TheBasicsofFinance
TheFrankJ.FabozziSeries FixedIncomeSecurities,SecondEdition byFrankJ.Fabozzi FocusonValue:ACorporateandInvestorGuidetoWealthCreation byJamesL.GrantandJamesA.Abate HandbookofGlobalFixedIncomeCalculations byDragomirKrgin ManagingaCorporateBondPortfolio byLelandE.CrabbeandFrankJ.Fabozzi RealOptionsandOption-EmbeddedSecurities byWilliamT.Moore CapitalBudgeting:TheoryandPractice byPamelaP.PetersonandFrankJ.Fabozzi TheExchange-TradedFundsManual byGaryL.Gastineau ProfessionalPerspectivesonFixedIncomePortfolioManagement,Volume3 editedbyFrankJ.Fabozzi InvestinginEmergingFixedIncomeMarkets editedbyFrankJ.FabozziandEfstathiaPilarinu HandbookofAlternativeAssets byMarkJ.P.Anson TheGlobalMoneyMarkets byFrankJ.Fabozzi,StevenV.Mann,andMooradChoudhry TheHandbookofFinancialInstruments editedbyFrankJ.Fabozzi InterestRate,TermStructure,andValuationModeling editedbyFrankJ.Fabozzi InvestmentPerformanceMeasurement byBruceJ.Feibel TheHandbookofEquityStyleManagement editedbyT.DanielCogginandFrankJ.Fabozzi TheTheoryandPracticeofInvestmentManagement editedbyFrankJ.FabozziandHarryM.Markowitz FoundationsofEconomicValueAdded,SecondEdition byJamesL.Grant FinancialManagementandAnalysis,SecondEdition byFrankJ.FabozziandPamelaP.Peterson MeasuringandControllingInterestRateandCreditRisk,SecondEdition byFrankJ.Fabozzi,StevenV.Mann,andMooradChoudhry ProfessionalPerspectivesonFixedIncomePortfolioManagement,Volume4 editedbyFrankJ.Fabozzi TheHandbookofEuropeanFixedIncomeSecurities editedbyFrankJ.FabozziandMooradChoudhry TheHandbookofEuropeanStructuredFinancialProducts editedbyFrankJ.FabozziandMooradChoudhry TheMathematicsofFinancialModelingandInvestmentManagement bySergioM.FocardiandFrankJ.Fabozzi ShortSelling:Strategies,Risks,andRewards editedbyFrankJ.Fabozzi TheRealEstateInvestmentHandbook byG.TimothyHaightandDanielSinger MarketNeutralStrategies editedbyBruceI.JacobsandKennethN.Levy SecuritiesFinance:SecuritiesLendingandRepurchaseAgreements editedbyFrankJ.FabozziandStevenV.Mann Fat-TailedandSkewedAssetReturnDistributions bySvetlozarT.Rachev,ChristianMenn,andFrankJ.Fabozzi FinancialModelingoftheEquityMarket:FromCAPMtoCointegration byFrankJ.Fabozzi,SergioM.Focardi,andPetterN.Kolm AdvancedBondPortfolioManagement:BestPracticesinModelingandStrategies editedbyFrankJ.Fabozzi,LionelMartellini,andPhilippePriaulet AnalysisofFinancialStatements,SecondEdition byPamelaP.PetersonandFrankJ.Fabozzi CollateralizedDebtObligations:StructuresandAnalysis,SecondEdition byDouglasJ.Lucas,LaurieS.Goodman,andFrankJ.Fabozzi HandbookofAlternativeAssets ,SecondEditionbyMarkJ.P.Anson IntroductiontoStructuredFinance byFrankJ.Fabozzi,HenryA.Davis,andMooradChoudhry FinancialEconometrics bySvetlozarT.Rachev,StefanMittnik,FrankJ.Fabozzi,SergioM.Focardi,andTeoJasic DevelopmentsinCollateralizedDebtObligations:NewProductsandInsights byDouglasJ.Lucas,LaurieS.Goodman,FrankJ.Fabozzi,andRebeccaJ.Manning RobustPortfolioOptimizationandManagement byFrankJ.Fabozzi,PeterN.Kolm,DessislavaA.Pachamanova,andSergioM.Focardi AdvancedStochasticModels,RiskAssessment,andPortfolioOptimizations bySvetlozarT.Rachev,StoganV.Stoyanov,andFrankJ.Fabozzi HowtoSelectInvestmentManagersandEvaluatePerformance byG.TimothyHaight,StephenO.Morrell,andGlennE.Ross BayesianMethodsinFinance bySvetlozarT.Rachev,JohnS.J.Hsu,BilianaS.Bagasheva,andFrankJ.Fabozzi TheHandbookofCommodityInvesting byFrankJ.Fabozzi,RolandF¨uss,andDieterG.Kaiser TheHandbookofMunicipalBonds editedbySylvanG.FeldsteinandFrankJ.Fabozzi SubprimeMortgageCreditDerivatives byLaurieS.Goodman,ShuminLi,DouglasJ.Lucas,ThomasAZimmerman,andFrankJ.Fabozzi IntroductiontoSecuritization byFrankJ.FabozziandVinodKothari StructuredProductsandRelatedCreditDerivatives editedbyBrianP.Lancaster,GlennM.Schultz,andFrankJ.Fabozzi HandbookofFinance:VolumeI:FinancialMarketsandInstruments editedbyFrankJ.Fabozzi HandbookofFinance:VolumeII:FinancialManagementandAssetManagement editedbyFrankJ.Fabozzi HandbookofFinance:VolumeIII:Valuation,FinancialModeling,andQuantitativeTools editedbyFrankJ.Fabozzi Finance:CapitalMarkets,FinancialManagement,andInvestmentManagement byFrankJ.FabozziandPamelaPetersonDrake ActivePrivateEquityRealEstateStrategy editedbyDavidJ.Lynn FoundationsandApplicationsoftheTimeValueofMoney byPamelaPetersonDrakeandFrankJ.Fabozzi LeveragedFinance:Concepts,Methods,andTradingofHigh-YieldBonds,Loans,andDerivatives byStephenAntczak,DouglasLucas,andFrankJ.Fabozzi ModernFinancialSystems:TheoryandApplications byEdwinNeave InstitutionalInvestmentManagement:EquityandBondPortfolioStrategiesandApplications byFrankJ.Fabozzi QuantitativeEquityInvesting:TechniquesandStrategies byFrankJ.Fabozzi,SergioM.Focardi,PetterN.Kolm BasicsofFinance:AnIntroductiontoFinancialMarkets,BusinessFinance,andPortfolioManagement byFrankJ.FabozziandPamelaPetersonDrake SimulationandOptimizationinFinance:ModelingwithMATLAB,@Risk,orVBA byDessislavaPachamanovaandFrankJ.Fabozzi
TheBasicsofFinance AnIntroductiontoFinancialMarkets,BusinessFinance,andPortfolioManagement PAMELAPETERSONDRAKEFRANKJ.FABOZZI JohnWiley&Sons,Inc.
Copyright C 2010byJohnWiley&Sons.Allrightsreserved.PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.PublishedsimultaneouslyinCanada.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedinanyformorbyanymeans,electronic,mechanical,photocopying,recording,scanning,orotherwise,exceptaspermittedunderSection107or108ofthe1976UnitedStatesCopyrightAct,withouteitherthepriorwrittenpermissionofthePublisher,orauthorizationthroughpaymentoftheappropriateper-copyfeetotheCopyrightClearanceCenter,Inc.,222RosewoodDrive,Danvers,MA01923,(978)750-8400,fax(978)646-8600,orontheWebatwww.copyright.com.RequeststothePublisherforpermissionshouldbeaddressedtothePermissionsDepartment,JohnWiley&Sons,Inc.,111RiverStreet,Hoboken,NJ07030,(201)748-6011,fax(201)748-6008,oronlineathttp://www.wiley.com/go/permissions.LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheirbesteffortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespecttotheaccuracyorcompletenessofthecontentsofthisbookandspecifcallydisclaimanyimpliedwarrantiesofmerchantabilityorftnessforaparticularpurpose.Nowarrantymaybecreatedorextendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategiescontainedhereinmaynotbesuitableforyoursituation.Youshouldconsultwithaprofessionalwhereappropriate.Neitherthepublishernorauthorshallbeliableforanylossofproftoranyothercommercialdamages,includingbutnotlimitedtospecial,incidental,consequential,orotherdamages.Forgeneralinformationonourotherproductsandservicesorfortechnicalsupport,pleasecontactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974,outsidetheUnitedStatesat(317)572-3993orfax(317)572-4002.Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappearsinprintmaynotbeavailableinelectronicbooks.FormoreinformationaboutWileyproducts,visitourwebsiteatwww.wiley.com. LibraryofCongressCataloging-in-PublicationData: Fabozzi,FrankJ.Thebasicsoffnance:anintroductiontofnancialmarkets,businessfnance,andportfoliomanagement/FrankJ.Fabozzi,PamelaPetersonDrake.p.cm.–(FrankJ.Fabozziseries;192)Includesindex.ISBN978-0-470-60971-2(cloth);978-0-470-87743-2(ebk);978-0-470-87771-5(ebk);978-0-470-87772-2(ebk)1.Finance.I.PetersonDrake,Pamela,1954-II.Title.HG173.F252010332–dc222010010863PrintedintheUnitedStatesofAmerica.10987654321
Tomyhusband,Randy,andmychildren,KenandErica —P.P.D. Tomywife,Donna,andmychildren,Francesco,Patricia,andKarly —F.J.F.
Contents Preface xiiiCHAPTER1WhatIsFinance?1 CapitalMarketsandCapitalMarketTheory3FinancialManagement4InvestmentManagement6OrganizationofThisBook7TheBottomLine8Questions8 PARTONE TheFinancialSystem CHAPTER2FinancialInstruments,Markets,andIntermediaries13 TheFinancialSystem13TheRoleofFinancialMarkets17TheRoleofFinancialIntermediaries18TypesofFinancialMarkets24TheBottomLine33Questions33 CHAPTER3TheFinancialSystem’sCastofCharacters37 DomesticNonfnancialSectors39NonfnancialBusinesses42DomesticFinancialSectors43ForeignInvestors60TheBottomLine60Questions61 vii
viii CONTENTS PARTTWO FinancialManagement CHAPTER4FinancialStatements65 AccountingPrinciples:WhatAreThey?66TheBasicFinancialStatements67HowAretheStatementsRelated?81WhyBotherabouttheFootnotes?82AccountingFlexibility83U.S.Accountingvs.OutsideoftheU.S.83TheBottomLine84SolutionstoTryIt!Problems85Questions86 CHAPTER5BusinessFinance89 FormsofBusinessEnterprise90TheObjectiveofFinancialManagement97TheBottomLine104SolutionstoTryIt!Problems105Questions105 CHAPTER6FinancialStrategyandFinancialPlanning109 StrategyandValue110TheBudgetingProcess115Budgeting119PerformanceEvaluation120StrategyandValueCreation124TheBottomLine128Questions129 CHAPTER7DividendandDividendPolicies133 Dividends134StockDistributions137DividendPolicies141StockRepurchases147TheBottomLine150SolutionstoTryIt!Problems151Questions151
Contents ix CHAPTER8TheCorporateFinancingDecision155 Debtvs.Equity156FinancialLeverageandRisk164FinancialDistress168TheCostofCapital171OptimalCapitalStructure:TheoryandPractice175TheBottomLine180SolutionstoTryIt!Problems182Questions183 CHAPTER9FinancialRiskManagement185 TheDefnitionofRisk185EnterpriseRiskManagement188ManagingRisks193TheBottomLine197Questions198 PARTTHREE ValuationandAnalyticalTools CHAPTER10TheMathofFinance201 WhytheTimeValueofMoney?201CalculatingtheFutureValue203CalculatingaPresentValue213DeterminingtheUnknownInterestRate216TheTimeValueofaSeriesofCashFlows217Annuities221LoanAmortization230InterestRatesandYields232TheBottomLine238SolutionstoTryIt!Problems239Questions240 CHAPTER11FinancialRatioAnalysis243 ClassifyingFinancialRatios244Liquidity247
x CONTENTS ProftabilityRatios253ActivityRatios255FinancialLeverage258ReturnonInvestment262TheDuPontSystem263Common-SizeAnalysis266UsingFinancialRatioAnalysis268TheBottomLine270SolutionstoTryIt!Problems270Questions271 CHAPTER12CashFlowAnalysis275 DiffcultieswithMeasuringCashFlow275FreeCashFlow283UsefulnessofCashFlowsAnalysis288RatioAnalysis290TheBottomLine292SolutionstoTryIt!Problems293Questions293 CHAPTER13CapitalBudgeting295 InvestmentDecisionsandOwners’Wealth296TheCapitalBudgetingProcess298DeterminingCashFlowsfromInvestments303CapitalBudgetingTechniques321TheBottomLine344SolutionstoTryIt!Problems344Questions345 CHAPTER14DerivativesforControllingRisk349 FuturesandForwardContracts350Options363Swaps376TheBottomLine379Appendix:Black-ScholesOptionPricingModel380SolutionstoTryIt!Problems383Questions385
Contents xi PARTFOUR InvestmentManagement CHAPTER15InvestmentManagement389 SettingInvestmentObjectives391EstablishinganInvestmentPolicy393ConstructingandMonitoringaPortfolio400MeasuringandEvaluatingPerformance401TheBottomLine410SolutionstoTryIt!Problems411Questions412 CHAPTER16TheTheoryofPortfolioSelection415 SomeBasicConcepts416EstimatingaPortfolio’sExpectedReturn418MeasuringPortfolioRisk421PortfolioDiversifcation426ChoosingaPortfolioofRiskyAssets428IssuesintheTheoryofPortfolioSelection434BehavioralFinanceandPortfolioTheory438TheBottomLine441SolutionstoTryIt!Problems442Questions443 CHAPTER17AssetPricingTheory445 CharacteristicsofanAssetPricingModel446TheCapitalAssetPricingModel447TheArbitragePricingTheoryModel461SomePrinciplestoTakeAway465TheBottomLine466SolutionstoTryIt!Problems467Questions467 CHAPTER18TheStructureofInterestRates469 TheBaseInterestRate470TheTermStructureofInterestRates476TermStructureofInterestRatesTheories484
xii CONTENTS SwapRateYieldCurve486TheBottomLine487SolutionstoTryIt!problems488Questions489 CHAPTER19ValuingCommonStock491 DiscountedCashFlowModels491RelativeValuationMethods503TheBottomLine509SolutionstoTryIt!Problems510Questions511 CHAPTER20ValuingBonds513 ValuingaBond514ConventionalYieldMeasures524ValuingBondsthatHaveEmbeddedOptions532TheBottomLine538SolutionstoTryIt!Problems539Questions540 Glossary 543 AbouttheAuthors 571 Index 573
Preface Aninvestmentinknowledgepaysthebestinterest. —BenjaminFranklin T hepurposeofthisbookistoprovideanintroductiontofnancialdecision-making,andtheframeworkinwhichthesedecisionsaremade. TheBasicsofFinance isanaccessiblebookforthosewhowanttogainabetterunder-standingofthisfeld,butlackastrongbusinessbackground.Inthisbook,wecovertheessentialconcepts,tools,methods,andstrategiesinfnancewithoutdelvingtoofarintotheory.In BasicsofFinance ,wediscussfnancialinstrumentsandmarkets,port-foliomanagementtechniques,understandingandanalyzingfnancialstate-ments,andcorporatefnancialstrategy,planning,andpolicy.Weexplainconceptsinvariousareasoffnancewithoutgettingtoocomplicated.Weexplore,inabasicway,topicssuchascashfowanalysis,assetvalu-ation,capitalbudgeting,andderivatives.Wealsoprovideasolidfoundationinthefeldoffnance,whichyoucanquicklybuildupon.Alongtheway,weprovidesampleproblems—Tryit!problems—sothatyoucantryoutanymaththatwedemonstrateinthechapter.Wealsoprovideend-of-chapterquestions—withsolutionseasilyaccessibleonourwebsite—thattestyourknowledgeofthebasictermsandconceptsthatwediscussinthechapter.Solutionstoend-of-chapterproblemscanbedownloadedbyvisitingwww.wiley.com/go/petersonbasics.Pleaselogintothewebsiteusingthispassword:Petersonbasics123. TheBasicsofFinance offersessentialguidanceonfnancialmarketsandinstitutions,businessfnance,portfoliomanagement,riskmanagement,andmuchmore.Ifyou’relookingtolearnmoreaboutfnance,thisistheplacetostart.WethankGlenLarsen,ProfessorofFinanceattheKelleySchoolofBusiness,IndianaUniversity,forcoauthoringwithusthesectiononrelativevaluationinChapter19.P AMELA P ETERSON D RAKE F RANK J.F ABOZZI May2010 xiii
CHAPTER 1 WhatIsFinance? Atrulygreatbusinessmusthaveanenduring‘moat’thatprotectsexcellentreturnsoninvestedcapital.Thedynamicsofcapitalismguaranteethatcompetitorswillrepeatedlyassaultanybusiness‘castle’thatisearninghighreturns.Thereforeaformidablebarriersuchasacompany’sbeingthelowcostproducer(GEICO,Costco)orpossessingapowerfulworld-widebrand(Coca-Cola,Gillette,AmericanExpress)isessentialforsustainedsuccess.Businesshistoryisflledwith‘RomanCandles,’companieswhosemoatsprovedillusoryandweresooncrossed. —WarrenBuffett,LettertoShareholdersofBerkshireHathaway,February2008 F inance istheapplicationofeconomicprinciplestodecision-makingthatinvolvestheallocationofmoneyunderconditionsofuncertainty.Inotherwords,infnanceweworryaboutmoneyandweworryaboutthefuture.Investorsallocatetheirfundsamongfnancialassetsinor-dertoaccomplishtheirobjectives,andbusinessesandgovernmentsraisefundsbyissuingclaimsagainstthemselvesandthenusethosefundsforoperations.Financeprovidestheframeworkformakingdecisionsastohowtogetfundsandwhatweshoulddowiththemoncewehavethem.Itisthefnancialsystemthatprovidestheplatformbywhichfundsaretransferredfromthoseentitiesthathavefundstothoseentitiesthatneedfunds.Thefoundationsforfnancedrawfromthefeldofeconomicsand,forthisreason,fnanceisoftenreferredtoas fnancialeconomics .Forexample,asyousawwiththequotebyWarrenBuffettatthebeginningofthischapter,competitionisimportantinthevaluationofacompany.Theabilitytokeep 1
2 WHATISFINANCE? MathematicsFinancialaccountingEconomicsProbabilitytheoryStatisticaltheoryPsychology Finance EXHIBIT1.1 FinanceandItsRelationtoOtherFields competitorsatbayisvaluablebecauseitensuresthatthecompanycancontinuetoearneconomicprofts. 1 FINANCEIS ... analytical,usingstatistical,probability,andmathematicstosolveproblems. basedoneconomicprinciples. usesaccountinginformationasinputstodecision-making. globalinperspective. thestudyofhowtoraisemoneyandinvestitproductively. Thetoolsusedinfnancialdecision-making,however,drawfrommanyareasoutsideofeconomics:fnancialaccounting,mathematics,probabilitytheory,statisticaltheory,andpsychology,asweshowinExhibit1.1.Wecanthinkofthefeldoffnanceascomprisedofthreeareas:capitalmarketsandcapitalmarkettheory,fnancialmanagement,andinvestment 1 Economicprofts areearningsbeyondthecostofcapitalusedtogeneratethoseearn-ings.Inotherwords,economicproftsarethoseinexcessofnormalprofts—thosereturnsexpectedbasedontheinvestment’srisk.
WhatIsFinance? 3 Capital marketsand capitalmarket theoryFinancialmanagementInvestmentmanagement EXHIBIT1.2 TheThreeAreaswithintheFieldofFinance management,asweillustrateinExhibit1.2.And,asthisexhibitillustrates,thethreeareasareallintertwined,basedonacommonsetoftheoriesandprinciples.Inthebalanceofthischapter,wediscusseachofthesespecialtyareas. CAPITALMARKETSANDCAPITALMARKETTHEORY Thefeldof capitalmarketsandcapitalmarkettheory focusesonthestudyofthefnancialsystem,thestructureofinterestrates,andthepricingofriskyassets.Thefnancialsystemofaneconomyconsistsofthreecomponents:(1)fnancialmarkets;(2)fnancialintermediaries;and(3)fnancialregula-tors.Forthisreason,weoftenrefertothisareaas fnancialmarketsandinstitutions .Severalimportanttopicsincludedinthisspecialtyareaoffnancearethepricingeffciencyoffnancialmarkets,theroleandinvestmentbehavioroftheplayersinfnancialmarkets,thebestwaytodesignandregulatefnancialmarkets,themeasurementofrisk,andthetheoryofassetpricing.Thepricingeffciencyofthefnancialmarketsiscriticalbecauseitdealswithwhetherinvestorscan“beatthemarket.”Ifamarketishighly priceeffcient ,itisextremelydiffcultforinvestorstoearnreturnsthataregreaterthanthoseexpectedfortheinvestment’slevelofrisk—thatis,itisdiffcultforinvestorstobeatthemarket.Aninvestorwhopursuesaninvestmentstrategythatseeksto“beatthemarket”mustbelievethatthesectorofthefnancialmarkettowhichthestrategyisappliedisnothighlypriceeffcient.Suchastrategyseekingto“beatthemarket”iscalledan activestrategy .Financialtheorytellsusthatifacapitalmarketiseffcient,theoptimal
4 WHATISFINANCE? strategyisnotanactivestrategy,butratherisa passivestrategy thatseekstomatchtheperformanceofthemarket.Infnance,beatingthemarketmeansoutperformingthemarketbygen-eratingareturnoninvestmentbeyondwhatisexpectedafteradjustingforriskandtransactioncosts.Tobeabletoquantitativelydeterminewhatis“expected”fromaninvestmentafteradjustingforrisk,itisnecessarytoformulateandempiricallytesttheoriesabouthowassetsarepricedor,equivalently,valuinganassettodetermineitsfairvalue. AcowforhermilkAhenforhereggs,Andastock,byheck,Forherdividends.Anorchardforfruit,Beesfortheirhoney,Andstocks,besides,Fortheirdividends.—JohnBurrWilliams“EvaluationoftheRuleofPresentWorth,” TheoryofInvestmentValue ,1937 Thefundamentalprincipleofvaluationisthatthevalueofanyfnancialassetisthepresentvalueoftheexpectedcashfows.Thus,thevaluationofafnancialassetinvolves(1)estimatingtheexpectedcashfows;(2)de-terminingtheappropriateinterestrateorinterestratesthatshouldbeusedtodiscountthecashfows;and(3)calculatingthepresentvalueoftheex-pectedcashfows.Forexample,invaluingastock,weoftenestimatefuturedividendsandgaugehowuncertainarethesedividends.Weusebasicmath-ematicsoffnancetocomputethepresentvalueordiscountedvalueofcashfows.Intheprocessofthiscalculationofthepresentvalueordiscountedvalue,wemustuseasuitableinterestrate,whichwewillrefertoasa discountrate .Capitalmarkettheoryprovidestheoriesthatguideinvestorsinselectingtheappropriateinterestrateorinterestrates. FINANCIALMANAGEMENT Financialmanagement ,sometimescalled businessfnance or corporatefnance ,isthespecialtyareaoffnanceconcernedwithfnancialdecision-makingwithinabusinessentity.Althoughfnancialmanagementisoften
WhatIsFinance? 5 referredtoascorporatefnance,theprinciplesoffnancialmanagementalsoapplytootherformsofbusinessandtogovernmententities.Financialmanagersareprimarilyconcernedwithinvestmentdecisionsandfnancingdecisionswithinorganizations,whetherthatorganizationisasolepropri-etorship,apartnership,alimitedliabilitycompany,acorporation,oragovernmentalentity.Regardinginvestmentdecisions,weareconcernedwiththeuseoffunds—thebuying,holding,orsellingofalltypesofassets:Shouldabusi-nesspurchaseanewmachine?Shouldabusinessintroduceanewproductline?Selltheoldproductionfacility?Acquireanotherbusiness?Buildamanufacturingplant?Maintainahigherlevelofinventory?Financingdecisionsareconcernedwiththeprocuringoffundsthatcanbeusedforlong-terminvestingandfnancingday-to-dayoperations.Shouldfnancialmanagersuseproftsraisedthroughthecompany’srevenuesordistributethoseproftstotheowners?Shouldfnancialmanagersseekmoneyfromoutsideofthebusiness?Acompany’soperationsandinvestmentscanbefnancedfromoutsidethebusinessbyincurringdebt—suchasthroughbankloansorthesaleofbonds—orbysellingownershipinterests.Becauseeachmethodoffnancingobligatesthebusinessindifferentways,fnancingdecisionsareextremelyimportant.Thefnancingdecisionalsoinvolvesthedividenddecision,whichinvolveshowmuchofacompany’sproftshouldberetainedandhowmuchtodistributetoowners.Acompany’sfnancialstrategicplanisaframeworkofachievingitsgoalofmaximizingowner’swealth.Implementingthestrategicplanrequiresbothlong-termandshort-termfnancialplanningthatbringstogetherforecastsofthecompany’ssaleswithfnancingandinvestmentdecision-making.Budgetsareemployedtomanagetheinformationusedinthisplanning;performancemeasuresareusedtoevaluateprogresstowardthestrategicgoals.The capitalstructure ofacompanyisthemixtureofdebtandequitythatmanagementelectstoraisetofnancetheassetsofthecompany.Thereareseveraleconomictheoriesabouthowthecompanyshouldbefnancedandwhetheranoptimalcapitalstructure(thatis,onethatmaximizesacompany’svalue)exists.Investmentdecisionsmadebythefnancialmanagerinvolvethelong-termcommitmentofacompany’sscarceresourcesinlong-terminvestments.Werefertothesedecisionsas capitalbudgetingdecisions .Thesedecisionsplayaprominentroleindeterminingthesuccessofabusinessenterprise.Althoughtherearecapitalbudgetingdecisionsthatareroutineand,hence,donotalterthecourseorriskofacompany,therearealsostrategiccapitalbudgetingdecisionsthateitheraffectacompany’sfuturemarketpositioninitscurrentproductlinesorpermitittoexpandintonewproductlinesinthefuture.
6 WHATISFINANCE? Afnancialmanagermustalsomakedecisionsaboutacompany’scur-rentassets. Currentassets arethoseassetsthatcouldreasonablybecon-vertedintocashwithinoneoperatingcycleoroneyear,whichevertakeslonger.Currentassetsincludecash,marketablesecurities,accountsreceiv-able,andinventories,andsupportthelong-terminvestmentdecisionsofacompany.Anothercriticaltaskinfnancialmanagementisthe riskmanagement ofacompany.Theprocessofriskmanagementinvolvesdeterminingwhichriskstoaccept,whichtoneutralize,andwhichtotransfer.Thefourkeyprocessesinriskmanagementarerisk: 1. Identifcation 2. Assessment 3. Mitigation 4. TransferenceThetraditionalprocessofriskmanagementfocusesonmanagingtherisksofonlypartsofthebusiness(products,departments,ordivisions),ignoringtheimplicationsforthevalueofthecompany.Today,someformof enterpriseriskmanagement isfollowedbylargecorporations,whichisriskmanagementappliedtothecompanyasawhole.Enterpriseriskmanagementallowsmanagementtoaligntheriskappetiteandstrategiesacrossthecompany,improvethequalityofthecompany’sriskresponsedecisions,identifytherisksacrossthecompany,andmanagetherisksacrossthecompany. Thefrststepintheriskmanagementprocessistoacknowledgetherealityofrisk.Denialisacommontacticthatsubstitutesdeliberateignoranceforthoughtfulplanning.—CharlesTremper INVESTMENTMANAGEMENT Investmentmanagement isthespecialtyareawithinfnancedealingwiththemanagementofindividualorinstitutionalfunds.Othertermscommonlyusedtodescribethisareaoffnanceare assetmanagement , portfolioman-agement , moneymanagement, and wealthmanagement .Inindustryjargon,anassetmanager“runsmoney.”
WhatIsFinance? 7 SettinginvestmentobjectivesEstablishingan investmentpolicySelectingspecific assetsSelecting aninvestmentstrategyMeasuringand evaluatinginvestmentperformance EXHIBIT1.3 InvestmentManagementActivities Investmentmanagementinvolvesfveprimaryactivities,aswedetailinExhibit1.3.Settinginvestmentobjectivesstartswithathoroughanalysisofwhattheentityorclientwantstoaccomplish.Giventheinvestmentobjectives,theinvestmentmanagerdevelopspolicyguidelines,takingintoconsiderationanyclient-imposedinvestmentconstraints,legal/regulatoryconstraints,andtaxrestrictions.Thistaskbeginswiththedecisionofhowtoallocateassetsintheportfolio(i.e.,howthefundsaretobeallocatedamongthemajorassetclasses).The portfolio issimplythesetofinvest-mentsthataremanagedforthebeneftoftheclientorclients.Next,theinvestmentmanagermustselectaportfoliostrategythatisconsistentwiththeinvestmentobjectivesandinvestmentpolicyguidelines.Ingeneral,portfoliostrategiesareclassifedaseitheractiveorpassive.Selectingthespecifcfnancialassetstoincludeintheportfolio,whichisreferredtoastheportfolioselectionproblem,isthenextstep.ThetheoryofportfolioselectionwasformulatedbyHarryMarkowitzin1952. 2 Thistheoryproposeshowinvestorscanconstructportfoliosbasedontwoparam-eters:meanreturnandstandarddeviationofreturns.Thelatterparameterisameasureofrisk.Animportanttaskistheevaluationoftheperformanceoftheassetmanager.Thistaskallowsaclienttodetermineanswerstoques-tionssuchas:Howdidtheassetmanagerperformafteradjustingfortherisksassociatedwiththeactivestrategyemployed?And,howdidtheassetmanagerachievethereportedreturn? ORGANIZATIONOFTHISBOOK Wehaveorganizedthisbookinpartstoenableyoutoseehowallthepiecesinfnancecometogether.InPartOne,weprovidethebasic 2 HarryM.Markowitz,“PortfolioSelection,” JournalofFinance 7(1952):77–91.
8 WHATISFINANCE? frameworkofthefnancialsystemandtheplayersinthissystem.InPartTwo,wefocusonfnancialmanagement,anddiscussfnancialstatements,fnan-cialdecision-makingwithinabusinessenterprise,strategy,anddecisionsincludingdividends,fnancing,andinvestmentmanagement.InPartThree,wefocusmoreontheanalyticalpartoffnance,whichinvolvesvaluingassets,makinginvestmentdecisions,andanalyzingper-formance.InPartFour,weintroduceyoutoinvestments,whichincludederivativesandriskmanagement,aswellasportfoliomanagement.Inthispart,wealsoexplainthebasicmethodsthatareusedtovaluestocksandbonds,andsomeofthetheoriesbehindthesevaluations. THEBOTTOMLINE Financeblendstogethereconomics,psychology,accounting,statistics,mathematics,andprobabilitytheorytomakedecisionsthatinvolvefutureoutcomes. Weoftencharacterizefnanceascomprisedofthreerelatedareas:capitalmarketsandcapitalmarkettheory,fnancialmanagement,andinvest-mentmanagement. Capitalmarketsandcapitalmarkettheoryfocusonthefnancialsystemthatincludesmarkets,intermediaries,andregulators. Financialmanagementfocusesonthedecision-makingofabusinessenterprise,whichincludesdecisionsrelatedtoinvestinginlong-livedassetsandfnancingtheseinvestments. Investmentmanagementdealswithmanagingtheinvestmentsofindi-vidualsandinstitutions. QUESTIONS 1. Whatdistinguishesinvestmentmanagementfromfnancialmanage-ment? 2. Whatistheroleofadiscountrateindecision-making? 3. Whatistheresponsibilityoftheinvestmentmanagerwithrespecttotheinvestmentportfolio? 4. Distinguishbetweencapitalbudgetingandcapitalstructure. 5. Whatarecurrentassets?
WhatIsFinance? 9 6. Ifamarketispriceeffcient, a. Cananinvestor“beatthemarket”? b. Whichtypeofportfoliomanagement—activeorpassive—isbest? 7. Whatdoesthefnancingdecisionofafrminvolve? 8. Listthegeneralstepsintheriskmanagementofacompany. 9. Whatisenterpriseriskmanagement? 10. Listthefveactivitiesofaninvestmentmanager.
PART One TheFinancialSystem
CHAPTER 2 FinancialInstruments,Markets,andIntermediaries Astrongfnancialsystemisvitallyimportant—notforWallStreet,notforbankers,butforworkingAmericans.Whenourmarketswork,peoplethroughoutoureconomybeneft—Americansseekingtobuyacarorbuyahome,familiesborrowingtopayforcollege,innovatorsborrowingonthestrengthofagoodideaforanewproductortechnology,andbusinessesfnancinginvestmentsthatcreatenewjobs.Andwhenourfnancialsystemisunderstress,millionsofworkingAmericansbeartheconsequences.Governmenthasaresponsibilitytomakesureourfnancialsystemisregulatedeffectively.Andinthisarea,wecandoabetterjob.Insum,theultimatebenefciariesfromimprovedfnancialregulationareAmerica’sworkers,families,andbusinesses—bothlargeandsmall. —HenryM.Paulson,Jr.,thenSecretaryoftheU.S.DepartmentoftheTreasury,March31,2008 THEFINANCIALSYSTEM Acountry’sfnancialsystemconsistsofentitiesthathelpfacilitatethefowoffundsfromthosethathavefundstoinvesttothosewhoneedfundstoinvest.Considerifyouhadtofnanceapurchaseofahomebyroundingupenoughfolkswillingtolendtoyou.Thiswouldbechallenging—andabitawkward.Inaddition,thiswouldrequirecarefulplanning—andlotsofpaperwork—tokeeptrackoftheloancontracts,andhowmuchyoumustrepayandtowhom.Andwhataboutthefolksyouborrowfrom?Howaretheygoingtoevaluatewhethertheyshouldlendtoyouandwhatinterestratetheyshouldchargeyoufortheuseoftheirfunds? 13
14 THEFINANCIALSYSTEM Inlendingandinvestingsituations,thereisnotonlytheawkwardnessofdealingdirectlywiththeotherpartyorparties,butthereistheproblemthatonepartyhasadifferentinformationsetthantheother.Inotherwords,thereis informationasymmetry. Afnancialsystemmakespossibleamoreeffcienttransferoffundsbymitigatingtheinformationasymmetryproblembetweenthosewithfundstoinvestandthoseneedingfunds.Inadditiontothelendersandthebor-rowers,thefnancialsystemhasthreecomponents:(1)fnancialmarkets,wheretransactionstakeplace;(2)fnancialintermediaries,whofacilitatethetransactions;and(3)regulatorsoffnancialactivities,whotrytomakesurethateveryoneisplayingfair.Inthischapter,welookateachofthesecomponentsandthemotivationfortheirexistence.Beforewediscusstheparticipants,weneedtofrstdiscussfnancialassets,whichrepresenttheborrowingsorinvestments. FinancialAssets An asset isanyresourcethatweexpecttoprovidefuturebeneftsand,hence,haseconomicvalue.Wecancategorizeassetsintotwotypes: tangibleassets and intangibleassets. Thevalueofatangibleassetdependsonitsphysicalproperties.Buildings,aircraft,land,andmachineryareexamplesoftangibleassets,whichweoftenrefertoas fxedassets. Anintangibleassetrepresentsalegalclaimtosomefutureeconomicbeneftorbenefts.Examplesofintangibleassetsincludepatents,copyrights,andtrademarks.Thevalueofanintangibleassetbearsnorelationtotheform,physicalorotherwise,inwhichtheclaimsarerecorded. Financialassets ,suchasstocksandbonds,arealsointangibleassetsbecausethefuturebeneftscomeintheformofaclaimtofuturecashfows.Anothertermweuseforafnancialassetis fnancialinstrument. Weoftenrefertocertaintypesoffnancialinstrumentsas securities ,whichincludestocksandbonds.Foreveryfnancialinstrument,thereisaminimumoftwoparties.Thepartythathasagreedtomakefuturecashpaymentsisthe issuer ;thepartythatownsthefnancialinstrumentandthereforetherighttoreceivethepaymentsmadebytheissueristhe investor. WhyDoWeNeedFinancialAssets? Financialassetsservetwoprincipalfunctions: 1. Theyallowthetransferenceoffundsfromthoseentitiesthathavesur-plusfundstoinvesttothosewhoneedfundstoinvestintangibleassets.
FinancialInstruments,Markets,andIntermediaries 15 Entitiesseeking fundsto invest intangible assetsFinancialintermediaryEntities withfundsavailable toinvest FUNDS FINANCIAL ASSETS EXHIBIT2.1 TheRoleoftheFinancialIntermediary 2. Theypermitthetransferenceoffundsinsuchawayastoredistributetheunavoidableriskassociatedwiththetangibleassets’cashfowamongthoseseekingandthoseprovidingthefunds.However,theclaimsheldbythefnalwealthholdersgenerallydif-ferfromtheliabilitiesissuedbythoseentitiesbecauseoftheactivityofentitiesoperatinginfnancialsystems—thefnancialintermediaries—whotransformthefnalliabilitiesintodifferentfnancialassetspreferredbyinvestors(seeExhibit2.1).Wediscussfnancialintermediariesinmoredetaillater. WhatIstheDifferencebetweenDebtandEquity? Wecanclassifyafnancialinstrumentbythetypeofclaimsthattheinvestorhasontheissuer.Afnancialinstrumentinwhichtheissueragreestopaytheinvestorinterest,plusrepaytheamountborrowed,isa debtinstrument or,simply, debt. Adebtcanbeintheformofanote,bond,orloan.Theissuermustpayinterestpayments,whicharefxedcontractually.InthecaseofadebtinstrumentthatisrequiredtomakepaymentsinU.S.dollars,theamountmaybeafxeddollaramountorpercentageofthefacevalueofthedebt,oritcanvarydependinguponsomebenchmark.Theinvestorwholendsthefundsandexpectsinterestandtherepaymentofthedebtisa creditor oftheissuer.Thekeypointisthattheinvestorinadebtinstrumentcanrealizenomorethanthecontractualamount.Forthisreason,weoftenrefertodebtinstrumentsas fxedincomeinstruments.
16 THEFINANCIALSYSTEM MICKEYMOUSEDEBT TheWaltDisneyCompanybondsissuedinJuly1993,whichmatureinJuly2093,payinterestatarateof7.55%.ThismeansthatDisneypaystheinvestorswhoboughtthebonds$7.55peryearforevery$100ofprincipalvalueofdebttheyown. Incontrasttoadebtobligation,an equityinstrument specifesthattheissuerpaytheinvestoranamountbasedonearnings,ifany,aftertheobli-gationsthattheissuerisrequiredtomaketothecompany’screditorsarepaid. Commonstock and partnershipshares areexamplesofequityinstru-ments.Commonstockistheownershipinterestinacorporation,whereasapartnershipshareisanownershipinterestinapartnership.Werefertoanydistributionofacompany’searningsas dividends. ANEXAMPLEOFCOMMONSTOCK Attheendof2008therewere3,032,717sharesofcommonstockoutstandingofProctor&Gamble,aU.S.consumerproductscompany.Atthattime,fnancialinstitutionsownedalmost60%ofthisstock.Theseinstitutionsincludepensionfundsandmutualfunds.IndividualinvestorsownedtheremainderofProctor&Gamble’sstock.ThestockislistedontheNewYorkStockExchangewiththetickersymbolPG. Somefnancialinstrumentsfallintobothcategoriesintermsoftheirattributes. Preferredstock issuchahybridbecauseitlookslikedebtbe-causeinvestorsinthissecurityareonlyentitledtoreceiveafxedcontrac-tualamount.Yetpreferredstockissimilartoequitybecausethepaymenttoinvestorsisonlymadeafterobligationstothecompany’screditorsaresatisfed.Becausepreferredstockholderstypicallyareentitledtoafxedcontrac-tualamount,werefertopreferredstockasafxedincomeinstrument.Hence,fxedincomeinstrumentsincludedebtinstrumentsandpreferredstock.Anotherhybridinstrumentisa convertiblebond or convertiblenote. Aconvertiblebondornoteisadebtinstrumentthatallowstheinvestorto
FinancialInstruments,Markets,andIntermediaries 17 convertitintosharesofcommonstockundercertaincircumstancesandataspecifedexchangeratio. DOYOUWANTDEBTORSTOCK? SiriusXMRadio(ticker:SIRI)issuedconvertiblenotesinOctober2004.Thesenotespayaninterestrateof3.25%,andcanbeexchangedforthecommonstockofSiriusXMRadioInc.atarateof188.6792sharesofthecompany’scommonstockforevery$1,000principalamountofthenotes.Thenotesmaturein2011,soinvestorsintheseconvertiblenoteshaveuntilthattimetoexchangetheirnoteforshares;otherwise,theywillreceivethe$1,000facevalueofthenotes. Theclassifcationofdebtandequityisimportantfortwolegalreasons.First,inthecaseofabankruptcyoftheissuer,investorsindebtinstrumentshaveapriorityontheclaimontheissuer’sassetsoverequityinvestors.Second,intheUnitedStates,thetaxtreatmentofthepaymentsbytheissuerdiffersdependingonthetypeofclass.Specifcally,interestpaymentsmadeondebtinstrumentsaretaxdeductibletotheissuer,whereasdividendsarenot. THEROLEOFFINANCIALMARKETS Investorsexchangefnancialinstrumentsinafnancialmarket.Themorepopulartermusedfortheexchangingoffnancialinstrumentsisthattheyare“traded.”Financialmarketsprovidethefollowingthreemajoreconomicfunctions:(1)pricediscovery,(2)liquidity,and(3)reducedtransactioncosts. Pricediscovery meansthattheinteractionsofbuyersandsellersinafnancialmarketdeterminethepriceofthetradedasset.Equivalently,theydeterminetherequiredreturnthatparticipantsinafnancialmarketdemandinordertobuyafnancialinstrument.Financialmarketssignalhowthefundsavailablefromthosewhowanttolendorinvestfundsareallocatedamongthoseneedingfunds.Thisisbecausethemotiveforthoseseekingfundsdependsontherequiredreturnthatinvestorsdemand.Second,fnancialmarketsprovideaforumforinvestorstosellafnancialinstrumentandthereforeofferinvestorsliquidity. Liquidity isthepresenceofbuyersandsellersreadytotrade.Thisisanappealingfeaturewhencir-cumstancesarisethateitherforceormotivateaninvestortosellafnancial
18 THEFINANCIALSYSTEM instrument.Withoutliquidity,aninvestorwouldbecompelledtoholdontoafnancialinstrumentuntileither(1)conditionsarisethatallowforthedis-posalofthefnancialinstrument,or(2)theissueriscontractuallyobligatedtopayitoff.Foradebtinstrument,thatiswhenitmatures,butforaneq-uityinstrumentthatdoesnotmature—butrather,isaperpetualsecurity—itisuntilthecompanyiseithervoluntarilyorinvoluntarilyliquidated.Allfnancialmarketsprovidesomeformofliquidity.However,thedegreeofliquidityisoneofthefactorsthatcharacterizedifferentfnancialmarkets.Thethirdeconomicfunctionofafnancialmarketisthatitreducesthecostoftransactingwhenpartieswanttotradeafnancialinstrument.Ingeneral,wecanclassifythecostsassociatedwithtransactingintotwotypes:searchcostsandinformationcosts. Searchcosts inturnfallintotwocategories:explicitcostsandimplicitcosts.Explicitcostsincludeexpensestoadvertiseone’sintentiontosellorpurchaseafnancialinstrument.Implicitcostsincludethevalueoftimespentinlocatinga counterparty —thatis,abuyerforasellerorasellerforabuyer—tothetransaction.Thepresenceofsomeformoforganizedfnancialmarketreducessearchcosts.Informationcostsarecostsassociatedwithassessingafnancialinstru-ment’sinvestmentattributes.Inaprice-effcientmarket,pricesrefecttheaggregateinformationcollectedbyallmarketparticipants. THEROLEOFFINANCIALINTERMEDIARIES Despitetheimportantroleoffnancialmarkets,theirroleinallowingtheeffcientallocationforthosewhohavefundstoinvestandthosewhoneedfundsmaynotalwaysworkasdescribedearlier.Asaresult,fnancialsys-temshavefoundtheneedforaspecialtypeoffnancialentity,a fnancialintermediary ,whenthereareconditionsthatmakeitdiffcultforlendersorinvestorsoffundstodealdirectlywithborrowersoffundsinfnancialmar-kets.Financialintermediariesincludedepositoryinstitutions,nondepositfnancecompanies,regulatedinvestmentcompanies,investmentbanks,andinsurancecompanies.Theroleoffnancialintermediariesistocreatemorefavorabletransac-tiontermsthancouldberealizedbylenders/investorsandborrowersdealingdirectlywitheachotherinthefnancialmarket.Financialintermediariesac-complishthisinatwo-stepprocess: 1. Obtainingfundsfromlendersorinvestors. 2. Lendingorinvestingthefundsthattheyborrowtothosewhoneedfunds.
FinancialInstruments,Markets,andIntermediaries 19 Thefundsthatafnancialintermediaryacquiresbecome,depend-ingonthefnancialclaim,eitherthedebtofthefnancialintermediaryorequityparticipantsofthefnancialintermediary.Thefundsthataf-nancialintermediarylendsorinvestsbecometheassetofthefnancialintermediary.Considertwoexamplesusingfnancialintermediariesthatwewillelab-orateuponfurther: Example1:ACommercialBank Acommercialbankisatypeofdepositoryinstitution.Everyoneknowsthatabankacceptsdepositsfromindividuals,corporations,andgovernments.Thesedepositorsarethelenderstothecommercialbank.Thefundsreceivedbythecommercialbankbecomethelia-bilityofthecommercialbank.Inturn,asexplainedlater,abanklendsthesefundsbyeithermakingloansorbuyingsecurities.Theloansandsecuritiesbecometheassetsofthecommercialbank. Example2:AMutualFund Amutualfundisonetypeofregulatedinvestmentcompany.Amutualfundacceptsfundsfrominvestorswhoinexchangereceivemutualfundshares.Inturn,themutualfundinveststhosefundsinaport-foliooffnancialinstruments.Themutualfundsharesrepresentanequityinterestintheportfoliooffnancialinstrumentsandthefnancialinstrumentsaretheassetsofthemutualfund.Basically,thisprocessallowsafnancialintermediarytotransformf-nancialassetsthatarelessdesirableforalargepartoftheinvestingpublicintootherfnancialassets—theirownliabilities—whicharemorewidelypreferredbythepublic.Thisassettransformationprovidesatleastoneofthreeeconomicfunctions: 1. Maturityintermediation. 2. Riskreductionviadiversifcation. 3. Costreductionforcontractingandinformationprocessing.Wedescribeeachoftheseshortly.Thereareotherservicesthatfnancialintermediariescanprovide.Theyinclude: Facilitatingthetradingoffnancialassetsforthefnancialintermediary’scustomersthroughbrokeringarrangements.
20 THEFINANCIALSYSTEM Facilitatingthetradingoffnancialassetsbyusingitsowncapitaltotaketheotherpositioninafnancialassettoaccommodateacustomer’stransaction. Assistinginthecreationoffnancialassetsforitscustomersandtheneitherdistributingthosefnancialassetstoothermarketparticipants. Providinginvestmentadvicetocustomers. Managingthefnancialassetsofcustomers. Providingapaymentmechanism.Wenowdiscussthethreeeconomicfunctionsoffnancialintermediarieswhentheytransformfnancialassets. MaturityIntermediation Inourexampleofthecommercialbank,youshouldnotetwothings.First,thedeposits’maturityistypicallyshortterm.Banksholddepositsthatarepayableupondemandorhaveaspecifcmaturitydate,andmostarelessthanthreeyears.Second,thematurityoftheloansmadebyacom-mercialbankmaybeconsiderablylongerthanthreeyears.Thinkaboutwhatwouldhappenifcommercialbanksdidnotexistinafnancialsys-tem.Inthisscenario,borrowerswouldhavetoeither(1)borrowforashorterterminordertomatchthelengthoftimelendersarewillingtoloanfunds;or(2)locatelendersthatarewillingtoinvestforthelengthoftheloansought.Nowputcommercialbanksbackintothefnancialsystem.Byissuingitsownfnancialclaims,thecommercialbank,inessence,transformsalonger-termassetintoashorter-termonebygivingtheborroweraloanforthelengthoftimesoughtandthedepositor—whoisthelender—afnancialassetforthedesiredinvestmenthorizon.Werefertothisfunctionofafnancialintermediarya maturityintermediation. Theimplicationsofmaturityintermediationforfnancialsystemsaretwofold.Thefrstimplicationisthatlenders/investorshavemorechoiceswithrespecttothematurityforthefnancialinstrumentsinwhichtheyinvestandborrowershavemorealternativesforthelengthoftheirdebtobligations.Thesecondimplicationisthatbecauseinvestorsarereluctanttocommitfundsforalongtime,theyrequirelong-termborrowerstopayahigherinterestratethanonshort-termborrowing.However,afnancialintermediaryiswillingtomakelonger-termloans,andatalowercosttotheborrowerthananindividualinvestorwouldbecausethefnancialintermedi-arycanrelyonsuccessivefundingsourcesoveralongtimeperiod(althoughatsomerisk).Forexample,adepositoryinstitutioncanreasonablyexpecttohavesuccessivedepositstobeabletofundalonger-terminvestment.As
FinancialInstruments,Markets,andIntermediaries 21 aresultofthisintermediation,thecostoflonger-termborrowingislikelyreducedinaneconomy. RiskReductionviaDiversification Considerthesecondexampleaboveofamutualfund.Supposethatthemutualfundinveststhefundsreceivedfrominvestorsinthestockofalargenumberofcompanies.Bydoingso,themutualfunddiversifesandreducesitsrisk. Diversifcation isthereductioninriskfrominvestinginassetswhosereturnsdonotmoveinthesamedirectionatthesametime.Investorswithasmallsumtoinvestwouldfnditdiffculttoachievethesamedegreeofdiversifcationasamutualfundbecauseoftheirlackofsuffcientfundstobuysharesofalargenumberofcompanies.Yetbyinvestinginthemutualfundforthesamedollarinvestment,investorscanachievethisdiversifcation,therebyreducingrisk.Financialintermediariesperformtheeconomicfunctionofdiversifca-tion,transformingmoreriskyassetsintolessriskyones.Thoughindividualinvestorswithsuffcientfundscanachievediversifcationontheirown,theymaynotbeabletoaccomplishitascosteffectivelyasfnancialinterme-diaries.Realizingcost-effectivediversifcationinordertoreduceriskbypurchasingthefnancialassetsofafnancialintermediaryisanimportanteconomicbeneftforfnancialsystems. ReducingtheCostsofContractingandInformationProcessing Investorspurchasingfnancialassetsmustdevelopskillsnecessarytoeval-uatetheirriskandreturn.Afterdevelopingthenecessaryskills,investorscanapplytheminanalyzingspecifcfnancialassetswhencontemplatingtheirpurchaseorsubsequentsale.Investorswhowanttomakealoantoaconsumerorbusinessneedtohavetheskilltowritealegallyenforceablecontractwithprovisionstoprotecttheirinterests.Afterinvestorsmakethisloan,theywouldhavetomonitorthefnancialconditionoftheborrowerand,ifnecessary,pursuelegalactioniftheborrowerviolatesanyprovisionsoftheloanagreement.Althoughsomeinvestorsmightenjoydevotingleisuretimetothistaskiftheyhadtheprerequisiteskillset,mostfndleisuretimetobeinshortsupplyandwantcompensationforsacrifcingit.Theformofcompensationcouldbeahigherreturnobtainedfromaninvestment.Inadditiontotheopportunitycostofthetimetoprocesstheinfor-mationaboutthefnancialassetanditsissuer,wemustconsiderthecostofacquiringthatinformation.Suchcostsareinformation-processingcosts.Thecostsassociatedwithwritingloanagreementsare contractingcosts.
22 THEFINANCIALSYSTEM Anotheraspectofcontractingcostsisthecostofenforcingthetermsoftheloanagreement.Withthesepointsinmind,considerourtwoexamplesoffnancialintermediaries—thecommercialbankandthemutualfund.Thestaffsofthesetwofnancialintermediariesincludeinvestmentprofessionalstrainedtoanalyzefnancialassetsandmanagethem.Inthecaseofloanagreements,eitherstandardizedcontractsmaybeprepared,orlegalcounselcanbepartoftheprofessionalstafftowritecontractsinvolvingtransactionsthataremorecomplex.Investmentprofessionalsmonitortheactivitiesofthebor-rowertoassurecompliancewiththeloanagreement’stermsand,wherethereisanyviolation,takeactiontoprotecttheinterestsofthefnancialintermediary.Itisclearlycosteffectiveforfnancialintermediariestomaintainsuchstaffsbecauseinvestingfundsistheirnormalbusiness.Thereareeconomiesofscalethatfnancialintermediariesrealizeincontractingandprocessinginformationaboutfnancialassetsbecauseoftheamountoffundsthattheymanage. 1 Thesereducedcosts,comparedtowhatindividualinvestorswouldhavetoincurtoprovidefundstothosewhoneedthem,accruetothebeneftof(1)investorswhopurchaseafnancialclaimofthefnancialintermediary;and(2)issuersoffnancialassets(aresultoflowerfundingcosts). RegulatingFinancialActivities Mostgovernmentsthroughouttheworldregulatevariousaspectsoffnancialactivitiesbecausetheyrecognizethevitalroleplayedbyacountry’sfnancialsystem.Althoughthedegreeofregulationvariesfromcountrytocountry,regulationtakesoneoffourforms: 1. Disclosureregulation. 2. Financialactivityregulation. 3. Regulationoffnancialinstitutions. 4. Regulationofforeignparticipants.Disclosureregulationrequiresthatanypubliclytradedcompanyprovidefnancialinformationandnonfnancialinformationonatimelybasisthatwouldbeexpectedtoaffectthevalueofitssecuritytoactualandpotentialinvestors.Governmentsjustifydisclosureregulationbypointingoutthat 1 Economiesofscale arethereductionofcostsperunitwhenthenumberofunitspro-ducedandsoldincreases.Inthiscontext,thisisthecostadvantageanintermediaryachieveswhenitincreasesthescaleofitsoperationsincontractingandprocessing.
FinancialInstruments,Markets,andIntermediaries 23 theissuerhasaccesstobetterinformationabouttheeconomicwell-beingoftheentitythanthosewhoownorarecontemplatingownershipofthesecurities.Economistsrefertothisunevenaccessorunevenpossessionofinforma-tionas asymmetricinformation. IntheUnitedStates,disclosureregulationisembeddedinvarioussecuritiesactsthatdelegatetotheSecuritiesandEx-changeCommission(SEC)theresponsibilityforgatheringandpublicizingrelevantinformation,andforpunishingthoseissuerswhosupplyfraudu-lentormisleadingdata.However,disclosureregulationdoesnotattempttopreventtheissuanceofriskyassets.Rather,theSEC’ssolemotivationistoassurethatissuerssupplydiligentandintelligentinvestorswiththeinformationneededforafairevaluationofthesecurities.Rulesabouttradersofsecuritiesandtradingonfnancialmarketscom-prisefnancialactivityregulation.Probablythebestexampleofthistypeofregulationisthesetofrulesprohibitingthetradingofasecuritybythosewho,becauseoftheirprivilegedpositioninacorporation,knowmoreabouttheissuer’seconomicprospectsthanthegeneralinvestingpublic.Suchindi-vidualsareinsidersandinclude,yetarenotlimitedto,corporatemanagersandmembersoftheboardofdirectors.Thoughitisnotillegalforinsid-erstobuyorsellthestockofacompanyinwhichtheyareconsideredaninsider, illegalinsidertrading isthetradinginasecurityofacompanybyapersonwhoisaninsider,andthetradeisbasedonmaterial,nonpublicinformation.Illegalinsidertradingisanotherproblemposedbyasymmetricinformation.TheSECisresponsibleformonitoringthetradesthatcorporateoffcers,directors,aswellasmajorstockholders,executeinthesecuritiesoftheirfrms.Anotherexampleoffnancialactivityregulationisthesetofrulesim-posedbytheSECregardingthestructureandoperationsofexchangeswheresecuritiestrade.Thejustifcationforsuchrulesisthatitreducesthelikeli-hoodthatmembersofexchangesmaybeable,undercertaincircumstances,tocolludeanddefraudthegeneralinvestingpublic.BoththeSECandtheself-regulatoryorganization,theFinancialIndustryRegulatoryAuthority(FINRA),areresponsiblefortheregulationofmarketsandsecuritiesfrmsintheUnitedStates.TheSECandtheCommodityFuturesTradingCommission(CFTC),anotherfederalgovernmententity,shareresponsibilityforthefederalregula-tionoftradinginoptions,futuresandotherderivativeinstruments. Deriva-tiveinstruments aresecuritieswhosevaluedependsonaspecifedothersecurityorasset.Forexample,acalloptiononastockisaderivativesecu-ritywhosevaluedependsonthevalueoftheunderlyingstock;ifthevalueofthestockincreases,thevalueofthecalloptiononthestockincreasesaswell.
24 THEFINANCIALSYSTEM Theregulationoffnancialinstitutionsisaformofgovernmentalmon-itoringthatrestrictstheiractivities.Suchregulationisjustifedbygovern-mentsbecauseofthevitalroleplayedbyfnancialinstitutionsinacountry’seconomy.Governmentregulationofforeignparticipantsinvolvestheimpositionofrestrictionsontherolesthatforeignfrmscanplayinacountry’sinternalmarketandtheownershiporcontroloffnancialinstitutions.Althoughmanycountrieshavethisformofregulation,therehasbeenatrendtolessentheserestrictions.WelistthemajorU.S.securitiesmarketandsecuritieslegislationinExhibit2.2.ThecurrentU.S.regulatorysysteminvolvesanarrayofindustryandmarket-focusedregulators.Thoughthespecifcsoffnancialregulatoryreformarenotdeterminedatthetimeofthiswriting,thereareseveralelementsofreformthatappearinthemajorproposals: Anadvanced-warningsystem,whichwouldattempttoidentifysystemicrisksbeforetheyaffectthegeneraleconomy. Increasedtransparencyinconsumerfnance,mortgagebrokerage,asset-bakedsecurities,andcomplexsecurities. Increasedtransparencyofcredit-ratingfrms. Enhancedconsumerprotections. Increasedregulationofnonbanklenders. Somemeasuretoaddresstheissueoffnancialinstitutionsthatmaybesolargethattheirfnancialdistressaffectstherestoftheeconomy. TYPESOFFINANCIALMARKETS Earlierweprovidedthegeneralroleoffnancialmarketsinafnancialsystem.Inthissection,wediscussthemanywaystoclassifyfnancialmarkets.Fromtheperspectiveofagivencountry,wecanbreakdownacoun-try’sfnancialmarketintoaninternalmarketandanexternalmarket.The internalmarket ,whichwealsorefertoasthe nationalmarket ,ismadeupoftwoparts:thedomesticmarketandtheforeignmarket.The domesticmarket iswhereissuersdomiciledinthecountryissuesecuritiesandwhereinvestorsthentradethosesecurities.Forexample,fromtheperspectiveoftheUnitedStates,securitiesissuedbyMicrosoft,aU.S.corporation,tradeinthedomesticmarket.The foreignmarket iswheresecuritiesofissuersnotdomiciledinthecountryaresoldandtraded.Forexample,fromaU.S.perspective,the
FinancialInstruments,Markets,andIntermediaries 25 EXHIBIT2.2 FederalRegulationofSecuritiesMarketsintheUnitedStates LawDescription SecuritiesActof1933Regulatesnewofferingsofsecuritiestothepublic.Itrequirestheflingofaregistrationstatementcontainingspecifcinformationabouttheissuingcorporationandprohibitsfraudulentanddeceptivepracticesrelatedtosecurityoffers.SecuritiesandExchangeActof1934EstablishestheSecuritiesandExchangeCommission(SEC)toenforcesecuritiesregulationsandextendsregulationtothesecondarymarkets.InvestmentCompanyActof1940GivestheSECregulatoryauthorityoverpubliclyheldcompaniesthatareinthebusinessofinvestingandtradinginsecurities.InvestmentAdvisersActof1940Requiresregistrationofinvestmentadvisorsandregulatestheiractivities.FederalSecuritiesActof1964ExtendstheregulatoryauthorityoftheSECtoincludetheover-the-countersecuritiesmarkets.SecuritiesInvestorProtectionActof1970CreatestheSecuritiesInvestorProtectionCorporation,whichischargedwiththeliquidationofsecuritiesfrmsthatareinfnancialtroubleandwhichinsuresinvestors’accountswithbrokeragefrms.InsiderTradingSanctionsActof1984Providesfortrebledamagestobeassessedagainstviolatorsofsecuritieslaws.InsiderTradingandSecuritiesFraudEnforcementActof1988Providespreventativemeasuresagainstinsidertradingandestablishesenforcementproceduresandpenaltiesfortheviolationofsecuritieslaws.PrivateSecuritiesLitigationReformActof1995Limitsshareholderlawsuitsagainstcompanies,providessafe-harborforforward-lookingstatementbycompanies,andprovidesforauditordisclosureofcorporatefraud.SecuritiesLitigationUniformStandardsActof1998CorrectsthePrivateSecuritiesLitigationReformActof1995,reducingtheabilityofplaintiffstobringsecuritiesfraudcasesthroughstatecourts.Sarbanes-OxleyActof2002Wide-sweepingchangesthatprovidereformsincorporateresponsibilityandfnancialdisclosures,createsthePublicCompanyAccountingOversightBoard,andincreasedpenaltiesforaccountingandcorporatefraud.
26 THEFINANCIALSYSTEM securitiesissuedbyToyotaMotorCorporationtradeintheforeignmar-ket.WerefertotheforeignmarketintheUnitedStatesasthe“Yankeemarket.”Theregulatoryauthoritieswherethesecurityisissuedimposetherulesgoverningtheissuanceofforeignsecurities.Forexample,non–U.S.corpora-tionsthatseektoissuesecuritiesintheUnitedStatesmustcomplywithU.S.securitieslaw.Anon-JapanesecorporationthatwantstosellitssecuritiesinJapanmustcomplywithJapanesesecuritieslawandregulationsimposedbytheJapaneseMinistryofFinance. YANKEEMARKETSANDMORE ... InJapantheforeignmarketisnicknamedthe“Samuraimarket,”intheUnitedKingdomthe“Bulldogmarket,”intheNetherlandsthe“Rembrandtmarket,”andinSpainthe“Matadormarket.” Theothersectorofacountry’sfnancialmarketisthe externalmarket. Thisisthemarketwheresecuritieswiththefollowingtwodistinguishingfeaturesaretrading: 1. Atissuancethesecuritiesareofferedsimultaneouslytoinvestorsinanumberofcountries. 2. Thesecuritiesareissuedoutsidethejurisdictionofanysinglecountry.Wealsorefertotheexternalmarketasthe internationalmarket ,the offshoremarket ,andthe Euromarket (despitethefactthatthismarketisnotlimitedtoEurope). TheMoneyMarket The moneymarket isthesectorofthefnancialmarketthatincludesfnancialinstrumentswithamaturityorredemptiondateoneyearorlessatthetimeofissuance.Typically,moneymarketinstrumentsaredebtinstrumentsandincludeTreasurybills,commercialpaper,negotiablecertifcatesofdeposit,repurchaseagreements,andbankers’acceptances. 2 Treasurybills (popularlyreferredtoas T-bills )areshort-termsecuri-tiesissuedbytheU.S.government;theyhaveoriginalmaturitiesoffour 2 Undercertaincircumstances,weconsiderpreferredstockasamoneymarketin-strument.
FinancialInstruments,Markets,andIntermediaries 27 weeks,threemonths,orsixmonths.T-billscarrynostatedinterestrate.Instead,thegovernmentsellsthesesecuritiesonadiscountedbasis.ThismeansthattheholderofaT-billrealizesareturnbybuyingthesesecuritiesforlessthanthematurityvalueandthenreceivingthematurityvalueatmaturity. Commercialpaper isapromissorynote—awrittenpromisetopay—issuedbyalarge,creditworthycorporationoramunicipality.Thisfnancialinstrumenthasanoriginalmaturitythattypicallyrangesfromonedayto270days.Theissuersofmostcommercialpaperbackupthepaperwithbanklinesofcredit,whichmeansthatabankisstandingbyreadytopaytheobligationiftheissuerisunableto.Commercialpapermaybeeitherinterestbearingorsoldonadiscountedbasis. Certifcatesofdeposit (CDs)arewrittenpromisesbyabanktopayadepositor.Investorscanbuyandsell negotiablecertifcatesofdeposit ,whichareCDsissuedbylargecommercialbanks.NegotiableCDstypicallyhaveoriginalmaturitiesbetweenonemonthandoneyearandhavedenominationsof$100,000ormore.InvestorspayfacevaluefornegotiableCDs,andreceiveafxedrateofinterestontheCD.Onthematuritydate,theissuerrepaystheprincipal,plusinterest.A EurodollarCD isanegotiableCDforaU.S.dollardepositatabanklocatedoutsidetheUnitedStatesorinU.S.InternationalBankingFacilities.TheinterestrateonEurodollarCDsisthe LondonInterbankOfferedRate ( LIBOR ),whichistherateatwhichmajorinternationalbanksarewillingtooffertermEurodollardepositstoeachother.Anotherformofshort-termborrowingisthe repurchaseagreement. Tounderstandarepurchaseagreement,wewillbriefydescribewhycompaniesusethisinstrument.Thereareparticipantsinthefnancialsystemthatuseleverageinimplementingtradingstrategiesinthebondmarket.Thatis,thestrategyinvolvesbuyingbondswithborrowedfunds.Ratherthanborrowingfromabank,amarketparticipantcanusethebondsithasacquiredascollateralforaloan.Specifcally,thelenderwillloanacertainamountoffundstoanentityinneedoffundsusingthebondsascollateral.Werefertothiscommonlendingagreementasarepurchaseagreementor repo becauseitspecifesthattheborrowersellsthebondstothelenderinexchangeforproceedsandatsomespecifedfuturedatetheborrowerrepurchasesthebondsfromthelenderataspecifedprice.Thespecifedprice,calledtherepurchaseprice,ishigherthanthepriceatwhichthebondsaresoldbecauseitembodiestheinterestcostthatthelenderischargingtheborrower.Theinterestrateinarepoisthe reporate. Thus,arepoisnothingmorethanacollateralizedloan;thatis,aloanbackedbyaspecifcasset.Weclassifyitasamoneymarketinstrumentbecausethetermofarepoistypicallylessthanoneyear.
28 THEFINANCIALSYSTEM Bankers’acceptances areshort-termloans,usuallytoimportersandex-porters,madebybankstofnancespecifctransactions.Anacceptanceiscreatedwhenadraft(apromisetopay)iswrittenbyabank’scustomerandthebank“accepts”it,promisingtopay.Thebank’sacceptanceofthedraftisapromisetopaythefaceamountofthedrafttowhoeverpresentsitforpayment.Thebank’scustomerthenusesthedrafttofnanceatransaction,givingthisdrafttothesupplierinexchangeforgoods.Becauseacceptancesarisefromspecifctransactions,theyareavailableinawidevarietyofprin-cipalamounts.Typically,bankers’acceptanceshavematuritiesoflessthan180days.Bankers’acceptancesaresoldatadiscountfromtheirfacevalue,andthefacevalueispaidatmaturity.Thelikelihoodofdefaultonbankers’acceptancesisverysmallbecauseacceptancesarebackedbyboththeissuingbankandthepurchaserofgoods. TheCapitalMarket The capitalmarket isthesectorofthefnancialmarketwherelong-termfnancialinstrumentsissuedbycorporationsandgovernmentstrade.Here“long-term”referstoafnancialinstrumentwithanoriginalmaturitygreaterthanoneyearandperpetualsecurities(thosewithnomaturity).Therearetwotypesofcapitalmarketsecurities:thosethatrepresentsharesofown-ershipinterest,alsocalledequity,issuedbycorporations,andthosethatrepresentindebtedness,issuedbycorporationsandbytheU.S.,state,andlocalgovernments.Earlierwedescribedthedistinctionbetweenequityanddebtinstru-ments.Equityincludescommonstockandpreferredstock.Becausecommonstockrepresentsownershipofthecorporation,andbecausethecorporationhasaperpetuallife,commonstockisaperpetualsecurity;ithasnomaturity.Preferredstockalsorepresentsownershipinterestinacorporationandcaneitherhavearedemptiondateorbeperpetual.Acapitalmarketdebtobligationisafnancialinstrumentwherebytheborrowerpromisestorepaythematurityvalueataspecifedperiodoftimebeyondoneyear.Wecanbreakdownthesedebtobligationsintotwocategories:bankloansanddebtsecurities.Whileatonetime,bankloanswerenotconsideredcapitalmarketinstruments,todaythereisamarketforthetradingofthesedebtobligations.Oneformofsuchabankloanisa syndicatedbankloan. Thisisaloaninwhichagroup(orsyndicate)ofbanksprovidesfundstotheborrower.Theneedforagroupofbanksarisesbecausetheexposureintermsofthecreditriskandtheamountsoughtbyaborrowermaybetoolargeforanyonebank.Debtsecuritiesinclude(1)bonds,(2)notes,(3)medium-termnotes,and(4)asset-backedsecurities.Thedistinctionbetweenabondandanote
FinancialInstruments,Markets,andIntermediaries 29 hastodowiththenumberofyearsuntiltheobligationmatureswhentheissueroriginallyissuedthesecurity.Historically,anoteisadebtsecuritywithamaturityatissuanceof10yearsorless;abondisadebtsecuritywithamaturitygreaterthan10years.Thedistinctionbetweenanoteandamedium-termnotehasnothingtodowiththematurity,butratherthemethodofissuingthesecurity. 3 Throughoutmostofthisbook,werefertoabond,anote,oramedium-termnoteassimplyabond.Wewillrefertotheinvestorsinanydebtobligationasthe debtholder , bondholder , creditor ,or noteholder . TheDerivativeMarket Weclassifyfnancialmarketsintermsofcashmarketsandderivativemar-kets.The cashmarket ,alsoreferredtoasthe spotmarket ,isthemarketfortheimmediatepurchaseandsaleofafnancialinstrument.Incontrast,somefnancialinstrumentsarecontractsthatspecifythatthecontractholderhaseithertheobligationorthechoicetobuyorsellsomethingatorbysomefuturedate.The“something”thatisthesubjectofthecontractisthe un-derlyingasset orsimplythe underlying. Theunderlyingcanbeastock,abond,afnancialindex,aninterestrate,acurrency,oracommodity.Suchcontractsderivetheirvaluefromthevalueoftheunderlying;hence,werefertothesecontractsas derivativeinstruments ,orsimply derivatives ,andthemarketinwhichtheytradeisthe derivativesmarket. Derivativesinstruments,orsimplyderivatives,includefutures,for-wards,options,swaps,caps,andfoors.Wepostponeadiscussionoftheseimportantfnancialinstruments,aswellastheirapplicationsincorporatefnanceandportfoliomanagement,tolaterchapters.Theprimaryroleofderivativeinstrumentsistoprovideatransactionallyeffcientvehicleforprotectingagainstvarioustypesofriskencounteredbyinvestorsandissuers.Admittedly,itisdiffculttoseeatthisearlystagehowderivativesareusefulforcontrollingriskinaneffcientwaysincetoooftenthepopularpressfocusesonhowderivativeshavebeenmisusedbycorporatetreasurersandportfoliomanagers. 3 Thisdistinctionbetweennotesandbondsisnotpreciselytrue,butisconsistentwithcommonusageofthetermsnoteandbond.Infact,notesandbondsaredistinguishedbywhetherornotthereisanindentureagreement,alegalcontractspecifyingthetermsoftheborrowingandanyrestrictions,andidentifyingatrusteetowatchoutforthedebtholders’interests.Abondhasanindentureagreement,whereasanotedoesnot.
30 THEFINANCIALSYSTEM ThePrimaryMarket Whenanissuerfrstissuesafnancialinstrument,itissoldinthe primarymarket. Companiessellnewissuesandthusraisenewcapitalinthismarket.Therefore,itisthemarketwhosesalesgenerateproceedsfortheissuerofthefnancialinstrument.IssuanceofsecuritiesmustcomplywiththeU.S.securitieslaws.Theprimarymarketconsistsofbothapublicmarketandaprivateplacementmarket.Thepublicmarketofferingofnewissuestypicallyinvolvestheuseofaninvestmentbank.Theprocessofinvestmentbanksbringingthesesecuritiestothepublicmarketsis underwriting .Anothermethodofofferingnewissuesisthroughan auctionprocess. Bondsbycertainentitiessuchasmunicipalgovernmentsandsomeregulatedentitiesareissuedinthisway.Therearedifferentregulatoryrequirementsforsecuritiesissuedtothegeneralinvestingpublicandthoseprivatelyplaced.Thetwomajorsecu-ritieslawsintheUnitedStates—theSecuritiesActof1933andtheSecu-ritiesExchangeActof1934—requirethatunlessotherwiseexempted,allsecuritiesofferedtothegeneralpublicmustregisterwiththeSEC.Oneoftheexemptionssetforthinthe1933Actisfor“transactionsbyanissuernotinvolvinganypublicoffering.”Werefertosuchofferingsas privateplacementofferings. Priorto1990,buyersofprivatelyplacedsecuri-tieswerenotpermittedtosellthesesecuritiesfortwoyearsafteracquisition.SECRule144A,approvedbytheSECin1990,eliminatesthetwo-yearholdingperiodifcertainconditionsaremet.Asaresult,theprivateplace-mentmarketisnowclassifedintotwocategories:Rule144Aofferingsandnon-Rule144A(commonlyreferredtoas traditionalprivateplacements ). TheSecondaryMarket A secondarymarket isoneinwhichfnancialinstrumentsareresoldamonginvestors.Issuersdonotraisenewcapitalinthesecondarymarketand,therefore,theissuerofthesecuritydoesnotreceiveproceedsfromthesale.Tradingtakesplaceamonginvestors.Investorswhobuyandsellsecuritiesonthesecondarymarketsmayobtaintheservicesofstockbrokers,entitieswhobuyorsellsecuritiesfortheirclients.Wecategorizesecondarymarketsbasedonthewayinwhichtheytrade,referredtoas marketstructure. Therearetwooverallmarketstructuresfortradingfnancialinstruments:orderdrivenandquotedriven. Marketstructure isthemechanismbywhichbuyersandsellersinteracttodeterminepriceandquantity.Inan order-drivenmarketstructure ,buyersandsellerssubmittheirbidsthroughtheirbroker,whorelaysthesebidstoacentralizedlocationforbid-matching,andtransactionexecution.Wealsorefertoanorder-drivenmarketasan auctionmarket.
FinancialInstruments,Markets,andIntermediaries 31 Ina quote-drivenmarketstructure ,intermediaries(marketmakersordealers)quotethepricesatwhichthepublicparticipantstrade. Marketmakers provideabidquote(tobuy)andanofferquote(tosell),andrealizerevenuesfromthespreadbetweenthesetwoquotes.Thus,marketmakersderiveaproftfromthespreadandtheturnoveroftheirinventoryofasecurity.Therearehybridmarketstructuresthathaveelementsofbothaquote-drivenandorder-drivenmarketstructure.Wecanalsoclassifysecondarymarketsintermsoforganizedex-changesandover-the-countermarkets. Exchanges arecentraltradinglo-cationswherefnancialinstrumentstrade.Thefnancialinstrumentsmustbethoselistedbytheorganizedexchange.By listed ,wemeanthefnancialinstrumenthasbeenacceptedfortradingontheexchange.Tobelisted,theissuermustsatisfyrequirementssetforthbytheexchange.Inthecaseofcommonstock,themajororganizedexchangeistheNewYorkStockExchange(NYSE).ForthecommonstockofacorporationtolistontheNYSE,forexample,itmustmeetminimumrequirementsforpretaxearnings,nettangibleassets,marketcapitalization,andnumberanddistributionofsharespubliclyheld.IntheUnitedStates,theSECmustapprovethemarkettoqualifyitasanexchange.Incontrast,an over-the-countermarket (OTCmarket)isgenerallywhereunlistedfnancialinstrumentstrade.Forcommonstock,therearelistedandunlistedstocks.Althoughtherearelistedbonds,bondsaretyp-icallyunlistedandthereforetradeover-the-counter.Thesameistrueofloans.TheforeignexchangemarketisanOTCmarket.Therearelistedandunlistedderivativeinstruments. MarketEfficiency Investorsdonotlikeriskandtheymustbecompensatedfortakingonrisk—thelargertherisk,themorethecompensation.Animportantquestionaboutfnancialmarkets,whichhasimplicationsforthedifferentstrategiesthatinvestorscanpursue,isthis:Caninvestorsearnareturnonfnancialassetsbeyondthatnecessarytocompensatethemfortherisk?Economistsrefertothisexcesscompensationasan abnormalreturn. Inlesstechnicaljargon,wereferredtothisinChapter1as“beatingthemarket.”Whetherthiscanbedoneinaparticularfnancialmarketisanempiricalquestion.Ifthereissuchastrategythatcangenerateabnormalreturns,theattributesthatleadonetoimplementsuchastrategyisreferredtoasa marketanomaly. Werefertohoweffcientlyafnancialmarketpricestheassetstradedinthatmarketas marketeffciency. Aprice-effcientmarket,orsimplyan effcientmarket ,isafnancialmarketwhereassetpricesrapidlyrefectallavailableinformation.Thismeansthatallavailableinformationisalreadyimpoundedintoanasset’sprice,soinvestorsshouldexpecttoearnareturn
32 THEFINANCIALSYSTEM necessarytocompensatethemfortheiranticipatedrisk.Thatwouldseemtoprecludeabnormalreturns.But,accordingtoEugeneFama,therearethefollowingthreelevelsofmarketeffciency:(1)weak-formeffcient,(2)semi-strong-formeffcient,and(3)strong-formeffcient. 4 Inthe weakformofmarketeffciency ,currentassetpricesrefectallpastpricesandpricemovements.Inotherwords,allworthwhileinformationabouthistoricalpricesofthestockisalreadyrefectedintoday’sprice;theinvestorcannotusethatsameinformationtopredicttomorrow’spriceandstillearnabnormalprofts. 5 Inthe semi-strongformofmarketeffciency ,thecurrentassetpricesrefectallpubliclyavailableinformation.Theimplicationisthatifinvestorsemployinvestmentstrategiesbasedontheuseofpubliclyavailableinfor-mation,theycannotearnabnormalprofts.Thisdoesnotmeanthatpriceschangeinstantaneouslytorefectnewinformation,butratherthatassetpricesrefectthisinformationrapidly.EmpiricalevidencesupportstheideathattheU.S.stockmarketisforthemostpartsemi-strongformeffcient.This,inturn,impliesthatcarefulanalysisofcompaniesthatissuestockscannotconsistentlyproduceabnormalreturns.Inthe strongformofmarketeffciency ,assetpricesrefectallpublicandprivateinformation.Inotherwords,themarket(whichincludesallin-vestors)knowseverythingaboutallfnancialassets,includinginformationthathasnotbeenreleasedtothepublic.Thestrongformimpliesthatin-vestorscannotmakeabnormalreturnsfromtradingoninsideinformation(discussedearlier),informationthathasnotyetbeenmadepublic.IntheU.S.stockmarket,thisformofmarketeffciencyisnotsupportedbyempir-icalstudies.Infact,weknowfromrecenteventsthattheoppositeistrue;gainsareavailablefromtradingoninsideinformation.Thus,theU.S.stockmarket,theempiricalevidencesuggests,isessentiallysemi-strongeffcientbutnotinthestrongform.Theimplicationsformarketeffciencyforissuersisthatifthefnancialmarketsinwhichtheyissuesecuritiesaresemi-strongeffcient,issuersshouldexpectinvestorstopayapriceforthosesharesthatrefectstheirvalue.Thisalsomeansthatifnewinformationabouttheissuerisrevealedtothepublic(forexample,concerninganewproduct),thepriceofthesecurityshouldchangetorefectthatnewinformation. 4 EugeneF.Fama,“EffcientCapitalMarkets:AReviewofTheoryandEmpiricalWork ,”JournalofFinance 25(1970):383–417. 5 EmpiricalevidencefromtheU.S.stockmarketsuggeststhatinthismarketthereisweak-formeffcient.Inotherwords,youcannotoutperform(“beat”)themarketbyusinginformationonpaststockprices.
FinancialInstruments,Markets,andIntermediaries 33 THEBOTTOMLINE Financialintermediariesservethefnancialsystembyfacilitatingthefowoffundsfromentitieswithfundstoinvesttoentitiesseekingfunds. Financialmarketsprovidepricediscovery,provideliquidity,andreducetransactionscostsinthefnancialsystem. Financialintermediariesnotonlyfacilitatethefowoffundsinthef-nancialsystem,buttheyalsotransformfnancialclaims,providingmorechoicesforbothinvestorsandborrowers,reducingriskthroughdiver-sifcation,andreducingcosts. Regulationoffnancialmarketstakesoneoffourforms:disclosurereg-ulation,fnancialactivityregulation,regulationoffnancialinstitutions,andregulationofforeignparticipants. Financialmarketscanbeclassifedasfollows:moneymarketsver-suscapitalmarkets,cashversusderivativesmarkets,primaryversussecondarymarkets,andmarketstructure(orderdrivenversusquotedriven). Marketpriceeffciencyfallsintothreecategories(weakform,semi-strongform,andstrongform),andtheformofthiseffciencydetermineswhetherinvestorscanconsistentlyearnabnormalprofts. QUESTIONS 1. Whatdistinguishesindebtednessandequity? 2. Ispreferredstockadebtorequityinstrument?Explain. 3. Howdoesamutualfundperformitsfunctionasafnancialintermediary? 4. Whatismeantbytheterm“maturityintermediation”? 5. IntheUnitedStates,whoaretheregulatorsoffnancialmarkets? 6. Whatareexamplesofmoneymarketsecurities?Provideatleastfourexamples. 7. Whatisthedifferencebetweenanexchangeandanover-the-countermarket? 8. Whatarethethreeformsofmarketeffciency? 9. Whatdistinguishesaprimarymarketfromasecondarymarket? 10. Whatdistinguishesaspotmarketfromaderivativesmarket? 11. Whatdistinguishesthemoneymarketfromthecapitalmarket? 12. Howdoestheeffciencyofamarketaffectaninvestor’sstrategy? 13. ThefollowingisanexcerpttakenfromaJanuary11,2008,speechentitled“MonetaryPolicyFlexibility,RiskManagement,andFinancial
34 THEFINANCIALSYSTEM Disruptions”byFederalReserveGovernorFredericS.Mishkin(www.federalreserve.gov/newsevents/speech/mishkin20080111a.htm): Althoughfnancialmarketsandinstitutionsdealwithlargevol-umesofinformation,someofthisinformationisbynatureasymmetric. ... Historically,banksandotherfnancialinterme-diarieshaveplayedamajorroleinreducingtheasymmetryofinformation,partlybecausethesefrmstendtohavelong-termrelationshipswiththeirclients.Thecontinuityofthisinformationfowiscrucialtotheprocessofpricediscovery. ... Duringperiodsoffnancialdis-tress,however,informationfowsmaybedisruptedandpricediscoverymaybeimpaired.Asaresult,suchepisodestendtogenerategreateruncertainty. Answerthefollowingquestionspertainingtothestatement: a. Whatismeantbyasymmetric“informationbynature”? b. Whatistheproblemcausedbyinformationasymmetryinfnancialmarkets? c. Howdoyouthinkbankshavehistorically“playedamajorroleinreducingtheasymmetryofinformation”? d. Whatismeantby“pricediscovery”? e. Whyisthecontinuityofinformationfowcriticaltotheprocessofpricediscovery? 14. ThefollowingisanexcerpttakenfromaNovember30,2007,speechentitled“Innovation,Information,andRegulationinFinancialMarkets”byFederalReserveGovernorRandallS.Kroszner(www.federalreserve.gov/newsevents/speech/kroszner20071130a.htm): Innovationsinfnancialmarketshavecreatedawiderangeofinvestmentopportunitiesthatallowcapitaltobeallocatedtoitsmostproductiveusesandriskstobedispersedacrossawiderangeofmarketparticipants.Yet,aswearenowseeing,in-novationcanalsocreatechallengesifmarketparticipantsfacediffcultiesinvaluinganewinstrumentbecausetheyrealizethattheydonothavetheinformationtheyneedoriftheyareun-certainabouttheinformationtheydohave.Insuchsituations,pricediscoveryandliquidityinthemarketforthoseinnovativeproductscanbecomeimpaired.
FinancialInstruments,Markets,andIntermediaries 35 Answerthequestionspertainingtothestatement: a. Whataretheinformationcostsassociatedwithfnancialassets? b. Whatismeantby“liquidity”? c. Whydoyouthinkthatforinnovativefnancialproductspricedis-coveryandliquiditycouldbecomeimpaired? 15. ThefollowingisanexcerpttakenfromaNovember30,2007,speechentitled“Innovation,Information,andRegulationinFinancialMarkets”byFederalReserveGovernorRandallS.Kroszner(www.federalreserve.gov/newsevents/speech/kroszner20071130a.htm): Anotherconsequenceofinformationinvestmentsisatendencytowardsgreaterstandardizationofmanyoftheaspectsofaninstrument,whichcanhelptoincreasetransparencyandre-ducecomplexity. ... Standardizationinthetermsandinthecontractualrightsandobligationsofpurchasersandsellersoftheproductreducestheneedformarketparticipantstoengageinextensiveeffortstoobtaininformationandreducestheneedtoverifytheinformationthatisprovidedinthemarketthroughduediligence.Reducedinformationcostsinturnlowertrans-actioncosts,therebyfacilitatingpricediscoveryandenhancingmarketliquidity.Also,standardizationcanreducelegalrisksbecauselitigationovercontracttermscanresultincaselawthatappliestosimilarsituations,thusreducinguncertainty. Answerthefollowingquestionspertainingtothestatement: a. WhatdoesGovernorKrosznermeanwhenhesaysstandardization“reducestheneedformarketparticipantstoengageinextensiveeffortstoobtaininformationandreducestheneedtoverifytheinformationthatisprovidedinthemarketthroughduediligence”? b. Howdo“Reducedinformationcostsinturnlowertransactioncosts,therebyfacilitatingpricediscoveryandenhancingmarketliquidity”?
CHAPTER 3 TheFinancialSystem’sCastofCharacters Financialcrisesareextremelydiffculttoanticipate,andeachepisodeoffnancialinstabilityseemstohaveuniqueaspects,buttwoconditionsarecommontomostsuchevents.First,majorcrisesusuallyinvolvefnancialinstitutionsormarketsthatareeitherverylargeorplaysomecriticalroleinthefnancialsystem.Second,theoriginsofmostfnancialcrises(excluding,perhaps,thoseattributabletonaturaldisasters,war,andothernonfnancialevents)canbetracedtofailuresofduediligenceor“marketdiscipline”byanimportantgroupofmarketparticipants. —BenBernanke,ChairmanoftheFederalReserveSystem,March6,2007 T hereisalargenumberofplayersinthefnancialsystemwhobuyandsellfnancialinstruments.TheFederalReserve(“theFed”),ininformationaboutthefnancialmarketsthatitpublishesquarterly,classifesplayersintosectors.WereportthebroadestclassifcationinExhibit3.1.Thepurposeofthischapteristointroduceyoutoalltheseplayersinthefnancialsystem,whichwewilldousingtheFederalReserve’sclassifcationbysectors.Householdsandnonproftsareselfexplanatory,sowewillfocusontheothersectors.Anotherwaytolookatthefnancialsystemisbyconsideringhowmucheachsectorcontributestothegrossdomesticproduct(GDP).ConsidertheGDPcomponentsfor2008fortheUnitedStates,asweshowinExhibit3.2.Asyoucansee,nonfnancialbusinessescontributethemosttoGDP.AswediscussedinChapter2,however,thefnancialsectorsfacilitatethefowoffundsintheeconomy.Therefore,thissectordoesnotproduceas 37
38 THEFINANCIALSYSTEM U.S. EconomyDomesticnonfinancialsectorsForeign sectorGovernmentsectorDepositoryinstitutionsNondepositoryfinanceinstitutionsNonfinancialbusinessesHouseholds &nonprofitsInsurancecompaniesInvestmentcompaniesDomesticfinance sectors EXHIBIT3.1 AMapoftheU.S.FinancialSystem EXHIBIT3.2 U.S.GrossDomesticProduct,2008 Datasource: U.S.CensusBureau,The2010StatisticalAbstract,www.census.gov.
TheFinancialSystem’sCastofCharacters 39 muchGDPasthenonfnancialbusinesses,thefnancialsectorsareimportantinthefnancingandinvestingactivitiesofnonfnancialbusinesses. DOMESTICNONFINANCIALSECTORS TheGovernmentSector Thegovernmentsectorincludesthefederalgovernment,aswellasstateandlocalgovernment: GovernmentsectorGovernment-ownedcorporationsGovernment-sponsoredenterprisesState and localgovernmentFederalgovernment Alsoincludedinthegovernmentsectorsaregovernment–ownedandgovernment-sponsoredenterprises. TheFederalGovernment TheU.S.federalgovernmentraisesfundsbyissuanceofsecurities.Thesecurities,referredtoas Treasurysecurities ,areissuedbytheU.S.DepartmentoftheTreasurythroughanauctionprocess.WeshowtheamountofU.S.governmentdebtovertimeandwhoownsthisdebtinExhibit3.3.Upuntilthemostrecentfnancialcrisis,themajorownerswereFederalReserveBanksandforeigninvestors;thelatterincludeforeigngovernments.InthelastfewquartersinExhibit3.3,youseetheaccumulationofgovernmentdebtbydepositoryinstitutions. Government-OwnedCorporations Thefederalgovernmenthasagenciesthatparticipateinthefnancialmarketbybuyingandsellingsecurities.ThefederalgovernmenthascharteredentitiestoprovidefundingforspecifcU.S.governmentprojects.Theseentitiesarecalled government-ownedcorpora-tions .AgoodexampleistheTennesseeValleyAuthority(TVA),whichwasestablishedbyCongressin1933primarilytoprovidefoodcontrol,nav-igation,andagriculturalandindustrialdevelopment,andtopromotetheuseofelectricpowerintheTennesseeValleyregion.Twootherexamplesofgovernment-ownedcorporationsaretheUnitedStatesPostalServiceandtheNationalRailroadPassengerCorporation(morepopularlyknownas
40 THEFINANCIALSYSTEM $4,000$6,000$8,000$10,000$12,000$14,000$16,000$18,000$20,000 In billions OtherForeign and international investorsMutual funds Insurance companiesPension fundsU.S. savings bondsDepository institutions $0$2,000 2000 June2001 June2002 June2003 June2004 June2005 June2006 June2007 June2008 June2009 June Privately heldFederal reserve andintragovernmentalholdings State and local governments EXHIBIT3.3 U.S.GovernmentDebt,2000Q2–2009Q2(inbillions) Datasource: U.S.DepartmentoftheTreasury. Amtrak).Infact,ofallthegovernment-ownedcorporations,theTVAistheonlyonethatisafrequentissuerofsecuritiesdirectlyintothefnancialmar-kets.Othergovernment-ownedcorporationsraisefundsthroughtheFederalFinancingBank(FFB).TheFFBisauthorizedtopurchaseorsellobligationsissued,sold,orguaranteedbyotherfederalagencies. Government-SponsoredEnterprises Anothertypeofgovernment-charteredentityisonethatischarteredtoprovidesupportfortwosectorsthatareviewedascriticallyimportanttotheU.S.economy:housingandagriculturalsectors.Theseentitiesare government-sponsoredenterprises (GSEs),andareprivatelyownedentities. 1 WeprovidealistingofGSEsinExhibit3.4.TherearetwotypesofGSEs.Thefrstisapubliclyownedshareholdercorporationwhosestockispubliclytraded.ThepubliclyownedGSEsin-cludetheFederalNationalMortgageAssociation,FederalHomeLoanMortgageCorporation,andFederalAgriculturalMortgageCorporation.ThefrsttwoarethemostwellknownGSEsbecauseofthekeyrolethattheyplayedinthehousingfnancemarket.BothFannieMaeandFreddieMachavesimilarpurposes,whicharetopromotehomeownershipthrough 1 Inothercountries,thetermstate-ownedcorporationisused.
TheFinancialSystem’sCastofCharacters 41 EXHIBIT3.4 U.S.GSEs NameNicknameTypePurpose FederalAgriculturalMortgageCorporateFAMCorFarmerMacPubliclyownedAgriculturalFederalFarmCreditSystemFFCSFundingentityAgriculturalFederalHomeLoanBanksFHLBFundingentityHousingFederalHomeLoanMortgageCorporationFHLMCorFreddieMacPubliclyownedHousingFederalNationalMortgageCorporationFNMAorFannieMaePubliclyownedHousing theavailabilityoffnancing.Theyaccomplishthisbybuyingmortgages,poolingthem,andsellingmortgaged-backedsecuritiestoinvestors.BecauseofthefnancialdiffcultiesfacedbybothFannieMaeandFreddieMac,theU.S.governmenttookcontrolofthesetwoGSEsbyplacingthemintoconservatorship. 2 TheothertypeofGSEisafundingentityofafederallycharteredbanklendingsystemandincludestheFederalHomeLoanBanksandtheFederalFarmCreditBanks.Government-sponsoredcorporationsareoftenconfusedwithgovernment-ownedcorporations.Animportantdistinctionisthatgovern-mentownedcorporationsdonotissuestocktothepublic,whereasGSEsissuestock.Anotherdistinctionisthatgovernment-ownedcorporationsarenotoperatedforaproft,whereasGSEsareproft-oriented.Stillanotherdistinctionisthattheentireboardofdirectorsofagovernment-ownedcorporationisappointedbytheU.S.President,whereasonlyfveofninedirectorsareappointedbythePresidentforGSEssuchasFannieMaeandFreddieMac. 3 StateandLocalGovernments Stateandlocalgovernmentsarebothissuersandinvestorsinthefnancialmarkets.Inaddition,theseentitiesestablishauthoritiesandcommissionsthatissuesecuritiesinthefnancialmarket.ExamplesincludetheNewYork/NewJerseyPortAuthority. 2 TheFederalHousingFinanceAgency(FHFA)istheconservatorofbothFannieMaeandFreddieMac,whichmeansthattheFHFAhasfullpowerovertheassetsandoperationsofthesefrms. 3 Thisis,ofcourse,notconsideringthecurrentlyconservatorship,whichgivesthefederalgovernmentmorepowerinGSEsthantypical.
42 THEFINANCIALSYSTEM Stateandlocalgovernmentsinvestwhentheyhaveexcesscashduetothemismatchbetweenthetimingoftaxorotherrevenuesandwhenthosefundshavetobespent.However,themajorreasonwhytheyparticipateasinvestorsisduetothefundsavailabletoinvestfromthepensionfundsthattheysponsorfortheiremployees.Morespecifcally,manystateandlocalgovernmentsprovideadefnedbeneftprogram,aformofpensionwheretheyguaranteebeneftstotheemployeesandtheirbenefciaries.Thefvelargeststateandlocalsponsorsofdefnedpensionfunds(referredtoas publicpensionfunds )andtheirsize,inbillionsoftotalassetsasofJanuary26,2009,accordingto Pension&Investments are:CaliforniaPublicEmployees$213.5CaliforniaStateTeachers$147.0NewYorkStateCommon$138.4FloridaStateBoard$114.5NewYorkCityRetirement$93.2 NONFINANCIALBUSINESSES Nonfnancialbusinessesareenterprisesformedbyindividualsandotherbusinessestoengageinactivitiesforaproft,wheretheseactivitiesarenotprimarilythoseofafnancialintermediary,suchasacommercialbank.Thesebusinessesissuedebtandequityinstruments,andtheyinvestinfnancialmarkets.Businessesparticipateasinvestorsinthefnancialmarketbyinvestingexcessfundsinthemoneymarketand,aswithstateandlocalgovernments,investthefundsofthedefnedbeneftplansinwhichtheysponsor.ThelargestdefnedbeneftpensionfundsofbusinessesintheUnitedStatesarethoseofnonfnancialcorporations.Accordingto Pensions&Investments ,thefvelargestasofJanuary26,2009,intermsoftotalasset(inbillions)are:GeneralMotors$91.0AT&T$61.9GeneralElectric$50.0IBM$49.4Boeing$42.5Somenonfnancialbusinesseshavesubsidiariesthatareinvolvedinthesameactivitiesasfnancialcorporations.Thefnancialsubsidiaries,whichwerefertoas captivefnancecompanies ,participateinthefnancialmarketbylendingfunds.ExamplesincludeFordMotorCredit(asubsidiaryofFord
TheFinancialSystem’sCastofCharacters 43 Motor)andGeneralElectricCreditCorporation(asubsidiaryofGeneralElectric). DOMESTICFINANCIALSECTORS Thefnancialsectorsincludeenterprisesthatandregulatorsthatprovidetheframeworkforfacilitatinglendingandborrowing.Wecanclassifytheseenterprisesintodifferentsectors,dependingonthetypeoftransactionstheyfacilitate: Domesticfinancial sectorDepositoryfinancialinstitutionsNondepositoryfinancialinstitutionsInsuranceInvestmentcompanies DepositoryInstitutions Depositoryinstitutions includecommercialbanksandthrifts.Thriftsincludesavingsandloanassociations,savingsbanks,andcreditunions.Asthenameindicates,theseentitiesacceptdepositsthatrepresenttheliabilities(i.e.,debt)ofthedeposit-acceptinginstitution.Withthefundsraisedthroughdepositsandnondepositsourcesobtainedbyissuingdebtobligationsinthefnancialmarket,depositoryinstitutionsmakeloanstovariousentities(businesses,consumers,andstateandlocalgovernments). Commercialbanks arethelargesttypeofdepositoryinstitutionandwillbethefocushere.Acommercialbankisafnancialinstitutionthatisownedbyshareholders,andengagesinacceptingdepositsandlendingforaproft.Abankmaybeownedbyabankholdingcompany(BHC),whichisacompanythatownsoneormorebanks.ThefvelargestbankholdingcompaniesintheUnitedStatesasofSeptember30,2009,andtheirtotalassetsinbillionsaccordingtotheFederalReserveSystem,NationalInformationCenterare:BankofAmerica$2,253J.P.MorganChase&Company$2,041Citigroup$1,889WellsFargo&Company$1,229GoldmanSachsGroup$883
44 THEFINANCIALSYSTEM BankServices Theprincipalservicesprovidedbycommercialbanksare: 1. Individualbanking 2. Institutionalbanking 3. GlobalbankingIndividualbankingincludesconsumerlending,residentialmortgagelending,consumerinstallmentloans,creditcardfnancing,automobileandboatfnancing,brokerageservices,studentloans,andindividual-orientedfnancialinvestmentservicessuchaspersonaltrustandinvestmentservices.Institutionalbankingincludesloanstobothnonfnancialandfnancialbusiness,governmententities(stateandlocalgovernmentsintheUnitedStatesandforeigngovernments),commercialrealestatefnancing,andleas-ingactivities.Inglobalbanking,commercialbankscompetehead-to-headwithan-othertypeoffnancialinstitution—investmentbankingcompanies. 4 Intheglobalarena,banksengageincorporatefnancingthatinvolves(1)procur-ingoffundsforabank’scustomers,whichcangobeyondtraditionalbankloanstoinvolvetheunderwritingofsecuritiesandprovidinglettersofcreditandothertypesofguarantees;and(2)fnancialadviceonsuchmattersasstrategiesforobtainingfunds,corporaterestructuring,divestitures,andacquisitions.Capitalmarketandforeignexchangeproductsandservicesin-volvetransactionswherethebankmayactasadealerorbrokerinaservice. BankFunding Banksarehighlyleveragedfnancialinstitutions,meaningthatmostoftheirfundscomefromborrowing. 5 Oneformofborrowingincludesdeposits.Therearefourtypesofdepositaccountsissuedbybanks:demanddeposits,savingsdeposits,timedeposits,andmoneymarketdemandaccounts. Demanddeposits ,morepopularlyknownascheckingaccounts,canbewithdrawnupondemandandofferminimalinterest. Savingsdeposits payinterest(typicallybelowmarketinterestrates),donothaveaspecifcmaturity,andusuallycanbewithdrawnupondemand. Timedeposits ,more 4 Wediscussinvestmentbankinglater,whichcoversabroadrangeofactivitiesin-volvingcorporatefnancingandcapitalmarketandforeignexchangeproductsandservices. 5 Atonetime,someoftheseactivitieswererestrictedbytheBankingActof1933,whichcontainedfoursections(popularlyreferredtoastheGlass-SteagallAct)bar-ringcommercialbanksfromcertaininvestmentbankingactivities.TherestrictionswereeffectivelyrepealedwiththeenactmentoftheGramm-Leach-BlileyActinNovember1999,whichexpandedthepermissibleactivitiesforbanksandbankholdingcompanies.
TheFinancialSystem’sCastofCharacters 45 popularlyreferredtoascertifcatesofdepositorCDs,haveafxedmaturitydateandpayeitherafxedorfoatinginterestrate.A moneymarketdemandaccount paysinterestbasedonshort-terminterestrates.Depositsourcesotherthanborrowingthatareavailabletobanksare(1)borrowingbytheissuanceofinstrumentsinthemoneyandbondmarkets;(2)borrowingreservesinthefederalfundsmarket;and(3)borrowingfromtheFederalReserve(Fed)throughthediscountwindowfacility.Thefrstsourceisself-explanatory.Thelasttworequireexplanation.Abankcannotinvest$1forevery$1itraisesviadepositbecauseitmustmaintainaspecifedpercentageofitsdepositsinanoninterest-bearingaccountatoneofthe12FederalReserveBanks.Thesespecifedpercentagesarethe reserveratios ,andthedollaramountsbasedonthemthatarerequiredtobekeptondepositataFederalReserveBankarecalled requiredreserves .ThereserveratiosareestablishedbytheFederalReserveBoardandrepresentoneofthemonetarypolicytoolsemployedbytheFed.Bankssat-isfythesereserverequirementsineachperiodby actualreserves ,whicharedefnedastheaverageamountofreservesheldatthecloseofbusinessattheFederalReserveBank.Ifactualreservesexceedrequiredreserves,thedifferenceisreferredtoas excessreserves .Becausereservesareplacedinnoninterest-bearingaccounts,anopportunitycostisassociatedwithexcessreserves.However,ifthereisshortfall,theFedimposespenalties.Conse-quently,thereisanincentiveforbankstomanagetheirreservessoastosatisfyreserverequirementsaspreciselyaspossible.Thereisamarketwherebanksthataretemporarilyshortoftheirrequiredreservescanborrowre-servesfrombankswithexcessreserves.Thismarketiscalledthe federalfundsmarket, andtheinterestratechargetoborrowfundsinthismarketiscalledthe federalfundsrate .Nowlet’slookathowabankcanborrowattheFeddiscountwindow.The Feddiscountwindow ischargedwiththelendingtobankstomeetliquidityneeds,withtheFederalReserveBankeffectivelybeingthebanker’sbank.ThismeansthattheFederalReserveBankisthebankoflastresort.Ifabankistemporarilyshortoffunds,itcanborrowfromtheFedatitsdiscountwindow.However,borrowingatthediscountwindowrequiresthatthebankseekingfundsputupcollateraltodoso.Thatis,theFediswillingtomakeasecuredorcollateralizedloan.TheFedestablishes(andperiodicallychanges)thetypesofcollateralthatareeligibleforborrowingatthediscountwindow.TheinterestratethattheFedchargestoborrowfundsatthediscountwindowiscalledthe discountrate .TheFedchangesthisrateperiodicallyinordertoimplementmonetarypolicy. BankRegulation Becauseoftheirimportantroleinfnancialmarkets,de-positoryinstitutionsarehighlyregulatedandsupervisedbyseveralfederal
46 THEFINANCIALSYSTEM andstategovernmententities.Atthefederallevel,supervisionisundertakenbytheFederalReserveBoard,theOffceoftheComptrolleroftheCurrency,andtheFederalDepositInsuranceCorporation(FDIC).BanksareinsuredbytheBankInsuranceFund(BIF),whichisadministeredbytheFederalDepositInsuranceCorporation.Federaldepositoryinsurancebeganinthe1930s,andtheinsuranceprogramisadministeredbytheFDIC.Asalreadynoted,thecapitalstructureofbanksisahighlyleveragedone.Thatis,theratioofequitycapitaltototalassetsislow,typicallylessthan8%.Consequently,thereareconcernsbyregulatorsaboutpotentialinsolvencyresultingfromthelowlevelofcapitalprovidedbytheowners.Anadditionalconcernisthattheamountofequitycapitalisevenlessadequatebecauseofpotentialliabilitiesthatdonotappearonthebank’sbalancesheet,so-called“off-balancesheet”obligationssuchaslettersofcreditandobligationsonOTCderivatives.Thisisaddressedbyregulatorsviarisk-basedcapitalrequirements.Theinternationalorganizationthathasestablishedguidelinesforrisk-basedcapitalrequirementsistheBaselCommitteeonBankingSupervision(“BaselCommittee”).Thiscommitteeismadeupofbankingsupervisoryauthoritiesfrom13countries.By“risk-based,”itismeantthatthecapitalrequirementsofabankdependonthevariousriskstowhichitisexposed. NondepositoryFinancialInstitutions Nondepositoryfnancialinstitutionsareintermediariesthatdonotacceptdeposits,butlendfundstoconsumersandbusinesses. 6 Examplesoftheseinstitutionsincludeconsumerloancompanies,trustcompanies,mortgageloancompanies,creditcounselingagencies,andfnancecompanies.Unlikedepositoryinstitutions,nondepositoryfnancialinstitutionshavebeenregulatedonlyatthestatelevelintheU.S.,butthereisacurrentdiscussiononincreasedregulationoftheseinstitutionsonthenationallevel,especiallyinthecaseoffailuresoflargenondepositoryfnancialinstitutions. 7 OnesuchfailurewasthatofCITGroup,Inc.,acommercialandconsumerfnancecompany,whichfledforbankruptcyin2009. 6 Nondepositoryfnancialinstitutionsarealsoreferredtoasnonbankfnancialinsti-tutions(NBFIs).ThedistinctionofthesetypesofcompaniesasfnancialinstitutionswasmadestartingwiththeAnnuzio-WylieAnti-MoneyLaunderingActof1992,whichbroadenedthedefnitionofafnancialinstitutionbeyonddepositacceptinginstitutions. 7 ChairmanBenS.Bernanke,“FinancialReformtoAddressSystemicRisk,”March10,2009.
TheFinancialSystem’sCastofCharacters 47 InsuranceCompanies Insurancecompaniesplayanimportantroleinaneconomyinthattheyareriskbearersortheunderwritersofriskforawiderangeofinsurableevents.Moreover,beyondtheirriskbearerrole,insurancecompaniesaremajorparticipantsinthefnancialmarketasinvestors.Tounderstandwhy,wewillexplainthebasiceconomicsoftheinsur-anceindustry.Ascompensationforinsurancecompaniessellingprotectionagainsttheoccurrenceoffutureevents,theyreceiveoneormorepay-mentsoverthelifeofthepolicy.Thepaymentthattheyreceiveiscalleda premium. Betweenthetimethatthepremiumismadebythepolicyholdertotheinsurancecompanyandaclaimontheinsurancecompanyispaidout(ifsuchaclaimismade),theinsurancecompanycaninvestthoseproceedsinthefnancialmarket.Theinsuranceproductssoldbyinsurancecompaniesinclude: Lifeinsurance .Policiesinsureagainstdeathwiththeinsurancecompanypayingthebenefciaryofthepolicyintheeventofthedeathoftheinsured.Lifepoliciescanbeforpurelifeinsurancecoverage(e.g.,termlifeinsurance)orcanhaveaninvestmentcomponent(e.g.,cashvaluelifeinsurance). Healthinsurance .Theriskinsuredisthecostofmedicaltreatmentfortheinsured. Propertyandcasualtyinsurance .Theriskinsuredagainstfnanciallossresultingfromthedamage,destruction,orlosstopropertyoftheinsuredpropertyattributabletoanidentifableeventthatissudden,unexpected,orunusual.Themajortypesofsuchinsuranceare(1)aresidentialpropertyhouseanditscontentsand(2)automobiles. Liabilityinsurance .Theriskinsuredagainstislitigation,theriskoflawsuitsagainsttheinsuredresultingfromtheactionsbytheinsuredorothers. Disabilityinsurance .Thisproductinsuresagainsttheinabilityofanem-ployedpersontoearnanincomeineithertheinsured’sownoccupationoranyoccupation. Long-termcareinsurance .Thisproductprovideslong-termcoverageforcustodialcareforthosenolongerabletocareforthemselves. Structuredsettlements .Thesepoliciesprovideforfxedguaranteedpe-riodicpaymentsoveralongperiodoftime,typicallyresultingfromasettlementonadisabilityorothertypeofpolicy. Investment-orientedproducts .Theproductshaveamajorinvestmentcomponent.Theyincludea guaranteedinvestmentcontract (GIC)and annuities .InthecaseofaGIC,alifeinsurancecompanyagreesthat
48 THEFINANCIALSYSTEM uponthepaymentofasinglepremium,itwillrepaythatpremiumplusapredeterminedinterestrateearnedonthatpremiumoverthelifeofthepolicy. 8 Whiletherearemanyformsofannuities,theyallhavetwofundamentalfeatures:(1)whethertheperiodicpaymentsbeginimme-diatelyoraredeferredtosomefuturedateand(2)whetherthedollaramountisfxed(i.e.,guaranteeddollaramount)orvariabledependingontheinvestmentperformancerealizedbytheinsurer. Financialguaranteeinsurance .Theriskinsuredbythisproductisthecreditriskthattheissuerofaninsuredbondorotherfnancialcontractwillfailtomaketimelypaymentofinterestandprincipal.Abondorotherfnancialobligationthathassuchaguaranteeissaidtohaveaninsurance“wrap.”Atonetime,alargepercentageofbondsissuedbymunicipalgovernmentswereinsuredbonds,aswellasasset-backedsecurities.Theleadinginsurancecompaniesglobally,intermsof2008revenues,are: 9 CompanyCountryTypeofInsurance JapanPostHoldingsJapanLife/healthAllianzGermanyProperty/casualtyBerkshireHathawayUnitedStatesProperty/casualtyAssicurazioniGeneraliItalyLife/healthAXAFranceLife/healthIntheUnitedStates,theleadingcompaniesincludeBerkshireHathaway,StateFarmInsurance,andMetLife. InvestmentCompanies Investmentcompanies, alsoknownas assetmanagementcompanies ,managethefundsofindividuals,businesses,andstateandlocalgovernments,andarecompensatedforthisservicebyfeesthattheycharge.Thefeeistiedtotheamountthatismanagedfortheclientand,insomecases,totheperformanceoftheassetsmanaged.Someassetmanagementcompanies 8 Basically,aGICisinsuringthatthepolicyholderwillreceiveaguaranteedinterestrateratherthanriskthatinterestratesdeclineoverthelifeofthepolicy.Inthecaseofanannuity,thepolicyholderpaysasinglepremiumforthepolicyandthelifeinsurancecompanyagreestomakeperiodicpaymentsovertimetothepolicyholder. 9 ThesourceofthisinformationistheInsuranceInformationInstitute.
TheFinancialSystem’sCastofCharacters 49 aresubsidiariesofcommercialbanks,insurancecompanies,andinvestmentbankingcompanies.Thetypesofaccounts,clients,andlinesofbusinessofassetmanagementcompaniesinclude: Regulatedinvestmentcompanies Exchange-tradedfunds Hedgefunds Separatelymanagedaccounts Pensionfunds RegulatedInvestmentCompanies Regulatedinvestmentcompanies (RICs)arefnancialintermediariesthatsellsharestothepublicandinvestthoseproceedsinadiversifedportfolioofsecurities.AssetmanagementcompaniesareretainedtomanagetheportfolioofRICs.VariousU.S.securitieslawsregulatetheseentities.TherearethreetypesofRICsmanagedbyassetmanagementcompanies:open-endfunds,closed-endfunds,andunitinvestmenttrusts(UITs).AsyoucanseeinExhibit3.5,mutualfundsarethepredominantformofRIC. EXHIBIT3.5 AssetsofRegulatedInvestmentCompanies,1995–2009(billions) NetAssets,inBillionsofDollars YearMutualFundsClosed-EndFundsUnitInvestmentTrusts 1995$2,811$143$7319963,5261477219974,4681528519985,5251569419996,8461479220006,9651437420016,9751414920026,3901593620037,4142143620048,1072543720058,90527741200610,39729850200712,0003135320089,60118829200911,12122838 Datasource: InvestmentCompanyInstitute.
50 THEFINANCIALSYSTEM EachsharesoldrepresentsaproportionalinterestintheportfolioofsecuritiesmanagedbytheRIConbehalfofitsshareholders.Additionally,thevalueofeachshareoftheportfolio(notnecessarilytheprice)iscalledthe netassetvalue (NAV)andiscomputedasfollows:NAV = Marketvalueofportfolio − Liabilities NumberofsharesForexample,supposethataRICwith20millionsharesoutstandinghasaportfoliowithamarketvalueof$430millionandliabilitiesof$30million.TheNAVisNAV = $430 , 000 , 000 − $30 , 000 , 000 20 , 000 , 000 = $20TheNAVisdeterminedonlyatthecloseofthetradingday. MutualFunds In open-endfunds ,commonlyreferredtosimplyas mutualfunds ,thenumberoffundsharesisnotfxed.AllnewinvestmentsintothefundarepurchasedattheNAVandallredemptions(saleofthefund)redeemedfromthefundarepurchasedattheNAV.Thetotalnumberofsharesinthefundincreasesifmoreinvestmentsthanwithdrawalsaremadeduringtheday,andviceversa.Forexample,assumethatatthebeginningofadayamutualfundport-folioisvaluedat$300million,withnoliabilities,and10millionsharesoutstanding.Thus,theNAVofthefundis$30.Assumethatduringthetradingdayinvestorsdeposit$5millionintothefundandwithdraw$2mil-lion,andthepricesofallthesecuritiesintheportfolioremainconstant.The$3millionnetinvestmentintothefundmeansthat100,000shareswereissued($3milliondividedby$30).Afterthetransaction,thereare10.1millionsharesandthemarketvalueoftheportfoliois$303million.Hence,theNAVis$30,unchangedfromthepriorday.If,instead,theportfolio’svalueandthenumberofshareschange,theNAVwillchange.However,attheendofday,NAVwillbethesameregard-lessofthenetsharesaddedorredeemed.Inthepreviousexample,assumethatattheendofthedaytheportfolio’svalueincreasesto$320million.Be-causenewinvestmentsandwithdrawalsarepricedattheend-of-dayNAV,whichisnow$32,the$5millionofnewinvestmentswillbecreditedwith$5million ÷ $32 = 156,250sharesandthe$2millionredeemedwillreducethenumberofsharesby$2million ÷ $32 = 62,500shares.Thus,attheendofthedaythefundhas10million + 156,250 − 62,500 = 10,093,750shares.Becausetheportfoliohasatotalvalueof$323million($320million
TheFinancialSystem’sCastofCharacters 51 plusthenewinvestmentof$3million),theend-of-dayNAVis$32andnotimpactedbythetransactions. Closed-EndFunds Unlikeopen-endfunds, closed-endfunds donotissueadditionalsharesorredeemshares.Thatis,thenumberoffundsharesisfxedatthenumbersoldatissuance(i.e.,atthetimeoftheinitialpublicoffering).Instead,investorswhowanttoselltheirsharesorinvestorswhowanttobuysharesmustdosointhesecondarymarketwherethesharesaretraded(eitheronanexchangeorintheover-the-countermarket).Supplyanddemandinthemarketinwhichfundsaretradeddeter-minethepriceofthesharesofaclosed-endfund.Hence,thefundshare’spricecantradebeloworabovetheNAV.SharessellingbelowNAVaresaidtobe“tradingatadiscount,”whilesharestradingaboveNAVare“tradingatapremium.”Investorswhotransactinclosed-endfundsharesmustpayabrokeragecommissionatthetimeofpurchaseandatthetimeofsale. UnitInvestmentTrusts ThereisathirdtypeofRICcalleda unitinvestmenttrust (UIT).ThistypeofRICisassembled,butnotactivelymanaged.Aunitinvestmenttrusthasafnitelifeandafxedportfolioofinvestments. CoststoInvestors InvestorsinRICsbeartwotypesofcosts:(1)ashare-holderfee,usuallycalledthesalescharge,whichisa“one-time”charge;and(2)anannualfundoperatingexpense,usuallycalledthe expenseratio ,whichcoversthefund’sexpenses.Thelargestexpensecomponentoftheexpenseratioisthemanagementfee(alsocalledtheinvestmentadvisoryfees),whichisanannualfeepaidtotheassetmanagementcompanyforitsservices.RICsareavailablewithdifferentinvestmentobjectivesandinvestingindifferentassetclasses—stockfunds,bondfunds,andmoneymarketfunds.Therearepassivelymanagedandactivelymanagedfunds. Passivefunds (morecommonlyreferredtoas indexfunds )aredesignedtorepli-cateamarketindex,suchastheS&P500stockindexinthecaseofcommonstock.Incontrast,with activefunds thefundadvisorattemptstooutperformanindexandotherfundsbyactivelytradingthefundportfolio. Exchange-TradedFunds Asaninvestmentvehicle,open-endfunds(i.e.,mutualfunds)areoftencriticizedfortworeasons.First,theirsharesarepricedat,andcanbetransactedonlyat,theend-of-the-dayorclosingprice.Specifcally,transactions(i.e.,purchasesandsales)cannotbemadeatintradayprices,butonlyatclosingprices.Second,whilewedidnot
52 THEFINANCIALSYSTEM $ 700$600$0$100$200$300$400$500 Year 19951996199719981999200020012002200320042005200620072008 EXHIBIT3.6 GrowthofETFAssets,1995–2008(billions) Datasource: InvestmentCompanyInstitute. discussthetaxtreatmentofopen-endfunds,wenotethattheyareineff-cienttaxvehicles.Thisisbecausewithdrawalsbysomefundshareholdersmaycausetaxablerealizedcapitalgainsforshareholderswhomaintaintheirpositions.Asaresultofthesetwodrawbacksofmutualfunds,in1993,anewinvestmentvehiclewithmanyofthesamefeaturesofmutualfundswasintroducedintotheU.S.fnancialmarket— exchange-tradedfunds (ETFs).Thisinvestmentvehicleissimilartomutualfundsbuttradeslikestocksonanexchange.Eventhoughtheyareopen-endfunds,ETFsare,inasense,similartoclosed-endfunds,whichhavesmallpremiumsordiscountsfromtheirNAV.InanETF,theinvestmentadvisorassumesresponsibilityformaintainingtheportfoliosuchthatitreplicatestheindexandtheindex’sreturnaccurately.Becausesupplyanddemanddeterminethesecondarymar-ketpriceoftheseshares,theexchangepricemaydeviateslightlyfromthevalueoftheportfolioand,asaresult,mayprovidesomeimprecisioninpricing.Deviationsremainsmall,however,becausearbitrageurscancreateorredeemlargeblocksofsharesonanydayatNAV,signifcantlylimitingthedeviations.AnotheradvantageofETFsinadditiontobeingabletotransactinETFsatcurrentpricesthroughoutthedayisthefexibilitytoplacelimitorders,stoporders,andorderstoshortsellandbuyonmargin,noneofwhichcanbedonewithopen-endfunds.Withrespecttotaxation,ETFsovercomethedisadvantagesofopen-endfundsbutwewillnotdiscusstheadvantageshere.From1995,upuntil2008,therehasbeenasteadygrowthinETFs,asweshowinExhibit3.6.ThereareETFsthatinvestinabroadrangeofassetclassesandnewonesbeingintroducedweekly.
TheFinancialSystem’sCastofCharacters 53 HedgeFunds TheU.S.securitieslawdoesnotprovideadefnitionofthepoolsofinvestmentfundsrunbyassetmanagersthatarereferredtoas hedgefunds . 10 Theseentitiesasofthiswritingarenotregulated.ThefollowingisadefnitionofhedgefundsofferedbytheUnitedKing-dom’sFinancialServicesAuthority,theregulatorybodyofallprovidersoffnancialservicesinthatcountry: 11 Thetermcanalsobedefnedbyconsideringthecharacteristicsmostcommonlyassociatedwithhedgefunds.Usually,hedgefunds: Areorganisedasprivateinvestmentpartnershipsoroffshorein-vestmentcorporations. Useawidevarietyoftradingstrategiesinvolvingposition-takinginarangeofmarkets. Employanassortmentoftradingtechniquesandinstruments,oftenincludingshort-selling,derivatives,andleverage. Payperformancefeestotheirmanagers. Haveaninvestorbasecomprisingwealthyindividualsandinsti-tutionsandarelativelyhighminimuminvestmentlimit(setatUS$100,000orhigherformostfunds). Thisdefnitionhelpsustounderstandseveralattributesofhedgefunds.Firstandforemost,theword“hedge”inhedgefundsismisleadingbecauseitisnotacharacteristicofhedgefundstoday.Second,hedgefundsuseawiderangeoftradingstrategiesandtechniquesinanattempttonotjustgenerateabnormalreturnsbutratherattempttogeneratestellarreturnsregardlessofhowthemarketmoves.Thestrategiesusedbyahedgefundcanincludeoneormoreofthefollowing: Leverage,whichistheuseofborrowedfunds Shortselling,whichisthesaleofafnancialinstrumentnotownedinanticipationofadeclineinthatfnancialinstrument’sprice Derivativestogreatleverageandcontrolrisk Simultaneousbuyingandsellingofrelatedfnancialinstrumentstore-alizeaproftfromthetemporarymisalignmentoftheirprices 10 Theterm hedgefund wasfrstusedby Fortune in1966todescribetheprivateinvestmentfundofAlfredWinslowJones.Inmanagingtheportfolio,Jonessoughtto“hedge”themarketriskofthefundbycreatingaportfoliothatwaslongandshortthestockmarketbyanequalamount. 11 FinancialServicesAuthority(2002,8).
54 THEFINANCIALSYSTEM Hedgefundsoperateinsectorsofthefnancialmarkets:cashmarketforstocks,bonds,andcurrencies,aswellasinderivativesmarkets.Third,inevaluatinghedgefunds,investorsareinterestedintheabsolutereturngeneratedbytheassetmanager,nottherelativereturn. Absolutereturn issimplythereturnrealizedratherthan relativereturn, whichisthedifferencebetweentherealizedreturnandthereturnonsomebenchmarkorindex,whichisquitedifferentfromthecriterionusedwhenevaluatingtheperformanceofanassetmanager.Fourth,themanagementfeestructureforhedgefundsisacombinationofafxedfeebasedonthemarketvalueofassetsmanagedplusashareofthepositivereturn.Thelatterisaperformance-basedcompensationreferredtoasan incentivefee .IntheUnitedStates,hedgefundsareavailabletoaccreditedinvestors.AsdefnedbytheSEC,accreditedinvestorsincludeindividualswithanetworthover$1million,banks,insurancecompanies,andregisteredinvest-mentcompanies. 12 SeparatelyManagedAccounts Insteadofinvestingdirectlyinstocksorbonds,orbymeansofalternativessuchasmutualfunds,ETFs,orhedgefunds,assetmanagementcompaniesofferindividualandinstitutionalin-vestorstheopportunitytoinvestina separatelymanagedaccount (alsocalledan individuallymanagedaccount ).Insuchaccounts,theinvestmentsselectedbytheassetmanagerarecustomizedtotheobjectivesofthein-vestor.AlthoughseparatelymanagedaccountsofferthecustomersofanassetmanagementaninvestmentvehiclethatovercomesallthelimitationsofRICs,theyaremoreexpensivethanRICsintermsofthefeescharged. PensionFunds Apensionplanfundisestablishedfortheeventualpay-mentofretirementbenefts.A plansponsor istheentitythatestablishesthepensionplan.Aplansponsorcanbe: Aprivatebusinessentityonbehalfofitsemployees,calleda corporateplan or privateplan . Afederal,state,andlocalgovernmentonbehalfofitsemployees,calleda publicplan. Auniononbehalfofitsmembers,calleda Taft-Hartleyplan . Anindividual,calledan individuallysponsoredplan. 12 DefnedinSecuritiesandExchangeCommissionRule501ofRegulationD.
TheFinancialSystem’sCastofCharacters 55 Twobasicandwidelyusedtypesofpensionplansaredefnedbeneftplansanddefnedcontributionplans.Inaddition,ahybridtypeofplan,calledacashbalanceplan,combinesfeaturesofbothpensionplantypes.Ina defnedbeneft (DB) plan ,theplansponsoragreestomakespecifeddollarpaymentstoqualifyingemployeesbeginningatretirement(andsomepaymentstobenefciariesincaseofdeathbeforeretirement).Effectively,theDBplanpensionobligationsareadebtobligationoftheplansponsorandconsequentlytheplansponsorassumestheriskofhavinginsuffcientfundsintheplantosatisfytheregularcontractualpaymentsthatmustbemadetocurrentlyretiredemployeesaswellasthosewhowillretireinthefuture.Aplansponsorhasseveraloptionsavailableindecidingwhoshouldmanagetheplan’sassets.Thechoicesare: Internalmanagement. Theplansponsorusesitsowninvestmentstafftomanagetheplan’sassets. Externalmanagement. Theplansponsorengagestheservicesofoneormoreassetmanagementcompaniestomanagetheplan’sassets. Combinationofinternalandexternalmanagement. Someoftheplan’sassetsaremanagedinternallybytheplansponsorandthebalancearemanagedbyoneormoreassetmanagementcompanies.Assetmanagerswhomanagetheassetsofdefnedbeneftplansreceivecompensationintheformofamanagementfee.Thereisfederallegislationthatregulatespensionplans—theEmployeeRetirementIncomeSecurityActof1974(ERISA).Responsibilityforadmin-isteringERISAisdelegatedtotheDepartmentofLaborandtheInternalRevenueService.ERISAestablishedfduciarystandardsforpensionfundtrustees,managers,oradvisors.Ina defnedcontribution (DC) plan ,theplansponsorisresponsibleonlyformakingspecifedcontributionsintotheplanonbehalfofqualifyingparticipantswiththeamountthatitmustcontributeoftenbeingeitherapercentageoftheemployee’ssalaryand/orapercentageoftheemployer’sprofts.Theplansponsordoesnotguaranteeanyspecifcamountatretire-ment.Theamountthattheemployeereceivesatretirementisnotguaranteed,butinsteaddependsonthegrowth(therefore,performance)oftheplanas-sets.Theplansponsordoesoffertheplanparticipantsvariousoptionsastotheinvestmentvehiclesinwhichtheymayinvest.Defnedcontributionpensionplanscomeinseverallegalforms:401(k)plans,moneypurchasepensionplans,and employeestockownershipplans (ESOPs).Ahybridpensionplanisacombinationofadefnedbeneftandde-fnedcontributionplanwiththemostcommontypebeingacashbalanceplan.Thisplandefnesfuturepensionbenefts,notemployercontributions.
56 THEFINANCIALSYSTEM Retirementbeneftsarebasedonafxedamountannualemployercontri-butionandaguaranteedminimumannualinvestmentreturn.Eachpartic-ipant’saccountinacashbalanceplaniscreditedwithadollaramountthatresemblesanemployercontributionandisgenerallydeterminedasapercentageofpay.Eachparticipant’saccountisalsocreditedwithinterestlinkedtosomefxedorvariableindexsuchastheconsumerpriceindex(CPI).Typically,acashbalanceplanprovidesbeneftsintheformofalumpsumdistributionsuchasanannuity. InvestmentBanks Aswithcommercialbanks,investmentbanksarehighlyleveragedentitiesthatplayimportantrolesinboththeprimaryandsecondarymarkets.In-vestmentbankingactivitiesinclude: Raisingfundsthroughpublicofferingsandprivateplacementofsecurities. Tradingofsecurities. Mergers,acquisitions,andfnancialrestructuringadvising. Merchantbanking. Securitiesfnanceandprimebrokerageservices.Thefrstroleisassistingintheraisingoffundsbycorporations,U.S.governmentagencies,stateandlocalgovernments,andforeignentities(sovereignsandcorporations).Thesecondroleisassistinginvestorswhowishtoinvestfundsbyactingasbrokersordealersinsecondarymarkettransactions.Wecanclassifyinvestmentbankingintotwocategories: 1. Companiesaffliatedwithlargefnancialservicesholdingcompanies. 2. Companiesthatareindependentofalargefnancialservicesholdingcompany.Thelargeinvestmentbanksareaffliatedwithlargecommercialbankholdingcompanies.Examplesofbankholdingcompanies,referredtoasbank-affliatedinvestmentbanks,areBancofAmericaSecurities(asub-sidiaryofBankofAmerica),JPMorganSecurities(asubsidiaryofJPMor-ganChase),andWachoviaSecurities(asubsidiaryofWellsFargo),andGoldmanSachs.Thesecondcategoryofinvestmentbanks,referredtoasindependentinvestmentbanks,isashrinkinggroup.Asofmid-2008,thisgroupincludesGreenhill&CompanyandHoulihanLokeyHoward&Zukin.
TheFinancialSystem’sCastofCharacters 57 Anotherwayofclassifyinginvestmentbankingcompaniesisbasedonthetypesofactivities(i.e.,thelinesofbusiness)inwhichtheyparticipate:full-serviceinvestmentbanksandboutiqueinvestmentbanks.Theformerareactiveinawiderangeofinvestmentbankingactivitieswhilethelatterspecializeinalimitednumberofthoseactivities.Inassistingentitiesintheraisingoffundsinthepublicmarket,invest-mentbankersperformoneormoreofthefollowingthreefunctions: Advisingtheissueronthetermsandthetimingoftheoffering. Underwriting. Distributingtheissuetothepublic.Intheiradvisoryrole,investmentbankersmayberequiredtodesignasecuritystructurethatismoreappealingtoinvestorsthancurrentlyavailablefnancialinstruments.Theunderwritingfunctioninvolvesthewayinwhichtheinvestmentbankagreestoplacethenewlyissuedsecurityinthemarketonbehalfoftheissuer.Thefeeearnedbytheinvestmentbankingcompanyfromunderwritingisthedifferencebetweenthepriceitpaidtotheissuerforthesecurityandthepriceitreoffersthesecuritytothepublic(calledthe reofferingprice ).Thisdifferenceisreferredtoasthe grossspread .Therearetwotypesofunderwritingarrangements:frmcommitmentandbestefforts.Ina frmcommitmentarrangement ,theinvestmentbankpurchasesthenewlyissuedsecurityfromtheissueratafxedpriceandthensellsthesecuritytothepublicatthereofferingprice.Ina best-effortsunderwritingarrangement ,theinvestmentbankingfrmdoesnotbuythenewlyissuedsecurityfromtheissuer.Instead,itagreesonlytouseitsexpertisetosellthesecuritytothepublicandearnsthegrossspreadononlywhatitcansell.Typicallyinafrm-commitmentunderwritingtherewillbeseveralin-vestmentbanksinvolvedbecauseofthecapitalcommitmentthatmustbemadeandthepotentiallossofthecompany’scapitalifthenewlyissuedsecuritycannotbesoldtothepublicatahigherpricethanthepurchaseprice.Thisisdonebyformingagroupofcompaniestounderwritetheissue,referredtoasan underwritingsyndicate bytheleadunderwriterorunder-writers.Thegrossspreadisthendividedamongtheleadunderwriter(s)andtheothercompaniesintheunderwritingsyndicate.Thedistributionfunctioniscriticaltoboththeissuerandtheinvestmentbank.Torealizethegrossspread,theentiresecuritiesissuemustbesoldtothepublicattheplannedreofferingpriceand,dependingonthesizeoftheissue,mayrequireagreatdealofmarketingeffort.Themembersoftheunderwritingsyndicatewillsellthenewlyissuedsecuritytotheirinvestorclientbase.Toincreasethepotentialinvestorbase,theleadunderwriter(s)
58 THEFINANCIALSYSTEM willoftenputtogethera sellinggroup .Thisgroupincludestheunderwritingsyndicateplusothercompaniesnotinthesyndicatewiththegrossspreadthendividedamongtheleadunderwriter(s),membersoftheunderwritingsyndicate,andmembersofthesellinggroup. PrivatePlacementofSecurities Asanalternativetoissuinganewse-curityinthepublicmarket,acompanycanissueasecurityviaaprivateplacementtoalimitednumberofinstitutionalinvestorssuchasinsurancecompanies,investmentcompanies,andpensionfunds.Privateplacementofferingsaredistinguishedbytype:non-Rule144Aofferings(traditionalprivateplacements)andRule144Aofferings.Rule144Aofferingsareun-derwrittenbyinvestmentbankers. TradingSecurities Anobviousactivityofinvestmentbanksisprovid-ingtransactionservicesforclients.Revenueisgeneratedontransactionsinwhichtheinvestmentbankactsasanagentorbrokerintheformofacom-mission.Insuchtransactions,theinvestmentbankisnottakingapositioninthetransaction,meaningthatitisnotplacingitsowncapitalatrisk.Inothertransactions,theinvestmentbankmayactasamarketmaker,plac-ingitsowncapitalatrisk.Revenuefromthisactivityisgeneratedthrough(1)thedifferencebetweenthepriceatwhichtheinvestmentbanksellsthesecurityandthepricepaidforthesecurities(calledthebid-askspread);and(2)appreciationofthepriceofthesecuritiesheldininventory.(Obviously,ifthepriceofthesecuritiesdecline,revenuewillbereduced.)Inadditiontoexecutingtradesinthesecondarymarketforclients,aswellasmarketmakinginthesecondarymarket,investmentbanksdoproprietarytrading(referredtoas proptrading ).Inthisactivity,thein-vestmentbank’straderspositionsomeofthecompany’scapitaltobetonmovementsinthepriceoffnancialinstruments,interestrates,orforeignexchange. AdvisinginMergers,Acquisitions,andFinancialRestructuringAdvising Investmentbanksareactiveinmergersandacquisitions(M&A),leveragedbuyouts(LBOs),restructuringandrecapitalizationofcompanies,andre-organizationofbankruptandtroubledcompanies.Theydosoinoneormoreofthefollowingways:(1)identifyingcandidatesforamergerorac-quisition,M&Acandidates;(2)advisingtheboardofdirectorsofacquiringcompaniesortargetcompaniesregardingpriceandnonpricetermsforanexchange;(3)assistingcompaniesthatarethetargetofanacquisitiontofendoffanunfriendlytakeoverattempt;(4)helpingacquiringcompaniestoobtaintheneededfundstocompleteanacquisition;and(5)providinga
TheFinancialSystem’sCastofCharacters 59 “fairnessopinion”totheboardofdirectorsregardingaproposedmerger,acquisition,orsaleofassets.Anotherareawhereinvestmentbanksadviseisonasignifcantmodifcationofacorporation’scapitalstructure,operatingstructure,and/orcorporatestrategywiththeobjectiveofimprovingeffciency.Suchmodifcationsarereferredtoas fnancialrestructuring ofacompany.Thismaybetheresultofacompanyseekingtoavoidabankruptcy,avoidaproblemwithcreditors,orreorganizethecompanyaspermittedbytheU.S.bankruptcycode.Theactivitiesdescribedabovegeneratefeeincomethatcaneitherbeafxedretainerorinthecaseofconsummatingamergeroracquisition,afeebasedonthesizeofthetransaction.Thus,formostoftheseactivities,theinvestmentbank’scapitalisnotatrisk.However,iftheinvestmentbankprovidesfnancingforanacquisition,itdoesplaceitscapitalatrisk.Thisbringsustotheactivityofmerchantbanking. MerchantBanking Theactivityofmerchantbankingisoneinwhichtheinvestmentbankcommitsitsowncapitalaseitheracreditorortotakeanequitystake.Therearedivisionsorgroupswithinaninvestmentbankdevotedtomerchantbanking.Inthecaseofequityinvesting,thismaybeintheformofaseriesofprivateequityfunds. Securities,Finance,andPrimeBrokerageServices Thereareclientsofinvestmentbanksthat,aspartoftheirinvestmentstrategy,mayneedtoeither(1)borrowfundsinordertopurchaseasecurityor(2)borrowsecuritiesinordertosellasecurityshortortocoverashortsale.Thestandardmechanismforborrowingfundsinthesecuritiesmarketisviaarepurchaseagreement(referredtoasa repo )ratherthroughbankborrowing.Arepoisacollateralizedloanwherethecollateralisthesecuritypurchased.Investmentbanksearninterestonrepotransactions.Acustomercanborrowasecurityinatransactionknownasa securitieslendingtransaction .Insuchtransactions,thelenderofthesecurityearnsafeeforlendingthesecurities.Theactivityofborrowingfundsorborrowingsecuritiesisreferredtoas securitiesfnance .Investmentbanksmayprovideapackageofservicestohedgefundandlargeinstitutionalinvestors.Thispackageofservices,referredtoas primebrokerage ,includessecuritiesfnancethatwejustdescribedaswellasglobalcustody,operationalsupport,andriskmanagementsystems. AssetManagement Aninvestmentbankmayhaveoneormoresub-sidiariesthatmanageassetsforclientssuchasinsurancecompanies,endow-ments,foundations,corporateandpublicpensionfunds,andhigh-net-worth
60 THEFINANCIALSYSTEM individuals.Theseassetmanagementdivisionsmayalsomanagemutualfundsandhedgefunds.Assetmanagementgeneratesfeeincomebasedonapercentageoftheassetsundermanagement. FOREIGNINVESTORS Thesectorreferredtoas foreigninvestors includesindividuals,nonfnancialbusiness,andfnancialentitiesthatarenotdomiciledintheUnitedStates,aswellasforeigncentralgovernmentsandsupranationals.Aforeigncentralbankisamonetaryauthorityoftheforeigncountry,suchasthePeople’sBankofChina(PBC),theEuropeanCentralBank,andtheBankofCanada.ForeigncentralbanksparticipateintheU.S.fnancialmarketfortworea-sons.ThefrstreasonistostabilizetheircurrencyrelativetotheU.S.dollar.Thesecondreasonistopurchaseafnancialinstrumentwithexcessfundsbecauseitisperceivedtobeanattractiveinvestmentvehicle.A supranationalinstitution isaninternationalentitythatiscreatedbytwoormorecentralgovernmentsthroughinternationaltreaties.Wecandividesupranationalsintotwocategories:multilateraldevelopmentbanksandothers.Theformeraresupranationalfnancialinstitutionswiththemandatetoprovidefnancialassistancewithfundsobtainedfrommembercountriestodevelopingcountriesandtopromoteregionalintegrationinspecifcgeographicalregions.ThelargestmultilateraldevelopmentbanksaretheEuropeanInvestmentBankwithmorethan$300billionintotalassetsandtheInternationalBankforReconstructionandDevelopment(popularlyreferredtoastheWorldBank)withmorethan$250billionintotalassets.Thenexttwolargest,theInter-AmericanDevelopmentBankandAsianDevelopmentBank,havelessthanathirdoftheassetsofthetwolargestmultilateraldevelopmentbanks. THEBOTTOMLINE Thefnancialsystemiscomprisedoffnancialfrms,governmentalen-tities,nonfnancialbusinessentities,households,andnonproftentities.Thelargestsectorinthesystemconsistsofnonfnancialbusinessentities. Governmententitiesinthefnancialsystemincludefederal,state,andlocalgovernments,aswellasgovernment-ownedandgovernment-sponsoredenterprises. Thefnancialsectorintheeconomyiscomprisedofdepositoryinsti-tutions,nondepositoryfnancialinstitutions,insurancecompanies,andinvestmentcompanies.
TheFinancialSystem’sCastofCharacters 61 Theprincipalservicesprovidedbycommercialbanksareindividualbanking,institutionalbanking,andglobalbanking. Insurancecompaniesareriskbearersoraretheunderwritersofriskforawiderangeofinsurableevents,andaremajorparticipantsinthefnancialmarketasinvestors. Investmentcompaniesmanagethefundsofindividuals,businesses,andstateandlocalgovernments,andarecompensatedforthisservicebyfeesthattheycharge.Thetypesofaccounts,clients,andlinesofbusinessofassetmanagementcompaniesincluderegulatedinvestmentcompanies,exchange-tradedfunds,hedgefunds,separatelymanagedaccounts,andpensionfunds. Investmentbanksplayimportantrolesinboththeprimaryandsec-ondarymarkets,andtheiractivitiesincluderaisingfundsthroughpub-licofferingsandprivateplacementofsecurities;tradingofsecurities;advisingonmergers,acquisitions,andfnancialrestructuring;merchantbanking;andsecuritiesfnanceandprimebrokerageservices. Foreigninvestorsincludeindividuals,nonfnancialbusiness,andfnan-cialentitiesthatarenotdomiciledintheUnitedStates,aswellasforeigncentralgovernmentsandsupranationalinstitutions. QUESTIONS 1. Whoaretheplayersinthegovernmentsector? 2. Whatisthedistinctionbetweenagovernment-ownedcorporationandagovernment-sponsoredenterprise? 3. Whatisthedistinctionbetweenadepositoryfnancialinstitutionandanondepositorybankfnancialinstitution? 4. Whatisanexcessreserveandhowisthisdifferentthanrequiredre-serves? 5. Listatleastfourdifferenttypesofinsurancecompanies. 6. Whatisthedifferencebetweenamutualfundandaclosed-endfund? 7. Ifamutualfundhasaportfoliowithamarketvalueof$1millionandliabilitiesof$0.2million,whatisthenetassetvalueifthefundhas0.5millionshares? 8. Listtwoadvantages,fromtheinvestorpointofview,ofanexchangetradedfund,vis-`a-visaclosed-endfund? 9. Distinguishbetweenadefnedbeneftpensionplanandadefnedcon-tributionplan. 10. Listatleastthreefunctionsofaninvestmentbank. 11. Listthemajortypesofdepositoryinstitutions. 12. Howdocommercialbanksobtaintheirfunds? 13. Whatisfnancialrestructuringadvising?Provideanexample.
62 THEFINANCIALSYSTEM 14. Thefollowingisanexcerptfromthe2009AnnualReportofBankofAmerica(p.24): ThroughourbankingandvariousnonbankingsubsidiariesthroughouttheUnitedStatesandinselectedinternationalmar-kets,weprovideadiversifedrangeofbankingandnonbankingfnancialservicesandproductsthroughsixbusinesssegments:Deposits,GlobalCardServices,HomeLoans&Insurance,GlobalBanking,GlobalMarketsandGlobalWealth&Invest-mentManagement. a. Whatismeantby“GlobalBanking”? b. Whatismeantby“GlobalWealth&InvestmentManagement”? 15. Thefollowingexcerptiffromthenotestothefnancialstatementsinthe2009AnnualReportofBankofAmerica(p.147): TheCorporationentersintotradingderivativestofacilitateclienttransactionsforproprietarytradingpurposes,andtomanageriskexposuresarisingfromtradingassetsandliabil-ities. a. Whatismeantby“proprietarytrading”? 16. Followingisanexcerptfrom“MerchantBanking:PastandPresent”byValentineV.Craig,publishedbytheFederalDepositInsuranceCorpo-ration(www.fdic.gov/bank/analytical/banking/2001sep/article2.html): Merchantbankinghasbeenaverylucrative—andrisky—endeavorforthesmallnumberofbankholdingcompaniesandbanksthathaveengagedinitunderexistinglaw.Recentlegislationhasexpandedthemerchant-bankingactivitythatispermissibletocommercialbanksandisthereforelikelytospurinterestinthislucrativespecialtyonthepartofagreaternum-berofsuchinstitutions. a. Whatismeantby“merchantbanking”? b. Whataretherisksassociatedwithmerchantbanking?
PART Two FinancialManagement
CHAPTER 4 FinancialStatements Threesuggestionsforinvestors:First,bewareofcompaniesdisplayingweakaccounting.Ifacompanystilldoesnotexpenseoptions,orifitspensionassumptionsarefanciful,watchout.Whenmanagementstakethelowroadinaspectsthatarevisible,itislikelytheyarefollowingasimilarpathbehindthescenes.Thereisseldomjustonecockroachinthekitchen. ... Second,unintelligiblefootnotesusuallyindicateuntrustworthymanagement.Ifyoucan’tunderstandafootnoteorothermanagerialexplanation,it’susuallybecausetheCEOdoesn’twantyouto.Enron’sdescriptionsofcertaintransactionsstillbaffeme.Finally,besuspiciousofcompaniesthattrumpetearningsprojectionsandgrowthexpectations.Businessesseldomoperateinatranquil,no-surpriseenvironment,andearningssimplydon’tadvancesmoothly(except,ofcourse,intheofferingbooksofinvestmentbankers). —WarrenBuffett,LettertoShareholdersofBerkshireHathaway,February21,2003 F inancialstatementsaresummariesoftheoperating,fnancing,andin-vestmentactivitiesofabusiness.Financialstatementsshouldprovideinformationusefultobothinvestorsandcreditorsinmakingcredit,invest-ment,andotherbusinessdecisions.Andthisusefulnessmeansthatinvestorsandcreditorscanusethesestatementstopredict,compare,andevaluatetheamount,timing,anduncertaintyoffuturecashfows.Inotherwords,fnancialstatementsprovidetheinformationneededtoassessacompany’sfutureearningsand,therefore,thecashfowsexpectedtoresultfromthoseearnings.Inthischapter,wediscussthefourbasicfnancialstatements:thebalancesheet,theincomestatement,thestatementofcashfows,andthestatementofshareholders’equity. 65
66 FINANCIALMANAGEMENT ACCOUNTINGPRINCIPLES:WHATARETHEY? Theaccountingdatainfnancialstatementsarepreparedbythecompany’smanagementaccordingtoasetofstandards,referredtoas generallyacceptedaccountingprinciples (GAAP).GenerallyacceptedaccountingprinciplesarebasedonthecodifedstandardspromulgatedbytheFinancialAccountingStandardsBoard(FASB),aspartofthe FASBAccountingStandardsCodifcation . 1 Thefnancialstatementsofacompanywhosestockispubliclytradedmust,bylaw,beauditedatleastannuallybyindependentpublicaccountants(i.e.,accountantswhoarenotemployeesofthecompany).Insuchanaudit,theaccountantsexaminethefnancialstatementsandthedatafromwhichthesestatementsarepreparedandattest—throughthepublishedauditor’sopinion—thatthesestatementshavebeenpreparedaccordingtoGAAP.Inthiscase,GAAPincludesnotonlytheFASBAccountingStandardsCodif-cation,butanyrulesandregulationsoftheSecuritiesandExchangeCom-mission.Theauditor’sopinionfocuseswhetherthestatementsconformtoGAAPandthatthereisadequatedisclosureofanymaterialchangeinac-countingprinciples.Thefnancialstatementsandtheauditors’fndingsarepublishedinthecompany’sannualandquarterlyreportssenttoshareholdersandthe10-Kand10-QflingswiththeSecuritiesandExchangeCommission(SEC).Alsoincludedinthereports,amongotheritems,isadiscussionbymanagement,entitled“Management’sDiscussionandAnalysisofFinancialConditionsandResultsofOperations,”whichisanoverviewofcompanyevents.Theannualreportsaremuchmoredetailedanddisclosemorefnancialinforma-tionthanthequarterlyreports. AssumptionsinCreatingFinancialStatements Thefnancialstatementsarecreatedusingseveralassumptionsthataffecthowweuseandinterpretthefnancialdata: Transactionsarerecordedathistoricalcost. Therefore,thevaluesshowninthestatementsarenotmarketorreplacementvalues,butratherrefecttheoriginalcost(adjustedfordepreciationinthecaseofadepreciableassets). 1 PriortoFinancialAccountingStandardsBoardStatementofFinancialAccountingStandardsNo.168,GAAPwasasubjecttoahierarchyofsourcesofprinciples,butthishasbeensimplifed,effectiveforcompanieswithfscalyearsendingafterSeptember15,2009.
FinancialStatements 67 Theappropriateunitofmeasurementisthedollar. Whilethisseemslogical,theeffectsofinfation,combinedwiththepracticeofrecordingvaluesathistoricalcost,maycauseproblemsinusingandinterpretingthesevalues. Thestatementsarerecordedforpredefnedperiodsoftime .Generally,statementsareproducedtocoverachosenfscalyearorquarter,withtheincomestatementandthestatementofcashfowsspanningaperiod’stimeandthebalancesheetandstatementofshareholders’equityasoftheendofthespecifedperiod.Butbecausetheendofthefscalyearisgenerallychosentocoincidewiththelowpointofactivityintheoperatingcycle,theannualbalancesheetandstatementofshareholders’equitymaynotberepresentativeofvaluesfortheyear. Statementsarepreparedusingaccrualaccountingandthematchingprinciple. Mostbusinessesuseaccrualaccounting,whereincomeandrevenuesarematchedintimingsothatincomeisrecordedintheperiodinwhichitisearnedandexpensesarereportedintheperiodinwhichtheyareincurredinanattempttogeneraterevenues.Theresultoftheuseofaccrualaccountingisthatreportedincomedoesnotnecessarilycoincidewithcashfows. Thebusinesswillcontinueasagoingconcern. Theassumptionthatthebusinessenterprisewillcontinueindefnitelyjustifestheappropriatenessofusinghistoricalcostsinsteadofcurrentmarketvaluesbecausetheseassetsareexpectedtobeusedupovertimeinsteadofsold. Thereisfulldisclosure .Fulldisclosurerequiresprovidinginformationbeyondthefnancialstatements.Therequirementthattherebefulldis-closuremeansthat,inadditiontotheaccountingnumbersforsuchaccountingitemsasrevenues,expenses,andassets,narrativeandad-ditionalnumericaldisclosuresareprovidedinnotesaccompanyingthefnancialstatements.Ananalysisoffnancialstatementsis,therefore,notcompletewithoutthisadditionalinformation. Statementsarepreparedassumingconservatism .Incasesinwhichmorethanoneinterpretationofaneventispossible,statementsarepreparedusingthemostconservativeinterpretation. THEBASICFINANCIALSTATEMENTS Thebasicfnancialstatementsarethebalancesheet,theincomestatement,thestatementofcashfows,andthestatementofshareholders’equity.Thebalancesheetisareportofwhatthecompanyhas—assets,debt,andequity—asoftheendofthefscalquarteroryear,andtheincomestatementisareportofwhatthecompanyearnedduringthefscalperiod.Thestatementofcashfowsisareportofthecashfowsofthecompanyoverthefscal
68 FINANCIALMANAGEMENT period,whereasthestatementofshareholders’equityisareconciliationoftheshareholders’equityfromonefscalyearendtoanother. TheBalanceSheet The balancesheet isareportoftheassets,liabilities,andequityofacom-panyatapointintime,generallyattheendofafscalquarterorfscalyear. Assets areresourcesofthebusinessenterprise,whicharecomprisedofcurrentorlong-livedassets.Howdidthecompanyfnancetheseresources?Itdidsowithliabilitiesandequity. Liabilities areobligationsofthebusinessenterprisethatmustberepaidatafuturepointintime,whereas equity istheownershipinterestofthebusinessenterprise.Therelationbetweenassets,liabilitiesandequityissimple,asrefectedinthebalanceofwhatisownedandhowitisfnanced,referredtoasthe accountingidentity : LiabilitiesAssetsEquity Assets Assetsareanythingthatthecompanyownsthathasavalue.Theseassetsmayhaveaphysicalinexistenceornot.Examplesofphysicalassetsincludeinventoryitemsheldforsale,offcefurniture,andproductionequip-ment.Ifanassetdoesnothaveaphysicalexistence,werefertoitasanintangibleasset,suchasatrademarkorapatent.Youcannotseeortouchanintangibleasset,butitstillcontributesvaluetothecompany.Assetsmayalsobecurrentorlong-term,dependingonhowfastthecompanywouldbeabletoconvertthemintocash.Assetsaregenerallyreportedinthebalancesheetinorderofliquidity,withthemostliquidassetlistedfrstandtheleastliquidlistedlast.Themostliquidassetsofthecompanyarethecurrentassets. Currentassets areassetsthatcanbeturnedintocashinoneoperatingcycleoroneyear,whicheverislonger.Thiscontrastswiththenoncurrentassets,whichcannotbeliquidatedquickly.Therearedifferenttypesofcurrentassets.Thetypicalsetofcurrentassetsisthefollowing: Cash,bills,andcurrencyareassetsthatareequivalenttocash(e.g.,bankaccount). Marketablesecurities ,whicharesecuritiesthatcanbereadilysold.
FinancialStatements 69 Accountsreceivable ,whichareamountsduefromcustomersarisingfromtradecredit. Inventories ,whichareinvestmentsinrawmaterials,work-in-process,andfnishedgoodsforsale.Acompany’sneedforcurrentassetsisdictated,inpart,byitsoperatingcycle.The operatingcycle isthelengthoftimeittakestoturntheinvestmentofcashintogoodsandservicesforsalebackintocashintheformofcollec-tionsfromcustomers,aswedisplayinExhibit4.1.Thelongertheoperatingcycle,thegreateracompany’sneedforliquidity.Mostcompanies’operatingcycleislessthanorequaltooneyear.Noncurrentassetscomprisebothphysicalandnonphysicalassets.Plantassetsarephysicalassets,suchasbuildingsandequipmentandarerefectedinthebalancesheetasgrossplantandequipmentandnetplantandequip-ment. Grossplantandequipment ,or grossproperty,plant,andequipment ,isthetotalcostofinvestmentinphysicalassets;thatis,whatthecompanyoriginallypaidfortheproperty,plant,andequipmentthatitcurrentlyowns. Netplantandequipment ,or netproperty,plant,andequipment ,isthedif-ferencebetweengrossplantandequipmentandaccumulateddepreciation,andrepresentsthebookvalueoftheplantandequipmentassets. Accumu-lateddepreciation isthesumofdepreciationtakenforphysicalassetsinthecompany’spossession. Collectpayment oncredit accountsCashInvest cash ininventorySell goods oncredit EXHIBIT4.1 TheOperatingCycle
70 FINANCIALMANAGEMENT EXHIBIT4.2 ABCCompanyBalanceSheets December31,2009December31,2008 Cash$50$100Accountsreceivable700600Inventory750 800 Totalcurrentassets$1,500$1,500Grossplantandequipment$12,000$10,000Accumulateddepreciation4,000 3,000 Netplantandequipment$8,000$7,000Intangibleassets500 500 Totalassets$10,000$9,000Accountspayable$350$300Wagespayable150 100 Totalcurrentliabilities$500$400Long-termdebt$6,660$6,660Commonstock100100Additionalpaid-incapital600600Retainedearnings2,2401,340Treasurystock200200Accumulatedothercomprehensiveincomeorloss100100Shareholders’equity2,840 1,940 Totalliabilitiesandequity$10,000$9,000 Companiesmaypresentjustthenetplantandequipmentfgureonthebalancesheet,placingthedetailwithrespecttoaccumulateddepreciationinafootnote.Interpretingfnancialstatementsrequiresknowingabitabouthowassetsaredepreciatedforfnancialreportingpurposes. Depreciation istheallocationofthecostofanassetoveritsusefullife(oreconomiclife).InthecaseofthefctitiousABCCompany,whosebalancesheetisshowninExhibit4.2,theoriginalcostofthefxedassets(i.e.,property,plant,andequipment)—lessanywrite-downsforimpairment—fortheyear2009is$900million.TheaccumulateddepreciationforABCin2009is$250million;thismeansthatthetotaldepreciationtakenonexistingfxedassetsovertimeis$270million.Thenetproperty,plant,andequipmentaccountbalanceis$630million.Thisisalsoreferredtoasthe bookvalue or carryingvalue oftheseassets. Intangibleassets areassetsthatarenotfnancialinstruments,yethavenophysicalexistence,suchaspatents,trademarks,copyrights,franchises,
FinancialStatements 71 andformulae.Intangibleassetsmaybeamortizedoversomeperiod,whichisakintodepreciation.Keepinmindthatacompanymayownanumberofintangibleassetsthatarenotreportedonthebalancesheet.Acompanymayonlyincludeanintangibleasset’svalueonitsbalancesheetif(1)therearelikelyfuturebeneftsattributablespecifcallytotheasset,and(2)thecostoftheintangibleassetcanbemeasured.Supposeacompanyhasanactive,ongoinginvestmentinresearchanddevelopmenttodevelopnewproducts.ItmustexpensewhatisspentonresearchanddevelopmenteachyearbecauseforagiveninvestmentinR&Ddoesnotlikelymeetthetwocriteriabecauseitisnotuntilmuchlater,aftertheR&Dexpenseismade,thattheeconomicviabilityoftheinvest-mentisdetermined.If,ontheotherhand,acompanybuysapatentfromanothercompany,thiscostmaybecapitalizedandthenamortizedovertheremaininglifeofthepatent.Sowhenyoulookatacompany’sassetsonitsbalancesheet,youmaynotbegettingthecompletepictureofwhatitowns. Liabilities Wegenerallyusetheterms“liability”and“debt”assynony-mousterms,though“liability”isactuallyabroaderterm,encompassingnotonlytheexplicitcontractsthatacompanyhas,intermsofshort-termandlong-termdebtobligations,butalsoincludesobligationsthatarenotspecifedinacontract,suchasenvironmentalobligationsorassetretire-mentobligations.Liabilitiesmaybeinterest-bearing,suchasabondissue,ornoninterestbearing,suchasamountsduetosuppliers.Inthebalancesheet,liabilitiesarepresentedinorderoftheirduedateandareoftenpresentedintwocategories,currentliabilitiesandlong-termliabilities. Currentliabilities areobligationsduewithinoneyearoroneoperatingcycle(whicheverislonger).Currentliabilitiesmayconsistof: Accountspayable ,amountsduetosuppliersforpurchasesoncredit; Wagesandsalariespayable,amountsdueemployees; Currentportionoflong-termindebtedness;and Shorttermbankloans. Long-termliabilities areobligationsthatareduebeyondoneyear.Therearedifferenttypesoflong-termliabilities,including: Notespayables and bonds ,whichareindebtedness(loans)intheformofsecurities;
72 FINANCIALMANAGEMENT Capitalleases ,whicharerentalobligationsthatarelong-term,fxedcommitments; Assetretirementliability ,whichisthecontractualorstatutoryobliga-tiontoretireordecommissionanassetattheendoftheasset’slifeandrestorethesitetorequiredstandards;and Deferredtaxes ,whicharetaxesthatmayhavetobepaidinthefuturethatarecurrentlynotdue,thoughtheyareexpensedforfnancialreport-ingpurposes.Deferredtaxesarisefromdifferencesbetweenaccountingandtaxmethods(e.g.,depreciationmethods). 2 Equity Theequityofacompanyistheownershipinterest.Thebookvalueofequity,whichforacorporationisoftenreferredtoasshareholders’equityorstockholders’equity,isbasicallytheamountthatinvestorspaidthecom-panyfortheirownershipinterest,plusanyearnings(orlessanylosses),andminusanydistributionstoowners.Foracorporation,equityistheamountthatinvestorspaidthecorporationforthestockwhenitwasinitiallysold,plusorminusanyearningsorlosses,lessanydividendspaid.Keepinmindthatforanycompany,thereportedamountofequityisanaccumulationovertimesincethecompany’sinception(orincorporation,inthecaseofacorporation). Shareholdersequity isthecarryingorbookvalueoftheownershipofacompany.Shareholders’equityiscomprisedof: Parvalue ,whichisanominalamountpershareofstock(sometimesprescribedbylaw),orthe statedvalue ,whichisanominalamountpershareofstockassignedforaccountingpurposesifthestockhasnoparvalue; Additionalpaid-incapital ,alsoreferredtoas capitalsurplus ,theamountpaidforsharesofstockbyinvestorsinexcessofparorstatedvalue; Retainedearnings ,whichistheaccumulationofpriorandcurrentpe-riods’earningsandlosses,lessanypriororcurrentperiods’dividends;and Accumulatedcomprehensiveincomeorloss ,whichisthetotalamountofincomeorlossthatarisesfromtransactionsthatresultinincomeorlosses,yetarenotreportedthroughtheincomestatement.Itemsgiving 2 Similartodeferredtaxliabilities,thereisalsoapossibilitythatthecompanyhasadeferredtaxasset,whichisataxbeneftexpectedinthefuture.Forexample,ifacompanyhasnetoperatinglossesthatitwilllikelyapplyagainstfuturetaxableincome,thedeferredtaxassetistheamountbywhichfuturetaxbillsarelikelytobereduced.
