’s coupon rate equals its yield to maturity, it trades at par. Q As a bond approaches maturity, the price of the bond approaches its face value. Q Bond prices change as interest rates change. When interest rates rise, bond prices fall, and vice versa. Q Long-term zero-coupon bonds are more sensitive to changes in interest rates than are short-term zerocoupon bonds. Q Bonds with low coupon rates are more sensitive to changes in interest rates than similar maturity bonds with high coupon rates.

clean price, p. 162 dirty price, p. 162 invoice price, p. 162 par, p. 156 premium, p. 156

MyFinanceLab Study Plan 6.4

6.5 Corporate Bonds Q When a bond issuer does not make a bond payment in full, the issuer has defaulted. Q The risk that default can occur is called default or credit risk. United States Treasury securities are free of default risk. Q The expected return of a corporate bond, which is the firm’s debt cost of capital, equals the risk-free rate of interest plus a risk premium. The expected return is less than the bond’s yield to maturity because the yield to maturity of a bond is calculated using the promised cash flows, not the expected cash flows. Q Bond ratings summarize the creditworthiness of bonds for investors. Q The difference between yields on Treasury securities and yields on corporate bonds is called the credit spread or default spread. The credit spread compensates investors for the difference between promised and expected cash flows and for the risk of default.

corporate bonds, p. 164 credit risk, p. 164 default (credit) spread, p. 166 high-yield bonds, p. 166 investment-grade bonds, p. 166 junk bonds, p. 166 speculative bonds, p. 166

MyFinanceLab Study Plan 6.5

Critical Thinking

171

Interactive Interest Rate Sensitivity Analysis

1. How is a bond like a loan? 2. How does an investor receive a return from buying a bond? 3. How is yield to maturity related to the concept of rate of return? 4. Does a bond’s yield to maturity determine its price or does the price determine the yield to maturity?

172

Part 2 Interest Rates and Valuing Cash Flows 5. Explain why the yield of a bond that trades at a discount exceeds the bond’s coupon rate. 6. Explain the relationship between interest rates and bond prices. 7. Why are longer-term bonds more sensitive to changes in interest rates than shorterterm bonds? 8. Explain why the expected return of a corporate bond does not equal its yield to maturity.

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Bond Terminology 1. Consider a ten-year bond with a face value of $1000 that has a coupon rate of 5.5%, with semiannual payments. a. What is the coupon payment for this bond? b. Draw the cash flows for the bond on a timeline. 2. Assume that a bond will make payments every six months as shown on the following timeline (using six-month periods): 0

1

2

3

20 ...

$20

$20

$20 $1000

$20

a. What is the maturity of the bond (in years)? b. What is the coupon rate (in percent)? c. What is the face value? 3. Your company wants to raise $10 million by issuing 20-year zero-coupon bonds. If the yield to maturity on the bonds will be 6% (annually compounded APR), what total principal amount of bonds must you issue? Zero-Coupon Bonds 4. The following table summarizes prices of various default-free zero-coupon bonds (expressed as a percentage of face value): Maturity (years) Price (per $100 face value)

1

2

3

4

5

$95.51

$91.05

$86.38

$81.65

$76.51

a. Compute the yield to maturity for each bond. b. Plot the zero-coupon yield curve (for the first five years). c. Is the yield curve upward sloping, downward sloping, or flat? Use the following information for Problems 5–7. The current zero-coupon yield curve for risk-free bonds is as follows: Maturity (years) YTM

1

2

3

4

5

5.00%

5.50%

5.75%

5.95%

6.05%

5. What is the price per $100 face value of a two-year, zero-coupon, risk-free bond? 6. What is the price per $100 face value of a four-year, zero-coupon, risk-free bond? 7. What is the risk-free interest rate for a five-year maturity?

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173

Coupon Bonds 8. For each of the following pairs of Treasury securities (each with $1000 par value), identify which will have the higher price: a. A three-year zero-coupon bond or a five-year zero coupon bond? b. A three-year zero-coupon bond or a three-year 4% coupon bond? c. A two-year 5% coupon bond or a two-year 6% coupon bond? 9. The yield to maturity of a $1000 bond with a 7% coupon rate, semiannual coupons, and two years to maturity is 7.6% APR, compounded semiannually. What must its price be? 10. Assume the current Treasury yield curve shows that the spot rates for 6 months, 1 year, and 1 1/2 years are 1%, 1.1%, and 1.3%, all quoted as semiannually compounded APRs. What is the price of a $1000 par, 4% coupon bond maturing in 1 1/2 years (the next coupon is exactly 6 months from now)? 11. Suppose a ten-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading for a price of $1034.74. a. What is the bond’s yield to maturity (expressed as an APR with semiannual compounding)? b. If the bond’s yield to maturity changes to 9% APR, what will the bond’s price be? 12. Suppose a five-year, $1000 bond with annual coupons has a price of $900 and a yield to maturity of 6%. What is the bond’s coupon rate? Why Bond Prices Change 13. The prices of several bonds with face values of $1000 are summarized in the following table: Bond

A

B

C

D

Price

$972.50

$1040.75

$1150.00

$1000.00

For each bond, state whether it trades at a discount, at par, or at a premium. 14. You have purchased a 10% coupon bond for $1040. What will happen to the bond’s price if market interest rates rise? 15. Suppose a seven-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading with a yield to maturity of 6.75%. a. Is this bond currently trading at a discount, at par, or at a premium? Explain. b. If the yield to maturity of the bond rises to 7.00% (APR with semiannual compounding), what price will the bond trade for? Suppose that General Motors Acceptance Corporation issued a bond with ten years until maturity, a face value of $1000, and a coupon rate of 7% (annual payments). The yield to maturity on this bond when it was issued was 6%. Use this information for Problems 16–18. 16. What was the price of this bond when it was issued? 17. Assuming the yield to maturity remains constant, what is the price of the bond immediately before it makes its first coupon payment? 18. Assuming the yield to maturity remains constant, what is the price of the bond immediately after it makes its first coupon payment?

174

Part 2 Interest Rates and Valuing Cash Flows 19. Your company currently has $1000 par, 6% coupon bonds with ten years to maturity and a price of $1078. If you want to issue new ten-year coupon bonds at par, what coupon rate do you need to set? Assume that for both bonds, the next coupon payment is due in exactly 6 months. 20. Suppose you purchase a ten-year bond with 6% annual coupons. You hold the bond for four years, and sell it immediately after receiving the fourth coupon. If the bond’s yield to maturity was 5% when you purchased and sold the bond, a. What cash flows will you pay and receive from your investment in the bond per $100 face value? b. What is the rate of return of your investment? Consider the following bonds for Questions 21 and 22: Bond

Coupon Rate (annual payments)

Maturity (years)

0%

15

0% 4% 8%

10 15 10

A B C D

21. What is the percentage change in the price of each bond if its yield to maturity falls from 6% to 5%? 22. Which of the bonds A–D is most sensitive to a 1% drop in interest rates from 6% to 5% and why? Which bond is least sensitive? Provide an intuition explanation for your answer. 23. Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 6%. You hold the bond for five years before selling it. a. If the bond’s yield to maturity is 6% when you sell it, what is the rate of return of your investment? b. If the bond’s yield to maturity is 7% when you sell it, what is the rate of return of your investment? c. If the bond’s yield to maturity is 5% when you sell it, what is the rate of return of your investment? d. Even if a bond has no chance of default, is your investment risk free if you plan to sell it before it matures? Explain. Corporate Bonds 24. The following table summarizes the yields to maturity on several one-year, zerocoupon securities: Security

Yield (%)

Treasury

3.1

AAA corporate

3.2

BBB corporate

4.2

B corporate

4.9

a. What is the price (expressed as a percentage of the face value) of a one-year, zerocoupon corporate bond with an AAA rating? b. What is the credit spread on AAA-rated corporate bonds? c. What is the credit spread on B-rated corporate bonds? d. How does the credit spread change with the bond rating? Why?

Chapter 6 Bonds

175

25. Andrew Industries is contemplating issuing a 30-year bond with a coupon rate of 7% (annual coupon payments) and a face value of $1000. Andrew believes it can get a rating of A from Standard & Poor’s. However, due to recent financial difficulties at the company, Standard & Poor’s is warning that it may downgrade Andrew Industries bonds to BBB. Yields on A-rated, long-term bonds are currently 6.5%, and yields on BBB-rated bonds are 6.9%. a. What is the price of the bond if Andrew Industries maintains the A rating for the bond issue? b. What will the price of the bond be if it is downgraded? 26. HMK Enterprises would like to raise $10 million to invest in capital expenditures. The company plans to issue five-year bonds with a face value of $1000 and a coupon rate of 6.5% (annual payments). The following table summarizes the yield to maturity for five-year (annual-pay) coupon corporate bonds of various ratings: Rating

AAA

AA

A

BBB

BB

YTM

6.20%

6.30%

6.50%

6.90%

7.50%

a. Assuming the bonds will be rated AA, what will the price of the bonds be? b. How much of the total principal amount of these bonds must HMK issue to raise $10 million today, assuming the bonds are AA rated? (Because HMK cannot issue a fraction of a bond, assume that all fractions are rounded to the nearest whole number.) c. What must the rating of the bonds be for them to sell at par? d. Suppose that when the bonds are issued, the price of each bond is $959.54. What is the likely rating of the bonds? Are they junk bonds? 27. A BBB-rated corporate bond has a yield to maturity of 8.2%. A U.S. Treasury security has a yield to maturity of 6.5%. These yields are quoted as APRs with semiannual compounding. Both bonds pay semiannual coupons at a rate of 7% and have five years to maturity. a. What is the price (expressed as a percentage of the face value) of the Treasury bond? b. What is the price (expressed as a percentage of the face value) of the BBB-rated corporate bond? c. What is the credit spread on the BBB bonds?

Data Case

You are an intern with Ford Motor Company in its corporate finance division. The firm is planning to issue $50 million of 12% annual coupon bonds with a ten-year maturity. The firm anticipates an increase in its bond rating. Your boss wants you to determine the gain in the proceeds of the new issue if it is rated above the firm’s current bond rating. To prepare this information, you will have to determine Ford’s current debt rating and the yield curve for its particular rating. 1. Begin by finding the current U.S. Treasury yield curve. At the Treasury Web site (www.treas.gov), search using the term “yield curve” and select “US Treasury— Daily Treasury Yield Curve.” Beware: There will likely be two links with the same title. Look at the description below the link and select the one that does NOT say “Real Yield p ” You want the nominal rates. Copy the table into Excel. 2. Find the current yield spreads for the various bond ratings. Unfortunately, the current spreads are available only for a fee, so you will use old ones. Go to BondsOnline (www.bondsonline.com) and click on “Today’s Market.” Next, click

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Part 2 Interest Rates and Valuing Cash Flows

3.

4.

5. 6. 7.

8.

on “US Corporate Bond Spreads.” Copy this table to the same Excel file as the Treasury yields. Find the current bond rating for Ford Motor Co. Go to Standard & Poor’s Web site (www.standardandpoors.com). Select your country. Look for the “Find a Rating” box under “Ratings” and enter Ford Motor Co. and select Ford Motor Co. from the list it returns. At this point you will have to register (it’s free) or enter the username and password provided by your instructor. Use the issuer credit rating for “local long term.” Return to Excel and create a timeline with the cash flows and discount rates you will need to value the new bond issue. a. To create the required spot rates for Ford’s issue, add the appropriate spread to the Treasury yield of the same maturity. b. The yield curve and spread rates you have found do not cover every year that you will need for the new bonds. Specifically, you do not have yields or spreads for four-, six-, eight-, and nine-year maturities. Fill these in by linearly interpolating the given yields and spreads. For example, the four-year spot rate and spread will be the average of the three- and five-year rates. The six-year rate and spread will be the average of the five- and seven-year rates. For years eight and nine you will have to spread the difference between years seven and ten across the two years. c. To compute the spot rates for Ford’s current debt rating, add the yield spread to the Treasury rate for each maturity. However, note that the spread is in basis points, which are 1/100th of a percentage point. d. Compute the cash flows that would be paid to bondholders each year and add them to the timeline. Use the spot rates to calculate the present value of each cash flow paid to the bondholders. Compute the issue price of the bond and its initial yield to maturity. Repeat steps 4–6 based on the assumption that Ford is able to raise its bond rating by one level. Compute the new yield based on the higher rating and the new bond price that would result. Compute the additional cash proceeds that could be raised from the issue if the rating were improved.

Chapter 6 Bonds

Chapter 6 APPENDIX A

177

Solving for the Yield to Maturity of a Bond Using a Financial Calculator

You are looking to purchase a three-year, $1000 par, 10% annual coupon bond. Payments begin one year from now in January 2012. The price of the bond is $1074.51 per $1000 par value. What is the yield to maturity of the bond? [answer: 7.15%] HP-10BII Press [Orange Shift] and then the [C] button to clear all previous entries. Enter the Number of periods.

C 3

N

1

0

0

PMT

1

0

0

0

FV

1

0

7

4

•

5

1

/ PV

I/YR

Enter the payment amount per period. Enter the par value of the bond you will receive in year 3. Enter present value or price of the bond you solved for earlier. Solves for the yield to maturity.

TI-BAII Plus Professional Press [2ND] and then the [FV] button to clear all previous entries. Enter the Number of periods.

2ND FV 3

N

1

0

0

PMT

1

0

0

0

FV

1

0

7

4

•

CPT

I/Y

5

1

/ PV

Enter the payment amount per period. Enter the par value of the bond you will receive in year 3. Enter present value or price of the bond you solved for earlier. Solves for the yield to maturity.

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Part 2 Interest Rates and Valuing Cash Flows

Chapter 6 APPENDIX B

The Yield Curve and the Law of One Price

Thus far, we have focused on the relationship between the price of an individual bond and its yield to maturity. In this section, we explore the relationship between the prices and yields of different bonds. In Chapter 3, we saw how market forces keep the same asset from having two prices at the same time—we call this the Valuation Principle’s Law of One Price. Using the Law of One Price, we show that given the spot interest rates, which are the yields of default-free zero-coupon bonds, we can determine the price and yield of any other default-free bond. As a result, the yield curve provides sufficient information to evaluate all such bonds.

Valuing a Coupon Bond with Zero-Coupon Prices We begin with the observation that it is possible to replicate the cash flows of a coupon bond using zero-coupon bonds. Therefore, we can use the Law of One Price to compute the price of a coupon bond from the prices of zero-coupon bonds. For example, we can replicate a three-year, $1000 bond that pays 10% annual coupons using three zerocoupon bonds as follows: 0

1

2

3

Coupon bond:

$100

$100

$1100

1-year zero: 2-year zero: 3-year zero:

$100

Zero-coupon bond portfolio:

$100 $1100 $100

$100

$1100

We match each coupon payment to a zero-coupon bond with a face value equal to the coupon payment and a term equal to the time remaining to the coupon date. Similarly, we match the final bond payment (final coupon plus return of face value) in three years to a three-year zero-coupon bond with a corresponding face value of $1100. Because the coupon bond cash flows are identical to the cash flows of the portfolio of zero-coupon bonds, the Law of One Price states that the price of the portfolio of zero-coupon bonds must be the same as the price of the coupon bond. To illustrate, assume that current zero-coupon bond yields and prices are as shown in Table 6.7 (they are the same as in Example 6.1). We can calculate the cost of the zero-coupon bond portfolio that replicates the threeyear coupon bond as follows: Zero-Coupon Bond

Face Value Required

Cost

1 Year

100

96.62

2 Years 3 Years

100 1100

92.45 11 * 87.63 = 963.93 Total Cost: $1153.00

Chapter 6 Bonds

TABLE 6.7 Yields and Prices (per $100 Face Value) for Zero-Coupon Bonds

Maturity

1 Year 3.50%

YTM Price

$96.62

2 Years 4.00% $92.45

3 Years 4.50% $87.63

179

4 Years 4.75% $83.06

By the Law of One Price, the three-year coupon bond must trade for a price of $1153. If the price of the coupon bond were higher, you could earn an arbitrage profit by selling the coupon bond and buying the zero-coupon bond portfolio. If the price of the coupon bond were lower, you could earn an arbitrage profit by buying the coupon bond and selling the zero-coupon bonds.

Valuing a Coupon Bond Using Zero-Coupon Yields To this point, we have used the zero-coupon bond prices to derive the price of the coupon bond. Alternatively, we can use the zero-coupon bond yields. Recall that the yield to maturity of a zero-coupon bond is the competitive market interest rate for a risk-free investment with a term equal to the term of the zero-coupon bond. Since the cash flows of the bond are its coupon payments and face value repayment, the price of a coupon bond must equal the present value of its coupon payments and face value discounted at the competitive market interest rates (see Eq. 5.7 in Chapter 5): Price of a Coupon Bond P = PV 1 Bond Cash Flows 2 =

CPN CPN CPN + FV + + g + 2 1 1 + YTMn 2 n 1 + YTM1 1 1 + YTM2 2

(6.4)

where CPN is the bond coupon payment, YTMn is the yield to maturity of a zero-coupon bond that matures at the same time as the nth coupon payment, and FV is the face value of the bond. For the three-year, $1000 bond with 10% annual coupons considered earlier, we can use Eq. 6.4 to calculate its price using the zero-coupon yields in Table 6.7: P =

100 100 100 + 1000 + + = +1153 2 1.035 1.04 1.0453

This price is identical to the price we computed earlier by replicating the bond. Thus, we can determine the no-arbitrage price of a coupon bond by discounting its cash flows using the zero-coupon yields. In other words, the information in the zero-coupon yield curve is sufficient to price all other risk-free bonds.

Coupon Bond Yields Given the yields for zero-coupon bonds, we can use Eq. 6.4 to price a coupon bond. In Section 6.3, we saw how to compute the yield to maturity of a coupon bond from its price. Combining these results, we can determine the relationship between the yields of zerocoupon bonds and coupon-paying bonds. Consider again the three-year, $1000 bond with 10% annual coupons. Given the zerocoupon yields in Table 6.7, we calculate a price for this bond of $1153. From Eq. 6.3, the yield to maturity of this bond is the rate y that satisfies: P = 1153 =

100 100 100 + 1000 + + 2 11 + y2 11 + y2 11 + y23

180

Part 2 Interest Rates and Valuing Cash Flows We can solve for the yield by using a financial calculator or spreadsheet:

Given: Solve for:

N 3

I/Y

PV 1153

PMT 100

FV 1000

4.44 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,100,1153,1000)

Therefore, the yield to maturity of the bond is 4.44%. We can check this result directly as follows: P =

100 + 1000 100 100 + = +1153 + 2 1.0444 1.0444 1.0444 3

Because the coupon bond provides cash flows at different points in time, the yield to maturity of a coupon bond is a weighted average of the yields of the zero-coupon bonds of equal and shorter maturities. The weights depend (in a complex way) on the magnitude of the cash flows each period. In this example, the zero-coupon bonds yields were 3.5%, 4.0%, and 4.5%. For this coupon bond, most of the value in the present value calculation comes from the present value of the third cash flow because it includes the principal, so the yield is closest to the three-year zero-coupon yield of 4.5%.

EXAMPLE 6.11 Yields on Bonds with the Same Maturity

Problem Given the following zero-coupon yields, compare the yield to maturity for a three-year zero-coupon bond, a three-year coupon bond with 4% annual coupons, and a three-year coupon bond with 10% annual coupons. All of these bonds are default free. Maturity

1 Year

2 Years

3 Years

4 Years

Zero-Coupon YTM

3.50%

4.00%

4.50%

4.75%

Solution Q Plan From the information provided, the yield to maturity of the three-year zero-coupon bond is 4.50%. Also, because the yields match those in Table 6.7, we already calculated the yield to maturity for the 10% coupon bond as 4.44%. To compute the yield for the 4% coupon bond, we first need to calculate its price, which we can do using Eq. 6.4. Since the coupons are 4%, paid annually, they are $40 per year for three years. The $1000 face value will be repaid at that time. Once we have the price, we can use Eq. 6.3 to compute the yield to maturity. Q Execute Using Eq. 6.4, we have: P =

40 40 40 + 1000 + + = +986.98 1.035 1.042 1.0453

The price of the bond with a 4% coupon is $986.98. From Eq. 6.4: 40 40 40 + 1000 + + 11 + y2 11 + y22 11 + y23 We can calculate the yield to maturity using a financial calculator or spreadsheet: +986.98 =

Given: Solve for:

N 3

I/Y

PV 986.98

PMT 40

FV 1000

4.47 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,40,986.98,1000)

Chapter 6 Bonds

181

To summarize, for the three-year bonds considered: Coupon Rate

0%

4%

10%

YTM

4.50%

4.47%

4.44%

Q Evaluate Note that even though the bonds all have the same maturity, they have different yields. In fact, holding constant the maturity, the yield decreases as the coupon rate increases. We discuss why below.

Example 6.11 shows that coupon bonds with the same maturity can have different yields depending on their coupon rates. The yield to maturity of a coupon bond is a weighted average of the yields on the zero-coupon bonds. As the coupon increases, earlier cash flows become relatively more important than later cash flows in the calculation of the present value. The shape of the yield curve keys us in on trends with the yield to maturity: 1. If the yield curve is upward sloping (as it is for the yields in Example 6.11), the resulting yield to maturity decreases with the coupon rate of the bond. 2. When the zero-coupon yield curve is downward sloping, the yield to maturity will increase with the coupon rate. 3. With a flat yield curve, all zero-coupon and coupon-paying bonds will have the same yield, independent of their maturities and coupon rates.

Treasury Yield Curves As we have shown in this section, we can use the zero-coupon yield curve to determine the price and yield to maturity of other risk-free bonds. The plot of the yields of coupon bonds of different maturities is called the coupon-paying yield curve. When U.S. bond traders refer to “the yield curve,” they are often referring to the coupon-paying Treasury yield curve. As we showed in Example 6.11, two coupon-paying bonds with the same maturity may have different yields. By convention, practitioners always plot the yield of the most recently issued bonds, termed the on-the-run bonds. Using similar methods to those employed in this section, we can apply the Law of One Price to determine the zerocoupon bond yields using the coupon-paying yield curve. Thus, either type of yield curve provides enough information to value all other risk-free bonds.

7

Stock Valuation

LEARNING OBJECTIVES

notation

182

Q Describe the basics of common stock, preferred stock, and stock quotes

Q Understand the tradeoff between dividends and growth in stock valuation

Q Compare how trades are executed on the NYSE and NASDAQ

Q Appreciate the limitations of valuing a stock based on expected dividends

Q Value a stock as the present value of its expected future dividends

Q Value a stock as the present value of the company’s total payout

Divt

dividends paid in year t

Pt

stock price at the end of year t

EPSt

earnings per share on date t

PV

present value

g

expected dividend growth rate

rE

equity cost of capital

N

terminal date or forecast horizon

INTERVIEW WITH

Christopher Ellis-Ferrara AllianceBersntein

Christopher Ellis-Ferrara is a business analyst covering U.S. real estate investment trusts (REITs) for the Bernstein Value Equities research department of AllianceBernstein in New York City. He received his degree in economics and geosciences at Williams College, Williamstown, Massachusetts, in 2007. “My primary responsibility is to conduct in-depth fundamental research on the real estate industry, including tracking and forecasting supply and demand for various markets and property types,” says Chris. “Senior analysts incorporate my research into their company analyses. I also assist the chief investment officer of my product in portfolio analytics and management.” In addition to an array of other valuation tools, AllianceBernstein uses the dividend discount model (DDM) to help identify undervalued stocks for clients. “One attraction of the DDM is that it allows us to express our views of a company’s forward earnings prospects in the valuation,” says Chris. “This is a characteristic absent in other common tools.” Chris acknowledges that forecasting future earnings and dividends is an inherently challenging task—but essential for an accurate valuation. “Relative to other companies, however, REIT earnings and dividends are generally more predictable.” No single valuation model is perfect, so AllianceBernstein uses several to arrive at intrinsic value. “In addition to the DDM, some of the models and metrics we use for real estate companies include price-tonet asset value (NAV), earnings and cash flow multiples, enterprise value to EBITDA, and discounted cash flow analysis. Once we have conviction that the market price of a stock is less than its intrinsic value and that it does not alter the acceptable risk in our portfolio, we will invest.” The recent stock market volatility has heightened the opportunity to earn higher returns. “Now more than ever, we strive to stay disciplined in our investment process and identify pricing anomalies that volatility inevitably generates. To take advantage of these anomalies, we have improved our nimbleness to respond quickly. We also spend more time on balance sheet analysis, because the credit crisis severely impaired access to capital for real estate companies.”

Williams College, 2007

“The dividend discount model allows us to express our views of a company’s forward earnings prospects in the valuation.”

At 5:00 P.M. on March 17, 2010, footwear and apparel maker Nike, Inc., announced that its quarterly revenue growth would be higher than expected and that revenue and profit growth for the following year would be strong as well. The next day, Nike’s stock price increased by more than 5% on the New York Stock Exchange to $74.66, with almost 11 million shares being traded—nearly four times its average daily volume. How might an investor decide whether to buy or sell a stock such as Nike at this price? Why would the stock suddenly be worth 5% more after the announcement of this news? What actions can Nike’s managers take to further increase the stock price? To answer these questions, we turn to the Valuation Principle. The Valuation Principle indicates that the price of a security should equal the present value of the expected cash flows an investor will receive from owning it. In this chapter, we apply this idea to stocks. Thus, to value a stock, we need to know the expected cash flows an investor will receive and the appropriate cost of capital with which to discount those cash flows. Both these quantities can be challenging to estimate, and we will develop many of the details needed to do so throughout the remainder of this text.

183

184

Part 2 Interest Rates and Valuing Cash Flows We begin our study of stock valuation by contrasting the different types of stocks, interpreting a stock quote, and explaining how specialists execute stock trades. We then turn to our first model of stock valuation, the dividend-discount model, which considers the dividends and capital gains received by investors who hold the stock for different periods.

7.1

Stock Basics As discussed in Chapter 1, the ownership of a corporation is divided into shares of stock. A public corporation has many owners and its shares trade on a stock market that provides liquidity for a company’s shares and determines the market price for those shares. In this section, we explain what a stock market quote is and introduce the two types of stocks, common and preferred.

Stock Market Reporting: Stock Quotes common stock A share of ownership in the corporation, which confers rights to any common dividends as well as rights to vote on election of directors, mergers, and other major events. ticker symbol A unique abbreviation assigned to each publicly traded company.

Figure 7.1 shows a stock quote with basic information about Nike’s stock from Google Finance (www.google.com/finance) for May 11, 2010.1 Nike’s stock is common stock, which means a share of ownership in the corporation gives its owner rights to any common dividends as well as rights to vote on the election of directors, mergers, and other major events. The Web page notes that the company is a public corporation (its shares are widely held and traded in a market) and that its shares trade on the NYSE (New York Stock Exchange) under the ticker symbol NKE. A ticker symbol is a unique abbreviation assigned to a publicly traded company used when its trades are reported on the ticker (a real-time electronic display of trading activity). Shares on the NYSE have ticker symbols consisting of three or fewer characters, while shares on the NASDAQ generally have four or more characters in their ticker symbols. During the time period February through early May 2010, Nike paid one quarterly dividend to its common shareholders, on March 4. The dividend is marked by a “D” and the amount of the dividend. In this case, the dividend was 27 cents per share. Thus, if you owned 1000 shares of NKE, you would have received +0.27 * 1000 = +270 when Nike paid that dividend. The chart also clearly shows the jump in the price of NKE shares in March 2010 that we discussed in the chapter introduction. Finally, the Web page displays some basic information about the performance of NKE stock. Notice the price of the last trade of NKE shares in the market ($76.43), the price that shares started at when the market opened that day ($75.80), the range of low to high prices reached during trading that day ($75.76 to $77.07), and the volume of trading for the day (3.43 million shares). The total value of all the equity of NKE is its market capitalization, equal to the price per share multiplied by the number of shares outstanding: on May 11, 2010, it was +76.43 * 485.7 million = +37.12 billion. Over the past 52 weeks, NKE achieved a high price of $78.55 and a low price of $48.76 and had average daily volume of shares traded of 2.79 million shares. Also, note some basic information about the company: the price-earnings ratio (P/E) and earnings per share (EPS), both of which we discussed in Chapter 2. The Web page also notes that NKE’s beta is 0.87.2

1

There are many places on the Internet to get free stock information, such as Yahoo! Finance (http:// finance.yahoo.com/), MSN Money (http://moneycentral.msn.com/), the Wall Street Journal’s Web site (www.wsj.com), and the exchange sites www.nyse.com and www.nasdaq.com. 2

Beta is a measure of risk that we will discuss in Chapter 12.

Chapter 7 Stock Valuation

FIGURE 7.1 Stock Price Quote for Nike (NKE)

185

This screenshot from Google Finance shows the basic stock price information and price history charting for the common stock of Nike. The historical price chart covers the period February through early May 2010. The price of $76.43 is for May 11, 2010.

Source : www.google.com/finance?q=nke.

Although the current price of NKE is $76.43, the stock’s price has varied over time. In preceding chapters, we have learned how financial managers make decisions that affect the value of their company.

Common Stock straight voting Voting for directors where shareholders must vote for each director separately, with each shareholder having as many votes as shares held. cumulative voting Voting for directors where each shareholder is allocated votes equal to the number of open spots multiplied by his or her number of shares.

We now examine the rights of common stockholders, including their voice in the running of the corporation. All rights accruing to the shareholders are in proportion to the number of shares they hold. Shareholder Voting. To illustrate the shareholder voting process, consider an election of ten directors at a company with only two shareholders: Donna and Jonathan. Donna has 600 shares and Jonathan has 400, but they have very different views of how the company should be run. If the company has straight voting, each shareholder has as many votes for each director as shares held. That is, for each director, Donna will have 600 votes and Jonathan 400, so Jonathan will lose every vote and have no representation on the board. If the company has cumulative voting, each shareholder’s total vote allocation for all directors is equal to the number of open spots multiplied by his or her number of shares. With ten directors up for election, Jonathan is allocated a total of 10 * 400 votes (4000

186

Part 2 Interest Rates and Valuing Cash Flows

classes Different types of common stock for the same company, often carrying different voting rights.

annual meeting Meeting held once per year where shareholders vote on directors and other proposals as well as ask managers questions. proxy A written authorization for someone else to vote your shares. proxy contest When two or more groups are competing to collect proxies to prevail in a matter up for shareholder vote (such as election of directors).

votes) and Donna is allocated 10 * 600 votes (6000 votes) to use across the ten director spots. Jonathan could allocate all his votes to four directors, ensuring that he has four directors representing his views on the board. Donna would do the same for six directors, ensuring her representation. With cumulative voting, even shareholders with minority blocks (less than 50%) have a chance at representation on the board. This example is based on the concept of one share, one vote. Some companies have different types of common stock, called classes, which carry different voting rights. This is typical in companies that are family run, or where the founder is still active. For example, Nike has Class A and Class B stock. Phil Knight, Nike’s founder, owns almost all the Class A stock, which carries the rights to elect 9 of the company’s 12 directors. Google also has Class A and Class B stock. Class A stock has been sold to the public, while Google’s founders and managers hold all the Class B stock, each share of which carries ten times the voting power of a share of Class A stock. Shareholder Rights. Each year, companies hold an annual meeting at which managers and directors answer questions from shareholders, and shareholders vote on the election of directors and other proposals. All shareholders have the right to attend the annual meeting and cast their votes directly. In practice, though, most either allow the board to vote for them or direct that their shares be voted for them via proxy, or explicit instructions on how they should be voted. Typically matters at the annual meeting are uncontested, but occasionally a dissident shareholder group will propose an alternative slate of directors or oppose a management proposal. In that case, each side will actively solicit the proxies of all the shareholders so they may win the vote in a proxy contest. As an ownership claim, common stock carries the right to share in the profits of the corporation through dividend payments. Recall from Chapter 1 that dividends are periodic payments, usually in the form of cash, that firms make to shareholders as a partial return on their investment in the corporation. The board of directors decides the timing and amount of each dividend. Shareholders are paid dividends in proportion to the number of shares they own. If the company is liquidated through bankruptcy and there are assets left over after satisfying the claims of the creditors, shareholders divide the remaining assets proportionally based on each shareholder’s number of shares.

Preferred Stock preferred stock Stock with preference over common shares in payment of dividends and in liquidation. cumulative preferred stock Preferred stock where all missed preferred dividends must be paid before any common dividends may be paid. non-cumulative preferred stock Preferred stock where missed dividends do not accumulate. Only the current dividend is owed before common dividends can be paid.

Some companies have an additional issue of stock called preferred stock, which has preference over common shares in the distribution of dividends or cash during liquidation. While the directors can at their discretion choose not to pay the preferred shareholders a dividend, they cannot pay a dividend to common stockholders unless they pay the promised dividend to preferred shareholders first. For example, Nike has preferred shares that pay a $0.10 dividend per share each year. The firm must pay this dividend before common shareholders can receive a dividend. Cumulative Versus Non-Cumulative Preferred Stock. There are two types of preferred stock: cumulative and non-cumulative. With cumulative preferred stock, any unpaid dividends are carried forward. For example, if DuPont fails to pay its preferred dividend for several years, its obligation to its cumulative preferred shareholders accumulates, and it cannot pay any dividends to common shareholders until it has paid all the unpaid preferred dividends. With non-cumulative preferred stock, missed dividends do not accumulate, and the firm can pay current dividend payments first to preferred and then to common stock shareholders. Almost all preferred stock is cumulative. Some preferred stock also gives preferred shareholders the right to elect one or more directors to the board if the firm is substantially in arrears on preferred dividends.

Chapter 7 Stock Valuation

187

Preferred Stock: Equity or Debt? You may be wondering how to think about preferred stock—is it equity or is it debt? Economically, it is like a perpetual bond because it has a promised cash flow to holders and there are consequences if these cash flows are not paid. However, unlike debtholders, preferred shareholders cannot force the firm into bankruptcy. Preferred shareholders stand in line in front of common shareholders for annual dividends, but behind regular bondholders, because interest is paid before dividends. If the firm is bankrupt, the same priority is followed in settling claims: bondholders, preferred shareholders, and then common shareholders. Finally, as long as the firm is meeting its preferred dividend obligations, the preferred shareholders have none of the control rights of owners, such as voting on directors or other important matters. However, despite all these similarities to debt, preferred shares are, for all tax and legal purposes, treated as equity.

Concept Check

7.2

floor broker A person at the NYSE with a trading license who represents orders on the floor, balancing speed and price to get the best execution.

1. What is a share of stock and what are dividends? 2. What are some key differences between preferred and common stock?

The Mechanics of Stock Trades Suppose you decide to invest in Nike (NKE), and so you place a market order to buy 100 shares of its stock. A market order means you do not specify a price, rather you want the order to execute immediately at the most favorable price available. If instead you wanted to specify a maximum price you were willing to pay, and you were willing to wait until the shares were available at that price, you would place a limit order. What actually happens when you place this market order to buy Nike stock? In market parlance, 100 shares is a “round lot” and would be considered a small order. Small orders such as this would typically be transmitted electronically to the stock exchange via a system called the Super Display Book system (which replaced the old SuperDOT system in 2009). Upon reaching the exchange, it would go directly to the workstation of the specialist who oversees trading in Nike stock. Recall from Chapter 1 that a specialist holds a trading license at the NYSE and acts as a market maker for a particular stock, maintaining orderly trading and stepping in to provide liquidity when needed. The small order would automatically execute against the specialist’s inventory in an average time of five milliseconds. If you were making a large trade, say, to buy 15,000 shares, the process would be more complex. At a physical stock market such as the NYSE, your trade would still be transmitted electronically to the exchange, but it would be sent to the wireless handheld terminal of a floor broker. A floor broker holds a trading license at the NYSE and works to get the best execution possible for investors. In this case, the floor broker would physically go to the station where NKE is traded and look for other floor brokers representing sellers of NKE shares. The NKE specialist is also there, standing ready to buy (a limited amount) at the quoted bid price and sell at the quoted ask price. The floor broker would take note of the bid and ask and then negotiate with any selling brokers to buy 15,000 shares at a price below the specialist’s ask price. If no sell orders are available, then the floor broker would trade with the specialist. Depending on how many shares the specialist had offered to trade at the ask price, the trade may need to execute slightly above the ask price in order to clear the full order. If you were buying a stock on an electronic exchange such as NASDAQ, the trade would proceed slightly differently. Recall from Chapter 1 that NASDAQ is a computer network with no physical location. Also, each stock listed on NASDAQ has an average of 24 dealers making a market in the stock. Each dealer posts bid and ask quotes and trades at those prices for its own account and for customer accounts. If you place an order through

188

Part 2 Interest Rates and Valuing Cash Flows your broker or online brokerage account to buy 100 shares of Dell (DELL), the order will be transmitted electronically to the NASDAQ network where it automatically executes against the best (lowest) ask quote for Dell. If you are trying to buy a bigger block, like 15,000 shares, then your stockbroker may need to negotiate with one or more of the dealers posting quotes to sell Dell. Because there is no physical location for this type of negotiation, it would take place over the phone. But how do you decide whether to buy or sell a stock in the first place? You must estimate the value of the stock and compare it to the current market price. In the rest of this chapter, we discuss one traditional approach to valuing a stock, the dividend-discount model.3

Concept Check

7.3

3. What is the role of a floor broker at the NYSE? 4. What is the role of a dealer at the NASDAQ?

The Dividend-Discount Model The Valuation Principle implies that to value any security, we must determine the expected cash flows that an investor will receive from owning it. We begin our analysis of stock valuation by considering the cash flows for an investor with a one-year investment horizon. We will show how the stock’s price and the investor’s return from the investment are related. We then consider the perspective of investors with a long investment horizon. Finally, we will reach our goal of establishing the first stock valuation method: the dividend-discount model.

A One-Year Investor There are two potential sources of cash flows from owning a stock: 1. The firm might pay out cash to its shareholders in the form of a dividend. 2. The investor might generate cash by selling the shares at some future date. The total amount received in dividends and from selling the stock will depend on the investor’s investment horizon. Let’s begin by considering the perspective of a one-year investor. When an investor buys a stock, she will pay the current market price for a share, P0 . While she continues to hold the stock, she will be entitled to any dividends the stock pays. Let Div1 be the total dividends the investor expects to be paid per share during the year. At the end of the year, the investor will sell her share at the new market price. Let P1 be the price the investor expects to sell her share at at the end of the year. Assuming for simplicity that all dividends are paid at the end of the year, we have the following timeline for this investment: 0

1

P0

Div1 P1

Of course, the future dividend payment and stock price in this timeline are not known with certainty. Rather, these values are based on the investor’s expectations at the time the stock is purchased. Given these expectations, the investor will be willing to pay 3

In Chapter 10, we return to the question of stock valuation with a discussion of additional approaches. As you will see, when estimating the value of a stock, it is best to try several different approaches to increase the confidence in your estimate.

Chapter 7 Stock Valuation

equity cost of capital The expected rate of return available in the market on other investments that have equivalent risk to the risk associated with the firm’s shares.

189

a price today up to the point at which the benefits equal the cost—that is, up to the point at which the current price equals the present value of the expected future dividend and sale price. Because these cash flows are risky, we cannot discount them using the risk-free interest rate, but instead must use the cost of capital for the firm’s equity. We have previously defined the cost of capital of any investment to be the expected return that investors could earn on their best alternative investment with similar risk and maturity. Thus we must discount the equity cash flows based on the equity cost of capital, rE , for the stock, which is the expected return of other investments available in the market with equivalent risk to the firm’s shares. Doing so leads to the following equation for the stock price: P0 =

Div1 + P1 1 + rE

(7.1)

If the current stock price were less than this amount, the cost would be less than the PV of the benefits, so investors would rush in and buy it, driving up the stock’s price. If the stock price exceeded this amount, selling would be attractive and the stock price would quickly fall.

Dividend Yields, Capital Gains, and Total Returns A critical part of Eq. 7.1 for determining the stock price is the firm’s equity cost of capital, rE . At the beginning of this section, we pointed out that an investor’s return from holding a stock comes from dividends and cash generated from selling the stock. We can rewrite Eq. 7.1 to show these two return components. If we multiply by 1 1 + rE 2 , divide by P0 , and subtract 1 from both sides, we have Total Return

rE =

Div1 + P1 - 1 = P0

Div1 P0 ()* Dividend Yield

dividend yield The expected annual dividend of a stock divided by its current price; the percentage return an investor expects to earn from the dividend paid by the stock. capital gain The amount by which the selling price of an asset exceeds its initial purchase price. capital gain rate An expression of capital gain as a percentage of the initial price of the asset. total return The sum of a stock’s dividend yield and its capital gain rate.

+

P1 - P0 P0 (')'*

(7.2)

Capital Gain Rate

The first term on the right side of Eq. 7.2 is the stock’s dividend yield, which is the expected annual dividend of the stock divided by its current price. The dividend yield is the percentage return the investor expects to earn from the dividend paid by the stock. The second term on the right side of Eq. 7.2 reflects the capital gain the investor will earn on the stock, which is the difference between the expected sale price and the original purchase price for the stock, P1 - P0 . We divide the capital gain by the current stock price to express the capital gain as a percentage return, called the capital gain rate. The sum of the dividend yield and the capital gain rate is called the total return of the stock. The total return is the expected return the investor will earn for a one-year investment in the stock. Equation 7.2 states that the stock’s total return should equal the equity cost of capital. In other words, the expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk. This result is exactly what we would expect: The firm must pay its shareholders a return commensurate with the return they can earn elsewhere while taking the same risk. If the stock offered a higher return than other securities with the same risk, investors would sell those other investments and buy the stock instead. This activity would then drive up the stock’s current price, lowering its dividend yield and capital gain rate until Eq. 7.2 holds true. If the stock offered a lower expected return, investors would sell the stock and drive down its price until Eq. 7.2 was again satisfied.

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Part 2 Interest Rates and Valuing Cash Flows

EXAMPLE 7.1

Problem

Stock Prices and Returns

Suppose you expect Longs Drug Stores to pay an annual dividend of $0.56 per share in the coming year and to trade for $45.50 per share at the end of the year. If investments with equivalent risk to Longs’ stock have an expected return of 6.80%, what is the most you would pay today for Longs’ stock? What dividend yield and capital gain rate would you expect at this price?

Solution Q Plan

We can use Eq. 7.1 to solve for the beginning price we would pay now 1 P0 2 given our expectations about dividends 1 Div1 = $0.56 2 and future price 1 P1 = $45.50 2 and the return we need to expect to earn to be willing to invest 1 rE = 0.068 2 . We can then use Eq. 7.2 to calculate the dividend yield and capital gain rate. Q Execute Using Eq. 7.1, we have P0 =

Div1 + P1 $0.56 + $45.50 = = $43.13 1 + rE 1.0680

Referring to Eq. 7.2, we see that at this price, Longs’ dividend yield is Div1/P0 = 0.56/43.13 = 1.30%. The expected capital gain is $45.50 - $43.13 = $2.37 per share, for a capital gain rate of 2.37/43.13 = 5.50%. Q Evaluate At a price of $43.13, Longs’ expected total return is 1.30% + 5.50% = 6.80%, which is equal to its equity cost of capital (the return being paid by investments with equivalent risk to Longs’). This amount is the most we would be willing to pay for Longs’ stock. If we paid more, our expected return would be less than 6.8% and we would rather invest elsewhere.

A Multiyear Investor We now extend the intuition we developed for the one-year investor’s return to a multiyear investor. Equation 7.1 depends upon the expected stock price in one year, P1 . But suppose we planned to hold the stock for two years. Then we would receive dividends in both year 1 and year 2 before selling the stock, as shown in the following timeline: 0

1

2

P0

Div1

Div2 P2

Setting the stock price equal to the present value of the future cash flows in this case implies:4 P0 =

Div1 Div2 + P2 + 1 + rE 1 1 + rE 2 2

(7.3)

Equations 7.1 and 7.3 are different: As a two-year investor we care about the dividend and stock price in year 2, but these terms do not appear in Eq. 7.1. Does this difference imply that a two-year investor will value the stock differently than a one-year investor? 4

In using the same equity cost of capital for both periods, we are assuming that the equity cost of capital does not depend on the term of the cash flows; that is, rE is not different for year 2 (or any other year). Otherwise, we would need to adjust for the term structure of the equity cost of capital (as we did with the yield curve for risk-free cash flows in Chapter 5). This step would complicate the analysis but would not change its results.

Chapter 7 Stock Valuation

191

The answer to this question is no. A one-year investor does not care about the dividend and stock price in year 2 directly. She will care about them indirectly, however, because they will affect the price for which she can sell the stock at the end of year 1. For example, suppose the investor sells the stock to another one-year investor with the same expectations. The new investor will expect to receive the dividend and stock price at the end of year 2, so he will be willing to pay P1 =

Div2 + P2 1 + rE

for the stock. Substituting this expression for P1 into Eq. 7.1, we get the same result as in Eq. 7.3: P1

$''%''& Div1 + P1 Div1 Div2 + P2 1 P0 = = + ¢ ≤ 1 + rE 1 + rE 1 + rE 1 + rE =

Div1 Div2 + P2 + 1 + rE 1 1 + rE 2 2

Thus the formula for the stock price for a two-year investor is the same as that for a sequence of two one-year investors.

Dividend-Discount Model Equation dividend-discount model A model that values shares of a firm according to the present value of the future dividends the firm will pay.

We can continue this process for any number of years by replacing the final stock price with the value that the next holder of the stock would be willing to pay. Doing so leads to the general dividend-discount model for the stock price, where the horizon N is arbitrary: Dividend-Discount Model Div1 Div2 DivN PN P0 = + + g + + 1 + rE 1 1 + rE 2 2 1 1 + rE 2 N 1 1 + rE 2 N

(7.4)

Equation 7.4 applies to a single N-year investor, who will collect dividends for N years and then sell the stock, or to a series of investors who hold the stock for shorter periods and then resell it. Note that Eq. 7.4 holds for any horizon N. As a consequence, all investors (with the same expectations) will attach the same value to the stock, independent of their investment horizons. How long they intend to hold the stock and whether they collect their return in the form of dividends or capital gains is irrelevant. For the special case in which the firm eventually pays dividends and is never acquired or liquidated, it is possible to hold the shares forever. In this scenario, rather than having a stopping point where we sell the shares, we rewrite Eq. 7.4 to show that the dividends go on into the future: P0 =

Div1 Div2 Div3 + + + g 2 1 + rE 1 1 + rE 2 1 1 + rE 2 3

(7.5)

That is, the price of the stock is equal to the present value of all of the expected future dividends it will pay.

Concept Check

5. How do you calculate the total return of a stock? 6. What discount rate do you use to discount the future cash flows of a stock?

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Part 2 Interest Rates and Valuing Cash Flows

7.4

Estimating Dividends in the Dividend-Discount Model Equation 7.5 expresses the value of a stock in terms of the expected future dividends the firm will pay. Of course, estimating these dividends—especially for the distant future—is difficult. A commonly used approximation is to assume that in the long run, dividends will grow at a constant rate. In this section, we consider the implications of this assumption for stock prices and explore the tradeoff between dividends and growth.

Constant Dividend Growth The simplest forecast for the firm’s future dividends states that they will grow at a constant rate, g, forever. That case yields the following timeline for the cash flows for an investor who buys the stock today and holds it: 0

1

2

3

Div1

Div1(1 g )

Div1(1 g )

... P0

2

Because the expected dividends are a constant growth perpetuity, we can use Eq. 4.7 to calculate their present value. We then obtain the following simple formula for the stock price:5 constant dividend growth model A model for valuing a stock by viewing its dividends as a constant growth perpetuity.

Constant Dividend Growth Model Div1 P0 = rE - g

(7.6)

According to the constant dividend growth model, the value of the firm depends on the dividend level next year, divided by the equity cost of capital adjusted by the growth rate.

EXAMPLE 7.2

Problem

Valuing a Firm with Constant Dividend Growth

Consolidated Edison, Inc. (Con Ed) is a regulated utility company that services the New York City area. Suppose Con Ed plans to pay $2.30 per share in dividends in the coming year. If its equity cost of capital is 7% and dividends are expected to grow by 2% per year in the future, estimate the value of Con Ed’s stock.

Solution Q Plan Because the dividends are expected to grow perpetually at a constant rate, we can use Eq. 7.6 to value Con Ed. The next dividend 1 Div1 2 is expected to be $2.30, the growth rate 1 g 2 is 2%, and the equity cost of capital 1 rE 2 is 7%. Q Execute

P0 =

Div1 +2.30 = = +46.00 rE - g 0.07 - 0.02

Q Evaluate You would be willing to pay 20 times this year’s dividend of $2.30 to own Con Ed stock because you are buying a claim to this year’s dividend and to an infinite growing series of future dividends. As discussed in Chapter 4, this formula requires that g 6 rE . Otherwise, the present value of the growing perpetuity is infinite. The implication here is that it is impossible for a stock’s dividends to grow at a rate g 7 rE forever. If the growth rate does exceed rE , the situation must be temporary, and the constant growth model cannot be applied in such a case. 5

Chapter 7 Stock Valuation

193

For another interpretation of Eq. 7.6, note that we can rearrange it as follows: rE =

Div1 + g P0

(7.7)

Comparing Eq. 7.7 with Eq. 7.2, we see that g equals the expected capital gain rate. In other words, with constant expected dividend growth, the expected growth rate of the share price matches the growth rate of the dividends.

Dividends Versus Investment and Growth In Eq. 7.6, the firm’s share price increases with the current dividend level, Div1 , and the expected growth rate, g. To maximize its share price, a firm would like to increase both these quantities. Often, however, the firm faces a tradeoff: Increasing growth may require investment, and money spent on investment cannot be used to pay dividends. The constant dividend growth model provides insight into this tradeoff. dividend payout rate The fraction of a firm’s earnings that the firm pays out as dividends each year.

A Simple Model of Growth. What determines the rate of growth of a firm’s dividends? If we define a firm’s dividend payout rate as the fraction of its earnings that the firm pays as dividends each year, then we can write the firm’s dividend per share at date t as follows: Divt =

Earningst * Dividend Payout Ratet Shares Outstanding t ('''')''''*

(7.8)

EPSt

That is, the dividend each year is equal to the firm’s earnings per share (EPS) multiplied by its dividend payout rate. The firm can, therefore, increase its dividend in three ways: 1. It can increase its earnings (net income). 2. It can increase its dividend payout rate. 3. It can decrease its number of shares outstanding. Suppose for now that the firm does not issue new shares (or buy back its existing shares), so that the number of shares outstanding remains fixed. We can then explore the tradeoff between options 1 and 2. A firm can do one of two things with its earnings: It can pay them out to investors, or it can retain and reinvest them. By investing cash today, a firm can increase its future dividends. For simplicity, let’s assume that absent reinvesting its retained earnings, the firm does not grow, so the current level of earnings generated by the firm remains constant. If all increases in future earnings result exclusively from new investment made with retained earnings, then Change in Earnings = New Investment * Return on New Investment retention rate The fraction of a firm’s current earnings that the firm retains.

(7.9)

New investment equals the firm’s earnings multiplied by its retention rate, or the fraction of current earnings that the firm retains: New Investment = Earnings * Retention Rate

(7.10)

Substituting Eq. 7.10 into Eq. 7.9 and dividing by earnings gives an expression for the growth rate of earnings: Earnings Growth Rate =

Change in Earnings Earnings

= Retention Rate * Return on New Investment

(7.11)

194

Part 2 Interest Rates and Valuing Cash Flows If the firm chooses to keep its dividend payout rate constant, then the growth in its dividends will equal the growth in its earnings: g = Retention Rate * Return on New Investment

(7.12)

Profitable Growth. Equation 7.12 shows that a firm can increase its growth rate by retaining more of its earnings. But if the firm retains more earnings, and as a result pays out a smaller fraction of those earnings as dividends, then according to Eq. 7.8 the firm may have to cut its dividend in the short run. If a firm wants to increase its share price, should it cut its dividend and invest more, or should it cut its investments and increase its dividend? Not surprisingly, the answer to this question will depend on the profitability of the firm’s investments. Let’s consider an example.

EXAMPLE 7.3 Cutting Dividends for Profitable Growth

Problem Crane Sporting Goods expects to have earnings per share of $6 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings as a dividend. With these expectations of no growth, Crane’s current share price is $60. Suppose Crane could cut its dividend payout rate to 75% for the foreseeable future and use the retained earnings to open new stores. The return on its investment in these stores is expected to be 12%. If we assume that the risk of these new investments is the same as the risk of its existing investments, then the firm’s equity cost of capital is unchanged. What effect would this new policy have on Crane’s stock price?

Solution Q Plan To figure out the effect of this policy on Crane’s stock price, we need to know several things. First, we need to compute its equity cost of capital. Next we must determine Crane’s dividend and growth rate under the new policy. Because we know that Crane currently has a growth rate of 0 1 g = 0 2 , a dividend of $6, and a price of $60, we can use Eq. 7.7 to estimate rE . Next, the new dividend will simply be 75% of the old dividend of $6. Finally, given a retention rate of 25% and a return on new investment of 12%, we can use Eq. 7.12 to compute the new growth rate 1 g 2 . Finally, armed with the new dividend, Crane’s equity cost of capital, and its new growth rate, we can use Eq. 7.6 to compute the price of Crane’s shares if it institutes the new policy. Q Execute Using Eq. 7.7 to estimate rE , we have Div1 $6 + g = + 0% = 0.10 + 0 rE = P0 $60 In other words, to justify Crane’s stock price under its current policy, the expected return of other stocks in the market with equivalent risk must be 10%. Next, we consider the consequences of the new policy. If Crane reduces its dividend payout rate to 75%, then from Eq. 7.8 its dividend this coming year will fall to Div1 = EPS1 * 75% = +6 * 75% = +4.50. At the same time, because the firm will now retain 25% of its earnings to invest in new stores, from Eq. 7.12 its growth rate will increase to g = Retention Rate * Return on New Investment = 0.25 * 0.12 = 0.03 = 3% Assuming Crane can continue to grow at this rate, we can compute its share price under the new policy using the constant dividend growth model of Eq. 7.6: Div1 +4.50 = = +64.29 P0 = rE - g 0.10 - 0.03 Q Evaluate Crane’s share price should rise from $60 to $64.29 if the company cuts its dividend in order to increase its investment and growth. By using its earnings to invest in projects that offer a rate of return (12%) greater than its equity cost of capital (10%), Crane has created value for its shareholders.

Chapter 7 Stock Valuation

195

In Example 7.3, cutting the firm’s dividend in favor of growth raised the firm’s stock price. This is not always the case, however, as Example 7.4 demonstrates.

EXAMPLE 7.4 Unprofitable Growth

Problem Suppose Crane Sporting Goods decides to cut its dividend payout rate to 75% to invest in new stores, as in Example 7.3. But now suppose that the return on these new investments is 8%, rather than 12%. Given its expected earnings per share this year of $6 and its equity cost of capital of 10% (we again assume that the risk of the new investments is the same as its existing investments), what will happen to Crane’s current share price in this case?

Solution Q Plan We will follow the steps in Example 7.3, except that in this case, we assume a return on new investments of 8% when computing the new growth rate 1 g 2 instead of 12% as in Example 7.3. Q Execute Just as in Example 7.3, Crane’s dividend will fall to $6 * 0.75 = $4.50. Its growth rate under the new policy, given the lower return on new investment, will now be g = 0.25 * 0.08 = 0.02 = 2%. The new share price is therefore Div1 $4.50 P0 = = = $56.25 rE - g 0.10 - 0.02 Q Evaluate Even though Crane will grow under the new policy, the return on its new investments is too low. The company’s share price will fall if it cuts its dividend to make new investments with a return of only 8%. By reinvesting its earnings at a rate (8%) that is lower than its equity cost of capital (10%), Crane has reduced shareholder value.

Comparing Example 7.3 with Example 7.4, we see that the effect of cutting the firm’s dividend to grow crucially depends on the value of the new investments the firm plans to make. In Example 7.3, the return on new investment of 12% exceeds the firm’s equity cost of capital of 10%, so the investment is a good one. In Example 7.4, however, the return on new investment is only 8%, so the new investment’s return is below the firm’s cost of capital. In that case, the new investment is not worthwhile even though it will lead to earnings growth. In this example, we can check that cutting the firm’s dividend to increase investment will create value and raise the stock price if, and only if, the new investments generate a return greater than their cost of capital. In the next chapter, we will consider more generally how to identify projects that create value and thus increase the stock price.

Changing Growth Rates Successful young firms often have very high initial earnings growth rates. During this period of high growth, firms often retain 100% of their earnings to exploit profitable investment opportunities. As they mature, their growth slows to rates more typical of established companies. At that point, their earnings exceed their investment needs and they begin to pay dividends. We cannot use the constant dividend growth model to value the stock of such a firm for two reasons: 1. These firms often pay no dividends when they are young. 2. Their growth rate continues to change over time until they mature.

196

Part 2 Interest Rates and Valuing Cash Flows However, we can use the general form of the dividend-discount model to value such a firm by applying the constant growth model to calculate the future share price of the stock PN once the firm matures and its expected growth rate stabilizes: 0

1

2

N

N1

N2

N3

DivN PN

DivN 1

DivN 1 (1 g )

DivN 1 (1 g ) 2

... Div1

Div2

...

Specifically, if the firm is expected to grow at a long-term rate g after year N + 1, then from the constant dividend growth model: DivN + 1 (7.13) PN = rE - g We can then use this estimate of PN as a final cash flow in the dividend-discount model. Intuitively, we value the stock as the present value of the dividends we will receive plus the present value of the price we expect to be able to sell the stock for in the future. For example, consider a company with expected dividends of $2.00, $2.50, and $3.00 in each of the next three years. After that point, its dividends are expected to grow at a constant rate of 5%. If its equity cost of capital is 12%, we can find the current price. Using Eq. 7.13, we can compute the price in year 3: PN =

+3.00 1 1.05 2 DivN + 1 = a b = 45.00 rE - g 0.12 - 0.05

Now, using Eq. 7.4, we calculate the current price as the PV of the first 3 years’ dividends and then the price at the end of year 3: P0 =

COMMON MISTAKE

+2.00 +2.50 +3.00 +45.00 + + + = +37.94 2 3 1.12 1 1.12 2 1 1.12 2 1 1.12 2 3

Forgetting to “Grow” This Year’s Dividend

The most common mistake in handling growing dividends is to use the current period’s dividend in the numerator of the growing perpetuity formula. In the example just discussed in the text, the dividends reached $3 in year 3, and then grew by 5% per year thereafter. A common mistake is to calculate the growing stream of dividends as 3.00 , 0.12 - 0.05

3.00 * 1 1.05 2 = +45. 0.12 - 0.05 Also, remember to avoid the common mistake from Chapter 4: The growing perpetuity formula gives the value in year N for dividends starting in year N + 1. In the example above, the formula gives the value in year 3 of the growing dividend stream starting in year 4. That is why we discount the $45 back only three years.

forgetting that next year’s dividend (the numerator) has already grown by 5%! As we show in the example, the correct calculation is

This example also reinforces an important point: The constant dividend growth model (Eq. 7.13) is just a special case of the general dividend-discount formula (Eq. 7.4). We can always value all the stream of dividends using Eq. 7.4. However, if we assume constant growth, we can apply the growing perpetuity shortcut to all or part of the dividend stream, depending on whether the constant growth starts now or at some point in the future.

Chapter 7 Stock Valuation

EXAMPLE 7.5 Valuing a Firm with Two Different Growth Rates

197

Problem Small Fry, Inc., has just invented a potato chip that looks and tastes like a french fry. Given the phenomenal market response to this product, Small Fry is reinvesting all of its earnings to expand its operations. Earnings were $2 per share this past year and are expected to grow at a rate of 20% per year until the end of year 4. At that point, other companies are likely to bring out competing products. Analysts project that at the end of year 4, Small Fry will cut its investment and begin paying 60% of its earnings as dividends. Its growth will also slow to a long-run rate of 4%. If Small Fry’s equity cost of capital is 8%, what is the value of a share today?

Solution Q Plan We can use Small Fry’s projected earnings growth rate and payout rate to forecast its future earnings and dividends. After year 4, Small Fry’s dividends will grow at a constant 4%, so we can use the constant dividend growth model (Eq. 7.13) to value all dividends after that point. Finally, we can pull everything together with the dividend-discount model (Eq. 7.4). Q Execute The following spreadsheet projects Small Fry’s earnings and dividends: Year 0 1 Earnings 1 EPS Growth Rate (versus prior year) 20% $2.00 $2.40 2 EPS Dividends 0% 3 Dividend Payout Rate $ — 4 Div

2

3

4

5

6

20% $2.88

20% $3.46

20% $4.15

4% $4.31

4% $4.49

0% —

60% $2.49

60% $2.59

60% $2.69

$

0% —

$

Starting from $2.00 in year 0, EPS grows by 20% per year until year 4, after which growth slows to 4%. Small Fry’s dividend payout rate is zero until year 4, when competition reduces its investment opportunities and its payout rate rises to 60%. Multiplying EPS by the dividend payout ratio, we project Small Fry’s future dividends in line 4. After year 4, Small Fry’s dividends will grow at the constant expected long-run rate of 4% per year. Thus we can use the constant dividend growth model to project Small Fry’s share price at the end of year 3. Given its equity cost of capital of 8%, Div4 +2.49 = = +62.25 P3 = rE - g 0.08 - 0.04 We then apply the dividend-discount model (Eq. 7.4) with this terminal value: Div1 Div2 Div3 P3 +62.25 + + + = = +49.42 P0 = 1 + rE 1 1 + rE 2 2 1 1 + rE 2 3 1 1 + rE 2 3 1 1.08 2 3 Q Evaluate The dividend-discount model is flexible enough to handle any forecasted pattern of dividends. Here the dividends were zero for several years and then settled into a constant growth rate, allowing us to use the constant dividend growth model as a shortcut.

Table 7.1 summarizes the dividend-discount model, including how to apply the shortcut for constant growth.

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Part 2 Interest Rates and Valuing Cash Flows

TABLE 7.1

The Dividend-Discount Model

General formula

If dividend growth is constant

If early growth is variable followed by constant growth

P0 =

Div1 Div2 DivN PN + + g + + 1 + rE 1 1 + rE 2 2 1 1 + rE 2 N 1 1 + rE 2 N

P0 =

Div1 rE - g

P0 =

DivN 1 1 + g 2 Div1 Div2 DivN 1 + + g + + ¢ ≤¢ ≤ 1 + rE rE - g 1 1 + rE 2 2 1 1 + rE 2 N 1 1 + rE 2 N

Value Drivers and the Dividend-Discount Model Now that we have fully developed the dividend-discount model, it is worth assessing how well it does capturing the intuitive drivers of stock value. When we think about how valuable a company is, we usually focus on how profitable it is now and how that profitability will grow or decline in the future, along with the risk of investing in the company. Where are these measures captured in the dividend-discount model? Profitability determines the company’s ability to pay dividends, so, implicitly in the forecasted dividend stream, we are forecasting the company’s profitability. As for the risk, that is captured in the equity cost of capital we use to discount those forecasted dividends. Riskier investments require higher expected returns, which enter the dividend-discount model as higher equity cost of capital.

Concept Check

7.5

7. What are three ways that a firm can increase the amount of its future dividends per share? 8. Under what circumstances can a firm increase its share price by cutting its dividend and investing more?

Limitations of the Dividend-Discount Model The dividend-discount model has two fundamental limitations that we will now address: its reliance on dividend forecasts and lack of applicability to non-dividend-paying stocks.

Uncertain Dividend Forecasts The dividend-discount model values a stock based on a forecast of the future dividends paid to shareholders. But unlike a Treasury bond, whose cash flows are known with virtual certainty, a firm’s future dividends carry a tremendous amount of uncertainty. Let’s reconsider the example of Nike (NKE). In 2010, NKE paid annual dividends of $1.08 (by paying four quarterly dividends of 27 cents each). With an equity cost of capital of 10% and expected dividend growth of 8.5%, the constant dividend growth model implies a share price for NKE of P0 =

+1.08 1 1 + 0.085 2 Div1 = = +78.12 rE - g 0.10 - 0.085

which is reasonably close to the $76.43 share price that the stock had at the time. With a 9% dividend growth rate, however, this estimate would rise to almost $118 per share; with a 6% dividend growth rate, the estimate falls to almost $29 per share. As we see in Figure 7.2, even small changes in the assumed dividend growth rate can lead to large changes in the estimated stock price. Furthermore, it is difficult to know which estimate of the dividend growth rate is more reasonable. NKE more than doubled its dividend between 2005 and 2010, but its earnings growth then moderated. Consequently, this rate of increase is not sustainable.

Chapter 7 Stock Valuation

FIGURE 7.2

199

Stock prices are based on the constant dividend growth model. We assume a dividend next year of $1.08 and an equity cost of capital of 10%. The expected dividend growth rate varies from 0% to 9%. Note how even a small change in the expected growth rate produces a large change in the stock price, especially at higher growth rates.

NKE Stock Prices for Different Expected Growth Rates

$120

$100

Stock Price

$80

$60

$40

$20

$0 0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Growth Rate

From Eq. 7.8, forecasting dividends requires forecasting the firm’s earnings, dividend payout rate, and future share count. Future earnings, however, will depend on interest expenses (which, in turn, depend on how much the firm borrows), and the firm’s share count and dividend payout rate will depend on whether NKE uses a portion of its earnings to repurchase shares. Because borrowing and repurchase decisions are at management’s discretion, they are more difficult to forecast reliably than other fundamental aspects of the firm’s cash flows.6

Non-Dividend-Paying Stocks Many companies do not pay dividends—Apple, Amazon.com, and Google are just a few examples. How then do we value those stocks? In the next section, we discuss a small modification to the dividend-discount model to capture total payouts to shareholders, whether the payouts are dividends or not. In Chapter 10, we will discuss other valuation approaches that do not rely on payouts. Those approaches will be more meaningful once we have covered how financial managers create value within the firm through decisions about which projects to approve. So, in the next two chapters, we will cover investment decision rules and project evaluation.

Concept Check

9. What are the main limitations of the dividend-discount model? 10. What pieces of information are needed to forecast dividends?

6

We discuss management’s decision to borrow funds or repurchase shares in Part 6 of the text.

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Part 2 Interest Rates and Valuing Cash Flows

7.6

share repurchase A transaction in which a firm uses cash to buy back its own stock.

Share Repurchases and the Total Payout Model In our discussion of the dividend-discount model, we implicitly assumed that any cash paid out by the firm to shareholders takes the form of a dividend. In recent years, an increasing number of firms have replaced dividend payouts with share repurchases. In a share repurchase, the firm uses excess cash to buy back its own stock. Share repurchases have two consequences for the dividend-discount model. First, the more cash the firm uses to repurchase shares, the less cash it has available to pay dividends. Second, by repurchasing shares, the firm decreases its share count, which increases its earnings and dividends on a per-share basis. In the dividend-discount model, we valued a share from the perspective of a single shareholder, discounting the dividends the shareholder will receive: P0 = PV 1 Future Dividends per Share 2

total payout model A method that values shares of a firm by discounting the firm’s total payouts to equity holders (that is, all the cash distributed as dividends and stock repurchases) and then dividing by the current number of shares outstanding.

(7.14)

An alternative method that may be more reliable when a firm repurchases shares is the total payout model, which values all of the firm’s equity, rather than a single share. To use this model, we discount the total payouts that the firm makes to shareholders, which is the total amount spent on both dividends and share repurchases (net of new share issuance).7 This gives the total value of the firm’s equity. We then divide by the current number of shares outstanding to determine the share price: Total Payout Model

P0 =

PV 1 Future Total Dividends and Net Repurchases 2 Shares Outstanding 0

(7.15)

We can apply the same simplifications to the total payout method that we obtained by assuming constant growth in Section 7.3. The only change is that we discount total dividends and share repurchases and use the growth rate of earnings (rather than earnings per share) when forecasting the growth of the firm’s total payouts. When the firm uses share repurchases, this method can be more reliable and easier to apply than the dividend-discount model.

EXAMPLE 7.6

Problem

Valuation with Share Repurchases

Titan Industries has 217 million shares outstanding and expects earnings at the end of this year of $860 million. Titan plans to pay out 50% of its earnings in total, paying 30% as a dividend and using 20% to repurchase shares. If Titan’s earnings are expected to grow by 7.5% per year and these payout rates remain constant, determine Titan’s share price assuming an equity cost of capital of 10%.

Solution Q Plan Based on the equity cost of capital of 10% and an expected earnings growth rate of 7.5%, we can compute the present value of Titan’s future payouts as a constant growth perpetuity. The only input missing here is Titan’s total payouts this year, which we can calculate as 50% of its earnings. The present value of all of Titan’s future payouts is the value of its total equity. To obtain the price of a share, we divide the total value by the number of shares outstanding (217 million). Q Execute Titan will have total payouts this year of 50% * +860 million = +430 million. Using the constant growth perpetuity formula, we have 7

You can think of the total payouts as the amount you would receive if you owned 100% of the firm’s shares: You would receive all the dividends, plus the proceeds from selling shares back to the firm in the share repurchase.

Chapter 7 Stock Valuation PV 1 Future Total Dividends and Repurchases 2 =

201

+430 million = +17.2 billion 0.10 - 0.075

This present value represents the total value of Titan’s equity (i.e., its market capitalization). To compute the share price, we divide by the current number of shares outstanding: P0 =

+17.2 billion = +79.26 per share 217 million shares

Q Evaluate Using the total payout method, we did not need to know the firm’s split between dividends and share repurchases. To compare this method with the dividend-discount model, note that Titan will pay a dividend of 30% * 1 +860 million/217 million shares 2 = +1.19 per share, for a dividend yield of 1.19/79.26 = 1.50%. From Eq. 7.7, we can solve for Titan’s expected growth rates of EPS, dividend, and share price: Div1 1.19 g = rE = = .10 = 0.085 = 8.5%. P0 79.26 This growth rate exceeds the 7.50% growth rate of earnings because Titan’s share count will decline over time owing to its share repurchases.8

Concept Check

7.7

11. How does the total payout model address part of the dividend-discount model’s limitations? 12. How does the growth rate used in the total payout model differ from the growth rate used in the dividenddiscount model?

Putting It All Together We now return to the questions posed at the beginning of the chapter. First, how would an investor decide whether to buy or sell Nike stock? She would value the stock using her own expectations. We showed one set of expectations about dividend growth that would be consistent with the price. If her expectations were substantially different, she might conclude that the stock was over- or under-priced at $76.43. Based on that conclusion, she would sell or buy the stock, and time would reveal whether her expectations were better than the market’s. Second, how could Nike stock suddenly be worth 5% more after Nike’s announcement? As investors digested the news in Nike’s announcement and updated their expectations, they would have determined that the previous day’s closing price was too low based on the new information about future earnings growth. Buying pressure would then drive the stock price up until the buys and sells came into balance. Third, what should Nike’s managers do to raise the stock price further? The only way to raise the stock price is to make value-increasing decisions. We turn to this task in the next section of the book. As shown in the next two chapters, through capital budgeting analysis, managers can identify projects that add value to the company. By increasing the value of the company through good investment decisions, Nike’s managers can increase the stock price. Chapter 10 returns to the question of stock valuation and extends the techniques developed here to incorporate the lessons of the next two chapters on project selection. 8

We can check that an 8.5% EPS growth rate is consistent with 7.5% earnings growth and Titan’s repurchase plans as follows: Given an expected share price of +79.26 * 1.085 = +86.00 next year, Titan will repurchase 20% * +860 million 1 +86.00 per share 2 = 2 million shares next year. With the decline in the number of shares from 217 million to 215 million, EPS grows by a factor of 1.075 * 1 217/215 2 = 1.085 or by 8.5%.

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Part 2 Interest Rates and Valuing Cash Flows

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

7.1 Stock Basics Q Ownership in a corporation is divided into shares of stock. These shares carry rights to share in the profits of the firm through future dividend payments. Q The shares also come with rights to vote to elect directors and decide on other important matters. Q Some firms issue preferred stock, which has preference over common stock in the payment of dividends and in liquidation, but typically carries no voting rights.

annual meeting, p. 186 classes, p. 186 common stock, p. 184 cumulative preferred stock, p. 186 cumulative voting, p. 185 non-cumulative preferred stock, p. 186 preferred stock, p. 186 proxy, p. 186 proxy contest, p. 186 straight voting, p. 185 ticker symbol, p. 184

MyFinanceLab Study Plan 7.1

7.2 The Mechanics of Stock Trades Q The NYSE has a physical trading location, but many small trades execute electronically. Q NASDAQ is a computer network without a specific trading location. Many trades execute automatically, while larger trades must be negotiated with one or more of the stock’s dealers.

floor broker, p. 187

MyFinanceLab Study Plan 7.2

7.3 The Dividend-Discount Model Q The Valuation Principle states that the value of a stock is equal to the present value of the dividends and future sale price the investor will receive. Because these cash flows are risky, they must be discounted at the equity cost of capital, which is the expected return of other securities available in the market with equivalent risk to the firm’s equity. The total return of a stock is equal to the dividend yield plus the capital gain rate. The expected total return of a stock should equal its equity cost of capital:

capital gain, p. 189 capital gain rate, p. 189 dividend-discount model, p. 191 dividend yield, p. 189 equity cost of capital, p. 189 total return, p. 189

MyFinanceLab Study Plan 7.3

rE =

Div1 + P1 Div1 - 1 = P0 P0 ()* Dividend Yield

+

P1 - P0 P0 (')'*

(7.2)

Capital Gain Rate

Q When investors have the same beliefs, the dividenddiscount model states that, for any horizon N, the stock price satisfies the following equation: P0 =

Div1 Div2 DivN PN (7.4) + + g + + 1 + rE 1 1 + rE 2 2 1 1 + rE 2 N 1 1 + rE 2 N

Q If the stock eventually pays dividends and is never acquired, the dividend-discount model implies that the stock price equals the present value of all future dividends.

Using Excel: Building a Dividend-Discount Model

Here is what you should know after reading this chapter. MyFinanceLab will helpChapter 7 Stock Valuation you identify what you know, and where to go when you need to practice. 7.4 Estimating Dividends in the Dividend-Discount Model Q The constant dividend growth model assumes that dividends grow at a constant expected rate, g. In that case, g is also the expected capital gain rate, and Div1 P0 = (7.6) rE - g Q Future dividends depend on earnings, shares outstanding, and the dividend payout rate: Divt =

constant dividend growth model, p. 192 dividend payout rate, p. 193 retention rate, p. 193

MyFinanceLab Study Plan 7.4

Earningst * Dividend Payout Ratet (7.8) Shares Outstanding t ('''')''''* EPSt

Q If all increases in future earnings result exclusively from new investments made with retained earnings, then earnings growth can be found as: Earnings Growth Rate =

Change in Earnings Earnings

(7.11)

= Retention Rate * Return on New Investment

(where Retention Rate = 1 - Payout Rate) Q If the dividend payout rate and the number of shares outstanding is constant, and if earnings change only as a result of new investment from retained earnings, then the growth rate of the firm’s earnings, dividends, and share price is calculated as follows: g = Retention Rate * Return on New Investment (7.12) Q Cutting the firm’s dividend to increase investment will raise the stock price if, and only if, the new investments generate a return greater than their cost of capital. Q If the firm has a long-term growth rate of g after the period N + 1, then we can apply the dividend-discount model and use the constant dividend growth formula to estimate the terminal stock value PN . 7.5 Limitations of the Dividend-Discount Model Q The dividend-discount model is sensitive to the dividend growth rate, which is difficult to estimate accurately. Q The dividend-discount model is not practical for valuing the majority of stocks not paying dividends. In Chapter 10, we discuss alternative approaches. 7.6 Share Repurchases and the Total Payout Model Q If the firm undertakes share repurchases, it is more reliable to use the total payout model to value the firm. In this model, the value of equity equals the present value of future total dividends and repurchases. To determine the stock price, we divide the equity value by the initial number of shares outstanding of the firm: PV 1 Future Total Dividends and Repurchases 2 P0 = (7.15) Shares Outstanding 0 Q The growth rate of the firm’s total payout is governed by the growth rate of earnings, not earnings per share.

MyFinanceLab Study Plan 7.5

share repurchase, p. 200 total payout model, p. 200

MyFinanceLab Study Plan 7.6

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Part 2 Interest Rates and Valuing Cash Flows

Critical Thinking

1. What rights come with a share of stock? 2. Which two components make up the total return to an investor in a share of stock? 3. What does the dividend-discount model say about valuing shares of stock? 4. What is the relationship between the return from reinvesting cash flows and the change in the price of the stock? 5. How can the dividend-discount model be used with changing growth rates in future dividends? 6. What are some of the drawbacks of the dividend-discount model? 7. What are share repurchases, and how can they be incorporated into the valuation of a stock?

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Stock Basics 1. If you own 15,000 shares of stock of Nike and it pays a dividend of $0.27 per share, then what is the total dividend you will receive? 2. You own 20% of the stock of a company that has ten directors on its board. How much representation can you get on the board if the company has cumulative voting? How much representation can you ensure if the company has straight voting? 3. Anzio, Inc., has two classes of shares. Class B has ten times the voting rights as Class A. If you own 10% of the class A shares and 20% of the Class B shares, what percentage of the total voting rights do you hold? The Dividend-Discount Model 4. Assume Evco, Inc., has a current stock price of $50 and will pay a $2 dividend in one year; its equity cost of capital is 15%. What price must you expect Evco stock to sell for immediately after the firm pays the dividend in one year to justify its current price? 5. Anle Corporation has a current stock price of $20 and is expected to pay a dividend of $1 in one year. Its expected stock price right after paying that dividend is $22. a. What is Anle’s equity cost of capital? b. How much of Anle’s equity cost of capital is expected to be satisfied by dividend yield and how much by capital gain? 6. Achi Corp. has preferred stock with an annual dividend of $3. If the required return on Achi’s preferred stock is 8%, what is its price? (Hint: For a preferred stock, the dividend growth rate is zero.) 7. Ovit, Inc., has preferred stock with a price of $20 and a dividend of $1.50 per year. What is its dividend yield? 8. Suppose Acap Corporation will pay a dividend of $2.80 per share at the end of this year and a dividend of $3 per share next year. You expect Acap’s stock price to be $52 in two years. Assume that Acap’s equity cost of capital is 10%.

Chapter 7 Stock Valuation

205

a. What price would you be willing to pay for a share of Acap stock today, if you planned to hold the stock for two years? b. Suppose instead you plan to hold the stock for one year. For what price would you expect to be able to sell a share of Acap stock in one year? c. Given your answer to part (b), what price would you be willing to pay for a share of Acap stock today, if you planned to hold the stock for one year? How does this price compare to your answer in part (a)? 9. Krell Industries has a share price of $22.00 today. If Krell is expected to pay a dividend of $0.88 this year and its stock price is expected to grow to $23.54 at the end of the year, what is Krell’s dividend yield and equity cost of capital? Estimating Dividends in the Dividend-Discount Model 10. NoGrowth Corporation currently pays a dividend of $0.50 per quarter, and it will continue to pay this dividend forever. What is the price per share of NoGrowth stock if the firm’s equity cost of capital is 15%? 11. Summit Systems will pay a dividend of $1.50 this year. If you expect Summit’s dividend to grow by 6% per year, what is its price per share if the firm’s equity cost of capital is 11%? 12. Dorpac Corporation has a dividend yield of 1.5%. Its equity cost of capital is 8%, and its dividends are expected to grow at a constant rate. a. What is the expected growth rate of Dorpac’s dividends? b. What is the expected growth rate of Dorpac’s share price? 13. Laurel Enterprises expects earnings next year of $4 per share and has a 40% retention rate, which it plans to keep constant. Its equity cost of capital is 10%, which is also its expected return on new investment. Its earnings are expected to grow forever at a rate of 4% per year. If its next dividend is due in one year, what do you estimate the firm’s current stock price to be? *14. DFB, Inc., expects earnings this year of $5 per share, and it plans to pay a $3 dividend to shareholders. DFB will retain $2 per share of its earnings to reinvest in new projects that have an expected return of 15% per year. Suppose DFB will maintain the same dividend payout rate, retention rate, and return on new investments in the future and will not change its number of outstanding shares. a. What growth rate of earnings would you forecast for DFB? b. If DFB’s equity cost of capital is 12%, what price would you estimate for DFB stock? c. Suppose instead that DFB paid a dividend of $4 per share this year and retained only $1 per share in earnings. That is, it chose to pay a higher dividend instead of reinvesting in as many new projects. If DFB maintains this higher payout rate in the future, what stock price would you estimate for the firm now? Should DFB follow this new policy? 15. Cooperton Mining just announced it will cut its dividend from $4 to $2.50 per share and use the extra funds to expand. Prior to the announcement, Cooperton’s dividends were expected to grow at a 3% rate, and its share price was $50. With the planned expansion, Cooperton’s dividends are expected to grow at a 5% rate. What share price would you expect after the announcement? (Assume that the new expansion does not change Cooperton’s risk.) Is the expansion a good investment? 16. Gillette Corporation will pay an annual dividend of $0.65 one year from now. Analysts expect this dividend to grow at 12% per year thereafter until the fifth year.

206

Part 2 Interest Rates and Valuing Cash Flows After then, growth will level off at 2% per year. According to the dividend-discount model, what is the value of a share of Gillette stock if the firm’s equity cost of capital is 8%? 17. Colgate-Palmolive Company has just paid an annual dividend of $0.96. Analysts are predicting an 11% per year growth rate in earnings over the next five years. After then, Colgate’s earnings are expected to grow at the current industry average of 5.2% per year. If Colgate’s equity cost of capital is 8.5% per year and its dividend payout ratio remains constant, for what price does the dividend-discount model predict Colgate stock should sell? *18. Halliford Corporation expects to have earnings this coming year of $3 per share. Halliford plans to retain all of its earnings for the next two years. Then, for the subsequent two years, the firm will retain 50% of its earnings. It will retain 20% of its earnings from that point onward. Each year, retained earnings will be invested in new projects with an expected return of 25% per year. Any earnings that are not retained will be paid out as dividends. Assume Halliford’s share count remains constant and all earnings growth comes from the investment of retained earnings. If Halliford’s equity cost of capital is 10%, what price would you estimate for Halliford stock? Share Repurchases and the Total Payout Model 19. Zoom Enterprises expects that one year from now it will pay a total dividend of $5 million and repurchase $5 million worth of shares. It plans to spend $10 million on dividends and repurchases every year after that forever, although it may not always be an even split between dividends and repurchases. If Zoom’s cost of equity capital is 13% and it has 5 million shares outstanding, what is its share price today? 20. AFW Industries has 200 million shares outstanding and expects earnings at the end of this year of $700 million. AFW plans to pay out 60% of its earnings in total, paying 40% as a dividend and using 20% to repurchase shares. If AFW’s earnings are expected to grow by 8% per year and these payout rates remain constant, determine AFW’s share price assuming an equity cost of capital of 12%. 21. Suppose Cisco Systems pays no dividends but spent $5 billion on share repurchases last year. If Cisco’s equity cost of capital is 12%, and if the amount spent on repurchases is expected to grow by 8% per year, estimate Cisco’s market capitalization. If Cisco has 6 billion shares outstanding, to what stock price does this correspond? *22. Maynard Steel plans to pay a dividend of $3 this year. The company has an expected earnings growth rate of 4% per year and an equity cost of capital of 10%. a. Assuming that Maynard’s dividend payout rate and expected growth rate remain constant, and that the firm does not issue or repurchase shares, estimate Maynard’s share price. b. Suppose Maynard decides to pay a dividend of $1 this year and to use the remaining $2 per share to repurchase shares. If Maynard’s total payout rate remains constant, estimate Maynard’s share price. c. If Maynard maintains the dividend and total payout rate given in part (b), at what rates are Maynard’s dividends and earnings per share expected to grow?

Chapter 7 Stock Valuation

PART

2

207

Integrative Case

This case draws on material from Chapters 3–7. Adam Rust looked at his mechanic and sighed. The mechanic had just pronounced a death sentence on his road-weary car. The car had served him well—at a cost of $500 it had lasted through four years of college with minimal repairs. Now, he desperately needs wheels. He has just graduated, and has a good job at a decent starting salary. He hopes to purchase his first new car. The car dealer seems very optimistic about his ability to afford the car payments, another first for him. The car Adam is considering is $35,000. The dealer has given him three payment options: 1. Zero percent financing. Make a $4000 down payment from his savings and finance the remainder with a 0% APR loan for 48 months. Adam has more than enough cash for the down payment, thanks to generous graduation gifts. 2. Rebate with no money down. Receive a $4000 rebate, which he would use for the down payment (and leave his savings intact), and finance the rest with a standard 48-month loan, with an 8% APR. He likes this option, as he could think of many other uses for the $4000. 3. Pay cash. Get the $4000 rebate and pay the rest with cash. While Adam doesn’t have $35,000, he wants to evaluate this option. His parents always paid cash when they bought a family car; Adam wonders if this really was a good idea. Adam’s fellow graduate, Jenna Hawthorne, was lucky. Her parents gave her a car for graduation. Okay, it was a little Hyundai, and definitely not her dream car, but it was serviceable, and Jenna didn’t have to worry about buying a new car. In fact, Jenna has been trying to decide how much of her new salary she could save. Adam knows that with a hefty car payment, saving for retirement would be very low on his priority list. Jenna believes she could easily set aside $3000 of her $45,000 salary. She is considering putting her savings in a stock fund. She just turned 22 and has a long way to go until retirement at age 65, and she considers this risk level reasonable. The fund she is looking at has earned an average of 9% over the past 15 years and could be expected to continue earning this amount, on average. While she has no current retirement savings, five years ago Jenna’s grandparents gave her a new 30-year U.S. Treasury bond with a $10,000 face value. Jenna wants to know her retirement income if she both (1) sells her Treasury bond at its current market value and invests the proceeds in the stock fund, and (2) saves an additional $3000 at the end of each year in the stock fund from now until she turns 65. Once she retires, Jenna wants those savings to last for 25 years until she is 90. Both Adam and Jenna need to determine their best options. 207

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Part 2 Interest Rates and Valuing Cash Flows

Case Questions 1. What are the cash flows associated with each of Adam’s three car financing options? 2. Suppose that, similar to his parents, Adam had plenty of cash in the bank so that he could easily afford to pay cash for the car without running into debt now or in the foreseeable future. If his cash earns interest at a 5.4% APR (based on monthly compounding) at the bank, what would be his best purchase option for the car? 3. In fact, Adam doesn’t have sufficient cash to cover all his debts including his (substantial) student loans. The loans have a 10% APR, and any money spent on the car could not be used to pay down the loans. What is the best option for Adam now? (Hint: Note that having an extra $1 today saves Adam roughly $1.10 next year because he can pay down the student loans. So, 10% is Adam’s time value of money in this case.) 4. Suppose instead Adam has a lot of credit card debt, with an 18% APR, and he doubts he will pay off this debt completely before he pays off the car. What is Adam’s best option now? 5. Suppose Jenna’s Treasury bond has a coupon interest rate of 6.5%, paid semiannually, while current Treasury bonds with the same maturity date have a yield to maturity of 5.4435% (expressed as an APR with semiannual compounding). If she has just received the bond’s tenth coupon, for how much can Jenna sell her treasury bond? 6. Suppose Jenna sells the bond, reinvests the proceeds, and then saves as she planned. If, indeed, Jenna earns a 9% annual return on her savings, how much could she withdraw each year in retirement? (Assume she begins withdrawing the money from the account in equal amounts at the end of each year once her retirement begins.) 7. Jenna expects her salary to grow regularly. While there are no guarantees, she believes an increase of 4% a year is reasonable. She plans to save $3000 the first year, and then increase the amount she saves by 4% each year as her salary grows. Unfortunately, prices will also grow due to inflation. Suppose Jenna assumes there will be 3% inflation every year. In retirement, she will need to increase her withdrawals each year to keep up with inflation. In this case, how much can she withdraw at the end of the first year of her retirement? What amount does this correspond to in today’s dollars? (Hint: Build a spreadsheet in which you track the amount in her retirement account each year.) 8. Should Jenna sell her Treasury bond and invest the proceeds in the stock fund? Give at least one reason for and against this plan. 9. At the last minute, Jenna considers investing in Coca-Cola stock at a price of $55.55 per share instead. The stock just paid an annual dividend of $1.76 and she expects the dividend to grow at 4% annually. If the next dividend is due in one year, what expected return is Coca-Cola stock offering?

Valuation and the Firm

PART

3

Valuation Principle Connection. One of the most important decisions

Chapter 8

facing a financial manager is choosing which investments the corporation should

Investment Decision Rules

make. These decisions fundamentally drive value in the corporation. In Chapter 8 we learn how the Valuation Principle allows us to apply the concept of net present value (NPV ) to compare the costs and benefits of a project in terms of a common unit—

Chapter 9

namely, dollars today. We will then be able to evaluate a decision by answering this

Fundamentals of Capital Budgeting

question: Does the cash value today of its benefits exceed the cash value today of its

costs? In addition, we will see that the difference between the cash values of the benefits and costs indicates the net amount by which the decision will increase the value of the firm and therefore the wealth of its investors. After establishing the usefulness of the NPV decision rule for making investment

Chapter 10 Stock Valuation: A Second Look

decisions, we discuss alternative rules found in practice and their drawbacks. The process of allocating the firm’s capital for investment is known as capital budgeting. In Chapter 9, we outline how to estimate a project’s incremental cash flows, which then become the inputs to the NPV decision rule. Chapter 9 also provides a practical demonstration of the power of the discounting tools that were introduced in Chapters 3 and 4. Capital budgeting drives value in the firm, so in Chapter 10, Stock Valuation: A Second Look, we return to valuing the ownership claim in the firm—its stock. In Chapter 7, we valued a stock by discounting its future dividends or total payments. In Chapter 10, we consider alternative methods such as discounting free cash flows or comparing its value to that of similar, publicly traded companies. 209

8

Investment Decision Rules

LEARNING OBJECTIVES Q Calculate Net Present Value

Q Choose between mutually exclusive alternatives

Q Use the NPV rule to make investment decisions

Q Evaluate projects with different lives

Q Understand alternative decision rules and their drawbacks

notation

210

Q Rank projects when a company’s resources are limited so that it cannot take all positive-NPV projects

CFn

cash flow that arrives at date n

NPV

net present value

g

growth rate

PV

present value

IRR

internal rate of return

r

discount rate

MIRR

modified internal rate of return

INTERVIEW WITH

Scott Ladner Parsons Brinckerhoff

Scott Ladner is an Associate Consultant at Parsons Brinckerhoff (PB), a firm that develops and operates major infrastructure projects around the world. Specializing in transportation-related infrastructure economics and project finance, he performs tolltraffic and revenue forecasting, operations and maintenance-cost estimation, benefit-cost evaluation, and project-funding assessments. “My B.S in Economics from the University of Washington, which I received in 2008, gave me the technical and quantitative skills my position requires. It also encouraged me to think critically about complex financial problems so that I would be able to apply them in personal situations,” Scott says. PB’s business focuses on the public sector. “Policymakers and government officials must allocate scarce resources to deliver public infrastructure projects that maximize benefits and minimize costs,” explains Scott. “We use cost-benefit analysis to rank projects based on their respective net present values (NPVs). Projects yielding higher net benefits will generally be granted more resources.” Scott analyzes a project’s potential costs and benefits over its life and discounts them to a present value. “An NPV greater than zero indicates that benefits outweigh the costs. NPV is also useful in comparing alternative investments, such as high-speed rail versus a new airport. Calculating the net present value shows us which alternative has a greater value to stakeholders.” PB also uses the internal rate of return (IRR), the discount rate at which a project’s NPV equals zero, to measure economic return on investment. “It is a good tool to compare similarly sized investments but not useful for investments of different scale. The construction of a $1 billion power plant may generate the same IRR as installing a residential solar system for $20,000. Intuitively, we know that the power plant offers substantially greater benefits, although the IRR rule suggests that the projects are equal.” Another decision rule, the payback period, evaluates investments over a predetermined and sometimes arbitrary time horizon. “Because this method considers a specific time period and not the entire cash flow stream, it may result in selecting an investment with a greater return in the short-run but a lower return over a longer time horizon.”

University of Washington, 2008

“Calculating the net present value shows us which alternative has a greater value to stakeholders.”

In 2000, Toshiba and Sony began experimenting with new DVD technology, leading to Sony’s decision to develop and produce Blu-ray high-definition DVD players and Toshiba’s decision to develop and produce the HD-DVD player and format. So began an eight-year format war that ended in February 2008 when Toshiba decided to stop producing HD-DVD players and abandon the format. How did Toshiba and Sony managers arrive at the decision to invest in new DVD formats? How did Toshiba managers conclude that the best decision was to stop producing HD-DVD? We focus in this chapter on the decisionmaking tools managers use to evaluate investment decisions. Examples of these decisions include new products, equipment purchases, and marketing campaigns. We begin the chapter by introducing the net present value (NPV) rule. Although the NPV investment rule maximizes the value of the firm, some firms nevertheless use other techniques to evaluate investments and decide which projects to pursue. As a result, it is important to understand those techniques, so we will explain some commonly used alternative techniques—namely, the payback rule and the

internal rate of return (IRR) rule. In each case, we define the decision rule and compare decisions based on this rule to decisions based on the NPV rule. We also illustrate the circumstances in which each of

211

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Part 3 Valuation and the Firm the alternative rules is likely to lead to bad investment decisions. After establishing these rules in the context of a single, stand-alone project, we broaden our perspective to include evaluating multiple opportunities to select the best one. We conclude with a look at project selection when the firm faces limits on capital or managers’ time.

8.1

The NPV Decision Rule In the previous chapters, we learned how to convert between cash today and cash in the future using the discount rate. As long as we convert costs and benefits to the same point in time, we can use the Valuation Principle to make a decision. In practice, most corporations prefer to measure values in terms of their present value—that is, in terms of cash today. In this section, we apply the Valuation Principle to derive the concept of the net present value or NPV, which we can use to define the “golden rule” of financial decision making, the NPV rule.

Net Present Value net present value (NPV) The difference between the present value of a project’s or investment’s benefits and the present value of its costs.

When the value of a cost or benefit is computed in terms of cash today, we refer to it as the present value (PV). Similarly, we define the net present value (NPV) of a project or investment as the difference between the present value of its benefits and the present value of its costs: Net Present Value NPV = PV 1 Benefits 2 - PV 1 Costs 2

(8.1)

Let’s consider a simple example. Suppose your firm is offered the following investment opportunity: In exchange for $500 today, you will receive $550 in one year. If the interest rate is 8% per year, then: PV 1 Benefit 2 = 1 +550 in one year 2 1 +1.08 in one year/+1 today 2 = +509.26 today This PV is the amount you would need to put in the bank today to generate $550 in one year 1 +509.26 * 1.08 = +550 2 . In other words, the present value is the amount you need to invest at the current interest rate to recreate the cash flow. We can think of this as the cash cost today of generating the cash flow ourselves. Once the costs and benefits are in present value terms, we can compare them by computing the investment’s NPV: NPV = +509.26 - +500 = +9.26 today The NPV is positive, so the benefits outweigh the costs, which means the firm should undertake this investment opportunity. But what if you don’t have the $500 needed to cover the initial cost of the project? Does the project still have the same value? Because we computed the value using competitive market prices, it should not depend on your tastes or the amount of cash you have in the bank. If you don’t have the $500, suppose you borrow $509.26 from the bank at the 8% interest rate and then take the project. What are your cash flows in this case? Today: +509.26 1 loan 2 - +500 1 invested in the project 2 = +9.26

In one year: +550 1 from project 2 - +509.26 * 1.08 1 loan balance 2 = +0

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This transaction leaves you with exactly $9.26 extra cash in your pocket today and no future net obligations. So taking the project is similar to having an extra $9.26 in cash up front. Thus, the NPV expresses the value of an investment decision as an amount of cash received today. As long as the NPV is positive, the decision increases the value of the firm and is a good decision regardless of your current cash needs or preferences regarding when to spend the money.

The NPV Decision Rule

NPV decision rule When choosing among investment alternatives, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.

As shown in the last example, the Valuation Principle implies that we should undertake projects with a positive NPV because undertaking those projects increase wealth. That is, good projects are those for which the present value of the benefits exceeds the present value of the costs. As a result, the value of the firm increases and investors are wealthier. Projects with negative NPVs have costs that exceed their benefits. Accepting them is equivalent to losing money today. We capture this logic in the NPV Decision Rule: When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. Because NPV is expressed in terms of cash today, using the NPV decision rule is a simple way to apply the Valuation Principle. Decisions that increase wealth are superior to those that decrease wealth. We don’t need to know anything about the investor’s preferences to reach this conclusion. As long as we have correctly captured all the cash flows of a project and applied the appropriate discount rate, we can determine whether the project makes us wealthier. Being wealthier increases our options and makes us better off, whatever our preferences are. A common way companies apply the NPV rule in financial practices is when deciding whether to accept or reject a project. Because rejecting the project generally has NPV = 0 (there are no new costs or benefits from not doing the project), the NPV decision rule implies that we should Q Accept positive-NPV projects; accepting them is equivalent to receiving their NPV in cash today, and Q Reject negative-NPV projects; accepting them would reduce the value of the firm, whereas rejecting them has no cost 1 NPV = 0 2 . If the NPV is exactly zero, then you will neither gain nor lose by accepting the project instead of rejecting it, which also has an NPV of zero. It is not a bad project because it does not reduce the firm’s value, but it does not add value to the firm either.

EXAMPLE 8.1 The NPV Is Equivalent to Cash Today

Problem After saving $1500 by waiting tables, you are about to buy a 50-inch LCD TV. You notice that the store is offering a “one year same as cash” deal. You can take the TV home today and pay nothing until one year from now, when you will owe the store the $1500 purchase price. If your savings account earns 5% per year, what is the NPV of this offer? Show that its NPV represents cash in your pocket.

Solution Q Plan You are getting something worth $1500 today (the TV) and in exchange will need to pay $1500 in one year. Think of it as getting back the $1500 you thought you would have to spend today to get the TV. We treat it as a positive cash flow.

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In one year

+ +1500

- +1500

The discount rate for calculating the present value of the payment in one year is your interest rate of 5%. You need to compare the present value of the cost ($1500 in one year) to the benefit today (a $1500 TV). Q Execute NPV = +1500 -

1500 = 1500 - 1428.57 = +71.43 1 1.05 2

You could take $1428.57 of the $1500 you had saved for the TV and put it in your savings account. With interest, in one year it would grow to +1428.57 * 1 1.05 2 = +1500, enough to pay the store. The extra $71.43 is money in your pocket to spend as you like (or put toward the speaker system for your new media room). Q Evaluate By taking the delayed payment offer, we have extra net cash flows of $71.43 today. If we put $1428.57 in the bank, it will be just enough to offset our $1500 obligation in the future. Therefore, this offer is equivalent to receiving $71.43 today, without any future net obligations.

Concept Check

8.2

1. What is the NPV decision rule? How is it related to the Valuation Principle? 2. Why doesn’t the NPV decision rule depend on the investor’s preferences?

Using the NPV Rule We continue our discussion of investment decision rules by considering a take-it-or-leaveit decision about a single, stand-alone project. By undertaking this project, the firm does not constrain its ability to take other projects. In the case of a stand-alone project, the alternatives we are considering are to accept or reject a project. The NPV rule then implies that we should compare the project’s NPV to zero (the NPV of rejecting the project and doing nothing). Thus, we should accept the project if its NPV is positive.1

Organizing the Cash Flows and Computing the NPV Researchers at Fredrick’s Feed and Farm have made a breakthrough. They believe they can produce a new, environmentally friendly fertilizer at a substantial cost saving over the company’s existing line of fertilizer. The fertilizer will require a new plant that can be built immediately at a cost of $81.6 million. Financial managers estimate that the benefits of the new fertilizer will be $28 million per year, starting at the end of the first year and lasting for four years, as shown by the following timeline: Year: Cash flow (in millions):

0 $81.60

1 $28

2 $28

3 $28

4 $28

Thus, the cash flows are an immediate $81.6 million outflow followed by an annuity inflow of $28 million per year for four years. Therefore, given a discount rate r, the NPV of this project is: 1

Some prefer to state the rule that the project should be accepted if its NPV is non-negative. Since the firm should be indifferent at an NPV of exactly zero (you will neither gain nor lose by accepting the project instead of rejecting it), we prefer to state it this way. A zero NPV project is not a bad project because it does not reduce the firm’s value, but it does not add value to the firm either.

Chapter 8 Investment Decision Rules NPV = -81.6 +

28 28 28 28 + + + 2 3 1 + r 11 + r2 11 + r2 11 + r24

215 (8.2)

We can also use the annuity formula from Chapter 4 to write the NPV as: NPV = -81.6 +

28 1 ¢1 ≤ r 11 + r24

(8.3)

To apply the NPV rule, we need to know the cost of capital. The financial managers responsible for this project estimate a cost of capital of 10% per year. If we replace r in Eq. 8.2 or 8.3 with the project’s cost of capital of 10%, we get an NPV of $7.2 million, which is positive. Recall that a net present value tells us the present value of the benefits (positive cash flows) net of the costs (negative cash flows) of the project. By putting everything into present values, it puts all the costs and benefits on an equal footing for comparison. In this case, the benefits outweigh the costs by $7.2 million in present value. The NPV investment rule indicates that by making the investment, Fredrick’s will increase the value of the firm today by $7.2 million, so Fredrick’s should undertake this project.

The NPV Profile

FIGURE 8.1

The graph in panel (b) shows the NPV as a function of the discount rate based on the data in panel (a). The NPV is positive, represented by the green-shaded area, only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of capital of 10%, the project has a positive NPV of $7.2 million. The red-shaded area indicates discount rates above the 14% IRR with negative NPVs.

NPV of Fredrick’s New Project

Panel (a)

Panel (b) $40

Discount NPV Rate ($ millions) $30.4 0% $25.0 2% $20.0 4% $15.4 6% $11.1 8% $7.2 10% $3.4 12% 14% $0.0 16% $3.3 18% $6.3 20% $9.1 22% $11.8 24% $14.3

$30

NPV ($ millions)

NPV profile A graph of a project’s NPV over a range of discount rates.

The NPV of the project depends on its appropriate cost of capital. Often, there may be some uncertainty regarding the project’s cost of capital. In that case, it is helpful to compute an NPV profile, which graphs the project’s NPV over a range of discount rates. It is easiest to prepare the NPV profile using a spreadsheet such as Excel. We simply repeat our calculation of the NPV above using a range of different discount rates instead of only 10%. Figure 8.1 presents the NPV profile for Fredrick’s project by plotting the NPV as a function of the discount rate, r.2

$20 $10 $7.2 $0 $10

2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% Cost of Capital

IRR 14%

$20 Discount Rate

2

In the online appendix to this chapter, we show you how to create an NPV profile in Excel.

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internal rate of return (IRR) The interest rate that sets the net present value of the cash flows equal to zero.

Notice that the NPV is positive only for discount rates that are less than 14% (the green shaded area on the graph). Referring to the graph and the accompanying data table, we see that at 14%, the NPV is zero. The discount rate that sets the net present value of the cash flows equal to zero is an investment’s internal rate of return (IRR). Thus, by constructing the NPV profile, we have determined that Fredrick’s project has an IRR of 14%. We can also compute the IRR without graphing the NPV by using a financial calculator or a spreadsheet’s IRR function (see the appendix to Chapter 4. The calculator instructions for solving for the rate of return can be used to solve for the IRR).

Given: Solve for:

N 4

I/Y

PV 81.6

PMT 28

FV 0

14 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(4,28,81.6,0)

Measuring Sensitivity with IRR In our Fredrick’s example, the firm’s managers provided the cost of capital. If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. The IRR can provide this information. For Fredrick’s, if the cost of capital estimate is more than the 14% IRR, the NPV will be negative (see the red shaded area in Figure 8.1). Therefore, as long as our estimate of the cost of capital of 10% is within 4% of the true cost of capital, our decision to accept the project is correct. In general, the difference between the cost of capital and the IRR tells us the amount of estimation error in the cost of capital estimate that can exist without altering the original decision.

Alternative Rules Versus the NPV Rule The NPV rule indicates that Fredrick’s should undertake the investment in fertilizer technology. As we evaluate alternative rules for project selection in the subsequent sections, keep in mind that sometimes other investment rules may give the same answer as the NPV rule, but at other times they may disagree. When the rules conflict, always base your decision on the NPV rule, which is the most accurate and reliable decision rule.

Concept Check

8.3

3. Explain the NPV rule for stand-alone projects. 4. How can you interpret the difference between the cost of capital and the IRR?

Alternative Decision Rules Even though the NPV rule is the most accurate and reliable rule, in practice a wide variety of rules are applied, often in tandem with the NPV rule. In a 2001 study, John Graham and Campbell Harvey3 found that 75% of the firms they surveyed used the NPV rule for making investment decisions. This result is substantially different from that found in a similar study in 1977 by L. J. Gitman and J. R. Forrester,4 who found that only 10% of 3

John Graham and Campbell Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics 60 (2001): 187–243. 4

L. J. Gitman and J. R. Forrester, Jr., “A Survey of Capital Budgeting Techniques Used by Major U.S. Firms,” Financial Management 6 (1977): 66–71.

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USING EXCEL

Here we discuss how to use Microsoft Excel to solve for NPV and IRR. We also identify some pitfalls to avoid when using Excel.

Computing NPV and IRR

Excel’s NPV function has the format NPV (rate, value1, value2, . . . ), where “rate” is the interest rate per period used to discount the cash flows, and “value1”, “value2”, etc., are the cash flows (or ranges of cash flows). The NPV function computes the present value of the cash flows assuming the first cash flow occurs at date 1. Therefore, if a project’s first cash flow occurs at date 0, we cannot use the NPV function by itself to compute the NPV. We can use the NPV function to compute the present value of the cash flows from date 1 onward, and then we must add the date 0 cash flow to that result to calculate the NPV. The screenshot below shows the difference. The first NPV calculation (outlined in blue) is correct: we used the NPV function for all of the cash flows occurring at time 1 and later and then added on the first cash flow occurring at time 0 since it is already in present value. The second calculation (outlined in green) is incorrect: we used the NPV function for all of the cash flows, but the function assumed that the first cash flow occurs in period 1 instead of immediately.

NPV Function: Leaving Out Date 0

NPV Function: Ignoring Blank Cells Another pitfall with the NPV function is that cash flows that are left blank are treated differently from cash flows that are equal to zero. If the cash flow is left blank, both the cash flow and the period are ignored. For example, the second set of cash flows below is equivalent to the first—we have simply left the cash flow for date 2 blank instead of entering a “0.” However, the NPV function ignores the blank cell at date 2 and assumes the cash flow is 10 at date 1 and 110 at date 2, which is clearly not what is intended and produces an incorrect answer (outlined in red).

Because of these idiosyncrasies, we avoid using Excel’s NPV function. It is more reliable to compute the present value of each cash flow separately in Excel, and then sum them to determine the NPV.

IRR Function Excel’s IRR function has the format IRR (values, guess ), where “values” is the range containing the cash flows, and “guess” is an optional starting guess where Excel begins its search for an IRR. Two things to note about the IRR function: 1. The values given to the IRR function should include all of the cash flows of the project, including the one at date 0. In this sense, the IRR and NPV functions in Excel are inconsistent. 2. Like the NPV function, the IRR ignores the period associated with any blank cells.

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FIGURE 8.2 The Most Popular Decision Rules Used by CFOs

The bar graph shows the most popular decision rules used by CFOs in Professors Graham and Harvey’s 2001 survey. Many CFOs used more than one method, but no other methods were mentioned by more than half of CFOs.

IRR

76%

NPV

75%

Payback

57% 0%

20%

40%

60%

80%

firms used the NPV rule. Business students in recent years have been listening to their finance professors! Even so, Graham and Harvey’s study indicates that one-fourth of U.S. corporations do not use the NPV rule. Exactly why other capital budgeting techniques are used in practice is not always clear. Figure 8.2 summarizes the top three decision rules given in the survey. Because you may encounter these techniques in the business world, you should know what they are, how they are used, and how they compare to NPV. In this section, we examine alternative decision rules for single, stand-alone projects within the firm. The focus here is on the payback rule and the IRR rule.

The Payback Rule payback investment rule Only projects that pay back their initial investment within the payback period are undertaken. payback period The amount of time until the cash flows from a project offset the initial investment. The time it takes to pay back the initial investment.

EXAMPLE 8.2 Using the Payback Rule

The simplest investment rule is the payback investment rule, which states that you should only accept a project if its cash flows pay back its initial investment within a prespecified period. The rule is based on the notion that an opportunity that pays back its initial investment quickly is a good idea. To apply the payback rule, 1. Calculate the amount of time it takes to pay back the initial investment, called the payback period. 2. Accept the project if the payback period is less than a prespecified length of time— usually a few years. 3. Reject the project if the payback period is greater than that prespecified length of time. For example, a firm might adopt any project with a payback period of less than two years.

Problem Assume Fredrick’s requires all projects to have a payback period of two years or less. Would the firm undertake the fertilizer project under this rule?

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Solution Q Plan In order to implement the payback rule, we need to know whether the sum of the inflows from the project will exceed the initial investment before the end of two years. The project has inflows of $28 million per year and an initial investment of $81.6 million. Q Execute The sum of the cash flows for years 1 and 2 is +28 * 2 = +56 million, which will not cover the initial investment of $81.6 million. In fact, it will not be until year 3 that the cash inflows exceed the initial investment 1 +28 * 3 = +84 million 2 . Because the payback period for this project exceeds two years, Fredrick’s will reject the project. Q Evaluate While simple to compute, the payback rule requires us to use an arbitrary cutoff period in summing the cash flows. Further, also note that the payback rule does not discount future cash flows. Instead, it simply sums the cash flows and compares them to a cash outflow in the present. In this case, Fredrick’s would have rejected a project that would have increased the value of the firm.

discounted payback rule Only accept projects where the sum of the discounted cash flows within the payback period is greater than or equal to the initial investment.

Relying on the payback rule analysis in Example 8.2, Fredrick’s will reject the project. However, as we saw earlier, with a cost of capital of 10%, the NPV is $7.2 million. Following the payback rule would be a mistake because Fredrick’s will pass up a project worth $7.2 million. The payback rule is not as reliable as the NPV rule because it (1) ignores the time value of money, (2) ignores cash flows after the payback period, and (3) lacks a decision criterion grounded in economics (what is the right number of years to require for a payback period?). Some companies have addressed the first failing by computing the payback period using discounted cash flows, called the discounted payback rule. However, this does not solve the fundamental problem because the other two failings remain. Despite these failings, Graham and Harvey found that about 57% of the firms they surveyed reported using the payback rule as part of the decision-making process. Why do some companies consider the payback rule? The answer probably relates to its simplicity. This rule is typically used for small investment decisions—for example, whether to purchase a new copy machine or to service the old one. In such cases, the cost of making an incorrect decision might not be large enough to justify the time required to calculate the NPV. The appeal of the payback rule is that it favors short-term projects. Some firms are unwilling to commit capital to long-term investments. Also, if the required payback period is short (one to two years), then most projects that satisfy the payback rule will have a positive NPV.

The Internal Rate of Return Rule internal rate of return (IRR) investment rule A decision rule that accepts any investment opportunity where the IRR exceeds the opportunity cost of capital and otherwise rejects the opportunity.

Similar to NPV, the internal rate of return (IRR) investment rule is based on the concept that if the return on the investment opportunity you are considering is greater than the return on other alternatives in the market with equivalent risk and maturity (i.e., the project’s cost of capital), you should undertake the investment opportunity. We state the rule formally as follows: IRR investment rule: Take any investment opportunity whose IRR exceeds the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital.

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Part 3 Valuation and the Firm The IRR investment rule will give the correct answer (that is, the same answer as the NPV rule) in many—but not all—situations. For instance, it gives the correct answer for Fredrick’s fertilizer opportunity. From Figure 8.1, whenever the cost of capital is in the green area below the IRR (14%), the project has a positive NPV and you should undertake the investment. Table 8.1 summarizes our analysis of Fredrick’s new project. The NPV and IRR rules agree, but using the payback rule with a required payback period of two years or less would cause Fredrick’s to reject the project.

TABLE 8.1 Summary of NPV, IRR, and Payback for Fredrick’s New Project

NPV at 10%

$7.2 million

Payback Period

3 years

IRR

14%

Accept 1 +7.2 million 7 0 2

Reject 1 3 years 7 2 year required payback 2 Accept 1 14% 7 10% cost of capital 2

In general, the IRR rule works for a stand-alone project if all of the project’s negative cash flows precede its positive cash flows. But in other cases, the IRR rule may disagree with the NPV rule and thus be incorrect. Let’s examine several situations in which the IRR fails. Delayed Investments. Star basketball player Evan Cole is graduating from college with a degree in finance and preparing for the NBA draft. Several companies have already approached him with endorsement contracts. Two competing sports drink companies are trying to sign him. QuenchIt offers him a single upfront payment of $1 million to exclusively endorse their sports drink for three years. PowerUp offers $500,000 per year, payable at the end of each of the next three years, to endorse their product exclusively. Which offer is better? One direct way to compare the two contracts is to realize that signing with QuenchIt causes Evan to forgo the PowerUp contract, or $500,000 per year. Considering the risk of his alternative income sources and available investment opportunities, Evan estimates his opportunity cost of capital to be 10%. The timeline of Evan’s investment opportunity is: 0

1

2

3

$1,000,000

$500,000

$500,000

$500,000

The NPV of Evan’s investment opportunity is: NPV = 1,000,000 -

500,000 500,000 500,000 1 + r 11 + r22 11 + r23

By setting the NPV equal to zero and solving for r, we find the IRR. We can use either a financial calculator or a spreadsheet to find the IRR: N I/Y PV PMT FV Given: 3 1,000,000 500,000 0 Solve for: 23.38 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,500000,1000000,0)

The 23.38% IRR is larger than the 10% opportunity cost of capital. According to the IRR rule, Evan should sign the deal. But what does the NPV rule say? NPV = 1,000,000 -

500,000 500,000 500,000 = - +243,426 2 1.1 1.1 1.13

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At a 10% discount rate, the NPV is negative, so signing the deal would reduce Evan’s wealth. He should not sign the endorsement deal with QuenchIt, but should sign with PowerUp instead. To resolve this conflict, we can prepare an NPV profile for the QuenchIt contract. Figure 8.3 plots the NPV of the investment opportunity for a range of discount rates. It shows that, no matter what the cost of capital is, the IRR rule and the NPV rule will give exactly opposite recommendations. That is, the NPV is positive only when the opportunity cost of capital is above 23.38% (the IRR). Evan should accept the investment only when the opportunity cost of capital is greater than the IRR, the opposite of what the IRR rule recommends. Figure 8.3 also illustrates the problem with using the IRR rule in this case. For most investment opportunities, expenses occur initially and cash is received later. In this case, Evan gets cash upfront from QuenchIt but the forgone cash flows from PowerUp occurred later. It is as if Evan borrowed money, and when you borrow money you prefer as low a rate as possible. Evan’s optimal rule is to borrow money so long as the rate at which he borrows is less than the cost of capital. Even though the IRR rule fails to give the correct answer in this case, the IRR itself still provides useful information in conjunction with the NPV rule. As mentioned earlier, the IRR provides information on how sensitive the investment decision is to uncertainty in the cost of capital estimate. In this case, the difference between the cost of capital and the IRR is large—10% versus 23.38%. Evan would have to have underestimated the cost of capital by 13.38% to make the NPV positive. Multiple IRRs. Evan has informed QuenchIt that it needs to sweeten the deal before he will accept it. In response, the company has agreed to make an additional payment of $600,000 in 10 years as deferred compensation for the long-term increase in sales that

NPV of Cole’s $1 Million QuenchIt Deal

When all the benefits of an investment occur at time zero and before the costs, the NPV is an increasing function of the discount rate. The NPV is positive in the green-shaded areas and negative in the red-shaded areas. Notice that the NPV is positive when the cost of capital is above 23.38%, the IRR, so the NPV and IRR rules conflict.

Cost of Capital

100

0

NPV ($ thousands)

FIGURE 8.3

100

5%

10%

15%

20%

25%

IRR 23.38%

200 243 300 400

Discount Rate

30%

35%

Part 3 Valuation and the Firm even a short-term endorsement by Evan would bring. Should he accept or reject the new offer? We begin with the new timeline: 0

1

2

3

4

9

10

0

$600,000

... $1,000,000 $500,000

$500,000

$500,000

0

The NPV of Evan’s new investment opportunity is: NPV = 1,000,000 -

500,000 500,000 500,000 600,000 + 2 3 1 + r 11 + r2 11 + r2 1 1 + r 2 10

We can find the IRR for this investment opportunity by creating an NPV profile and noting where it crosses zero. Figure 8.4 plots the NPV of the opportunity at different discount rates. In this case, there are two IRRs—that is, there are two values of r that set the NPV equal to zero. You can verify this fact by substituting IRRs of 5.79% and 13.80% for r into the equation. Because there is more than one IRR, we cannot apply the IRR rule. It is also worth noting that you should take special care when using a spreadsheet or financial calculator to determine the IRR. Both solve for the IRR through trial and error because you cannot calculate IRR directly. In cases where there is more than one IRR, the spreadsheet or calculator will simply produce the first one that it finds, with no mention that there could be others! Some financial calculators will return an error message if there are multiple IRRs. Thus, it always pays to create the NPV profile. For guidance, let’s turn to the NPV rule. If the cost of capital were either below 5.79% or above 13.80%, Evan should undertake the opportunity. But given his cost of capital of 10%, he should still turn it down. Notice that even though the IRR rule fails in this case, the two IRRs are still useful as bounds on the cost of capital estimate. If the cost of

FIGURE 8.4 NPV of Evan’s Sports Drink Deal with Additional Deferred Payments

The graph in panel (b) shows the NPV of Evan’s deal with additional deferred payment based on the data in panel (a). In this case, there are two IRRs, invalidating the IRR rule. If the opportunity cost of capital is either below 5.79% or above 13.80%, Evan should accept the deal because the NPV is then positive, as indicated by the green-shaded areas. At any point between the two IRRs, the NPV is negative (see the red-shaded area). Panel (a) 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24%

100,000 72,680 50,267 32,151 17,793 6724 1469 7148 10,632 12,201 12,100 10,547 7732 3823 1030 6698 13,065 20,030 27,502 35,403 43,663 52,219 61,019 70,014 79,161

Panel (b) $120,000 $100,000 $80,000 NPV

222

$60,000 $40,000 $20,000 $0

$20,000

IRR 5.79%

5%

10%

15%

Cost of Capital

20%

IRR 13.80%

Discount Rate

25%

30%

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COMMON MISTAKE

223

IRR Versus the IRR Rule

Throughout this subsection, we have distinguished between the IRR itself and the IRR rule. While we have pointed out the shortcomings of using the IRR rule to make investment decisions, the IRR itself remains a very useful

tool. The IRR measures the average return of the investment and indicates the sensitivity of the NPV to estimation error in the cost of capital. Thus, knowing the IRR can be very useful, but relying on it to make investment decisions can be hazardous.

capital estimate is wrong, and it is actually smaller than 5.79% or larger than 13.80%, the decision not to pursue the project will change because it will have a positive NPV. There is no easy fix for the IRR rule when there are multiple IRRs. Although the NPV is negative between the IRRs in this example, the reverse is also possible (see Figure 8.5). In that case, the project would have a positive NPV for discount rates between the IRRs rather than for discount rates lower or higher than the IRRs. Furthermore, there are situations in which more than two IRRs exist.5 In such situations, our only choice is to rely on the NPV rule. modified internal rate of return (MIRR) The discount rate that sets the NPV of modified cash flows of a project equal to zero. Cash flows are modified so there is only one negative cash flow (and one sign-change) to ensure that only one IRR exists.

Modified Internal Rate of Return The fact that there can be multiple IRRs for the cash flows from a project is a clear disadvantage for the IRR. To overcome this, some have proposed various ways of modifying the cash flows before computing the IRR. All these modifications have the common feature that they group the cash flows so that there is only one negative cash flow, occurring at either the beginning or the end. In that case, there is only one sign-change for the cash flows as a whole and hence only one IRR. This new IRR, computed as the discount rate that sets the NPV of the modified cash flows of the project equal to zero, is called the modified internal rate of return (MIRR).

FIGURE 8.5

The graph shows the NPV profile for the multiple-IRR project with cash flows of - +1000, $2500 and - +1540 in years 0, 1, and 2, respectively. As the NPV profile shows, the project has two IRRs: 10% and 40%.

NPV Profile for a Project with Multiple IRRs

$20

NPV

$10 $9.45 $0 $10 $20

10% 20% Cost of Capital IRR

30%

40%

50%

60%

IRR

$30 $40 $50 Discount Rate

5

In general, there can be as many IRRs as the number of times the project’s cash flows change sign over time.

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Why Do Rules Other Than the NPV Rule Persist? Professors Graham and Harvey found that a sizable minority of firms (25%) in their study do not use the NPV rule at all. In addition, about 50% of firms surveyed used the payback rule. Furthermore, it appears that most firms use both the NPV rule and the IRR rule. Why do firms use rules other than NPV if they can lead to erroneous decisions? One possible explanation for this phenomenon is that Graham and Harvey’s survey results might be misleading. CFOs who were using the IRR as a sensitivity measure in conjunction with the NPV rule might have checked both the IRR box and the NPV box on the survey. The question they were asked was, “How frequently does your firm use the following techniques when deciding which projects or acquisitions to pursue?” By computing the IRR and using it in conjunction with the NPV rule to estimate the sensitivity of their results, they might have felt they were using both techniques. Nevertheless, a significant minority of managers surveyed replied that they used only the IRR rule, so this explanation cannot be the whole story. One common reason that managers give for using the IRR rule exclusively is that you do not need to know the opportunity

cost of capital to calculate the IRR. On a superficial level, this is true: The IRR does not depend on the cost of capital. You may not need to know the cost of capital to calculate the IRR, but you certainly need to know the cost of capital when you apply the IRR rule. Consequently, the opportunity cost is as important to the IRR rule as it is to the NPV rule. In our opinion, some firms use the IRR rule exclusively because the IRR sums up the attractiveness of investment opportunity in a single number without requiring the person running the numbers to make an assumption about the cost of capital. However, if a CFO wants a brief summary of an investment opportunity but does not want her employee to make a cost of capital assumption, she can also request a plot of the NPV as a function of the discount rate. Neither this request nor a request for the IRR requires knowing the cost of capital, but the NPV profile has the distinct advantage of being much more informative and reliable.

MIRR Technique. Let’s clarify this with an example. You are considering a project that has the following three cash flows: 0 $1000

1 $2500

2 $1540

The NPV profile for this project, shown in Figure 8.5, identifies the two IRRs for this project as 10% and 40%. Assume that your discount rate for this project is 15%. As Figure 8.5 shows, the NPV of the project at 15% is $9.45. We could modify the cash flows of the project to eliminate the multiple IRR problem. By discounting all of the negative cash flows to the present and compounding all of the positive cash flows to the end of the project, we have only two cash flows, yielding a single IRR. What discount rate and compounding rate should we use? One natural choice is our cost of capital for this project, which is 15%. 0 $1000 $1540 $1000 2164.46 (1.15)2

1 $2500

2 $1540 2500(1.15)1 2875

Figure 8.6 presents the NPV profile for our modified cash flows. As Figure 8.6 shows, there is now only a single IRR, at 15.25%. Because our cost of capital is 15%, we would properly accept the project using the IRR rule. Also note that the advantage of using 15% as our discount and compounding rates when modifying the cash flows is that the NPV of the modified cash flows at 15% is the same as the NPV of the true cash flows at 15%. Figure 8.6 also makes an important point: we are no longer evaluating the true cash flows of the project. Instead, we have modified them to force them to produce a single IRR. The NPV profile of the true cash flows of the project is given earlier in Figure 8.5 and is clearly different from the one produced by the modified cash flows in Figure 8.6.

Chapter 8 Investment Decision Rules

FIGURE 8.6 NPV Profile of Modified Cash Flows for the Multiple-IRR Project from Figure 8.5

225

The graph presents the NPV profile for the modified project cash flows of -2164.46 in year 0 and 2875 in year 2. The modified cash flows have only one IRR: 15.25%. Given the 15% cost of capital, the IRR rule confirms that we should accept the project.

$400 IRR 15.25%

$200 $9.45

NPV

$0 $200

10% 20% Cost of Capital

30%

40%

50%

60%

$400 $600 $800 Discount Rate

There is no set way to modify project cash flows to produce an MIRR. Two other approaches that each solve the multiple IRR problem are: 1. Discount all the negative cash flows to time 0 and leave the positive cash flows alone. 2. Leave the initial cash flow alone and compound all the remaining cash flows to the final period of the project. In this approach, you are implicitly reinvesting all the cash flows from the project at your compound rate until the project is complete. Again, in either case if you use the project’s cost of capital as your discount and compounding rate, you will not alter the NPV of the project at that discount rate. Further, a decision to accept or reject the project based on the modified IRR will be the same as the one based on the NPV decision rule. MIRR: A Final Word. There is considerable debate about whether MIRR is truly better than IRR. Most of the argument centers on whether it is advisable to modify the cash flows of the project. The IRR is truly an internal rate of return based solely on the actual cash flows of the project. However, the IRR implicitly assumes that all cash flows generated by the project are reinvested at the project’s IRR rather than at the firm’s cost of capital until the project ends. For a project with a high IRR, this may be an unrealistic assumption. Further, there may be more than one IRR, which complicates its use. The MIRR avoids these problems, but is based on a set of cash flows modified through the use of a chosen discount and compounding rate. Thus, it is not really an internal rate of return and is no longer based solely on the actual cash flows of the project. Finally, MIRR still does not solve some of the other problems associated with using IRR when choosing among projects.

Concept Check

5. How do you apply the payback rule? 6. Under what conditions will the IRR rule lead to the same decision as the NPV rule?

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8.4

mutually exclusive projects Projects that compete with one another; by accepting one, you exclude the others.

EXAMPLE 8.3 NPV and Mutually Exclusive Projects

Choosing Between Projects Thus far, we have considered only decisions where the choice is either to accept or to reject a single, stand-alone project. Sometimes, however, a firm must choose just one project from among several possible projects. For example, a manager may be evaluating alternative package designs for a new product. The manager must choose only one of the designs. When choosing any one project excludes us from taking the other projects, we are facing mutually exclusive projects. When projects, such as the package designs, are mutually exclusive, it is not enough to determine which projects have positive NPVs. With mutually exclusive projects, the manager’s goal is to rank the projects and choose only the best one. In this situation, the NPV rule provides a straightforward answer: Pick the project with the highest NPV. Problem You own a small piece of commercial land near a university. You are considering what to do with it. You have been approached recently with an offer to buy it for $220,000. You are also considering three alternative uses yourself: a bar, a coffee shop, and an apparel store. You assume that you would operate your choice indefinitely, eventually leaving the business to your children. You have collected the following information about the uses. What should you do? Initial Investment

Cash Flow in the First Year 1 CF1 2

Growth Rate (g)

Cost of Capital (r)

Bar

$400,000

$60,000

3.5%

12%

Coffee shop

$200,000

$40,000

3%

10%

Apparel Store

$500,000

$75,000

3%

13%

Solution Q Plan Since you can only do one project (you only have one piece of land), these are mutually exclusive projects. In order to decide which project is most valuable, you need to rank them by NPV. Each of these projects (except for selling the land) has cash flows that can be valued as a growing perpetuity, so from Chapter 4, the present value of the inflows is CF1/ 1 r - g 2 . The NPV of each investment will be: CF1 - Initial Investment r - g Q Execute The NPVs are: +60,000 - +400,000 = +305,882 0.12 - 0.035 +40,000 Coffee Shop: - +200,000 = +371,429 0.10 - 0.03 +75,000 - +500,000 = +250,000 Apparel Store: 0.13 - 0.03 Bar:

So, the ranking is

Alternative

NPV

Coffee Shop

$371,429

Bar

$305,882

Apparel Store

$250,000

Sell the Land

$220,000

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227

and you should choose the coffee shop. Q Evaluate All the alternatives have positive NPVs, but you can take only one of them, so you should choose the one that creates the most value. Even though the coffee shop has the lowest cash flows, its lower start-up cost coupled with its lower cost of capital (it is less risky) make it the best choice.

Because the IRR is a measure of the expected return of investing in the project, you might be tempted to extend the IRR investment rule to the case of mutually exclusive projects by picking the project with the highest IRR. Unfortunately, picking one project over another simply because it has a larger IRR can lead to mistakes. Problems arise when the mutually exclusive investments have differences in scale (require different initial investments) and when they have different cash flow patterns. We discuss each of these situations in turn.

Differences in Scale Would you prefer a 200% return on $1 or a 10% return on $1 million? The former return certainly sounds impressive and gives you great bragging rights, but at the end of the day you make only $2. The latter opportunity may sound much more mundane, but you make $100,000. This comparison illustrates an important shortcoming of IRR: Because it is a return, you cannot tell how much value has actually been created without knowing the basis for the return—a 10% IRR can have very different value implications for an initial investment of $1 million versus an initial investment of $100 million. If a project has a positive NPV, then if we can double its size, its NPV will double: By the Valuation Principle, doubling the cash flows of an investment opportunity must make it worth twice as much. However, the IRR rule does not have this property—it is unaffected by the scale of the investment opportunity because the IRR measures the average return of the investment. Hence, the IRR rule cannot be used to compare projects of different scales. Let’s illustrate this concept in the context of an example. Identical Scale. We begin by considering two mutually exclusive projects with the same scale. Javier is evaluating two investment opportunities. If he went into business with his girlfriend, he would need to invest $10,000 and the business would generate incremental cash flows of $6000 per year for three years. Alternatively, he could start a two-computer Internet café. The computer setup will cost a total of $10,000 and will generate $5000 for three years. The opportunity cost of capital for both opportunities is 12% and both will require all his time, so Javier must choose between them. How valuable is each opportunity, and which one should Javier choose? Let’s consider both the NPV and IRR of each project. The timeline for the investment with Javier’s girlfriend is: 0 10,000

1 6000

2 6000

3 6000

The NPV of the investment opportunity when r = 0.12 is: NPV = -10,000 +

6000 6000 6000 + + = +4411 1.12 1.12 2 1.12 3

We can determine the IRR of this investment by using a financial calculator or spreadsheet:

Part 3 Valuation and the Firm

Given: Solve for:

N 3

I/Y

PV 10,000

PMT 6000

FV 0

36.3 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,6000,10000,0)

Thus, the IRR for Javier’s investment in his girlfriend’s business is 36.3%. The timeline for his investment in the Internet café is: 0 10,000

1

2

5000

3

5000

5000

The NPV of the investment opportunity is: NPV = -10,000 +

5000 5000 5000 + = +2009 + 2 1.12 1.12 1.12 3

The $2009 NPV of the Internet café is lower than the $4411 NPV for his girlfriend’s business, so Javier should join his girlfriend in business. Luckily, it appears that Javier does not need to choose between his checkbook and his relationship! We could also compare IRRs. For the Internet café, we would find that the IRR is 23.4%. The Internet café has a lower IRR than the investment in his girlfriend’s business. As Figure 8.7 shows, in this case the project with the higher IRR has the higher NPV. Change in Scale. What happens if we change the scale of one of the projects? Javier’s finance professor points out that, given the space available in the facility, he could just as

FIGURE 8.7 NPV of Javier’s Investment Opportunities with the Two-Computer Internet Café

The NPV of his girlfriend’s business is always larger than the NPV of the two-computer Internet café. The same is true for the IRR; the IRR of his girlfriend’s business is 36.3%, while the IRR for the Internet café is 23.4%.

$12,000 $10,000 $8000 $6000 NPV

228

$4000

Girlfriend’s business IRR

$2000 $0 $2000 $4000

12% Cost of Capital

23.4%

IRR Discount Rate

36.3% Internet café

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229

easily install five times as many computers in the Internet café. His setup cost would now be $50,000 and his annual cash flows would be $25,000. What should Javier do now? Note that the IRR is unaffected by the scale. Because we are scaling all the cash flows

Given: Solve for:

N 3

I/Y

PV 50,000

PMT 25,000

FV 0

23.4 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,25000,50000,0)

up by a factor of 5, a ten-machine Internet café has exactly the same IRR as a two-machine Internet café, so his girlfriend’s business still has a higher IRR than the Internet café: However, the NPV of the Internet café does grow by the scale—it is five times larger: NPV = -50,000 +

25,000 25,000 25,000 + + = +10,046 2 1.12 1.12 1.12 3

Now Javier should invest in the ten-computer Internet café. As Figure 8.8 shows, the NPV of the ten-computer Internet café exceeds the NPV of going into business with his girlfriend whenever the cost of capital is less than 20%. In this case, even though the IRR of going into business with his girlfriend exceeds the IRR of the Internet café, picking the investment opportunity with the higher IRR does not result in taking the opportunity with the higher NPV. Percentage Return Versus Dollar Impact on Value. This result might seem counterintuitive and you can imagine Javier having a difficult time explaining to his girlfriend why he is choosing a lower return over going into business with her. Why would anyone turn

NPV of Javier’s Investment Opportunities with the Ten-Computer Internet Café

As in Figure 8.7, the IRR of his girlfriend’s business is 36.3%, while the IRR for the Internet café is 23.4%. But in this case, the NPV of his girlfriend’s business is larger than the NPV of the ten-computer Internet café only for discount rates over 20%.

$12,000 $10,000

Internet café (10 computers)

$8000 $6000 NPV

FIGURE 8.8

$4000 Crossover $2000 $0 $2000 $4000

12% Cost of Capital

20% 23.4%

IRR Discount Rate

Girlfriend’s business IRR

36.3% Internet café (2 computers)

230

Part 3 Valuation and the Firm down an investment opportunity with a 36.3% return (IRR) in favor of one with only a 23.4% return? The answer is that the latter opportunity, the Internet café, makes more money. Recall the comparison at the beginning of this section: a 200% return on $1 versus a 10% return on $1 million. We agreed that ranking the returns was not the same as ranking the value created. The IRR is a measure of the average return, which can be valuable information. When you are comparing mutually exclusive projects of different scale, however, you need to know the dollar impact on value—the NPV.

INTERVIEW WITH

DICK GRANNIS

Dick Grannis is Senior Vice President and Treasurer of QUALCOMM Incorporated, a world leader in digital wireless communications technology and semiconductors, headquartered in San Diego. He joined the company in 1991 and oversees the company’s $10 billion cash investment portfolio. He works primarily on investment banking, capital structure, and international finance. QUESTION: QUALCOMM has a wide variety of products in different business lines. How does your capital budgeting process for new products work? ANSWER:

QUALCOMM evaluates new projects (such as new products, equipment, technologies, research and development, acquisitions, and strategic investments) by using traditional financial measurements including DCF models, IRR levels, peak funding requirements, the time needed to reach cumulative positive cash flows, and the short-term impact of the investment on our reported net earnings. For strategic investments, we consider the possible value of financial, competitive, technology and/or market value enhancements to our core businesses—even if those benefits cannot be quantified. Overall, we make capital budgeting decisions based on a combination of objective analyses and our own business judgment. We do not engage in capital budgeting and analysis if the project represents an immediate and necessary requirement for our business operations. One example is new software or production equipment to start a project that has already received approval. We are also mindful of the opportunity costs of allocating our internal engineering resources on one project vs. another project. We view this as a constantly challenging but worthwhile exercise, because we have many attractive opportunities but limited resources to pursue them. QUESTION: How often does QUALCOMM evaluate its hurdle rates and what factors does it consider in setting them? How do you allocate capital across areas and regions and assess the risk of non-U.S. investments?

ANSWER:

QUALCOMM encourages its financial planners to utilize hurdle (or discount) rates that vary according to the risk of the particular project. We expect a rate of return commensurate with the project’s risk. Our finance staff considers a wide range of discount rates and chooses one that fits the project’s expected risk profile and time horizon. The range can be from 6.00% to 8.00% for relatively safe investments in the domestic market to 50% or more for equity investments in foreign markets that may be illiquid and difficult to predict. We re-evaluate our hurdle rates at least every year. We analyze key factors including: (i) market adoption risk (whether or not customers will buy the new product or service at the price and volume we expect), (ii) technology development risk (whether or not we can develop and patent the new product or service as expected), (iii) execution risk (whether we can launch the new product or service cost effectively and on time), and (iv) dedicated asset risk (the amount of resources that must be consumed to complete the work).