FinancialStatements 73 risetothisincomeincludeforeigncurrencytranslationadjustmentsandunrealizedgainsorlossesonavailable-for-saleinvestments.Inaddition,acompanythatbuysbackitsownstockfromshareholdersmayretainthisstockforuseinemployeestockoptions.TheaccountthatrepresentsthisstockisTreasurystock.Thisisadeductionfromtheotheraccountstoarriveatshareholders’equity. ANoteonMinorityInterest Onmanycompanies’consolidatedfnancialstatements,youwillnoticeabalancesheetaccountentitled“MinorityIn-terest”asanaccountinshareholders’equity.Whenacompanyownsasubstantialportionofanothercompany,accountingprinciplesrequirethatthecompanyconsolidatethatcompany’sfnancialstatementsintoitsown.Basicallywhathappensinconsolidatingthefnancialstatementsisthattheparentcompanywilladdtheaccountsofthesubsidiarytoitsaccounts(i.e.,subsidiaryinventory + parentinventory = consolidatedinventory). 3 Iftheparentdoesnotown100%ofthesubsidiary’sownershipinterest,anac-countiscreated,referredtoas minorityinterest ,whichrefectstheamountofthesubsidiary’sassets not ownedbytheparent.Priorto2009,thisaccountwaspresentedbetweenliabilitiesandequityontheconsolidatedbalancesheet.However,from2009forward,companiesarerequiredtoreportthisamountinshareholders’equityasequity.Butisminorityinterestconsideredequity?No.Therefore,whenweanalyzeacompany’sfnancialstatement,weremoveminorityinterestfromequity.Ifweleavethisaccountinequity,wewillriskdistortingmeasuresofhowacompanyfnancesitself.Asimilaradjustmenttakesplaceontheincomestatement.Theminorityinterestaccountontheincomestatementrefectstheincome(orloss)inproportiontotheequityinthesubsidiary not ownedbytheparent.Begin-ningwith2009fnancialstatements,companiesarenotrequiredtosubtractminorityinterestfromtheirearnings,butneedonlydisclosewhethertheseearningsareinreportedtheparentcompany’snetincome.Underthenewrules,somecompaniesmaychoosetoreporttwodifferentamountsfornetincome(totalandparent-only),whereasothercompaniesmaysimplyreportonenetincomefgureandfootnotetheminorityinterest.Intheformercase,wewouldusethenetincomeafteradjustingforminorityearnings.Inthelattercase,weneedtosubtractminorityinterestearningsfromreportednetincome. 3 Therearesomeotheradjustmentsthataremadeforinter-corporatetransactions,butwewon’tdiscussthosehere.
74 FINANCIALMANAGEMENT StructureoftheBalanceSheet ConsiderasimplebalancesheetfortheABCCompanyshowninExhibit4.2fortwofscalyears.Afewitemstonote: Theaccountingidentityholds;thatis,totalassetsareequaltothesumofthetotalliabilitiesandthetotalshareholders’equity. Theassetaccountsareorderedfromthemostliquidtotheleastliquid. Theliabilitiesarelistedinorderofpriorityofclaims,withtradecreditorsandemployeeshavingthebestclaims. TheIncomeStatement The incomestatement isasummaryofoperatingperformanceoveraperiodoftime(e.g.,afscalquarterorafscalyear).Westartwiththerevenueofthecompanyoveraperiodoftimeandthensubtractthecostsandexpensesrelatedtothatrevenue.Thebottomlineoftheincomestatementconsistsoftheowners’earningsfortheperiod.Toarriveatthis“bottomline,”weneedtocomparerevenuesandexpenses.WeprovidethebasicstructureoftheincomestatementinExhibit4.3.Thoughthestructureoftheincomestatementvariesbycompany,thebasicideaistopresenttheoperatingresultsfrst,followedbynon-operatingresults.The costofsales ,alsoreferredtoasthe costofgoodssold ,isdeductedfromrevenues,producingagrossproft;thatis,aproftwithoutconsideringallothergeneraloperatingcosts.Thesegeneraloperatingexpensesarethoseexpensesrelatedtothesupportofthegeneraloperationsofthecompany,whichincludessalaries,marketingcosts,andresearchanddevelopment.Depreciation,whichistheamortizedcostofphysicalassets,isalsodeductedfromgrossproft.Theamountofthedepreciationexpenserepresentsthecostofthewearandtearontheproperty,plant,andequipmentofthecompany.Oncewehavetheoperatingincome,wehavesummarizedthecompany’sperformancewithrespecttotheoperationsofthebusiness.Butthereisgenerallymoretothecompany’sperformance.Fromoperatingincome,wedeductinterestexpenseandaddanyinterestincome.Further,adjustmentsaremadeforanyotherincomeorcostthatisnotapartofthecompany’scorebusiness.Thereareanumberofotheritemsthatmayappearasadjustmentstoarriveatnetincome.Oneoftheseisextraordinaryitems,whicharedefnedasunusualandinfrequentgainsorlosses.Anotheradjustmentwouldbefortheexpenserelatedtothewrite-downofanasset’svalue.InthecaseoftheABCCompany,whoseincomestatementweprovideinExhibit4.4,theincomefromoperations—itscorebusiness—is$2,000million,whereasthenetincome(i.e.,the“bottomline”)is$1,000million.
FinancialStatements 75 EXHIBIT4.3 TheBasicStructureoftheIncomeStatement RevenuesorsalesRepresenttheamountofgoodsorservicessold,intermsofpricepaidbycustomers–CostofgoodssoldTheamountofgoodsorservicessold,intermsofcosttothecompanyGrossproftThedifferencebetweensalesandcostofgoodssold–SellingandgeneraladministrativeexpensesSalaries,administrative,marketingexpenditures,etc.OperatingproftIncomefromoperations;earningsbeforeinterestandtaxes(EBIT),operatingincome,andoperatingearnings–InterestexpenseInterestpaidondebtIncomebeforetaxesEarningsbeforetaxes–TaxexpenseTaxesexpenseforthecurrentperiodNetincomeOperatingproftlessfnancingexpenses(e.g.,interest)andtaxes–PreferredstockdividendsDividendspaidtopreferredshareholdersEarningsavailabletocommonshareholdersNetincomelesspreferredstockdividends;residualincome EarningsPerShare Companiesprovideinformationon earningspershare (EPS)intheirannualandquarterlyfnancialstatementinformation,aswellasintheirperiodicpressreleases.Generally,EPSiscalculatedasnetincomedividedbythenumberofsharesoutstanding.Companiesmustreportbothbasicanddilutedearningspershare. EXHIBIT4.4 TheABCCompanyIncomeStatementfortheperiodsendingDecember31,2008and2009(inmillions) Revenuesorsales$10,000Costofgoodssold7,000 Grossproft$3,000Sellingandgeneraladministrativeexpenses1,000 Operatingproft$2,000Interestexpense333 Incomebeforetaxes$1,667Taxexpense667 Netincome$1,000
76 FINANCIALMANAGEMENT Basicearningspershare isnetincome(minuspreferreddividends)di-videdbytheaveragenumberofsharesoutstanding. Dilutedearningspershare isnetincome(minuspreferreddividends)dividedbythenumberofsharesoutstandingconsideringalldilutivesecurities(e.g.,convertibledebt,options). 4 Dilutedearningspershare,therefore,givestheshareholderin-formationaboutthe potential dilutionofearnings.Forcompanieswithalargenumberofdilutivesecurities(e.g.,stockoptions,convertiblepreferredstock,orconvertiblebonds),therecanbeasignifcantdifferencebetweenbasicanddilutedEPS.YoucanseetheeffectofdilutionbycomparingthebasicanddilutedEPS. MoreonDepreciation Therearedifferentmethodsthatcanbeusedtoallocateanasset’scostoveritslife.Generally,iftheassetisexpectedtohavevalueattheendofitseconomiclife,theexpectedvalue,referredtoasa salvagevalue (or residualvalue ),isnotdepreciated;rather,theassetisdepreciateddowntoitssalvagevalue.Therearedifferentmethodsofdepreciationthatweclassifyaseitherstraight-lineoraccelerated. Straight-linedepreciation allocatesthecost(lesssalvagevalue)inauni-formmanner(equalamountperperiod)throughouttheasset’slife. Accelerateddepreciation allocatestheasset’scost(lesssalvagevalue)suchthatmoredepreciationistakenintheearlieryearsoftheasset’slife.Therearealternativeacceleratedmethodsavailable,including: Decliningbalancemethod ,inwhicha constant rateappliedtoa declin-ing amount(theundepreciatedcost). Sum-of-the-years’digitsmethod ,inwhicha declining rateappliedtotheasset’s depreciablebasis andthisrateisratiooftheremainingyearsdividedbythesumoftheyears. 5 Acceleratedmethodsresultinhigherdepreciationexpensesinearlieryears,relativetostraight-line.Asaresult,acceleratedmethodsresultinlowerreportedearningsinearlieryears,relativetostraight-line,butalsolowernetproperty,plant,andequipmentinearlieryearsaswell.Comparingcompanies,itisimportanttounderstandwhetherthecompaniesusedifferentmethodsofdepreciationbecausethechoiceofdepreciationmethodaffectsboththebalancesheet(throughthecarrying 4 Inthecaseofdilutedearningspershare,ifthedilutionpotentialisfromconvertibledebt,earningsareadjustedfortheinterestonthisconvertibledebt. 5 Forexample,foranassetwithafveyearlife,thefrstyear’sdepreciationis5/15,thesecondyear’sdepreciationis4/15,andsoon.
FinancialStatements 77 valueoftheasset)andtheincomestatement(throughthedepreciationex-pense).Amajorsourceofdeferredincometaxliabilityanddeferredtaxassetsistheaccountingmethodusedforfnancialreportingpurposesandtaxpurposes.Inthecaseoffnancialaccountingpurposes,thecompanychoosesthemethodthatbestrefectshowitsassetslosevalueovertime,thoughmostcompaniesusethestraight-linemethod.However,fortaxpurposesthecompanyhasnochoicebuttousetheprescribedratesofdepreciation,usingthe ModifedAcceleratedCostRecoverySystem (MACRS).Fortaxpurposes,acompanydoesnothavediscretionovertheasset’sdepreciablelifeortherateofdepreciation—theymustusetheMACRSsystem.TheMACRSsystemdoesnotincorporatesalvagevalueandisbasedonadecliningbalancesystem.Thedepreciablelifefortaxpurposesmaybelongerthanorshorterthanthatusedforfnancialreportingpurposes.WeprovidetheMACRSratesfor3,5,7and10-yearassetsinExhibit4.5.You’llnoticethefactthata3-yearassetisdepreciatedoverfouryearsanda5-yearassetisdepreciatedoversixyears,andsoon.Thatistheresultofusingwhatisreferredtoasa half-yearconvention —usingonlyhalfayear’sworthofdepreciationinthefrstyearofanasset’slife.Thissystemresultsinaleftoveramountthatmuststillbedepreciatedinthelastyear(i.e.,thefourthyearinthecaseofa3-yearassetandthesixthyearinthecaseofa5-yearasset).WecancompareMACRSwithstraight-line,usinganexampleofanassetthatcosts$100,000thathasaneight-yearusefullifebutisclassifedasa7-yearMACRSassetfortaxpurposes.Ifthecompanyusesstraight-line EXHIBIT4.5 MACRSRates MACRSLife,inYears Year3-year5-year7-year10-year 133.33%20.00%14.29%10.00%244.44%32.00%24.49%18.00%314.81%19.20%17.49%14.40%47.41%11.52%12.49%11.52%511.52%8.92%9.22%65.76%8.92%7.37%78.92%6.55%84.46%6.55%96.55%106.55%113.28%
78 FINANCIALMANAGEMENT depreciationforfnancialreportingpurposes,therewillbeadifferenceinincomeandtaxexpensefortaxandfnancialreportingpurposes.Let’sassumethattheassethasnosalvagevalue,thatthecompanyhasnetincomebeforetaxesanddepreciationof$50,000,andthatthetaxrateis30%.Theamountdepreciatedisthesameunderbothmethods,buttheannualdepreciationisdifferent: DepreciationRateDepreciationExpense YearMACRSStraight-lineMACRSStraight-line 114.29%12.50%$14,286$12,500224.49%12.50%$24,490$12,500317.49%12.50%$17,493$12,500412.49%12.50%$12,495$12,50058.92%12.50%$8,925$12,50068.92%12.50%$8,925$12,50078.92%12.50%$8,925$12,50084.46%12.50%$4,462 $12,500 Sum$100,000$100,000 Therefore,thedifferenceinthesemethodsisnotthetotalthatisde-preciated,butratherthetimingofthedepreciation.Theeffectsontaxableincomeandtaxexpensearealsoamatteroftiming: TaxableIncomeTaxExpense YearMACRSStraight-lineMACRSStraight-line 1$35,714$37,500$10,714$11,2502$25,510$37,500$7,653$11,2503$32,507$37,500$9,752$11,2504$37,505$37,500$11,252$11,2505$41,075$37,500$12,323$11,2506$41,075$37,500$12,323$11,2507$41,075$37,500$12,323$11,2508$45,538 $37,500 $13,661 $11,250 Sum$300,000$300,000$90,000$90,000
FinancialStatements 79 Inthisexample,thecompanywouldhaveadeferredtaxliabilitycre-atedwhenMACRStaxexpenseislessthanthestraight-linetaxexpense,butthiswouldreverseinlateryears—reducingthedeferredtaxliability—asthetaxexpenseusingstraight-lineislessthanthetaxexpenseunderMACRS. TRYIT!MACRSDEPRECIATION Supposeacompanyacquiresanassetattheendof2010thathasacostof$20,000andisclassifedasa3-yearMACRSasset.Whatisthedepreciationexpenseeachyear? TheStatementofCashFlows The statementofcashfows isthesummaryofacompany’scashfows,summarizedbyoperations,investmentactivities,andfnancingactivities.WeprovideasimplifedcashfowstatementinExhibit4.6forthefctitious EXHIBIT4.6 StatementofCashFlowsforABCCompanyforfscalyearendingDecember31,2009 OperatingactivitiesNetincome$1,000Add:Depreciation1,000Subtract:increaseinaccountsreceivable − 100Add:Decreaseininventory + 50Add:Increaseinaccountspayable + 50Add:Increaseinwagespayable + 50 Cashfowfromoperations$2,050InvestingactivitiesCapitalexpenditures − $2,000 Cashfowfrominvesting − $2,000FinancingactivitiesDividendspaid − $100 Cashfowfromfnancing − $100 Netchangeincash − $50
80 FINANCIALMANAGEMENT ABCCompany. Cashfowfromoperations iscashfowfromday-to-dayoperations.Cashfowfromoperatingactivitiesisbasicallynetincomead-justedfor(1)noncashexpenditures,and(2)changesinworkingcapitalaccounts.Theadjustmentforchangesinworkingcapitalaccountsisnecessarytoadjustnetincomethatisdeterminedusingtheaccrualmethodtoacashfowamount.Increasesincurrentassetsanddecreasesincurrentliabilitiesarepositiveadjustmentstoarriveatthecashfow;decreasesincurrentassetsandincreasesincurrentliabilitiesarenegativeadjustmentstoarriveatthecashfow. Cashfowfor/frominvesting isthecashfowsrelatedtotheacquisition(purchase)ofplant,equipment,andotherassets,aswellastheproceedsfromthesaleofassets. Cashfowfor/fromfnancingactivities isthecashfowfromactivitiesrelatedtothesourcesofcapitalfunds(e.g.,buybackcommonstock,paydividends,issuebonds).FortheABCCompany,thesearefairlystraightforward.Notalloftheclassifcationsrequiredbyaccountingprinciplesarecon-sistentwiththetruefowforthethreetypesofactivities.Forexample,interestexpenseisafnancingcashfow,yetitaffectsthecashfowfromoperatingactivitiesbecauseitisadeductiontoarriveatnetincome.Thisinconsistencyisalsothecaseforinterestincomeanddividendincome,bothofwhichresultfrominvestingactivities,butshowupinthecashfowfromoperatingactivitiesthroughtheircontributiontonetincome.Thesourcesofacompany’scashfowscanrevealagreatdealaboutthecompanyanditsprospects.Forexample,afnanciallyhealthycompanytendstoconsistentlygeneratecashfowsfromoperations(thatis,positiveoperatingcashfows)andinvestscashfows(thatis,negativeinvestingcashfows).Toremainviable,acompanymustbeabletogeneratefundsfromitsoperations;togrow,acompanymustcontinuallymakecapitalinvestments.Thechangeincashfow—alsocalled netcashfow —isthebottomlineinthestatementofcashfowsandisequaltothechangeinthecashac-countasreportedonthebalancesheet.FortheABCCompany,showninExhibit4.6,thenetchangeincashfowisa − $50million;thisisequaltothechangeinthecashaccountfrom$100millionin2008to$50millionin2009.Bystudyingthecashfowsofacompanyovertime,wecangaugeacompany’sfnancialhealth.Forexample,ifacompanyreliesonexternalfnancingtosupportitsoperations(thatis,reliantoncashfowsfromf-nancingandnotfromoperations)foranextendedperiodoftime,thisisawarningsignoffnancialtroubleupahead.
FinancialStatements 81 TRYIT!CASHFLOWFROMOPERATIONS Supposeacompanyhasnetincomeof$1millionanddepreciationof$0.2million.Ifthecompany’sinventorydecreasedby$0.3millionandaccountsreceivableincreasedby$0.4million,whatisthiscompany’scashfowfromoperations? TheStatementofStockholders’Equity The statementofstockholders’equity (alsoreferredtoasthe statementofshareholders’equity )isasummaryofthechangesintheequityaccounts,includinginformationonstockoptionsexercised,repurchasesofshares,andTreasuryshares.Thebasicstructureistoincludeareconciliationofthebalanceineachcomponentofequityfromthebeginningofthefscalyearwiththeendofthefscalyear,detailingchangesattributedtonetincome,dividends,purchasesorsalesofTreasurystock.Thecomponentsarecommonstock,additionalpaid-incapital,retainedearnings,andTreasurystock.Foreachofthesecomponents,thestatementbeginswiththebalanceofeachattheendofthepreviousfscalperiodandthenadjustmentsareshowntoproducethebalanceattheendofthecurrentfscalperiod.Inaddition,thereisareconciliationofanygainsorlossesthataffectstockholders’equitybutwhichdonotfowthroughtheincomestatement,suchasforeign-currencytranslationadjustmentsandunrealizedgainsoninvestments.Theseitemsareofinterestbecausetheyarepartofcomprehen-siveincome,andhenceincometoowners,buttheyarenotrepresentedonthecompany’sincomestatement. HOWARETHESTATEMENTSRELATED? Thefourbasicstatementsaretheresultoftransactionsthatrecordeachactivityofthecompany.Asaresult,thefnancialstatementsareinter-related.Forexample, Thechangeincash,thebottomlineofthestatementcashfows,isequaltothechangeinthecashbalancefromthepreviousfscalperiodtothecurrentfscalperiod.
82 FINANCIALMANAGEMENT Netincome,thebottomlineoftheincomestatement,isthestartingpointofthestatementofcashfows,andcontributestoretainedearningsinthebalancesheetandthestatementofshareholders’equity. Thechangesintheworkingcapitalaccountsareadjustmentstothearriveatthecashfowfromoperatingactivitiesinthestatementofcashfows,thechangesintheassetaccountscontributetochangesincashfowsfrominvestingactivities,anddebtissuancesandrepayments,aswellasissuanceorrepurchaseofstockcontributetothechangeincashfowsforfnancingactivities. WHYBOTHERABOUTTHEFOOTNOTES? Footnotestothefnancialstatementscontainadditionalinformation,sup-plementingorexplainingfnancialstatementdata.Thesenotesarepresentedinboththeannualreportandthe10-Kfling(withtheSEC),thoughthelatterusuallyprovidesagreaterdepthofinformation.Thefootnotestothefnancialstatementsprovideinformationpertain-ingto: Thesignifcantaccountingpoliciesandpracticesthatthecompanyuses. Thishelpstheanalystwiththeinterpretationoftheresults,comparabilityoftheresultstoothercompaniesandtootheryearsforthesamecompany,andinassessingthequalityofthereportedinformation. Incometaxes. Thefootnotestellusaboutthecompany’scurrentanddeferredincometaxes,breakdownsbythetypeoftax(e.g.,federalversusstate),andtheeffectivetaxratethatthecompanyispaying. Pensionplansandotherretirementprograms. Thedetailaboutpensionplans,includingthepensionassetsandthepensionliability,isimportantindeterminingwhetheracompany’spensionplanisoverfundedorunderfunded. Leases. Youcanlearnaboutboththecapitalleases,whicharethelong-termleaseobligationsthatarereportedonthebalancesheet,andaboutthefuturecommitmentsunderoperatingleases,whicharenotrefectedonthebalancesheet. Long-termdebt. Youcanfnddetailedinformationaboutthematuritydatesandinterestratesonthecompany’sdebtobligations. Stock-basedcompensation. Youcanfnddetailedinformationaboutstockoptionsgrantedtooffcersandemployees.Thisfootnotealsoincludescompany’saccountingmethodforstock-basedcompensationandtheimpactofthemethodonthereportedresults.
FinancialStatements 83 Derivativeinstruments. Thisdescribesaccountingpoliciesforcer-tainderivativeinstruments(fnancialandcommodityderivativeinstru-ments),aswellasthetypesofderivativeinstruments.Thephrase“thedevilisinthedetails”appliesaptlytothefootnotesofacompany’sfnancialstatement.Throughthefootnotes,acompanyisprovidinginformationthatiscrucialinanalyzingacompany’sfnancialhealthandperformance.Iffootnotesarevagueorconfusing,astheywereinthecaseofEnronpriortothebreakinthescandal,theanalystmustaskquestionstohelpunderstandthisinformation. ACCOUNTINGFLEXIBILITY Thegenerallyacceptedaccountingprinciplesprovidesomechoicesinthemannerinwhichsometransactionsandassetsareaccounted.Forexample,acompanymaychoosetoaccountforinventory,andhencecostsofsales,using Last-in,First-out (LIFO)or First-in,First-out (FIFO).WithLIFO,themostrecentcostsofitemsinventoryareusedtodeterminecostofgoodssold,whereaswithFIFOtheoldestcostsareused.Thisisintentionalbecausetheseprinciplesareappliedtoabroadsetofcompaniesandnosinglesetofmethodsoffersthebestrepresentationofacompany’sconditionorperfor-manceforallcompanies.Ideally,acompany’smanagement,inconsultationwiththeaccountants,choosesthoseaccountingmethodsandpresentationsthataremostappropriateforthecompany.Acompany’smanagementhasalwayshadtheabilitytomanageearningsthroughthejudiciouschoiceofaccountingmethodswithintheGAAPframe-work.Thecompany’s“watchdogs”(i.e.,theaccountants)shouldkeepthecompany’smanagementincheck.However,recentscandalshaverevealedthatthewatchdogfunctionoftheaccountingcompanieswasnotwork-ingwell.Additionally,somecompanies’managementusedmanipulationoffnancialresultsandoutrightfraudtodistortthefnancialpicture.TheSarbanes-OxleyActof2002offerssomecomfortintermsofcre-atingtheoversightboardfortheauditingaccountingcompanies.Inaddi-tion,theSecuritiesandExchangeCommission,theFinancialAccountingStandardsBoard,andtheInternationalAccountingStandardsBoardaretighteningsomeofthefexibilitythatcompanieshadinthepast. U.S.ACCOUNTINGVS.OUTSIDEOFTHEU.S. ThegenerallyacceptedaccountingstandardsintheUnitedStates(U.S.GAAP)differfromthoseusedinothercountriesaroundtheworld.But
84 FINANCIALMANAGEMENT notforlong.Whatishappeningisaninternationalconvergenceofaccount-ingstandards.Thefrstmajorstepwastheagreementin2002betweentwomajorstandardsettingbodies—theU.S.’sFinancialAccountingStandardsBoard(FASB)andtheInternationalAccountingStandardsBoard(IASB)—toworktogetherforeventualconvergenceofaccountingprinciples.Thesec-ondmajorstepwastherequirementofInternationalFinancialReportingStandards(IFRS)bytheEuropeanCommission,effectivein2005.ThethirdmajorstepisthevoluntaryapplicationofIFRSbyU.S.domiciledcompaniesforfscalyearsendingafterDecember15,2009. 6 IFRSarepromulgatedbytheIASBandmustbeusedbyallpub-liclytradedandprivatecompaniesintheEuropeanUnion.IFRSarealsoused,invaryingdegrees,bycompaniesinAustralia,HongKong,Russia,andChina.TherearemoresimilaritiesthandifferencesbetweenIFRSandU.S.GAAP.IFRS,likeGAAP,useshistoricalcostasthemainaccountingconven-tion.However,IFRSpermitstherevaluationofintangibleassets,property,plant,andequipment,andinvestmentproperty.IFRSalsorequiresfairval-uationofcertaincategoriesoffnancialinstrumentsandcertainbiologicalassets.U.S.GAAP,ontheotherhand,prohibitsrevaluationsexceptforcer-taincategoriesoffnancialinstruments,whichmustbecarriedatfairvalue,andgoodwill,whichistestedeachyearforimpairment(thatis,alossofvalue).Becausetherehasbeenalong“roadmap”toconvergence,andbe-causemanyoftheaccountingprinciplesissuedinthepastfewyearshavebeenissuedjointlybyFASBandIASB,convergence,whenithappens,shouldnotresultinadramaticchangeinthefnancialstatementsofU.S.companies. THEBOTTOMLINE Financialstatementsprovideinformationaboutacompany’soperatingperformance,aswellasitsfnancialcondition.Thesestatementsarepreparedaccordingtogenerallyacceptedaccountingprinciples. Theassumptionsinpreparingfnancialstatementsarethat(1)transac-tionsarerecordedathistoricalcost,(2)theappropriateunitofmeasure-mentisthedollar,(3)statementsarerecordedforpredefnedperiods 6 Thecurrent“roadmap”toconvergencehasa2014targetformandatoryapplicationofIFRStoU.S.companies.
FinancialStatements 85 oftime,(4)statementsarepreparedusingaccrualaccountingandthematchingprinciple,(5)thebusinesswillcontinueasagoingconcern,(6)thereisfulldisclosure,and(7)ifmorethanoneinterpretationofaneventispossible,statementsarepreparedusingthemostconservativeinterpretation. Thebasicstatementsarethebalancesheet,theincomestatement,thestatementofcashfows,andthestatementofshareholders’equity. Thereissomefexibilitybuiltintoaccountingprinciples,soitisimpor-tanttounderstandjusthowmuchfexibilitythereisandhowchoicesacompanymakeaffectthereportedfnancialstatements.Forexample,companiescanchooseamonganumberofmethodsfordepreciationforfnancialreportingpurposes,thoughtheMACRSsystemisusedfortaxpurposes. Thefootnotestothefnancialstatementsprovideinformationpertainingto(1)signifcantaccountingpoliciesandpracticesthatthecompanyuses,(2)incometaxes,(3)pensionplansandotherretirementprograms,(4)leases,(5)long-termdebt,(6)stock-basedcompensationgrantedtooffcersand(7)derivativeinstruments. SOLUTIONSTOTRYIT!PROBLEMS MACRSDepreciationYearRateMACRSDepreciation 133.33%$6,666.67244.44%$8,888.89314.81%$2,962.9647.41%$1,481.48 Sum$20,000.00 CashFlowfromOperations Netincome$1.0Plusdepreciation$0.2Plusdecreaseininventory$0.3Lessincreaseinaccountsreceivable − $0.4 Cashfowfromoperations$1.1
86 FINANCIALMANAGEMENT QUESTIONS 1. Whatistheaccountingidentity? 2. Listatleastthreeoftheassumptionsunderlyingfnancialstatements. 3. Identifyatleastthreecurrentassetaccounts. 4. Whatistheoperatingcycle? 5. Identifythreecurrentliabilityaccounts. 6. Whatareretainedearnings? 7. Istheminorityinterestaccountonthebalancesheetaliability,equity,orneither? 8. Whatisthedifferencebetweenbasicearningspershareanddilutedearningspershare? 9. IfanassetisdepreciatedfortaxpurposesusingMACRS,butdepreciatedusingstraight-linedepreciationforfnancialreportingpurposes,howaredeferredtaxliabilitiescreated? 10. Whatisthesumofthecashfowsfromoperatingactivities,fnancingactivities,andinvestingactivities? 11. Whatdoesitmeanthatthefnancialstatementsarepreparedbasedonhistoricalcost? 12. Wherecananinvestorfndoutmoreaboutdeferredtaxesreportedinthebalancesheet? 13. Whatfollowsisinformationfromthebalancesheet(inmillionsofdollars)forMicrosoftCorporationforits2009fscalyear(endingJune30,2009)withcertaininformationintentionallydeleted. AssetsLiabilitiesandStockholders’Equity CashandcashequivalentsShort-terminvestmentsAccountsreceivableInventoriesDeferredincometaxes,currentportionOthercurrentassetsNetpropertyandequipmentEquityandotherinvestmentsGoodwillIntangibleassets,netDeferredincometaxesOtherlong-termassets$6,07625,37111,1927172,2133,7117,5354,93312,5031,7592791,599AccountspayableShort-termdebtAccruedcompensationIncometaxesShort-termunearnedrevenueSecuritieslendingpayableOtherLong-termdebtLong-termunearnedrevenueOtherlong-termliabilitiesStockholders’equity:Commonstockandpaid-incapital—sharesauthorized24,000;outstanding8,908Retaineddefcit,includingaccumulatedothercomprehensiveincomeof$969$3,3242,0003,15672513,0031,6843,1423,7461,2816,26962,382(22,824)
FinancialStatements 87 ComputeeachofthefollowingbasedonMicrosoftCorporation’sbal-ancesheet: a. Totalcurrentassets b. Totalassets c. Totalliabilities d. Stockholders’equity e. Totalliabilitiesplusstockholders’equity 14. Thefollowingisatableshowingthecalculationofearningspershareasitappearsinthe2009fnancialstatementsofMicrosoftCorporation. Inmillions,exceptearningspershare YearEndedJune30, 200920082007 Netincomeavailableforcommonshareholders(A)$14,569$17,681$14,065Weightedaverageoutstandingsharesofcommonstock(B)8,9459,3289,742Dilutiveeffectofstock-basedawards51142144Commonstockandcommonstockequivalents(C)8,9969,4709,886Earningspershare:Basic(A/B)$1.63$1.90$1.44Diluted(A/C)$1.62$1.87$1.42 a. Whyaretheretwoearningspersharenumbersreported? b. Whatdoes“Basic”meanunder“Earningspershare”? c. Whatdoes“Diluted”meanunder“Earningspershare”? d. Forallthreefscalyears,bothearningspersharemeasuresinagivenfscalyeararecloseinvalue.Whatdoesthatsuggest? 15. ThefollowingexcerptistakenfromapublicationoftheAmericanInstituteofCertifedPublicAccountants(wewon’tgivethetitlesinceitistheanswertooneofthequestions): GreatstrideshavebeenmadebytheFASBandtheIASBtoconvergethecontentofIFRSandU.S.GAAP.ThegoalisthatbythetimetheSECallowsormandatestheuseofIFRSforUS.publicly-tradedcompanies,mostorallofthekeydifferenceswillhavebeenresolved.Becauseoftheseongoingconvergenceprojects,theextentofthespecifcdifferencesbetweenIFRSandU.S.GAAPisshrinking.Yetsignifcantdifferencesdoremain.ForexampleIFRSdoesnotpermitLastInFirstOut(LIFO)asaninventorycostingmethod. a. WhatistheFASB? b. WhatistheIFRS? c. WhatismeantbyGAAP?
CHAPTER 5 BusinessFinance Corporategovernanceisaboutmaintaininganappropriatebalanceofaccountabilitybetweenthreekeyplayers:thecorporation’sowners,thedirectorswhomtheownerselect,andthemanagerswhomthedirectorsselect.Accountabilityrequiresnotonlygoodtransparency,butalsoaneffectivemeanstotakeactionforpoorperformanceorbaddecisions. —ChairmanMaryL.Schapiro,U.S.SecuritiesandExchangeCommission,September17,2009 F inancialmanagementencompassesmanydifferenttypesofdecisions.Wecanclassifythesedecisionsintothreegroups:investmentdecisions,f-nancingdecisions,anddecisionsthatinvolvebothinvestingandfnancing.Investmentdecisionsareconcernedwiththeuseoffunds—thebuying,hold-ing,orsellingofalltypesofassets:Shouldwebuyanewdiestampingmachine?Shouldweintroduceanewproductline?Selltheoldproductionfacility?Buyanexistingcompany?Buildawarehouse?Keepourcashinthebank?Financingdecisionsareconcernedwiththeacquisitionoffundstobeusedforinvestingandfnancingday-to-dayoperations.Shouldmanagementusethemoneyraisedthroughthecompanies’revenues?Shouldmanagementseekfundsfromoutsideofthebusiness?Acompany’soperationsandinvest-mentcanbefnancedfromoutsidethebusinessbyincurringdebts,suchasthroughbankloansandthesaleofbonds,orbysellingownershipinterests.Becauseeachmethodoffnancingobligatesthebusinessindifferentways,fnancingdecisionsareveryimportant.Manybusinessdecisionssimultaneouslyinvolvebothinvestingandf-nancingdecisions.Forexample,acompanymaywishtoacquireanothercompany—aninvestmentdecision.However,thesuccessoftheacquisition 89
90 FINANCIALMANAGEMENT maydependonhowitisfnanced:byborrowingcashtomeetthepurchaseprice,bysellingadditionalsharesofstock,orbyexchangingitssharesofstockforthestockorassetsofthecompanyitisseekingtoacquire.Ifmanagementdecidestoborrowmoney,theborrowedfundsmustberepaidwithinaspecifedperiodoftime.Creditors(thoselendingthemoney)gener-allydonotshareinthecontrolofproftsoftheborrowingcompany.If,ontheotherhand,managementdecidestoraisefundsbysellingownershipin-terests,thesefundsneverhavetobepaidback.However,suchasaledilutesthecontrolof(andproftsaccruingto)thecurrentowners.Inthischapter,weprovideanoverviewoffnancialmanagement:theformsofbusinessenterprise,theobjectivesoffnancialmanagement,andtherelationshipbetweenfnancialmanagersandshareholdersandotherstakeholders. FORMSOFBUSINESSENTERPRISE Financialmanagementisnotrestrictedtolargecorporations:Itisnecessaryinallformsandsizesofbusinesses.Thethreemajorformsofbusinessorga-nizationarethesoleproprietorship,thepartnership,andthecorporation.Theseformsdifferinanumberoffactors,ofwhichthosemostimportanttofnancialdecision-makingare: Taxation Degreeofcontrol Owners’liability Easeoftransferringownership. Abilitytoraiseadditionalfunds. Longevityofthebusiness.Wesummarizetheadvantagesanddisadvantagesofthemajorformsofbusinessfromthepointofviewoffnancialdecision-makinginExhibit5.1. SoleProprietorshipsandPartnerships Asoleproprietorshipisabusinessentityownedbyoneparty,andisthesimplestoftheformsofbusiness: Itiseasytoform. Thebusinessincomeistaxedalongwiththeowner’sotherincome. Theownerisliableforthedebtsofthebusiness. Theownercontrolsthedecisionsofthebusiness. Thebusinessendswhentheownerdoes.
BusinessFinance 91 EXHIBIT5.1 CharacteristicsoftheBasicFormsofBusiness AdvantagesDisadvantages 1.Theproprietoristhesolebusinessdecision-maker.2.Theproprietorreceivesallincomefromthebusiness.3.Incomefromthebusinessistaxedonce,attheindividualtaxpayerlevel.1.Theproprietorisliableforalldebtsofthebusiness(unlimitedliability).2.Theproprietorshiphasalimitedlife.3.Thereislimitedaccesstoadditionalfunds. SoleProprietorship 1.Partnersreceiveincomeaccordingtotermsinpartnershipagreement.2.Incomefrombusinessistaxedonceasthepartners’personalincome.3.Decision-makingrestswiththegeneralpartnersonly.1.Eachpartnerisliableforallthedebtsofthepartnership.2.Thepartnership’slifeisdeterminedbyagreementorthelifeofthepartners.3.Thereislimitedaccesstoadditionalfunds. Partnership 1.Eachpartnerisliableforallthedebtsofthepartnership.2.Thepartnership’slifeisdeterminedbyagreementorthelifeofthepartners.3.Thereislimitedaccesstoadditionalfunds.1.Incomepaidtoownersissubjectedtodoubletaxation.2.Ownershipandmanagementareseparatedinlargerorganizations. Corporation Thesoleproprietorshipisoftenthestartingpointforasmall,fedglingbusiness.Butasoleproprietorshipisoftenlimitedinitsaccesstofundsbeyondbankloans.Anotherformofbusinessthatoffersadditionalsourcesoffundsisthepartnership.A partnership isanagreementbetweentwoormorepersonstooperateabusiness.Apartnershipissimilartoasoleproprietorshipexceptinsteadofoneproprietor,thereismorethanone.Thefactthatthereismorethanoneproprietorintroducessomeissues:Whohasasayintheday-to-dayoperationsofthebusiness?Whoisliable(thatis,fnanciallyresponsible)forthedebtsofthebusiness?Howistheincomedistributedamongtheowners?Howistheincometaxed?Someoftheseissuesareresolvedwiththepart-nershipagreement;othersareresolvedbylaws.Thepartnershipagreementdescribeshowproftsandlossesaretobesharedamongthepartners,anditdetailstheirresponsibilitiesinthemanagementofthebusiness.Mostpartnershipsare generalpartnerships ,consistingonlyofgeneralpartnerswhoparticipatefullyinthemanagementofthebusiness,shareinits
92 FINANCIALMANAGEMENT proftsandlosses,andareresponsibleforitsliabilities.Eachgeneralpartnerispersonallyandindividuallyliableforthedebtsofthebusiness,evenifthosedebtswerecontractedbyotherpartners.A limitedpartnership consistsofatleastonegeneralpartnerandone limitedpartner .Limitedpartnersinvestinthebusiness,butdonotpartici-pateinitsmanagement.Alimitedpartner’sshareintheproftsandlossesofthebusinessislimitedbythepartnershipagreement.Inaddition,alimitedpartnerisnotliableforthedebtsincurredbythebusinessbeyondhisorherinitialinvestment.Apartnershipisnottaxedasaseparateentity.Instead,eachpartnerreportshisorhershareofthebusinessproftorlossonhisorherpersonalincometaxreturn.Eachpartner’sshareistaxedasifitwerefromasoleproprietorship.Thelifeofapartnershipmaybelimitedbythepartnershipagreement.Forexample,thepartnersmayagreethatthepartnershipistoexistonlyforaspecifednumberofyearsoronlyforthedurationofaspecifcbusi-nesstransaction.Thepartnershipmustbeterminatedwhenanyoneofthepartnersdies,nomatterwhatisspecifedinthepartnershipagreement.Part-nershipinterestscannotbepassedtoheirs;atthedeathofanypartner,thepartnershipisdissolvedandperhapsrenegotiated.Oneofthedrawbacksofpartnershipsisthatapartner’sinterestinthebusinesscannotbesoldwithouttheconsentoftheotherpartners.Soapartnerwhoneedstosellhisorherinterestbecauseof,say,personalfnancialneedsmaynotbeabletodoso.Stillanotherprobleminvolvesendingapartnershipandsettlingup,mainlybecauseitisdiffculttodeterminethevalueofthepartnershipandofeachpartner’sshare.Anotherdrawbackisthepartnership’slimitedaccesstonewfunds.Shortofsellingpartoftheirownownershipinterest,thepartnerscanraisemoneyonlybyborrowingfrombanks—andheretoothereisalimittowhatabankwilllenda(usuallysmall)partnership. Corporations A corporation isalegalentitycreatedunderstatelawsthroughtheprocessofincorporation.Thecorporationisanorganizationcapableofenteringintocontractsandcarryingoutbusinessunderitsownname,separatefromitowners.Tobecomeacorporation,statelawsgenerallyrequirethatacompanymustdothefollowing:(1)flearticlesofincorporation,(2)adoptasetofbylaws,and(3)formaboardofdirectors.The articlesofincorporation specifythelegalnameofthecorporation,itsplaceofbusiness,andthenatureofitsbusiness.Thiscertifcategives
BusinessFinance 93 “life”toacorporationinthesensethatitrepresentsacontractbetweenthecorporationanditsowners.Thiscontractauthorizesthecorporationtoissueunitsofownership,called shares ,andspecifestherightsoftheowners,the shareholders .The bylaws aretherulesofgovernanceforthecorporation.Thebylawsdefnetherightsandobligationsofoffcers,membersoftheboardofdirec-tors,andshareholders.Inmostlargecorporations,itisnotpossibleforeachownertoparticipateinmonitoringthemanagementofthebusiness.There-fore,theownersofacorporationelectaboardofdirectorstorepresenttheminthemajorbusinessdecisionsandtomonitortheactivitiesofthecorpora-tion’smanagement.Theboardofdirectors,inturn,appointsandoverseestheoffcersofthecorporation.Directorswhoarealsoemployeesofthecorporationarecalled insiderdirectors ;thosewhohavenootherpositionwithinthecorporationare outsidedirectors or independentdirectors .Thestaterecognizestheexistenceofthecorporationinthecorporatecharter.Oncecreated,thecorporationcanenterintocontracts,adoptalegalname,sueorbesued,andcontinueinexistenceforever.Thoughownersmaydie,thecorporationcontinuestolive.Theliabilityofownersislimitedtotheamountstheyhaveinvestedinthecorporationthroughthesharesofownershiptheypurchased.Thecorporationisataxableentity.Itflesitsownincometaxreturnandpaystaxesonitsincome.Iftheboardofdirectorsdecidestodistributecashtotheowners,thatmoneyispaidoutofincomeleftoverafterthecorporateincometaxhasbeenpaid.Theamountofthatcashpayment,or dividend ,mustalsobeincludedinthetaxableincomeoftheowners(theshareholders).Therefore,aportionofthecorporation’sincome(theportionpaidouttoowners)issubjecttodoubletaxation:onceascorporateincomeandonceastheindividualowner’sincome.Theownershipofacorporation,alsoreferredtoasstockorequity,isrepresentedassharesofstock.Acorporationthathasjustafewownerswhoexertcompletecontroloverthedecisionsofthecorporationisreferredtoasa closelyheldcorporation ora closecorporation .Acorporationwhoseownershipsharesaresoldoutsideofaclosedgroupofownersisreferredtoasa publiclyheldcorporation ora publiccorporation .MarsInc.,producerofM&Mcandiesandotherconfectioneryproducts,isacloselyheldcorporation;HersheyFoods,alsoaproducerofcandyproductsamongotherthings,isapubliclyheldcorporation.Thesharesofpubliccorporationsarefreelytradedinsecuritiesmar-kets,suchastheNewYorkStockExchange.Hence,theownershipofapubliclyheldcorporationismoreeasilytransferredthantheownershipofaproprietorship,apartnership,oracloselyheldcorporation.
94 FINANCIALMANAGEMENT HOWISINCOMEDOUBLETAXED? Consideracorporationwith$100millionoftaxableincome.Let’sassumeasimpletaxsystemwithafatcorporatetaxrateis35%.Thecorporationpays$35millionintaxes,andthereforehas$65millioninearningsaftertaxes.Nowsupposethatsamecorporationpaysallofitsearningstoitsshareholdersintheformofacashdividend.Let’sassumeasimpletaxsystemwithafatindividualtaxrateof30%.Therefore,thetaxtheownerspayis:Individualincometax = 0 . 3 × $65million = $19 . 5millionThetotaltaxpaidonthiscompany’sincomeis,effectively$35 + $19.5million = $54.4million.Therefore,everydollarofincomeofthecorporationistaxedattherateof = $54.5million ÷ $100million = 54.4%. CompanieswhosestockistradedinpublicmarketsarerequiredtofleaninitialregistrationstatementwiththeSecuritiesandExchangeCommission,afederalagencycreatedtooverseetheenforcementofU.S.securitieslaws.Thestatementprovidesfnancialstatements,articlesofincorporation,anddescriptiveinformationregardingthenatureofthebusiness,thedebtandstockofthecorporation,theoffcersanddirectors,andanyindividualswhoownmorethan10%ofthestock,amongotheritems. TRYIT!EFFECTIVETAXRATE Consideracompanythatgenerates$2millionintaxableincomeforayear.Ifthecorporatetaxrateis38%andtheindividualshareholders’taxrateis40%,whatistheeffectivetaxrateonthecorporation’sincomeifallofthecorporation’sincomeaftertaxisdistributedtoownersintheformofdividends? TheLimitedLiabilityCompany Apopularformofbusiness,especiallywithsmallbusinesses,isthehybridformofbusiness,the limitedliabilitycompany (LLC)or alimitedliability
BusinessFinance 95 partnership (LLP),whichcombinethebestfeaturesofapartnershipandacorporation.In1988,theInternalRevenueService(IRS)ruledthattheLLCmaybetreatedasapartnershipfortaxpurposes,whileretainingitslimitedliabilityforitsowners.Sincethisruling,everystatehaspassedlegislationpermittinglimitedliabilitycompanies.TheLLCdiffersslightlyfromtheLLP,becauseinthelatterthepartnersmaybeliableforsome,butnotall,ofthedebtsofthebusiness.However,thedistinctionissubtleandmostrulesthatapplytoanLLCapplytoanLLPaswell.Thoughstatelawsvaryslightly,ingeneral,theownersofLLCshavelimitedliability.Therefore,theLLCandLLPformsrepresentsahybrid,withthebestofbothpartnershipsandcorporations.TheownersofanLLCarereferredtoasmembers,andtheseownersmaybeindividuals,partnerships,corporations,orotherentities.ThoughtherearefewrestrictionstowhomayformanLLC,banksandinsurancecompaniesarenotpermittedtooperateasLLCs.SometypesofcompaniesthatareprohibitedfromdoingbusinessasacorporationmaybepermittedtoformanLLC.Forexample,accountingcompaniesmayoperateasanLLCoranLLP,butcannotoperateasacorporation.TheLLCisnotconsideredaformofbusinessfortaxpurposes,soacompanyformedasanLLCmustfleasacorporation,apartnership,orasoleproprietorship.Ingeneral,aLLPmustfleasapartnership.TheIRSconsiderstheLLCtobetaxedasapartnershipifthecompanyhasnomorethantwoofthefollowingcharacteristics:(1)limitedliability,(2)centralizedmanagement,(3)freetransferabilityofownershipinterests,and(4)continuityoflife.Ifthecompanyhasmorethantwoofthese,itwillbetreatedasacorporationfortaxpurposes,subjectingtheincometotaxationatboththecompanylevelandtheowners’.AdrawbackofanLLCfortaxpurposesisthatiftheLLChasanetoperatingloss,theamountofthelossthatisdeductiblefortaxpurposesislimitedbecausetheowners’liabilityislimited. OtherFormsofBusiness Inadditiontotheproprietorship,partnership,andcorporateformsofbusi-ness,anenterprisemaybeconductedusingotherformsofbusiness,suchasthemasterlimitedpartnership,theprofessionalcorporation,andthejointventure.A masterlimitedpartnership (MLP)isapartnershipwithlimitedpartnerownershipintereststhataretradedonanorganizedexchange.Forexample,morethantwodozenmasterlimitedpartnershipsarelistedontheNewYorkStockExchange,includingtheCedarFair,GlobalPartners,andSunocoLogisticsPartnerspartnerships.ManyoftheseMLPsoperateintheoiland
96 FINANCIALMANAGEMENT gasindustry.Ownershipinterests,whichrepresentaspecifedownershippercentage,aretradedinmuchthesamewayasthesharesofstockofacorporation.Onedifference,however,isthatacorporationcanraisenewcapitalbyissuingnewownershipinterests,whereasamasterlimitedpartnershipcannotbecauseitisnotpossibletosellmorethana100%interestinthepartnership,yetitispossibletoselladditionalsharesofstockinacorporation.Anotherdifferenceisthattheincomeofamasterlimitedpartnershipistaxedonlyonce,aspartners’individualincome.Anothervariantofthecorporateformofbusinessistheprofessionalcorporation.A professionalcorporation isanorganizationthatisformedunderstatelawandtreatedasacorporationforfederaltaxlawpurposes,yetthathasunlimitedliabilityforitsowners—theownersarepersonallyliableforthedebtsofthecorporation.Businessesthatarelikelytoformsuchcorporationsarethosethatprovideservicesandrequirestatelicensing,suchasphysicians’,architects’,andattorneys’practicessinceitisgenerallyfeltthatitisinthepublicinteresttoholdsuchprofessionalsresponsiblefortheliabilitiesofthebusiness.A jointventure ,whichmaybestructuredaseitherapartnershiporasacorporation,isabusinessundertakenbyagroupofpersonsorentities(suchasapartnershiporcorporation)foraspecifcbusinessactivityand,therefore,doesnotconstituteacontinuingrelationshipamongtheparties.Fortaxandotherlegalpurposes,ajointventurepartnershipistreatedasapartnershipandajointventurecorporationistreatedasacorporation.U.S.corporationshaveenteredintojointventureswithforeigncorpo-rations,enhancingparticipationandcompetitionintheglobalmarketplace.Jointventuresarebecomingincreasinglypopularasawayofdoingbusi-ness.Participants—whetherindividuals,partnerships,orcorporations—gettogethertoexploitaspecifcbusinessopportunity.Afterward,theventurecanbedissolved.Recentalliancesamongcommunicationandentertainmentcompanieshavesparkedthoughtaboutwhatthefutureformofdoingbusi-nesswillbe.Somebelievethatwhatliesaheadisavirtualenterprise—atem-poraryalliancewithoutallthebureaucracyofthetypicalcorporation—thatcanmovequicklyanddecisivelytotakeadvantageofproftablebusinessopportunities. Prevalence ThenumberofsoleproprietorshipsintheU.S.issignifcantlylargerthanthatofpartnershipsandcorporations,asyoucanseeinExhibit5.2fortheU.S.basedon2006taxreturns.However,thenetincomeofcorporations,whichtypicallyarelargerfrmsthanpartnershipsandsoleproprietorships,comprisesthelargerportionoftaxableincomeintheU.S.
BusinessFinance 97 EXHIBIT5.2 PrevalenceofFormsofBusiness,BasedonTaxReturnsFiledin2006 Sourceofdata: StatisticsofIncome,InternalRevenueService. THEOBJECTIVEOFFINANCIALMANAGEMENT Sofarwehaveseenthatfnancialmanagersareprimarilyconcernedwithinvestmentdecisionsandfnancingdecisionswithinbusinessorganizations.Thegreatmajorityofthesedecisionsaremadewithinthecorporatebusinessstructure,whichbetteraccommodatesgrowthandisresponsibleforover67%ofU.S.businessnetincome.Onesuchissueconcernstheobjectiveoffnancialdecision-making.Whatgoal(orgoals)domanagershaveinmindwhentheychoosebetweenf-nancialalternatives—say,betweendistributingcurrentincomeamongshare-holdersandinvestingittoincreasefutureincome?Thereisactuallyonef-nancialobjective:themaximizationoftheeconomicwell-being,orwealth,oftheowners.Wheneveradecisionistobemade,managementshouldchoosethealternativethatmostincreasesthewealthoftheownersofthebusiness. AMeasureofOwners’EconomicWell-Being Thepriceofashareofstockatanytime,orits marketvalue ,representsthepricethatbuyersinafreemarketarewillingtopayforit.The marketvalueofshareholders’equity isthevalueofallowners’interestinthecorporation.Thismarketvalueisalsoreferredtoasthestock’s marketcapitalization ,orsimplyits marketcap .Itiscalculatedastheproductofthemarketvalueofoneshareofstockandthenumberofsharesofstockoutstanding:Marketvalueofshareholders’equity = Marketpricepershareofstock × Numberofsharesoutstanding
98 FINANCIALMANAGEMENT Thenumberofsharesofstockoutstandingisthetotalnumberofsharesthatareownedbyshareholders.Forexample,onDecember24,2009,therewere3.81billionWal-Martcommonsharesoutstanding.Thepricepershareattheclosingonthatdatewas$53.50.Therefore,themarketvalueofWal-Mart’scommonstockis3.81billion × $53.60 = $204.216billion.Investorsbuysharesofstockinanticipationoffuturedividendsandincreasesinthemarketvalueofthestock.Howmucharetheywillingtopaytodayforthisfuture—andhenceuncertain—streamofdividends?Theyarewillingtopayexactlywhattheybelieveitisworthtoday,anamountthatiscalledthe presentvalue ,animportantfnancialconceptthatwediscussinChapter10.Thepresentvalueofashareofstockrefectsthefollowingfactors: Theuncertaintyassociatedwithreceivingfuturepayments. Thetimingofthesefuturepayments. Compensationfortyingupfundsinthisinvestment.Themarketpriceofashareisameasureofowners’economicwell-being.Doesthismeanthatifthesharepricegoesup,managementisdoingagoodjob?Notnecessarily.Sharepricesoftencanbeinfuencedbyfactorsbeyondthecontrolofmanagement.Thesefactorsincludeexpectationsregardingtheeconomy,returnsavailableonalternativeinvestments(suchasbonds),andevenhowinvestorsviewthecompanyandtheideaofinvesting.Thesefactorsinfuencethepriceofsharesthroughtheireffectsonex-pectationsregardingfuturecashfowsandinvestors’evaluationofthosecashfows.Nonetheless,managerscanstillmaximizethevalueofowners’equity,givencurrenteconomicconditionsandexpectations.Theydosobycarefullyconsideringtheexpectedbenefts,risk,andtimingofthereturnsonproposedinvestments. TRYIT!MARKETCAPITALIZATION Thefollowingdataisavailableforacompanyataspecifcpointintime:Averagedailyvolumeofsharestraded11.5millionBookvaluepershare$18.27Marketpricepershare$64.70Numberofsharesoutstanding2.76billionWhatisthemarketcapitalizationofthiscompany?
BusinessFinance 99 FinancialManagementandtheMaximizationofOwners’Wealth Finan-cialmanagersarechargedwiththeresponsibilityofmakingdecisionsthatmaximizeowners’wealth.Foracorporation,thatresponsibilitytranslatesintomaximizingthevalueofshareholders’equity.Ifthemarketforstocksiseffcient,thevalueofashareofstockinacorporationshouldrefectinvestors’expectationsregardingthefutureprospectsofthecorporation.Thevalueofastockwillchangeasinvestors’expectationsaboutthefuturechange.Forfnancialmanagers’decisionstoaddvalue,thepresentvalueofthebeneftsresultingfromdecisionsmustoutweightheassociatedcosts,wherecostsincludethecostsofcapital.Ifthereisaseparationoftheownershipandmanagementofacompany—thatis,theownersarenotalsothemanagersofthecompany—thereareadditionalissuestoconfront.Whatifadecisionisinthebestin-terestsofthecompany,butnotinthebestinterestofthemanager?Howcanownersensurethatmanagersarewatchingoutfortheowners’interests?Howcanownersmotivatemanagerstomakedecisionsthatarebestfortheowners?Weaddresstheseissuesandmoreinthenextsection. TheAgencyRelationship Ifyouarethesoleownerofabusiness,youmakethedecisionsthataffectyourownwell-being.Butwhatifyouareafnancialmanagerofabusinessandyouarenotthesoleowner?Inthiscase,youaremakingdecisionsforownersotherthanyourself;you,thefnancialmanager,areanagent.An agent isapersonwhoactsfor—andexertspowersof—anotherpersonorgroupofpersons.Theperson(orgroupofpersons)theagentrepresentsisreferredtoasthe principal .Therelationshipbetweentheagentandhisorherprincipalisanagencyrelationship.Thereisan agencyrelationship betweenthemanagersandtheshareholdersofcorporations. 1 ProblemswiththeAgencyRelationship Inanagencyrelationship,theagentischargedwiththeresponsibilityofactingfortheprincipal.Isitpossibletheagentmaynotactinthebestinterestoftheprincipal,butinsteadactinhisorherownself-interest?Yes—becausetheagenthashisorherownobjectiveofmaximizingpersonalwealth.Inalargecorporation,forexample,themanagersmayenjoymanyfringebenefts,suchasgolfclubmemberships,accesstoprivatejets,andcompany 1 TheagencyrelationshipwasfrstdescribedinMichaelC.JensenandWilliamH.Meckling,“TheoryoftheFirm:ManagerialBehavior,AgencyCosts,andOwnershipStructure,” JournalofFinancialEconomics 3(1976):305–360.
100 FINANCIALMANAGEMENT cars.Thesebenefts(alsocalled perquisites or perks )maybeusefulincon-ductingbusinessandmayhelpattractorretainmanagementpersonnel,butthereisroomforabuse.Whatifthemanagersstartspendingmoretimeatthegolfcoursethanattheirdesks?Whatiftheyusethecompanyjetsforpersonaltravel?Whatiftheybuycompanycarsfortheirteenagerstodrive?Theabuseofperquisitesimposescostsonthecompany—andultimatelyontheownersofthecompany.Thereisalsoapossibilitythatmanagerswhofeelsecureintheirpositionsmaynotbothertoexpendtheirbesteffortstowardthebusiness.Thisisreferredtoas shirking ,andittooimposesacosttothecompany.Finally,thereisthepossibilitythatmanagerswillactintheirownself-interest,ratherthanintheinterestoftheshareholderswhenthoseinterestsclash.Forexample,managementmayfghttheacquisitionoftheircom-panybysomeothercompany,eveniftheacquisitionwouldbeneftshare-holders.Why?Inmosttakeovers,themanagementpersonneloftheacquiredcompanygenerallylosetheirjobs.Envisionthatsomecompanyismakinganoffertoacquirethecompanythatyoumanage.Areyouhappythattheacquiringcompanyisofferingtheshareholdersofyourcompanymorefortheirstockthanitscurrentmarketvalue?Ifyouarelookingoutfortheirbestinterests,youshouldbe.Areyouhappyaboutthelikelyprospectoflosingyourjob?Mostlikelynot.Defensivenessbycorporatemanagersinthecaseoftakeovers,whetherwarrantedornot,emphasizesthepotentialforconfictbetweentheinter-estsoftheownersandtheinterestsofmanagement. 2 Defendingagainstatakeoverthatwouldnotproduceabeneftfortheshareholdersisconsistentwithmanagement’sobligations.However,defendingagainstatakeoverthatwouldproduceabeneftforshareholders,butalsoadetrimenttomanage-ment(e.g.,lostjobs),wouldbecontrarytomanagement’sdutytoshare-holders. CostsoftheAgencyRelationship Therearecostsinvolvedwithanyefforttominimizethepotentialforconfictbetweentheprincipal’sinterestandtheagent’sinterest.Suchcostsarecalled agencycosts ,andtheyareofthreetypes:monitoringcosts,bondingcosts,andresidualloss. Monitoringcosts arecostsincurredbytheprincipaltomonitororlimittheactionsoftheagent.Inacorporation,shareholdersmayrequire 2 Therewasabusebysomecompaniesduringthemergermaniaofthe1980s.Somefoughtacquisitionoftheircompanies—whichtheylabeled hostiletakeovers —byproposingchangesinthecorporatecharterorevenlobbyingforchangesinstatelawstodiscouragetakeovers.Someadoptedlucrativeexecutivecompensationpackages—called goldenparachutes —thatweretogointoeffectiftheylosttheirjobs.
BusinessFinance 101 managerstoperiodicallyreportontheiractivitiesviaauditedaccountingstatements,whicharesenttoshareholders.Thefeesforauditingandprepar-ingthefnancialstatementsandthemanagementtimelostinpreparingsuchstatementsaremonitoringcosts.Anotherexampleistheimplicitcostin-curredwhenshareholderslimitthedecision-makingpowerofmanagers.Bydoingso,theownersmaymissproftableinvestmentopportunities;theforegoneproftisamonitoringcost.Theboardofdirectorsofacorporationhasa fduciaryduty toshare-holders;thatisthelegalresponsibilitytomakedecisions(ortoseethatdecisionsaremade)thatareinthebestinterestsofshareholders.Partofthatresponsibilityistoensurethatmanagerialdecisionsarealsointhebestinterestsoftheshareholders.Therefore,atleastpartofthecostofhavingdirectorsisamonitoringcost. Bondingcosts areincurredbyagentstoassureprincipalsthattheywillactintheprincipal’sbestinterest.Thenamecomesfromtheagent’spromiseorbondtotakecertainactions.Amanagermayenterintoacontractthatrequireshimorhertostayonwiththecompanyeventhoughanothercompanyacquiresit;animplicitcostisthenincurredbythemanager,whoforegoesotheremploymentopportunities.Evenwhenmonitoringandbondingdevicesareused,theremaybesomedivergencebetweentheinterestsofprincipalsandthoseofagents.Theresultingcost,calledthe residualloss ,istheimplicitcostthatresultsbecausetheprincipal’sandtheagent’sinterestscannotbeperfectlyalignedevenwhenmonitoringandbondingcostsareincurred. MotivatingManagers:ExecutiveCompensation Onewaytoencouragemanagementtoactinshareholders’bestinter-ests,andsominimizeagencyproblemsandcosts,isthroughexecutivecompensation—howtopmanagementispaid.Thereareseveraldifferentwaystocompensateexecutives,including: Salary .Thedirectpaymentofcashofafxedamountperperiod. Bonus .Acashrewardbasedonsomeperformancemeasure,say,earn-ingsofadivisionorthecompany. Stockappreciationright .Acashpaymentbasedontheamountbywhichthevalueofaspecifednumberofshareshasincreasedoveraspecifedperiodoftime(supposedlyduetotheeffortsofmanagement). Performanceshares .Sharesofstockgiventheemployees,inanamountbasedonsomemeasureofoperatingperformance,suchasearningspershare. Stockoption .Therighttobuyaspecifednumberofsharesofstockinthecompanyatastatedprice—referredtoasanexercisepriceatsome
102 FINANCIALMANAGEMENT timeinthefuture.Theexercisepricemaybeabove,at,orbelowthecurrentmarketpriceofthestock. Restrictedstockgrant .Thegrantofsharesofstocktotheemployeeatlowornocost,conditionalonthesharesnotbeingsoldforaspecifedtime.Thesalaryportionofthecompensation—theminimumcashpaymentanexecutivereceives—mustbeenoughtoattracttalentedexecutives.Butabonusshouldbebasedonsomemeasureofperformancethatisinthebestinterestsofshareholders—notjustonthepastyear’saccountingearnings.Forexample,abonuscouldbebasedongainsinmarketshare.Thebasicideabehindstockoptionsandrestrictedstockgrantsistomakemanagersowners,sincetheincentivetoconsumeexcessiveperksandtoshirkarereducedifmanagersarealsoowners.Asowners,managersnotonlysharethecostsofperksandshirks,buttheyalsobeneftfnanciallywhentheirdecisionsmaximizethewealthofowners.Hence,thekeytomotivationthroughstockisnotreallythe value ofthestock,butrather ownership ofthestock.Forthisreason,stockappreciationrightsandperformanceshares,whichdonotinvolveaninvestmentonthepartoftherecipients,arenoteffectivemotivators.Stockoptionsdoworktomotivateperformanceiftheyrequireowningthesharesoveralongtimeperiod;areexercisableatapricesignifcantly above thecurrentmarketpriceoftheshares,thusencouragingmanagerstogetthesharepriceup,andrequiremanagerstotieuptheirownwealthintheshares.Unfortunately,executivestockoptionprogramshavenotalwaysbeendesignedinwaystosuffcientlymotivateexecutives.Publicly-tradedcompaniesmustdisclosethecompensationinatable,aswellasprovideadiscussionofkeyelementsinthe“CompensationDiscus-sionandAnalysis”portionoftheirSEC10-Kflingandproxystatements. 3 Thetableprovidestheinvestorwithinformationonthecompensationthatisbothcash-basedandstock-based,withdetailsontheoptionsgrantedandexercisedbythetoppaidemployees.Thistableenablesthecomparisonyear-to-yearofeachoftheelementsofamanager’scompensation.Currently,thereisagreatdealofconcerninsomecorporationsbecauseexecutivecompensationisnotlinkedtoperformance.Inrecentyears,manyU.S.companieshavedownsized,restructured,andlaidoffmanyemployeesandallowedthewagesofemployeeswhosurvivethecutstostagnate.Atthesametime,corporationshaveincreasedthepayoftopexecutivesthroughbothsalaryandlucrativestockoptions.Ifthesechangesleadtobettervalue 3 Rule33-8732,August11,2006.
BusinessFinance 103 forshareholders,shouldn’tthetopexecutivesberewarded?Therearetwoissueshere.First,suchasituationresultsinangeranddisenchantmentamongbothsurvivingemployeesandformeremployees.Second,thedownsizing,restructuring,andlay-offsmaynotresultinimmediate(oreven,eventual)increasedproftability.Ownershaveonemoretoolwithwhichtomotivatemanagement—thethreatoffring.Aslongasownerscanfremanagers,managerswillbeencouragedtoactintheowners’interest.However,iftheownersaredividedorapathetic—astheymightbeinlargecorporations—oriftheyfailtomonitormanagement’sperformanceandthereactionofdirectorstothatperformance,thethreatmaynotbecredible.Theremovalofafewpoormanagerscan,however,makethisthreatpalpable. ShareholderWealthMaximizationandAccounting“Irregularities” Therehavebeenanumberofscandalsandallegationsregardingthefnancialinformationthatisbeingreportedtoshareholdersandthemarket.Finan-cialresultsreportedintheincomestatementsandbalancesheetsofsomecompaniesindicatedmuchbetterperformancethanthetrueperformanceormuchbetterfnancialconditionthanactual.ExamplesincludeXerox,whichwasforcedtorestateearningsforseveralyearsbecauseithadinfatedpretaxproftsby$1.4billion,Enron,whichwasaccusedofinfatingearningsandhidingsubstantialdebt,andWorldcom,whichfailedtoproperlyaccountfor$3.8billionofexpenses.However,somecompanieshavealsoencounteredproblemswhenman-agersunderstateearnings.Forexample,ifacompany’searningsarenotsuffcienttomeetbonustargets,byunderstatingincomeinoneperiod—forexample,movingexpensesforwardintimeordelayingrecognitionofrevenues—thereisabetterpossibilitythatthecompanywillmeetthebonustargetsinthefollowingyear.Alongwiththesefnancialreportingissues,theindependenceoftheau-ditorsandtheroleoffnancialanalystshavebeenbroughttotheforefront.Forexample,thenow-defunctpublicaccountingcompanyofArthurAn-dersenwasfoundguiltyofobstructionofjusticein2002fortheirroleintheshreddingofdocumentsrelatingtoEnron.Asanexampleoftheprob-lemsassociatedwithfnancialanalysts,thesecuritiescompanyofMerrillLynchpaida$100millionfnefortheirroleinhypingstockstohelpwininvestment-bankingbusiness. 4 Itisunclearatthistimetheextenttowhichthesescandalsandproblemsweretheresultofsimplybaddecisionsorduetocorruption.Theeagerness 4 MerrillLynchisnowapartofBankofAmerica.
104 FINANCIALMANAGEMENT ofmanagerstopresentfavorableresultstoshareholdersandthemarketappearstobeafactorinseveralinstances.Andpersonalenrichmentattheexpenseofshareholdersseemstoexplainsomecases.Whateverthemoti-vation,chiefexecutiveoffcers(CEOs),chieffnancialoffcers(CFOs),andboardmembersarebeinghelddirectlyaccountableforfnancialdisclosures.TheSarbanes-OxleyAct,passedin2002,addressestheseandotherissuespertainingtodisclosuresandgovernanceinpubliccorporations.ThisActaddressesauditsbyindependentpublicaccountants,fnancialreportinganddisclosures,confictsofinterest,andcorporategovernanceatpubliccompa-nies.EachoftheprovisionsofthisActcanbetracedtooneormorescandalsthatoccurredinthefewyearsleadinguptothepassageoftheAct.Theaccountingscandalscreatedanawarenessoftheimportanceofcorporategovernance,theimportanceoftheindependenceofthepublicaccountingauditingfunction,theroleoffnancialanalysts,andtherespon-sibilitiesofCEOsandCFOs.Therecenteconomiccrisishasagainraisedtheissueofpay-for-performanceascompaniesreceivinggovernmentbailoutsarescrutinizedfortheirexecutivepaypractices.Thissuggeststhatmorereformmaybenec-essarytoinsuretransparencyoffnancialinformationandabetterlinkagebetweenpayandperformance. ShareholderWealthMaximizationandSocialResponsibility Whenfnan-cialmanagersassessapotentialinvestmentinanewproduct,theyexaminetherisksandthepotentialbeneftsandcosts.Iftherisk-adjustedbeneftsdonotoutweighthecosts,theywillnotinvest.Similarly,managersassesscurrentinvestmentsforthesamepurpose;ifbeneftsdonotcontinuetooutweighcosts,theywillnotcontinuetoinvestintheproductbutwillshifttheirinvestmentelsewhere.Thisisconsistentwiththegoalofshare-holderwealthmaximizationandwiththeeffcientallocationofresourcesintheeconomy.Discontinuinginvestmentinanunproftablebusiness,however,maymeaneffectsonotherstakeholdersofthecompany:closingdownplants,layingoffworkers,affectingsuppliers’businesses,and,perhapsdestroyinganentiretownthatdependsonthebusinessforincome.Sodecisionstoinvestordisinvestmayaffectgreatnumbersofpeople. THEBOTTOMLINE Therearefourprimaryformsofdoingbusiness:thesoleproprietorship,thepartnership,thecorporation,andthelimitedliabilitycompany.
BusinessFinance 105 Thechoiceoftheformofbusinessaffectsthetaxationofthecom-pany’sincome,aswellasthedegreeofcontroltheownershaveonthecompany’sdecision-making. Theobjectiveoffnancialmanagementistomaximizeowners’wealth,whichforacorporationmeansmaximizingthevalueoftheequity. Whenthemanagementofthecompanyisseparatedfromtheownershipofthecompany,asinthecaseoflargecorporations,therearepoten-tialproblemsandcostsassociatedwiththerelationshipbetweenthedecision-makersandtheowners.Thechallengeistodeviseamanage-mentcompensationstructurethatsuffcientlymotivatesmanagementtoactinowners’bestinterest,andwhichminimizesagencycosts. SOLUTIONSTOTRYIT!PROBLEMS EffectiveTaxRate Taxoncorporateincome = $2million × 0.38 = $0.76millionIncometoshareholders = $2million − $0.76million = $1.24millionTaxonshareholders’income = $1.24 × 0.40 = $0.496millionEffectivetaxrate = ($0.76million + $0.496million) ÷ $2million = 62.8% MarketCapitalization Marketcap = 2.76billionshares × $64.70pershare = $178.572billion QUESTIONS 1. Whatdistinguishesapartnershipfromacorporation? 2. Whatislimitedliability? 3. Howdoesincomegettaxedtwiceinthecaseofacorporation? 4. Whichformsofbusinesshaveaperpetuallife? 5. Whatareagencycosts? 6. Whatistheobjectiveofthefnancialmanagementofacompany? 7. Listthreetypesofcompensationforacompany’smanagement. 8. Howareoptionsintendedtoaligntheinterestsofmanagersandownersofacorporation? 9. Ifamanagersignsacontractwithastrictprovisionprohibitingthemanagerfromcompetingagainstthiscompanyifthemanagerleavesthecompany,whattypeofagencycostisthisprovision? 10. Whatincentivedoesamanagerhavetounderstateearnings?
106 FINANCIALMANAGEMENT 11. Whatismeantbyacompany’smarketcapitalization? 12. TheU.S.taxcodeallowsthecreationofataxableentityknownasanScorporation.AccordingtotheInternalRevenueService(www.irs.gov/businesses/small/article/0,,id=98263,00.html): Scorporationsarecorporationsthatelecttopasscorporatein-come,losses,deductionsandcreditthroughtotheirsharehold-ersforfederaltaxpurposes.ShareholdersofScorporationsreportthefow-throughofincomeandlossesontheirpersonaltaxreturnsandareassessedtaxattheirindividualincometaxrates.ThisallowsScorporationstoavoiddoubletaxationonthecorporateincome.Scorporationsareresponsiblefortaxoncertainbuilt-ingainsandpassiveincome.CorporationsthatdonotelecttobetreatedasScorpora-tionsarecalledCcorporations. a. HowdoesincomegettaxedtwiceinthecaseofaCcorporation? b. TheshareholdersofanScorporationarestillentitledtolimitedliabilityinthecaseofbankruptcyofthecorporation.WhataretheadvantagesofbeinganScorporationifanentitycanqualifytodoso? 13. Thefollowingstatementappearsin“AgencyCostsandUnregulatedBanks:CouldDepositorsProtectThemselves?”byCatherineEngland( CatoJournal 7,no,3[Winter1988]): Theagencycostsliteraturearguesthatbothagentsandprinci-palsareawareofthepotentialconfictsofinterestandabusesthatcanariseinanagencyrelationship.Butneithergroupisex-pectedtopassivelyacceptthelimitationsimposedbythepoten-tialproblemsandineffciencies.Therecognitionofagencycostscreatesincentivesforbothgroupstotakestepstominimizeandcontroltheproblem.Toprotecttheirinterests,principalshavereasontodevelopandincorporatecontractualtermsdesignedtochannelthebehaviorofagentsindesirabledirectionsand/ortolimittheirabilitytoengageinunacceptableactivities.Inaddition,principalssettingavalueonagents’serviceswillcon-siderthecostsassociatedwiththeprincipal/agentrelationshipandreduceaccordinglythecompensationthatwouldbepaidtoagentsinaworldofperfectinformation.Facedwiththepos-sibilityofreducedcompensation,agentswillnotonlyagreeto
BusinessFinance 107 contractualtermsthatreassureprincipals,butwillalsodevelopmechanismsthattendtomakeprincipalsmoreconfdent. a. Whatareagencycosts? b. Whatcanprincipalsdotoreduceagencycosts? 14. Thefollowingtwostatementswerepostedonawebsite(www.interfuidity.com)inadiscussionofagencycostsandleveragedinvestmentfunds.Leveragedinvestmentfundsarefundssuchasahedgefundsthatborrowaconsiderableamountofmoneytoinvestmentinsecurities. Limitedliabilitycreatesapotentialconfictofinterestbetweeninvestmentfundsandtheircreditors.Ifafundisheavilylever-aged,fundinvestorscanreaplargerewardsbyassumingriskypositionswiththeunderstandingthatifthosepositionsgosour,alargefractionofthecostcanbeshifted(viaactualorthreat-enedbankruptcy)tothefund’screditors. a. Whatismeantby“limitedliability”? b. Explainwhetheryouagreeordisagreewiththeexcerpt. Likeanyothersortofinvestmentmanager,theinterestsofthosewhomanagefundsforpensions,universityendowments,andcharitablefoundationsmaydivergefromtheinterestsoftheirdiverseclientele.Inparticular,rational,self-interestedman-agersmaydeterminethatpursuingpeer-competitiveshort-termgainsiswiserthancarefullymanagingthelong-termrisksoffundstakeholders. c. Whatdoeconomistscallthetypesofcostsassociatedwiththeactionsdescribedinthisexcerpt? d. Whatismeantby“stakeholders”?
CHAPTER 6 FinancialStrategyandFinancialPlanning Thoughwearedelightedwithwhatweown,wearenotpleasedwithourprospectsforcommittingincomingfunds.Pricesarehighforbothbusinessesandstocks.Thatdoesnotmeanthatthepricesofeitherwillfall—wehaveabsolutelynoviewonthatmatter—butitdoesmeanthatwegetrelativelylittleinprospectiveearningswhenwecommitfreshmoney.Underthesecircumstances,wetrytoexertaTedWilliamskindofdiscipline.Inhisbook TheScienceofHitting, Tedexplainsthathecarvedthestrikezoneinto77cells,eachthesizeofabaseball.Swingingonlyatballsinhis“best”cell,heknew,wouldallowhimtobat.400;reachingforballsinhis“worst”spot,thelowoutsidecornerofthestrikezone,wouldreducehimto.230.Inotherwords,waitingforthefatpitchwouldmeanatriptotheHallofFame;swingingindiscriminatelywouldmeanatickettotheminors.Iftheyareinthestrikezoneatall,thebusiness“pitches”wenowseearejustcatchingtheloweroutsidecorner.Ifweswing,wewillbelockedintolowreturns.Butifweletalloftoday’sballsgoby,therecanbenoassurancethatthenextonesweseewillbemoretoourliking.Perhapstheattractivepricesofthepastweretheaberrations,notthefullpricesoftoday.UnlikeTed,wecan’tbecalledoutifweresistthreepitchesthatarebarelyinthestrikezone;nevertheless,juststandingthere,dayafterday,withmybatonmyshoulderisnotmyideaoffun. —WarrenBuffett,LettertoShareholdersofBerkshireHathaway,1997 109
110 FINANCIALMANAGEMENT A company’s strategicplan isamethodofachievingthegoalofmaximizingshareholderwealth.Thisstrategicplanrequiresbothlong-andshort-termfnancialplanningthatbringstogetherforecastsofthecompany’ssaleswithfnancingandinvestmentdecisionmaking.Budgets,suchasthecashbudgetandtheproductionbudget,areusedtomanagetheinformationusedinthisplanning,whereasperformancemeasures,suchasthebalancedscorecardandeconomicvalueadded,areusedtoevaluateprogresstowardthestrategicgoals.A strategy isadirectionthecompanyintendstotaketoreachanob-jective.Oncethecompanyhasitsstrategy,itneedsaplan,inparticularthestrategicplan,whichisthesetofactionsthecompanyintendstousetofollowitsstrategy.Theinvestmentopportunitiesthatenablethecompanytofollowitsstrategycomprisethecompany’s investmentstrategy. Thechieffnancialoffcer(CFO),underthesupervisionoftheboardofdirectors,looksatthecompany’sinvestmentdecisionsandconsidershowtofnancethem. Budgeting ismappingoutthesourcesandusesoffundsforfutureperiods.Budgetingrequiresbotheconomicanalysis(includingforecasting)andaccountinginformation.Economicanalysisincludesbothmarketingandproductionanalysistodevelopforecastsoffuturesalesandcosts.Accountingtechniquesareusedasameasurementdevice:Butinsteadofusingaccountingtosummarizewhathashappened,companiesuseac-countingtorepresentwhatthemanagementexpectstohappeninthefuture.Therefore,budgetinginvolveslookingforwardintothefuture.Wesumma-rizethisprocessinExhibit6.1.Oncetheseplansareputintoeffect,themanagementmustcomparewhathappenswithwhatwasplanned.Companiesusethispostaudit-ingto: Evaluatetheperformanceofmanagement. Analyzeanydeviationsofactualresultsfromplannedresults. Evaluatetheplanningprocesstodeterminejusthowgooditis.Thepurposeofthischapteristoexplainstrategicplanningandhowfnancialplanningandbudgetingareusedinthisprocess. STRATEGYANDVALUE The strategicplan isthepaththatthecompanyintendstofollowtoachieveitsobjective,whichistoputitsassetstotheirbestuse,addingvalue.Inthisstrategicplanisamethodtomakeinvestmentsthatwilladdvaluetothecompany.Thewaytoaddvalueistoinvestinproftableprojects.But
FinancialStrategyandFinancialPlanning 111 Define theobjectiveDevelop astrategy and astrategic planDevelopbudgetsDevelop thefinancingstrategyEvaluateperformanceDevelop theinvestmentstrategy EXHIBIT6.1 StrategyandBudgeting wheredotheseopportunitiescomefrom?Theycomefromthecompany’scomparativeadvantageoritscompetitiveadvantages. ComparativeandCompetitiveAdvantages A comparativeadvantage istheadvantageonecompanyhasoverothersintermsofthecostofproducingordistributinggoodsorservices.Forexam-ple,Wal-MartStores,Inc.hadforyearsacomparativeadvantageoveritscompetitors(suchasKmart)throughitsvastnetworkofwarehousesanditsdistributionsystem.Wal-Martinvestedinasystemofregionalwarehousesanditsowntruckingsystem.Combinedwithbulkpurchasesandauniquecustomerapproach,Wal-Mart’scomparativeadvantagesinitswarehousinganddistributionsystemshelpeditgrowtobeamajor(andveryproftable)retailerinaveryshortspanoftime.However,aswithmostcomparativead-vantages,ittookafewyearsforcompetitorstocatchupandforWal-Mart’sadvantagestodisappear.A competitiveadvantage istheadvantageonecompanyhasoveranotherbecauseofthestructureofthemarkets,inputandoutputmarkets,inwhichtheybothoperate.Forexample,onecompanymayhaveacompetitivead-vantageduetobarrierstoothercompaniesenteringthesamemarket.This
112 FINANCIALMANAGEMENT happensinthecaseofgovernmentalregulationsthatlimitthenumberofcompaniesinamarket,aswithbanks,orinthecaseofgovernment-grantedmonopolies.Acompanyitselfmaycreatebarrierstoentry(althoughwiththehelpofthegovernment)thatincludepatentsandtrademarks.NutraSweetCom-pany,aunitofMonsantoCompany,hadtheexclusivepatentontheartifcialsweetener,aspartame,whichitmarketedunderthebrandnameNutraSweet.However,thispatentexpiredDecember14,1992.Thelossofthemonopolyontheartifcialsweetenerreducedthepriceofaspartamefrom$70perpoundto$20to$35perpound,sinceothercompaniescouldproduceandsellaspartameproductsstartingDecember15,1992.NutraSweethadacompetitiveadvantageaslongasithadthepatent.Butassoonasthepatentexpired,thiscompetitiveadvantagewaslostandcompetitorswerelininguptoenterthemarket. 1 Estimatesofthevalueofpatentsvarybycountryandindustry,butstudieshaveshownthatuptoonequarterofthereturnfromresearchanddevelopmentisattributedtopatents.Thebottomlineisthatacompanyinvestsinsomethingandgetsmorebackinreturnonlybyhavingsometypeofadvantage.Inotherwords,acomparativeorcompetitiveadvantageallowsthecompanytogenerateeconomicprofts—thatis,proftsinexcessofitscostofcapital.Sofrstamanagementhastofgureoutwherethecompanyhasacomparativeorcompetitiveadvantagebeforethecompany’sstrategycanbedetermined. StrategyandAddingValue Oftencompaniesconceptualizeastrategyintermsoftheconsumersofthecompany’sgoodsandservices.Forexample,managementmayhaveastrat-egytobecometheworld’sleadingproducerofmicrocomputerchipsbyproducingthebestqualitychiporbyproducingchipsatthelowestcost,developingacost(andprice)advantageoveritscompetitors.Somanage-ment’sfocusisonproductqualityandcost.Isthisstrategyinconfictwithmaximizingowners’wealth?No.Managementmustfocusonthereturnsandrisksoffuturecashfowstostockholdersinordertoaddvalue.Andmanagementlooksataproject’sproftabilitywhenmakingdecisionsregardingwhethertoinvestinit.Astrategyofgainingacompetitiveorcomparativeadvantageisconsistentwithmaximizingshareholderwealth.Thisisbecauseproftableprojectsarisewhenthecompanyhasacompetitiveorcomparativeadvantageoverothercompanies. 1 Monsantosolditssweetenerdivisionin2000.
FinancialStrategyandFinancialPlanning 113 Supposeanewpieceofequipmentisexpectedtogenerateareturngreaterthanwhatisexpectedfortheproject’srisk(thatis,greaterthanitscostofcapital).Buthowcanacompanycreatevaluesimplybyinvestinginapieceofequipment?Howcanitmaintainacompetitiveadvantage?Ifinvestinginthisequipmentcancreatevalue,wouldn’tthecompany’scompetitorsalsowantthisequipment?Ofcourse—iftheycoulduseittocreatevalue,theywouldsurelybeinterestedinit.Nowsupposethatthecompany’scompetitorsfacenobarrierstobuyingtheequipmentandexploitingitsbenefts.Whatwillhappen?Thecompanyanditscompetitorswillcompetefortheequipment,biddingupitsprice.Whendoesitallend?Itendswhenthedifferencebetweenthepresentvalueoftheinfowsandthepresentvalueoftheoutfowsfortheequipmentiszero. 2 Supposeinsteadthatthecompanyhasapatentonthenewpieceofequipmentandcanthuskeepitscompetitorsfromexploitingtheequipment’sbenefts.Thentherewouldbenocompetitionfortheequipmentandthecompanywouldbeabletoexploitittoaddvalue. Ouracquisitiondecisionswillbeaimedatmaximizingrealeco-nomicbenefts,notatmaximizingeithermanagerialdomainorreportednumbersforaccountingpurposes.(Inthelongrun,man-agementsstressingaccountingappearanceovereconomicsubstanceusuallyachievelittleofeither.)—WarrenBuffett,LettertoShareholdersofBerkshireHathaway,1981 Consideranexamplewheretryingtogainacomparativeadvantagewentwrong.SchlitzBrewingCompanyattemptedtoreduceitscoststogainanadvantageoveritscompetitors:Itreduceditslaborcostsandshortenedthebrewingcycle.Reducingcostsallowedittoreduceitspricesbelowcompetitors’prices.Butproductqualitysuffered—somuchthatSchlitzlostmarketshare,insteadofgainingit.SchlitzBrewingattemptedtogainacomparativeadvantage,butwasnottruetoalargerstrategytosatisfyitscustomers—whoapparentlywantedqualitybeermorethantheywantedcheapbeer.AndthelossofmarketsharewasrefectedinSchlitz’sdecliningstockprice. 3 2 AsyouwillseelaterinChapter13,thisiswhenthenetpresentvalueisequaltozero. 3 ThecaseofSchlitzBrewingisdetailedinGeorgeS.DayandLiamFahey,“PuttingStrategyintoShareholderValueAnalysis,” HarvardBusinessReview 68(March–April1990):156–162.
114 FINANCIALMANAGEMENT Valuecanbecreatedonlywhenthecompanyhasacompetitiveorcomparativeadvantage.Ifacompanyanalyzesaprojectanddeterminesthatitisproftable,thefrstquestionshouldbe:Wheredidtheseproftscomefrom? FinancialPlanningandBudgeting Astrategyisthedirectionacompanytakestomeetitsobjective,whereasastrategicplanishowacompanyintendstogointhatdirection.Forman-agement,astrategicinvestmentplanincludespoliciestoseekoutpossibleinvestments.Astrategicplanalsoincludesresourceallocation.Ifacompanyintendstoexpand,wheredoesitgetthecapitaltodoso?Ifacompanyre-quiresmorecapital,thetiming,amount,andtypeofcapital(whetherequityordebt)compriseelementsofacompany’sfnancialstrategicplan.Thesethingsmustbeplannedtoimplementthestrategy. Financialplanning allocatesacompany’sresourcestoachieveitsinvest-mentobjectives.Financialplanningisimportantforseveralreasons.First,fnancialplanninghelpsmanagersassesstheimpactofaparticularstrategyontheircompany’sfnancialposition,itscashfows,itsreportedearnings,anditsneedforexternalfnancing. Byfailingtoprepareyouarepreparingtofail.—BenjaminFranklin Second,byformulatingfnancialplans,managementisinabetterpo-sitiontoreacttoanychangesinmarketconditions,suchasslowerthanexpectedsales,orunexpectedproblems,suchasareductioninthesupplyofrawmaterials.Byconstructingafnancialplan,managementbecomesmorefamiliarwiththesensitivityofthecompany’scashfowsanditsfnancingneedstochangesinsalesorsomeotherfactor.Third,creatingafnancialplanhelpsmanagementunderstandthetrade-offsinherentinitsinvestmentandfnancingplans.Forexample,bydevelop-ingafnancialplan,managementisbetterabletounderstandthetrade-offthatexistsbetweenhavingsuffcientinventorytosatisfycustomerdemandsandtheneedtofnancetheinvestmentininventory.Financialplanningconsistsofthecompany’sinvestmentandfnancingplans.Onceweknowthecompany’sinvestmentplan,managementneedstofgureoutwhenfundsareneededandwheretheywillcomefrom.Thisisaccomplishedbydevelopinga budget ,whichisbasicallythecompany’sinvestmentandfnancingplansexpressedinmonetaryterms.Abudgetcanrepresentdetailssuchaswhattodowithcashinexcessofneedsonadaily
FinancialStrategyandFinancialPlanning 115 basis,oritcanrefectbroadstatementsofacompany’sbusinessstrategyoverthenextdecade.Exhibit6.2illustratesthebudgetingprocess.Budgetingfortheshortterm(lessthanayear)isusuallyreferredtoas operationalbudgeting ;budgetingforthelongterm(typicallythreetofveyearsahead)isreferredtoas long-runplanning or long-termplanning. Butsincelong-termplanningdependsonwhatisdoneintheshortterm,theoperationalbudgetingandlong-termplanningarecloselyrelated. THEBUDGETINGPROCESS Thebudgetingprocessinvolvesputtingtogetherthefnancingandinvest-mentstrategyintermsthatallowthoseresponsibleforthefnancingofthecompanytodeterminewhatinvestmentscanbemadeandhowtheseinvest-mentsshouldbefnanced.Inotherwords,budgetingpullstogetherdecisionsregardingcapitalbudgeting,capitalstructure,andworkingcapital.Consideracompanywhoselineofbusinessisoperatingretailstores.Itsstorerenovationplanispartofitsoverallstrategyofregainingitsshareoftheretailmarketbyofferingcustomersbetterqualityandservice.Fixingupitsstoresisseenasaninvestmentstrategy.Thecompanyevaluatesitsrenovationplanusingcapitalbudgetingtechniques(e.g.,netpresentvalue).Buttherenovationprogramrequiresfnancing—thisiswherethecapitalstructuredecisioncomesin.Ifitneedsmorefunds,wheredotheycomefrom?Debt?Equity?Both?Andlet’snotforgettheworkingcapitaldecisions.Asthecompanyrenovatesitsstores,willthischangeitsneedforcashonhand?Willtherenovationaffectinventoryneeds?Ifthecompanyexpectstoincreasesalesthroughthisprogram,howwillthisaffectitsinvestmentinaccountsreceivable?Andwhataboutshort-termfnancing?Willitneedmoreorlessshort-termfnancingwhenitrenovates? It’sclearlyabudget.It’sgotalotofnumbersinit.—GeorgeW.Bush Whilethecompanyisundergoingarenovationprogram,itneedstoes-timatewhatfundsitneeds,inboththeshortandthelongrun.Thisiswherecashbudgetandproformafnancialstatementsareuseful.Thestartingpointisgenerallyasalesforecast,whichisrelatedcloselytothepurchasing,production,andotherforecastsofthecompany.Whatarethecompany’sexpectedsalesintheshortterm?Inthelongterm?Also,theamountthatthecompanyexpectstosellaffectsitspurchases,salespersonnel,andadvertis-ingforecasts.PuttingtogetherforecastsrequirescooperationamongSears’smarketing,purchasing,andfnancestaff.
116 FINANCIALMANAGEMENT Oncethecompanyhasitssalesandrelatedforecasts,thenextstepisacashbudget,detailingthecashinfowsandoutfowseachperiod.Oncethecashbudgetisestablished,proformabalancesheetandincomestatementscanbeconstructed.Followingthis,thecompanymustverifythatitsbudgetisconsistentwithitsobjectiveanditsstrategies.Budgetinggenerallybeginsfourtosixmonthspriortotheendofthecurrentfscalperiod.Mostcompanieshaveasetofproceduresthatmustbefollowedincompilingthebudget.ThebudgetprocessisusuallymanagedbyeithertheCFO,avicepresidentofplanning,thedirectorofthebudget,thevicepresidentoffnance,orthecontroller.Eachdivisionordepartmentprovidesitsownbudgetsthatarethenmergedintoacompany’scentralizedbudgetbythemanagerofthebudget.Abudgetlooksforwardandbackward.Itidentifesresourcesthatthecompanywillgenerateorneedinthenearandlongterm,anditservesasameasureofthecurrentandpastperformanceofdepartments,divi-sions,orindividualmanagers.Butmanagementhastobecarefulwhenmeasuringdeviationsbetweenbudgetedandactualresultstoseparatelyidentifydeviationsthatwerecontrollablefromdeviationsthatwereun-controllable.Forexample,supposemanagementdevelopsabudgetexpect-ing$10millionsalesfromanewproduct.Ifactualsalesturnouttobe$6million,doweinterpretthisresultaspoorperformanceonthepartofmanagement?Maybe,maybenot:Ifthelower-than-expectedsalesareduetoanunexpecteddownturnintheeconomy,probablynot;butyes,iftheyareduetowhatturnsouttobeobviouslypoormanagementforecastsofconsumerdemand. SaleForecasting Salesforecastsareanimportantpartoffnancialplanning.Inaccuratefore-castscanresultinshortagesofinventory,inadequateshort-termfnancingarrangements,andsoon.Ifacompany’ssalesforecastmissesitsmark,eitherunderstatingoroverstatingsales,therearemanypotentialproblems.ConsiderNintendo,whichmisseditsmark.ThiscompanyintroducedtheWiigameconsoleinNovember2006,whichenjoyedrunawaypopularity.Infact,thisgameconsolewassopopularthatNintendocouldnotkeepupwithdemand.ItwasinsuchdemandandinventorysodepletedthatNintendowassellingthegamefasterthantheyproducedthem. 4 4 Itwasnotuntil2009thatNintendo’ssupplyofWiigameconsolescaughtuptoitsdemand.
FinancialStrategyandFinancialPlanning 117 Nintendomisseditsmark,signifcantlyunderestimatingthedemandforWii.Whilehavingapopulargameconsolemayseemlikeadreamforacompany,thisproductcreatedproblems.WithnoWiigameconsolesonstoreshelves,othermanufacturerswithgamingsystemswithsimilar(butnotidentical)features,wereabletocapturesomeofNintendo’smarket.Also,consumersmaybegrudgethecompanyforcreatingthedemandforthegamethroughadvertising,butnothavingsuffcientgameconsolestosatisfythedemand.Topredictcashfowsmanagementforecastssales,whichareuncertainbecausetheyareaffectedbyfutureeconomic,industry,andmarketcondi-tions.Nevertheless,managementcanusuallyassignmeaningfuldegreesofuncertaintytoitsforecasts.Salescanbeforecastedbyregressionanalysis,marketsurveys,oropinionsofmanagement. ForecastingwithRegressionAnalysis Regressionanalysis isastatisticalmethodthatenablesustoftastraightlinethatonaveragerepresentsthebestpossiblegraphicalrelationshipbetweensalesandtime.Thisbestftiscalledthe regressionline. Onewayregressionanalysiscanbeusedistosimplyextrapolatefuturesalesbasedonthetrendinpastsales.Anotherwayofusingregressionanalysisistolookattherelationbetweentwomeasures,say,salesandcapitalexpenditures.Whileregressionanalysisgivesuswhatmayseemtobeaprecisemeasureoftherelationshipamongvariables,thereareanumberofwarningsthatmanagementmustheedinusingit: Usinghistoricaldatatopredictthefutureassumesthatthepastrela-tionshipswillcontinueintothefuture,whichisnotalwaystrue. Theperiodoverwhichtheregressionisestimatedmaynotberepre-sentativeofthefuture.Forexample,datafromarecessionaryperiodoftimewillnottellmuchaboutaperiodthatispredictedtobeaneconomicboom. Thereliabilityoftheestimateisimportant:Ifthereisahighdegreeoferrorintheestimate,theregressionestimatesmaynotbeuseful. Thetimeperiodoverwhichtheregressionisestimatedmaybetooshorttoprovideabasisforprojectinglong-termtrends. Theforecastofonevariablemayrequireforecastsofothervariables.Forexample,themanagementmaybeconvincedthatsalesareaffectedbygrossdomesticproduct(GDP)anduseregressiontoanalyzethisrelationship.Buttouseregressiontoforecastsales,managementmustfrstforecastGDP.Inthiscase,management’sforecastofsalesisonlyasgoodastheforecastofGDP.
118 FINANCIALMANAGEMENT MarketSurveys Marketsurveysofcustomerscanprovideestimatesoffuturerevenues.InthecaseofIntel,forexample,managementwouldneedtofocusonthecomputerindustryand,specifcally,oncomputer,netbooks,phones,andgamingmarkets.Foreachofthesemarkets,managementwouldhavetoassessIntel’smarketshareandalsotheexpectedsalesforeachmarket.Managementshouldexpecttolearnfromthesemarketsurveys: ProductdevelopmentandintroductionsbyIntelanditscompetitors Thegeneraleconomicclimateandtheprojectedexpendituresoncom-putersandotherelectronicdevicesthatrequiremicroprocessorsIngeneral,managementcanusethecompany’sownmarketsurveydepartmenttosurveyitscustomers.Oritcanemployoutsidemarketsurveyspecialists. ManagementForecasts Inadditiontomarketsurveys,thecompany’smanagersmaybeabletopro-videforecastsoffuturesales.Theexperienceofacompany’smanagementandtheirfamiliaritywiththecompany’sproducts,customers,andcompeti-torsmakethemreliableforecastersoffuturesales.Thecompany’sownmanagersshouldhavetheexpertisetopredictthemarketforthegoodsandservicesandtoevaluatethecostsofproducingandmarketingthem.Buttherearepotentialproblemsinusingmanage-mentforecasts.Considerthecaseofamanagerwhoforecastsrosyout-comesforanewproduct.Theseforecastsmaypersuadethecompanytoallocatemoreresources—suchasalargercapitalbudgetandadditionalpersonnel—tothatmanager.Iftheseforecastscometrue,thecompanywillbegladtheseadditionalresourceswereallocated.Butifthesefore-caststurnedouttobetoorosy,thecompanyhasunnecessarilyallocatedtheseresources.Forecastingisanimportantelementinplanningforboththeshortandthelongterm.Butforecastsaremadebypeople.Forecasterstendtobeoptimistic,whichusuallyresultsinrosier-than-deservedforecastsoffuturesales.Inaddition,peopletendtofocusonwhatworkedinthepast,sopastsuccessescarrymoreweightindevelopingforecaststhanananalysisofthefuture.Onewaytoavoidthisistomakemanagersresponsiblefortheirforecasts,rewardingaccurateforecastsandpenalizingmanagersforbeingwayoffthemark.
FinancialStrategyandFinancialPlanning 119 BUDGETING Inbudgeting,webringtogetheranalysesofcashfows,projectedincomestatements,andprojectedbalancesheets.Thecashfowanalysesaremostimportant,thoughthefnancialmanagementstaffneedstogeneratetheincomestatementandbalancesheetaswell.Mostcompaniesextendorreceivecredit,socashfowsandnetincomedonotcoincide.Typically,thefnancestaffmustdeterminecashfowsfromaccountinginformationonrevenuesandexpenses.Forexample,combiningsalesprojectionswithestimatesofcollectionsofaccountsreceivableresultsinanestimateofcashreceipts. TheCashBudget A cashbudget isadetailedstatementofthecashinfowsandoutfowsexpectedinfutureperiods.Thisbudgethelpsmanagementidentifyfnancingandinvestmentneeds.Acashbudgetcanalsobeusedtocompareactualcashfowsagainstplannedcashfowssothatmanagementcanevaluatebothmanagement’sperformanceandmanagement’sforecastingability.Cashfowscomeintothecompanyfrom: Operations,suchasreceiptsfromsalesandcollectionsonaccountsreceivable Theresultsoffnancingdecisions,suchasborrowings,salesofsharesofcommonstock,andsalesofpreferredstock Theresultsofinvestmentdecisions,suchassalesofassetsandincomefrommarketablesecuritiesCashfowsleavethecompanyfrom: Operations,suchaspaymentsonaccountspayable,purchasesofgoods,andthepaymentoftaxes Financingobligations,suchasthepaymentofdividendsandinterest,andtherepurchaseofsharesofstockortheredemptionofbonds Investments,suchasthepurchaseofplantandequipmentAswenotedbefore,thecashbudgetisdrivenbythesalesforecast.Thecashbudget,byprovidingestimatesofcashinfowsandoutfows,providesanestimateofthecompany’sneedforfunds,requiringshort-orlong-termcapital,orexcessfunds,requiringthecompanytoinvestthefunds,paydowndebt,orreturncapitaltoowners.
120 FINANCIALMANAGEMENT ProFormaFinancialStatements A proformabalancesheet isaprojectedbalancesheetforafutureperiod—amonth,quarter,oryear—thatsummarizesassets,liabilities,andequity. 5 A proformaincomestatement istheprojectedincomestatementforafutureperiod—amonth,quarter,oryear—thatsummarizesrevenuesandexpenses.Togetherbothprojectionshelpmanagementidentifythecompany’sinvest-mentandfnancingneeds. PERFORMANCEEVALUATION Planningandforecastingareimportant,butwithoutsometypeofperfor-manceevaluation,theexecutionofastrategyandtheaccuracyofforecastingcannotbeaddressed.Therearemanyperformanceevaluationmeasuresandsystemsavailable.Wewilladdresstwoofthese,economicvalueaddedandthebalancedscorecard,toprovideexamplesofhowthesemayassistinassessingperformance. EconomicValueAdded Arisingfromtheneedforbettermethodsofevaluatingperformance,severalconsultingcompaniesadvocateperformanceevaluationmethodsthatareappliedtoevaluateacompany’sperformanceasawholeandtoevaluatespecifcmanagers’performances.Thesemethodsare,insomecases,sup-plantingtraditionalmethodsofmeasuringperformance,suchasthereturnonassetsdiscussedinotherchaptersofthisbook.Asaclass,thesemea-suresareoftenreferredtoasvalue-basedmetricsoreconomicvalue–addedmeasures.Thereisacacophonyofacronymstoaccompanythesemeasures,includingeconomicvalueadded(EVA R ),marketvalueadded(MVA),cashfowreturnoninvestment(CFROI),shareholdervalueadded(SVA),cashvalueadded(CVA),andrefnedeconomicvalueadded(REVA). 6 Acompany’smanagementcreatesvaluewhendecisionsprovidebeneftsthatexceedthecosts.Thesebeneftsmaybereceivedinthenearordistantfuture.Thecostsincludeboththedirectcostoftheinvestmentaswellasthe 5 Youshouldnotconfuseaproformafnancialstatementwithproformaearningsthatacompanymayannounce.Proformaearnings,inthelattercontext,areearningsrestatedusingprinciplesthatarenotgenerallyacceptedaccountingprinciples. 6 Forafurtherdiscussionofthesemeasures,seeFrankJ.FabozziandJamesL.Grant(eds.), ValueBasedMetrics:FoundationsandPractice (Hoboken,NJ:JohnWiley&Sons,2000).
FinancialStrategyandFinancialPlanning 121 lessobviouscost,thecostofcapital.Thecostofcapitalistheexplicitandimplicitcostsassociatedwithusinginvestors’funds.Theattentiontothecostofcapitalsetsthevalue-basedmetricsapartfromtraditionalmeasuresofperformancesuchasthereturnoninvestment.Thereareanumberofvalue-addedmeasuresavailable.Themostcom-monlyusedmeasuresareeconomicvalueaddedandmarketvalueadded. Economicvalueadded ,alsoreferredtoas economicproft ,isthedifferencebetweenoperatingproftsandthecostofcapital,wherethecostofcapitalisexpressedindollarterms.WediagramthekeyelementsofestimatingeconomicvalueaddedinExhibit6.2. WecontinuetouseEconomicValueAddedasthebasisfordisci-plineddecisionmakingaroundtheuseofcapital.EVAisatoolthatconsidersbothfnancialearningsandacostofcapitalinmeasuringperformance.WelookforopportunitiestoimproveEVAbecausewebelievethereisastrongcorrelationbetweenEVAimprovementandcreationofshareholdervalue.—TheWilliamsCompanies,2007AnnualReport Thedifferencebetweentheoperatingproftandthecostofcapitalistheestimateofthecompany’seconomicvalueadded,oreconomicproft.Thecostofcapitalistherateofreturnrequiredbythesuppliersofcapitaltothecompany.Forabusinessthatfnancesitsoperationsorinvestmentsusingbothdebtandequity,thecostofcapitalincludesnotonlytheexplicitinterestonthedebt,butalsotheimplicitminimumreturnthatownersrequire.This Step 1 • Calculate the company’s operating profit after taxes from financial statement data, making adjustments to accounting profit to better reflect operating results. • Estimate the company’s cost of capital. • Compare operating profit after taxes with cost of capital specified in dollar terms. The difference is the economic value added. Step 2Step 3 EXHIBIT6.2 CalculatingEconomicProft
122 FINANCIALMANAGEMENT minimumreturntoownersisnecessarysothatownerskeeptheirinvestmentcapitalinthecompany.Ameasurecloselyrelatedtoeconomicproftis marketvaluedadded. Marketvalueaddedisthedifferencebetweenthecompany’smarketvalueanditscapital.Essentially,marketvalueaddedisameasureofwhatthecompany’smanagementhasbeenabletodowithagivenlevelofresources(theinvestedcapital):Marketvalueaddedisthedifferencebetweenthemarketvalueofthecompany(thatis,debtandequity),lessthecapitalinvested.Likeeconomicproft,marketvalueaddedisintermsofdollarsandthegoalofthecompanyistoincreaseaddedvalue.Calculatingthemarketvalueaddedrequirescomparingthemarketvalueofacompany’scapitalwiththecapitalinvested;thedifferencebetweenthesetwoamountsisthemarketvalueadded.Theprimarydistinctionbetweeneconomicvalueaddedandmarketvalueaddedisthatthelatterincorporatesmarketdatainthecalculation. BalancedScorecard Thetraditionalmeasuresofacompany’sperformancearegenerallyhistor-ical,fnancialmeasures.Withthepopularityofeconomicvalueaddedandmarketvaluemeasures,manycompaniesbegantoadoptforward-lookingfnancialmeasures.Takingastepfurther,manycompaniesareadoptingtheconceptofabalancedscorecard.A balancedscorecard isasetofmeasuresofperformancethataddressdifferentaspectsofacompany’sstrategicplan.Abalancedscorecardisamanagementtoolusedto: Helpputacompany’sstrategicplanintoaction Usemeasurementdevicestoevaluateperformancerelativetothestrate-gicplan ProvidefeedbackmechanismstoallowforcontinuousimprovementtowardthestrategicgoalsRobertKaplanandDavidNortondevelopedtheconceptofabalancedscorecardtoaddresstheneedofcompaniestobalancetheneedsofcus-tomers,fnancialneeds,internalmanagementneeds,andtheneedsforinno-vationandlearningwithintheenterprise. 7 Theycontendthatsinglemetricsdonotadequatelyaddressthestrategicobjectivesofacompany;rather,mul-tiplemeasures—bothlaggingandleadingindicators—shouldbeusedtomeet 7 RobertS.KaplanandDavidP.Norton, TheBalancedScorecard ,(Boston:HarvardBusinessSchoolPress,1996);andRobertS.KaplanandDavidP.Norton, TheStrategy-FocusedOrganization (Boston:HarvardBusinessSchoolPress,2001).
FinancialStrategyandFinancialPlanning 123 Step 4: Providingfeedback on units’performance andcompanyperformanceStep 3: Planning,budgeting, andtarget settingStep 2:Communicating andlinking thedifferent businessunits’ measures tothe company’sstrategyStep 1:Understanding thecompany’s strategyand vision EXHIBIT6.3 TheBalancedScorecardProcess acompany’sstrategicgoals.Thesemeasures,referredtoas keyperformanceindicators ,includeshort-termandlong-termmeasures,fnancialandnon-fnancialmeasures,andhistoricalandleadingmeasures.Thebalancedscore-card,therefore,goesbeyondthetraditionalfnancialmeasuresoftherateofreturnandproftabilitytocaptureotherdimensionsofacompany’sperfor-manceandusethisinformationtohelpattainthecompany’sstrategicgoals.Thebalancedscorecardisreallyaprocessofassessingtheeffectivenessofthecompany’sstrategyinmeetingthecompany’sobjective,identifyingmeasurestoevaluatewhetherthecompanyismeetingitsshort-termandlong-termgoals,settingtargets,andthenprovidingfeedbackfromthesemeasures.WeillustratethisprocessinExhibit6.3.Theactualbalancedscorecarddoesnotprescribethemeasurestouse,butratherspecifesthedimensionsofthecompanythatshouldbeconsideredinthesystem.Thedevelopersofthebalancedscorecardarguethatmeasuresandmet-ricsusedtoevaluatedifferentbusinessunitsandthecompanyshouldrepre-sentdifferentdimensionsofperformance,includingfnancialperformance,customerrelations,internalbusinessprocesses,andorganizationallearningandgrowth.WeillustratethesedimensionsinExhibit6.4.However,nospecifcmeasuresareprescribed;rather,thechoiceofmeasuresshouldbetailoredtothecompany’sindividualsituation.Thebasicidea,however,istoselectthekeyperformanceindicatorsthatcapturethefourdimensions.
124 FINANCIALMANAGEMENT FinancialperformanceInternalbusinessprocessesOrganizationallearning andgrowthCustomerrelations Return on investmentNet profit marginEconomic value addedMarket value addedGrowth rate of revenuesCustomer profitabilityNumber of customer complaintsCustomer surveysRepeat customersOn-time deliveryCustomer profitabilityRepeat customersCustomer surveysNumber of customer complaintsOn-time deliveryEmployee motivationEmployee empowermentEmployee capabilitiesHours spent on training employees EXHIBIT6.4 PossiblePerformanceIndicatorsinFourDimensionsofStrategy Withineachofthesedimensions,theremaybeanynumberofdifferentmeasures.Thesemeasuresaregenerallytailoredtothespecifcbusinessandshouldbeconsistentwiththecompany’sorunit’sgoals.WeprovideanumberofpossiblemetricswithineachofthesedimensionsinExhibit6.4. STRATEGYANDVALUECREATION Thecompany’schieffnancialoffcerisinagoodpositiontolinkthecorpo-ratestrategywithvaluecreation.MostsurveysindicatethatCFOsfeelthattheirfocusisshiftingfromhistoricalassessmentofperformancetoforward-lookingtaskssuchasthedevelopmentofstrategyanddecisionmaking.Forexample,aMarch2006reportpreparedbyCFOResearchServicesincollaborationwithDeloitteConsultingfoundthatCFOsnotonlypar-ticipateinthedevelopmentofacompany’sstrategy,butinmanycasesthe
FinancialStrategyandFinancialPlanning 125 CFOisalsochargedwithexecutingthestrategyandmeasuringthecom-pany’sprogresstowardthestrategicgoals. 8 TheCFOrolehasexpandedfromthetraditionalfunctions—controller,fnancialreporting,compliance,andsupport—toincludeservingthecompany’sstrategythroughfnancialdecisionmaking.Thisexpansionhasbroadenedtherolefromaservicefunctiontoanactivistfunction.AccordingtoanApril2005reportpreparedbyCFOResearchServicesandBoozAllenHamilton: 9 Activism—again,defnedasfnanceinarolebeyondcontroller-shipanddecisionsupport—occursmoreoftenamongsurveyre-spondentswhosaytheirfnanceteamshavebecomemorecloselyengagedwiththeboardofdirectorsinthelasttwoyears. Thissurvey,however,indicatesthatthosecompanieswithcloserre-lationswiththeboardofdirectorsarealsocompaniesthathavegreaterpressurefromanalysts,highturnoverintopmanagement,andaneedtochangethecompany’soperatingmodel—inotherwords,thosecompaniesunderthemicroscopeofthebusinesscommunity.ItisinterestingthatsurveyssuggestaninconsistencyintheCFO’sroleinacompany’sstrategyandvaluecreation. 10 ThemajorityofCFOsfeelthatstrategyistheirtoppriority,yettheyalsofeelthatthisisnottheperceptionoftheCFO’sroleamongotherfunctionswithinthecompany: ... foundthat60%oftheCFOssurveyedcitetheirroleinthedevelopment/formulationofcorporatestrategyasapriority.Yetonly25%saytherestoftheorganizationviewsfnanceasavalueaddedfunctiontobeconsultedonallimportantdecisions. A2005surveybyFinancialExecutivesInternationalCanada,“TheRoleoftheCFOTodayandBeyond,”foundthatCFOsaredirectlyaccountableforfnancialanalysis(93%),fnancialriskmanagement(92.3%),forecast-ingandprojections(87.3%),businessandfnancialsystemsandreporting(82.4%),andfnancingandcapitalstructurechanges(79.6%).IntermsoffunctionsinwhichCFOsarecloselyinvolved,thetopthreefunctionsareinvolvementintheoperationalriskmanagement(70.4%),writingsomeorallofthestrategicplan(69%),andstrategicandbusinessplanning(59.9%).TheresultsofthissurveyillustratethebreadthoftheCFO’sresponsibility. 8 “DifferentPathstoOneTruth:FinanceBringsValueDisciplinetoStrategyExecution.” 9 CFOResearchServicesandBoozAllenHamilton,“TheActivistCFO—AlignmentwithStrategy,NotJustwiththeBusiness,”p.15. 10 MarkFrigo, TheStateofManagementAccounting:TheErnst&YoungandIMASurvey ,InstituteofManagementAccountsResearchTeamMember,2003,p.7.
126 FINANCIALMANAGEMENT EXHIBIT6.5 Porter’sFiveForces SourcesofValueCreation Acompany’sstrategyisapathtocreatevalue.Butvaluecannotbecreatedoutofthinair.Valuecreation—thatis,generatingeconomicproft—requiresidentifyingcomparativeandcompetitiveadvantages,anddevelopingastrat-egythatexploitstheseadvantages.Onewaytolookattheseadvantagesistousetheframeworkintro-ducedbyMichaelPorter. 11 Heanalyzedcompetitivestructureofindustriesandidentifedfvecompetitiveforcesthatcaptureanindustry’scompetitiverivalry,asweillustrateinExhibit6.5. Porter’sFiveForces relatetothecompany’sorindustry’sabilitytogenerateeconomicprofts.Briefy, Thebargainingpowerofsuppliersrelatestothepoweroftheprovidersofinputs—bothgoodsandservices. Thebargainingpowerofbuyersrelatestothepowerofthosewhobuythecompany’sgoodsandservices. Thethreatofnewentrantsisrelatedtobarrierstoentryintotheindustry. 12 Thethreatofsubstitutesrelatestoalternativegoodsandservicesthecompany’scustomersmaybuy. Thecompetitiverivalryamongexistingmembersoftheindustryisaf-fectedbythenumberandrelativesizeofthecompaniesintheindustry,thestrategiesofthecompanies,thedifferentiationamongproducts,andthegrowthofthesalesintheindustry. 11 MichaelPorter, CompetitiveStrategy:TechniquesforAnalyzingIndustriesandCompetitors (NewYork:Simon&Schuster,1998). 12 Abarriertoentryisanimpedimentsuchaseconomiesofscale,highinitialstart-upcosts,costadvantagesduetoexperienceofexistingparticipants,loyaltyamongcustomers,protectionssuchaspatents,licenses,orcopyrights,orregulatoryorgovernmentactionthatlimitsentrantsintotheindustry.
FinancialStrategyandFinancialPlanning 127 EXHIBIT6.6 Porter’sFiveForces:ThreatsandPowers ForceHighLow BargainingpowerofbuyersBuyersareconcentrated.Suppliershavehighfxedcosts.Readysubstitutes.Buyercouldproducethegoodorserviceitself.Manypotentialbuyers.Buyervolumeislow.Fewsubstitutes.Buyerscannotbackwardintegrate.BargainingpowerofsuppliersThemarketisdominatedbyafewlargecompanies.Therearenosubstitutesfortheinput.Thecostofswitchinginputsishigh.Thebuyersarefragmentedwithlittlebuyingpower.Thesuppliersmayintegrateforwardtocapturehigherpricesandmargins.Manysuppliers.Readilyavailablesubstitutes.Lowcosttoswitchinginputs.ThreatofnewentrantsFewbarrierstoentry.Littlecustomerloyalty.Lowcapitalrequirements.Highprofts.Signifcantbarrierstoentry.Strongcustomerloyalty.Highlearningcurve.Signifcantcapitalinvestment.ThreatofsubstitutesLittlebrandloyaltyamongcustomers.Noclosecustomerrelations.Lowcoststoswitchinggoodsandservices.Substitutesarelowerpriced.Highbrandloyalty.Strongcustomerrelations.Highcoststoswitchinggoods.Substitutesarenotlowerpriced.RivalryHighbarrierstoexit.Concentratedindustry.Lowbarrierstoentry.Largenumberoffrms.Slowgrowth.Lowcostsforcustomerstoswitchproducts.Highfxedcosts.Lowbarrierstoexit.Highbarrierstoentry.Signifcantproductdifferentiation.Highcostsforcustomerstoswitchproducts. Weprovideexamplesofhowcharacteristicsoftheindustries(theprod-ucts,suppliers,andmarketstructure)affecttherivalryamongcompaniesinanindustryinExhibit6.6.Forexample,ifbuyersareconcentrated,thebargainingpowerofbuyersishigh,whichmakesitmorediffcultforcom-paniestoextracteconomicprofts.Ontheotherhand,iftherearemanysuppliers,thepowerofthesuppliersislowandcompaniesinthisindustrymaybeabletoextractmoreeconomicproft.
128 FINANCIALMANAGEMENT Porter’sFiveForcesdonotprovideamagicformulafordeterminingwhetheracompanycancreatevalue.Rather,thepurposeofthefveforcesistoprovideaframeworkforthinkingaboutthepowersandthreatsthataffectanindustry’s—andcompany’s—abilitytogenerateeconomicprofts.Thebottomlineofallofthisisthattheabilityofacompanytocreateandmaintainacomparativeorcompetitiveadvantageiscomplex.Porter’sforcesare,basically,anelaborationofthetheoriesofeconomicsthattellushowacompanycreateseconomicproft.ThoughPorter’sforcesmayseemoversimplisticinadynamiceconomy,theyprovideastartingpointforanalysisofacompany’sabilitytoaddvalue.Porterarguesthatanindividualcompanymaycreateacompetitiveadvantagethroughrelativecost,differentiation,andrelativeprices.Management,inevaluatingacom-pany’scurrentandfutureperformance,canusetheseforcesandstrategiestoidentifythecompany’ssourcesofeconomicproft.Managementshouldneverignorethebasiceconomicsthatliebehindvaluecreation.Ifacompanyhasauniqueadvantage,thiscanleadtovaluecreation.Iftheadvantageisonethatcanbereplicatedeasilybyothers,thisadvantage—andhenceanyvaluecreationrelatedtoit—mayerodequickly.Theherdingbehaviorofcompanies,seekingtomimicthestrategiesofthebetter-performingcompanies,mayresultintheerosionofvaluefromthatstrategy.Thisherdingbehaviorthereforerequiresthatstrategicplanningbedynamicandthatfeedbackfromperformanceevaluationisimportantinthisplanningprocess.Therefore,strategicplanningshouldbeacontinualprocessthatrequiressettingstrategicobjectives,developingthestrategy,periodicallymeasuringprogresstowardthosegoals,andthenreevaluatingthestrategicobjectivesandstrategy. THEBOTTOMLINE Addingvaluetoacompanyrequiresdevisingastrategyandastrategicplantoexploitthecompany’scomparativeorcompetitiveadvantages. Animportantelementinfnancialplanningforabusinessisforecastingrevenuesandexpenses,andthendevelopingthebudgets. Evaluatingacompany’sperformancerequiresestimatingthecompany’seconomicproftandmeasuringitsvalue-added.Ausefultoolistouseabalancedscorecardprocess,whichbeginswiththecompany’sstrategyandrequiresmeasurementandfeedbackofthecompany’sperformance,aswellasthatofthedifferentunitsofthecompany. Porter’sFiveForcesframeworkisusefulinidentifyingthedegreeofrivalryinanindustrybyfocusingonthecompany’sbargainingpower
FinancialStrategyandFinancialPlanning 129 withsuppliers,thebuyers’bargainingpowerwiththecompany,thethreatofnewentrantsintheindustry,andthethreatofsubstitutes. QUESTIONS 1. Whatistherelationbetweenastrategyandanobjective? 2. Howarecomparativeadvantagesdifferentfromcompetitiveadvan-tages? 3. Whatisastrategicplan? 4. Whatisafnancialplan,andhowdoesitrelatetoacompany’sstrategicplan? 5. Whatisregressionanalysis,andhowmightitassistafnancialmanagerinplanning? 6. Whatisaproformafnancialstatement? 7. Whatiseconomicvalueaddedandwhydofnancialmanagerscareaboutthis? 8. Explainwhatismeantbyabalancedscorecard. 9. Ifcompaniesinanindustryhavesignifcantproftsandtherearenobar-rierstoentry,howdothesecharacteristicsftinthecontextofPorter’sFiveForces? 10. Whataresourcesofeconomicproftsforacompanyoranindustry? 11. Thefollowingisanexcerptthatappearedinanarticle“StrategicPlan-ning:NotJustforBigBusiness”publishedatwww.smallbusinessnotes.com/planning/strategicplanning.html,sponsoredby“StrategicPlanningMadeEasy”: Strategicplanninghasbecomeaconceptthatiscommonlysug-gestedasthe“solution”tomanybusinessproblems.Somedaysitappearsthatthechiefproductofmanybusinessesistheirstrategicplan.Don’tmisunderstandme,strategicplansarewonderfulwhenusedappropriately,buttheydoneedtobeatoolofabusiness,notagoaluntothemselves.And,mostdefnitely,theyshouldnotbeamajorconsumerofvaluableemployer/employeetime.Manyentrepreneurialventuresmistakenlybelievethatstrategicplanningisonlyforlargebusinessesthatcanaffordthetimeandpersonneltodevelopasoundplan.However,ifyouaretocompeteinthemarketplaceagainstthe“bigguys,”youneedtolearnsomeoftheirgameplans—andstrategicplan-ningisamajorpartofanysuccessful,largebusiness.Thatdoesnotmeanthatyourstartupneedsallthebellsandwhistlesof
130 FINANCIALMANAGEMENT themorecomplexplans.Youcaninamatterofhourssketchoutagoodworkingdraftthatwillhelpkeepyouoncoursetobecomingasolidcompetitor. a. Howdoesa“strategicplan”relatetoacompany’sobjectives? b. Whyarestrategicplansconsideredatoolandnotasolution? 12. Thefollowingexcerptisfrom“IntegratingStrategicandFinancialPlan-ning”byLeeAnnRuny(2005),whichappearedonhospitalconnect.com(www.hhnmag.com/hhnmag app/hospitalconnect/search/article.jsp?dcrpath=HHNMAG/PubsNewsArticle/data/0506HHN FEA Gatefold&domain=HHNMAG): Integratingstrategicandfnancialplanningisthebestwayforhealthcareorganizationstoensurethattheyarespendingmoneywisely. ... Toooften,projectsgetapprovedonlytobeshelvedbecausethemoneyisn’tavailable.And,hospitalsneedanaccuratevisionoftheircommunityandtheneedsandwantsoftheircustomersbeforeembarkingoncostlyexpansionsandnewservices.Itisadynamicprocess:Justasbudgetsmustbeupdatedyearly,strategicplansmustbereassessedtoensurethattheor-ganization’sassumptionsandprojectionsareontrack.Itisim-portantthatplansremainup-to-dateortheorganizationriskscostly,unnecessaryexpendituresormaymissoutonagoodopportunity.Athoroughplanningprocessincorporatesstrategicplan-ning,fnancialandoperationalplanningandcapitalallocation.“Afnancialplanwithoutstrategyisn’tmuchofaplan,”saysBlaineO’Connell,chieffnancialoffceratFroedertHospitalinMilwaukee.“Astrategicplanwithoutfnancialbackingisn’tmuchofastrategy.” a. Whatistherelationshipbetweenstrategicplanningandfnancialplanning? b. Whatdoesfnancialplanninginvolve? c. Whatdoyouthink“operationalplanning”meansintheexcerpt? d. Whatdoyouthink“capitalallocation”meansintheexcerpt? e. Explainwhyyouagreeordisagreewiththestatementintheexcerpt:“Afnancialplanwithoutstrategyisn’tmuchofaplan.” 13. Fortune Magazinepublisheda1998interviewwithPeterDrucker(“PeterDruckerTakestheLongView:TheOriginalManagementGurushareshisvisionofthefuturewith Fortune ’sBrentSchlender ”)
FinancialStrategyandFinancialPlanning 131 wherethefollowingappeared(money.cnn.com/magazines/fortune/fortune archive/1998/09/28/248706/index.htm): ... thereisnoproftunlessyouearnthecostofcapital.AlfredMarshallsaidthatin1896,PeterDruckersaidthatin1954andin1973,andnowEVA(economicvalueadded)hassystematizedthisidea,thankGod. a. WhatisEVAandhowdoesittakeintoaccountthecostofcapital? b. WhatistherelationshipbetweenEVAandeconomicproft? 14. In“UsingtheBalancedScorecardasaStrategicManagementSystem”byRobertS.KaplanandDavidP.Norton( HarvardBusinessReview ,January–February1996),thefollowingappearedonpage2ofthearticle: Managersusingthebalancedscorecarddonothavetorelyonshort-termfnancialmeasuresasthesoleindicatorsofthecom-pany’sperformance.Thescorecardletsthemintroducefournewmanagementprocessesthat,separatelyandincombina-tion,contributetolinkinglong-termstrategicobjectiveswithshort-termactions. a. Howdoesabalancedscorecardassistinlinkingobjectiveswithac-tions? b. Whatarethe“fournewmanagementprocesses”mentionedinthequote?
CHAPTER 7 DividendandDividendPolicies Theevidencethat,controllingforcharacteristics,frmsbecomelesslikelytopaydividendssaysthattheperceivedbeneftsofdividendshavedeclinedthroughtime.Some(butsurelynotall)ofthepossibilitiesare:(i)lowertransactionscostsforsellingstocksforconsumptionpurposes,inpartduetoanincreasedtendencytoholdstocksviaopenendmutualfunds;(ii)largerholdingsofstockoptionsbymanagerswhoprefercapitalgainstodividends;and(iii)bettercorporategovernancetechnologies(e.g.,moreprevalentuseofstockoptions)thatlowerthebeneftsofdividendsincontrollingagencyproblemsbetweenstockholdersandmanagers. —EugeneF.FamaandKennethR.French,“DisappearingDividends:ChangingFirmCharacteristicsorLowerPropensitytoPay?” JournalofFinancialEconomics 60(2001):3–43 M anycorporationspaycashdividendstotheirshareholdersdespitethetaxconsequencesofthesedividendsandthefactthatthesefundscouldotherwisebeplowedbackintothecorporationforinvestmentpurposes.Thesedividendsareoftenviewedasasignalofthecorporation’sfutureprosperity.Corporationsmayalso“pay”stockdividendsorsplitthestock,dividingtheequitypieintosmallerpieces,theannouncementofwhichisoftenviewedaspositivenewsbyinvestors.Inadditiontodividends,acorporationcandistributefundstoshare-holdersotherthanintheformofacashdividend.Forexample,acorpo-rationmayrepurchaseitssharesfromshareholdersthroughopenmarketpurchases,tenderoffers,ortargetedblockrepurchases.Thepurposeofthischapteristodescribethemechanismsofprovidingfundstoshareholdersintheformofdividends,stockdividendsandsplits,andstockrepurchases. 133
134 FINANCIALMANAGEMENT DIVIDENDS A dividend isthecash,stock,oranytypeofpropertyacorporationdis-tributestoitsshareholders.Theboardofdirectorsmaydeclareadividendatanytime,butdividendsarenotalegalobligationofthecorporation—itistheboard’schoice.Unlikeinterestondebtsecurities,ifacorporationdoesnotpayadividend,thereisnoviolationofacontract,noranylegalrecourseforshareholders.Whentheboardofdirectorsdeclaresadistribution,itspecifestheamountofthedistribution,thedateonwhichthedistributionispaid,andthe dateofrecord ,whichdetermineswhohastherighttothedistributions.Becausesharesaretradedfrequentlyandittakestimetoprocesstransac-tions,theexchangeshavedevisedawayofdeterminingwhichinvestorsreceivethedividend:theexchangestaketherecorddate,asspecifedbytheboardofdirectors,andidentifythe ex-dividenddate ,whichistwobusinessdayspriortotherecorddate.Theex-dividenddateisoftenreferredtosimplyasthe ex-date .Therefore,therearefourkeydatesinadistribution: 1. The declarationdate ,whichisthedatetheboarddeclaresthedistribu-tion. 2. The ex-dividenddate ,whichisthedatethatdetermineswhichinvestorsreceivethedividend.Anyinvestorwhoownsthestockthedaybeforetheex-datereceivestheforthcomingdividend.Anyinvestorwhobuysthestockontheex-datedoesnotreceivethedividend. 3. The dateofrecord ,whichisspecifedbytheboardofdirectorsasthedatethatdetermineswhoreceivesthedividend. 4. The paymentdate ,whichisthedaythedistributionismade.Mostdividendsareintheformofcash.Cashdividendsarepaymentsmadedirectlytoshareholdersinproportiontothesharestheyown.Whencashdividendsarepaid,theyarepaidonalloutstandingsharesofaclassofstock. 1 Afewcompaniespay specialdividends or extradividends occasionally—identifyingthesedividendsapartfromtheirregulardividends.Weusuallydescribethecashdividendsthatacompanypaysintermsof dividendpershare ,whichwecalculateas:Dividendpershare = Cashdividends Numberofsharesoutstanding 1 Therefore,acorporationmaypaydividendsonitspreferredstock,butnotonitscommonstock.
DividendandDividendPolicies 135 Anotherwayofdescribingcashdividendsisintermsofthepercentageofearningspaidoutindividends,whichwerefertoasthe dividendpayoutratio. Wecanexpressthedividendintermsoftheproportionofearningsoverafscalperiod:Dividendpayoutratio = Cashdividends EarningsavailabletoshareholdersIfwetakethislastequationanddivideboththenumeratorandthedenominatorbythenumberofcommonsharesoutstanding,wecanrewritethedividendpayoutratioas:Dividendpayoutratio = Dividendpershare EarningspershareThedividendpayoutratioisthecomplementofthe retentionratio ,alsoreferredtoasthe plowbackratio :Retentionratio = Earningsavailabletoshareholders − Cashdividends Earningsavailabletoshareholders = 1 − DividendpayoutratioTheretentionratioistheproportionofearningsthatthecompanyretains,thatis,theproportionofearningsreinvestedbackintothecompany.WedemonstratethesecalculationsinExhibit7.1,applyingthesecalcu-lationstoWal-MartStores,Inc. EXHIBIT7.1 TheDividendsofWal-MartStores,Inc. Forfscalyear2008,Wal-MartStoresreportedthefollowingfnancialresults:Earningsavailabletocommonshares$13.400billionDividendspaid$3.746billionNumberofcommonsharesoutstanding3.81billionTherefore,Wal-MartStores’dividendpershareanddividendpayoutratioare:Dividendpershare = $3.746billion/$3.81billion = $0.9832pershareDividendpayoutratio = $3.746billion/$13.400billion = 27.955%Or,intermsofdividendspershareandearningspershare,wegetthesameresult:Dividendpayoutratio = $0.9832/$3.5171 = 27.955%
136 FINANCIALMANAGEMENT TRYIT!DIVIDENDS Consideracompanywiththefollowinginformationforthefscalyear:Dividendspaid$2millionNetincome$5millionNumberofsharesoutstanding1millionThecompanyhasnopreferredstockoutstanding.Completethefollowing:Dividendspershare Earningspershare Dividendpayoutratio Retentionratio DividendReinvestmentPlans ManyU.S.corporationsallowshareholderstoreinvestautomaticallytheirdividendsinthesharesofthecorporationpayingthem.A dividendreinvest-mentplan (DRPorDRIP)isaprogramthatallowsshareholderstoreinvesttheirdividends,buyingadditionalsharesofstockofthecompanyinsteadofreceivingthecashdividend.ADRPoffersbeneftstobothshareholdersandthecorporation: 1. Shareholdersbuyshareswithouttransactionscosts—brokers’commissions—andatadiscountfromthecurrentmarketprice. 2. Thecorporationretainscashwithoutthecostofanewstockissue.Onesticklerinallthis,however,isthatthedividendsaretaxedasin-comebeforetheyarereinvested,eventhoughtheshareholdersneverseethedividend.Theresultissimilartoadividendcut,butwithataxconse-quencefortheshareholders:Thecashfowthatwouldhavebeenpaidtoshareholdersisplowedbackintothecorporation.ManycorporationsfndhighratesofparticipationinDRPs.Ifsomanyshareholderswanttoreinvesttheirdividends—evenafterconsideringthetaxconsequences—whyisthecorporationpayingdividends?Thissuggests
DividendandDividendPolicies 137 thatthereissomerationale,suchassignaling,thatcompelscorporationstopaydividends. STOCKDISTRIBUTIONS Inadditiontocashdividends,acorporationmayprovideshareholderswithdividendsintheformofadditionalsharesofstockor,rarely,sometypesofpropertyownedbythecorporation.Whendividendsarenotincash,theyareusuallyadditionalsharesofstock.Additionalsharesofstockcanbedistributedtoshareholdersintwoways:payingastockdividendandsplittingthestock. TypesofDistributions A stockdividend isthedistributionofadditionalsharesofstocktoshare-holders.Stockdividendsaregenerallystatedasapercentageofexistingshareholdings.Ifacorporationpaysastockdividend,itisnottransferringanythingofvaluetotheshareholders.Theassetsofthecorporationremainthesameandeachshareholder’sproportionateshareofownershipremainsthesame.Allthecorporationisdoingiscuttingitsequity“pie”intomoreslicesandatthesametimecuttingeachshareholder’sportionofthatequityintomoreslices.Sowhypayastockdividend?Astocksplitissomethinglikeastockdividend.A stocksplit splitsthenumberofexistingsharesintomoreshares.Forexample,ina2:1split—referredtoas“twoforone”—eachshareholdergetstwosharesforeveryoneowned.Ifaninvestorowns1,000sharesandthestockissplit2:1,theinvestorthenowns2,000sharesafterthesplit.Hastheportionoftheinvestor’sownershipinthecompanychanged?No,theinvestornowsimplyownstwiceasmanyshares—andsodoeseveryothershareholder.Iftheinvestorowned1%ofthecorporation’sstockbeforethesplit,theinvestorstillowns1%afterthesplit.A reversestocksplit issimilartoastocksplit,butbackwards:a1:2reversestocksplitreducesthenumberofsharesofstocksuchthatashare-holderreceiveshalfthenumberofsharesheldbeforethereversestocksplit.Astocksplitinwhichmoresharesaredistributedtoshareholdersissome-timesreferredtoasa forwardstocksplit todistinguishitfromareversestocksplit.Similartoboththestockdividendandthestocksplit,thereisnoactualdistributionorcontributionmade,butsimplyadivisionoftheequitypie—inthiscase,intofewerpieces.
138 FINANCIALMANAGEMENT Stockdistributions,similartocashdividends,areadecisionoftheboardofdirectors,butinthiscasethe“payment”dateissimilarwhentheaddi-tionalsharesareprovidedtoshareholders,orsharesexchanged,inthecaseofaforwardorareversestocksplit. ReasonsforStockDistributions Thereareacoupleofreasonsforpayingdividendsintheformofstockdividends.Oneistoprovideinformationtothemarket.Acompanymaywanttocommunicategoodnewstotheshareholderswithoutpayingcash.Forexample,ifthecorporationhasanattractiveinvestmentopportunityandneedsfundsforit,payingacashdividenddoesn’tmakeanysense—sothecorporationpaysastockdividendinstead.Butisthisaneffectivewayofcommunicatinggoodnewstotheshareholders?Itcostsverylittletopayastockdividend—justminorexpensesforrecordkeeping,printing,anddistribution.Butifitcostsverylittle,doinvestorsreallytrustitasasignal?Anotherreasongivenforpayingastockdividendistoreducethepriceofthestock.Ifthepriceofastockishighrelativetomostotherstocks,theremaybehighercostsrelatedtoinvestors’transactionsofthestock,asinahigherbroker’scommission.Bypayingastockdividend—whichslicestheequitypieintomorepieces—thepriceofthestockshoulddecline.Let’sseehowthisworks.Supposeaninvestorowns1,000shares,eachworth$50pershare,foratotalinvestmentof$50,000.Ifthecorporationpaystheinvestora5%stockdividend,theinvestorthenowns1,050sharesafterthedividend.Isthereisanyreasonforyourholdingstochangeinvalue?Nothingeconomichasgoneonhere—thecompanyhasthesameassets,thesameliabilities,andthesameequity—totalequityisjustcutupintosmallerpieces.Thereisnoreasonforthevalueoftheportionoftheequitythisinvestorownstochange.Butthepricepershareshoulddecline:from$50pershareto$47.62pershare.Theargumentforreducingthesharepriceonlyworksifthemarketbringsdownthepricesubstantially,fromanunattractivetradingrangetoamoreattractivetradingrangeintermsofreducingbrokeragecommissionsandenablingsmallinvestorstopurchaseevenlotsof100shares.Sowhysplit?Likeastockdividend,thesplitreducesthetradingpriceofshares.Ifaninvestorowns1,000sharesofthestocktradingfor$50persharepriortoa2:1split,thesharesshouldtradefor$25pershareafterthesplit.Asidefromaminordifferenceinaccounting,stocksplitsandstockdivi-dendsareessentiallythesame.Thestockdividendrequiresashiftwithinthestockholders’equityaccounts,fromretainedearningstopaid-incapital,for
DividendandDividendPolicies 139 theamountofthedistribution;thestocksplitrequiresonlyamemorandumentry.A2:1splithasthesameeffectonastock’spriceasa100%stockdividend,a1.5to1splithasthesameeffectonastock’spriceasa50%stockdividend,andsoon.Thebasisoftheaccountingrulesisrelatedtothereasonsbehindthedistributionofadditionalshares.Ifcompanieswanttobringdowntheirshareprice,theytendtodeclareastocksplit;ifcompanieswanttocommunicatenews,theyoftendeclareastockdividend.Companiestendtoreversestocksplitwhenthestock’spriceisextremelylow,solowthattheyareatriskofbeingdelistedfromanexchange. 2 Alowstockpriceisafunctionofhowmanysharesareoutstanding,butmostlyafunctionofpoorperformancewhichhasledtoalowshareprice.Howcaninvestorstellwhatthemotivationisbehindstockdividendsandsplits?Theycannot,buttheycangetageneralideaofhowinvestorsinterprettheseactionsbylookingatwhathappenstothecorporation’ssharepricewhenacorporationannouncesitsdecisiontopayastockdividendorsplititsstock,orreversesplit.Ifthesharepricetendstogoupwhentheannouncementismade,thedecisionisprobablygoodnews;ifthepricetendstogodown,thestockdividendisprobablybadnews.Thisissupportedbyevidencethatindicatescorporation’searningstendtoincreasefollowingstocksplitsanddividends. 3 Thesharepriceofcompaniesannouncingstockdistributionsandfor-wardstocksplitsgenerallyincreaseatthetimeoftheannouncement.Thestockpricetypicallyincreasesby1%to2%whenthesplitorstockdividendisannounced.Whenthestockdividendisdistributedorthesplitiseffected(ontheex-date),theshare’spricetypicallydeclinesaccordingtotheamountofthedistribution.Supposeacompanyannouncesa2:1split.Itssharepricemayincreaseby1%to2%whenthisisannounced,butwhenthesharesaresplit,thesharepricewillgodowntoapproximatelyhalfofitspresplitvalue.Themostlikelyexplanationisthatthisdistributionisinterpretedasgoodnews—thatmanagementbelievesthatthefutureprospectsofthecompanyarefavorableorthatthesharepriceismoreattractivetoinvestors.Wepro-videanexampleofaforwardandareversestocksplitinExhibit7.2,usingthesplitsandstockpricesofSunMicrosystemstoillustratethepriceeffects.Asyoucanseeinthisexample,theadjustmentofthepriceiscloseto—butnotprecisely—theadjustmentweexpectonthebasisoftheamountofthesplit. 2 Areversestocksplit,especiallythosesuchas1:300or1:1,000,mayalsobeusedtoreducethenumberofshareholders,andhencetakethecompanyprivate. 3 See,forexample,MaureenMcNicholsandAjayDravid,“StockDividends,StockSplits,andSignaling,” JournalofFinance 45,no.3(1990):857–879.
140 FINANCIALMANAGEMENT EXHIBIT7.2 SunMicrosystemsForwardandReverse SunMicrosystems(ticker:JAVA)hasdeclarednumerousstocksplitsthroughoutitshistory,butalsodeclaredareversestocksplit.Considertwosplits:ForwardsplitDecember6,20002:1ReversesplitNovember12,20071:4ThepriceofSunMicrosystemsbeforeandaftereachsplit: TwoDaysBeforeDayBeforeSplitDayDayAfterTwoDaysAfter Forward$78.88$91.75$44.25$42.81$38.94Reverse$5.30$5.14$20.51$21.38$21.60Thepricedoesnotadjustsolelybythesplitbecauseoftheinfuenceofothermarketandeconomicevents,buttheadjustmentisveryclose:thestockpriceisalmost 1 / 2 thatofthepresplitforthe2:1split,andthestockpriceisslightlymorethan4timesthatpresplitforthe1:4split. TRYIT!SPLITSANDDIVIDENDS Foreachofthefollowingcases,whichistheexpectedsharepricepost-splitorstockdividend? CasePre-DistributionPricePerShareNumberofSharesOutstandingPre-DistributionDistri-butionTypeExpectedPricePerShareNumberofSharesOutstandingPost-SplitorStockDividend A$501million2:1ForwardsplitB$201.5million1.5:1ForwardsplitC$510million1:5ReversesplitD$401million25%Stockdividend
DividendandDividendPolicies 141 DIVIDENDPOLICIES A dividendpolicy isacorporation’sdecisionaboutthepaymentofcashdividendstoshareholders.Thereareseveralbasicwaysofdescribingacorporation’sdividendpolicy: Nodividends. Constantgrowthindividendspershare. Constantpayoutratio. Lowregulardividendswithperiodicextradividends.Thecorporationsthattypicallydonotpaydividendsarethosethataregenerallyviewedasyounger,fastergrowingcompanies.Forexample,MicrosoftCorporationwasfoundedin1975andwentpublicin1986,butitdidnotpayacashdividenduntilJanuary2003.Acommonpatternofcashdividendstendstobetheconstantgrowthofdividendspershare.Anotherpatternistheconstantpayoutratio.Manyothercompaniesinthefoodprocessingindustry,suchasKelloggandTootsieRollIndustries,paydividendsthatarearelativelyconstantpercent-ageofearnings.Somecompaniesdisplaybothaconstantdividendpayoutratioandaconstantgrowthindividends.Thistypeofdividendpatternischaracteristicoflarge,maturecompaniesthathavepredictableearningsgrowth—thedividendsgrowthtendstomimictheearningsgrowth,resultinginaconstantpayout.U.S.corporationsthatpaydividendstendtopayeitherconstantorin-creasingdividendspershare.Dividendstendtobelowerinindustriesthathavemanyproftableopportunitiestoinvesttheirearnings.Butasacom-panymaturesandfndsfewerandfewerproftableinvestmentopportunities,itgenerallypaysoutagreaterportionofitsearningsindividends.Manycorporationsarereluctanttocutdividendsbecausethecorpo-ration’ssharepriceusuallyfallswhenadividendreductionisannounced.Forexample,theU.S.automanufacturerscutdividendsduringtherecessionintheearly1990s.Asearningspersharedeclinedtheautomakersdidnotcutdividendsuntilearningspersharewerenegative—andinthecaseofGeneralMotors,notuntilithadexperiencedtwoconsecutivelossyears.Butasearningsrecoveredinthemid-1990s,dividendswereincreased. 4 Becauseinvestorstendtopenalizecompaniesthatcutdividends,cor-porationstendtoonlyraisetheirregularquarterlydividendwhentheyaresuretheycankeepitupinthefuture.Bygivingaspecialorextradividend, 4 GeneralMotorsincreaseddividendsuntilcuttingthemonceagainin2006asitincurredsubstantiallosses.
142 FINANCIALMANAGEMENT Freeport-McMoran (cker: FCX) is a copper and gold mining company.The company pays regular cash dividends in January, March, July, andOctober each year. The company also pays a supplemental dividendduring periods of higher profits: Cash Dividend Month EXHIBIT7.3 ExtraSpecialDividends Datasource: Freeport-McMoranInvestorCenter,Dividends. thecorporationisabletoprovidemorecashtotheshareholderswithoutcommittingitselftopayinganincreaseddividendeachperiodintothefu-ture.WeprovideanexampleofspecialdividendsinExhibit7.3forthecaseofFreeport-McMoran,whichpaidspecialdividends,whichitreferredtoassupplementaldividendsin2005and2006.Thereisnogeneralagreementwhetherdividendsshouldorshouldnotbepaid.Hereareseveralviews: Thedividendirrelevancetheory. Thepaymentofdividendsdoesnotaffectthevalueofthecompanysincetheinvestmentdecisionisinde-pendentofthefnancingdecision. The“birdinthehand”theory. Investorspreferacertaindividendstreamtoanuncertainpriceappreciation. Thetax-preferenceexplanation. Duetothewayinwhichdividendsaretaxed,investorsshouldprefertheretentionoffundstothepaymentofdividends.
DividendandDividendPolicies 143 Thesignalingexplanation. Dividendsprovideawayforthemanagementtoinforminvestorsaboutthecompany’sfutureprospects. Theagencyexplanation. Thepaymentofdividendsforcesthecompanytoseekmoreexternalfnancing,whichsubjectsthecompanytothescrutinyofinvestors. TheDividendIrrelevanceTheory ThedividendirrelevanceargumentwasdevelopedbyMertonMillerandFrancoModigliani. 5 Basically,theargumentisthatifthereisa perfectcapitalmarket —notaxes,notransactionscosts,nocostsrelatedtoissuingnewsecurities,andnocostsofsendingorreceivinginformation—thevalueofthecorporationisunaffectedbypaymentofdividends.Howcanthisbe?Supposeinvestmentdecisionsarefxed—thatis,thecompanywillinvestincertainprojectsregardlesshowtheyarefnanced.Thevalueofthecorporationisthepresentvalueofallfuturecashfowsofthecompany—whichdependontheinvestmentdecisionsthatmanagementmakes, not onhowtheseinvestmentsarefnanced.Iftheinvestmentdecisionisfxed,whetheracorporationpaysadividendornotdoesnotaffectthevalueofthecorporation.Acorporationraisesadditionalfundseitherthroughearningsorbysellingsecurities—suffcienttomeetitsinvestmentdecisionsanditsdivi-denddecision.Thedividenddecisionthereforeaffectsonlythefnancingdecision—howmuchcapitalthecompanyhastoraisetofulfllitsinvest-mentdecisions.TheMillerandModiglianiargumentimpliesthatthedividenddecisionisaresidualdecision:Ifthecompanyhasnoproftableinvestmentstounder-take,thecompanycanpayoutfundsthatwouldhavegonetoinvestmentstoshareholders.Andwhetherornotthecompanypaysdividendsisofnoconsequencetothevalueofthecompany.Inotherwords,dividendsareirrelevant.Butcompaniesdon’texistinaperfectworldwithaperfectcapitalmarket.Aretheimperfections(taxes,transactionscosts,etc.)enoughtoaltertheconclusionsofMillerandModigliani?Itisn’tclear. The“BirdintheHand”Theory Apopularviewisthatdividendsrepresentasurethingrelativetosharepriceappreciation.Thereturntoshareholdersiscomprisedoftwoparts:the 5 MertonMillerandFrancoModigliani,“DividendPolicy,GrowthandtheValuationofShares,” JournalofBusiness 34(1961):411–433.
144 FINANCIALMANAGEMENT returnfromdividends—the dividendyield —andthereturnfromthechangeintheshareprice—the capitalyield. Corporationsgenerateearningsandcaneitherpaythemoutincashdividendsorreinvestearningsinproftableinvestments,increasingthevalueofthestockand,hence,shareprice.Onceadividendispaid,itisacertaincashfow.Shareholderscancashtheirquarterlydividendchecksandreinvestthefunds.Butanincreaseinsharepriceisnotasurething.Itonlybecomesasurethingwhentheshare’spriceincreasesoverthepricetheshareholderpaidandheorshesellstheshares.Wecanobservethatpricesofdividend-payingstocksarelessvolatilethannondividend-payingstocks.Butaredividend-payingstockslessriskybecausetheypaydividends?Orarelessriskycompaniesmorelikelytopaydividends?Mostoftheevidencesupportsthelatter.Companiesthathavegreaterrisk—businessrisk,fnancialrisk,orboth—tendtopaylittleornodividends.Inotherwords,companieswhosecashfowsaremorevariabletendtoavoidlargedividendcommitmentsthattheycouldnotsatisfyduringperiodsofpoorerfnancialperformance. Abirdinthehand’sworthtwofeeingby.—Scottishproverb TheTax-PreferenceExplanation Ifdividendincomeistaxedatthesameratesascapitalgainincome,investorsmayprefercapitalgainsbecauseofthetimevalueofmoney:capitalgainsareonlytaxedwhenrealized—thatis,whentheinvestorsellsthestock—whereasdividendincomeistaxedwhenreceived.If,ontheotherhand,dividendincomeistaxedatrateshigherthanthatappliedtocapitalgainincome,investorsshouldpreferstockpriceappreciationtodividendincomebecauseofboththetimevalueofmoneyandthelowerrates.Historically,capitalgainincomeintheUnitedStateshasbeentaxedatrateslowerthanthatappliedtodividendincomeforindividualinvestors.However,thecurrentsituationforindividualsisthatdividendincomeandcapitalgainincomearetaxedatthesamerates.Evenwiththesameratesappliedtoincome,capitalgainincomeisstillpreferredbecausethetaxonanystockappreciationisdeferreduntilthestockissold—whichcanbemanyyearsintothefuture.Butthetaximpactisdifferentfordifferenttypesofshareholders.Acorporationreceivingadividendfromanothercorporationmaytakea
DividendandDividendPolicies 145 dividendsreceiveddeduction —adeductionofalargeportionofthedivi-dendincome. 6 Thedividendsreceiveddeductionrangesfrom70%to100%,dependingontheownershiprelationbetweenthetwocorporations.There-fore,corporationspaytaxesonasmallportionoftheirdividendincome,mitigatingsome,andperhapsallofdoubletaxationoncorporateincomedistributedtoothercorporations.Stillothershareholdersmaynotevenbetaxedondividendincome.Forexample,apensionfundbenefciarydoesnotpaytaxesonthedividendincomeitgetsfromitsinvestments(theseearningsareeventuallytaxedwhenthepensionispaidouttotheemployeeafterretirement).Evenifdividendincomeweretaxedatrateshigherthanthatofcapi-talgains,investorscouldtakeinvestmentactionsthataffectthisdifference.First,investorsthathavehighmarginaltaxratesmaygravitatetowardstocksthatpaylittleornodividends.Thismeanstheshareholdersofdivi-dendpayingstockshavelowermarginaltaxrates.Thisisreferredtoasa taxclientele —investorswhochoosestocksonthebasisofthetaxestheyhavetopay.Second,investorswithhighmarginaltaxratescanuselegitimateinvestmentstrategies—suchasborrowingtobuystockandusingthededuc-tionfromtheinterestpaymentsontheloantooffsetthedividendincomeinordertoreducethetaximpactofdividends. TheSignalingExplanation Companiesthatpaydividendsseemtomaintainarelativelystabledividend,eitherintermsofaconstantorgrowingdividendpayoutratioorintermsofaconstantorgrowingdividendpershare.Andwhencompanieschangetheirdividend—eitherincreasingorreducing(“cutting”)thedividend—thepriceofthecompany’ssharesseemstobeaffected:Whenadividendisincreased,thepriceofthecompany’ssharestypicallygoesup;whenadividendiscut,thepriceusuallygoesdown.Thisreactionisattributedtoinvestors’perceptionofthemeaningofthedividendchange:Increasesaregoodnews,decreasesarebadnews.Theboardofdirectorsislikelytohavesomeinformationthatinvestorsdonothave,achangeindividendmaybeawayfortheboardtosignalthisprivateinformation.Becausemostboardsofdirectorsareawarethatwhendividendsarelowered,thepriceofashareusuallyfalls,mostinvestorsdonotexpectboardstoincreaseadividendunlesstheythoughtthecompany 6 Inotherwords,thedividendsareincludedinincome,butthenthereceivingcorpo-rationtakesalargededuction.
146 FINANCIALMANAGEMENT couldmaintainitintothefuture.Realizingthis,investorsmayviewadiv-idendincreaseastheboard’sincreasedconfdenceinthefutureoperatingperformanceofthecompany. TheAgencyExplanation Therelationbetweentheownersandthemanagersofacompanyisanagencyrelationship:Theownersaretheprincipalsandthemanagersaretheagents.Managementischargedwithactinginthebestinterestsoftheowners.Nevertheless,therearepossibilitiesforconfictsbetweentheinterestsofthetwo.Ifthecompanypaysadividend,thecompanymaybeforcedtoraisenewcapitaloutsideofthecompany—thatis,issuenewsecuritiesinsteadofusinginternallygeneratedcapital—subjectingthemtothescrutinyofequityresearchanalystsandotherinvestors.Thisextrascrutinyhelpsre-ducethepossibilitythatmanagerswillnotworkinthebestinterestsoftheshareholders.Butissuingnewsecuritiesisnotcostless.Therearecostsofissuingnewsecurities—fotationcosts.In“agencytheory-speak,”thesecostsarepartofmonitoringcosts—incurredtohelpmonitortheman-agers’behaviorandinsurebehaviorisconsistentwithshareholderwealthmaximization.Thepaymentofdividendsalsoreducestheamountoffreecashfowun-dercontrolofmanagement. Freecashfow isthecashinexcessofthecashneededtofnanceproftableinvestmentopportunities.Aproftableinvest-mentopportunityisanyinvestmentthatprovidesthecompanywithareturngreaterthanwhatshareholderscouldgetelsewhereontheirmoney—thatis,areturngreaterthantheshareholders’opportunitycost.Becausefreecashfowisthecashfowleftoverafterallproftableprojectsareundertaken,theonlyprojectsleftaretheunproftableones.Shouldfreecashbereinvestedintheunproftableinvestmentsorpaidouttoshareholders?Ofcourseifboardsmakedecisionsconsistentwithshareholderwealthmaximization,anyfreecashfowshouldbepaidouttoshareholderssince—bythedefnitionofaproftableinvestmentopportunity—theshareholderscouldgetabetterreturninvestingthefundstheyreceive.Ifthecompanypaysadividend,fundsarepaidouttoshareholders.Ifthecompanyneedsadditionalfunds,itcouldberaisedbyissuingnewsecurities;inthisevent,shareholderswishingtoreinvestthefundsreceivedasdividendsinthecompanycouldbuythesenewsecurities.Oneviewoftheroleofdividendsisthatthepaymentofdividendsthereforereducesthecashfowinthehandsofmanagement,reducingthepossibilitythatmanagerswillinvestfundsinunproftableinvestmentopportunities.
DividendandDividendPolicies 147 ToPayorNottoPayDividends Wecanfgureoutreasonswhyacompanyshouldorshouldnotpaydivi-dends,butnotwhytheyactuallydoordonot—thisisthe“dividendpuzzle”coinedbyFischerBlack. 7 Butwedoknowfromlookingatdividendsandthemarket’sreactiontodividendactionsthat: Ifacompanyincreasesitsdividendsorpaysadividendforthefrsttime,thisisviewedasgoodnews—itssharepriceincreases. Ifacompanydecreasesitsdividendoromitsitcompletely,thisisviewedasbadnews—itssharepricedeclines.Thatiswhycorporationsmustbeawareoftherelationbetweendivi-dendsandthevalueofthecommonstockinestablishingorchangingdivi-dendpolicy. STOCKREPURCHASES Corporationshaverepurchasedtheircommonstockfromtheirsharehold-ers.Acorporationrepurchasingitsownsharesiseffectivelypayingacashdividend,withoneimportantdifference:taxes.Cashdividendsareordinarytaxableincometotheshareholder.Acompany’srepurchaseofshares,ontheotherhand,resultsinacapitalgainorlossfortheshareholder,depend-ingonthepricepaidwhentheywereoriginallypurchased.Ifthesharesarerepurchasedatahigherprice,thedifferencemaybetaxedascapitalgains,whichmaybetaxedatrateslowerthanordinaryincome. MethodsofRepurchasingStock Thecompanymayrepurchaseitsownstockbyanyofthreemethods:(1)atenderoffer,(2)openmarketpurchases,and(3)atargetedblockrepurchase.A tenderoffer isanoffermadetoallshareholders,withaspecifeddeadlineandaspecifednumberofsharesthecorporationiswillingtobuyback.Thetenderoffermaybeafxedpriceoffer,wherethecorporationspecifesthepriceitiswillingtopayandsolicitspurchasesofsharesofstockatthatprice. 7 FischerBlack,“TheDividendPuzzle,” JournalofPortfolioManagement 2(1976):5–8.
148 FINANCIALMANAGEMENT Atenderoffermayalsobeconductedasa Dutchauction inwhichthecorporationspecifesaminimumandamaximumprice,solicitingbidsfromshareholdersforanypricewithinthisrangeatwhichtheyarewillingtoselltheirshares.Afterthecorporationreceivesthesebids,theypayalltenderingshareholdersthemaximumpricesuffcienttobuybackthenumberofsharestheywant.ADutchauctionreducesthechancethatthecompanypaysapricehigherthanneededtoacquiretheshares.Dutchauctionsaregaininginpopularityrelativetofxed-priceoffers.Biogen,abiotechnologycompany,announcedaDutchauctiontenderofferinMay2007forsharesofitscommonstock.InExhibit7.4,theofferwasforupto57millionsharesofstock,atapricenotlessthan$47pershareandnotmorethan$53pershare.Biogenaccepted56,424,155sharesat$53pershare,or16.4%ofitssharesoutstandingatthetimeoftheoffer.Acorporationmayalsobuybacksharesdirectlyintheopenmarket.Thisinvolvesbuyingthesharesthroughabroker.Acorporationthatwantstobuysharesmayhavetospreaditspurchasesovertimesoasnottodrivetheshare’spriceuptemporarilybybuyinglargenumbersofshares.Thethirdmethodofrepurchasingstockistobuyitfromaspecifcshareholder.Thisinvolvesdirectnegotiationbetweenthecorporationandtheshareholder.Thismethodisreferredtoasa targetedblockrepurchase ,sincethereisaspecifcshareholder(the“target”)andtherearealargenumberofshares(a“block”)tobepurchasedatonetime.Targetedblockrepurchases,alsoreferredtoas“greenmail,”wereusedinthe1980stofghtcorporatetakeovers. ReasonstoRepurchaseStock Corporationsrepurchasetheirstockforanumberofreasons.First,are-purchaseisawaytodistributecashtoshareholdersatalowercosttoboththecompanyandtheshareholdersthandividends.Ifcapitalgainsaretaxedatrateslowerthanordinaryincome,whichuntilrecentlyhasbeenthecasewithU.S.taxlaw,repurchasingisalowercostwayofdistributingcash.However,sinceshareholdershavedifferenttaxrates—especiallywhencom-paringcorporateshareholderswithindividualshareholders—thebeneftismixed.Thereasonisthatsomeshareholders’incomeistax-free(e.g.,pen-sionfunds),someshareholdersareonlytaxedonaportionofdividends(e.g.,corporationsreceivingdividendsfromothercorporations),andsomeshareholdersaretaxedonthefullamountofdividends(e.g.,individualtaxpayers).Anotherreasontorepurchasestockistoincreaseearningspershare.Acompanythatrepurchasesitssharesincreasesitsearningspersharesimply
DividendandDividendPolicies 149 becausetherearefewersharesoutstandingaftertherepurchase.Buttherearetwoproblemswiththismotive.First,cashispaidtotheshareholders,solesscashisavailableforthecorporationtoreinvestinproftableprojects.Second,becausetherearefewershares,theearningspieisslicedinfewerpieces,resultinginhigherearningspershare.Theindividual“slices”arebigger,butthepieitselfremainsthesamesize.Lookingathowsharepricesrespondtogimmicksthatmanipulateearn-ings,thereisevidencethatacompanycannotfoolthemarketbyplayinganearnings-per-sharegame.Themarketcanseethroughtheearningspersharetowhatisreallyhappeningandthatthecompanywillhavelesscashtoinvest.Stillanotherreasonforstockrepurchaseisthatitcouldtiltthedebt-equityratiosoastoincreasethevalueofthecompany.Bybuyingbackstock—therebyreducingequity—thecompany’sassetsarefnancedtoagreaterdegreebydebt.Doesthisseemwrong?It’snot.Toseethis,supposeacorporationhasabalancesheetconsistingofassetsof$100million,lia-bilitiesof$50million,and$50millionofequity.Thatis,thecorporationhasfnanced50%ofitsassetswithdebt,and50%withequity.Ifthiscor-porationuses$20millionofitsassetstobuybackstockworth$20million,itsbalancesheetwillhaveassetsof$80millionfnancedby$50millionofliabilitiesand$30millionofequity.Itnowfnances62.5%ofitsassetswithdebtand37.5%withequity.Iffnancingthecompanywithmoredebtisgood—thatis,thebeneftsfromdeductinginterestondebtoutweighthecostofincreasingtheriskofbankruptcy—repurchasingstockmayincreasethevalueofthecompany.Butthereisthefip-sidetothisargument:Financingthecompanywithmoredebtmaybebadiftheriskoffnancialdistress—diffcultypayinglegalobligations—outweighsthebeneftsfromtaxdeductibilityofinterest.So,repurchasingsharesfromthisperspectivewouldhavetobejudgedonacase-by-casebasistodetermineifit’sbenefcialordetrimental.Onemorereasonforastockrepurchaseisthatitreducestotaldividendpayments—withoutseemingto.Ifthecorporationcutsdownonthenumberofsharesoutstanding,thecorporationcanstillpaythesameamountofdividends pershare ,butthe total dividendpaymentsarereduced.Ifthesharesarecorrectlyvaluedinthemarket(thereisnoreasontobelieveotherwise),thepaymentfortherepurchasedsharesequalsthereductioninthevalueofthecompany—andtheremainingsharesareworththesameastheywerebefore.Somearguethatarepurchaseisasignalaboutfutureprospects.Thatis,bybuyingbacktheshares,themanagementiscommunicatingtoinvestorsthatthecompanyisgeneratingsuffcientcashtobeabletobuybackshares.
150 FINANCIALMANAGEMENT Butdoesthismakesense?Notreally.Ifthecompanyhasproftableinvest-mentopportunities,thecashcouldbeusedtofnancetheseinvestments,insteadofpayingitouttotheshareholders.Astockrepurchasemayalsoreduceagencycostsbyreducingtheamountofcashthemanagementhasonhand.Similartotheargumentsuggestedfordividendpayments,repurchasingsharesreducestheamountoffreecashfowand,therefore,reducesthepossibilitythatmanagementwillinvestitunproftably.Manycompaniesusestockbuybackstomitigatethedilu-tionresultingfromexecutivestockoptions,aswellastoshoreuptheirstockprice.Repurchasingsharestendstoshrinkthecompany:Cashispaidoutandthevalueofthecompanyissmaller.Canrepurchasingsharesbeconsistentwithwealthmaximization?Yes.Ifthebestuseoffundsistopaythemouttoshareholders,repurchasingsharesmaximizesshareholders’wealth.Ifthecompanyhasnoproftableinvestmentopportunities,itisbetterforacompanytoshrinkbypayingfundstotheshareholdersthantoshrinkbyinvestinginlousyinvestments.Sohowdoesthemarketreacttoacompany’sintentiontorepurchaseshares?Anumberofstudieshavelookedathowthemarketreactstosuchannouncements.Ingeneral,thesharepricegoesupwhenacompanyan-nouncesitisgoingtorepurchaseitsownshares.Itisdiffculttoiden-tifythereasonthemarketreactsfavorablytosuchannouncementssincesomanyotherthingsarehappeningatthesametime.Bypiecingbitsofevidencetogether,however,weseethatitislikelythatinvestorsviewtheannouncementofarepurchaseasgoodnews—asignalofgoodthingstocome. THEBOTTOMLINE Companiesmaydistributefundstoownersintheformofperiodiccashdividends.Acompany’sboardofdirectorsdecidesontheamountandtimingofdividends. Companiesmaymakestockdividendsorsplitthestock.Thoughnotaneventthatresultsinanyeconomicvaluetoowners,investorsofteninterpretthedecisiontopayastockdividendortosplitthestockasconveyinginformationaboutthecompany’sfutureprospects. Thereareseveraltheoriesrelatedtowhycompaniespaydividends,includingthedividendirrelevancetheory,thebird-in-the-handtheory,thetax-preferencetheory,signalingtheory,andagencytheory.
DividendandDividendPolicies 151 Asanalternativetopayingdividends,acompanymaychoosetodis-tributefundstoshareholdersbyrepurchasingitsownstockfromshare-holders,eitherthroughatenderoffer,openmarketpurchases,orablockrepurchase. SOLUTIONSTOTRYIT!PROBLEMS Dividends Dividendspershare $ 2 Earningspershare $ 5 Dividendpayoutratio 40% Retentionratio 60% StockDistributionsCaseExpectedPricePerSharePost-DistributionNumberofSharesOutstandingPost-Distribution A$25.002millionB$13.332.25millionC$25.002millionD$32.001.25million QUESTIONS 1. Distinguishbetweenthedividendpayoutratioandthedividendpershare. 2. Ifacompanyhasadividendpayoutratioof80%,whatisthecompany’sretentionratio? 3. Ifacompanyhasadividendpershareof$2andearningspershareof$8,whichisthecompany’sdividendpayoutratio? 4. Whatarethebeneftsfromtheperspectiveofashareholderofadividendreinvestmentplan? 5. Whatisthedifferencebetweenastockdividendandastocksplit? 6. Whywouldacompanywanttouseareversestocksplit? 7. Ifacompanysplitsitsstock,whatistheexpectedeffectonthestock’sshareprice?
152 FINANCIALMANAGEMENT 8. Whymightacompany“pay”asastockdividend? 9. Listthethreepossibleexplanationsforwhycompaniespaycashdivi-dends. 10. Identifythreedifferentmethodsthatacompanycanusetorepurchaseitsownstockfrominvestors. 11. Completethefollowingtable: StockPricePerShareBeforeDistributionNumberofSharesOutstandingBeforetheDistributionDistributionExpectedPricePerShareAftertheDistributionNumberofSharesOutstandingAftertheDistribution ABC$201million2:1DEF$400.5million1:5GHI$252million2.5:1 12. Supposeacompanywithnetincomeof$200millionand3millionsharesoutstandingpays$50millionincashdividends. a. Whatisthedividendpayoutratio? b. Whatisthedividendpershare? 13. Ifacompany’sstockhasadividendpershareof$2andearningspershareof$5,whatisthecompany’sretentionratio? 14. Thefollowingisfromthe2008AnnualReportofPhilipsCompanyre-gardingitsdividendpolicy(www.annualreport2008.philips.com/pages/investor information/dividend policy.asp) Ouraimistosustainablygrowourdividendovertime.Philips’presentdividendpolicyisbasedonanannualpay-outratioof40to50%ofcontinuingnetincome. Whatdoesthismean? 15. Thefollowingexcerptsaretakenfrom“DividendPolicyDeterminants:AnInvestigationoftheInfuencesofStakeholderTheory”byMarkE.Holder,FrederickW.Langrehr,andJ.LawrenceHexter,publishedintheAutumn1998issueof FinancialManagement : Thereisconsiderabledebateonhowdividendpolicyaffectsfrmvalue.Someresearchersbelievethatdividendsincreaseshareholderwealth ... ,othersbelievethatdividendsareirrele-vant ... ,andstillothersbelievethatdividendsdecreaseshare-holderwealth.
DividendandDividendPolicies 153 a. Whataretheargumentsinsupportofthedividendpolicyincreasingshareholderwealth? b. Whataretheargumentsinsupportoftheirrelevanceofdividendpolicy? c. Whataretheargumentsinsupportofthedividendpolicydecreasingshareholderwealth? Onegroupoffnancialtheorists ... providesahypothesisfordividendpolicyirrelevance.Thisgroupbasesitstheoryontheassumptionsof1)perfectcapitalmarkets ... ;2)rationalbehav-ioronthepartofparticipantsinthemarket,valuingsecuritiesbasedonthediscountedvalueoffuturecashfowsaccruingtoinvestors;3)certaintyabouttheinvestmentpolicyofthefrmandcompleteknowledgeofthesecashfows;and4)managersthatactasperfectagentsoftheshareholders. d. Whatismeantbyaperfectcapitalmarket? e. Whatisassumedaboutthecompany’sinvestmentpolicy? f. Whatismeantby“managersthatactasperfectagentsoftheshare-holders”?
CHAPTER 8 TheCorporateFinancingDecision Howmuchdoesthecompanyowe,andhowmuchdoesitown?Debtversusequity.It’sjustthekindofthingaloanoffcerwouldwanttoknowaboutyouindecidingifyouareagoodcreditrisk.Anormalcorporatebalancesheethastwosides.Ontheleftsidearetheassets(inventories,receivables,plantandequipment,etc.).Therightsideshowshowtheassetsarefnanced.Onequickwaytodeterminethefnancialstrengthofacompanyistocomparetheequitytothedebtontherightsideofthebalancesheet. —PeterLynchwithJohnRothchild, OneUponWallStreet (NewYork:PenguinBooks,1989),p.201 A businessinvestsinnewplantandequipmenttogenerateadditionalrev-enuesandincome—thebasisforitsgrowth.Onewaytopayforin-vestmentsistogeneratecapitalfromthecompany’soperations.Earningsgeneratedbythecompanybelongtotheownersandcaneitherbepaidtothem—intheformofcashdividends—orplowedbackintothecompany.Theowners’investmentinthecompanyisreferredtoas owners’eq-uity or,simply, equity. Ifearningsareplowedbackintothecompany,theownersexpectittobeinvestedinprojectsthatwillenhancethevalueofthecompanyand,hence,enhancethevalueoftheirequity.Butearningsmaynotbesuffcienttosupportallproftableinvestmentopportunities.Inthatcasemanagementisfacedwithadecision:Foregoproftableinvestmentopportunitiesorraiseadditionalcapital.Newcapitalcanberaisedbyeitherborrowingorsellingadditionalownershipinterestsorboth.Werefertothemixofdebtandequitythatacompanyusesasits capitalstructure. Thedecisionabouthowthecompanyshouldbefnanced,whetherwithdebtorequity,isreferredtoasthe capitalstructuredecision .Inthischap-ter,wediscussthecapitalstructuredecision.Therearedifferenttheories 155
156 FINANCIALMANAGEMENT abouthowthecompanyshouldbefnancedandwereviewthesetheoriesinthischapter. DEBTVS.EQUITY Thecapitalstructureofacompanyissomemixofthethreesourcesofcapital:debt,internallygeneratedequity,andnewequity.Butwhatistherightmixture?Thebestcapitalstructuredependsonseveralfactors.Ifacompanyfnancesitsactivitieswithdebt,thecreditorsexpecttheinterestandprincipal—fxed,legalcommitments—tobepaidbackaspromised.Failuretopaymayresultinlegalactionsbythecreditors.Ifthecompanyfnancesitsactivitieswithequity,theownersexpectareturnintermsofcashdividends,anappreciationofthevalueoftheequityinterestor,asismostlikely,somecombinationofboth.Supposeacompanyborrows$100millionandpromisestorepaythe$100millionplus$5millioninoneyear.Considerwhatmayhappenwhenthe$100isinvested: So,ifthecompanyreinveststhefundsandgeneratesmorethanthe$100million + $5million = $105million,thecompanykeepsalltheprofts.Butiftheprojectgenerates$105millionorless,thelenderstillgetsherorhis$5million—butthereisnothingleftforthecompany’sowners.Thisisthebasicideabehind fnancialleverage —theuseoffnancingthathasfxed,butlimitedpayments.Ifthecompanyhasabundantearnings,theownersreapallthatremainsoftheearningsafterthecreditorshavebeenpaid.Ifearningsarelow,the
TheCorporateFinancingDecision 157 creditorsstillmustbepaidwhattheyaredue,leavingtheownersnothingoutoftheearnings.Failuretopayinterestorprincipalaspromisedmayresultinfnancialdistress. Financialdistress istheconditionwhereacom-panymakesdecisionsunderpressuretosatisfyitslegalobligationstoitscreditors.Thesedecisionsmaynotbeinthebestinterestsoftheownersofthecompany.Withequityfnancingthereisnoobligation.Thoughthecompanymaychoosetodistributefundstotheownersintheformofcashdividends,thereisnolegalrequirementtodoso.Furthermore,interestpaidondebtisdeductiblefortaxpurposes,whereasdividendpaymentsarenottaxde-ductible.Onemeasureoftheextentdebtisusedtofnanceacompanyisthe debtratio, theratioofdebttoequity:Debtratio = Debt EquityThisisrelativemeasureofdebttoequity.Thegreaterthedebtratio,thegreateristheuseofdebtforfnancingoperationsrelativetoequityfnancing.Anothermeasureisthe debt-to-assetsratio, whichistheextenttowhichtheassetsofthecompanyarefnancedwithdebt:Debt-to-assetsratio = Debt TotalassetsThisistheproportionofdebtinacompany’scapitalstructure,measuredusingthebook,orcarryingvalueofthedebtandassets.Itisoftenusefultofocusonthelong-termcapitalofacompanywhenevaluatingthecapitalstructureofacompany,lookingattheinterest-bearingdebtofthecompanyincomparisonwiththecompany’sequityorwithitscapital.The capital ofacompanyisthesumofitsinterest-bearingdebtanditsequity.Thedebtratiocanberestatedastheratiooftheinterest-bearingdebtofthecompanytothecompany’sequity:Debt-equityratio = Interest-bearingdebt Equityandthedebt-to-assetscanberestatedastheproportionofinterest-bearingdebtofthecompany’scapital:Debt-equityratio = Interest-bearingdebt Totalcapital
158 FINANCIALMANAGEMENT Byfocusingonthelong-termcapital,theworkingcapitaldecisionsofacompanythataffectcurrentliabilitiessuchasaccountspayable,areremovedfromthisanalysis.Theequitycomponentofalloftheseratiosisoftenstatedinbook,orcarryingvalueterms.However,whentakingamarketsperspectiveofthecompany’scapitalstructure,itisoftenusefultocomparedebtcapitalwiththemarketvalueofequity.Inthislatterformulation,forexample,thetotalcapitalofthecompanyisthesumofthemarketvalueofinterest-bearingdebtandthemarketvalueofequity.Ifmarketvaluesofdebtandequityarethemostusefulfordecision-making,shouldmanagementignorebookvalues?No,becausebookval-uesarerelevantindecision-makingalso.Forexample,bondcovenantsareoftenspecifedintermsofbookvaluesorratiosofbookvalues.Asanotherexample,dividendsaredistinguishedfromthereturnofcapitalbasedontheavailabilityofthebookvalueofretainedearnings.Therefore,thoughthefocusisprimarilyonthemarketvaluesofcapital,managementmustalsokeepaneyeonthebookvalueofdebtandequityaswell.Thereisatendencyforcompaniesinsomesectorsandindustriestousemoredebtthanothers.Wecanmakesomegeneralizationsaboutdifferencesincapitalstructuresacrosssectors: Companiesthataremorereliantuponresearchanddevelopmentfornewproductsandtechnology—forexample,pharmaceuticalcompanies—tendtohavelowerdebt-to-assetratiosthancompanieswithoutsuchresearchanddevelopmentneeds. Companiesthatrequirearelativelyheavyinvestmentinfxedassetstendtohavelowerdebt-to-assetratios.Consideringthesegeneralizationsandotherobservationsrelatedtodif-feringcapitalstructures,whydosomeindustriestendtohavecompanieswithhigherdebtratiosthanotherindustries?Byexaminingtheroleoff-nancialleveraging,fnancialdistress,andtaxes,wecanexplainsomeofthevariationindebtratiosamongindustries.Andbyanalyzingthesefactors,wecanexplainhowthecompany’svaluemaybeaffectedbyitscapitalstructure. CapitalStructureandFinancialLeverage Debtandequityfnancingcreatedifferenttypesofobligationsforthecom-pany.Debtfnancingobligatesthecompanytopaycreditorsinterestandprincipal—usuallyafxedamount—whenpromised.Ifthecompanyearnsmorethannecessarytomeetitsdebtpayments,itcaneitherdistributethe
TheCorporateFinancingDecision 159 surplustotheownersorreinvest.Equityfnancingdoesnotobligatethecom-panytodistributeearnings.Thecompanymaypaydividendsorrepurchasestockfromtheowners,butthereisnoobligationtodoso. Creditorshavebettermemoriesthandebtors.—BenjaminFranklin Thefxedandlimitednatureofthedebtobligationaffectstheriskoftheearningstotheowners.Weillustratetheeffectonearningsusingthreedifferentcompanies,eachwithadifferentcapitalstructure: CompanyNL,withnodebt CompanyL,withsomedebt CompanyLL,withlotsofdebtLet’sassumethateachcompanyhas$100millioninassets.CompanyNLfnancestheseassetscompletelywithequity.CompanyLfnancesitsassetswith25%debtand75%equity,whileCompanyLLfnancesitsassetswith75%debtand25%equity: InMillionsCompanyNLCompanyLCompanyLL Assets$100$100$100Debt$0$25$75Equity$100$75$25Theleverageratiosofthesecompaniesaretherefore: CompanyNLCompanyLCompanyLL Debt-equity0%33%300%Debt-to-assets0%25%75%Let’sfurtherassumethatthecompanieshaveidenticaloperatingearn-ings,$10million,andthatanydebthasaninterestrateof5%. 1 Operatingearningsaretheincomefromtheoperationsofthebusiness(thatis,revenueslesscostofgoodssoldandoperatingexpenses),butbeforeanyoutlaystothe 1 Assumingthattheinterestrateondebtisthesame,nomattertheleverage,thiswillatleasthelpillustratetheimmediateissues.
160 FINANCIALMANAGEMENT providersofcapital,suchasinterestondebtanddividendstoowners.Let’salsoassume,forrightnow,thattherearenotaxesonincome.Therefore,thenetincomeofthesecompaniesis: CompanyNLCompanyLCompanyLL Operatingearnings$10.00$10.00$10.00Interestondebt0.002.253.75Netincome$10.00$8.75$6.25Andthereturnonassetsandreturnonequityforeachare: CompanyNLCompanyLCompanyLL Returnonassets10.00%8.75%6.25%Returnonequity10.00%11.67%25.00%Thereturnonassetsistheratioofthecompany’snetincometoitstotalassets,whereasthereturnonequityistheratioofthecompany’snetincometoowners’equity.CompanyLLhasthehighestreturnonequity,thoughthelowestreturnonassets.ThisisbecauseCompanyLLpaysthehigherinterestondebt,whichlowersnetincomeandhenceproducesthelowerreturnonassets,buthasthelowestamountofequity,sowhenthelowerincomeiscomparedtothelowershareholders’equity,CompanyLLhasthehighestreturntoshareholders.Nowlet’sassumethatoperatingearningsare,instead,$4million.Inthiscase: CompanyNLCompanyLCompanyLL Operatingearnings$4.00$4.00$4.00Interestondebt$0.00 $1.25 $3.75 Netincome$4.00$2.75$0.25Andthereturnsare: CompanyNLCompanyLCompanyLL Returnonassets4.00%2.75%0.25%Returnonequity4.00%3.67%1.00%
TheCorporateFinancingDecision 161 Inthiscase,CompanyLLhasthelowestnetincomeandthelowestreturns. Whenyoucombineignoranceandleverage,yougetsomeprettyinterestingresults.—WarrenBuffett Thisexampleillustratestheroleofdebtfnancingontheriskassociatedwithearnings:thegreatertheuseofdebtvis-`a-visequity,thegreatertheriskassociatedwithearningstoowners.Or,usingtheleverageterminology,thegreaterthedegreeoffnancialleverage,thegreaterthefnancialrisk.Theeffectoffnancialriskinadditiontotheoperatingriskmagnifestherisktotheowners.Comparingtheresultsofeachofthethreecompaniesprovidesinfor-mationontheeffectsofusingdebtfnancing.Asmoredebtisusedinthecapitalstructure,thegreaterthe“swing”inreturns,asweshowinExhibit8.1forarangeofoperatingearningsforCompaniesNL,L,andLL.Aninterestingexerciseistoseeatwhichlevelofearningsthereturnsarethesamefortwoormoredifferenttypesoffnancing.Inourexample,whenoperatingearningsare$5million,thereturnsonequityforCompanyNL, –60%–40%–20%0%20%40%60%$2($1)($4)($7)($10)$5$8$11$14 Return on Equity Operating Earnings Company NL Company L Company LL EXHIBIT8.1 ReturnstoEquityforCompanyNL,CompanyL,andCompanyLL,IgnoringTaxesandAssumingInterestonDebtof5%
162 FINANCIALMANAGEMENT CompanyL,andCompanyLLarethesameat5%.Therefore,thebreak-evenoperatingearningsforthesecompanies—beforeweconsidertaxesandas-sumingthattheinterestondebtisthesameacrosscompanies—is$5million. TRYIT!RETURNSWITHLEVERAGE Supposewehaveanothercompany,CompanySL,thathasthesameinterestrateondebtasCompanyLinourexample.Ifweassumethattherearenotaxes,completethefollowingifCompanySLhasacapitalstructureof$50milliondebtand$50equity: InMillions Operatingearnings$5.00Interestondebt Netincome Returnonassets Returnonequity InterestDeductibility IntheUnitedStates,theinterestabusinesspaysondebtisdeductiblefortaxpurposes.Becausedividendspaidonstockarenotdeductible,thisde-ductibilityofinterestondebtprovidesadistinctadvantagetousingdebtbecauseiteffectivelylowersthecostofthisformoffnancing.Let’scontinueourexample,butnowintroducetaxes.Assumingthatallthreecompaniespaytaxesatarateof30%ontaxableincome,weseethatthisdeductibilityincreasesthenetincomeofthecompaniesfnancedwithdebt,relativetotheno-taxcase.Ifoperatingearningsare$10million,then: InMillionsCompanyNLCompanyLCompanyLL Operatingearnings$10.00$10.00$10.00Interestondebt$0.00 $1.25 $3.75 Taxableincome$10.00$8.75$6.25Taxesat30%$3.00 $2.63 $1.88 Netincome$7.00$6.13$4.38Returnonassets7.00%6.13%4.38%Returnonequity7.00%8.17%17.50%
TheCorporateFinancingDecision 163 Andifoperatingearningsare$4million,then: InMillionsCompanyNLCompanyLCompanyLL Operatingearnings$4.00$4.00$4.00Interestondebt$0.00 $1.25 $3.75 Taxableincome$4.00$2.75$0.25Taxesat30%$1.20 $0.83 $0.08 Netincome$2.80$1.93$0.18Returnonassets2.80%1.93%0.18%Returnonequity2.80%2.57%0.70%Thedeductibilityofinterestrepresentsaformofagovernmentsubsidyoffnancingactivities.Byallowinginteresttobedeductedfromtaxableincome,thegovernmentissharingthecompany’scostofdebt.Whobeneftsfromthistaxdeductibility?Theowners.Aninterestingelementintroducedintothecapitalstructuredecisionisthereductionoftaxesduetothepaymentofinterestondebt.Werefertothebeneftfrominterestdeductibilityasthe interesttaxshield , becausetheinterestexpenseshieldsincomefromtaxation.ThetaxshieldfrominterestdeductibilityisInteresttaxshield = Taxrate × InterestexpenseCompanyLhas$25millionof5%debtandissubjecttoataxof30%onnetincome,thetaxshieldisTaxshield = 0 . 30($25 × 0 . 05) = 0 . 30 × $1 . 25 = $0 . 375millionA$1.25millioninterestexpensemeansthat$1.25millionofincomeisnottaxedat30%,savingthecompany$0.375million.CompanyLL,withmoredebt,hasataxshieldofthefollowing:Taxshield = 0 . 30($75 × 0 . 05) = 0 . 30 × $3 . 75 = $1 . 125millionRecognizingthattheinterestexpenseistheinterestrateonthedebt, r d ,multipliedbythefacevalueofdebtthetaxshieldforacompanyisTaxshield = Taxrate × Interestrate × FacevalueofdebtWeshouldspecifythatthetaxrateisthe marginaltaxrate — thetaxrateonthenextdollarofincome.
164 FINANCIALMANAGEMENT Howdoesthistaxshieldaffectthevalueofthecompany?Thetaxshieldreducesthenetincomeofthecompanythatgoestopaytaxes.Andbecausemanagementisconcernedwithhowinterestprotectsincomefromtaxation,thefocusshouldbeonhowitshieldstaxableincomebeyondtheincomethatisshieldedbyallothertaxdeductibleexpenses.Aslongasthecompanycanusethesetaxshields—thatis,itgeneratesincomethatinterestreduces—thetaxshieldisvaluabletoowners. TRYIT!RETURNSWITHLEVERAGEANDTAXES Supposewehaveanothercompany,CompanySL,thathasthesameinterestrateondebtasCompanyLinourexample.Ifweassumeataxrateof30%,completethefollowingifCompanySLhasacapitalstructureof$50milliondebtand$50equity: InMillions Operatingearnings$5.00Interestondebt Taxableincome Taxes Netincome Returnonassets Returnonequity FINANCIALLEVERAGEANDRISK Theuseoffnancialleverage(thatis,theuseofdebtinfnancingacompany)increasestherangeofpossibleoutcomesforownersofthecompany.Aswesawpreviously,theuseofdebtfnancing,relativetoequityfnancing,increasesboththeupsideanddownsidepotentialearningsforowners.Inotherwords,fnancialleverageincreasestherisktoowners.Nowthatweunderstandthebasicsofleverage,let’squantifyitseffectontheriskofearningstoowners.Anotherwaytoviewthechoiceoffnancingistocalculatethedegreeoffnancialleverage,denotedbyDFL,whichistheratioofoperatingearningstoearningsafterdeductinginterest:DFL = Operatingearnings Operatingearnings − Interest
TheCorporateFinancingDecision 165 CalculatingtheDFLforthethreecompaniesatdifferentlevelsofoper-atingearnings,weseethedifferencesinDFLamongthethreecompanies,withCompanyLLhavingthehighestdegreeoffnancialleverage: DFL OperatingEarningsinMillionsCompanyNLCompanyLCompanyLL $41.001.4516.00$51.001.334.00$61.001.262.67$71.001.222.15$81.001.191.88$91.001.161.71$101.001.141.60TheinterpretationoftheDFLissimilartoanyelasticitymeasure:IftheDFLis4,thismeansa1%changeinoperatingearningswillproducea1% × 4 = 4%changeinearningstoowners.Equityownerscanreapmostoftherewardsthroughfnancialleveragewhentheircompanydoeswell.Buttheymaysufferadownsidewhenthecompanydoespoorly.Whathappensifearningsaresolowthatitcannotcoverinterestpayments?Interestmustbepaidnomatterhowlowtheearn-ings.Howdoesacompanyobtainmoneywithwhichtopayinterestwhenearningsareinsuffcient? Byreducingtheassetsinsomeway,suchasusingworkingcapitalneededforoperationsorsellingbuildingsorequipment Bytakingonmoredebtobligations ByissuingmoresharesofstockWhicheverthecompanychooses,theburdenultimatelyfallsupontheowners. LeverageandFinancialFlexibility Theuseofdebtalsoreducesacompany’sfnancialfexibility.Acompanywithdebtcapacitythatisunused,sometimesreferredtoas fnancialslack ,ismorepreparedtotakeadvantageofinvestmentopportunitiesinthefuture.Thisabilitytoexploitthesefuture,strategicoptionsisvaluableand,hence,takingondebtincreasestheriskthatthecompanymaynotbesuffcientlynimbletoactonvaluableopportunities.
166 FINANCIALMANAGEMENT Thereisevidencethatsuggeststhatcompaniesthathavemorecashfowvolatilitytendtobuildupmorefnancialslackand,hence,theirinvestmentsarenotassensitivetotheirabilitytogeneratecashfowsinternally.Rather,thefnancialslackallowsthemtoexploitinvestmentopportunitieswithoutrelyingonrecentinternallygeneratedcashfows.Inthecontextoftheeffectofleverageonrisk,thismeansthatcompaniesthattendtohavehighlyvolatileoperatingearningsmaywanttomaintainsomeleveloffnancialfexibilitybynottakingonsignifcantleverageintheformofdebtfnancing. GovernanceValueofDebtFinancing Acompany’suseofdebtfnancingmayprovideadditionalmonitoringofacompany’smanagementanddecisions,reducingagencycosts.Agencycostsarethecoststhatarisefromtheseparationofthemanagementandtheownershipofacompany,whichisparticularlyacuteinlargecorporations.Thesecostsarethecostsnecessarytoresolvetheagencyproblemthatmayexistbetweenmanagementandownershipofthecompanyandmayincludethecostofmonitoringcompanymanagement.Thesecostsincludethecostsassociatedwiththeboardofdirectorsandprovidingfnancialinformationtoshareholdersandotherinvestors.Anagencyproblemthatmayariseinacompanyishoweffectivelyacompanyusesitscashfows.Thefreecashfowofacompanyis,basically,itscashfowlessanycapitalexpendituresanddividends.Onetheorythathasbeenwidelyregardedisthatbyusingdebtfnancing,thecompanyreducesitsfreecashfowsand,therefore,itmustreenterthedebtmarkettoraisenewcapital. 2 Itisarguedthatthisbeneftsthecompanyintwoways.First,therearefewerresourcesundercontrolofmanagementandlesschanceofwastingtheseresourcesinunproftableinvestments.Second,thecontinualdependenceofthedebtmarketforcapitalimposesamonitoringorgovernancedisciplineonthecompanythatwouldnothavebeenthereotherwise.Ifweassumethattherearenodirectorindirectcoststofnancialdistress,thecostofcapitalforthecompanyshouldbethesame,nomatterthemethodoffnancing.Iftheoperatingearningsare$7.14million,whichproducesareturnonequityof5%forCompanyNL(thatis,netincomedividedbyequity)andthecostofcapitalis5%,thedebtaddstothevalueofequity,benefttingowners,asweshowinExhibit8.2. 2 MichaelC.Jensen,“AgencyCostofFreeCashFlow,CorporateFinance,andTakeovers,” AmericanEconomicReview 76(1986):323–329.
TheCorporateFinancingDecision 167 EXHIBIT8.2 ValueAddedbytheTaxDeductibilityofDebt InMillionsCompanyNLCompanyLCompanyLL Operatingincome$7.14$7.14$7.14Interestexpense0.00 1.25 3.75 Taxableincome$7.14$5.89$3.39Taxesat30%2.14 1.77 1.02 Incometoowners$5.00 $4.13 $2.38 Incometothegovernment$2.14$1.77$1.02Incometocreditors0.001.253.75Incometoowners5.00 4.13 2.38 Incometoall$7.14 $7.14 $7.14 Valuetocreditors$0.00$25.00$75.00Valuetoowners100.00 82.50 47.50 Valueofcompany$100.00 $107.50 $122.50 Capitalcontributedby:Creditors$0.00$25.00$75.00Owners100.00 75.00 25.00 Totalcontributedcapital$100.00 $100.00 $100.00 Valueaddedbythetaxdeductibilityofdebt$0.00$7.50$22.50Returnonequity5.00%5.50%9.50% AfewnotesaboutwhatweshowinExhibit8.2: 1. Theincometoownersislessatthisreturnonequityifthecompanyhasmoredebt,butthecapitalcontributedbyownersislessifdebtfnancingisused. 2. Theincometothegovernmentislessasmoredebtisusedbecausemoreincomeisshieldedfromtaxation. 3. Thevaluetocreditorsisthefaceamountofthedebt,whereasthevaluetoownersistoday’svalueoftheincometoowners,valuedasaperpetuity(thatis,incomedividedbythecostofequity,5%). 4. Theownersreapthebeneftsfromtheuseofdebt,withmorevalue-addedasmoredebtisused. 5. Theownershaveagreaterreturnontheirinvestment,asmeasuredbythereturnonequity,themoredebtfnancinginrelationtoequity.
168 FINANCIALMANAGEMENT FINANCIALDISTRESS Acompanythathasdiffcultymakingpaymentstoitscreditorsisinfnancialdistress.Notallcompaniesinfnancialdistressultimatelyenterintothelegalstatusofbankruptcy.However,extremefnancialdistressmayverywellleadtobankruptcy. 3 TheRoleofLimitedLiability Limitedliability limitsowners’liabilityforobligationstotheamountoftheiroriginalinvestmentinthesharesofstock.Limitedliabilityforownersofsomeformsofbusinesscreatesavaluablerightandaninterestingincen-tiveforshareholders.Thisvaluablerightistherighttodefaultonobligationstocreditors—thatis,therightnottopaycreditors.Becausethemostshare-holderscanloseistheirinvestment,thereisanincentiveforthecompanytotakeonveryriskyprojects:Iftheprojectsturnoutwell,thecompanypayscreditorsonlywhatitowesandkeepstheremainderandiftheprojectsturnoutpoorly,itpayscreditorswhatitowes—ifthereisanythingleft.Thefactthatownerswithlimitedliabilitycanloseonlytheirinitialinvestment—theamounttheypaidfortheirshares—createsanincentiveforownerstotakeonriskierprojectsthaniftheyhadunlimitedliability:Theyhavelittletoloseandmuchtogain.Ownersofacompanywithlimitedliabilityhaveanincentivetotakeonriskyprojectssincetheycanonlylosetheirinvestmentinthecompany.Buttheycanbeneftsubstantiallyifthepayoffontheinvestmentishigh.YoucanseethisbylookingbackatExhibit8.2.ThereturnonequityforCompanyLLismuchmorethanthatofCompanyNL. 4 Forcompanieswhoseownershavelimitedliability,themoretheassetsarefnancedwithdebt,thegreatertheincentivetotakeonriskyprojects,leavingcreditors“holdingthebag”iftheprojectsturnouttobeunproftable.Thisisaproblemforitposesaconfictofinterestbetweenshareholders’interestsandcreditors’interests.Theinvestmentdecisionsaremadebyman-agement(whorepresenttheshareholders)and,becauseoflimitedliability,thereisanincentiveformanagementtoselectriskierprojectsthatmayharmcreditorswhohaveentrustedtheirfunds(bylendingthem)tothecompany. 3 Whilebankruptcyisoftenaresultoffnancialdiffcultiesarisingfromproblemsinpayingcreditors,somebankruptcyflingsaremadepriortodistresswhenalargeclaimismadeonassets(forexample,classactionliabilitysuit). 4 Aslongasthereturnonequityisabovethebreak-evenpoint,thereturnontheleveredcompanyisgreaterthanthereturnonthenonleveredcompany.Belowthatbreak-evenpointiswheretheadvantageoflimitedliabilitylies.
TheCorporateFinancingDecision 169 Therighttodefaultisa calloption :Theownershavetheoptiontobuybacktheentirecompanybypayingoffthecreditorsatthefacevalueoftheirdebt.Aswithothertypesofoptions,theoptionismorevaluable,theriskierthecashfows.However,creditorsareawareofthisanddemandahigherreturnondebt(andhenceahighercosttothecompany).JensenandMecklinganalyzetheagencyproblemsassociatedwithlimitedliability. 5 Theyarguethatcreditorsareawareoftheincentivesthecompanyhastotakeonriskierprojects.Creditorswilldemandahigherreturnandmayalsorequireprotectiveprovisionsintheloancontract.Theresultisthatshareholdersultimatelybearahighercostofdebt. CostsofFinancialDistress Thecostsrelatedtofnancialdistresswithoutlegalbankruptcycantakedifferentforms.Forexample,tomeetcreditors’demands,acompanytakesonprojectsexpectedtoprovideaquickpayback.Indoingso,thefnancialmanagermaychooseaprojectthatdecreasesowners’wealthormayforgoaproftableproject.Anothercostoffnancialdistressisthecostassociatedwithlostsales.Ifacompanyishavingfnancialdiffculty,potentialcustomersmayshyawayfromitsproductsbecausetheymayperceivethecompanyunabletoprovidemaintenance,replacementparts,andwarranties.Lostsalesduetocustomerconcernsrepresentacostoffnancialdistress—anopportunitycost,somethingofvalue(sales)thatthecompanywouldhavehadifitwerenotinfnancialdiffculty.Stillanotherexampleofacostoffnancialdistressisthecostassociatedwithsuppliers.Ifthereisconcernoverthecompany’sabilitytomeetitsobligationstocreditors,suppliersmaybeunwillingtoextendtradecreditormayextendtradecreditonlyatunfavorableterms.Also,suppliersmaybeunwillingtoenterintolong-termcontractstosupplygoodsormaterials.Thisincreasestheuncertaintythatthecompanywillbeabletoobtaintheseitemsinthefutureandraisesthecostsofrenegotiatingcontracts. BankruptcyandBankruptcyCosts Whenacompanyishavingdiffcultypayingitsdebts,thereisapossibilitythatcreditorswillforeclose(thatis,demandpayment)onloans,causingthecompanytosellassetsthatcouldim-pairorceasethecompany’soperations.Butifsomecreditorsforcepayment, 5 MichaelC.JensenandWilliamH.Meckling,“TheoryoftheFirm:ManagerialBehavior,AgencyCosts,andOwnershipStructure,” JournalofFinancialEconomics 3(1976):305–360.
170 FINANCIALMANAGEMENT thismaydisadvantageothercreditors.Sowhathasdevelopedisanorderlywayofdealingwiththeprocessofthecompanypayingitscreditors—theprocessiscalled bankruptcy .BankruptcyintheUnitedStatesisgovernedbytheBankruptcyCode,whichisfoundunderU.S.CodeTitle11.AcompanymaybereorganizedunderChapter11ofthisCode,resultinginarestructuringofitsclaims,orliquidatedunderChapter7.Chapter11bankruptcyprovidesthetroubledcompanywithprotectionfromitscreditorswhileittriestoovercomeitsfnancialdiffculties.Acom-panythatflesbankruptcyunderChapter11continuesoperationsduringtheprocessofsortingoutwhichofitscreditorsgetpaidandhowmuch.Ontheotherhand,acompanythatflesunderbankruptcyChapter7,underthemanagementofatrustee,terminatesitsoperations,sellsitsassets,anddistributestheproceedstocreditorsandowners.Wecanclassify bankruptcycosts intodirectandindirectcosts.Directcostsincludethelegal,administrative,andaccountingcostsassociatedwiththeflingforbankruptcyandtheadministrationofbankruptcy.Theindirectcostsofbankruptcyaremorediffculttoevaluate.Operatingacompanywhileinbankruptcyisdiffcult,sincethereareoftendelaysinmakingde-cisions,creditorsmaynotagreeontheoperationsofthecompany,andtheobjectivesofcreditorsmaybeatvariancewiththeobjectiveofeffcientoperationofthecompany.Anotherindirectcostofbankruptcyisthelossinvalueofcertainassets.Ifthecompanyhasassetsthatareintangibleorforwhichtherearevaluablegrowthopportunitiesoroptions,itislesslikelytoborrowbecausethelossofvalueinthecaseoffnancialdistressisgreaterthan,say,acompanywithmarketableassets.Becausemanyintangibleassetsderivetheirvaluefromthecontinuingoperationsofthecompany,thedisruptionofoperationsduringbankruptcymaychangethevalueofthecompany.Theextenttowhichthevalueofabusinessenterprisedependsonintangiblesvariesamongindustriesandamongcompanies;sothepotentiallossinvaluefromfnancialdistressvariesaswell.Forexample,adrugcompanymayexperienceagreaterdisruptioninitsbusinessactivities,thansay,asteelmanufacturer,sincemuchofthevalueofthedrugcompanymaybederivedfromtheresearchanddevelopmentthatleadstonewproducts. FinancialDistressandCapitalStructure Therelationshipbetweenfnan-cialdistressandcapitalstructureissimple:Asmoredebtfnancingisused,fxedlegalobligationsincrease(interestandprincipalpayments),andtheabilityofthecompanytosatisfytheseincreasingfxedpaymentsdecreases.Therefore,asmoredebtfnancingisused,theprobabilityoffnancialdistressandthenbankruptcyincreases.
TheCorporateFinancingDecision 171 Foragivendecreaseinoperatingearnings,acompanythatusesdebttoagreaterextentinitscapitalstructure(thatis,acompanythatusesmorefnancialleverage),hasagreaterriskofnotbeingabletosatisfythedebtobligationsandincreasestheriskofearningstoowners.Anotherfactortoconsiderinassessingtheprobabilityoffnancialdis-tressisthebusinessriskofthecompany.Asdiscussedearlier,thebusinessriskinteractswiththefnancialrisktoaffecttheriskofthecompany.Management’sconcerninassessingtheeffectoffnancialdistressonthevalueofthecompanyisthepresentvalueoftheexpectedcostsoffnan-cialdistress.Andthepresentvaluedependsontheprobabilityoffnancialdistress:Thegreatertheprobabilityoffnancialdistress,thegreatertheexpectedcostsoffnancialdistress.Thepresentvalueofthecostsoffnancialdistressincreaseswiththeincreasingrelativeuseofdebtfnancingbecausetheprobabilityoffnancialdistressincreaseswithincreaseswithfnancialleverage.Inotherwords,asthedebtratioincreases,thepresentvalueofthecostsoffnancialdistressincreases,lesseningsomeofthevaluegainedfromtheuseoftaxdeductibilityofinterestexpense.Managementdoesnotknowtheprecisemannerinwhichtheprobabilityofdistressincreasesasthedebt-to-equityratioincreases.Yet,itisreasonabletothinkthatasthecompanyincreasesitsuseofdebt,relativetoequity,infnancingitsoperationsandassets: Thelikelihoodofdistressincreases. Thebeneftfromthetaxdeductibilityofinterestincreases. Thepresentvalueofthecostoffnancialdistressincreases. THECOSTOFCAPITAL Thecapitalstructureofacompanyisintertwinedwiththecompany’scostofcapital.The costofcapital isthereturnthatmustbeprovidedfortheuseofaninvestor’sfunds.Ifthefundsareborrowed,thecostisrelatedtotheinterestthatmustbepaidontheloan.Ifthefundsareequity,thecostisthereturnthatinvestorsexpect,bothfromthestock’spriceappreciationanddividends.Thecostofcapitalisa marginal concept.Thatis,thecostofcapitalisthecostassociatedwithraisingonemoredollarofcapital.Therearetworeasonsfordeterminingacorporation’scostofcapi-tal.First,thecostofcapitalisoftenusedasastartingpoint(abench-mark)fordeterminingthecostofcapitalforaspecifcproject.Oftenincapitalbudgetingdecisions,thecompany’scostofcapitalisadjustedupwardordownwarddependingonwhethertheproject’sriskismore
172 FINANCIALMANAGEMENT thanorlessthanthecompany’stypicalproject.Second,manyofacom-pany’sprojectshaverisksimilartotheriskofthecompanyasawhole.Sothecostofcapitalofthecompanyisareasonableapproximationforthecostofcapitalofoneofitsprojectsthatareunderconsiderationforinvestment.Acompany’scostofcapitalisthecostofitslong-termsourcesoffunds:debt,preferredstock,andcommonstock.Andthecostofeachsourcere-fectstheriskoftheassetsthecompanyinvestsin.Acompanythatinvestsinassetshavinglittleriskwillbeabletobearlowercostsofcapitalthanacompanythatinvestsinassetshavingahighrisk.Moreover,thecostofeachsourceoffundsrefectsthehierarchyoftheriskassociatedwithitsseniorityovertheothersources.Foragivencompany,thecostoffundsraisedthroughdebtislessthanthecostoffundsfrompreferredstockwhich,inturn,islessthanthecostoffundsfromcommonstock.Thisisbecausecreditorshaveseniorityoverpreferredshareholders,whohaveseniorityovercommonshareholders.Iftherearediffcultiesinmeetingobligations,thecreditorsreceivetheirpromisedinterestandprincipalbeforethepreferredshare-holderswho,inturn,receivetheirpromiseddividendsbeforethecommonshareholders.Foragivencompany,debtislessriskythanpreferredstock,whichislessriskythancommonstock.Therefore,preferredshareholdersrequireagreaterreturnthanthecreditorsandcommonshareholdersrequireagreaterreturnthanpreferredshareholders.Figuringoutthecostofcapitalrequiresustodeterminethecostofeachsourceofcapitalthecompanyexpectstouse,alongwiththerelativeamountsofeachsourceofcapitalthecompanyexpectstoraise.Puttingtogetherallthesepieces,thecompanycanthenestimatethemarginalcostofraisingadditionalcapital.Weestimatethecompany’scostofcapitalinthreesteps:
TheCorporateFinancingDecision 173 Weestimatetheproportionofeachsourceofcapitalusingthecom-pany’stargetcapitalstructure.Wedonotusebookvaluesofcapitalfromthebalancesheetbecausethesearehistoricalcostsandmaynotrepresenthowthecompanyintendstoraisenewcapital.Incalculatingthecostofeachfnancingsource,weestimatethecostofraisingadditionalcapitalfromeachsource;inotherwords,theirmarginalcosts.Thecostofdebtistheafter-taxcostofdebt,whichwecanestimatebyusingcurrentyieldsonthecompany’sdebt,multipliedbyoneminusthecompany’smarginaltaxrate.If r d isthemarginalcostofdebtbeforeadjustingfortaxesand t isthemarginaltaxrate,thentheafter-taxcostofdebt, r ∗ d ,is r ∗ d = r d × (1 − t )Whyadjustfortaxes?Becauseinterestondebtisdeductiblefortaxpurposes,sothecostofthedebtisnotthecurrentyield,butrathertheyieldadjustedforthetaxdeductibilityofinterest.Wecanestimatethecostofpreferredstockbyusingcurrentyieldsonthecompany’spreferredstock,ifapplicable.However,thecostofequityisbyfarmuchmorediffculttoestimate.Thereareseveralmodelsavailableforestimatingthecostofequity,includingthedividendvaluationmodelandthecapitalassetpricingmodel.Whatiscriticaltounderstandisthatthesedifferentmodelscangeneratesignifcantlydifferentestimatesforthecostofcommonstockand,asaresult,theestimatedcostofcapitalwillbehighlysensitivetothemodelselected.Inthecaseofbothpreferredstockandcommonstock,thereisnoadjustmentfortaxesbecausethedistributionstoshareholdersarepaidoutofafter-taxdollars.Inotherwords,dividendspaidonstockarenottaxdeductible.Thelaststepistoweightthecostofeachsourceoffundingbythepro-portionofthatsourceinthetargetcapitalstructure.Thisweightedaveragerepresentsthemarginalcostofraisinganadditional$1ofnewcapital.SeeExhibit8.3.Asacompanyadjustsitscapitalstructure,itscostofcapitalalsochanges.Uptoapoint,usingmoredebtrelativetoequitywilllowerthecostofcapitalbecausetheafter-taxcostofdebtislessthanthecostofequity.Thereissomepoint,however,whenthelikelihoodand,hence,costoffnancialdistressincreasesandmayinfactoutweighthebeneftfromtaxes.Afterthispoint—whereverthismaybe—thecostofbothdebtandequityincreasesbecausebotharemuchriskier.Therefore,thetrade-offtheoryofcapitalstructuredictatesthatasthecompanyusesmoredebtrelativetoequity,thevalueofthecompanyis
174 FINANCIALMANAGEMENT EXHIBIT8.3 ExampleoftheCostofCapitalCalculation Consideracompanywiththefollowinginformation: SourceofCapitalTargetCapitalStructureProportionsPretaxCostsofCapital Debt40%5%Preferredstock10%6%Commonstock50%12%Whatisthiscompany’scostofcapitalifthecompany’smarginaltaxrateis40%? Solution Theafter-taxcostofdebtis5% × (1 − 0.40) = 3%.Therefore,theweightedaverageofthecostsofcapitalis7.8%:Costofcapital = (40% × 3%) + (10% × 6%) + (50% × 12%) = 7 . 8%Thismeansthatforevery$1thecompanyplanstoobtainfromfnancing,thecostis7.8%. enhancedfromthebeneftoftheinteresttaxshields.Butthetheoryalsostatesthatthereissomepointatwhichthelikelihoodoffnancialdistressincreasessuchthatthereisanever-increasinglikelihoodofbankruptcy. 6 Therefore: Thevalueofthecompanydeclinesasmoreandmoredebtisused,relativetoequity. Thecostofcapitalincreasesbecausethecostsofthedifferentsourcesofcapitalincrease.Thoughthetrade-offtheorysimplifestheworldtoomuch,itgivesthemanagementanideaofthetrade-offsinvolved.Introducethevalueoffnancialfexibilityandthegovernancevalueofdebt,andmanagementhasthekeyinputstoconsiderinthecapitalstructuredecision. 6 ThisiswhywenotedearlierinthechapterthatweassumedthattheinterestondebtwasthesameforCompanyLandforCompanyLL,eventhoughthiswasnotrealistic.Becauseoftheincreasedlikelihoodofdistress,CompanyLL’scostofdebtshouldbehigherthanthatofCompanyL.
TheCorporateFinancingDecision 175 TRYIT!COSTOFCAPITAL Consideracompanywiththefollowinginformation: SourceofCapitalTargetCapitalStructureProportionsPretaxCostsofCapital Debt25%6.5%Commonstock75%10%Ifthecompany’smarginaltaxrateis40%,whatisthecompany’scostofcapital? OPTIMALCAPITALSTRUCTURE:THEORYANDPRACTICE Managementcantrytoevaluatewhetherthereisacapitalstructurethatmaximizesthevalueofthecompany.Thiscapitalstructure,ifitexists,isre-ferredtoasthe optimalcapitalstructure. However,evenifthecompany’sop-timalcapitalstructurecannotbedeterminedprecisely,managementshouldunderstandthatthereisaneconomicbeneftfromthetaxdeductibilityoftaxes,buteventuallythisbeneftmaybereducedbythecostsoffnancialdistress.Lookingatthefnancingbehaviorofcompaniesinconjunctionwiththeirdividendandinvestmentopportunities,wecanmakeseveralobservations: Companiespreferusinginternallygeneratedcapital(retainedearnings)toexternallyraisedfunds(issuingequityordebt). Companiestrytoavoidsuddenchangesindividends. Wheninternallygeneratedfundsaregreaterthanneededforinvestmentopportunities,companiespayoffdebtorinvestinmarketablesecurities. Wheninternallygeneratedfundsarelessthanneededforinvestmentop-portunities,companiesuseexistingcashbalancesorselloffmarketablesecurities. Ifcompaniesneedtoraisecapitalexternally,theyissuethesafestsecurityfrst;forexample,debtisissuedbeforepreferredstock,whichisissuedbeforecommonequity.
176 FINANCIALMANAGEMENT Thetrade-offamongtaxesandthecostsoffnancialdistressleadstothebeliefthatthereissomeoptimalcapitalstructure,suchthatthevalueofthecompanyismaximized.Yetitisdiffculttoreconcilethiswithsomeobservationsinpractice.Why?Onepossibleexplanationisthatthetrade-offanalysisisincomplete.Wedidn’tconsidertherelativecostsofraisingfundsfromdebtandequity.Becausetherearenoout-of-pocketcoststoraisinginternallygeneratedfunds(retainedearnings),itmaybepreferredtodebtandtoexternallyraisedfunds.Becausethecostofissuingdebtislessthanthecostofraisingasimilaramountfromissuingcommonstock(typicallyfotationcostsof2.2%versus7.1%),debtmaybepreferredtoissuingstock.Anotherexplanationforthedifferencesbetweenwhatweobserveandwhatwebelieveshouldexististhatcompaniesmaywishtobuildupfnancialslack , intheformofcash,marketablesecurities,orunuseddebtcapacity,toavoidthehighcostofissuingnewequity.Stillanotherexplanationisthatmanagementmaybeconcernedaboutthesignalgiventoinvestorswhenequityisissued.Ithasbeenobservedthattheannouncementofanewcommonstockissueisviewedasanegativesignal,sincetheannouncementisaccompaniedbyadropinthevalueoftheequityofthecompany.Itisalsoobservedthattheannouncementoftheissuanceofdebtdoesnotaffectthemarketvalueofequity.Therefore,managementmustconsidertheeffectthatthenewsecurityannouncementmayhaveonthevalueofequityandthereforemayshyawayfromissuingnewequity.Theconcernovertherelativecostsofdebtandequityandtheconcernovertheinterpretationbyinvestorsoftheannouncementofequityfnancingleadstoapreferredordering,or peckingorder , ofsourcesofcapital:frstinternalequity,thendebt,thenpreferredstock,thenexternalequity(newcommonstock).Aresultofthispreferredorderingisthatcompaniesprefertobuildupfunds,intheformofcashandmarketablesecurities,soasnottobeforcedtoissueequityattimeswheninternalequity(thatis,retainedearnings)isinadequatetomeetnewproftableinvestmentopportunities. 7 Modigliani-MillerTheoryofCapitalStructure FrancoModiglianiandMertonMillerprovideatheoryofcapitalstructurethatisaframeworkforthediscussionofthefactorsmostimportantinacom-pany’scapitalstructuredecision:taxes,fnancialdistress,andrisk.Though 7 Foramorecompletediscussionofthepeckingorderexplanation,especiallytheroleofasymmetricinformation,seeStewartC.Myers,“TheCapitalStructurePuzzle,” MidlandCorporateFinanceJournal 3(1985):65–76.
TheCorporateFinancingDecision 177 thistheorydoesnotgiveaprescriptionforcapitalstructuredecisions,itdoesofferamethodofexaminingtheroleoftheseimportantfactorsthatpro-videthefnancialmanagerwiththebasicdecision-makingtoolsinanalyzingthecapitalstructuredecision.Withintheirtheory,ModiglianiandMillerdemonstratethatwithouttaxesandcostsoffnancialdistress,thecapitalstructuredecisionisirrelevanttothevalueofthecompany.Thecapitalstructuredecisionbecomesvalue-relevantwhentaxesareintroducedintothesituation,suchthataninteresttaxshieldfromthetaxdeductibilityofinterestondebtobligationsencouragestheuseofdebtbe-causethisshieldbecomesasourceofvalue.Financialdistressbecomesrel-evantbecausecostsassociateddistressmitigatethebeneftsofdebtinthecapitalstructure,offsettingorpartiallyoffsettingthebeneftfrominterestdeductibility.Thevalueofacompany—meaningthevalueofallitsassets—isequaltothesumofitsliabilitiesanditsequity(theownershipinterest).Doesthewaywefnancethecompany’sassetsaffectthevalueofthecompanyandhencethevalueofitsowners’equity?Yes.Howdoesitaffectthevalueofthecompany? M&MIrrelevanceProposition FrancoModiglianiandMertonMillerde-velopedthebasicframeworkfortheanalysisofcapitalstructureandhowtaxesaffectthevalueofthecompany. 8 Theessenceofthisframeworkisthatwhatmattersinthevalueofthecompanyisthecompany’soperatingcashfowsandtheuncertaintyassociatedwiththesecashfows.ModiglianiandMiller(M&M)reasonedthatifthefollowingconditionshold,thevalueofthecompanyisnotaffectedbyitscapitalstructure: Condition1 : Individualsandcorporationscanborrowandlendatthesameterms(referredtoas equalaccess ). Condition2 : Thereisnotaxadvantageassociatedwithdebtfnancingvis-`a-vistoequityfnancing. Condition3 : Debtandequitytradeinamarketwhereassetsthataresubstitutesforoneanother,theytradeatthesameprice.Underthefrstcondition,individualscanborrowandlendonthesametermsasthebusinessentities.Therefore,ifindividualsareseekingagivenlevelofrisktheycaneither:(1)borroworlendontheirown,or(2)investinabusinessthatborrowsorlends.Inotherwords,ifanindividualinvestor 8 FrancoModiglianiandMertonH.Miller,“TheCostofCapital,CorporationFi-nance,andtheTheoryofInvestment,” AmericanEconomicReview 48(1958):261–297.
178 FINANCIALMANAGEMENT wantstoincreasetheriskoftheinvestment,theinvestorcouldchoosetoinvestinacompanythatusesdebttofnanceitsassets.Ortheindividualcouldinvestinacompanywithnofnancialleverageandtakeoutapersonalloan—increasingtheinvestor’sownfnancialleverage.Thesecondconditionisolatestheeffectoffnancialleverage.Ifdeductinginterestfromearningsisallowedintheanalysis,itwouldbediffculttofgureoutwhateffectfnancialleverageitselfhasonthevalueofthecompany.M&Mrelaxthislater,butatthispointassumenotaxadvantageexistsbetweendebtorequitysecurities—eitherforthecompanyortheinvestor.Thethirdconditionensuresthatassetsarepricedaccordingtotheirriskandreturncharacteristics.Thisconditionestablisheswhatisreferredtoasaperfectcapitalmarket:Ifassetsaretradedinaperfectmarket,thevalueofassetswiththesameriskandreturncharacteristicstradeforthesameprice.Undertheseconditions,thevalueofacompanyisthesame,nomatterhowitchoosestofnanceitself.The total cashfowtoownersandcreditorsisthesameandthevalueofthecompanyisthepresentvalueofthecompany’soperatingcashfowsinperpetuity.M&Mshowthatinthesimplifedworldwithouttaxesorcostsofdistress,thevalueofthecompanydependsonthecashfowsofthecompany,notonhowthecompany’scashfowsaredividedbetweencreditorsandowners.AnimplicationoftheM&Manalysisisthattheuseofdebtfnancingincreasestheriskofthefuturecashfowstoownersand,therefore,increasesthediscountrateinvestorsusetovaluethesefutureearnings.M&Mreasonthattheeffectthattheincreasedexpectedcashfowshasonthevalueofequityisjustoffsetbytheincreaseddiscountrateappliedtotheseriskierearnings,keepingthecostofcapitalthesamenomatterthecapitalstructure. M&MwithTaxDeductibilityofInterestPaidonDebt M&M’ssecondpropositionisthatwheninterestondebtisdeductedindeterminingtaxableincome,butdividendsarenot,thevalueofthecompanyisenhancedbecauseofthistaxdeductibilityofinterest.WhenModiglianiandMillerintroducethetaxdeductibilityofinterestintotheframework,theuseofdebthasadistinctadvantageoverfnancingwithstock.Thedeductibilityofinterestrepresentsaformofagovernmentsubsidyoffnancingactivities;thegov-ernmentissharingthecompany’scostofdebt.Werefertothebeneftfrominterestdeductibilityasthe interesttaxshield becausetheinterestexpenseshieldsincomefromtaxation.Thetaxshieldfrominterestdeductibilityistheamountbywhichtaxesarereducedbythedeductionforinterest.Iftherearenocostsassociatedwithfnancialdistress,thenthevalueofthecompanyincreaseswithever-increasinguseofdebtfnancingbecauseofthevalueenhancementfromtheuseoftheinteresttaxshield.Further,iftherearenocoststofnancialdistress,thecostofcapitalforthecompany
TheCorporateFinancingDecision 179 decreaseswithever-increasinguseofdebtfnancingbecausetheafter-taxcostofdebtaffectsthecostofcapitalforthecompanyasawholesuchthattheincreaseduseofthedebtreducesthecostofcapital.Istherealimittohowmuchdebtacompanycantakeon?Aslongastherearenocoststofnancialdistress,theonlylimitistheexistenceofatleastasmallpercentageofequityinthecapitalstructure. 9 CapitalStructureTheoryandCoststoFinancialDistress Ifthedebtbur-denistoomuch,thecompanymayexperiencefnancialdistress,resultinginanincreasingcostofcapital:Atsomepoint,thevalueofthecompanydeclinesandthecostofcapitalincreaseswithincreasinguseofdebtf-nancing.Financialdistressresultsinbothdirectandindirectcostsincludinglegalcosts,opportunitycostsforprojects,andtheeffectofdistressontherelationshipwithcustomersandsuppliers.Atsomecapitalstructure,thesecostsbegintooffsetthebeneftoftheinterestdeductibilityofdebt.Theoptimalcapitalstructureisthepointatwhichthevalueofthecompanyismaximized.Upuntiltheoptimalcapitalstructure,thebeneftsfromthetaxdeductibilityofinterestoutweighthecostoffnancialdistress.Whentheamountoffnancialleverageexceedstheoptimalcapitalstructure,thebeneftsfromthetaxdeductibilityofinterestareoutweighedbythecostoffnancialdistress.Becauseoftherelationbe-tweenthevalueofthecompanyandthecostofcapital,thecapitalstructurethatmaximizesthevalueofthecompanyisthesamecapitalstructurethatminimizesthecostofcapital.Theproblemisthatwecannotdeterminebeforehandwhattheoptimalcapitalstructureisforagivencompany.Thetheoryisnotprescriptiveintermsofidentifyingthisprecisepoint.Whatwecanobserveiswhenacompanytakesontoomuchdebtanddistressoccurs.Theoptimalcapitalstructuredepends,inlargepart,onthebusinessriskofthecompany:thegreaterthebusinessriskofthecompany,thesoonerthisoptimalcapitalstructureisreached.Sowhatgoodisthetheoryofcapitalstructureiffnancialmanagerscannotdeterminetheoptimalcapitalstructure?TheM&Mtheory,alongwithsubsequent,relatedtheoriesandevidence,providesaframeworkfordecisionmaking: Thereisabenefttotakingondebt—toapoint. Thecostofcapitalofacompanydecreaseswithever-increasinguseofdebtfnancing—toapoint. 9 Intheoryandinpracticality,therealwaysmustbesomeequityinacompany,evenifitisverylittle.
180 FINANCIALMANAGEMENT Theoptimalcapitalstructuredependsontheriskassociatedwiththecompany’soperatingcashfows. CurrentCapitalStructureTheoryandPractice TheM&Mtheoryof-fersatrade-offmodelofcapitalstructure:somebalanceexistsbetweenthepresentvalueoftheinteresttaxshieldsandthepresentvalueofthecostsoffnancialdistress.Wesimplycannotdetermine,basedonthistheory,wherethispointisforagivencompany.SinceM&Mintroducedtheirtheoryofcapitalstructureinaseriesofarticles,therehavebeenmanyotherconsiderationsofferedbyresearchers,including: Agencycoststhatmaycomplicatethemaximizationofshareholders’wealth. 10 Asymmetricinformationandsignalingthatresultinapeckingorderoffnancingchoices. 11 Nonfnancialstakeholderissuesthatmayaffectthecostsoffnancialdistress. 12 Theseadditionalconsiderationscomplicatetheanalysis,butdonotreplacethefundamentalconceptthatthereisatrade-offbetweenthebeneftsofdebtandthecostsofhavingtoomuchdebt. THEBOTTOMLINE Acompanymayfnanceitsbusinessoperationsbyraisingfundsinter-nally,throughretainedearnings,issuingstock,orborrowing. Usingborrowedfunds,ascomparedtousingequity,asasourceoffnancingincreasestherisktoownersatthesametimepotentiallyen-hancingthereturnstoownersthroughaleveragingeffect. Awaytoviewthechoiceoffnancingistocalculatethedegreeoffnancialleverage,whichistheratioofoperatingearningstoearningsafterdeductinginterest. 10 JensenandMeckling,“TheoryoftheFirm:ManagerialBehavior,AgencyCosts,andOwnershipStructure.” 11 Myers,“TheCapitalStructurePuzzle”;andStewartC.MyersandN.S.Majluf,“CorporateFinancingandInvestmentDecisionswhenFirmsHaveInformationInvestorsDoNotHave,” JournalofFinancialEconomics 13(1984):187–221. 12 MarkGrinblattandSheridanTitman, FinancialMarketsandCorporateStrategy (Boston:Irwin/McGraw-Hill,2002).
TheCorporateFinancingDecision 181 Failuretopayinterestorprincipalaspromisedmayresultinfnancialdistress,theconditionwhereacompanymakesdecisionsunderpres-suretosatisfyitslegalobligationstoitscreditors.Thesedecisionsmaynotbeinthebestinterestsoftheownersofthecompany.Thecostsrelatedtofnancialdistresswithoutlegalbankruptcycantakedifferentforms. Theuseofdebtalsoreducesacompany’sfnancialfexibility.Theman-agementofacompanythathasfnancialslack(i.e.,debtcapacitythatisunused)ismorepreparedtotakeadvantageofinvestmentopportunitiesinthefuture. Theuseofdebtmayenhancethevalueofequitybecauseownersdonothavetoshareincomewithcreditorsbeyondtherequiredinterestpaymentonthedebt,whileownersbeneftfromthetaxsubsidypro-videdtocompaniesthatusedebtfnancing.Theremaybeapoint,however,whenamountoffnancingfromdebtbecomestoomuch,andthecompanybecomesdistressedandmayendupinbankruptcy. Thoughtheoryidentifesthebeneftsofdebtandthepotentialfnancialdistresswhenacompanytakesontoomuchdebt,wecannottellatwhatpointacompanyhastakenontoomuchdebt—untilitbecomesdistressed. Thecostofcapitalofacompanyisaffectedbythemixofdebtandequityfnancing:thecostofcapitalisreducedasthecompanytakesonmoredebt,butonlytoapoint—afterwhichitrisesasthecompanyencounterscostsoffnancialdistressthatoutweighthetaxadvantagesofdebt. Managementcantrytoevaluatewhetherthereisanoptimalcapitalstructure(i.e.,acapitalstructurethatmaximizesthevalueofthecom-pany).However,evenifthecompany’soptimalcapitalstructurecannotbedeterminedprecisely,managementshouldunderstandthatthereisaneconomicbeneftfromthetaxdeductibilityoftaxes,buteventuallythisbeneftmaybereducedbythecostsoffnancialdistress. TheModiglianiMillertheoryofcapitalstructureprovidesaframeworkforthediscussionofthefactorsmostimportantinacompany’scapitalstructuredecision:taxes,fnancialdistress,andrisk.Thoughthistheorydoesnotgiveaprescriptionforcapitalstructuredecisions,itdoesofferamethodofexaminingtheroleoftheseimportantfactorsthataidman-agementwiththebasicdecision-makingtoolsinanalyzingthecapitalstructuredecision. AccordingtotheModigliani-Millertheoryofcapitalstructure,intheabsenceoftaxesandcostsoffnancialdistress,thecapitalstructuredecisionisirrelevanttothevalueofthecompany.Thecapitalstructuredecisionbecomesrelevantwhentaxesareintroducedintotheanalysis,
182 FINANCIALMANAGEMENT suchthataninteresttaxshieldfromthetaxdeductibilityofinterestondebtobligationsencouragestheuseofdebtbecausethisshieldbecomesasourceofvalue. SOLUTIONSTOTRYIT!PROBLEMS ReturnswithLeverageInMillions Operatingearnings$5.00Interestondebt $ 2.50 Netincome $ 2.50 Returnonassets 2.5% Returnonequity 5.0% ReturnswithLeverageandTaxesInMillions Operatingearnings$5.00Interestondebt $ 2.50 Taxableincome $ 2.50 Taxesat40% $ 1.00 Netincome $ 1.50 Returnonassets 1.5% Returnonequity 3.0% CostofCapitalSourceofCapitalTargetCapitalStructureProportionsPretaxCostsofCapitalCostsofCapitalWeight × Cost Debt25%6.5%3.9%0.975%Commonstock75% 10%10%7.500% 100%Costofcapital = 8.475%
TheCorporateFinancingDecision 183 QUESTIONS 1. Briefyexplaintheroleoffnancialleverageinaffectingreturnsonequity. 2. Whatisaninteresttaxshield,andhowdoesthisaffectthevalueofacompany? 3. Ifacompany’smarginaltaxrateweretoincrease,whatistheeffectontheinteresttaxshieldfromthecompany’sdebt? 4. Ifacompanyhasadegreeoffnancialleverageof2.0,whatistheexpectedeffectofa2%increaseinoperatingearningstotheearningstoowners? 5. Howmayusingdebtfnancingincreasethegovernanceofacompany? 6. Explainhowlimitedliabilitymayaffectthecapitalstructuredecisionsofacorporation. 7. Iftherearecostsassociatedwithfnancialdistress,howmaythisaffectthecapitalstructuredecisionofacompany? 8. Whydoweadjustfortaxesindeterminingthecostofdebt,butnotforthecostsofpreferredstockandcommonstock? 9. Whatistradedoffinthetrade-offtheoryofcapitalstructure? 10. Whatistherelationbetweenacompany’soperatingriskanditsoptimalcapitalstructure? 11. Whatismeantbythepeckingordertheoryofcapitalstructure? 12. WhataretheimplicationsoftheModigliani-Millertheoryofcapitalstructurewhentheassumptionofnocorporatetaxesisnotvalid? 13. Considerthreefnancingalternatives:AlternativeA:FinancesolelywithequityAlternativeB:Financeusing50%debt,50%equityAlternativeC:Financesolelywithdebt a. Whichofthethreealternativesinvolvesthegreatestfnancialleverage? b. Whichofthethreealternativesinvolvestheleastfnancialleverage? 14. Listthepotentialcostsassociatedwithfnancialdistress. 15. Listthepotentialdirectandindirectcostsassociatedwithbankruptcy. 16. Regardingfnancialslack: a. Whatisit? b. Howisslackcreated? c. Whydocompanieswishtohavefnancialslack?
CHAPTER 9 FinancialRiskManagement Butinnovationismorethananewmethod.Itisanewviewoftheuniverse,asoneofriskratherthanofchanceorofcertainty.Itisanewviewofman’sroleintheuniverse;hecreatesorderbytakingrisks.Andthismeansthatinnovation,ratherthanbeinganassertionofhumanpower,isanacceptanceofhumanresponsibility. —PeterF.Drucker, LandmarksofTomorrow (NewYork:HarperColophonBooks,1959) A llcompaniesfaceavarietyofrisks.ScandalssuchasEnron,WorldCom,Tyco,andAdelphia,thetragiceventssuchas9/11,andtheeconomicdownturnassociatedwiththeU.S.subprimemortgagecrisishavereinforcedtheneedofcompaniestomanagerisk.Moreover,riskmanagementshouldnotbeanafter-thought,butinsteadshouldbeakeyelementofanyinvest-mentorfnancingdecision.Inthischapterwediscussthefourkeyprocessesinfnancialriskman-agement:riskidentifcation,riskassessment,riskmitigation,andrisktrans-ferring.Theprocessofriskmanagementinvolvesdeterminingwhichriskstoaccept,whichtoneutralize,andwhichtotransfer. THEDEFINITIONOFRISK Thereisnoshortageofdefnitionsforrisk.Weoftenreferto risk astheuncertaintyregardingwhatmayhappeninthefuture.Insomedefnitions,riskisdistinguishedfromuncertainty,suchthatriskisuncertaintythatcanbequantifed.Ineverydayparlance,riskisoftenviewedassomethingthatisnegative,suchasadanger,ahazard,oraloss.Butweknowthatsomeriskslead 185
186 INVESTMENTS toeconomicgains,whileothershavepurelynegativeconsequences.Forexample,thepurchaseofalotteryticketinvolvesanactionthatresultsintheriskofthelossequaltothecostoftheticket,butpotentiallyhasasubstantialmonetaryreward.Incontrast,theriskofdeathorinjuryfromarandomshootingispurelyanegativeconsequence.Inthecorporateworld,acceptingrisksisnecessarytoobtainacompeti-tiveadvantageandgenerateaproft.Introducinganewproductorexpand-ingproductionfacilitiesinvolvesbothreturnandrisk.Whenacompanyisexposedtoaneventthatcancauseashortfallinatargetedfnancialmea-sureorvalue,thisis fnancialrisk .Thefnancialmeasureorvaluecouldbeearningspershare,returnonequity,orcashfows,tonamesomeoftheimportantones.Financialrisksincludemarketrisk,creditrisk,marketliquidityrisk,operationalrisk,andlegalrisk. Theword“risk”isderivedfromtheItalianverb riscare ,whichmeans“todare.”Businessentitiestherefore“dareto”generateproftsbytakingadvantageoftheopportunisticsideofrisk. Wecanclassifyrisksas corerisks and noncorerisks .Thedistinctionisimportantinthemanagementofrisk.Inattemptingtogenerateareturnoninvestedfundsthatexceedstherisk-freeinterestrate,acompanymustbearrisk.Thecorerisksarethoserisksthatthecompanyisinthebusinesstobearandtheterm businessrisk isusedtodescribethisrisk.Incontrasttocorerisk,risksthatareincidentaltotheoperationsofabusinessare noncorerisks .Tounderstandthedifference,considertheriskassociatedwiththeuncertaintyaboutthepriceofelectricity.Foracom-panythatproducesandsellselectricity,theriskthatthepriceofelectricitythatitsuppliesmaydeclineisacorerisk.However,foramanufacturingcompanythatuseselectricitytooperateitsplants,thepriceriskassociatedwithelectricity(i.e.,thepriceincreasing)isanoncorerisk.Yetchangingthecircumstancescouldresultinadifferentclassifcation.Forexample,supposethatthecompanyproducingandsellingelectricityisdoingsoonafxed-pricecontractforthenextthreeyears.Inthiscase,thepriceriskassociatedwithelectricityisanoncorerisk. SustainabilityRisk Inthepast,themanagementofrisksthatacompanyfaceshasfocusedonitsbusinessandfnancialrisks.Thebusinessrisksincludethe salesrisk —driven
FinancialRiskManagement 187 bycompetitionanddemand—and operatingrisks ,affectedbythestruc-tureofoperatingcosts.Thefnancialrisksrelatetotheuseofdebtinthecompany’scapitalstructure. Takecalculatedrisk.Thatisquitedifferentfrombeingrash.—GeorgePatton Inthepasttwodecadestherehasbeenabroadeningoftheperceptionofrisktoextendtraditionalbusinessandfnancialriskstothecompletespec-trumofriskthatacompanyfacesthatincludessocialandenvironmentalresponsibilities.Thisbroadspectrumofriskis sustainabilityrisk .Forexam-ple,thesocialresponsibilitiesofacompanyincludelaborandhumanrights,workingconditions,training,governance,andethics,whereastheenviron-mentalresponsibilitiesincluderecyclingandwastemanagement,oversight,reporting,andresourceuse.Withouteffectivemanagementoftheserisks,abusinessrisksthepotentialdamagesfromboycotts,shareholderactions,lawsuits,andadditionalregulations.Theconceptofsustainabilityhasslowlygainedprominenceinthepasttwodecadesasinvestors,regulators,andcompaniesgrappledwiththeeffectsofcorporatescandals,catastrophes,andtragedies.Manybegantoquestionwhethertheobjectiveofthecompanyasshareholderwealthmaximizationistoosimplistic.Inotherwords,thequestionarisesastowhetheracompanyisvaluedconsideringnotonlyitsfnancialperformance,butitsenvironmentalandsocialresponsibilityrecordsaswell.Thereisnodefnitiveempiricalevidencethattheenvironmentalandsocialdimensionsofacompanyaffectitsvalue,butthereisanecdotalevidencethatinvestorsmayconsiderthesedimensions.Astheissueofsustainabilityhasgrowninprominence,therehasalsobeenasurgeofmeasuresofcompanies’sustainabilityrisk,includingtheInstitutionalShareholdersServicesSustainabilityRiskReportsandtheDeloitteSustainabilityReportingScorecard.Inaddition,indexes,includingtheDowJonesSustainabilityIndexes(DJSI)andtheFTSE4Goodindexes,havebeencreatedthattracktheperformanceofcompaniesfocusingonsus-tainability.Further,manycompaniesarenowreportingtheirsustainabilityriskandriskmanagementeffortstoinvestors.Forexample,somecom-paniesnowreportonsustainabilityusingtheframeworkprovidedbytheGlobalReportingInitiative(GRI),thoughothersdeveloptheirownreport-ingframeworks.ThoughGRIandothermeasuresarestillevolving,thereisincreasingpressureforsomeformofreportingontheserisks.
188 INVESTMENTS Alotofpeopleapproachriskasifit’stheenemywhenit’sreallyfortune’saccomplice.—Sting,inaquotefromanessayStingwroteentitled“Risk:LetYourSoulBeYourBookie”thatappearsinSarahBanBreathnachandMichaelSegell, AMan’sJourneytoSimpleAbundance (NewYork:Scribner,2000) ENTERPRISERISKMANAGEMENT Thetraditionalprocessofriskmanagementfocusesonmanagingtherisksofonlypartsofthebusiness(products,departments,ordivisions),ignoringtheimplicationsforthevalueofthecompany.Theorganizationofariskmanagementprocessfocusingononlypartsofabusinessisreferredtoasa silostructure .Whatisneededisaprocessthatmanagementcanemploytoeffectivelyhandleuncertaintyandevaluatehowtherisksandopportunitiesthatacompanyfacescaneithercreate,destroy,orpreserveacompany’svalue.Thisprocessshouldallowmanagementto: Aligntheriskappetiteandstrategiesacrossthecompany. Improvethequalityofthecompany’srisk-responsedecisions. Identifytherisksacrossthecompany. Managetherisksacrossthecompany.Thisprocessis enterpriseriskmanagement (ERM).Acompany’sinternalcontrolsprovideamechanismformitigatingrisks,andincreasethelikelihoodthatacompanywillachieveitsfnancialobjec-tive.Aswewillexplain,ERMgoesbeyondinternalcontrolsinthreesig-nifcantways.First,whenestablishingitsstrategyforthecompany,ERMrequiresthattheboardconsiderrisks.Second,ERMrequiresthattheboardidentifywhatlevelofriskitiswillingtoaccept.Finally,ERMrequiresthatriskmanagementdecisionsbemadethroughoutthecompanyinamannerconsistentwiththeriskpolicyestablished. DefinitionsofERM Enterpriseriskmanagementisanongoingprocessthatprovidesastructuredmeansforreducingtheadverseconsequencesofbigsurprisesduetonaturalcatastrophes,terrorism,changesintheeconomic,political,andlegalen-vironments,taxlitigation,failureofthecompany’scorporategovernance,
FinancialRiskManagement 189 andproductandfnancialmarketvolatility.Infact,Moody’sstatesthattheultimateobjectiveofacompany’sriskmanagementorganizationshouldbetomakesurethattherearenomajorsurprisesthatplacethecompanyinperil. 1 Second,thestartingpointforaneffectiveERMsystemisattheboardlevel.Thismeansthatcorporategovernanceisacriticalelement. DEFINITIONSOFENTERPRISERISKMANAGEMENT ThemostpopulardefnitionisproposedbytheCommitteeofSpon-soringOrganizationsoftheTreadwayCommission(COSO): “aprocess,effectedbyanentity’sboardofdirectors,man-agementandotherpersonnel,appliedinstrategysettingandacrosstheenterprise,designedtoidentifypotentialeventsthatmayaffecttheentity,andmanagerisktobewithinitsriskap-petite,toprovidereasonableassuranceregardingtheachieve-mentofentityobjectives.” * TheCasualtyActuarialSociety(CAS)providesabroaderdefnitionofERM: “thedisciplinebywhichanorganizationinanyindustryas-sesses,controls,exploits,fnances,andmonitorsriskfromallsourcesforthepurposesofincreasingtheorganization’sshort-andlong-termvaluetoitsstakeholders.” ** * CommitteeofSponsoringOrganizationsoftheTreadwayCommission, EnterpriseRiskManagement—IntegratedFrameworkExecutiveSummary (September2004),p.8. ** CasualtyActuarialSociety,OverviewofEnterpriseRiskManagement(May2003). Theterm“enterprise”canhavedifferentmeaningswithinERM. 2 OneisthatERMislinkedtostrategicplanningandorganizationalobjectivesofthe 1 Moody’s,“RiskManagementAssessments,” Moody’sResearchMethodology (July2004). 2 AstheSocietyofActuaries(SOA)pointsout,therearetwomaindefnitions[SocietyofActuaries ,EnterpriseRiskManagementSpecialtyGuide (May2006),p.9].
190 INVESTMENTS businessenterprise.Theseconddefnitionisintermsof modernportfoliotheory (MPT)thatwedescribeinChapter16.Inthistheory,formulatedbyHarryMarkowitz,thefocusisontheriskoftheportfolioandnottheindividualsecuritiescomprisingtheportfolio. 3 Inotherwords,theenterpriseisaportfoliointhiscontext.Thisleadstotheconclusionthatitisnotthestand-aloneriskofanindividualsecuritythatisrelevantbutonlythecontributionofthatasassetmakestoaportfolio’srisk.AportfoliomanagercanusethebasicideasfromMPTtocreateeffcientportfolios,assemblingaportfoliothatoffersthemaximumexpectedreturnforagivenlevelofrisk.Theportfoliomanager’staskistoselectoneoftheseeffcientportfoliosgiventhemanager’sorclient’sriskappetite.ThemanagercanusederivativesinstrumentsthatwedescribeinChapter14toaltertheriskprofleofaportfolioandcanuseriskbudgetingtodecidehowtoallocaterisk.InthecontextofERM,theenterpriseisviewedasa“portfolioofrisks.”Itisnotstand-aloneriskthatiskey,buttherisktotheentirecompany.Theriskproflecanbealteredusingderivativeinstrumentsaswellasotherrisktransferproductsandstrategiesdiscussedlaterinthischapter. ERMProcess ThereisnofxedformulafordevelopinganERMsystem,butrathersomegeneralprinciplesthatprovideguidance.Thisisbecausethereisconsider-ablevariationincompanysize,organizationalstructures(centralizedversusdecentralized,forexample),andtypesofriskfacedindifferentindustries.So,althoughdifferentinternalcontrolsvaryfromcompanytocompany,theunderlyingprinciplesdonot.Intheliterature,thereareseveralproposalsfortheERMprocess.ThefourriskobjectivesofERMarethefollowing: 4 1. Strategic. Supportingthecorporation’sstrategicgoals(i.e.,high-levelgoals). 2. Operations. Achievingperformancegoalsandtakingmeasurestosafe-guardagainstlossthroughoperationaleffciency. 3. Reporting. Providingreliablefnancialandoperationaldataandreportsinternallyandexternally. 4. Compliance. Complyingwithlawsandregulationsatalllevels(local,state,national,andinothercountrieswherethecompanyoperates). 3 HarryM.Markowitz,“PortfolioSelection,” JournalofFinance 7(1952):77–91. 4 ThesearefromtheCommitteeofSponsoringOrganizations(COSO)framework.
FinancialRiskManagement 191 Whiletherearecommonriskssharedbyallcompaniesandtherearerisksuniquetosomecompanies,thebuildingblocksfortheERMprocessarecommontoallcompanies.Basically,ERMischiefyconcernedwith evaluatingthecompany’sriskprocessesandriskcontrols,and identifyingandquantifyingriskexposures.ERMisbroaderinitsscopethantraditionalriskmanagement,whichfocusesonproducts,departments,ordivisionspracticedwithinasilostruc-ture.InERM,alltherisksofacompanyaretreatedasaportfolioofrisksandmanagedonaportfolioorcompanylevel.Thatis,theriskcontextisthecompany,notindividualproducts,departments,ordivisions.Forexample,supposethatacompanyhasatargetminimumearningsfgureestablishedeitherbyitsownfnancialplanorbasedonWallStreetanalysts’consensusearnings.ERMcanbeusedtoidentifythethreatstothecompanyofhittingthattarget.Oncethoserisksareidentifedandpriori-tized,managementcanexaminethepotentialshortfallthatmayoccuranddecidehowtoreducethelikelihoodthattherewillbeashortfallusingsomerisktransferstrategies. ThemesofERM Therearefourthemesinenterpriseriskmanagement,aswedetailinExhibit9.1. 5 The riskcontrol processinvolvesidentifying,evaluating,monitoring,andmanagingrisk.Theprocessofrefectingriskandriskcapitalinstrategicoptionsfromwhichacorporationcanselectiscalled strategicriskmanage-ment .Thisprocessrequiresadjustingforriskinvaluinginvestments,makinginvestmentdecisions,andevaluatinganinvestment’sperformance.Catastrophiceventsareextremeeventsthatcouldthreatenthesurvivalofacompany. Catastrophicriskmanagement involvesplanningsoastominimizetheimpactofpotentialcatastrophiceventsandhavinginplaceanearlywarningsystemthat,ifpossible,couldidentifyapotentialdisaster.Incatastrophiccontrol,severalanalysesprovideinformation.Forex-ample,trendanalysiscanidentifyanypatternssuggestingpotentialemer-genceofcatastrophes,andstresstestingcanshowtheimpactofacatas-tropheonthefnancialconditionandreputationofthecompany.Oncewehaveanunderstandingregardingthepossiblescenarios,wecanplanfor 5 Thefourthemesareproposedbythe EnterpriseRiskManagementSpecialtyGuide ,pp.26–38.
192 INVESTMENTS Risk controlStrategic riskmanagementRisk managementcultureCatastrophiccontrol • Identify risks• Evaluate risks• Monitor risks• Set risk limits• Avoid certain risks• Offset certain risks• Transfer risks• Review and evaluate new investments• Estimate economic capital• Value investments• Make investment decisions• Evaluate performance• Perform trend analysis• Perform stress testing• Plan for contingencies• Evaluate risk transfer• Identify best risk management practices• Develop supporting documentation• Communicate• Reinforce through education and training EXHIBIT9.1 TheFourThemesofEnterpriseRiskManagement contingencies,preparecommunicationstrategiesforstakeholders,andcon-sidereffectivenessandcosttotransferrisk.TheSocietyofActuaries(SOA)defnesa riskmanagementculture asanenvironmentinwhichtheentityhasanapproachtodealingwithrisks,andthatthisapproachispartoftheentity’sculture.Hence,whenariskeventoccurs,aplanisinplacefordealingwiththisrisk. 6 Reportsthatsaysomethinghasn’thappenedarealwaysinterest-ingtomebecause,asweknow,thereareknownknowns;therearethingsweknowweknow.Wealsoknowthereareknownun-knowns;thatistosay,weknowtherearesomethingswedonotknow.Buttherearealsounknownunknowns—theoneswedon’tknowwedon’tknow.—DonaldRumsfeld,U.S.SecretaryofDefense(PressConference,Brussels,Belgium,June6,2002) Thisculturerequiresthattheentityidentifyandmeasurerisks,andexaminebestpracticesinthemanagementofrisk.Inaddition,theriskman-agementculturerequiresthattheentitydevelopasystemofdocumentingriskandriskmanagementandcommunicatingriskmanagementpoliciesandpracticestostakeholders.Further,ariskmanagementcultureshouldedu-cateallemployeesorotherdecision-makersinriskmanagementandprovidetrainingregardingriskmanagement.Thiseducationandtrainingreinforcestheimportanceofriskmanagement. 6 Exhibit9.1isasummaryofthedescriptionofthethemesofriskmanagementprovidedby EnterpriseRiskManagementSpecialtyGuide ,p.26–28.
FinancialRiskManagement 193 SpecifyinganEntity’sRiskPolicy TheimplementationofanERMpolicyrequiresthattheamountofriskthatacompanyiswillingtoacceptbespecifed.Corporationsthroughtheirboardsettheboundariesastohowmuchriskthecompanyispreparedtoaccept.Ofteninreferringtorisk,theterms riskappetite and risktolerance areusedinterchangeably.However,thereisasubtledistinctionbetweenthetwoconcepts.Basically,thecompany’sriskappetiteistheamountofriskexposurethattheentitydecidesitiswillingtoacceptorretain. 7 Whentheriskexposureoftheentityexceedstherisktolerancethreshold,riskmanagementprocesseskickintoreturntheexposurelevelbackwithintheacceptedrange.Onceanentityhasimplementedariskpolicyofthecompany,itisimportanttocommunicateittostakeholders.Foracorporation,thisisthroughthemanagementdiscussionandanalysissectionrequiredinSECflings(8-Kand10-K),pressreleases,communicationswithratingagencies,andinvestormeetings.NowthatthecreditratingservicesareincorporatingERMmeasuresintothecreditratingprocess,itismoreimportantthaneverforcompaniestopayattentiontothecompany’sERMsystemandtocommunicatethissystemtostakeholders. MANAGINGRISKS Acompany’s riskretentiondecision ishowitelectstomanageanidentifedrisk.Thisdecisionismorethanariskmanagementdecision,itisalsoafnancingdecision.Thechoicesare: Retain Neutralize TransferOfcourse,eachidentifedriskfacedbythecompanycanbetreatedinadifferentway.Foreachofthethreechoices—retention,neutralization,andtransferofrisk—thereareinturntwofurtherdecisionsastohowtheycanbehandled. RetainedRiskandRiskFinance Thedecisionbyacompanyofwhichidentifedriskstoretainisbasedonaneconomicanalysisoftheexpectedbeneftsversusexpectedcostsassociatedwithbearingthatparticularrisk.Theaggregateofalltherisksacrossthe 7 EnterpriseRiskManagement—IntegratedFrameworkExecutiveSummary ,p.2.
194 INVESTMENTS companythatithaselectedtobeariscalledits retainedrisk .Becauseifaretainedriskisrealizeditwilladverselyimpactthecompany’searningsandcashfows,acompanymustdecidetofundornotfundaretainedrisk.An unfundedretainedrisk isaretainedriskforwhichpotentiallossesarenotfnanceduntiltheyoccur.Incontrast,a fundedretainedrisk isaretainedriskforwhichanappropriateamountissetasideupfront(eitherascashoranidentifedsourceforraisingfunds)toabsorbthepotentialloss.Forexample,withrespecttocorporatetaxes,managementmaydecidetoholdascashreservesalloraportionofthepotentialadverseoutcomeoflitigationwithtaxauthorities.Thismanagementofretainedriskisreferredtoas riskfnance . RiskNeutralization Ifacompanyelectsnottoretainanidentifedrisk,itcaneitherneutralizetheriskortransfertherisk. Riskneutralization isariskmanagementpolicywherebyacompanyactsonitsowntomitigatetheoutcomeofanexpectedlossfromanidentifedriskwithouttransferringthatrisktoathirdparty.Thiscaninvolvereducingthelikelihoodoftheidentifedriskoccurringorreducingtheseverityofthelossshouldtheidentifedriskberealized.Riskneutralizationmanagementforsomerisksmaybeanaturaloutcomeofthebusinessorfnancialfactorsaffectingthecompany.Consideranexampleinvolvingabusinessrisk.Supposethatacompanyprojectsanannuallossof$30millionto$50millionfromreturnsduetoproductdefects,andthisamountismaterialrelativetoitsproftability.Acompanycanintroduceimprovedproductionprocessestoreducetheupperrangeofthepotentialloss.Asanexampleinvolvingafnancialfactor,aU.S.multinationalcom-panywilltypicallyhavecashinfowsandoutfowsinthesamecurrencysuchastheeuro.Asaresult,thereiscurrencyrisk—theriskthattheexchangeratemovesadverselytothecompany’sexposureinthatcurrency.Butthisriskhasoffsettingtendenciesiftherearebothcashinfowsandoutfowsinthesamecurrency.Assumingthecurrencyistheeuro,thecashinfowsareexposedtoadepreciationoftheeurorelativetotheU.S.dollar;thecashoutfowsareexposedtoanappreciationoftheeurorelativetotheU.S.dol-lar.Ifthecompanyprojectsfuturecashinfowsoveracertaintimeperiodof € 50millionandacashoutfowoverthesameperiodof € 40million,thecompany’snetcurrencyexposureisa € 10millioncashinfow.Thatis, € 40millionexposureishedgednaturally. RiskTransfer Forcertainidentifablerisks,thecompanymaydecidetotransfertheriskfromshareholderstoathirdparty.Thiscanbedoneeitherbyenteringinto
FinancialRiskManagement 195 acontractwithacounterpartywillingtotakeontheriskthecompanyseekstotransfer,orbyembeddingthatriskinastructuredfnancialtransaction,therebytransferringittobondinvestorswillingtoacceptthatrisk.Therearevariousformsof risktransfermanagement .Thevehiclesorinstrumentsfortransferringriskincludetraditionalinsurance,derivatives,alternativerisktransfer,andstructuredfnance. TraditionalInsurance Theoldestformofrisktransfervehicleisinsurance.Aninsurancepolicyisacontractwherebyaninsurancecompanyagreestomakeapaymenttotheinsuredifadefnedadverseeventistriggered.Theinsuredreceivestheprotectionbypayingaspecifedamountperiodically,calledthe insurancepremium .Thecontractcanbeavaluedcontractorunvaluedcontract.Ina valuedcontract ,thepolicyspecifestheagreedvalueofthepropertyin-sured.Withtheexceptionoflifeinsurancecontractspurchasedbycompa-nies,valuedcontractsarenotcommonlyusedasaformofrisktransfer.Thereareexceptions,ofcourse,suchasanartmuseuminsuringvaluableworksofartwiththeamountfxedatthetimeofnegotiationofthecon-tracttoavoidneedinganappraisaloftheartworkaftertheinsuredeventistriggered.Inan unvaluedcontract ,alsocalleda contractofindemnity ,thevalueoftheinsuredpropertyisnotfxed.Rather,theremaybeamaximumamountpayable,yetthepaymentiscontingentontheactualamountoftheinsured’slossresultingfromthetriggerevent.Acontractofindemnityisthetypicaltypeofcontractusedinrisktransfer. Derivatives AswillbeexplainedinChapter14,therearecapitalmarketproductsavailabletotransferrisksthatarenotreadilyinsurablebyaninsurancecompany.Suchrisksincluderisksassociatedwithariseinthepriceofacommoditypurchasedasaninput,adeclineinacommoditypriceofaproductthecompanysells,ariseinthecostofborrowingfunds,andanadverseexchange-ratemovement. Derivateinstruments ,whicharecapitalmarketinstruments,canbeusedtoprovidesuchprotection.Theseinstrumentsincludefuturescontracts,forwardcontracts,optioncontracts,swapagreements,andcapandfooragreements.Therehavebeenshareholderconcernsabouttheuseofderivativeinstru-mentsbycompanies.Thisconcernarisesfrommajorlossesresultingfrompositionsinderivativeinstruments.However,aninvestigationofthereasonformajorlosseswouldshowthatthelosseswerenotduetoderivativesperse,buttheimproperuseofthembymanagementthateitherwasignorantabouttherisksassociatedwithusingderivativeinstrumentsorsoughttousetheminaspeculativemannerratherthanasameansformanagingrisk.
196 INVESTMENTS MISHAPSINRISKMANAGEMENTTHROUGHDERIVATIVES Procter&Gamblelost$195.5millioninaninterestrateswapin1994,butitsobligationtopaythistoBankersTrustwasforgiveninasettlement. AmaranthAdvisors,ahedgefund,lost$6.4billionin2006infuturescontractsonnaturalgas. Overseveralyears,AmericanInternationalGroupsoldcreditde-faultswaps.Whenthecreditqualityofmanybondsdeterioratedastheeconomyenteredintoarecession,AIG’ssellingofswapsresultedinitslosingmorethan$18billionin2008. AlternativeRiskTransfer Alternativerisktransfer (ART),alsoknownas structuredinsurance ,pro-videsuniquewaystotransfertheincreasinglycomplexrisksfacedbycor-porationsthatcannotbehandledbytraditionalinsuranceandhasledtothegrowthintheuseofthisformofrisktransfer.Theseproductscombineelementsoftraditionalinsuranceandcapitalmarketinstrumentstocreatehighlysophisticatedrisktransferstrategiestailoredforacorporateclient’sspecifcneedsandliabilitystructurethattraditionalinsurancecannothan-dle. 8 Forthisreason,ARTissometimesreferredtoas“insurance-basedinvestmentbanking.”AnexampleofonetypeofARTisan insurance-linkednote (ILN).ThistypeofARThasbeenprimarilyusedbylifeinsurersandpropertyandcasualtyinsurerstobypasstheconventionalreinsurancemarketandsyntheticallyreinsureagainstlossesbytappingthecapitalmarkets.Basically,anILNisameansforsecuritizinginsuranceriskandistypicallyreferredtoas catastrophe-linkedbonds orsimply catbonds .Thefrstuseofcatastrophe-linkedbondsincorporateriskmanagementbyanoninsurancecompanywasbytheowner-operatorofTokyoDisney-land,OrientalLandCo.Ratherthanobtaintraditionalinsuranceagainst 8 ForadetaileddiscussionofART,seeChristopherL.Culp, StructuredFinanceandInsurance:TheARTofManagingCapitalandRisk (Hoboken,NJ:JohnWiley&Sons,2006)andErikBanks, AlternativeRiskTransfer:IntegratedRiskManage-mentThroughInsurance,ReinsuranceandtheCapitalMarkets (Hoboken,NJ:JohnWiley&Sons,2004).
FinancialRiskManagement 197 earthquakedamageforthepark,itissueda$200millioncatbondin1999.Threeyearslater,VivendiUniversalobtainedprotectionforearthquakedamageforitsstudios(UniversalStudios)inCaliforniabyissuinga$175millioncatbondwithamaturityof3.5years.Whereascatastrophe-linkedbondshaveprimarilybeenusedforperilssuchasearthquakesandhurricanes,corporationsareusingtheminotherways.Forexample,therisktothelessor(i.e.,theowneroftheleasedequipment)inaleasingtransactionisthatthevalueoftheleasedequipmentwhentheleaseterminates(theresidualvalue)isbelowitsexpectedvaluewhentheleasewasnegotiated. CASEINPOINT:CATBONDS ToyotaMotorCreditCorp.wasconcernedthatthe260,0001998motorvehicles(carsandlight-dutytrucks)itleasedtocustomerswoulddeclineinvalueiftheused-carmarketweakened.Toprotectitself,Toyotaissuedacatbondthatprovidedprotectionforitselfagainstalossinmarketvalueofthefeetofleasedmotorvehicles. StructuredFinance Structuredfnance involvesthecreationofnontraditional-typesecuritieswithriskandreturnproflestargetedtocertaintypesofinvestors.Structuredfnanceincludesassetsecuritization,structurednotes,andleasing. THEBOTTOMLINE Financialriskmanagementinvolvesidentifyingandmeasuringrisk,aswellasdetermininghowmuch,ifany,risktoretain. Wecancategorizerisksascorerisksandnoncorerisks.Thecorerisksarebusinessrisks,thoserisksthatthecompanyisinthebusinesstobear.Noncorerisksarerisksthatareincidentaltotheoperationsofabusiness. Sustainabilityriskistheextensionoftraditionalbusinessandfnancialriskstothecompletespectrumofriskthatacompanyfacesthatincludessocialandenvironmentalresponsibilities. Enterpriseriskmanagementistheholisticapproachtoriskmanage-ment,whereriskismanagedfromtheperspectiveoftheentireentityorportfolio.
198 INVESTMENTS Anentitycandecidewhethertoretainrisk,neutralizeit,ortransferittoanotherparty. Retainedrisksaretheaggregateofalltherisksacrossthecompanythatacompany’smanagementhaselectedtobear.Becausemanagementdecidestofundornotfundaretainedrisk,managementofretainedriskisreferredtoasriskfnance. Riskneutralizationisariskmanagementpolicywherebyacompanyactsonitsowntomitigatetheoutcomeofanexpectedlossfromanidentifedriskwithouttransferringthatrisktoathirdparty. Risktransfermanagementinvolvestransferringcertainidentifablerisksfromshareholderstoathirdpartyeitherbyenteringintoacontractwithacounterpartywillingtotakeontheriskthecompanyseekstotransferorbyembeddingthatriskinastructuredfnancialtransaction. QUESTIONS 1. Whatisthedifferencebetweencoreandno-corerisk? 2. Howdoesthetheoryofportfolioriskrelatetoenterpriseriskmanagement? 3. Whatismeantbysustainabilityrisk? 4. Whatarethethreechoicesavailabletomanagementfordealingwithrisk? 5. Whatdistinguishesanunfundedfromafundedretainedrisk? 6. Whatisthefunctionofaninsurance-linkednoteforriskmanagement? 7. Whatmethodscanacompanyusetotransferrisk? 8. Howdoesacoreriskdifferfromanoncorerisk? 9. Howcanderivativesbeusedinriskmanagement? 10. Whatisacatbondandhowcanitbeusedtomanagerisk? 11. Thefollowing“CompanyOverview”ofAIGRiskFinancewasde-scribedontheInternet(investing.businessweek.com/research/stocks/private/snapshot.asp?privcapId=11673577): AIGRiskFinancedesignsandimplementsriskfnancingsolu-tions.Thecompanyoffersstructuredinsurance,exoticbuyouts,andunconventionallifeprograms. ... AIGRiskFinanceoper-atesasasubsidiaryofAmericanInternationalGroup,Inc. a. Whatismeantby“structuredinsurance”? b. Whatisanalternativenameforstructuredinsurance? c. Givetwoexamplesofstructuredinsurance.
PART Three ValuationandAnalyticalTools
CHAPTER 10 TheMathofFinance Thepricethenthattheborrowerhastopayfortheloanofcapital,andwhichheregardsasinterest,isfromthepointofviewofthelendermoreproperlytoberegardedasprofts:foritincludesinsuranceagainstriskswhichareoftenveryheavy,andearningsofarrangementforthetask,whichisoftenveryarduous,ofkeepingthoserisksassmallaspossible.Variationsinthenatureoftheserisksandofthetaskofmanagementwillofcourseoccasioncorrespondingvariationsinthegrossinterest—socalledthatispaidoftheuseofmoney. —AlfredMarshall, PrinciplesofEconomics : Volume2 (London:MacMillan&Co.,1890),p.623 I nvestmentdecisionsmadebyfnancialmanagers,toacquirecapitalassetssuchasplantandequipment,andassetmanagers,toacquiresecuritiessuchasstocksandbonds,requirethevaluationofinvestmentsandthedeterminationofyieldsoninvestments.Theconceptthatmustbeunderstoodtodeterminethevalueofaninvestment,theyieldonaninvestment,andthecostoffundsisthetimevalueofmoney.Thissimplemathematicalconceptallowsfnancialandassetmanagerstotranslatefuturecashfowstoavalueinthepresent,translateavaluetodayintoavalueatsomefuturepointintime,andcalculatetheyieldonaninvestment.Thetime-value-of-moneymathematicsallowsanevaluationandcomparisonofinvestmentsandfnancingarrangementsandisthesubjectofthischapter. WHYTHETIMEVALUEOFMONEY? Thenotionthatmoneyhasatimevalueisoneofthemostbasicconceptsininvestmentanalysis.Makingdecisionstodayregardingfuturecashfows 201
202 VALUATIONANDANALYTICALTOOLS requiresunderstandingthatthevalueofmoneydoesnotremainthesamethroughouttime.Adollartodayisworthlessthanadollaratsomefuturefortworeasons: Reason1 : Cashfowsoccurringatdifferenttimeshavedifferentvaluesrelativetoanyonepointintime. Onedollaroneyearfromnowisnotasvaluableasonedollartoday.Afterall,youcaninvestadollartodayandearninterestsothatthevalueitgrowstonextyearisgreaterthantheonedollartoday.Thismeanswehavetotakeintoaccountthe timevalueofmoney toquantifytherelationbetweencashfowsatdifferentpointsintime. Reason2 : Cashfowsareuncertain. Expectedcashfowsmaynotmaterialize.Uncertaintystemsfromthenatureofforecastsofthetimingandtheamountofcashfows.Wedonotknowforcertainwhen,whether,orhowmuchcashfowswillbeinthefuture.Thisuncertaintyregardingfuturecashfowsmustsomehowbetakenintoaccountinassessingthevalueofaninvestment.Translatingacurrentvalueintoitsequivalentfuturevalueis compound-ing .Translatingafuturecashfoworvalueintoitsequivalentvalueinapriorperiodis discounting .Inthischapter,weoutlinethebasicmathematicaltechniquesofcompoundinganddiscounting.Supposesomeonewantstoborrow$100todayandpromisestopaybacktheamountborrowedinonemonth.Wouldtherepaymentofonlythe$100befair?Probablynot.Therearetwothingstoconsider.First,ifthelenderdidn’tlendthe$100,whatcouldheorshehavedonewithit?Second,isthereachancethattheborrowermaynotpaybacktheloan?So,whenconsideringlendingmoney,wemustconsidertheopportunitycost(thatis,whatcouldhavebeenearnedorenjoyed),aswellastheuncertaintyassociatedwithgettingthemoneybackaspromised.Let’ssaythatsomeoneiswillingtolendthemoney,butthattheyrequirerepaymentofthe$100plussomecompensationfortheopportunitycostandanyuncertaintytheloanwillberepaidaspromised.Then: theamountoftheloan,the$100,istheprincipal;and thecompensationrequiredforallowingsomeoneelsetousethe$100istheinterest.Lookingatthissamesituationfromtheperspectiveoftimeandvalue,theamountthatyouarewillingtolendtodayistheloan’spresentvalue.Theamountthatyourequiretobepaidattheendoftheloanperiodis
TheMathofFinance 203 theloan’sfuturevalue.Therefore,thefutureperiod’svalueiscomprisedoftwoparts:AmountpaidattheendoftheloanPrincipalInterest Futurevalue = Presentvalue + Interestor,usingnotation, FV = PV + ( i × PV ) Ifyouwouldknowthevalueofmoney,goandtrytoborrowsome.—BenjaminFranklin Theinterestiscompensationfortheuseoffundsfortheperiodoftheloan.Itconsistsof: 1. compensationforthelengthoftimethemoneyisborrowed;and 2. compensationfortheriskthattheamountborrowedwillnotberepaidexactlyassetforthintheloanagreement. CALCULATINGTHEFUTUREVALUE Supposeyoudeposit$1,000intoasavingsaccountattheSafeSavingsBankandyouarepromised5%interestperperiod.Attheendofoneperiod,youwouldhave$1,050.This$1,050consistsofthereturnofyourprincipalamountoftheinvestment(the$1,000)andtheinterestorreturnonyourinvestment(the$50).Let’slabelthesevalues: $1,000isthevaluetoday,thepresentvalue, PV . $1,050isthevalueattheendofoneperiod,thefuturevalue, FV . 5%istherateinterestisearnedinoneperiod,theinterestrate, i .Togettothefuturevaluefromthepresentvalue: FV = PV + Interest FV = PV + PV × iFV = PV × (1 + i )$1,050 = $1,000 × (1.05)
204 VALUATIONANDANALYTICALTOOLS Ifthe$50interestiswithdrawnattheendoftheperiod,theprincipalislefttoearninterestatthe5%rate.Wheneveryoudothis,youearn simpleinterest .Itissimplebecauseitrepeatsitselfinexactlythesamewayfromoneperiodtothenextaslongasyoutakeouttheinterestattheendofeachperiodandtheprincipalremainsthesame. Timeismoney.—BenjaminFranklin If,ontheotherhand,boththeprincipalandtheinterestareleftondepositattheSafeSavingsBank,thebalanceearnsinterestonthepreviouslypaidinterest,referredtoas compoundinterest .Earninginterestoninterestiscalledcompoundingbecausethebalanceatanytimeisacombinationoftheprincipal,interestonprincipal,and interestonaccumulatedinterest (orsimply, interestoninterest ).Ifyoucompoundinterestforonemoreperiodinourexample,theoriginal$1,000growsto$1,052.50: FV = Principal + Firstperiodinterest + Secondperiodinterest = PV + PV × i + [ PV (1 + i )] × i = $1,000.00 + ($1,000.00 × 0.05) + ($1,050.00 × 0.05) = $1,000.00 + 50.00 + 52.50 = $1,052.50Thepresentvalueoftheinvestmentis$1,000,theinterestearnedovertwoyearsis$52.50,andthefuturevalueoftheinvestmentaftertwoyearsis$1,052.50.Ifthisweresimpleinterest,thefuturevaluewouldbe$1,050.Therefore,theinterestoninterest—theresultsofcompounding—is$2.50.WecanusesomeshorthandtorepresenttheFVattheendoftwoperiods:FV = PV(1 + i ) 2 Thebalanceintheaccounttwoyearsfromnow,$1,052.50,iscomprisedofthreeparts: Theprincipal,$1,000. Interestonprincipal:$50inthefrstperiodplus$50inthesecondperiod. Interestoninterest:5%ofthefrstperiod’sinterest,or0.05 × $50 = $2.50.
TheMathofFinance 205 Todeterminethefuturevaluewithcompoundinterestformorethantwoperiods,wefollowalongthesamelines:FV = PV(1 + i ) N (10.1)Thevalueof N isthenumberofcompoundingperiods,whereacom-poundingperiodistheunitoftimeafterwhichinterestispaidattherate i .Aperiodmaybeanylengthoftime:aminute,aday,amonth,orayear.Theimportantthingistobeconsistentthroughthecalculations.Theterm“(1 + i ) N ”isthe compoundfactor ,anditistherateofexchangebetweenpresentdollarsandfuturedollars, n compoundingperiodsintothefuture. TheentireessenceofAmericaisthehopetofrstmakemoney—thenmakemoneywithmoney—thenmakelotsofmoneywithlotsofmoney.—PaulErdman Equation(10.1)isthefoundationoffnancialmathematics.Itrelatesavalueatonepointintimetoavalueatanotherpointintime,consideringthecompoundingofinterest.Weshowtherelationbetweenpresentandfuturevaluesforaprincipalof$1,000andinterestof5%perperiodthrough10compoundingperiodsinExhibit10.1.Forexample,thevalueof$1,000,earninginterestat5%perperiod,is$1,628.89,whichis10periodsintothefuture: FV = $1 , 000(1 + 0 . 05) 10 = $1 , 000(1 . 62898) = $1 , 628 . 89Aftertenyears,therewillbe$1,628.89intheaccount,consistingof: Theprincipal,$1,000; Interestontheprincipalof$1,000:$50perperiodfor10periodsor$500;and Interestoninteresttotaling$128.89.Ifyouleftthemoneyinthebank,after50yearsyouwouldhave: FV = $1 , 000(1 + 0 . 05) 50 = $11 , 467 . 40Ifthisweresimpleinterestinsteadofcompoundinterest,thebalanceafter50yearswouldbe:$1,000 + [50 × $1,000 × 0.05] = $3,500.Inotherwords,the$11,467.40–3,500 = $7,967.40.Thisisthepowerofcompounding.
206 VALUATIONANDANALYTICALTOOLS Value at the End of the Period Number of Compound Periods EXHIBIT10.1 TheFutureValueof$1,000Investedfor10YearsinanAccountThatPays10%CompoundedInterestperYear Wecanusefnancialcalculators,scientifccalculatorswithfnancialfunctions,orspreadsheetstosolvemostanyfnancialproblem.Considertheproblemofcalculatingthefuturevalueof$1,000at5%for10years: Hewlett-Packard10BTexasInstruments83/84MicrosoftExcel 1000 + / − PV10N5I/YRPVN = 10I% = 5PV =− 1000 Placecursorat FV = andthen SOLVE = FV(.05,10,0, − 1000)Afewnotesaboutenteringthedataintothecalculatororspreadsheet: 1. Youneedtochangethesignofthepresentvaluetonegative,refectingtheinvestment(negativecashfow). 2. Youenterinterestratesaswholevaluesformwhenusingthefnancialfunctionswithinacalculator,butentertheseindecimalformifus-ingthemathfunctionsofacalculationorthefnancialfunctionsofaspreadsheet.
TheMathofFinance 207 3. Ifyouareusingthefnancialfunctionofascientifccalculator,youneedtofrstenterthisfunction.InthecaseoftheTexasInstruments83or84calculator,forexample,thisisdonethroughAPPS > Finance > TVMSolver. 4. Ifyouareusingaspreadsheetfunction,youmustentera0inplaceofanunusedargument. 1 EXAMPLE10.1:GUARANTEEDINVESTMENTCONTRACTS Acommoninvestmentproductofalifeinsurancecompanyisaguar-anteedinvestmentcontract(GIC).Withthisinvestment,aninsurancecompanyguaranteesaspecifedinterestrateforaperiodofyears.Supposethatthelifeinsurancecompanyagreestopay6%annuallyforafve-yearGICandtheamountinvestedbythepolicyholderis$10million.Theamountoftheliability(thatis,theamountthislifeinsurancecompanyhasagreedtopaytheGICpolicyholder)isthefuturevalueof$10millionwheninvestedat6%interestforfveyears: PV = $10 , 000 , 000 , i = 6% , and N = 5 , sothatthefuturevalueis FV = $10 , 000 , 000(1 + 0 . 06) 5 = $13 , 382 , 256 TRYIT!FUTUREVALUE Ifyoudeposit$100inasavingaccountthatpays2%interestperyear,compoundedannually,howmuchwillyouhaveintheaccountattheendof a. fveyears? b. 10years? c. 20years? 1 Forexample,theFVfunctionhasthefollowingarguments:interestrate,numberofperiods,payment,andpresentvalue.Becausethislastproblemdoesnotinvolveanyperiodicpayments,weusedazeroforthatargument.
208 VALUATIONANDANALYTICALTOOLS GrowthRatesandReturns Wecanexpressthechangeinthevalueofthesavingsbalanceasagrowthrate.A growthrate istherateatwhichavalueappreciates(apositivegrowth)ordepreciates(anegativegrowth)overtime.Our$1,000grewatarateof5%peryearoverthe10-yearperiodto$1,628.89.Theaverageannualgrowthrateofourinvestmentof$1,000is5%—thevalueofthesavingsaccountbalanceincreased5%peryear.Wecouldalsoexpresstheappreciationinoursavingsbalanceintermsofareturn.A return istheincomeonaninvestment,generallystatedasachangeinthevalueoftheinvestmentovereachperioddividedbytheamountattheinvestmentatthebeginningoftheperiod.Wecouldalsosaythatourinvestmentof$1,000providesanaverageannualreturnof5%peryear.Theaverageannualreturnisnotcalculatedbytakingthechangeinvalueovertheentire10-yearperiod($1,629.89 − $1,000)anddividingitby$1,000.Thiswouldproducean arithmeticaveragereturn of62.889%overthe10-yearperiod,or6.2889%peryear.Butthearithmeticaverageignorestheprocessofcompounding,sothisisnotthecorrectannualreturn.Thecorrectwayofcalculatingtheaverageannualreturnistousea geometricaveragereturn :Geometricaveragereturn = N FV PV − 1(10.2)whichisarearrangementofequation(10.1).Usingthevaluesfromtheexample,Geometricaveragereturn = 10 $1 , 628 . 89 $1 , 000 . 00 − 1 = 5%Therefore,theannualreturnontheinvestmentasthe compoundaverageannualreturn orthe truereturn —is5%peryear. Hewlett-Packard10BTexasInstruments83/84MicrosoftExcel 1000 + / − PV10N1628.89FVI/YRN = 10PV =− 1000FV = 1628.89 Placecursorat I% = andthen SOLVE = RATE(10,0, − 1000,1628.89)
TheMathofFinance 209 TRYIT!GROWTHRATES Supposeyouinvest$2,000todayandyoudoubleyourmoneyafterfveyears.Whatistheannualgrowthrateonyourinvestment? CompoundingMoreThanOnceperYear Aninvestmentmaypayinterestmorethanonetimeperyear.Forexample,interestmaybepaidsemiannually,quarterly,monthly,weekly,ordaily,eventhoughthestatedrateisquotedonanannualbasis.Iftheinterestisstatedas,say,4%peryear,compoundedsemiannually,thenominalrate—oftenreferredtoasthe annualpercentagerate (APR)—is4%.Supposeweinvest$10,000inanaccountthatpaysintereststatedatarateof4%peryear,withinterestcompoundedquarterly.Howmuchwillwehaveafterfveyearsifwedonotmakeanywithdrawals?Wecanapproachproblemswhencompoundingismorefrequentthanonceperyearusingtwodifferentmethods: Method1:Converttheinformationintocompoundingperiodsandsolve Theinputs: PV = $10,000 N = 5 × 4 = 20 i = 4% ÷ 4 = 1%Solvefor FV:FV = $10,000(1 + 0.01) 20 = $12,201.90 Method2:ConverttheAPRintoaneffectiveannualrateandsolve Theinputs: PV = $10,000 N = 5 i = (1 + 0.01) 4 − 1 = 4.0604%Solvefor FV:FV = $10,000(1 + 0.040601) 5 = $12,201.90Bothmethodswillgetyoutothecorrectanswer.InMethod1,youneedtoadjustboththenumberofperiodsandtherate.InMethod2,youneedtofrstcalculatetheeffectiveannualrate,inthiscase4.0601%,beforecalculatingthefuturevalue.
210 VALUATIONANDANALYTICALTOOLS CompoundingfrequencyCompoundperiodRate percompoundperiodNumber ofcompound periodsin 10 yearsFuturevalue Annual1 year8%10$215.89Semiannual6 months4%20$219.11Quarterly3 months2%40$220.80Monthly1 month0.67%120$221.96$6,000MonthlyAnnual$1,000$00412101620 Number of Years Future Value 24283236404448$2,000$3,000$4,000$5,000 EXHIBIT10.2 Valueof$100InvestedintheAccountThatPays8%InterestperYearfor10YearsforDifferentFrequenciesofCompounding Thefrequencyofcompoundingmatters.Toseehowthisworks,let’suseanexampleofadepositof$100inanaccountthatpaysinterestatarateof8%peryear,withinterestcompoundedfordifferentcompoundingfrequencies.Howmuchisintheaccountafter,say,10yearsdependsonthecompoundingfrequency,asweshowinExhibit10.2.Attheendoftenyears,thedifferenceinthefuturevaluesbetweenannualandmonthlycompoundingisalittlemorethan$6.After50years,thedifferenceis$5,388–4,690 = $698. EXAMPLE10.2:QUARTERLYCOMPOUNDING Supposeweinvest$200,000inaninvestmentthatpays4%interestperyear,compoundedquarterly.Whatwillbethefuturevalueofthisinvestmentattheendof10years?
TheMathofFinance 211 Solution: Thegiveninformationis: i = 4% / 4 = 1%and N = 10 × 4 = 40quarters . Therefore, FV = $200,000(1 + 0.01) 40 = $297,772.75 TRYIT!MOREGROWTHRATES Completethefollowingtable,calculatingtheannualgrowthrateforeachinvestment. PresentValueFutureValueNumberofYearsGrowthRate $1$36 $1,000$2,0009 $500$6007 $1$1.504 ContinuousCompounding Theextremefrequencyofcompoundingis continuouscompounding —interestiscompoundedinstantaneously.Thefactorforcompoundingcon-tinuouslyforoneyearis e APR ,where e is2.71828 ... ,thebaseofthenaturallogarithm.Andthefactorforcompoundingcontinuouslyfortwoyearsis e APR × e APR or e 2APR .Thefuturevalueofanamountthatiscompoundedcontinuouslyfor N yearsis FV = PVe N (APR) (10.3)whereAPRistheannualpercentagerateand e N (APR) isthecompoundfactor.
212 VALUATIONANDANALYTICALTOOLS If$1,000isdepositedinanaccountforfveyears,withinterestof12%peryear,compoundedcontinuously, FV = $1 , 000 e 5(0 . 12) = $1 , 000( e 0 . 60 ) = $1 , 000 × 1 . 82212 = $1 , 822 . 12Comparingthisfuturevaluewiththatifinterestiscompoundedannuallyat12%peryearforfveyears,$1,000(1 + 0.12) 5 = $1,762.34,weseetheeffectsofthisextremefrequencyofcompounding. Thisprocessofgrowingproportionately,ateveryinstant,tothemagnitudeatthatinstant,somepeoplecallalogarithmicrateofgrowing.Unitlogarithmicrateofgrowthisthatratewhichinunittimewillcause1togrowto2.718281.Itmightalsobecalledtheorganicrateofgrowing:becauseitischaracteristicoforganicgrowth(incertaincircumstances)thattheincrementoftheorganisminagiventimeisproportionaltothemagnitudeoftheorganismitself.—SilvanusP.Thompson, CalculusMadeEasy (London:MacMillanandCo.Limited,1914),p.140 TRYIT!FREQUENCYOFCOMPOUNDING Ifyoudeposit$100inasavingaccounttodaythatpays2%interestperyear,howmuchwillyouhaveintheaccountattheendof10yearsifinterestiscompounded: a. annually? b. quarterly? c. continuously? MultipleRates Inourdiscussionthusfar,wehaveassumedthattheinvestmentwillearnthesameperiodicinterestrate, i .Wecanextendthecalculationofafuturevaluetoallowfordifferentinterestratesorgrowthratesfordifferentperiods.
TheMathofFinance 213 Supposeaninvestmentof$10,000pays5%duringthefrstyearand4%duringthesecondyear.Attheendofthefrstperiod,thevalueoftheinvestmentis$10,000(1 + 0.05),or$10,500.Duringthesecondperiod,this$10,500earnsinterestat4%.Therefore,thefuturevalueofthis$10,000attheendofthesecondperiodis FV = $10 , 000(1 + 0 . 05)(1 + 0 . 4) = $10 , 920Wecanwritethismoregenerallyas: FV = PV (1 + i 1 )(1 + i 2 )(1 + i 3 ) ... (1 + i N )(10.4)where i N istheinterestrateforperiod N . EXAMPLE10.3:DIFFERENTINTERESTRATESFORDIFFERENTPERIODS Considera$50,000investmentinaone-yearbank certifcateofdeposit (CD)todayandrolledoverannuallyforthenexttwoyearsintoone-yearCDs.Thefuturevalueofthe$50,000investmentwilldependontheone-yearCDrateeachtimethefundsarerolledover.Assumethattheone-yearCDratetodayis5%andthatitisexpectedthattheone-yearCDrateoneyearfromnowwillbe6%,andtheone-yearCDratetwoyearsfromnowwillbe6.5%. a. Whatisthefuturevalueofthisinvestmentattheendofthreeyears? b. WhatistheaverageannualreturnonyourCDinvestment? Solution a. FV = $50,000(1 + 0.05)(1 + 0.06)(1 + 0.065) = $59,267.25 b. i = 3 $59 , 267 . 25 $50 , 000 − 1 = 5 . 8315% CALCULATINGAPRESENTVALUE Nowthatweunderstandhowtocomputefuturevalues,let’sworktheprocessinreverse.Supposethatforborrowingaspecifcamountofmoneytoday,theTrustworthyCompanypromisestopaylenders$5,000twoyears
214 VALUATIONANDANALYTICALTOOLS fromtoday.HowmuchshouldthelendersbewillingtolendTrustworthyinexchangeforthispromise?Thisdilemmaisdifferentthancalculatingafuturevalue.Herewearegiventhefuturevalueandhavetocalculatethepresentvalue.Butwecanusethesamebasicideafromthefuturevalueproblemstosolvepresentvalueproblems.Ifyoucanearn5%onotherinvestmentsthathavethesameamountofuncertaintyasthe$5,000Trustworthypromisestopay,then: Thefuturevalue, FV = $5,000. Thenumberofcompoundingperiods, N = 2. Theinterestrate, i = 5%.Wealsoknowthebasicrelationbetweenthepresentandfuturevalues: FV = PV (1 + i ) N Substitutingtheknownvaluesintothisequation:$5 , 000 = PV (1 + 0 . 05) 2 Todeterminehowmuchyouarewillingtolendnow, PV ,toget$5,000oneyearfromnow, FV ,requiressolvingthisequationfortheunknownpresentvalue: FV = PV (1 + i ) N $5 , 000 = PV (1 + 0 . 05) 2 Therefore,youwouldbewillingtolend$4,535.15toreceive$5,000oneyearfromtodayifyouropportunitycostis5%.Wecancheckourworkbyreworkingtheproblemfromthereverseperspective.Supposeyouinvested$4,535.15fortwoyearsanditearned5%peryear.Whatisthevalueofthisinvestmentattheendoftheyear?Weknow: PV = $4,535.15.25, N = 5%or0.05,and i = 2.Therefore,thefuturevalueis$5,000: FV = PV (1 + i ) N = $4 , 535 . 15(1 + 0 . 05) 2 = $5 , 000 . 00Compoundingtranslatesavalueinonepointintimeintoavalueatsomefuturepointintime.Theoppositeprocesstranslatesfuturevaluesintopresentvalues:Discountingtranslatesavaluebackintime.Fromthebasicvaluationequation, FV = PV (1 + i ) N wedividebothsidesby(1 + i ) N andexchangesidestogetthepresentvalue, PV = FV (1 + i ) N = FV 1 1 + i N = FV 1 (1 + i ) N (10.5)
TheMathofFinance 215 $5,000.00$4,761.90$4,535.15$4,319.19$4,113.15 $3,917.63$3,731.08$3,553.41$3,384.20$3,223.04$3,069.57$2,923.40$2,784.19$2,651.61$2,525.34$2,405.09 $0$1,000$2,000$3,000$4,000$5,0000123456789101112131415 Number of Discount Periods Present Value EXHIBIT10.3 PresentValueof$5,000for0to15Periods,ataDiscountRateof5%perPeriod Intheright-mostform,theterminsquarebracketsisreferredtoasthe discountfactor sinceitisusedtotranslateafuturevaluetoitsequivalentpresentvalue.Wecanrestateourproblemas: PV = $5 , 000 (1 + 0 . 05) 2 = $5 , 000 1 (1 + 0 . 05) 2 = $5 , 000 × 0 . 90703 = $4 , 535 . 15 , wherethediscountfactoris0.90703.Weprovidethepresentvalueof$5,000fordiscountperiodsrangingfrom0to15inExhibit10.3.Wecanalsocalculatethispresentusingacalculatororaspreadsheet.Considerthepresentvalueofthe$5,000at5%fortenyears: Hewlett-Packard10BTexasInstruments83/84MicrosoftExcel 5000FV10N5I/YRPVN = 10FV = 5000I% = 5PlacecursoratI% = andthenSOLVE = PV(.05,10,0,5000)Ifthefrequencyofcompoundingisgreaterthanonceayear,wemakeadjustmentstotherateperperiodandthenumberofperiodsaswedidincompounding.Forexample,ifthefuturevaluefveyearsfromtodayis$100,000andtheinterestis6%peryear,compoundedsemiannually,
216 VALUATIONANDANALYTICALTOOLS i = 6% ÷ 2 = 3%, N = 5 × 2 = 10,andthepresentvalueis$134,392: PV = $100 , 000(1 + 0 . 03) 10 = $100 , 000 × 1 . 34392 = $134 , 392 TRYIT!PRESENTVALUE Youarepresentedwithaninvestmentthatpromises$1,000intenyears.Ifyouconsidertheappropriatediscountratetobe6%,basedonwhatyoucanearnonsimilarriskinvestments,whatwouldyoubewillingtopayforthisinvestmenttoday? EXAMPLE10.4:MEETINGASAVINGSGOAL Supposethatthegoalistohave$75,000inanaccountbytheendoffouryears.Andsupposethatinterestonthisaccountispaidatarateof5%peryear,compoundedsemiannually.Howmuchmustbedepositedintheaccounttodaytoreachthisgoal? Solution Wearegiven FV = $75,000, i = 5% × 2 = 2.5%persixmonths,and N = 4 × 2 = 8six-monthperiods.Therefore,theamountoftherequireddepositis: PV = $75 , 000 (1 + 0 . 025) 8 = $61 , 555 . 99 DETERMININGTHEUNKNOWNINTERESTRATE Aswesawearlierinourdiscussionofgrowthrates,wecanrearrangethebasicequationtosolvefor i : i = N FV PV − 1
TheMathofFinance 217 whichisthesameas: i = ( FV / PV ) 1 / N − 1Asanexample,supposethatthevalueofaninvestmenttodayis$2,000andtheexpectedvalueoftheinvestmentinfveyears$3,000.Whatistheannualrateofappreciationinvalueofthisinvestmentoverthefve-yearperiod? i = 5 $3 , 000 $2 , 000 − 1 = 8 . 447%Therearemanyapplicationsinfnancewhereitisnecessarytodeterminetherateofchangeinvaluesoveraperiodoftime.Ifvaluesareincreasingovertime,werefertotherateofchangeasthegrowthrate.Tomakecomparisonseasier,weusuallyspecifythegrowthrateasarateperyear. EXAMPLE10.5:INTERESTRATES ConsiderthegrowthrateofdividendsforGeneralElectric.GeneralElectricpaysdividendseachyear.In1996,forexample,GeneralElec-tricpaiddividendsof$0.317pershareofitscommonstock,whereasin2006thecompanypaid$1.03individendspersharein2006. Solution Thisrepresentsagrowthrateof12.507%: i = 10 $1 . 03 $0 . 317 − 1 = 12 . 507% THETIMEVALUEOFASERIESOFCASHFLOWS Applicationsinfnancemayrequiredeterminingthepresentorfuturevalueofaseriesofcashfowsratherthansimplyasinglecashfow.Theprinciplesofdeterminingthefuturevalueorpresentvalueofaseriesofcashfowsarethesameasforasinglecashfow,yetthemathbecomesabitmorecumbersome.
218 VALUATIONANDANALYTICALTOOLS SupposethatthefollowingdepositsaremadeinaThriftySavingsandLoanaccountpaying5%interest,compoundedannually: PeriodEndofPeriodCashFlow 0$1,0001$2,0002$1,500Whatisthebalanceinthesavingsaccountattheendofthesecondyeariftherearenowithdrawalsandinterestispaidannually?Let’ssimplifyanyproblemlikethisbyreferringtotodayastheendofperiod0,andidentifyingtheendofthefrstandeachsuccessiveperiodas1,2,3,andsoon.Representeachend-of-periodcashfowas CF withasubscriptspecifyingtheperiodtowhichitcorresponds.Thus, CF 0 isacashfowtoday, CF 10 isacashfowattheendofperiod10,and CF 25 isacashfowattheendofperiod25,andsoon.Inourexample, CF 0 is$1,000, CF 1 is$2,000,and CF 2 is$1,500.Representingtheinformationinourexampleusingcashfowandperiodnotation: FV = CF 0 (1 + i ) 2 + CF 1 (1 + i ) 1 + CF 2 (1 + i ) 0 Itisimportanttogetthecompoundingcorrect.Forexample,thereisnocompoundingofthecashfowthatoccursattheendofthesecondperiodtoarriveatafuturevalueattheendofthesecondperiod.Hence,thefactoris(1 + i ) 0 = 1.WecanrepresentthesecashfowsinatimelineinExhibit10.4tohelpgraphicallydepictandsortouteachcashfowinaseries.Fromthisexample,youcanseethatthefuturevalueoftheentireseriesisthesumofeachofthe EXHIBIT10.4 TimeLinefortheFutureValueofaSeriesofUnevenCashFlowsDepositedtoEarn5%CompoundInterestperPeriod 012||| |||$1,000.00$2,000.00$1,500.00 $2,000(1 + 0.05) = 2,100.00 $1,000.00(1 + 0.05) 2 = 1,102.50 $4,702.50
TheMathofFinance 219 compoundedcashfowscomprisingtheseries.Inmuchthesameway,wecandeterminethefuturevalueofaseriescomprisinganynumberofcashfows.Andifweneedto,wecandeterminethefuturevalueofanumberofcashfowsbeforetheendoftheseries.Todeterminethepresentvalueofaseriesoffuturecashfows,eachcashfowisdiscountedbacktothepresent,wherewedesignatethebeginningofthefrstperiod,today,as0.Asanexample,considertheThriftySavings&Loanproblemfromadifferentangle.Insteadofcalculatingwhatthedepositsandtheinterestonthesedepositswillbeworthinthefuture,let’scalculatethepresentvalueofthedeposits.Thepresentvalueiswhatthesefuturedepositsareworthtoday.Supposeyouarepromisedthefollowingcashfows: PeriodCashFlowEndofPeriodCashFlow 0 CF 0 $1,0001 CF 1 $2,0002 CF 2 $1,500Whatisthepresentvalueofthesecashfows—thatis,attheendofperiod0—ifthediscountrateis5%?Wewouldusethesamemethodthatweusedinthepreviousproblem—justbackwards.WeshowthisinExhibit10.5.Asyoucanseeinthisexhibit,wedon’tdiscountthecashfowthatoccurstoday.Wediscountthefrstperiod’scashfowoneperiod,anddiscountthesecondperiod’scashfowtwoperiods. EXHIBIT10.5 TimeLineforthePresentValueofaSeriesofUnevenCashFlowsDepositedtoEarn5%CompoundedInterestperPeriod 012||| |||$1,000.00$2,000.00$1,500.001,904.76$2 , 000 (1 + 0 . 05) 1,360.54 $1 , 500 (1 + 0 . 05) 2 $4,265.30
220 VALUATIONANDANALYTICALTOOLS Youmayalsonoticearelationbetweenthefuturevaluethatwecal-culatedinExhibit10.4andthepresentvaluethatwecalculatedinEx-hibit10.5,withbothexamplesusingthesamesetofcashfowsandsameinterestrate—justgoingindifferentdirections:$4 , 265 . 30(1 + 0 . 05) 2 = $4 , 702 . 50 Gettin’Fancy Wecanrepresentthefuturevalueofaseriesofcashfowsas: FV = N t = 0 CF t (1 + i ) N − t (10.6)This,simply,meansthatthefuturevalueofaseriesofcashfowsisthesumofthefuturevalueofeachcashfow,whereeachofthefuturevalueconsiderstheamountofthecashfowandthenumberofcompoundingperiod.Therefore,ifthereare10periods,thecashfowfromoccurringattheendofthesixthperiod, CF 6 ,wouldhaveinterestcompounded N − t = 10 − 6 = 4periods,andthecashfowoccurringattheendofthetenthperiodwouldnothaveanycompounding.And,likewise,wecanrepresentthepresentvalueofaseriesusingsum-mationnotationas: PV = N t = 0 CF t (1 + i ) t (10.7)withasimilarexplanation.Forexample,thecashfowoccurringattheendoftheffthperiodisdiscountedfveperiodsatthediscountrateof i . MultipleRates Inourillustrationsthusfar,wehaveusedoneinterestratetocomputethepresentvalueofallcashfowsinaseries.However,thereisnoreasonthatoneinterestratemustbeused.Forexample,supposethatthecashfowisthesameasusedearlier:$1,000today,$2,000attheendofperiod1,and$1,500attheendofperiod2.Now,insteadofassumingthata5%interestratecanbeearnedifasumisinvestedtodayuntiltheendofperiod1andtheendofperiod2,itisassumedthatanamountinvestedtodayforoneperiodcanearn5%butanamountinvestedtodayfortwoperiodscanearn6%.Inthiscase,thecalculationofthepresentvalueofthecashfowattheendofperiod1(the$2,000)isobtainedinthesamewayasbefore:computingthepresentvalueusinganinterestrateof5%.However,we
TheMathofFinance 221 EXHIBIT10.6 TimeLineforthePresentValueofaSeriesofUnevenCashFlowsDepositedtoEarn5%CompoundedInterestperPeriod 012||| |||$1,000.00$2,000.00$1,500.001,904.76$2 , 000 (1 + 0 . 05) 1,334.99 $1 , 500 (1 + 0 . 06) 2 $4,239.75 mustcalculatethepresentvalueforthecashfowattheendofperiod2(the$1,500)usinganinterestrateof6%.WedepictthepresentvaluecalculationinExhibit10.6.Asexpected,thepresentvalueofthecashfowsislessthana5%interestrateisassumedtobeearnedfortwoperiods($4,239.75versus$4,265.39).Althoughinmanyillustrationsandapplicationsthroughoutthisbookwewillassumeasingleinterestratefordeterminingthepresentvalueofaseriesofcashfows,inmanyreal-worldapplicationsmultipleinterestratesareused.Thisisbecauseinreal-worldfnancialmarketstheinterestratethatcanbeearneddependsontheamountoftimetheinvestmentisexpectedtobeoutstanding.Typically,thereisapositiverelationshipbetweeninterestratesandthelengthoftimetheinvestmentmustbeheld.Therelationshipbetweeninterestratesoninvestmentsandthelengthoftimetheinvestmentmustbeheldiscalledtheyieldcurve.Theformulaforthepresentvalueofaseriesofcashfowswhenthereisadifferentinterestrateisasimplemodifcationofthesingleinterestratecase.Intheformula, i isreplacedby i withasubscripttodenotetheperiod, i t .Thatis, PV = N t = 0 CF t (1 + i t ) t ANNUITIES Therearevaluationproblemsthatrequireustoevaluateaseriesoflevelcashfows—eachcashfowisthesameamountastheothers—receivedatregularintervals.Let’ssupposeyouexpecttodeposit$2,000attheendof
222 VALUATIONANDANALYTICALTOOLS EXHIBIT10.7 TimeLineforaSeriesofEvenCashFlowsDepositedtoEarn5%InterestperPeriod A:FutureValue 01234||||| ||||$2,000.00$2,000.00$2,000.00$2,000.00 2,100.00 2,205.00 2,315.25 $8,620.25 B:PresentValue 01234||||| ||||$2,000.00$2,000.00$2,000.00$2,000.00$1,904.76 1,814.06 1,727.68 1,645.40 $7,091.90 eachofthenextfouryearsinanaccountearning8%compoundedinterest.Howmuchwillyouhaveavailableattheendofthefourthyear?Aswejustdidforthefuturevalueofaseriesofunevencashfows,wecancalculatethefuturevalue(asoftheendofthefourthyear)ofeach$2,000deposit,compoundinginterestat5%,asweshowinExhibit10.7.Thefuturevalueofthisseriesis$8,620.25.Modifyingthefuturevalueofaseriesequationtorefectthatallofthecashfowsarethesame, FV = N t = 0 CF (1 + i ) N − t = CF N t = 0 (1 + i ) N − t (10.8)Aseriesofcashfowsofequalamount,occurringatevenintervalsisreferredtoasan annuity. Determiningthevalueofanannuity,whethercompoundingordiscounting,issimplerthanvaluingunevencashfows.Considerthesameseriesof$2,000forfourperiods,butcalculatethepresentvalueoftheseries.WeshowthiscalculationinPanelBofExhibit10.7.Thepresentvalueofthisseriesis$7,091.90.
TheMathofFinance 223 EXAMPLE10.6:FUTUREVALUEOFANANNUITY Supposeyouwishtodeterminethefuturevalueofaseriesofdepositsof$1,000,depositedeachyearintheNoFaultVaultBankforfveyears,withthefrstdepositmadeattheendofthefrstyear.IftheNFVBankpays5%interestonthebalanceintheaccountattheendofeachyearandnowithdrawalsaremade,whatisthebalanceintheaccountattheendofthefveyears? Solution Inequationform, FV = $1 , 000 5 t = 1 (1 + 0 . 05) N − t = $1 , 000(5 . 5263) = $5 , 525 . 63Summingtheindividualfuturevalues: CashFlowAmountFutureValue CF 1 $1,000$1,215.51 CF 2 $1,0001,157.63 CF 3 $1,0001,102.50 CF 4 $1,0001,050.00 CF 5 $1,0001.000.00 Total$5,525.63Calculatorandspreadsheetinputs:Periodicpayment = PMT = 1,000i = 5%(inputas5forcalculator,0.05forspreadsheet)N = 5SolveforFV Aswedidwiththefuturevalueofanevenseries,wecansimplifytheequationforthepresentvalueofaseriesoflevelcashfowsbeginningafteroneperiodas: PV = N t = 0 CF (1 + i ) t = CF N t = 0 1 (1 + i ) t (10.9)
224 VALUATIONANDANALYTICALTOOLS EXHIBIT10.8 TimeLineforaSeriesofEvenCashFlowsDepositedtoEarn4%InterestperPeriod A:FutureValueoftheOrdinaryAnnuity 01234||||| ||||$500.00$500.00$500.00$500.00 520.00 540.80 562.43 $2,123.23 B:FutureValueoftheAnnuityDue 01234|||||||||$500.00$500.00$500.00$500.00 $520.00 540.80 562.43584.93 $2,208.16 Anotherwayoflookingatthisisthatthepresentvalueofanannuityisequaltotheamountofonecashfowmultipliedbythesumofthediscountfactors.Ifthecashfowsoccurattheendofeachperiod(thatis,thefrstcashfowoccursoneperiodfromtoday),werefertothisasan ordinaryannuity .ThetwoexamplesthatweprovideinExhibit10.8arebothordinaryannuities. EXAMPLE10.7:PRESENTVALUEOFANANNUITY Considerafve-paymentannuity,withpaymentsof$500attheendofeachofthenextfveyears. a. Iftheappropriatediscountrateis4%,whatisthepresentvalueofthisannuity? b. Iftheappropriatediscountrateis5%,whatisthepresentvalueofthisannuity?
TheMathofFinance 225 Solution a. Given: PMT = $500; i = 4%; N = 5.Solvefor PV . PV = $2,225.91 b. Given: PMT = $500, i = 4%, N = 5.Solvefor PV . PV = $2,164.74Note:Thehigherthediscountrate,thelowerthepresentvalueoftheannuity.Equations(10.8)and(10.9)arethevaluation—futureandpresentvalue—formulasforanordinaryannuity.Anordinaryannuityisthere-foreaspecialformofannuity,wherethefrstcashfowoccursattheendofthefrstperiod.Thisannuityshort-cutisbuiltintofnancialcalculatorsandspread-sheetfunctions.Forexample,inthecaseofthepresentvalueofthefour-paymentordinaryannuityof$2,000at5%: Hewlett-Packard10BTexasInstruments83/84MicrosoftExcel 2000PMT4N5I/YRPVN = 4I% = 5PMT = 2000FV = 0 Placecursorat PV = andthen SOLVE = PV(.05,4,2000,0) ValuingaPerpetuity Therearesomecircumstanceswherecashfowsareexpectedtocontinueforever.Forexample,acorporationmaypromisetopaydividendsonpre-ferredstockforever,or,acompanymayissueabondthatpaysinteresteverysixmonths,forever.Howdoyouvaluethesecashfowstreams?Recallthatwhenwecalculatedthepresentvalueofanannuity,wetooktheamountofonecashfowandmultiplieditbythesumofthediscountfactorsthatcorrespondedtotheinterestrateandnumberofpayments.Butwhatifthenumberofpaymentsextendsforever—intoinfnity?Aseriesofcashfowsthatoccuratregularintervals,forever,isa perpe-tuity .Valuingaperpetualcashfowstreamisjustlikevaluinganordinary
226 VALUATIONANDANALYTICALTOOLS annuity,buttheNisreplacedby ∞ : PV = CF ∞ t = 1 1 1 + i t Asthenumberofdiscountingperiodsapproachesinfnity,thesumma-tionapproaches1/ i ,so: PV = CF i (10.10)Supposeyouareconsideringaninvestmentthatpromisestopay$100eachperiodforever,andtheinterestrateyoucanearnonalternativeinvest-mentsofsimilarriskis5%perperiod.Whatareyouwillingtopaytodayforthisinvestment? PV = $100 0 . 05 = $2 , 000Therefore,youwouldbewillingtopay$2,000todayforthisinvestmenttoreceive,inreturn,thepromiseof$100eachperiodforever. EXAMPLE10.8:PERPETUITY Supposethatyouaregiventheopportunitytopurchaseaninvestmentfor$5,000thatpromisestopay$50attheendofeveryperiodforever.Whatistheperiodicinterestperperiod—thereturn—associatedwiththisinvestment? Solution Weknowthatthepresentvalueis PV = $5,000andtheperiodic,perpetualpaymentis CF = $50.Insertingthesevaluesintotheformulaforthepresentvalueofaperpetuity,$5 , 000 = $50 i Solvingfor i ,CF = $50, i = 0.01or1%.Therefore,aninvestmentof$5,000thatgenerates$50perperiodprovides1%compoundedinterestperperiod.
TheMathofFinance 227 ValuinganAnnuityDue Intheordinaryannuitycashfowanalysis,weassumethatcashfowsoccurattheendofeachperiod.However,thereisanotherfairlycommoncashfowpatterninwhichlevelcashfowsoccuratregularintervals,butthefrstcashfowoccursimmediately.Thispatternofcashfowsiscalledan annuitydue .Forexample,ifyouwintheMegaMillionsgrandprize,youwillreceiveyourwinningsin20installments(aftertaxes,ofcourse).The20installmentsarepaidoutannually,beginningimmediately.Thelotterywinningsarethereforeanannuitydue.Likethecashfowswehaveconsideredthusfar,thefuturevalueofanannuityduecanbedeterminedbycalculatingthefuturevalueofeachcashfowandsummingthem.And,thepresentvalueofanannuitydueisdeterminedinthesamewayasapresentvalueofanystreamofcashfows.Let’sconsiderfrstanexampleofthefuturevalueofanannuitydue,comparingthevaluesofanordinaryannuityandanannuitydue,eachcomprisingfourcashfowsof$500,compoundedattheinterestrateof4%perperiod.WeshowthecalculationofthefuturevalueofboththeordinaryannuityandtheannuitydueattheendofthreeperiodsinExhibit10.8.Youwillnoticethatthefuturevalueoftheannuitydueis1 + i multipliedbythefuturevalueoftheordinaryannuity.Thisisbecauseeachcashfowearnsinterestforonemoreperiodsinthecaseoftheannuitydue.Thepresentvalueoftheannuitydueiscalculatedinasimilarmanner,adjustingtheordinaryannuityformulaforthedifferentnumberofdiscountperiods.Becausethecashfowsintheannuityduesituationareeachdis-countedonelessperiodthanthecorrespondingcashfowsintheordinaryannuity,thepresentvalueoftheannuitydueisgreaterthanthepresentvalueoftheordinaryannuityforanequivalentamountandnumberofcashfows.WeshowthisinExhibit10.9forthesamefour-payment,$500annuity,butthistimewecomparethepresentvalueoftheordinaryannuitywiththepresentvalueoftheannuitydue.Youwillnoticethatthereisonemoreperiodofdiscountingforeachcashfowintheordinaryannuity,ascomparedtotheannuitydue.Therefore,thepresentvalueoftheannuitydueisequaltothepresentvalueoftheordinaryannuitymultipliedby1 + i ;thatis,$1,814.95(1 + 0.04) = $1,887.55.Calculatingthevalueofanannuitydueusingacalculatororaspread-sheetissimilartothatoftheordinaryannuity,butwithonesmalldiffer-ence.Withcalculators,youneedtochangethemodetothe“due”or“begin”mode.Forexample,whencalculatingthepresentvalueofthefour-payment,$500annuitywiththeHP10Bcalculator,
228 VALUATIONANDANALYTICALTOOLS EXHIBIT10.9 TimeLineforaSeriesofEvenCashFlowsDepositedtoEarn4%InterestperPeriod A:PresentValueoftheOrdinaryAnnuity 01234||||| ||||$500.00$500.00$500.00$500.00$480.77 462.28 444.50 427.40 $1,814.95 B:PresentValueoftheAnnuityDue 01234||||| ||||$500.00$500.00$500.00$500.00480.77 462.28 444.50 $1,887.55 OrdinaryAnnuityAnnuityDue PMT = 500i = 4N = 4ENDmodePMT = 500i = 4N = 4BEGmodeUsingspreadsheets,theonlydifferenceisthelastargumentinthefunc-tion(0ornothingforanordinaryannuity,1foranannuitydue): OrdinaryAnnuityAnnuityDue = PV(0.04,4,500,0,0) = PV(0.04,4,500,0,1)
TheMathofFinance 229 ValuingaDeferredAnnuity A deferredannuity hasastreamofcashfowsofequalamountsatregularperiodsstartingatsometimeaftertheendofthefrstperiod.Whenwecalculatedthepresentvalueofanannuity,webroughtaseriesofcashfowsbacktothebeginningofthefrstperiod—or,equivalentlytheendoftheperiod0.Withadeferredannuity,wedeterminethepresentvalueoftheordinaryannuityandthendiscountthispresentvaluetoanearlierperiod.Supposeyouwanttodepositanamounttodayinanaccountsuchthatyoucanwithdraw$100peryearforthreeyears,withthefrstwithdrawaloccurringthreeyearsfromtoday.WediagramthissetofcashfowsinPanelAofExhibit10.9.Wecansolvethisproblemintwosteps: Step1 :Solveforthepresentvalueofthewithdrawals. Step2 :Discountthispresentvaluetothepresent.Thefrststeprequiresdeterminingthepresentvalueofathree-cash-fowordinaryannuityof$100.Thiscalculationprovidesthepresentvalueasoftheendofthesecondyear(oneperiodpriortothefrstwithdrawal),usinganordinaryannuity.Basedonthiscalculation(presentvalueofanordinaryannuity, N = 3 ,i = 5% ,PMT = $100),youneed$272.32intheaccountattheendofthesecondperiodinordertosatisfythethreewithdrawals.WeshowthisinPanelBofExhibit10.9. 2 Thenextstepistodeterminehowmuchyouneedtodeposittodaytomeetthesavingsgoalof$272.32attheendofthesecondyear.The$272.32isthefuturevalue, N = 2,and i = 5%.Therefore,youneedtodeposit$247.01todaysothatyouwillhave$272.32intwoyears,sothatyoucanthenbegintomakewithdrawalsstartingattheendofthethirdyear.WeshowthisinPanelCofExhibit10.9.Wecancheckourworkbylookingatthebalanceintheaccountattheendofeachperiod,asweshowinPanelDofExhibit10.9.Ifwehaveperformedthecalculationscorrectly,weshouldendupwithazerobalanceatthetimeofthelast$100withdrawal.Remember,thefundsleftintheaccountearn5%.Therefore,forexample,inthethirdperiod,youbeginwith$272.33intheaccount.Theaccountbalanceearns5%or$13.62ofinterestduringthethirdyear.Thisbringsthebalanceintheaccountto 2 Wecouldhavealsosolvedthisproblemusinganannuitydueinthefrststep,whichwouldmeanthatwewoulddiscountthevaluefromthefrststepthreeperiodsinsteadoftwo.
230 VALUATIONANDANALYTICALTOOLS $272.33 + 13.62 = $285.95.Onceweremovethe$100,thebalanceattheendofthethirdyearis$185.95. EXAMPLE10.9:DEFERREDANNUITY Supposeyouwanttoretireandbeabletowithdraw$40,000peryeareachyearfortwentyyearsafteryourretirement.Ifyouplantostopdepositsinyourretirementaccounttenyearspriortoretirement,whatisthebalancethatyoumusthaveinyourretirementaccounttenyearsbeforeyouretireifyoucanearn4%peryearonyourretirementinvestments? Solution Balanceintheaccountoneyearbeforeretirementisthepresentvalueofanordinaryannuitywith: PMT = $40,000 N = 20 i = 4%Solvefor PV . PV oneyearbeforeretirement = $543,613.05Balanceneededtenyearsbeforeretirement: PV 10yearsbeforeretirement = PV oneyearbeforeretirement ÷ (1 + 0.04) 9 = $381,935.32 Deferredannuityproblemscanbecomemorecomplex,suchasdeter-miningasetofpaymentsneededforsomefuturegoal.However,allde-ferredannuityproblemscanbesolvedeasilybybreakingdowntheproblemintosteps. 3 LOANAMORTIZATION Ifanamountisloanedandthenrepaidininstallments,wesaythattheloanisamortized.Therefore, loanamortization istheprocessofcalculating 3 Unfortunately,therearenocalculatorfunctionsorspreadsheetfunctionsthatper-formdeferredannuitycalculationsspecifcally,becausetherearesomanyvariationspossibleonhowthesearedesigned.
TheMathofFinance 231 theloanpaymentsthatamortizetheloanedamount.Wecandeterminetheamountoftheloanpaymentsonceweknowthefrequencyofpayments,theinterestrate,andthenumberofpayments.Consideraloanof$100,000.Iftheloanisrepaidinfourannualinstall-ments(attheendofeachyear)andtheinterestrateis6%peryear.Thefrstthingweneedtodoistocalculatetheamountofeachpayment.Inotherwords,weneedtosolvefor CF: $100 , 000 = 4 t = 1 CF (1 + 0 . 06) t Wewanttosolvefortheloanpayment,thatis,theamountoftheannuity.Thecalculatorandspreadsheetinputsforthiscalculationare: PV = 100,000 i = 6% N = 4andthensolvefor PMT .Thisisthe CF ,theloanpayment.Theloanpaymentis$28,859.15.Wecancalculatetheamountofinter-estandprincipalrepaymentassociatedwitheachloanpaymentusingaloanamortizationschedule,asweshowinPanelAofExhibit10.10.Theloanpaymentsaredeterminedsuchthatafterthelastpaymentismadethereisnoloanbalanceoutstanding.Thus,theloanisreferredtoasa fullyamortizingloan .YoucanseethisinPanelBofExhibit10.3.Eventhoughtheloanpaymenteachyearisthesame,theproportionofinterestandprincipaldifferswitheachpayment:theinterestis5%oftheprincipalamountoftheloanthatremainsatthebeginningoftheperiod,whereastheprincipalrepaidwitheachpaymentisthedifferencebetweenthepaymentandtheinterest.Asthepaymentsaremade,theremainderisappliedtorepaymentoftheprincipal.Thisisthescheduledprincipalrepaymentorthe amortization .Astheprincipalremainingontheloandeclines,lessinterestispaidwitheachpayment.Loanamortizationworksthesamewhetherthisisamortgageloantopurchaseahome,atermloan,oranyotherloansuchasanautomobileloaninwhichtheinterestpaidisdeterminedonthebasisoftheremainingamountoftheloan.Youcanmodifythecalculationoftheloanamortizationtosuitdifferentprincipalrepayments,suchasadditionallump-sumpayments,knownas balloonpayments .SeeExhibit10.11.
232 VALUATIONANDANALYTICALTOOLS A. The savings problem 012345|||||||||||| ?$100$100$100 B. Determining goal at the beginning of the payments 012345|||||||||||| ?$100$100$100$95.24 90.70 86.38 $272.32 C. Determining the deposit that meets goal 012345|||||||||||| ?$100$100$100$272.32$247.01 D. Checking the calculations $300$0 Period $0.00$272.33$259.36$247.01 Balance in the Account $95.24$185.95012345$50$100$150$200$250 EXHIBIT10.10 DeferredAnnuityTimeLinesforaThree-Period,$100AnnuitywiththeFirstCashFlowDeferredThreePeriods INTERESTRATESANDYIELDS Calculatingthepresentorfuturevalueofalump-sumorsetofcashfowsrequiresinformationonthetimingofcashfowsandthecompoundordiscountrate.However,therearemanyapplicationsinwhichwearepre-sentedwithvaluesandcashfows,andwishtocalculatetheyieldorimplied
TheMathofFinance 233 YearBeginningbalance ofthe loanoutstandingPaymentInterest = 6% × beginningbalance ofthe loan Principalrepaid withpayment = payment –interest Remainingprincipal = beginningbalance –principalrepaid 1$100,000.00$28,859.15$6,000.00$22,859.15$77,140.85 2$77,140.85$28,859.15$4,628.45$24,230.70$52,910.15 3$52,910.15$28,859.15$3,174.61$25,684.54$27,225.61 4$27,225.61$100,000$100,000.00$00 Loan Balance Remaining 12 Year 34$20,000$40,000$60,000$80,000$28,859.15$1,633.54$27,225.61$0.00 A. Amortization of the loanB. Payoff of loan $77,140.85$52,910.15$27,225.61$0.0 EXHIBIT10.11 LoanAmortizationofaFour-Year$100,000Loan,withanInterestRateof6% interestrateassociatedwiththesevaluesandcashfows.Bycalculatingtheyieldorimpliedinterestrate,wecanthencompareinvestmentorfnancingopportunities. AnnualPercentageRatevs.EffectiveAnnualRate Acommonprobleminfnanceiscomparingalternativefnancingorinvest-mentopportunitieswhentheinterestratesarespecifedinawaythatmakesitdiffculttocompareterms.TheTruthinSavingsActof1991requiresinstitutionstoprovidetheannualpercentageyieldforsavingsaccounts.Asaresultofthislaw,consumerscancomparetheyieldsondifferentsavings
234 VALUATIONANDANALYTICALTOOLS arrangements.Butthislawdoesnotapplybeyondsavingsaccounts.Oneinvestmentmaypay10%interestcompoundedsemiannually,whereasan-otherinvestmentmaypay9%interestcompoundeddaily.Onefnancingarrangementmayrequireinterestcompoundingquarterly,whereasanothermayrequireinterestcompoundingmonthly.Wanttocompareinvestmentsorfnancingwithdifferentfrequenciesofcompounding?Wemustfrsttranslatethestatedinterestratesintoacommonbasis.Therearetwowaystoconvertinterestratesstatedoverdifferenttimeintervalssothattheyhaveacommonbasis:theannualpercentagerateandtheeffectiveannualinterestrate.Oneobviouswaytorepresentratesstatedinvarioustimeintervalsonacommonbasisistoexpresstheminthesameunitoftime—soweannualizethem.Theannualizedrateistheproductofthestatedrateofinterestpercompoundperiodandthenumberofcompoundingperiodsinayear.Let i betherateofinterestperperiodand n bethenumberofcompoundingperiodsinayear.Theannualizedrate,whichisasweindicatedearlierinthischapteralsoreferredtoasthenominalinterestrateortheannualpercentagerate(APR),is APR = i × n (10.11)Anotherwayofconvertingstatedinterestratestoacommonbasisistheeffectiverateofinterest.The effectiveannualrate ( EAR )isthetrueeconomicreturnforagiventimeperiodbecauseittakesintoaccountthecompoundingofinterest.Wealsorefertothisrateasthe effectiverateofinterest .Theformulais EAR = (1 + i ) n − 1(10.12)Let’slookhowthe EAR isaffectedbythecompounding.SupposethattheSafeSavingsandLoanpromisestopay2%interestonaccounts,com-poundedannually.Becauseinterestispaidonce,attheendoftheyear,theeffectiveannualreturn, EAR ,is2%.Ifthe2%interestispaidonasemi-annualbasis—1%everysixmonths—theeffectiveannualreturnislargerthan2%sinceinterestisearnedonthe1%interestearnedattheendofthefrstsixmonths.Inthiscase,tocalculatethe EAR ,theinterestratepercom-poundingperiod—sixmonths—is0.01(thatis,0.02 ÷ 2)andthenumberofcompoundingperiodsinanannualperiodis2: EAR = (1 + 0 . 01) 2 − 1 = 1 . 0201 − 1 = 0 . 0201or2 . 01%Inthecaseofcontinuouscompounding,theEARissimply: EAR continuouscompounding = e APR − 1(10.13)
TheMathofFinance 235 Extendingthisexampletothecaseofquarterlycompoundingandcon-tinuouscompoundingwithanominalinterestrateof2%,wefrstcalculatetheinterestrateperperiod, i ,andthenumberofcompoundingperiodsinayear, n : FrequencyofCompoundingCalculationEffectiveAnnualRate Annual(1 + 0.02) 1 − 12.00%Semiannual(1 + 0.01) 2 − 12.01%Quarterly(1 + 0.005) 4 − 12.02%Continuous e 0.02 − 12.02%Figuringouttheeffectiveannualrateisusefulwhencomparinginter-estratesfordifferentinvestments.Itdoesn’tmakesensetocomparetheAPRsfordifferentinvestmentshavingadifferentfrequencyofcompound-ingwithinayear.ButsincemanyinvestmentshavereturnsstatedintermsofAPRs,weneedtounderstandhowtoworkwiththem.Toillustratehowtocalculateeffectiveannualrates,considertheratesofferedbytwobanks,BankAandBankB.BankAoffers4.2%compoundedsemiannuallyandBankBotheroffers4.158%compoundedcontinuously.Wecancomparetheseratesusingthe EAR s.Whichbankoffersthehighestinterestrate?TheeffectiveannualrateforBankAis(1 + 0.021) 2 − 1 = 4.2441%.TheeffectiveannualrateforBankBise 0.04158 –1 = 4.2457%.Therefore,BankBoffersaslightlyhigherinterestrate. YieldsonInvestments Supposeaninvestmentopportunityrequiresaninvestortoputup$10,000millionandofferscashinfowsof$4,000afteroneyearand$7,000aftertwoyears.Thereturnonthisinvestment,or yield ,istheinterestratethatequatesthepresentvaluesofthe$4,000and$7,000cashinfowstoequalthepresentvalueofthe$1millioncashoutfow.Thisyieldisalsoreferredtoasthe internalrateofreturn ( IRR )andiscalculatedastheratethatsolvesthefollowing:$10 , 000 = $4 , 000 (1 + IRR ) 1 + $7 , 000 (1 + IRR ) 2 Unfortunately,thereisnodirectmathematicalsolution(thatis,closed-formsolution)forthe IRR ,butratherwemustuseaniterativeprocedure.Fortunately,fnancialcalculatorsandfnancialsoftwareeaseourburden
236 VALUATIONANDANALYTICALTOOLS inthiscalculation.The IRR thatsolvesthisequationis6.023%.Inotherwords,ifyouinvest$10,000todayandreceive$4,000inoneyearand$7,000intwoyears,thereturnonyourinvestmentis6.023%.Anotherwayoflookingatthissameyieldistoconsiderthataninvest-ment’s IRR istheinterestratethatmakesthepresentvalueofallexpectedfuturecashfows—boththecashoutfowsfortheinvestmentandthesubse-quentinfows—equaltozero.WecanrepresenttheIRRastheratethatsolves$0 = N t = 0 CF t (1 + IRR ) t Wecanuseacalculatororaspreadsheettosolvefor IRR .Todothis,however,wemustentertheseriesofcashfowsinamannerthatcanbeusedwiththeappropriatefunction.Considertheproblemwiththepresentvalueof$10,000andcashfowsof$4,000and$7,000.Thefnancialroutinesrequirethatthecashfowsbeenteredinchronologicalorder,andthentheIRRfunctionbeusedwiththesecashfows. 4 Hewlett-Packard10BTexas InstrumentsMicrosoft Excel83/84 10000 + / − CFj4000 CFj7000 CFjIRR{4000,7000} STO L1IRR( − 10000,L1)1234A − 1000040007000 = IRR(A1:A3) EXAMPLE10.10:CALCULATINGAYIELD Supposeaninvestmentof$1millionproducesnocashfowinthefrstyearbutcashfowsof$200,000,$300,000,and$900,000two,three,andfouryearsfromnow,respectively.Whatisthereturnonthisinvestment? 4 Ifthereisnocashfowforagivenperiod,boththecalculatorsandthespreadsheetsrequireyoutoenterazeroinplaceofthatcashfow;failingtodosowillresultinanincorrect IRR .