How are projects categorized and how are the hurdle rates for new projects determined? What would happen if QUALCOMM simply evaluated all new projects against the same hurdle rate?

QUESTION:

ANSWER: We primarily categorize projects by risk level, but we also categorize projects by the expected time horizon. We consider short-term and long-term projects to balance our needs and achieve our objectives. For example, immediate projects and opportunities may demand a great amount of attention, but we also stay focused on long-term projects because they often create greater long-term value for stockholders. If we were to evaluate all new projects against the same hurdle rate, then our business planners would, by default, consistently choose to invest in the highest risk projects because those projects would appear to have the greatest expected returns in DCF models or IRR analyses. That approach would probably not work well for very long.

Chapter 8 Investment Decision Rules

EXAMPLE 8.4 Computing the Crossover Point

231

Problem Solve for the crossover point for Javier from Figure 8.8.

Solution Q Plan The crossover point is the discount rate that makes the NPV of the two alternatives equal. We can find the discount rate by setting the equations for the NPV of each project equal to each other and solving for the discount rate. In general, we can always compute the effect of choosing the Internet café over his girlfriend’s business as the difference of the NPVs. At the crossover point the difference is 0. Q Execute Setting the difference equal to 0: NPV = -50,000 +

25,000 25,000 25,000 + + 1 + r 11 + r22 11 + r23

- ¢ -10,000 +

6,000 6,000 6,000 + + ≤ = 0 2 11 + r2 11 + r2 11 + r23

combining terms, we have -40,000 +

19,000 19,000 19,000 + + = 0 2 11 + r2 11 + r2 11 + r23

As you can see, solving for the crossover point is just like solving for the IRR, so we will need to use a financial calculator or spreadsheet:

Given: Solve for:

N 3

I/Y

PV 40,000

PMT 19,000

FV 0

20.04 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,19000,40000,0)

And we find that the crossover occurs at a discount rate of 20.04%. Q Evaluate Just as the NPV of a project tells us the value impact of taking the project, so the difference of the NPVs of two alternatives tells us the incremental impact of choosing one project over another. The crossover point is the discount rate at which we would be indifferent between the two projects because the incremental value of choosing one over the other would be zero.

Timing of the Cash Flows Even when projects have the same scale, the IRR may lead you to rank them incorrectly due to differences in the timing of the cash flows. The reason for this is that the IRR is expressed as a return, but the dollar value of earning a given return—and therefore the NPV—depends on how long the return is earned. Consider a high-IRR project with cash flows paid back quickly. It may have a lower NPV than a project with a lower IRR whose cash flows are paid back over a longer period. This sensitivity to timing is another reason why you cannot use the IRR to choose between mutually exclusive investments. To see this in the context of an example, let’s return to Javier’s Internet café. Javier believes that after starting the Internet café, he may be able to sell his stake in the business at the end of the first year for $40,000 (he will continue to stay on and manage the business after he sells). Thus, counting his first-year profit of $25,000, he would earn a total of $65,000 after one year. In that case, the timeline is: 0

1

$50,000

$65,000

Part 3 Valuation and the Firm

FIGURE 8.9 NPV With and Without Selling

The IRR from selling after one year (30%) is larger than the IRR without selling (23.4%). However, the NPV from selling after one year exceeds the NPV without selling only for discount rates that are in excess of 16.3% (see the yellow-shaded area vs. the blue-shaded area). Thus, given a cost of capital of 12%, it is better not to sell the Internet café after one year, despite the higher IRR.

$12,000 $10,000

Internet café (without selling)

$8000 Crossover

$6000 NPV

232

Internet café (sell in one year)

$4000

IRR

$2000 $0 $2000 $4000

12% 16.3% Cost of Capital

23.4%

30%

IRR Discount Rate

Figure 8.9 plots the NPV profile for the café with and without selling it after one year. If he sells, the NPV profile crosses the x-axis at 30%, which is its IRR. The IRR for the café if he does not sell is still 23.4%. Therefore, if Javier picks the alternative with the higher IRR, he will sell. However, since the height of each line indicates the NPV of that decision, we can see that his NPV given a 12% cost of capital is higher if he chooses not to sell. (In fact, the NPV is higher as long as the cost of capital is less than 16.3%.) The intuition is as follows: While the 30% IRR from selling is high, this return is only earned in the first year. While the 23.4% IRR from not selling is not as high, it is still attractive relative to the cost of capital, and it is earned over a longer period. Again, only by comparing the NPV can we determine which option is truly more valuable. The Bottom Line on IRR. As these examples make clear, picking the investment opportunity with the largest IRR can lead to a mistake. In general, it is dangerous to use the IRR in cases where you are choosing between projects, or anytime when your decision to accept or reject one project would affect your decision on another project. In such a situation, always rely on NPV.

Concept Check

8.5

7. What is the most reliable way to choose between mutually exclusive projects? 8. For mutually exclusive projects, explain why picking one project over another because it has a larger IRR can lead to mistakes.

Evaluating Projects with Different Lives Often, a company will need to choose between two solutions to the same problem. A complication arises when those solutions last for different periods of time. For example, a firm could be considering two vendors for its internal network servers. Each vendor offers the

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233

same level of service, but they use different equipment. Vendor A offers a more expensive server with lower per-year operating costs that it guarantees to last for three years. Vendor B offers a less expensive server with higher per-year operating costs that it will only guarantee for two years. The costs are shown in Table 8.2 along with the present value of the costs of each option, discounted at the 10% cost of capital for this project.

TABLE 8.2 Cash Flows ($ Thousands) for Network Server Options

equivalent annual annuity (EAA) The level annual cash flow that has the same present value as the cash flows of a project. Used to evaluate alternative projects with different lives.

Year

PV at 10%

0

1

2

3 -1

A

-12.49

-10

-1

-1

B

-10.47

-7

-2

-2

Note that all of the cash flows are negative, and so is the present value. This is a choice of an internal server, where the project must be taken and the benefits are diffuse (the company could not function effectively without an internal network). Thus, we are trying to minimize the cost of providing this service for the company. Table 8.2 shows that option A is more expensive on a present value basis 1 - +12,487 versus - +10,471 2 . However, the comparison is not that simple: option A lasts for three years while option B only lasts for two. The decision comes down to whether it is worth paying $2000 more for option A to get the extra year. One method that is used to evaluate alternatives such as these that have different lives is to compute the equivalent annual annuity (EAA) for each project, which is the level annual cash flow with the same present value as the cash flows of the project. The intuition is that we can think of the cost of each solution as the constant annual cost that gives us the same present value of the lumpy cash flows of buying and operating the server. On a timeline, equivalent annual annuity cash flows would appear as follows: 0

1

2

3

NPV = –12.49

EAA

EAA

EAA

When you have a level cash flow at a constant interval, you are dealing with an annuity and that is exactly how to approach this problem. We know the present value 1 - +12.49 2 the number of years (3), and the discount rate (10%). We need to solve for the cash flow of an equivalent annuity. Recall from Chapter 4 that the formula (Eq. 4.9) for solving for the cash flow in an annuity is: Cash Flow =

Present Value 1 1 ¢1 ≤ r 11 + r2N

=

-12.49 1 1 ¢1 ≤ 0.10 1 1.10 2 3

= -5.02

So, buying and operating server A is equivalent to spending $5020 per year to have a network server. We can repeat the calculation for server B, but for a two-year annuity because server B has only a two-year life (the change in exponent is highlighted): Cash Flow =

Present Value 1 1 ¢1 ≤ r 11 + r2N

=

-10.47 1 1 ¢1 ≤ 0.10 1 1.10 2 2

= -6.03

Therefore, we can reinterpret the cost of each alternative as shown in Table 8.3: Now we are ready to choose between the two servers. Server A is equivalent to spending $5020 per year and server B is equivalent to spending $6030 per year to have a network server. Seen in this light, server A appears to be the less expensive solution.

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Part 3 Valuation and the Firm

TABLE 8.3

Year

Cash Flows ($ Thousands) for Network Server Options, Expressed as Equivalent Annual Annuities

EXAMPLE 8.5

PV at 10%

0

1

2

3

A

-12.49

0

-5.02

-5.02

-5.02

B

-10.47

0

-6.03

-6.03

Problem

Computing an Equivalent Annual Annuity

You are about to sign the contract for server A from Table 8.2 when a third vendor approaches you with another option that lasts for four years. The cash flows for server C are given below. Should you choose the new option or stick with server A? 0 1 2 3 4 Server C 14 ($ thousands)

1.2

1.2

1.2

1.2

Solution Q Plan In order to compare this new option to server A, we need to put server C on an equal footing by computing its annual cost. We can do this by: 1. Computing its NPV at the 10% discount rate we used above. 2. Computing the equivalent four-year annuity with the same present value. Q Execute PV = -14 - 1.2 a Cash Flow =

1 1 b c1 d = -17.80 0.10 1 1.10 2 4

- 17.80 PV = = -5.62 1 1 1 1 1 c1 d c d r 0.10 1 1.10 2 4 11 + r2N

Server C’s annual cost of $5620 is greater than the annual cost of server A ($5020), so we should still choose server A. Q Evaluate In this case, the additional cost associated with purchasing and maintaining server C is not worth the extra year we get from choosing it. By putting all of these costs into an equivalent annuity, the EAA tool allows us to see that.

Important Considerations When Using the Equivalent Annual Annuity Although server A appears to be the lowest-cost alternative, there are a number of factors to consider before making our decision. Required Life. We computed the equivalent annual cost of server A assuming we would use it for three years. But suppose it is likely that we will not need the server in the third year. Then we would be paying for something that we would not use. In that case, it may be cheaper to purchase server B, which provides coverage for the years we will need it at a lower total cost.6 Replacement Cost. When we compare servers A and B based on their equivalent annual cost, we are assuming that the cost of servers will not change over time. But suppose we 6

In this scenario, we should also consider any salvage value that server A might have if we sold it after two years.

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believe a dramatic change in technology will reduce the cost of servers by the third year to an annual cost of $2000 per year. Then server B has the advantage that we can upgrade to the new technology sooner. The cost of three years of service from either server in this case can be represented as follows: Year

PV at 10%

0

1

2

3

A

-12.49

0

-5.02

-5.02

-5.02

B

-11.97

0

-6.03

-6.03

-2.00

Therefore, when cost or performance is expected to change significantly over time, it may be cheaper to purchase server B despite its higher equivalent annual cost because it gives us the option to switch to the new technology sooner.

Concept Check

9. Explain why choosing the option with the highest NPV is not always correct when the options have different lives. 10. What issues should you keep in mind when choosing among projects with different lives?

8.6

Choosing Among Projects When Resources Are Limited In the previous sections, we compared projects that had identical resource needs. For example, in Javier’s case, we assumed that both the Internet café and his girlfriend’s business demanded 100% of his time. In this section, we develop an approach for situations where the choices have differing resource needs.

Evaluating Projects with Different Resource Requirements In some situations, different investment opportunities demand different amounts of a particular resource. If there is a fixed supply of the resource so that you cannot undertake all possible opportunities, simply picking the highest NPV opportunity might not lead to the best decision. We usually assume that you will be able to finance all positive NPV projects that you have. In reality, managers work within the constraint of a budget that restricts the amount of capital they may invest in a given period. Such a constraint would force a manager to choose among positive NPV projects to maximize the total NPV while staying within her budget. For example, assume you are considering the three projects in Table 8.4, and that you have a budget of $200 million. Table 8.4 shows the NPV of each project and the initial investment that each project requires. Project A has the highest NPV but it uses up the entire budget. Projects B and C can both be undertaken (together they use the entire budget), and their combined NPV exceeds the NPV of project A; thus, you should initiate them both. Together, their NPV is $145 million compared to just $100 million for project A alone.

TABLE 8.4 Possible Projects for $200 Million Budget

Project

NPV ($ millions)

Initial Investment ($ millions)

NPV/Initial Investment

A

100

200

0.500

B C

75 70

120 80

0.625 0.875

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profitability index (PI) Measures the NPV per unit of resource consumed.

Profitability Index. Note that in the last column of Table 8.4 we included the ratio of the project’s NPV to its initial investment. We can interpret this as telling us that for every dollar invested in project A, we will generate 50 cents in value (over and above the dollar investment).7 Both projects B and C generate higher NPVs per dollar invested than project A, consistent with the fact that given our budget of $200 million, the two of them together created a higher NPV than just project A. In this simple example, identifying the optimal combination of projects to undertake is straightforward. In actual situations replete with many projects and resources, finding the optimal combination can be difficult. Practitioners often use the profitability index (PI) to help identify the optimal combination of projects to undertake in such situations: Profitability Index Value Created NPV Profitability Index = = Resource Consumed Resource Consumed

(8.4)

The profitability index measures the “bang for your buck”—that is, the value created in terms of NPV per unit of resource consumed. After computing the profitability index, we can rank projects based on it. Starting with the project with the highest index, we move down the ranking, taking all projects until the resource is consumed. In Table 8.4, the ratio in the last column is the profitability index. Note how the profitability index rule would correctly select projects B and C.

EXAMPLE 8.6

Problem

Profitability Index with a Human Resource Constraint

Your division at NetIt, a large networking company, has put together a project proposal to develop a new home networking router. The expected NPV of the project is $17.7 million, and the project will require 50 software engineers. NetIt has a total of 190 engineers available, and is unable to hire additional qualified engineers in the short run. Therefore, the router project must compete with the following other projects for these engineers: Project Router Project A Project B Project C Project D Project E Project F Total

NPV ($ millions)

Engineering Headcount

17.7

50

22.7 8.1 14.0 11.5 20.6 12.9 107.5

47 44 40 61 58 32 332

How should NetIt prioritize these projects?

Solution Q Plan The goal is to maximize the total NPV that we can create with 190 engineers (at most). We can use Eq. 8.4 to determine the profitability index for each project. In this case, since engineers are our limited resource, we will use Engineering Headcount in the denominator. Once we have the profitability index for each project, we can sort them based on the index.

7

Sometimes, practitioners add 1 to this ratio such that the interpretation would be that every dollar invested returned $1.50. Leaving off the additional 1 allows the ratio to be applied to resources other than budgets as we show in Example 8.6.

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Q Execute Project

NPV ($ millions)

Engineering Headcount (EHC)

Profitability Index (NPV per EHC)

Cumulative EHC Required

Project A

22.7

47

0.483

47

Project F

12.9

32

0.403

79 1 47 + 32 2

Project E

20.6

58

0.355

Router

17.7

50

0.354

Project C

14.0

40

0.350

Project D

11.5

61

0.189

Project B

8.1

44

0.184

137 1 79 + 58 2

187 1 137 + 50 2

As shown in the table above, we assigned the resource to the projects in descending order according to the profitability index. The final column shows the cumulative use of the resource as each project is taken on until the resource is used up. To maximize NPV within the constraint of 190 engineers, NetIt should choose the first four projects on the list. Q Evaluate By ranking projects in terms of their NPV per engineer, we find the most value we can create, given our 190 engineers. There is no other combination of projects that will create more value without using more engineers than we have. This ranking also shows us exactly what the engineering constraint costs us—this resource constraint forces NetIt to forgo three otherwise valuable projects (C, D, and B) with a total NPV of $33.6 million.

Shortcomings of the Profitability Index. Although the profitability index is simple to compute and use, in some situations it does not give an accurate answer. For example, suppose in Example 8.6 that NetIt has an additional small project with an NPV of only $100,000 that requires three engineers. The profitability index in this case is 0.1/3 = 0.03, so this project would appear at the bottom of the ranking. However, notice that three of the 190 employees are not being used after the first four projects are selected. As a result, it would make sense to take on this project even though it would be ranked last because it would exactly use up our constraint. In general, because the profitability index already includes the cost of capital (in computing the NPV), it would be better if the firm could raise additional funding to relieve the constraint. If the constraint is something else (such as engineers or physical capacity), there may be no way to relieve the constraint quickly enough to avoid having to choose among projects. Nonetheless, because all of the projects being ranked are valueincreasing positive NPV projects, it is still better to focus on relieving the constraint. A more serious problem occurs when multiple resource constraints apply. In this case, the profitability index can break down completely. The only surefire way to find the best combination of projects is to search through all of them. Although this process may sound exceedingly time-consuming, there are more advanced techniques that can tackle this specific kind of problem.8 By using these techniques on a computer, the solution can usually be obtained almost instantaneously.

Concept Check

11. Explain why picking the project with the highest NPV might not be optimal when you evaluate projects with different resource requirements. 12. What does the profitability index tell you? 8

Specifically, there are techniques called integer and linear programming that can be used to find the combination with the highest NPV when there are multiple constraints that must be satisfied. These methods are available, for example, in many spreadsheet programs.

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8.7

Putting It All Together In Table 8.5, we summarize the decision rules outlined in this chapter. As a financial manager, you are likely to run into many different types of investment decision rules in your

TABLE 8.5 Summary of Decision Rules

NPV Definition

Q The difference between the present value of an investment’s benefits and the present value of its costs

Rule

Q Take any investment opportunity where the NPV is positive; turn down any opportunity where it is negative

Advantages

Q Corresponds directly to the impact of the project on the firm’s value Q Direct application of the Valuation Principle

Disadvantages

Q Relies on an accurate estimate of the discount rate Q Can be time-consuming to compute

IRR Definition

Q The interest rate that sets the net present value of the cash flows equal to zero; the average return of the investment

Rule

Q Take any investment opportunity where IRR exceeds the opportunity cost of capital; turn down any opportunity whose IRR is less than the opportunity cost of capital

Advantages

Q Related to the NPV rule and usually yields the same (correct) decision

Disadvantages

Q Q Q Q

Hard to compute Multiple IRRs lead to ambiguity Cannot be used to choose among projects Can be misleading if inflows come before outflows

Payback Period Definition

Q The amount of time it takes to pay back the initial investment

Rule

Q If the payback period is less than a prespecified length of time—usually a few years—accept the project; otherwise, turn it down

Advantages

Q Simple to compute Q Favors liquidity

Disadvantages

Q No guidance as to correct payback cutoff Q Ignores cash flows after the cutoff completely Q Not necessarily consistent with maximizing shareholder wealth

Profitability Index Definition

Q NPV/Resource Consumed

Rule

Q Rank projects according to their PI based on the constrained resource and move down the list accepting value-creating projects until the resource is exhausted

Advantages

Q Uses the NPV to measure the benefit Q Allows projects to be ranked on value created per unit of resource consumed

Disadvantages

Q Breaks down when there is more than one constraint Q Requires careful attention to make sure the constrained resource is completely utilized

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career. In fact, in the interview in this chapter, the Treasurer of QUALCOMM mentions five different decision rules used by his company when evaluating investments. We have demonstrated that while alternative decision rules may sometimes (or even often) agree with the NPV decision rule, only the NPV decision rule is always correct. This is because the NPV provides you with a dollar-value measure of the impact of the project on shareholder wealth. Thus, it is the only rule that is directly tied to your goal of maximizing shareholder wealth. Computing the IRR can be a useful supplement to the NPV because knowing the IRR allows you to gauge how sensitive your decision is to errors in your discount rate. And some decision metrics are much simpler to calculate, such as the payback period. However, you should never rely on an alternative rule to make investment decisions. If you are employed by a firm that uses the IRR rule (or another rule) exclusively, our advice is to always calculate the NPV. If the two rules agree, you can feel comfortable reporting the IRR rule recommendation. If they do not agree, you should investigate why the IRR rule failed by using the concepts in this chapter. Once you have identified the problem, you can alert your superiors to it and perhaps persuade them to adopt the NPV rule.

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

8.1 The NPV Decision Rule Q The net present value (NPV) of a project is

net present value (NPV), p. 212 NPV decision rule, p. 213

MyFinanceLab Study Plan 8.1

internal rate of return (IRR), p. 217 NPV profile, p. 215

MyFinanceLab Study Plan 8.2

PV 1 Benefits 2 - PV 1 Costs 2

(8.1)

Q A good project is one with a positive net present value. Q The NPV decision rule states that when choosing from among a set of alternatives, choose the one with the highest NPV. The NPV of a project is equivalent to the cash value today of the project. Q Regardless of our preferences for cash today versus cash in the future, we should always first maximize NPV. We can then borrow or lend to shift cash flows through time and find our most preferred pattern of cash flows. 8.2 Using the NPV Rule Q If your objective is to maximize wealth, the NPV rule always gives the correct answer. Q The difference between the cost of capital and the IRR is the maximum amount of estimation error that can exist in the cost of capital estimate without altering the original decision.

Financial Calculator Tutorial: Calculating the Net Present Value of a Series of Uneven Cash Flows

Using Excel: Making an NPV Profile

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8.3 Alternative Decision Rules Q Payback investment rule: Calculate the amount of time it takes to pay back the initial investment (the payback period). If the payback period is less than a prespecified length of time, accept the project. Otherwise, turn it down. Q IRR investment rule: Take any investment opportunity whose IRR exceeds the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital. Q The IRR rule may give the wrong answer if the cash flows have an upfront payment (negative investment). When there are multiple IRRs or the IRR does not exist, the IRR rule cannot be used. Q Project cash flows can be modified to eliminate the multiple IRR problem. The modified IRR is calculated based on these modified cash flows.

discounted payback rule, p. 219 internal rate of return (IRR) investment rule, p. 219 modified internal rate of return (MIRR), p. 223 payback investment rule, p. 218 payback period, p. 218

MyFinanceLab Study Plan 8.3

8.4 Choosing Between Projects Q When choosing among mutually exclusive investment opportunities, pick the opportunity with the highest NPV. Do not use IRR to choose among mutually exclusive investment opportunities.

mutually exclusive projects, p. 226

MyFinanceLab Study Plan 8.4

8.5 Evaluating Projects with Different Lives Q When choosing among projects with different lives, you need a standard basis of comparison. First compute an annuity with an equivalent present value to the NPV of each project. Then the projects can be compared on their cost or value created per year.

equivalent annual annuity (EAA), p. 233

MyFinanceLab Study Plan 8.5

8.6 Choosing Among Projects When Resources Are Limited Q When choosing among projects competing for the same resource, rank the projects by their profitability indices and pick the set of projects with the highest profitability indices that can still be undertaken given the limited resource. Value Created Profitability Index = Resource Consumed NPV = (8.4) Resource Consumed

profitability index (PI), p. 236

MyFinanceLab Study Plan 8.6

Critical Thinking

Interactive IRR Analysis Financial Calculator Tutorial: Solving for the Internal Rate of Return

1. What is the NPV rule? 2. How is the NPV rule related to the goal of maximizing shareholder wealth? 3. What is the intuition behind the payback rule? What are some of its drawbacks? 4. What is the intuition behind the IRR rule? What are some of its drawbacks?

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5. Under what conditions will the IRR rule and the NPV rule give the same accept/reject decision? 6. When is it possible to have multiple IRRs? 7. How does the MIRR solve the problem of multiple IRRs? 8. Why is it generally a bad idea to use IRR to choose between mutually exclusive projects? 9. When should you use the equivalent annual annuity? 10. What is the intuition behind the profitability index?

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. If a problem requires you to calculate IRR, you should use a spreadsheet or financial calculator. The NPV Decision Rule 1. You have an opportunity to invest $50,000 now in return for $60,000 in one year. If your cost of capital is 8%, what is the NPV of this investment? 2. You have an opportunity to invest $100,000 now in return for $80,000 in one year and $30,000 in two years. If your cost of capital is 9%, what is the NPV of this investment? 3. Your storage firm has been offered $100,000 in one year to store some goods for one year. Assume your costs are $95,000, payable immediately, and the cost of capital is 8%. Should you take the contract? 4. You run a construction firm. You have just won a contract to build a government office building. Building it will require an investment of $10 million today and $5 million in one year. The government will pay you $20 million in one year upon the building’s completion. Assume the cost of capital is 10%. a. What is the NPV of this opportunity? b. How can your firm turn this NPV into cash today? 5. You have been offered a unique investment opportunity. If you invest $10,000 today, you will receive $500 one year from now, $1500 two years from now, and $10,000 ten years from now. a. What is the NPV of the opportunity if the cost of capital is 6% per year? Should you take the opportunity? b. What is the NPV of the opportunity if the cost of capital is 2% per year? Should you take it now? 6. Marian Plunket owns her own business and is considering an investment. If she undertakes the investment, it will pay $4000 at the end of each of the next three years. The opportunity requires an initial investment of $1000 plus an additional investment at the end of the second year of $5000. What is the NPV of this opportunity if the cost of capital is 2% per year? Should Marian take it? Using the NPV Rule 7. Your factory has been offered a contract to produce a part for a new printer. The contract would last for three years and your cash flows from the contract would be $5 million per year. Your upfront setup costs to be ready to produce the part would

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Part 3 Valuation and the Firm be $8 million. Your cost of capital for this contract is 8%. a. What does the NPV rule say you should do? b. If you take the contract, what will be the change in the value of your firm? 8. You are considering opening a new plant. The plant will cost $100 million upfront and will take one year to build. After that, it is expected to produce profits of $30 million at the end of every year of production. The cash flows are expected to last forever. Calculate the NPV of this investment opportunity if your cost of capital is 8%. Should you make the investment? Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged. 9. Bill Clinton reportedly was paid $10 million to write his book My Life. The book took three years to write. In the time he spent writing, Clinton could have been paid to make speeches. Given his popularity, assume that he could earn $8 million per year (paid at the end of the year) speaking instead of writing. Assume his cost of capital is 10% per year. a. What is the NPV of agreeing to write the book (ignoring any royalty payments)? b. Assume that, once the book was finished, it was expected to generate royalties of $5 million in the first year (paid at the end of the year) and these royalties were expected to decrease at a rate of 30% per year in perpetuity. What is the NPV of the book with the royalty payments? *10. FastTrack Bikes, Inc., is thinking of developing a new composite road bike. Development will take six years and the cost is $200,000 per year. Once in production, the bike is expected to make $300,000 per year for ten years. The cash inflows begin at the end of year 7. Assuming the cost of capital is 10%: a. Calculate the NPV of this investment opportunity. Should the company make the investment? b. Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged. c. How long must development last to change the decision? Assuming the cost of capital is 14%: a. Calculate the NPV of this investment opportunity. Should the company make the investment? b. How much must this cost of capital estimate deviate to change the decision? c. How long must development last to change the decision? 11. OpenSeas, Inc., is evaluating the purchase of a new cruise ship. The ship would cost $500 million, but would operate for 20 years. OpenSeas expects annual cash flows from operating the ship to be $70 million and its cost of capital is 12%. a. Prepare an NPV profile of the purchase. b. Identify the IRR on the graph. c. Should OpenSeas go ahead with the purchase? d. How far off could OpenSeas’ cost of capital estimate be before your purchase decision would change? Alternative Decision Rules 12. You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The sign will cost $5000 and will be posted for one year. You expect that it will generate additional revenue of $500 per month. What is the payback period?

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13. Does the IRR rule agree with the NPV rule in Problem 7? 14. How many IRRs are there in part (a) of Problem 9? Does the IRR rule give the right answer in this case? 15. How many IRRs are there in part (b) of Problem 9? Does the IRR rule work in this case? 16. Professor Wendy Smith has been offered the following deal: A law firm would like to retain her for an upfront payment of $50,000. In return, for the next year the firm would have access to eight hours of her time every month. Smith’s rate is $550 per hour and her opportunity cost of capital is 15% per year. What does the IRR rule advise regarding this opportunity? What about the NPV rule? 17. Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The product is expected to generate profits of $1 million per year for ten years. The company will have to provide product support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year. a. What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount rates of 2% and 11%. b. How many IRRs does this investment opportunity have? c. What does the IRR rule indicate about this investment? 18. You own a coal mining company and are considering opening a new mine. The mine itself will cost $120 million to open. If this money is spent immediately, the mine will generate $20 million for the next ten years. After that, the coal will run out and the site must be cleaned and maintained at environmental standards. The cleaning and maintenance are expected to cost $2 million per year in perpetuity. What does the IRR rule say about whether you should accept this opportunity? If the cost of capital is 8%, what does the NPV rule say? 19. Your firm is considering a project that will cost $4.55 million upfront, generate cash flows of $3.5 million per year for three years, and then have a cleanup and shutdown cost of $6 million in the fourth year. a. How many IRRs does this project have? b. Calculate a modified IRR for this project discounting the outflows and leaving the inflows unchanged. Assume a discount and compounding rate of 10%. c. Using the MIRR and a cost of capital of 10%, would you take the project? 20. You have just been offered a contract worth $1 million per year for five years. However, to take the contract, you will need to purchase some new equipment. Your discount rate for this project is 12%. You are still negotiating the purchase price of the equipment. What is the most you can pay for the equipment and still have a positive NPV? *21. You are getting ready to start a new project that will incur some cleanup and shutdown costs when it is completed. The project costs $5.4 million upfront and is expected to generate $1.1 million per year for ten years and then have some shutdown costs in year 11. Use the MIRR approach to find the maximum shutdown costs you could incur and still meet your cost of capital of 15% on this project. *22. You are considering investing in a new gold mine in South Africa. Gold in South Africa is buried very deep, so the mine will require an initial investment of $250 million. Once this investment is made, the mine is expected to produce revenues of $30 million per year for the next 20 years. It will cost $10 million per year to operate

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Part 3 Valuation and the Firm the mine. After 20 years, the gold will be depleted. The mine must then be stabilized on an ongoing basis, which will cost $5 million per year in perpetuity. Calculate the IRR of this investment. (Hint: Plot the NPV as a function of the discount rate.) 23. You are considering making a movie. The movie is expected to cost $10 million upfront and take a year to make. After that, it is expected to make $5 million in the year it is released and $2 million for the following four years. What is the payback period of this investment? If you require a payback period of two years, will you make the movie? Does the movie have positive NPV if the cost of capital is 10%? Choosing Between Projects 24. You are choosing between two projects, but can only take one. The cash flows for the projects are given in the following table:

A

- +50

0

1 25

2 20

3 20

4 15

B

- +100

20

40

50

60

a. What are the IRRs of the two projects? b. If your discount rate is 5%, what are the NPVs of the two projects? c. Why do IRR and NPV rank the two projects differently? 25. You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment A will generate $2 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.5 million at the end of the first year and its revenues will grow at 2% per year for every year after that. a. Which investment has the higher IRR? b. Which investment has the higher NPV when the cost of capital is 7%? c. In this case, when does picking the higher IRR give the correct answer as to which investment is the better opportunity? 26. You are considering the following two projects and can only take one. Your cost of capital is 11%.

a. b. c. d.

0

1

2

3

4

A

-100

25

30

40

50

B

-100

50

40

30

20

What is the NPV of each project at your cost of capital? What is the IRR of each project? At what cost of capital are you indifferent between the two projects? What should you do?

27. You need a particular piece of equipment for your production process. An equipment-leasing company has offered to lease you the equipment for $10,000 per year if you sign a guaranteed five-year lease. The company would also maintain the equipment for you as part of the lease. Alternatively, you could buy and maintain the equipment yourself. The cash flows (in thousands) from doing so are listed below (the equipment has an economic life of five years). If your discount rate is 7%, what should you do? 0 -40

1 -2

2 -2

3 -2

4 -2

5 -2

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Evaluating Projects with Different Lives 28. Gateway Tours is choosing between two bus models. One is more expensive to purchase and maintain, but lasts much longer than the other. Its discount rate is 11%. It plans to continue with one of the two models for the foreseeable future; which one should it choose? Based on the costs of each model shown below, which should it choose? Model

0

Old Reliable Short and Sweet

1

2

3

4

5 p

7

-4 p

-4

-200

-4

-4

-4

-4

-100

-2

-2

-2

-2

29. Hassle-Free Web is bidding to provide Web-page hosting services for Hotel Lisbon. Hotel Lisbon pays its current provider $10,000 per year for hosting its Web page and handling transactions on it, etc. Hassle-Free figures that it will need to purchase equipment worth $15,000 upfront and then spend $2000 per year on monitoring, updates, and bandwidth to provide the service for three years. If Hassle-Free’s cost of capital is 10%, can it bid less than $10,000 per year to provide the service and still increase its value by doing so? Choosing Among Projects When Resources Are Limited 30. Fabulous Fabricators needs to decide how to allocate space in its production facility this year. It is considering the following contracts: NPV

Use of Facility

A B

$2 million $1 million

100% 60%

C

$1.5 million

40%

a. What are the profitability indexes of the projects? b. What should Fabulous Fabricators do? 31. Kartman Corporation is evaluating four real estate investments. Management plans to buy the properties today and sell them three years from today. The annual discount rate for these investments is 15%. The following table summarizes the initial cost and the sale price in three years for each property:

Parkside Acres Real Property Estates Lost Lake Properties Overlook

Cost Today

Sale Price in Year 3

$650,000

$1,150,000

800,000 650,000 150,000

1,400,000 1,050,000 350,000

Kartman has a total capital budget of $800,000 to invest in properties. Which properties should it choose? 32. Orchid Biotech Company is evaluating several development projects for experimental drugs. Although the cash flows are difficult to forecast, the company has come up with the following estimates of the initial capital requirements and NPVs for the projects. Given a wide variety of staffing needs, the company has also estimated the number of research scientists required for each development project (all cost values are given in millions of dollars).

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Initial Capital

Number of Research Scientists

I II III IV V

$10 15 15 20 30

2 3 4 3 12

NPV $10.1 19.0 22.0 25.0 60.2

a. Suppose that Orchid has a total capital budget of $60 million. How should it prioritize these projects? b. Suppose that Orchid currently has 12 research scientists and does not anticipate being able to hire any more in the near future. How should Orchid prioritize these projects?

Data Case

After the close of trading on May 6, 2009, Vanda Pharmaceuticals (VNDA) announced that the Food and Drug Administration had approved its drug, Fanapt, for the treatment of schizophrenia. Imagine that you were working as a stock analyst for a large investment firm and Vanda is one of the firms you track. On May 7, 2009, Vanda’s stock price increased substantially and your boss wants to you to issue a statement about the size of the cash flows necessary to support the stock price reaction. Therefore, she wants you to estimate the net cash flows the market had anticipated from sales of the new drug. She advises that you treat the value anticipated by the market as the NPV of selling the drug, then work backward from the NPV to determine the annual cash flows necessary to generate that value. Your boss advises that the best way to capture the value is to take the change in stock price from closing on May 6, 2009 to closing on May 7, 2009. You nod your head in agreement, trying to look like you understand how to proceed. You are relatively new to the job and the term NPV is somewhat familiar to you. 1. To determine the change in stock price over this period, go to Yahoo! Finance (http://finance.yahoo.com) and enter the stock symbol for Vanda (VNDA). Then click on “Historical Prices” and enter the appropriate dates. Use the adjusted closing prices for the two dates. 2. To determine the change in value, multiply the change in stock price by the number of shares outstanding. The number of shares outstanding around those dates can be found by going to the company’s investor relations Web site. Start at http://www.vandapharma.com and then click on “Investor Relations”. Next, select the “SEC Filings” link on the left side of the screen, and locate the 10-Q from May 11, 2009. The fastest way to do this is to select “Quarterly Filings” from the dropdown menu under Groupings Filter and then click “Search”. Next, click on the Excel symbol in the “5/11/09 10-Q” row and open the Excel spreadsheet. In the Balance Sheet tab, under the March 31, 2009 column, you will find the number of shares of Common Stock (in thousands) as of March 31, 2009. Because the change in value represents the “expected” NPV of the project, you will have to find the annual net cash flows that would provide this NPV. For this analysis, you will need to estimate the cost of capital for the project. We show how to calculate the cost of capital in subsequent chapters; for now, use the New York University (NYU) cost of capital Web site (http://pages.stern.nyu.edu/~adamodar/ New_Home_Page/datafile/wacc.htm). Locate the cost of capital in the far-right column for the “Biotechnology” industry. 3. Use the cost of capital from the NYU Web site and the NPV you computed to calculate the constant annual cash flow that provides this NPV. Compute cash flows for 5-, 10-, and 15-year horizons.

9

Fundamentals of Capital Budgeting

LEARNING OBJECTIVES Q Identify the types of cash flows needed in the capital budgeting process

Q Assess the sensitivity of a project’s NPV to changes in your assumptions

Q Forecast incremental earnings in a pro forma earnings statement for a project

Q Identify the most common options available to managers in projects and understand why these options can be valuable

Q Convert forecasted earnings to free cash flows and compute a project’s NPV Q Recognize common pitfalls that arise in identifying a project’s incremental free cash flows

notation

CapEx capital expenditures

NPV

net present value

EBIT

earnings before interest and taxes

NWCt

net working capital in year t

FCFt

free cash flow in year t

PV

present value

IRR

internal rate of return

r

projected cost of capital

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INTERVIEW WITH

Kelly Cox Boeing Corporation

After graduating from California State University, Long Beach in 2007 with a B.S. in business administration, finance, Kelly Cox joined Boeing Corporation’s Defense Systems division in Long Beach. As part of the Finance Business Skills Rotational program, she has worked in three areas of finance, most recently as a procurement financial analyst responsible for cost analysis of supplier’s proposals for C-17 and B-1 bomber aircraft projects. “My finance courses prepared me well for my assignments. My professors gave me a solid understanding of how and why to use a particular formula and also used real-world examples to enhance what they taught.” Boeing’s Long Beach site invests in developmental and modernization programs to enhance C-17 and B-1 bombers for the U.S. Air Force fleet, as well as production of the C-17 plane for both domestic and foreign customers. “Boeing uses cash flow analysis, NPV, and IRR calculations to evaluate proposed investments,” she explains. “We also conduct a sensitivity analysis on each project that applies different capital structures. Compiling accurate data for our cash flows requires coordination with engineers, project managers, and others,” Kelly says. “Often we estimate a project’s revenue and cost projections using comparables from similar projects and adjust cost projections based on the project’s greater or lesser complexity.” Boeing sets hurdle rates for investment projects based on its cost of capital, which has a return on capital built in. In addition to an organization-wide rate, the company also sets project-specific hurdle rates that take into account business unit differences. Risk is another key factor in Boeing’s investment analyses. “We look at risk throughout the life of the programs. Our project managers identify potential risks, such as schedule or cost overruns, and use a proprietary risk analysis tool to develop a high, likely, and low dollar value. The program usually maintains additional budget for such contingencies, which have a direct affect on profit. If the risk is realized, then additional budget is added to cover that risk.”

An important responsibility of corporate financial managers is determining which projects or investments a firm should undertake. Capital budgeting, the focus of this chapter, is the process of analyzing investment opportunities and deciding which ones to accept. In doing so, we are allocating the firm’s funds to various projects—we are budgeting its capital. Chapter 8 covered the various methods for evaluating projects and proved that NPV will be the most reliable and accurate method for doing so. In retrospect, this may not be surprising as it is the only rule directly tied to the Valuation Principle. To implement the NPV rule, we must compute the NPV of our projects and accept only those projects for which the NPV is positive. We spoke in the last chapter about Sony and Toshiba each using investment decision rules to pursue competing high-definition DVD standards (and eventually for Toshiba, to decide to abandon HD-DVD). In order to implement the investment decision rules, financial managers from Toshiba, for example, had to first forecast the incremental cash flows associated with the investments and later to forecast the incremental cash flows associated with the decision to stop investing in HDDVD. The process of forecasting those cash flows, crucial inputs in the investment decision process, is our focus in this chapter.

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California State University, Long Beach, 2007

“Boeing uses cash flow analysis, NPV, and IRR calculations to evalute proposed investments.”

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We begin by estimating the project’s expected cash flows by forecasting the project’s revenues and costs. Using these cash flows, we can compute the project’s NPV—its contribution to shareholder value. Then, because the cash flow forecasts almost always contain uncertainty, we demonstrate how to compute the sensitivity of the NPV to the uncertainty in the forecasts. Finally, we examine the relationship between a project’s flexibility and its NPV.

9.1 capital budget Lists all of the projects that a company plans to undertake during the next period. capital budgeting The process of analyzing investment opportunities and deciding which ones to accept.

FIGURE 9.1 Cash Flows in a Typical Project

The Capital Budgeting Process The first step in analyzing various investment opportunities is compiling a list of potential projects. A capital budget lists the projects and investments that a company plans to undertake during future years. To create this list, firms analyze alternate projects and decide which ones to accept through a process called capital budgeting. This process begins with forecasts of each project’s future consequences for the firm. Some of these consequences will affect the firm’s revenues; others will affect its costs. Our ultimate goal is to determine the effect of the decision to accept or reject a project on the firm’s cash flows, and evaluate the NPV of these cash flows to assess the consequences of the decision for the firm’s value. Figure 9.1 depicts the types of cash flows found in a typical project. We will examine each of these as we proceed through our discussion of capital budgeting. Of course, forecasting these cash flows is frequently challenging. We will often need to rely on different experts within the firm to obtain estimates for many of them. For example, the marketing department may provide sales forecasts, the operations manager may provide information about production costs, and the firm’s engineers may estimate the upfront research and development expenses that are required to launch the project. Another important source of information comes from looking at past projects of the firm, or those of other firms in the same industry. In particular, practitioners often base their assessments of a project’s revenues and costs using information on revenues and costs that can be learned from the historical financial statements of the firm or its competitors. Once we have these estimates, how do we organize them? One common starting point is first to consider the consequences of the project for the firm’s earnings. Thus, we

The diagram shows some typical cash flows in project analysis and their timing.

Initial Outlay

On-Going Cash Flows

Terminal Cash Flows

Purchase Equipment

Incremental Revenues

Sale of Equipment (Net of any taxes)

Initial Development Costs

Incremental Costs

Shut-Down Costs

Taxes Increase in Net Working Capital (Increase inventories, raw materials, etc.)

Change in Net Working Capital (Change in inventories, raw materials, accounts receivable and payable)

Decrease in Net Working Capital (Decrease inventories, raw materials, etc.)

250

Part 3 Valuation and the Firm

incremental earnings The amount by which a firm’s earnings are expected to change as a result of an investment decision.

Concept Check

9.2

will begin our analysis in Section 9.2 by determining the incremental earnings of a project—that is, the amount by which the firm’s earnings are expected to change as a result of the investment decision. The incremental earnings forecast tells us how the decision will affect the firm’s reported profits from an accounting perspective. However, as we emphasized in Chapter 2, earnings are not actual cash flows. We need to estimate the project’s cash flows to determine its NPV and decide whether it is a good project for the firm. Therefore, in Section 9.3, we demonstrate how to use the incremental earnings to forecast the actual cash flows of the project. Understanding how to compute the cash flow consequences of an investment based on its earning consequences is important for a number of reasons. First, as a practical matter, financial managers often begin by forecasting earnings. Second, if we are looking at historical data, accounting information is often the only information that is readily available. 1. What is capital budgeting, and what is its goal? 2. Why is computing a project’s effect on the firm’s earnings insufficient for capital budgeting?

Forecasting Incremental Earnings Let’s begin our discussion of incremental earnings with a simple example that we will examine throughout this section. Suppose you are considering whether to upgrade your manufacturing plant to increase its capacity by purchasing a new piece of equipment. The equipment costs $1 million, plus an additional $20,000 to transport it and install it. You will also spend $50,000 on engineering costs to redesign the plant to accommodate the increased capacity. What are the initial earnings consequences of this decision?

Operating Expenses Versus Capital Expenditures

straight-line depreciation A method of depreciation in which an asset’s cost is divided equally over its life.

Most projects require some form of upfront investment—we may need to conduct a marketing survey, develop a prototype, or launch an ad campaign. These types of costs are accounted for as operating expenses in the year that they are incurred. However, many projects also include investments in plant, property, and/or equipment, called capital expenditures. Recall from Chapter 2 that while investments in plant, property, and equipment are a cash expense, they are not directly listed as expenses when calculating earnings. Instead, the firm deducts a fraction of the cost of these items each year as depreciation. Financial managers use several different methods to compute depreciation. The simplest method is straight-line depreciation, in which the asset’s cost is divided equally over its depreciable life (we discuss another common method in Section 9.4). In our example, the upfront costs associated with the decision to increase capacity have two distinct consequences for the firm’s earnings. First, the $50,000 spent on redesigning the plant is an operating expense reported in year 0. For the $1,020,000 spent to buy, ship, and install the machine, accounting principles as well as tax rules require you to depreciate the $1,020,000 over the depreciable life of the equipment. Assuming that the equipment has a five-year depreciable life and that we use the straight-line method, we would expense +1,020,000/5 = +204,000 per year for five years. (The motivation for this accounting treatment is to match the cost of acquiring the machine to the timing of the revenues it will generate.) 1 Year 2 Operating Expenses (Plant Redesign) 3 Depreciation (New Equipment)

0 $50,000

1

2

3

4

5

$204,000 $204,000 $204,000 $204,000 $204,000

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As the timeline shows, the upfront cash outflow of $1,020,000 to purchase and set up the machine is not recognized as an expense in year 0. Instead, it appears as depreciation expenses in years 1 through 5. Remember that these depreciation expenses do not correspond to actual cash outflows. This accounting and tax treatment of capital expenditures is one of the key reasons why earnings are not an accurate representation of cash flows. We will return to this issue in Section 9.3.1

Incremental Revenue and Cost Estimates Our next step is to estimate the ongoing revenues and costs for the project. Forecasting future revenues and costs is challenging. The most successful practitioners collect as much information as possible before tackling this task—they will talk to members of marketing and sales teams as well as company economists to develop an estimate of sales, and they will talk to engineering and production teams to refine their estimate of costs. There are several factors to consider when estimating a project’s revenues and costs, including the following: 1. A new product typically has lower sales initially, as customers gradually become aware of the product. Sales will then accelerate, plateau, and ultimately decline as the product nears obsolescence or faces increased competition. 2. The average selling price of a product and its cost of production will generally change over time. Prices and costs tend to rise with the general level of inflation in the economy. The prices of technology products, however, often fall over time as newer, superior technologies emerge and production costs decline. 3. For most industries, competition tends to reduce profit margins over time. Our focus here is on how to get from these forecasts to incremental earnings and then to cash flows; Chapter 18 discusses forecasting methods in more detail. All our revenue and cost estimates should be incremental, meaning that we only account for additional sales and costs generated by the project. For example, if we are evaluating the purchase of a faster manufacturing machine, we are only concerned with how many additional units of the product we will be able to sell (and at what price) and any additional costs created by the new machine. We do not forecast total sales and costs because those include our production using the old machine. Remember, we are evaluating how the project will change the cash flows of the firm. That is why we focus on incremental revenues and costs. Let’s return to our plant upgrade example. Assume that after we have bought and installed the machine and redesigned the plant, our additional capacity will allow us to generate incremental revenues of $500,000 per year for five years. Those incremental revenues will be associated with $150,000 per year in incremental costs. In that case our revenue, cost, and depreciation estimates for the project are as shown below (in thousands of dollars): 1 2 3 4

1

Year Incremental Revenues Incremental Costs Depreciation

0 50

1 500 150 204

2 500 150 204

3 500 150 204

4 500 150 204

5 500 150 204

Some students might note that for financial reporting, the asset should be depreciated to salvage value. For tax purposes, salvage value is always treated as zero, so this is the relevant method for capital budgeting.

252

Part 3 Valuation and the Firm Now that we have these estimates, we are ready to compute the consequences of our project for the firm’s earnings. As we saw in Chapter 2, both depreciation expenses and the actual costs of producing (e.g., cost of goods sold) must be subtracted from revenues, so that: Incremental Earnings Before Interest and Taxes 1 EBIT 2 = Incremental Revenue -Incremental Costs - Depreciation (9.1)

Taxes marginal corporate tax rate The tax rate a firm will pay on an incremental dollar of pre-tax income.

The final expense we must account for is corporate taxes. The correct tax rate to use is the firm’s marginal corporate tax rate, which is the tax rate it will pay on an incremental dollar of pre-tax income. The incremental income tax expense is calculated as: Income Tax = EBIT * The Firm>s Marginal Corporate Tax Rate

(9.2)

Incremental Earnings Forecast We’re now ready to put the pieces together for an incremental earnings forecast. Assume our firm faces a marginal tax rate of 40% and that the firm as a whole has at least $50,000 in profits in year 0 for the incremental costs in that year to offset. Then the incremental earnings (or net income) are as follows (in thousands of dollars):2 1 2 3 4 5 6 7

Year Incremental Revenues Incremental Costs Depreciation EBIT Income Tax at 40% Incremental Earnings

0 50 50 20 30

1 2 3 4 5 500 500 500 500 500 150 150 150 150 150 204 204 204 204 204 146 146 146 146 146 58.4 58.4 58.4 58.4 58.4 87.6 87.6 87.6 87.6 87.6

We can also combine Eq. 9.1 and Eq. 9.2 to compute incremental earnings directly. For example, in years 1 through 5 we have: Incremental Earnings = 1 Incremental Revenues - Incremental Cost -Depreciation 2 * 1 1 - Tax Rate 2 Incremental Earnings = 1 500,000 - 150,000 - 204,000 2 * 1 1 - 0.4 2 = 87,600

EXAMPLE 9.1

(9.3)

Problem

Incremental Earnings

Suppose that Linksys is considering the development of a wireless home networking appliance, called HomeNet, that will provide both the hardware and the software necessary to run an entire home from any Internet connection. In addition to connecting PCs and printers, HomeNet will control new Internet-capable stereos, digital video recorders, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on. The major competitor for HomeNet is a product being developed by Brandt-Quigley Corporation. Based on extensive marketing surveys, the sales forecast for HomeNet is 50,000 units per year. Given the pace of technological change, Linksys expects the product will have a four-year life and an expected 2

While revenues and costs occur throughout the year, the standard convention, which we adopt here, is to list revenues and costs in the year in which they occur. Thus, cash flows that occur at the end of one year will be listed in a different column than those that occur at the start of the next year, even though they may occur only weeks apart. When additional precision is required, cash flows are often estimated on a quarterly or monthly basis.

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wholesale price of $260 (the price Linksys will receive from stores). Actual production will be outsourced at a cost (including packaging) of $110 per unit. To verify the compatibility of new consumer Internet-ready appliances, as they become available, with the HomeNet system, Linksys must also establish a new lab for testing purposes. It will rent the lab space, but will need to purchase $7.5 million of new equipment. The equipment will be depreciated using the straight-line method over a five-year life. Linksys’ marginal tax rate is 40%. The lab will be operational at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to spend $2.8 million per year on rental costs for the lab space, as well as marketing and support for this product. Forecast the incremental earnings from the HomeNet project.

Solution Q Plan We need four items to calculate incremental earnings: (1) incremental revenues, (2) incremental costs, (3) depreciation, and (4) the marginal tax rate: Incremental revenues are: Additional units sold * price = 50,000 * +260 = +13,000,000 Incremental costs are:

Additional units sold * production costs = 50,000 * +110 = +5,500,000 Selling, general, and administrative = +2,800,000 for rent, marketing, and support

Depreciation is:

Depreciable basis/Depreciable life = +7,500,000/5 = +1,500,000

Marginal tax rate:

40%

Note that even though the project lasts for four years, the equipment has a five-year life, so we must account for the final depreciation charge in the fifth year. Q Execute (in $000s) 1 2 3 4 5 6 7 8 9

Year Revenues Cost of Goods Sold Gross Profit Selling, General, and Administrative Depreciation EBIT Income Tax at 40% Incremental Earnings

0

1 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920

2 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920

3 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920

4 5 – 13,000 – 5,500 – 7,500 – 2,800 1,500 1,500 3,200 1,500 600 1,280 1,920 900

Q Evaluate These incremental earnings are an intermediate step on the way to calculating the incremental cash flows that would form the basis of any analysis of the HomeNet project. The cost of the equipment does not affect earnings in the year it is purchased, but does so through the depreciation expense in the following five years. Note that the depreciable life, which is based on accounting rules, does not have to be the same as the economic life of the asset—the period over which it will have value. Here, the firm will use the equipment for four years, but will depreciate it over five years.

pro forma Describes a statement that is not based on actual data but rather depicts a firm’s financials under a given set of hypothetical assumptions.

Pro Forma Statement. The table calculating incremental earnings that we produced for our plant upgrade, and again in Example 9.1, is often referred to as a pro forma statement, because it is not based on actual data but rather depicts the firm’s financials under a given set of hypothetical assumptions. In the HomeNet example, the firm’s forecasts of revenues and costs were assumptions that allowed Linksys to forecast incremental earnings in a pro forma statement. Taxes and Negative EBIT. Notice that in year 0 of our plant upgrade project, and in year 5 of the HomeNet example, EBIT is negative. Why are taxes relevant in this case? Consider the HomeNet example. HomeNet will reduce Linksys’s taxable income in year 5 by $1.5

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Part 3 Valuation and the Firm million. As long as Linksys earns taxable income elsewhere in year 5 against which it can offset HomeNet’s losses, Linksys will owe +1.5 million * 40% = +600,000 less in taxes in year 5 than if it were not undertaking the project. Because the tax savings come from the depreciation expense on equipment for the HomeNet project, the firm should credit this tax savings to the HomeNet project.

EXAMPLE 9.2 Taxing Losses for Projects in Profitable Companies

Problem Kellogg Company plans to launch a new line of high-fiber, zero-trans-fat breakfast pastries. The heavy advertising expenses associated with the new product launch will generate operating losses of $15 million next year for the product. Kellogg expects to earn pre-tax income of $460 million from operations other than the new pastries next year. If Kellogg pays a 40% tax rate on its pre-tax income, what will it owe in taxes next year without the new pastry product? What will it owe with the new product?

Solution Q Plan We need Kellogg’s pre-tax income with and without the new product losses and its tax rate of 40%. We can then compute the tax without the losses and compare it to the tax with the losses. Q Execute Without the new product, Kellogg will owe +460 million * 40% = +184 million in corporate taxes next year. With the new product, Kellogg’s pre-tax income next year will be only $460 million - $15 million = $445 million, and it will owe +445 million * 40% = +178 million in tax. Q Evaluate Thus, launching the new product reduces Kellogg’s taxes next year by $184 million - $178 million = $6 million. Because the losses on the new product reduce Kellogg’s taxable income dollar for dollar, it is the same as if the new product had a tax bill of negative $6 million.

unlevered net income Net income that does not include interest expenses associated with debt.

Concept Check

What About Interest Expenses? In Chapter 2, we saw that to compute a firm’s net income, we must first deduct interest expenses from EBIT. When evaluating a capital budgeting decision, however, we generally do not include interest expenses. Any incremental interest expenses will be related to the firm’s decision regarding how to finance the project, which is a separate decision. Here, we wish to evaluate the earnings contributions from the project on its own, separate from the financing decision. Ultimately, managers may also look at the additional earnings consequences associated with different methods of financing the project. Thus, we evaluate a project as if the company will not use any debt to finance it (whether or not that is actually the case), and we postpone the consideration of alternative financing choices until Parts 5 and 6 of this book. Because we calculate the net income assuming no debt (no leverage), we refer to the net income we compute using Eq. 9.3, as in the pro forma in Example 9.1, as the unlevered net income of the project, to indicate that it does not include any interest expenses associated with debt. 3. How are operating expenses and capital expenditures treated differently when calculating incremental earnings? 4. Why do we focus only on incremental revenues and costs, rather than all revenues and costs of the firm?

9.3

Determining Incremental Free Cash Flow As discussed in Chapter 2, earnings are an accounting measure of the firm’s performance. They do not represent real profits: The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay dividends to shareholders. To do those things,

Chapter 9 Fundamentals of Capital Budgeting free cash flow The incremental effect of a project on a firm’s available cash.

255

the firm needs cash. Thus, to evaluate a capital budgeting decision, we must determine its consequences for the firm’s available cash. The incremental effect of a project on the firm’s available cash is the project’s incremental free cash flow.

Converting from Earnings to Free Cash Flow As discussed in Chapter 2, there are important differences between earnings and cash flow. Earnings include non-cash charges, such as depreciation, but do not include expenditures on capital investment. To determine a project’s free cash flow from its incremental earnings, we must adjust for these differences. Capital Expenditures and Depreciation. As we have noted, depreciation is not a cash expense that is paid by the firm. Rather, it is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life. Because depreciation is not a cash flow, we do not include it in the cash flow forecast. However, that does not mean we can ignore depreciation. The depreciation expense reduces our taxable earnings and in doing so reduces our taxes. Taxes are cash flows, so because depreciation affects our cash flows, it still matters. Our approach for handling depreciation is to add it back to the incremental earnings to recognize the fact that we still have the cash flow associated with it. For example, a project has incremental gross profit (revenues minus costs) of $1 million and a $200,000 depreciation expense. If the firm’s tax rate is 40%, then the incremental earnings will be 1 +1,000,000 - +200,000 2 * 1 1 - 0.40 2 = +480,000. However, the firm will still have $680,000 because the $200,000 depreciation expense is not an actual cash outflow. Table 9.1 shows the calculation to get the incremental free cash flow in this case. Blue boxes indicate all of the actual cash flows in the column labeled “Correct.” A good way to check to make sure the incremental free cash flow is correct is to sum the actual cash flows. In this case, the firm generated $1,000,000 in gross profit (a positive cash flow), paid $320,000 in taxes (a negative cash flow), and was left with +1,000,000 - +320,000 = +680,000, which is the amount shown as the incremental free cash flow. In the last column, labeled “Incorrect,” we show what would happen if you just ignored depreciation altogether. Because EBIT would be too high, the taxes would be too high as well and consequently, the incremental free cash flow would be too low. (Note that the difference of $80,000 between the two cases is entirely due to the difference in tax payments.)

TABLE 9.1 Deducting and Then Adding Back Depreciation

EXAMPLE 9.3 Incremental Free Cash Flows

Incremental Gross Profit Depreciation EBIT Tax at 40% Incremental Earnings Add Back depreciation Incremental Free Cash Flow

Correct

Incorrect

$1,000,000 -200,000 $800,000 - +320,000 $480,000 $200,000 $680,000

$1,000,000 $1,000,000 - +400,000 $600,000 $600,000

Problem Let’s return to the HomeNet example. In Example 9.1, we computed the incremental earnings for HomeNet, but we need the incremental free cash flows to decide whether Linksys should proceed with the project.

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Part 3 Valuation and the Firm Solution Q Plan The difference between the incremental earnings and incremental free cash flows in the HomeNet example will be driven by the equipment purchased for the lab. We need to recognize the $7.5 million cash outflow associated with the purchase in year 0 and add back the $1.5 million depreciation expenses from year 1 to 5 as they are not actually cash outflows. Q Execute (in $000s) We recognize the outflow for the equipment in row 11 and we add back the depreciation expenses in row 10. 1 2 3 4 5 6 7 8 9 10 11 12

Year 0 Revenues Cost of Goods Sold Gross Profit Selling, General, and Administrative Depreciation EBIT Income Tax at 40% Incremental Earnings Add Back Depreciation Purchase of Equipment 7,500 Incremental Free Cash Flows 7,500

1 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

2 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

3 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

3,420

3,420

3,420

4 5 13,000 – 5,500 – 7,500 – 2,800 – 1,500 1,500 3,200 1,500 1,280 600 1,920 900 1,500 1,500 3,420

600

Q Evaluate By recognizing the outflow from purchasing the equipment in year 0, we account for the fact that $7.5 million left the firm at that time. By adding back the $1.5 million depreciation expenses in years 1–5, we adjust the incremental earnings to reflect the fact that the depreciation expense is not a cash outflow.

Net Working Capital (NWC). Another way that incremental earnings and free cash flows can differ is if there are changes in net working capital. We defined net working capital in Chapter 2 as the difference between current assets and current liabilities. The main components of net working capital are cash, inventory, receivables, and payables: Net Working Capital = Current Assets - Current Liabilities = Cash + Inventory + Receivables - Payables

trade credit The difference between receivables and payables that is the net amount of a firm’s capital consumed as a result of those credit transactions; the credit that a firm extends to its customers.

(9.4)

Note that as discussed in Chapter 2, we do not include short-term financing such as notes payable or short-term debt because those represent financing decisions that we keep separate from our investment decisions. Most projects will require the firm to invest in net working capital. Firms may need to maintain a minimum cash balance3 to meet unexpected expenditures, and inventories of raw materials and finished product to accommodate production uncertainties and demand fluctuations. Also, customers may not pay for the goods they purchase immediately. While sales are immediately counted as part of earnings, the firm does not receive any cash until the customers actually pay. In the interim, the firm includes the amount that customers owe in its receivables. Thus, the firm’s receivables measure the total credit that the firm has extended to its customers. In the same way, payables measure the credit the firm has received from its suppliers. The difference between receivables and payables is the net amount of the firm’s capital that is consumed as a result of these credit transactions, known as trade credit. We care about net working capital because it reflects a short-term investment that ties up cash flow that could be used elsewhere. For example, when a firm holds a lot of 3

The cash included in net working capital is cash that is not invested to earn a market rate of return. It includes cash held in the firm’s checking account, in a company safe or cash box, in cash registers (for retail stores), and other sites.

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unsold inventory or has a lot of outstanding receivables, cash flow is tied up in the form of inventory or in the form of credit extended to customers. It is costly for the firm to tie up that cash flow because it delays the time until the cash flow is available for reinvestment or distribution to shareholders. Since we know that money has time value, we cannot ignore this delay in our forecasts for the project. Thus, whenever net working capital increases, reflecting additional investment in working capital, it represents a reduction in cash flow that year. It is important to note that only changes in net working capital impact cash flows. For example, consider a three-year project that causes the firm to build up initial inventory by $20,000 and maintain that level of inventory in years 1 and 2, before drawing it down as the project ends and the last product is sold. It is often necessary for the initial increase in inventory to occur prior to the first sale so that the higher level of inventory would be achieved by the end of year 0. The level of the incremental net working capital in each year, the associated change in net working capital and the cash flow implications, would be: 1 2 3 4

Year Level of Incremental NWC Change in Incremental NWC Cash Flow from Change in NWC

0 20,000 20,000 20,000

1 20,000 0 0

3

2 20,000 0 0

0 20,000 20,000

Note that the cash flow effect from a change in net working capital is always equal and opposite in sign to the change in net working capital. For example, an increase in inventory represents an investment or cash outflow, while a reduction in that inventory frees up that investment of capital and represents a cash inflow. Thus in capital budgeting we subtract changes in net working capital to arrive at the cash flows. Also notice that since the level of incremental net working capital did not change in years 1 and 2, there was no new cash flow effect. Intuitively, as the firm is using up inventory and replenishing it, the net new investment in inventory is zero, so no additional cash outflow is required. Finally, note that over the life of the project, the incremental net working capital returns to zero so that the changes 1 +20,000 in year 0 and -20,000 in year 3 2 sum to zero. Accounting principles ensure this by requiring the recapture of working capital over the life of the project. More generally, we define the change in net working capital in year t as: Change in NWC in Year t = NWCt - NWCt - 1

(9.5)

When a project causes a change in NWC, that change must be subtracted from incremental earnings to arrive at incremental free cash flows.

EXAMPLE 9.4 Incorporating Changes in Net Working Capital

Problem Suppose that HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to customers). However, receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold (COGS). Fifteen percent of $13 million in sales is $1.95 million and 15% of $5.5 million in COGS is $825,000. HomeNet’s net working capital requirements are shown in the following table: 1 2 3 4 5 6 7

Year Net Working Capital Forecast ($000s) Cash Requirements Inventory Receivables (15% of Sales) Payables (15% of COGS) Net Working Capital

0

1

0 0 0 0 0

How does this requirement affect the project’s free cash flow?

2

3

4

5 0 0 0 0 0

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Part 3 Valuation and the Firm Solution Q Plan Any increases in net working capital represent an investment that reduces the cash available to the firm and so reduces free cash flow. We can use our forecast of HomeNet’s net working capital requirements to complete our estimate of HomeNet’s free cash flow. In year 1, net working capital increases by $1.125 million. This increase represents a cost to the firm. This reduction of free cash flow corresponds to the fact that in year 1, $1.950 million of the firm’s sales and $0.825 million of its costs have not yet been paid. In years 2–4, net working capital does not change, so no further contributions are needed. In year 5, when the project is shut down, net working capital falls by $1.125 million as the payments of the last customers are received and the final bills are paid. We add this $1.125 million to free cash flow in year 5. Q Execute (in $000s) 1 2 3 4

Year Net Working Capital Change in NWC Cash Flow Effect

0 0

3 1,125 0 0

5 4 0 1,125 0 1,125 0 1,125

2 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

3 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

4 5 13,000 0 5,500 0 7,500 0 2,800 0 1,500 1,500 3,200 1,500 1,280 600 1,920 900 1,500 1,500

0 3,420

0 3,420

1 2 1,125 1,125 1,125 0 1,125 0

The incremental free cash flows would then be: 1 2 3 4 5 6 7 8 9 10 11 12 13

Year 0 1 Revenues 13,000 Costs of Goods Sold 5,500 Gross Profit 7,500 Selling, General, and Administrative 2,800 Depreciation 1,500 EBIT 3,200 Income Tax at 40% 1,280 Incremental Earnings 1,920 Add Back Depreciation 1,500 Purchase of Equipment 7,500 Subtract Changes in NWC 1,125 Incremental Free Cash Flows 7,500 2,295

0 3,420

1,125 1,725

Q Evaluate The free cash flows differ from unlevered net income by reflecting the cash flow effects of capital expenditures on equipment, depreciation, and changes in net working capital. Note that in the first year, free cash flow is lower than unlevered net income, reflecting the upfront investment in equipment. In later years, free cash flow exceeds unlevered net income because depreciation is not a cash expense. In the last year, the firm ultimately recovers the investment in net working capital, further boosting the free cash flow.

Calculating Free Cash Flow Directly As we noted at the outset of this chapter, because practitioners usually begin the capital budgeting process by first forecasting earnings, we have chosen to do the same. However, we can calculate a project’s free cash flow directly by using the following shorthand formula: Free Cash Flow Unlevered Net Income

$'''''''''''%'''''''''''& Free Cash Flow = 1 Revenues - Costs - Depreciation 2 * 1 1 - Tax Rate 2 + Depreciation - CapEx - Change in NWC

(9.6)

Note that we first deduct depreciation when computing the project’s incremental earnings and then add it back (because it is a non-cash expense) when computing free cash

Chapter 9 Fundamentals of Capital Budgeting

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flow. Thus, the only effect of depreciation is to reduce the firm’s taxable income. Indeed, we can rewrite Eq. 9.6 as: Free Cash Flow = 1 Revenues - Costs 2 * 1 1 - Tax Rate 2 - CapEx - Change in NWC + Tax Rate * Depreciation

depreciation tax shield The tax savings that result from the ability to deduct depreciation.

(9.7)

The last term in Eq. 9.7, Tax Rate * Depreciation, is called the depreciation tax shield, which is the tax savings that results from the ability to deduct depreciation. As a consequence, depreciation expenses have a positive impact on free cash flow. Returning to our example in Table 9.1, if the firm ignored depreciation, its taxes were $400,000 instead of $320,000, leaving it with incremental free cash flow of $600,000 instead of $680,000. Notice that the $80,000 difference is exactly equal to the tax rate (40%) multiplied by the depreciation expense ($200,000). Every dollar of depreciation expense saves the firm 40 cents in taxes, so the $200,000 depreciation expense translates into an $80,000 tax savings. Firms often report a different depreciation expense for accounting and for tax purposes. Because only the tax consequences of depreciation are relevant for free cash flow, we should use the depreciation expense that the firm will use for tax purposes in our forecast. For tax purposes, many firms use a system called Modified Accelerated Cost Recovery System, which we discuss in the next section.

Calculating the NPV The goal of forecasting the incremental free cash flows is to have the necessary inputs to calculate the project’s NPV. To compute a project’s NPV, we must discount its free cash flow at the appropriate cost of capital. As discussed in Chapter 5, the cost of capital for a project is the expected return that investors could earn on their best alternative investment with similar risk and maturity. We will develop the techniques needed to estimate the cost of capital in Part 4 of the text, when we discuss risk and return. For now, we take the cost of capital as given. We compute the present value of each free cash flow in the future by discounting it at the project’s cost of capital. As explained in Chapter 3, using r to represent the cost of capital, the present value of the free cash flow in year t (or FCFt) is: PV 1 FCFt 2 =

FCFt = FCFt * 11 + r2t

1 11 + r2t ('')''*

(9.8)

[email protected] discount factor

EXAMPLE 9.5 Calculating the Project’s NPV

Problem Assume that Linksys’s managers believe that the HomeNet project has risks similar to its existing projects, for which it has a cost of capital of 12%. Compute the NPV of the HomeNet project.

Solution Q Plan From Example 9.4, the incremental free cash flows for the HomeNet project are (in $000s): 1 Year 2 Incremental Free Cash Flows

0 1 7,500 2,295

2 3,420

3 3,420

4 3,420

5 1,725

To compute the NPV, we sum the present values of all of the cash flows, noting that the year 0 cash outflow is already a present value. Q Execute Using Eq. 9.8, NPV = -7500 +

3420 3420 3420 1725 2295 + + + + = 2862 1 2 3 4 1 1.12 2 1 1.12 2 1 1.12 2 1 1.12 2 1 1.12 2 5

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Part 3 Valuation and the Firm

Q Evaluate Based on our estimates, HomeNet’s NPV is $2.862 million. While HomeNet’s upfront cost is $7.5 million, the present value of the additional free cash flow that Linksys will receive from the project is $10.362 million. Thus, taking the HomeNet project is equivalent to Linksys having an extra $2.862 million in the bank today.

Concept Check

5. If depreciation expense is not a cash flow, why do we have to subtract it and add it back? Why not just ignore it? 6. Why does an increase in net working capital represent a cash outflow?

9.4

Other Effects on Incremental Free Cash Flows When computing the incremental free cash flows of an investment decision, we should include all changes between the firm’s free cash flows with the project versus without the project. These include opportunities forgone due to the project and effects of the project on other parts of the firm. In this section, we discuss these other effects, some of the pitfalls and common mistakes to avoid, and the complications that can arise when forecasting incremental free cash flows.

Opportunity Costs

opportunity cost The value a resource could have provided in its best alternative use.

Many projects use a resource that the company already owns. Because the firm does not need to pay cash to acquire this resource for a new project, it is tempting to assume that the resource is available for free. However, in many cases the resource could provide value for the firm in another opportunity or project. The opportunity cost of using a resource is the value it could have provided in its best alternative use.4 Because this value is lost when the resource is used by another project, we should include the opportunity cost as an incremental cost of the project. For example, your company may be considering building a retail store on some land that it owns. Even though it already owns the land, it is not free to the store project. If it did not put its store on the land, the company could sell the land, for example. This forgone market price for the land is an opportunity cost of the retail store project.

COMMON MISTAKE

The Opportunity Cost of an Idle Asset

A common mistake is to conclude that if an asset is currently idle, its opportunity cost is zero. For example, the firm might have a warehouse that is currently empty or a machine that is not being used. Often, the asset may have been idled in anticipation of taking on the new project, and

project externalities Indirect effects of a project that may increase or decrease the profits of other business activities of a firm.

would have otherwise been put to use by the firm. Even if the firm has no alternative use for the asset, the firm could choose to sell or rent the asset. The value obtained from the asset’s alternative use, sale, or rental represents an opportunity cost that must be included as part of the incremental cash flows.

Project Externalities Project externalities are indirect effects of a project that may increase or decrease the profits of other business activities of the firm. For instance, some purchasers of Apple’s iPhone would otherwise have bought Apple’s iPod Nano. When sales of a new product

4

In Chapter 5, we defined the opportunity cost of capital as the rate you could earn on an alternative investment with equivalent risk. We similarly define the opportunity cost of using an existing asset in a project as the cash flow generated by the next-best alternative use for the asset.

Chapter 9 Fundamentals of Capital Budgeting cannibalization When sales of a firm’s new product displace sales of one of its existing products.

261

displace sales of an existing product, the situation is often referred to as cannibalization. The lost sales of the existing project are an incremental cost to the company of going forward with the new product.

Sunk Costs sunk cost Any unrecoverable cost for which a firm is already liable.

A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs have been or will be paid regardless of the decision whether or not to proceed with the project. Therefore, they are not incremental with respect to the current decision and should not be included in its analysis. You may hire a market research firm to do market analysis to determine whether there is demand for a new product you are considering and the analysis may show that there is not enough demand, so you decide not to go forward with the project. Does that mean you do not have to pay the research firm’s bill? Of course you still have to pay the bill, emphasizing that the cost was sunk and incurred whether you went forward with the project or not. A good rule to remember is that if your decision does not affect a cash flow, then the cash flow should not affect your decision. If the cash flow is the same regardless of the decision, then it is not relevant to your decision. The following are some common examples of sunk costs you may encounter.

overhead expenses Those expenses associated with activities that are not directly attributable to a single business activity but instead affect many different areas of a corporation.

Fixed Overhead Expenses. Overhead expenses are associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation. Examples include the cost of maintaining the company’s headquarters and the salary of the CEO. These expenses are often allocated to the different business activities for accounting purposes. To the extent that these overhead costs are fixed and will be incurred in any case, they are not incremental to the project and should not be included. Only include as incremental expenses the additional overhead expenses that arise because of the decision to take on the project.

COMMON MISTAKE

The Sunk Cost Fallacy

Being influenced by sunk costs is such a widespread mistake that it has a special name: sunk cost fallacy. The most common problem is that people “throw good money after bad.” That is, people sometimes continue to invest in a project that has a negative NPV because they have already invested a large amount in the project and feel that by not continuing it, the prior investment will be wasted. The sunk cost fallacy is also sometimes called the “Concorde effect,” a term that refers to the British and French governments’ decision

to continue funding the joint development of the Concorde aircraft even after it was clear that sales of the plane would fall far short of what was necessary to justify its continued development. The project was viewed by the British government as a commercial and financial disaster. However, the political implications of halting the project—and thereby publicly admitting that all past expenses on the project would result in nothing— ultimately prevented either government from abandoning the project.

Past Research and Development Expenditures. A pharmaceutical company may spend tens of millions of dollars developing a new drug, but if it fails to produce an effect in trials (or worse, has only negative effects), should it proceed? The company cannot get its development costs back and the amount of those costs should have no bearing on whether to continue developing a failed drug. When a firm has already devoted significant resources to develop a new product, there may be a tendency to continue investing in the product even if market conditions

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Part 3 Valuation and the Firm have changed and the product is unlikely to be viable. The rationale that is sometimes given is that if the product is abandoned, the money that has already been invested will be “wasted.” In other cases, a decision is made to abandon a project because it cannot possibly be successful enough to recoup the investment that has already been made. In fact, neither argument is correct: Any money that has already been spent is a sunk cost and therefore irrelevant. The decision to continue or abandon should be based only on the incremental costs and benefits of the product going forward.

Adjusting Free Cash Flow Here, we describe a number of complications that can arise when estimating a project’s free cash flow. Timing of Cash Flows. For simplicity, we have treated the cash flows in our examples as if they occur at annual intervals. In reality, cash flows will be spread throughout the year. While it is common to forecast at the annual level, we can forecast free cash flow on a quarterly or monthly basis when greater accuracy is required. In practice, firms often choose shorter intervals for riskier projects so that they might forecast cash flows at the monthly level for projects that carry considerable risk. For example, cash flows for a new facility in Europe may be forecasted at the quarterly or annual level, but if that same facility were located in a politically unstable country, the forecasts would likely be at the monthly level.

MACRS depreciation The most accelerated cost recovery system allowed by the IRS. Based on the recovery period, MACRS depreciation tables assign a fraction of the purchase price that the firm can depreciate each year.

EXAMPLE 9.6 Computing Accelerated Depreciation

Accelerated Depreciation. Because depreciation contributes positively to the firm’s cash flow through the depreciation tax shield, it is in the firm’s best interest to use the most accelerated method of depreciation that is allowable for tax purposes. By doing so, the firm will accelerate its tax savings and increase their present value. In the United States, the most accelerated depreciation method allowed by the IRS is MACRS (Modified Accelerated Cost Recovery System) depreciation. With MACRS depreciation, the firm first categorizes assets according to their recovery period. Based on the recovery period, MACRS depreciation tables assign a fraction of the purchase price that the firm can recover each year. We provide MACRS tables and recovery periods for common assets in the appendix at the end of this chapter. As we explain in the appendix, MACRS allows for partial depreciation in year 0, when the asset is purchased and put into service. Problem What depreciation deduction would be allowed for HomeNet’s $7.5 million lab equipment using the MACRS method, assuming the lab equipment is designated to have a five-year recovery period? (See this chapter’s appendix for information on MACRS depreciation schedules.)

Solution Q Plan Table 9.4 (in the appendix) provides the percentage of the cost that can be depreciated each year. Under MACRS, we take the percentage in the table for each year and multiply it by the original purchase price of the equipment to calculate the depreciation for that year. Q Execute Based on the table, the allowable depreciation expense for the lab equipment is shown below (in thousands of dollars): 1 2 3 4 5

Year MACRS Depreciation Lab Equipment Cost MACRS Depreciation Rate Depreciation Expense

0

1

2

3

4

7,500 20.00% 32.00% 19.20% 11.52% 11.52% 864 864 1,500 2,400 1,440

5

5.76% 432

Chapter 9 Fundamentals of Capital Budgeting

263

Q Evaluate Compared with straight-line depreciation, the MACRS method allows for larger depreciation deductions earlier in the asset’s life, which increases the present value of the depreciation tax shield and thus will raise the project’s NPV. In the case of HomeNet, computing the NPV using MACRS depreciation leads to an NPV of $3.179 million.

Liquidation or Salvage Value. Assets that are no longer needed often have a resale value, or some salvage value if the parts are sold for scrap. Some assets may have a negative liquidation value. For example, it may cost money to remove and dispose of the used equipment. In the calculation of free cash flow, we include the liquidation value of any assets that are no longer needed and may be disposed of. When an asset is liquidated, any capital gain is taxed as income. We calculate the capital gain as the difference between the sale price and the book value of the asset: Capital Gain = Sale Price - Book Value

(9.9)

The book value is equal to the asset’s original cost less the amount it has already been depreciated for tax purposes: Book Value = Purchase Price - Accumulated Depreciation

(9.10)

We must adjust the project’s free cash flow to account for the after-tax cash flow that would result from an asset sale: [email protected] Cash Flow from Asset Sale = Sale Price - 1 Tax Rate * Capital Gain 2 (9.11)

EXAMPLE 9.7 Computing AfterTax Cash Flows from an Asset Sale

Problem As production manager, you are overseeing the shutdown of a production line for a discontinued product. Some of the equipment can be sold for a total price of $50,000. The equipment was originally purchased four years ago for $500,000 and is being depreciated according to the five-year MACRS schedule. If your marginal tax rate is 35%, what is the after-tax cash flow you can expect from selling the equipment?

Solution Q Plan In order to compute the after-tax cash flow, you will need to compute the capital gain, which, as Eq. 9.9 shows, requires you to know the book value of the equipment. The book value is given in Eq. 9.10 as the original purchase price of the equipment less accumulated depreciation. Thus, you need to follow these steps: 1. 2. 3. 4.

Use the MACRS schedule to determine the accumulated depreciation. Determine the book value as purchase price minus accumulated depreciation. Determine the capital gain as the sale price less the book value. Compute the tax owed on the capital gain and subtract it from the sale price, following Eq. 9.11, and then subtract the tax owed from the sale price.

Q Execute From the chapter’s appendix, we see that the first five rates of the five-year MACRS schedule (including year 0) are: 1 Year 2 Depreciation Rate 3 Depreciation Amount

0 20.00% 100,000

1 32.00% 160,000

2 19.20% 96,000

3 11.52% 57,600

4 11.52% 57,600

Thus, the accumulated depreciation is 100,000 + 160,000 + 96,000 + 57,600 + 57,600 = 471,200, such that the remaining book value is +500,000 - +471,200 = +28,800. (Note we could have also

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Part 3 Valuation and the Firm calculated this by summing the rates for years remaining on the MACRS schedule: Year 5 is 5.76%, so .0576 * 500,000 = 28,800). The capital gain is then +50,000 - +28,800 = +21,200 and the tax owed is 0.35 * +21,200 = +7,420. Your after-tax cash flow is then found as the sale price minus the tax owed: +50,000 - +7,420 = +42,580. Q Evaluate Because you are only taxed on the capital gain portion of the sale price, figuring the after-tax cash flow is not as simple as subtracting the tax rate multiplied by the sale price. Instead, you have to determine the portion of the sale price that represents a gain and compute the tax from there. The same procedure holds for selling equipment at a loss relative to book value—the loss creates a deduction for taxable income elsewhere in the company.

tax loss carryforwards and carrybacks Two features of the U.S. tax code that allow corporations to take losses during a current year and offset them against gains in nearby years. Since 1997, companies can “carry back” losses for two years and “carry forward” losses for 20 years.

Tax Carryforwards. A firm generally identifies its marginal tax rate by determining the tax bracket that it falls into based on its overall level of pre-tax income. Two additional features of the tax code, called tax loss carryforwards and carrybacks, allow corporations to take losses during a current year and offset them against gains in nearby years. Since 1997, companies can “carry back” losses for two years and “carry forward” losses for 20 years. This tax rule means that a firm can offset losses during one year against income for the last two years, or save the losses to be offset against income during the next 20 years. When a firm can carry back losses, it receives a refund for back taxes in the current year. Otherwise, the firm must carry forward the loss and use it to offset future taxable income. When a firm has tax loss carryforwards well in excess of its current pre-tax income, then additional income it earns today will simply increase the taxes it owes after it exhausts its carryforwards.

Replacement Decisions Often the financial manager must decide whether to replace an existing piece of equipment. The new equipment may allow increased production, resulting in incremental revenue, or it may simply be more efficient, lowering costs. The typical incremental effects associated with such a decision are salvage value from the old machine, purchase of the new machine, cost savings and revenue increases, and depreciation effects.

EXAMPLE 9.8 Replacing an Existing Machine

Problem You are trying to decide whether to replace a machine on your production line. The new machine will cost $1 million, but will be more efficient than the old machine, reducing costs by $500,000 per year. Your old machine is fully depreciated, but you could sell it for $50,000. You would depreciate the new machine over a five-year life using MACRS. The new machine will not change your working capital needs. Your tax rate is 35%, and your cost of capital is 9%. Should you replace the machine?

Solution Q Plan Incremental revenues: 0 Incremental costs:

-500,000 (a reduction in costs will appear as a positive number in the costs line of our analysis)

Depreciation schedule (from the appendix): 1 Year 2 Depreciation Rate 3 Depreciation Amount

0 20.00% 200,000

1 32.00% 320,000

2 19.20% 192,000

3 11.52% 115,200

4 11.52% 115,200

5 5.76% 57,600

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Capital gain on salvage = +50,000 - +0 = +50,000

Cash flow from salvage value: +50,000 - 1 50,000 2 1 .35 2 = 32,500 Q Execute (values in thousands) 1 2 3 4 5 6 7 8 9 10 11 12

Year 0 Incremental Revenues Incremental Costs of Goods Sold Incremental Gross Profit 200 Depreciation 200 EBIT 70 Income Tax at 35% 130 Incremental Earnings 200 Add Back Depreciation Purchase of Equipment 1,000 Salvage Cash Flow 32.5 Incremental Free Cash Flows 897.5

NPV = -897.50 +

1 500 500 320 180 63 117 320

437

2

3

4

5

500 500 500 500 500 500 500 500 115.2 115.2 57.6 192 384.8 384.8 442.4 308 107.8 134.68 134.68 154.84 250.12 250.12 287.56 200.2 192 115.2 115.2 57.6

392.2

365.32

365.32

345.16

365.32 365.32 345.16 437.00 392.20 + + + = 598.75 + 1.09 1.092 1.093 1.094 1.095

Q Evaluate Even though the decision has no impact on revenues, it still matters for cash flows because it reduces costs. Further, both selling the old machine and buying the new machine involve cash flows with tax implications. The NPV analysis shows that replacing the machine will increase the value of the firm by almost $599 thousand.

Concept Check

9.5

7. Should we include sunk costs in the cash flows of a project? Why or why not? 8. Explain why it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes.

Analyzing the Project When evaluating a capital budgeting project, financial managers should make the decision that maximizes NPV. As we have discussed, to compute the NPV for a project you need to estimate the incremental free cash flows and choose a discount rate. Given these inputs, the NPV calculation is relatively straightforward. The most difficult part of capital budgeting is deciding how to estimate the cash flows and cost of capital. These estimates are often subject to significant uncertainty. In this section, we look at methods that assess the importance of this uncertainty and identify the drivers of value in the project.

Sensitivity Analysis sensitivity analysis An important capital budgeting tool that determines how the NPV varies as a single underlying assumption is changed.

An important capital budgeting tool for assessing the effect of uncertainty in forecasts is sensitivity analysis. Sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. In this way, sensitivity analysis allows us to explore the effects of errors in our NPV estimates for a project. By conducting a sensitivity analysis, we learn which assumptions are the most important; we can then invest further resources and effort to refine these assumptions. Such an analysis also reveals which aspects of a project are most critical when we are actually managing the project. In fact, we have already performed a type of sensitivity analysis in Chapter 8 when we constructed an NPV profile. By graphing the NPV of a project as a function of the discount rate, we are assessing the sensitivity of our NPV calculation to uncertainty about the cor-

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Part 3 Valuation and the Firm rect cost of capital to use as a discount rate. In practice, financial managers explore the sensitivity of their NPV calculation to many more factors than just the discount rate. To illustrate, consider the assumptions underlying the calculation of HomeNet’s NPV in Example 9.5. There is likely to be significant uncertainty surrounding each revenue and cost assumption. In addition to the base case assumptions about units sold, sale price, cost of goods sold, net working capital, and cost of capital, Linksys’s managers would also identify best- and worst-case scenarios for each. For example, assume that they identified the best- and worst-case assumptions listed in Table 9.2. Note that these are best- and worst-case scenarios for each parameter rather than representing one worst-case scenario and one best-case scenario. To determine the importance of this uncertainty, we recalculate the NPV of the HomeNet project under the best- and worst-case assumptions for each parameter. For example, if the number of units sold is only 35,000 per year, the NPV of the project falls to - +1.13 million. We repeat this calculation for each parameter. The result is shown in Figure 9.2, which reveals that the parameter assumptions with the largest effect on NPV are the number of units sold and the sale price per unit. As a result, these assumptions deserve the greatest scrutiny during the estimation process. In addition, as the most important drivers of the project’s value, these factors deserve close attention when managing the project after it starts.

TABLE 9.2 Best- and Worst-Case Assumptions for Each Parameter in the HomeNet Project

FIGURE 9.2 HomeNet’s NPV Under Bestand Worst-Case Parameter Assumptions

Parameter Units Sold (thousands) Sale Price ($/unit) Cost of Goods ($/unit) NWC ($ thousands) Cost of Capital

Initial Assumption

Worst Case

Best Case

50 260 110 1125 12%

35 240 120 1525 15%

65 280 100 725 10%

Bars show the change in NPV going from the best-case assumption to the worst-case assumption for each parameter. For example, the NPV of the project ranges from - +1.13 million if only 35,000 units are sold to $6.85 million if 65,000 units are sold. Under the initial assumptions, HomeNet’s NPV is $2.862 million.

Units Sold (000s per year)

35

50

65

Sales Price ($ per unit)

240

260

280

Cost of Goods ($ per unit)

120 110 100 Net Working Capital ($ thousands)

1525

Cost of Capital 3 2 1

15% 0

1

1125

12% 2

2.862

725

10% 4

NPV ($ million)

5

6

7

8

9

Chapter 9 Fundamentals of Capital Budgeting

267

Break-Even Analysis break-even The level of a parameter for which an investment has an NPV of zero.

break-even analysis A calculation of the value of each parameter for which the NPV of the project is zero.

A natural extension of the sensitivity analysis is to ask at what level of each parameter would the project have an NPV of zero. For each parameter, this level is its break-even. One example that we have already considered is the calculation of the internal rate of return (IRR). Recall from Chapter 8 that the difference between the IRR of a project and the cost of capital tells you how much error in the cost of capital it would take to change the investment decision. By either graphing the NPV profile or using the Excel function IRR, we would find that the incremental cash flows of HomeNet given in Example 9.5 imply an IRR of 26.6%. Hence, the true cost of capital can be as high as 26.6% and the project will still have a positive NPV. We can determine the uncertainty of other parameters as well. In a break-even analysis, for each parameter we calculate the value at which the NPV of the project is zero. This would be tedious to do by hand, so in practice it is always done with a spreadsheet. As with the NPV profile for the discount rate, we can graph the NPV as a function of each of the critical assumptions. In each case, we keep all of the other parameters fixed at their initially assumed values and vary only the parameter in question. Figure 9.3 does this for HomeNet. Accounting Break-Even. We have examined the break-even levels in terms of the project’s NPV, which is the most useful perspective for decision making. Other accounting notions of break-even are sometimes considered, however. For example, we could compute the EBIT break-even for sales, which is the level of sales for which the project’s EBIT is zero. Recall from Eq. 9.1 that the project’s EBIT is Revenues - Costs - Depreciation. Costs include cost of goods sold, and selling, general, and administrative expense (SG&A). Revenues equal Units Sold * Sale Price, and cost of goods sold equals Units Sold * Cost per Unit, so we have EBIT = 1 Units Sold * Sale Price 2 1 Units Sold * Cost per Unit 2 - SG&A - Depreciation. Setting this equal to zero and solving for units sold:

EBIT break-even The level of a particular parameter for which a project’s EBIT is zero.

Units Sold * 1 Sale Price - Cost per Unit 2 - SG&A - Depreciation = 0

Units Sold =

FIGURE 9.3

SG&A + Depreciation 2,800,000 + 1,500,000 = = 28,667 Sales Price - Cost per Unit 260 - 110

Break-Even Analysis Graphs

The graphs in panels (a) and (b) relate two of the key parameters to the project’s NPV to identify the parameters’ break-even points. For example, based on the initial assumptions, the HomeNet project will break even with a sales level of 39,242 units per year. Similarly, holding sales and the other parameters constant at their initial assumed values, the project will break even at a cost of goods sold of just over $142 per unit. Panel (a) Break-Even Point Based on Units Sold

Panel (b) Break-Even Point Based on Costs of Goods Sold

$8000

$5000

$6000

$4000 $3000 NPV

NPV

$4000 $2000 $0

20

30

40

50

$2000 $4000

60

70

$2000 $1000 $0

$1000 Units Sold (000s)

$2000

80 90 100 110 120 130 140 150 160 Cost of Goods Sold ($/unit)

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Part 3 Valuation and the Firm However, this EBIT break-even number is misleading. While HomeNet’s EBIT break-even level of sales is only 28,667 units per year, given the large upfront investment required in HomeNet, its NPV is - +2.81 million at that sales level.

INTERVIEW WITH

DAVID HOLLAND

David Holland, currently Senior Vice President of Sports and Entertainment Solutions where he is responsible for accelerating development and adoption of Cisco solutions in that market. He was previously Senior Vice President and Treasurer of Cisco, and was responsible for managing all funding, risk, and capital market activities related to the firm’s $50 billion balance sheet. QUESTION: What is the importance of considering free cash flow, as opposed to just the earnings implications of a financial decision? ANSWER: There is an adage saying, “Cash flow is a fact and earnings are an opinion.” Earnings use an accounting framework and are governed by many rules, making it hard to know what earnings tell the investor. The economics of cash flow are clear: We can’t dispute whether cash has come in or gone out. Cisco’s investment decisions are based primarily on cash flow models because they take project risk into account and show the impact on value creation for owners of the business. QUESTION: What key financial metrics does Cisco use to make investment decisions? ANSWER:

Cisco focuses primarily on net present value (NPV) for investment decisions. Robust NPV analysis goes beyond simply accepting projects with positive NPVs and rejecting those with negative NPVs. It identifies the key drivers that affect project success and demonstrates the interplay between factors that affect cash flow. For example, running a model using a lower margin approach shows us the impact on revenue growth and on operating cost structures. We can compare that to a higher margin (premium pricing) approach. The business unit manager learns how to control aspects of the business model to alleviate risk or accelerate the upside potential. We prefer NPV to internal rate of return (IRR), which may return multiple answers or give false signals as to an investment’s profitability, depending on the organization of cash flows. An attraction of IRR analysis is the ease of comparing percentage returns. However, this method hides the scope of a project. A project with a 25% return may generate $1 million in shareholder value, while another with a 13% IRR might produce $1 billion. NPV captures the size of the return in dollar terms and shows a project’s impact on share price. NPV also creates an ownership framework for

employees whose compensation package includes some form of stock ownership, directly tying the decision-making criteria to stock price.

When developing a model to analyze a new investment, how do you deal with the uncertainty surrounding estimates, especially for new technologies?

QUESTION:

ANSWER: Cisco relies on strong financial modeling for the thousands of investment decisions we make every year. Our 2500 finance people worldwide work with the internal client—the business lead—to understand the assumptions in the model and to check the model’s result against alternative assumptions. Evaluating the cash flows for technology projects, especially new technology, is difficult. When you buy an oil refinery, you can see the throughput and the cash flows. Identifying the relevant savings from a component technology for a larger router or switch product or a strategic move into a new area is more complex and intangible. Scenario and sensitivity analyses and game theory help us control risk by adjusting our strategy. We also look at the qualitative aspects, such as how the strategy fits into the customer sector and the directions customers are moving with their tech platforms. QUESTION:

How does Cisco adjust for risk?

ANSWER: To stay competitive in the technology space, we must be prepared to take some level of risk, even in down markets. We apply the same discount rate to all projects in a category, based on their market risk (i.e., sensitivity to market conditions). We do not adjust the discount rate to account for project-specific risks, because our required return has not changed and that would distort the true value of the company. To assess a project’s unique risks, we model the upside or downside of cash flows with scenario and sensitivity analysis. We might analyze the sensitivity of a project’s NPV to a 1% change in both revenue growth and operating costs. Then we run the model with other assumptions, developing base, optimistic, and bearish cases. We discuss these models with the business lead and rerun the models based on their input. This process improves our potential outcome and project profitability.

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Scenario Analysis scenario analysis An important capital budgeting tool that determines how the NPV varies as a number of the underlying assumptions are changed simultaneously.

In the analysis thus far, we have considered the consequences of varying only one parameter at a time. In reality, certain factors may affect more than one parameter. Scenario analysis considers the effect on NPV of changing multiple project parameters. For example, lowering HomeNet’s price may increase the number of units sold. We can use scenario analysis to evaluate alternative pricing strategies for the HomeNet product in Table 9.3. In this case, the current strategy is optimal. Figure 9.4 shows the combinations of price and volume that lead to the same NPV of $2.862 million for HomeNet as the current strategy. Only strategies with price and volume combinations above the curve will lead to a higher NPV.

TABLE 9.3 Scenario Analysis of Alternative Pricing Strategies

FIGURE 9.4 Price and Volume Combinations for HomeNet with Equivalent NPV

Strategy

Sale Price ($/unit)

Current Strategy Price Reduction Price Increase

Expected Units Sold (thousands)

NPV ($ thousands)

260

50

2862

245 275

55 45

2729 2729

The graph shows alternative price per unit and annual volume combinations that lead to an NPV of $2.862 million. Pricing strategies with combinations above this curve will lead to a higher NPV and are superior. For example, if Linksys managers think they will be able to sell 48,000 units at a price of $275, this strategy would yield a higher NPV ($3,607 million).

$285 48,000 units at a price of $275 each produces an NPV $2.862 million

$280 $275

Sale Price

$270 $265 $260 $255 52,000 units at a price of $250 each produces an NPV $2.862 million

$250 $245 $240 44

46

48

50 Units Sold (000s)

Concept Check

9. What is sensitivity analysis? 10. How does scenario analysis differ from sensitivity analysis?

52

54

56

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9.6

real option The right to make a particular business decision, such as a capital investment.

Real Options in Capital Budgeting Our approach to capital budgeting thus far has focused on the initial investment decision without explicitly considering future decisions that may need to be made over the life of a project. Rather, we assumed that our forecast of a project’s expected future cash flows already incorporated the effect of future decisions that would be made. In truth, most projects contain real options. A real option is the right, but not the obligation, to make a particular business decision. Because you are not obligated to take the action, you will only do so if it increases the NPV of the project. In particular, because real options allow a decision maker to choose the most attractive alternative after new information has been learned, the presence of real options adds value to an investment opportunity. The tools to estimate the actual value created by real options are beyond the scope of this chapter and are contained later in the book. However, we introduce the concept here to give you a sense of the types of real options you may encounter and establish the intuition that flexibility (more options) is valuable. Let’s look at some of the most common real options in the context of Linksys’s HomeNet project.

Option to Delay option to delay commitment The option to time a particular investment

The option to delay commitment (the option to time the investment) is almost always present. Linksys could wait to commit to the HomeNet project. Waiting could be valuable if Linksys expects prices of the components to decrease substantially, soon-to-be-released new technology that will make the existing components obsolete, or increased sales of Web-ready appliances (heightening the demand for HomeNet). In addition, Linksys may simply want more time to gather information about the potential market for HomeNet. As with any other capital budgeting decision, Linksys would only choose to delay if doing so would increase the NPV of the project.

Option to Expand

option to expand The option to start with limited production and expand only if the project is successful.

abandonment option An option for an investor to cease making investments in a project. Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful.

In the section on sensitivity analysis, we looked at changes in our assumptions about units sold. All of the analysis was performed, however, under the assumption that Linksys would fully commit to and roll out the HomeNet product worldwide. We did not consider the option to expand, which is the option to start with limited production and expand only if the product is successful. Linksys could, instead, test market the product in limited release before committing to it fully. Doing so would create an option to expand worldwide only if HomeNet were successful in limited release. It is possible that, by reducing its upfront commitment and only choosing to expand if the product is successful, Linksys will increase the NPV of the HomeNet product. However, in this particular case, there are large costs of development that would be paid whether Linksys sells one or one million units, so limiting the initial market does not reduce the financial commitment substantially. Thus, in the case of HomeNet, it is unlikely that Linksys would choose a limited release with an option to expand.

Option to Abandon An abandonment option is the option to walk away. Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful. Imagine that a competitor developed new technology that allowed it to introduce a competing product priced at $170. At that price, HomeNet would produce negative cash flows every year. But would Linksys continue to sell HomeNet if it had to do so at a loss? Probably

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not. Linksys has an option to abandon the project. It could stop producing HomeNet and sell the equipment. Depending on how much Linksys believes the equipment would sell for if it abandoned the project, the abandonment option could make HomeNet attractive even if there was a substantial risk of a competing product. All these options point to the same conclusion: if you can build greater flexibility into your project, you will increase the NPV of the project. In Chapter 21, we will discuss how to value options so that you can estimate just how much more valuable the project is with greater flexibility. Many industries regularly make use of real options. For example, most movie producers build in an option for a sequel if the first movie does well. Pharmaceutical developers like Merck develop new drugs in stages, allowing them to abandon development if tests do not go well.

Concept Check

11. What are real options? 12. Why do real options increase the NPV of the project?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

9.1 The Capital Budgeting Process Q Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept. A capital budget is a list of all projects that a company plans to undertake during the next period. Q We use the NPV rule to evaluate capital budgeting decisions, making decisions that maximize NPV. When deciding to accept or reject a project, we accept projects with a positive NPV.

capital budget, p. 249 capital budgeting, p. 249 incremental earnings, p. 250

MyFinanceLab Study Plan 9.1

9.2 Forecasting Incremental Earnings Q The incremental earnings of a project comprise the amount by which the project is expected to change the firm’s earnings. Q Incremental earnings should include all incremental revenues and costs associated with the project. Incremental Earnings = 1 Incremental Revenues - Incremental Cost - Depreciation 2 * 1 1 - Tax Rate 2 (9.3) Q Interest and other financing-related expenses are excluded to determine the project’s unlevered net income.

marginal corporate tax rate, p. 252 pro forma, p. 253 straight-line depreciation, p. 250 unlevered net income, p. 254

MyFinanceLab Study Plan 9.2

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9.3 Determining Incremental Free Cash Flow Q We compute free cash flow from incremental earnings by eliminating all non-cash expenses and including all capital investment. Q Depreciation is not a cash expense, so it is added back. Q Actual capital expenditures are deducted. Q Increases in net working capital are deducted and decreases are added. Net working capital is defined as:

depreciation tax shield, p. 259 free cash flow, p. 255 trade credit, p. 256

MyFinanceLab Study Plan 9.3

9.4 Other Effects on Incremental Free Cash Flows Q An opportunity cost is the cost of using an existing asset. Q Project externalities are cash flows that occur when a project affects other areas of the company’s business. Q A sunk cost is an unrecoverable cost that has already been incurred. Q Depreciation expenses affect free cash flow only through the depreciation tax shield. The firm should use the most accelerated depreciation schedule possible. Q The discount rate for a project is its cost of capital: the expected return of securities with comparable risk and horizon. Q When you sell an asset, the portion of the proceeds above its book value is taxed: [email protected] Cash Flow from Asset Sale = Sale Price - 1 Tax Rate * Capital Gain 2 (9.11)

cannibalization, p. 261 MACRS depreciation, p. 262 opportunity cost, p. 260 overhead expenses, p. 261 project externalities, p. 260 sunk cost, p. 261 tax loss carryforwards and carrybacks, p. 264

MyFinance Lab Study Plan 9.4

9.5 Analyzing the Project Q Sensitivity analysis breaks the NPV calculation down into its component assumptions, showing how the NPV varies as the values of the underlying assumptions change. Q Break-even analysis computes the level of a parameter that makes the project’s NPV equal zero. Q Scenario analysis considers the effect of changing multiple parameters simultaneously.

break-even, p. 267 break-even analysis, p. 267 EBIT break-even, p. 267 scenario analysis, p. 269 sensitivity analysis, p. 265

MyFinanceLab Study Plan 9.5

9.6 Real Options in Capital Budgeting Q Real options are options to make a business decision, often after gathering more information. The presence of real options in a project increases the project’s NPV.

abandonment option, p. 270 option to delay commitment, p. 270 option to expand, p. 270 real option, p. 270

MyFinanceLab Study Plan 9.6

Cash + Inventory + Receivables - Payables (9.4) Q The basic calculation for free cash flow is:

Free Cash Flow = 1 Revenues - Costs - Depreciation 2 (9.6) * 1 1 - Tax Rate 2 + Depreciation -CapEx - Change in NWC

HomeNet Example Spreadsheet

Interactive Sensitivity Analysis, Using Excel: Performing Sensitivity Analysis

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1. What are pro forma incremental earnings? 2. What is the difference between pro forma incremental earnings and pro forma free cash flow? 3. Why do we convert from incremental earnings to free cash flow when performing capital budgeting? 4. What is the role of net working capital in projects? 5. How does net working capital affect the cash flows of a project? 6. Why is it important to adjust project sales and costs for externalities? 7. Does accelerated depreciation generally increase or decrease NPV relative to straight-line depreciation? 8. How is sensitivity analysis performed and what is its purpose?

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Forecasting Incremental Earnings 1. Daily Enterprises is purchasing a $10 million machine. It will cost $50,000 to transport and install the machine. The machine has a depreciable life of five years and will have no salvage value. If Daily uses straight-line depreciation, what are the depreciation expenses associated with this machine? 2. The machine in Problem 1 will generate incremental revenues of $4 million per year along with incremental costs of $1.2 million per year. If Daily’s marginal tax rate is 35%, what are the incremental earnings associated with the new machine? 3. You are upgrading to better production equipment for your firm’s only product. The new equipment will allow you to make more of your product in the same amount of time. Thus, you forecast that total sales will increase next year by 20% over the current amount of 100,000 units. If your sales price is $20 per unit, what are the incremental revenues next year from the upgrade? 4. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $20 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 40% will come from customers who switch to the new, healthier pizza instead of buying the original version. a. Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza? b. Suppose that 50% of the customers who would switch from Pisa Pizza’s original pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case? 5. Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi Munch. Kokomochi plans to spend $5 million on TV, radio, and print advertising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9 million this year and by $7 million next year. In addition, the company expects that new consumers who try the Mini Mochi

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Part 3 Valuation and the Firm Munch will be more likely to try Kokomochi’s other products. As a result, sales of other products are expected to rise by $2 million each year. Kokomochi’s gross profit margin for the Mini Mochi Munch is 35%, and its gross profit margin averages 25% for all other products. The company’s marginal corporate tax rate is 35% both this year and next year. What are the incremental earnings associated with the advertising campaign? 6. Hyperion, Inc., currently sells its latest high-speed color printer, the Hyper 500, for $350. It plans to lower the price to $300 next year. Its cost of goods sold for the Hyper 500 is $200 per unit, and this year’s sales are expected to be 20,000 units. a. Suppose that if Hyperion drops the price to $300 immediately, it can increase this year’s sales by 25% to 25,000 units. What would be the incremental impact on this year’s EBIT of such a price drop? b. Suppose that for each printer sold, Hyperion expects additional sales of $75 per year on ink cartridges for the next three years, and Hyperion has a gross profit margin of 70% on ink cartridges. What is the incremental impact on EBIT for the next three years of a price drop this year? Determining Incremental Free Cash Flow 7. You have a depreciation expense of $500,000 and a tax rate of 35%. What is your depreciation tax shield? 8. You have forecast pro-forma earnings of $1,000,000. This includes the effect of $200,000 in depreciation. You also forecast a decrease in working capital of $100,000 that year. What is your forecast of free cash flows for that year? 9. Your pro-forma income statement shows sales of $1,000,000, cost of goods sold as $500,000, depreciation expense of $100,000, and taxes of $160,000 due to a tax rate of 40%. What are your pro-forma earnings? What is your pro-forma free cash flow? 10. You are forecasting incremental free cash flows for Daily Enterprises. Based on the information in Problems 1 and 2, what are the incremental free cash flows associated with the new machine? 11. Castle View Games would like to invest in a division to develop software for video games. To evaluate this decision, the firm first attempts to project the working capital needs for this operation. Its chief financial officer has developed the following estimates (in millions of dollars) (see MyFinanceLab for the data in Excel format): 1 2 3 4 5

Year Cash Accounts Receivable Inventory Accounts Payable

1 6 21 5 18

2 12 22 7 22

3 15 24 10 24

4 15 24 12 25

5 15 24 13 30

Assuming that Castle View currently does not have any working capital invested in this division, calculate the cash flows associated with changes in working capital for the first five years of this investment. 12. In the HomeNet example from the chapter, its receivables are 15% of sales and its payables are 15% of COGS. Forecast the required investment in net working capital for HomeNet assuming that sales and cost of goods sold (COGS) will be (see MyFinanceLab for the data in Excel format): 1 Year 2 Sales 3 COGS

0

1 23,500 9,500

2 26,438 10,688

3 23,794 9,619

4 8,566 3,483

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13. Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two years (in millions of dollars) (see MyFinanceLab for the data in Excel format): 1 2 3 4 5 6 7

Year Revenues Operating Expenses (other than depreciation) Depreciation Increase in Net Working Capital Capital Expenditures Marginal Corporate Tax Rate

1 125 40 25 2 30 35%

2 160 60 36 8 40 35%

a. What are the incremental earnings for this project for years 1 and 2? b. What are the free cash flows for this project for the first two years? 14. Cellular Access, Inc., is a cellular telephone service provider that reported net income of $250 million for the most recent fiscal year. The firm had depreciation expenses of $100 million, capital expenditures of $200 million, and no interest expenses. Net working capital increased by $10 million. Calculate the free cash flow for Cellular Access for the most recent fiscal year. 15. Recall the HomeNet example from the chapter. Suppose HomeNet’s lab will be housed in warehouse space that the company could have otherwise rented out for $200,000 per year during years 1–4. How does this opportunity cost affect HomeNet’s incremental earnings? *16. One year ago, your company purchased a machine used in manufacturing for $110,000. You have learned that a new machine is available that offers many advantages; you can purchase it for $150,000 today. It will be depreciated on a straight-line basis over ten years and has no salvage value. You expect that the new machine will produce a gross margin (revenues minus operating expenses other than depreciation) of $40,000 per year for the next ten years. The current machine is expected to produce a gross margin of $20,000 per year. The current machine is being depreciated on a straight-line basis over a useful life of 11 years, and has no salvage value, so depreciation expense for the current machine is $10,000 per year. The market value today of the current machine is $50,000. Your company’s tax rate is 45%, and the opportunity cost of capital for this type of equipment is 10%. Should your company replace its year-old machine? *17. Beryl’s Iced Tea currently rents a bottling machine for $50,000 per year, including all maintenance expenses. It is considering purchasing a machine instead and is comparing two options: a. Purchase the machine it is currently renting for $150,000. This machine will require $20,000 per year in ongoing maintenance expenses. b. Purchase a new, more advanced machine for $250,000. This machine will require $15,000 per year in ongoing maintenance expenses and will lower bottling costs by $10,000 per year. Also, $35,000 will be spent upfront in training the new operators of the machine. Suppose the appropriate discount rate is 8% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the rental of the machine. Assume also that the machines will be depreciated via the straightline method over seven years and that they have a ten-year life with a negligible salvage value. The marginal corporate tax rate is 35%. Should Beryl’s Iced Tea continue to rent, purchase its current machine, or purchase the advanced machine?

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Part 3 Valuation and the Firm Other Effects on Incremental Free Cash Flows 18. You have just completed a $20,000 feasibility study for a new coffee shop in some retail space you own. You bought the space two years ago for $100,000, but if you sold it today, you would net $115,000 after taxes. Outfitting the space for a coffee shop would require a capital expenditure of $30,000 plus an initial investment of $5,000 in inventory. What is the correct initial cash flow for your analysis of the coffee shop opportunity? 19. You purchased a machine for $1 million three years ago and have been applying straight-line depreciation to zero for a seven-year life. Your tax rate is 35%. If you sell the machine right now (after three years of depreciation) for $700,000, what is your incremental cash flow from selling the machine? 20. The Jones Company has just completed the third year of a five-year MACRS recovery period for a piece of equipment it originally purchased for $300,000. a. What is the book value of the equipment? b. If Jones sells the equipment today for $180,000 and its tax rate is 35%, what is the after-tax cash flow from selling it? 21. Just before it is about to sell the equipment from Problem 20, Jones receives a new order. It can take the new order if it keeps the old equipment. Is there a cost to taking the order and if so, what is it? Explain. 22. Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should be included as part of the incremental earnings for the proposed new retail store? a. The original purchase price of the land where the store will be located. b. The cost of demolishing the abandoned warehouse and clearing the lot. c. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead. d. The $10,000 in market research spent to evaluate customer demand. e. Construction costs for the new store. f. The value of the land if sold. g. Interest expense on the debt borrowed to pay the construction costs. 23. If Daily Enterprises uses MACRS instead of straight-line depreciation, which incremental free cash flows from Problem 10 would increase and which would decrease? 24. Markov Manufacturing recently spent $15 million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 35%. The company plans to use straight-line depreciation. a. What is the annual depreciation expense associated with this equipment? b. What is the annual depreciation tax shield? c. Rather than straight-line depreciation, suppose Markov will use the MACRS depreciation method for the five-year life of the property. Calculate the deprecia-

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tion tax shield each year for this equipment under this accelerated depreciation schedule. d. If Markov has a choice between straight-line and MACRS depreciation schedules, and its marginal corporate tax rate is expected to remain constant, which schedule should it choose? Why? e. How might your answer to part (d) change if Markov anticipates that its marginal corporate tax rate will increase substantially over the next five years? 25. You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s report on your desk, and complains, “We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over and give me your opinion.” You open the report and find the following estimates (in thousands of dollars) (see MyFinanceLab for the data in Excel format): 1 2 3 4 5 6 7 8 9

Year Sales Revenue Costs of Goods Sold Gross Profit General, Sales, and Administrative Expenses Depreciation EBIT Income Tax Net Income

1 30,000 18,000 12,000 2,000 2,500 7,500 2,625 4,875

2 30,000 18,000 12,000 2,000 2,500 7,500 2,625 4,875

…

9 30,000 18,000 12,000 2,000 2,500 7,500 2,625 4,875

10 30,000 18,000 12,000 2,000 2,500 7,500 2,625 4,875

All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year 0), which is what the accounting department recommended. They also calculated the depreciation assuming no salvage value for the equipment, which is the company’s assumption in this case. The report concludes that because the project will increase earnings by $4.875 million per year for ten years, the project is worth $48.75 million. You think back to your glory days in finance class and realize there is more work to be done! First, you note that the consultants have not factored in the fact that the project will require $10 million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see they have attributed $2 million of selling, general, and administrative expenses to the project, but you know that $1 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on! a. Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed project? b. If the cost of capital for this project is 14%, what is your estimate of the value of the new project? Analyzing the Project 26. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the incremental free cash flow projections shown on the next page (in millions of dollars) (see MyFinanceLab for the data in Excel format). a. For this base-case scenario, what is the NPV of the plant to manufacture lightweight trucks?

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Part 3 Valuation and the Firm 1 2 3 4 5 6 7 8 9 10 11 12 13

Year Revenues Manufacturing Expenses (other than depreciation) Marketing Expenses Depreciation EBIT Taxes at 35% Unlevered Net Income Depreciation Additions to Net Working Capital Capital Expenditures Continuation Value Free Cash Flow

0

1–9 100.0 35.0 10.0 15.0 40.0 14.0 26.0 15.0 5.0

10 100.0 35.0 10.0 15.0 40.0 14.0 26.0 15.0 5.0

36.0

12.0 48.0

150.0 150.0

b. Based on input from the marketing department, Bauer is uncertain about its revenue forecast. In particular, management would like to examine the sensitivity of the NPV to the revenue assumptions. What is the NPV of this project if revenues are 10% higher than forecast? What is the NPV if revenues are 10% lower than forecast? c. Rather than assuming that cash flows for this project are constant, management would like to explore the sensitivity of its analysis to possible growth in revenues and operating expenses. Specifically, management would like to assume that revenues, manufacturing expenses, and marketing expenses are as given in the table for year 1 and grow by 2% per year every year starting in year 2. Management also plans to assume that the initial capital expenditures (and therefore depreciation), additions to working capital, and continuation value remain as initially specified in the table. What is the NPV of this project under these alternative assumptions? How does the NPV change if the revenues and operating expenses grow by 5% per year rather than by 2%? d. To examine the sensitivity of this project to the discount rate, management would like to compute the NPV for different discount rates. Create a graph, with the discount rate on the x-axis and the NPV on the y-axis, for discount rates ranging from 5% to 30%. For what ranges of discount rates does the project have a positive NPV? *27. Billingham Packaging is considering expanding its production capacity by purchasing a new machine, the XC-750. The cost of the XC-750 is $2.75 million. Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $50,000 feasibility study to analyze the decision to buy the XC-750, resulting in the following estimates: Q Marketing: Once the XC-750 is operational next year, the extra capacity is expected to generate $10 million per year in additional sales, which will continue for the ten-year life of the machine. Q Operations: The disruption caused by the installation will decrease sales by $5 million this year. As with Billingham’s existing products, the cost of goods for the products produced by the XC-750 is expected to be 70% of their sale price. The increased production will also require increased inventory on hand of $1 million during the life of the project, including year 0. Q Human Resources: The expansion will require additional sales and administrative personnel at a cost of $2 million per year. Q Accounting: The XC-750 will be depreciated via the straight-line method over the ten-year life of the machine. The firm expects receivables from the new sales to be 15% of revenues and payables to be 10% of the cost of goods sold. Billingham’s marginal corporate tax rate is 35%.

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a. Determine the incremental earnings from the purchase of the XC-750. b. Determine the free cash flow from the purchase of the XC-750. c. If the appropriate cost of capital for the expansion is 10%, compute the NPV of the purchase. d. While the expected new sales will be $10 million per year from the expansion, estimates range from $8 million to $12 million. What is the NPV in the worst case? In the best case? e. What is the break-even level of new sales from the expansion? What is the breakeven level for the cost of goods sold? f. Billingham could instead purchase the XC-900, which offers even greater capacity. The cost of the XC-900 is $4 million. The extra capacity would not be useful in the first two years of operation, but would allow for additional sales in years 3–10. What level of additional sales (above the $10 million expected for the XC-750) per year in those years would justify purchasing the larger machine? Real Options in Captial Budgeting 28. Why is it that real options must have positive value? 29. What kind of real option does the XC-900 machine provide to Billingham in Problem 27? 30. If Billingham knows that it can sell the XC-750 to another firm for $2 million in two years, what kind of real option would that provide?

Data Case

You have just been hired by Dell Computers in its capital budgeting division. Your first assignment is to determine the net cash flows and NPV of a proposed new type of portable computer system similar in size to a BlackBerry handheld, but which has the operating power of a high-end desktop system. Development of the new system will initially require an investment equal to 10% of net property, plant, and equipment (PPE) for the fiscal year ended January 29, 2010. The project will then require an additional investment equal to 10% of the initial investment after the first year of the project, 5% of initial investment after the second year, and 1% of initial investment after the third, fourth, and fifth years. The product is expected to have a life of five years. First-year revenues for the new product are expected to be 3% of total revenue for Dell’s fiscal year ended January 29, 2010. The new product’s revenues are expected to grow at 15% for the second year, then 10% for the third, and 5% annually for the final two years of the expected life of the project. Your job is to determine the rest of the cash flows associated with this project. Your boss has indicated that the operating costs and net working capital requirements are similar to the rest of the company’s products and that depreciation is straight-line for capital budgeting purposes. Welcome to the “real world.” Since your boss hasn’t been much help, here are some tips to guide your analysis: 1. Obtain Dell’s financial statements. (If you “really” worked for Dell you would already have this data, but at least here you won’t get fired if your analysis is off target.) Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from MarketWatch (www.marketwatch .com). Enter Dell’s ticker symbol (DELL) and then go to “Financials.” Export the income statements and balance sheets to Excel by right-clicking while the cursor is inside each statement (if this doesn’t work—just copy and paste them). 2. You are now ready to determine the free cash flow. Compute the free cash flow for each year using Eq. 9.6 from this chapter:

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Part 3 Valuation and the Firm Unlevered Net Income

$'''''''''''%'''''''''''& Free Cash Flow = 1 Revenues - Costs - Depreciation 2 * 1 1 - Tax Rate 2 +Depreciation - CapEx - Change in NWC Set up the timeline and computation of the free cash flow in separate, contiguous columns for each year of the project life. Be sure to make outflows negative and inflows positive. a. Assume that the project’s profitability will be similar to Dell’s existing projects in 2010 and estimate 1 Revenues - Costs 2 each year by using the 2010 EBITDA/Sales profit margin. b. Determine the annual depreciation by assuming Dell depreciates these assets by the straight-line method over a ten-year life. c. Determine Dell’s tax rate by dividing Dell’s income taxes by its income before tax in 2010. d. Calculate the net working capital required each year by assuming that the level of NWC will be a constant percentage of the project’s sales. Use Dell’s 2010 NWC/Sales to estimate the required percentage. (Use only accounts receivable, accounts payable, and inventory to measure working capital. Other components of current assets and liabilities are harder to interpret and are not necessarily reflective of the project’s required NWC—e.g., Dell’s cash holdings.) e. To determine the free cash flow, calculate the additional capital investment and the change in net working capital each year. 3. Determine the IRR of the project and the NPV of the project at a cost of capital of 12% using the Excel functions. For the calculation of NPV, include cash flows 1 through 5 in the NPV function and then subtract the initial cost 1 i.e., = NPV 1 rate, CF1 ⬊ CF5 2 + CF0 2 . For IRR, include cash flows 0 through 5 in the cash flow range.

Chapter 9 APPENDIX

MACRS Depreciation

The U.S. tax code allows for accelerated depreciation of most assets. The depreciation method that you use for any particular asset is determined by the tax rules in effect at the time you place the asset into service. (Congress has changed the depreciation rules many times over the years, so many firms that have held property for a long time may have to use several depreciation methods simultaneously.) For most business property placed in service after 1986, the IRS allows firms to depreciate the asset using the MACRS (Modified Accelerated Cost Recovery System) method. Under this method, you categorize each business asset into a recovery class that determines the time period over which you can write off the cost of the asset. The most commonly used items are classified as shown below: Q 3-year property: Tractor units, race horses over 2 years old, and horses over 12 years old. Q 5-year property: Automobiles, buses, trucks, computers and peripheral equipment, office machinery, and any property used in research and experimentation. Also includes breeding and dairy cattle.

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Q 7-year property: Office furniture and fixtures, and any property that has not been designated as belonging to another class. Q 10-year property: Water transportation equipment, single-purpose agricultural or horticultural structures, and trees or vines bearing fruit or nuts. Q 15-year property: Depreciable improvements to land such as fences, roads, and bridges. Q 20-year property: Farm buildings that are not agricultural or horticultural structures. Q 27.5-year property: Residential rental property. Q 39-year property: Nonresidential real estate, including home offices. (Note that the value of land may not be depreciated.) Generally speaking, residential and nonresidential real estate is depreciated via the straight-line method, but other classes can be depreciated more rapidly in early years. Table 9.4 shows the standard depreciation rates for assets in the other recovery classes; refinements of this table can be applied depending on the month that the asset was placed into service (consult IRS guidelines). The table indicates the percentage of the asset’s cost that may be depreciated each year, with year 0 indicating the year the asset was first put into use. Generally, year 0 is the acquisition year and the table contains the “half-year” convention, allowing for a half year of depreciation in the acquisition year itself. This is why the first year’s depreciation percentage is smaller than the second year’s.

TABLE 9.4 MACRS Depreciation Table Showing the Percentage of the Asset’s Cost That May Be Depreciated Each Year Based on Its Recovery Period

Depreciation Rate for Recovery Period 7 Years 10 Years 15 Years

Year

3 Years

5 Years

20 Years

0

33.33

20.00

14.29

10.00

5.00

3.750

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

44.45 14.81 7.41

32.00 19.20 11.52 11.52 5.76

24.49 17.49 12.49 8.93 8.92 8.93 4.46

18.00 14.40 11.52 9.22 7.37 6.55 6.55 6.56 6.55 3.28

9.50 8.55 7.70 6.93 6.23 5.90 5.90 5.91 5.90 5.91 5.90 5.91 5.90 5.91 2.95

7.219 6.677 6.177 5.713 5.285 4.888 4.522 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 2.231

10

Stock Valuation: A Second Look

LEARNING OBJECTIVES Q Value a stock as the present value of the company’s free cash flows Q Value a stock by applying common multiples based on the values of comparable firms

notation

Q Describe some of the behavioral biases that influence the way individual investors trade

Divt

dividends paid in year t

N

terminal date or forecast horizon

EBIT

earnings before interest and taxes

Pt

stock price at the end of year t

PV

present value

rE

equity cost of capital

rwacc

weighted average cost of capital

Vt

enterprise value on date t

EBITDA earnings before interest, taxes, depreciation, and amortization

282

Q Understand how information is incorporated into stock prices through competition in efficient markets

EPSt

earnings per share on date t

FCFt

free cash flow on date t

g

expected dividend growth rate

gFCF

expected free cash flow growth rate

INTERVIEW WITH

David Mandell William Blair & Company

David Mandell, a finance and accounting major who graduated from the University of Michigan in 2008, is an equity research associate at the Chicago-based investment bank William Blair & Company. “In addition to financial analysis techniques, my education also gave me the strong oral and written communication skills and experience working in teams required to be successful at my job.” His research group focuses on valuing and understanding the fundamentals of primarily small- and mid-cap industrial companies. The firm does not assign specific “price targets,” but does assign stock ratings based on calculated risk/reward potential. In performing his analyses, David prepares models of future earnings, cash flows, and other financial measures, monitors economic variables and industry trends, and collects historical data. “We use several methodologies to value our companies,” says David. “One of the methods we look at is the P/E (price/earnings) ratio. We also look at other valuation methods, including price-to-tangible-book value (price-to-book value), the ratio of enterprise value to EBITDA, and free cash flow yield (free cash flow divided by stock price). When using these tools, we consider the prospects for future company growth, the level of confidence we have in our forecast, risks, and management execution as well as historical averages, peer group averages, and recent M&A transactions.” The analysts also consider historical trends and how stocks move compared with other indicators such as gross domestic product (GDP), nonresidential construction, and the ISM index (manufacturing activity). “These indicators help us understand which economic variables can serve as buy or sell signals,” David explains. “The stock market volatility stemming from the global financial crisis did not significantly change my team’s valuation methodology,” David says. During that time period, his group used price-to-tangiblebook value, free cash flow yield, and dividend yield to identify companies that were creating tangible value for shareholders at a discounted price. “Now we are asking if the P/Es of our stock group will reach the same peaks as in prior economic cycles, or if the P/E range has compressed.”

University of Michigan, 2008

“The stock market volatility stemming from the global financial crisis did not significantly change my team’s valuation methodology.”

In mid-2010, the three most valuable U.S. companies were ExxonMobil, Microsoft, and Apple, with Google not far behind. Apple and Google do not pay a dividend, and until 2004, neither did Microsoft (yet in 2002 it was the most valuable company in the world). In Chapter 7, we discussed the basics of stocks and valued them using the dividend-discount model. As we pointed out at the end of that chapter, the dividend-discount model is not a practical approach for valuing the stock of the thousands of companies like Apple and Google that do not pay dividends. We then modified the dividend-discount model to include other forms of payout such as repurchases. Some companies, especially young ones, neither repurchase shares nor pay dividends. In this chapter, we develop a more broadly applicable method to value companies—it can even be used to value companies that currently make no cash payouts to investors. Termed the Discounted Free Cash Flow model, it is very closely linked to the concepts we just learned for capital budgeting. In fact, you will see that just as the discounted cash flows of a project determine the value of a project to the firm, the discounted cash flows of the firm as a whole determine its value to its investors.

283

284

Part 3 Valuation and the Firm The final valuation method we discuss in this chapter, the method of comparables, or “comps,” is also broadly applicable to all types of companies. This method, in which we compare the firm to others in the same line of business, is based on the intuitive idea that similar companies should be valued similarly. We will learn how to use the market’s valuation of one company to estimate a value of a similar company. We close the chapter with a discussion of the role of competition in markets. We explain how information is reflected in stock prices through investor competition and discuss the implication for investors and corporate managers. Finally, we describe some common trading biases of individual investors.

10.1

discounted free cash flow model A method for estimating a firm’s enterprise value by discounting its future free cash flow.

The Discounted Free Cash Flow Model In Chapter 7, we developed the dividend-discount model to value the stock of a dividendpaying firm. In this section, we outline an alternative approach to valuing the firm’s shares that avoids some of the difficulties of the dividend-discount model. Specifically, we consider the discounted free cash flow model, which focuses on the cash flows to all of the firm’s investors, both debt and equity holders. This model allows us to avoid the difficulties associated with estimating the impact of the firm’s borrowing decisions on earnings. It also demonstrates the important connection between the capital budgeting analysis we did in the previous chapter and its implications for the firm’s stock price. The dividend-discount model values a single share of stock. In the total payout model, we first value the firm’s equity, rather than just a single share. The discounted free cash flow model goes one step further and begins by determining the total value of the firm to all investors—both equity holders and debt holders. We begin by estimating the firm’s enterprise value, which we defined in Chapter 2 as follows:1 Enterprise Value = Market Value of Equity + Debt - Cash

(10.1)

Because the enterprise value is the value of the firm’s underlying business, unencumbered by debt and separate from any cash or marketable securities, it is also the value of the underlying business to all investors. We can interpret the enterprise value as the net cost of acquiring the firm’s equity, paying off all debt, and taking its cash; in essence, it is equivalent to owning the unlevered business. The advantage of the discounted free cash flow model is that it allows us to value a firm without explicitly forecasting its dividends, share repurchases, or use of debt.

Valuing the Enterprise How can we estimate a firm’s enterprise value? To estimate the value of the firm’s equity, we compute the present value of the firm’s total payouts to equity holders. Likewise, to estimate a firm’s enterprise value, we compute the present value of the free cash flow (FCF) that the firm has available to pay all investors, both debt and equity holders. We saw how to compute the free cash flow for a project in Chapter 9; we now perform the same calculation for the entire firm: Free Cash Flow = EBIT * 1 1 - Tax Rate 2 + Depreciation - Capital Expenditures - Increases in Net Working Capital

(10.2)

Free cash flow measures the cash generated by the firm before any payments to debt or equity holders are considered. 1

To be precise, when we say “cash,” we are referring to the firm’s cash in excess of its working capital needs, which is the amount of cash it has invested at a competitive market interest rate.

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Thus, just as we determine the value of a project by calculating the NPV of the project’s free cash flow, we estimate a firm’s current enterprise value, V0 , by computing the present value of the firm’s free cash flow: Discounted Free Cash Flow Model V0 = PV 1 Future Free Cash Flow of Firm 2

(10.3)

Given the enterprise value, we can estimate the share price by using Eq. 10.1 to solve for the value of equity and then divide by the total number of shares outstanding: P0 =

V0 + Cash0 - Debt 0 Shares Outstanding 0

(10.4)

In the dividend-discount model, the firm’s cash and debt are included indirectly through the effect of interest income and expenses on earnings. By contrast, in the discounted free cash flow model, we ignore interest income and expenses because free cash flow is based on EBIT (Earnings Before Interest and Taxes), but we then adjust for cash and debt directly (in Eq. 10.4).

Implementing the Model

weighted average cost of capital (WACC) The cost of capital that reflects the risk of the overall business, which is the combined risk of the firm’s equity and debt.

A key difference between the discounted free cash flow model and the earlier models we have considered is the discount rate. In previous calculations, we used the firm’s equity cost of capital, rE , because we were discounting the cash flows to equity holders. Here, we are discounting the free cash flow that will be paid to both debt and equity holders. Thus we should use the firm’s weighted average cost of capital (WACC), denoted by rwacc it is the cost of capital that reflects the risk of the overall business, which is the combined risk of the firm’s equity and debt. We interpret rwacc as the expected return the firm must pay to investors to compensate them for the risk of holding the firm’s debt and equity together. If the firm has no debt, then rwacc = rE . We will develop methods to calculate the WACC explicitly in Part 4 of this text. Given the firm’s weighted average cost of capital, we implement the discounted free cash flow model in much the same way as we did the dividend-discount model. That is, we forecast the firm’s free cash flow up to some horizon, together with a terminal (continuation) value of the enterprise: V0 =

FCF1 FCF2 FCFN VN + + g + + 2 N 1 + rwacc 1 1 + rwacc 2 1 1 + rwacc 2 1 1 + rwacc 2 N

(10.5)

Often, we estimate the terminal value by assuming a constant long-run growth rate gFCF for free cash flows beyond year N, so that VN =

FCFN + 1 1 + gFCF = ¢ ≤ * FCFN rwacc - gFCF rwacc - gFCF

(10.6)

The long-run growth rate gFCF is typically based on the expected long-run growth rate of the firm’s revenues.

EXAMPLE 10.1 Valuing Nike, Inc., Stock Using Free Cash Flow

Recall our example of Nike, Inc., from Chapter 7. Nike had sales of $19.2 billion in 2009. Suppose you expect its sales to grow at a rate of 10% in 2010, but then slow by 1% per year to the long-run growth rate that is characteristic of the apparel industry—5%—by 2015. Based on Nike’s past profitability and investment needs, you expect EBIT to be 10% of sales, increases in net working capital requirements to be 10% of any increase in sales, and capital expenditures to equal depreciation expenses. If Nike has $2.3 billion in cash, $32 million in debt, 486 million shares outstanding, a tax rate of 24%, and a weighted average cost of capital of 10%, what is your estimate of the value of Nike’s stock in early 2010?

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Part 3 Valuation and the Firm Solution Q Plan We can estimate Nike’s future free cash flow by constructing a pro forma statement as we did for HomeNet in Chapter 9. The only difference is that the pro forma statement is for the whole company, rather than just one project. Further, we need to calculate a terminal (or continuation) value for Nike at the end of our explicit projections. Because we expect Nike’s free cash flow to grow at a constant rate after 2015, we can use Eq. 10.6 to compute a terminal enterprise value. The present value of the free cash flows during the years 2010–2015 and the terminal value will be the total enterprise value for Nike. From that value, we can subtract the debt, add the cash, and divide by the number of shares outstanding to compute the price per share (Eq. 10.4). Q Execute The spreadsheet below presents a simplified pro forma for Nike based on the information we have: 1 2 3 4 5 6 7 8 9 10

Year 2009 2010 FCF Forecast ($ million) Sales 19,200.0 21,120.0 Growth versus Prior Year 10.0% EBIT (10% of sales) 2,112.0 Less: Income Tax (24%) 506.9 Plus: Depreciation — Less: Capital Expenditures — Less: Increase in NWC (10% Sales) 192.0 Free Cash Flow 1,413.1

2011

2012

23,020.8 9.0% 2,302.1 552.5 — — 190.1 1,559.5

24,862.5 8.0% 2,486.2 596.7 — — 184.2 1,705.3

2014

2015

26,602.8 28,199.0 7.0% 6.0% 2,660.3 2,819.9 638.5 676.8 — — — — 174.0 159.6 1,847.8 1,983.5

29,609.0 5.0% 2,960.9 710.6 — — 141.0 2,109.3

2013

Because capital expenditures are expected to equal depreciation, lines 7 and 8 in the spreadsheet cancel out. We can set them both to zero rather than explicitly forecast them. Given our assumption of constant 5% growth in free cash flows after 2015 and a weighted average cost of capital of 10%, we can use Eq. 10.6 to compute a terminal enterprise value: 1 + gFCF 1.05 ≤ * 2,109.3 = +44,295 million ≤ * FCF2015 = ¢ V2015 = ¢ rwacc - gFCF 0.10 - 0.05 From Eq. 10.5, Nike’s current enterprise value is the present value of its free cash flows plus the present value of the firm’s terminal value: 1,413.1 1,559.5 1,705.3 1,847.8 1,983.5 2,109.3 44,295.0 V0 = + + + + + = +32,542.4 million + 1.10 1.102 1.103 1.104 1.105 1.106 1.106 We can now estimate the value of a share of Nike’s stock using Eq. 10.4: P0 =

$32,542.4 + $2,300 - $32 = $71.63 486

Q Evaluate The total value of all of the claims, both debt and equity, on the firm must equal the total present value of all cash flows generated by the firm, in addition to any cash it currently has. The total present value of all cash flows to be generated by Nike is $32,542 million and it has $2,300 million in cash. Subtracting off the value of the debt claims ($32 million), leaves us with the total value of the equity claims and dividing by the number of shares produces the value per share.

Connection to Capital Budgeting There is an important connection between the discounted free cash flow model and the NPV rule for capital budgeting we developed in Chapter 9. Because the firm’s free cash flow is equal to the sum of the free cash flows from the firm’s current and future investments, we can interpret the firm’s enterprise value as the sum of the present value of its existing projects and the NPV of future new ones. Hence, the NPV of any investment deci-

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sion represents its contribution to the firm’s enterprise value. To maximize the firm’s share price, we should therefore accept those projects that have a positive NPV. Recall also from Chapter 9 that many forecasts and estimates were necessary to estimate the free cash flows of a project. The same is true for the firm: We must forecast its future sales, operating expenses, taxes, capital requirements, and other factors to obtain its free cash flow. On the one hand, estimating free cash flow in this way gives us flexibility to incorporate many specific details about the future prospects of the firm. On the other hand, some uncertainty inevitably surrounds each assumption. Given this fact, it is important to conduct a sensitivity analysis, as described in Chapter 9, to translate this uncertainty into a range of potential values for the stock.

EXAMPLE 10.2 Sensitivity Analysis for Stock Valuation

Problem In Example 10.1, Nike’s EBIT was assumed to be 10% of sales. If Nike can reduce its operating expenses and raise its EBIT to 11% of sales, how would the estimate of the stock’s value change?

Solution Q Plan In this scenario, EBIT will increase by 1% of sales compared to Example 10.1. From there, we can use the tax rate (24%) to compute the effect on the free cash flow for each year. Once we have the new free cash flows, we repeat the approach in Example 10.1 to arrive at a new stock price. Q Execute In year 1, EBIT will be 1% * +21,120.0 million = +211.2 million higher. After taxes, this increase will raise the firm’s free cash flow in year 1 by 1 1 - 0.24 2 * +211.2 million = +160.5 million, to $1,573.6 million. Doing the same calculation for each year, we get the following revised FCF estimates: Year

2010

2011

2012

2013

2014

2015

FCF

1,573.6

1,734.5

1,894.3

2,050.0

2,197.8

2,334.3

We can now reestimate the stock price as in Example 10.1. The terminal value is V2015 = [1.05/ 1 0.10 - 0.05 2 ] * 2,334.3 = +49,020.3 million, so V0 =

1,573.6 1,734.5 1,894.3 2,050.0 2,197.8 2,334.3 49,020.3 + + + + + + = +36,040.4 million 1.10 1.102 1.103 1.104 1.105 1.106 1.106

The new estimate for the value of the stock is P0 = 1 36,040.6 + 2,300 - 32 2 /486 = +78.82 per share, a difference of about 10% compared to the result found in Example 10.1. Q Evaluate

Nike’s stock price is fairly sensitive to changes in the assumptions about its profitability. A 1% permanent change in its margins affects the firm’s stock price by 10%.