TheMathofFinance 237 Solution The IRR forthisinvestmentistheinterestratethatsolves:$1 , 000 , 000 = $200 , 000 (1 + IRR ) 2 + $300 , 000 (1 + IRR ) 3 + $900 , 000 (1 + IRR ) 4 Thereturnis10.172%. Wecanusethisapproachtocalculatetheyieldonanytypeofinvest-ment,aslongasweknowthecashfows—bothpositiveandnegative—andthetimingofthesefows.Considerthecaseoftheyieldtomaturityonabond.Mostbondspayinterestsemiannually—thatis,everysixmonths.Therefore,whencalculatingtheyieldonabond,wemustconsiderthetimingofthecashfowstobesuchthatthediscountperiodissixmonths. TRYIT!THEYIELDONANINVESTMENT Supposeyouinvest$1,000todayinaninvestmentthatpromisesyou$1,000intwoyearsand$10,000inthreeyears.Whatisthe IRR onthisinvestment? EXAMPLE10.11:CALCULATINGTHEYIELDONABOND Considerabondthathasacurrentpriceof90;thatis,iftheparvalueofthebondis$1,000,thebond’spriceis90%of$1,000or$900.Andsupposethatthisbondhasfveyearsremainingtomaturityandan8%couponrate.Withfveyearsremainingtomaturity,thebondhas10six-monthperiodsremaining.( continued )
238 VALUATIONANDANALYTICALTOOLS ( Continued ) Solution Withacouponrateof8%,thismeansthatthecashfowsforinterestis$40everysixmonths.Foragivenbond,wethereforehavethefollowinginformation:Presentvalue = $900Numberofperiodstomaturity = 10Cashfoweverysixmonths = $40Additionalcashfowatmaturity = $1,000Thesix-monthyield, r d ,isthediscountratethatsolves:$900 = 10 t = 1 $40 (1 + r d ) t + $1 , 000 (1 + r d ) 10 Usingacalculatororspreadsheet,wecalculatethesix-monthyieldas5.315%[PV = $900;N = ’10;PMT = $40;FV = $1,000].Bondyieldsaregenerallystatedonthebasisofanannualizedyield,referredtoasthe yieldtomaturity onabond-equivalentbasis.Thismeasureisanalogoustothe APR withsemiannualcompounding.Therefore,yieldtomaturityis10.63%. THEBOTTOMLINE Thetimevalueofmoneyisoneofthefoundationconceptsandtoolsinfnancialandinvestmentmanagement. Usingcompoundinterest,wecanestimateavalueofinthefuture;usingdiscounting,wecantranslateafuturevalueintoavaluetoday—apresentvalue. Itisimportanttoconsiderthetypeofinterest—compoundingvs.simple—andthefrequencyofcompoundingindeterminingapresentvalueofafuturevalue. Thetimevalueofmoneymathematicscanbeusedtodeterminethepresentvalueorfuturevalueofalump-sumamountorofaseriesofcashfows,thegrowthrateofvalues,thenumberofperiodsofinteresttomeetagoal,ortosimplyamortizealoan.
TheMathofFinance 239 Giventhecostofaninvestmentanditscashfows,wecancalculatetheyieldorimpliedinterestrate.Bycalculatingtheyieldorimpliedinterestrate,wecanthencompareinvestmentorfnancingopportunities.Theyieldorinternalrateofreturnonaninvestmentistheinterestrateatwhichthepresentvalueofthecashfowsequalstheinitialinvestmentoutlay. SOLUTIONSTOTRYIT!PROBLEMS FutureValuea. FV = $100(1 + 0.02) 5 = $110.41 b. FV = $100(1 + 0.02) 10 = $121.90 c. FV = $100(1 + 0.02) 20 = $148.59 GrowthRates PV = $2,000; FV = $4,000; N = 5Solvefor i . i = 14.87% MoreGrowthRatesPresentValueFutureValueNumberofPeriodsGrowthRate $1$36 20.094% $1000$20009 8.006% $500$6007 2.639% $1$1.504 10.668% FrequencyofCompoundinga. $100(1 + 0.02) 10 = $121.899 b. $100(1 + 0.005) 40 = $122.079 c. $100e 0.2 = $122.140 PresentValue PV = $1,000 ÷ (1 + 0.06)10 = $558.39 TheYieldonanInvestment Cashfowsare − $10,000,$0,$1,000and$10,000.Theyieldis3.332%
240 VALUATIONANDANALYTICALTOOLS QUESTIONS 1. Whatistherelationshipbetweencompoundinganddiscountingofalump-sum? 2. Completethefollowing:“Thelargertheinterestrate,the (larger/smaller)thefuturevalueofavaluetoday.” 3. Holdingeverythingelsethesame,whatistheeffectofusingahigherdiscountratetodiscountafuturevaluetothepresent? 4. Ifyouinvestthesameamountineachofthreeaccountstoday,whichaccountproducesthehighestfuturevalueiftheannualpercentagerateisthesame?AccountA:annualcompounding,AccountB:quarterlycompounding,AccountC:continuouscompounding. 5. Whatdistinguishesanordinaryannuityfromanannuitydue? 6. Whatdistinguishesanordinaryannuityfromadeferredannuity? 7. Ifacashfowisthesameamounteachperiod, adinfnitum ,howdowevaluethepresentvalueofthisseriesofcashfows? 8. Whichismostappropriatetouseindescribingtheannualgrowthofthevalueofaninvestment:thearithmeticaveragegrowthrateorthegeometricaveragegrowthrate?Why? 9. Howcanwebreakdownthevaluationofadeferredannuityintoman-ageablepartsforcomputationpurposes? 10. Whichhasthehighestpresentvalueifthepaymentsandnumberofpaymentsareidentical,anordinaryannuityoranannuitydue? 11. Ifyouareofferedtwoinvestments,onethatpays5%simpleinterestperyearandonethatpays5%compoundinterestperyear,whichwouldyouchoose?Why? 12. Consideraborrowingarrangementinwhichtheannualpercentagerate(APR)is8%. a. Underwhatconditionsdoestheeffectiveannualrateofinterest(EAR)differfromtheAPRof8%? b. Asthefrequencyofcompoundingincreaseswithintheannualperiod,whathappenstotherelationshipbetweentheEARandtheAPR? 13. Supposeyoudeposit$1,000inanaccountwithanAPRof4%,withcompoundingquarterly. a. After10years,whatisthebalanceintheaccountifyoumakenowithdrawals? b. After10years,howmuchinterestoninterestdidyouearn? 14. Supposeyouarepromised$10,000fveyearsfromtoday.Iftheap-propriatediscountrateis6%,whatisthis$10,000worthtoyoutoday?
TheMathofFinance 241 15. Supposeyoubuyacartodayandfnance$10,000ofitscostatanAPRof3%,withpaymentsmademonthly. a. Ifyoufnancethecarfor24months,whatistheamountofyourmonthlycarpayment? b. Ifyoufnancethecarfor36months,whatistheamountofyourmonthlycarpayment?
CHAPTER 11 FinancialRatioAnalysis Amanwhokeepsallhispropertyintheformofcashandgovernmentbondshascomparativelylittletoworryorthinkabout;butontheotherhand,heisnotusinghisresourcesproductively.Asthesamemanproceedswiththedevelopmentofsomebusinessenterprise,heputsmoreandmoreofhiscapitalintothevariousformsoftangibleandintangibleassetswhicharerequiredfortheupbuildingofthebusiness.Presently,ifheisnotcareful,hemayfndhimselfshortofcashandunabletomeethisobligations,althoughhemaybeearninggoodprofts.Thesametendencyispresenteverywhere.Theexecutiveswhoaremanagingthefnancialaffairsofacompanycannotassistinmakingthebusinessproftablemerelybypilingupunnecessarycashresources.Theymustbepreparedtoventureoutintothemaincurrentofbusinessaffairsalongwiththeirassociates.Andastheyventurefartherandfarther,thedangerincreasesthattheirfnancialcraftmaybesweptoutoftheircontrol.Itrequiresconstantwatchfulnessandsoundknowledgetosteeramiddlecoursebetweenexcessivecautionontheonesideandrashnessinfnancialmanagementontheother. —WilliamH.Lough, BusinessFinance (NewYork:TheRonaldPressCompany,1919),p.500 F inancialanalysisinvolvestheselection,evaluation,andinterpretationoffnancialdataandotherpertinentinformationtoassistinevaluatingtheoperatingperformanceandfnancialconditionofacompany.Theinforma-tionthatisavailableforanalysisincludeseconomic,market,andfnancialinformation.Butsomeofthemostimportantfnancialdataareprovidedbythecompanyinitsannualandquarterlyfnancialstatements. 243
244 VALUATIONANDANALYSISTOOLS Theoperatingperformanceofacompanyisameasureofhowwellacompanyhasuseditsresourcestoproduceareturnonitsinvestment.Thefnancialconditionofacompanyisameasureofitsabilitytosatisfyitsobligations,suchasthepaymentofinterestonitsdebtinatimelymanner.Aninvestorhasmanytoolsavailableintheanalysisoffnancialinformation.Thesetoolsincludefnancialratioanalysisandcashfowanalysis.Cashfowsprovideawayoftransformingnetincomebasedonanaccrualsystemtoamorecomparablebasis.Additionally,cashfowsareessentialingredientsinvaluationbecausethevalueofacompanytodayisthepresentvalueofitsexpectedfuturecashfows.Therefore,understandingpastandcurrentcashfowsmayhelpinforecastingfuturecashfowsand,hence,determinethevalueofthecompany.Moreover,understandingcashfowallowstheassessmentoftheabilityofacompanytomaintaincurrentdividendsanditscurrentcapitalexpenditurepolicywithoutrelyingonexternalfnancing.Inthischapterandthenext,wedescribeandillustratethebasictoolsoffnancialanalysis.Inthischapter,ourfocusisonfnancialratioanalysis.Inthenextchapter,wecovercashfowanalysis. CLASSIFYINGFINANCIALRATIOS Afnancialratioisacomparisonbetweenonebitoffnancialinformationandanother.Considertheratioofcurrentassetstocurrentliabilities,whichwerefertoasthe currentratio. Thisratioisacomparisonbetweenassetsthatcanbereadilyturnedintocash—currentassets—andtheobligationsthataredueinthenearfuture—currentliabilities.Acurrentratioof2,or2:1,meansthatwehavetwiceasmuchincurrentassetsasweneedtosatisfyobligationsdueinthenearfuture.Wecanclassifyratiosaccordingtothewaytheyareconstructedandthefnancialcharacteristictheyaredescribing.Forexample,wewillseethatthecurrentratioisconstructedasacoverageratio(i.e.,theratioofcurrentassets—availablefunds—tocurrentliabilities,i.e.,theobligation)thatweusetodescribeacompany’sliquidity(itsabilitytomeetitsimmediateneeds).Wecanalsoclassifyratiosaccordingtothedimensionofthecompany’sperformanceorcondition.Forexample,acurrentratioprovidesinformationonacompany’sliquidity,whereasaturnoverratioprovidesinformationontheeffectivenesstowhichthecompanyputsitsassettouse.Thereareasmanydifferentfnancialratiosastherearepossiblecom-binationsofitemsappearingontheincomestatement,balancesheet,andstatementofcashfows.Wecanclassifyratiosaccordingtothefnancialcharacteristicthattheycapture.Whenweassessacompany’soperatingperformance,aconcerniswhetherthecompanyisapplyingitsassetsinaneffcientandproftable
FinancialRatioAnalysis 245 manner.Whenaninvestorassessesacompany’sfnancialcondition,acon-cerniswhetherthecompanyisabletomeetitsfnancialobligations.Theinvestorcanusefnancialratiostoevaluatefveaspectsofoperatingperfor-manceandfnancialcondition: 1. Liquidity 2. Proftability 3. Activity 4. Financialleverage 5. ReturnoninvestmentThereareseveralratiosrefectingeachofthefveaspectsofacompany’soperatingperformanceandfnancialcondition.WeapplytheseratiostotheExemplarCorporation,whosebalancesheets,incomestatements,andstatementofcashfowsfortwoyearsweshowinExhibits11.1,11.2,and EXHIBIT11.1 ExemplarCorporation’sBalanceSheets Asof InMillionsDec.31,20X2Dec.31,20X1Dec.31,20X0 Cashandcashequivalents$110$105$100Accountsreceivable200250175Inventory490 510 500 Totalcurrentassets$800$865$775Grossproperty,plant,andequipment1,2001,1001,000Accumulateddepreciation400 300 200 Netproperty,plant,andequipment800800$800Intangibleassets505050Goodwill75 75 75 Totalassets$1,725$1,790$1,700Accountspayable$100$90$100Currentportionoflong-termdebt30 25 20 Totalcurrentliabilities$130$115$120Long-termdebt163319$300Commonstock$20$20$20Paid-incapitalinexcessofpar100100100Retainedearnings1,3321,2561,170Treasurystock20 20 10 Shareholders’equity$1,432 $1,356 $1,280 Totalliabilitiesandequity$1,725$1,790$1,700
246 VALUATIONANDANALYSISTOOLS EXHIBIT11.2 ExemplarCorporation’sIncomeStatements FortheYearEnding InMillionsDec.31,20X2Dec.31,20X1 Revenues$2,000$1,900Costofgoodssold1,600 1,500 Grossproft$400$400Selling,general,andadministrativeexpenses200 180 Earningsbeforeinterestandtaxes$200$220Interestexpense17 16 Earningsbeforetaxes$183$204Taxes73 82 Netincome$110$122 11.3,respectively.Werefertothemostrecentfscalyearforwhichfnancialstatementsareavailable,FY20X2,asthe“currentyear.”The“prioryear”isthefscalyearpriortothecurrentyear.Theratiosweintroduceherearebynomeanstheonlyonesthatcanbeformedusingfnancialdata,thoughtheyaresomeofthemorecommonly EXHIBIT11.3 ExemplarCorporation’sStatementofCashFlows FortheYearEnding InMillionsDec.31,20X2Dec.31,20X1 Netincome$110$122Add:depreciationexpense100100ChangesinworkingcapitalaccountsAccountsreceivable50 − 75Inventory20 − 10Accountspayable10 − 10 Cashfowfor/fromoperations$290$127Capitalexpenditures − $100 − $100Saleofproperty,plantandequipment0 0 Cashfowfor/frominvestment − $100 − $100Borrowings$0$25Repaymentsofdebt − 1520Dividends3337Repurchaseofstock0 10 Cashfowfor/fromfnancing − $185 − $22 Changeincash$5$5
FinancialRatioAnalysis 247 used.Further,whenweformaratiousingabalancesheetaccount,suchasinventory,wearesimplifyingthingsabitbecauseinapplyingtheseratiostoevaluateacompany’sperformancewecouldmoreappropriatelyuseanaverageofthatbalancesheetaccountthroughtheyearinsomecases,ratherthantheyear-endvalue.However,ourprimarypurposeinthischapteristoestablishthebasicconcepts,defnitions,andcalculationsinfnancialratioanalysisbeforegettingtootechnical. LIQUIDITY Liquidity refectstheabilityofacompanytomeetitsshort-termobligationsusingthoseassetsthataremostreadilyconvertedintocash.Assetsthatmaybeconvertedintocashinashortperiodoftimearereferredtoasliquidassets;theyarelistedinfnancialstatementsascurrentassets.Weoftenrefertocurrentassetsas workingcapital ,becausetheyrepresenttheresourcesneededfortheday-to-dayoperationsofthecompany’slong-termcapitalinvestments.Currentassetsareusedtosatisfyshort-termobligations,orcurrentliabilities.Theamountbywhichcurrentassetsexceedcurrentliabilitiesisreferredtoasthe networkingcapital. OperatingCycle Howmuchliquidityacompanyneedsdependsonitsoperatingcycle.The operatingcycle isthedurationfromthetimecashisinvestedingoodsandservicestothetimethatinvestmentproducescash.Whatdoestheoperatingcyclehavetodowithliquidity?Thelongertheoperatingcycle,themorecurrentassetsareneeded(relativetocurrentliabilities)sinceittakeslongertoconvertinventoriesandreceivablesintocash.Inotherwords,thelongertheoperatingcycle,thegreatertheamountofnetworkingcapitalrequired.WecanestimatetheoperatingcycleforExemplarCorporationforthecurrentyearusingthebalancesheetandincomestatementdata.ThenumberofdaysExemplartiesupfundsininventoryisdeterminedbythetotalamountofmoneyrepresentedininventoryandtheaverageday’scostofgoodssold.Thecurrentinvestmentininventory—thatis,themoney“tiedup”ininventory—istheendingbalanceofinventoryonthebalancesheet.The averageday’scostofgoodssold isthecostofgoodssoldonanaveragedayintheyear,whichcanbeestimatedbydividingthecostofgoodssold(whichisfoundontheincomestatement)bythenumberofdaysintheyear:Averageday’scostofgoodssold = Costofgoodssold 365(11.1)
248 VALUATIONANDANALYSISTOOLS Exemplar’saverageday’scostofgoodssoldforFY20X2is$1,600 ÷ 265 = $4.384millionperday.Exemplarhas$490millionofinventoryonhandattheendoftheyear.Howmanydays’worthofgoodssoldisthis?OnewaytolookatthisistoimaginethatExemplarstoppedbuyingmorerawmaterialsandjustfnishedproducingwhateverwasonhandininventory,usingavailablerawmaterialsandwork-in-process.HowlongwouldittakeExemplartorunoutofinventory?Wecomputethe dayssalesininventory (DSI),alsoknownasthe numberofdaysofinventory ,bycalculatingtheratiooftheamountofinventoryonhand(indollars)totheaverageday’scostofgoodssold(indollarsperday):Dayssalesininventory(DSI) = Inventory Averageday’scostofgoodssold(11.2)ForExemplar,theDSIis$490million ÷ $4.384million = 111.78days.Inotherwords,Exemplarhasapproximately112daysofgoodsonhandattheendofthecurrentyear.Ifsalescontinuedatthesameprice,itwouldtakeExemplar112daystorunoutofinventory.Wecanextendthesamelogicforcalculatingthenumberofdaysbetweenasale—whenanaccountreceivableiscreated—andthetimeitiscollectedincash.IfweassumethatExemplarsellsallgoodsoncredit,wecanfrstcalculatetheaveragecreditsalesperdayandthencalculatehowmanydays’worthofcreditsalesarerepresentedbytheendingbalanceofreceivables.The averagecreditsalesperday aretheratioofcreditsalestothenumberofdaysinayear:Averagecreditsalesperday = Creditsales 365(11.3)Ifallofitssalesareoncredit,Exemplargenerates$2,000million ÷ 365 = $5.479millionofcreditsalesperday.The dayssalesoutstanding (DSO),alsoknownasthe numberofdaysofcredit ,inthisendingbalanceiscalculatedbytakingtheratioofthebalanceintheaccountsreceivableaccounttothecreditsalesperday:Dayssalesoutstanding(DSO) = Accountsreceivable Averagecreditsalesperday(11.4)Withanendingbalanceofaccountsreceivableof$200millionandassumingallsalesareoncredit,Exemplar’sDSOforFY20X2is$200million ÷ $5,479million = 36.5days.
FinancialRatioAnalysis 249 Iftheendingbalanceofreceivablesattheendoftheyearisrepresentativeofthereceivablesonanydaythroughouttheyear,thenittakes,onaverage,approximately36.5daystocollecttheaccountsreceivable.Theoperatingcycleisthesumofthedayssalesininventoryandthedayssalesoutstanding:Operatingcycle = DSI + DSO(11.5)Usingwhatwehavedeterminedfortheinventorycycleandcashcy-cle,weseethatforExemplartheoperatingcycleis111.78 + 36.5 = 148.281days.Wealsoneedtolookattheliabilitiesonthebalancesheettoseehowlongittakesacompanytopayitsshort-termobligations.Wecanapplythesamelogictoaccountspayableaswedidtoaccountsreceivableandinventories.Howlongdoesittakeacompany,onaverage,togofromcreatingapayable(buyingoncredit)topayingforitincash?First,weneedtodeterminetheamountofanaverageday’spurchasesoncredit.However,purchasesarenotidentifedonthefnancialstate-ments,butinsteadwemustinferthisamountfromaccountsinboththeincomestatementandthebalancesheet.IfweassumealltheExemplarpurchasesaremadeoncreditandtherewasnochangeinthelevelofin-ventory,thetotalpurchasesfortheyearwouldbethecostofgoodssoldlessanyamountsincludedincostofgoodssoldthatarenotpurchases,suchasdepreciation.Becausewedonothaveabreakdownonthecom-pany’scostofgoodssoldshowinghowmuchwaspaidforincashandhowmuchwasoncredit,wewillassumethatthefollowingrelationshipholdsforExemplar:Beginninginventory + Purchases = Costofgoodssold − Depreciation + Endinginventory(11.6)ForExemplarinFY20X2,weinferpurchasesof$1,480million.There-fore,thepurchasesperdayareAveragepurchasesperday = Annualpurchases 365(11.7)whichforExemplarare$4.055million.The dayspayablesoutstanding (DPO),alsoknownasthe numberofdaysofpurchases ,representedintheendingbalanceinaccountspayableis
250 VALUATIONANDANALYSISTOOLS calculatedastheratioofthebalanceintheaccountspayableaccounttotheaverageday’spurchases:Dayspayablesoutstanding(DPO) = Accountspayable Averagepurchasesperday(11.8)ForExemplarinthecurrentyear,theDPOis$100million ÷ $4.055million = 24.662days.ThismeansthatonaverageExemplartakesapprox-imately25daystopayoutcashforapurchase.Theoperatingcycleishowlongittakestoconvertaninvestmentincashbackintocash(bywayofinventoryandaccountsreceivable).Thenumberofdaysofpayablestellsushowlongittakestopayonpurchasesmadetocreatetheinventory.Ifweputthesetwopiecesofinformationtogether,wecanseehowlong,onnet,wetieupcash.Thedifferencebetweentheoperatingcycleandthenumberofdaysofpurchasesisthe cashconversioncycle (CCC),alsoknownasthe netoperatingcycle :Cashconversioncycle = DSI + DSO − DPO(11.9)ForExemplar’sFY20X2,Cashconversioncycle = 11 . 781 + 36 . 500 − 24 . 662 = 123 . 619daysThecashconversioncycleishowlongittakesforthecompanytogetcashbackfromitsinvestmentsininventoryandaccountsreceivable,con-sideringthatpurchasesmaybemadeoncredit.Bynotpayingforpurchasesimmediately(thatis,usingtradecredit),thecompanyreducesitsliquidityneeds.Therefore,thelongerthenetoperatingcycle,thegreatertherequiredliquidity. TRYIT!THEOPERATINGCYCLE CompletethefollowingusingExemplarCorporation’sFY20X1fnan-cialstatements: Dayssalesoutstanding Dayssalesininventory Dayspurchasesoutstanding Operatingcycle Cashconversioncycle
FinancialRatioAnalysis 251 MeasuresofLiquidity Wecandescribeacompany’sabilitytomeetitscurrentobligationsinseveralways.Wecanformthecurrentratio,whichisoneofthemostcommonlyusedmeasuresofliquidity:Currentratio = Currentassets Currentliabilities(11.10)Thecurrentratioisanindicationofhowmanytimesthecompanycancoveritscurrentliabilities,usingitscurrentassets.Exemplar’scurrentratioforFY20X2is$800million ÷ $130 = 6.154times.Anotherliquiditymeasureisthequickratio,whichissimilartothecurrentratio,exceptweremovetheleastliquidofthecurrentassetsfromthenumerator:Quickratio = Currentassets − Inventory Currentliabilities(11.11) Thetwo-for-oneratioofquickassetstocurrentliabilitiesdoesnothavetobeexplainedindetailbecauseitsuseissogeneralinstate-mentanalysis.Itisthefrststeptowardestablishingastudentinproportions.Itsadoptionasatestresultedfromthecertainknowl-edge,acquiredbybitterexperience,thatashrinkagemighteasilyoccurinasset,butrarelyinliabilities.—RobertMorrisAssociates,FinancialStatements,AnExplanationinBriefofaNewSystemforTheirAnalysisfromtheStandpointoftheCreditGrantorandBusinessExecutive,1921 Byleavingouttheleastliquidasset,thequickratioprovidesamoreconservativeviewofliquidity.Thequickratioisalsoknownasthe acidtestratio. ForExemplarinthecurrentyear,thequickratiois2.385times.Stillanotherwaytomeasurethecompany’sabilitytosatisfyshort-termobligationsisthe networkingcapital-to-salesratio ,whichcomparesnetworkingcapital(currentassetslesscurrentliabilities)withsales:Networkingcapitaltosales = Networkingcapital Revenues(11.12)Thisratiotellsusthe“cushion”availabletomeetshort-termobligationsrelativetosales.Considertwocompanieswithidenticalworkingcapitalof$100,000,butonehassalesof$500,000andtheothersalesof$1,000,000.
252 VALUATIONANDANALYSISTOOLS Iftheyhaveidenticaloperatingcycles,thismeansthatthecompanywiththegreatersaleshasmorefundsfowinginandoutofitscurrentassetinvest-ments(inventoriesandreceivables).Thecompanywithmorefundsfowinginandoutneedsalargercushiontoprotectitselfincaseofadisruptioninthecycle,suchasalaborstrikeorunexpecteddelaysincustomerpayments.Thelongertheoperatingcycle,themoreofacushion(i.e.,networkingcapital)acompanyneedsforagivenlevelofsales.ForExemplarCorporation,thenetworkingcapitaltosalesratioforFY20X2isNetworkingcapitaltosales = $ 800million − 130million $ 2,000million = 0 . 335Theratioof0.335tellsusthatforeverydollarofsales,Exemplarhas33.5centsofnetworkingcapitaltosupportit.Giventhemeasuresoftimerelatedtothecurrentaccounts—theop-eratingcycleandthecashconversioncycle—andthethreemeasuresofliquidity—currentratio,quickratio,andnetworkingcapital-to-salesratio—weknowthefollowingaboutExemplarCorporation’sabilitytomeetitsshort-termobligations: Inventoryislessliquidthanaccountsreceivable(comparingdaysofinventorywithdaysofcredit). Currentassetsaregreaterthanneededtosatisfycurrentliabilitiesinayear(fromthecurrentratio). ThequickratiotellsusthatExemplarcanmeetitsshort-termobligationsevenwithoutresortingtosellinginventory. Thenetworkingcapital“cushion”is33.5centsforeverydollarofsales(fromthenetworkingcapital-to-salesratio.)Unfortunately,theseliquidityratiosdon’tprovideuswithanswerstothefollowingquestions: Howliquidaretheaccountsreceivable?Howmuchoftheaccountsreceivablewillbecollectible?Whereasweknowittakes,onaverage,36.5daystocollect,wedonotknowhowmuchwillneverbecollected. Whatisthenatureofthecurrentliabilities?Howmuchofcurrentliabilitiesconsistsofitemsthatrecur(suchasaccountspayableandwagespayable)eachperiodandhowmuchconsistsofoccasionalitems(suchasincometaxespayable)? Arethereanyunrecordedliabilities(suchasoperatingleases)thatarenotincludedincurrentliabilities?
FinancialRatioAnalysis 253 TRYIT!LIQUIDITYRATIOS CompletethefollowingusingExemplarCorporation’sFY20X1fnan-cialstatements: Currentratio Quickratio Networkingcapitaltosales PROFITABILITYRATIOS Liquidityratiosindicateacompany’sabilitytomeetitsimmediateobliga-tions.Nowweextendtheanalysisbyadding proftabilityratios ,whichhelptheinvestorgaugehowwellacompanyismanagingitsexpenses. Proftmarginratios comparecomponentsofincomewithsales.Theygivetheinvestoranideaofwhichfactorsmakeupacompany’sincomeandareusuallyexpressedasaportionofeachdollarofsales.Forexample,theproftmarginratioswediscussheredifferonlyinthenumerator.Itisinthenumeratorthatwecanevaluateperformancefordifferentaspectsofthebusiness.Forexample,supposetheinvestorwantstoevaluatehowwellpro-ductionfacilitiesaremanaged.Theinvestorwouldfocusongrossproft(revenueslesscostofgoodssold),ameasureofincomethatisthedirectre-sultofproductionmanagement.Comparinggrossproftwithsalesproducesthe grossproftmargin: Grossproftmargin = Grossproft Revenues(11.13)Thisratiotellsustheportionofeachdollarofsalesthatremainsafterdeductingproductionexpenses.ForExemplarCorporationforthecurrentyear,Grossproftmargin = $ 400million $ 2,000million = 20%
254 VALUATIONANDANALYSISTOOLS Foreachdollarofrevenues,thecompany’sgrossproftis35cents.Lookingatsalesandcostofgoodssold,wecanseethatthegrossproftmarginisaffectedby: Changesinsalesvolume,whichaffectcostofgoodssoldandsales. Changesinsalesprice,whichaffectrevenues. Changesinthecostofproduction,whichaffectcostofgoodssold.Anychangeingrossproftmarginfromoneperiodtothenextiscausedbyoneormoreofthosethreefactors.Similarly,differencesingrossmarginratiosamongcompaniesaretheresultofdifferencesinthosefactors.Toevaluateoperatingperformance,weneedtoconsideroperatingex-pensesinadditiontothecostofgoodssold.Todothis,removeoperatingexpenses(e.g.,sellingandgeneraladministrativeexpenses)fromgrossproft,leavingoperatingproft,alsoreferredtoas earningsbeforeinterestandtaxes .Therefore,the operatingproftmargin isOperatingproftmargin = Operatingproft Revenues(11.14)ForExemplarinthecurrentyear,theoperatingproftmarginis10%.Therefore,foreachdollarofrevenues,Exemplarhas10centsofoperatingincome.Theoperatingproftmarginisaffectedbythesamefactorsasgrossproftmargin,plusoperatingexpenses.Boththegrossproftmarginandtheoperatingproftmarginrefectacompany’soperatingperformance.Buttheydonotconsiderhowtheseoperationshavebeenfnanced.Toevaluatebothoperatingandfnancingdecisions,theinvestormustcomparenetincome(thatis,earningsafterdeductinginterestandtaxes)withrevenues.Theresultisthe netproftmargin :Netproftmargin = Netproft Revenues(11.15)Thenetproftmarginisthenetincomegeneratedfromeachdollarofrevenues;itconsidersfnancingcoststhattheoperatingproftmargindoesnotconsider.ForExemplarforthecurrentyear,thenetproftmarginis5.484%.Inotherwords,foreverydollarofrevenues,Exemplargenerates5.484centsinnetprofts.
FinancialRatioAnalysis 255 Theproftabilityratiosindicatethefollowingabouttheoperatingper-formanceofExemplarforFY20X2: Eachdollarofrevenuescontributes20centstogrossproftand10centstooperatingproft. Everydollarofrevenuescontributes5.484centstoowners’earnings. Bycomparingthe20centsoperatingproftmarginwiththe5.484centsnetproftmargin,weseethatExemplarhasalittlemorethan14centsoffnancingcostsforeverydollarofrevenues.Whattheseratiosdonotindicateaboutproftabilityisthesensitivityofgross,operating,andnetproftmarginstochangesinthesalespriceandchangesinthevolumeofsales.Lookingattheproftabilityratiosforonecompanyforoneperiodgivestheinvestorverylittleinformationthatcanbeusedtomakejudgmentsregardingfutureproftability.Nordotheseratiosprovidetheinvestoranyinformationaboutwhycurrentproftabilityiswhatitis.Weneedmoreinformationtomakethesekindsofjudgments,particularlyregardingthefutureproftabilityofthecompany.Forthat,turntoactivityratios,whicharemeasuresofhowwellassetsarebeingused. TRYIT!PROFITABILITYRATIOS CompletethefollowingusingExemplarCorporation’sFY20X1fnan-cialstatements: Grossproftmargin Operatingproftmargin Netproftmargin ACTIVITYRATIOS Weuse activityratios —forthemostpart,turnoverratios—toevaluatethebeneftsproducedbyspecifcassets,suchasinventoryoraccountsreceivable,ortoevaluatethebeneftsproducedbythetotalityofthecompany’sassets.
256 VALUATIONANDANALYSISTOOLS Inventorymanagement The inventoryturnoverratio isameasureofhowquicklyacompanyhasusedinventorytogeneratethegoodsandservicesthataresold.Theinventoryturnoveristheratioofthecostofgoodssoldtoinventory:Inventoryturnover = Costofgoodssold Inventory(11.16)ForExemplarforthecurrentyear,theinventoryturnoveris3.265times.ThisratioindicatesthatExemplarturnsoveritsinventory3.265timesperyear.Onaverage,cashisinvestedininventory,goodsandservicesareproduced,andthesegoodsandservicesaresold3.265timesayear.Lookingbacktothenumberofdaysofinventory,weseethatthisturnovermeasureisconsistentwiththeresultsofthatcalculation:Thereare111.78calendardaysofinventoryonhandattheendoftheyear;dividing365daysby111.78days,wefndthatinventorycyclesthrough(thatis,fromcashtosales)3.265timesayear. AccountsReceivableManagement Inmuchthesamewayinventoryturnovercanbeevaluated,aninvestorcanevaluateacompany’smanagementofitsaccountsreceivableanditscreditpolicy.The accountsreceivableturnover ratioisameasureofhoweffectivelyacompanyisusingcreditextendedtocustomers.Thereasonforextendingcreditistoincreasesales.Thedownsidetoextendingcreditisthepossibilityofdefault—customersnotpayingwhenpromised.Thebeneftobtainedfromextendingcreditisreferredtoasnetcreditsales—salesoncreditlessreturnsandrefunds.Accountsreceivableturnover = Creditsales Accountsreceivable(11.17)LookingattheExemplarCorporationincomestatement,weseeanentryforrevenues,butwedonotknowhowmuchoftheamountstatedisoncredit.Inthecaseofevaluatingacompany,aninvestorwouldhaveanestimateoftheamountofcreditsales.Letusassumethattheentiresalesamountrepresentsnetcreditsales.ForExemplarforthecurrentyear,theaccountsreceivableturnoveris$2,000million ÷ $200million = 10times.Therefore,10timesintheyearthereis,onaverage,acyclethatbeginswithasaleoncreditandfnisheswiththereceiptofcashforthatsale.
FinancialRatioAnalysis 257 Thenumberoftimesaccountsreceivablecyclethroughtheyearisconsistentwiththedayssalesoutstanding(36.5days)thatwecalculatedearlier—accountsreceivableturnover10timesduringtheyear,andtheaveragenumberofdaysofsalesintheaccountsreceivablebalanceis365days ÷ 10times = 36.5days. OverallAssetManagement Theinventoryandaccountsreceivableturnoverratiosrefectthebeneftsobtainedfromtheuseofspecifcassets(inventoryandaccountsreceivable).Foramoregeneralpictureoftheproductivityofthecompany,aninvestorcancomparethesalesduringaperiodwiththetotalassetsthatgeneratedtheserevenues.Onewayiswiththe totalassetturnoverratio ,orsimplythe assetturnover ,whichishowmanytimesduringtheyearthevalueofacom-pany’stotalassetsisgeneratedinrevenues:Totalassetturnover = Revenues Totalassets(11.18)ForExemplarinthecurrentyear,thetotalassetturnoveris$2,000million ÷ $1,175 = 1.159times.Theturnoverratioof1.159indicatedthatinthecurrentyear,everydollarinvestedintotalassetsgenerates$1.159ofrevenues.Becausetotalassetsincludebothtangibleandintangibleassets,thisturnoverindicateshoweffcientlyallassetswereused.Fromtheseratiostheinvestorcandeterminethat: Inventoryfowsinandoutalmost3.3timesayear(fromtheinventoryturnoverratio). Accountsreceivablearecollectedincash,onaverage,36.5daysafterasale(fromthenumberofdaysofcredit).Inotherwords,accountsreceivablefowinandoutalmost10timesduringtheyear(fromtheaccountsreceivableturnoverratio).Butwhattheseratiosdonotindicateaboutthecompany’suseofitsassets: Thesalesnotmadebecausecreditpoliciesaretoostringent. Howmuchofcreditsalesisnotcollectible. Whichassetscontributemosttothetotalassetturnover.
258 VALUATIONANDANALYSISTOOLS TRYIT!ACTIVITYRATIOS CompletethefollowingusingExemplarCorporation’sFY20X1fnan-cialstatements: Turnover Numberofdays Productoftheturnoverandthenumberofdays Inventory Accountsreceivable FINANCIALLEVERAGE Acompanycanfnanceitsassetswithequityorwithdebt.Financingwithdebtlegallyobligatesthecompanytopayinterestandtorepaytheprincipalaspromised.Equityfnancingdoesnotobligatethecompanytopayanythingbecausedividendsarepaidatthediscretionoftheboardofdirectors.Thereisalwayssomerisk,whichwerefertoas businessrisk ,inherentinanybusi-nessenterprise.Buthowacompanychoosestofnanceitsoperations—theparticularmixofdebtandequity—mayaddfnancialriskontopofbusi-nessrisk. Financialrisk isriskassociatedwithacompany’sabilitytosatisfyitsdebtobligations,andisoftenmeasuredusingtheextenttowhichdebtfnancingisusedrelativetoequity.Weusefnancialleverageratiostoassesshowmuchfnancialriskthecompanyhastakenon.Therearetwotypesoffnancialleverageratios:com-ponentpercentagesandcoverageratios.Componentpercentagescompareacompany’sdebtwitheitheritstotalcapital(debtplusequity)oritsequitycapital.Coverageratiosrefectacompany’sabilitytosatisfyfxedfnancingobligations,suchasinterest,principalrepayment,orleasepayments. ComponentPercentageRatios Aratiothatindicatestheproportionofassetsfnancedwithdebtisthe debt-to-assetsratio ,whichcomparestotalliabilities(Short-termdebt + Long-termdebt)withtotalassets:Debttoassets = Debt Totalassets(11.19)
FinancialRatioAnalysis 259 ForExemplarinthecurrentyear,thedebttoassetsis16.959%.Thisratioindicatesthat16.959%ofthecompany’sassetsarefnancedwithdebt(bothshorttermandlongterm).Anotherwaytolookatthefnancialriskisintermsoftheuseofdebtrelativetotheuseofequity.The debt-to-equityratio ,orsimplythe debt-equityratio, isameasurehowthecompanyfnancesitsoperationswithdebtrelativetothebookvalueofitsshareholders’equity:Debttoequity = Debt Shareholders’equity(11.20)Shareholders’equityisthebookvalue,orcarryingvalue,ofsharehold-ers’equityasreportedonthecompany’sbalancesheet.ForExemplarforFY20X2,thedebttoequityratiois($130million + 163million) ÷ $1,432millionor0.204.Foreveryonedollarofbookvalueofshareholders’equity,Exemplaruses20.4centsofdebt.Bothoftheseratioscanbestatedintermsoftotaldebt,asabove,orintermsoflong-termdebtorevensimplyinterest-bearingdebt.Anditisnotalwaysclearinwhichform—total,long-termdebt,orinterest-bearing—theratioiscalculated.Additionally,itisoftenthecasethatthecurrentportionoflong-termdebtisexcludedinthecalculationofthelong-termversionsofthesedebtratios.Oneproblemwithusingafnancialratiobasedonthebookvalueofequitytoanalyzefnancialriskisthatthereisseldomastrongrelationshipbetweenthebookvalueandmarketvalueofastock.Thedistortioninvaluesonthebalancesheetisobviousbylookingatthebookvalueofequityandcomparingitwiththemarketvalueofequity.Thebookvalueofequityconsistsof: Theproceedstothecompanyofallthestockissuessinceitwasfrstincorporated,lessanystockrepurchasedbythecompany. Theaccumulativeearningsofthecompany,lessanydividends,sinceitwasfrstincorporated.Thebookvalueofequitygenerallydoesnotgiveatruepictureoftheinvestmentofshareholdersinthecompanybecause: Earningsarerecordedaccordingtoaccountingprinciples,whichmaynotrefectthetrueeconomicsoftransactions. Duetoinfation,theearningsandproceedsfromstockissuedinthepastdonotrefecttoday’svalues.
260 VALUATIONANDANALYSISTOOLS Inotherwords,thebookvalueoftenunderstatesthevalueofsharehold-ers’equity.Themarketvalueofequity,ontheotherhand,isthevalueofequityasperceivedbyinvestors.Itiswhatinvestorsarewillingtopay.Sowhybotherwithbookvalue?Fortworeasons:First,ifthecompanyisnotpubliclytraded,itiseasiertoobtainthebookvaluethanthemarketvalueofacompany’ssecurities.Second,manyfnancialservicesreportratiosusingbookvalueratherthanmarketvalue.However,youcaneasilyrestateanyoftheratiospresentedinthischapterthatusethebookvalueofequityusingthemarketvalueofequity. CoverageRatios Theratiosthatcomparedebttoequityordebttoassetsindicatetheamountoffnancialleverage,whichenablesaninvestortoassessthefnancialcon-ditionofacompany.Anotherwayoflookingatthefnancialconditionandtheamountoffnancialleverageusedbythecompanyistoseehowwellitcanhandlethefnancialburdensassociatedwithitsdebtorotherfxedcommitments.Onemeasureofacompany’sabilitytohandlefnancialburdensisthe interestcoverageratio ,alsoreferredtoasthe timesinterest-coveredratio. Thisratiotellsushowwellthecompanycancoverormeettheinterestpaymentsassociatedwithdebt.Theratiocomparesthefundsavailabletopayinterest(thatis,earningsbeforeinterestandtaxes)withtheinterestexpense:Interestcoverageratio = EBIT Interestexpense(11.21)Thegreatertheinterestcoverageratio,thebetterablethecompanyistopayitsinterestexpense.ForExemplarforthecurrentyear,theinterestcoverageratiois$200million ÷ $17million = 11.617times.Aninterestcoverageratioof11.617timesmeansthatthecompany’searningsbeforeinterestandtaxesare11.617timesgreaterthanitsinterestpayments.Theinterestcoverageratioprovidesinformationaboutacompany’sabilitytocovertheinterestrelatedtoitsdebtfnancing.However,thereareothercoststhatdonotarisefromdebtbutthatneverthelessmustbeconsid-eredinthesamewayweconsiderthecostofdebtinacompany’sfnancialobligations.Forexample,leasepaymentsarefxedcostsincurredinfnanc-ingoperations.Likeinterestpayments,theyrepresentlegalobligations.Wecouldalsoconsideranotherfxedcharge,suchaspreferredstockdividends,
FinancialRatioAnalysis 261 whichthecompanymustpaybeforeacompanypaysanycommonstockdividends. 1 Uptonow,weconsideredearningsbeforeinterestandtaxesasfundsavailabletomeetfxedfnancialcharges.EBITincludesnoncashitemssuchasdepreciationandamortization.Ifaninvestoristryingtocomparefundsavailabletomeetobligations,abettermeasureofavailablefundsiscashfowfromoperations,asreportedinthestatementofcashfows.Aratiothatconsiderscashfowsfromoperationsasfundsavailabletocoverinterestpaymentsisreferredtoasthe cashfowinterestcoverageratio: Cashfowinterestcoverage = Cashfowfromoperations + Interest + Taxes Interest(11.22)Wetaketheamountofcashfowfromoperationsthatisinthestatementofcashfowsisnetofinterestandtaxes.Therefore,wemustaddbackinterestandtaxestocashfowfromoperationstoarriveatthecashfowamountbeforeinterestandtaxesinordertodeterminethecashfowavailabletocoverinterestpayments.ForExemplarforthecurrentyear,thecashfowinterestcoverageisCashfowinterestcoverage = $ 290million + 17million + 73million $ 17million = 22 . 565Thiscoverageratioindicatesthat,intermsofcashfows,Exemplarhas22.565timesmorecashthanisneededtopayitsinterest.Thisisabetterpictureofinterestcoveragethanthe11.617timesrefectedbyEBIT.Whythedifference?Becausecashfowconsidersnotjusttheaccountingincome,butnoncashitemsaswell.InthecaseofExemplar,depreciationisanoncashchargethatreducedEBITbutnotcashfowfromoperations—itisaddedbacktonetincometoarriveatcashfowfromoperations.TheseratiosindicatethatExemplarusesitsfnancialleverageasfol-lows: Assetsare17%fnancedwithdebt,measuredusingbookvalues. Long-termdebtisapproximately20%ofequity. 1 Whenwealtertheinterestcoverageratiotoconsidertheseotherfxedobligations,wealterthenumeratoraswelltorestateittorefectthefundsavailabletocovertheseobligations.
262 VALUATIONANDANALYSISTOOLS Theseratiosdonotindicate: Whatotherfxed,legalcommitmentsthecompanyhasthatwecan-notseebysimplylookingatthebalancesheet(forexample,operatingleases). Whattheintentionsofmanagementareregardingtakingonmoredebtastheexistingdebtmatures. TRYIT!FINANCIALLEVERAGERATIOS CompletethefollowingusingExemplarCorporation’sFY20X1fnan-cialstatements: Debttoassets Debttoequity Interestcoverageratio Cashfowinterestcoverage RETURNONINVESTMENT Return-on-investmentratios comparemeasuresofbenefts,suchasearningsornetincome,withmeasuresofinvestment.Forexample,ifaninvestorwantstoevaluatehowwellthecompanyusesitsassetsinitsoperations,hecouldcalculatethereturnonassets—sometimescalledthe basicearningpowerratio —astheratioofearningsbeforeinterestandtaxes(alsoknownasoperatingearnings)tototalassets:Basicearningpower = Earningsbeforeinterestandtaxes Totalassets(11.23)ForExemplarCorporation,forthecurrentyear,thebasicearningpowerratiois$110million ÷ $1,725million = 11.594%.Thismeansthatforeverydollarinvestedinassets,Exemplarearnedabout11.6centsinthecurrentyear.Thismeasuredealswithearningsfromoperations;itdoesnotconsiderhowtheseoperationsarefnanced.
FinancialRatioAnalysis 263 Anotherreturn-on-assetsratiousesnetincome—operatingearningslessinterestandtaxes—insteadofearningsbeforeinterestandtaxes.Thisisthemorecommonlyusedreturnonassetsratio:Returnonassets = Netincome Totalassets(11.24)ForExemplarinthecurrentyear,thereturnonassetsis$110million ÷ $1,725million = 6.358%.Thus,withouttakingintoconsiderationhowassetsarefnanced,thereturnonassetsforExemplaris11.594%.Takingintoconsiderationhowassetsarefnanced,thereturnonassetsis6.358%.ThedifferenceisduetoExemplarfnancingpartofitstotalassetswithdebt,incurringinterestof$17millioninthecurrentyear.IfwelookatExemplar’sliabilitiesandequities,weseethattheassetsarefnancedbybothliabilitiesandequity.Investorsmaynotbeinterestedinthereturnthecompanygetsfromitstotalinvestment(debtplusequity),butrathershareholdersareinterestedinthereturnthecompanycangenerateontheirinvestment.The returnonequity istheratioofthenetincomeshareholdersreceivetotheirequityinthestock:Returnonequity = Netincome Shareholders’equity(11.25)ForExemplarCorporation,thereisonlyonetypeofshareholder:com-mon.Forthecurrentyear,thereturnonequityis$110million ÷ $1,725million = 7.656%. THEDUPONTSYSTEM Thereturns-on-investmentratiosprovidea“bottomline”ontheperfor-manceofacompany,butdonottellusanythingaboutthe“why”behindthisperformance.Foranunderstandingofthe“why,”aninvestormustdigabitdeeperintothefnancialstatements.AmethodthatisusefulinexaminingthesourceofperformanceistheDuPontsystem.The DuPontsystem isamethodofbreakingdownreturnratiosintotheircomponentstodeterminewhichareasareresponsibleforacompany’sperformance.Toseehowitisused,letustakeacloserlookatthefrstdefnitionofthebasicearningpowerinequation(11.23).Wecanbreakdownthisratiointoitscomponents:proftmarginandactivity.Wedothisbyrelatingboththenumeratorandthedenominatortosalesactivity.Divide
264 VALUATIONANDANALYSISTOOLS boththenumeratorandthedenominatorofthebasicearningpowerratiobyrevenues,whichproducesBasicearningpower = EBIT Revenues × Revenues TotalassetsInotherwords,theearningpowerofthecompanyisrelatedtoprof-itability(inthiscase,operatingproftorEBIT)andameasureofactivity(Totalassetturnover = Revenues/Totalassets):Basicearningpower = Operatingproftmargin × TotalassetturnoverTherefore,whenanalyzingachangeinthecompany’sbasicearningpower,aninvestorcouldlookatthisbreakdowntoseethechangeinitscomponents:operatingproftmarginandtotalassetturnover.Let’slookatthereturnonassetsofExemplarforthetwoyears.Itsreturnsonassetswere20%intheprioryearand18.18%inthecurrentyear.Wecandecomposethecompany’sreturnsonassetsforthetwoyearstoobtain:FY20X2:11.594% = $ 200 $ 2,000 × $ 2,000 $ 1,725 = 10% × 1 . 1594FY20X1:12.291% = $ 180 $ 1,090 × $ 1,900 $ 1,790 = 11 . 579% × 1 . 0615Weseethatoperatingproftmargindeclinedoverthetwoyears,yetassetturnoverimprovedslightly.Therefore,thedeclineinthereturn-on-assetsisattributabletolowerproftmargins.Wecanbreakdownthereturnonassetsandthereturnonequityintocomponentsinasimilarmanner.Expandingequation(11.24),Returnonassets = Netincome Revenues × Revenues Totalassets = Netproftmargin × TotalassetturnoverRecognizingtheaccountingrelationshipbetweenoperatingproftandnetincome,andlettingEBT = EBIT–interest,thenNetincome Revenues = EBIT Revenues × EBT EBIT × (1 − Taxrate)
FinancialRatioAnalysis 265 and,therefore,Returnonassets = EBIT Revenues × EBT EBIT × (1 − Taxrate) × Revenues TotalassetsInotherwords,thereturnonassetsis: Positivelyrelatedtotheoperatingproftmargin,EBIT Revenues. Negativelyrelatedtotheamountofinterest,relativetoearnings(thegreatertheinterest,thelowerisEBT EBIT. Negativelyrelatedtothetaxrate. Positivelyrelatedtotheassetturnover.Thebreakdownofareturn-on-equityratiofromequation(11.25)requiresabitmoredecompositionbecauseinsteadoftotalassetsasthedenominator,thedenominatorinthereturnisshareholders’equity.Becauseactivityratiosrefecttheuseofalloftheassets,notjusttheproportionf-nancedbyequity,weneedtoadjusttheactivityratiobytheproportionthatassetsarefnancedbyequity(i.e.,theratioofthebookvalueofshareholders’equitytototalassets):Returnonequity = Netincome Totalassets × Totalassets Shareholders’equityIdentifyingtheratiooftotalassetstoshareholders’equityastheequitymultiplier,whichcapturesthecompany’sfnancialleverage,wecanrephrasereturnonequityasReturnonequity = Returnonassets × EquitymultiplierIfwesubstitutethebreakdownofthereturnonassetsintothisequationforthereturnonequity,wehaveReturnonequity = EBIT Revenues × EBT EBIT × (1 − Taxrate) × Revenues Totalassets × Totalassets Shareholders’equityInotherwords,thereturnonequityisafunctionofoperatingproft,thecompany’sinterestburden,thetaxrate,assetutilization,andfnancialleverage.ApplyingthistoExemplarforFY20X2,Returnonequity = 0 . 010 × 0 . 914 × (1 − 0 . 4) × 1 . 159 × 1 . 204 = 7 . 656%
266 VALUATIONANDANALYSISTOOLS TRYIT!BREAKINGDOWNTHERETURNONEQUITY CompletethefollowingusingExemplarCorporation’sFY20X1fnan-cialstatements: Returnonequity Basicearningpowerratio Operatingproftmargin EBT/EBIT Taxrate Equitymultiplier COMMON-SIZEANALYSIS Aninvestorcanevaluateacompany’soperatingperformanceandfnancialconditionthroughratiosthatrelatevariousitemsofinformationcontainedinthefnancialstatements.Anotherwaytoanalyzeacompanyistolookatitsfnancialdatamorecomprehensively. Common-sizeanalysis isamethodofanalysisinwhichthecomponentsofafnancialstatementarecompared.Intheverticalcommon-sizeanalysis,eachfnancialstatementitemiscomparedtoabenchmarkitemforthatsameyear.Thefrststepinthisformofcommon-sizeanalysisistobreakdownafnancialstatement—eitherthebalancesheetortheincomestatement—intoitsparts.Thenextstepistocalculatetheproportionthateachitemrepresentsrelativetosomebenchmark.Inthecaseofaverticalcommonsizeanalysisofthebalancesheet,thebenchmarkistotalassets;inthecaseoftheincomestatement,thebenchmarkisrevenues.Anotherformofcommon-sizeanalysisis horizontalcommon-sizeanalysis ,inwhichweuseeitheranincomestatementorabalancesheetinafscalyearandcompareaccountstothecorrespondingitemsinanotheryear.Letusseehowitworksbydoingsomecommon-sizefnancialanal-ysisfortheExemplarCorporation.Intheincomestatement,aswiththebalancesheet,theitemsmayberestatedasaproportionofsales;thisstate-mentisreferredtoasthecommon-sizeincomestatement.Weprovidethe
FinancialRatioAnalysis 267 EXHIBIT11.4 ExemplarCorporation’sVerticalCommon-SizeIncomeStatements ForYearEnding Dec.31,20X2Dec.31,20X1 Revenues100%100%Costofgoodssold80% 79% Grossproft20%21%Selling,general,andadministrativeexpenses10% 9% Earningsbeforeinterestandtaxes10%12%Interestexpense1% 1% Earningsbeforetaxes9%11%Taxes4% 4% Netincome5%6% common-sizeincomestatementsforExemplarforthetwoyearsinExhibit11.4.Forthecurrentyear,themajorcostsareassociatedwithgoodssold(80%).Lookingatgrossproft,EBIT,andnetincome,theseproportionsaretheproftmarginswecalculatedearlier.Usingthecommon-sizeincomestatement,welearnabouttheproftabilityofdifferentaspectsofthecom-pany’sbusiness.Again,thepictureisnotyetcomplete.Foramorecompletepicture,theinvestormustlookattrendsovertimeandmakecomparisonswithothercompaniesinthesameindustry.Werestatethecompany’sbalancesheetinExhibit11.5.Thisstatementdoesnotlookpreciselylikethebalancesheetwehaveseenbefore.Neverthe-less,thedataarethesamebutreorganized.Eachitemintheoriginalbalancesheethasbeenrestatedasaproportionoftotalassetsforthatyear.Hence,werefertothisasthe common-sizebalancesheet .Inthiscommon-sizebalancesheet,wesee,forexample,thatinthecurrentyearcashis6%oftotalassets.Thelargestinvestmentisinplantandequipment,whichcomprises46%oftotalassets.Ontheliabilitiesside,currentliabilitiesare8%ofliabilitiesandequity.Usingthecommon-sizebalancesheet,wecansee,inverygeneralterms,howExemplarhasraisedcapitalandwherethiscapitalhasbeeninvested.Aswithfnancialratios,however,thepictureisnotcompleteuntiltrendsareexaminedandcomparedwiththoseofothercompaniesinthesameindustry.Weprovideahorizontalcommon-sizeanalysisforExemplar’sbalancesheetinExhibit11.6.Inthisanalysis,weseethatcurrentandtotalassetshavedeclinedsinceFY20X1,thecompanyisusinglesslong-termdebt,andequityhasincreased.Ifwewantedtolookatrelativetrends,wecouldcarrythisoutover5or10fscalperiods.
268 VALUATIONANDANALYSISTOOLS EXHIBIT11.5 ExemplarCorporation’sVerticalCommon-SizeBalanceSheets Asof Dec.31,20X2Dec.31,20X1 Cashandcashequivalents6%6%Accountsreceivable12%14%Inventory28% 28% Totalcurrentassets46%48%Grossproperty,plant,andequipment70%61%Accumulateddepreciation23% 17% Netproperty,plant,andequipment46%45%Intangibleassets3%3%Goodwill4% 4% Totalassets100%100%Accountspayable6%5%Currentportionoflong-termdebt2% 1% Totalcurrentliabilities8%6%Long-termdebt9%18%Commonstock1%1%Paid-incapitalinexcessofpar6%6%Retainedearnings77%70%Treasurystock1% 1% Shareholders’equity83% 76% Totalliabilitiesandequity100%100% Note: Eachaccountisdividedbytotalassets.Forexample,FY20X2inventoryof$490million,dividedbytotalassetsof$1,725,resultsin28.41%. USINGFINANCIALRATIOANALYSIS Financialanalysisprovidesinformationconcerningacompany’soperatingperformanceandfnancialcondition.Thisinformationisusefulforanin-vestorinevaluatingtheperformanceofthecompanyasawhole,aswellasofdivisions,products,andsubsidiaries.Aninvestormustalsobeawarethatfnancialanalysisisalsousedbyinvestorsandinvestorstogaugethefnancialperformanceofthecompany.Butfnancialratioanalysiscannottellthewholestoryandmustbeinterpretedandusedwithcare.Financialratiosareusefulbut,asnotedinthediscussionofeachratio,thereisinformationthattheratiosdonotreveal.Forexample,incalculatinginventoryturnoverweneedtoassumethattheinventoryshownonthebalancesheetisrepresentativeofinventory
FinancialRatioAnalysis 269 EXHIBIT11.6 ExemplarCorporation’sHorizontalCommon-SizeAnalysisBalanceSheet( baseyearisfscalyear20X1 ) Dec.31,20X2Dec.31,20X1 Cashandcashequivalents105%100%Accountsreceivable80%100%Inventory96%100%Totalcurrentassets92%100%Grossproperty,plant,andequipment109%100%Accumulateddepreciation133%100%Netproperty,plant,andequipment100%100%Intangibleassets100%100%Goodwill100%100%Totalassets96%100%Accountspayable111%100%Currentportionoflong-termdebt120%100%Totalcurrentliabilities113%100%Long-termdebt51%100%Commonstock100%100%Paid-incapitalinexcessofpar100%100%Retainedearnings106%100%Treasurystock100%100%Shareholders’equity106%100%Totalliabilitiesandequity96%100% Note: EachaccountinY20X2isdividedbytheaccount’svalueinFY20X1.Forexample,theFY20X2inventorydividedbyFY20X1inventory,$490million ÷ 510million,is96.08%. throughouttheyear.Anotherexampleisinthecalculationofaccountsreceivableturnover.Weassumedthatallsaleswereoncredit.Ifweareontheoutsidelookingin—thatis,evaluatingacompanybasedonitsfnancialstatementsonly,suchasthecaseofafnancialinvestororinvestor—and,therefore,donothavedataoncreditsales,assumptionsmustbemadethatmayormaynotbecorrect.Inaddition,thereareotherareasofconcernthataninvestorshouldbeawareofinusingfnancialratios: Limitationsintheaccountingdatausedtoconstructtheratios. Selectionofanappropriatebenchmarkcompanyorcompaniesforcom-parisonpurposes. Interpretationoftheratios.
270 VALUATIONANDANALYSISTOOLS Pitfallsinforecastingfutureoperatingperformanceandfnancialcon-ditionbasedonpasttrends. THEBOTTOMLINE Financialratiosareusefulinevaluatingtheoperatingperformanceandfnancialconditionofacompany.Withratios,wecanexamineacom-pany’sliquidity,proftability,andeffciencyinputtingitsassetstouse,aswellasitsabilitytomeetitdebtobligations. Liquidityrefectstheabilityofacompanytomeetitsshort-termobliga-tionsusingthoseassetsthataremostreadilyconvertedintocash.Twoofthemostcommonlyusedliquidityratiosarethecurrentratioandthequickratio. Proftabilityratioshelpinvestorsgaugehowwellacompanyismanagingitsexpenses.Proftmarginratioscomparecomponentsofincomewithsales. Activityratioshelpinvestorsandanalystsevaluatethebeneftsproducedbyspecifcassets,suchasinventoryoraccountsreceivable,orevaluatethebeneftsproducedbythetotalityofthecompany’sassets.Forthemostpart,activityratiosareturnoverratios. Financialleverageratiosaidinvestorsandanalystsinassessingtheex-posureofthecompanytofnancialrisk.Therearetwotypesoffnancialleverageratios:componentpercentagesandcoverageratios. Return-on-investmentratiosprovideinvestorsandanalystswithawaytocomparemeasuresofbenefts,suchasearningsornetincome,withmeasuresofinvestment. Wecanbreakdownoverallperformancemeasures,suchasthereturnonassets,intocomponentsusingtheDuPontsystem.Thisbreakdownisusefulinexaminingthedriverstochangesinreturns. Wecanusecommon-sizeanalysistoexaminerelativechangesinac-countsovertime,eitherusinghorizontalanalysisorverticalanalysis. SOLUTIONSTOTRYIT!PROBLEMS TheOperatingCycle Dayssalesoutstanding124.1Dayssalesininventory48.026Dayspurchasesoutstanding23.298Operatingcycle172.126Cashconversioncycle148.828
FinancialRatioAnalysis 271 LiquidityRatios Currentratio7.522Quickratio3.087Networkingcapitaltosales0.395 ProftabilityRatios Grossproftmargin21.053%Operatingproftmargin11.579%Netproftmargin6.442% ActivityRatiosTurnoverNumberofDaysProductoftheTurnoverandtheNumberofDays Inventory2.941124.100365Accountsreceivable7.60048.036365 FinancialLeverageRatios Debttoassets24.264%Debttoequity0.320Interestcoverageratio13.75Cashfowinterestcoverage8.963 BreakingDowntheReturnonEquity Returnonequity9.029%Basicearningpowerratio12.291%Operatingproftmargin11.579%EBT/EBIT0.927Taxrate40%Equitymultiplier1.320 QUESTIONS 1. Whatistherelationbetweenacompany’scurrentratioanditsquickratio? 2. Whatistherelationbetweenthecashconversioncycleandacompany’sneedforliquidity?
272 VALUATIONANDANALYSISTOOLS 3. Canacompany’scashconversioncycleeverbenegative?Explain. 4. Whatistherelationbetweenacompany’sinventoryturnoverandthenumberofdays’inventory? 5. Ifacompanyhasareturnonassetsof10%andanetproftmarginof5%,whatisthecompany’stotalassetturnover? 6. Ifacompanyhasadebt-to-assetsratioof35%,whatisthecompany’sdebt-to-equityratio? 7. Ifacompany’suseofdebtfnancingincreases,ascomparedtoequityfnancing,whatwouldyouexpecttofndintermsofachangeinreturnonequityifthecompany’sreturnonassetsremainsthesame? 8. Ifacompanyhasnodebtinitsbalancesheet,whatistherelationbetweenthereturnonassetsandthereturnonequity? 9. Whenwouldyouwanttousethebasicearningpowertocomparecompaniesinsteadofthereturnonassets? 10. Ifacompanyhasareturnonassetsof10%andhasadebt-to-assetsratioof50%,whatisthecompany’sreturnonequity? 11. Supposeyoucalculatethefollowingratiosfortwocompanies,AandB. CompanyACompanyB Currentratio2.02.0Quickratio1.01.5 Whatcanyousayabouttherelativeinvestmentininventory? 12. Supposeyouarecomparingtwocompaniesthatareinthesamelineofbusiness.CompanyChasanoperatingcycleof40days,andCompanyDhasanoperatingcycleof60days.CompanyChasacurrentratioof3,andCompanyDhasacurrentratioof2.5.Commentontheliquidityofthetwocompanies.Whichcompanyhasmoreriskofnotsatisfyingitsnear-termobligations?Why? 13. Supposeyoucalculateareturnonfxedassetsof20%for2008and15%for2009foracompany.ExplainhowyouwouldusetheDuPontsystemtofurtherinvestigatethischangeinthereturnonfxedassets. 14. Inexaminingthetrendofreturnsonassetsovera20-yearperiodforacompany,youfndthatthereturnshavebeendeclininggraduallyoverthisperiod.Whatinformationwouldyoulookattofurtherexplainthistrend?
FinancialRatioAnalysis 273 15. DatafortheLubbockCorporationisprovidedasfollows: LubbockCorporation BalanceSheetAsofDecember31,2009(inmillions) Cash$100Accountspayable$300Marketablesecurities300Othercurrentliabilities200Accountsreceivable600Long-termdebt500Inventory1,000Commonstock2,000Netplantandequipment4,000Retainedearnings3,000Totalassets$6,000Totalliabilitiesandequity$6,000 LubbockCorporation IncomeStatementForYearEndingDecember31,2009(inmillions) Sales$12,000Costofgoodssold*10,800 Grossproft$1,200Administrationexpenses150 Earningsbeforeinterestandtaxes$1,050Interestexpense50 Earningsbeforetaxes$1,000Taxes400 Netincome$600 *Includesdepreciationof$800. CalculatethefollowingratiosfortheLubbockCorporation: a. Currentratio b. Quickratio c. Inventoryturnoverratio d. Totalassetturnoverratio e. Grossproftmargin f. Operatingproftmargin g. Netproftmargin h. Debt-to-assetsratio i. Debt-to-equityratio j. Returnonassets(basicearningpower) k. Returnonequity 16. Considertwocompanies,eachwithareturnonassetsof10%.CompanyXhasareturnonequityof15%,andCompanyYhasareturnonequityof20%.Whichcompanyusesmorefnancialleverage?Explain.
274 VALUATIONANDANALYSISTOOLS 17. ConstructthecommonsizebalancesheetforGrishamCompanyfor2009:BalanceSheet(inmillions) Cash$50Currentliabilities$30Accountsreceivable30Long-termdebt90Inventory80Equity240 Plantandequipment200 Totalassets$360Totalliabilitiesandequity$360
CHAPTER 12 CashFlowAnalysis Drivenbythedownturn,CFOsandtreasurersareincreasinglyswitchingtheircompanies’fnancialyardsticksfromearningstocash.Asaresult,they’retrackingthefowofcashintoandoutofeverynookandcrannyoftheircompanies’operations.Andthecash-managementbuzzwordofthedayisvisibility. —DavidM.Katz,“TheNewCashManagers,” CFOMagazine ,November23,2009 O neofthekeyfnancialmeasuresthataninvestorshouldunderstandisthecompany’scashfow.Thisisbecausethecashfowaidsinassessingtheabilityofthecompanytosatisfyitscontractualobligationsandmaintaincurrentdividendsandcurrentcapitalexpenditurepolicywithoutrelyingonexternalfnancing.Moreover,aninvestormustunderstandwhythismeasureisimportantforexternalparties,specifcallystockanalystscoveringthecompany.Thereasonisthatthebasicvaluationprincipleisthatthevalueofacompanytodayisthepresentvalueofitsexpectedfuturecashfows.Inthischapter,wediscusscashfowanalysis. DIFFICULTIESWITHMEASURINGCASHFLOW Cashfow isthefowoffundswithinacompanyduringaperiodoftime.Theprimarydiffcultywithmeasuringacashfowisthatitisafow:Cashfowsintothecompany(i.e.,cashinfows)andcashfowsoutofthecompany(i.e.,cashoutfows).Atanypointintime,thereisastockofcashonhand,butthestockofcashonhandvariesamongcompaniesbecauseofthesizeofthecompany,thecashdemandsofthebusiness,andacompany’smanagementofworkingcapital.Sowhatiscashfow?Isitthetotalamount 275
276 VALUATIONANDANALYSISTOOLS ofcashfowingintothecompanyduringaperiod?Isitthetotalamountofcashfowingoutofthecompanyduringaperiod?Isitthenetofthecashinfowsandoutfowsforaperiod?Well,thereisnospecifcdefnitionofcashfow—andthat’sprobablywhythereissomuchconfusionregardingthemeasurementofcashfow.Ideally,ameasureofthecompany’soperatingperformancethatiscomparableamongcompaniesisneeded—somethingotherthannetincome.Asimple,yetcrudemethodofcalculatingcashfowrequiressimplyaddingnoncashexpenses(e.g.,depreciationandamortization)tothere-portednetincomeamounttoarriveatcashfow:Cashfow(Defnition1) = Netincome + Depreciationandamortization(12.1)ConsidertheexampleoftheExemplarCorporation,whosebalancesheet,incomestatement,andstatementofcashfowswepresentinEx-hibits12.1,12.2,and12.3,respectively.Thesimplestcashfowestimate,whichwerefertoasDefnition1,is:Netincome$110PlusDepreciation100 EqualsCashfow(Defnition1)$210Thisamountisnotreallyacashfow,butsimplyearningsbeforedepre-ciationandamortization.Isthisacashfowthatweshoulduseinvaluingacompany?Thoughnotacashfow,thisestimatedcashfowdoesallowaquickcomparisonofincomeacrosscompaniesthatmayusedifferentdepre-ciationmethodsanddepreciablelives.Theproblemwiththismeasureisthatitignoresthemanyothersourcesandusesofcashduringtheperiod.Considerthesaleofgoodsforcredit.Thistransactiongeneratessalesfortheperiod.Salesandtheaccompanyingcostofgoodssoldarerefectedintheperiod’snetincomeandtheestimatedcashfowamount.However,untiltheaccountreceivableiscollected,thereisnocashfromthistransaction.Ifcollectiondoesnotoccuruntilthenextperiod,thereisamisalignmentoftheincomeandcashfowarisingfromthistransaction.Therefore,thesimpleestimatedcashfowignoressomecashfowsthat,formanycompanies,aresignifcant.Anotherestimateofcashfowthatissimpletocalculateis earningsbeforeinterest,taxes,depreciation,andamortization (EBITDA):Cashfow(Defnition2) = Earningsbeforeinterestandtaxes + Depreciationandamortization(12.2)
CashFlowAnalysis 277 EXHIBIT12.1 ExemplarCorporation’sBalanceSheets Asof InMillionsDec.31,20X2Dec.31,20X1Dec.31,20X0 Cashandcashequivalents$110$105$100Accountsreceivable200250175Inventory490 510 500 Totalcurrentassets$800$865$775Grossproperty,plant,andequipment1,2001,1001,000Accumulateddepreciation400 300 200 Netproperty,plant,andequipment$800$800$800Intangibleassets505050Goodwill75 75 75 Totalassets$1,725$1,790$1,700Accountspayable$100$90$100Currentportionoflong-termdebt30 25 20 Totalcurrentliabilities$130$115$120Long-termdebt163319300Commonstock202020Paid-incapitalinexcessofpar100100100Retainedearnings1,3321,2561,170Treasurystock20 20 10 Shareholders’equity$1,432 $1,356 $1,280 Totalliabilitiesandequity$1,725$1,790$1,700 ForExemplar’s20X2fscalyear:Earningsbeforeinterestandtaxes$200P LUS Depreciationandamortization100 E QUALS Cashfow(Defnition2):EBITDA$300However,thismeasuresuffersfromthesameaccrual-accountingbiasasthepreviousmeasure,whichmayresultintheomissionofsignifcantcashfows.Additionally,EBITDAdoesnotconsiderinterestandtaxes,whichmayalsobesubstantialcashoutfowsforsomecompanies.Thesetworoughestimatesofcashfowsareusedinpracticenotonlyfortheirsimplicity,butbecausetheyexperiencedwidespreadusepriortothedisclosureofmoredetailedinformationinthestatementofcashfows.
278 VALUATIONANDANALYSISTOOLS EXHIBIT12.2 ExemplarCorporation’sIncomeStatements FortheYearEnding InMillionsDec.31,20X2Dec.31,20X1 Revenues$2,000$1,900Costofgoodssold1,600 1,500 Grossproft$400$400Selling,general,andadministrativeexpenses200 180 Earningsbeforeinterestandtaxes$200$220Interestexpense17 16 Earningsbeforetaxes$183$204Taxes73 82 Netincome$110$122 EXHIBIT12.3 ExemplarCorporation’sStatementsofCashFlows FortheYearEnding InMillionsDec.31,20X2Dec.31,20X1 Operations Netincome$110$122Add:depreciationexpense100100 Changesinworkingcapitalaccounts Accountsreceivable50 − 75Inventory20 − 10Accountspayable10 − 10 Cashfowfor/fromoperations$290$127 Investments Capitalexpenditures − $100 − $100Saleofproperty,plant,andequipment0 0 Cashfowfor/frominvestment − $100 − $100 Financing Borrowings$0$25Repaymentsofdebt − 1520Dividends − 33 − 37Repurchaseofstock0 − 10 Cashfowfor/fromfnancing − $185 − $23 Changeincash$5$5
CashFlowAnalysis 279 Currently,themeasuresofcashfowarewide-ranging,includingthesimplis-ticcashfowmeasures,measuresdevelopedfromthestatementofcashfows,andmeasuresthatseektocapturethetheoreticalconceptof freecashfow. CashFlowsandtheStatementofCashFlows Priortotheadoptionofthestatementofcashfows,theinformationre-gardingcashfowswasquitelimited.Thefrststatementthataddressedtheissueofcashfowswasthestatementoffnancialposition,whichwasrequiredstartingin1971.Thisstatementwasquitelimited,requiringananalysisofthesourcesandusesoffundsinavarietyofformats.Initsearlieryearsofadoption,mostcompaniesprovidedthisinformationusingwhatisreferredtoasthe workingcapitalconcept —apresentationofworkingcapitalprovidedandappliedduringtheperiod.Overtime,manycompaniesbeganpresentingthisinformationusingthecashconcept,whichisamostdetailedpresentationofthecashfowsprovidedbyoperations,investing,andfnancingactivities.Consistentwiththecashconceptformatofthefundsfowstatement,thestatementofcashfowsisnowarequiredfnancialstatement.Therequire-mentthatcompaniesprovideastatementofcashfowsappliestofscalyearsafter1987. 1 Thisstatementrequiresthecompanytoclassifycashfowsintothreecategories,basedontheactivity:operating,investing,andfnancing.Cashfowsaresummarizedbyactivityandwithinactivitybytype(e.g.,assetdispositionsarereportedseparatelyfromassetacquisitions).Wehavehigh-lightedtheactivitiesinthestatementweshowinExhibit12.3:operations,investments,andfnancing. CASHFLOWSFROMANDFOR Thestatementofcashfowprovidesinformationonthreeactivities:operations,investments,andfnancing.Thecashfowsareusuallyindicatedas“from”ifthecashfowsarepositiveforthatactivity,and“for”ifthecashfowisnegative—thatis,cashfowsoutofthecompany.( continued ) 1 StatementofFinancialAccountingStandardsNo.95,“StatementofCashFlows.”
280 VALUATIONANDANALYSISTOOLS ( Continued )However,insomefnancialstatements,thecashfowmaysimplybereportedas“from,”nomatterthesign—positiveornegative—thecashfow.Thekeyistolookatthesummedamountfortheactivity:positivemeansthatfundshavefowedtothecompanyandnegativemeansthatfundshavefowedfromthecompany.Youmayalsoseevariationsinthenameofthesummation.Forexample,youmayseeforoperations,“Cashfowfromoperations”or“Cashfowfromoperatingactivities.” Thereportingcompanymayreportthecashfowsfromoperatingactivi-tiesonthestatementofcashfowsusingeitherthe directmethod —reportingallcashinfowsandoutfows—ortheindirectmethod—startingwithnetin-comeandmakingadjustmentsfordepreciationandothernoncashexpensesandforchangesinworkingcapitalaccounts.Thoughthedirectmethodisrecommended,itisalsothemostburdensomeforthereportingcompanytoprepare.Mostcompaniesreportcashfowsfromoperationsusingtheindirectmethod.Theindirectmethodhastheadvantageofprovidingthefnancialstatementuserwithareconciliationofthecompany’snetincomewiththechangeincash.Theindirectmethodproducesacashfowfromoperationsthatissimilartotheestimatedcashfowmeasurediscussedpre-viously,yetitencompassesthechangesinworkingcapitalaccountsthatthesimplemeasuredoesnot.Thecashfowfromoperationsisourthirddefnitionofcashfow:Cashfow(Defnition3) = Netincome + Depreciationandamortization − Increaseinworkingcapital(12.3)FromExhibit12.3,weseethatExemplar’scashfowfromoperationsis$290millioninFY20X2:Netincome$110P LUS Depreciationexpense100P LUS Increaseinworkingcapitalaccounts80 E QUALS Cashfow(Defnition3)$290Theclassifcationofcashfowsintothethreetypesofactivitiespro-videsusefulinformationthatcanbeusedbyananalysttosee,forexample,
CashFlowAnalysis 281 whetherthecompanyisgeneratingsuffcientcashfowsfromoperationstosustainitscurrentrateofgrowth.However,theclassifcationofparticu-laritemsisnotnecessarilyasusefulasitcouldbe.Considersomeoftheclassifcations: Cashfowsrelatedtointerestexpenseareclassifedinoperations,thoughtheyareclearlyfnancingcashfows. 2 Incometaxesareclassifedasoperatingcashfows,thoughtaxesareaffectedbyfnancing(e.g.,deductionforinterestexpensepaidondebt)andinvestmentactivities(e.g.,thereductionoftaxesfromtaxcreditsoninvestmentactivities). Interestincomeanddividendsreceivedareclassifedasoperatingcashfows,thoughthesefowsarearesultofinvestmentactivities.Whethertheseitemshaveasignifcanteffectontheanalysisdependsontheparticularcompany’ssituation.Exemplar,forexample,hasnointerestanddividendincome,anditsinterestexpenseof$17millionisnotlargerelativetoitsearningsbeforeinterestandtaxes($200million).However,forsomecompaniesandsomeoperations,thesearesignifcant.Lookingattherelationamongthethreecashfowsinthestatementprovidesasenseoftheactivitiesofthecompany.Ayoung,fast-growingcompanymayhavenegativecashfowsfromoperations,yetpositivecashfowsfromfnancingactivities(i.e.,operationsmaybefnancedinlargepartwithexternalfnancing).Asacompanygrows,itmayrelytoalesserex-tentonexternalfnancing.Thetypical,maturecompanygeneratescashfromoperationsandreinvestspartorallofitbackintothecompany.Therefore,cashfowrelatedtooperationsispositive(i.e.,asourceofcash)andcashfowrelatedtoinvestingactivitiesisnegative(i.e.,auseofcash).Asacompanymatures,itmayseeklessfnancingexternallyandmayevenusecashtoreduceitsrelianceonexternalfnancing(e.g.,repaydebts).Anothervariationintheestimationofcashfowisthediscretionarycashfow. 3 Startingwiththefrstdefnitionofcashfow,weadjustforchangesinworkingcapitaltoarriveatanoperatingcashfow.Fromthis,wesubtract 2 Theinterestexpenseisdeductedfromearningsbeforeinterestandtaxes,and,therefore,affectsthenetincomeandcashfowfromoperations. 3 ThisisbasedonthecashfowdefnitionpromotedbyMartinFridsonin FinancialStatementAnalysis:APractitioner’sGuide (NewYork:JohnWiley&Son,1995).Thisdefnitionresultsfromreformattingthestatementofcashfowstoremovethenondiscretionarycashfows.
282 VALUATIONANDANALYSISTOOLS thecapitalexpenditurestoarriveatourfourthdefnitionofcashfow,thediscretionarycashfow: Cashfow(Defnition4) = Netincome + Depreciationandamortization − Increaseinworkingcapital − Capitalexpenditures (12.4)Thecashfowsrelatedtofnancingarethenprovided,resultinginabottom-linecashfow.Byrestructuringthestatementofcashfowsinthisway,itcanbeseenhowmuchfexibilitythecompanyhaswhenitmustmakebusinessdecisionsthatmayadverselyimpactthelong-runfnancialhealthoftheenterprise.WeshowthisrestatedcashfowstatementinExhibit12.4.Forexample,consideracompanywithabasiccashfowof$800millionandoperatingcashfowof$500million.Supposethatthiscompanypaysdividendsof$130millionandthatitscapitalexpenditureis$300million.Thediscretionarycashfowforthiscompanyis$200millionfoundbysubtractingthe$300millioncapitalexpenditurefromtheoperatingcashfowof$500million.Thismeansthatevenaftermaintainingadividendpaymentof$130million,itscashfowispositive.Noticethatassetsalesandotherinvestingactivity,whichareconsidered“Otherinvestingactivities,”arenotneededtogeneratecashtomeetthedividendpaymentsbecausetheseitemsaresubtractedafteraccountingforthedividendpayments.Infact,ifthiscompanyplannedtoincreaseitscapitalexpenditures,thisbreakdown EXHIBIT12.4 ReformattedCashFlowStatement,HighlightingtheExemplarCorporation’sFinancialFlexibility FortheYearEnding Dec.31,20X2Dec.31,20X1 Netincome$110$122P LUS Depreciationexpense100 100 Cashfow(Defnition1)$210$222L ESS Increaseinworkingcapital − 80 95 Operatingcashfow(Defnition3)$290$127L ESS Capitalexpenditures100 100 Discretionarycashfow(Defnition4)$190$27L ESS Dividends3337L ESS Otherinvestingactivities0 0 Cashfowbeforefnancing$157 − $10P LUS Borrowings024L ESS Repaymentsofdebt1520L ESS Repurchaseofstock0 10 Changeincash$5$4
CashFlowAnalysis 283 ofcashfowsintodiscretionaryandnondiscretionarycanbeusedtoassesshowmuchthatexpansioncanbebeforeaffectingdividendsorincreasingfnancingneeds.Thoughwecanclassifyacompanybasedonthesourcesandusesofcashfows,moredataisneededtoputthisinformationinperspective.Whatisthetrendinthesourcesandusesofcashfows?Whatmarket,industry,orcompany-specifceventsaffectthecompany’scashfows?Howdoesthecompanybeinganalyzedcomparewithothercompaniesinthesameindustryintermsofthesourcesandusesoffunds? TRYIT!CALCULATINGCASHFLOWS CalculatethecashfowusingeachofthefourdefnitionsandExem-plar’sFY20X1fnancialinformation: Cashfow(Defnition1) Cashfow(Defnition2) Cashfow(Defnition3) Cashfow(Defnition4) FREECASHFLOW Cashfowswithoutanyadjustmentmaybemisleadingbecausetheydonotrefectthecashoutfowsthatarenecessaryforthefutureexistenceofacompany.Analternativemeasure,freecashfow,wasdevelopedbyMichaelJenseninhistheoreticalanalysisofagencycostsandcorporatetakeovers. 4 Intheory, freecashfow isthecashfowleftoverafterthecompanyfundsallpositivenetpresentvalueprojects.Positivenetpresentvalueprojectsarethosecapitalinvestmentprojectsforwhichthepresentvalueofexpectedfuturecashfowsexceedsthepresentvalueofprojectoutlays,alldiscountedatthecostofcapital. 5 Inotherwords,freecashfow 4 MichaelC.Jensen,“AgencyCostsofFreeCashFlow,CorporateFinance,andTakeovers,” AmericanEconomicReview 76(1985):323–329. 5 The costofcapital isthecosttothecompanyoffundsfromcreditorsandshare-holders.Thecostofcapitalisbasicallyahurdle:Ifaprojectreturnsmorethanitscostofcapital,itisaproftableprojectspentonlow-returnexplorationand
284 VALUATIONANDANALYSISTOOLS isthecashfowofthecompany,lesscapitalexpendituresnecessarytostayinbusiness(i.e.,replacingfacilitiesasnecessary)andgrowattheexpectedrate(whichrequiresincreasesinworkingcapital).ThetheoryoffreecashfowwasdevelopedbyJensentoexplainbehav-iorsofcompaniesthatcouldnotbeexplainedbyexistingeconomictheories.Jensenobservedthatcompaniesthatgeneratefreecashfowshoulddisgorgethatcashratherthaninvestthefundsinlessproftableinvestments.Therearemanywaysinwhichcompaniescandisgorgethisexcesscashfow,in-cludingthepaymentofcashdividends,therepurchaseofstock,anddebtissuanceinexchangeforstock.Thedebt-for-stockexchange,forexample,increasesthecompany’sleverageandfuturedebtobligations,obligatingthefutureuseofexcesscashfow.Ifacompanydoesnotdisgorgethisfreecashfow,thereisthepossibilitythatanothercompany—acompanywhosecashfowsarelessthanitsproftableinvestmentopportunitiesoracompanythatiswillingtopurchaseandlever-upthecompany—willattempttoacquirethefree-cash-fow-ladencompany.Asacaseinpoint,Jensenobservedthattheoilindustryillustratesthecaseofwastingresources:Thefreecashfowsgeneratedinthe1980swerespentonlow-returnexplorationanddevelopment,andonpoordiversifca-tionattemptsthroughacquisitions.Hearguesthatthesecompanieswouldhavebeenbetteroffpayingtheseexcesscashfowstoshareholdersthroughsharerepurchasesorexchangeswithdebt.Byitself,thefactthatacompanygeneratesfreecashfowisneithergoodnorbad.Whatthecompanydoeswiththisfreecashfowiswhatisimpor-tant.Andthisiswhereitisimportanttomeasurethefreecashfowasthatcashfowinexcessofproftableinvestmentopportunities.Considerthesim-plenumericalexercisewiththeWinnerCompanyandtheLoserCompany: WinnerCompanyLoserCompany Cashfowbeforecapitalexpenditures$1,000$1,000Capitalexpenditures,positivenetpresentvalueprojects750250Capitalexpenditures,negativenetpresentvalueprojects0 500 Cashfow$250$250Freecashfow$250$750 developmentandonpoordiversifcationattemptsthroughacquisitions.Jensenar-guesthatthesecompanieswouldhavebeenbetteroffpayingtheseexcesscashfowstoshareholdersthroughsharerepurchasesorexchangeswithdebt.
CashFlowAnalysis 285 Thesetwocompanieshaveidenticalcashfowsandthesametotalcapitalexpenditures.However,theWinnerCompanyspendsonlyonprojectsthataddvalue(intermsofpositivenetpresentvalueprojects),whereastheLoserCompanyspendsonbothproftableprojectsandwastefulprojects.TheWinnerCompanyhasalowerfreecashfowthantheLoserCompany,indicatingthattheyareusingthegeneratedcashfowsinamoreproftablemanner.Thelessonisthattheexistenceofahighleveloffreecashfowisnotnecessarilygood—itmaysimplysuggestthatthecompanyiseitheraverygoodtakeovertargetorthecompanyhasthepotentialforinvestinginunproftableinvestments.Positivefreecashfowmaybegoodorbadnews;likewise,negativefreecashfowmaybegoodorbadnews: FreeCashFlowGoodNewsBadNews + Generatingsubstantialoperatingcashfows,beyondthosenecessaryforproftableprojects.Generatingmorecashfowsthanitneedsforproftableprojectsandmaywastethesecashfowsonunproftableprojects. − Hasmoreproftableprojectsthanithasoperatingcashfowsandmustrelyonexternalfnancingtofundtheseprojects.Unabletogeneratesuffcientoperatingcashfowstosatisfyitsinvestmentneedsforfuturegrowth.Therefore,oncethefreecashfowiscalculated,otherinformation(e.g.,trendsinproftability)mustbeconsideredtoevaluatetheoperatingperfor-manceandfnancialconditionofthecompany. CalculatingFreeCashFlow Thereissomeconfusionwhenthistheoreticalconceptisappliedtoactualcompanies.Theprimarydiffcultyisthattheamountofcapitalexpendituresnecessarytomaintainthebusinessatitscurrentrateofgrowthisgenerallynotknown;companiesdonotreportthisitemandmaynotevenbeabletodeterminehowmuchofaperiod’scapitalexpendituresareattributedtomaintenanceandhowmuchareattributedtoexpansion.Oneapproachistoestimatefreecashfowbyassumingthatallcapitalexpendituresarenecessaryforthemaintenanceofthecurrentgrowthofthecompany.Thoughthereislittlejustifcationinusingall
286 VALUATIONANDANALYSISTOOLS expenditures,thisisapracticalsolutiontoanimpracticalcalculation.Thisassumptionallowsustoestimatefreecashfowsusingpublishedfnancialstatements.Anotherissueinthecalculationisdefningwhatistruly“free”cashfow.Generallywethinkof“free”cashfowaswhatisleftoverafterallnecessaryfnancingexpendituresarepaid;thismeansthatfreecashfowisafterinterestondebtispaid.Otherscalculatefreecashfowbeforesuchfnancingexpenditures,otherscalculatefreecashfowafterinterest,andstillotherscalculatefreecashfowafterbothinterestanddividends(assumingthatdividendsareacommitment,thoughnotalegalcommitment).Thereisnoonecorrectmethodofcalculatingfreecashfowanddifferentanalystsmayarriveatdifferentestimatesoffreecashfowforacompany.Theproblemisthatitisimpossibletomeasurefreecashfowasdictatedbythetheory,somanymethodshavearisentocalculatethiscashfow.Asimplemethodistostartwiththecashfowfromoperationsandthendeductcapitalexpenditures:Freecashfow(Defnition1) = Cashfowfromoperations − Capitalexpendiures(12.5)Thisisthesameasthediscretionarycashfow,ourfourthdefnitionofcashfowthatwediscussedpreviously.ForExemplarinFY20X2:Cashfowfromoperations$290L ESS Capitalexpenditures100 E QUALS Freecashfow(Defnition1)$190Anotherestimateoffreecashfowistoadjustthecashfowfromop-erationsfortheafter-taxinterest,addingthisamountbacktoarriveatanadjustedcashfowfromoperations.Wemakethisadjustmentbecausewewanttoestimatehowmuchfreecashfowisavailabletobothbondholdersandequityowners: 6 Freecashfow(Defnition2) = Cashfowfromoperations − Adjustedinterest − Capitalexpenditures(12.6) 6 Thisdefnitionissimilartostillanotherdefnitionoffreecashfow, netfreecashfow ,whichadjustsforbothinterestexpenses,butonlydeductscashtaxes,notthesumofdeferredtaxesandcashtaxesasrepresentedbythetaxexpenseonacompany’sincomestatement.
CashFlowAnalysis 287 Weoftenrefertothiscalculationoffreecashfowasthe freecashfowtothefrm (FCFF)becauseitisthefowavailabletothesuppliersofcapital.Exemplar’sinterestexpenseis$17millionanditstaxrateis40%.Makinganadjustmentfortheafter-taxinterestandfnancingexpenses,$17million(1–0.4) = $10.2million(whichweroundto$10mil-lionforsimplicityinourexample),wehaveanothermeasureoffreecashfow:Cashfowfromoperations$290P LUS Adjustedinterest10 Adjustedcashfowfromoperations$300L ESS Capitalexpenditures100 E QUALS Freecashfow,FCFF(Defnition2)$200Stillanotherfreecashfowisacashfowthatadjustsforthenetbor-rowingsofthecompany.Thebasicideaisthatifwewanttofocusonthefundsavailabletotheowners,weneedtoconsidernotonlythecapitalexpenditures,whichreducecashfowavailabletoowners,butalsofundsraisedthroughborrowing,whichareavailabletoowners. Freecashfow(Defnition3) = Cashfowfromoperations − Capitalexpenditures + Borrowings − Debtrepayments(12.7) Thisfreecashfowdefnitionbeginswithcashfowfromoperations,removescapitalexpenditures,addsnewborrowings,andsubtractsdebtrepayments:Cashfowfromoperations$290L ESS Capitalexpenditures100P LUS Borrowings0L ESS Debtrepayments152 E QUALS Freecashfow,FCFE(Defnition3)$38Basedonthisthirddefnitionoffreecashfow,ExemplarhasfreecashfowavailabletospendforFY20X2of$38million.Werefertothisdefnitionoffreecashfowasthe freecashfowtoequity ,FCFE,becauseitisthecashfowavailableforthecompany’sowners.
288 VALUATIONANDANALYSISTOOLS TRYIT!CALCULATINGFREECASHFLOWS CalculatethefreecashfowusingeachofthethreedefnitionsandExemplar’sFY20X1fnancialinformation: Freecashfow(Defnition1) Freecashfow(Defnition2) Freecashfow(Defnition3) USEFULNESSOFCASHFLOWSANALYSIS Theusefulnessofcashfowsforfnancialanalysisdependsonwhethercashfowsprovideuniqueinformationorprovideinformationinamannerthatismoreaccessibleorconvenientfortheanalyst.Thecashfowinformationprovidedinthestatementofcashfows,forexample,isnotnecessarilyuniquebecausemost,ifnotall,oftheinformationisavailablethroughanalysisofthebalancesheetandincomestatement.Whatthestatementdoesprovideisaclassifcationschemethatpresentsinformationinamannerthatiseasiertouseand,perhaps,moreillustrativeofthecompany’sfnancialposition.Ananalysisofcashfowsandthesourcesofcashfowscanrevealthefollowinginformation: Thesourcesoffnancingthecompany’scapitalspending. Doesthecom-panygenerateinternally(i.e.,fromoperations)aportionorallofthefundsneededforitsinvestmentactivities?Ifacompanycannotgeneratecashfowfromoperations,thismayindicateproblemsupahead.Re-lianceonexternalfnancing(e.g.,equityordebtissuance)mayindicateacompany’sinabilitytosustainitselfovertime. Thecompany’sdependenceonborrowing. Doesthecompanyrelyheav-ilyonborrowingthatmayresultindiffcultyinsatisfyingfuturedebtservice? Thequalityofearnings. Largeandgrowingdifferencesbetweenincomeandcashfowssuggestalowqualityofearnings.
CashFlowAnalysis 289 KRISPYKREME:NOTSOSWEET KrispyKreme,awholesalerandretailerofdoughnuts,grewrapidlyafteritsinitialpublicoffering(IPO)in2000.IncomegrewasKrispyKremeincreasedthenumberofretailstores,butthetideinincometurnedinthe2004fscalyearandlossescontinuedthereafter: $100,000–$100,000–$200,000–$300,000 2/1/19981/31/19991/30/20001/28/20012/3/20022/2/20032/1/20041/30/20051/29/20061/28/20072/3/20082/1/2009 $0$200,000Operating income Income, in Thousands Fiscal Year End Net income KrispyKreme’sgrowthafteritsIPOwasfnancedbybothoperat-ingactivitiesandexternalfnancing,asevidentfromitscashfows: $100,000$50,000–$50,000$150,000–$150,000–$100,000–$200,000 2/1/19981/31/19991/30/20001/28/20012/3/20022/2/20032/1/20041/30/20051/29/20061/28/20072/3/20082/1/2009 $0$200,000Cash flow from operating activitiesCash flow from investing activitiesCash flow from financing activities Cash Flow, in Thousands Fiscal Year End ( continued )
290 VALUATIONANDANALYSISTOOLS ( Continued )Asyoucansee,approximatelyhalfofthefundstosupportitsrapidgrowthcamefromfnancing,inparticulardebtfnancing.Thisresultedinproblemsasthecompany’sdebtburdenbecamealmostthreetimesitsequityasrevenuegrowthslowedbythe2005fscalyear. RATIOANALYSIS Oneuseofcashfowinformationisinratioanalysis,primarilywiththebalancesheetandincomestatementinformation.Onesuchratioisthecashfow–basedratio,thecashfowinterestcoverageratio,whichcanbeusedasameasureoffnancialrisk.Thereareanumberofothercashfow–basedratiosthatananalystmayfndusefulinevaluatingtheoperatingperformanceandfnancialconditionofacompany.Ausefulratiotohelpfurtherassessacompany’scashfowisthe cashfowtocapitalexpendituresratio ,or capitalexpenditurescoverageratio :Cashfowtocapitalexpenditures = Cashfow Capitalexpenditures(12.8)Thecashfowmeasureinthenumeratorshouldbeonethathasnotalreadyremovedcapitalexpenditures;forexample,includingfreecashfowinthenumeratorwouldbeinappropriate.Thisratioprovidesinformationaboutthefnancialfexibilityofthecompanyandisparticularlyusefulforcapital-intensivecompaniesandutil-ities. 7 Thelargertheratiois,thegreaterthefnancialfexibility.However,onemustcarefullyexaminethereasonswhythisratiomaybechangingovertimeandwhyitmightbeoutoflinewithcomparablecompaniesinthein-dustry.Forexample,adecliningratiocanbeinterpretedintwoways.First,thecompanymayeventuallyhavediffcultyaddingtocapacityviacapitalexpenditureswithouttheneedtoborrowfunds.Thesecondinterpretationisthatthecompanymayhavegonethroughaperiodofmajorcapitalex-pansionandthereforeitwilltaketimeforrevenuestobegeneratedthatwillincreasethecashfowfromoperationstobringtheratiotosomenormallong-runlevel. 7 Fridson, FinancialStatementAnalysis:APractitioner’sGuide ,173.
CashFlowAnalysis 291 Anotherusefulcashfowratioisthe cashfowtodebtratio :Cashfowtodebt = Cashfow Debt(12.9)wheredebtcanberepresentedastotaldebt,long-termdebt,oradebtmea-surethatcapturesaspecifcrangeofmaturity(e.g.,debtmaturinginfveyears).Thisratiogivesameasureofacompany’sabilitytomeetmatur-ingdebtobligations.AmorespecifcformulationofthisratioisFitch’s CFAR ratio,whichcomparesacompany’sthree-yearaveragenetfreecashfowtoitsmaturingdebtoverthenextfveyears.Bycomparingthecom-pany’saveragenetfreecashfowtotheexpectedobligationsinthenearterm(i.e.,fveyears),thisratioprovidesinformationonthecompany’screditquality. UsingCashFlowInformation Theanalysisofcashfowsprovidesinformationthatcanbeusedalongwithotherfnancialdatatohelpassessthefnancialconditionofacompany.Considerthecash-fow-to-capital-expendituresandthecash-fow-to-debtratioscalculatedusingthedifferentmeasuresofcashfowforExemplarCorporationforthe20X2fscalyear: CashFlowtoDebtRatioCashFlowtoCapitalExpenditures Cashfow(Defnition1)0.7172.224Cashfow(Defnition2)1.0253.200Cashfow(Defnition3)0.9901.274Cashfow(Defnition4)0.6480.274Freecashfow(Defnition1)0.6480.274Freecashfow(Defnition2)0.6830.370Freecashfow(Defnition3)0.1290.520Thecashfowtocapitalexpendituresratiorangesfrom0.274to3.2,whereasthecashfowtodebtratiorangesfrom0.129to1.025.Asyoucansee,itisimportanttounderstandthedifferencesamongthecashfowmeasures,especiallywheninterpretingcashfowsandratiosinvolvingcashfows.
292 VALUATIONANDANALYSISTOOLS CASHFLOWMATTERS JamesLargayandClydeStickneyanalyzedthefnancialstatementsofW.T.Grantduringthe1966–1974periodprecedingitsbankruptcyin1975andultimateliquidation. 8 Theynotedthatfnancialindica-torssuchasproftabilityratios,turnoverratios,andliquidityratiosshowedsomedownwardtrends,butprovidednodefnitecluestothecompany’simpendingbankruptcy.Astudyofcashfowsfromoperations,however,revealedthatthecompany’soperationswerecausinganincreasingdrainoncash,ratherthanprovidingcash.Thisnecessitatedanincreaseduseofexternalfnancing,therequiredinterestpaymentsonwhichexacerbatedthecashfowdrain.CashfowanalysisclearlywasavaluabletoolinthiscasesinceW.T.Granthadbeenrunninganegativecashfowfromoperationsforyears. 8 JamesA.LargayandClydeP.Stickney,“CashFlows,RatioAnalysisandtheW.T.GrantCompanyBankruptcy,” FinancialAnalystsJournal 36(1980):51–54. THEBOTTOMLINE Cashfowanalysisisimportantbecauseacompany’ssustainabilityde-pendsonitsabilitytogeneratecashfows.Therearealternativemeasuresofcashfow,includingcashfowfromoperationsandfreecashfow. Acompany’sfreecashfowisthecashfowitgeneratesinexcessofwhatisneededforitscapitalexpenditures. Wecanexaminesourcesandusesofcashfowstogaugeacompany’sabilitytofnanceitsownoperations.Especiallyusefulinthistaskisthecashfowsfromoperatingactivities,fnancingactivities,andinvestingactivitiesthatacompanyreportsonitsstatementofcashfows.Wecanalsousecashfowfnancialratiostoevaluateacompany’sperformanceandcondition. Freecashfowisacompany’scashfowthatremainsaftermakingcapitalinvestmentsthatmaintainthecompany’scurrentrateofgrowth.Itisnotpossibletocalculatefreecashfowprecisely,resultinginmanydifferentvariationsincalculationsofthismeasure.
CashFlowAnalysis 293 SOLUTIONSTOTRYIT!PROBLEMS CalculatingCashFlows Cashfow(Defnition1)$222Cashfow(Defnition2)$320Cashfow(Defnition3)$127Cashfow(Defnition4)$27 CalculatingFreeCashFlows Freecashfow(Defnition1)$27Freecashfow(Defnition2)$37Freecashfow(Defnition3)$52 QUESTIONS 1. Whyisdepreciationaddedbacktonetincometoarriveatcashfow? 2. Whydoweadjustnetincomeforchangesinworkingcapitalaccounts? 3. Ifacompanyhascashfowfromoperationsof$3million,deprecia-tionandamortizationof$2million,anditsworkingcapitalaccountsdidnotchangefromthepreviousperiod,whatitsnetincomeforthisperiod? 4. Howdoesthestatementofcashfowsrelatetothebalancesheet? 5. Howdoesthestatementofcashfowsrelatetotheincomestatement? 6. Isitpossibleforacompanytohaveanetlossforaperiod,yetstillhaveapositivecashfow? 7. Whatdistinguishesthefreecashfowofafrmfromitscashfowfromoperations? 8. WhatistherelationbetweenEBITDAandcashfowfromoperations? 9. Howcananegativefreecashfowbeconsideredgoodnews? 10. Howcanapositivefreecashfowbeconsideredbadnews? 11. ConsidertheAustinCompany,whichhasafreecashfowtoequityof$100million,andfreecashfowtothefrmof$125million.IftheAustinCompanyhadinterestaftertaxof$10million,whatistheamountofnetborrowingfortheAustinCompanyforthisperiod? 12. SupposethecashfowfromoperationsoftheKnoxvilleCompanyis$200millionandthecompanyhadcapitalexpendituresof$50millionduringthisperiod.IfKnoxvillehasnodebtinitscapitalstructure,whatisitscashfowtothefrm?Whatisitscashfowtoequity?
294 VALUATIONANDANALYSISTOOLS 13. SupposeProvo,Inc.,hadnetincomeof$30millionforthemostre-centfscalperiod.Ifitsdepreciationandamortizationfortheperiodis$3millionanditscashfowfromoperationsis$35million,whatisitschangeinworkingcapitalforthismostrecentfscalperiod? 14. UsingthedatainthischapterfortheExemplarCompanyforfscalyear20X2andthecashfowfromoperationsasthemeasureofcashfow(cashfowdefnition3),calculatethe: a. Cashfowtocapitalexpendituresratio. b. Cashfowtodebtratio.
CHAPTER 13 CapitalBudgeting Thegeneralprincipleis,therefore,thatoutofthevariousincome-streamsatthedisposalofthecapitalist,hechoosesthemostadvantageous,ormorefullyexpressed,theonewhich,comparedwithanyother,offersadvantageswhich,reckonedinpresentestimationatthegivenrateofinterest,outweighthedisadvantages;andthisisevidentlymerelyanewformulationoftheoriginalprinciplethattheusechosenwillbethatwhichhasthemaximumpresentvalueatthegivenrateofinterest. —IrvingFisher, TheRateofInterest:ItsNature,DeterminationandRelationtoEconomicPhenomena (NewYork:MacMillanCompany,1907),p.152 C apitalbudgetingdecisionsinvolvethelong-termcommitmentofacom-pany’sscarceresourcesinlong-terminvestments.Thesedecisionsplayaprominentroleindeterminingwhetheracompanywillbesuccessful.Thecommitmentoffundstoaparticularcapitalprojectcanbeenormousandmaybeirreversible.Whereassomecapitalbudgetingdecisionsareroutinedecisionsthatdonotchangethecourseorriskofacompany,therearestrategiccapitalbudgetingdecisionsthatwilleitherhaveanimpactonthecompany’sfuturemarketpositioninitscurrentproductlinesorpermitittoexpandintoanewproductlineinthefuture.Thecompany’scapitalinvestmentdecisionmaybecomprisedofanum-berofdistinctdecisions,eachreferredtoasa project .Acapitalprojectisasetofassetsthatarecontingentononeanotherandareconsideredtogether.Forexample,supposeacompanyisconsideringtheproductionofanewprod-uct.Thiscapitalprojectrequiresthecompanytoacquireland,buildfacili-ties,andpurchaseproductionequipment.Andthisprojectmayalsorequirethecompanytoincreaseitsinvestmentinitsworkingcapital—inventory, 295
296 VALUATIONANDANALYSISTOOLS cash,oraccountsreceivable. Workingcapital isthecollectionofassetsneededforday-to-dayoperationsthatsupportacompany’slong-terminvestments.Thereareseveraltechniquesthatareusedinpracticetoevaluatecapi-talbudgetingproposals.Evaluatingwhetheracompanyshouldinvestinacapitalprojectrequiresananalysisofwhethertheprojectaddsvaluetothecompany.Inthischapterwecoverthecapitalbudgetingdecision.First,weexplainthecapitalbudgetingprocessandtheclassifcationofinvestmentprojects.Second,weshowhowtoestimatetheexpectedchangetoacom-pany’sfuturecashfowasaresultofacapitalinvestmentdecision.Aswillbecomeapparent,estimatingcashfowisanimpreciseartatbest.Finally,welookatthetechniquesusedtoevaluatecapitalbudgetingprojects. INVESTMENTDECISIONSANDOWNERS’WEALTH Managersmustevaluateanumberoffactorsinmakinginvestmentdeci-sions.Notonlydoesthefnancialmanagerneedtoestimatehowmuchthecompany’sfuturecashfowswillchangeifitinvestsinaproject,butthemanagermustalsoevaluatetheuncertaintyassociatedwiththesefuturecashfows.Thevalueofthecompanytodayisthepresentvalueofallitsfuturecashfows.Butweneedtounderstandbetterwherethesefuturecashfowscomefrom.Theycomefromassetsthatarealreadyinplace,whicharetheassetsaccumulatedasaresultofallpastinvestmentdecisions,andfutureinvestmentopportunities.Thevalueofacompanyisthereforethepresentvalueofthecompany’sfuturecashfows,wherethesefuturecashfowsincludethecashfowsfromallassetsinplaceandthecashfowsfromfutureinvestmentopportunities.Thesefuturecashfowsarediscountedataratethatrepresentsinvestors’assessmentsoftheuncertaintythatthesecashfowswillfowintheamountsandwhenexpected.Asyoucansee,weneedtoevaluatetheriskofthesefu-turecashfowsinordertounderstandtheriskofanyinvestmentopportunityonthevalueofthecompany.Cashfowriskcomesfromtwobasicsources: 1.Salesrisk. Thedegreeofuncertaintyrelatedtothenumberofunitsthatwillbesoldandthepriceofthegoodorservice. 2.Operatingrisk. Thedegreeofuncertaintyconcerningoperatingcashfowsthatarisesfromtheparticularmixoffxedandvariableoperatingcosts.
CapitalBudgeting 297 Salesrisk isrelatedtotheeconomyandthemarketinwhichthecom-pany’sgoodsandservicesaresold. Operatingrisk ,forthemostpart,isdeterminedbytheproductorservicethatthecompanyprovidesandisre-latedtothesensitivityofoperatingcashfowstochangesinsales.Werefertothecombinationofthesetworisksas businessrisk. Aproject’sbusinessriskisrefectedinthediscountrate,whichistherateofreturnrequiredtocompensatethesuppliersofcapital(bondholdersandowners)fortheamountofrisktheybear.Fromtheperspectiveofinvestors,thediscountrateisthe requiredrateofreturn (RRR).Fromthecompany’sperspective,thediscountrateisthe costofcapital —whatitcoststhecom-panytoraiseadollarofnewcapital.Thecostofcapitalandtherequiredrateofreturnarethesameconcept,butfromdifferentperspectives:thecostofcapitalisgenerallyfromtheperspectiveofthebusinessenterprise,whereastherequiredrateofreturnisfromtheperspectiveofthesuppliersofcapital,thecreditorsandowners.Therefore,wewillusethetermsinterchangeablyinourstudyofcapitalbudgeting.Inthecontextofevaluatingcapitalprojects,thecostofcapitalisthecostofraisingnewcapitalappropriatefortheriskoftheproject;hence,thecostofcapitalisproject-specifc.Forexample,supposeacompanyinvestsinanewproject,ProjectX.HowdoestheProjectXaffectthecompany’svalue? IfProjectXgeneratescashfowsthatjustcompensatethesuppliersofcapitalfortherisktheybearonthisproject(thatis,itearnsthecostofcapital),thevalueofthecompanydoesnotchange. IfProjectXgeneratescashfowsgreaterthanneededtocompensatethemfortherisktheytakeon,itearnsmorethanthecostofcapital,increasingthevalueofthecompany. IfProjectXgeneratescashfows less thanneeded,itearnslessthanthecostofcapital,decreasingthevalueofthecompany.Howdoweknowwhetherthecashfowsaremorethanorlessthanneededtocompensatefortheriskthattheywillindeedneed?Ifwediscountallthecashfowsatthecostofcapital,wecanassesshowthisprojectaffectsthepresentvalueofthecompany.Iftheexpectedchangeinthevalueofthecompanyfromaninvestmentis: Positive,theprojectreturnsmorethanthecostofcapital,andthereforeitaddsvaluetothecompany. Negative,theprojectreturnslessthanthecostofcapital,andthereforeitreducesthevalueofthecompany. Zero,theprojectreturnsthecostofcapital,andthereforeitdoesnotaffectthevalueofthecompany.
298 VALUATIONANDANALYSISTOOLS Capitalbudgeting istheprocessofidentifyingandselectinginvestmentsinlong-livedassets;thatis,selectingassetsexpectedtoproducebeneftsovermorethanoneyear. THECAPITALBUDGETINGPROCESS Becauseacompanymustcontinuallyevaluatepossibleinvestments,capitalbudgetingisanongoingprocess.However,beforeacompanybeginsthink-ingaboutcapitalbudgeting,itmustfrstdetermineitscorporatestrategy—itsbroadsetofobjectivesforfutureinvestment.Forexample,theWaltDisneyCompanyhasstatedthatitsobjectiveisto“beoneoftheworld’sleadingproducersandprovidersofentertainmentandinformation,usingitsportfolioofbrandstodifferentiateitscontent,services,andconsumerproducts.”Howdoesacompanyachieveitscorporatestrategy?Thisisaccom-plishedbymakinginvestmentsinlong-livedassetsthatmaximizeowners’wealth.Selectingtheseprojectsiswhatcapitalbudgetingisallabout. StagesintheCapitalBudgetingProcess Thougheverycompanyhasitsownsetofproceduresandprocessesforcapitalbudgeting,wecangeneralizetheprocessasconsistingoffvestages,asweillustrateinExhibit13.1. Stage1:InvestmentScreeningandSelection Projectsconsistentwiththecorporatestrategyareidentifedbyproduction,marketing,andresearchanddevelopmentmanagementofthecompany.Onceidentifed,projectsareevaluatedandscreened • Investment screening and selection• Capital budgeting proposal• Budgeting approval and authorization• Post- comptetion audit• Project tracking Stage 1Stage 2Stage 5Stage 4Stage 3 EXHIBIT13.1 TheCapitalBudgetingProcess
CapitalBudgeting 299 byestimatinghowtheyaffectthefuturecashfowsofthecompanyand,hence,thevalueofthecompany. Stage2:CapitalBudgetingProposal Acapitalbudgetisproposedfortheprojectssurvivingthescreeningandselectionprocess.Thebudgetliststherecommendedprojectsandthedollaramountofinvestmentneededforeach.Thisproposalmaystartasanestimateofexpectedrevenuesandcosts,butastheprojectanalysisisrefned,datafrommarketing,purchasing,engineering,accounting,andfnancefunctionsareputtogether. Stage3:BudgetingApprovalandAuthorization Projectsincludedinthecapitalbudgetareauthorized,allowingfurtherfactgatheringandanalysis,andapproved,allowingexpen-dituresfortheprojects.Insomecompanies,theprojectsareautho-rizedandapprovedatthesametime.Inothers,aprojectmustfrstbeauthorized,requiringmoreresearchbeforeitcanbeformallyapproved.Formalauthorizationandapprovalproceduresaretyp-icallyusedonlargerexpenditures;smallerexpendituresareatthediscretionofmanagement. Stage4:ProjectTracking Afteraprojectisapproved,workonitbegins.Themanagerreportsperiodicallyonitsexpenditures,aswellasonanyrev-enuesassociatedwithit.Thisisreferredtoas projecttracking ,thecommunicationlinkbetweenthedecisionmakersandtheop-eratingmanagementofthecompany.Forexample,trackingcanidentifycostover-runsanduncovertheneedformoremarketingresearch. Stage5:Post-completionAudit Nomatterthenumberofstagesinacompany’scapitalbudgetingprocess,mostcompaniesincludesomeformof post-completionaudit thatinvolvesacomparisonoftheactualcashfromoperationsoftheprojectwiththeestimatedcashfowusedtojustifytheproject.Therearetworeasonswhythepost-completionauditisbenefcial.First,manycompaniesfndthattheknowledgethatapost-completionauditwillbeundertakencausesprojectproposerstobemorecarefulbeforeendorsingaproject.Second,itwillhelpse-niormanagementidentifyproposerswhoareconsistentlyoptimisticorpessimisticwithrespecttocashfowestimates.Seniormanage-mentwillthenbeinabetterpositiontoevaluatethebiasthatmaybeexpectedwhenaparticularindividualorgroupproposesaproject.
300 VALUATIONANDANALYSISTOOLS ClassifyingInvestmentProjects Financialdecision-makersmayclassifyprojectsindifferentways,basedontheprojects’usefullife,risk,ordependenceonotherprojects.Classifyingprojectsmayhelpthedecision-makerintermsofestimatingthecashfowsoftheprojectsandthemethodsusedtoanalyzetheprojects.Wetakeabrieflookatthedifferentwaysprojectsmaybeclassifed. ClassifyingbyEconomicLife Aninvestmentgenerallyprovidesbeneftsoveralimitedperiodoftime,referredtoasits economiclife .Theeconomiclifeorusefullifeofanassetisdeterminedbyfactorsincludingphysicaldeterioration,obsolescence,andthedegreeofcompetitioninthemarketforaproduct.Theeconomiclifeisanestimateofthelengthoftimethattheassetwillprovidebeneftstothecompany.Afteritsusefullife,therevenuesgeneratedbytheassettendtodeclinerapidlyanditsexpensestendtoincrease.Typically,aninvestmentrequiresexpendituresupfront—immediately—andprovidesbeneftsintheformofcashfowsreceivedinthefuture.Ifbeneftsarereceivedonlywithinthecurrentperiod—withinoneyearofmakingtheinvestment—werefertotheProjectXasashort-terminvestment.Ifthesebeneftsarereceivedbeyondthecurrentperiod,werefertotheProjectXasalong-termprojectandrefertotheexpenditureasacapitalexpenditure.Anyprojectrepresentinganinvestmentmaycompriseoneormoreas-sets.Forexample,anewproductmayrequireinvestmentinproductionequipment,abuilding,andtransportationequipment—allmakingupthebundleofassetscomprisingtheprojectweareevaluating.Short-termin-vestmentdecisionsinvolve,primarily,investmentsincurrentassets:cash,marketablesecurities,accountsreceivable,andinventory.Theobjectiveofinvestinginshort-termassetsisthesameaslong-termassets:maximizingowners’wealth.Nevertheless,weconsiderthemseparatelyfortwopracticalreasons: 1. Decisionsaboutlong-termassetsarebasedonprojectionsofcashfowsfarintothefutureandrequireustoconsiderthetimevalueofmoney. 2. Long-termassetsdonotfgureintothedailyoperatingneedsofthecompany.Decisionsregardingshort-terminvestments,orcurrentassets,arecon-cernedwithday-to-dayoperations.Andacompanyneedssomelevelofcurrentassetstoactasacushionincaseofunusuallypooroperatingperi-ods,whencashfowsfromoperationsarelessthanexpected.
CapitalBudgeting 301 ClassifyingbyRisk Supposeyouarefacedwithtwoinvestments,AandB,eachpromisinga$100cashinfow10yearsfromtoday.IfAisriskierthanB,whataretheyworthtoyoutoday?Ifyoudonotlikerisk,youwouldconsiderAlessvaluablethanBbecausethechanceofgettingthe$100in10yearsislessforAthanforB.Therefore,valuingaprojectrequiresconsideringtheriskassociatedwithitsfuturecashfows.Theproject’sriskofreturncanbeclassifedaccordingtothenatureoftheprojectrepresentedbytheinvestment: Replacementprojects: investmentsinthereplacementofexistingequip-mentorfacilities. Expansionprojects: investmentsinprojectsthatbroadenexistingprod-uctlinesandexistingmarkets. Newproductsandmarkets: projectsthatinvolveintroducinganewproductorenteringintoanewmarket. Mandatedprojects: projectsrequiredbygovernmentlawsoragencyrules. Replacementprojects includethemaintenanceofexistingassetstocon-tinuethecurrentlevelofoperatingactivity.Projectsthatreducecosts,suchasreplacingoldertechnologywithnewertechnologyorimprovingtheeff-ciencyofequipmentorpersonnel,arealsoconsideredreplacementprojects.Toevaluatereplacementprojectsweneedtocomparethevalueofthecompanywiththereplacementassettothevalueofthecompanywithoutthatsamereplacementasset.Whatwe’rereallydoinginthiscomparisonislookingatopportunitycosts:whatcashfowswouldhavebeenifthecompanyhadstayedwiththeoldasset.There’slittleriskinthecashfowsfromreplacementprojects.Thecom-panyissimplyreplacingequipmentorbuildingsalreadyoperatingandpro-ducingcashfows.Andthecompanytypicallyhasexperienceinmanagingsimilarnewequipment. Expansionprojects areintendedtoenlargeacompany’sestablishedproductormarket.Thereislittleriskassociatedwithexpansionprojects.Thereason:Acompanywithahistoryofexperienceinaproductormar-ketcanestimatefuturecashfowswithmorecertaintywhenconsider-ingexpansionthanwhenintroducinganewproductoutsideitsexistingproductline.Investmentprojectsthatinvolveintroducingnewproductsorenteringintonewmarketsareriskierthanthereplacementandexpansionprojects.That’sbecausethecompanyhaslittleornomanagementexperienceinthenewproductormarket.Hence,thereismoreuncertaintyaboutthefuturecashfowsfrominvestmentsinnewproductornewmarketprojects.
302 VALUATIONANDANALYSISTOOLS Acompanyisforcedorcoercedintoits mandatedprojects .Thesearegovernmentmandatedprojectstypicallyfoundin“heavy”industries,suchasutilities,transportation,andchemicals,allindustriesrequiringalargepor-tionoftheirassetsinproductionactivities.Governmentagencies,suchastheOccupationalSafetyandHealthAdministration(OSHA)ortheEnviron-mentalProtectionAgency(EPA),mayimposerequirementsthatcompaniesinstallspecifcequipmentoraltertheiractivities,suchashowtheydisposeofwasteorremediateproperty. ClassifyingbyDependenceonOtherProjects Inadditiontoconsid-eringthefuturecashfowsgeneratedbyproject,acompanymustcon-siderhowitaffectstheassetsalreadyinplace—theresultsofpreviousprojectdecisions—aswellasotherprojectsthatmaybeundertaken.Projectscanbeclassifedasfollowsaccordingtothedegreeofdependencewithotherprojects:independentprojects,mutuallyexclusiveprojects,contingentprojects,andcomplementaryprojects.An independentproject isonewhosecashfowsarenotrelatedtothecashfowsofanyotherproject.Inotherwords,acceptingorrejectinganindependentprojectdoesnotaffecttheacceptanceorrejectionofotherprojects.Anindependentprojectcanbeevaluatedstrictlyontheeffectitwillhaveonthevalueofacompanywithouthavingtoconsiderhowitaffectsthecompany’sotherinvestmentopportunities,andviceversa.Projectsare mutuallyexclusiveprojects iftheacceptanceofonepre-cludestheacceptanceofotherprojects.Therearesomesituationswhereitistechnicallyimpossibletotakeonmorethanoneproject.Forexample,supposeamanufacturerisconsideringwhethertoreplaceitsproductionfa-cilitieswithmoremodernequipment.Thecompanymaysolicitbidsamongthedifferentmanufacturersofthisequipment.Thedecisionconsistsofcom-paringtwochoices: 1. Keepingitsexistingproductionfacilities,or 2. Replacingthefacilitieswiththemodernequipmentofonemanufacturer.Becausethecompanycannotusemorethanoneproductionfacility,itmustevaluateeachbidanddeterminethemostattractiveone.Thealternativeproductionfacilitiesaremutuallyexclusiveprojects:thecompanycanacceptonlyonebid.Thealternativesofkeepingexistingfacilitiesorreplacingthemarealsomutuallyexclusiveprojects.Thecompanycannotkeeptheexistingfacilitiesandreplacethem! Contingentprojects aredependentontheacceptanceofanotherproject.Forexample,toyandvideo-gametie-inagreementswithmoviesarede-pendentonthemoviecomingtothemarket.Or,asanotherexample,the
CapitalBudgeting 303 manufacturerofanautomobilepart,suchasaspecifcally-designedelectricwindow,iscontingentonthesaleoftheautomobile.Anotherformofdependenceisfoundin complementaryprojects .Projectsarecomplementaryprojectsiftheinvestmentinoneenhancesthecashfowsofoneormoreotherprojects.Consideramanufacturerofper-sonalcomputerequipment.Thesaleofcomputersthathavevideo-gamingcapabilitiesmayspursalesofvideo-gamesorvideo-gamecontrols. DETERMININGCASHFLOWSFROMINVESTMENTS Acompanyinvestsonlytomakeitsowners“betteroff,”meaningincreasingthevalueoftheirownershipinterest.Acompanywillhavecashfowsinthefuturefromitspastinvestmentdecisions.Whenitinvestsinnewassets,itexpectsthefuturecashfowstobegreaterthanwithoutthisnewinvestment.Otherwiseitdoesn’tmakesensetomakethisinvestment.Thedifferencebetweenthecashfowsofthecompanywiththeinvestmentprojectandthecashfowsofthecompanywithouttheinvestmentproject—bothoverthesameperiodoftime—isreferredtoastheproject’s incrementalcashfows .Toevaluateaninvestment,we’llhavetolookathowitwillchangethefuturecashfowsofthecompany.Inotherwords,weexaminehowmuchthevalueofthecompanychangesasaresultoftheinvestment.Thechangeinacompany’svalueasaresultofanewinvestmentisthedifferencebetweenitsbeneftsanditscosts:Changeinthevalueofthecompany = Project’sbenefts − Project’scostsAmoreusefulwayofevaluatingthechangeinthevalueisthebreakdowntheproject’scashfowsintotwocomponents: 1. Thepresentvalueofthecashfowsfromtheproject’soperatingactivities(revenuesandoperatingexpenses),referredtoastheproject’s operatingcashfows (OCF);and 2. Thepresentvalueoftheinvestmentcashfows,whicharetheexpen-dituresneededtoacquiretheproject’sassetsandanycashfowsfromdisposingtheproject’sassets.or,Changeinthevalueofthecompany = Presentvalueofthechangeinoperatingcashfows + Presentvalueofinvestmentcashfows
304 VALUATIONANDANALYSISTOOLS Thepresentvalueofaproject’soperatingcashfowsistypicallypos-itive(indicatingpredominantlycashinfows)andthepresentvalueoftheinvestmentcashfowsistypicallynegative(indicatingpredominantlycashoutfows). InvestmentCashFlows Whenweconsiderthecashfowsofaninvestmentwemustalsoconsiderallthecashfowsassociatedwithacquiringanddisposingofassetsintheinvestment.Aninvestmentmaycomprise: oneassetormanyassets; anassetpurchasedandanothersold;and cashoutlaysthatoccuratthebeginningoftheprojectorspreadoverseveralyears.Let’sfrstbecomefamiliarwithcashfowsrelatedtoacquiringassets;thenwe’lllookatcashfowsrelatedtodisposingassets. AssetAcquisition Inacquiringanyasset,therearethreecashfowstoconsider: 1. Thecostoftheasset, 2. Set-upexpenditures,includingshippingandinstallation;and 3. Anytaxcredit.Thetaxcreditmaybeaninvestmenttaxcreditoraspecialcredit—suchasacreditforapollutioncontroldevice—dependingonthetaxlaw.Thecashfowassociatedwithacquiringanassetis:Cashfowfromacquiringassets = Cost + Set-upexpenditures + Taxcredit.Supposethecompanybuysequipmentthatcosts$100,000anditcosts$10,000toinstall.Ifthecompanyiseligiblefora10%tax-creditonthisequipment(thatis,10%ofthetotalcostofbuyingandinstallingtheequip-ment),thechangeinthecompany’scashfowfromacquiringtheassetis$99,000:Cashfowfromacquiringassets =− $100,000 − 10,000 + 0 . 10($100,000 + 10,000) =− $100,000 − 10,000 + $11,000 =− $99,000
CapitalBudgeting 305 Thecashoutfowis − $99,000whenthisassetisacquired: − $110,000tobuyandinstalltheequipmentand$11,000infromthereductionintaxes.Whataboutexpendituresmadeinthepastforassetsorresearchthatwouldbeusedintheprojectwe’reevaluating?Supposethecompanyspent$1,000,000overthepastthreeyearsdevelopinganewtypeoftoothpaste.Shouldthecompanyconsiderthis$1,000,000spentonresearchanddevel-opmentwhendecidingwhethertoproducethisnewprojectweareconsider-ing?No!Theseexpenseshavealreadybeenmadeanddonotaffecthowthenewproductchangesthefuturecashfowsofthecompany.Werefertothis$1,000,000asasunkcostanddonotconsideritintheanalysisofournewproject.Whetherornotthecompanygoesaheadwiththisnewproduct,this$1,000,000hasbeenspent.A sunkcost isanycostthathasalreadybeenincurredthatdoesnotaffectfuturecashfowsofthecompany.Let’sconsideranotherexample.Supposethecompanyownsabuildingthatiscurrentlyempty.Let’ssaythecompanysuddenlyhasanopportunitytouseitfortheproductionofanewproduct.Isthecostofthebuildingrelevanttothenewproductdecision?Thecostofthebuildingitselfisasunkcostbecauseitwasanexpendituremadeaspartofsomepreviousinvestmentdecision.Thecostofthebuildingdoesnotaffectthedecisiontogoaheadwiththenewproduct.Supposethecompanyisusingthebuildinginsomewayproducingcash(i.e.,rentingit)andthenewprojectisgoingtotakeovertheentirebuilding.Thecashfowsgivenuprepresentopportunitycoststhatmustbeincludedintheanalysisofthenewproject.However,theseforgonecashfowsarenotassetacquisitioncashfows.Becausetheyrepresentoperatingcashfowsthatcouldhaveoccurred,butwillnotbecauseofthenewproject,theymustbeconsideredpartoftheproject’sfutureoperatingcashfows.Further,ifweincurcostsinrenovatingthebuildingtomanufacturethenewproduct,therenovationcostsarerelevantandshouldbeincludedinourassetacquisitioncashfows. EXAMPLE13.1:INITIALCASHFLOW Supposeacompanyspends$1milliononresearchanddevelopmentofanewdrug.Thecosttobuythenecessaryequipmenttoproduceanddistributethedrugis$2.5million.Workingcapitalisexpectedtoincreaseby$250,000whenthecompanyembarksonthenewproduct.Whatistheinitialcashfowforthisproject?( continued )
306 VALUATIONANDANALYSISTOOLS ( Continued ) Solution CashFlow Costofequipment − $2,500,000Increaseinworkingcapital − 250,000 Initialcashfow − $2,750,000 AssetDisposition Manynewinvestmentsrequiregettingridofoldassets.Attheendoftheusefullifeofanasset,thecompanymaybeabletosellitormayhavetopaysomeonetohaulitaway.Ifthecompanyismakingadecisionthatinvolvesreplacinganexistingasset,thecashfowfromdispos-ingoftheoldassetmustbeincludedbecauseitisacashfowrelevanttotheacquisitionofthenewasset.Ifthecompanydisposesofanasset,whetherattheendofitsusefullifeorwhenitisreplaced,wemustconsidertwotypesofcashfows: 1. whatyoureceiveorpayindisposingoftheasset;and 2. anytaxconsequencesresultingfromthedisposal.orCashfowfromdisposingassets = Proceedsorpaymentfromdisposingassets − TaxesfromdisposingassetsTheproceedsarewhatyouexpecttoselltheassetforifyoucangetsomeonetobuyit.Ifthecompanymustpayforthedisposaloftheasset,thiscostisacashoutfow.Considertheinvestmentinadrycleaner.Thecurrentownermaywanttoleavethebusiness(retire,whatever),sellingthedrycleaningbusinesstoanotherdrycleanerproprietor.Butifabuyercannotbefoundbecauseoflackofbuyersinthearea,thecurrentownermayberequiredtomitigatethesiteforanyenvironmentaldamagefromthesolvents.Thus,acostisincurredattheendoftheasset’slife.Thetaxconsequencesareabitmorecomplicated.Taxesdependon: theexpectedsalesprice,and thebookvalueoftheassetfortaxpurposesatthetimeofdisposition.
CapitalBudgeting 307 Ifacompanysellstheassetformorethanitsbookvaluebutlessthanitsoriginalcost,thedifferencebetweenthesalespriceandthebookvalueisagain,taxableatordinarytaxrates.Ifacompanysellstheassetformorethanitsoriginalcost,thenthegainisbrokenintotwoparts: 1. Capitalgain: thedifferencebetweenthesalespriceandtheoriginalcost;and 2. Recaptureofdepreciation: thedifferencebetweentheoriginalcostandthebookvalue.Thecapitalgainisthebeneftfromtheappreciationinthevalueoftheassetandmaybetaxedatspecialrates,dependingonthetaxlawatthetimeofsale.Therecaptureofdepreciationrepresentstheamountbywhichthecompanyhasover-depreciatedtheassetduringitslife.Thismeansthatmoredepreciationhasbeendeductedfromincome(reducingtaxes)thannecessarytorefecttheusageoftheasset.Therecaptureportionistaxedattheordinarytaxrates,sincethisexcessdepreciationtakenalltheseyearshasreducedtaxableincome.Ifacompanysellsanassetforlessthanitsbookvalue,theresultisacapitalloss.Inthiscase,theasset’svaluehasdecreasedbymorethantheamounttakenfordepreciationfortaxpurposes.Acapitallossisgivenspecialtaxtreatment: Iftherearecapitalgainsinthesametaxyearasthecapitalloss,theyarecombined,sothatthecapitallossreducesthetaxespaidoncapitalgains,and Iftherearenocapitalgainstooffsetagainstthecapitalloss,thecapitallossisusedtoreduceordinarytaxableincome.Thebeneftfromalossonthesaleofanassetistheamountbywhichtaxesarereduced.Thereductionintaxableincomeisreferredtoasataxshield,sincethelossshieldssomeincomefromtaxation.Ifthecompanyhasalossof$1,000onthesaleofanassetandhasataxrateof40%,thismeansthatitstaxableincomeis$1,000lessanditstaxesare$400lessthantheywouldhavebeenwithoutthesaleoftheasset.WesummarizethebreakdownofgainsonsalesofassetsinExhibit13.2.Thekeyistocomparethesalespriceoftheassetwithitsoriginalcostandbookvalue.Supposeyouareevaluatinganassetthatcosts$10,000thatyouexpecttosellinfveyears.Supposefurtherthatthebookvalueoftheassetfortaxpurposeswillbe$3,000afterfveyearsandthatthecompany’staxrateis40%.Whataretheexpectedcashfowsfromdisposingthisasset?Ifyou
308 VALUATIONANDANALYSISTOOLS Sales price > Original cost Recapture =Original cost– Book valueLoss =Book value – Sales priceRecapture =Original cost– Book valueCapital gain =Sales price – Original cost Original cost > Sales price> Book valueBook value > Sales price EXHIBIT13.2 GainsandLossesonSales expectthecompanytoselltheassetfor$8,000infveyears,$10,000 − 3,000 = $7,000oftheasset’scostwillbedepreciated,yettheassetlostonly$10,000 − 8,000 = $2,000invalue.Therefore,thecompanyhas over -depreciatedtheassetby$5,000.Becausethisover-depreciationrepresentsdeductionstobetakenonthecompany’staxreturnsoverthefveyearsthatdon’trefecttheactualdepreciationinvalue(theassetdoesn’tlose$7,000invalue,only$2,000),this$5,000istaxedatordinarytaxrates.Ifthecompany’staxrateis40%,thetaxis40% × $5,000,or$2,000.Thecashfowfromdispositionisthesumofthedirectcashfow(some-onepaysusfortheassetorthecompanypayssomeonetodisposeofit)andthetaxconsequences.Inthisexample,thecashfowisthe$8,000weexpectsomeonetopaythecompanyfortheasset,lessthe$2,000intaxesweexpectthecompanytopay,or$6,000cashinfow.Supposeinsteadthatyouexpectthecompanytosellthisassetinfveyearsfor$12,000.Again,theassetisover-depreciatedby$7,000.Infact,theassetisnotexpectedtodepreciate,butratherappreciateoverthefveyears.The$7,000indepreciationisrecapturedafterfveyearsandtaxedatordinaryrates:40%of$7,000,or$2,800.The$2,000capitalgainistheappreciationinthevalueoftheassetandmaybetaxedatspecialrates.Ifthetaxrateoncapitalgainincomeis30%,youexpectthecompanytopay30%of$2,000,or$600intaxesonthisgain.Sellingtheassetinfveyearsfor$12,000thereforeresultsinanexpectedcashinfowof$12,000 − 2,800 − 600 = $8,600.Supposeyouexpectthecompanytoselltheassetinfveyearsfor$1,000.Ifthecompanycanreduceitsordinarytaxableincomebytheamountofthecapitalloss,$3,000 − 1,000 = $2,000,ourtaxwillbe40%of$2,000,or$800becauseofthisloss.Werefertothisreductioninthetaxesasataxshield,sincetheloss“shields”$2,000ofincomefromtaxes.Combiningthe$800taxreductionwiththecashfowfromsellingtheasset,the$1,000,givesthecompanyacashinfowof$1,800.
CapitalBudgeting 309 Let’salsonotforgetaboutdisposingofanyexistingassets.Supposethecompanyboughtequipment10yearsagoandatthattimeexpectedtobeabletosellffteenyearslaterfor$10,000.Ifthecompanydecidestodaytoreplacethisequipment,itmustconsiderwhatitisgivingupbynotdisposingofanassetasplanned.Ifthecompanydoesnotreplacetheequipmenttoday,itwouldcontinuetodepreciateitforfvemoreyearsandthensellitfor$10,000;ifthecompanyreplacestheequipmenttoday,itwouldnothavefvemoreyears’depreciationonthereplacedequipmentanditwouldnothave$10,000infveyears(butperhapssomeotheramounttoday).This$10,000infveyears,lessanytaxes,isaforgonecashfowthatwemustfgureintotheinvestmentcashfows.Also,thedepreciationthecompanywouldhavehadonthereplacedassetmustbeconsideredinanalyzingthereplacementasset’soperatingcashfows. TRYIT!DISPOSITIONCASHFLOWS,USINGSTRAIGHT-LINE Considerequipmentthatisboughtfor$500,000.Supposeitisdepre-ciatedoverfouryearsatastraight-linerateof25%peryear.Attheendoftwoyears,theequipmentissoldfor$100,000.Whatisthecashfoweffectofthissale?Assumea35%taxrate. OperatingCashFlows Inthesimplestformofinvestment,therewillbeacashoutfowwhentheas-setisacquiredandtheremaybeeitheracashinfoworanoutfowattheendofitseconomiclife.Inmostcasesthesearenottheonlycashfows—theinvestmentmayresultinchangesinrevenues,expenditures,taxes,andwork-ingcapital.Theseareoperatingcashfowsbecausetheyresultdirectlyfromtheoperatingactivities—theday-to-dayactivitiesofthecompany.Whatweareafterhereareestimatesofoperatingcashfows.Wecannotknowforcertainwhatthesecashfowswillbeinthefuture,butwemustattempttoestimatethem.Whatisthebasisfortheseestimates?Webasethemonmarketingresearch,engineeringanalyses,operationsresearch,analysisofourcompetitors—andourmanagerialexperience.Thekeyintheanalysisofoperatingcashfowsistodeterminetheincrementalcashfows:“Howarethecashfowsofthecompanyexpectedtochangewhenthenewprojectisundertaken?”
310 VALUATIONANDANALYSISTOOLS ChangeinRevenues Supposeweareafoodprocessorconsideringanewinvestmentinalineoffrozendinnerproducts.Ifweintroduceanewready-to-eatdinnerproductthatisnotfrozen,ourmarketingresearchwillindi-catehowmuchweshouldexpecttosell.Butwheredothesenewproductsalescomefrom?Somemaycomefromconsumerswhodonotalreadybuyfrozendinnerproducts.Butsomeofthenot-frozendinnerproductsalesmaycomefromconsumerswhochoosetobuythenot-frozendin-nerproductinsteadoffrozendinners.Itwouldbeniceiftheseconsumersaregivingupbuyingourcompetitors’frozendinners.Yetsomeofthemmaybegivingupbuyingourfrozendinners.So,whenweintroduceanewproduct,wearereallyinterestedinhowitchangesthesalesoftheentirecompany(thatis,theincrementalsales),ratherthanthesalesofthenewproductalone.Wealsoneedtoconsideranyforegonerevenues—opportunitycosts—relatedtoourinvestment.Supposeourcompanyownsabuildingcurrentlybeingrentedtoanothercompany.Ifweareconsideringtermi-natingthatrentalagreementsowecanusethebuildingforanewproject,weneedtoconsidertheforegonerent—whatwewouldhaveearnedfromthebuilding.Therefore,therevenuesfromthenewprojectarereallyonlytheadditionalrevenues—therevenuesfromthenewprojectminustherevenuewecouldhaveearnedfromrentingthebuilding.So,whenacompanyundertakesanewproject,thefnancialmanagerswanttoknowhowitchangesthecompany’stotalrevenues,notmerelythenewproduct’srevenues. ChangeinExpenses Whenacompanytakesonanewproject,allthecostsassociatedwithitchangethecompany’sexpenses.Iftheinvestmentinvolveschangingthesalesofanexistingproduct,weneedanestimatethechangeinunitsales.Oncewehaveanestimateinhowsalesmaychange,wecandevelopanestimateoftheadditionalcostsofproducingtheadditionalnum-berofunitsbyconsultingwithproductionmanagement.And,wewillwantanestimateofhowtheproduct’sinventorymaychangewhenproductionandsalesoftheproductchange.Iftheinvestmentinvolveschangesinthecostsofproduction,wecom-parethecostswithoutthisinvestmentwiththecostswiththisinvestment.Forexample,iftheinvestmentisthereplacementofanassemblylinema-chinewithamoreeffcientmachine,weneedtoestimatethechangeinthecompany’soverallproductioncostssuchaselectricity,labor,materials,andmanagementcosts.Anewinvestmentmaychangenotonlyproductioncostsbutalsoop-eratingcosts,suchasrentalpaymentsandadministrationcosts.Changesin
CapitalBudgeting 311 operatingcostsasaresultofanewinvestmentmustbeconsideredaspartofthechangesinthecompany’sexpenses.Increasingcashexpensesarecashoutfows,anddecreasingcashexpensesarecashinfows. ChangeinTaxes Taxesfgureintotheoperatingcashfowsintwoways.First,ifrevenuesandexpenseschange,taxableincomeand,therefore,taxeschange.Thatmeansweneedtoestimatethechangeintaxableincomeresult-ingfromthechangesinrevenuesandexpensesresultingfromanewprojecttodeterminetheeffectoftaxesonthecompany.Second,thedeductionfordepreciationreducestaxes.Depreciationitselfisnotacashfow.Butdepre-ciationreducesthetaxesthatmustbepaid,shieldingincomefromtaxation.Thetaxshieldfromdepreciationislikeacashinfow.Supposeacompanyisconsideringanewproductthatisexpectedtogenerateadditionalsalesof$200,000andincreaseexpensesby$150,000.Ifthecompany’staxrateis40%,consideringonlythechangeinsalesandexpenses,taxesgoupby$50,000 × 40%or$20,000.Thismeansthatthecompanyisexpectedtopay$20,000moreintaxesbecauseoftheincreaseinrevenuesandexpenses.Let’schangethisaroundandconsiderthattheproductwillgenerate$200,000inrevenuesand$250,000inexpenses.Consideringonlythechangeinrevenuesandexpenses,ifthetaxrateis40%,taxesgodownby$50,000 × 40%,or$20,000.Thismeansthatwereduceourtaxesby$20,000,whichislikehavingacashinfowof$20,000fromtaxes.Now,considerdepreciation.Whenacompanybuysanassetthatpro-ducesincome,thetaxlawsallowittodepreciatetheasset,reducingtaxableincomebyaspecifedpercentageoftheasset’scosteachyear.Byreducingtaxableincome,thecompanyisreducingitstaxes.Thereductionintaxesislikeacashinfowsinceitreducesthecompany’scashoutfowtothegovernment.Supposeacompanyhastaxableincomeof$50,000beforedepreciationandafattaxrateof40%.Ifthecompanyisallowedtodeductdepreciationof$10,000,howhasthischangedthetaxesitpays? WithoutDepreciationWithDepreciation Taxableincome$50,000$40,000Taxrate × 0.40 × 0.40 Taxes$20,000$16,000Depreciationreducesthecompany’stax-relatedcashoutfowby$20,000 − 16,000 = $4,000or,equivalently,by$10,000 × 40% = $4,000.
312 VALUATIONANDANALYSISTOOLS Areductionisanoutfow(taxesinthiscase)isaninfow.Werefertotheeffectdepreciationhasontaxesasthe depreciationtaxshield .Depreciationitselfisnotacashfow.Butindeterminingcashfows,weareconcernedwiththeeffectdepreciationhasonourtaxes—andweallknowthattaxesareacashoutfow.Becausedepreciationreducestaxablein-come,depreciationreducesthetaxoutfow,whichamountstoacashinfow.Fortaxpurposes,companiesuseaccelerateddepreciation;specifcally,theratesspecifedunderthe ModifedAcceleratedCostRecoverySystem (MACRS)orstraight-line.Anacceleratedmethodispreferredinmostsitu-ationsbecauseitresultsinlargerdeductionssoonerintheasset’slifethanusingstraight-linedepreciation.Therefore,accelerateddepreciation,ifavail-able,ispreferabletostraight-lineduetothetimevalueofmoney.WeprovidetheMACRSdepreciationratesinExhibit13.3.Depreciableassetsareclas-sifedbytypeandthesetofratesforthatclassprescribedbytheU.S.TaxCode.Forexample,atruckisclassifedasa5-yearMACRSasset,sotheratesassociatedwiththe5-yearcolumninExhibit13.3areappliedagainstthecostoftheasset.Supposeyouhaveanassetthatcosts$100,000andisconsidereda3-yearMACRSasset.Whatisthedepreciationexpensefortaxpurposeseachyear?Whatisthedepreciationtaxshieldeachyear?Ifyoukeeptheassetforfveyearsandthetaxrateis35%, DepreciationExpenseEndingBookValueDepreciationTaxShield Year$100,000 × MACRSRateOriginalCost—AccumulatedDepreciationDepreciation × 35% 1$33,330$66,670$11,6662$44,450$22,220$15,5583$14,810$7,410$5,1844$7,410$0$2,5945$0$0$0Underthepresenttaxcode,assetsaredepreciatedtoazerobookvalue. Salvagevalue —whatweexpecttheassettobeworthattheendofitslife—isnotconsideredincalculatingdepreciation.Soissalvagevaluetotallyirrele-vanttotheanalysis?No.Salvagevalueisourbestguesstodayofwhattheassetwillbeworthattheendofitsusefullife,sometimeinthefuture.Inotherwords,salvagevalueisourestimateofhowmuchwecangetwhenwe
CapitalBudgeting 313 EXHIBIT13.3 MACRSDepreciationRates Year3-Year5-Year7-Year10-Year15-Year 133.33%20.00%14.29%10.00%5.00%244.4532.0024.4918.009.50314.8119.2017.4914.408.5547.4111.5212.4911.527.70511.528.939.226.9365.768.927.376.2378.936.555.9084.466.555.9096.565.91106.555.90113.285.91125.90135.91145.90155.91162.95 disposeoftheasset.Justrememberyoucan’tuseittofguredepreciationfortaxpurposes.Let’slookatanotherdepreciationexample,thistimeconsideringtheeffectofreplacinganassethasonthedepreciationtaxshieldcashfow.Supposeyouarereplacingamachinethatyouboughtfveyearsagofor$75,000.Youweredepreciatingthisoldmachineusingstraight-linedepreciationover10years,or$7,500depreciationperyear.Ifyoureplaceitwithanewmachinethatcosts$50,000andisdepreciatedoverfveyears,or$10,000eachyear,howdoesthechangeindepreciationaffectthecashfowsifthecompany’staxrateis30%?Wecancalculatetheeffecttwoways: 1. Wecancomparethedepreciationandrelatedtaxshieldfromtheoldandthenewmachines.Thedepreciationtaxshieldontheoldmachineis30%of$7,500,or$2,250.Thedepreciationtaxshieldonthenewmachineis30%of$10,000,or$3,000.Therefore,thechangeinthecashfowfromdepreciationis$3,000 − $2,250 = $750. 2. Wecancalculatethechangeindepreciationandcalculatethetaxshieldrelatedtothechangeindepreciation.Thechangeindepreciationis$10,000 − 7,500 = $2,500.Thechangeinthedepreciationtaxshieldis30%of$2,500,or$750.
314 VALUATIONANDANALYSISTOOLS TRYIT!ASSETDISPOSITIONCASHFLOWS,USINGMACRS Considerequipmentthatisboughtfor$500,000.Supposeitisde-preciatedasathree-yearMACRSasset.Attheendoftwoyears,theequipmentissoldfor$100,000.Whatisthecashfoweffectofthissale?Assumea35%taxrate. ChangeinWorkingCapital Workingcapitalconsistsofshort-termassets,alsoreferredtoascurrentassets,whichsupporttheday-to-dayoperatingactivityofthebusiness.Networkingcapitalisthedifferencebetweencurrentassetsandcurrentliabili-ties.Networkingcapitaliswhatwouldbeleftoverifthecompanyhadtopayoffitscurrentobligationsusingitscurrentassets.Theadjustmentwemakeforchangesinnetworkingcapitalisattributabletotwosources: 1. achangeincurrentassetaccountsfortransactionsorprecautionaryneeds;and 2. theuseoftheaccrualmethodofaccounting.Aninvestmentmayincreasethecompany’slevelofoperations,resultinginanincreaseinthenetworkingcapitalneeded(alsoconsideredtransac-tionsneeds).Iftheinvestmentistoproduceanewproduct,thecompanymayhavetoinvestmoreininventory(rawmaterials,work-in-process,andfnishedgoods).Iftoincreasesalesmeansextendingmorecredit,thenthecompany’saccountsreceivablewillincrease.Iftheinvestmentrequiresmain-tainingahighercashbalancetohandletheincreasedleveloftransactions,thecompanywillneedmorecash.Iftheinvestmentmakesthecompany’sproductionfacilitiesmoreeffcient,itmaybeabletoreducethelevelofinventory.Becauseofanincreaseintheleveloftransactions,thecompanymaywanttokeepmorecashandinventoryonhandforprecautionarypur-poses.Thatisbecauseasthelevelofoperationsincrease,theeffectofanyfuctuationsindemandforgoodsandservicesmayincrease,requiringthecompanytokeepadditionalcashandinventory“justincase.”Thecompanymayincreaseworkingcapitalasaprecautionbecauseifthereisgreatervari-abilityofcashandinventory,agreatersafetycushionwillbeneeded.Ontheotherhand,ifaprojectenablesthecompanytobemoreeffcientor
CapitalBudgeting 315 lowerscosts,itmayloweritsinvestmentincash,marketablesecurities,orinventory,releasingfundsforinvestmentelsewhereinthecompany.Wealsousethechangeinworkingcapitaltoadjustaccountingincome(revenueslessexpenses)toacashbasisbecausecashfowisultimatelywhatwearevaluing,notaccountingnumbers.Butsincewegenerallyhaveonlytheaccountingnumberstoworkfrom,weusethisinformation,makingadjustmentstoarriveatcash.Toseehowthisworks,let’slookatthecashfowfromsales.Noteverydollarofsalesiscollectedintheyearofsale.Customersmaypaysometimeafterthesale.Usinginformationfromtheaccountsreceivabledepartmentabouthowpaymentsarecollected,wecandeterminethechangeinthecashfowsfromrevenues.Supposeweexpectsalesinthefrstyeartoincreaseby$20,000permonthandittypicallytakescustomersthirtydaystopay.Thechangeincashfowsfromsalesinthefrstyearis$20,000 × 11 = $220,000—not$20,000 × 12 = $240,000.Thewayweadjustforthisdifferencebetweenwhatissoldandwhatiscollectedincashistokeeptrackofthechangeinworkingcapital,whichisthechangeinaccountsreceivableinthiscase.Anincreaseinworkingcapitalisusedtoadjustrevenuesdownwardtocalculatecashfow:Changeinrevenues$240,000Less:Increaseinaccountsreceivable20,000 Changeincashinfowfromsales$220,000Ontheothersideofthebalancesheet,ifthecompanyisincreasingitspurchasesofrawmaterialsandincurringmoreproductioncosts,suchaslabor,thecompanymayincreaseitslevelofshort-termliabilities,suchasaccountspayableandsalaryandwagespayable.Supposeexpensesformaterialsandsuppliesareforecastedat$10,000permonthforthefrstyearandittakesthecompanythirtydaystopay.Expensesforthefrstyearare$10,000 × 12 = $120,000,yetcashoutfowfortheseexpensesisonly$10,000 × 11 = $110,000sincethecompanydoesnotpaythelastmonth’sexpensesuntilthefollowingyear.Accountspayableincreasesby$10,000,representingonemonthofexpenses.Theincreaseinnetworkingcapital(increaseinaccountspayable increasescurrentliabilities increasesnetworkingcapital)reducesthecostofgoodssoldtogiveusthecashoutfowfromexpenses:Costofgoodssold$120,000Less:increaseinaccountspayable10,000 Changeincashfowfromexpenses$110,000
316 VALUATIONANDANALYSISTOOLS Anewprojectmayresultineither: anincreaseinnetworkingcapital; adecreaseinnetworkingcapital;or nochangeinnetworkingcapital. CLASSIFYINGWORKINGCAPITALCHANGES Inmanyapplications,wecanarbitrarilyclassifythechangeinworkingcapitalaseitherinvestmentcashfowsoroperatingcashfows.Andtheclassifcationdoesn’treallymattersinceit’sthebottomline,thenetcashfows,thatmatter.Howweclassifythechangeinworkingcapitaldoesn’taffectaproject’sattractiveness. Further,workingcapitalmaychangeatthebeginningoftheprojectandatanypointduringthelifeoftheproject.Forexample,asanewproductisintroduced,salesmaybeterrifcinthefrstfewyears,requiringanincreaseincash,accountsreceivable,andinventorytosupporttheseincreasedsales.Butallofthisrequiresanincreaseinworkingcapital—acashoutfow.Butlatersalesmayfalloffascompetitorsenterthemarket.Assalesandproductionfalloff,theneedfortheincreasedcash,accountsreceivable,andinventoryfallsoffalso.Ascash,accountsreceivable,andinventoryarereduced,thereisacashinfowintheformofthereductioninthefundsthatbecomeavailableforotheruseswithinthecompany.Achangeinnetworkingcapitalcanbethoughtofspecifcallyaspartoftheinitialinvestment—theamountnecessarytogettheprojectgoing.Oritcanbeconsideredgenerallyaspartofoperatingactivity—theday-to-daybusinessofthecompany.Sowheredoweclassifythecashfowassoci-atedwithnetworkingcapital?Withtheassetacquisitionanddispositionrepresentedinthenewprojectorwiththeoperatingcashfows?Ifaprojectrequiresachangeinthecompany’snetworkingcapitalaccountsthatpersistsforthedurationoftheproject—say,anincreaseininventorylevelsstartingatthetimeoftheinvestment—wetendtoclassifythechangeaspartoftheacquisitioncostsatthebeginningoftheprojectandaspartofdispositionproceedsattheendofproject.If,ontheotherhand,thechangeinnetworkingcapitalisduetothefactthataccrualaccountingdoesnotcoincidewithcashfows,wetendtoclassifythechangeispartoftheoperatingcashfows.
CapitalBudgeting 317 PuttingItAllTogether Here’swhatweneedtoputtogethertocalculatethechangeinthecompany’soperatingcashfowsrelatedtoanewinvestmentweareconsidering: Changesinrevenuesandexpenses; Cashfowfromchangesintaxesfromchangesinrevenuesandexpenses; Cashfowfromchangesincashfowsfromdepreciationtaxshields;and Changesinnetworkingcapital.Therearemanywaysofcompilingthecomponentcashfowchangestoarriveatthechangeinoperatingcashfow.Wewillstartbyfrstcalculatingtaxableincome,makingadjustmentsforchangesintaxes,noncashexpenses,andnetworkingcapitaltoarriveatoperatingcashfow.Supposeyouareevaluatingaprojectthatisexpectedtoincreasesalesby$200,000andexpensesby$150,000.Accountsreceivableareexpectedtoin-creaseby$20,000andaccountspayableareexpectedtoincreaseby$5,000,butnochangesincashorinventoryareexpected.Further,supposetheproject’sassetswillhavea$10,000depreciationexpensefortaxpurposes.Ifthetaxrateis40%,whatistheoperatingcashfowfromthisproject?Changeinsales$200,000LessChangeinexpenses150,000LessChangeindepreciation10,000 EqualsChangeintaxableincome$40,000LessTaxes16,000 EqualsChangeinincomeaftertaxes$24,000PlusDepreciation10,000LessIncreaseinworkingcapital15,000 EqualsChangeinoperatingcashfow$19,000Sothatwecanmathematicallyrepresenthowtocalculatethechangeinoperatingcashfowsforaproject,let’susethesymbol“ ”toindicate“changein”: OCF = changeinoperatingcashfow; R = changeinrevenues; E = changeinexpenses; D = changeindepreciation; t = taxrate;and NWC = changeinworkingcapital
318 VALUATIONANDANALYSISTOOLS Thechangeintheoperatingcashfowis: OCF = ( R − E − D)(1 − t ) + D − NWCWecanalsowritethisas: OCF = ( R − E)(1 − t ) + Dt − NWCApplyingtheseequationstothepreviousexample, OCF = ( R − E − D) × (1 − t ) + D − NWC OCF = ( $ 200,000 − 150,000 − 10,000) × (1 − 0 . 40) + $10,000 − $15,000 OCF = $19,000or,usingtherearrangementoftheequation, OCF = ( R − E)(1 − t ) + Dt − NWC OCF = ( $ 200,000 − 150,000) × (1 − 0.40) + ($10,000 × 0 . 40) − $15,000 OCF = $19,000 . Let’slookatonemoreexampleforthecalculationofoperatingcashfows.Supposeyouareevaluatingmodernequipmentwhichyouexpectwillreduceexpensesby$100,000duringthefrstyear.And,sincethenewequipmentismoreeffcient,youcanreducethelevelofinventoryby$20,000duringthefrstyear.Theoldmachinecost$200,000andwasdepreciatedusingstraight-lineover10years,withfveyearsremaining.Thenewmachinecost$300,000andwillbedepreciatedusingstraight-lineover10years.Ifthecompany’staxrateis30%,whatistheexpectedoperatingcashfowinthefrstyear?Let’sidentifythecomponents: R = $0Thenewmachinedoesnotaffectrevenues. E =− $100,000Thenewmachinereducesexpensesthatwillreducetaxesandincreasecashfows. D =+ 10,000Thenewmachineincreasesthedepreciationexpensefrom$20,000to$30,000. NWC =− $20,000Thecompanycanreduceitsinvestmentininventoryreleasingfundstobeinvestedelsewhere. t = 30%
CapitalBudgeting 319 Theoperatingcashfowfromthefrstyearistherefore: OCF = ( R − E − D) × (1 − t ) + D − NWC OCF = ($100,000 − 10,000) × (1 − 0 . 30) + $10,000 − $20,000 OCF = $63,000 + $10,000 + $20,000 OCF = $93,000 EXAMPLE13.2:CHANGEINDEPRECIATION SupposetheInter.ComCompanyisevaluatingitsdepreciationmethodsonanewpieceofequipmentthatcosts$100,000.Andsupposetheequipmentcanbedepreciatedusingstraight-lineoverfveyearsortreatingitasa3-yearMACRSasset.Whatisthedifferenceinthecashfowsassociatedwithdepreciationunderthesetwomethodsinthesecondyearifitsmarginaltaxrateis40%? Solution Differenceindepreciation = $20,000–44,450 = $24,450Taxshieldofdifference = 0.40 × $24,450 = $9,780 TRYIT!CHANGEINEXPENSES Ifaprojectisexpectedtoincreasecostsby$50,000peryearandthetaxrateofthecompanyis40%,whatisthenetcashfowfromthechangeincosts? NetCashFlows Bynowweshouldknowthataninvestment’scashfowsconsistof:(1)cashfowsrelatedtoacquiringanddisposingtheassetsrepresentedintheinvestment,and(2)howitaffectscashfowsrelatedtooperations.Toevaluateanyinvestmentproject,wemustcon-siderbothtodeterminewhetherornotthecompanyisbetteroffwithorwithoutit.