Figure 10.1 summarizes the different valuation methods we have discussed so far. We use the present value of a stock’s future dividends to determine its value. We can estimate the total market capitalization of the firm’s equity from the present value of the firm’s total payouts, which includes dividends and share repurchases. Finally, the present value of the firm’s free cash flow, which is the amount of cash the firm has available to make payments to equity or debt holders, determines the firm’s enterprise value.

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FIGURE 10.1 A Comparison of Discounted Cash Flow Models of Stock Valuation

Concept Check

10.2

method of comparables An estimate of the value of a firm based on the value of other, comparable firms or other investments that are expected to generate very similar cash flows in the future.

valuation multiple A ratio of a firm’s value to some measure of the firm’s scale or cash flow.

By computing the present value of the firm’s dividends, total payouts, or free cash flows, we can estimate the value of the stock, the total value of the firm’s equity, or the firm’s enterprise value. The final column details what adjustment is necessary to obtain the stock price. Present Value of...

Determines the...

To Get Stock Price Estimate...

Dividend Payments

Stock Price

No adjustment necessary

Total Payouts (All dividends and repurchases)

Equity Value

Divide by shares oustanding

Free Cash Flow (Cash available to pay all security holders)

Enterprise Value

Subtract what does not belong to equity holders (debt and perferred stock), add back cash and marketable securities, and divide by shares outstanding

1. What is the relation between capital budgeting and the discounted free cash flow model? 2. Why do we ignore interest payments on the firm’s debt in the discounted free cash flow model?

Valuation Based on Comparable Firms So far, we have valued a firm or its stock by considering the expected future cash flows it will provide to its owner. The Valuation Principle then tells us that its value is the present value of its future cash flows, because the present value is the amount we would need to invest elsewhere in the market to replicate the cash flows with the same risk. Another application of the Valuation Principle is the method of comparables. In the method of comparables (or “comps”), rather than value the firm’s cash flows directly, we estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future. For example, consider the case of a new firm that is identical to an existing publicly traded company. Recall that from competitive market prices, the Valuation Principle implies that two securities with identical cash flows must have the same price. Thus, if these firms will generate identical cash flows, we can use the market value of the existing company to determine the value of the new firm. Of course, identical companies do not really exist. Even two firms in the same industry selling the same types of products, while similar in many respects, are likely to be of a different size or scale. For example, Hewlett-Packard and Dell both sell personal computers directly to consumers using the Internet. In 2009, Hewlett-Packard had sales of $115 billion, whereas Dell had sales of approximately $53 billion. In this section, we consider ways to adjust for scale differences to use comparables to value firms with similar businesses and then discuss the strengths and weaknesses of this approach.

Valuation Multiples We can adjust for differences in scale between firms by expressing their value in terms of a valuation multiple, which is a ratio of the value to some measure of the firm’s scale. As

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289

an analogy, consider valuing an office building. A natural measure to consider would be the price per square foot for other buildings recently sold in the area. Multiplying the size of the office building under consideration by the average price per square foot would typically provide a reasonable estimate of the building’s value. We can apply this same idea to stocks, replacing square footage with some more appropriate measure of the firm’s scale. The Price-Earnings Ratio. The most common valuation multiple is the price-earnings ratio, which we introduced in Chapter 2. The P/E ratio is so common that it is almost always part of the basic statistics computed for a stock (as shown in Figure 10.2, the screenshot from Google Finance for Nike). A firm’s P/E ratio is equal to the share price divided by its earnings per share. The intuition behind its use is that, when you buy a stock, you are in a sense buying the rights to the firm’s future earnings. If differences in the scale of firms’ earnings are likely to persist, you should be willing to pay proportionally more for a stock with higher current earnings. Using this idea we can estimate the value of a share of stock of a firm by using the P/E ratios of other firms. For example, we can estimate the stock price of a private firm by multiplying its current earnings per share (EPS) by the average P/E ratio of comparable public firms.

FIGURE 10.2 Stock Price Quote for Nike (NKE)

This screenshot from Google Finance shows the basic stock price information and price history charting for the common stock of Nike. The historical price chart covers the period February through early May 2010. Notice that the price-earnings (P/E) ratio is listed as part of the basic information.

Source: www.google.com/finance?q=nke.

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EXAMPLE 10.3

Problem

Valuation Using the Price-Earnings Ratio

Suppose furniture manufacturer Herman Miller, Inc., has earnings per share of $1.38. If the average P/E of comparable furniture stocks is 21.3, estimate a value for a share of Herman Miller’s stock using the P/E as a valuation multiple. What are the assumptions underlying this estimate?

Solution Q Plan We estimate a share price for Herman Miller by multiplying its EPS by the P/E of comparable firms:

EPS * P/E = Earnings per Share * 1 Price per Share Earnings per Share 2 = Price per Share

Q Execute P0 = +1.38 * 21.3 = +29.39. This estimate assumes that Herman Miller will have similar future risk, payout rates, and growth rates to comparable firms in the industry. Q Evaluate Although valuation multiples are simple to use, they rely on some very strong assumptions about the similarity of the comparable firms to the firm you are valuing. It is important to consider whether these assumptions are likely to be reasonable—and thus to hold—in each case.

trailing earnings A firm’s earnings over the prior 12 months. forward earnings A firm’s anticipated earnings over the coming 12 months. trailing P/E A firm’s price-earnings (P/E) ratio calculated using trailing (past) earnings. forward P/E A firm’s price-earnings (P/E) ratio calculated using forward (expected) earnings.

We can compute a firm’s P/E ratio by using either trailing earnings—earnings over the prior 12 months—or forward earnings—expected earnings over the coming 12 months—with the resulting ratio being called the trailing P/E or the forward P/E, respectively. For valuation purposes, the forward P/E is generally preferred, as we are most concerned about future earnings. To understand how P/E ratios relate to the other valuation techniques we have discussed, consider the dividend discount model introduced in Chapter 7.2 For example, in the case of constant dividend growth (see Eq. 7.6), we had P0 =

Div1 rE - g

Dividing through by EPS1 , we find that Forward P/E =

P0 Div1/EPS1 Dividend Payout Rate = = rE - g rE - g EPS1

(10.7)

In Chapter 7, we showed that Nike’s current price is consistent with an equity cost of capital of 10% and an expected dividend growth rate of 8.5%. From the Nike quote, we can also see that Nike has earnings per share (EPS) of $3.51 and a dividend of $0.27 per quarter, or $1.08 per year which gives a dividend payout rate of 1.08/3.51 = 0.308. Assuming that earnings growth and payout rates remain at this level for the foreseeable future, then we could compute the forward P/E as: Forward P/E =

1.08/3.51 = 20.51, which is not far off its reported P/E of 21.78. .10 - 0.085

Equation 10.7 suggests that firms and industries that have high growth rates, and that generate cash well in excess of their investment needs so that they can maintain high payout rates, should have high P/E multiples. Taking the example of Nike we showed that 2

We use the dividend discount model rather than discounted cash flows because price and earnings are variables associated exclusively with equity.

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291

at an expected growth rate of 8.5%, it would have a P/E ratio of 20.51. If our growth expectations were lower, its P/E would drop. Holding current earnings, dividends, and equity cost of capital constant, but decreasing the growth rate to 5%, we would have: Forward P/E =

1.08/3.51 = 6.15 .10 - 0.05

This result is much lower than its current P/E of 21.78 making it clear that simply comparing P/E ratios without taking into account growth prospects can be highly misleading. Figure 10.3 shows the relationship between expected earnings growth and P/E ratios.

FIGURE 10.3 Relating the P/E Ratio to Expected Future Growth

The graph shows the expected growth in earnings under two growth scenarios for Nike: 8.5% and 5%. Current earnings per share is $3.51. Higher growth increases the PV of the earnings stream, which means that the price increases. The result is that the higher price divided by current earnings yields a higher P/E ratio. We found that a growth rate of 8.5% implied a P/E ratio of 20.51 while a growth rate of 5% implied a P/E ratio of 6.15. The graph shows how higher expected growth translates into a higher P/E.

30

Growth at 8.5% Growth at 5%

25 Higher growth translates to a P/E of 20.51

Earnings

20 15

10

Current earnings of $3.51

5

0

Low growth translates to a P/E of 6.15 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Years

EXAMPLE 10.4 Growth Prospects and the Price-Earnings Ratio

Problem Amazon.com and Macy’s are both retailers. In 2010, Amazon had a price of $138.71 and forward earnings per share of $2.61. Macy’s had a price of $20.87 and forward earnings per share of $1.87. Calculate their forward P/E ratios and explain the difference.

Solution Q Plan We can calculate their P/E ratios by dividing each company’s price per share by its forward earnings per share. The difference we find is most likely due to different growth expectations. Q Execute Forward P/E for Amazon = $138.71/$2.61 = 53.15. Forward P/E for Macy’s = $20.87/$1.87 = 11.16. Amazon’s P/E ratio is higher because investors expect its earnings to grow more than Macy’s.

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Q Evaluate Although both companies are retailers, they have very different growth prospects, as reflected in their P/E ratios. Investors in Amazon.com are willing to pay 53 times this year’s expected earnings because they are also buying the present value of high future earnings created by expected growth.

Enterprise Value Multiples. The P/E ratio has the same limitations as the dividend discount model—because it relates exclusively to equity, it ignores the effect of debt. Consequently, it is also common practice to use valuation multiples based on the firm’s enterprise value. By representing the total value of the firm’s underlying business rather than just the value of equity, the enterprise value allows us to compare firms with different amounts of leverage. Because the enterprise value represents the entire value of the firm before the firm pays its debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows before interest payments are made. Common multiples to consider are enterprise value to EBIT, EBITDA (earnings before interest, taxes, depreciation, and amortization), and free cash flow. However, because capital expenditures can vary substantially from period to period (e.g., a firm may need to add capacity and build a new plant one year, but then may not need to expand further for many years), most practitioners rely on enterprise value to EBITDA (EV/EBITDA) multiples. Enterprise value multiples value the entire firm, and so they are most closely related to the discount cash flow model. When expected free cash flow growth is constant, we can use Eq. 10.6 to write enterprise value to EBITDA as FCF1 V0 rwacc - gFCF FCF1/EBITDA1 = = rwacc - gFCF EBITDA1 EBITDA1

(10.8)

As with the P/E multiple, this valuation multiple is higher for firms with high growth rates and low capital requirements (which means that free cash flow is high in proportion to EBITDA).

EXAMPLE 10.5 Valuation Using the Enterprise Value Multiple

Problem Fairview, Inc., is an ocean transport company with EBITDA of $50 million, cash of $20 million, debt of $100 million, and 10 million shares outstanding. The ocean transport industry as a whole has an average EV/EBITDA ratio of 8.5. What is one estimate of Fairview’s enterprise value? What is a corresponding estimate of its stock price?

Solution Q Plan To estimate Fairview’s enterprise value, we multiply its EBITDA by the average EV/EBITDA ratio of its industry. From there, we can subtract Fairview’s debt and add its cash to calculate its equity value. Finally, we can divide by the number of shares outstanding to arrive at its stock price. Q Execute Fairview’s enterprise value estimate is +50 million * 8.5 = +425 million. Next, subtract the debt from its enterprise value and add in its cash: +425 million - +100 million + +20 million = +345 million, which is an estimate of the equity value. Its stock price estimate is equal to its equity value estimate divided by the number of shares outstanding: +345 million 10 million = +34.50.

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Q Evaluate If we assume that Fairview should be valued similarly to the rest of the industry, then $425 million is a reasonable estimate of its enterprise value and $34.50 is a reasonable estimate of its stock price. However, we are relying on the assumption that Fairview’s expected free cash flow growth is similar to the industry average. If that assumption is wrong, so is our valuation.

Other Multiples. Many other valuation multiples are used. Looking at the enterprise value as a multiple of sales can be useful if it is reasonable to assume the firm will maintain a similar margin in the future. For firms with substantial tangible assets, the ratio of price-to-book value of equity per share is sometimes used as a valuation multiple. Some multiples are specific to an industry. In the cable TV industry, for example, analysts compare enterprise value per subscriber.

Limitations of Multiples If comparable firms were identical to the firm being valued, the firms’ multiples would match precisely. Of course, firms are not identical, so the usefulness of a valuation multiple will inevitably depend on the nature of the differences between firms and the sensitivity of the multiples to these differences. Table 10.1 lists several valuation multiples, as of May 2010, for firms in the footwear industry that could be used as comparables for Nike. Also shown in the table is the average for each multiple, together with the range around the average (in percentage terms). The bottom rows showing the range make it clear that the footwear industry has a lot of dispersion for all the multiples (for example, Deckers has a price-to-book (P/B) of 3.59, while Rocky Shoes and Boots has a P/B of only 0.56). While the P/E multiple shows the smallest variation, even with it we cannot expect to obtain a precise estimate of a firm’s value.

TABLE 10.1 Stock Prices and Multiples for the Footwear Industry (excluding Nike), May 2010

Name Adidas AG Puma AG

Market Capitalization ($ million)

Enterprise Value ($ million)

P/E

Price/Book

Enterprise Value/Sales

Enterprise Value/EBITDA

8,950

8,554

21.90

2.34

0.82

11.08

3,680

2,984

17.91

2.92

1.21

11.48

Deckers Outdoor Corp.

1,760

1,400

14.63

3.59

1.68

6.94

Skechers U.S.A.

1,730

1,420

17.11

2.20

0.89

8.37

Wolverine World Wide

1,460

1,380

18.72

3.08

1.22

9.28

531

455

21.21

2.37

1.62

12.64

Weyco Group

281

252

20.24

1.74

1.11

10.75

LaCrosse Footwear

118

99

15.14

1.95

0.67

6.54

R. G. Barry Corp.

114

79

11.11

1.96

0.63

4.64

Volcom, Inc.

Rocky Shoes & Boots

45

89

25.96

0.56

0.38

5.45

Average

18.39

2.27

1.02

8.72

Maximum

+41%

+58%

+64%

+45%

Minimum

-40%

-75%

-63%

-47%

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Part 3 Valuation and the Firm The differences in these multiples most likely reflect differences in expected future growth rates, risk (and therefore costs of capital), and, in the case of Puma and Adidas, differences in accounting conventions between the United States and Germany. Investors in the market understand that these differences exist, so the stocks are priced accordingly. When valuing a firm using multiples, however, there is no clear guidance about how to adjust for these differences other than by narrowing the set of comparables used. Another limitation of comparables is that they provide only information regarding the value of the firm relative to the other firms in the comparison set. Using multiples will not help us determine whether an entire industry is overvalued, for example. This issue became especially important during the Internet boom of the late 1990s. Because many of these firms did not have positive cash flows or earnings, new multiples were created to value them (for instance, price to “page views”). While these multiples could justify the value of these firms in relationship to one another, it was much more difficult to justify the stock prices of many of these firms using a realistic estimate of cash flows and the discounted free cash flow approach.

Comparison with Discounted Cash Flow Methods The use of a valuation multiple based on comparables is best viewed as a shortcut. Rather than separately estimate the firm’s cost of capital and future earnings or free cash flows, we rely on the market’s assessment of the value of other firms with similar future prospects. In addition to its simplicity, the multiples approach has the advantage of being based on actual stock prices of real firms, rather than on what may be unrealistic forecasts of future cash flows. The most important shortcoming of the comparables approach is that it does not take into account materially important differences among firms. For example, the approach ignores the fact that some firms have exceptionally talented managers, others have developed more efficient manufacturing process, and still others might hold a patent on a new technology. Discounted cash flow methods have an advantage because they allow us to incorporate specific information about the firm’s cost of capital or future growth. Thus, because the true driver of value for any firm is its ability to generate cash flows for its investors, the discounted cash flow methods have the potential to be more accurate than the use of a valuation multiple.

Stock Valuation Techniques: The Final Word In the end, no single technique provides a final answer regarding a stock’s true value. Indeed, all approaches inevitably require assumptions or forecasts that are too uncertain to provide a definitive assessment of the firm’s value. Most real-world practitioners use a combination of these approaches and gain confidence in the outcome if the results are consistent across a variety of methods. Figure 10.4 compares the ranges of values for Nike stock using the different valuation methods discussed in this chapter and in Chapter 7. The firm’s stock price of $76.43 on May 11, 2010 was within the range of some methods, but higher than the range suggested by some of the multiples. Hence, based on this evidence alone, we would not conclude that the stock is obviously under- or over-priced. But if this were not the case —what if these valuation techniques produce valuations markedly different to what the stock is trading at in the market? In the next section, we tackle this question.

Concept Check

3. What are some common valuation multiples? 4. What implicit assumptions do we make when valuing a firm using multiples based on comparable firms?

Chapter 10 Stock Valuation: A Second Look

FIGURE 10.4 Range of Valuations for Nike Stock Using Various Valuation Methods

295

Valuations from multiples are based on the low, high, and average values of the comparable firms from Table 10.1 (see Problems 12 and 13 at the end of this chapter). The constant dividend growth model is based on a 10% equity cost of capital and dividend growth rates of 6% to 9%, as discussed at the beginning of Section 7.5. The discounted free cash flow model is based on Example 10.1 with the range of parameters in Problem 8 at the end of this chapter. Midpoints are based on average multiples or base-case assumptions. Red and blue regions show the variation between the lowest-multiple/worstcase scenario and the highest-multiple/best-case scenario. Nike’s actual share price of $76.43 is indicated by the gray line.

Valuation Method

Discounted FCF Constant Dividend Growth EV/EBITDA EV/Sales Price/Book P/E 0

10

20

30

40

50

60

70

80

90

100

110

120

Value per Share ($)

INTERVIEW WITH

MARILYN FEDAK

Marilyn G. Fedak is the Vice Chair, Investment Services, and was formerly head of Global Value Equities, at AllianceBernstein, a publicly traded global asset management firm with approximately $450 billion in assets.

What valuation methods do you use to identify buying opportunities for value stocks?

QUESTION:

ANSWER: We use both a dividend-discount model (DDM) and a proprietary quantitative return model called the Global Edge Model (GEM). For our non-U.S. portfolios, we use the GEM model; in the U.S., we use a combination of GEM and the DDM. At its most basic level, the DDM provides a way to evaluate how much we need to pay today for a company’s future earnings and cash flow.* All things being equal, we are looking to buy as much earnings power as cheaply as we can. It is a very reliable methodology, if you have the right forecasts for companies’ future earnings. Our GEM model encompasses a variety of valuation measures, such as P/E and price-to-book ratios and selected success factors—for example, ROE and price momentum.

In both the U.S. and non-U.S. portfolios, we use these valuation tools to rank companies from the most undervalued to the most expensive. We focus on the stocks that rank the highest. Our decision-making bodies, the investment policy groups, meet with analysts to quality-control the forecasts for the highest ranked group of stocks. Once the forecasts are approved, we add risk tools to construct optimal portfolios. QUESTION:

Are there drawbacks to these models?

ANSWER: Both models have advantages and drawbacks. The DDM is a very reliable valuation methodology. However, its focus on forecasts of cash flow or earnings over some future period requires a large, highly skilled body of research analysts. And, it is oriented to the long term, so the timing of purchases and sales can be too early. The Global Edge Model is very useful to efficiently evaluate investments within large universes. However, it is very oriented to

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current profitability and valuation metrics—not the future. As such, judgment has to be applied to determine if a company is likely to sustain similar characteristics going forward.

Did the precipitous decline in stock prices in late 2008 and early 2009 cause you to retool your valuation methodology?

QUESTION:

ANSWER:

In 2006, we began studying the interaction of the DDM and GEM models and determined that combining the two models gives us superior results to a single methodology when evaluating U.S. securities. The DDM focuses on forecasts of a company’s future, whereas the quant [quantitative] return model captures a

10.3

company’s history and current status. This new methodology was very helpful to us in 2008, when the GEM model signaled caution for certain sectors that looked inexpensive based on the DDM. We have also broadened our research to incorporate more external inputs and have assigned a higher probability to unlikely events such as the recent government intervention in the financial and auto industries. On the risk side, we have added a refinancing risk tool and are tracking short interest in various equities. *Because of historical usage, many practitioners use the term “dividend-discount model” to refer to the entire class of cash flow discount models.

Information, Competition, and Stock Prices As shown in Figure 10.5, the models described in this chapter and in Chapter 7 link the firm’s expected future cash flows, its cost of capital (determined by its risk), and the value of its shares. But what conclusions should we draw if the actual market price of a stock does not appear to be consistent with our estimate of its value? Is it more likely that the stock is mispriced or that we are mistaken about its risk and future cash flows?

Information in Stock Prices Suppose you are a new junior analyst assigned to research Nike’s stock and assess its value. You scrutinize the company’s recent financial statements, look at the trends in the industry, and forecast the firm’s future earnings, dividends, and free cash flows. After you carefully crunch the numbers, you estimate the stock’s value to be $85 per share. On your way to present your analysis to your boss, you run into a slightly more experienced colleague in the elevator. It turns out that your colleague has been researching the same stock. But according to her analysis, the value of Nike stock is only $65 per share. What would you do? Although you could just assume your colleague is wrong, most of us would reconsider our own analysis. The fact that someone else who has carefully studied the same stock has come to a very different conclusion is powerful evidence that we might be mistaken. In the face of this information from our colleague, you would probably adjust your

FIGURE 10.5 The Valuation Triad

Valuation models determine the relationship among the firm’s future cash flows, its cost of capital, and the value of its shares. We can use the stock’s expected cash flows and cost of capital to assess its market price (share value). Conversely, we can use the market price to assess the firm’s future cash flows or cost of capital. Share Value

Future Cash Flows Valuation Model Cost of Capital

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assessment of the stock’s value downward. Of course, your colleague might also revise her opinion upward based on your assessment. After sharing the analyses, we would likely end up with a consensus estimate somewhere between $65 and $85 per share. This type of encounter happens millions of times every day in the stock market. When a buyer seeks to buy a stock, the willingness of other parties to sell the same stock suggests that they value the stock differently. This information should lead both buyers and sellers to revise their valuations. Ultimately, investors trade until they reach a consensus regarding the value (market price) of the stock. In this way, stock markets aggregate the information and views of many different investors. Thus, if your valuation model suggests a stock is worth $30 per share when it is trading for $20 per share in the market, the discrepancy is equivalent to knowing that thousands of investors—many of them professionals who have access to the best information about the stock available—disagree with your assessment. This knowledge should make you reconsider your original analysis. You would need a very compelling reason to trust your own estimate in the face of such contrary opinions. What conclusion can we draw from this discussion? Recall Figure 10.5, in which a valuation model links the firm’s future cash flows, its cost of capital, and its share price. In other words, given accurate information about any two of these variables, a valuation model allows us to make inferences about the third variable. Thus the way we use a valuation model will depend on the quality of our information: The model will tell us the most about the variable for which our prior information is the least reliable. For a publicly traded firm, its market price should already provide very accurate information, aggregated from a multitude of investors, regarding the true value of its shares. In these situations, the best use of a valuation model is to inform us about the things we cannot observe directly—the firm’s future cash flows or cost of capital. Only in the relatively rare case in which we have some superior information that other investors lack regarding the firm’s cash flows and cost of capital would it make sense to secondguess the stock price.

EXAMPLE 10.6 Using the Information in Market Prices

Problem Suppose Tecnor Industries will have free cash flows next year of $40 million. Its weighted average cost of capital is 11%, and you expect its free cash flows to grow at a rate of approximately 4% per year, though you are somewhat unsure of the precise growth rate. Tecnor has 10 million shares outstanding, no debt, and $20 million in cash. If Tecnor’s stock is currently trading for $55.33 per share, how would you update your beliefs about its dividend growth rate?

Solution Q Plan If we apply the growing perpetuity formula for the growing FCF based on a 4% growth rate, we can estimate a stock price using Eq. 10.3 and Eq. 10.4. If the market price is higher than our estimate, it implies that the market expects higher growth in FCF than 4%. Conversely, if the market price is lower than our estimate, the market expects FCF growth to be less than 4%. Q Execute

Applying the growing perpetuity formula, we have PV 1 FCF 2 = 40 1 0.11 - 0.04 2 = $571.43 million. Applying Eq. 10.4, the price per share would be 1 +571.43 million - 0 + +20 million 2 10 million shares = +59.14 per share. The market price of $55.33, however, implies that most investors expect FCF to grow at a somewhat slower rate. Q Evaluate Given the $55.33 market price for the stock, we should lower our expectations for the FCF growth rate from 4% unless we have very strong reasons to trust our own estimate.

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efficient markets hypothesis The idea that competition among investors works to eliminate all positive-NPV trading opportunities. It implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors.

Competition and Efficient Markets The notion that market prices reflect the information of many investors is a natural consequence of investor competition. If information were available that indicated buying a stock had a positive NPV, investors with that information would choose to buy the stock; their attempts to purchase it would then drive up the stock’s price. By a similar logic, investors with information that selling a stock had a positive NPV would sell it, so the stock’s price would fall. The idea that competition among investors works to eliminate all positive-NPV trading opportunities is the efficient markets hypothesis. It implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors.

Forms of Market Efficiency The type of market efficiency we describe here, where all publicly available information is incorporated very quickly into stock prices, is often called semistrong form market efficiency. The term “semistrong” indicates that it is not as complete as strong form market efficiency, where prices immediately incorporate all information, including private information known, for example, only to managers. Finally, the term weak form market efficiency means that only the history of past prices is already reflected in the stock price. It helps to think of the different forms of market efficiency as meaning that prices incorporate a steadily increasing set of information, each of which encompasses all the lower forms. For example, since the history of past prices is public information, semistrong form efficiency encompasses weak form. The diagram illustrates the idea. In the diagram, the information sets of weak form, semistrong form, and strong form efficiency are represented by the blue, green, and yellow circles, respectively. Not all market participants believe that the stock market is semistrong form efficient. Technical analysts, who look for patterns in stock prices, do not believe the market is even weak form efficient. Mutual fund managers and fundamental analysts, such as those who work for brokerages and make stock recommendations, believe that mispricing can be uncovered by careful analysis of company fundamentals. There is evidence

that traders with inside information about upcoming merger or earnings announcements can make abnormal returns by trading (illegally) on that information, so the market is clearly not strong form efficient.

All information

All public information

History of stock prices

What happens when new information about a stock arrives? The answer depends on the degree of competition, that is, on the number of investors who have access to this new information. Consider two important cases. Public, Easily Interpretable Information. Information that is available to all investors includes information in news reports, financial statements, corporate press releases, or other public data sources. If investors can readily ascertain the effects of this information on the firm’s future cash flows, then all investors can determine how this information will change the firm’s value. In this situation, we expect competition between investors to be fierce and the stock price to react nearly instantaneously to such news. A few lucky investors might be able to trade a small quantity of shares before the price has fully adjusted. Most investors, however, would find that the stock price already reflected the new information before they were able to trade on it. In other words, the efficient markets hypothesis holds very well with respect to this type of information.

Chapter 10 Stock Valuation: A Second Look

EXAMPLE 10.7 Stock Price Reactions to Public Information

299

Problem Myox Labs announces that it is pulling one of its leading drugs from the market, owing to the potential side effects associated with the drug. As a result, its future expected free cash flow will decline by $85 million per year for the next ten years. Myox has 50 million shares outstanding, no debt, and an equity cost of capital of 8%. If this news came as a complete surprise to investors, what should happen to Myox’s stock price upon the announcement?

Solution Q Plan In this case, we can use the discounted free cash flow method. With no debt, rwacc = rE = 8%. The effect on the Myox’s enterprise value will be the loss of a ten-year annuity of $85 million. We can compute the effect today as the present value of that annuity. Q Execute Using the annuity formula, the decline in expected free cash flow will reduce Myox’s enterprise value by $85 million *

1 1 ¢1 ≤ = $570.36 million 0.08 1.0810

Thus, the stock price should fall by +570/50 = $11.41 per share. Q Evaluate Because this news is public and its effect on the firm’s expected free cash flow is clear, we would expect the stock price to drop by $11.41 per share nearly instantaneously.

Private or Difficult-to-Interpret Information. Of course, some information is not publicly available. For example, an analyst might spend considerable time and effort gathering information from a firm’s employees, competitors, suppliers, or customers that is relevant to the firm’s future cash flows. This information is not available to other investors who have not devoted a similar effort to gathering it. Even when information is publicly available, it may be difficult to interpret. Nonexperts in the field may find it challenging to evaluate research reports on new technologies, for example. It may take a great deal of legal and accounting expertise and effort to understand the full consequences of a highly complicated business transaction. Certain consulting experts may have greater insight into consumer tastes and the likelihood of a product’s acceptance. In these cases, while the fundamental information may be public, the interpretation of how that information will affect the firm’s future cash flows is itself private information. As an example, imagine that Phenyx Pharmaceuticals has just announced the development of a new drug for which the company is seeking approval from the U.S. Food and Drug Administration (FDA). If the drug is approved and subsequently launched in the U.S. market, the future profits from the new drug will increase Phenyx’s market value by $750 million, or $15 per share given its 50 million shares outstanding. Assume that the development of this drug comes as a surprise to investors, and that the average likelihood of FDA approval is 10%. In that case, because many investors probably know the chance of FDA approval is 10%, competition should lead to an immediate jump in Phenyx’s stock price of 10% * +15 = +1.50 per share. Over time, however, analysts and experts in the field will likely make their own assessments of the probable efficacy of the drug. If they conclude that the drug looks more promising than average, they will begin to trade on their private information and buy the stock, and the firm’s price will tend to drift higher over time. If the experts conclude that the drug looks less promising than average, however, they will tend to sell the stock, and the firm’s price will drift lower over time. Of course, at the time of the announcement, uninformed investors do not know which way it will go. Examples of possible price paths are shown in Figure 10.6.

Part 3 Valuation and the Firm

FIGURE 10.6

Phenyx’s stock price jumps on the announcement based on the average likelihood of FDA approval. The stock price then drifts up (green path) or down (orange path) as informed traders trade on their more accurate assessment of the drug’s likelihood of approval and hence entry into the U.S. market. At the time of the announcement, uninformed investors do not know which way the stock will go.

Possible Stock Price Paths for Phenyx Pharmaceuticals

$9 $8

Stock Price

300

$7

Announcement

$6 $5 $4 $3 Time

When private information is in the hands of only a relatively small number of investors, these investors may be able to profit by trading on their information.3 In this case, the efficient markets hypothesis will not hold in the strict sense. However, as these informed traders begin to trade, their actions will tend to move prices, so over time prices will begin to reflect their information as well. If the profit opportunities from having this type of information are large, other individuals will attempt to gain the expertise and devote the resources needed to acquire it. As more individuals become better informed, competition to exploit this information will increase. Thus, in the long run, we should expect that the degree of “inefficiency” in the market will be limited by the costs of obtaining the information.

Lessons for Investors and Corporate Managers The effect of competition based on information about stock prices has important consequences for both investors and corporate managers. Consequences for Investors. As in other markets, investors should be able to identify positive-NPV trading opportunities in securities markets only if some barrier or restriction to free competition exists. An investor’s competitive advantage may take several 3

Even with private information, informed investors may find it difficult to profit from that information, because they must find others who are willing to trade with them; that is, the market for the stock must be sufficiently liquid. A liquid market requires that other investors in the market have alternative motives to trade (for example, selling shares of a stock to purchase a house) and so are willing to trade even when facing the risk that other traders may be better informed.

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forms. For instance, the investor may have expertise or access to information known to only a few people. Alternatively, the investor may have lower trading costs than other market participants and so can exploit opportunities that others would find unprofitable. In all cases, the source of the positive-NPV trading opportunity must be something that is difficult to replicate; otherwise, any gains would be competed away in short order. While the fact that positive-NPV trading opportunities are hard to come by may be disappointing, there is some good news as well. If stocks are fairly priced according to our valuation models, then investors who buy stocks can expect to receive future cash flows that fairly compensate them for the risk of their investment. In such cases, the average investor can invest with confidence, even if he or she is not fully informed. Implications for Corporate Managers. If stocks are fairly valued according to the models we have described in this chapter and in Chapter 7, then the value of the firm is determined by the cash flows that it can pay to its investors. This result has several key implications for corporate managers: Q Focus on NPV and free cash flow. A manager seeking to boost the price of her firm’s stock should make investments that increase the present value of the firm’s free cash flow. Thus the capital budgeting methods outlined in Chapter 9 are fully consistent with the objective of maximizing the firm’s share price. Q Avoid accounting illusions. Many managers make the mistake of focusing on accounting earnings as opposed to free cash flows. According to the efficient markets hypothesis, the accounting consequences of a decision do not directly affect the value of the firm and should not drive decision making. Q Use financial transactions to support investment. With efficient markets, the firm can sell its shares at a fair price to new investors. As a consequence, the firm should not be constrained from raising capital to fund positive-NPV investment opportunities.

The Efficient Markets Hypothesis Versus No Arbitrage There is an important distinction between the efficient markets hypothesis and the notion of no arbitrage that we introduced in Chapter 3. An arbitrage opportunity is a situation in which two securities (or portfolios) with identical cash flows have different prices. Because anyone can earn a sure profit in this situation by buying the low-priced security and selling the high-priced one, we expect investors to immediately exploit and eliminate these opportunities. Thus, arbitrage opportunities will not be found. The efficient markets hypothesis states that the best estimate of the value of a share of stock is its market price. That is, investors’ own estimates of value are not as accurate as the market price. But that does not mean that the market price always correctly estimates the value of a share of stock. There is a difference between the best estimate and being correct. Thus there is no reason to expect the market price to always assess value accurately; rather, the price is best viewed as an approximation. However, because the price is the best estimate, the efficient market hypothesis implies that you cannot tell which prices overestimate and which underestimate the true value of the stock.

Concept Check

5. State the efficient markets hypothesis. 6. What are the implications of the efficient markets hypothesis for corporate managers?

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Part 3 Valuation and the Firm

10.4

Individual Biases and Trading Not all investors accept the notion that second guessing the stock prices requires specialized knowledge and unusual skills. Instead they attempt to make money by trading and in most cases end up losing money. In this next section we will briefly discuss some common psychological biases and consider how they affect individuals’ trading behavior. In an efficient market, these biases can be costly, resulting in lower realized returns and reduced wealth.

Excessive Trading and Overconfidence

overconfidence hypothesis The tendency of individual investors to trade too much based on the mistaken belief that they can pick winners and losers better than investment professionals.

Trading is expensive; you must pay commissions on top of the difference between the bid and ask price, called the spread. Given how hard it should be to identify over- and undervalued stocks, you might then expect individual investors to take a conservative approach to trading. However, in an influential study of the trading behavior of individual investors that held accounts at a discount brokerage, researchers Brad Barber and Terrance Odean found that individual investors tend to trade very actively, with average turnover almost 50% above the average of all investors including institutions during the time period of their study.4 What might explain this trading behavior? Psychologists have known since the 1960s that uninformed individuals tend to overestimate the precision of their knowledge. For example, many sports fan sitting in the stands confidently second-guess the coaching decisions on the field, truly believing that they can do a better job. In finance we call investors’ presumptuousness of their ability to beat the market by overtrading the overconfidence hypothesis. Barber and Odean hypothesized that this kind of behavior also characterizes individual investment decision making: Like sports fans, individual investors believe they can pick winners and losers when, in fact, they cannot; this overconfidence leads them to trade too much. An implication of this overconfidence hypothesis is that, assuming they have no true ability, investors who trade more will not earn higher returns. Instead, their performance will be worse once we take into account the costs of trading (due to both commissions and bid-ask spreads). Figure 10.7 documents precisely this result, showing that much investor trading appears not to be based on rational assessments of performance.

Hanging On to Losers and the Disposition Effect disposition effect The tendency to hold on to stocks that have lost value and sell stocks that have risen in value since the time of purchase.

Investors tend to hold on to stocks that have lost value and sell stocks that have risen in value since the time of purchase. We call this tendency to keep losers and sell winners the disposition effect. Researchers Hersh Shefrin and Meir Statman, building on the work of psychologists Daniel Kahneman and Amos Tversky, suggest that this effect arises due to investors’ increased willingness to take on risk in the face of possible losses.5 It may also reflect a reluctance to admit a mistake by taking the loss. Researchers have verified the disposition effect in many studies. For example, in a study of all trades in the Taiwanese stock market from 1995–1999, investors in aggregate were twice as likely to realize gains as they were to realize losses. Also, nearly 85% of 4

B. Barber and T. Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55 (2000) 773–806. 5

H. Shefrin and M. Statman, “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence,” Journal of Finance 40 (1985): 777–790, and D. Kahneman and A. Tversky, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47 (1979): 263–291. 6

B. Barber, Y. T. Lee, Y. J. Liu, and T. Odean, “Is the Aggregate Investor Reluctant to Realize Losses? Evidence from Taiwan,” European Financial Management, 13 (2007): 423–447.

Chapter 10 Stock Valuation: A Second Look

FIGURE 10.7

303

The plot shows the average annual return (net of commissions and trading costs) for individual investors at a large discount brokerage from 1991–1997. Investors are grouped into quintiles based on their average annual turnover. While the least-active investors had slightly (but not significantly) better performance than the S&P 500, performance declined with the rate of turnover.

Individual Investor Returns Versus Portfolio Turnover

Annual Return

20%

15%

10%

5%

0%

Q1

Q2

Q3

(Lowest turnover)

Q4

Q5

S&P 500

(Highest turnover)

Source: B. Barber and T. Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55 (2000) 773–806.

individual investors were subject to this bias.6 On the other hand, mutual funds and foreign investors did not exhibit the same tendency, and other studies have shown that more sophisticated investors appear to be less susceptible to the disposition effect.7 This behavioral tendency to sell winners and hang on to losers is costly from a tax perspective. Because capital gains are taxed only when the asset is sold, it is optimal for tax purposes to postpone taxable gains by continuing to hold profitable investments; delaying the tax payment reduces its present value. On the other hand, investors should capture tax losses by selling their losing investments, especially near the year’s end, in order to accelerate the tax write-off. Of course, keeping losers and selling winners might make sense if investors forecast that the losing stocks would ultimately “bounce back” and outperform the winners going forward. While investors may in fact have this belief, it does not appear to be justified—if anything, the losing stocks that investors continue to hold tend to underperform the winners they sell. According to one study, losers underperformed winners by 3.4% over the year after the winners were sold.8

Investor Attention, Mood, and Experience Individual investors generally are not full-time traders. As a result, they have limited time and attention to spend on their investment decisions and may be influenced by attentiongrabbing news stories or other events. Studies show that individuals are more likely to buy stocks that have recently been in the news, engaged in advertising, experienced

7

R. Dhar and N. Zhu, “Up Close and Personal: Investor Sophistication and the Disposition Effect,” Management Science, 52 (2006): 726–740. 8

T. Odean, “Are Investors Reluctant to Realize Their Losses?” Journal of Finance 53 (1998): 1775–1798.

304

Part 3 Valuation and the Firm exceptionally high trading volume, or have had extreme (either positive or negative) returns.9 Investment behavior also seems to be affected by investors’ moods. For example, sunshine generally has a positive effect on mood, and studies have found that stock returns tend to be higher when it is a sunny day at the location of the stock exchange. In New York City, the annualized market return on perfectly sunny days is approximately 24.8% per year versus 8.7% per year on perfectly cloudy days.10 Further evidence of the link between investor mood and stock returns comes from the effect of major sports events on returns. One recent study estimates that a loss in the World Cup elimination stage lowers the next day’s stock returns in the losing country by about 0.50%, presumably due to investors’ poor moods.11 Finally, investors appear to put too much weight on their own experience rather than considering all the historical evidence. As a result, people who grow up and live during a time of high stock returns are more likely to invest in stocks than people who grow up and live during a time of low stock returns.12 Why would investors continue to make such mistakes? Even if they started with such misconceptions, wouldn’t they be able to learn over time the cost of these errors? The challenge is that stock returns are extremely volatile, and this volatility masks the small differences in returns from different trading strategies. We will start the next chapter with a review of the historical evidence on average stock returns and their volatility. There you will see how variable returns are and how there have been long stretches of good returns, like the 1990s, but also stretches where the total return was negative, like the 2000s.

Concept Check

7. What are several systematic behavioral biases that individual investors fall prey to? 8. Why would excessive trading lead to lower realized returns?

9 See G. Grullon, G. Kanatas, and J. Weston, “Advertising, Breadth of Ownership, and Liquidity,” Review of Financial Studies, 17 (2004): 439–461; M. Seasholes and G. Wu, “Predictable Behavior, Profits, and Attention,” Journal of Empirical Finance, 14 (2007): 590–610; B. Barber and T. Odean, “All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors,” Review of Financial Studies, 21 (2008): 785–818. 10

Based on data from 1982–1997; see D. Hirshleifer and T. Shumway, “Good Day Sunshine: Stock Returns and the Weather,” Journal of Finance, 58 (2003): 1009–1032.

11

A. Edmans, D. Garcia, and O. Norli, “Sports Sentiment and Stock Returns,” Journal of Finance, 62 (2007): 1967–1998.

12

U. Malmendier and S. Nagel, “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?” NBER working paper no. 14813.

Chapter 10 Stock Valuation: A Second Look

305

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

10.1 The Discounted Free Cash Flow Model Q When a firm has leverage, it is more reliable to use the discounted free cash flow model. In this model, the enterprise value of the firm equals the present value of the firm’s future free cash flow:

discounted free cash flow model, p. 284 weighted average cost of capital (WACC), p. 285

MyFinanceLab Study Plan 10.1

10.2 Valuation Based on Comparable Firms Q We can also value stocks by using valuation multiples based on comparable firms. Multiples commonly used for this purpose include the P/E ratio and the ratio of enterprise value (EV) to EBITDA. When we use multiples, we assume that comparable firms have the same risk and future growth as the firm being valued. Q No valuation model provides a definitive value for the stock. It is best to use several methods to identify a reasonable range for the value.

forward earnings, p. 290 forward P/E, p. 290 method of comparables, p. 288 trailing earnings, p. 290 trailing P/E, p. 290 valuation multiple, p. 288

MyFinanceLab Study Plan 10.2

10.3 Information, Competition, and Stock Prices Q Stock prices aggregate the information of many inve

Corporate Finance SECOND EDITION

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FUNDAMENTALS OF

Corporate Finance SECOND EDITION

Jonathan Berk

Peter DeMarzo

Jarrad Harford

STANFORD UNIVERSITY

STANFORD UNIVERSITY

UNIVERSITY OF WASHINGTON

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Moffett Cases in International Finance

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10 9 8 7 6 5 4 3 2 1

ISBN 10: ISBN 13:

0-132-14823-4 978-0-13-214823-8

Brief Contents PART 1

Introduction CHAPTER 1 CHAPTER 2

PART 2

Corporate Finance and the Financial Manager 2 Introduction to Financial Statement Analysis 23

Interest Rates and Valuing Cash Flows CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER

PART 3

1

3 4 5 6 7

61

Time Value of Money: An Introduction 62 Time Value of Money: Valuing Cash Flow Streams Interest Rates 117 Bonds 144 Stock Valuation 182

Valuation and the Firm

83

209

CHAPTER 8 Investment Decision Rules 210 CHAPTER 9 Fundamentals of Capital Budgeting 247 CHAPTER 10 Stock Valuation: A Second Look 282

PART 4

Risk and Return

315

CHAPTER 11 Risk and Return in Capital Markets 316 CHAPTER 12 Systematic Risk and the Equity Risk Premium CHAPTER 13 The Cost of Capital 381

PART 5

Long-Term Financing

409

CHAPTER 14 Raising Equity Capital CHAPTER 15 Debt Financing 438

PART 6

345

410

Capital Structure and Payout Policy

459

CHAPTER 16 Capital Structure 460 CHAPTER 17 Payout Policy 498

PART 7

Financial Planning and Forecasting

533

CHAPTER 18 Financial Modeling and Pro Forma Analysis CHAPTER 19 Working Capital Management 564 CHAPTER 20 Short-Term Financial Planning 591

PART 8

Special Topics

534

621

CHAPTER 21 Option Applications and Corporate Finance CHAPTER 22 Mergers and Acquisitions 648 CHAPTER 23 International Corporate Finance 679

622

vii

Detailed Contents PART 1 CHAPTER 1

Introduction

1

Corporate Finance and the Financial Manager 2 Q INTERVIEW WITH Leslie Tillquist, PA Consulting Group 3

1.1 Why Study Finance? 4 1.2 The Four Types of Firms 4 Sole Proprietorships 5 Partnerships 5 Limited Liability Companies 6 Corporations 6 Tax Implications for Corporate Entities 7 1.3 The Financial Manager 9 Q Corporate Taxation Around the World 9 Making Investment Decisions 10 Making Financing Decisions 10 Managing Short-Term Cash Needs 10 The Goal of the Financial Manager 11 1.4 The Financial Manager’s Place in the Corporation 11 The Corporate Management Team 11 Ethics and Incentives in Corporations 12 1.5 The Stock Market 14 The Largest Stock Markets 14 Primary Versus Secondary Markets 14 Physical Stock Markets 15 Over-the-Counter Stock Markets 15 Q NYSE, AMEX, DJIA, S&P 500: Awash in Acronyms 16 Listing Standards 16 Other Financial Markets 17 1.6 Financial Institutions 17 The Financial Cycle 17 Types of Financial Institutions 18 Role of Financial Institutions 18 Summary 19 Q Problems 21

CHAPTER 2

viii

Introduction to Financial Statement Analysis 23 Q INTERVIEW WITH Hiral Tolia, CBIZ Valuation Group, LLC 24

2.1 Firms’ Disclosure of Financial Information 25 Preparation of Financial Statements 25 Types of Financial Statements 25 Q International Financial Reporting Standards 26 2.2 The Balance Sheet 26 Assets 27 Liabilities 28 Stockholders’ Equity 28 2.3 Balance Sheet Analysis 30 Market-to-Book Ratio 30 Debt-Equity Ratio 30 Enterprise Value 31 Other Balance Sheet Information 32 2.4 The Income Statement 33 Earnings Calculations 33 2.5 Income Statement Analysis 35 Profitability Ratios 35 Asset Efficiency 36 Working Capital Ratios 36 EBITDA 37 Leverage Ratios 37 Investment Returns 37 The DuPont Identity 38 Valuation Ratios 39 Q COMMON MISTAKE Mismatched Ratios 40 2.6 The Statement of Cash Flows 42 Operating Activity 42 Investment Activity 44 Financing Activity 44 2.7 Other Financial Statement Information 45 Management Discussion and Analysis 45 Statement of Stockholders’ Equity 46 Notes to the Financial Statements 46 2.8 Financial Reporting in Practice 46 Enron 46 The Sarbanes-Oxley Act 47 Q Practitioner INTERVIEW WITH Sue Frieden, Ernst & Young 48 The Financial Statements: A Useful Starting Point 49 Summary 49 Q Critical Thinking 52 Q Problems 52 Q Data Case 58

Detailed Contents

PART 2 CHAPTER 3

Interest Rates and Valuing Cash Flows 61 Time Value of Money: An Introduction 62 Q INTERVIEW WITH Nicole Wickswat, Intel Corporation 63

3.1 Cost-Benefit Analysis 64 Role of the Financial Manager 64 Quantifying Costs and Benefits 64 Q When Competitive Market Prices Are Not Available 66

Q COMMON MISTAKE Discounting One Too Many Times 92 4.3 Annuities 92 Present Value of an Annuity 92 Future Value of an Annuity 95 4.4 Growing Cash Flows 96 Growing Perpetuity 96 Growing Annuity 98 4.5 Solving for Variables Other Than Present Value or Future Value 99 Solving for the Cash Flows 100 Rate of Return 102 Solving for the Number of Periods 104

3.2 Market Prices and the Valuation Principle 66 The Valuation Principle 67 Why There Can Be Only One Competitive Price for a Good 67 Q Your Personal Financial Decisions 68

Summary 106 Q Critical Thinking 108 Q Problems 108 Q Data Case 113 CHAPTER 4 APPENDIX Using a Financial Calculator 114 Specifying Decimal Places 114 Toggling Between the Beginning and End of a Period 114 Set the Number of Periods per Year 114 General TVM Buttons 114 Solving for the Future Value of an Annuity (Example 4.5) 115 Solving for the Rate of Return 115

3.3 The Time Value of Money and Interest Rates 68 The Time Value of Money 69 The Interest Rate: Converting Cash Across Time 70 Timelines 72 3.4 Valuing Cash Flows at Different Points in Time 73 Rule 1: Comparing and Combining Values 73 Q COMMON MISTAKE Summing Cash Flows Across Time 74 Rule 2: Compounding 74 Q Rule of 72 76 Rule 3: Discounting 76 Q Using a Financial Calculator 78 Summary 78 Q Critical Thinking 80 Q Problems 80

CHAPTER 4

Time Value of Money: Valuing Cash Flow Streams 83 Q INTERVIEW WITH Gregory Goin, McFee Financial Group 84

4.1 Valuing a Stream of Cash Flows 85 Applying the Rules of Valuing Cash Flows to a Cash Flow Stream 85 Q Using a Financial Calculator: Solving for Present and Future Values of Cash Flow Streams 88 4.2 Perpetuities 89 Perpetuities 89 Q Historical Examples of Perpetuities 91

ix

CHAPTER 5

Interest Rates

117

Q INTERVIEW WITH Jason Moore, Bradford & Marzec, LLC 118 5.1 Interest Rate Quotes and Adjustments 119 The Effective Annual Rate 119 Adjusting the Discount Rate to Different Time Periods 120 Annual Percentage Rates 121 Q COMMON MISTAKE Using the EAR in the Annuity Formula 122 5.2 Application: Discount Rates and Loans 124 Computing Loan Payments 124 Computing the Outstanding Loan Balance 126 5.3 The Determinants of Interest Rates 127 Inflation and Real Versus Nominal Rates 127 Investment and Interest Rate Policy 128 Q How Is Inflation Actually Calculated? 130 The Yield Curve and Discount Rates 130 Q Practitioner INTERVIEW WITH Frederic S. Mishkin, Columbia University 132 Q COMMON MISTAKE Using the Annuity Formula When Discount Rates Vary 133 The Yield Curve and the Economy 133

x

Detailed Contents 5.4 The Opportunity Cost of Capital 136 Q Interest Rates, Discount Rates, and the Cost of Capital 137 Summary 138 Q Critical Thinking 139 Q Problems 140

CHAPTER 6

Bonds

144

Q INTERVIEW WITH Andrew DeWitt, PIMCO 145 6.1 Bond Terminology 146 6.2 Zero-Coupon Bonds 147 Zero-Coupon Bond Cash Flows 148 Yield to Maturity of a Zero-Coupon Bond 148 Risk-Free Interest Rates 149 6.3 Coupon Bonds 151 Coupon Bond Cash Flows 151 Q The U.S. Treasury Market 152 Yield to Maturity of a Coupon Bond 152 Q Finding Bond Prices on the Web 154 Coupon Bond Price Quotes 155 6.4 Why Bond Prices Change 156 Interest Rate Changes and Bond Prices 156 Time and Bond Prices 158 Interest Rate Risk and Bond Prices 160 Q Clean and Dirty Prices for Coupon Bonds 162 Bond Prices in Practice 163 6.5 Corporate Bonds 164 Credit Risk 164 Q Practitioner INTERVIEW WITH Lisa Black, Teachers Insurance and Annuity Association 165 Corporate Bond Yields 166 Bond Ratings 166 Corporate Yield Curves 166 Q The Credit Crisis and Bond Yields 168 Summary 170 Q Critical Thinking 171 Q Problems 172 Q Data Case 175 CHAPTER 6 APPENDIX A Solving for the Yield to Maturity of a Bond Using a Financial Calculator 177 CHAPTER 6 APPENDIX B The Yield Curve and the Law of One Price 178

CHAPTER 7

Stock Valuation

182

Q INTERVIEW WITH Christopher Ellis-Ferrara, AllianceBernstein 183 7.1 Stock Basics 184 Stock Market Reporting: Stock Quotes 184

Common Stock 185 Preferred Stock 186 7.2 The Mechanics of Stock Trades 187 7.3 The Dividend-Discount Model 188 A One-Year Investor 188 Dividend Yields, Capital Gains, and Total Returns 189 A Multiyear Investor 190 Dividend-Discount Model Equation 191 7.4 Estimating Dividends in the Dividend-Discount Model 192 Constant Dividend Growth 192 Dividends Versus Investment and Growth 193 Changing Growth Rates 195 Q COMMON MISTAKE Forgetting to “Grow” This Year’s Dividend 196 Value Drivers and the Dividend-Discount Model 198 7.5 Limitations of the Dividend-Discount Model 198 Uncertain Dividend Forecasts 198 Non-Dividend-Paying Stocks 199 7.6 Share Repurchases and the Total Payout Model 200 7.7 Putting It All Together 201 Summary 202 Q Critical Thinking 204 Q Problems 204 PART 2 INTEGRATIVE CASE 207

PART 3

Valuation and the Firm

CHAPTER 8

Investment Decision Rules

209 210

Q INTERVIEW WITH Scott Ladner, Parsons Brinckerhoff 211 8.1 The NPV Decision Rule 212 Net Present Value 212 The NPV Decision Rule 213 8.2 Using the NPV Rule 214 Organizing the Cash Flows and Computing the NPV 214 The NPV Profile 215 Measuring Sensitivity with IRR 216 Alternative Rules Versus the NPV Rule 216 8.3 Alternative Decision Rules 216 Q USING EXCEL Computing NPV and IRR 217 The Payback Rule 218 The Internal Rate of Return Rule 219 Q COMMON MISTAKE IRR Versus the IRR Rule 223

Detailed Contents Break-Even Analysis 267 Q Practitioner INTERVIEW WITH David Holland, Sports and Entertainment Solutions 268 Scenario Analysis 269

Modified Internal Rate of Return 223 Q Why Do Rules Other Than the NPV Rule Persist? 224 8.4 Choosing Between Projects 226 Differences in Scale 227 Q Practitioner INTERVIEW WITH Dick Grannis, QUALCOMM 230 Timing of the Cash Flows 231 8.5 Evaluating Projects with Different Lives 232 Important Considerations When Using the Equivalent Annual Annuity 234

xi

9.6 Real Options in Capital Budgeting 270 Option to Delay 270 Option to Expand 270 Option to Abandon 270 Summary 271 Q Critical Thinking 273 Q Problems 273 Q Data Case 279

8.6 Choosing Among Projects When Resources Are Limited 235 Evaluating Projects with Different Resource Requirements 235

CHAPTER 9 APPENDIX MACRS Depreciation 280

8.7 Putting It All Together 238 Summary 239 Q Critical Thinking 240 Q Problems 241 Q Data Case 246

CHAPTER 9

Fundamentals of Capital Budgeting 247 Q INTERVIEW WITH Kelly Cox, Boeing Corporation 248

9.1 The Capital Budgeting Process 249 9.2 Forecasting Incremental Earnings 250 Operating Expenses Versus Capital Expenditures 250 Incremental Revenue and Cost Estimates 251 Taxes 252 Incremental Earnings Forecast 252 9.3 Determining Incremental Free Cash Flow 254 Converting from Earnings to Free Cash Flow 255 Calculating Free Cash Flow Directly 258 Calculating the NPV 259 9.4 Other Effects on Incremental Free Cash Flows 260 Opportunity Costs 260 Q COMMON MISTAKE The Opportunity Cost of an Idle Asset 260 Project Externalities 260 Sunk Costs 261 Q COMMON MISTAKE The Sunk Cost Fallacy 261 Adjusting Free Cash Flow 262 Replacement Decisions 264 9.5 Analyzing the Project 265 Sensitivity Analysis 265

CHAPTER 10

Stock Valuation: A Second Look 282 Q INTERVIEW WITH David Mandell, William Blair & Company 283

10.1 The Discounted Free Cash Flow Model 284 Valuing the Enterprise 284 Implementing the Model 285 Connection to Capital Budgeting 286 10.2 Valuation Based on Comparable Firms 288 Valuation Multiples 288 Limitations of Multiples 293 Comparison with Discounted Cash Flow Methods 294 Stock Valuation Techniques: The Final Word 294 Q Practitioner INTERVIEW WITH Marilyn Fedak, AllianceBernstein 295 10.3 Information, Competition, and Stock Prices 296 Information in Stock Prices 296 Competition and Efficient Markets 298 Forms of Market Efficiency 298 Lessons for Investors and Corporate Managers 300 The Efficient Markets Hypothesis Versus No Arbitrage 301 10.4 Individual Biases and Trading 302 Excessive Trading and Overconfidence 302 Hanging On to Losers and the Disposition Effect 302 Investor Attention, Mood, and Experience 303 Summary 305 Q Critical Thinking 306 Q Problems 306 Q Data Case 310 PART 3 INTEGRATIVE CASE 312

xii

Detailed Contents

PART 4 CHAPTER 11

Risk and Return

Computing a Portfolio’s Variance and Standard Deviation 354 The Volatility of a Large Portfolio 356 Q NOBEL PRIZE Harry Markowitz 357

315

Risk and Return in Capital Markets 316 Q INTERVIEW WITH Sunita S. Mohanty, Absolute Return for Kids 317

11.1 A First Look at Risk and Return 318 11.2 Historical Risks and Returns of Stocks 320 Computing Historical Returns 321 Average Annual Returns 323 Q Arithmetic Average Returns Versus Compound Annual Returns 325 The Variance and Volatility of Returns 326 Q COMMON MISTAKE Mistakes When Computing Standard Deviation 328 Q USING EXCEL Computing the Standard Deviation of Historical Returns 328 The Normal Distribution 329 11.3 The Historical Tradeoff Between Risk and Return 331 The Returns of Large Portfolios 331 The Returns of Individual Stocks 332 11.4 Common Versus Independent Risk 332 Theft Versus Earthquake Insurance: An Example 332 Types of Risk 333

12.3 Measuring Systematic Risk 358 Role of the Market Portfolio 358 Stock Market Indexes as the Market Portfolio 359 Market Risk and Beta 359 Q Index Funds 360 Q COMMON MISTAKE Mixing Standard Deviation and Beta 362 Estimating Beta from Historical Returns 363 Q USING EXCEL Calculating a Stock’s Beta 365 12.4 Putting It All Together: The Capital Asset Pricing Model 366 The CAPM Equation Relating Risk to Expected Return 366 Q Why Not Estimate Expected Returns Directly? 367 Q NOBEL PRIZE William Sharpe The Security Market Line 368 The CAPM and Portfolios 370 Summary of the Capital Asset Pricing Model 371 The Big Picture 371 Summary 372 Q Critical Thinking 373 Q Problems 373

11.5 Diversification in Stock Portfolios 334 Unsystematic Versus Systematic Risk 334 Diversifiable Risk and the Risk Premium 337 The Importance of Systematic Risk 337 Q COMMON MISTAKE A Fallacy of Long-Run Diversification 339 Summary 339 Q Critical Thinking 341 Q Problems 342

CHAPTER 12

Systematic Risk and the Equity Risk Premium 345 Q INTERVIEW WITH Alexander Morgan, Pantheon Ventures 346

12.1 The Expected Return of a Portfolio 347 Portfolio Weights 347 Portfolio Returns 347 Expected Portfolio Return 349 12.2 The Volatility of a Portfolio 350 Diversifying Risks 350 Measuring Stocks’ Co-movement: Correlation 352 Q USING EXCEL Calculating the Correlation Between Two Sets of Returns 354

CHAPTER 12 APPENDIX Alternative Models of Systematic Risk 378

CHAPTER 13

The Cost of Capital

381

Q INTERVIEW WITH John Drum, KPMG LLP 382 13.1 A First Look at the Weighted Average Cost of Capital 383 The Firm’s Capital Structure 383 Opportunity Cost and the Overall Cost of Capital 384 Weighted Averages and the Overall Cost of Capital 384 Weighted Average Cost of Capital Calculations 384 13.2 The Firm’s Costs of Debt and Equity Capital 386 Cost of Debt Capital 386 Q COMMON MISTAKE Using the Coupon Rate as the Cost of Debt 387

Detailed Contents Cost of Preferred Stock Capital 388 Cost of Common Stock Capital 388 13.3 A Second Look at the Weighted Average Cost of Capital 390 WACC Equation 391 Weighted Average Cost of Capital in Practice 391 Methods in Practice 392 13.4 Using the WACC to Value a Project 394 Key Assumptions 394 WACC Method Application: Extending the Life of a DuPont Facility 395 Summary of the WACC Method 396 13.5 Project-Based Costs of Capital 396 Cost of Capital for a New Acquisition 397 Divisional Costs of Capital 397 Q Practitioner INTERVIEW WITH Shelagh Glaser, Intel 398 13.6 When Raising External Capital Is Costly 399 Summary 401 Q Critical Thinking 402 Q Problems 403 Q Data Case 406 PART 4 INTEGRATIVE CASE 408

PART 5 CHAPTER 14

Long-Term Financing Raising Equity Capital

409

14.4 Raising Additional Capital: The Seasoned Equity Offering 429 SEO Process 429 SEO Price Reaction 431 SEO Costs 432 Summary 433 Q Critical Thinking 434 Q Problems 434

CHAPTER 15

14.3 IPO Puzzles 425 Underpriced IPOs 425 “Hot” and “Cold” IPO Markets 427 Q 2008–2009: A Very Cold IPO Market 427 High Cost of Issuing an IPO 428 Poor Post-IPO Long-Run Stock Performance 429

438

15.1 Corporate Debt 440 Private Debt 440 Q Debt Financing at Hertz: Bank Loans 440 Q Debt Financing at Hertz: Private Placements 441 Public Debt 441 Q Debt Financing at Hertz: Public Debt 443 15.2 Bond Covenants 445 Types of Covenants 445 Advantages of Covenants 445 Application: Hertz’s Covenants 446 15.3 Repayment Provisions 446 Call Provisions 446 Sinking Funds 449 Convertible Provisions 449 Summary 452 Q Critical Thinking 453 Q Problems 453

Q INTERVIEW WITH Sandra Pfeiler, Goldman Sachs 411

14.2 Taking Your Firm Public: The Initial Public Offering 416 Advantages and Disadvantages of Going Public 416 Primary and Secondary IPO Offerings 417 Other IPO Types 422 Q Google’s IPO 425

Debt Financing

Q INTERVIEW WITH Eric Hassberger, Strategic Hotels & Resorts 439

410

14.1 Equity Financing for Private Companies 412 Sources of Funding 412 Securities and Valuation 414 Exiting an Investment in a Private Company 416

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CHAPTER 15 APPENDIX Using a Financial Calculator to Calculate Yield to Call 455 PART 5 INTEGRATIVE CASE 456

PART 6 CHAPTER 16

Capital Structure and Payout Policy 459 Capital Structure

460

Q INTERVIEW WITH Christopher Cvijic, Morgan Stanley 461 16.1 Capital Structure Choices 462 Capital Structure Choices Across Industries 462 Capital Structure Choices Within Industries 462 16.2 Capital Structure in Perfect Capital Markets 464 Application: Financing a New Business 465 Leverage and Firm Value 466

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Detailed Contents Q COMMON MISTAKE Repurchases and the Supply of Shares 506 Alternative Policy 3: High Dividend (Equity Issue) 506 Modigliani-Miller and Dividend Policy Irrelevance 507 Q COMMON MISTAKE The Bird in the Hand Fallacy 508 Dividend Policy with Perfect Capital Markets 508

The Effect of Leverage on Risk and Return 467 Homemade Leverage 469 Leverage and the Cost of Capital 469 Q COMMON MISTAKE Capital Structure Fallacies 470 MM and the Real World 472 Q NOBEL PRIZE Franco Modigliani and Merton Miller 472 16.3 Debt and Taxes 473 The Interest Tax Deduction and Firm Value 473 Value of the Interest Tax Shield 474 The Interest Tax Shield with Permanent Debt 476 Leverage and the WACC with Taxes 477 Debt and Taxes: The Bottom Line 477 16.4 The Costs of Bankruptcy and Financial Distress 479 Direct Costs of Bankruptcy 479 Q Bankruptcy Can Be Expensive 479 Indirect Costs of Financial Distress 479 16.5 Optimal Capital Structure: The Tradeoff Theory 480 Differences Across Firms 481 Optimal Leverage 481 16.6 Additional Consequences of Leverage: Agency Costs and Information 482 Agency Costs 483 Q Airlines Use Financial Distress to Their Advantage 483 Q Financial Distress and Rolling the Dice, Literally 484 Debt and Information 485

17.3 The Tax Disadvantage of Dividends 509 Taxes on Dividends and Capital Gains 509 Optimal Dividend Policy with Taxes 509 Tax Differences Across Investors 512 17.4 Payout Versus Retention of Cash 514 Retaining Cash with Perfect Capital Markets 514 Retaining Cash with Imperfect Capital Markets 515 17.5 Signaling with Payout Policy 518 Dividend Smoothing 518 Dividend Signaling 519 Q Royal & SunAlliance’s Dividend Cut 520 Signaling and Share Repurchases 520 Q Practitioner INTERVIEW WITH John Connors, Microsoft (Retired) 521 17.6 Stock Dividends, Splits, and Spin-Offs 522 Stock Dividends and Splits 522 Q Berkshire Hathaway’s A and B Shares 523 Spin-Offs 523 17.7 Advice for the Financial Manager 524 Summary 525 Q Critical Thinking 527 Q Problems 527 Q Data Case 529

16.7 Capital Structure: Putting It All Together 487 Summary 488 Q Critical Thinking 490 Q Problems 490 CHAPTER 16 APPENDIX The Bankruptcy Code 497

CHAPTER 17

Payout Policy

498

Q INTERVIEW WITH Nitin Garg, Intuit 499 17.1 Cash Distributions to Shareholders 500 Dividends 501 Share Repurchases 502 17.2 Dividends Versus Share Repurchases in a Perfect Capital Market 503 Alternative Policy 1: Pay a Dividend with Excess Cash 504 Alternative Policy 2: Share Repurchase (No Dividend) 504

PART 6 INTEGRATIVE CASE 531

PART 7 CHAPTER 18

Financial Planning and Forecasting 533 Financial Modeling and Pro Forma Analysis 534 Q INTERVIEW WITH David Hollon, Goldman Sachs 535

18.1 Goals of Long-Term Financial Planning 536 Identify Important Linkages 536 Analyze the Impact of Potential Business Plans 536 Plan for Future Funding Needs 536 18.2 Forecasting Financial Statements: The Percent of Sales Method 537

Detailed Contents Percent of Sales Method 537 Pro Forma Income Statement 538 Pro Forma Balance Sheet 539 Q COMMON MISTAKE Confusing Stockholders’ Equity with Retained Earnings 540 Making the Balance Sheet Balance: Net New Financing 540 Choosing a Forecast Target 542 18.3 Forecasting a Planned Expansion 542 KMS Designs’ Expansion: Financing Needs 543 KMS Designs’ Expansion: Pro Forma Income Statement 544 Q COMMON MISTAKE Treating Forecasts as Fact 546 Forecasting the Balance Sheet 546 18.4 Growth and Firm Value 547 Sustainable Growth Rate and External Financing 548 18.5 Valuing the Expansion 551 Forecasting Free Cash Flows 551 Q COMMON MISTAKE Confusing Total and Incremental Net Working Capital 553 KMS Designs’ Expansion: Effect on Firm Value 553 Optimal Timing and the Option to Delay 556 Summary 557 Q Critical Thinking 558 Q Problems 558 CHAPTER 18 APPENDIX The Balance Sheet and Statement of Cash Flows 562

CHAPTER 19

Working Capital Management 564 Q INTERVIEW WITH Waleed Husain, Comcast 565

19.1 Overview of Working Capital 566 The Cash Cycle 566 Working Capital Needs by Industry 568 Firm Value and Working Capital 569 19.2 Trade Credit 570 Trade Credit Terms 571 Trade Credit and Market Frictions 571 Q COMMON MISTAKE Using APR Instead of EAR to Compute the Cost of Trade Credit 572 Managing Float 573 19.3 Receivables Management 574 Determining the Credit Policy 574 Q The 5 C’s of Credit 574 Monitoring Accounts Receivable 576

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19.4 Payables Management 578 Determining Accounts Payable Days Outstanding 578 Stretching Accounts Payable 579 19.5 Inventory Management 580 Benefits of Holding Inventory 580 Costs of Holding Inventory 581 Q Inventory Management Adds to the Bottom Line at Gap 581 19.6 Cash Management 582 Motivation for Holding Cash 582 Alternative Investments 582 Q Cash Balances 584 Summary 584 Q Critical Thinking 586 Q Problems 586 Q Data Case 589

CHAPTER 20

Short-Term Financial Planning

591

Q INTERVIEW WITH Teresa Wendt, Lockheed Martin 592 20.1 Forecasting Short-Term Financing Needs 593 Application: Springfield Snowboards, Inc. 593 Negative Cash Flow Shocks 594 Positive Cash Flow Shocks 594 Seasonalities 595 The Cash Budget 596 20.2 The Matching Principle 598 Permanent Working Capital 598 Temporary Working Capital 598 Permanent Versus Temporary Working Capital 598 Financing Policy Choices 599 20.3 Short-Term Financing with Bank Loans 601 Single, End-of-Period Payment Loan 601 Line of Credit 601 Bridge Loan 602 Common Loan Stipulations and Fees 602 20.4 Short-Term Financing with Commercial Paper 604 Q Short-Term Financing and the Financial Crisis of the Fall of 2008 604 20.5 Short-Term Financing with Secured Financing 606 Accounts Receivable as Collateral 606 Q A Seventeenth-Century Financing Solution 606 Inventory as Collateral 607 20.6 Putting It All Together: Creating a Short-Term Financial Plan 609 Summary 610 Q Critical Thinking 611 Q Problems 612 PART 7 INTEGRATIVE CASE 616

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Detailed Contents

PART 8 CHAPTER 21

Special Topics

621

Option Applications and Corporate Finance 622 Q INTERVIEW WITH Deniz Gulunay, BP 623

21.1 Option Basics 624 Option Contracts 624 Stock Option Quotations 625 Options on Other Financial Securities 627 Q Options Are for More Than Just Stocks 627 21.2 Option Payoffs at Expiration 627 The Long Position in an Option Contract 628 The Short Position in an Option Contract 629 Profits for Holding an Option to Expiration 631 Returns for Holding an Option to Expiration 633 21.3 Factors Affecting Option Prices 634 Strike Price and Stock Price 634 Option Prices and the Exercise Date 634 Option Prices and the Risk-Free Rate 635 Option Prices and Volatility 635 21.4 The Black-Scholes Option Pricing Formula 636 21.5 Put-Call Parity 638 Portfolio Insurance 638

22.4 The Takeover Process 659 Valuation 659 The Offer 660 Merger “Arbitrage” 662 Tax and Accounting Issues 663 Board and Shareholder Approval 664 22.5 Takeover Defenses 665 Poison Pills 665 Staggered Boards 666 White Knights 667 Golden Parachutes 667 Recapitalization 667 Other Defensive Strategies 667 Regulatory Approval 668 Q Weyerhaeuser’s Hostile Bid for Willamette Industries 668 22.6 Who Gets the Value Added from a Takeover? 669 The Free Rider Problem 669 Toeholds 670 The Leveraged Buyout 670 Q The Leveraged Buyout of RJR-Nabisco by KKR 672 The Freezeout Merger 673 Competition 673 Summary 674 Q Critical Thinking 676 Q Problems 676

21.6 Options and Corporate Finance 641 Summary 643 Q Critical Thinking 644 Q Problems 644 Q Data Case 646

CHAPTER 22

Mergers and Acquisitions

648

Q INTERVIEW WITH Kyle Finegan, Croft & Bender LLC 649 22.1 Background and Historical Trends 650 Merger Waves 650 Types of Mergers 652 22.2 Market Reaction to a Takeover 652 22.3 Reasons to Acquire 653 Economies of Scale and Scope 653 Vertical Integration 654 Expertise 654 Monopoly Gains 654 Efficiency Gains 655 Tax Savings from Operating Losses 655 Diversification 656 Earnings Growth 657 Managerial Motives to Merge 658

CHAPTER 23

International Corporate Finance 679 Q INTERVIEW WITH Rob Harvey, Cisco Systems 680

23.1 Foreign Exchange 681 The Foreign Exchange Market 682 Exchange Rates 683 23.2 Exchange Rate Risk 683 Exchange Rate Fluctuations 684 Hedging with Forward Contracts 686 Cash-and-Carry and the Pricing of Currency Forwards 687 Hedging Exchange Rate Risk with Options 691 23.3 Internationally Integrated Capital Markets 692 Q COMMON MISTAKE Forgetting to Flip the Exchange Rate 694 23.4 Valuation of Foreign Currency Cash Flows 694 Application: Ityesi, Inc. 695

Detailed Contents The Law of One Price as a Robustness Check 697 23.5 Valuation and International Taxation 698 A Single Foreign Project with Immediate Repatriation of Earnings 699 Multiple Foreign Projects and Deferral of Earnings Repatriation 699 23.6 Internationally Segmented Capital Markets 700 Differential Access to Markets 700 Macro-Level Distortions 700 Implications of Internationally Segmented Capital Markets 701 23.7 Capital Budgeting with Exchange Rate Risk 703 Application: Ityesi, Inc. 703 Conclusion 705 Summary 705 Q Critical Thinking 707 Q Problems 707 Q Data Case 711

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CHAPTERS ON THE WEB These Web Chapters are on MyFinanceLab at www.myfinancelab.com

Leasing WEB CHAPTER 2 Insurance and Risk Management WEB CHAPTER 3 Corporate Governance WEB CHAPTER 1

About the Authors Jonathan Berk

is the A.P. Giannini Professor of Finance at the Graduate School of Business, Stanford University, and is a Research Associate at the National Bureau of Economic Research. Prior to Stanford, he was the Sylvan Coleman Professor of Finance at the Haas School of Business at the University of California, Berkeley, where he taught the introductory Corporate Finance course. Before earning his PhD from Yale University, he worked as an associate at Goldman Sachs, where his education in finance really began. His research has won a number of awards including the TIAA-CREF Paul A. Samuelson Award, the Smith Breeden Prize, Best Paper of the Year in The Review of Financial Studies, and the FAME Research Prize. His paper “A Critique of Jonathan Berk, Peter DeMarzo, and Jarrad Harford Size-Related Anomalies” was selected as one of the two best papers ever published in The Review of Financial Studies. In recognition of his influence on the practice of finance, he has received the Bernstein-Fabozzi/Jacobs Levy Award, the Graham and Dodd Award of Excellence, and the Roger F. Murray Prize. He served as an Associate Editor of the Journal of Finance for eight years and is currently an Advisory Editor at the journal. Born in Johannesburg, South Africa, Professor Berk is married, has two daughters, and is an avid skier and biker.

Peter DeMarzo is the Mizuho Financial Group Professor of Finance and Senior Associate Dean for Academic Affairs at Stanford Graduate School of Business. He is also a Research Associate at the National Bureau of Economic Research. He currently teaches MBA and PhD courses in Corporate Finance and Financial Modeling. Prior to Stanford, he taught at the Haas School of Business and the Kellogg Graduate School of Management, and he was a National Fellow at the Hoover Institution. Professor DeMarzo received the Sloan Teaching Excellence Award at Stanford in 2004 and 2006 and the Earl F. Cheit Outstanding Teaching Award at the University of California, Berkeley, in 1998. Professor DeMarzo has served as an Associate Editor for The Review of Financial Studies, Financial Management, and the B.E. Journals in Economic Analysis and Policy, as well as a Director of the American Finance Association. He is currently President of the Western Finance Association. Professor DeMarzo has received numerous awards for his research including the Western Finance Association Corporate Finance Award and the Barclays Global Investors/Michael Brennan Best Paper Award from The Review of Financial Studies. Professor DeMarzo was born in Whitestone, New York, is married, and has three sons. He and his family enjoy hiking, biking, and skiing.

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About the Authors

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Jarrad Harford is the Marion B. Ingersoll Professor of Finance at the University of Washington. Prior to Washington, Professor Harford taught at the Lundquist College of Business at the University of Oregon. He received his PhD in Finance with a minor in Organizations and Markets from the University of Rochester. Professor Harford has taught the core undergraduate finance course, Business Finance, for over thirteen years, as well as an elective in Mergers and Acquisitions, and “Finance for Non-financial Executives” in the executive education program. He has won numerous awards for his teaching, including the UW Finance Professor of the Year (2010), Interfraternity Council Excellence in Teaching Award (2007 and 2008), ISMBA Excellence in Teaching Award (2006), and the Wells Fargo Faculty Award for Undergraduate Teaching (2005). He is also the Faculty Director of the UW Business School Undergraduate Honors Program. Professor Harford serves as an Associate Editor for The Journal of Financial Economics, Journal of Financial and Quantitative Analysis, and Journal of Corporate Finance. Professor Harford was born in State College, Pennsylvania, is married, and has two sons. He and his family enjoy traveling, hiking, and skiing.

Bridging Theory and Practice Study Aids with a Practical Focus

EXAMPLE 7.1

To be successful, students need to master the core concepts and learn to identify and solve problems that today’s practitioners face.

Stock Prices and Returns

Suppose you expect Longs Drug Stores to pay an annual dividend of $0.56 per share in the coming year and to trade for $45.50 per share at the end of the year. If investments with equivalent risk to Longs’ stock have an expected return of 6.80%, what is the most you would pay today for Longs’ stock? What dividend yield and capital gain rate would you expect at this price?

Solution

Q The Valuation Principle is presented as the foundation of all financial decision making: The central idea is that a firm should take projects or make investments that increase the value of the firm. The tools of finance determine the impact of a project or investment on the firm’s value by comparing the costs and benefits in equivalent terms. The Valuation Principle is first introduced in Chapter 3, revisited in the part openers, and integrated throughout the text. Q Guided Problem Solutions (GPS) are Examples that accompany every important concept using a consistent problem-solving methodology that breaks the solution process into three steps: Plan, Execute, and Evaluate. This approach aids student comprehension, enhances their ability to model the solution process when tackling problems on their own, and demonstrates the importance of interpreting the mathematical solution.

Problem

◗ Plan

We can use Eq. 7.1 to solve for the beginning price we would pay now 1 P0 2 given our expectations about dividends 1 Div1 = $0.56 2 and future price 1 P1 = $45.50 2 and the return we need to expect to earn to be willing to invest 1 rE = 0.068 2 . We can then use Eq. 7.2 to calculate the dividend yield and capital gain rate. ◗ Execute Using Eq. 7.1, we have P0 =

Div1 + P1 $0.56 + $45.50 = $43.13 = 1 + rE 1.0680

Referring to Eq. 7.2, we see that at this price, Longs’ dividend yield is Div1/P0 = 0.56/43.13 = 1.30%. The expected capital gain is $45.50 - $43.13 = $2.37 per share, for a capital gain rate of 2.37/43.13 = 5.50%. ◗ Evaluate At a price of $43.13, Longs’ expected total return is 1.30% + 5.50% = 6.80%, which is equal to its equity cost of capital (the return being paid by investments with equivalent risk to Longs’). This amount is the most we would be willing to pay for Longs’ stock. If we paid more, our expected return would be less than 6.8% and we would rather invest elsewhere.

Personal Finance

EXAMPLE 4.4

Q Personal Finance GPS Examples showcase the use of financial analysis in everyday life by setting problems in scenarios such as purchasing a new car or house, and saving for retirement.

Present Value of a Lottery Prize Annuity

Problem You are the lucky winner of the $30 million state lottery. You can take your prize money either as (a) 30 payments of $1 million per year (starting today), or (b) $15 million paid today. If the interest rate is 8%, which option should you take?

Solution ◗ Plan Option (a) provides $30 million in prize money but paid over time. To evaluate it correctly, we must convert it to a present value. Here is the timeline: 0

1

2

29 ...

$1 million

$1 million

$1 million

$1 million

Because the first payment starts today, the last payment will occur in 29 years (for a total of 30 payments).2 The $1 million at date 0 is already stated in present value terms, but we need to compute the present value of the remaining payments. Fortunately, this case looks like a 29-year annuity of $1 million per year, so we can use the annuity formula. ◗ Execute

Q Common Mistake boxes alert students to frequently made mistakes stemming from misunderstanding core concepts and calculations—in the classroom and in the field.

COMMON MISTAKE

We use the annuity formula: PV 1 [email protected] annuity of +1 million at 8% annual interest 2 = +1 million *

= +1 million * 11.16 = +11.16 million today

Summing Cash Flows Across Time

Once you understand the time value of money, our first rule may seem straightforward. However, it is very common, especially for those who have not studied finance, to violate this rule, simply treating all cash flows as comparable regardless of when they are received. One example is in sports contracts. In 2007, Alex Rodriguez and the New York Yankees were negotiating what was repeatedly referred to as a “$275 million” contract. The $275 million comes from simply adding up all

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1 1 ≤ ¢1 0.08 1.0829

the payments Rodriguez would receive over the ten years of the contract and an additional ten years of deferred payments— treating dollars received in 20 years the same as dollars received today. The same thing occurred when David Beckham signed a “$250 million” contract with the LA Galaxy soccer team.

Applications That Reflect Real Practice Applications That Reflect Real Practice INTERVIEW WITH

Nicole Wickswat Intel Corporation

Fundamentals of Corporate Finance features actual companies and practitioners in the field.

“As a Senior Strategic Analyst in Intel Corporation’s Data Center Group, I strive to uphold the company’s finance charter by being ‘a full partner in business decisions to maximize shareholder value,’” says Nicole Wickswat, a 2006 graduate of the University of Oregon’s Business Honors Program with a degree in finance. “I work on a team with engineers and marketing people, helping them develop products for data center and cloud computer environments that are competitive, financially feasible, and provide the required return.” Nicole analyzes the potential financial impact of her group’s business decisions, evaluating the return to Intel on current and proposed products and making recommendations to management on whether they continue to add value. “A good investment decision should be aligned with the strategic objectives of the business,” she says. “We want the benefits to outweigh the associated costs, and we also take into account product launch timing and a project’s incremental financial value. Then we take a comprehensive view of the decision on the company as a whole, assessing the impact a decision would have on other products and/or groups.” Intel uses present value calculations within all business groups to compare the present values of costs and benefits that happen at different points in time. This gives management a consistent metric to compare different investments and projects, set priorities, and make tradeoffs where necessary to allocate funds to the optimal investments. The analysis continues throughout the product life cycle. “We assess the competitive landscape and determine whether the cost of adding or removing specific product features will benefit us in terms of increased market segment share, volume, and/or average selling price. We also look at whether adding the product feature negatively affects other groups or products and, if so, incorporate that into the analysis.” Nicole’s analysis helps the Data Center Group establish product cost targets that are aligned with long-term profitability goals. “These cost targets play a key role in product development decisions because they put pressure on engineers to design with profitability in mind and encourage us to get the most value out of the product line.”

INTERVIEW WITH

University of Oregon, 2006

“A good investment decision should be aligned with the strategic objectives of the business.”

Shelagh Glaser Shelagh Glaser is the

Finance Director for Intel’s Mobility Group, which provides solutions for the mobile computing market. Prior to that she was Group Controller for Sales & Marketing and co-Group Controller for Digital Enterprise Group. QUESTION: Does Intel set the discount rate at the corporate or project level? ANSWER: We typically set the discount rate at the corporate level. As

a company, Intel makes a broad set of products that sell into similar markets, so one hurdle rate makes sense for our core business. To justify an investment, every project has to earn or exceed that level of return for our shareholders.

We may use a different discount rate for mergers and acquisitions. For example, recently we’ve done more software acquisitions. That industry is very different from semiconductors and has different risk factors, so we take those considerations into account to set the hurdle rate.

Q Chapter-Opening Interviews with recent college graduates now working in the field of finance underscore the relevance of these concepts to students who are encountering them for the first time.

Q Practitioner Interviews from notable professionals featured in many chapters highlight leaders in the field and address the effects of the financial crisis.

QUESTION: How does Intel compute the cost of capital for new investment opportunities? ANSWER: We reexamine our weighted average cost of capital (WACC) each year to see that we have the right inputs and if any have changed: What is the current market risk premium? Are we using the right risk-free rate? How should we weight historical

The Credit Crisis and Bond Yields The financial crisis that engulfed the world’s economies in 2008 originated as a credit crisis that first emerged in August 2007. At that time, problems in the mortgage market had led to the bankruptcy of several large mortgage lenders. The default of these firms, and the downgrading of many of the bonds backed by mortgages these firms had made, caused many investors to reassess the risk of other bonds in their portfolios. As perceptions of risk increased, and investors attempted to move into safer U.S. Treasury securities, the prices of corporate bonds fell and so their credit spreads rose relative to Treasuries, as shown in Figure 6.7. Panel A of the figure shows

the yield spreads for long-term corporate bonds, where we can see that spreads of even the highest-rated Aaa bonds increased dramatically, from a typical level of 0.5% to over 2% by the fall of 2008. Panel B shows a similar pattern for the rate banks had to pay on short-term loans compared to the yields of short-term Treasury bills. This increase in borrowing costs made it more costly for firms to raise the capital needed for new investment, slowing economic growth. The decline in these spreads in early 2009 was viewed by many as an important first step in mitigating the ongoing impact of the financial crisis on the rest of the economy.

Q General Interest boxes highlight timely material from financial publications that shed light on business problems and real-company practices.

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Teaching Every Student to Think Finance Simplified Presentation of Mathematics

notation

Because one of the hardest parts of learning finance for non-majors is mastering the jargon, math, and non-standardized notation, Fundamentals of Corporate Finance systematically uses: Q Notation Boxes. Each chapter begins with a Notation box that defines the variables and the acronyms used in the chapter and serves as a “legend” for students’ reference.

C

cash flow

Cn

cash flow at date n

FV

future value

FVn

future value on date n

g

growth rate

Chapter 4 APPENDIX

Q Numbered and Labeled Equations. The first time a full equation is given in notation form it is numbered. Key equations are titled and revisited in the summary and in end papers.

N

date of the last cash flow in a stream of cash flows

P

initial principal or deposit, or equivalent present value

PV

present value

r

interest rate or rate of return

Using a Financial Calculator

Specifying Decimal Places Make sure you have plenty of decimal places displayed! HP-10BII DISP

4

TI BAII Plus Professional

Q Timelines. Introduced in Chapter 3, timelines are emphasized as the important first step in solving every problem that involves cash flow.

2ND

4

ENTER

Toggling Between the Beginning and End of a Period You should always make sure that your calculator is in end-of-period mode. HP-10BII

Q Financial Calculator instructions, including a box in Chapter 4 on solving for future and present values, and appendices to Chapters 4, 6, and 15 with keystrokes for HP-10BII and TI BAII Plus Professional, highlight this problem-solving tool. Q Spreadsheet Tables. Select tables are available on MyFinanceLab as Excel files, enabling students to change inputs and manipulate the underlying calculations.

•

MAR TI BAII Plus Professional 2ND

TABLE 18.2 KMS Designs’ Pro Forma Income Statement for 2011

Q Using Excel boxes describe Excel techniques and include screenshots to serve as a guide for students using this technology.

PMT

1 2 3 4 5 6 7 8 9 10 11

Year Income Statement ($000s) Sales Costs Except Depreciation EBITDA Depreciation EBIT Interest Expense (net) Pretax Income Income Tax (35%) Net Income

2010

2011

Calculation

74,889 88,369 74,889 1.18 58,413 68,928 78% of Sales 16,476 19,441 Lines 3 4 5,492 6,480 7.333% of Sales 10,984 12,961 Lines 5 6 306 306 Remains the same 10,678 12,655 Lines 7 8 4,429 35% of Line 9 3,737 8,226 Lines 9 10 6,941

USING EXCEL

Here we discuss how to use Microsoft Excel to solve for NPV and IRR. We also identify some pitfalls to avoid when using Excel.

Computing NPV and IRR

Excel’s NPV function has the format NPV (rate, value1, value2, . . . ), where “rate” is the interest rate per period used to discount the cash flows, and “value1”, “value2”, etc., are the cash flows (or ranges of cash flows). The NPV function computes the present value of the cash flows assuming the first cash flow occurs at date 1. Therefore, if a project’s first cash flow occurs at date 0, we cannot use the NPV function by itself to compute the NPV. We can use the NPV function to compute the present value of the cash flows from date 1 onward, and then we must add the date 0 cash flow to that result to calculate the NPV. The screenshot below shows the difference. The first NPV calculation (outlined in blue) is correct: we used the NPV function for all of the cash flows occurring at time 1 and later and then added on the first cash flow occurring at time 0 since it is already in present value. The second calculation (outlined in green) is incorrect: we used the NPV function for all of the cash flows, but the function assumed that the first cash flow occurs in period 1 instead of immediately.

NPV Function: Leaving Out Date 0

NPV Function: Ignoring Blank Cells Another pitfall with the NPV function is that cash flows that are left blank are treated differently from cash flows that are equal to zero. If the cash flow is left blank, both the cash flow and the period are ignored. For example, the second set of cash flows below is equivalent to the first—we have simply left the cash flow for date 2 blank instead of entering a “0.” However, the NPV function ignores the blank cell at date 2 and assumes the cash flow is 10 at date 1 and 110 at date 2, which is clearly not what is intended and

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Practice Finance to Learn Finance Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

MyFinanceLab Study Plan 4.1

4.1 Valuing a Stream of Cash Flows ◗ The present value of a cash flow stream is: C1 C2 CN + + g + PV = C0 + (4.3) 11 + r2 11 + r22 11 + r2N 4.2 Perpetuities ◗ A perpetuity is a stream of equal cash flows C paid every period, forever. The present value of a perpetuity is: PV 1 C in perpetuity 2 =

C r

Online Practice Opportunities

consol, p. 89 perpetuity, p. 89

MyFinanceLab Study Plan 4.2

(4.4)

4.3 Annuities annuity, p. 92 ◗ An annuity is a stream of equal cash flows C paid every period for N periods. The present value of an annuity is: 1 1 C * a1 (4.5) b r 11 + r2N ◗ The future value of an annuity at the end of the annuity is: 1 C * 1 11 + r2N - 12 (4.6) r

MyFinanceLab Study Plan 4.3 Interactive Annuity Calculator Financial Calculator Tutorials: Calculating the Present Value of an Annuity and Solving for the Future Value of an Annuity

Working problems is the proven way to cement and demonstrate an understanding of finance. Q Concept Check questions at the end of each section enable students to test their understanding and target areas in which they need further review. Q End-of-chapter problems written personally by Jonathan Berk, Peter DeMarzo, and Jarrad Harford offer instructors the opportunity to assign first-rate materials to students for homework and practice with the confidence that the problems are consistent with the chapter content. All end-of-chapter problems are available in MyFinanceLab, the fully integrated homework and tutorial system. Both the problems and solutions, which were also written by the authors, have been class-tested and accuracy checked to ensure quality. Excel icons indicate the availability of instructor solutions and student templates in the Textbook Resources tab of MyFinanceLab.

End-of-Chapter Materials Reinforce Learning Testing understanding of central concepts is crucial to learning finance. Q MyFinanceLab Chapter Summary presents the key points and conclusions from each chapter, provides a list of key terms with page numbers, and indicates online practice opportunities. Q Data Cases present in-depth scenarios in a business setting with questions designed to guide students’ analysis. Many questions involve the use of Internet resources. Q Integrative Cases occur at the end of most parts and present a capstone extended problem for each part with a scenario and data for students to analyze based on that subset of chapters.

Data Case

Assume today is August 1, 2010. Natasha Kingery is 30 years old and has a Bachelor of Science degree in computer science. She is currently employed as a Tier 2 field service representative for a telephony corporation located in Seattle, Washington, and earns $38,000 a year that she anticipates will grow at 3% per year. Natasha hopes to retire at age 65 and has just begun to think about the future. Natasha has $75,000 that she recently inherited from her aunt. She invested this money in ten-year Treasury bonds. She is considering whether she should further her education and would use her inheritance to pay for it. She has investigated a couple of options and is asking for your help as a financial planning intern to determine the financial consequences associated with each option. Natasha has already been accepted to two programs and could start either one soon. One alternative that Natasha is considering is attaining a certification in network design. This certification would automatically promote her to a Tier 3 field service representative in her company. The base salary for a Tier 3 representative is $10,000 more than the salary of a Tier 2 representative, and she anticipates that this salary differential will grow at a rate of 3% a year for as long as she keeps working. The certification program requires the completion of 20 Web-based courses and a score of 80% or better on an exam at the end of the course work. She has learned that the average amount of time necessary to finish the program is one year. The total cost of the program is $5,000, due when she

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Preface Finance professors are united by their commitment to shaping future generations of financial professionals as well as instilling financial awareness and skills in non-majors. Our goal with Fundamentals of Corporate Finance is to provide an accessible presentation for both finance and non-finance majors. We know from experience that countless undergraduate students have felt that corporate finance is challenging. It is tempting to make finance seem accessible by de-emphasizing the core principles and instead concentrating on the results. In our over 45 years of combined teaching experience, we have found that emphasizing the core concepts in finance—which are clear and intuitive at heart—is what makes the subject matter accessible. What makes the subject challenging is that it is often difficult for a novice to distinguish between these core ideas and other intuitively appealing approaches that, if used in financial decision making, will lead to incorrect decisions. The 2007–2009 financial crisis was fueled in part by many practitioners’ poor decision making when they did not understand—or chose to ignore—the core concepts that underlie finance and the pedagogy in this book. With this point in mind, we present finance as one unified whole based on two simple, powerful ideas: (1) valuation drives decision making—the firm should take projects for which the value of the benefits exceeds the value of the costs, and (2) in a competitive market, market prices (rather than individual preferences) determine values. We combine these two ideas with what we call the Valuation Principle, and from it we establish all of the key ideas in corporate finance.

New to This Edition In general terms, in our work on the second edition we took great care to update all text discussions and figures, tables, and facts to reflect key developments in the field and to provide the clearest presentation possible. Specific highlights include the following: Q Reorganized Flow of Topics in Chapters 3 and 4. Mastering the tools for discounting

cash flows is central to students’ success in the introductory course. As always, mastery comes with practice and by approaching complex topics in manageable units. We begin our step-by-step look at the time value of money in Chapter 3, which provides intuition for time value concepts, introduces the Valuation Principle, and presents rules for valuing cash flows. Chapter 4 addresses cash flow valuation for multi-period investments. Q New Two-Pronged Approach to Stock Valuation. Immediately following bond valuation, Chapter 7 opens with key background coverage of stock quotes and the mechanics of stock trades and then presents the dividend-discount model. We delay the discussion of the discounted cash flow model until after we have covered capital budgeting. In Chapter 10, we introduce the discounted cash flow model by building on concepts already developed in the capital budgeting chapters. Chapter 10 also discusses market efficiency and includes a new discussion of investor behavior. Q New and Updated Interviews. A number of new and updated practitioner and recent graduate interviews support the book’s practical perspective and incorporate timely xxiv

Preface

xxv

viewpoints related to the recent financial crisis. Our popular interviews with highlevel practitioners incorporate an “inside” perspective on the financial crisis of 2007–2009 and include new interviews with Frederic S. Mishkin, former Federal Reserve Board governor; David Holland, Senior Vice President and Treasurer of Cisco; and Shelagh Glaser, Director for Intel’s Mobility Group. Q Expanded Special Topics Section. The new mergers and acquisitions chapter looks at

the overall market for takeovers, motivations for pursuing acquisitions, and the typical process. Additional chapters now available online—leasing, insurance and risk management, and corporate governance—allow professors to choose favorite topics. Q New Problems and MyFinanceLab Upgrade. We added 100 new problems to the

Second Edition, once again personally writing and solving each one. In addition, every single problem is available in MyFinanceLab, the groundbreaking homework and tutorial system that accompanies the book. The system recognizes typical mistakes and provides immediate feedback, allowing the student to learn instantaneously from the mistake.

Emphasis on Valuation As painful as the financial crisis was, there is a silver lining: with the increasing focus on finance in the news, today’s undergraduate students arrive in the classroom with an interest in finance. We strive to use that natural interest and motivation to overcome their fear of the subject and communicate time-tested core principles. Again, we take what has worked in the classroom and apply it to the text: By providing examples involving familiar companies such as Starbucks and Apple, making consistent use of real-world data, and demonstrating personal finance applications of core concepts, we strive to keep both nonfinance and finance majors engaged. By learning to apply the Valuation Principle, students develop the skills to make the types of comparisons—among loan options, investments, projects, and so on—that turn them into knowledgeable, confident financial consumers and managers. When students see how to apply finance to their personal lives and future careers, they grasp that finance is more than abstract, mathematically based concepts.

Table of Contents Overview Fundamentals of Corporate Finance offers coverage of the major topical areas for introductory-level undergraduate courses. Our focus is on financial decision making related to the corporation’s choice of which investments to make or how to raise the capital required to fund an investment. We designed the book with the need for flexibility and with consideration of time pressures throughout the semester in mind.

Part 1: Introduction Ch. 1: Corporate Finance and the Financial Manager Ch. 2: Introduction to Financial Statement Analysis

Part 2: Interest Rates and Valuing Cash Flows Ch. 3: Time Value of Money: An Introduction Ch. 4: Time Value of Money: Valuing Cash Flow Streams

Introduces the Valuation Principle and time value of money techniques for single-period investments

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Preface Ch. 5: Interest Rates Ch. 6: Bonds Ch. 7: Stock Valuation

Part 3: Valuation and the Firm Ch. 8: Investment Decision Rules Ch. 9: Fundamentals of Capital Budgeting Ch. 10: Stock Valuation: A Second Look

Part 4: Risk and Return Ch. 11: Risk and Return in Capital Markets Ch. 12: Systematic Risk and the Equity Risk Premium Ch. 13: The Cost of Capital

Part 5: Long-Term Financing

Presents how interest rates are quoted and compounding for all frequencies New chapter introduces stocks and presents the dividend discount model as an application of the time value of money Introduces the NPV rule as the “golden rule” against which we evaluate other investment decision rules Provides a clear focus on the distinction between earnings and free cash flow

Ch. 14: Raising Equity Capital Ch. 15: Debt Financing

Builds on capital budgeting material by valuing the ownership claim to the firm’s free cash flows and addresses market efficiency and behavioral finance

Part 6: Capital Structure and Payout Policy

Calculates and uses the firm’s overall costs of capital with the WACC method

Ch. 16: Capital Structure Ch. 17: Payout Policy

Part 7: Financial Planning and Forecasting Ch. 18: Financial Modeling and Pro Forma Analysis Ch. 19: Working Capital Management Ch. 20: Short-Term Financial Planning

Part 8: Special Topics Ch. 21: Option Applications and Corporate Finance Ch. 22: Mergers and Acquisitions Ch. 23: International Corporate Finance

Online Chapters (on MyFinanceLab at www.myfinancelab.com) Leasing Insurance and Risk Management Corporate Governance

These chapters begin with perfect markets and then show how frictions, including agency costs and asymmetric information, can influence financial policy

Makes the critical distinction between sustainable and value-increasing growth in determining the firm’s value

New chapter looks at the overall market for M&A and considers the motivations for and the typical process of a transaction Opportunities for course customization with online-only chapter offerings

A Complete Instructor and Student Support Package MyFinanceLab This fully integrated online homework system gives students the hands-on practice and tutorial help they need to learn finance efficiently. Ample opportunities for online practice and assessment in MyFinanceLab (www.myfinancelab.com) are seamlessly integrated into each chapter and organized by section within the chapter summaries. For more details, see the inside front cover.

Preface

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Videos Video clips available in MyFinanceLab profile well-known firms such as Boeing and Intel through interviews and analysis. The videos focus on core topical areas such as capital budgeting and risk and return.

Solutions Manual The printed Solutions Manual provides students with detailed, accuracy-verified solutions to the problems in the book. The solutions, like the problems, were written by the authors themselves. Spreadsheet solutions in Excel®, which allow the student to see the effect of changes in the input variables on the outcome, are also available to instructors for designated problems at the Instructor Resource Center (www.pearsonhighered.com/irc) and on the Instructor’s Resource CD-ROM.

Study Guide Written by Julie Dahlquist of the University of Texas at San Antonio, the Study Guide provides students with valuable extra practice, offering an in-depth chapter synopsis, answers to the Concept Check questions in the book, additional step-by-step examples following the Guided Problem Solution framework introduced in the text, practice questions and problems, and a self test. To order, visit MyPearsonStore.com.

PowerPoint Presentations The PowerPoint Presentation, authored by Janet Payne and William Chittenden of Texas State University, is available in lecture form and includes art and tables from the book and additional examples. The PowerPoint presentation includes all tables and figures, examples, key terms, and spreadsheet tables from the textbook. All PowerPoint presentations are included on the Instructor’s Resource CD-ROM and are also available for download from the Instructor Resource Center at www.pearsonhighered.com/irc.

Test Item File The Test Item File, edited by Janet Payne and William Chittenden of Texas State University, provides a wealth of accuracy-verified testing material. Each chapter offers a wide variety of true/false, short answer, and multiple-choice questions contributed by Salil Sarkar of the University of Texas at Arlington, Karan Bhanot of the University of Texas at San Antonio, and instructional designer David Stuart. Questions are verified by difficulty level and skill type, and correlated to the chapter topics. Numerical problems include step-by-step solutions. Every question in the Test Item File is available in TestGen® software for both Windows® and Macintosh® computers. This easy-to-use testing software is a valuable test preparation tool that allows professors to view, edit, and add questions. Both the Test Item File and the TestGen computerized test bank are included on the Instructor’s Resource CD-ROM, are available for download from the Instructor Resource Center at www.pearsonhighered.com/irc, and all questions can be assigned via MyFinanceLab.

Instructor’s Manual The Instructor’s Manual was written by Mary R. Brown of the University of Illinois–Chicago, and contains annotated chapter outlines, lecture launchers and questions for further class discussion. It also contains the solutions to the Data Cases and partending case problems, as well as answers to the chapter-ending Critical Thinking questions in the book. As an additional resource to guide instructors with students who

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Preface are planning to take the CFA exam, CFA learning outcomes met in each chapter are listed. A section also details how the end-of-chapter problems map to the accreditation standards set by the Association to Advance Collegiate Schools of Business (AACSB), so that instructors can track students’ mastery of the AACSB standards. The Instructor’s Manual is included on the Instructor’s Resource CD-ROM and is also available for download as Microsoft® Word files or as Adobe® PDF files from the Instructor Resource Center at www.pearsonhighered.com/irc.

Instructor’s Resource CD-ROM The Instructor’s Resource CD-ROM offers the complete set of instructor supplements for Fundamentals of Corporate Finance, Second Edition, including Microsoft® Word and Adobe® PDF files of the Instructor’s Manual, Solutions Manual, and Microsoft® Word files of the Test Item Files; complete PowerPoint® presentations; selected Excel® spreadsheet solutions; and the TestGen® Computerized Test Bank.

Acknowledgments Given the scope of this project, identifying the many people who made it happen is a tall order. This textbook was the product of the expertise and hard work of many talented colleagues. We are especially gratified with the work of those who developed the array of print supplements that accompany the book: Janet Payne and William Chittenden for the question writing on the Test Item File and PowerPoint presentations; Mary R. Brown, for the Instructor’s Manual; Julie Dahlquist, for the Study Guide; James Linck, for serving as advisor for the videos; and our MyFinanceLab content development team, including Carlos Bazan, Shannon Donovan, Michael J. Woodworth, Christopher Kelly, Jody Lotz, and Michael P. Griffin. We’re also deeply appreciative of Marlene Bellamy’s work conducting the lively interviews with recent graduates that open each chapter and Susan White’s contributions to the part-ending cases. Creating a truly error-free text is a challenge we could not have lived up to without our team of expert error checkers. Anand Goel, Robert James, and Timothy Sullivan each subjected the text and problem solutions to their exacting standards. We are indebted to our team of Research Assistants—Nathan Walcott, Jared Stanfield, Miguel Palacios, Rob Schonlau, Alex Paulsen, and Jonathan Kalodimos—for their adept support throughout the writing process. At Prentice Hall, we would like to single out Donna Battista, for her continued leadership and market insight; Tessa O’Brien, for her unparalleled commitment to the project; Rebecca Ferris-Caruso, for her critical eye and uncanny ability to juggle the writing, reviewing, and editing process without missing a beat; and our production team, Nancy Freihofer and Gillian Hall, for expertly managing the transformation of our Word files into a beautiful bound book. We are truly thankful for the indispensable help provided by these and other professionals, including: Elisa Adams, Alison Eusden, Miguel Leonarte, Kerri McQueen, Melissa Pellerano, Nicole Sackin, and Susan Schoenberg. We are indebted to our colleagues for the time and expertise invested as manuscript reviewers, class testers, and focus group participants. We list all of these contributors on the following pages, but want to single out one group, our First Edition editorial board, for special notice: Tom Berry, DePaul University; Elizabeth Booth, Michigan State University; Julie Dahlquist, the University of Texas–San Antonio; Michaël Dewally, Marquette University; Robert M. Donchez, the University of Colorado–Boulder; Belinda Mucklow, the University of Wisconsin–Madison; Coleen Pantalone, Northeastern University; and Susan White, the University of Maryland. We strived to incorporate every contributor’s input and are truly grateful for each comment and suggestion. The book has benefited enormously from this input.

Preface

Reviewers Pankaj Agrrawal, University of Maine Daniel Ahern, California State University–Chico Paul Asabere, Temple University Ajeyo Banerjee, University of Colorado–Denver Tom Berry, DePaul University Karan Bhanot, University of Texas–San Antonio Rafiqul Bhuyan, California State University–San Bernardino Eugene Bland, Texas A&M University–Corpus Christi Matej Blasko, University of Georgia Elizabeth Booth, Michigan State University Mary Brown, University of Illinois–Chicago Bill Brunsen, Eastern New Mexico University David G. Cazier, Brigham Young University–Provo Leo Chan, Delaware State University Cindy Chen, California State University–Long Beach Haiyu Chen, Youngstown State University James F. Cotter, Wake Forest University Vicentiu Covrig, California State University–Northridge Julie Dahlquist, University of Texas–San Antonio Pieter de Jong, University of Texas–Arlington Andrea L. DeMaskey, Villanova University Xiaohui Deng, California State University–Fresno Michaël Dewally, Marquette University Robert M. Donchez, University of Colorado Boulder Gang Dong, Rutgers University Dean Drenk, Montana State University Robert Dubil, University of Utah Hsing Fang, California State University–Los Angeles David O. Fricke, University of North Carolina–Pembroke Scott Fung, California State University–East Bay Sharon Garrison, University of Arizona Rakesh Gupta, Central Queensland University Joseph D. Haley, St. Cloud State University Thomas Hall, Christopher Newport University Karen L. Hamilton, Georgia Southern University Mahfuzul Haque, Indiana State University Edward C. Howell, Northwood University Ping Hsiao, San Francisco State University Xiaoqing Hu, University of Illinois at Chicago Pankaj Jain, University of Memphis Robert James, Babson College Susan Ji, Baruch College, City University of New York Domingo Joaquin, Illinois State University Fred R. Kaen, University of New Hampshire Terrill Keasler, Appalachian State University Howard Keen, Temple University Brett A. King, University of North Alabama

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Daniel Klein, Bowling Green State University Gregory Kuhlemeyer, Carroll University Rose Neng Lai, University of Macau Keith Lam, University of Macau Reinhold P. Lamb, University of North Florida Douglas Lamdin, University of Maryland–Baltimore County Mark J. Laplante, University of Georgia Sie Ting Lau, Nanyang Technological University Richard LeCompte, Wichita State University Adam Y.C. Lei, Midwestern State University Qian Li, Midwestern State University Wei Liu, Texas A&M University Hugh Marble III, University of Vermont James Milanese, University of North Carolina at Greensboro Sunil K. Mohanty, University of St. Thomas Ted Moorman, Northern Illinois University James Morris, University of Colorado–Denver Belinda Mucklow, University of Wisconsin–Madison Rick Nelson, University of Minnesota Tom C. Nelson, University of Colorado–Boulder Anthony C. Ng, Hong Kong Polytechnic University Coleen Pantalone, Northeastern University Daniel Park, Azusa Pacific University Janet Payne, Texas State University Lynn Pi, Hong Kong University of Science and Technology J. Michael Pinegar, Brigham Young University Annette Poulsen, University of Georgia Eric Powers, University of South Carolina Rose M. Prasad, Central Michigan University Shoba Premkumar, Iowa State University Mark K. Pyles, College of Charleston A.A.B. Resing, Hogeschool Van Amsterdam Greg Richey, California State University, San Bernardino David L. Robbins, University of New Mexico Andrew Samwick, Dartmouth College Salil K. Sarkar, University of Texas–Arlington Oliver Schnusenberg, University of North Florida Kenneth Scislaw, University of Alabama–Huntsville Roger Severns, Minnesota State University–Mankato Tatyana Sokolyk, University of Wyoming Andrew C. Spieler, Hofstra University Timothy G. Sullivan, Bentley College Janikan Supanvanij, St. Cloud State University Oranee Tawatnuntachai, Pennsylvania State University–Harrisburg Robert Terpstra, University of Macau Thomas Thomson, University of Texas–San Antonio Olaf J. Thorp, Babson College

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Preface

Emery Trahan, Northeastern University Joe Ueng, University of St. Thomas Mo Vaziri, California State University–San Bernardino Premal P. Vora, Pennsylvania State University–Harrisburg Hefei Wang, University of Illinois–Chicago Gwendolyn Webb, Baruch College Paul M. Weinstock, Ohio State University Susan White, University of Maryland Annie Wong, Western Connecticut State University Zhong-gou Zhou, California State University–Northridge Kermit C. Zieg, Jr., Florida Institute of Technology

Focus Group Participants Anne-Marie Anderson, Lehigh University Sung Bae, Bowling Green State University H. Kent Baker, American University Steven Beach, Radford University Rafiqul Bhuyan, California State University–San Bernardino Deanne Butchey, Florida International University Leo Chan, Delaware State University George Chang, Grand Valley State University Haiwei Chen, California State University–San Bernardino Haiyu Chen, Youngstown State University Massimiliano De Santis, Dartmouth College Jocelyn Evans, College of Charleston Kathleen Fuller, University of Mississippi Xavier Garza Gomez, University of Houston–Victoria William Gentry, Williams College Axel Grossmann, Radford University Pankaj Jain, University of Memphis Zhenhu Jin, Valparaiso University Steve Johnson, University of Northern Iowa Steven Jones, Samford University Yong-Cheol Kim, University of Wisconsin–Milwaukee Robert Kiss, Eastern Michigan University Ann Marie Klingenhagen, DePaul University Thomas J. Krissek, Northeastern Illinois University Olivier Maisondieu Laforge, University of Nebraska–Omaha Douglas Lamdin, University of Maryland–Baltimore County D. Scott Lee, Texas A&M University Stanley A. Martin, University of Colorado–Boulder Jamshid Mehran, Indiana University, South Bend Sunil Mohanty, University of St. Thomas

Karyn L. Neuhauser, State University of New York–Plattsburgh Thomas O’Brien, University of Connecticut Hyuna Park, Minnesota State University–Mankato G. Michael Phillips, California State University–Northridge Wendy Pirie, Valparaiso University Antonio Rodriguez, Texas A&M International University Camelia S. Rotaru, St. Edward’s University Salil Sarkar, University of Texas at Arlington Mark Sunderman, University of Wyoming Chu-Sheng Tai, Texas Southern University Oranee Tawatnuntachai, Pennsylvania State University–Harrisburg Benedict Udemgba, Alcorn State University Rahul Verma, University of Houston–Downtown Angelo P. Vignola, Loyola University–Chicago Premal Vora, Pennsylvania State University–Harrisburg Eric Wehrly, Seattle University Yan A. Xie, University of Michigan–Dearborn Fang Zhao, Siena College Sophie Zong, California State University–Stanislaus

Class Testers Tom Berry, DePaul University Eugene Bland, Texas A&M University–Corpus Christi Charles Blaylock, Murray State University Mary Brown, University of Illinois–Chicago Bill Brunsen, Eastern New Mexico University Sarah Bryant Bower, Shippensburg University of Pennsylvania Alva Wright Butcher, University of Puget Sound David G. Cazier, Brigham Young University–Provo Asim G. Celik, University of Nevada–Reno Michaël Dewally, Marquette University Richard Gaddis, Oklahoma Wesleyan University TeWhan Hahn, Auburn University–Montgomery Matthew Hood, University of Southern Mississippi Zhenhu Jin, Valparaiso University Travis Jones, Florida Gulf Coast University Francis E. Laatsch, Bowling Green State University Diane Lander, Saint Michael’s College Vance Lesseig, Texas State University Frances Maloy, University of Washington Jamshid Mehran, Indiana University–South Bend Belinda Mucklow, University of Wisconsin–Madison Kuo-Chung Tseng, California State University–Fresno Kermit C. Zieg, Jr., Florida Institute of Technology

PART

Introduction

1

Valuation Principle Connection. What is corporate finance? No matter

Chapter 1

what your role in a corporation, an understanding of why and how financial decisions

Corporate Finance and the Financial Manager

are made is essential. The focus of this book is how to make optimal corporate financial decisions. In this part of the book, we lay the foundation for our study of corporate finance. In Chapter 1, we begin by introducing the corporation and related business forms. We then examine the role of financial managers and outside investors in decision making for the firm. To make optimal decisions, a decision maker needs

Chapter 2 Introduction to Financial Statement Analysis

information. As a result, in Chapter 2 we review and analyze an important source of information for corporate decision making—the firm’s accounting statements. These chapters will introduce us to the role and objective of the financial manager and some of the information the financial manager uses in applying the Valuation Principle to make optimal decisions. Then, in the next section of the book, we will introduce and begin applying the Valuation Principle.

1

1

Corporate Finance and the Financial Manager

LEARNING OBJECTIVES Q Grasp the importance of financial information in both your personal and business lives Q Understand the important features of the four main types of firms and see why the advantages of the corporate form have led it to dominate economic activity Q Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the three main types of decisions a financial manager makes

2

Q Know how a corporation is managed and controlled, the financial manager’s place in it, and some of the ethical issues financial managers face Q Understand the importance of financial markets, such as stock markets, to a corporation and the financial manager’s role as liaison to those markets Q Recognize the role that financial institutions play in the financial cycle of the economy

INTERVIEW WITH

Leslie Tillquist PA Consulting Group

Leslie Tillquist, who received a B.S. in Business Administration in Finance and Marketing from the University of Colorado, Boulder in 2007, wasn’t sure what she wanted to do after graduation. “I enjoyed marketing’s focus on understanding human motivations and interactions, but I realized that finance provides a real-world understanding and skill set that leads to incredibly diverse career paths,” she explains. “It is hard to make credible decisions in business or nonprofit organizations without financially supporting and defending them. Understanding financial techniques allows individuals in all careers to pursue opportunities and solve problems in business situations.” She joined the Denver office of PA Consulting Group, Inc., an international consulting firm based in London with offices in more than 35 countries. “I wanted a high-energy, project-based environment where I could interact with the decision makers in a rapidly changing industry and also have the opportunity to work abroad,” she says. Her finance degree gave her that opportunity within PA Consulting’s Global Energy Practice. “Within seven months, I have joined in projects for international banks, government, and a Fortune 500 company. Work has taken me across the United States as well as to England and South Africa.” Her responsibilities include performing financial analysis and energy research that support client business analysis and the resulting strategic recommendations. For example, she uses different metrics to value assets, contracts, and companies, and creates company financial statements used in acquiring financing and evaluating opportunities. Leslie encourages students not to be intimidated by the rigor of finance courses. “They give you essential fundamentals for business analysis in whatever area interests you, as well as the work ethic for further on-the-job learning,” she says. “Although it is sometimes hard to appreciate at the time, finance classes provide the tools you need to resolve complex financial problems—whether your career is in finance or not.” She adds that she was very hesitant to study and work in finance. “I could not be more grateful for the opportunities available to me because I stuck with it. The work pays off immensely when I can communicate ideas eloquently and thoughtfully in business discussions.”

University of Colorado, 2007

“Finance classes provide the tools you need to resolve complex financial problems—whether your career is in finance or not.”

This book focuses on how people in corporations make financial decisions. Despite its name, much of what we discuss in corporate finance applies to the financial decisions made within any organization, including not-for-profit entities such as charities and universities. In this chapter, we introduce the four main types of firms. We stress corporations, however, because they represent 85% of U.S. business revenue. We also highlight the financial manager’s critical role inside any business enterprise. What products to launch, how to pay to develop those products, what profits to keep and how to return profits to investors—all of these decisions and many more fall within corporate finance. The financial manager makes these decisions with the goal of maximizing the value of the business, which is determined in the financial markets. In this chapter and throughout the book, we will focus on this goal, provide you with the tools to make financial management decisions, and show you how the financial markets provide funds to a corporation and produce market prices that are key inputs to any financial manager’s investment analysis.

3

4

Part 1 Introduction

1.1

Why Study Finance? Finance and financial thinking are everywhere in our daily lives. Consider your decision to go to college. You surely weighed alternatives, such as starting a full-time job immediately, and then decided that college provided you with the greatest net benefit. More and more, individuals are taking charge of their personal finances with decisions such as: Q Q Q Q

When to start saving and how much to save for retirement. Whether a car loan or lease is more advantageous. Whether a particular stock is a good investment. How to evaluate the terms of a home mortgage.

Our career paths have become less predictable and more dynamic. In previous generations, it was common to work for one employer your entire career. Today, that would be highly unusual. Most of us will instead change jobs, and possibly even careers, many times. With each new opportunity, we must weigh all the costs and benefits, financial and otherwise. Some financial decisions, such as whether to pay $2.00 for your morning coffee, are simple, but most are more complex. In your business career, you may face questions such as: Q Q Q Q Q

Should your firm launch a new product? Which supplier should your firm choose? Should your firm produce a part of the product or outsource production? Should your firm issue new stock or borrow money instead? How can you raise money for your start-up firm?

In this book, you will learn how all of these decisions in your personal life and inside a business are tied together by one powerful concept, the Valuation Principle. The Valuation Principle shows how to make the costs and benefits of a decision comparable so that we can weigh them properly. Learning to apply the Valuation Principle will give you the skills to make the types of comparisons—among loan options, investments, and projects—that will turn you into a knowledgeable, confident financial consumer and manager. In each chapter you will hear from a former student—someone who opened a book like this one not that long ago—who talks about his or her job and the critical role finance plays in it. From 2007 to 2009 we witnessed a credit freeze, a severe stock market decline, and the failures of well-known financial institutions. Attempts to understand these elements of the crisis, their origins, and how they affect our businesses and personal finances have highlighted the need for learning core financial principles and concepts. Whether you plan to major in finance or simply take this one course, you will find the fundamental financial knowledge gained here to be essential in your personal and business lives.

1.2

The Four Types of Firms We begin our study of corporate finance by examining the types of firms that financial managers run. There are four major types of firms: sole proprietorships, partnerships, limited liability companies, and corporations. We explain each organizational form in turn, but our primary focus is on the most important form—the corporation.

Chapter 1 Corporate Finance and the Financial Manager

5

Sole Proprietorships sole proprietorship A business owned and run by one person.

A sole proprietorship is a business owned and run by one person. Sole proprietorships are usually very small with few, if any, employees. Although they do not account for much sales revenue in the economy, they are the most common type of firm in the world. In 2007, an estimated 71% of businesses in the United States were sole proprietorships, although they generated only 5% of the revenue.1 We now consider the key features of a sole proprietorship. 1. Sole proprietorships have the advantage of being straightforward to set up. Consequently, many new businesses use this organizational form. 2. The principal limitation of a sole proprietorship is that there is no separation between the firm and the owner—the firm can have only one owner who runs the business. If there are other investors, they cannot hold an ownership stake in the firm. 3. The owner has unlimited personal liability for the firm’s debts. That is, if the firm defaults on any debt payment, the lender can (and will) require the owner to repay the loan from personal assets. An owner who cannot afford to repay a loan for which he or she is personably liable must declare personal bankruptcy. 4. The life of a sole proprietorship is limited to the life of the owner. It is also difficult to transfer ownership of a sole proprietorship. For most growing businesses, the disadvantages of a sole proprietorship outweigh the advantages. As soon as the firm reaches the point at which it can borrow without the owner agreeing to be personally liable, the owners typically convert the business into another form. Conversion also has other benefits that we will consider as we discuss the other forms below.

Partnerships partnership A business owned and run by more than one owner.

limited partnership A partnership with two kinds of owners, general partners and limited partners. limited liability When an investor’s liability is limited to her investment.

A partnership is a business owned and run by more than one owner. Key features include the following: 1. All partners are liable for the firm’s debt. That is, a lender can require any partner to repay all the firm’s outstanding debts. 2. The partnership ends in the event of the death or withdrawal of any single partner. 3. Partners can avoid liquidation if the partnership agreement provides for alternatives such as a buyout of a deceased or withdrawn partner. Some old and established businesses remain as partnerships or sole proprietorships. Often these firms are the types of businesses in which the owners’ personal reputations are the basis for the businesses. For example, law firms, medical practices, and accounting firms are frequently organized as partnerships. For such enterprises, the partners’ personal liability increases the confidence of the firm’s clients that the partners will strive to maintain the firm’s reputation. A limited partnership is a partnership with two kinds of owners, general partners and limited partners. In this case, the general partners have the same rights and privileges as partners in any general partnership—they are personally liable for the firm’s debt obligations. Limited partners, however, have limited liability—that is, their liability is limited to their investment. Their private property cannot be seized to pay off the firm’s outstanding debts. Furthermore, the death or withdrawal of a limited partner does not dissolve the 1

U.S. Census Bureau National Data Book.

6

Part 1 Introduction partnership, and a limited partner’s interest is transferable. However, a limited partner has no management authority and cannot legally be involved in the managerial decision making for the business.

Limited Liability Companies limited liability company (LLC) A limited partnership without a general partner.

A limited liability company (LLC) is like a limited partnership but without a general partner. That is, all the owners (referred to as members) have limited liability, but unlike limited partners, they can also run the business (as managing members). The LLC is a relatively new phenomenon in the United States. The first state to pass a statute allowing the creation of an LLC was Wyoming in 1977; the last was Hawaii in 1997. Internationally, companies with limited liability are much older and established. LLCs first rose to prominence in Germany over 100 years ago as a Gesellschaft mit beschränkter Haftung (GmbH) and then in other European and Latin American countries. An LLC is known in France as a Société à responsabilité limitée (SAR), and by similar names in Italy (SRL) and Spain (SL).

Corporations corporation A legally defined, artificial being, separate from its owners.

A corporation is a legally defined, artificial being (a legal entity), separate from its owners. As such, it has many of the legal powers that people have. It can enter into contracts, acquire assets, and incur obligations, and it enjoys protection under the U.S. Constitution against the seizure of its property. Because a corporation is a legal entity separate and distinct from its owners, it is solely responsible for its own obligations. Consequently, the owners of a corporation (or its employees, customers, etc.) are not liable for any obligations the corporation enters into. Similarly, the corporation is not liable for any personal obligations of its owners. In the same way that it is difficult to imagine modern business life without e-mail and cell phones, the corporation revolutionized the economy. On February 2, 1819, the U.S. Supreme Court established the legal precedent that the property of a corporation, similar to that of a person, is private and entitled to protection under the U.S. Constitution.2 This decision led to dramatic growth in the number of U.S. corporations from under 1,000 in 1830 to 50,000 in 1890. Today the corporate structure is ubiquitous, not only in the United States (where they are responsible for 85% of business revenue), but all over the world. Formation of a Corporation. A corporation must be legally formed, which means that the state in which it is incorporated must formally give its consent to the incorporation by chartering it. Setting up a corporation is therefore considerably more costly than setting up a sole proprietorship. The state of Delaware has a particularly attractive legal environment for corporations, so many corporations choose to incorporate there. For jurisdictional purposes, a corporation is a citizen of the state in which it is incorporated. Most firms hire lawyers to create a corporate charter that includes formal articles of incorporation and a set of bylaws. The corporate charter specifies the initial rules that govern how the corporation is run.

stock The ownership or equity of a corporation divided into shares.

Ownership of a Corporation. There is no limit on the number of owners a corporation can have. Because most corporations have many owners, each owner owns only a fraction of the corporation. The entire ownership stake of a corporation is divided into shares known as stock. The collection of all the outstanding shares of a corporation is known as

2

The case was Dartmouth vs. Woodward and the full text of John Marshall’s decision can be found at www.constitution.org/dwebster/dartmouth_decision.htm.

Chapter 1 Corporate Finance and the Financial Manager equity The collection of all the outstanding shares of a corporation. shareholder (also stockholder or equity holder) An owner of a share of stock or equity in a corporation. dividend payments Payments made at the discretion of the corporation to its equity holders.

7

the equity of the corporation. An owner of a share of stock in the corporation is known as a shareholder, stockholder, or equity holder. Shareholders are entitled to dividend payments; that is, payments made at the discretion of the corporation to its equity holders. Shareholders usually receive a share of the dividend payments that is proportional to the amount of stock they own. For example, a shareholder who owns 25% of the firm’s shares would be entitled to 25% of the total dividend payment. An important feature of a corporation is that there is no limitation on who can own its stock. That is, an owner of a corporation need not have any special expertise or qualification. This feature allows free and anonymous trade in the shares of the corporation and provides one of the most important advantages of organizing a firm as a corporation. Corporations can raise substantial amounts of capital because they can sell ownership shares to anonymous outside investors. The availability of outside funding has enabled corporations to dominate the economy. Let’s look at one of the world’s largest firms, Microsoft Corporation, as an example. Microsoft reported annual revenue of $58.4 billion over the 12 months from July 2008 through June 2009. The total value of the company (the wealth in the company the owners collectively owned) as of April 2010 was $267.1 billion. The company employed 93,000 people. Putting these numbers into perspective, treating the sales of $58.4 billion as gross domestic product (GDP) in 2009 would rank Microsoft (just ahead of Ecuador) as the sixty-fifth richest country (out of more than 200).3 Ecuador has almost 13.5 million people, about 145 times as many people as employees at Microsoft. Indeed, if the number of Microsoft employees were used as the “population” of the corporation, Microsoft would rank just above Seychelles as the eighteenth least-populous country on earth!

Tax Implications for Corporate Entities An important difference among the types of corporate organizational forms is the way they are taxed. Because a corporation is a separate legal entity, a corporation’s profits are subject to taxation separate from its owners’ tax obligations. In effect, shareholders of a corporation pay taxes twice. First, the corporation pays tax on its profits, and then when the remaining profits are distributed to the shareholders, the shareholders pay their own personal income tax on this income. This system is sometimes referred to as double taxation.

EXAMPLE 1.1

Problem

Taxation of Corporate Earnings

You are a shareholder in a corporation. The corporation earns $5.00 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend (we make this simplifying assumption, but should note that most corporations retain some of their earnings for reinvestment). The dividend is income to you, so you will then pay taxes on these earnings. The corporate tax rate is 40% and your tax rate on dividend income is 15%. How much of the earnings remains after all taxes are paid?

Solution Q Plan Earnings before taxes: $5.00

Corporate tax rate: 40%

Personal dividend tax rate: 15%

To calculate the corporation’s earnings after taxes, first we subtract the taxes paid at the corporate level from the pre-tax earnings of $5.00. The taxes paid will be 40% (the corporate tax rate) of $5.00. Since all of the after-corporate tax earnings will be paid to you as a dividend, you will pay taxes of 15% on that amount. The amount leftover is what remains after all taxes are paid.

3

World Development Indicators database, April 13, 2010. For quick reference tables on GDP, go to www.worldbank.org/data/quickreference.html.

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Part 1 Introduction

Q Execute $5.00 per share * 0.40 = $2.00 in taxes at the corporate level, leaving $5.00 - $2.00 = $3.00 in aftercorporate tax earnings per share to distribute. You will pay $3.00 * 0.15 = $0.45 in taxes on that dividend, leaving you with $2.55 from the original $5.00 after all taxes. Q Evaluate As a shareholder, you keep $2.55 of the original $5.00 in earnings; the remaining $2.00 + $0.45 = $2.45 is paid as taxes. Thus, your total effective tax rate is 2.45/5 = 49%. S corporations Those corporations that elect subchapter S tax treatment and are exempted by the U.S. Internal Revenue Service’s tax code from double taxation. C corporations Corporations that have no restrictions on who owns their shares or the number of shareholders; they cannot qualify for subchapter S treatment and are subject to direct taxation.

EXAMPLE 1.2 Taxation of S Corporation Earnings

S Corporations. The corporate organizational structure is the only organizational structure subject to double taxation. However, the U.S. Internal Revenue Code exempts S corporations from double taxation because they elect subchapter S tax treatment. Under subchapter S tax regulations, the firm’s profits (and losses) are not subject to corporate taxes, but instead are allocated directly to shareholders based on their ownership share. The shareholders must include these profits as income on their individual tax returns (even if no money is distributed to them). However, after the shareholders have paid income taxes on these profits, no further tax is due. C Corporations. The government places strict limitations on the qualifications for subchapter S tax treatment. In particular, the shareholders of such corporations must be individuals who are U.S. citizens or residents, and there can be no more than 100 of them. Because most corporations have no restrictions on who owns their shares or the number of shareholders, they cannot qualify for subchapter S treatment. Thus, most corporations are C corporations, which are corporations subject to corporate taxes. Problem Rework Example 1.1, assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 30%.

Solution Q Plan Earnings before taxes: $5.00

Corporate tax rate: 0%

Personal tax rate: 30%

In this case, the corporation pays no taxes. It earned $5.00 per share. In an S corporation, all income is treated as personal income to you, whether or not the corporation chooses to distribute or retain this cash. As a result, you must pay a 30% tax rate on those earnings. Q Execute Your income taxes are 0.30 * $5.00 = $1.50, leaving you with $5.00 - $1.50 = $3.50 in after-tax earnings. Q Evaluate The $1.50 in taxes that you pay is substantially lower than the $2.45 you paid in Example 1.1. As a result, you are left with $3.50 per share after all taxes instead of $2.55. However, note that in a C corporation, you are only taxed when you receive the income as a dividend, whereas in an S corporation, you pay taxes on the income immediately regardless of whether the corporation distributes it as a dividend or reinvests it in the company.

As we have discussed, there are four main types of firms: sole proprietorships, partnerships (general and limited), limited liability companies, and corporations (“S” and “C”). To help you see the differences among them, Table 1.1 compares and contrasts the main characteristics of each.

Chapter 1 Corporate Finance and the Financial Manager

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Corporate Taxation Around the World In most countries, there is some relief from double taxation. As of August 2010, thirty-one countries make up the Organization for Economic Co-operation and Development (OECD), and of these countries, only Ireland and Switzerland offer no relief from double taxation. The United

States offers no relief on dividend income compared to other sources of income. As of 2010 dividend income is taxed at the investor’s personal income tax rate. A few countries, including Australia, Finland, Mexico, New Zealand, and Norway, offer complete relief by effectively not taxing dividend income.

TABLE 1.1 Number of Owners

Liability for Firm’s Debts

Owners Manage the Firm

Ownership Change Dissolves Firm

Taxation

Sole Proprietorship

One

Yes

Yes

Yes

Personal

Partnership

Unlimited

Yes

Yes

Personal

GP-Yes LP-No

GP-Yes LP-No

Personal

Characteristics of the Different Types of Firms

Limited Partnership

Yes; each partner is liable for the entire amount At least one general GP-Yes partner (GP), no limit LP-No on limited partners (LP)

Limited Liability Unlimited Company

No

Yes

No*

Personal

S Corporation

At most 100

No

No (but they legally may)

No

Personal

C Corporation

Unlimited

No

No (but they legally may)

No

Double

*However, most LLCs require the approval of the other members to transfer your ownership.

Concept Check

1.3

1. What is a limited liability company (LLC)? How does it differ from a limited partnership? 2. What are the advantages and disadvantages of organizing a business as a corporation?

The Financial Manager As of January 2010, Apple, Inc. had just under 906.8 million shares of stock held by 30,476 owners.4 Because there are many owners of a corporation, each of whom can freely trade their stock, it is often not feasible for the owners of a corporation to have direct control of the firm. It falls to the financial manager to make the financial decisions of the business for the stockholders. Within the corporation, the financial manager has three main tasks: 1. Make investment decisions. 2. Make financing decisions. 3. Manage short-term cash needs. We will discuss each of these in turn, along with the financial manager’s overarching goal. 4

Apple, Inc., Notice of 2010 Annual Meeting of Shareholders, January 12, 2010.

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Part 1 Introduction

Making Investment Decisions The financial manager’s most important job is to make the firm’s investment decisions. The financial manager must weigh the costs and benefits of each investment or project and decide which of them qualify as good uses of the money stockholders have invested in the firm. These investment decisions fundamentally shape what the firm does and whether it will add value for its owners. For example, it may seem hard to imagine now, but there was a time when Apple’s financial managers were evaluating whether to invest in the development of the first iPhone. They had to weigh the substantial development and production costs against uncertain future sales. Their analysis indicated that it was a good investment, and the rest is history. In this book, you will learn all the tools necessary to make these investment decisions.

Making Financing Decisions Once the financial manager has decided which investments to make, he or she also decides how to pay for them. Large investments may require the corporation to raise additional money. The financial manager must decide whether to raise more money from new and existing owners by selling more shares of stock (equity) or to borrow the money instead (bonds and other debt). A bond is a security sold by governments and corporations to raise money from investors today in exchange for a promised future payment. It can be viewed as a loan from those investors to the issuer. In this book, we will discuss the characteristics of each source of money and how to decide which one to use in the context of the corporation’s overall mix of debt and equity.

Managing Short-Term Cash Needs The financial manager must ensure that the firm has enough cash on hand to meet its obligations from day to day. This job, also commonly known as managing working capital,5 may seem straightforward, but in a young or growing company, it can mean the difference between success and failure. Even companies with great products require a lot of money to develop and bring those products to market. Consider the costs to Starbucks of launching their VIA instant coffee, which included developing the instant coffee crystals and creating a big marketing campaign around them, or the costs to Boeing of producing the 787—billions of dollars were spent before the first 787 finally left the ground in December 2009. A company typically burns through a significant amount of cash before the sales of the product generate income. The financial manager’s job is to make sure that access to cash does not hinder the firm’s success.

The Goal of the Financial Manager All of these decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of the owners, the stockholders. The stockholders have invested in the corporation, putting their money at risk to become the owners of the corporation. Thus, the financial manager is a caretaker of the stockholders’ money, making decisions in their interests. Many corporations have thousands of owners (shareholders). These shareholders vary from large institutions to small first-time investors, from retirees living off their investments to young employees just starting to save for retirement. Each owner is likely to have different interests and prior5

Working capital refers to things such as cash on hand, inventories, raw materials, loans to suppliers, and payments from customers—the grease that keeps the wheels of production moving. We will discuss working capital in more detail in the next chapter and devote all of Chapter 19 to working capital management.

Chapter 1 Corporate Finance and the Financial Manager

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ities. Whose interests and priorities determine the goals of the firm? You might be surprised to learn that the interests of shareholders are aligned for many, if not most, important decisions. Regardless of their own personal financial position and stage in life, all the shareholders will agree that they are better off if the value of their investment in the corporation is maximized. For example, suppose the decision concerns whether to develop a new product that will be a profitable investment for the corporation. All shareholders will very likely agree that developing this product is a good idea. Returning to our iPhone example, by October 2010, Apple shares were worth 3 times as much as they were in January 2007, when the first iPhone was introduced. All Apple shareholders at the time of the development of the first iPhone are clearly much better off because of it, whether they have since sold their shares of Apple to pay for retirement, or are still holding those shares in their retirement savings account. Even when all the owners of a corporation agree on the goals of the corporation, these goals must be implemented. In the next section, we discuss the financial manager’s place in the corporation and how owners exert control over the corporation. Shareholder Value Versus Stakeholder Value While the goal of a financial manager is to increase the value of the firm to its shareholders, this responsibility does not imply that the impact of the firm’s decisions on other stakeholders, such as employees or customers, can be ignored. By creating additional value for customers, the firm can raise prices and increase profits. Similarly, if the firm makes decisions that benefit employees (for example,

Concept Check

1.4

increasing their job security), it will be able to offer lower wages or benefit from increased productivity. On the other hand if customers or employees anticipate that the firm is likely to exploit them, they will demand lower prices or higher wages. Thus, to maximize shareholder value, the financial manager must consider the impact of her decision on all stakeholders of the firm.

3. What are the main types of decisions that a financial manager makes? 4. What is the goal of the financial manager?

The Financial Manager’s Place in the Corporation We’ve established that the stockholders own the corporation but rely on financial managers to actively manage the corporation. The board of directors and the management team headed by the chief executive officer possess direct control of the corporation. In this section, we explain how the responsibilities for the corporation are divided between these two entities and describe conflicts that arise between stockholders and the management team.

The Corporate Management Team board of directors A group of people elected by shareholders who have the ultimate decisionmaking authority in the corporation. chief executive officer (CEO) The person charged with running the corporation by instituting the rules and policies set by the board of directors.

The shareholders of a corporation exercise their control by electing a board of directors, a group of people who have the ultimate decision-making authority in the corporation. In most corporations, each share of stock gives a shareholder one vote in the election of the board of directors, so investors with more shares have more influence. When one or two shareholders own a very large proportion of the outstanding stock, these shareholders might either be on the board of directors themselves, or they may have the right to appoint a number of directors. The board of directors makes rules on how the corporation should be run (including how the top managers in the corporation are compensated), sets policy, and monitors the performance of the company. The board of directors delegates most decisions that involve the day-to-day running of the corporation to its management. The chief executive officer (CEO) is charged with running the corporation by instituting the rules and policies set

12

Part 1 Introduction by the board of directors. The size of the rest of the management team varies from corporation to corporation. In some corporations, the separation of powers between the board of directors and CEO is not always distinct. In fact, the CEO can also be the chairman of the board of directors. The most senior financial manager is the chief financial officer (CFO), often reporting directly to the CEO. Figure 1.1 presents part of a typical organizational chart for a corporation, highlighting the positions a financial manager may take.

Ethics and Incentives in Corporations A corporation is run by a management team, separate from its owners. How can the owners of a corporation ensure that the management team will implement their goals?

agency problem When managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of those shareholders.

FIGURE 1.1 The Financial Functions Within a Corporation

Agency Problems. Many people claim that because of the separation of ownership and control in a corporation, managers have little incentive to work in the interests of the shareholders when this means working against their own self-interest. Economists call this an agency problem—when managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of those shareholders. Managers face the ethical dilemma of whether to adhere to their responsibility to put the interests of shareholders first, or to do what is in their own personal best interests. This problem is commonly addressed in practice by minimizing the number of decisions managers make that require putting their self-interest against the interests of the shareholders. For example, managers’ compensation contracts are designed to ensure that most decisions in the shareholders’ interest are also in the managers’ interests; shareholders often tie the compensation of top managers to the corporation’s profits or perhaps to its stock price. There is, however, a limitation to this strategy. By tying compensation too closely to performance, the shareholders might be asking managers to take on more risk than they are comfortable taking. As a result, the managers may not make decisions that the shareholders want them to, or it

The board of directors, representing the stockholders, controls the corporation and hires the top management team. A financial manager might hold any of the green-shaded positions, including the Chief Financial Officer (CFO) role. The controller oversees accounting and tax functions. The treasurer oversees more traditional finance functions, such as capital budgeting (making investment decisions), risk management (managing the firm’s exposure to movements in the financial markets), and credit management (managing the terms and policies of any credit the firm extends to its customers).

Board of Directors Chief Executive Officer Chief Financial Officer Controller

Chief Operating Officer

Treasurer Accounting

Capital Budgeting

Tax Department

Risk Management Credit Management

Chapter 1 Corporate Finance and the Financial Manager

13

might be hard to find talented managers willing to accept the job. For example, biotech firms take big risks on drugs that fight cancer, AIDS, and other widespread diseases. The market for a successful drug is huge, but the risk of failure is high. Investors who put only some of their money in biotech may be comfortable with this risk, but a manager who has all of his or her compensation tied to the success of such a drug might opt to develop a less risky drug that has a smaller market. Further potential for conflicts of interest and ethical considerations arise when some stakeholders in the corporation benefit and others lose from a decision. Shareholders and managers are two stakeholders in the corporation, but others include the regular employees and the communities in which the company operates, for example. Managers may decide to take the interests of other stakeholders into account in their decisions, such as keeping a loss-generating factory open because it is the main provider of jobs in a small town, paying above local market wages to factory workers in a developing country, or operating a plant at a higher environmental standard than local law mandates. In some cases, these actions that benefit other stakeholders may also benefit the firm’s shareholders by creating a more dedicated workforce, generating positive publicity with customers, or other indirect effects. In other instances, when these decisions benefit other stakeholders at shareholders’ expense, they represent a form of corporate charity. Indeed, many if not most corporations explicitly donate (on behalf of their shareholders) to local and global causes. Shareholders often approve of such actions, even though they are costly and so reduce their wealth. While it is the manager’s job to make decisions that maximize shareholder value, shareholders—who own the firm—also want the firm’s actions to reflect their moral and ethical values. Of course, shareholders may not have identical preferences in these matters, leading to potential sources of conflict.

hostile takeover A situation in which an individual or organization, sometimes referred to as a corporate raider, purchases a large fraction of a target corporation’s stock and in doing so gets enough votes to replace the target’s board of directors and its CEO.

The CEO’s Performance. Another way shareholders can encourage managers to work in the interests of shareholders is to discipline them if they do not. If shareholders are unhappy with a CEO’s performance, they could, in principle, pressure the board to oust the CEO. Disney’s Michael Eisner, Hewlett-Packard’s Carly Fiorina, and Home Depot’s Robert Nardelli were all forced to resign by their boards. Despite these high-profile examples, directors and top executives are rarely replaced through a grassroots shareholder uprising. Instead, dissatisfied investors often choose to sell their shares. Of course, somebody must be willing to buy the shares from the dissatisfied shareholders. If enough shareholders are dissatisfied, the only way to entice investors to buy (or hold) the shares is to offer them a low price. Similarly, investors who see a well-managed corporation will want to purchase shares, which drives the stock price up. Thus, the stock price of the corporation is a barometer for corporate leaders that continuously gives them feedback on the shareholders’ opinion of their performance. When the stock performs poorly, the board of directors might react by replacing the CEO. In some corporations, however, the senior executives might be entrenched because boards of directors do not have the independence or motivation to replace them. Often the reluctance to fire results when the board is comprised of people who are close friends of the CEO and lack objectivity. In corporations in which the CEO is entrenched and doing a poor job, the expectation of continued poor performance will cause the stock price to be low. Low stock prices create a profit opportunity. In a hostile takeover, an individual or organization—sometimes known as a corporate raider—can purchase a large fraction of the company’s stock and in doing so get enough votes to replace the board of directors and the CEO. With a new superior management team, the stock is a much more attractive investment, which would likely result in a price rise and a profit for the corporate raider and the other shareholders. Although the words “hostile” and “raider” have negative connotations, corporate raiders themselves provide an important service to shareholders. The mere threat of being removed as a result of a hostile takeover is often

14

Part 1 Introduction enough to discipline bad managers and motivate boards of directors to make difficult decisions. Consequently, the fact that a corporation’s shares can be publicly traded creates a “market for corporate control” that encourages managers and boards of directors to act in the interests of their shareholders.

Concept Check

5. How do shareholders control a corporation? 6. What types of jobs would a financial manager have in a corporation? 7. What ethical issues could confront a financial manager?

1.5

stock markets (also stock exchanges or bourses) Organized markets on which the shares of many corporations are traded.

primary market When a corporation issues new shares of stock and sells them to investors. secondary market Markets, such as NYSE or NASDAQ, where shares of a corporation are traded between investors without the involvement of the corporation.

In Section 1.3, we established the goal of the financial manager: to maximize the wealth of the owners, the stockholders. The value of the owners’ investments in the corporation is determined by the price of a share of the corporation’s stock. Corporations can be private or public. A private corporation has a limited number of owners and there is no organized market for its shares, making it hard to determine the market price of its shares at any point in time. A public corporation has many owners and its shares trade on an organized market, called a stock market (or stock exchange or bourse). These markets provide liquidity for a company’s shares and determine the market price for those shares. An investment is liquid if it can easily be turned into cash by selling it immediately at a competitive market price. An investor in a public company values the ability to turn his investment into cash easily and quickly by simply selling his shares on one of these markets. In this section, we provide an overview of the functioning of the major stock markets. The analysis and trading by participants in these markets provides an evaluation of the financial managers’ decisions that determines the stock price and provides essential feedback to the managers on their decisions.

The Largest Stock Markets The best known U.S. stock market and one of the largest stock markets in the world is the New York Stock Exchange (NYSE). Billions of dollars of stock are exchanged every day on the NYSE. Other U.S. stock markets include the American Stock Exchange (AMEX), NASDAQ (the National Association of Security Dealers Automated Quotation system), and regional exchanges such as the Midwest Stock Exchange. Most other countries have at least one stock market. Outside the United States, the biggest stock markets are the London Stock Exchange (LSE) and the Tokyo Stock Exchange (TSE). Figure 1.2 ranks the world’s largest stock exchanges by trading volume.

Primary Versus Secondary Markets All of the markets in Figure 1.2 are secondary markets. The primary market refers to a corporation issuing new shares of stock and selling them to investors. After this initial transaction between the corporation and investors, the shares continue to trade in a secondary market between investors without the involvement of the corporation. For example, if you wish to buy 100 shares of Starbucks Coffee, you could place an order on the NASDAQ, where Starbucks trades under the ticker symbol SBUX. You would buy your shares from someone who already held shares of Starbucks, not from Starbucks itself.

Photo by Konstantine Protopapas.

liquid Describes an investment that can easily be turned into cash because it can be sold immediately at a competitive market price.

The Stock Market

Chapter 1 Corporate Finance and the Financial Manager

FIGURE 1.2 Worldwide Stock Markets Ranked by Volume of Trade

15

The bar graph shows the 10 biggest stock markets in the world ranked by total value of shares traded on exchange in 2009. NASDAQ OMX NYSE Euronext (US) Shanghai Stock Exchange Tokyo Stock Exchange London Stock Exchange Deutsche Börse NYSE Euronext (Europe) BME Spanish Exchanges Korea Exchanges

market makers Individuals on a stock exchange who match buyers with sellers. specialists Individuals on the trading floor of the NYSE who match buyers with sellers; also called market makers. bid price The price at which a market maker or specialist is willing to buy a security. ask price The price at which a market maker or specialist is willing to sell a security. auction market A market where share prices are set through direct interaction of buyers and sellers. bid-ask spread The amount by which the ask price exceeds the bid price. transaction cost In most markets, an expense such as a broker commission and the bid-ask spread investors must pay in order to trade securities. over-the-counter (OTC) market A market without a physical location, in which dealers are connected by computers and telephones.

Hong Kong Exchanges 0

$5000 $10,000 $15,000 $20,000 $25,000 $30,000 Total Value of Shares Traded in $ Billions

Source: www.world-exchanges.org.

Physical Stock Markets The NYSE is an example of a physical market. It is located at 11 Wall Street in New York City. On the floor of the NYSE, market makers (known on the NYSE as specialists) match buyers and sellers. They post two prices for every stock they make a market in: the price they stand willing to buy the stock at (the bid price) and the price they stand willing to sell the stock for (the ask price). If a customer comes to them wanting to make a trade at these prices, they will honor the price (up to a limited number of shares) and make the trade even if they do not have another customer willing to take the other side of the trade. In this way, they ensure that the market is liquid because customers can always be assured they can trade at the posted prices. The exchange has rules that attempt to ensure that bid and ask prices do not get too far apart and that large price changes take place through a series of small changes, rather than in one big jump. Large investment banks and brokerages buy trading licenses that entitle them to access the floor and trade on the exchange. Because license holders can go to IBM’s trading post, for example, and directly sell IBM shares to the highest bidder or buy IBM shares at the lowest offered price, the exchange is an auction market. Ask prices exceed bid prices. This difference is called the bid-ask spread. Because investors buy at the ask (the higher price) and sell at the bid (the lower price), the bid-ask spread is a transaction cost they have to pay in order to trade. When specialists in a physical market such as the NYSE take the other side of the trade from their customers, this transaction cost accrues to them as a profit. It is the compensation they demand for providing a liquid market by standing ready to honor any quoted price. Investors also pay other forms of transactions costs such as commissions.

Over-the-Counter Stock Markets In today’s technology-driven economy, a stock market does not need to have a physical location. Stock transactions can be made over the phone or by computer network. Consequently, stock markets such as NASDAQ, which are called over-the-counter (OTC) markets, are a collection of dealers or market makers connected by computer networks

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Part 1 Introduction

dealer market A market where dealers buy and sell for their own accounts.

and telephones. An important difference between the NYSE and NASDAQ is that on the NYSE, each stock has only one market maker. On NASDAQ, stocks can and do have multiple market makers who compete with each other. Each market maker must post bid and ask prices in the NASDAQ network, where they can be viewed by all participants. Because investors do not directly interact to set the prices, NASDAQ and other over-the-counter markets are dealer markets. The NASDAQ system posts the best prices first and fills orders accordingly. This process guarantees investors the best possible price at the moment, whether they are buying or selling.

Listing Standards listing standards Outlines of the requirements a company must meet to be traded on the exchange.

Each exchange has its own listing standards, outlines of the requirements a company must meet to be traded on the exchange. These standards usually require that the company have enough shares outstanding for shareholders to have a liquid market and to be of interest to a broad set of investors. The NYSE’s standards are more stringent than those of NASDAQ; traditionally, there has been a certain pride in being listed on the NYSE. Many companies would start on the NASDAQ and then move to the NYSE as they grew. However, NASDAQ has retained many big, successful companies such as Starbucks, Apple, and Microsoft. The two exchanges compete actively over listings of larger companies, and the decision of where to list often comes down to which exchange the company’s board believes will give its stockholders the best execution and liquidity for their trades.

NYSE, AMEX, DJIA, S&P 500: Awash in Acronyms With all of these acronyms floating around, it’s easy to get confused. You may have heard of the “Dow Jones” or “Dow Jones (Industrial) Average” and the “S&P 500” on news reports about the stock markets. The NYSE, AMEX, and NASDAQ are all stock markets where the prices of stocks are determined through trading. However, when commentators talk about whether stocks are up or down in general in a given day, they often refer to the Dow Jones Industrial Average (DJIA) and the Standard and Poor’s 500 (S&P 500). The DJIA and S&P 500 are simply measures of the aggregate price level of collections of pre-selected stocks—30 in the case of the DJIA and 500 in the case of the S&P 500. These stocks were selected by Dow Jones (the publisher of the Wall Street Journal ) or Standard & Poor’s as representative of the overall market. The S&P 500 con-

sists of 500 of the highest-valued U.S. companies. While fewer in number, the 30 stocks in the DJIA include companies such as Microsoft, Wal-Mart, Boeing, and 3M, and are selected to cover the important sectors in the U.S. economy. The table below shows the 30 stocks in the DJIA as of March 2010. Dow Jones editors choose these stocks to reflect the overall U.S. economy. The membership of the index has changed over time to reflect the U.S. economy’s transition from being industrial-driven to being more services and technology based. For example, they added Bank of America and Chevron in 2008 to capture the economy’s move toward financial services and the growing importance of energy. Both the DJIA and S&P 500 include stocks that are traded on the NYSE and stocks that are traded on NASDAQ and so are distinct from the exchanges themselves.

Composition of the Dow Jones Industrial Average (DJIA) 3M Co. Alcoa Inc. American Express Co. AT&T Inc. Bank of America Corp. Boeing Co. Caterpillar Inc. Chevron Corp. Cisco Systems Inc. Coca-Cola Co.

Source: djindexes.com.

E.I. DuPont de Nemours & Co. Exxon Mobil Corp. General Electric Co. Hewlett-Packard Co. Home Depot Inc. Intel Corp. International Business Machines Johnson & Johnson JPMorgan Chase & Co. Kraft Foods Inc.

McDonald’s Corp. Merck & Co. Inc. Microsoft Corp. Pfizer Inc. Procter & Gamble Co. Travelers Cos. Inc. United Technologies Corp. Verizon Communications Inc. Wal-Mart Stores Inc. Walt Disney Co.

Chapter 1 Corporate Finance and the Financial Manager

17

Other Financial Markets Of course, stock markets are not the only financial markets. There are markets to trade practically anything—some of them are physical places like the NYSE and others are purely electronic, like the NASDAQ. Two of the largest financial markets in the world, the bond market and the foreign exchange market, are simply networks of dealers connected by phone and computer. We will discuss these markets in more detail in later chapters (Chapters 6 and 15 for bonds and Chapter 23 for foreign exchange). Commodities like oil, wheat, and soybeans are traded on physical exchanges like the New York Mercantile Exchange. Derivative securities, which are complicated financial products used to hedge risks, are traded in locations like the Chicago Board Options Exchange (discussed in Chapter 21).

Concept Check

1.6 financial institutions Entities that provide financial services, such as taking deposits, managing investments, brokering financial transactions, or making loans.

8. What advantage does a stock market provide to corporate investors? To financial managers? 9. What are the main differences between the NYSE and NASDAQ?

Financial Institutions The spread of the 2008 financial crisis from subprime mortgages to Wall Street to traditional banks and businesses drew everyone’s attention to financial institutions and their role in the economy. In general, financial institutions are entities that provide financial services, such as taking deposits, managing investments, brokering financial transactions, or making loans. In this section, we describe the key types of financial institutions and their functions.

The Financial Cycle Keeping the names and roles of the different types of financial institutions straight can be challenging. It is helpful to think of the basic financial cycle, depicted in Figure 1.3, as context. In the financial cycle, (1) people invest and save their money, (2) that money, through loans and stock, flows to companies who use it to fund growth through new products, generating profits and wages, and (3) the money then flows back to the savers and investors. All financial institutions play a role at some point in this cycle of connecting money with ideas and returning the profits back to the investors.

FIGURE 1.3 The Financial Cycle

This figure depicts the basic financial cycle, which matches funds from savers to companies that have projects requiring funds and then returns the profits from those projects back to the savers.

Money Money

Savers Companies with projects and new ideas

Wages, profits, and interest

18

Part 1 Introduction

Types of Financial Institutions Table 1.2 lists the major categories of financial institutions, provides examples of representative firms, and summarizes the institutions’ sources and uses of funds. Financial conglomerates, sometimes referred to as financial services firms, combine more than one type of institution. Examples include Bank of America, JPMorgan Chase, and Deutsche Bank, all of which engage in commercial banking (like Wells Fargo) as well as investment banking. Investment banking refers to the business of advising companies in major financial transactions. Examples include buying and selling companies or divisions, and raising new capital by issuing stock or bonds. Goldman Sachs and Morgan Stanley are financial institutions that are focused on investment banking activities.

Role of Financial Institutions Financial institutions have a role beyond moving funds from those who have extra funds (savers) to those who need funds (borrowers and firms): They also move funds through time. For example, suppose you need a $20,000 car loan. You need $20,000 now, but do not have it. However, you will have it in the future as you earn a salary. The financial institution, in this case a bank or credit union, helps transfer your future salary into funds today by issuing you a loan. Financial institutions also help spread out risk-bearing. Insurance companies essentially pool premiums together from policyholders and pay the claims of those who have an accident, fire, medical need, or die. This process spreads the financial risk of these events out across a large pool of policyholders and the investors in the insurance company. Similarly, mutual funds and pension funds take your savings and spread them out among the stocks and bonds of many different companies, limiting your risk exposure to any one company.

TABLE 1.2 Financial Institutions and Their Roles in the Financial Cycle

Institution Banks and Credit Unions Examples: Wells Fargo, SunTrust

Source of Money Deposits (savings)

Use of Money Loans to people and businesses

Insurance Companies Examples: Liberty Mutual, Allstate

Premiums and investment earnings

Invests mostly in bonds and some stocks, using the investment income to pay claims

Mutual Funds Examples: Vanguard, Fidelity

People’s investments (savings)

Buys stocks, bonds, and other financial instruments on behalf of its investors

Pension Funds Examples: CalPERS, REST

Retirement savings contributed through the workplace

Similar to mutual funds, except with the purpose of providing retirement income

Hedge Funds Examples: Bridgewater, Soros Fund

Investments by wealthy individuals and endowments

Invests in any kind of investment in an attempt to maximize returns

Venture Capital Funds Examples: Kleiner Perkins, Sequoia Capital

Investments by wealthy individuals and endowments

Invests in start-up, entrepreneurial firms

Private Equity Funds Examples: TPG Capital, KKR

Investments by wealthy individuals and endowments

Purchases whole companies by using a small amount of equity and borrowing the rest

Chapter 1 Corporate Finance and the Financial Manager

19

While you may have seen coverage of the stock markets and discussion of financial institutions on the news, it is unlikely that you have had any exposure to the finance function within the firm. In this chapter, we provided a sense of what corporate finance is all about, what a financial manager does, and the importance of stock markets and financial institutions. In the coming chapters, you will learn how to make financial management decisions and how to use financial market information. We will explore the tools of financial analysis hand-in-hand with a clear understanding of when to apply them and why they work.

Concept Check

10. What is the basic financial cycle? 11. What are the three main roles financial institutions play?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

Online Practice Opportunities

1.1 Why Study Finance? Q Finance and financial decisions are everywhere in our daily lives. Q Many financial decisions are simple, but others are complex. All are tied together by the Valuation Principle—the foundation for financial decision making—which you will learn in this book. 1.2 The Four Types of Firms Q There are four types of firms in the United States: sole proprietorships, partnerships, limited liability companies, and corporations. Q Firms with unlimited personal liability include sole proprietorships and partnerships. Q Firms with limited liability include limited partnerships, limited liability companies, and corporations. Q A corporation is a legally defined artificial being (a judicial person or legal entity) that has many of the legal powers people have. It can enter into contracts, acquire assets, and incur obligations, and it enjoys protection under the U.S. Constitution against the seizure of its property. Q The shareholders in a C corporation effectively must pay tax twice. The corporation pays tax once and then investors must pay personal tax on any funds that are distributed. S corporations are exempt from the corporate income tax. Q The ownership of a corporation is divided into shares of stock collectively known as equity. Investors in these shares are called shareholders, stockholders, or equity holders.

C corporations, p. 8 corporation, p. 6 dividend payments, p. 7 equity, p. 7 equity holder, p. 7 limited liability, p. 5 limited liability company (LLC), p. 6 limited partnership, p. 5 partnership, p. 5 S corporations, p. 8 shareholder, p. 7 sole proprietorship, p. 5 stock, p. 6 stockholder, p. 7

MyFinanceLab Study Plan 1.2

20 Part 1 Introduction Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where 1.3 The Financial Manager Q The financial manager makes investing, financing, and cash flow management decisions. Q The goal of the financial manager is to maximize the wealth of the shareholders (maximize the stock price).

MyFinanceLab Study Plan 1.3

1.4 The Financial Manager’s Place in the Corporation Q The ownership and control of a corporation are separate. Shareholders exercise their control indirectly through the board of directors.

agency problem, p. 12 board of directors, p. 11 chief executive officer (CEO), p. 11 hostile takeover, p. 13

MyFinanceLab Study Plan 1.4

1.5 The Stock Market Q The shares of public corporations are traded on stock markets. The shares of private corporations do not trade on a stock market. Q When a firm sells shares to investors, that is a primary market. The stock markets, such as NYSE and NASDAQ, are secondary markets where investors trade shares among each other. Q NASDAQ is a dealer market, characterized by market makers trading for their own accounts.

ask price, p. 15 auction market, p. 15 bid-ask spread, p. 15 bid price, p. 15 bourses, p. 14 dealer market, p. 16 liquid, p. 14 listing standards, p. 16 market makers, p. 15 over-the-counter (OTC) market, p. 15 primary market, p. 14 secondary market, p. 14 specialists, p. 15 stock exchange, p. 14 stock market, p. 14 transaction cost, p. 15

MyFinanceLab Study Plan 1.5

1.6 Financial Institutions Q In the basic financial cycle, money flows from savers and investors to companies and entrepreneurs with ideas, and then back to the savers and investors in the form of profits and interest. Q Financial institutions all play some role in this cycle. Q Financial institutions also help move money through time (e.g., loans against future wages) and spread risk across large investor bases.

financial institutions, p. 17

MyFinanceLab Study Plan 1.6

Chapter 1 Corporate Finance and the Financial Manager

Problems

21

All Problems are available in MyFinanceLab. The Four Types of Firms 1. What is the most important difference between a corporation and all other organizational forms? 2. What does the phrase limited liability mean in a corporate context? 3. Which organizational forms give their owners limited liability? 4. What are the main advantages and disadvantages of organizing a firm as a corporation? 5. Explain the difference between an S and a C corporation. 6. You are a shareholder in a C corporation. The corporation earns $2.00 per share before taxes. Once it has paid taxes it will distribute the rest of its earnings to you as a dividend. Assume the corporate tax rate is 40% and the personal tax rate on (both dividend and non-dividend) income is 30%. How much is left for you after all taxes are paid? 7. Repeat Problem 6 assuming the corporation is an S corporation. The Financial Manager 8. What is the most important type of decision that the financial manager makes? 9. Why do all shareholders agree on the same goal for the financial manager? The Financial Manager’s Place in the Corporation 10. Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interests of the owners, rather than in their own interests. What strategies are available to shareholders to help ensure that managers are motivated to act this way? 11. Think back to the last time you ate at an expensive restaurant where you paid the bill. Now think about the last time you ate at a similar restaurant, but your parents paid the bill. Did you order more food (or more expensive food) when your parents paid? Explain how this relates to the agency problem in corporations. 12. Suppose you are considering renting an apartment. You, the renter, can be viewed as an agent while the company that owns the apartment can be viewed as the principal. What agency conflicts do you anticipate? Suppose, instead, that you work for the apartment company. What features would you put into the lease agreement that would give the renter incentives to take good care of the apartment? 13. You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. What is the nature of the agency conflict here and how is it related to ethical considerations?

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Part 1 Introduction The Stock Market 14. What is the difference between a public and a private corporation? 15. What is the difference between a primary and a secondary market? 16. What are some of the differences between the NYSE and NASDAQ? 17. Explain why the bid-ask spread is a transaction cost. 18. The following quote on Yahoo! stock appeared on April 13, 2010, on Yahoo! Finance:

If you wanted to buy Yahoo!, what price would you pay per share? How much would you receive per share if you wanted to sell Yahoo!? Financial Institutions 19. What is the financial cycle? 20. How do financial institutions help with risk-bearing? 21. What role do investment banks play in the economy? 22. What are some of the similarities and differences among mutual funds, pension funds, and hedge funds?

2

Introduction to Financial Statement Analysis

LEARNING OBJECTIVES Q Know why the disclosure of financial information through financial statements is critical to investors Q Understand the function of the balance sheet Q Use the balance sheet to analyze a firm Q Understand how the income statement is used

Q Interpret a statement of cash flows Q Know what management’s discussion and analysis and the statement of stockholders’ equity are Q Understand the main purpose and aspects of the Sarbanes-Oxley reforms following Enron and other financial scandals

Q Analyze a firm through its income statement, including using the DuPont Identity

23

INTERVIEW WITH

Hiral Tolia CBIZ Valuation Group, LLC

As a senior consultant for CBIZ Valuation Group, LLC, in Dallas, Texas, Hiral Tolia works on client projects that focus on determining a company’s value. For example, a privately held company wishing to issue stock to its employees may hire CBIZ to determine its value before setting a stock price. In mergers and acquisitions, a company may need CBIZ to value certain assets owned by the acquired company, as required for financial reporting purposes. Hiral, who received a Bachelor of Engineering in Computer Science in 2003 from the University of Mumbai and an MBA in 2006 from the University of Texas, Arlington, uses the concepts she learned in her various finance classes on a daily basis. “Because we have clients from various industry sectors, we need an in-depth knowledge of each of those market segments. I use financial statement analysis extensively to understand a company’s performance and how it compares to its industry peers.” Analyzing financial statements gives Hiral insight into a company’s current financial position and its performance over time. “This information is useful in making economic decisions, such as to determine a company’s future cash flows, the effect of cyclical trends in the industry on operations over a period of time and in the future, and whether to invest in the company’s securities or recommend them to other investors,” she explains. “Thus, it is important to understand financial statements whether you are an owner of the company, an employee, an investor, or an analyst.” The first step in valuing a company is assessing past performance and determining its current financial position using information contained in the publicly available financial statements. “We use income statements to analyze revenue and expenses and the balance sheets and statement of cash flows to analyze short-term cash flow needs and determine capital expenditures.” One of CBIZ’s valuation methods involves the review of pricing and performance information for public companies in a generally similar industry to the subject company. “Ratio analysis helps to compare the subject company to market participants, so we can apply our valuation models and determine a fair value for the company.”

As we discussed in Chapter 1, anyone with money to invest is a potential investor who can own shares in a corporation. As a result, corporations are often widely held, with investors ranging from individuals who hold one share to large financial institutions that own millions of shares. For example, in 2010 International Business Machines Corporation (IBM) had over 1.3 billion shares outstanding held by over 546,000 stockholders. Although the corporate organizational structure greatly facilitates the firm’s access to investment capital, it also means that stock ownership is most investors’ sole tie to the company. How, then, do investors learn enough about a company to know whether or not they should invest in it? One way firms evaluate their performance and communicate this information to investors is through their financial statements. Financial statements also enable financial managers to assess the success of their own firm and compare it to competitors. Firms regularly issue financial statements to communicate financial information to the investment community. A detailed description of the preparation and analysis of these statements is sufficiently

24

University of Texas, Arlington, 2006

“I use financial statement analysis extensively to understand a company’s performance and how it compares to its industry peers.”

Chapter 2 Introduction to Financial Statement Analysis

25

complicated that to do it justice would require an entire book. In this chapter, we briefly review the subject, emphasizing only the material that investors and corporate financial managers need in order to make the corporate finance decisions we discuss in the text. We review the four main types of financial statements, present examples of these statements for a firm, and discuss where an investor or manager might find various types of information about the company. We also discuss some of the financial ratios used to assess a firm’s performance and value. We close the chapter with a look at financial reporting abuses and the Sarbanes-Oxley regulatory response.

2.1 financial statements Accounting reports issued by a firm quarterly and/or annually that present past performance information and a snapshot of the firm’s assets and the financing of those assets. annual report The yearly summary of business, accompanying or including financial statements, sent by U.S. public companies to their stockholders.

Firms’ Disclosure of Financial Information Financial statements are accounting reports issued by a firm periodically (usually quarterly and annually) that present past performance information and a snapshot of the firm’s assets and the financing of those assets. Public companies in the United States are required to file their financial statements with the U.S. Securities and Exchange Commission (SEC) on a quarterly basis on form 10-Q and annually on form 10-K.1 They must also send an annual report with their financial statements to their shareholders each year. Often, private companies also prepare financial statements, but they usually do not have to disclose these reports to the public. Financial statements are important tools with which investors, financial analysts, and other interested outside parties (such as creditors) obtain information about a corporation. They are also useful for managers within the firm as a source of information for the corporate financial decisions we discussed in the previous chapter. In this section, we examine the guidelines for preparing financial statements and introduce the different types of financial statements.

Preparation of Financial Statements Generally Accepted Accounting Principles (GAAP) A common set of rules and a standard format for public companies to use when they prepare their financial reports. auditor A neutral third party, which corporations are required to hire, that checks a firm’s annual financial statements to ensure they are prepared according to GAAP, and provides evidence to support the reliability of the information.

Reports about a company’s performance must be understandable and accurate. In the United States, the Financial Accounting Standards Board (FASB) establishes Generally Accepted Accounting Principles (GAAP) to provide a common set of rules and a standard format for public companies to use when they prepare their reports. This standardization also makes it easier to compare the financial results of different firms. Investors also need some assurance that the financial statements are prepared accurately. Corporations are required to hire a neutral third party, known as an auditor, to check the annual financial statements, ensure they are prepared according to GAAP, and provide evidence to support the reliability of the information.

Types of Financial Statements Every public company is required to produce four financial statements: the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders’ equity. These financial statements provide investors and creditors with an overview of the firm’s financial performance. In the sections that follow, we take a close look at the content of these financial statements.

1

The Securities and Exchange Commission was established by Congress in 1934 to regulate securities (for example, stocks and bonds) issued to the public and the financial markets (exchanges) on which those securities trade.

26

Part 1 Introduction

International Financial Reporting Standards Generally Accepted Accounting Principles (GAAP) differ among countries. As a result, companies face tremendous accounting complexities when they operate internationally. Investors also face difficulty interpreting financial statements of foreign companies, which discourages them from investing abroad. As companies and capital markets become more global, however, interest in harmonization of accounting standards across countries has increased. The most important harmonization project began in 1973 when representatives of ten countries (including the United States) established the International Accounting Standards Committee. This effort led to the creation of the International Accounting Standards Board (IASB) in 2001, with headquarters in London. Now the IASB has issued a set of International Financial Reporting Standards (IFRS).

Concept Check

2.2 balance sheet A list of a firm’s assets and liabilities that provides a snapshot of the firm’s financial position at a given point in time. assets The cash, inventory, property, plant and equipment, and other investments a company has made. liabilities A firm’s obligations to its creditors. shareholders’ equity, stockholders’ equity An accounting measure of a firm’s net worth that represents the difference between the firm’s assets and its liabilities. common stock and paidin surplus The amount that stockholders have directly invested in the firm through purchasing stock from the company.

The IFRS are taking root throughout the world. The European Union (EU) approved an accounting regulation in 2002 requiring all publicly traded EU companies to follow IFRS in their consolidated financial statements starting in 2005. Many other countries have adopted IFRS for all listed companies, including Australia and several countries in Latin America and Africa. In fact, all major stock exchanges around the world accept IFRS except the United States and Japan, which maintain their local GAAP. Convergence to IFRS in the United States is likely within the near future. In 2008, the SEC eliminated the requirement for foreign firms listing in U.S. markets to reconcile IFRS to U.S. GAAP. In 2010, the SEC further affirmed its support of a single standard, with IFRS as the preferred method. The SEC will study and revisit the issue in 2011, with the possibility of requiring U.S. companies to start reporting according to IFRS as soon as 2015 or 2016.

1. What is the role of an auditor? 2. What are the four financial statements that all public companies must produce?

The Balance Sheet The balance sheet, or statement of financial position,2 lists the firm’s assets and liabilities, providing a snapshot of the firm’s financial position at a given point in time. Table 2.1 shows the balance sheet for a fictitious company, Global Corporation. Notice that the balance sheet is divided into two parts (“sides”) with the assets on the left side and the liabilities on the right side. 1. The assets list the firm’s cash, inventory, property, plant and equipment, and any other investments the company has made. 2. The liabilities show the firm’s obligations to its creditors. 3. Also shown with liabilities on the right side of the balance sheet is the stockholders’ equity. Stockholders’ equity (also shareholders’ equity), the difference between the firm’s assets and liabilities, is an accounting measure of the firm’s net worth. For Global, the stockholders’ equity has two parts: (1) common stock and paid-in surplus, the amount that stockholders have directly invested in the firm through purchasing stock from the company; and (2) retained earnings, which are profits made by the firm, but retained within the firm and reinvested in assets or held as cash. We will take a more detailed look at retained earnings in our discussion of the statement of cash flows later in this chapter. The assets on the left side show how the firm uses its capital (its investments), and the information on the right side summarizes the sources of capital, or how the firm raises the money it needs. Because of the way stockholders’ equity is calculated, the left and right sides must balance: The Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity

(2.1)

2 In IFRS and recent U.S. GAAP pronouncements, the balance sheet is referred to as the statement of financial position.

Chapter 2 Introduction to Financial Statement Analysis

TABLE 2.1 Global Corporation Balance Sheet for 2010 and 2009 ($ millions)

Assets

2010

2009

Current Assets

Liabilities and Stockholders’ Equity

23.2

20.5

Accounts payable

Accounts receivable

18.5

13.2

Notes payable/short-term debt

Inventories

15.3

14.3

57.0

48.0

Long-Term Assets Net property, plant, and equipment Total long-term assets

2010

2009

29.2

26.5

5.5

3.2

34.7

29.7

113.2

78.0

113.2

78.0

147.9

107.7

8.0

8.0

Current Liabilities

Cash

Total current assets

27

Total current liabilities Long-Term Liabilities

113.1

80.9

113.1

80.9

Long-term debt Total long-term liabilities Total Liabilities Stockholders’ Equity Common stock and paid-in surplus

Total Assets

170.1

128.9

Retained earnings

14.2

13.2

Total Stockholders’ Equity

22.2

21.2

170.1

128.9

Total Liabilities and Stockholders’ Equity

retained earnings Profits made by the firm, but retained within the firm and reinvested in assets or held as cash.

In Table 2.1, total assets for 2010 ($170.1 million) are equal to total liabilities ($147.9 million) plus stockholders’ equity ($22.2 million). We now examine the firm’s assets, liabilities, and stockholders’ equity in more detail. Following this, we evaluate the firm’s financial standing by analyzing the information contained in the balance sheet.

current assets Cash or assets that could be converted into cash within one year.

Assets

marketable securities Short-term, low-risk investments that can be easily sold and converted to cash. accounts receivable Amounts owed to a firm by customers who have purchased goods or services on credit. inventories A firm’s raw materials as well as its work-in-progress and finished goods. long-term assets Assets that produce tangible benefits for more than one year.

In Table 2.1, Global’s assets are divided into current and long-term assets. We discuss each in turn. Current Assets. Current assets are either cash or assets that could be converted into cash within one year. This category includes: 1. Cash and other marketable securities, which are short-term, low-risk investments that can be easily sold and converted to cash (such as money market investments, like government debt, that mature within a year); 2. Accounts receivable, which are amounts owed to the firm by customers who have purchased goods or services on credit; 3. Inventories, which are composed of raw materials as well as work-in-progress and finished goods; and 4. Other current assets, which is a catch-all category that includes items such as prepaid expenses (such as rent or insurance). Long-Term Assets. Assets such as real estate or machinery that produce tangible benefits for more than one year are called long-term assets. If Global spends $2 million on new equipment, this $2 million will be included with net property, plant, and equipment under long-term assets on the balance sheet. Because equipment tends to wear out or

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Part 1 Introduction

depreciation A yearly deduction a firm makes from the value of its fixed assets (other than land) over time, according to a depreciation schedule that depends on an asset’s life span. book value The acquisition cost of an asset less its accumulated depreciation.

become obsolete over time, Global will reduce the value recorded for this equipment through a yearly deduction called depreciation according to a depreciation schedule that depends on an asset’s life span. Depreciation is not an actual cash expense that the firm pays; it is a way of recognizing that buildings and equipment wear out and thus become less valuable the older they get. The book value of an asset is equal to its acquisition cost less accumulated depreciation. The figures for net property, plant, and equipment show the total book value of these assets. Other long-term assets can include such items as property not used in business operations, start-up costs in connection with a new business, trademarks and patents, and property held for sale. The sum of all the firms’ assets is the total assets at the bottom of the left side of the balance sheet in Table 2.1.

Liabilities We now examine the liabilities, shown on the right side of the balance sheet, which are divided into current and long-term liabilities. current liabilities Liabilities that will be satisfied within one year. accounts payable The amounts owed to creditors for products or services purchased with credit. notes payable, shortterm debt Loans that must be repaid in the next year. net working capital The difference between a firm’s current assets and current liabilities that represents the capital available in the short term to run the business.

Current Liabilities. Liabilities that will be satisfied within one year are known as current liabilities. They include: 1. Accounts payable, the amounts owed to suppliers for products or services purchased with credit. 2. Notes payable and short-term debt, loans that must be repaid in the next year. Any repayment of long-term debt that will occur within the next year would also be listed here as current maturities of long-term debt. 3. Accrual items, such as salary or taxes, that are owed but have not yet been paid, and deferred or unearned revenue, which is revenue that has been received for products that have not yet been delivered. The difference between current assets and current liabilities is the firm’s net working capital, the capital available in the short term to run the business. While notes payable and short-term debt are included in current liabilities, they are different from accounts payable and accrual items. Notes payable and short-term debt are related to financing decisions of the firm, while accounts payable and accruals arise from operating decisions of the firm. This distinction is important later when we see that financial managers generally try to keep these two decisions (operating and financing) separate. Net Working Capital = Current Assets - Current Liabilities

long-term debt Any loan or debt obligation with a maturity of more than a year. book value of equity The difference between the book value of a firm’s assets and its liabilities; also called shareholders’ equity and stockholders’ equity, it represents the net worth of a firm from an accounting perspective.

(2.2)

For example, in 2010 Global’s net working capital totaled $22.3 million ($57.0 million in current assets - +34.7 million in current liabilities). Firms with low (or negative) net working capital may face a shortage of funds. In such cases, the liabilities due in the short term exceed the company’s cash and expected payments on receivables. Long-Term Liabilities. Long-term liabilities are liabilities that extend beyond one year. When a firm needs to raise funds to purchase an asset or make an investment, it may borrow those funds through a long-term loan. That loan would appear on the balance sheet as long-term debt, which is any loan or debt obligation with a maturity of more than a year.

Stockholders’ Equity The sum of the current liabilities and long-term liabilities is total liabilities. The difference between the firm’s assets and liabilities is the stockholders’ equity; it is also called the book value of equity or shareholders’ equity. As we stated earlier, it represents the net worth of the firm from an accounting perspective. The two main components are com-

Chapter 2 Introduction to Financial Statement Analysis

market capitalization The total market value of equity; equals the market price per share times the number of shares.

EXAMPLE 2.1 Market Versus Book Value

29

mon stock and paid-in surplus and retained earnings. These two components form the book value of stockholders’ ownership claims, stemming from their direct investment and reinvestment of profits. Ideally, the balance sheet would provide us with an accurate assessment of the true value of the firm’s equity. Unfortunately, this is unlikely to be the case. First, many of the assets listed on the balance sheet are valued based on their historical cost rather than their true value today. For example, an office building is listed on the balance sheet according to its historical cost less its accumulated depreciation. But the actual value of the office building today may be very different than this amount; in fact, if real estate prices went up it will be worth more than the amount the firm paid for it years ago. The same is true for other property, plant, and equipment: The true value today of an asset may be very different from, and even exceed, its book value. A second, and probably more important, problem is that many of the firm’s valuable assets are not captured on the balance sheet. Consider, for example, the expertise of the firm’s employees, the firm’s reputation in the marketplace, the relationships with customers and suppliers, and the quality of the management team. All these assets add to the value of the firm but do not appear on the balance sheet. For these reasons, the book value of equity is an inaccurate assessment of the actual value of the firm’s equity. Thus, it is not surprising that it will often differ substantially from the amount investors are willing to pay for the equity. The total market value of a firm’s equity equals the market price per share times the number of shares, referred to as the company’s market capitalization. The market value of a stock does not depend on the historical cost of the firm’s assets; instead, it depends on what investors expect those assets to produce in the future. To see the difference, think about what happens when a company like Boeing unveils a new plane. Investors’ expectations about future cash flows from selling those planes increase the stock price immediately, elevating the market value of Boeing. However, the revenue from selling the planes will only be reflected in Boeing’s financial statements when it actually sells them. Problem If Global has 3.6 million shares outstanding, and these shares are trading for a price of $10.00 per share, what is Global’s market capitalization? How does the market capitalization compare to Global’s book value of equity?

Solution Q Plan Market capitalization is equal to price per share times shares outstanding. We can find Global’s book value of equity at the bottom of the right side of its balance sheet. Q Execute Global’s market capitalization is (10.00/share) * (3.6 million shares) = $36 million. This market capitalization is significantly higher than Global’s book value of equity of $22.2 million. Q Evaluate Global must have sources of value that do not appear on the balance sheet. These include potential opportunities for growth, the quality of the management team, relationships with suppliers and customers, etc.

Finally, we note that the book value of equity can be negative (liabilities exceed assets), and that a negative book value of equity is not necessarily an indication of poor performance. Successful firms are often able to borrow in excess of the book value of their assets because creditors recognize that the market value of the assets is far higher. For example, in June 2005 Amazon.com had total liabilities of $2.6 billion and a book value of equity of -$64 million. At the same time, the market value of its equity was over $15 billion. Clearly,

30

Part 1 Introduction investors recognized that Amazon’s assets were worth far more than the book value reported on the balance sheet. By 2010, several years of strong growth had brought its book equity to over $5 billion and its market value of equity to more than $50 billion!

Concept Check

2.3 liquidation value The value of a firm after its assets are sold and liabilities paid.

3. What is depreciation designed to capture? 4. The book value of a company’s assets usually does not equal the market value of those assets. What are some reasons for this difference?

Balance Sheet Analysis What can we learn from analyzing a firm’s balance sheet? Although the book value of a firm’s equity is not a good estimate of its true value as an ongoing firm, it is sometimes used as an estimate of the liquidation value of the firm, the value that would be left after its assets were sold and liabilities paid. We can also learn a great deal of useful information from a firm’s balance sheet that goes beyond the book value of the firm’s equity. We now discuss analyzing the balance sheet to assess the firm’s value, its leverage, and its short-term cash needs.

Market-to-Book Ratio market-to-book ratio (price-to-book [P/B] ratio) The ratio of a firm’s market (equity) capitalization to the book value of its stockholders’ equity.

value stocks Firms with low market-to-book ratios. growth stocks Firms with high market-to-book ratios. leverage A measure of the extent to which a firm relies on debt as a source of financing. debt-equity ratio The ratio of a firm’s total amount of short- and long-term debt (including current maturities) to the value of its equity, which may be calculated based on market or book values.

In Example 2.1, we compared the market and book values of Global’s equity. A common way to make this comparison is to compute the market-to-book ratio (also called the price-to-book [P/B] ratio), which is the ratio of a firm’s market capitalization to the book value of stockholders’ equity. [email protected]@Book Ratio =

Market Value of Equity Book Value of Equity

(2.3)

It is one of many financial ratios used to evaluate a firm. The market-to-book ratio for most successful firms substantially exceeds 1, indicating that the value of the firm’s assets when put to use exceeds their historical cost (or liquidation value). The ratio will vary across firms due to differences in fundamental firm characteristics as well as the value added by management. Thus, this ratio is one way a company’s stock price provides feedback to its managers on the market’s assessment of their decisions. In early 2010, AmeriServ Financial, Inc. (ASRV) had a market-to-book ratio of 0.52, a reflection of investors’ assessment that many of AmeriServ’s assets were unlikely to be profitable and were worth less than their book value. Citigroup’s market-to-book ratio of 0.82 tells a similar story. Figure 2.1 shows that at the same time, the average market-tobook ratio for the financial services industry was about 1, and for large U.S. firms it was close to 3. In contrast, consider that Amazon.com, Inc. (AMZN) had a market-to-book ratio of over 11, and the average for technology firms was about 6. Analysts often classify firms with low market-to-book ratios as value stocks, and those with high market-to-book ratios as growth stocks.

Debt-Equity Ratio Another important piece of information that we can learn from a firm’s balance sheet is the firm’s leverage, or the extent to which it relies on debt as a source of financing. The debt-equity ratio is a common ratio used to assess a firm’s leverage that we calculate by dividing the total amount of short- and long-term debt (including current maturities) by the total stockholders’ equity: [email protected] Ratio =

Total Debt Total Equity

(2.4)

Chapter 2 Introduction to Financial Statement Analysis

FIGURE 2.1

31

This figure presents market-to-book ratios of different firms and groups of firms in 2010. Firms that might be classified as value stocks (low market-to-book ratios) are in red and those that might be classified as growth stocks (high market-to-book ratios) are in blue.

Market-to-Book Ratios in 2010

Market-to-Book Ratio

12 10 8 6 4 2 0

AmeriServ

Citigroup

Financial Services

Large U.S. Firms

Tech Stocks

Amazon

Firm or Industry

We can calculate this ratio using either book or market values for equity and debt. From Table 2.1, Global’s debt in 2010 includes notes payable ($5.5 million) and long-term debt ($113.2 million), for a total of $118.7 million. Therefore, using the book value of equity, its book debt-equity ratio is 118.7/22.2 = 5.3. Note the large increase from 2009, when the book debt-equity ratio was only 1 3.2 + 78 2 /21.2 = 3.8. Because of the difficulty interpreting the book value of equity, the book debt-equity ratio is not especially useful. It is more informative to compare the firm’s debt to the market value of its equity. Global’s debt-equity ratio in 2010, using the market value of equity (from Example 2.1), is 118.7/36 = 3.3, which means Global’s debt is a bit more than triple the market value of its equity.3 As we will see later in the text, a firm’s market debt-equity ratio has important consequences for the risk and return of its stock.

Enterprise Value enterprise value The total market value of a firm’s equity and debt, less the value of its cash and marketable securities. It measures the value of the firm’s underlying business.

A firm’s market capitalization measures the market value of the firm’s equity, or the value that remains after the firm has paid its debts. So it includes any cash the firm holds. But what if you are interested in just the value of the business itself? The enterprise value of a firm assesses the value of the underlying business assets, unencumbered by debt and separate from any cash and marketable securities. We compute it as follows: Enterprise Value = Market Value of Equity + Debt - Cash

(2.5)

For example, given its market capitalization from Example 2.1, Global’s enterprise value in 2010 is 36 + 118.7 - 23.2 = +131.5 million. We can interpret the enterprise value as the cost to take over the business. That is, it would cost 36 + 118.7 = +154.7 million to buy all of Global’s equity and pay off its debts. Because we would acquire Global’s $23.2 million in cash (which can be used to pay off Global’s debt), the net cost is only 154.7 - 23.2 = +131.5 million. 3

In this calculation, we have compared the market value of equity to the book value of debt. Strictly speaking, it would be best to use the market value of debt. But because the market value of debt is generally not very different from its book value, this distinction is often ignored in practice.

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Part 1 Introduction

EXAMPLE 2.2 Computing Enterprise Value

Problem In April 2010, H. J. Heinz Co. (HNZ) had a share price of $46.15, 316.2 million shares outstanding, a market-to-book ratio of 7.99, a book debt-equity ratio of 2.64, and cash of $562.3 million. What was Heinz’s market capitalization (its market value of equity)? What was its enterprise value?

Solution Q Plan Share Price Shares Outstanding Market-to-Book Cash Debt-to-Equity (Book)

$46.15 316.2 million 7.99 $562.3 million 2.64

We will solve the problem using Eq. 2.5: Enterprise Value = Market Value of Equity + Debt - Cash. We can compute the market capitalization by multiplying the share price by the shares outstanding. We are given the amount of cash. We are not given the debt directly, but we are given the book debt-to-equity ratio. If we knew the book value of equity, we could use the ratio to infer the value of the debt. Since we can compute the market value of equity (market capitalization) and we have the market-to-book ratio, we can compute the book value of equity, so that is the last piece of information we will need. Q Execute Heinz had a market capitalization of +46.15/share * 316.2 million shares = +14.59 billion. Since Heinz’s [email protected]@book = 7.99 = +14.59 billion/book equity, then book equity = +14.59 billion/7.99 = +1.83 billion. Given that the book equity is $1.83 billion and a book debt-to-equity ratio of 2.64, the total value of Heinz’s debt is +1.83 billion * 2.64 = +4.83 billion. Q Evaluate Thus, Heinz’s enterprise value was 14.59 + 4.83 - 0.5623 = +18.858 billion.

Other Balance Sheet Information current ratio The ratio of current assets to current liabilities. quick ratio The ratio of current assets other than inventory to current liabilities.

Creditors often compare a firm’s current assets and current liabilities to assess whether the firm has sufficient working capital to meet its short-term needs. This comparison is sometimes summarized in the firm’s current ratio, the ratio of current assets to current liabilities, or its quick ratio (“acid-test” ratio), the ratio of current assets other than inventory to current liabilities. A higher current or quick ratio implies less risk of the firm experiencing a cash shortfall in the near future. Current Ratio = Quick Ratio =

Current Assets Current Liabilities

Current Assets - Inventory Current Liabilities

(2.6) (2.7)

Analysts also use the information on the balance sheet to watch for trends that could provide information regarding the firm’s future performance. For example, an unusual increase in inventory could be an indicator that the firm is having difficulty selling its products. Table 2.2 summarizes balance sheet ratios and provides typical values of those ratios during an economic expansion as well as what happened to those ratios during the recent financial crisis and subsequent recession. Many of the recession effects noted here and in future tables are generally short-term in nature because once it is clear that the economy is in a recession, firms take actions to mitigate these effects. The table gives average values for the manufacturing, retail, and service sectors along with the 500 firms in the S&P

Chapter 2 Introduction to Financial Statement Analysis

TABLE 2.2 Balance Sheet Ratios

Ratio

Formula

Manufacturing Retail

Service S&P 500

33

Financial Crisis and Recession

Market Value of Equity Book Value of Equity

2.53

2.40

2.73

2.31

T

Total Debt Book Value of Total Equity

18.9%

31.7%

8.7%

32.4%

c

Market DebtTotal Debt to-Equity Ratio Market Value of Total Equity

7.1%

14.8%

2.5%

13.2%

cc

Current Ratio

Current Assets Current Liabilities

2.31

1.51

1.52

1.47

—

Current Assets - Inventory Current Liabilities

1.59

0.73

1.43

1.14

—

Market-toBook Ratio Book Debt-toEquity Ratio

Quick Ratio

Notes: A “—” in the recession column indicates that any changes in the ratio during the recession were too small to be economically significant or were not broadly felt across sectors. Two arrows indicate a larger move than a single arrow. Source: Standard and Poors’ Compustat.

500 index. The market-to-book ratio is an indicator of potential growth and of managers’ ability to generate value from the firm’s assets above their historical cost. The other ratios measure the financial health of the firm by assessing its leverage (debt-to-equity and equity multiplier) or liquidity (current and quick ratios).

Concept Check

2.4 income statement A list of a firm’s revenues and expenses over a period of time. net income or earnings The last or “bottom” line of a firm’s income statement that is a measure of the firm’s income over a given period of time.

gross profit The third line of an income statement that represents the difference between a firm’s sales revenues and its costs.

5. What does a high debt-to-equity ratio tell you? 6. What is a firm’s enterprise value?

The Income Statement When you want someone to get to the point, you might ask them for the “bottom line.” This expression comes from the income statement. The income statement lists the firm’s revenues and expenses over a period of time. The last or “bottom” line of the income statement shows the firm’s net income, which is a measure of its profitability during the period. The income statement is sometimes called a profit and loss or P&L statement, and the net income is also referred to as the firm’s earnings. In this section, we examine the components of the income statement in detail and introduce ratios we can use to analyze this data.

Earnings Calculations Whereas the balance sheet shows the firm’s assets and liabilities at a given point in time, the income statement shows the flow of revenues and expenses generated by those assets and liabilities between two dates. Table 2.3 shows Global’s income statement for 2010 and 2009. We examine each category on the statement. Gross Profit. The first two lines of the income statement list the revenues from sales of products and the costs incurred to make and sell the products. Note that in accounting, the terms revenues and net sales are equivalent. Net sales is simply gross sales minus any returns, discounts, and allowances. We will simply use the term sales from here forward. The third line is gross profit, the difference between sales revenues and the costs.

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Part 1 Introduction

TABLE 2.3

GLOBAL CORPORATION Income Statement Year ended December 31 (in $ millions)

Global Corporation’s Income Statement Sheet for 2010 and 2009

2010

2009

186.7

176.1

Cost of sales

-153.4

-147.3

Gross Profit

33.3

28.8

Net sales

-13.5

-13

Research and development

-8.2

-7.6

Depreciation and amortization

-1.2

-1.1

Operating Income

10.4

7.1

Selling, general, and administrative expenses

Other income

—

—

Earnings Before Interest and Taxes (EBIT)

10.4

7.1

Interest income (expense)

-7.7

-4.6

2.7

2.5

-0.7

-0.6

2.0

1.9

Earnings per share:

$0.56

$0.53

Diluted earnings per share:

$0.53

$0.50

Pretax Income Taxes Net Income

operating income A firm’s gross profit less its operating expenses.

EBIT A firm’s earnings before interest and taxes are deducted.

earnings per share (EPS) A firm’s net income divided by the total number of shares outstanding.

Operating Expenses. The next group of items is operating expenses. These are expenses from the ordinary course of running the business that are not directly related to producing the goods or services being sold. They include administrative expenses and overhead, salaries, marketing costs, and research and development expenses. The third type of operating expense, depreciation and amortization (a charge that captures the change in value of acquired assets), represents an estimate of the costs that arise from wear and tear or obsolescence of the firm’s assets.4 It is not an actual cash expense. The firm’s gross profit net of operating expenses is called operating income. Earnings Before Interest and Taxes. We next include other sources of income or expenses that arise from activities that are not the central part of a company’s business. Cash flows from the firm’s financial investments are one example of other income that would be listed here. After we have adjusted for other sources of income or expenses, we have the firm’s earnings before interest and taxes, or EBIT. Pretax and Net Income. From EBIT, we deduct the interest paid on outstanding debt to compute Global’s pretax income, and then we deduct corporate taxes to determine the firm’s net income. Net income represents the total earnings of the firm’s equity holders. It is often reported on a per-share basis as the firm’s earnings per share (EPS), which we compute by dividing net income by the total number of shares outstanding: EPS = 4

Net Income +2.0 million = = +0.56 per share Shares Outstanding 3.6 million shares

(2.8)

Only certain types of amortization are deductible as a pretax expense (e.g., amortization of the cost of an acquired patent). Amortization of goodwill is not a pretax expense and is generally included as an extraordinary item after taxes are deducted.

Chapter 2 Introduction to Financial Statement Analysis stock options The right to buy a certain number of shares of stock by a specific date at a specific price. convertible bonds Corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock. dilution An increase in the total number of shares that will divide a fixed amount of earnings.

Concept Check

2.5 diluted EPS The earnings per share a company would have based on the total number of shares including the effects of all stock options and convertible bonds. gross margin The ratio of gross profit to revenues (sales), it reflects the ability of the company to sell a product for more than the sum of the direct costs of making it.

operating margin The ratio of operating income to revenues, it reveals how much a company has earned from each dollar of sales before deducting interest and taxes.

35

Although Global has only 3.6 million shares outstanding as of the end of 2010 (from Example 2.1), the number of shares outstanding may grow if Global has made commitments that would cause it to issue more shares. Consider these two examples: 1. Suppose Global compensates its employees or executives with stock options that give the holder the right to buy a certain number of shares by a specific date at a specific price. If employees “exercise” these options, the company issues new stock and the number of shares outstanding will grow. 2. The number of shares may also grow if the firm issues convertible bonds, a form of debt that can be converted into shares of common stock. In the cases of stock options and convertible bonds, because there will be more total shares to divide the same earnings, this growth in the number of shares is referred to as dilution. Firms disclose the potential for dilution from options they have awarded by reporting diluted EPS, which shows the earnings per share the company would have if the stock options were exercised. For example, if Global has awarded options for 200,000 shares of stock to its key executives, its diluted EPS is +2.0 million/3.8 million shares = +0.53. 7. What do a firm’s earnings measure? 8. What is dilution?

Income Statement Analysis The income statement provides very useful information regarding the profitability of a firm’s business and how it relates to the value of the firm’s shares. We now discuss several ratios that are often used to evaluate a firm’s performance and value.

Profitability Ratios We introduce three profitability ratios: gross margin, operating margin, and net profit margin. Gross Margin. The gross margin of a firm is the ratio of gross profit to revenues (sales): Gross Margin =

Gross Profit Sales

(2.9)

The gross margin simply reflects the ability of the company to sell a product for more than the sum of the direct costs of making it. All of the firm’s other expenses of doing business (those not directly related to producing the goods sold) must be covered by this margin. In 2010 Global’s gross profit was $33.3 million and its sales were $186.7 million, for a gross margin of 33.3/186.7 = 17.84%. Operating Margin. Because operating income reflects all of the expenses of doing business, another important profitability ratio is the operating margin, the ratio of operating income to revenues: Operating Margin =

Operating Income Sales

(2.10)

The operating margin reveals how much a company earns before interest and taxes from each dollar of sales. Global’s operating margin in 2010 was 10.4/186.7 = 5.57%, an increase from its 2009 operating margin of 7.1/176.1 = 4.03%. By comparing operating margins across firms within an industry, we can assess the relative efficiency of firms’

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Part 1 Introduction operations. For example, in 2010 American Airlines (AMR) had an operating margin of -5.04% (i.e., they lost 5 cents for each dollar in revenues). However, competitor Southwest Airlines (LUV) had an operating margin of 2.53%. Differences in operating margins can also result from differences in strategy. For example, in 2010, Wal-Mart Stores had an operating margin of 5.87% while high-end retailer Nordstrom had an operating margin of 9.67%. In this case, Wal-Mart’s lower operating margin is not a result of its inefficiency but is part of its strategy of offering lower prices to sell common products in high volume. Indeed, Wal-Mart’s sales were more than 45 times higher than those of Nordstrom.

net profit margin The ratio of net income to revenues, it shows the fraction of each dollar in revenues that is available to equity holders after the firm pays its expenses, plus interest and taxes.

Net Profit Margin. A firm’s net profit margin is the ratio of net income to revenues: Net Profit Margin =

Net Income Sales

(2.11)

The net profit margin shows the fraction of each dollar in revenues that is available to equity holders after the firm pays its expenses, plus interest and taxes. Global’s net profit margin in 2010 was 2.0/186.7 = 1.07%. Differences in net profit margins can be due to differences in efficiency, but they can also result from differences in leverage (the firm’s reliance on debt financing), which determines the amount of interest payments.

Asset Efficiency A financial manager can use the combined information in the firm’s income statement and balance sheet to gauge how efficiently his or her firm is utilizing its assets. A first broad measure of efficiency is asset turnover, the ratio of sales to total assets: Asset Turnover =

Sales Total Assets

(2.12)

Low values of asset turnover indicate that the firm is not generating much revenue (sales) per dollar of assets. In 2010 Global’s $170.1 million in assets generated $186.7 million in sales, for an asset turnover ratio of 1.1 ( = $186.7/$170.1). Since total assets includes assets, such as cash, that are not directly involved in generating sales, Global’s manager might also look at Global’s fixed asset turnover, which is equal to sales divided by fixed assets: Fixed Asset Turnover =

Sales Fixed Assets

(2.13)

Global’s fixed assets in 2010 were $113.1 million worth of property, plant, and equipment, yielding a fixed asset turnover of 1.7 1 = +186.7/+113.1 2 . Low asset turnover ratios indicate that the firm is generating relatively few sales given the amount of assets it employs.

Working Capital Ratios accounts receivable days (average collection period or days sales outstanding) An expression of a firm’s accounts receivable in terms of the number of days’ worth of sales that the accounts receivable represents.

Global’s managers might be further interested in how efficiently they are managing their net working capital. We can express the firm’s accounts receivable in terms of the number of days’ worth of sales that it represents, called the accounts receivable days, average collection period, or days sales outstanding:5 Accounts Receivable Days =

5

Accounts Receivable Average Daily Sales

(2.14)

Accounts receivable days can also be calculated based on the average accounts receivable at the end of the current and prior years.

Chapter 2 Introduction to Financial Statement Analysis accounts payable days An expression of a firm’s accounts payable in terms of the number of days’ worth of cost of goods sold that the accounts payable represents. inventory days An expression of a firm’s inventory in terms of the number of days’ worth or cost of goods sold that the inventory represents. inventory turnover ratio The cost of goods sold divided by either the latest cost of inventory or the average inventory over the year, it shows how efficiently companies turn their inventory into sales.

37

Given average daily sales of +186.7 million/365 = +0.51 million in 2010, Global’s receivables of $18.5 million represent 18.5/0.51 = 36 days¿ worth of sales. In other words, Global takes a little over one month to collect payment from its customers, on average. In 2009, Global’s accounts receivable represented only 27.5 days worth of sales. Although the number of receivable days can fluctuate seasonally, a significant unexplained increase could be a cause for concern (perhaps indicating the firm is doing a poor job collecting from its customers or is trying to boost sales by offering generous credit terms). Similar ratios exist for accounts payable and inventory. Those ratios are called accounts payable days (accounts payable divided by average daily cost of goods sold) and inventory days (inventory divided by average daily cost of goods sold). We can also compute how efficiently firms use inventory. The inventory turnover ratio is equal to the cost of goods sold divided by either the latest cost of inventory or the average inventory over the year. We use the cost of goods sold because that is how inventory costs are reflected on the income statement. It is also common to use sales in the numerator to make the ratio more like the asset turnover ratios. Inventory Turnover =

Cost of Goods Sold Inventory

(2.15)

A normal level for this ratio, similar to the others in this section, can vary substantially for different industries, although a higher level (more dollars of sales per dollar of inventory) is generally better.

EBITDA EBITDA A computation of a firm’s earnings before interest, taxes, depreciation, and amortization are deducted. interest coverage ratio or times interest earned (TIE) ratio An assessment by lenders of a firm’s leverage, it is equal to a measure of earnings divided by interest.

Financial analysts often compute a firm’s earnings before interest, taxes, depreciation, and amortization, or EBITDA. Because depreciation and amortization are not cash expenses for the firm, EBITDA reflects the cash a firm has earned from its operations. Global’s EBITDA in 2010 was 10.4 + 1.2 = +11.6 million.

Leverage Ratios Lenders often assess a firm’s leverage by computing an interest coverage ratio, also known as a times interest earned (TIE) ratio, which is equal to a measure of earnings divided by interest. Financial managers watch these ratios carefully because they assess how easily the firm will be able to cover its interest payments. There is no one accepted measure of earnings for these ratios; it is common to consider operating income, EBIT, or EBITDA as a multiple of the firm’s interest expenses. When this ratio is high, it indicates that the firm is earning much more than is necessary to meet its required interest payments.

Investment Returns return on equity (ROE) The ratio of a firm’s net income to the book value of its equity.

Analysts and financial managers often evaluate the firm’s return on investment by comparing its income to its investment using ratios such as the firm’s return on equity (ROE):6 Return on Equity =

Net Income Book Value of Equity

(2.16)

Global’s ROE in 2010 was 2.0/22.2 = 9.0%. The ROE provides a measure of the return that the firm has earned on its past investments. A high ROE may indicate the firm 6

Because net income is measured over the year, the ROE can also be calculated based on the average book value of equity at the end of the current and prior years.

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Part 1 Introduction

return on assets (ROA) The ratio of net income to the total book value of the firm’s assets.

DuPont Identity Expresses return on equity as the product of profit margin, asset turnover, and a measure of leverage.

is able to find investment opportunities that are very profitable. Of course, one weakness of this measure is the difficulty in interpreting the book value of equity. Another common measure is the return on assets (ROA), which is net income divided by the total assets. A firm must earn both a positive ROE and ROA to grow.

The DuPont Identity Global’s financial manager will need to know that its ROE is 9%, but that financial manager would also need to understand the drivers of his or her firm’s return on equity. High margins, efficient use of assets, or even simply high leverage could all lead to a higher return on equity. By delving deeper into the sources of return on equity, the financial manager can gain a clear sense of the firm’s financial picture. One common tool for doing so is the DuPont Identity, named for the company that popularized it, which expresses return on equity as the product of profit margin, asset turnover, and a measure of leverage. To understand the DuPont Identity, we start with ROE and decompose it in steps into the drivers identified in the identity. First, we simply multiply ROE by (sales/sales), which is just 1, and rearrange terms: ROE = a

Net Income Sales Net Income Sales ba b = a ba b Total Equity Sales Sales Total Equity

(2.17)

This expression says that ROE can be thought of as net income per dollar of sales (profit margin) times the amount of sales per dollar of equity. For example, Global’s ROE comes from its profit margin of 1.07% multiplied by its sales per dollar of equity 1 186.7/22.2 = 8.41 2 : 1.07% * 8.41 = 9%. We can take the decomposition further by multiplying Eq. 2.17 by (total assets / total assets), which again is just 1, and rearranging the terms: DuPont Identity Net Income Sales Total Assets ROE = a ba ba b Sales Total Equity Total Assets Net Income Sales Total Assets (2.18) = a ba ba b Sales Total Assets Total Equity

equity multiplier A measure of leverage equal to total assets divided by total equity.

This final expression says that ROE is equal to net income per dollar of sales (profit margin) times sales per dollar of assets (asset turnover) times assets per dollar of equity (a measure of leverage called the equity multiplier). Equation 2.18 is the DuPont Identity, expressing return on equity as the product of profit margin, asset turnover, and the equity multiplier. Turning to Global, its equity multiplier is 7.7 1 =170.1/22.2 2 . A financial manager at Global looking for ways to increase ROE could assess the drivers behind its current ROE with the DuPont Identity. With a profit margin of 1.07%, asset turnover of 1.1, and an equity multiplier of 7.7, we have: ROE = 9% = 1 1.07% 2 1 1.1 2 1 7.7 2

This decomposition of ROE shows that leverage is already high (confirmed by the fact that the book debt-to-equity ratio shows that Global’s debt is more than five times its equity). However, Global is operating with only 1% profit margins and relatively low asset turnover. Thus, Global’s managers should focus on utilizing the firm’s existing assets more efficiently and lowering costs to increase the profit margin.7

7

Although the DuPont Identity makes it look like you can increase ROE just by increasing leverage, it is not quite that simple. An increase in leverage will increase your interest expense, decreasing your profit margin.

Chapter 2 Introduction to Financial Statement Analysis

EXAMPLE 2.3 DuPont Analysis

39

Problem The following table contains information about Wal-Mart (WMT) and Nordstrom (JWN). Compute their respective ROEs and then determine how much Wal-Mart would need to increase its profit margin in order to match Nordstrom’s ROE. Profit Margin

Asset Turnover

Equity Multiplier

3.6% 7.7%

2.4 1.7

2.6 2.4

Wal-Mart Nordstrom

Solution Q Plan and Organize The table contains all the relevant information to use the DuPont Identity to compute the ROE. We can compute the ROE of each company by multiplying together its profit margin, asset turnover, and equity multiplier. In order to determine how much Wal-Mart would need to increase its profit margin to match Nordstrom’s ROE, we can set Wal-Mart’s ROE equal to Nordstrom’s, keep its turnover and equity multiplier fixed, and solve for the profit margin. Q Execute Using the DuPont Identity, we have: ROEWMT = 3.6% * 2.4 * 2.6 = 22.5% ROEJWN = 7.7% * 1.7 * 2.4 = 31.4% Now, using Nordstrom’s ROE, but Wal-Mart’s asset turnover and equity multiplier, we can solve for the profit margin that Wal-Mart needs to achieve Nordstrom’s ROE: 31.4% = Margin * 2.4 * 2.6 Margin = 31.4%/6.24 = 5.0% Q Evaluate Wal-Mart would have to increase its profit margin from 3.6% to 5% in order to match Nordstrom’s ROE. It would be able to achieve Nordstrom’s ROE even with a lower profit margin than Nordstrom (5.0% vs. 7.7%) because of its higher turnover and slightly higher leverage.

Valuation Ratios price-earnings ratio (P/E) The ratio of the market value of equity to the firm’s earnings, or its share price to its earnings per share.

PEG ratio The ratio of a firm’s P/E to its expected earnings growth rate.

Analysts and investors use a number of ratios to gauge the market value of the firm. The most important is the firm’s price-earnings ratio (P/E): P/E Ratio =

Market Capitalization Share Price = Net Income Earnings per Share

(2.19)

That is, the P/E ratio is the ratio of the value of equity to the firm’s earnings, either on a total basis or on a per-share basis. Following Eq. 2.19, Global’s P/E ratio in 2010 was 36/2.0 = 10/0.56 = 18. The P/E ratio is a simple measure that is used to assess whether a stock is over- or under-valued, based on the idea that the value of a stock should be proportional to the level of earnings it can generate for its shareholders. P/E ratios can vary widely across industries and tend to be higher for industries with high growth rates. For example, in 2010 the average large U.S. firm had a P/E ratio of about 18. But airlines, which had very low current earnings due to the recession, but the promise of higher future earnings as the economy recovered, had an average P/E ratio of 31. One way to capture the idea that a higher P/E ratio can be justified by a higher growth rate is to compare it to the company’s expected earnings growth rate. For example, if Global’s expected growth rate is 18%, then it would have a P/E to Growth, or PEG ratio, of 1. Some investors consider PEG ratios of 1 or below as indicating the stock is fairly priced, but would question whether the company is potentially overvalued if the PEG is higher than 1.

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Part 1 Introduction The P/E ratio considers the value of the firm’s equity and so depends on its leverage. Recall that the amount of assets controlled by the equity holders can be increased through the use of leverage. To assess the market value of the underlying business, it is common to consider valuation ratios based on the firm’s enterprise value. Typical ratios include the ratio of enterprise value to revenue, or enterprise value to operating income or EBITDA. These ratios compare the value of the business to its sales, operating profits, or cash flow. Similar to the P/E ratio, managers use these ratios to make intra-industry comparisons of how firms are priced in the market.

COMMON MISTAKE

Mismatched Ratios

When considering valuation (and other) ratios, be sure that the items you are comparing both represent amounts related to the entire firm or that both represent amounts related solely to equity holders. For example, a firm’s share price and market capitalization are values associated with the firm’s equity. Thus, it makes sense to compare them to the firm’s earnings per share or net income, which are amounts to

equity holders after interest has been paid to debt holders. We must be careful, however, if we compare a firm’s market capitalization to its revenues, operating income, or EBITDA. These amounts are related to the whole firm, and both debt and equity holders have a claim to them. Therefore, it is better to compare revenues, operating income, or EBITDA to the enterprise value of the firm, which includes both debt and equity.

The P/E ratio is not useful when the firm’s earnings are negative. In this case, it is common to look at the firm’s enterprise value relative to sales. The risk in doing so, however, is that earnings might be negative because the firm’s underlying business model is fundamentally flawed, as was the case for many Internet firms in the late 1990s.

EXAMPLE 2.4 Computing Profitability and Valuation Ratios

Problem Consider the following data from 2010 for Wal-Mart Stores and Target Corporation ($ billions):

Sales Operating Income Net Income Market Capitalization Cash Debt

Wal-Mart Stores (WMT)

Target Corporation (TGT)

408 24 14 203 8 41

65 5 2 41 2 17

Compare Wal-Mart and Target’s operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales.

Solution Q Plan The table contains all of the raw data, but we need to compute the ratios using the inputs in the table. Operating Margin = Operating Income/Sales Net Profit Margin = Net Income/Sales P/E ratio = Price/Earnings = Market Capitalization/Net Income Enterprise value to operating income = Enterprise Value/Operating Income Enterprise value to sales = Enterprise Value/Sales Q Execute Wal-Mart had an operating margin of 24/408 = 5.9%, a net profit margin of 14/408 = 3.4%, and a P/E ratio of 203/14 = 14.5. Its enterprise value was 203 + 41 - 8 = +236 billion. Its ratio to operating income is 236/24 = 9.8, and its ratio to sales is 236/408 = 0.58.

Chapter 2 Introduction to Financial Statement Analysis

41

Target had an operating margin of 5/65 = 7.7%, a net profit margin of 2/65 = 3.1%, and a P/E ratio of 41/2 = 20.5. Its enterprise value was 41 + 17 - 2 = +56 billion. Its ratio to operating income is 56/5 = 11.2, and its ratio to sales is 56/65 = 0.86. Q Evaluate Despite a slightly lower overall profit margin, Target has higher P/E and enterprise value ratios, suggesting that the market expects greater growth from Target than from Wal-Mart.

Table 2.4 summarizes income statement ratios and provides typical values of those ratios during an economic expansion as well as what happened to them during the Financial Crisis and ensuing recession.

TABLE 2.4 Income Statement Ratios

Ratio Profitability Ratios Gross margin Operating margin Net Profit margin Leverage Ratio Interest coverage ratio (TIE)

Formula Gross Profit Sales Operating Income Sales Net Income Sales

34.3%

30.8%

50.4%

38.4%

—

8.4%

7.4%

8.7%

19.7%

T

2.0%

2.3%

2.1%

8.7%

TT

Operating Income Interest Expense

4.78

7.16

3.58

12.13

T

7.9%

10.6%

7.9%

15.8%

T

Net Income Total Assets

1.6%

4.3%

1.1%

5.4%

TT

Share Price Earnings per Share

10.0

15.2

9.3

18.0

T*

56.8

6.7

62.5

57.5

—

Investment Return Ratios Net Income Return on equity Book Value of Equity Return on assets Valuation Ratio Price-to-earnings ratio

Manufacturing Retail

Financial Crisis and Service S&P 500 Recession

Efficiency and Working Capital Ratios Accounts Receivable Accounts receivable days Average Daily Sales Fixed asset turnover

Sales Fixed Assets

5.6

6.3

11.8

5.2

—

Total asset turnover

Sales Total Assets

0.9

1.8

0.8

0.7

—

Inventory turnover

Cost of Goods Sold Inventory

4.2

6.5

21.5

6.2

—

Notes: A “—” in the recession column indicates that any changes in the ratio during the recession were too small to be economically significant or were not broadly felt across sectors. Two arrows indicate a larger move than a single arrow. *

Because many firms had losses (negative earnings) during the recession, the P/E ratio was not meaningful and was not calculated. For those that maintained positive earnings, the ratio fell.

Source : Standard and Poors’ Compustat.

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Part 1 Introduction

Concept Check

2.6

statement of cash flows An accounting statement that shows how a firm has used the cash it earned during a set period.

9. How can a financial manager use the DuPont Identity to assess the firm’s ROE? 10. How do you use the price-earnings (P/E) ratio to gauge the market value of a firm?

The Statement of Cash Flows The income statement provides a measure of the firm’s profit over a given time period. However, it does not indicate the amount of cash the firm has earned. There are two reasons that net income does not correspond to cash earned. First, there are non-cash entries on the income statement, such as depreciation and amortization. Second, certain uses, such as the purchase of a building or expenditures on inventory, and sources of cash, such as the collection of accounts receivable, are not reported on the income statement. The firm’s statement of cash flows utilizes the information from the income statement and balance sheet to determine how much cash the firm has generated, and how that cash has been allocated, during a set period. Cash is important: It is needed to pay bills and maintain operations and is the source of any return of investment for investors. Thus, from the perspective of an investor attempting to value the firm or a financial manager concerned about cash flows (vs. earnings), the statement of cash flows provides what may be the most important information of the four financial statements. The statement of cash flows is divided into three sections: operating activities, investment activities, and financing activities. These sections roughly correspond to the three major jobs of the financial manager. 1. Operating activities starts with net income from the income statement. It then adjusts this number by adding back all non-cash entries related to the firm’s operating activities. 2. Investment activities lists the cash used for investment. 3. Financing activities shows the flow of cash between the firm and its investors. Global’s statement of cash flows is shown in Table 2.5. In this section, we take a close look at each component of the statement of cash flows.

Operating Activity The first section of Global’s statement of cash flows adjusts net income by all non-cash items related to operating activity. For instance, depreciation is deducted when computing net income, but it is not an actual cash expense. Thus, we add it back to net income when determining the amount of cash the firm has generated. Similarly, we add back any other non-cash expenses (for example, deferred taxes). Next, we adjust for changes to net working capital that arise from changes to accounts receivable, accounts payable, or inventory. When a firm sells a product, it records the revenue as income even though it may not receive the cash from that sale immediately. Instead, it may grant the customer credit and let the customer pay in the future. The customer’s obligation adds to the firm’s accounts receivable. We use the following guidelines to adjust for changes in working capital: 1. Accounts receivable: When a sale is recorded as part of net income, but the cash has not yet been received from the customer, we must adjust the cash flows by deducting the increases in accounts receivable. This increase represents additional lending by the firm to its customers and it reduces the cash available to the firm. 2. Accounts payable: We add increases in accounts payable. Accounts payable represents borrowing by the firm from its suppliers. This borrowing increases the cash available to the firm.

Chapter 2 Introduction to Financial Statement Analysis

TABLE 2.5 Global Corporation’s Statement of Cash Flows for 2010 and 2009

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GLOBAL CORPORATION Statement of Cash Flows Year ended December 31 (in $ millions) Operating activities Net income Depreciation and amortization Cash effect of changes in Accounts receivable Accounts payable Inventory Cash from operating activities Investment activities Capital expenditures Acquisitions and other investing activity Cash from investing activities Financing activities Dividends paid Sale or purchase of stock Increase in short-term borrowing Increase in long-term borrowing Cash from financing activities Change in cash and cash equivalents

2010

2009

2.0 1.2

1.9 1.1

-5.3 2.7

-0.3 -0.5

-1.0 -0.4

-1.0 1.2

-33.4

-4.0

-33.4

-4.0

-1.0 — 2.3 35.2 36.5

-1.0 — 3.0 2.5 4.5

2.7

1.7

3. Inventory: Finally, we deduct increases in inventory. Increases in inventory are not recorded as an expense and do not contribute to net income (the cost of the goods are only included in net income when the goods are actually sold). However, the cost of increasing inventory is a cash expense for the firm and must be deducted. Working capital adjustments address the difference between the time when sales and costs are recorded on the income statement and when the cash actually goes in and out of the firm. For example, Table 2.5 shows that in 2010 we subtracted the $5.3 million increase in accounts receivable from net income as part of the operating cash flow calculation. What happened? From Table 2.3, we see that Global had $10.6 million more in sales in 2010 than in 2009. However, from Table 2.1, we also see that Global’s accounts receivable increased from $13.2 million in 2009 to $18.5 million in 2010. So, even though Global’s sales were up considerably, it has not yet collected all the cash flow for those sales—instead, Global’s customers owe it $5.3 million more at the end of 2010 than they did at the end of 2009. Because the statement of cash flows starts with net income, which includes sales for which Global has not yet been paid, we deduct the additional $5.3 million in sales Global is still owed when computing the actual cash flows it generated. We must make a similar adjustment for inventory. Global does not record the cost of the inventory until it is sold, when it is included in the cost of goods sold. However, when it actually pays for the inventory, cash has flowed out of Global, decreasing operating cash flow. The opposite is true for accounts payable—Global has recorded additional expenses without actually paying for them yet. Those expenses reduce net income, but do not represent cash outflows.

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Part 1 Introduction Finally, we add depreciation to net income before calculating operating cash flow. Depreciation is an accounting adjustment to book value that is an expense, but not a cash outflow. That is, when Global’s property, plant, and equipment depreciate by $1.2 million, it does not literally cost Global $1.2 million in cash flow. Because this is an expense that reduces net income, but not an actual cash outflow, we must add it back to calculate cash flow. We will talk more about depreciation when we do capital budgeting in Chapter 9. All these adjustments mean that cash flows can be very different from net income. Although Global showed positive net income on the income statement, it actually had a negative $0.4 million cash flow from operating activity, in large part because of the increase in accounts receivable.

Investment Activity capital expenditures Purchases of new property, plant, and equipment.

The next section of the statement of cash flows shows the cash required for investment activities. Purchases of new property, plant, and equipment are capital expenditures. Recall that capital expenditures do not appear immediately as expenses on the income statement. Instead, the firm depreciates these assets and deducts depreciation expenses over time. To determine the firm’s cash flow, we already added back depreciation because it is not an actual cash expense. Now, we subtract the actual capital expenditure that the firm made. Similarly, we also deduct other assets purchased or investments made by the firm, such as acquisitions. In Table 2.5, we see that in 2010, Global spent $33.4 million in cash on investing activities.

Financing Activity

retained earnings The difference between a firm’s net income and the amount it spends on dividends. payout ratio The ratio of a firm’s dividends to its net income.

The last section of the statement of cash flows shows the cash flows from financing activities. Dividends paid to shareholders are a cash outflow. Global paid $1 million to its shareholders as dividends in 2010. The difference between a firm’s net income and the amount it spends on dividends is referred to as the firm’s retained earnings for that year: Retained Earnings = Net Income - Dividends

(2.20)

Global retained +2 million - +1 million = +1 million, or 50% of its earnings in 2010. This makes its payout ratio for 2010 equal to 50%. A firm’s payout ratio is the ratio of its dividends to its net income: Payout Ratio =

Dividends Net Income

(2.21)

Also listed under financing activity is any cash the company received from the sale of its own stock, or cash spent buying (repurchasing) its own stock. Global did not issue or repurchase stock during this period. The last items to include in this section result from changes to Global’s short-term and long-term borrowing. Global raised money by issuing debt, so the increases in shortterm and long-term borrowing represent cash inflows. The last line of the statement of cash flows combines the cash flows from these three activities to calculate the overall change in the firm’s cash balance over the period of the statement. In this case, Global had cash inflows of $2.7 million in 2010. By looking at the statement in Table 2.5 as a whole, we can determine that Global chose to borrow (mainly in the form of long-term debt) to cover the cost of its investment and operating activities. Although the firm’s cash balance has increased, Global’s negative operating cash flows and relatively high expenditures on investment activities might give investors some reasons for concern. If this pattern continues, Global will need to continue to borrow to remain in business.

Chapter 2 Introduction to Financial Statement Analysis

EXAMPLE 2.5 The Impact of Depreciation on Cash Flow

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Problem Suppose Global had an additional $1 million depreciation expense in 2010. If Global’s tax rate on pretax income is 26%, what would be the impact of this expense on Global’s earnings? How would it impact Global’s cash at the end of the year?

Solution Q Plan Depreciation is an operating expense, so Global’s operating income, EBIT, and pretax income would be affected. With a tax rate of 26%, Global’s tax bill will decrease by 26 cents for every dollar that pretax income is reduced. In order to determine how Global’s cash would be impacted, we have to determine the effect of the additional depreciation on cash flows. Recall that depreciation is not an actual cash outflow, even though it is treated as an expense, so the only effect on cash flow is through the reduction in taxes. Q Execute Global’s operating income, EBIT, and pretax income would fall by $1 million because of the $1 million in additional operating expense due to depreciation. This $1 million decrease in pretax income would reduce Global’s tax bill by 26% * +1 million = +0.26 million. Therefore, net income would fall by +1 - +0.26 = +0.74 million. On the statement of cash flows, net income would fall by $0.74 million, but we would add back the additional depreciation of $1 million because it is not a cash expense. Thus, cash from operating activities would rise by - +0.74 + 1 = +0.26 million. Therefore, Global’s cash balance at the end of the year would increase by $0.26 million, the amount of the tax savings that resulted from the additional depreciation deduction. Q Evaluate The increase in cash balance comes completely from the reduction in taxes. Because Global pays $0.26 million less in taxes even though its cash expenses have not increased, it has $0.26 million more in cash at the end of the year.

Concept Check

2.7 management discussion and analysis (MD&A) A preface to the financial statements in which a company’s management discusses the recent year (or quarter), providing a background on the company and any significant events that may have occurred. off-balance sheet transactions Transactions or arrangements that can have a material impact on a firm’s future performance yet do not appear on the balance sheet.

11. Why does a firm’s net income not correspond to cash earned? 12. What are the components of the statement of cash flows?

Other Financial Statement Information The most important elements of a firm’s financial statements are the balance sheet, income statement, and the statement of cash flows, which we have already discussed. Several other pieces of information contained in the financial statements warrant brief mention: the management discussion and analysis, the statement of stockholders’ equity, and notes to the financial statement.

Management Discussion and Analysis The management discussion and analysis (MD&A) is a preface to the financial statements in which the company’s management discusses the recent year (or quarter), providing a background on the company and any significant events that may have occurred. Management may also discuss the coming year, and outline goals and new projects. Management must also discuss any important risks that the firm faces or issues that may affect the firm’s liquidity or resources. Management is also required to disclose any off-balance sheet transactions, which are transactions or arrangements that can have a material impact on the firm’s future performance yet do not appear on the balance sheet. For example, if a firm has made guarantees that it will compensate a buyer for losses related to an asset purchased from the firm, these guarantees represent a potential future liability for the firm that must be disclosed as part of the MD&A.

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Part 1 Introduction

Statement of Stockholders’ Equity statement of stockholders’ equity An accounting statement that breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing new shares versus retained earnings.

Concept Check

2.8

The statement of stockholders’ equity breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing new shares versus retained earnings. Because the book value of stockholders’ equity is not a useful assessment of value for financial purposes, the information contained in the statement of stockholders’ equity is also not particularly insightful, so we do not spend time on the statement here.

Notes to the Financial Statements In addition to the four financial statements, companies provide extensive notes with additional details on the information provided in the statements. For example, the notes document important accounting assumptions that were used in preparing the statements. They often provide information specific to a firm’s subsidiaries or its separate product lines. They show the details of the firm’s stock-based compensation plans for employees and the different types of debt the firm has outstanding. Details of acquisitions, spin-offs, leases, taxes, and risk management activities are also given. The information provided in the notes is often very important to a full interpretation of the firm’s financial statements. 13. Where do off-balance sheet transactions appear in a firm’s financial statements? 14. What information do the notes to financial statements provide?

Financial Reporting in Practice The various financial statements we have examined are of critical importance to investors and financial managers alike. Even with safeguards such as GAAP and auditors, financial reporting abuses unfortunately do take place. We now review one of the most infamous recent examples and offer some concluding thoughts to guide financial managers through the complexities of financial statements.

Enron Enron is the most well-known of the accounting scandals of the early 2000s. Enron started as an operator of natural gas pipelines but evolved into a global trader dealing in a range of products including gas, oil, electricity, and even broadband Internet capacity. A series of events unfolded that led Enron to file what was at the time the largest bankruptcy filing in U.S. history in December 2001. By the end of 2001, the market value of Enron’s shares had fallen by over $60 billion. Interestingly, throughout the 1990s and up to late 2001, Enron was touted as one of the most successful and profitable companies in America. Fortune rated Enron “The Most Innovative Company in America” for six straight years, from 1995 to 2000. But while many aspects of Enron’s business were successful, subsequent investigations suggest that Enron executives had been manipulating Enron’s financial statements to mislead investors and artificially inflate the price of Enron’s stock and to maintain its credit rating. In 2000, for example, 96% of Enron’s reported earnings were the result of accounting manipulation.8 Although the accounting manipulations that Enron used were quite sophisticated, the essence of most of the deceptive transactions was surprisingly simple. Enron sold assets at inflated prices to other firms (or, in many cases, business entities that Enron’s CFO Andrew Fastow had created), together with a promise to buy back those assets at an 8

John R. Kroger, “Enron, Fraud and Securities Reform: An Enron Prosecutor’s Perspective,” University of Colorado Law Review, December 2005, pp. 57–138.

Chapter 2 Introduction to Financial Statement Analysis

47

even higher future price. Thus, Enron was effectively borrowing money, receiving cash today in exchange for a promise to pay more cash in the future. But Enron recorded the incoming cash as revenue and then hid the promises to buy the assets back in a variety of ways.9 In the end, much of their revenue growth and profits in the late 1990s were the result of this type of manipulation.

The Sarbanes-Oxley Act Sarbanes-Oxley Act (SOX) Legislation passed by Congress in 2002, intended to improve the accuracy of financial information given to both boards and to shareholders.

Accurate and up-to-date financial statements are essential to investors evaluating investment opportunities. In 2002, Congress passed the Sarbanes-Oxley Act (SOX). While SOX contains many provisions, the overall intent of the legislation was to improve the accuracy of information given to both boards and to shareholders. SOX attempted to achieve this goal in three ways: (1) by overhauling incentives and independence in the auditing process, (2) by stiffening penalties for providing false information, and (3) by forcing companies to validate their internal financial control processes. Many of the problems at Enron and elsewhere were kept hidden from boards and shareholders until it was too late. In the wake of these scandals, many people felt that the accounting statements of these companies, while often remaining true to the letter of GAAP, did not present an accurate picture of the financial health of a company. Auditing firms are supposed to ensure that a company’s financial statements accurately reflect the financial state of the firm. In reality, most auditors have a long-standing relationship with their audit clients; this extended relationship and the auditors’ desire to keep the lucrative auditing fees make auditors less willing to challenge management. More importantly, perhaps, most accounting firms have developed large and extremely profitable consulting divisions. Obviously, if an audit team refuses to accommodate a request by a client’s management, that client will be less likely to choose the accounting firm’s consulting division for its next consulting contract. SOX addressed this concern by putting strict limits on the amount of non-audit fees (consulting or otherwise) that an accounting firm can earn from the same firm that it audits. It also required that audit partners rotate every five years to limit the likelihood that auditing relationships become too cozy over long periods of time. Finally, SOX called on the SEC to force companies to have audit committees that are dominated by outside directors, and required that at least one outside director have a financial background. SOX also stiffened the criminal penalties for providing false information to shareholders. It required both the CEO and the CFO to personally attest to the accuracy of the financial statements presented to shareholders and to sign a statement to that effect. Penalties for providing false or misleading financial statements were increased under SOX—fines of as much as $5 million and imprisonment of a maximum of 20 years are permitted. Further, CEOs and CFOs must return bonuses or profits from the sale of stock or the exercise of options during any period covered by statements that are later restated. Finally, Section 404 of SOX requires senior management and the boards of public companies to attest to the effectiveness and validity with the process through which funds are allocated and controlled, and outcomes monitored throughout the firm. Section 404 has arguably garnered more attention than any other section in SOX because of the potentially enormous burden it places on every firm to validate its entire financial control system. When the SEC estimated the cost of implementing Section 404, its staff economists put the total cost at $1.24 billion. In 2005, surveys by Financial Executives International and the American Electronics Association predicted that the actual cost

9

In some cases, these promises were called “price risk management liabilities” and hidden with other trading activities; in other cases they were off-balance sheet transactions that were not fully disclosed.

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Part 1 Introduction

INTERVIEW WITH

SUE FRIEDEN

Sue Frieden is Ernst & Young’s Global Managing Partner, Quality & Risk Management. A member of the Global Executive board, she is responsible for every aspect of quality and risk management—employees, services, procedures, and clients.

Do today’s financial statements give the investing public what they need?

QUESTION:

ANSWER: Globally, we

are seeing an effort to provide more forwardlooking information to investors. But fundamental questions remain, such as how fully do investors understand financial statements and how fully do they read them? Research shows that most individual investors don’t rely on financial statements much at all. We need to determine how the financial statement and related reporting models can be improved. To do that we will need a dialogue involving investors, regulators, analysts, auditors, stock exchanges, academics and others to ensure that financial statements and other reporting models are as relevant as they can be.

Ernst & Young is a global organization. How do accounting standards in the U.S. compare to those elsewhere?

QUESTION:

ANSWER: In January of 2005, 100 countries outside the U.S. began the process of adopting new accounting standards (International Financial Reporting Standards) that would in large measure be based on principles rather than rules. As global markets become more complex, we all need to be playing by the same set of rules. As a first step, we need consistency from country to country. There are definite challenges to overcome in reconciling principlebased and rules-based systems, but we are optimistic that these challenges will inevitably get resolved. At the same time, there are efforts underway to ensure that auditing standards are globally consistent. Ultimately, financial statements prepared under global standards and audited under consistent global auditing standards will better serve investors.

What role does the audit firm play in our financial markets, and how has that changed since the collapse of Arthur Andersen?

QUESTION:

ANSWER: The accounting profession has seen unprecedented change in the past few years. The passage of Sarbanes-Oxley and other changes are helping to restore public trust. We’re now engaging on a regular basis with a wider range of stakeholders—companies, boards, policymakers, opinion leaders, investors, and academia. And we’ve had the chance to step back and ask ourselves why we do what we do as accounting professionals, and why it matters. In terms of the services we offer, much of what we do helps companies comply with regulations, guard against undue risks, and implement sound transactions. Part of the value in what we do is providing all stakeholders the basis to understand whether companies are playing by the rules—be they accounting, financial reporting, or tax rules. We help create confidence in financial data. The public may not understand precisely what auditors do or how we do it, but they care that we exist, because it provides them the confidence they so badly need and want.

Accounting standards seem to be shifting from historical cost-based methods to methods that rely on current market values of assets. During the financial crisis, however, many financial institutions complained that “mark-to-market” rules exacerbated their financial difficulties. Do you believe accounting professionals should rethink the wisdom of moving to market-based accounting methods?

QUESTION:

ANSWER:

Fair value accounting can certainly be improved, particularly in light of the difficulty in applying fair value in illiquid markets, which the financial crisis highlighted, and because of some of the anomalies that fair value accounting can produce. But, by and large, fair value accounting provided transparency into reality for investors. It is the most transparent way to reflect the economic reality of prevailing market conditions and provide investors and companies with current financial information on which they can base investment and management decisions. Fair value accounting did not cause the economic crisis; it simply kept a fair scorecard.

Chapter 2 Introduction to Financial Statement Analysis

49

would be between $20 billion and $35 billion.10 The burden of complying with this provision is greater, as a fraction of revenue, for smaller companies. The surveys cited earlier found that multibillion-dollar companies would pay less than 0.05% of their revenues to comply, whereas small companies with less than $20 million in revenues would pay more than 3% of their revenues to comply.

The Financial Statements: A Useful Starting Point In this chapter, we have highlighted the role of the financial statements in informing outside analysts, investors, and the financial managers themselves about the performance, position, and financial condition of the firm. However, especially from the financial manager’s perspective, financial statements are only a starting point. For example, we have emphasized the importance of market values over book values. We have also shown that while much can be learned through ratio analysis, these ratios are only markers that point the financial manager toward areas where the firm is doing well or where he or she needs to focus effort for improvement. No single ratio tells the whole story. However, by studying all of the financial statements and considering ratios that assess profitability, leverage, and efficiency, you should be able to develop a clear sense of the health and performance of the firm. Finally, the usefulness of the financial statements to investors relies on the ethics of those constructing them. However, even in cases of deception, an informed reader of the financial statements could have spotted the warning signs by focusing on the statement of cash flows and carefully reading the notes to the financial statements.

Concept Check

15. Describe the transactions Enron used to increase its reported earnings. 16. What is the Sarbanes-Oxley Act?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

2.1 Firms’ Disclosure of Financial Information Q Financial statements are accounting reports that a firm issues periodically to describe its past performance. Q Investors, financial analysts, managers, and other interested parties, such as creditors, rely on financial statements to obtain reliable information about a corporation. Q The main types of financial statements are the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders’ equity.

annual report, p. 25 auditor, p. 25 financial statements, p. 25 Generally Accepted Accounting Principles (GAAP), p. 25

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Online Practice Opportunities MyFinanceLab Study Plan 2.1

American Electronics Association, “Sarbanes-Oxley Section 404: The ‘Section’ of Unintended Consequences and Its Impact on Small Business” (2005).

Here is what you know after reading this chapter. MyFinanceLab will help you identify what you know, and 50 Partshould 1 Introduction where to go when you need to practice. 2.2 The Balance Sheet Q The balance sheet shows the current financial position (assets, liabilities, and stockholders’ equity) of the firm at a single point in time. Q The two sides of the balance sheet must balance: Assets = Liabilities + Stockholders¿ Equity (2.1) Q Stockholders’ equity is the book value of the firm’s equity. It differs from the market value of the firm’s equity, its market capitalization, because of the way assets and liabilities are recorded for accounting purposes.

accounts payable, p. 28 MyFinanceLab accounts receivable, p. 27 Study Plan 2.2 assets, p. 26 balance sheet, p. 26 book value, p. 28 book value of equity, p. 28 common stock and paid-in surplus, p. 26 current assets, p. 27 current liabilities, p. 28 depreciation, p. 28 inventories, p. 27 liabilities, p. 26 long-term assets, p. 27 long-term debt, p. 28 market capitalization, p. 29 marketable securities, p. 27 net working capital, p. 28 notes payable, p. 28 retained earnings, p. 26 shareholders’ equity, p. 26 short-term debt, p. 28 stockholders’ equity, p. 26

2.3 Balance Sheet Analysis Q A successful firm’s market-to-book ratio typically exceeds 1. Q A common ratio used to assess a firm’s leverage is: Total Debt [email protected] Ratio = (2.4) Total Equity Q This ratio is most informative when computed using the market value of equity. It indicates the degree of leverage of the firm. Q The enterprise value of a firm is the total value of its underlying business operations: Enterprise Value = Market Value of Equity + Debt - Cash (2.5)

current ratio, p. 32 debt-equity ratio, p. 30 enterprise value, p. 31 growth stocks, p. 30 leverage, p. 30 liquidation value, p. 30 market-to-book ratio (price- to-book [P/B] ratio), p. 30 quick ratio, p. 32 value stocks, p. 30

MyFinanceLab Study Plan 2.3

2.4 The Income Statement Q The income statement reports the firm’s revenues and expenses, and it computes the firm’s bottom line of net income, or earnings. Q Net income is often reported on a per-share basis as the firm’s earnings per share: Earnings per Share (EPS) = Net Income/Shares Outstanding (2.8) Q We compute diluted EPS by adding to the number of shares outstanding the possible increase in the number of shares from the exercise of stock options the firm has awarded.

convertible bonds, p. 35 diluted EPS, p. 35 dilution, p. 35 earnings per share (EPS), p. 34 EBIT, p. 34 gross profit, p. 33 income statement, p. 33 net income or earnings, p. 33 operating income, p. 34 stock options, p. 35

MyFinanceLab Study Plan 2.4

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what Analysis you know, and where Chapter 2 Introduction to Financial Statement 51 to go when you need to practice. 2.5 Income Statement Analysis Q Profitability ratios show the firm’s operating or net income as a fraction of sales, and they are an indication of a firm’s efficiency and its pricing strategy. Q Asset efficiency ratios assess how efficiently the firm is using its assets by showing how many dollars of revenues the firm produces per dollar of assets. Q Working capital ratios express the firm’s working capital as a number of days of sales (for receivables) or cost of sales (for inventory or payables). Q Interest coverage ratios indicate the ratio of the firm’s income or cash flows to its interest expenses, and they are a measure of financial strength. Q Return on investment ratios, such as ROE or ROA, express the firm’s net income as a return on the book value of its equity or total assets. Q Valuation ratios compute market capitalization or enterprise value of the firm relative to its earnings or operating income. Q The P/E ratio computes the value of a share of stock relative to the firm’s EPS. P/E ratios tend to be high for fast-growing firms. Q When comparing valuation ratios, it is important to be sure both the numerator and denominator match in terms of whether they include debt.

accounts payable days, MyFinanceLab p. 37 Study Plan 2.5 accounts receivable days, p. 36 average collection period, days sales outstanding, p. 36 Dupont Identity, p. 38 EBITDA, p. 37 equity multiplier, p. 38 gross margin, p. 35 interest coverage ratio, p. 37 inventory days, p. 37 inventory turnover ratio, p. 37 net profit margin, p. 36 operating margin, p. 35 PEG ratio, p. 39 price-earnings ratio (P/E), p. 39 return on assets (ROA), p. 38 return on equity (ROE), p. 37 times interest earned (TIE) ratio, p. 37

2.6 The Statement of Cash Flows Q The statement of cash flows reports the sources and uses of the firm’s cash. It shows the adjustments to net income for non-cash expenses and changes to net working capital, as well as the cash used (or provided) from investing and financing activities.

capital expenditures, p. 44 payout ratio, p. 44 retained earnings, p. 44 statement of cash flows, p. 42

MyFinanceLab Study Plan 2.6

2.7 Other Financial Statement Information Q The management discussion and analysis section of the financial statement contains management’s overview of the firm’s performance, as well as disclosure of risks the firm faces, including those from offbalance sheet transactions. Q The statement of stockholders’ equity breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing new shares versus retained earnings. It is not particularly useful for financial valuation purposes. Q The notes to a firm’s financial statements generally contain important details regarding the numbers used in the main statements.

management discussion and analysis (MD&A), p. 45 off-balance sheet transactions, p. 45 statement of stockholders’ equity, p. 46

MyFinanceLab Study Plan 2.7

Here is what you know after reading this chapter. MyFinanceLab will help you identify what you know, and where 52 Partshould 1 Introduction to go when you need to practice. 2.8 Financial Reporting in Practice Q Recent accounting scandals have drawn attention to the importance of financial statements. New legislation has increased the penalties for fraud, and tightened the procedures firms must use to ensure that statements are accurate.

Critical Thinking

Sarbanes-Oxley Act (SOX), p. 47

MyFinanceLab Study Plan 2.8

1. Why do firms disclose financial information? 2. Who reads financial statements? List at least three different categories of people. For each category, provide an example of the type of information they might be interested in and discuss why. 3. What is the purpose of the balance sheet? 4. How can you use the balance sheet to assess the health of the firm? 5. What is the purpose of the income statement? 6. How are the balance sheet and the income statement related? 7. What is the DuPont Identity and how can a financial manager use it? 8. How does the statement of cash flows differ from the income statement? 9. Can a firm with positive net income run out of cash? Explain. 10. What can you learn from management’s discussion in the financial statements or the notes to the financial statements? 11. How did accounting fraud contribute to the collapse of Enron?

Problems

All Problems are available in MyFinanceLab. An asterisk * indicates Problems with a higher level of difficulty. Firms’ Disclosure of Financial Information 1. What four financial statements can be found in a firm’s 10-K filing? What checks are there on the accuracy of these statements? 2. What is GAAP and who oversees it? 3. Confirm that you can find the most recent financial statements for Starbucks Corporation (SBUX) using the following sources: a. From the company’s Web page (www.starbucks.com). (Hint: Search for “investor relations.”) b. From the SEC Web site (www.sec.gov). (Hint: Search for company filings in the EDGAR database.) c. From the Yahoo! Finance Web site (finance.yahoo.com). d. From at least one other source. (Hint: Enter “SBUX 10K” at www.bing.com.) The Balance Sheet 4. Consider the following potential events that might have occurred to Global on December 30, 2010. For each one, indicate which line items in Global’s balance sheet

Chapter 2 Introduction to Financial Statement Analysis

53

would be affected and by how much. Also indicate the change to Global’s book value of equity. a. Global used $20 million of its available cash to repay $20 million of its long-term debt. b. A warehouse fire destroyed $5 million worth of uninsured inventory. c. Global used $5 million in cash and $5 million in new long-term debt to purchase a $10 million building. d. A large customer owing $3 million for products it already received declared bankruptcy, leaving no possibility that Global would ever receive payment. e. Global’s engineers discover a new manufacturing process that will cut the cost of its flagship product by over 50%. f. A key competitor announces a radical new pricing policy that will drastically undercut Global’s prices. 5. What was the change in Global’s book value of equity from 2009 to 2010 according to Table 2.1? Does this imply that the market price of Global’s shares increased in 2010? Explain. 6. Use Google Finance (www.google.com/finance) to find the balance sheet data for Qualcomm as of the end of 2009. a. How much did Qualcomm have in cash and short-term investments? b. What were Qualcomm’s total accounts receivable? c. What were Qualcomm’s total assets? d. What were Qualcomm’s total liabilities? How much of this was long-term debt? e. What was the book value of Qualcomm’s equity? 7. Find the annual 10-K report for Peet’s Coffee and Tea (PEET) online, filed for 2008 (filed in early 2009). Answer the following questions from its balance sheet: a. How much cash did Peet’s have at the end of 2008? b. What were Peet’s total assets? c. What were Peet’s total liabilities? How much debt did Peet’s have? d. What was the book value of Peet’s equity? Balance Sheet Analysis 8. In June 2007, General Electric (GE) had a book value of equity of $117 billion, 10.3 billion shares outstanding, and a market price of $38.00 per share. GE also had cash of $16 billion, and total debt of $467 billion. a. What was GE’s market capitalization? What was GE’s market-to-book ratio? b. What was GE’s book debt-equity ratio? What was GE’s market debt-equity ratio? c. What was GE’s enterprise value? 9. In July 2007, Apple had cash of $7.12 billion, current assets of $18.75 billion, and current liabilities of $6.99 billion. It also had inventories of $0.25 billion. a. What was Apple’s current ratio? b. What was Apple’s quick ratio? c. In July 2007, Dell had a quick ratio of 1.25 and a current ratio of 1.30. What can you say about the asset liquidity of Apple relative to Dell? 10. In April 2010, the following information was true about Abercrombie and Fitch (ANF) and The Gap (GPS), both clothing retailers. Values (except price per share) are in millions of dollars.

ANF GPS

Book Equity

Price Per Share

Number of Shares

1,788 4,769

46.67 25.00

88.17 667.42

54

Part 1 Introduction a. What is the market-to-book ratio of each company? b. What conclusions do you draw from comparing the two ratios? The Income Statement and Income Statement Analysis 11. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008. Answer the following questions from the income statement: a. What were Peet’s revenues for 2008? By what percentage did revenues grow from 2007? b. What were Peet’s operating and net profit margins in 2008? How do they compare with its margins in 2007? c. What were Peet’s diluted earnings per share in 2008? What number of shares is this EPS based on? 12. Local Co. has sales of $10 million and cost of sales of $6 million. Its selling, general and administrative expenses are $500,000 and its research and development is $1 million. It has annual depreciation charges of $1 million and a tax rate of 35%. a. What is Local’s gross margin? b. What is Local’s operating margin? c. What is Local’s net profit margin? 13. If Local Co., the company in Problem 12, had an increase in selling expenses of $300,000, how would that affect each of its margins? 14. If Local Co., the company in Problem 12, had interest expense of $800,000, how would that affect each of its margins? 15. Chutes & Co. has interest expense of $1 million and an operating margin of 10% on total sales of $30 million. What is Chutes’ interest coverage ratio? 16. Ladders, Inc. has a net profit margin of 5% on sales of $50 million. It has book value of equity of $40 million and total liabilities with a book value of $30 million. What is Ladders’ ROE? ROA? 17. JPJ Corp has sales of $1 million, accounts receivable of $50,000, total assets of $5 million (of which $3 million are fixed assets), inventory of $150,000, and cost of goods sold of $600,000. What is JPJ’s accounts receivable days? Fixed asset turnover? Total asset turnover? Inventory turnover? 18. If JPJ Corp (the company from the previous question) is able to increase sales by 10% but keep its total and fixed asset growth to only 5%, what will its new asset turnover ratios be? *19. Suppose that in 2010, Global launched an aggressive marketing campaign that boosted sales by 15%. However, their operating margin fell from 5.57% to 4.50%. Suppose that they had no other income, interest expenses were unchanged, and taxes were the same percentage of pretax income as in 2009. a. What was Global’s EBIT in 2010? b. What was Global’s income in 2010? c. If Global’s P/E ratio and number of shares outstanding remained unchanged, what was Global’s share price in 2010? 20. Suppose a firm’s tax rate is 35%. a. What effect would a $10 million operating expense have on this year’s earnings? What effect would it have on next year’s earnings? b. What effect would a $10 million capital expense have on this year’s earnings, if the capital is depreciated at a rate of $2 million per year for five years? What effect would it have on next year’s earnings?

Chapter 2 Introduction to Financial Statement Analysis

55

21. You are analyzing the leverage of two firms and you note the following (all values in millions of dollars): Firm A Firm B

a. b. c. d.

Debt

Book Equity

Market Equity

Operating Income

Interest Expense

500 80

300 35

400 40

100 8

50 7

What is the market debt-to-equity ratio of each firm? What is the book debt-to-equity ratio of each firm? What is the interest coverage ratio of each firm? Which firm will have more difficulty meeting its debt obligations?

22. For 2010, Wal-Mart and Target had the following information (all values are in millions of dollars):

Wal-Mart Target

Sales (Income Statement)

Cost of Goods Sold (Income Statement)

Accounts receivable (Balance Sheet)

Inventory (Balance Sheet)

408,214 65,357

304,657 45,583

4,144 6,966

30,254 7,179

a. What is each company’s accounts receivable days? b. What is each company’s inventory turnover? c. Which company is managing its accounts receivable and inventory more efficiently? *23. Quisco Systems has 6.5 billion shares outstanding and a share price of $18.00. Quisco is considering developing a new networking product in-house at a cost of $500 million. Alternatively, Quisco can acquire a firm that already has the technology for $900 million worth (at the current price) of Quisco stock. Suppose that absent the expense of the new technology, Quisco will have EPS of $0.80. a. Suppose Quisco develops the product in house. What impact would the development cost have on Quisco’s EPS? Assume all costs are incurred this year and are treated as an R&D expense, Quisco’s tax rate is 35%, and the number of shares outstanding is unchanged. b. Suppose Quisco does not develop the product in house but instead acquires the technology. What effect would the acquisition have on Quisco’s EPS this year? (Note that acquisition expenses do not appear directly on the income statement. Assume the acquired firm has no revenues or expenses of its own, so that the only effect on EPS is due to the change in the number of shares outstanding.) c. Which method of acquiring the technology has a smaller impact on earnings? Is this method cheaper? Explain. 24. In January 2009, American Airlines (AMR) had a market capitalization of $1.7 billion, debt of $11.1 billion, and cash of $4.6 billion. American Airlines had revenues of $23.8 billion. British Airways (BABWF) had a market capitalization of $2.2 billion, debt of $4.7 billion, cash of $2.6 billion, and revenues of $13.1 billion. a. Compare the market capitalization-to-revenue ratio (also called the price-to-sales ratio) for American Airlines and British Airways. b. Compare the enterprise value-to-revenue ratio for American Airlines and British Airways. c. Which of these comparisons is more meaningful? Explain. *25. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008 (filed in early 2009). a. Compute Peet’s net profit margin, total asset turnover, and equity multiplier. b. Verify the DuPont Identity for Peet’s ROE. c. If Peet’s managers wanted to increase its ROE by 1 percentage point, how much higher would their asset turnover need to be?

56

Part 1 Introduction 26. Repeat the analysis from parts a and b of the previous problem using Starbucks Corporation (SBUX) instead. Based on the DuPont Identity, what explains the difference between the two firms’ ROEs? 27. Consider a retail firm with a net profit margin of 3.5%, a total asset turnover of 1.8, total assets of $44 million, and a book value of equity of $18 million. a. What is the firm’s current ROE? b. If the firm increased its net profit margin to 4%, what would its ROE be? c. If, in addition, the firm increased its revenues by 20% (while maintaining this higher profit margin and without changing its assets or liabilities), what would its ROE be? The Statement of Cash Flows 28. Find online the 2008 annual 10-K report for Peet’s Coffee and Tea (PEET), filed in early 2009. Answer the following questions from its cash flow statement: a. How much cash did Peet’s generate from operating activities in 2008? b. What was Peet’s depreciation expense in 2008? c. How much cash was invested in new property and equipment (net of any sales) in 2008? d. How much did Peet’s raise from the sale of shares of its stock (net of any purchases) in 2008? 29. See the cash flow statement below for H. J. Heinz (HNZ) (all values in thousands of dollars) (see MyFinanceLab for the data in Excel format): a. What were Heinz’s cumulative earnings over these four quarters? What were its cumulative cash flows from operating activities?

Period Ending

29-Oct-08

30-Jul-08

30-Apr-08

30-Jan-08

228,964

194,062

218,532

75,733 (13,142) (53,218) (111,577) (114,121) (26,574)

74,570 48,826 100,732 201,725 85,028 12,692

73,173 (47,993) (84,711) 39,949 57,681 (2,097)

Total Cash Flow From Operating Activities 227,502 Investing Activities, Cash Flows Provided By or Used In Capital expenditures (82,584) Investments (5,465) Other cashflows from investing activities (108,903)

(13,935)

717,635

254,534

(41,634) 5,465 732

(100,109) (93,153) (58,069)

(69,170) (48,330) 20,652

Total Cash Flows From Investing Activities (196,952) Financing Activities, Cash Flows Provided By or Used In Dividends paid (131,483) Sale purchase of stock 78,774 Net borrowings 515,709 Other cash flows from financing activities (282)

(35,437)

(251,331)

(96,848)

(131,333) 1,210 114,766 2,000

(119,452) (76,807) (283,696) (46,234)

(121,404) (79,288) 64,885 39,763

Net income 276,710 Operating Activities, Cash Flows Provided By or Used In Depreciation 69,997 Adjustments to net income 14,359 Changes In accounts receivables (38,869) Changes in liabilities 82,816 Changes in inventories (195,186) Changes in other operating activities 17,675

Total Cash Flows From Financing Activities Effect of exchange rate changes

462,718 (119,960)

(13,357) (610)

(526,189) 32,807

(96,044) 6,890

Change In Cash and Cash Equivalents

$373,308

(63,339)

(27,078)

$68,532

Chapter 2 Introduction to Financial Statement Analysis

57

b. What fraction of the cash from operating activities was used for investment over the four quarters? c. What fraction of the cash from operating activities was used for financing activities over the four quarters? 30. Suppose your firm receives a $5 million order on the last day of the year. You fill the order with $2 million worth of inventory. The customer picks up the entire order the same day and pays $1 million up front in cash; you also issue a bill for the customer to pay the remaining balance of $4 million within 40 days. Suppose your firm’s tax rate is 0% (i.e., ignore taxes). Determine the consequences of this transaction for each of the following: a. Revenues d. Inventory b. Earnings e. Cash c. Receivables 31. Nokela Industries purchases a $40 million cyclo-converter. The cyclo-converter will be depreciated by $10 million per year over four years, starting this year. Suppose Nokela’s tax rate is 40%. a. What impact will the cost of the purchase have on earnings for each of the next four years? b. What impact will the cost of the purchase have on the firm’s cash flow for the next four years? Other Financial Statement Information 32. The balance sheet information for Clorox Co. (CLX) in 2004–2005 is shown here (all values in thousands of dollars) (see MyFinanceLab for the data in Excel format): Balance Sheet: Assets Current Assets Cash and cash equivalents Net receivables Inventory Other current assets

31-Mar-05

31-Dec-04

30-Sep-04

30-Jun-04

293,000 401,000 374,000 60,000

300,000 362,000 342,000 43,000

255,000 385,000 437,000 53,000

232,000 460,000 306,000 45,000

Total Current Assets Long-term investments Property, plant, and equipment Goodwill Other assets

1,128,000 128,000 979,000 744,000 777,000

1,047,000 97,000 991,000 748,000 827,000

1,130,000 — 995,000 736,000 911,000

1,043,000 200,000 1,052,000 742,000 797,000

Total Assets Liabilities Current Liabilities Accounts payable Short/current long-term debt Other current liabilities

3,756,000

3,710,000

3,772,000

3,834,000

876,000 410,000 —

1,467,000 2,000 —

922,000 173,000 —

980,000 288,000 —

Total Current Liabilities Long-term debt Other liabilities

1,286,000 2,381,000 435,000

1,469,000 2,124,000 574,000

1,095,000 474,000 559,000

1,268,000 475,000 551,000

4,102,000 –346,000 $3,756,000

4,167,000 –457,000 $3,710,000

2,128,000 1,644,000 $3,772,000

2,294,000 1,540,000 $3,834,000

Total Liabilities Total Stockholder Equity Total Liabilities and Stockholder Equity

58

Part 1 Introduction a. What change in the book value of Clorox’s equity took place at the end of 2004? b. Is Clorox’s market-to-book ratio meaningful? Is its book debt-equity ratio meaningful? Explain. c. Find Clorox’s other financial statements from that time online. What was the cause of the change to Clorox’s book value of equity at the end of 2004? d. Does Clorox’s book value of equity in 2005 imply that the firm is unprofitable? Explain. Financial Reporting in Practice 33. Find online the annual 10-K report for Peet’s Coffee and Tea (PEET) for 2008, filed in early 2009. a. Which auditing firm certified these financial statements? b. Which officers of Peet’s certified the financial statements?

Data Case

This is your second interview with a prestigious brokerage firm for a job as an equity analyst. You survived the morning interviews with the department manager and the vice president of equity. Everything has gone so well that they want to test your ability as an analyst. You are seated in a room with a computer and a list with the names of two companies—Caterpillar (CAT) and Microsoft (MSFT). You have 90 minutes to complete the following tasks: 1. Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from MarketWatch (www.marketwatch .com). Enter each company’s stock symbol and then go to “financials.” Copy and paste the financial statements into Excel. 2. Find historical stock prices for each firm from Yahoo! Finance (finance.yahoo.com). Enter the stock symbol, click on “Historical Prices” in the left column, and enter the proper date range to cover the last day of the month corresponding to the date of each financial statement. Use the closing stock prices (not the adjusted close). To calculate the firm’s market capitalization at each date, multiply the number of shares outstanding (see “Basic Weighted Shares Outstanding” on the income statement) by the firm’s historic stock price. 3. For each of the four years of statements, compute the following ratios for each firm: Valuation Ratios Price-earnings ratio (for EPS use diluted EPS total) Market-to-book ratio Enterprise value-to-EBITDA (For debt, include long-term and short-term debt; for cash, include marketable securities.) Profitability Ratios Operating margin (use operating income after depreciation) Net profit margin Return on equity Financial Strength Ratios Current ratio Book debt–equity ratio Market debt–equity ratio Interest coverage ratio 1 EBIT interest expense 2

Chapter 2 Introduction to Financial Statement Analysis

59

4. Obtain industry averages for each firm from Reuters.com (www.reuters.com/ finance/stocks). Enter the stock symbol at the top of the page in the “Symbol lookup” and then click on the “Financials” button, and then click on “Search”. a. Scroll down to “Valuation Ratios,” and compare each firm’s ratios to the available industry ratios for the most recent year. (Ignore the “Company” column as your calculations will be different.) b. Analyze the performance of each firm versus the industry and comment on any trends in each individual firm’s performance. Identify any strengths or weaknesses you find in each firm. 5. Examine the market-to-book ratios you calculated for each firm. Which, if either, of the two firms can be considered “growth firms” and which, if either, can be considered “value firms”? 6. Compare the valuation ratios across the two firms. How do you interpret the difference between them? 7. Consider the enterprise value of both firms for each of the four years. How have the values of both firms changed over the time period?

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Interest Rates and Valuing Cash Flows

PART

2

Valuation Principle Connection. In this part of the text, we introduce

Chapter 3

the basic tools for making financial decisions. Chapter 3 presents the most important

Time Value of Money: An Introduction

idea in this book, the Valuation Principle. The Valuation Principle states that we can use market prices to determine the value of an investment opportunity to the firm. As we progress through our study of corporate finance, we will demonstrate that the Valuation Principle is the one unifying principle that underlies all of finance and links all the ideas throughout this book. Every day, managers in companies all over the world make financial decisions. These range from relatively minor decisions such as a local hardware store owner’s

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

determination of when to restock inventory, to major decisions such as Starbucks’ 2008 closing of over 600 stores, Microsoft’s 2008 attempt to buy Yahoo!, and Apple’s

Chapter 5

2010 launch of a tablet device called the iPad. What do these far-ranging decisions

Interest Rates

have in common? They all were made by comparing the costs of the action against the value to the firm of the benefits. Specifically, a company’s managers must

Chapter 6

determine what it is worth to the company today to receive the project’s future cash

Bonds

inflows while paying its cash outflows. In Chapter 3, we start to build the tools to undertake this analysis with a central concept in financial economics—the time value of money. In Chapter 4, we explain

Chapter 7

how to value any series of future cash flows and derive a few useful shortcuts for

Stock Valuation

valuing various types of cash flow patterns. Chapter 5 discusses how interest rates are quoted in the market and how to handle interest rates that compound more frequently than once per year. In Chapter 6 we will apply what we have learned about interest rates and the present value of cash flows to the task of valuing bonds. In the last chapter of this section, Chapter 7, we discuss the features of common stocks and learn how to calculate an estimate of their value.

61

Time Value of Money: An Introduction

3

LEARNING OBJECTIVES

notation

62

Q Identify the roles of financial managers and competitive markets in decision making

Q Assess the effect of interest rates on today’s value of future cash flows

Q Understand the Valuation Principle, and how it can be used to identify decisions that increase the value of the firm

Q Calculate the value of distant cash flows in the present and of current cash flows in the future

r

interest rate

C

cash flow

PV

present value

n

number of periods

FV

future value

INTERVIEW WITH

Nicole Wickswat Intel Corporation

“As a Senior Strategic Analyst in Intel Corporation’s Data Center Group, I strive to uphold the company’s finance charter by being ‘a full partner in business decisions to maximize shareholder value,’” says Nicole Wickswat, a 2006 graduate of the University of Oregon’s Business Honors Program with a degree in finance. “I work on a team with engineers and marketing people, helping them develop products for data center and cloud computer environments that are competitive, financially feasible, and provide the required return.” Nicole analyzes the potential financial impact of her group’s business decisions, evaluating the return to Intel on current and proposed products and making recommendations to management on whether they continue to add value. “A good investment decision should be aligned with the strategic objectives of the business,” she says. “We want the benefits to outweigh the associated costs, and we also take into account product launch timing and a project’s incremental financial value. Then we take a comprehensive view of the decision on the company as a whole, assessing the impact a decision would have on other products and/or groups.” Intel uses present value calculations within all business groups to compare the present values of costs and benefits that happen at different points in time. This gives management a consistent metric to compare different investments and projects, set priorities, and make tradeoffs where necessary to allocate funds to the optimal investments. The analysis continues throughout the product life cycle. “We assess the competitive landscape and determine whether the cost of adding or removing specific product features will benefit us in terms of increased market segment share, volume, and/or average selling price. We also look at whether adding the product feature negatively affects other groups or products and, if so, incorporate that into the analysis.” Nicole’s analysis helps the Data Center Group establish product cost targets that are aligned with long-term profitability goals. “These cost targets play a key role in product development decisions because they put pressure on engineers to design with profitability in mind and encourage us to get the most value out of the product line.”

University of Oregon, 2006

“A good investment decision should be aligned with the strategic objectives of the business.”

In 2009, Google decided to directly enter the mobile phone market with its own Android operating system and the Nexus One handset. How did Google’s managers decide this was the right decision for the company? Every decision has future consequences that will affect the value of the firm. These consequences will generally include both benefits and costs. For example, in addition to the up-front cost of developing its own mobile phone and software, Google will also incur ongoing costs associated with future software development for the platform, marketing efforts, and customer support for handset buyers. The benefits to Google include the revenues from the sales as well as the future licensing of its software and the value of having a direct position in the growing mobile market. This decision will increase Google’s value if these benefits outweigh the costs. More generally, a decision is good for the firm’s investors if it increases the firm’s value by providing benefits whose value exceeds the costs. But how do we compare costs and benefits that occur at different points in time, or are in different currencies, or have different risks associated with them? To make a valid comparison, we must use the tools of finance to express all costs and benefits in common terms.

63

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Part 2 Interest Rates and Valuing Cash Flows We convert all costs and benefits into a common currency and common point of time, such as dollars today. In this chapter, we learn (1) how to use market information to evaluate costs and benefits and (2) why market prices are so important. Then, we will start to build the critical tools relating to the time value of money. These tools will allow you to correctly compare the costs and benefits of a decision no matter when they occur.

3.1

Cost-Benefit Analysis The first step in decision making is to identify the costs and benefits of a decision. In this section, we look at the role of financial managers in evaluating costs and benefits and the tools they use to quantify them.

Role of the Financial Manager A financial manager’s job is to make decisions on behalf of the firm’s investors. Our objective in this book is to explain how to make decisions that increase the value of the firm to its investors. In principal, the idea is simple and intuitive: For good decisions, the benefits exceed the costs. Of course, real-world opportunities are usually complex and the costs and benefits are often difficult to quantify. Quantifying them often means using skills from other management disciplines, as in the following examples: Marketing: to determine the increase in revenues resulting from an advertising campaign Economics: to determine the increase in demand from lowering the price of a product Organizational Behavior: to determine the effect of changes in management structure on productivity Strategy: to determine a competitor’s response to a price increase Operations: to determine production costs after the modernization of a manufacturing plant For the remainder of this text, we will assume we can rely on experts in these areas to provide this information so the costs and benefits associated with a decision have already been identified. With that task done, the financial manager’s job is to compare the costs and benefits and determine the best decision for the value of the firm.

Quantifying Costs and Benefits Any decision in which the value of the benefits exceeds the costs will increase the value of the firm. To evaluate the costs and benefits of a decision, we must value the options in the same terms—cash today. Let’s make this concrete with a simple example. Suppose a jewelry manufacturer has the opportunity to trade 200 ounces of silver for 10 ounces of gold today. An ounce of silver differs in value from an ounce of gold. Consequently, it is incorrect to compare 200 ounces to 10 ounces and conclude that the larger quantity is better. Instead, to compare the cost of the silver and the benefit of the gold, we first need to quantify their values in equivalent terms—cash today. Consider the silver. What is its cash value today? Suppose silver can be bought and sold for a current market price of $10 per ounce. Then the 200 ounces of silver we would give up has a cash value of:1

1 200 ounces of silver 2 * 1 +10/ounce of silver 2 = +2000

1

You might wonder whether commissions and other transactions costs need to be included in this calculation. For now, we will ignore transactions costs, but we will discuss their effect in later chapters.

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If the current market price for gold is $500 per ounce, then the 10 ounces of gold we would receive has a cash value of

1 10 ounces of gold 2 * 1 +500/ounce of gold 2 = +5000

We have now quantified the decision. The jeweler’s opportunity has a benefit of $5000 and a cost of $2000. The net benefit of the decision is +5000 - +2000 = +3000 today. The net value of the decision is positive, so by accepting the trade, the jewelry firm will be richer by $3000.

EXAMPLE 3.1 Comparing Costs and Benefits

Problem Suppose you work as a customer account manager for an importer of frozen seafood. A customer is willing to purchase 300 pounds of frozen shrimp today for a total price of $1500, including delivery. You can buy frozen shrimp on the wholesale market for $3 per pound today and arrange for delivery at a cost of $100 today. Will taking this opportunity increase the value of the firm?

Solution Q Plan To determine whether this opportunity will increase the value of the firm, we need to evaluate the benefits and the costs using market prices. We have market prices for our costs: Wholesale price of shrimp: $3/pound

Delivery cost: $100

We have a customer offering the following market price for 300 pounds of shrimp delivered: $1500. All that is left is to compare them. Q Execute The benefit of the transaction is $1500 today. The costs are (300 lbs.) * +3/lb. = +900 today for the shrimp, and $100 today for delivery, for a total cost of $1000 today. If you are certain about these costs and benefits, the right decision is obvious: You should seize this opportunity because the firm will gain +1500 - +1000 = +500. Q Evaluate Thus, taking this opportunity contributes $500 to the value of the firm, in the form of cash that can be paid out immediately to the firm’s investors.

competitive market A market in which the good can be bought and sold at the same price.

EXAMPLE 3.2 Competitive Market Prices Determine Value

Role of Competitive Market Prices. Suppose the jeweler works exclusively on silver jewelry or thinks the price of silver should be higher. Should his decision change? The answer is no—he can always make the trade and then buy silver at the current market price. Even if he has no use for the gold, he can immediately sell it for $5000, buy back the 200 ounces of silver at the current market price of $2000, and pocket the remaining $3000. Thus, independent of his own views or preferences, the value of the silver to the jeweler is $2000. Because the jeweler can both buy and sell silver at its current market price, his personal preferences or use for silver and his opinion of the fair price are irrelevant in evaluating the value of this opportunity. This observation highlights an important general principle related to goods trading in a competitive market, a market in which a good can be bought and sold at the same price. Whenever a good trades in a competitive market, that price determines the value of the good. This point is one of the central and most powerful ideas in finance. It will underlie almost every concept we develop throughout the text. Problem You have just won a radio contest and are disappointed to find out that the prize is four tickets to the Def Leppard reunion tour (face value $40 each). Not being a fan of 1980s power rock, you have no intention of going to the show. However, the radio station offers you another option: two tickets to your favorite band’s sold-out show (face value $45 each). You notice that, on eBay, tickets to the Def Leppard show are being

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Part 2 Interest Rates and Valuing Cash Flows bought and sold for $30 apiece and tickets to your favorite band’s show are being bought and sold at $50 each. What should you do?

Solution Q Plan Market prices, not your personal preferences (or the face value of the tickets), are relevant here: 4 Def Leppard tickets at $30 apiece 2 of your favorite band’s tickets at $50 apiece You need to compare the market value of each option and choose the one with the highest market value. Q Execute The Def Leppard tickets have a total value of +120 (4 * +30) versus the $100 total value of the other 2 tickets (2 * +50). Instead of taking the tickets to your favorite band, you should accept the Def Leppard tickets, sell them on eBay, and use the proceeds to buy 2 tickets to your favorite band’s show. You’ll even have $20 left over to buy a T-shirt. Q Evaluate Even though you prefer your favorite band, you should still take the opportunity to get the Def Leppard tickets instead. As we emphasized earlier, whether this opportunity is attractive depends on its net value using market prices. Because the value of Def Leppard tickets is $20 more than the value of your favorite band’s tickets, the opportunity is appealing.

When Competitive Market Prices Are Not Available Competitive market prices allow us to calculate the value of a decision without worrying about the tastes or opinions of the decision maker. When competitive prices are not available, we can no longer do this. Prices at retail stores, for example, are one-sided: You can buy at the posted price, but you cannot sell the good to the store at that same price. We cannot use these one-sided prices to determine an exact cash value. They determine the maximum value of the good (since it can always be purchased at that price), but an individual may value it for much less depending on his or her preference for the good. Let’s consider an example. It has long been common for banks to try to entice people to open accounts by offering them something free in exchange (it used to be a toaster). In 2007 Key Bank offered college students a free iPod Nano if they

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would open a new checking account and make two deposits. At the time, the retail price of that model of Nano was $199. Because there is no competitive market to trade iPods, the value of the Nano to you depends on whether you were going to buy one or not. If you planned to buy one anyway, then its value to you is $199, the price you would otherwise pay for it. In this case, the value of the bank’s offer is $199. But suppose you do not want or need a Nano. If you were to get it from the bank and then sell it, the value to you of taking the deal would be whatever price you could get for the Nano. For example, if you could sell the Nano for $150 to your friend, then the bank’s offer is worth $150 to you. Thus, depending on your desire to own a new Nano, the bank’s offer is worth somewhere between $150 (you don’t want a Nano) and $199 (you definitely want one).

1. When costs and benefits are in different units or goods, how can we compare them? 2. If crude oil trades in a competitive market, would an oil refiner that has a use for the oil value it differently than another investor would?

Market Prices and the Valuation Principle In the previous examples, the right decisions for the firms were clear because the costs and benefits were easy to evaluate and compare. They were easy to evaluate because we were able to use current market prices to convert them into equivalent cash values. Once we can express costs and benefits in terms of cash today, it is a straightforward process to compare them and determine whether the decision will increase the firm’s value.

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The Valuation Principle Our discussion so far establishes competitive market prices as the way to evaluate the costs and benefits of a decision in terms of cash today. Once we do this, it is a simple matter to determine the best decision for the firm. The best decision makes the firm and its investors wealthier, because the value of its benefits exceeds the value of its costs. We call this idea the Valuation Principle: The Valuation Principle: The value of a commodity or an asset to the firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using those market prices. When the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm. The Valuation Principle provides the basis for decision making throughout this text. In the remainder of this chapter, we apply it to decisions whose costs and benefits occur at different points in time.

EXAMPLE 3.3 Applying the Valuation Principle

Problem You are the operations manager at your firm. Due to a pre-existing contract, you have the opportunity to acquire 200 barrels of oil and 3000 pounds of copper for a total of $25,000. The current market price of oil is $90 per barrel and for copper is $3.50 per pound. You are not sure that you need all the oil and copper, so you are wondering whether you should take this opportunity. How valuable is it? Would your decision change if you believed the value of oil or copper would plummet over the next month?

Solution Q Plan We need to quantify the costs and benefits using market prices. We are comparing $25,000 with: 200 barrels of oil at $90 per barrel 3000 pounds of copper at $3.50 per pound Q Execute Using the competitive market prices we have: (200 barrels of oil) * (+90/barrel today) = +18,000 today (3000 pounds of copper) * (+3.50/pound today) = +10,500 today The value of the opportunity is the value of the oil plus the value of the copper less the cost of the opportunity, or +18,000 + +10,500 - +25,000 = +3500 today. Because the value is positive, we should take it. This value depends only on the current market prices for oil and copper. If we do not need all of the oil and copper, we can sell the excess at current market prices. Even if we thought the value of oil or copper was about to plummet, the value of this investment would be unchanged. (We can always exchange them for dollars immediately at the current market prices.) Q Evaluate Since we are transacting today, only the current prices in a competitive market matter. Our own use for or opinion about the future prospects of oil or copper do not alter the value of the decision today. This decision is good for the firm and will increase its value by $3500.