320 VALUATIONANDANALYSISTOOLS Thesumofthecashfowsfromassetacquisitionanddispositionandfromoperationsisthe netcashfows (NCF).Andthissumiscalculatedforeachperiod.Ineachperiod,weaddthecashfowfromassetacquisitionanddispositionandthecashfowfromoperations.Foragivenperiod,Netcashfow = Investmentcashfow + ChangeinoperatingcashfowTheanalysisofthecashfowsofinvestmentprojectscanbecomequitecomplex.Butbyworkingthroughanyproblemsystematically,line-by-line,youwillbeabletosortouttheinformationandfocusonthoseitemsthatdeterminecashfows. AComprehensiveExample TheAcme.ComCompanyisevaluatingreplacingitsproductionequipmentthatproducesanvils.Thecurrentequipmentwaspurchased10yearsagoatacostof$1.5million.AcmedepreciateditscurrentequipmentusingMACRS,consideringtheequipmenttobea5-yearMACRSasset.Iftheysellthecurrentequipment,theyestimatethattheycanget$100,000.Thenewequipmentwouldcost$2.5millionandwouldbedepreciatedasa5-yearMACRSasset.Thenewequipmentwouldnotaffectsales,butwouldresultinacostssavingsof$400,000eachyearoftheasset’s10-yearusefullife.Attheendofits10-yearlife,Acmeestimatesthatitcanselltheequip-mentfor$30,000.Also,becausethenewequipmentwouldbemoreef-fcient,Acmewouldhavelesswork-in-processanvils,reducinginventoryneedsinitiallyby$20,000.Acme’smarginaltaxrateis40%.Assumethattheequipmentpurchase(andsaleoftheoldequipment)occursattheendofYear0andthatthefrstyearofoperatingthisequipmentisYear1andthelastyearofoperatingtheequipmentisYear10.Fromthisscenario,wecanpickoutpiecesofinformationthatweneedinouranalysis: Bookvalueofexistingequipment = $0 Saleofcurrentequipment = $100,000cashinfow Taxonsaleofcurrentequipment = $40,000cashoutfow Initialoutlayfornew = $2,500,000cashoutfow R = $0 E = $400,000eachyear WC =− $20,000cashoutfowinitially WC = $20,000cashinfowattheendofproject
CapitalBudgeting 321 Thedepreciationonthenewequipment,basedonMACRSrates,is: YearCalculationDepreciationexpense 10.2000 × $2,500,000$500,00020.3200 × $2,500,000$800,00030.1920 × $2,500,000$480,00040.1152 × $2,500,000$288,00050.1152 × $2,500,000$288,00060.0576 × $2,500,000$144,000ThereisnodepreciationexpenseafterYear6.WeprovidethecashfowcalculationsinExhibit13.4.Thenetcashfowinitiallyisnegative,butthenispositiveforeachyearthereafter. Simplifications Toactuallyanalyzeaproject’scashfows,weneedtomakeseveralsimplifcations: Weassumethatcashfowsintooroutofthecompanyatcertainpointsintime,typicallyattheendoftheyear,althoughwerealizeaproject’scashfowsintoandoutofthecompanyatirregularintervals. Weassumethattheassetsarepurchasedandputtoworkimmediately. Bycombininginfowsandoutfowsineachperiod,weareassumingthatallinfowsandoutfowsinagivenperiodhavethesamerisk.Becausetherearesomanyfowstoconsider,wefocusonfowswithinaperiod(sayayear),assumingtheyalloccurattheendoftheperiod.Weassumethistoreducethenumberofthingswehavetokeeptrackof.Whetherornotthisassumptionmattersdependson:(1)thedifferencebetweentheactualtimeofcashfowandwhetherweassumeitfowsattheendoftheperiod(thatis,afowonJanuary2is364daysfromDecember31,butafowonDecember30isonlyonedayfromDecember31),and(2)theopportunitycostoffunds.Also,assumingthatcashfowsoccuratspecifcpointsintimesimplifesthefnancialmathematicsweuseinvaluingthesecashfows. CAPITALBUDGETINGTECHNIQUES Theestimationofthenetcashfowsofaprojectisanimportantstepinthecapitalbudgetingdecision,butmakingacapitalbudgetingdecisionrequiresanalyzingthesecashfowstodeterminewhethertheprojectshouldbeundertaken.
EXHIBIT13.4 Acme.comCashFlowAnalysis Year012345678910 Initialpayment − $2,500,000Saleofnew100,000$30,000Taxonsaleofnew − 40,000 − 12,000Changeinworkingcapital20,000 − 20,000 Investmentcashfows − $2,420,000 − $2,000Changeinrevenues$0$0$0$0$0$0$0$0$0$0Changeinexpenses − 400,000 − 400,000 − 400,000 − 400,000 − 400,000 − 400,000 − 400,000 − 400,000 − 400,000 − 400,000Changeindepreciation500,000 800,000 480,000 288,000 288,000 144,000 $0 $0 $0 $0 Changeintaxableincome − $100,000 − $400,000 − $80,000$112,000$112,000$256,000$400,000$400,000$400,000$400,000Changeintaxes − 40,000 − 160,000 − 32,000 44,800 44,800 102,400 160,000 160,000 160,000 160,000 Changeinafter-taxincome − $60,000 − $240,000 − $48,000$67,200$67,200$153,600$240,000$240,000$240,000$240,000Changeindepreciation500,000 800,000 480,000 288,000 288,000 144,000 0 0 0 0 Changeinoperatingcashfows$440,000 $560,000 $432,000 $355,200 $355,200 $297,600 $240,000 $240,000 $240,000 $240,000 Netcashfow − $2,420,000$440,000$560,000$432,000$355,200$355,200$297,600$240,000$240,000$240,000$238,000 322
CapitalBudgeting 323 Thevalueofacompanytodayisthepresentvalueofallitsfuturecashfows.Thesefuturecashfowscomefromassetsthatarealreadyinplaceandfromfutureinvestmentopportunities.Thevalueofthecompanytodayisthepresentvalueofthesefuturecashfows,discountedataratethatrepresentsinvestors’assessmentsoftheuncertaintythattheywillfowintheamountsandwhenexpected.Thedegreeofuncertainty,orrisk,ofaprojectisrefectedintheproject’scostofcapital.Thecostofcapitaliswhatthecompanymustpayforthefundstofnanceitsinvestment.Givenestimatesofincrementalcashfowsforaprojectandgivenacostofcapitalthatrefectstheproject’srisk,welookatalternativetechniquesthatareusedtoselectprojects.Fornowallweneedtounderstandaboutaproject’sriskisthatwecanincorporateriskineitheroftwoways:(1)wecandiscountfuturecashfowsusingahigherdiscountrate,thegreaterthecashfow’srisk,or(2)wecanrequireahigherannualreturnonaproject,thegreatertheriskofitscashfows. EvaluationTechniques Welookatsixtechniquesthatarecommonlyusedbycompaniestoevalu-atinginvestmentsinlong-termassets: 1. Paybackperiod 2. Discountedpaybackperiod 3. Netpresentvalue 4. Proftabilityindex 5. Internalrateofreturn 6. ModifedinternalrateofreturnWeareinterestedinhowwelleachtechniquediscriminatesamongthedifferentprojects,steeringustowardtheprojectsthatmaximizeowners’wealth.Anevaluationtechniqueshould: Considerallthefutureincrementalcashfowsfromtheproject Considerthetimevalueofmoney Considertheuncertaintyassociatedwithfuturecashfows HaveanobjectivecriterionbywhichtoselectaprojectProjectsselectedusingatechniquethatsatisfesallfourcriteriawill,undermostgeneralconditions,maximizeowners’wealth.
324 VALUATIONANDANALYSISTOOLS EXHIBIT13.5 EstimatedCashFlowsforProjectOneandProjectTwo EndofPeriodCashFlows YearProjectOneProjectTwo 20X1 − $100,000 − $100,00020X2$0$30,00020X3$0$30,00020X4$0$30,00020X5$140,000$30,000 Inadditiontojudgingwhethereachtechniquesatisfesthesecriteria,wewillalsolookatwhichonescanbeusedinspecialsituations,suchaswhenadollarlimitisplacedonthecapitalbudget.Weusetwoprojects,ProjectOneandProjectTwo,toillustratethetechniques.WeshowthecashfowsrelatedtoeachprojectinExhibit13.5.CanyoutellbylookingatthecashfowsforProjectOnewhetherornotitenhanceswealth?Or,canyoutellbyjustlookingatProjectsOneandTwowhichoneisbetter?Perhapswithsomeprojectsyoumaythinkyoucanpickoutwhichoneisbettersimplybygutfeelingoreyeballingthecashfows.Butwhydoitthatwaywhenthereareprecisemethodstoevaluateinvestmentsbytheircashfows? PaybackPeriod The paybackperiod foraprojectisthetimefromtheinitialcashoutfowtoinvestinituntilthetimewhenitscashinfowsadduptotheinitialcashoutfow.Inotherwords,howlongittakestogetyourmoneyback.Thepaybackperiodisalsoreferredtoasthe payoffperiod orthe capitalrecoveryperiod. Ifyouinvest$10,000todayandarepromised$5,000oneyearfromtodayand$5,000twoyearsfromtoday,thepaybackperiodistwoyears—ittakestwoyearstogetyour$10,000back.Howlongdoesittaketogetyour$100,000fromProjectOneback?ThepaybackperiodforProjectOneisfouryears: YearProjectOneCashFlowsAccumulatedProjectOneCashFlows 20X1 − $100,000 − $100,00020X2$0 − $100,00020X3$0 − $100,00020X4$0 − $100,00020X5$130,000$30,000
CapitalBudgeting 325 Bytheendof20X4,thefull$100,000isnotpaidback,butby20X5,theaccumulatedcashfowispositive.Therefore,thepaybackperiodforProjectOneisfouryears.ThepaybackperiodforProjectTwoisalsofouryears.Itisnotuntiltheendof20X5thatthe$100,000originalinvestment(andmore)ispaidback:Attheendofthethirdyear,20X4,allbut$10,000ispaidback,butattheendof20X5,theentire$100,000ispaidback.Wehaveassumedthatthecashfowsarereceivedattheendoftheyear.Sowealwaysarriveatapaybackperiodintermsofawholenumberofyears.Ifweassumethatthecashfowsarereceived,say,uniformly,suchasmonthlyorweekly,throughouttheyear,wearriveatapaybackperiodintermsofyearsandfractionsofyears.Ifthecompanyreceivescashfowsuniformlythroughouttheyear,thepaybackperiodforProjectTwois3 2 / 3 years.Ourassumptionofend-of-periodcashfowsmaybeunrealistic,butitisconvenienttousethisassumptiontodemonstratehowtousethevariousevaluationtechniques.Usingthisassumption,thepaybackforbothProjectOneandProjectTwoisfouryears.Wewillcontinuetousethisend-of-periodassumptionthroughoutthecoverageofcapitalbudgetingtechniques.IsProjectOneorTwomoreattractive?Ashorterpaybackperiodisbetterthanalongerpaybackperiod.Yetthereisnoclear-cutruleforhowshortisbetter.Ifweassumethatallcashfowsoccurattheendoftheyear,ProjectOneprovidesthesamepaybackasProjectTwo.Therefore,wedonotknowinthisparticularcasewhetherquickerisbetter.Inadditiontohavingnowell-defneddecisioncriteria,paybackperiodanalysisfavorsinvestmentswith“front-loaded”cashfows:aninvestmentlooksbetterintermsofthepaybackperiodthesooneritscashfowsarere-ceivednomatterwhatitslatercashfowslooklike.Paybackperiodanalysisisatypeof“break-even”measure.Ittendstoprovideameasureoftheeco-nomiclifeoftheinvestmentintermsofitspaybackperiod.Themorelikelythelifeexceedsthepaybackperiod,themoreattractivetheinvestment.Theeconomiclifebeyondthepaybackperiodisreferredtoasthe post-paybackduration .Ifpost-paybackdurationiszero,theinvestmentisworthless,nomatterhowshortthepayback.Thisisbecausethesumofthefuturecashfowsisnogreaterthantheinitialinvestmentoutlay.Andsincethesefuturecashfowsarereallyworthlesstodaythaninthefuture,azeropost-paybackdurationmeansthatthepresentvalueofthefuturecashfowsislessthantheproject’sinitialinvestment.Thepaybackmethodshouldonlybeusedasacoarseinitialscreenofinvestmentprojects.Butitcanbeausefulindicatorofsomethings.Becauseadollarofcashfowintheearlyyearsisworthmorethanadollarofcashfowinlateryears,thepaybackperiodmethodprovidesasimple,yetcrudemeasureoftheliquidityoftheinvestment.
326 VALUATIONANDANALYSISTOOLS Thepaybackperiodalsoofferssomeindicationontheriskoftheinvestment.Inindustrieswhereequipmentbecomesobsoleterapidlyorwherethereareverycompetitiveconditions,investmentswithearlierpay-backaremorevaluable.That’sbecausecashfowsfartherintothefuturearemoreuncertainandthereforehavelowerpresentvalue.Intheper-sonalcomputerindustry,forexample,thefercecompetitionandrapidlychangingtechnologyrequiresinvestmentinprojectsthathaveapaybackoflessthanoneyearsincethereisnoexpectationofprojectbeneftsbeyondoneyear.Becausethepaybackmethoddoesn’ttellustheparticularpaybackpe-riodthatmaximizeswealth,wecannotuseitastheprimarydecisiontoolfortheinvestmentinlong-livedassets. DiscountedPaybackPeriod The discountedpaybackperiod isthetimeneededtopaybacktheoriginalinvestmentintermsofdiscountedfuturecashfows.Therefore,wemustdiscounteachcashfowtothebeginningoftheproject;thediscountedpaybackperiodisthelengthoftimeittakestheseaccumulatedcashfowstobecomepositive.Eachcashfowisdiscountedbacktothebeginningofprojectataratethatrefectsboththetimevalueofmoneyandtheuncertaintyofthefuturecashfows.Thisrateisthecostofcapital—thereturnrequiredbythesuppliersofcapital(creditorsandowners)tocompensatethemfortimevalueofmoneyandtheriskassociatedwiththeinvestment.Themoreuncertainthefuturecashfows,thegreaterthecostofcapital.Wediscountanuncertainfuturecashfowtothepresentatsomeratethatrefectsthedegreeofuncertaintyassociatedwiththisfuturecashfow.Themoreuncertain,thelessthecashfowisworthtoday—thismeansthatahigherdiscountrateisusedtotranslateitintoavaluetoday.Thisdiscountrateisaratethatrefectstheopportunitycostoffunds.Werefertothisopportunitycostasthecostofcapital. Wedon’twanttodoanythingthatdoesn’tcreatemorethanadollar’sworthofvalueforeverydollarexpended.Andwe’lldothebestwecan.—WarrenBuffett,PresentationtotheWhartonSchool,2008 ReturningtoProjectOneandProjectTwo,supposethateachhasacostofcapitalof5%.Thefrststepindeterminingthediscountedpaybackperiodistodiscounteachyear’scashfowtothebeginningoftheinvestment(theendoftheyear20X1)atthecostofcapital:
CapitalBudgeting 327 ProjectOneYearCashFlowsDiscountedCashFlowsAccumulatedDiscountedCashFlows 20X1 − $100,000 − $100,000 − $100,00020X2$0$0 − $100,00020X3$0$0 − $100,00020X4$0$0 − $100,00020X5$130,000$106,951$6,951 ProjectTwoYearCashFlowsDiscountedCashFlowsAccumulatedDiscountedCashFlows 20X1 − $100,000 − $100,000 − $100,00020X2$30,000$28,571 − $71,42920X3$30,000$27,211 − $44,21820X4$30,000$25,915 − $18,30320X5$30,000$24,681$6,379Howlongdoesittakeforeachinvestment’sdiscountedcashfowstopaybackits$100,000investment?ThediscountedpaybackperiodforbothProjectsOneandTwoisfouryears.Itappearsthattheshorterthepaybackperiod,thebetter,whetherusingdiscountedornondiscountedcashfows.Buthowshortisbetter?Wedon’tknow.Allweknowisthataninvestment“breaks-even”intermsofdiscountedcashfowsatthediscountedpaybackperiod—thepointintimewhentheaccumulateddiscountedcashfowsequaltheamountoftheinvestment.Ifaprojectneverpaysbackintermsofthediscountedpaybackpe-riod,weknowthatthisprojectisnotacceptable.Usingthelengthofthediscountedpaybackasabasisforselectinginvestmentsthatdopayback,intermsofdiscountedcashfow,wecannotdistinguishProjectsOneandTwo.Bothhaveadiscountedpaybackperiodoffouryears.Butwe’veig-noredsomevaluablecashfowsforbothinvestments,thosebeyondwhatisnecessaryforrecoveringtheinitialcashoutfow. NetPresentValue Ifofferedaninvestmentthatcosts$1,000todayandpromisestopayyou$1,200twoyearsfromtoday,andifyouropportunitycostforprojectsofsimilarriskis5%,wouldyoumakethisinvestment?Todeterminewhether
328 VALUATIONANDANALYSISTOOLS ornotthisisagoodinvestmentyouneedtocompareyour$1,000investmentwiththe$1,200cashfowyouexpectintwoyears.Becauseyoudeterminethatadiscountrateof5%refectsthedegreeofuncertaintyassociatedwiththe$1,200expectedintwoyears,todayitisworth:Presentvalueof$1,200tobereceivedin2years = $1,200 (1 + 0 . 05) 2 = $1,088.44Byinvesting$1,000,todayyouaregettinginreturn,apromiseofacashfowinthefuturethatisworth$1,088.44today.Youincreaseyourwealthby$88.44,whichwerefertoasthenetpresentvalue.The netpresentvalue ( NPV )isthepresentvalueofallexpectedcashfows.Theword“net”inthistermindicatesthatweconsiderallcashfows—bothpositiveandnegative.Wecanrepresentthenetpresentvalueusingsummationnotation,where t indicatesanyparticularperiod, CF t representsthecashfowattheendofperiod t , i representsthecostofcapital,and N thenumberofperiodscomprisingtheeconomiclifeoftheinvestment: NPV = N t = 0 CF t (1 + i ) t (13.1)Cashinfowsarepositivevaluesof CF t andcashoutfowsarenegativevaluesof CF t .Foranygivenperiod t ,wecollectallthecashfows(positiveandnegative)andnetthemtogether.Tomakethingsabiteasiertotrack,let’sjustrefertocashfowsasinfowsoroutfows,andnotspecifcallyidentifythemasoperatingorinvestmentcashfows.TakeanotherlookatProjectsOneandTwo.Usinga5%costofcapital,thenetpresentvaluesare$6,951and$6,379,respectively: ProjectOneYearCashFlowsDiscountedCashFlows 20X1 − $100,000 − $100,00020X2$0020X3$0020X4$0020X5$130,000106,951 Netpresentvalue = $6,951
CapitalBudgeting 329 ProjectTwoYearCashFlowsDiscountedCashFlows 20X1 − $100,000 − $100,00020X2$30,00028,57120X3$30,00027,21120X4$30,00025,91520X5$30,00024,681 Netpresentvalue = $6,379Thesevaluesshouldlookfamiliarbecauseweusedthesediscountedcashfowsinthediscountedpaybackperiod.TheNPVforProjectOneindicatesthatifweinvestinthisproject,weexpecttoincreasethevalueofthecompanyby$6,951.Calculatedinasimilarmanner,thenetpresentvalueofProjectTwois$6,379.WecanuseafnancialcalculatortosolvefortheNPV,keyinginthecashfowsinorder.WecanalsouseMicrosoftExcel’sNPVfunctiontosolveforthenetpresentvalue: Microsoft Excel HP10B TI-83/84 {0,0,0,130000}STO listname NPV(5,100000, listname )100000+/CF j 0 CF j 0 CF j 0 CF j 130000CF j 5 i/YRNPVAB1YearProject One220X1$100,000320X2$0420X3$0520X4$0620X5$130,000 NPV(.1,B3:B6)+B2 NetPresentValueDecisionRule Apositivenetpresentvaluemeansthattheinvestmentincreasesthevalueofthecompany—thereturnismorethansuffcienttocompensatefortherequiredreturnoftheinvestment.Anotherwayofstatingthisisthataprojectthathasapositivenetpresentvalueisproftableinaneconomicsense. 1 1 Thisdoesnotmean,however,thattheprojectisproftableintermsoffnancialaccounting.
330 VALUATIONANDANALYSISTOOLS Anegativenetpresentvaluemeansthattheinvestmentdecreasesthevalueofthecompany—thereturnislessthanthecostofcapital.Azeronetpresentvaluemeansthatthereturnjustequalsthereturnrequiredbyownerstocompensatethemforthedegreeofuncertaintyoftheinvestment’sfuturecashfowsandthetimevalueofmoney.Therefore, If ... thismeansthattheinvestmentisexpected ... andyoushould ... NPV > $0toincreaseshareholderwealthaccepttheproject.NPV < $0todecreaseshareholderwealthrejecttheproject.NPV = $0nottochangeshareholderwealthbeindifferentbetweenacceptingorrejectingtheproject.ProjectOneisexpectedtoincreasethevalueofthecompanyby$6,951,whereasProjectTwoisexpectedtoadd$6,379invalue.Ifthesearein-dependentinvestments,bothshouldbetakenonbecausebothincreasethevalueofthecompany.IfProjectsOneandTwoaremutuallyexclusive,suchthattheonlychoiceiseitherOneorTwo,ProjectOneispreferredsinceithasthegreaterNPV. TheInvestmentProfile Wemaywanttoseehowsensitiveisourdecisiontoacceptaprojecttochangesinourcostofcapital.Wecanseethissensitivityinhowaproject’snetpresentvaluechangesasthediscountratechangesbylookingataproject’s investmentprofle ,alsoreferredtoasthe netpresentvalueprofle .Theinvestmentprofleisagraphicaldepictionoftherelationbetweenthenetpresentvalueofaprojectandthediscountrate:theprofleshowsthenetpresentvalueofaprojectforeachdiscountrate,withinsomerange.WeprovidethenetpresentvalueprofleforthetwoprojectsinExhibit13.6fordiscountratesfrom0%to20%.TheNPVforProjectOneispositivefordiscountratesfrom0%to6.779%,andnegativefordiscountrateshigherthan6.779%.The6.779%istheinternalrateofre-turn;thatis,thediscountrateatwhichthenetpresentvalueisequalto$0.Therefore,ProjectOneincreasesowners’wealthifthecostofcapitalonthisprojectislessthan6.779%,anddecreasesowners’wealthifthecostofcapitalonthisprojectisgreaterthan6.779%.Ifthediscountrateislessthan5.361%,ProjectOneaddsmorevaluethanProjectTwo,butifthediscountrateismorethan5.361%butless
CapitalBudgeting 331 $40,000$30,000$20,000$10,000$0 NPV Required Rate of Return –$10,000–$20,000–$30,000–$40,000–$50,0000%2%4%6%8%6.779%5.361%7.714%Project OneProject Two10%12%14%16%18%20% EXHIBIT13.6 TheInvestmentProflesofProjectsOneandTwo than7.714%,ProjectTwoincreaseswealthmorethanProjectOne.Ifthediscountrateisgreaterthan7.714%,weshouldinvestinneitherprojectbecausebothwoulddecreasewealth.The5.361%isthe cross-overdiscountrate whichproducesidenticalNPVsforthetwoprojects.Ifthediscountrateis5.361%,thenetpresentvalueofbothinvestmentsis$5,492. SolvingfortheCross-OverRate ForProjectsOneandTwo,thecross-overrateistheratethatcausesthenetpresentvalueofthetwoinvestmentstobeequal.Basically,thisboilsdowntoasimpleapproach:calculatethedifferencesinthecashfowsandthensolvefortheinternalrateofreturnofthesedifferences. YearProjectOneProjectTwoDifference 20X1 − $100,000 − $100,000$020X2$0$30,000 − $30,00020X3$0$30,000 − $30,00020X4$0$30,000 − $30,00020X5$130,000$30,000$100,000Theinternalrateofreturnofthesedifferencesisthecross-overrate,or5.361%.Doesitmatterwhichproject’scashfowsyoudeductfromthe
332 VALUATIONANDANALYSISTOOLS other?Notatall—justbeconsistenteachperiod.Usingafnancialcalculatororspreadsheetprogram: TI-83/84HP10BMicrosoft Excel {30000, 30000,30000,100000} STO listname IRR(0, listname )0CF j 30000+/CF j 30000+/CF j 30000+/CF j 100000CF j IRRAB1YearProject Two220X1$0320X2$30,000420X3$30,000520X4$30,000620X5$100,000 NPV(.1,B3B6)+B2 ProfitabilityIndex The proftabilityindex usessomeofthesameinformationweusedforthenetpresentvalue,butitisstatedintermsofanindex.Whereasthenetpresentvalueis: NPV = N t = 0 CF t (1 + i ) t Theproftabilityindex, PI ,is: PI = N t = 0 CIF t (1 + i ) t COF t (1 + i ) t (13.2)whereCIFandCOFarecashinfowsandcashoutfows,respectively.ForProjectOne,theproftabilityindexis: PI ProjectOne = $106,951 $100,000 = 1 . 06951Theindexvalueisgreaterthanone,whichmeansthattheinvestmentproducesmoreintermsofbeneftsthancosts.ThedecisionrulefortheproftabilityindexisthereforedependsonthePIrelativeto1.0:
CapitalBudgeting 333 If ... thismeansthattheinvestmentisexpectedto ... andyoushould ... PI > 1.0increaseshareholderwealthaccepttheproject.PI < 1.0decreaseshareholderwealthrejecttheproject.PI = 1.0nottochangeshareholderwealthbeindifferentbetweenacceptingorrejectingtheproject.TheproftabilityindexforProjectTwois1.06379.Therefore,bothprojectsareacceptableaccordingtotheproftabilityindexcriteria.ThereisnodirectsolutionforPIonyourcalculator;whatyouneedtodoiscalculatethepresentvalueofallthecashinfowsandthendividethisvaluebythepresentvalueofthecashoutfows.InthecaseofProjectOne,thereisonlyonecashoutfowanditisalreadyinpresentvalueterms(i.e.,itoccursattheendof20X1). TRYIT!NPVANDPI Consideraprojectthatrequiresa$10,000cashoutlayandprovides$5,000afteroneyearand$7,000afterthreeyears.Ifthecostofcapitalofthisprojectis10%,whatisthenetpresentvalueandproftabilityofthisproject? InternalRateofReturn Supposeyouareofferedaninvestmentopportunitythatrequiresyoutoputup$1,000andhasanexpectedcashinfowof$1,200aftertwoyears.Thereturnonthisinvestmentisthediscountratethatcausesthepresentvaluesofthe$1,200cashinfowtoequalthepresentvalueofthe$1,000cashoutfow:$1,000 = $1,200 (1 + IRR) 2 Anotherwaytolookatthisistoconsidertheinvestment’scashfowsdiscountedatarateof5%.TheNPVofthisprojectifthediscountrateis5%(theIRRinthisexample),ispositive,$88.44.Therefore,weknowthattheratethatcausestheNPVtobezeroisgreaterthan5%.Ifweapplya
334 VALUATIONANDANALYSISTOOLS 10%discountrate,theNPVis − $8.26.Therefore,weknowthattheIRRisbetween5%and10%,andcloserto10%.Aninvestment’s internalrateofreturn (IRR)isthediscountratethatmakesthepresentvalueofallexpectedfuturecashfowsequaltozero.WecanrepresenttheIRRastheratethatsolves:$0 = N t = 0 CF t (1 + IRR) t (13.3)TheIRRfortheinvestmentof$1,000thatproduces$1,200twoyearslateris9.545%.ReturningonceagaintoProjectsOneandTwo,theIRRofProjectOneis6.951%andtheIRRofProjectTwois7.714%.Asyoumayrecallfromourdiscussionoftheinvestmentprofles,thesearethediscountratesatwhicheachprojectcrossesthehorizontalaxis(i.e.,NPV = $0).WecanuseafnancialcalculatororaspreadsheetprogramtosolvefortheIRR.Forexample,forProjectOne, TI-83/84 HP10B Microsoft Excel {0,0,0,130000} STO listname –100000+/– CF j 0 CF j 0 CF j 0 CF j 130000CF j IRR A B 1 Year Project One 2 20X1 –$100,000 3 20X2 $0 4 20X3 $0 5 20X4 $0 6 20X5 $130,000 =IRR(B2:B6) IRR(–100000, listname ) Theinternalrateofreturnisayield—whatweearn,onaverage,peryear.Howdoweuseittodecidewhichinvestment,ifany,tochoose?Let’srevisitInvestmentsAandBandtheIRRswejustcalculatedforeach.If,forsimilarriskinvestments,ownersearn10%peryear,thenbothAandBareattractive.Theybothyieldmorethantherateownersrequireforthelevelofriskofthesetwoinvestments: ProjectIRRRequiredRateofReturn One6.779%5%Two7.714%5%
CapitalBudgeting 335 Thedecisionrulefortheinternalrateofreturnistoinvestinaprojectifitprovidesareturngreaterthanthecostofcapital.Thecostofcapi-tal,inthecontextoftheIRR,isahurdlerate—theminimumacceptablerateofreturn.Forindependentprojectsandsituationsinwhichthereisnocapitalrationing,wecomparetheIRRwiththerequiredrateofreturn,RRR: If ... thismeansthattheinvestmentisexpectedto ... andyoushould ... IRR > RRRincreaseshareholderwealthaccepttheproject.IRR < RRRdecreaseshareholderwealthrejecttheproject.IRR = RRRnotchangeshareholderwealthbeindifferentbetweenacceptingorrejectingtheproject.WhatifwewereforcedtochoosebetweenProjectsOneandTwobe-causetheyaremutuallyexclusive?ProjectTwohasahigherIRRthanProjectOne—soatfrstglancewemightwanttoacceptProjectTwo.WhatabouttheNPVofOneandTwo?WhatdoestheNPVtellustodo?IfwechooseonthebasisofthehigherIRR,wegowithProjectTwo.IfwechoosetheprojectwiththehigherNPVwhenthecostofcapitalis5%,wegowithProjectOne.Whichiscorrect?Choosingtheprojectwiththehighernetpresentvalueisconsistentwithmaximizingowners’wealth.Why?Becauseifthecostofcapitalis5%,wewouldcalculatedifferentNPVsandcometoadifferentconclusion,asyoucanseefromtheinvestmentproflesinExhibit13.6.Whenevaluatingmutuallyexclusiveprojects,theonewiththehighestIRRmaynotbetheonewiththebestNPV.TheIRRmaygiveadifferentdecisionthanNPVwhenevaluatingmutuallyexclusiveprojectsbecauseofthebuilt-inassumptionswiththesemethods: NPVassumescashfowsreinvestedatthecostofcapital. IRRassumescashfowsreinvestedattheinternalrateofreturn.Theseassumptionsmaycausedifferentdecisionsinchoosingamongmutuallyexclusiveprojectswhen: thetimingofthecashfowsisdifferentamongtheprojects, therearescaledifferences(thatis,verydifferentcashfowamounts),or theprojectshavedifferentusefullives.
336 VALUATIONANDANALYSISTOOLS THETROUBLEWITHIRR “Howlargeisthepotentialimpactofafawedreinvestment-rateas-sumption?Managersatonelargeindustrialcompanyapproved23majorcapitalprojectsoverfveyearsonthebasisofIRRsthataver-aged77%.Recently,however,whenweconductedananalysiswiththereinvestmentrateadjustedtothecompany’scostofcapital,thetrueaveragereturnfelltojust16%.Theorderofthemostattrac-tiveprojectsalsochangedconsiderably.Thetop-rankedprojectbasedonIRRdroppedtothetenth-most-attractiveproject.Moststriking,thecompany’shighest-ratedprojects—showingIRRsof800,150,and130%—droppedtojust15,23,and22%,respectively,oncearealis-ticreinvestmentratewasconsidered.Unfortunately,theseinvestmentdecisionshadalreadybeenmade.” TheMcKinseyQuarterly ,McKinsey&Co.,October20,2004. Withrespecttotheroleofthetimingofcashfowsinchoosingbetweentwoprojects:ProjectTwo’scashfowsarereceivedsoonerthanProjectOne’s.Partofthereturnoneitherisfromthereinvestmentofitscashinfows.And,inthecaseofProjectTwo,thereismorereturnfromthereinvestmentofcashinfows.Thequestionis“Whatdoyoudowiththecashinfowswhenyougetthem?”Wegenerallyassumethatifyoureceivecashinfows,you’llreinvestthosecashfowsinotherassets.Withrespecttothereinvestmentrateassumptioninchoosingbetweentheseprojects,supposewecanreasonablyexpecttoearnonlythecostofcapitalonourinvestments.ThenforprojectswithanIRRabovethecostofcapitalwewouldbeoverstatingthereturnontheinvestmentusingtheIRR.Thebottomline?IfweevaluateprojectsonthebasisoftheirIRR,wemayselectonethatdoesnotmaximizevalue.WithrespecttotheNPVmethod:ifthebestwecandoisreinvestcashfowsatthecostofcapital,theNPVassumesthemorereasonablerate(thecostofcapital).Ifthereinvestmentrateisassumedtobetheproject’scostofcapital,wewouldevaluateprojectsonthebasisoftheNPVandselecttheonethatmaximizesowners’wealth.Butwhatifthereiscapitalrationing?SupposeProjectsOneandTwoare independentprojects .Projectsareindependentifthattheacceptanceofonedoesnotpreventtheacceptanceoftheother.Andsupposethecapitalbudgetislimitedto$100,000.WearethereforeforcedtochoosebetweenProjects
CapitalBudgeting 337 OneandTwo.IfweselecttheonewiththehighestIRR,wechooseProjectTwo.ButTwoisexpectedtoincreasewealthlessthanProjectOne.RankingandselectinginvestmentsonthebasisoftheirIRRsmaynotmaximizewealth.ThesourceoftheprobleminthecaseofcapitalrationingisthattheIRRisapercentage,notadollaramount.Becauseofthis,wecannotdeterminehowtodistributethecapitalbudgettomaximizewealthbecausetheinvest-mentorgroupofinvestmentsproducingthehighestyielddoesnotmeantheyaretheonesthatproducethegreatestwealth.Thetypicalprojectusuallyinvolvesonlyonelargenegativecashfowinitially,followedbyaseriesoffuturepositivefows.Butthat’snotalwaysthecase.Supposeyouareinvolvedinaprojectthatusesenvironmentallysensitivechemicals.Itmaycostyouagreatdealtodisposeofthem.Andthatwillmeananegativecashfowattheendoftheproject.Supposeweareconsideringaprojectthathascashfowsasfollows: PeriodEndofPeriodCashFlow 0 − $1,0101 + 2,4002 − 1,400Whatisthisproject’sIRR?OnepossiblesolutionisIRR = 2.85%,yetanotherpossiblesolutionisIRR = 34.78%,asweshowinExhibit13.7.RememberthattheIRRisthediscountratethatcausestheNPVtobezero.Intermsofthisgraph,thismeansthattheIRRisthediscountratewheretheNPVis$0,thepointatwhichthepresentvaluechangessign—frompositivetonegativeorfromnegativetopositive. $30$20$10$0 NPV Internal rate of return –$10–$20–$30–$400%4%8%12%16%20%24%28%32%36%40%44%48% EXHIBIT13.7 TheCaseofMultipleIRRs
338 VALUATIONANDANALYSISTOOLS TRYIT!IRR Consideraprojectthatrequiresa$1,000outlayandprovides$1,000inoneyearand$200intwoyears.WhatistheIRRofthisproject? ModifiedInternalRateofReturn Whenweusetheinternalrateofreturnmethod,weareassumingthatanycashinfowsarereinvestedattheinvestment’sinternalrateofreturn.ConsiderProjectOne.TheIRRis10.17188%.IfwetakeeachofthecashinfowsfromProjectTwoandreinvestthemat5%,wewillhave$129,304attheendof20X5: YearProjectTwoCashFlowsFutureValueofCashInfows 20X1 − $100,00020X2$30,000$34,72920X3$30,00033,07520X4$30,00031,50020X5$30,00030,000 Terminalvalue$129,304The$129,304istheproject’s terminalvalue . 2 TheterminalvalueishowmuchthecompanyhasfromthisinvestmentifallproceedsarereinvestedattheIRR.Whentheterminalvalueisused,thereturncalculatedisthe modifedinternalrateofreturn ( MIRR ).TheMIRRforProjectTwousingtheterminalvalueasthefuturevaluewehave: FV = $129,304 PV = $100,000 N = 4years MIRR = 4 $129,304 $100,000 − 1 = 6 . 636% 2 Forexample,the2008cashfowof$200,000isreinvestedat10.17188%fortwoperiods(thatis,for2009and2010),or$200,000(1 + 0.1017188) 2 = $242,756.88.
CapitalBudgeting 339 Inotherwords,byinvesting$1,000,000attheendof20X1andreceiv-ing$129,304producesanaverageannualreturnof6.636%,whichistheproject’sinternalrateofreturn.TheMIRRisthereturnontheprojectassumingreinvestmentofthecashfowsataspecifedrate.ConsiderProjectOneifthereinvestmentrateis6%: YearProjectTwoCashFlowsFutureValueofCashInfows 20X1 − $100,00020X2$30,000$34,72920X3$30,00033,07520X4$30,00031,50020X5$30,00030,000 Terminalvalue$131,238Ifthereinvestmentrateis6%,theMIRRis7.032%:Ifwe,instead,rein-vestProjectTwo’scashfowsatProjectTwo’sIRR,7.714%,wecalculatetheMIRRtobe7.714%.TheMIRRisthereforeafunctionofboththereinvestmentrateandthepatternofcashfows,withhigherthereinvestmentratesleadingtogreaterMIRRs: If ... thismeansthattheinvestmentisexpectedto ... andyoushould ... MIRR > RRRreturnmorethanrequiredaccepttheproject.MIRR < RRRreturnlessthanrequiredrejecttheproject.MIRR = RRRreturnwhatisrequiredbeindifferentbetweenacceptingorrejectingtheproject.YoucanseethisinExhibit13.8,wherethe MIRR sofbothProjectOneandProjectTwoareplottedfordifferentreinvestmentrates.ProjectTwo’sMIRRissensitivetothereinvestmentrate;ProjectOne’sMIRRisthesameasitsIRRbecauseithasasinglecashinfowattheendofthelifeoftheproject. IssuestoConsider Scaledifferences—differencesintheamountofthecashfows—betweenprojectscanleadtoconfictinginvestmentdecisionsamongthediscountedcashfowtechniques.Considertwoprojects,ProjectBigandProjectLit-tle.Eachhasarequiredrateofreturnof5%peryearwiththefollowingcashfows:
340 VALUATIONANDANALYSISTOOLS 12%Project OneProject Two12%14%10%10%8%8%6%6%4%4%2%2%0%0% MIRR Reinvestment Rate EXHIBIT13.8 MIRRsforProjectOneandProjectTwo EndofPeriodProjectBigCashFlowsProjectLittleCashFlows 0$1,000,000$1.001 + 400,000 + 0.402 + 400,000 + 0.403 + 400,000 + 0.50Applyingthediscountedcashfowtechniquestoeachproject,andas-sumingreinvestmentattherequiredrateofreturnfortheMIRR,weseethatselectingtheprojectwiththehigherproftabilityindex,internalrateofreturn,ormodifedinternalrateofreturnwillresultinselectingtheprojectthataddstheleastvalue: TechniqueProjectBigProjectLittle NPV$89,299$0.1757PI1.08931.1757IRR9.7010%13.7789%MIRR8.0368%10.8203%Wealreadyhaveseenthatwhenselectingbetweenmutuallyexclusiveprojects,weshouldusetheNPVinsteadoftheIRR.Now,consideringscaledifferences,weaddanotherprecaution:Whenselectingamongprojectsofdifferentscales,theproftabilityindexandthemodifedinternalrateofreturnmayleadtoanincorrectdecision.Supposeacompanyissubjecttocapitalrationing—sayalimitof$1,000,000—andBigandLittleareindependentprojects.Whichprojectshouldthecompanychoose?Thecompanycanonlychooseone—spend$1or$1,000,000,butnot$1,000,001.IfyougostrictlybythePI,IRR,orMIRRcriteria,thecompanywouldchooseProjectLittle.Butisthisthebetter
CapitalBudgeting 341 project?Again,thetechniquesthatignorethescaleoftheinvestment—PI,IRR,andMIRR—mayleadtoanincorrectdecision. ComparingTechniques Ifwearedealingwithmutuallyexclusiveprojects,theNPVmethodleadsustoinvestinprojectsthatmaximizewealth,thatis,capitalbudgetingdecisionsconsistentwithowners’wealthmaximization.Ifwearedealingwithalimitonthecapitalbudget,theNPVandPImethodsleadustoinvestinthesetofprojectsthatmaximizewealth.Wesummarizetheadvantagesanddisadvantagesofeachofthetech-niquesforevaluatinginvestmentsinExhibit13.9.Weseeinthistablethatthediscountedcashfowtechniquesarepreferredtothenondiscountedcashfowtechniques.Thediscountedcashfowtechniques—NPV,PI,IRR,MIRR—arepreferablesincetheyconsider(1)allcashfows,(2)thetimevalueofmoney,and(3)theriskoffuturecashfows.Thediscountedcashfowtechniquesarealsousefulbecausewecanapplyobjectivedecisioncriteria—criteriawecanactuallyusethattellsuswhenaprojectincreaseswealthandwhenitdoesnot.Wealsoseeinthistablethatnotallofthediscountedcashfowtech-niquesarerightforeverysituation.Therearequestionsweneedtoaskwhenevaluatingaproject,andtheanswersdeterminetheappropriatetechniqueistheonetouseforthatinvestment: Aretheprojectsmutuallyexclusiveorindependent? Aretheprojectssubjecttocapitalrationing? Aretheprojectsofthesamerisk? Aretheprojectsofthesamescaleofinvestment?Herearesomesimplerules: 1. Ifprojectsareindependentandnotsubjecttocapitalrationing,wecanevaluatethemanddeterminetheonesthatmaximizewealthbasedonanyofthediscountedcashfowtechniques. 2. Iftheprojectsaremutuallyexclusive,havethesameinvestmentout-lay,andhavethesamerisk,wemustuseonlytheNPVortheMIRRtechniquestodeterminetheprojectsthatmaximizewealth. 3. Ifprojectsaremutuallyexclusiveandareofdifferentrisksorareofdifferentscales,NPVispreferredoverMIRR.Ifthecapitalbudgetislimited,wecanuseeithertheNPVorthePI.Wemustbecareful,however,nottoselectprojectsonthebasisoftheirNPV(thatis,rankingonNPVandselectingthehighestNPVprojects),butratherhowwecanmaximizetheNPVofthetotalcapitalbudget.
342 VALUATIONANDANALYSISTOOLS EXHIBIT13.9 AdvantagesandDisadvantagesoftheCapitalBudgetingTechniques PaybackPeriod Advantages 1. Simpletocompute. 2. Providessomeinformationontheriskoftheinvestment. 3. Providesacrudemeasureofliquidity.Disadvantages 1. Noconcretedecisioncriteriatoindicatewhetheraninvestmentincreasesthecompany’svalue. 2. Ignorescashfowsbeyondthepaybackperiod,thetimevalueofmoney,andtheriskoffuturecashfows. DiscountedPaybackPeriod Advantages 1. Considersthetimevalueofmoney. 2. Considerstheproject’scashfows’riskthroughthecostofcapital.Disadvantages 1. Noconcretedecisioncriteriathatindicatewhethertheinvestmentincreasesthecompany’svalue. 2. Requiresanestimateofthecostofcapitalinordertocalculatethepayback. 3. Ignorescashfowsbeyondthediscountedpaybackperiod. NetPresentValue Advantages 1. Indicateswhethertheinvestmentisexpectedtoincreasethecompany’svalue. 2. Considersallthecashfows,thetimevalueofmoney,andtheriskoffuturecashfows.Disadvantages 1. Requiresanestimateofthecostofcapitalinordertocalculatethenetpresentvalue. 2. Expressedintermsofdollars. ProftabilityIndex Advantages 1. Tellswhetheraninvestmentincreasesthecompany’svalue. 2. Considersallcashfowsoftheproject,thetimevalueofmoney,andfuturecashfows’risk. 3. Usefulinrankingandselectingprojectswhencapitalisrationed.Disadvantages 1. Requiresanestimateofthecostofcapitalinordertocalculatetheproftabilityindex. 2. Maynotgivethecorrectdecisionwhenusedtocomparemutuallyexclusiveprojects.
CapitalBudgeting 343 EXHIBIT13.9 ( Continued ) InternalRateofReturn Advantages 1. Tellswhetheraninvestmentincreasesthecompany’svalue. 2. Considersallcashfowsoftheproject,thetimevalueofmoney,andfuturecashfows’risk.Disadvantages 1. Requiresanestimateofthecostofcapitalinordertomakeadecision. 2. Maynotgivethevalue-maximizingdecisionwhenusedtocomparemutuallyexclusiveprojects. 3. Maynotgivethevalue-maximizingdecisionwhenusedtochooseprojectswhenthereiscapitalrationing. 4. Cannotbeusedinsituationsinwhichthesignofthecashfowsofaprojectchangemorethanonceduringtheproject’slife. ModifedInternalRateofReturn Advantages 1. Indicateswhetheraninvestmentisexpectedtoincreasethecompany’svalue. 2. Considersallcashfowsoftheproject,thetimevalueofmoney,andfuturecashfows’risk.Disadvantages 1. Requiresanestimateofthecostofcapitalinordertomakeadecision. 2. Maynotgivethevalue-maximizingdecisionwhenusedtocomparemutuallyexclusiveprojectsorwhenthereiscapitalrationing. TRYIT!ACME.COM UsingthecashfowsoftheAcme.comprojectthatweprovideinExhibit13.4,calculate: 1. Paybackperiod, 2. Discountedpaybackperiod, 3. Netpresentvalue, 4. Proftabilityindex, 5. Internalrateofreturn,and 6. Modifedinternalrateofreturn.Assumearequiredrateofreturnof6%andareinvestmentrateof6%.
344 VALUATIONANDANALYSISTOOLS THEBOTTOMLINE Capitalbudgetinginvolvesallocatingcapitalamonglong-livedinvest-mentprojects.Capitalbudgetingrequiresestimatingtheincrementalcashfowsthattheprojectisexpectedtogenerate,andthenapplyingtechniquessuchasthenetpresentvalueortheinternalrateofreturntoevaluatethecashfowsanddeterminewhethertheinvestmentintheprojectisconsistentwithmaximizingowners’wealth. Thekeytoevaluatingcashfowsistoidentifyhowthecompany’scashfowschangeiftheinvestmentismade.Thisrequiresestimat-ingcashfowspertainingtotheacquisitionandeventualdisposalofthecapitalprojectassets,aswellasthechangeinthecompany’soperatingcashfows. Themethodsavailabletoevaluateacapitalprojectincludethepaybackperiod,thediscountedpaybackperiod,thenetpresentvalue,theprof-itabilityindex,theinternalrateofreturn,andthemodifedinternalrateofreturn. Thepreferredmethodofevaluatingcapitalprojectsinthenetpresentvaluemethod,thoughincertaincircumstanceswewouldarriveatthesamedecisionusingothermethods,suchastheinternalrateofreturn. SOLUTIONSTOTRYIT!PROBLEMS DispositionCashFlows,UsingStraight-Line Bookvalue(BV)atthetimeofsale = $500,000 × (1 − 0 . 25 − 0 . 25) = $250,000Loss = $100,000 − 250,000 =− $150,000Taxbeneft = 0 . 35 × $150,000 = $52,500CF = $100,000 + 52,500 = $152,500 DispositionCashFlows,UsingMACRS Bookvalue(BV)atthetimeofsale = $500,000 × (1 − 0 . 3333 − 0 . 4445) = $111,100Loss = $100,000 − 111,100 =− $11,000Taxbeneft = 0 . 35 × $11,100 = $3,885CF = $100,000 + 3,885 = $103,885
CapitalBudgeting 345 ChangeinExpenses Cashfow =− $50,000 + 20,000 =− $30,000 NPV&PI NPV =− $195 . 34PI = 0 . 9805 IRR IRR = 17 . 082% Acme.com Paybackperiod6yearsDiscountedpaybackperiod9yearsNetpresentvalue$197,928Proftabilityindex1.082Internalrateofreturn8.009%Modifedinternalrateofreturn6.8412% QUESTIONS 1. Ifaprojectdoesnotaffectacompany’srevenues,butreducesitscosts,howcanthisaffectthevalueofthecompany? 2. Whatisadepreciationtaxshield,andhowdoesthisaffectacapitalbudgetingdecision? 3. Ifacompanyismakinganinvestmentdecisiontouseafacilitythatiscurrentlyidle,howdoesthecostofthisfacilityenterintothedecision? 4. Ifacapitalprojecthasapositivenetpresentvalue,doesitpaybackintermsofdiscountedcashfows?Explain. 5. Ifacompanysellsanassetforlessthanitsoriginalcost,butmorethanitsbookvalue,howisthatgainclassifedandtaxed? 6. Ifacompanychoosestousestraight-linedepreciationinsteadofMACRSdepreciationforanasset,howdoesthisdecisionaffecttheproftabilityoftheproject? 7. Ifacompanyisdecidingbetweentwoprojects,andcanonlyselectoneofthetwoprojects,whatevaluationtechniquesshouldthiscompanyuseintheanalysisoftheseprojects?
346 VALUATIONANDANALYSISTOOLS 8. Suppose,whenevaluatingtwomutuallyexclusiveprojects,thecompanymakesthevalue-maximizingdecisiontoselecttheonewiththelowerinternalrateofreturn.Whatdoesthistellyouregardingtherelationbetweenthediscountrateandthecross-overrate? 9. Whenselectingcapitalprojectsandthereisalimittothecapitalbudget,whichevaluationtechniquesareappropriatetouse? 10. Thenetpresentvaluemethodandtheinternalrateofreturnmethodmayproducedifferentdecisionswhenselectingamongmutuallyexclusiveprojects.Whatisthesourceofthisconfict? 11. Classifyeachofthefollowingprojectsforatoymanufacturerintooneofthethreecategories:replacement,newproductormarket,ormandated,bycheckingtheappropriatebox: NewProductReplacementorMarketMandated Openingaretailoutlet Introducinganewlineofdolls Introducinganewactionfgureinanexistinglineofactionfgures Addingpollutioncontrolequipmenttoavoidenvironmentalfnes Computerizingthedollmoldingequipment Introducingachild’sversionofanexistingadultboardgame 12. Ashoemanufacturerisconsideringintroducinganewlineofboots.Whenevaluatingtheincrementalrevenuesfromthisnewline,whatshouldbeconsidered? 13. ThePittsburghSteelCompanyisconsideringtwodifferentwiresolder-ingmachines.Machine1hasaninitialcostof$100,000,costs$20,000tosetup,andisexpectedtobesoldfor$20,000after10years.Ma-chine2hasaninitialcostof$80,000,costs$30,000tosetup,andisexpectedtobesoldfor$10,000after10years.Bothmachineswouldbedepreciatedover10yearsusingstraight-linedepreciation.ThecompanyPittsburghhasataxrateof35%. a. Whatarethecashfowsrelatedtotheacquisitionofeachmachine? b. Whatarethecashfowsrelatedtothedispositionofeachmachine?
CapitalBudgeting 347 14. ThepresidentofFly-by-NightAirlineshasaskedyoutoevaluatetheproposedacquisitionofanewjet.Thejet’spriceis$40million,anditisclassifedinthe10-yearMACRSclass.Thepurchaseofthejetwouldrequireanincreaseinnetworkingcapitalof$200,000.Thejetwouldincreasethefrm’sbefore-taxrevenuesby$20millionperyear,butwouldalsoincreaseoperatingcostsby$5millionperyear.Thejetisexpectedtobeusedforthreeyearsandthensoldfor$25million.Thefrm’smarginaltaxrateis40%. a. Whatistheamountoftheinvestmentoutlayrequiredatthebegin-ningoftheproject? b. Whatistheamountoftheoperatingcashfoweachyear? c. Whatistheamountofthenonoperatingcashfowinthethirdyear? d. Whatistheamountofthenetcashfowforeachyear? 15. Supposeyoucalculateaproject’snetpresentvaluetobe$10million.Whatdoesthismean? 16. Supposeyoucalculateaproject’sproftabilityindextobe1.3.Whatdoesthismean? 17. Supposeyoucalculateaproject’snetpresentvaluetobe$30million.Iftherequiredoutlayforthisprojectis$100million,whatistheproject’sproftabilityindex? 18. Youareevaluatinganinvestmentprojectwiththefollowingcashfows: PeriodCashFlow 0 − $100,000135,000235,000335,000435,000 Calculatethefollowing: a. Paybackperiod b. Discountedpaybackperiod,assuminga10%costofcapital c. Discountedpaybackperiod,assuminga16%costofcapital d. Netpresentvalue,assuminga10%costofcapital e. Netpresentvalue,assuminga16%costofcapital f. Proftabilityindex,assuminga10%costofcapital g. Proftabilityindex,assuminga16%costofcapital h. Internalrateofreturn i. Modifedinternalrateofreturn,assumingreinvestmentat0% j. Modifedinternalrateofreturn,assumingreinvestmentat10%
348 VALUATIONANDANALYSISTOOLS 19. Supposeyouareevaluatingtwomutuallyexclusiveprojects,Thing1andThing2,withthefollowingcashfows: End-of-YearCashFlows YearThing1Thing2 0 − $10,000 − $10,00013,293023,293033,293043,29314,641 a. Ifthecostofcapitalonbothprojectsis5%,whichproject,ifany,wouldyouchoose?Why? b. Ifthecostofcapitalonbothprojectsis8%,whichproject,ifany,wouldyouchoose?Why? c. Ifthecostofcapitalonbothprojectsis11%,whichproject,ifany,wouldyouchoose?Why? d. Ifthecostofcapitalonbothprojectsis14%,whichproject,ifany,wouldyouchoose?Why? e. Atwhatdiscountratewouldyoubeindifferentwhenchoosingbe-tweenThing1andThing2? f. Onthesamegraph,drawtheinvestmentproflesofThing1andThing2,indicatingthefollowingitems: Cross-overdiscountrate NPVofThing1ifthecostofcapitalis5% NPVofThing2ifthecostofcapitalis5% IRRofThing1 IRRofThing2
CHAPTER 14 DerivativesforControllingRisk SARBANES:“WarrenBuffetthaswarnedusthatderivativesaretimebombs,bothforthepartiesthatdealinthemandtheeconomicsystem.The FinancialTimes hassaidsofar,therehasbeennoexplosion,buttherisksofthisfastgrowingmarketremainreal.Howdoyourespondtotheseconcerns?”BERNANKE:“Iammoresanguineaboutderivativesthanthepositionyouhavejustsuggested.Ithink,generallyspeaking,theyareveryvaluable.Theyprovidemethodsbywhichriskscanbeshared,sliced,anddiced,andgiventothosemostwillingtobearthem.Theyadd,Ibelieve,tothefexibilityofthefnancialsysteminmanydifferentways.Withrespecttotheirsafety,derivatives,forthemostpart,aretradedamongverysophisticatedfnancialinstitutionsandindividualswhohaveconsiderableincentivetounderstandthemandtousethemproperly.TheFederalReserve’sresponsibilityistomakesurethattheinstitutionsitregulateshavegoodsystemsandgoodproceduresforensuringthattheirderivativesportfoliosarewellmanagedanddonotcreateexcessiveriskintheirinstitutions.” —InterchangebetweenSenatorPaulSarbanesandFederalReserveBankChairmanBenBernanke,SenateBankingCommitteehearing,November2005 D erivativeinstrumentsplayanimportantroleinfnancialmarketsaswellascommoditymarketsbyallowingmarketparticipantstocontroltheirexposuretodifferenttypesofrisk.Inthischapter,wedescribefourtypesofderivativecontracts: 1. Futures, 2. Forwards, 349
350 VALUATIONANDANALYSISTOOLS 3. Options,and 4. Swaps.Aswediscussthesederivatives,youwilllikelybegintoseethecommonthreadsamongthem.First,theseinstrumentsderivetheirvaluefromanothersecurityorasset,whichwerefertoasthe underlyingasset ,orsimplyasthe underlying .Second,thevalueofaderivativeisdependentnotonlyonthevalueoftheunderlying,butalsoonthefeaturesofthederivativeitself. Derivativesarelikeprescriptiondrugs.Theycanbebenefcialwhenusedappropriately,buttheymaybehabit-formingandcarrytheriskofunpleasantsideeffects.—DavidLitvack, Risk ,April2006,p.20 FUTURESANDFORWARDCONTRACTS Futuresandforwardcontractsarecontractsbetweenabuyerandasellerforthefuturedelivery,ataspecifedpointintime,ofaspecifedcommodity,security,orotherasset.Futurescontractsarestandardizedagreementsastothedeliverydate(ormonth)andqualityofthedeliverable,andaretradedonorganizedexchanges.Aforwardcontractdiffersinthatitisusuallynon-standardized(thatis,thetermsofeachcontractarenegotiatedindividuallybetweenbuyerandseller).Wewillfrstlookatfuturescontracts,andthenfocusonforwardcontracts. FuturesContracts A futurescontract isalegalagreementbetweenabuyerandasellerinwhich: Thebuyeragreestotakedeliveryofsomethingataspecifedpriceattheendofadesignatedperiodoftime. Theselleragreestomakedeliveryofsomethingataspecifedpriceattheendofadesignatedperiodoftime.Ofcourse,noonebuysorsellsanythingwhenenteringintoafuturescontract.Rather,thosewhoenterintoacontractagreetobuyorsellaspecifcamountofaspecifcitemataspecifedfuturedate.Whenwespeakofthe“buyer”orthe“seller”ofacontract,wearesimplyadoptingthejargonofthefuturesmarket,whichreferstopartiesofthecontractintermsofthefutureobligationtheyarecommittedto.Let’slookcloselyatthekeyelementsofthiscontract.Thepriceatwhichthepartiesagreetotransactinthefutureisthe futuresprice. Thedesignated
DerivativesforControllingRisk 351 dateatwhichthepartiesmusttransactisthe settlementdate or deliverydate. The“something”thatthepartiesagreetoexchangeistheunderlying.Werefertothepartyontheoppositesideofthetransactionasthe counterparty .Therefore,thebuyeristhecounterpartyoftheseller,andtheselleristhecounterpartytothebuyer.Toillustrate,supposeafuturescontractistradedonanexchangewheretheunderlyingtobeboughtorsoldisassetXYZ,andthesettlementisthreemonthsfromnow.AssumefurtherthatBertbuysthisfuturescontract,andErniesellsthisfuturescontract,andthepriceatwhichtheyagreetotransactinthefutureis$100.Then$100isthefuturesprice.Atthesettlementdate,ErniewilldeliverassetXYZtoBert.BertwillgiveErnie$100,thefuturesprice.Whenaninvestortakesapositioninthemarketbybuyingafuturescontract(oragreeingtobuyatthefuturedate),theinvestorissaidtobeina longposition ortobe longfutures. If,instead,theinvestor’sopeningpositionisthesaleofafuturescontract(whichmeansthecontractualobligationtosellsomethinginthefuture),theinvestorissaidtobeina shortposition or shortfutures. Thebuyerofafuturescontractrealizesaproftifthefuturespriceincreases;thesellerofafuturescontractrealizesaproftifthefuturespricedecreases.Forexample,supposethatonemonthafterBertandErnietaketheirpositionsinthefuturescontract,thefuturespriceofassetXYZincreasesto$120.Bert,thebuyerofthefuturescontract,couldthensellthefuturescontractandrealizeaproftof$20.Effectively,atthesettlementdate,hehasagreedtobuyassetXYZfor$100andhasagreedtosellassetXYZfor$120.Ernie,thesellerofthefuturescontract,willrealizealossof$20.Ifthefuturespricefallsto$40andErniebuysbackthecontractat$40,herealizesaproftof$60becauseheagreedtosellassetXYZfor$100andnowcanbuyitfor$40.Bertwouldrealizealossof$60.Thus,ifthefuturespricedecreases,thebuyerofthefuturescontractrealizesalosswhilethesellerofthefuturescontractrealizesaproft: PriceofUnderlyingatSettlementIs$120PriceofUnderlyingatSettlementIs$60 BertErnieBertErnie Selltheunderlying$120$100$60$100Buytheunderlying100 120 100 60 Proftorloss$20 − $20 − $40$40
352 VALUATIONANDANALYSISTOOLS LiquidatingaPosition MostfnancialfuturescontractshavesettlementdatesinthemonthsofMarch,June,September,orDecember.Thismeansthatatapredeterminedtimeinthesettlementmonth,thecontractstopstrading,andapriceisdeterminedbytheexchangeforsettlementofthecontract.Forexample,onJanuary4,200X,supposeBertbuysandErniesellsafuturescontractthatsettlesonthethirdFridayofMarchof200X.Then,onthatdate,BertandErniemustperform—BertagreeingtobuyassetXYZat$100,andErnieagreeingtosellassetXYZat$100.Theexchangewilldetermineasettlementpriceforthefuturescontractforthatspecifcdate.Forexample,iftheexchangedeterminesasettlementpriceof$130,thenBerthasagreedtobuyassetXYZfor$100butcansettlethepositionfor$130,therebyrealizingaproftof$30.Erniewouldrealizealossof$30.InsteadofBertorErnieenteringintoafuturescontractonJanuary4,200XthatsettlesinMarch,theycouldhaveselectedasettlementinJune,September,orDecember.Thecontractwiththeclosestsettlementdateiscalledthe nearbyfuturescontract. The nextfuturescontract istheonethatsettlesjustafterthenearbycontract.Thecontractfarthestawayintimefromsettlementiscalledthe mostdistantfuturescontract. Apartytoafuturescontracthastwochoicesregardingtheliquidationoftheposition.First,thepositioncanbeliquidatedpriortothesettlementdate.Forthispurpose,thepartymusttakeanoffsettingpositioninthesamecontract.Forthebuyerofafuturescontract,thismeanssellingthesamenumberofidenticalfuturescontracts;forthesellerofafuturescon-tract,thismeansbuyingthesamenumberofidenticalfuturescontracts.Anidenticalcontractmeansthecontractforthesameunderlyingandthesamesettlementdate.So,forexample,ifBertbuysonefuturescontractforassetXYZwithsettlementinMarch200XonJanuary4,200X,andwantstoliquidateapositiononFebruary14,200X,hecansellonefuturescontractforassetXYZwithsettlementinMarch200X.Similarly,ifErniesellsonefuturescontractforassetXYZwithsettlementinMarch200XonJanuary4,200X,andwantstoliquidateapositiononFebruary22,200X,hecanbuyonefuturescontractforassetXYZwithsettlementinMarch200X.AfuturescontractonassetXYZthatsettlesinJune200XisnotthesamecontractasafuturescontractonassetXYZthatsettlesinMarch200X.Thealternativeistowaituntilthesettlementdate.Atthattime,thepartypurchasingafuturescontractacceptsdeliveryoftheunderlying;thepartythatsellsafuturescontractliquidatesthepositionbydeliveringtheunder-lyingattheagreeduponprice.Forsomefuturescontractsthatweshalldescribelaterinlaterchapters,settlementismadeincashonly.Suchcon-tractsarereferredtoas cashsettlementcontracts.
DerivativesforControllingRisk 353 Ausefulstatisticformeasuringtheliquidityofacontractisthenumberofcontractsthathavebeenenteredintobutnotyetliquidated.Thisfgureiscalledthecontract’s openinterest. Anexchangereportsanopeninterestfgureforeveryfuturescontractstradedontheexchange. TheRoleoftheClearinghouse Associatedwitheveryfuturesexchangeisaclearinghouse,whichperformsseveralfunctions.Oneofthesefunc-tionsistoguaranteethatthetwopartiestothetransactionwillperform.Becauseoftheclearinghouse,thetwopartiesneednotworryaboutthef-nancialstrengthandintegrityoftheotherpartytakingtheoppositesideofthecontract.Afterinitialexecutionofanorder,therelationshipbe-tweenthetwopartiesends.Theclearinghouseinterposesitselfasthebuyerforeverysaleandasthesellerforeverypurchase.Thus,thetwopar-tiesarethenfreetoliquidatetheirpositionswithoutinvolvingtheotherpartyintheoriginalcontract,andwithoutworrythattheotherpartymaydefault. MarginRequirements Whenapositionisfrsttakeninafuturescontract,theinvestormustdepositaminimumdollaramountpercontractasspecifedbytheexchange.Thisamount,called initialmargin, isrequiredasadepositforthecontract.Theinitialmarginmaybeintheformofaninterest-bearingsecurity,suchasaU.S.Treasurybill.Theinitialmarginisplacedinanaccount,andtheamountinthisaccountisreferredtoasthe investor’sequity. Asthepriceofthefuturescontractfuctuateseachtradingday,thevalueoftheinvestor’sequityinthepositionchanges.Attheendofeachtradingday,theexchangedeterminesthe“settlementprice”forthefuturescontract.Thesettlementpriceisdifferentfromtheclosingprice,whichisthepriceofthesecurityinthefnaltradeoftheday(wheneverthattradeoccurredduringtheday).Bycontrast,thesettlementpriceisthatvaluetheexchangeconsiderstoberepresentativeoftradingattheendoftheday.Theexchangeusesthesettlementpricetomarktomarkettheinvestor’sposition,sothatanygainorlossfromthepositionisquicklyrefectedintheinvestor’sequityaccount.A maintenancemargin istheminimumlevel(specifedbytheexchange)bywhichaninvestor’sequitypositionmayfallasaresultofunfavorablepricemovementsbeforetheinvestorisrequiredtodepositadditionalmargin.Themaintenancemarginrequirementisadollaramountthatislessthantheinitialmarginrequirement.Itsetsthefoorthattheinvestor’sequityaccountcanfalltobeforetheinvestorisrequiredtofurnishadditionalmargin.Theadditionalmargindeposited,called variationmargin, isanamountnecessarytobringtheequityintheaccountbacktoitsinitialmarginlevel.Unlikeinitial
354 VALUATIONANDANALYSISTOOLS margin,variationmarginmustbeincash,notinterest-bearinginstruments.Anyexcessmarginintheaccountmaybewithdrawnbytheinvestor.Ifapartytoafuturescontractwhoisrequiredtodepositavariationmarginfailstodosowithin24hours,thefuturespositionisliquidatedbytheclearinghouse. 1 Regardingthevariationmargin,weshouldnotetwothings:First,thevariationmarginmustbecash.Second,theamountofvariationmarginrequiredistheamounttobringtheequityuptotheinitialmargin,notthemaintenancemargin. Leveraging Whentakingapositioninafuturescontract,apartyneednotputuptheentireamountoftheinvestment.Instead,theexchangerequiresthatonlytheinitialmarginbeinvested.Toseethecrucialconsequencesofthisfact,supposeBerthas$100andwantstoinvestinassetXYZbecausehebelievesitspricewillappreciate.IfassetXYZissellingfor$100,hecanbuyoneunitoftheassetinthecashmarket,themarketwheregoodsaredelivereduponpurchase.HispayoffwillthenbebasedonthepriceactionofoneunitofassetXYZ.SupposethattheexchangewherethefuturescontractforassetXYZistradedrequiresaninitialmarginofonly5%,whichinthiscasewouldbe$5.ThenBertcanpurchase20contractswithhis$100investment.(ThisexampleignoresthefactthatBertmayneedfundsforvariationmargin.)Hispayoffwillthendependonthepriceactionof20unitsofassetXYZ.Thus,hecanleveragetheuseofhisfunds.(Thedegreeofleverageequals1/marginrate.Inthiscase,thedegreeofleverageequals1/0.05,or20.)Whilethedegreeofleverageavailableinthefuturesmarketvariesfromcontracttocontract,astheinitialmarginrequirementvaries,theleverageattainableisconsiderablygreaterthaninthecashmarket.Atfrst,theleverageavailableinthefuturesmarketmaysuggestthatthemarketbeneftsonlythosewhowanttospeculateonpricemovements.Thisisnottrue.Asweshallsee,futuresmarketscanbeusedtoreduce 1 Althoughthereareinitialandmaintenancemarginrequirementsforbuyingse-curitiesonmargin,theconceptofmargindiffersforsecuritiesandfutures.Whensecuritiesareacquiredonmargin,thedifferencebetweenthepriceofthesecurityandtheinitialmarginisborrowedfromthebroker.Thesecuritypurchasedservesascollateralfortheloan,andtheinvestorpaysinterest.Forfuturescontracts,theinitialmargin,ineffect,servesas“good-faith”money,anindicationthattheinvestorwillsatisfytheobligationofthecontract.Normally,nomoneyisborrowedbytheinvestor.
DerivativesforControllingRisk 355 pricerisk.Withouttheleveragepossibleinfuturestransactions,thecostofreducingpriceriskusingfutureswouldbetoohighformanymarketparticipants. ForwardContracts A forwardcontract ,justlikeafuturescontract,isanagreementforthefuturedeliveryoftheunderlyingataspecifedpriceattheendofadesignatedperiodoftime.Unlikefutures,thereisnoclearinghouse,andsecondarymarketsareoftennonexistentorextremelythin.Aforwardcontractisanover-the-counterinstrument.Becausethereisnoclearinghousethatguaranteestheperformanceofacounterpartyinaforwardcontract,thepartiestoaforwardcontractareexposedto counterpartyrisk, theriskthattheotherpartytothetransactionwillfailtoperform.Futurescontractsaremarkedtomarketattheendofeachtradingday,whileforwardcontractsusuallyarenot.Consequently,futurescontractsaresubjecttointerimcashfowsbecauseadditionalmarginmayberequiredinthecaseofadversepricemovementsorbecausecashmaybewithdrawninthecaseoffavorablepricemovements.Aforwardcontractmayormaynotbemarkedtomarket.Wherethecounterpartiesaretwohigh-credit-qualityentities,thetwopartiesmayagreenottomarkpositionstomarket.However,ifoneorbothofthepartiesareconcernedwiththecounterpartyriskoftheother,thenpositionsmaybemarkedtomarket.Thus,whenaforwardcontractismarkedtomarket,thereareinterimcashfowsjustaswithafuturescontract.Whenaforwardcontractisnotmarkedtomarket,thentherearenointerimcashfows.Otherthanthesedifferences,whatwesaidaboutfuturescontractsap-pliestoforwardcontractstoo. TheBasicsofPricingFuturesandForwardContracts Whenusingderivatives,amarketparticipantshouldunderstandthebasicprinciplesofhowtheyarevalued.Whiletherearemanymodelsthathavebeenproposedforvaluingfnancialinstrumentsthattradeinthecash(spot)market,theval-uationofallderivativemodelsarebasedonarbitragearguments.Basically,thisinvolvesdevelopingastrategyoratradewhereinapackageconsistingofapositionintheunderlying(thatis,theunderlyingassetorinstrumentforthederivativecontract)andborrowingorlendingsoastogeneratethesamecashfowprofleasthederivative.Thevalueofthepackageisthenequaltothetheoreticalpriceofthederivative.Ifthemarketpriceofthederiva-tivedeviatesfromthetheoreticalprice,thentheactionsofarbitrageurswill
356 VALUATIONANDANALYSISTOOLS drivethemarketpriceofthederivativetowarditstheoreticalpriceuntilthearbitrageopportunityiseliminated.Indevelopingastrategytocaptureanymispricing,certainassump-tionsaremade.Whentheseassumptionsarenotsatisfedintherealworld,thetheoreticalpricecanonlybeapproximated.Moreover,acloseexam-inationoftheunderlyingassumptionsnecessarytoderivethetheoreticalpriceindicateshowapricingformulamustbemodifedtovaluespecifccontracts.Herewedescribehowfuturesandforwardarevalued.Thepricingoffuturesandforwardcontractsissimilar.Iftheunderlyingassetforbothcontractsisthesame,thedifferenceinpricingisduetodifferencesinfeaturesofthecontractthatmustbedealtwithbythepricingmodel.Weillustratethebasicmodelforpricingfuturescontract.By“basic,”wemeanthatweareextrapolatingfromthenuisancesoftheunderlyingforaspecifccontract.Theissuesassociatedwithapplyingthebasicpricingmodeltosomeofthemorepopularfuturescontractsarenotdescribedhere.Moreover,whilethemodeldescribedhereissaidtobeamodelforpricingfutures,technically,itisamodelforpricingforwardcontractswithnomark-to-marketrequirements.Ratherthanderivingtheformulaalgebraically,wedemonstratethebasicpricingmodelusinganexample.Wemakethefollowingsixassumptionsforafuturescontractthathasnoinitialandvariationmargin: 1. ThepriceofAssetUinthecashmarketis$100. 2. ThereisaknowncashfowforAssetUoverthelifeofthefuturescontract. 3. ThecashfowforAssetUis$8peryearpaidquarterly($2perquarter). 4. Thenextquarterlypaymentisexactlythreemonthsfromnow. 5. Thefuturescontractrequiresdeliverythreemonthsfromnow. 6. Thecurrentthree-monthinterestrateatwhichfundscanbelentorborrowedis4%peryear.Theobjectiveistodeterminewhatthefuturespriceofthiscontractshouldbe.Todoso,supposethatthefuturespriceinthemarketis$105.Let’sseeifthatisthecorrectprice.Wecancheckthisbyimplementingthefollowingsimplestrategy: Sellthefuturescontractat$105. PurchaseAssetUinthecashmarketfor$100. Borrow$100forthreemonthsat4%peryear($1perquarter).
DerivativesforControllingRisk 357 ThepurchaseofAssetUisaccomplishedwiththeborrowedfunds.Hence,thisstrategydoesnotinvolveanyinitialcashoutlay.Attheendofthreemonths,thefollowingoccurs: $2isreceivedfromholdingAssetU. AssetUisdeliveredtosettlethefuturescontract. Theloanisrepaid.Thisstrategyresultsinthefollowingoutcome,indicatingwhathappensnowandlater(thatis,threemonthsfromnow): NowLater ActionCashFlowActionCashFlow Sellfutures$0Payoffloan − $100Borrow$100100Interestonloan − 1BuyAssetU − 100DeliverAssetU105 Receivepayment2 Cashfow$0Cashfow$6Theproftof$6fromthisstrategyisguaranteedregardlessofwhatthecashpriceofAssetUisthreemonthsfromnow.Thisisbecauseintheprecedinganalysisoftheoutcomeofthestrategy,thecashpriceofAssetUthreemonthsfromnowneverenterstheanalysis.Moreover,thisproftisgeneratedwithnoinvestmentoutlay;thefundsneededtoacquireAssetUareborrowedwhenthestrategyisexecuted.Infnancialterms,theproftinthestrategywehavejustillustratedarisesfromarisklessarbitragebetweenthepriceofAssetUinthecashmarketandthepriceofAssetUinthefuturesmarket.Inawell-functioningmarket,arbitrageurswhocouldrealizethisrisklessproftforazeroinvestmentwouldimplementthestrategydescribedabove.BysellingthefuturesandbuyingAssetUinordertoimplementthestrategy,thiswouldforcethefuturespricedownsothatatsomepriceforthefuturescontract,thearbitrageproftiseliminated.Thisstrategythatresultedinthecapturingofthearbitrageproftisreferredtoasa cash-and-carrytrade .Thereasonforthisnameisthatim-plementationofthestrategyinvolvesborrowingcashtopurchasetheun-derlyingand“carrying”thatunderlyingtothesettlementdateofthefuturescontract.
358 VALUATIONANDANALYSISTOOLS Fromthecash-and-carrytradeweseethatthefuturespricecannotbe$105.Supposeinsteadthatthefuturespriceis$95ratherthan$105.Let’strythefollowingstrategytoseeifthatpricecanbesustainedinthemarket: Buythefuturescontractat$95. Sell(short)AssetUfor$100. Invest(lend)$100forthreemonthsat1%peryear.Weassumeonceagainthatinthisstrategythereisnoinitialmarginandvariationmarginforthefuturescontract.Inaddition,weassumethatthereisnocosttosellingtheassetshortandlendingthemoney.Giventheseassumptions,thereisnoinitialcashoutlayforthestrategyjustaswiththecash-and-carrytrade.Thisstrategyproducesthefollowingnowandlater,attheendofthreemonths: NowLater ActionCashFlowActionCashFlow Buyfutures$0Receiveloanrepayment$100Lend$100 − 100Receiveinterestonloan1SellAssetU + 100BuyAssetUtocovershortsale − 95 Makepayment − 2 Cashfow$0Cashfow$4Aswiththecash-and-carrytrade,the$4proftfromthisstrategyisarisklessarbitrageproft.Thisstrategyrequiresnoinitialcashoutlay,butwillgenerateaproftwhateverthepriceofAssetUisinthecashmarketatthesettlementdate.Inreal-worldmarkets,thisopportunitywouldleadarbi-trageurstobuythefuturescontractandshortAssetU.Theimplementationofthisstrategywouldbetoraisethefuturespriceuntilthearbitrageproftdisappeared.Thisstrategytocapturethearbitrageproftisknownasa reversecash-and-carrytrade .Thatis,withthisstrategy,theunderlyingissoldshortandtheproceedsreceivedfromtheshortsaleareinvested.Wecanseethatthefuturespricecannotbe$95or$105.Whatisthetheoreticalfuturespricegiventheassumptionsinourillustration?AsweshowinExhibit14.1,ifthefuturespriceis$99thereisnoopportunityforanarbitrageproft.Thatis,neitherthecash-and-carrytradenorthereversecash-and-carrytradegeneratesanarbitrageproft.
DerivativesforControllingRisk 359 EXHIBIT14.1 CashFlowWhenThereIsaNo-ArbitrageFuturesPrice CashandCarryCashFlowsiftheFuturesPriceIs$99 NowLater ActionCashFlowActionCashFlow Sellfutures$0Payoffloan − $100Borrow$100100Interestonloan − 1BuyAssetU − 100DeliverAssetU99 Receivepayment2 Cashfow$0Cashfow$0 ReverseCashandCarryCashFlowiftheFuturesPriceIs$99 NowLater ActionCashFlowActionCashFlow Buyfutures$0Receiveloanrepayment$100SellAssetU + 100Receiveinterestonloan1Lend$100 − 100BuyAssetUtocovershortsale − 99 Makepayment − 2 Cashfow$0Cashfow$0 Ingeneral,theformulafordeterminingthetheoreticalpricegiventheassumptionsofthemodelis:Theoreticalfuturesprice − Cashmarketprice + Cashmarketprice × Financingcost − Cashyield (14.1)Intheformulagivenbyequation(14.1),“Financingcost”istheinterestratetoborrowfundsand“Cashyield”isthepaymentreceivedfromin-vestingintheassetasapercentageofthecashprice.Inourillustration,thefnancingcostis1%andthecashyieldis2%.Inourillustration,becausethecashpriceofAssetUis$100,thetheo-reticalfuturespriceis:$100 + [$100 × (1% − 2%)] = $99Thefuturepricecanbeaboveorbelowthecashpricedependingonthedifferencebetweenthefnancingcostandcashyield.Thedifferencebetweentheseratesisthe netfnancingcost .Amorecommonlyusedtermforthenet
360 VALUATIONANDANALYSISTOOLS fnancingcostisthe costofcarry ,or,simply, carry . Positivecarry meansthatthecashyieldexceedsthefnancingcost. 2 Negativecarry meansthatthefnancingcostexceedsthecashyield.Asaresult, Positivecarry Futures price < Cash priceFutures price > Cash priceFutures price = Cash price NegativecarryZerocarry Notethatatthesettlementdateofthefuturescontract,thefuturespricemustequalthecashmarketprice.Thereasonisthatafuturescontractwithnotimeleftuntildeliveryisequivalenttoacashmarkettransaction.Thus,asthedeliverydateapproaches,thefuturespriceconvergestothecashmarketprice.Thisfactisevidentfromtheformulaforthetheoreticalfuturespricegivenbyequation(14.1).Thefnancingcostapproacheszeroasthedeliverydateapproaches.Similarly,theyieldthatcanbeearnedbyholdingtheunderlyingapproacheszero.Hence,thecostofcarryapproacheszero,andthefuturespriceapproachesthecashmarketprice. TRYIT!FUTURES Supposeyouborrow$1,000at8%peryearsothatyoucanusethismoneytobuyAssetW.YoualsosellafuturescontractonAssetW,withdeliveryinoneyear. 1. Whattypeoftransactionisthis? 2. Isthisaproftabletransactionifthefuturespriceis$1,010? ACloserLookattheTheoreticalFuturesPrice Inderivingtheoreticalfuturespriceusingthearbitrageargument,wemadeseveralassumptions.Theseassumptions,aswellasthedifferencesincontractspecifcations,result 2 Notethatwhilethedifferencebetweenthefnancingcostandthecashyieldisanegativevalue,carryissaidtobepositive.
DerivativesforControllingRisk 361 inthefuturespriceinthemarketdeviatingfromthetheoreticalfuturespriceasgivenbyequation(14.1).Itmaybepossibletoincorporatetheseinstitutionalandcontractspecifcationdifferencesintotheformulaforthetheoreticalfuturesprice.Ingeneral,however,becauseitisoftentoodiffculttoallowforthesedifferencesinbuildingamodelforthetheoreticalfuturesprice,theendresultisthatonecandevelopbandsorboundariesforthetheoreticalfuturesprice.Solongasthefuturespriceinthemarketremainswithintheband,noarbitrageopportunityispossible.Therearesomeinstitutionalandcontractspecifcationdifferencesthatcausepricestodeviatefromthetheoreticalfuturesprice,asgivenbythebasicpricingmodel: Interimcashfows. Inthederivationofabasicpricingmodel,weassumethatnointerimcashfowsarisebecauseofchangesinfuturesprices(thatis,thereisnovariationmargin).Asnotedearlier,intheabsenceofinitialandvariationmargins,thetheoreticalpriceforthecontractistechnicallythetheoreticalpriceforaforwardcontractthatisnotmarkedtomarket,ratherthanafuturescontract.Inaddition,themodelassumesimplicitlythatanydividendsorcouponinterestpaymentsarepaidatthesettlementdateofthefuturescontractratherthanatanytimebetweeninitiationofthecashpositionandsettlementofthefuturescontract.However,weknowthattheunderlyingforfnancialfuturescontracts(suchasstockindexfuturescontractsandbondfuturescontracts)dohaveinterimcashfows. Differencesinborrowingandlendingrates .Intheformulaforthethe-oreticalfuturesprice,itisassumedinthecash-and-carrytradeandthereversecash-and-carrytradethattheborrowingrateandlendingrateareequal.Typically,however,theborrowingrateishigherthanthelendingrate.Theimpactofthisinequalityisthatthereisabandoffuturesprices;withinthisband,therearenoarbitrageopportunities. Transactioncosts .Thetwostrategiestoexploitanypricediscrepanciesbetweenthecashmarketandtheoreticalpriceforthefuturescontractrequirethearbitrageurtoincurtransactioncosts.Inreal-worldfnan-cialmarkets,thecostsofenteringintoandclosingthecashposition,aswellasround-triptransactioncostsforthefuturescontract,affectthefuturesprice.Asinthecaseofdifferentialborrowingandlend-ingrates,transactioncostswidenthebandsforthetheoreticalfuturesprice. Shortselling .Thereversecash-and-strategytraderequirestheshortsellingoftheunderlying.Itisassumedinthisstrategythattheproceedsfromtheshortsalearereceivedandreinvested.Inpractice,forindividualinvestors,theproceedsarenotreceived,and,infact,theindividual
362 VALUATIONANDANALYSISTOOLS investorisrequiredtodepositmargin(securitiesmarginandnotfuturesmargin)toshortsell.Forinstitutionalinvestors,theunderlyingmaybeborrowed,butthereisacosttoborrowing.Thiscostofborrowingcanbeincorpo-ratedintothemodelbyreducingthecashyieldontheunderlying.Forstrategiesappliedtostockindexfutures,ashortsaleofthecomponentsstocksintheindexmeansthatallstocksintheindexmustbesoldsi-multaneously.Thismaybediffculttodoand,therefore,wouldwidenthebandforthetheoreticalfutureprice. Deliverableisabasketofsecurities .Somefuturescontractshaveastheunderlyingabasketofassetsoranindex,ratherthanasingleasset.Stockindexfuturesarethemostobviousexample. UsingFuturesandForwardContracts Asweexplained,futuresandforwardcontractscanbeusedforleverage.Itisthemisuseofthesecontracts,indeedthemisuseofallderivativesde-scribedinthischapter,bycorporatetreasurersandinvestmentmanagersforspeculativepurposes(i.e.,bettingonsomethingoccurring)thatisoftendiscussedinthemedia.Butderivativesprovideameansforcontrollingrisk,astheillustrationstofollowwillmakeclear.Thefocusofthemediaisonthosecasesofmisusingderivatives,notonhowparticipantsinthefnancialmarkethaveusedderivativestosuccessfullyprotectagainstmajorlossesduetoadversemovementsinprices,foreignexchange,orinterestrates.Itisimportanttonotethatfuturesandforwardcontractsare risk-sharinginstruments .Thismeansthatbothpartiestothetransactionaresharingtheriskassociatedwiththeunderlying.Soiftheunderlyingis,say,acommoditysuchaswheat,thenbothpartiestoatradeareexposedtothepriceriskofwheat.Onepartywillbeexposedtothepriceofwheatdeclining(thelongposition)andtheotherpartywillbeexposedtothepriceofwheatincreasing(theshortposition).Let’scontinuewiththewheatexampleforourfrstapplication.Considertheeconomicexposuretopriceriskbyafarmerwhogrowswheatandafoodmanufacturerthatuseswheattocreateitsproducts.Thefarmerisexposedtotheriskthatthepriceofwheatwilldeclinebythetimethewheatisbroughttomarket.Thefoodmanufacturerisexposedtotheriskthatthepriceofwheatwillincreaseinthefutureandthereforethecostofoneofitsmajorinputswillincrease.Ifboththefarmerandthefoodmanufacturerwantedtobasicallyeliminatetheirrespectiveexposurestothepriceriskassociatedwithwheat,theycandosobyusingfuturescontracts.Thefarmercouldlockinafuturepriceforwheatbybuyingafuturescontract;thefoodmanufacturercouldlockinafuturepriceforwheatbysellingafuturescontract.Thus,
DerivativesforControllingRisk 363 eachpartyhasshiftedtheundesiredpricerisktotheotherparty.Noticethatneitherpartywillbeneftifthereisfavorablepricemovementforwheat.Thatis,ifthepriceofwheatrisesinthefuture,thefarmercannotbeneft;ifthepriceofwheatdeclinesinthefuture,thefoodmanufacturercannotbeneft.Thesamesituationappliestoentitiesthathaveexposuretochangesinaforeigncurrency.Thepriceofaforeigncurrencyisgivenbytheexchangeratebetweentwocurrencies.SupposethetwocurrenciesaretheU.S.dollarandtheeuro.AU.S.manufacturerthatsellsproductsinFranceandispaidineurosbytheFrenchcustomerisconcernedthatthevalueoftheeurowilldecline(i.e.,depreciate)relativetotheU.S.dollar.Incontrast,anotherU.S.manufacturerwhobuysmaterialfromafrminSpainandmustpayforthatmaterialineurosisconcernedthattheeurowillincrease(i.e.,appreciate)relativetotheU.S.dollar.Toprotectagainsttheadversefuctuationofthecurrency,thetwoU.S.manufacturingfrmscantaketheappropriatepositioninforeignexchangefuturesorforwardcontracts.Asourfnalapplication,supposeacorporatetreasurerknowsthat$200millionmustbeborrowedsixmonthsfromnow.Theconcernthatthecorporatetreasurerhasisthatinthefutureinterestratesmayrise,makingthecostofborrowingmoreexpensive.Supposethattheportfoliomanagerofapensionfundknowsthatsixmonthsfromnowtherewillbe$200millionincashinfowstoinvestandplanstoinvestthatsuminbonds.Theriskfacedbytheportfoliomanageristhatinterestrateswilldeclineandthereforetheportfoliowillearnalowerinterestrateonthefundsinvestedsixmonthsfromnow.Again,boththecorporatetreasurerandtheportfoliomanagerareexposedtoanunfavorablemovementinsomething;thatsomethinginthiscaseisinterestrates.Butonceagainwhatisanadversemovementtoonepartyisafavorableonetotheotherparty.Toprotectagainstanadversemovementininterestrates,thereareinterestratefuturescontractsthatthetwopartiescanemploy. OPTIONS Wenowturntoanotherderivativeinstrument,anoptioncontract.An option isacontractinwhichtheoptionsellergrantstheoptionbuyertherighttoenterintoatransactionwiththesellertoeitherbuyorsellanunderlyingassetataspecifedpriceonorbeforeaspecifeddate. BasicFeaturesofOptions Aninvestorwhobuysanoptionhasthechoiceofexercisingit—thatis,buyingtheunderlyingasset—ornot.Unlikeafuturescontract,theinvestor
364 VALUATIONANDANALYSISTOOLS inanoptioncansimplynotdoanything,lettingtheoptionexpire.Theoptionsellergrantsthisrightinexchangeforacertainamountofmoney,whichisthe optionpremium or optionprice .Theoptionselleristhe optionwriter ,whiletheoptionbuyeristhe optionholder .Thespecifedpricethattheoptionbuyermaybuyorselltheunderlyingisthe strikeprice or exerciseprice whichisfxedintheoptioncontract.Thespecifeddateistheexpirationdate.Theassetthatisthesubjectoftheoptionistheunderlying,andtheunderlyingcanbeanindividualstock,astockindex,abond,orevenanotherderivativeinstrument,suchasafuturescontract.Theoptionwritercangranttheoptionholderoneoftworights.Iftherightistopurchasetheunderlying,theoptionisa calloption .Iftherightistoselltheunderlying,theoptionisa putoption .Wecancategorizeanoptionaccordingtowhenitmaybeexercisedbythebuyer.Thisistheexercisestyle.A Europeanoption canonlybeexercisedattheexpirationdateofthecontract.An Americanoption ,incontrast,canbeexercisedanytimeonorbeforetheexpirationdate.Anoptionthatcanbeexercisedbeforetheexpirationdate,butonlyonspecifeddatesiscalleda Bermudaoption oran Atlanticoption .Thetermsoftheexchangearerepresentedbythecontractunitandarestandardizedformostcontracts.Theoptionholderentersintothecontractwithanopeningtransaction.Subsequently,theoptionholderthenhasthechoicetoexerciseortoselltheoption.Thesaleofanexistingoptionbytheholderisa closingsale .Let’suseanillustrationtodemonstratethefundamentaloptioncontract.SupposethatJackbuysacalloptionfor$3(theoptionprice)withthefollowingterms: FeatureSpecifcation UnderlyingOneunitofassetABCExerciseprice$100Expirationdate3monthsfromnowExercisestyleAmericanAtanytimeuptoandincludingtheexpirationdate,JackcandecidetobuyfromthewriterofthisoptiononeunitofassetABC,forwhichhewillpayapriceof$100.IfitisnotbenefcialforJacktoexercisetheoption,hewillnot;we’llexplainshortlyhowhedecideswhenitwillbebenefcial.WhetherJackexercisestheoptionornot,the$3hepaidforitwillbekeptbytheoptionwriter.
DerivativesforControllingRisk 365 IfJackbuysaputoptionratherthanacalloption,thenhewouldbeabletosellassetABCtotheoptionwriterforapriceof$100.Likethecalloption,hewillonlyexercisetheputoptionifitisbenefcialtodoso.Themaximumamountthatanoptionbuyercanloseistheop-tionprice.Themaximumproftthattheoptionwritercanrealizeistheoptionprice.Theoptionbuyerhassubstantialupsidereturnpotential,whiletheoptionwriterhassubstantialdownsiderisk.We’llinvestigatetherisk/rewardrelationshipforoptionpositionslaterinthischapter.Options,likeotherfnancialinstruments,maybetradedeitheronanorganizedexchangeorintheover-the-counter(OTC)market.Theadvan-tagesofanexchange-tradedoptionareasfollows.First,theexercisepriceandexpirationdateofthecontractarestandardized.Second,asinthecaseoffuturescontracts,thedirectlinkbetweenbuyerandsellerisseveredaftertheorderisexecutedbecauseoftheinterchangeabilityofexchange-tradedoptions.Theclearinghouseassociatedwiththeexchangewheretheoptiontradesperformsthesamefunctionintheoptionsmarketthatitdoesinthefuturesmarket.Finally,thetransactionscostsarelowerforexchange-tradedoptionsthanforOTCoptions.ThehighercostofanOTCoptionrefectsthecostofcustomizingtheoptionforthemanysituationswhereacorporationseekingtouseanoptiontomanageriskneedstohaveatailor-madeoptionbecausethestandardizedexchange-tradedoptiondoesnotsatisfyitsobjectives.SomecommercialandinvestmentandbankingfrmsactasprincipalsaswellasbrokersintheOTCoptionsmarket.OTCoptionsaresometimesreferredtoas dealeroptions. WhileanOTCoptionislessliquidthananexchange-tradedoption,thisistypicallynotofconcerntotheuserofsuchanoption. DifferencesBetweenOptionsandFuturesContracts Noticethat,unlikeinafuturescontract,onepartytoanoptioncontractisnotobligatedtotransact—specifcally,theoptionbuyerhastherightbutnottheobligationtotransact.Theoptionwriterdoeshavetheobligationtoperform.Thisisdifferentthaninthecaseofafuturescontractwherebothbuyerandsellerareobligatedtoperform. 3 Consequently,therisk/rewardcharacteristicsofthetwocontractsarealsodifferent.Inthecaseofafuturescontract,thebuyerofthecontractrealizesadollar-for-dollargainwhenthepriceofthefuturescontractin-creasesandsuffersadollar-for-dollarlosswhenthepriceofthefutures 3 Ofcourse,afuturesbuyerdoesnotpaythesellertoaccepttheobligation,whileanoptionbuyerpaysthesellertheoptionprice.
366 VALUATIONANDANALYSISTOOLS contractdrops.Theoppositeoccursforthesellerofafuturescontract.Becauseofthisrelationship,futuresarereferredtoashavinga“linearpayoff.”Optionsdonotprovidethissymmetricrisk/rewardrelationship.Themostthatthebuyerofanoptioncanloseistheoptionprice.Whilethebuyerofanoptionretainsallthepotentialbenefts,thegainisalwaysreducedbytheamountoftheoptionprice.Themaximumproftthatthewritermayrealizeistheoptionprice;thisisoffsetagainstsubstantialdownsiderisk.Becauseofthischaracteristic,optionsarereferredtoashavinga nonlinearpayoff .Thedifferenceinthetypeofpayoffbetweenfuturesandoptionsisextremelyimportantbecausemarketparticipantscanusefuturestoprotectagainstsymmetricriskandoptionstoprotectagainstasymmetricrisk. RiskandReturnofOptions Hereweillustratetheriskandreturncharacteristicsofthefourbasicoptionpositions—buyingacalloption,sellingacalloption,buyingaputoption,andsellingaputoption.Theillustrationsassumethateachoptionpositionisheldtotheexpirationdateandnotexercisedearly.Also,tosimplifytheillustrations,weignoretransactionscosts. BuyingCallOptions Thepurchaseofacalloptioncreatesapositionre-ferredtoasa longcallposition .Toillustratethisposition,assumethatthereisacalloptiononAssetXthatexpiresinonemonthandhasanexercisepriceof$60.Theoptionpriceis$2.Whatistheproftorlossfortheinvestorwhopurchasesthiscalloptionandholdsittotheexpirationdate?TheproftandlossfromthestrategywilldependonthepriceofAs-setXattheexpirationdate.Anumberofoutcomesarepossible. 4 We 4 Inaddition,theillustrationsdonotaddressthecostoffnancingthepurchaseoftheoptionpriceortheopportunitycostofinvestingtheoptionprice.Specifcally,thebuyerofanoptionmustpaythesellertheoptionpriceatthetimetheoptionispurchased.Thus,thebuyermustfnancethepurchasepriceoftheoptionor,assumingthepurchasepricedoesnothavetobeborrowed,thebuyerlosestheincomethatcanbeearnedbyinvestingtheamountoftheoptionpriceuntiltheoptionissoldorexercised.Incontrast,assumingthatthesellerdoesnothavetousetheoptionpriceasmarginfortheshortpositionorcanuseaninterest-earningassetassecurity,thesellerhastheopportunitytoearnincomefromtheproceedsoftheoptionsale.
DerivativesforControllingRisk 367 providethedetailcalculationsforpricesofAssetXbetween$58and$65: PriceofAssetXExercise?CalculationOptionBuyerProftorLoss $58No − $2$59No − $2$60No − $2$61Yes$61 − 60 − 2 =− $1$62Yes$62 − 60 − 2 = $0$63Yes$63 − 60 − 2 = $1$64Yes$64 − 60 − 2 = $2$65Yes$65 − 60 − 2 = $3 IfthepriceofAssetXattheexpirationdateislessthanorequalto$60(theoptionprice),theinvestorwillnotexercisetheoption.Itwouldbefoolishtopaytheoptionwriter$60whenAssetXcanbepurchasedinthemarketatalowerprice.Inthiscase,theoptionbuyerlosestheentireoptionpriceof$2. IfAssetX’spriceismorethan$60theoptionbuyerwillexercisetheoption. Iflessthan$62attheexpirationdate,theoptionbuyerwillexer-cisetheoption.Byexercising,theoptionbuyercanpurchaseAssetXfor$60(theexerciseprice)andsellitinthemarketforthehigherprice. IfAssetX’spriceattheexpirationdateisequalto$62thein-vestorbreakseven,realizingagainof$2thatoffsetsthecostoftheoption,$2. IfAssetX’spriceattheexpirationdateismorethan$62,theinvestorwillexercisetheoptionandrealizeaproft. Writing(Selling)CallOptions Thewriterofacalloptionissaidtobeina shortcallposition .Toillustratetheoptionseller’s(i.e.,writer’s)position,weusethesamecalloptionweusedtoillustratebuyingacalloption.Theproftandlossprofleoftheshortcallposition(thatis,thepositionofthecalloptionwriter)isthemirrorimageoftheproftandlossprofleofthelongcallposition(thepositionofthecalloptionbuyer).Considerthe
368 VALUATIONANDANALYSISTOOLS proftorlossfortheoptionwriterforpricesofAssetXbetween$58and$65: PriceofAssetXWilltheOptionBuyerExercise?CalculationOptionWriterProftorLoss $58No$2$59No$2$60No$2$61Yes$60 − 61 + 2 = $1$62Yes$60 − 62 + 2 = $0$63Yes$60 − 63 + 2 =− $1$64Yes$60 − 64 + 2 =− $2$65Yes$60 − 65 + 2 =− $3Consequently,themaximumproftthattheshortcallpositioncanpro-duceistheoptionprice.ThemaximumlossisnotlimitedbecauseitisthehighestpricereachedbyAssetXonorbeforetheexpirationdate,lesstheoptionprice;thispricecanbeindefnitelyhigh.Weprovideagraphoftheproft/lossprofleforboththeoptionbuyerandtheoptionwriterforthisoptioninExhibit14.2forpricesoftheunder-lyingfrom$40to$70.Asyoucanseeinthisgraph,Thatis,theproftoftheshortcallpositionforanygivenpriceforAssetXattheexpirationdateisthesameasthelossofthelongcallposition. –$12–$8–$4$0$4$8$12$40$45$50$55$60$65$70 Price of the Underlying Profit or Loss Call option buyer Call option writer EXHIBIT14.2 ProftorLossfortheCallOptionBuyerandWriterforanOptionwithanExercisePriceof$60andaCallPremiumof$2
DerivativesforControllingRisk 369 TRYIT!THEPAYOFFFROMACALLOPTION Supposeyoubuyacalloptionwithanexercisepriceof$50,payinganoptionpremiumof$3.Iftheunderlyingstock’spriceis$60atthetimeyouexercisethisoption,whatisyourproftonthisoption? BuyingPutOptions Thebuyingofaputoptioncreatesafnancialpositionreferredtoasa longputposition .Toillustratethisposition,weassumeahypotheticalputoptionononeunitofAssetYwithonemonthtomaturityandanexercisepriceof$100.Assumetheputoptionissellingfor$3.TheproftorlossforthispositionattheexpirationdatedependsonthemarketpriceofAssetY.ConsiderthepossibleoutcomesfortheputoptionbuyerforpricesofAssetYfrom$93to$103: PriceofAssetYExercise?CalculationOptionBuyerProftorLoss $93Yes$100 − 93 − 3 = $4$94Yes$100 − 94 − 3 = $3$95Yes$100 − 95 − 3 = $2$96Yes$100 − 96 − 3 = $1$97Yes$100 − 97 − 3 = $0$98Yes$100 − 98 − 3 =− $1$99Yes$100 − 99 − 3 =− $2$100No − $3$101No − $3$102No − $3$103No − $3 IfAssetY’spriceisgreaterthan$100,thebuyeroftheputoptionwillnotexerciseitbecauseexercisingwouldmeanselling. IfthepriceofAssetYatexpirationisequalto$100,thebuyeroftheputoptionwillnotexerciseit,leavingtheputbuyerwithalossequaltotheoptionpriceof$3. AnypriceforAssetYthatislessthan$100butgreaterthan$97willresultinaloss;exercisingtheputoption,however,limitsthelosstolessthantheoptionpriceof$2. Ata$97priceforAssetYattheexpirationdate,theputbuyerwillbreakeven.Theinvestorwillrealizeagainof$3bysellingAssetY
370 VALUATIONANDANALYSISTOOLS tothewriteroftheoptionfor$100,offsettingthecostoftheoption,the$3. IfAssetY’spriceisbelow$97attheexpirationdate,thelongputposition(theputbuyer)willrealizeaproft. Writing(Selling)PutOptions Writingaputoptioncreatesapositionre-ferredtoasa shortputposition .Theproftandlossprofleforashortputoptionisthemirrorimageofthelongputoption.Themaximumproftfromthispositionistheoptionprice.Thetheoreticalmaximumlosscanbesubstantialshouldthepriceoftheunderlyingfall;attheextreme,ifthepriceweretofallallthewaytozero,thelosswouldbeaslargeastheexercisepricelesstheoptionprice.InthecaseoftheoptiononAssetY,withanexercisepriceof$100andanoptionpremiumof$3: PriceofAssetYExercise?CalculationOptionWriterProftorLoss $93Yes$100 − 93 − 3 =− $4$94Yes$100 − 94 − 3 =− $3$95Yes$100 − 95 − 3 =− $2$96Yes$100 − 96 − 3 =− $1$97Yes$100 − 97 − 3 = $0$98Yes$100 − 98 − 3 =+ $1$99Yes$100 − 99 − 3 =+ $2$100No + $3$101No + $3$102No + $3$103No + $3Weprovidetheproftandlossprofleforthelongputpositioningraphi-calforminExhibit14.3.Aswithalllongoptionpositions,thelossislimitedtotheoptionpremiumpaidbytheinvestor.Theproftpotential,however,issubstantial:ThetheoreticalmaximumproftisgeneratedifAssetY’spricefallstozero.Contrastthisproftpotentialwiththatofthebuyerofacallop-tion.ThetheoreticalmaximumproftforacallbuyercannotbedeterminedbeforehandbecauseitdependsonthehighestpricethatcanbereachedbyAssetYbeforeorattheoptionexpirationdate.Tosummarize,buyingcallsorsellingputsallowstheinvestortogainifthepriceoftheunderlyingrises.Sellingcallsandbuyingputsallowstheinvestortogainifthepriceoftheunderlyingfalls.
DerivativesforControllingRisk 371 –$20–$16–$12–$8–$4$0$4$8$12$16$20$80$85$90$95$100$105$110 Price of the Underlying Profit or Loss Put option buyer Put option writer EXHIBIT14.3 ProftorLossforthePutOptionBuyerandWriterforanOptionwithanExercisePriceof$100anda$3OptionPremium TRYIT!THEPAYOFFFROMAPUTOPTION Supposeyoubuyaputoptionwithanexercisepriceof$50,payinganoptionpremiumof$3.Iftheunderlyingstock’spriceis$48atthetimeyouexercisethisoption,whatisyourproftorlossonthisoption? BasicComponentsoftheOptionPrice Theoptionpriceisarefectionoftheoption’s intrinsicvalue andanyaddi-tionalamountoveritsintrinsicvalue.Thepremiumoverintrinsicvalueisoftenreferredtoasthe timepremium .Aswithfuturesandforwardcontracts,thetheoreticalpriceofanoptionisalsoderivedfromargumentsbasedonarbitrage.However,thepricingofoptionsisnotassimpleasthepricingoffuturesandforwardcontracts.Thetheoreticalpriceofanoptionismadeupoftwocomponents:theintrinsicvalueandapremiumoverintrinsicvalue.The intrinsicvalue istheoption’seconomicvalueifitisexercisedimmediately.Ifnopositiveeconomicvaluewouldresultfromexercisingimmediately,theintrinsicvalueiszero.Anoption’sintrinsicvalueiseasytocomputegiventhepriceoftheunderlyingandthestrikeprice.
372 VALUATIONANDANALYSISTOOLS Foracalloption,theintrinsicvalueisthedifferencebetweenthecurrentmarketpriceoftheunderlyingandthestrikeprice.Ifthatdifferenceispositive,thentheintrinsicvalueequalsthatdifference;ifthedifferenceiszeroornegative,thentheintrinsicvalueisequaltozero.Forexample,ifthestrikepriceforacalloptionis$100andthecurrentpriceoftheunderlyingis$109,theintrinsicvalueis$9.Thatis,anoptionbuyerexercisingtheoptionandsimultaneouslysellingtheunderlyingwouldrealize$109fromthesaleoftheunderlying,whichwouldbecoveredbyacquiringtheunderlyingfromtheoptionwriterfor$100,therebynettinga$9gain.Anoptionthathasapositiveintrinsicvalueissaidtobe in-the-money .Whenthestrikepriceofacalloptionexceedstheunderlying’smarketprice,ithasnointrinsicvalueandissaidtobe out-of-the-money .Anoptionforwhichthestrikepriceisequaltotheunderlying’smarketpriceissaidtobe at-the-money .Bothat-the-moneyandout-of-the-moneyoptionshaveintrinsicvaluesofzerobecauseitisnotproftabletoexercisethem.Ourcalloptionwithastrikepriceof$100wouldbe: inthemoneywhenthemarketpriceoftheunderlyingismorethan$100; outofthemoneywhenthemarketpriceoftheunderlyingislessthan$100;and atthemoneywhenthemarketpriceoftheunderlyingis$100.Foraputoption,theintrinsicvalueisequaltotheamountbywhichtheunderlying’smarketpriceisbelowthestrikeprice.Forexample,ifthestrikepriceofaputoptionis$100andthemarketpriceoftheunderlyingis$95,theintrinsicvalueis$5.Thatis,thebuyeroftheputoptionwhosimultaneouslybuystheunderlyingandexercisestheputoptionwillnet$5byexercising.Theunderlyingwillbesoldtothewriterfor$100andpurchasedinthemarketfor$95.Withastrikepriceof$100,theputoptionwouldbe(1)inthemoneywhentheunderlying’smarketpriceislessthan$100;(2)outofthemoneywhentheunderlying’smarketpriceexceeds$100;and(3)atthemoneywhentheunderlying’smarketpriceisequalto$100.Thetimepremiumofanoption,alsoreferredtoasthe timevalueoftheoption ,istheamountbywhichtheoption’smarketpriceexceedsitsintrinsicvalue.Itistheexpectationoftheoptionbuyerthatatsometimepriortotheexpirationdatechangesinthemarketpriceoftheunderlyingwillincreasethevalueoftherightsconveyedbytheoption.Becauseofthisexpectation,theoptionbuyeriswillingtopayapremiumabovetheintrinsicvalue.Forexample,ifthepriceofacalloptionwithastrikepriceof$100is$12whentheunderlying’smarketpriceis$104,thetimepremiumofthisoptionis$8($12minusitsintrinsicvalueof$4).Hadtheunderlying’smarketprice
DerivativesforControllingRisk 373 been$95insteadof$104,thetimepremiumofthisoptionwouldbetheentire$12becausetheoptionhasnointrinsicvalue.Allotherthingsbeingequal,thetimepremiumofanoptionwillincreasewiththeamountoftimeremainingtoexpiration.Anoptionbuyerhastwowaystorealizethevalueofanoptionposition.Thefrstwayisbyexercisingtheoption.Thesecondwayistoselltheoptioninthemarket.Inthefrstexampleabove,sellingthecallfor$12ispreferabletoexercising,becausetheexercisewillrealizeonly$4(theintrinsicvalue),butthesalewillrealize$12.Asthisexampleshows,exercisecausestheimmediatelossofanytimepremium.Itisimportanttonotethattherearecircumstancesunderwhichanoptionmaybeexercisedpriortotheexpirationdate.Thesecircumstancesdependonwhetherthetotalproceedsattheexpirationdatewouldbegreaterbyholdingtheoptionorexercisingandreinvestinganyreceivedcashproceedsuntiltheexpirationdate. FactorsThatInfluenceanOption’sPrice Thefactorsthataffectthepriceofanoptioninclude: 1. Marketpriceoftheunderlying. 2. Strikepriceoftheoption. 3. Timetoexpirationoftheoption. 4. Expectedvolatilityoftheunderlyingoverthelifeoftheoption. 5. Short-term,risk-freeinterestrateoverthelifeoftheoption. 6. Anticipatedcashpaymentsontheunderlyingoverthelifeoftheoption.Theimpactofeachofthesefactorsmaydependonwhether(1)theoptionisacalloraput,and(2)theoptionisanAmericanoptionoraEuropeanoption.WesummarizethesefactorsinExhibit14.4andhoweachofthesixfactorslistedaboveaffectsthepriceofaputandcalloption.Here,webriefyexplainwhythefactorshavetheparticulareffects. Marketpriceoftheunderlyingasset. Theoptionpricewillchangeasthepriceoftheunderlyingchanges.Foracalloption,astheunderly-ing’spriceincreases(allotherfactorsbeingconstant),theoptionpriceincreases.Theoppositeholdsforaputoption:Asthepriceoftheun-derlyingincreases,thepriceofaputoptiondecreases. Strikeprice. Thestrikepriceisfxedforthelifeoftheoption.Allotherfactorsbeingequal,thelowerthestrikeprice,thehigherthepriceforacalloption.Forputoptions,thehigherthestrikeprice,thehighertheoptionprice. Timetoexpirationoftheoption .Aftertheexpirationdate,anop-tionhasnovalue.Allotherfactorsbeingequal,thelongerthetimeto
374 VALUATIONANDANALYSISTOOLS EXHIBIT14.4 SummaryofFactorsthatAffectthePriceofanOption EffectofanIncreaseofaFactoronthe ... FactorCallOptionPricePutOptionPrice Marketpriceoftheunderlying Strikepriceoftheoption Timetoexpirationoftheoption Expectedvolatilityoftheunderlyingoverthelifeoftheoption Short-term,risk-freeinterestrateoverthelifeoftheoption Anticipatedcashpaymentsontheunderlyingoverthelifeoftheoption expirationoftheoption,thehighertheoptionprice.Thisisbecause,asthetimetoexpirationdecreases,lesstimeremainsfortheunderlying’spricetorise(foracallbuyer)orfall(foraputbuyer),andthereforetheprobabilityofafavorablepricemovementdecreases.Consequently,asthetimeremaininguntilexpirationdecreases,theoptionpriceap-proachesitsintrinsicvalue. Expectedvolatilityoftheunderlyingoverthelifeoftheoption .Allotherfactorsbeingequal,thegreatertheexpectedvolatility(asmeasuredbythestandarddeviationorvariance)oftheunderlying,themoretheoptionbuyerwouldbewillingtopayfortheoption,andthemoreanoptionwriterwoulddemandforit.Thisoccursbecausethegreatertheexpectedvolatility,thegreatertheprobabilitythatthemovementoftheunderlyingwillchangesoastobenefttheoptionbuyeratsometimebeforeexpiration. Short-term,risk-freeinterestrateoverthelifeoftheoption .Buyingtheunderlyingrequiresaninvestmentoffunds.Buyinganoptiononthesamequantityoftheunderlyingmakesthedifferencebetweentheunderlying’spriceandtheoptionpriceavailableforinvestmentataninterestrateatleastashighastherisk-freerate.Consequently,allotherfactorsbeingconstant,thehighertheshort-term,risk-freeinterestrate,thegreaterthecostofbuyingtheunderlyingandcarryingittotheexpirationdateofthecalloption.Hence,thehighertheshort-term,risk-freeinterestrate,themoreattractivethecalloptionwillberelative
DerivativesforControllingRisk 375 tothedirectpurchaseoftheunderlying.Asaresult,thehighertheshort-term,risk-freeinterestrate,thegreaterthepriceofacalloption. Anticipatedcashpaymentsontheunderlyingoverthelifeoftheoption. Cashpaymentsontheunderlyingtendtodecreasethepriceofacalloptionbecausethecashpaymentsmakeitmoreattractivetoholdtheunderlyingthantoholdtheoption.Forputoptions,cashpaymentsontheunderlyingtendtoincreasetheprice. OptionPricingModels Earlierinthischapter,weexplainedhowthetheo-reticalpriceofafuturescontractandforwardcontractisdeterminedbasedonarbitragearguments.Anoptionpricingmodelusesasetofassumptionsandarbitrageargumentstoderiveatheoreticalpriceforanoption.Derivingatheoreticaloptionpriceismuchmorecomplicatedthanderivingathe-oreticalfuturesorforwardpricebecausetheoptionpricedependsontheexpectedvolatilityoftheunderlyingoverthelifeoftheoption.Severalmodelshavebeendevelopedtodeterminethetheoreticalpriceofanoption.ThemostpopularonewasdevelopedbyFischerBlackandMyronScholesforvaluingEuropeancalloptionsoncommonstock. 5 Becauseofthetechnicalnatureofthismodel,wedescribeitintheappendixtothischapter. UsingOptions Unlikefuturesandforwardcontracts,whicharerisk-sharinginstruments,optionsare insurance-typeinstruments .Thebuyeroftheoptionpaystheseller/writeroftheoptiontheoptionpricetoobtainthedesiredprotection.Thisisthereasontheoptionpriceisoftenreferredtoastheoptionpremium,thetermusedintheinsuranceindustryforthecostofbuyinginsurance.Becauseanoptioncontractobligatesonlythesellerandnotthebuyertoperform,apartythatbuysanoptioncanbeneftfromafavorablemovementintheunderlying.Recallthatwhenwediscussedtheuseoffuturesandforwardcontracts,thatwasnotanattributeofthoseinstruments.Let’slookathowthewheatfarmerandthefoodmanufacturerinourearlierdiscussionontheapplicationsoffuturesandforwardcontractscouldhaveusedoptions.Toprotectagainstadeclineinthepriceofwheat,thefarmercouldpurchaseaputoptiononwheat.Theminimumpriceatwhichthefarmercouldthensellwheatistheexercisepriceoftheoption.However, 5 FischerBlackandMyronScholes,“PricingofOptionsandCorporateLiabilities,” JournalofPoliticalEconomy 81(1973):637–654.
376 VALUATIONANDANALYSISTOOLS sincethefarmermustpaytheoptionprice,theeffectivesalepriceforwheatbybuyingtheoptionistheexercisepricereducedbythecostoftheoption.Noticethatthisisthedownsidepriceriskforthefarmer.Thefarmerwillbeneftfromanincreaseinthepriceofwheat,butthatupsideisreducedbythecostoftheoption.Thefoodmanufacturercanbuyacalloptiononwheat.Bydoingso,thefoodmanufacturerknowsthatitwillnothavetopaymoreforwheatthantheexerciseprice.Sincethefoodmanufacturermustpaytheoptionpremium,theeffectivemaximumpricethatthefoodmanufacturerwillhavetopayforwheatisthesumoftheexercisepriceandthecostoftheoption.Shouldthepriceofwheatdecline,thefoodmanufacturercanbeneft,butthesavingsfromthepricedeclinearereducedbythecostoftheoption. SWAPS A swap isanagreementwherebytwoparties(called counterparties )agreetoexchangeperiodicpayments.Thedollaramountofthepaymentsexchangedisbasedonsomepredetermineddollarprincipal,whichiscalledthe notionalprincipalamount orsimply notionalamount .Thedollaramounteachcoun-terpartypaystotheotheristheagreed-uponperiodicratemultipliedbythenotionalamount.Theonlydollarsexchangedbetweenthepartiesaretheagreed-uponpayments,notthenotionalamount.Aswapisanover-the-countercontract.Hence,thecounterpartiestoaswapareexposedtocounterpartyrisk.Welookatfourtypesofswaps—interestrateswaps,currencyswaps,commodityswaps,andcreditdefaultswaps—thatarethemostcommonswapsusedbybusinesses.Weillustratethesetypesofswapsinthissection. InterestRateSwap Inan interestrateswap ,thecounterpartiesswappaymentsinthesamecurrencybasedonaninterestrate.Forexample,oneofthecounterpartiescanpayafxedinterestrateandtheotherpartyafoatinginterestrate.Thefoatinginterestrateiscommonlyreferredtoasthe referencerate .Forexample,supposethecounterpartiestoaswapagreementareFarmEquipCorporation(amanufacturingfrm)andPNCBank.Thenotionalamountofthisswapis$100millionandthetermoftheswapisfveyears.Everyyearforthenextfveyears,FarmEquipCorporationagreestopayPNCBank8%peryear,whilePNCBankagreestopayFarmEquipCor-porationtheone-yearLIBORasthereferencerate.Thismeansthateveryyear,FarmEquipCorporationwillpay$8million(8%times$100million)
DerivativesforControllingRisk 377 toPNCBank.TheamountPNCBankwillpayFarmEquipCorporationdependsonLIBOR.Forexample,one-yearLIBORis6%,PNCBankwillpayFarmEquipCorporation$6million(6%times$100million). Thebestadvicemaybethis:treatexoticderivativeslikepowerfulmedicines,largedosesofwhichcanbeharmful.Usetheminmoder-ation,foraparticularpurpose(suchasriskmanagement)andonlyafterhavingreadtheinstructionsonthebottle.—PhilippeJorion, BadBetsGoneBad (NewYork:AcademicPress,1995),p.57 Takingthisastepfurther,iftheLIBORis6%, PNC Bank pays$7 millionFarm EquipCorporationpays $8 million Onlythenetcashfowisactuallyexchanged,sointhiscaseFarmEquippays$1milliontoPNCBank.If,instead,theLIBORis9%, PNC Bank pays$10 millionFarm EquipCorporationpays $8 million Inthiscasethenetcashfowis$2million,paidfromPNCtoFarmEquipCorporation.Whyuseaninterestrateswap?Thoughwe’lldiscussthislaterinthebookwhenwediscusshowacompanyfnancesitself,themotivationrelatestothecostsoffnancing,andwhetherthefnancingisfxed(suchasthecommitmentthatFarmEquiphasmade)orfoating(suchasthecommitmentthatPNCBankhasmade).
378 VALUATIONANDANALYSISTOOLS CurrencySwaps Ina currencyswap ,twopartiesagreetoswappaymentsbasedondifferentcurrencies.Companiesusecurrencyswapstoraisefundsoutsideoftheirhomecurrencyandthenswapthepaymentsintotheirhomecurrency.Thisallowsacorporationwithoperationsoutsidetheirhomecountrytoeliminatecurrencyrisk(i.e.,unfavorableexchangerateorcurrencymovements)whenborrowingoutsideofitsdomesticcurrency.Toillustrateacurrencyswap,supposetherearetwocounterparties:HighQualityElectronicsCorporation(aU.S.manufacturingfrm)andCitibank.Thenotionalamountis$100millionanditsSwissfranc(CHF)equivalent.Atthetimethecontractwasenteredinto,$100millionwasequaltoCHF127million.Andsupposetheswaptermiseightyears.EveryyearforthenexteightyearstheU.S.manufacturingfrmagreestopayCitibankSwissfrancsequalto5%oftheSwissfrancnotionalamount,orCHF6.35million.Inturn,CitibankagreestopayHighQualityElectronics7%oftheU.S.notionalprincipalamountof$100million,or$7million.IftheexchangeratebetweentheU.S.dollarandtheCHFchanges,thevalueofwhatisexchangedchanges. CommoditySwaps Ina commodityswap ,theexchangeofpaymentsbythecounterpartiesisbasedonthevalueofaparticularphysicalcommodity.Physicalcommoditiesincludepreciousmetals,basemetals,energystores(suchasnaturalgasorcrudeoil),andfood(includingporkbellies,wheat,andcattle).Mostcommodityswapsinvolveoil.Forexample,supposethatthetwocounterpartiestothisswapagree-mentareComfortAirlinesCompany,acommercialairline,andPrebonEnergy(anenergybroker).Thenotionalamountofthecontractis1millionbarrelsofcrudeoileachyearandthecontractisforthreeyears.Theswappriceis$19perbarrel.Eachyearforthenextthreeyears,ComfortAirlinesCompanyagreestobuy1millionbarrelsofcrudeoilfor$19perbarrel.So,eachyearComfortAirlinesCompanypays$19milliontoPrebonEnergy($19perbarreltimes1millionbarrels)andreceives1millionbarrelsofcrudeoil.ThemotiveforComfortAirlinesofusingthecommodityswapisthatitallowsthecompanytolockinapricefor1millionbarrelsofcrudeoilat$19perbarrelregardlessofhowhighcrudeoil’spriceincreasesoverthenextthreeyears.
DerivativesforControllingRisk 379 CreditDefaultSwaps A creditdefaultswap (CDS)isanOTCderivativethatpermitsthebuyingandsellingofcreditprotectionagainstparticulartypesofeventsthatcanadverselyaffectthecreditqualityofabondsuchasthedefaultofthebor-rower.Althoughitisreferredtoasa“swap,”itdoesnotfollowthegeneralcharacteristicsofaswapdescribedearlier.Therearetwoparties:the creditprotectionbuyer and creditprotectionseller .OverthelifeoftheCDS,theprotectionbuyeragreestopaytheprotectionsellerapaymentatspecifeddatestoinsureagainsttheimpairmentofthedebtofa referenceentity duetoacredit-relatedevent.Thereferenceentityisaspecifcissuer,say,FordMotorCompany.Thespecifccredit-relatedeventsareidentifedinthecontractthatwilltriggerapaymentbythecreditprotectionsellertothecreditprotectionbuyerarereferredtoas creditevents .Ifacrediteventdoesoccur,thecreditprotectionbuyeronlymakesapaymentuptothecrediteventdateandmakesnofurtherpayment.Atthistime,theprotectionbuyerisobligatedtofulfllitsobligation.Thecontractwillcallfortheprotectionsellertocompensateforthelossinthevalueofthedebtobligation.Thespecifcmethodforcompensatingtheprotectionbuyerisnotimportantatthistimeforthisbriefdescriptionofthisderivativecontract. THEBOTTOMLINE Derivativesarecontractswhosevaluedependsonsomeotherasset.Derivativesincludefuturescontracts,forwardcontracts,options,andswaps. Thetraditionalpurposeofderivativeinstrumentsistoprovideanim-portantopportunitytomanageagainsttheriskofadversefutureprice,exchangerate,orinterestratemovements. Futurescontractsarecreationsofexchanges,whichrequireinitialmar-ginfromparties.Eachdaypositionsaremarkedtomarket.Additionalmarginisrequirediftheequityinthepositionfallsbelowthemain-tenancemargin.Theclearinghouseguaranteesthatthepartiestothefuturescontractwillsatisfytheirobligations. Aforwardcontractdiffersinseveralimportantwaysfromafuturescontract.Incontrasttoafuturescontract,thepartiestoaforwardcontractareexposedtotheriskthattheotherpartytothecontractwillfailtoperform.Thepositionsofthepartiesmaynotnecessarilymarkedtomarket,soinsuchcasestherearenointerimcashfowsassociated
380 VALUATIONANDANALYSISTOOLS withaforwardcontract.Finally,unwindingapositioninaforwardcontractmaybediffcult. Bothfuturesandforwardcontractsarerisk-sharinginstruments,allow-ingapartytocontrolriskbylockinginafuturevaluebutgivinguptheopportunitytobeneftfromafavorablemovementinthevalueoftheunderlying. Anoptiongrantsthebuyeroftheoptiontherighteithertobuyfrom(inthecaseofacalloption)ortosellto(inthecaseofaputoption)theseller(writer)oftheoptiontheunderlyingattheexercise(strike)pricebytheoption’sexpirationdate.Thepricethattheoptionbuyerpaystothewriteroftheoptionistheoptionpriceoroptionpremium. ThemostpopularmodelusedtodeterminethefairmarketvalueofanoptionistheBlack-Scholesoptionpricingmodel. Thebuyerofanoptioncannotrealizealossgreaterthantheoptionprice,andhasalltheupsidepotential.Bycontrast,themaximumgainthatthewriter(seller)ofanoptioncanrealizeistheoptionprice;thewriterisexposedtoallthedownsiderisk. Unlikefuturesandforwardcontractsthatarerisk-sharinginstruments,optionsareinsurance-typecontracts.Thebuyeroftheoptionpaystheoptionpricetoobtainprotectionagainstadversemovementsinthevalueoftheunderlyingbutmaintainstheupsidepotential(reducedbythecostoftheoption). Theoptionpriceconsistsoftwocomponents:theintrinsicvalueandthetimepremium.Theintrinsicvalueistheeconomicvalueoftheoptionifitisexercisedimmediately(exceptthatifthereisnopositiveeconomicvaluethatwillresultfromexercisingimmediately,thentheintrinsicvalueiszero).Thetimepremiumistheamountbywhichtheoptionpriceexceedstheintrinsicvalue. Swapcontractsallowfortheexchangeofasetofcashfows,andcanbebasedoninterestrates,currencyexchangerates,commodityprices,orcreditprotection. APPENDIX:BLACK-SCHOLESOPTIONPRICINGMODEL Inthechapter,weexplainedthebasicfactorsthataffectthevalueofanoption,alsoreferredtoastheoptionprice.Theoptionpriceisarefectionoftheoption’sintrinsicvalueandanyadditionalamountoveritsintrin-sicvalue,calledthetimepremium.Inthisappendix,weexplainhowthetheoreticalpriceofanon-dividend-payingEuropeancalloptioncanbedeter-minedusingawell-knownfnancialmodel,the Black-Scholesoptionpricing
DerivativesforControllingRisk 381 model .Wedonotprovidethedetailswithrespecttohowthemodelwasderivedbyitsdevelopers.Rather,wewillsetforththebasicsofthemodel.RecallthataEuropeanoptionisonethatcannotbeexercisedpriortotheexpirationdate.Basically,theideabehindthearbitrageargumentinderivingtheoptionpricingmodelisthatifthepayofffromowningacalloptioncanbereplicatedby(1)purchasingthestockunderlyingthecalloption;and(2)borrowingfunds,thenthepriceoftheoptionwillbe(atmost)thecostofcreatingthepayoffreplicatingstrategy.Byimposingcertainassumptions(tobediscussedlater)andusingarbi-tragearguments,theBlack-Scholesoptionpricingmodelcomputesthefair(ortheoretical)priceofaEuropeancalloptiononanon-dividend-payingstockwiththefollowingequation: C = SN ( d 1 ) − Xe − rt N ( d 2 )(14A.1)where: d 1 = ln S X + r + 0 . 5 s 2 t s √ t ; d 2 = d 1 − s √ t ;ln = Naturallogarithm; C = Calloptionprice; S = Priceoftheunderlyingasset; X = Strikeprice; r = Short-termrisk-freerate; e = 2.718(thenaturalantilogof1); t = Timeremainingtotheexpirationdate,asafractionofayear; s = Standarddeviationofthevalueoftheunderlyingasset;and N (.) = Cumulativeprobabilitydensity. 6 Noticethatfveofthefactorsthatweindicatedinthechapterthatinfuencethepriceofanoptionareincludedintheformula.Anticipatedcashdividendsarenotincludedbecausethemodelisforanon-dividend-payingstock.IntheBlack-Scholesoptionpricingmodel,thedirectionoftheinfuenceofeachofthesefactorsisthesameasstatedinthechapter.Fourofthefactors—strikeprice,priceofunderlyingasset,timetoexpiration,andrisk-freerate—areeasilyobserved.Thestandarddeviationofthepriceoftheunderlyingassetmustbeestimated. 6 Weobtainthevaluefor N (.)fromanormaldistributionfunctionthatistabulatedinmoststatisticstextbooksorfromspreadsheetsthathavethisbuilt-infunction.
382 VALUATIONANDANALYSISTOOLS TheoptionpricederivedfromtheBlack-Scholesoptionpricingmodelis“fair”inthesensethatifanyotherpriceexisted,itwouldbepossibletoearnrisklessarbitrageproftsbytakinganoffsettingpositionintheunderlyingasset.Thatis,ifthepriceofthecalloptioninthemarketishigherthanthatderivedfromtheBlack-Scholesoptionpricingmodel,aninvestorcouldsellthecalloptionandbuyacertainquantityoftheunderlyingasset.Ifthereverseistrue,thatis,themarketpriceofthecalloptionislessthanthe“fair”pricederivedfromthemodel,theinvestorcouldbuythecalloptionandsellshortacertainamountoftheunderlyingasset.Thisprocessofhedgingbytakingapositionintheunderlyingassetallowstheinvestortolockintherisklessarbitrageproft.ToillustratetheBlack-Scholesoptionpricingformula,assumethefol-lowingvalues:Stockprice = S = $47Strikeprice = X = $45Risk-freerateofinterest = r = 10%Timeremainingtoexpiration = t = 183days ÷ 365days = 0.5Expectedpricevolatility = s = 25%SubstitutingthesevaluesintotheBlack-Scholesoptionpricingmodel,weget d 1 = ln 47 45 + 0 . 1 + (0 . 5 × 0 . 25 2 ) 0 . 5 0 . 25 √ 0 . 5 = 0 . 6172and d 2 = 0 . 6172 − 0 . 25 √ 0 . 5 = 0 . 4404Fromanormaldistributiontable, N (0 . 6172) = 0 . 7315and N (0 . 4404) = 0 . 6702Substitutingthesevaluesintoequation(14A.1), C = ($47 × 0 . 7315) − $45(e − (0 . 10 × 0 . 5 × 0 . 6702) ) = $5 . 69Therefore,thevalueofthecalloptionis$5.69.Let’slookatwhathappenstothetheoreticaloptionpriceiftheexpectedpricevolatilityis40%ratherthan25%.Then
DerivativesforControllingRisk 383 Fromanormaldistributiontable, N (0 . 4719) = 0 . 6815and N (0 . 1891) = 0 . 5750Then C = ($47 × 0 . 6815) − $45(e − (0 . 10 × 0 . 5 × 0 . 5750) ) = $7 . 42Noticethatthehighertheassumedexpectedpricevolatilityoftheun-derlyingasset,thehigherthepriceofacalloption.InExhibit14.5A,weshowtheoptionvalueascalculatedfromtheBlack-Scholesoptionpricingmodelfordifferentassumptionsconcerningthestandarddeviation(PanelA),thetimeremainingtoexpiration(PanelB),andtherisk-freerateofinterest(PanelC).Noticethattheoptionpricevariesdirectlywithallthreevariables.Thatis, thehigherthevolatility,thehighertheoptionprice; thelongerthetimeremainingtoexpiration,thehighertheoptionprice; thehighertherisk-freerate,thehighertheoptionprice.Allofthisagreeswithwhatwestatedinthischapterabouttheeffectofachangeinoneofthefactorsonthepriceofacalloption.TheBlack-ScholesoptionpricingmodelassumesthatthecalloptionisaEuropeancalloption.Becausethemodelisforanon-dividend-payingstock,earlyexerciseofanoptionwillnotbeeconomicalbecausebysellingratherthanexercisingthecalloption,theoptionholdercanrecouptheoption’stimepremium. SOLUTIONSTOTRYIT!PROBLEMS Futures1. Cashandcarry 2. $2 NowLater ActionCashFlowActionCashFlow Sellfutures$0Payoffloan − $1,000Borrow1,000Interestonloan − 8BuyAssetU − 1,000 DeliverAssetU1,010 Cashfow$0 Cashfow$2
384 VALUATIONANDANALYSISTOOLS $0$5$10$15$20$2565%60%55%50%45%40%35%30%25%20% Value of the Call OptionValue of the Call OptionValue of the Call Option Standard Deviation $0 $2 $4 $6 $8 $10 10%9%8%7%6%5%4%3%2%1%100%90%80%70%60%50%40%30%20%10% Risk-Free Rate of Interest $0 $2 $4 $6 $8 $10 Time Remaining (as a percentage of a year) A. Changes in the standard deviation, all else held constantB. Changes in the time to expiration, all else held constantC. Changes in the risk-free rate of interest, all else held constant EXHIBIT14.5 TheValueofanOptionBasedontheBlack-ScholesModel
DerivativesforControllingRisk 385 Thepayofffromacalloption Proft = $60 − 50 − 3 = $7 Thepayofffromaputoption Loss = $50 − 48 − 3 =− $1 QUESTIONS 1. Whatisthedifferencebetweenacashandcarrytradeandareversecashandcarrytrade? 2. Ifthereisnoarbitrageopportunity,whatistheexpectedproftfromacashandcarryinfutures? 3. Whatisthedifferencebetweenforwardsandfutures? 4. Ifacalloption’sexercisepriceis$100andtheunderlyingiscurrently$90,isthisoptionin,at,oroutofthemoney? 5. Ifthepayoffofacalloptionataspecifedpriceis$5,whatisthepayoffforthecallwriteratthatprice? 6. Whatistherelationbetweenthetimetoexpirationandthevalueofa: a. calloption? b. putoption? 7. Whatistherelationbetweenthevolatilityofthepriceoftheunderlyingandthevalueofa: a. calloption? b. putoption? 8. Ifyoubelievethatastock’spricewillfalloverthenextfewmonths,whatoptiontransactionareyoumostlikelytouse? 9. Ifyoubelievethatastock’spricewillfalloverthenextfewmonths,whatoptiontransactionsareyoumostlikelytouse? 10. Whatisthetransactionthatinvolvesonepartyagreeingtopayafxedinterestrate,basedonanotionalamount,andtheotherpartyagreeingtopayinterestthatispeggedtosomereferencerate? 11. Thefollowingappearsinthe200010-KofInternationalBusinessMachines: Thecompanyemploysanumberofstrategiestomanagetheserisks,includingtheuseofderivativefnancialinstruments.Derivativesinvolvetheriskofnon-performancebythecoun-terparty. Explainwhatismeantinthelastsentenceofthisquotation.
386 VALUATIONANDANALYSISTOOLS 12. Amanufactureroffurnitureisconcernedthatthepriceoflumberwillincreaseoverthenextthreemonths.Explainhowthemanufacturercanprotectagainstariseinthepriceoflumberusinglumberfuturescontracts. 13. Thechieffnancialoffcerofthecorporationyouworkforrecentlytoldyouthathehadastrongpreferencetouseforwardcontractsratherthanfuturescontractstohedge:“Youcangetcontractstailor-madetosuityourneeds.” a. CommentontheCFO’sstatement. b. Whatotherfactorsinfuencethedecisiontousefuturesorforwardcontracts? 14. Whatisthedifferencebetweenaputoptionandacalloption? 15. WhatdistinguishesanAmericanoptionfromaEuropeanoption? 16. “There’snorealdifferencebetweenoptionsandfutures.Botharetoolsforcontrollingrisk,andbotharederivativeproducts.It’sjustthatwithoptionsyouhavetopayanoptionprice,whilefuturesrequirenoup-frontpaymentexceptforagood-faithmargin.Ican’tunderstandwhyanyonewoulduseoptions.”Doyouagreewiththisstatement? 17. ThetreasureroftheKSiRCorporationisattemptingtomanagerisksusingoptions. a. Whatoptionstrategycanthetreasurertaketoprotectagainstariseinthecostofoneofthecompany’sinputsintheproductionprocess,assumingthatthereisanoptionavailable? b. Whatoptionstrategycanthetreasurertaketoprotectagainstadeclineinthesellingpriceofoneofthecompany’sproductsassumingthatthereisanoptionavailable? 18. Howdoesthepriceofanoptionandtheexercisepriceaffectthepayofffromanoption. 19. Supposethatthepriceoftheunderlyingis$40andthattheoptionpriceis$5. a. Iftheexercisepriceforaputoptionis$42,whataretheintrinsicvalueandthetimepremiumforthisoption? b. Iftheexercisepriceforacalloptionis$50,whataretheintrinsicvalueandthetimepremiumforthisoption? 20. OronoBankandthePortlandManufacturingCorp.enterintothefol-lowingseven-yearswapwithanotionalamountof$75millionandthefollowingterms:Everyyearforthenextsevenyears,OronoBankagreestopayPortlandManufacturing7%peryearandreceiveLIBORfromPortlandManufacturing. a. Whattypeofswapisthis? b. Inthefrstyearpaymentsaretobeexchanged,supposethatLIBORis4%.Whatistheamountofthepaymentthatthetwopartiesmustmaketoeachother?
PART Four InvestmentManagement
CHAPTER 15 InvestmentManagement Investors,whocannotorwhowillnottakethetroubletocomprehendthelawsthatgovernstocktransactions,mustbecontentwithaverymoderatereturn.Theymay,iftheychoose,learnthecharacteroftherisks,andunderstandtheconditionsofsuccess,bytheexerciseofordinaryintelligence.NoProspero’swandisneededinordertoavoidfailure;butonlycommonsenseandcommonprudence,suchasallmaycultivate.Ontheotherhand,therearenoshortandsurecutstosuccess.Itdoesnotcomebywishingandwaitingforit.Thepropermeansmustbeused,likelyopportunitiesturnedtoadvantage,andacarefuljudgmentmustbeexercised.Ifitbethoughtthatinoneortwotransactionsoffveortenthousandeachagreatfortunewillbeinstantlysecured,thereiscertaintobeaspeedyprocessofdisillusioning.Neithercanitbeexpectedthateveryventurewillprovelucrative.“Thebestlaidschemeso’micean’mengangaftagley.”Nomechanismissoautomaticallyperfectinitworkingastobefreefromallriskoffriction.Itisthesamewithinvestments.Howevercarefullymade,itsometimeshappensthatunexpectedcomplicationsarise,suchasnoforesightcouldhaveanticipatedorguardedagainst.Yetthelawofaveragesiscertaintooperate,asisthecasewithaccidents,withfres,andwitheverybusiness. —WilliamHickmanSmithAubrey, StockExchangeInvestments:TheirHistory;Practice;andResults ,4thed.(London:Simpkin,Marshall,HamiltonKent&Co.Ltd.,1897),pp.210–211 389
390 INVESTMENTMANAGEMENT A portfolio ,simplyput,isagroupofinvestments.Theseinvestmentsmayincludecash,commonstocks,bonds,andrealestate,amongotherassets,andaremanagedforaspecifcobjectiveorpurpose. Investmentmanagement —whichisalsoknownas portfoliomanage-ment , assetmanagement ,and moneymanagement— istheprocessofman-agingaportfolio.Accordingly,theindividualwhomanagesaportfolioofinvestmentsisreferredtoasan investmentmanager ,a portfoliomanager ,an assetmanager ,ora moneymanager. Inindustryjargon,aninvestmentmanager“runsmoney.”Tobeeffective,theinvestmentmanagermustun-derstandthevariousinvestmentvehicles,thewaytheseinvestmentvehiclesarevalued,andthevariousstrategiestoselecttheinvestmentvehiclestoincludeinaportfoliotoaccomplishtheinvestmentobjectives.Thepurposeofthischapteristodescribetheprocessofinvestmentmanagement,whichcanbeappliedtoinstitutionalinvestorsorindividualinvestors.WeillustratetheinvestmentmanagementprocessinExhibit15.1.Thoughtheprocessbeginswithsettingtheinvestmentobjective,itisreallyacyclicalprocesswhereperformanceevaluationmayresultinfeedback,affectingchangestotheobjectives,policies,strategies,andcompositionoftheportfolio. Measure &evaluateperformanceSet theinvestmentobjectiveEstablish theinvestmentpolicySelect theinvestmentstrategyConstructthe portfolio& monitorperformance EXHIBIT15.1 TheInvestmentManagementProcess
InvestmentManagement 391 SETTINGINVESTMENTOBJECTIVES Settinginvestmentobjectivesstartswithathoroughanalysisoftheinvest-mentobjectivesoftheentitywhosefundsarebeingmanaged.Theseentitiescanbeclassifedasindividualinvestorsandinstitutionalinvestors.Withineachofthesebroadclassifcationsisawiderangeofinvestmentobjectives.Theobjectivesofanindividualinvestormaybetoaccumulatefundstopurchaseahomeorothermajoracquisition,tohavesuffcientfundstobeabletoretireataspecifedage,ortoaccumulatefundstopayforcollegetuitionforchildren.Anindividualinvestormayengagetheservicesofafnancialadvisor/consultantinestablishinginvestmentobjectives.Institutionalinvestorsinclude: Pensionfunds. Depositoryinstitutions(commercialbanks,savingsandloanassocia-tions,andcreditunions). Insurancecompanies(lifecompanies,propertyandcasualtycompanies,andhealthcompanies). Regulatedinvestmentcompanies(mutualfundsandclosed-endfunds). Hedgefunds. Endowmentsandfoundations. Treasurydepartmentsofcorporations,municipalgovernments,andgovernmentagencies.Nomattertheinvestor,thefrststepintheinvestmentprocessisthesame:Setanobjectivefortheportfolio. ClassificationofInvestmentObjectives Ingeneral,wecanclassifytheinvestmentobjectivesofinvestorsintothefollowingtwobroadcategories: Liability-drivenobjectives. Nonliability-drivenobjectives.Aliabilityinthiscontextisacashoutlaythatmustbemadeataspecifcfuturedateinordertosatisfythecontractualtermsofanobligation.Forexample,apensionfundmanagerisconcernedwithboththeamountandtimingofliabilitieswhenmanagingaplanthathasadefnedbeneftbecausetheportfoliomustproducecashfowstomeetpaymentspromisedtoretirees
392 INVESTMENTMANAGEMENT inatimelyway.Similarly,anindividualmaymanagetheirinvestmentstomeetspecifcaretirementobjectiveorcollegetuition.Aportfoliomanagedforanonliabilityobjectiveisnotseekingaparticu-larcashfowstream,butratherismanagedtomeetareturnorriskobjective.Anexampleofaninstitutionalinvestorthatisnotdrivenbyliabilitiesisamutualfund.Someinstitutionalinvestorsmayhaveaccountsthathavebothnonliability-drivenobjectivesandliability-drivenobjectives.Forexample,alifeinsurancecompanymayhaveobligationsthatarefxedinamount,suchasaguaranteedinvestmentcontract(GIC),andvariable,aswithavariableannuityaccount.Withavariableannuityaccount,aninvestormakesei-therasinglepaymentoraseriesofpaymentstothelifeinsurancecompanyand,inturn,thelifeinsurancecompanyinveststhepaymentsreceivedandmakespaymentstotheinvestoratsomefuturedate.Thepaymentsthatthelifeinsurancecompanymakesdependontheperformanceoftheinsurancecompany’sassetmanager.Whilethelifeinsurancecompanydoeshavealiability,itdoesnotguaranteeanyspecifcdollarpayment. Benchmark Regardlessofthetypeofinvestmentobjective,weneedtoestablishabench-marktoevaluatetheperformanceofanassetmanager.A benchmark isaportfolioorindexthatisusedforcomparisonpurposesinevaluatingaportfolio’sperformance.Thebenchmarkshouldbesimilartotheinvestor’sinvestmentobjectiveintermsofthe: Assetclassorclassesintheportfolio. Riskobjectiveoftheportfolio. Sensitivitytoeconomicfactors.Insomecases,determiningabenchmarkisfairlysimple—andinothercases,not.Forexample,inthecaseofaliability-drivenobjective,thebench-markistypicallyaninterestratetarget,wherethatinterestrateisexpectedtosatisfytheneededcashfowstream.Inthecaseofanonliability-drivenobjective,thebenchmarkistypicallytheassetclassinwhichtheassetsareinvested.Forexample,benchmarksforequityportfoliosareoftenindexes,suchastheS&P500index.Theremaynotalwaysbeareadilyavailablebenchmarkforaspecifcinvestmentobjective,soitmaybenecessarytodevelopacustomizedbench-mark.Thebottomline,however,isthatthebenchmarkservesasabasisofcomparisonfortheperformanceoftheportfolio.
InvestmentManagement 393 ESTABLISHINGANINVESTMENTPOLICY Thesecondmajoractivityintheinvestmentmanagementprocessisestab-lishingpolicyguidelinestosatisfytheinvestmentobjectives.Settingpolicybeginswiththeassetallocationdecision.Theassetallocationdecisionad-dressesthequestion:Howshouldtheportfolio’sinvestmentsbedistributedamongthemajorassetclasses?Inotherwords,whatshouldbethemixofassetsintheportfolio? AssetAllocation Theterm assetallocation meansdifferentthingstodifferentpeopleandindifferentcontexts.Wecandivideassetallocationintothreetypes: 1. Policyassetallocation. 2. Dynamicassetallocation. 3. Tacticalassetallocation. 1 Wecanlooselycharacterize policyassetallocation asalong-termassetallocationdecision,inwhichtheinvestorseeksanappropriatelong-termassetmixthatrepresentstheriskandreturnconsistentwiththeinvestmentobjective,seekingthegreatestpossiblereturnfortheappropriatelevelofrisk.Investorsoftenusethemean-varianceportfolioallocationmodelindeterminingthepolicyassetallocation.Thestrategiesthatofferthegreatestprospectsforstronglong-termrewardstoaccomplishtheinvestmentob-jectivestendtobeinherentlyriskystrategies.Thestrategiesthatofferthegreatestsafetytendtoofferonlymodestreturnopportunities.Policyassetallocationisthebalancingoftheseconfictinggoals.In dynamicassetallocation, theassetmixismechanisticallyshiftedinresponsetochangingmarketconditions.Oncethepolicyassetallocationhasbeenestablished,theinvestorcanturnattentiontothepossibilityofactivedeparturesfromthenormalassetmixestablishedbypolicy.Thatis,supposethatthelong-runassetmixisestablishedbythepolicyallocationas60%equitiesand40%bonds.Indynamicassetallocation,adeparturefromthismixmaybeallowedundercertaincircumstances.Ifadecisiontodeviatefromthismixisbaseduponrigorousobjectivemeasuresofvalue,werefertothisas tacticalassetallocation. Tacticalassetallocation,however,isnotasingle,clearlydefnedstrategy. 1 BasedonRobertD.ArnottandFrankJ.Fabozzi,“TheManyDimensionsoftheAssetAllocationDecision,”in ActiveAssetAllocation, ed.RobertD.ArnottandFrankJ.Fabozzi,3–8(Chicago:Probus,1992).
394 INVESTMENTMANAGEMENT Tacticalassetallocationbroadlyreferstoactivestrategiesthatseektoenhanceperformancebyopportunisticallyshiftingtheassetmixofaportfolioinresponsetothechangingpatternsofrewardavailableinthecapitalmarkets.Notably,tacticalassetallocationtendstorefertodisciplinedprocessesforevaluatingprospectiveratesofreturnonvariousassetclassesandestablishinganassetallocationresponseintendedtocapturehigherrewards.Manyvariationsandnuancesareinvolvedinbuildingatacticalal-locationprocess.Oneoftheproblemsinreviewingtheconceptsofassetallocationisthatthesametermsareoftenusedfordifferentconcepts.Theterm“dynamicassetallocation”hasbeenusedtorefertothelong-termpolicydecisionandtointermediate-termeffortstostrategicallypositiontheportfoliotobeneftfrommajormarketmoves,aswellastorefertoaggres-sivetacticalstrategies.Asaninvestor’sriskexpectationsandtoleranceforriskchange,thenormalorpolicyassetallocationmaychange. Agoodportfolioismorethanalonglistofgoodsstocksandbonds.Itisabalancedwhole,providingtheinvestorwithprotectionsandopportunitieswithrespecttoawiderangeofcontingencies.—HarryM.Markowitz, PortfolioSelection:EffcientDiversifcationofInvestments (NewYork:JohnWiley&Sons,1959) AssetClasses Wecanclassifyinvestableinvestmentsintofourmajorassetclassesbasedonthetypeandriskassociatedwiththeinvestments’cashfowsandvalue,legalandregulationissues,andsensitivitytoeconomicinfuences: 1. Commonstocks 2. Bonds 3. Cashequivalents 4. RealestateBasedonthiswayofdefninganassetclass,thecorrelationbetweenthereturnsofdifferentassetclasseswouldbelow.Wecanextendthefourmajorassetclassestocreateotherassetclasses.Forexample,wecanexpandfourmajorassetclassesseparatingforeignse-curitiesfromdomesticsecurities,asweshowinExhibit15.2.Commonstocksaretheownershipinterestsinacorporation,whereasbondsare
InvestmentManagement 395 InvestableassetsCommonstocksBondsCash equivalentsReal estateDomesticcommon stocksForeign bondsForeign commonstocksDomestic bonds EXHIBIT15.2 InvestableAssetsandTraditionalAssetClasses indebtednessofanentity.Cashequivalentsareliquid,low-riskinvestmentsthatcanbe,bydefnition,convertedquicklyintocash.CashequivalentsincludeTreasurybills,certifcatesofdeposit,andmoneymarketaccounts.Realestateinvestmentsincludephysicalproperty,aswellasinterestsinrealestate,suchasthroughrealestateinvestmenttrusts.Ourfocusinthischap-terisoncommonstocksandbondsbecausetheserepresentthepredominantassetclassesinmostindividualandinstitutionalportfolios. CommonStockStyleCategories Intheearly1970s,academicstudiesfoundthattherewerecategoriesofstocksthathadsimilarcharacteristicsandperformancepatterns.Moreover,thereturnsofthesestockcategoriesperformeddifferentlythandidthoseofothercategoriesofstocks.Thatis,thereturnsofstockswithinacategorywerehighlycorrelated,andthere-turnsbetweencategoriesofstockswererelativelyuncorrelated.Inthelatterhalfofthe1970s,otherstudiessuggestedthatanevensimplercategorizationbysize,produceddifferentperformancepatterns.Practitionersbegantoviewthesecategoriesorclustersofstockswithsimilarperformanceasastyleofinvesting.Today,thenotionofan equityinvestmentstyle iswidelyacceptedintheinvestmentcommunity.Wecanseetheacceptanceofequitystyleinvestingfromtheproliferationofstyleindexespublishedbyseveralvendorsthatserveasbenchmarksforportfoliosmanagedaccordingtodifferentstyles.
396 INVESTMENTMANAGEMENT Wecanclassifystocksbystyleinmanyways.Themostcommonisintermsofoneormoremeasuresofgrowthandvalue.Withinagrowthandvaluestyle,thereisasubstylebasedonsomemeasureofsize,suchasmarketcapitalization.The marketcapitalization ofacorporationisthetotalmarketvalueofitscommonstockoutstanding,whichistheproductofthepricepershareofstockandthenumberofsharesofstockoutstanding.Forexample,supposethatacorporationhas500millionsharesofcommonstockoutstandingandeachsharehasamarketvalueof$50.Thenthemarketcapitalizationofthiscompanyis500millionshares × $50pershare = $25billion.Acompany’smarketcapitalizationiscommonlyreferredtoasits marketcap or,simply, cap. Themostplain-vanillaclassifcationbasedonmarketcapis: Largecapitalizationstocks(morethan$10billion). Mid-capitalizationstocks(between$2billionand$10billion). Smallcapitalizationstocks(between$300millionand$2billion).Othercategoriesincludemega-capstocks(morethan$200billion),micro-capstocks(between$50millionand$300million),andnano-capstocks(lessthan$50million).Wecanexplainthemotivationforthevalue/growth–stylecategoriesintermsofthemostcommonlyusedmeasureforclassifyingstocksasgrowthorvalue—theprice-to-bookvaluepershare(P/B)ratio.First,considerthatearningsgrowthincreasesthebookvaluepersharein(thedenominatorofP/B).Second,assumingnochangeintheP/Bratio,astock’spricewillincreaseifearningsgrow(affectingthenumeratorofP/B).Aninvestmentmanagerwhoisgrowth-orientedisconcernedwithearn-ingsgrowth,andseeksthosestocksfromauniverseofstocksthathavehigherrelativeearningsgrowth.Thegrowthmanager’srisksarethatgrowthinearningsdoesnotmaterializeand/orthattheP/Bratiodecline.Aninvest-mentmanagerwhoisvalue-orientedisconcernedwiththepriceratherthanwiththefutureearningsgrowth.Valuestockswithinauniverseofstocksareviewedas“cheap”intermsoftheirP/Bratio.BycheapwemeanthattheP/Bratioislowrelativetothatoftheuniverseofstocks.TheexpectationofthemanagerwhofollowsavaluestyleisthattheP/Bratioreturnstosomenormalleveland,thus,evenwithbookvaluepershareconstant,thepricewillrise.TheriskisthattheP/Bratiodoesnotincrease.Wecanclassifyonthebasisofwhethertheissuerisdomesticorforeign.Becausethecorrelationofreturnsofstocksothernondomesticcompaniesmaynotbehighlycorrelatedwiththoseofthedomesticcorporations,thereareopportunitiestoincreasediversifcationwithinthecommonstockassetclassonthebasisofthedomicileoftheissuingcompany.
InvestmentManagement 397 BondInvestmentCategories Wecanclassifybondsdifferentways.Onewaytoclassifybondsistoclassifybondsbytheissuer: Governmentbonds Municipalbonds Corporatebonds Asset-backedbondsGovernmentbondsarebondsissuedbyacountry’scentralgovernment.IntheUnitedStates,thesebondsareU.S.Treasurybondsthatareindebted-nesswithmaturitiesbeyondoneyear.Municipalbondsareissuedbystateandlocalgovernments.Corporatebonds,asthenameimplies,areissuedbycorporations.Asset-backedsecuritiesareissuedbydealerswhopoolassetstogether,suchasresidentialmortgages,commercialmortgages,andissueclaimsthatarebackedbytheseassets.Wecanalsoclassifybondsbywhethertheyareissuedbyadomes-ticissuerorbyanondomestic,orforeignissuer.Wecanfurtherclassifytheforeignissuersbythedevelopmentofthefnancialmarkets,intoeitherdevel-opedmarketsoremergingmarkets.Emergingmarketsarethoseincountriesthat(1)haveeconomiesthatareintransitionbuthavestartedimplement-ingpolitical,economic,andfnancialmarketreformsinordertoparticipateintheglobalcapitalmarket;(2)mayexposeinvestorstosignifcantpricevolatilityattributabletopoliticalriskandtheunstablevalueoftheircur-rency;and(3)haveashortperiodoverwhichtheirfnancialmarketshaveoperated.WeprovideaclassifcationofbondinvestmentsinExhibit15.3.Thoughotherclassifcationschemesexist,thisprovidesyouwithonepossiblewayoflookingatbondinvestments. AlternativeAssetClasses Withtheexceptionofrealestate,alloftheassetclasseswehaveidentifedabovearereferredtoas traditionalassetclasses. Otherinvestmentsare nontraditionalassetclasses or alternativeassetclasses. Theseincludehedgefunds,privateequity,andcommodities.Hedgefundsarepoolsofinvestments,inwhichtheseinvestmentsarewide-ranging.Becauseoftheirtypicallyhigh-risknature,theinvestmentinhedgefundsislimitedtoprofessionalinvestorsandwealthyinvestors.Privateequityinvestmentsareinvestmentsthatprovidethelong-termequitybaseofacompanythatisnotlistedonanyexchangeandconsequentlydoesnothavetheabilitytoraisecapitalinthepublicstockmarket.Commodityinvestmentsareinvestmentsintheactualcommodityorcontractsbasedoncommoditiesrangingfromagriculturalproducts(suchascorn,porkbellies,andorangejuice)topreciousmetals(suchasgoldandsilver).
398 INVESTMENTMANAGEMENT BondsDomesticbondsGovernmentbondsMunicipalbondsAsset-backedbondsDevelopednationsEmergingmarketsGovernmentand municipalbondsResidentialmortgage-backed securitiesOther asset-backedsecuritiesCommericalmortagage-backed securitiesCorporatebondsCorporatebondsGovernmentand municipalbondsForeignbondsCorporatebonds EXHIBIT15.3 ClassifcationofBondInvestments InvestmentFactors Inthedevelopmentofaninvestmentpolicy,clientconstraints,regulatoryconstraints,andtaxesmustbeconsidered. Client-ImposedConstraints Examplesofclient-imposedconstraintsarerestrictionsthatspecifythetypesofsecuritiesthatamanagermayinvestandconcentrationlimitsonhowmuchorlittlemaybeinvestedinaparticularassetclassorinaparticularissuer.Wheretheobjectiveistomeettheperformanceofaparticularmarketorcustomizedbenchmark,theremaybearestrictionastothedegreetowhichthemanagermaydeviatefromsomekeycharacteristicsofthebenchmark. RegulatoryConstraints Regulatoryconstraintsinvolveconstraintsontheassetclassesthatarepermissibleandconcentrationlimitsoninvestments.Moreover,inmakingtheassetallocationdecision,theinvestmentmanagermustconsideranyrisk-basedcapitalrequirements,whicharepresentinportfoliosmanagedforbankingandinsuranceinstitutions.Theamountofstatutorycapitalrequiredforbankingandinsurancecompaniesisrelatedto
InvestmentManagement 399 thequalityoftheassetsinwhichtheinstitutionhasinvested. 2 Asanexampleofanothertypeofregulatoryconstraint,regulatedinvestmentmanagementcompaniesfacerestrictionsontheamountofleveragetheyemploy. 3 TaxConsiderations Taxconsiderationsareimportantforseveralreasons.First,certaininstitutionalinvestorssuchaspensionfunds,endowments,andfoundationsareexemptfromfederalincometaxation.Consequently,theassetclassesinwhichtheyinvestwillnotbethosethataretax-advantagedinvestments.Second,therearetaxfactorsthatmustbeincorporatedintotheinvestmentpolicy.Forexample,whileapensionfundmightbetax-exempt,theremaybecertainassetsortheuseofsomeinvestmentvehiclesinwhichitinvestswhoseearningsmaybetaxed. SelectingaPortfolioStrategy Anothermajoractivityintheinvestmentmanagementprocessisselectingaportfoliostrategyconsistentwiththeinvestmentobjectivesandinvestmentpolicyguidelinesoftheclientorinstitution.Portfoliostrategiesmaybeactiveorpassivestrategies,orsomeblendofthetwo.An activeportfoliostrategy usesavailableinformationandforecastingtechniquestoseekabetterperformancethanaportfoliothatissimplydi-versifedbroadly.Essentialtoallactivestrategiesareexpectationsaboutthefactorsthathavebeenfoundtoinfuencetheperformanceofanassetclass.Inthecaseofactivecommonstockstrategies,thismayincludeforecastsoffutureearnings,dividends,orprice-earningsratios.Withactivelymanagedbondportfolios,expectationsmayinvolveforecastsoffutureinterestratesandsectorspreads.Activeportfoliostrategiesinvolvingforeignsecuritiesmayrequireforecastsoflocalinterestratesandexchangerates.A passiveportfoliostrategy involvesminimalexpectationsinput,andinsteadreliesondiversifcationtomatchtheperformanceofsomemarketindex.Ineffect,apassivestrategyassumesthatthemarketplaceeffcientlyrefectsallavailableinformationinthepricepaidforsecurities.Betweentheseextremesofactiveandpassivestrategies,severalstrategieshavesprungupthathaveelementsofboth.Forexample,thecoreofaportfoliomaybepassivelymanagedwiththebalanceactivelymanaged. 2 Statutorycapital istheamountofequityandequivalentsthatacompanymusthavetomeetminimumregulatorystandards.Risk-basedcapitalstandardsspecifythattheamountofcapitalneededasaminimumisbasedontheriskinessoftheassetsofthecompany. 3 Leverageinthiscontextisborrowingfundsinordertomakeinvestments.
400 INVESTMENTMANAGEMENT Ausefulwayofthinkingaboutactiveversuspassivemanagementisintermsofthethreeactivitiesperformedbythemanager: 1. Portfolioconstruction(decidingonthestockstobuyandsell). 2. Tradingofsecurities. 3. Portfoliomonitoring.Generally,activemanagersdevotethemajorityoftheirtimetoportfolioconstruction.Incontrast,passivestrategiesmanagersdevotelesstimetothisactivity.Withbondinvestments,thereareseveralstrategiesclassifedas struc-turedportfoliostrategies thatareatypeofliability-drivenstrategy.Astruc-turedportfoliostrategyisoneinwhichaportfolioisdesignedtoachievetheperformanceofsomepredeterminedliabilitiesthatmustbepaidout.Thesestrategiesarefrequentlyusedwhentryingtomatchthefundsreceivedfromaninvestmentportfoliotothefutureliabilitiesthatmustbepaidandaretherefore liability-drivenstrategies. Giventhechoiceamongactiveandpassivemanagement,whichshouldbeselected?Theanswerdependsonthe: 1. Client’sormoneymanager’sviewofhow“price-effcient”themarketis. 2. Client’srisktolerance. 3. Natureoftheclient’sliabilities.AswediscussedinChapter1,marketpriceeffciencyishowdiffcultitwouldbetoearnagreaterreturnthanpassivemanagementafteradjustingfortheriskassociatedwithastrategyandthetransactioncostsassociatedwithimplementingthatstrategy. CONSTRUCTINGANDMONITORINGAPORTFOLIO Onceaportfoliostrategyisselected,theinvestmentmanagermustselecttheassetstobeincludedintheportfolio.Theinvestmentmanagementprocessincludes: Producingrealisticandreasonablereturnexpectationsandforecasts. Constructinganeffcientportfolio. Monitoring,controlling,andmanagingriskexposure. Managingtradesandtransactioncosts.Inseekingtoproducerealisticandreasonablereturnexpectations,theinvestmentmanagerhasseveralanalyticaltoolsavailable.Anactiveport-foliomanagerseekstoidentifymispricedsecuritiesormarketsectors.This
InvestmentManagement 401 informationisthenusedasinputstoconstructaneffcientportfolio.An effcientportfolio isaportfoliothatoffersthegreatestexpectedreturnforagivenlevelofriskor,equivalently,thelowestriskforagivenexpectedreturn.Onceaportfolioisconstructed,theinvestmentmanagermustmoni-tortheportfoliotodeterminehowtheportfolio’sriskexposuremayhavechangedgivenprevailingmarketconditionsandinformationabouttheas-setsintheportfolio.Thecurrentportfoliomaynolongerbeeffcientand,asaresult,theinvestmentmanagerislikelytorebalancetheportfolioinordertoproduceaneffcientportfolio.Transactioncostsaffectperformance.Theinvestmentmanagermustconsidertransactionscostsnotonlyintheinitialconstructionoftheportfo-lio,butwhentheportfolioisrebalanced. MEASURINGANDEVALUATINGPERFORMANCE Themeasurementandevaluationofinvestmentperformanceinvolvestwoactivities.Thefrstactivityisperformancemeasurementwhichinvolvesproperlycalculatingthereturnrealizedbyaninvestmentmanageroversometimeinterval,referredtoasthe evaluationperiod. Thesecondactivityisper-formanceevaluation,whichisconcernedwithdeterminingwhetherthein-vestmentmanageraddedvaluebyoutperformingtheestablishedbenchmark. MeasuringPerformance Thestartingpointforevaluatingtheperformanceofanassetmanagerismeasuringreturn.Thismightseemquitesimple,butseveralpracticalis-suesmakethetaskcomplexbecausewemusttakeintoaccountanycashdistributionsmadefromaportfolioduringtheevaluationperiod. AlternativeReturnMeasures Thedollarreturnrealizedonaportfolioforanyevaluationperiod(i.e.,ayear,month,orweek)isequaltothesumof: 1. Thedifferencebetweenthemarketvalueoftheportfolioattheendoftheevaluationperiodandthemarketvalueatthebeginningoftheevaluationperiod. 2. Anycapitalorincomedistributionsfromtheportfoliotoaclientorbenefciaryoftheportfolio.The rateofreturn ,orsimply return ,expressesthedollarreturnintermsoftheamountofthemarketvalueatthebeginningoftheevaluationperiod.
402 INVESTMENTMANAGEMENT Thus,thereturncanbeviewedastheamount(expressedasafractionoftheinitialportfoliovalue)thatcanbewithdrawnattheendoftheevaluationperiodwhilemaintainingtheinitialmarketvalueoftheportfoliointact.Wecanexpresstheportfolio’sreturnas R p = V 1 − V 0 + D V 0 (15.1)where: R p isthereturnontheportfolio. V 1 isthemarketvalueoftheportfolioattheendoftheevaluationperiod. V 0 isthemarketvalueoftheportfolioatthebeginningoftheevaluationperiod. D isthecashdistributionfromtheportfolio,ifany,duringtheevaluationperiod. EXAMPLE15.1:RETURNFORAPERIOD Consideraportfoliothatbeginsthequarterwithamarketvalueof$3million,distributes$0.1milliontoinvestors,andendsthequarterwithamarketvalueof$3.2million.Whatisthereturnonthisportfolioforthisquarter? Solution R p = $3 . 2million + 3 . 0million + 0 . 1million $3 . 0million Whencalculatingthereturnonaportfoliointhismannerwearemakingthreeassumptions: 1. Allcashinfowsfromdividendsandinterestduringtheevaluationperiodarereinvestedintotheportfolio. 2. Iftherearedistributionsfromtheportfolio,theyeitheroccurattheendoftheevaluationperiodorareheldintheformofcashuntiltheendoftheevaluationperiod. 3. Therearenocashcontributionsmadeafterthestartoftheevaluationperiod.
InvestmentManagement 403 TRYIT!RETURNFORAPERIOD Whatisthereturnforeachofthefollowingperiods? PeriodValueattheBeginningPeriodDividendValueattheEndofthePeriod 1$10$1$92$100$5$1013$1,000$5$1,100 Thus,whilewecandeterminethereturncalculationforaportfolious-ingequation(15.1)foranevaluationperiodofanylengthoftime(suchasoneday,onemonth,orfveyears),fromapracticalpointofviewtheassumptionsofthisapproachlimititsapplication.Notonlydoesthevio-lationoftheassumptionsmakeitdiffculttocomparethereturnsoftwomoneymanagersoversomeevaluationperiod,butitisalsonotusefulforevaluatingperformanceoverdifferentperiods.Thewaytohandlethesepracticalissuesistocalculatethereturnforashortunitoftimesuchasamonthoraquarter.Wecallthereturnsocalculatedthe subperiodreturn. Togetthereturnfortheevaluationperiod,thesubperiodreturnsarethenaveraged.So,forexample,iftheevaluationperiodisoneyear,andwecalculate12monthlyreturns,themonthlyreturnsarethesubperiodreturnsandweaveragethesetogettheone-yearreturn.Ifwewantathree-yearreturn,andwehaveavailable12quarterlyreturns,thequarterlyreturnsarethesubperiodreturns,andweaveragethesetogetthethree-yearreturn.Forcomparabilitywithotherinvestments,wewillthenwanttoconvertthisthree-yearreturnintoanannualreturn.Fornow,let’sfocusoncalculatingthesubperiodreturn.Wecancalculateanaverageofthesubperiodreturnsusingoneofthreemethodologies: 1. Thearithmeticaveragerateofreturn 2. Thetime-weightedrateofreturn 3. Thedollar-weightedreturn
404 INVESTMENTMANAGEMENT Wedemonstrateandcomparetheseaveragesusingthefollowingexam-pleoftheABCPortfolio,withdollaramountsinmillions: EndofQuarterBeginningValueEndingValueReturnfortheQuarter Q1$1.0$1.550%Q2$1.5$1.0–33%Q3$1.0$1.550%Q4$1.5$1.0–33%Assumethattherearenocontributionsto,norwithdrawalsfrom,thisportfoliooverthesefourquarters.WhatistheaveragequarterlyreturnfortheABCPortfolio? ArithmeticAverageRateofReturn The arithmeticaveragerateofreturn , R a ,isanunweightedaverageofthesubperiodreturns: R a = R 1 + R 2 + R 3 +··· R n n = nt = 1 R t n where: R a isthearithmeticaveragereturn, R t isthereturnforperiod t , n isthenumberofperiods.Inourexample,thearithmeticaveragequarterlyreturnfortheABCportfoliois R a = 0 . 5 − 0 . 333 − 0 . 5 − 0 . 333 4 = 8 . 333%Thisillustratesamajorproblemwithusingthearithmeticaveragerateofreturn.Toseethisproblem,considerthattherewerenocontributionstoorcashwithdrawalsfromthisportfolio,andtheportfolio’svalueattheendofthefourquartersisexactlywhatitwastobeginwith.Yetthearithmeticaveragerateofreturnis8.333%.Notabadreturn,consideringthattheportfolio’svaluedidnotchange.Butthinkaboutthisnumber.Theportfolio’sinitialmarketvaluewas$1million.Itsmarketvalueattheendoffourquartersis$1million.Thereturnoverthisfour-monthevaluationperiodiszero.Yetthearithmeticrateofreturnsaysitis8.333%.Nowyoucanseewhywedonotusethearithmeticaverageinevaluatinginvestmentperformance.
InvestmentManagement 405 Time-WeightedRateofReturn The time-weightedrateofreturn measuresthecompoundedrateofgrowthoftheinitialportfoliomarketvalueduringtheevaluationperiod,assumingthatallcashdistributionsarereinvestedintheportfolio.Wealsorefertothisreturnasthe geometricmeanreturn becauseitiscomputedbytakingthegeometricaverageoftheportfoliosubperiodreturns.Thetime-weightedrateofreturn, R TW ,is R TW = 4 n t = 1 (1 + R t )Inourexample,thequarterlyaveragetime-weightedreturniszerofortheABCportfolio: R p = 4 (1 + R 1 )(1 + R 2 )(1 + R 3 )(1 + R 4 ) − 1 R p = 4 (1 . 50)(0 . 667)(1 . 5)(0 . 667) − 1 = 0% EXAMPLE15.2:TIME-WEIGHTEDRATEOFRETURN Considerportfolioreturnsof–10%,20%,and5%inJuly,August,andSeptember,respectively.Whatisthetime-weightedmonthlyrateofreturn? Solution R TW ={ [1 + ( − 0 . 10)](1 + 0 . 20)(1 + 0 . 05) } 1 / 3 − 1 = [(0 . 90)(1 . 20)(1 . 05)] 1 / 3 − 1 = 0 . 043or4 . 3%Inotherwords,$1investedintheportfolioatthebeginningofJulywouldhavegrownatarateof4.3%permonthduringthethree-monthevaluationperiod. Ingeneral,thearithmeticandtime-weightedaveragereturnsproducedifferentvaluesfortheportfolioreturn.Thisisbecauseinthearithmeticaveragerateofreturncalculationweassumethattheamountinvestedismaintained(throughadditionsorwithdrawals)atitsinitialportfoliomar-ketvalue.Inourexample,theportfoliovaluechangeseachquarter.The
406 INVESTMENTMANAGEMENT time-weightedreturn,ontheotherhand,isthereturnonaportfoliothatvariesinsizebecauseoftheassumptionthatallproceedsarereinvested. Dollar-WeightedRateofReturn The dollar-weightedrateofreturn ,orthe money-weightedrateofreturn ,istherateofinterestrateequatesthepresentvalueofthecashfowsfromallthesubperiodsintheevaluationperiod,includingtheterminalmarketvalueoftheportfolio,totheinitialmarketvalueoftheportfolio.Thecashfowforeachsubperiodrefectsthedifferencebetweenthecashinfowsduetoinvestmentincome(i.e.,dividendsandinterest)andtocontributionsmadebytheclienttotheportfolioandthecashoutfowsrefectingdistributionstotheclient.Noticethatitisnotnecessarytoknowthemarketvalueoftheportfolioforeachsubperiodtodeterminethedollar-weightedrateofreturn.Thedollar-weightedrateofreturnissimplyaninternalrateofreturncalculation.Thedollar-weightedreturn, R DW ,solvesthefollowing: V 0 = n t = 1 CF t (1 + R DW ) t + V n (1 + R DW ) n where: CF t isthecashfowfortheportfolio(cashinfowsminuscashoutfows)forsubperiod t . V 0 istheinitialvalueoftheportfolio. V n istheendingvalueoftheportfolio. EXAMPLE15.3:DOLLAR-WEIGHTEDRATEOFRETURN Consideraportfoliowithamarketvalueof$100,000atthebeginningofJuly,capitalwithdrawalsof$5,000attheendofmonthsJuly,August,andSeptember,nocashinfowsfromtheclientinanymonth,andamarketvalueattheendofSeptemberof$110,000.Whatisthedollar-weightedmonthlyrateofreturn? Solution $100 , 000 = $5 , 000 (1 + R DW ) 1 + $5 , 000 (1 + R DW ) 2 + $115 , 000 (1 + R DW ) 3
InvestmentManagement 407 Intermsofafnancialcalculatororaspreadsheet,thecashfowsare: CF 0 = –$100,000 CF 1 = $5,000 CF 2 = $5,000 CF 3 = $115,000Thedollar-weightedreturn,calculatedusingafnancialcalculatororaspreadsheet,is8.078%. InthecaseoftheABCPortfolio, V n = V 0 ,sothedollar-weightedaveragequarterlyreturn, R DW ,is0%:$1 . 0 = $1 . 0 (1 + R DW ) 4 Thedollar-weightedrateofreturnandthetime-weightedrateofreturnproducethesameresultifnowithdrawalsorcontributionsovertheevalu-ationperiod,andifalloftheportfolio’scashinfowsfromdividendsandinterestarereinvested.Therefore,fortheABCPortfolio,thetime-weightedanddollar-weightedaveragequarterlyreturnsarethesame,0%.Theproblemwiththedollar-weightedrateofreturnisthatitisaffectedbyfactorsthatarebeyondthecontroloftheinvestmentmanager.Specif-ically,anycontributionsmadebytheclientorwithdrawalsthattheclientrequiresaffectthecalculateddollar-weightedrateofreturn.Thismakesitdiffculttocomparetheperformanceoftwomoneymanagersorbetweenaportfolioanditsbenchmark.Toseehowthisworks,considerthefollowinginvestmentcashfowsfortheDEFPortfolio,whicharesimilartotheearlierproblem,buttheinvestorinvestsanadditional$1millionattheendofthesecondquarterandtherearetwodistributions,oneattheendofthethirdquarterandoneattheendofthefourthquarter: CashFlows QuarterBeginningValueChangeinMarketValueCashContributionsCashWithdrawalsEndingValue Q1$1.0$0.5$1.5Q2$1.5 − $0.5$1.0$2.0Q3$2.0$0.5$0.5$2.0Q4$2.0 − $0.5$1.0$0.5
408 INVESTMENTMANAGEMENT Thetime-weightedaveragequarterlyreturnfortheDEFPortfoliois17.02%: EndofQuarterCalculationReturn Q1$0 . 5 / $1 . 050.0%Q2( − $0 . 5) / $1 . 5 − 33.3%Q3($0 . 5 + 0 . 5) / $2 . 050.0%Q4 − ($0 . 5 + 1) / $2 . 025.0%Average(1 + 0.5)(1–0.333)(1 + 0.5)(1 + 0.25)17.02%Eachquarter’sreturnrequirescomparingthechangeinvalueandanywithdrawalswiththevalueoftheportfolioatthebeginningofthequarter.Thedollar-weightedaveragequarterlyreturnfortheDEFPortfoliois0%: EndofQuarterTypeofCashFlowCashFlows Q1Initialinvestment–$1.0Q2Contribution–$1.0Q3Withdrawal + $0.5Q4Withdrawal,plusendingvalue + $1.5WesummarizetheadvantagesanddisadvantagesofeachmethodinExhibit15.4.Ingeneral,weusethetime-weightedaveragewhenwearefocusingonevaluatingtheportfoliomanager,becausethisaverageisnot EXHIBIT15.4 AdvantagesandDisadvantagestoAlternativeRateofReturnCalculations TypeofAverageAdvantagesDisadvantages ArithmeticaverageEasytocalculateIgnorescompoundingTimeweightedNotsensitivetocashcontributionsanddistributionsConsiderscompoundingofreturnsthroughtimeRequiresthemarketvalueattheendofeachsubperiodDollarweightedMakesintuitivesenseasaninternalrateofreturnNoneedtoknowvalueofportfolioineachsubperiodDistortediftherearecashcontributionsordistributionsRequiresiterativeprocesstosolve
InvestmentManagement 409 affectedbycashinfowsandoutfowsoftheportfoliothatareoftenout-sideoftheportfoliomanager’scontrol.Thetime-weightedreturn,however,requiresthemarketvalueoftheinvestmentattheendofeachperiod.Thedollar-weightedaverageprovidestheaveragereturnonallfundsinvestedintheportfolio,whichprovidesagoodmeasureoftheportfolio’sperformanceiftheportfoliomanagerhascontrolovercashinfowsandoutfowsoftheportfolio. TRYIT!RETURNS Consideraportfoliowithamarketvalueof$10millionatthebegin-ningofJanuary,capitalwithdrawalsof$1millionattheendofmonthsJanuary,February,andMarch,nocashinfowsfromtheclientinanymonth,andamarketvalueattheendofSeptemberof$9million. a. Whatisthetime-weightedmonthlyreturnonthisportfolio? b. Whatisthedollar-weightedmonthlyreturnonthisportfolio? EvaluatingPerformance Aperformancemeasuredoesnotanswertwoquestions: 1. Howdidtheassetmanagerperformafteradjustingfortheriskassoci-atedwiththeactivestrategyemployed? 2. Howdidtheassetmanagerachievethereportedreturn?Theanswerstothesetwoquestionsarecriticalinassessinghowwellorhowpoorlytheassetmanagerperformedrelativetosomebenchmark.Inansweringthefrstquestion,wemustconsiderrisksothatwecanthenjudgewhethertheperformancewasacceptableinthefaceoftherisk.Theanswertothesecondquestiontellsuswhethertheassetmanager,infact,achievedareturnbyfollowingtheanticipatedstrategy.Whileaclientwouldexpectthatanysuperiorreturnaccomplishedisaresultofastatedstrategy,thismaynotalwaysbethecase.Webriefydescribemethodologiesforadjustingreturnsforrisksoyoucananalyzethereturnofaportfoliotouncoverthereasonswhyareturnwasrealized.Werefertothisanalysisas performanceevaluation. Single-IndexPerformanceEvaluationMeasures Inthe1960s,severalsingle-indexmeasureswereusedtoevaluatetherelativeperformanceofmoneymanagers.Thesemeasuresofperformanceevaluationdidnotspecify
410 INVESTMENTMANAGEMENT howorwhyamoneymanagermayhaveoutperformedorunderperformedabenchmark.Thethreemeasures,orindexes,aretheTreynorindex,theSharpeindex,andtheJensenindex. 4 Allthreemeasuresassumethatthereisalinearrelationshipbetweentheportfolio’sreturnandthereturnonsomebroad-basedmarketindex. PerformanceAttributionModels Inbroadterms,wecanexplainanac-tivelymanagedportfolio’sreturnperformancebythreetypesofactionsoftheinvestmentmanager.Thefrstisactivelymanagingaportfoliotocapi-talizeonfactorsexpectedtoperformbetterthanotherfactors.Thesecondisactivelymanagingaportfoliototakeadvantageofanticipatedmovementsinthemarket.Forexample,themanagerofacommonstockportfoliocanincreasetheportfolio’sbetawhenthemarketisexpectedtoincrease,anddecreaseitwhenthemarketisexpectedtodecline.Thethirdisactivelyman-agingtheportfoliobybuyingsecuritiesthatarebelievedtobeundervalued,andselling(orshorting)securitiesthatarebelievedtobeovervalued.Attributionmodelsevaluatetheperformanceofaportfolio,attributingaportfolio’sperformancetostyleandselection.Oneofthekeyelementsofsuchmodelsistoexplainwhyaportfolio’sperformancedifferedfromthatofitsbenchmark.Iftheportfolio’sreturndifferedfromthebenchmark,wasthisduetoassetallocation(thatis,howmuchisallocatedtoeachclass)?Howmuchisduetotheparticularinvestmentselectionwithintheassetclasses? THEBOTTOMLINE Theinvestmentmanagementprocessbeginswiththesettingofinvest-mentobjectives,andthenprocesswithsettingapolicy,selectingastrat-egy,constructingaportfolio,andthenevaluatingtheperformanceoftheportfoliointhecontextoftheinvestmentobjectives. Theinvestmentobjectivesofinvestorsfallintotwobroadcategories:liability-drivenobjectivesandnon-liability-drivenobjectives.Abench-markisneededtoevaluatetheperformanceofanassetmanager. Theassetallocationdecisioninvolvesdetermininghowtheportfolio’sinvestmentsshouldbedistributedamongthemajorassetclasses.Thethreedifferenttypesofassetallocationdecisionsarepolicyassetalloca-tion,dynamicassetallocation,andtacticalassetallocation. 4 JackTreynor,“HowtoRateManagementofInvestmentFunds,” HarvardBusinessReview 44(1965):63–75;WilliamF.Sharpe,“MutualFundPerformance,” JournalofBusiness 34(1966):119–138;and,MichaelC.Jensen,“ThePerformanceofMutualFundsinthePeriod1945–1964,” JournalofFinance 23(1968):389–416.
InvestmentManagement 411 Investableinvestmentsareclassifedintoassetclassesbasedonthetypeandriskassociatedwiththeinvestments’cashfowsandvalue,legalandregulatoryissues,andsensitivitytoeconomicinfuences.Thefourmajorassetclassesarecommonstocks,bonds,cashequivalents,andrealestate.Tocreateotherassetclasses,thefourmajorassetclassescanbeextendedby,forexample,separatingforeignsecuritiesfromdomesticsecurities.Therearenontraditionalassetclasses(suchashedgefunds)thatarereferredtoasalternativeassetclasses. Informulatinganinvestmentpolicy,clientconstraints,regulatorycon-straints,andtaxesmustbeconsidered. Portfoliostrategiesmaybeactiveorpassivestrategies,orsomeblendofthetwo.Anactiveportfoliostrategyusesavailableinformationandforecastingtechniquestoseekabetterperformancethanaportfoliothatissimplydiversifedbroadly.Apassiveportfoliostrategyinvolvesmin-imalexpectationsinput,andinsteadreliesondiversifcationtomatchtheperformanceofsomemarketindex. Theselectionofthespecifcassetstobeincludedinaportfolioaftertheportfoliostrategyisselectedinvolvesproducingrealisticandreasonablereturnexpectationsandforecasts;constructinganeffcientportfolio;monitoring,controlling;managingriskexposure;andmanagingtradesandtransactioncosts.Aneffcientportfolioisaportfoliothatoffersthegreatestexpectedreturnforagivenlevelofriskor,equivalently,thelowestriskforagivenexpectedreturn. Themeasurementandevaluationofinvestmentperformanceinvolvesperformancemeasurement(i.e.,properlycalculatingthereturnrealizedbyaninvestmentmanagerovertheevaluationperiod)andperformanceevaluation(i.e.,determiningwhethertheinvestmentmanageraddedvaluebyoutperformingtheestablishedbenchmark). Evaluatingtheperformanceofaninvestmentportfoliorequiresestimat-ingreturns,adjustingforrisk,andcomparingtheportfolio’sperfor-manceagainstabenchmarkportfolio’sperformance. SOLUTIONSTOTRYIT!PROBLEMS ReturnforaPeriodPeriodSolution 1 R = $9 + 1 − 10 $10 = 0%2 R = $101 + 5 − 100 $100 = 6%3 R = $1 , 100 + 5 − 1 , 000 $1 , 000 = 10 . 5%
412 INVESTMENTMANAGEMENT Returnsa. R TW = [(1 + 0 . 10)(1 + 0 . 10)(1 + 0 . 00)] 1 / 3 − 1 = 1 . 21 1 / 3 − 1 = 6 . 56% b. $10 = $1 (1 + R DW ) 1 + $1 (1 + R DW ) 1 + $1 + 9 (1 + R DW ) 1 ; R DW = 6 . 886% QUESTIONS 1. Whatarethefourmajorassetclasses? 2. Distinguishbetweenpolicyassetallocationanddynamicassetalloca-tion. 3. Whatismeantby“marketcap,”andhowdoesthisaffectcommonstockportfoliodecisions? 4. Whatdistinguishesapassiveportfoliostrategyfromanactiveportfoliostrategy? 5. Howdoespriceeffciencyinfuencethedecisiontopursueanactiveorpassiveportfoliostrategy? 6. Whatistheprimaryproblemwiththearithmeticaveragerateofreturninevaluatingaportfolio’sperformance? 7. Ifyouwanttoevaluatetheperformanceofaportfoliomanager,whichwouldbemoreappropriatetouseincalculatingsubperiodreturns:thedollar-weightedaverageorthetime-weightedaverage?Why? 8. Consideraportfoliothathasavalueof$5atthebeginningofJanuary,withreturnsof–5%,10%,and10%inJanuary,February,andMarch,respectively.Iftherearenocashcontributionsorwithdrawalsduringthethreemonths,whatisthetime-weightedaveragemonthlyrateofreturn? 9. Consideraportfoliothathasavalueof$5atthebeginningofJanuary,withreturnsof–5%,10%,and10%inJanuary,February,andMarch,respectively.Iftherearenocashcontributionsorwithdrawalsduringthethreemonths,whatisthemoney-weightedaveragemonthlyrateofreturn? 10. Whatisthepurposeofaperformanceattributionmodel? 11. Intermsoftheprice-to-book(P/B)ratio,whyarevaluestocksgenerallyconsideredthosewithlowP/Bratios? 12. Commentonthefollowingstatements: a. “Alloneneedstoknowaboutaportfoliomanager’sabilityistocomparethereturnontheportfoliotothereturnonthebenchmark.” b. “Bylookingatthedifferencebetweentheportfolioreturnandthereturnonabenchmark,onecandeterminehowaportfoliomanagerwasabletooutperformorunderperformabenchmark.”
InvestmentManagement 413 c. “Inestablishinganinvestmentpolicy,investorsshouldignoreanyliabilitiesandjustselectamarketindexthattheywanttooutper-form.” 13. Whattypeofconstraintsmayaclientimposeonaportfoliomanager? 14. Ifaninvestmentinstockhasavalueof$3,000atthebeginningoftheyearand$3,500attheendoftheyear,andpaidadividendof$250attheendoftheyear,whatisthereturnonthestockfortheyear? 15. Consideraninvestmentwiththefollowingreturns: YearReturn 15%2 − 3%34%45% Whatisthetime-weightedannualreturnforthisinvestmentforthefour-yearperiod?
CHAPTER 16 TheTheoryofPortfolioSelection Throughoutmostofthehistoryofstockmarkets—about200yearsintheUnitedStatesandevenlongerinsomeEuropeancountries—itneveroccurredtoanyonetodefneriskwithanumber.Stockswereriskyandsomewereriskierthanothers,andpeopleletitgoatthat.Riskwasinthegut,notinthenumbers.Foraggressiveinvestors,thegoalwassimplytomaximizereturn;thefaint-heartedwerecontentwithsavingsaccountsandhigh-gradelong-termbonds. —PeterL.Bernstein, AgainsttheGods:TheRemarkableStoryofRisk (NewYork:JohnWiley&Sons,1996),p.247 I nthischapterandthenext,wesetforththeoriesthataretheunderpinningsforthemanagementofportfolios:portfoliotheoryandcapitalmarketthe-ory.Portfoliotheorydealswiththeselectionofportfoliosthatmaximizeexpectedreturnsconsistentwithindividuallyacceptablelevelsofrisk.Usingquantitativemodelsandhistoricaldata,portfoliotheorydefnes“expectedportfolioreturns”and“acceptablelevelsofportfoliorisk,”andshowshowtoconstructanoptimalportfolio.Capitalmarkettheorydealswiththeef-fectsofinvestordecisionsonsecurityprices.Morespecifcally,itshowstherelationshipthatshouldexistbetweensecurityreturnsandriskifinvestorsconstructedportfoliosasindicatedbyportfoliotheory.Together,portfolioandcapitalmarkettheoriesprovideaframeworktospecifyandmeasurein-vestmentriskandtodeveloprelationshipsbetweenexpectedsecurityreturnandrisk(andhencebetweenriskandrequiredreturnonaninvestment).Thegoalofportfolioselectionistheconstructionofportfoliosthatmaximizeexpectedreturnsconsistentwithindividuallyacceptablelevelsofrisk.Usingbothhistoricaldataandinvestorexpectationsoffuturere-turns,portfolioselectionusesmodelingtechniquestoquantify“expected 415
416 INVESTMENTS portfolioreturns”and“acceptablelevelsofportfoliorisk,”andprovidesmethodstoselectanoptimalportfolio.Thetheoryallowsinvestmentman-agerstoquantifytheinvestmentriskandexpectedreturnofaportfolio,providinganobjectivecomplementtothesubjectiveartofinvestmentmanagement.Moreimportantly,whereasatonetimethefocusofport-foliomanagementusedtobetheriskofindividualassets,thetheoryofportfolioselectionhasshiftedthefocustotheriskoftheentireportfolio.Thistheoryshowsthatitispossibletocombineriskyassetsandproduceaportfoliowhoseexpectedreturnrefectsitscomponents,butwiththepoten-tialforconsiderablylowerrisk.Inotherwords,itispossibletoconstructaportfoliowhoseriskislessthanthesumofallitsindividualparts.Inthischapter,wepresentthetheoryofportfolioselectionasformulatedbyHarryMarkowitz. 1 Thistheoryisalsoreferredtoas mean-varianceportfolioanalysis orsimply mean-varianceanalysis. Wealsotakeabrieflookatbehavioralfnance,andhowthetheoriesformulatedbyproponentsofthisfeldoffnancerelatetoinvestorchoices. SOMEBASICCONCEPTS Portfoliotheorydrawsonconceptsfromtwofelds:fnancialeconomicthe-oryandprobabilityandstatisticaltheory.Thissectionpresentstheconceptsfromfnancialeconomictheoryweuseinportfoliotheory.Whilemanyoftheconceptspresentedherehaveamoretechnicalorrigorousdefnition,thepurposeistokeeptheexplanationssimpleandintuitivesothereadercanappreciatetheimportanceandcontributionoftheseconceptstothedevelopmentofmodernportfoliotheory. UtilityFunctionandIndifferenceCurves Inlifetherearemanysituationswhereentities(i.e.,individualsandfrms)facetwoormorechoices.Theeconomic“theoryofchoice”usestheconceptofautilityfunctiontodescribethewayentitiesmakedecisionswhenfacedwithasetofchoices.A utilityfunction assignsanumericvaluetoallpossiblechoicesfacedbytheentity.Thehigherthevalueofaparticularchoice,thegreatertheutilityderivedfromthatchoice.Thechoicethatisselectedistheonethatresultsinthemaximumutilitygivenasetof(budget)constraintsfacedbytheentity. 1 HarryM.Markowitz,“PortfolioSelection,” JournalofFinance 7(1952):77–91.
TheTheoryofPortfolioSelection 417 Inportfoliotheorytoo,entitiesarefacedwithasetofchoices.Differentportfolioshavedifferentlevelsofexpectedreturnandrisk.Also,thehigherthelevelofexpectedreturnis,thelargertherisk.Entitiesarefacedwiththedecisionofchoosingaportfoliofromthesetofallpossiblerisk–returncombinations:wherereturnisadesirablethatincreasesthelevelofutility,andriskisanundesirablethatdecreasesthelevelofutility.Therefore,entitiesobtaindifferentlevelsofutilityfromdifferentrisk-returncombinations.Theutilityobtainedfromanypossiblerisk–returncombinationisexpressedbytheutilityfunction.Putsimply,theutilityfunctionexpressesthepreferencesofentitiesoverperceivedriskandexpectedreturncombinations.Autilityfunctioncanbeexpressedingraphicalformbyasetofindif-ferencecurves.InExhibit16.1,weshowindifferencecurveslabeled u 1 , u 2 ,and u 3 . Byconvention,thehorizontalaxismeasuresriskandtheverticalaxismeasuresexpectedreturn.Eachcurverepresentsasetofportfolioswithdifferentcombinationsofriskandreturn.Allthepointsonagivenindiffer-encecurveindicatecombinationsofriskandexpectedreturnthatwillgivethesamelevelofutilitytoagiveninvestor.Forexample,onutilitycurve u 1 ,therearetwopoints, U and U ,with U havingahigherexpectedreturnthan U ,butalsohavingahigherrisk.Becausethetwopointslieonthesameindifferencecurve,theinvestorhasanequalpreferencefor(orisindifferentto)thetwopoints,or,forthatmatter,anypointonthecurve.The(positive)slopeofanindifferencecurverefectsthefactthat,toobtainthesamelevel u 1 u 1 u 3 Expected Return Risk u 2 u 2 u 3 U'U EXHIBIT16.1 UtilityFunctionsandIndifferenceCurves
418 INVESTMENTS ofutility,theinvestorrequiresahigherexpectedreturninordertoaccepthigherrisk.ForthethreeindifferencecurvesshowninExhibit16.1,theutilitytheinvestorreceivesisgreaterthefurthertheindifferencecurveisfromthehorizontalaxis,becausethatcurverepresentsahigherlevelofreturnateverylevelofrisk.Thus,forthethreeindifferencecurvesshownintheexhibit, u 3 hasthehighestutilityand u 1 thelowest. EfficientPortfoliosandtheOptimalPortfolio Portfoliosthatprovidethelargestpossibleexpectedreturnforgivenlevelsofriskarecalled effcientportfolios. Toconstructaneffcientportfolio,itisnecessarytomakesomeassumptionabouthowinvestorsbehavewhenmakinginvestmentdecisions.Onereasonableassumptionisthatinvestorsare riskaverse. Arisk-averseinvestorisaninvestorwho,whenfacedwithchoosingbetweentwoinvestmentswiththesameexpectedreturnbuttwodifferentrisks,preferstheonewiththelowerrisk.Inselectingportfolios,aninvestorseekstomaximizetheexpectedport-folioreturngivenhistoleranceforrisk.Alternativelystated,aninvestorseekstominimizetheriskthatheisexposedtogivensometargetexpectedreturn.Givenachoicefromthesetofeffcientportfolios,an optimalportfolio istheonethatismostpreferredbytheinvestor. RiskyAssetsvs.Risk-FreeAssets Ariskyassetisoneforwhichthereturnthatwillberealizedinthefutureisuncertain.Commonstockisconsideredariskyassetbecauseoftheuncer-taintyaboutthefuturedividendsandpricewhentheinvestorwantstosellthestock.Thesameistrueforbondsbecauseoftherisktheissuermightdefault.Thereareassets,however,forwhichthereturnthatwillberealizedinthefutureisknownwithcertaintytoday.Suchassetsarereferredtoas risk-free or risklessassets. Therisk-freeassetiscommonlydefnedasashort-termobligationoftheU.S.government.Forexample,ifaninvestorbuysaU.S.governmentsecuritythatmaturesinoneyearandplanstoholdthatsecurityforoneyear,thenthereisnouncertaintyaboutthereturnthatwillberealized.Theinvestorknowsthatinoneyear,thematuritydateofthesecurity,thegovernmentwillpayapredeterminedamounttoretirethedebt. ESTIMATINGAPORTFOLIO’SEXPECTEDRETURN Wearenowreadytodefneandmeasuretheactualandexpectedreturnofariskyassetandaportfolioofriskyassets.
TheTheoryofPortfolioSelection 419 ForaSingle-PeriodPortfolioReturn Theactualreturnonaportfolioofassetsoversomespecifctimeperiodisaweightedaverageofthereturnsontheindividualassetsintheportfolio,andisstraightforwardtocalculateusingthefollowing: R p = w 1 R 1 + w 2 R 2 +···+ w G R G (16.1)where: R p istherateofreturnontheportfolioovertheperiod, R g istherateofreturnonasset g overtheperiod, w g istheweightofasset g intheportfolio(i.e.,marketvalueofasset g isaproportionofthemarketvalueofthetotalportfolio)atthebeginningoftheperiod,and G isthenumberofassetsintheportfolio.Inshorthandnotation,wecanexpressequation(16.1)as R p = G g = 1 w g R g (16.2)Inequation(16.2),thereturnonaportfolio, R p ,of G assetsisequaltothesumovertheproductsoftheindividualassets’weightsintheportfolioandtheirrespectivereturn.Theportfolioreturn R p issometimescalledthe holdingperiodreturn orthe expostreturn .Forexample,considerthefollowingportfolioconsistingofthreeassets: AssetMarketValueattheBeginningoftheHoldingPeriodHoldingPeriodReturn 1$6million12%28million10%311million 5%Total$25millionRestatingthis,usingtheproportionofthetotalmarketvalueforeachasset: AssetProportionofPortfolio’sMarketValueHoldingPeriodReturn 1$6million ÷ $25million = 24%12%2$8million ÷ $25million = 32%10%3$11million ÷ $25million = 44%5%
420 INVESTMENTS Noticethatthesumoftheweightsisequalto1.Substitutingintoequa-tion(16.1),wegettheholdingperiodportfolioreturn, R p = (0 . 24 × 0 . 12) + (0 . 32 × 0 . 10) + (0 . 44 × 0 . 05) = 8 . 28%Theholdingperiodportfolioreturnis8.28%.Therefore,thegrowthintheportfolio’svalueinmonetarytermsovertheholdingperiodis$25million × 0.0828 = $2.07million. ForaPortfolioofRiskyAssets Inequation(16.1),weshowhowtocalculatetheactualreturnofaportfoliooversomespecifctimeperiod.Inportfoliomanagement,theinvestoralsowantstoknowtheexpected(oranticipated)returnfromaportfolioofriskyassets.Inotherwords,the exantereturn. Theexpectedportfolioreturnistheweightedaverageoftheexpectedreturnofeachassetintheportfolio.Theweightassignedtotheexpectedreturnofeachassetisthepercentageofthemarketvalueoftheassettothetotalmarketvalueoftheportfolio.Thatis, E ( R p ) = w 1 E ( R 1 ) + w 2 E ( R 2 ) +···+ w G E ( R G )(16.3)The E ()signifesexpectations,and E ( R p )istheexpectedportfolioreturnoversomespecifctimeperiod.Wecalculatetheexpectedreturn, E ( R i ),onariskyasset i asfollows.First,wespecifytheprobabilitydistributionforthepossibleratesofreturnweexpecttooccurinthefutureperiod.A probabilitydistribution isafunc-tionthatassignsaprobabilityofoccurrencetoallpossibleoutcomesforarandomvariable.Giventheprobabilitydistribution,theexpectedvalueofarandomvariableissimplytheweightedaverageofthepossibleoutcomes,wheretheweightistheprobabilityassociatedwiththepossibleoutcome.Inourcase,therandomvariableistheuncertainreturnofasset i. Hav-ingspecifedaprobabilitydistributionforthepossibleratesofreturn,theexpectedvalueoftherateofreturnforasset i istheweightedaverageofthepossibleoutcomes.Finally,ratherthanusetheterm“expectedvalueofthereturnofanasset,”wesimplyusetheterm“expectedreturn.”Mathe-matically,theexpectedreturnofasset i isexpressedas E ( R i ) = p 1 R 1 + p 2 R 2 +···+ p N R N (16.4)where: R n isthe n thpossiblerateofreturnforasset i . p n istheprobabilityofattainingtherateofreturn n forasset i . N isthenumberofpossibleoutcomesfortherateofreturn.
TheTheoryofPortfolioSelection 421 EXHIBIT16.2 ProbabilityDistributionfortheReturnforAssetXYZandAssetABC PossibleOutcomeReturnonAssetXYZReturnonAssetABCProbabilityofOccurrenceReturnonAssetXYZ × ProbabilityReturnonAssetABC × Probability 112%21%18%0.02160.037821014240.02400.0336389290.02320.0261444160.00640.00645 − 4 − 313 − 0.0052 − 0.0039 Total100%0.07000.1000Expectedreturn7%10% InExhibit16.2weprovidetheprobabilitydistributionfortwohypo-theticalassets,AssetXYZandAssetABC.TheexpectedreturnforAssetXYZis7%andtheexpectedreturnforAssetABCis10%. TRYIT!EXPECTEDRETURN WhatistheexpectedreturnforAssetThreeandforAssetFour,giventhefollowingprobabilitydistributions? PossibleOutcomeProbabilityofOccurrenceReturnonAssetThreeReturnonAssetFour 125%12%21%245%10%14%330%8%9% MEASURINGPORTFOLIORISK Thedictionarydefnesriskas“hazard,peril,exposuretolossorinjury.”Withrespecttoinvestments,investorshaveusedavarietyofdefnitionstodescriberisk.Markowitzquantifedtheconceptofriskusingthewell-knownstatisticalmeasuresofvariancesandcovariances.Hedefnedtheriskofa
422 INVESTMENTS portfolioasthesumofthevariancesoftheinvestmentsandcovariancesamongtheinvestments.Thenotionofintroducingthecovariancesamongreturnsoftheinvestmentsintheportfoliotomeasuretheriskofaportfolioforeverchangedhowtheinvestmentcommunitythoughtabouttheconceptofrisk. VarianceandStandardDeviationasaMeasureofRisk The varianceofarandomvariable isameasureofthedispersionorvari-abilityofthepossibleoutcomesaroundtheexpectedvalue. 2 Inthecaseofanasset’sreturn,thevarianceisameasureofthedispersionofthepossiblerateofreturnoutcomesaroundtheexpectedreturn.Theequationforthevarianceoftheexpectedreturnforasset i ,denoted σ 2 ( R i ),is σ 2 ( R i ) = p 1 ( r 1 − E ( R i )) 2 + p 2 ( r 2 − E ( R i )) 2 +···+ p N ( r N − E ( R i )) 2 (16.5)assuming N possibleoutcomes.Thiscanalsobeexpressedas σ 2 ( R i ) = N n = 1 p n ( r n − E ( R i )) 2 Thevarianceassociatedwithadistributionofreturnsmeasuresthecompactnesswithwhichthedistributionisclusteredaroundthemeanorexpectedreturn.Markowitzarguedthatthisvarianceisequivalenttotheuncertaintyorriskinessoftheinvestment.Ifanassetisriskless,ithasanexpectedreturndispersionofzero.Inotherwords,thereturn(whichisalsotheexpectedreturninthiscase)iscertain,orguaranteed.Becausethevarianceisinsquaredunits,itiscommontoseethevarianceconvertedtothestandarddeviation, σ ,bytakingthepositivesquarerootofthevariance: σ ( R i ) = σ 2 ( R i )WeprovidethecalculationofthestandarddeviationofthedistributionofthereturnsonAssetXYZusingthisformulainExhibit16.3(PanelA).Becauseexpectedreturnandvariancearetheonlytwoparametersthatinvestorsareassumedtoconsiderinmakinginvestmentdecisions,weoftenrefertotheMarkowitzformulationofportfoliotheoryasa two-parameter 2 Theexpectedvalueistheweightedmeanoftheprobabilitydistribution,wheretheprobabilitiesaretheweights.
TheTheoryofPortfolioSelection 423 EXHIBIT16.3 StandardDeviationoftheDistributionofReturnsforAssetXYZandAssetABC A.AssetXYZ PossibleOutcomeReturnLessExpectedReturnSquareofDeviationProbability × SquaredDeviation 10.05000.00250.000520.03000.00090.000230.01000.00010.00004 − 0.03000.00090.00015 − 0.11000.01210.0016 Variance = 0.0024Standarddeviation = 4.90% B.AssetABC PossibleOutcomeReturnLessExpectedReturnSquareofDeviationProbability × SquaredDeviation 10.11000.01210.002220.04000.00160.00043 − 0.01000.00010.00004 − 0.06000.00360.00065 − 0.13000.01690.0022 Variance = 0.0054Standarddeviation = 7.32% model or mean-varianceanalysis .Therehavebeenmodelsthatproposeincludingadditionalmeasuresofareturndistributionintotheportfolioselectionmodel. TRYIT!STANDARDDEVIATIONOFADISTRIBUTION WhatisthestandarddeviationofthefollowingdistributionofreturnsforAssetFiveandAssetSix? PossibleOutcomeProbabilityofOccurrenceReturnonAssetFiveReturnonAssetSix 125%20%25%250%10%5%325% − 5% − 15%
424 INVESTMENTS MeasuringthePortfolioRiskofaTwo-AssetPortfolio Inequation(16.5),weprovidethevarianceforanindividualasset’sreturn.Thevarianceofaportfolioconsistingoftwoassetsisalittlemorediffculttocalculate.Itdependsnotonlyonthevarianceofthetwoassets,butalsouponhowcloselythereturnsofoneassettrackthoseoftheotherasset.Theformulaforthevarianceoftheportfoliois σ 2 ( R p ) = w 2 i σ 2 i + w 2 i σ 2 i + 2 w i w j cov( R i , R j )(16.6)wherecov( R i , R j )isthecovariancebetweenthereturnforassets i and j. Inotherwords,thevarianceoftheportfolioreturnisthesumofthesquaredweightedvariancesofthetwoassets,plustwotimestheweightedcovariancebetweenthetwoassets.Wecangeneralizethisequationtothecasewheremorethantwoassetsareintheportfolio. Covariance Likethevariance,the covariance hasaprecisemathematicaltranslation.Itspracticalmeaningisthedegreetowhichthereturnsontwoassets co varyorchangetogether.Infact,thecovarianceisjustageneralizedconceptofthevarianceappliedtomultipleassets.Apositivecovariancebetweentwoassetsmeansthatthereturnsontwoassetstendtomoveorchangeinthesamedirection,whileanegativecovariancemeansthereturnstendtomoveinoppositedirections.Thecovariancebetweenanytwoassets i and j iscomputedusingthefollowingformula:cov( R i , R j ) = p 1 ( r i 1 − E ( R i )) r j 1 − ER j + p 2 ( r i 2 − E ( R i )) r j 2 − ER j +···+ p N ( r iN − E ( R i )) r jN − ER j (16.7)where: r in isthe n thpossiblerateofreturnforasset i.r jn isthe n thpossiblerateofreturnforasset j.p n istheprobabilityofattainingtherateofreturn n forassets i and j.N isthenumberofpossibleoutcomesfortherateofreturn.The correlation betweenthereturnsforassets i and j ,denotedby ρ i , j isthecovarianceofthetwoassetsdividedbytheproductoftheirstandarddeviations: ρ i , j = cov( R i , R j ) σ i σ j (16.8)
TheTheoryofPortfolioSelection 425 EXHIBIT16.4 CalculationofCovarianceandCorrelationbetweenAssets i and j PossibleOutcomeProbabilityDeviationforAssetXYZ( r i XYZ − E ( R XYZ ))DeviationforAssetABC( r i ABC − E ( R ABC ))ProductoftheDeviationsandProbability 118%0.05000.11000.0010224%0.03000.04000.0003329%0.0100 − 0.01000.0000416% − 0.0300 − 0.06000.0003513% − 0.1100 − 0.13000.0019 Covariance = 0.0034Correlation = 0.9441 Thecorrelationcoeffcientcanhavevaluesrangingfrom + 1.0,denot-ingperfectcomovementinthesamedirection,to–1.0,denotingperfectco-movementintheoppositedirection.Becausestandarddeviationsareal-wayspositive,thecorrelationcanonlybenegativeifthecovarianceisaneg-ativenumber.Acorrelationofzeroimpliesthatthereturnsareuncorrelated.Thecorrelationandthecovarianceareconceptuallysimilarterms,yetscaleddifferently.Thecorrelationbetweentworandomvariablesistheco-variancedividedbytheproductoftheirstandarddeviations.Becausethecorrelationisastandardizednumber(i.e.,ithasbeencorrectedfordiffer-encesinthestandarddeviationofthereturns),thecorrelationiscomparableacrossdifferentassets.ThecorrelationbetweenthereturnsforAssetXYZandAssetABCis0.9441.WeprovidethedetailsofthiscalculationinExhibit16.4. TRYIT!CORRELATIONANDCOVARIANCE Completethefollowingtable: PortfolioStandardDeviationofAssetOne’sReturnsStandardDeviationofAssetTwo’sReturnsCorrelationoftheReturnsofAssetOneandAssetTwoCovarianceoftheReturnsofAssetOneandAssetTwo 120%30% 0.030220% 0.2000.020360%30% − 0.500 4 25%0.2500.016540%20% 0.064
426 INVESTMENTS MeasuringtheRiskofaPortfolioComprisedofMorethanTwoAssets Sofarwehavedefnedtheriskofaportfolioconsistingoftwoassets.Theextensiontothreeassets— i , j ,and k —isasfollows: σ 2 R p = w 2 i σ 2 ( R i ) + w 2 j σ 2 R j + w 2 k σ 2 ( R k ) + 2 w i w j cov( R i R j ) + 2 w i w k cov( R i R k ) + 2 w j w k cov( R j R k )(16.9)Inwords,equation(16.9)statesthatthevarianceoftheportfolioreturnisthesumofthesquaredweightedvariancesoftheindividualassetsplustwotimesthesumoftheweightedpairwisecovariancesoftheassets.Ingeneral,foraportfoliowith G assets,theportfoliovarianceisgivenby σ 2 R p = G g = 1 G h = 1 w g w h cov( R g R h )(16.10)Inequation(16.10),thetermsforwhich h = g resultsinthevariancesofthe G assets,andthetermsforwhich h = g resultsinallpossiblepairwisecovariancesamongstthe G assets.Therefore,equation(16.10)isshorthandnotationforthesumofall G variancesandthepossiblecovariancesamongstthe G assets. PORTFOLIODIVERSIFICATION Often,onehearsinvestorstalkingaboutdiversifyingtheirportfolio.Aninvestorwho diversifes constructsaportfolioinsuchawayastoreduceportfolioriskwithoutsacrifcingreturn.Thisiscertainlyagoalthatinvestorsshouldseek.However,thequestionishowtodothisinpractice.Amajorcontributionofthetheoryofportfolioselectionisthatbyusingtheconceptsdiscussedabove,wecanquantifythediversifcationofaportfolio,anditisthismeasurethatinvestorscanusetoachievethemaximumdiversifcationbenefts.TheMarkowitzdiversifcationstrategyisprimarilyconcernedwiththedegreeofcovariancebetweenassetreturnsinaportfolio.IndeedakeycontributionofMarkowitzdiversifcationistheformulationofanasset’sriskintermsofaportfolioofassets,ratherthaninisolation.Markowitzdiversifcationseekstocombineassetsinaportfoliowithreturnsthatarelessthanperfectlypositivelycorrelated,inanefforttolowerportfoliorisk(variance)withoutsacrifcingreturn.Itistheconcernformaintainingreturn,
TheTheoryofPortfolioSelection 427 whileloweringriskthroughananalysisofthecovariancebetweenassetreturns,thatseparatesMarkowitzdiversifcationfromanaiveapproachtodiversifcationandmakesitmoreeffective.WeillustrateMarkowitzdiversifcationandtheimportanceofassetcorrelationswithasimpletwo-assetportfolioexample.Todothis,wefrstshowthegeneralrelationshipbetweentheriskofatwo-assetportfolioandthecorrelationofreturnsofthecomponentassets.Thenwelookattheeffectsonportfolioriskofcombiningassetswithdifferentcorrelations. PortfolioRiskandCorrelation Inourtwo-assetportfolio,assumethatAssetCandDareavailablewithexpectedreturnsandstandarddeviationsof: Asset E ( R ) σ ( R ) AssetC12%30%AssetD18%40%Ifanequal50%weightingisassignedtobothAssetCandD,theexpectedportfolioreturnusingequation(16.1)is15%andthevarianceofthereturnonthetwo-assetportfoliofromequation(16.6)is σ 2 ( R p ) = [0 . 5 2 × 0 . 3 2 ] + [0 . 5 2 × 0 . 4 2 ] + [2 × 0 . 5 2 × 0 . 5 2 × cov( R C , R D )]Usingtherelationbetweenthecovarianceandthestandarddeviationsofthetwosecuritiesfromequation(16.8), ρ C , D = cov( R C , R D ) σ C σ D (16.11)socov( R C , R D ) = σ ( R C ) σ ( R D ) ρ ( R C , R D )Because σ ( R C ) = 30%and σ ( R D ) = 40%,thencov( R C , R D ) = (30% × 40%) ρ ( R C , R D ) = 0 . 12 ρ ( R C , R D )Substitutingintotheexpressionfor σ 2 ( R p ),weget σ 2 ( R p ) = [0 . 5 2 × 0 . 3 2 ] + [0 . 5 2 × 0 . 4 2 ] + [2 × 0 . 5 × 0 . 5 × 0 . 12 ρ ( R C , R D )]
428 INVESTMENTS Therefore, σ 2 ( R p ) = 0 . 0225 + 0 . 04 + 0 . 06 ρ ( R C , R D )Multiplyingandtakingthesquarerootofthevariancegives σ R p = 0 . 0625 + (0 . 06 ρ ( R C R D ))Let’slookatourtwo-assetportfoliowithdifferentcorrelationsbetweenthereturnsofthecomponentassets.Specifcally,considerthefollowingthreecasesfor ρ ( R C , R D ): + 1.0,0,and–1.0.Substitutingintoequation(16.11)forthesethreecasesof ρ ( R C , R D ),wegetthefollowing: Correlation E ( R p ) σ ( R p ) + 1.015%35%0.015%25%–1.015%5%AsthecorrelationbetweentheexpectedreturnsonAssetCandAssetDdecreasesfrom + 1.0to0.0to–1.0,thestandarddeviationoftheexpectedportfolioreturnalsodecreasesfrom35%to5%.However,theex-pectedportfolioreturnremains15%foreachcase.ThisisanexampleofMarkowitzdiversifcation.TheprincipleofMarkowitzdiversifcationisthatasthecorrelationbetweenthereturnsforassetsthatarecombinedinaportfoliodecreases,sodoesthevariance(hencethestandarddeviation)ofthereturnfortheportfolio. Inchoosingaportfolio,investorsshouldseekbroaddiversifcation.Further,theyshouldunderstandthatequities—andcorporatebondsalso—involverisk;thatmarketsinevitablyfuctuate,andtheport-folioshouldbesuchthattheyarewillingtorideoutthebadaswellasthegoodtimes.—HarryMarkowitz,October7,2008 CHOOSINGAPORTFOLIOOFRISKYASSETS DiversifcationinthemannersuggestedbyMarkowitzleadstotheconstruc-tionofportfoliosthathavethehighestexpectedreturnatagivenlevelof
TheTheoryofPortfolioSelection 429 risk.Werefertosuchportfoliosas effcientportfolios .Inordertoconstructeffcientportfolios,thetheorymakessomebasicassumptionsaboutassetselectionbehaviorbyinvestors.Theassumptionsareasfollows: 1. Theonlytwoparametersthataffectaninvestor’sdecisionaretheex-pectedreturnandthevariance.(Thatis,investorsmakedecisionsusingthetwo-parametermodelformulatedbyMarkowitz.) 2. Investorsareriskaverse.Thatis,whenfacedwithtwoinvestmentswiththesameexpectedreturnbuttwodifferentrisks,investorswillprefertheonewiththelowerrisk. 3. Allinvestorsseektoachievethehighestexpectedreturnatagivenlevelofrisk. 4. Allinvestorshavethesameexpectationsregardingexpectedreturn,variance,andcovariancesforallriskyassets.Thisassumptionisreferredtoasthe homogeneousexpectationsassumption. 5. Allinvestorshaveacommonone-periodinvestmenthorizon. ConstructingEfficientPortfolios Thetechniqueofconstructingeffcientportfoliosfromlargegroupsofas-setsrequiresamassivenumberofcalculations.Foraportfolioofjust50securities,thereare1,224covariancesthatmustbecalculated.For100securities,thereare4,950.Furthermore,inordertosolvefortheportfo-liothatminimizesriskforeachlevelofreturn,amathematicaltechniquecalled quadraticprogramming mustbeused.Adiscussionofthistech-niqueisbeyondthescopeofthischapter.However,itispossibletoillustratethegeneralideaoftheconstructionofeffcientportfoliosbyreferringagaintothesimpletwo-assetportfolioconsistingofAssetsCandD.Recallthatforthesetwoassets, E ( R C ) = 12%and σ ( R C ) = 30% E ( R D ) = 18%and σ ( R D ) = 40%Nowfurtherassumethat ρ ( R C , R D ) = –0.5.WeprovidetheexpectedportfolioreturnandstandarddeviationforfvedifferentportfoliosmadeupofvaryingproportionsofCandDinExhibit16.5.AsyoucanseeinPanelAofExhibit16.5,themixof50–50forCandDintheportfolioresultsintheloweststandarddeviationofthefvemixes.InPanelBofExhibit16.5,weshowtheportfoliostandarddeviationforawiderrangeofmixesofAssetCandD,youcanseethattheportfolio’sstandarddeviationislowestaround60%AssetCand40%AssetD.
430 INVESTMENTS A. Portfolio standard deviation for five different mixes of Asset C and Asset D MixWeightof CWeightof DExpectedreturnVarianceStandarddeviation 1100%0%12.00%0.0900030.00%275%25%13.50%0.0381319.53%350%50%15.00%0.0325018.03%425%75%16.50%0.0731327.04%50%100%18.00%0.1600040.00% B. Portfolio standard deviation for weights of Asset C from 100% to 0% 0%10%20%30%40%50%100%85%70%55%40%25%10% Percent Invested in Asset C Portfolio Standard Deviation EXHIBIT16.5 PortfolioExpectedReturnandStandardDeviationforaPortfolioComprisedofAssetCandD FeasibleandEfficientPortfolios A feasibleportfolio isanyportfoliothataninvestorcanconstructgiventheassetsavailable.ThefveportfoliospresentedinExhibit16.5areallfeasibleportfolios.Thecollectionofallfeasibleportfoliosiscalledthe feasiblesetofportfolios. Withonlytwoassets,thefeasiblesetofportfoliosisgraphedasacurvethatrepresentsthosecombinationsofriskandexpectedreturnthatareattainablebyconstructingportfoliosfromallpossiblecombinationsofthetwoassets.InPanelBofExhibit16.5,weshowthefeasiblesetofportfoliosforallcombinationsofassetsCandD.Incontrasttoafeasibleportfolio,aneffcientportfolioisonethatgivesthehighestexpectedreturnofallfeasibleportfolioswiththesamerisk.Aneffcientportfolioisalsosaidtobea mean-varianceeffcientportfolio. Thus,foreachlevelofriskthereisaneffcientportfolio.Thecollectionofalleffcientportfoliosiscalledthe effcientset.
TheTheoryofPortfolioSelection 431 Expected Return Standard Deviaon EXHIBIT16.6 EffcientPortfolioswithAssetsCandD WeprovidetheeffcientsetforthefeasiblesetpresentedinExhibit16.6.EffcientportfoliosarethecombinationsofAssetsCandDthatresultintherisk–returncombinationsonthecurvefromPortfolio3to5.Theseportfoliosofferthehighestexpectedreturnatagivenlevelofrisk.NoticethatPortfolios1and2arenotincludedintheeffcientset.Thisisbecausethereisatleastoneportfoliointheeffcientset(forexample,Portfolio3)thathasahigherexpectedreturnandlowerriskthanbothofthem.WecanalsoseethatPortfolio4hasahigherexpectedreturnandlowerriskthanPortfolio1.Infact,thewholecurvesection1–3isnoteffcient.Foranygivenrisk-returncombinationonthiscurvesection,thereisacombina-tion(onthecurvesection3–5)thathasthesameriskandahigherreturn,orthesamereturnandalowerrisk,orboth.Inotherwords,foranyportfoliothatresultsinthereturn-riskcombinationonthecurvesection1–3(exclud-ingPortfolio3),thereexistsaportfoliothatdominatesitbyhavingthesamereturnandlowerrisk,orthesameriskandahigherreturn,oralowerriskandahigherreturn.Forexample,Portfolio4dominatesPortfolio1,andPortfolio3dominatesbothPortfolio1and2.InExhibit16.7weillustratethefeasibleandeffcientsetswhentherearemorethantwoassets.Inthiscase,thefeasiblesetisnotacurve,butratheranarea.Thisisbecause,unlikethetwo-assetcase,itispossibletocreateassetportfoliosthatresultinrisk–returncombinationsthatnotonlyresultincombinationsthatlieonthecurveI–II–III,butallcombinationsthatlieintheshadedarea.However,theeffcientsetisgivenbythecurveII–III.Itiseasilyseenthatalltheportfoliosontheeffcientsetdominatetheportfoliosintheshadedarea.
432 INVESTMENTS Expected Return RiskIIIIII EXHIBIT16.7 FeasibleandEffcientPortfolioswithMoreThanTwoAssets Wesometimesrefertotheeffcientsetofportfoliosasthe effcientfrontier ,becausegraphicallyalltheeffcientportfolioslieontheboundaryofthesetoffeasibleportfoliosthathavethemaximumreturnforagivenlevelofrisk.Anyrisk–returncombinationabovetheeffcientfrontiercannotbeachieved,whilerisk–returncombinationsoftheportfoliosthatmakeuptheeffcientfrontierdominatethosethatliebelowtheeffcientfrontier. ChoosingtheOptimalPortfoliointheEfficientSet Nowthatwehaveconstructedtheeffcientsetofportfolios,thenextstepistodeterminetheoptimalportfolio.Becauseallportfoliosontheeffcientfrontierprovidethegreatestpos-siblereturnattheirlevelofrisk,aninvestororentitywillwanttoholdoneoftheportfoliosontheeffcientfrontier.Noticethattheportfoliosontheeffcientfrontierrepresenttrade-offsintermsofriskandreturn.Movingfromlefttorightontheeffcientfrontier,theriskincreases,butsodoestheexpectedreturn.Thequestioniswhichoneofthoseportfoliosshouldaninvestorhold?Thebestportfoliotoholdofallthoseontheeffcientfrontieristhe optimalportfolio. Intuitively,theoptimalportfolioshoulddependontheinvestor’sprefer-enceoverdifferentrisk-returntrade-offs.Asexplainedearlier,thispreferencecanbeexpressedintermsofautilityfunction.
TheTheoryofPortfolioSelection 433 u 1 u 1 u 3 Expected Return Risk u 2 u 2 u 3 Efficientfrontier Optimalportfolio EXHIBIT16.8 SelectingtheOptimalPortfolio WedrewthethreeindifferencecurvesrepresentingautilityfunctionandtheeffcientfrontierinExhibit16.8,drawnonthesamediagram.Anindifferencecurveindicatesthecombinationsofriskandexpectedreturnthatgivethesamelevelofutility.Moreover,thefarthertheindifferencecurvefromthehorizontalaxis,thehighertheutility.FromExhibit16.8,wecandeterminetheoptimalportfolioforthein-vestorwiththeseindifferencecurves.Rememberthattheinvestorwantstogettothehighestindifferencecurveachievablegiventheeffcientfron-tier.Giventhatrequirement,theoptimalportfolioisrepresentedbythepointwhereanindifferencecurveistangenttotheeffcientfrontier.InExhibit16.8,thatistheportfolio.Consequently,fortheinvestor’spreferencesoverriskandreturnasde-terminedbytheshapeoftheindifferencecurvesrepresentedinExhibit16.8.Ifthisinvestorprefersmorereturnandlessrisk,theoptimalportfolioisasindicatedinExhibit16.8:atthepointoftangencyoftheeffcientfrontierandutilitycurve u 2 .Ifthisinvestorhadadifferentpreferenceforexpectedriskandreturn,therewouldhavebeenadifferentoptimalportfolio.Atthispointinourdiscussion,anaturalquestionishowtoestimateaninvestor’sutilityfunctionsothattheindifferencecurvesand,hence,theoptimalportfoliocanbedetermined.Unfortunately,thereislittleguidanceabouthowtoconstructone.Ingeneral,economistshavenotbeensuccessfulinestimatingutilityfunctions.Theinabilitytoestimateutilityfunctionsdoesnotmeanthatthetheoryisfawed.Whatitdoesmeanisthatonceaninvestorconstructstheeffcientfrontier,theinvestorwillsubjectivelydeterminethateffcientportfolioisappropriategivenhisorhertolerancetorisk.
434 INVESTMENTS ISSUESINTHETHEORYOFPORTFOLIOSELECTION ThetheoryofportfolioselectionsetforthbyMarkowitzwasbasedonsomemodelingassumptionsregardingthebehaviorofinvestorswhenmakinginvestmentdecisionsandabouttheprobabilitydistributionofthereturnonassetsthatmadeitacceptabletousethevarianceorstandarddeviationasameasureofrisk.Moreover,intermsofimplementationoftheportfolioselectionmodelthatreliedontheestimationofinputsfromhistoricaldata,noconsiderationwasgiventotheimplicationsofwhathappensifaportfoliomanagermisestimatestheinputsrequiredbythemodel:expectedreturns,variances,andcovariancesofreturns.Inthissection,welookattheissuessurroundingthetheoryofportfolioselectionandtheimplementationofthemodel. AlternativeRiskMeasuresforPortfolioSelection Ifthereturndistributionisnormallydistributed,thenthevarianceisause-fulmeasureofrisk.Thenormaldistributionisasymmetricdistributionsooutcomesaboveandbelowtheexpectedvalueareequallylikely.However,therearebothempiricalstudiesofreal-worldfnancialmarketsaswellastheoreticalargumentsthatsuggestthatweshouldrejectthenormaldistri-butionassumption. 3 Markowitzconsideredtheproblemsassociatedwithusingthevarianceofreturnsasameasureofinvestmentrisk.Infact,herecognizedthatanalternativetothevarianceisthesemivariance.The semivariance issimilartothevarianceexceptthatinthecalculationnoconsiderationisgiventoreturnsabovetheexpectedreturn.Portfolioselectioncouldberecastintermsofmean-semivariance.However,ifthereturndistributionissymmetric,Markowitzarguesthatboththevarianceandthesemivarianceproducesimilardecisions,andthat,further,thevarianceisamorefamiliarstatisticthanthesemivariance. 4,5 3 Forareviewoftheempiricalevidence,seeSvetlozarT.Rachev,ChristianMenn,andFrankJ.Fabozzi, Fat-TailedandSkewedAssetReturnDistributions:ImplicationsforRiskManagement,PortfolioSelection,andOptionPricing (Hoboken,NJ:JohnWiley&Sons,2005). 4 HarryM.Markowitz, PortfolioSelection:EffcientDiversifcationofInvestment (NewYork:JohnWiley&Sons,1959),190,193–194. 5 Themeanandthevariancearethefrsttwomomentsofaprobabilitydistribution.Thethirdmomentisameasureofskewnessandthefourthmomentisameasureofkurtosis.Ageneralizationofthemean-varianceframeworkthatincorporateshighermoments,suchasskewnessandkurtosis,hasbeendeveloped.Becauseofthetechnicalcomplexityofthesemodels,wedonotdiscussthemhere.
TheTheoryofPortfolioSelection 435 Thereisdebateonthebestriskmeasurestouseforoptimizinganinvestor’sportfolio.Accordingtotheliteratureonportfoliotheory,twodis-jointedcategoriesofriskmeasurescanbedefned:dispersionmeasuresandsafety-riskmeasures.Wedescribesomeofthemostwell-knowndispersionmeasuresandsafety-frstmeasuresnext. VARIANCEVS.SEMIVARIANCE Thevarianceofaprobabilitydistribution, σ 2 ,is σ 2 = N n = 1 p n ( x n − E ( x )) 2 Thesemivariance, σ 2 S ,iscalculatedusingonlythoseobservationsbelowtheexpectedvalue: σ 2 S = N fornifx n < E ( x ) p n ( x n − E ( x )) 2 DispersionMeasures Thevarianceorstandarddeviation(moretechni-callyreferredtoasthe mean-standarddeviation )isadispersionmeasure.Thereareseveraldifferentmeasuresofdispersionavailable.Themostcommonlyusedmeasure(andeasiesttounderstand)isthemean-absolutedeviation.The mean-absolutedeviation (MAD)dispersionmeasureisbasedontheabsolutevalueofthedeviationsfromthemeanratherthanthesquaredde-viationsasinthecaseofthemean-standarddeviation.Whereasthevarianceisaffectedbyoutliers,especiallybecauseofthesquaringofdeviationsfromthemean,theMADislessaffectedbyoutliers. Safety-FirstRiskMeasures Manysuggest safety-frstrules asacriterionfordecisionmakingunderuncertainty. 6 Inthesemodels,asubsistence,a 6 See,amongothers,AndrewD.Roy,“Safety-FirstandtheHoldingofAssets,” Econometrica 20(1952):431–449;LesterG.Tesler,“SafetyFirstandHedging,” ReviewofEconomicStudies 23(1955/1956):1–16;VijayS.Bawa,“Admissi-blePortfolioforAllIndividuals,” JournalofFinance 31(1976):1169–1183;andVijayS.Bawa,“Safety-FirstStochasticDominanceandOptimalPortfolioChoice,” JournalofFinancialandQuantitativeAnalysis 13(1978):255–271.
436 INVESTMENTS benchmark,oradisasterlevelofreturnsisidentifed.Theobjectiveisthemaximizationoftheprobabilitythatthereturnsareabovethebenchmark.Thus,mostofthesafety-frstriskmeasuresproposedintheliteraturearelinkedtothebenchmark-basedapproach.Someofthemostwell-knownsafety-frstriskmeasuresproposedintheliteratureare: Classicalsafety-frst Valueatrisk Conditionalvalueatrisk/expectedtailloss LowerpartialmomentInthe classicalsafety-frst portfoliochoiceproblem,theriskmeasureistheprobabilityoflossor,moregenerally,theprobabilityofportfolioreturnlessthansomespecifedvalue. 7 Intermsofimplementation,generally,thisapproachrequiressolvingamuchmorecomplexoptimizationproblemtofndtheoptimalportfoliosincontrasttothemean-variancemodel.Probablythemostwell-knowndownsideriskmeasureis valueatrisk (VaR).Thismeasureisrelatedtothepercentilesoflossdistributions,andmeasuresthepredictedmaximumlossataspecifedprobabilitylevel(forexample,95%)overacertaintimehorizon(forexample,10days).ThemaincharacteristicofVaRisthatofsynthesizinginasinglevaluethepos-siblelossesthatcouldoccurwithagivenprobabilityinagiventemporalhorizon.Thisfeature,togetherwiththeveryintuitiveconceptofmaximumprobableloss,allowsinvestorstofgureouthowriskyaportfolioortradingpositionis.TherearevariouswaystocalculatetheVaRofasecurityoraportfoliobutadiscussionofthesemethodologiesisbeyondthescopeofthisbook.DespitetheadvantagescitedforVaRasameasureofrisk,itdoeshaveseveraltheoreticallimitations.Specifcally,itignoresreturnsbeyondtheVaR(i.e.,itdoesnotconsidertheconcentrationofreturnsinthetailsbeyondVaR).Toovercometheselimitationsandproblems,the conditionalvalueatrisk (CVaR)hasbeensuggestedasanalternativeriskmeasure.CVaR,whichwealsorefertoasthe expectedshortfall or expectedtailloss ,measurestheexpectedvalueofportfolioreturns,giventhattheVaRhasbeenexceeded.Anaturalextensionofsemivarianceisthe lowerpartialmomentriskmeasure. 8 Thismeasure,alsocalled downsiderisk ,dependsontwo 7 SeeRoy,“Safety-FirstandtheHoldingofAssets.” 8 SeeBawa,“AdmissiblePortfolioforAllIndividuals”;andPeterC.Fishburn,“Mean-riskAnalysiswithRiskAssociatedwithBelow-TargetReturns,” AmericanEconomicReview 67(1977):116–126.
TheTheoryofPortfolioSelection 437 parameters:(1)apowerindex,whichisaproxyfortheinvestor’sdegreeofriskaversion;and(2)thetargetrateofreturn,whichistheminimumreturnthatmustbeearned.Thoughthemathematicsofthesemeasuresarecomplex,thebottomlineisthatmeasuresexistthatinvestorscanuseinadditiontothemean-varianceanalysistoassistintheconstructionofaportfolio. RobustPortfolioOptimization Despitetheinfuenceandtheoreticalimpactofmodernportfoliotheory,today—almost60yearsafterMarkowitz’ssem-inalwork—fullrisk–returnoptimizationattheassetlevelisprimarilydoneonlyatthemorequantitatively-orientedassetmanagementfrms.Theavail-abilityofquantitativetoolsisnottheissue—today’soptimizationtechnologyismatureandmuchmoreuser-friendlythanitwasatthetimeMarkowitzfrstproposedthetheoryofportfolioselection—yetmanyassetmanagersavoidusingthequantitativeportfolioallocationframeworkaltogether.Amajorreasonforthereluctanceofportfoliomanagerstoapplyquanti-tativerisk–returnoptimizationisthattheyhaveobservedthatitmaybeun-reliableinpractice.Specifcally,mean-varianceoptimization(oranymeasureofriskforthatmatter)isverysensitivetochangesintheinputs.Inthecaseofmean-varianceoptimization,suchinputsincludetheexpectedreturn,thevarianceofeachasset,andtheassetcovariancebetweeneachpairofassets.Whileitcanbediffculttomakeaccurateestimatesoftheseinputs,estimationerrorsintheforecastssignifcantlyaffecttheresultingportfolioweights.Asaresult,theoptimalportfoliosgeneratedbythemean-varianceanalysisgenerallyhaveextremeorcounterintuitiveweightsforsomeas-sets. 9 Suchexamples,however,arenotnecessarilyasignthatthetheoryofportfolioselectionisfawed;ratherthat,whenusedinpractice,themean-varianceanalysisaspresentedbyMarkowitzhastobemodifedinordertoachievereliability,stability,androbustnesswithrespecttomodelandestimationerrors.Itgoeswithoutsayingthatadvancesinthemathematicalandphysicalscienceshavehadamajorimpactuponfnance.Inparticular,mathematicalareassuchasprobabilitytheory,statistics,econometrics,operationsresearch,andmathematicalanalysishaveprovidedthenecessarytoolsanddisciplineforthedevelopmentofmodernfnancialeconomics.Substantial 9 SeeMichaelJ.BestandRobertR.Grauer,“OntheSensitivityofMean-VarianceEffcientPortfoliostoChangesinAssetMeans:SomeAnalyticalandComputationalResults,” ReviewofFinancialStudies 4(1991):315–342;MarkBroadie,“Comput-ingEffcientFrontiersUsingEstimatedParameters,” AnnalsofOperationsResearch 45(1993):21–58;andVijayK.ChopraandWilliamT.Ziemba,“TheEffectsofErrorsinMeans,Variances,andCovariancesonOptimalPortfolioChoice,” Jour-nalofPortfolioManagement 19(1993):6–11.
438 INVESTMENTS advancesintheareasofrobustestimationandrobustoptimizationweremadeduringthe1990s,andhaveproventobeofgreatimportanceforthepracticalapplicabilityandreliabilityofportfoliomanagementandoptimization.Anystatisticalestimateissubjecttoerror—estimationerror.Arobustestimationisastatisticalestimationtechniquethatislesssensitivetoout-liersinthedata.Forexample,inpractice,itisundesirablethatoneorafewextremereturnshavealargeimpactontheestimationoftheaveragereturnofastock.Nowadays,statisticaltechniquessuchasBayesiananalysisandrobuststatisticsaremorecommonplaceinassetmanagement.Takingitonestepfurther,practitionersarestartingtoincorporatetheuncertaintyintro-ducedbyestimationerrorsdirectlyintotheoptimizationprocess.Thisisverydifferentfromtraditionalmean-varianceanalysis,whereonesolvestheportfoliooptimizationproblemasaproblemwithdeterministicinputs(i.e.,inputsthatareassumedtobeknownwithcertainty),withouttakingtheesti-mationerrorsintoaccount.Inparticular,thestatisticalprecisionofindivid-ualestimatesisexplicitlyincorporatedintotheportfolioallocationprocess.Providingthisbeneftistheunderlyinggoalofrobustportfoliooptimization. BEHAVIORALFINANCEANDPORTFOLIOTHEORY Inbuildingeconomicmodels,fnancialeconomistsmakeassumptionsaboutthebehaviorofthosewhomakeinvestmentdecisionsinfnancialmarkets.Werefertotheseentitiesas economicagents. Morespecifcally,theymakeassumptionsabouthoweconomicagentsmakeinvestmentchoicesinselect-ingassetstoincludeintheirportfolio.Theunderlyingeconomictheorythatfnancialeconomistsdrawuponinformulatingvarioustheoriesofchoiceisutilitytheory.Thereareconcernswiththerelianceonsuchtheories.Prominenteconomists,suchasJohnMay-nardKeynes,havearguedthatinvestorpsychologyaffectssecurityprices.Supportforthisviewcameinthelate1970whentwopsychologists,DanielKahnemanandAmosTversky,demonstratedthattheactionsofeconomicagentsinmakinginvestmentdecisionsunderuncertaintyareinconsistentwiththeassumptionsmadebyfnancialeconomistsinformulatingfnancialtheories. 10 Basedonnumerousexperiments,KahnemanandTverskyattackedutil-itytheoryandpresentedtheirownviewastohowinvestorsmadechoices 10 SeeDanielKahnemanandAmosTversky,“AdvancesinProspectTheory:Cumu-lativeRepresentationofUncertainty,” JournalofRiskandUncertainty 5(1992):297–323.
TheTheoryofPortfolioSelection 439 underuncertaintythattheycalled prospecttheory. Prospecttheoryfocusesondecision-makingunderuncertainty,describingbehaviorasinvolvingaheuristic. 11 First,individualsconsiderthepossibleinvestmentsanddecidewhichonesaresimilarandwhichonesaredifferent.Second,individualsevaluatethepossibleoutcomesandprobabilities,selectingtheinvestmentbasedondecisionweighting,suchthattheseweightsdonotnecessarilyre-latetoprobabilities.AnimportantcontributionoftheworkofKahnemanandTverskyisthattheyarguethatindividualsbehavedifferentlyregardinggainsandlosses.Thisisincontrasttothemean-variancetheoriesthatusevariance,whichassumesinvestorsviewgainsandlossesassymmetric.Otherattacksontheassumptionsoftraditionalfnancialtheorydrawingfromthefeldofpsychologyleadtothespecializedfeldinfnanceknownasbehavioralfnance. 12 Behavioralfnancelooksathowpsychologyaffectsinvestordecisionsandtheimplicationsnotonlyforthetheoryofportfolioselection,butinderivingatheoryaboutassetpricing.Thefoundationsofbehavioralfnancehavethefollowingthreebehav-ioralthemes: 13 Theme1: Whenmakinginvestmentdecisions,investorsmakeerrorsbecausetheyrelyonrulesofthumb. Theme2: Investorsareinfuencedbyformaswellassubstanceinmakinginvestmentdecisions. Theme3: Pricesinthefnancialmarketareaffectedbyerrorsanddeci-sionframes. 11 “Prospecttheory”doesnotrelatetoprospecting.AsrelatedbyPeterBernsteininhisbook AgainsttheGods:TheRemarkableStoryofRisk (NewYork:JohnWiley&Sons,1996),Kahnemanstates,“Wejustwantedanamethatpeoplewouldnoticeandremember.” 12 Forafurtherdiscussionofbehavioralfnance,seethefollowingchaptersinFrankJ.Fabozzi(ed.), HandbookofFinance, vol.2(Hoboken,NJ:JohnWiley&Sons,2008):MeirStatman,Chapter9,“WhatIsBehavioralFinance”;JarrodW.Wilcox,Chapter8,“BehavioralFinance”;VictorRicciardi,Chapter10,“ThePsychologyofRisk:TheBehavioralFinancePerspective”;andFrankJ.Fabozzi(ed.), HandbookofFinance, vol.2(Hoboken,NJ:JohnWiley&Sons,2008):VictorRicciardi,Chapter2,“Risk:TraditionalFinanceversusBehavioralFinance.” 13 ThesethemesarefromHershShefrin, BeyondGreedandFear:UnderstandingBehavioralFinanceandthePsychologyofInvesting (NewYork:OxfordUniversityPress,2002)andarebasedonDanielKahneman,PaulSlovic,andAmosTversky, JudgmentunderUncertainty:HeuristicsandBiases (NewYork:CambridgeUniver-sityPress,1982).
440 INVESTMENTS BehavioralFinanceTheme1involvestheconceptof heuristics. Heuris-ticsarerulesofthumborguidesthatindividualswillpursuetoreducethetimerequiredtomakeadecision.Forexample,inplanningforretirement,aruleofthumbthathasbeensuggestedforhavingsuffcientfundstoretireistoinvest10%ofannualpretaxincome.Asforwhattoinvestintoreachthatretirementgoal(thatis,theallocationamongassetclasses),aruleofthumbthathasbeensuggestedisthatthepercentagethataninvestorshouldallocatetobondsshouldbedeterminedbysubtractingthatinvestor’sagefrom100.So,forexample,a45-yearoldindividualshouldinvest55%ofhisorherretirementfundsinbonds.Althoughtherearecircumstanceswhereheuristicscanworkfairlywell,studiesinthefeldofpsychologysuggestthatheuristicscanleadtosys-tematicbiasesindecisionmaking.Thissystematicbiasisreferredtobypsychologistsas cognitivebiases. Inthecontextoffnance,thesebiasesleadtoerrorsinmakinginvestmentdecisions,or heuristic-drivenbiases. 14 Con-trastthiswiththeassumptionmadeinthetheoryofportfolioselectionthatallinvestorsestimatethemeanandvarianceofeveryassetreturnandbasedonthoseestimatesconstructanoptimalportfolioforeachlevelofrisk(i.e.,theeffcientfrontier). EXAMPLESOFCOGNITIVEBIASES Anchoring. Thetendencyforanindividualtofocuseitheronapastreferenceoronaspecifcpieceofinformation,withoutconsideringthecompletesetofinformation. Bandwagoneffect. Thetendencyofindividualstogoalongwithwhatothersaredoing. Confrmationbias. Theinterpretationorseekingofinformationthatsupportsoneselforconfrmsahypothesis. Dispositioneffect. Thetendencyofinvestorstoholdontoassetsthathavedeclinedinvalue,yetsellassetsthathaveincreasedinvalue. Framing. Makingdecisionsconsideringthemannerorpresenta-tionofthesituation. 14 Shefrin, BeyondGreedandFear:UnderstandingBehavioralFinanceandthePsy-chologyofInvesting .
TheTheoryofPortfolioSelection 441 Gamblers’fallacy. Thebeliefthatprobabilitiesinthefutureareaffectedbypastevents. Negativebias. Thetendencyforindividualstofocusmoreonthenegativethanpositive. Overconfdencebias. Thetendencytoexaggerateone’sownabilitytojudgethevalueofanasset. Self-servingbias. Interpretationofinformationthatputsoneselfinabetterlight. BehavioralFinanceTheme2involvestheconceptof framing. Thistermdealswiththewayinwhichasituationorchoiceispresentedtoaninvestor.Behavioralfnancetheoristsarguethattheframingofinvestmentchoicescanresultinsignifcantlydifferentassessmentsbyaninvestorastotheriskandreturnofeachchoiceand,therefore,theultimatedecisionmade. 15 BehavioralFinanceTheme3recognizesthatnotallparticipantsinmarketsarerationalandthatoccasionalmispricingmayoccurduetothisirrationality.Thisirrationalitymaystemfromcognitivebiasessuchasover-confdenceandherding,andmayresultinadivergencebetweenanasset’sprice,asobservedinthemarket,andanasset’sintrinsicvalue.Behavioraltheoriesmayexplainwhatweobservethatmaynotbecon-sistentwithtraditionaltheoriesoffnance,butitalsohelpsexplainwhyinvestorsmakethechoicestheydobasedonriskaversion. THEBOTTOMLINE Combiningassetsinaportfoliowhosereturnsarenotperfectly,posi-tivelycorrelatedwithoneanothercanreducetheriskoftheportfoliothroughdiversifcation.Diversifcationallowsanentitytoreducerisk,toapoint,withoutnecessarilysacrifcingreturn. Giventhesetofallpossiblecombinationsofassetsthatwecanform,therewillbesomeportfoliosthatarebetterthanothersintermsofriskandreturn.Theeffcientfrontieristhesetofportfoliosthathavethehighestreturnforagivenlevelofriskor,equivalently,thelowestriskforagivenreturn. 15 SeeAmosTverskyandDanielKahneman,“TheFramingofDecisionsandthePsychologyofChoice,” Science 211(1961):453–458;andAmosTverskyandDanielKahneman,“RationalChoiceandtheFramingofDecisions,” JournalofBusiness 59(1986):S251–S278.
442 INVESTMENTS Foragiveninvestor,theportfoliothatisbestfromthoseontheeffcientfrontierdependsontheinvestor’sindividualpreferenceforreturnanddislikeforrisk. Thoughportfoliotheoryfocusesontheportfolio’svarianceandstan-darddeviationasmeasuresofrisk,therearealternativemeasuresofriskthatfocusonthedownsiderisk,includingthemeanabsolutedeviation,semivariance,andvalueatrisk. Behavioralfnanceusestheanalysisofcognitivebiasesofindividualstoexplainobservedmarketbehavior,someofwhichmaynotbeconsistentwiththetraditionalviewoftherationalinvestor. SOLUTIONSTOTRYIT!PROBLEMS CorrelationandCovariancePortfolioStandardDeviationofAssetOne’sReturnsStandardDeviationofAssetTwo’sReturnsCorrelationoftheReturnsofAssetOneandAssetTwoCovarianceoftheReturnsofAssetOneandAssetTwo 120%30%0.5000.030220%50%0.2000.020360%30% − 0.500 − 0.090425%25%0.2500.016540%20%0.8000.064 ExpectedReturnPossibleOutcomeProbabilityofOccurrenceReturnonAssetThreeReturnonAssetFourReturnonAssetThree × ProbabilityReturnonAssetFour × Probability 125%12%21%0.03000.0525245%10%14%0.04500.0630330% 8%9%0.0240 0.0270 Total100%0.09900.1425ExpectedreturnonAssetThree = 9.9%ExpectedreturnonAssetFour = 14.25%
TheTheoryofPortfolioSelection 443 StandardDeviationofaDistribution AssetFive PossibleOutcomeReturnLessExpectedReturnReturnLessExpectedReturnSquaredProbability × SquaredDeviation 10.20000.20000.200020.20000.20000.200030.20000.20000.2000 Variance = 0.0080Standarddeviation = 8.93% AssetSix PossibleOutcomeReturnLessExpectedReturnReturnLessExpectedReturnSquaredProbability × SquaredDeviation 10.20000.04000.010020.00000.00000.00003 − 0.20000.04000.0100 Variance = 0.0200Standarddeviation = 14.14% QUESTIONS 1. Whatismeantbyautilityfunction? 2. Iftwoassets’returnsarepositivelycorrelated,whatisthecovariancebetweenthereturnsofthesetwoassets? 3. Whatistherelationbetweenthecorrelationbetweenandamongassetsanddiversifcation? 4. Howdoesaneffcientportfoliorelatetoafeasibleportfolio? 5. Whatinformationdoesthesemivarianceconvey? 6. Whatisasafety-frstrule? 7. Whatisprospecttheory? 8. Whatismeantbyframingandhowmaythisaffectaninvestor’sdecisionmaking? 9. Identifythreesafety-frstmethods. 10. Whatisacognitivebiasandhowmightitaffectinvestors’decisionmaking?
444 INVESTMENTS 11. ThecovarianceofreturnsonAssetAandAssetBarenegative. a. Whatdoesthistellusaboutthecorrelationcoeffcientfortheirreturns? b. IfweformaportfoliocomprisedofAssetAandAssetB,whatistherelationbetweentheportfolio’sriskandtherisksofAssetAandAssetBconsideredseparately? 12. Considerthefollowingstocksandtheirexpectedreturnsandstandarddeviations: StockExpectedReturnStandardDeviation A10%14%B10%13%C12%12%D12%14% a. BetweenStockAandStockB,whichwouldarisk-averseinvestorprefer?Explain. b. BetweenStockCandStockD,whichwouldarisk-averseinvestorprefer?Explain. c. BetweenStockBandStockC,whichwouldarisk-averseinvestorprefer?Explain. 13. Iftheeconomyrecoversnextyear,analystsexpectStockX’sreturnfortheyeartobe20%;iftheeconomydoesnotrecover,analystsexpectStockX’sreturnfortheyeartobe − 5%.Ifthereisa40%chancethattheeconomywillrecoveranda60%thatitwillnot,whatis: a. TheexpectedreturnonStockXfornextyear? b. ThestandarddeviationofthereturnonStockXfornextyear? 14. Iftheeconomyrecoversnextyear,analystsexpectStockY’sreturnfortheyeartobe15%;iftheeconomydoesnotrecover,analystsexpectStockY’sreturnfortheyeartobe − 15%.Ifthereisa50%chancethattheeconomywillrecover,anda50%thatitwillnot,whatis: a. TheexpectedreturnonStockYfornextyear? b. ThestandarddeviationofthereturnonStockYfornextyear? 15. Consideraportfoliocomprisedoftwosecurities,MandN.Thecor-relationofthereturnsonthesesecuritiesis0.25.Andsupposethatthesesecuritieshavedifferentstandarddeviations.Explainhowdiffer-entcombinationsofthesetwosecuritiescanresultindifferentestimatesforportfoliorisks.
CHAPTER 17 AssetPricingTheory TherearetwokeymessagesinCAPM,ifyougetdowntothebedrock.Oneisthatabroadlydiversifedmarket-likeportfolioisaverygoodthingtothinkabout.Thatgaverisetothenotionoftheindexfund.Thatisanimportantmessage,asstrangeandhereticalasitseemedwhenwefrststarted.Theothermessageisthattogetahigherexpectedreturn,youhavegottoacceptahigherbetavalue.Thereisalsoabroaderversion.Whatkindofriskdoyouexpecttogetrewardedforinthelongterm?Answer:theriskofdoingbadlyinbadtimes.Ifthereisarewardforbearingrisk,italmosthastobethat.Otherwise,theworldmakesnosenseatall.Thepremiumforbearingriskisrelatedtotheriskthatjustwhenyouneedit,youaregoingtobepoor.Ifthatkindofriskisnotrewarded,thenthereisnoreasontobelievethatthereisariskpremiumforstocksasopposedtoputtingyourmoneyinthebank.IntheCAPMworld,betaisthemeasureofhowbadlyyoudoinbadtimes—highbetasecuritiesorportfoliosaregoingtoreallytankifthemarketgoesdown. —WilliamF.Sharpe,“TheGurus,” CFOMagazine ,January2000 A ssetpricingtheoryseekstodescribetherelationshipbetweenriskandexpectedreturn.Althoughwerefertoassetpricingmodelsinthischap-ter,whatwemeanistheexpectedreturninvestorsrequiregiventheriskassociatedwithaninvestment.Thetwomostwell-knownequilibriumassetpricingmodelsarethecapitalassetpricingmodelandthearbitragepricingtheorymodel.Inthischapter,wedescribethesetwomodels. 445
446 INVESTMENTS CHARACTERISTICSOFANASSETPRICINGMODEL Inwell-functioningcapitalmarkets,aninvestorshouldberewardedforacceptingthevariousrisksassociatedwithinvestinginanasset.Weoftenrefertorisksas“riskfactors”or“factors.”Wecanexpressan assetpricingmodel ingeneraltermsbasedonriskfactorsasfollows: E ( R i ) = f ( F 1 , F 2 , F 3 ,... F N )(17.1)where: E(R i ) istheexpectedreturnforasset i . F k istheriskfactor k . N isthenumberofriskfactors.Inotherwords,theexpectedreturnonanassetisthefunctionof N riskfactors.Thetrickistodeterminewhattheriskfactorsareandtospecifythepreciserelationshipbetweenexpectedreturnandtheriskfactors.Wecanfne-tunetheassetpricingmodelgivenbyequation(17.1)bythinkingabouttheminimumexpectedreturnwewouldwantfrominvestinginanasset.SecuritiesissuedbytheU.S.DepartmentoftheTreasuryofferaknownreturnifheldoversomeperiodoftime.Theexpectedreturnofferedonsuchsecuritiesistherisk-freereturnortherisk-freeratebecausewebelievethesesecuritiestohavenodefaultrisk.Byinvestinginanassetotherthansuchsecurities,investorswilldemandapremiumovertherisk-freerate.Thatis,theexpectedreturnthataninvestorwillrequireis: E ( R i ) = R f + Riskpremiumwhere R f istherisk-freerate.The“riskpremium,”oradditionalreturnexpectedovertherisk-freerate,dependsontheriskfactorsassociatedwithinvestingintheasset.Thus,wecanrewritethegeneralformoftheassetpricingmodelgivenbyequation(17.1)as: E ( R i ) = R f + f ( F 1 , F 2 , F 3 ,... F N )(17.2)Wecandivideriskfactorsintotwogeneralcategories.Thefrstcategoryisriskfactorsthatcannotbereducedwithdiversifcation.Thatis,nomatterwhattheinvestordoes,theinvestorcannoteliminatetheseriskfactors.We
AssetPricingTheory 447 refertotheseriskfactorsas systematicriskfactors or nondiversifableriskfactors. Thesecondcategoryisriskfactorsthatcanbeeliminatedthroughdiversifcation.Theseriskfactorsareuniquetotheassetandarereferredtoas unsystematicriskfactors or diversifableriskfactors. SYSTEMATICRISKVS.SYSTEMICRISK Therecentfnancialcrisishaselevatedtheuseofthewordsystemic.Systemicriskshouldnotbeconfusedwithsystematicrisk: Systemicrisk isriskthatisinherentwithinanentireeconomyororganismandgenerallyreferstotheriskthattheeconomyororganismmaycollapse. Systematicrisk istheriskthatcannotbediversifedaway. THECAPITALASSETPRICINGMODEL Thefrstassetpricingmodel,the capitalassetpricingmodel (CAPM),wasde-rivedfromeconomictheoryformulatedbytheindividualworksofWilliamSharpe,JohnLintner,JackTreynor,andJanMossin. 1 TheCAPMhasonlyonesystematicriskfactor—theriskoftheoverallmovementofthemarket,whichwerefertoas marketrisk. So,intheCAPM,marketriskandsystem-aticriskareinterchangeableterms.Marketriskmeanstheriskassociatedwithholdingaportfolioconsistingofallassets;thatis,themarketportfolio.Inthemarketportfolio,anassetisheldinproportiontoitsmarketvalue.Forexample,ifthetotalmarketvalueofallassetsis$ X andthemarketvalueofasset j is$ Y ,thenasset j comprises$ Y ÷ $ X ofthemarketportfolio. 1 WilliamF.Sharpe,“CapitalAssetPrices,” JournalofFinance 19(1964):425–442;JohnLintner,“TheValuationofRiskAssetsandtheSelectionofRiskyInvestmentsinStockPortfolioandCapitalBudgets,” ReviewofEconomicsandStatistics 47(1965):13–37;JackL.Treynor,“TowardaTheoryofMarketValueofRiskyAssets,”unpublishedmanuscript,1962;andJanMossin,“EquilibriuminCapitalAssetMarket,” Econometrica 34(1965):768–783.
448 INVESTMENTS IntheCAPM,theexpectedreturnonasset i is E ( R i ) = R f + β i [ E ( R M ) − R f ](17.3)where: E ( R M )istheexpectedreturnonthemarketportfolio. β i isthemeasuresofsystematicriskofasset i relativetothemarketportfolio.Whatdoesthistellusabouttheexpectedreturns?Theexpectedreturnforanasset i, accordingtotheCAPM,isequaltotherisk-freerateplusariskpremium.Theriskpremiumis β i [ E ( R M ) − R f )].Anotherwayoflookingatthisisthattheriskpremiumonthemarketportfoliois E ( R M ) − R f ,andweuse β i toadjustthisforthesystematicriskofasset i. Beta, β i ,isameasureofthesensitivityofthereturnofasset i tothereturnofthemarketportfolio.Therefore, β i = 1.0Theassetorportfoliohasthesamequantityofriskasthemarketportfolio. β i > 1.0Theassetorportfoliohasmoremarketriskthanthemarketportfolio. β i < 1.0Theassetorportfoliohaslessmarketriskthanthemarketportfolio.ThesecondcomponentoftheriskpremiumintheCAPMisthedif-ferencebetweentheexpectedreturnonthemarketportfolio, E ( R M ),andtherisk-freerate.Itmeasuresthepotentialrewardfortakingontheriskofthemarketabovewhatcanearnedbyinvestinginanassetthatoffersarisk-freerate.Takentogether,theriskpremiumisaproductofthequantityofmarketrisk(asmeasuredbybeta, β i )andthepotentialcompensationoftakingonmarketrisk, E ( R M ) − R f .Let’susesomevaluesforbetatoseeifallofthismakessense.Supposethataportfoliohasabetaofzero.Thatis,thereturnforthisportfoliohasnomarketrisk.Substitutingzerofor β i intheCAPMgivenbyequation(17.3),theexpectedreturnisequaltotherisk-freerate.Thismakessensesinceaportfoliothathasnomarketriskshouldhaveanexpectedreturnequaltotherisk-freerate.Consideraportfoliothathasabetaof1.Thisportfoliohasthesamemarketriskasthemarketportfolio.Substituting1for β i intheCAPMgivenbyequation(17.3),theexpectedreturnisequaltothatofthemarketportfolio.Again,thisiswhatoneshouldexpectforthereturnofthisport-foliosinceithasthesamemarketriskexposureasthemarketportfolio.
AssetPricingTheory 449 Ifaportfoliohasgreatermarketriskthanthemarketportfolio,betawillbegreaterthan1andtheexpectedreturnwillbegreaterthanthatofthemarketportfolio.Ifaportfoliohaslessmarketriskthanthemarketportfolio,betawillbelessthan1andtheexpectedreturnwillbelessthanthatofthemarketportfolio. AssumptionsoftheCAPM TheCAPMisanabstractionofrealworldcapitalmarketsand,assuch,isbasedonsomeassumptions.Theseassumptionssimplifymattersagreatdeal,andsomeofthemmayevenseemunrealistic.However,theseassump-tionsmaketheCAPMmoretractablefromamathematicalstandpoint.TheCAPMassumptionsareasfollows: Assumption1: InvestorsmakeinvestmentdecisionsbasedontheexpectedreturnandvarianceofreturnsandsubscribetotheMarkowitzmethodofportfoliodiversifcation. Assumption2: Investorsarerationalandriskaverse. Assumption3: Investorsallinvestforthesameperiodoftime. Assumption4: Investorshavethesameexpectationsabouttheexpectedreturnandvarianceofallassets. Assumption5: Thereisarisk-freeassetandinvestorscanborrowandlendanyamountattherisk-freerate. Assumption6: Capitalmarketsarecompletelycompetitiveandfriction-less.Thefrstfourassumptionsdealwiththewayinvestorsmakedecisions.Thelasttwoassumptionsrelatetocharacteristicsofthecapitalmarket.Theseassumptionsrequirefurtherexplanation.ManyoftheseassumptionshavebeenchallengedresultinginmodifcationsoftheCAPM.Behavioralfnanceishighlycriticaloftheseassumptions,resultingintheformulationofadifferentCAPMtheorythatwedescribelater.Let’slookatAssumption1.RecallfromthetheoryofportfolioselectionthatHarryMarkowitzformulatedaframeworkforconstructingaportfo-liothatmaximizesexpectedreturnsconsistentwithindividuallyacceptablelevelsofrisk. 2 ThemeasureofriskthatMarkowitzproposedisthevarianceorstandarddeviationofthereturnofanasset.Inthisframework,investorsmakedecisionsbasedonexpectedreturnsandthevarianceofreturns. 2 HarryM.Markowitz,“PortfolioSelection,” JournalofFinance 7(1952):77–91.
450 INVESTMENTS Theexpectedreturnforanasset’sreturnistypicallyestimatedfromthehistoricalmeanofanasset’sreturnoversometimeperiod.Consequently,theterms“expectedreturn”and“meanreturn”areoftenusedinterchangeably.Forthisreason,thetheoryofportfolioselectionisoftenreferredtoasmean-varianceportfolioanalysisorsimplymean-varianceanalysis.Thefocusofportfolioselectionisnotontheriskofindividualsecuritiesbuttheriskoftheportfolio.Thistheoryshowsthatitispossibletocombineriskyassetstoproduceaportfoliowhoseexpectedreturnrefectsitscomponents,butwithconsiderablylowerrisk.Inotherwords,itispossibletoconstructaportfoliowhoseriskissmallerthanthesumofallitsindividualparts.Assumption2indicatesthatinordertoacceptgreaterrisk,investorsmustbecompensatedbytheopportunityofrealizingahigherreturn.Werefertothebehaviorofsuchinvestorsasbeing riskaverse. Whatthismeansisthatifaninvestorfacesachoicebetweentwoportfolioswiththesameexpectedreturn,theinvestorwillselecttheportfoliowiththelowerrisk.Assumption3statesthatallinvestorsmakeinvestmentdecisionsoversomesingle-periodinvestmenthorizon.Thetheorydoesnotspecifyhowlongthatperiodis(i.e.,sixmonths,oneyear,twoyears,andsoon).Inreality,theinvestmentdecisionprocessismorecomplexthanthat,withmanyinvestorshavingmorethanoneinvestmenthorizon.Nonetheless,theassumptionofaone-periodinvestmenthorizonisnecessarytosimplifythemathematicsofthetheory.Assumption4statesthatinvestorshavethesameexpectationswithrespecttotheinputsthatareusedtoderiveeffcientportfolios:assetreturns,variances,andcorrelations/covariances.Theassumptionallowsinvestorstocomputetheeffcientfrontier,whichisthesetofportfolioswiththebestrisk–returncombination.WerefertoAssumption4asthe“homogeneousexpectationsassumption.”Assumption5isimportantinderivingtheCAPMbecauseitallowsforarisk-freeasset,andunlimitedborrowingandlendingatthisrisk-freerate.Thisisbecauseeffcientportfoliosarecreatedforportfoliosconsistingofriskyassets.IntheCAPM,weassumenotonlythatthereisarisk-freeasset,butthataninvestorcanborrowfundsatthesameinterestratepaidonarisk-freeasset.Thisisacommonassumptioninmanyeconomicmodelsdevelopedinfnancedespitethefactitiswellunderstoodinrealitythatthereisadifferentrateatwhichinvestorscanborrowandlendfunds.Finally,Assumption6specifesthatthecapitalmarketisperfectlycom-petitive.Ingeneral,thismeansthenumberofbuyersandsellersissuffcientlylarge,andallinvestorsaresmallenoughrelativetothemarketsothatnoindividualinvestorcaninfuenceanasset’sprice.Consequently,allinvestorsarepricetakers,andthemarketpriceisdeterminedwherethereisequality
AssetPricingTheory 451 Expected Return Standard Deviation MP B R f P A EfficientfrontierCapitalmarket line EXHIBIT17.1 TheCAPMandtheEffcientFrontier ofsupplyanddemand.Inaddition,accordingtothisassumption,therearenotransactioncostsorimpedimentsthatinterferewiththesupplyofanddemandforanasset. 3 Ineconomicmodeling,themodelismodifedbyrelaxingoneormoreoftheassumptions.ThereareseveralextensionsandmodifcationsoftheCAPM,butwewillnotreviewthemhere.Nomattertheextensionormodifcation,however,thebasicimplicationsareunchanged:investorsareonlyrewardedfortakingonsystematicriskandtheonlysystematicriskismarketrisk. TheCapitalMarketLine ToderivetheCAPM,webeginwiththeeffcientfrontierfromthetheoryofportfolioselection,whichweshowinExhibit17.1.Everypointontheeffcientfrontierisderivedasexplainedearlierandisthemaximumportfolioreturnforagivenlevelofrisk.Inthefgure,riskismeasuredonthehorizontalaxisbythestandarddeviationoftheportfolio’sreturn,whichisthesquarerootofthevariance.Intheeffcientfrontier,thereisnoconsiderationofarisk-freeasset.Intheabsenceofarisk-freerate,wecanconstructeffcientportfoliosbased 3 Economistsrefertothesevariouscostsandimpedimentsas“frictions.”Thecostsassociatedwithfrictionsgenerallyresultinbuyerspayingmorethanintheabsenceoffrictionsandsellersreceivingless.
452 INVESTMENTS onaportfolio’sexpectedreturnandvariance,withtheoptimalportfoliobeingtheoneportfoliothatistangenttotheinvestor’sindifferencecurve.Theeffcientfrontierchanges,however,oncearisk-freeassetisintroducedandweassumethatinvestorscanborrowandlendattherisk-freerate(Assumption6).WeillustratethisinExhibit17.1.Everycombinationoftherisk-freeassetandtheeffcientportfoliode-notedbypoint M isshownonthelinedrawnfromtheverticalaxisattherisk-freeratetangenttotheeffcientfrontier.Thepointoftangencyisdenotedby M. Alltheportfoliosonthestraightlinearefeasibleforthein-vestortoconstructbycombiningthemarketportfolioandeitherborrowingorlending. Portfoliostotheleftofportfolio M representcombinationsofriskyassetsandtherisk-freeasset. Portfoliostotherightof M includepurchasesofriskyassetsmadewithfundsborrowedattherisk-freerate.Suchaportfolioiscalleda leveragedportfolio becauseitinvolvestheuseofborrowedfunds.Thelinefromtherisk-freeratethatistangenttoportfolio M iscalledthe capitalmarketline (CML).Let’scompareaportfolioontheCMLtoaportfolioontheeffcientfrontierwiththesamerisk.Forexample,compareportfolio P A ,whichisontheeffcientfrontier,withportfolio P B ,whichisontheCMLand,therefore,iscomprisedofsomecombinationoftherisk-freeassetandtheeffcientportfolio M. Noticethatforthesamerisk,theexpectedreturnisgreaterfor P B thanfor P A .ByAssumption2,arisk-averseinvestorwillprefer P B to P A .Thatis, P B willdominate P A .Infact,thisistrueforallbutoneportfolioontheCML:portfolio M ,themarketportfolio.Onceweintroducetherisk-freeassetintothemix,wecannowsaythataninvestorwillselectaportfolioontheCMLthatrepresentsacombinationofborrowingorlendingattherisk-freerateandtheeffcientportfolio M. TheparticulareffcientportfolioontheCMLthattheinvestorselectsdependsontheinvestor’sriskpreference.ThiscanbeseeninExhibit17.2,whichissimilartoExhibit17.1,butwehaveaddedtheinvestor’sindifferencecurves.TheinvestorselectstheportfolioontheCMLthatistangenttothehighestindifferencecurve, u 2 intheexhibit.Noticethatwithouttherisk-freeasset,aninvestorcouldonlygetto u 1 ,whichistheindifferencecurvethatistangenttotheeffcientfrontier.Thus,theopportunitytoborroworlendattherisk-freerateresultsinacapitalmarketwhererisk-averseinvestorswillprefertoholdportfoliosconsistingofcombinationsoftherisk-freeassetandsomeportfolio M ontheeffcientfrontier.
AssetPricingTheory 453 Expected Return Standard Deviation EfficientfrontierCapitalmarket line P D P C R f Mu 2 u 1 EXHIBIT17.2 TheCAPMandUtilityCurves Basedonthemodelassumptions,wecanuseabitofalgebratode-rivetheformulafortheCML.Basedontheassumptionofhomogeneousexpectations(Assumption4),allinvestorscancreateaneffcientportfolioconsistingof w f ,placedintherisk-freeasset,and w M inportfolio M ,where w representsthecorrespondingpercentageweightoftheportfolioallocatedtoeachasset.Wewillrefertoportfolio M astheriskyasset.Therefore, w f + w M = 1or w f = 1 − w M Theexpectedreturnisequaltotheweightedaverageoftheexpectedreturnofthetwoassets.Therefore,theexpectedportfolioreturn, E ( R p ),is E ( R p ) = w f R f + w M E ( R M )Weknowthat w f = 1– w M ,sowecanrewrite E ( R p )as E ( R p ) = (1 − w M ) R f + w M E ( R M )Basedonthemodelassumptionsandabitofalgebra, E ( R p ) = R f + w M [ E ( R M ) − R f ](17.4)
454 INVESTMENTS where w representsthepercentage(weight)oftheportfolioallocatedtoanassetwiththesubscript f and M denotingthepercentageallocatedtotherisk-freeassetandriskyasset,respectively.Notethatthesumofthetwoweightsmustequal1.Nowlet’sdeterminetheformulaforthevarianceforatwo-assetport-folio,withtherisk-freeassetandoneriskyasset M asthetwoassets: σ 2 ( R p ) = w 2 i σ 2 ( R f ) + w 2 j σ 2 ( R M ) + 2 w f w M cov ( R f R M )Thevarianceoftherisk-freeassetiszero(i.e., σ 2 ( R f ) = 0),andthecovariancebetweentheriskyassetandtherisk-freeassetisalsozero(i.e., cov ( R f R M ) = 0).Thevarianceoftherisk-freeassetiszerobecausethereisnopossiblevariationinthereturnsincethefuturereturnisknown.Thecovariancebetweentherisk-freeassetandtheriskyassetiszerobecausetherisk-freeassethasnovariability.Thevarianceoftheportfolioconsistingoftherisk-freeassetandriskyassetisthen: σ 2 R p = w 2 j σ 2 ( R M )Inotherwords,thevarianceoftheportfolioisrepresentedbytheweightedvarianceoftheriskyasset M. Wecansolvefortheweightoftheriskyasset M bysubstitutingstandarddeviationsforvariances.Becausethestandarddeviationoftheportfolio( σ ( R p ))isthesquarerootofthevariance,wecanwritethestandarddeviationoftheportfolioconsistingoftherisk-freeassetandtheriskyasset M as σ ( R p ) = w M σ ( R M )and,therefore, w M = σ ( R p ) σ ( R M )Ifwesubstitutetheaboveresultfor w M inequation(17.4)andrearrangetermswegettheCML: E ( R p ) = R f + E ( R M ) − R f σ ( R M ) σ R p (17.5)
AssetPricingTheory 455 WhatIsPortfolio M ? Nowthatweknowthatriskyasset M ispivotaltotheCML,whatisriskyasset M ?Thatis,howdoesaninvestorselectriskyasset M ?Ithasbeenprovenbyfnancialtheoriststhatriskyasset M isnotasingleassetbutratheraportfolioconsistingofallassetsavailabletoinvestors,witheachassetheldinproportiontoitsmarketvaluerelativetothetotalmarketvalueofallassets. 4 Thatis,portfolio M isthemarketportfoliodescribedearlier.So,ratherthanreferringtoriskyasset M asthemarketportfolio,weoftensimplyrefertothisportfolioasthemarket. TheRiskPremiumintheCapitalMarketLine Withhomogeneousexpectations, σ ( R M )and σ ( R p )arethemarket’scon-sensusfortheexpectedreturndistributionsforportfolio M andportfolio p. TheriskpremiumfortheCMLis E ( R M − R f ) σ ( R M ) σ ( R p )Let’sexaminetheeconomicmeaningoftheriskpremium.Thenumer-atorofthefrstterm, E ( R M ) − R f ,istheexpectedreturnfrominvestinginthemarketbeyondtherisk-freereturn.Itisameasureoftherewardforholdingtheriskymarketportfolioratherthantherisk-freeasset.Thede-nominator, σ ( R M ),isthemarketriskofthemarketportfolio.Thus,thefrstterm, E R M − R f σ ( R M ),isthemeasuretherewardperunitofmarketrisk.BecausetheCMLrepresentsthereturnofferedtocompensateforaper-ceivedlevelofrisk,eachpointontheCMLisabalancedmarketcondition,orequilibrium.TheslopeoftheCML(thatis,thefrstterm)determinestheadditionalreturnneededtocompensateforaunitchangeinrisk.ThatiswhywerefertotheslopeoftheCMLastheequilibriummarketpriceofrisk.Therefore,alongtheCML,theexpectedreturnonaportfolioisequaltotherisk-freerate,plusariskpremiumequaltothemarketpriceofrisk(asmeasuredbytherewardperunitofmarketrisk),multipliedbythequantityofriskfortheportfolio(asmeasuredbythestandarddeviationoftheportfolio).Thatis, E ( R p ) = R f + (Marketpriceofrisk × Quantityofrisk) 4 EugeneF.Fama,“EffcientCapitalMarkets:AReviewofTheoryandEmpiricalWork,” JournalofFinance 25(1970):383–417.
456 INVESTMENTS SystematicandUnsystematicRisk Nowweknowthatarisk-averseinvestorwhomakesdecisionsbasedonexpectedreturnandvarianceshouldconstructaneffcientportfoliousingacombinationofthemarketportfolioandtherisk-freerate.ThecombinationsareidentifedbytheCML.Wecanfne-tuneourthinkingabouttheriskassociatedwithanasset,usingthepricingmodeldevelopedbyWilliamSharpe. 5 Specifcally,wecanshowthattheappropriateriskthatinvestorsshouldbecompensatedforacceptingisnotthevarianceofanasset’sreturnbutsomeotherquantity.Inordertodothis,let’stakeacloserlookatrisk.Wecandothisbylookingatthevarianceoftheportfolio.Thevarianceofthemarketportfoliocontaining N assetsisequalto σ 2 ( R M ) = w 1 , M cov( R 1 , R M ) + w 2 , M cov( R 2 , R M ) + w 3 , M cov( R 3 , R M ) +···+ w N , M cov( R N , R M )(17.6)where w i , M isequaltotheproportioninvestedinasset i inthemarketportfolio.Noticethattheportfoliovariancedoesnotdependonthevarianceoftheassetscomprisingthemarketportfolio,butrathertheircovariancewiththemarketportfolio.Sharpedefnesthedegreetowhichanassetcovarieswiththemarketportfolioastheasset’ssystematicrisk.Morespecifcally,hedefnessystem-aticriskastheportionofanasset’svariabilitythatcanbeattributedtoacommonfactor.Systematicriskistheminimumlevelofriskthatcanbeobtainedforaportfoliobymeansofdiversifcationacrossalargenumberofrandomlychosenassets.Assuch,systematicriskisthatwhichresultsfromgeneralmarketandeconomicconditionsthatcannotbediversifedaway.Sharpedefnestheportionofanasset’svariabilitythatcanbediversifedawayas nonsystematicrisk. Thisistheriskthatisuniquetoanasset. SYSTEMATICANDUNSYSTEMATICRISK SystematicRiskIsalsoKnownas:UnsystematicRiskIsalsoKnownas: MarketriskDiversifableriskUndiversifableriskUniqueriskNondiversifableriskResidualriskCompany-specifcrisk 5 Sharpe,“CapitalAssetPrices.”
AssetPricingTheory 457 Portfolio Risk Number of Holdings in the Portfolio EXHIBIT17.3 ComponentsofPortfolioRisk Consequently,totalrisk(asmeasuredbythevariance)canbepartitionedintosystematicriskasmeasuredbythecovarianceofasset i ’sreturnwiththemarketportfolio’sreturnandnonsystematicrisk.Therelevantriskfordecision-makingpurposesisthesystematicrisk.Weillustratehowdiversifcationreducesnonsystematicriskforportfo-liosinExhibit17.3.Theverticalaxisshowsthevarianceoftheportfolioreturn.Thevarianceoftheportfolioreturnrepresentsthetotalriskfortheportfolio(thatis,systematicplusnonsystematic).Thehorizontalaxisshowsthenumberofholdingsofdifferentassets(e.g.,thenumberofcommonstockheldofdifferentissuers).Asyoucansee,asthenumberofassetholdingsin-creases,thelevelofnonsystematicriskisalmostcompletelyeliminated(thatis,diversifedaway).Studiesofdifferentassetclassessupportthis.Forexam-ple,forcommonstock,severalstudiessuggestthataportfoliosizeofabout20randomly-selectedcompanieswillcompletelyeliminatenonsystematicriskleavingonlysystematicrisk. 6 TheSecurityMarketLine TheCMLrepresentsanequilibriumconditioninwhichtheexpectedreturnonaportfolioofassetsisalinearfunctionoftheexpectedreturnofthemarketportfolio.IndividualassetsdonotfallontheCML.Forindividualassets,weexpectthefollowingtohold: E ( R i ) = R f + E ( R M ) − R f σ 2 ( R M )cov( R i , R M )(17.7)Thisisthe securitymarketline (SML). 6 WayneH.WagnerandShielaC.Lau,“TheEffectofDiversifcationonRisks,” FinancialAnalystsJournal 27(1971):48–53.
458 INVESTMENTS Inequilibrium,theexpectedreturnofindividualassetsliesontheSML,butnotontheCML.Thisisbecauseofthehighdegreeofnonsystematicriskthatremainsinindividualassetsthatcanbediversifedoutofportfolios.Inequilibrium,onlyeffcientportfolioslieonboththeCMLandtheSML.WecanalsoexpresstheSMLas E ( R i ) = R f + E ( R M ) − R f cov( R i , R M ) σ 2 ( R M ) (17.8)Howcanweestimatetheratioinequation(17.8)foreachasset?Wecandosoempiricallyusingreturndataforthemarketportfolioandthereturnontheasset.Theempiricalanalogueforequation(17.8)is r it − R f = α i + β i ( r Mt − r ft ) + ε it (17.9)where ε it istheerrorterm,and β i istheestimateofcov( R i , R M ) /σ 2 ( R M ).Equation(17.8)isthe characteristicline. Substituting β i intotheSMLgivenbyequation(17.8)givesthebetaversionoftheSML: E ( R i ) = R f + β i ( E ( R M ) − R f )(17.10)ThisistheCAPMformgivenbyequation(17.3).Thisequationstatesthat,giventheassumptionsoftheCAPM,theexpectedreturnonanindi-vidualassetisapositive,linearfunctionofitsindexofsystematicriskasmeasuredbybeta.Thehigherthebeta,thehighertheexpectedreturn. EXAMPLE17.1 Supposetherisk-freeasset’srateofreturnis2%andyouforecastareturnonthemarketportfolioof8%.Ifthebetaforsomeasset x is1.2,whatistheexpectedreturnonasset x ? Solution E ( R i ) = R f + β i ( E ( R M ) − R f ) E ( R i ) = 0 . 02 + 1 . 2(0 . 08 − 0 . 02) = 9 . 2%
AssetPricingTheory 459 Aninvestorpursuinganactiveportfoliostrategysearchesforunder-pricedassetstopurchaseorretainandoverpricedassetstoselloravoid(ifheldinthecurrentportfolio,orsoldshortifpermitted).IfaninvestorbelievesthattheCAPMisthecorrectassetpricingmodel,theinvestorcanusetheSMLtoidentifymispricedsecurities. Anassetisperceivedtobeunderpriced(thatis,undervalued)ifthe“expected”returnprojectedbytheinvestorisgreaterthanthereturnstipulatedbytheSML. Anassetisperceivedtobeoverpriced(thatis,overvalued),iftheex-pectedreturnprojectedbytheinvestorislessthanthereturnstipulatedbytheSML.Saidanotherway,iftheexpectedreturnofanassetplotsabovetheSML,theassetisunderpriced;ifitplotsbelowtheSML,itisoverpriced. TRYIT!EXPECTEDRETURNS Completethefollowingtable: AssetReturnontheRisk-FreeAssetExpectedReturnontheMarketBetaExpectedReturnontheAsset 11.0%10.0% 10.00%22.0% 0.810.80%3 8.0%1.39.65%43.0%9.0%0.9 TestsoftheCAPM Now,that’sthetheory.Thequestioniswhetherornotthetheoryissup-portedbyempiricalevidence.Therehasbeenalargenumberofacademicpaperswrittenonthesubject,withresearchersinalmostallstudiesusingcommonstocktotestthetheory.Thesepaperscovernotonlytheempiricalevidence,butthechallengestotestingthetheory.Let’sstartwiththeempiricalevidence.TherearetwoimportantresultsoftheempiricaltestsoftheCAPMthatquestionitsvalidity.First,ithasbeenfoundthatstockswithlowbetashaveexhibitedhigherreturnsthanthe
460 INVESTMENTS CAPMpredictsandstockswithhighbetashavebeenfoundtohavelowerreturnsthantheCAPMpredicts.Second,marketriskisnottheonlyriskfactorpricedbythemarket.Severalstudieshavediscoveredotherfactorsthatexplainstockreturns.WhileontheempiricallevelthereareseriousquestionsraisedabouttheCAPM,thereisanimportantpaperchallengingthevalidityoftheseempiricalstudies.RichardRolldemonstratesthattheCAPMisnottestableuntiltheexactcompositionofthe“true”marketportfolioisknown,andtheonlyvalidtestoftheCAPMistoobservewhethertheexantetruemarketportfolioismean-varianceeffcient. 7 Asaresultofhiswork,RollarguesthattherewillneverbeanunambiguoustestoftheCAPM.HedoesnotsaythattheCAPMisinvalid.Rather,RollsaysthatthereislikelytobenounambiguouswaytotesttheCAPManditsimplicationsduetothefactthatwecannotobservethetrue,theoreticalmarketportfolioanditscharacteristics. CriticismsoftheCAPM TherehavebeenattacksontheCAPMfromthosewhobelievethatthiscor-nerstonetheoryoffnanceisonshakygrounds.Thethreemajorattacksare Attack1: Theuseofthestandarddeviationorvarianceasameasureofriskdoesnotcapturewhatisobservedinfnancialmarketsregardingtheprobabilitydistributionofassetreturns. Attack2: ThebehavioralassumptionsoftheCAPMdonotrefectthewayinvestorsmakeportfoliodecisionsintherealworld. Attack3: Thereisevidencethatthereismorethanoneriskfactorthataffectsassetreturns.Attack1isessentiallyacriticismofanassumptionthatthereturndis-tributionforassetreturnsfollowsanormaldistribution.Attack2isthecriticismofproponentsofbehavioralfnancetheorywho,asexplainedinthepreviouschapter,haveattackedeconomictheoriesbasedonobservinghoweconomicagentssuchasinvestorsactuallygoaboutmakingdecisions.Finally,analternativeeconomictheoryofassetpricing,suchasthearbi-tragepricingmodel,isbasedonmorethanonefactor.Onesuchmodelisthesubjectofthenextsection. 7 RichardR.Roll,“ACritiqueoftheAssetPricingTheory’sTests,” JournalofFinancialEconomic 4(1977):129–176.
AssetPricingTheory 461 THEARBITRAGEPRICINGTHEORYMODEL StephenRossdevelopedanalternativetotheequilibriumasset-pricingmodeljustdiscussed,anasset-pricingmodelbasedpurelyonarbitragearguments. 8 Themodel,calledthe arbitragepricingtheory (APT) model ,postulatesthatanasset’sexpectedreturnisinfuencedbyavarietyofriskfactors,asopposedtojustmarketriskassuggestedbytheCAPM.AccordingtotheAPTmodel,thereturnonanassetislinearlyrelatedtoanumberofriskfactors.However,theAPTmodeldoesnotspecifywhattheseriskfactorsare,butinthemodeltherelationshipbetweenassetreturnsandtheriskfactorsislinear.Moreover,intheAPTmodel,unsystematicriskcanbeeliminatedsothataninvestorisonlycompensatedforacceptingthesystematicriskfactors. TheArbitragePrinciple TheAPTreliesonarbitragearguments,butwhatisarbitrage?Initssimpleform,arbitrageisthesimultaneousbuyingandsellingofanassetattwodifferentpricesintwodifferentmarkets.Thearbitrageurproftswithoutriskbybuyingcheaplyinonemarketandsimultaneouslysellingatthehigherpriceintheothermarket.However,suchopportunitiesarerareinfnancialmarkets.Infact,asinglearbitrageurwithunlimitedabilitytosellshortcouldcorrectamispricingconditionbyfnancingpurchasesintheunderpricedmarketwithproceedsofshortsalesintheoverpricedmarket. 9 Thismeansthatanyarbitrageopportunitiesareshort-lived.Lessobviousarbitrageopportunitiesexistinsituationswhereapackageofassetscanproduceapayoff(thatis,expectedreturn)identicaltoanassetthatispriceddifferently.Thisarbitragereliesonafundamentalprincipleoffnance,the lawofoneprice ,whichstatesthatagivenassetmusthavethesamepriceregardlessofthemeansbywhichonegoesaboutcreatingthatasset.Thelawofonepriceimpliesthatifaninvestorcansyntheticallycreatethepayoffofanassetusingapackageofassets,thepriceofthepackageandthepriceoftheassetwhosepayoffitreplicatesmustbeequal.Whenasituationisdiscoveredwherebythepriceofthepackageofassetsdiffersfromthatofanassetwiththesamepayoff,rationalinvestorswilltradetheseassetsinsuchawayastorestorepriceequilibrium.TheAPTassumesthatthisarbitragemechanismispossible,andisfoundedonthefactthatanarbitragetransactiondoesnotexposethe 8 StephenA.Ross,“TheArbitrageTheoryofCapitalAssetPricing,” JournalofEconomicTheory 13(1976):343–362. 9 Shortsellingmeanssellinganassetthatisnotownedinanticipationofapricedecline.
462 INVESTMENTS investortoanyadversemovementinthemarketpriceoftheassetsinthetransaction.Forexample,letusconsiderhowwecanproduceanarbitrageopportunityinvolvingthethreeassetsA,B,andC.Theseassetscanbepur-chasedtodayatthepricesshown,andcaneachproduceonlyoneoftwopayoffs(referredtoasState1andState2)ayearfromnow: AssetPricePayoffinState1PayoffinState2 A$70$50$100B6030120C8038112Whileitisnotobviousfromthedatapresentedher,aninvestorcanconstructaportfolioconsistingofassetsAandBthatwillhavetheidenticalreturnasassetCinbothState1andState2.Let w A and w B betheproportionofassetsAandB,respectively,intheportfolio.Wecanspecifythepayoff(thatis,theterminalvalueoftheportfolio)underthetwostatesas:IfState1occurs:Payoff = $50 w A + $30 w B IfState2occurs:Payoff = $100 w A + $120 w B CanwecreateaportfolioconsistingofassetsAandBthatwillreproducethepayoffofCregardlessofthestatethatoccursoneyearfromnow?Yes.Hereishow:Foreithercondition(State1andState2),wesettheexpectedpayoffoftheportfolioequaltotheexpectedpayoffforC,asfollows:State1:Payoff = $50 w A + $30 w B = $38State2:Payoff = $100 w A + $120 w B = $112Becausetheproportionsinvestedinthetwoassetsmustsumtoone,wealsoknowthat w A + w B = 1.Ifwesolvefortheweightsfor w A and w B thatwouldsimultaneouslysatisfytheprecedingequations,wewouldfndthattheportfolioshouldhave40%inassetA(thatis, w A = 0.4)and60%inassetB(thatis, w B = 0.6).Thecostofthatportfoliowillbeequalto:Costoftheportfoliowith w A of0 . 4and w B of0 . 6 = (0 . 4 × $70) + (0 . 6 × $60) = $64Ourportfolio(thatis,packageofassets)comprisedofassetsAandBhasthesamepayoffinState1andState2asthepayoffofassetC.ThecostofassetCis$80,whereasthecostoftheportfolioisonly$64.Thisisan
AssetPricingTheory 463 arbitrageopportunitythatcanbeexploitedbybuyingassetsAandBintheproportionsgivenandshorting(selling)assetC.Forexample,supposethatweinvest$1milliontocreatetheportfoliowithassetsAandB.The$1millionisobtainedbysellingshortassetC.TheproceedsfromtheshortsaleofassetCprovidethefundstopurchaseassetsAandB.Thus,therewouldbenocashoutlaybytheinvestor.ThepayoffsforStates1and2are: Payoffin AssetInvestmentState1State2 A$400,000$285,715$571,429B600,000300,0001,200,000C − 1,000,000 − 475,000 − 1,400,000 Total$0$110,715$371,429IneitherState1or2,theinvestorproftswithoutrisk.TheAPTmodelassumesthatsuchanopportunitywouldbequicklyeliminatedbythemar-ketplace. APTModelFormulation TheAPTmodelpostulatesthatanasset’sexpectedreturnisinfuencedbyavarietyofriskfactors,asopposedtojustmarketriskinthecaseoftheCAPM.Thatis,theAPTmodelassertsthatthereturnonanassetislinearlyrelatedto H “factors.”TheAPTdoesnotspecifywhatthesefactorsare,butitisassumedthattherelationshipbetweenassetreturnsandthefactorsislinear.Specifcally,theAPTmodelassertsthattherateofreturnonasset i isgivenbythefollowingrelationship: R i = E ( R i ) + β i , 1 F 1 + β i , 2 F 2 +···+ β i , H F H + e i where: R i = therateofreturnonasset iE ( R i ) = theexpectedreturnonasset iF h = the h thfactorthatiscommontothereturnsofallassets( h = 1, ... , H ) β i , h = thesensitivityofthe i thassettothe h thfactor e i = theunsystematicreturnforasset i Forequilibriumtoexist,thefollowingconditionsmustbesatisfed:Usingnoadditionalfunds(wealth)andwithoutincreasingrisk,itshouldnotbepossible,onaverage,tocreateaportfoliotoincreasereturn.Inessence,
464 INVESTMENTS thisconditionstatesthatthereisnoso-calledmoneymachineavailableinthemarket.Rossderivedthefollowingrelationship,whichiswhatisreferredtoastheAPTmodel: E ( R i ) = R f + β i , F 1 [ E ( R F 1 ) − R f ] + β i , F 2 [ E ( R F 2 ) − R f ] +···+ β i , FH [ E ( R FH ) − R f ]where[ E ( R Fj ) − R f ]istheexcessreturnofthe j thsystematicriskfactorovertherisk-freerate,andcanbethoughtofastheprice(orriskpremium)forthe j thsystematicriskfactor.ThederivationoftheAPTmodelismuchmoremathematicallycomplicatedthanderivingtheCAPM,sowewillnotprovidethedetailshere.TheAPTmodelassertsthatinvestorswanttobecompensatedforalltheriskfactorsthatsystematicallyaffectthereturnofanasset.Thecompen-sationisthesumoftheproductsofeachriskfactor’ssystematicrisk( β i , Fh ),andtheriskpremiumassignedtoitbythefnancialmarket[ E ( R Fh ) − R f ].AsinthecaseoftheCAPM,aninvestorisnotcompensatedforacceptingunsystematicrisk.However,theCAPMstatesthatsystematicriskismarketrisk,whiletheAPTmodeldoesnotspecifythesystematicrisks.SupportersoftheAPTmodelarguethatithasseveralmajoradvantagesovertheCAPM.First,itmakeslessrestrictiveassumptionsaboutinvestorpreferencestowardriskandreturn.Asexplainedearlier,theCAPMtheoryassumesinvestorstradeoffbetweenriskandreturnsolelyonthebasisoftheexpectedreturnsandstandarddeviationsofprospectiveinvestments.TheAPTmodel,incontrast,simplyrequiressomeratherunobtrusiveboundsbeplacedonpotentialinvestorutilityfunctions.Second,noassumptionsaremadeaboutthedistributionofassetreturns.Finally,becausetheAPTmodeldoesnotrelyontheidentifcationofthetruemarketportfolio,thetheoryispotentiallytestable. MultifactorRiskModelsinPractice TheAPTmodelprovidestheoreticalsupportforanassetpricingmodelwherethereismorethanoneriskfactor.Consequently,werefertothesemodelsas multifactorriskmodels .Thesemodelsprovidethetoolsforquan-tifyingtheriskprofleofaportfoliorelativetoabenchmark,forconstructingaportfoliorelativetoabenchmark,andforcontrollingrisk.Therearetwotypesofmultifactorriskmodelsusedinbothequityandbondportfoliomanagement:statisticalfactormodelsandfundamentalfactormodels.Ina statisticalfactormodel ,historicalandcross-sectionaldataonstockreturnsaretossedintoastatisticalmodel.Thegoalofthestatisticalmodelis
AssetPricingTheory 465 tobestexplaintheobservedstockreturnswithfactorsthatarelinearreturncombinationsanduncorrelatedwitheachother.Forexample,supposethatyoucomputethemonthlyreturnsfor5,000companiesfor10years.Thegoalofthestatisticalanalysisistoproducefactorsthatbestexplainthevarianceoftheobservedstockreturns.Forexample,supposethattherearesixfactorsthatdothis.Thesefactorsarestatisticalartifacts.Theobjectiveinastatisticalfactormodelthenbecomestodeterminetheeconomicmeaningofeachofthesestatisticallyderivedfactors.Becauseoftheproblemofinterpretation,itisdiffculttousethefactorsfromastatisticalfactormodelforvaluation,portfolioconstruction,andriskcontrol.Instead,practitionerspreferthenextmodeldescribed,whichallowsanassetmanagertoprespecifymeaningfulfactorsandthusproduceamoreintuitivemodel. Fundamentalfactormodels usecompanyandindustryattributesandmarketdataasrawdescriptors.Examplesofrawdescriptorsinequityfac-tormodelsareprice/earningsratios,book/priceratios,estimatedeconomicgrowth,andstocktradingactivity.Theinputsintoafundamentalfactormodelarestockreturnsandtherawdescriptorsaboutacompany.Thosefundamentalvariablesaboutacompanythatarepervasiveinexplainingstockreturnsarethentherawdescriptorsretainedinthemodel.Usingcross-sectionalanalysis,thesensitivityofastock’sreturntoarawdescriptorcanbeestimated. SOMEPRINCIPLESTOTAKEAWAY Inthischapterwehavecoveredthetwoprincipalmodelsassociatedwithassetpricingtheory.Wehaveemphasizedtheassumptionsandtheircrit-icalroleinthedevelopmentofthesetheories.Whileyoumayunderstandthetopicscovered,youmaystillbeuncomfortableaboutwherewehaveprogressedinfnancialtheory,giventhelackoftheoreticalandempiricalsupportfortheCAPMorthediffcultyofidentifyingthefactorsintheAPTmodel.You’renotalone.Agoodnumberofpractitionersandacademicsfeeluncomfortablewiththesemodels,particularlytheCAPM.Nevertheless,whatiscomfortingisthatthereareseveralgeneralprin-ciplesofinvestingthatarederivedfromthesetheoriesthatveryfewwouldquestion.Theyare: Investinghastwodimensions,riskandreturn.Therefore,focusingonlyontheactualreturnwithoutlookingattheriskthathastobeacceptedtoachievethatreturnisinappropriate. Itisalsoinappropriatetolookattheriskofanindividualassetwhendecidingwhetheritshouldbeincludedinaportfolio.Whatisimportant
466 INVESTMENTS ishowtheinclusionofanassetintoaportfoliowillaffecttheriskoftheportfolio. Whetherinvestorsconsideroneriskorathousandrisks,riskcanbedi-videdintotwogeneralcategories:systematicrisksthatcannotbeelim-inatedbydiversifcation,andunsystematicrisksthatcanbediversifedaway. Investorsshouldbecompensatedonlyforacceptingsystematicrisks.Thus,itiscriticalinformulatinganinvestmentstrategytoidentifythesystematicrisks. THEBOTTOMLINE Assetpricinginvolvesdeterminingtheexpectedreturninvestorsrequireinordertoinvestinriskyassets.Thetwomostwell-knownequilibriumpricingmodelsarethecapitalassetpricingmodeldevelopedinthe1960sandthearbitragepricingtheorymodeldevelopedinthemid-1970s. Therisksassociatedwithassetsandportfolioscanbedividedintosys-tematicriskandunsystematicrisk.Thelatterriskscanbeeliminatedbydiversifcation;theformerriskscannotbeeliminatedbydiversifying. InderivingtheCAPM,assumptionsaremade.AkeyassumptionisthatinvestorsmakeinvestmentdecisionsinaccordancewiththetheoryofportfolioselectionasformulatedbyMarkowitz.Thegoalofportfolioselectionistheconstructionofportfoliosthatmaximizeexpectedreturnsconsistentwithindividuallyacceptablelevelsofrisk. Inthetheoryofportfolioselection,riskismeasuredbythevariance(orstandarddeviation)andevaluatedconsideringtheexpectedreturn,andhencethisisoftenreferredtoasmean-varianceanalysis.TheCAPMformalizestherelationshipthatshouldexistbetweenassetreturnsandriskifinvestorsbehaveinahypothesizedmanner.Together,thetheoryofportfolioselectionandCAPMprovideaframeworktospecifyandmeasureinvestmentrisk,andtodeveloprelationshipsbetweenexpectedassetreturnandrisk(andhencebetweenriskandrequiredreturnonaninvestment). TheCAPMassertsthattheonlyriskthatispricedbyrationalinvestorsissystematicrisk,becausethatriskcannotbeeliminatedbydiversifcation.Essentially,theCAPMsaysthattheexpectedreturnofanassetoraportfolioisequaltotherateonarisk-freesecurityassetplusariskpremium.TheriskpremiumintheCAPMistheproductofthequantityofriskasmeasuredbybetamultipliedbythemarketpriceofrisk.Anassetorportfolio’sbetaisanindexofthesystematicriskoftheasset.
AssetPricingTheory 467 TherehavebeennumerousempiricaltestsoftheCAPM,and,ingeneral,thesehavefailedtofullysupportthetheory.However,thesestudieshavebeencriticizedbecauseofthediffcultyofidentifyingthetruemarketportfolio.Further,suchtestsarenotlikelytoappearsoon,ifatall,accordingtofnancialtheorists. Thearbitragepricingtheorymodelisdevelopedpurelyfromarbitragearguments.Thetheorypostulatesthattheexpectedreturnonanassetoraportfolioisinfuencedbyseveralriskfactors.ProponentsoftheAPTmodelciteitslessrestrictiveassumptionsasafeaturethatmakesitmoreappealingthantheCAPM.Moreover,testingtheAPTmodeldoesnotrequireidentifcationofthetruemarketportfolio. Despitethefactthatthetwomajorassetpricingtheories—CAPMandAPT—arecontroversialormaybediffculttoimplementinpractice,thereareseveralprinciplesofinvestingthatarenotcontroversialthatcanbetakenawayfromthesetheoriesandappliedinformulatingport-foliomanagementstrategies. SOLUTIONSTOTRYIT!PROBLEMS ExpectedReturnsAssetReturnontheRisk-FreeAssetExpectedReturnontheMarketBetaExpectedReturnontheAsset 11.0%10.0% 1.0 10.00%22.0% 13.0% 0.810.80%3 2.5% 8.0%1.39.65%43.0%9.0%0.9 8.40% QUESTIONS 1. Whatisdiversifablerisk? 2. Whatistheroleofdiversifcationinthecapitalassetpricingmodel? 3. Ifinvestorsareriskaverse,whichwouldtheyprefer:astockwithanexpectedreturnof5%withabetaof1.2orastockwithanexpectedreturnof6%withabetaof1.3?Explain. 4. Ifastockhasbothdiversifableriskandnondiversifablerisk,which,ifany,oftheserisksareconsideredinthepricingoftheasset?
468 INVESTMENTS 5. InthecontextoftheCAPM,whatisthetermrepresentedby E ( R M ) − R f ? 6. Explainwhatbetarepresentsintermsofassetpricing. 7. IfassetA’sbetaisgreaterthanassetB’sbeta,doesthismeanthatassetAhasmoreriskthanassetB?Explain. 8. Whatisthedifferencebetweenthesecuritymarketlineandthecapitalmarketline? 9. Ifastock’sreturnandriskaresuchthatthiswouldplotabovethesecuritymarketline,isthisstockoverpricedorunderpriced? 10. Supposeyouexpectedthereturnonthemarkettobe10%andthereturnontherisk-freeassettobe2%.Ifyouareconsideringastockwithabetaof1.2,whatistheexpectedreturnonthisstockaccordingtothesecuritymarketline? 11. Howshouldaninvestorconstructaneffcientportfoliointhepresenceofarisk-freeasset? 12. WhatisthetheoreticalprobleminherentinverifyingtheCAPMempir-ically? 13. WhyistheCAPM’sassumptionthatinvestorscanborrowandlendattherisk-freeratequestionable? 14. Whatismeantbythe“homogeneousassumption”intheCAPM? 15. Whatismeantbythelawofoneprice,andwhatdoesitimplyaboutapackageofsecuritiesandagivensecuritythathavethesamepayoff? 16. WhatarethefundamentalprinciplesunderlyingtheAPTmodel? 17. WhataretheadvantagesoftheAPTmodelrelativetotheCAPM? 18. Whatarethediffcultiesofapplyingthearbitragepricingtheorymodelinpractice? 19. Indicatewhyyouagreeordisagreewiththefollowingstatements: a. “Asapercentageofthetotalrisk,theunsystematicriskofadiversi-fedportfolioisgreaterthanthatofanindividualasset.” b. “Aninvestorshouldbecompensatedforacceptingunsystematicrisk.” 20. “IntheCAPM,investorsshouldbecompensatedforacceptingsys-tematicrisk;fortheAPTmodel,investorsarerewardedforacceptingbothsystematicriskandunsystematicrisk.”Doyouagreewiththisstatement?
CHAPTER 18 TheStructureofInterestRates Somediscussionofthearithmeticoflonger-termyieldsprovidesausefulperspectiveonrecentdevelopmentsinbondmarkets.Theten-yearTreasuryyield,forexample,canbeviewedasaweightedaverageofthecurrentone-yearrateandnineone-yearforwardrates,withtheweightsdependingonthecouponyieldofthesecurity.[E]achoftheseforwardratescanbesplitfurtherinto(1)aportionequaltotheone-yearspotratethatmarketparticipantscurrentlyexpecttoprevailatthecorrespondingdateinthefuture,and(2)aportionthatrefectsadditionalcompensationtothebondholderfortheriskofholdinglonger-datedinstruments.Currentandnear-termforwardratesareparticularlysensitivetomonetarypolicyactions,whichdirectlyaffectspotshort-terminterestratesandstronglyinfuencemarketexpectationsofwherespotratesarelikelytostandinthenextyearortwo. —BenS.,Bernanke,ChairmanoftheFederalReserve,SpeechbeforetheEconomicClubofNewYork,NewYork,March20,2006 A casualexaminationofthefnancialpagesofajournalwouldbeenoughtoconveytheideathatnobodytalksaboutan“interestrate.”Thereareinterestratesreportedforborrowingmoneyandinvesting.Theseratesarenotrandomlydetermined;thatis,therearefactorsthatsystematicallydeterminehowinterestratesondifferenttypesofloansanddebtinstrumentsvaryfromeachother.Werefertothisasthe structureofinterestrates andwediscussthefactorsthataffectthisstructureinthischapter. 469
470 INVESTMENTS THEBASEINTERESTRATE ThesecuritiesissuedbytheU.S.DepartmentoftheTreasury,popularlyreferredtoasTreasurysecuritiesorsimplyTreasuries,arebackedbythefullfaithandcreditoftheU.S.government.Atthetimeofthiswriting,marketparticipantsthroughouttheworldviewU.S.Treasuriesasbeingfreeofdefaultrisk,althoughthereisthepossibilitythatunwiseeconomicpolicybytheU.S.governmentmayalterthatperception.WhilehistoricallyTreasurysecuritieshaveservedasthebenchmarkinterestratesthroughouttheU.S.economyaswellasininternationalcapitalmarkets,thereareotherimportantinterestratebenchmarksusedbymarketparticipantsthatwewilldiscusslater.The baseinterestrate isthesumoftherealinterestrateandtherateofin-fation.Thisistheinterestrateappropriateforaninvestmentwithnodefaultrisk.Afactorthatisimportantindeterminingthelevelofinterestratesistheexpectedrateofinfation.Thatis,wecanexpressthebaseinterestrateas:Baseinterestrate = Realinterestrate + ExpectedrateofinfationThe realinterestrate istheratethatwouldexistintheeconomyintheabsenceofinfation. TheRiskPremium DebtinstrumentsnotissuedorbackedbythefullfaithandcreditoftheU.S.governmentareavailableinthemarketataninterestrateoryieldthatisdifferentfromanotherwisecomparablematurityTreasurysecurity.Werefertothedifferencebetweentheinterestrateofferedonanon-TreasurysecurityandacomparablematurityTreasurysecurityasthe spread .Forexample,iftheyieldonafve-yearnon-Treasurysecurityis5.4%andtheyieldona10-yearTreasurysecurityis4%,thespreadissaidtobe1.4%.Ratherthanreferringtothespreadinpercentageterms,suchas1.4%,marketparticipantsrefertothespreadintermsofbasispoints.Abasispointisequalto0.01%.Consequently,1%isequalto100basispoints.Inourexample,thespreadof1.4%isequalto140basispoints.ThespreadexistsbecauseoftheadditionalriskorriskstowhichaninvestorisexposedbyinvestinginasecuritythatisnotissuedbytheU.S.government.Consequently,thespreadisreferredtoasa riskpremium .Thus,wecanexpresstheinterestrateofferedonanon-TreasurysecuritywiththesamematurityasaTreasurysecurityas:Interestrate = Baseinterestrate + Spread
TheStructureofInterestRates 471 or,equivalently,Interestrate = Baseinterestrate + RiskpremiumWhilethespreadorriskpremiumistypicallypositive,therearefactorsthatcancausetheriskpremiumtobenegative.Thegeneralfactorsthataffecttheriskpremiumbetweenanon-TreasurysecurityandaTreasurysecuritywiththesamematurityare: Themarket’sperceptionofthecreditriskofthenon-Treasurysecurity. Anyfeaturesprovidedofthenon-Treasurysecuritythatmakeitattrac-tiveorunattractivetoinvestors. Thetaxtreatmentoftheinterestincomefromthenon-Treasurysecurity. Theexpectedliquidityofthenon-Treasuryissue. RiskPremiumDuetoDefaultRisk Defaultrisk referstotheriskthattheissuerofadebtobligationmaybeunabletomaketimelypaymentofinterestortheprincipalamountwhenitisdue.Mostmarketparticipantsgaugedefaultriskintermsofthecreditratingassignedbythethreemajorcommercialratingcompanies:(1)Moody’sInvestorsService,(2)Standard&Poor’sCorporation,and(3)FitchRatings.Thesecompanies,referredtoas ratingagencies ,performcreditanalysesofissuersandissuesandexpresstheirconclusionsbyasystemofratings.WesummarizetheratingsystemsusedbythethreemajorservicesinExhibit18.1.Thesearethemajorratingclasses,thoughtheratingservices S&P andFitchMoody’sAAAAaa AAAaHighqualityAABBBBaaInvestmentgradeBBBaBBCCNon-investmentgrade EXHIBIT18.1 CreditRatings
472 INVESTMENTS breakdownsomeoftheseclassestoprovidemoreinformation.Forexam-ple,Moody’suses1,2,or3toprovideanarrowercreditqualitybreak-downwithineachclass;S&PandFitchuseplusandminussignsforthesamepurpose.Inallratingsystemstheterm highgrade meanslowcreditriskor,conversely,highprobabilityoffuturepayments.BondsratedAAA(orAaa)throughBBB(orBaa)areconsidered investmentgradebonds .Issuesthatcarryaratingbelowthetopfourcategoriesarereferredtoas noninvestment-gradebonds ,ormorepopularlyas high-yieldbonds or junkbonds .ThespreadorriskpremiumbetweenTreasurysecuritiesandnon-Treasurysecurities,whichareidenticalinallrespectsexceptforcreditrating,isthe creditspread .Forexample,onAugust5,2008,fnance.yahoo.comre-ported(basedoninformationsuppliedbyValuBond)thatthefve-yearTrea-suryyieldwas3.29%.Theyieldandcreditspreadsonfve-yearcorporatebondsratedAAA,AA,andAwere: RatingYieldAugust5,2008CreditSpreadinBasisPoints AAArated5.01%172AArated5.50%221Arated5.78%249Notethatthelowerthecreditrating,thehigherthecreditspread. TRYIT!CREDITSPREADS Completethefollowingtablewhentheyieldonasimilar-maturityTreasurybondis3.73%: RatedBondYieldCreditSpread AAArated4.92% AArated5.43% Arated5.90% BBBrated6.32%
TheStructureofInterestRates 473 InclusionofAttractiveandUnattractiveProvisions Thetermsoftheloanagreementmaycontainprovisionsthatmakethedebtinstrumentmoreorlessattractivecomparedtootherdebtinstrumentsthatdonothavesuchprovisions.Whenthereisaprovisionattractivetoaninvestor,thespreaddecreasesrelativetoaTreasurysecurityofthesamematurity.Theoppositeoccurswhenthereisanunattractiveprovision:Thespreadincreasesrelativetoacomparable-maturityTreasurysecurity.Thethreemostcommonfeaturesfoundinbondissuesarethe: 1. Callprovision, 2. Putprovision,and 3. Conversionprovision.Abondmayhaveoneofmoreofthesefeatures—ornoneofthesefeatures.A callprovision grantstheissuertherighttoretirethebondissuepriortothescheduledmaturitydate.Abondissuethatcontainssuchaprovisionisa callablebond .Theinclusionofacallprovisionbeneftstheissuerbyallowingittoreplacethatbondissuewithalowerinterestcostbondissueshouldinterestratesinthemarketdecline.Effectively,acallprovisionallowstheissuertoalterthematurityofthebondissue.Acallprovisionisanunattractivefeaturefortheinvestor(i.e.,thebondholder)becausethebondholderwillnotonlybeuncertainaboutmaturity,butfacestheriskthattheissuerwillexercisethecallprovisionwheninterestrateshavedeclinedbelowtheinterestrateonthebondissue.Asaresult,thebondholdermustreinvesttheproceedsreceivedwhenthebondissueiscalledintoanotherbondissuepayingalowerinterestrate.Thisriskassociatedwithacallablebondis reinvestmentrisk .Forthisreason,investorsrequirecompensationforacceptingreinvestmentriskandtheyreceivethiscompensationintheformofahigherspreadorriskpremium.Abondissuewitha putprovision grantsthebondholdertherighttoselltheissuebacktotheissueratparvalueondesignateddates.Abondthatcontainsthisprovisionisa putablebond. Unlikeacallprovision,aputprovisionisanadvantagetothebondholder.Thereasonisthatifinterestratesriseaftertheissuanceofthebond,thepriceofthebondwilldecline.Theputprovisionallowsthatbondholdertosellthebondbacktotheissuer,avoidingamarketvaluelossonthebondandallowingthebondholdertoreinvesttheproceedsfromthesaleofthebondatahigherinterestrate.Hence,abondissuethatcontainsaputprovisionwillsellinthemarketatalowerspreadthananotherwisecomparable-maturityTreasurysecurity.A conversionprovision grantsthebondholdertherighttoexchangethebondissueforaspecifednumberofsharesofcommonstock.Abond
474 INVESTMENTS withthisprovisionisa convertiblebond .Theconversionprovisionallowsthebondholdertheopportunitytobeneftfromafavorablemovementinthepriceofthestockintowhichitcanexchangethebond.Hence,theconversionprovisionresultsinalowerspreadrelativetoacomparable-maturityTreasuryissue.Forexample,theprovisionmayspecifythatthebondmaybeexchangedinto50sharesofthecommonstockoftheissue.Theinvestorthencomparesthevalueofthebondasabondwiththevalueconvertedintothecommonstock.Thethreeprovisionswehavedescribedare,effectively,options.Unlikeatradedoption,suchasastockoption,theseprovisionsarereferredtoas embeddedoptions becausetheyareoptionsembeddedinabondissue. EXAMPLE18.1:CALLABLEDEBT KelloggCo.issued$1.1ofcallabledebenturesin2001thatmatureApril1,2031.ThedebenturesarecallablebyKelloggatparvalue.Therefore,Kellogghasacalloptiononthesedebentures:itcanbuythesedebenturesbackfromtheinvestorsat100%oftheprincipalamount,plusaccruedinterest. TaxabilityofInterest TheU.S.federaltaxcodespecifesthatinterestincomeistaxableatthefederalincometaxlevelunlessotherwiseexempted.Thefederaltaxcodespecifcallyexemptstheinterestincomefromqualifedmunicipalbondissuesfromtaxationatthefederallevel.Municipalbondsaresecuritiesissuedbystateandlocalgovernmentsandbytheircreations,suchas“authorities”andspecialdistricts.Thetax-exemptfeatureofmunicipalbondsisanattractivefeaturetoaninvestorbecauseitreducestaxesand,therefore,thespreadisoftensuchthatthemunicipalbondissuesellsinthemarketatalowerinterestratethanacomparable-maturitybondissue.Forexample,onAugust5,2008fnance.yahoo.comreported(basedoninformationsuppliedbyValuBond)thatthefve-yearTreasuryyieldwas3.29%andtheyieldonfve-yearmunicipalbondswasasfollows:AAA-ratedbonds2.95%,AAratedbonds3.04%,andAratedbonds3.27%.Whencomparingtheyieldonamunicipalbondissuetothatoftheyieldonacomparable-maturityTreasuryissue,themarketconventionisnottocomputethebasispointdifference(i.e.,thespread)betweenthetwobondissues.Instead,themarketconventionistocomputetheratiooftheyieldofamunicipalbondissuetotheyieldofacomparable-maturityTreasury
TheStructureofInterestRates 475 security.Theresultingratioisthe municipalyieldratio orthe muni-Treasuryyieldratio : RatingYieldAugust5,2008Muni-TreasuryYieldRatio AAArated2.95%0.90AArated3.04%0.92Arated3.27%0.99Inselectingbetweenataxablebond(suchasacorporatebond)andamunicipalbondwiththesamematurityandcreditrating,aninvestorcancalculatetheyieldthatmustbeofferedonataxablebondissuetogivethesameafter-taxyieldasamunicipalbondissue.Thisyieldmeasureiscalledthe equivalenttaxableyield andisdeterminedasfollows:Equivalenttaxableyield = Tax-exemptyield (1 − Marginaltaxrate)Forexample,supposeaninvestorisconsideringthepurchaseofanAAratedfve-yearmunicipalbondonAugust5,2008offeringayieldof3.04%(thetax-exemptyield).ThenEquivalenttaxableyield = 0 . 0304 (1 − 0 . 35) = 4 . 677%Thatis,foraninvestorinthe35%marginaltaxbracket,ataxablebondwitha4.677%yieldwouldprovidetheequivalentofa3.04%tax-exemptyield. TRYIT!EQUIVALENTTAXABLEYIELD Completethefollowingtable: Tax-ExemptYieldMarginalTaxRateEquivalentTaxableYield 5%40% 4%45% 6%30%
476 INVESTMENTS ExpectedLiquidityofaBondIssue Whenaninvestorwantstosellaparticularbondissue,heorsheisconcernedwhetherthepricethatcanbeobtainedfromthesalewillbeclosetothe“true”valueoftheissue.Forexample,ifrecenttradesinthemarketforaparticularbondissuehavebeenbetween87.25and87.75andmarketconditionshavenotchanged,aninvestorwouldexpecttosellthebondsomewhereinthe87.25to87.75range.Theconcernthattheinvestorhaswhencontemplatingthepurchaseofaparticularbondissueisthatheorshewillhavetosellitbelowitstruevaluewherethetruevalueisindicatedbyrecenttransactions.Thisriskisreferredtoas liquidityrisk .Thegreatertheliquidityriskthatinvestorsperceivethereiswithaparticularbondissue,thegreaterthespreadorriskpremiumrelativetoacomparable-maturityTreasurysecurity.ThereasonisthatTreasurysecuritiesarethemostliquidsecuritiesintheworld. THETERMSTRUCTUREOFINTERESTRATES Thepriceofadebtinstrumentwillfuctuateoveritslifeasyieldsinthemarketchange.Thepricevolatilityofabonddependsonitsmaturity,amongotherthings.Holdingallotherfactorsconstant,thelongerthematurityofabondthegreateristhepricevolatilityresultingfromachangeinmarketinterestrates.Thespreadbetweenanytwomaturitiesinasectorofamarketisthe maturityspread. Althoughwecancalculatethisspreadforanysectorofthemarket,itismostcommonlycalculatedfortheTreasurysector.Therelationshipbetweentheyieldsoncomparablesecuritiesbutdiffer-entmaturitiesisthe termstructureofinterestrates .Again,theprimaryfocusistheTreasurymarket.ThegraphicthatdepictstherelationshipbetweentheyieldsonTreasurysecuritieswithdifferentmaturitiesisknownasthe yieldcurve and,therefore,wealsorefertothematurityspreadasthe yieldcurvespread .WeshowthreehypotheticalTreasuryyieldcurvesinExhibit18.2.ThoughwehaveobservedallthreetypesintheU.S.,thepredominanttypeistheupwardslopingyieldcurve.TheTreasuryyieldcurveplaystheroleasabenchmarkforsettingyieldsinmanyothersectorsofthedebtmarket.However,aTreasuryyieldcurvebasedonobservedyieldsontheTreasurymarketisanunsatisfactorymeasureoftherelationbetweenrequiredyieldandmaturity.Thekeyreasonisthatsecuritieswiththesamematuritymayactuallyprovidedifferentyields.Hence,itisnecessarytodevelopmoreaccurateandreliableestimatesoftheTreasuryyieldcurve.Specifcally,thekeyistoestimatethetheoretical
TheStructureofInterestRates 477 YieldYieldYield UpwardslopingDownwardslopingMaturity(A)Maturity(B)Maturity ( C ) Flat EXHIBIT18.2 ThreeObservedShapesfortheYieldCurve interestratethattheU.S.Treasurywouldhavetopayassumingthatthesecurityitissuedisazero-couponsecurity.Dueitscomplexity,wewillnotexplainhowthisisdone.However,atthispointallthatisnecessarytoknowisthatthereareproceduresforestimatingthetheoreticalinterestrateoryieldthattheU.S.Treasurywouldhavetopayforbondswithdifferentmaturities.Theseinterestratesarereferredtoasthe Treasuryspotrates .WecanobtainvaluableinformationformarketparticipantsfromtheTreasuryspotrates.Theseratesare forwardrates .Let’sseehowweob-taintheseratesandthenwewilldiscusstheoriesaboutwhatdeterminesforwardrates. ForwardRates ConsiderthefollowingtwoTreasuryspotrates:thespotrateforazero-couponTreasurysecuritymaturinginoneyearis4%andthespotrateforazero-couponTreasurysecuritymaturingintwoyearsis5%.Let’slookat
478 INVESTMENTS thissituationfromtheperspectiveofaninvestorwhowantstoinvestfundsfortwoyears.Theinvestor’schoicesareasfollows: Alternative1. Investorbuysatwo-yearzero-couponTreasurysecurity. Alternative2. Investorbuysaone-yearzero-couponTreasurysecurityandwhenitmaturesinoneyeartheinvestorbuysanotherone-yearinstrument.WithAlternative1,theinvestorwillearnthetwo-yearspotrateandthatrateisknownwithcertainty:5%.Incontrast,withAlternative2,theinvestorwillearntheone-yearspotrate,4%,buttheone-yearspotoneyearfromnowisunknown.Therefore,forAlternative2,theratethatwillbeearnedoverthetwo-yearplannedinvestmentperiodisnotknownwithcertainty. 1 Puttingthenumberstothis, Alternative1: Annualreturn = 5% Alternative2: Annualreturn = (1 + 0 . 04)(1 + f )where f istheunknownone-yearspotrateoneyearfromtoday.Supposethatthisinvestorexpectsthatoneyearfromnowtheone-yearspotratewillbehigherthanitistoday.TheinvestormightthenfeelAlternative2wouldbethebetterinvestment.However,thisisnotnecessarilytrue.Tounderstandwhyitisnecessarytoknowwhattheforwardrateis,let’scontinuewithourillustration.Theinvestorwillbeindifferenttothetwoalternativesiftheyproducethesametotaldollarsoverthetwo-yearinvestmenthorizon.Giventhetwo-yearspotrate,thereissomespotrateonaone-yearzero-couponTreasurysecurityoneyearfromnowthatwillmaketheinvestorindifferentbetweenthetwoalternatives.Wecandeterminethevalueof f giventhetwo-yearspotrateandtheone-yearspotratebysolvingfortherate f suchthattheinvestmentin 1 Alternative2usesthecalculationofthegeometricmeanreturn.Fortwoperiods,with r 1 therateinthefrstperiodand r 2 theexpectedrateinthesecondperiod,thetwo-yearrateistheaverageannualreturnoverthetwoperiods,whichisthesquarerootof(1 + r 1 )(1 + r 2 ),ortwo-yearrate = 2 (1 + r 1 )(1 + r 2 ).Therefore,inAlternative2wesolvefortheone-yearrateexpectedoneyearfromnowbasedonthetwo-yearreturnandtheone-yearreturninthefrstperiod.