Why There Can Be Only One Competitive Price for a Good The Valuation Principle and finance in general rely on using a competitive market price to value a cost or benefit. We cannot have two different competitive market prices for the same good—otherwise we would arrive at two different values. Fortunately, powerful market forces keep competitive prices the same. To illustrate, imagine what you would do

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Law of One Price In competitive markets, securities with the same cash flows must have the same price. arbitrage The practice of buying and selling equivalent goods to take advantage of a price difference. arbitrage opportunity Any situation in which it is possible to make a profit without taking any risk or making any investment.

if you saw gold simultaneously trading for two different prices. You and everyone else who noticed the difference would buy at the low price and sell at the high price for as many ounces of gold as possible, making instant risk-free profits. The flood of buy and sell orders would push the two prices together until the profit was eliminated. These forces establish the Law of One Price, which states that in competitive markets, the same good or securities must have the same price. More generally, securities that produce exactly the same cash flows must have the same price. In general, the practice of buying and selling equivalent goods in different markets to take advantage of a price difference is known as arbitrage. We refer to any situation in which it is possible to make a profit without taking any risk or making any investment as an arbitrage opportunity. Because an arbitrage opportunity’s benefits are more valuable than its costs, whenever an arbitrage opportunity appears in financial markets, investors will race to take advantage of it and their trades will eliminate the opportunity. Retail stores often quote different prices for the same item in different countries. Here, we compare prices for the iPod Shuffle as of April 2010. The price in the local currency and converted to U.S. dollars is listed. Of course, these prices are not examples of competitive market prices, because you can only buy the iPod at these prices. Hence they do not present an arbitrage opportunity. Even if shipping were free, you could buy as many Shuffles as you could get your hands on in Hong Kong but you would not necessarily be able to sell them in São Paulo for a profit. City

Local Cost

US$ Cost

HK$448 $58 Hong Kong New York $59 $59 Tokyo ¥5800 $62 London £46 $71 Melbourne A$79 $73 Frankfurt :55 $75 Brussels :55 $75 Paris :59 $80 Rome :61 $83 São Paulo R$259 $147 Sources: Apple.com for prices and Citibank for exchange rates.

Your Personal Financial Decisions While the focus of this text is on the decisions a financial manager makes in a business setting, you will soon see that concepts and skills you will learn here apply to personal decisions as well. As a normal part of life we all make decisions that trade off benefits and costs across time. Going to college, purchasing this book, saving for a new car or

Concept Check

3.3

house down payment, taking out a car loan or home loan, buying shares of stock, and deciding between jobs are just a few examples of decisions you have faced or could face in the near future. As you read through this book, you will see that the Valuation Principle is the foundation of all financial decision making—whether in a business or in a personal context.

3. How do investors’ profit motives keep competitive market prices correct? 4. How do we determine whether a decision increases the value of the firm?

The Time Value of Money and Interest Rates Unlike the examples presented so far, most financial decisions have costs and benefits that occur at different points in time. For example, typical investment projects incur costs up

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front and provide benefits in the future. In this section, we show how to account for this time difference when using the Valuation Principle to make a decision.

The Time Value of Money Consider a firm’s investment opportunity with the following cash flows: Cost: $100,000 today Benefit: $105,000 in one year

time value of money The difference in value between money received today and money received in the future; also, the observation that two cash flows at two different points in time have different values.

FIGURE 3.1 Converting Between Dollars Today and Gold or Dollars in the Future

Both are expressed in dollar terms. Are the cost and benefit directly comparable? No. Calculating the project’s net value as +105,000 - +100,000 = +5000 is incorrect because it ignores the timing of the costs and benefits. That is, it treats money today as equivalent to money in one year. Just like silver and gold, money today and money tomorrow are not the same thing. We compare them just like we did with silver and gold—using competitive market prices. But in the case of money, what is the price? It is the interest rate, the price for exchanging money today for money in a year. We can use the interest rate to determine values in the same way we used competitive market prices. In general, a dollar received today is worth more than a dollar received in one year: If you have $1 today, you can invest it now and have more money in the future. For example, if you deposit it in a bank account paying 10% interest, you will have $1.10 at the end of one year. We call the difference in value between money today and money in the future the time value of money. Today

One Year

$100,000

$105,000

$1.00

$1.10

Figure 3.1 illustrates how we use competitive market prices and interest rates to convert between dollars today and other goods, or dollars in the future. Once we quantify all the costs and benefits of an investment in terms of dollars today, we can rely on the Valuation Principle to determine whether the investment will increase the firm’s value.

We can convert dollars today to different goods or points in time by using the competitive market price or interest rate. Once values are in equivalent terms, we can use the Valuation Principle to make a decision.

Gold Price ($/oz) Ounces of Gold Today Gold Price ($/oz)

Dollars Today

with interest Dollars in One Year before interest

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The Interest Rate: Converting Cash Across Time

interest rate The rate at which money can be borrowed or lent over a given period. interest rate factor One plus the interest rate, it is the rate of exchange between dollars today and dollars in the future. It has units of “$ in the future/$ today.”

We now develop the tools needed to value our $100,000 investment opportunity correctly. By depositing money into a savings account, we can convert money today into money in the future with no risk. Similarly, by borrowing money from the bank, we can exchange money in the future for money today. The rate at which we can exchange money today for money in the future is determined by the current interest rate. In the same way that an exchange rate allows us to convert money from one currency to another, the interest rate allows us to convert money from one point in time to another. In essence, an interest rate is like an exchange rate across time: It tells us the market price today of money in the future. Suppose the current annual interest rate is 10%. By investing $1 today we can convert this $1 into $1.10 in one year. Similarly, by borrowing at this rate, we can exchange $1.10 in one year for $1 today. More generally, we define the interest rate, r, for a given period as the interest rate at which money can be borrowed or lent over that period. In our example, the interest rate is 10% and we can exchange 1 dollar today for 1 1 + .10 2 dollars in one year. In general, we can exchange 1 dollar today for 1 1 + r 2 dollars in one year, and vice versa. We refer to 1 1 + r 2 as the interest rate factor for cash flows; it defines how we convert cash flows across time, and has units of “$ in one year/$ today.” Like other market prices, the interest rate ultimately depends on supply and demand. In particular, the interest rate equates the supply of savings to the demand for borrowing. But regardless of how it is determined, once we know the interest rate, we can apply the Valuation Principle and use it to evaluate other decisions in which costs and benefits are separated in time. Value of $100,000 Investment in One Year. Let’s reevaluate the investment we considered earlier, this time taking into account the time value of money. If the interest rate is 10%, we can express the cost of the investment as: Cost = 1 +100,000 today 2 * 1 1.10 dollars in one year/1 dollar today 2 = +110,000 in one year Think of this amount as the opportunity cost of spending $100,000 today: The firm gives up the $110,000 it would have had in one year if it had left the money in the bank. Alternatively, by borrowing the $100,000 from the same bank, the firm would owe $110,000 in one year.

Investment Bank

Today

One Year

$100,000 $100,000

$105,000 $110,000

We have used a market price, the interest rate, to put both the costs and benefits in terms of “dollars in one year,” so now we can use the Valuation Principle to compare them and compute the investment’s net value by subtracting the cost of the investment from the benefit in one year: +105,000 - +110,000 = - +5000 in one year In other words, the firm could earn $5000 more in one year by putting the $100,000 in the bank rather than making this investment. Because the net value is negative, we should reject the investment: If we took it, the firm would be $5000 poorer in one year than if we didn’t.

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Value of $100,000 Investment Today. The preceding calculation expressed the value of the costs and benefits in terms of dollars in one year. Alternatively, we can use the interest rate factor to convert to dollars today. Consider the benefit of $105,000 in one year. What is the equivalent amount in terms of dollars today? That is, how much would we need to have in the bank today so we end up with $105,000 in the bank in one year? We find this amount by dividing $105,000 by the interest rate factor: Benefit = 1 +105,000 in one year 2 1 +1.10 in one year/+1 today 2 = +95,454.55 today

This is also the amount the bank would lend to us today if we promised to repay $105,000 in one year.2 Thus, it is the competitive market price at which we can “buy” or “sell” $105,000 in one year. Today Value of Cost Today Value of Benefit Today

One Year

$100,000 $95,454.55

$105,000 105,000 1.10

Now we are ready to compute the net value of the investment by subtracting the cost from the benefit: +95,454.55 - +100,000 = - +4,545.45 today Because this net value is calculated in terms of dollars today (in the present), it is typically called the net present value. We will formally introduce this concept in Chapter 8. Once again, the negative result indicates that we should reject the investment. Taking the investment would make the firm $4,545.45 poorer today because it gave up $100,000 for something worth only $95,454.55. Present Versus Future Value. This calculation demonstrates that our decision is the same whether we express the value of the investment in terms of dollars in one year or dollars today: We should reject the investment. Indeed, if we convert from dollars today to dollars in one year, present value (PV) The value of a cost or benefit computed in terms of cash today. future value (FV) The value of a cash flow that is moved forward in time.

discount factor The value today of a dollar received in the future. discount rate The appropriate rate to discount a cash flow to determine its value at an earlier time.

1 - +4545.45 today 2 * 1 +1.10 in one year/+1 today 2 = - +5000 in one year

we see that the two results are equivalent, but expressed as values at different points in time. When we express the value in terms of dollars today, we call it the present value (PV) of the investment. If we express it in terms of dollars in the future, we call it the future value (FV) of the investment. Discount Factors and Rates. In the preceding calculation, we can interpret 1 1 = = 0.90909 1 + r 1.10 as the price today of $1 in one year. In other words, for just under 91 cents, you can “buy” $1 to be delivered in one year. Note that the value is less than $1—money in the future is worth less today, so its price reflects a discount. Because it provides the discount at which we can purchase money in the future, the amount 1/ 1 1 + r 2 is called the oneyear discount factor. The interest rate is also referred to as the discount rate for an investment. 2

We are assuming the bank is willing to lend at the same 10% interest rate, which would be the case if there were no risk associated with the cash flow.

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EXAMPLE 3.4 Comparing Revenues at Different Points in Time

Problem The launch of Sony’s PlayStation 3 was delayed until November 2006, giving Microsoft’s Xbox 360 a full year on the market without competition. Imagine that it is November 2005 and you are the marketing manager for the PlayStation. You estimate that if PlayStation 3 were ready to be launched immediately, you could sell $2 billion worth of the console in its first year. However, if your launch is delayed a year, you believe that Microsoft’s head start will reduce your first-year sales by 20%. If the interest rate is 8%, what is the cost of a delay of the first year’s revenues in terms of dollars in 2005?

Solution Q Plan Revenues if released today: $2 billion

Revenue decrease if delayed: 20%

Interest rate: 8%

We need to compute the revenues if the launch is delayed and compare them to the revenues from launching today. However, in order to make a fair comparison, we need to convert the future revenues of the PlayStation if they are delayed into an equivalent present value of those revenues today. Q Execute If the launch is delayed to 2006, revenues will drop by 20% of $2 billion, or $400 million, to $1.6 billion. To compare this amount to revenues of $2 billion if launched in 2005, we must convert it using the interest rate of 8%: +1.6 billion in 2006 (+1.08 in 2006/+1 in 2005) = +1.481 billion in 2005 Therefore, the cost of a delay of one year is +2 billion - +1.481 billion = +0.519 billion (+519 million). Q Evaluate Delaying the project for one year was equivalent to giving up $519 million in cash. In this example, we focused only on the effect on the first year’s revenues. However, delaying the launch delays the entire revenue stream by one year, so the total cost would be calculated in the same way by summing the cost of delay for each year of revenues.

Timelines timeline A linear representation of the timing of (potential) cash flows.

Our visual representation of the cost and benefit of the $100,000 investment in this section is an example of a timeline, a linear representation of the timing of the expected cash flows. Timelines are an important first step in organizing and then solving a financial problem. We use them throughout this text. Constructing a Timeline. To understand how to construct a timeline, assume a friend owes you money. He has agreed to repay the loan by making two payments of $10,000 at the end of each of the next two years. We represent this information on a timeline as follows: Year 1

Year 2

Date 0 Cash Flow $0 Today

1

2

$10,000

$10,000

End Year 1

Begin Year 2

Identifying Dates on a Timeline. To track cash flows, we interpret each point on the timeline as a specific date. The space between date 0 and date 1 represents the first year of the loan. Date 0 is today, the beginning of the first year, and date 1 is the end of the first year. The $10,000 cash flow below date 1 is the payment you will receive at the end of the first year. Similarly, date 1 is the beginning of the second year, date 2 is the end of the

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second year, and the $10,000 cash flow below date 2 is the payment you will receive at the end of the second year. Note that date 1 signifies both the end of year 1 and the beginning of year 2, which makes sense since those dates are effectively the same point in time.3 Distinguishing Cash Inflows from Outflows. In this example, both cash flows are inflows. In many cases, however, a financial decision will include inflows and outflows. To differentiate between the two types of cash flows, we assign a different sign to each: Inflows (cash flows received) are positive cash flows, whereas outflows (cash flows paid out) are negative cash flows. To illustrate, suppose you have agreed to lend your brother $10,000 today. Your brother has agreed to repay this loan with interest by making payments of $6000 at the end of each of the next two years. The timeline is: Year 1 Date

0

Cash Flow $10,000

Year 2 1

2

$6000

$6000

Notice that the first cash flow at date 0 (today) is represented as –$10,000 because it is an outflow. The subsequent cash flows of $6000 are positive because they are inflows. Representing Various Time Periods. So far, we have used timelines to show the cash flows that occur at the end of each year. Actually, timelines can represent cash flows that take place at any point in time. For example, if you pay rent each month, you could use a timeline such as the one in our first example to represent two rental payments, but you would replace the “year” label with “month.” Many of the timelines included in this chapter are simple. Consequently, you may feel that it is not worth the time or trouble to construct them. As you progress to more difficult problems, however, you will find that timelines identify events in a transaction or investment that are easy to overlook. If you fail to recognize these cash flows, you will make flawed financial decisions. Therefore, approach every problem by drawing the timeline as we do in this chapter and the next.

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5. How is an interest rate like a price? 6. Is the value today of money to be received in one year higher when interest rates are high or when interest rates are low?

Valuing Cash Flows at Different Points in Time The example of the $100,000 investment in the previous section laid the groundwork for how we will compare cash flows that happen at different points in time. In this section, we will generalize from the example by introducing three important rules central to financial decision making that allow us to compare or combine values across time.

Rule 1: Comparing and Combining Values Our first rule is that it is only possible to compare or combine values at the same point in time. This rule restates a conclusion from the last section: Only cash flows in the same

3

That is, there is no real time difference between a cash flow paid at 11:59 P.M. on December 31 and one paid at 12:01 A.M. on January 1, although there may be some other differences such as taxation, which we will overlook for now.

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Part 2 Interest Rates and Valuing Cash Flows units can be compared or combined. A dollar today and a dollar in one year are not equivalent. Having money now is more valuable than having money in the future; if you have the money today you can earn interest on it.

COMMON MISTAKE

Summing Cash Flows Across Time the payments Rodriguez would receive over the ten years of the contract and an additional ten years of deferred payments— treating dollars received in 20 years the same as dollars received today. The same thing occurred when David Beckham signed a “$250 million” contract with the LA Galaxy soccer team.

Once you understand the time value of money, our first rule may seem straightforward. However, it is very common, especially for those who have not studied finance, to violate this rule, simply treating all cash flows as comparable regardless of when they are received. One example is in sports contracts. In 2007, Alex Rodriguez and the New York Yankees were negotiating what was repeatedly referred to as a “$275 million” contract. The $275 million comes from simply adding up all

To compare or combine cash flows that occur at different points in time, you first need to convert the cash flows into the same units by moving them to the same point in time. The next two rules show how to move the cash flows on the timeline.

Rule 2: Compounding Suppose we have $1000 today, and we wish to determine the equivalent amount in one year’s time. If the current market interest rate is 10%, we saw in the last section that we can use that rate as an exchange rate, meaning the rate at which we exchange money today for money in one year, to move the cash flow forward in time. That is:

1 +1000 today 2 * 1 +1.10 in one year/+1 today 2 = +1100 in one year

compounding Computing the return on an investment over a long horizon by multiplying the return factors associated with each intervening period.

In general, if the market interest rate for the year is r, then we multiply by the interest rate factor, 1 1 + r 2 , to move the cash flow from the beginning to the end of the year. We multiply by 1 1 + r 2 because at the end of the year you will have 1 1 * your original investment 2 plus interest in the amount of 1 r * your original investment 2 . This process of moving forward along the timeline to determine a cash flow’s value in the future (its future value) is known as compounding. Our second rule stipulates that to calculate a cash flow’s future value, you must compound it. We can apply this rule repeatedly. Suppose we want to know how much the $1000 is worth in two years’ time. If the interest rate for year 2 is also 10%, then we convert as we just did:

1 +1100 in one year 2 * 1 +1.10 in two years/+1 in one year 2 = +1210 in two years

Let’s represent this calculation on a timeline: 0 $1000

1 1.10

$1100

2 1.10

$1210

Chapter 3 Time Value of Money: An Introduction

FIGURE 3.2 The Composition of Interest over Time

Given a 10% interest rate, all of the cash flows—$1000 at date 0, $1100 at date 1, and $1210 at date 2—are equivalent. They have the same value but are expressed in different units (different points in time). An arrow that points to the right indicates that the value is being moved forward in time—that is, compounded. In the preceding example, $1210 is the future value of $1000 two years from today. Note that the value grows as we move the cash flow further in the future. In the last section, we defined the time value of money as the difference in value between money today and money in the future. Here, we can say that $1210 in two years is the equivalent amount to $1000 today. The reason money is more valuable to you today is that you have opportunities to invest it. As in this example, by having money sooner, you can invest it (here at a 10% return) so that it will grow to a larger amount of money in the future. Note also that the equivalent amount grows by $100 the first year, but by $110 the second year. In the second year, we earn interest on our original $1000, plus we earn interest on the $100 interest we received in the first year. This effect of earning interest on both the original principal plus the accumulated interest, so that you are earning “interest on interest,” is known as compound interest. Figure 3.2 shows how over time the amount of money you earn from interest on interest grows so that it will eventually exceed the amount of money that you earn as interest on your original deposit.

This bar graph shows how the account balance and the composition of the interest changes over time when an investor starts with an original deposit of $1000, represented by the red area, in an account earning 10% interest over a 20-year period. Note that the turquoise area representing interest on interest grows, and by year 15 has become larger than the interest on the original deposit, shown in green. By year 20, the interest on interest the investor earned is $3727.50, while the interest earned on the original $1000 is $2000.

$8000 7000 6000

Total Future Value

compound interest The effect of earning “interest on interest.”

75

Interest on interest

5000 4000 3000

Interest on the original $1000

2000 1000

Original $1000 0

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year

76

Part 2 Interest Rates and Valuing Cash Flows How does the future value change in the third year? Continuing to use the same approach, we compound the cash flow a third time. Assuming the competitive market interest rate is fixed at 10%, we get: +1000 * 1 1.10 2 * 1 1.10 2 * 1 1.10 2 = +1000 * 1 1.10 2 3 = +1331

In general, to compute a cash flow C’s value n periods into the future, we must compound it by the n intervening interest rate factors. If the interest rate r is constant, this calculation yields: Future Value of a Cash Flow FVn = C * 1 1 + r 2 * 1 1 + r 2 * g * 1 1 + r 2 = C * 1 1 + r 2 n (3.1) ('''''''')''''''''* n times

Rule of 72

Another way to think about the effect of compounding is to consider how long it will take your money to double given different interest rates. Suppose you want to know how many years it will take for $1 to grow to a future value of $2. You want the number of years, n, to solve: FVn = +1 * 1 1 + r 2 n = +2

If you solve this formula for different interest rates, you will find

the following approximation: Years to double ⬇ 72 (interest rate in percent) This simple “Rule of 72” is fairly accurate (that is, within one year of the exact doubling time) for interest rates higher than 2%. For example, if the interest rate is 9%, the doubling time should be about 72 9 = 8 years. Indeed, 1.098 = 1.99! So, given a 9% interest rate, your money will approximately double every 8 years.

Rule 3: Discounting The third rule describes how to put a value today on a cash flow that comes in the future. Suppose you would like to compute the value today of $1000 that you anticipate receiving in one year. If the current market interest rate is 10%, you can compute this value by converting units as we did in the last section:

1 +1000 in one year 2 1 +1.10 in one year/+1 today 2 = +909.09 today

discounting Finding the equivalent value today of a future cash flow by multiplying by a discount factor, or equivalently, dividing by 1 plus the discount rate.

That is, to move the cash flow back along the timeline, we divide it by the interest rate factor, 1 1 + r 2 , where r is the interest rate. This process of finding the equivalent value today of a future cash flow is known as discounting. Our third rule stipulates that to calculate the value of a future cash flow at an earlier point in time, we must discount it. Suppose that you anticipate receiving the $1000 two years from today rather than in one year. If the interest rate for both years is 10%, you can prepare the following timeline: 0 $826.45

1 1.10

$909.09

2 1.10

$1000

When the interest rate is 10%, all of the cash flows—$826.45 at date 0, $909.09 at date 1, and $1000 at date 2—are equivalent. They represent the same value in different units (different points in time). The arrow points to the left to indicate that the value is being moved backward in time or discounted. Note that the value decreases the further in the future is the original cash flow. The value of a future cash flow at an earlier point on the timeline is its present value at the earlier point in time. That is, $826.45 is the present value at date 0 of $1000 in two years. Recall from earlier that the present value is the “do-it-yourself ” price to produce a

Chapter 3 Time Value of Money: An Introduction

77

future cash flow. Thus, if we invested $826.45 today for two years at 10% interest, we would have a future value of $1000, using the second rule of valuing cash flows: 0

1

$826.45

1.10

2

$909.09

1.10

$1000

Suppose the $1000 were three years away and you wanted to compute the present value. Again, if the interest rate is 10%, we have: 0 $751.31

1 1.10

2 1.10

3 1.10

$1000

That is, the present value today of a cash flow of $1000 in three years is given by:

+1000 1 1.10 2 1 1.10 2 1 1.10 2 = +1000 1 1.10 2 3 = +751.31

In general, to compute the present value of a cash flow C that comes n periods from now, we must discount it by the n intervening interest rate factors. If the interest rate r is constant, this yields: Present Value of a Cash Flow C PV = C 1 1 + r 2 n = 11 + r2n Personal Finance

EXAMPLE 3.5 Present Value of a Single Future Cash Flow

(3.2)

Problem You are considering investing in a savings bond that will pay $15,000 in ten years. If the competitive market interest rate is fixed at 6% per year, what is the bond worth today?

Solution Q Plan First, set up your timeline. The cash flows for this bond are represented by the following timeline:

0

1

2

9

10

... $15,000 Thus, the bond is worth $15,000 in ten years. To determine the value today, we compute the present value using Equation 3.2 and our interest rate of 6%. Q Execute PV =

15,000 = +8375.92 today 1.0610

Q Evaluate The bond is worth much less today than its final payoff because of the time value of money.

As we’ve seen in this section, we can compare cash flows at different points in time as long as we follow the Three Rules of Valuing Cash Flows, summarized in Table 3.1. Armed with these three rules, a financial manager can compare an investment’s costs and benefits that are spread out over time and apply the Valuation Principle to make the right decision. In the next chapter, we will show you how to apply these rules to situations involving multiple cash flows at different points in time.

78

Part 2 Interest Rates and Valuing Cash Flows

TABLE 3.1 The Three Rules of Valuing Cash Flows

Rule

Formula

1: Only values at the same point in time can be compared or combined.

None

2: To calculate a cash flow’s future value, we must compound it.

Future value of a cash flow: FVn = C * (1 + r )n

3: To calculate the present value of a future cash flow, we must discount it.

Present value of a cash flow: PV = C (1 + r )n =

C (1 + r )n

Using a Financial Calculator Financial calculators are programmed to perform most present and future value calculations. However, we recommend that you develop an understanding of the formulas before using the shortcuts. We provide a more extensive discussion of financial calculators on page 88 and in the appendix to Chapter 4, but we’ll cover the relevant functions for this chapter here. To use financial calculator functions, you always enter the known values first and then the calculator solves for the unknown. To answer Example 3.5 with a financial calculator, do the following:

Concept Calculator Key Enter

Interest Rate per Period I/Y 6

Number of Periods N 10

Recurring Payments PMT 0

Future Value FV 15000

Because you are solving for the present value (PV), press the PV key last (on an HP calculator), or press CPT then the PV key on a TI calculator. The calculator will return -8375.92. Note that the calculator balances inflows with outflows, so because the FV is positive (an inflow), it returns the PV as a negative (an outflow). If you were solving for the future value instead, you would enter:

N 10 And finally, on an HP press the

Concept Check

FV

I/Y 6 key or on a TI, press

PV 8375.92 CPT

PMT 0

and then the

FV

key.

7. Can you compare or combine cash flows at different times? 8. What do you need to know to compute a cash flow’s present or future value?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

Online Practice Opportunities

3.1 Cost-Benefit Analysis Q To evaluate a decision, we must value the incremental costs and benefits associated with that decision. A good decision is one for which the value of the benefits exceeds the value of the costs.

competitive market, p. 65

MyFinanceLab Study Plan 3.1

Chapter 3 Time Value of Money: An Introduction

79

Q To compare costs and benefits that occur at different points in time we must put all costs and benefits in common terms. Typically, we convert costs and benefits into cash today. Q A competitive market is one in which a good can be bought and sold at the same price. We use prices from competitive markets to determine the cash value of a good. 3.2 Market Prices and the Valuation Principle Q Arbitrage is the process of trading to take advantage of equivalent goods that have different prices in different competitive markets. Q If equivalent goods or securities trade simultaneously in different competitive markets, they will trade for the same price in each market. This is equivalent to saying that no arbitrage opportunities should exist. Q The Valuation Principle states that the value of a commodity or an asset to the firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using those market prices. When the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm.

arbitrage, p. 68 arbitrage opportunity, p. 68 Law of One Price, p. 68 Valuation Principle, p. 67

MyFinanceLab Study Plan 3.2

3.3 The Time Value of Money and Interest Rates Q The time value of money is the difference in value between money today and money in the future. Q The rate at which we can exchange money today for money in the future by borrowing or investing is the current market interest rate. Q The present value (PV) of a cash flow is its value in terms of cash today. Q Timelines are a critical first step in organizing the cash flows in a financial problem.

discount factor, p. 71 discount rate, p. 71 future value (FV), p. 71 interest rate, p. 70 interest rate factor, p. 70 present value (PV), p. 71 time value of money, p. 69 timeline, p. 72

MyFinanceLab Study Plan 3.3

3.4 Valuing Cash Flows at Different Points in Time Q There are three rules of valuing cash flows: a. Only cash flows that occur at the same point in time can be compared or combined. b. To calculate a cash flow’s future value, you must compound it. c. To calculate a cash flow’s present value, you must discount it. Q The future value in n years of a cash flow C today is: (3.1) C * 11 + r2n Q The present value today of a cash flow C received in n years is: C 11 + r2n (3.2)

compounding, p. 74 compound interest, p. 75 discounting, p. 76

MyFinanceLab Study Plan 3.4 Financial Calculator Tutorials: Calculating the Future Value of a Lump Sum and Solving for the Present Value of a Single Future Cash Flow

80

Part 2 Interest Rates and Valuing Cash Flows

Critical Thinking

1. What makes an investment decision a good one? 2. How important are our personal preferences in valuing an investment decision? 3. Why are market prices useful to a financial manager? 4. Why is arbitrage important to competitive market prices? 5. How does the Valuation Principle help a financial manager make decisions? 6. Can we directly compare dollar amounts received at different points in time? 7. Why is a cash flow in the future worth less than the same amount today? 8. What is a discount rate? 9. What is compound interest? 10. What is the intuition behind the geometric growth in interest?

Problems

All Problems are available in MyFinanceLab. An asterisk * indicates Problems with a higher level of difficulty. Cost-Benefit Analysis 1. Honda Motor Company is considering offering a $2000 rebate on its minivan, lowering the vehicle’s price from $30,000 to $28,000. The marketing group estimates that this rebate will increase sales over the next year from 40,000 to 55,000 vehicles. Suppose Honda’s profit margin with the rebate is $6000 per vehicle. If the change in sales is the only consequence of this decision, what are its costs and benefits? Is it a good idea? 2. You are an international shrimp trader. A food producer in the Czech Republic offers to pay you 2 million Czech koruna today in exchange for a year’s supply of frozen shrimp. Your Thai supplier will provide you with the same supply for 3 million Thai baht today. If the current competitive market exchange rates are 25.50 koruna per dollar and 41.25 baht per dollar, what is the value of this exchange to you? 3. Suppose your employer offers you a choice between a $5000 bonus and 100 shares of the company’s stock. Whichever one you choose will be awarded today. The stock is currently trading for $63 per share. a. Suppose that if you receive the stock bonus, you are free to trade it. Which form of the bonus should you choose? What is its value? b. Suppose that if you receive the stock bonus, you are required to hold it for at least one year. What can you say about the value of the stock bonus now? What will your decision depend on? 4. Suppose Big Bank offers an interest rate of 5.5% on both savings and loans, and Bank Enn offers an interest rate of 6% on both savings and loans. a. What profit opportunity is available? b. Which bank would experience a surge in the demand for loans? Which bank would receive a surge in deposits? c. What would you expect to happen to the interest rates the two banks are offering? 5. If the cost of buying a CD and ripping the tracks to your iPod (including your time) is $25, what is the most Apple could charge on iTunes for a whole 15-track CD? 6. Some companies cross-list their shares, meaning that their stock trades on more than one stock exchange. For example, Research In Motion, the maker of BlackBerry

Chapter 3 Time Value of Money: An Introduction

81

mobile devices, trades on both the Toronto Stock Exchange and NASDAQ. If its price in Toronto is 50 Canadian dollars per share and anyone can exchange Canadian dollars for U.S. dollars at the rate of US$0.95 per C$1.00, what must RIM’s price be on NASDAQ? Market Prices and the Valuation Principle 7. Bubba is a shrimp farmer. In an ironic twist, Bubba is allergic to shellfish, so he cannot eat any shrimp. Each day he has a one-ton supply of shrimp. The market price of shrimp is $10,000 per ton. a. What is the value of a ton of shrimp to him? b. Would this value change if he were not allergic to shrimp? Why or why not? 8. Brett has almond orchards, but he is sick of almonds and prefers to eat walnuts instead. The owner of the walnut orchard next door has offered to swap this year’s crop with him. Assume he produces 1000 tons of almonds and his neighbor produces 800 tons of walnuts. If the market price of almonds is $100 per ton and the market price of walnuts is $110 per ton: a. Should he make the exchange? b. Does it matter whether he prefers almonds or walnuts? Why or why not? The Time Value of Money and Interest Rates 9. You have $100 and a bank is offering 5% interest on deposits. If you deposit the money in the bank, how much will you have in one year? 10. You expect to have $1000 in one year. A bank is offering loans at 6% interest per year. How much can you borrow today? 11. A friend asks to borrow $55 from you and in return will pay you $58 in one year. If your bank is offering a 6% interest rate on deposits and loans: a. How much would you have in one year if you deposited the $55 instead? b. How much money could you borrow today if you pay the bank $58 in one year? c. Should you loan the money to your friend or deposit it in the bank? 12. You plan to borrow $1000 from a bank. In exchange for $1000 today, you promise to pay $1080 in one year. What does the cash flow timeline look like from your perspective? What does it look like from the bank’s perspective? Valuing Cash Flows at Different Points in Time 13. Suppose the interest rate is 4%. a. Having $200 today is equivalent to having what amount in one year? b. Having $200 in one year is equivalent to having what amount today? c. Which would you prefer, $200 today or $200 in one year? Does your answer depend on when you need the money? Why or why not? 14. Consider the following alternatives: i. $100 received in one year ii. $200 received in 5 years iii. $300 received in 10 years a. Rank the alternatives from most valuable to least valuable if the interest rate is 10% per year. b. What is your ranking if the interest rate is only 5% per year? c. What is your ranking if the interest rate is 20% per year?

82

Part 2 Interest Rates and Valuing Cash Flows *15. Suppose you invest $1000 in an account paying 8% interest per year. a. What is the balance in the account after 3 years? How much of this balance corresponds to “interest on interest”? b. What is the balance in the account after 25 years? How much of this balance corresponds to “interest on interest”? 16. Calculate the future value of $2000 in a. 5 years at an interest rate of 5% per year. b. 10 years at an interest rate of 5% per year. c. 5 years at an interest rate of 10% per year. *d. Why is the amount of interest earned in part (a) less than half the amount of interest earned in part (b)? 17. What is the present value of $10,000 received a. 12 years from today when the interest rate is 4% per year? b. 20 years from today when the interest rate is 8% per year? c. 6 years from today when the interest rate is 2% per year? 18. Your brother has offered to give you either $5000 today or $10,000 in 10 years. If the interest rate is 7% per year, which option is preferable? 19. Your cousin is currently 12 years old. She will be going to college in 6 years. Your aunt and uncle would like to have $100,000 in a savings account to fund her education at that time. If the account promises to pay a fixed interest rate of 4% per year, how much money do they need to put into the account today to ensure that they will have $100,000 in 6 years? 20. Your mom is thinking of retiring. Her retirement plan will pay her either $250,000 immediately on retirement or $350,000 five years after the date of her retirement. Which alternative should she choose if the interest rate is a. 0% per year? b. 8% per year? c. 20% per year? 21. You are planning to invest $5000 in an account earning 9% per year for retirement. a. If you put the $5000 in an account at age 23, and withdraw it 42 years later, how much will you have? b. If you wait 10 years before making the deposit, so that it stays in the account for only 32 years, how much will you have at the end? *22. Your grandfather put some money in an account for you on the day you were born. You are now 18 years old and are allowed to withdraw the money for the first time. The account currently has $3996 in it and pays an 8% interest rate. a. How much money would be in the account if you left the money there until your twenty-fifth birthday? b. What if you left the money until your sixty-fifth birthday? c. How much money did your grandfather originally put in the account?

Time Value of Money: Valuing Cash Flow Streams

4

LEARNING OBJECTIVES Q Value a series of many cash flows Q Value a perpetual series of regular cash flows called a perpetuity Q Value a common set of regular cash flows called an annuity

notation

C

cash flow

Cn

cash flow at date n

FV

future value

FVn

future value on date n

g

growth rate

Q Value both perpetuities and annuities when the cash flows grow at a constant rate Q Compute the number of periods, cash flow, or rate of return of a loan or investment

N

date of the last cash flow in a stream of cash flows

P

initial principal or deposit, or equivalent present value

PV

present value

r

interest rate or rate of return

83

INTERVIEW WITH

Gregory Goin McFee Financial Group

After receiving his degree in finance and marketing from Iowa State University in 2010, Gregory Goin joined McFee Financial Group in Minneapolis, Minnesota, a private wealth management firm. As Manager of Private Client Relations, he assists in reviewing client investment portfolios, researching new investment opportunities, and preparing client presentations. “We help our clients set goals and develop appropriate investment strategies to achieve them, including bonds, dividend-paying stocks, or stocks in companies with high growth potential,” he says. The financial plan McFee proposes takes into account the client’s age, risk tolerance, how much he or she needs for each goal, and the timeframe to accumulate the funds. “The key is to invest regularly and to reinvest the income so that your money grows even faster, thanks to compounding and time value of money.” One of the tools Greg uses to develop an investment plan for a client is time value of money (TVM). “TVM illustrates the profound impact that compounding has on your ability to achieve your future financial goals,” he says. “It tells you how much to save to reach those goals and also the impact of different rates of return. Assume that you want to buy a house in seven years and need a down payment of $35,000. TVM calculations show you how much to save each month: If you earn 5% a year on your funds, it’s about $350 a month; 7%, $325; 3%, $375.” In today’s volatile market environment, rates of return on securities are much harder to predict. “This has changed people’s view on financial planning, because the assumption of long-term savings now is a return of money (capital preservation) versus a return on money,” says Greg. Most investment professionals agree that future returns will not approach historical returns, so investors must lower their expectations. “When the actual rates of return you can earn are lower than you projected, you must invest more to reach your financial targets. This may require making lifestyle changes and lowering your standard of living to achieve financial independence.” With TVM, Greg can help McFee’s clients find realistic savings plans that will achieve their goals.

As we discussed in Chapter 3, to evaluate a project a financial manager must compare its costs and benefits. In most cases, the cash flows in financial investments involve more than one future period. Thus, the financial manager is faced with the task of trading off a known upfront cost against a series of uncertain future benefits. We learned to value those costs and benefits by computing their cash value today—their present values. In financial management, as well as your personal finances, you will need to evaluate series of cash flows occurring across time. In this chapter, we build on the tools we developed in Chapter 3 to value any series of cash flows. We will develop shortcuts for valuing annuities, perpetuities, and other special cases of assets with cash flows that follow regular patterns. In Chapter 5, we will learn how interest rates are quoted and determined. Once we understand how interest rates are quoted, it will be straightforward to extend the tools of this chapter to cash flows that occur more frequently than once per year.

84

Iowa State University, 2010

“Time value of money tells you how much to save to reach your future financial goals, and also the impact of different rates of return.”

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

4.1 stream of cash flows A series of cash flows lasting several periods.

85

Valuing a Stream of Cash Flows We refer to a series of cash flows lasting several periods as a stream of cash flows. As with single cash flows, we can represent a stream of cash flows on a timeline. In this chapter we will continue to use timelines and the rules of cash flow valuation introduced in Chapter 3 to organize and then solve financial problems.

Applying the Rules of Valuing Cash Flows to a Cash Flow Stream Most investment opportunities have multiple cash flows that occur at different points in time. In Chapter 3, we learned the rules to value such cash flows: Rule 1: Only values at the same point in time can be compared or combined. Rule 2: To calculate a cash flow’s future value, we must compound it using Eq. 3.1 from Chapter 3. (4.1) FVn = C * 1 1 + r 2 n Rule 3: To calculate the present value of a future cash flow, we must discount it using Eq. 3.2 of Chapter 3. C PV = C 1 1 + r 2 n = (4.2) 11 + r2n The rules of cash flow valuation allow us to compare and combine cash flows that occur at different points in time. Suppose we plan to save $1000 today and $1000 at the end of each of the next two years. If we earn a fixed 10% interest rate on our savings, how much will we have three years from today? Again, we start with a timeline: 0

1

2

3

$1000

$1000

$1000

?

The timeline shows the three deposits we plan to make. We need to compute their value at the end of three years. We can use the cash flow valuation rules in a number of ways to solve this problem. First, we can take the deposit at date 0 and move it forward to date 1. Because it is then in the same time period as the date 1 deposit, we can combine the two amounts to find out the total in the bank on date 1: 0

1

2

3

$1000

$1000

$1000

?

1.10

$1100 $2100

Using the first two rules, we find that our total savings on date 1 will be $2100. Continuing in this fashion, we can solve the problem as follows: 0

1

2

$1000

$1000

$1000

1.10

3

$1100 $2100 1.10

$2310 $3310 1.10

$3641

Part 2 Interest Rates and Valuing Cash Flows The total amount we will have in the bank at the end of three years is $3641. This amount is the future value of our $1000 savings deposits. Another approach to the problem is to compute the future value in year 3 of each cash flow separately. Once all three amounts are in year 3 dollars, we can then combine them. 0

1

$1000

2

1.10

$1000

3

1.10

1.10

1.10

1.10

$1000

$1331 $1210 $1100 $3641

1.10

Both calculations give the same future value of $3641. As long as we follow the rules, we get the same result. The order in which we apply the rules does not matter. The calculation we choose depends on which is more convenient for the problem at hand. Now we formalize this approach by deriving a general formula for valuing a stream of cash flows. Consider a stream of cash flows: C0 at date 0, C1 at date 1, and so on, up to CN at date N. We represent this cash flow stream on a timeline as follows: 0

1

2

N ...

C0

C1

C2

CN

Using the rules of cash flow valuation, we compute the present value of this cash flow stream in two steps. First, we compute the present value of each individual cash flow. Then, once the cash flows are in common units of dollars today, we can combine them. For a given interest rate r, we represent this process on the timeline as follows: 1

0

2

N ...

C0

C2

C1

C1 —–—– (1 r)

CN

(1 r)

C2 —–—— (1 r)2

(1 r)2

...

86

CN (1 r)N

————–—

C0

(1 r)N

C1 C2 CN —–—— —–—— . . . ———–—— (1 r) (1 r) 2 (1 r)N

This timeline provides the general formula for the present value of a cash flow stream: PV = C0 +

C1 C2 CN + + g + 11 + r2 11 + r22 11 + r2N

(4.3)

That is, the present value of the cash flow stream is the sum of the present values of each cash flow. Recall from Chapter 3 that we defined the present value as the dollar amount you would need to invest today to produce the single cash flow in the future. The same

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

87

idea holds in this context. The present value is the amount you need to invest today to generate the cash flows stream C0 , C1 , p , CN . That is, receiving those cash flows is equivalent to having their present value in the bank today. Personal Finance

EXAMPLE 4.1 Present Value of a Stream of Cash Flows

Problem You have just graduated and need money to buy a new car. Your rich Uncle Henry will lend you the money so long as you agree to pay him back within four years, and you offer to pay him the rate of interest that he would otherwise get by putting his money in a savings account. Based on your earnings and living expenses, you think you will be able to pay him $5000 in one year, and then $8000 each year for the next three years. If Uncle Henry would otherwise earn 6% per year on his savings, how much can you borrow from him?

Solution Q Plan The cash flows you can promise Uncle Henry are as follows: 0

1

2

3

4

$5000

$8000

$8000

$8000

How much money should Uncle Henry be willing to give you today in return for your promise of these payments? He should be willing to give you an amount that is equivalent to these payments in present value terms. This is the amount of money that it would take him to produce these same cash flows. We will (1) solve the problem using Equation 4.3 and then (2) verify our answer by calculating the future value of this amount. Q Execute 1. We can calculate the PV as follows: 5000 8000 8000 8000 + + + 1.06 1.062 1.063 1.064 = 4716.98 + 7119.97 + 6716.95 + 6336.75

PV =

= +24,890.65 Now suppose that Uncle Henry gives you the money, and then deposits your payments to him in the bank each year. How much will he have four years from now? We need to compute the future value of the annual deposits. One way to do so is to compute the bank balance each year: 0

1

2

3

4

$5000

$8000

$8000

$8000

1.06

$5300 $13,300

1.06

$14,098 $22,098

1.06

$23,423.88 $31,423.88

2. To verify our answer, suppose your uncle kept his $24,890.65 in the bank today earning 6% interest. In four years he would have: FV = +24,890.65 * 1 1.06 2 4 = +31,423.87 in 4 years

We get the same answer both ways (within a penny, which is because of rounding). Q Evaluate Thus, Uncle Henry should be willing to lend you $24,890.65 in exchange for your promised payments. This amount is less than the total you will pay him 1 +5000 + +8000 + +8000 + +8000 = +29,000 2 due to the time value of money.

88

Part 2 Interest Rates and Valuing Cash Flows Example 4.1 illustrates that if you want to compute the future value of a stream of cash flows, you can do it directly (the first approach used in Example 4.1), or you can first compute the present value and then move it to the future (the second approach). As always, we use Eq. 4.1 to calculate the future value of any present value. Because we obey the rules of valuing cash flows in both cases, we get the same result.

Using a Financial Calculator: Solving for Present and Future Values of Cash Flow Streams So far, we have used formulas to compute present values and future values of cash flow streams. As we discussed at the end of Chapter 3, both financial calculators and spreadsheets have these formulas pre-programmed to quicken the process. In this box, we focus on financial calculators, but spreadsheets such as Excel have very similar shortcut functions. Financial calculators have a set of functions that perform the calculations that finance professionals do most often. The functions are all based on the following timeline, which among other things can handle most types of loans: 0

1

2

NPER ...

PV

PMT

PMT FV

PMT

There are a total of five variables: number of periods (N or NPER ), present value (PV ), cash flow or “payment” (PMT ), future value (FV ), and the interest rate, denoted I/Y. Each function takes four of these variables as inputs and returns the value of the fifth one that ensures that the sum of the present value of the cash flows is zero. By setting the recurring payments equal to 0, you could compute present and future values of single cash flows such as we have done above using Equations 4.2 and 4.1. In the examples in Sections 4.2 through 4.4, we will calculate cash flows using the [PMT] button. The best way to learn to use a financial calculator is by practicing. We present one example below. We will also show the calculator buttons for any additional examples in this chapter that can be solved with financial calculator functions. Finally, the appendix to this chapter contains step-by-step instructions for using the two most popular financial calculators. Example Suppose you plan to invest $20,000 in an account paying 8% interest. You will invest an additional $1000 at the end of each year for 15 years. How much will you have in the account in 15 years? We represent this problem with the following timeline: 0

1

2 ...

PV $20,000

PMT $1000

NPER 15

$1000

FV ?

To compute the solution, we enter the four variables we know, N = 15, I/Y = 8, PV = -20,000, PMT = - +1000, and solve for the one we want to determine: FV. Specifically, for the HP-10BII or TI-BAII Plus calculators: 1. 2. 3. 4. 5.

Enter 15 and press the [N] button. Enter 8 and press the [I/Y] button ([I/YR] for the HP calculator). Enter -20,000 and press the [PV] button. Enter -$1000 and press the [PMT] button. Press the [FV] button (for the Texas Instruments calculator, press [CPT] and then [FV]).

Given: Solve for:

N 15

I/Y 8

PV 20,000

PMT 1000

FV 90,595.50

Excel Formula: FV(0.08,15,1000,20000) The calculator then shows a future value of $90,595.50. Note that we entered PV and PMT as negative numbers (the amounts we are putting into the bank), and FV is shown as a positive number (the amount we can take out of the bank). It is important to use signs correctly to indicate the direction in which the money is flowing when using the calculator functions. You will see more examples of getting the sign of the cash flows correct throughout the chapter. Excel has the same functions, but it calls “N,” “NPER” and “I/Y,” “RATE”. Also, it is important to note that you enter an interest rate of 8% as “8” in a financial calculator, but as “0.08” in Excel.

Chapter 4 Time Value of Money: Valuing Cash Flow Streams Personal Finance

EXAMPLE 4.2 Computing the Future Value

89

Problem Let’s revisit the savings plan we considered earlier: We plan to save $1000 today and at the end of each of the next two years. At a fixed 10% interest rate, how much will we have in the bank three years from today?

Solution Q Plan We’ll start with the timeline for this savings plan: 0

1

2

3

$1000

$1000

$1000

?

Let’s solve this problem in a different way than we did in the text, while still following the rules we established. First we’ll compute the present value of the cash flows. Then we’ll compute its value three years later (its future value). Q Execute There are several ways to calculate the present value of the cash flows. Here, we treat each cash flow separately and then combine the present values. 0 1 2 3

$1000 $909.09 $826.45 $2735.54

$1000

$1000

?

1.10 1.102

Saving $2735.54 today is equivalent to saving $1000 per year for three years. Now let’s compute future value in year 3 of that $2735.54: 0

1

2

3

$2735.54 1.103

$3641

Q Evaluate This answer of $3641 is precisely the same result we found earlier. As long as we apply the three rules of valuing cash flows, we will always get the correct answer.

Concept Check

4.2

perpetuity A stream of equal cash flows that occurs at regular intervals and lasts forever. consol A bond that promises its owner a fixed cash flow every year, forever.

1. How do you calculate the present value of a cash flow stream? 2. How do you calculate the future value of a cash flow stream?

Perpetuities The formulas we have developed so far allow us to compute the present or future value of any cash flow stream. In this section and the next one, we consider two types of cash flow streams, perpetuities and annuities, and learn shortcuts for valuing them. These shortcuts are possible because the cash flows follow a regular pattern.

Perpetuities A perpetuity is a stream of equal cash flows that occur at regular intervals and last forever. One example is the British government bond called a consol (or perpetual bond ). Consol bonds promise the owner a fixed cash flow every year, forever.

90

Part 2 Interest Rates and Valuing Cash Flows Here is the timeline for a perpetuity: 0

1

2

3 ...

C

C

C

Note from the timeline that the first cash flow does not occur immediately; it arrives at the end of the first period. This timing is sometimes referred to as payment in arrears and is a standard convention in loan payment calculations and elsewhere, so we adopt it throughout this text. Using the formula for the present value, the present value of a perpetuity with payment C and interest rate r is given by: C C C + + + g PV = 11 + r2 11 + r22 11 + r23 Notice that all the cash flows (C in the formula) are the same because the cash flow for a perpetuity is constant. Also, because the first cash flow is in one period, there is no cash flow at time 0 1 C0 = 0 2 . To find the value of a perpetuity by discounting one cash flow at a time would take forever—literally! You might wonder how, even with a shortcut, the sum of an infinite number of positive terms could be finite. The answer is that the cash flows in the future are discounted for an ever-increasing number of periods, so their contribution to the sum eventually becomes negligible. To derive the shortcut, we calculate the value of a perpetuity by creating our own perpetuity. The Valuation Principle tells us that the value of a perpetuity must be the same as the cost we incurred to create our own identical perpetuity. To illustrate, suppose you could invest $100 in a bank account paying 5% interest per year forever. At the end of one year, you will have $105 in the bank—your original $100 plus $5 in interest. Suppose you withdraw the $5 interest and reinvest the $100 for a second year. Again, you will have $105 after one year, and you can withdraw $5 and reinvest $100 for another year. By doing this year after year, you can withdraw $5 every year in perpetuity: 0

1

2

3 ...

$100

$105 $100

$105 $100

$105 $100

$5

$5

$5

By investing $100 in the bank today, you can, in effect, create a perpetuity paying $5 per year. Because the bank will “sell” us (allow us to create) the perpetuity for $100, the present value of the $5 per year in perpetuity is this “do-it-yourself” cost of $100. Now let’s generalize this argument. Suppose we invest an amount P in a bank account with an interest rate r. Every year we can withdraw the interest we have earned, C = r * P, leaving the principal, P, in the bank. Because our cost for creating the perpetuity is only the initial investment of principal (P), the value of receiving C in perpetuity is therefore the upfront cost P. Rearranging C = r * P to solve for P we have P = C/r. Therefore: Present Value of a Perpetuity PV 1 C in perpetuity 2 =

C r

(4.4)

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

91

C C By depositing the amount today, we can withdraw interest of * r = C each period r r in perpetuity. Note the logic of our argument. To determine the present value of a cash flow stream, we computed the “do-it-yourself” cost of creating those same cash flows at the bank. This is an extremely useful and powerful approach—and is much simpler and faster than summing those infinite terms!1

Historical Examples of Perpetuities Perpetual bonds were some of the first bonds ever issued. The oldest perpetuities that are still making interest payments were issued by the Hoogheemraadschap Lekdijk Bovendams, a seventeenthcentury Dutch water board responsible for upkeep of the local dikes. The oldest bond dates from 1624. Two finance professors at Yale University, William Goetzmann and Geert Rouwenhorst, personally verified that these bonds continue to pay interest. On behalf of Yale, they purchased one of these bonds on July 1, 2003, and collected 26 years of back interest. On its issue date in 1648, this bond originally paid interest in Carolus guilders.

Personal FInance

Over the next 355 years, the currency of payment changed to Flemish pounds, Dutch guilders, and most recently euros. Recently, the bond was paying interest of :11.34 annually. Although the Dutch bonds are the oldest perpetuities still in existence, the first perpetuities date from much earlier times. For example, cencus agreements and rentes, which were forms of perpetuities and annuities, were issued in the twelfth century in Italy, France, and Spain. They were initially designed to circumvent the usury laws of the Catholic Church: Because they did not require the repayment of principal, in the eyes of the church they were not considered loans.

Problem

EXAMPLE 4.3

You want to endow an annual graduation party at your alma mater. You want the event to be a memorable one, so you budget $30,000 per year forever for the party. If the university earns 8% per year on its investments, and if the first party is in one year’s time, how much will you need to donate to endow the party?

Endowing a Perpetuity

Solution Q Plan The timeline of the cash flows you want to provide is: 0 1

2

3 ...

$30,000

$30,000

$30,000

This is a standard perpetuity of $30,000 per year. The funding you would need to give the university in perpetuity is the present value of this cash flow stream. Q Execute Use the formula for a perpetuity: PV = C/r = +30,000/0.08 = +375,000 today Q Evaluate If you donate $375,000 today, and if the university invests it at 8% per year forever, then the graduates will have $30,000 every year for their graduation party.

1

Another mathematical derivation of this result exists (see the online appendix), but it is less intuitive.

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Part 2 Interest Rates and Valuing Cash Flows

COMMON MISTAKE

Discounting One Too Many Times flows occur regularly. From the perspective of date 1, this is a perpetuity, and we can apply the formula. From the preceding calculation, we know we need $375,000 on date 1 to have enough to start the parties on date 2. We rewrite the timeline as follows: 0 1 2 3 ... $375,000 $30,000 $30,000

The perpetuity formula assumes that the first payment occurs at the end of the first period (at date 1). Sometimes perpetuities have cash flows that start later. In this case, we can adapt the perpetuity formula to compute the present value, but we need to do so carefully to avoid a common mistake. To illustrate, consider the graduation party described in Example 4.3. Rather than starting in one year, suppose the first party will be held two years from today. How would this delay change the amount of the donation required? Now the timeline looks like this: 0 1 2 3 ... $30,000 $30,000

Our goal can now be restated more simply: How much do we need to invest today to have $375,000 in one year? This is a simple present value calculation: PV = +375,000/1.08 = +347,222 today A common mistake is to discount the $375,000 twice because the first party is in two periods. Remember—the present value formula for the perpetuity already discounts the cash flows to one period prior to the first cash flow. Keep in mind that this common mistake may be made with perpetuities, annuities, and all the other special cases discussed in this chapter. All these formulas discount the cash flows to one period prior to the first cash flow.

We need to determine the present value of these cash flows, as it tells us the amount of money needed in the bank today to finance the future parties. We cannot apply the perpetuity formula directly, however, because these cash flows are not exactly a perpetuity as we defined it. Specifically, the cash flow in the first period is “missing.” But consider the situation on date 1— at that point, the first party is one period away and then the cash

Concept Check

4.3 annuity A stream of equal cash flows arriving at a regular interval and ending after specified time period.

3. What are some examples of perpetuities? 4. What is the intuition behind the fact that an infinite stream of cash flows has a finite present value?

Annuities An annuity is a stream consisting of a fixed number of equal cash flows paid at regular intervals. So the difference between an annuity and a perpetuity is that an annuity ends after some fixed number of payments whereas a perpetuity continues forever. Most car loans, mortgages, and some bonds are annuities. We represent the cash flows of an annuity on a timeline as follows: 0

1

2

N ...

C

C

C

Note that just as with the perpetuity, we adopt the convention that the first payment takes place at date 1, one period from today. The present value of an N-period annuity with payment C and interest rate r is: PV =

C C C C + + + g + 11 + r2 11 + r22 11 + r23 11 + r2N

Present Value of an Annuity To find a simpler formula, we use the same approach we followed with the perpetuity: find a way to create your own annuity. To illustrate, suppose you invest $100 in a bank account paying 5% interest. At the end of one year, you will have $105 in the bank—your original $100 plus $5 in interest. Using the same strategy as you did for calculating the value of a perpetuity, suppose you withdraw the $5 interest and reinvest the $100 for a second year. Once again you will have $105 after one year. You can repeat the process, withdrawing $5

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

93

and reinvesting $100, every year. For a perpetuity, you left the principal in the bank forever. Alternatively, you might decide after 20 years to close the account and withdraw the principal. In that case, your cash flows will look like this: 0

1

2

20 ...

$100

$105 $100

$105 $100

$105

$5

$5

$5 $100

With your initial $100 investment, you have created a 20-year annuity of $5 per year, plus you will receive an extra $100 at the end of 20 years. The Valuation Principle’s Law of One Price tells us that things that produce exactly the same cash flows must have the same value. Because it only took an initial investment of $100 to create the cash flows on the timeline, the present value of these cash flows is $100, or: +100 = PV 1 [email protected] annuity of +5 per year 2 + PV 1 +100 in 20 years 2

So if we invest $100 now, we can receive $5 per year for 20 years as well as $100 in the 20th year, representing the following cash flows: 0

1

2

20 ...

$100

$5

$5 $100

$5

Rearranging the equation above shows that the cost of a 20-year annuity of $5 per year is $100 minus the present value of $100 in 20 years. PV 1 [email protected] annuity of +5 per year 2 = +100 - PV 1 +100 in 20 years 2 +100 = +100 = +100 - +37.69 = +62.31 1 1.05 2 20 0

1

20

2 ...

$100

$5

$5 $100

$5

Removing the $100 in 20 years and its present value ($37.69) leaves the following cash flows: $62.31

$5

$5

...

$5

So the present value of $5 for 20 years is $62.31. Intuitively, the value of the annuity is the initial investment in the bank account minus the present value of the principal that will be left in the account after 20 years. The $5 we receive every year is the interest on the $100 and can be written as +100 1 .05 2 = +5. Rearranging this equation, we have +100 = +5/.05. If we substitute $5/.05 into our formula above, we can represent the PV of the annuity as a function of its cash flow ($5), the discount rate (5%) and the number of years (20): C N +5 +5 .05 +5 1 PV 1 [email protected] annuity of +5 per year 2 = = ¢1 ≤ .05 .05 1 1.05 2 20 1 1.05 2 20 = +5 *

1 1 ≤ ¢1 .05 1 1.05 2 20 r

94

Part 2 Interest Rates and Valuing Cash Flows This method is very useful because we will most often want to know the PV of the annuity given its cash flow, discount rate, and number of years. We can write this as a general formula for the present value of an annuity of C for N periods: Present Value of an Annuity PV 1 annuity of C for N periods with interest rate r 2 = C * Personal Finance

1 1 ≤ (4.5) ¢1 r 11 + r2N

Problem

EXAMPLE 4.4

You are the lucky winner of the $30 million state lottery. You can take your prize money either as (a) 30 payments of $1 million per year (starting today), or (b) $15 million paid today. If the interest rate is 8%, which option should you take?

Present Value of a Lottery Prize Annuity

Solution Q Plan Option (a) provides $30 million in prize money but paid over time. To evaluate it correctly, we must convert it to a present value. Here is the timeline:

0

1

2

29 ...

$1 million

$1 million

$1 million

$1 million

Because the first payment starts today, the last payment will occur in 29 years (for a total of 30 payments).2 The $1 million at date 0 is already stated in present value terms, but we need to compute the present value of the remaining payments. Fortunately, this case looks like a 29-year annuity of $1 million per year, so we can use the annuity formula. Q Execute We use the annuity formula: PV 1 [email protected] annuity of +1 million at 8% annual interest 2 = +1 million *

1 1 ¢1 ≤ 0.08 1.0829

= +1 million * 11.16 = +11.16 million today Thus, the total present value of the cash flows is +1 million + +11.16 million = +12.16 million. In timeline form: 0 1 2 29 ... $1 million

$1 million

$1 million

$1 million

$11.16 million $12.16 million

Option (b), $15 million upfront, is more valuable—even though the total amount of money paid is half that of option (a). Financial calculators or Excel can handle annuities easily—just enter the cash flow in the annuity as the PMT:

Given: Solve for:

2

N 29

I/Y 8

PV

PMT 1,000,000

FV 0

11,158,406 Excel Formula: PV(RATE,NPER,PMT,FV)PV(0.08,29,1000000,0)

An annuity in which the first payment occurs immediately is sometimes called an annuity due. Throughout this text, we always use the term “annuity” to mean one that is paid in arrears.

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

95

Both the financial calculator and Excel will give you the PV of the 29 payments ($11,158,406, or 11.16 million), to which you must add the first payment of $1 million just as shown. Q Evaluate The reason for the difference is the time value of money. If you have the $15 million today, you can use $1 million immediately and invest the remaining $14 million at an 8% interest rate. This strategy will give you +14 million * 8% = +1.12 million per year in perpetuity! Alternatively, you can spend +15 million - +11.16 million = +3.84 million today, and invest the remaining $11.16 million, which will still allow you to withdraw $1 million each year for the next 29 years before your account is depleted.

Future Value of an Annuity Now that we have derived a simple formula for the present value of an annuity, it is easy to find a simple formula for the future value. If we want to know the value N years in the future, we move the present value N periods forward on the timeline. 0

1

2

20 ...

C PV

C

r

a1

C

C

1 b (1r)N

FV

C

r

1

a1 (1r)N b (1 r)N

As the timeline shows, we compound the present value for N periods at interest rate r: Future Value of an Annuity

FV 1 annuity 2 = PV * 1 1 + r 2 N =

1 C ¢1 ≤ * 11 + r2N r 11 + r2N

= C *

1 1 11 + r2N - 12 r

(4.6)

This formula is useful if we want to know how a savings account will grow over time and the investor deposits the same amount every period. Personal Finance

EXAMPLE 4.5 Retirement Savings Plan Annuity

Problem Ellen is 35 years old and she has decided it is time to plan seriously for her retirement. At the end of each year until she is 65, she will save $10,000 in a retirement account. If the account earns 10% per year, how much will Ellen have in the account at age 65?

Solution Q Plan As always, we begin with a timeline. In this case, it is helpful to keep track of both the dates and Ellen’s age:

35 0

36 1

37 2

65 30 ...

$10,000

$10,000

$10,000

Ellen’s savings plan looks like an annuity of $10,000 per year for 30 years. (Hint : It is easy to become confused when you just look at age, rather than at both dates and age. A common error is to think there are only 65 - 36 = 29 payments. Writing down both dates and age avoids this problem.) To determine the amount Ellen will have in the account at age 65, we’ll need to compute the future value of this annuity.

96

Part 2 Interest Rates and Valuing Cash Flows

Q Execute

1 1 1.1030 - 1 2 0.10 = +10,000 * 164.49

FV = +10,000 *

= +1.645 million at age 65 Using a financial calculator or Excel:

Given: Solve for:

N 30

I/Y 10

PV 0

PMT 10,000

FV

1,644,940 Excel Formula: FV(RATE,NPER, PMT, PV)FV(0.10,30,10000,0)

Q Evaluate By investing $10,000 per year for 30 years (a total of $300,000) and earning interest on those investments, the compounding will allow her to retire with $1.645 million.

Concept Check

4.4

5. What are some examples of annuities? 6. What is the difference between an annuity and a perpetuity?

Growing Cash Flows So far, we have considered only cash flow streams that have the same cash flow every period. If, instead, the cash flows are expected to grow at a constant rate in each period, we can also derive a simple formula for the present value of the future stream.

Growing Perpetuity growing perpetuity A stream of cash flows that occurs at regular intervals and grows at a constant rate forever.

A growing perpetuity is a stream of cash flows that occur at regular intervals and grow at a constant rate forever. For example, a growing perpetuity with a first payment of $100 that grows at a rate of 3% has the following timeline: 0

1

2

3

4

$100

$100 1.03 $103

$103 1.03 $106.09

$106.09 1.03 $109.27

...

To derive the formula for the present value of a growing perpetuity, we follow the same logic used for a regular perpetuity: Compute the amount you would need to deposit today to create the perpetuity yourself. In the case of a regular perpetuity, we created a constant payment forever by withdrawing the interest earned each year and reinvesting the principal. To increase the amount we can withdraw each year, the principal that we reinvest each year must grow. We therefore withdraw less than the full amount of interest earned each period, using the remaining interest to increase our principal. Let’s consider a specific case. Suppose you want to create a perpetuity growing at 2%, so you invest $100 in a bank account that pays 5% interest. At the end of one year, you will have $105 in the bank—your original $100 plus $5 in interest. If you withdraw only $3, you will have $102 to reinvest—2% more than the amount you had initially. This amount will then grow to +102 * 1.05 = +107.10 in the following year, and you can withdraw +3 * 1.02 = +3.06, which will leave you with principal of +107.10 - +3.06 = +104.04. Note that +102 * 1.02 = +104.04. That is, both the amount you withdraw and the principal you reinvest grow by 2% each year. On a timeline, these cash flows look like this:

Chapter 4 Time Value of Money: Valuing Cash Flow Streams 0

1

2

97

3 ...

$100

$105 $102

$107.10 $104.04

$3

$3.06 $3 1.02

$109.24 $106.12 $3.12 $3 (1.02)2

By following this strategy, you have created a growing perpetuity that starts at $3 and grows 2% per year. This growing perpetuity must have a present value equal to the cost of $100. We can generalize this argument. If we want to increase the amount we withdraw from the bank each year by g, then the principal in the bank will have to grow by the same factor g. That is, instead of reinvesting P in the second year, we should reinvest P 1 1 + g 2 = P + gP. In order to increase our principal by gP, we need to leave gP of the interest in the account, so of the total interest of rP, we can only withdraw rP - gP = P 1 r - g 2 . We demonstrate this for the first year of our example: Initial amount deposited

$100

P

Interest earned

(.05)($100)

rP

Amount needed to increase principal

(.02)($100)

gP

Amount withdrawn

(.05)($100) - (.02)($100)

rP - gP

= $100(.05 - .02)

= P1r - g2

Denoting our withdrawal as C, we have C = P 1 r - g 2 . Solving this equation for P, the initial amount deposited in the bank account, gives the present value of a growing perpetuity with initial cash flow C:3 Present Value of a Growing Perpetuity C PV 1 growing perpetuity 2 = r - g

(4.7)

To understand intuitively the formula for a growing perpetuity, start with the formula for a perpetuity. In the earlier case, you had to put enough money in the bank to ensure that the interest earned matched the cash flows of the regular perpetuity. In the case of a growing perpetuity, you need to put more than that amount in the bank because you have to finance the growth in the cash flows. How much more? If the bank pays interest at a rate of 5%, then all that is left to take out, if you want to make sure the principal grows 2% per year, is the difference: 5% - 2% = 3%. So instead of the present value of the perpetuity being the first cash flow divided by the interest rate, it is now the first cash flow divided by the difference between the interest rate and the growth rate.

Suppose g r. Then the cash flows grow even faster than they are discounted; each term in the sum of discounted cash flows gets larger, rather than smaller. In this case, the sum is infinite! What does an infinite present value mean? Remember that the present value is the “do-it-yourself” cost of creating the cash flows. An infinite present value means that no matter how much money you start with, it is impossible to reproduce those cash flows on your own. Growing perpetuities of this sort cannot exist in practice because no one would be willing to offer one at any finite price. A promise to pay an amount that forever grew faster than the interest rate is also unlikely to be kept (or believed by any savvy buyer). The only viable growing perpetuities are those where the growth rate is less than the interest rate, so we assume that g 6 r for a growing perpetuity. 3

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Part 2 Interest Rates and Valuing Cash Flows Personal Finance

Problem

EXAMPLE 4.6

In Example 4.3, you planned to donate money to your alma mater to fund an annual $30,000 graduation party. Given an interest rate of 8% per year, the required donation was the present value of:

Endowing a Growing Perpetuity

PV = +30,000/0.08 = +375,000 today Before accepting the money, however, the student association has asked that you increase the donation to account for the effect of inflation on the cost of the party in future years. Although $30,000 is adequate for next year’s party, the students estimate that the party’s cost will rise by 4% per year thereafter. To satisfy their request, how much do you need to donate now?

Solution Q Plan

0

1

2

3

$30,000

$30,000 1.04

$30,000 1.042

...

The cost of the party next year is $30,000, and the cost then increases 4% per year forever. From the timeline, we recognize the form of a growing perpetuity and can value it that way. Q Execute To finance the growing cost, you need to provide the present value today of:

PV = +30,000/ 1 0.08 - 0.04 2 = +750,000 today

Q Evaluate You need to double the size of your gift!

Growing Annuity growing annuity A stream of cash flows, growing at a constant rate and paid at regular intervals, that end afer a specified number of periods.

A growing annuity is a stream of N growing cash flows, paid at regular intervals. It is a growing perpetuity that eventually comes to an end. The following timeline shows a growing annuity with initial cash flow C, growing at rate g every period until period N: 0

1

2

N ...

C

C (1g)

C(1g) N – 1

The conventions used earlier still apply: (1) The first cash flow arrives at the end of the first period, and (2) the first cash flow is before growth. The last cash flow therefore reflects only N - 1 periods of growth. The present value of an N-period growing annuity with initial cash flow C, growth rate g, and interest rate r is given by Present Value of a Growing Annuity PV = C *

1 + g N 1 ¢1 - ¢ ≤ ≤ r - g 1 + r

(4.8)

Because the annuity has only a finite number of terms, Eq. 4.8 also works when g 7 r.4 The process of deriving this simple expression for the present value of a growing annuity is the same as for a regular annuity. Interested readers may consult the online appendix for details.

Eq. 4.8 does not work for g = r. But in that case, growth and discounting cancel out, and the present value is equivalent to receiving all the cash flows at date 1: PV = C * N/ 1 1 + r 2 . 4

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

EXAMPLE 4.7 Retirement Savings with a Growing Annuity

99

Problem In Example 4.5, Ellen considered saving $10,000 per year for her retirement. Although $10,000 is the most she can save in the first year, she expects her salary to increase each year so that she will be able to increase her savings by 5% per year. With this plan, if she earns 10% per year on her savings, how much will Ellen have in the account at age 65?

Solution Q Plan Her new savings plan is represented by the following timeline: 35 0

36 1

37 2

65 30 ...

$10,000

$10,000 (1.05)

$10,000 (1.05)29

This example involves a 30-year growing annuity, with a growth rate of 5%, and an initial cash flow of $10,000. We can use Eq. 4.8 to solve for the present value of this growing annuity. Then we can use Eq. 4.1 to calculate the future value. Q Execute The present value of Ellen’s growing annuity is given by PV = +10,000 *

1.05 30 1 ¢1 - ¢ ≤ ≤ 0.10 - 0.05 1.10

= +10,000 * 15.0463 = +150,463 today Ellen’s proposed savings plan is equivalent to having $150,463 in the bank today. To determine the amount she will have at age 65, we need to move this amount forward 30 years: FV = +150,463 * 1.1030 = +2.625 million in 30 years Q Evaluate Ellen will have $2.625 million at age 65 using the new savings plan. This sum is almost $1 million more than she had without the additional annual increases in savings. Because she is increasing her savings amount each year and the interest on the cumulative increases continues to compound, her final savings is much greater.

Concept Check

4.5

7. How can an infinitely growing stream of cash flows have a finite value? 8. What is an example of a growing perpetuity?

Solving for Variables Other Than Present Value or Future Value So far, we have calculated the present value or future value of a stream of cash flows. Sometimes, however, we know the present value or future value, but do not know one of the variables that so far we have been given as an input. For example, when you take out a loan, you may know the amount you would like to borrow, but may not know the loan payments that will be required to repay it. Or, if you make a deposit into a bank account, you may want to calculate how long it will take before your balance reaches a certain level. In such situations, we use the present and/or future values as inputs, and solve for the variable we are interested in. We examine several special cases in this section.

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Part 2 Interest Rates and Valuing Cash Flows

Solving for the Cash Flows Let’s consider an example where we know the present value of an investment, but do not know the cash flows. The best example is a loan—you know how much you want to borrow (the present value) and you know the interest rate, but you do not know how much you need to repay each year. Suppose you are opening a business that requires an initial investment of $100,000. Your bank manager has agreed to lend you this money. The terms of the loan state that you will make equal annual payments for the next ten years and will pay an interest rate of 8% with the first payment due one year from today. What is your annual payment? From the bank’s perspective, the timeline looks like this: 0

1

2

10 ...

$100,000

+C

+C

+C

The bank will give you $100,000 today in exchange for ten equal payments over the next decade. You need to determine the size of the payment C that the bank will require. For the bank to be willing to lend you $100,000, the loan cash flows must have a present value of $100,000 when evaluated at the bank’s interest rate of 8%. That is: 100,000 = PV 1 [email protected] annuity of C per year, evaluated at the loan rate 2

Using the formula for the present value of an annuity (Eq. 4.5), 100,000 = C *

1 1 ¢1 ≤ = C * 6.71 0.08 1.0810

Solving this equation for C gives: C =

100,000 = +14,903 6.71

You will be required to make ten annual payments of $14,903 in exchange for $100,000 today. We can also solve this problem with a financial calculator or Excel (from your standpoint the $100,000 is positive and the payments are negative):

Given: Solve for:

N 10

I/Y 8

PV 100,000

PMT

FV 0

14,903 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.08,10,100000,0)

In general, when solving for a loan payment, think of the amount borrowed (the loan principal) as the present value of the payments. If the payments of the loan are an annuity, we can solve for the payment of the loan by inverting the annuity formula. Writing the equation for the payments formally for a loan with principal P, requiring N periodic payments of C and interest rate r, we have: Cash flow in an Annuity (Loan Payment) P C = 1 1 ¢1 ≤ r 11 + r2N

(4.9)

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

EXAMPLE 4.8 Computing a Loan Payment

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Problem Your firm plans to buy a warehouse for $100,000. The bank offers you a 30-year loan with equal annual payments and an interest rate of 8% per year. The bank requires that your firm pay 20% of the purchase price as a down payment, so you can borrow only $80,000. What is the annual loan payment?

Solution Q Plan We start with the timeline (from the bank’s perspective): 0

1

2

30 ...

$80,000

C

C

C

Using Eq. 4.9, we can solve for the loan payment, C, given N = 30, r = 0.08 and P = +80,000. Q Execute Eq. 4.9 gives the following payment (cash flow): C =

P

1 1 ¢1 ≤ r 11 + r2N = +7106.19

=

80,000 1 1 ¢1 ≤ 0.08 1 1.08 2 30

Using a financial calculator or Excel:

Given: Solve for:

N 30

I/Y 8

PV 80,000

PMT

FV 0

7106.19 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.08,30,80000,0)

Q Evaluate Your firm will need to pay $7106.19 each year to repay the loan. The bank is willing to accept these payments because the PV of 30 annual payments of $7106.19 at 8% interest rate per year is exactly equal to the $80,000 it is giving you today.

We can use this same idea to solve for the cash flows when we know the future value rather than the present value. As an example, suppose you have just graduated from college and you decide to be prudent and start saving for a down payment on a house. You would like to have $60,000 saved 10 years from now. If you can earn 7% per year on your savings, how much do you need to save each year to meet your goal? The timeline for this example is: 0

1

2

10 ...

$C

$C

$C $60,000

That is, you plan to save some amount C per year, and then withdraw $60,000 from the bank in ten years. Therefore, we need to find the annuity payment that has a future value of $60,000 in ten years. Use the formula for the future value of an annuity from Eq. 4.6: 60,000 = FV 1 annuity 2 = C *

1 1 1.0710 - 1 2 = C * 13.816 0.07

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Part 2 Interest Rates and Valuing Cash Flows 60,000 = +4,343. Thus, you need to save $4,343 per year. If you do, then 13.816 at a 7% interest rate your savings will grow to $60,000 in 10 years when you are ready to buy a house. Now let’s solve this problem using a financial calculator or Excel: Therefore, C =

Given: Solve for:

N 10

I/Y 7

PV 0

PMT

FV 60,000

4343 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.07,10,0,60000)

Once again, we find that you need to save $4343 per year for 10 years to accumulate $60,000.

Rate of Return In some situations, you know the cost of an investment opportunity and the expected cash flows from it, but you do not know the rate of return. The rate of return on the investment opportunity is the rate at which the present value of the benefits exactly offsets the cost. For example, suppose you have an investment opportunity that requires a $1000 investment today and will have a $2000 payoff in six years. This would appear on a timeline as: 0

1

2

6 ...

$1000

$2000

One way to analyze this investment is to ask the question: What interest rate, r, would you need so that the present value of what you get is exactly equal to the present value of what you give up? 2000 1000 = 11 + r26 Rearranging this calculation gives the following:

1000 * 1 1 + r 2 6 = 2000

That is, r is the interest rate you would need to earn on your $1000 to have a future value of $2000 in six years. We can solve for r as follows: 1

2000 6 1 + r = a b = 1.1225 1000 Or, r = 0.1225. This rate is the rate of return of this investment opportunity. Making this investment is like earning 12.25% per year on your money for six years. When there are just two cash flows, as in the preceding example, it is straightforward to compute the rate of return. Consider the general case in which you invest an amount P today, and receive FV in N years: P * 1 1 + r 2 N = FV 1 + r = 1 FV/P 2 1/N

That is, we take the total return of the investment over N years, FV/P, and convert it to an equivalent one-year rate by raising it to the power 1/N. Now let’s consider a more sophisticated example. Suppose your firm needs to purchase a new forklift. The dealer gives you two options: (1) a price for the forklift if you pay

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cash and (2) the annual payments if you take out a loan from the dealer. To evaluate the loan that the dealer is offering you, you will want to compare the rate on the loan with the rate that your bank is willing to offer you. Given the loan payment that the dealer quotes, how do you compute the interest rate charged by the dealer? In this case, we need to compute the rate of return of the dealer’s loan. Suppose the cash price of the forklift is $40,000, and the dealer offers financing with no down payment and four annual payments of $15,000. This loan has the following timeline: 0 $40,000

1

2

$15,000

3

$15,000

$15,000

4 $15,000

From the timeline, it is clear that the loan is a four-year annuity with a payment of $15,000 per year and a present value of $40,000. Setting the present value of the cash flows equal to zero requires that the present value of the payments equals the purchase price: 40,000 = 15,000 *

1 1 ¢1 ≤ r 11 + r24

The value of r that solves this equation is the interest rate charged on the loan. Unfortunately, in this case there is no simple way to solve for the interest rate r.5 The only way to solve this equation is to guess at values of r until you find the right one. Start by guessing r = 10%. In this case, the value of the annuity is: 15,000 *

1 1 ¢1 ≤ = 47,548 0.10 1 1.10 2 4

The present value of the payments is too large. To lower it, we need to use a higher interest rate. We guess 20% this time: 15,000 *

1 1 ¢1 ≤ = 38,831 0.20 1 1.20 2 4

Now the present value of the payments is too low, so we must pick a rate between 10% and 20%. We continue to guess until we find the right rate. Let’s try 18.45%: 15,000 *

1 1 ¢1 ≤ = 40,000 0.1845 1 1.1845 2 4

The interest rate charged by the dealer is 18.45%. An easier solution than guessing the rate of return and manually calculating values is to use a spreadsheet or calculator to automate the guessing process. When the cash flows are an annuity, as in this example, we can use a financial calculator or Excel to compute the rate of return. Both solve (with slightly varying notation—recall that I/Y is the discount rate and PMT is the cash flow or payment) the following equation: 0 = PV + PMT *

1 1 FV ¢1 ≤ + N I/Y 1 1 + I/Y 2 1 1 + I/Y 2 N

The equation ensures that the value of investing in the annuity is zero in that the present value of the costs and benefits exactly offset each other. When the unknown variable is the interest rate, it will solve for the interest rate that sets the equation equal to zero. 5

With five or more periods and general cash flows, there is no general formula to solve for r; trial and error (by hand or computer) is the only way to compute it.

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Part 2 Interest Rates and Valuing Cash Flows For this case, you could use a financial calculator or Excel, as follows: Given: Solve for:

N 4

I/Y

PV 40,000

PMT 15,000

FV 0

18.45 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(4,15000,40000,0)

Both the financial calculator and Excel correctly compute a rate of return of 18.45%. Personal Finance

EXAMPLE 4.9 Computing the Rate of Return with a Financial Calculator

Problem Let’s return to the lottery prize in Example 4.4. How high of a rate of return do you need to earn investing on your own in order to prefer the $15 million payout?

Solution Q Plan Recall that the lottery offers you the following deal: take either (a) 30 payments of $1 million per year starting immediately, or (b) a $15 million lump sum payment immediately. The first option is an annuity of 29 payments of $1 million plus an initial $1 million payment.

0

1

2

29 ...

$1 million

$1 million

$1 million

$1 million

We need to solve for the rate of return that makes the two offers equivalent. Anything above that rate of return would make the present value of the annuity lower than the $15 million lump sum payment, and anything below that rate of return would make it greater than the $15 million. Q Execute First, we set the present value of option (a) equal to option (b), which is already in present value since it is an immediate payment of $15 million: +15 million = +1 million + +1 million * +14 million = +1 million *

1 1 ¢1 ≤ r 1 1 + r 2 29

1 1 ¢1 ≤ r 1 1 + r 2 29

Using a financial calculator to solve for r :

N I/Y PV PMT FV Given: 29 14,000,000 1,000,000 0 Solve for: 5.72 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(29,1000000,14000000,0) The rate of return equating the two options is 5.72%. Q Evaluate 5.72% is the rate of return that makes giving up the $15 million payment and taking the 30 installments of $1 million an even trade in terms of present value. If you could earn more than 5.72% investing on your own, then you could take the $15 million, invest it and generate 30 installments that are each more than $1 million. If you could not earn at least 5.72% on your investments, you would be unable to replicate the $1 million installments on your own and would be better off taking the installment plan.

Solving for the Number of Periods In addition to solving for cash flows or the interest rate, we can solve for the amount of time it will take a sum of money to grow to a known value. In this case, the interest rate,

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present value, and future value are all known. We need to compute how long it will take for the present value to grow to the future value. Suppose we invest $10,000 in an account paying 10% interest, and we want to know how long it will take for the amount to grow to $20,000. We want to determine N. 0

1

2

N ...

$10,000

$20,000

In terms of our formulas, we need to find N so that the future value of our investment equals $20,000: FV = +10,000 * 1.10N = +20,000

(4.10)

One approach is to use trial and error to find N, as with the rate of return we calculated earlier. For example, with N = 7 years, FV = +19,487, so it will take longer than 7 years. With N = 8 years, FV = +21,436, so it will take between 7 and 8 years. Alternatively, this problem can be solved on a financial calculator or Excel. In this case, we solve for N: N I/Y PV PMT FV 10 10,000 0 20,000 Given: 7.27 Solve for: Excel Formula: NPER(RATE,PMT,PV,FV)NPER(0.10,0,10000,20000)

It will take about 7.3 years for our savings to grow to $20,000. The problem of solving for the number of periods can also be solved mathematically using logarithms. Personal Finance

EXAMPLE 4.10 Solving for the Number of Periods in a Savings Plan

Problem Let’s return to your savings for a down payment on a house. Imagine that some time has passed and you have $10,050 saved already, and you can now afford to save $5000 per year at the end of each year. Also, interest rates have increased so that you now earn 7.25% per year on your savings. How long will it take you to get to your goal of $60,000?

Solution Q Plan The timeline for this problem is: 0

1

2

N ...

$10,050

$5000

$5000

$5000 $60,000 We need to find N so that the future value of your current savings plus the future value of your planned additional savings (which is an annuity) equals your desired amount. There are two contributors to the future value: the initial lump sum of $10,050 that will continue to earn interest, and the annuity contributions of $5,000 per year that will earn interest as they are contributed. Thus, we need to find the future value of the lump sum plus the future value of the annuity.

Q Execute We can solve this problem using a financial calculator or Excel:

N I/Y PV PMT FV 7.25 10,050 5000 60,000 Given: 7.00 Solve for: Excel Formula: NPER(RATE,PMT,PV,FV)NPER(0.0725,5000,10050,60000)

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Part 2 Interest Rates and Valuing Cash Flows There is also a mathematical solution. We can calculate the future value of the initial cash flow by using Eq. 4.1 and the future value of the annuity using Eq. 4.6: 10,050 * 1.0725N + 5000 *

1 1 1.0725N - 1 2 = 60,000 0.0725

Rearranging the equation to solve for N, 1.0725N =

60,000 * 0.0725 + 5000 = 1.632 10,050 * 0.0725 + 5000

we can then solve for N: N =

ln 1 1.632 2 = 7 years ln 1 1.0725 2

Q Evaluate It will take seven years to save the down payment.

We began this chapter with the goal of further developing the tools a financial manager needs to be able to apply the Valuation Principle by valuing the costs and benefits of a decision. Starting from Chapter 3’s fundamental concept of the time value of money—a dollar today is worth more than a dollar tomorrow—we learned how to calculate the equivalent value of a stream of future cash flows today and today’s cash flows in the future. We then learned some shortcuts for handling common sets of regular cash flows such as those found in perpetuities and loans. As we have seen, the discount rate is a critical input to any of our present value or future value calculations. Throughout this chapter, we have taken the discount rate as given. What determines these discount rates? The Valuation Principle shows us that we must rely on market information to assess the value of cash flows across time. In the next chapter, we will learn the drivers of market interest rates as well as how they are quoted. Understanding interest rate quoting conventions will also allow us to extend the tools we developed in this chapter to situations where the interest rate is compounded more frequently than once per year.

Concept Check

9. How do you calculate the cash flow of an annuity? 10. How do you calculate the rate of return on an investment?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Key Points and Equations 4.1 Valuing a Stream of Cash Flows Q The present value of a cash flow stream is: C1 C2 CN PV = C0 + + + g + (4.3) 2 11 + r2 11 + r2 11 + r2N

Terms

Online Practice Opportunities MyFinanceLab Study Plan 4.1

Chapter 4 Time Value of Money: Valuing Cash Flow Streams 4.2 Perpetuities Q A perpetuity is a stream of equal cash flows C paid every period, forever. The present value of a perpetuity is: PV 1 C in perpetuity 2 =

C r

consol, p. 89 perpetuity, p. 89

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MyFinanceLab Study Plan 4.2

(4.4)

4.3 Annuities annuity, p. 92 Q An annuity is a stream of equal cash flows C paid every period for N periods. The present value of an annuity is: 1 1 C * a1 (4.5) b r 11 + r2N Q The future value of an annuity at the end of the annuity is: 1 C * 1 11 + r2N - 12 (4.6) r

4.4 Growing Cash Flows Q In a growing perpetuity, the cash flows grow at a constant rate g each period. The present value of a growing perpetuity is: C (4.7) r - g

growing annuity, p. 98 growing perpetuity, p. 96

MyFinanceLab Study Plan 4.3 Interactive Annuity Calculator Financial Calculator Tutorials: Calculating the Present Value of an Annuity and Solving for the Future Value of an Annuity MyFinanceLab Study Plan 4.4

Q A growing annuity is like a growing perpetuity, but with an ending point. The present value of a growing annuity is: PV = C *

1 + g N 1 ¢1 - ¢ ≤ ≤ r - g 1 + r

(4.8)

4.5 Solving for Variables Other Than Present Value or Future Value Q The annuity and perpetuity formulas can be used to solve for the annuity payments when either the present value or the future value is known. Q The periodic payment on an N-period loan with principal P and interest rate r is: P C = (4.9) 1 1 ¢1 ≤ r 11 + r2N Q The rate of return of an investment opportunity is the interest rate at which the PV of the benefits of the investment opportunity exactly offset the PV of the costs. Q The annuity formulas can be used to solve for the number of periods it takes to save a fixed amount of money.

MyFinanceLab Study Plan 4.5

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Part 2 Interest Rates and Valuing Cash Flows

Critical Thinking

1. What is the intuition behind the fact that the present value of a stream of cash flows is just the sum of the present values of each individual cash flow? 2. What must be true about a cash flow stream in order for us to be able to use the shortcut formulas? 3. What is the difference between an annuity and a perpetuity? 4. What are some examples of perpetuities? 5. How can a perpetuity have a finite value? 6. What are some examples of annuities? 7. What must be true about the growth rate in order for a growing perpetuity to have a finite value? 8. In what types of situations would it be useful to solve for the number of periods or the rate of return?

Problems

All problems are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Valuing a Stream of Cash Flows 1. You have just taken out a five-year loan from a bank to buy an engagement ring. The ring costs $5000. You plan to put down $1000 and borrow $4000. You will need to make annual payments of $1000 at the end of each year. Show the timeline of the loan from your perspective. How would the timeline differ if you created it from the bank’s perspective? 2. You currently have a one-year-old loan outstanding on your car. You make monthly payments of $300. You have just made a payment. The loan has four years to go (i.e., it had an original term of five years). Show the timeline from your perspective. How would the timeline differ if you created it from the bank’s perspective? 3. You plan to deposit $500 in a bank account now and $300 at the end of one year. If the account earns 3% interest per year, what will the balance be in the account right after you make the second deposit? 4. You have just received a windfall from an investment you made in a friend’s business. She will be paying you $10,000 at the end of this year, $20,000 at the end of the following year, and $30,000 at the end of the year after that (three years from today). The interest rate is 3.5% per year. a. What is the present value of your windfall? b. What is the future value of your windfall in three years (on the date of the last payment)? 5. Suppose you receive $100 at the end of each year for the next three years. a. If the interest rate is 8%, what is the present value of these cash flows? b. What is the future value in three years of the present value you computed in (a)? c. Suppose you deposit the cash flows in a bank account that pays 8% interest per year. What is the balance in the account at the end of each of the next three years (after your deposit is made)? How does the final bank balance compare with your answer in (b)?

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6. You have a loan outstanding. It requires making three annual payments of $1000 each at the end of the next three years. Your bank has offered to allow you to skip making the next two payments in lieu of making one large payment at the end of the loan’s term in three years. If the interest rate on the loan is 5%, what final payment will the bank require you to make so that it is indifferent to the two forms of payment? Perpetuities 7. You want to endow a scholarship that will pay $10,000 per year forever, starting one year from now. If the school’s endowment discount rate is 7%, what amount must you donate to endow the scholarship? 8. How would your answer to Problem 7 change if you endow it now, but it makes the first award to a student 10 years from today? 9. The British government has a consol bond outstanding paying £100 per year forever. Assume the current interest rate is 4% per year. a. What is the value of the bond immediately after a payment is made? b. What is the value of the bond immediately before a payment is made? Annuities 10. What is the present value of $1000 paid at the end of each of the next 100 years if the interest rate is 7% per year? 11. Your grandmother has been putting $1000 into a savings account on every birthday since your first (that is, when you turned one). The account pays an interest rate of 3%. How much money will be in the account immediately after your grandmother makes the deposit on your eighteenth birthday? 12. Assume that your parents wanted to have $160,000 saved for college by your eighteenth birthday and they started saving on your first birthday. They saved the same amount each year on your birthday and earned 8% per year on their investments. a. How much would they have to save each year to reach their goal? b. If they think you will take five years instead of four to graduate and decide to have $200,000 saved just in case, how much more would they have to save each year to reach their new goal? *13. When you purchased your car, you took out a five-year annual-payment loan with an interest rate of 6% per year. The annual payment on the car is $5000. You have just made a payment and have now decided to pay the loan off by repaying the outstanding balance. What is the payoff amount if a. you have owned the car for one year (so there are four years left on the loan)? b. you have owned the car for four years (so there is one year left on the loan)? 14. You figure that the total cost of college will be $100,000 per year 18 years from today. If your discount rate is 8% compounded annually, what is the present value today of 4 years of college costs starting 18 years from today? 15. Assume that Social Security promises you $40,000 per year starting when you retire 45 years from today (the first $40,000 will come 45 years from now). If your discount rate is 7%, compounded annually, and you plan to live for 15 years after retiring (so that you will get a total of 16 payments including the first one), what is the value today of Social Security’s promise? (See MyFinanceLab for the data in Excel Format.)

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Part 2 Interest Rates and Valuing Cash Flows *16. When Alex Rodriguez moved to the Texas Rangers in 2001, he received a lot of attention for his “$252 million” contract (the total of the payments promised was $252 million). Assume the following about the contract: Rodriguez earns $16 million in the first year, $17 million in years 2 through 4, $19 million in years 5 and 6, $23 million in year 7, and $27 million in years 8 through 10. He would also receive his $10 million signing bonus spread equally over the first 5 years ($2 million per year). His deferred payments begin in 2011. The deferred payment amounts total $33 million and are $5 million, then $4 million, then 8 amounts of $3 million (ending in 2020). However, the actual payouts will be different. All of the deferred payments will earn 3% per year until they are paid. For example, the $5 million is deferred from 2001 to 2011, or 10 years, meaning that it will actually be $6.7196 million when paid. Assume that the $4 million payment deferred to 2012 is deferred from 2002 (each payment is deferred 10 years). The contract is a 10-year contract, but each year has a deferred component so that cash flows are paid out over a total of 20 years. The contractual payments, signing bonus, and deferred components are given below. Note that, by contract, the deferred components are not paid in the year they are earned, but instead are paid (plus interest) 10 years later. 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

$16M

$17M

$17M

$17M

$19M

$19M

$23M

$27M

$27M

$27M

$2M

$2M

$2M

$2M

$2M

$4M

$3M

$3M

$3M

$3M

$3M

$3M

$3M

$3M

Deferred $5M

Assume that an appropriate discount rate for A-Rod to apply to the contract payments is 7% per year. a. Calculate the true promised payments under this contract, including the deferred payments with interest. b. Draw a timeline of all of the payments. c. Calculate the present value of the contract. d. Compare the present value of the contract to the quoted value of $252 million. What explains the difference? *17. You are trying to decide how much to save for retirement. Assume you plan to save $5000 per year with the first investment made 1 year from now. You think you can earn 10% per year on your investments and you plan to retire in 43 years, immediately after making your last $5000 investment. a. How much will you have in your retirement account on the day you retire? b. If, instead of investing $5000 per year, you wanted to make one lump-sum investment today for your retirement that will result in the same retirement saving, how much would that lump sum need to be? c. If you hope to live for 20 years in retirement, how much can you withdraw every year in retirement (starting one year after retirement) so that you will just exhaust your savings with the twentieth withdrawal (assume your savings will continue to earn 10% in retirement)? d. If, instead, you decide to withdraw $300,000 per year in retirement (again with the first withdrawal one year after retiring), how many years will it take until you exhaust your savings? e. Assuming the most you can afford to save is $1000 per year, but you want to retire with $1 million in your investment account, how high of a return do you need to earn on your investments?

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Growing Cash Flows 18. A rich relative has bequeathed you a growing perpetuity. The first payment will occur in a year and will be $1000. Each year after that, you will receive a payment on the anniversary of the last payment that is 8% larger than the last payment. This pattern of payments will go on forever. If the interest rate is 12% per year, a. what is today’s value of the bequest? b. what is the value of the bequest immediately after the first payment is made? *19. You are thinking of building a new machine that will save you $1000 in the first year. The machine will then begin to wear out so that the savings decline at a rate of 2% per year forever. What is the present value of the savings if the interest rate is 5% per year? 20. When Alfred Nobel died, he left the majority of his estate to fund five prizes, each to be awarded annually in perpetuity starting one year after he died (the sixth one, in economics, was added later). a. If he wanted the cash award of each of the five prizes to be $45,000 and his estate could earn 7% per year, how much would he need to fund his prizes? b. If he wanted the value of each prize to grow by 4% per year (perhaps to keep up with inflation), how much would he need to leave? Assume that the first amount was still $45,000. c. His heirs were surprised by his will and fought it. If they had been able to keep the amount of money you calculated in (b), and had invested it at 7% per year, how much would they have in 2014, 118 years after he died? 21. You work for a pharmaceutical company that has developed a new drug. The patent on the drug will last 17 years. You expect that the drug’s profits will be $2 million in its first year and that this amount will grow at a rate of 5% per year for the next 17 years. Once the patent expires, other pharmaceutical companies will be able to produce the same drug and competition will likely drive profits to zero. What is the present value of the new drug if the interest rate is 10% per year? 22. A rich aunt has promised you $5000 one year from today. In addition, each year after that, she has promised you a payment (on the anniversary of the last payment) that is 3% larger than the last payment. She will continue to show this generosity for 20 years, giving a total of 20 payments. If the interest rate is 5%, what is her promise worth today? Solving for Variables Other Than Present Value or Future Value 23. You are thinking about buying a savings bond. The bond costs $50 today and will mature in 10 years with a value of $100. What annual interest rate will the bond earn? 24. You have an investment account that started with $1000 ten years ago and which now has grown to $5000. a. What annual rate of return have you earned (you have made no additional contributions to the account)? b. If the savings bond earns 15% per year from now on, what will the account’s value be ten years from now? 25. You have an investment opportunity that requires an initial investment of $5000 today and will pay $6000 in one year. What is the rate of return of this opportunity? 26. You have decided to buy a perpetual bond. The bond makes one payment at the end of every year forever and has an interest rate of 5%. If the bond initially costs $1000, what is the payment every year?

112

Part 2 Interest Rates and Valuing Cash Flows 27. You are thinking of purchasing a house. The house costs $350,000. You have $50,000 in cash that you can use as a down payment on the house, but you need to borrow the rest of the purchase price. The bank is offering a 30-year mortgage that requires annual payments and has an interest rate of 7% per year. What will your annual payment be if you sign up for this mortgage? *28. You are thinking about buying a piece of art that costs $50,000. The art dealer is proposing the following deal: He will lend you the money, and you will repay the loan by making the same payment every two years for the next 20 years (i.e., a total of 10 payments). If the interest rate is 4% per year, how much will you have to pay every two years? *29. You would like to buy the house and take the mortgage described in Problem 27. You can afford to pay only $23,500 per year. The bank agrees to allow you to pay this amount each year, yet still borrow $300,000. At the end of the mortgage (in 30 years), you must make a balloon payment; that is, you must repay the remaining balance on the mortgage. How much will this balloon payment be? *30. You are saving for retirement. To live comfortably, you decide you will need to save $2 million by the time you are 65. Today is your twenty-second birthday, and you decide, starting today and continuing on every birthday up to and including your 65th birthday, that you will put the same amount into a savings account. If the interest rate is 5%, how much must you set aside each year to make sure that you will have $2 million in the account on your 65th birthday? 31. You graduate and get a $10,000 check from your grandparents. You decide to save it toward a down payment on a house. You invest it earning 10% per year and you think you will need to have $20,000 saved for the down payment. How long will it be before the $10,000 has grown to $20,000? 32. A local bank is running the following advertisement in the newspaper: “For just $1000 we will pay you $100 forever!” The fine print in the ad says that for a $1000 deposit, the bank will pay $100 every year in perpetuity, starting one year after the deposit is made. What interest rate is the bank advertising (what is the rate of return of this investment)? *33. You are thinking of making an investment in a new plant. The plant will generate revenues of $1 million per year for as long as you maintain it. You expect that the maintenance costs will start at $50,000 per year and will increase 5% per year thereafter. Assume that all revenue and maintenance costs occur at the end of the year. You intend to run the plant as long as it continues to make a positive cash flow (as long as the cash generated by the plant exceeds the maintenance costs). The plant can be built and become operational immediately and the interest rate is 6% per year. a. What is the present value of the revenues? b. What is the present value of the maintenance costs? c. If the plant costs $10 million to build, should you invest in the plant? *34. You have just turned 22 years old, have just received your bachelor’s degree, and have accepted your first job. Now you must decide how much money to put into your retirement plan. The plan works as follows: Every dollar in the plan earns 7% per year. You cannot make withdrawals until you retire on your sixty-fifth birthday. After that point, you can make withdrawals as you see fit. You decide that you will plan to live to 100 and work until you turn 65. You estimate that to live comfortably in retirement, you will need $100,000 per year, starting at the end of the first year of

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

113

retirement and ending on your one-hundredth birthday. You will contribute the same amount to the plan at the end of every year that you work. How much do you need to contribute each year to fund your retirement?

Data Case

Assume today is August 1, 2010. Natasha Kingery is 30 years old and has a Bachelor of Science degree in computer science. She is currently employed as a Tier 2 field service representative for a telephony corporation located in Seattle, Washington, and earns $38,000 a year that she anticipates will grow at 3% per year. Natasha hopes to retire at age 65 and has just begun to think about the future. Natasha has $75,000 that she recently inherited from her aunt. She invested this money in ten-year Treasury bonds. She is considering whether she should further her education and would use her inheritance to pay for it. She has investigated a couple of options and is asking for your help as a financial planning intern to determine the financial consequences associated with each option. Natasha has already been accepted to two programs and could start either one soon. One alternative that Natasha is considering is attaining a certification in network design. This certification would automatically promote her to a Tier 3 field service representative in her company. The base salary for a Tier 3 representative is $10,000 more than the salary of a Tier 2 representative, and she anticipates that this salary differential will grow at a rate of 3% a year for as long as she keeps working. The certification program requires the completion of 20 Web-based courses and a score of 80% or better on an exam at the end of the course work. She has learned that the average amount of time necessary to finish the program is one year. The total cost of the program is $5,000, due when she enrolls in the program. Because she will do all the work for the certification on her own time, Natasha does not expect to lose any income during the certification. Another option is going back to school for an MBA degree. With an MBA degree, Natasha expects to be promoted to a managerial position in her current firm. The managerial position pays $20,000 a year more than her current position. She expects that this salary differential will also grow at a rate of 3% per year for as long as she keeps working. The evening program, which will take three years to complete, costs $25,000 per year, due at the beginning of each of her three years in school. Because she will attend classes in the evening, Natasha doesn’t expect to lose any income while she is earning her MBA if she chooses to undertake the MBA. 1. Determine the interest rate Natasha is currently earning on her inheritance by going to Yahoo! Finance (http://finance.yahoo.com) and clicking on the 10 Yr Bond link in the Market Summary section. Then go to the Historical Prices link and enter the appropriate date, August 2, 2010 (August 1st is a Sunday), to obtain the closing yield or interest rate that she is earning. Use this interest rate as the discount rate for the remainder of this problem. 2. Create a timeline in Excel for her current situation, as well as the certification program and MBA degree options, using the following assumptions: a. Salaries for the year are paid only once, at the end of the year. b. The salary increase becomes effective immediately upon graduating from the MBA program or being certified. That is, because the increases become effective immediately but salaries are paid at the end of the year, the first salary increase will be paid exactly one year after graduation or certification. 3. Calculate the present value of the salary differential for completing the certification program. Subtract the cost of the program to get the value of undertaking the certification program.

114

Part 2 Interest Rates and Valuing Cash Flows 4. Calculate the present value of the salary differential for completing the MBA degree. Calculate the present value of the cost of the MBA program. Based on your calculations, determine the value of undertaking the MBA. 5. Based on your answers to Questions 3 and 4, what advice would you give to Natasha? What if the two programs are mutually exclusive? If Natasha undertakes one of the programs, there is no further benefit to undertaking the other program. Would your advice change?

Chapter 4 APPENDIX

Using a Financial Calculator

Specifying Decimal Places Make sure you have plenty of decimal places displayed! HP-10BII DISP

4

TI BAII Plus Professional 2ND

•

4

ENTER

Toggling Between the Beginning and End of a Period You should always make sure that your calculator is in end-of-period mode. HP-10BII MAR

TI BAII Plus Professional 2ND

PMT

Set the Number of Periods per Year To avoid a lot of confusion later, always set your periods per year (P/Y) to 1: HP-10BII PMT

1

TI BAII Plus Professional 2ND I/Y

1

ENTER

PV

PMT

FV

PV

PMT

FV

General TVM Buttons HP-10BII N

I/YR

TI BAII Plus Professional N

I/Y

Chapter 4 Time Value of Money: Valuing Cash Flow Streams

115

Solving for the Future Value of an Annuity (Example 4.5) Ellen is 35 years old, and she has decided it is time to plan seriously for her retirement. At the end of each year until she is 65, she will save $10,000 in a retirement account. If the account earns 10% per year, how much will Ellen have in the account at age 65? [Answer: 1,644,940] HP-10BII

3

0

N

Press [Orange Shift] and then the [C] button to clear all previous entries. Enter the Number of periods.

1

0

I/YR

Enter the market annual interest rate.

1

0

0

0

PV

C

0

0

PMT

FV

Enter the Payment amount per period. Indicate that there is no initial amount in the retirement account. Solve for the Future Value.

TI-BAII Plus Professional 2ND

FV

3

0

N

1

0

I/Y

1

0

0

0

PV

CPT

FV

Press [2ND] and then the [FV] button to clear all previous entries. Enter the Number of periods. Enter the market annual interest rate.

0

0

PMT

Enter the payment amount per period. Indicate that there is no initial amount in the retirement account. Solve for the Future Value.

Solving for the Rate of Return If you have an initial cash outflow of $2000 and one cash inflow per year for the following four years of $1000, $400, $400, and $800, what is the rate of return on the project per year (sometimes called the Internal Rate of Return or IRR on the calculators)? [Answer: 12.12%] HP-10BII C 2

0

0

0

/

1

0

0

0

CF j

4

0

0

CF j

CF j

2 8

0 CST

0

CF j

CF j

Press [Orange Shift] and then the [C] button to clear all previous entries. Enter the initial cash outflow. Enter the first cash inflow. Enter the second cash inflow. Enter the number of consecutive periods the second cash inflow occurs. Enter the fourth cash inflow. Press [Orange Shift] and then the [CST] button to calculate the IRR/year.

116

Part 2 Interest Rates and Valuing Cash Flows TI-BAII Plus Professional Access Cash Flow Worksheet. Press [2ND] and then the [CE/C] button to clear all previous entries.

CF 2ND

CE 円 C

2

0

0

0

/

ENTER

Enter the initial cash outflow.

1

0

0

0

ENTER

4

0

0

ENTER

0

ENTER

Enter the first cash inflow. Leave the frequency of the initial cash inflow at 1 (Default Setting). Enter the second cash inflow. Enter the frequency of the second cash inflow as 2. Enter the fourth cash inflow. Leave the frequency of the fourth cash inflow at 1 (Default Setting). Solve for the IRR.

2 8

IRR

CPT

ENTER 0

5

Interest Rates

LEARNING OBJECTIVES

notation

Q Understand the different ways interest rates are quoted

Q Know how inflation, expectations, and risk combine to determine interest rates

Q Use quoted rates to calculate loan payments and balances

Q See the link between interest rates in the market and a firm’s opportunity cost of capital

APR

annual percentage rate

n

number of periods

APY

annual percentage yield

N

C

cash flow

date of the last cash flow in a stream of cash flows

Cn

cash flow that arrives in period n

PV

present value

EAR

effective annual rate

r

interest rate or discount rate

FV

future value

rn

interest rate or discount rate for an n-year term

m

number of compounding periods per year

117

INTERVIEW WITH

Jason Moore Bradford & Marzec, LLC

Jason Moore graduated in 2004 from the California State University, Long Beach, with a major in business finance. As a fixed-income analyst at Bradford & Marzec, LLC, a Los Angeles-based institutional fixed-income manager with over $4 billion in assets, he pays close attention to interest rate movements. “I perform corporate credit research for basic industries such as metals, mining, chemicals, and forest products, following industry and company news and trends,” Jason explains. Then he formulates an opinion and communicates purchase and sell recommendations to the portfolio managers. One of the trends he watches is inflation, which affects the purchasing power of a given amount of money. When prices increase due to inflation, the value of a given amount of currency declines. Inflation therefore influences the interest rate a lender charges a borrower. “The interest rate charged is often fixed for a long period of time,” says Jason. “Any unexpected change in inflation over that time period affects the purchasing power of those fixed future payments, so all interest rates include an inflation expectation. If inflation increases, the purchasing power of those fixed future payments decreases, and vice versa.” This means that investors’ inflation expectations influence the return they expect to receive when lending money. If they think inflation will rise, they will want a higher interest rate. In addition, investors’ interest rate expectations should be reflected in the length of time an investor is willing to lend funds. “If investors believe that interest rates will rise, they should choose a short-term investment, rather than tie up their money at the current lower interest rate,” he says. “If investors believe interest rates will fall, they should choose a longer-term investment, locking in the current higher interest rate.” When economic activity slows and the financial climate is uncertain, as it was in 2008, investors seek lower-risk investment opportunities. “Lenders evaluate borrowers more closely,” says Jason. “As a consumer currently seeking a loan for education expenses, a car, or a house, your perceived risk of default—not being able to repay the loan—is more important now than it was just a few years ago.”

In Chapters 3 and 4, we explored the mechanics of computing present values and future values given a market interest rate. Recall that an interest rate allows us to convert money at one point in time to another. But how do we determine that interest rate? In this chapter, we consider the factors that affect interest rates and discuss how to determine the appropriate discount rate for a set of cash flows. We begin by looking at the way interest is paid and interest rates are quoted, and we show how to calculate the effective interest paid in one year given different quoting conventions. We then consider some of the main determinants of interest rates—namely, inflation and economic growth. Because interest rates tend to change over time, investors will demand different interest rates for different investment horizons, based on their expectations and the risk involved in longer time horizons.

118

California State University, Long Beach, 2004

“As a consumer currently seeking a loan for education expenses, a car, or a house, your perceived risk of default—not being able to repay the loan—is more important now than it was just a few years ago.”

Chapter 5 Interest Rates

5.1

119

Interest Rate Quotes and Adjustments If you spend some time looking through a newspaper, you will find literally dozens of interest rates discussed and advertised, from savings deposit rates to auto loan rates to interest rates being paid on the government’s debt. Interest rates are clearly central to the functioning of any financial system. To understand interest rates, it’s important to think of interest rates as a price—the price of using money. When you borrow money to buy a car, you are using the bank’s money now to get the car and paying the money back over time. The interest rate on your loan is the price you pay to be able to convert your future loan payments into a car today. Similarly, when you deposit money into a savings account, you are letting the bank use your money until you withdraw it later. The interest the bank pays you on your deposit is the price it pays to have the use of your money (for things like making car loans). Just like any other price, interest rates are set by market forces, in particular the supply of and demand for funds. When the supply (savings) is high and the demand (borrowing) is low, interest rates are low, other things being equal. Additionally, as we discuss later in the chapter, interest rates are also influenced by expected inflation and risk. In order to be able to study and use interest rates, we have to understand how they are quoted. In practice, interest is paid, and interest rates are quoted, in different ways. For example, in mid-2006 ING Direct, an Internet bank, offered savings accounts with an interest rate of 5.25% paid at the end of one year, while New Century Bank offered an interest rate of 5.12%, but with the interest paid on a daily basis. Interest rates can also differ depending on the investment horizon. In January 2004, investors earned only about 1% on one-year risk-free investments, but could earn more than 5% on 15-year risk-free investments. Interest rates can also vary due to risk. For example, the U.S. government is able to borrow at a much lower interest rate than General Motors. Because interest rates may be quoted for different time intervals, such as monthly, semiannual, or annual, it is often necessary to adjust the interest rate to a time period that matches that of our cash flows. We explore these mechanics of interest rates in this section.

The Effective Annual Rate effective annual rate (EAR) or annual percentage yield (APY) The total amount of interest that will be earned at the end of one year.

Interest rates are often reported as an effective annual rate (EAR) or annual percentage yield (APY), which indicates the total amount of interest that will be earned at the end of one year.1 We have used this method of quoting the interest rate thus far in this textbook, and in Chapters 3 and 4 we used the EAR as the discount rate r in our time value of money calculations. For example, with an EAR of 5%, a $100 investment grows to +100 * 1 1 + r 2 = +100 * 1 1.05 2 = +105

in one year. After two years it will grow to:

+100 * 1 1 + r 2 2 = +100 * 1 1.05 2 2 = +110.25

Month: Cash flow:

1

0

1

2

$100

(1.05)

$105

(1.05)

$100

(1.05)2

$110.25

$100

(1.1025)

$110.25

$110.25

The effective annual rate is also referred to as the effective annual yield (EAY).

120

Part 2 Interest Rates and Valuing Cash Flows

Adjusting the Discount Rate to Different Time Periods The preceding example shows that earning an effective annual rate of 5% for two years is equivalent to earning 10.25% in total interest over the entire period: +100 * 1 1.05 2 2 = +100 * 1.1025 = +110.25

In general, by raising the interest rate factor 1 1 + r 2 to the appropriate power, we can compute an equivalent interest rate for a longer time period. We can use the same method to find the equivalent interest rate for periods shorter than one year. In this case, we raise the interest rate factor 1 1 + r 2 to the appropriate fractional power. For example, earning 5% interest in one year is equivalent to receiving

1 1 + r 2 0.5 = 1 1.05 2 0.5 = +1.0247

for each $1 invested every six months (0.5 years). That is, a 5% effective annual rate is equivalent to an interest rate of approximately 2.47% earned every six months. We can verify this result by computing the interest we would earn in one year by investing for two six-month periods at this rate:

1 1 + r 2 2 = 1 1.0247 2 2 = +1.05 1 2

Month:

0

Cash flow:

$1

(1.0247)

$1

(1.0247)2

$1.05

$1

(1.05)

$1.05

1

$1.0247 (1.0247) $1.05

In general, we can convert a discount rate of r for one period to an equivalent discount rate for n periods using the following formula: Equivalent [email protected] Discount Rate = 1 1 + r 2 n - 1

(5.1)

In this formula, n can be larger than 1 (to compute a rate over more than one period) or smaller than 1 (to compute a rate over a fraction of a period). When computing present or future values, you should adjust the discount rate to match the time period of the cash flows. This adjustment is necessary to apply the perpetuity or annuity formulas to non-annual cash flows, as in the following example. Personal Finance

EXAMPLE 5.1 Valuing Monthly Cash Flows

Problem Suppose your bank account pays interest monthly with an effective annual rate of 6%. What amount of interest will you earn each month? If you have no money in the bank today, how much will you need to save at the end of each month to accumulate $100,000 in 10 years?

Solution Q Plan We can use Eq. 5.1 to convert the EAR to a monthly rate, answering the first question. The second question is a future value of an annuity question. It is asking how big a monthly annuity we would have to deposit in order to end up with $100,000 in 10 years. However, in order to do this problem, we need to write the timeline in terms of monthly periods because our cash flows (deposits) will be monthly:

Chapter 5 Interest Rates

Month:

0

1

2

121

120 ...

Cash flow:

C

C

C

That is, we can view the savings plan as a monthly annuity with 10 * 12 = 120 monthly payments. We have the future value of the annuity ($100,000), the length of time (120 months), and we will have the monthly interest rate from the first part of the question. We can then use the future value of an annuity formula (Eq. 4.6) to solve for the monthly deposit. Q Execute

From Eq. 5.1, a 6% EAR is equivalent to earning 1 1.06 2 1/12 - 1 = 0.4868% per month. The exponent in this equation is 1/12 because the period is 1/12th of a year (a month). To determine the amount to save each month to reach the goal of $100,000 in 120 months, we must determine the amount C of the monthly payment that will have a future value of $100,000 in 120 months, given an interest rate of 0.4868% per month. Now that we have all of the inputs in terms of months (monthly payment, monthly interest rate, and total number of months), we use the future value of annuity formula from Chapter 4 to solve this problem: FV 1 annuity 2 = C *

1 3 11 + r2n - 14 r

We solve for the payment C using the equivalent monthly interest rate r = 0.4868%, and n = 120 months: C =

FV 1 annuity 2 1 3 11 + r2n - 14 r

=

+100,000 = +615.47 per month 1 3 1 1.004868 2 120 - 1 4 0.004868

We can also compute this result using a financial calculator or spreadsheet:

N I/Y PV PMT FV Given: 120 0.4868 0 100,000 Solve for: 615.47 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.004868,120,0,100000) Q Evaluate Thus, if we save $615.47 per month and we earn interest monthly at an effective annual rate of 6%, we will have $100,000 in 10 years. Notice that the timing in the annuity formula must be consistent for all of the inputs. In this case, we had a monthly deposit, so we needed to convert our interest rate to a monthly interest rate and then use total number of months (120) instead of years.

Annual Percentage Rates annual percentage rate (APR) Indicates the amount of interest earned in one year without the effect of compounding. simple interest Interest earned without the effect of compounding.

The most common way to quote interest rates is in terms of an annual percentage rate (APR), which indicates the amount of simple interest earned in one year, that is, the amount of interest earned without the effect of compounding. Because it does not include the effect of compounding, the APR quote is typically less than the actual amount of interest that you will earn. To compute the actual amount that you will earn in one year, you must first convert the APR to an effective annual rate. For example, suppose Granite Bank advertises savings accounts with an interest rate of “6% APR with monthly compounding.” When it quotes a rate this way, Granite Bank really means that you will earn 6%/12 = 0.5% every month. That is, an APR with monthly compounding is actually a way of quoting a monthly interest rate, rather than an annual interest rate. In this case, the actual rate being quoted is 0.5% per month, and

122

Part 2 Interest Rates and Valuing Cash Flows

COMMON MISTAKE

Using the EAR in the Annuity Formula

At this point, many students make the mistake of trying to use the EAR in the annuity formula. The interest rate in the annuity formula must match the frequency of the cash flows. That’s why in Example 5.1 we first converted the EAR into a monthly rate and then used the annuity formula to compute the monthly loan payments. The common mistake in this case would be to use the EAR in the annuity formula to obtain annual cash flows, and then divide those cash flows by 12 to obtain the monthly payments. This process will produce the wrong answer. To see why, consider the timing of the first deposit in Example 5.1. With a monthly rate and monthly payments, the annuity formula

assumes that the first payment will be made one month from now. It then assumes that you will be making 11 more monthly deposits before the end of the first year. Each of those deposits will start earning interest as soon you make it. In contrast, if you use an EAR and calculate an annual cash flow, the formula assumes that you will make your first deposit one year from now, so that you will forgo a whole year of interest before you start earning anything. Thus, you can see that the EAR approach misses the fact that you are making deposits earlier and more often than annually, so you are adding to your interest-earning principal more frequently than once per year.

by convention, the bank states it as an APR by multiplying by 12 months. Because the interest compounds each month, you will actually have +1 * 1 1.005 2 12 = +1.061678

at the end of one year, for an effective annual rate of 6.1678%. The 6.1678% that you earn on your deposit is higher than the quoted 6% APR due to compounding: In later months, you earn interest on the interest paid in earlier months. To summarize, an actual rate of 0.5% per month can be stated in either of the following ways: Q 6% APR, compounded monthly Q EAR of 6.1678%, which is the actual rate earned per year It is important to remember that because the APR does not reflect the true amount you will earn over one year, the APR itself cannot be used as a discount rate. Instead, the APR is a way of quoting the actual interest earned each compounding period: Interest Rate per Compounding Period =

APR m

1 m = number of compounding periods per year 2

(5.2)

Once we have computed the interest earned per compounding period from Eq. 5.2, we can compute the equivalent interest rate for any other time interval using Eq. 5.1. Thus, the effective annual rate corresponding to an APR is given by the following conversion formula: Converting an APR to an EAR 1 + EAR = ¢1 +

APR m ≤ m

1 m = number of compounding periods per year 2

(5.3)

Table 5.1 shows the effective annual rates that correspond to an APR of 6% with different compounding intervals. The EAR increases with the frequency of compounding because of the ability to earn interest on interest sooner. Investments can compound even more frequently than daily. In principle, the compounding interval could be hourly or every second. As a practical matter, compounding more frequently than daily has a negligible impact on the effective annual rate and is rarely observed. When working with APRs, we must first convert the APR to a discount rate per compounding interval using Eq. 5.2, or to an EAR using Eq. 5.3, before evaluating the present or future value of a set of cash flows.

Chapter 5 Interest Rates

TABLE 5.1 Effective Annual Rates for a 6% APR with Different Compounding Periods

Compounding Interval

Effective Annual Rate

Annual Semiannual Monthly Daily

EXAMPLE 5.2 Converting the APR to a Discount Rate

123

¢1 +

0.06 1 ≤ - 1 = 6% 1

¢1 +

0.06 2 ≤ - 1 = 6.09% 2

¢1 +

0.06 12 ≤ - 1 = 6.1678% 12

¢1 +

0.06 365 ≤ - 1 = 6.1831% 365

Problem Your firm is purchasing a new telephone system that will last for four years. You can purchase the system for an upfront cost of $150,000, or you can lease the system from the manufacturer for $4000 paid at the end of each month. The lease price is offered for a 48-month lease with no early termination—you cannot end the lease early. Your firm can borrow at an interest rate of 6% APR with monthly compounding. Should you purchase the system outright or pay $4000 per month?

Solution Q Plan The cost of leasing the system is a 48-month annuity of $4000 per month: Month:

0

1

2

48 ...

Payment: $4000 $4000 $4000 We can compute the present value of the lease cash flows using the annuity formula, but first we need to compute the discount rate that corresponds to a period length of one month. To do so, we convert the borrowing cost of 6% APR with monthly compounding to a monthly discount rate using Eq. 5.2. Once we have a monthly rate, we can use the present value of annuity formula Eq. 4.5 to compute the present value of the monthly payments and compare it to the cost of buying the system.

Q Execute As Eq. 5.2 shows, the 6% APR with monthly compounding really means 6%/12 = 0.5% every month. The 12 comes from the fact that there are 12 monthly compounding periods per year. Now that we have the true rate corresponding to the stated APR, we can use that discount rate in the annuity formula Eq. 4.5 to compute the present value of the monthly payments: PV = 4000 *

1 1 ¢1 ≤ = +170,321.27 0.005 1.00548

Using a financial calculator or spreadsheet:

Given: Solve for:

N 48

I/Y 0.5

PV

PMT 4000

FV 0

170,321.27 Excel Formula: PV(RATE,NPER,PMT,FV)PV(0.005,48,4000,0)

Q Evaluate Thus, paying $4000 per month for 48 months is equivalent to paying a present value of $170,321.27 today. This cost is +170,321.27 - +150,000 = +20,321.27 higher than the cost of purchasing the system, so it is better to pay $150,000 for the system rather than lease it. One way to interpret this result is as follows: At a 6% APR with monthly compounding, by promising to repay $4000 per month your firm can borrow $170,321 today. With this loan it could purchase the phone system and have an additional $20,321 to use for other purposes.

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Concept Check

5.2

1. What is the difference between an EAR and an APR quote? 2. Why can’t the APR be used as a discount rate?

Application: Discount Rates and Loans Now that we have explained how to compute the discount rate from an interest rate quote, let’s apply the concept to solve two common financial problems: calculating a loan payment and calculating the remaining balance on a loan.

Computing Loan Payments amortizing loan A loan on which the borrower makes monthly payments that include interest on the loan plus some part of the loan balance.

Many loans, such as mortgages and car loans, have monthly payments and are quoted in terms of an APR with monthly compounding. These types of loans are amortizing loans, which means that each month you pay interest on the loan plus some part of the loan balance. Each monthly payment is the same, and the loan is fully repaid with the final payment. Typical terms for a new car loan might be “6.75% APR for 60 months.” When the compounding interval for the APR is not stated explicitly, it is equal to the interval between the payments, or one month in this case. Thus, this quote means that the loan will be repaid with 60 equal monthly payments, computed using a 6.75% APR with monthly compounding. It sometimes helps to look at the loan from the bank’s point of view: the bank will give you $30,000 in cash today to use to buy the car. In return, you will give the bank 60 equal payments each month for 60 months, starting one month from now. In order for the bank to be willing to accept this exchange, it must be true that the present value of what you will give the bank, discounted at the loan’s interest rate, is equal to the amount of cash the bank is giving you now. Consider the timeline for a $30,000 car loan with these terms: Month:

0

1

2

60 ...

C

Cash flow: $30,000

C

C

The payment, C, is set so that the present value of the cash flows, evaluated using the loan interest rate, equals the original principal amount of $30,000. In this case, the 6.75% APR with monthly compounding corresponds to a one-month discount rate of 6.75%/12 = 0.5625%. It is important that the discount rate match the frequency of the cash flows—here we have a monthly discount rate and a monthly loan payment, so we can proceed. Because the loan payments are an annuity, we can use Eq. 4.9 to find C: P 30,000 C = = = +590.50 1 1 1 1 ¢1 ≤ ¢1 ≤ r 0.005625 11 + r2N 1 1 + 0.005625 2 60 Alternatively, we can solve for the payment C using a financial calculator or spreadsheet:

Given: Solve for:

N 60

I/Y 0.5625

PV 30,000

PMT

FV 0

590.50 Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.005625,60,30000,0)

Your loan payment each month includes interest and repayment of part of the principal, reducing the amount you still owe. Because the loan balance (the amount you still owe) is decreasing each month, the interest that accrues on that balance is decreasing. As a

Chapter 5 Interest Rates

125

result, even though your payment stays the same over the entire 60-month life of the loan, the part of that payment needed to cover interest each month is constantly decreasing and the part left over to reduce the principal further is constantly increasing. We illustrate this effect in panel (a) of Figure 5.1, where we show the proportion of each monthly

FIGURE 5.1 Amortizing Loan

Panel (a) shows how the interest (red) and principal portions (turquoise) of the monthly payment on the $30,000 car loan change over the life of the loan. Panel (b) illustrates the effect on the outstanding balance (principal) of the loan. Note that as the balance decreases, the amount of the payment needed to cover interest on that balance decreases, allowing more of the payment to be used to reduce the principal. Panel (a) $700

Principal Payment Interest Payment

$600 $500 $400 $300 $200 $100 $0

1

4

7

10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 60 Months

Panel (b) $35,000

Principal Outstanding

$30,000 $25,000 $20,000 $15,000 $10,000 $5000 $0

1

4

7

10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 60 Months

126

Part 2 Interest Rates and Valuing Cash Flows loan payment that covers interest (red) and the portion left over to reduce the principal (turquoise). As you can see, $168.75 of your first $590.50 payment is needed just to cover interest accrued over the first month 1 +30,000 * 0.005625 = +168.75 2 . However, this amount steadily decreases so that by the end of the loan, nearly all of your payment is going toward principal. Panel (b) of Figure 5.1 shows the effect of your payments on the loan balance. When you make your first payment of $590.50, $168.75 covers interest on the loan, leaving $421.75 to reduce the principal to +30,000 - +421.75 = +29,578.25. The next month, you owe interest only on the $29,578.25 loan balance, which is $166.38, leaving more of your $590.50 payment to reduce the principal further. This effect continues so that each month more of your payment is available to reduce the principal, causing the principal to decrease rapidly toward the end of the loan as you are taking bigger and bigger chunks out of the balance.

Computing the Outstanding Loan Balance As Figure 5.1 shows, the outstanding balance on an amortizing loan is different each month. The amount you owe at any point in time can be calculated as the present value of your future obligations on the loan. So, the outstanding balance, also called the outstanding principal, is equal to the present value of the remaining future loan payments, again evaluated using the loan interest rate. We calculate the outstanding loan balance by determining the present value of the remaining loan payments using the loan rate as the discount rate. Personal Finance

EXAMPLE 5.3 Computing the Outstanding Loan Balance

Problem Let’s say that you are now three years into your $30,000 car loan from the previous section and you decide to sell the car. When you sell the car, you will need to pay whatever the remaining balance is on your car loan. After 36 months of payments, how much do you still owe on your car loan?

Solution Q Plan We have already determined that the monthly payments on the loan are $590.50. The remaining balance on the loan is the present value of the remaining 2 years, or 24 months, of payments. Thus, we can just use the annuity formula with the monthly rate of 0.5625%, a monthly payment of $590.50, and 24 months remaining. Q Execute Balance with 24 months remaining = +590.50 *

1 1 ¢1 ≤ = +13,222.32 0.005625 1.00562524

Thus, after three years, you owe $13,222.32 on the loan. Using a financial calculator or spreadsheet:

N I/Y PV PMT FV Given: 24 0.5625 590.50 0 Solve for: 13,222.32 Excel Formula: PV(RATE,NPER,PMT,FV)PV(0.005625,24,590.50,0) You could also compute this as the FV of the original loan amount after deducting payments:

N I/Y PV PMT FV Given: 36 0.5625 30,000 590.50 Solve for: 13,222.56 Excel Formula: FV(RATE,NPER,PMT,PV)FV(0.005625,36,590.50,30000)

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127

The 24 cent difference is due to rounding on the payment amount. Q Evaluate At any point in time, including when you first take out the loan, you can calculate the balance of the loan as the present value of your remaining payments. Recall that when the bank gave you the $30,000 in the first place, it was willing to take 60 monthly payments of $590.50 in return only because the present value of those payments was equivalent to the cash it was giving you. Any time that you want to end the loan, the bank will charge you a lump sum equal to the present value of what it would receive if you continued making your payments as planned. As the second approach shows, the amount you owe can also be thought of as the future value of the original amount borrowed after deducting payments made along the way.

Concept Check

5.3

3. How is the principal repaid in an amortizing loan? 4. Why does the part of your loan payment covering interest change over time?

The Determinants of Interest Rates Now that we understand how interest rates are quoted and used in loans, we turn to a broader question: How are interest rates determined? Fundamentally, interest rates are determined by market forces based on the relative supply and demand of funds. This supply and demand is in turn determined by the willingness of individuals, banks, and firms to borrow, save, and lend. Changes in interest rates affect consumer decisions, such as how much you can borrow for a car loan or mortgage. Because they change the present value of future cash flows, changes in interest rates also have a broad impact on capital budgeting decisions within the firm. In this section, we look at some of the factors that may influence interest rates, such as inflation, current economic activity, and expectations of future growth.

Inflation and Real Versus Nominal Rates

nominal interest rates Interest rates quoted by banks and other financial institutions that indicate the rate at which money will grow if invested for a certain period of time.

real interest rate The rate of growth of purchasing power after adjusting for inflation.

Inflation measures how the purchasing power of a given amount of currency declines due to increasing prices. How many times have you heard the expression, “A dollar just doesn’t buy what it used to”? We’ve all witnessed the steady upward climb of prices—for example, your morning coffee probably costs a little more today than it did five years ago. Inflation affects how we evaluate the interest rates being quoted by banks and other financial institutions. Those interest rates, and the ones we have used for discounting cash flows in this book, are nominal interest rates, which indicate the rate at which your money will grow if invested for a certain period. Of course, if prices in the economy are also increasing due to inflation, the nominal interest rate does not represent the true increase in purchasing power that will result from investing. For example, let’s say that a cup of coffee costs $1 this year. If you have $100, you could buy 100 coffees. Instead, if you put that $100 in a bank account earning 5.06% per year, you will have $105.06 at the end of the year. But how much better off will you really be? That depends on how much prices have increased over the same year. If inflation was 3% over the year, then that cup of coffee would cost 3% more, or $1.03 at the end of the year. Thus, you could take your $105.06 and buy +105.06/+1.03 = 102 coffees, so you’re really only 2% better off. That 2% is your real interest rate: the rate of growth of your purchasing power, after adjusting for inflation. Just as in the example, we can calculate the rate of growth of purchasing power as follows: 1 + Nominal Rate Growth in Purchasing Power = 1 + Real Rate = 1 + Inflation Rate Growth of Money = (5.4) Growth of Prices

128

Part 2 Interest Rates and Valuing Cash Flows We can rearrange Eq. 5.4 to find the following formula for the real interest rate, together with a convenient approximation for the real interest rate when inflation rates are low: The Real Interest Rate Nominal Rate - Inflation Rate Real Rate = ⬇ Nominal Rate - Inflation Rate (5.5) 1 + Inflation Rate That is, the real interest rate is approximately equal to the nominal interest rate less the rate of inflation.2

EXAMPLE 5.4

Problem

Calculating the Real Interest Rate

In the year 2000, short-term U.S. government bond rates were about 5.8% and the rate of inflation was about 3.4%. In 2003, bond rates were about 1% and the rate of inflation was about 1.9%. What was the real interest rate in 2000 and 2003?

Solution Q Plan The bond rates tell us the nominal rates. Given the nominal rates and inflation rates for each year, we can use Eq. 5.5 to calculate the real interest rate. Q Execute Eq. 5.5 says: Real Rate =

Nominal Rate - Inflation Rate 1 + Inflation Rate

Thus, the real interest rate in 2000 was 1 5.8% - 3.4% 2 / 1 1.034 2 = 2.32% (which is approximately equal to the difference between the nominal rate and inflation: 5.8% - 3.4% = 2.4%). In 2003, the real interest rate was 1 1% - 1.9% 2 / 1 1.019 2 = -0.88%. Q Evaluate Note that the real interest rate was negative in 2003, indicating that interest rates, given by the bond rates, were insufficient to keep up with inflation. As a result, investors in U.S. government bonds were able to buy less at the end of the year than they could have purchased at the start of the year.

Figure 5.2 shows the history of nominal interest rates and inflation rates in the United States since 1955. Note that the nominal interest rate tends to move with inflation. Intuitively, individuals’ willingness to save will depend on the growth in purchasing power they can expect (given by the real interest rate). Thus, when the inflation rate is high, a higher nominal interest rate is needed to induce individuals to save. This was evident in the late 1970s and early 1980s when inflation reached double-digits in the United States, and nominal rates increased in response.

Investment and Interest Rate Policy Interest rates affect not only individuals’ propensity to save, but also firms’ incentive to raise capital and invest. Consider an opportunity that requires an upfront investment of 2

The real interest rate should not be used as a discount rate for future cash flows. It can be used as a discount rate only if the cash flows are not the expected cash flows that will be paid, but are the equivalent cash flows before adjusting them for growth due to inflation (in that case, we say the cash flows are in real terms). This approach is error prone, however, so throughout this book we will always forecast cash flows including any growth due to inflation, and discount using nominal interest rates.

Chapter 5 Interest Rates

U.S. Interest Rates and Inflation Rates, 1955–2009

The graph shows U.S. nominal interest rates (in blue) and inflation rates (in red) from 1955–2009. Note that interest rates tend to be high when inflation is high. Interest rates are average three-month Treasury bill rates and inflation rates are based on annual increases in the U.S. Bureau of Labor Statistics’ consumer price index.

Inflation Rate

16.00

Nominal Interest Rate 14.00 12.00 10.00 Rate (%)

FIGURE 5.2

129

8.00 6.00 4.00 2.00 0.00 1960

1970

1980

1990

2000

2010

Year Source: St. Louis Federal Reserve Economic Data (FRED).

$10 million and generates a cash flow of $3 million per year for four years. If the interest rate is 5%, this investment’s benefits have a PV of: 3 3 3 3 PV = + + + = +10.638 million 2 3 1.05 1.05 1.05 1.054 If the interest rate is 9%, the PV falls to PV =

3 3 3 3 + + + = +9.719 million 1.09 1.092 1.093 1.094

and the investment is no longer profitable given its $10 million cost. The reason, of course, is that we are discounting the positive cash flows at a higher rate, which reduces their present value. The cost of $10 million occurs today, however, so its present value is independent of the discount rate. More generally, when the costs of an investment precede the benefits, an increase in the interest rate will make the investment less attractive. All else being equal, higher interest rates will therefore tend to shrink the set of good investments available to firms. The Federal Reserve in the United States and central banks in other countries attempt to use this relationship between interest rates and investment incentives when trying to guide the economy. They will often lower interest rates in an attempt to stimulate investment if the economy is slowing, and they will raise interest rates to reduce investment if the economy is “overheating” and inflation is on the rise.

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How Is Inflation Actually Calculated? Inflation is calculated as the rate of change in the Consumer Price Index (CPI). The CPI measures what it costs each month to purchase a standard set of goods that the average consumer would buy. How controversial can price data be? To gather the price information, data collectors visit stores and gather 80,000 retail price quotes and 5000 housing rent quotes. The data is sent daily to Washington, DC, where analysts at the Bureau of Labor Statistics seek to determine if part of a price change captures a change in quality or inflation. Because this adjustment can be subjective, herein lies the controversy in the CPI calculation. The Wall Street Journal, covering the controversy, reported the following examples: Q A 57-inch television in which the price dropped from $2238.99 to $1909.97. Going over the checklist, the data gatherer in the field discovered the old version had a built-in high-definition tuner. The new one did not. The analyst estimated that the tuner was valued at $513.69. This turned what appeared to be a 14.7% price decrease into a 10.7% increase.

Q A 27-inch television where the price appeared to stay the same, but an analyst determined that the price had declined. The latest model had a flat screen, something that consumers value more than the curved screen in the old model. The newer TV also had a ten-watt stereo, compared with the weaker six-watt stereo in the older model. Critics argue that this quality adjustment most often ends up making a price increase look smaller or even turning it into a decline. Thus, they conclude that the government underestimates the true rate of inflation. Supporters argue that these adjustments are necessary because paying more for a better product is not equivalent to paying more for the same product. This debate is important because many union contracts, for example, have wages linked to inflation, and investors need good inflation data to determine what interest rate to demand. WSJ Source : Aeppel, T., “New and Improved: An Inflation Debate Brews Over Intangibles at the Mall—Critics Say U.S. Plays Down CPI Through Adjustments For Quality, Not Just Price—Value of a TV’s Flat Screen,” 9 May 2005, A1.

The Yield Curve and Discount Rates

term structure The relationship between the investment term and the interest rate. yield curve A plot of bond yields as a function of the bonds’ maturity date. risk-free interest rate The interest rate at which money can be borrowed or lent without risk over a given period.