TheStructureofInterestRates 479 thetwo-yearsecurityat5%isequivalenttoaninvestmentinaone-yearinvestmentat4%andasubsequentone-yearinvestmentattherate f :(1 + 0 . 05) 2 = (1 + 0 . 04)(1 + f )Usingabitofalgebratosolvefor f ,(1 + f ) = (1 + 0 . 05) 2 (1 + 0 . 04) f = 6 . 01%Wecancheckourworktoseeifbothalternativesprovidethesamenumberofdollarsattheendofthetwo-yearinvestmenthorizon: Alternative1: Ifaninvestorplaced$100inthetwo-yearzero-couponTreasurysecurityearning5%,thetotaldollarsthatattheendoftwoyearsis$100 × (1.05) 2 = $110.25. Alternative2: Theproceedsfrominvestingintheone-yearTreasurysecurityat4%generates$104attheendofthefrstyear.Investingthisforthenextperiodat6.01%producesanendofperiodvalueof$104 × (1 + 0.0601) = $110.25.Hereishowweusethisforwardrateof6.01%.Iftheone-yearspotrateoneyearfromnowislessthan6.01%,thenthetotaldollarsattheendoftwoyearswouldbehigherbyinvestinginthetwo-yearzero-couponTreasurysecurity(Alternative1).Iftheone-yearspotrateoneyearfromnowisgreaterthan6.01%,thenthetotaldollarsattheendoftwoyearswouldbehigherbyinvestinginaone-yearzero-couponTreasurysecurityandreinvestingtheproceedsoneyearfromnowattheone-yearspotrateatthattime(Alternative2).Ofcourse,iftheone-yearspotrateoneyearfromnowis6.01%,thetwoalternativesgivethesametotaldollarsattheendoftwoyears.Nowthatwehavetheforwardrate, f, inwhichweareinterestedandweknowhowthatratecanbeused,let’sreturntothequestionthatweposedattheoutset.Supposetheinvestorexpectsthatoneyearfromnow,theone-yearspotrateoneyearfromnowwillbe5.5%.Thatis,theinvestorexpectstheone-yearspotrateoneyearfromnowwillbehigherthanitscurrentlevel.ShouldtheinvestorselectAlternative2becausetheone-year
480 INVESTMENTS spotrateoneyearfromnowisexpectedtobehigher?Theanswerisno,becausethisproducesavaluelessthaninvestingat5%fortwoyears:Investmentvalueattheendoftwoyears = $100 × 1 . 40 × 1 . 055 = $109 . 72Inthisexample,ifthespotrateinthesecondyearislessthan6.01%,thenAlternative1isthebetteralternative.Ifthisinvestorexpectsarateof5.5%,thenheorsheshouldselectAlternative1despitethefactthatheorsheexpectstheone-yearspotratetobehighernextyearthanitistoday.Thisisasomewhatsurprisingresultforsomeinvestors.Butthereasonforthisisthatthemarketpricesitsexpectationsoffutureinterestratesintotheratesofferedoninvestmentswithdifferentmaturities.Thisiswhyknowingforwardratesiscritical.Somemarketparticipantsbelievethattheforwardrateisthemarket’sconsensusoffutureinterestrates.Similarly,borrowersneedtounderstandwhatismeantbyaforwardrate.Forexample,supposeaborrowermustchoosebetweenatwo-yearloanandaseriesoftwoone-yearloans.Iftheforwardrateislessthantheborrower’sexpectationsofone-yearratesoneyearfromnow,theborrowerwillbebetteroffwithatwo-yearloan.If,instead,theborrower’sexpec-tationsarethattheone-yearrateoneyearfromnowwillbelessthantheforwardrate,theborrowerwillbebetteroffbychoosingaseriesoftwoone-yearloans.Inpractice,acompany’streasurerneedstoknowbothforwardratesandfuturespreads.AcompanyoftenpaystheTreasuryrate(i.e.,thebenchmark)plusaspreadonitsborrowings,sounderstandingcurrentandfutureratesiscritical.Anaturalquestionaboutforwardratesishowwelltheydoatpredictingfutureinterestrates.Studieshavedemonstratedthatforwardratesdonotdoagoodjobinpredictingfutureinterestrates.Then,whythebigdealaboutunderstandingforwardrates?Thereason,aswedemonstratedinourillustrationofhowtoselectbetweentwoalternativeinvestments,isthattheforwardratesindicatehowaninvestor’sandborrower’sexpectationsmustdifferfromthemarketconsensus,asmeasuredbyforwardrates,inordertomakethecorrectdecision.Inourillustration,theone-yearforwardratemaynotberealized.Thatisirrelevant.Thefactisthattheone-yearforwardrateindicatedtotheinvestorthatifexpectationsabouttheone-yearrateonemonthfromnowarelessthan6.01%,theinvestorwouldbebetteroffwithAlternative1.Forthisreason,aswellasothersexplainedlater,somemarketpartici-pantsdonotrefertoforwardratesasbeingmarketconsensusrates.Instead,theyrefertoforwardratesas hedgeablerates .Forexample,byinvestingin
TheStructureofInterestRates 481 thetwo-yearTreasurysecurity,theinvestorwasabletohedgetheone-yearrateoneyearfromnow.Similarly,acorporationissuingatwo-yearsecurityishedgingtheone-yearrateoneyearfromnow. TRYIT!FORWARDRATES Completethefollowingtablefortheone-yearrateoneyearfromnowthatwouldmaketheinvestorindifferentbetweenthetwo-yearzero-couponsecurityandtwo,successiveone-yearzero-couponsecurities: Case2-YearSpotRate1-YearSpotRateOne-YearRateOneYearfromNow A5.00%4.25% B2.25%1.75% C3.00%2.75% D4.00%3.80% DeterminantsoftheShapeoftheTermStructure Atagivenpointintime,ifweplotthetermstructure—theyieldtomaturity,orthespotrate,atsuccessivematuritiesagainstmaturity—wewouldobserveoneofthethreeshapesweshowinExhibit18.2.InExhibit18.3,weshowayieldcurvewheretheyieldincreaseswithmaturity.Thistypeofyieldcurveisan upward-slopingyieldcurve ora positivelyslopedyieldcurve .Weprovidefourexamplesofupward-slopingyieldcurvesinPanelAofExhibit18.4.Wedistinguishupwardslopingyieldcurvesbasedonthesteepnessoftheyieldcurve.Thesteepnessoftheyieldcurveistypicallymeasuredintermsofthematurityspreadbetweenlong-termandshort-termyields.Whiletherearemanymaturitycandidatestoproxyforlong-termandshort-termyields,manymarketparticipantsusethematurityspreadsbetweenthe30-yearyieldandsix-monthyield.ConsidertheupwardslopingcurvesinExhibit18.3forJune12,1991andJanuary1,2010.Thespreadbetweenthe30-yearandsix-monthyieldsare248basispointsand461basispoints,respectively.Therefore,wewouldconcludethattheyieldcurveinJanuary2010issteeperthanthatofJune1991.Inpractice,werefertoaTreasurypositivelyslopedyieldcurvewhosematurityspreadasmeasuredbythe30-yearyieldsandsix-monthyieldsas
482 INVESTMENTS 6/12/1991 1/11/2010 5/23/2007 1/2/2001 11/20/2000 0%1% 2%3%4%5%6%7%8%9% 3 mos.1 yr.2 yrs.3 yrs.5 yrs.7 yrs.10 yrs.20 yrs.30 yrs. 6/12/1991 1/11/2010 5/23/2007 1/2/2001 11/20/2000 EXHIBIT18.3 FourObservedActualYieldCurves Source: U.S.Treasury. anormalyieldcurvewhenthespreadis300basispointsorless.TheyieldcurveonJune12,1991isthereforeanormalyieldcurve.Whenthematurityspreadismorethan300basispoints,theyieldcurveissaidtobeasteepyieldcurve.TheyieldcurveonJanuary11,2010isasteepyieldcurve.Wealsoprovidetwoexamplesofdownward-slopingor invertedyieldcurves ,whereyieldsingeneraldeclineasmaturityincreases:November20,2000andJanuary2,2001.TherehavenotbeenmanyinstancesintherecenthistoryoftheU.S.Treasurymarketwheretheyieldcurveexhibitedthischaracteristic.WeprovideadditionalexamplesinExhibit18.4,PanelB.ThemostnotableisonAugust14,1981,whenTreasuryyieldswereatahistorichigh.Theyieldonthetwo-yearTreasurywas16.91%anddeclinedforeachsubsequentmaturityuntilitreached13.95%forthe30-yearmaturity.Wealsoshowa fatyieldcurve fromMay23,2007inExhibit18.3.Forafatyieldcurve,theyieldsarenotidenticalforeachmaturity;rather,theyieldsforallmaturitiesaresimilar.YoucanseeadditionalexamplesofthistypeofyieldcurveinPanelCofExhibit18.4.Avariantofthefatyieldcurveisoneinwhichtheyieldonshort-termandlong-termTreasuriesaresimilarbuttheyieldonintermediate-termTreasuriesaremuchlowerthanthesix-monthand30-yearyields.Suchayieldcurveisreferredtoasa humpedyieldcurve .WeprovideexamplesofhumpedyieldcurvesinPanelDofExhibit18.4.
EXHIBIT18.4 ExamplesofActualYieldCurves A:Upwardsloping Day3mos.6mos.1yr.2yrs.3yrs.5yrs.7yrs.10yrs.20yrs.30yrs.Spread 04/15/19923.70%3.84%4.14%5.22%5.77%6.66%7.02%7.37%NA7.87%403bp02/05/20100.030.100.170.310.771.282.233.004.364.51441bp B:Downwardsloping Day3mos.6mos.1yr.2yrs.3yrs.5yrs.7yrs.10yrs.20yrs.30yrs.Spread 02/21/20075.18%5.16%5.05%4.82%4.74%4.68%4.68%4.69%4.90%4.79% − 37bp01/19/20076.336.156.466.46.316.356.166.295.926.3318bp C:Flat Day3mos.6mos.1yr.2yrs.3yrs.5yrs.7yrs.10yrs.20yrs.30yrs.Spread 01/03/19907.89%7.94%7.85%7.94%7.96%7.92%8.04%7.99%NA8.04%10bp05/23/20074.915.014.964.854.794.794.804.865.095.010bp D:Humped Day3mos.6mos.1yr.2yrs.3yrs.5yrs.7yrs.10yrs.20yrs.30yrs.Spread 11/24/20006.34%6.12%5.86%5.84%5.63%5.70%5.63%5.86%5.67%6.34%22bp01/02/20005.875.585.114.874.824.764.974.925.465.35 − 23bp Note: 1.NAindicatesnosecuritieswiththatmaturityforthatdate2.Thespreadisthedifferenceinbasispointsbetweenthe30-yearmaturityandthe6-monthmaturity. Source: U.S.Treasury. 483
484 INVESTMENTS TERMSTRUCTUREOFINTERESTRATESTHEORIES Therearetwomajoreconomictheoriesthathaveevolvedtoaccountfortheobservedshapesoftheyieldcurve:the expectationstheory andthe marketsegmentationtheory . ExpectationsTheories Therearetwoformsoftheexpectationstheory:pureexpectationstheoryandbiasedexpectationstheory.Boththeoriesshareahypothesisaboutthebehaviorofshort-termforwardratesandalsoassumethattheforwardratesincurrentlong-termbondsarecloselyrelatedtothemarket’sexpectationsaboutfutureshort-termrates.Thetwotheoriesdiffer,however,onwhetherornototherfactorsalsoaf-fectforwardrates,andhow.The pureexpectationstheory postulatesthatnosystematicfactorsotherthanexpectedfutureshort-termratesaffectforwardrates;the biasedexpectationstheory assertsthatthereareotherfactors. PureExpectationsTheory Accordingtothepureexpectationstheory,theforwardratesexclusivelyrepresenttheexpectedfuturerates.Thus,theentiretermstructureatagiventimerefectsthemarket’scurrentexpectationsofthefamilyoffutureshort-termrates.Underthisview,anupward-slopingyieldcurveindicatesthatthemarketexpectsshort-termratestorisethroughouttherelevantfuture.Similarly,afattermstructurerefectsanexpectationthatfutureshort-termrateswillbemostlyconstant,whileafallingtermstructuremustrefectanexpectationthatfutureshortrateswilldeclinesteadily.Amajorshortcomingofthepureexpectationstheoryisthatitignorestherisksinherentininvestingindebtinstruments.Ifforwardrateswereperfectpredictorsoffutureinterestrates,thenthefuturepricesofbondswouldbeknownwithcertainty.Thereturnoveranyinvestmentperiodwouldbecertainandindependentofthematurityofthedebtinstrumentinitiallyacquiredandofthetimeatwhichtheinvestorneededtoliquidatethedebtinstrument.However,withuncertaintyaboutfutureinterestratesandhenceaboutfuturepricesofbonds,thesedebtinstrumentsbecomeriskyinvestmentsinthesensethatthereturnoversomeinvestmenthorizonisunknown.Similarly,fromaborrower’sperspective,thecostofborrowingforanyrequiredperiodoffnancingwouldbecertainandindependentofthematu-rityofthedebtinstrumentiftherateatwhichtheborrowermustrefnancedebtinthefutureisknown.Butwithuncertaintyaboutfutureinterestrates,
TheStructureofInterestRates 485 thecostofborrowingisuncertainiftheborrowermustrefnanceatsometimeovertheperiodinwhichthefundsareinitiallyneeded. BiasedExpectationsTheory Biasedexpectationstheoriestakeintoac-counttheshortcomingsofthepureexpectationstheory.Thetwotheoriesaretheliquiditytheoryandthepreferredhabitattheory.Accordingtothe liquiditytheory ,theforwardrateswillnotbeanun-biasedestimateofthemarket’sexpectationsoffutureinterestratesbecausetheyembodyapremiumtocompensateforrisk;thisriskpremiumisa liquiditypremium .Therefore,anupward-slopingyieldcurvemayrefectex-pectationsthatfutureinterestrateswilleitherrise,fall,orremainthesame,butwithaliquiditypremiumincreasingfastenoughwithmaturitysoastoproduceanupward-slopingyieldcurve.The preferredhabitattheory alsoadoptstheviewthatthetermstruc-turerefectstheexpectationofthefuturepathofinterestratesaswellasariskpremium.However,thepreferredhabitattheoryrejectstheassertionthattheriskpremiummustriseuniformlywithmaturity.Instead,propo-nentsofthepreferredhabitattheorysaythatthelatterconclusioncouldbeacceptedifallinvestorsintendtoliquidatetheirinvestmentatthefrstpossibledate,whileallborrowersareeagertoborrowlong.However,thisisanassumptionthatcanberejectedforanumberofreasons.Theargumentisthatdifferentfnancialinstitutionshavedifferentinvestmenthorizonsandhaveapreferenceforthematuritiesinwhichtheyinvest.Thepreferenceisbasedonthematurityoftheirliabilities.Toinduceafnancialinstitutionoutofthatmaturitysector,apremiummustbepaid.Thus,theforwardratesincludealiquiditypremiumandcompensationforinvestorstomoveoutoftheirpreferredmaturitysector.Consequently,forwardratesdonotrefectthemarket’sconsensusoffutureinterestrates. MarketSegmentationTheory The marketsegmentationtheory alsorecognizesthatinvestorshavepre-ferredhabitatsdictatedbysavingandinvestmentfows.Thistheoryalsoproposesthatthemajorreasonfortheshapeoftheyieldcurveliesinasset/liabilitymanagementconstraints(eitherregulatoryorself-imposed)and/orcreditorsrestrictingtheirlendingorborrowersrestrictingtheirf-nancingtospecifcmaturitysectors.Themarketsegmentationtheorydiffersfromthepreferredhabitattheorybecausethemarketsegmentationtheoryassumesthatneitherin-vestorsnorborrowersarewillingtoshiftfromonematuritysectortoan-othertotakeadvantageofopportunitiesarisingfromdifferencesbetween
486 INVESTMENTS expectationsandforwardrates.Thus,accordingtothemarketsegmentationtheory,theshapeoftheyieldcurveisdeterminedbythesupplyofandthedemandforsecuritieswithineachmaturitysector. SWAPRATEYIELDCURVE Anotherbenchmarkinterestratethatisusedbyglobalinvestorsistheswaprate.AsexplainedinChapter14,inagenericinterestrateswapthepartiesexchangeinterestpaymentsonspecifeddates:Onepartypaysinterestbasedonafxedrateandtheotherpartybasedonafoatingrateoverthelifeoftheswap.InatypicalswapthefoatingrateisbasedonareferencerateandthereferencerateistypicallyLIBOR.Thefxedinterestratethatispaidbythefxedratecounterpartyisthe swaprate .Therelationshipbetweentheswaprateandmaturityofaswapisthe swaprateyieldcurve ,ormorecommonlythe swapcurve .Becausetherefer-encerateistypicallyLIBOR,theswapcurveisalsocalledthe LIBORcurve .TheswapcurveisusedasabenchmarkinmanycountriesoutsidetheUnitedStates.Unlikeacountry’sgovernmentbondyieldcurve,however,theswapcurveisnotadefault-freeyieldcurve.Instead,itrefectsthecreditriskofthecounterpartytoaninterestrateswap.Becausethecounterpartytoaninterestrateswapistypicallyabank-relatedentity,theswapcurverefectstheaveragecreditriskofrepresentativebanksthatprovideinterestrateswaps.Morespecifcally,aswapcurveisviewedasthe interbankyieldcurve .Itisalsoreferredtoasthe AAratedyieldcurve becausethebanksthatborrowmoneyfromeachotheratLIBORhavecreditratingsofAa/AAorabove.WeseetheeffectofthiscreditriskwhenwecomparetheyieldcurvebasedonU.S.Treasurieswiththeswapratecurve.Forexample,considertheratesforAugust22,2008: 1yr.2yrs.3yrs.4yrs.5yrs.7yrs.10yrs.30yrs. Yieldcurve,U.S.Treasuries2.15%2.35%2.62%NA3.07%3.39%3.82%4.44%Swapcurve3.05%3.38%3.73%3.95%4.10%4.36%4.58%4.92%Spreadinbasispoints90103111NA103977648 Thespreadbetweenthesetwocurvesrangesfrom48basispointsfor30-yearyieldto111basispointsforthree-yearyield.
TheStructureofInterestRates 487 Therearereasonswhyinvestorsprefertouseacountry’sswapcurveifitavailablethanacountry’syieldcurveobtainedfromitsgovernmentbonds. 2 THEBOTTOMLINE Infnancialmarketsthereisnotoneinterestratebutratherastructureofinterestratesthatisaffectedbyvariousriskfactorsandtaxfactors.Becauseasecurity’svaluedepends,inpart,ontheexpectedyieldorrateofreturninvestorswant,thestructureofinterestratesaffectsthevalueofasecurity. Thebaseinterestrateisthesumoftherealinterestrateandtheexpectedrateofinfation.BecausesecuritiesissuedbytheU.S.DepartmentoftheTreasuryarebackedbythefullfaithandcreditoftheU.S.government,theinterestrateonthesesecuritiesisviewedasthebaseinterestrate. Aninterestraterefectsthebaseinterestrateandrisk.Theriskpremiumismeasuredusingthespreadontheyieldsbetweenariskysecurityandthatofasimilar-maturityrisk-freesecurity,suchasaU.S.Trea-surysecurity.Factorsthataffecttheriskpremiumincludethemarket’sperceptionofthecreditriskofthenon-Treasurysecurity,anyfeaturesofthenon-Treasurysecuritythatmakeitattractiveorunattractivetoinvestors,andtheexpectedliquidityofthenon-Treasuryissue. Thetermstructureofinterestratesistherelationshipbetweentheyieldsoncomparablesecuritiesbutdifferentmaturities.Theyieldcurveisthegraphicthatdepictsthisrelationship.Theyieldcurvespreadmeasuresthedifferenceintheyieldbetweentwomaturities.Historically,theyieldcurveisnormallyupwardsloping,refectinghigheryieldsforlonger-termsecurities,thoughfat,humped,anddownwardslopingyieldcurveshavebeenobserved. Forwardratescanbeextrapolatedfromthetermstructureofinterestratestoprovidevaluableinformationforborrowingstrategiesandin-vestingstrategies.Aforwardrateistherateforafuturetimeperiod.Althoughmarketparticipantsoftenstatethatforwardratesarethemar-ket’sconsensusoffuturerates,themostusefulwaytothinkoftheseratesisasratesthatcanbelockedintoday(thatis,hedgeablerates). Therearetwomaintheoriesthatseektoexplaintheshapeoftheyieldcurve:expectationstheoryandmarketsegmentationtheory.Thereare 2 Formoreinformation,seeUriRon,“APracticalGuidetoSwapCurveCon-struction,”inFrankJ.Fabozzi(ed.), InterestRate,TermStructure,andValuationModeling (Hoboken,NJ:JohnWiley&Sons,2002).
488 INVESTMENTS twoformsoftheexpectationstheory:pureexpectationstheoryandbi-asedexpectationstheory.Thetheoriesseektoexplainthebehaviorofshort-termforwardratesandalsoassumethattheforwardratesincur-rentlong-termbondsarecloselyrelatedtothemarket’sexpectationsaboutfutureshort-termrates.Thetwotheoriesastotheextentthatfactorsotherthanthemarket’sexpectationstheory,alsoaffectforwardrates,andhow.Accordingtothepureexpectationstherearenosys-tematicfactorsotherthanexpectedfutureshort-termratesthataffectforwardrates;thebiasedexpectationstheoryassertsthatthereareotherfactorssuchasliquidity(liquiditytheory)andthepreferredmaturitysectorofinvestors(preferredhabitattheory).Themarketsegmentationtheoryassumesthatneitherinvestorsnorborrowersarewillingtoshiftfromonematuritysectortoanothertotakeadvantageofopportunitiesarisingfromdifferencesbetweenexpectationsandforwardrates. Anotherbenchmarkinterestrateusedbyglobalinvestorsistheswaprate.Therelationshipbetweentheswaprateandmaturityofaswapistheswaprateyieldcurveorswapcurve.Theseratesdonotrefectdefault-freeratesbutratherrefecttheaverageriskofbanksthatareinvolvedininterestrateswaps. SOLUTIONSTOTRYIT!PROBLEMS CreditSpreadsRatedBondYieldCreditSpread AAArated4.92%119AArated5.43%170Arated5.90%217BBBrated6.32%259 EquivalentTaxableYieldsTax-ExemptYieldMarginalTaxRateEquivalentTaxableYield 5%40%8.33%4%45%7.27%6%30%8.57%
TheStructureofInterestRates 489 ForwardRatesCase2-YearRate1-YearRateOne-YearSpotRateOneYearfromNow A5.00%4.25%5.76%B2.25%1.75%2.75%C3.00%2.75%3.25%D4.00%3.80%4.20% QUESTIONS 1. Whatisthebaseinterestrate? 2. Supposetheyieldona10-yearcorporatebondis6.2%andtheyieldonasimilar-maturityTreasurysecurityis4.5%. a. Whatistheyieldspreadforthiscorporatebond? b. Whyisthereayieldspreadbetweenthesetwosecurities? 3. Howdoesaconversionprovisiononadebtobligationprovideanoptiontotheinvestor? 4. IftheyieldonaTreasurysecurityis3%andthatofasimilar-maturitymunicipalbondis2.5%,whatisthemuni-Treasuryyieldratioforthismunicipalbond? 5. Explaintherelationbetweenatax-exemptyieldandataxableyieldforbondswithsimilarmaturityandfeatures. 6. Whatisamaturityspread? 7. Ifathree-yearsecurityhasayieldof5%,andatwo-yearTreasurysecurityhasayieldof4.5%,whatistheone-yearforwardratetwoyearsfromnow? 8. Whatistheshapeofthenormalyieldcurve? 9. Listthepossibleexplanationsforobservedyieldcurves. 10. Whatistherelevanceoftheswapratecurve? 11. Typically,howdomarketparticipantsgaugethecreditriskassociatedwithabondissue? 12. Whatistherelationshipbetweencreditriskandtheriskpremium? 13. Supposethattheone-yearspotrateis4.1%andthetwo-yearspotrateis4.6%.Whatistheone-yearforwardrateoneyearfromnow? 14. Completethefollowingtable: 2-YearSpotRate1-YearSpotRate1-YearForwardRate 5%4% 4%3.8% 3.5%3.25%
490 INVESTMENTS 15. Commentonthefollowingstatement:“Forwardratesaregoodpredic-torsoffutureinterestrates.” 16. Whycanforwardratesbeviewedashedgeablerates? 17. Considerthefollowingyieldstomaturity: YearstoMaturityYieldtoMaturity 13.0%23.5%33.9%44.4%54.8%65.2% a. Graphtheyieldtomaturityagainstthetimetomaturity. b. Isthisyieldcurveconsistentwithanyoftheyieldcurvetheories?Explain. 18. Acorporatetreasurerisconsideringborrowingfundsfor10years.Howcanthecorporatetreasureruseforwardratesindeterminingwhethertoborrowtodayorpostponeborrowing? 19. Whyare“biased”expectationtheoriesofthetermstructureofinterestratesbiased? 20. Commentonthefollowing:“Thereisnotheoryofthetermstructureofinterestratesthatwouldexplainayieldcurveinwhichinterestratesincreasewithmaturityforthefrsttwoyears,declinewithmaturityuntilyear5,andthenincreasewithmaturityafteryear5.”
CHAPTER 19 ValuingCommonStock Duringthe20thCentury,theDowadvancedfrom66to11,497.Thisgain,thoughitappearshuge,shrinksto5.3%whencompoundedannually.AninvestorwhoownedtheDowthroughoutthecenturywouldalsohavereceivedgenerousdividendsformuchoftheperiod,butonlyabout2%orsointhefnalyears.Itwasawonderfulcentury. —WarrenBuffett,LettertoShareholdersofBerkshireHathaway,February2008,p.19 I nthischapter,wediscusspracticalmethodsofvaluingcommonstockusingtwomethods:discountedcashfowmodelsandrelativevaluationmodels.Bothmethodsrequirestrongassumptionsandexpectationsaboutthefuture.Noonesinglevaluationmodelormethodisperfect.Allvaluationestimatesaresubjecttomodelerrorandestimationerror.Nevertheless,investorsusethesemodelstohelpformtheirexpectationsaboutafairmarketprice. DISCOUNTEDCASHFLOWMODELS Ifaninvestorbuysacommonstock,heorshehasboughtsharesthatrepre-sentanownershipinterestinthecorporation.Sharesofcommonstockareaperpetualsecurity—thatis,thereisnomaturity.Theinvestorwhoownssharesofcommonstockhastherighttoreceiveacertainportionofany ∗ ThesectiononrelativevaluationiscoauthoredwithGlenLarsen. 491
492 INVESTMENTS cashdividends—butdividendsarenotasurething.Whetherornotacorpo-rationpaysdividendsisuptoitsboardofdirectors—therepresentativesofthecommonshareholders.Typically,weseesomepatterninthedividendscompaniespay:Dividendsareeitherconstantorgrowataconstantrate.Butthereisnoguaranteethatdividendswillbepaidinthefuture.Itisreasonabletofgurethatwhataninvestorpaysforashareofstockshouldrefectwhatheorsheexpectstoreceivefromit—areturnontheinvestor’sinvestment.Whataninvestorreceivesarecashdividendsinthefuture.Howcanwerelatethatreturntowhatashareofcommonstockisworth?Well,thevalueofashareofstockshouldbeequaltothepresentvalueofallthefuturecashfowsaninvestorexpectstoreceivefromthatshare.Tovaluestock,therefore,aninvestormustprojectfuturecashfows,which,inturn,meansprojectingfuturedividends.Thisapproachtothevaluationofcommonstockisreferredtothediscountedcashfowapproach.Therearevariousdiscountedcashfow(DCF)modelsthatwecanusetovaluecommonstock.Wewillnotdescribeallofthemodels.Ratherourprimaryfocusisonmodelsthatarereferredtoasdividenddiscountmodels. DividendDiscountModels Most dividenddiscountmodels (DDM)usecurrentdividends,somemeasureofhistoricalorprojecteddividendgrowth,andanestimateoftherequiredrateofreturn.Popularmodelsincludethebasicdividenddiscountmodelthatassumesaconstantdividendgrowthandthemultiple-phasemodels.Herewediscussthesedividenddiscountmodelsandtheirlimitations,beginningwithareviewofthevariouswaystomeasuredividends.Thenwelookathowdividendsandstockpricesarerelated. DividendMeasures Dividendsaremeasuredusingthreedifferentmetrics:dividendspershare,dividendyield,anddividendpayoutratio.Thevalueofashareofstocktodayistheinvestors’assessmentoftoday’sworthoffuturecashfowsforeachshare.Becausefuturecashfowstoshareholdersaredividends,weneedameasureofdividendsforeachshareofstocktoestimatefuturecashfowspershare.The dividendspershare isthedollaramountofdividendspaidoutduringtheperiodpershareofcommonstock:Dividendspershare = Dividendspaidtocommonshareholders Numberofsharesofcommonstockoutstanding
ValuingCommonStock 493 Ifacompanyhaspaid$600,000individendstocommonsharehold-ersduringtheperiodandthereare1.5millionsharesofcommonstockoutstanding,thenDividendspershare = $600 , 000 1 , 500 , 000shares = $0 . 40pershareThecompanypaidout40centsindividendspercommonshareduringthisperiod.Anothermeasureofdividendsisthe dividendyield ,whichistheratioofdividendstothecommonstock’scurrentprice:Dividendyield = Annualcashdividendspercommonshare MarketpricepercommonshareWealsorefertothedividendyieldasthe dividend-priceratio . 1 Stillanotherwayofdescribingdividendspaidoutduringaperiodistostatethedividendsasaportionofearningsfortheperiod.Thisisthe dividendpayoutratio :Dividendpayoutratio = Dividendspaidtocommonshareholders EarningsavailabletocommonshareholdersIfacompanypays$360,000individendstocommonshareholdersandhasearningsavailabletocommonshareholdersof$1.2million,thedividendpayoutratiois30%:Dividendpayoutratio = $360 , 000 $1 , 200 , 000 = 0 . 30or30%Thismeansthatthecompanypaidout30%ofitsearningstocommonshareholders. 2 Theproportionofearningspaidoutindividendsvariesbycompanyandindustry.Iftheboardofdirectorsofacompanyfocusesonmaintainingaconstantdividendpershareoraconstantgrowthindividendspershareinestablishingtheirdividendpolicy,thedividendpayoutratiowillfuctuatealongwithearnings.Wegenerallyobservethatcorporateboardssetthe 1 Historically,thedividendyieldforU.S.stockshasbeenalittlelessthan5%accord-ingtoastudybyJohnY.CampbellandRobertJ.Shiller,“ValuationRatiosandtheLong-RunStockMarketOutlook,” JournalofPortfolioManagement 24(1998):11–26. 2 Thecomplementtothedividendpayoutratioistheplowbackratio,whichisthepercentageofearningsretainedbythecompanyduringtheperiod.
494 INVESTMENTS dividendpolicysuchthatdividendspersharegrowatarelativelyconstantrate,resultingindividendpayoutsthatfuctuatefromyeartoyear. Whatisthepresentvalueofthefuturedividend?Thequotedpriceoftheordinarystockattheendof1873isthesalevalue.Isthatthemathematicalvalue?Thisvaluecanonlybeestimatedfromprospectivedividends,whichwillturnuponthedifferencebetweentheincomeandtheoutgothroughaseriesofyears.—WilliamFarr,“OntheValuationofRailwaysTelegraphs,WaterCompanies,Canals,andotherCommercialConcerns,withProspective,Deferred,Increasing,Decreasing,orTerminatingProfts,” JournaloftheRoyalStatisticalSociety, 1876,p.476 TRYIT!DIVIDENDMEASURES Calculatethe: 1. Dividendspershare 2. Dividendpayoutratio,and 3. Dividendyield,foreachofthefollowingcompanies: CompanyCashDividendstoCommonShareholdersNumberofSharesofCommonStockOutstandingEarningsAvailabletoCommonShareholdersCurrentPriceperShare P$40,000100,000$200,000$20Q$800,000200,000$4,000,000$40R$250,000250,000$750,000$15S$5,00010,000$25,000$10 BasicDividendDiscountModels Asdiscussed,thebasisforthedividenddiscountmodelissimplytheappli-cationofpresentvalueanalysis,whichassertsthatthefairpriceofanasset
ValuingCommonStock 495 isthepresentvalueoftheexpectedcashfows. 3 Thecashfowsaretheex-pecteddividendspershare.WecanexpressthebasicDDMmathematicallyas: P 0 = D 1 (1 + r 1 ) 1 + D 2 (1 + r 2 ) 2 + D 3 (1 + r 3 ) 3 +··· or, P 0 = ∞ t = 1 D t (1 + r t ) t (19.1)where: P 0 isthecurrentpriceofthestock, D t isthedividendpershareinperiod t ,and r t isthediscountrateappropriateforthecashfowinperiod t .Inthismodel,weexpecttoreceivedividends.Ifinvestorsneverexpectedadividendtobepaid,thismodelimpliesthatthestockwouldhavenovalue.Toreconcilethefactthatstocksnotpayingacurrentdividenddo,infact,haveapositivemarketvaluewiththismodel,wemustassumethatinvestorsexpectthatsomeday,atsometime N ,thecompanymustpayoutsomecash,evenifonlyaliquidatingdividend. TheFinite-LifeGeneralDividendDiscountModel WecanmodifytheDDMgivenbyequation(19.1)byassumingafnitelifefortheexpectedcashfows.Inthiscase,theexpectedcashfowsaretheexpecteddividendspershareandtheexpectedsalepriceofthestockatsomefuturedate.Werefertothisexpectedpriceinthefutureastheterminalprice,anditcapturesthefuturevalueofallsubsequentdividends.Thismodelisthe fnite-lifegeneralDDM andwhichwecanexpressmathematicallyas: P 0 = D 1 (1 + r 1 ) 1 + D 2 (1 + r 2 ) 2 +···+ P N (1 + r N ) N or P 0 = N t = 1 D t (1 + r t ) t + P N (1 + r N ) N where P N istheexpectedvalueofthestockattheendofperiod N . 3 ThismodelwasfrstsuggestedbyJohnBurrWilliams, TheTheoryofInvestmentValue (Boston,MA:HarvardUniversityPress,1938).
496 INVESTMENTS AssumingaConstantDiscountRate Aspecialcaseofthefnite-lifegeneralDDMthatismorecommonlyusedinpracticeassumesthatthediscountrateisconstant.Thatis,weassumeeach r t isthesameforall t .Denotingthisconstantdiscountrateby r ,thevalueofashareofstocktodaybecomes: P 0 = D 1 (1 + r ) 1 + D 2 (1 + r ) 2 +···+ P N (1 + r ) N or P 0 = N t = 1 D t (1 + r ) t + P N (1 + r ) N (19.2)Equation(19.2)istheconstantdiscountrateversionofthefnite-lifegeneralDDM,andisthemoregeneralformofthemodel.Let’sillustratethefnitelifegeneralDDMbasedonaconstantdiscountrate,assumingeachperiodisayear.SupposethataninvestormakesthefollowingestimatesandassumptionsforstockXYZ: Requiredrateofreturnof10%. Currentdividendof$2pershare. Growthindividendsof4%peryear. Expectedpriceofthestockattheendoffouryearsis$29.835.Basedonthesedata,thefairpriceofstockXYZis P 0 = $2 . 08 (1 + 0 . 10) 1 + $2 . 16 (1 + 0 . 10) 2 + $2 . 25 (1 + 0 . 10) 3 + $2 . 34 (1 + 0 . 10) 4 + $29 . 835 (1 + 0 . 10) 4 = $27 . 34Theexpectedpricetoday,$27.34,isourestimateofthevalueofashareofthestockbasedonourestimatesandassumptions. Ifalittlemoneydoesnotgoout,greatmoneywillnotcomein.—Confucius,philosopher RequiredInputs Thefnite-lifegeneralDDMrequiresthreesetsofforecastsasinputstocalculatethefairvalueofastock: Expectedterminalprice, P N ; Dividendsuptotheassumedhorizon, D 1 to D N ,and Discountrates, r 1 to r N ,or r inthecaseoftheconstantdiscountrateversion.Thus,therelevantissueishowaccuratelytheseinputscanbeforecasted.
ValuingCommonStock 497 Theterminalpriceisthemostdiffcultofthethreeforecasts.Accordingtotheory, P N isthepresentvalueofallfuturedividendsafter N ;thatis, D N + 1 , D N + 2 , ... , D ∞ . Also,wemustestimatethediscountrate, r .Inprac-tice,wemakeforecastsofeitherdividends( D N )orearnings( E N )frst,andthentheprice P N basedonan“appropriate”requirementforyield,price-earningsratio,orcapitalizationrate.Notethatthepresentvalueoftheexpectedterminalprice P N ÷ (1 + r ) N becomesverysmallif N isverylarge.Theforecastingofdividendsissomewhateasier.Usually,informationonpastdividendsisreadilyavailableandwecanestimatecashfowsforagivenscenario.Thediscountrate r istherequiredrateofreturn,andforecastingthisrateismorecomplex.Inpracticeforagivencompany,weassumethat r isconstantforallperiods,andtypicallyestimatethisratefromthecapitalassetpricingmodel(CAPM).WecanusetheCAPMtoestimatetheexpectedreturnforacompanybasedontheexpectedrisk-freerate,theexpectedmarketriskpremium,andthestock’ssystematicrisk,itsbeta. 4 EXAMPLE19.1:ESTIMATINGTHEDISCOUNTRATE Considerthreecompanies,A,B,andC.Supposethat Themarketriskpremiumis5%,and Therisk-freerateis4.63%.Thebetaestimateforeachcompanyis: CompanyBeta A0.9B1.0C1.2Thediscountrate, r ,foreachcompanybasedontheCAPMistherefore: CompanyBetaCalculationDiscountRate A0.90.0463 + (0.9 × 0.05)9.13%B1.00.0463 + (1.0 × 0.05)9.63%C1.20.0463 + (1.2 × 0.05)10.63% 4 UsingtheCAPM,theexpectedreturnisthesumoftherisk-freerateofinterestandapremiumforbearingrisk.Thepremiumforbearingriskofaspecifcassetistheproductoftheasset’sbetaandthemarket’sriskpremium.
498 INVESTMENTS AssessingRelativeValue Oncewehaveanestimateofastock’svaluefromusingtheDDM,wheredowegofromthere?Wethencompareourestimateofthestock’svaluewiththeobservedpriceofthestock,ifthispriceisreadilyavailable.Ifthemarketpriceisbelowthefairpricederivedfromthemodel,thestockisundervaluedorcheap.Theoppositeholdsforastockwhosemarketpriceisgreaterthanthemodel-derivedprice.Inthiscase,thestockissaidtobeovervaluedorexpensive.Astocktradingequaltoorclosetoitsfairpriceisfairlyvalued.TheuseoftheDDMtellsustherelativevaluebutdoesnottelluswhenthepriceofthestockshouldbeexpectedtomovetoitsfairprice.Thatis,themodelsaysthatbasedontheinputsgeneratedbytheinvestor,thestockmaybecheap,expensive,orfair.However,itdoesnottellusthatifitismispricedhowlongitwilltakebeforethemarketrecognizesthemispricingandcorrectsit.Asaresult,aninvestormayholdontoastockperceivedtobecheapforanextendedperiodoftimeandmayunderperformduringthatperiod.Whileastockmaybemispriced,aninvestormustalsoconsiderhowmispriceditisinordertotaketheappropriateaction(thatis,buyacheapstockandexpecttosellitwhenthepricerises,orsellshortanexpensivestockexpectingitspricetodecline).Thiswilldependonbyhowmuchthestockistradingfromitsfairvalueandtransactioncosts.Aninvestorshouldalsoconsiderthatastockmaylookasifitismispriced(basedontheestimatesandthemodel),butthismaybetheresultofestimatesandtheuseoftheseestimatesinthemodelmayintroduceerrorinthevaluation. ConstantGrowthDividendDiscountModel Ifweassumethatfuturediv-idendsgrowataconstantrate, g ,andweuseasinglediscountrate, r ,thefnite-lifegeneralDDMassumingaconstantgrowthrategivenbyequation(19.2)becomes: P 0 = D 0 (1 + g ) 1 (1 + r ) 1 + D 0 (1 + g ) 2 (1 + r ) 2 +···+ D 0 (1 + g ) N (1 + r ) N + P N (1 + r ) N Itcanbeshownthatif N isassumedtoapproachinfnity,thisequationisequalto: P 0 = D 0 (1 + g ) r − g (19.3)Equation(19.3)isthe constantgrowthdividenddiscountmodel . 5 Therefore,thegreatertheexpectedgrowthrateofdividends,thegreatertheestimatedvalueofashareofstock. 5 MyronGordonandEliShapiro,“CapitalEquipmentAnalysis:TheRequiredRateofProft,” ManagementScience 3(1956):102–110.
ValuingCommonStock 499 Howdoweestimate g ?Ifwebelievethatdividendswillgrowinthefutureatasimilarrateastheygrewinthepast,wecanestimatethedividendgrowthratebyusingthecompoundedrateofgrowthofhistoricaldividends.Thecompoundgrowthrate, g ,isfoundusingthefollowingformula: 6 g = ⎛⎝ Numberofyears Lastyear’sdividend Firstyear’sdividend ⎞⎠ − 1(19.4)Let’sestimatethevalueofastock,usingthepastgrowthasourbestestimateofthefuturegrowthofdividends.Supposeacompanypaid$1.50individendsin20X1andpaid$2.00individendsin20X5.Usingthetimevalueofmoneymathematics,the20X5dividendisthefuturevalue,thestartingdividendisthepresentvalue,andthenumberofyearsisthenumberofperiods;solvingfortheinterestrateproducesthegrowthrate.Substitutingthevaluesforthestartingandendingdividendamountsandthenumberofperiodsintotheformula,weget: g = ⎛⎝ 4 $2 . 00 $1 . 50 ⎞⎠ − 1 = 7 . 457%Ifthediscountrate, r ,forthiscompany’sdividendsis15%,thevalueofashareofstockin20X5is: P 0 = $2 . 00(1 + 0 . 07457) 0 . 15 − 0 . 07457 = $2 . 14914 0 . 07543 = $28 . 49Keepinmindthatwearevaluingthisstockasof20X5,whichmeansthatthenumeratorinthisvaluationequationistheexpecteddividendin20X6,whichisthe20X5dividendmultipliedby1 + g .Whatifyouestimateastock’svalueandtheestimatedvalueisconsid-erablyoffthemarkwhencomparedtothestock’sactualprice?Thereasonsforthisdiscrepancymayinclude: Themarket’sexpectationsofthecompany’sdividendgrowthpatternmaynotbeforconstantgrowth;and Thegrowthrateofdividendsinthepastmaynotberepresentativeofwhatinvestorsexpectinthefuture. 6 Thisformulaisequivalenttocalculatingthegeometricmeanof1plusthepercentagechangeoverthenumberofyears.
500 INVESTMENTS Anotherproblemthatarisesinusingtheconstantgrowthratemodelisthattheestimatedgrowthrateofdividendsmayexceedthediscountrate, r .Therefore,therearesomecasesinwhichitisinappropriatetousetheconstantrateDDM. TRYIT!THECONSTANTGROWTHMODEL Estimatethevalueofashareofstockforeachofthefollowingcom-paniesusingtheconstantgrowthmodelandestimatingtheaverageannualgrowthrateofdividendsfrom20X1through20X6asgivenbelowasthebasisforestimatedgrowthbeyond20X6: CompanyDividendsperShare,20X1DividendsperShare,20X6DiscountRate 1$1.00$1.208%2$2.00$1.809%3$0.50$0.607%4$0.25$0.3012% MultiphaseDividendDiscountModels Theassumptionofconstantgrowthmaybeunrealisticandcanevenbemisleading.Instead,mostpractitionersmodifytheconstantgrowthDDMbyassumingthatcompanieswillgothroughdifferentgrowthphases,butwithinagivenphase,itisassumedthatdividendsgrowataconstantrate. 7 Themostpopularmultiphasemodelemployedbypractitionersappearstobethe three-stageDDM .Thismodelassumesthatallcompaniesgothroughthreephases,analogoustotheconceptoftheproductlifecycle.Inthegrowthphase,acompanyexperiencesrapidearningsgrowthasitproducesnewproductsandexpandsmarketshare.Inthetransitionphase 7 ForapioneeringworkthatmodifedtheDDMtoaccommodatedifferentgrowthrates,seeNicholasMolodovsky,CatherineMay,andShermanChattiner,“CommonStockValuation—Principles,Tables,andApplications,” FinancialAnalystsJournal 21(1965):104–123.
ValuingCommonStock 501 thecompany’searningsbegintomatureanddeceleratetotherateofgrowthoftheeconomyasawhole.Atthispoint,thecompanyisinthematu-rityphaseinwhichearningscontinuetogrowattherateofthegeneraleconomy.Wecandesignathree-phasemodeltoftdifferentgrowthpatterns.Forexample,anemerginggrowthcompanywouldhavealongergrowthphasethanamorematurecompany.Somecompaniesareconsideredtohavehigherinitialgrowthratesandhencelongergrowthandtransitionphases.Othercompaniesmaybeconsideredtohavelowercurrentgrowthratesandhenceshortergrowthandtransitionphases. Doyouknowhowtomarktangibleassetstotheirtruemarketvalueorimplementamultistagedividenddiscountmodel?Probablynot.Whyshouldyou?Mostpeoplealsodon’tknowhowtodoacoronarybypassoroperateabackhoe.Thatwhyyouhiresomeonewhodoes.—KenGregoryandSteveSavage,“WhyWePreferFunds,” Kiplinger’s ,August2002,p.59 ExpectedReturnsandDividendDiscountModels Thusfar,wehaveseenhowtocalculatethefairpriceofastockgiventheestimatesofdividends,discountrates,terminalprices,andgrowthrates. 8 Wethencomparethemodel-derivedpricetotheactualpriceandtheappropriateactionistaken.Wecanrecastthemodelintermsofexpectedreturn.Thisisfoundbycalculatingtheinterestratethatwillmakethepresentvalueoftheex-pectedcashfowsequaltothemarketprice.Mathematically,wecanexpressthisas: r = D 0 (1 + g ) P 0 + g = D 1 P 0 + g (19.5)Inotherwords,theexpectedreturnisthediscountratethatequatesthepresentvalueoftheexpectedfuturecashfowswiththepresentvalue 8 TheformulaforthismodelcanbefoundinEricSorensenandWilliamson,“SomeEvidenceoftheValueofDividendDiscountModels,” FinancialAnalystsJournal 41(1985):60–69.
502 INVESTMENTS ofthestock.Thehighertheexpectedreturn—foragivensetoffuturecashfows—thelowerthecurrentvalue.Thisrearrangementofthedividenddiscountmodelprovidesaperspec-tiveontheexpectedreturn:theexpectedreturnisthesumofthedividendyield(thatis, D 1 /P 0 )andtheexpectedrateofgrowthofdividends.Thelatterrepresentstheappreciation(ordepreciation,ifnegative)anticipatedforthestock.Therefore,thisistheexpectedcapitalgainorloss(or,simply,capitalyield)onthestock.Consideracompanythatcurrentlypaysadividendof$1pershare,hasacurrentsharepriceof$20,anddividendsareexpectedtogrowatarateof5%peryear.Usingthisinformation,weestimatethediscountrateas10.25%: r = $1(1 + 0 . 05) $20 + 0 . 05 = $1 . 05 $20 + 0 . 05 = 10 . 25%Giventheexpectedreturnandtherequiredreturn(thatis,thevaluefor r ),anymispricingcanbeidentifed.Iftheexpectedreturnexceedstherequiredreturn,thenthestockisundervalued;ifitislessthantherequiredreturnthenthestockisovervalued.Astockisfairlyvaluediftheexpectedreturnisequaltotherequiredreturn.Withthesamesetofinputs,theidentifcationofastockbeingmispricedorfairlyvaluedwillbethesameregardlessofwhetherthefairvalueisdeterminedandcomparedtothemarketpriceortheexpectedreturniscalculatedandcomparedtotherequiredreturn. TRYIT!ESTIMATINGTHEEXPECTEDRETURN Estimatetheexpectedreturnforeachofthefollowingcompanies: CompanyCurrentDividendsperShareExpectedGrowthRateofDividendsCurrentValueoftheStock T$1.002%$25U$0.503%$20V$1.251%$10W$0.252%$15
ValuingCommonStock 503 RELATIVEVALUATIONMETHODS AlthoughstockandcompanyvaluationisverystronglytiltedtowardtheuseofDCFmethods,itisimpossibletoignorethefactthatmanyinvestorsuseothermethodstovalueequityandentirecompanies.Theprimaryalternativevaluationmethodistheuseofmultiples(thatis,ratios)thathavepriceorvalueasthenumeratorandsomeformofearningsorcashfowgeneratingperformancemeasureforthedenominatorandthatareobservableforothersimilarorlike-kindcompanies.Thesemultiplesaresometimescalled“price/Xratios,”wherethedenom-inator“X”istheappropriatecashfowgeneratingperformancemeasure.Forexample,theprice/earnings(P/E)ratioisapopularmultipleusedforrelativevaluation,whereanearningsestimateisthecashfowgeneratingperformancemeasure.Keepinmindthatthetermsrelativevaluationandvaluationbymultiplesareusedinterchangeablyhereasarethetermspriceandvalue.Theessenceofvaluationbymultiplesassumesthatsimilarorcompara-blecompaniesarefairlyvaluedinthemarket.Asaresult,thescaledpriceorvalue(thepresentvalueofexpectedfuturecashfows)ofsimilarcompa-niesshouldbemuchthesame.Thatis,comparablecompaniesshouldhavesimilarprice/Xratios.Thekeyistofndthecomparablecompaniesthatwecanuseforvaluingatargetcompanyusingvaluationbymultiples.Valuationbymultiples,orsimplyrelativevaluation,isquickandcon-venient.Thesimplicityandconvenienceofvaluationbymultiples,however,constituteboththeappealofthisvaluationmethodandtheproblemsasso-ciatedwithitsuse.Simplicity,however,meansthattoomanyfactsaresweptunderthecarpetandtoomanyquestionsremainunasked.Multiplesshouldneverbeaninvestor’sonlyvaluationmethodandpreferablynoteventheprimaryfocusbecausenotwocompanies,orevengroupsofcompanies,areexactlythesame.Theterm“similar”entailsjustasmuchuncertaintyastheconceptof“expectedfuturecashfows”inDCFvaluationmethods.Actu-ally,whenaninvestorhasmorethanfveminutestovalueacompany,theDCFmethod,whichforcesaninvestortoconsiderthemanyaspectsofanongoingconcern,isthepreferredvaluationmethodandtheuseofmultiplesshouldbesecondary.Havingsaidthis,valuationbymultiplescanprovideavaluable“sanitycheck.”Ifaninvestorhascompletedathoroughvaluation,hecancomparehispredictedmultiples,suchastheP/Eratioandmarketvaluetobookvalue(MV/BV)ratio,torepresentativemultiplesofsimilarcompanies.IntheMV/BVratio,thebookvalueofassetsisthecashfowgeneratingper-formancemeasure.Thatis,eachdollarofbookvalueofassetsisassumedtogeneratecashfowforthecompany.Ifaninvestor’spredictedmultiples
504 INVESTMENTS arecomparable,hecan,perhaps,feelmoreassuredofthevalidityofhisanalysis.Ontheotherhand,ifaninvestor’spredictedmultiplesareoutoflinewiththerepresentativemultiplesofthemarket,theinvestorshouldre-examinetheassumptions,theappropriatenessofthecomparables,andtheappropriatenessofthemultipletothesituationathand.Whenusingrelativevaluation,aninvestordoesnotattempttoexplainobservedpricesofcompanies.Instead,aninvestorusestheappropriatelyscaledaveragepriceofsimilarcompaniestoestimatevalueswithoutspec-ifyingwhypricesarewhattheyare.Thatis,theaveragepriceofsimilarcompaniesisscaledbytheappropriate“price/X”ratio.Inaddition,thereisnothingtosaythatmultipleprice/Xratioscanbeusedorisappropriateforthesituationandthateachonewillgenerallyprovideadifferentestimateofvalue.Hence,thetrickinvaluingwithmultiplesisselectingtrulycompara-blecompaniesandchoosingtheappropriatescalingbases—theappropriate“X”measure. TheBasicPrinciplesofRelativeValuation Tousetheword“multiples”istouseafancynameformarketpricesdivided(or“scaled”)bysomemeasureofperformance,a“Price/X”ratiowhere“X”isthemeasureofperformancethatishighlycorrelatedwithcashfow.Inatypicalvaluationwithmultiples,theaveragemultiple—theaveragepricescaled(divided)bysomemeasureofperformance—isappliedtoaperfor-mancemeasureofthetargetcompanythataninvestorisattemptingtovalue.Forexample,supposeaninvestorchoosesearningsasthescalingmea-sure;thatis,theinvestorchoosesearningstobetheperformancemeasurebywhichpricesofsimilarcompanieswillbescaled.Toscaletheobservedpricesofcompaniesbytheirearnings,theinvestorcomputesforeachcompanytheratioofitspricetoitsearnings—itsP/Eratiooritsearningsmultiple.HethenaveragestheindividualP/Eratiostoestimatea“representative”P/Eratio,orarepresentativeearningsmultiple.Tovalueacompany,thein-vestormultipliestheprojectedproftsofthecompanybeingvaluedbytherepresentativeearningsmultiple,theaverageP/E.Whenvaluingwithmultiples,theinvestorisagnosticregardingwhatdeterminesprices.Thismeansthatthereisnotheorytoguidetheinvestoronhowbesttoscaleobservedmarketpricesbyoneofthefollowing:netearnings,earningsbeforeinterestandtaxes(EBIT),sales,orbookvalueofassets.Inpractice,thismeansthatvaluationwithmultiplesrequirestheuseofseveralscalingfactorsor,inotherwords,severalmultiples.Oftenthebestmultiplesforoneindustrymaynotbethepreferredmultiplesinanotherindustry.Thisimplies,forexample,thatthepracticeofcomparingP/Eratiosofcompaniesindifferentindustriesisproblematic
ValuingCommonStock 505 Choose comparablecompaniesValue of thecompanyApply the multipleto the subjectcompany’s baseEstimate the base ofthe multiple for thesubject companyDetermine theappropriate multipleCalculate the multiplefor the comparablecompanies EXHIBIT19.1 TheProcessofRelativeValuation (andinmanycasesinappropriatealtogether).Thisfurtherimpliesthatwhentheinvestorperformsamultiple-basedvaluation,itisimportantfrsttofndwhattheindustryconsidersasthebestmeasureofrelativevalues.Althoughvaluationbymultiplesdiffersfromvaluationbydiscount-ingcashfows,itsapplicationentailsasimilarprocedure—frstprojectingperformance,andthenconvertingprojectedperformancetovaluesusingmarketprices,aswedetailinExhibit19.1.Specifcally,ifaninvestorbelieves,basedonastudyofcomparablecompanies,thatanappropriateforward-lookingP/E(oranyprice/Xratio)forasubjectcompanyis17andexpectsearningstobe$3.00pershareinthenextperiod,anestimateofafairmarketpricebasedonrelativevaluationassumptionsis:AppropriateP / Eratio × Expectedearnings = 17 × $3 = $51pershare ChooseComparableCompanies Thewholeideaistoestimateavalueofthesubjectcompanyusingthemultipleimplicitinthepricingofthecomparablecompanies.Therefore,wewanttoselectcomparablecompaniesthatareassimilaraspossibletothecompanybeingvalued.Thefipsideofthisargument,however,isthatbyspecifyingtoostringentcriteriaforsimilarity,theinvestorendsupwithtoofewcompaniestocompare.Withasmallsampleofcomparablecompanies,theidiosyncrasiesofindividualcompaniesaffecttheaveragemultiplestoomuchsothattheaveragemultipleisnolongerarepresentativemultiple.In
506 INVESTMENTS selectingthesampleofcomparablecompanies,theinvestorhastobalancethesetwoconfictingconsiderations.Theideaistoobtainaslargeasampleaspossiblesothattheidiosyncrasiesofasinglecompanydonotaffectthevaluationbymuch,yetnottochoosesolargeasamplethatthe“comparablecompanies”arenotcomparabletotheonebeingvalued.Financialtheorystatesthatassetsthatareofequivalentriskshouldbepricedthesame,allelseequal.Thekeyideahereisthatweassumethatcomparablecompaniesareofequivalentrisk.Thus,theconceptofbeingabletofndcomparablecompaniesisthefoundationforvaluationbymultiples.Iftherearenocomparablecompanies,thenvaluationbymultiplesisnotanoption. DetermineanAppropriateMultiple Toconvertmarketpricesofcomparablecompaniestoavalueforthecom-panybeinganalyzed,aninvestorhastoscalethevaluedcompanyrelativetothecomparablecompanies.Thisistypicallydonebyusingseveralbasesofcomparison.Somegenericmeasuresofrelativesizeoftenusedinvaluationbymultiplesaresales,grossprofts,earnings,andbookvalues.Often,however,industry-specifcmultiplesaremoresuitablethangenericmultiples.Examplesofindustry-specifcmultiplesarepriceperrestaurantforfast-foodchains,paidmilesfownforairlines,andpricepersquarefootoffoorspaceforretailers.Ingeneral,thehigher-upthatthescalingbasisisintheincomestatement,thelessitissubjecttothevagariesofaccountingprinciples.Thus,scalingbasisofsalesismuchlessdependentonaccountingmethodsthanearningspershare(EPS).Forexample,depreci-ationortreatmentofconvertiblesecuritiescriticallyaffectEPScalculations,buthardlyaffectsales.Ontheotherhand,thehigher-upthatthescalingbasisisintheincomestatement,thelessitrefectsdifferencesinoperatingeff-ciencyacrosscompanies—differencesthatcriticallyaffectthevaluesofthecomparablecompaniesaswellasthevalueofthecompanybeinganalyzed. CalculatetheMultiplefortheComparableCompanies Onceaninvestorhasasampleofcompaniesthatheisconsideringsimilartothecompanybeingvalued,anaverageofthemultiplesprovidesameasureofwhatinvestorsarewillingtopayforcomparablecompaniesinordertoestimatea“fair”priceforthesubjectcompany.Forexample,afterdividingeachcomparablecompany’ssharepricebyitsEPStogetindividualP/Eratios,theinvestorcanaveragetheP/Eratiosofallcomparablecompaniestoestimatetheearningsmultiplethatinvestorsthinkisfairforcompanies
ValuingCommonStock 507 withthesecharacteristics.Thesamethingcanbedoneforallthescalingbaseschosen,calculatinga“fairprice”perdollarofsales,perrestaurant,persquarefootofretailspace,perdollarofbookvalueofequity,andsoon.Notethatweput“fairprice”inquotationmarks:BecausethereisnomarketforeitherEPSorsalesoranyotherscalingmeasure,thecomputationofaveragemultiplesismerelyascalingexerciseandnotanexerciseinfnding“howmuchthemarketiswillingtopayforadollarofearnings.”Investorsdonotwanttobuyearnings;theyonlywantcashfows(intheformofeitherdividendsorcapitalgains).Earnings(orsales)arepaidforonlytotheextentthattheygeneratecash.Incomputingaverageratiosforvariousbases,weimplicitlyassumethattheabilityofcompaniestoconverteachbasis(e.g.,sales,bookvalue,andearnings)tocashisthesame.Keepinmindthatthisassumptionismoretenableinsomecasesthaninothersandforsomescalingfactorsthanforothers.Realizethatweusethetermaveragetomeantheappropriatevaluethatisdeterminedbytheaveragecompanyinthecomparablegroup.Itmaynotbethestrictaverage.Itmaybeamean,median,ormode.Theinvestorisalsofreetothrowoutoutliersthatdonotseemtoconformtothemajorityofcompaniesinthegroup.Outliersaremostlikelysobecausethemarkethasdeterminedthattheyaredifferentforanynumberofreasons. EstimatetoBaseoftheMultiplefortheSubjectCompany Oncewehavethemultipleforthecomparable,weapplyittotheprojectedperformanceofthecompanythatwearevaluing.Therefore,theinvestorneedstoprojectthesamemeasuresoftherelativesizeusedinscalingthepricesofthecomparablecompaniesforthecompanybeingvalued.ConsideranexampleinwhichwewanttovalueCompanyX,usingthecomparablesA,B,andC.AndsupposeweestimatetheaverageP/EofcompaniesA,B,andCtobe15.IfweprojectearningspershareofCompanyXas$2,thenapplyingthecomparables’multipleof15givesusanestimateofthevaluepershareforCompanyXof$30.Thesimplestapplicationofvaluationwithmultiplesisbyprojectingthescalingbasesoneyearforwardandapplyingtheaveragemultipleofcomparablecompaniestotheseprojections.Forexample,thecomparablecompanies’averageP/Eratiototheprojectednextyear’searningsofthecom-panybeingvaluedisapplied.Clearly,byapplyingtheaveragemultipletothenextyear’sprojections,aninvestoroveremphasizestheimmediateprospectsofthecompanyandgivesnoweighttomoredistantprospects.Toovercomethisweaknessoftheone-step-aheadprojections,wecanuseamoresophisticatedapproach,applyingtheaveragemultiplesto
508 INVESTMENTS representativeprojections—projectionsthatbetterrepresentthelong-termprospectsofthecompany.Forexample,insteadofapplyingtheaverageP/Eratiotonextyear’searnings,thecomparableP/EratiototheprojectedaverageEPSoverthenextfveyearscanbeprojected.Inthisway,therepresentativeearnings’projectionscanalsocapturesomeofthelong-termprospectsofthecompany,whilenextyear’sfgures(withtheiridiosyncrasies)donotdominatevaluations. ApplytheMultipletotheSubjectCompany’sBase Inthefnalstep,aninvestorcombinestheaveragemultiplesofcomparablecompaniestotheprojectedparametersofthesubjectcompany(i.e.,thecompanytobevalued)toobtainanestimatedvalue.Onthefaceofit,thisismerelyasimpletechnicalstep.Yetoftenitisnot.Thevaluesthatweobtainfromvariousmultiples(i.e.,byusingseveralscalingbases)aretypicallynotthesame;infact,frequentlytheyarequitedifferent.Thismeansthatthissteprequiressomeanalysisofitsown—explainingwhyvaluationbytheaverageP/Eratioyieldsalowervaluethanthevaluationbythesalesmultiple(e.g.,thevaluedcompanyhashigherthannormalselling,general,andadministrativeexpenses)orwhytheMV/BVratioyieldsarelatively TRYIT!RELATIVEVALUATION ConsiderCompanyRVthathasprojectedearningspershareof$2.5andaprojectedbookvaluepershareof$20.DeterminetheestimatedvalueofthisCompanyRV,basedonarelativevalueusing: Theprice-earningsratio,and Themarketvaluetobookvalueratio,andusingtheaverageoftherespectivemultiplesofthecomparables: ComparableValueperShareEarningsperShareBookValueperShare X$15$1$10Y$32$2$8Z$60$5$40
ValuingCommonStock 509 lowvalue.Thecombinationofseveralvaluesintoafnalestimateofvalue,therefore,requiresaneconomicanalysisofboth“appropriate”multiplesandhowmultiple-basedvaluesshouldbeadjustedtoyieldvaluesthatareeconomicallyreasonable. THEBOTTOMLINE Thebasisforthedividenddiscountmodelissimplytheapplicationofpresentvalueanalysis,whichassertsthatthefairpriceofanassetisthepresentvalueofitsexpectedcashfows. Mostdividenddiscountmodelsusecurrentdividends,somemeasureofhistoricalorprojecteddividendgrowth,andanestimateoftherequiredrateofreturn.Thethreemostcommondividendmeasuresaredividendspershare,dividendyield,anddividendpayout. Variationsofthedividenddiscountmodelsallowtheinvestortovaryassumptionsregardingdividendgrowthtoaccommodatedifferentpat-ternsofdividends.Popularmodelsincludethefnite-lifegeneraldividenddiscountmodel,theconstantgrowthdividenddiscountmodel,andthemultiphasedividenddiscountmodel. Adividenddiscountmodelcanberecastintermsofexpectedreturn.Theexpectedreturnisfoundbycalculatingtheinterestratethatwillmakethepresentvalueoftheexpectedcashfowsbeequaltothemarketprice. Analternativevaluationmethodtothedividenddiscountmodelistheuseofmultiplesthathavepriceorvalueasthenumeratorandsomeformofearningsorcashfowgeneratingperformancemeasureforthedenominatorandthatareobservableforothersimilarorlike-kindcom-panies.Thesemultiplesaresometimescalled“price/Xratios,”wherethedenominator“X”istheappropriatecashfowgeneratingperformancemeasure. Theessenceofvaluationbymultiplesassumesthatsimilarorcompa-rablecompaniesarevaluedfairlyinthemarket.Whenusingrelativevaluation,noattemptismadebyaninvestortoexplainobservedpricesofcompanies.Rather,aninvestoremployssuitablyscaledaveragepricesofsimilarcompaniestoestimatevalueswithoutspecifyingwhypricesarewhattheyare. Despitethefactthatvaluationbymultiplesdiffersfromvaluationbydis-countingcashfows,theapplicationentailsasimilarprocedure,whichinvolvesfrstforecastingperformance,andthenconvertingprojectedperformancetovaluesusingmarketprices.
510 INVESTMENTS SOLUTIONSTOTRYIT!PROBLEMS DividendMeasuresCompanyDividendsperShareDividendPayoutRatioDividendYield P$1.0020%2.00%Q$1.0020%10.00%R$1.0033%6.67%S$1.0020%5.00% TheConstantGrowthModelCompanyDividendsperShare,20X1DividendsperShare,20X6DiscountRateEstimatedGrowthRateEstimateValueperShare 1$1.00$1.208%3.71%$29.0362$2.00$1.809% − 2.09%$15.8993$0.50$0.607%3.71%$18.9364$0.25$0.3012%3.71%$3.755 EstimatingtheExpectedReturnCompanyCurrentDividendsperShareExpectedGrowthRateofDividendsCurrentValueoftheStockDiscountRate, r T$1.002%$256.08%U$0.503%$205.58%V$1.251%$1013.63%W$0.252%$153.70% RelativeValuationComparableP/EMV/BV X15.001.5Y16.004Z12.001.5Average14.332.33CompanyRV’sbase × $2.50 × $20 Estimatedvaluepershare$35.83$46.67
ValuingCommonStock 511 QUESTIONS 1. Ifacompanymaintainsaconstantrateofgrowthforthedividendspersharethatitpays,whatisthelikelyeffectonthecompany’sdividendpayoutratio? 2. Whatistherelationshipbetweenthediscountrateappliedtoastock’sfuturecashfowsandthevalueofastock? 3. Ifthedividendspershareofastockarenotexpectedtogrow,whateffectdoesthishaveonthevaluationofthestock? 4. Supposethedividendsofacompanyare$2inoneyearand$3threeyearsfollowing.Whatistheaverageannualgrowthindividendsoverthesethreeyears? 5. Intheconstantgrowthdividenddiscountmodel,whatistherelationshipbetweentherequiredrateofreturnandtheexpectedgrowthrateofdividends? 6. Ifacompany’sdividendsareexpectedtodecline,isitpossibletostillusetheconstantgrowthdividenddiscountmodel? 7. Whatistherelationbetweentheexpectedreturnonastockandthestock’sdividendyield? 8. Concerningadividendvaluationmodelwithmultiplestagesofgrowth, a. Whywouldaninvestoruseamultiphasedividenddiscountmodel? b. Inathree-phasedividenddiscountmodel,whatarethethreephases? 9. IftheaverageP/Emultipleforcomparablesis15andthecompanyyouwanttovaluehasexpectedearningspershareof$2,whatistheestimateofthiscompany’spricepershareofstock? 10. Whymightyouprefertouseameasureofcashfowgeneratingabilitysuchasearningsinsteadofsalesinrelativevaluation? 11. Ifananalystexpectsacompany’sdividendtobe$2.50nextyear,$3intwoyears,andthenconstantat$3.25forever,whatisthevalueofthecompany’sstockifinvestorsrequireareturnof8%? 12. Ifinvestorsexpectareturnof12%onastockthatisexpectedtohaveadividendyieldof4%nextyear,whatistheexpectedgrowthrateonthisstock? 13. Explainwhetheryouagreeordisagreewiththefollowingstatement:“Unlikeadividenddiscountmodel,relativevaluationseekstoexplainthefactorsthatdeterminetheobservedvalueofashareofcommonstock.” 14. Towhatextentistheproceduresimilarforvaluationbasedondiscount-ingcashfowsandvaluationbymultiples? 15. Inseekingtoestablishcomparablecompaniesinrelativevaluationanal-ysis,whatistheproblemwithspecifyingtoostringentcriteriaforcom-paniestobeincludedinthecomparablegroup?
CHAPTER 20 ValuingBonds x Investinginjunkbondsandinvestinginstocksarealikeincertainways:Bothactivitiesrequireustomakeaprice-valuecalculationandalsotoscanhundredsofsecuritiestofndtheveryfewthathaveattractivereward/riskratios.Butthereareimportantdifferencesbetweenthetwodisciplinesaswell.Instocks,weexpecteverycommitmenttoworkoutwellbecauseweconcentrateonconservativelyfnancedbusinesseswithstrongcompetitivestrengths,runbyableandhonestpeople.Ifwebuyintothesecompaniesatsensibleprices,lossesshouldberare. ... Purchasingjunkbonds,wearedealingwithenterprisesthatarefarmoremarginal.Thesebusinessesareusuallyoverloadedwithdebtandoftenoperateinindustriescharacterizedbylowreturnsoncapital.Additionally,thequalityofmanagementissometimesquestionable.Managementmayevenhaveintereststhataredirectlycountertothoseofdebtholders.Therefore,weexpectthatwewillhaveoccasionallargelossesinjunkissues. —WarrenBuffett,LettertoShareholdersofBerkshireHathaway,February21,2003,p.16 I nthischapterweexplainhowtodeterminethepriceofabondaswellastherelationshipbetweenpriceandyield.Thenwediscussvariousyieldmeasuresandtheirmeaningforevaluatingthepotentialperformanceoversomeinvestmenthorizon.Inparticular,weexplainthevariousconventionsformeasuringtheyieldofabondandwhyconventionalyieldmeasuresfailtoidentifythepotentialreturnfrominvestinginabondoversomeinvestmenthorizon. 513
514 INVESTMENTS VALUINGABOND Thepriceofanyfnancialinstrumentisequaltothepresentvalueoftheexpectedcashfowsfromthefnancialinstrument.Therefore,determiningthepricerequires: Anestimateoftheexpectedcashfows. Anestimateoftheappropriaterequiredyield.Theexpectedcashfowsforsomefnancialinstrumentsaresimpletocompute;forothers,thetaskismorediffcult.The requiredyield refectstheyieldforfnancialinstrumentswithcomparablerisk.Thefrststepindeterminingthepriceofabondistoestimateitscashfows.Thecashfowsforabondthattheissuercannotretirepriortoitsstatedmaturitydate(thatis,anoption-freebond)consistsof: Periodiccouponinterestpaymentstothematuritydate. Theparvalueatmaturity.Ourillustrationsofbondpricingusethreeassumptionstosimplifytheanalysis: Thecouponpaymentsaremadeeverysixmonths.(FormostU.S.bondissues,couponinterestisinfactpaidsemiannually.) Thenextcouponpaymentforthebondisreceivedexactlysixmonthsfromnow. Thecouponinterestisfxedforthetermofthebond.Whileourfocusinthischapterisonoption-freebonds,laterinthischapterweexplainhowtovaluebondswithembeddedoptions.Consequently,thecashfowsforanoption-freebondconsistofanan-nuityofafxedcouponinterestpaymentpaidsemiannuallyandthematurityvalue.The maturityvalue isthelump-sumpaymentthatrepresentsthere-paymentoftheloanedamount,whichwealsorefertoastheparvalueorthefacevalueofthebond.Forexample,a20-yearbondwitha10%couponrateandapar,ormaturity,valueof$1,000hasthefollowingcashfowsfromcouponinterest:Annualcouponinterest = $1 , 000 × 0 . 10 = $100Semiannualcouponinterest = $100 ÷ 2 = $50
ValuingBonds 515 Therefore,thereare40semiannualcashfowsof$50,andthereisa$1,000cashfow40six-monthperiodsfromnow.Noticethetreatmentoftheparvalue.Itisnottreatedasifitisreceived20yearsfromnow.Instead,itistreatedonabasisconsistentwiththecouponpayments,whicharesemiannual.Therequiredyieldisdeterminedbyinvestigatingtheyieldsofferedoncomparablebondsinthemarket.Inthiscase,comparableinvestmentswouldbeoption-freebondswiththesamecreditratingandthesamema-turity.Therequiredyieldtypicallyisexpressedasanannualinterestrate.Whenthecashfowsoccursemiannually,themarketconventionistouseone-halftheannualinterestrateastheperiodicinterestratewithwhichtodiscountthecashfows.Giventhecashfowsofabondandtherequiredyield,wehavealltheinformationneededtopriceabond.Becausethepriceofabondisthepresentvalueoftheexpectedcashfows,itisdeterminedbyaddingthesetwopresentvalues: Thepresentvalueofthesemiannualcouponpayments. Thepresentvalueofthepar,ormaturity,valueatthematuritydate.Ingeneral,wecanestimatethevalueofabondusingthefollowingformula: P = C (1 + r ) 1 + C (1 + r ) 2 + C (1 + r ) 3 +···+ C (1 + r ) n + M (1 + r ) n or P = n t = 1 C (1 + r ) t + M (1 + r ) n (20.1)where: P isthepriceindollars. n isthenumberofperiodsuntilmaturity,whichisthenumberofyears × 2forabondthatpaysinterestsemiannually. C isthecouponpaymentindollarsperperiod. r istheperiodicinterestrate,whichforasemiannual-paybondistherequiredannualyield ÷ 2. M isthematurityvalue. t thetimeperiodwhenthecashfowisexpected.Thecouponpaymentsareequivalenttoanordinaryannuity,sowecanestimatethepresentvalueofthecouponpaymentsasanordinaryannuity.
516 INVESTMENTS Financialcalculatorsandspreadsheetspermitustovalueabondinonesinglecalculation,valuingboththeannuityportion(i.e.,thecouponpayments)andthelump-sumpayment(i.e.,thematurityvalue)where: ThebondparameterofInthecalculatororspreadsheetas Couponpaymentindollarsperperiod C PMTPeriodicinterestrate i iNumberofperiodsuntilmaturity n NMaturityvalue M FV Toillustratehowtocomputethepriceofabond,considerBondA,a20-year10%couponbondwithaparvalueof$1,000andinterestpaidsemiannually. P = 40 t = 1 $50 (1 + 0 . 055) t + $1 , 000 (1 + 0 . 055) 40 = $802 . 31 Let’ssupposethattherequiredyieldonthisbondis11%.Theinputsforafnancialcalculationtocomputethepriceforthisbondareasfollows: C = 10% × $1 , 000 ÷ 2 = $ 50everysixmonths M = $1 , 000 r = 11% ÷ 2 = 5 . 5%persix-monthperiod n = 20 × 2 = 40six-monthperiod Supposethatinsteadofan11%requiredyield,therequiredyieldis6.8%( r = 3.4%).Thepriceofthebondwouldthenbe$1,347.04,demonstratedasfollows:Thepresentvalueofthecashfowsusingaperiodicinterestrateof3.4%(6.8%/2)is P = 40 t = 1 $50 (1 + 0 . 034) t + $1 , 000 (1 + 0 . 034) 40 = $1 , 347 . 04Iftherequiredyieldisequaltothecouponrateof10%( r = 5%),thevalueofthebondwouldbeitsparvalue,$1,000: P = 40 t = 1 $50 (1 + 0 . 05) t + $1 , 000 (1 + 0 . 05) 40 = $1 , 000
ValuingBonds 517 With zero-couponbonds ,issuersdonotmakeanyperiodiccouponpayments.Instead,theinvestorrealizesinterestasthedifferencebetweenthematurityvalueandthepurchaseprice.Thepriceofazero-couponbondiscalculatedbysubstitutingzerofor C inequation(20.1): P = M (1 + r ) n (20.2)Aswestateinequation(20.2),thepriceofazero-couponbondissimplythepresentvalueofthematurityvalue.Inthepresentvaluecomputation,however,thenumberofperiodsusedfordiscountingisnotthenumberofyearstomaturityofthebond,butrather,doublethenumberofyears.Thediscountrateisone-halftherequiredannualyield. 1 EXAMPLE20.1:VALUINGAZERO-COUPONBOND Considerazero-couponbondthathasamaturityvalueof$1,000,maturesinfveyears,andhasarequiredannualyieldof8%.Whatisthepriceofthisbond? Solution P = $1 , 000 (1 + 0 . 04) 10 = $456 . 387 Afundamentalpropertyofabondisthatitspricechangesintheoppositedirectionfromthechangeintherequiredyield.Thereasonisthatthepriceofthebondisthepresentvalueofthecashfows.Astherequiredyieldincreases,thepresentvalueofthecashfowsdecreases;hence,thepricedecreases.Theoppositeistruewhentherequiredyielddecreases:Thepresentvalueofthecashfowsincreases,and,therefore,thepriceofthebondincreases.YoucanseethisinExhibit20.1,whereweshowthepriceofBondAforarangeofrequiredannualyields.BondAisa20-year,10%couponbondwithamaturityvalueof$1,000.InExhibit20.2weplotthepriceofthesamebondforarangeofannualrequiredyields. 1 Thismayseemcounterintuitivebecausebydefnitionazero-couponbonddoesnotpayinterest,soasemiannualperiodismeaningless.However,weusethesameconventionforzero-couponbondsascouponbondssothatthevaluationandyieldsareconsistentbetweenthetwotypesofbonds.
518 INVESTMENTS EXHIBIT20.1 ThePrice-YieldRelationshipforBondA Forabondwitha$1,000maturityvalue,20yearsremainingtomaturity,andacoupon(paidsemiannually)of10%: C =$50 M =$1,000 n =40andtherefore: RequiredAnnualYieldPrice 9.0%$1,092.019.5%$1,044.4110.0%$1,000.0010.5%$958.5311.0%$919.7711.5%$883.5012.0%$849.5412.5%$817.70 AsyoucanseeinExhibit20.2,therelationshipbetweenthevalueofthebondandtheyieldisthebowedshape.Inotherwords,thisrelationshipis convex. Theconvexityoftheprice/yieldrelationshiphasimportantimpli-cationsfortheinvestmentpropertiesofabond,asweexplainlaterinthischapter. $0$500$1,000$1,500$2,000$2,500$3,00024%20%16%12%8%4%0% Price of the Bond Required Annual Yield EXHIBIT20.2 ThePrice-YieldRelationshipoveraWideRangeofRequiredAnnualYieldsforBondA
ValuingBonds 519 TRYIT!BONDVALUES Foreachofthefollowingbonds,calculatethevalueofthebond.Eachbondhasamaturityvalueof$1,000andpaysinterestsemiannually. BondCouponRateNumberofYearstoMaturityRequiredAnnualYield A5%106%B6%207%C5%104%D8.5%157% RelationshipBetweenCouponRate,Yield,andPrice Asyieldsinthemarketplacechange,theonlyvariablethatcanchangetocompensateaninvestorinanexistingbondisthepriceofthatbond.Whenthecouponrateisequaltotherequiredyield,thepriceofthebondwillbeequaltoitsparvalueaswefoundearlier.Whenyieldsinthemarketplaceriseabovethecouponrateatagivenpointintime,thepriceofthebondadjustssothattheinvestorcanrealizesomeadditionalinterest.Thisisaccomplishedbythepricefallingbelowitsparvalue.Thecapitalappreciationrealizedbyholdingthebondtoma-turityrepresentsaformofinterestincometotheinvestortocompensateforacouponratethatislowerthantherequiredyield.Whenabondsellsbelowitsparvalue,itissaidtobesellingata discount. Inourearliercalculationofbondprice,wesawthatwhentherequiredyieldisgreaterthanthecouponrate,thepriceofthebondisalwayslowerthantheparvalue($1,000).Whentherequiredyieldinthemarketisbelowthecouponrate,thebondmustsellaboveitsparvalue.Thisisbecauseinvestorswhowouldhavetheopportunitytopurchasethebondatparvaluewouldbegettingacouponrateinexcessofwhatthemarketrequires.Asaresult,investorswouldbidupthepriceofthebondbecauseitsyieldissoattractive.Thepricewouldeventuallybebiduptoalevelwherethebondofferstherequiredyieldinthemarket.Abondwhosepriceisaboveitsparvalueissaidtobesellingata premium. Therelationshipbetweencouponrate,requiredyield,andpricecanbesummarizedasfollows:
520 INVESTMENTS Ifthenandwerefertothisbondasa Couponrate < RequiredyieldPrice < PardiscountbondCouponrate = RequiredyieldPrice = ParparbondCouponrate > RequiredratePrice > Parpremiumbond RelationshipBetweenaBond’sPriceandTime Iftherequiredyielddoesnotchangebetweenthetimethebondispurchasedandthematuritydate,whatwillhappentothepriceofthebond?Forabondsellingatparvalue,thecouponrateisequaltotherequiredyield.Asthebondmovesclosertomaturity,thebondwillcontinuetosellatparvalue.Thepriceofabondwillnotremainconstantforabondsellingatapremiumoradiscount,however.Adiscountbond’spriceincreasesasitapproachesmaturity,assumingtherequiredyielddoesnotchange.Forapremiumbond,theoppositeoccurs.Forbothbonds,thepricewillequalparvalueatthematuritydate.ConsiderBondB,whichhasaparvalueof$1,000,acouponrateof5%,and10yearsremainingtomaturity.Let’sassumethatthebondiscurrentlypricedbythemarketsothatithasayieldof8%,andifthisyieldremainsuntilthebondmatures.AsweshowinExhibit20.3,thebondiscurrently Price of the Bond Years Remaining until Maturity EXHIBIT20.3 ThePrice-TimeRelationshipforaDiscountBond:BondB(10-Year,5%CouponBondwithaParValueof$1,000SellingtoYield8%)
ValuingBonds 521 pricedat$796.15.BondB’spriceincreasesasitapproachesmaturity.Iftheyieldisconstant,thispathisupward,withaslightcurvature. EXAMPLE20.2:BONDPRICEOVERTIME Considerabondthathasacouponrateof6%andispricedtoyield8%.Ifthebond’sparvalueis$1,000,whatisthepriceofthebondifthereis: a. fveyearsremainingtomaturity? b. 10yearsremainingtomaturity? c. 20yearsremainingtomaturity? Solution Inputs: C = $60/2 = $30 M = $1,000 r = 8%/2 = 4% a. $918.89 b. $864.10 c. $902.07 Abondcurrentlysellingforapremiumapproachesitsmaturityvaluefromabove.ConsiderBondC,whichissimilartoBondBwitha5%annualcouponratebutiscurrentlypricedtoyield4%.IncontrasttoBondB,whichisadiscountbond,BondCisapremiumbond.AsyoucanseeinExhibit20.4,thepriceofthispremiumbondwilldeclineovertimeasthebondapproachesitsmaturity. ReasonsfortheChangeinthePriceofaBond Thepriceofabondwillchangeforoneormoreofthefollowingthreereasons: 1. Thereisachangeintherequiredyieldduetochangesinthecreditqualityoftheissuer.Thatis,therequiredyieldchangesbecausethe
522 INVESTMENTS Price of the Bond Years Remaining until Maturity EXHIBIT20.4 ThePrice-TimeRelationshipforaPremiumBond:BondC(10-Year,5%CouponBondwithaParValueof$1,000SellingtoYield4%) marketnowcomparesthebondyieldwithyieldsfromadifferentsetofbondswiththesamecreditrisk. 2. Thereisachangeinthepriceofthebondsellingatapremiumoradiscountwithoutanychangeintherequiredyield,simplybecausethebondismovingtowardmaturity. 3. Thereisachangeintherequiredyieldduetoachangeintheyieldoncomparablebonds.Thatis,marketinterestrateschange. DifferentDiscountRatesApplytoEachCashFlow Sofar,we’veassumedthatitisappropriatetodiscounteachcashfowusingthesamediscountrate.However,wecanviewabondasapackageofzero-couponbonds,inwhichcaseauniquediscountrateshouldbeusedtodeterminethepresentvalueofeachcashfow.Thismeansdiscountingeachcashfowatthespotratefortheperiodwhenthecashfowisexpectedtobereceived.Thatis,weusetheyieldonatwo-yearzero-couponbondtodiscountthecashfowthatoccurstwoyearsfromnow,weusetheyieldonathree-yearzero-couponbondtodiscountthecashfowsthatoccursthreeyearsfromnow,andsoon.ConsiderBondDthathasa5%semiannualcoupon,threeyearsre-mainingtomaturity,andaparvalueof$1,000.Andsupposewehavethefollowingsetofspotratesforeachsix-monthrangeofmaturity:
ValuingBonds 523 MaturitySpotRate(Annualized) 6months4.5%1year5.0%1.5years5.5%2years6.0%2.5years6.5%3years7.0%Ifweapplytheseratesinsteadofafxeddiscountyield,suchas6%,wearriveatadifferentvalueforthebond,asweshowinExhibit20.5.Inthisexhibit,weshowthatthatthepriceofthebondishigherusingthespotratesfromanupward-slopingyieldcurve,ascomparedtousingtheaverageoftherates(i.e.,6%)orthethree-yearspotrateof7%. PriceQuotes Wehaveassumedinourillustrationsthatthematurity,orpar,valueofabondis$1,000.Abondmayhaveamaturity,orpar,valuegreaterorlessthan$1,000.Consequently,whenquotingbondprices,tradersquotethepriceasapercentageofparvalue.Abondsellingatparvalueisquotedas100,meaning100%ofitsparvalue.Abondsellingatadiscountwillbesellingforlessthan100;abondsellingatapremiumwillbesellingformorethan100.Theprocedureforconvertingapricequotetoadollarpriceisasfollows:(Priceper$100ofparvalue ÷ 100) × ParvalueForexample,ifabondisquotedat96.5andhasaparvalueof$100,000,thenthedollarpriceis(96 . 5 ÷ 100) × $100 , 000 = $96 , 500 EXHIBIT20.5 ValuingaBondUsingDifferentSpotRates:BondD(3-Year,10%CouponBondwithaParValueof$1,000) PeriodCashFlowDiscountedat6%Discountedat7%SpotRate(Annualized)DiscountedUsingaSetofSpotRates 6months$25$24.27$24.154.5%$24.451year25$23.56$23.345.0%$23.801.5years25$22.88$22.555.5%$23.052years25$22.21$21.796.0%$22.212.5years25$21.57$21.056.5%$21.313years1,025$858.42 $833.84 7.0%$833.84 ValueofBondD$972.91$946.71$948.65
524 INVESTMENTS Ifabondisquotedat103.59375andhasaparvalueof$1million,thenthedollarpriceis:Dollarvalue = (103 . 59375 ÷ 100) × $1 , 000 , 000 = $1 , 035 , 937 . 50Whenaninvestorpurchasesabondbetweencouponpayments,theinvestormustcompensatethesellerfortheaccruedinterest. 2 CONVENTIONALYIELDMEASURES Relatedtothepriceofabondisitsyield.Wecalculatethepriceofabondfromtheexpectedcashfowsandtherequiredyield.Wecalculatetheyieldofabondfromtheexpectedcashfowsandthemarketpriceplusaccruedinterest.Inthissection,wediscussvariousyieldmeasuresandtheirmeaningforevaluatingtherelativeattractivenessofabond.Therearethreebondyieldmeasurescommonlyquotedbydealersandusedbyportfoliomanagers:(1)currentyield,(2)yieldtomaturity,and(3)yieldtocall.Inourillustrationsbelowweassumethatthenextcouponpaymentissixmonthsfromnowandthereforethereisnoaccruedinterest. CurrentYield The currentyield relatestheannualcouponinteresttothemarketprice.Theformulaforthecurrentyieldis:Currentyield = Annualdollarcoupon PriceForexample,thecurrentyieldfora15-year,7%couponbondwithaparvalueof$1,000sellingfor$769.40is9.1%:Currentyield = $70 $769 = 9 . 1%Thecurrentyieldcalculationtakesintoaccountonlythecouponinter-estandnoothersourceofreturnthatwillaffectaninvestor’syield.Noconsiderationisgiventothecapitalgainthattheinvestorwillrealizewhen 2 Wedonotdelveintothenuancesofvaluingabondwithaccruedinterest.Fortu-nately,youcanusespecifcspreadsheetfunctionsandfnancialcalculatorfunctionstovaluebondsbetweeninterestpayments.
ValuingBonds 525 abondispurchasedatadiscountandheldtomaturity;noristhereanyrecognitionofthecapitallossthattheinvestorwillrealizeifabondpur-chasedatapremiumisheldtomaturity.Thetimevalueofmoneyisalsoignored. YieldtoMaturity The yieldtomaturity istheinterestratethatwillmakethepresentvalueofabond’sremainingcashfows(ifheldtomaturity)equaltotheprice(plusaccruedinterest,ifany).Mathematically,wesolvefortheyieldtomaturity,YTM,usingthesameformulaweusedforthevalueofabond—butthistimeweknowthevalueandaresolvingfor r .Forabondthatpaysinterestsemiannuallyandthathasnoaccruedinterest,wesolvefor r using: P = n t = 1 C (1 + r ) t + M (1 + r ) n Becausethecashfowsareeverysixmonths,theratethatwesolveforis r ,whichisasemiannualyieldtomaturity.Oncewesolvefor r ,weneedtoconvertthisintoanannualyield.Wehavetwochoicesforannualizingthisyield:(1)doublingthesemiannualyieldor(2)compoundingtheyield.Themarketconventionistoannualizethesemiannualyieldbysimplydoublingitsvalue.Theyieldtomaturitycomputedonthebasisofthismarketconventionofdoublingtheyieldisthe bond-equivalentyield. Wealsorefertoitastheyieldona bond-equivalentbasis. Thereisnotdirectsolutionfor r ,soweneedtoresorttoaniterativeprocedure.Toillustratethecomputation,considerBondE,a15-year,7%couponbondwithamaturityvalueof$1,000.Usingafnancialcalculatororaspreadsheet,PMT = $35N = 30FV = $1,000PV = $769.40Solvingfor r ,weget5%.Thereforetheyieldtomaturityis5% × 2 = 10%.WeshowtheyieldtomaturityfordifferentpricesofBondEinEx-hibit20.6.Forexample,ifthepriceofBondEis$1,000,theyieldtomaturityisthecouponrate,7%,whereasifthepriceofBondEis$1,200,theyieldtomaturityis5.1%.
526 INVESTMENTS 11.2% 10.3%9.5%8.8%8.2%7.6%7.0%6.5%6.0%5.5%5.1%4.7%4.3% 0%2%4%6%8%10%12%$700$800$900$1,000$1,100$1,200$1,300 Yield to Maturity Bond Price EXHIBIT20.6 YieldtoMaturityforDifferentPricesofBondE(15-Year,7%CouponBondwithaMaturityValueof$1,000) Itisimportanttoknowtherelationbetweenthepriceandparvalueandthevariousyieldmeasuresdiscussedearlierweknow: Abondsellingat:thereforehas: ParCouponrate = Currentyield = YieldtomaturityDiscountCouponrate < Currentyield < YieldtomaturityPremiumCouponrate > Currentyield > YieldtomaturityTheyield-to-maturitycalculationtakesintoaccountnotonlythecurrentcouponincomebutalsoanycapitalgainorlosstheinvestorwillrealizebyholdingthebondtomaturity.Inaddition,theyieldtomaturityconsidersthetimingofthecashfows.WeshowtherelationshipbetweentheyieldtomaturityandthecurrentyieldforBondEfordifferentpricesofthebond 0%2%4%6%8%10%12%$700$800$900$1,000$1,100$1,200$1,300 Yield Value of the Bond Yield to maturity Current yield EXHIBIT20.7 YieldtoMaturityandCurrentYieldforDifferentPricesofBondE
ValuingBonds 527 inExhibit20.7.Boththeyieldtomaturityandthecurrentyielddeclineforhigherbondprices,butyoucanseetheeffectsofthetimevalueofmoneyonthecurvatureoftheyield-pricerelationshipfortheyieldtomaturity. EXAMPLE20.3:YIELDS Considerabondthathasacouponrateof5%,withinterestpaidsemi-annually,thatmaturesin10years.Ifthecurrentpriceofthebondis$975andthematurityvalueofthebondis$1,000,whatistheyieldtomaturityandcurrentyieldonthisbond? Solution Fortheyieldtomaturity,solvethefollowingfor r andthenmultiplyby2:$975 = 20 t = 1 $25 (1 + r ) t + $1 , 000 (1 + r ) 20 r = 2.663%.Thereforetheyieldtomaturityis5.326%.Forthecurrentyield,theannualcouponis$50,whichwedivideby$975.Therefore,thecurrentyieldis5.12%. TRYIT!YIELDS Calculatetheyieldtomaturityandthecurrentyieldforeachofthefollowingbonds: BondCouponRateNumberofYearstoMaturityPrice E5.0%5$1,000F6.0%10$900G5.0%15$1,200H8.5%20$750
528 INVESTMENTS YieldtoCall Theissuermaybeentitledtocallabondpriortothestatedmaturitydate.Whenthebondmaybecalledandatwhatpriceisspecifedintheindenture.Thepriceatwhichtheissuermaycallthebondisreferredtoasisthe callprice. Forsomeissues,thecallpriceisthesameregardlessofwhentheissueiscalled.Forothercallableissues,thecallpricedependsonwhentheissueiscalled.Thatis,thereisa callschedule thatspecifesacallpriceforeachcalldate.Forcallableissues,thepracticehasbeentocalculatea yieldtocall aswellasayieldtomaturity.Theyieldtocallassumesthattheissuerwillcallthebondatsomeassumedcalldate,andthecallpriceisthenthecallpricespecifedinthecallschedule.Typically,investorscalculatea yieldtofrstcall anda yieldtoparcall. Theyieldtofrstcallassumesthattheissuewillbecalledonthefrstcalldate.Theyieldtofrstparcallassumesthattheissuewillbecalledthefrsttimeonthecallschedulewhentheissuerisentitledtocallthebondatparvalue.Theprocedureforcalculatingtheyieldtoanyassumedcalldateisthesameasforanyyieldcalculation:Determinetheinterestratethatwillmakethepresentvalueoftheexpectedcashfowsequaltothepriceplusaccruedinterest.Inthecaseofyieldtofrstcall,theexpectedcashfowsarethecouponpaymentstothefrstcalldateandthecorrespondingcallprice.Fortheyieldtofrstparcall,theexpectedcashfowsarethecouponpaymentstothefrstdateatwhichtheissuermaycallthebondatpar.Mathematically,wecanexpresstheyieldtocallas: P = ⎛⎝ n * t = 1 C (1 + r ) t ⎞⎠ + M * (1 + r ) n *where M *isthecallpriceand n *isthenumberofperiodstothecalldate.Ifthecouponispaidsemiannually,wefrstcalculate r andthenmultiplythisrateby2toarriveattheyieldtocall,YTC.Toillustratethecomputation,considerBondF,an18-year,11%couponbondwithamaturityvalueof$1,000sellingfor$1,168.97.Supposethatthefrstcalldateis13yearsfromnowandthatthecallpriceis$1,055.Thecashfowsforthisbondifitiscalledin13yearsconsistof 26couponpaymentsof$55everysixmonthsand $1,055duein26six-monthperiodsfromnow.Wefrstsolvefor r thatequatesthecurrentvalueofthebondwiththeexpectedcashfows,andthenmultiplythisrateby2:$1 , 168 . 97 = 26 t = 1 $55 (1 + r ) t + $1 , 055 (1 + r ) 26
ValuingBonds 529 Usingafnancialcalculatororaspreadsheet,theinputsare:PV = $1,168.97FV = $1,055PMT = $55N = 26Inthiscase,thatsix-monthrateis4.5%.Therefore,theyieldtofrstcallonabond-equivalentbasisis9%.Investorstypicallycomputeboththeyieldtocallandtheyieldtomaturityforacallablebondsellingatapremium.Theythenselectthelowerofthetwoastheyieldmeasure.Thelowestyieldbasedoneverypossiblecalldateandtheyieldtomaturityisreferredtoasthe yieldtoworst. TRYIT!YIELDTOWORST Estimatetheyieldtoworstforthefollowingcallablebonds BondCouponRateCurrentPriceNumberofYearstoMaturityNumberofYearstoFirstCallCallPriceatFirstCall 15%$1,100105$1,00026%$1,0002010$1,00035%$1,05052$1,01047%$1,100155$1,050 PotentialSourcesofaBond’sDollarReturn Aninvestorwhopurchasesabondcanexpecttoreceiveadollarreturnfromoneormoreofthesesources: 1. Theperiodiccouponinterestpaymentsmadebytheissuer. 2. Incomefromreinvestmentoftheperiodicinterestpayments(theinterest-on-interestcomponent). 3. Anycapitalgain(orcapitalloss—negativedollarreturn)whenthebondmatures,iscalled,orissold.
530 INVESTMENTS Anymeasureofabond’spotentialyieldshouldtakeintoconsiderationeachofthesethreepotentialsourcesofreturn.Thecurrentyieldconsidersonlythecouponinterestpayments.Noconsiderationisgiventoanycapitalgain(orloss)ortointerest-on-interest.Theyieldtomaturitytakesintoaccountcouponinterestandanycapitalgainorloss.Italsoconsiderstheinterest-on-interestcomponent;implicitintheyield-to-maturitycomputation,however,istheassumptionthatthecouponpaymentscanbereinvestedatthecomputedyieldtomaturity.Theyieldtomaturity,therefore,isapromisedyield;thatis,itwillberealizedonlyif(1)thebondisheldtomaturityand(2)thecouponinterestpaymentsarereinvestedattheyieldtomaturity.Ifeither(1)or(2)doesnotoccur,theactualyieldrealizedbyaninvestorcanbegreaterthanorlessthantheyieldtomaturitywhenthebondispurchased.Theyieldtocallalsotakesintoaccountallthreepotentialsourcesofreturn.Inthiscase,theassumptionisthatthecouponpaymentscanbereinvestedatthecomputedyieldtocall.Therefore,theyield-to-callmeasuresuffersfromthesamedrawbackinherentintheimplicitassumptionofthereinvestmentrateforthecouponinterestpayments.Also,itassumesthatthebondwillbehelduntiltheassumedcalldate,atwhichtimethebondwillbecalled. TheYieldtoMaturityandReinvestmentRisk Theyield-to-maturitymeasureassumesthatthereinvestmentrateistheyieldtomaturity.Forexample,let’sconsiderBondG,whichhasfveyearsremainingtomaturityandan8%coupon.Andlet’sfurtherassumethatBondGhasamaturityvalueof$1,000andacurrentmarketpriceof$923.Theyieldtomaturityforthisbondis10%.Let’slookatthepotentialtotaldollarreturnfromholdingthisbondtomaturity,whichwedetailinExhibit20.8.Asmentionedearlier,thedollarreturncomesfromthreesources.Inourexample:Cashfowsfrominterest$400Capitalgain77Interestoninterest,fromreinvestingtheinteresteverysixmonthsat10%103 Dollarreturn$580Thepotentialdollarreturnifthecouponscanbereinvestedattheyieldtomaturityof10%isthen$580.Inotherwords,theinvestorinvests$923
ValuingBonds 531 EXHIBIT20.8 TheDollarReturnonBondG(5-Year,8%Coupon,Sellingat$923) Assumingallcashfowsarereinvestedat10%peryear(or5%everysixmonths) Six-MonthPeriodCashFlowFutureValueofCashFlow 1$40$62.052$40$59.103$40$56.284$40$53.605$40$51.056$40$48.627$40$46.318$40$44.109$40$42.0010$1,040$1,040.00 $1,400$1,503.00Presentvalueofbond$923Yield10% andthenhassomethingworth$1,503attheendoffveyears.Thereturnonthisinvestment,usingtheinputs: PV = $923 FV = $1,503 N = 5is10%peryear.Soaninvestorwhoinvests$923forfveyearsat10%peryear(5%semiannually)expectstoreceiveattheendoffveyearstheinitialinvestmentplus$580.Thisispreciselywhatwefoundbybreakingdownthedollarreturnonthebond,assumingareinvestmentrateequaltotheyieldtomaturityof10%.Theinvestorwillrealizetheyieldtomaturityatthetimeofpurchaseonlyifthebondisheldtomaturityandthecouponpaymentscanberein-vestedattheyieldtomaturity.Theriskthattheinvestorfacesisthatfuturereinvestmentrateswillbelessthantheyieldtomaturityatthetimethebondispurchased.Thisriskiscalled reinvestmentrisk. Twocharacteristicsofabonddeterminetheimportanceoftheinterest-on-interestcomponentand,therefore,thedegreeofreinvestmentrisk:thelengthoftimetomaturityandthecouponrate.
532 INVESTMENTS Foragivenyieldtomaturityandagivencouponrate,thelongerthematurity,themoredependentthebond’stotaldollarreturnisontheinterest-on-interestcomponentinordertorealizetheyieldtomaturityatthetimeofpurchase.Inotherwords,thelongerthematurity,thegreatertherein-vestmentrisk.Theimplicationisthattheyield-to-maturitymeasureforlong-termcouponbondstellslittleaboutthepotentialyieldthataninvestormayrealizeifthebondisheldtomaturity.Forlong-termbonds,theinterest-on-interestcomponentmaybeashighas80%ofthebond’spotentialtotaldollarreturn.Turningtothecouponrate,foragivenmaturityandagivenyieldtomaturity,thehigherthecouponrate,themoredependentthebond’stotaldollarreturnwillbeonthereinvestmentofthecouponpaymentsinordertoproducetheyieldtomaturityanticipatedatthetimeofpurchase.Thismeansthatwhenmaturityandyieldtomaturityareheldconstant,premiumbondsaremoredependentontheinterest-on-interestcomponentthanarebondssellingatpar.Discountbondsarelessdependentontheinterest-on-interestcomponentthanarebondssellingatpar.Forzero-couponbonds,noneofthebond’stotaldollarreturnisdependentontheinterest-on-interestcomponent.Soazero-couponbondhasnoreinvestmentriskifheldtomaturity.Thus,theyieldearnedonazero-couponbondheldtomaturityisequaltothepromisedyieldtomaturity. VALUINGBONDSTHATHAVEEMBEDDEDOPTIONS Ourapproachtovaluationsofarhasfocusedonoption-freebonds.Thatis,we’vebeendealingwithbondswhosebondagreementprovisionsdonotgranttheissuerorthebondholdertheoptiontoalterthematuritydateorexchangethebondforanothertypeoffnancialinstrument.Hence,assum-ingtheissuerdoesnotdefault,itisratherstraightforwardtoestimatethecashfows.Bondvaluationbecomesmorediffcultwheneithertheissuerorbond-holderhasanoptiontoeitheralterthematurityofthebondortoconvertthebondintoanothersecurity.Werefertobondsthathaveoneormoresuchoptionsasbondswith embeddedoptions .Thesebondsincludecallablebonds,putablebonds,andconvertiblebonds. A callablebond isabondissuethatgrantstheissuertherighttoretire(thatis,call)thebondissuepriortothestatedmaturitydate. A putablebond isabondissuethatgrantsthebondholdertherighttohavetheissuerretirethebondissuepriortothestatedmaturitydate.
ValuingBonds 533 Inthecaseofa convertiblebond ,thebondholderhastherighttoconvertthebondissueintotheissuer’scommonstock.Moreover,allconvertiblebondsarecallableandsomeareputable.Therearesectorsofthebondmarketthathaveevenmorecomplexstructuresthatmakevaluationharderbecauseitisdiffculttoestimatethebond’sfuturecashfows.Forexample,amajorsectorofthebondmar-ketisthemarketforsecuritiesbackedbyresidentialmortgageloans,called mortgage-backedsecurities .Thecashfowsforthesesecuritiesaremonthlyandincludetheinterestpayment,thescheduledprincipalrepayment,andanyamountinexcessofthescheduledprincipalrepayment.Itisthislastcomponentofamortgage-backedsecurity’scashfows—thepaymentinex-cessoftheregularlyscheduledprincipalpayment—thatmakesitdiffculttoprojectcashfows.Thiscomponentofthecashfowiscalleda prepayment .Therightofhomeownerswhosemortgageloanisincludedinthepoolofloansbackingthemortgage-backedsecuritytoprepaytheirloanatanytimeinwholeorinpartisanoption.Thatoptioniseffectivelyequivalenttotheoptioninacallablebondbecausetheborrowerwillfnditattractivetomakeprepaymentswhenmortgageratesinthemarketdeclinebelowtheborrower’sloanrate.Inaddition,therearesecuritiesthatarebackedbyloansthatarenotresidentialmortgageloans.Thesesecuritiesarereferredtoas asset-backedsecurities .Thestructureofthesesecuritiesiscomplexduetopotentialde-faults,uncertainrecoveryrates,andpotentialprepayments,whichcauseuncertaintyintheamountandtimingofthecashfows.Wewon’tgointothevaluationofthesesecuritieshere,but,needlesstosay,thesevaluationsarecomplex.Akeyfactordeterminingwhetherthebondissuerinthecaseofacallablebondorthebondholderinthecaseofaputablebondwouldexerciseanoptiontoalterthematuritydateistheprevailinglevelofinterestratesrelativetothebond’scouponrate.Specifcally,foracallablebond,iftheprevailingmarketratethattheissuercanrealizebyretiringtheoutstandingbondissueandissuinganewbondissueissuffcientlybelowtheoutstandingbondissue’scouponratesoastojustifythecostsassociatedwithrefundingtheissue,theissuerislikelytocalltheissue.Foraputablebond,iftheinterestrateoncomparablebondsinthemarketrisessuchthatthevalueoftheputablebondfallsbelowthevalueatwhichitmustberepurchasedbytheissuer(i.e.,theputprice),thentheinvestorwillputtheissue.Whatthismeansisthattoproperlyestimatethecashfowsofabondwithanembeddedoption,weneedtoincorporateintotheanalysishowinterestratescanchangeinthefutureandhowsuchchangesaffectthecashfows.Thisisdoneinmorecomplicatedbondvaluationmodels.Practitioners
534 INVESTMENTS commonlyusetwomodelsinsuchcases:thelatticemodelandtheMonteCarlosimulationmodel.Thelatticemodelisusedtovaluecallablebondsandputablebonds. 3 TheMonteCarlosimulationmodelisusedtovaluemortgage-backedsecuritiesandcertaintypesofasset-backedsecurities.ThelatticemodelandtheMonteCarlosimulationmodelarebeyondthescopeofthisbook.Whatisimportanttounderstandisthatthesevalua-tionmodelsusetheprinciplesofvaluationdescribedearlierinthischapter.Basically,thesemodelslookatpossiblepathsthatinterestratescantakeinthefutureandwhatthebond’svaluewouldbeonagiveninterestratepath.Abond’svalueisthenanaverageofthesepossibleinterestratepathvalues. ValuingConvertibleBonds Aconvertiblebondisabondthatcanbeconvertedintocommonstockattheoptionofthebondholder.Theconversionprovisionofaconvertiblebondgrantsthebondholdertherighttoconvertthebondintoapredeterminednumberofsharesofcommonstockoftheissuer.Aconvertiblebondis,therefore,abondwithanembeddedcalloptiontobuythecommonstockoftheissuer.Inillustratingthecalculationofthevariousconceptsdescribednext,wewilluseaconvertiblebondissueofCompanyH,whichhasacouponof5%andmaturesin30years.Forthisconvertiblebondissue,themarketpriceofthebondis80,or$800foreach$1,000parvalue.Therefore,theyieldtomaturityonforthisbondis6.528%.The conversionratio isthenumberofsharesofcommonstockthatthebondholderwillreceivefromexercisingthecalloptionofaconvertiblebond.Theconversionprivilegemayextendforalloronlysomeportionofthebond’slife,andthestatedconversionratiomayfallovertime.FortheCompanyHconvertibleissue,supposetheconversionratiois150shares.Thismeansthatforeach$1,000ofparvalueofthisissuethebondholderexchangesforCompanyHcommonstock,150shareswillbereceived.Atthetimeofissuanceofaconvertiblebond,theissuereffectivelygrantsthebondholdertherighttopurchasethecommonstockatapriceequalto: P = Parvalueoftheconvertiblebond Conversionratio 3 ThelatticemodelforvaluingbondswithembeddedoptionswasdevelopedinAndrewJ.Kalotay,GeorgeO.Williams,andFrankJ.Fabozzi,“AModelfortheValuationofBondsandEmbeddedOptions,” FinancialAnalystsJournal 49(1993):35–46.
ValuingBonds 535 Intheprospectus,thispriceisreferredtoasthe statedconversionprice .ThestatedconversionpricefortheconvertibleissueofCompanyHper$1,000parvalueis:Statedconversionprice = $1 , 000 150shares = $6 . 67pershareTherearetwoapproachestovaluationofconvertiblebonds:thetradi-tionalapproachandtheoption-basedapproach.Thelatterapproachusestheoptionpricingmodelstovalueaconvertiblebondandwillnotbedis-cussedinthischapter.Thetraditionalapproachmakesnoattempttovaluetheoptionthatthebondholderhasbeengranted. TraditionalValueofConvertibleBonds The conversionvalue ,or parityvalue ,ofaconvertiblebondisitsvalueifitisconvertedimmediately.Thatis,Conversionvalue = Marketpriceofcommonstock × ConversionratioTheminimumpriceofaconvertiblebondisthegreaterofits: Conversionvalue,or Valueasabondwithouttheconversionoption—thatis,basedontheconvertiblebond’scashfowsifnotconverted.Thissecondvalueisthebond’s straightvalue or investmentvalue .Toestimatethestraightvalue,wemustdeterminetherequiredyieldonanon-convertiblebondwiththesamecreditratingandsimilarinvestmentchar-acteristics.Giventhisestimatedrequiredyield,thestraightvalueisthenthepresentvalueofthebond’scashfowsusingthisyieldtodiscountthecashfows.Iftheconvertiblebonddoesnotsellforthegreaterofthesetwovalues,arbitrageproftscouldberealized.Forexample,supposetheconversionvalueisgreaterthanthestraightvalue,andthebondtradesatitsstraightvalue.Aninvestorcanbuytheconvertiblebondatthestraightvalueandconvertit.Bydoingso,theinvestorrealizesagainequaltothedifferencebetweentheconversionvalueandthestraightvalue.Suppose,instead,thestraightvalueisgreaterthantheconversionvalue,andthebondtradesatitsconversionvalue.Bybuyingtheconvertiblebondattheconversionvalue,theinvestorwillrealizeahigheryieldthanacomparablestraightbond.
536 INVESTMENTS SupposeCompanyH’sstockpricewas$5.Fortheconvertibleissue,theconversionvalueper$1,000ofparvalueistherefore:Conversionvalue = $5 × 150 = $750Thestraightvalue,usingadiscountrateof6.53%fortheoreticalpur-posesonly,is$800.BecausetheminimumvalueoftheBondHconvertibleissueisthegreateroftheconversionvalueandthestraightvalue,themin-imumvalue,orfoor,is$800.WeshowthisvaluationgraphicallyinEx-hibit20.9.Thevalueofthebondasastraightbondis$800forallvaluesofCompanyH’sstock.Theconversionvalueofthebondfollowsthestraightlineupward,increasingasthepriceofthestockincreases.Thepriceaninvestoreffectivelypaysforthecommonstockiftheconvertiblebondispurchasedinthemarketandthenconvertedintothecommonstockisthe marketconversionprice (alsocalledthe conversionparityprice ):Marketconversionprice = Marketpriceoftheconvertiblebond Conversionratio $0$200$400$600$800$1,000$1,200$1,400$1,600$4$5$6$7$8$9$10 Value of the Bond Market Value Per Share of Stock Conversion value of Bond HStraight value of Bond H Value of Bond H EXHIBIT20.9 ValueoftheConvertibleBondofCompanyHforDifferentMarketPricesofCompanyHStock
ValuingBonds 537 Inotherwords,ifaninvestorboughtBondHfor$800,heorshecouldexchangeitfor150sharesworth$5 × 150 = $750.Buttheinvestorisnotlikelytoconvertthebondatthisstockpriceandwouldthereforeholdontothebondthatisworth$800.ThemarketconversionpriceforBondH,assumingthemarketpriceisitsstraightbondat$800,is$800 ÷ 150 = $5.333.Thevalueoftheconvertiblebond,whichisthegreateroftheconversionvalueorthestraightvalue,followsthethickerlinethatbeginsat$800andthenincreasesoncethepriceofthestockisbeyondthemarketconversionpriceof$5.333,asweshowinExhibit20.9.Themarketconversionpriceisausefulbenchmarkbecause,oncetheactualmarketpriceofthestockrisesabovethemarketconversionprice,anyfurtherstockpriceincreaseiscertaintoincreasethevalueoftheconvertiblebondbyatleastthesamepercentage.Therefore,themarketconversionpricecanbeviewedasabreak-evenpoint.Aninvestorwhopurchasesaconvertiblebondratherthantheunderly-ingstockpaysapremiumoverthecurrentmarketpriceofthestock.Thispremiumpershare,whichwerefertoasthe marketconversionpremiumpershare ,isthedifferencebetweenthemarketconversionpriceandthecurrentmarketpriceofthecommonstock.Thatis,Marketconversionpremiumpershare = Marketconversionprice − CurrentmarketpriceWeusuallyexpressthemarketconversionpremiumpershareasaper-centageofthecurrentmarketprice:Marketconversionpremiumratio = Marketconversionpremiumpershare Marketpriceofcommonstock EXAMPLE20.4:CONVERTIBLEMEASURESFORTHECONVERTIBLEBONDOFCOMPANYH Marketconversionprice = $800 150shares = $5 . 333pershareMarketconversionpremiumpershare = $5 . 333 − $5 = $0 . 333Marketconversionpremiumratio = $0 . 333 $5 = 6 . 66%
538 INVESTMENTS Whywouldsomeonebewillingtopayapremiumtobuythestock?Recallthattheminimumpriceofaconvertiblebondisthegreaterofitscon-versionvalueoritsstraightvalue.Thus,asthecommonstockpricedeclines,thepriceoftheconvertiblebondwillnotfallbelowitsstraightvalue.Thestraightvaluethereforeactsasafoorfortheconvertiblebond’sprice.Viewedinthiscontext,themarketconversionpremiumpersharecanbeseenasthepriceofacalloption.Thebuyerofacalloption—inthiscase,theinvestorintheconvertiblebond—limitsthedownsiderisktotheoptionprice.Thedifferencebetweenthebuyerofacalloptionandthebuyerofaconvertiblebondisthattheformerknowspreciselythedollaramountofthedownsiderisk,whilethelatterknowsonlythatthemostthatcanbelostisthedifferencebetweentheconvertiblebond’spriceandthestraightvalue.Thestraightvalueatsomefuturedate,however,isunknown;thevaluewillchangeasinterestratesintheeconomychange.Theinvestmentcharacteristicsofaconvertiblebonddependonthecom-monstockprice.Ifthepriceislow,sothatthestraightvalueisconsiderablyhigherthantheconversionvalue,thebondwilltrademuchlikeastraightbond.Theconvertiblebondinsuchinstancesisreferredtoasa fxedincomeequivalent ora bustedconvertible .Whenthepriceofthestockissuchthattheconversionvalueisconsid-erablyhigherthanthestraightvalue,thentheconvertiblebondwilltradeasifitwereanequityinstrument;inthiscase,itissaidtobea commonstockequivalent .Insuchcases,themarketconversionpremiumpersharewillbesmall.Betweenthesetwocases,fxedincomeequivalentandcommonstockequivalent,theconvertiblebondtradesasa hybridsecurity ,havingthecharacteristicsofbothabondandcommonstock. THEBOTTOMLINE Thevalueofabondisthepresentvalueofitsexpectedcouponpaymentsandthebond’smaturityvalue,discountedatthebond’srequiredyield. Afundamentalpropertyofabondisthatitspricechangesintheoppositedirectionfromthechangeintherequiredyield.Thevalueofabondalsochangeswithtime,approachingitsmaturityvalueasthebondmatures. Whetherabondtradesatadiscountorapremiumtoitsmaturity(par)valuedependsontherelationshipbetweenthecouponrateofthebondandtheyieldthatthemarketrequiresonthebond.Whentherequiredyieldinthemarketisbelowthecouponrate,thebondtradesaboveitsparvalue.Whentherequiredyieldinthemarketisabovethecouponrate,thebondtradesbelowitsparvalue.Abondtradesatitsparvaluewhenthecouponrateisequaltotheyieldrequiredbythemarket.
ValuingBonds 539 Thethreebondyieldmeasurescommonlyquotedinthemarketarethecurrentyield,yieldtomaturity,andyieldtocall. Thedollarreturnfrominvestinginabondcomesfromoneormoreofthefollowingthreesources:(1)periodiccouponinterestpayments,(2)reinvestmentincome,and(3)anycapitalgain(orcapitalloss—negativedollarreturn)whenthebondmatures,iscalled,orissold. Alimitationoftheyield-to-maturitymeasureisthatitassumesthatreinvestmentincome(interestoninterest)willbegeneratedbyreinvest-ingtheperiodiccouponincomeatayieldequaltothecomputedyieldtomaturity.Reinvestmentriskistheriskthatcouponincomewillbereinvestedatalowerratethanthecomputedyieldtomaturity. Thevaluationofabondthathasanembeddedoption,suchasacallable,putable,orconvertiblebond,ismorecomplexthananoption-freebondbecausetheoptionaffectsthebond’svalue. Thevalueofaconvertiblebondisthegreaterofitsstraightvalueoritsconversionvalue. SOLUTIONSTOTRYIT!PROBLEMS BondValuesBondValue A$925.61B$893.22C$1,081.76D$1,137.94 YieldsBondYieldtoMaturityCurrentYield E5.00%5.00%F7.44%6.67%G3.30%4.17%H11.78%11.33% YieldtoWorstBondYieldtoMaturityYieldtoCallYieldtoWorst 13.8%2.8%2.8%26.0%6.0%6.0%33.9%2.9%2.9%46.0%5.6%5.6%
540 INVESTMENTS QUESTIONS 1. Listthefourinputsneededtovalueabond. 2. Whenvaluingazero-couponbond,whyaresemiannualperiodsusedindiscounting? 3. Describetherelationshipbetweenthepriceofabondandtheyieldtomaturityofthebond. 4. Supposeabondhasacouponrateof6%andayieldtomaturityof8%.Willthisbondbepricedasadiscountbondorapremiumbond?Explain. 5. Whymayabond’spricechangesimplybecauseofthepassageoftime? 6. Whatisthedifferencebetweenabond’scurrentyieldanditsyieldtomaturity? 7. Whatistheyieldtoworst? 8. Concerningreinvestmentofinterestonabond, a. Whatassumptionismadeaboutreinvestmentofcashfowswhenusingtheyieldtomaturity? b. Whatcharacteristicsofabondaffectitsreinvestmentrisk? 9. Ifabondisputable,whattypeofoptiondoestheinvestorinthisbondhave? 10. Supposeabondhasamarketpriceof$90andhasfveyearsremainingtomaturity.Ifthebondispricedtoyield5%,isitscouponrategreaterthan,lessthan,orequalto5%?Explainyourreasoning. 11. Completethefollowingtable,providingthedollarpriceofthefollowingbonds: MarketPriceParValueDollarPrice $94.0$1,000 $102.00$100,000 $75.50$10,000 $86.40$1,000,000 12. Considerabondwithcouponrateof7%andaparvalueof$1,000.Thematurityforthisbondisgreaterthanoneyear.Alsoassumethattherequiredyieldbythemarketforthisbondis8%.Forthefollowingthreebondprices,explainwhythebondmayormaynottradeattherespectiveprice. a. $1,200 b. $1,000 c. $900
ValuingBonds 541 13. Supposethattwoyearsagoa10-yearbondinyourportfoliowassell-ingfor$1,100.Today,thesamebondissellingfor$1,050.Youhaveresearchedthepriceof10-yearbondsofthesamecreditratingoverthepasttwoyearsandfoundthatinterestrateshavedeclined.Explainwhythebond’spricedeclineddespitethefactthat10-yearinterestrateshavedeclined. 14. Whichofthefollowingtwobondshasgreaterreinvestmentrisk:a10-year8%couponbondora25-yearzero-couponbond?Why? 15. Whyisitdiffculttovalueacallablebond? 16. Ifaconvertiblebondhasavalueasastraightbondof$1,100andaconversionvalueof$1,050,atwhatpricewillthisbondtrade?Why?
Glossary AAratedyieldcurve See Swaprateyieldcurve. Abnormalreturn Areturnonanassetinexcessofthatexpectedfortheasset’srisk. Absolutereturn Realizedreturnonaninvestment. Accelerateddepreciation Depreciationinwhichmoredepreciationisdeductedearlyintheasset’slife,relativetostraight-linedepreciation. Accountingidentity Therelationshipamongaccountssuchthatassetsareequaltothesumofliabilitiesandequity. Accountspayable Amountsduetosuppliesforpurchasesoncredit. Accountsreceivable Amountsowedbycustomers. Accountsreceivableturnover Thenumberoftimes,onaverage,thatacreditaccountiscreatedforacustomerandthisaccountisthenpaid. Accumulatedcomprehensiveincomeorloss Thetotalamountofincomeorlossthatarisesfromtransactionsthatresultinincomeorlosses,yetarenotreportedthroughtheincomestatement. Acid-testratio See Quickratio. Activeportfoliostrategy Aprocessofmanagingaportfoliothatinvolvesalter-ingtheportfoliototakeadvantageofmarketconditionsandmispricings. Activestrategy Aninvestmentstrategythatseeksto“beatthemarket”throughactivelytradingsecurities. Activityratios Ratiosthatprovideinformationontheeffectivenessofputtingacompany’sassetstouse. Actualreserve AverageamountofreservesheldbyabankatthecloseofbusinessattheFederalReserve. Additionalpaid-incapital Theamountpaidbyshareholdersforstockatis-suanceinexcessofparvalue. Agencycosts Coststhatarisefromconfictsofinterestbetweentheagentandtheprincipalsinanagencyrelationship. Agent Thepartywhoactsintheinterestoftheprincipalinanagencyrelation-ship. Alternativerisktransfer Acombinationofaninsurancecontractandacapitalmarketinstrumentsusedtotransferrisktoanotherparty. Americanoption Anoptionthatcanbeexercisedanytimeonorbeforetheexpirationdate. 543
544 GLOSSARY Annualpercentagereturn Thereturnforayear,determinedastheproductoftheinterestratepercompoundingperiodandthenumberofcompoundingperiodsinayear. Annuitydue Anevenseriesofcashfowsoccurringatevenintervalsoftime,withcashfowsoccurringatthebeginningofeachperiod. APR See AnnualPercentageRate. Arithmeticrateofreturn Thearithmeticaverageofsubperiodratesofreturn. ART See Alternativerisktransfer. Articlesofincorporation Alegaldocumentthatspecifesthenameofthecor-poration,itsplaceofbusiness,andthenatureofitsbusiness. Assetallocation Themixofinvestmentsfromdifferentassetclassesinaport-folio. Assetmanagement See Investmentmanagement. Assetmanagementcompanies See Investmentcompany. Assetmanager See Portfoliomanager. Assetpricingmodel Atheoreticalmodelofhowinvestorspriceassetsinthemarket. Assetretirementliability Contractualorstatutoryobligationtoretireorde-commissionanasset. Assetturnover See Totalassetturnover. Asset-backedsecurities Debtobligationsthatarebackedbyassetsotherthanresidentialmortgages. Assets Resourcesofabusinessenterprise,whichmayconsistofcash,inven-tory,property,andequipment. Asymmetricinformation Unevenpossessionoraccesstoinformationnecessarytovalueassets. Atlanticoption See Bermudaoption. At-the-moneyoption Thesituationinwhichacalloption’sexercisepriceisequaltotheunderlying’svalueoraputoption’sexercisepriceisequaltotheunderlying’svalue. Averagecreditsalesperday Thecreditsalesforaperiod,dividedbythenumberofdaysintheperiod. Averageday’scostofgoodssold Thecostofgoodssoldoveraperiod,dividedbythenumberofdaysintheperiod. Averagepurchasesperday Thepurchasesoveraperiod,dividedbythenumberofdaysintheperiod. Balancesheet Areportofassets,liabilities,andequityofacompanyatapointintime. Balancedscorecard Asetofmeasuresofperformancethataddressdifferentaspectsofacompany’sstrategicplan. Bankers’acceptance Short-termloanthatisbackedbyabank’spromisetopay.Generallyusedinimportandexporttransactions. Bankruptcy Alegalprocessofsettlingtheclaimsofcreditorsandownersforacompanyinfnancialdistress.
Glossary 545 Bankruptcycosts ThedirectandindirectcostsassociatedwithacompanyinChapter11bankruptcy. Baseinterestrate Theinterestrateforaninvestmentwithoutanydefaultrisk,whichisthesumoftherealinterestrateandtheexpectedrateofinfation. Basicearningspershare Netearningstocommonshareholdersoverafscalperiod,dividedbytheweightedaveragesharesoutstandingduringthefscalperiod. Bermudaoption Anoptionthatcanbeexercisedbeforetheexpirationdate,butonlyonspecifeddates. Best-effortsunderwriting Anunderwritingarrangementwherebytheinvest-mentbankdoesnotbuytheissuefromtheissuer,butrathersellsthesecuritytothepublic,earningaproftonthosesharesitsells. Beta Ameasureofthesensitivityofthereturnsonanassettochangesinthereturnsinthemarket. Biasedexpectationstheory Thetheorythatpurportsthatforwardratesrepre-sentbothexpectedfuturerates,aswellasotherfactors. Black-Scholesoptionpricingmodel AnoptionpricingmodelofaEuropeanoption,thatvaluesanoptionbasedonthepriceoftheunderlying,theexerciseprice,theriskfreerateofinterest,thetimeremainingtoexpiration,andthevolatilityoftheunderlyingasset’svalue. Bond Indebtednessthathasanindentureagreement.Ingeneraluse,adebtwithanoriginalmaturitygreaterthan10years. Bond Indebtednessintheformofasecurity. Bondingcosts Costsincurredbytheagentinanagencyrelationshiptoinsurethattheagentactsintheprincipal’sbestinterest. Bonus Acashrewardbasedonsomeperformancemeasure. Bookvalue Thevalueofanassetatapointintimeaccordingtofnancialreportingstandards. Budget Acompany’sinvestmentandfnancingplans,expressedinmonetaryterms. Budgeting Themappingoutofthesourcesandusesoffundsforfutureperiods. Businessfnance See Financialmanagement. Businessrisk Theuncertaintyassociatedwiththesalesandoperatingproftofabusiness,determinedinlargepartbythebusinessenterprise’slineofbusiness. Businessrisk Theriskassociatedwiththeuncertaintyofoperatingearnings;thecombinationofsalesandoperatingrisk. Bustedconvertible See Fixedincomeequivalent. Bylaws Rulesofgovernanceofacorporation. Callprovision Aprovisionofasecuritythatallowstheissuerofthesecuritytobuythesecurityfrominvestorsataspecifedprice,thecallprice. Callschedule Ascheduleofcallpricescorrespondingtodifferentdatesonwhichacallablesecuritycanbeboughtbackbytheissuer.
546 GLOSSARY Callablebond Adebtobligationthatmaybeboughtbackbytheissuerataspecifedprice. Capital Long-termsourcesoffnancing,whichincludeinterest-bearingdebtandequity. Capitalassetpricingmodel Anassetpricingmodelthatallowsforonlyoneriskfactor(marketrisk)toaffectthepricesofassets. Capitalbudgeting Thedecisionprocessofallocatingacompany’sfundstolong-terminvestments. Capitalbudgeting Theprocessofidentifyingandselectinginvestmentsinlong-livedassets;thatis,selectingassetsexpectedtoproducebeneftsovermorethanoneyear. Capitallease Rentalobligationsthatarelong-term,fxedobligations. Capitalmarket Themarketforlong-termfnancialinstruments. Capitalmarketline Thelinedepictingtherelationbetweenthereturnonaportfolioandrisk,whereriskismeasuredintermsofthevarianceofthereturnsoftheportfolio. Capitalstructure Acompany’smixtureofdebtandequitythatisusedtosupporttheoperatingandinvestingactivitiesofacompany. Capitalstructure Themixofdebtandequityusedtofnanceacompany. Capitalyield Thereturnonashareofstockfromthechangeinthevalueoftheshareofstock. CAPM See Capitalassetpricingmodel. Carryingvalue See Bookvalue. Cash-and-carrytrade Afuturespositioninwhichtheinvestorsellfuturesandborrowstobuytheunderlyingasset,andthendeliversthisassetandpaysofftheloanattheendofthecontract. Cashconversioncycle Thelengthoftimeabusinessenterprisetiesupcash,onaverage,innetworkingcapital. Cashfow Thefowoffundsofacompanywithinaperiodoftime. Cashfowfromfnancingactivities Thecashfowassociatedwithborrowing,debtrepayment,issuanceofstock,thepaymentofdividends,andrepur-chasingstock. Cashfowfrominvestingactivities Thecashfowassociatedwithcapitalex-penditures,assetretirement,orotherchangesinlong-terminvestments. Cashfowfromoperatingactivities Thesumofnetincome,noncashexpenses,lessanydecreaseinworkingcapitalaccounts. Cashfowfromoperations See Cashfowfromoperatingactivities. Cashfowinterestcoverageratio Thenumberoftimesthataperiod’sinterestexpensescouldbepaidbythecompany’scashfowbeforeinterestandtaxesforthatperiod;ameasureofacompanytosatisfyitsdebtobligations. Cashfowtocapitalexpenditurescoverageratio Theratioofcashfowofacompanyoveraperiodtothecompany’scapitalexpendituresfortheperiod. Cashfowtodebtratio Theratioofcashfowtothesumofacompany’sdebtobligations.
Glossary 547 Cashmarket Theexchangeofanassetforcash. Cashsettlementcontracts Futurescontractsthataresettledincash,insteadoftakinganoffsettingposition. Catbond See Insurance-linkednote. Catastrophe-linkedbond See Insurance-linkednote. Catastrophicriskmanagement Theplanningintendedtominimizetheimpactofpotentialcatastrophicevents. CD See Certifcateofdeposit. CDS See Creditdefaultswap. Certifcateofdeposit Apromissorynoteofabanktopayadepositor. Characteristicline Theempiricalmodelsuchthattheexcessreturnsonastockarealinearfunctionoftheexcessreturnonthemarketportfolio. Classicalsafety-frstrules Decisionrulesthatfocusontheminimizationoftheprobabilityofloss. Closecorporation See Closelyheldcorporation. Closed-endfund Aregulatedinvestmentcompanyinvestsinaportfolioofinvestments,butwhichdoesnotissueadditionalsharesorredeemshares. Closelyheldcorporation Acorporationthathasafewownerswhoexertcompletecontroloverthedecisionsofthecorporation. CML See Capitalmarketline. Cognitivebiases Systematicbiasindecisionmaking. Commercialbank Depositoryinstitution,whichacceptsdepositsfromsaversandlendsorinveststhesedeposits. Commercialpaper Apromissorynoteissuedbyalarge,creditworthycompanyormunicipality. Commodityswap Anagreementinwhichtwopartiesagreetoexchangepay-mentsbasedonthevalueofaspecifedcommodity. Commonstock Thesecuritythatrepresentstheresidualownershipinacor-poration. Common-sizeanalysis Ananalysisofthefnancialaccountsofacompanythatrequirescomparinganaccounttoabenchmark. Comparativeadvantage Theadvantageacompanyhasoverothercompaniesintermsofthecostofproducingordistributinggoodsandservices. Competitiveadvantage Theadvantageacompanyhasoverothercompaniesasaresultofthemarket’sstructure. Complementaryprojects Projectsinwhichtheinvestmentinoneenhancesthecashfowsofoneormoreotherprojects. Compoundinterest Anarrangementinwhichinterestispaidonboththeprincipalamountandtheaccumulatedinterest. Compounding Theprocessofinterestbeingpaidonboththeprincipalandtheinterestalreadyearnedonthisprincipal. Conditionalvalueatrisk Asafety-frstrulethatfocusesonexpectedvalueofaportfolio’sreturns,giventhatthevalueatriskhasbeenexceeded.
548 GLOSSARY Contingentprojects Projectsthataredependentontheacceptanceofanotherproject. Continuouscompounding Interestthatiscompoundedinstantaneously. Contractingcosts Thecostsassociatedwithcreatingandenforcingcontractualagreements,suchasaloan. Conversionparityprice See Marketconversionprice. Conversionprovision Aprovisionofasecuritythatallowstheinvestortoexchangethesecurityforanothersecurity. Conversionratio Thenumberofsharesofcommonstockthattheinvestorinaconvertiblesecurityreceivesiftheinvestorchoosestoconvertthesecurityintostock. Conversionvalue Thevalueofthestockthataninvestorinaconvertiblere-ceivesinexchangefortheconvertiblesecurity;theproductoftheconversionratioandthemarketpriceofthestock. Convertiblebond Anindebtednessthatmaybeconvertedintoownershipunitsoftheissuerattheoptionoftheinvestorataspecifedrate. Convertiblebond Adebtobligationthatpermitstheinvestortoexchangethebondforanothersecurity,suchasthecommonstockofthebondissuer. Convertiblenote See Convertiblebond. Corerisk Risksthatabusinessenterpriseisinthebusinesstobear. Corporatefnance See Financialmanagement. Corporation Anentitygranteditsexistencebyastate,operatedtothebeneftoftheowners(theshareholders),whohavelimitedliability. Correlation Astandardizedmeasureofhowtheoutcomesoftwoassetsco-vary,whichrangesfrom–1to + 1;theresultofthecovarianceoftwoassets’possibleoutcomesdividedbytheproductofthetwoassets’standarddeviations. Costofcapital Thereturnthatprovidersofcapital(creditorsandowners)expectfortheuseoftheirfunds;themarginalcostofraisinganadditionaldollarofcapital. Counterparty Theotherpartytoanexchange. Counterparty Thepartyontheoppositesideofthetransaction. Counterpartyrisk Theuncertaintyregardingtheabilityofthecounterpartytoperforminatransaction. Covarianceofarandomvariable Ameasureofhowtwoassets’returnsvarytogetherforagivenprobabilitydistribution. Creditdefaultswap Anagreementforcreditprotectionagainstspecifedeventsthataffectthecreditqualityofabond. Creditprotectionbuyer Thepartytoacreditdefaultswapthatpaysforpro-tectionfromspecifceventsthataffectthecreditqualityofasecurity. Creditprotectionseller Thepartytoacreditdefaultswapthatagreestoinsureagainsttheimpairmentofthecreditqualityofasecurity.
Glossary 549 Creditspread TheriskpremiumbetweentheyieldsonTreasurysecuritiesandnon–Treasurysecurities. Creditor Thelenderoffunds. Crossoverrate Thediscountrateatwhichthenetpresentvaluesoftwoprojectsareequal. Currencyswap Anagreementinwhichtwopartiesagreetoswapcashfowsindifferentcurrencies. Currentassets Assetsthatcanreasonablybeconvertedintocashwithinoneoperatingcycleoroneyear,whicheverislonger. Currentliability Anobligationthatisduewithinoneyearoroneoperatingcycle,whicheverislonger. Currentratio Aliquidityratiothatmeasuresthecompany’sabilitytomeetsitscurrentobligations,calculatedasistheratioofcurrentassetsdividedbycurrentliabilities. Currentyield Theratiooftheannualcoupononabondtoitsmarketvalue. CVaR See Conditionalvalueatrisk. Dateofrecord Thedatethatdetermineswhichinvestorsreceiveaparticulardistribution. Dayspurchasesoutstanding Onaverage,thenumberofdaysofpurchasesoutstandingattheendoftheperiod. Dayssalesininventory Thenumberdaysofinventoryonhandatapointintime,consideringtheaveragedays’sales. Dayssalesoutstanding Thenumberofdaysofcreditsalesthatarerepresentedbytheaccountbalanceinaccountsreceivable. DDM See Dividenddiscountmodels Debt Apromisetorepaytheamountborrowed,plusinterest,ataspecifedpointoftimeinthefuture. Debtinstrument See Debt. Debtratio Theratioofdebttoequity. Debt-equityratio See Debt-to-equityratio. Debt-to-assetsratio Theproportionoftheassetsofacompanythataref-nancedbydebtobligations;theratioofdebttototalassets. Debt-to-capitalratio Theratioofinterest-bearingdebttototalcapital. Debt-to-equityratio Theratioofdebttoequityofacompany. Declarationdate Thedatetheboardofdirectorsdeclaresadistribution. Decliningbalancemethod Depreciationmethodinwhichaconstantrateisappliedagainstadecliningcarryingvalueofanasset. Defaultrisk Theriskthattheissuerofasecuritywillbeunabletomaketimelypaymentofinterestorprincipalwhendue. Deferredannuity Anevenseriesofcashfowsoccurringatevenintervalsoftime,withthefrstcashfowoccurringbeyondoneperiodfromtoday. Deferredtaxliability Anaccountthatrepresentstheexpectedtaxobligation.
550 GLOSSARY Defnedbeneftplan Apensionplaninwhichtheplansponsorpromisedtomakespecifedpaymentstoqualifyingemployeesatretirement. Defnedcontributionplan Apensionplaninwhichtheplansponsorcommitstoaspecifedcontribution,buttheamountuponretirementisnotguaran-teed. Degreeoffnancialleverage Ameasureofthesensitivityofearningstoownerstochangesinoperatingearnings,attributedtotheuseofdebtfnancing. Deliverydate See Settlementdate Demanddeposit Fundsdepositedwithabankthatcanbewithdrawnupondemandofthedepositor. Depositoryinstitutions Anentitythatacceptsdepositsandloansfunds. Depreciationtaxshield Theamountofthereductionintaxesresultingfromthedepreciationdeduction. Derivative Asecuritywhosevaluedependsonthevalueofanunderlyingasset,suchasastock. Derivativeinstrument See Derivative. DFL See Degreeoffnancialleverage. Dilutedearningspershare Adjustednetearningstocommonshareholdersoverafscalperiod,dividedbytheweightedaveragesharespotentiallyout-standingduringthefscalperiod,wherepotentialsharesrefectconvertiblesecuritiesandexecutivestockoptions. Discountrate TherateofinterestthatFederalReserveBankchargesbankswhoborrowusingtheFeddiscountwindow. Discountrate Rateofinterestusedtotranslatefuturecashfowsintoavaluetoday. Discountedpaybackperiod Thetimeittakesforaproject’sdiscountedcashinfowstoadduptotheinitialcashoutfow. Discounting Theprocessofdeterminingapresentvalueofsomefuturevalueorsetofcashfows. Diversifableriskfactors See Unsystematicriskfactors. Diversifcation Thereductionofriskfrominvestinginassetswhosereturnsarenotperfectlycorrelatedwithoneanother. Diversifcation Thereductionofrisk,withoutsacrifcingreturn,byinvestinginassetswhosereturnsarenotperfectly,positivelycorrelated. Diversify Theapplicationofdiversifcationprinciplestoreducetheriskofaportfolio. Dividend Adistributiontoshareowners. Dividend Adistributiontotheownersofacorporation. Dividenddiscountmodels Modelsforvaluingstockthatusesanestimateofcurrentdividends,expectedgrowthindividends,andarequiredrateofreturn. Dividendpayoutratio Theproportionofearningspaidintheformofcashdividendsduringaperiod.
Glossary 551 Dividendpayoutratio Theproportionofearningspaidoutintheformofcashdividendstoshareholders. Dividendpershare Themonetaryamountofdividendpaidpershareofstock. Dividendreinvestmentplan Aprogramthatallowsshareholderstoreinvestcashdividendsinsharesofthecompany. Dividendyield Thereturnonashareofstockintheformofdividends;theratioofdividendpersharetotheshareprice. Dividendyield Theratioofdividendsonashareofstocktothemarketvalueofthestock. Dividend–priceratio See Dividendyield. Dividendspershare Amonetaryamountofdividendsthatarepaidpershareofstock. Dividendsreceiveddeduction Adeductionavailabletocorporationsofapor-tionofthedividendsreceivedfromanothercorporation. Dollarreturn Thesumofthechangeinthemarketvalueofaportfolioandanycapitalorincomedistributionsfromtheportfolio. Dollar-weightedrateofreturn Theinternalrateofreturnofaninvestment. Domesticmarket Marketinwhichissuersdomiciledinacountryissuesecuri-tiesandinwhichthesesecuritiesaretraded. Downsiderisk See Lowerpartialmomentriskmeasure. DPO See Dayspayablesoutstanding. DRP See Dividendreinvestmentplan. DSI See Dayssalesininventory. DSO See Dayssalesoutstanding. DuPontsystem Amethodofdecomposingareturnratiointoitscomponents,suchasproftmarginsandturnovers,tofacilitateunderstandingofchangeinthereturnratio. Dutchauction Anoffertobuythatspecifesarangeofprices,withthosewillingtosellspecifyingapricewithintherange.Onceoffersaremade,thebuyerpaysthatprice(basedonbids)necessarytopurchasethedesiredquantity. Dynamicassetallocation Anprocessofalteringthemixofassetsinaport-foliofromtheportfolio’slong-termmixinresponsetochangingmarketconditions. EAR See Effectiveannualrate. Earningsbeforeinterest,depreciation,andamortization Operatingincomeofacompanybeforethedeductionfordepreciationexpenseandamortization. EBITDA See Earningsbeforeinterest,depreciation,andamortization. Economicagents Entitiesthatmakeinvestmentdecisionsinfnancialmarkets. Economiclife Thelengthoftimethattheinvestmentprovideseconomicprofts. Economicvalueadded Ameasureofacompany’seconomicproft.
552 GLOSSARY Effectiveannualrate Therateofinterestforanannualperiodthattakesintoaccountthecompoundingofinterestwithintheyear. Effectiverateofinterest See Effectiveannualrate. Effcientfrontier Thesetofeffcientportfoliosforasetofassets. Effcientportfolio Aportfoliothatprovidesthehighestexpectedreturnforagivenlevelofrisk. Employeestockownershipplan Adefnedcontributionpensionplanthatisdesignedtoinvestintheemployerstockonthebehalfoftheemployee. Enterpriseriskmanagement Themanagementoftheriskofabusinessenter-prisethatisinclusiveofthedifferentoperations,segments,andsubsidiariesofabusinessentity,whichviewsriskoftheentireenterprise. Equity Theownershipinterestinabusinessenterprise. Equityinstrument Asecurityorunitofownershipinacompany. Equityinvestmentstyle Aprocessofclassifyingequitysecuritiesbasedonadimensionorcharacteristic,suchassizeoramultiple,withexpectationoftakingadvantageofsuperiorreturnsthatareattributedtothedimensionorcharacteristic. Equivalenttaxableyield Theyieldonataxablesecuritythatisequivalent,aftertax,tothereturnonasimilarmaturity,features,andrisktoamunicipal,nontaxablesecurity. ERM See Enterpriseriskmanagement. ESOP See Employeestockownershipplan. ETF See Exchange-tradedfund. Euromarket See Externalmarket. Europeanoption Anoptionthatcanonlybeexercisedattheendoftheexpi-rationperiod. EVA See Economicvalueadded. Excessreserve Theamountbywhichactualreservesexceedrequiredreservesofabank. Exchange Amarketwithaphysicallocationforthetradingofassets. Exchange-tradedfund Afund,similartoanopen-endfundoraclosed-endfund,withunitsrepresentingsharesofthisfundtradedmuchlikestocks. Ex-date See ex-dividenddate. Ex-dividenddate Thedatedeterminedbytheexchangestoidentifywhichinvestorsareownersasofthedeclareddateofrecord. Exerciseprice See Strikeprice. Expansionproject Aprojectthatenlargesthecompany’sestablishedmarketorproductline. Expectationstheory Atheorythatstatesthattheobservedstructureofinterestratesrefectsinvestors’expectationsregardingfutureinterestrates. Expectedshortfall See Conditionalvalueatrisk. Expectedtailloss See Conditionalvalueatrisk.
Glossary 553 Expenseratio Anannualoperatingexpenseassociatedwitharegulatedinvest-mentcompany. Externalmarket Amarketinwhichsecuritiesareofferedatissuancesimul-taneouslytoinvestorsinanumberofcountriesandissuedoutsidethejurisdictionofanysinglecountry. Facevalue See Maturityvalue. Feasibleportfolio Anyportfoliothatcanbeconstructedwithavailableassets. Feddiscountwindow ThelendingoffundstobanksbytheFederalReservetomeetbanksliquidityneeds. Federalfundsmarket Themarketthatbanksusetomanageanyshortageintherequiredreserve. Federalfundsrate Therateofinterestchargedtobanksonborrowedfunds. Fiduciaryduty Thelegalresponsibilitytomakedecisionsortoseethatdeci-sionsaremadethatareinthebestinterestofaparty. FIFO See First-in,First-out. Finance Theapplicationofeconomicprinciplestodecisionmakingthatin-volvestheallocationofmoneyunderconditionsofuncertainty. Financialanalysis Theanalysisofthefnancialperformanceandfnancialcon-ditionofacompany. Financialasset Intangibleassetthatrepresentsaclaimonfuturecashfows. Financialdistress Situationinwhichacompanymakesdecisionsunderpres-suretosatisfyitslegalobligationstocreditors. Financialeconomics Anothertermusedtoidentifyfnance,whichemphasizestheroleofeconomicsinfnancialdecisionmaking. Financialinstrument Evidenceofownershiptoaclaimonfuturecashfows,suchasastockorabond. Financialintermediary Anentitythatfacilitatesthefowoffundsfromthosewithexcessfundstothoseinneedoffundsforinvestmentpurposes. Financialleverage Theuseofdebttofnanceabusinessenterprise. Financialmanagement Thefnancialdecisionmakingofabusinessentity.Alsoreferredtoasbusinessfnanceandcorporatefnance. Financialplanning Theallocationofacompany’sfnancialresourcestoachieveacompany’sinvestmentobjectives. Financialrestructuring Asignifcantalterationofacompany’scapitalstruc-ture. Financialrisk Uncertaintyassociatedwithaparty’srelianceondebtfnancing,relativetoequityfnancing. Financialrisk Theuncertaintyassociatedwiththeearningstotheownersofabusinessduetotheuseofdebt,whichgenerallyhasafxedcostandcommitsthebusinesstoalegalobligationtorepaythedebt. Financialrisk Theuncertaintyregardingtheoutcomeintermsofafnancialmeasure,suchasearnings.
554 GLOSSARY FinitelifegeneralDDM Aspecifcdividenddiscountmodelthatusesaterminalorexpectedfuturepriceofthestockatsomefutureperiodinplaceofasetofdividendsbeyondthatpointintime. Firmcommitmentoffering Anunderwritingarrangementwherebytheinvest-mentbankbuysthesecuritiesfromtheissuerandthensellsthesesecuritiestoinvestors. First-in,frst-out Inventorymethodinwhichtheoldestcostsofinventoryareusedincalculatingcostsofgoodssold. Fixedasset Along-termassetthathasaphysicalexistence,suchasequipmentorabuilding. Fixedincomeequivalent Thevalueofaconvertiblesecurityasastraightbond,whichresultsfromthevalueinconversionbeingsignifcantlybelowthesecurity’sstraightvalue. Fixedincomeinstrument Financialassetswhosecashfowsarespecifedcon-tractually,suchasabondoranote. Flatyieldcurve Ayieldcurveinwhichtheratesofhigher-andshorter-maturitysecuritiesaresimilar. Foreignmarket Marketinwhichissuersnotdomiciledinacountryissuese-curitiesandthesecuritiesaretraded. Foreignmarket Themarketforsecuritiesthatareissuedbyissuerswhoarenotdomiciledinthecountry. Forwardrate Theinterestratethatisexpectedtoexistinthefuture. Forwardstocksplit See Stocksplit. Framing Decisionmakingthatisinfuencedbythesituationorthemannerinwhichthesituationispresented. Freecashfow Thecashfowofacompanyinexcessoftheexpendituresforproftableinvestments. Freecashfowtoequity Cashfowfromoperations,lesscapitalexpenditures,plusnetborrowings. Freecashfowtothefrm Cashfowfromoperations,adjustedfortheafter-taxinterestexpense,lesscapitalexpenditures. Fundedretainedrisk Anassumedriskinwhichfundsaresetasidetoabsorbpotentiallosses. Futurescontract Alegalagreementbetweenabuyerandsellersuchthattheselleragreestomakeadeliveryandthebuyeragreestotakedeliveryofsomethingataspecifedpriceattheendofaspecifedperiodoftime. Futuresprice Thepriceagreedtoinafuturescontractforaspecifctransaction. GAAP See Generallyacceptedaccountingprinciples. Generalpartnership Apartnershipinwhichthepartnersshareinthemanage-mentofthebusiness,shareinitsproftsandlosses,andareresponsiblefortheliabilitiesofthebusiness. Generallyacceptedaccountingprinciples IntheUnitedStates,accountingmethodsthatarecodifedbytheFinancialAccountingStandardsBoard.
Glossary 555 Government-ownedcorporation Corporateentitiesfundedbythefederalgov-ernmentforspecifcprojects. Government-sponsoredenterprise Acorporationscreatedbythefederalgov-ernment. Grossplantandequipment Thetotalcostofphysicalassets. Grossproftmargin Theratioofgrossprofttorevenues. Grossproperty,plant,andequipment See Grossplantandequipment . Growthrate Therateatwhichavalueappreciatesordepreciates. GSE See Government-sponsoredenterprise. Hedgefund Apoolofinvestmentfundsthatarenotregulatedandareavailableforinvestmentonlytoaccreditedinvestors. Hedgeablerate See Forwardrate. Heuristic Aruleofthumborguidethatreducesdecisiontime. Holdingperiodreturn Theyieldonanassetoveraspecifedperiod,consideringthechangeinthevalueoftheassetandanycashfows,suchasinterestordividends. Horizontalcommon-sizeanalysis Therestatementandcomparisonofaccountsrelativetoabenchmark,wherethatbenchmarkisthataccountsvalueinaselectedbaseyear. Humpedyieldcurve Ayieldcurveinwhichtheratesoflonger-maturityse-curitiesaresimilartothoseofshorter-maturitysecurities,butlessthantheratesonintermediate-maturitysecurities. Illegalinsidertrading Thetradingofthestockofacompanybasedonnon-public,materialinformationbyaninsiderofthecompany. Incomestatement Asummaryofoperatingperformanceofabusinessentityoveraperiodoftime. Incrementalcashfows Thechangeinacompany’scashfowsrelatedtoaspecifcproject. Independentdirectors See Outsidedirectors. Independentprojects Projectswhosecashfowarenotrelatedtothoseofanotherproject. Indexedfunds Aregulatedinvestmentcompanythatinvestsfundsinaportfo-liothatisintendedtoreplicateanindex. Individuallymanagedaccount See Separatelymanagedaccount. Individuallysponsoredplan Apensionplanthatisforaspecifcindividual. Informationasymmetry Thesituationinwhichapartyorpartiestoatransac-tionhavemoreinformationthantheotherpartyorpartiestothetransac-tion. Initialmargin Theminimumamountdepositedpercontractattheinceptionofaposition. Insidedirectors Membersoftheboardofdirectorswhoareemployeesofthecorporation. Insurancepremium Thepaymentmadeforinsuranceprotection.
556 GLOSSARY Insurance-linkednote Syntheticallyinsuranceintheformofacapitalmarketdebtobligation,oftenusedforinsurancelargelosses,suchascatastrophelosses. Intangibleasset Anassetthathasnophysicalexistence. Intangibleasset Anonfnancialassetthatdoesnothaveaphysicalexistence,butcreatesfuturecashfowsforacompany. Interbankyieldcurve See Swaprateyieldcurve. Interestcoverageratio Thenumberoftimesthataperiod’sinterestexpensescouldbepaidbythecompany’searningsbeforeinterestandtaxesforthatperiod;ameasureofacompanytosatisfyitsdebtobligations. Interestrateswap Anagreementinwhichtwopartiesagreetoswapcashfowsbasedoninterestrates. Interesttaxshield Theamountoftaxsavingsduetothedeductibilityofinteresttoarriveattaxableincome,computedastheproductofthemarginaltaxrateandtheinterestexpense. Internalmarket Thedomesticandforeignmarketsforsecuritiesissuedinthedomesticmarket. Internalrateofreturn Theyieldonaninvestment,assumingthatallinterme-diatecashfowsarereinvestedatthisyield;thediscountrateatwhichthepresentvalueofallcashfowsofaninvestmentisequaltozero. In-the-moneyoption Thesituationinwhichacalloption’sexercisepriceislessthantheunderlying’svalueoraputoption’sexercisepriceisgreaterthantheunderlying’svalue. Intrinsicvalue Thevalueofanoptionifexercisedimmediately. Inventories Investmentsinrawmaterial,workinprocess,andfnishedgoods,whichareexpectedtobesoldtocustomers. Inventoryturnover Thenumberoftimes,onaverage,thatinventoryfowsintoandoutofacompany. Invertedyieldcurve Ayieldcurveinwhichtheratesoflonger-maturitysecu-ritiesarelowerthanthoseofshorter-maturitysecurities. Investmentcompany Anentitythatmanagethefundsofindividuals,busi-nesses,andstateandlocalgovernments. Investmentmanagement Thedecisionmakingregardingindividualandinstitu-tionalfunds.Alsoreferredtoasassetmanagement,portfoliomanagement,moneymanagement,andwealthmanagement. Investmentmanager See Portfoliomanager. Investmentprofle Angraphofacapitalproject’snetpresentvalueasafunc-tionofitscostofcapital. Investmentvalue See Straightvalue. Investor Apartythatbuysanasset,suchasasecurity,withtheanticipationofareturnintheformoffuturecashfows. Investor’sequity Thevalueofaninvestmentpositionreducedbyanyborrowedamount.
Glossary 557 IRR See Internalrateofreturn. Issuer Anentitythatprovidesasecurity,suchasastockorabond,inexchangeforfunds. Jointventure Abusinessentityformedaseitheracorporationorapartnership,generallyforaspecifcbusinesspurposeandlife. Keyperformanceindicators Measuresusedinabalancedscorecard. Last-in,frst-out Inventorymethodinwhichthemostrecentcostsofinventoryareusedincalculatingcostsofgoodssold. Leveragedportfolio Aportfolioinwhichtheinvestorborrowsfundstopur-chasesomeoftheassetsintheportfolio. Liabilities Obligationstorepaytheamountowed,insomecaseswithinterest. LIBOR See LondonInterbankOfferedRate. LIFO See Last-in,First-out. Limitedliability Thepresenceofalimitonowners’liabilityforobligationsofthebusinessenterprise. Limitedliabilitycompany Aformofbusinessinwhichtheownershavelimitedliability,butthebusinessmayelecttobetaxedasapartnership. Limitedliabilitypartnership Aformofbusinessinwhichtheownershavelimitedliability. Limitedpartnership Apartnershipthathasatleastonegeneralpartnerandonelimitedpartner,wherethebusinessisconductedbythegeneralpartnerandthelimitedpartnerorpartnershavealimitedinterestintheproftsandlossesofthebusiness. Liquidity Inthecontextofamarket,thepresenceofbuyersandsellersreadytotrade.Inthecontextofabusinessenterprise,theabilityofabusinessenterprisetosatisfyitsshort-termobligations. Liquiditypremium Theadditionalcompensationfortheriskassociatedwithbeingabletosellasecurityforclosetoitstruevalue. Liquidityrisk Theriskassociatedwiththeabilitytosellasecurityatavalueclosetoitstruevalue. Liquiditytheory Thetheorythatpurportsthatthehigherratesforlonger-maturitysecuritiesinanupward-slopingyieldcurverepresentscompensa-tionforliquidityand,therefore,theforwardratesderivedfromtheyieldcurvearenotunbiasedestimatesoffutureinterestrates. Listed Thesituationinwhichanissuerofsecuritieshasselectedtohaveitssecuritiestradedinthemarket. LLC See Limitedliabilitycompany. LLP See Limitedliabilitypartnership. Loanamortization Anarrangementinwhichtheprincipalamountofaloanispaidoffovertime,withmoreprincipalrepaidineachsuccessivepayment. LondonInterbankOfferedRate TheratemajorinternationalbanksarewillingtoofferonEurodollardepositstoeachother. Longcallposition Aninvestmentpositionthatinvolvesbuyingcalloptions.