The interest rates that banks offer on investments or charge on loans depend on the horizon, or term, of the investment or loan. For example, suppose you are willing to put your money in a CD (certificate of deposit)3 that matures in two years (meaning that you cannot get the money back before then without a penalty). The bank will offer you a higher rate of interest for this CD than if you put your money in a statement savings account, where you can withdraw your funds at any time. The relationship between the investment term and the interest rate is called the term structure of interest rates. We can plot this relationship on a graph called the yield curve. Figure 5.3 shows the term structure and corresponding yield curve of U.S. interest rates that were available to investors in November of 2006, 2007, and 2008. In each case, note that the interest rate depends on the horizon, and that the difference between short-term and long-term interest rates was especially pronounced in 2008. The rates plotted are interest rates for U.S. Treasury securities, which are considered to be free of any risk of default (the U.S. government will not default on its loans). Thus, each of these rates is a risk-free interest rate, which is the interest rate at which money can be borrowed or lent without risk over a given period. We can use the term structure to compute the present and future values of a risk-free cash flow over different investment horizons. For example, $100 invested for one year at the one-year interest rate in November 2008 would grow to a future value of +100 * 1.0091 = +100.91

3

A certificate of deposit is a short- or medium-term debt instrument offered by banks. You deposit money in the bank for a stated period of time and normally receive a fixed rate of interest. The rate is higher than it would be on a savings account because you cannot withdraw your money early without paying a penalty.

Chapter 5 Interest Rates

131

FIGURE 5.3 Term Structure of Risk-Free U.S. Interest Rates, November 2006, 2007, and 2008 The figure shows the interest rate available from investing in risk-free U.S. Treasury securities with different investment terms. In each case, the interest rates differ depending on the

0.5 1 2 3 4 5 6 7 8 9 10 15 20

Nov-06 5.23% 4.99% 4.80% 4.72% 4.63% 4.64% 4.65% 4.66% 4.69% 4.70% 4.73% 4.89% 4.87%

6%

Date Nov-07 3.32% 3.16% 3.16% 3.12% 3.34% 3.48% 3.63% 3.79% 3.96% 4.00% 4.18% 4.44% 4.45%

Nov-08 0.47% 0.91% 0.98% 1.26% 1.69% 2.01% 2.49% 2.90% 3.21% 3.38% 3.41% 3.86% 3.87%

November 2006 5%

Interest Rate (EAR)

Term (years)

horizon. For example, in 2008, the interest rate on a 10-year loan (3.41%) was more than three times the rate on a 1-year loan (0.91%).

4% November 2007 3% November 2008 2% 1% 0%

0

2

4

6

8 10 12 Term (Years)

14

16

18

20

(Data from U.S. Treasury securities.)

at the end of one year, and $100 invested for ten years at the ten-year interest rate in November 2008 would grow to:4 +100 * 1 1.0341 2 10 = +139.84

We can apply the same logic when computing the present value of cash flows with different maturities. A risk-free cash flow received in two years should be discounted at the two-year interest rate, and a cash flow received in ten years should be discounted at the ten-year interest rate. In general, a risk-free cash flow of Cn received in n years has the present value PV =

Cn 1 1 + rn 2 n

(5.6)

where rn is the risk-free interest rate for an n-year term. In other words, when computing a present value we must match the term of the cash flow and term of the discount rate. Combining Eq. 5.6 for cash flows in different years leads to the general formula for the present value of a cash flow stream: Present Value of a Cash Flow Stream Using a Term Structure of Discount Rates C1 C2 CN PV = (5.7) + + g + 2 1 + r1 1 1 + r2 2 1 1 + rN 2 N

4

We could also invest for ten years by investing at the one-year interest rate for ten years in a row. However, because we do not know what future interest rates will be, our ultimate payoff would not be risk free.

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Part 2 Interest Rates and Valuing Cash Flows

INTERVIEW WITH

FREDERIC S. MISHKIN

Frederic Mishkin, Alfred Lerner Professor of Banking and Financial Institutions at Columbia University Graduate School of Business, served as a governor of the Federal Reserve Board from 2006 to 2008. QUESTION: What are the main policy instruments used by central banks to control the economy? ANSWER: Short-term interest rates are one of the main policy instru-

ments used by central banks to control the economy. Specifically, central banks like the U.S. Federal Reserve (Fed) will act to lower short-term interest rates in order to stimulate investment if the economy is in a recession. For example, while the economy was slowing down in 2007 and 2008, the Fed cut its short-term interest rate target aggressively, from 5.25% down to 0% by year’s end. The Fed can affect interest rates by changing the amount of liquidity in the financial system. By purchasing U.S. Treasury and federal agency securities or making loans to the financial system, the Fed increases banks available reserves. This expansion of bank’s liquidity increases the availability of credit, thereby lowering interest rates. Similarly, if the Fed sells securities to financial firms, the cash they use to purchase the securities is no longer available to be lent, and this shortage of liquidity raises interest rates.

heating up. Consumers reduce spending when faced with higher interest rates on mortgages, credit cards, and car loans. Likewise, firms cut back on projects when the cost to finance them goes up.

During the 2007–2009 financial crisis, the Fed became concerned about the risk of deflation. Why is deflation a concern?

QUESTION:

ANSWER: The dangers of deflation—or a negative inflation rate— are every bit as serious as the dangers of inflation. Deflation also creates uncertainty about future price levels and makes debt more expensive to repay in terms of goods and services. When borrowers struggle to repay debt or default on their debt obligations, the economy suffers. Deflation also limits the effectiveness of monetary policy. The Federal Reserve can only control nominal interest rates. But investors’ decisions to save or invest are determined by real interest rates, which determine the amount they will actually earn after accounting for inflation. If the inflation rate falls significantly below the nominal interest, then the real interest rate can remain high and offset the Fed’s attempt to stimulate the economy.

QUESTION: We often hear that the Fed is concerned about inflation—why? How does the Fed act to fight inflation?

QUESTION:

Recently, the Fed has been buying long-term Treasury Bonds. Why would the Fed do this?

ANSWER: A primary objective of a central bank is price stability, maintaining a low and stable inflation rate. Getting to the “right” number—an inflation rate that is neither too high nor too low—is one of the key challenges of monetary policy today. High inflation is almost always accompanied by high variability of inflation, making it difficult for consumers, businesses, and government to plan for the future and thus reducing economic efficiency. The Federal Reserve tries to curb inflation by raising interest rates. Higher interest rates constrain demand in the economy, bringing it into balance with supply and preventing inflation from

ANSWER: When traditional monetary policy tools fall short, the Federal Reserve pursues other options. So in 2008–2009, the Fed provided liquidity directly to certain credit markets, lowering interest rates on loans and on securities that have credit risk. The Fed’s purchase on long-term Treasury bonds is another example. In 2009, when short-term rates were close to 0 percent, the Fed bought long-term Treasury bonds. Because of the inverse relationship between bond prices and interest rates, this action lowered long-term interest rates relative to short-term rates.

Note the difference between Eq. 5.7 and Eq. 4.3. Here, we use a different discount rate for each cash flow, based on the rate from the yield curve with the same term. When interest rates are very similar across maturities, we say that the yield curve is flat, because it is close to a flat line. When the yield curve is relatively flat, as it was in November 2006, the distinction of using different rates for each cash flow is relatively minor and is often ignored by discounting using a single “average” interest rate r. But when short-term and long-term interest rates vary widely, as they did in November 2008, Eq. 5.7 should be used. Warning: All of our shortcuts for computing present values (annuity and perpetuity formulas, and financial calculators) are based on discounting all of the cash flows at the same rate. They cannot be used in situations in which cash flows need to be discounted at different rates.

Chapter 5 Interest Rates

EXAMPLE 5.5

133

Problem

Using the Term Structure to Compute Present Values

Compute the present value of a risk-free 5-year annuity of $1000 per year, given the yield curve for November 2008 in Figure 5.3.

Solution Q Plan The timeline of the cash flows of the annuity is:

0

1

2

3

4

5

$1000

$1000

$1000

$1000

$1000

We can use the table next to the yield curve to identify the interest rate corresponding to each length of time: 1, 2, 3, 4, and 5 years. With the cash flows and those interest rates, we can compute the PV. Q Execute From Figure 5.3, we see that the interest rates are: 0.91%, 0.98%, 1.26%, 1.69%, and 2.01%, for terms of 1, 2, 3, 4, and 5 years, respectively. To compute the present value, we discount each cash flow by the corresponding interest rate: PV =

1000 1000 1000 1000 1000 + + + + = +4775 2 3 4 1.0091 1.0098 1.0126 1.0169 1.02015

Q Evaluate The yield curve tells us the market interest rate per year for each different maturity. In order to correctly calculate the PV of cash flows from five different maturities, we need to use the five different interest rates corresponding to those maturities. Note that we cannot use the annuity formula here because the discount rates differ for each cash flow.

COMMON MISTAKE

Using the Annuity Formula When Discount Rates Vary

When computing the present value of an annuity, a common mistake is to use the annuity formula with a single interest rate even though interest rates vary with the investment horizon. For example, we cannot compute the present value of the five-year annuity in Example 5.5 using the five-year interest rate from November 2008: PV Z +1000 *

1 1 ¢1 ≤ = +4712 0.0201 1.02015

If we want to find the single interest rate that we could use to value the annuity, we must first compute the present value of the annuity using Eq. 5.7 and then solve for its rate of return. For the annuity in Example 5.5, we use a financial calculator or spreadsheet to find its rate of return of 1.55%. The rate of return of the annuity is always between the highest and lowest discount rates used to calculate its present value, as is the case in this example.

Given: Solve for:

N 5

I/Y

PV 4775

PMT 1000

FV 0

1.55 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(5,1000,4775,0)

The Yield Curve and the Economy As Figure 5.4 illustrates, the yield curve changes over time. Sometimes, short-term rates are close to long-term rates, and at other times they may be very different. What accounts for the changing shape of the yield curve?

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Part 2 Interest Rates and Valuing Cash Flows

FIGURE 5.4

Yield Curve Shapes example of a steep yield curve is from October 1991. Finally, the green line depicts an inverted yield curve, so called because it slopes downward instead of upward. This happens when shortterm rates are higher than long-term rates as they were in January 1981. We discuss why the shape of the yield curve changes over time in the rest of this section.

0

5

10

20

Years

(a) Normal Yield Curve

federal funds rate The overnight loan rate charged by banks with excess reserves at a Federal Reserve bank (called federal funds ) to banks that need additional funds to meet reserve requirements.

30

16% 14% 12% 10% 8% 6% 4% 2% 0%

Interest Rate

16% 14% 12% 10% 8% 6% 4% 2% 0%

Interest Rate

Interest Rate

The figure shows three different yield curve shapes. The blue line represents a “normal” yield curve. Most of the time the yield curve has this shape—moderately upward sloping. The red line depicts a steep yield curve—note the larger than normal difference between short-term rates (2%) and long-term rates (7%), making the yield curve look steeper than normal. This

0

5

10

20

Years

(b) Steep Yield Curve

30

16% 14% 12% 10% 8% 6% 4% 2% 0%

0

5

10

20

30

Years

(c) Inverted Yield Curve

Interest Rate Determination. The Federal Reserve determines very short-term interest rates through its influence on the federal funds rate, which is the rate at which banks can borrow cash reserves on an overnight basis. All other interest rates on the yield curve are set in the market and are adjusted until the supply of lending matches the demand for borrowing at each loan term. As we shall see in a moment, expectations of future interest rate changes have a major effect on investors’ willingness to lend or borrow for longer terms and, therefore, on the shape of the yield curve. Suppose short-term interest rates are equal to long-term interest rates. If interest rates are expected to rise in the future, investors would not want to make long-term investments. Instead, they could do better by investing on a short-term basis and then reinvesting after interest rates rose. Thus, if interest rates are expected to rise, long-term interest rates will tend to be higher than short-term rates to attract investors. Similarly, if interest rates are expected to fall in the future, then borrowers would not wish to borrow at long-term rates that are equal to short-term rates. They would do better by borrowing on a short-term basis, and then taking out a new loan after rates fall. So, if interest rates are expected to fall, long-term rates will tend to be lower than short-term rates to attract borrowers. Yield Curve Shape. These arguments indicate that the shape of the yield curve will be strongly influenced by interest rate expectations. A sharply increasing (steep) yield curve, with long-term rates much higher than short-term rates, generally indicates that interest rates are expected to rise in the future. A decreasing (inverted ) yield curve, with longterm rates lower than short-term rates, generally signals an expected decline in future interest rates. Because interest rates tend to drop in response to a slowdown in the economy, an inverted yield curve is often interpreted as a negative forecast for economic growth. Indeed, as Figure 5.5 illustrates, each of the last seven recessions in the United States was preceded by a period in which the yield curve was inverted (note the red shaded areas before the gray bars indicating a recession). Conversely, the yield curve tends to be steep (and therefore shaded blue) as the economy comes out of a recession and interest rates are expected to rise.

Chapter 5 Interest Rates

FIGURE 5.5

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Short-Term Versus Long-Term U.S. Interest Rates and Recessions Research. Note that inverted yield curves tend to precede recessions as determined by the National Bureau of Economic Research. In recessions, interest rates tend to fall, with shortterm rates dropping further. As a result, the yield curve tends to be steep coming out of a recession.

One-year and ten-year U.S. Treasury rates are plotted, with the spread between them shaded in green if the shape of the yield curve is increasing (the one-year rate is below the ten-year rate) and in red if the yield curve is inverted (the one-year rate exceeds the ten-year rate). Gray bars show the dates of U.S. recessions as determined by the National Bureau of Economic

18 10-year Interest Rate 1-year Interest Rate Recession

16

Interest Rate (%)

14 12 10 8 6 4

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

0

1962

2

Year

The normal shape of the yield curve is moderately upward sloping. This would be the case if investors almost always believed that interest rates were going to rise in the future. But that is unlikely, so there have to be other forces at work to cause long-term interest rates normally to be higher than short-term rates. The most commonly cited reason is that long-term loans are riskier than short-term loans. If you make a 30-year loan today and lock in the interest rate, the present value of the payments you receive on the loan is very sensitive to even small changes in market interest rates. This sensitivity is due to the effect of compounding a change in interest rates over a 30-year period. To see this effect, consider the following example.

EXAMPLE 5.6 Long-Term Versus Short-Term Loans

Problem You work for a bank that has just made two loans. In one, you loaned $909.09 today in return for $1000 in one year. In the other, you loaned $909.09 today in return for $15,863.08 in 30 years. The difference between the loan amount and repayment amount is based on an interest rate of 10% per year. Imagine that immediately after you make the loans, news about economic growth is announced that increases inflation expectations, so that the market interest rate for loans like these jumps to 11%. Loans make up a major part of a bank’s assets, so you are naturally concerned about the value of these loans. What is the effect of the interest rate change on the value to the bank of the promised repayment of these loans?

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Part 2 Interest Rates and Valuing Cash Flows Solution Q Plan Each of these loans has only one repayment cash flow at the end of the loan. They differ only by the time to repayment: Loan Today 1

909.09

1000

Loan Today

1…29

30

909.09

0

15,863.08

The effect on the value of the future repayment to the bank today is just the PV of the loan repayment, calculated at the new market interest rate. Q Execute For the one-year loan: PV =

+1000 = +900.90 1 1.11 2 1

For the 30-year loan: PV =

+15,863.08 = +692.94 1 1.11 2 30

Q Evaluate The value of the one-year loan decreased by +909.09 - +900.90 = +8.19, or 0.9%, but the value of the 30-year loan decreased by +909.09 - +692.94 = +216.15, or almost 24%! The small change in market interest rates, compounded over a longer period, resulted in a much larger change in the present value of the loan repayment. You can see why investors and banks view longer-term loans as being riskier than short-term loans.

In addition to specifying the discount rates for risk-free cash flows that occur at different horizons, it is also a potential leading indicator of future economic growth. Due to these qualities, the yield curve provides extremely important information for a business manager.

Concept Check

5.4

5. What is the difference between a nominal and real interest rate? 6. How are interest rates and the level of investment made by businesses related?

The Opportunity Cost of Capital As we have seen in this chapter, the interest rates we observe in the market will vary based on quoting conventions, the term of the investment, and risk. In this chapter, we have developed the tools to account for these differences and gained some insights into how interest rates are determined. This knowledge will provide the foundation for our study of bonds in the next chapter. In Chapter 3, we argued that the Valuation Principle tells us to use the “market interest rate” to compute present values and evaluate an investment opportunity. But with so many interest rates to choose from, the term “market interest rate” is inherently ambiguous. Therefore, going forward in the textbook, we will base the discount rate that we use to evaluate cash flows on the investor’s opportunity cost of capital (or more simply, the cost of capital), which is the best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted.

Chapter 5 Interest Rates opportunity cost of capital or cost of capital The best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted; the return the investor forgoes on an alternative investment of equivalent risk and term when the investor takes on a new investment.

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In order to understand the definition of opportunity cost of capital, it helps to think of yourself as a financial manager competing with financial managers at other firms to attract investors’ funds (capital). In order to attract investors to invest in your firm or creditors to lend to your firm, you have to be able to offer them an expected return at least as good as what they could get elsewhere in the market for the same risk and length of investment. Now it is easier to see where the term (opportunity) cost of capital comes from—investors in your firm are giving up the opportunity to invest their funds elsewhere. This is an opportunity cost to them and to overcome it you must offer them a return equal to or better than their opportunity cost of capital. Even if you already have the funds internally in the firm to invest, the logic still applies. You could either return the funds to your shareholders to invest elsewhere, or reinvest them in a new project; however, you should only reinvest them if doing so provides a better return than the shareholders’ other opportunities.

Interest Rates, Discount Rates, and the Cost of Capital By now, you may have noticed that we are using three terms to refer to rates of return. While many people use these three terms interchangeably, they are distinct. Throughout this book, we will use “interest rate” to

mean a quoted rate in the market. A “discount rate” is the appropriate rate for discounting a given cash flow, matched to the frequency of the cash flow. Finally, we use “cost of capital” to indicate the rate of return on an investment of similar risk.

The opportunity cost of capital is the return the investor forgoes when the investor takes on a new investment. For a risk-free project, it will typically correspond to the interest rate on U.S. Treasury securities with a similar term. But the cost of capital is a much more general concept that can be applied to risky investments as well.

EXAMPLE 5.7 The Opportunity Cost of Capital

Problem Suppose a friend offers to borrow $100 from you today and in return pay you $110 one year from today. Looking in the market for other options for investing the $100, you find your best alternative option that you view as equally risky as lending it to your friend. That option has an expected return of 8%. What should you do?

Solution Q Plan Your decision depends on what the opportunity cost is of lending your money to your friend. If you lend her the $100, then you cannot invest it in the alternative with an 8% expected return. Thus, by making the loan, you are giving up the opportunity to invest for an 8% expected return. You can make your decision by using your 8% opportunity cost of capital to value the $110 in one year. Q Execute The value of the $110 in one year is its present value, discounted at 8%: PV =

+110 = +101.85 1 1.08 2 1

The $100 loan is worth $101.85 to you today, so you make the loan. Q Evaluate The Valuation Principle tells us that we can determine the value of an investment by using market prices to value the benefits net of the costs. As this example shows, market prices determine what our best alternative opportunities are, so that we can decide whether an investment is worth the cost.

Chapter 3 introduced the Valuation Principle as a unifying theme in finance. In this and the preceding chapters, we have developed the fundamental tools a financial manager

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Part 2 Interest Rates and Valuing Cash Flows needs to value cash flows at different points in time. In this last section, we have reiterated the importance of using market information to determine the opportunity cost of capital, which is your discount rate in valuation calculations. In the next chapter, we will study bonds and how they are priced, which provides us with an immediate application of the knowledge we have built so far.

Concept Check

7. What is the opportunity cost of capital? 8. Can you ignore the cost of capital if you already have the funds inside the firm?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

5.1 Interest Rate Quotes and Adjustments Q Just like any other price, interest rates are set by market forces, in particular the supply and demand of funds. Q The effective annual rate (EAR) (or annual percentage yield—APY) indicates the actual amount of interest earned in one year. The EAR can be used as a discount rate for annual cash flows. Q Given an EAR r, the equivalent discount rate for an nyear time interval, where n may be more than one year or less than or equal to one year (a fraction), is:

annual percentage rate (APR), p. 121 annual percentage yield (APY), 119 effective annual rate (EAR), p. 119 simple interest, p. 121

MyFinanceLab Study Plan 5.1

amortizing loan, p. 125

MyFinanceLab Study Plan 5.2

Equivalent n-period Discount Rate = 11 + r2n - 1

(5.1)

Q An annual percentage rate (APR) is a common way of quoting interest rates. The actual interest rate per period is the APR/number of compounding periods per year. APRs cannot be used as discount rates. Q We need to know the compounding interval of an APR to determine the EAR: 1 + EAR = ¢ 1 +

APR m ≤ m

(5.3)

m = number of compounding periods per year. Q For a given APR, the EAR increases with the compounding frequency. 5.2 Application: Discount Rates and Loans Q Loan rates are typically stated as APRs. The outstanding balance of a loan is equal to the present value of the loan cash flows, when evaluated using the actual interest rate per payment interval based on the loan rate. Q In each loan payment on an amortizing loan, you pay interest on the loan plus some part of the loan balance.

Here is what you should know after reading this chapter. MyFinanceLab will help you identify youRates know, and Chapter 5 what Interest where to go when you need to practice. 5.3 The Determinants of Interest Rates Q Quoted interest rates are nominal interest rates, which indicate the rate of growth of the money invested. The real interest rate indicates the rate of growth of one’s purchasing power after adjusting for inflation. Q Given a nominal interest rate and an inflation rate, the real interest rate is: Nominal Rate - Inflation Rate Real Rate = 1 + Inflation Rate ⬇ Real Rate - Inflation Rate (5.5)

federal funds rate, p. 134 nominal interest rates, p. 127 real interest rate, p. 127 risk-free interest rate, p. 130 term structure, p. 130 yield curve, p. 130

MyFinanceLab Study Plan 5.3

(opportunity) cost of capital, p. 136

MyFinanceLab Study Plan 5.4

139

Interactive Yield Curve

Q Nominal interest rates tend to be high when inflation is high and low when inflation is low. Q Higher interest rates tend to reduce the attractiveness of typical investment projects. The U.S. Federal Reserve raises interest rates to moderate investment and combat inflation and lowers interest rates to stimulate investment and economic growth. Q Interest rates differ with the investment horizon according to the term structure of interest rates. The graph plotting interest rates as a function of the horizon is called the yield curve. Q Cash flows should be discounted using the discount rate that is appropriate for their horizon. Thus, the PV of a cash flow stream is: C2 CN C1 (5.7) + + g + PV = 1 + r1 1 1 + r2 2 2 1 1 + rN 2 N Q Annuity and perpetuity formulas cannot be applied when discount rates vary with the horizon. Q The shape of the yield curve tends to vary with investors’ expectations of future economic growth and interest rates. It tends to be inverted prior to recessions and to be steep coming out of a recession. Because investors view long-term loans as riskier, long-term rates are generally higher than short-term rates. 5.4 The Opportunity Cost of Capital Q An investor’s opportunity cost of capital (or simply, the cost of capital) is the best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted.

Critical Thinking

1. Explain how an interest rate is just a price. 2. Why is the EAR for 6% APR, with semiannual compounding, higher than 6%? 3. Why is it so important to match the frequency of the interest rate to the frequency of the cash flows?

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Part 2 Interest Rates and Valuing Cash Flows 4. Why aren’t the payments for a 15-year mortgage twice the payments for a 30-year mortgage at the same rate? 5. What mistake do you make when you discount real cash flows with nominal discount rates? 6. How do changes in inflation expectations impact interest rates? 7. Can the nominal interest rate available to an investor be negative? (Hint: Consider the interest rate earned from saving cash “under the mattress.”) Can the real interest rate be negative? 8. In the early 1980s, inflation was in the double-digits and the yield curve sloped sharply downward. What did the yield curve say about investors’ expectations about future inflation rates? 9. What do we mean when we refer to the “opportunity cost” of capital?

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Interest Rate Quotes and Adjustments 1. Your bank is offering you an account that will pay 20% interest in total for a twoyear deposit. Determine the equivalent discount rate for a period length of a. six months. b. one year. c. one month. 2. You are considering two ways of financing a spring break vacation. You could put it on your credit card, at 15% APR, compounded monthly, or borrow the money from your parents, who want an 8% interest payment every six months. Which is the lower rate? 3. Which do you prefer: a bank account that pays 5% per year (EAR) for three years or a. an account that pays 2.5% every six months for three years? b. an account that pays 7.5% every 18 months for three years? c. an account that pays 0.5% per month for three years? 4. You have been offered a job with an unusual bonus structure. As long as you stay with the firm, you will get an extra $70,000 every seven years, starting seven years from now. What is the present value of this incentive if you plan to work for the company for a total of 42 years and the interest rate is 6% (EAR)? 5. You have found three investment choices for a one-year deposit: 10% APR compounded monthly, 10% APR compounded annually, and 9% APR compounded daily. Compute the EAR for each investment choice. (Assume that there are 365 days in the year.) 6. Your bank account pays interest with an EAR of 5%. What is the APR quote for this account based on semiannual compounding? What is the APR with monthly compounding? 7. Suppose the interest rate is 8% APR with monthly compounding. What is the present value of an annuity that pays $100 every six months for five years? 8. You have been accepted into college. The college guarantees that your tuition will not increase for the four years you attend college. The first $10,000 tuition payment

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is due in six months. After that, the same payment is due every six months until you have made a total of eight payments. The college offers a bank account that allows you to withdraw money every six months and has a fixed APR of 4% (semiannual) guaranteed to remain the same over the next four years. How much money must you deposit today if you intend to make no further deposits and would like to make all the tuition payments from this account, leaving the account empty when the last payment is made? Application: Discount Rates and Loans 9. You make monthly payments on your car loan. It has a quoted APR of 5% (monthly compounding). What percentage of the outstanding principal do you pay in interest each month? 10. Suppose Capital One is advertising a 60-month, 5.99% APR motorcycle loan. If you need to borrow $8000 to purchase your dream Harley-Davidson, what will your monthly payment be? 11. Suppose Oppenheimer Bank is offering a 30-year mortgage with an EAR of 6.80%. If you plan to borrow $150,000, what will your monthly payment be? 12. You have just taken out a $20,000 car loan with a 6% APR, compounded monthly. The loan is for five years. When you make your first payment in one month, how much of the payment will go toward the principal of the loan and how much will go toward interest? *13. You are buying a house and the mortgage company offers to let you pay a “point” (1% of the total amount of the loan) to reduce your APR from 6.5% to 6.25% on your $400,000, 30-year mortgage with monthly payments. If you plan to be in the house for at least five years, should you do it? 14. You have decided to refinance your mortgage. You plan to borrow whatever is outstanding on your current mortgage. The current monthly payment is $2356 and you have made every payment on time. The original term of the mortgage was 30 years, and the mortgage is exactly four years and eight months old. You have just made your monthly payment. The mortgage interest rate is 6.375% (APR). How much do you owe on the mortgage today? *15. You have just sold your house for $1,000,000 in cash. Your mortgage was originally a 30-year mortgage with monthly payments and an initial balance of $800,000. The mortgage is currently exactly 18 1/2 years old, and you have just made a payment. If the interest rate on the mortgage is 5.25% (APR), how much cash will you have from the sale once you pay off the mortgage? 16. You have just purchased a car and taken out a $50,000 loan. The loan has a five-year term with monthly payments and an APR of 6%. a. How much will you pay in interest, and how much will you pay in principal, during the first month, second month, and first year? (Hint: Compute the loan balance after one month, two months, and one year.) b. How much will you pay in interest, and how much will you pay in principal, during the fourth year (i.e., between three and four years from now)? 17. You are thinking about leasing a car. The purchase price of the car is $30,000. The residual value (the amount you could pay to keep the car at the end of the lease) is $15,000 at the end of 36 months. Assume the first lease payment is due one month after you get the car. The interest rate implicit in the lease is 6% APR, compounded monthly. What will your lease payments be for a 36-month lease?

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Part 2 Interest Rates and Valuing Cash Flows *18. You have some extra cash this month and you are considering putting it toward your car loan. Your interest rate is 7%, your loan payments are $600 per month, and you have 36 months left on your loan. If you pay an additional $1000 with your next regular $600 payment (due in one month), how much will it reduce the amount of time left to pay off your loan? *19. You have an outstanding student loan with required payments of $500 per month for the next four years. The interest rate on the loan is 9% APR (monthly). You are considering making an extra payment of $100 today (i.e., you will pay an extra $100 that you are not required to pay). If you are required to continue to make payments of $500 per month until the loan is paid off, what is the amount of your final payment? What effective rate of return (expressed as an APR with monthly compounding) have you earned on the $100? *20. Consider again the setting of Problem 19. Now that you realize your best investment is to prepay your student loan, you decide to prepay as much as you can each month. Looking at your budget, you can afford to pay an extra $250 per month in addition to your required monthly payments of $500, or $750 in total each month. How long will it take you to pay off the loan? *21. If you decide to take the mortgage in Problem 11, Oppenheimer Bank will offer you the following deal: Instead of making the monthly payment you computed in that problem every month, you can make half the payment every two weeks (so that you will make 52/2 = 26 payments per year). How long will it take to pay off the mortgage if the EAR remains the same at 6.80%. *22. Your friend tells you he has a very simple trick for taking one-third off the time it takes to repay your mortgage: Use your Christmas bonus to make an extra payment on January 1 of each year (that is, pay your monthly payment due on that day twice). If you take out your mortgage on July 1, so your first monthly payment is due August 1, and you make an extra payment every January 1, how long will it take to pay off the mortgage? Assume that the mortgage has an original term of 30 years and an APR of 12%. 23. The mortgage on your house is five years old. It required monthly payments of $1402, had an original term of 30 years, and had an interest rate of 10% (APR). In the intervening five years, interest rates have fallen and so you have decided to refinance—that is, you will roll over the outstanding balance into a new mortgage. The new mortgage has a 30-year term, requires monthly payments, and has an interest rate of 6 5/8% (APR). a. What monthly repayments will be required with the new loan? b. If you still want to pay off the mortgage in 25 years, what monthly payment should you make after you refinance? c. Suppose you are willing to continue making monthly payments of $1402. How long will it take you to pay off the mortgage after refinancing? d. Suppose you are willing to continue making monthly payments of $1402, and want to pay off the mortgage in 25 years. How much additional cash can you borrow today as part of the refinancing? 24. You have credit card debt of $25,000 that has an APR (monthly compounding) of 15%. Each month you pay a minimum monthly payment only. You are required to pay only the outstanding interest. You have received an offer in the mail for an otherwise identical credit card with an APR of 12%. After considering all your alternatives, you decide to switch cards, roll over the outstanding balance on the old card into the new card, and borrow additional money as well. How much can you

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borrow today on the new card without changing the minimum monthly payment you will be required to pay? 25. Your firm has taken out a $500,000 loan with 9% APR (compounded monthly) for some commercial property. As is common in commercial real estate, the loan is a 5year loan based on a 15-year amortization. This means that your loan payments will be calculated as if you will take 15 years to pay off the loan, but you actually must do so in 5 years. To do this, you will make 59 equal payments based on the 15-year amortization schedule and then make a final 60th payment to pay the remaining balance. a. What will your monthly payments be? b. What will your final payment be? The Determinants of Interest Rates 26. In 1975, interest rates were 7.85% and the rate of inflation was 12.3% in the United States. What was the real interest rate in 1975? How would the purchasing power of your savings have changed over the year? 27. If the rate of inflation is 5%, what nominal interest rate is necessary for you to earn a 3% real interest rate on your investment? 28. Assume the inflation rate is 3% APR, compounded annually. Would you rather earn a nominal return of 5% APR, compounded semiannually, or a real return of 2% APR, compounded quarterly? 29. You are pleased to see that you have been given a 5% raise this year. However, you read on the Wall Street Journal Web site that inflation over the past year has been 2%. How much better off are you in terms of real purchasing power? 30. What is the shape of the yield curve given in the following term structure? What expectations are investors likely to have about future interest rates? Term

1 year

2 years

3 years

5 years

7 years

10 years

20 years

Rate (EAR, %)

1.99

2.41

2.74

3.32

3.76

4.13

4.93

The Opportunity Cost of Capital 31. You are thinking about investing $5000 in your friend’s landscaping business. Even though you know the investment is risky and you can’t be sure, you expect your investment to be worth $5750 next year. You notice that the rate for one-year Treasury bills is 1%. However, you feel that other investments of equal risk to your friend’s landscape business offer a 10% expected return for the year. What should you do?

6

Bonds

LEARNING OBJECTIVES Q Understand bond terminology

Q Analyze why bond prices change over time

Q Compute the price and yield to maturity of a zero-coupon bond

Q Know how credit risk affects the expected return from holding a corporate bond

Q Compute the price and yield to maturity of a coupon bond

notation

144

CPN

coupon payment on a bond

y

yield to maturity

FV

face value of a bond

YTM

yield to maturity

n

number of periods

YTMn

P

initial price of a bond

yield to maturity on a zero-coupon bond with n periods to maturity

PV

present value

INTERVIEW WITH

Andrew DeWitt PIMCO

PIMCO is a leading global investment management firm with approximately $1.1 trillion in assets under management as of June 30, 2010. The company offers individual and institutional investors bond funds that cover all the major fixed-income (bond-related) strategies in the market, ranging from municipal and high-yield bonds to investment-grade corporate issues. In his position as vice president in PIMCO’s Global Portfolio Associate Hub, Andrew DeWitt oversees the associates who provide support to the portfolio management team. “In layman’s terms, we provide support to the group of people deciding how our strategy and economic outlook will be implemented,” says Andrew, who graduated from Brown University in 2006 with majors in business economics and public- and private-sector organizations. “We serve as intermediaries between all of the parties in bond transactions and assist with almost every aspect of the portfolio management process. For example, we monitor risk metrics for different types of bonds, exposure to foreign currencies, and allocation across industry sectors.” “Considering that the global fixed-income bond market is about two-and-a-half times the size of the equity market, knowing how bonds are priced and sold could help you evaluate almost any investment opportunity,” says Andrew. “Fixed-income investments appeal to investors because bonds generally behave differently from stocks and therefore play an integral role in diversifying an investor’s overall portfolio and enhancing its absolute return potential. During the 2008–2009 financial crisis, we saw record inflows to the fixed-income sector.” Investors must consider many factors when selecting fixed-income securities. “Pension plans in the United States often look to protect their liabilities (the future benefits they will owe workers) by investing in Treasury Inflation-Protected Securities (TIPS), bonds linked to the consumer price index (the standard inflation metric),” Andrew says. “A worker nearing retirement who wants to preserve her savings in a readily accessible vehicle might consider a short-term bond fund that invests primarily in high-rated securities with an average maturity of three to six months.”

Brown University, 2006

“Fixed-income investments appeal to investors because bonds generally behave differently from stocks and . . . diversify an investor’s overall portfolio.”

In this chapter, we introduce bonds and apply our tools for valuing cash flows to them. Bonds are simply loans. When an investor buys a bond from an issuer, the investor is lending money to the bond issuer. Who are the issuers of bonds? Federal and local governments issue bonds to finance long-term projects, and many companies issue bonds as part of their debt financing. Understanding bonds and their pricing is useful for several reasons. First, we can use the prices of risk-free government bonds to determine the risk-free interest rates that produce the yield curves discussed in Chapter 5. As we saw there, the yield curve provides important information for valuing riskfree cash flows and assessing expectations of inflation and economic growth. Second, firms often issue bonds to fund their own investments. The return investors receive on those bonds is one factor determining a firm’s cost of capital. Finally, bonds provide an opportunity to begin our study of how securities are priced in a competitive market. The bond markets are very large and very liquid; there are more than

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Part 2 Interest Rates and Valuing Cash Flows $34 trillion of bonds outstanding in the U.S. markets alone.1 Further, the ideas we develop in this chapter will be helpful when we turn to the topic of valuing stocks in Chapter 7. Pricing bonds gives us an opportunity to apply what we’ve learned in the last three chapters about valuing cash flows using competitive market prices. As we explained in Chapter 3, the Valuation Principle implies that the price of a security in a competitive market should be the present value of the cash flows an investor will receive from owning it. Thus, we begin the chapter by evaluating the promised cash flows for different types of bonds. If a bond is risk-free, so that the promised cash flows will be paid with certainty, we can use the Law of One Price to directly relate the return of a bond and its price. We then discuss how and why bond prices change over time. Once we have a firm understanding of the pricing of bonds in the absence of risk, we add the risk of default, where cash flows are not known with certainty. The risk of default and its implications are important considerations for a financial manager who is considering issuing corporate bonds. (In Chapter 15 we will discuss the details of issuing debt financing and cover some additional corporate bond features.)

6.1 bond certificate States the terms of a bond as well as the amounts and dates of all payments to be made. maturity date The final repayment date of a bond. term The time remaining until the final repayment date of a bond. face value, par value, principal amount The notional amount of a bond used to compute its interest payments. The face value of the bond is generally due at the bond’s maturity. coupons The promised interest payments of a bond, paid periodically until the maturity date of the bond. coupon rate Determines the amount of each coupon payment of a bond. The coupon rate, expressed as an APR, is set by the issuer and stated on the bond certificate.

Bond Terminology Recall from Chapter 1 that a bond is a security sold by governments and corporations to raise money from investors today in exchange for a promised future payment. The terms of the bond are described as part of the bond certificate, which indicates the amounts and dates of all payments to be made. A bond certificate is shown in Figure 6.1. Payments on the bond are made until a final repayment date called the maturity date of the bond. The time remaining until the repayment date is known as the term of the bond. Bonds typically make two types of payments to their holders. The principal or face value (also known as par value or principal amount) of a bond is the notional amount we use to compute the interest payments. Typically, the face value is repaid at maturity. It is generally denominated in standard increments such as $1000. A bond with a $1000 face value, for example, is often referred to as a “$1000 bond.” In addition to the face value, some bonds also promise additional payments called coupons. The bond certificate typically specifies that the coupons will be paid periodically (for example, semiannually) until the maturity date of the bond. As you can see from Figure 6.1, historically, on a payment date the holder of the bond would clip off the next coupon for the next payment and present it for payment. It follows that the interest payments on the bond are called coupon payments. Today, the majority of bonds are registered electronically but the term remains. The amount of each coupon payment is determined by the coupon rate of the bond. This coupon rate is set by the issuer and stated on the bond certificate. By convention, the coupon rate is expressed as an APR, so the amount of each coupon payment, CPN, is: Coupon Payment Coupon Rate * Face Value CPN = Number of Coupon Payments per Year

(6.1)

For example, a “$1000 bond with a 10% coupon rate and semiannual payments” will pay coupon payments of 1 10% * +1000 2 /2 = +50 every six months. Table 6.1 summarizes the bond terminology we have presented thus far.

1

Outstanding U.S. Bond Market Debt, www.sifma.org. December 2009.

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147

FIGURE 6.1 A Bearer Bond and Its Unclipped Coupons Issued by the Elmira and Williamsport Railroad Company for $500

Source: Courtesy Heritage Auctions, Inc. © 1999–2006.

TABLE 6.1 Review of Bond Terminology

Bond Certificate

States the terms of a bond as well as the amounts and dates of all payments to be made.

Coupons

The promised interest payments of a bond. Usually paid semiannually, but the frequency is specified in the bond certificate. They are determined by the coupon rate, which is stated on the bond certificate. The amount paid is equal to: Coupon Rate * Face Value Number of Coupon Payments per Year

Concept Check

6.2 zero-coupon bond A bond that makes only one payment at maturity. Treasury bills Zerocoupon bonds, issued by the U.S. government, with a maturity of up to one year.

Maturity Date

Final repayment date of the bond. Payments continue until this date.

Principal or Face Value

The notional amount used to compute the interest payment. It is usually repaid on the maturity date. Also called par value.

Term

The time remaining until the repayment date.

1. What types of cash flows does a bond buyer receive? 2. How are the periodic coupon payments on a bond determined?

Zero-Coupon Bonds Not all bonds have coupon payments. Bonds without coupons are called zero-coupon bonds. As these are the simplest type of bond, we shall analyze them first. The only cash payment an investor in a zero-coupon bond receives is the face value of the bond on the maturity date. Treasury bills, which are U.S. government bonds with a maturity of up to one year, are zero-coupon bonds. The general name for risk-free zero coupon bonds is “STRIPS,” which is an abbreviation of Separately Tradable Registered Interest and Principal Securities.

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Zero-Coupon Bond Cash Flows There are only two cash flows if we purchase and hold a zero-coupon bond. First, we pay the bond’s current market price at the time we make the purchase. Then, at the maturity date, we receive the bond’s face value. For example, suppose that a one-year, risk-free, zero-coupon bond with a $100,000 face value has an initial price of $96,618.36. If you purchased this bond and held it to maturity, you would have the following cash flows:

discount A price at which bonds trade that is less than their face value. pure discount bonds Zero-coupon bonds.

0

1

$96,618.36

$100,000

Note that although the bond pays no “interest” directly, as an investor you are compensated for the time value of your money by purchasing the bond at a discount to its face value. Recall from Chapter 3 that the present value of a future cash flow is less than the cash flow itself. As a result, prior to its maturity date, the price of a zero-coupon bond is always less than its face value. That is, zero-coupon bonds always trade at a discount (a price lower than the face value), so they are also called pure discount bonds.

Yield to Maturity of a Zero-Coupon Bond

yield to maturity (YTM) The rate of return of an investment in a bond that is held to its maturity date, or the discount rate that sets the present value of the promised bond payments equal to the current market price for the bond.

Now that we understand the cash flows associated with a zero-coupon bond, we can calculate the rate of return of buying a bond and holding it until maturity. Recall from Chapter 4 that we can always find the rate of return of an investment opportunity as the discount rate that equates the present value of the investment to its costs. With a zerocoupon bond, the price is the cost of the bond. So, the rate of return on the zero-coupon bond is the discount rate that makes the present value of the future cash flow received (that is, the bond principal) equal to the cost of the bond. We can extend this concept to a coupon bond: the rate of return is the discount rate at which the present value of all future cash flows from the bond equals the price of the bond. The rate of return of an investment in a bond is given a special name, the yield to maturity (YTM) or just the yield: The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond. Intuitively, the yield to maturity for a zero-coupon bond is the return you will earn as an investor by buying the bond at its current market price, holding the bond to maturity, and receiving the promised face value payment. Let’s determine the yield to maturity of the one-year zero-coupon bond discussed earlier. According to the definition, the yield to maturity of the one-year bond solves the following equation: 96,618.36 =

100,000 1 + YTM1

In this case: 1 + YTM1 =

100,000 = 1.035 96,618.36

That is, the yield to maturity for this bond is 3.5%. Because the bond is risk free, investing in this bond and holding it to maturity is like earning 3.5% interest on your initial investment: +96,618.36 * 1.035 = +100,000

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We can use a similar method to find the yield to maturity for any maturity zero-coupon bond: Yield to Maturity of an n-Year Zero-Coupon Bond Face Value 1/n 1 + YTMn = ¢ ≤ (6.2) Price

The yield to maturity 1 YTMn 2 in Eq. 6.2 is the per-period rate of return for holding the bond from today until maturity on date n.

EXAMPLE 6.1 Yields for Different Maturities

Problem Suppose the following zero-coupon bonds are trading at the prices shown below per $100 face value. Determine the corresponding yield to maturity for each bond. Maturity

1 year

2 years

3 years

4 years

Price

$96.62

$92.45

$87.63

$83.06

Solution Q Plan We can use Eq. 6.2 to solve for the YTM of the bonds. The table gives the prices and number of years to maturity and the face value is $100 per bond. Q Execute Using Eq. 6.2, we have

YTM1 = 1 100/96.62 2 1/1 - 1 = 3.50% YTM2 = 1 100/92.45 2 1/2 - 1 = 4.00% YTM3 = 1 100/87.63 2 1/3 - 1 = 4.50%

YTM4 = 1 100/83.06 2 1/4 - 1 = 4.75% Q Evaluate Solving for the YTM of a zero-coupon bond is the same process we used to solve for the rate of return in Chapter 4. Indeed, the YTM is the rate of return of buying the bond.

Risk-Free Interest Rates

spot interest rates Default-free, zero-coupon yields.

Above, we calculated the yield to maturity of the one-year risk-free bond as 3.5%. But recall that the Valuation Principle’s Law of One Price implies that all one-year risk-free investments must earn this same return of 3.5%. That is, 3.5% must be the competitivemarket risk-free interest rate. More generally, in the last chapter we discussed the competitive market interest rate rn available from today until date n for risk-free cash flows. Recall that we used this interest rate as the cost of capital for a risk-free cash flow that occurs on date n. A default-free zero-coupon bond that matures on date n provides a risk-free return over the same period. So the Law of One Price guarantees that the risk-free interest rate equals the yield to maturity on such a bond. Consequently, we will often refer to the yield to maturity of the appropriate maturity, zero-coupon risk-free bond as the risk-free interest rate. Some financial professionals also use the term spot interest rates to refer to these default-free, zero-coupon yields because these rates are offered “on the spot” at that point in time. In Chapter 5, we introduced the yield curve, which plots the risk-free interest rate for different maturities. These risk-free interest rates correspond to the yields of risk-free zero-coupon bonds. Thus, the yield curve we introduced in Chapter 5 is also referred to

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Part 2 Interest Rates and Valuing Cash Flows

zero-coupon yield curve A plot of the yield of riskfree zero-coupon bonds (STRIPS) as a function of the bond’s maturity date.

FIGURE 6.2 Zero-Coupon Yield Curve Consistent with the Bond Prices in Example 6.1

as the zero-coupon yield curve. Figure 6.2 illustrates the yield curve consistent with the zero-coupon bond prices in Example 6.1. In the previous example, we used the bond’s price to compute its yield to maturity. But from the definition of the yield to maturity, we can also use a bond’s yield to compute its price. In the case of a zero-coupon bond, the price is simply equal to the present value of the bond’s face value, discounted at the bond’s yield to maturity.

Recall from Chapter 5 that a yield curve simply plots the yield to maturity of investments of different maturities. In this figure, we show the yield curve that would be produced by plotting the yield to maturities determined by the bond prices in Example 6.1. Note that as in this figure, the longer maturities generally have higher yields. 5.50 Longer maturity Higher yield

Yield to Maturity (%)

5.00

4.50

4.00

3.50 Shorter maturity Lower yield 3.00

0

1

2

3

4

5

6

Maturity (years)

EXAMPLE 6.2 Computing the Price of a ZeroCoupon Bond

Problem Given the yield curve shown in Figure 6.2, what is the price of a five-year risk-free zero-coupon bond with a face value of $100?

Solution Q Plan We can compute the bond’s price as the present value of its face amount, where the discount rate is the bond’s yield to maturity. From the yield curve, the yield to maturity for five-year risk-free zero-coupon bonds is 5.0%. Q Execute

P = 100/ 1 1.05 2 5 = 78.35

Q Evaluate We can compute the price of a zero-coupon bond simply by computing the present value of the face amount using the bond’s yield to maturity. Note that the price of the five-year zero-coupon bond is even lower than the price of the other zero-coupon bonds in Example 6.1, because the face amount is the same but we must wait longer to receive it.

Chapter 6 Bonds

Concept Check

6.3 coupon bonds Bonds that pay regular coupon interest payments up to maturity, when the face value is also paid. Treasury notes A type of U.S. Treasury coupon security, currently traded in financial markets, with original maturities from one to ten years. Treasury bonds A type of U.S. Treasury coupon security, currently traded in financial markets, with original maturities of more than ten years.

EXAMPLE 6.3 The Cash Flows of a Coupon Bond or Note

151

3. Why would you want to know the yield to maturity of a bond? 4. What is the relationship between a bond’s price and its yield to maturity?

Coupon Bonds Similar to zero-coupon bonds, coupon bonds pay investors their face value at maturity. In addition, these bonds make regular coupon interest payments. As Table 6.2 indicates, two types of U.S. Treasury coupon securities are currently traded in financial markets: Treasury notes, which have original maturities from one to ten years, and Treasury bonds, which have original maturities of more than ten years. The original maturity is the term of the bond at the time it was originally issued.

TABLE 6.2 Existing U.S. Treasury Securities

Treasury Security

Type

Original Maturity

Bills

Discount

4, 13, and 26 weeks

Notes

Coupon

2, 3, 5, and 10 year

Bonds

Coupon

20 and 30 year

Coupon Bond Cash Flows While an investor’s return on a zero-coupon bond comes from buying it at a discount to its principal value, the return on a coupon bond comes from two sources: (1) any difference between the purchase price and the principal value, and (2) its periodic coupon payments. Before we can compute the yield to maturity of a coupon bond, we need to know all of its cash flows, including the coupon interest payments and when they are paid. In the following example, we take a bond description and translate it into the bond’s cash flows. Problem Assume that it is May 15, 2010 and the U.S. Treasury has just issued securities with a May 2015 maturity, $1000 par value, and a 2.2% coupon rate with semiannual coupons. Since the original maturity is only five years, these would be called “notes” as opposed to “bonds.” The first coupon payment will be paid on November 15, 2010. What cash flows will you receive if you hold this note until maturity?

Solution Q Plan The description of the note should be sufficient to determine all of its cash flows. The phrase “May 2015 maturity, $1000 par value” tells us that this is a note with a face value of $1000 and five years to maturity. The phrase “2.2% coupon rate with semiannual coupons” tells us that the note pays a total of 2.2% of its face value each year in two equal semiannual installments. Finally, we know that the first coupon is paid on November 15, 2010. Q Execute The face value of this note is $1000. Because this note pays coupons semiannually, using Eq. 6.1 you can compute that you will receive a coupon payment every six months of CPN = 1 2.2% * +1000 2 /2 = +11. Here is the timeline based on a six-month period and there are a total of ten cash flows:

May 2010

Nov. 2010

May 2011

Nov. 2011

May 2015 ...

$11

$11

$11

$11 $1000

Note that the last payment occurs five years (ten 6-month periods) from now and is composed of both a coupon payment of $11 and the face value payment of $1000.

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Part 2 Interest Rates and Valuing Cash Flows

Q Evaluate Since a note is just a package of cash flows, we need to know those cash flows in order to value the note. That’s why the description of the note contains all of the information we would need to construct its cash flow timeline.

The U.S. Treasury Market debt outstanding was almost $11.91 trillion. Treasury securities are held by institutional investors such as insurance companies, pension funds and bond mutual funds, individual investors, and even other governmental agencies (such as the Federal Reserve) as shown in the pie chart below. The figures are in billions of dollars (5127 billion is 5.127 trillion).

In most years, the U.S. Federal Government spends more than it takes in through taxes and other revenue sources. To finance this deficit, the U.S. Department of the Treasury issues debt instruments, commonly known as “Treasuries.” The market for Treasury securities is huge and extremely liquid. In 2009, the total amount of public

$196 $503 Federal Reserve and Government Accounts

$5,127

Depository Institutions $3,497

Other Savings Bonds Pension Funds Mutual Funds Foreign State and Local Governments Insurance Companies

$643 $501 $192

$1,051

$199

Source: Treasury Bulletin Ownership of Federal Securities, www.fms.treas.gov/bulletin/index.html, September 2009.

Yield to Maturity of a Coupon Bond Once we have determined the coupon bond’s cash flows, given its market price we can determine its yield to maturity. Recall that the yield to maturity for a bond is the rate of return of investing in the bond and holding it to maturity. This investment has the cash flows shown in the timeline below: 0

1

2

3

N ...

P

CPN

CPN

CPN

CPNFV

Annunity of N payments of CPN Single CF from repayment of Face Value

The yield to maturity of the bond is the single discount rate that equates the present value of the bond’s remaining cash flows to its current price. For zero-coupon bonds, there were only two cash flows. But coupon bonds have many cash flows, complicating

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153

the yield to maturity calculation. From the timeline we see that the coupon payments represent an annuity, so the yield to maturity is the interest rate y that solves the following equation: Yield to Maturity of a Coupon Bond Annuity Factor using the YTM (y)

P = CPN *

1 1 a1 b y (1 + y)N

+

Present Value of all of the periodic coupon payments

FV (1 + y)N

(6.3)

Present Value of the Face Value repayment using the YTM ( y)

Unfortunately, unlike zero-coupon bonds, there is no simple formula to solve for the yield to maturity directly. Instead, we need to use either trial and error or, more commonly, a financial calculator or a spreadsheet (both of which we demonstrate in Example 6.4). When we calculate a bond’s yield to maturity by solving Eq. 6.3, the yield we compute will be a rate per coupon interval. However, yields are typically quoted as APRs, so we multiply by the number of coupons per year, thereby converting the answer into an APR quote with the same compounding interval as the coupon rate.

EXAMPLE 6.4 Computing the Yield to Maturity of a Coupon Bond

Problem Consider the five-year, $1000 bond with a 2.2% coupon rate and semiannual coupons described in Example 6.3. If this bond is currently trading for a price of $963.11, what is the bond’s yield to maturity?

Solution Q Plan We worked out the bond’s cash flows in Example 6.3. From the cash flow timeline, we can see that the bond consists of an annuity of ten payments of $11, paid every six months, and one lump-sum payment of $1000 in five years (in ten 6-month periods). We can use Eq. 6.3 to solve for the yield to maturity. However, we must use six-month intervals consistently throughout the equation. Q Execute Because the bond has ten remaining coupon payments, we compute its yield y by solving Eq. 6.3 for this bond: 963.11 = 11 *

1 1000 1 ¢1 ≤ + 10 y 11 + y2 1 1 + y 2 10

We can solve it by trial and error, financial calculator, or a spreadsheet. To use a financial calculator, we enter the price we pay as a negative number for the PV (it is a cash outflow), the coupon payments as the PMT, and the bond’s par value as its FV. Finally, we enter the number of coupon payments remaining (10) as N.

N I/Y PV PMT FV Given: 10 963.11 11 1000 Solve for: 1.50 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(10,11,963.11,1000) Therefore, y = 1.5%. Because the bond pays coupons semiannually, this yield is for a six-month period. We convert it to an APR by multiplying by the number of coupon payments per year. Thus, the bond has a yield to maturity equal to a 3% APR with semiannual compounding. Q Evaluate As the equation shows, the yield to maturity is the discount rate that equates the present value of the bond’s cash flows with its price. Note that the YTM is higher than the coupon rate and the price is lower than the par value. We will discuss why in the next section.

154

Part 2 Interest Rates and Valuing Cash Flows We can also use Eq. 6.3 to compute a bond’s price based on its yield to maturity. We simply discount the cash flows using the yield, as in Example 6.5.

Finding Bond Prices on the Web Unlike the NYSE where many stocks are traded, there is no particular physical location where bonds are traded. Instead, they are traded electronically. Recently, the Financial Industry Regulatory Authority (FINRA) has made an effort to make bond prices more widely available. Their

The bond pays fixed coupons of 8.000% The last trade was at $135.162 per $100 face value, implying a yield to maturity of 4.608% Coupons are paid semiannually in March and September Source: www.finra.org/marketdata, May 25, 2010.

Web site, www.finra.org/marketdata, allows anyone to search for the most recent trades and quotes for bonds. Here we show a screen shot from the Web site displaying the pricing information for one of Proctor and Gamble’s (PG) bonds.

Chapter 6 Bonds

EXAMPLE 6.5 Computing a Bond Price from Its Yield to Maturity

155

Problem Consider again the five-year, $1000 bond with a 2.2% coupon rate and semiannual coupons in Example 6.4. Suppose interest rates drop and the bond’s yield to maturity decreases to 2% (expressed as an APR with semiannual compounding). What price is the bond trading for now? And what is the effective annual yield on this bond?

Solution Q Plan Given the yield, we can compute the price using Eq. 6.3. First, note that a 2% APR is equivalent to a semiannual rate of 1%. Also, recall that the cash flows of this bond are an annuity of ten payments of $11, paid every six months, and one lump-sum cash flow of $1000 (the face value), paid in five years (ten 6-month periods). In Chapter 5 we learned how to compute an effective annual rate from an APR using Eq. 5.3. We do the same here to compute the effective annual yield from the bond’s yield to maturity expressed as an APR. Q Execute Using Eq. 6.3 and the six-month yield of 1%, the bond price must be: P = 11 *

1 1 1000 ¢1 ≤ + = +1009.47 0.01 1.0110 1.0110

We can also use a financial calculator or spreadsheet:

Given: Solve for:

N 10

I/Y 1

PV

PMT 11

FV 1000

1009.47 Excel Formula: PV(RATE,NPER,PMT,FV)PV(.01,10,11,1000)

The effective annual yield corresponding to 1% every six months is:

1 1 + .01 2 2 - 1 = .0201, or 2.01%

Q Evaluate The bond’s price has risen to $1009.47, lowering the return from investing in it from 1.5% to 1% per 6month period. Interest rates have dropped, so the lower return brings the bond’s yield into line with the lower competitive rates being offered for similar risk and maturity elsewhere in the market.

Coupon Bond Price Quotes Because we can convert any price into a yield, and vice versa, prices and yields are often used interchangeably. For example, the bond in Example 6.5 could be quoted as having a yield of 2% or a price of $1009.47 per $1000 face value. Indeed, bond traders generally quote bond yields rather than bond prices. One advantage of quoting the yield to maturity rather than the price is that the yield is independent of the face value of the bond. When prices are quoted in the bond market, they are conventionally quoted per $100 face value. Thus, the bond in Example 6.5 would be quoted as having a price of $100.947 (per $100 face value), which would imply an actual price of $1009.47 given the $1000 face value of the bond.

Concept Check

5. What cash flows does a company pay to investors holding its coupon bonds? 6. What do we need in order to value a coupon bond?

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Part 2 Interest Rates and Valuing Cash Flows

6.4 premium A price at which coupon bonds trade that is greater than their face value. par A price at which coupon bonds trade that is equal to their face value.

Why Bond Prices Change As we mentioned earlier, zero-coupon bonds always trade for a discount—that is, prior to maturity, their price is less than their face value. But as shown in Example 6.4 and Example 6.5, coupon bonds may trade at a discount, or at a premium (a price greater than their face value). In this section, we identify when a bond will trade at a discount or premium, as well as how the bond’s price will change due to the passage of time and fluctuations in interest rates. Most issuers of coupon bonds choose a coupon rate so that the bonds will initially trade at, or very close to, par (that is, at the bond’s face value). For example, the U.S. Treasury sets the coupon rates on its notes and bonds in this way. After the issue date, the market price of a bond generally changes over time for two reasons. First, as time passes, the bond gets closer to its maturity date. Holding fixed the bond’s yield to maturity, the present value of the bond’s remaining cash flows changes as the time to maturity decreases. Second, at any point in time, changes in market interest rates affect the bond’s yield to maturity and its price (the present value of the remaining cash flows). We explore these two effects in the remainder of this section.

Interest Rate Changes and Bond Prices If a bond sells at par (at its face value), the only return investors will earn is from the coupons that the bond pays. Therefore, the bond’s coupon rate will exactly equal its yield to maturity. As interest rates in the economy fluctuate, the yields that investors demand to invest in bonds will also change. Imagine that your company issues a bond when market interest rates imply a YTM of 8%, setting the coupon rate to be 8%. Suppose interest rates then rise so that new bonds have a YTM of 9%. These new bonds would have a coupon rate of 9% and sell for $1000. So, for $1000, the investor would get $90 per year until the bond matured. Your existing bond was issued when rates were lower such that its coupon is fixed at 8%, so it offers payments of $80 per year until maturity. Because its cash flows are lower, the 8% bond must have a lower price than the 9% bond.2 Thus, the price of the 8% bond will fall until the investor is indifferent between buying the 8% bond and buying the 9% bond. Figure 6.3 illustrates the relationship between the bond’s price and its yield to maturity. In our example, the price of the 8% bond will drop to below face value ($1000), so it will be trading at a discount (also called trading below par). If the bond trades at a discount, an investor who buys the bond will earn a return both from receiving the coupons and from receiving a face value that exceeds the price paid for the bond. As a result, if a bond trades at a discount, its yield to maturity will exceed its coupon rate. A bond that pays a coupon can also trade at a premium to its face value (trading above par). Imagine what would have happened in our example if interest rates had gone down to 7% instead of up to 9%. Then, the holder of the existing 8% bond would not part with it for $1000. Instead, its price would have to rise until the yield to maturity from buying it at that price would be 7%. In this case, an investor’s return from the coupons is diminished by receiving a face value less than the price paid for the bond. Thus, a bond trades at a premium whenever its yield to maturity is less than its coupon rate.3 2

Otherwise, if the 8% bond had the same or higher price, there would be an arbitrage opportunity: one could sell the 8% bond and buy the 9% bond, receiving cash today and higher coupons going forward. 3

The terms “discount” and “premium” are simply descriptive and are not meant to imply that you should try to buy bonds at a discount and avoid buying bonds at a premium. In a competitive market, the Law of One Price ensures that all similar bonds are priced to earn the same return. When you buy a bond, the price exactly equals the present value of the bond’s cash flows, so that you earn a fair return, but not an abnormally good (or bad) return.

Chapter 6 Bonds

FIGURE 6.3 A Bond’s Price vs. Its Yield to Maturity

157

At a price of $1000, the 8% semiannual coupon bond offers an 8% YTM. In order for the 8% coupon bond to offer a competitive yield to maturity, its price must fall until its yield to maturity rises to the 9% yield being offered by otherwise similar bonds. In the example depicted here, for a bond with five years left to maturity, its price must fall to $960.44 before investors will be indifferent between buying it and the 9% coupon bond priced at $1000. The curve depicts this bond’s price at yields to maturity between 6% and 10%. $1100 1. Price/YTM of bond when initially released.

$1080 $1060 $1040

2. Price/YTM of bond when interest rates rise, making investors indifferent between it and a 9% coupon bond priced at $1000.

Bond Price

$1020 $1000 $980 $960 $940 $920 $900 6.00%

6.50%

7.00%

7.50%

8.00%

8.50%

9.00%

9.50% 10.00%

Yield to Maturity

This example illustrates a general phenomenon. A higher yield to maturity means that investors demand a higher return for investing. They apply a higher discount rate to the bond’s remaining cash flows, reducing their present value and hence the bond’s price. The reverse holds when interest rates fall. Investors then demand a lower yield to maturity, reducing the discount rate applied to the bond’s cash flows and raising the price. Therefore, as interest rates and bond yields rise, bond prices will fall, and vice versa, so that interest rates and bond prices always move in the opposite direction. Table 6.3 summarizes the relationship between interest rates and bond prices.

TABLE 6.3 Bond Prices Immediately After a Coupon Payment

When the bond price is . . .

greater than the face value

equal to the face value

less than the face value

We say the bond trades . . .

“above par” or “at a premium”

“at par”

“below par” or “at a discount”

This occurs when . . .

Coupon Rate > Yield to Maturity

Coupon Rate = Yield to Maturity

Coupon Rate < Yield to Maturity

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Part 2 Interest Rates and Valuing Cash Flows

EXAMPLE 6.6 Determining the Discount or Premium of a Coupon Bond

Problem Consider three 30-year bonds with annual coupon payments. One bond has a 10% coupon rate, one has a 5% coupon rate, and one has a 3% coupon rate. If the yield to maturity of each bond is 5%, what is the price of each bond per $100 face value? Which bond trades at a premium, which trades at a discount, and which trades at par?

Solution Q Plan From the description of the bonds, we can determine their cash flows. Each bond has 30 years to maturity and pays its coupons annually. Therefore, each bond has an annuity of coupon payments, paid annually for 30 years, and then the face value paid as a lump sum in 30 years. They are all priced so that their yield to maturity is 5%, meaning that 5% is the discount rate that equates the present value of the cash flows to the price of the bond. Therefore, we can use Eq. 6.3 to compute the price of each bond as the PV of its cash flows, discounted at 5%. Q Execute For the 10% coupon bond, the annuity cash flows are $10 per year (10% of each $100 face value). Similarly, the annuity cash flows for the 5% and 3% bonds are $5 and $3 per year. We use a $100 face value for all of the bonds. Using Eq. 6.3 and these cash flows, the bond prices are: P 1 10% coupon 2 = 10 *

1 1 100 ¢1 ≤ + = +176.86 1 trades at a premium 2 0.05 1.0530 1.0530

P 1 5% coupon 2 = 5 * P 1 3% coupon 2 = 3 *

1 1 100 ¢1 ≤ + = +100.00 1 trades at par 2 30 0.05 1.05 1.0530

1 1 100 ¢1 ≤ + = +69.26 1 trades at a discount 2 0.05 1.0530 1.0530

Q Evaluate The prices reveal that when the coupon rate of the bond is higher than its yield to maturity, it trades at a premium. When its coupon rate equals its yield to maturity, it trades at par. When its coupon rate is lower than its yield to maturity, it trades at a discount.

Time and Bond Prices Let’s consider the effect of time on the price of a bond. As the next payment from a bond grows nearer, the price of the bond increases to reflect the increasing present value of that cash flow. Take a bond paying semiannual coupons of $50 and imagine tracking the price of the bond starting on the day after the last coupon payment was made. The price would slowly rise over the following six months as the next $50 coupon payment grows closer and closer. It will peak right before the coupon payment is made, when buying the bond still entitles you to receive the $50 payment immediately. If you buy the bond right after the coupon payment is made, you do not have the right to receive that $50 coupon. The price you are willing to pay for the bond will therefore be $50 less than it was right before the coupon was paid. This pattern—the price slowly rising as a coupon payment nears and then dropping abruptly after the payment is made—continues for the life of the bond. Figure 6.4 illustrates this phenomenon.

Chapter 6 Bonds

FIGURE 6.4 The Effect of Time on Bond Prices

159

The graph illustrates the effects of the passage of time on bond prices when the yield remains constant, in this case 5%. The price of a zero-coupon bond rises smoothly. The prices of the coupon bonds are indicated by the zigzag lines. Notice that the prices rise between coupon payments, but tumble on the coupon date, reflecting the amount of the coupon payment. For each coupon bond, the gray line shows the trend of the bond price just after each coupon is paid.

200

Bond Price (% of Face Value)

180 160

10% Coupon Rate

140 120

5% Coupon Rate

100 80 3% Coupon Rate

60 40 20 0

Zero Coupon 0

5

10

15

20

25

30

Year

EXAMPLE 6.7 The Effect of Time on the Price of a Bond

Problem Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 5%. For a face value of $100, the bond will initially trade for: P 1 30 years to maturity 2 =

100 = +23.14 1.0530

If the bond’s yield to maturity remains at 5%, what will its price be five years later? If you purchased the bond at $23.14 and sold it five years later, what would the rate of return of your investment be?

Solution Q Plan If the bond was originally a 30-year bond and 5 years have passed, then it has 25 years left to maturity. If the yield to maturity does not change, then you can compute the price of the bond with 25 years left exactly as we did for 30 years, but using 25 years of discounting instead of 30. Once you have the price in five years, you can compute the rate of return of your investment just as we did in Chapter 4. The FV is the price in five years, the PV is the initial price ($23.14), and the number of years is 5. Q Execute P 1 25 years to maturity 2 =

100 = +29.53 1.0525

160

Part 2 Interest Rates and Valuing Cash Flows If you purchased the bond for $23.14 and then sold it after five years for $29.53, the rate of return of your investment would be ¢

29.53 1/5 ≤ - 1 = 5.0% 23.14

That is, your return is the same as the yield to maturity of the bond. Q Evaluate Note that the bond price is higher, and hence the discount from its face value is smaller, when there is less time to maturity. The discount shrinks because the yield has not changed, but there is less time until the face value will be received. This example illustrates a more general property for bonds: If a bond’s yield to maturity does not change, then the rate of return of an investment in the bond equals its yield to maturity even if you sell the bond early.

Interest Rate Risk and Bond Prices While the effect of time on bond prices is predictable, unpredictable changes in interest rates will also affect bond prices. Further, bonds with different characteristics will respond differently to changes in interest rates—some bonds will react more strongly than others. We showed in Chapter 5 that investors view long-term loans to be riskier than short-term loans. Because bonds are just loans, the same is true of short- versus long-term bonds.

EXAMPLE 6.8

Problem

The Interest Rate Sensitivity of Bonds

Consider a 10-year coupon bond and a 30-year coupon bond, both with 10% annual coupons. By what percentage will the price of each bond change if its yield to maturity increases from 5% to 6%?

Solution Q Plan We need to compute the price of each bond for each yield to maturity and then calculate the percentage change in the prices. For both bonds, the cash flows are $10 per year for $100 in face value and then the $100 face value repaid at maturity. The only difference is the maturity: 10 years and 30 years. With those cash flows, we can use Eq. 6.3 to compute the prices. Q Execute YTM 5%

6%

10-Year, 10% Annual Coupon Bond

30-Year, 10% Annual Coupon Bond

10 *

1 1 100 ¢1 ≤ + = +138.61 0.05 1.0510 1.0510

10 *

1 1 100 ¢1 ≤ + = +176.86 0.05 1.0530 1.0530

10 *

1 100 1 ¢1 ≤ + = +129.44 0.06 1.0610 1.0610

10 *

1 1 100 ¢1 ≤ + = +155.06 0.06 1.0630 1.0630

The price of the 10-year bond changes by 1 129.44 - 138.61 2 /138.61 = -6.6% if its yield to maturity increases from 5% to 6%. For the 30-year bond, the price change is 1 155.06 - 176.86 2 /176.86 = -12.3%. Q Evaluate The 30-year bond is almost twice as sensitive to a change in the yield than is the 10-year bond. In fact, if we graph the price and yields of the two bonds, we can see that the line for the 30-year bond, shown in blue, is steeper throughout than the green line for the 10-year bond, reflecting its heightened sensitivity to interest rate changes.

Chapter 6 Bonds

190

161

30-year Maturity 10-year Maturity

170

Price

150 130 110 90 70 50

5%

6%

7%

8%

9%

10% 11% 12% 13% 14% 15%

Yield to Maturity

The example illustrates how bonds of different maturity will have different sensitivities to interest rate changes. However, even bonds with the same maturity will differ in interest rate sensitivity if their coupon rates are different. Bonds with higher coupon rates—because they pay higher cash flows upfront—are less sensitive to interest rate changes than otherwise identical bonds with lower coupon rates.4 Table 6.4 summarizes this conclusion.

TABLE 6.4 Bond Prices and Interest Rates

EXAMPLE 6.9

Bond Characteristic

Effect on Interest Rate Risk

Longer term to maturity

Increase

Higher coupon payments

Decrease

Problem

Coupons and Interest Rate Sensitivity

Consider two bonds, each of which pays semiannual coupons and has five years left until maturity. One has a coupon rate of 5% and the other has a coupon rate of 10%, but both currently have a yield to maturity of 8%. By what percentage will the price of each bond change if its yield to maturity decreases from 8% to 7%?

Solution Q Plan As in Example 6.8, we need to compute the price of each bond at 8% and 7% yield to maturities and then compute the percentage change in price. Each bond has ten semiannual coupon payments remaining along with the repayment of par value at maturity. The cash flows per $100 of face value for the first bond are $2.50 every six months and then $100 at maturity. The cash flows per $100 of face value for the second bond are $5 every six months and then $100 at maturity. Since the cash flows are semiannual, the yield to maturity is quoted as a semiannually compounded APR, so we convert the yields to match the frequency of the cash flows by dividing by 2. With semiannual rates of 4% and 3.5%, we can use Eq. 6.3 to compute the prices.

4

The duration of a bond measures its sensitivity to interest rate changes. A full discussion of the concept of duration is beyond the scope of this book.

162

Part 2 Interest Rates and Valuing Cash Flows

Q Execute YTM 8%

7%

5-Year, 5% Coupon Bond

5-Year, 10% Coupon Bond

2.50 *

100 1 1 ¢1 ≤+ = +87.83 10 0.04 1.04 1.0410

5 *

1 1 100 ¢1 ≤+ = +108.11 10 0.04 1.04 1.0410

2.50 *

1 1 100 ≤+ = +91.68 ¢1 0.035 1.03510 1.03510

5 *

1 100 1 ≤+ = +112.47 ¢1 0.035 1.03510 1.03510

The 5% coupon bond’s price changed from $87.83 to $91.68, or 4.4%, but the 10% coupon bond’s price changed from $108.11 to $112.47, or 4.0%. You can calculate the price change very quickly with a financial calculator or spreadsheet. For example, take the 5% coupon bond at 8% YTM (4% per 6 months):

Given: Solve for:

dirty price or invoice price A bond’s actual cash price. clean price A bond’s cash price less an adjustment for accrued interest, the amount of the next coupon payment that has already accrued.

N 10

I/Y 4

PV

PMT 2.50

FV 100

87.83 Excel Formula: PV(RATE,NPER,PMT,FV)PV(.04,10,2.5,100)

With all of the basic bond information entered, you can simply change the I/Y by entering 3.5 and pressing I/Y and then solve for PV again. So, with just a few keystrokes, you will have the new price of $91.68. Q Evaluate The bond with the smaller coupon payments is more sensitive to changes in interest rates. Because its coupons are smaller relative to its par value, a larger fraction of its cash flows are received later. As we learned in Example 6.8, later cash flows are affected more greatly by changes in interest rates, so compared to the 10% coupon bond, the effect of the interest change is greater for the cash flows of the 5% coupon bond.

Clean and Dirty Prices for Coupon Bonds As Figure 6.4 illustrates, coupon bond prices fluctuate around the time of each coupon payment in a sawtooth pattern: The value of the coupon bond rises as the next coupon payment gets closer and then drops after it has been paid. This fluctuation occurs even if there is no change in the bond’s yield to maturity. Bond traders are more concerned about changes in the bond’s price that arise due to changes in the bond’s yield, rather than these predictable patterns around coupon payments. As a result, they often do not quote the price of a bond in terms of its actual cash price, which is also called the dirty price or invoice price of the bond. Instead, bonds are often quoted in terms of a clean price, which is the bond’s cash price less an adjustment for accrued interest, the amount of the next coupon payment that has already accrued: Clean Price = Cash 1 Dirty 2 Price - Accrued Interest

Note that immediately before a coupon payment is made, the accrued interest will equal the full amount of the coupon. Immediately after the coupon payment is made, the accrued interest will be zero. Thus, accrued interest will rise and fall in a sawtooth pattern as each coupon payment passes. If we subtract accrued interest from the bond’s cash price and compute the clean price, the sawtooth pattern is eliminated.

Days Since Last Coupon Payment ≤ Days in Current Coupon Period

Accrued Interest

Accrued Interest = Coupon Amount * ¢

Coupon

0

1

2

Time (Coupon Periods)

3

Chapter 6 Bonds

163

Bond Prices in Practice In actuality, bond prices are subject to the effects of both the passage of time and changes in interest rates. Bond prices converge to the bond’s face value due to the time effect, but simultaneously move up and down due to unpredictable changes in bond yields. Figure 6.5 illustrates this behavior by demonstrating how the price of the 30-year, zero-coupon bond might change over its life. Note that the bond price tends to converge to the face value as the bond approaches the maturity date, but also moves higher when its yield falls and lower when its yield rises.

Panel (a) The Bond’s Yield to Maturity over Time

Yield to Maturity (%)

Yield to Maturity and Bond Price Fluctuations over Time

The graphs illustrate changes in price and yield for a 30-year zero-coupon bond over its life. Panel (a) illustrates the changes in the bond’s yield to maturity (YTM) over its life. In Panel (b), the actual bond price is shown in blue. Because the YTM does not remain constant over the bond’s life, the bond’s price fluctuates as it converges to the face value over time. Also shown is the price if the YTM remained fixed at 4%, 5%, or 6%. Panel (a) shows that the bond’s YTM mostly remained between 4% and 6%. The broken lines in Panel (b) show the price of the bond if its YTM had remained constant at those levels. Note that in all cases, the bond’s price must eventually converge to $100 on its maturity date.

6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0

0

5

10

15

20

25

30

25

30

Year Panel (b) The Bond’s Price over Time (Price +100 on Maturity Date)

100

Actual Bond Price Price with 5% Yield Price with 4% Yield Price with 6% Yield

90 Bond Price (% of Face Value)

FIGURE 6.5

80 70 60 50 40 30 20 10 0

0

5

10

15 Year

20

164

Part 2 Interest Rates and Valuing Cash Flows As the fluctuating price in Figure 6.5 demonstrates, prior to maturity the bond is exposed to interest rate risk. If an investor chooses to sell and the bond’s yield to maturity has decreased, then the investor will receive a high price and earn a high return. If the yield to maturity has increased, the bond price is low at the time of sale and the investor will earn a low return.

Concept Check

6.5 corporate bonds Bonds issued by a corporation.

7. Why do interest rates and bond prices move in opposite directions? 8. If a bond’s yield to maturity does not change, how does its cash price change between coupon payments?

Corporate Bonds In the previous sections, we developed the basics of bond pricing in the context of U.S. Treasury bonds, which have no risk of default. In this section, our focus is on corporate bonds, which are bonds issued by corporations. We will examine the role of default risk in the price and yield to maturity of corporate bonds. As we will see, corporations with higher default risk will need to pay higher coupons to attract buyers to their bonds.

Credit Risk

credit risk The risk of default by the issuer of any bond that is not default free; it is an indication that the bond’s cash flows are not known with certainty.

Table 6.5 lists the interest rates paid by a number of different borrowers in early 2010 for a five-year bond. Why do these interest rates vary so widely? The lowest interest rate is the 2.41% rate paid on U.S. Treasury notes. United States Treasury securities are widely regarded to be risk-free because there is virtually no chance the government will fail to pay the interest and default on these bonds. Thus, as we noted in Section 6.2, when we refer to the “risk-free interest rate,” we mean the rate on U.S. Treasuries. The remaining bonds are all corporate bonds. With corporate bonds, the bond issuer may default—that is, it might not pay back the full amount promised in the bond prospectus. For example, a company with financial difficulties may be unable to fully repay the loan. This risk of default, which is known as the credit risk of the bond, means that the bond’s cash flows are not known with certainty. To compensate for the risk that the firm may default, investors demand a higher interest rate than the rate on U.S. Treasuries.5

TABLE 6.5 Borrower U.S. Government (Treasury Notes) Abbott Laboratories Kraft Foods, Inc. Time Warner, Inc. RadioShack Corp. Goodyear Tire and Rubber Co.

Interest Rates on Five-Year Bonds for Various Borrowers, March 2010

Interest Rate 2.41% 2.65% 3.46% 4.39% 5.84% 8.58%

Credit Spread 0.24% 1.05% 1.98% 3.43% 6.17%

0

1

2

3

4

5

6

Percent

5

Because trading in corporate bonds is much less liquid than trading in Treasuries, part of the increased interest rate is to compensate investors for this lack of liquidity.

Chapter 6 Bonds

165

The difference between the interest rate of the loan and the Treasury rate will depend on investors’ assessment of the likelihood that the firm will default. For example, investors place a higher probability of default on Goodyear Tire than on Abbott Labs, forcing Goodyear to pay a larger credit spread, which is reflected in a higher interest rate.

INTERVIEW WITH

LISA BLACK

Lisa Black is Managing Director at Teachers Insurance and Annuity Association, a major financial services company. A Chartered Financial Analyst, she oversees a variety of fixed income funds, including money market, intermediate bond, high-yield, emerging market debt, and inflation-linked bond funds.

When many people think about the financial markets, they picture the equity markets. How big and how active are the bond markets compared to the equity markets?

QUESTION:

ANSWER: The

dollar volume of bonds traded daily is about ten times that of equity markets. For example, a single $15 billion issue of ten-year Treasury bonds will sell in one day. The market value of the Barclays Capital U.S. Universal Bond Index of dollardenominated debt as of June 30, 2009, was $13.8 trillion, with the U.S. Aggregate Index (investment-grade debt) accounting for almost 90%. It includes Treasuries, agencies, corporate bonds, and mortgage-backed securities. Other major sectors of the Universal Index include corporate high-yield bonds, Eurodollar bonds, emerging markets, and private placements.

QUESTION:

How do the bond markets operate?

ANSWER: Firms and governments turn to bond markets when they need to borrow money to fund new construction projects, finance acquisitions, and for general corporate purposes. On the other side, institutions like TIAA-CREF, endowments, and foundations have funds to invest. Wall Street investment bankers serve as intermediaries, matching up borrowers with creditors in terms of maturity needs and risk appetite. Because we provide annuities for college professors, for example, we invest money for longer periods of time than an insurance company that needs funds to pay claims. In the institutional world, bond funds typically trade in blocks of bonds ranging from $5 million to $50 million at a time. QUESTION:

What drives changes in the values of Treasury

bonds? ANSWER: The simple answer is that when interest rates rise, bond prices fall. The key is to dig below that reality to see why interest rates rise and fall. A major factor is investors’ expectations for inflation and economic growth. Interest rates generally rise when the expectation is that growth will accelerate, because inflation

won’t be far behind. During the 2008–2009 recession, interest rates dropped as the Federal Reserve injected liquidity into the system. There was also a flight to quality after the bankruptcy of Lehman Brothers. The value of The Reserve Fund fell drastically as its holdings of about $785 million of Lehman’s short-term debt securities became all but worthless. Worried retail and institutional investors sold their money market funds and purchased U.S. Treasury bills and notes to protect their principal. With increased demand, interest rates on risk-free Treasury securities fell sharply. At one point T-bills even had a negative yield.

What impact did the 2008–2009 financial crisis have on the bond market? What changes do you anticipate going forward as a result?

QUESTION:

ANSWER: While the effects of the crisis on equity markets have been widely discussed, the effects on the bond market have been just as profound. Particularly noteworthy is the role governments and central bankers have played—and likely will continue to play—to stabilize financial institutions deemed too big or important to fail. The Fed introduced an unprecedented number of stimulus programs to unfreeze credit markets, including programs to guarantee money funds. The challenge will be how and when the various support programs and financial infusions will end and/or be paid back. In addition, the rating agencies’ role and ratings methodologies will likely be subject to greater scrutiny, both from regulators and investors. In the corporate sector, many borrowers—the automotive industries, for example—could not raise debt financing during the crisis. Credit spreads widened dramatically as investors shunned even AAA- and AA-rated credits. Major institutional investors sat on the sidelines for several months, and the corporate bond newissue market was essentially nonexistent. Not until the federal government announced programs to increase liquidity did institutional investors reenter the market, first buying only the highest credit-quality instruments, such as first mortgage bonds issued by utilities and government-guaranteed mortgage-backed securities. Investors then began to move down the credit-quality chain, selectively focusing on issuers that could weather an economic downturn.

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Part 2 Interest Rates and Valuing Cash Flows

Corporate Bond Yields How does the credit risk of default affect bond prices and yields? The cash flows promised by the bond are the most that bondholders can hope to receive. Due to credit risk, the cash flows that a purchaser of a corporate bond actually expects to receive may be less than that amount. For example, GM struggled financially in 2006 and 2007, substantially increasing the chance that they would default on their bonds, and GM subsequently did in 2009. Realizing this risk, investors in GM bonds incorporated an increased probability that the bond payments would not be made as promised and prices of the bonds fell. Because the yield to maturity of GM’s bonds is computed by comparing the price to the promised cash flows, the yield to maturity increased as the probability of being paid as promised decreased. This example highlights the following general truths: 1. Investors pay less for bonds with credit risk than they would for an otherwise identical default-free bond. 2. Because the yield to maturity for a bond is calculated using the promised cash flows instead of the expected cash flows, the yield of bonds with credit risk will be higher than that of otherwise identical default-free bonds. These two points lead us to an important conclusion: the yield to maturity of a defaultable bond is not equal to the expected return of investing in the bond. The promised cash flows used to determine the yield to maturity are always higher than the expected cash flows investors use to calculate the expected return. As a result, the yield to maturity will always be higher than the expected return of investing in the bond. Moreover, a higher yield to maturity does not necessarily imply that a bond’s expected return is higher.

Bond Ratings investment-grade bonds Bonds in the top four categories of creditworthiness with a low risk of default. speculative bonds, junk bonds, or high-yield bonds Bonds in one of the bottom five categories of creditworthiness (below investment grade) that have a high risk of default. default spread or credit spread The difference between the risk-free interest rate on U.S. Treasury notes and the interest rates on all other loans. The magnitude of the credit spread will depend on investors’ assessment of the likelihood that a particular firm will default.

The probability of default is clearly important to the price you are willing to pay for a corporate bond. How do you assess a firm’s likelihood of default? Several companies rate the creditworthiness of bonds and make this information available to investors. By consulting these ratings, investors can assess the creditworthiness of a particular bond issue. The ratings therefore encourage widespread investor participation and relatively liquid markets. The two best-known bond-rating companies are Standard & Poor’s and Moody’s. Table 6.6 summarizes the rating classes each company uses. Bonds with the highest rating (Aaa or AAA) are judged to be least likely to default. Bonds in the top four categories are often referred to as investment-grade bonds because of their low default risk. Bonds in the bottom five categories are often called speculative bonds, junk bonds, or high-yield bonds because their likelihood of default is high and so they promise higher yields. The rating depends on the risk of bankruptcy as well as the bondholders’ ability to lay claim to the firm’s assets in the event of such a bankruptcy. Thus, debt issues with a low-priority claim in bankruptcy will have a lower rating than issues from the same company that have a high priority in bankruptcy or that are backed by a specific asset such as a building or a plant.

Corporate Yield Curves Just as we can construct a yield curve from risk-free Treasury securities, we can plot a similar yield curve for corporate bonds. Figure 6.6 shows the average yields of U.S. corporate coupon bonds with three different Standard & Poor’s bond ratings: two curves are for investment-grade bonds (AAA and BBB) and one is for junk bonds (B). Figure 6.6 also includes the U.S. (coupon-paying) Treasury yield curve. We refer to the difference between the yields of the corporate bonds and the Treasury yields as the default spread or

Chapter 6 Bonds

TABLE 6.6 Moody’s

167

Bond Ratings and the Number of U.S. Public Firms with Those Ratings at the End of 2009 Standard & Poor’s

Number of Public Firms

Description (Moody’s)

Investment Grade Debt Aaa

AAA

5

Judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as “gilt edged.”

Aa

AA

28

A

A

164

Possess many favorable investment attributes and are considered as upper-mediumgrade obligations. Factors giving security to principal and interest are considered adequate at present, but may not remain that way.

Baa

BBB

399

Are considered as medium-grade obligations (i.e., they are neither highly protected nor poorly secured).

Judged to be of high quality by all standards. Together with the Aaa group, they constitute what are generally known as high-grade bonds.

Speculative Bonds (“Junk Bonds”) Ba

BB

318

Judged to have speculative elements; their future cannot be considered as well assured.

B

B

296

Generally lack characteristics of the desirable investment. Assurance of interest and principal payments over any long period of time may be small.

Caa

CCC

27

Ca

CC

4

Are speculative to a high degree. Such issues are often in default or have other marked shortcomings.

C

C, D

8

Lowest-rated class of bonds, and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing.

Are of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest.

Source: www.moodys.com and S&P Compustat.

Corporate Yield Curves for Various Ratings, March 2010

This figure shows the yield curve for U.S. Treasury securities and yield curves for corporate securities with ratings AA (in red), BBB (in green), and B (in purple). Note how the yield to maturity is higher for the corporate bonds, which have a higher probability of default than the U.S. Treasury securities. 10 9 8 Yield to Maturity (%)

FIGURE 6.6

7 6 5 4 3

U.S. Industrials (B) U.S. Industrials (BBB) U.S. Industrials (AA) U.S. Treasury Yield Curve

2 1 0

0

Source: Bloomberg.

2

4

6

8 10 Years to Maturity

12

14

16

168

Part 2 Interest Rates and Valuing Cash Flows credit spread. This difference can be seen in Figure 6.6 as the distance between the bottom blue line for Treasuries and each of the red, green, and purple lines as default probability increases. Credit spreads fluctuate as perceptions regarding the probability of default change. Note that the credit spread is high for bonds with low ratings and therefore a greater likelihood of default.

EXAMPLE 6.10 Credit Spreads and Bond Prices

Problem Your firm has a credit rating of AA. You notice that the credit spread for 10-year maturity AA debt is 90 basis points (0.90%). Your firm’s ten-year debt has a coupon rate of 5%. You see that new ten-year Treasury notes are being issued at par with a coupon rate of 4.5%. What should the price of your outstanding ten-year bonds be?

Solution Q Plan If the credit spread is 90 basis points, then the yield to maturity (YTM) on your debt should be the YTM on similar Treasuries plus 0.9%. The fact that new ten-year Treasuries are being issued at par with coupons of 4.5% means that with a coupon rate of 4.5%, these notes are selling for $100 per $100 face value. Thus, their YTM is 4.5% and your debt’s YTM should be 4.5% + 0.9% = 5.4%. The cash flows on your bonds are $5 per year for every $100 face value, paid as $2.50 every six months. The six-month rate corresponding to a 5.4% yield is 5.4%/2 = 2.7%. Armed with this information, you can use Eq. 6.3 to compute the price of your bonds. Q Execute 2.50 *

1 1 100 ¢1 ≤ + = +96.94 0.027 1.02720 1.02720

Q Evaluate Your bonds offer a higher coupon (5% vs. 4.5%) than Treasuries of the same maturity, but sell for a lower price ($96.94 vs. $100). The reason is the credit spread. Your firm’s higher probability of default leads investors to demand a higher YTM on your debt. To provide a higher YTM, the purchase price for the debt must be lower. If your debt paid 5.4% coupons, it would sell at $100, the same as the Treasuries. But to get that price, you would have to offer coupons that are 90 basis points higher than those on the Treasuries— exactly enough to offset the credit spread.

The Credit Crisis and Bond Yields The financial crisis that engulfed the world’s economies in 2008 originated as a credit crisis that first emerged in August 2007. At that time, problems in the mortgage market had led to the bankruptcy of several large mortgage lenders. The default of these firms, and the downgrading of many of the bonds backed by mortgages these firms had made, caused many investors to reassess the risk of other bonds in their portfolios. As perceptions of risk increased, and investors attempted to move into safer U.S. Treasury securities, the prices of corporate bonds fell and so their credit spreads rose relative to Treasuries, as shown in Figure 6.7. Panel A of the figure shows

the yield spreads for long-term corporate bonds, where we can see that spreads of even the highest-rated Aaa bonds increased dramatically, from a typical level of 0.5% to over 2% by the fall of 2008. Panel B shows a similar pattern for the rate banks had to pay on short-term loans compared to the yields of short-term Treasury bills. This increase in borrowing costs made it more costly for firms to raise the capital needed for new investment, slowing economic growth. The decline in these spreads in early 2009 was viewed by many as an important first step in mitigating the ongoing impact of the financial crisis on the rest of the economy.

Chapter 6 Bonds

FIGURE 6.7 Yield Spreads and the Financial Crisis

169

Panel A shows the yield spread between long-term (30-year) U.S. corporate and Treasury bonds. Panel B shows the yield spread of short-term loans to major international banks (called LIBOR) and U.S. Treasury bills (also referred to as the Treasury-Eurodollar or “TED” spread). Note the dramatic increase in these spreads beginning in August 2007 and again in September 2008, before beginning to decline in late 2008 and early 2009. Panel A: Yield Spread of Long-Term Corporate Bonds Versus U.S. Treasury Bonds

6

Aaa

A

Baa

Spread (%)

5 4 3 2 1 0 2005

Spread (%)

5

2006

2007

2008

2009

Panel B: Yield Spread of Short-Term Loans to Major International Banks (LIBOR) Versus U.S. Treasury Bonds

4 3 2 1 0 2005

2006

2007

2008

2009

Source: Bloomberg.com.

As we indicated at the beginning of this chapter, the bond market, while less wellknown than the stock markets, is large and important. Because debt is a substantial part of the financing of most corporations, a financial manager needs to understand bonds and how investors price the company’s bonds. In this chapter, we have introduced you to the major types of bonds, how bonds repay investors, and how they are priced. In Chapter 15, we will discuss the bond markets further, including the process a firm goes through to issue debt.

Concept Check

9. What is a junk bond? 10. How will the yield to maturity of a bond vary with the bond’s risk of default?

170

Part 2 Interest Rates and Valuing Cash Flows

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

6.1 Bond Terminology Q Bonds pay both coupon and principal or face value payments to investors. By convention, the coupon rate of a bond is expressed as an APR, so the amount of each coupon payment, CPN, is:

bond certificate, p. 146 coupon rate, p. 146 coupons, p. 146 face value, p. 146 maturity date, p. 146 par value, p. 146 principal amount, p. 146 term, p. 146

MyFinanceLab Study Plan 6.1

discount, p. 148 pure discount bond, p. 148 spot interest rates, p. 149 Treasury bills, p. 147 yield to maturity (YTM), p. 148 zero-coupon bond, p. 147 zero-coupon yield curve, p. 150

MyFinanceLab Study Plan 6.2

coupon bonds, p. 151 Treasury bonds, p. 151 Treasury notes, p. 151

MyFinanceLab Study Plan 6.3

CPN =

Coupon Rate * Face Value Number of Coupon Payments per Year

(6.1)

6.2 Zero-Coupon Bonds Q Zero-coupon bonds make no coupon payments, so investors receive only the bond’s face value. Q The rate of return of a bond is called its yield to maturity (or yield). The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond. Q The yield to maturity for a zero-coupon bond is given by: 1 + YTMn = ¢

Face Value 1/n ≤ Price

(6.2)

Financial Calculator Tutorial: Solving for the Yield to Maturity of a Bond

Q The risk-free interest rate for an investment until date n equals the yield to maturity of a risk-free zero-coupon bond that matures on date n. A plot of these rates against maturity is called the zero-coupon yield curve. 6.3 Coupon Bonds Q The yield to maturity for a coupon bond is the discount rate, y, that equates the present value of the bond’s future cash flows with its price: P = CPN *

1 1 FV ¢1 ≤ + y 11 + y2N 11 + y2N

(6.3)

Financial Calculator Tutorial: Bond Valuation with Interest Compounded Semiannually

Chapter 6 Bonds

6.4 Why Bond Prices Change Q A bond will trade at a premium if its coupon rate exceeds its yield to maturity. It will trade at a discount if its coupon rate is less than its yield to maturity. If a bond’s coupon rate equals its yield to maturity, it trades at par. Q As a bond approaches maturity, the price of the bond approaches its face value. Q Bond prices change as interest rates change. When interest rates rise, bond prices fall, and vice versa. Q Long-term zero-coupon bonds are more sensitive to changes in interest rates than are short-term zerocoupon bonds. Q Bonds with low coupon rates are more sensitive to changes in interest rates than similar maturity bonds with high coupon rates.

clean price, p. 162 dirty price, p. 162 invoice price, p. 162 par, p. 156 premium, p. 156

MyFinanceLab Study Plan 6.4

6.5 Corporate Bonds Q When a bond issuer does not make a bond payment in full, the issuer has defaulted. Q The risk that default can occur is called default or credit risk. United States Treasury securities are free of default risk. Q The expected return of a corporate bond, which is the firm’s debt cost of capital, equals the risk-free rate of interest plus a risk premium. The expected return is less than the bond’s yield to maturity because the yield to maturity of a bond is calculated using the promised cash flows, not the expected cash flows. Q Bond ratings summarize the creditworthiness of bonds for investors. Q The difference between yields on Treasury securities and yields on corporate bonds is called the credit spread or default spread. The credit spread compensates investors for the difference between promised and expected cash flows and for the risk of default.

corporate bonds, p. 164 credit risk, p. 164 default (credit) spread, p. 166 high-yield bonds, p. 166 investment-grade bonds, p. 166 junk bonds, p. 166 speculative bonds, p. 166

MyFinanceLab Study Plan 6.5

Critical Thinking

171

Interactive Interest Rate Sensitivity Analysis

1. How is a bond like a loan? 2. How does an investor receive a return from buying a bond? 3. How is yield to maturity related to the concept of rate of return? 4. Does a bond’s yield to maturity determine its price or does the price determine the yield to maturity?

172

Part 2 Interest Rates and Valuing Cash Flows 5. Explain why the yield of a bond that trades at a discount exceeds the bond’s coupon rate. 6. Explain the relationship between interest rates and bond prices. 7. Why are longer-term bonds more sensitive to changes in interest rates than shorterterm bonds? 8. Explain why the expected return of a corporate bond does not equal its yield to maturity.

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Bond Terminology 1. Consider a ten-year bond with a face value of $1000 that has a coupon rate of 5.5%, with semiannual payments. a. What is the coupon payment for this bond? b. Draw the cash flows for the bond on a timeline. 2. Assume that a bond will make payments every six months as shown on the following timeline (using six-month periods): 0

1

2

3

20 ...

$20

$20

$20 $1000

$20

a. What is the maturity of the bond (in years)? b. What is the coupon rate (in percent)? c. What is the face value? 3. Your company wants to raise $10 million by issuing 20-year zero-coupon bonds. If the yield to maturity on the bonds will be 6% (annually compounded APR), what total principal amount of bonds must you issue? Zero-Coupon Bonds 4. The following table summarizes prices of various default-free zero-coupon bonds (expressed as a percentage of face value): Maturity (years) Price (per $100 face value)

1

2

3

4

5

$95.51

$91.05

$86.38

$81.65

$76.51

a. Compute the yield to maturity for each bond. b. Plot the zero-coupon yield curve (for the first five years). c. Is the yield curve upward sloping, downward sloping, or flat? Use the following information for Problems 5–7. The current zero-coupon yield curve for risk-free bonds is as follows: Maturity (years) YTM

1

2

3

4

5

5.00%

5.50%

5.75%

5.95%

6.05%

5. What is the price per $100 face value of a two-year, zero-coupon, risk-free bond? 6. What is the price per $100 face value of a four-year, zero-coupon, risk-free bond? 7. What is the risk-free interest rate for a five-year maturity?

Chapter 6 Bonds

173

Coupon Bonds 8. For each of the following pairs of Treasury securities (each with $1000 par value), identify which will have the higher price: a. A three-year zero-coupon bond or a five-year zero coupon bond? b. A three-year zero-coupon bond or a three-year 4% coupon bond? c. A two-year 5% coupon bond or a two-year 6% coupon bond? 9. The yield to maturity of a $1000 bond with a 7% coupon rate, semiannual coupons, and two years to maturity is 7.6% APR, compounded semiannually. What must its price be? 10. Assume the current Treasury yield curve shows that the spot rates for 6 months, 1 year, and 1 1/2 years are 1%, 1.1%, and 1.3%, all quoted as semiannually compounded APRs. What is the price of a $1000 par, 4% coupon bond maturing in 1 1/2 years (the next coupon is exactly 6 months from now)? 11. Suppose a ten-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading for a price of $1034.74. a. What is the bond’s yield to maturity (expressed as an APR with semiannual compounding)? b. If the bond’s yield to maturity changes to 9% APR, what will the bond’s price be? 12. Suppose a five-year, $1000 bond with annual coupons has a price of $900 and a yield to maturity of 6%. What is the bond’s coupon rate? Why Bond Prices Change 13. The prices of several bonds with face values of $1000 are summarized in the following table: Bond

A

B

C

D

Price

$972.50

$1040.75

$1150.00

$1000.00

For each bond, state whether it trades at a discount, at par, or at a premium. 14. You have purchased a 10% coupon bond for $1040. What will happen to the bond’s price if market interest rates rise? 15. Suppose a seven-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading with a yield to maturity of 6.75%. a. Is this bond currently trading at a discount, at par, or at a premium? Explain. b. If the yield to maturity of the bond rises to 7.00% (APR with semiannual compounding), what price will the bond trade for? Suppose that General Motors Acceptance Corporation issued a bond with ten years until maturity, a face value of $1000, and a coupon rate of 7% (annual payments). The yield to maturity on this bond when it was issued was 6%. Use this information for Problems 16–18. 16. What was the price of this bond when it was issued? 17. Assuming the yield to maturity remains constant, what is the price of the bond immediately before it makes its first coupon payment? 18. Assuming the yield to maturity remains constant, what is the price of the bond immediately after it makes its first coupon payment?

174

Part 2 Interest Rates and Valuing Cash Flows 19. Your company currently has $1000 par, 6% coupon bonds with ten years to maturity and a price of $1078. If you want to issue new ten-year coupon bonds at par, what coupon rate do you need to set? Assume that for both bonds, the next coupon payment is due in exactly 6 months. 20. Suppose you purchase a ten-year bond with 6% annual coupons. You hold the bond for four years, and sell it immediately after receiving the fourth coupon. If the bond’s yield to maturity was 5% when you purchased and sold the bond, a. What cash flows will you pay and receive from your investment in the bond per $100 face value? b. What is the rate of return of your investment? Consider the following bonds for Questions 21 and 22: Bond

Coupon Rate (annual payments)

Maturity (years)

0%

15

0% 4% 8%

10 15 10

A B C D

21. What is the percentage change in the price of each bond if its yield to maturity falls from 6% to 5%? 22. Which of the bonds A–D is most sensitive to a 1% drop in interest rates from 6% to 5% and why? Which bond is least sensitive? Provide an intuition explanation for your answer. 23. Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 6%. You hold the bond for five years before selling it. a. If the bond’s yield to maturity is 6% when you sell it, what is the rate of return of your investment? b. If the bond’s yield to maturity is 7% when you sell it, what is the rate of return of your investment? c. If the bond’s yield to maturity is 5% when you sell it, what is the rate of return of your investment? d. Even if a bond has no chance of default, is your investment risk free if you plan to sell it before it matures? Explain. Corporate Bonds 24. The following table summarizes the yields to maturity on several one-year, zerocoupon securities: Security

Yield (%)

Treasury

3.1

AAA corporate

3.2

BBB corporate

4.2

B corporate

4.9

a. What is the price (expressed as a percentage of the face value) of a one-year, zerocoupon corporate bond with an AAA rating? b. What is the credit spread on AAA-rated corporate bonds? c. What is the credit spread on B-rated corporate bonds? d. How does the credit spread change with the bond rating? Why?

Chapter 6 Bonds

175

25. Andrew Industries is contemplating issuing a 30-year bond with a coupon rate of 7% (annual coupon payments) and a face value of $1000. Andrew believes it can get a rating of A from Standard & Poor’s. However, due to recent financial difficulties at the company, Standard & Poor’s is warning that it may downgrade Andrew Industries bonds to BBB. Yields on A-rated, long-term bonds are currently 6.5%, and yields on BBB-rated bonds are 6.9%. a. What is the price of the bond if Andrew Industries maintains the A rating for the bond issue? b. What will the price of the bond be if it is downgraded? 26. HMK Enterprises would like to raise $10 million to invest in capital expenditures. The company plans to issue five-year bonds with a face value of $1000 and a coupon rate of 6.5% (annual payments). The following table summarizes the yield to maturity for five-year (annual-pay) coupon corporate bonds of various ratings: Rating

AAA

AA

A

BBB

BB

YTM

6.20%

6.30%

6.50%

6.90%

7.50%

a. Assuming the bonds will be rated AA, what will the price of the bonds be? b. How much of the total principal amount of these bonds must HMK issue to raise $10 million today, assuming the bonds are AA rated? (Because HMK cannot issue a fraction of a bond, assume that all fractions are rounded to the nearest whole number.) c. What must the rating of the bonds be for them to sell at par? d. Suppose that when the bonds are issued, the price of each bond is $959.54. What is the likely rating of the bonds? Are they junk bonds? 27. A BBB-rated corporate bond has a yield to maturity of 8.2%. A U.S. Treasury security has a yield to maturity of 6.5%. These yields are quoted as APRs with semiannual compounding. Both bonds pay semiannual coupons at a rate of 7% and have five years to maturity. a. What is the price (expressed as a percentage of the face value) of the Treasury bond? b. What is the price (expressed as a percentage of the face value) of the BBB-rated corporate bond? c. What is the credit spread on the BBB bonds?

Data Case

You are an intern with Ford Motor Company in its corporate finance division. The firm is planning to issue $50 million of 12% annual coupon bonds with a ten-year maturity. The firm anticipates an increase in its bond rating. Your boss wants you to determine the gain in the proceeds of the new issue if it is rated above the firm’s current bond rating. To prepare this information, you will have to determine Ford’s current debt rating and the yield curve for its particular rating. 1. Begin by finding the current U.S. Treasury yield curve. At the Treasury Web site (www.treas.gov), search using the term “yield curve” and select “US Treasury— Daily Treasury Yield Curve.” Beware: There will likely be two links with the same title. Look at the description below the link and select the one that does NOT say “Real Yield p ” You want the nominal rates. Copy the table into Excel. 2. Find the current yield spreads for the various bond ratings. Unfortunately, the current spreads are available only for a fee, so you will use old ones. Go to BondsOnline (www.bondsonline.com) and click on “Today’s Market.” Next, click

176

Part 2 Interest Rates and Valuing Cash Flows

3.

4.

5. 6. 7.

8.

on “US Corporate Bond Spreads.” Copy this table to the same Excel file as the Treasury yields. Find the current bond rating for Ford Motor Co. Go to Standard & Poor’s Web site (www.standardandpoors.com). Select your country. Look for the “Find a Rating” box under “Ratings” and enter Ford Motor Co. and select Ford Motor Co. from the list it returns. At this point you will have to register (it’s free) or enter the username and password provided by your instructor. Use the issuer credit rating for “local long term.” Return to Excel and create a timeline with the cash flows and discount rates you will need to value the new bond issue. a. To create the required spot rates for Ford’s issue, add the appropriate spread to the Treasury yield of the same maturity. b. The yield curve and spread rates you have found do not cover every year that you will need for the new bonds. Specifically, you do not have yields or spreads for four-, six-, eight-, and nine-year maturities. Fill these in by linearly interpolating the given yields and spreads. For example, the four-year spot rate and spread will be the average of the three- and five-year rates. The six-year rate and spread will be the average of the five- and seven-year rates. For years eight and nine you will have to spread the difference between years seven and ten across the two years. c. To compute the spot rates for Ford’s current debt rating, add the yield spread to the Treasury rate for each maturity. However, note that the spread is in basis points, which are 1/100th of a percentage point. d. Compute the cash flows that would be paid to bondholders each year and add them to the timeline. Use the spot rates to calculate the present value of each cash flow paid to the bondholders. Compute the issue price of the bond and its initial yield to maturity. Repeat steps 4–6 based on the assumption that Ford is able to raise its bond rating by one level. Compute the new yield based on the higher rating and the new bond price that would result. Compute the additional cash proceeds that could be raised from the issue if the rating were improved.

Chapter 6 Bonds

Chapter 6 APPENDIX A

177

Solving for the Yield to Maturity of a Bond Using a Financial Calculator

You are looking to purchase a three-year, $1000 par, 10% annual coupon bond. Payments begin one year from now in January 2012. The price of the bond is $1074.51 per $1000 par value. What is the yield to maturity of the bond? [answer: 7.15%] HP-10BII Press [Orange Shift] and then the [C] button to clear all previous entries. Enter the Number of periods.

C 3

N

1

0

0

PMT

1

0

0

0

FV

1

0

7

4

•

5

1

/ PV

I/YR

Enter the payment amount per period. Enter the par value of the bond you will receive in year 3. Enter present value or price of the bond you solved for earlier. Solves for the yield to maturity.

TI-BAII Plus Professional Press [2ND] and then the [FV] button to clear all previous entries. Enter the Number of periods.

2ND FV 3

N

1

0

0

PMT

1

0

0

0

FV

1

0

7

4

•

CPT

I/Y

5

1

/ PV

Enter the payment amount per period. Enter the par value of the bond you will receive in year 3. Enter present value or price of the bond you solved for earlier. Solves for the yield to maturity.

178

Part 2 Interest Rates and Valuing Cash Flows

Chapter 6 APPENDIX B

The Yield Curve and the Law of One Price

Thus far, we have focused on the relationship between the price of an individual bond and its yield to maturity. In this section, we explore the relationship between the prices and yields of different bonds. In Chapter 3, we saw how market forces keep the same asset from having two prices at the same time—we call this the Valuation Principle’s Law of One Price. Using the Law of One Price, we show that given the spot interest rates, which are the yields of default-free zero-coupon bonds, we can determine the price and yield of any other default-free bond. As a result, the yield curve provides sufficient information to evaluate all such bonds.

Valuing a Coupon Bond with Zero-Coupon Prices We begin with the observation that it is possible to replicate the cash flows of a coupon bond using zero-coupon bonds. Therefore, we can use the Law of One Price to compute the price of a coupon bond from the prices of zero-coupon bonds. For example, we can replicate a three-year, $1000 bond that pays 10% annual coupons using three zerocoupon bonds as follows: 0

1

2

3

Coupon bond:

$100

$100

$1100

1-year zero: 2-year zero: 3-year zero:

$100

Zero-coupon bond portfolio:

$100 $1100 $100

$100

$1100

We match each coupon payment to a zero-coupon bond with a face value equal to the coupon payment and a term equal to the time remaining to the coupon date. Similarly, we match the final bond payment (final coupon plus return of face value) in three years to a three-year zero-coupon bond with a corresponding face value of $1100. Because the coupon bond cash flows are identical to the cash flows of the portfolio of zero-coupon bonds, the Law of One Price states that the price of the portfolio of zero-coupon bonds must be the same as the price of the coupon bond. To illustrate, assume that current zero-coupon bond yields and prices are as shown in Table 6.7 (they are the same as in Example 6.1). We can calculate the cost of the zero-coupon bond portfolio that replicates the threeyear coupon bond as follows: Zero-Coupon Bond

Face Value Required

Cost

1 Year

100

96.62

2 Years 3 Years

100 1100

92.45 11 * 87.63 = 963.93 Total Cost: $1153.00

Chapter 6 Bonds

TABLE 6.7 Yields and Prices (per $100 Face Value) for Zero-Coupon Bonds

Maturity

1 Year 3.50%

YTM Price

$96.62

2 Years 4.00% $92.45

3 Years 4.50% $87.63

179

4 Years 4.75% $83.06

By the Law of One Price, the three-year coupon bond must trade for a price of $1153. If the price of the coupon bond were higher, you could earn an arbitrage profit by selling the coupon bond and buying the zero-coupon bond portfolio. If the price of the coupon bond were lower, you could earn an arbitrage profit by buying the coupon bond and selling the zero-coupon bonds.

Valuing a Coupon Bond Using Zero-Coupon Yields To this point, we have used the zero-coupon bond prices to derive the price of the coupon bond. Alternatively, we can use the zero-coupon bond yields. Recall that the yield to maturity of a zero-coupon bond is the competitive market interest rate for a risk-free investment with a term equal to the term of the zero-coupon bond. Since the cash flows of the bond are its coupon payments and face value repayment, the price of a coupon bond must equal the present value of its coupon payments and face value discounted at the competitive market interest rates (see Eq. 5.7 in Chapter 5): Price of a Coupon Bond P = PV 1 Bond Cash Flows 2 =

CPN CPN CPN + FV + + g + 2 1 1 + YTMn 2 n 1 + YTM1 1 1 + YTM2 2

(6.4)

where CPN is the bond coupon payment, YTMn is the yield to maturity of a zero-coupon bond that matures at the same time as the nth coupon payment, and FV is the face value of the bond. For the three-year, $1000 bond with 10% annual coupons considered earlier, we can use Eq. 6.4 to calculate its price using the zero-coupon yields in Table 6.7: P =

100 100 100 + 1000 + + = +1153 2 1.035 1.04 1.0453

This price is identical to the price we computed earlier by replicating the bond. Thus, we can determine the no-arbitrage price of a coupon bond by discounting its cash flows using the zero-coupon yields. In other words, the information in the zero-coupon yield curve is sufficient to price all other risk-free bonds.

Coupon Bond Yields Given the yields for zero-coupon bonds, we can use Eq. 6.4 to price a coupon bond. In Section 6.3, we saw how to compute the yield to maturity of a coupon bond from its price. Combining these results, we can determine the relationship between the yields of zerocoupon bonds and coupon-paying bonds. Consider again the three-year, $1000 bond with 10% annual coupons. Given the zerocoupon yields in Table 6.7, we calculate a price for this bond of $1153. From Eq. 6.3, the yield to maturity of this bond is the rate y that satisfies: P = 1153 =

100 100 100 + 1000 + + 2 11 + y2 11 + y2 11 + y23

180

Part 2 Interest Rates and Valuing Cash Flows We can solve for the yield by using a financial calculator or spreadsheet:

Given: Solve for:

N 3

I/Y

PV 1153

PMT 100

FV 1000

4.44 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,100,1153,1000)

Therefore, the yield to maturity of the bond is 4.44%. We can check this result directly as follows: P =

100 + 1000 100 100 + = +1153 + 2 1.0444 1.0444 1.0444 3

Because the coupon bond provides cash flows at different points in time, the yield to maturity of a coupon bond is a weighted average of the yields of the zero-coupon bonds of equal and shorter maturities. The weights depend (in a complex way) on the magnitude of the cash flows each period. In this example, the zero-coupon bonds yields were 3.5%, 4.0%, and 4.5%. For this coupon bond, most of the value in the present value calculation comes from the present value of the third cash flow because it includes the principal, so the yield is closest to the three-year zero-coupon yield of 4.5%.

EXAMPLE 6.11 Yields on Bonds with the Same Maturity

Problem Given the following zero-coupon yields, compare the yield to maturity for a three-year zero-coupon bond, a three-year coupon bond with 4% annual coupons, and a three-year coupon bond with 10% annual coupons. All of these bonds are default free. Maturity

1 Year

2 Years

3 Years

4 Years

Zero-Coupon YTM

3.50%

4.00%

4.50%

4.75%

Solution Q Plan From the information provided, the yield to maturity of the three-year zero-coupon bond is 4.50%. Also, because the yields match those in Table 6.7, we already calculated the yield to maturity for the 10% coupon bond as 4.44%. To compute the yield for the 4% coupon bond, we first need to calculate its price, which we can do using Eq. 6.4. Since the coupons are 4%, paid annually, they are $40 per year for three years. The $1000 face value will be repaid at that time. Once we have the price, we can use Eq. 6.3 to compute the yield to maturity. Q Execute Using Eq. 6.4, we have: P =

40 40 40 + 1000 + + = +986.98 1.035 1.042 1.0453

The price of the bond with a 4% coupon is $986.98. From Eq. 6.4: 40 40 40 + 1000 + + 11 + y2 11 + y22 11 + y23 We can calculate the yield to maturity using a financial calculator or spreadsheet: +986.98 =

Given: Solve for:

N 3

I/Y

PV 986.98

PMT 40

FV 1000

4.47 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,40,986.98,1000)

Chapter 6 Bonds

181

To summarize, for the three-year bonds considered: Coupon Rate

0%

4%

10%

YTM

4.50%

4.47%

4.44%

Q Evaluate Note that even though the bonds all have the same maturity, they have different yields. In fact, holding constant the maturity, the yield decreases as the coupon rate increases. We discuss why below.

Example 6.11 shows that coupon bonds with the same maturity can have different yields depending on their coupon rates. The yield to maturity of a coupon bond is a weighted average of the yields on the zero-coupon bonds. As the coupon increases, earlier cash flows become relatively more important than later cash flows in the calculation of the present value. The shape of the yield curve keys us in on trends with the yield to maturity: 1. If the yield curve is upward sloping (as it is for the yields in Example 6.11), the resulting yield to maturity decreases with the coupon rate of the bond. 2. When the zero-coupon yield curve is downward sloping, the yield to maturity will increase with the coupon rate. 3. With a flat yield curve, all zero-coupon and coupon-paying bonds will have the same yield, independent of their maturities and coupon rates.

Treasury Yield Curves As we have shown in this section, we can use the zero-coupon yield curve to determine the price and yield to maturity of other risk-free bonds. The plot of the yields of coupon bonds of different maturities is called the coupon-paying yield curve. When U.S. bond traders refer to “the yield curve,” they are often referring to the coupon-paying Treasury yield curve. As we showed in Example 6.11, two coupon-paying bonds with the same maturity may have different yields. By convention, practitioners always plot the yield of the most recently issued bonds, termed the on-the-run bonds. Using similar methods to those employed in this section, we can apply the Law of One Price to determine the zerocoupon bond yields using the coupon-paying yield curve. Thus, either type of yield curve provides enough information to value all other risk-free bonds.

7

Stock Valuation

LEARNING OBJECTIVES

notation

182

Q Describe the basics of common stock, preferred stock, and stock quotes

Q Understand the tradeoff between dividends and growth in stock valuation

Q Compare how trades are executed on the NYSE and NASDAQ

Q Appreciate the limitations of valuing a stock based on expected dividends

Q Value a stock as the present value of its expected future dividends

Q Value a stock as the present value of the company’s total payout

Divt

dividends paid in year t

Pt

stock price at the end of year t

EPSt

earnings per share on date t

PV

present value

g

expected dividend growth rate

rE

equity cost of capital

N

terminal date or forecast horizon

INTERVIEW WITH

Christopher Ellis-Ferrara AllianceBersntein

Christopher Ellis-Ferrara is a business analyst covering U.S. real estate investment trusts (REITs) for the Bernstein Value Equities research department of AllianceBernstein in New York City. He received his degree in economics and geosciences at Williams College, Williamstown, Massachusetts, in 2007. “My primary responsibility is to conduct in-depth fundamental research on the real estate industry, including tracking and forecasting supply and demand for various markets and property types,” says Chris. “Senior analysts incorporate my research into their company analyses. I also assist the chief investment officer of my product in portfolio analytics and management.” In addition to an array of other valuation tools, AllianceBernstein uses the dividend discount model (DDM) to help identify undervalued stocks for clients. “One attraction of the DDM is that it allows us to express our views of a company’s forward earnings prospects in the valuation,” says Chris. “This is a characteristic absent in other common tools.” Chris acknowledges that forecasting future earnings and dividends is an inherently challenging task—but essential for an accurate valuation. “Relative to other companies, however, REIT earnings and dividends are generally more predictable.” No single valuation model is perfect, so AllianceBernstein uses several to arrive at intrinsic value. “In addition to the DDM, some of the models and metrics we use for real estate companies include price-tonet asset value (NAV), earnings and cash flow multiples, enterprise value to EBITDA, and discounted cash flow analysis. Once we have conviction that the market price of a stock is less than its intrinsic value and that it does not alter the acceptable risk in our portfolio, we will invest.” The recent stock market volatility has heightened the opportunity to earn higher returns. “Now more than ever, we strive to stay disciplined in our investment process and identify pricing anomalies that volatility inevitably generates. To take advantage of these anomalies, we have improved our nimbleness to respond quickly. We also spend more time on balance sheet analysis, because the credit crisis severely impaired access to capital for real estate companies.”

Williams College, 2007

“The dividend discount model allows us to express our views of a company’s forward earnings prospects in the valuation.”

At 5:00 P.M. on March 17, 2010, footwear and apparel maker Nike, Inc., announced that its quarterly revenue growth would be higher than expected and that revenue and profit growth for the following year would be strong as well. The next day, Nike’s stock price increased by more than 5% on the New York Stock Exchange to $74.66, with almost 11 million shares being traded—nearly four times its average daily volume. How might an investor decide whether to buy or sell a stock such as Nike at this price? Why would the stock suddenly be worth 5% more after the announcement of this news? What actions can Nike’s managers take to further increase the stock price? To answer these questions, we turn to the Valuation Principle. The Valuation Principle indicates that the price of a security should equal the present value of the expected cash flows an investor will receive from owning it. In this chapter, we apply this idea to stocks. Thus, to value a stock, we need to know the expected cash flows an investor will receive and the appropriate cost of capital with which to discount those cash flows. Both these quantities can be challenging to estimate, and we will develop many of the details needed to do so throughout the remainder of this text.

183

184

Part 2 Interest Rates and Valuing Cash Flows We begin our study of stock valuation by contrasting the different types of stocks, interpreting a stock quote, and explaining how specialists execute stock trades. We then turn to our first model of stock valuation, the dividend-discount model, which considers the dividends and capital gains received by investors who hold the stock for different periods.

7.1

Stock Basics As discussed in Chapter 1, the ownership of a corporation is divided into shares of stock. A public corporation has many owners and its shares trade on a stock market that provides liquidity for a company’s shares and determines the market price for those shares. In this section, we explain what a stock market quote is and introduce the two types of stocks, common and preferred.

Stock Market Reporting: Stock Quotes common stock A share of ownership in the corporation, which confers rights to any common dividends as well as rights to vote on election of directors, mergers, and other major events. ticker symbol A unique abbreviation assigned to each publicly traded company.

Figure 7.1 shows a stock quote with basic information about Nike’s stock from Google Finance (www.google.com/finance) for May 11, 2010.1 Nike’s stock is common stock, which means a share of ownership in the corporation gives its owner rights to any common dividends as well as rights to vote on the election of directors, mergers, and other major events. The Web page notes that the company is a public corporation (its shares are widely held and traded in a market) and that its shares trade on the NYSE (New York Stock Exchange) under the ticker symbol NKE. A ticker symbol is a unique abbreviation assigned to a publicly traded company used when its trades are reported on the ticker (a real-time electronic display of trading activity). Shares on the NYSE have ticker symbols consisting of three or fewer characters, while shares on the NASDAQ generally have four or more characters in their ticker symbols. During the time period February through early May 2010, Nike paid one quarterly dividend to its common shareholders, on March 4. The dividend is marked by a “D” and the amount of the dividend. In this case, the dividend was 27 cents per share. Thus, if you owned 1000 shares of NKE, you would have received +0.27 * 1000 = +270 when Nike paid that dividend. The chart also clearly shows the jump in the price of NKE shares in March 2010 that we discussed in the chapter introduction. Finally, the Web page displays some basic information about the performance of NKE stock. Notice the price of the last trade of NKE shares in the market ($76.43), the price that shares started at when the market opened that day ($75.80), the range of low to high prices reached during trading that day ($75.76 to $77.07), and the volume of trading for the day (3.43 million shares). The total value of all the equity of NKE is its market capitalization, equal to the price per share multiplied by the number of shares outstanding: on May 11, 2010, it was +76.43 * 485.7 million = +37.12 billion. Over the past 52 weeks, NKE achieved a high price of $78.55 and a low price of $48.76 and had average daily volume of shares traded of 2.79 million shares. Also, note some basic information about the company: the price-earnings ratio (P/E) and earnings per share (EPS), both of which we discussed in Chapter 2. The Web page also notes that NKE’s beta is 0.87.2

1

There are many places on the Internet to get free stock information, such as Yahoo! Finance (http:// finance.yahoo.com/), MSN Money (http://moneycentral.msn.com/), the Wall Street Journal’s Web site (www.wsj.com), and the exchange sites www.nyse.com and www.nasdaq.com. 2

Beta is a measure of risk that we will discuss in Chapter 12.

Chapter 7 Stock Valuation

FIGURE 7.1 Stock Price Quote for Nike (NKE)

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This screenshot from Google Finance shows the basic stock price information and price history charting for the common stock of Nike. The historical price chart covers the period February through early May 2010. The price of $76.43 is for May 11, 2010.

Source : www.google.com/finance?q=nke.

Although the current price of NKE is $76.43, the stock’s price has varied over time. In preceding chapters, we have learned how financial managers make decisions that affect the value of their company.

Common Stock straight voting Voting for directors where shareholders must vote for each director separately, with each shareholder having as many votes as shares held. cumulative voting Voting for directors where each shareholder is allocated votes equal to the number of open spots multiplied by his or her number of shares.

We now examine the rights of common stockholders, including their voice in the running of the corporation. All rights accruing to the shareholders are in proportion to the number of shares they hold. Shareholder Voting. To illustrate the shareholder voting process, consider an election of ten directors at a company with only two shareholders: Donna and Jonathan. Donna has 600 shares and Jonathan has 400, but they have very different views of how the company should be run. If the company has straight voting, each shareholder has as many votes for each director as shares held. That is, for each director, Donna will have 600 votes and Jonathan 400, so Jonathan will lose every vote and have no representation on the board. If the company has cumulative voting, each shareholder’s total vote allocation for all directors is equal to the number of open spots multiplied by his or her number of shares. With ten directors up for election, Jonathan is allocated a total of 10 * 400 votes (4000

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classes Different types of common stock for the same company, often carrying different voting rights.

annual meeting Meeting held once per year where shareholders vote on directors and other proposals as well as ask managers questions. proxy A written authorization for someone else to vote your shares. proxy contest When two or more groups are competing to collect proxies to prevail in a matter up for shareholder vote (such as election of directors).

votes) and Donna is allocated 10 * 600 votes (6000 votes) to use across the ten director spots. Jonathan could allocate all his votes to four directors, ensuring that he has four directors representing his views on the board. Donna would do the same for six directors, ensuring her representation. With cumulative voting, even shareholders with minority blocks (less than 50%) have a chance at representation on the board. This example is based on the concept of one share, one vote. Some companies have different types of common stock, called classes, which carry different voting rights. This is typical in companies that are family run, or where the founder is still active. For example, Nike has Class A and Class B stock. Phil Knight, Nike’s founder, owns almost all the Class A stock, which carries the rights to elect 9 of the company’s 12 directors. Google also has Class A and Class B stock. Class A stock has been sold to the public, while Google’s founders and managers hold all the Class B stock, each share of which carries ten times the voting power of a share of Class A stock. Shareholder Rights. Each year, companies hold an annual meeting at which managers and directors answer questions from shareholders, and shareholders vote on the election of directors and other proposals. All shareholders have the right to attend the annual meeting and cast their votes directly. In practice, though, most either allow the board to vote for them or direct that their shares be voted for them via proxy, or explicit instructions on how they should be voted. Typically matters at the annual meeting are uncontested, but occasionally a dissident shareholder group will propose an alternative slate of directors or oppose a management proposal. In that case, each side will actively solicit the proxies of all the shareholders so they may win the vote in a proxy contest. As an ownership claim, common stock carries the right to share in the profits of the corporation through dividend payments. Recall from Chapter 1 that dividends are periodic payments, usually in the form of cash, that firms make to shareholders as a partial return on their investment in the corporation. The board of directors decides the timing and amount of each dividend. Shareholders are paid dividends in proportion to the number of shares they own. If the company is liquidated through bankruptcy and there are assets left over after satisfying the claims of the creditors, shareholders divide the remaining assets proportionally based on each shareholder’s number of shares.

Preferred Stock preferred stock Stock with preference over common shares in payment of dividends and in liquidation. cumulative preferred stock Preferred stock where all missed preferred dividends must be paid before any common dividends may be paid. non-cumulative preferred stock Preferred stock where missed dividends do not accumulate. Only the current dividend is owed before common dividends can be paid.

Some companies have an additional issue of stock called preferred stock, which has preference over common shares in the distribution of dividends or cash during liquidation. While the directors can at their discretion choose not to pay the preferred shareholders a dividend, they cannot pay a dividend to common stockholders unless they pay the promised dividend to preferred shareholders first. For example, Nike has preferred shares that pay a $0.10 dividend per share each year. The firm must pay this dividend before common shareholders can receive a dividend. Cumulative Versus Non-Cumulative Preferred Stock. There are two types of preferred stock: cumulative and non-cumulative. With cumulative preferred stock, any unpaid dividends are carried forward. For example, if DuPont fails to pay its preferred dividend for several years, its obligation to its cumulative preferred shareholders accumulates, and it cannot pay any dividends to common shareholders until it has paid all the unpaid preferred dividends. With non-cumulative preferred stock, missed dividends do not accumulate, and the firm can pay current dividend payments first to preferred and then to common stock shareholders. Almost all preferred stock is cumulative. Some preferred stock also gives preferred shareholders the right to elect one or more directors to the board if the firm is substantially in arrears on preferred dividends.

Chapter 7 Stock Valuation

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Preferred Stock: Equity or Debt? You may be wondering how to think about preferred stock—is it equity or is it debt? Economically, it is like a perpetual bond because it has a promised cash flow to holders and there are consequences if these cash flows are not paid. However, unlike debtholders, preferred shareholders cannot force the firm into bankruptcy. Preferred shareholders stand in line in front of common shareholders for annual dividends, but behind regular bondholders, because interest is paid before dividends. If the firm is bankrupt, the same priority is followed in settling claims: bondholders, preferred shareholders, and then common shareholders. Finally, as long as the firm is meeting its preferred dividend obligations, the preferred shareholders have none of the control rights of owners, such as voting on directors or other important matters. However, despite all these similarities to debt, preferred shares are, for all tax and legal purposes, treated as equity.

Concept Check

7.2

floor broker A person at the NYSE with a trading license who represents orders on the floor, balancing speed and price to get the best execution.

1. What is a share of stock and what are dividends? 2. What are some key differences between preferred and common stock?

The Mechanics of Stock Trades Suppose you decide to invest in Nike (NKE), and so you place a market order to buy 100 shares of its stock. A market order means you do not specify a price, rather you want the order to execute immediately at the most favorable price available. If instead you wanted to specify a maximum price you were willing to pay, and you were willing to wait until the shares were available at that price, you would place a limit order. What actually happens when you place this market order to buy Nike stock? In market parlance, 100 shares is a “round lot” and would be considered a small order. Small orders such as this would typically be transmitted electronically to the stock exchange via a system called the Super Display Book system (which replaced the old SuperDOT system in 2009). Upon reaching the exchange, it would go directly to the workstation of the specialist who oversees trading in Nike stock. Recall from Chapter 1 that a specialist holds a trading license at the NYSE and acts as a market maker for a particular stock, maintaining orderly trading and stepping in to provide liquidity when needed. The small order would automatically execute against the specialist’s inventory in an average time of five milliseconds. If you were making a large trade, say, to buy 15,000 shares, the process would be more complex. At a physical stock market such as the NYSE, your trade would still be transmitted electronically to the exchange, but it would be sent to the wireless handheld terminal of a floor broker. A floor broker holds a trading license at the NYSE and works to get the best execution possible for investors. In this case, the floor broker would physically go to the station where NKE is traded and look for other floor brokers representing sellers of NKE shares. The NKE specialist is also there, standing ready to buy (a limited amount) at the quoted bid price and sell at the quoted ask price. The floor broker would take note of the bid and ask and then negotiate with any selling brokers to buy 15,000 shares at a price below the specialist’s ask price. If no sell orders are available, then the floor broker would trade with the specialist. Depending on how many shares the specialist had offered to trade at the ask price, the trade may need to execute slightly above the ask price in order to clear the full order. If you were buying a stock on an electronic exchange such as NASDAQ, the trade would proceed slightly differently. Recall from Chapter 1 that NASDAQ is a computer network with no physical location. Also, each stock listed on NASDAQ has an average of 24 dealers making a market in the stock. Each dealer posts bid and ask quotes and trades at those prices for its own account and for customer accounts. If you place an order through

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Part 2 Interest Rates and Valuing Cash Flows your broker or online brokerage account to buy 100 shares of Dell (DELL), the order will be transmitted electronically to the NASDAQ network where it automatically executes against the best (lowest) ask quote for Dell. If you are trying to buy a bigger block, like 15,000 shares, then your stockbroker may need to negotiate with one or more of the dealers posting quotes to sell Dell. Because there is no physical location for this type of negotiation, it would take place over the phone. But how do you decide whether to buy or sell a stock in the first place? You must estimate the value of the stock and compare it to the current market price. In the rest of this chapter, we discuss one traditional approach to valuing a stock, the dividend-discount model.3

Concept Check

7.3

3. What is the role of a floor broker at the NYSE? 4. What is the role of a dealer at the NASDAQ?

The Dividend-Discount Model The Valuation Principle implies that to value any security, we must determine the expected cash flows that an investor will receive from owning it. We begin our analysis of stock valuation by considering the cash flows for an investor with a one-year investment horizon. We will show how the stock’s price and the investor’s return from the investment are related. We then consider the perspective of investors with a long investment horizon. Finally, we will reach our goal of establishing the first stock valuation method: the dividend-discount model.

A One-Year Investor There are two potential sources of cash flows from owning a stock: 1. The firm might pay out cash to its shareholders in the form of a dividend. 2. The investor might generate cash by selling the shares at some future date. The total amount received in dividends and from selling the stock will depend on the investor’s investment horizon. Let’s begin by considering the perspective of a one-year investor. When an investor buys a stock, she will pay the current market price for a share, P0 . While she continues to hold the stock, she will be entitled to any dividends the stock pays. Let Div1 be the total dividends the investor expects to be paid per share during the year. At the end of the year, the investor will sell her share at the new market price. Let P1 be the price the investor expects to sell her share at at the end of the year. Assuming for simplicity that all dividends are paid at the end of the year, we have the following timeline for this investment: 0

1

P0

Div1 P1

Of course, the future dividend payment and stock price in this timeline are not known with certainty. Rather, these values are based on the investor’s expectations at the time the stock is purchased. Given these expectations, the investor will be willing to pay 3

In Chapter 10, we return to the question of stock valuation with a discussion of additional approaches. As you will see, when estimating the value of a stock, it is best to try several different approaches to increase the confidence in your estimate.

Chapter 7 Stock Valuation

equity cost of capital The expected rate of return available in the market on other investments that have equivalent risk to the risk associated with the firm’s shares.

189

a price today up to the point at which the benefits equal the cost—that is, up to the point at which the current price equals the present value of the expected future dividend and sale price. Because these cash flows are risky, we cannot discount them using the risk-free interest rate, but instead must use the cost of capital for the firm’s equity. We have previously defined the cost of capital of any investment to be the expected return that investors could earn on their best alternative investment with similar risk and maturity. Thus we must discount the equity cash flows based on the equity cost of capital, rE , for the stock, which is the expected return of other investments available in the market with equivalent risk to the firm’s shares. Doing so leads to the following equation for the stock price: P0 =

Div1 + P1 1 + rE

(7.1)

If the current stock price were less than this amount, the cost would be less than the PV of the benefits, so investors would rush in and buy it, driving up the stock’s price. If the stock price exceeded this amount, selling would be attractive and the stock price would quickly fall.

Dividend Yields, Capital Gains, and Total Returns A critical part of Eq. 7.1 for determining the stock price is the firm’s equity cost of capital, rE . At the beginning of this section, we pointed out that an investor’s return from holding a stock comes from dividends and cash generated from selling the stock. We can rewrite Eq. 7.1 to show these two return components. If we multiply by 1 1 + rE 2 , divide by P0 , and subtract 1 from both sides, we have Total Return

rE =

Div1 + P1 - 1 = P0

Div1 P0 ()* Dividend Yield

dividend yield The expected annual dividend of a stock divided by its current price; the percentage return an investor expects to earn from the dividend paid by the stock. capital gain The amount by which the selling price of an asset exceeds its initial purchase price. capital gain rate An expression of capital gain as a percentage of the initial price of the asset. total return The sum of a stock’s dividend yield and its capital gain rate.

+

P1 - P0 P0 (')'*

(7.2)

Capital Gain Rate

The first term on the right side of Eq. 7.2 is the stock’s dividend yield, which is the expected annual dividend of the stock divided by its current price. The dividend yield is the percentage return the investor expects to earn from the dividend paid by the stock. The second term on the right side of Eq. 7.2 reflects the capital gain the investor will earn on the stock, which is the difference between the expected sale price and the original purchase price for the stock, P1 - P0 . We divide the capital gain by the current stock price to express the capital gain as a percentage return, called the capital gain rate. The sum of the dividend yield and the capital gain rate is called the total return of the stock. The total return is the expected return the investor will earn for a one-year investment in the stock. Equation 7.2 states that the stock’s total return should equal the equity cost of capital. In other words, the expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk. This result is exactly what we would expect: The firm must pay its shareholders a return commensurate with the return they can earn elsewhere while taking the same risk. If the stock offered a higher return than other securities with the same risk, investors would sell those other investments and buy the stock instead. This activity would then drive up the stock’s current price, lowering its dividend yield and capital gain rate until Eq. 7.2 holds true. If the stock offered a lower expected return, investors would sell the stock and drive down its price until Eq. 7.2 was again satisfied.

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EXAMPLE 7.1

Problem

Stock Prices and Returns

Suppose you expect Longs Drug Stores to pay an annual dividend of $0.56 per share in the coming year and to trade for $45.50 per share at the end of the year. If investments with equivalent risk to Longs’ stock have an expected return of 6.80%, what is the most you would pay today for Longs’ stock? What dividend yield and capital gain rate would you expect at this price?

Solution Q Plan

We can use Eq. 7.1 to solve for the beginning price we would pay now 1 P0 2 given our expectations about dividends 1 Div1 = $0.56 2 and future price 1 P1 = $45.50 2 and the return we need to expect to earn to be willing to invest 1 rE = 0.068 2 . We can then use Eq. 7.2 to calculate the dividend yield and capital gain rate. Q Execute Using Eq. 7.1, we have P0 =

Div1 + P1 $0.56 + $45.50 = = $43.13 1 + rE 1.0680

Referring to Eq. 7.2, we see that at this price, Longs’ dividend yield is Div1/P0 = 0.56/43.13 = 1.30%. The expected capital gain is $45.50 - $43.13 = $2.37 per share, for a capital gain rate of 2.37/43.13 = 5.50%. Q Evaluate At a price of $43.13, Longs’ expected total return is 1.30% + 5.50% = 6.80%, which is equal to its equity cost of capital (the return being paid by investments with equivalent risk to Longs’). This amount is the most we would be willing to pay for Longs’ stock. If we paid more, our expected return would be less than 6.8% and we would rather invest elsewhere.

A Multiyear Investor We now extend the intuition we developed for the one-year investor’s return to a multiyear investor. Equation 7.1 depends upon the expected stock price in one year, P1 . But suppose we planned to hold the stock for two years. Then we would receive dividends in both year 1 and year 2 before selling the stock, as shown in the following timeline: 0

1

2

P0

Div1

Div2 P2

Setting the stock price equal to the present value of the future cash flows in this case implies:4 P0 =

Div1 Div2 + P2 + 1 + rE 1 1 + rE 2 2

(7.3)

Equations 7.1 and 7.3 are different: As a two-year investor we care about the dividend and stock price in year 2, but these terms do not appear in Eq. 7.1. Does this difference imply that a two-year investor will value the stock differently than a one-year investor? 4

In using the same equity cost of capital for both periods, we are assuming that the equity cost of capital does not depend on the term of the cash flows; that is, rE is not different for year 2 (or any other year). Otherwise, we would need to adjust for the term structure of the equity cost of capital (as we did with the yield curve for risk-free cash flows in Chapter 5). This step would complicate the analysis but would not change its results.

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191

The answer to this question is no. A one-year investor does not care about the dividend and stock price in year 2 directly. She will care about them indirectly, however, because they will affect the price for which she can sell the stock at the end of year 1. For example, suppose the investor sells the stock to another one-year investor with the same expectations. The new investor will expect to receive the dividend and stock price at the end of year 2, so he will be willing to pay P1 =

Div2 + P2 1 + rE

for the stock. Substituting this expression for P1 into Eq. 7.1, we get the same result as in Eq. 7.3: P1

$''%''& Div1 + P1 Div1 Div2 + P2 1 P0 = = + ¢ ≤ 1 + rE 1 + rE 1 + rE 1 + rE =

Div1 Div2 + P2 + 1 + rE 1 1 + rE 2 2

Thus the formula for the stock price for a two-year investor is the same as that for a sequence of two one-year investors.

Dividend-Discount Model Equation dividend-discount model A model that values shares of a firm according to the present value of the future dividends the firm will pay.

We can continue this process for any number of years by replacing the final stock price with the value that the next holder of the stock would be willing to pay. Doing so leads to the general dividend-discount model for the stock price, where the horizon N is arbitrary: Dividend-Discount Model Div1 Div2 DivN PN P0 = + + g + + 1 + rE 1 1 + rE 2 2 1 1 + rE 2 N 1 1 + rE 2 N

(7.4)

Equation 7.4 applies to a single N-year investor, who will collect dividends for N years and then sell the stock, or to a series of investors who hold the stock for shorter periods and then resell it. Note that Eq. 7.4 holds for any horizon N. As a consequence, all investors (with the same expectations) will attach the same value to the stock, independent of their investment horizons. How long they intend to hold the stock and whether they collect their return in the form of dividends or capital gains is irrelevant. For the special case in which the firm eventually pays dividends and is never acquired or liquidated, it is possible to hold the shares forever. In this scenario, rather than having a stopping point where we sell the shares, we rewrite Eq. 7.4 to show that the dividends go on into the future: P0 =

Div1 Div2 Div3 + + + g 2 1 + rE 1 1 + rE 2 1 1 + rE 2 3

(7.5)

That is, the price of the stock is equal to the present value of all of the expected future dividends it will pay.

Concept Check

5. How do you calculate the total return of a stock? 6. What discount rate do you use to discount the future cash flows of a stock?

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Part 2 Interest Rates and Valuing Cash Flows

7.4

Estimating Dividends in the Dividend-Discount Model Equation 7.5 expresses the value of a stock in terms of the expected future dividends the firm will pay. Of course, estimating these dividends—especially for the distant future—is difficult. A commonly used approximation is to assume that in the long run, dividends will grow at a constant rate. In this section, we consider the implications of this assumption for stock prices and explore the tradeoff between dividends and growth.

Constant Dividend Growth The simplest forecast for the firm’s future dividends states that they will grow at a constant rate, g, forever. That case yields the following timeline for the cash flows for an investor who buys the stock today and holds it: 0

1

2

3

Div1

Div1(1 g )

Div1(1 g )

... P0

2

Because the expected dividends are a constant growth perpetuity, we can use Eq. 4.7 to calculate their present value. We then obtain the following simple formula for the stock price:5 constant dividend growth model A model for valuing a stock by viewing its dividends as a constant growth perpetuity.

Constant Dividend Growth Model Div1 P0 = rE - g

(7.6)

According to the constant dividend growth model, the value of the firm depends on the dividend level next year, divided by the equity cost of capital adjusted by the growth rate.

EXAMPLE 7.2

Problem

Valuing a Firm with Constant Dividend Growth

Consolidated Edison, Inc. (Con Ed) is a regulated utility company that services the New York City area. Suppose Con Ed plans to pay $2.30 per share in dividends in the coming year. If its equity cost of capital is 7% and dividends are expected to grow by 2% per year in the future, estimate the value of Con Ed’s stock.

Solution Q Plan Because the dividends are expected to grow perpetually at a constant rate, we can use Eq. 7.6 to value Con Ed. The next dividend 1 Div1 2 is expected to be $2.30, the growth rate 1 g 2 is 2%, and the equity cost of capital 1 rE 2 is 7%. Q Execute

P0 =

Div1 +2.30 = = +46.00 rE - g 0.07 - 0.02

Q Evaluate You would be willing to pay 20 times this year’s dividend of $2.30 to own Con Ed stock because you are buying a claim to this year’s dividend and to an infinite growing series of future dividends. As discussed in Chapter 4, this formula requires that g 6 rE . Otherwise, the present value of the growing perpetuity is infinite. The implication here is that it is impossible for a stock’s dividends to grow at a rate g 7 rE forever. If the growth rate does exceed rE , the situation must be temporary, and the constant growth model cannot be applied in such a case. 5

Chapter 7 Stock Valuation

193

For another interpretation of Eq. 7.6, note that we can rearrange it as follows: rE =

Div1 + g P0

(7.7)

Comparing Eq. 7.7 with Eq. 7.2, we see that g equals the expected capital gain rate. In other words, with constant expected dividend growth, the expected growth rate of the share price matches the growth rate of the dividends.

Dividends Versus Investment and Growth In Eq. 7.6, the firm’s share price increases with the current dividend level, Div1 , and the expected growth rate, g. To maximize its share price, a firm would like to increase both these quantities. Often, however, the firm faces a tradeoff: Increasing growth may require investment, and money spent on investment cannot be used to pay dividends. The constant dividend growth model provides insight into this tradeoff. dividend payout rate The fraction of a firm’s earnings that the firm pays out as dividends each year.

A Simple Model of Growth. What determines the rate of growth of a firm’s dividends? If we define a firm’s dividend payout rate as the fraction of its earnings that the firm pays as dividends each year, then we can write the firm’s dividend per share at date t as follows: Divt =

Earningst * Dividend Payout Ratet Shares Outstanding t ('''')''''*

(7.8)

EPSt

That is, the dividend each year is equal to the firm’s earnings per share (EPS) multiplied by its dividend payout rate. The firm can, therefore, increase its dividend in three ways: 1. It can increase its earnings (net income). 2. It can increase its dividend payout rate. 3. It can decrease its number of shares outstanding. Suppose for now that the firm does not issue new shares (or buy back its existing shares), so that the number of shares outstanding remains fixed. We can then explore the tradeoff between options 1 and 2. A firm can do one of two things with its earnings: It can pay them out to investors, or it can retain and reinvest them. By investing cash today, a firm can increase its future dividends. For simplicity, let’s assume that absent reinvesting its retained earnings, the firm does not grow, so the current level of earnings generated by the firm remains constant. If all increases in future earnings result exclusively from new investment made with retained earnings, then Change in Earnings = New Investment * Return on New Investment retention rate The fraction of a firm’s current earnings that the firm retains.

(7.9)

New investment equals the firm’s earnings multiplied by its retention rate, or the fraction of current earnings that the firm retains: New Investment = Earnings * Retention Rate

(7.10)

Substituting Eq. 7.10 into Eq. 7.9 and dividing by earnings gives an expression for the growth rate of earnings: Earnings Growth Rate =

Change in Earnings Earnings

= Retention Rate * Return on New Investment

(7.11)

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Part 2 Interest Rates and Valuing Cash Flows If the firm chooses to keep its dividend payout rate constant, then the growth in its dividends will equal the growth in its earnings: g = Retention Rate * Return on New Investment

(7.12)

Profitable Growth. Equation 7.12 shows that a firm can increase its growth rate by retaining more of its earnings. But if the firm retains more earnings, and as a result pays out a smaller fraction of those earnings as dividends, then according to Eq. 7.8 the firm may have to cut its dividend in the short run. If a firm wants to increase its share price, should it cut its dividend and invest more, or should it cut its investments and increase its dividend? Not surprisingly, the answer to this question will depend on the profitability of the firm’s investments. Let’s consider an example.

EXAMPLE 7.3 Cutting Dividends for Profitable Growth

Problem Crane Sporting Goods expects to have earnings per share of $6 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings as a dividend. With these expectations of no growth, Crane’s current share price is $60. Suppose Crane could cut its dividend payout rate to 75% for the foreseeable future and use the retained earnings to open new stores. The return on its investment in these stores is expected to be 12%. If we assume that the risk of these new investments is the same as the risk of its existing investments, then the firm’s equity cost of capital is unchanged. What effect would this new policy have on Crane’s stock price?

Solution Q Plan To figure out the effect of this policy on Crane’s stock price, we need to know several things. First, we need to compute its equity cost of capital. Next we must determine Crane’s dividend and growth rate under the new policy. Because we know that Crane currently has a growth rate of 0 1 g = 0 2 , a dividend of $6, and a price of $60, we can use Eq. 7.7 to estimate rE . Next, the new dividend will simply be 75% of the old dividend of $6. Finally, given a retention rate of 25% and a return on new investment of 12%, we can use Eq. 7.12 to compute the new growth rate 1 g 2 . Finally, armed with the new dividend, Crane’s equity cost of capital, and its new growth rate, we can use Eq. 7.6 to compute the price of Crane’s shares if it institutes the new policy. Q Execute Using Eq. 7.7 to estimate rE , we have Div1 $6 + g = + 0% = 0.10 + 0 rE = P0 $60 In other words, to justify Crane’s stock price under its current policy, the expected return of other stocks in the market with equivalent risk must be 10%. Next, we consider the consequences of the new policy. If Crane reduces its dividend payout rate to 75%, then from Eq. 7.8 its dividend this coming year will fall to Div1 = EPS1 * 75% = +6 * 75% = +4.50. At the same time, because the firm will now retain 25% of its earnings to invest in new stores, from Eq. 7.12 its growth rate will increase to g = Retention Rate * Return on New Investment = 0.25 * 0.12 = 0.03 = 3% Assuming Crane can continue to grow at this rate, we can compute its share price under the new policy using the constant dividend growth model of Eq. 7.6: Div1 +4.50 = = +64.29 P0 = rE - g 0.10 - 0.03 Q Evaluate Crane’s share price should rise from $60 to $64.29 if the company cuts its dividend in order to increase its investment and growth. By using its earnings to invest in projects that offer a rate of return (12%) greater than its equity cost of capital (10%), Crane has created value for its shareholders.

Chapter 7 Stock Valuation

195

In Example 7.3, cutting the firm’s dividend in favor of growth raised the firm’s stock price. This is not always the case, however, as Example 7.4 demonstrates.

EXAMPLE 7.4 Unprofitable Growth

Problem Suppose Crane Sporting Goods decides to cut its dividend payout rate to 75% to invest in new stores, as in Example 7.3. But now suppose that the return on these new investments is 8%, rather than 12%. Given its expected earnings per share this year of $6 and its equity cost of capital of 10% (we again assume that the risk of the new investments is the same as its existing investments), what will happen to Crane’s current share price in this case?

Solution Q Plan We will follow the steps in Example 7.3, except that in this case, we assume a return on new investments of 8% when computing the new growth rate 1 g 2 instead of 12% as in Example 7.3. Q Execute Just as in Example 7.3, Crane’s dividend will fall to $6 * 0.75 = $4.50. Its growth rate under the new policy, given the lower return on new investment, will now be g = 0.25 * 0.08 = 0.02 = 2%. The new share price is therefore Div1 $4.50 P0 = = = $56.25 rE - g 0.10 - 0.02 Q Evaluate Even though Crane will grow under the new policy, the return on its new investments is too low. The company’s share price will fall if it cuts its dividend to make new investments with a return of only 8%. By reinvesting its earnings at a rate (8%) that is lower than its equity cost of capital (10%), Crane has reduced shareholder value.

Comparing Example 7.3 with Example 7.4, we see that the effect of cutting the firm’s dividend to grow crucially depends on the value of the new investments the firm plans to make. In Example 7.3, the return on new investment of 12% exceeds the firm’s equity cost of capital of 10%, so the investment is a good one. In Example 7.4, however, the return on new investment is only 8%, so the new investment’s return is below the firm’s cost of capital. In that case, the new investment is not worthwhile even though it will lead to earnings growth. In this example, we can check that cutting the firm’s dividend to increase investment will create value and raise the stock price if, and only if, the new investments generate a return greater than their cost of capital. In the next chapter, we will consider more generally how to identify projects that create value and thus increase the stock price.

Changing Growth Rates Successful young firms often have very high initial earnings growth rates. During this period of high growth, firms often retain 100% of their earnings to exploit profitable investment opportunities. As they mature, their growth slows to rates more typical of established companies. At that point, their earnings exceed their investment needs and they begin to pay dividends. We cannot use the constant dividend growth model to value the stock of such a firm for two reasons: 1. These firms often pay no dividends when they are young. 2. Their growth rate continues to change over time until they mature.

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Part 2 Interest Rates and Valuing Cash Flows However, we can use the general form of the dividend-discount model to value such a firm by applying the constant growth model to calculate the future share price of the stock PN once the firm matures and its expected growth rate stabilizes: 0

1

2

N

N1

N2

N3

DivN PN

DivN 1

DivN 1 (1 g )

DivN 1 (1 g ) 2

... Div1

Div2

...

Specifically, if the firm is expected to grow at a long-term rate g after year N + 1, then from the constant dividend growth model: DivN + 1 (7.13) PN = rE - g We can then use this estimate of PN as a final cash flow in the dividend-discount model. Intuitively, we value the stock as the present value of the dividends we will receive plus the present value of the price we expect to be able to sell the stock for in the future. For example, consider a company with expected dividends of $2.00, $2.50, and $3.00 in each of the next three years. After that point, its dividends are expected to grow at a constant rate of 5%. If its equity cost of capital is 12%, we can find the current price. Using Eq. 7.13, we can compute the price in year 3: PN =

+3.00 1 1.05 2 DivN + 1 = a b = 45.00 rE - g 0.12 - 0.05

Now, using Eq. 7.4, we calculate the current price as the PV of the first 3 years’ dividends and then the price at the end of year 3: P0 =

COMMON MISTAKE

+2.00 +2.50 +3.00 +45.00 + + + = +37.94 2 3 1.12 1 1.12 2 1 1.12 2 1 1.12 2 3

Forgetting to “Grow” This Year’s Dividend

The most common mistake in handling growing dividends is to use the current period’s dividend in the numerator of the growing perpetuity formula. In the example just discussed in the text, the dividends reached $3 in year 3, and then grew by 5% per year thereafter. A common mistake is to calculate the growing stream of dividends as 3.00 , 0.12 - 0.05

3.00 * 1 1.05 2 = +45. 0.12 - 0.05 Also, remember to avoid the common mistake from Chapter 4: The growing perpetuity formula gives the value in year N for dividends starting in year N + 1. In the example above, the formula gives the value in year 3 of the growing dividend stream starting in year 4. That is why we discount the $45 back only three years.

forgetting that next year’s dividend (the numerator) has already grown by 5%! As we show in the example, the correct calculation is

This example also reinforces an important point: The constant dividend growth model (Eq. 7.13) is just a special case of the general dividend-discount formula (Eq. 7.4). We can always value all the stream of dividends using Eq. 7.4. However, if we assume constant growth, we can apply the growing perpetuity shortcut to all or part of the dividend stream, depending on whether the constant growth starts now or at some point in the future.

Chapter 7 Stock Valuation

EXAMPLE 7.5 Valuing a Firm with Two Different Growth Rates

197

Problem Small Fry, Inc., has just invented a potato chip that looks and tastes like a french fry. Given the phenomenal market response to this product, Small Fry is reinvesting all of its earnings to expand its operations. Earnings were $2 per share this past year and are expected to grow at a rate of 20% per year until the end of year 4. At that point, other companies are likely to bring out competing products. Analysts project that at the end of year 4, Small Fry will cut its investment and begin paying 60% of its earnings as dividends. Its growth will also slow to a long-run rate of 4%. If Small Fry’s equity cost of capital is 8%, what is the value of a share today?

Solution Q Plan We can use Small Fry’s projected earnings growth rate and payout rate to forecast its future earnings and dividends. After year 4, Small Fry’s dividends will grow at a constant 4%, so we can use the constant dividend growth model (Eq. 7.13) to value all dividends after that point. Finally, we can pull everything together with the dividend-discount model (Eq. 7.4). Q Execute The following spreadsheet projects Small Fry’s earnings and dividends: Year 0 1 Earnings 1 EPS Growth Rate (versus prior year) 20% $2.00 $2.40 2 EPS Dividends 0% 3 Dividend Payout Rate $ — 4 Div

2

3

4

5

6

20% $2.88

20% $3.46

20% $4.15

4% $4.31

4% $4.49

0% —

60% $2.49

60% $2.59

60% $2.69

$

0% —

$

Starting from $2.00 in year 0, EPS grows by 20% per year until year 4, after which growth slows to 4%. Small Fry’s dividend payout rate is zero until year 4, when competition reduces its investment opportunities and its payout rate rises to 60%. Multiplying EPS by the dividend payout ratio, we project Small Fry’s future dividends in line 4. After year 4, Small Fry’s dividends will grow at the constant expected long-run rate of 4% per year. Thus we can use the constant dividend growth model to project Small Fry’s share price at the end of year 3. Given its equity cost of capital of 8%, Div4 +2.49 = = +62.25 P3 = rE - g 0.08 - 0.04 We then apply the dividend-discount model (Eq. 7.4) with this terminal value: Div1 Div2 Div3 P3 +62.25 + + + = = +49.42 P0 = 1 + rE 1 1 + rE 2 2 1 1 + rE 2 3 1 1 + rE 2 3 1 1.08 2 3 Q Evaluate The dividend-discount model is flexible enough to handle any forecasted pattern of dividends. Here the dividends were zero for several years and then settled into a constant growth rate, allowing us to use the constant dividend growth model as a shortcut.

Table 7.1 summarizes the dividend-discount model, including how to apply the shortcut for constant growth.

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TABLE 7.1

The Dividend-Discount Model

General formula

If dividend growth is constant

If early growth is variable followed by constant growth

P0 =

Div1 Div2 DivN PN + + g + + 1 + rE 1 1 + rE 2 2 1 1 + rE 2 N 1 1 + rE 2 N

P0 =

Div1 rE - g

P0 =

DivN 1 1 + g 2 Div1 Div2 DivN 1 + + g + + ¢ ≤¢ ≤ 1 + rE rE - g 1 1 + rE 2 2 1 1 + rE 2 N 1 1 + rE 2 N

Value Drivers and the Dividend-Discount Model Now that we have fully developed the dividend-discount model, it is worth assessing how well it does capturing the intuitive drivers of stock value. When we think about how valuable a company is, we usually focus on how profitable it is now and how that profitability will grow or decline in the future, along with the risk of investing in the company. Where are these measures captured in the dividend-discount model? Profitability determines the company’s ability to pay dividends, so, implicitly in the forecasted dividend stream, we are forecasting the company’s profitability. As for the risk, that is captured in the equity cost of capital we use to discount those forecasted dividends. Riskier investments require higher expected returns, which enter the dividend-discount model as higher equity cost of capital.

Concept Check

7.5

7. What are three ways that a firm can increase the amount of its future dividends per share? 8. Under what circumstances can a firm increase its share price by cutting its dividend and investing more?

Limitations of the Dividend-Discount Model The dividend-discount model has two fundamental limitations that we will now address: its reliance on dividend forecasts and lack of applicability to non-dividend-paying stocks.

Uncertain Dividend Forecasts The dividend-discount model values a stock based on a forecast of the future dividends paid to shareholders. But unlike a Treasury bond, whose cash flows are known with virtual certainty, a firm’s future dividends carry a tremendous amount of uncertainty. Let’s reconsider the example of Nike (NKE). In 2010, NKE paid annual dividends of $1.08 (by paying four quarterly dividends of 27 cents each). With an equity cost of capital of 10% and expected dividend growth of 8.5%, the constant dividend growth model implies a share price for NKE of P0 =

+1.08 1 1 + 0.085 2 Div1 = = +78.12 rE - g 0.10 - 0.085

which is reasonably close to the $76.43 share price that the stock had at the time. With a 9% dividend growth rate, however, this estimate would rise to almost $118 per share; with a 6% dividend growth rate, the estimate falls to almost $29 per share. As we see in Figure 7.2, even small changes in the assumed dividend growth rate can lead to large changes in the estimated stock price. Furthermore, it is difficult to know which estimate of the dividend growth rate is more reasonable. NKE more than doubled its dividend between 2005 and 2010, but its earnings growth then moderated. Consequently, this rate of increase is not sustainable.

Chapter 7 Stock Valuation

FIGURE 7.2

199

Stock prices are based on the constant dividend growth model. We assume a dividend next year of $1.08 and an equity cost of capital of 10%. The expected dividend growth rate varies from 0% to 9%. Note how even a small change in the expected growth rate produces a large change in the stock price, especially at higher growth rates.

NKE Stock Prices for Different Expected Growth Rates

$120

$100

Stock Price

$80

$60

$40

$20

$0 0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Growth Rate

From Eq. 7.8, forecasting dividends requires forecasting the firm’s earnings, dividend payout rate, and future share count. Future earnings, however, will depend on interest expenses (which, in turn, depend on how much the firm borrows), and the firm’s share count and dividend payout rate will depend on whether NKE uses a portion of its earnings to repurchase shares. Because borrowing and repurchase decisions are at management’s discretion, they are more difficult to forecast reliably than other fundamental aspects of the firm’s cash flows.6

Non-Dividend-Paying Stocks Many companies do not pay dividends—Apple, Amazon.com, and Google are just a few examples. How then do we value those stocks? In the next section, we discuss a small modification to the dividend-discount model to capture total payouts to shareholders, whether the payouts are dividends or not. In Chapter 10, we will discuss other valuation approaches that do not rely on payouts. Those approaches will be more meaningful once we have covered how financial managers create value within the firm through decisions about which projects to approve. So, in the next two chapters, we will cover investment decision rules and project evaluation.

Concept Check

9. What are the main limitations of the dividend-discount model? 10. What pieces of information are needed to forecast dividends?

6

We discuss management’s decision to borrow funds or repurchase shares in Part 6 of the text.

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Part 2 Interest Rates and Valuing Cash Flows

7.6

share repurchase A transaction in which a firm uses cash to buy back its own stock.

Share Repurchases and the Total Payout Model In our discussion of the dividend-discount model, we implicitly assumed that any cash paid out by the firm to shareholders takes the form of a dividend. In recent years, an increasing number of firms have replaced dividend payouts with share repurchases. In a share repurchase, the firm uses excess cash to buy back its own stock. Share repurchases have two consequences for the dividend-discount model. First, the more cash the firm uses to repurchase shares, the less cash it has available to pay dividends. Second, by repurchasing shares, the firm decreases its share count, which increases its earnings and dividends on a per-share basis. In the dividend-discount model, we valued a share from the perspective of a single shareholder, discounting the dividends the shareholder will receive: P0 = PV 1 Future Dividends per Share 2

total payout model A method that values shares of a firm by discounting the firm’s total payouts to equity holders (that is, all the cash distributed as dividends and stock repurchases) and then dividing by the current number of shares outstanding.

(7.14)

An alternative method that may be more reliable when a firm repurchases shares is the total payout model, which values all of the firm’s equity, rather than a single share. To use this model, we discount the total payouts that the firm makes to shareholders, which is the total amount spent on both dividends and share repurchases (net of new share issuance).7 This gives the total value of the firm’s equity. We then divide by the current number of shares outstanding to determine the share price: Total Payout Model

P0 =

PV 1 Future Total Dividends and Net Repurchases 2 Shares Outstanding 0

(7.15)

We can apply the same simplifications to the total payout method that we obtained by assuming constant growth in Section 7.3. The only change is that we discount total dividends and share repurchases and use the growth rate of earnings (rather than earnings per share) when forecasting the growth of the firm’s total payouts. When the firm uses share repurchases, this method can be more reliable and easier to apply than the dividend-discount model.

EXAMPLE 7.6

Problem

Valuation with Share Repurchases

Titan Industries has 217 million shares outstanding and expects earnings at the end of this year of $860 million. Titan plans to pay out 50% of its earnings in total, paying 30% as a dividend and using 20% to repurchase shares. If Titan’s earnings are expected to grow by 7.5% per year and these payout rates remain constant, determine Titan’s share price assuming an equity cost of capital of 10%.

Solution Q Plan Based on the equity cost of capital of 10% and an expected earnings growth rate of 7.5%, we can compute the present value of Titan’s future payouts as a constant growth perpetuity. The only input missing here is Titan’s total payouts this year, which we can calculate as 50% of its earnings. The present value of all of Titan’s future payouts is the value of its total equity. To obtain the price of a share, we divide the total value by the number of shares outstanding (217 million). Q Execute Titan will have total payouts this year of 50% * +860 million = +430 million. Using the constant growth perpetuity formula, we have 7

You can think of the total payouts as the amount you would receive if you owned 100% of the firm’s shares: You would receive all the dividends, plus the proceeds from selling shares back to the firm in the share repurchase.

Chapter 7 Stock Valuation PV 1 Future Total Dividends and Repurchases 2 =

201

+430 million = +17.2 billion 0.10 - 0.075

This present value represents the total value of Titan’s equity (i.e., its market capitalization). To compute the share price, we divide by the current number of shares outstanding: P0 =

+17.2 billion = +79.26 per share 217 million shares

Q Evaluate Using the total payout method, we did not need to know the firm’s split between dividends and share repurchases. To compare this method with the dividend-discount model, note that Titan will pay a dividend of 30% * 1 +860 million/217 million shares 2 = +1.19 per share, for a dividend yield of 1.19/79.26 = 1.50%. From Eq. 7.7, we can solve for Titan’s expected growth rates of EPS, dividend, and share price: Div1 1.19 g = rE = = .10 = 0.085 = 8.5%. P0 79.26 This growth rate exceeds the 7.50% growth rate of earnings because Titan’s share count will decline over time owing to its share repurchases.8

Concept Check

7.7

11. How does the total payout model address part of the dividend-discount model’s limitations? 12. How does the growth rate used in the total payout model differ from the growth rate used in the dividenddiscount model?

Putting It All Together We now return to the questions posed at the beginning of the chapter. First, how would an investor decide whether to buy or sell Nike stock? She would value the stock using her own expectations. We showed one set of expectations about dividend growth that would be consistent with the price. If her expectations were substantially different, she might conclude that the stock was over- or under-priced at $76.43. Based on that conclusion, she would sell or buy the stock, and time would reveal whether her expectations were better than the market’s. Second, how could Nike stock suddenly be worth 5% more after Nike’s announcement? As investors digested the news in Nike’s announcement and updated their expectations, they would have determined that the previous day’s closing price was too low based on the new information about future earnings growth. Buying pressure would then drive the stock price up until the buys and sells came into balance. Third, what should Nike’s managers do to raise the stock price further? The only way to raise the stock price is to make value-increasing decisions. We turn to this task in the next section of the book. As shown in the next two chapters, through capital budgeting analysis, managers can identify projects that add value to the company. By increasing the value of the company through good investment decisions, Nike’s managers can increase the stock price. Chapter 10 returns to the question of stock valuation and extends the techniques developed here to incorporate the lessons of the next two chapters on project selection. 8

We can check that an 8.5% EPS growth rate is consistent with 7.5% earnings growth and Titan’s repurchase plans as follows: Given an expected share price of +79.26 * 1.085 = +86.00 next year, Titan will repurchase 20% * +860 million 1 +86.00 per share 2 = 2 million shares next year. With the decline in the number of shares from 217 million to 215 million, EPS grows by a factor of 1.075 * 1 217/215 2 = 1.085 or by 8.5%.

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Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

7.1 Stock Basics Q Ownership in a corporation is divided into shares of stock. These shares carry rights to share in the profits of the firm through future dividend payments. Q The shares also come with rights to vote to elect directors and decide on other important matters. Q Some firms issue preferred stock, which has preference over common stock in the payment of dividends and in liquidation, but typically carries no voting rights.

annual meeting, p. 186 classes, p. 186 common stock, p. 184 cumulative preferred stock, p. 186 cumulative voting, p. 185 non-cumulative preferred stock, p. 186 preferred stock, p. 186 proxy, p. 186 proxy contest, p. 186 straight voting, p. 185 ticker symbol, p. 184

MyFinanceLab Study Plan 7.1

7.2 The Mechanics of Stock Trades Q The NYSE has a physical trading location, but many small trades execute electronically. Q NASDAQ is a computer network without a specific trading location. Many trades execute automatically, while larger trades must be negotiated with one or more of the stock’s dealers.

floor broker, p. 187

MyFinanceLab Study Plan 7.2

7.3 The Dividend-Discount Model Q The Valuation Principle states that the value of a stock is equal to the present value of the dividends and future sale price the investor will receive. Because these cash flows are risky, they must be discounted at the equity cost of capital, which is the expected return of other securities available in the market with equivalent risk to the firm’s equity. The total return of a stock is equal to the dividend yield plus the capital gain rate. The expected total return of a stock should equal its equity cost of capital:

capital gain, p. 189 capital gain rate, p. 189 dividend-discount model, p. 191 dividend yield, p. 189 equity cost of capital, p. 189 total return, p. 189

MyFinanceLab Study Plan 7.3

rE =

Div1 + P1 Div1 - 1 = P0 P0 ()* Dividend Yield

+

P1 - P0 P0 (')'*

(7.2)

Capital Gain Rate

Q When investors have the same beliefs, the dividenddiscount model states that, for any horizon N, the stock price satisfies the following equation: P0 =

Div1 Div2 DivN PN (7.4) + + g + + 1 + rE 1 1 + rE 2 2 1 1 + rE 2 N 1 1 + rE 2 N

Q If the stock eventually pays dividends and is never acquired, the dividend-discount model implies that the stock price equals the present value of all future dividends.

Using Excel: Building a Dividend-Discount Model

Here is what you should know after reading this chapter. MyFinanceLab will helpChapter 7 Stock Valuation you identify what you know, and where to go when you need to practice. 7.4 Estimating Dividends in the Dividend-Discount Model Q The constant dividend growth model assumes that dividends grow at a constant expected rate, g. In that case, g is also the expected capital gain rate, and Div1 P0 = (7.6) rE - g Q Future dividends depend on earnings, shares outstanding, and the dividend payout rate: Divt =

constant dividend growth model, p. 192 dividend payout rate, p. 193 retention rate, p. 193

MyFinanceLab Study Plan 7.4

Earningst * Dividend Payout Ratet (7.8) Shares Outstanding t ('''')''''* EPSt

Q If all increases in future earnings result exclusively from new investments made with retained earnings, then earnings growth can be found as: Earnings Growth Rate =

Change in Earnings Earnings

(7.11)

= Retention Rate * Return on New Investment

(where Retention Rate = 1 - Payout Rate) Q If the dividend payout rate and the number of shares outstanding is constant, and if earnings change only as a result of new investment from retained earnings, then the growth rate of the firm’s earnings, dividends, and share price is calculated as follows: g = Retention Rate * Return on New Investment (7.12) Q Cutting the firm’s dividend to increase investment will raise the stock price if, and only if, the new investments generate a return greater than their cost of capital. Q If the firm has a long-term growth rate of g after the period N + 1, then we can apply the dividend-discount model and use the constant dividend growth formula to estimate the terminal stock value PN . 7.5 Limitations of the Dividend-Discount Model Q The dividend-discount model is sensitive to the dividend growth rate, which is difficult to estimate accurately. Q The dividend-discount model is not practical for valuing the majority of stocks not paying dividends. In Chapter 10, we discuss alternative approaches. 7.6 Share Repurchases and the Total Payout Model Q If the firm undertakes share repurchases, it is more reliable to use the total payout model to value the firm. In this model, the value of equity equals the present value of future total dividends and repurchases. To determine the stock price, we divide the equity value by the initial number of shares outstanding of the firm: PV 1 Future Total Dividends and Repurchases 2 P0 = (7.15) Shares Outstanding 0 Q The growth rate of the firm’s total payout is governed by the growth rate of earnings, not earnings per share.

MyFinanceLab Study Plan 7.5

share repurchase, p. 200 total payout model, p. 200

MyFinanceLab Study Plan 7.6

203

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Critical Thinking

1. What rights come with a share of stock? 2. Which two components make up the total return to an investor in a share of stock? 3. What does the dividend-discount model say about valuing shares of stock? 4. What is the relationship between the return from reinvesting cash flows and the change in the price of the stock? 5. How can the dividend-discount model be used with changing growth rates in future dividends? 6. What are some of the drawbacks of the dividend-discount model? 7. What are share repurchases, and how can they be incorporated into the valuation of a stock?

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Stock Basics 1. If you own 15,000 shares of stock of Nike and it pays a dividend of $0.27 per share, then what is the total dividend you will receive? 2. You own 20% of the stock of a company that has ten directors on its board. How much representation can you get on the board if the company has cumulative voting? How much representation can you ensure if the company has straight voting? 3. Anzio, Inc., has two classes of shares. Class B has ten times the voting rights as Class A. If you own 10% of the class A shares and 20% of the Class B shares, what percentage of the total voting rights do you hold? The Dividend-Discount Model 4. Assume Evco, Inc., has a current stock price of $50 and will pay a $2 dividend in one year; its equity cost of capital is 15%. What price must you expect Evco stock to sell for immediately after the firm pays the dividend in one year to justify its current price? 5. Anle Corporation has a current stock price of $20 and is expected to pay a dividend of $1 in one year. Its expected stock price right after paying that dividend is $22. a. What is Anle’s equity cost of capital? b. How much of Anle’s equity cost of capital is expected to be satisfied by dividend yield and how much by capital gain? 6. Achi Corp. has preferred stock with an annual dividend of $3. If the required return on Achi’s preferred stock is 8%, what is its price? (Hint: For a preferred stock, the dividend growth rate is zero.) 7. Ovit, Inc., has preferred stock with a price of $20 and a dividend of $1.50 per year. What is its dividend yield? 8. Suppose Acap Corporation will pay a dividend of $2.80 per share at the end of this year and a dividend of $3 per share next year. You expect Acap’s stock price to be $52 in two years. Assume that Acap’s equity cost of capital is 10%.

Chapter 7 Stock Valuation

205

a. What price would you be willing to pay for a share of Acap stock today, if you planned to hold the stock for two years? b. Suppose instead you plan to hold the stock for one year. For what price would you expect to be able to sell a share of Acap stock in one year? c. Given your answer to part (b), what price would you be willing to pay for a share of Acap stock today, if you planned to hold the stock for one year? How does this price compare to your answer in part (a)? 9. Krell Industries has a share price of $22.00 today. If Krell is expected to pay a dividend of $0.88 this year and its stock price is expected to grow to $23.54 at the end of the year, what is Krell’s dividend yield and equity cost of capital? Estimating Dividends in the Dividend-Discount Model 10. NoGrowth Corporation currently pays a dividend of $0.50 per quarter, and it will continue to pay this dividend forever. What is the price per share of NoGrowth stock if the firm’s equity cost of capital is 15%? 11. Summit Systems will pay a dividend of $1.50 this year. If you expect Summit’s dividend to grow by 6% per year, what is its price per share if the firm’s equity cost of capital is 11%? 12. Dorpac Corporation has a dividend yield of 1.5%. Its equity cost of capital is 8%, and its dividends are expected to grow at a constant rate. a. What is the expected growth rate of Dorpac’s dividends? b. What is the expected growth rate of Dorpac’s share price? 13. Laurel Enterprises expects earnings next year of $4 per share and has a 40% retention rate, which it plans to keep constant. Its equity cost of capital is 10%, which is also its expected return on new investment. Its earnings are expected to grow forever at a rate of 4% per year. If its next dividend is due in one year, what do you estimate the firm’s current stock price to be? *14. DFB, Inc., expects earnings this year of $5 per share, and it plans to pay a $3 dividend to shareholders. DFB will retain $2 per share of its earnings to reinvest in new projects that have an expected return of 15% per year. Suppose DFB will maintain the same dividend payout rate, retention rate, and return on new investments in the future and will not change its number of outstanding shares. a. What growth rate of earnings would you forecast for DFB? b. If DFB’s equity cost of capital is 12%, what price would you estimate for DFB stock? c. Suppose instead that DFB paid a dividend of $4 per share this year and retained only $1 per share in earnings. That is, it chose to pay a higher dividend instead of reinvesting in as many new projects. If DFB maintains this higher payout rate in the future, what stock price would you estimate for the firm now? Should DFB follow this new policy? 15. Cooperton Mining just announced it will cut its dividend from $4 to $2.50 per share and use the extra funds to expand. Prior to the announcement, Cooperton’s dividends were expected to grow at a 3% rate, and its share price was $50. With the planned expansion, Cooperton’s dividends are expected to grow at a 5% rate. What share price would you expect after the announcement? (Assume that the new expansion does not change Cooperton’s risk.) Is the expansion a good investment? 16. Gillette Corporation will pay an annual dividend of $0.65 one year from now. Analysts expect this dividend to grow at 12% per year thereafter until the fifth year.

206

Part 2 Interest Rates and Valuing Cash Flows After then, growth will level off at 2% per year. According to the dividend-discount model, what is the value of a share of Gillette stock if the firm’s equity cost of capital is 8%? 17. Colgate-Palmolive Company has just paid an annual dividend of $0.96. Analysts are predicting an 11% per year growth rate in earnings over the next five years. After then, Colgate’s earnings are expected to grow at the current industry average of 5.2% per year. If Colgate’s equity cost of capital is 8.5% per year and its dividend payout ratio remains constant, for what price does the dividend-discount model predict Colgate stock should sell? *18. Halliford Corporation expects to have earnings this coming year of $3 per share. Halliford plans to retain all of its earnings for the next two years. Then, for the subsequent two years, the firm will retain 50% of its earnings. It will retain 20% of its earnings from that point onward. Each year, retained earnings will be invested in new projects with an expected return of 25% per year. Any earnings that are not retained will be paid out as dividends. Assume Halliford’s share count remains constant and all earnings growth comes from the investment of retained earnings. If Halliford’s equity cost of capital is 10%, what price would you estimate for Halliford stock? Share Repurchases and the Total Payout Model 19. Zoom Enterprises expects that one year from now it will pay a total dividend of $5 million and repurchase $5 million worth of shares. It plans to spend $10 million on dividends and repurchases every year after that forever, although it may not always be an even split between dividends and repurchases. If Zoom’s cost of equity capital is 13% and it has 5 million shares outstanding, what is its share price today? 20. AFW Industries has 200 million shares outstanding and expects earnings at the end of this year of $700 million. AFW plans to pay out 60% of its earnings in total, paying 40% as a dividend and using 20% to repurchase shares. If AFW’s earnings are expected to grow by 8% per year and these payout rates remain constant, determine AFW’s share price assuming an equity cost of capital of 12%. 21. Suppose Cisco Systems pays no dividends but spent $5 billion on share repurchases last year. If Cisco’s equity cost of capital is 12%, and if the amount spent on repurchases is expected to grow by 8% per year, estimate Cisco’s market capitalization. If Cisco has 6 billion shares outstanding, to what stock price does this correspond? *22. Maynard Steel plans to pay a dividend of $3 this year. The company has an expected earnings growth rate of 4% per year and an equity cost of capital of 10%. a. Assuming that Maynard’s dividend payout rate and expected growth rate remain constant, and that the firm does not issue or repurchase shares, estimate Maynard’s share price. b. Suppose Maynard decides to pay a dividend of $1 this year and to use the remaining $2 per share to repurchase shares. If Maynard’s total payout rate remains constant, estimate Maynard’s share price. c. If Maynard maintains the dividend and total payout rate given in part (b), at what rates are Maynard’s dividends and earnings per share expected to grow?

Chapter 7 Stock Valuation

PART

2

207

Integrative Case

This case draws on material from Chapters 3–7. Adam Rust looked at his mechanic and sighed. The mechanic had just pronounced a death sentence on his road-weary car. The car had served him well—at a cost of $500 it had lasted through four years of college with minimal repairs. Now, he desperately needs wheels. He has just graduated, and has a good job at a decent starting salary. He hopes to purchase his first new car. The car dealer seems very optimistic about his ability to afford the car payments, another first for him. The car Adam is considering is $35,000. The dealer has given him three payment options: 1. Zero percent financing. Make a $4000 down payment from his savings and finance the remainder with a 0% APR loan for 48 months. Adam has more than enough cash for the down payment, thanks to generous graduation gifts. 2. Rebate with no money down. Receive a $4000 rebate, which he would use for the down payment (and leave his savings intact), and finance the rest with a standard 48-month loan, with an 8% APR. He likes this option, as he could think of many other uses for the $4000. 3. Pay cash. Get the $4000 rebate and pay the rest with cash. While Adam doesn’t have $35,000, he wants to evaluate this option. His parents always paid cash when they bought a family car; Adam wonders if this really was a good idea. Adam’s fellow graduate, Jenna Hawthorne, was lucky. Her parents gave her a car for graduation. Okay, it was a little Hyundai, and definitely not her dream car, but it was serviceable, and Jenna didn’t have to worry about buying a new car. In fact, Jenna has been trying to decide how much of her new salary she could save. Adam knows that with a hefty car payment, saving for retirement would be very low on his priority list. Jenna believes she could easily set aside $3000 of her $45,000 salary. She is considering putting her savings in a stock fund. She just turned 22 and has a long way to go until retirement at age 65, and she considers this risk level reasonable. The fund she is looking at has earned an average of 9% over the past 15 years and could be expected to continue earning this amount, on average. While she has no current retirement savings, five years ago Jenna’s grandparents gave her a new 30-year U.S. Treasury bond with a $10,000 face value. Jenna wants to know her retirement income if she both (1) sells her Treasury bond at its current market value and invests the proceeds in the stock fund, and (2) saves an additional $3000 at the end of each year in the stock fund from now until she turns 65. Once she retires, Jenna wants those savings to last for 25 years until she is 90. Both Adam and Jenna need to determine their best options. 207

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Part 2 Interest Rates and Valuing Cash Flows

Case Questions 1. What are the cash flows associated with each of Adam’s three car financing options? 2. Suppose that, similar to his parents, Adam had plenty of cash in the bank so that he could easily afford to pay cash for the car without running into debt now or in the foreseeable future. If his cash earns interest at a 5.4% APR (based on monthly compounding) at the bank, what would be his best purchase option for the car? 3. In fact, Adam doesn’t have sufficient cash to cover all his debts including his (substantial) student loans. The loans have a 10% APR, and any money spent on the car could not be used to pay down the loans. What is the best option for Adam now? (Hint: Note that having an extra $1 today saves Adam roughly $1.10 next year because he can pay down the student loans. So, 10% is Adam’s time value of money in this case.) 4. Suppose instead Adam has a lot of credit card debt, with an 18% APR, and he doubts he will pay off this debt completely before he pays off the car. What is Adam’s best option now? 5. Suppose Jenna’s Treasury bond has a coupon interest rate of 6.5%, paid semiannually, while current Treasury bonds with the same maturity date have a yield to maturity of 5.4435% (expressed as an APR with semiannual compounding). If she has just received the bond’s tenth coupon, for how much can Jenna sell her treasury bond? 6. Suppose Jenna sells the bond, reinvests the proceeds, and then saves as she planned. If, indeed, Jenna earns a 9% annual return on her savings, how much could she withdraw each year in retirement? (Assume she begins withdrawing the money from the account in equal amounts at the end of each year once her retirement begins.) 7. Jenna expects her salary to grow regularly. While there are no guarantees, she believes an increase of 4% a year is reasonable. She plans to save $3000 the first year, and then increase the amount she saves by 4% each year as her salary grows. Unfortunately, prices will also grow due to inflation. Suppose Jenna assumes there will be 3% inflation every year. In retirement, she will need to increase her withdrawals each year to keep up with inflation. In this case, how much can she withdraw at the end of the first year of her retirement? What amount does this correspond to in today’s dollars? (Hint: Build a spreadsheet in which you track the amount in her retirement account each year.) 8. Should Jenna sell her Treasury bond and invest the proceeds in the stock fund? Give at least one reason for and against this plan. 9. At the last minute, Jenna considers investing in Coca-Cola stock at a price of $55.55 per share instead. The stock just paid an annual dividend of $1.76 and she expects the dividend to grow at 4% annually. If the next dividend is due in one year, what expected return is Coca-Cola stock offering?

Valuation and the Firm

PART

3

Valuation Principle Connection. One of the most important decisions

Chapter 8

facing a financial manager is choosing which investments the corporation should

Investment Decision Rules

make. These decisions fundamentally drive value in the corporation. In Chapter 8 we learn how the Valuation Principle allows us to apply the concept of net present value (NPV ) to compare the costs and benefits of a project in terms of a common unit—

Chapter 9

namely, dollars today. We will then be able to evaluate a decision by answering this

Fundamentals of Capital Budgeting

question: Does the cash value today of its benefits exceed the cash value today of its

costs? In addition, we will see that the difference between the cash values of the benefits and costs indicates the net amount by which the decision will increase the value of the firm and therefore the wealth of its investors. After establishing the usefulness of the NPV decision rule for making investment

Chapter 10 Stock Valuation: A Second Look

decisions, we discuss alternative rules found in practice and their drawbacks. The process of allocating the firm’s capital for investment is known as capital budgeting. In Chapter 9, we outline how to estimate a project’s incremental cash flows, which then become the inputs to the NPV decision rule. Chapter 9 also provides a practical demonstration of the power of the discounting tools that were introduced in Chapters 3 and 4. Capital budgeting drives value in the firm, so in Chapter 10, Stock Valuation: A Second Look, we return to valuing the ownership claim in the firm—its stock. In Chapter 7, we valued a stock by discounting its future dividends or total payments. In Chapter 10, we consider alternative methods such as discounting free cash flows or comparing its value to that of similar, publicly traded companies. 209

8

Investment Decision Rules

LEARNING OBJECTIVES Q Calculate Net Present Value

Q Choose between mutually exclusive alternatives

Q Use the NPV rule to make investment decisions

Q Evaluate projects with different lives

Q Understand alternative decision rules and their drawbacks

notation

210

Q Rank projects when a company’s resources are limited so that it cannot take all positive-NPV projects

CFn

cash flow that arrives at date n

NPV

net present value

g

growth rate

PV

present value

IRR

internal rate of return

r

discount rate

MIRR

modified internal rate of return

INTERVIEW WITH

Scott Ladner Parsons Brinckerhoff

Scott Ladner is an Associate Consultant at Parsons Brinckerhoff (PB), a firm that develops and operates major infrastructure projects around the world. Specializing in transportation-related infrastructure economics and project finance, he performs tolltraffic and revenue forecasting, operations and maintenance-cost estimation, benefit-cost evaluation, and project-funding assessments. “My B.S in Economics from the University of Washington, which I received in 2008, gave me the technical and quantitative skills my position requires. It also encouraged me to think critically about complex financial problems so that I would be able to apply them in personal situations,” Scott says. PB’s business focuses on the public sector. “Policymakers and government officials must allocate scarce resources to deliver public infrastructure projects that maximize benefits and minimize costs,” explains Scott. “We use cost-benefit analysis to rank projects based on their respective net present values (NPVs). Projects yielding higher net benefits will generally be granted more resources.” Scott analyzes a project’s potential costs and benefits over its life and discounts them to a present value. “An NPV greater than zero indicates that benefits outweigh the costs. NPV is also useful in comparing alternative investments, such as high-speed rail versus a new airport. Calculating the net present value shows us which alternative has a greater value to stakeholders.” PB also uses the internal rate of return (IRR), the discount rate at which a project’s NPV equals zero, to measure economic return on investment. “It is a good tool to compare similarly sized investments but not useful for investments of different scale. The construction of a $1 billion power plant may generate the same IRR as installing a residential solar system for $20,000. Intuitively, we know that the power plant offers substantially greater benefits, although the IRR rule suggests that the projects are equal.” Another decision rule, the payback period, evaluates investments over a predetermined and sometimes arbitrary time horizon. “Because this method considers a specific time period and not the entire cash flow stream, it may result in selecting an investment with a greater return in the short-run but a lower return over a longer time horizon.”

University of Washington, 2008

“Calculating the net present value shows us which alternative has a greater value to stakeholders.”

In 2000, Toshiba and Sony began experimenting with new DVD technology, leading to Sony’s decision to develop and produce Blu-ray high-definition DVD players and Toshiba’s decision to develop and produce the HD-DVD player and format. So began an eight-year format war that ended in February 2008 when Toshiba decided to stop producing HD-DVD players and abandon the format. How did Toshiba and Sony managers arrive at the decision to invest in new DVD formats? How did Toshiba managers conclude that the best decision was to stop producing HD-DVD? We focus in this chapter on the decisionmaking tools managers use to evaluate investment decisions. Examples of these decisions include new products, equipment purchases, and marketing campaigns. We begin the chapter by introducing the net present value (NPV) rule. Although the NPV investment rule maximizes the value of the firm, some firms nevertheless use other techniques to evaluate investments and decide which projects to pursue. As a result, it is important to understand those techniques, so we will explain some commonly used alternative techniques—namely, the payback rule and the

internal rate of return (IRR) rule. In each case, we define the decision rule and compare decisions based on this rule to decisions based on the NPV rule. We also illustrate the circumstances in which each of

211

212

Part 3 Valuation and the Firm the alternative rules is likely to lead to bad investment decisions. After establishing these rules in the context of a single, stand-alone project, we broaden our perspective to include evaluating multiple opportunities to select the best one. We conclude with a look at project selection when the firm faces limits on capital or managers’ time.

8.1

The NPV Decision Rule In the previous chapters, we learned how to convert between cash today and cash in the future using the discount rate. As long as we convert costs and benefits to the same point in time, we can use the Valuation Principle to make a decision. In practice, most corporations prefer to measure values in terms of their present value—that is, in terms of cash today. In this section, we apply the Valuation Principle to derive the concept of the net present value or NPV, which we can use to define the “golden rule” of financial decision making, the NPV rule.

Net Present Value net present value (NPV) The difference between the present value of a project’s or investment’s benefits and the present value of its costs.

When the value of a cost or benefit is computed in terms of cash today, we refer to it as the present value (PV). Similarly, we define the net present value (NPV) of a project or investment as the difference between the present value of its benefits and the present value of its costs: Net Present Value NPV = PV 1 Benefits 2 - PV 1 Costs 2

(8.1)

Let’s consider a simple example. Suppose your firm is offered the following investment opportunity: In exchange for $500 today, you will receive $550 in one year. If the interest rate is 8% per year, then: PV 1 Benefit 2 = 1 +550 in one year 2 1 +1.08 in one year/+1 today 2 = +509.26 today This PV is the amount you would need to put in the bank today to generate $550 in one year 1 +509.26 * 1.08 = +550 2 . In other words, the present value is the amount you need to invest at the current interest rate to recreate the cash flow. We can think of this as the cash cost today of generating the cash flow ourselves. Once the costs and benefits are in present value terms, we can compare them by computing the investment’s NPV: NPV = +509.26 - +500 = +9.26 today The NPV is positive, so the benefits outweigh the costs, which means the firm should undertake this investment opportunity. But what if you don’t have the $500 needed to cover the initial cost of the project? Does the project still have the same value? Because we computed the value using competitive market prices, it should not depend on your tastes or the amount of cash you have in the bank. If you don’t have the $500, suppose you borrow $509.26 from the bank at the 8% interest rate and then take the project. What are your cash flows in this case? Today: +509.26 1 loan 2 - +500 1 invested in the project 2 = +9.26

In one year: +550 1 from project 2 - +509.26 * 1.08 1 loan balance 2 = +0

Chapter 8 Investment Decision Rules

213

This transaction leaves you with exactly $9.26 extra cash in your pocket today and no future net obligations. So taking the project is similar to having an extra $9.26 in cash up front. Thus, the NPV expresses the value of an investment decision as an amount of cash received today. As long as the NPV is positive, the decision increases the value of the firm and is a good decision regardless of your current cash needs or preferences regarding when to spend the money.

The NPV Decision Rule

NPV decision rule When choosing among investment alternatives, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.

As shown in the last example, the Valuation Principle implies that we should undertake projects with a positive NPV because undertaking those projects increase wealth. That is, good projects are those for which the present value of the benefits exceeds the present value of the costs. As a result, the value of the firm increases and investors are wealthier. Projects with negative NPVs have costs that exceed their benefits. Accepting them is equivalent to losing money today. We capture this logic in the NPV Decision Rule: When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. Because NPV is expressed in terms of cash today, using the NPV decision rule is a simple way to apply the Valuation Principle. Decisions that increase wealth are superior to those that decrease wealth. We don’t need to know anything about the investor’s preferences to reach this conclusion. As long as we have correctly captured all the cash flows of a project and applied the appropriate discount rate, we can determine whether the project makes us wealthier. Being wealthier increases our options and makes us better off, whatever our preferences are. A common way companies apply the NPV rule in financial practices is when deciding whether to accept or reject a project. Because rejecting the project generally has NPV = 0 (there are no new costs or benefits from not doing the project), the NPV decision rule implies that we should Q Accept positive-NPV projects; accepting them is equivalent to receiving their NPV in cash today, and Q Reject negative-NPV projects; accepting them would reduce the value of the firm, whereas rejecting them has no cost 1 NPV = 0 2 . If the NPV is exactly zero, then you will neither gain nor lose by accepting the project instead of rejecting it, which also has an NPV of zero. It is not a bad project because it does not reduce the firm’s value, but it does not add value to the firm either.

EXAMPLE 8.1 The NPV Is Equivalent to Cash Today

Problem After saving $1500 by waiting tables, you are about to buy a 50-inch LCD TV. You notice that the store is offering a “one year same as cash” deal. You can take the TV home today and pay nothing until one year from now, when you will owe the store the $1500 purchase price. If your savings account earns 5% per year, what is the NPV of this offer? Show that its NPV represents cash in your pocket.

Solution Q Plan You are getting something worth $1500 today (the TV) and in exchange will need to pay $1500 in one year. Think of it as getting back the $1500 you thought you would have to spend today to get the TV. We treat it as a positive cash flow.

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Part 3 Valuation and the Firm Cash flows: Today

In one year

+ +1500

- +1500

The discount rate for calculating the present value of the payment in one year is your interest rate of 5%. You need to compare the present value of the cost ($1500 in one year) to the benefit today (a $1500 TV). Q Execute NPV = +1500 -

1500 = 1500 - 1428.57 = +71.43 1 1.05 2

You could take $1428.57 of the $1500 you had saved for the TV and put it in your savings account. With interest, in one year it would grow to +1428.57 * 1 1.05 2 = +1500, enough to pay the store. The extra $71.43 is money in your pocket to spend as you like (or put toward the speaker system for your new media room). Q Evaluate By taking the delayed payment offer, we have extra net cash flows of $71.43 today. If we put $1428.57 in the bank, it will be just enough to offset our $1500 obligation in the future. Therefore, this offer is equivalent to receiving $71.43 today, without any future net obligations.

Concept Check

8.2

1. What is the NPV decision rule? How is it related to the Valuation Principle? 2. Why doesn’t the NPV decision rule depend on the investor’s preferences?

Using the NPV Rule We continue our discussion of investment decision rules by considering a take-it-or-leaveit decision about a single, stand-alone project. By undertaking this project, the firm does not constrain its ability to take other projects. In the case of a stand-alone project, the alternatives we are considering are to accept or reject a project. The NPV rule then implies that we should compare the project’s NPV to zero (the NPV of rejecting the project and doing nothing). Thus, we should accept the project if its NPV is positive.1

Organizing the Cash Flows and Computing the NPV Researchers at Fredrick’s Feed and Farm have made a breakthrough. They believe they can produce a new, environmentally friendly fertilizer at a substantial cost saving over the company’s existing line of fertilizer. The fertilizer will require a new plant that can be built immediately at a cost of $81.6 million. Financial managers estimate that the benefits of the new fertilizer will be $28 million per year, starting at the end of the first year and lasting for four years, as shown by the following timeline: Year: Cash flow (in millions):

0 $81.60

1 $28

2 $28

3 $28

4 $28

Thus, the cash flows are an immediate $81.6 million outflow followed by an annuity inflow of $28 million per year for four years. Therefore, given a discount rate r, the NPV of this project is: 1

Some prefer to state the rule that the project should be accepted if its NPV is non-negative. Since the firm should be indifferent at an NPV of exactly zero (you will neither gain nor lose by accepting the project instead of rejecting it), we prefer to state it this way. A zero NPV project is not a bad project because it does not reduce the firm’s value, but it does not add value to the firm either.

Chapter 8 Investment Decision Rules NPV = -81.6 +

28 28 28 28 + + + 2 3 1 + r 11 + r2 11 + r2 11 + r24

215 (8.2)

We can also use the annuity formula from Chapter 4 to write the NPV as: NPV = -81.6 +

28 1 ¢1 ≤ r 11 + r24

(8.3)

To apply the NPV rule, we need to know the cost of capital. The financial managers responsible for this project estimate a cost of capital of 10% per year. If we replace r in Eq. 8.2 or 8.3 with the project’s cost of capital of 10%, we get an NPV of $7.2 million, which is positive. Recall that a net present value tells us the present value of the benefits (positive cash flows) net of the costs (negative cash flows) of the project. By putting everything into present values, it puts all the costs and benefits on an equal footing for comparison. In this case, the benefits outweigh the costs by $7.2 million in present value. The NPV investment rule indicates that by making the investment, Fredrick’s will increase the value of the firm today by $7.2 million, so Fredrick’s should undertake this project.

The NPV Profile

FIGURE 8.1

The graph in panel (b) shows the NPV as a function of the discount rate based on the data in panel (a). The NPV is positive, represented by the green-shaded area, only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of capital of 10%, the project has a positive NPV of $7.2 million. The red-shaded area indicates discount rates above the 14% IRR with negative NPVs.

NPV of Fredrick’s New Project

Panel (a)

Panel (b) $40

Discount NPV Rate ($ millions) $30.4 0% $25.0 2% $20.0 4% $15.4 6% $11.1 8% $7.2 10% $3.4 12% 14% $0.0 16% $3.3 18% $6.3 20% $9.1 22% $11.8 24% $14.3

$30

NPV ($ millions)

NPV profile A graph of a project’s NPV over a range of discount rates.

The NPV of the project depends on its appropriate cost of capital. Often, there may be some uncertainty regarding the project’s cost of capital. In that case, it is helpful to compute an NPV profile, which graphs the project’s NPV over a range of discount rates. It is easiest to prepare the NPV profile using a spreadsheet such as Excel. We simply repeat our calculation of the NPV above using a range of different discount rates instead of only 10%. Figure 8.1 presents the NPV profile for Fredrick’s project by plotting the NPV as a function of the discount rate, r.2

$20 $10 $7.2 $0 $10

2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% Cost of Capital

IRR 14%

$20 Discount Rate

2

In the online appendix to this chapter, we show you how to create an NPV profile in Excel.

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Part 3 Valuation and the Firm

internal rate of return (IRR) The interest rate that sets the net present value of the cash flows equal to zero.

Notice that the NPV is positive only for discount rates that are less than 14% (the green shaded area on the graph). Referring to the graph and the accompanying data table, we see that at 14%, the NPV is zero. The discount rate that sets the net present value of the cash flows equal to zero is an investment’s internal rate of return (IRR). Thus, by constructing the NPV profile, we have determined that Fredrick’s project has an IRR of 14%. We can also compute the IRR without graphing the NPV by using a financial calculator or a spreadsheet’s IRR function (see the appendix to Chapter 4. The calculator instructions for solving for the rate of return can be used to solve for the IRR).

Given: Solve for:

N 4

I/Y

PV 81.6

PMT 28

FV 0

14 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(4,28,81.6,0)

Measuring Sensitivity with IRR In our Fredrick’s example, the firm’s managers provided the cost of capital. If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. The IRR can provide this information. For Fredrick’s, if the cost of capital estimate is more than the 14% IRR, the NPV will be negative (see the red shaded area in Figure 8.1). Therefore, as long as our estimate of the cost of capital of 10% is within 4% of the true cost of capital, our decision to accept the project is correct. In general, the difference between the cost of capital and the IRR tells us the amount of estimation error in the cost of capital estimate that can exist without altering the original decision.

Alternative Rules Versus the NPV Rule The NPV rule indicates that Fredrick’s should undertake the investment in fertilizer technology. As we evaluate alternative rules for project selection in the subsequent sections, keep in mind that sometimes other investment rules may give the same answer as the NPV rule, but at other times they may disagree. When the rules conflict, always base your decision on the NPV rule, which is the most accurate and reliable decision rule.

Concept Check

8.3

3. Explain the NPV rule for stand-alone projects. 4. How can you interpret the difference between the cost of capital and the IRR?

Alternative Decision Rules Even though the NPV rule is the most accurate and reliable rule, in practice a wide variety of rules are applied, often in tandem with the NPV rule. In a 2001 study, John Graham and Campbell Harvey3 found that 75% of the firms they surveyed used the NPV rule for making investment decisions. This result is substantially different from that found in a similar study in 1977 by L. J. Gitman and J. R. Forrester,4 who found that only 10% of 3

John Graham and Campbell Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics 60 (2001): 187–243. 4

L. J. Gitman and J. R. Forrester, Jr., “A Survey of Capital Budgeting Techniques Used by Major U.S. Firms,” Financial Management 6 (1977): 66–71.

Chapter 8 Investment Decision Rules

217

USING EXCEL

Here we discuss how to use Microsoft Excel to solve for NPV and IRR. We also identify some pitfalls to avoid when using Excel.

Computing NPV and IRR

Excel’s NPV function has the format NPV (rate, value1, value2, . . . ), where “rate” is the interest rate per period used to discount the cash flows, and “value1”, “value2”, etc., are the cash flows (or ranges of cash flows). The NPV function computes the present value of the cash flows assuming the first cash flow occurs at date 1. Therefore, if a project’s first cash flow occurs at date 0, we cannot use the NPV function by itself to compute the NPV. We can use the NPV function to compute the present value of the cash flows from date 1 onward, and then we must add the date 0 cash flow to that result to calculate the NPV. The screenshot below shows the difference. The first NPV calculation (outlined in blue) is correct: we used the NPV function for all of the cash flows occurring at time 1 and later and then added on the first cash flow occurring at time 0 since it is already in present value. The second calculation (outlined in green) is incorrect: we used the NPV function for all of the cash flows, but the function assumed that the first cash flow occurs in period 1 instead of immediately.

NPV Function: Leaving Out Date 0

NPV Function: Ignoring Blank Cells Another pitfall with the NPV function is that cash flows that are left blank are treated differently from cash flows that are equal to zero. If the cash flow is left blank, both the cash flow and the period are ignored. For example, the second set of cash flows below is equivalent to the first—we have simply left the cash flow for date 2 blank instead of entering a “0.” However, the NPV function ignores the blank cell at date 2 and assumes the cash flow is 10 at date 1 and 110 at date 2, which is clearly not what is intended and produces an incorrect answer (outlined in red).

Because of these idiosyncrasies, we avoid using Excel’s NPV function. It is more reliable to compute the present value of each cash flow separately in Excel, and then sum them to determine the NPV.

IRR Function Excel’s IRR function has the format IRR (values, guess ), where “values” is the range containing the cash flows, and “guess” is an optional starting guess where Excel begins its search for an IRR. Two things to note about the IRR function: 1. The values given to the IRR function should include all of the cash flows of the project, including the one at date 0. In this sense, the IRR and NPV functions in Excel are inconsistent. 2. Like the NPV function, the IRR ignores the period associated with any blank cells.

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FIGURE 8.2 The Most Popular Decision Rules Used by CFOs

The bar graph shows the most popular decision rules used by CFOs in Professors Graham and Harvey’s 2001 survey. Many CFOs used more than one method, but no other methods were mentioned by more than half of CFOs.

IRR

76%

NPV

75%

Payback

57% 0%

20%

40%

60%

80%

firms used the NPV rule. Business students in recent years have been listening to their finance professors! Even so, Graham and Harvey’s study indicates that one-fourth of U.S. corporations do not use the NPV rule. Exactly why other capital budgeting techniques are used in practice is not always clear. Figure 8.2 summarizes the top three decision rules given in the survey. Because you may encounter these techniques in the business world, you should know what they are, how they are used, and how they compare to NPV. In this section, we examine alternative decision rules for single, stand-alone projects within the firm. The focus here is on the payback rule and the IRR rule.

The Payback Rule payback investment rule Only projects that pay back their initial investment within the payback period are undertaken. payback period The amount of time until the cash flows from a project offset the initial investment. The time it takes to pay back the initial investment.

EXAMPLE 8.2 Using the Payback Rule

The simplest investment rule is the payback investment rule, which states that you should only accept a project if its cash flows pay back its initial investment within a prespecified period. The rule is based on the notion that an opportunity that pays back its initial investment quickly is a good idea. To apply the payback rule, 1. Calculate the amount of time it takes to pay back the initial investment, called the payback period. 2. Accept the project if the payback period is less than a prespecified length of time— usually a few years. 3. Reject the project if the payback period is greater than that prespecified length of time. For example, a firm might adopt any project with a payback period of less than two years.

Problem Assume Fredrick’s requires all projects to have a payback period of two years or less. Would the firm undertake the fertilizer project under this rule?

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Solution Q Plan In order to implement the payback rule, we need to know whether the sum of the inflows from the project will exceed the initial investment before the end of two years. The project has inflows of $28 million per year and an initial investment of $81.6 million. Q Execute The sum of the cash flows for years 1 and 2 is +28 * 2 = +56 million, which will not cover the initial investment of $81.6 million. In fact, it will not be until year 3 that the cash inflows exceed the initial investment 1 +28 * 3 = +84 million 2 . Because the payback period for this project exceeds two years, Fredrick’s will reject the project. Q Evaluate While simple to compute, the payback rule requires us to use an arbitrary cutoff period in summing the cash flows. Further, also note that the payback rule does not discount future cash flows. Instead, it simply sums the cash flows and compares them to a cash outflow in the present. In this case, Fredrick’s would have rejected a project that would have increased the value of the firm.

discounted payback rule Only accept projects where the sum of the discounted cash flows within the payback period is greater than or equal to the initial investment.

Relying on the payback rule analysis in Example 8.2, Fredrick’s will reject the project. However, as we saw earlier, with a cost of capital of 10%, the NPV is $7.2 million. Following the payback rule would be a mistake because Fredrick’s will pass up a project worth $7.2 million. The payback rule is not as reliable as the NPV rule because it (1) ignores the time value of money, (2) ignores cash flows after the payback period, and (3) lacks a decision criterion grounded in economics (what is the right number of years to require for a payback period?). Some companies have addressed the first failing by computing the payback period using discounted cash flows, called the discounted payback rule. However, this does not solve the fundamental problem because the other two failings remain. Despite these failings, Graham and Harvey found that about 57% of the firms they surveyed reported using the payback rule as part of the decision-making process. Why do some companies consider the payback rule? The answer probably relates to its simplicity. This rule is typically used for small investment decisions—for example, whether to purchase a new copy machine or to service the old one. In such cases, the cost of making an incorrect decision might not be large enough to justify the time required to calculate the NPV. The appeal of the payback rule is that it favors short-term projects. Some firms are unwilling to commit capital to long-term investments. Also, if the required payback period is short (one to two years), then most projects that satisfy the payback rule will have a positive NPV.

The Internal Rate of Return Rule internal rate of return (IRR) investment rule A decision rule that accepts any investment opportunity where the IRR exceeds the opportunity cost of capital and otherwise rejects the opportunity.

Similar to NPV, the internal rate of return (IRR) investment rule is based on the concept that if the return on the investment opportunity you are considering is greater than the return on other alternatives in the market with equivalent risk and maturity (i.e., the project’s cost of capital), you should undertake the investment opportunity. We state the rule formally as follows: IRR investment rule: Take any investment opportunity whose IRR exceeds the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital.

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Part 3 Valuation and the Firm The IRR investment rule will give the correct answer (that is, the same answer as the NPV rule) in many—but not all—situations. For instance, it gives the correct answer for Fredrick’s fertilizer opportunity. From Figure 8.1, whenever the cost of capital is in the green area below the IRR (14%), the project has a positive NPV and you should undertake the investment. Table 8.1 summarizes our analysis of Fredrick’s new project. The NPV and IRR rules agree, but using the payback rule with a required payback period of two years or less would cause Fredrick’s to reject the project.

TABLE 8.1 Summary of NPV, IRR, and Payback for Fredrick’s New Project

NPV at 10%

$7.2 million

Payback Period

3 years

IRR

14%

Accept 1 +7.2 million 7 0 2

Reject 1 3 years 7 2 year required payback 2 Accept 1 14% 7 10% cost of capital 2

In general, the IRR rule works for a stand-alone project if all of the project’s negative cash flows precede its positive cash flows. But in other cases, the IRR rule may disagree with the NPV rule and thus be incorrect. Let’s examine several situations in which the IRR fails. Delayed Investments. Star basketball player Evan Cole is graduating from college with a degree in finance and preparing for the NBA draft. Several companies have already approached him with endorsement contracts. Two competing sports drink companies are trying to sign him. QuenchIt offers him a single upfront payment of $1 million to exclusively endorse their sports drink for three years. PowerUp offers $500,000 per year, payable at the end of each of the next three years, to endorse their product exclusively. Which offer is better? One direct way to compare the two contracts is to realize that signing with QuenchIt causes Evan to forgo the PowerUp contract, or $500,000 per year. Considering the risk of his alternative income sources and available investment opportunities, Evan estimates his opportunity cost of capital to be 10%. The timeline of Evan’s investment opportunity is: 0

1

2

3

$1,000,000

$500,000

$500,000

$500,000

The NPV of Evan’s investment opportunity is: NPV = 1,000,000 -

500,000 500,000 500,000 1 + r 11 + r22 11 + r23

By setting the NPV equal to zero and solving for r, we find the IRR. We can use either a financial calculator or a spreadsheet to find the IRR: N I/Y PV PMT FV Given: 3 1,000,000 500,000 0 Solve for: 23.38 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,500000,1000000,0)

The 23.38% IRR is larger than the 10% opportunity cost of capital. According to the IRR rule, Evan should sign the deal. But what does the NPV rule say? NPV = 1,000,000 -

500,000 500,000 500,000 = - +243,426 2 1.1 1.1 1.13

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At a 10% discount rate, the NPV is negative, so signing the deal would reduce Evan’s wealth. He should not sign the endorsement deal with QuenchIt, but should sign with PowerUp instead. To resolve this conflict, we can prepare an NPV profile for the QuenchIt contract. Figure 8.3 plots the NPV of the investment opportunity for a range of discount rates. It shows that, no matter what the cost of capital is, the IRR rule and the NPV rule will give exactly opposite recommendations. That is, the NPV is positive only when the opportunity cost of capital is above 23.38% (the IRR). Evan should accept the investment only when the opportunity cost of capital is greater than the IRR, the opposite of what the IRR rule recommends. Figure 8.3 also illustrates the problem with using the IRR rule in this case. For most investment opportunities, expenses occur initially and cash is received later. In this case, Evan gets cash upfront from QuenchIt but the forgone cash flows from PowerUp occurred later. It is as if Evan borrowed money, and when you borrow money you prefer as low a rate as possible. Evan’s optimal rule is to borrow money so long as the rate at which he borrows is less than the cost of capital. Even though the IRR rule fails to give the correct answer in this case, the IRR itself still provides useful information in conjunction with the NPV rule. As mentioned earlier, the IRR provides information on how sensitive the investment decision is to uncertainty in the cost of capital estimate. In this case, the difference between the cost of capital and the IRR is large—10% versus 23.38%. Evan would have to have underestimated the cost of capital by 13.38% to make the NPV positive. Multiple IRRs. Evan has informed QuenchIt that it needs to sweeten the deal before he will accept it. In response, the company has agreed to make an additional payment of $600,000 in 10 years as deferred compensation for the long-term increase in sales that

NPV of Cole’s $1 Million QuenchIt Deal

When all the benefits of an investment occur at time zero and before the costs, the NPV is an increasing function of the discount rate. The NPV is positive in the green-shaded areas and negative in the red-shaded areas. Notice that the NPV is positive when the cost of capital is above 23.38%, the IRR, so the NPV and IRR rules conflict.

Cost of Capital

100

0

NPV ($ thousands)

FIGURE 8.3

100

5%

10%

15%

20%

25%

IRR 23.38%

200 243 300 400

Discount Rate

30%

35%

Part 3 Valuation and the Firm even a short-term endorsement by Evan would bring. Should he accept or reject the new offer? We begin with the new timeline: 0

1

2

3

4

9

10

0

$600,000

... $1,000,000 $500,000

$500,000

$500,000

0

The NPV of Evan’s new investment opportunity is: NPV = 1,000,000 -

500,000 500,000 500,000 600,000 + 2 3 1 + r 11 + r2 11 + r2 1 1 + r 2 10

We can find the IRR for this investment opportunity by creating an NPV profile and noting where it crosses zero. Figure 8.4 plots the NPV of the opportunity at different discount rates. In this case, there are two IRRs—that is, there are two values of r that set the NPV equal to zero. You can verify this fact by substituting IRRs of 5.79% and 13.80% for r into the equation. Because there is more than one IRR, we cannot apply the IRR rule. It is also worth noting that you should take special care when using a spreadsheet or financial calculator to determine the IRR. Both solve for the IRR through trial and error because you cannot calculate IRR directly. In cases where there is more than one IRR, the spreadsheet or calculator will simply produce the first one that it finds, with no mention that there could be others! Some financial calculators will return an error message if there are multiple IRRs. Thus, it always pays to create the NPV profile. For guidance, let’s turn to the NPV rule. If the cost of capital were either below 5.79% or above 13.80%, Evan should undertake the opportunity. But given his cost of capital of 10%, he should still turn it down. Notice that even though the IRR rule fails in this case, the two IRRs are still useful as bounds on the cost of capital estimate. If the cost of

FIGURE 8.4 NPV of Evan’s Sports Drink Deal with Additional Deferred Payments

The graph in panel (b) shows the NPV of Evan’s deal with additional deferred payment based on the data in panel (a). In this case, there are two IRRs, invalidating the IRR rule. If the opportunity cost of capital is either below 5.79% or above 13.80%, Evan should accept the deal because the NPV is then positive, as indicated by the green-shaded areas. At any point between the two IRRs, the NPV is negative (see the red-shaded area). Panel (a) 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24%

100,000 72,680 50,267 32,151 17,793 6724 1469 7148 10,632 12,201 12,100 10,547 7732 3823 1030 6698 13,065 20,030 27,502 35,403 43,663 52,219 61,019 70,014 79,161

Panel (b) $120,000 $100,000 $80,000 NPV

222

$60,000 $40,000 $20,000 $0

$20,000

IRR 5.79%

5%

10%

15%

Cost of Capital

20%

IRR 13.80%

Discount Rate

25%

30%

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COMMON MISTAKE

223

IRR Versus the IRR Rule

Throughout this subsection, we have distinguished between the IRR itself and the IRR rule. While we have pointed out the shortcomings of using the IRR rule to make investment decisions, the IRR itself remains a very useful

tool. The IRR measures the average return of the investment and indicates the sensitivity of the NPV to estimation error in the cost of capital. Thus, knowing the IRR can be very useful, but relying on it to make investment decisions can be hazardous.

capital estimate is wrong, and it is actually smaller than 5.79% or larger than 13.80%, the decision not to pursue the project will change because it will have a positive NPV. There is no easy fix for the IRR rule when there are multiple IRRs. Although the NPV is negative between the IRRs in this example, the reverse is also possible (see Figure 8.5). In that case, the project would have a positive NPV for discount rates between the IRRs rather than for discount rates lower or higher than the IRRs. Furthermore, there are situations in which more than two IRRs exist.5 In such situations, our only choice is to rely on the NPV rule. modified internal rate of return (MIRR) The discount rate that sets the NPV of modified cash flows of a project equal to zero. Cash flows are modified so there is only one negative cash flow (and one sign-change) to ensure that only one IRR exists.

Modified Internal Rate of Return The fact that there can be multiple IRRs for the cash flows from a project is a clear disadvantage for the IRR. To overcome this, some have proposed various ways of modifying the cash flows before computing the IRR. All these modifications have the common feature that they group the cash flows so that there is only one negative cash flow, occurring at either the beginning or the end. In that case, there is only one sign-change for the cash flows as a whole and hence only one IRR. This new IRR, computed as the discount rate that sets the NPV of the modified cash flows of the project equal to zero, is called the modified internal rate of return (MIRR).

FIGURE 8.5

The graph shows the NPV profile for the multiple-IRR project with cash flows of - +1000, $2500 and - +1540 in years 0, 1, and 2, respectively. As the NPV profile shows, the project has two IRRs: 10% and 40%.

NPV Profile for a Project with Multiple IRRs

$20

NPV

$10 $9.45 $0 $10 $20

10% 20% Cost of Capital IRR

30%

40%

50%

60%

IRR

$30 $40 $50 Discount Rate

5

In general, there can be as many IRRs as the number of times the project’s cash flows change sign over time.

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Why Do Rules Other Than the NPV Rule Persist? Professors Graham and Harvey found that a sizable minority of firms (25%) in their study do not use the NPV rule at all. In addition, about 50% of firms surveyed used the payback rule. Furthermore, it appears that most firms use both the NPV rule and the IRR rule. Why do firms use rules other than NPV if they can lead to erroneous decisions? One possible explanation for this phenomenon is that Graham and Harvey’s survey results might be misleading. CFOs who were using the IRR as a sensitivity measure in conjunction with the NPV rule might have checked both the IRR box and the NPV box on the survey. The question they were asked was, “How frequently does your firm use the following techniques when deciding which projects or acquisitions to pursue?” By computing the IRR and using it in conjunction with the NPV rule to estimate the sensitivity of their results, they might have felt they were using both techniques. Nevertheless, a significant minority of managers surveyed replied that they used only the IRR rule, so this explanation cannot be the whole story. One common reason that managers give for using the IRR rule exclusively is that you do not need to know the opportunity

cost of capital to calculate the IRR. On a superficial level, this is true: The IRR does not depend on the cost of capital. You may not need to know the cost of capital to calculate the IRR, but you certainly need to know the cost of capital when you apply the IRR rule. Consequently, the opportunity cost is as important to the IRR rule as it is to the NPV rule. In our opinion, some firms use the IRR rule exclusively because the IRR sums up the attractiveness of investment opportunity in a single number without requiring the person running the numbers to make an assumption about the cost of capital. However, if a CFO wants a brief summary of an investment opportunity but does not want her employee to make a cost of capital assumption, she can also request a plot of the NPV as a function of the discount rate. Neither this request nor a request for the IRR requires knowing the cost of capital, but the NPV profile has the distinct advantage of being much more informative and reliable.

MIRR Technique. Let’s clarify this with an example. You are considering a project that has the following three cash flows: 0 $1000

1 $2500

2 $1540

The NPV profile for this project, shown in Figure 8.5, identifies the two IRRs for this project as 10% and 40%. Assume that your discount rate for this project is 15%. As Figure 8.5 shows, the NPV of the project at 15% is $9.45. We could modify the cash flows of the project to eliminate the multiple IRR problem. By discounting all of the negative cash flows to the present and compounding all of the positive cash flows to the end of the project, we have only two cash flows, yielding a single IRR. What discount rate and compounding rate should we use? One natural choice is our cost of capital for this project, which is 15%. 0 $1000 $1540 $1000 2164.46 (1.15)2

1 $2500

2 $1540 2500(1.15)1 2875

Figure 8.6 presents the NPV profile for our modified cash flows. As Figure 8.6 shows, there is now only a single IRR, at 15.25%. Because our cost of capital is 15%, we would properly accept the project using the IRR rule. Also note that the advantage of using 15% as our discount and compounding rates when modifying the cash flows is that the NPV of the modified cash flows at 15% is the same as the NPV of the true cash flows at 15%. Figure 8.6 also makes an important point: we are no longer evaluating the true cash flows of the project. Instead, we have modified them to force them to produce a single IRR. The NPV profile of the true cash flows of the project is given earlier in Figure 8.5 and is clearly different from the one produced by the modified cash flows in Figure 8.6.

Chapter 8 Investment Decision Rules

FIGURE 8.6 NPV Profile of Modified Cash Flows for the Multiple-IRR Project from Figure 8.5

225

The graph presents the NPV profile for the modified project cash flows of -2164.46 in year 0 and 2875 in year 2. The modified cash flows have only one IRR: 15.25%. Given the 15% cost of capital, the IRR rule confirms that we should accept the project.

$400 IRR 15.25%

$200 $9.45

NPV

$0 $200

10% 20% Cost of Capital

30%

40%

50%

60%

$400 $600 $800 Discount Rate

There is no set way to modify project cash flows to produce an MIRR. Two other approaches that each solve the multiple IRR problem are: 1. Discount all the negative cash flows to time 0 and leave the positive cash flows alone. 2. Leave the initial cash flow alone and compound all the remaining cash flows to the final period of the project. In this approach, you are implicitly reinvesting all the cash flows from the project at your compound rate until the project is complete. Again, in either case if you use the project’s cost of capital as your discount and compounding rate, you will not alter the NPV of the project at that discount rate. Further, a decision to accept or reject the project based on the modified IRR will be the same as the one based on the NPV decision rule. MIRR: A Final Word. There is considerable debate about whether MIRR is truly better than IRR. Most of the argument centers on whether it is advisable to modify the cash flows of the project. The IRR is truly an internal rate of return based solely on the actual cash flows of the project. However, the IRR implicitly assumes that all cash flows generated by the project are reinvested at the project’s IRR rather than at the firm’s cost of capital until the project ends. For a project with a high IRR, this may be an unrealistic assumption. Further, there may be more than one IRR, which complicates its use. The MIRR avoids these problems, but is based on a set of cash flows modified through the use of a chosen discount and compounding rate. Thus, it is not really an internal rate of return and is no longer based solely on the actual cash flows of the project. Finally, MIRR still does not solve some of the other problems associated with using IRR when choosing among projects.

Concept Check

5. How do you apply the payback rule? 6. Under what conditions will the IRR rule lead to the same decision as the NPV rule?

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8.4

mutually exclusive projects Projects that compete with one another; by accepting one, you exclude the others.

EXAMPLE 8.3 NPV and Mutually Exclusive Projects

Choosing Between Projects Thus far, we have considered only decisions where the choice is either to accept or to reject a single, stand-alone project. Sometimes, however, a firm must choose just one project from among several possible projects. For example, a manager may be evaluating alternative package designs for a new product. The manager must choose only one of the designs. When choosing any one project excludes us from taking the other projects, we are facing mutually exclusive projects. When projects, such as the package designs, are mutually exclusive, it is not enough to determine which projects have positive NPVs. With mutually exclusive projects, the manager’s goal is to rank the projects and choose only the best one. In this situation, the NPV rule provides a straightforward answer: Pick the project with the highest NPV. Problem You own a small piece of commercial land near a university. You are considering what to do with it. You have been approached recently with an offer to buy it for $220,000. You are also considering three alternative uses yourself: a bar, a coffee shop, and an apparel store. You assume that you would operate your choice indefinitely, eventually leaving the business to your children. You have collected the following information about the uses. What should you do? Initial Investment

Cash Flow in the First Year 1 CF1 2

Growth Rate (g)

Cost of Capital (r)

Bar

$400,000

$60,000

3.5%

12%

Coffee shop

$200,000

$40,000

3%

10%

Apparel Store

$500,000

$75,000

3%

13%

Solution Q Plan Since you can only do one project (you only have one piece of land), these are mutually exclusive projects. In order to decide which project is most valuable, you need to rank them by NPV. Each of these projects (except for selling the land) has cash flows that can be valued as a growing perpetuity, so from Chapter 4, the present value of the inflows is CF1/ 1 r - g 2 . The NPV of each investment will be: CF1 - Initial Investment r - g Q Execute The NPVs are: +60,000 - +400,000 = +305,882 0.12 - 0.035 +40,000 Coffee Shop: - +200,000 = +371,429 0.10 - 0.03 +75,000 - +500,000 = +250,000 Apparel Store: 0.13 - 0.03 Bar:

So, the ranking is

Alternative

NPV

Coffee Shop

$371,429

Bar

$305,882

Apparel Store

$250,000

Sell the Land

$220,000

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and you should choose the coffee shop. Q Evaluate All the alternatives have positive NPVs, but you can take only one of them, so you should choose the one that creates the most value. Even though the coffee shop has the lowest cash flows, its lower start-up cost coupled with its lower cost of capital (it is less risky) make it the best choice.

Because the IRR is a measure of the expected return of investing in the project, you might be tempted to extend the IRR investment rule to the case of mutually exclusive projects by picking the project with the highest IRR. Unfortunately, picking one project over another simply because it has a larger IRR can lead to mistakes. Problems arise when the mutually exclusive investments have differences in scale (require different initial investments) and when they have different cash flow patterns. We discuss each of these situations in turn.

Differences in Scale Would you prefer a 200% return on $1 or a 10% return on $1 million? The former return certainly sounds impressive and gives you great bragging rights, but at the end of the day you make only $2. The latter opportunity may sound much more mundane, but you make $100,000. This comparison illustrates an important shortcoming of IRR: Because it is a return, you cannot tell how much value has actually been created without knowing the basis for the return—a 10% IRR can have very different value implications for an initial investment of $1 million versus an initial investment of $100 million. If a project has a positive NPV, then if we can double its size, its NPV will double: By the Valuation Principle, doubling the cash flows of an investment opportunity must make it worth twice as much. However, the IRR rule does not have this property—it is unaffected by the scale of the investment opportunity because the IRR measures the average return of the investment. Hence, the IRR rule cannot be used to compare projects of different scales. Let’s illustrate this concept in the context of an example. Identical Scale. We begin by considering two mutually exclusive projects with the same scale. Javier is evaluating two investment opportunities. If he went into business with his girlfriend, he would need to invest $10,000 and the business would generate incremental cash flows of $6000 per year for three years. Alternatively, he could start a two-computer Internet café. The computer setup will cost a total of $10,000 and will generate $5000 for three years. The opportunity cost of capital for both opportunities is 12% and both will require all his time, so Javier must choose between them. How valuable is each opportunity, and which one should Javier choose? Let’s consider both the NPV and IRR of each project. The timeline for the investment with Javier’s girlfriend is: 0 10,000

1 6000

2 6000

3 6000

The NPV of the investment opportunity when r = 0.12 is: NPV = -10,000 +

6000 6000 6000 + + = +4411 1.12 1.12 2 1.12 3

We can determine the IRR of this investment by using a financial calculator or spreadsheet:

Part 3 Valuation and the Firm

Given: Solve for:

N 3

I/Y

PV 10,000

PMT 6000

FV 0

36.3 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,6000,10000,0)

Thus, the IRR for Javier’s investment in his girlfriend’s business is 36.3%. The timeline for his investment in the Internet café is: 0 10,000

1

2

5000

3

5000

5000

The NPV of the investment opportunity is: NPV = -10,000 +

5000 5000 5000 + = +2009 + 2 1.12 1.12 1.12 3

The $2009 NPV of the Internet café is lower than the $4411 NPV for his girlfriend’s business, so Javier should join his girlfriend in business. Luckily, it appears that Javier does not need to choose between his checkbook and his relationship! We could also compare IRRs. For the Internet café, we would find that the IRR is 23.4%. The Internet café has a lower IRR than the investment in his girlfriend’s business. As Figure 8.7 shows, in this case the project with the higher IRR has the higher NPV. Change in Scale. What happens if we change the scale of one of the projects? Javier’s finance professor points out that, given the space available in the facility, he could just as

FIGURE 8.7 NPV of Javier’s Investment Opportunities with the Two-Computer Internet Café

The NPV of his girlfriend’s business is always larger than the NPV of the two-computer Internet café. The same is true for the IRR; the IRR of his girlfriend’s business is 36.3%, while the IRR for the Internet café is 23.4%.

$12,000 $10,000 $8000 $6000 NPV

228

$4000

Girlfriend’s business IRR

$2000 $0 $2000 $4000

12% Cost of Capital

23.4%

IRR Discount Rate

36.3% Internet café

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easily install five times as many computers in the Internet café. His setup cost would now be $50,000 and his annual cash flows would be $25,000. What should Javier do now? Note that the IRR is unaffected by the scale. Because we are scaling all the cash flows

Given: Solve for:

N 3

I/Y

PV 50,000

PMT 25,000

FV 0

23.4 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,25000,50000,0)

up by a factor of 5, a ten-machine Internet café has exactly the same IRR as a two-machine Internet café, so his girlfriend’s business still has a higher IRR than the Internet café: However, the NPV of the Internet café does grow by the scale—it is five times larger: NPV = -50,000 +

25,000 25,000 25,000 + + = +10,046 2 1.12 1.12 1.12 3

Now Javier should invest in the ten-computer Internet café. As Figure 8.8 shows, the NPV of the ten-computer Internet café exceeds the NPV of going into business with his girlfriend whenever the cost of capital is less than 20%. In this case, even though the IRR of going into business with his girlfriend exceeds the IRR of the Internet café, picking the investment opportunity with the higher IRR does not result in taking the opportunity with the higher NPV. Percentage Return Versus Dollar Impact on Value. This result might seem counterintuitive and you can imagine Javier having a difficult time explaining to his girlfriend why he is choosing a lower return over going into business with her. Why would anyone turn

NPV of Javier’s Investment Opportunities with the Ten-Computer Internet Café

As in Figure 8.7, the IRR of his girlfriend’s business is 36.3%, while the IRR for the Internet café is 23.4%. But in this case, the NPV of his girlfriend’s business is larger than the NPV of the ten-computer Internet café only for discount rates over 20%.

$12,000 $10,000

Internet café (10 computers)

$8000 $6000 NPV

FIGURE 8.8

$4000 Crossover $2000 $0 $2000 $4000

12% Cost of Capital

20% 23.4%

IRR Discount Rate

Girlfriend’s business IRR

36.3% Internet café (2 computers)

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Part 3 Valuation and the Firm down an investment opportunity with a 36.3% return (IRR) in favor of one with only a 23.4% return? The answer is that the latter opportunity, the Internet café, makes more money. Recall the comparison at the beginning of this section: a 200% return on $1 versus a 10% return on $1 million. We agreed that ranking the returns was not the same as ranking the value created. The IRR is a measure of the average return, which can be valuable information. When you are comparing mutually exclusive projects of different scale, however, you need to know the dollar impact on value—the NPV.

INTERVIEW WITH

DICK GRANNIS

Dick Grannis is Senior Vice President and Treasurer of QUALCOMM Incorporated, a world leader in digital wireless communications technology and semiconductors, headquartered in San Diego. He joined the company in 1991 and oversees the company’s $10 billion cash investment portfolio. He works primarily on investment banking, capital structure, and international finance. QUESTION: QUALCOMM has a wide variety of products in different business lines. How does your capital budgeting process for new products work? ANSWER:

QUALCOMM evaluates new projects (such as new products, equipment, technologies, research and development, acquisitions, and strategic investments) by using traditional financial measurements including DCF models, IRR levels, peak funding requirements, the time needed to reach cumulative positive cash flows, and the short-term impact of the investment on our reported net earnings. For strategic investments, we consider the possible value of financial, competitive, technology and/or market value enhancements to our core businesses—even if those benefits cannot be quantified. Overall, we make capital budgeting decisions based on a combination of objective analyses and our own business judgment. We do not engage in capital budgeting and analysis if the project represents an immediate and necessary requirement for our business operations. One example is new software or production equipment to start a project that has already received approval. We are also mindful of the opportunity costs of allocating our internal engineering resources on one project vs. another project. We view this as a constantly challenging but worthwhile exercise, because we have many attractive opportunities but limited resources to pursue them. QUESTION: How often does QUALCOMM evaluate its hurdle rates and what factors does it consider in setting them? How do you allocate capital across areas and regions and assess the risk of non-U.S. investments?

ANSWER:

QUALCOMM encourages its financial planners to utilize hurdle (or discount) rates that vary according to the risk of the particular project. We expect a rate of return commensurate with the project’s risk. Our finance staff considers a wide range of discount rates and chooses one that fits the project’s expected risk profile and time horizon. The range can be from 6.00% to 8.00% for relatively safe investments in the domestic market to 50% or more for equity investments in foreign markets that may be illiquid and difficult to predict. We re-evaluate our hurdle rates at least every year. We analyze key factors including: (i) market adoption risk (whether or not customers will buy the new product or service at the price and volume we expect), (ii) technology development risk (whether or not we can develop and patent the new product or service as expected), (iii) execution risk (whether we can launch the new product or service cost effectively and on time), and (iv) dedicated asset risk (the amount of resources that must be consumed to complete the work).

How are projects categorized and how are the hurdle rates for new projects determined? What would happen if QUALCOMM simply evaluated all new projects against the same hurdle rate?

QUESTION:

ANSWER: We primarily categorize projects by risk level, but we also categorize projects by the expected time horizon. We consider short-term and long-term projects to balance our needs and achieve our objectives. For example, immediate projects and opportunities may demand a great amount of attention, but we also stay focused on long-term projects because they often create greater long-term value for stockholders. If we were to evaluate all new projects against the same hurdle rate, then our business planners would, by default, consistently choose to invest in the highest risk projects because those projects would appear to have the greatest expected returns in DCF models or IRR analyses. That approach would probably not work well for very long.

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EXAMPLE 8.4 Computing the Crossover Point

231

Problem Solve for the crossover point for Javier from Figure 8.8.

Solution Q Plan The crossover point is the discount rate that makes the NPV of the two alternatives equal. We can find the discount rate by setting the equations for the NPV of each project equal to each other and solving for the discount rate. In general, we can always compute the effect of choosing the Internet café over his girlfriend’s business as the difference of the NPVs. At the crossover point the difference is 0. Q Execute Setting the difference equal to 0: NPV = -50,000 +

25,000 25,000 25,000 + + 1 + r 11 + r22 11 + r23

- ¢ -10,000 +

6,000 6,000 6,000 + + ≤ = 0 2 11 + r2 11 + r2 11 + r23

combining terms, we have -40,000 +

19,000 19,000 19,000 + + = 0 2 11 + r2 11 + r2 11 + r23

As you can see, solving for the crossover point is just like solving for the IRR, so we will need to use a financial calculator or spreadsheet:

Given: Solve for:

N 3

I/Y

PV 40,000

PMT 19,000

FV 0

20.04 Excel Formula: RATE(NPER,PMT,PV,FV)RATE(3,19000,40000,0)

And we find that the crossover occurs at a discount rate of 20.04%. Q Evaluate Just as the NPV of a project tells us the value impact of taking the project, so the difference of the NPVs of two alternatives tells us the incremental impact of choosing one project over another. The crossover point is the discount rate at which we would be indifferent between the two projects because the incremental value of choosing one over the other would be zero.

Timing of the Cash Flows Even when projects have the same scale, the IRR may lead you to rank them incorrectly due to differences in the timing of the cash flows. The reason for this is that the IRR is expressed as a return, but the dollar value of earning a given return—and therefore the NPV—depends on how long the return is earned. Consider a high-IRR project with cash flows paid back quickly. It may have a lower NPV than a project with a lower IRR whose cash flows are paid back over a longer period. This sensitivity to timing is another reason why you cannot use the IRR to choose between mutually exclusive investments. To see this in the context of an example, let’s return to Javier’s Internet café. Javier believes that after starting the Internet café, he may be able to sell his stake in the business at the end of the first year for $40,000 (he will continue to stay on and manage the business after he sells). Thus, counting his first-year profit of $25,000, he would earn a total of $65,000 after one year. In that case, the timeline is: 0

1

$50,000

$65,000

Part 3 Valuation and the Firm

FIGURE 8.9 NPV With and Without Selling

The IRR from selling after one year (30%) is larger than the IRR without selling (23.4%). However, the NPV from selling after one year exceeds the NPV without selling only for discount rates that are in excess of 16.3% (see the yellow-shaded area vs. the blue-shaded area). Thus, given a cost of capital of 12%, it is better not to sell the Internet café after one year, despite the higher IRR.

$12,000 $10,000

Internet café (without selling)

$8000 Crossover

$6000 NPV

232

Internet café (sell in one year)

$4000

IRR

$2000 $0 $2000 $4000

12% 16.3% Cost of Capital

23.4%

30%

IRR Discount Rate

Figure 8.9 plots the NPV profile for the café with and without selling it after one year. If he sells, the NPV profile crosses the x-axis at 30%, which is its IRR. The IRR for the café if he does not sell is still 23.4%. Therefore, if Javier picks the alternative with the higher IRR, he will sell. However, since the height of each line indicates the NPV of that decision, we can see that his NPV given a 12% cost of capital is higher if he chooses not to sell. (In fact, the NPV is higher as long as the cost of capital is less than 16.3%.) The intuition is as follows: While the 30% IRR from selling is high, this return is only earned in the first year. While the 23.4% IRR from not selling is not as high, it is still attractive relative to the cost of capital, and it is earned over a longer period. Again, only by comparing the NPV can we determine which option is truly more valuable. The Bottom Line on IRR. As these examples make clear, picking the investment opportunity with the largest IRR can lead to a mistake. In general, it is dangerous to use the IRR in cases where you are choosing between projects, or anytime when your decision to accept or reject one project would affect your decision on another project. In such a situation, always rely on NPV.

Concept Check

8.5

7. What is the most reliable way to choose between mutually exclusive projects? 8. For mutually exclusive projects, explain why picking one project over another because it has a larger IRR can lead to mistakes.

Evaluating Projects with Different Lives Often, a company will need to choose between two solutions to the same problem. A complication arises when those solutions last for different periods of time. For example, a firm could be considering two vendors for its internal network servers. Each vendor offers the

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233

same level of service, but they use different equipment. Vendor A offers a more expensive server with lower per-year operating costs that it guarantees to last for three years. Vendor B offers a less expensive server with higher per-year operating costs that it will only guarantee for two years. The costs are shown in Table 8.2 along with the present value of the costs of each option, discounted at the 10% cost of capital for this project.

TABLE 8.2 Cash Flows ($ Thousands) for Network Server Options

equivalent annual annuity (EAA) The level annual cash flow that has the same present value as the cash flows of a project. Used to evaluate alternative projects with different lives.

Year

PV at 10%

0

1

2

3 -1

A

-12.49

-10

-1

-1

B

-10.47

-7

-2

-2

Note that all of the cash flows are negative, and so is the present value. This is a choice of an internal server, where the project must be taken and the benefits are diffuse (the company could not function effectively without an internal network). Thus, we are trying to minimize the cost of providing this service for the company. Table 8.2 shows that option A is more expensive on a present value basis 1 - +12,487 versus - +10,471 2 . However, the comparison is not that simple: option A lasts for three years while option B only lasts for two. The decision comes down to whether it is worth paying $2000 more for option A to get the extra year. One method that is used to evaluate alternatives such as these that have different lives is to compute the equivalent annual annuity (EAA) for each project, which is the level annual cash flow with the same present value as the cash flows of the project. The intuition is that we can think of the cost of each solution as the constant annual cost that gives us the same present value of the lumpy cash flows of buying and operating the server. On a timeline, equivalent annual annuity cash flows would appear as follows: 0

1

2

3

NPV = –12.49

EAA

EAA

EAA

When you have a level cash flow at a constant interval, you are dealing with an annuity and that is exactly how to approach this problem. We know the present value 1 - +12.49 2 the number of years (3), and the discount rate (10%). We need to solve for the cash flow of an equivalent annuity. Recall from Chapter 4 that the formula (Eq. 4.9) for solving for the cash flow in an annuity is: Cash Flow =

Present Value 1 1 ¢1 ≤ r 11 + r2N

=

-12.49 1 1 ¢1 ≤ 0.10 1 1.10 2 3

= -5.02

So, buying and operating server A is equivalent to spending $5020 per year to have a network server. We can repeat the calculation for server B, but for a two-year annuity because server B has only a two-year life (the change in exponent is highlighted): Cash Flow =

Present Value 1 1 ¢1 ≤ r 11 + r2N

=

-10.47 1 1 ¢1 ≤ 0.10 1 1.10 2 2

= -6.03

Therefore, we can reinterpret the cost of each alternative as shown in Table 8.3: Now we are ready to choose between the two servers. Server A is equivalent to spending $5020 per year and server B is equivalent to spending $6030 per year to have a network server. Seen in this light, server A appears to be the less expensive solution.

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TABLE 8.3

Year

Cash Flows ($ Thousands) for Network Server Options, Expressed as Equivalent Annual Annuities

EXAMPLE 8.5

PV at 10%

0

1

2

3

A

-12.49

0

-5.02

-5.02

-5.02

B

-10.47

0

-6.03

-6.03

Problem

Computing an Equivalent Annual Annuity

You are about to sign the contract for server A from Table 8.2 when a third vendor approaches you with another option that lasts for four years. The cash flows for server C are given below. Should you choose the new option or stick with server A? 0 1 2 3 4 Server C 14 ($ thousands)

1.2

1.2

1.2

1.2

Solution Q Plan In order to compare this new option to server A, we need to put server C on an equal footing by computing its annual cost. We can do this by: 1. Computing its NPV at the 10% discount rate we used above. 2. Computing the equivalent four-year annuity with the same present value. Q Execute PV = -14 - 1.2 a Cash Flow =

1 1 b c1 d = -17.80 0.10 1 1.10 2 4

- 17.80 PV = = -5.62 1 1 1 1 1 c1 d c d r 0.10 1 1.10 2 4 11 + r2N

Server C’s annual cost of $5620 is greater than the annual cost of server A ($5020), so we should still choose server A. Q Evaluate In this case, the additional cost associated with purchasing and maintaining server C is not worth the extra year we get from choosing it. By putting all of these costs into an equivalent annuity, the EAA tool allows us to see that.

Important Considerations When Using the Equivalent Annual Annuity Although server A appears to be the lowest-cost alternative, there are a number of factors to consider before making our decision. Required Life. We computed the equivalent annual cost of server A assuming we would use it for three years. But suppose it is likely that we will not need the server in the third year. Then we would be paying for something that we would not use. In that case, it may be cheaper to purchase server B, which provides coverage for the years we will need it at a lower total cost.6 Replacement Cost. When we compare servers A and B based on their equivalent annual cost, we are assuming that the cost of servers will not change over time. But suppose we 6

In this scenario, we should also consider any salvage value that server A might have if we sold it after two years.

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believe a dramatic change in technology will reduce the cost of servers by the third year to an annual cost of $2000 per year. Then server B has the advantage that we can upgrade to the new technology sooner. The cost of three years of service from either server in this case can be represented as follows: Year

PV at 10%

0

1

2

3

A

-12.49

0

-5.02

-5.02

-5.02

B

-11.97

0

-6.03

-6.03

-2.00

Therefore, when cost or performance is expected to change significantly over time, it may be cheaper to purchase server B despite its higher equivalent annual cost because it gives us the option to switch to the new technology sooner.

Concept Check

9. Explain why choosing the option with the highest NPV is not always correct when the options have different lives. 10. What issues should you keep in mind when choosing among projects with different lives?

8.6

Choosing Among Projects When Resources Are Limited In the previous sections, we compared projects that had identical resource needs. For example, in Javier’s case, we assumed that both the Internet café and his girlfriend’s business demanded 100% of his time. In this section, we develop an approach for situations where the choices have differing resource needs.

Evaluating Projects with Different Resource Requirements In some situations, different investment opportunities demand different amounts of a particular resource. If there is a fixed supply of the resource so that you cannot undertake all possible opportunities, simply picking the highest NPV opportunity might not lead to the best decision. We usually assume that you will be able to finance all positive NPV projects that you have. In reality, managers work within the constraint of a budget that restricts the amount of capital they may invest in a given period. Such a constraint would force a manager to choose among positive NPV projects to maximize the total NPV while staying within her budget. For example, assume you are considering the three projects in Table 8.4, and that you have a budget of $200 million. Table 8.4 shows the NPV of each project and the initial investment that each project requires. Project A has the highest NPV but it uses up the entire budget. Projects B and C can both be undertaken (together they use the entire budget), and their combined NPV exceeds the NPV of project A; thus, you should initiate them both. Together, their NPV is $145 million compared to just $100 million for project A alone.

TABLE 8.4 Possible Projects for $200 Million Budget

Project

NPV ($ millions)

Initial Investment ($ millions)

NPV/Initial Investment

A

100

200

0.500

B C

75 70

120 80

0.625 0.875

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Part 3 Valuation and the Firm

profitability index (PI) Measures the NPV per unit of resource consumed.

Profitability Index. Note that in the last column of Table 8.4 we included the ratio of the project’s NPV to its initial investment. We can interpret this as telling us that for every dollar invested in project A, we will generate 50 cents in value (over and above the dollar investment).7 Both projects B and C generate higher NPVs per dollar invested than project A, consistent with the fact that given our budget of $200 million, the two of them together created a higher NPV than just project A. In this simple example, identifying the optimal combination of projects to undertake is straightforward. In actual situations replete with many projects and resources, finding the optimal combination can be difficult. Practitioners often use the profitability index (PI) to help identify the optimal combination of projects to undertake in such situations: Profitability Index Value Created NPV Profitability Index = = Resource Consumed Resource Consumed

(8.4)

The profitability index measures the “bang for your buck”—that is, the value created in terms of NPV per unit of resource consumed. After computing the profitability index, we can rank projects based on it. Starting with the project with the highest index, we move down the ranking, taking all projects until the resource is consumed. In Table 8.4, the ratio in the last column is the profitability index. Note how the profitability index rule would correctly select projects B and C.

EXAMPLE 8.6

Problem

Profitability Index with a Human Resource Constraint

Your division at NetIt, a large networking company, has put together a project proposal to develop a new home networking router. The expected NPV of the project is $17.7 million, and the project will require 50 software engineers. NetIt has a total of 190 engineers available, and is unable to hire additional qualified engineers in the short run. Therefore, the router project must compete with the following other projects for these engineers: Project Router Project A Project B Project C Project D Project E Project F Total

NPV ($ millions)

Engineering Headcount

17.7

50

22.7 8.1 14.0 11.5 20.6 12.9 107.5

47 44 40 61 58 32 332

How should NetIt prioritize these projects?

Solution Q Plan The goal is to maximize the total NPV that we can create with 190 engineers (at most). We can use Eq. 8.4 to determine the profitability index for each project. In this case, since engineers are our limited resource, we will use Engineering Headcount in the denominator. Once we have the profitability index for each project, we can sort them based on the index.

7

Sometimes, practitioners add 1 to this ratio such that the interpretation would be that every dollar invested returned $1.50. Leaving off the additional 1 allows the ratio to be applied to resources other than budgets as we show in Example 8.6.

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Q Execute Project

NPV ($ millions)

Engineering Headcount (EHC)

Profitability Index (NPV per EHC)

Cumulative EHC Required

Project A

22.7

47

0.483

47

Project F

12.9

32

0.403

79 1 47 + 32 2

Project E

20.6

58

0.355

Router

17.7

50

0.354

Project C

14.0

40

0.350

Project D

11.5

61

0.189

Project B

8.1

44

0.184

137 1 79 + 58 2

187 1 137 + 50 2

As shown in the table above, we assigned the resource to the projects in descending order according to the profitability index. The final column shows the cumulative use of the resource as each project is taken on until the resource is used up. To maximize NPV within the constraint of 190 engineers, NetIt should choose the first four projects on the list. Q Evaluate By ranking projects in terms of their NPV per engineer, we find the most value we can create, given our 190 engineers. There is no other combination of projects that will create more value without using more engineers than we have. This ranking also shows us exactly what the engineering constraint costs us—this resource constraint forces NetIt to forgo three otherwise valuable projects (C, D, and B) with a total NPV of $33.6 million.

Shortcomings of the Profitability Index. Although the profitability index is simple to compute and use, in some situations it does not give an accurate answer. For example, suppose in Example 8.6 that NetIt has an additional small project with an NPV of only $100,000 that requires three engineers. The profitability index in this case is 0.1/3 = 0.03, so this project would appear at the bottom of the ranking. However, notice that three of the 190 employees are not being used after the first four projects are selected. As a result, it would make sense to take on this project even though it would be ranked last because it would exactly use up our constraint. In general, because the profitability index already includes the cost of capital (in computing the NPV), it would be better if the firm could raise additional funding to relieve the constraint. If the constraint is something else (such as engineers or physical capacity), there may be no way to relieve the constraint quickly enough to avoid having to choose among projects. Nonetheless, because all of the projects being ranked are valueincreasing positive NPV projects, it is still better to focus on relieving the constraint. A more serious problem occurs when multiple resource constraints apply. In this case, the profitability index can break down completely. The only surefire way to find the best combination of projects is to search through all of them. Although this process may sound exceedingly time-consuming, there are more advanced techniques that can tackle this specific kind of problem.8 By using these techniques on a computer, the solution can usually be obtained almost instantaneously.

Concept Check

11. Explain why picking the project with the highest NPV might not be optimal when you evaluate projects with different resource requirements. 12. What does the profitability index tell you? 8

Specifically, there are techniques called integer and linear programming that can be used to find the combination with the highest NPV when there are multiple constraints that must be satisfied. These methods are available, for example, in many spreadsheet programs.

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8.7

Putting It All Together In Table 8.5, we summarize the decision rules outlined in this chapter. As a financial manager, you are likely to run into many different types of investment decision rules in your

TABLE 8.5 Summary of Decision Rules

NPV Definition

Q The difference between the present value of an investment’s benefits and the present value of its costs

Rule

Q Take any investment opportunity where the NPV is positive; turn down any opportunity where it is negative

Advantages

Q Corresponds directly to the impact of the project on the firm’s value Q Direct application of the Valuation Principle

Disadvantages

Q Relies on an accurate estimate of the discount rate Q Can be time-consuming to compute

IRR Definition

Q The interest rate that sets the net present value of the cash flows equal to zero; the average return of the investment

Rule

Q Take any investment opportunity where IRR exceeds the opportunity cost of capital; turn down any opportunity whose IRR is less than the opportunity cost of capital

Advantages

Q Related to the NPV rule and usually yields the same (correct) decision

Disadvantages

Q Q Q Q

Hard to compute Multiple IRRs lead to ambiguity Cannot be used to choose among projects Can be misleading if inflows come before outflows

Payback Period Definition

Q The amount of time it takes to pay back the initial investment

Rule

Q If the payback period is less than a prespecified length of time—usually a few years—accept the project; otherwise, turn it down

Advantages

Q Simple to compute Q Favors liquidity

Disadvantages

Q No guidance as to correct payback cutoff Q Ignores cash flows after the cutoff completely Q Not necessarily consistent with maximizing shareholder wealth

Profitability Index Definition

Q NPV/Resource Consumed

Rule

Q Rank projects according to their PI based on the constrained resource and move down the list accepting value-creating projects until the resource is exhausted

Advantages

Q Uses the NPV to measure the benefit Q Allows projects to be ranked on value created per unit of resource consumed

Disadvantages

Q Breaks down when there is more than one constraint Q Requires careful attention to make sure the constrained resource is completely utilized

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career. In fact, in the interview in this chapter, the Treasurer of QUALCOMM mentions five different decision rules used by his company when evaluating investments. We have demonstrated that while alternative decision rules may sometimes (or even often) agree with the NPV decision rule, only the NPV decision rule is always correct. This is because the NPV provides you with a dollar-value measure of the impact of the project on shareholder wealth. Thus, it is the only rule that is directly tied to your goal of maximizing shareholder wealth. Computing the IRR can be a useful supplement to the NPV because knowing the IRR allows you to gauge how sensitive your decision is to errors in your discount rate. And some decision metrics are much simpler to calculate, such as the payback period. However, you should never rely on an alternative rule to make investment decisions. If you are employed by a firm that uses the IRR rule (or another rule) exclusively, our advice is to always calculate the NPV. If the two rules agree, you can feel comfortable reporting the IRR rule recommendation. If they do not agree, you should investigate why the IRR rule failed by using the concepts in this chapter. Once you have identified the problem, you can alert your superiors to it and perhaps persuade them to adopt the NPV rule.

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

8.1 The NPV Decision Rule Q The net present value (NPV) of a project is

net present value (NPV), p. 212 NPV decision rule, p. 213

MyFinanceLab Study Plan 8.1

internal rate of return (IRR), p. 217 NPV profile, p. 215

MyFinanceLab Study Plan 8.2

PV 1 Benefits 2 - PV 1 Costs 2

(8.1)

Q A good project is one with a positive net present value. Q The NPV decision rule states that when choosing from among a set of alternatives, choose the one with the highest NPV. The NPV of a project is equivalent to the cash value today of the project. Q Regardless of our preferences for cash today versus cash in the future, we should always first maximize NPV. We can then borrow or lend to shift cash flows through time and find our most preferred pattern of cash flows. 8.2 Using the NPV Rule Q If your objective is to maximize wealth, the NPV rule always gives the correct answer. Q The difference between the cost of capital and the IRR is the maximum amount of estimation error that can exist in the cost of capital estimate without altering the original decision.

Financial Calculator Tutorial: Calculating the Net Present Value of a Series of Uneven Cash Flows

Using Excel: Making an NPV Profile

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Part 3 Valuation and the Firm

8.3 Alternative Decision Rules Q Payback investment rule: Calculate the amount of time it takes to pay back the initial investment (the payback period). If the payback period is less than a prespecified length of time, accept the project. Otherwise, turn it down. Q IRR investment rule: Take any investment opportunity whose IRR exceeds the opportunity cost of capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital. Q The IRR rule may give the wrong answer if the cash flows have an upfront payment (negative investment). When there are multiple IRRs or the IRR does not exist, the IRR rule cannot be used. Q Project cash flows can be modified to eliminate the multiple IRR problem. The modified IRR is calculated based on these modified cash flows.

discounted payback rule, p. 219 internal rate of return (IRR) investment rule, p. 219 modified internal rate of return (MIRR), p. 223 payback investment rule, p. 218 payback period, p. 218

MyFinanceLab Study Plan 8.3

8.4 Choosing Between Projects Q When choosing among mutually exclusive investment opportunities, pick the opportunity with the highest NPV. Do not use IRR to choose among mutually exclusive investment opportunities.

mutually exclusive projects, p. 226

MyFinanceLab Study Plan 8.4

8.5 Evaluating Projects with Different Lives Q When choosing among projects with different lives, you need a standard basis of comparison. First compute an annuity with an equivalent present value to the NPV of each project. Then the projects can be compared on their cost or value created per year.

equivalent annual annuity (EAA), p. 233

MyFinanceLab Study Plan 8.5

8.6 Choosing Among Projects When Resources Are Limited Q When choosing among projects competing for the same resource, rank the projects by their profitability indices and pick the set of projects with the highest profitability indices that can still be undertaken given the limited resource. Value Created Profitability Index = Resource Consumed NPV = (8.4) Resource Consumed

profitability index (PI), p. 236

MyFinanceLab Study Plan 8.6

Critical Thinking

Interactive IRR Analysis Financial Calculator Tutorial: Solving for the Internal Rate of Return

1. What is the NPV rule? 2. How is the NPV rule related to the goal of maximizing shareholder wealth? 3. What is the intuition behind the payback rule? What are some of its drawbacks? 4. What is the intuition behind the IRR rule? What are some of its drawbacks?

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5. Under what conditions will the IRR rule and the NPV rule give the same accept/reject decision? 6. When is it possible to have multiple IRRs? 7. How does the MIRR solve the problem of multiple IRRs? 8. Why is it generally a bad idea to use IRR to choose between mutually exclusive projects? 9. When should you use the equivalent annual annuity? 10. What is the intuition behind the profitability index?

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. If a problem requires you to calculate IRR, you should use a spreadsheet or financial calculator. The NPV Decision Rule 1. You have an opportunity to invest $50,000 now in return for $60,000 in one year. If your cost of capital is 8%, what is the NPV of this investment? 2. You have an opportunity to invest $100,000 now in return for $80,000 in one year and $30,000 in two years. If your cost of capital is 9%, what is the NPV of this investment? 3. Your storage firm has been offered $100,000 in one year to store some goods for one year. Assume your costs are $95,000, payable immediately, and the cost of capital is 8%. Should you take the contract? 4. You run a construction firm. You have just won a contract to build a government office building. Building it will require an investment of $10 million today and $5 million in one year. The government will pay you $20 million in one year upon the building’s completion. Assume the cost of capital is 10%. a. What is the NPV of this opportunity? b. How can your firm turn this NPV into cash today? 5. You have been offered a unique investment opportunity. If you invest $10,000 today, you will receive $500 one year from now, $1500 two years from now, and $10,000 ten years from now. a. What is the NPV of the opportunity if the cost of capital is 6% per year? Should you take the opportunity? b. What is the NPV of the opportunity if the cost of capital is 2% per year? Should you take it now? 6. Marian Plunket owns her own business and is considering an investment. If she undertakes the investment, it will pay $4000 at the end of each of the next three years. The opportunity requires an initial investment of $1000 plus an additional investment at the end of the second year of $5000. What is the NPV of this opportunity if the cost of capital is 2% per year? Should Marian take it? Using the NPV Rule 7. Your factory has been offered a contract to produce a part for a new printer. The contract would last for three years and your cash flows from the contract would be $5 million per year. Your upfront setup costs to be ready to produce the part would

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Part 3 Valuation and the Firm be $8 million. Your cost of capital for this contract is 8%. a. What does the NPV rule say you should do? b. If you take the contract, what will be the change in the value of your firm? 8. You are considering opening a new plant. The plant will cost $100 million upfront and will take one year to build. After that, it is expected to produce profits of $30 million at the end of every year of production. The cash flows are expected to last forever. Calculate the NPV of this investment opportunity if your cost of capital is 8%. Should you make the investment? Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged. 9. Bill Clinton reportedly was paid $10 million to write his book My Life. The book took three years to write. In the time he spent writing, Clinton could have been paid to make speeches. Given his popularity, assume that he could earn $8 million per year (paid at the end of the year) speaking instead of writing. Assume his cost of capital is 10% per year. a. What is the NPV of agreeing to write the book (ignoring any royalty payments)? b. Assume that, once the book was finished, it was expected to generate royalties of $5 million in the first year (paid at the end of the year) and these royalties were expected to decrease at a rate of 30% per year in perpetuity. What is the NPV of the book with the royalty payments? *10. FastTrack Bikes, Inc., is thinking of developing a new composite road bike. Development will take six years and the cost is $200,000 per year. Once in production, the bike is expected to make $300,000 per year for ten years. The cash inflows begin at the end of year 7. Assuming the cost of capital is 10%: a. Calculate the NPV of this investment opportunity. Should the company make the investment? b. Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged. c. How long must development last to change the decision? Assuming the cost of capital is 14%: a. Calculate the NPV of this investment opportunity. Should the company make the investment? b. How much must this cost of capital estimate deviate to change the decision? c. How long must development last to change the decision? 11. OpenSeas, Inc., is evaluating the purchase of a new cruise ship. The ship would cost $500 million, but would operate for 20 years. OpenSeas expects annual cash flows from operating the ship to be $70 million and its cost of capital is 12%. a. Prepare an NPV profile of the purchase. b. Identify the IRR on the graph. c. Should OpenSeas go ahead with the purchase? d. How far off could OpenSeas’ cost of capital estimate be before your purchase decision would change? Alternative Decision Rules 12. You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The sign will cost $5000 and will be posted for one year. You expect that it will generate additional revenue of $500 per month. What is the payback period?

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13. Does the IRR rule agree with the NPV rule in Problem 7? 14. How many IRRs are there in part (a) of Problem 9? Does the IRR rule give the right answer in this case? 15. How many IRRs are there in part (b) of Problem 9? Does the IRR rule work in this case? 16. Professor Wendy Smith has been offered the following deal: A law firm would like to retain her for an upfront payment of $50,000. In return, for the next year the firm would have access to eight hours of her time every month. Smith’s rate is $550 per hour and her opportunity cost of capital is 15% per year. What does the IRR rule advise regarding this opportunity? What about the NPV rule? 17. Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The product is expected to generate profits of $1 million per year for ten years. The company will have to provide product support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year. a. What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount rates of 2% and 11%. b. How many IRRs does this investment opportunity have? c. What does the IRR rule indicate about this investment? 18. You own a coal mining company and are considering opening a new mine. The mine itself will cost $120 million to open. If this money is spent immediately, the mine will generate $20 million for the next ten years. After that, the coal will run out and the site must be cleaned and maintained at environmental standards. The cleaning and maintenance are expected to cost $2 million per year in perpetuity. What does the IRR rule say about whether you should accept this opportunity? If the cost of capital is 8%, what does the NPV rule say? 19. Your firm is considering a project that will cost $4.55 million upfront, generate cash flows of $3.5 million per year for three years, and then have a cleanup and shutdown cost of $6 million in the fourth year. a. How many IRRs does this project have? b. Calculate a modified IRR for this project discounting the outflows and leaving the inflows unchanged. Assume a discount and compounding rate of 10%. c. Using the MIRR and a cost of capital of 10%, would you take the project? 20. You have just been offered a contract worth $1 million per year for five years. However, to take the contract, you will need to purchase some new equipment. Your discount rate for this project is 12%. You are still negotiating the purchase price of the equipment. What is the most you can pay for the equipment and still have a positive NPV? *21. You are getting ready to start a new project that will incur some cleanup and shutdown costs when it is completed. The project costs $5.4 million upfront and is expected to generate $1.1 million per year for ten years and then have some shutdown costs in year 11. Use the MIRR approach to find the maximum shutdown costs you could incur and still meet your cost of capital of 15% on this project. *22. You are considering investing in a new gold mine in South Africa. Gold in South Africa is buried very deep, so the mine will require an initial investment of $250 million. Once this investment is made, the mine is expected to produce revenues of $30 million per year for the next 20 years. It will cost $10 million per year to operate

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Part 3 Valuation and the Firm the mine. After 20 years, the gold will be depleted. The mine must then be stabilized on an ongoing basis, which will cost $5 million per year in perpetuity. Calculate the IRR of this investment. (Hint: Plot the NPV as a function of the discount rate.) 23. You are considering making a movie. The movie is expected to cost $10 million upfront and take a year to make. After that, it is expected to make $5 million in the year it is released and $2 million for the following four years. What is the payback period of this investment? If you require a payback period of two years, will you make the movie? Does the movie have positive NPV if the cost of capital is 10%? Choosing Between Projects 24. You are choosing between two projects, but can only take one. The cash flows for the projects are given in the following table:

A

- +50

0

1 25

2 20

3 20

4 15

B

- +100

20

40

50

60

a. What are the IRRs of the two projects? b. If your discount rate is 5%, what are the NPVs of the two projects? c. Why do IRR and NPV rank the two projects differently? 25. You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment A will generate $2 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.5 million at the end of the first year and its revenues will grow at 2% per year for every year after that. a. Which investment has the higher IRR? b. Which investment has the higher NPV when the cost of capital is 7%? c. In this case, when does picking the higher IRR give the correct answer as to which investment is the better opportunity? 26. You are considering the following two projects and can only take one. Your cost of capital is 11%.

a. b. c. d.

0

1

2

3

4

A

-100

25

30

40

50

B

-100

50

40

30

20

What is the NPV of each project at your cost of capital? What is the IRR of each project? At what cost of capital are you indifferent between the two projects? What should you do?

27. You need a particular piece of equipment for your production process. An equipment-leasing company has offered to lease you the equipment for $10,000 per year if you sign a guaranteed five-year lease. The company would also maintain the equipment for you as part of the lease. Alternatively, you could buy and maintain the equipment yourself. The cash flows (in thousands) from doing so are listed below (the equipment has an economic life of five years). If your discount rate is 7%, what should you do? 0 -40

1 -2

2 -2

3 -2

4 -2

5 -2

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Evaluating Projects with Different Lives 28. Gateway Tours is choosing between two bus models. One is more expensive to purchase and maintain, but lasts much longer than the other. Its discount rate is 11%. It plans to continue with one of the two models for the foreseeable future; which one should it choose? Based on the costs of each model shown below, which should it choose? Model

0

Old Reliable Short and Sweet

1

2

3

4

5 p

7

-4 p

-4

-200

-4

-4

-4

-4

-100

-2

-2

-2

-2

29. Hassle-Free Web is bidding to provide Web-page hosting services for Hotel Lisbon. Hotel Lisbon pays its current provider $10,000 per year for hosting its Web page and handling transactions on it, etc. Hassle-Free figures that it will need to purchase equipment worth $15,000 upfront and then spend $2000 per year on monitoring, updates, and bandwidth to provide the service for three years. If Hassle-Free’s cost of capital is 10%, can it bid less than $10,000 per year to provide the service and still increase its value by doing so? Choosing Among Projects When Resources Are Limited 30. Fabulous Fabricators needs to decide how to allocate space in its production facility this year. It is considering the following contracts: NPV

Use of Facility

A B

$2 million $1 million

100% 60%

C

$1.5 million

40%

a. What are the profitability indexes of the projects? b. What should Fabulous Fabricators do? 31. Kartman Corporation is evaluating four real estate investments. Management plans to buy the properties today and sell them three years from today. The annual discount rate for these investments is 15%. The following table summarizes the initial cost and the sale price in three years for each property:

Parkside Acres Real Property Estates Lost Lake Properties Overlook

Cost Today

Sale Price in Year 3

$650,000

$1,150,000

800,000 650,000 150,000

1,400,000 1,050,000 350,000

Kartman has a total capital budget of $800,000 to invest in properties. Which properties should it choose? 32. Orchid Biotech Company is evaluating several development projects for experimental drugs. Although the cash flows are difficult to forecast, the company has come up with the following estimates of the initial capital requirements and NPVs for the projects. Given a wide variety of staffing needs, the company has also estimated the number of research scientists required for each development project (all cost values are given in millions of dollars).

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Part 3 Valuation and the Firm Project Number

Initial Capital

Number of Research Scientists

I II III IV V

$10 15 15 20 30

2 3 4 3 12

NPV $10.1 19.0 22.0 25.0 60.2

a. Suppose that Orchid has a total capital budget of $60 million. How should it prioritize these projects? b. Suppose that Orchid currently has 12 research scientists and does not anticipate being able to hire any more in the near future. How should Orchid prioritize these projects?

Data Case

After the close of trading on May 6, 2009, Vanda Pharmaceuticals (VNDA) announced that the Food and Drug Administration had approved its drug, Fanapt, for the treatment of schizophrenia. Imagine that you were working as a stock analyst for a large investment firm and Vanda is one of the firms you track. On May 7, 2009, Vanda’s stock price increased substantially and your boss wants to you to issue a statement about the size of the cash flows necessary to support the stock price reaction. Therefore, she wants you to estimate the net cash flows the market had anticipated from sales of the new drug. She advises that you treat the value anticipated by the market as the NPV of selling the drug, then work backward from the NPV to determine the annual cash flows necessary to generate that value. Your boss advises that the best way to capture the value is to take the change in stock price from closing on May 6, 2009 to closing on May 7, 2009. You nod your head in agreement, trying to look like you understand how to proceed. You are relatively new to the job and the term NPV is somewhat familiar to you. 1. To determine the change in stock price over this period, go to Yahoo! Finance (http://finance.yahoo.com) and enter the stock symbol for Vanda (VNDA). Then click on “Historical Prices” and enter the appropriate dates. Use the adjusted closing prices for the two dates. 2. To determine the change in value, multiply the change in stock price by the number of shares outstanding. The number of shares outstanding around those dates can be found by going to the company’s investor relations Web site. Start at http://www.vandapharma.com and then click on “Investor Relations”. Next, select the “SEC Filings” link on the left side of the screen, and locate the 10-Q from May 11, 2009. The fastest way to do this is to select “Quarterly Filings” from the dropdown menu under Groupings Filter and then click “Search”. Next, click on the Excel symbol in the “5/11/09 10-Q” row and open the Excel spreadsheet. In the Balance Sheet tab, under the March 31, 2009 column, you will find the number of shares of Common Stock (in thousands) as of March 31, 2009. Because the change in value represents the “expected” NPV of the project, you will have to find the annual net cash flows that would provide this NPV. For this analysis, you will need to estimate the cost of capital for the project. We show how to calculate the cost of capital in subsequent chapters; for now, use the New York University (NYU) cost of capital Web site (http://pages.stern.nyu.edu/~adamodar/ New_Home_Page/datafile/wacc.htm). Locate the cost of capital in the far-right column for the “Biotechnology” industry. 3. Use the cost of capital from the NYU Web site and the NPV you computed to calculate the constant annual cash flow that provides this NPV. Compute cash flows for 5-, 10-, and 15-year horizons.

9

Fundamentals of Capital Budgeting

LEARNING OBJECTIVES Q Identify the types of cash flows needed in the capital budgeting process

Q Assess the sensitivity of a project’s NPV to changes in your assumptions

Q Forecast incremental earnings in a pro forma earnings statement for a project

Q Identify the most common options available to managers in projects and understand why these options can be valuable

Q Convert forecasted earnings to free cash flows and compute a project’s NPV Q Recognize common pitfalls that arise in identifying a project’s incremental free cash flows

notation

CapEx capital expenditures

NPV

net present value

EBIT

earnings before interest and taxes

NWCt

net working capital in year t

FCFt

free cash flow in year t

PV

present value

IRR

internal rate of return

r

projected cost of capital

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INTERVIEW WITH

Kelly Cox Boeing Corporation

After graduating from California State University, Long Beach in 2007 with a B.S. in business administration, finance, Kelly Cox joined Boeing Corporation’s Defense Systems division in Long Beach. As part of the Finance Business Skills Rotational program, she has worked in three areas of finance, most recently as a procurement financial analyst responsible for cost analysis of supplier’s proposals for C-17 and B-1 bomber aircraft projects. “My finance courses prepared me well for my assignments. My professors gave me a solid understanding of how and why to use a particular formula and also used real-world examples to enhance what they taught.” Boeing’s Long Beach site invests in developmental and modernization programs to enhance C-17 and B-1 bombers for the U.S. Air Force fleet, as well as production of the C-17 plane for both domestic and foreign customers. “Boeing uses cash flow analysis, NPV, and IRR calculations to evaluate proposed investments,” she explains. “We also conduct a sensitivity analysis on each project that applies different capital structures. Compiling accurate data for our cash flows requires coordination with engineers, project managers, and others,” Kelly says. “Often we estimate a project’s revenue and cost projections using comparables from similar projects and adjust cost projections based on the project’s greater or lesser complexity.” Boeing sets hurdle rates for investment projects based on its cost of capital, which has a return on capital built in. In addition to an organization-wide rate, the company also sets project-specific hurdle rates that take into account business unit differences. Risk is another key factor in Boeing’s investment analyses. “We look at risk throughout the life of the programs. Our project managers identify potential risks, such as schedule or cost overruns, and use a proprietary risk analysis tool to develop a high, likely, and low dollar value. The program usually maintains additional budget for such contingencies, which have a direct affect on profit. If the risk is realized, then additional budget is added to cover that risk.”

An important responsibility of corporate financial managers is determining which projects or investments a firm should undertake. Capital budgeting, the focus of this chapter, is the process of analyzing investment opportunities and deciding which ones to accept. In doing so, we are allocating the firm’s funds to various projects—we are budgeting its capital. Chapter 8 covered the various methods for evaluating projects and proved that NPV will be the most reliable and accurate method for doing so. In retrospect, this may not be surprising as it is the only rule directly tied to the Valuation Principle. To implement the NPV rule, we must compute the NPV of our projects and accept only those projects for which the NPV is positive. We spoke in the last chapter about Sony and Toshiba each using investment decision rules to pursue competing high-definition DVD standards (and eventually for Toshiba, to decide to abandon HD-DVD). In order to implement the investment decision rules, financial managers from Toshiba, for example, had to first forecast the incremental cash flows associated with the investments and later to forecast the incremental cash flows associated with the decision to stop investing in HDDVD. The process of forecasting those cash flows, crucial inputs in the investment decision process, is our focus in this chapter.

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California State University, Long Beach, 2007

“Boeing uses cash flow analysis, NPV, and IRR calculations to evalute proposed investments.”

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We begin by estimating the project’s expected cash flows by forecasting the project’s revenues and costs. Using these cash flows, we can compute the project’s NPV—its contribution to shareholder value. Then, because the cash flow forecasts almost always contain uncertainty, we demonstrate how to compute the sensitivity of the NPV to the uncertainty in the forecasts. Finally, we examine the relationship between a project’s flexibility and its NPV.

9.1 capital budget Lists all of the projects that a company plans to undertake during the next period. capital budgeting The process of analyzing investment opportunities and deciding which ones to accept.

FIGURE 9.1 Cash Flows in a Typical Project

The Capital Budgeting Process The first step in analyzing various investment opportunities is compiling a list of potential projects. A capital budget lists the projects and investments that a company plans to undertake during future years. To create this list, firms analyze alternate projects and decide which ones to accept through a process called capital budgeting. This process begins with forecasts of each project’s future consequences for the firm. Some of these consequences will affect the firm’s revenues; others will affect its costs. Our ultimate goal is to determine the effect of the decision to accept or reject a project on the firm’s cash flows, and evaluate the NPV of these cash flows to assess the consequences of the decision for the firm’s value. Figure 9.1 depicts the types of cash flows found in a typical project. We will examine each of these as we proceed through our discussion of capital budgeting. Of course, forecasting these cash flows is frequently challenging. We will often need to rely on different experts within the firm to obtain estimates for many of them. For example, the marketing department may provide sales forecasts, the operations manager may provide information about production costs, and the firm’s engineers may estimate the upfront research and development expenses that are required to launch the project. Another important source of information comes from looking at past projects of the firm, or those of other firms in the same industry. In particular, practitioners often base their assessments of a project’s revenues and costs using information on revenues and costs that can be learned from the historical financial statements of the firm or its competitors. Once we have these estimates, how do we organize them? One common starting point is first to consider the consequences of the project for the firm’s earnings. Thus, we

The diagram shows some typical cash flows in project analysis and their timing.

Initial Outlay

On-Going Cash Flows

Terminal Cash Flows

Purchase Equipment

Incremental Revenues

Sale of Equipment (Net of any taxes)

Initial Development Costs

Incremental Costs

Shut-Down Costs

Taxes Increase in Net Working Capital (Increase inventories, raw materials, etc.)

Change in Net Working Capital (Change in inventories, raw materials, accounts receivable and payable)

Decrease in Net Working Capital (Decrease inventories, raw materials, etc.)

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Part 3 Valuation and the Firm

incremental earnings The amount by which a firm’s earnings are expected to change as a result of an investment decision.

Concept Check

9.2

will begin our analysis in Section 9.2 by determining the incremental earnings of a project—that is, the amount by which the firm’s earnings are expected to change as a result of the investment decision. The incremental earnings forecast tells us how the decision will affect the firm’s reported profits from an accounting perspective. However, as we emphasized in Chapter 2, earnings are not actual cash flows. We need to estimate the project’s cash flows to determine its NPV and decide whether it is a good project for the firm. Therefore, in Section 9.3, we demonstrate how to use the incremental earnings to forecast the actual cash flows of the project. Understanding how to compute the cash flow consequences of an investment based on its earning consequences is important for a number of reasons. First, as a practical matter, financial managers often begin by forecasting earnings. Second, if we are looking at historical data, accounting information is often the only information that is readily available. 1. What is capital budgeting, and what is its goal? 2. Why is computing a project’s effect on the firm’s earnings insufficient for capital budgeting?