558 GLOSSARY Longfutures See Longpositioninfutures. Longpositioninfutures Theinvestmentpositioninwhichtheinvestorbuysafuturescontract. Longputposition Aninvestmentpositionthatinvolvesbuyingputoptions. Long-runplanning See Long-termplanning. Long-termliability Obligationsduebeyondoneyear. Long-termplanning Financialplanningforfutureperiods,usuallythreetofveyearsinthefuture. Lowerpartialmomentriskmeasure Asafety-frstrulethatusesboththein-vestor’sriskaversionandatargetrateofreturn. MACRS See ModifedCostRecoverySystem. MAD See Mean-absolutedeviation. Maintenancemargin Theminimumlevelthataninvestor’sequitymayfallfromadversepricemovementsbeforetheinvestorisrequiredtodepositadditionalfunds. Mandatedproject Aprojectthatisrequiredbyanoutsideparty,suchasagovernmentagency. Marginaltaxrate Thetaxrateonthenextdollaroftaxableincome. Marketanomaly Astrategythatcangenerateabnormalreturns. Marketcap See Marketcapitalization. Marketcapitalization Thetotalvalueofstockoutstanding,whichiscalculatedastheproductofthemarketpricepershareandthenumberofsharesoutstanding. Marketconversionpremiumpershare Thedifferencebetweenthemarketconversionpriceforaconvertiblesecurityandthecurrentmarketpriceofthestockthatcanbeobtainedthroughconversion. Marketconversionpremiumratio Themarketconversionpremium,statedasapercentageofthemarketvalueofthestockforwhichaconvertiblesecuritycanbeexchanged. Marketconversionprice Theeffectivevaluepershareofstockinconversionofaconvertiblesecurity;theratioofthemarketpriceofaconvertiblebondtotheconversionratio. Marketrisk Theriskrelatedtotheoverallmovementofthemarket. Marketsegmentationtheory Thetheorythatpurportsthattheshapeoftheyieldcurveisduetopreferredmaturitiesofinvestors. Marketstructure Themechanisminwhichbuyersandsellersinteracttode-terminethepriceandquantityinanexchange. Marketvalueadded Ameasureofthedifferencebetweenthemarketvalueofcapitalandtheamountofinvestedcapital. Marketablesecurities Securitiesthatcanbesomequickly. Markowitzdiversifcation See Diversifcation. Masterlimitedpartnership Alimitedpartnershipwithlimitedpartnerintereststradedonapublicexchange.
Glossary 559 Maturityintermediation Thetransformationoflonger-termassetsintoshorter-termassets. Maturityspread Thespreadbetweenanytwomaturitiesinasectorofamarket. Maturityvalue Theamountofaloandueattheendoftheloanperiod. Mean-absolutedeviation Ameasureofdispersionthatisbasedontheabsolutevalueofdeviationsfromthemean. Mean-standarddeviation See Standarddeviation. Mean-varianceanalysis See Mean-varianceportfolioanalysis. Mean-varianceeffcientportfolio See Effcientportfolio. Mean-varianceportfolioanalysis ThetheoryproposedbyHarryMarkowitzthatfocusesonassets’meanandvarianceascriteriaforportfolioselection. Merchantbanking Aninvestmentbankthatcommitsitsowncapitalinlendingortakinganequitystakeinabusinessentity. Minorityinterest Inabalancesheet,theproportionofacompany’sassetsnotownedbytheparentcompany.Inanincomestatement,theearningsofacompanyrepresentingtheinterestnotownedbytheparentcompany. MLP See Masterlimitedpartnership. Modernportfoliotheory ThetheorydevelopedbyHarryMarkowitzthatfo-cusesontheroleofdiversifcationwithinaportfolioinaffectingtheriskandreturnofaportfolioofinvestedassets. ModifedAcceleratedCostRecoverySystem AdepreciationsystemusedforU.S.taxesthatisbasedonanacceleratedmethodofdepreciation. ModifedCostRecoverySystem AsystemofdepreciationprescribedbytheU.S.TaxCode. Modifedinternalrateofreturn Thereturnonaninvestment,consideringaspecifcreinvestmentrate. Moneymanagement See Investmentmanagement. Moneymanagement See Portfoliomanagement. Moneymanager See Portfoliomanager. Moneymarket Themarketforshort-termsecurities. Moneymarketdemandaccount Anaccountinwhichfundsaredepositedandearninterest,thoughrestrictionsmaybeplacedonwithdrawals. Money-weightedrateofreturn See Dollar-weightedrateofreturn. Monitoringcosts Costsassociatedwithmonitoringorlimitingtheactionsofanagentinanagencyrelationship. Mortgage-backedsecurities Securitiesthatarebacked,orsecuredwithmort-gages. MPT See Modernportfoliotheory. Municipalyieldratio Theratioofthemunicipalbondyieldtoacomparable-maturityTreasurysecurity. Muni-Treasuryyieldratio See Municipalyieldratio
560 GLOSSARY Mutualfund Aregulatedinvestmentcompanythatsolicitsfundsfromin-vestorsandtheninveststhesefundsinaportfolioofinvestments,withtheopportunityforinvestorstoredeemsharesandtoinvestadditionalfunds. Mutuallyexclusiveprojects Projectsforwhichtheacceptanceofoneprecludestheacceptanceoftheother(s). MVA See Marketvalueadded. Nationalmarket See Internalmarket. NCF See Netcashfow. Nearbyfuturescontract Thefuturescontractwiththeclosestsettlementdatetotheparticularcontract. NegotiableCD See Negotiablecertifcateofdeposit. Negotiablecertifcateofdeposit Apromissorynoteofabankthatcanbeboughtandsoldbyinvestors. Netcashfow Thesumofoperatingandinvestmentcashfowsinagivenperiodofaninvestment’seconomiclife. Netoperatingcycle See Cashconversioncycle. Netplantandequipment Costofphysicalassets,lessaccumulateddeprecia-tion. Netpresentvalue Thevaluetodayofallcashfowsofaproject,discountedattheproject’scostofcapital. Netpresentvalueprofle See Investmentprofle. Netproftmargin Theratioofnetincometorevenues. Netproperty,plant,andequipment See Netplantandequipment. Networkingcapital Theshort-termassetsthatwouldremainifcurrentliabili-tiesaresatisfed;thedifferencebetweencurrentassetsandcurrentliabilities. Networkingcapitaltosalesratio Thecurrentassetsavailable,aftermeetingcurrentobligations,perdollarofsales. Nextfuturescontract Thefuturescontractwithasettlementdatejustafteraparticularcontract’ssettlementdate. Noncorerisk Risksthatareincidentaltotheoperationsofabusiness. Nondiversifableriskfactors See Systematicriskfactors. Nonlinearpayoff Apayoffonaninvestmentsuchthatthedownsideriskisdifferentthantheupsidepotential. Nonsystematicrisk Theriskthatcanbediversifedaway. Note Indebtednessthatdoesnothaveanindentureagreement.Ingeneraluse,adebtwithanoriginalmaturitylessthanorequalto10years. Notespayable Indebtednessinthefrmofasecurity. Notionalamount See Notionalprincipalamount. Notionalprincipalamount Principalamountthatservesasthebasisforthedeterminationofcashfowsinaswapagreement. NPV See Netpresentvalue. Numberofdaysofcredit See Dayssalesoutstanding. Numberofdaysofinventory See Dayssalesininventory.
Glossary 561 Numberofdaysofpurchases See Dayspayablesoutstanding. OCF See Operatingcashfows. Offshoremarket See Externalmarket. Openinterest Thenumberofcontractsenteredintobutnotyetliquidated. Open-endfund See Mutualfund. Operatingcashfows Thecashfowsrelatedtotherevenues,expenses,anddepreciationofassetsinvolvedinacapitalproject. Operatingcycle Thelengthoftimeittakestoturntheinvestmentofcashintogoodsandservicesforsalebackintocashintheformofcollectionsfromcustomers. Operatingproftmargin Theratioofoperatingprofttorevenues. Operatingrisk Thedegreeofuncertaintyconcerningoperatingcashfowsthatarisesfromtheparticularmixoffxedandvariableoperatingcosts. Operationalbudgeting Short-termfnancialplanning. Optimalcapitalstructure Themixofdebtandequityfnancingthecompanythatmaximizesthevalueofthecompany. Optimalportfolio Thebestportfolioofthesetofportfoliosontheeffcientfrontier;thepointoftangencyoftheeffcientfrontierandaninvestor’sutilitycurve. Optionpremium Thecostofanoption. Optionprice See Optionpremium. Optionwriter Thesellerofanoption. Order-drivenmarketstructure Amarketinwhichcentralizedbid-matchingmatchestheordersofthebuyersandsellers. Ordinaryannuity Anevenseriesofcashfowsoccurringatevenintervalsoftime,withcashfowsoccurringattheendofeachperiod. OTC See Over-the-countermarket. Out-of-the-moneyoption Thesituationinwhichacalloption’sexercisepriceisgreaterthantheunderlying’svalueoraputoption’sexercisepriceislessthantheunderlying’svalue. Outsidedirectors Membersoftheboardofdirectorswhoarenotemployeesofthecorporation. Over-the-countermarket Amarketthatdoesnothaveaphysicalexistence,butwhichtradessecuritiesorotherassetsthroughanetworkofdealers. Owners’equity See Equity. Parvalue Astatedamountofasecurity.Inthecaseofabond,theparvalueisthebond’smaturityvalue. Parityvalue See Conversionvalue. Partnership Abusinessownedbymorethanoneparty. Partnershipshare Ownershipunitinapartnership. Passivefunds See Indexedfunds. Passiveportfoliostrategy Aprocessofmanagingaportfoliothatisfocusedontheconstructionofaportfoliothatisconsistentwiththeportfolioobjectives,
562 GLOSSARY butwithoutsignifcantmanagementofinvestmentsaftertheconstructionoftheportfolio. Passivestrategy Aninvestmentstrategythatdoesnotinvolveactivemanage-mentofaportfolio,andinvolvesminimaltradingofsecuritiesintheport-folio. Paybackperiod Thetimeittakesforthecashinfowsfromaprojecttoadduptotheinitialcashoutfow. Paymentdate Thedate,determinedbytheboardofdirectors,onwhichadividenddistributionismade. Performanceevaluation Themeasurementofthereturnonaportfolio,con-sideringtheportfolio’sbenchmark’sreturnandtheportfolio’srisk. Performanceshares Shareofstockgiventoemployees,basedonsomemeasureofoperatingperformance. Perpetuity Auniformseriesofcashfowsoccurringatevenintervalsoftimeforever. PI See Proftabilityindex. Plansponsor Anentitythatestablishesapensionplan,suchasabusinessoraunion. Plowbackratio See Retentionratio. Policyassetallocation Thelong-termassetmixofaportfolio. Porter’sFiveForces Forcesthataffecttheabilityofcompaniesinanindustrytogenerateeconomicprofts:bargainingpowerofsuppliers,bargainingpowerofbuyers,threatofnewentrants,threatofsubstituteproducts,andrivalry. Portfolio Setofinvestmentsthataremanagedforthebeneftoftheclientorclients. Portfoliomanagement Theprocessofmanaginginvestments. Portfoliomanager Thepersonwhomanagesaportfoliobyselectinginvest-ments,monitoringtheportfolio’sperformance,andmeasuringandevalu-atingtheportfolio’sperformance. Positivelyslopedyieldcurve See Upward-slopingyieldcurve. Postpaybackduration Theeconomiclifeofaprojectbeyonditspaybackpe-riod. Preferredhabitattheory Thetheorythatpurportsthatyieldsinayieldcurverepresentbothfutureinterestrates,butalsoapremiumforrisk. Preferredstock Anownershipinterestinacorporationthathasasupe-riorclaimtotheincomeandassetsofacompanyrelativetocommonstockowners,whichmayhaveafxedmaturityormaybeaperpetualsecurity. Premium Inthecontextofinsurance,theamountpaidtoreceiveprotectionagainstanoccurrenceofanevent. Prepayment Theoptionthataborrowerhastoprepayaportionoralloftheloanpriortomaturity. Pricediscovery Theprocessofdeterminingapriceofanassetbytheinterac-tionsofbuyersandsellers.
Glossary 563 Priceeffciency Acharacteristicofmarketswhichdescribesassetpricesasrefectingavailableinformation,suchthatitisnotpossibletoearnreturnsinexcessofthatconsideringtheasset’sfuturecashfowsandrisk. Primarymarket Themarketinwhichanissuerfrstissuesasecuritytoinvestor,receivingfundsinexchangeforthesecurity. Principal Thepersonorgroupofpersonstheagentrepresentsinanagencyrelationship. Privateplan Apensionplansponsoredbyabusinessentityforitsemployees. Proformabalancesheet Aprojectedbalancesheet,whichsummarizesexpectedamountsofassets,liabilities,andequity. Proformaincomestatement Aprojectedincomestatementwhichsummarizesexpectedincomeandexpenses. Probabilitydistribution Asetofprobabilitiesforeachpossibleoutcomeforarandomvariable. Professionalcorporation Aformofbusinessinwhichownershaveunlimitedliability,butwhichistreatedasapartnershipfortaxpurposes. Proftabilityindex Theratioofthepresentvalueofthecashinfowstothepresentvalueofcashoutfowsofaproject. Proftabilityratios Ratiosthatprovideinformationonwhatisleftofrevenuesafterexpenses. Prospecttheory Atheoryofdecisionmakingunderuncertainty,describingbehaviorasinvolvingaheuristic:frst,individualsconsiderthepossiblein-vestmentsanddecidewhichonesaresimilarandwhichonesaredifferent;second,theindividualsthenevaluatethepossibleoutcomesandprobabili-ties,selectingtheinvestmentthathasthehighestutility. Publiccorporation See Publiclyheldcorporation. Publiclyheldcorporation Acorporationwithownershipinterestssoldoutsideofaclosegroup. Pureexpectationstheory Thetheorythatpurportsthatforwardratesareex-pectedfutureinterestrates. Putprovision Aprovisionofasecuritythatallowstheinvestortosellthesecuritybacktotheissuerataspecifedprice. Putablebond Adebtobligationthatmaybesoldbacktotheissuerataspecifedprice. Quickratio Aliquidityratiothatmeasuresthecompany’sabilitytomeetitscurrentobligations,calculatedastheratioofcurrentassets,lessinventory,dividedbycurrentliabilities. Quote-drivenmarketstructure Amarketinwhichintermediaries,suchasmar-ketmakers,providequotesforpurchaseandsales,andstandreadytobuyorsellatthesequotes. Rateofreturn Thedollarreturnonaninvestment,expressedasapercentageoftheinitialinvestment. Ratingagencies Companiesthatevaluateandratethedefaultriskofdebtobligations.
564 GLOSSARY Realinterestrate Therateofinterestthatwouldexistintheeconomyintheabsenceofinfation. Recorddate See Dateofrecord. Regressionanalysis Theapplicationofstatisticaltechniquestogaugetherela-tionbetweentwoofmorevariables. Regressionline Astatisticaldepictionoftheaveragerelationshipbetweentwo(ormore)variables. Regulatedinvestmentcompany Afnancialintermediarythatsellssharestothepublicandinveststhoseproceedsinadiversifedportfolioofsecurities. Reinvestmentrisk Theriskthattheinvestormayfaceyieldsonreinvestedcashfowsthatarelowerthantheyieldtomaturityofasecurity. Relativereturn Differencebetweentherealizedreturnandtheexpectedreturn. Relativevaluation Amethodofvaluingastockoracompanythatrequiresusingmultiplesofsimilarorcomparablecompanies,andapplyingthesemultiplestothestockorcompany. Reofferingprice Thepriceatwhichaninvestmentbankofferssecuritiesthatitisunderwritingtoinvestors. Replacementproject Aprojectthatinvolvesthemaintenanceofexistingassetstocontinuethecurrentlevelofoperatingactivity. Repo See Repurchaseagreement. Reporate Theinterestratechargedinarepurchaseagreement. Repurchaseagreement Ashort-termloanbackedbyspecifccollateral. Requiredrateofreturn Thereturnexpectedbythesuppliersofcapitalfortheriskoftheinvestment. Requiredreserve Dollaramountoffundsrequiredtobemaintainedonhand,basedonthereserveratio. Requiredyield Thereturnthatinvestorsdemand,whichrelatestothetimevalueofmoneyandtheuncertaintyofthesecurity’scashfows. Reserveratio Percentageofdepositsthatabankmustmaintainonhand. Residualloss Theagencycostsotherthanmonitoringcostsandbondingcosts. Restrictedstockgrant Thegrantofsharesofstocktotheemployeeatlowornocost,conditionalonthesharesnotbeingsoldforaspecifedtime. Retainedearnings Theaccumulationofearningsovertime,lessdividendspaidovertime. Retentionratio Theproportionofearningsretainedbythecompanyduringaperiod. Return See Rateofreturn. Reversecash-and-carrytrade Afuturespositioninwhichtheinvestorbuysfutures,sellstheasset,andlendsfundsattheinceptionofthecontract,andthenbuystheassetandhastheloanpaidoffattheendofthecontract. Reversestocksplit Areductionofthenumberofsharesofstock,specifedasthenumberofsharespost-splittothenumberofsharespresplit,e.g.,1:4. RIC See Regulatedinvestmentcompany.
Glossary 565 Risk Uncertaintyregardingafutureoutcome. Riskappetite Theamountofriskthatanentityiswillingtoacceptorretain. Riskcontrol Theprocessofidentifying,evaluating,monitoring,andmanagingtheriskofanbusinessenterprise. Riskfnance Themanagementoftheretainedriskofanenterprise. Riskmanagement Theprocessofidentifyingrisksandmanagingthoserisksthroughacceptance,mitigation,andtransference. Riskmanagementculture Theenvironmentinwhichtheentityhasanap-proachtodealingwithrisksandthatapproachispartofthebusiness’smanagementculture. Riskneutralization Ariskmanagementpolicyinwhichthemanagementofanentitypursuesariskmanagementpolicytomitigateanexpectedlosswithouttransferringtheassociatedrisktoanotherparty. Riskpremium Additionalcompensationrequiredbyinvestorsforbearingrisk. Riskretention Theamountofriskanenterpriseiswillingtoassume. Risktolerance Theamountofriskthatistolerated,withanyriskexceedingthistolerancetriggeringactiontoreducerisk. Risktransfermanagement Thetransferofriskbymanagementtoathirdpartyviainsurance,derivatives,structuredfnancialproducts,orsomeothermeans. Risk-freeasset Anassetwhoseexpectedreturnisknownwithcertainty. Risklessasset See Risk-freeasset. Safety-frstrules Decisionrulesthatseektomaximizetheprobabilitiesofpro-ducingreturnsabovesomebenchmarkreturn. Salary Adirectpaymentofcashofafxedamountperperiod. Salesrisk Thedegreeofuncertaintyrelatedtothenumberofunitsthatwillbesoldandthepriceofthegoodorservice. Salvagevalue Theexpectedvalueofanassetattheendofitseconomiclife. Savingsdeposit Fundsdepositedwithabankthatearninterestandcangener-allybewithdrawnbythedepositorupondemand. Secondarymarket Themarketinwhichinvestorstradesecuritiesorotherassets. Securitiesfnance Theborrowingorlendingofsecurities. Securitieslendingtransaction Thelendingofsecuritiesbyonepartytoaninvestorinneedofthosesecuritiesonatemporarybasis. Security Afnancialassetthatrepresentsaclaimonfuturecashfows,suchasabondorastock. Securitymarketline Thelinedepictingtherelationbetweenthereturnonastocktoitsmarketrisk. Sellinggroup Agroupofinvestmentbanksandothersthatmarketasecurityissue. Semi-strongformofmarketeffciency Thedegreeofmarketeffciencyinwhichcurrentpricesrefectallavailablepublicinformation.
566 GLOSSARY Semivariance Ameasureofdispersionthatconsidersonlythepossibleout-comesbelowtheexpectedvalue. Separatelymanagedaccount Aprofessionallymanagedportfoliotailoredtotheinvestor’sobjectives. Settlementdate Thedesignateddateofthetransactioninafuturescontract. Share Ownershipinterestinacorporation. Shareholder Ownerofaninterestinacorporation. Shareholders’equity Theownershipinterestinacorporation. Shortcallposition Aninvestmentpositionthatinvolvessellingorwritingcalloptions. Shortfutures See Shortpositioninfutures. Shortpositioninfutures Theinvestmentpositioninwhichtheinvestorsellsafuturescontract. Shortputposition Aninvestmentpositionthatinvolvessellingorwritingputoptions. Silostructure Thestructureofabusinessenterpriseinwhicheachpartofthebusinessisoperatedindependentlyoftheotherpartsofthebusiness. Simpleinterest Anarrangementinwhichinterestispaidonlyontheprincipalamount. SML See Securitymarketline. Soleproprietorship Abusinessownedbyasingleindividual. Spotmarket See Cashmarket. Spread Thedifferenceininterestratesoryields,generallyexpressedintermsofbasispoints. Standarddeviationofarandomvariable Ameasureofdispersionorpossibleoutcomesaroundtheexpectedvalue,calculatedasthesquarerootofthevariance. Statedconversionprice Theratiooftheparvalueofaconvertiblebondtotheconversionratio. Statedvalue See Parvalue. Stockappreciationright Acashpaymentbasedontheamountbywhichthevalueofaspecifednumberofshareshasincreasedoveraspecifedperiodoftime. Stockdividend Distributionofadditionalsharesofstocktoshareholders,gen-erallyspecifedintermsoftheproportionofnewsharestothenumberofexistingshares,e.g.,25%. Stockoption Therighttobuyaspecifednumberofsharesofstockinthecompanyatastatedprice—referredtoasanexercisepriceatsometimeinthefuture.Theexercisepricemaybeabove,at,orbelowthecurrentmarketpriceofthestock. Stocksplit Distributionofadditionalsharesofstocktoshareholders,generallyspecifedintermsoftheratioofsharesafterthedistributiontothenumberofexistingshares,e.g.,2:1.
Glossary 567 Straightvalue Thevalueofabondwithoutconsideringthevalueofanyem-beddedoption. Straight-linedepreciation Depreciationinwhichthesameproportionofanasset’scostisdepreciatedeachperiod. Strategicplan Thepaththatthecompanyintendstofollowtoachieveitsobjective. Strategy Adirectionthecompanyintendstotaketoreachanobjective. Strikeprice Thepriceatwhichtheoptionbuyercanbuytheunderlyingasset,inthecaseofacalloption,orselltheunderlyingasset,inthecaseofaputoption. Strongformofmarketeffciency Thedegreeofmarketeffciencyinwhichcurrentpricesrefectallpublicandprivateinformation. Structureofinterestrates Therelationshipamonginterestratesofdebtinstru-mentsbasedonanumberoffactors,includingriskandmaturity. Structuredfnance Securitiescreatedforspecifcriskandreturnprofles,suchasassetsecuritizationandstructurednotes. Stylebox AmethoddevelopedbyMorningstartocharacterizesecuritiesbasedontwodimensions;forstocksthesedimensionsaremarketcapitalizationandstyle,whereasforbondstheyarecreditqualityandmaturity. Sum-of-year’sdigitsmethod Adepreciationmethodthatusesadecliningrateappliedtotheasset’sdepreciablebasis,withthisrateasratiooftheremain-ingyearsdividedbythesumoftheyears. Supranational Anorganizationthatextendsbeyondasinglecountry’sbound-aries,whichsharesindecisionmakingoftheorganization. Sustainabilityrisk Abroadspectrumoftheriskofabusinessenterprisethatincludessocialandenvironmentalresponsibilities. Swap Anagreementwherebytwoparties(called counterparties )agreetoex-changeperiodicpayments. Swapcurve See Swaprateyieldcurve. Swaprate Thefxedratepaidbythefxed-ratecounterpartyinaswap. Swaprateyieldcurve Theratesfordifferentmaturitiesthatrefecttheaveragecreditriskofbanksthatprovideinterestrateswaps. Syndicatedbankloan Abankloaninwhichagroupofbankslendsfundstoaborrower. Systematicrisk See Marketrisk. Systematicriskfactors Factorsthataffecttheriskofaninvestmentthatcannotbediversifedaway. Tacticalassetallocation Aformofdynamicassetallocationthatisbasedonopportunitiestocaptureabnormalreturns. Taft-Hartleyplan Apensionplansponsoredbyauniononthebehalfofitsmembers. Tangibleasset Anassetwithphysicalproperties,suchasamachineorinven-tory.
568 GLOSSARY Tenderoffer Anoffer,madedirectlytoshareholders,topurchasesharesofacompany. Three-stagedividenddiscountmodel Amultiphasedividenddiscountmodelthatassumesthattherearethreedistinctphasesofgrowthinastock’sdividendsinthefuture. Timedeposit Fundsdepositedwithafnancialinstitutionthathaveafxedmaturitydateandearninterest.Morecommonlyreferredtoas certifcatesofdeposit . Timepremium Thedifferencebetweenanoption’spriceandtheintrinsicvalue;thevalueofanoptionattributedtothepossibilitythattheoptionmaybecomemorevaluableinthetimeremainingtoexpiration. Timevalueofanoption See Timepremium. Time-weightedrateofreturn Thegeometricmeanofsubperiodratesofreturn. Totalassetturnover Theratioofrevenuestoassets;ameasureoftheeffec-tivenessofputtingassetstousetogeneraterevenues. Treasurybill Ashort-termsecurityissuedbyagovernment.IntheUnitedStates,thesebillshavematuritiesoffourweeks,threemonths,andsixmonths. Treasurysecurities Securitiesissuedbyagovernment. Treasuryspotrates ThetheoreticalratesthatwouldexistforagivenyieldcurvethatrepresentwhattheU.S.Treasurywouldhavetopayifthesecu-ritiesarezero-couponsecurities. Treasurystock Stockofacompanythatisboughtbackbythecompanyforuseinexecutivestockoptionsandotherpurposes. Two-parametermodel See Mean-varianceportfolioanalysis. Underlying See Underlyingasset. Underlying Thebasisofaderivativecontract,whichmaybeastock,abond,oranyotherasset. Underlyingasset Theassetorsecurityspecifedinaderivativeinstrument,suchthatthevalueandorcashfowsofthederivativeinstrumentdependonthespecifedassetorsecurity. Underwritingsyndicate Agroupofinvestmentbanksthatunderwriteanissue. Unfundedretainedrisk Anassumedriskforwhichlossesarenotfnanceduntiltheyoccur. Unitinvestmenttrust Aregulatedinvestmentthathasafnitelifeandafxedportfolioofinvestments. Unsystematicriskfactors Risksthatcanbereducedoreliminatedthroughdiversifcation. Unvaluedcontract Aninsurancearrangementinwhichthevalueoftheinsuredpropertyisnotfxed. Upward-slopingyieldcurve Ayieldcurveinwhichtheratesoflonger-maturitysecuritiesarehigherthanthoseofshorter-maturitysecurities. Usefullife See Economiclife.
Glossary 569 Utilityfunction Aseriesofvaluesassignedtopossiblechoicesthatanentityfaces. Valueatrisk Asafety-frstrulethatfocusesonthemaximumlossataspecifedprobabilityleveloveraspecifedtimehorizon. Valuedcontract Aninsurancearrangementinwhichthevalueoftheinsuredpropertyisfxed. VaR See Valueatrisk. Varianceofarandomvariable Ameasureofdispersionorpossibleoutcomesaroundtheexpectedvalue. Variationmargin Theamountofmarginbeyondtheinitialmargin,generallyrequiredincash. Verticalcommon-sizeanalysis Therestatementandcomparisonofaccountsrelativetoabenchmarkaccount’svalueforthatperiod;forabalancesheet,thisbenchmarkistotalassets,andforanincomestatementthisbenchmarkisrevenues. Weakformofmarketeffciency Thedegreeofmarketeffciencyinwhichcurrentpricesrefectalloftheinformationavailableinpastprices. Wealthmanagement See Investmentmanagement. Workingcapital Currentassets,whichservetomeettheneedsoftheday-to-dayoperationsofabusiness. Yankeemarket TheforeignmarketintheUnitedStates. Yieldcurve TheyieldsonTreasurysecuritiesatapointintimeforsecuritieswithdifferentmaturities. Yieldcurvespread See Maturityspread. Yield-to-frstcall Theyieldonacallablesecurity,assumingthatthesecuritywillbecalledbytheissueratthefrstavailablecalldate. Yieldtomaturity Theexpectedreturnonasecurity,basedonthesecurity’scurrentvalue,maturityvalue,andexpectedcashfows,suchascouponpayments. Yield-to-parcall See Yield-to-frstcall. Yieldtoworst Thelowerofacallablesecurity’syieldtomaturityandyieldtocall. Zero-couponbond Abondthatdoesnotpayinterest;rather,theinvestorreceivesareturnfrombuyingthesecurityatadiscountfromthebond’sfacevalue.
AbouttheAuthors FrankJ.Fabozzi,PH.D.,CFA,CPA ,isaProfessorinthePracticeofFinanceandBectonFellowatYaleUniversity’sSchoolofManagement,EditoroftheJournalofPortfolioManagement,andAssociateEditoroftheJournalofStructuredFinanceandtheJournalofFixedIncome.Frank’swritingspansthegamutfromthebasicsofcorporatefnancetocomplexstructuredproductsandfnancialeconometrics. PamelaPetersonDrake,PH.D.,CFA ,istheJ.GrayFergusonProfessorofFinanceandDepartmentHeadofFinanceandBusinessLawatJamesMadisonUniversity.PriortojoiningJamesMadisonUniversity,shewasaProfessorofFinanceatFloridaStateUniversity,andanAssociateDeanandProfessorofFinanceatFloridaAtlanticUniversity.PamhascollaboratedwithFrankinanumberofbooks,includingbooksonthebasicsoffnance,fnancialanalysis,andfnancialmanagement.AtJamesMadisonUniversity,Pamteachesfnancialanalysis,analyticalmethodsinfnance,andadvancedfnancialpolicy. 571
Index AA-ratedyieldcurve,486,557Abnormalreturn,31,557Absolutereturn,54,557ABSs. See Asset-backedsecuritiesAccelerateddepreciation,76,557Accountingdata,limitations,269fexibility,83identity,68,557income,adjustment,315irregularities,shareholderwealthmaximization(relationship),103–104principles,66–67scandals,104AccountingStandardsCodifcation(FASB),66Accountspayable,71,557Accountsreceivable,557collection,257currentasset,68cycle,number,257information,usage,315management,256–257turnover,557ratio,256Accrualaccountingbasis,277usage,67Accumulatedcomprehensiveincome/loss,72–73,557Accumulateddepreciation,69Accumulatedinterest. See InterestonaccumulatedinterestAcid-testratio(quickratio),557Acquisitions,investmentbankassistance,58Activefunds,51Activeportfoliostrategy,399,557pursuit,459Activestrategy,3–4,557Activityratios,245,255–258,557example,258Actualreserve,45,557Additionalpaid-incapital,72,557Adelphia,scandal,185Advanced-warningsystem,24Agencybusinessrelationship,99–101costs,100–101problems,99–100explanation,143,146problem,166Agencycosts,100–101,557impact,180reduction,stockrepurchase(impact),150Agent,99,557Agreed-uponperiodicrate,376Alternativeassetclasses,397Alternativerateofreturncalculations,advantages/disadvantages,408eAlternativereturnmeasures,401–404Alternativeriskmeasures. See PortfolioselectionAlternativerisktransfer(ART),196–197,557AmaranthAdvisors,futurescontractloss,196AmericanInternationalGroup(AIG),swapsloss,196 573
574 INDEX Americanoption,373,557Amortization,231Amtrak. See NationalRailroadPassengerCorporationAnchoring,cognitivebias,440Annualfnancialstatements,243Annualfundoperatingexpense(expenseratio),51Annualpercentagerate(APR),209,211,558calculation,234conversion,209effectiveannualrate,comparison,233–235Annualpercentagereturn,557Annualreturn,478Annuities,221–230futurevalue,223presentvalue,example,224–225value,determination,222–223Annuitydue,558futurevalue,227valuation,227APR. See AnnualpercentagerateAPT. See ArbitragepricingtheoryArbitrage,371opportunities,461principle,461–463Arbitragepricingtheory(APT)model,461–466factors,identifcation,465–466formulation,463–464Arbitrageurs,risklessproft,357Arithmeticaveragerateofreturn,403–404Arithmeticaveragereturn,208Arithmeticrateofreturn,558ART. See AlternativerisktransferArticlesofincorporation,92–93,558Assetallocation,393–394,558. Seealso Dynamicassetallocation;Policyassetallocation;TacticalassetallocationAsset-backedbonds,397Asset-backedsecurities(ABSs),533,558debtsecurity,28issuance,397Assetdispositioncashfows,MACRS(usage),314Asset/liabilitymanagementconstraints,486Assetmanager,558Assetpricingmodel,558characteristics,446–447Assetpricingtheory,445Assetreturncorrelation,424distributions,standarddeviation,423eprobabilitydistribution,421eAssets,68–71,558. Seealso Intangibleassets;Tangibleassetsacquisition,304–306carryingvalue,70classes,392,394–398. Seealso Alternativeassetclassescost,304covariance/correlation,calculation,425edisposition,306–309importance,309expectedreturn,448,450management,6,59–60,257–258,558companies,48–49,558usage,390marketprice,adversemovement,462purchase,accomplishment,357retirementliability,72,558salvagevalue,absence,77transformation,19turnover,558. Seealso TotalassetturnoverAsymmetricinformation,23,558impact,180Atlanticoption,364,558At-the-moneyoption,372,558Attractiveprovisions,inclusion,473–474
Index 575 Auctionmarket,30Auctionprocess,30Averagecreditsalesperday,558calculation,248Averageday’scostofgoodssold,247–248,558calculation,247Averageday’spurchasesoncredit,determination,249Averagepurchasesperday,558calculation,249Balancedmarketcondition,455Balancedscorecard,122–124,558managementtool,122process,123eBalancesheet,266,558. Seealso Proformabalancesheetexample,70e,277eintangibleassetvalue,71structure,74Balloonpayments,231BancofAmericaSecurities,56Bandwagoneffect,cognitivebias,440Bankcollateral,45funding,44–45loans,5regulation,45–46Bankers’acceptance,26,558short-termloans,28Bankholdingcompanies,totalassets,43BankInsuranceFund(BIF),46BankofCanada,60Bankruptcy,169–170,558costs,169–170,558classifcation,170directcosts,170increase,170indirectcosts,170likelihood,increase,174Baseinterestrate,470–476,558calculation,470BaselCommitteeonBankingSupervision,risk-basedcapitalrequirementsguidelines,46Basic,term(usage),356Basicearningpower,calculation,262,264Basicearningspershare,76,558Basicearningspowerratio,262Behavioralfnance,portfoliotheory(relationship),438–441Benchmark,392Benchmark-basedapproach,436Bermudaoption,364,559Best-effortsunderwriting,57,559Beta,559values,448–449Biasedexpectationstheory,484,485,559Bid-askspread,58BIF. See BankInsuranceFundBills,currentasset,68Biogen,Dutchauction,148eBirdinthehandtheory,142,143–144Black,Fischer,147Black-Scholesoptionpricingmodel,380–383,559Boardofdirectorsdistributiondeclaration,134fduciaryduty,101formation,92,93information,145Bond-equivalentbasis,525Bond-equivalentyield,525Bondholder,29Bondingcosts,101,559Bondinvestmentscategories,397classifcation,398eBondpriceschange,reasons,521–522example,521quotes,523–524time,relationship,520–521yieldtomaturity,526e
576 INDEX Bonds,71,559cashfow,estimation,533–534debtsecurity,28dollarreturn,531esources,529–530impact,394investmentproperties,518issues,expectedliquidity,476price-yieldrelationship,518eproperty,518sale,5valuation,513–524embeddedoptions,inclusion,532–538values,519Bonus,559Bookvalue,70,559Borrowingrates,differences,361Break-evenmeasure,325Brokers,commissions(absence),136Budget,559development,114–115Budgeting,110,119–120,559. Seealso Capitalbudgeting;Operationalbudgetingapproval/authorization,299fnancialplanning,relationship,114–115initiation,116process,115–118strategy,relationship,111eBulldogmarket,26Businessenterprise,forms,90–97Businessentity,fnancialdecision-making,4–5Businessfnance,4–5,89,559Businessforms,95–96characteristics,91eprevalence,97eBusinessrisk,186–187,258,559combination,297involvement,example,194Bustedconvertible,538,559Buyers/sellers,interactions,17Bylaws,559adoption,92,93Callablebond,473,533,559valuation,534Callabledebt,474Calloptionsbuyer/writer,proft/loss,368edefaultright,169purchase,366–367writing/selling,367–368Callposition. See Longcallposition;ShortcallpositionCallprovision,473,559Callschedule,528,559Capital,559generation,146investmentdecision,295lease,72,560loss,529rationing,340–341recoveryperiod,324surplus,72yield,144,560Capitalassetpricingmodel(CAPM),447–460,559assumptions,449–451criticisms,460effcientfrontier,relationship,451etests,459–460utilitycurves,relationship,453Capitalbudgeting,295,559decision,5process,298–303illustration,298estages,298–299proposal,299techniques,321–343advantages/disadvantages,342e–343eusage,115Capitalcost,171–175,297,562calculation,example,174echange,173determination,reasons,171–172example,175operatingproft,contrast,121–122representation,328–329
Index 577 Capitalexpenditurescoverageratio,290Capitalgain,307,529income,taxation,144Capitalgainstax,147Capital-intensivecompanies,290Capitalmarket,2–4,28–29,560. Seealso Perfectcapitalmarketdebt,28theory,2,3–4Capitalmarketline(CML),451–454,560riskpremium,calculation,455Capitalstructure,5,155,560companyadjustment,173decisions,155–156,176–177differences,158fnancialdistress,relationship,170–171fnancialleverage,relationship,158–172Modigliani-Millertheory,176–180theory,179–180status,180value,179–180trade-offtheory,173–174CAPM. See CapitalassetpricingmodelCaptivefnancecompanies,42–43Carry,360. Seealso Negativecarry;PositivecarryCarryingvalue,70,560CAS. See CasualtyActuarialSocietyCashbudget,119change,81conversioncycle,560calculation,250currentasset,68dividends,stockdistributions(comparison),138equivalents,impact,394market,29,560payment,amount,93yield,359Cash-and-carrytrade,357–358,560. Seealso Reversecash-and-carrytradeCashfow,279–283,560. Seealso Incrementalcashfows;Operatingcashfowsanalysis,275example,322eusefulness,288–290calculation,276change,80defnition,280depreciation,contrast,312determination,investment(usage),303–321discountrates,application,522–523entry,119estimate,276estimation,example,324eexit,119fundsfow,275–276generation,80information,usage,291interestcoverageratio,560calculation,261measurementdiffculties,275–283no-arbitragefuturesprice,presence,359eoccurrence,224,227prediction,117promise,219receipt,assumption,325relation,281–282remainder,146risk,sources,296–297statement,79–81,279–283example,79e,246e,278etimeline,222e,224e,228etiming,role,336uncertainty,202usage,218value,change,202Cashfowfromacquiringassets,calculation,304Cashfowfromdisposingassets,calculation,306
578 INDEX Cashfowfromfnancingactivities. See FinancingactivitiesCashfowfromoperatingactivities. See OperatingactivitiesCashfowfromoperations. See OperationsCashfowreturnoninvestment(CFROI),120Cashfowseriesfuturevalue,220occurrence,225–226timevalue,217–221Cashfowtocapitalexpenditurescoverageratio,560calculation,290Cashfowtodebtratio,560calculation,291Cashinfow(CIF),194positivevalue,328Cashoutfow(COF),194calculation,305Cashsettlementcontracts,352,560Cashvalueadded(CVA),120CasualtyActuarialSociety(CAS),ERMdefnition,189Catastrophe-linkedbond,196,560example,197Catastrophicriskmanagement,191,560Catbond,560CD. See CertifcateofdepositCDS. See CreditdefaultswapCedarFair,masterlimitedpartnership,95Certifcateofdeposit(CD),395,560. Seealso Negotiablecertifcateofdepositwrittenpromises,27CFROI. See CashfowreturnoninvestmentCFTC. See CommodityFuturesTradingCommissionCharacteristicline,458,560ChiefFinancialOffcer(CFO),function,124–125CIF. See CashinfowCITGroup,Inc.,failure,46Classicalsafety-frstportfolio,436Classicalsafety-frstrules,561Clearinghouse,role,353Client-imposedconstraints,398Closecorporation,93,561Closed-endfund,49,51,561Closelyheldcorporation,93,561Closingprice,51–52CML. See CapitalmarketlineCOF. See CashoutfowCognitivebiases,440,561examples,440–441COGS. See CostofgoodssoldCommercialbank,43,561fnancialintermediary,usage,19services,44Commercialpaper,26,561promissornote,27CommitteeofSponsoringOrganizationsoftheTreadwayCommission(COSO),ERMdefnition,189CommodityFuturesTradingCommission(CFTC),23Commodityswap,378,561Common-sizeanalysis,266–268,561Common-sizebalancesheet,267Commonstock,16,561cost,173example,16impact,394purchaseright,534–535stylecategories,395–396valuation,491Companiesbase,multiples(application),508–509borrowingdependence,288capitalcost,172estimation,172–173capitalstructureadjustment,173decisions,176–177
Index 579 cashfowexit,119commitmentarrangement,57comparison,76–77competitors,barriers(absence),113debtusage,171dividendcuts,investorpenalization,141–142payments,145economicprofts,generation,126fnancialhealth,examination,80fnancialrestructuring,59fnancingbehavior,174liquidity,244multiplesbase,estimation,507–508calculation,506–507OCF,change(calculation),317operatingperformance,244postauditing,usage,110stockdistribution,shareprice,139strategy,effectiveness(measurement),123sustainabilityrisk,189value,change,303Comparativeadvantage,111,561Competitiveadvantage,111–112,561Complementaryprojects,561dependenceform,303Compliance,ERMriskobjective,190Componentpercentageratios,258–260Compoundaverageannualreturn,208Compoundfactor,205Compoundgrowthrate,499Compounding,202,561. Seealso Continuouscompoundingfrequencies,210e,215–216example,212multiplicity,209–211periods,conversion,209translation,214–215Compoundinterest,204,561Conditionalvalueatrisk(CVaR),436,561Confrmationbias,cognitivebias,440Constantdiscountrate,assumption,496ConstantgrowthDDM,498–500ConstantrateDDM,usage,500Consumerfnance,transparency(increase),24Consumerpriceindex(CPI),interest(linkage),56Consumerprotection,enhancement,24Contingentprojects,302–303,561Continuouscompounding,211–212,561Contractingcosts,561reduction,21–22Contractofindemnity. See IndemnitycontractConversionparityprice,536,561Conversionprovision,473–474,561Conversionratio,534,561Conversionvalue,561equation,535Convertible. See BustedconvertibleConvertiblebond,16–17,76,474,562conversion,533convertiblemeasures,537parvalue,534–535sale,problem,535–536traditionalvalue,535–538valuation,534–538example,536eConvertiblenote,16–17,562Convertiblepreferredstock,76Copyrights,intangibleasset,70Corerisk,186,562. Seealso NoncoreriskCorporatebonds,397Corporatefnance,4–5,562Corporatefnancingdecision,155Corporatemanagers,takeoverdefensiveness,100Corporateplan,54Corporateriskmanagement,catastrophe-linkedbonds(usage),196–197
580 INDEX Corporations,92–94,562balancesheets,245eboardofdirectors,fduciaryduty,101capitalcost,determination(reasons),171–172cashretention,136characteristics,91eDRPbenefts,136incomestatements,example,246elegalentity,92marketcapitalization,396ownership,93shares,buyback,148Correlation,562coeffcient,425COSO. See CommitteeofSponsoringOrganizationsoftheTreadwayCommissionCostofcapital. See CapitalcostCostofcarry,360Costofgoodssold(COGS),74,247usage,254Costofsales,74Costreduction,economicfunction,19Counterparty,351,376,562risk,355,562exposure,376Couponinterest,514Couponpayments,514Couponrate,yield/price(relationship),519–520Covariance,424–425Covarianceofarandomvariable. See RandomvariableCoverageratio,260–262. Seealso Interestcoverageratiofxedfnancingobligationsatisfaction,258indication,261CPI. See ConsumerpriceindexCreditevents,379ratings,471erisk,186spread,472,562Creditdefaultswap(CDS),379,562Creditors,29,562problems,168–169Creditprotectionbuyer,379,562seller,379,562Credit-ratingfrms,transparency(increase),24Crossoverrate,562solution,331–332Currencycurrentasset,68risk,194swap,378,562Currentassets,68,244,562. Seealso Noncurrentassetscompanyrequirement,69requirement,252types,68–69Currentliability,71,244,562Currentratio,244,562calculation,251Currentyield,524–525,562calculation,524yieldtomaturity,relationship,526eCustomerneeds,balance,122CVA. See CashvalueaddedCVaR. See ConditionalvalueatriskDateofrecord(recorddate),134,562Dayspayablesoutstanding(DPO),249–250calculation,250Dayspurchasesoutstanding(DPO),563Dayssalesininventory(DSI),563calculation,248Dayssalesoutstanding(DSO),563calculation,248DB. See DefnedbeneftDC. See DefnedcontributionDCF. See DiscountedcashfowDDM. See Dividenddiscountmodel
Index 581 Debt,15,563acquisition,17after-taxcost,173equity,contrast,15–17,156–164fnancinggovernancevalue,166–167role,161instrument,15,26,563interestpayment,taxdeductibility,178–179marginalcost,173marketvalues,158obligation,fxed/limitednature,159principalvalue,example,16ratio,563calculation,157relativecosts,concern,176securities,components,28–29taxdeductibility,value,167eDebt-equityratio. See Debt-to-equityratioDebtholder,29Debt-to-assetsratio,258,563calculation,157Debt-to-capitalratio,563Debt-to-equityratio(debt-equityratio),563calculation,157,259stockrepurchaseft,149Declarationdate,563Decliningbalancemethod,76,563Default-freeyieldcurve,486Defaultright,169Defaultrisk,563impact,471–472Deferredannuity,230,563problems,230timelines,232evaluation,229–230Deferredincometaxliability,source,77Deferredtaxassets,source,77Deferredtaxes,72liability,563Defnedbeneft(DB)plan,55,563Defnedcontribution(DC)pensionplans,legalforms,55Defnedcontribution(DC)plan,55,563Degreeoffnancialleverage(DFL),563calculation,164interpretation,165Deliverydate,351,563Demanddeposit,44–45,563Deposit. See Demanddeposit;Savingsdeposit;Timedepositsources,45Depositoryinstitution,43–46,563Depreciablebasis,76Depreciation,70,76–79. Seealso Accumulateddepreciationcashfow,contrast,312change,example,319examples,312–313inclusion/exclusion,311methods,72recapture,307taxshield,563timing,77Derivativecontracts,types,349–350Derivativeinstruments,23,29,563companyinformation,83usage,shareholderconcerns,195Derivatives,563market,29risk,195usage,349hedgefundstrategy,53DFL. See DegreeoffnancialleverageDilutedearningspershare,76,563Directcosts,170Disabilityinsurance,47Disclosureregulation,22Discount,519Discountbond,price-timerelationship,520eDiscountedcashfow(DCF)methods,503models,491–502techniques,application,340–341
582 INDEX Discountedpaybackperiod,323,564payback,326–327Discounting,202,564periods,number,226Discountrate,45,297,564estimation,497example,215eDiscretionarycashfow,282Dispersionmeasures,435Dispositioncashfows,straight-linerate(usage),309Dispositioneffect,cognitivebias,440Distributions. See Stocksboardofdirectorsdeclaration,134types,137–138Diversifableriskfactors,447,564Diversifcation,564achievement,21economicfunction,21impact,446–447reliance,399–400usage,19Diversify,term(usage),564Dividenddiscountmodel(DDM),492–494,564. Seealso FinitelifegeneralDDM;Three-stageDDMexamples,494–501expectedreturns,relationship,501–502usage,498Dividendirrelevancetheory,142,143Dividend-payingstocks,pricevolatility,144Dividendpayoutratio,564calculation,135constancy,141equation,493Dividendpershare,134–135,564calculation,134constantgrowth,141Dividend-priceratio,493,564Dividendreinvestmentplan(DRP)(DRIP),136–137,564shareholder/corporationbenefts,135Dividends,93,133–137,564. Seealso Stocksabsence,141cashform,134cutting,145date. See Ex-dividenddatedecision,residualdecision(comparison),143example,136expectedgrowthrate,498measures,492–494example,494paymentdecision,146–147theories,142–143policies,133,141–147puzzle,146–147yield,144,564Dividendspershare,564equation,492–493Dividendsreceiveddeduction,144–145,564range,145DJSI. See DowJonesSustainabilityIndexDollarreturn,564Dollar-weightedaveragequarterlyreturn,408Dollar-weightedrateofreturn,403–404,406–409. Seealso Returndetermination,406example,406–407result,407Domesticfnancialsectors,43–60Domesticmarket,24,564Domesticnonfnancialsectors,39–42DowJonesSustainabilityIndex(DJSI),187Downsiderisk,436–437564Downward-slopingyieldcurve,482DPO. See Dayspayablesoutstanding;DayspurchasesoutstandingDRIP. See DividendreinvestmentplanDRP. See Dividendreinvestmentplan
Index 583 DSI. See DayssalesininventoryDSO. See DayssalesoutstandingDuPontsystem,263–266,565Dutchauction,147–148,565Dynamicassetallocation,393,394,565EAR. See EffectiveannualrateEarningspotentialdilution,76quality,288Earningsbeforeinterest,tax,depreciation,andamortization(EBITDA),565calculation,276Earningsbeforeinterestandtaxes(EBIT),254,504inclusion,261Earningspershare(EPS),75–76,506. Seealso Basicearningspershare;Dilutedearningspersharedecline,141increase,149EBIT. See EarningsbeforeinterestandtaxesEBITDA. See Earningsbeforeinterest,tax,depreciation,andamortizationEconomicagents,438,565Economicfactors,sensitivity,392Economiclife,565investmentprojectclassifcation,300Economicmodeling,451Economicproft,121calculation,121eEconomictheoryofchoice,416–417Economicvalueadded(EVA),120–122,565. Seealso RefnedeconomicvalueaddedEconomy,fnancialsystem(components),3–4Effectiveannualrate(EAR),565annualpercentagerate,contrast,233–235calculation,235trueeconomicreturn,234Effectiverateofinterest. See InterestEffectivetaxrate,94Effcientfrontier,565CAPM,relationship,451eEffcientportfolio,401,418,565. Seealso Mean-varianceeffcientportfolioassets,inclusion,431e,432econstruction,429–430feasibleportfolio,430–432optimalportfolio,relationship,418reference,429risk-freeasset,combination,452Effcientset,430–431optimalportfolio,choice,432–4338-Kflings,193Embeddedoption,474Emergingmarkets,397EmployeeRetirementIncomeSecurityActof1974(ERISA),55Employeestockownershipplan(ESOP),55,565End-of-dayNAV,50–51End-of-the-dayprice,51–52Endowments,391Enronearningsinfation,103scandal,185Enterprise,term(usage),189–190Enterpriseriskmanagement(ERM),188–193,565application,6CASdefnition,189concern,191COSOdefnition,189defnition,188–190riskobjectives,190scope,191themes,191–192illustration,192eEntity,riskpolicyspecifcation,193EPS. See Earningspershare
584 INDEX Equity,72–73,155,565. Seealso Investor;Ownersbookvalue,259components,28debt,contrast,15–17,156–164fnancing,159obligation,absence,157freecashfow,567instrument,16,565investmentstyle,395,565marketvalues,158,260owners,rewards,165portfolios,benchmarks,392relativecosts,concern,176return,160example,161eEquivalenttaxableyield,473,565ERISA. See EmployeeRetirementIncomeSecurityActof1974ERM. See EnterpriseriskmanagementESOP. See EmployeestockownershipplanETF. See Exchange-tradedfundEurodollarCD,27Euromarket,26,565EuropeanCentralBank,60EuropeanInvestmentBank,60Europeanoption,364,373,565EuropeanUnioncompanies,IFRSusage,84EVA. See EconomicvalueaddedEvaluationperiod,401Excessmargin,354Excessreserve,45,565opportunitycost,45Exchange,31,565Exchange-tradedfund(ETF),49,51–52,566assets,growth,52epremiums/discounts,52Ex-date,134,566Ex-dividenddate,134,566Executivecompensation,101–104performance,relationship(absence),102–103Exerciseprice,566Exercisestyle,364Expansionproject,566impact,301Expectationstheory,484,566. Seealso PureexpectationstheoryExpectedcashfowsestimation,4,514presentvalue,328calculation,4Expecteddividendspershare,495Expectedportfolioreturns,415–416Expectedreturn,450calculation,420–421dividenddiscountmodels,relationship,501–502estimation,example,502Expectedshortfall,566Expectedtailloss,566Expenseratio,51,566Expensescashoutfow,315–316change,310–311,317–318example,319Expirationdate,367Explicitcosts,18Expostreturn,419Externalmanagement,plansponsoroption,55Externalmarket,26,566Extradividends,134periodicpayments,141Extraspecialdividends,142eFacevalue,566Factors,446Fairnessopinion,59Fairprice,507FASB. See FinancialAccountingStandardsBoardFDIC. See FederalDepositInsuranceCorporationFeasibleportfolio,430–432,566assets,inclusion,432eFeddiscountwindow,45,566FederalDepositInsuranceCorporation(FDIC),46
Index 585 Federaldepositoryinsurance,initiation,46Federalfundsmarket,45,566Federalfundsrate,45Federalgovernment,39FederalHomeLoanMortgageCorporation(FHLMC),government-sponsoredenterprise,40–41FederalNationalMortgageAssociation(FNMA),government-sponsoredenterprise,40–41FederalReserveBoard,46FederalReserve(Fed),37borrowing,45FHLMC. See FederalHomeLoanMortgageCorporationFiduciaryduty,101,566FIFO. See First-in,frst-outFinance,566defnition,15explanation,2feld,components,2–3,3emath,201relationship,2eFinancialAccountingStandardsBoard(FASB),66,83AccountingStandardsCodifcation,66IASB,cooperation,84Financialactivitiesregulation,22–24regulators,14Financialanalysis,566Financialassets,14,566creation,assistance,20management,20requirement,reasons,14–15trading,facilitation,20Financialcalculators,usage,206,334,516Financialdecision-making,tools,2Financialdistress,157,168–171,566bankruptcycosts,169–170capitalstructure,relationship,170–171direct/indirectcosts,absence,166increase,171taxes,trade-off,176Financialdistresscosts,169–171absence,178–179capitalstructuretheory,relationship,179–180presentvalue,increase,171Financialeconomics,566reference,1–2Financialfactor,involvement,194Financialfexibility,leverage(relationship),165–166Financialguaranteeinsurance,48FinancialIndustryRegulatoryAuthority(FINRA),23Financialinstitutionregulation,22,24Financialinstrument,13,566purchase/sale,hedgefundstrategy,53Financialintermediaries,3,14,566funds,acquisition,19role,15e,18–24staff,maintenance,22Financialleverage,245,258–262,566capitalstructure,relationship,158–162degree. See Degreeoffnancialleverageelevation,165effect,isolation,178ratios,example,262risk,relationship,164–167Financialmanagement,2,4–6,566objective,97–104ownerwealthmaximization,relationship,99Financialmanagers,decisions,6Financialmarkets,3,14economicunction,17–18provision,17–18role,17–18types,24–32Financialmeasures,123Financialneeds,122
586 INDEX Financialplanning,109,566budgeting,relationship,114–115components,114–115Financialplans,formulation,114Financialratiosanalysis,243usage,268–270classifcation,244–247usage,245Financialregulators,3Financialrestructuring,567. Seealso Companiesinvestmentbankinvolvement,58–59Financialrisk,258,567components,186management,185FinancialServicesAuthority(UnitedKingdom),53Financialservicesholdingcompanies,affliation,56Financialslack,165Financialstatements,65basics,67–81creation,assumptions,66–67footnotes,examination(reasons),82–83Financialstrategicplan,5Financialstrategy,109Financialsystem,13–17. Seealso UnitedStatescomponents,14,37Financialtheory,439Financingactivities,cashfow,80,560comparison,234cost,359decisions,5Finite-lifegeneralDDM,495,567assumption,498–499example,496inputs,496–497FINRA. See FinancialIndustryRegulatoryAuthorityFirm,freecashfow,567Firmcommitmenteffort,57offering,567underwriting,57First-in,frst-out(FIFO),83,567FitchRatings,471Fixedasset,567Fixedfnancingobligations,satisfaction,258Fixedincomeequivalent,538,567Fixedincomeinstruments,15Flatyieldcurve,482,567Flotationcosts,146FNMA. See FederalNationalMortgageAssociationFordMotorCredit,captivefnancecompany,42–43Forecastingimportance,118regressionanalysis,usage,117Foreigncurrencychanges,exposure,363translationadjustments,81Foreigninvestors,60Foreignmarket,24,26,567Foreignparticipantsgovernmentregulation,24regulation,22Formulae,intangibleasset,71Forward-lookingP/E,505Forwardrate,477–481,567predictionability,480Forwards,derivativecontracts,349Forwardscontracts,350,355–362position,liquidation,352–353pricing,basics,355–360usage,362–363Forwardstocksplit,137,567shareprice,139Foundations,391401(k)plans,55Framing,567cognitivebias,440Franchises,intangibleasset,70
Index 587 Freecashfow,146,287,567calculation,288reduction,dividendpayment(impact),146Freecashfowtoequity. See EquityFreecashfowtothefrm. See FirmFreeport-McMoran,specialdividendpayments,142eFront-loadedcashfows,325FTSE4GoodIndex,189Fulldisclosure,requirement,67Fullyamortizingloan,231Fundamentalfactormodels,465Fundedretainedrisk,567Fundingentity,government-sponsoredenterprise,41Fundsacquisition,fnancingdecisions,89long-termsources,172transference,14–15Futurecashfows,dividends(comparison),492Futuredividends,investoranticipation,98Futuresderivativecontract,349longposition,570price,350–351,567Futurescontracts,350–363,567. Seealso Nextfuturescontractinitialmargin/variationmargin,absence,358legalagreement,350options,differences,365–366position,liquidation,352–353pricing,basics,355–360sale,362–363usage,362–363Futurevaluecalculation,203–213example,207determination,compoundinterest(impact),205evenseries,223–224presentvalue,relationship,214representation,220timeline,218eGAAP. See GenerallyacceptedaccountingprinciplesGambler’sfallacy,cognitivebias,441GDP. See GrossdomesticproductGeneralElectricCreditCorporation,captivefnancecompany,43Generallyacceptedaccountingprinciples(GAAP),66,568framework,83GeneralMotors(GM),earningspersharedecline,141Generalpartnership,91–92,568Geometricaveragereturn,208Geometricmeanreturn,405GIC. See GuaranteedinvestmentcontractGlobalbanking,bankservice,44GlobalPartners,masterlimitedpartnership,95GlobalReportingInitiative(GRI),187Goingconcern,businesscontinuation,67Goldenparachutes,100GoldmanSachs,56Governmentbonds,397debt. See UnitedStatesdisclosureregulation,justifcation,22–23sector,39–42subsidy,representation,163Government-ownedcorporation,39–40,568Government-sponsoredcorporation,41Government-sponsoredenterprise(GSE),40–41,568types,40–41Grant,W.T.,292Greenhill&Company,56GRI. See GlobalReportingInitiative
588 INDEX Grossdomesticproduct(GDP). See UnitedStatessectors,contribution,37Grossplantandequipment,69,568Grossproftmargin,568calculation,253Grossproperty,plant,andequipment,69,568Grossspread,57Growthpatterns,three-phasemodeldesign,501Growthrates,208equation,216–217examples,209,211multiplicity,212–213GSE. See Government-sponsoredenterpriseGuaranteedinvestmentcontract(GIC),47–48,392example,207Half-yearconvention,77Healthinsurance,47Hedgeablerate,480–481,568Hedgefunds,49,53–54,568institutionalinvestor,391operation,54strategies,53Heuristic,term(usage),568Heuristic-drivenbiases,440High-credit-qualityentities,counterparties,355Highgrade,term(usage),472High-yieldbonds,472Historicalcosts,usage,84Holdingperiodreturn,419,568Homogeneousexpectations,453Horizontalcommon-sizeanalysis,266–268,568example,269eHoulihanLokeyHoward&Zukin,56Humpedyieldcurve,482,568Hybridpensionplan,55–56IASB. See InternationalAccountingStandardsBoardIFRS. See InternationalFinancialReportingStandardsIllegalinsidertrading,23,568Implicitcosts,18Incentivefee,54Income,doubletaxation,94Incomestatement,74–79,266,568. Seealso Proformaincomestatementexample,75e,246e,278estructure,75eIncometaxesclassifcation,281companyinformation,82Incorporation,articles,92–93,558Incrementalcashfows,303,568Indebtedness,representation,28Indemnitycontract,195Independentdirectors,93,568Independentprojects,302,336–337,568Indexedfunds,568Indifferencecurves,416–418,433illustration,417eIndirectcosts,170Individualbanking,bankservice,44Individuallymanagedaccount,568Individuallysponsoredplan,54,568Industry,economicproftgenerationability,126Industry-specifcmultiples,determination,506Informationasymmetry,14,568Informationprocessingcostreduction,21–22time,opportunitycost,21–22Initialcashfow,example,305–306Initialmargin,353,568absence,358requirement,variation,354–355Innovation,needs,122Insidedirectors,568Institutionalbanking,bankservice,44
Index 589 Institutionalinvestorscomponents,391Institutionalinvestors,borrowingcost(absence),362Institutionalportfolios,395Insurance,195companies,47–48institutionalinvestor,391premium,195,569products,sale,47–48Insurance-linkednote,196,569Intangibleassets,14,70–71,569Interbankyieldcurve,569Interestamount,calculation,231creditorexpectation,156deductibility,162–164,178governmentsubsidyrepresentation,163effectiverate,234,565expensecashfow,relationship,281usage,163income,281taxtreatment,471U.S.federaltaxcodespecifcation,474taxability,474–475taxdeductibility,beneft(increase),171taxshield,178,569calculation,163Interest-bearinginstruments,353Interest-bearingratio,259Interestcoverageratio,569calculation,260companyinformation,260–261Interestonaccumulatedinterest,204Interestoninterest,204Interestrate,217. Seealso Baseinterestrate;Realinterestratecalculation,470–471determination,4,216–217differences,213structure,469,579swap,376–377,569usage,reason,377termstructure,476–483theories,termstructure,484–486yield,relationship,232–238Interimcashfows,361Intermediaries,13Internalmanagementneeds,122plansponsoroption,55Internalmarket,569Internalrateofreturn(IRR),235–236,323569. Seealso Modifedinternalrateofreturn;MultipleIRRscross-overrate,contrast,331–332decisionrule,335discountrate,comparison,337problems,336usage,333–338yield,comparison,334InternationalAccountingStandardsBoard(IASB),83FASB,cooperation,84InternationalBankforReconstructionandDevelopment,60InternationalFinancialReportingStandards(IFRS),84Internationalmarket,26In-the-moneyoption,569Intrinsicvalue,371–373,569difference,372Inventories,569currentasset,68fows,257level,reduction,318management,256,390reduction,252,320turnover,31calculation,256ratio,256Invertedyieldcurve,482,569Investableassets,395eInvestedcapital,resourcelevel,122Investmentbankerfunds,raising,57
590 INDEX Investmentbankingcompanies,classifcation,56–57Investmentbanks,56–60classifcation,56Investmentcashfow,304–309presentvalue,303Investmentcompanies,48–49,569Investmentmanagement,2–3,6–7,389,569activities,7eprocess,390e,400–401Investmentobjectivesclassifcation,391–392setting,7,391–392Investment-orientedproducts,47–48Investmentsadvice,provision,20client-imposedconstraints,398comparison,234consideration,226decisions,296–298discontinuation,104evaluationtechniques,323–324factors,398–399futurevalue,example,206eimpact,314manager,569outlay,absence,357policy,establishment,393–400presentvalue,204profle,330–331,569example,331eprojects,classifcation,300–303regulatoryconstraints,398–399return,increase,167riskindication,paybackperiod(usage),326screening/selection,298–299strategy,110taxconsiderations,399uncertainty,214unrealizedgains,81value,569yields,235–238Investor,569equity,569riskexpectations,394IRR. See InternalrateofreturnIrrelevanceproposition(M&M),177–178Issuer,569Jointventure,96,570JPMorganSecurities,56Junkbonds,472Kahneman,Daniel,438–439Kaplan,Robert,122Kellogg,dividendpayments,141Keynes,JohnMaynard,438Keyperformanceindicators(KPIs),570measures,123KPIs. See KeyperformanceindicatorsKrispyKreme,analysis,289–290Laggingindicators,122–123Largay,James,292Largecapitalizationstocks,396Last-in,First-out(LIFO),83,570Lawofoneprice,461Leadingindicators,122–123Leases. See Capitalleasecompanyinformation,82payments,258Legalrisk,186Lendingrates,differences,361Lettersofcredit(LOCs),46Leverageavailability,354–355fnancialfexibility,relationship,165–166hedgefundstrategy,53usage,example,162,164Leveragedportfolio,570Leveraging,354–355Liabilities,68,71–72,570Liability-drivenobjectives,391,392Liability-drivenstrategies,400Liabilityinsurance,47
Index 591 LIBOR. See LondonInterbankOfferedRateLifeinsurance,47LIFO. See Last-in,First-outLimitedliability,570role,168–169Limitedliabilitycompany(LLC),94–95,570Limitedliabilitypartnership(LLP),94–95,570Limitedpartner,92Limitedpartnership,92Linearpayoff,366Lintner,John,447Liquidity,17,245–253,570impact,18measures,251–252premium,570ratios,253risk,570theory,485,570Listed,term(usage),31,570LLC. See LimitedliabilitycompanyLLP. See LimitedliabilitypartnershipLoanamortization,230–232,570example,233eLoanpayments,calculationprocess,230–231Localgovernment,issuer/investorrole,41–42LOCs. See LettersofcreditLondonInterbankOfferedRate(LIBOR),376–377,486,570EurodollarCDinterestrate,27Longcallposition,366–367,570Longfutures,351,570Longposition,351Longpositioninfutures. See FuturesLongputposition,369,570Long-runplanning,115,570Long-termassets,decisions,300Long-termborrowers,interestrate(elevation),20Long-termcapital,focus,158Long-termcareinsurance,47Long-termdebtcompanyinformation,82exclusion,259Long-termindebtedness,71Long-terminvesting,fundsprocurement,5Long-termliability,571types,71–72Long-termplanning,115,571Lostsales,fnancialdistresscost,169Lowerpartialmoment,436riskmeasure,436–437Low-riskinvestments,395Lump-sum,present/futurevalue(calculation),232–233M&A. See MergersandacquisitionsMACRS. See ModifedAcceleratedCostRecoverySystemMAD. See Mean-absolutedeviationMaintenancemargin,353,571Managementfocus,112–113forecasts,118. Seealso Salesperformance,evaluation,110Managers,motivation(executivecompensation),101–104Mandatedproject,571governmentrequirement,301Marginaltaxrate,571calculation,usage,173Marginrequirements,353–354Market,13anomaly,571capitalization(marketcap),97–98,571example,98conversionprice,536,571liquidityrisk,186makers,31priceeffciency,400risk,186,447,571structure,30,571. Seealso Order-drivenmarketstructure;Quote-drivenmarketstructuresurveys,118
592 INDEX Marketablesecurities,571currentasset,68Marketconversionpremiumpershare,571equation,537Marketconversionpremiumratio,equation,537Marketeffciency,31–32issuerimplications,32semi-strongform,32,578strongform,32,579weakform,32,581Marketsegmentationtheory,485–486,571Marketvalueadded(MVA),120,122,571Marketvalueofshareholderequity. See ShareholdersMarketvaluetobookvalue(MV/BV)ratio,503–504Markowitz,Harry,7,190,421–422,450formulation,422–423. Seealso PortfoliotheoryMarkowitzdiversifcation,571strategy,426–427Mark-to-marketrequirements,absence,356Masterlimitedpartnership(MLP),95–96,571ownershipinterests,96Matadormarket,26Matchingprinciple,usage,67Maturityintermediation,20–21,571economicfunction,19Maturityspread,476,571Maturityvalue,514–515,571MBSs. See Mortgage-backedsecuritiesMean-absolutedeviation(MAD),435,571Meanreturn,450Mean-standarddeviation,571Mean-varianceanalysis,424,437,450,571Mean-varianceeffcientportfolio,430,572Medium-termnotes,debtsecurity,28Merchantbanking,572activity,59Mergers,investmentbankadvice,58–59Mergersandacquisitions(M&A),58–59Mid-capitalizationstocks,396Miller,Merton,143,176–178irrelevanceproposition,177–178Minorityinterest,572information,73MIRR. See ModifedinternalrateofreturnMLP. See MasterlimitedpartnershipMMDA. See MoneymarketdemandaccountModernportfoliotheory(MPT),190,572ModifedAcceleratedCostRecoverySystem(MACRS),77–79,572asset,320depreciation,79rates,313erates,77eusage,312,314,338–339Modifedinternalrateofreturn(MIRR),323,572example,340eModigliani,Franco,143,176–178irrelevanceproposition,176–177Moneymanagement,6,390,572manager,390,572market,26–28,572timevalue,326value,determination,201–203Moneymarketaccounts,395Moneymarketdemandaccount(MMDA),45,572Moneypurchasepensionplans,55Money-weightedrateofreturn,406,572
Index 593 Monitoringcosts,572MonsantoCompany,entrybarriers,112MonteCarlosimulationmodel,534Moody’sInvestorsService,471Mortgage-backedsecurities(MBSs),533,572Mossin,Jan,447Mostdistantfuturescontract,352MPT. See ModernportfoliotheoryMultifactorriskmodels,464–465MultiphaseDDM,500–501Multiplegrowthrates,212–213MultipleIRRs,337eMunicipalbonds,397Municipalyieldratio,475,572Muni-Treasuryyieldratio,475,572Mutualfunds,50–51fnancialintermediary,usage,19Mutuallyexclusiveprojects,302,335,572MVA. See MarketvalueaddedMV/BV. See MarketvaluetobookvalueNationalmarket,24,572NationalRailroadPassengerCorporation(Amtrak),government-ownedcorporation,39–40NAV. See NetassetvalueNCF. See NetcashfowNearbyfuturescontract,352,572Negativebias,cognitivebias,441Negativecarry,360Negativeinvestingcashfows,80Negativenetpresentvalue,330Negotiablecertifcateofdeposit,26,572investorpurchase/sale,27Netassetvalue(NAV),calculation,50Netcashfow(NCF),80,319–320,573calculation,320Netfnancingcost,359costofcarry,term,360Netincome,267examination,82Netoperatingcycle,573Netplantandequipment,69,573Netpresentvalue(NPV),323,573decisionrule,329–330example,333profle,330–331quality,335usage,327–332Netproftmargin,573calculation,254Netproperty,plant,andequipment,69,573Networkingcapital,247,573change,316cushion,252increase,314Networkingcapitaltosalesratio,252,573calculation,251Newproducts/markets,301NewYork/NewJerseyPortAuthority,41NewYorkStockExchange(NYSE),31MLPlisting,95Nextfuturescontract,352,573Nintendo,salesforecastexample,116–117No-arbitragefuturesprice,absence,359eNominalinterestrate,234Non-banklenders,regulation(increase),24Noncashexpenditures,80Noncorerisk,185,573Noncurrentassets,69Nondepositoryfnancialinstitutions,46Nondiversifableriskfactors,447,573Nonfnancialbusinesses,42–43Non-fnancialmeasures,123Nonfnancialstakeholderissues,180Noninvestment-gradebonds,472Nonliability-drivenobjectives,391–392Nonlinearpayoff,573
594 INDEX Nonsystematicrisk,573reduction,diversifcation(usage),457Nontraditionalassetclasses,397Non-Treasuryissues,expectedliquidity,471Non-U.S.corporations,securitiesissuance,26Norton,David,122Note,573debtsecurity,28Noteholder,29Notespayable,71,573Notionalamount,376,573Notionalprincipalamount,376,573NPV. See NetpresentvalueNumberofdaysofcredit,248,573Numberofdaysofinventory,573Numberofdaysofpurchase,249–250,573NutraSweetCompany,entrybarriers,112NYSE. See NewYorkStockExchangeOCF. See OperatingcashfowsOff-balancesheetobligations,46OffceoftheComptrolleroftheCurrency,46Offshoremarket,26,573Open-endfund,49,50,573Openinterest,573Openmarketpurchases,147Operatingactivities,cashfow,560Operatingcashfows(OCF),303,309–313,573analysis,309calculation,317–319change,317–318classifcation,281presentvalue,304taxes,impact,311Operatingcycle,247–250,573calculation,249examples,69e,250investmentconversion,250Operatingearnings,262decrease,171example,162–163Operatingincome,74Operatingperformance,244aspects,245Operatingproft,capitalcost(contrast),121–122Operatingproftmargin,573calculation,254decline,265Operatingrisk,187,296,573determination,297Operationalbudgeting,115,573Operationalrisk,186Operationalriskmanagement,125Operationscashfow,80,81,560ERMriskobjective,190Optimalcapitalstructure,573theory/practice,175–180Optimalportfolio,418,432–433,574effcientportfolios,relationship,418selection,433eOptionbuyerlossmaximum,365proft/lossprofle,368Optionholder,364Optionlifeanticipatedcashpayments,373,375expectedvolatility,373,374short-termrisk-freeinterestrate,373,374–375Optionpremium,364,574Optionprice,364,574components,371–375factors,373–375list,374eOptionpricingmodel,375. Seealso Black-ScholesoptionpricingmodelOptions,363–376derivativecontract,350expirationdate,370features,363–365
Index 595 futurescontracts,differences,365–366intrinsicvalue,371risk/return,366–371strikeprice,373timetoexpiration,373–374timevalue,372–373,580usage,375–376Optionwriter,364,574proft/lossprofle,368Order-drivenmarketstructure,30,574Ordinaryannuity,224,574OrientalLand,Co,catastrophe-linkedbonds(usage),196–197OTC. See Over-the-counterOut-of-the-moneyoption,372,574Outsidedirectors,93,574Overallassetmanagement,257–258Overconfdencebias,cognitivebias,441Over-the-counter(OTC)derivatives,46,379Over-the-counter(OTC)market,31,574Over-the-counter(OTC)option,365Ownersdownsidepotentialearnings,164earnings,risk(increase),171economicwell-being,measurement,97–99equity,155,574limitedliability,168upsidepotentialearnings,164wealth,296–298decrease,169maximization,99Ownershipinterests,73,96sale,5Par,presentvalue,515Partnerships,90–92,574. Seealso Generalpartnership;Limitedpartnership;Masterlimitedpartnershipagreement,91limitation,92characteristics,91edisadvantage,92Partnershipshare,16,574Parvalue,72,574Parvalueatmaturity,514Passivefunds,51,574Passiveportfoliostrategy,399,574Passivestrategy,4,574Patents,intangibleasset,70Paybackmethod,usage,325–326Paybackperiod,323,574usage,324–326Paymentdate,134,574Payoffperiod,324Payoutratio. See DividendsPBC. See People’sBankofChinaPensionfunds,49,54–56Pensionplans,companyinformation,82People’sBankofChina(PBC),60Perfectcapitalmarket,143,178Performanceattributionmodels,410evaluation,120–124,401–410,574. Seealso Managementmeasure,409–410executivecompensation,relationship(absence),102–103indicators,124emeasurement,401–410motivation,stockoptions(usage),102shares,101,574transactioncosts,impact,401Periodiccouponinterestpayments,514issuercreation,530Periodicinterestpayments,reinvestmentincome,529Periodnotation,218Perpetuity,574example,226valuation,225–226Physicalproperty,395
596 INDEX PI. See ProftabilityindexPlanningprocess,evaluation,110Plansponsor,574options,55Plowbackratio,574Policyassetallocation,393,574Porter,Michael,126Porter’sfveforces,126e,575disadvantages,128threats/powers,127ePortfolio,390,575construction,400–401cost,462–463creation,463–464diversifcation,426–428expectedreturn,430eestimation,418–421investmentset,7management,6,390,575manager,575monitoring,400–401nonliabilityobjective,392risk-returncombination,432robustoptimization,437–438selectiontheory,issues,434–438strategy. See Passiveportfoliostrategyclassifcation,7selection,399–400variance,454Portfolio M , 455Portfolioreturncalculation,402–403expression,402variance,457Portfolioriskacceptablelevels,415–416components,457ecorrelation,427–428measurement,421–426objective,392Portfolioselectionalternativeriskmeasures,434–435concepts,416–418goal,415–416theory,7,415Portfoliotheorybehavioralfnance,relationship,438–441Markowitzformulation,422–423Position,liquidation,352–353Positivecarry,360Positivelyslopedyieldcurve,481–482,575Positivenetpresentvalue,329–330Postauditing,usage,110Post-completionaudit,299Postpaybackduration,575Post-paybackduration,325Powerindex,437Preferredhabitattheory,485,575Preferredshareholder,creditorseniority,172Preferredstock,16,575cost,173dividends,260Premium,519–520,575Premiumbond,price-timerelationship,522ePrepayment,575Presentvalue,203calculation,213–216,220,328calculator,usage,215determination,219examples,215e,216formula,221futurevalue,relationship,214timeline,219e,221ePretaxearnings,minimumrequirements,31Price,couponrate/yield(relationship),519–520Pricediscovery,17,575Price/earningsratio(P/Eratio),503averaging,506–507comparison,504–505Price-earningsratios,399Priceeffciency,3,575Price-effcientmarket,31–32Price-to-bookvaluepershare(P/B)ratio,396
Index 597 Price/Xratios,503,504Price-yieldrelationship,518ePrimarymarket,30,575Primebrokeragesecurities,59Principal,575creditorexpectation,156Principalrepayment,258amount,calculation,231Privateplacement. See Securitiesofferings,30Privateplan,54,575Probabilitydistribution,575Procter&Gamblecommonstock,example,16interestrateswaploss,196Productioncost,changes,254Professionalcorporation,96,575Proftabilityindex(PI),323,575example,333NPVinformation,usage,332–333Proftabilityratio,245,253–255,575example,255indication,255Proftmargin. See Grossproftmargin;Netproftmargin;Operatingproftmarginratio,253Proformabalancesheet,120,575Proformaincomestatement,120,575Project,295. Seealso Independentprojectscashfowanalysis,321consideration,337estimation,example,324echoice,335classifcation. See Investmentsdependence,investmentprojectclassifcation,302–303discountedcashfowtechniques,application,340evaluation,317NPV,333–334OCF,presentvalue,304paybackperiod,324–326result,316tracking,299workingcapital,change,316Propertyandcasualtyinsurance,47Proprietarytrading(proptrading),58Prospecttheory,439,575Publiccorporation,576shares,trading,93Publiclyheldcorporation,93,576Publicly-tradedcompanies,compensationdisclosure,102Publicmarketofferings,30Publicpensionfunds,42Publicplan,54Pureexpectationstheory,484–485,576Putablebond,473,533,576valuation,534Putoptions,364buyer/writer,proft/loss,371epurchase,369–370,375writing/selling,370–371Putposition. See Longputposition;ShortputpositionPutprovision,473,576Quadraticprogramming,429–430Quantitativerisk-returnoptimization,application,437Quarterlycompounding,example,210–211Quarterlyfnancialstatements,243Quickassetstocurrentliabilities,two-for-oneratio,251–252Quickratio(acid-testratio),557calculation,251Quote-drivenmarketstructure,31,576Randomvariablecovariance,562standarddeviation,578variance,422Rateofreturn. See ReturnRatingagencies,471,576
598 INDEX Ratiosanalysis,290–291application,245interpretation,269Ratios,classifcation,244–245R&D. See ResearchanddevelopmentRealestate,impact,394Realinterestrate,470,576Recorddate. See DateofrecordReferenceentity,379Referencerate,376Refnedeconomicvalueadded(REVA),120Regressionanalysis,117,576Regressionline,576Regulatedinvestmentcompany(RIC),49–51,576assets,49ecosts,types,51institutionalinvestor,391investorcost,51types,49Regulatoryconstraints,398–399Reinvestmentrate,339assumption,336yieldtomaturity,relationship,530–532Reinvestmentrisk,473,576Relativereturn,54,576Relativevaluation,576methods,503–509principles,504–505process,505eRelativevalue,assessment,498Rembrandtmarket,26Reofferingprice,57,576Replacementproject,576components,301Repo. See RepurchaseagreementReporting,ERMriskobjective,190Repurchaseagreement(repo),26,59,576rate,27short-termborrowing,27Requiredrateofreturn(RRR),297,576Requiredreserve,576Requiredyield,577Researchanddevelopment(R&D),investment,71Reserveratio,45,577Residualloss,101,577Residualvalue,76Restrictedstockgrant,102,577Retailstoresoperation,115Retainedearnings,72,577Retainedrisk,193–194. Seealso FundedretainedriskRetentionratio,577calculation,135Retirementbenefts,basis,56Retirementprograms,companyinformation,82Return,401–402,577. Seealso Absolutereturn;Portfolioreturn;Relativereturnarithmeticreturn,558defnition,208dollar-weightedrate,564internalrate. See Internalrateofreturnleverage,usage(example),162measures. Seealso Alternativereturnmeasuresprobabilitydistribution,421erate,401–402,576. Seealso Money-weightedrateofreturn;Time-weightedrateofreturnrequiredrate. See RequiredrateofreturnReturnonassets(ROA)calculation,263,265examination,264Returnonequity(ROE)calculation,263,265dissection,264example,266ratio,breakdown,265Returnoninvestment(ROI),245,262–263ratios,262
Index 599 REVA. See RefnedeconomicvalueaddedRevenues,change,310,317–318Reversecash-and-carrytrade,358,361,577Reversestocksplit,137,577RIC. See RegulatedinvestmentcompanyRisk,577aggregate,193–194appetite,577aversion,450classifcation,186corporateacceptance,186defnition,185factors,446. Seealso Nondiversifableriskfactors;Unsystematicriskfactorsfnance,193–194,577fnancialleverage,relationship,164–167investmentprojectclassifcation,301–302measurement,3,417variance/standarddeviation,422–423neutralization,194,577policy,specifcation,193premium,446–447,470–471,577defaultrisk,impact,471–472reduction,diversifcation(usage),19,21retention,577decision,193tolerance,577transfer,194–195management,195Risk-basedcapitalrequirements,46Riskcontrol,577derivatives,usage,349process,191Risk-freeasset,450,577consideration,absence,451–452effcientportfolio,combination,452rateofreturn,example,458riskyasset,contrast,418variance,454Risklessasset,577Riskmanagement,193–197,577. Seealso Catastrophicriskmanagementculture,577SOAdefnition,192decision,193importance,6mishaps,derivatives(impact),196processes,6Risk-returncombinations,417Risksharinginstruments,362Risktransfermanagement,577Riskyassetsportfolio,420–421selection,428–433risk-freeassets,contrast,418variance,454ROA. See ReturnonassetsRobustportfoliooptimization,437–438ROE. See ReturnonequityROI. See ReturnoninvestmentRRR. See RequiredrateofreturnSafety-frstriskmeasures,435–437Safety-frstrules,577Salariespayable,71Salary,101,577Salescharge,51cost,74forecasts,116–117gains/loses,308emanagementforecasts,117price,changes,254ratio. See Networkingcapitaltosalesratiorisk,296,577economy,relationship,297volume,changes,254Salvagevalue,76,577absence,78Samuraimarket,26Sarbanes-OxleyActof2002,83,104
600 INDEX Savingsdeposit,44–45,577Savingsgoal,meeting,216,229Scheduledprincipalrepayment,231Scientifccalculators,usage,206SEC. See SecuritiesandExchangeCommissionSecondarymarket,30–31,578classifcation,31Securitiesfnance,59,578lendingtransaction,59,578markets,federalregulation,25eprivateplacement,58traders/tradingrules,23trading,58,400SecuritiesActof1933,30SecuritiesandExchangeCommission(SEC),838-Kflings,193informationgathering/publicationresponsibility,23Rule144A,30offerings,5810-Kflings,66,82,102,19310-Qflings,66SecuritiesExchangeActof1934,30Security,578Securitymarketline(SML),457–459,578expression,458Self-servingbias,cognitivebias,441Sellinggroup,58,578Semiannualcashfows,presentvalue,515Semiannualyield,doubling,525Semi-strongform. See MarketeffciencySemivariance,434–435,578variance,contrast,435Separatelymanagedaccount,49,54,578Settlementdate,351,578alternative,352Settlementprice,353Set-upexpenditures,304Share,578marketprice,98Shareholders,93,578DRPbenefts,136equity,72,578marketvalue,97–98statement,81fee,51sharepurchases,transactioncosts(absence),136wealthmaximizationaccountingirregularities,relationship,103–104complication,180socialresponsibility,104Shareholdervalueadded(SVA),120Sharpe,William,447,456Shirking,100Shortcallposition,578Shortfutures,351,578Shortposition,351Shortputposition,578Shortselling,361–362Shortselling,hedgefundstrategy,53Short-termassets,investmentobjective,300Short-termbankloans,71Short-termforwardrates,behavior,484Short-termobligations,satisfaction,247,252Short-termrisk-freeinterestrate,373,374–375Signalingexplanation,143,145Silostructure,578Simpleinterest,204,578Single-indexperformanceevaluationmeasures,409–410Single-periodinvestmenthorizon,450Single-periodportfolioreturn,419–420SiriusXMRadio,convertiblenotesissuance,17Smallcapitalizationstocks,396SML. See SecuritymarketlineSOA. See SocietyofActuaries
Index 601 Socialresponsibility,shareholderwealthmaximization(relationship),104SocietyofActuaries(SOA),riskmanagementculturedefnition,192Soleproprietorship,90–92,578characteristics,91eprevalence,96Specialdividends,134Spotmarket,29,578Spread,578existence,470–471Spreadsheets,516program,usage,334usage,228,236StandardandPoor’s500(S&P500)index,392StandardandPoor’sCorporation,471Standarddeviation,430e. Seealso RandomvariableStatedconversionprice,578Statedvalue,578Stategovernments,issuer/investorrole,41–42Statementofcashfows. See CashfowStatementofshareholders’equity. See ShareholderStatementofstockholders’equity. See StockholderequityStatements,relationship,81–82Statisticalestimate,error,438Statisticalfactormodel,464–465Stickney,Clyde,292Stock-basedcompensation,82Stockdistributions,137–140cashdividends,comparison,138reasons,138–140shareprice,139types,137–138Stockdividends,578accountingdifferences,138–139example,140paymentreason,138Stockholderequity,statement,81Stocksacquisition,17appreciationright,101,578options,76,579purchaseright,101–102presentvalue,501–502repurchases,147–150methods,147–148reasons,148–150returns,historical/cross-sectionaldata,464–465shares,investorpurchase,98Stocksplits,137,579accountingdifferences,138–139example,140stockdividend,comparison,137Straight-linedepreciation,76,312,579Straightvalue,536,579StrategicERMriskobjective,190Strategicplan,110,579path,110–111Strategicriskmanagement,191Strategy,110,579budgeting,relationship,111ecompanyconceptualization,112dimensions,performanceindicators,124evalueaddition,112–114creation,relationship,124–128relationship,110–115Strikeprice,364,372,579level,372–373Strongform. See MarketeffciencyStructure. See InterestrateStructuredfnance,197,578Structuredportfoliostrategies,400Structuredsettlements,47Stylebox,578Subperiodreturn,403average,calculationmethodologies,403–404Subsidiary,ownershipinterest,73Sum-of-year’sdigitsmethod,76,579Sunkcost,305
602 INDEX SunMicrosystems,forward/reversestocksplits,140eSunocoLogisticsPartners,masterlimitedpartnership,95Supranational,579institution,60Sustainability,concept,189Sustainabilityrisk,186–188,579SVA. See ShareholdervalueaddedSwapcurve,579Swaprate,579yieldcurve,486–487,579Swaps,376–379,579derivativecontract,350types,376Syndicatedbankloan,28,579Systematicrisk,456–457,579examples,456factors,447,579systemicrisk,contrast,447Tacticalassetallocation,393–394,579Taft-Hartleyplan,54,579Tangibleassets,14,580Targetedblockrepurchase,147,148Targetrateofreturn,437Taxeschange,311–313considerations,399credit,304fnancialdistresscosts,trade-off,176usage,example,164Tax-freeincome,148–149Tax-preferencecalculation,142,144–145Taxshield. See Interestcalculation,163T-bills. See Treasurybills10-Kflings,66,82,10210-Qflings,66Tenderoffer,147–148,580TennesseeValleyAuthority(TVA),government-ownedcorporation,39Terminalprice,497Terminalvalue,usage,338–339Termstructure,shapedeterminants,481–482Theoreticalfuturesprice,360–362Three-cash-fowordinaryannuity,presentvalue(determination),229Three-stageDDM,500–501,580Timedeposit,44–45,580Timepremium,371–372,580Timesinterest-coveredratio,260Timevalue. See OptionTime-weightedaveragequarterlyreturn,408Time-weightedrateofreturn,403–406,580example,405result,407TokyoDisneyland,catastrophe-linkedbonds(usage),196–197TootsieRollIndustries,dividendpayments,141Totalassetturnover,580calculation,257ToyotaMotorCreditCorp.,motorvehiclevaluedecline,197Trademarks,intangibleasset,70Trade-offtheory,173–174Tradingatadiscount,51Tradingatapremium,51Traditionalassetclasses,395e,397Traditionalfnancialtheory,439Transactioncosts,361avoidance,366impact,401reduction,17Transactionshistoricalcostlevelrecording,assumption,66level,increase,314–315Treasurybills(T-bills),26–27,395,580Treasurysecurities,580Treasuryspotrates,477,580Treasurystock,580Treasuryyieldcurve,role,476–477Treynor,Jack,447Truereturn,208
Index 603 TruthinSavingsActof1991,233–234Turnoverratio,244indication,257TVA. See TennesseeValleyAuthorityTversky,Amos,438–439Two-assetportfolio,427–428example,427portfoliorisk,measurement,424varianceformula,454Twoforonestocksplit,137,139Two-parametermodel,422–423,580Two-yearinvestmenthorizon,478–479Tyco,scandal,185UIT. See UnitinvestmenttrustUnattractiveprovisions,inclusion,473–474Uncertainty,degree,323,326Underlyingexpectedvolatility,373marketprice,373term,usage,29,350,580Underlyingasset,29,350,580Underwriting,30arrangements,types,57function,57syndicate,57–58,580Unevencashfows,218eUnfundedretainedrisk,194,580UnitedKingdom,FinancialServicesAuthority,53UnitedStatesaccounting,contrast,83–84corporationsdividendpayments,141foreigncorporationjointventures,96fnancialsystem,map,38eGDP,38egovernmentdebt,40egovernment-sponsoredenterprise,examples,41esecuritiesmarkets,federalregulation,25eUnitedStatesPostalService(USPS),government-ownedcorporation,39–40Unitinvestmenttrust(UIT),49,51,580Unknowninterestrate,determination,216–217Unsystematicrisk,456–457examples,456factors,447,580Unvaluedcontract,195,580Upward-slopingyieldcurve,481–482,485,580Usefullife,580USPS. See UnitedStatesPostalServiceUtilitycurves,CAPM(relationship),453eUtilityfunction,416–418,580illustration,418eValuation,fundamentalprinciple,4ValuBond,472Valueaddition,112–114creation,114sources,126–128strategy,relationship,124–128strategy,relationship,110–115Valueatrisk(VaR),436,580. Seealso Conditionalvalueatriskadvantages,436Valuedcontract,195,581. Seealso UnvaluedcontractValue-orientedinvestmentmanager,396VaR. See ValueatriskVariance. See Randomvariablesemivariance,contrast,435Variationmargin,353,581absence,358Verticalcommon-sizeanalysis,581example,267eVerticalcommon-sizebalancesheets,268eVivendiUniversal,earthquakedamageprotection,197
604 INDEX WachoviaSecurities,56Wagespayable,71Wal-MartStores,Inc.comparativeadvantage,111dividends,135eWaltDisneyCompany,bondsissuance,16Weakform. See MarketeffciencyWealthmanagement,6,581Workingcapital,247,581. Seealso Networkingcapitalaccounts,changes,80,82change,314–320classifcation,316concept,279decisions,115WorldBank,60WorldComexpensesaccounting,absence,103scandal,185Xerox,earningsrestatement,103Yankeemarket,581example,26Yield. See Capital;Equivalenttaxableyieldcalculation,232–233,528example,236–237compounding,525couponrate/price,relationship,519–520estimate,514example,527interestrate,relationship,232–238investmentreturn,235measure,475,524–532ratio. See Muni-TreasuryyieldratioYieldcurve,221,581examples,483eobservation,482eobservedshapes,477espread,581Yieldtocall(YTC),528–529Yieldtofrstcall,528Yield-to-frstcall,581Yieldtomaturity(YTM),525–527,581calculation,525currentyield,relationship,526ereinvestmentrisk,relationship,530–532Yieldtoparcall,528Yield-to-parcall,581Yieldtoworst,529,581Zero-couponbond,517,581package,522–523valuation,517Zero-couponsecurity,issuance,477Zero-couponTreasurysecurity,purchase,478
APPENDIX SolutionstoEndofChapterQuestions CHAPTER1 1. Financialmanagementisthemanagementofresourcesofabusinessen-tity,whereasinvestmentmanagementisthemanagementofinvestmentsinaportfoliothatismanagedforanindividual,aninstitution,oranentity. 2. Thediscountrateistheinterestratethattranslatesfuturecashfowsfromaninvestmentintoavaluetoday. 3. Theresponsibilitiesincludemanagingtheportfoliotobeconsistentwiththebenefciary’sinvestmentobjectives,constraints,andtaxsituation,whilealsoconsideringlegalconstraints. 4. Capitalbudgetingisdecision-makingpertainingtolongterminvest-ments,whereascapitalstructureisthemixoflong-termsourcesoffunding. 5. Currentassetsareassetsofanentitythatcanreasonablybeconvertedtocashwithinoneoperatingcycleoroneyear,whicheverislonger. 6.a. No.Aninvestorcannotconsistentlyearnabnormalproftsinaneffcientmarket. b. Ifamarketiseffcient,passiveportfoliomanagementisbest. 7. Thefnancingdecisioninvolvesdeterminingtheformofthefnancing(debtorstock),thetenor(thatis,thematurity)oftheobligationsthecompanywishestotakeon,andtheterms(e.g.,theinterestrateonthedebtorthenumberofsharesofstock). 8. Identifyrisk,assessit,andattempttomitigateitand/ortransferit. 9. Enterpriseriskmanagementisthemanagementoftherisksforanentityasawhole. 10. Setobjectives,establishinvestmentpolicy,selectaninvestmentstrategy,selectspecifcassets,measureperformance. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
APPENDIX SolutionstoEndofChapterQuestions CHAPTER2 1. Inthecaseofindebtedness,theborrowerhasacontractualcommitmenttorepaytheamountborrowedandinterest.Equityisanownershipinterestandtheexpectationofareturnontheinvestmentisintheformofdividendsandanypriceappreciation. 2. Preferredstockisequity,butitisafxedincomesecurity.Preferredstockmayormaynothaveafxedterm. 3. Mutualfundstakefundsfrominvestorsandtheninvestthesefundsinagroupofinvestments. 4. Maturityintermediationistheconversionofassetsorsecuritieswithshort-termmaturitiesintoassetsorsecuritieswithlonger-termmaturi-ties,orviceversa. 5. TheSecuritiesandExchangeCommission(SEC),CommodityFu-turesTradingCommission(CFTC),andFinancialIndustryRegulatoryAuthority(FINRA). 6. Examples:Commercialpaper,Treasurybills,negotiablecertifcatesofdeposit,bankers’acceptance,repurchaseagreements. 7. Anexchangehasaphysicalpresence,whereasanover-the-countermarketisanetworkofdealerormarketmakers. 8. Weakform(pricesrefectpastpriceinformation),semi-strongform(pricesrefectpublicinformation),andstrongform(pricesrefectpublicandprivateinformation). 9. Inaprimarymarket,theissuerobtainsfundsfrominvestors;inthesecondarymarket,theissuerofthesecurityisnotinvolvedinthetrans-action. 10. Aspotmarketisacashmarket,foranexchangetoday.Aderivativesmarketinvolvestradinginsecuritieswhosevaluedependsonsomeas-set’svalueofcashfows. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11. Themoneymarketisthemarketforsecuritieswithamaturityofoneyearorless.Thecapitalmarketisthemarketforsecuritieswithmatu-ritiesofgreaterthanoneyearandforsecuritieswithnomaturity(thatis,perpetualsecurities,suchascommonstock). 12. Aninvestor’sstrategyisaffectedbythedegreeofeffciencyinthemarketbecausethisdictateswhatisimpoundedinasecurity’sprice.Ifthemarketisonlyweakformeffcient,thentradingonthebasicofpubliclyavailableinformationcouldgenerateabnormalprofts;butifthemarketissemi-strongeffcient,therewouldbenoincentivetotradeonpubliclyavailableinformation. 13.a. Informationisasymmetriciftheresomemarketparticipantshavemoreinformationthanothersthatisrelevanttothevaluationofanasset. b. Ifmarketparticipantsbelievethatsomeotherparticipantshaveanunfairadvantageintermsofrelevantinformation,theymaynottrade,resultinginlessliquidityinthemarket. c. Asintermediaries,bankshaveservedaroleofprovidinginformationtomarketparticipants. d. Pricediscoveryistheprocessofdeterminingthevalueofanassetthroughthetradingamongbuyersandsellers. e. Withoutthefowofinformationrelevanttovalueanasset,theremaynotbereadybuyersandsellersand,hence,tradingleadingtopricediscovery. 14.a. Theinformationcostsoffnancialassetsarethecostsofsecuringinformationnecessaryforthevaluationoftheassets. b. Amarketisliquidiftherearebuyersandsellersreadytotradeanasset. c. Innovativeproductsmayinvolvecomplexitiesthatarediffculttounderstandandmayimposemoreinformationcoststoproperlyvaluetheproducts. 15.a. Standardizationreducesthecomplexityofthevariousfnancialas-sets,andhencereducesinformationcosts. b. Loweringinformationcostsresultsinmoreparticipationbybuyersandsellers,andhencemorepricediscoveryandliquidity. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER3 1. Thefederalgovernment,thestateandlocalgovernments,government-sponsoredenterprises,andgovernment-ownedcorporations. 2. Government-ownedcorporationsdonothavepublicly-tradedstockandareoperatedasnot-for-proftentities.GSEsareownedbyshareholdersandoperateforaproft. 3. Bothlendfundstoindividualsandbusinesses,butnondepositoryinsti-tutionsdonotacceptdeposits,whereasdepositoryinstitutionsdoacceptdeposits. 4. Requiredreservesaretheminimumreservesrequiredtobeheldbybanks,whereasexcessreservesaretheamountbywhichactualreservesexceedrequiredreserves. 5. Lifeinsurance,healthinsurance,property-casualtyinsurance,liabil-ityinsurance,disabilityinsurance,long-termcareinsurance,struc-turedsellements,investment-orientedproducts,andfnancialguaranteeinsurance. 6. Amutualfundwillacceptadditionalfundsforinvestment,whereasaclosed-endfunddoesnot. 7. Netassetvalue = ($1 − 0.2) ÷ 0.5 = $1.60. 8. Cantradethroughoutthetradingday,priceshaveonlysmalldeviationsfromnetassetvalue,andtaxadvantages. 9. Inadefnedbeneftplan,theplansponsorcommitstoaspecifcamountofbeneftuponretirement.Inadefnedcontributionplan,theplansponsorcommitstoaspecifccontributiontotheemployee’sretirementplan,butnottoaspecifcbeneftamountuponretirement. 10. Assistcompaniesinraisingfunds,tradingsecurities,advisinginmergersandacquisitions(amongothertransactions),merchantbanking,andprovidingbrokerageservices. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11. Depositoryinstitutions:commercialbanks,savingsandloanassocia-tions,savingsbanks,andcreditunions. 12. Commercialbanksobtainmostoftheirfundsbyborrowing,includ-ingacceptingdeposits(e.g.,checkingaccounts,savingsaccounts,timedeposits,andmoneymarketaccounts).Thesebanksalsoobtainfundsbyissuingsecurities(debtandequity),andborrowingfromtheFederalReserve. 13. Financialrestructuringadvisingisguidancetocompanyonitsfnancingandcapitalstructure,itsoperatingstructure,oritsstrategy.Thisad-visingmayseektosimplyimprovethecompany’soperationsor,intheextreme,toforestallabankruptcy. 14.a. Globalbankingistheareaoffnancethatinvolvesfnancingofen-tities,restructuring,andmergersandacquisitions.Thisisanareainwhichcommercialbanksandinvestmentbankscompete. b. Globalwealthandinvestmentmanagementinvolvesinvestmentpoli-cies,investmentstrategies,selectionofinvestments,andevaluatinginvestments’performance. 15. Proprietarytradingistradingforacompany’sownaccount.Financialintermediariesmaygenerateincomefromcommissionswhentheyfacil-itatetrades,butinproprietarytradingtheseinstitutionsdonotgeneratecommissionincome,butratherareinvestingontheirownaccountintheexpectationofgeneratinggain(thoughlossesarealsopossible). 16.a. Merchantbankingistheinvestmentbyafnancialinstitutionincom-panies,typicallyinvolvinganequityinterest. b. Therisksofmerchantbankingincludetheriskoflossofvalue,thediffcultyinvaluinginvestments(especiallythoseofprivately-heldinvestments),andthelackofliquidityassociatedwithsometypesofmerchantbankingactivity. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER4 1. Assets = Liabilities + Equity. 2. (1)transactionsarerecordedathistoricalcost;(2)thedollaristheap-propriateunitofmeasure;(3)statementsarepreparedusingtheaccrualbasisandthematchingprinciple;(4)thebusinesswillcontinueasagoingconcern;(5)thereisfulldisclosure;and(6)thestatementsarepreparedonthebasisofconservatism. 3. Cash,marketablesecuritiesinventory,andaccountsreceivable. 4. Thelengthoftimeittakesforaninvestmentininventorytoreturncashintheformofaccountscollectedfromcustomers. 5. Accountspayable,wagespayable,currentportionoflong-termdebt,andshort-termbankloans. 6. Inthebalancesheet,retainedearningsaretheaccumulationofearningsthathavenotbeenpaidoutintheformofdividendstoowners.Inconnectiontotheincomestatement,retainedearningsareearnings,lessdividends. 7. Neither.Theminorityinterestistheequityinacompanythatrepresentstheportionofthecompanynotownedbytheparentcompany.Forreportingpurposes,theminorityinterestappearsinshareholders’equity. 8. BasicEPSisnetincometocommonshareholders,dividedbytheaveragesharesoutstanding.DilutedEPSisnetincometocommonshareholders,adjusted,dividendbythepotentialsharesoutstandingconsideringstockoptionsandotherdilutions,forexample,fromconvertibleshares. 9. UnderMACRS,thetaxliabilityislessthanthatreportedinthefnancialstatements,sothedeferredtaxliabilityrepresentsthetaxobligationinthefuture,whichwillbepaidasMACRSdepreciationbecomeslessthanstraight-line. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 10. Thesumisthechangeinthebalanceofcashfromthepreviousfscalperiodtothecurrentfscalperiod. 11. Historicalcostsaretheactualexpendituresmadeforanasset.Forexam-ple,abuilding’svalueonthebalancesheetingrossplantandequipmentisitscostatthetimeofthecompanyboughtitorbuiltit.Depreciationonthebuildingisbasedontheoriginalcost,sothatthebuilding’svalueinnetplantandequipmentrefectsitsoriginalcost,lessdepreciation. 12. Thefootnotesthataccompanythefnancialstatementsprovidemoreinformationondeferredtaxes.Thefootnotethatisoftenentitled“Incometaxes”providesinformationaboutthecompany’staxliability,taxexpense,and,ifrelevant,deferredtaxes. 13. Allinmillions a. Currentassets = $6,076 + 25,371 + 11,192 + 717 + 2,213 + 3,711 = $49,280 b. Totalassets = $49,280 + 7,535 + 4,933 + 12,503 + 1,759 + 279 + 1,599 = $77,888 c. Totalliabilities = $3,324 + 2,000 + 3,156 + 725 + 13,003 + 1,684 + 3,142 + 3,746 + 1,281 + 6,269 = $38,330 d. Stockholders’equity = $62,382 − 22,824 = $39,558 e. Totalliabilities,plusstockholders’equity = $38,330 + 39,558 = $77,888Note:Assets = Liabilities + Stockholders’equity$77,888 = $38,330 + 39,558 14.a. BothBasicEPSandDilutedEPSarepresentedtoprovideinformationtoinvestorsregardingtheearningspersharegiventhecurrentsharesoutstanding(BasicEPS),andtheearningspersharethatwouldbeifallpotentialshares(e.g.,fromexerciseofexecutivestockoptions,anywarrantexercise,andanyconvertibledebtconversion)wereissued(DilutedEPS).DilutedEPSisa“worstcasescenario”EPSintermsofpossibledilutionfromadditionalissuanceofshares. b. BasicEPSmeanstheearningspersharebasedonthecurrentsharesoutstanding(usingaweightedaverageofsharesoutstandingduringtheperiodtheearningswereearned. c. DilutedEPSmeanstheearningspersharebasedonthepotentialsharesoutstandinggivenallpossibledilutions. d. TheclosenessofBasicEPSandDilutedEPSindicatesthatthereislittlepotentialfordilution. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
Appendix:SolutionstoEndofChapterQuestions 3 15.a. TheFinancialAccountingStandardsBoard(FASB)isthestandard-settingbodyforU.S.accounting. b. TheInternationalFinancialReportingStandards(IFRS)aretheac-countingstandardsacceptedinmanycountriesoutsidetheU.S.ThesestandardsarepromulgatedbytheInternationalAccountingStan-dardsBoard(IASB).Eventually,theU.S.GAAPandIFRSwillcon-vergetoonesetofstandards. c. Generallyacceptedaccountingprinciples(GAAP)areasetofstan-dardsthataretheacceptedstandardsforaccounting.U.S.GAAPisthesetofstandardspromulgatedbytheFinancialAccountingStan-dardsBoard(FASB). TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER5 1. Twoprimarydifferences:(1)Apartnershipistaxedonlyatthepartnerlevel,whereasthecorporationistaxedatthecorporateandshareholderlevels;(2)Apartnershiphasmorelimitedaccesstofundsthanacorpo-ration. 2. Limitedliabilityisthelegalsituationinwhichtheownersofacompanyarenotliableforallofthedebtsofthebusiness.Inthecaseofacor-porationoranLLC,whichbothhavelimitedliability,themostownerscanloseistheirinvestmentinthebusiness. 3. (1)Atthecorporatelevel,and(2)Attheshareholderlevelondistributedincomeintheformofcashdividends. 4. AcorporationandanLLCmayhaveperpetuallives. 5. Agencycostsofcostsbornebytheagent,theprincipal,orboth.Forexample,intheagencyrelationshipinacorporation,theprincipals(theshareholders)bearthecostofexcessiveperquisiteconsumptionbymanagement. 6. Theobjectiveistomaximizethevalueoftheshareholders’interestinthecompany. 7. Salary,bonus,options,performanceshares. 8. Optionsareintendedtoencouragemanagerstobeconcernedaboutthevalueofthestockofthecompanybecausethegreaterthevalueofthestock,thegreaterthevalueoftheexecutivestockoptions. 9. Thisprovisionrepresentsthebondingcosts;themanagerbearsacostintermsoffuturebeneftfromworkingforthecompany’scompetitorsfollowingemploymentbythecompany. 10. Ifearningsareunderstatedinoneperiod,theyarelikelyoverstated.Bymovingexpensessooner,forexample,theexpensesinthefollowingperiod(s)arelessand,hence,earningsaremore. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11. Acompany’smarketcapitalizationisthemarketvalueofitsstock.Thisistheproductofthecurrentmarketpricepershareandthenumberofsharesofstockoutstanding. 12.a. WithaCcorporation,incomeistaxedatthecorporatelevel(withthecompany’sflingofitstaxForm1020),andthenonceagainwhenitisdistributedtoshareholdersintheformofdividends(iftheshareholdersareindividuals,thenthedividendincomeisreportedontheindividuals’taxForm1040). b. Theadvantagesareprimarilythesingleleveloftaxationandthelimitedliability. 13.a. Agencycostsarecosts(explicitorimplicit)thatarisewhentheparties—theagentactingintheinterestsoftheprincipal,andtheprincipal—diverge. b. Principalscanreduceagencycostsby“bonding”;thatis,makingcommitmentsthatwouldbecostlyifinterestsdiverge(e.g.,anon-competeclauseifthemanagerleavestheemploymentofthecompany). 14.a. Limitedliabilityisthelimitonthefnancialresponsibilityofapartytotheobligationsofanentity. b. Agree:Thelimitedliabilityimposesaburdenonthecreditorsbecausetheymaynotreceivethefullamountthattheyaredueifthefundisbankrupt.Disagree:Thoughthelimitedliabilityimposesabur-den,theadditionalriskprovidesapotentialforadditionalrewards,whichwouldinthatcaseoffermoreprotectionoftheinterestsofthecreditors. c. Theseekingofshort-termgainsattheexpenseoflong-termvalueandriskswouldbeaformofagencycosts.Themotivesofafundmanagertobe“competitive”andperhapsevenaffectshort-termcompensationareself-servingmotives. d. Stakeholdersareanypartyaffectedbytheactionsofanother.Inthecaseofthemanagementoffunds,thestakeholdersincludenotonlythefundbenefciaries,butanypartythatbecomesobligatedtomakeupshort-falls,anyoneemployedbythecharitythatmaylosetheirjob,anyonewhoseservicesarecurtailedbecauseofalackoffunds. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER6 1. Astrategyisthegeneraldirectionacompanytakesforreachinganobjective. 2. Comparativeadvantagesrelatetocoststructureandproductdifferenti-ation,whereascompetitiveadvantagesrelatetomarketstructure. 3. Astrategicplanisthespecifcactionsorroadmapacompanyintendstotaketoreachanobjective. 4. Afnancialplanrelatestotheallocationofcompanyresourcesandaplanofhowthecompanywillfnanceitsinvestmentdecisions.Afnancialplanisonecomponentinacompany’sstrategicplan. 5. Regressionanalysisisastatisticalapproachtoestimatingthehistori-calrelationbetweentwoormorefactors.Itisusefultogaugegeneralrelationshipsthatexistedinthepast,andisuseful,tosomeextent,inforecasting. 6. Aproformafnancialstatementisaprojectedfnancialstatement,basedonsalesandcashforecasting. 7. Economicvalueaddediseconomicproft.Financialmanagers,whoseektomaximizeshareholderwealth,areinterestedinmakingdecisionsthatenhancethevalueofthefrm,andhenceaddeconomicvalue. 8. Abalancedscorecardisasetofmeasuresusedtoevaluatedifferentaspectsofacompany’sperformance. 9. Signifcantproftsandlowbarriersofentrywillattractentrants.IntermsofPorter’sforces,thethreatofentrantsishighand,hence,thereissignifcantrivalry. 10. Economicproftsarisefromacomparativeorcompetitiveadvantage. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11.a. Astrategicplanisdesignedtoguidethecompanytowardsitsobjec-tives,assistingmanagementinboththeoperationalandthefnancialdecision-makinginabusinessentity. b. Thestrategicplanisusefulinguidingdecision-making,butcondi-tionschange,requiringadjustmentsinthisplan.Financialdecision-makingisdynamic,andstrategicplansmustevolvethroughtime. 12.a. Strategicplanningisaplantoachieveacompany’sobjectives.Finan-cialplanningisacomponentofstrategicplanning,usedinconjunc-tionwithbudgetsandperformancemetrics. b. Financialplanninginvolvesbudgeting(includingsalesprojectionsandprojectionsoffnancingneeds)andperformancemeasurement. c. Operationalplanningisthebudgetingandevaluationofday-to-dayoperations,includingafocusonmanagementofoperatingexpensesandshort-termfnancingneedstosupportoperations. d. Capitalallocationreferstothelong-terminvestmentofacompanyinplant,property,andequipment. e. Agree:Afnancialplanisnotmeaningfulwithoutastrategybecauseyoudonotknowthetargetsthathelpguidethedecision-making. 13.a. EVAiseconomicvalueadded,ameasureofeconomicproftthatconsidersnotonlyrevenuesandexpenditures,butalsothecostofcapital.Economicvalueaddediscalculatedasrevenues,lessexpen-dituresandtaxesonacashbasis,lessthedollarvalueofthecostofcapital. b. EVAisabrandedversionoftheeconomicconstructofproft. 14.a. Thebalancedscorecardprovidesmultipledimensionsforevaluatingperformance. b. Thefournewprocessesare:(1)understandingthestrategy,(2)com-municatingandlinkingmeasurestothecompany’sstrategy,(3)plan-ning,budgetingandtargetsetting,and(4)providingfeedbackonperformance. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER7 1. Thedividendpayoutratioisthe proportion ofearningspaidtoshare-holdersintheformofcashdividends.Thedividendpershareisthe amount ofdividendpaidpershare. 2. Theretentionrate = 1 − 0.80 = 20%. 3. Dividendpayoutratio = $2 ÷ $8 = 25%. 4. Lowornotransactionscosts. 5. Technically,thedifferenceistheaccountingentry(shiftfromretainedearningstopaid-incapitalforastockdividend,amemoentryforastocksplit).Practically,thesize:astocksplitisgenerallyusedmoreoftenforlargerdistributions,astockdividendforsmallerdistributions. 6. Areversestocksplitisintendedtoincreasetheshareprice,possiblyforestallingdelistingfromanexchange. 7. Astocksplitisexpectedtoreduceasharepricetoaproportionofthepredistributionprice;a2:1shouldreducethepricetoone-half,a4:1shouldreducethepriceto1/4,etc. 8. (1)Signalthefutureprospectsofthecompanywithoutacashoutlay;and(2)Reducethepricepershare. 9. (1)Investors’preferenceforastreamofcertaincashfows;(2)Signalfutureprospectsofthecompany;(3)Forcethecompanytoseekexternalfunds,resultinginincreasedmonitoringofthecompany. 10. Tenderoffer&Dutchtenderoffer;openmarketrepurchase;targetedblockrepurchase. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11. StockExpectedpricepershareafterdistributionNumberofsharesoutstandingafterthedistribution ABC$20 ÷ 2 = $101million × 2 = 2millionDEF$40 × 5 = $2000.5million ÷ 5 = 0.1millionGHI$25 × 2.5 = $62.502million × 2.5 = 5million 12. Dividends = $50million;Netincome = $200million;Sharesoutstand-ing = 3million a. Dividendpayoutratio = $50million ÷ $200million = 25% b. Dividendpershare = $50million ÷ 3million = $16.67pershare 13. Retentionratio = 1 − ($2 ÷ $5) = 1 − 0.4 = 0.6or60% 14. Growingthedividendovertime,whenthedividendisbasedonarel-ativelyfxeddividendpayout,canbeinterpretedasthecompany’sex-pectationthatearningsfromcontinuingoperations(thatis,beforeex-traordinaryandspecialitems)willgrow. 15.a. (1)Abird-in-thehand—thatis,adividendpaid—isworthmorethantheexpectationofanincreasingshareprice.(2)Acompanypayingdividendsmaybesignalingthattheyareabletosustaintheincreaseddividendpayoutinthefuture,andhencearesignalingpositiveex-pectationsaboutfutureearnings.(3)Thepaymentofdividendsusesfundsthatcouldbeinvestedinlong-termcapitalprojects,whichthenforcesthecompanytoborrow—henceincreasingthemonitoringofthecompanybycreditorsandinvestors. b. Payingdividendsaffectsonlythefnancingdecision,andcompaniespayingdividendswillsimplyneedtoborrowtofundproftablein-vestmentprojects.Becausethevalueofacompanyisthepresentvalueofallfuturecashfowsthatitgenerates,thevalueofthecom-panyisaffectedbythereturnonitscapitalprojects,nothowtheseprojectsarefnanced. c. Becausedividendsaretypicallytaxedatrateshigherthancapitalgains,shareholderswhopaytaxesshouldprefertoreceiveareturnontheirstockintheformofshareappreciation,ratherthanthroughdividends. d. Aperfectcapitalmarketisoneinwhichtherearenotaxes,notrans-actionscosts,nocostsforinformation,andnofotationcostswhenissuingsecurities. e. Theassumedinvestmentpolicyisoneinwhichthecompanyinvestsinallproftableprojects. f. Managersareperfectagentsofshareholdersiftheyactinsharehold-ers’bestinterests,ratherthantheirown.Inotherwords,therearenoagencycosts. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER8 1. Financialleverageincreasesthesensitivityofthereturnstoequitytochangesinoperatingearnings.Thegreaterthefnancialleverage,thegreaterthereturnonequityforearningsbeyondbreak-even,andthelowerthereturnonequityforearningsbelowbreak-evenearnings. 2. Theinteresttaxshieldistheamountoftaxesthatinterestshieldsfromtaxationbecauseofthedeductibilityofinterestindeterminingtaxableincome. 3. Ifthemarginaltaxrateincreases,theinteresttaxshieldincreases—andhence,thevalueofthistaxshieldtoowners. 4. A2%increaseinoperatingearningswillresultina2% × 2 = 4%increaseinearningstoowners. 5. Debtfnancing(1)reducesthefundsavailablethatmaybewasted,and(2)providesadditionalmonitoringfromthemarket(evaluatingadebtissue). 6. Becauseownersreapthebeneftsofgains,butdonotsharefullyinthelosses,limitedliabilityencouragesrisktaking. 7. Coststofnancialdistressdiscouragedebtfnancing,counterbalancingthebeneftfrominterestdeductibilityatsomepoint. 8. Interestondebtistaxdeductibleforthepayingcompany,whereasdividendspaidarenottaxdeductible. 9. Thetrade-offisbetweenthebeneftfrominterestdeductibilityandcostsoffnancialdistress. 10. Thegreateracompany’soperatingrisk,thesoonerthecompanyreachesanoptimalcapitalstructureintermsoftheproportionofdebtusedtofnancethecompany. 11. Thepeckingordertheoryofcapitalstructureisthetheorythatstatesthatcompanieshavepreferenceinthecapitalthattheyraise,withthe TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS preferenceorderofinternalequity(thatis,retainedearnings),debt,andthennewequity. 12. Whentherearetaxes,theModigliani-Millertheoryimpliesthattheoptimalcapitalstructureistheonewithasmuchdebtaspossible—aslongastherearenocostsassociatedwithfnancialdistress. 13.a. AlternativeCinvolvesthegreatestfnancialleverage. b. AlternativeAinvolvestheleastfnancialleverage. 14. Costsassociatedwithfnancialdistressincludedirectcosts,suchaslegalfeesorconsultingfees,andindirectcosts,includingforegoneproftableopportunities,alossofmarketshareorcompetitiveadvantage,andtheinabilitytosecurelong-termcontracts. 15. Costsassociatedwithbankruptcyincludethedirectcosts,suchasauditandlegalfees,andindirectcosts,includingforegoneproftableoppor-tunities,thereducedvalueofintangiblesbecauseofaninabilitytofullyexploittheseassets,alossofmarketshareorcompetitiveadvantage,andtheinabilitytosecurelong-termcontracts. 16.a. Financialslackistheunuseddebtcapacityofacompany. b. Financialslackiscreatedwhenthecompanyintentionallymanagesitsfnancingactivitysothatitscapitalstructureislessthanwhatthecompanycanhandle. c. Companiesdesirefnancialslackbecauseitgivesthemfexibility,theabilitytoengageininvestmentopportunitiesthatmaycomealongforwhichfnancingisneededtomaketheinvestment. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER9 1. Corerisksarethebusinessoroperatingriskthatrelatetothecompany’slineofbusiness.Non-corerisksarethosethatareincidentaltothecompany’slineofbusiness. 2. Portfoliotheoryfocusestheattentionontheriskofthewhole,ratherthanonindividualinvestments.Enterpriseriskmanagementfocusesontheriskofthewholeaswell. 3. Sustainabilityriskisabroadspectrumoftheriskofabusinessenterprisethatincludessocialandenvironmentalresponsibilities. 4. Retain,neutralize,transfer. 5. Afundedretainedriskisoneinwhichfundshavebeensetasidetosatisfythepotentialloss,whereasanunfundedretainedriskisoneinwhichnoprovisionhasbeenmadeforthepotentialloss. 6. Insurance-linkednotesandbondstransferrisktotheinvestorofthesecurity. 7. Derivatives,insurance,structuredfnance,andalternativerisktransfer(suchasaninsurance-linkednote). 8. Thecoreriskrelatestoabusiness’smainenterprise,whereanoncoreriskisincidentaltothebusiness. 9. Derivativescanbeusedtotransferrisk,suchasusingfuturescontractstotransfertheriskofacommodity’spricetoanotherparty. 10. Acatbond,orcatastrophe-linkedbond,transferstheriskoftheidenti-fedeventfromthebusinesstoinvestors. 11. Valuestocksaregenerallyviewedasthosestocksthathavemarketvaluesthatcurrentlyrefectlowerexpectationsregardingfuturegrowththanotherstocksinthemarket(and,hence,lowerP/Bratios),andthereforeastheP/Breturnstonormalortypicallymarketlevels,thepriceofthestockwillrise. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 12.a. Thisstatementleavesoutanimportantconsideration:theriskoftheportfolio(relativetothatofthebenchmark). b. Furtherevaluationofthereturndifferenceisnecessarytoattributeperformance(e.g.,tothestyleofselection). c. Leveragecanexaggeratereturns—bothupanddown—andmustbeconsideredaspartoftheinvestmentpolicy. 13. Constraintsmaybeimposedregardingrisk,theassetallocation,andthecashfowsfromtheinvestments. 14. Return = ($3,500 − 3,000 + 250) ÷ $3,000 = 25% 15. Time-weightedreturn = [(1.05)(0.97)(1.04)(1.05)] 0.25 = 1.112202 0.25 − 1 = 2.6942% TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER10 1. Thediscountingisthereverseprocessofcompounding.Incompound-ing,weseekthefuturevalueofalump-sum,whereasindiscountingweseekthepresentvalueofalump-sum. 2. Larger. 3. Smaller. 4. Continuouscompounding.Thegreaterthefrequencyofcompounding,thegreaterthefuturevalueforagivenannualpercentagerate. 5. Inanordinaryannuity,thefrstcashfowoccursoneperiodfromtoday(thatis,end-of-periodcashfows).Inanannuitydue,thefrstcashfowoccurstoday(thatis,beginning-of-the-periodcashfows). 6. Inanordinaryannuity,thefrstcashfowoccursoneperiodfromtoday(thatis,end-of-periodcashfows).Inadeferredannuity,thefrstcashfowoccursbeyondoneperiodfromtoday. 7. Thisisaperpetuity.Wecalculatethepresentvaluebydividingtheperiodiccashfowbythediscountrate. 8. Thegeometricaverageismostappropriatebecauseitconsiderscom-pounding.Thearithmeticaveragedoesnot. 9. Adeferredannuitycanbesolvedbyfrstsolvingforthepresentvalueofanordinaryannuity,andthendiscountingthisthepresent.Thedis-countinginthesecondstepmaybealump-sumoranannuity,dependingonthenatureoftheproblem. 10. Theannuityduewillhavethehigherpresentvalue,relativetotheordi-naryannuity,becauseeachcashfowisreceivedsoonerthanthatoftheordinarycashfow. 11. Ingeneral,theinvestmentwithcompoundinterestproducesagreatervaluethantheinvestmentwiththesameinterestratebutwithsimpleinterest.Theonlyexceptionisinthecaseofannualcompoundingand TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS youarecomparingthevalueofaone-yearinvestment;inthiscase,thevaluewouldbethesame. 12.a. Aslongasinterestiscompoundednomorethanasingletime,attheendoftheyear,theEARisequivalenttotheAPR. b. EARandAPRdivergeasthefrequencyofcompoundingincreases.Themorefrequentthecompounding,themoreEARexceedstheAPR. 13. Forcompoundinterest,i = 0.04 ÷ 4 = 0.01or1%;N = 10 × 4 = 40 a. Balanceintheaccount = FV = $1,000(1 + 0.04 / 4 ) 40 = $1,000(1 + 0.01) 40 = $1,488.86. b. Interestoninterest = FV compound − FV simple = $1,488.86 − [$1,000 + (10 × 0.04 × $1,000)] = $1,488.86 − 1,400 = $88.86. 14. PV = $10,000 ÷ (1 + 0.06) 5 = $10,000 ÷ 1.3382 = $10,000 × 0.747258 = $7,472.58 15. PV = $10,000;i = 3% ÷ 12 = 0.0025or0.25% a. N = 24;PMT = $429.81permonth b. N = 36;PMT = $290.81permonth TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER11 1. Boththecurrentratioandthequickratioareliquiditymeasures.Thequickratioremovestheleastliquidcurrentasset,inventory,fromthenumeratorofthecurrentratio,providingamorestringentliquiditymeasure.Numerically,thecurrentratioisalwaysgreaterthanorequaltothequickratioatagivenpointintime. 2. Thelongerthecashconversioncycle,thegreateracompany’sneedforliquidity. 3. Acashconversioncyclemaybenegativeifthecompanyreceivesmoregenerouscredittermsfromitssuppliersthanitprovidesitscustomers. 4. Theinventoryturnover,multipliedbythenumberofdaysininventory,isequaltothenumberofdaysintheperiod. 5. Thetotalassetturnovermustbe2.0,basedontheDuPontrelationship:netproftmargin × totalassetturnover = returnonassets. 6. Ifdebt ÷ assets = 0.35,thismeansthatequityis65%ofassets,orthedebtequityratiois0.35 ÷ 0.65 = 0.5385. 7. Iftheuseofdebtincreases,vis-`a-visequity,thenequitymultiplierin-creasesandthereturnonequityincreases. 8. Ifthecompanydoesnothaveanydebt,thereturnonassetsisequaltothereturnondebt. 9. Thebasicearningpowerallowsyoutocomparecompanieswithoutregardtohowtheychosetofnancetheiroperations.Thisisusefulwhencomparingcompaniesthatoperateinthesamelineofbusiness,inwhichtheyshouldexperiencethesamelevelofbusinessrisk. 10. Ifdebt-to-assetsis50%,thismeansthattheequitymultiplieris2andthereforethereturnonequityis20%. 11. BecauseCompanyB’squickratioisgreaterthanCompanyA’s,wecanconcludethatCompanyAhasrelativelymoreinventorythanCompany TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS B.Weconcludethisbecausethecurrentratiosarethesame,yetCom-panyA’squickratioislessthanCompany’sB,whichindicatesthatthenumeratorofthequickratiohasalargersubtractionforinventoryinthecaseofCompanyA. 12. CompanyDhasalongeroperatingcycle,andthereforemostlikelyhasagreaterneedforliquiditythanCompanyC.However,CompanyDdoesnothavemoreliquiditythanCompanyC,andthereforehasmoreriskofnotsatisfyingitsnear-termobligations. 13. Areturnonfxedassetswouldbearatioofnetincomeoroperatingincometofxedassets.Youcouldbreakthisintotwocomponents,afxedassetturnoverandaproftmargin. 14. Itwouldbeusefultohaveinformationonthetrendinthecompany’sassetturnover,operatingproftmargin,interestburden,andtaxburden.Itwouldalsobeusefultoseeifthecompany’slinesofbusinesschangedoverthisperiod(forexample,throughacquisitions),thatmaysuggestchangesinthecompany’sunderlyingfundamentalrelationships. 15.a. Currentratio = $2,000 ÷ $500 = 4 b. Quickratio = $1,000 ÷ $500 = 2 c. Inventoryturnoverratio = $10,800 ÷ $1,000 = 10.8times d. Totalassetturnoverratio = $12,000 ÷ $6,000 = 2times e. Grossproftmargin = $1,200 ÷ $12,000 = 10% f. Operatingproftmargin = $1,050 ÷ $12,000 = 8.75% g. Netproftmargin = $600 ÷ $12,000 = 5% h. Debt-to-assetsratio = $1,000 ÷ $6,000 = 0.1667 i. Debt-to-equityratio = $1,000 ÷ $5,000 = 0.2 j. Returnonassets,basicearningpower = $1,050 ÷ $6,000 = 17.5% k. Returnonequity = $600 ÷ $5,000 = 12% 16. CompanyYhasmoreleverage.Itsequitymultiplier(thatis,totalassetsdividedbyshareholders’equity)is2.0,whereasCompanyX’sequitymultiplieris1.5. 17. Cash13.89%Currentliabilities8.33% Accountsreceivable8.33%Long-termdebt25.00%Inventory22.22%Equity66.67% Plant&equipment55.56% Totalassets100.00%Totalliabilitiesandequity100.00% TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER12 1. Depreciationisnotaacashoutfow,butratherisanoncashexpensethatreducednetincome.Therefore,depreciationisaddedbacktonetincomeinthecalculationofcashfow. 2. Thefnancialstatementspreparedusingaccrualaccountingrefectsnon-cashitemsinincome,suchassalesoncredit.Theadjustmentforchangesinworkingcapitalaccountisdonetoconvertnetincomebasedonaccrualaccountingintocashfow. 3. Netincomeis$3millionless$2million,or$1million. 4. Thechangesinworkingcapitalaccountsareusedindeterminingcashfowfromoperations.Thesumofthecashfowsfromoperating,fnanc-ing,andinvestmentactivitiesisthechangeinthecashaccountfromoneyeartothenext. 5. Netincomefromtheincomestatementisthestartingpointforthecashfowfromoperationsstatementofcashfows. 6. Yes,ifthedepreciationexpense,theamortizationexpense,orthechangesinworkingcapitalaccountsaresuffcientlylarge. 7. Twoitems:after-taxinterestexpenseandcapitalexpenditures. 8. EBITDAandcashfowfromoperationsdifferduetothechangesinworkingcapitalaccounts,interestexpense,andtaxes. 9. Anegativefreecashfowindicatesthattherearenofundsthatcanbeinvestedinvaluedestroyinginvestments. 10. Apositivefreecashfowindicatesthattherearefundsavailablethatcouldbeinvestedinvaluedestroyinginvestments. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11. FCFE = $100million;FCFF = $125million;Interestaftertax = $10.Fromthebasicformulasforfreecashfow:Defnition2:FCFF = CFO − adjustedinterest − capitalexpendituresDefnition3:FCFE = CFO − capitalexpenditures + borrowings − debtrepaymentsTherefore,FCFE = FCFF − adjustedinterest + borrowings − debtrepayments$100million = $125million − 10million + borrowings − debtrepaymentsBorrowings − debtrepayments =− $15or,inotherwords,netdebtrepaymentof$15million 12. Freecashfowtoequity(FCFE) = $200million − 50million = $150millionFreecashfowtothefrm(FCFF) = $200million − 50million = $150million 13. CFO = Netincome + depreciation − changeinworkingcapital.$35million = $30million + $3million − changeinworkingcapitalChangeinworkingcapital =− $2million,whichmeansthatwork-ingcapitalinvestmentdeclinedduringtheperiod. 14. Forfscalyear20X2,Cashfow = netincome + depreciationandamor-tization − increaseinworkingcapital = $290. a. Cashfowtocapitalexpenditures = $290 ÷ $100 = 2.9 b. Usingtotalliabilitiesasthemeasureofdebt,Cashfowtodebtratio = $290 ÷ ($130 + 163) = $290 ÷ $293 = 0.9898 TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER13 1. Byreducingexpenses,itincreasesacompany’scashfows.Reducingexpenseswillincreasetaxes,buttherewillbeanetbeneftfromthereductioninexpenditures. 2. Thedepreciationtaxshieldistheamountoftaxesreducedbydeductingdepreciation.Thedepreciationtaxshieldincreasesavailablecashfow,andhencemakestheprojectmoreattractive. 3. Ifthefacilityhadnootheruse,thiswouldbeasunkcostandthiscostdoesnotaffecttheinvestmentdecision.Ifthefacilitycouldhavebeenused(e.g.,rentedout),thenthisforgonerentshouldbeconsideredintheinvestmentdecision. 4. Mathematically,iftheprojecthasapositivenetpresentvalue,itmustpaybackintermsofundiscountedanddiscountedcashfows. 5. Thedifferenceisarecaptureofdepreciation,andistaxedasordinaryincome. 6. Straight-linedepreciationwillresultinlowerdepreciationintheearlieryears,andhencelowerdepreciationtaxshields,vis-`a-visMACRSde-preciation.Thelowercashfowsearlierintheproject’slifewillreduceitsnetpresentvalue. 7. Inthecaseofmutuallyexclusiveprojects,theNPVandPImethodscanbeused. 8. Thismeansthatthediscountrateislessthanthecross-overrate. 9. Ifthereisalimittothecapitalbudget,thenetpresentvaluemethodismostappropriate. 10. Thedifferingreinvestmentassumptions:theNPVmethodassumesrein-vestmentatthecostofcapital;theIRRmethodassumesreinvestmentattheIRR. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11. OpeningaretailoutletNewmarket IntroducinganewlineofdollsNewproductIntroducinganewactionfgureinanexistinglineofactionfguresNewproductAddingpollutioncontrolequipmenttoavoidenvironmentalfnesMandatedComputerizingthedollmoldingequipmentReplacementIntroducingachild’sversionofanexistingadultboardgameNewproduct 12. Expectedsalesofthenewboots,aswellasthepotentiallossofsalesfromtheexistinglineofboots. 13. Thebookvalueattheendofthe10thyeariszeroforbothmachines,sothesalespriceisequivalenttothegain. Machine1Machine2 a.AcquisitionInitialcost$100,000$80,000Set-upcost$20,000 $30,000 Totalacquisitioncashfow − $120,000 − $110,000b.DispositionCashfromsale$20,000$10,000Taxongain7,0003,500Cashfowfromdisposition$13,000$6,500 14. Seethetablebelowfordetails. a. $40.2million b. $11.4million,$13.320million,and$12.456million c. $15.984million d. − $40.2initially,andthen$15.4million,$20.52million,and$42.632million TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
Appendix:SolutionstoEndofChapterQuestions 3 Year 0123 Initialcost − $40,000,000Changeinworkingcapital − 200,000$200,000Saleprice25,000,000Taxongainonsale − 784,000Investmentcashfows − $40,200,000$0$0$24,416,000Changeinrevenues$20,000,000$20,000,000$20,000,000Changeinoperatingcosts5,000,0005,000,0005,000,000Changeindepreciation4,000,0007,200,0005,760,000Changeintaxableincome$19,000,000$22,200,000$20,760,000Changeintaxes7,600,0008,880,0008,304,000Changeinincomeaftertaxes$11,400,000$13,320,000$12,456,000Add:depreciation4,000,0007,200,0005,760,000Operatingcashfows$15,400,000$20,520,000$18,216,000Netcashfows − $40,200,000$15,400,000$20,520,000$42,632,000Note: Year 123 Bookvalueofthejet,endofperiod$36,000,000$28,800,000$23,040,000 Taxongainonsale Salesprice$25,000,000Bookvalue23,040,000 Gain$1,960,000Taxrate40% Taxongain$784,000 15. Thismeansthatifyouinvestintheproject,youexpecttoincreasethevalueofthecompanyby$10million. 16. Thismeansthat(1)theratioofthepresentvalueofthecashinfowstothepresentvalueofthecashoutfowsis1.3,and(2)theprojecthasapositivenetpresentvalue. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
4 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 17. Theproftabilityindexis($30 + 100) ÷ $100 = 1.3 18. a.Payback = 3years b.Discountedpaybackat10% = 4yearsc.Discountedpaybackat16% = Doesnotpaybackd.Netpresentvalueat10% = $10,945.29e.Netpresentvalueat16% =− $2,063.68f.Proftabilityindexat10% = 1.11g.Proftabilityindexat16% = 0.98h.Internalrateofreturn = 15%i.Modifedinternalrateofreturnwithreinvestmentat0%[Terminalvalue = $140,000] = 8.8%j.Modifedinternalrateofreturnwithreinvestmentat10%[Terminalvalue = $162,435] = 12.9% 19.a. Atacostofcapitalof5%,NPV Thing1 = $1,677andNPV Thing2 = $2,045.PreferThing2. b. Atacostofcapitalof8%,NPV Thing1 = $907andNPV Thing2 = $762.PreferThing1. c. Atacostofcapitalof11%,NPV Thing1 = $216andNPV Thing2 =− $356.PreferThing1. d. Atacostofcapitalof14%,NPV Thing1 =− $405andNPV Thing2 =− $1,331.Rejectboth. e. Cross-overdiscountrateis7.09% TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
Appendix:SolutionstoEndofChapterQuestions 5 f. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER14 1. Inthecashandcarrytrade,theinvestorsellsfutures,buystheasset,fnancingit,andthendeliversitattheendofthecontract.Inareversecashandcarrytrade,theinvestorbuysfutures,sellstheasset,andlendstheproceeds,takingdeliveryoftheassetattheendofthecontract. 2. Theproftiszero. 3. Futuresandforwardsaresimilar,butfuturesarestandardizedcontractsandtradinginvolvesaclearinghouse,whereasforwardsarenotstan-dardizedandaretradedover-the-counter,subjecttocounterpartyrisk. 4. Theoptionisout-of-the-moneybecausetheunderlying’svalueislessthantheexerciseprice. 5. Thepayoffis − $5. 6. Thegreaterthetimetoexpiration,thegreaterthecallandtheputoption—becausethereismoretimeremainingfortheoptiontobecomevaluable. 7. Themorevolatilityoftheunderlying’svalue,themorevaluableboththecallandtheputoption. 8. Youcouldbuyaputoptionoryoucouldsellacalloption. 9. Youcouldbuyacalloptionoryoucouldsellaputoption. 10. Interestrateswap. 11. Inthecaseofderivatives,thereissomeunderlyingthatisinvolvedinapotentialtransactioninthefuture.Forexample,inthecaseofaninterestrateswap,thereisafutureexchangeofthenetcashfowsateachagreed-uponfuturedate.Thereisriskthatoneoftheparties—theotherparty,thecounterparty—willnotcomplywiththeagree-uponexchangeatoneofthefuturedates. 12. Themanufacturercouldenterintoafuturescontractnowtolockinthepriceofthelumberthreemonthsfromnow.Themanufacturerwould TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS bethebuyer,withacommitmenttotakedeliveryofthelumberatafuturepointattimeataspecifedprice. 13.a. Forwardcontractsdohavetheadvantagethattheycanbecus-tomized,butunlikefuturescontracts,thereiscounterpartyrisk—theriskthattheotherpartytothetransactiondoesnotcarryouttheirobligationsunderthecontract. b. Afactortoconsideristhatbytailoringittothecorporation’sneeds,theremustbeanotherpartywillingtotaketheothersideofthetransaction,astailoredasitis. 14. Aputoptionisanoptiontoselltheunderlying.Acalloptionisanoptiontobuytheunderlying. 15. AnAmericanoptionmaybeexercisedatanytimepriortotheexpirationdate.AEuropeanoptionmaybeexercisedonlyattheexpirationdate. 16. Disagree.Inthecaseofanoption,thebuyeroftheoptionhasachoicewhethertoexercisetheoption.Inthecaseoffutures,thebuyeriscom-mittedtoatransactionunlessanoffsettingtransactionismade. 17.a. Acalloption:anoptiontobuytheunderlyingataspecifedprice. b. Aputoption:anoptiontoselltheunderlyingataspecifedprice. 18. Thepayoff(thatis,proft)foracalloptionisthepriceoftheunderlying − exerciseprice − optionpremium;thegreatertheoptionpremium,themorethattheunderlying’spricemustexceedtheexercisepriceforaproft.Thepayoff(thatis,proft)foraputoptionisthepriceexerciseprice − priceoftheunderlying − optionpremium;thegreatertheoptionpremium,themorethatthepriceoftheunderlyingmustbelessthanthepriceoftheunderlyingtobeproftable. 19.a. intrinsicvalue = $42 − 40 = $2;timevalue = $5 − 2 = $3 b. intrinsicvalue = $40 − 50 =− $10 → $0;timevalue = $5 − 0 = $5 20.a. Interestrateswap b. Oronopays7% × $75million = $5,250,000;Portlandpays4% × $75million = $3,000,000.Thenetpayment(OronotoPortland)is$2,250,000,or3%of$75million. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER15 1. Equity;Bonds;Realestate;cashequivalents. 2. Policyassetallocationfocusesonthelong-termobjective,seekingthegreatestreturnforthelevelofriskconsistentwiththeinvestmentobjec-tive.Thedynamicassetallocationistheadjustmentoftheassetmixofaportfolioinresponsetoanticipatedmarketconditions. 3. Marketcapismarketcapitalization,themarketvalueofequityout-standingofacorporation.Someadvocatethatthereturnstostocksofcompanieswithsmallversuslargecapitalizationaredifferent,andselectcommonstocksappropriatewiththisbelief. 4. Anactiveportfoliostrategyinvolveschangingtheinvestmentsintheportfoliotoseekbetterportfolioreturns.Apassiveportfoliostrategyfocusesontheinitialconstructionoftheportfolio,ratherthanalteringinvestments.Apassiveportfolioisconsistentwiththebeliefthatthemarketsareeffcient,whereasanactiveportfoliostrategyseeksabnor-malreturnsthatarisefrompricingineffciencies. 5. Aprice-effcientmarketisoneinwhichthecurrentpricesofassetsrefectallpubliclyavailableinformation. 6. Thearithmeticaveragereturnignorescompoundingofreturnsfromonesubperiodtothenext. 7. Thetime-weightedreturnisbetterforevaluatingaportfoliomanagerbecauseitisnotaffectedbythecontributionsandwithdrawalsofthefund. 8. R TW = (0.95 × 1.1 × 1.1) 1/3 − 1 = 4.754%. 9. PV = $1;FV = $1 × 0.95 × 1.1 × 1.1 = $1.1495;N = 3;IRR = 4.754%. 10. Thepurposeofperformanceattributionmodelsistoassesstheper-formanceofaninvestmentorfundassociatedwiththeselectionofinvestmentsandtheallocationamonginvestments. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11.a. Structuredinsuranceisaformofrisktransferthatcombinestradi-tionalinsurancewithsecurities,inwhichinvestorsinthesecuritiesbearsomeoftherisk. b. Anothernameforstructuredinsuranceis“insurance-linkedsecuri-ties”. c. Anexampleofstructuredinsuranceisthecatastrophe-linkedbond(or“catbond”). TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER16 1. Autilityfunctionisatheoreticaldescriptionofthetradeoffanindividualeconomicagenthasbetweenreturnandrisk. 2. Ifthecorrelationispositive,thecovariancebetweenthetwoassets’returnsisalsopositive. 3. Diversifcationisachievedbycombininginvestmentswhosereturnsarenotperfectlypositivelycorrelated.Greaterdiversifcationisachievedthelowerthecorrelation. 4. Theeffcientportfolioisoneofthefeasibleportfolios.Itisthefeasibleportfoliowiththehighestreturnforagivenlevelofrisk. 5. Thesemivarianceprovidesinformationonthedispersionbelowthemeanorexpectedvalue,whereasthevarianceprovidesinformationonthedispersionaboveandbelowthemean. 6. Asafety-frstruleisadecisionrulethatminimizestheprobabilityoffallingbelowaspecifedvalue. 7. Prospecttheoryisatheoryofindividuals’behaviorsuchthatdecision-makingdependsonhowaproblemisframed,thatthefocusisonhowvalueschange,ratherthanthevaluesthemselves,andthatthedecisionweightgiventogainsisdifferentthanthatgiventolosses. 8. Framingisthesituation.Somebehavioraltheoriesarguethatinvestorsareinfuencedbythesituationorhowaninvestmentispresented,ratherthansimplyonaninvestment’sexpectedreturnandvariance. 9. Classicalsafety-frst,valueatrisk,conditionalvalueatrisk,lowerpartialmoment. 10. Acognitivebiasisabiasindecision-makingthatresultsfromerrorsinjudgment.Theseerrorsincludeframingandoverconfdence. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11.a. Ifthecovarianceisnegative,thecorrelationisnegative. b. Theportfolio’sriskwillbelessthantheweightedaverageoftherisksofAssetAandAssetB. 12.a. B:samereturn,lowerrisk b. C:samereturn,lowerrisk c. C:higherreturn,lowerrisk 13.a. Expectedreturnis5% b. Standarddeviationis12.247% CalculationsScenarioProbabilityPossibleoutcomeProbabilityweightedoutcomeDeviationfromtheexpectedvalueSquareddeviationProbabilityweightedsquareddeviation Recovers40%0.200000.080000.150000.022500.00900Doesnotrecover60% − 0.05000 − 0.03000 − 0.100000.010000.00600 Expectedvalue = 0.050000.05000 Variance = 0.01500Standarddeviation = 0.12247 14.a. Expectedvalue = 0% b. Standarddeviation = 15% CalculationsScenarioProbabilityPossibleoutcomeProbabilityweightedoutcomeDeviationfromtheexpectedvalueSquareddeviationProbabilityweightedsquareddeviation Recovers50%0.150000.075000.150000.022500.01125Doesnotrecover50% − 0.15000 − 0.07500 − 0.150000.022500.01125 Expectedvalue = 0.00000 Variance = 0.02250Standarddeviation = 0.15000 15. Alteringtheweightsofthesecuritieswillchangetheportfoliorisk,similartoExhibit16.5,becausetheweightsofthetwosecuritiesareusedincalculationofthevarianceoftheportfolio[seeEquation16.6]. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER17 1. Diversifableriskistheriskthataninvestorcanreduceoreliminatebycombiningassetsinaportfoliosuchthattheseassets’returnsarenotperfectlypositivelycorrelatedamongthemselves. 2. IntheCAPM,weassumethatinvestorswillseekthemostreturnfortheseleastamountofrisk.Alargecomponentofthisisholdingawell-diversifedportfolio.Therefore,proponentsoftheCAPMmodelarguethatassetsarepricedsuchthatinvestorsareonlycompensatedfortheriskthattheycannotdiversifyaway. 3. Thischoicecannotbedeterminedwithoutaddressingtheindividualinvestor’sutilityfunctionbecauseneitherstockdominatestheotherintermsofriskandreturn. 4. Inpricingassets,onlythenondiversifableriskiscompensated. 5. Thisisthemarketriskpremium.Thisistheexpectedriskpremiumforthemarketasawhole. 6. Betaisthesensitivity(a.k.a.elasticity)ofastock’sreturntochangesinthereturnonthemarket. 7. ItmeansthatAssetAhasmoresystematicriskthanAssetB.However,itdoesnotmeanthatAssetAnecessarilyhasmorerisk(systematicplusunsystematic)thanAssetB. 8. Thecapitalmarketlineistherelationbetweenexpectedreturnandrisk,asmeasuredbyvariance.Thesecuritymarketlineistherelationbetweenexpectedreturnandsystematicrisk,asrepresentedbybeta. 9. Plottingabovethesecuritymarketlinemeansthatthestockisunder-valued:biddingupthestock’spricewillreduceitsreturn,forcingitontheSML. 10. Expectedreturn = 0.02 + 1.2(0.10 − 0.02) = 0.02 + 0.096 = 11.6%. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11. Aneffcientportfoliointhepresenceofariskfreeassetisformedbycombininganinvestmentinthemarketportfoliowitheitheraninvest-mentintherisk-freeassetorborrowingattherisk-freerate. 12. TheCAPMcannotbetestedunlesswespecifythecorrectmarketport-folio,whichisthevalue-weightedportfolioofallriskyassets. 13. Theassumptionregardingborrowingandlendingattherisk-freerateofinterestisquestionablebecauseinvestorscannotborrowattheriskfreerate. 14. ThehomogeneousassumptionintheCAPMistheassumptionthatallinvestorsperceivethesameexpectedreturnandriskassociatedwiththeassets. 15. Thelawofonepriceimpliesthatassetsthathavesimilarpayoffs,bothintermsofexpectedreturnsandrisk,shouldbepricedthesame;iftheyarenotpricedthesame,thereisanarbitrageopportunity. 16. ThefundamentalprinciplesoftheAPTmodelarethatassetpricesaredeterminedbyoneormorefactorsandthatreturnsonassetsaredrivenbyunanticipatedchangesinthesefactors. 17. TheAPTismoregeneralbecauseitallowsforthepossibilityofmorethanonefactortoaffectassetprices(thatis,itisamultifactormodel),andtheAPTdoesnotrequirespecifyingamarketportfolio. 18. TheAPTfactorsareunknown,andthereforecannotbeadequatelytested. 19.a. Disagree:Unsystematicriskisnearlyeliminatedinadiversifedport-folio,whereastheunsystematicriskofanindividualassetintheportfoliomaybesignifcant. b. Disagree:Investorsarecompensatedonlyfortheriskthattheycannotgetridof;investorsarenotcompensatedfordiversifable(thatis,unsystematic)riskbecausetheycouldreduceitiftheywishedtobydiversifying. 20. Disagree.AswiththeCAPM,investorsarenotcompensatedforriskthattheycouldremovebutchoosenotto. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER18 1. Thesumoftherealinterestrateandtheexpectedrateofinfation. 2. Theyieldspreadis170basispoints.Thisspreadistheadditionalpre-miumforbearingcreditrisk. 3. Theinvestorhastheoptiontoexchangethedebtforanothersecurityataspecifedexchangerate. 4. Themuni-Treasuryyieldratio = 0.025 − 0.03 = 0.83. 5. Therateonataxablesecuritythatisequivalent,onanafter-taxbasis,tothatofanon-taxablesecurity. 6. Thedifferenceinyields,expressedinbasispoints,betweenTreasurysecuritiesofdifferentmaturities. 7. (1 + 0.05) 3 = (1 + 0.045) 2 (1 + f );1.157625 = 1.092025(1 + f ); f = 6.01%. 8. Thenormalyieldcurveisupwardsloping. 9. Expectationsregardingfutureinterestrates;liquiditypremiumsforlongermaturities;preferredhabitatamonginvestors;marketsegmen-tation. 10. Usedasasetofbenchmarkinterestratesforloansandbonds. 11. Marketparticipantsgenerallygaugethecreditriskofabondissuebyrelyingonthecreditratingsbytheratingagencies. 12. Thegreaterthecreditriskofabond,thegreatertheriskpremiumonthebond(and,hence,thegreaterthebond’syield). 13. Solvefor r inthefollowing:(1 + 0.046) 2 = (1 + 0.041) × (1 + r )1.094116 = 1.041 × (1 + r )(1 + r ) = 1.094116 ÷ 1.041 r = 5.1024% TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 14. 2-yearspotrate1-yearspotrate1-yearforwardrate 5%4%(1.1025 ÷ 1.04) − 1 = 6.0096%4%3.8%(1.0816 ÷ 1.038) − 1 = 4.2%3.5%3.25%(1.071225 ÷ 1.0325) − 1 = 3.7506% 15. Forwardratesarenotaperfectpredictoroffutureratesbecauseiftheywere,thenwewouldknowwhatbondpriceswouldbeinthefuture.Further,empiricalevidenceindicatesthatforwardratesarenotgoodpredictors. 16. Forwardratesarereferredtoashedgeableratesbecausetheyindicatehowaninvestor’sexpectationsmustdifferfromthemarketconsensustomakeacorrectdecision.Theforwardratesareahedgeablemeasureoffuturerates. 17. Thisisanupward-slopingyieldcurve. 18. Bycalculatingtheforwardrates,basedontoday’sratesforvariousmaturities,he/shecanderivetheslopeoftheyieldcurve,whichsuggeststheexpectationsforinterestratesinthefuture. 19. The“bias”inbiasedexpectationstheoriesisthebeliefthatinterestratesincludepremiumsforliquiditypreference(thatis,risk)andtoinduceinvestorsfromtheirpreferredhabitat. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
Appendix:SolutionstoEndofChapterQuestions 3 20. Whatisdescribedinthequoteisahumpedyieldcurve.Ahumpedyieldcurveisnotconsistentwiththeliquiditypreferencetheoryandthemarketsegmentationtheory.However,ahumpedyieldcurvemaybeconsistentwiththepreferredhabitattheory,inwhichinterestratesaredeterminedbythesupplyanddemandforsecuritiesatthedifferentmaturities. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER19 1. Ifearningsgrowataratesimilartothedividends,thedividendpayoutwillremainconstant.However,ifearningsfuctuate,thiswillhavetheeffectofavaryingdividendpayoutratio. 2. Thegreaterthediscountrate,thelowerthepresentvalueofthestock.Thediscountrateshouldrefecttheuncertaintyassociatedwiththeamountandtimingofdividends. 3. Thevalueofthestockwillbebasedonaperpetualstreamofcashfows.Usingthedividenddiscountmodel,thismeansthatthegrowthrate, g ,willbezero. 4. Theaverageannualgrowthis g = ( 3 $3 $2) − 1 = 14 . 47% . 5. Therequiredrateofreturnmustbegreaterthantheexpectedgrowthrate;otherwise,theresultdoesnotmakesense(thatis,anegativevalueforthestock). 6. Yes.Anegativegrowthratestillworksinthedividenddiscountmodel. 7. Theexpectedreturnonthestockisthesumoftheexpecteddividendyieldandtheexpectedcapitalyieldofthestock. 8.a. Assumingaconstantgrowthrateadinfnitummaynotbeappropri-ate.Companiestendtoexperiencegrowthphasesthroughouttheirlifecycles,andtheexpectedgrowthratesshouldchangeaccordingly. b. Growth,transition,andmaturity. 9. Theestimateis$2 × 15 = $30pershare. 10. Earningscapturestheresultsofbothoperationsandfnancingdecisions,whereassalesdoesnotrefectoperatingeffciencyorfnancialleverage. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 11. Valueofthestock = $39.7162 YearExpectedDividendExpectedTerminalValueTotalCashFlowPresentValue (Cashfowdiscountedat8%)1$2.50$2.5000$2.31482$3.00$40.6250$43.6250$37.40143$3.25Value = $39.7162 Note:Terminalvalue(endofYear2) = $3.25 ÷ 0.08 = $40.6250[valuedasaperpetuity] 12. Requiredrateofreturn = dividendyield + growthrate12% = 4% + growthrateTherefore,thegrowthrateis8% 13. Agree.Relativevaluationfocusesmoreonthefundamentalfactorsbe-hindthegrowth,ratherthanstrictlydealingwithdividendsandexpectedgrowthindividends.Disagree:Thedividenddiscountmodelcanbeevaluatedintermsoffundamentalfactorsbyrestateddividendsintermsofdividendpayoutsandretentionrate,multiples,etc. 14. Boththedividenddiscountmodelsandtherelativevaluationmodelsuseproxiesforthemarket’sexpectations(dividendsandgrowthwiththedividenddiscountmodels;comparablecompanies’multiplesfortherelativevaluationmodels). 15. Ifyouaretoostringent,youwillhavealimitednumberofobserva-tions/estimationsofthemarket’svaluation. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
APPENDIX SolutionstoEndofChapterQuestions CHAPTER20 1. Maturityvalue(FV),yieldtomaturity(r × 2),numberofperiodstomaturity(n),periodiccashfow(theinterest,orPMT). 2. Theuseofsemiannualperiodsistoputthezero-couponbondvaluationonthesamebasisasthetypicalsemiannualcouponbond. 3. Thereisanegativerelationbetweentheyieldonabondandthebond’svalue:thegreatertheyieldtomaturity,thelowerthevalueofthebond. 4. Whentheyieldtomaturityishigherthanthecouponrate,thebondwillsellatadiscountfromitsfacevalue.Thisisbecausethemarketisdemandingthehigheryieldthanwhatthebondproducesthroughthecoupon;theremainderoftheyieldisfromtheappreciationinthebondfromitsdiscountedvaluetoitsfacevalue. 5. Ifthebondissellingatadiscountfromitsfacevalue,thebond’svaluewillriseuntilitreachesitsfacevalue.Ifthebondissellingatapremiumtoitsfacevalue,thebond’svaluewilldeclineuntilitreachesitsfacevalue. 6. Thecurrentyieldisaroughapproximationofthebond’struereturn,ignoringthetimevalueofmoney.Theyieldtomaturityconsidersthetimevalueofmoney,andassumesthatanycouponsonthebondarereinvestedinasimilaryieldinginvestment. 7. Theyieldtoworstistheloweroftheyieldtomaturityandtheyieldtocallforacallablebond. 8.a. Weareassumingthateachcashfromisreinvestedimmediatelyinasimilaryieldinvestment. b. Couponrateandmaturity. 9. Theinvestorhasanoptiontosellthebondbacktotheissuerifthebondisputable. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi 1
2 APPENDIX:SOLUTIONSTOENDOFCHAPTERQUESTIONS 10. Thecouponrateislessthantheyieldtomaturitybecausethebondissellingatadiscountfromitsfacevalue. 11. MarketPriceDollarPrice 94.0$940.00102.0$102,00075.0$7,50086.4$864,000 12. PMT = 3.5;FV = 100;i = 4% a. Not.PV = 120 → Nwouldbenegative(usingacalculator)—inotherwords,itdoesnotmakesense.Therefore,thebondwillnottradefor120ifitsmaturityismorethanoneyearbasedonthegivenyield. b. Not.PV = 100 → Nwouldbe0,whichisnotplausibleifthematurityisactuallymorethanoneyear. c. Possible.PV = 90 → Nis41.035,whichisslightlymorethantwentyyears. 13. Asapremiumthebondapproachesmaturity,itsvalueconvergestowardthebond’smaturityvalue. 14. The10-yearcouponbondhasmorereinvestmentrateriskbecause(1)ithasacoupon,whichrequiresreinvestmenteachperiod,and(2)itmaturessoonerthanthezero-couponbond. 15. Acallablebondisdiffculttovaluebecauseitisnotpossibletospecifypreciselyifandwhenthebondswillbecalledfromtheinvestors.Theissuer’sdecisionisbasedonbothinterestratesonanyrefundingandthecostsofissuingnewbonds. 16. Theconvertiblebondwilltradeatthegreaterofitsvalueasastraightbondanditsconversionvalue,andthereforewilltradeat$1,100. TheBasicsofFinance byPamelaPetersonDrakeandFrankJ.Fabozzi
T HE B ASICS OF F INANCE + Web Site Written by the experienced author team of Pamela Peterson Drake and Frank Fabozzi, The Basics of Finance puts the essential elements of this discipline in perspective and will allow you to gain a better understanding of today’s dynamic world of f nance.Divided into four comprehensive parts, this reliable resource will help you to see how all the pieces of f nance f t together. Page by informative page, The Basics of Finance: • Provides the basic framework of the f nancial system and the players in this system• Discusses f nancial management and topics such as f nancial statement analysis and f nancial decision-making within a business enterprise• Examines the analytical part of f nance, which involves valuing assets and analyzing performance• Covers the essentials of investment management, which includes portfolio theory and asset pricingAlong the way, sample problems with detailed solutions are provided in many chapters, allowing you to practice any math demonstrated in those specif c sections. End-of-chapter questions are also included for each chapter, along with select solutions easily accessible on the companion Web site, so you can test your knowledge of the basic terms and concepts discussed in each chapter.If you’re looking to gain an understanding of what f nance is really about at the fundamental level, look no further than this book.