Forecasting Incremental Earnings Let’s begin our discussion of incremental earnings with a simple example that we will examine throughout this section. Suppose you are considering whether to upgrade your manufacturing plant to increase its capacity by purchasing a new piece of equipment. The equipment costs $1 million, plus an additional $20,000 to transport it and install it. You will also spend $50,000 on engineering costs to redesign the plant to accommodate the increased capacity. What are the initial earnings consequences of this decision?

Operating Expenses Versus Capital Expenditures

straight-line depreciation A method of depreciation in which an asset’s cost is divided equally over its life.

Most projects require some form of upfront investment—we may need to conduct a marketing survey, develop a prototype, or launch an ad campaign. These types of costs are accounted for as operating expenses in the year that they are incurred. However, many projects also include investments in plant, property, and/or equipment, called capital expenditures. Recall from Chapter 2 that while investments in plant, property, and equipment are a cash expense, they are not directly listed as expenses when calculating earnings. Instead, the firm deducts a fraction of the cost of these items each year as depreciation. Financial managers use several different methods to compute depreciation. The simplest method is straight-line depreciation, in which the asset’s cost is divided equally over its depreciable life (we discuss another common method in Section 9.4). In our example, the upfront costs associated with the decision to increase capacity have two distinct consequences for the firm’s earnings. First, the $50,000 spent on redesigning the plant is an operating expense reported in year 0. For the $1,020,000 spent to buy, ship, and install the machine, accounting principles as well as tax rules require you to depreciate the $1,020,000 over the depreciable life of the equipment. Assuming that the equipment has a five-year depreciable life and that we use the straight-line method, we would expense +1,020,000/5 = +204,000 per year for five years. (The motivation for this accounting treatment is to match the cost of acquiring the machine to the timing of the revenues it will generate.) 1 Year 2 Operating Expenses (Plant Redesign) 3 Depreciation (New Equipment)

0 $50,000

1

2

3

4

5

$204,000 $204,000 $204,000 $204,000 $204,000

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As the timeline shows, the upfront cash outflow of $1,020,000 to purchase and set up the machine is not recognized as an expense in year 0. Instead, it appears as depreciation expenses in years 1 through 5. Remember that these depreciation expenses do not correspond to actual cash outflows. This accounting and tax treatment of capital expenditures is one of the key reasons why earnings are not an accurate representation of cash flows. We will return to this issue in Section 9.3.1

Incremental Revenue and Cost Estimates Our next step is to estimate the ongoing revenues and costs for the project. Forecasting future revenues and costs is challenging. The most successful practitioners collect as much information as possible before tackling this task—they will talk to members of marketing and sales teams as well as company economists to develop an estimate of sales, and they will talk to engineering and production teams to refine their estimate of costs. There are several factors to consider when estimating a project’s revenues and costs, including the following: 1. A new product typically has lower sales initially, as customers gradually become aware of the product. Sales will then accelerate, plateau, and ultimately decline as the product nears obsolescence or faces increased competition. 2. The average selling price of a product and its cost of production will generally change over time. Prices and costs tend to rise with the general level of inflation in the economy. The prices of technology products, however, often fall over time as newer, superior technologies emerge and production costs decline. 3. For most industries, competition tends to reduce profit margins over time. Our focus here is on how to get from these forecasts to incremental earnings and then to cash flows; Chapter 18 discusses forecasting methods in more detail. All our revenue and cost estimates should be incremental, meaning that we only account for additional sales and costs generated by the project. For example, if we are evaluating the purchase of a faster manufacturing machine, we are only concerned with how many additional units of the product we will be able to sell (and at what price) and any additional costs created by the new machine. We do not forecast total sales and costs because those include our production using the old machine. Remember, we are evaluating how the project will change the cash flows of the firm. That is why we focus on incremental revenues and costs. Let’s return to our plant upgrade example. Assume that after we have bought and installed the machine and redesigned the plant, our additional capacity will allow us to generate incremental revenues of $500,000 per year for five years. Those incremental revenues will be associated with $150,000 per year in incremental costs. In that case our revenue, cost, and depreciation estimates for the project are as shown below (in thousands of dollars): 1 2 3 4

1

Year Incremental Revenues Incremental Costs Depreciation

0 50

1 500 150 204

2 500 150 204

3 500 150 204

4 500 150 204

5 500 150 204

Some students might note that for financial reporting, the asset should be depreciated to salvage value. For tax purposes, salvage value is always treated as zero, so this is the relevant method for capital budgeting.

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Part 3 Valuation and the Firm Now that we have these estimates, we are ready to compute the consequences of our project for the firm’s earnings. As we saw in Chapter 2, both depreciation expenses and the actual costs of producing (e.g., cost of goods sold) must be subtracted from revenues, so that: Incremental Earnings Before Interest and Taxes 1 EBIT 2 = Incremental Revenue -Incremental Costs - Depreciation (9.1)

Taxes marginal corporate tax rate The tax rate a firm will pay on an incremental dollar of pre-tax income.

The final expense we must account for is corporate taxes. The correct tax rate to use is the firm’s marginal corporate tax rate, which is the tax rate it will pay on an incremental dollar of pre-tax income. The incremental income tax expense is calculated as: Income Tax = EBIT * The Firm>s Marginal Corporate Tax Rate

(9.2)

Incremental Earnings Forecast We’re now ready to put the pieces together for an incremental earnings forecast. Assume our firm faces a marginal tax rate of 40% and that the firm as a whole has at least $50,000 in profits in year 0 for the incremental costs in that year to offset. Then the incremental earnings (or net income) are as follows (in thousands of dollars):2 1 2 3 4 5 6 7

Year Incremental Revenues Incremental Costs Depreciation EBIT Income Tax at 40% Incremental Earnings

0 50 50 20 30

1 2 3 4 5 500 500 500 500 500 150 150 150 150 150 204 204 204 204 204 146 146 146 146 146 58.4 58.4 58.4 58.4 58.4 87.6 87.6 87.6 87.6 87.6

We can also combine Eq. 9.1 and Eq. 9.2 to compute incremental earnings directly. For example, in years 1 through 5 we have: Incremental Earnings = 1 Incremental Revenues - Incremental Cost -Depreciation 2 * 1 1 - Tax Rate 2 Incremental Earnings = 1 500,000 - 150,000 - 204,000 2 * 1 1 - 0.4 2 = 87,600

EXAMPLE 9.1

(9.3)

Problem

Incremental Earnings

Suppose that Linksys is considering the development of a wireless home networking appliance, called HomeNet, that will provide both the hardware and the software necessary to run an entire home from any Internet connection. In addition to connecting PCs and printers, HomeNet will control new Internet-capable stereos, digital video recorders, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on. The major competitor for HomeNet is a product being developed by Brandt-Quigley Corporation. Based on extensive marketing surveys, the sales forecast for HomeNet is 50,000 units per year. Given the pace of technological change, Linksys expects the product will have a four-year life and an expected 2

While revenues and costs occur throughout the year, the standard convention, which we adopt here, is to list revenues and costs in the year in which they occur. Thus, cash flows that occur at the end of one year will be listed in a different column than those that occur at the start of the next year, even though they may occur only weeks apart. When additional precision is required, cash flows are often estimated on a quarterly or monthly basis.

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wholesale price of $260 (the price Linksys will receive from stores). Actual production will be outsourced at a cost (including packaging) of $110 per unit. To verify the compatibility of new consumer Internet-ready appliances, as they become available, with the HomeNet system, Linksys must also establish a new lab for testing purposes. It will rent the lab space, but will need to purchase $7.5 million of new equipment. The equipment will be depreciated using the straight-line method over a five-year life. Linksys’ marginal tax rate is 40%. The lab will be operational at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to spend $2.8 million per year on rental costs for the lab space, as well as marketing and support for this product. Forecast the incremental earnings from the HomeNet project.

Solution Q Plan We need four items to calculate incremental earnings: (1) incremental revenues, (2) incremental costs, (3) depreciation, and (4) the marginal tax rate: Incremental revenues are: Additional units sold * price = 50,000 * +260 = +13,000,000 Incremental costs are:

Additional units sold * production costs = 50,000 * +110 = +5,500,000 Selling, general, and administrative = +2,800,000 for rent, marketing, and support

Depreciation is:

Depreciable basis/Depreciable life = +7,500,000/5 = +1,500,000

Marginal tax rate:

40%

Note that even though the project lasts for four years, the equipment has a five-year life, so we must account for the final depreciation charge in the fifth year. Q Execute (in $000s) 1 2 3 4 5 6 7 8 9

Year Revenues Cost of Goods Sold Gross Profit Selling, General, and Administrative Depreciation EBIT Income Tax at 40% Incremental Earnings

0

1 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920

2 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920

3 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920

4 5 – 13,000 – 5,500 – 7,500 – 2,800 1,500 1,500 3,200 1,500 600 1,280 1,920 900

Q Evaluate These incremental earnings are an intermediate step on the way to calculating the incremental cash flows that would form the basis of any analysis of the HomeNet project. The cost of the equipment does not affect earnings in the year it is purchased, but does so through the depreciation expense in the following five years. Note that the depreciable life, which is based on accounting rules, does not have to be the same as the economic life of the asset—the period over which it will have value. Here, the firm will use the equipment for four years, but will depreciate it over five years.

pro forma Describes a statement that is not based on actual data but rather depicts a firm’s financials under a given set of hypothetical assumptions.

Pro Forma Statement. The table calculating incremental earnings that we produced for our plant upgrade, and again in Example 9.1, is often referred to as a pro forma statement, because it is not based on actual data but rather depicts the firm’s financials under a given set of hypothetical assumptions. In the HomeNet example, the firm’s forecasts of revenues and costs were assumptions that allowed Linksys to forecast incremental earnings in a pro forma statement. Taxes and Negative EBIT. Notice that in year 0 of our plant upgrade project, and in year 5 of the HomeNet example, EBIT is negative. Why are taxes relevant in this case? Consider the HomeNet example. HomeNet will reduce Linksys’s taxable income in year 5 by $1.5

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Part 3 Valuation and the Firm million. As long as Linksys earns taxable income elsewhere in year 5 against which it can offset HomeNet’s losses, Linksys will owe +1.5 million * 40% = +600,000 less in taxes in year 5 than if it were not undertaking the project. Because the tax savings come from the depreciation expense on equipment for the HomeNet project, the firm should credit this tax savings to the HomeNet project.

EXAMPLE 9.2 Taxing Losses for Projects in Profitable Companies

Problem Kellogg Company plans to launch a new line of high-fiber, zero-trans-fat breakfast pastries. The heavy advertising expenses associated with the new product launch will generate operating losses of $15 million next year for the product. Kellogg expects to earn pre-tax income of $460 million from operations other than the new pastries next year. If Kellogg pays a 40% tax rate on its pre-tax income, what will it owe in taxes next year without the new pastry product? What will it owe with the new product?

Solution Q Plan We need Kellogg’s pre-tax income with and without the new product losses and its tax rate of 40%. We can then compute the tax without the losses and compare it to the tax with the losses. Q Execute Without the new product, Kellogg will owe +460 million * 40% = +184 million in corporate taxes next year. With the new product, Kellogg’s pre-tax income next year will be only $460 million - $15 million = $445 million, and it will owe +445 million * 40% = +178 million in tax. Q Evaluate Thus, launching the new product reduces Kellogg’s taxes next year by $184 million - $178 million = $6 million. Because the losses on the new product reduce Kellogg’s taxable income dollar for dollar, it is the same as if the new product had a tax bill of negative $6 million.

unlevered net income Net income that does not include interest expenses associated with debt.

Concept Check

What About Interest Expenses? In Chapter 2, we saw that to compute a firm’s net income, we must first deduct interest expenses from EBIT. When evaluating a capital budgeting decision, however, we generally do not include interest expenses. Any incremental interest expenses will be related to the firm’s decision regarding how to finance the project, which is a separate decision. Here, we wish to evaluate the earnings contributions from the project on its own, separate from the financing decision. Ultimately, managers may also look at the additional earnings consequences associated with different methods of financing the project. Thus, we evaluate a project as if the company will not use any debt to finance it (whether or not that is actually the case), and we postpone the consideration of alternative financing choices until Parts 5 and 6 of this book. Because we calculate the net income assuming no debt (no leverage), we refer to the net income we compute using Eq. 9.3, as in the pro forma in Example 9.1, as the unlevered net income of the project, to indicate that it does not include any interest expenses associated with debt. 3. How are operating expenses and capital expenditures treated differently when calculating incremental earnings? 4. Why do we focus only on incremental revenues and costs, rather than all revenues and costs of the firm?

9.3

Determining Incremental Free Cash Flow As discussed in Chapter 2, earnings are an accounting measure of the firm’s performance. They do not represent real profits: The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay dividends to shareholders. To do those things,

Chapter 9 Fundamentals of Capital Budgeting free cash flow The incremental effect of a project on a firm’s available cash.

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the firm needs cash. Thus, to evaluate a capital budgeting decision, we must determine its consequences for the firm’s available cash. The incremental effect of a project on the firm’s available cash is the project’s incremental free cash flow.

Converting from Earnings to Free Cash Flow As discussed in Chapter 2, there are important differences between earnings and cash flow. Earnings include non-cash charges, such as depreciation, but do not include expenditures on capital investment. To determine a project’s free cash flow from its incremental earnings, we must adjust for these differences. Capital Expenditures and Depreciation. As we have noted, depreciation is not a cash expense that is paid by the firm. Rather, it is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life. Because depreciation is not a cash flow, we do not include it in the cash flow forecast. However, that does not mean we can ignore depreciation. The depreciation expense reduces our taxable earnings and in doing so reduces our taxes. Taxes are cash flows, so because depreciation affects our cash flows, it still matters. Our approach for handling depreciation is to add it back to the incremental earnings to recognize the fact that we still have the cash flow associated with it. For example, a project has incremental gross profit (revenues minus costs) of $1 million and a $200,000 depreciation expense. If the firm’s tax rate is 40%, then the incremental earnings will be 1 +1,000,000 - +200,000 2 * 1 1 - 0.40 2 = +480,000. However, the firm will still have $680,000 because the $200,000 depreciation expense is not an actual cash outflow. Table 9.1 shows the calculation to get the incremental free cash flow in this case. Blue boxes indicate all of the actual cash flows in the column labeled “Correct.” A good way to check to make sure the incremental free cash flow is correct is to sum the actual cash flows. In this case, the firm generated $1,000,000 in gross profit (a positive cash flow), paid $320,000 in taxes (a negative cash flow), and was left with +1,000,000 - +320,000 = +680,000, which is the amount shown as the incremental free cash flow. In the last column, labeled “Incorrect,” we show what would happen if you just ignored depreciation altogether. Because EBIT would be too high, the taxes would be too high as well and consequently, the incremental free cash flow would be too low. (Note that the difference of $80,000 between the two cases is entirely due to the difference in tax payments.)

TABLE 9.1 Deducting and Then Adding Back Depreciation

EXAMPLE 9.3 Incremental Free Cash Flows

Incremental Gross Profit Depreciation EBIT Tax at 40% Incremental Earnings Add Back depreciation Incremental Free Cash Flow

Correct

Incorrect

$1,000,000 -200,000 $800,000 - +320,000 $480,000 $200,000 $680,000

$1,000,000 $1,000,000 - +400,000 $600,000 $600,000

Problem Let’s return to the HomeNet example. In Example 9.1, we computed the incremental earnings for HomeNet, but we need the incremental free cash flows to decide whether Linksys should proceed with the project.

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Part 3 Valuation and the Firm Solution Q Plan The difference between the incremental earnings and incremental free cash flows in the HomeNet example will be driven by the equipment purchased for the lab. We need to recognize the $7.5 million cash outflow associated with the purchase in year 0 and add back the $1.5 million depreciation expenses from year 1 to 5 as they are not actually cash outflows. Q Execute (in $000s) We recognize the outflow for the equipment in row 11 and we add back the depreciation expenses in row 10. 1 2 3 4 5 6 7 8 9 10 11 12

Year 0 Revenues Cost of Goods Sold Gross Profit Selling, General, and Administrative Depreciation EBIT Income Tax at 40% Incremental Earnings Add Back Depreciation Purchase of Equipment 7,500 Incremental Free Cash Flows 7,500

1 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

2 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

3 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

3,420

3,420

3,420

4 5 13,000 – 5,500 – 7,500 – 2,800 – 1,500 1,500 3,200 1,500 1,280 600 1,920 900 1,500 1,500 3,420

600

Q Evaluate By recognizing the outflow from purchasing the equipment in year 0, we account for the fact that $7.5 million left the firm at that time. By adding back the $1.5 million depreciation expenses in years 1–5, we adjust the incremental earnings to reflect the fact that the depreciation expense is not a cash outflow.

Net Working Capital (NWC). Another way that incremental earnings and free cash flows can differ is if there are changes in net working capital. We defined net working capital in Chapter 2 as the difference between current assets and current liabilities. The main components of net working capital are cash, inventory, receivables, and payables: Net Working Capital = Current Assets - Current Liabilities = Cash + Inventory + Receivables - Payables

trade credit The difference between receivables and payables that is the net amount of a firm’s capital consumed as a result of those credit transactions; the credit that a firm extends to its customers.

(9.4)

Note that as discussed in Chapter 2, we do not include short-term financing such as notes payable or short-term debt because those represent financing decisions that we keep separate from our investment decisions. Most projects will require the firm to invest in net working capital. Firms may need to maintain a minimum cash balance3 to meet unexpected expenditures, and inventories of raw materials and finished product to accommodate production uncertainties and demand fluctuations. Also, customers may not pay for the goods they purchase immediately. While sales are immediately counted as part of earnings, the firm does not receive any cash until the customers actually pay. In the interim, the firm includes the amount that customers owe in its receivables. Thus, the firm’s receivables measure the total credit that the firm has extended to its customers. In the same way, payables measure the credit the firm has received from its suppliers. The difference between receivables and payables is the net amount of the firm’s capital that is consumed as a result of these credit transactions, known as trade credit. We care about net working capital because it reflects a short-term investment that ties up cash flow that could be used elsewhere. For example, when a firm holds a lot of 3

The cash included in net working capital is cash that is not invested to earn a market rate of return. It includes cash held in the firm’s checking account, in a company safe or cash box, in cash registers (for retail stores), and other sites.

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unsold inventory or has a lot of outstanding receivables, cash flow is tied up in the form of inventory or in the form of credit extended to customers. It is costly for the firm to tie up that cash flow because it delays the time until the cash flow is available for reinvestment or distribution to shareholders. Since we know that money has time value, we cannot ignore this delay in our forecasts for the project. Thus, whenever net working capital increases, reflecting additional investment in working capital, it represents a reduction in cash flow that year. It is important to note that only changes in net working capital impact cash flows. For example, consider a three-year project that causes the firm to build up initial inventory by $20,000 and maintain that level of inventory in years 1 and 2, before drawing it down as the project ends and the last product is sold. It is often necessary for the initial increase in inventory to occur prior to the first sale so that the higher level of inventory would be achieved by the end of year 0. The level of the incremental net working capital in each year, the associated change in net working capital and the cash flow implications, would be: 1 2 3 4

Year Level of Incremental NWC Change in Incremental NWC Cash Flow from Change in NWC

0 20,000 20,000 20,000

1 20,000 0 0

3

2 20,000 0 0

0 20,000 20,000

Note that the cash flow effect from a change in net working capital is always equal and opposite in sign to the change in net working capital. For example, an increase in inventory represents an investment or cash outflow, while a reduction in that inventory frees up that investment of capital and represents a cash inflow. Thus in capital budgeting we subtract changes in net working capital to arrive at the cash flows. Also notice that since the level of incremental net working capital did not change in years 1 and 2, there was no new cash flow effect. Intuitively, as the firm is using up inventory and replenishing it, the net new investment in inventory is zero, so no additional cash outflow is required. Finally, note that over the life of the project, the incremental net working capital returns to zero so that the changes 1 +20,000 in year 0 and -20,000 in year 3 2 sum to zero. Accounting principles ensure this by requiring the recapture of working capital over the life of the project. More generally, we define the change in net working capital in year t as: Change in NWC in Year t = NWCt - NWCt - 1

(9.5)

When a project causes a change in NWC, that change must be subtracted from incremental earnings to arrive at incremental free cash flows.

EXAMPLE 9.4 Incorporating Changes in Net Working Capital

Problem Suppose that HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to customers). However, receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold (COGS). Fifteen percent of $13 million in sales is $1.95 million and 15% of $5.5 million in COGS is $825,000. HomeNet’s net working capital requirements are shown in the following table: 1 2 3 4 5 6 7

Year Net Working Capital Forecast ($000s) Cash Requirements Inventory Receivables (15% of Sales) Payables (15% of COGS) Net Working Capital

0

1

0 0 0 0 0

How does this requirement affect the project’s free cash flow?

2

3

4

5 0 0 0 0 0

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Part 3 Valuation and the Firm Solution Q Plan Any increases in net working capital represent an investment that reduces the cash available to the firm and so reduces free cash flow. We can use our forecast of HomeNet’s net working capital requirements to complete our estimate of HomeNet’s free cash flow. In year 1, net working capital increases by $1.125 million. This increase represents a cost to the firm. This reduction of free cash flow corresponds to the fact that in year 1, $1.950 million of the firm’s sales and $0.825 million of its costs have not yet been paid. In years 2–4, net working capital does not change, so no further contributions are needed. In year 5, when the project is shut down, net working capital falls by $1.125 million as the payments of the last customers are received and the final bills are paid. We add this $1.125 million to free cash flow in year 5. Q Execute (in $000s) 1 2 3 4

Year Net Working Capital Change in NWC Cash Flow Effect

0 0

3 1,125 0 0

5 4 0 1,125 0 1,125 0 1,125

2 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

3 13,000 5,500 7,500 2,800 1,500 3,200 1,280 1,920 1,500

4 5 13,000 0 5,500 0 7,500 0 2,800 0 1,500 1,500 3,200 1,500 1,280 600 1,920 900 1,500 1,500

0 3,420

0 3,420

1 2 1,125 1,125 1,125 0 1,125 0

The incremental free cash flows would then be: 1 2 3 4 5 6 7 8 9 10 11 12 13

Year 0 1 Revenues 13,000 Costs of Goods Sold 5,500 Gross Profit 7,500 Selling, General, and Administrative 2,800 Depreciation 1,500 EBIT 3,200 Income Tax at 40% 1,280 Incremental Earnings 1,920 Add Back Depreciation 1,500 Purchase of Equipment 7,500 Subtract Changes in NWC 1,125 Incremental Free Cash Flows 7,500 2,295

0 3,420

1,125 1,725

Q Evaluate The free cash flows differ from unlevered net income by reflecting the cash flow effects of capital expenditures on equipment, depreciation, and changes in net working capital. Note that in the first year, free cash flow is lower than unlevered net income, reflecting the upfront investment in equipment. In later years, free cash flow exceeds unlevered net income because depreciation is not a cash expense. In the last year, the firm ultimately recovers the investment in net working capital, further boosting the free cash flow.

Calculating Free Cash Flow Directly As we noted at the outset of this chapter, because practitioners usually begin the capital budgeting process by first forecasting earnings, we have chosen to do the same. However, we can calculate a project’s free cash flow directly by using the following shorthand formula: Free Cash Flow Unlevered Net Income

$'''''''''''%'''''''''''& Free Cash Flow = 1 Revenues - Costs - Depreciation 2 * 1 1 - Tax Rate 2 + Depreciation - CapEx - Change in NWC

(9.6)

Note that we first deduct depreciation when computing the project’s incremental earnings and then add it back (because it is a non-cash expense) when computing free cash

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flow. Thus, the only effect of depreciation is to reduce the firm’s taxable income. Indeed, we can rewrite Eq. 9.6 as: Free Cash Flow = 1 Revenues - Costs 2 * 1 1 - Tax Rate 2 - CapEx - Change in NWC + Tax Rate * Depreciation

depreciation tax shield The tax savings that result from the ability to deduct depreciation.

(9.7)

The last term in Eq. 9.7, Tax Rate * Depreciation, is called the depreciation tax shield, which is the tax savings that results from the ability to deduct depreciation. As a consequence, depreciation expenses have a positive impact on free cash flow. Returning to our example in Table 9.1, if the firm ignored depreciation, its taxes were $400,000 instead of $320,000, leaving it with incremental free cash flow of $600,000 instead of $680,000. Notice that the $80,000 difference is exactly equal to the tax rate (40%) multiplied by the depreciation expense ($200,000). Every dollar of depreciation expense saves the firm 40 cents in taxes, so the $200,000 depreciation expense translates into an $80,000 tax savings. Firms often report a different depreciation expense for accounting and for tax purposes. Because only the tax consequences of depreciation are relevant for free cash flow, we should use the depreciation expense that the firm will use for tax purposes in our forecast. For tax purposes, many firms use a system called Modified Accelerated Cost Recovery System, which we discuss in the next section.

Calculating the NPV The goal of forecasting the incremental free cash flows is to have the necessary inputs to calculate the project’s NPV. To compute a project’s NPV, we must discount its free cash flow at the appropriate cost of capital. As discussed in Chapter 5, the cost of capital for a project is the expected return that investors could earn on their best alternative investment with similar risk and maturity. We will develop the techniques needed to estimate the cost of capital in Part 4 of the text, when we discuss risk and return. For now, we take the cost of capital as given. We compute the present value of each free cash flow in the future by discounting it at the project’s cost of capital. As explained in Chapter 3, using r to represent the cost of capital, the present value of the free cash flow in year t (or FCFt) is: PV 1 FCFt 2 =

FCFt = FCFt * 11 + r2t

1 11 + r2t ('')''*

(9.8)

[email protected] discount factor

EXAMPLE 9.5 Calculating the Project’s NPV

Problem Assume that Linksys’s managers believe that the HomeNet project has risks similar to its existing projects, for which it has a cost of capital of 12%. Compute the NPV of the HomeNet project.

Solution Q Plan From Example 9.4, the incremental free cash flows for the HomeNet project are (in $000s): 1 Year 2 Incremental Free Cash Flows

0 1 7,500 2,295

2 3,420

3 3,420

4 3,420

5 1,725

To compute the NPV, we sum the present values of all of the cash flows, noting that the year 0 cash outflow is already a present value. Q Execute Using Eq. 9.8, NPV = -7500 +

3420 3420 3420 1725 2295 + + + + = 2862 1 2 3 4 1 1.12 2 1 1.12 2 1 1.12 2 1 1.12 2 1 1.12 2 5

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Part 3 Valuation and the Firm

Q Evaluate Based on our estimates, HomeNet’s NPV is $2.862 million. While HomeNet’s upfront cost is $7.5 million, the present value of the additional free cash flow that Linksys will receive from the project is $10.362 million. Thus, taking the HomeNet project is equivalent to Linksys having an extra $2.862 million in the bank today.

Concept Check

5. If depreciation expense is not a cash flow, why do we have to subtract it and add it back? Why not just ignore it? 6. Why does an increase in net working capital represent a cash outflow?

9.4

Other Effects on Incremental Free Cash Flows When computing the incremental free cash flows of an investment decision, we should include all changes between the firm’s free cash flows with the project versus without the project. These include opportunities forgone due to the project and effects of the project on other parts of the firm. In this section, we discuss these other effects, some of the pitfalls and common mistakes to avoid, and the complications that can arise when forecasting incremental free cash flows.

Opportunity Costs

opportunity cost The value a resource could have provided in its best alternative use.

Many projects use a resource that the company already owns. Because the firm does not need to pay cash to acquire this resource for a new project, it is tempting to assume that the resource is available for free. However, in many cases the resource could provide value for the firm in another opportunity or project. The opportunity cost of using a resource is the value it could have provided in its best alternative use.4 Because this value is lost when the resource is used by another project, we should include the opportunity cost as an incremental cost of the project. For example, your company may be considering building a retail store on some land that it owns. Even though it already owns the land, it is not free to the store project. If it did not put its store on the land, the company could sell the land, for example. This forgone market price for the land is an opportunity cost of the retail store project.

COMMON MISTAKE

The Opportunity Cost of an Idle Asset

A common mistake is to conclude that if an asset is currently idle, its opportunity cost is zero. For example, the firm might have a warehouse that is currently empty or a machine that is not being used. Often, the asset may have been idled in anticipation of taking on the new project, and

project externalities Indirect effects of a project that may increase or decrease the profits of other business activities of a firm.

would have otherwise been put to use by the firm. Even if the firm has no alternative use for the asset, the firm could choose to sell or rent the asset. The value obtained from the asset’s alternative use, sale, or rental represents an opportunity cost that must be included as part of the incremental cash flows.

Project Externalities Project externalities are indirect effects of a project that may increase or decrease the profits of other business activities of the firm. For instance, some purchasers of Apple’s iPhone would otherwise have bought Apple’s iPod Nano. When sales of a new product

4

In Chapter 5, we defined the opportunity cost of capital as the rate you could earn on an alternative investment with equivalent risk. We similarly define the opportunity cost of using an existing asset in a project as the cash flow generated by the next-best alternative use for the asset.

Chapter 9 Fundamentals of Capital Budgeting cannibalization When sales of a firm’s new product displace sales of one of its existing products.

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displace sales of an existing product, the situation is often referred to as cannibalization. The lost sales of the existing project are an incremental cost to the company of going forward with the new product.

Sunk Costs sunk cost Any unrecoverable cost for which a firm is already liable.

A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs have been or will be paid regardless of the decision whether or not to proceed with the project. Therefore, they are not incremental with respect to the current decision and should not be included in its analysis. You may hire a market research firm to do market analysis to determine whether there is demand for a new product you are considering and the analysis may show that there is not enough demand, so you decide not to go forward with the project. Does that mean you do not have to pay the research firm’s bill? Of course you still have to pay the bill, emphasizing that the cost was sunk and incurred whether you went forward with the project or not. A good rule to remember is that if your decision does not affect a cash flow, then the cash flow should not affect your decision. If the cash flow is the same regardless of the decision, then it is not relevant to your decision. The following are some common examples of sunk costs you may encounter.

overhead expenses Those expenses associated with activities that are not directly attributable to a single business activity but instead affect many different areas of a corporation.

Fixed Overhead Expenses. Overhead expenses are associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation. Examples include the cost of maintaining the company’s headquarters and the salary of the CEO. These expenses are often allocated to the different business activities for accounting purposes. To the extent that these overhead costs are fixed and will be incurred in any case, they are not incremental to the project and should not be included. Only include as incremental expenses the additional overhead expenses that arise because of the decision to take on the project.

COMMON MISTAKE

The Sunk Cost Fallacy

Being influenced by sunk costs is such a widespread mistake that it has a special name: sunk cost fallacy. The most common problem is that people “throw good money after bad.” That is, people sometimes continue to invest in a project that has a negative NPV because they have already invested a large amount in the project and feel that by not continuing it, the prior investment will be wasted. The sunk cost fallacy is also sometimes called the “Concorde effect,” a term that refers to the British and French governments’ decision

to continue funding the joint development of the Concorde aircraft even after it was clear that sales of the plane would fall far short of what was necessary to justify its continued development. The project was viewed by the British government as a commercial and financial disaster. However, the political implications of halting the project—and thereby publicly admitting that all past expenses on the project would result in nothing— ultimately prevented either government from abandoning the project.

Past Research and Development Expenditures. A pharmaceutical company may spend tens of millions of dollars developing a new drug, but if it fails to produce an effect in trials (or worse, has only negative effects), should it proceed? The company cannot get its development costs back and the amount of those costs should have no bearing on whether to continue developing a failed drug. When a firm has already devoted significant resources to develop a new product, there may be a tendency to continue investing in the product even if market conditions

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Part 3 Valuation and the Firm have changed and the product is unlikely to be viable. The rationale that is sometimes given is that if the product is abandoned, the money that has already been invested will be “wasted.” In other cases, a decision is made to abandon a project because it cannot possibly be successful enough to recoup the investment that has already been made. In fact, neither argument is correct: Any money that has already been spent is a sunk cost and therefore irrelevant. The decision to continue or abandon should be based only on the incremental costs and benefits of the product going forward.

Adjusting Free Cash Flow Here, we describe a number of complications that can arise when estimating a project’s free cash flow. Timing of Cash Flows. For simplicity, we have treated the cash flows in our examples as if they occur at annual intervals. In reality, cash flows will be spread throughout the year. While it is common to forecast at the annual level, we can forecast free cash flow on a quarterly or monthly basis when greater accuracy is required. In practice, firms often choose shorter intervals for riskier projects so that they might forecast cash flows at the monthly level for projects that carry considerable risk. For example, cash flows for a new facility in Europe may be forecasted at the quarterly or annual level, but if that same facility were located in a politically unstable country, the forecasts would likely be at the monthly level.

MACRS depreciation The most accelerated cost recovery system allowed by the IRS. Based on the recovery period, MACRS depreciation tables assign a fraction of the purchase price that the firm can depreciate each year.

EXAMPLE 9.6 Computing Accelerated Depreciation

Accelerated Depreciation. Because depreciation contributes positively to the firm’s cash flow through the depreciation tax shield, it is in the firm’s best interest to use the most accelerated method of depreciation that is allowable for tax purposes. By doing so, the firm will accelerate its tax savings and increase their present value. In the United States, the most accelerated depreciation method allowed by the IRS is MACRS (Modified Accelerated Cost Recovery System) depreciation. With MACRS depreciation, the firm first categorizes assets according to their recovery period. Based on the recovery period, MACRS depreciation tables assign a fraction of the purchase price that the firm can recover each year. We provide MACRS tables and recovery periods for common assets in the appendix at the end of this chapter. As we explain in the appendix, MACRS allows for partial depreciation in year 0, when the asset is purchased and put into service. Problem What depreciation deduction would be allowed for HomeNet’s $7.5 million lab equipment using the MACRS method, assuming the lab equipment is designated to have a five-year recovery period? (See this chapter’s appendix for information on MACRS depreciation schedules.)

Solution Q Plan Table 9.4 (in the appendix) provides the percentage of the cost that can be depreciated each year. Under MACRS, we take the percentage in the table for each year and multiply it by the original purchase price of the equipment to calculate the depreciation for that year. Q Execute Based on the table, the allowable depreciation expense for the lab equipment is shown below (in thousands of dollars): 1 2 3 4 5

Year MACRS Depreciation Lab Equipment Cost MACRS Depreciation Rate Depreciation Expense

0

1

2

3

4

7,500 20.00% 32.00% 19.20% 11.52% 11.52% 864 864 1,500 2,400 1,440

5

5.76% 432

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Q Evaluate Compared with straight-line depreciation, the MACRS method allows for larger depreciation deductions earlier in the asset’s life, which increases the present value of the depreciation tax shield and thus will raise the project’s NPV. In the case of HomeNet, computing the NPV using MACRS depreciation leads to an NPV of $3.179 million.

Liquidation or Salvage Value. Assets that are no longer needed often have a resale value, or some salvage value if the parts are sold for scrap. Some assets may have a negative liquidation value. For example, it may cost money to remove and dispose of the used equipment. In the calculation of free cash flow, we include the liquidation value of any assets that are no longer needed and may be disposed of. When an asset is liquidated, any capital gain is taxed as income. We calculate the capital gain as the difference between the sale price and the book value of the asset: Capital Gain = Sale Price - Book Value

(9.9)

The book value is equal to the asset’s original cost less the amount it has already been depreciated for tax purposes: Book Value = Purchase Price - Accumulated Depreciation

(9.10)

We must adjust the project’s free cash flow to account for the after-tax cash flow that would result from an asset sale: [email protected] Cash Flow from Asset Sale = Sale Price - 1 Tax Rate * Capital Gain 2 (9.11)

EXAMPLE 9.7 Computing AfterTax Cash Flows from an Asset Sale

Problem As production manager, you are overseeing the shutdown of a production line for a discontinued product. Some of the equipment can be sold for a total price of $50,000. The equipment was originally purchased four years ago for $500,000 and is being depreciated according to the five-year MACRS schedule. If your marginal tax rate is 35%, what is the after-tax cash flow you can expect from selling the equipment?

Solution Q Plan In order to compute the after-tax cash flow, you will need to compute the capital gain, which, as Eq. 9.9 shows, requires you to know the book value of the equipment. The book value is given in Eq. 9.10 as the original purchase price of the equipment less accumulated depreciation. Thus, you need to follow these steps: 1. 2. 3. 4.

Use the MACRS schedule to determine the accumulated depreciation. Determine the book value as purchase price minus accumulated depreciation. Determine the capital gain as the sale price less the book value. Compute the tax owed on the capital gain and subtract it from the sale price, following Eq. 9.11, and then subtract the tax owed from the sale price.

Q Execute From the chapter’s appendix, we see that the first five rates of the five-year MACRS schedule (including year 0) are: 1 Year 2 Depreciation Rate 3 Depreciation Amount

0 20.00% 100,000

1 32.00% 160,000

2 19.20% 96,000

3 11.52% 57,600

4 11.52% 57,600

Thus, the accumulated depreciation is 100,000 + 160,000 + 96,000 + 57,600 + 57,600 = 471,200, such that the remaining book value is +500,000 - +471,200 = +28,800. (Note we could have also

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Part 3 Valuation and the Firm calculated this by summing the rates for years remaining on the MACRS schedule: Year 5 is 5.76%, so .0576 * 500,000 = 28,800). The capital gain is then +50,000 - +28,800 = +21,200 and the tax owed is 0.35 * +21,200 = +7,420. Your after-tax cash flow is then found as the sale price minus the tax owed: +50,000 - +7,420 = +42,580. Q Evaluate Because you are only taxed on the capital gain portion of the sale price, figuring the after-tax cash flow is not as simple as subtracting the tax rate multiplied by the sale price. Instead, you have to determine the portion of the sale price that represents a gain and compute the tax from there. The same procedure holds for selling equipment at a loss relative to book value—the loss creates a deduction for taxable income elsewhere in the company.

tax loss carryforwards and carrybacks Two features of the U.S. tax code that allow corporations to take losses during a current year and offset them against gains in nearby years. Since 1997, companies can “carry back” losses for two years and “carry forward” losses for 20 years.

Tax Carryforwards. A firm generally identifies its marginal tax rate by determining the tax bracket that it falls into based on its overall level of pre-tax income. Two additional features of the tax code, called tax loss carryforwards and carrybacks, allow corporations to take losses during a current year and offset them against gains in nearby years. Since 1997, companies can “carry back” losses for two years and “carry forward” losses for 20 years. This tax rule means that a firm can offset losses during one year against income for the last two years, or save the losses to be offset against income during the next 20 years. When a firm can carry back losses, it receives a refund for back taxes in the current year. Otherwise, the firm must carry forward the loss and use it to offset future taxable income. When a firm has tax loss carryforwards well in excess of its current pre-tax income, then additional income it earns today will simply increase the taxes it owes after it exhausts its carryforwards.

Replacement Decisions Often the financial manager must decide whether to replace an existing piece of equipment. The new equipment may allow increased production, resulting in incremental revenue, or it may simply be more efficient, lowering costs. The typical incremental effects associated with such a decision are salvage value from the old machine, purchase of the new machine, cost savings and revenue increases, and depreciation effects.

EXAMPLE 9.8 Replacing an Existing Machine

Problem You are trying to decide whether to replace a machine on your production line. The new machine will cost $1 million, but will be more efficient than the old machine, reducing costs by $500,000 per year. Your old machine is fully depreciated, but you could sell it for $50,000. You would depreciate the new machine over a five-year life using MACRS. The new machine will not change your working capital needs. Your tax rate is 35%, and your cost of capital is 9%. Should you replace the machine?

Solution Q Plan Incremental revenues: 0 Incremental costs:

-500,000 (a reduction in costs will appear as a positive number in the costs line of our analysis)

Depreciation schedule (from the appendix): 1 Year 2 Depreciation Rate 3 Depreciation Amount

0 20.00% 200,000

1 32.00% 320,000

2 19.20% 192,000

3 11.52% 115,200

4 11.52% 115,200

5 5.76% 57,600

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Capital gain on salvage = +50,000 - +0 = +50,000

Cash flow from salvage value: +50,000 - 1 50,000 2 1 .35 2 = 32,500 Q Execute (values in thousands) 1 2 3 4 5 6 7 8 9 10 11 12

Year 0 Incremental Revenues Incremental Costs of Goods Sold Incremental Gross Profit 200 Depreciation 200 EBIT 70 Income Tax at 35% 130 Incremental Earnings 200 Add Back Depreciation Purchase of Equipment 1,000 Salvage Cash Flow 32.5 Incremental Free Cash Flows 897.5

NPV = -897.50 +

1 500 500 320 180 63 117 320

437

2

3

4

5

500 500 500 500 500 500 500 500 115.2 115.2 57.6 192 384.8 384.8 442.4 308 107.8 134.68 134.68 154.84 250.12 250.12 287.56 200.2 192 115.2 115.2 57.6

392.2

365.32

365.32

345.16

365.32 365.32 345.16 437.00 392.20 + + + = 598.75 + 1.09 1.092 1.093 1.094 1.095

Q Evaluate Even though the decision has no impact on revenues, it still matters for cash flows because it reduces costs. Further, both selling the old machine and buying the new machine involve cash flows with tax implications. The NPV analysis shows that replacing the machine will increase the value of the firm by almost $599 thousand.

Concept Check

9.5

7. Should we include sunk costs in the cash flows of a project? Why or why not? 8. Explain why it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes.

Analyzing the Project When evaluating a capital budgeting project, financial managers should make the decision that maximizes NPV. As we have discussed, to compute the NPV for a project you need to estimate the incremental free cash flows and choose a discount rate. Given these inputs, the NPV calculation is relatively straightforward. The most difficult part of capital budgeting is deciding how to estimate the cash flows and cost of capital. These estimates are often subject to significant uncertainty. In this section, we look at methods that assess the importance of this uncertainty and identify the drivers of value in the project.

Sensitivity Analysis sensitivity analysis An important capital budgeting tool that determines how the NPV varies as a single underlying assumption is changed.

An important capital budgeting tool for assessing the effect of uncertainty in forecasts is sensitivity analysis. Sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. In this way, sensitivity analysis allows us to explore the effects of errors in our NPV estimates for a project. By conducting a sensitivity analysis, we learn which assumptions are the most important; we can then invest further resources and effort to refine these assumptions. Such an analysis also reveals which aspects of a project are most critical when we are actually managing the project. In fact, we have already performed a type of sensitivity analysis in Chapter 8 when we constructed an NPV profile. By graphing the NPV of a project as a function of the discount rate, we are assessing the sensitivity of our NPV calculation to uncertainty about the cor-

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Part 3 Valuation and the Firm rect cost of capital to use as a discount rate. In practice, financial managers explore the sensitivity of their NPV calculation to many more factors than just the discount rate. To illustrate, consider the assumptions underlying the calculation of HomeNet’s NPV in Example 9.5. There is likely to be significant uncertainty surrounding each revenue and cost assumption. In addition to the base case assumptions about units sold, sale price, cost of goods sold, net working capital, and cost of capital, Linksys’s managers would also identify best- and worst-case scenarios for each. For example, assume that they identified the best- and worst-case assumptions listed in Table 9.2. Note that these are best- and worst-case scenarios for each parameter rather than representing one worst-case scenario and one best-case scenario. To determine the importance of this uncertainty, we recalculate the NPV of the HomeNet project under the best- and worst-case assumptions for each parameter. For example, if the number of units sold is only 35,000 per year, the NPV of the project falls to - +1.13 million. We repeat this calculation for each parameter. The result is shown in Figure 9.2, which reveals that the parameter assumptions with the largest effect on NPV are the number of units sold and the sale price per unit. As a result, these assumptions deserve the greatest scrutiny during the estimation process. In addition, as the most important drivers of the project’s value, these factors deserve close attention when managing the project after it starts.

TABLE 9.2 Best- and Worst-Case Assumptions for Each Parameter in the HomeNet Project

FIGURE 9.2 HomeNet’s NPV Under Bestand Worst-Case Parameter Assumptions

Parameter Units Sold (thousands) Sale Price ($/unit) Cost of Goods ($/unit) NWC ($ thousands) Cost of Capital

Initial Assumption

Worst Case

Best Case

50 260 110 1125 12%

35 240 120 1525 15%

65 280 100 725 10%

Bars show the change in NPV going from the best-case assumption to the worst-case assumption for each parameter. For example, the NPV of the project ranges from - +1.13 million if only 35,000 units are sold to $6.85 million if 65,000 units are sold. Under the initial assumptions, HomeNet’s NPV is $2.862 million.

Units Sold (000s per year)

35

50

65

Sales Price ($ per unit)

240

260

280

Cost of Goods ($ per unit)

120 110 100 Net Working Capital ($ thousands)

1525

Cost of Capital 3 2 1

15% 0

1

1125

12% 2

2.862

725

10% 4

NPV ($ million)

5

6

7

8

9

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Break-Even Analysis break-even The level of a parameter for which an investment has an NPV of zero.

break-even analysis A calculation of the value of each parameter for which the NPV of the project is zero.

A natural extension of the sensitivity analysis is to ask at what level of each parameter would the project have an NPV of zero. For each parameter, this level is its break-even. One example that we have already considered is the calculation of the internal rate of return (IRR). Recall from Chapter 8 that the difference between the IRR of a project and the cost of capital tells you how much error in the cost of capital it would take to change the investment decision. By either graphing the NPV profile or using the Excel function IRR, we would find that the incremental cash flows of HomeNet given in Example 9.5 imply an IRR of 26.6%. Hence, the true cost of capital can be as high as 26.6% and the project will still have a positive NPV. We can determine the uncertainty of other parameters as well. In a break-even analysis, for each parameter we calculate the value at which the NPV of the project is zero. This would be tedious to do by hand, so in practice it is always done with a spreadsheet. As with the NPV profile for the discount rate, we can graph the NPV as a function of each of the critical assumptions. In each case, we keep all of the other parameters fixed at their initially assumed values and vary only the parameter in question. Figure 9.3 does this for HomeNet. Accounting Break-Even. We have examined the break-even levels in terms of the project’s NPV, which is the most useful perspective for decision making. Other accounting notions of break-even are sometimes considered, however. For example, we could compute the EBIT break-even for sales, which is the level of sales for which the project’s EBIT is zero. Recall from Eq. 9.1 that the project’s EBIT is Revenues - Costs - Depreciation. Costs include cost of goods sold, and selling, general, and administrative expense (SG&A). Revenues equal Units Sold * Sale Price, and cost of goods sold equals Units Sold * Cost per Unit, so we have EBIT = 1 Units Sold * Sale Price 2 1 Units Sold * Cost per Unit 2 - SG&A - Depreciation. Setting this equal to zero and solving for units sold:

EBIT break-even The level of a particular parameter for which a project’s EBIT is zero.

Units Sold * 1 Sale Price - Cost per Unit 2 - SG&A - Depreciation = 0

Units Sold =

FIGURE 9.3

SG&A + Depreciation 2,800,000 + 1,500,000 = = 28,667 Sales Price - Cost per Unit 260 - 110

Break-Even Analysis Graphs

The graphs in panels (a) and (b) relate two of the key parameters to the project’s NPV to identify the parameters’ break-even points. For example, based on the initial assumptions, the HomeNet project will break even with a sales level of 39,242 units per year. Similarly, holding sales and the other parameters constant at their initial assumed values, the project will break even at a cost of goods sold of just over $142 per unit. Panel (a) Break-Even Point Based on Units Sold

Panel (b) Break-Even Point Based on Costs of Goods Sold

$8000

$5000

$6000

$4000 $3000 NPV

NPV

$4000 $2000 $0

20

30

40

50

$2000 $4000

60

70

$2000 $1000 $0

$1000 Units Sold (000s)

$2000

80 90 100 110 120 130 140 150 160 Cost of Goods Sold ($/unit)

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Part 3 Valuation and the Firm However, this EBIT break-even number is misleading. While HomeNet’s EBIT break-even level of sales is only 28,667 units per year, given the large upfront investment required in HomeNet, its NPV is - +2.81 million at that sales level.

INTERVIEW WITH

DAVID HOLLAND

David Holland, currently Senior Vice President of Sports and Entertainment Solutions where he is responsible for accelerating development and adoption of Cisco solutions in that market. He was previously Senior Vice President and Treasurer of Cisco, and was responsible for managing all funding, risk, and capital market activities related to the firm’s $50 billion balance sheet. QUESTION: What is the importance of considering free cash flow, as opposed to just the earnings implications of a financial decision? ANSWER: There is an adage saying, “Cash flow is a fact and earnings are an opinion.” Earnings use an accounting framework and are governed by many rules, making it hard to know what earnings tell the investor. The economics of cash flow are clear: We can’t dispute whether cash has come in or gone out. Cisco’s investment decisions are based primarily on cash flow models because they take project risk into account and show the impact on value creation for owners of the business. QUESTION: What key financial metrics does Cisco use to make investment decisions? ANSWER:

Cisco focuses primarily on net present value (NPV) for investment decisions. Robust NPV analysis goes beyond simply accepting projects with positive NPVs and rejecting those with negative NPVs. It identifies the key drivers that affect project success and demonstrates the interplay between factors that affect cash flow. For example, running a model using a lower margin approach shows us the impact on revenue growth and on operating cost structures. We can compare that to a higher margin (premium pricing) approach. The business unit manager learns how to control aspects of the business model to alleviate risk or accelerate the upside potential. We prefer NPV to internal rate of return (IRR), which may return multiple answers or give false signals as to an investment’s profitability, depending on the organization of cash flows. An attraction of IRR analysis is the ease of comparing percentage returns. However, this method hides the scope of a project. A project with a 25% return may generate $1 million in shareholder value, while another with a 13% IRR might produce $1 billion. NPV captures the size of the return in dollar terms and shows a project’s impact on share price. NPV also creates an ownership framework for

employees whose compensation package includes some form of stock ownership, directly tying the decision-making criteria to stock price.

When developing a model to analyze a new investment, how do you deal with the uncertainty surrounding estimates, especially for new technologies?

QUESTION:

ANSWER: Cisco relies on strong financial modeling for the thousands of investment decisions we make every year. Our 2500 finance people worldwide work with the internal client—the business lead—to understand the assumptions in the model and to check the model’s result against alternative assumptions. Evaluating the cash flows for technology projects, especially new technology, is difficult. When you buy an oil refinery, you can see the throughput and the cash flows. Identifying the relevant savings from a component technology for a larger router or switch product or a strategic move into a new area is more complex and intangible. Scenario and sensitivity analyses and game theory help us control risk by adjusting our strategy. We also look at the qualitative aspects, such as how the strategy fits into the customer sector and the directions customers are moving with their tech platforms. QUESTION:

How does Cisco adjust for risk?

ANSWER: To stay competitive in the technology space, we must be prepared to take some level of risk, even in down markets. We apply the same discount rate to all projects in a category, based on their market risk (i.e., sensitivity to market conditions). We do not adjust the discount rate to account for project-specific risks, because our required return has not changed and that would distort the true value of the company. To assess a project’s unique risks, we model the upside or downside of cash flows with scenario and sensitivity analysis. We might analyze the sensitivity of a project’s NPV to a 1% change in both revenue growth and operating costs. Then we run the model with other assumptions, developing base, optimistic, and bearish cases. We discuss these models with the business lead and rerun the models based on their input. This process improves our potential outcome and project profitability.

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Scenario Analysis scenario analysis An important capital budgeting tool that determines how the NPV varies as a number of the underlying assumptions are changed simultaneously.

In the analysis thus far, we have considered the consequences of varying only one parameter at a time. In reality, certain factors may affect more than one parameter. Scenario analysis considers the effect on NPV of changing multiple project parameters. For example, lowering HomeNet’s price may increase the number of units sold. We can use scenario analysis to evaluate alternative pricing strategies for the HomeNet product in Table 9.3. In this case, the current strategy is optimal. Figure 9.4 shows the combinations of price and volume that lead to the same NPV of $2.862 million for HomeNet as the current strategy. Only strategies with price and volume combinations above the curve will lead to a higher NPV.

TABLE 9.3 Scenario Analysis of Alternative Pricing Strategies

FIGURE 9.4 Price and Volume Combinations for HomeNet with Equivalent NPV

Strategy

Sale Price ($/unit)

Current Strategy Price Reduction Price Increase

Expected Units Sold (thousands)

NPV ($ thousands)

260

50

2862

245 275

55 45

2729 2729

The graph shows alternative price per unit and annual volume combinations that lead to an NPV of $2.862 million. Pricing strategies with combinations above this curve will lead to a higher NPV and are superior. For example, if Linksys managers think they will be able to sell 48,000 units at a price of $275, this strategy would yield a higher NPV ($3,607 million).

$285 48,000 units at a price of $275 each produces an NPV $2.862 million

$280 $275

Sale Price

$270 $265 $260 $255 52,000 units at a price of $250 each produces an NPV $2.862 million

$250 $245 $240 44

46

48

50 Units Sold (000s)

Concept Check

9. What is sensitivity analysis? 10. How does scenario analysis differ from sensitivity analysis?

52

54

56

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9.6

real option The right to make a particular business decision, such as a capital investment.

Real Options in Capital Budgeting Our approach to capital budgeting thus far has focused on the initial investment decision without explicitly considering future decisions that may need to be made over the life of a project. Rather, we assumed that our forecast of a project’s expected future cash flows already incorporated the effect of future decisions that would be made. In truth, most projects contain real options. A real option is the right, but not the obligation, to make a particular business decision. Because you are not obligated to take the action, you will only do so if it increases the NPV of the project. In particular, because real options allow a decision maker to choose the most attractive alternative after new information has been learned, the presence of real options adds value to an investment opportunity. The tools to estimate the actual value created by real options are beyond the scope of this chapter and are contained later in the book. However, we introduce the concept here to give you a sense of the types of real options you may encounter and establish the intuition that flexibility (more options) is valuable. Let’s look at some of the most common real options in the context of Linksys’s HomeNet project.

Option to Delay option to delay commitment The option to time a particular investment

The option to delay commitment (the option to time the investment) is almost always present. Linksys could wait to commit to the HomeNet project. Waiting could be valuable if Linksys expects prices of the components to decrease substantially, soon-to-be-released new technology that will make the existing components obsolete, or increased sales of Web-ready appliances (heightening the demand for HomeNet). In addition, Linksys may simply want more time to gather information about the potential market for HomeNet. As with any other capital budgeting decision, Linksys would only choose to delay if doing so would increase the NPV of the project.

Option to Expand

option to expand The option to start with limited production and expand only if the project is successful.

abandonment option An option for an investor to cease making investments in a project. Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful.

In the section on sensitivity analysis, we looked at changes in our assumptions about units sold. All of the analysis was performed, however, under the assumption that Linksys would fully commit to and roll out the HomeNet product worldwide. We did not consider the option to expand, which is the option to start with limited production and expand only if the product is successful. Linksys could, instead, test market the product in limited release before committing to it fully. Doing so would create an option to expand worldwide only if HomeNet were successful in limited release. It is possible that, by reducing its upfront commitment and only choosing to expand if the product is successful, Linksys will increase the NPV of the HomeNet product. However, in this particular case, there are large costs of development that would be paid whether Linksys sells one or one million units, so limiting the initial market does not reduce the financial commitment substantially. Thus, in the case of HomeNet, it is unlikely that Linksys would choose a limited release with an option to expand.

Option to Abandon An abandonment option is the option to walk away. Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful. Imagine that a competitor developed new technology that allowed it to introduce a competing product priced at $170. At that price, HomeNet would produce negative cash flows every year. But would Linksys continue to sell HomeNet if it had to do so at a loss? Probably

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not. Linksys has an option to abandon the project. It could stop producing HomeNet and sell the equipment. Depending on how much Linksys believes the equipment would sell for if it abandoned the project, the abandonment option could make HomeNet attractive even if there was a substantial risk of a competing product. All these options point to the same conclusion: if you can build greater flexibility into your project, you will increase the NPV of the project. In Chapter 21, we will discuss how to value options so that you can estimate just how much more valuable the project is with greater flexibility. Many industries regularly make use of real options. For example, most movie producers build in an option for a sequel if the first movie does well. Pharmaceutical developers like Merck develop new drugs in stages, allowing them to abandon development if tests do not go well.

Concept Check

11. What are real options? 12. Why do real options increase the NPV of the project?

Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

9.1 The Capital Budgeting Process Q Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept. A capital budget is a list of all projects that a company plans to undertake during the next period. Q We use the NPV rule to evaluate capital budgeting decisions, making decisions that maximize NPV. When deciding to accept or reject a project, we accept projects with a positive NPV.

capital budget, p. 249 capital budgeting, p. 249 incremental earnings, p. 250

MyFinanceLab Study Plan 9.1

9.2 Forecasting Incremental Earnings Q The incremental earnings of a project comprise the amount by which the project is expected to change the firm’s earnings. Q Incremental earnings should include all incremental revenues and costs associated with the project. Incremental Earnings = 1 Incremental Revenues - Incremental Cost - Depreciation 2 * 1 1 - Tax Rate 2 (9.3) Q Interest and other financing-related expenses are excluded to determine the project’s unlevered net income.

marginal corporate tax rate, p. 252 pro forma, p. 253 straight-line depreciation, p. 250 unlevered net income, p. 254

MyFinanceLab Study Plan 9.2

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Part 3 Valuation and the Firm

9.3 Determining Incremental Free Cash Flow Q We compute free cash flow from incremental earnings by eliminating all non-cash expenses and including all capital investment. Q Depreciation is not a cash expense, so it is added back. Q Actual capital expenditures are deducted. Q Increases in net working capital are deducted and decreases are added. Net working capital is defined as:

depreciation tax shield, p. 259 free cash flow, p. 255 trade credit, p. 256

MyFinanceLab Study Plan 9.3

9.4 Other Effects on Incremental Free Cash Flows Q An opportunity cost is the cost of using an existing asset. Q Project externalities are cash flows that occur when a project affects other areas of the company’s business. Q A sunk cost is an unrecoverable cost that has already been incurred. Q Depreciation expenses affect free cash flow only through the depreciation tax shield. The firm should use the most accelerated depreciation schedule possible. Q The discount rate for a project is its cost of capital: the expected return of securities with comparable risk and horizon. Q When you sell an asset, the portion of the proceeds above its book value is taxed: [email protected] Cash Flow from Asset Sale = Sale Price - 1 Tax Rate * Capital Gain 2 (9.11)

cannibalization, p. 261 MACRS depreciation, p. 262 opportunity cost, p. 260 overhead expenses, p. 261 project externalities, p. 260 sunk cost, p. 261 tax loss carryforwards and carrybacks, p. 264

MyFinance Lab Study Plan 9.4

9.5 Analyzing the Project Q Sensitivity analysis breaks the NPV calculation down into its component assumptions, showing how the NPV varies as the values of the underlying assumptions change. Q Break-even analysis computes the level of a parameter that makes the project’s NPV equal zero. Q Scenario analysis considers the effect of changing multiple parameters simultaneously.

break-even, p. 267 break-even analysis, p. 267 EBIT break-even, p. 267 scenario analysis, p. 269 sensitivity analysis, p. 265

MyFinanceLab Study Plan 9.5

9.6 Real Options in Capital Budgeting Q Real options are options to make a business decision, often after gathering more information. The presence of real options in a project increases the project’s NPV.

abandonment option, p. 270 option to delay commitment, p. 270 option to expand, p. 270 real option, p. 270

MyFinanceLab Study Plan 9.6

Cash + Inventory + Receivables - Payables (9.4) Q The basic calculation for free cash flow is:

Free Cash Flow = 1 Revenues - Costs - Depreciation 2 (9.6) * 1 1 - Tax Rate 2 + Depreciation -CapEx - Change in NWC

HomeNet Example Spreadsheet

Interactive Sensitivity Analysis, Using Excel: Performing Sensitivity Analysis

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1. What are pro forma incremental earnings? 2. What is the difference between pro forma incremental earnings and pro forma free cash flow? 3. Why do we convert from incremental earnings to free cash flow when performing capital budgeting? 4. What is the role of net working capital in projects? 5. How does net working capital affect the cash flows of a project? 6. Why is it important to adjust project sales and costs for externalities? 7. Does accelerated depreciation generally increase or decrease NPV relative to straight-line depreciation? 8. How is sensitivity analysis performed and what is its purpose?

Problems

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates problems with a higher level of difficulty. Forecasting Incremental Earnings 1. Daily Enterprises is purchasing a $10 million machine. It will cost $50,000 to transport and install the machine. The machine has a depreciable life of five years and will have no salvage value. If Daily uses straight-line depreciation, what are the depreciation expenses associated with this machine? 2. The machine in Problem 1 will generate incremental revenues of $4 million per year along with incremental costs of $1.2 million per year. If Daily’s marginal tax rate is 35%, what are the incremental earnings associated with the new machine? 3. You are upgrading to better production equipment for your firm’s only product. The new equipment will allow you to make more of your product in the same amount of time. Thus, you forecast that total sales will increase next year by 20% over the current amount of 100,000 units. If your sales price is $20 per unit, what are the incremental revenues next year from the upgrade? 4. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $20 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 40% will come from customers who switch to the new, healthier pizza instead of buying the original version. a. Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza? b. Suppose that 50% of the customers who would switch from Pisa Pizza’s original pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case? 5. Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi Munch. Kokomochi plans to spend $5 million on TV, radio, and print advertising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9 million this year and by $7 million next year. In addition, the company expects that new consumers who try the Mini Mochi

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Part 3 Valuation and the Firm Munch will be more likely to try Kokomochi’s other products. As a result, sales of other products are expected to rise by $2 million each year. Kokomochi’s gross profit margin for the Mini Mochi Munch is 35%, and its gross profit margin averages 25% for all other products. The company’s marginal corporate tax rate is 35% both this year and next year. What are the incremental earnings associated with the advertising campaign? 6. Hyperion, Inc., currently sells its latest high-speed color printer, the Hyper 500, for $350. It plans to lower the price to $300 next year. Its cost of goods sold for the Hyper 500 is $200 per unit, and this year’s sales are expected to be 20,000 units. a. Suppose that if Hyperion drops the price to $300 immediately, it can increase this year’s sales by 25% to 25,000 units. What would be the incremental impact on this year’s EBIT of such a price drop? b. Suppose that for each printer sold, Hyperion expects additional sales of $75 per year on ink cartridges for the next three years, and Hyperion has a gross profit margin of 70% on ink cartridges. What is the incremental impact on EBIT for the next three years of a price drop this year? Determining Incremental Free Cash Flow 7. You have a depreciation expense of $500,000 and a tax rate of 35%. What is your depreciation tax shield? 8. You have forecast pro-forma earnings of $1,000,000. This includes the effect of $200,000 in depreciation. You also forecast a decrease in working capital of $100,000 that year. What is your forecast of free cash flows for that year? 9. Your pro-forma income statement shows sales of $1,000,000, cost of goods sold as $500,000, depreciation expense of $100,000, and taxes of $160,000 due to a tax rate of 40%. What are your pro-forma earnings? What is your pro-forma free cash flow? 10. You are forecasting incremental free cash flows for Daily Enterprises. Based on the information in Problems 1 and 2, what are the incremental free cash flows associated with the new machine? 11. Castle View Games would like to invest in a division to develop software for video games. To evaluate this decision, the firm first attempts to project the working capital needs for this operation. Its chief financial officer has developed the following estimates (in millions of dollars) (see MyFinanceLab for the data in Excel format): 1 2 3 4 5

Year Cash Accounts Receivable Inventory Accounts Payable

1 6 21 5 18

2 12 22 7 22

3 15 24 10 24

4 15 24 12 25

5 15 24 13 30

Assuming that Castle View currently does not have any working capital invested in this division, calculate the cash flows associated with changes in working capital for the first five years of this investment. 12. In the HomeNet example from the chapter, its receivables are 15% of sales and its payables are 15% of COGS. Forecast the required investment in net working capital for HomeNet assuming that sales and cost of goods sold (COGS) will be (see MyFinanceLab for the data in Excel format): 1 Year 2 Sales 3 COGS

0

1 23,500 9,500

2 26,438 10,688

3 23,794 9,619

4 8,566 3,483

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13. Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two years (in millions of dollars) (see MyFinanceLab for the data in Excel format): 1 2 3 4 5 6 7

Year Revenues Operating Expenses (other than depreciation) Depreciation Increase in Net Working Capital Capital Expenditures Marginal Corporate Tax Rate

1 125 40 25 2 30 35%

2 160 60 36 8 40 35%

a. What are the incremental earnings for this project for years 1 and 2? b. What are the free cash flows for this project for the first two years? 14. Cellular Access, Inc., is a cellular telephone service provider that reported net income of $250 million for the most recent fiscal year. The firm had depreciation expenses of $100 million, capital expenditures of $200 million, and no interest expenses. Net working capital increased by $10 million. Calculate the free cash flow for Cellular Access for the most recent fiscal year. 15. Recall the HomeNet example from the chapter. Suppose HomeNet’s lab will be housed in warehouse space that the company could have otherwise rented out for $200,000 per year during years 1–4. How does this opportunity cost affect HomeNet’s incremental earnings? *16. One year ago, your company purchased a machine used in manufacturing for $110,000. You have learned that a new machine is available that offers many advantages; you can purchase it for $150,000 today. It will be depreciated on a straight-line basis over ten years and has no salvage value. You expect that the new machine will produce a gross margin (revenues minus operating expenses other than depreciation) of $40,000 per year for the next ten years. The current machine is expected to produce a gross margin of $20,000 per year. The current machine is being depreciated on a straight-line basis over a useful life of 11 years, and has no salvage value, so depreciation expense for the current machine is $10,000 per year. The market value today of the current machine is $50,000. Your company’s tax rate is 45%, and the opportunity cost of capital for this type of equipment is 10%. Should your company replace its year-old machine? *17. Beryl’s Iced Tea currently rents a bottling machine for $50,000 per year, including all maintenance expenses. It is considering purchasing a machine instead and is comparing two options: a. Purchase the machine it is currently renting for $150,000. This machine will require $20,000 per year in ongoing maintenance expenses. b. Purchase a new, more advanced machine for $250,000. This machine will require $15,000 per year in ongoing maintenance expenses and will lower bottling costs by $10,000 per year. Also, $35,000 will be spent upfront in training the new operators of the machine. Suppose the appropriate discount rate is 8% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the rental of the machine. Assume also that the machines will be depreciated via the straightline method over seven years and that they have a ten-year life with a negligible salvage value. The marginal corporate tax rate is 35%. Should Beryl’s Iced Tea continue to rent, purchase its current machine, or purchase the advanced machine?

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Part 3 Valuation and the Firm Other Effects on Incremental Free Cash Flows 18. You have just completed a $20,000 feasibility study for a new coffee shop in some retail space you own. You bought the space two years ago for $100,000, but if you sold it today, you would net $115,000 after taxes. Outfitting the space for a coffee shop would require a capital expenditure of $30,000 plus an initial investment of $5,000 in inventory. What is the correct initial cash flow for your analysis of the coffee shop opportunity? 19. You purchased a machine for $1 million three years ago and have been applying straight-line depreciation to zero for a seven-year life. Your tax rate is 35%. If you sell the machine right now (after three years of depreciation) for $700,000, what is your incremental cash flow from selling the machine? 20. The Jones Company has just completed the third year of a five-year MACRS recovery period for a piece of equipment it originally purchased for $300,000. a. What is the book value of the equipment? b. If Jones sells the equipment today for $180,000 and its tax rate is 35%, what is the after-tax cash flow from selling it? 21. Just before it is about to sell the equipment from Problem 20, Jones receives a new order. It can take the new order if it keeps the old equipment. Is there a cost to taking the order and if so, what is it? Explain. 22. Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should be included as part of the incremental earnings for the proposed new retail store? a. The original purchase price of the land where the store will be located. b. The cost of demolishing the abandoned warehouse and clearing the lot. c. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead. d. The $10,000 in market research spent to evaluate customer demand. e. Construction costs for the new store. f. The value of the land if sold. g. Interest expense on the debt borrowed to pay the construction costs. 23. If Daily Enterprises uses MACRS instead of straight-line depreciation, which incremental free cash flows from Problem 10 would increase and which would decrease? 24. Markov Manufacturing recently spent $15 million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 35%. The company plans to use straight-line depreciation. a. What is the annual depreciation expense associated with this equipment? b. What is the annual depreciation tax shield? c. Rather than straight-line depreciation, suppose Markov will use the MACRS depreciation method for the five-year life of the property. Calculate the deprecia-

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tion tax shield each year for this equipment under this accelerated depreciation schedule. d. If Markov has a choice between straight-line and MACRS depreciation schedules, and its marginal corporate tax rate is expected to remain constant, which schedule should it choose? Why? e. How might your answer to part (d) change if Markov anticipates that its marginal corporate tax rate will increase substantially over the next five years? 25. You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s report on your desk, and complains, “We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over and give me your opinion.” You open the report and find the following estimates (in thousands of dollars) (see MyFinanceLab for the data in Excel format): 1 2 3 4 5 6 7 8 9

Year Sales Revenue Costs of Goods Sold Gross Profit General, Sales, and Administrative Expenses Depreciation EBIT Income Tax Net Income

1 30,000 18,000 12,000 2,000 2,500 7,500 2,625 4,875

2 30,000 18,000 12,000 2,000 2,500 7,500 2,625 4,875

…

9 30,000 18,000 12,000 2,000 2,500 7,500 2,625 4,875

10 30,000 18,000 12,000 2,000 2,500 7,500 2,625 4,875

All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year 0), which is what the accounting department recommended. They also calculated the depreciation assuming no salvage value for the equipment, which is the company’s assumption in this case. The report concludes that because the project will increase earnings by $4.875 million per year for ten years, the project is worth $48.75 million. You think back to your glory days in finance class and realize there is more work to be done! First, you note that the consultants have not factored in the fact that the project will require $10 million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see they have attributed $2 million of selling, general, and administrative expenses to the project, but you know that $1 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on! a. Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed project? b. If the cost of capital for this project is 14%, what is your estimate of the value of the new project? Analyzing the Project 26. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the incremental free cash flow projections shown on the next page (in millions of dollars) (see MyFinanceLab for the data in Excel format). a. For this base-case scenario, what is the NPV of the plant to manufacture lightweight trucks?

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Part 3 Valuation and the Firm 1 2 3 4 5 6 7 8 9 10 11 12 13

Year Revenues Manufacturing Expenses (other than depreciation) Marketing Expenses Depreciation EBIT Taxes at 35% Unlevered Net Income Depreciation Additions to Net Working Capital Capital Expenditures Continuation Value Free Cash Flow

0

1–9 100.0 35.0 10.0 15.0 40.0 14.0 26.0 15.0 5.0

10 100.0 35.0 10.0 15.0 40.0 14.0 26.0 15.0 5.0

36.0

12.0 48.0

150.0 150.0

b. Based on input from the marketing department, Bauer is uncertain about its revenue forecast. In particular, management would like to examine the sensitivity of the NPV to the revenue assumptions. What is the NPV of this project if revenues are 10% higher than forecast? What is the NPV if revenues are 10% lower than forecast? c. Rather than assuming that cash flows for this project are constant, management would like to explore the sensitivity of its analysis to possible growth in revenues and operating expenses. Specifically, management would like to assume that revenues, manufacturing expenses, and marketing expenses are as given in the table for year 1 and grow by 2% per year every year starting in year 2. Management also plans to assume that the initial capital expenditures (and therefore depreciation), additions to working capital, and continuation value remain as initially specified in the table. What is the NPV of this project under these alternative assumptions? How does the NPV change if the revenues and operating expenses grow by 5% per year rather than by 2%? d. To examine the sensitivity of this project to the discount rate, management would like to compute the NPV for different discount rates. Create a graph, with the discount rate on the x-axis and the NPV on the y-axis, for discount rates ranging from 5% to 30%. For what ranges of discount rates does the project have a positive NPV? *27. Billingham Packaging is considering expanding its production capacity by purchasing a new machine, the XC-750. The cost of the XC-750 is $2.75 million. Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $50,000 feasibility study to analyze the decision to buy the XC-750, resulting in the following estimates: Q Marketing: Once the XC-750 is operational next year, the extra capacity is expected to generate $10 million per year in additional sales, which will continue for the ten-year life of the machine. Q Operations: The disruption caused by the installation will decrease sales by $5 million this year. As with Billingham’s existing products, the cost of goods for the products produced by the XC-750 is expected to be 70% of their sale price. The increased production will also require increased inventory on hand of $1 million during the life of the project, including year 0. Q Human Resources: The expansion will require additional sales and administrative personnel at a cost of $2 million per year. Q Accounting: The XC-750 will be depreciated via the straight-line method over the ten-year life of the machine. The firm expects receivables from the new sales to be 15% of revenues and payables to be 10% of the cost of goods sold. Billingham’s marginal corporate tax rate is 35%.

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a. Determine the incremental earnings from the purchase of the XC-750. b. Determine the free cash flow from the purchase of the XC-750. c. If the appropriate cost of capital for the expansion is 10%, compute the NPV of the purchase. d. While the expected new sales will be $10 million per year from the expansion, estimates range from $8 million to $12 million. What is the NPV in the worst case? In the best case? e. What is the break-even level of new sales from the expansion? What is the breakeven level for the cost of goods sold? f. Billingham could instead purchase the XC-900, which offers even greater capacity. The cost of the XC-900 is $4 million. The extra capacity would not be useful in the first two years of operation, but would allow for additional sales in years 3–10. What level of additional sales (above the $10 million expected for the XC-750) per year in those years would justify purchasing the larger machine? Real Options in Captial Budgeting 28. Why is it that real options must have positive value? 29. What kind of real option does the XC-900 machine provide to Billingham in Problem 27? 30. If Billingham knows that it can sell the XC-750 to another firm for $2 million in two years, what kind of real option would that provide?

Data Case

You have just been hired by Dell Computers in its capital budgeting division. Your first assignment is to determine the net cash flows and NPV of a proposed new type of portable computer system similar in size to a BlackBerry handheld, but which has the operating power of a high-end desktop system. Development of the new system will initially require an investment equal to 10% of net property, plant, and equipment (PPE) for the fiscal year ended January 29, 2010. The project will then require an additional investment equal to 10% of the initial investment after the first year of the project, 5% of initial investment after the second year, and 1% of initial investment after the third, fourth, and fifth years. The product is expected to have a life of five years. First-year revenues for the new product are expected to be 3% of total revenue for Dell’s fiscal year ended January 29, 2010. The new product’s revenues are expected to grow at 15% for the second year, then 10% for the third, and 5% annually for the final two years of the expected life of the project. Your job is to determine the rest of the cash flows associated with this project. Your boss has indicated that the operating costs and net working capital requirements are similar to the rest of the company’s products and that depreciation is straight-line for capital budgeting purposes. Welcome to the “real world.” Since your boss hasn’t been much help, here are some tips to guide your analysis: 1. Obtain Dell’s financial statements. (If you “really” worked for Dell you would already have this data, but at least here you won’t get fired if your analysis is off target.) Download the annual income statements, balance sheets, and cash flow statements for the last four fiscal years from MarketWatch (www.marketwatch .com). Enter Dell’s ticker symbol (DELL) and then go to “Financials.” Export the income statements and balance sheets to Excel by right-clicking while the cursor is inside each statement (if this doesn’t work—just copy and paste them). 2. You are now ready to determine the free cash flow. Compute the free cash flow for each year using Eq. 9.6 from this chapter:

280

Part 3 Valuation and the Firm Unlevered Net Income

$'''''''''''%'''''''''''& Free Cash Flow = 1 Revenues - Costs - Depreciation 2 * 1 1 - Tax Rate 2 +Depreciation - CapEx - Change in NWC Set up the timeline and computation of the free cash flow in separate, contiguous columns for each year of the project life. Be sure to make outflows negative and inflows positive. a. Assume that the project’s profitability will be similar to Dell’s existing projects in 2010 and estimate 1 Revenues - Costs 2 each year by using the 2010 EBITDA/Sales profit margin. b. Determine the annual depreciation by assuming Dell depreciates these assets by the straight-line method over a ten-year life. c. Determine Dell’s tax rate by dividing Dell’s income taxes by its income before tax in 2010. d. Calculate the net working capital required each year by assuming that the level of NWC will be a constant percentage of the project’s sales. Use Dell’s 2010 NWC/Sales to estimate the required percentage. (Use only accounts receivable, accounts payable, and inventory to measure working capital. Other components of current assets and liabilities are harder to interpret and are not necessarily reflective of the project’s required NWC—e.g., Dell’s cash holdings.) e. To determine the free cash flow, calculate the additional capital investment and the change in net working capital each year. 3. Determine the IRR of the project and the NPV of the project at a cost of capital of 12% using the Excel functions. For the calculation of NPV, include cash flows 1 through 5 in the NPV function and then subtract the initial cost 1 i.e., = NPV 1 rate, CF1 ⬊ CF5 2 + CF0 2 . For IRR, include cash flows 0 through 5 in the cash flow range.

Chapter 9 APPENDIX

MACRS Depreciation

The U.S. tax code allows for accelerated depreciation of most assets. The depreciation method that you use for any particular asset is determined by the tax rules in effect at the time you place the asset into service. (Congress has changed the depreciation rules many times over the years, so many firms that have held property for a long time may have to use several depreciation methods simultaneously.) For most business property placed in service after 1986, the IRS allows firms to depreciate the asset using the MACRS (Modified Accelerated Cost Recovery System) method. Under this method, you categorize each business asset into a recovery class that determines the time period over which you can write off the cost of the asset. The most commonly used items are classified as shown below: Q 3-year property: Tractor units, race horses over 2 years old, and horses over 12 years old. Q 5-year property: Automobiles, buses, trucks, computers and peripheral equipment, office machinery, and any property used in research and experimentation. Also includes breeding and dairy cattle.

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Q 7-year property: Office furniture and fixtures, and any property that has not been designated as belonging to another class. Q 10-year property: Water transportation equipment, single-purpose agricultural or horticultural structures, and trees or vines bearing fruit or nuts. Q 15-year property: Depreciable improvements to land such as fences, roads, and bridges. Q 20-year property: Farm buildings that are not agricultural or horticultural structures. Q 27.5-year property: Residential rental property. Q 39-year property: Nonresidential real estate, including home offices. (Note that the value of land may not be depreciated.) Generally speaking, residential and nonresidential real estate is depreciated via the straight-line method, but other classes can be depreciated more rapidly in early years. Table 9.4 shows the standard depreciation rates for assets in the other recovery classes; refinements of this table can be applied depending on the month that the asset was placed into service (consult IRS guidelines). The table indicates the percentage of the asset’s cost that may be depreciated each year, with year 0 indicating the year the asset was first put into use. Generally, year 0 is the acquisition year and the table contains the “half-year” convention, allowing for a half year of depreciation in the acquisition year itself. This is why the first year’s depreciation percentage is smaller than the second year’s.

TABLE 9.4 MACRS Depreciation Table Showing the Percentage of the Asset’s Cost That May Be Depreciated Each Year Based on Its Recovery Period

Depreciation Rate for Recovery Period 7 Years 10 Years 15 Years

Year

3 Years

5 Years

20 Years

0

33.33

20.00

14.29

10.00

5.00

3.750

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

44.45 14.81 7.41

32.00 19.20 11.52 11.52 5.76

24.49 17.49 12.49 8.93 8.92 8.93 4.46

18.00 14.40 11.52 9.22 7.37 6.55 6.55 6.56 6.55 3.28

9.50 8.55 7.70 6.93 6.23 5.90 5.90 5.91 5.90 5.91 5.90 5.91 5.90 5.91 2.95

7.219 6.677 6.177 5.713 5.285 4.888 4.522 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 2.231

10

Stock Valuation: A Second Look

LEARNING OBJECTIVES Q Value a stock as the present value of the company’s free cash flows Q Value a stock by applying common multiples based on the values of comparable firms

notation

Q Describe some of the behavioral biases that influence the way individual investors trade

Divt

dividends paid in year t

N

terminal date or forecast horizon

EBIT

earnings before interest and taxes

Pt

stock price at the end of year t

PV

present value

rE

equity cost of capital

rwacc

weighted average cost of capital

Vt

enterprise value on date t

EBITDA earnings before interest, taxes, depreciation, and amortization

282

Q Understand how information is incorporated into stock prices through competition in efficient markets

EPSt

earnings per share on date t

FCFt

free cash flow on date t

g

expected dividend growth rate

gFCF

expected free cash flow growth rate

INTERVIEW WITH

David Mandell William Blair & Company

David Mandell, a finance and accounting major who graduated from the University of Michigan in 2008, is an equity research associate at the Chicago-based investment bank William Blair & Company. “In addition to financial analysis techniques, my education also gave me the strong oral and written communication skills and experience working in teams required to be successful at my job.” His research group focuses on valuing and understanding the fundamentals of primarily small- and mid-cap industrial companies. The firm does not assign specific “price targets,” but does assign stock ratings based on calculated risk/reward potential. In performing his analyses, David prepares models of future earnings, cash flows, and other financial measures, monitors economic variables and industry trends, and collects historical data. “We use several methodologies to value our companies,” says David. “One of the methods we look at is the P/E (price/earnings) ratio. We also look at other valuation methods, including price-to-tangible-book value (price-to-book value), the ratio of enterprise value to EBITDA, and free cash flow yield (free cash flow divided by stock price). When using these tools, we consider the prospects for future company growth, the level of confidence we have in our forecast, risks, and management execution as well as historical averages, peer group averages, and recent M&A transactions.” The analysts also consider historical trends and how stocks move compared with other indicators such as gross domestic product (GDP), nonresidential construction, and the ISM index (manufacturing activity). “These indicators help us understand which economic variables can serve as buy or sell signals,” David explains. “The stock market volatility stemming from the global financial crisis did not significantly change my team’s valuation methodology,” David says. During that time period, his group used price-to-tangiblebook value, free cash flow yield, and dividend yield to identify companies that were creating tangible value for shareholders at a discounted price. “Now we are asking if the P/Es of our stock group will reach the same peaks as in prior economic cycles, or if the P/E range has compressed.”

University of Michigan, 2008

“The stock market volatility stemming from the global financial crisis did not significantly change my team’s valuation methodology.”

In mid-2010, the three most valuable U.S. companies were ExxonMobil, Microsoft, and Apple, with Google not far behind. Apple and Google do not pay a dividend, and until 2004, neither did Microsoft (yet in 2002 it was the most valuable company in the world). In Chapter 7, we discussed the basics of stocks and valued them using the dividend-discount model. As we pointed out at the end of that chapter, the dividend-discount model is not a practical approach for valuing the stock of the thousands of companies like Apple and Google that do not pay dividends. We then modified the dividend-discount model to include other forms of payout such as repurchases. Some companies, especially young ones, neither repurchase shares nor pay dividends. In this chapter, we develop a more broadly applicable method to value companies—it can even be used to value companies that currently make no cash payouts to investors. Termed the Discounted Free Cash Flow model, it is very closely linked to the concepts we just learned for capital budgeting. In fact, you will see that just as the discounted cash flows of a project determine the value of a project to the firm, the discounted cash flows of the firm as a whole determine its value to its investors.

283

284

Part 3 Valuation and the Firm The final valuation method we discuss in this chapter, the method of comparables, or “comps,” is also broadly applicable to all types of companies. This method, in which we compare the firm to others in the same line of business, is based on the intuitive idea that similar companies should be valued similarly. We will learn how to use the market’s valuation of one company to estimate a value of a similar company. We close the chapter with a discussion of the role of competition in markets. We explain how information is reflected in stock prices through investor competition and discuss the implication for investors and corporate managers. Finally, we describe some common trading biases of individual investors.

10.1

discounted free cash flow model A method for estimating a firm’s enterprise value by discounting its future free cash flow.

The Discounted Free Cash Flow Model In Chapter 7, we developed the dividend-discount model to value the stock of a dividendpaying firm. In this section, we outline an alternative approach to valuing the firm’s shares that avoids some of the difficulties of the dividend-discount model. Specifically, we consider the discounted free cash flow model, which focuses on the cash flows to all of the firm’s investors, both debt and equity holders. This model allows us to avoid the difficulties associated with estimating the impact of the firm’s borrowing decisions on earnings. It also demonstrates the important connection between the capital budgeting analysis we did in the previous chapter and its implications for the firm’s stock price. The dividend-discount model values a single share of stock. In the total payout model, we first value the firm’s equity, rather than just a single share. The discounted free cash flow model goes one step further and begins by determining the total value of the firm to all investors—both equity holders and debt holders. We begin by estimating the firm’s enterprise value, which we defined in Chapter 2 as follows:1 Enterprise Value = Market Value of Equity + Debt - Cash

(10.1)

Because the enterprise value is the value of the firm’s underlying business, unencumbered by debt and separate from any cash or marketable securities, it is also the value of the underlying business to all investors. We can interpret the enterprise value as the net cost of acquiring the firm’s equity, paying off all debt, and taking its cash; in essence, it is equivalent to owning the unlevered business. The advantage of the discounted free cash flow model is that it allows us to value a firm without explicitly forecasting its dividends, share repurchases, or use of debt.

Valuing the Enterprise How can we estimate a firm’s enterprise value? To estimate the value of the firm’s equity, we compute the present value of the firm’s total payouts to equity holders. Likewise, to estimate a firm’s enterprise value, we compute the present value of the free cash flow (FCF) that the firm has available to pay all investors, both debt and equity holders. We saw how to compute the free cash flow for a project in Chapter 9; we now perform the same calculation for the entire firm: Free Cash Flow = EBIT * 1 1 - Tax Rate 2 + Depreciation - Capital Expenditures - Increases in Net Working Capital

(10.2)

Free cash flow measures the cash generated by the firm before any payments to debt or equity holders are considered. 1

To be precise, when we say “cash,” we are referring to the firm’s cash in excess of its working capital needs, which is the amount of cash it has invested at a competitive market interest rate.

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285

Thus, just as we determine the value of a project by calculating the NPV of the project’s free cash flow, we estimate a firm’s current enterprise value, V0 , by computing the present value of the firm’s free cash flow: Discounted Free Cash Flow Model V0 = PV 1 Future Free Cash Flow of Firm 2

(10.3)

Given the enterprise value, we can estimate the share price by using Eq. 10.1 to solve for the value of equity and then divide by the total number of shares outstanding: P0 =

V0 + Cash0 - Debt 0 Shares Outstanding 0

(10.4)

In the dividend-discount model, the firm’s cash and debt are included indirectly through the effect of interest income and expenses on earnings. By contrast, in the discounted free cash flow model, we ignore interest income and expenses because free cash flow is based on EBIT (Earnings Before Interest and Taxes), but we then adjust for cash and debt directly (in Eq. 10.4).

Implementing the Model

weighted average cost of capital (WACC) The cost of capital that reflects the risk of the overall business, which is the combined risk of the firm’s equity and debt.

A key difference between the discounted free cash flow model and the earlier models we have considered is the discount rate. In previous calculations, we used the firm’s equity cost of capital, rE , because we were discounting the cash flows to equity holders. Here, we are discounting the free cash flow that will be paid to both debt and equity holders. Thus we should use the firm’s weighted average cost of capital (WACC), denoted by rwacc it is the cost of capital that reflects the risk of the overall business, which is the combined risk of the firm’s equity and debt. We interpret rwacc as the expected return the firm must pay to investors to compensate them for the risk of holding the firm’s debt and equity together. If the firm has no debt, then rwacc = rE . We will develop methods to calculate the WACC explicitly in Part 4 of this text. Given the firm’s weighted average cost of capital, we implement the discounted free cash flow model in much the same way as we did the dividend-discount model. That is, we forecast the firm’s free cash flow up to some horizon, together with a terminal (continuation) value of the enterprise: V0 =

FCF1 FCF2 FCFN VN + + g + + 2 N 1 + rwacc 1 1 + rwacc 2 1 1 + rwacc 2 1 1 + rwacc 2 N

(10.5)

Often, we estimate the terminal value by assuming a constant long-run growth rate gFCF for free cash flows beyond year N, so that VN =

FCFN + 1 1 + gFCF = ¢ ≤ * FCFN rwacc - gFCF rwacc - gFCF

(10.6)

The long-run growth rate gFCF is typically based on the expected long-run growth rate of the firm’s revenues.

EXAMPLE 10.1 Valuing Nike, Inc., Stock Using Free Cash Flow

Recall our example of Nike, Inc., from Chapter 7. Nike had sales of $19.2 billion in 2009. Suppose you expect its sales to grow at a rate of 10% in 2010, but then slow by 1% per year to the long-run growth rate that is characteristic of the apparel industry—5%—by 2015. Based on Nike’s past profitability and investment needs, you expect EBIT to be 10% of sales, increases in net working capital requirements to be 10% of any increase in sales, and capital expenditures to equal depreciation expenses. If Nike has $2.3 billion in cash, $32 million in debt, 486 million shares outstanding, a tax rate of 24%, and a weighted average cost of capital of 10%, what is your estimate of the value of Nike’s stock in early 2010?

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Part 3 Valuation and the Firm Solution Q Plan We can estimate Nike’s future free cash flow by constructing a pro forma statement as we did for HomeNet in Chapter 9. The only difference is that the pro forma statement is for the whole company, rather than just one project. Further, we need to calculate a terminal (or continuation) value for Nike at the end of our explicit projections. Because we expect Nike’s free cash flow to grow at a constant rate after 2015, we can use Eq. 10.6 to compute a terminal enterprise value. The present value of the free cash flows during the years 2010–2015 and the terminal value will be the total enterprise value for Nike. From that value, we can subtract the debt, add the cash, and divide by the number of shares outstanding to compute the price per share (Eq. 10.4). Q Execute The spreadsheet below presents a simplified pro forma for Nike based on the information we have: 1 2 3 4 5 6 7 8 9 10

Year 2009 2010 FCF Forecast ($ million) Sales 19,200.0 21,120.0 Growth versus Prior Year 10.0% EBIT (10% of sales) 2,112.0 Less: Income Tax (24%) 506.9 Plus: Depreciation — Less: Capital Expenditures — Less: Increase in NWC (10% Sales) 192.0 Free Cash Flow 1,413.1

2011

2012

23,020.8 9.0% 2,302.1 552.5 — — 190.1 1,559.5

24,862.5 8.0% 2,486.2 596.7 — — 184.2 1,705.3

2014

2015

26,602.8 28,199.0 7.0% 6.0% 2,660.3 2,819.9 638.5 676.8 — — — — 174.0 159.6 1,847.8 1,983.5

29,609.0 5.0% 2,960.9 710.6 — — 141.0 2,109.3

2013

Because capital expenditures are expected to equal depreciation, lines 7 and 8 in the spreadsheet cancel out. We can set them both to zero rather than explicitly forecast them. Given our assumption of constant 5% growth in free cash flows after 2015 and a weighted average cost of capital of 10%, we can use Eq. 10.6 to compute a terminal enterprise value: 1 + gFCF 1.05 ≤ * 2,109.3 = +44,295 million ≤ * FCF2015 = ¢ V2015 = ¢ rwacc - gFCF 0.10 - 0.05 From Eq. 10.5, Nike’s current enterprise value is the present value of its free cash flows plus the present value of the firm’s terminal value: 1,413.1 1,559.5 1,705.3 1,847.8 1,983.5 2,109.3 44,295.0 V0 = + + + + + = +32,542.4 million + 1.10 1.102 1.103 1.104 1.105 1.106 1.106 We can now estimate the value of a share of Nike’s stock using Eq. 10.4: P0 =

$32,542.4 + $2,300 - $32 = $71.63 486

Q Evaluate The total value of all of the claims, both debt and equity, on the firm must equal the total present value of all cash flows generated by the firm, in addition to any cash it currently has. The total present value of all cash flows to be generated by Nike is $32,542 million and it has $2,300 million in cash. Subtracting off the value of the debt claims ($32 million), leaves us with the total value of the equity claims and dividing by the number of shares produces the value per share.

Connection to Capital Budgeting There is an important connection between the discounted free cash flow model and the NPV rule for capital budgeting we developed in Chapter 9. Because the firm’s free cash flow is equal to the sum of the free cash flows from the firm’s current and future investments, we can interpret the firm’s enterprise value as the sum of the present value of its existing projects and the NPV of future new ones. Hence, the NPV of any investment deci-

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sion represents its contribution to the firm’s enterprise value. To maximize the firm’s share price, we should therefore accept those projects that have a positive NPV. Recall also from Chapter 9 that many forecasts and estimates were necessary to estimate the free cash flows of a project. The same is true for the firm: We must forecast its future sales, operating expenses, taxes, capital requirements, and other factors to obtain its free cash flow. On the one hand, estimating free cash flow in this way gives us flexibility to incorporate many specific details about the future prospects of the firm. On the other hand, some uncertainty inevitably surrounds each assumption. Given this fact, it is important to conduct a sensitivity analysis, as described in Chapter 9, to translate this uncertainty into a range of potential values for the stock.

EXAMPLE 10.2 Sensitivity Analysis for Stock Valuation

Problem In Example 10.1, Nike’s EBIT was assumed to be 10% of sales. If Nike can reduce its operating expenses and raise its EBIT to 11% of sales, how would the estimate of the stock’s value change?

Solution Q Plan In this scenario, EBIT will increase by 1% of sales compared to Example 10.1. From there, we can use the tax rate (24%) to compute the effect on the free cash flow for each year. Once we have the new free cash flows, we repeat the approach in Example 10.1 to arrive at a new stock price. Q Execute In year 1, EBIT will be 1% * +21,120.0 million = +211.2 million higher. After taxes, this increase will raise the firm’s free cash flow in year 1 by 1 1 - 0.24 2 * +211.2 million = +160.5 million, to $1,573.6 million. Doing the same calculation for each year, we get the following revised FCF estimates: Year

2010

2011

2012

2013

2014

2015

FCF

1,573.6

1,734.5

1,894.3

2,050.0

2,197.8

2,334.3

We can now reestimate the stock price as in Example 10.1. The terminal value is V2015 = [1.05/ 1 0.10 - 0.05 2 ] * 2,334.3 = +49,020.3 million, so V0 =

1,573.6 1,734.5 1,894.3 2,050.0 2,197.8 2,334.3 49,020.3 + + + + + + = +36,040.4 million 1.10 1.102 1.103 1.104 1.105 1.106 1.106

The new estimate for the value of the stock is P0 = 1 36,040.6 + 2,300 - 32 2 /486 = +78.82 per share, a difference of about 10% compared to the result found in Example 10.1. Q Evaluate

Nike’s stock price is fairly sensitive to changes in the assumptions about its profitability. A 1% permanent change in its margins affects the firm’s stock price by 10%.

Figure 10.1 summarizes the different valuation methods we have discussed so far. We use the present value of a stock’s future dividends to determine its value. We can estimate the total market capitalization of the firm’s equity from the present value of the firm’s total payouts, which includes dividends and share repurchases. Finally, the present value of the firm’s free cash flow, which is the amount of cash the firm has available to make payments to equity or debt holders, determines the firm’s enterprise value.

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FIGURE 10.1 A Comparison of Discounted Cash Flow Models of Stock Valuation

Concept Check

10.2

method of comparables An estimate of the value of a firm based on the value of other, comparable firms or other investments that are expected to generate very similar cash flows in the future.

valuation multiple A ratio of a firm’s value to some measure of the firm’s scale or cash flow.

By computing the present value of the firm’s dividends, total payouts, or free cash flows, we can estimate the value of the stock, the total value of the firm’s equity, or the firm’s enterprise value. The final column details what adjustment is necessary to obtain the stock price. Present Value of...

Determines the...

To Get Stock Price Estimate...

Dividend Payments

Stock Price

No adjustment necessary

Total Payouts (All dividends and repurchases)

Equity Value

Divide by shares oustanding

Free Cash Flow (Cash available to pay all security holders)

Enterprise Value

Subtract what does not belong to equity holders (debt and perferred stock), add back cash and marketable securities, and divide by shares outstanding

1. What is the relation between capital budgeting and the discounted free cash flow model? 2. Why do we ignore interest payments on the firm’s debt in the discounted free cash flow model?

Valuation Based on Comparable Firms So far, we have valued a firm or its stock by considering the expected future cash flows it will provide to its owner. The Valuation Principle then tells us that its value is the present value of its future cash flows, because the present value is the amount we would need to invest elsewhere in the market to replicate the cash flows with the same risk. Another application of the Valuation Principle is the method of comparables. In the method of comparables (or “comps”), rather than value the firm’s cash flows directly, we estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future. For example, consider the case of a new firm that is identical to an existing publicly traded company. Recall that from competitive market prices, the Valuation Principle implies that two securities with identical cash flows must have the same price. Thus, if these firms will generate identical cash flows, we can use the market value of the existing company to determine the value of the new firm. Of course, identical companies do not really exist. Even two firms in the same industry selling the same types of products, while similar in many respects, are likely to be of a different size or scale. For example, Hewlett-Packard and Dell both sell personal computers directly to consumers using the Internet. In 2009, Hewlett-Packard had sales of $115 billion, whereas Dell had sales of approximately $53 billion. In this section, we consider ways to adjust for scale differences to use comparables to value firms with similar businesses and then discuss the strengths and weaknesses of this approach.

Valuation Multiples We can adjust for differences in scale between firms by expressing their value in terms of a valuation multiple, which is a ratio of the value to some measure of the firm’s scale. As

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an analogy, consider valuing an office building. A natural measure to consider would be the price per square foot for other buildings recently sold in the area. Multiplying the size of the office building under consideration by the average price per square foot would typically provide a reasonable estimate of the building’s value. We can apply this same idea to stocks, replacing square footage with some more appropriate measure of the firm’s scale. The Price-Earnings Ratio. The most common valuation multiple is the price-earnings ratio, which we introduced in Chapter 2. The P/E ratio is so common that it is almost always part of the basic statistics computed for a stock (as shown in Figure 10.2, the screenshot from Google Finance for Nike). A firm’s P/E ratio is equal to the share price divided by its earnings per share. The intuition behind its use is that, when you buy a stock, you are in a sense buying the rights to the firm’s future earnings. If differences in the scale of firms’ earnings are likely to persist, you should be willing to pay proportionally more for a stock with higher current earnings. Using this idea we can estimate the value of a share of stock of a firm by using the P/E ratios of other firms. For example, we can estimate the stock price of a private firm by multiplying its current earnings per share (EPS) by the average P/E ratio of comparable public firms.

FIGURE 10.2 Stock Price Quote for Nike (NKE)

This screenshot from Google Finance shows the basic stock price information and price history charting for the common stock of Nike. The historical price chart covers the period February through early May 2010. Notice that the price-earnings (P/E) ratio is listed as part of the basic information.

Source: www.google.com/finance?q=nke.

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Part 3 Valuation and the Firm

EXAMPLE 10.3

Problem

Valuation Using the Price-Earnings Ratio

Suppose furniture manufacturer Herman Miller, Inc., has earnings per share of $1.38. If the average P/E of comparable furniture stocks is 21.3, estimate a value for a share of Herman Miller’s stock using the P/E as a valuation multiple. What are the assumptions underlying this estimate?

Solution Q Plan We estimate a share price for Herman Miller by multiplying its EPS by the P/E of comparable firms:

EPS * P/E = Earnings per Share * 1 Price per Share Earnings per Share 2 = Price per Share

Q Execute P0 = +1.38 * 21.3 = +29.39. This estimate assumes that Herman Miller will have similar future risk, payout rates, and growth rates to comparable firms in the industry. Q Evaluate Although valuation multiples are simple to use, they rely on some very strong assumptions about the similarity of the comparable firms to the firm you are valuing. It is important to consider whether these assumptions are likely to be reasonable—and thus to hold—in each case.

trailing earnings A firm’s earnings over the prior 12 months. forward earnings A firm’s anticipated earnings over the coming 12 months. trailing P/E A firm’s price-earnings (P/E) ratio calculated using trailing (past) earnings. forward P/E A firm’s price-earnings (P/E) ratio calculated using forward (expected) earnings.

We can compute a firm’s P/E ratio by using either trailing earnings—earnings over the prior 12 months—or forward earnings—expected earnings over the coming 12 months—with the resulting ratio being called the trailing P/E or the forward P/E, respectively. For valuation purposes, the forward P/E is generally preferred, as we are most concerned about future earnings. To understand how P/E ratios relate to the other valuation techniques we have discussed, consider the dividend discount model introduced in Chapter 7.2 For example, in the case of constant dividend growth (see Eq. 7.6), we had P0 =

Div1 rE - g

Dividing through by EPS1 , we find that Forward P/E =

P0 Div1/EPS1 Dividend Payout Rate = = rE - g rE - g EPS1

(10.7)

In Chapter 7, we showed that Nike’s current price is consistent with an equity cost of capital of 10% and an expected dividend growth rate of 8.5%. From the Nike quote, we can also see that Nike has earnings per share (EPS) of $3.51 and a dividend of $0.27 per quarter, or $1.08 per year which gives a dividend payout rate of 1.08/3.51 = 0.308. Assuming that earnings growth and payout rates remain at this level for the foreseeable future, then we could compute the forward P/E as: Forward P/E =

1.08/3.51 = 20.51, which is not far off its reported P/E of 21.78. .10 - 0.085

Equation 10.7 suggests that firms and industries that have high growth rates, and that generate cash well in excess of their investment needs so that they can maintain high payout rates, should have high P/E multiples. Taking the example of Nike we showed that 2

We use the dividend discount model rather than discounted cash flows because price and earnings are variables associated exclusively with equity.

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291

at an expected growth rate of 8.5%, it would have a P/E ratio of 20.51. If our growth expectations were lower, its P/E would drop. Holding current earnings, dividends, and equity cost of capital constant, but decreasing the growth rate to 5%, we would have: Forward P/E =

1.08/3.51 = 6.15 .10 - 0.05

This result is much lower than its current P/E of 21.78 making it clear that simply comparing P/E ratios without taking into account growth prospects can be highly misleading. Figure 10.3 shows the relationship between expected earnings growth and P/E ratios.

FIGURE 10.3 Relating the P/E Ratio to Expected Future Growth

The graph shows the expected growth in earnings under two growth scenarios for Nike: 8.5% and 5%. Current earnings per share is $3.51. Higher growth increases the PV of the earnings stream, which means that the price increases. The result is that the higher price divided by current earnings yields a higher P/E ratio. We found that a growth rate of 8.5% implied a P/E ratio of 20.51 while a growth rate of 5% implied a P/E ratio of 6.15. The graph shows how higher expected growth translates into a higher P/E.

30

Growth at 8.5% Growth at 5%

25 Higher growth translates to a P/E of 20.51

Earnings

20 15

10

Current earnings of $3.51

5

0

Low growth translates to a P/E of 6.15 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Years

EXAMPLE 10.4 Growth Prospects and the Price-Earnings Ratio

Problem Amazon.com and Macy’s are both retailers. In 2010, Amazon had a price of $138.71 and forward earnings per share of $2.61. Macy’s had a price of $20.87 and forward earnings per share of $1.87. Calculate their forward P/E ratios and explain the difference.

Solution Q Plan We can calculate their P/E ratios by dividing each company’s price per share by its forward earnings per share. The difference we find is most likely due to different growth expectations. Q Execute Forward P/E for Amazon = $138.71/$2.61 = 53.15. Forward P/E for Macy’s = $20.87/$1.87 = 11.16. Amazon’s P/E ratio is higher because investors expect its earnings to grow more than Macy’s.

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Part 3 Valuation and the Firm

Q Evaluate Although both companies are retailers, they have very different growth prospects, as reflected in their P/E ratios. Investors in Amazon.com are willing to pay 53 times this year’s expected earnings because they are also buying the present value of high future earnings created by expected growth.

Enterprise Value Multiples. The P/E ratio has the same limitations as the dividend discount model—because it relates exclusively to equity, it ignores the effect of debt. Consequently, it is also common practice to use valuation multiples based on the firm’s enterprise value. By representing the total value of the firm’s underlying business rather than just the value of equity, the enterprise value allows us to compare firms with different amounts of leverage. Because the enterprise value represents the entire value of the firm before the firm pays its debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows before interest payments are made. Common multiples to consider are enterprise value to EBIT, EBITDA (earnings before interest, taxes, depreciation, and amortization), and free cash flow. However, because capital expenditures can vary substantially from period to period (e.g., a firm may need to add capacity and build a new plant one year, but then may not need to expand further for many years), most practitioners rely on enterprise value to EBITDA (EV/EBITDA) multiples. Enterprise value multiples value the entire firm, and so they are most closely related to the discount cash flow model. When expected free cash flow growth is constant, we can use Eq. 10.6 to write enterprise value to EBITDA as FCF1 V0 rwacc - gFCF FCF1/EBITDA1 = = rwacc - gFCF EBITDA1 EBITDA1

(10.8)

As with the P/E multiple, this valuation multiple is higher for firms with high growth rates and low capital requirements (which means that free cash flow is high in proportion to EBITDA).

EXAMPLE 10.5 Valuation Using the Enterprise Value Multiple

Problem Fairview, Inc., is an ocean transport company with EBITDA of $50 million, cash of $20 million, debt of $100 million, and 10 million shares outstanding. The ocean transport industry as a whole has an average EV/EBITDA ratio of 8.5. What is one estimate of Fairview’s enterprise value? What is a corresponding estimate of its stock price?

Solution Q Plan To estimate Fairview’s enterprise value, we multiply its EBITDA by the average EV/EBITDA ratio of its industry. From there, we can subtract Fairview’s debt and add its cash to calculate its equity value. Finally, we can divide by the number of shares outstanding to arrive at its stock price. Q Execute Fairview’s enterprise value estimate is +50 million * 8.5 = +425 million. Next, subtract the debt from its enterprise value and add in its cash: +425 million - +100 million + +20 million = +345 million, which is an estimate of the equity value. Its stock price estimate is equal to its equity value estimate divided by the number of shares outstanding: +345 million 10 million = +34.50.

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Q Evaluate If we assume that Fairview should be valued similarly to the rest of the industry, then $425 million is a reasonable estimate of its enterprise value and $34.50 is a reasonable estimate of its stock price. However, we are relying on the assumption that Fairview’s expected free cash flow growth is similar to the industry average. If that assumption is wrong, so is our valuation.

Other Multiples. Many other valuation multiples are used. Looking at the enterprise value as a multiple of sales can be useful if it is reasonable to assume the firm will maintain a similar margin in the future. For firms with substantial tangible assets, the ratio of price-to-book value of equity per share is sometimes used as a valuation multiple. Some multiples are specific to an industry. In the cable TV industry, for example, analysts compare enterprise value per subscriber.

Limitations of Multiples If comparable firms were identical to the firm being valued, the firms’ multiples would match precisely. Of course, firms are not identical, so the usefulness of a valuation multiple will inevitably depend on the nature of the differences between firms and the sensitivity of the multiples to these differences. Table 10.1 lists several valuation multiples, as of May 2010, for firms in the footwear industry that could be used as comparables for Nike. Also shown in the table is the average for each multiple, together with the range around the average (in percentage terms). The bottom rows showing the range make it clear that the footwear industry has a lot of dispersion for all the multiples (for example, Deckers has a price-to-book (P/B) of 3.59, while Rocky Shoes and Boots has a P/B of only 0.56). While the P/E multiple shows the smallest variation, even with it we cannot expect to obtain a precise estimate of a firm’s value.

TABLE 10.1 Stock Prices and Multiples for the Footwear Industry (excluding Nike), May 2010

Name Adidas AG Puma AG

Market Capitalization ($ million)

Enterprise Value ($ million)

P/E

Price/Book

Enterprise Value/Sales

Enterprise Value/EBITDA

8,950

8,554

21.90

2.34

0.82

11.08

3,680

2,984

17.91

2.92

1.21

11.48

Deckers Outdoor Corp.

1,760

1,400

14.63

3.59

1.68

6.94

Skechers U.S.A.

1,730

1,420

17.11

2.20

0.89

8.37

Wolverine World Wide

1,460

1,380

18.72

3.08

1.22

9.28

531

455

21.21

2.37

1.62

12.64

Weyco Group

281

252

20.24

1.74

1.11

10.75

LaCrosse Footwear

118

99

15.14

1.95

0.67

6.54

R. G. Barry Corp.

114

79

11.11

1.96

0.63

4.64

Volcom, Inc.

Rocky Shoes & Boots

45

89

25.96

0.56

0.38

5.45

Average

18.39

2.27

1.02

8.72

Maximum

+41%

+58%

+64%

+45%

Minimum

-40%

-75%

-63%

-47%

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Part 3 Valuation and the Firm The differences in these multiples most likely reflect differences in expected future growth rates, risk (and therefore costs of capital), and, in the case of Puma and Adidas, differences in accounting conventions between the United States and Germany. Investors in the market understand that these differences exist, so the stocks are priced accordingly. When valuing a firm using multiples, however, there is no clear guidance about how to adjust for these differences other than by narrowing the set of comparables used. Another limitation of comparables is that they provide only information regarding the value of the firm relative to the other firms in the comparison set. Using multiples will not help us determine whether an entire industry is overvalued, for example. This issue became especially important during the Internet boom of the late 1990s. Because many of these firms did not have positive cash flows or earnings, new multiples were created to value them (for instance, price to “page views”). While these multiples could justify the value of these firms in relationship to one another, it was much more difficult to justify the stock prices of many of these firms using a realistic estimate of cash flows and the discounted free cash flow approach.

Comparison with Discounted Cash Flow Methods The use of a valuation multiple based on comparables is best viewed as a shortcut. Rather than separately estimate the firm’s cost of capital and future earnings or free cash flows, we rely on the market’s assessment of the value of other firms with similar future prospects. In addition to its simplicity, the multiples approach has the advantage of being based on actual stock prices of real firms, rather than on what may be unrealistic forecasts of future cash flows. The most important shortcoming of the comparables approach is that it does not take into account materially important differences among firms. For example, the approach ignores the fact that some firms have exceptionally talented managers, others have developed more efficient manufacturing process, and still others might hold a patent on a new technology. Discounted cash flow methods have an advantage because they allow us to incorporate specific information about the firm’s cost of capital or future growth. Thus, because the true driver of value for any firm is its ability to generate cash flows for its investors, the discounted cash flow methods have the potential to be more accurate than the use of a valuation multiple.

Stock Valuation Techniques: The Final Word In the end, no single technique provides a final answer regarding a stock’s true value. Indeed, all approaches inevitably require assumptions or forecasts that are too uncertain to provide a definitive assessment of the firm’s value. Most real-world practitioners use a combination of these approaches and gain confidence in the outcome if the results are consistent across a variety of methods. Figure 10.4 compares the ranges of values for Nike stock using the different valuation methods discussed in this chapter and in Chapter 7. The firm’s stock price of $76.43 on May 11, 2010 was within the range of some methods, but higher than the range suggested by some of the multiples. Hence, based on this evidence alone, we would not conclude that the stock is obviously under- or over-priced. But if this were not the case —what if these valuation techniques produce valuations markedly different to what the stock is trading at in the market? In the next section, we tackle this question.

Concept Check

3. What are some common valuation multiples? 4. What implicit assumptions do we make when valuing a firm using multiples based on comparable firms?

Chapter 10 Stock Valuation: A Second Look

FIGURE 10.4 Range of Valuations for Nike Stock Using Various Valuation Methods

295

Valuations from multiples are based on the low, high, and average values of the comparable firms from Table 10.1 (see Problems 12 and 13 at the end of this chapter). The constant dividend growth model is based on a 10% equity cost of capital and dividend growth rates of 6% to 9%, as discussed at the beginning of Section 7.5. The discounted free cash flow model is based on Example 10.1 with the range of parameters in Problem 8 at the end of this chapter. Midpoints are based on average multiples or base-case assumptions. Red and blue regions show the variation between the lowest-multiple/worstcase scenario and the highest-multiple/best-case scenario. Nike’s actual share price of $76.43 is indicated by the gray line.

Valuation Method

Discounted FCF Constant Dividend Growth EV/EBITDA EV/Sales Price/Book P/E 0

10

20

30

40

50

60

70

80

90

100

110

120

Value per Share ($)

INTERVIEW WITH

MARILYN FEDAK

Marilyn G. Fedak is the Vice Chair, Investment Services, and was formerly head of Global Value Equities, at AllianceBernstein, a publicly traded global asset management firm with approximately $450 billion in assets.

What valuation methods do you use to identify buying opportunities for value stocks?

QUESTION:

ANSWER: We use both a dividend-discount model (DDM) and a proprietary quantitative return model called the Global Edge Model (GEM). For our non-U.S. portfolios, we use the GEM model; in the U.S., we use a combination of GEM and the DDM. At its most basic level, the DDM provides a way to evaluate how much we need to pay today for a company’s future earnings and cash flow.* All things being equal, we are looking to buy as much earnings power as cheaply as we can. It is a very reliable methodology, if you have the right forecasts for companies’ future earnings. Our GEM model encompasses a variety of valuation measures, such as P/E and price-to-book ratios and selected success factors—for example, ROE and price momentum.

In both the U.S. and non-U.S. portfolios, we use these valuation tools to rank companies from the most undervalued to the most expensive. We focus on the stocks that rank the highest. Our decision-making bodies, the investment policy groups, meet with analysts to quality-control the forecasts for the highest ranked group of stocks. Once the forecasts are approved, we add risk tools to construct optimal portfolios. QUESTION:

Are there drawbacks to these models?

ANSWER: Both models have advantages and drawbacks. The DDM is a very reliable valuation methodology. However, its focus on forecasts of cash flow or earnings over some future period requires a large, highly skilled body of research analysts. And, it is oriented to the long term, so the timing of purchases and sales can be too early. The Global Edge Model is very useful to efficiently evaluate investments within large universes. However, it is very oriented to

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current profitability and valuation metrics—not the future. As such, judgment has to be applied to determine if a company is likely to sustain similar characteristics going forward.

Did the precipitous decline in stock prices in late 2008 and early 2009 cause you to retool your valuation methodology?

QUESTION:

ANSWER:

In 2006, we began studying the interaction of the DDM and GEM models and determined that combining the two models gives us superior results to a single methodology when evaluating U.S. securities. The DDM focuses on forecasts of a company’s future, whereas the quant [quantitative] return model captures a

10.3

company’s history and current status. This new methodology was very helpful to us in 2008, when the GEM model signaled caution for certain sectors that looked inexpensive based on the DDM. We have also broadened our research to incorporate more external inputs and have assigned a higher probability to unlikely events such as the recent government intervention in the financial and auto industries. On the risk side, we have added a refinancing risk tool and are tracking short interest in various equities. *Because of historical usage, many practitioners use the term “dividend-discount model” to refer to the entire class of cash flow discount models.

Information, Competition, and Stock Prices As shown in Figure 10.5, the models described in this chapter and in Chapter 7 link the firm’s expected future cash flows, its cost of capital (determined by its risk), and the value of its shares. But what conclusions should we draw if the actual market price of a stock does not appear to be consistent with our estimate of its value? Is it more likely that the stock is mispriced or that we are mistaken about its risk and future cash flows?

Information in Stock Prices Suppose you are a new junior analyst assigned to research Nike’s stock and assess its value. You scrutinize the company’s recent financial statements, look at the trends in the industry, and forecast the firm’s future earnings, dividends, and free cash flows. After you carefully crunch the numbers, you estimate the stock’s value to be $85 per share. On your way to present your analysis to your boss, you run into a slightly more experienced colleague in the elevator. It turns out that your colleague has been researching the same stock. But according to her analysis, the value of Nike stock is only $65 per share. What would you do? Although you could just assume your colleague is wrong, most of us would reconsider our own analysis. The fact that someone else who has carefully studied the same stock has come to a very different conclusion is powerful evidence that we might be mistaken. In the face of this information from our colleague, you would probably adjust your

FIGURE 10.5 The Valuation Triad

Valuation models determine the relationship among the firm’s future cash flows, its cost of capital, and the value of its shares. We can use the stock’s expected cash flows and cost of capital to assess its market price (share value). Conversely, we can use the market price to assess the firm’s future cash flows or cost of capital. Share Value

Future Cash Flows Valuation Model Cost of Capital

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assessment of the stock’s value downward. Of course, your colleague might also revise her opinion upward based on your assessment. After sharing the analyses, we would likely end up with a consensus estimate somewhere between $65 and $85 per share. This type of encounter happens millions of times every day in the stock market. When a buyer seeks to buy a stock, the willingness of other parties to sell the same stock suggests that they value the stock differently. This information should lead both buyers and sellers to revise their valuations. Ultimately, investors trade until they reach a consensus regarding the value (market price) of the stock. In this way, stock markets aggregate the information and views of many different investors. Thus, if your valuation model suggests a stock is worth $30 per share when it is trading for $20 per share in the market, the discrepancy is equivalent to knowing that thousands of investors—many of them professionals who have access to the best information about the stock available—disagree with your assessment. This knowledge should make you reconsider your original analysis. You would need a very compelling reason to trust your own estimate in the face of such contrary opinions. What conclusion can we draw from this discussion? Recall Figure 10.5, in which a valuation model links the firm’s future cash flows, its cost of capital, and its share price. In other words, given accurate information about any two of these variables, a valuation model allows us to make inferences about the third variable. Thus the way we use a valuation model will depend on the quality of our information: The model will tell us the most about the variable for which our prior information is the least reliable. For a publicly traded firm, its market price should already provide very accurate information, aggregated from a multitude of investors, regarding the true value of its shares. In these situations, the best use of a valuation model is to inform us about the things we cannot observe directly—the firm’s future cash flows or cost of capital. Only in the relatively rare case in which we have some superior information that other investors lack regarding the firm’s cash flows and cost of capital would it make sense to secondguess the stock price.

EXAMPLE 10.6 Using the Information in Market Prices

Problem Suppose Tecnor Industries will have free cash flows next year of $40 million. Its weighted average cost of capital is 11%, and you expect its free cash flows to grow at a rate of approximately 4% per year, though you are somewhat unsure of the precise growth rate. Tecnor has 10 million shares outstanding, no debt, and $20 million in cash. If Tecnor’s stock is currently trading for $55.33 per share, how would you update your beliefs about its dividend growth rate?

Solution Q Plan If we apply the growing perpetuity formula for the growing FCF based on a 4% growth rate, we can estimate a stock price using Eq. 10.3 and Eq. 10.4. If the market price is higher than our estimate, it implies that the market expects higher growth in FCF than 4%. Conversely, if the market price is lower than our estimate, the market expects FCF growth to be less than 4%. Q Execute

Applying the growing perpetuity formula, we have PV 1 FCF 2 = 40 1 0.11 - 0.04 2 = $571.43 million. Applying Eq. 10.4, the price per share would be 1 +571.43 million - 0 + +20 million 2 10 million shares = +59.14 per share. The market price of $55.33, however, implies that most investors expect FCF to grow at a somewhat slower rate. Q Evaluate Given the $55.33 market price for the stock, we should lower our expectations for the FCF growth rate from 4% unless we have very strong reasons to trust our own estimate.

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efficient markets hypothesis The idea that competition among investors works to eliminate all positive-NPV trading opportunities. It implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors.

Competition and Efficient Markets The notion that market prices reflect the information of many investors is a natural consequence of investor competition. If information were available that indicated buying a stock had a positive NPV, investors with that information would choose to buy the stock; their attempts to purchase it would then drive up the stock’s price. By a similar logic, investors with information that selling a stock had a positive NPV would sell it, so the stock’s price would fall. The idea that competition among investors works to eliminate all positive-NPV trading opportunities is the efficient markets hypothesis. It implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors.

Forms of Market Efficiency The type of market efficiency we describe here, where all publicly available information is incorporated very quickly into stock prices, is often called semistrong form market efficiency. The term “semistrong” indicates that it is not as complete as strong form market efficiency, where prices immediately incorporate all information, including private information known, for example, only to managers. Finally, the term weak form market efficiency means that only the history of past prices is already reflected in the stock price. It helps to think of the different forms of market efficiency as meaning that prices incorporate a steadily increasing set of information, each of which encompasses all the lower forms. For example, since the history of past prices is public information, semistrong form efficiency encompasses weak form. The diagram illustrates the idea. In the diagram, the information sets of weak form, semistrong form, and strong form efficiency are represented by the blue, green, and yellow circles, respectively. Not all market participants believe that the stock market is semistrong form efficient. Technical analysts, who look for patterns in stock prices, do not believe the market is even weak form efficient. Mutual fund managers and fundamental analysts, such as those who work for brokerages and make stock recommendations, believe that mispricing can be uncovered by careful analysis of company fundamentals. There is evidence

that traders with inside information about upcoming merger or earnings announcements can make abnormal returns by trading (illegally) on that information, so the market is clearly not strong form efficient.

All information

All public information

History of stock prices

What happens when new information about a stock arrives? The answer depends on the degree of competition, that is, on the number of investors who have access to this new information. Consider two important cases. Public, Easily Interpretable Information. Information that is available to all investors includes information in news reports, financial statements, corporate press releases, or other public data sources. If investors can readily ascertain the effects of this information on the firm’s future cash flows, then all investors can determine how this information will change the firm’s value. In this situation, we expect competition between investors to be fierce and the stock price to react nearly instantaneously to such news. A few lucky investors might be able to trade a small quantity of shares before the price has fully adjusted. Most investors, however, would find that the stock price already reflected the new information before they were able to trade on it. In other words, the efficient markets hypothesis holds very well with respect to this type of information.

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EXAMPLE 10.7 Stock Price Reactions to Public Information

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Problem Myox Labs announces that it is pulling one of its leading drugs from the market, owing to the potential side effects associated with the drug. As a result, its future expected free cash flow will decline by $85 million per year for the next ten years. Myox has 50 million shares outstanding, no debt, and an equity cost of capital of 8%. If this news came as a complete surprise to investors, what should happen to Myox’s stock price upon the announcement?

Solution Q Plan In this case, we can use the discounted free cash flow method. With no debt, rwacc = rE = 8%. The effect on the Myox’s enterprise value will be the loss of a ten-year annuity of $85 million. We can compute the effect today as the present value of that annuity. Q Execute Using the annuity formula, the decline in expected free cash flow will reduce Myox’s enterprise value by $85 million *

1 1 ¢1 ≤ = $570.36 million 0.08 1.0810

Thus, the stock price should fall by +570/50 = $11.41 per share. Q Evaluate Because this news is public and its effect on the firm’s expected free cash flow is clear, we would expect the stock price to drop by $11.41 per share nearly instantaneously.

Private or Difficult-to-Interpret Information. Of course, some information is not publicly available. For example, an analyst might spend considerable time and effort gathering information from a firm’s employees, competitors, suppliers, or customers that is relevant to the firm’s future cash flows. This information is not available to other investors who have not devoted a similar effort to gathering it. Even when information is publicly available, it may be difficult to interpret. Nonexperts in the field may find it challenging to evaluate research reports on new technologies, for example. It may take a great deal of legal and accounting expertise and effort to understand the full consequences of a highly complicated business transaction. Certain consulting experts may have greater insight into consumer tastes and the likelihood of a product’s acceptance. In these cases, while the fundamental information may be public, the interpretation of how that information will affect the firm’s future cash flows is itself private information. As an example, imagine that Phenyx Pharmaceuticals has just announced the development of a new drug for which the company is seeking approval from the U.S. Food and Drug Administration (FDA). If the drug is approved and subsequently launched in the U.S. market, the future profits from the new drug will increase Phenyx’s market value by $750 million, or $15 per share given its 50 million shares outstanding. Assume that the development of this drug comes as a surprise to investors, and that the average likelihood of FDA approval is 10%. In that case, because many investors probably know the chance of FDA approval is 10%, competition should lead to an immediate jump in Phenyx’s stock price of 10% * +15 = +1.50 per share. Over time, however, analysts and experts in the field will likely make their own assessments of the probable efficacy of the drug. If they conclude that the drug looks more promising than average, they will begin to trade on their private information and buy the stock, and the firm’s price will tend to drift higher over time. If the experts conclude that the drug looks less promising than average, however, they will tend to sell the stock, and the firm’s price will drift lower over time. Of course, at the time of the announcement, uninformed investors do not know which way it will go. Examples of possible price paths are shown in Figure 10.6.

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FIGURE 10.6

Phenyx’s stock price jumps on the announcement based on the average likelihood of FDA approval. The stock price then drifts up (green path) or down (orange path) as informed traders trade on their more accurate assessment of the drug’s likelihood of approval and hence entry into the U.S. market. At the time of the announcement, uninformed investors do not know which way the stock will go.

Possible Stock Price Paths for Phenyx Pharmaceuticals

$9 $8

Stock Price

300

$7

Announcement

$6 $5 $4 $3 Time

When private information is in the hands of only a relatively small number of investors, these investors may be able to profit by trading on their information.3 In this case, the efficient markets hypothesis will not hold in the strict sense. However, as these informed traders begin to trade, their actions will tend to move prices, so over time prices will begin to reflect their information as well. If the profit opportunities from having this type of information are large, other individuals will attempt to gain the expertise and devote the resources needed to acquire it. As more individuals become better informed, competition to exploit this information will increase. Thus, in the long run, we should expect that the degree of “inefficiency” in the market will be limited by the costs of obtaining the information.

Lessons for Investors and Corporate Managers The effect of competition based on information about stock prices has important consequences for both investors and corporate managers. Consequences for Investors. As in other markets, investors should be able to identify positive-NPV trading opportunities in securities markets only if some barrier or restriction to free competition exists. An investor’s competitive advantage may take several 3

Even with private information, informed investors may find it difficult to profit from that information, because they must find others who are willing to trade with them; that is, the market for the stock must be sufficiently liquid. A liquid market requires that other investors in the market have alternative motives to trade (for example, selling shares of a stock to purchase a house) and so are willing to trade even when facing the risk that other traders may be better informed.

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forms. For instance, the investor may have expertise or access to information known to only a few people. Alternatively, the investor may have lower trading costs than other market participants and so can exploit opportunities that others would find unprofitable. In all cases, the source of the positive-NPV trading opportunity must be something that is difficult to replicate; otherwise, any gains would be competed away in short order. While the fact that positive-NPV trading opportunities are hard to come by may be disappointing, there is some good news as well. If stocks are fairly priced according to our valuation models, then investors who buy stocks can expect to receive future cash flows that fairly compensate them for the risk of their investment. In such cases, the average investor can invest with confidence, even if he or she is not fully informed. Implications for Corporate Managers. If stocks are fairly valued according to the models we have described in this chapter and in Chapter 7, then the value of the firm is determined by the cash flows that it can pay to its investors. This result has several key implications for corporate managers: Q Focus on NPV and free cash flow. A manager seeking to boost the price of her firm’s stock should make investments that increase the present value of the firm’s free cash flow. Thus the capital budgeting methods outlined in Chapter 9 are fully consistent with the objective of maximizing the firm’s share price. Q Avoid accounting illusions. Many managers make the mistake of focusing on accounting earnings as opposed to free cash flows. According to the efficient markets hypothesis, the accounting consequences of a decision do not directly affect the value of the firm and should not drive decision making. Q Use financial transactions to support investment. With efficient markets, the firm can sell its shares at a fair price to new investors. As a consequence, the firm should not be constrained from raising capital to fund positive-NPV investment opportunities.

The Efficient Markets Hypothesis Versus No Arbitrage There is an important distinction between the efficient markets hypothesis and the notion of no arbitrage that we introduced in Chapter 3. An arbitrage opportunity is a situation in which two securities (or portfolios) with identical cash flows have different prices. Because anyone can earn a sure profit in this situation by buying the low-priced security and selling the high-priced one, we expect investors to immediately exploit and eliminate these opportunities. Thus, arbitrage opportunities will not be found. The efficient markets hypothesis states that the best estimate of the value of a share of stock is its market price. That is, investors’ own estimates of value are not as accurate as the market price. But that does not mean that the market price always correctly estimates the value of a share of stock. There is a difference between the best estimate and being correct. Thus there is no reason to expect the market price to always assess value accurately; rather, the price is best viewed as an approximation. However, because the price is the best estimate, the efficient market hypothesis implies that you cannot tell which prices overestimate and which underestimate the true value of the stock.

Concept Check

5. State the efficient markets hypothesis. 6. What are the implications of the efficient markets hypothesis for corporate managers?

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10.4

Individual Biases and Trading Not all investors accept the notion that second guessing the stock prices requires specialized knowledge and unusual skills. Instead they attempt to make money by trading and in most cases end up losing money. In this next section we will briefly discuss some common psychological biases and consider how they affect individuals’ trading behavior. In an efficient market, these biases can be costly, resulting in lower realized returns and reduced wealth.

Excessive Trading and Overconfidence

overconfidence hypothesis The tendency of individual investors to trade too much based on the mistaken belief that they can pick winners and losers better than investment professionals.

Trading is expensive; you must pay commissions on top of the difference between the bid and ask price, called the spread. Given how hard it should be to identify over- and undervalued stocks, you might then expect individual investors to take a conservative approach to trading. However, in an influential study of the trading behavior of individual investors that held accounts at a discount brokerage, researchers Brad Barber and Terrance Odean found that individual investors tend to trade very actively, with average turnover almost 50% above the average of all investors including institutions during the time period of their study.4 What might explain this trading behavior? Psychologists have known since the 1960s that uninformed individuals tend to overestimate the precision of their knowledge. For example, many sports fan sitting in the stands confidently second-guess the coaching decisions on the field, truly believing that they can do a better job. In finance we call investors’ presumptuousness of their ability to beat the market by overtrading the overconfidence hypothesis. Barber and Odean hypothesized that this kind of behavior also characterizes individual investment decision making: Like sports fans, individual investors believe they can pick winners and losers when, in fact, they cannot; this overconfidence leads them to trade too much. An implication of this overconfidence hypothesis is that, assuming they have no true ability, investors who trade more will not earn higher returns. Instead, their performance will be worse once we take into account the costs of trading (due to both commissions and bid-ask spreads). Figure 10.7 documents precisely this result, showing that much investor trading appears not to be based on rational assessments of performance.

Hanging On to Losers and the Disposition Effect disposition effect The tendency to hold on to stocks that have lost value and sell stocks that have risen in value since the time of purchase.

Investors tend to hold on to stocks that have lost value and sell stocks that have risen in value since the time of purchase. We call this tendency to keep losers and sell winners the disposition effect. Researchers Hersh Shefrin and Meir Statman, building on the work of psychologists Daniel Kahneman and Amos Tversky, suggest that this effect arises due to investors’ increased willingness to take on risk in the face of possible losses.5 It may also reflect a reluctance to admit a mistake by taking the loss. Researchers have verified the disposition effect in many studies. For example, in a study of all trades in the Taiwanese stock market from 1995–1999, investors in aggregate were twice as likely to realize gains as they were to realize losses. Also, nearly 85% of 4

B. Barber and T. Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55 (2000) 773–806. 5

H. Shefrin and M. Statman, “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence,” Journal of Finance 40 (1985): 777–790, and D. Kahneman and A. Tversky, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47 (1979): 263–291. 6

B. Barber, Y. T. Lee, Y. J. Liu, and T. Odean, “Is the Aggregate Investor Reluctant to Realize Losses? Evidence from Taiwan,” European Financial Management, 13 (2007): 423–447.

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FIGURE 10.7

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The plot shows the average annual return (net of commissions and trading costs) for individual investors at a large discount brokerage from 1991–1997. Investors are grouped into quintiles based on their average annual turnover. While the least-active investors had slightly (but not significantly) better performance than the S&P 500, performance declined with the rate of turnover.

Individual Investor Returns Versus Portfolio Turnover

Annual Return

20%

15%

10%

5%

0%

Q1

Q2

Q3

(Lowest turnover)

Q4

Q5

S&P 500

(Highest turnover)

Source: B. Barber and T. Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55 (2000) 773–806.

individual investors were subject to this bias.6 On the other hand, mutual funds and foreign investors did not exhibit the same tendency, and other studies have shown that more sophisticated investors appear to be less susceptible to the disposition effect.7 This behavioral tendency to sell winners and hang on to losers is costly from a tax perspective. Because capital gains are taxed only when the asset is sold, it is optimal for tax purposes to postpone taxable gains by continuing to hold profitable investments; delaying the tax payment reduces its present value. On the other hand, investors should capture tax losses by selling their losing investments, especially near the year’s end, in order to accelerate the tax write-off. Of course, keeping losers and selling winners might make sense if investors forecast that the losing stocks would ultimately “bounce back” and outperform the winners going forward. While investors may in fact have this belief, it does not appear to be justified—if anything, the losing stocks that investors continue to hold tend to underperform the winners they sell. According to one study, losers underperformed winners by 3.4% over the year after the winners were sold.8

Investor Attention, Mood, and Experience Individual investors generally are not full-time traders. As a result, they have limited time and attention to spend on their investment decisions and may be influenced by attentiongrabbing news stories or other events. Studies show that individuals are more likely to buy stocks that have recently been in the news, engaged in advertising, experienced

7

R. Dhar and N. Zhu, “Up Close and Personal: Investor Sophistication and the Disposition Effect,” Management Science, 52 (2006): 726–740. 8

T. Odean, “Are Investors Reluctant to Realize Their Losses?” Journal of Finance 53 (1998): 1775–1798.

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Part 3 Valuation and the Firm exceptionally high trading volume, or have had extreme (either positive or negative) returns.9 Investment behavior also seems to be affected by investors’ moods. For example, sunshine generally has a positive effect on mood, and studies have found that stock returns tend to be higher when it is a sunny day at the location of the stock exchange. In New York City, the annualized market return on perfectly sunny days is approximately 24.8% per year versus 8.7% per year on perfectly cloudy days.10 Further evidence of the link between investor mood and stock returns comes from the effect of major sports events on returns. One recent study estimates that a loss in the World Cup elimination stage lowers the next day’s stock returns in the losing country by about 0.50%, presumably due to investors’ poor moods.11 Finally, investors appear to put too much weight on their own experience rather than considering all the historical evidence. As a result, people who grow up and live during a time of high stock returns are more likely to invest in stocks than people who grow up and live during a time of low stock returns.12 Why would investors continue to make such mistakes? Even if they started with such misconceptions, wouldn’t they be able to learn over time the cost of these errors? The challenge is that stock returns are extremely volatile, and this volatility masks the small differences in returns from different trading strategies. We will start the next chapter with a review of the historical evidence on average stock returns and their volatility. There you will see how variable returns are and how there have been long stretches of good returns, like the 1990s, but also stretches where the total return was negative, like the 2000s.

Concept Check

7. What are several systematic behavioral biases that individual investors fall prey to? 8. Why would excessive trading lead to lower realized returns?

9 See G. Grullon, G. Kanatas, and J. Weston, “Advertising, Breadth of Ownership, and Liquidity,” Review of Financial Studies, 17 (2004): 439–461; M. Seasholes and G. Wu, “Predictable Behavior, Profits, and Attention,” Journal of Empirical Finance, 14 (2007): 590–610; B. Barber and T. Odean, “All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors,” Review of Financial Studies, 21 (2008): 785–818. 10

Based on data from 1982–1997; see D. Hirshleifer and T. Shumway, “Good Day Sunshine: Stock Returns and the Weather,” Journal of Finance, 58 (2003): 1009–1032.

11

A. Edmans, D. Garcia, and O. Norli, “Sports Sentiment and Stock Returns,” Journal of Finance, 62 (2007): 1967–1998.

12

U. Malmendier and S. Nagel, “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?” NBER working paper no. 14813.

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Here is what you should know after reading this chapter. MyFinanceLab will help you identify what you know, and where to go when you need to practice.

Online Practice Opportunities

Key Points and Equations

Terms

10.1 The Discounted Free Cash Flow Model Q When a firm has leverage, it is more reliable to use the discounted free cash flow model. In this model, the enterprise value of the firm equals the present value of the firm’s future free cash flow:

discounted free cash flow model, p. 284 weighted average cost of capital (WACC), p. 285

MyFinanceLab Study Plan 10.1

10.2 Valuation Based on Comparable Firms Q We can also value stocks by using valuation multiples based on comparable firms. Multiples commonly used for this purpose include the P/E ratio and the ratio of enterprise value (EV) to EBITDA. When we use multiples, we assume that comparable firms have the same risk and future growth as the firm being valued. Q No valuation model provides a definitive value for the stock. It is best to use several methods to identify a reasonable range for the value.

forward earnings, p. 290 forward P/E, p. 290 method of comparables, p. 288 trailing earnings, p. 290 trailing P/E, p. 290 valuation multiple, p. 288

MyFinanceLab Study Plan 10.2

10.3 Information, Competition, and Stock Prices Q Stock prices aggregate the information of many inve